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########## Risk-free Interest Rate

The risk-free interest rate is the interest rate that it is assumed can be obtained by investing in financial instruments with no default risk.
Though a truly risk-free asset exists only in theory, in practice most professionals and academics use short-dated government bonds of the currency in question. For USD investments, usually US Treasury bills are used, while a common choice for EUR investments are German government bills or Euribor rates.

These securities are considered to be risk-free because the likelihood of these governments defaulting is extremely low,

######### Fiat Currency

fiat currency or fiat money is money that has value primarily because a government demands it in payment of taxes, and that government has credible enforcement of its demand

The term “fiat” money has been used to distinguish such money from representative money, which is pegged or fixed to a quantity or mass of precious metal. While representative money is often associated with a legal requirement that the bank of issue pay in fixed weights of a given precious metal or (in theory) fixed amount of any other precious good, fiat money’s value is fixed only to its value in transactions controlled by government authority, such as taxation.

Fiat money is a subset of general credit money, but a special one in which a government, often through a central bank or reserve bank, has taken the responsibility (monetary authority) of being the major creditor backing the currency. An economy may function on credit money which is not fiat money, such as United States paper currency during periods when the U.S. did not have a central bank, or the banknotes of the Scottish clearing banks, which function in Scotland as currency, even though not backed by the government of Scotland.

Usually, a fiat-money currency loses value once the government which acts as the creditor refuses to further guarantee its value through taxation, but a strong private banking system and consensus of the population may prevent this. For example, the so-called Swiss dinar continued to retain value as a type of credit money in Kurdish Iraq, as a result of backing by private banks and acceptance from individuals there, even after its fiat-money status was officially completely withdrawn by the backing government (the central government of Iraq).

######### risk premium

A risk premium (plural risk premia) is the minimum difference between the expected value of an uncertain bet that a person is willing to take and the certain value that he is indifferent to.

Let’s assume that in a game, a contestant is given two choices of each either an offer behind door 1, $1000 or door 2, $0 (or the two choices can be $4000 and $2000 for door 1 and 2, respectively). In addition, a third choice is offered that the contestant can take without actually playing the game, take $500 and walk away (or for the second set, $3000 and walk off).

Statistically, if the game is played long enough, on average, a contestant gets $500 (or in case of the second set of choices, $3000) — that’s drived from 1000 + 0 /2 = 500 or 4000 + 2000 / 2 = 3000 — remember these numbers, 500 and 3000 are “expected value,” in this case deduced from an average of both good and bad door. So the risk that the contestant is willing to take on such cirumstances is $500 and $3000 respectively. It’s wise for him/her to take the money because the probability of him getting $500 or $3000 in either case is pretty much equal.

In this case, the contestant is “indifferent” (he gets $500 or $3000 if he goes with the third choice) to the “value of an uncertain bet” (choice between the good door or bad door) he is “willing to take” because the outcome of choosing between the good and bad door are much likely to be the same amount he would get by just taking the cash offer without actually playing the game. In this case, we say the premium risk is (less than or equal to) zero because [($1000 – $0) / 2] – $500 = 0 or [($4000 – $2000) / 2) – $3000 = 0.

However, if the offer behind the good door is to increase to $2000 (up from $1000) for the first set of offers ($1000 and $0), or $6000 (up from $4000) for the second set of offers ($4000 and $2000), the risk premium goes up — For the first set, it becomes [($2000 + $0) / 2] – $500 = 1000 and for the second set [($6000 + $2000) / 2] – $3000 = 1000. Now if the third offer remains the same, $500 for the first set, and $3000 for the second set, obviously, the contestant is more likely to “take a risk” and choose one of the doors rather than quit the game and take the third choice, the offered cash value. Because at this point, the chances of making more money (risk premium of $1000 as oppose to $500 and risk premium of $4000 as oppose to $3000) has increased.

In finance, the risk premium can be the expected rate of return above the risk-free interest rate. That should be clear by now why; examining the example described above, you can see that the higher the risk premium, the more willing the contestant (or the risk taker) is to go with two options presented to him because the return (of that risk) is higher than the average (of risk-free) outcome. In reality, such measurement of risk is based with “virtually” risk-free return on Treasuary bons (T-bills) and the very risky return on other investments (of course with higher rate of return). The difference between these two returns can be interpreted as a measure of the excess return on the average risky asset. This excess return is known as the risk premium.
Equity Risk Premium: Expectations Great and Small

######### Annuity

In its most general sense, an annuity is an agreement for one person or organization to pay another a stream or series of payments. Usually the term “annuity” relates to a contract between you and a life insurance company, but a charity or a trust can take the place of the insurance company.

There are many categories of annuities. They can be classified by:

* Nature of the underlying investment – fixed or variable
* Primary purpose – accumulation or pay-out (deferred or immediate)
* Nature of pay-out commitment – fixed period, fixed amount, or lifetime
* Tax status – qualified or nonqualified
* Premium payment arrangement – single premium or flexible premium

######### Capital Gains Tax
In finance, a capital gain is profit that results from the sale or exchange of a capital asset with proceeds of sale exceeding purchase price. A capital loss arises if the sale proceeds of a capital asset are less than the purchase price. Capital gains arise in relation to real assets, such as property, financial assets, such as shares or bonds, and intangible assets such as Goodwill.

A capital gains tax (abbreviated: CGT) is a tax charged on capital gains, the profit realized on the sale of a non-inventory asset that was purchased at a lower price. The most common capital gains are realized from the sale of stocks, bonds, precious metals and property. These fiscal obligations may vary from jurisdiction to jurisdiction because, among other reasons, it could be assumed that taxation is already incorporated into the stock price through the different taxes companies pay to the state.

In the United States, individuals and corporations pay income tax on the net total of all their capital gains just as they do on other sorts of income. The amount an investor is taxed depends on both his or her tax bracket, and the amount of time the investment was held before being sold. Short-term capital gains are taxed at the investor’s ordinary income tax rate, and are defined as investments held for a year or less before being sold. Long-term capital gains, which apply to assets held for more than one year, are taxed at a lower rate than short-term gains.

The “holding period” is the amount of time you held some security before you sold it. For reasons explained later, the IRS cares about how long you have held capital assets that you have sold. The nominal start of the holding period clock is the day after the trade date, not the settlement date. (I say nominal because there are various IRS rules that will change the holding period in certain circumstances.) For example, if your trade date is March 18, then you start counting the holding period on March 19. Then, you compute the length of the holding period using the day of the month (not the number of days). Continuing the example, on April 18, your holding period is one month, on April 19 your holding period is more than one month, and so on.

In 2003, this rate was reduced to 15%, and to 5% for individuals in the lowest two income tax brackets. After 2010, dividends will be taxed at the taxpayer’s ordinary income tax rate, regardless of his or her tax bracket. After 2010, the long-term capital gains tax rate will be 20% (10% for taxpayers in the 15% tax bracket).

The United States is unlike other countries in that its citizens are subject to U.S. tax on their worldwide income no matter where in the world they reside. U.S. citizens therefore find it difficult to take advantage of personal tax havens. Although there are some offshore bank accounts that advertise as tax havens, U.S. law requires reporting of income from those accounts and failure to do so constitutes tax evasion.

Capital gains tax can be deferred or reduced if a seller utilizes the proper sales method and/or deferral technique. The IRS allows for individuals to defer capital gains taxes with tax planning strategies such as the Structured sale (Ensured Installment Sale), charitable trust (CRT), installment sale, private annuity trust, and a 1031 exchange.

* Deferred Sales Trust – Allows the seller of property to defer capital gains tax due at the time of sale over a period of time.
* 1031 exchange – Defer tax by exchanging for “like kind” property. Pay capital gains when it is realized.
* Structured sale annuity (aka Ensured Installment Sale) – Defer and reduce capital gains tax while gaining safety and a stream of guaranteed income.

* Charitable trust – Defer and reduce capital gains by giving equity to a charity.
* Installment Sale – Defer capital gains by taking payments from a buyer over a period of years. No protection from buyer default.
* Self Directed Installment Sale (SDIS) – Allows for the deferral of capital gains taxes while removing the risks from buyer default under a traditional installment sale.
According to the IRS literature, “The highest tax rate on a net capital gain is generally 15% (or 5%, if it would otherwise be taxed at 15% or less). There are 3 exceptions:”

* “The taxable part of a gain from qualified small business stock is taxed at a maximum 28% rate.”
* “Net capital gain from selling collectibles (such as coins or art) is taxed at a maximum 28% rate.”
* “The part of any net capital gain from selling Section 1250 real property that is required to be recaptured in excess of straight-line depreciation is taxed at a maximum 25% rate.”
Saturday, December 29, 2007
The Year In Review And a Look Ahead for 2008

They “defend” lending rate target by either injecting liquidity (cash) into the banking system, or withdrawing it from the banking system. To inject “cash” they temporarily take in various debt securities (Treasuries and others) from banks, and issue them cash – much like you’d pawn your Rolex, diamond ring or handgun.

Let’s say you have a good income and a car that only has a minimum liability coverage insurance. A week later, your car is stolen; in order to scramble enough money to purchase a new one, since you are desperate to get to work so you don’t lose your job, you’d pawn some of your assets (i.e. Jewlery, famous painting, etc.). In fact what you are doing is “liquidating” and get an equivalent of amount of cash for what you just sold.

However, you have to get these assets back later on by repurchasing them from the pawn shop “with interest.” This is an equivalent of a personal TOMO (Temporary Open Market Operation). TOMO’s are conducted daily in the normal course of operation of the banking system and are relatively short term (up to a month) and when they expire, you are “required” to give the pawn shop (or the Fed) back the cash with “interest.”

You have to realize that your liquidation automatically puts you under feduciary of repurchasing the assets. That is, at some near future you have to go back and return the “cash” with some interest and get your belongings back. In case of Fed, these debts are work out in various securities such as Treasuries and Bonds “from banks” which later on have to be returned.

So what’s exactly what you do; you work for a month, become spend thrift and manage your expenditure tightly so you can acquire a new car to get to work. Now you have a means of transportation and you keep your job — you are saved. At the same time, after a month you need to repurchase your stuff back from the pawn shop because the TOMO matured, but this time you have an interest payment on your back as well.

When The Fed “injects liquidity” they have not created money; in fact, they have made the bank’s balance sheets more encumbered because the interest has to be paid too. “liquidity” isn’t hard cash. It’s a loan, it carries interest, and it has to be paid back – on a short term basis. The Fed is powerless to impact what is going on in this fashion in the end, as loans always have to be paid back, they would lose the only real weapon they have: The power of the mouth.

Inflation is always a monetary phenomenon, as is deflation. The effects of inflation or deflation are usually found in prices for goods and services, but they may show up in various items in different ways. The monetary supply, to maintain balance, must grow at a rate which approximates the growth in productive output, otherwise the money system will eventually starve itself of liquidity. An example will make this clear.

To keep the money from being destroyed when a value of paid merchant for instance drops and things from getting out of control, the banking regulators are supposed to enforce reserve requirements, and the markets are supposed to enforce margin requirements. This is done because although there are deflationary pressures in any market, if they ever get out of control, asset prices will fall and quite rapidly this becomes a self-fulfilling spiral.

If you wish to buy a car (or house), but see that the prices for cars are going down rather than up or remaining stable, assuming you do not immediately need the car (your old one still runs) and you have the cash you are well ahead of the game to wait! After all, if cars will be cheaper in six months, why buy now? This destroys demand, which in turn means that the guy who makes cars can’t pay his suppliers because he hasn’t sold his stock of vehicles. That results in more defaults on debt which further deflates the money supply. This, in turn, causes prices to fall further, and on it goes!

Let’s say that you have 1,000 mortgages that you’ve written to all sorts of people. Their actual risk if defaulting on their mortgages is reasonably low, especially when you look at all 1,000 of them as a pool, instead of each individual mortgage. Let’s say for the sake of argument that the actual “risk premium” – that is, the reasonable cost of the money compared to a “risk free” investment such as US Treasury bonds, is 200 basis points – that is, a 2% higher interest rate “fairly” compensates for the risk you won’t pay.

So if the long-term Treasuary bond is yielding at 5% (risk-free, or default-rate interest rate that the morgage company is “indifference” to because that’s the rate in which company can make eventually without much of disturbance to the outcome), the risk premium would be 7% (“2% higher interest rate” with respect to “risk free”: 5% + 2%).

Everyone who touches that pool wants a piece of the action. If I’m an investment bank I can’t possibly do this work for free, so I want 25 basis points of that 200 for my profit in “putting all these together and managing them.” Then there is the company that services the loans. They take the payments from each homeowner and make sure that they’re correctly accounted for. This requires staff, phones, computers, etc. They too want to be paid – let’s call that another 25 basis points.

So now we have 150 basis points left of “margin” over the 10 year Treasury rate. If we sold “slices” of this debt off, at best we could “allow” a coupon that reflected that 150 basis points (1.5%) — unfortunately greed got into the equation.

The banks figured out that they could structure these 1,000 mortgages into different “tranches” with different characteristics, risk-wise. If you take all the money coming in (from the interests) and look at this as one big pool, that gives everyone only one thing to buy. But if we take that pool and split it up into a bunch of different levels of risk, we can now offer slices that have different levels of return (i.e. high risk at 11%, midum at 7%, and low risk at 5%. Of course, the percentage of each slice and category of risks should be such that the total premium risk would end up being 2%, i.e. 200 of loans are paid at 11%, the rest can be calculated by solving this equation: 200 x 11% + (800 – y) x 7% + y x 5% / 1000 = 7% which yields y = 400. That means we have 200 loans at 11%, 400 at 7%, and 400 at 5%).
The Bush Capital Gains Tax Cut after Four Years: More Growth, More Investment, More Revenues
Did the 2003 Tax Cut Increase the Budget Deficit?

Over the past 30 years a consistent pattern has emerged: every time the capital gains tax has been cut, capital gains tax revenues have risen. Every time the capital gains tax has been raised, capital gains tax revenues have fallen
CBO A series of issue summaries from
the Congressional Budget Office
October 9, 2002

Capital Gains Taxes and Federal Revenues
October 11, 2001
Capital Gains Tax Cuts: Myths and Facts
by The Heritage Foundation
April 1, 1995
Issues in the Indexation of Capital Gains
by Arthur P. Hall, Ph.D.

A capital gain occurs, in general, when a taxpayer sells an asset for a price that exceeds the purchase price. Indexing capital gains means adjusting the dollar value of an asset’s purchase price (usually upward) for inflation. This procedure reduces the amount of a capital gain subject to taxation.

Historically, U.S. taxpayers have had to pay taxes on capital gains that result solely from inflation. This practice has led, in many instances, to effective tax rates on inflation-adjusted capital gains that substantially exceed 100 percent.

For an average stock purchased in June of different years and sold in June of 1994, the current capital gains tax results from real versus inflation-induced gains. The average stock, as bible / describes, is represented by the value of the Standard and Poor’s index of 500 stocks in June of each year from 1954 to 1994. Therefore, the fraction of the capital gains tax that is on real gains fluctuates, depending upon both the real and inflation-induced price of the stock at the time of purchase date and sale date.
Counting Capital Gains
October 3, 2006
Inflation Index Capital Gains
Phil Kerpen – Thursday, March 22, 2007 – 10:37am

The better question is why in our tax system do we reward capital more than work? Are we trying to say that we would prefer you to be rich and lazy, instead of middle of the road and hard working? As your post is about indexing capital gains I won’t get into how ridiculous the tax system is, instead I will easily refute this idea.

All gains are inflated. Not just capital gains. Interest income by the very financial definition is nothing more than a inflation. So if you are a risk adverse saver and keep your money in treasuries rather than stocks you will get an average return of 3-5%, presuming you are in a 30% tax bracket your return is diminished to 2-3.5%. Long term inflation is 2-3.5% so therefore you have not made any money, just beat inflation.

As a libertarian you should be grossly against indexing capital gains. Think about it, the free market already prices inflation into stock price. By indexing inflation you have now corrupted the free market inputs into the price of the stock and artificially changed returns.

Additionally should our incomes be adjusted for inflation? Well I got a 2% raise but inflation was 3% so…….. exactly it’s ludicrous. Some of these financial reporters are without question some of the biggest morons out there. Richard Brahn needs to give his head a shake.
Citizens for Tax Justice
May 13, 2008 Contact: Bob McIntyre (202) 299-1066 x22
Capital Gains and Dividends Tax Cuts Offer Almost No Benefit to
Middle-Income Americans and Add to the Nation’s Fiscal Problems

in every single state, the benefits from the capital gains and dividends tax breaks are concentrated among the richest one percent. The average
tax cut for these fortunate households runs in the tens of thousands of dollars, while the average tax cut for the poorest 60 percent is perhaps enough to buy a single meal, and in many states is even less. They argue that a large number of Americans have investment income, but they fail to mention that most of that is not taxable investment income.

AGI group Total # of % of all # with CGD tax Total CGD tax Average tax % of total tax
returns returns cut cut $billions cut breaks
Under $30K 66,636,249 49.6% 3,079,593 $ –0.4 $ –5 0.4%
$30-50K 24,558,911 18.3% 3,372,812 –0.8 –34 0.9%
$50-75K 18,351,037 13.7% 4,126,681 –1.7 –93 1.9%
$75-100K 10,449,989 7.8% 3,280,362 –1.9 –184 2.1%
$100-200K 10,810,367 8.0% 5,148,904 –6.4 –595 7.0%
$200-500K 2,737,802 2.0% 1,976,715 –13.1 –4,789 14.3%
$500K-1 mill 524,506 0.4% 433,693 –10.8 –20,662 11.8%
$1-2 mill 184,540 0.1% 156,743 –9.8 –53,132 10.7%
$2-5 mill 84,070 0.1% 72,054 –12.3 –146,125 13.4%
$5-10 mill 21,431 0.02% 18,189 –8.5 –396,105 9.3%
$10 mill+ 13,776 0.01% 11,433 –25.8 –1,876,280 28.2%
TOTAL 134,372,678 100.0% 21,677,179 $ –91.7 $ –682 100.0%

$500K + 828,323 0.6% 692,112 –67.3 –81,204 73.4%

First 81.6% lower tax bracket [(0.496 x 5) + (0.183 x 34) + (0.137 x 93)] / (0.816) = 18.65

89.4%……….[15.226 + (0.078 x 184)] / (0.894) = 33.08

97.4%……….[29.578 + (0.08 x 595)] / (0.974) = 79.23

Top 2.6%
[(0.02 x 4789) + (0.004 x 20662) + (0.001 x 53132) + (0.001 x 146125) + (0.0002 x 396105) + (0.0001 x 1876280)] / (0.0263) = 24507

# The special low tax rates on capital gains and dividends reduced income tax payments
by $91.7 billion in 2005.
# The 67 million tax filers who reported adjusted gross incomes of less than $30,000 —
half of all filers — got virtually none of the benefits of the capital gains and dividends
tax breaks.
# In contrast, the 828,000 filers with reported incomes above $500,000 — 0.6 percent of
all filers — got 73.4 percent of the total tax reductions, saving an average of $81,204
# Most amazing, the 13,776 tax filers with adjusted gross incomes in excess of $10
million — a mere 0.01 percent of all filers — got 28.2 percent of the total tax savings.
Their average tax break was $1,876,280 each.

The tax cuts were deficit-financed, meaning they resulted in an increase in the national debt that must eventually be paid off — with interest. To accomplish this, Congress will have to increase taxes, cut back public services that Americans depend on, or both. About three trillion dollars have been added to the national debt during the Bush years, and about half of that is due to the Bush tax cuts.

Presidential candidate John McCain recently said on ABC’s “This Week” that it would be a terrible idea to allow the Bush tax cut for capital gains to expire because “100 million people have investments.” The reality is that most stock owned by middle-income people is in 401(k) plans, Individual Retirement Accounts (IRAs) or other similar retirement savings vehicles. Taxes on these investments are deferred until retirement, at which point they are taxed as “ordinary income,” meaning they don’t benefit from the tax cuts for capital gains and dividends.

This is supported by the IRS data in the table above. The figures show that in 2005, fewer than 22 million taxpayers received any benefit at all from the special low rates for capital gains and dividends — far fewer than the 100 million implied by Senator McCain.

A small group of ideologues associated with “supply-side economics” believes that tax cuts —
especially capital gains tax cuts — can actually increase revenues. They ignore the fact that the
revenue collected from the capital gains tax steadily climbed and then reached its peak during
the Clinton years, when the tax rate was higher.

A capital gain is the profit one makes when selling property that has increased in value since it
was purchased. The supply-siders’ idea is that lowering the tax on that profit will lure more
people to make investments and sell them later at a profit (to “realize” gains). These increased
“realizations,” supply-siders argue, will be so large that more capital gains taxes will be paid
even at the lower tax rate.

The chart below is based on data from the non-partisan Congressional Budget Office.1 It shows
that the ups and downs in revenue collected by the capital gains tax seem to have more to do
with what’s happening in the stock market and the broader economy than with tax policy. In
the early and mid-1990s, when the top capital gains tax rate was 28 percent, capital gains tax
revenues shot through the roof. They continued to climb for a while after the rate was lowered
to 20 percent in 1997, but at no faster rate than the previous trend. Then in 2001 and 2002,
capital gains taxes fell precipitously. This was not due to any change in tax policy, but was
instead clearly linked to the bursting of the “” bubble and its ramifications for the
stock market.

Capital gains tax revenue did increase after 2003, when the rate was cut again to 15 percent,
but we would expect the revenue to rise from the low point of the recession, regardless of
what changes were made to the tax code. (In fact, it would have been shocking if capital gains
revenue did not swing back upwards after the recession of the early 2000s.)

The rate increase that he was referring to was part of the 1986 Tax Reform Act that was signed
by President Reagan, which set capital gains tax rates the same as the rates on other income.
Capital gains realizations surged in anticipation of the rate increase (which took effect in
1987). In other words, an increase in the tax rate actually increased realizations, albeit
temporarily, as people rushed to cash in their gains before the new, higher rate took effect.
After that, with fewer gains to realize, realizations predictably declined, and eventually
returned to their normal level — until the Clinton administration, when the stock market went
up so much that realizations boomed.

There is one sense in which the supply-siders are right. Yes, capital gains realizations might
increase somewhat if taxes on capital gains are reduced. But one big reason for that is that
wealthy people can convert ordinary income (which for them is taxed at a rate of 35 percent)
into capital gains (which are only taxed at 15 percent) through various tax sheltering schemes.
Volcker Rule or any regulation will do nothing as long as short term speculation is so profitable.

The banks and investment houses will always reap huge profits either at the expense of clients and/or shareholders as long as it is so profitable to do versus the risk. How do you change that equation, without one single extra regulaiton or regulator? Change the tax code on short term capital gains, derivatives income and gains, and futures trading PLUS establish uniform margin requirements on all trading that requires 80% collateral behind any trade.

Those 2 elements are what changed in the US markets since the 1980s and those 2 specific facts: low taxes on trading (certain option income is actually now taxes at only 10%!) and laxed margin lending requirements (FX Carry Trade by hedge funds lever 1 to 100 now) led to the collapse of the financial system and still pose an ongoing risk to any financial stability.

Leveraged speculation today is incredibly profitable – extremely low short term capital gains taxes and preferred tax treatment for option trading and margin debt expense. When middle income America is facing higher and higher taxes with fewer and fewer services, it is ironic they pay higher taxes than a trader of a hedge fund – and by a wide margin.

After WWII the typical short term cap gains tax was tied to the top marginal income tax rate, which was up to 70%. Under Reagan the top marginal tax rate dropped by nearly 50%. The cap gains tax difference between long term gains (investment held over one year) vs. short term gains (investment held under one year) decreased immensely (28% vs. 20%) making short term trading very, very profitable. There was no incentive to buy and “hold” since the tax rate difference was minimal.

On top of that Reagan’s tax changes up held the deductibility of margin interest expense (interest paid on borrowed money used to buy investments) yet deductions for credit card debt, auto debt, school debt, etc. were eliminated!! Again middle America saw their taxes go up while speculators benefited from lower rates.

By 1986 Wall Street had a tax code that mimicked the 1920s: extremely low cap gains taxes, available credit, and a new Fed. Reserve chairman who was not going to interfere with the big roulette table.
Right now, income from the riskiest transaction in stock trading – selling a put or call on a major market index (i.e. S&P 500) – is only taxed at 10%. This one example emphasizes how the US tax code supports speculation by giving the riskiest behavior the lowest tax rate.

The remedy?
1. Capital gains tax rate brackets based on length of holding period. When trades are held under one day, gains taxed at 90%. Graduate the tax down the longer the holding period, i.e. investment held over 10 years sees a tax rate of 5% for the first $100,000.

2. All derivative transactions (options, swaps, futures etc.) taxed at 80%, on both income and gains.

3. Eliminate the deductibility of margin interest expense.

4. Raise the Federal Reserve Margin Requirement (the amount of money the investor has to put up himself) to 80% for all investment classes (bonds, stocks, etc.). No exception for hedge funds, off-shore, FX, futures, etc.

5. Limit preferential capital gains and dividend tax rates (now at 15%) to only the first $100,000. Then establish new Federal gains/dividend tax brackets ($1.0 million, $10 MM, $100 MM, etc) where the highest tax rate reaches 75% as in the 1970s. This change would not only decrease speculation in the US financial markets, but it would start to shift the tax burden away from the middle class.
################# coupon

n finance, coupons are “attached” to bonds, either physically, as with old bonds (with a stapler), or electronically. Each coupon represents a predetermined payment promised to the bond-holder in return for his or her loan of money to the bond-issuer. The bond-holder is typically not the original lender, but receives this payment for effectively lending the money.

The coupon rate, the amount promised per dollar of the face value of the bond, helps determine the interest rate or yield on the bond.

n finance, with respect to bonds, a coupon is the interest rate that the issuer pays to the bond holders.

########### speculators

Victor Niederhoffer
The Speculator as Hero

Let’s consider some of the principles that explain the causes of shortages and surpluses and the role of speculators. When a harvest is too small to satisfy consumption at its normal rate, speculators come in, hoping to profit from the scarcity by buying. Their purchases raise the price, thereby checking consumption so that the smaller supply will last longer. Producers encouraged by the high price further lessen the shortage by growing or importing to reduce the shortage. On the other side, when the price is higher than the speculators think the facts warrant, they sell. This reduces prices, encouraging consumption and exports and helping to reduce the surplus.

Another service provided by speculators to a market is that by risking their own capital in the hope of profit, they add liquidity to the market and make it easier for others to offset risk, including those who may be classified as hedgers and arbitrageurs.

Speculators may trade with other speculators as well as with hedgers. In most financial derivatives markets, the value of speculative trading is far higher than the value of true hedge trading. As well as outright speculation, derivatives traders may also look for arbitrage opportunities between different derivatives on identical or closely related underlying securities.

############## Basis point
A basis point (often denoted as bp, bps -basis points- or rarely, permyriad) is a unit that is equal to 1/100th of a percentage point. It is frequently used to express percentage point changes less than 1. It avoids the ambiguity between relative and absolute discussions about rates. For example, a “1% increase” in a 10% interest rate could mean an increase from 10% to 10.1%, or from 10% to 11%.
A rate change from 5% to 6%, reflects a change of 1 percentage point or 100 basis points.

A rate change from 6.7% to 6.9% reflects a change of 0.2 of a percentage point or 20 basis points.

A rate change from 2.75% to 3.20% reflects a change of 0.45 of a percentage point or 45 basis points.

############## Securitization
Securitization is the method which participants of structured finance utilize to create the pools of assets that are used in the creation of the end product financial instruments.

Securitization is a structured finance process, which involves pooling and repackaging of cash-flow producing financial assets into securities that are then sold to investors. The name “securitization” is derived from the fact that the form of financial instruments used to obtain funds from the investors are securities.

All assets can be securitized so long as they are associated with cash flow. Hence, the securities, which are the outcome of securitization processes, are termed asset-backed securities (ABS). From this perspective, securitization could also be defined as a financial processes leading to an emission of ABS.

“Structured finance” is a broad term used to describe a sector of finance that was created to help transfer risk using complex legal and corporate entities.

There are several main types of structured finance instruments.

* Asset-backed securities (ABS) are bonds or notes based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets.
* Mortgage-backed securities (MBS) are asset-backed securities whose cash flows are backed by the principal and interest payments of a set of mortgage loans.
* Collateralized debt obligations (CDOs) consolidate a group of fixed income assets such as high-yield debt or asset-backed securities into a pool, which is then divided into various tranches.
* Collateralized mortgage obligations (CMOs) are CDOs backed primarily by mortgages.
* Collateralized bond obligations (CBOs) are CDOs backed primarily by corporate bonds.
* Collateralized loan obligations (CLOs) are CDOs backed primarily by leveraged bank loans.
* Credit derivatives are contracts to transfer the risk of the total return on a credit asset falling below an agreed level, without transfer of the underlying asset.

Securitization often utilizes a special purpose vehicle (SPV) (alternatively known as a special purpose entity [SPE] or special purpose company [SPC]) in order to reduce the risk of bankruptcy and thereby obtain lower interest rates from potential lenders.

a mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. Payments are typically made monthly over the lifetime of the underlying loans.

Residential mortgagors in the United States have the option to pay more than the required monthly payment (curtailment) or to pay off the loan in its entirety (prepayment). Because curtailment and prepayment affect the remaining loan principal, the monthly cash flow of an MBS is not known in advance, and therefore presents an additional risk to MBS investors.

######### special purpose entity
special purpose entity (SPE) (sometimes, especially in Europe, “special purpose vehicle”) is a body corporate (usually a limited company of some type or, sometimes, a limited partnership) created to fulfill narrow, specific or temporary objectives, primarily to isolate financial risk, usually bankruptcy but sometimes a specific taxation or regulatory risk.

A special purpose entity may be owned by one or more other entities and certain jurisdictions may require ownership by certain parties in specific percentages. Often it is important that the SPE not be owned by the entity on whose behalf the SPE is being set up (the sponsor). For example, in the context of a loan securitisation, if the SPE securitisation vehicle were owned or controlled by the bank whose loans were to be secured, the SPE would be consolidated with the rest of the bank’s group for regulatory, accounting, and bankruptcy purposes, which would defeat the point of the securitisation. Therefore many SPEs are set up as ‘orphan’ companies with their shares settled on charitable trust and with professional directors provided by an administration company to ensure there is no connection with the sponsor.

######### Hedging
Insurance and Hedging

One use of derivatives is to be used as a tool to transfer risk by taking the opposite position in the underlying asset. For example, a wheat farmer and a wheat miller could enter into a futures contract to exchange cash for wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the wheat miller, the availability of wheat.

########## Derivative
Derivatives are financial instruments whose value changes in response to the changes in underlying variables. The main types of derivatives are futures, forwards, options, and swaps.

The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a huge range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), bonds, interest rates, exchange rates, or indexes (such as a stock market index, consumer price index (CPI) — see inflation derivatives — or even an index of weather conditions, or other derivatives).

########## ETF
ETFs are securities certificates that state legal right of ownership over part of a basket of individual stock certificates. Several different kinds of financial firms are needed for ETFs to come into being, trade at prices that closely match their underlying assets, and unwind when investors no longer want them. Laying all the groundwork is the fund manager. This is the main backer behind any ETF, and they must submit a detailed plan for how the ETF will operate to be given permission by the SEC to proceed.

In theory all that a fund manager needs to do is establish clear procedures and describe precisely the composition of the ETF (which changes infrequently) to the other firms involved in ETF creation and redemption. In practice, however, only the very biggest institutional money management firms with experience in indexing tend to play this role, such as The Vanguard Group and Barclays Global Investors. They direct pension funds with enormous baskets of stocks in markets all over the world to loan stocks necessary for the creation process. They also create demand by lining up customers, either institutional or retail, to buy a newly introduced ETF.

The creation of an ETF officially begins with an authorized participant, also referred to as a market maker or specialist. Highly scrutinized for their integrity and operational competence, these middlemen assemble the appropriate basket of stocks and send them to a specially designated custodial bank for safekeeping. These baskets are normally quite large, sufficient to purchase 10,000 to 50,000 shares of the ETF in question. The custodial bank doublechecks that the basket represents the requested ETF and forwards the ETF shares on to the authorized participant. This is a so-called in-kind trade of essentially equivalent items that does not trigger capital gains for investors.

Once the authorized participant obtains the ETF from the custodial bank, it is free to sell it into the open market. From then on ETF shares are sold and resold freely among investors on the open market.

Redemption is simply the reverse. An authorized participant buys a large block of ETFs on the open market and sends it to the custodial bank and in return receives back an equivalent basket of individual stocks which are then sold on the open market or typically returned to their loanees.

The fund manager takes a small portion of the fund’s annual assets as their fee, clearly stated in the prospectus available to all investors. The investors who loan stocks to make up a basket make a small interest fee for the favor. The custodial bank makes a small portion of assets likewise, usually paid for by the fund manager out of management fees. The authorized participant is primarily driven by profits from the difference in price between the basket of stocks and the ETF and on part of the bid-ask spread of the ETF itself. Whenever there is an opportunity to earn a little by buying one and selling the other, the authorized participant will jump in.

The process might seem cumbersome but it does allow for transparency and liquidity at modest cost. Everyone can see what goes into an ETF, investor fees are clearly laid out, investors can be confident that they can exit at any time, and even the authorized participant’s fees are guaranteed to be modest. If one allows ETF prices to deviate from the underlying net asset value of the component stocks, another can step in and take profit on the difference, so their competition tends to keep ETF prices very close to it underlying Net Asset Value (value of component stocks).

############ Short Selling

When you short sell, your losses can be infinite. A short sale loses when the stock price rises, and a stock is (theoretically, at least) not limited on how high it can go. On the other hand, a stock can’t go below 0, so your upside is limited. Bottom line: you can lose more than you initially invest, but the best you can earn is a 100% gain if a company goes out of business.

Shorting stocks involves using borrowed money, otherwise known as margin trading. Just as when you go long on margin, it’s easy for losses to get out of hand because you must meet the minimum maintenance requirement of 25%. If your account slips below this, you’ll be subject to a margin call – you’ll be forced to put in more cash or liquidate your position.

hedge funds were taking advantage of loopholes in the existing regulation to short stock without actually locating the stock to be borrowed first and/or not delivering the shorted stock within the 3 day settlement period.

############ Naked Short Selling
Naked short selling, or naked shorting, is the practice of selling a stock short without first borrowing the shares or ensuring that the shares can be borrowed. Naked shorting is not necessarily a violation of the federal securities laws, and can contribute to market liquidity, but is illegal when it drives down stock prices.

This is what has been in the papers lately because you can theoretically manipulate the price of a stock by shorting a lot of shares you do not have/temporarily increasing the float, and driving the price down.

To do this, the trader simply enters a naked short with no intention of ever delivering the shares.[3] A large enough short sale could cause the price to fall, as is the case with any stock being sold. As long as the trade is large enough to move the share price, the short sale is likely to be profitable. On the other hand, the short seller is vulnerable to a “short squeeze.”[citation needed] That is the condition where the stock price unexectedly (from the short sellers’ point of view) rises and short sellers try, all at once, to close out their money-losing short positions by buying back in the open market the shares they had shorted, thereby driving prices ever higher in a self-reinforcing feedback loop.

It also can batter down the price by increasing the number of shares on the market to be sold. When there are more sell orders then buy orders the price is going to go down. So essentially with naked shorting, you are shorting shres of stock you do not have, so in theory you could take down the price of a stock (if you were a fund manager and had that kind of capital) In the short term, a stocks prices are determined by supply and demand, not fundimentals.
January 20th, 2008 by Patrick Byrne

I will explain to you a financial crime that is occurring on Wall Street. It will not be difficult to understand. In fact, the crime’s simplicity will probably amaze you.

From three years of experience explaining this crime to many people, however, I know that there are two hurdles people face in understanding it. The first seems big but is, in fact, easy to surmount. The second is small, but is the one that trips people up. I have an easy way to get you over both hurdles, but to do so, I will ask you, esteemed reader, to make two promises to me. If you keep these promises you will overcome both hurdles.

Hurdle #1: Because it is a financial crime, people who are not too conversant with financial issues may shrink from technical-sounding jargon. The way over that hurdle is this:

1) I will start by giving a super-simplified explanation that any high school kid could follow. It will be accurate, but only metaphorically accurate.

2) Then I will give an explanation that is literally accurate, but is still somewhat simplified, and uses just a little jargon.

3) Next I will give an explanation that is literally accurate, and includes technical jargon.

4) Last, I will provide links to numerous articles, news reports, interviews, and explanations that have appeared in academic papers and the financial media, for those who want to bury themselves in the technical details.

In sum, I will start with simplified explanation, then move through the explanation again and again, getting more accurate with each pass, but also, more technical.

Promise #1: Please make the first promise to yourself that you will not plough through this material until it defeats you. Instead, start by reading the first, metaphorical explanation and, if you understand to your own satisfaction, stop. If you are not sure you understand or remain unconvinced, read through the second, literal-but-simple explanation. If you get it then, stop. If you still are not sure you get it or remain unconvinced, read on through the fuller literal explanation, etc. etc. That is, promise that you will not wade through this material until it leaves you defeated and unconvinced. Instead, just read as far as you need to before you feel you get it, then feel free to bail out.

Hurdle #2: I have discovered that, given the right explanation, anyone can understand this crime. The second hurdle, however, is that when people start to understand it, their minds react as follows: “No way. No way. There’s no way that could be happening in our country. No way.”

Promise #2: Please make a second promise to yourself. That is, when you reach the point where your mind is reacting this way, you’ll go back and read Promise #1.

Posted in 4) The Crime: “Naked Shorts” & Other Insincere IOUs | 1 Comment »
The Simple, Metaphorical Explanation
January 20th, 2008 by Patrick Byrne

When you or I travel to another country, the first thing we do when we land is change some US dollars into the local currency. Perhaps you change enough to get a cab to the hotel, go out and buy a meal, etc. For the duration of your stay you keep changing your dollars into the local currency to get around. Then when you are ready to leave, you take whatever you have left and you convert it back into dollars, or spend it, or give it away, and board the plane back to the United States.

Yet imagine that there are some travelers to whom special privilege is granted. When they go to a foreign country, they are allowed to take a small machine that prints out the local currency. If they are in Paris, it prints out Euros. If they are in London, it spits out British Pounds. When in Mexico City, it prints pesos. And so on and so forth. On every trip, however, this special “currency machine” keeps track of how many Euros, pounds, or pesos it has spit out. When its owner goes to the airport to leave the country, a government official reads the machine’s printout and makes the traveler settle his account. For example, if the traveler visits Paris, then as he stands in the airport ready to depart, the official reads his machine and says, “Monsieur, you printed out €1,000 (one thousand euros) while you were here. At today’s exchange rate that is equal to $1,500 US.” The traveler hands over US $1,500 in cash, then boards his plane for the US.

Why are such boxes allowed? Because the people to whom this privilege is granted are wealthy hedge fund managers and Wall Street brokers. It is more convenient for them to carry these currency machines, and print what is in effect “temporary” local currency, than to do what the rest of us do, changing currency every morning at our hotel’s front desk. Besides, they’re rich. Everyone knows they are good for it: in fact, when one of them arrives in a new country, before he gets to use his curency machine he has to prove that he is wealthy, so that no matter how much local currency he prints and spends, he’ll have the dollars to buy them all back at the end of his trip, at current exchange rates. That way, when he is ready to leave the country and at the airport his machine is read to find out how much of the temporary local currency he printed on his visit, and that number is converted into US dollars, he can simply reach into his valise and pull out the requisite cash, even if it is thousands, or millions, of US dollars.

Imagine now that between the two Caribbean nations of St. Bart’s and St. Maarten’s there is a small island nation, St. Smallcap. It may be poor in comparison with the United States, but it has a working, even vibrant, economy. Its currency trades at parity with the US dollar (that is, one of the first converts to one of the other, and vice-versa). No one knows what the future holds for St. Smallcap. Perhaps it will stay as it is for generations. Perhaps it will develop into a prosperous island nation like Bermuda. Maybe it will become a destitute, impoverished nation like many other small island nations. Perhaps it will become an economic powerhouse, like Hong Kong or Singapore. There is no way to tell.

One day, as if on cue, a dozen hedge fund managers and Wall Street bankers show up in St. Smallcap. No one thinks much of it as these fellows start driving around Smallcap with their special machines. They print off the local currency with great abandon, using that currency to buy drinks and dinners on the town, pay for taxis, and gamble at the casino. In time, they begin buying the island’s houses, cars, yachts, and cargo ships. They even buy Smallcap National Airline’s sole 727 jet. They buy anything that is not nailed down, paying for it all along with the local currency, which they print off their special currency machines as they need it.

After a few weeks something funny begins to happen. There is so much extra currency floating around, it begins to affect the economy. As everyone realizes that there is a lot of extra currency sloshing around the island, prices for goods rise in anticipation that Smallcap’s currency will become less valuable. It may even happen that prices soar, as they did in Weimar Republic Germany after WWI, in a bout of hyper-inflation. Of course, as this happens, the rate at which Smallcap’s currency can be exchanged against other currencies, including the dollar, collapses.

There is an even more insidious effect, however, that one can understand by thinking about the nature of prices. There are many ways to think about prices. Often we see them simply as obstacles preventing us from getting what we want (”Jim wants a new Mercedes but on his teacher’s salary he cannot pay the price.”) Another way to think of prices, however (a way many economists think of them), is to see prices as little bits of information passing back-and-forth around the economy, permitting millions of strangers to coordinate their economic activities. Prices for corn are going up and prices for wheat are dropping? That is a signal to farmers that they should cut back on wheat production and plant corn instead. Rents soar in a city while prices for office space stagnate? That is a signal that someone should convert some office space to apartments and condominiums. A city is washed out because of a hurricane, and prices for flashlights are soaring? That is a signal to surivivors within the city to share the scarce resource of flashlights, and a signal to outsiders to start trucking in flashlights for resale (i.e., “profiteering,” which to economists means, “responding quickly to price signals without regard for ethical concerns such as loyalty”).

Like any other normal economy, in order to function St. Smallcap’s economy relies on prices to pass information around the economy. The hedge fund managers and their special currency machines, however, print out so much of their “temporary” currency that Smallcap’s economy becomes awash in it. Imagine listening to a radio playing across the room while someone plays white noise in speakers set up next to your ears: you would not be able to hear what was being said. Similarly, this flood of “temporary” currency washes out the signals that prices normally carry within St. Smallcap’s economy. No one knows whether to grow wheat or corn, and since seed prices are rising but no one knows what income can be generated from any crop, fewer farmers plant anything. Savings drop: it makes less and less sense to save, because what is the point of delaying consumption today in return for a future benefit that cannot be estimated? Since less money is being saved, banks have less capital to loan to businesses to expand, or even maintain, current production. As a result, manufacturing on the island also collapses.

One can imagine a situation where, if Smallcap’s economy were small enough, and the Wall Street bankers and hedge funds swept down on Smallcap with enough currency-printing machines, that they could flood Smallcap with so much of its own currency that the price signals of the local economy would be mostly lost. The white noise of massive amounts of this “temporary” currency would disrupt real economic activity, like farming and manufacturing, until the economy of Smallcap cracked. Hyper-inflation, starvation, and mass unemployment might set in. People would begin trading anything they have in return for a ticket to flee the island.

Throughout it all, the Wall Street bankers and hedge fund managers continue using their machines to print local currency with which they can buy, buy, buy.

After six months, when nothing of value is left on the island that they do not already own, the bankers and hedge fund managers take everything they bought and load it onto their new cargo ships and yachts. They gather at the airport to board their new jet.

A government official arrives and sets about to find out how much of the local currency they printed while visiting the island. The official reads the print-out from each of their machines, sums it up and exclaims, “100 million!”

One hedge fund managers speaks for the rest: “Yes, but that is not 100 million US dollars. It is 100 million in your local currency. And while we have been visiting your country your local currency seems to have collapsed. That is hardly surprising, given that your farms are vacant and your factories are boarded up. It seems that on the international markets your currency is worth 1/10,000th of what it was worth when we arrived six months ago. Thus, in US currency, we owe you precisely… $10,000.” He flashes his thick wallet and counts out the sum. Laughing, his hedge fund colleagues and banker friends board their jet and take off, banking to watch their new cargo ships sail out of the harbor loaded with the wealth of the country, for which, in the end, they paid $10,000.

Imagine also that surprisingly few reporters seem interested in these events, or notice the pattern of it happening to one small island nation after another. Those who do notice it take it for granted that small island nations are supposed to be the way they are: destitute and impoverished. Only rarely does a reporter challenge the bankers and fund managers on their actions, but the financiers respond in unison so perfect it appears rehearsed, “Are you kidding? Don’t you know what a dump that island is? The last time I saw St. Smallcap its farms were barren, its businesses were boarded up, and everyone was fleeing. I tell you, the place is just a disaster.”

If you can understand the story above, then you can understand the crime that is occurring in our financial markets (the metaphor is a sound one, if I say so myself). The point of subsequent posts in this category will be to convert the story you just read into Wall Street lingo, one step at a time. You will see how the preceding story precisely expresses behavior that is occurring on Wall Street, routinely, today.

In reality, of course, the “special machines” that bankers and hedge fund managers are using are not actual physical machines, and what they are destroying are not “small island nations,” and what they are printing is not “currency.” In reality, the “special machines” are loopholes in our legal system, what the bankers and hedge funds are destroying are small companies, and the “currency” they are printing off to do so are shares of stock in those small companies.

Posted in 4) The Crime: “Naked Shorts” & Other Insincere IOUs | 1 Comment »
The Simple, Literal Explanation
February 11th, 2008 by Patrick Byrne

The “St. Smallcap” example conveyed the dynamics of the manipulation, but it was only a metaphor. This blog will provide an explanation whose truth is more literal.

You and I enter a stock trade. You buy a share of stock from me. You hand over your money, and I hand over the share of stock. That is called, “settlement.”

It may surprise you to learn that there are loopholes in our nation’s regulations that permit some people, when it comes time to settle, to hand over nothing but an IOU. By using one of these loopholes, when the time comes for settlement I can take your money but say, “I’m not delivering you any stock. I’m just giving you an IOU for a share of stock that I will deliver later.”

There are reasons these loopholes came into existence. If someone made a mistake by signing the wrong line on a form, for example, or mistakenly sold more shares than he really had, one would not want the entire system to vapor-lock as the mistake was rectified. So the system has been designed so that the gears do not get hung up on minor mistakes. The general idea is that, if someone sells shares it turns out he cannot deliver, he can create these IOU’s and send them on as though they were real shares, giving himself time to clean up whatever error he is experiencing, and sending the real shares a couple days later.

There is no system in place to alert you to the fact that you sent me your money and received nothing but an IOU. The system treats these IOU’s just as though they were real shares. Your brokerage statement will say that you got shares, even though I never sent anything but an IOU. You can sell them, and that IOU will pass on through the system into someone else’s account.

The problem is, suppose I (having mastered these loopholes) start using the system’s “forgiveness” strategically? Suppose I find a company that is likely to need capital to expand, or simply survive, in the near future? They plan on raising that capital by issuing shares of stock to the public (there is no crime in that: for example, lots of young pharmaceutical companies sip at the capital markets for years as they get going). Imagine that I target one of them, and deliberately go out selling that company’s shares into the marketplace, yet instead of delivering stock, I deliver nothing but IOU’s. I flood the market with them, always standing ready to sell more than anyone wants to buy. My IOU’s are anything but temporary: they drift around in the market for weeks, months, and eventually years. If anyone gets mad and tells me that I have to deliver real shares against one of the IOU’s I sold, I say, “Sure, I’ll deliver shares against that IOU,” but what I deliver is … just another IOU. Eventually I flood the market with so many IOU’s that people end up reselling them, and they go and on until there are more share-IOU’s bouncing around than there are actual shares.

What will the effect be on the price of those shares? If I have chosen a company like, for example, IBM, the effect will be negligible (just as in the example of the preceding blog, if the hedge funds brought their money machines to Paris and printed off 100 million “temporary” Euros to spend around France and Germany, it would not cause any real harm before they bought them all back as they departed).

But remember how the hedge fund managers destroyed the economy of St. Smallcap, so that the “temporary” currency they had issued could be paid off in the end for next-to-nothing? Similarly, if instead of choosing IBM I choose a tiny company, and I generate more IOU’s than there are shares of stock in the company, then the market in those shares will crack just as surely as $100 million of fake currency would crack the tiny island economy of St. Smallcap. Once cracked, the stock becomes next-to-worthless. And if I manage to issue enough IOU’s in my target company’s stock that it cracks and becomes near-worthless, they become barely an obligation at all. Who cares about millions of IOU’s, if those IOU’s are for something with infinitesimal value?

I walk away with my winnings. The company, however, is in a fix: they planned on issuing stock to raise capital, but now their stock price has been destroyed through my manipulations, and they cannot raise capital. Maybe they run out of funds and disappear, or maybe they go into hibernation mode in order to nurse what capital they have. In either case, society is deprived of the output and the jobs that would have existed were it not for my villainy.

It may be hard to believe, but such loopholes really do exist (I will be explaining several of them in subsequent blogs). In reality, however, neither you (if you are like most Americans) nor I can actually use them. Only large hedge funds and broker-dealers can access these loopholes to create IOU’s (just as, in the story of St. Smallcap, only hedge funds were allowed to own the currency machines with which to print off that “temporary” currency). As we will see in more detail, these hedge funds and broker-dealers have learned how to manipulate these loopholes in the stock settlement system so as to flood the market with over a billion IOU’s (maybe many billion) in hundreds of companies. In doing so, they have disrupted the market for shares of companies that are researching cures for cancer and other illnesses, figuring out how to make blood substitutes to treat cases of acute blood loss, and building mine-resistant vehicles for troops in Iraq. Hundreds of such corporate “St. Smallcaps” have been damaged or destroyed. Thus, cancer patients are being deprived of treatments, accident victims are dying of acute blood loss, and soldiers in Iraq are dying from IED’s, so that some hedge fund ass-clowns can drive new Ferraris.

It really is that simple.

I have explained the issue through metaphor (”St. Smallcap”), and now, provided this literal explanation. I will continue with more detailed explanations and citations for further reading for those who wish to gain a more thorough understanding of the workings of the US stock settlement system and precisely how loopholes permeate it. The general reader, however, may feel satisfied with the account thus far and, feeling no need to learn intricacies of stock settlement, may wish to move on to subsequent chapters, where I discuss in greater detail the harms being done to society, who is doing it, and who has taken part in the cover-up.

Posted in 4) The Crime: “Naked Shorts” & Other Insincere IOUs | 3 Comments »

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############ Margin Trading
Buying on margin is borrowing money from a broker to purchase stock. You can think of it as a loan from your brokerage. Margin trading allows you to buy more stock than you’d be able to normally. To trade on margin, you need a margin account. This is different from a regular cash account, in which you trade using the money in the account. By law, your broker is required to obtain your signature to open a margin account.

The margin account may be part of your standard account opening agreement or may be a completely separate agreement. An initial investment of at least $2,000 is required for a margin account, though some brokerages require more. This deposit is known as the minimum margin. Once the account is opened and operational, you can borrow up to 50% of the purchase price of a stock. This portion of the purchase price that you deposit is known as the initial margin. It’s essential to know that you don’t have to margin all the way up to 50%. You can borrow less, say 10% or 25%. Be aware that some brokerages require you to deposit more than 50% of the purchase price.

You can keep your loan as long as you want, provided you fulfill your obligations. First, when you sell the stock in a margin account, the proceeds go to your broker against the repayment of the loan until it is fully paid. Second, there is also a restriction called the maintenance margin, which is the minimum account balance you must maintain before your broker will force you to deposit more funds or sell stock to pay down your loan. When this happens, it’s known as a margin call.

Borrowing money isn’t without its costs. Regrettably, marginable securities in the account are collateral. You’ll also have to pay the interest on your loan. The interest charges are applied to your account unless you decide to make payments. Over time, your debt level increases as interest charges accrue against you. As debt increases, the interest charges increase, and so on.

The Federal Reserve Board regulates which stocks are marginable. As a rule of thumb, brokers will not allow customers to purchase penny stocks, over-the-counter Bulletin Board (OTCBB) securities or initial public offerings (IPOs) on margin because of the day-to-day risks involved with these types of stocks.

Let’s say that you deposit $10,000 in your margin account. Because you put up 50% of the purchase price, this means you have $20,000 worth of buying power. Then, if you buy $5,000 worth of stock, you still have $15,000 in buying power remaining. You have enough cash to cover this transaction and haven’t tapped into your margin. You start borrowing the money only when you buy securities worth more than $10,000.

In volatile markets, prices can fall very quickly. If the equity (value of securities minus what you owe the brokerage) in your account falls below the maintenance margin, the brokerage will issue a “margin call”. A margin call forces the investor to either liquidate his/her position in the stock or add more cash to the account.

Let’s say you purchase $20,000 worth of securities by borrowing $10,000 from your brokerage and paying $10,000 yourself. If the market value of the securities drops to $15,000, the equity in your account falls to $5,000 ($15,000 – $10,000 = $5,000). Assuming a maintenance requirement of 25%, you must have $3,750 in equity in your account (25% of $15,000 = $3,750). Thus, you’re fine in this situation as the $5,000 worth of equity in your account is greater than the maintenance margin of $3,750. But let’s assume the maintenance requirement of your brokerage is 40% instead of 25%. In this case, your equity of $5,000 is less than the maintenance margin of $6,000 (40% of $15,000 = $6,000). As a result, the brokerage may issue you a margin call.

If for any reason you do not meet a margin call, the brokerage has the right to sell your securities to increase your account equity until you are above the maintenance margin. Even scarier is the fact that your broker may not be required to consult you before selling! Under most margin agreements, a firm can sell your securities without waiting for you to meet the margin call. You can’t even control which stock is sold to cover the margin call.

Why use margin? It’s all about leverage. Just as companies borrow money to invest in projects, investors can borrow money and leverage the cash they invest. Leverage amplifies every point that a stock goes up. If you pick the right investment, margin can dramatically increase your profit.

############ dead cat bounce

A dead cat bounce is a term used by traders in the finance industry to describe a pattern wherein a spectacular decline in the price of a stock is immediately followed by a moderate and temporary rise before resuming its downward movement, with the connotation that the rise was not an indication of improving circumstances in the fundamentals of the stock. It is derived from the notion that “even a dead cat will bounce if it falls from a great height”.

The reasons for such a bounce can be technical, as investors may have standing orders to buy shorted stocks if they fall below a certain level or to cover certain option positions. Once those limits are reached, the buy orders are activated and the sudden rise in demand causes the price of the stock to rise as well. The bounce may also be the result of speculation. Since bounces often occur, traders buy into what they hope is the bottom of the market, expecting a bounce and thus making a quick profit. Thus, the very act of anticipating a bounce can create and magnify it.

############# CDO/CMO
Crisis explainer: Uncorking CDOs

Marketplace Senior Editor Paddy Hirsch gives a bubbly explanation of the intricacies of “collateralized debt obligations” — those financial instruments that got us into this financial mess.

Decades ago, when you wanted to buy a house you went to local bank and applied for a mortgage. If the mortgage was less than three times your annual income and you had a good credit history, the bank would loan you the money and you would pay them interest and some principal every month for 30 years. Then Wall St. got a bright idea: buy up all the mortgages from the banks, collect a few thousand into a pool called a CDO (Collateralized Debt Obligation) and sell shares in it. The owner of each share would get a pro-rata share of the incoming monthly mortgage payments, analogous to what a bond owner gets.

What happened? It sounded like a great idea and soon all mortgages were sold and repackaged into shares. It didn’t take long before the banks realized that they could issue mortgages of five, six, even eight times the buyer’s annual income or sell them to people with terrible credit histories. After all, the shaky mortgages would soon be somebody else’s headache. That’s what happened. Lehman, Merrill, and others bought billions of dollars of mortgages that the homeowners had no hope of ever repaying on schedule and nobody wanted to buy shares in these worthless CDOs, so the brokers got stuck holding the bag with billions in worthless loans.

############## Trader Tax Status
By Jim Forester, Tax Director of Traders Accounting*
Posted: September 14, 2007

The Internal Revenue Service has two tax classifications for individuals who buy and sell securities, mutual funds, options, futures, commodities and other derivatives: Trader and investor.

The minority who trade for a living under the IRS definition are classified as traders and afforded an attractive menu of tax breaks. The majority, who trade part-time in addition to full-time W-2 employment or as a retirement hobby, do not enjoy the tax advantages that accompany trader status.

So, how do the two match up come tax time? If your trading left you in the black, you could save thousands. If your trading resulted in a substantial loss, however, the ability to write off that loss in the year it occurred could result in a windfall of $20,000 or more.

How Traders Trump Investors

As a trader, you trump investors in two main ways: You can fully deduct all of your trading expenses, and you can write off 100 percent of your losses in one year (provided you elected the mark-to-market accounting method).

Investors who itemize their deductions on Schedule A are limited to a handful of deductible investment expenses, including legal and accounting fees, investment counseling and advice and investment newsletters. These must be listed as miscellaneous itemized deductions and can only be deductible to the extent that they exceed 2 percent of adjusted gross income.

As a trader, however, you can deduct all your business-related expenses, including your datafeed, dues and subscriptions, equipment, utilities, seminars, transportation, travel and entertainment. You can also take advantage of the home office deduction if you work from home.

So far, the IRS has left further delineation in the hands of the tax court, whose rulings tend to uphold the denial of trader status without shedding much light on how individuals might qualify for trader status in the first place.

Expense Deductions Add Up Fast

Here’s how the additional expense deductions would benefit Janet Trader compared to Johnny Investor if both had identical trading gains and business expenses. Note that Johnny Investor is subject to the 2 percent threshold for the few deductible expenses he is qualified to claim:

* Total household income: $140,000
* Trading profits: $40,000
* Trading expenses: $24,230
* Janet Trader’s tax savings: $7,269
* Johnny Investor’s tax savings: $1,644
* Benefit of trader tax status: $5,625
* Risk insurance: The Capital Loss Deduction

When it comes to covering losses, traders fare even better: The IRS allows traders who elected mark-to-market to write off their entire loss in one year. You can even apply the loss to taxable income from past years and generate a tax refund!

Investors, meanwhile, have a maximum allowable net capital loss of $3,000 in any tax year. That means if you lose more than $3,000, your only recourse is to carry over the remaining balance until it’s used up but, again, only to a maximum of $3,000 a year.

Here’s how a $40,000 loss would affect Janet Trader and Johnny Investor. (Note that Janet Trader was able to offset her regular $100,000 income with her $40,000 loss while Johnny Investor is limited to the $3,000 capital loss deduction.)

* Total household income: $140,000
* Trading loss:
* Trading expenses: $24,230
* Janet Trader’s tax savings: $19,269
* Johnny Investor’s tax savings: $984
* Benefit of trader tax status: $18,285

Investors also face another limit: They may only deduct investment interest up to the amount of their net investment income, defined as total investment income (earnings, interest, dividends and royalty income) less the deductible investment expenses previously discussed. Any investment interest that exceeds that cap is non-deductible but may be carried forward to future tax years.

One of the best ways to secure and protect your trader tax status is to trade as a business entity. The IRS treats business filers in a far more consistent and advantageous way than it does individual traders.

Benefits of Trader Status

How trader status may reduce your income tax.

What’s the big deal about being a trader? How do you end up being treated better than an investor? Here’s a rundown on major tax benefits of trader status:
Interest Expense

Investors can claim interest expense only if they itemize, and only to the extent permitted under the investment interest limitation. Traders deduct their interest expense on Schedule C, so they don’t have to itemize and the investment interest limitation doesn’t apply.

Investors aren’t permitted to claim a deduction for the cost of investment seminars. If a trader attends a seminar to improve his ability to trade, the cost may be deductible.
Home Office

Home office deductions are not allowed in connection with investing. A trader may be able to claim a home office deduction, however.
Other Expenses

Various other expenses of an investor, such as the cost of books and subscriptions, are “miscellaneous deductions” that are allowed only if the investor itemizes, and only to the extent the total miscellaneous deductions exceed 2% of adjusted gross income. A trader deducts these items on Schedule C.

Being a trader makes you eligible for mark-to-market accounting — but only if you make the mark-to-market election. If you qualify as a trader and you make this election, the following additional benefits are available:

* The wash sale rule won’t apply to your trading activity.
* If you have an overall loss for the year, your loss deduction won’t be subject to the $3,000 capital loss limitation.


The biggest disadvantage of filing as a trader is audit risk. There are no clear standards for determining whether you are a trader. If you claim to be a trader, and the IRS determines that you are not a trader, you may end up with substantial liability for tax, interest and penalties.
If you make the mark-to-market election, you have two other potential disadvantages to deal with:

* Your trading profits are ordinary income, not capital gains.
* At the end of the year you have to report all your profits, including profits from unsold stocks.

There’s another disadvantage of filing as a trader: relatively few tax professionals are familiar with the rules. You may have difficulty finding someone who can provide competent help with your tax return.
Bottom Line

Because of uncertainty about the definition of trader, and the potential for inviting an IRS audit, I counsel against filing as a trader unless both of the following are true:

* You have enough at stake so that the tax benefit outweighs the hassle of going through an audit, and
* You have at least a reasonably strong claim to trader status by reason of an extended period of extensive short-term trading.
Do “traders” have to pay Social Security and Medicare self employment taxes? And do they lose long-term capital gains rates?
Most traders will enjoy not paying taxes for self employment such as Social Security and Medicare.
One of the interesting features of the unique trader tax status is that, unlike other sole proprietors and unincorporated businesses, traders will not be paying taxes on Social Security and Medicare, also known as self-employment taxes. These tax consequences of day trading apply regardless of whether you use the mark-to-market or cash accounting method. That’s because trading gains are not considered “earned income” by the IRS for stock trading tax purposes.

As with many aspects of stock trading taxes, there are exceptions. If you work as an independent contractor, most commonly to manage a sub-trading account for a broker/dealer, you likely will pay into Social Security and Medicare. That’s because independent contractor trading gains, captured on your employer’s Form 1099-Misc. from the IRS are considered “earned income,” and therefore subject to self-employment taxes.

On the question of capital gains, if you elect the mark-to-market accounting method, you convert those capital gains/losses into ordinary income/loss for tax purposes. (The tradeoff, of course, is that you also are exempt from the $3,000 capital gains limit, leading some to call this feature “loss insurance.”)

The best way to protect the capital gains on your long-term, non-trader holdings is to establish a separate account for these investments, preferably with a brokerage that does not handle your day trading business. If you take gains to keep separate, detailed records of your personal investments and never commingle your long-term and short-term accounts, you’ll enjoy the best of both worlds.

############## Wash Sale
How the wash sale rule works

By Kaye A. Thomas
Updated May 30, 2007

Accounting for Active Traders

A rule that postpones losses if you buy replacement shares around the same time.

When the value of your stock goes down you get that sinking feeling — you’ve lost money. But the tax law doesn’t allow that loss until you sell the stock. In a way that’s good, because it means you can control the timing of your deduction, taking it when the benefit is the greatest.

The problem is, you may have a conflict. You want to deduct the loss, but you also want to keep the stock because you think it’s going to bounce back. It’s tempting to think you can sell the stock and claim the loss, then buy it back right away. And that’s where the wash sale rule comes in. If you buy replacement stock shortly after the sale — or shortly before the sale — you can’t deduct your loss.
General Rule

In general you have a wash sale if you sell stock at a loss, and buy substantially identical securities within 30 days before or after the sale.

Example: On March 31 you sell 100 shares of XYZ at a loss. On April 10 you buy 100 shares of XYZ. The sale on March 31 is a wash sale.

The wash sale period for any sale at a loss consists of 61 days: the day of the sale, the 30 days before the sale and the 30 days after the sale. (These are calendar days, not trading days. Count carefully!) If you want to claim your loss as a deduction, you need to avoid purchasing the same stock during the wash sale period. For a sale on March 31, the wash sale period includes all of March and April.

Basis Adjustment

The basis adjustment is important: it preserves the benefit of the disallowed loss. You’ll receive that benefit on a future sale of the replacement stock.

Example: Some time ago you bought 80 shares of XYZ at $50. The stock has declined to $30, and you sell it to take the loss deduction. But then you see some good news on XYZ and buy it back for $32, less than 31 days after the sale.

You can’t deduct your loss of $20 per share. But you add $20 per share to the basis of your replacement shares. Those shares have a basis of $52 per share: the $32 you paid, plus the $20 wash sale adjustment. In other words, you’re treated as if you bought the shares for $52. If you end up selling them for $55, you’ll only report $3 per share of gain. And if you sell them for $32 (the same price you paid to buy them), you’ll report a loss of $20 per share.

Because of this basis adjustment, a wash sale usually isn’t a disaster. In most cases, it simply means you’ll get the same tax benefit at a later time. If you receive the benefit later in the same year, the wash sale may have no effect at all on your taxes.

There are times, though, when the wash sale rule can have truly painful consequences.

* If you don’t sell the replacement stock in the same year, your loss will be postponed, possibly to a year when the deduction is of far less value.
* If you die before selling the replacement stock, neither you nor your heirs will benefit from the basis adjustment.
* You can also lose the benefit of the deduction permanently if you sell stock and arrange to have a related person — or your IRA — buy replacement stock.
* As explained in my book, Consider Your Options, a wash sale involving shares of stock acquired through an incentive stock option can be a planning disaster.

Holding Period

When you make a wash sale, your holding period for the replacement stock includes the period you held the stock you sold. This rule prevents you from converting a long-term loss into a short-term loss.

Example: You’ve held shares of XYZ for years and it’s been a dog. You sell it at a loss but then buy it back within the wash sale period. When you sell the replacement stock, your gain or loss will be long-term — no matter how soon you sell it.

In many situations you get more tax savings from a short-term loss than a long-term loss, so this rule generally works against you.
Additional Rules

There’s a lot more to the wash sale rule. We get questions on our message board about all of the following issues:

* You don’t have a wash sale unless you acquire (or enter into a contract or option to acquire) substantially identical securities.
* You don’t have a wash sale, even though you bought identical shares within the previous 30 days, if the shares you bought aren’t replacement shares.
* There are mechanical rules to handle the situation where you don’t buy exactly the same number of shares you sold, or where you bought and sold multiple lots of shares. See Wash Sale Mechanics.
* If a person who’s related to you — or an entity related to you, such as your IRA — buys replacement property, your loss may be disallowed under a different rule: you may be treated as if you made an indirect sale to a related person.
* You don’t actually have to purchase stock within the wash sale period to have a wash sale. It’s enough if you merely enter into a contract or option to acquire replacement stock.
* Short sales present a special problem in connection with the wash sale rule.
* There are special considerations in applying the wash sale rule to traders.

Losses Only

The wash sale rule only applies to losses. You can’t wipe out a gain from a sale by buying the same stock back within 30 days.
Planning for Wash Sales

What can you safely do to plan around the wash sale rule? No technique is completely safe. Here are some ideas to consider.

* Most obviously, you can sell the stock and wait 31 days before buying it again. (Check your calendar carefully!) The risk here is that the stock may rise in price before you can repurchase it.
* If you’re truly convinced the stock is at rock bottom, you might consider buying the replacement stock 31 days before the sale. If the stock happens to go up during that period your gain is doubled, and if it stays even you can sell the older stock and claim your loss deduction. But if you’re wrong about the stock, a further decline in value could be painful.
* If your stock has a strong tendency to move in tandem with some other stock, you may be able to reduce your risk of missing a big gain by purchasing stock in a different company as “replacement” stock. This is not a wash sale because the stocks are not substantially identical. Thirty-one days later you can switch back to your original stock if that is your wish. But there’s no guarantee that any two stocks will move in the same direction, or with the same magnitude.

There’s no risk-free way to get around the wash sale rule. But then again, continuing to hold a stock that has lost value isn’t risk-free, either. In the end it’s up to you to evaluate all the risks, and balance them against the benefit you’ll receive if you can claim a deduction for your loss.

Pending Mergers

Suppose you own stock in a company that’s about to be acquired by Bigco. Usually that means a boost in the stock price, but if you have a loss on your shares, the following plan may seem to make sense. Just before the merger you sell your stock and buy shares of Bigco — shares you would have received in the merger if you hadn’t sold your original shares. That shouldn’t be a wash sale because Bigco isn’t substantially identical to the company you sold, right?

Wrong. The tax regulations say that if two different stocks are linked together in such a way that any change in the price of one will be reflected in the price of another, they’re likely to be treated as substantially identical securities for purposes of the wash sale rule. If you use this maneuver, the wash sale rule disallows the loss.
Wash Sales and Replacement Stock

By Kaye A. Thomas
Updated June 1, 2007

You don’t have a wash sale unless the shares you bought “replace” the shares you sold.

In general, the wash sale rule prevents you from reporting a loss on the sale of stock if you acquired substantially identical stock on the same day as the sale, or within 30 days before or after that day. But the wash sale rule doesn’t apply if the stock you bought wasn’t replacement stock.

This rule is best understood through a series of examples. In all of these examples, assume that there are no purchases or sales of stock other than those described.
1: Selling All

On June 1 you buy 200 shares of XYZ for $10,000. On June 12 you sell all 200 shares for $8,000 (a loss of $2,000).

Most people wouldn’t even think about applying the wash sale rule here. You know instinctively it shouldn’t apply, even though there’s a purchase of identical stock less than 31 days before the sale. Your instincts are correct: the wash sale rule doesn’t apply because the stock you bought isn’t replacement stock for the stock you sold. That’s true because you sold the same stock you bought.
2: Selling Half

On June 1 you buy 200 shares of XYZ for $10,000. On June 12 you sell 100 shares for $4,000 (a loss of $1,000). You continue to hold the other 100 shares.

The answer here is a little less obvious. After the sale, you hold shares identical to the shares you sold, and you bought those shares less than 31 days before the sale. But you probably still feel that the wash sale rule shouldn’t apply here. And the IRS agrees, in the situation where you bought the 200 shares in a single lot. Furthermore, although the IRS doesn’t say this, the result shouldn’t change if you gave a single buy order for 200 and your broker happened to execute it by buying two lots of 100 shares each. It’s clear the shares you have left after the sale weren’t bought to replace the shares you sold.
3: Separate Purchases

You buy 100 shares of XYZ in the morning, and decide to buy another 100 shares in the afternoon of the same day. Within 30 days, you sell the morning shares at a loss.

For all we know, the price of this stock dropped between morning and afternoon, and your afternoon purchase is for the purpose of claiming a loss while maintaining your investment. In other words, you may have been trying to get the result the wash sale rule is designed to prevent. So the IRS will probably contend that the wash sale rule applies in this situation.

The result should be different, though, if you gave a single buy order for 200 and your broker happened to execute it by buying two lots of 100 shares each. In this case it’s clear the shares you have left after the sale weren’t bought to replace the shares you sold.
4: Old Shares

You have held 100 shares of XYZ for more than 30 days. You buy an additional 100 shares for $5,000. Less than 31 days later, you sell these shares (the new ones) for $4,000 (a $1,000 loss). You continue to hold the old shares.

There are no rulings that mention this situation. But the requirement for replacement stock should prevent the wash sale rule from applying here. The older shares shouldn’t be considered replacement shares for the newer ones.

Note that you have to use specific identification to sell the newer shares. Unless you follow this procedure, the tax law assumes you sold the older shares. If you have a loss on those shares, the wash sale rule applies.
5: Not So Old Shares

Same as the previous example, except the “old” shares aren’t as old. You bought the old shares on June 1, the new shares on June 10, and sold the new shares at a loss on June 20.

Once again, you had to use specific identification to sell the new shares. The question is, do you have a wash sale here because of the fact that you bought the old shares less than 31 days before you sold the new ones?

As a matter of logic, it’s clear that the answer should be no. The old shares can’t possibly be replacement shares for the newer ones. You bought them before you bought the shares you sold, so they should be ignored in applying the wash sale rule.

Unfortunately, in a ruling dealing with an unrelated point, the IRS gave an example like the one above, and said the wash sale rule applied. The ruling was designed to establish that shares bought on margin are subject to the wash sale rule. It’s possible that the person who drafted the ruling simply didn’t think about the fact that the shares in that example weren’t replacement shares.

My feeling is that the wash sale rule should never apply if the “replacement” shares were bought at the same time as, or earlier than, the shares that were sold. There isn’t any opportunity for abusive tax planning in this situation. But the issue is in doubt because the IRS has issued a ruling that, in my opinion, is erroneous.

############### Order Type

# The limit price for buy orders is placed below the current market price. The limit price for sell orders is placed above the current market price. Limit orders will be filled at the limit price or better, but are not guaranteed a fill.
# MARKET (also known as “not held”) – order used to guarantee an execution, but not guarantee a price or time of execution. The risk of market orders is that you have no control over what the execution price is. We strongly suggest you avoid using them with options, especially option spreads.

STOP (also known as “stop loss”) – order used to open or close a position by buying if the market rises or selling if the market falls. The stop price for buy orders is placed above the current market price. The stop price for sell orders is placed below the current market price. A stop order turns into a market order when the stop is triggered, so the final execution price or time of a stop order is not guaranteed. The same risks of market orders apply to stop orders.

# STOP LIMIT – order used to open or close a position by buying if the market rises or selling if the market falls, but that turns into a limit order when the stop price is triggered. Stop limit orders have a stop price and a limit price. When the stop price is triggered, the limit order is activated. The stop price for buy orders is placed above the current market price. The stop price for sell orders is placed below the current market price. The stop price does not need to be the same as the limit price. Just as with a limit order, the stop limit order will be filled at the limit price or better, but may not be filled at all.
# TRAILING STOP – stop order that continually adjusts the stop price based on changes in the market price. A trailing stop to sell raises the stop price as the market price increases, but does not lower the stop price when the market price decreases. A trailing stop to buy lowers the stop price as the market price decreases, but does not increase the stop price as the market price increases. In both cases, the stop “trails” the market price. When the stop price is reached, the order becomes a market order. The same risk of market orders applies to trailing stops.

############# Who is a Trader
The word trader has a special meaning in the tax law. It refers to someone who trades to catch short-term swings in market prices (not long-term appreciation or dividends and interest), and does so in a large enough volume, consistently over a long enough period of time. The biggest problem with trader status is the absence of a clear definition. There are no precise standards telling us when trades are considered short-term, or how large a volume you need, or how long a period you must continue the activity to be considered a trader. Sometimes it’s easy to determine that someone is or is not a trader, but in many cases the answer isn’t clear.

Tax Benefits

If you’re a trader, you’re likely to be able to claim more deductions than an investor. Some deductions that would be claimed as itemized deductions subject to various limits will be allowed as business deductions, without such limits. And there are some deductions traders can claim even though investors can’t claim them at all.
In addition, traders are eligible to make the mark-to-market election. If you make this election, your trading losses won’t be subject to the $3,000 capital loss limitation. This limitation can be very painful for a trader who has a bad year.
Filing as a Trader

If you’re a trader who has not made the mark-to-market election, your trading expenses go on Schedule C, the form used to report business income and expenses. But your trading income is capital gain, and has to be reported on Schedule D. This looks very strange indeed to tax professionals who are not familiar with trader filing, but this is how it is done.

Trading Activity Test

The first test distinguishes between the activity of investing and the activity of trading. Your activity is investing if it’s designed to benefit from long-term appreciation in securities, or to produce a significant amount of dividend or interest income. Investors are likely to be interested in a company’s balance sheet, market share, industry trends and other indicators of long-term viability. They typically ignore short-term price fluctuations — or try to, anyway.
Trading activity, for purposes of this test, consists of trying to capture short-term price swings. Many traders have little interest in the long-term prospects of the companies they trade. They may know little about the company other than the way the price of its stock has moved in the recent past. If a trader happens to capture a dividend, that’s likely to be merely coincidental. Traders seek their profits in the market’s zigs and zags.
The precise limits of this test have never been established. It’s reasonably clear that you don’t have to be a day trader to be a trader. People who hold positions overnight, or for a few days at a time, are still engaged in trading activity. The point where your average holding period indicates you’re an investor rather than a trader is almost surely more than a few days, and probably less than six months. There isn’t a lot to go on if you’re looking for a more refined answer than that. If your typical holding period is 60 days, you’re in no man’s land.
Substantial Activity Test

Even if you engage in trading activity, you have to do enough of it, regularly enough, over a long enough period of time, to be considered a trader. I call this the substantial activity test.
Different words have been used to express this test. The Supreme Court said the taxpayer must be “involved in the activity with continuity and regularity.” The Tax Court has used the words “frequent, regular and continuous.” The basic point is that you aren’t a trader unless you do a lot of trading, and keep at it on a regular basis over an extended period of time.
Here again there is no bright line. Are 10 trades a week enough? 20? No one can say for certain. My feeling about the way the courts should decide the question is to look at whether the activity was carried on the way someone would if they treated it as a serious business. If you have a good business reason for executing only a few trades, or none at all, for a period of time, then your absence from the market should not disqualify you from trader status. But if your spotty trading activity, or low volume, indicates a lack of commitment to trading as a business, then you aren’t a trader. It remains to be seen whether the courts will take the approach I advocate.

Strictly speaking, trader status isn’t an election. Either you are a trader, or you are not. Traders are eligible to make the mark-to-market election, but you can be a trader without making this election or any other election.
Yet the IRS is never going to audit a non-trader return and say you should have filed as a trader. In theory there could be a reason for the IRS to do that, but as a practical matter it’s almost never a disadvantage to be a trader.
That means you don’t have to file as a trader if you don’t want to do so. You may feel that the tax benefits are too small to justify the risk that filing as a trader may provoke an audit of your tax return. Or you may just want to keep things simple. The bottom line: filing as a trader isn’t an election, but it is effectively elective.

Part-Time Traders

The IRS’ Frequently Asked Questions about trader status includes the following statement:

“Basically, if your day trading activity goal is to profit from short-term swings in the market rather than from long-term capital appreciation of investments, and is expected to be your primary income for meeting your personal living expenses, i.e. you do not have another regular job, your trading activity might be a business.”

That seems to imply that you can’t be a trader if you have another regular job, which is plainly incorrect. It’s firmly established that you can have a part-time activity that’s recognized as a “trade or business” under the tax law, and there’s no reason to suppose that the business of trading securities is different from all other businesses in this regard. Naturally, if your activity is part-time you will have a greater burden in showing that it was substantial enough to qualify as a business, but having a different full-time job doesn’t prevent you from qualifying as a trader.

############ Mark-to-market
Consequences of the Election

Marking to market. The most obvious consequence of the election is that at the end of each year you must mark your securities to market. What this means is you treat any stocks you hold at the end of the day on December 31 as if you sold them on that day for the current market value. If the stock has gone down, you get to report a loss without actually selling it. If the stock has gone up, you have to report that gain. Your basis for the stock is adjusted to reflect the gain or loss you report, so that you don’t report the same gain or loss again when you actually sell the stock.
For a true day trader, this aspect of the election is of no significance. You don’t hold stocks at the end of the day, so you don’t hold stocks at the end of the year. Your gains and losses are already in the book. This isn’t true for a position trader (a trader who holds positions longer than a day trader). A position trader who makes the mark-to-market election loses the ability to do year-end tax planning by selling losers and holding winners.

No wash sales. The wash sale rule doesn’t apply to a trader who has made the mark-to-market election. There’s a simple logic to this: if all your gains and losses are going to be flushed out on December 31, there’s no reason for the tax law to be concerned about wash sales that may occur during the year.
Wash sales can be a significant headache for a trader even if they don’t affect the amount of tax the trader has to pay. If you make hundreds of trades in the same stock, many of the trades are likely to result in wash sales. At some point, accounting for all the wash sales becomes nearly impossible. Eliminating this concern is a significant benefit of the mark-to-market election.

Ordinary income and loss. If you make the mark-to-market election, your trading gains and losses are converted to ordinary income and loss. You’ll report the gains and losses on Form 4797 (sales of business property), not Schedule D (capital gains and losses).
This does not mean that your trading gains are now subject to self-employment tax. In a 1998 tax law, Congress clarified that although your trading income becomes ordinary income, it is not self-employment income. This also means you can’t use this income to support a contribution to an IRA or other retirement plan.
Traders usually generate all or nearly all of their gains as short-term capital gains, which are taxed at the same rate as ordinary income. In most situations, changing to a system where the trader reports the gains as ordinary income will not have any tax cost. If the trader has capital losses from an investment that isn’t part of the trading activity, though, the trader will lose the ability to offset those losses with capital gains from trading.
For many traders, the flip side will be more important. Even good traders sometimes have losing years. When they do, the capital loss limitation rears its ugly head. A trader who has not made the mark-to-market election can deduct only $3,000 of net capital loss, with the excess loss carrying forward only, not back to earlier, profitable years. If you make the election, your trading loss isn’t subject to this limitation, and can carry back as well as forward. The difference can be huge.

three impulse waves in his Elliott Wave theory, and many of the most reliable candlestick chart patterns require three candlesticks to reveal what is happening with price action. Prices often unfold in three phases reflecting the psychological attitude of the trading masses –

the unbelieving or skeptic phase,
then a realization and acceptance of the developing trend,
then a period of jumping on the bandwagon of the trend move before it all starts to unravel,
first with doubts about a trend change as the original trend loses momentum,
then with fear about missing or not being onboard the new trending move and
then with giving in to the reality of the trend change.

The cycle repeats itself over and over, as analysts from both the East and West have recognized with their different styles of charts. There is something in this type of price action that seems to be universal and basic to human behavior in any chart language.

############## Banks
* MAY 12, 2009

Inside the Fall of Bear Stearns
In 72 nail-biting hours, an investment bank turned from healthy to nearly insolvent


Bear Stearns Cos., the 85-year-old Wall Street firm known for its tough trading culture, was rescued from impending bankruptcy by a deal with J.P. Morgan Chase & Co. on March 16, 2008 — making Bear the first major casualty of the financial crisis. The firm spiraled from being healthy to practically insolvent in about 72 hours.
[Street Fighters]

Adapted from “Street Fighters: The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street” by Kate Kelly, to be published by Portfolio, a member of Penguin Group (USA) Inc., on Tuesday. Copyright 2009 by Kate Kelly.

The meltdown began in earnest the evening of Thursday, March 13, 2008, when Bear executives made a shocking discovery: They were nearly out of cash. Faced with a slew of withdrawals from worried clients and a sudden pullback from lenders, the firm had less than $3 billion on hand — not enough to open for business on Friday.

Bear chief executive Alan Schwartz immediately called J.P. Morgan, which as Bear’s clearing agent managed its cash, to ask CEO Jamie Dimon for an overnight loan. Mr. Schwartz knew that if a deep-pocketed creditor like J.P. Morgan didn’t come through, Bear’s only option was bankruptcy, and he later phoned New York Federal Reserve Bank president Tim Geithner to say so.

Mr. Dimon, a veteran dealmaker, was willing to try to help. But, concerned about making a major financial commitment after just a few hours of research, he prevailed on the Federal Reserve Board for the funding instead.

During the wee hours of March 14, Fed officials relied on legislative powers that hadn’t been used since the 1930s to find a temporary solution: a loan to Bear of undetermined size, to be provided through J.P. Morgan. What follows is an account of some of the events that surrounded their move.

Thursday, March 13, around 7:45 p.m.

Tim Geithner wasn’t surprised to hear that night from Bear. Early Thursday morning, he had received a call from Alan Schwartz, who had warned him that a cash crisis might be looming.
72 Hours

Government officials and bankers raced the clock through the weekend to sell Bear Stearns.
[Thursday] Corbis
Thursday, March 13, 2008

6:00 p.m.

Chief Executive Alan Schwartz, Chief Financial Officer Sam Molinaro, and other senior Bear executives meet to discuss the firm’s cash position. The shocking news: They’re down to less than $3 billion, not enough to open for business on Friday.
[Geithner] Bloomberg News
Friday, March 14

4:45 a.m.

Federal Reserve Chairman Ben Bernanke, Tim Geithner, president of the Federal Reserve Bank of New York at the time, left, then-Treasury Secretary Hank Paulson, and other government officials hold a nail-biting conference call. They discuss Bear’s precarious position and what a Bear bankruptcy could mean for the broader markets. Fearing disaster, Fed Board members authorize an emergency loan to the troubled investment bank, to be provided through J.P. Morgan.
[Nasdaq] Bloomberg News

7:30 p.m.

En route home from his worst day on the job ever, Mr. Schwartz gets a call from Messrs. Geithner and Paulson, who tell him he must have a deal to sell Bear by Sunday evening. He calls Mr. Molinaro with the news, and they prepare to meet first thing the next morning at the office.
Saturday, March 15

6:00 p.m.

After a long day of due-diligence meetings with executives from J.P. Morgan, who are interested in buying Bear, Mr. Schwartz receives a tentative bid from the large bank: between $8 and $12 per share. He and his team are grim that the price isn’t higher, but relieved to have a potential deal in the works.
[Sunday] Getty Images
Sunday, March 16

9:00 a.m.

J.P. Morgan executives meet to discuss the Bear purchase after a sleepless night of reviewing the smaller firm’s books. Hearing of his team’s grave concerns about the quality of mortgage assets in Bear’s portfolio, J.P Morgan Chase & Co. chairman and CEO Jamie Dimon decides to call off the talks.

Mr. Geithner alerts Messrs. Paulson, right, and Bernanke to the latest development. They discuss whether the government can backstop a J.P. Morgan purchase of Bear by agreeing to absorb potential losses.
[Losses] Reuters

4:45 p.m.

Bear’s investment banker gets a call from J.P. Morgan with the bank’s final bid: $2 per share. Despite misgivings among Bear’s board members, including chairman Jimmy Cayne, directors reluctantly approve the deal.

7:05 p.m.

The down-to-the-wire purchase is announced to the world. About 10 minutes later, the Fed reveals plans to “open the discount window” and allow investment banks to borrow directly from the government, an unprecedented move designed to aid other struggling firms.

Mr. Geithner had spent much of the day talking to his staff and other regulators about the issues that faced the troubled investment bank, trying to gauge how swiftly it might slide downhill. Unlike some officials at the Securities and Exchange Commission, he had taken cold comfort in knowing that Bear had opened that morning with close to $10 billion. What mattered, he felt, wasn’t the hard cash the firm kept on hand, but how long that cash could last under such punitive market conditions. Not long, had been his guess.

The New York Fed president had spoken to Mr. Schwartz earlier in the evening and knew he was contacting J.P. Morgan for a loan. Until he got an update, however, all Mr. Geithner could do was wait. He was eating dinner with his wife and children at their suburban home when Bear’s CEO called with terrible news.

“We’re down to three or four billion and we feel like we’ve got no option but to file,” Mr. Schwartz said, in a reference to bankruptcy.

Mr. Schwartz had also spoken to Jamie Dimon that evening, interrupting the J.P. Morgan chief’s 52nd birthday celebration with his family. “Let’s do something,” the Bear CEO had told him. It was too short notice for a wholesale purchase of Bear, he knew, but the firm wouldn’t open on Friday without a quick cash infusion. He asked Mr. Dimon to consider providing a $25 billion line of credit. Mr. Dimon agreed to look in to it.

After hanging up with Mr. Schwartz, the J.P. Morgan CEO focused on tracking down Steve Black, his point person on a deal of this nature. On vacation with his family in Anguilla, Mr. Black, the co-chief of J.P. Morgan’s investment bank and an old ally of Mr. Dimon’s from their shared days at Citibank, had left his cellphone back at the hotel while he dined out with his wife. Mr. Dimon needed to figure out where his division head was eating and get the phone number of that restaurant.

Friday, 8:30 a.m.

On the sixth floor of Bear’s Madison Avenue headquarters, it was chaos. The elation people had felt at hearing about the Fed’s emergency loan soon gave way to a panicked obsession over the language of the press release that would announce it. Naturally, Bear wanted the wording to sound as upbeat as possible, as though they’d be carrying on business as usual. They also wanted to hint that, just in case things didn’t go well, J.P. Morgan was keen to buy them. But there was debate over how explicit to be about Bear’s merger talks with other parties, which were still at a very early stage.

Another flashpoint was the length of time the Fed money would last. Government officials and J.P. Morgan had proposed suggesting 28 days, a figure that would take Bear well beyond the critical day ahead and give the public the idea that Bear was safe for the moment. Bear lawyers, however, wanted to say “at least 28 days,” in order to leave their options open. But the other side held firm. It would be 28 days at the most, Bear was told.

During these debates, Bear Treasurer Bob Upton scurried between executives’ offices, collecting opinions on the text. But after 90 minutes going back and forth, Mr. Upton snapped. “We gotta get this thing done!” he told Richie Metrick, one of Bear’s senior investment bankers. “Get it into the marketplace.”
Full Coverage

* Bear Stearns — A Year Later
* From Fabled to Forgotten (3/14/09)

But the executives couldn’t figure out which version was the final copy. The treasurer made a quick round of checks, grabbed a printout of what he thought was the right draft, and was rushing over to a copier when Mr. Metrick came screaming out of the CFO’s corner office, where Mr. Schwartz was waiting. “Give me the f- document already!” Mr. Metrick bellowed at Mr. Upton. “I’m trying to get it f- finished!” the treasurer screamed back. He hurtled toward the copier, draft in hand.

Some 15 minutes later, at 9:13, J.P. Morgan’s official press release went out on the business wire and was blasted all over computer news feeds and on CNBC. “JP Morgan Chase and Federal Reserve Bank of New York to Provide Financing to Bear Stearns,” it read. The release went on to say that the bank and the government would together lend Bear “secured funding,” or money backed by collateral, for “an initial period of up to 28 days.” Its last sentence was the most intriguing: “JPMorgan Chase is working closely with Bear Stearns on securing permanent financing or other alternatives for the company.”

Then, at 9:21, a similarly worded release from Bear was issued. Neither press release contained a statement of support from the Fed, whose full board had not yet met to officially approve the loan.

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Bear Stearns
Associated Press
Bear Stearns
Bear Stearns

A few minutes later, the New York Stock Exchange opened for business, and In the 17 minutes between the issuance of the first release and the opening of U.S. stock markets for official trading, Bear shares launched an impressive rally, rising more than 9%. Mortgage traders on the seventh floor were thrilled. “We’re alive!” somebody yelled. The cost of purchasing insurance protection against a default by Bear on its debts was dropping to its lowest point in days, and there was gleeful talk about how the so-called “shorts” — traders hoping to make money on Bear shares’ decline — would get “squeezed,” or lose their shirts.

Mr. Black was packing his things in Anguilla when he caught word of the stock activity. J.P. Morgan had located a corporate jet in Miami, and it was on its way to whisk the executive and his family back to New York, where he could advise on whether to purchase Bear — one of the options now on the table. He shook his head. “People don’t understand what just happened here,” he told his wife. “I guarantee by the time we land, that stock is going to be in half.”

View Full Image
Associated Press

J.P. Morgan CEO Jamie Dimon, left, and Bear Stearns CEO Alan Schwartz, right, testify before the Senate Banking Committee in April 2008. “I just simply have not been able to come up with anything,” Mr. Schwartz said, “even with the benefit of hindsight, which would have made a difference.”

A few minutes later, the New York Stock Exchange opened for business, and those purchasing Bear shares during the light before-market trading period were replaced by a gusher of sellers. The stock quickly erased its gains and began a swift drop.

In Washington, Treasury Secretary Hank Paulson was just beginning a conference call with industry executives. He wanted to get the tone right, so he had sketched out some potential talking points on a legal pad. He didn’t want rapacious trading tactics to further wound a gravely injured Bear, so he decided to put it to the firms straight: I expect you to behave yourselves.

The call began ominously. Technical difficulties made it hard to hear some people. Mr. Schwartz was dialing in from a patchy cellphone, and Mr. Dimon didn’t surface until the conversation was 15 or 20 minutes under way.

When things finally settled down, Mr. Paulson was the first to speak. “I want you to deal with Bear Stearns as a responsible counterparty,” he told the group. “When you’re at a company, you think about protecting yourself at all times,” he added. But these were not normal times. He expected firms not to make unreasonable collateral demands, or calls for extra cash or securities to back up loans, and to trade in good faith with Bear.

Meanwhile, in the nation’s stock markets, Bear wasn’t the only one hurting. Within the first hour of trading, the Dow Jones Industrial Average, the index that tracks blue chip stocks, had fallen more than 300 points, with 29 of its 30 component stocks taking losses. Other financial names, including J.P. Morgan itself, were tumbling.

Having arrived at the airport, Mr. Black found a television. He couldn’t believe how fast the stock declines had been. He had expected Bear shares to fall by the time he landed in four or five hours — not 45 minutes after the opening.

“Paul Friedman liked to joke that Bear people were “not big on titles,” but his was chief operating officer of the firm’s all-important fixed-income division, which handled the trading of mortgages and other bonds” Read the diary of a Bear Stearns Executive

By then the Federal Reserve Board had gathered in its headquarters in the Foggy Bottom section of Washington and approved the emergency loan. Fed Chairman Ben Bernanke and his colleagues hated the thought of financing a bank run with government dollars, but they believed that helping Bear survive the day would be better than allowing it to collapse.

The vote in favor was unanimous.

Sunday, 8:30 a.m.

Mr. Schwartz stood in the twelfth-floor boardroom, surrounded by more than 100 Bear employees. He spoke to the merits of the potential Bear-J.P. Morgan combination. It was the right thing to do, he told the group, and already the cultures seemed to be meshing well, under stressful circumstances.

“We have a deal,” he told the group, “but you’re not going to like it.”
How one bank avoided the meltdown
BNP Paribas helped spark the global credit crunch when it froze three funds a year ago. So why is it the largest bank in the world that hasn’t had to raise any capital?
By Telis Demos, writer-reporter
Last Updated: August 27, 2008: 12:27 PM EDT

NEW YORK (Fortune) — Not every player in banking is getting clobbered these days. BNP Paribas, which sparked part of the very first global credit-crunch panic when it froze three funds on Aug. 9, 2007, may emerge as the bank least affected by the industry’s carnage.

The third-biggest bank in Europe by market value, behind Britain’s HSBC and Spain’s Banco Santander, is the largest bank in the world that has not had to raise any capital since the middle of last year. (Those three funds, frozen because BNP could not decide how to value their securities, re-opened a few weeks later and sustained only small losses.)

The once-government controlled bank, headquartered in an elegant eighteenth-century building in Paris’s opera district, has not had an unprofitable quarter since the crisis began  an honor it shares only with Goldman Sachs (GS, Fortune 500) among comparable financial institutions. Its write-downs and loan losses have been relatively limited: only $3.6 billion worth of subprime-backed debt and leveraged loans out of its $1.8 trillion in assets (vs., say, Merrill Lynch’s (MER, Fortune 500) $51.8 billion in write-downs with just half the asset base). BNP now has the highest S&P creditworthiness rating, AA+, of any global bank of its size. As its competitors flail, BNP has moved up to the world’s tenth-largest bank by market capitalization.

So how did a bank so big manage to avoid the market chaos around it? Unlike many of its peers with sizable investment bank operations, about two-thirds of BNP Paribas’s revenues come from retail banking, mostly in France, Italy, and Spain. With substantial retail deposits (about $650 billion at the end of 2007), it can fund its investment-banking operations with existing capital instead of having to tap short-term lending markets or highly leveraging itself. “People have forgotten that retail banking is a good business model,” says Lewis Kaufman, a portfolio manager at Thornburg Investments who is long on the bank.

Investment banking is seen as an add-on to the core retail business, so BNP Paribas’s focus is on client services that generate fees, not trading those assets to make money for itself. By contrast, the Big Five U.S. investment banks (including the late Bear Stearns) generated more than half their revenues from trading in 2006, up from 41% in 2000, a big chunk of that in mortgage-backed securities. But all that, of course, came crashing down in the second half of last year.

BNP Paribas avoided the temptation of that gusher. “They are very conservative, very traditional bankers,” says Kimon Kalamboussis, an equity analyst at Citigroup in London, “and they won’t touch things unless they understand exactly what they are.”

In 2005, when the worst of the worst subprime-backed securities were being created and sold, BNP was just setting up its desk to trade on behalf of clients who wanted to invest in the U.S. mortgage market. Most of what it bought, it hedged by buying insurance. In June, CEO Baudoin Prot, a former French civil servant who started working at the bank in the early ’80s when it was still state controlled, told analysts that only $1 billion of the bank’s investment assets had been exposed to subprime mortgages.

That prudence is now translating into new opportunities. BNP Paribas has improved its market share in M&A advisory, snagging key roles in deals like Time Warner’s spinoff of its cable business and UBS’s stock sale. It has moved up the league tables in global leveraged-loan issuance (deals in which clients look for strong balance sheets in their lenders), from No. 14 to No. 9, according to deal-tracking firm Dealogic.

With momentum like that, some are wondering whether the bank ought to loosen the reins to take on a bit more risk and raise capital to finance faster growth. Analysts and some within the bank are now urging BNP to buy a big competitor on the cheap to put itself permanently in the bulge bracket. Not likely, say some observers, a few jokingly citing the bank’s use of Carla Bruni to advertise its mutual funds in the 1990s as one of its riskiest moves.

BNP has made several smaller deals this year, including nabbing Bank of America’s prime brokerage unit after other reeling suitors backed off, buying asset-management firms in the Netherlands and the U.K., and taking a stake in a Libyan bank. But CEO Prot and his team who did an $11 billion deal for bank BNL in Italy in 2006 passed on the chance to bid for Société Générale after it was smacked by a rogue trader, and on Citigroup’s Germany retail banking operations when they were put up for sale.

Published speculation that Wachovia would make a good fit proved unfounded, as BNP said it wasn’t considering the move. Same for a suggestion by Merrill Lynch’s analysts that Zions Bank, based in Utah and with branches around the Pacific Northwest, would be a good addition to BNP’s existing U.S. retail subsidiary, Bank of the West in California. “We would rather not invest even if we may miss some short-term revenue opportunities,” says head of asset management and services Alain Papiasse, speaking for the bank.

Though they have not ruled out a capital raise to get a deal done, BNP Paribas’s top management says it isn’t going to be tempted by fire-sale prices. “We are not fashion victims,” says Papiasse. “We are ambitious but still cautious.” French banking, a bastion of stability – who knew

Chaos on Wall Street
The big banks’ fear of big losses is threatening to bring down the entire system, with dire consequences for all of us. Here’s what’s going on, and what we can do about it.
By Allan Sloan, senior editor at large

(Fortune Magazine) — What in the world is going on here? Why is Washington spending billions to bail out Wall Street titans while leaving struggling homeowners to fend for themselves? Why are the Federal Reserve and the Treasury acting as if they’re afraid the world may come to an end, while the stock market seems much less concerned? And finally, what does all this mean to those of us who aren’t financial professionals?

Okay, take a few breaths, pour yourself a beverage of your choice, and I’ll tell you what’s happening – and what I think is going to happen. Although I expect these problems will resolve themselves without a catastrophic meltdown, I’ll also tell you why I’m more nervous about the world financial system now than I’ve ever been in my 40 years of covering business and markets.

Finally, I’ll tell you why I fear that the Wall Street enablers of the biggest financial mess of my lifetime will escape with relatively light damage, leaving the rest of us – and our children and grandchildren – to pay for their misdeeds.

We’re suffering the aftereffects of the collapse of a Tinker Bell financial market, one that depended heavily on borrowed money that has now vanished like pixie dust. Like Tink, the famous fairy from Peter Pan, this market could exist only as long as everyone agreed to believe in it.

So because it was convenient – and oh, so profitable! – players embraced fantasies like U.S. house prices never falling and cheap short-term money always being available. They created, bought, and sold, for huge profits, securities that almost no one understood. And they goosed their returns by borrowing vast amounts of money.
The first shoe

The fantasies began to fade last June when Bear Stearns (BSC, Fortune 500) let two of its hedge funds collapse because of mortgage-backed-securities problems. Debt market – both here and abroad – went sour big-time. That, in turn, became a huge drag on the U.S. economy, bringing on the current economic slowdown.

And before you ask: It’s irrelevant whether or not we’re in a recession, which National Bureau of Economic Research experts define as “a significant decline in economic activity spread across the economy, lasting more than a few months.” What matters is that we’re in a dangerous and messy situation that has produced an economic slowdown unlike those we’re used to seeing.

How is this slowdown different from other slowdowns? Normally the economy goes bad first, creating financial problems. In this slowdown the markets are dragging down the economy – a crucial distinction, because markets are harder to fix than the economy.

A leading political economist, Allan Meltzer of Carnegie Mellon, calls it “an unusual situation, but not unprecedented.” When was the last time it happened in the U.S.? “In 1929,” he says. And it touched off the Great Depression.

No, Meltzer isn’t saying that a Great Depression – 25% unemployment, social unrest, mass hunger, millions of people’s savings wiped out in bank collapses – is upon us. Nor, for that matter, am I. But the precedent is unsettling, to say the least. You can only imagine how unsettling it is to Federal Reserve chairman Ben Bernanke, a former economics professor who made his academic bones writing about the Great Depression.

Academics now feel that the 1929 slowdown morphed into a Great Depression in large part because the Fed tightened credit rather than loosening it. With that precedent in mind, you can see why Bernanke’s Fed is cutting rates rapidly and throwing everything but the kitchen sink at today’s problems. (Bernanke will probably throw that in too, if the Fed’s plumbers can unbolt it.) None of this Alan Greenspan (remember him?) quarter-point-at-a-time stuff for him.
Fear is the culprit

So why hasn’t the cure worked? The problem is that vital markets that most people never see – the constant borrowing and lending and trading among huge institutions – have been paralyzed by losses, fear, and uncertainty. And you can’t get rid of losses, fear, and uncertainty by cutting rates.

Giant institutions are, to use the technical term, scared to death. They’ve had to come back time after time and report additional losses on their securities holdings after telling the market that they had cleaned everything up. It’s whack-a-mole finance – the problems keep appearing in unexpected places. Since the Tink market began tanking, so many shoes have dropped that it looks like Imelda Marcos’s closet.

We’ve had problems with mortgage-backed securities, collateralized debt obligations, collateralized loan obligations, financial insurers, structured investment vehicles, asset-backed commercial paper, auction rate securities, liquidity puts. By the time you read this, something else – my bet’s on credit default swaps – may have become the disaster du jour.

To paraphrase what a top Fednik told me in a moment of candor last fall: You realize that you don’t know what’s in your own portfolio, so how can you know what’s in the portfolio of people who want to borrow from you?

Combine that with the fact that big firms are short of capital because of their losses (some of which have to do with accounting rules I won’t inflict on you today) and that they’re afraid of not being able to borrow enough short-term money to fund their obligations, and you can see why credit has dried up.

The fear – a justifiable one – is that if one big financial firm fails, it will lead to cascading failures throughout the world. Big firms are so interlinked with one another and with other market players that the failure of one large counterparty, as they’re called, can drag down counterparties all over the globe. And if the counterparties fail, it could drag down the counterparties’ counterparties, and so on. Meltdown City.
The long-term view

In 1998 the Fed orchestrated a bailout of the Long-Term Capital Management hedge fund because it had $1.25 trillion in transactions with other institutions. These days that’s almost small beer, because Wall Street has created a parallel banking system in which hedge funds, investment banks, and other essentially unregulated entities took over much of what regulated commercial banks used to do.

But there’s a vital difference. Conventional banks have reason to take something of a long-term view: Mess up and you have no reputation, no bank, no job, no one talking to you at the country club.

In the parallel system a different ethos prevails. If you take big, even reckless, bets and win, you have a great year and you get a great bonus – or in the case of hedge funds, 20% of the profits. If you lose money the following year, you lose your investors’ money rather than your own – and you don’t have to give back last year’s bonus. Heads, you win; tails, you lose someone else’s money.

Bernanke and his point man on Wall Street, New York Fed president Tim Geithner, know everything I’ve said, of course. As does Treasury Secretary Hank Paulson, former head of Goldman Sachs (GS, Fortune 500).

They know a lot more too – such as which specific institutions are running out of the ability to borrow and have huge obligations they need to refinance day in and day out. Walk by Fed facilities in New York City or Washington, and you can feel the fear emanating from the building.

Because these aren’t normal times, the Fed has tried to reassure the markets by inventing three new ways to inundate the financial system with staggering amounts of short-term money. This is in addition to the Fed’s existing mechanisms, which are vast.
Alt-A is the New Subprime

By now, everyone in the world is aware of how bad the subprime mortgage business was. Now it’s time to get ready to hear the same tale, told again, about Alt-A mortgages. These are mortgages made to borrowers with better credit scores than subprime borrowers, but who couldn’t or decided not to document their income. One estimate is that 70% of Alt-A borrowers may have exaggerated their incomes (Wholesale Access). More than half of those people exaggerated their incomes by 50% or more! (Mortgage Asset Research Institute)

How much are we talking about? Around 3 million US borrowers have Alt-A mortgages totaling $1 trillion, compared with $855 billion of subprime loans outstanding. $400 billion of that was sold in 2006. Almost 16% of securitized Alt-A loans issued since January 2006 are at least 60 days late.

Many of these loans (around $270 billion) were interest-only or with a low teaser rate, and the resets were at 3- and 5-year lengths. These are called Option ARMs. That means we’re going to start to see a wave of mortgages resetting to new rates. And it’s no modest increase: Rates can jump 4-8% or more from teaser levels. Some Option ARMs are resetting at 12.25%. That can double a payment.

Wachovia (WB) and Washington Mutual (WM) were big sellers of Alt-A loans, and had $122 billion and $53 billion, respectively, on their books at the end of the second quarter. Is it any wonder their stocks are under pressure?

That’s why it’s so hard to quantify how many more write-offs there will be. You don’t write down a mortgage until it starts to develop problems. These problems may not show up for a few years. I continue to stress I don’t want to own a financial stock that has exposure to mortgage paper. Write-downs are going to continue for a long time.

This means there will be a steady wave of foreclosures for the next 2 years in communities all over the US. As long as these homes keep coming onto the market, they are going to exert downward pressure on prices. Foreclosure sales are up by 109 from this time last year.

3.5 Million Unemployed and Counting

The number of people receiving unemployment benefits jumped to 3.525 million, the highest level since 2003. My friend, Wachovia Chief Economist John Silvia, forecasts that unemployment will rise to 6.7% in 2009 (from 5.5% today) and above 7% in 2010.

Given the inability of US consumers to borrow against their homes, and with rising unemployment, is it any wonder that consumer spending data released this morning showed retail sales dropping 0.3% in August for the second month in a row (July was down 0.5%)? Excluding automobiles, sales dropped 0.7% in August – the most this year.

Countrywide Bondholders Settle; Paulson Bails as Next Wave of Approaches
October 14, 2008

Before we get to the evolution of the bailout, some pending business from the land of restructuring, where the Countrywide Financial saga continues.

On or about October 10, 2008, Bank of New York Mellon (NYSE:BK) and mortgage lender Countrywide Financial, a subsidiary of Bank of America (NYSE:BAC), agreed to settle a Delaware Chancery Court lawsuit involving Countrywide bondholders. “Under the settlement agreement, Countrywide has agreed to commence a tender offer by Oct. 20 for its Series B floating rate convertible senior debentures due 2037. The purchase price for the tender offer will be $980 per $1,000 principal amount of bonds, plus accrued interest,” reports CNN Money.

A reader named Michele writes in agitated spirit, accusing us of poor journalism and worse for not predicting that BAC, behalf of the Countrywide Financial bond holders, would fold so quickly and make these creditors whole. Could Michele be short the CDS? Remember dear friends, The IRA is not an investment advisory service, merely our thoughts on the world. Those of you who speculate on the possible default on a given name or security should seek the counsel of a cleric or bartender.

Says Michele: “There are 2 tranches of convertible debt, the series A and the series B. How do you explain that the series A which are puttable at par this week have been paid off voluntarily by BAC? Secondly the series B action was regarding change of control language, nothing to do with fear of bankruptcy, and finally did you know (apparently not) that BAC in exchange for the MSR put in a 20 billion $ on demand promissory note to pay off all CFC debt obligations. I can’t imagine any explanation on your part other than you got this one wrong.”

No Michele, we was and are right. But let us again go through the saga, the final endgame of which even we still don’t entirely understand. The key to being a good analyst/journalist is always say when you don’t know.

First, even with the $20 billion consideration paid by BAC for the Countrywide servicing business, there still may not be enough assets remaining to satisfy the liquidated and unliquidated claims. This is the key point we made with respect to BAC’s peculiar handling of the Countrywide purchase, a point which was confirmed by the trustee’s lawsuit in Delaware Court. For our original report on the Countrywide/BAC union, (See “Are Countrywide Financial Bonds Bankruptcy Remote?”).

Second, to the holders of Series B floating rate convertible senior debentures due 2037, all we can say is don’t count your chickens until 90 days have elapsed since the payment date. An aggressive bankruptcy trustee might well seek to recover the funds paid out in the tender. But it may not come to a restructuring. And just where are the other indenture trustees behalf of the other countrywide debt holders given the action in DE court?

A cynic might say that BAC has had it both ways with Countrywide; BAC purchased the servicing portfolio out of Countrywide as Michele correctly states, keeping this asset safely out of the way of a bankruptcy, and paying well for same with a $20 billion IOU. This generosity caused the indenture trustee for at least one class of Countrywide Financial debt to rouse itself and to demand repayment, but that still leaves the other creditors and, most important, the unliquidated claims currently in litigation, unresolved. Do we discern a pattern?

Keep in mind that the FDIC-insured bank subsidiary of the firm now known as Countrywide, Countrywide Bank FSB, is losing money at a pretty rapid clip. ROE as of June 30, 2008 was -36% and ROA was -2.58% vs. the bank’s $118 billion in total assets. From a creditor perspective, you have to wonder what if anything will be left if Countrywide Bank must be recapitalized with the remaining assets in the parent holding company. The bank had over 6% tier one capital leverage as of the end of Q2 2008, but look at the negative ROE and the 275bp of default (annualized) through the same date and do the math.

Third, no, we see nothing nefarious in BAC paying the Series A as contracted. To us, the key pattern of consistency in this strange saga has been that the BAC personnel (a) have nothing to say on or off the record and (b) have played the liquidation of Countrywide Financial entirely straight. There is nothing we know of in the public record that suggests that BAC has been anything but fair in administering the claims against Countrywide Financial. Who is to say that BAC is not hoping to pay all or most of the liquidated claims against Countrywide Financial, and then allow one of the remaining creditors to flush the litigation in a bankruptcy?

Note the way in which BAC has been content to allow other parties to make the moves with respect to Countrywide Financial. BAC has allowed one creditor to extricate themselves from the Countrywide mess sans bankruptcy. Given the settlement announcement Friday, there appears to be sufficient basis for the other indenture trustees to demand repayment as well. Meanwhile, various civil plaintiffs and state AGs continue to press their as yet unliquidated claims in the courts.

We see BAC strategy with respect to Countrywide as the classic passive aggressive. The BAC managers won’t do anything unless compelled to do so, so as not to create the basis for an adversarial claim in a possible bankruptcy. But what happens when the bank sub starts consuming the remaining assets? Our view only, you understand.

Why Bailout the Banksters?

And now to the crisis. The equity infusion concept seems to have penetrated the thick cranial cavities of the Washington elite, yet according to today’s headlines some $250 billion in public largesse seems to be flowing to the investment banking friends of Hank Paulson instead of to support banks. What gives?

According to our friend Josh Rosner, the money gets distributed accordingly: New capital for $25 billion each to Citi & JPMorgan; $20 billion to BAC & Wells Fargo (NYSE:WFC); $10 billion each for Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS); $2 to $3 billion for BK and State Street (NYSE:STT); WFC will get additional $5 billion for Wachovia and BAC gets additional $5 billion for acquiring Merrill Lynch (NYSE:MER).

Click here to see the September 23, 3008 letter to member of Congress by John Allison, Chairman & CEO of BB&T (NYSE:BBT). Writes Allison: “We think it is important that Congress hear from the well run financial institutions as most of the concerns have been focused on the problem companies. It is inappropriate that the debate is largely being shaped by the financial institutions who made very poor decisions.” We support equity injections into solvent depositories to support loans and customer deposits, but subsidizing the broker-dealer operations of the remaining banksters and their rancid derivatives books seems a tad ridiculous.

In the wake of the bankruptcy of Lehman Brothers, it is clear to us, at least, that the GS and MS should be sold to or merged with commercial banks and as soon as possible. The legacy, “franchise value” of these firms will never be higher. And of course the Mitsubishi UFJ Financial Group (NYSE:MTU) arrives in the nick of time. Yet again our friends in Tokyo are shown to be a lagging indicator.

But do we really want to lend taxpayer support to floating the last dinosaurs on Wall Street? Please. The reason we are a seller of the GS and MS franchises has to do with the changing business model. That special culture that made GS, MS and other independent dealer firms swashbuckling, borderline criminal enterprises is heading for extinction. Why? Because both of these securities dealers are about to become regulated banks or part of banks, that is, utilities, where payouts to deal guys and gals will be constrained.

Within a matter of weeks or even months, the exodus of smart people will begin as the deal makers migrate to alternative platforms where they can best be compensated for ideas and relationships. Investment banking, after all, is about communicating ideas, nothing more, so the lower the SG&A, the better the yield to commission. The rise of new boutique banking firms is already well underway, but they may well be spending most of their time on restructuring.

In practical terms, due to the depth of the hole which the financial markets have dug for themselves in the US, EU and elsewhere, there must be a substantial role for the government as market maker and capital provider for depository institutions. But we should not expect the government to replace private capital or banking professionals in making the markets function, nor use public funds to bailout speculative activities.

It’s All About Deflation

Six months ago, the problem affecting the markets was perceived to be liquidity or lack thereof. More recently, we have seen the emphasis shift to solvency or the fear of not getting paid, the difference between a market disturbance and a systemic panic.

But ahead lies the prospect of global deflation as the combination of greatly reduced credit availability and sharply lower consumption send the US and the Rest of the World into a prolonged period of economic contraction. It’s not that we are bearish, you understand, but instead we merely observe the global economic system adjusting to significant changes in the underlying financial model.

Just as the financial system skewed to the downside during the 2004-2007 mortgage bubble, pretending that risk equaled zero and value was price, now we are skewing to the other extreme, where risk is infinite and price is effectively zero for many asset classes, whether performing or not. This environment makes writing new business difficult if not impossible for banks.

James Bianco observed to a thread the other day: “The problem is more than banks unwilling to lend to each other, they are also unwilling to borrow from each other. Banks can get all the funding they need (and then some) from their central bank so they do not need to seek a loan from another bank.” True, but we have also eliminated trillions of dollars in financing capacity from the global economy.

We can foresee a situation where it may be necessary to allow counterparties in the interbank/interdealer markets to face the DTCC, with the federal reserve banks and clearinghouse members in each district guaranteeing trades for a short period, say from now through the end of 2008. This could help to eliminate counterparty risk and restore function to the markets. But to Bianco’s point, such moves may not even be necessary.

In fact, maybe the first sign of true recovery will be when the Fed slowly starts to force banks back into the private markets to seek funding, this even while Treasury very publicly makes capital available. To this end, it might be useful for the banking industry to proactively embrace some type of cross-guarantee structure, using the carrot of lower insurance premiums and the stick of enforcement actions to keep all institutions in line when it comes to performance and safety and soundness. Given the FDIC’s power to tax bank capital and earnings, a cross-guarantee scheme seems an obvious way for banks to bolster confidence and claim credit for being proactive.

In our view, the FDIC should combine an aggressive program to work through the troubled bank list with an enhanced regime of performance benchmarking to bolster the industry for approaching losses in 2H 2008 and 2009. Remember, just as the risk skew on the downside during 2004-2007 period was extreme, the mean reversion process now underway could take bank loan loss rates in the US well above early 1990s levels, the highest peak loss rate period since the Depression. The $250 billion in capital injections for the Friends of Hank will be just the down payment to get through the wave of loan losses headed for some of the larger players in the US banking sector. But don’t forget that most smaller, better managed banks in the US will neither want nor need government assistance. More on this next week.;_ylt=AmEMYUAAya1NNAhIBpTvpDJk7ot4?tickers=JPM,C,BAC,XLF,WFC,AIG,FNM

Bailout Nation: More Govt. Control of JPMorgan, Citi, BofA Coming
Posted Oct 20, 2008 11:32am EDT by Aaron Task in Investing, Recession, Banking
Related: JPM, C, BAC, XLF, WFC, AIG, FNM

Rather than resolving the crisis, the government’s plan to inject capital into big banks is “merely the appetizer and soup course” in what will ultimate be a multi-course meal, says Christopher Whalen, managing director at Institutional Risk Analytics.

So what does Whalen see as the main course? Greater government control, if not outright ownership, of the nation’s biggest banks, including:

* Citigroup, which Whalen says is the “riskiest” of the group because of its exposure to consumer loans.
* Bank of America, which faces more Countrywide-related litigation and keeps more of its loans in house, meaning it has “whole loan” risk.
* JPMorgan, which is heavily exposed to potential defaults by businesses and is what Whalen calls an “over-the-counter derivatives exchange with a bank attached.”

Whalen, lauded for forecasting the banking crisis when most others were sanguine, believes the U.S. banking system is going to face $250 billion to $300 billion in additional loan losses in the coming 6 to 9 months. In anticipation of such heavy losses, banks are now diverting capital into loan loss reserves rather than seeking to make new loans.

So when policymakers and politicians say the taxpayer monies injected into the banks is going to be used to make loans, “they are lying to us,” Whalen says, using the kind of candor others are afraid of or can’t afford.

Federal Reserve sets stage for Weimar-style Hyperinflation PDF Print E-mail

F. William Engdahl, 17 December 2008

The Federal Reserve has bluntly refused a request by a major US financial news service to disclose the recipients of more than $2 trillion of emergency loans from US taxpayers and to reveal the assets the central bank is accepting as collateral. Their lawyers resorted to the bizarre argument that they did so to protect ‘trade secrets.’ Is the secret that the US financial system is de facto bankrupt? The latest Fed move is further indication of the degree of panic and lack of clear strategy within the highest ranks of the US financial institutions. Unprecedented Federal Reserve expansion of the Monetary Base in recent weeks sets the stage for a future Weimar-style hyperinflation perhaps before 2010.

On November 7 Bloomberg filed suit under the US Freedom of Information Act (FOIA) requesting details about the terms of eleven new Federal Reserve lending programs created during the deepening financial crisis.

The Fed responded on December 8 claiming it’s allowed to withhold internal memos as well as information about ‘trade secrets’ and ‘commercial information.’ The central bank did confirm that a records search found 231 pages of documents pertaining to the requests.

The Bernanke Fed in recent weeks has stepped in to take a role that was the original purpose of the Treasury’s $700 billion Troubled Asset Relief Program (TARP). The difference between a Fed bailout of troubled financial institutions and a Treasury bailout is that central bank loans do not have the oversight safeguards that Congress imposed upon the TARP. Perhaps those are the ‘trade secrets the hapless Fed Chairman,Ben Bernanke, is so jealously guarding from the public.

Coming hyperinflation?

The total of such emergency Fed lending exceeded $2 trillion on Nov. 6. It had risen by an astonishing 138 percent, or $1.23 trillion, in the 12 weeks since Sept. 14, when central bank governors relaxed collateral standards to accept securities that weren’t rated AAA. They did so knowing that on the following day a dramatic shock to the financial system would occur because they, in concert with the Bush Administration, had decided to let it occur.

On September 15 Bernanke, New York Federal Reserve President, Tim Geithner, the new Obama Treasury Secretary-designate, along with the Bush Administration, agreed to let the fourth largest investment bank, Lehman Brothers, go bankrupt, defaulting on untold billions worth of derivatives and other obligations held by investors around the world. That event, as is now widely accepted, triggered a global systemic financial panic as it was no longer clear to anyone what standards the US Government was using to decide which institutions were ‘too big to fail’ and which not. Since then the US Treasury Secretary has reversed his policies on bank bailouts repeatedly leading many to believe Henry Paulson and the Washington Administration along with the Fed have lost control.

In response to the deepening crisis, the Bernanke Fed has decided to expand what is technically called the Monetary Base, defined as total bank reserves plus cash in circulation, the basis for potential further high-powered bank lending into the economy. Since the Lehman Bros. default, this money expansion rose dramatically by end October at a year-year rate of growth of 38%, has been without precedent in the 95 year history of the Federal Reserve since its creation in 1913. The previous high growth rate, according to US Federal Reserve data, was 28% in September 1939, as the US was building up industry for the evolving war in Europe.

By the first week of December, that expansion of the monetary base had jumped to a staggering 76% rate in just 3 months. It has gone from $836 billion in December 2007 when the crisis appeared contained, to $1,479 billion in December 2008, an explosion of 76% year-on-year. Moreover, until September 2008, the month of the Lehman Brothers collapse, the Federal Reserve had held the expansion of the Monetary Base virtually flat. The 76% expansion has almost entirely taken place within the past three months, which implies an annualized expansion rate of more than 300%.

Despite this, banks do not lend further, meaning the US economy is in a depression free-fall of a scale not seen since the 1930’s. Banks do not lend in large part because under Basle BIS lending rules, they must set aside 8% of their capital against the value of any new commercial loans. Yet the banks have no idea how much of the mortgage and other troubled securities they own are likely to default in the coming months, forcing them to raise huge new sums of capital to remain solvent. It’s far ‘safer’ as they reason to pass on their toxic waste assets to the Fed in return for earning interest on the acquired Treasury paper they now hold. Bank lending is risky in a depression.

Hence the banks exchange $2 trillion of presumed toxic waste securities consisting of Asset-Backed Securities in sub-prime mortgages, stocks and other high-risk credits in exchange for Federal Reserve cash and US Treasury bonds or other Government securities rated (still) AAA, i.e. risk-free. The result is that the Federal Reserve is holding some $2 trillion in largely junk paper from the financial system. Borrowers include Lehman Brothers, Citigroup and JPMorgan Chase, the US’s largest bank by assets. Banks oppose any release of information because that might signal ‘weakness’ and spur short-selling or a run by depositors.

Making the situation even more drastic is the banking model used first by US banks beginning in the late 1970’s for raising deposits, namely the acquiring of ‘wholesale deposits’ by borrowing from other banks on the overnight interbank market. The collapse in confidence since the Lehman Bros. default is so extreme that no bank anywhere, dares trust any other bank enough to borrow. That leaves only traditional retail deposits from private and corporate savings or checking accounts.

To replace wholesale deposits with retail deposits is a process that in the best of times will take years, not weeks. Understandably, the Federal Reserve does not want to discuss this. That is clearly also behind their blunt refusal to reveal the nature of their $2 trillion assets acquired from member banks and other financial institutions. Simply put, were the Fed to reveal to the public precisely what ‘collateral’ they held from the banks, the public would know the potential losses that the government may take.

Congress is demanding more transparency from the Federal Reserve and US Treasury on its bailout lending. On December 10 in Congressional hearings by the House Financial Services Committee, Representative David Scott, a Georgia Democrat, said Americans had ‘been bamboozled,’ slang for defrauded.

Hiccups and Hurricanes

Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson said in September they would meet congressional demands for transparency in a $700 billion bailout of the banking system. The Freedom of Information Act obliges federal agencies to make government documents available to the press and public.

In early December the Congress oversight agency, GAO, issued its first mandated review of the lending of the US Treasury’s $700 billion TARP program (Troubled Asset Relief Program). The review noted that in 30 days since the program began, Henry Paulson’s office had handed out $150 billion of taxpayer money to financial institutions with no effective accountability of how the money is being used. It seems Henry Paulson’s Treasury has indeed thrown a giant ‘tarp’ over the entire taxpayer bailout.

Further adding to the troubles in the world’s former financial Mecca, the US Congress, acting on largely ideological grounds, shocked the financial system when it refused to give even a meager $14 billion emergency loan to the Big Three automakers-General Motors, Chrysler and Ford.

While it is likely that the Treasury will extend emergency credit to the companies until January 20 or until the newly elected Congress can consider a new plan, the prospect of a chain-reaction bankruptcy collapse of the three giant companies is very near. What is being left out of the debate is that those three companies account for a combined 25% of all US corporate bonds outstanding. They are held by private pension funds, mutual funds, banks and others. If the auto parts suppliers of the Big Three are included, an estimated $1 trillion of corporate bonds are now at risk of chain-reaction default. Such a bankruptcy failure could trigger a financial catastrophe which would make what has happened since Lehman Bros. appear as a mere hiccup in a hurricane.

As well, the Federal Reserve’s panic actions since September, by their explosive expansion of the monetary base, has set the stage for a Zimbabwe-style hyperinflation. The new money is not being ‘sterilized’ by offsetting actions by the Fed, a highly unusual move indicating their desperation. Prior to September the Fed’s infusions of money were sterilized, making the potential inflation effect ‘neutral.’

Defining a Very Great Depression

That means once banks begin finally to lend again, perhaps in a year or so, that will flood the US economy with liquidity in the midst of a deflationary depression. At that point or perhaps well before, the dollar will collapse as foreign holders of US Treasury bonds and other assets run. That will not be pleasant as the result would be a sharp appreciation in the Euro and a crippling effect on exports in Germany and elsewhere should the nations of the EU and other non-dollar countries such as Russia, OPEC members and, above all, China not have arranged a new zone of stabilization apart from the dollar.

The world faces the greatest financial and economic challenges in history in coming months. The incoming Obama Administration faces a choice of literally nationalizing the credit system to insure a flow of credit to the real economy over the next 5 to 10 years, or face an economic Armageddon that will make the 1930’s appear a mild recession by comparison.

Leaving aside what appears to have been blatant political manipulation by the present US Administration of key economic data prior to the November election in a vain attempt to downplay the scale of the economic crisis in progress, the figures are unprecedented. For the week ended December 6 initial jobless claims rose to the highest level since November 1982. More than four million workers remained on unemployment, also the most since 1982 and in November US companies cut jobs at the fastest rate in 34 years. Some 1,900,000 US jobs have vanished so far in 2008.

As a matter of relevance, 1982, for those with long memories, was the depth of what was then called the Volcker Recession. Paul Volcker, a Chase Manhattan appendage of the Rockefeller family, had been brought down from New York to apply his interest rate ‘shock therapy’ to the US economy in order as he put it, ‘to squeeze inflation out of the economy.’ He squeezed far more as the economy went into severe recession, and his high interest rate policy detonated what came to be called the Third World Debt Crisis. The same Paul Volcker has just been named by Barack Obama as chairman-designate of the newly formed President’s Economic Recovery Advisory Board, hardly grounds for cheer.

The present economic collapse across the United States is driven by the collapse of the $3 trillion market for high-risk sub-prime and Alt-A home mortgages. Fed Chairman Bernanke is on record stating that the worst should be over by end of December. Nothing could be farther from the truth, as he well knows. The same Bernanke stated in October 2005 that there was ‘no housing bubble to go bust.’ So much for the predictive quality of that Princeton economist. The widely-used S&P Schiller-Case US National Home Price Index showed a 17% year-year drop in the third Quarter, trend rising. By some estimates it will take another five to seven years to see US home prices reach bottom. In 2009 as interest rate resets on some $1 trillion worth of Alt-A US home mortgages begin to kick in, the rate of home abandonments and foreclosures will explode. Little in any of the so-called mortgage amelioration programs offered to date reach the vast majority affected. That process in turn will accelerate as millions of Americans lose their jobs in the coming months.

John Williams of the widely-respected Shadow Government Statistics report, recently published a definition of Depression, a term that was deliberately dropped after World War II from the economic lexicon as an event not repeatable. Since then all downturns have been termed ‘recessions.’ Williams explained to me that some years ago he went to great lengths interviewing the respective US economic authorities at the Commerce Department’s Bureau of Economic Analysis and at the National Bureau of Economic Research (NBER), as well as numerous private sector economists, to come up with a more precise definition of ‘recession,’ ‘depression’ and ‘great depression.’ His is pretty much the only attempt to give a more precise definition to these terms.

What he came up with was first the official NBER definition of recession: Two or more consecutive quarters of contracting real GDP, or measures of payroll employment and industrial production. A depression is a recession in which the peak-to-bottom growth contraction is greater than 10% of the GDP. A Great Depression is one in which the peak-to-bottom contraction, according to Williams, exceeds 25% of GDP.

In the period from August 1929 until he left office President Herbert Hoover oversaw a 43-month long contraction of the US economy of 33%. Barack Obama looks set to break that record, to preside over what historians could likely call the Very Great Depression of 2008-2014, unless he finds a new cast of financial advisers before Inauguration Day, January 20. Required are not recycled New York Fed presidents, Paul Volckers or Larry Summers types. Needed is a radically new strategy to put virtually the entire United States economy into some form of an emergency ‘Chapter 11′ bankruptcy reorganization where banks take write-offs of up to 90% on their toxic assets, that, in order to save the real economy for the American population and the rest of the world. Paper money can be shredded easily. Not human lives. In the process it might be time for Congress to consider retaking the Federal Reserve into the Federal Government as the Constitution originally specified, and make the entire process easier for all. If this sounds extreme, perhaps revisit this article in six months again.

########## TED Spread
The TED spread is the difference between the interest rates on interbank loans and short-term U.S. government debt (“T-bills”).

Initially, the TED spread was the difference between the interest rates for three-month U.S. Treasuries contracts and the three-month Eurodollars contract as represented by the London Interbank Offered Rate (LIBOR). However, since the Chicago Mercantile Exchange dropped T-bill futures, the TED spread is now calculated as the difference between the three-month T-bill interest rate and three-month LIBOR.

TED is an acronym formed from T-Bill and ED, the ticker symbol for the Eurodollar futures contract. The size of the spread is usually denominated in basis points (bps). For example, if the T-bill rate is 5.10% and ED trades at 5.50%, the TED spread is 40 bps. The TED spread fluctuates over time, but historically has often remained within the range of 10 and 50 bps (0.1% and 0.5%), until 2007. A rising TED spread often presages a downturn in the U.S. stock market, as it indicates that liquidity is being withdrawn.


The TED spread is an indicator of perceived credit risk in the general economy.[1] This is because T-bills are considered risk-free while LIBOR reflects the credit risk of lending to commercial banks. When the TED spread increases, that is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. Interbank lenders therefore demand a higher rate of interest, or accept lower returns on safe investments such as T-bills. When the risk of bank defaults is considered to be decreasing, the TED spread decreases.[2]

[edit] Historical levels

During 2007, the subprime mortgage crisis ballooned the TED spread to a region of 150-200 bps. On September 17, 2008, the record set after the Black Monday crash of 1987 was broken as the TED spread exceeded 300 bps.[3] Some higher readings for the spread were due to inability to obtain accurate LIBOR rates in the absence of a liquid unsecured lending market.[4] On October 10, 2008, the TED spread reached another new high of 465 basis points. The longterm average of the TED has been 30 basis points.

[If] you’re lending your money to the U.S. government for three months, you feel pretty much 100 percent certain that in three months the U.S. government is going to be in a position to pay you back. That’s seen as the base of the whole global risk system. Nothing should be cheaper than that, because nothing is less risky.

But pretty close to the second least risky thing is banks lending money to other banks for a period of something like three months. … LIBOR is the London Interbank Offered Rate; it’s the rate set every morning by the British Bankers Association. Basically LIBOR is — if one major top bank in the world wants to lend money for three months to another major top bank in the world, that’s the rate that they do it at. …

The TED Spread, the distance between the Treasury rate and the LIBOR rate, should be very small because that should just be the tiny bit of additional risk between the U.S. government and one of the top banks in the world. It’s mostly been for the last several years before this time around 20 basis points, which means 0.2 percent. Very little daylight between these two rates. Most of its history, I think around 50 basis points, very small, very close together. And suddenly it starts skyrocketing up.

In August ’07.

In August ’07. … It’s close to unprecedented. And really weird stuff happening. In the past, you would see it spike, and then it would come down right away. But it’s sustaining that high, high level. And that’s telling you that banks are not lending money to other banks unless they’re really coaxed into it by giving them a lot of money in return.

And that for sure is beginning to scare the Treasury secretary, the Fed chairman, lots of market players. This is the base of capitalism. This is the base of our financial system — banks lending money to other banks.

############## Derivatives

The Definition
Derivatives are financial products with value that stems from an underlying asset or set of assets. These can be stocks, debt issues, or almost anything. A derivative’s value is based on an asset, but ownership of a derivative doesn’t mean ownership of the asset.

Derivatives are financial instruments whose values depend on the value of other underlying financial instruments. The main types of derivatives are futures, forwards, options and swaps.

The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a wide range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), residential mortgages, commercial real estate loans, bonds, interest rates, exchange rates, or indices (such as a stock market index, consumer price index (CPI)

The Future of Healthy Hen Farms
Gail, the owner of Healthy Hen Farms, is worried about the volatility of the chicken market with all the sporadic reports of bird flu coming out of the east. Gail wants a way to protect her business against another spell of bad news. Gail meets with an investor who enters into a futures contract with her.

The investor agrees to pay $30 per bird when the birds are ready for slaughter, say, in six months time, regardless of the market price. If, at that time, the price is above $30, the investor will get the benefit as he or she will be able to buy the birds for less than market cost and sell them onto the market at a higher price for a gain.

If the price goes below $30, then Gail will be receiving the benefit because she will be able to sell her birds for more than the current market price, or what she would have gotten for the birds in the open market.

By entering into a futures contract, Gail is protected from price changes in the market, as she has locked in a price of $30 per bird. She may lose out if the price flies up to $50 per bird on a mad cow scare, but she will be protected if the price falls to $10 on news of a bird flu outbreak.

By hedging with a futures contract, Gail is able to focus on her business and limit her worry about price fluctuations.

Gail has decided that it’s time to take Healthy Hen Farms to the next level. She has already acquired all the smaller farms near her and is looking at opening her own processing plant. She tries to get more financing, but the lender, Lenny, rejects her.

The reason is that Gail financed her takeovers of the other farms through a massive variable-rate loan and the lender is worried that, if interest rates rise, Gail won’t be able to pay her debts. He tells Gail that he will only lend to her if she can convert the loan to a fixed-rate. Unfortunately, her other lenders refuse to change her current loan terms because they are hoping interest rates will increase too.

Gail gets a lucky break when she meets Sam, the owner of a chain of restaurants. Sam has a fixed-rate loan about the same size as Gail’s and he wants to convert it to a variable-rate loan because he hopes interest rates will decline in the future.

For similar reasons, Sam’s lenders won’t change the terms of the loan. Gail and Sam decide to swap loans. They work out a deal by which Gail’s payments go toward Sam’s loan and his go toward Gail’s loan. Although the names on the loans haven’t changed, their contract allows them both to get the type of loan they want

This is a bit risky for both of them because if one of them defaults or goes bankrupt, the other will be snapped back into his or her old loan, which may require a payment for which either Gail of Sam may be unprepared. But it allows for them to modify their loans to meet their individual needs.

Buying Debt
Lenny, Gail’s financier, ponies up the additional capital at a favorable interest rate and Gail goes away happy. Lenny is pleased as well because his money is out there getting a return, but he is also a little worried that Sam or Gail may fail in their business.

To make matters worse, Lenny’s friend Dale comes to him asking for money to start his own film company. Lenny knows Dale has a lot of collateral and that the loan would be at a higher interest rate because of the more volatile nature of the movie industry, so he’s kicking himself for loaning all his capital to Gail.

Fortunately for Lenny, derivatives offer another solution. Lenny spins Gail’s loan into a credit derivative and sells it to a speculator at a discount to the true value. Although Lenny doesn’t see the full return on the loan, he gets his capital back and can issue it out again to his friend Dale.

Lenny likes this system so much that he continues to spin out his loans as credit derivatives, taking modest returns in exchange for less risk of default and more liquidity.

Years later, Healthy Hen Farms is a publicly traded corporation (the ticker symbol is (obviously) HEN) and is America’s largest poultry producer. Gail and Sam are both looking forward to retirement.

Over the years, Sam bought quite a few shares of HEN. In fact, he has more than $100,000 invested in the company. Sam is getting nervous because he is worried that some shock, another case of bird flu for example, might wipe out a huge chunk of his retirement money. Sam starts looking for someone to take the risk off his shoulders. Lenny, financier extraordinaire and an active writer of options, agrees to give him a hand.

Lenny outlines a deal in which Sam pays Lenny a fee to for the right (but not the obligation) to sell Lenny the HEN shares in a year’s time at their current price of $25 per share. If the share prices plummet, Lenny protects Sam from the loss of his retirement savings.

Lenny is OK because he has been collecting the fees and can handle the risk. This is called a put option, but it can be done in reverse by someone agreeing to buy a stock in the future at a fixed price (called a call option).

################## Collateral

What does it Mean? Properties or assets that are offered to secure a loan or other credit. Collateral becomes subject to seizure on default.
Investopedia Says… Collateral is a form of security to the lender in case the borrower fails to pay back the loan.

For example, if you get a mortgage, your collateral would be your house. In margin trading, the securities in your account act as collateral in the case of a margin call.

################ Liquidity

Liquidity is the term used to describe how easy it is to convert assets to cash. The most liquid asset, and what everything else is compared to, is cash. This is because it can always be used easily and immediately.

Certificates of deposit are slightly less liquid, because there is usually a penalty for converting them to cash before their maturity date. Savings bonds are also quite liquid, since they can be sold at a bank fairly easily. Finally, shares of stock, bonds, options and commodities are considered fairly liquid, because they can usually be sold readily and you can receive the cash within a few days. Each of the above can be considered as cash or cash equivalents because they can be converted to cash with little effort, although sometimes with a slight penalty

Moving down the scale, we run into assets that take a bit more effort or time before they can be realized as cash. One example would be preferred or restricted shares, which usually have covenants dictating how and when they might be sold. Other examples are items like coins, stamps, art, and other collectibles. If you were to sell to another collector, you might get full value but it could take a while, even with the internet easing the way. If you go to a dealer instead, you could get cash more quickly, but you may receive less of it.

The least liquid asset is usually considered to be real estate because that can take weeks or months to sell.

When we invest in any assets, we need to keep their liquidity levels in mind because it can be difficult or time consuming to convert certain assets back into cash.

Other than selling an asset, cash can be obtained by borrowing against it. While this may be done privately between two people, it is more often done through a bank. A bank has the cash from many depositors pooled together and can more easily meet the needs of any borrower.

Furthermore, if a depositor needs cash right away, that person can just withdraw it from the bank rather than going to the borrower and demanding payment of the entire note. Thus, banks act as financial intermediaries between lenders and borrowers, allowing for a smooth flow of money and meeting the needs of each side of a loan.

Liquidity and the Stock Market
In the market, liquidity has a slightly different meaning, although still tied to how easily assets, in this case shares of stock, can be converted to cash. The market for a stock is said to be liquid if the shares can be rapidly sold and the act of selling has little impact on the stock’s price. Generally, this translates to where the shares are traded and the level of interest that investors have in the company. Company stock traded on the major exchanges can usually be considered liquid. Often, approximately 1% of the float trades hands daily, indicating a high degree of interest in the stock. On the other hand, company stock traded on the pink sheets or over the counter are often non-liquid, with very few, even zero, shares traded daily.

Another way to judge liquidity in a company’s stock is to look at the bid/ask spread. For liquid stocks, such as Microsoft or General Electric, the spread is often just a few pennies – much less than 1% of the price. For illiquid stocks, the spread can be much larger, amounting to a few percent of the trading price

Liquidity and Companies
One last understanding of liquidity is especially important for investors: the liquidity of companies that we may wish to invest in.

Cash is a company’s lifeblood. In other words, a company can sell lots of widgets and have good net earnings, but if it can’t collect the actual cash from its customers on a timely basis, it will soon fold up, unable to pay its own obligations.

A more stringent measure is the quick ratio, sometimes called the acid test ratio. This uses current assets (excluding inventory) and compares them to current liabilities. Inventory is removed because, of the various current assets such as cash, short-term investments or accounts receivable, this is the most difficult to convert into cash. A value of greater than one is usually considered good from a liquidity viewpoint, but this is industry dependent.

############### Intagible Assets

What can explain the runaway success of an initial public offering from a company with no earnings history? On the other hand, why can a bit of bad news or an earnings report that just misses market expectations send a healthy company’s share price into a nosedive?

When the market ignores a company’s historical financial performance, the market is often responding to “information asymmetry”. The asymmetry occurs because traditional financial reporting methods – audited financial reports, analyst reports, press releases and the like – disclose only a fraction of the information that is relevant to investors. The value of intangible assets – research and development (R&D), patents, copyrights, customer lists and brand equity – represents a large part of that information gap.

Any business professor will tell you that the value of companies has been shifting markedly from tangible assets, “bricks and mortar”, to intangible assets like intellectual capital. These invisible assets are the key drivers of shareholder value in the knowledge economy, but accounting rules do not acknowledge this shift in the valuation of companies. Statements prepared under generally accepted accounting principles do not record these assets. Left in the dark, investors must rely largely on guesswork to judge the accuracy of a company’s value.

A study comparing market value to the book value of 3,500 U.S. companies over a period of two decades shows the dramatic upward rise in intangible value. In 1978, market value and book value were pretty much matched: book value was 95% of market value. Twenty years on, book value was just 28% of market value. Lev Baruch, an accounting professor at New York University’s Stern School of Business, reckons that in the late 1990s businesses invested a staggering $1 trillion per year in intangible assets.

Accounting rules have not kept pace. For instance, if the R&D efforts of a pharmaceuticals company create a new drug that passes clinical trials, the value of that development is not found in the financial statements. It doesn’t show up until sales are actually made, which could be several years down the road. Or consider the value of an e-commerce retailer. Arguably, almost all of its value comes from software development and copyrights and its user base. While the market reacts immediately to clinical trial results or online retailers’ customer churn, these assets slip through financial statements.

There is a serious disconnection between what happens in capital markets and what accounting systems reflect. Accounting value is based on the historical costs of equipment and inventory, whereas market value comes from expectations about a company’s future cash flow, which comes in large part from intangibles such as R&D efforts, patents and good ol’ workforce “know-how”.

Investors’ jumpiness about valuation hardly comes as a surprise. Imagine investing in a company with $2 billion market capitalization but with revenues to date of only $100 million. You would probably suspect that there is a big grey area in the valuation picture. Perhaps you would turn to analysts to supply missing information. But analysts’ metrics help only so much. Rumor and innuendo, PR and the press, speculation and hype tend to fill the information space.

In order to better milk their patents and brands, many companies do measure their worth. But these numbers are rarely available for public consumption. Even when used internally, they can be troublesome. Miscalculating the future cash flows generated from a patent, say, could prompt a management team to build a factory that it cannot afford.

To be sure, investors could benefit from financial reporting that includes improved disclosure. Already a dozen or so countries, including the U.K. and France, allow recognition of brand as a balance sheet asset. The Financial Accounting Standards Board is currently involved in a study to determine whether or not it should require intangibles on the balance sheet. However, because of the enormous difficulty of actually valuing intangibles and the big risk of inaccurate measurements or surprise write-downs, investors should not expect that decision to come any time soon.

It nevertheless pays for investors to try to get a grip on intangibles. Much accounting research is devoted to coming up with ways of valuing them, and, fortunately, techniques are improving. While opinions on suitable approaches still vary sharply, it is worthwhile for investors to take a look.

Here is a place to start: try calculating the total value of a company’s intangible assets. One method is calculated intangible value (CIV). This method overcomes drawbacks of the market-to-book method of valuing intangibles, which simply subtracts a company’s book value from its market value and labels the difference. Because it rises and falls with market sentiment, the market-to-book figure cannot give a fixed value of intellectual capital. CIV, on the other hand, examines earnings performance and identifies the assets that produced those earnings. In many cases, CIV also points to the enormity of the unrecorded value.

Using microprocessor giant Intel as an example, CIV goes something like this:

Step 1: Calculate average pre-tax earnings for the past three years. For Intel, that’s $9.5 billion.

Step 2: Go to the balance sheet and get the average year-end tangible assets for the same three years, which, in this case, is $37.6 billion.

Step 3: Calculate Intel’s return on assets (ROA), by dividing earnings by assets: 25% (nice business to be making chips).

Step 4: For the same three years, find the industry’s average ROA. The average for the semiconductor industry is around 11%.

Step 5: Calculate the excess ROA by multiplying the industry average ROA (11%) by the company’s tangible assets ($37.6 billion). Subtract that from the pre-tax earnings in step one ($9.5 billion). For Intel, the excess is $5.36 billion. This tells you how much more than the average chip maker Intel earns from its assets.

Step 6: Pay the taxman. Calculate the three-year average income tax rate and multiply this by the excess return. Subtract the result from the excess return to come up with an after-tax number, the premium attributable to intangible assets. For Intel (average tax rate 34%), that figure is $3.53 billion.

Step 7: Calculate the net present value of the premium. Do this by dividing the premium by an appropriate discount rate, such as the company’s cost of capital. Using an arbitrary discount rate of 10% yields $35.3 billion.

That’s it. The calculated intangible value of Intel’s intellectual capital – what doesn’t appear on the balance sheet – amounts to a whopping $35.3 billion! Assets that big deserve to see the light of day.

############ Money Market

The money market is a subsection of the fixed income market. We generally think of the term fixed income as being synonymous to bonds. In reality, a bond is just one type of fixed income security. The difference between the money market and the bond market is that the money market specializes in very short-term debt securities (debt that matures in less than one year). Money market investments are also called cash investments because of their short maturities.

One of the main differences between the money market and the stock market is that most money market securities trade in very high denominations. This limits access for the individual investor. Furthermore, the money market is a dealer market, which means that firms buy and sell securities in their own accounts, at their own risk. Compare this to the stock market where a broker receives commission to acts as an agent, while the investor takes the risk of holding the stock. Another characteristic of a dealer market is the lack of a central trading floor or exchange. Deals are transacted over the phone or through electronic systems.

The easiest way for us to gain access to the money market is with a money market mutual funds, or sometimes through a money market bank account. These accounts and funds pool together the assets of thousands of investors in order to buy the money market securities on their behalf. However, some money market instruments, like Treasury bills, may be purchased directly. Failing that, they can be acquired through other large financial institutions with direct access to these markets.

Treasury Bills (T-bills) are the most marketable money market security. Their popularity is mainly due to their simplicity. Essentially, T-bills are a way for the U.S. government to raise money from the public. In this tutorial, we are referring to T-bills issued by the U.S. government, but many other governments issue T-bills in a similar fashion.

T-bills are short-term securities that mature in one year or less from their issue date. They are issued with three-month, six-month and one-year maturities. T-bills are purchased for a price that is less than their par (face) value; when they mature, the government pays the holder the full par value. Effectively, your interest is the difference between the purchase price of the security and what you get at maturity. For example, if you bought a 90-day T-bill at $9,800 and held it until maturity, you would earn $200 on your investment. This differs from coupon bonds, which pay interest semi-annually.

Treasury bills (as well as notes and bonds) are issued through a competitive bidding process at auctions. If you want to buy a T-bill, you submit a bid that is prepared either non-competitively or competitively. In non-competitive bidding, you’ll receive the full amount of the security you want at the return determined at the auction. With competitive bidding, you have to specify the return that you would like to receive. If the return you specify is too high, you might not receive any securities, or just a portion of what you bid for. (More information on auctions is available at the TreasuryDirect website.)

The biggest reasons that T-Bills are so popular is that they are one of the few money market instruments that are affordable to the individual investors. T-bills are usually issued in denominations of $1,000, $5,000, $10,000, $25,000, $50,000, $100,000 and $1 million. Other positives are that T-bills (and all Treasuries) are considered to be the safest investments in the world because the U.S. government backs them. In fact, they are considered risk-free. Furthermore, they are exempt from state and local taxes.

********** Commercial Bank
A commercial bank is a type of financial intermediary and a type of bank. Commercial banking is also known as business banking. It is a bank that provides checking accounts, savings accounts, and money market accounts and that accepts time deposits.[1] After the Great Depression, the U.S. Congress required that banks engage only in banking activities, whereas investment banks were limited to capital market activities. As the two no longer have to be under separate ownership under U.S. law, some use the term “commercial bank” to refer to a bank or a division of a bank primarily dealing with deposits and loans from corporations or large businesses. In some other jurisdictions, the strict separation of investment and commercial banking never applied. Commercial banking may also be seen as distinct from retail banking, which involves the provision of financial services direct to consumers. Many banks offer both commercial and retail banking services.

Commercial bank has two possible meanings:

* Commercial bank is the term used for a normal bank to distinguish it from an investment bank.

This is what people normally call a “bank”. The term “commercial” was used to distinguish it from an investment bank. Since the two types of banks no longer have to be separate companies, some have used the term “commercial bank” to refer to banks that focus mainly on companies. In some English-speaking countries outside North America, the term “trading bank” was and is used to denote a commercial bank. During the great depression and after the stock market crash of 1929, the U.S. Congress passed the Glass-Steagall Act 1933-35 (Khambata 1996) requiring that commercial banks engage only in banking activities (accepting deposits and making loans, as well as other fee based services), whereas investment banks were limited to capital markets activities. This separation is no longer mandatory.

It raises funds by collecting deposits from businesses and consumers via checkable deposits, savings deposits, and time (or term) deposits. It makes loans to businesses and consumers. It also buys corporate bonds and government bonds. Its primary liabilities are deposits and primary assets are loans and bonds.

* Commercial banking can also refer to a bank or a division of a bank that mostly deals with deposits and loans from corporations or large businesses, as opposed to normal individual members of the public (retail banking).

Types of loans granted by commercial banks

[edit] Secured loan

A secured loan is a loan in which the borrower pledges some asset (e.g., a car or property) as collateral (i.e., security) for the loan.

[edit] Mortgage loan

A mortgage loan is a very common type of debt instrument, used to purchase real estate. Under this arrangement, the money is used to purchase the property. Commercial banks, however, are given security – a lien on the title to the house – until the mortgage is paid off in full. If the borrower defaults on the loan, the bank would have the legal right to repossess the house and sell it, to recover sums owing to it.

In the past, commercial banks have not been greatly interested in real estate loans and have placed only a relatively small percentage of their assets in mortgages. As their name implies, such financial institutions secured their earning primarily from commercial and consumer loans and left the major task of home financing to others. However, due to changes in banking laws and policies, commercial banks are increasingly active in home financing.

Changes in banking laws now allow commercial banks to make home mortgage loans on a more liberal basis than ever before. In acquiring mortgages on real estate, these institutions follow two main practices. First, some of the banks maintain active and well-organized departments whose primary function is to compete actively for real estate loans. In areas lacking specialized real estate financial institutions, these banks become the source for residential and farm mortgage loans. Second, the banks acquire mortgages by simply purchasing them from mortgage bankers or dealers.

In addition, dealer service companies, which were originally used to obtain car loans for permanent lenders such as commercial banks, wanted to broaden their activity beyond their local area. In recent years, however, such companies have concentrated on acquiring mobile home loans in volume for both commercial banks and savings and loan associations. Service companies obtain these loans from retail dealers, usually on a nonrecourse basis. Almost all bank/service company agreements contain a credit insurance policy that protects the lender if the consumer defaults.

[edit] Unsecured loan

Unsecured loans are monetary loans that are not secured against the borrowers assets (i.e., no collateral is involved). These may be available from financial institutions under many different guises or marketing packages:

* credit card debt,
* personal loans,
* bank overdrafts
* credit facilities or lines of credit
* corporate bonds

************** Investment banking

An Investment Bank is a financial institution that deals with raising capital, trading in securities and managing corporate mergers and acquisitions. Investment banks profit from companies and governments by raising money through issuing and selling securities in the capital markets (both equity, bond) and insuring bonds (selling CDS or Credit Default Swaps), as well as providing advice on transactions such as mergers and acquisitions. To perform these services in the United States, an adviser must be a licensed broker-dealer, and is subject to SEC (FINRA) regulation. Until the late 1980s, the United States maintained a separation between investment banking and commercial banks. Other developed countries (including G7 countries) have not maintained this separation historically. A majority of investment banks offer strategic advisory services for mergers, acquisitions, divestiture or other financial services for clients, such as the trading of derivatives, fixed income, foreign exchange, commodity, and equity securities.

Trading securities for cash or securities (i.e., facilitating transactions, market-making), or the promotion of securities (i.e., underwriting, research, etc.) was referred to as the “sell side”.

Dealing with the pension funds, mutual funds, hedge funds, and the investing public who consumed the products and services of the sell-side in order to maximize their return on investment constitutes the “buy side”. Many firms have buy and sell side components.

The last two major bulge bracket firms on Wall Street were Goldman Sachs and Morgan Stanley until both banks elected to convert to traditional banking institutions on September 22, 2008, as part of a response to the U.S. financial crisis.[1] Barclays, Citigroup, Credit Suisse, Deutsche Bank, HSBC, JP Morgan Chase, and UBS AG are “universal banks” rather than bulge-bracket investment banks, since they also accept deposits (though not all of them have U.S. branches).

Front office

* Investment banking is the traditional aspect of the investment banks which also involves helping customers raise funds in the capital markets and advise on mergers and acquisitions. These jobs pay well, so are often extremely competitive and difficult to land. Investment banking may involve subscribing investors to a security issuance, coordinating with bidders, or negotiating with a merger target. Other terms for the investment banking division include mergers and acquisitions (M&A) and corporate finance. The investment banking division (IBD) is generally divided into industry coverage and product coverage groups. Industry coverage groups focus on a specific industry such as healthcare, industrials, or technology, and maintain relationships with corporations within the industry to bring in business for a bank. Product coverage groups focus on financial products, such as mergers and acquisitions, leveraged finance, equity, and high-grade debt.

* Investment management is the professional management of various securities (shares, bonds, etc.) and other assets (e.g. real estate), to meet specified investment goals for the benefit of the investors. Investors may be institutions (insurance companies, pension funds, corporations etc.) or private investors (both directly via investment contracts and more commonly via collective investment schemes eg. mutual funds). The investment management division of an investment bank is generally divided into separate groups, often known as Private Wealth Management and Private Client Services. Asset Management market making, traders will buy and sell financial products with the goal of making an incremental amount of money on each trade. Sales is the term for the investment banks sales force, whose primary job is to call on institutional and high-net-worth investors to suggest trading ideas (on caveat emptor basis) and take orders. Sales desks then communicate their clients’ orders to the appropriate trading desks, who can price and execute trades, or structure new products that fit a specific need.

* Structuring has been a relatively recent division as derivatives have come into play, with highly technical and numerate employees working on creating complex structured products which typically offer much greater margins and returns than underlying cash securities. The necessity for numerical ability has created jobs for physics and math Ph.D.s who act as quantitative analysts.

* Merchant banking is a private equity activity of investment banks.[2] Current examples include Goldman Sachs Capital Partners and JPMorgan’s One Equity Partners. (Originally, “merchant bank” was the British English term for an investment bank.)

* Research is the division which reviews companies and writes reports about their prospects, often with “buy” or “sell” ratings. While the research division generates no revenue, its resources are used to assist traders in trading, the sales force in suggesting ideas to customers, and investment bankers by covering their clients. There is a potential conflict of interest between the investment bank and its analysis in that published analysis can affect the profits of the bank. Therefore in recent years the relationship between investment banking and research has become highly regulated requiring a Chinese wall between public and private functions.

* Strategy is the division which advises external as well as internal clients on the strategies that can be adopted in various markets. Ranging from derivatives to specific industries, strategists place companies and industries in a quantitative framework with full consideration of the macroeconomic scene. This strategy often affects the way the firm will operate in the market, the direction it would like to take in terms of its proprietary and flow positions, the suggestions salespersons give to clients, as well as the way structurers create new products.

[edit] Middle office

* Risk management involves analyzing the market and credit risk that traders are taking onto the balance sheet in conducting their daily trades, and setting limits on the amount of capital that they are able to trade in order to prevent ‘bad’ trades having a detrimental effect to a desk overall. Another key Middle Office role is to ensure that the above mentioned economic risks are captured accurately (as per agreement of commercial terms with the counterparty), correctly (as per standardized booking models in the most appropriate systems) and on time (typically within 30 minutes of trade execution). In recent years the risk of errors has become known as “operational risk” and the assurance Middle Offices provide now includes measures to address this risk. When this assurance is not in place, market and credit risk analysis can be unreliable and open to deliberate manipulation.

* Finance areas are responsible for an investment bank’s capital management and risk monitoring. By tracking and analyzing the capital flows of the firm, the Finance division is the principal adviser to senior management on essential areas such as controlling the firm’s global risk exposure and the profitability and structure of the firm’s various businesses. In the United States and United Kingdom, a Financial Controller is a senior position, often reporting to the Chief Financial Officer.

* Compliance areas are responsible for an investment bank’s daily operations’ compliance with government regulations and internal regulations. Often also considered a back-office division.

[edit] Back office

* Operations involves data-checking trades that have been conducted, ensuring that they are not erroneous, and transacting the required transfers. While some[who?] believe that operations provides the greatest job security and the bleakest career prospects of any division within an investment bank, many banks have outsourced operations. It is, however, a critical part of the bank. Due to increased competition in finance related careers, college degrees are now mandatory at most Tier 1 investment banks.[citation needed] A finance degree has proved significant in understanding the depth of the deals and transactions that occur across all the divisions of the bank.

* Technology refers to the information technology department. Every major investment bank has considerable amounts of in-house software, created by the technology team, who are also responsible for technical support. Technology has changed considerably in the last few years as more sales and trading desks are using electronic trading. Some trades are initiated by complex algorithms for hedging purposes.

[edit] Chinese wall

An investment bank can also be split into private and public functions with a Chinese wall which separates the two to prevent information from crossing. The private areas of the bank deal with private insider information that may not be publicly disclosed, while the public areas such as stock analysis deal with public information.

Size of industry

Global investment banking revenue increased for the fifth year running in 2007, to $84.3 billion.[3] This was up 21% on the previous year and more than double the level in 2003. Despite a record year for fee income, many investment banks have experienced large losses related to their exposure to U.S. sub-prime securities investments.

The United States was the primary source of investment banking income in 2007, with 53% of the total, a proportion which has fallen somewhat during the past decade. Europe (with Middle East and Africa) generated 32% of the total, slightly up on its 30% share a decade ago. Asian countries generated the remaining 15%. Over the past decade, fee income from the US increased by 80%. This compares with a 217% increase in Europe and 250% increase in Asia during this period. The industry is heavily concentrated in a small number of major financial centres, including New York City, London and Tokyo.

Investment banking is one of the most global industries and is hence continuously challenged to respond to new developments and innovation in the global financial markets. Throughout the history of investment banking, it is only known that many have theorized that all investment banking products and services would be commoditized. New products with higher margins are constantly invented and manufactured by bankers in hopes of winning over clients and developing trading know-how in new markets. However, since these can usually not be patented or copyrighted, they are very often copied quickly by competing banks, pushing down trading margins.[citation needed]

For example, trading bonds and equities for customers is now a commodity business[citation needed], but structuring and trading derivatives retains higher margins in good times – and the risk of large losses in difficult market conditions, such as the credit crunch that began in 2007. Each over-the-counter contract has to be uniquely structured and could involve complex pay-off and risk profiles. Listed option contracts are traded through major exchanges, such as the CBOE, and are almost as commoditized as general equity securities.

In addition, while many products have been commoditized, an increasing amount of profit within investment banks has come from proprietary trading, where size creates a positive network benefit (since the more trades an investment bank does, the more it knows about the market flow, allowing it to theoretically make better trades and pass on better guidance to clients).

The fastest growing segment of the investment banking industry are private investments into public companies (PIPEs, otherwise known as Regulation D or Regulation S). Such transactions are privately negotiated between companies and accredited investors. These PIPE transactions are non-rule 144A transactions. Large bulge bracket brokerage firms and smaller boutique firms compete in this sector. Special purpose acquisition companies (SPACs) or blank check corporations have been created from this industry.[citations needed]

[edit] Vertical integration

In the U.S., the Glass-Steagall Act, initially created in the wake of the Stock Market Crash of 1929, prohibited banks from both accepting deposits and underwriting securities which led to segregation of investment banks from commercial banks. Glass-Steagall was effectively repealed for many large financial institutions by the Gramm-Leach-Bliley Act in 1999.

Another development in recent years has been the vertical integration of debt securitization.[citation needed] Previously, investment banks had assisted lenders in raising more lending funds and having the ability to offer longer term fixed interest rates by converting the lenders’ outstanding loans into bonds. For example, a mortgage lender would make a house loan, and then use the investment bank to sell bonds to fund the debt, the money from the sale of the bonds can be used to make new loans, while the lender accepts loan payments and passes the payments on to the bondholders. This process is called securitization. However, lenders have begun to securitize loans themselves, especially in the areas of mortgage loans. Because of this, and because of the fear that this will continue, many investment banks have focused on becoming lenders themselves,[4] making loans with the goal of securitizing them. In fact, in the areas of commercial mortgages, many investment banks lend at loss leader interest rates[citation needed] in order to make money securitizing the loans, causing them to be a very popular financing option for commercial property investors and developers.[citation needed] Securitized house loans may have exacerbated the subprime mortgage crisis beginning in 2007, by making risky loans less apparent to investors.

[edit] Possible conflicts of interest

Potential conflicts of interest may arise between different parts of a bank, creating the potential for financial movements that could be market manipulation. Authorities that regulate investment banking (the FSA in the United Kingdom and the SEC in the United States) require that banks impose a Chinese wall which prohibits communication between investment banking on one side and equity research and trading on the other.

Some of the conflicts of interest that can be found in investment banking are listed here:

* Historically, equity research firms were founded and owned by investment banks. One common practice is for equity analysts to initiate coverage on a company in order to develop relationships that lead to highly profitable investment banking business. In the 1990s, many equity researchers allegedly traded positive stock ratings directly for investment banking business. On the flip side of the coin: companies would threaten to divert investment banking business to competitors unless their stock was rated favorably. Politicians acted to pass laws to criminalize such acts. Increased pressure from regulators and a series of lawsuits, settlements, and prosecutions curbed this business to a large extent following the 2001 stock market tumble.[citation needed]

* Many investment banks also own retail brokerages. Also during the 1990s, some retail brokerages sold consumers securities which did not meet their stated risk profile. This behavior may have led to investment banking business or even sales of surplus shares during a public offering to keep public perception of the stock favorable.

* Since investment banks engage heavily in trading for their own account, there is always the temptation or possibility that they might engage in some form of front running. Front running is the illegal practice of a stock broker executing orders on a security for their own account before filling orders previously submitted by their customers, thereby benefiting from any changes in prices induced by those orders.

********** Spin out
From Wikipedia, the free encyclopedia
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Spin out refers to a type of spin off where a company “splits off” sections of itself as a separate business.

The common definition of spin out is when a division of a company or organization becomes an independent business. The “spin out” company takes assets, intellectual property, technology, and/or existing products from the parent organization.

Many times the management team of the new company are from the same parent organization. Often, a spin-out offers the opportunity for a division to be backed by the company but not be affected by the parent company’s image or history, giving potential to grow existing ideas that had been languishing in an old environment and help them grow in a new environment.

In most cases, the parent company or organization offers support doing one or more of the following:

* investing equity in the new firm,
* being the first customer of the spin-out (helps to create cash flow),
* providing incubation space (desk, chairs, phones, internet access, etc.) or
* providing services such as legal, finance, technology, etc.

All the support from the parent company is provided with the explicit purpose of helping the spin-out grow.

************* J.P. Morgan & Co.
From Wikipedia, the free encyclopedia
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J.P. Morgan & Co. J. P. Morgan & Co. Logo ( 2008 )
Fate Acquired by Chase Manhattan Bank
Successor JPMorgan Chase & Co.
Founded 1871
Founder(s) J. Pierpont Morgan
Defunct 2000
Headquarters New York, NY
J.P. Morgan & Co. logo prior to its merger with Chase Manhattan Bank in 2000
JPMorgan logo prior to its 2008 rebranding

See also: JPMorgan Chase and J.P. Morgan

J.P. Morgan & Co. was a commercial and investment banking institution based in the United States founded by J. Pierpont Morgan and commonly known as the House of Morgan or simply Morgan.

The firm is the direct predecessor of two of the largest banking institutions in the United States and globally, JPMorgan Chase and Morgan Stanley.

In 2000, J.P. Morgan was acquired by Chase Manhattan Bank to form JPMorgan Chase & Co., one of the largest global banking institutions. Today, the J.P. Morgan brand is used to market certain JPMorgan Chase wholesale businesses, including investment banking, commercial banking and asset management. The J.P. Morgan branding was revamped in 2008 to return to its more traditional appearance after several years of depicting the “Chase symbol to the right of a condensed and modernized “JPMorgan”.

Between 1959 and 1989, J.P. Morgan operated as the Morgan Guaranty Trust, following its merger with .
[edit] Early History
23 Wall Street. Former headquarters of J.P. Morgan & Co.

The origins of the firm date back to 1854 when Junius S. Morgan joined a London-based banking business headed by George Peabody. Over the next ten years, Junius took control of George Peabody & Co., changing the name to J.S. Morgan & Co. Junius’s son, J. Pierpont Morgan, came to work with his father and would later found what would later become J.P. Morgan & Co.

J.P. Morgan & Co., was founded in New York in 1871 as Drexel, Morgan & Co. by J. Pierpont Morgan and Philadelphia banker Anthony J. Drexel.[1] The new merchant banking partnership served initially as an agent for Europeans investing in the United States.

[edit] The House of Morgan

In 1895, Drexel, Morgan & Co. became J.P. Morgan & Co. (see also: John Pierpont Morgan). It financed the formation of the United States Steel Corporation, which took over the business of Andrew Carnegie and others and was the world’s first billion-dollar corporation. In 1895, it supplied the United States government with $62 million in gold to float a bond issue and restore the treasury surplus of $100 million. In 1892, the company began to finance the New York, New Haven and Hartford Railroad and led it through a series of acquisitions that made it the dominant railroad transporter in New England.
September 16 1920: a bomb exploded in front of the headquarters of J.P. Morgan Inc. at 23 Wall Street, injuring 400 and killing 38 people.

Built in 1914, 23 Wall Street was known as “The Corner” and “The House of Morgan,” and for decades the bank’s headquarters was the most important address in American finance. At noon, on September 16, 1920, an anarchist bomb exploded in front of the bank, injuring 400 and killing 38. Shortly before the bomb went off, a warning note was placed in a mailbox at the corner of Cedar Street and Broadway. The warning read: “Remember we will not tolerate any longer. Free the political prisoners or it will be sure death for all of you. American Anarchists Fighters.” While theories abound about who was behind the Wall Street bombing and why they did it, after twenty years of investigation the FBI rendered the file inactive in 1940 without ever finding the perpetrators.

In August 1914, Henry P. Davison, a Morgan partner, traveled to the UK and made a deal with the Bank of England to make J.P. Morgan & Co. the monopoly underwriter of war bonds for UK and France. The Bank of England became a “fiscal agent” of J.P. Morgan & Co. and vice versa. The company also invested in the suppliers of war equipment to Britain and France. Thus, the company profited from the financing and purchasing activities of the two European governments.

[edit] Glass-Steagall and Morgan Stanley

In the 1930s, all J.P. Morgan & Co. along with all integrated banking businesses in the United States, was required by the provisions of the Glass-Steagall Act to separate its investment banking from its commercial banking operations. J.P. Morgan & Co. chose to operate as a commercial bank, because at the time commercial lending was perceived to be more profitable and prestigious business in the post depression era. Additionally, many within J.P. Morgan believed that a change in the climate would allow the company to resume its securities businesses but it would be nearly impossible to reconstitute the bank if it were disassembled.

In 1935, after being barred from securities business for over a year, the heads of J.P. Morgan made the decision to spin off its investment banking operations. Led by J.P. Morgan partners Henry S. Morgan (son of Jack Morgan and grandson of J. Pierpont Morgan) and Harold Stanley, Morgan Stanley was founded on September 16, 1935 with $6.6 million of nonvoting preferred stock from J.P. Morgan partners. In its infancy, Morgan Stanley was headquartered at 2 Wall Street, just down the street from J.P. Morgan and Morgan Stanley bankers routinely used 23 Wall Street for transaction closings.

[edit] Morgan Guaranty Trust

In the years following the spin-off of Morgan Stanley, the securities business proved robust while the parent firm, which incorporated in 1940,[2] was a sleepy firm. By the 1950s J.P. Morgan was only a mid-size bank. In order to bolster its position, in 1959, J.P. Morgan merged with the Guaranty Trust Company of New York to form the Morgan Guaranty Trust Company. As a result of the numerous relationships between the two banks and the complementary characteristics (J.P. Morgan brought a prestigious name and high quality clients and bankers while Guaranty Trust brought significant amounts of capital). Although Guaranty Trust was nearly four times the size of J.P. Morgan at the time of the merger in 1959, the newly-formed Morgan Guaranty was managed primarily by legacy J.P. Morgan employees and J.P. Morgan was considered the buyer.

[edit] Return of J.P. Morgan & Co.

Although ten years after the merger, Morgan Guaranty would establish a bank holding company called J.P. Morgan & Co. Incorporated, it would continue to operate as Morgan Guaranty through the 1980s before beginning to migrate back toward the use of the J.P. Morgan brand. In 1988, the company once again began operating exclusively as J.P. Morgan & Co.

Also, in the 1980s, J.P. Morgan along with other commercial banks pushed the envelope of product offerings toward investment banking, beginning with the issuance of commercial paper. In 1989, the Federal Reserve permitted J.P. Morgan to be the first commercial bank to underwrite a corporate debt offering[3] In the 1990s, J.P. Morgan moved quickly to rebuild its investment banking operations and by the late 1990s would emerge as a top-five player in securities underwriting.

[edit] JPMorgan Chase

By the late 1990s, J.P. Morgan had emerged as a large but not dominant commercial and investment banking franchise with an attractive brand name and a strong presence in debt and equity securities underwriting. Beginning in 1998, J.P. Morgan openly discussed the possibility of a merger and speculation of a pairing with banks including Goldman Sachs, Chase Manhattan Bank, Credit Suisse and Deutsche Bank AG were prevalent.[4] In 2000, Chase Manhattan Bank, which had emerged as one of the largest and fastest growing commercial banks in the United States through a series of mergers over the previous decade, was looking for yet another transformational merger to improve its position in investment banking. On September 13, 2000, Chase Manhattan Bank announced the acquisition of J.P. Morgan & Co. for $30.9 billion.[5][6]

The Gramm-Leach-Bliley Act, passed just a year earlier, repealed the restrictions of Glass-Steagall and allowed consolidation of investment banking and commercial banking operations allowing for the merger of J.P. Morgan and Chase as well as the purchase of Donaldson, Lufkin & Jenrette by Credit Suisse earlier in 2000.

The combined JPMorgan Chase would become one of the largest banks both in the United States and globally offering a full complement of investment banking, commercial banking, retail banking, asset management, private banking and private equity businesses.

*********** Exchange-traded fund
From Wikipedia, the free encyclopedia
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An exchange-traded fund (or ETF) is an investment vehicle traded on stock exchanges, much like stocks. An ETF holds assets such as stocks or bonds and trades at approximately the same price as the net asset value of its underlying assets over the course of the trading day. Most ETFs track an index, such as the Dow Jones Industrial Average or the S&P 500. ETFs may be attractive as investments because of their low costs, tax efficiency, and stock-like features. In a survey of investment professionals conducted in March 2008, 67% called ETFs the most innovative investment vehicle of the last two decades and 60% reported that ETFs have fundamentally changed the way they construct investment portfolios. [1] [2]

Only so-called authorized participants (typically, large institutional investors) actually obtain or redeem shares of an ETF directly from the fund manager, and only then in creation units, large blocks of tens of thousands of ETF shares that can be exchanged in-kind with baskets of the underlying securities. Authorized participants may hold the ETF shares or they may act as market makers on the open market, using their ability to exchange creation units with their underlying securities to provide liquidity of the ETF shares and help ensure that their intraday market price approximates the net asset value of the underlying assets.[3] Other investors, such as individuals using a retail brokerage, trade ETF shares on this secondary market.

An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be purchased or redeemed at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be substantially more or less than its net asset value. Closed-end funds are not considered to be exchange-traded funds, even though they are funds and are traded on an exchange. ETFs have been available in the US since 1993 and in Europe since 1999. ETFs traditionally have been index funds, but in 2008 the U.S. Securities and Exchange Commission began to authorize the creation of actively-managed ETFs

*********** Bulge bracket

The term ‘bulge bracket’ also refers to the first group of investment banks listed on the “tombstone” (financial industry advertisement) notifying the public of a financial transaction or deal. In a public securities offering, within the underwriting syndicate, the bookrunning manager (the bank responsible for maintaining the order book when marketing the offering and therefore in control of allocation of securities to investors) appears above the others in the tombstone and on the cover of the prospectus. The font size of the name of this bank, or banks if there are co-bookrunning managers, is larger and it may “bulge” out.

In common use, the term ‘bulge bracket’ refers loosely (in the US) to the group of investment banks considered to be the largest and most profitable in the world, as measured by various league table standings. Since the criteria for this judgment are unclear, there is often debate over which banks form part of the bulge bracket.

Ultimately it is a subjective term, sometimes based on Thomson Reuters League Tables[1] or other deal and market share rankings. It is also a reference to the most prestigious institutions.

[edit] Firms considered part of the Bulge Bracket
Commonly, the following banks are widely considered to have Bulge Bracket status:[citation needed]

* Bank of America
* Barclays Capital
* Citigroup
* Credit Suisse
* Deutsche Bank
* Goldman Sachs
* JPMorgan
* Morgan Stanley

Prior to 2007-08 Subprime Mortgage Crisis

The five American Bulge Bracket firms on Wall Street prior to late 2008 were, from largest to smallest: Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers, and Bear Stearns.

This list shrunk to none as a result of the 2008 subprime mortgage crisis, with Bear Stearns being purchased by JPMorgan Chase, Lehman Brothers having filed for bankruptcy, Merrill Lynch being purchased by Bank of America, and Goldman Sachs and Morgan Stanley moving to become bank holding companies.

[edit] Banks formerly part of the Bulge Bracket

* Bear Stearns, acquired by JPMorgan Chase in March 2008.
* Dillon, Read & Co., acquired by Swiss Bank Corporation in 1997.
* First Boston, acquired by Credit Suisse in 1988 and branded Credit Suisse First Boston, later renamed to Credit Suisse.
* Kuhn, Loeb & Co., merged with Lehman Brothers in 1977, forming Lehman Brothers, Kuhn, Loeb Inc.
* Lehman Brothers, declared bankrupt in September 2008. The Asian and European operations were bought by Nomura. Barclays Capital acquired the North American Lehman operations.
* Merrill Lynch, acquired by Bank of America in September 2008.
* Salomon Brothers, acquired by Travelers (eventually Citigroup) in 1998.

**************** Salomon Brothers

was a Wall Street investment bank. Founded in 1910, it remained a partnership until the early 1980s, when it was acquired by the commodity trading firm then known as Phibro Corporation. This proved a “wag the dog” type merger as the parent company became first Phibro-Salomon and then Salomon Inc.[1] and the commodity operations were sold. Eventually Salomon (NYSE:SB) was acquired by Travelers Group in 1998, and following the latter’s merger with Citicorp that same year, Salomon became part of Citigroup.

Period of Innovation

John Gutfreund became managing partner in 1978 and took the company public, staying on as CEO. During its time of greatest prominence in the 1980s, Salomon became noted for its innovation in the bond market, selling the first mortgage-backed security, a hitherto obscure species of financial instrument created by Ginnie Mae. Shortly thereafter, Saloman purchased home mortgages from thrifts throughout the United States and packaged them into mortgage-backed securities, which it sold to local and international investors. Later, it moved away from traditional investment banking (helping companies raise funds in the capital market and negotiating mergers and acquisitions) to almost exclusively proprietary trading (the buying and selling of stocks, bonds, options, etc. for the profit of the company).

Salomon had an expertise in fixed income trading, betting large amounts of money on certain swings in the bond market on a daily basis. The top bond traders called themselves “Big Swinging Dicks”, and were the inspiration for the books The Bonfire of the Vanities and Liar’s Poker (see below).

During this period however the performance of the firm was not to the satisfaction of its upper management. The amount of money being made relative to the amount being invested was small, and the company’s traders were paid in a flawed way which was disconnected from their true profitability (fully accounting for both the amount of money they used and the risk they took). There were debates as to which direction the firm should head in, whether it should prune down its activities to focus on certain areas. For example, the commercial paper business (providing short term day to day financing for large companies), was apparently unprofitable, although some in the firm argued that it was a good activity because it kept the company in constant contact with other businesses’ key financial personnel. It was decided that the firm should try to imitate Drexel Burnham Lambert, using its investment bankers and its own money to urge companies to restructure or engage in leveraged buyouts which would result in financing business for Salomon Brothers. The first moves in this direction were for the firm to compete on the leveraged buyout of RJR Nabisco, followed by the leveraged buyout of Revco stores (which ended in failure).

[edit] Treasury Bond Scandal

In 1991, Salomon trader Paul Mozer was caught submitting false bids to the U.S. Treasury by Deputy Assistant Secretary Mike Basham, in an attempt to purchase more Treasury bonds than permitted by one buyer between December 1990 and May 1991. Salomon was fined $290 million, the largest fine ever levied on an investment bank at the time, weakening it and eventually leading to its acquisition by Travelers Group. CEO Gutfreund left the company in August 1991; a SEC settlement resulted in a fine of $100,000 and his being barred from serving as a chief executive of a brokerage firm.[2] The scandal is covered extensively in the 1993 book Nightmare on Wall Street.

After the acquisition, the parent company (Travelers Group, and later Citigroup) proved culturally averse to the volatile profits and losses caused by proprietary trading, instead preferring slower and more steady growth. Salomon suffered a $100 million loss when it incorrectly bet that MCI Communications would merge with Sprint instead of Worldcom. Subsequently, most of its proprietary trading business was disbanded.

For some time after the mergers the combined investment banking operations were known as Salomon Smith Barney, but reorganization has renamed this entity as Citigroup Global Markets Inc. The Salomon Brothers name, like the Smith Barney name, is now a division and service mark of Citigroup Global Markets.

*************** Bank holding company
A bank holding company is a company which controls one or more banks.

Bank holding company status

New or smaller banks often re-structure themselves into bank holding companies to take advantage of the greater financial flexibility this corporate and legal status permits. Becoming a bank holding company makes it easier for the firm to raise capital than as a traditional bank. The holding company can assume debt of shareholders on a tax free basis, borrow money, acquire other banks and non-bank entities more easily, and issue stock with greater regulatory ease. It also has a greater legal authority to conduct share repurchases of its own stock.

The downside includes responding to an additional regulatory authorities, especially if there are more than 300 shareholders, at which point the bank holding company is forced to register with the Securities and Exchange Commission. There are also added expenses of operating with an extra layer of administration.

[edit] 2008 Credit Crisis

As a result of the Global financial crisis of 2008, many traditional investment banks and finance corporations such as Goldman Sachs, American Express, CIT Group and General Motors Acceptance Corporation[3] successfully converted to bank holding companies in order to gain access to liquidity and funding. This arrangement allows them access to the Federal Reserve’s discount window and benefit from the Troubled Assets Relief Program, but the companies are now subject to more regulation and their ability to have exposure to risk will be limited.

*********** Morgan Stanley

Morgan Stanley (NYSE: MS) is a global financial services provider headquartered in New York City, New York, United States. It serves a diversified group of corporations, governments, financial institutions, and individuals. Morgan Stanley also operates in 33 countries around the world with 600 offices, with an approximate employee workforce of 45,000.[3] The company reports US$779 billion as assets under its management[4].

The corporation, formed by J.P. Morgan & Co. employees Henry S. Morgan (grandson of J.P. Morgan), Harold Stanley and others, came into existence on September 16, 1935. In its first year the company operated with a 24% market share (US$1.1 billion) in public offerings and private placements. The main areas of business for the firm today are Global Wealth Management, Institutional Securities and Investment Management.

The company found itself in the midst of a management crisis in the late 1990s[5] that saw it lose a lot of talent and competence[6] and ultimately saw the firing of its then CEO Philip Purcell in 2005.

On September 21, 2008, it was reported that the Federal Reserve allowed Morgan Stanley to change its status from investment bank to bank holding company. On September 29, 2008, it was announced that Mitsubishi UFJ Financial Group, Japan’s largest bank, will take a stake of $9 billion in Morgan Stanley equity.[7] In the midst of the October 2008 stock market crash, concerns over the completion of the Mitsubishi deal caused a dramatic fall in Morgan Stanley’s stock price to levels last seen in 1994. The stock grew considerably after Mitsubishi UFJ closed the deal to buy 21% of Morgan Stanley on October 14, 2008.

Recent years: 1991–present
Historical logo used by Morgan Stanley in the early 2000s

In 1996, Morgan Stanley acquired Van Kampen American Capital. On February 5, 1997, the company merged with Dean Witter Reynolds, and Discover & Co. the spun-off financial services business of Sears Roebuck. The merged company was briefly known as “Morgan Stanley Dean Witter Discover & Co.” until 1998 when it was known as “Morgan Stanley Dean Witter & Co.” until late 2001. To foster brand recognition and marketing the Dean Witter name was dropped and the firm became “Morgan Stanley”. Morgan Stanley acquired AB Asesores of Spain and entered India in a joint venture with JM Financials in 1999.

In 2001, Morgan Stanley lost ten employees in the September 11, 2001 attacks. In 2005 it moved 2,300 of its employees back to lower Manhattan, at that time the largest such move [13].

In 2004, Morgan Stanley co-managed the Google IPO which is the largest internet IPO in U.S. history. In the same year Morgan Stanley acquired the Canary Wharf Group. On December 19, 2006, after reporting 4th quarter earnings, Morgan Stanley announced the spin-off of its Discover Card unit. In order to cope up with the write-downs during the Subprime mortgage crisis, Morgan Stanley announced on December 19, 2007 that it would receive a US$5 billion capital infusion from the China Investment Corporation in exchange for securities that would be convertible to 9.9% of its shares in 2010.[14]

In August 2008, Morgan Stanley was contracted by the United States Treasury to advise the government on potential rescue strategies for Fannie Mae and Freddie Mac [15].

On September 17, 2008, the British evening-news analysis program Newsnight reported that Morgan Stanley was facing difficulties after a 42% slide in its share price. CEO John Mack wrote in a memo to staff “we’re in the midst of a market controlled by fear and rumours and short-sellers are driving our stock down.” The company was said to explore merger possibilities with CITIC, Wachovia, HSBC, Banco Santander and Nomura.[16]

On September 22, 2008, the last two bulge bracket investment banks in the US, Morgan Stanley and Goldman Sachs, both announced that they would become traditional bank holding companies, bringing an end to the era of investment banking on Wall Street. [17] The Federal Reserve’s approval of their bid to become banks ends the ascendancy of the securities firms, 75 years after Congress separated them from deposit-taking lenders, and caps weeks of chaos that sent Lehman Brothers Holdings Inc. into bankruptcy and led to the rushed sale of Merrill Lynch & Co. to Bank of America Corp. [18]

[edit] Organization

Morgan Stanley splits its businesses into three core business units. These follow below.

[edit] Institutional Securities

Institutional Securities has been the most profitable business segment[19] for Morgan Stanley in recent times. This business segment provides institutions with services such as capital raising and financial advisory services including advice on mergers and acquisitions, restructurings, real estate and project finance, corporate lending etc. The segment also encompasses the Equities and the Fixed Income divisions of the firm.

[edit] Global Wealth Management Group

Global Wealth Management Group provides brokerage and investment advisory services. As of 2008 Q1 this segment has reported an annual increase of 12 percent in the pre-tax income[20]. This segment provides financial and wealth planning services to its clients who are mainly high net worth individuals and hedge funds.

[edit] Asset Management

Asset Management provides global asset management products and services in equity, fixed income, alternative investments and private equity to institutional and retail clients through third-party retail distribution channels, intermediaries and Morgan Stanley’s institutional distribution channel. Morgan Stanley’s asset management activities are principally conducted under the Morgan Stanley and Van Kampen brands. It provides asset management products and services to institutional investors worldwide, including pension plans, corporations, private funds, non-profit organizations, foundations, endowments, governmental agencies, insurance companies and banks. As of 2008 Q1 the segment posted a pre-tax loss of US$161 million

********** Smith Barney
From Wikipedia, the free encyclopedia
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Smith Barney Smith Barney logo
Type Subsidiary of Citigroup
Founded 1873
Founder(s) Charles D. Barney
Edward B. Smith
Headquarters New York, USA
Key people Charles Johnston President
Industry Finance and Insurance
Products Brokerage
Investment Banking
Asset Management
Revenue $10.5 Billion USD 2007
Net income $1.4 Billion USD 2007
Employees 14,858

Smith Barney is a division of Citigroup Global Capital Markets Inc., a global, full-service financial firm, that provides brokerage, investment banking and asset management services to corporations, governments and individuals around the world. In 800 offices, Financial Advisors service 9.6 million domestic client accounts representing $1.562 trillion in client assets worldwide.[1] Clients range from individual investors to small- and mid-sized businesses, as well as large corporations, non-profit organizations and family foundations.

[edit] Origins

Smith Barney & Co. was formed in 1938 through the merger of Charles D. Barney & Co., founded in 1873, and Edward B. Smith & Co., founded in 1892. In the late 1980s the retail brokerage firm Smith Barney was owned by Primerica Financial Services. Commercial Credit purchased Primerica in 1988, for $1.5 billion. In 1992, they paid $722 million to buy a 27 percent share of Travelers Insurance. By the end of 1993, the merged company was known as Travelers Group Inc. In September 1997, Travelers acquired Salomon Inc. (parent company of Salomon Brothers Inc.), for over $9 billion in stock, and merged it with its own investment arm to create Salomon Smith Barney.

In April 1998 Travelers Group announced an agreement to undertake a $76 billion merger between Travelers and Citicorp, creating the largest single financial services company in the world. It now has over one trillion U.S. dollars in assets.

On January 13, 2009, Morgan Stanley and Citigroup announced the merger of Smith Barney with Morgan Stanley’s Global Wealth Management Group, with Morgan Stanley paying US$2.7 billion cash upfront to Citigroup for a 51 percent stake in the joint venture. The joint venture will operate under the name Morgan Stanley Smith Barney.[2]

************* Gramm-Leach-Bliley Act

Who’s More to Blame: Wall Street or the Repealers of the Glass-Steagall Act?

Morgan Housel and Christopher Barker
April 6, 2009

Join the Fool as we assess blame for this financial meltdown — March Madness bracket style! Below is the final matchup for ultimate blame. With your vote, you will declare the worst offender!

The case for Wall Street, by Morgan Housel
How ironic that as the masses are irked over the ever-growing role of government in our economy, many of the same people are furious with a group of political renegades who allowed free markets to reign.

But it’s true: The repealers of the Glass-Steagall Act really, really screwed things up. Every time you think of the damage Citigroup (NYSE: C) and Bank of America (NYSE: BAC) continue to inflict on our economy, please, think of those lawmakers and clench your fists.

They should not, however, be targeted as more to blame than Wall Street itself. Ambition, instability, and most importantly greed flourished on Wall Street well before Glass-Steagall was canned a decade ago. The act’s enforcement would not have prevented a tremendous amount of our financial fiasco.

For example, the shadow banking system — nonbank lenders like Bear Stearns, Lehman Brothers, and the former incarnations of Goldman Sachs (NYSE: GS), and Morgan Stanley (NYSE: MS) — sits at the epicenter of the financial meltdown, yet resides largely outside of Glass-Steagall’s reach. Such joys as 30-to-1 leverage, unfettered risk taking, and the threat of “too big to fail” could — and did — occur with Glass-Steagall in place. Anyone remember Long-Term Capital Management?

Besides, plenty of commercial banks collapsed without the investment banking units Glass-Steagall would have prevented. Look no further than the failures and absurd lending practices of Washington Mutual, Wachovia, or IndyMac. Many of these commercial banks were also pioneers of lending practices that fueled the housing boom. The machine of lax underwriting by standalone commercial banks securitized by the shadow banking system could have operated efficiently and legally with Glass-Steagall in place.

The repeal of Glass-Steagall did indeed add fuel to a roaring fire, but the fire itself was the greed, immorality, and stupidity of Wall Street.

The case for the repealers of the Glass-Steagall act, by Christopher Barker
When Shamu the killer whale performs, decked out in nature’s tuxedo, the only threat to audience members is the soaking from a choreographed splash.

In the regulated aquarium environment, Shamu’s predatory instincts are tamed into submission. In the wild, however, orcas are fierce and crafty predators, feasting mercilessly upon cute little seals and beloved dolphins. As deplorable as their behavior might be to the fans of charismatic sea mammals, we don’t condemn the wild orca for being a killer whale.

The culture of greed that pervades Wall Street presents a similar conundrum. In boom times, greed is cheered as the engine of capitalism, and even touted in the mantras of oracles like Berkshire-Hathaway’s (NYSE: BRK-A) Warren Buffett. Now that we’ve gone bust once more, greed is again unfashionable, and regulatory controls like those set by Glass-Steagall after the prior depression are destined to return.

The sharks on Wall Street have committed outrageous acts, and they swim within a sea of shame, but the greater shame belongs to their would-be handlers. In removing the Glass-Steagall safety net, Congress betrayed its constituents, Alan Greenspan doomed his legacy, and lobbyists for companies like Citigroup and JPMorgan Chase (NYSE: JPM) earned their keep.

By setting banks and brokerages free from the regulated swimming pool, the repealers of Glass-Steagall knowingly unleashed a swarm of killer whales into the ocean of global finance. Thomas Jefferson considered banks “more dangerous than standing armies,” while Andrew Jackson called them “a den of vipers and thieves,” so the nature of the beast has been well known for centuries. For ignoring that danger and permitting systemic risk to multiply in the shadows — most notably through the $1 quadrillion global market for derivatives — the repealers of Glass-Steagall unmistakably carry the greatest burden of blame for this ongoing crisis.

The Motley Fool: Print Article (12 May 2009)

The Gramm-Leach-Bliley Act, also known as the Gramm-Leach-Bliley Financial Services Modernization Act, Pub.L. 106-102, 113 Stat. 1338, enacted November 12, 1999, is an Act of the United States Congress which repealed part of the Glass-Steagall Act of 1933, opening up competition among banks, securities companies and insurance companies. The Glass-Steagall Act prohibited a bank from offering investment, commercial banking, and insurance services.

The Gramm-Leach-Bliley Act (GLBA) allowed commercial and investment banks to consolidate. For example, Citibank merged with Travelers Group, an insurance company, and in 1998 formed the conglomerate Citigroup, a corporation combining banking and insurance underwriting services under brands including Smith-Barney, Shearson, Primerica and Travelers Insurance Corporation. This combination, announced in 1993 and finalized in 1994, would have violated the Glass-Steagall Act and the Bank Holding Company Act by combining insurance and securities companies, if not for a temporary waiver process [1]. The law was passed to legalize these mergers on a permanent basis. Historically, the combined industry has been known as the financial services industry.

Legislative history
Final Congressional vote by chamber and party, November 4th, 1999

The banking industry had been seeking the repeal of the 1933 Glass-Steagall Act since the 1980s, if not earlier. In 1987 the Congressional Research Service prepared a report which explored the case for preserving Glass-Steagall and the case against preserving the act.[1]

The bills were introduced in the U.S. Senate by Phil Gramm (R-Texas) and in the U.S. House of Representatives by Jim Leach (R-Iowa). The third lawmaker associated with the bill was Rep. Thomas J. Bliley, Jr. (R-Virginia), Chairman of the House Commerce Committee from 1995 to 2001. On May 6, 1999, the Senate passed the bills by a 54-44 vote along party lines (53 Republicans and one Democrat in favor; 44 Democrats opposed).[2] On July 20, the House passed a different version of the bill on an uncontested and uncounted voice vote. When the two chambers could not agree on a joint version of the bill, the House voted on July 30 by a vote of 241-132 (R 58-131; D 182-1) to instruct its negotiators to work for a law which ensured that consumers enjoyed medical and financial privacy as well as “robust competition and equal and non-discriminatory access to financial services and economic opportunities in their communities” (i.e., protection against exclusionary redlining) [3] [4] The bill then moved to a joint conference committee to work out the differences between the Senate and House versions. Democrats agreed to support the bill after Republicans agreed to strengthen provisions of the anti-redlining Community Reinvestment Act and address certain privacy concerns; the conference committee then finished its work by the beginning of November.[3] [5] On November 4, the final bill resolving the differences was passed by the Senate 90-8 [6] and by the House 362-57.[7] This legislation was signed into law by Democratic President Bill Clinton on November 12, 1999.[8]

[edit] Changes caused by the Act

Many of the largest banks, brokerages, and insurance companies desired the Act at the time. The justification was that individuals usually put more money into investments when the economy is doing well, but they put most of their money into savings accounts when the economy turns bad. With the new Act, they would be able to do both ‘savings’ and ‘investment’ at the same financial institution, which would be able to do well in both good and bad economic times.

Prior to the Act, most financial services companies were already offering both saving and investment opportunities to their customers. On the retail/consumer side, a bank called Norwest which would later merge with Wells Fargo Bank led the charge in offering all types of financial services products in 1986. American Express attempted to own almost every field of financial business (although there was little synergy among them). Things culminated in 1998 when Travelers, a financial services company with everything but a retail/commercial bank, bought out Citibank, creating the largest and the most profitable company in the world. The move was technically illegal and provided impetus for the passage of the Gramm-Leach-Bliley Act.

Also prior to the passage of the Act, there were many relaxations to the Glass-Steagall Act. For example, a few years earlier, commercial Banks were allowed to get into investment banking, and before that banks were also allowed to get into stock and insurance brokerage. Insurance underwriting was the only main operation they weren’t allowed to do, something rarely done by banks even after the passage of the Act.

Much consolidation occurred in the financial services industry since, but not at the scale some had expected. Retail banks, for example, do not tend to buy insurance underwriters, as they seek to engage in a more profitable business of insurance brokerage by selling products of other insurance companies. Other retail banks were slow to market investments and insurance products and package those products in a convincing way. Brokerage companies had a hard time getting into banking, because they do not have a large branch and backshop footprint. Banks have recently tended to buy other banks, such as the 2004 Bank of America and Fleet Boston merger, yet they have had less success integrating with investment and insurance companies. Many banks have expanded into investment banking, but have found it hard to package it with their banking services, without resorting to questionable tie-ins which caused scandals at Smith Barney.

Remaining restrictions

Crucial to the passing of this Act was an amendment made to the GLBA, stating that no merger may go ahead if any of the financial holding institutions, or affiliates thereof, received a “less than satisfactory [sic] rating at its most recent CRA exam”, essentially meaning that any merger may only go ahead with the strict approval of the regulatory bodies responsible for the Community Reinvestment Act (CRA).[9]. This was an issue of hot contention, and the Clinton Administration stressed that it “would veto any legislation that would scale back minority-lending requirements.” [10]

The GLBA also did not remove the restrictions on banks placed by the Bank Holding Company Act of 1956 which prevented financial institutions from owning non-financial corporations. It conversely prohibits corporations outside of the banking or finance industry from entering retail and/or commercial banking. Many assume Wal-Mart’s desire to convert its industrial bank to a commercial/retail bank ultimately drove the banking industry to back the GLBA restrictions.

Some restrictions remain to provide some amount of separation between the investment and commercial banking operations of a company. For example, licensed bankers must have separate business cards, e.g., “Personal Banker, Wells Fargo Bank” and “Investment Consultant, Wells Fargo Private Client Services”. Much of the debate about financial privacy is specifically centered around allowing or preventing the banking, brokerage, and insurances divisions of a company from working together.

In terms of compliance, the key rules under the Act include The Financial Privacy Rule which governs the collection and disclosure of customers’ personal financial information by financial institutions. It also applies to companies, regardless of whether they are financial institutions, who receive such information. The Safeguards Rule requires all financial institutions to design, implement and maintain safeguards to protect customer information. The Safeguards Rule applies not only to financial institutions that collect information from their own customers, but also to financial institutions – such as credit reporting agencies – that receive customer information from other financial institutions.

Regulatory changes 1995

In July 1993, President Clinton asked regulators to reform the CRA in order to make examinations more consistent, clarify performance standards, and reduce cost and compliance burden.[15] Robert Rubin, the Assistant to the President for Economic Policy, under President Clinton, explained that this was in line with President Clinton’s strategy to “deal with the problems of the inner city and distressed rural communities”. Discussing the reasons for the Clinton administration’s proposal to strengthen the CRA and further reduce red-lining, Lloyd Bentsen, Secretary of the Treasury at that time, affirmed his belief that availability of credit should not depend on where a person lives, “The only thing that ought to matter on a loan application is whether or not you can pay it back, not where you live.” Bentsen said that the proposed changes would “make it easier for lenders to show how they’re complying with the Community Reinvestment Act”, and “cut back a lot of the paperwork and the cost on small business loans”.[13]

In 1995, the CRA regulations were substantially revised to address criticisms that the regulations, and the agencies’ implementation of them through the examination process, were too process-oriented, burdensome, and not sufficiently focused on actual results. The agencies also changed the CRA examination process to incorporate these revisions.[15] Information about banking institutions’ CRA ratings were made available via web page for public comment.[13] The Office of the Comptroller of the Currency (OCC) also revised its regulations, allowing lenders subject to the CRA to claim community development loan credits for loans made to help finance the environmental cleanup or redevelopment of industrial sites when it was part of an effort to revitalize the low- and moderate-income community where the site was located.[25]

During March 1995 congressional hearings William A. Niskanen, chair of the Cato Institute, criticized the proposals for political favoritism in allocating credit and micromanagement by regulators, and that there was no assurance that banks would not be expected to operate at a loss. He predicted they would be very costly to the economy and banking system, and that the primary long term effect would be to contract the banking system. He recommended Congress repeal the Act.[26]

Responding to concerns that the CRA would lower bank profitability, a 1997 research paper by economists at the Federal Reserve found that “[CRA] lenders active in lower-income neighborhoods and with lower-income borrowers appear to be as profitable as other mortgage-oriented commercial banks”.[27] Speaking in 2007, Federal Reserve Chair Ben Bernanke noted that, “managers of financial institutions found that these loan portfolios, if properly underwritten and managed, could be profitable” and that the loans “usually did not involve disproportionately higher levels of default”.[9]

According to a 2000 United States Department of the Treasury study of lending trends in 305 U.S. cities between 1993 and 1998, $467 billion in mortgage credit flowed from CRA-covered lenders to low- and medium-income borrowers and areas. In that period, the total number of loans to poorer Americans by CRA-eligible institutions rose by 39% while loans to wealthier individuals by CRA-covered institutions rose by 17%. The share of total US lending to low and meduim income borrowers rose from 25% in 1993 to 28% in 1998 as a consequence. [28]

In October 1997, First Union Capital Markets and Bear, Stearns & Co launched the first publicly available securitization of Community Reinvestment Act loans, issuing $384.6 million of such securities. The securities were guaranteed by Freddie Mac and had an implied “AAA” rating.[29][22] The public offering was several times oversubscribed, predominantly by money managers and insurance companies who were not buying them for CRA credit.[30]

[edit] Legislative changes 1999

In 1999 the Congress enacted and President Clinton signed into law the Gramm-Leach-Bliley Act, also known as the “Financial Services Modernization Act,” which repealed the part of the Glass-Steagall Act, which prohibited a bank from offering a full range of investment, commercial banking, and insurance services. The bill was killed in 1998 because Senator Phil Gramm wanted the bill to expand the number of banks which no longer would be covered by the CRA. He also demanded full disclosure of any financial deals which community groups had with banks, accusing such groups of “extortion.” In 1999 Senators Christopher Dodd and Charles E. Schumer broke another deadlock by forcing a compromise between Gramm and the Clinton administration which wanted to prevent banks from expanding into insurance or securities unless they were compliant with the CRA. In the final compromise, the CRA would cover bank expansions into new lines of business, community groups would have to disclose certain kinds of financial deals with banks, and smaller banks would be reviewed less frequently for CRA compliance.[31][32][33] On signing the Gramm-Leach-Bliley Act, President Clinton said that it, “establishes the principles that, as we expand the powers of banks, we will expand the reach of the [Community Reinvestment] Act”.

Credit defaults swaps (CDS) are financial instruments used as a hedge and protection for debtholders, in particular MBS investors, from the risk of default. As the net worth of banks and other financial institutions deteriorated because of losses related to subprime mortgages, the likelihood increased that those providing the insurance would have to pay their counterparties. This created uncertainty across the system, as investors wondered which companies would be required to pay to cover mortgage defaults.

Like all swaps and other financial derivatives, CDS may either be used to hedge risks (specifically, to insure creditors against default) or to profit from speculation. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. CDS are lightly regulated. As of 2008, there was no central clearinghouse to honor CDS in the event a party to a CDS proved unable to perform his obligations under the CDS contract. Required disclosure of CDS-related obligations has been criticized as inadequate. Insurance companies such as American International Group (AIG), MBIA, and Ambac faced ratings downgrades because widespread mortgage defaults increased their potential exposure to CDS losses. These firms had to obtain additional funds (capital) to offset this exposure. AIG’s having CDSs insuring $440 billion of MBS resulted in its seeking and obtaining a Federal government bailout.[140]

Like all swaps and other pure wagers, what one party loses under a CDS, the other party gains; CDSs merely reallocate existing wealth. Hence the question is which side of the CDS will have to pay and will it be able to do so. When investment bank Lehman Brothers went bankrupt in September 2008, there was much uncertainty as to which financial firms would be required to honor the CDS contracts on its $600 billion of bonds outstanding.[141][142] Merrill Lynch’s large losses in 2008 were attributed in part to the drop in value of its unhedged portfolio of collateralized debt obligations (CDOs) after AIG ceased offering CDS on Merrill’s CDOs. The loss of confidence of trading partners in Merrill Lynch’s solvency and its ability to refinance its short-term debt led to its acquisition by the Bank of America.[143][144]

Economist Joseph Stiglitz summarized how credit default swaps contributed to the systemic meltdown: “With this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else-or even of one’s own position. Not surprisingly, the credit markets froze.”[145]

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The Wall Street Fix FRONTLINE
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mr. weill goes to washington

The politics and the impact of Sandy Weill’s creation of Citigroup, the first full-service superbank, and the repeal of the Glass-Steagall Act that stood in his way.

Citigroup, formed by the 1998 merger of Travelers and Citicorp, is the biggest financial institution in the world, combining one of the largest insurance companies (Travelers), one of the largest investment banks (Salomon Smith Barney), and the largest commercial bank (Citibank) in America. But before it could come together, Travelers CEO Sanford I. Weill, who had proposed the merger to Citicorp’s John Reed, had to overcome one major obstacle: the historic Glass-Steagall Act of 1933, which in the wake of the 1929 crash had prohibited commercial banks from underwriting securities. The law, still on the books in 1998 but weakened over the years, separated investment banking from commercial banking in order to prevent conflicts of interest and protect investors.

Sandy Weill’s creation of Citigroup — the first so-called “superbank” — and his successful lobbying for repeal of the Glass-Steagall Act that stood in his way, was a demonstration of Weill’s and Wall Street’s political muscle. But what has been the impact of Glass-Steagall’s demise and the merging of investment banks and commercial banks within a single financial behemoth? Did the emergence of full-service superbanks like Citigroup contribute to the abuses of the late-1990s bubble? Addressing these questions, in excerpts from their FRONTLINE interviews, are former SEC Chairman Arthur Levitt, former Federal Reserve Board member Alan Blinder, New York State Attorney General Eliot Spitzer, financial historian Charles Geisst, the Precusor Group’s Scott Cleland, and Kenneth Guenther of the Independent Community Bankers of America.

Related Feature

[ The Long Demise of Glass-Steagall ]
A chronology tracing the life of the Glass-Steagall Act, from its passage in 1933 to its death throes in the 1990s, and how Citigroup’s Sandy Weill dealt the coup de grâce.
Related Links

[ “The New York Times: Banking Reform” ]
A resource from The New York Times on the repeal of Glass-Steagall and its impact. Includes a timeline and articles from The Times’ archive back to 1933.

[ “How Citigroup’s CEO Rewrote the Rules…” ]
“[Sandy Weill] outlasted Glass-Steagall, and tore down the wall between commercial and investment banking, but his victory could prove to be his undoing.” (Slate, Nov. 20, 2002)

[ “One Helluva Candy Store!” ]
A definitive article on Weill, this is the story of how Citicorp and Travelers came together, and the men who made it happen, as told by Fortune magazine’s Carol Loomis. (Fortune, May 11, 1998)

Greenspan, Weill & Company:

The Washington Connection
photo of levitt

arthur levitt
A former investment banker and chairman of the American Stock Exchange, he served as chairman of the Securities and Exchange Commission from 1993 to 2001.
read the full interview

When you came in as head of the SEC in the early 1990s, what was the situation with Glass-Steagall and the banking laws?

It was apparent to me that the protections of Glass-Steagall had already largely eroded. But Congress, at several times, nearly passed a bill to do away with Glass-Steagall. It was clear that it was a question not of whether but when Glass-Steagall would go. Millions of dollars were pouring in the campaign coffers of senators and congressmen who were set to do this.

Who was pushing?

The insurance industry, the Federal Reserve Board, the White House, the investment bankers, the commercial bankers — just about everybody wanted it. …

It was an incredible scene, but I saw it played through twice. Once was during a period of time when Al D’Amato chaired the [Senate] Banking Committee — and was not successful in getting the repeal of Glass-Steagall — where hundreds of lobbyists descended upon the Congress, were in the hallways morning, day, and night. Lobbyists for the insurance companies, for the investment banks, for the commercial banks, pulling for their own parochial interests.

Then when Phil Gramm became chairman of the banking committee, the same group came down, only they were now supplemented by lobbyists for the derivatives industry, for other new products that had developed, and for the stock exchanges and the options exchanges. They were buttonholing senators and congressmen, morning, day, and night.

From the standpoint of investors, I was concerned that the vital investor protection, in terms of SEC oversight of securities matters, would be eroded by turning over to the banks all of the responsibility for initiatives that, in the past, were the province of securities firms under the SEC jurisdiction.

This wasn’t merely a turf battle. This was a question of two different cultures: a culture of risk, which was the securities business, and a culture of protection of depositors, which was the culture of banking. Two very different cultures. …

Now at the Federal Reserve, which oversees banking, they had gradually been granting more and more exceptions to Glass-Steagall. … What had been going on in the 1980s and 1990s?

Clearly, over the 1980s and 1990s, a number of exemptions were granted by the Federal Reserve regulators, in terms of what banks could and could not do. The Comptroller of the Currency had involvement in this, as well. … They allowed the banks to do things that they could not do in the past. They permitted certain practices that were not acceptable in the past, and as a result of that, the protections of Glass-Steagall were almost totally eroded by the time this bill passed. …

So when Congress finally acts, it’s basically to ratify?

Congress gave legislative sanction to practices that the regulators had allowed to develop over the past two decades.

And the dramatic development, in 1998, was the merger of Citibank and Travelers. …

The merger of Travelers and Citibank was the death knell of Glass-Steagall, obviously. …

photo of blinder

alan blinder
Professor of economics at Princeton, former vice chairman of the Federal Reserve Board, and former member of the Council of Economic Advisors under President Bill Clinton.

read the full interview

Dr. Blinder, take me back to the late 1980s and early 1990s, and explain to me about the steps that were being taken by the Federal Reserve Board to relax, to liberalize, the provisions of the Glass-Steagall Act.

In the late 1980s, after some agitation before that, banks started getting even more serious about getting into securities, from which they had been more or less banned since the Glass-Steagall Act in the 1930s. There were, first, some legal cases. Then there was a ruling by the Federal Reserve Board, allowing a greater participation by banks in, for example, underwriting securities stocks. The amount by which they were allowed to do that gradually went up in a couple of stages — the biggest stage happening in 1996, when it was raised to a degree [25 percent of overall revenues] that, except in some extraordinary cases, was probably enough for almost any bank to do almost any amount of securities underwriting that they’d actually want to do.

In other words, it was very close to repeal of Glass-Steagall, although not literally repealing Glass-Steagall. Glass-Steagall was still on the books. …

You were on the Federal Reserve Board at this time. What was the thinking?

The thinking was manifold. One was that the market had practically repealed Glass-Steagall, anyway. The lines among insurance, securities, and banking had been becoming successively blurred. Securities companies like Merrill Lynch were into things that looked a lot like banking. Banks like J.P. Morgan were looking a lot like securities houses, and so on — all under the current legal framework. So the market had almost done away with it.

Secondly, there was a belief that you could enhance competition in all of these domains if the banks could compete in the domains of the securities houses, and the securities houses could compete in the domains of the banks, and so on. You’d have a more competitive and, therefore, more efficient financial system. …

For those few organizations that couldn’t do what they’d like to do under the existing regulatory framework, repeal of Glass-Steagall would make it possible. Citigroup was the most prominent example, because of the scale of the insurance company. With Travelers, an immense insurance company, and an immense bank [Citibank], and a pretty immense brokerage [Salomon Smith Barney], coming together under Citigroup, they really needed repeal of Glass-Steagall or even greater liberalization of the regulations — more than was likely. …

What was Chairman Alan Greenspan’s role in this? What was his thinking? Was he for this? Was he an advocate? What did he do?

He was certainly for it. The Federal Reserve Board, in fact, had been for repeal repeatedly through the 1990s. … I think [Greenspan] played a substantial role, in the sense that were he against it, it could not have happened. He could not have stopped the market from encroaching over boundaries — those were sort of natural market events. But he could’ve stopped — at least slowed down and, I think, probably stopped — the friendlier regulatory environment. …

I don’t think in any sense — at least from my knowledge — was he driving the political process that led eventually to repeal. But he was definitely an advocate. He was called to testify on this many times in front of the Congress over many years, and was always in favor of repealing Glass-Steagall. …

What about, then, the decision [by the Fed] to approve the merger of Citibank and Travelers — which goes well beyond the 25 percent rule?

I think, actually, they had very little choice about that. There are merger guidelines. The guidelines were met, including the possibility that if the repeal of Glass-Steagall didn’t come through — which it did — Citigroup would’ve had to divest itself of at least a large part of Travelers. … Probably, in fact, it would’ve meant the whole thing. So Citi was prepared, if they had to, if the law wasn’t changed, to make the proper divestitures that would’ve kept them legal. So the Fed had really no grounds to oppose it. …

Doesn’t Sandy Weill have rather special access if he’s talking directly to Alan Greenspan and to Bob Rubin at Treasury and to the president of the United States?

Absolutely, he does, and not every country banker in America can get that kind of access. … But you’ve got to remember this deal that Sandy Weill was coming to talk to these people about was not opening a new branch in Texas or something. This was a very big deal. They were creating the biggest financial company on the face of the earth. I think it’s very, very appropriate.

It would’ve been foolish as a pure business matter — never mind politics, which, of course, gets involved — as a pure business matter, it would’ve been foolish to just bull ahead with that without informing Alan Greenspan, Bob Rubin, and so on, even if it’s just as a courtesy.

You say, “Never mind politics,” but politics does get involved. What do you mean, “politics?”

Politics gets involved, because [Weill and Reed] knew at the time that they were going to need a change in the law to hold this enterprise together. … And that was going to come out of the political system. Alan Greenspan couldn’t do it for them. Bob Rubin couldn’t do it for them — though both of them can help, of course, by saying that they like the idea. The Congress had to do it.

photo of guenther

kenneth guenther
President and CEO, Independent Community Bankers of America.

We are talking about the largest financial merger in the world. We are talking about, for the first time in the modern history of the United States, since 1933, the largest bank, one of the largest securities firms, one of the largest insurance firms, being put together under common ownership.

Legislation is pending to make that legal, and here you have the leadership — Sandy Weill of Travelers and John Reed of Citicorp — saying, “Look, the Congress isn’t moving fast enough. Let’s do it on our own. To heck with the Congress. Let us effect this.” And so they move towards effecting it, and they get the blessing of the chairman of the Federal Reserve system in early April, when legislation is pending.

I mean, this is hubris in the worst sense of the word. Who do they think they are? Other people, firms, cannot act like this. … Citicorp and Travelers were so big that they were able to pull this off. They were able to pull off the largest financial conglomeration — the largest financial coming together of banking, insurance, and securities — when legislation was still on the books saying this was illegal. And they pulled this off with the blessings of the president of the United States, President Clinton; the chairman of the Federal Reserve system, Alan Greenspan; and the secretary of the treasury, Robert Rubin.

And then, when it’s all over, what happens? The secretary of the treasury becomes the vice chairman of the emerging Citigroup.

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charles geisst
A professor of finance at Manhattan College, he is the author of numerous books on Wall Street and financial history.

read the full interview

The decisions of the Federal Reserve had pretty well washed away Glass-Steagall. Nonetheless, does Sandy Weill need legislation to put Glass-Steagall in a coffin — to kill it?

Yes, he does. …

Did Sandy Weill push for legislation in Congress? And why?

Certainly, Citigroup pushed for legislation to get rid of Glass-Steagall, pass what was called HR10 at the time, which became the Financial Services Modernization Act [of 1999].

Part of [Weill’s] deal with the Federal Reserve was to get rid of all Glass-Steagall violations in the new Citigroup within two years. Otherwise, he would have been faced with a divestiture of a company which had just been put together, because of an old law which is still on the books. So it clearly behooved him, and many other people in the financial services industry who wanted to accomplish essentially the same sort of thing in the future, to push to get Glass-Steagall repealed. …

So they pushed hard?

Pushed very hard. … They pushed so hard that the legislation, HR10, House Resolution 10, which became the Financial Services Modernization Act, was referred to as “the Citi-Travelers Act” on Capitol Hill. …

Did the Fed’s approval of the Citibank-Travelers merger really give impetus to Congress to pass the act?

Yes. Without the Fed’s approval, Congress would have probably dragged their feet. … But once the Fed gave its imprimatur, it was only a matter of time before it would fall. Part of this had to do with the general halo effect around Alan Greenspan on Wall Street at the time. …

What was the impact politically on Congress of Sandy Weill’s pushing for repeal of Glass-Steagall?

When Weill clearly wanted to get rid of Glass-Steagall so that his new organization would survive, many in Congress — important folks in Congress, who had previously been opposed to modernizing legislation — decided to get on board. …

They were brought into the stream by the same sorts of arguments which Alan Greenspan had been making for the past 10 years, which Weill had been making and others, Merrill Lynch, had been making. I think they realized if they didn’t get on board, they could be seen to be getting in the way of financial progress.

What made Sandy Weill so influential with Congress?

His success. … Sandy Weill proved that when, for instance, Smith Barney and Travelers could join up and succeed, that the old prohibitions maybe were based on politics from [the past] which were no longer valid. His success was showing people that the old law was exactly that, it was antiquated.

Did he do much personal lobbying? Phone calls to key members of Congress, like Paul Sarbanes, and what-not?

Yes, his organization did. … In the year previous to the Financial Services Modernization Act, the thing that overruled Glass-Steagall, Citibank spent $100 million on lobbying and public relations, which is a good indication.

And most or all of that to repeal Glass-Steagall?

Yes. They spent a small fortune, a king’s ransom, if you will, getting rid of Glass-Steagall. In fact, when thrown in with other financial firms’ lobbying, it was closer to $200 million over the short period of time. …

What Sandy Wrought:

The Impact of the Superbank
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scott cleland
A top telecom strategist, Cleland is the founder and CEO of the Precursor Group, a research boutique for institutional investors.

read the full interview

What difference did it make that Glass-Steagall was repealed, and you could put these megabanks together?

The repeal of Glass-Steagall was a big deal. It enabled kind of colossal combinations that just weren’t envisioned before, where you brought the savvy of an investment banking house like Salomon Smith Barney together with a Citibank. Citibank could loan an enormous amount of money. So when you put those two things together, it’s kind of an unbeatable combination. Saying you can investment bank them and commercial bank them at the same time, it’s a very powerful combination.

So Sandy Weill and his team can market across the board to [WorldCom CEO] Bernie Ebbers. “You don’t need to go anywhere else, Bernie.”

It’s a one-stop shop strategy. It’s very powerful.

How much is that responsible for the investment fever, and this “get on the team,” “get on the bandwagon” feeling that you’ve got in the late 1990s?

The repeal of Glass-Steagall was an important contributor to the bubble.

In what way?

Well, it added to the frenzy. It added to the investment banking fervor. It added to the amount of money that was staked on this. Essentially, you had a bigger shoulder pushing that rock up the hill. …

The death knell of Glass-Steagall is really the Citibank-Travelers merger, which comes in 1998, through an exception granted by the Federal Reserve Board. If you look back at this, do you understand what Sandy Weill was up to when he was pushing for this merger, and that he was changing the whole landscape of banking?

… No, at the time I don’t think people connected the dots. But in hindsight, the repeal of Glass-Steagall was an accelerator for the telecom bubble, because remember, telecom companies need to raise an enormous amount of capital, both through equity and through debt. And these Glass-Steagall-enabled companies were able to provide whatever capital a telecom company could ever hope to raise. …

photo of levitt

arthur levitt
A former investment banker and chairman of the American Stock Exchange, he served as chairman of the Securities and Exchange Commission from 1993 to 2001.

read the full interview

The idea [of Glass-Steagall] was separating different kinds of banking so that you didn’t get the kind of collapse that you got in 1929?

Yes. … Glass-Steagall was enacted [in 1933] to respond to some of the scandals of the early part of the century, where individual investors were grievously hurt by banks who were promoting stocks that were of interest to the banks, rather than to investors. That was a very sensible division of investment banking and commercial banking.

What worries me about combining those two interests once again is the inducement, the likelihood, that commercial banks will tie their lending activities to their investment activities. …

Were you worried about a climate in which anything goes? “Trust the market, and the investors can take care of themselves?”

Yes, I worried about the power assumed by the commercial banks that now had the ability to be a financial services warehouse that could satisfy the needs of everybody, but whose overriding interest, I felt, would favor their corporate interests as opposed to the individual investor. …

So you worried that the individual investor and depositor and their protections get lost in the superbank concept?

Yes, I was very worried about that, because I felt that the culture of banking and the culture of investment banking were so different. … The lure of investment banking, and the amount of money that that meant to the commercial banks, was so much greater than whatever they got from depositors that the weighting of their emphasis would favor commercial business over the individual investor. …

You were worried about the erosion of the standards of commercial banking. …

The kind of scrutiny that a commercial bank would give to a loan has to erode. … One of the inducements offered to that bank would be, “We’ll give you not only our lending business but we’ll give you our investment banking business, as well.” …

Let’s say that a commercial bank underwrites a company. Millions of shares are outstanding in the public’s hands, and the company’s fortunes sink. Ordinarily, that commercial bank would place the interests of their depositors above all others at that point. … What kind of judgment are they going to make at this point, where they have perhaps a million investors out there who have bought shares in the company that their name is on? They will probably go a step further and lend more money and more money, and more money. Then we have the shareholders and the depositors in the bank at risk. …

Will that bank have the same kind of restraint, the same kind of controls on their lending operation, that they might have had if they were free of that investment banking obligation to the millions of shareholders that they’ve marketed shares to? … You can’t let this company go down. It’s the reputation of the bank that’s at stake now. So that’s where the nexus of Glass-Steagall becomes very, very sticky. …

The merger of investment bank and commercial bank interests has created conflicts of interest that clearly hurt the public investor. Only extraordinary activity by both the banking and security regulators can begin to address [the] issue.

photo of blinder

alan blinder
Professor of economics at Princeton, former vice chairman of the Federal Reserve Board, and former member of the Council of Economic Advisors under President Bill Clinton.

read the full interview

What about [the argument that] the bigger the institution, the broader the spread, the greater potential conflict of interest? … Were any of those issues salient in your mind [when you were on the Federal Reserve Board in the mid-1990s]? Concern about conflicts of interest in a superbank?

I don’t think too much, because there had been a fair amount of what some people would call “revisionist history” — but I could call “history” — of what went on in the 1930s … the cauldron that gave birth to Glass-Steagall. I think a fair reading of that would’ve been there were many, many misdeeds, many things went on that should never have been allowed to go on — plenty of crookedness — but very little, nearly zero of it, had its roots in the joining of banking and securities underwriting.

That is, look what’s just happened in the last few years, with the scandals in the securities industry. This hasn’t really had to do with the conjoining of banking and securities. It had to do with shenanigans going on in companies I won’t name here, with analysts and others, that should never have happened. But the fact that some of them might’ve been associated with banks was pretty much irrelevant to them. …

Are you saying that none of the abuses that we see on Wall Street were a product of this merger of all these different services?

Yes, very nearly. That is right. There were abuses. Some of them needed to be legislated against; some of them need to be penalized in the legal system; but I think precious little, if any, have to do with [repeal of Glass-Steagall]. …

You can argue, people did argue in the long-standing debate over Glass-Steagall, that there was a cultural difference between, say, the securities business and banking, and the bad side of that is that the more the securities culture “infected” banking, the worse banking would be.

There was another way to run the argument, which was the more the banking relationship culture, quote, “infected” — or, I should say “affected”? — securities, the better the securities industry would be. So this can go both ways. …

The point is that I’m not at all convinced — it would take a lot to convince me of this — I just don’t see the evidence that [the late-1990s] bubble was made worse, not to mention immeasurably worse, by the conjoining of some banks and some securities companies. … Citi happened to be combined with a very big bank. But lots of the same things — as bad or worse — were going on where there was no such agglomeration.

See, if you want to make the case that a lot of shady things were happening in this period and a lot of bad judgment was exercised, I’m with you 100 percent. But if you want to make the case that it was in large measure because of the tearing down of the barriers among insurance, banking, and securities, I just don’t see that. …

photo of spitzer

Eliot Spitzer
Spitzer is the attorney general of New York. He spearheaded the investigations into Wall Street practices that led to the historic $1.4 billion settlement announced on April 28, 2003.

read the full interview

One of the allegations made by a number of people who follow the banking industry is that the mere formation of a superbank like Citigroup — and putting insurance, brokerage, investment banking, and commercial banking under one roof — inherently increases the conflicts of interests. … Does the formation of superbanks increase conflicts of interest that have the potential of hurting investors?

Absolutely. No question about it. There is no question that we have created a web of relationships that provide the opportunity for massive abuse. And what we uncovered last year demonstrates there was massive abuse. The only remaining question, then, is do you create, and can you create, a way to mediate among these conflicts to protect the consumer? Or do you have to rip apart the structure? I think we have an enormous policy debate that is facing us.

You’re saying, in other words, we have to go back and reconsider whether or not it was smart to allow the formation of these superbanks?

I think that’s absolutely something we have to reconsider. I don’t think that the Congress and the Fed right now are willing to ask that fundamental question. I think they are trying to create firewalls between or among these various pieces to protect against the conflicts. But the enormous question facing us is how do you protect consumers, and businesses that are consumers in their own way, against this web of conflicts of interest? …

Specifically, I was wondering whether or not you all looked at the fact that the Travelers arm of Citigroup granted a $1 billion mortgage to [WorldCom CEO] Bernie Ebbers? …

We looked at some of those issues relating to CEOs and Bernie Ebbers and the way that money flowed to him, and in fact we brought law suits against some CEOs alleging that these conflicts were civil wrongs. So, yes, we are deeply troubled by that and it’s one more manifestation of the failure of the bank to operate within proper business parameters.

Are you talking about that billion-dollar mortgage?

We’re talking about the fact that loans were being made and at the same time that those CEOs were being solicited for investment banking, underwriting business. We view that as intentionally — and in some cases, illegally — improper. …

So you’re saying the repeal of Glass-Steagall and the permission for these huge superbanks is one of the proximate causes of the corruption on Wall Street?

Absolutely. There’s no question about it. On the day that I announced the global settlement, on Dec. 20, [2002], I began by saying that the problem at its root is a flawed business model, and that business model is the product of a government regulatory decision to repeal Glass-Steagall administratively and legislatively, and to seek this tremendous concentration of power, and then the abuse of that power by the investment houses.

But it was that effort to create these one full-service banks, and that model that was the proximate cause for all of this.

And do you see evidence that anybody wants to break that model up?

I see evidence that very thoughtful people are questioning it. I don’t see any evidence in Washington that there is a will to do so.

Do you see Sandy Weill doing it at Citigroup?

The bankers are never going to do it themselves. They benefit from it. Only when Congress, which has the power to pass the laws, or the Fed, that has the power ultimately to make the rules about banks, or the SEC, determines that the conflicts of interest are so intractable and so beyond the capacity of the investment houses to mediate, only when they reach that conclusion will they be forced to say this model isn’t going to work.
The Long Demise of Glass-Steagall

A chronology tracing the life of the Glass-Steagall Act, from its passage in 1933 to its death throes in the 1990s, and how Citigroup’s Sandy Weill dealt the coup de grâce.


Glass-Steagall Act creates new banking landscape

Following the Great Crash of 1929, one of every five banks in America fails. Many people, especially politicians, see market speculation engaged in by banks during the 1920s as a cause of the crash.

In 1933, Senator Carter Glass (D-Va.) and Congressman Henry Steagall (D-Ala.) introduce the historic legislation that bears their name, seeking to limit the conflicts of interest created when commercial banks are permitted to underwrite stocks or bonds. In the early part of the century, individual investors were seriously hurt by banks whose overriding interest was promoting stocks of interest and benefit to the banks, rather than to individual investors. The new law bans commercial banks from underwriting securities, forcing banks to choose between being a simple lender or an underwriter (brokerage). The act also establishes the Federal Deposit Insurance Corporation (FDIC), insuring bank deposits, and strengthens the Federal Reserve’s control over credit.

The Glass-Steagall Act passes after Ferdinand Pecora, a politically ambitious former New York City prosecutor, drums up popular support for stronger regulation by hauling bank officials in front of the Senate Banking and Currency Committee to answer for their role in the stock-market crash.

In 1956, the Bank Holding Company Act is passed, extending the restrictions on banks, including that bank holding companies owning two or more banks cannot engage in non-banking activity and cannot buy banks in another state.


First efforts to loosen Glass-Steagall restrictions

Beginning in the 1960s, banks lobby Congress to allow them to enter the municipal bond market, and a lobbying subculture springs up around Glass-Steagall. Some lobbyists even brag about how the bill put their kids through college.

In the 1970s, some brokerage firms begin encroaching on banking territory by offering money-market accounts that pay interest, allow check-writing, and offer credit or debit cards.


Fed begins reinterpreting Glass-Steagall; Greenspan becomes Fed chairman

In December 1986, the Federal Reserve Board, which has regulatory jurisdiction over banking, reinterprets Section 20 of the Glass-Steagall Act, which bars commercial banks from being “engaged principally” in securities business, deciding that banks can have up to 5 percent of gross revenues from investment banking business. The Fed Board then permits Bankers Trust, a commercial bank, to engage in certain commercial paper (unsecured, short-term credit) transactions. In the Bankers Trust decision, the Board concludes that the phrase “engaged principally” in Section 20 allows banks to do a small amount of underwriting, so long as it does not become a large portion of revenue. This is the first time the Fed reinterprets Section 20 to allow some previously prohibited activities.

In the spring of 1987, the Federal Reserve Board votes 3-2 in favor of easing regulations under Glass-Steagall Act, overriding the opposition of Chairman Paul Volcker. The vote comes after the Fed Board hears proposals from Citicorp, J.P. Morgan and Bankers Trust advocating the loosening of Glass-Steagall restrictions to allow banks to handle several underwriting businesses, including commercial paper, municipal revenue bonds, and mortgage-backed securities. Thomas Theobald, then vice chairman of Citicorp, argues that three “outside checks” on corporate misbehavior had emerged since 1933: “a very effective” SEC; knowledgeable investors, and “very sophisticated” rating agencies. Volcker is unconvinced, and expresses his fear that lenders will recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public. For many critics, it boiled down to the issue of two different cultures – a culture of risk which was the securities business, and a culture of protection of deposits which was the culture of banking.

In March 1987, the Fed approves an application by Chase Manhattan to engage in underwriting commercial paper, applying the same reasoning as in the 1986 Bankers Trust decision, and in April it issues an order outlining its rationale. While the Board remains sensitive to concerns about mixing commercial banking and underwriting, it states its belief that the original Congressional intent of “principally engaged” allowed for some securities activities. The Fed also indicates that it will raise the limit from 5 percent to 10 percent of gross revenues at some point in the future. The Board believes the new reading of Section 20 will increase competition and lead to greater convenience and increased efficiency.

In August 1987, Alan Greenspan — formerly a director of J.P. Morgan and a proponent of banking deregulation — becomes chairman of the Federal Reserve Board. One reason Greenspan favors greater deregulation is to help U.S. banks compete with big foreign institutions.


Further loosening of Glass-Steagall

In January 1989, the Fed Board approves an application by J.P. Morgan, Chase Manhattan, Bankers Trust, and Citicorp to expand the Glass-Steagall loophole to include dealing in debt and equity securities in addition to municipal securities and commercial paper. This marks a large expansion of the activities considered permissible under Section 20, because the revenue limit for underwriting business is still at 5 percent. Later in 1989, the Board issues an order raising the limit to 10 percent of revenues, referring to the April 1987 order for its rationale.

In 1990, J.P. Morgan becomes the first bank to receive permission from the Federal Reserve to underwrite securities, so long as its underwriting business does not exceed the 10 percent limit.


Congress repeatedly tries and fails to repeal Glass-Steagall

In 1984 and 1988, the Senate passes bills that would lift major restrictions under Glass-Steagall, but in each case the House blocks passage. In 1991, the Bush administration puts forward a repeal proposal, winning support of both the House and Senate Banking Committees, but the House again defeats the bill in a full vote. And in 1995, the House and Senate Banking Committees approve separate versions of legislation to get rid of Glass-Steagall, but conference negotiations on a compromise fall apart.

Attempts to repeal Glass-Steagall typically pit insurance companies, securities firms, and large and small banks against one another, as factions of these industries engage in turf wars in Congress over their competing interests and over whether the Federal Reserve or the Treasury Department and the Comptroller of the Currency should be the primary banking regulator.


Fed renders Glass-Steagall effectively obsolete

In December 1996, with the support of Chairman Alan Greenspan, the Federal Reserve Board issues a precedent-shattering decision permitting bank holding companies to own investment bank affiliates with up to 25 percent of their business in securities underwriting (up from 10 percent).

This expansion of the loophole created by the Fed’s 1987 reinterpretation of Section 20 of Glass-Steagall effectively renders Glass-Steagall obsolete. Virtually any bank holding company wanting to engage in securities business would be able to stay under the 25 percent limit on revenue. However, the law remains on the books, and along with the Bank Holding Company Act, does impose other restrictions on banks, such as prohibiting them from owning insurance-underwriting companies.

In August 1997, the Fed eliminates many restrictions imposed on “Section 20 subsidiaries” by the 1987 and 1989 orders. The Board states that the risks of underwriting had proven to be “manageable,” and says banks would have the right to acquire securities firms outright.

In 1997, Bankers Trust (now owned by Deutsche Bank) buys the investment bank Alex. Brown & Co., becoming the first U.S. bank to acquire a securities firm.


Sandy Weill tries to merge Travelers and J.P. Morgan; acquires Salomon Brothers

In the summer of 1997, Sandy Weill, then head of Travelers insurance company, seeks and nearly succeeds in a merger with J.P. Morgan (before J.P. Morgan merged with Chemical Bank), but the deal collapses at the last minute. In the fall of that year, Travelers acquires the Salomon Brothers investment bank for $9 billion. (Salomon then merges with the Travelers-owned Smith Barney brokerage firm to become Salomon Smith Barney.)

April 1998

Weill and John Reed announce Travelers-Citicorp merger

At a dinner in Washington in February 1998, Sandy Weill of Travelers invites Citicorp’s John Reed to his hotel room at the Park Hyatt and proposes a merger. In March, Weill and Reed meet again, and at the end of two days of talks, Reed tells Weill, “Let’s do it, partner!”

On April 6, 1998, Weill and Reed announce a $70 billion stock swap merging Travelers (which owned the investment house Salomon Smith Barney) and Citicorp (the parent of Citibank), to create Citigroup Inc., the world’s largest financial services company, in what was the biggest corporate merger in history.

The transaction would have to work around regulations in the Glass-Steagall and Bank Holding Company acts governing the industry, which were implemented precisely to prevent this type of company: a combination of insurance underwriting, securities underwriting, and commecial banking. The merger effectively gives regulators and lawmakers three options: end these restrictions, scuttle the deal, or force the merged company to cut back on its consumer offerings by divesting any business that fails to comply with the law.

Weill meets with Alan Greenspan and other Federal Reserve officials before the announcement to sound them out on the merger, and later tells the Washington Post that Greenspan had indicated a “positive response.” In their proposal, Weill and Reed are careful to structure the merger so that it conforms to the precedents set by the Fed in its interpretations of Glass-Steagall and the Bank Holding Company Act.

Unless Congress changed the laws and relaxed the restrictions, Citigroup would have two years to divest itself of the Travelers insurance business (with the possibility of three one-year extensions granted by the Fed) and any other part of the business that did not conform with the regulations. Citigroup is prepared to make that promise on the assumption that Congress would finally change the law — something it had been trying to do for 20 years — before the company would have to divest itself of anything.

Citicorp and Travelers quietly lobby banking regulators and government officials for their support. In late March and early April, Weill makes three heads-up calls to Washington: to Fed Chairman Greenspan, Treasury Secretary Robert Rubin, and President Clinton. On April 5, the day before the announcement, Weill and Reed make a ceremonial call on Clinton to brief him on the upcoming announcement.

The Fed gives its approval to the Citicorp-Travelers merger on Sept. 23. The Fed’s press release indicates that “the Board’s approval is subject to the conditions that Travelers and the combined organization, Citigroup, Inc., take all actions necessary to conform the activities and investments of Travelers and all its subsidiaries to the requirements of the Bank Holding Company Act in a manner acceptable to the Board, including divestiture as necessary, within two years of consummation of the proposal. … The Board’s approval also is subject to the condition that Travelers and Citigroup conform the activities of its companies to the requirements of the Glass-Steagall Act.”


Intense new lobbying effort to repeal Glass-Steagall

Following the merger announcement on April 6, 1998, Weill immediately plunges into a public-relations and lobbying campaign for the repeal of Glass-Steagall and passage of new financial services legislation (what becomes the Financial Services Modernization Act of 1999). One week before the Citibank-Travelers deal was announced, Congress had shelved its latest effort to repeal Glass-Steagall. Weill cranks up a new effort to revive bill.

Weill and Reed have to act quickly for both business and political reasons. Fears that the necessary regulatory changes would not happen in time had caused the share prices of both companies to fall. The House Republican leadership indicates that it wants to enact the measure in the current session of Congress. While the Clinton administration generally supported Glass-Steagall “modernization,” but there are concerns that mid-term elections in the fall could bring in Democrats less sympathetic to changing the laws.

In May 1998, the House passes legislation by a vote of 214 to 213 that allows for the merging of banks, securities firms, and insurance companies into huge financial conglomerates. And in September, the Senate Banking Committee votes 16-2 to approve a compromise bank overhaul bill. Despite this new momentum, Congress is yet again unable to pass final legislation before the end of its session.

As the push for new legislation heats up, lobbyists quip that raising the issue of financial modernization really signals the start of a fresh round of political fund-raising. Indeed, in the 1997-98 election cycle, the finance, insurance, and real estate industries (known as the FIRE sector), spends more than $200 million on lobbying and makes more than $150 million in political donations. Campaign contributions are targeted to members of Congressional banking committees and other committees with direct jurisdiction over financial services legislation.

Oct.-Nov. 1999

Congress passes Financial Services Modernization Act

After 12 attempts in 25 years, Congress finally repeals Glass-Steagall, rewarding financial companies for more than 20 years and $300 million worth of lobbying efforts. Supporters hail the change as the long-overdue demise of a Depression-era relic.

On Oct. 21, with the House-Senate conference committee deadlocked after marathon negotiations, the main sticking point is partisan bickering over the bill’s effect on the Community Reinvestment Act, which sets rules for lending to poor communities. Sandy Weill calls President Clinton in the evening to try to break the deadlock after Senator Phil Gramm, chairman of the Banking Committee, warned Citigroup lobbyist Roger Levy that Weill has to get White House moving on the bill or he would shut down the House-Senate conference. Serious negotiations resume, and a deal is announced at 2:45 a.m. on Oct. 22. Whether Weill made any difference in precipitating a deal is unclear.

On Oct. 22, Weill and John Reed issue a statement congratulating Congress and President Clinton, including 19 administration officials and lawmakers by name. The House and Senate approve a final version of the bill on Nov. 4, and Clinton signs it into law later that month.

Just days after the administration (including the Treasury Department) agrees to support the repeal, Treasury Secretary Robert Rubin, the former co-chairman of a major Wall Street investment bank, Goldman Sachs, raises eyebrows by accepting a top job at Citigroup as Weill’s chief lieutenant. The previous year, Weill had called Secretary Rubin to give him advance notice of the upcoming merger announcement. When Weill told Rubin he had some important news, the secretary reportedly quipped, “You’re buying the government?”
More Awful Truths About Republicans

Daily Article by Robert B. Ekelund and Mark Thornton | Posted on 9/4/2008 12:00:00 AM

As the economic debacle facing Americans continues to materialize, those responsible are running for cover with ten Republican senators refusing to attend their own national convention. Four years ago we observed that the so-called “Republican philosophy” of small government, sound money, and balanced budgets was illusory in terms of the history and then-current policies of the Republican Party.[1] However, even we would never have guessed how awful the Republican Party economic policy would become. From mere mercantilism, the Republican Party is now flirting with comprehensive socialist economic policy and another Great Depression.

The Republican Party was founded on big government and economic intervention with roots in the economic platforms of Federalist icon Alexander Hamilton and Whig leader Henry Clay. Indeed, the term “New Deal” was coined in 1865 to characterize Lincoln and his Republican Party economic platform. Republicans became the “mercantile” party of big business, big government, external protection, centralized monetary control, strong restrictions on immigration, and aggressive foreign policy.

From FDR’s New Deal to LBJ’s Great Society, Democratic policies forced many free-market activists into the Republican fold. People like Robert Taft, Barry Goldwater, Ronald Reagan, and of course Ron Paul, represent this free-market faction in the Republican Party. For example, free markets, deregulation, and balanced budgets became the Republican mantra (if not reality) during the Reagan administration. The orchestrated marginalization of Ron Paul is just one indicator that the free-market faction has been routed and that the mercantilists are firmly in control. In fact, as we endure the current economic malaise, we can note that the Republican-dominated Congress (1994–2006) and the administrations of George W. Bush have morphed Republican-style mercantilism into corporate socialism.

Harmful military spending, unbalanced budgets, fiscal irresponsibility, protectionist and monopoly handouts to friends is the old style Republican playbook. The new style is audacious, unprecedented, and truly awful for the economy. It begins with the Republican-controlled Federal Reserve, which, under Alan Greenspan and Ben Bernanke, has flooded the economy with money and credit and bailed out every economic crisis since 1987. Greenspan’s admonitions against “irrational exuberance” apparently were not intended to restrain the Federal Reserve’s irresponsible monetary policy. Who in their right mind could honestly say that the Fed had nothing to do with the housing bubble after driving the nominal interest rate to 1% and proclaiming that the mortgage market was well regulated?

But an insidious form of “market-based policy” is also a real culprit in the current mess. In 1999 a bill was passed by a Republican Congress and signed by Democratic President Bill Clinton that rescinded the Depression era’s divorce of commercial banking activities from investment banking, called the Glass-Stegall Act of 1933. That opened a floodgate of “creative” financial instruments backed by notes and other commercial paper. Much of the banking regulation of the Roosevelt administration — including abandonment of the gold standard — made absolutely no sense, but markets can fail with dire short-run consequences under a fiat monetary system. With Glass-Stegall, Congress put its finger on and mitigated the tendency and temptations of banks to create massive costly externalities to society, in this case, by holding bundled mortgage-backed securities which were deemed safe by rating agencies but which ultimately failed the market test.

The Financial Services Modernization Act of 1999 would make perfect sense in a world regulated by a gold standard, 100% reserve banking, and no FDIC deposit insurance; but in the world as it is, this “deregulation” amounts to corporate welfare for financial institutions and a moral hazard that will make taxpayers pay dearly. Such government privileges are nothing new to Republicans — consider the effective subsidies to the pharmaceutical, sugar, and steel industries — but this particular gift to financial institutions is what allowed the credit bubble to expand to such absurd proportions, because it allowed banks of all types to engage in increasingly risky transactions and to greatly expand the leverage of their balance sheets. As the crisis unfolds, credit continues to contract, the risk of bank failures increases, and the possibility of far more serious economic consequences become more apparent. The S&L crisis cost the taxpayers a few hundred billion, but this crisis has the potential of saddling the taxpayer with several trillion in bailouts.

So far, the Republican solution has been to bail out lenders — wealthy financial-industry professionals for the most part — who made unwise market decisions with subsidies and election-year subventions. With Hank Paulson, the former CEO of Goldman Sachs, as Secretary of the Treasury and the big banks on the Board of Directors of the New York Fed, it should not be too surprising that the Fed has been listening only to Wall Street while ignoring Main Street.

But the real problem is that their policies will lead to the nationalization of much of the mortgage-real-estate market. On July 30, 2008, President George Bush signed a bill into law that bails out Fannie Mae and Freddie Mac to the tune of an estimated $25 billion dollars in taxpayer losses, according to the Congressional Budget Office (CBO). The bailout is intended to stabilize the short-term economy, but this ill-conceived nod to socialism will have disastrous long-term effects. First, according to most economic estimates, the bill that taxpayers would have to eat is many times larger than the laughably small CBO estimate. Economist Don A. Rich has calculated the possible losses at as low as $1.3 to $1.6 trillion given likely housing price declines and as high as $2.5 trillion (if the housing price fall mimics that of the Great Depression).[2] The fallout from either of these scenarios would be catastrophic as the Federal Reserve accommodated (within the fiat money system) the taxpayer-backed debt. The real debt would be inflated away and America’s real income could be reduced by as much as twenty percent.

The expansion of Federal Reserve authority is almost as alarming as nationalizing the mortgage industry. While the bailout includes the typical reductions in the Federal Funds Rate and the Discount Rate, it also includes the unprecedented moves to auction off discount rate loans, accept mortgage-backed securities in exchange for the Fed’s Treasury Notes and the financing of J.P. Morgan’s takeover of Bear Sterns. In May, the Fed began to allow investment firms to draw emergency loans directly from the central bank, and in July, it began to allow Fannie Mae and Freddie Mac to do the same even though such lending privileges had traditionally been restricted to commercial banks that have been subject to stricter regulatory supervision. All of this is predictable given the repeal of Glass-Stegall, which expanded the bad business practices that now “require” an expansion of the bailout.

But we see an even more insidious long-term economic problem, if that is imaginable. Moral hazard is endemic to this Bush-backed scheme to “relieve” an election-year economy. While the bill passed in late July does include some tighter regulation for the mortgage companies, it undeniably increases incentives for market participants — buyers and sellers — to engage in risky behavior. That is one of the products of financial socialism under a fiat monetary system — a system that mainly benefits wealthy lenders. Heads you win, tails you do not lose.


Further, every incentive by profit-seeking lenders and asset-poor buyers will be in place for a continuing or recurrent mortgage debacle. Financial institutions will not only have mercantile “protection” from the federal government in terms of regulations; they will become social arms of that government. While Democrats certainly facilitated these economic actions as fellow travelers, Republicans, most especially George W. Bush, acquiesced. (His only objection was a $4 billion grant to states and cities to “refurbish” foreclosed homes). The economic choice is clear: either maintain a fiat-money-creation system and reinstate the asset proscriptions of the Glass-Stegall Act or abandon or modify the existing system of money and banking altogether, possibly including elements of a gold standard. Without some basic alteration in rules, the entire economic system will continue to be at risk, as will America’s predominance in the world of finance.

What did you think of Alan Greenspan, [chairman of the Federal Reserve Board, 1987-2006], at the time he was leaving office?

Greenspan had a really good record over a large number of years. His most memorable decision was recognizing that the productivity growth in the late ’90s was stronger than the rest of us understood. So he allowed the economy to expand more, allowed unemployment to come down more, allowed incomes to rise more than I think others making monetary policy at the time would have done. I think that’s really probably, more than anything else, what gained him his reputation. …

What was the bold thing that Greenspan did? …

Deregulation was one of the most important things he did. That looked better at the time than it does to some people now. My sense is that deregulation gets a bad name. It was deregulation without adequate supervision by the bank supervisors and by the SEC and others. Deregulation was a bold step. It allowed banks to broaden their activities; it allowed banks to operate in national markets in a way they hadn’t before.

But in terms of the growth of the economy, when the unemployment rate was coming down in the late ’90s, and a lot of people were saying, “Well, we’ve got to slow this economy down; we can’t continue to grow at this rate,” Greenspan said, “No, what’s really going on now is not excessive demand, but a more rapid productivity growth than we’ve been accustomed to in the past, and therefore the old speed limits don’t count. We can grow at this faster rate and still have low inflation.”

That was true for a number of years there. And so we got more years of growth, more declines in unemployment, higher real incomes than somebody without his judgment … would have allowed.

Was there a mistake that he made, something he missed?

… He may have kept it going too long. He certainly kept it going longer than most of us, including myself, would have wanted, and yet he was right for most of that time.

So where was he wrong? …

I think [Greenspan] was wrong in the early part of this decade, when fearing deflation, fearing of falling prices, he brought down interest rates very dramatically and announced that interest rates would be held at a low level. The advantage of that, he thought correctly, was that it would bring down medium-term rates. … But by promising that those rates would be kept low for quite a while, he brought down longer-term rates. That, in turn, brought down mortgage rates; that stimulated the housing market and took us away from the deflation that he feared.

He explained at the time that it was a balance of risks. On the one hand, if you didn’t do something like this, there was the danger that the price level would continue to decline. Since you could only bring interest rates down to zero, if the price level was actually falling, the real cost of funds, meaning interest rates adjusted for inflation, would be greater than zero, and the economy could slow more and we could deflate faster, and so the real interest rate would be even higher, and we’d be in a trap from which the Fed could not rescue us. So that was the risk on one hand.

But there was also the risk that if you lowered interest rates a lot, it would lead to inflation. And he said: “There are these two risks, and I have to make the judgment about which was the greater risk.” And he said, I think correctly, that between those two risks, the greater risk was deflation, because if we had moved back up to an inflation rate of, say, 4 or 5 percent, well, the Fed knows how to cure that problem.

What he didn’t take into account was the risk of a rapid rise in asset prices. … And it’s the asset bubble, particularly in housing, but also in the stock market, that has become a major problem for us now in the ending years of this decade.

[What are the tools available to the Federal Reserve?]

What the Fed does is called monetary policy, and more recently might be called credit market policy. What the Treasury does — taxes, tax cuts, tax increases, spending — is called fiscal policy. … Monetary policy means changes in interest rates, changes in the money supply. It’s what the Fed does.

Credit policy — we’ve seen recently the Fed providing all kinds of credit and credit guarantees, offering to buy commercial paper and things like that. The Treasury can also engage in credit policies, providing guarantees to money market mutual funds as they did. And fiscal policy, actual outright purchases of goods and services, spending on everything from transfer payments to defense, that’s the job of the Treasury and the Congress, of course. …

Seems like we always heard about Greenspan, but Treasury secretaries were not in the headlines in quite the same way.

No, that’s a very important point. Until this recent downturn, economists would say — I would be one of them — that fiscal policy ought to aim at the long run. We ought to get our tax incentives right; we ought to spend money on the things we need to spend money on, but we shouldn’t be using fluctuations in taxes or fluctuations in spending to try to stabilize the economy. That’s the job of the Federal Reserve and of monetary policy. …

What’s happening now is really an exception to what we’ve done over the last several decades, and it’s an exception to what the textbooks would say, because we are in a very different kind of recession now than we’ve been in for the entire postwar period.

Unlike anything you’ve seen in your life?

Unlike anything I’ve seen or anything since the Depression that I’ve studied. So it’s a very different kind of downturn that requires us to go beyond the traditional tool of monetary policy and to use fiscal policy, to use government spending and tax changes to stimulate the economy.

We’re out a little into terra incognito?

We are, but again, I think we have little choice about what needs to be done. I think the Federal Reserve under Ben Bernanke has tried to do everything that was in the textbook or outside the textbook. They’ve been very bold. Nobody will accuse Ben Bernanke and this Federal Reserve of not trying everything. But there’s only a limit to what the Federal Reserve can do. Indeed, many people would think they’ve gone beyond the normal limits of what a central bank should do. And so it really is up to the Treasury; it’s up to the government with the backing of the Congress to do more if we’re going to get out of this very serious downturn. …

Did you know about these sort of sophisticated, fancy instruments, all the credit default swaps [CDS] and —

Yeah, I knew a lot about those. …

[What are credit default swaps, and what role did they play in the crisis?]

A credit default swap is a kind of insurance policy. A bank makes a loan to a company; it’s a concern that it’s a large loan. … It says either I have to sell off some of this loan to others, or I have to find some way of getting a guarantee or getting somebody who will back up this loan in case it defaults.

So it buys what is called a credit default swap. It buys a kind of insurance policy that says if that loan fails, then the people who have sold the credit default insurance will pay up the amount of default to the first bank. So it’s a very good idea because it allows banks to make loans to institutions they know and yet not have to bear all of the risk, and it does it in a very efficient way.

The trouble is that once this good idea got going, people realized that this could be used not just to provide insurance for somebody who made a loan, but any two people who had different views about the likely solvency, the ability of Ford Motor Company to pay the interest on its bonds, could agree to buy and sell a credit default swap. And so we ended up having vastly more credit default swaps outstanding than there were really insurable interests, people who had the initial claims; $62 trillion of credit default swaps were out there. And anything anybody had any risk on, there was an opportunity for people to take a gamble on that, in some cases to protect a position, in other cases just because two consenting adults wanted to gamble with each other.

It was a casino.

It was a market. We have lots of markets. We have puts and calls on stocks where you don’t have to own the stock to buy a put or a call. And so it’s not different from a lot of other markets, but it was very, very, very big.

And once defaults began to happen, then a lot of institutions that had sold this insurance were in trouble because they had to pay up to others who were the recipients of this, who had bought the insurance. And it wasn’t just somebody who had an insurable interest, somebody who had made a loan or held a bond, but somebody who was just speculating on the risk that that particular default would occur.

And it wasn’t just Joe paying Peter and Peter paying Bill; some of those institutions went bankrupt. When they went bankrupt, they couldn’t pay. So half of the transaction paid and the other half didn’t pay, and that added to the chaos. …

So what did you think?

I thought, and spoke about it at a Federal Reserve conference in the summer of 2007, that this combination of credit default swaps on mortgage-backed securities, that all of this was a potentially very, very dangerous combination; that the decline in house prices that had begun in the summer of 2006 was because of these mortgage-backed securities and because of the derivatives based on these mortgage-backed securities, that this could do tremendous damage to the balance sheets of financial institutions.

You knew how broad the problem was? …

Yes. Once you understood that that was out there, then you had a pretty good idea that this was a very serious problem, and that as house prices came down, we would see more mortgages becoming greater than the value of the house; we’d see more people with less equity in the house, with negative equity in their homes, meaning their loans would be greater than the value of the house, and that that would cause very serious problems. …

Things are happening with the banks around then, too, yes? There’s a kind of credit crisis starting?

… The credit crisis in the banks, the unwillingness to lend to each other and to others, really reflected the fact that there was a lack of confidence on the part of the banks in the creditworthiness of other financial institutions. And why? Because everybody knew that everybody else had these mortgage-backed securities and fancy derivatives based on these mortgage-backed securities. They didn’t know how much, but what they knew was that those things were not worth what they claimed to be on paper, and therefore the danger was that another institution to which you lent wasn’t going to be able to pay you back. …

So the easiest thing for a financial institution was to say: “Thanks, but no thanks. I don’t want to lend to other financial institutions.” So our credit markets really froze up, and lending stopped.

What are the implications that suggest themselves?

One implication is that if we don’t fix this, the economy is going to be in very serious trouble; that it’s not just a problem about the financial institutions, because if the financial institutions won’t lend, then if we don’t have credit, then businesses can’t borrow. If businesses can’t borrow, they can’t invest, can’t get to the demand for equipment. We don’t get the productivity gains and growth that comes from that. If households can’t borrow, then the consumer spending freezes. …

So while we had excessive borrowing, excessive leverage by households, and to some extent by businesses until 2007, once this problem became clear to the financial institutions, we had a freezing up in the availability of credit.

When you know, does Bernanke know?

… It’s very hard to know what they actually know, because in part they don’t want to alarm the public; they don’t want to alarm financial markets.

But I think it’s fair to say that they underestimated the magnitude of the problem. They didn’t really begin cutting interest rates in a serious way until early 2008. And at that point, they recognized that this was serious, and rates started coming down very quickly.

But if you know it, are you alone in this world?

No, I wasn’t alone. But people have different views, and many people said at the time: … “This is a problem with subprime mortgages. That’s just a small part of the mortgage market. The mortgage market is a small part of the credit markets more generally. Therefore, it’s a self-contained problem, and it will work itself out.”

That was wrong. It was wrong because the problem was a more fundamental one. It was that credit in general had been badly priced. People were giving out loans too generously to not just subprime borrowers, but other borrowers. We saw many loans, 90 and 100 percent loan-to-value ratios. We saw share prices which were very high relative to underlying earnings and dividends. But it took a while for market participants, including officials, to recognize that.

Where were the regulators? Where were the people supposedly watching this?

The bank supervisors from the Fed, from the controller of the currency part of the Treasury, from the state banking, their job is to make sure that the banks have adequate capital and that they have quality assets appropriate for a banking institution.

They were asleep at the switch. They really did not adequately evaluate the quality of the assets. They said: “Well, look, some rating agency has said this mortgage-backed security, this complicated synthetic thing that has been put together, is a AAA security. Well, that’s good enough for us if it was good enough for Moody’s and S&P to put that Good Housekeeping Seal of Approval on it.”

And when it came to capital, we kept hearing that the banks were well capitalized. Basically what the banks did, in order to conform to the capital requirements, was to set up these off-balance-sheet entities, these so-called special-purpose vehicles, which somehow were not subject to the same kind of capital requirements as the rest of the bank’s balance sheet.

So yes, they technically conformed to the capital requirements, but you would think that a savvy, even not a brilliant, supervisor — and we’re not talking about Ben Bernanke; we’re talking about the staff that are out there in the trenches — they should have recognized that there were all these off-balance-sheet accounts which were somehow undercapitalized, and that if anything started to go wrong, the banks would find themselves with inadequate capital.

You said they were asleep at the switch. How can that be?

How did it happen? They went in, and they looked at the assets, and they saw that these were highly rated assets, AAA mortgage-backed securities. They asked themselves about the off-balance-sheet special-purpose vehicles. The banks could reply, “Well, under the international banking rules, the so-called Basel rules, those don’t have to have as much capital as ordinary on-balance-sheet obligations.” Mortgages are allowed to have half the capital of loans to AAA companies. So these are strange rules, but the supervisors didn’t make them up.

And you can then say, well, why in the world did the international banking folk come up with these rules? I suppose they looked at history and said: “Well, mortgages have been very safe assets, while companies are not so safe. And we have to have rules that were in many countries, and so we can’t have different standards for a AAA U.S. company and a AAA German company, so that’s the way we do it.”

These mortgage-backed securities that were rated AAA were a relatively recent invention of the financial engineers. They could take a group of low-quality mortgages and create out of that a series of bonds, of mortgage-backed securities — that’s a fancy way of saying bonds — some of which were considered very risky, but others were considered very safe.

This is a CDO that you’re talking about now?

Yeah, it’s a particular form of collateralized debt obligation. Let me describe a very simple way in which this might work. You take 1,000 subprime mortgages; each one of those is a risky security. But you know they’re not all going to fail, so you agree on the following thing: Somebody will get the payments on the first 100 to fail. So if none fail, he gets full interest on whatever the obligation is. But the first 100 to fail are his problem, that institution’s problem. So that’s very risky. He knows that. He says, “I’ll only buy that security if you give me a very high interest rate,” and that’s agreed.

But the chance that there will be more than 100 failures is pretty small. So the next 100 to fail is considered a different security, and that security carries a lower interest rate … therefore the fellow who’s got the 201st mortgage, very low. So that’s already probably a AA or a AAA security because it’s so unlikely based on history that it would fail.

So you take these tranches — these slices — one after another, and by the time you get to the third or fourth slice, people would say: “Well, there’s no chance at all based on the history that we have examined that there will be any defaults there at all. That is better than a AAA bond; that is better than a U.S. government security.” And so those things were called super senior debt.

So the idea was that they created these different-quality mortgage-backed securities out of a pool of otherwise look-alike, very poor-quality underlying mortgages.

One of the problems was that when they did this, they based this rating, how likely or unlikely it is that these will default, on very recent history, last five years or so. Well, those were five wonderful years for the real estate market. House prices were going up, in some years at double-digit rates. So it was very unlikely that there would be defaults on individual mortgages, and therefore, things looked much better than [they] turned out to be.

Once house prices peaked and started coming down, then we began to see very substantial defaults, and the thing that triggered the crisis in the middle of 2006 and on into 2007 was that there were many more defaults on subprime loans than anybody expected, because all of these ratings were based on a favorable period in which house prices were rising, and now we were in an unfavorable period in which house prices were falling.

So instead of going back 20 years and saying what’s the worst year, what’s the best year, and finding a good average that way?

Right. But the rating agencies, in their defense, would say the world is always changing, and so we look at the recent past because the distant past may be very different. Well, it turns out that the future may be very different from the recent past as well, and that’s where they got it wrong. …

Some people say there wasn’t enough regulation, there weren’t enough regulators out there. Other people say there were plenty of regulators out there.

I would change the word “regulator” to “supervisor,” and yes, there were a lot of supervisors, but they obviously were not asking the right question. They were looking at the fact that others more technical than themselves had evaluated these mortgage-backed securities and given them AAA ratings or super senior ratings. And so they, the supervisor on the ground in the banks, could say: “Well, we’re not supposed to dig down more deeply into these complex securities. Somebody else has done it for us, and we’ll take their word for it.” That was the mistake.

There were also in these processes lots of people who say to us: “I’m at a party. The punch bowl is there; I’m not going to leave the party.” …

People get drunk doing that. [William] McChesney Martin was chairman of the Federal Reserve back a number of years ago, [from 1951 to 1970], who said the job of the Federal Reserve was to take away the punch bowl when the party is just getting good. He was talking about it in terms not of individual securities but of an economy that could be overheating. And so it was the job of the Fed to slow the economy down to prevent inflation. But you could use that same analogy here and say the supervisors should have done something; perhaps even the Fed in its monetary policy should have done something to slow down this housing bubble. …

When you see storm clouds gathering in 2007, are you seeing them specifically around Bear Stearns?

Not specifically. …

So you’re looking at the world. Is your worry as specific as Bear, Lehman [Brothers], Merrill [Lynch], Goldman Sachs, private investment banks, or is it they’ll fall first and then something will happen? Are you creating doomsday scenarios in your mind, or calculations?

Not company by company, not company-specific ones, but [at] this talk that I gave at the Federal Reserve Bank’s conference in 2007, I painted this picture in which we were going to see what was already beginning to happen: that there would be a lack of confidence by financial institutions in each other, and therefore unwillingness to lend, and therefore a totally dysfunctional credit market. And so it didn’t matter what the names of the institutions were or even whether they were investment banks or commercial banks; they were going to have a hard time getting credit, and they were going to be unwilling to give credit. …

They’re all just kind of circling each other, I suppose, and worried about each other. When in that incredible week in March Bear Stearns goes from pretty good liquidity, I guess —

They said they had lots of liquidity, right. But then nobody wanted to extend or roll over liquidity to them, didn’t want to keep giving them liquidity, and that’s how they got in trouble.

Why didn’t they want to give it to them?

Because, again, you weren’t sure. You’re a financial institution; you need liquidity; you need to be able to pay your bills. If you give some of your cash to another institution, and they promise to give it back to you, well, that in the old days was good enough. But now you weren’t sure that the people you were about to give it to would be able to give it back to you next week or next month when you needed it. So you said: “It’s not worth doing. I’ll hold onto it. I want to be liquid.”

Are you surprised at how fast Bear Stearns went down?

… Once you think about the way in which liquidity goes away, … it’s not surprising. Once people are afraid to lend, then the spigots get turned off and there’s no money available. And all these institutions depend on being able to get liquidity, being able to get credit quickly from each other.

… Were you surprised at all that the government was involved in the brokering of a marriage between JPMorgan and Bear Stearns?

… No. If you go back to a decade or so earlier when we had the S&L problems, savings and loan problems, the government did a lot of marriage making. It went around findings savings and loans that were in trouble and found others that were healthy that could absorb them. So it’s not at all unprecedented. …

What do you think the rationale was for saving Bear Stearns? Was there a valid argument to let them go?

No, I think these institutions — and you’re going to ask me about Lehman next — these institutions are so interdependent that there are so many credit lines and credit-related instruments, like credit default swaps, out there that the failure of one of these institutions has very widespread repercussions. So the fact that they could prevent that in the case of Bear Stearns by getting JPMorgan to take over the entire balance sheet, all of the risks, except for a relatively small amount that the Fed agreed to take onto its balance sheet, was a sensible way of preventing what could have been a very harmful episode in the financial markets.

So the counterargument, which is let them go; let the market wash itself out?

This was letting the market work with a little help. In other words, this was not the government taking it onto its balance sheet; it was the government providing some relatively small piece of guarantee for a small part of the money that Morgan put up. So Morgan and its people went in and looked at the entrails of Bear Stearns, all of their assets, all of their liabilities, and said: “This is a good business, and it’s worth our having. The assets exceed the liabilities, but there are some pieces of it that are very risky. Maybe it will all work out, but we’d like to have some guarantee on this” — I think it was [the] $30 billion piece of it. And the Fed said, “Yes, that’s worth it to us to provide that guarantee.”

So far, months later, the Fed has recognized, I think, $2 billion of losses on that. The magnitude of the losses that could have occurred had they allowed Bear Stearns to fail could have been much, much bigger. …

The conservatorship of Fannie [Mae (Federal National Mortgage Association)] and Freddie [Mac (Federal Home Mortgage Corp.)], again, a surprise that this step would be taken, or a necessity?

I think it was a necessity. These were government entities. They were a strange, inappropriate hybrid of a government lending institution and a privately owned — that is, shareholder-owned — company. So between the two of them, they had $5 trillion of either outright liabilities, bonds or guarantees, which the federal government was guaranteeing, and yet they were out there to make profits for their shareholders. Quite unusual — nothing like it elsewhere in the economy. Their purpose on paper was to facilitate lower interest rates and the spread of mortgage availability to low-income individuals, but because there were no creditors watching, of course, why would you care what risks they were taking if you had a U.S. government guarantee? They were able to take outrageous risks, and that’s what we saw happen.

And they contributed to the problem in a sort of big and fundamental way.

They did, yes.

So then, by early September, Lehman is in big trouble. It’s almost like a replay of Bear Stearns except the government decides not to help them.

Again, not being an insider, I don’t know everything there is to know. The Fed and the Treasury have said about Lehman that they did not then have the legal authority to take over Lehman. Unlike Bear Stearns, where they could find a private buyer, there was no private buyer for Lehman. … And they did not have the TARP [Troubled Asset Relief Program] at the time, and so there was no way that they could save Lehman, they said.

Now, could they have? Could they have found, with the help of their clever lawyers, a way around it? I don’t know. But it was certainly something that had very adverse consequences in global capital markets. …

… Some say the entire Lehman circumstances, the overlay is the idea of moral hazard brought to bear: Look, we’ve just got to send a message to the Street that this excess, these fat cats can’t just live off the government. It’s not going to work if we do this.

We’ll never know. At least I don’t know, and perhaps at some point we will get a more detailed accounting from the insiders. But at this point, they are sticking to their story that the Fed didn’t feel that this was something they could just take onto their balance sheet with all of the potential losses associated with it. And the Treasury was not in a position to say, “Well, that’s OK then; we will guarantee those losses.” So in that sense, it was very different from Bear.

Can you give me a definition of moral hazard?

Moral hazard has nothing to do with morals or morality. It is that people will respond, institutions will respond, to incentives to take risks or to do other things that are inappropriate because of the incentive structure.

So, what’s a good example of that? If people have very good insurance, they may be less careful about locking their car when they park it, because if it’s stolen, well, the insurance company will pay for it. An economist would say that’s an example of moral hazard. If they didn’t have that insurance, they’d have locked the car.

So translating that into Wall Street, if you think you can take very big risks as a financial institution and in the end get saved by the Federal Reserve or the Treasury coming along, then you’re going to take very big risks. You’re not going to bother to lock the car. And so that’s the moral hazard that they worry about.

I don’t think you could convince the people at Bear Stearns that what happened to them represented an example of getting away easily. The senior executives of those firms were completely wiped out; many of the less senior executives lost all of their deferred compensation, their shares and everything, and their jobs. So it wasn’t at all obvious that you had to have an outright failure to punish people so that they wouldn’t succumb to the temptations of moral hazard.

How surprised were you by the events of that Tuesday, then? Lehman goes down on Sunday night, and the stock market is kind of up on Monday, and by Tuesday, everything kind of stops. Money stops.

Absolutely amazing. Around the world, people said, “This is a new world we’re in.” And people just said: “We’re not sure what’s going to happen. The government is clearly not going to be there to protect us the way we thought they were a few days ago.”

That’s the moment, isn’t it?

I think so. I can’t say to the hour, but people around the world tell me that they felt it in the days after the Lehman collapse.

What did they feel? What is it?

They saw a lot of losses happening immediately. Securities that they thought were worth 100 cents were worth nothing. Banks that were dependent upon those securities saw that they were taking big losses, and they had thought that if something like this happened, that this institution would be deemed to be too big to fail and that the Fed or the Treasury would come in and rescue them.

Now, of course Lehman was not a bank; it was an investment bank. It was not a member of the Federal Reserve, and as a member of the Federal Reserve in principle, it might have been able to go to the Fed and ask for a line of credit. But in the old days, if it didn’t have an adequate amount of quality collateral to post, it wouldn’t get that credit. These days, collateral standards, both here and in Europe, have been relaxed dramatically. But they may not have had even that much. In any case, they weren’t eligible because they were an investment bank. And as we’ve seen, other investment banks have now rushed to convert themselves into commercial banks and to sign up for the Fed so that at least as long as they have what the Fed would deem to be adequate collateral, they would be able to get lines of credit.

So Merrill jumps into Bank of America. Merrill goes into Bank of America, right? And Goldman and Morgan Stanley basically become commercial banks to protect themselves?

Right. So we worried for a long time about how the Fed would regulate investment banks. We don’t have any investment banks, so that problem has gone away.

Gone forever, maybe.

In a sense. I mean, other institutions will come to play the role of investment banks. We’ll have to give them a new name. Maybe we’ll call them investment banks eventually again. …

Then there’s the TARP moment, the bailout moment. Paulson and Bernanke come to Congress. Finally Congress enters our story. Where have they been through all of this?

They’ve been leaving it to the Fed.

As usual?

Yeah. I mean, this is, again, a very different thing. It’s not fiscal policy; it’s not monetary policy. It’s a kind of credit policy and going beyond the risks that the Fed can appropriately take. So the Fed looks correctly to government to say, “Yes, you can do these things and we will take the risk, or we will just do them.”

[Was Bernanke uniquely prepared for this because his research was on the Great Depression?]

There’s a lot of relevance to it. But it certainly is a different world now. It’s a globalized world. It’s a world of capital markets rather than banks. …

There really are two sets of problems. One is the modern analog of the collapsing bank in the 1930s, and that’s the fact that all these financial institutions are frozen and won’t lend to each other. So that isn’t the problem of the ’30s, but it is the financial-sector side of the story.

The other side is this fact that unemployment is rising rapidly, that with the destruction of household wealth, consumer spending is going to fall very rapidly, and something has to be done to replace that. And that’s the fiscal part of this that the Obama administration will turn its attention to.

But nobody really knows whether any of that stuff is going to work?

It’s very hard to imagine that it won’t work to some extent. The question is how much they do, the form in which they do it. Those things will determine how effective it is. In the 1930s there were a lot of programs, but there wasn’t that much government spending. We had programs to stabilize prices and programs to protect unions and programs to do this and do that. But until the Lend-Lease programs of developing military equipment to lend to the British and others got going, and until we went into World War II, the economy still languished with an unemployment rate of over 10 percent.

So the government has to get involved — that’s the one thing we all sort of know — and involved in big ways?

We at least think that that is the lesson of history with respect to this. We’ve gone as far as we can with monetary policy. Credit policies are stopping things from spinning down. It’s hard to see what you can do other than either government spending or really massive tax cuts of one sort or another.

And making all this money, trillions and trillions of dollars, worried about inflation? It seems inevitable, yes?

Not inevitable, possible. Depends on how the Fed undoes this money, takes it back later on. After all, they don’t drop it from helicopters; they do buy assets. They either buy government bonds or they buy private bonds in exchange for money. So they’ve got those, and when the time comes, they can sell them, put them back into the market and take that money back out.

That’s the hope? That’s the plan?

That’s the implicit plan.

Let’s back up just for a second. … When Paulson and Bernanke sit in [Speaker of the House] Nancy Pelosi’s office with all the heads of the House and Senate and [Chairman of the House Financial Services Committee] Barney Frank [D-Mass.] and [Chairman of the Senate Banking Committee] Chris Dodd [D-Conn.], and they say, “If we don’t do something about this by Monday, there is no economy,” was it hyperbole or a genuine fear?

I’m sure it was a genuine fear. Whether it was correct or not, I don’t know. Well, I suppose the answer is it was not correct because they got the $700 billion, they didn’t do much with it, and the economy is still here. It’s not getting better, but it didn’t disappear. …

Did you think TARP was a good idea?

No, I did not. No, I said that at the time.


Remember, the TARP started with a strategy that they were going to buy back these impaired securities, these mortgage-backed securities. There were $2.5 trillion worth of negative equity securities, so they didn’t have enough money to buy them back, even if they could pinpoint and target them. The way they were going to buy them back, by so-called reverse auction, that couldn’t possibly work with as much [of a] heterogeneous group of securities as was out there.

And they didn’t deal with the fundamental problem, which was that house prices were falling. The decline in house prices was creating an incentive to walk away because people had more and more negative equity in their homes. And in the United States, unlike every other country in the world, if you have negative equity and you want to walk away, you walk away, and in general, they cannot take more than the house itself. … Unlike the rest of the world, where people know that the creditors will take whatever other assets they have and then will attach their future wage income, here it led to, and would continue to lead to, defaults and foreclosures, pushing prices down. And this original plan for the TARP did nothing to deal with that.


Because that would have been a bigger, more complicated thing to do than to go and buy securities.

Now, in fact, they never did buy many securities, because they decided it was too hard. So they changed the strategy, and TARP II was [designed] to inject capital into the banks. And that they did do, because that was very easy to do. You’ve got 10 people in the room, and you can hand out $250 billion or something close to it. But that didn’t do anything either, because that wasn’t really the problem. And again, they didn’t do anything to deal with the true root cause of this, which was the downward spiral and the potential downward spiral in house prices associated with growing negative equity and the lack of recourse on loans.

Seems a little bit like they were just kind of veering from thing to thing?

They were making up new things that they thought would help. In each case, they had a story, a reason to think it would help. But in fact, quantitatively, it didn’t make sense.

You have a bank of the size of Citigroup with a $2 trillion balance sheet, and you invest $25 billion in them, what’s that going to do? It’s not going to do much. It’s not going to make Citigroup look more creditworthy to others. If you were nervous about how much they were underwater before, $25 billion isn’t going to change things very much, and it wasn’t going to induce them, Citi, to go and lend that money out, because they’re trying to get as much liquidity as they can. So these were bad ideas. …

The film airs in the middle of February, but here we stand: Is it possible that we just don’t know what to do; that it’s bad enough, that it’s new enough, that it’s big enough, that it’s worldwide enough that we just don’t know what to do?

In February, we’re going to think we know what we’re doing. We’re going to hope that it’s going to work. But we’re certainly not going to be sure that it’s going to work.

What do you mean?

At this time, we know that the Fed has brought the interest rate down essentially to zero. We know that the Obama administration has introduced a massive and unprecedented peacetime spending program. What we don’t know is how successful it’s going to be. And we can hope that this program is going to substitute for a lot of the private demand that has been lost because people are cutting back on consumer spending; construction is down; business investment is down. But we really can’t be sure of how much additional stimulus is actually going to come from these hundreds of billions of dollars of spending commitment by the new administration.

I mean, the fact is we’ve never been here before.

That’s true. Well, we haven’t been here since the 1930s.

Please, take a look at this clip where Ron Paul asks McCain about the role of president’s Working Group on Financial Markets (this is a team that battle in the “finacial” war room when market goes haywire) which for certainly has been meeting and assembling for the last few days to discuss the turmoil in the financial market. Watch how McCain veers off on a tangent line, babbling about how he is planning to secure advising positions for likes of Phil “Foreclosure” Gramm who incidentally has been blamed as one of the player to drill a regulatory hole to ease the sub-prime market and creation of CDO, CLO, and grotesque CDO squared’s.

Ron Paul DID NOT ASK ABOUT YOUR FUCKING CIRCLE OF AQUANTANCES; THAT WAS A CLEAR CUT QUESTION WITH REGARD TO THE RESPONSIBILITY OF Plung Protection Team, YOU DUMB FUCK… There is no one there tell this guy, “HEY! MORON, YOU STILL NEED TO ANSWER THE QUESTION.” I am so fucking upset at this moment that this guy probably going to be our next president while letting cronies and vultures devoure and rape our country — I sincerely wish I could restrain my anger in not burying a fist in to the monitor at this moment. “Phil Gramm… Phil Gramm” ARRRRGHHHHHHH! He doesn’t even know which counsile on his adminstration deals with the market, let alone be considered as an expert in dealing with market crisis. I can’t stand this inanity. Here’s another clip — almost the same — catching McCain touting about his “expertise” on economy:

Ok, if I wasn’t scared… Now I am.

The Wall St. Model is Broken . . . and Won’t Soon be Fixed!!

Posted by Larry Doyle on November 12, 2008 12:15 pm

Despite billions and now trillions of dollars in capital injections and equity investments made by our government, private equity, and sovereign wealth funds, our economic turmoil is a long way from being over. I do find it interesting that despite numerous Wall St. titans having indicated to us at different points over the last year that we were in the 7th inning of this fiasco, that now a recurring theme is that we should not expect any real economic recovery until 2010. Actually maybe we were in the 7th inning but it was the 7th inning of the first game of a 4 game set.

Well, if we want to figure out where and when we are moving forward, I think it would be beneficial to know from where and when we came.

For those over 50 years of age, perhaps you remember when mortgage money dried up. Perhaps you also recall the days of putting down 20% before you even thought of buying a home. In any event, the growth of the secondary mortgage market in the mid 1980s was a result of some very sharp financial minds on Wall St. who engineered a product called a Collateralized Mortgage Obligation (CMO).

CMOS and their cousins that grew from that model were and are not necessarily bad structures. However, much like prescription drugs. if and when they are abused. they can be deadly.

CMOs used the stream of cash flows from a standard fixed rate mortgage to create specific bonds which met the investment desires of a wide array of investors, including money market funds, bank portfolios, insurance companies, money managers, and pension funds. Prior to the development of the CMO, mortgages were an investment that typically only met the needs of bank portfolios.

As the CMO market grew, two developments occurred. First and foremost, Wall St. firms (which were making on average 1 point on each deal … on an average deal size of 300 million, the Wall St. underwriter made $3 million dollars … not too shabby) had an appetite for more and more mortgage collateral to do more and more deals.

In the mid-1980s, most CMO deals were done with private homebuilders such as Pulte Homes, Centex, Ryland et al. The second development was more substantial. If Wall St. could use mortgage collateral to execute CMOs, why couldn’t they use other forms of loans/assets to create similar sorts of structured products. Thus in the late 1980s the Asset Backed Securities market was launched using credit card loans, auto loans, computer leases, equipment leases, and the like. Again, all Wall St. was doing was using the stream of cash flows from these well underwritten loans to create securities that met the guidelines and needs of a wide array of investors. Again prior to the developments of these markets, the banks underwrote these loans at rates and terms that met their own portfolio needs (REMEMBER THIS POINT!!).

In the late ’80s Freddie Mac and Fannie Mae got a whiff of the profitability of these CMO deals and used their significant lobbying power to get legislation passed that made it advantageous from a tax standpoint for CMOs to be launched through them. While some Wall St. firms were reluctant to support Freddie and Fannie in this process, given F/F ’s position in the business they won out. (REMEMBER THIS POINT!!)

As the CMO and ABS engines grew ever stronger throughout the early to mid 90s, Wall St. needed to find more and more collateral to continue to feed this profit monster. Some Wall St. firms either purchased or made strategic alliances with originators (Lehman Bros bought Aurora Mortgage in Aurora, Colorado … Bear Stearns owned EMC Mortgage in Texas … Merrill Lynch purchased First Franklin, a sub-prime originator, from National City Bank) while some originators formed their own broker dealers to retain the profits of distributing these products (Countrywide Mortgage formed Countrywide Securities, JPM Chase grew its own investment banking presence in the late ’90s as did Bank of America)

In the midst of this growth, Wall St. continued to use this CMO model not only across other consumer asset classes but then branched out and used it with corporate loans as well. Thus Wall St. structured CLOs (collateralized loan obligations using the same financial engineering).

While there were hiccups with different deals for the most part the machine ran smoothly. The machine, though, was built on the premise of strict underwriting of the underlying loans and a robust ratings process.

However, at the turn of the century there were two critically important developments that occurred to truly escalate the disastrous situation we have currently. A number of individuals from Wall St. realized that they could form their own firms (hedge funds) which allowed them a greater share of the profits from this structured financial engineering with less internal or external oversight. (REMEMBER THIS POINT!!)

A large number of qualified analysts from the rating agencies left those firms to come to Wall St. to participate in the profit machine. This shift of talent both to hedge funds and from ratings agencies dramatically exacerbated and accelerated the financial meltdown of the last two years. (***given the amount of money in these hedge funds as well as the amount “earned” by the hedge fund managers it should be no surprise that they became very influential in currying political favor … especially with Barack this go round!!)

At the turn of the century, the Wall Street model was a pure “originate to distribute” model with little to no residual risk on behalf of the originators or underwriters. When there is no residual risk, those who “WIN” are the players that can purely process the most volume. Well, how does one get volume? Lower the credit standards, put fewer restrictions on borrowers, little to no covenants (NINA Loans … no income no asset check). WOW!!! What were we thinking?? Well Wall St. felt, “let’s worry about it tomorrow or maybe not at all because we are making too much money today.”

Hedge funds factored into the fray in two ways. They partnered with their friends on Wall St. in managing CBOs and CLOs and they purchased the cheapest bonds in the deals or so they thought. Rating agencies either were not smart enough to know what they were rating or were blinded by their own stream of profits given the growing volume of deals. They were negligent or complicit or both. Honestly there was nobody who truly was looking out for the investors, who it was assumed should look out for themselves. Where was the SEC when you really needed them??!! This was all hunky dory as long as the economy was humming and delinquencies and defaults by consumers, homeowners, and corporations were well behaved.

In 2005 or thereabouts Wall St. had such a voracious appetite for volume of collateral product that they pressed the envelope even further and came up with “synthetic” structures. These structures purely used a pool of known collateral (be it sub-prime mortgages, home equity loans, corporate loans, et al) as a reference pool for the stream of cash flows in the deal. Wow!!

Without the need for actual collateral Wall St. really rocked. (REMEMBER THIS POINT)

Under the “originate to distribute” model Wall St. hired reams of financial quants and engineers to structure deals. Wall St. grew their distribution efforts globally to sell these products far and wide.

Life was good!! … or so they thought.

Wall St. actually started to think they were as smart as everybody told them. Wall St. thought that their own models were so robust because they had the smartest minds build them. Wall St. thought that they had become so effective at “distributing” risk that they were blind to the fact of just how much risk they “created”. Then the music stopped. The Fed needed to increase rates to slow the pace of inflation that was emanating from global economic growth especially in Asia. Mortgage rates reset at higher levels. Freddie and Fannie started to show signs of distress. Wall St. pressed so hard that they “killed the goose that had laid the golden eggs”.

Against that backdrop, through the 3rd quarter in 2008, check out the volume of underwritings in these respective sectors vs 3rd quarter 2007.
Deals using mortgage collateral … … down 95%!!!!!!!!
Deals using commercial mortgage collateral … … down 89%!!!!!!!!
Deals using consumer assets … … down 75%!!!!!!!!

The mortgage and asset backed markets (including commercial mortgages) are twice the size of the overall U.S. government bond market and app half the size of the U.S. equity markets. The mortgage market doubled in size from the end of 2003 until the end of 2007!!!

Investors now fully appreciate that with the economy slowing and seemingly picking up speed that delinquencies and defaults will continue to ratchet higher. The embedded losses are only exacerbated by the massive leveraging that occurred via the use of “synthetic” cash flows. No, the media has no appreciation for this and will not share it with the public.

Where are the other shoes that have yet to drop??

Please refer back to the “synthetic” structure that I discussed. These synthetic structures grew exponentially with the growth of a product called the “credit default swap” or CDS. This product, in theory, is outstanding because it acts to protect investors against defaults on the underlying referenced corporation or entity (such as sub-prime mortgages). That said, instead of helping to distribute risk the CDS market has effectively “created” risk because it has grown to the point where it now is 10 times the size of the overall corporate bond market that it is supposed to be tracking.

Yes, the tail is very much wagging the dog. Hedge funds dominate the trading activity with close to 60% of the overall trading volume. Hedge funds have gotten good press so far for not having had many “blow ups”!!

Give it time, because hedge funds do not have to report to anybody as to what their positions are and where they have them marked. There is no doubt that they have positions that are grossly mismarked and that they have many positions that are totally illiquid. For many investors in these funds these are truly “roach motels”. Hedge funds will sell what is most liquid when they can to meet redemption requests. We should expect a significant number of hedge fund liquidations, consolidations, and out and out disasters.

Read more how “Hedge Funds on Hot Seat.”

In the S&L crisis of the late ’80s the overall cost was estimated to be $100bln+ with the government taking over and liquidating failed institutions. Now given the tremendous systemic risk that links Wall. St investment banks to hedge funds to insurance companies, to sovereign wealth funds to commercial banks to municipalities the losses are untold.

To think that a stimulus package of even $300bln along with the $700bln commitment that has already been made is going to “fix” our economy is foolhardy. We will definitely get “bear market” rallies in the stock market and politicians and market timers who will tell you that all is well but don’t get fooled by “that man behind the curtain”. The losses in the banking system alone are upwards of $1 trillion. From there let’s move into insurance companies, hedge funds et al. Paulson, Sheila Baer, Bernanke and others know that any money that goes into the system is purely going to help the banks recapitalize themselves in the face of these losses.

When Barney Frank, Nancy Pelosi, and Barack Obama complain that they need to make sure that credit lines open and remain open, they are not addressing the fact that the banks have an overwhelming amount of non-performing assets already and that those assets are likely going to grow in the face of an unemployment rate headed up by 2% to 4%!!

Please read this article in Monday’s WSJ highlighting how Uncle Sam is reworking the terms of the rescue package for AIG. This article highlights the systemic risk (Goldman Sachs is widely speculated to have the greatest counterparty risk exposure to AIG) and the very fluid nature of the deteriorating situation. Guess what? As taxpayers we have the bulk of the risk as we own 80% of AIG and will very likely lose a lot of money on this deal. That said, the near term losses would very likely be even greater if AIG were not propped up by the government. It is not a given that our longer term losses and negative impact on GDP won’t exceed the perils of immediate losses. We have a high stakes game of craps on our hands.

“Government, AIG Near Pact to Scrap Original Terms of Deal” … oh what fun!!

I have little doubt that we will also in large measure “nationalize” the auto industry. Read here how the “Auto Makers Force Bailout Issue” …

IMO, there are only a few moves that Obama, Summers, Geithner, Volcker, Buffet or Rubin can do to change this situation for the better. Those moves include:

1. lowering the tax rate on capital gains (I’m not so sure that Barack wants to do that)
2. categorically state that tax rates will not change (not sure he will do that either)
3. spending freeze!! (also not sure he wants to do this either).

Even with those moves, it may only shorten the length of our very deep recession but will not negate it.

Honestly, I have to believe that Barack is kicking himself thinking that his entire program to create social change may very well be at the mercy of these economic constraints. IMO, if he and/or the Democratic leadership aggressively push the tax/spend agenda, the markets will punish them in very short order.

With the unemployment rate headed higher, to at least 8% if not 9% or 10%+, I firmly believe that people will use any money from the government to simply pay off existing debt. That is the rational move at this point. Our U.S. personal savings rate is 1%!!! In China the personal savings rate is 40%!! The party’s over, the lights have come back on, and somebody has to pay the bill. Yep, that’s right and regrettably that bill is on the U.S. taxpayer. Screwed again.

The government has already massively increased it’s own debt and will “crowd out ” lending into other sectors.

If we go back to the first point I asked you to remember, with the “originate to distribute” model broken and not soon if ever to return, banks will now only underwrite those loans (consumer or corporate) that they feel comfortable putting into their own portfolio at terms and rates that are amenable to both sides. That is why I think rates for these loans will be higher and volumes will be lower. Batten down the hatches.

Paulson knew of the consequences of this scenario earlier this year. He hoped the banks could sell assets, he says as much in this piece … “Paulson, Bernanke Strained for Consensus In Bailout.”

As Maryann Hurley a Vice-President of D.A. Davidson recently said, “When the banks shed their balance sheets of a lot of these unwanted and poorly performing assets.” they may start to lend again. Hurley added that consumers need to fix their balance sheets as well after years of going into debt. The lack of a rigorous underwriting process is coming home to roost.

She adds, “I’m guessing it’s not going to be before 2010 at best and it’s most likely 2011 before the economy really starts to turn around.”

7th inning of game 1 of a 4 game series …

May 2009

The crash has laid bare many unpleasant truths about the United States. One of the most alarming, says a former chief economist of the International Monetary Fund, is that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time.

by Simon Johnson
The Quiet Coup

Image credit: Jim Bourg/Reuters/Corbis

One thing you learn rather quickly when working at the International Monetary Fund is that no one is ever very happy to see you. Typically, your “clients” come in only after private capital has abandoned them, after regional trading-bloc partners have been unable to throw a strong enough lifeline, after last-ditch attempts to borrow from powerful friends like China or the European Union have fallen through. You’re never at the top of anyone’s dance card.

The reason, of course, is that the IMF specializes in telling its clients what they don’t want to hear. I should know; I pressed painful changes on many foreign officials during my time there as chief economist in 2007 and 2008. And I felt the effects of IMF pressure, at least indirectly, when I worked with governments in Eastern Europe as they struggled after 1989, and with the private sector in Asia and Latin America during the crises of the late 1990s and early 2000s. Over that time, from every vantage point, I saw firsthand the steady flow of officials—from Ukraine, Russia, Thailand, Indonesia, South Korea, and elsewhere—trudging to the fund when circumstances were dire and all else had failed.

Every crisis is different, of course. Ukraine faced hyperinflation in 1994; Russia desperately needed help when its short-term-debt rollover scheme exploded in the summer of 1998; the Indonesian rupiah plunged in 1997, nearly leveling the corporate economy; that same year, South Korea’s 30-year economic miracle ground to a halt when foreign banks suddenly refused to extend new credit.

But I must tell you, to IMF officials, all of these crises looked depressingly similar. Each country, of course, needed a loan, but more than that, each needed to make big changes so that the loan could really work. Almost always, countries in crisis need to learn to live within their means after a period of excess—exports must be increased, and imports cut—and the goal is to do this without the most horrible of recessions. Naturally, the fund’s economists spend time figuring out the policies—budget, money supply, and the like—that make sense in this context. Yet the economic solution is seldom very hard to work out.

No, the real concern of the fund’s senior staff, and the biggest obstacle to recovery, is almost invariably the politics of countries in crisis.

Typically, these countries are in a desperate economic situation for one simple reason—the powerful elites within them overreached in good times and took too many risks. Emerging-market governments and their private-sector allies commonly form a tight-knit—and, most of the time, genteel—oligarchy, running the country rather like a profit-seeking company in which they are the controlling shareholders. When a country like Indonesia or South Korea or Russia grows, so do the ambitions of its captains of industry. As masters of their mini-universe, these people make some investments that clearly benefit the broader economy, but they also start making bigger and riskier bets. They reckon—correctly, in most cases—that their political connections will allow them to push onto the government any substantial problems that arise.

In Russia, for instance, the private sector is now in serious trouble because, over the past five years or so, it borrowed at least $490 billion from global banks and investors on the assumption that the country’s energy sector could support a permanent increase in consumption throughout the economy. As Russia’s oligarchs spent this capital, acquiring other companies and embarking on ambitious investment plans that generated jobs, their importance to the political elite increased. Growing political support meant better access to lucrative contracts, tax breaks, and subsidies. And foreign investors could not have been more pleased; all other things being equal, they prefer to lend money to people who have the implicit backing of their national governments, even if that backing gives off the faint whiff of corruption.

But inevitably, emerging-market oligarchs get carried away; they waste money and build massive business empires on a mountain of debt. Local banks, sometimes pressured by the government, become too willing to extend credit to the elite and to those who depend on them. Overborrowing always ends badly, whether for an individual, a company, or a country. Sooner or later, credit conditions become tighter and no one will lend you money on anything close to affordable terms.

The downward spiral that follows is remarkably steep. Enormous companies teeter on the brink of default, and the local banks that have lent to them collapse. Yesterday’s “public-private partnerships” are relabeled “crony capitalism.” With credit unavailable, economic paralysis ensues, and conditions just get worse and worse. The government is forced to draw down its foreign-currency reserves to pay for imports, service debt, and cover private losses. But these reserves will eventually run out. If the country cannot right itself before that happens, it will default on its sovereign debt and become an economic pariah. The government, in its race to stop the bleeding, will typically need to wipe out some of the national champions—now hemorrhaging cash—and usually restructure a banking system that’s gone badly out of balance. It will, in other words, need to squeeze at least some of its oligarchs.

Squeezing the oligarchs, though, is seldom the strategy of choice among emerging-market governments. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government, such as preferential access to foreign currency, or maybe a nice tax break, or—here’s a classic Kremlin bailout technique—the assumption of private debt obligations by the government. Under duress, generosity toward old friends takes many innovative forms. Meanwhile, needing to squeeze someone, most emerging-market governments look first to ordinary working folk—at least until the riots grow too large.

Eventually, as the oligarchs in Putin’s Russia now realize, some within the elite have to lose out before recovery can begin. It’s a game of musical chairs: there just aren’t enough currency reserves to take care of everyone, and the government cannot afford to take over private-sector debt completely.

So the IMF staff looks into the eyes of the minister of finance and decides whether the government is serious yet. The fund will give even a country like Russia a loan eventually, but first it wants to make sure Prime Minister Putin is ready, willing, and able to be tough on some of his friends. If he is not ready to throw former pals to the wolves, the fund can wait. And when he is ready, the fund is happy to make helpful suggestions—particularly with regard to wresting control of the banking system from the hands of the most incompetent and avaricious “entrepreneurs.”

Of course, Putin’s ex-friends will fight back. They’ll mobilize allies, work the system, and put pressure on other parts of the government to get additional subsidies. In extreme cases, they’ll even try subversion—including calling up their contacts in the American foreign-policy establishment, as the Ukrainians did with some success in the late 1990s.

Many IMF programs “go off track” (a euphemism) precisely because the government can’t stay tough on erstwhile cronies, and the consequences are massive inflation or other disasters. A program “goes back on track” once the government prevails or powerful oligarchs sort out among themselves who will govern—and thus win or lose—under the IMF-supported plan. The real fight in Thailand and Indonesia in 1997 was about which powerful families would lose their banks. In Thailand, it was handled relatively smoothly. In Indonesia, it led to the fall of President Suharto and economic chaos.

From long years of experience, the IMF staff knows its program will succeed—stabilizing the economy and enabling growth—only if at least some of the powerful oligarchs who did so much to create the underlying problems take a hit. This is the problem of all emerging markets.

Becoming a Banana Republic

In its depth and suddenness, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again). In each of those cases, global investors, afraid that the country or its financial sector wouldn’t be able to pay off mountainous debt, suddenly stopped lending. And in each case, that fear became self-fulfilling, as banks that couldn’t roll over their debt did, in fact, become unable to pay. This is precisely what drove Lehman Brothers into bankruptcy on September 15, causing all sources of funding to the U.S. financial sector to dry up overnight. Just as in emerging-market crises, the weakness in the banking system has quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people.

But there’s a deeper and more disturbing similarity: elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.

Top investment bankers and government officials like to lay the blame for the current crisis on the lowering of U.S. interest rates after the dotcom bust or, even better—in a “buck stops somewhere else” sort of way—on the flow of savings out of China. Some on the right like to complain about Fannie Mae or Freddie Mac, or even about longer-standing efforts to promote broader homeownership. And, of course, it is axiomatic to everyone that the regulators responsible for “safety and soundness” were fast asleep at the wheel.

But these various policies—lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership—had something in common. Even though some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector. Policy changes that might have forestalled the crisis but would have limited the financial sector’s profits—such as Brooksley Born’s now-famous attempts to regulate credit-default swaps at the Commodity Futures Trading Commission, in 1998—were ignored or swept aside.

The financial industry has not always enjoyed such favored treatment. But for the past 25 years or so, finance has boomed, becoming ever more powerful. The boom began with the Reagan years, and it only gained strength with the deregulatory policies of the Clinton and George W. Bush administrations. Several other factors helped fuel the financial industry’s ascent. Paul Volcker’s monetary policy in the 1980s, and the increased volatility in interest rates that accompanied it, made bond trading much more lucrative. The invention of securitization, interest-rate swaps, and credit-default swaps greatly increased the volume of transactions that bankers could make money on. And an aging and increasingly wealthy population invested more and more money in securities, helped by the invention of the IRA and the 401(k) plan. Together, these developments vastly increased the profit opportunities in financial services.

Click the chart above for a larger view

Not surprisingly, Wall Street ran with these opportunities. From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.

The great wealth that the financial sector created and concentrated gave bankers enormous political weight—a weight not seen in the U.S. since the era of J.P. Morgan (the man). In that period, the banking panic of 1907 could be stopped only by coordination among private-sector bankers: no government entity was able to offer an effective response. But that first age of banking oligarchs came to an end with the passage of significant banking regulation in response to the Great Depression; the reemergence of an American financial oligarchy is quite recent.

The Wall Street–Washington Corridor

Of course, the U.S. is unique. And just as we have the world’s most advanced economy, military, and technology, we also have its most advanced oligarchy.

In a primitive political system, power is transmitted through violence, or the threat of violence: military coups, private militias, and so on. In a less primitive system more typical of emerging markets, power is transmitted via money: bribes, kickbacks, and offshore bank accounts. Although lobbying and campaign contributions certainly play major roles in the American political system, old-fashioned corruption—envelopes stuffed with $100 bills—is probably a sideshow today, Jack Abramoff notwithstanding.

Instead, the American financial industry gained political power by amassing a kind of cultural capital—a belief system. Once, perhaps, what was good for General Motors was good for the country. Over the past decade, the attitude took hold that what was good for Wall Street was good for the country. The banking-and-securities industry has become one of the top contributors to political campaigns, but at the peak of its influence, it did not have to buy favors the way, for example, the tobacco companies or military contractors might have to. Instead, it benefited from the fact that Washington insiders already believed that large financial institutions and free-flowing capital markets were crucial to America’s position in the world.

One channel of influence was, of course, the flow of individuals between Wall Street and Washington. Robert Rubin, once the co-chairman of Goldman Sachs, served in Washington as Treasury secretary under Clinton, and later became chairman of Citigroup’s executive committee. Henry Paulson, CEO of Goldman Sachs during the long boom, became Treasury secretary under George W.Bush. John Snow, Paulson’s predecessor, left to become chairman of Cerberus Capital Management, a large private-equity firm that also counts Dan Quayle among its executives. Alan Greenspan, after leaving the Federal Reserve, became a consultant to Pimco, perhaps the biggest player in international bond markets.

These personal connections were multiplied many times over at the lower levels of the past three presidential administrations, strengthening the ties between Washington and Wall Street. It has become something of a tradition for Goldman Sachs employees to go into public service after they leave the firm. The flow of Goldman alumni—including Jon Corzine, now the governor of New Jersey, along with Rubin and Paulson—not only placed people with Wall Street’s worldview in the halls of power; it also helped create an image of Goldman (inside the Beltway, at least) as an institution that was itself almost a form of public service.

Wall Street is a very seductive place, imbued with an air of power. Its executives truly believe that they control the levers that make the world go round. A civil servant from Washington invited into their conference rooms, even if just for a meeting, could be forgiven for falling under their sway. Throughout my time at the IMF, I was struck by the easy access of leading financiers to the highest U.S. government officials, and the interweaving of the two career tracks. I vividly remember a meeting in early 2008—attended by top policy makers from a handful of rich countries—at which the chair casually proclaimed, to the room’s general approval, that the best preparation for becoming a central-bank governor was to work first as an investment banker.

A whole generation of policy makers has been mesmerized by Wall Street, always and utterly convinced that whatever the banks said was true. Alan Greenspan’s pronouncements in favor of unregulated financial markets are well known. Yet Greenspan was hardly alone. This is what Ben Bernanke, the man who succeeded him, said in 2006: “The management of market risk and credit risk has become increasingly sophisticated. … Banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks.”

Of course, this was mostly an illusion. Regulators, legislators, and academics almost all assumed that the managers of these banks knew what they were doing. In retrospect, they didn’t. AIG’s Financial Products division, for instance, made $2.5 billion in pretax profits in 2005, largely by selling underpriced insurance on complex, poorly understood securities. Often described as “picking up nickels in front of a steamroller,” this strategy is profitable in ordinary years, and catastrophic in bad ones. As of last fall, AIG had outstanding insurance on more than $400 billion in securities. To date, the U.S. government, in an effort to rescue the company, has committed about $180 billion in investments and loans to cover losses that AIG’s sophisticated risk modeling had said were virtually impossible.

Wall Street’s seductive power extended even (or especially) to finance and economics professors, historically confined to the cramped offices of universities and the pursuit of Nobel Prizes. As mathematical finance became more and more essential to practical finance, professors increasingly took positions as consultants or partners at financial institutions. Myron Scholes and Robert Merton, Nobel laureates both, were perhaps the most famous; they took board seats at the hedge fund Long-Term Capital Management in 1994, before the fund famously flamed out at the end of the decade. But many others beat similar paths. This migration gave the stamp of academic legitimacy (and the intimidating aura of intellectual rigor) to the burgeoning world of high finance.

As more and more of the rich made their money in finance, the cult of finance seeped into the culture at large. Works like Barbarians at the Gate, Wall Street, and Bonfire of the Vanities—all intended as cautionary tales—served only to increase Wall Street’s mystique. Michael Lewis noted in Portfolio last year that when he wrote Liar’s Poker, an insider’s account of the financial industry, in 1989, he had hoped the book might provoke outrage at Wall Street’s hubris and excess. Instead, he found himself “knee-deep in letters from students at Ohio State who wanted to know if I had any other secrets to share. … They’d read my book as a how-to manual.” Even Wall Street’s criminals, like Michael Milken and Ivan Boesky, became larger than life. In a society that celebrates the idea of making money, it was easy to infer that the interests of the financial sector were the same as the interests of the country—and that the winners in the financial sector knew better what was good for America than did the career civil servants in Washington. Faith in free financial markets grew into conventional wisdom—trumpeted on the editorial pages of The Wall Street Journal and on the floor of Congress.

From this confluence of campaign finance, personal connections, and ideology there flowed, in just the past decade, a river of deregulatory policies that is, in hindsight, astonishing:

• insistence on free movement of capital across borders;

• the repeal of Depression-era regulations separating commercial and investment banking;

• a congressional ban on the regulation of credit-default swaps;

• major increases in the amount of leverage allowed to investment banks;

• a light (dare I say invisible?) hand at the Securities and Exchange Commission in its regulatory enforcement;

• an international agreement to allow banks to measure their own riskiness;

• and an intentional failure to update regulations so as to keep up with the tremendous pace of financial innovation.

The mood that accompanied these measures in Washington seemed to swing between nonchalance and outright celebration: finance unleashed, it was thought, would continue to propel the economy to greater heights.

America’s Oligarchs and the Financial Crisis

The oligarchy and the government policies that aided it did not alone cause the financial crisis that exploded last year. Many other factors contributed, including excessive borrowing by households and lax lending standards out on the fringes of the financial world. But major commercial and investment banks—and the hedge funds that ran alongside them—were the big beneficiaries of the twin housing and equity-market bubbles of this decade, their profits fed by an ever-increasing volume of transactions founded on a relatively small base of actual physical assets. Each time a loan was sold, packaged, securitized, and resold, banks took their transaction fees, and the hedge funds buying those securities reaped ever-larger fees as their holdings grew.

Because everyone was getting richer, and the health of the national economy depended so heavily on growth in real estate and finance, no one in Washington had any incentive to question what was going on. Instead, Fed Chairman Greenspan and President Bush insisted metronomically that the economy was fundamentally sound and that the tremendous growth in complex securities and credit-default swaps was evidence of a healthy economy where risk was distributed safely.

In the summer of 2007, signs of strain started appearing. The boom had produced so much debt that even a small economic stumble could cause major problems, and rising delinquencies in subprime mortgages proved the stumbling block. Ever since, the financial sector and the federal government have been behaving exactly the way one would expect them to, in light of past emerging-market crises.

By now, the princes of the financial world have of course been stripped naked as leaders and strategists—at least in the eyes of most Americans. But as the months have rolled by, financial elites have continued to assume that their position as the economy’s favored children is safe, despite the wreckage they have caused.

Stanley O’Neal, the CEO of Merrill Lynch, pushed his firm heavily into the mortgage-backed-securities market at its peak in 2005 and 2006; in October 2007, he acknowledged, “The bottom line is, we—I—got it wrong by being overexposed to subprime, and we suffered as a result of impaired liquidity in that market. No one is more disappointed than I am in that result.” O’Neal took home a $14 million bonus in 2006; in 2007, he walked away from Merrill with a severance package worth $162 million, although it is presumably worth much less today.

In October, John Thain, Merrill Lynch’s final CEO, reportedly lobbied his board of directors for a bonus of $30 million or more, eventually reducing his demand to $10million in December; he withdrew the request, under a firestorm of protest, only after it was leaked to The Wall Street Journal. Merrill Lynch as a whole was no better: it moved its bonus payments, $4 billion in total, forward to December, presumably to avoid the possibility that they would be reduced by Bank of America, which would own Merrill beginning on January 1. Wall Street paid out $18 billion in year-end bonuses last year to its New York City employees, after the government disbursed $243 billion in emergency assistance to the financial sector.

In a financial panic, the government must respond with both speed and overwhelming force. The root problem is uncertainty—in our case, uncertainty about whether the major banks have sufficient assets to cover their liabilities. Half measures combined with wishful thinking and a wait-and-see attitude cannot overcome this uncertainty. And the longer the response takes, the longer the uncertainty will stymie the flow of credit, sap consumer confidence, and cripple the economy—ultimately making the problem much harder to solve. Yet the principal characteristics of the government’s response to the financial crisis have been delay, lack of transparency, and an unwillingness to upset the financial sector.

The response so far is perhaps best described as “policy by deal”: when a major financial institution gets into trouble, the Treasury Department and the Federal Reserve engineer a bailout over the weekend and announce on Monday that everything is fine. In March 2008, Bear Stearns was sold to JP Morgan Chase in what looked to many like a gift to JP Morgan. (Jamie Dimon, JP Morgan’s CEO, sits on the board of directors of the Federal Reserve Bank of New York, which, along with the Treasury Department, brokered the deal.) In September, we saw the sale of Merrill Lynch to Bank of America, the first bailout of AIG, and the takeover and immediate sale of Washington Mutual to JP Morgan—all of which were brokered by the government. In October, nine large banks were recapitalized on the same day behind closed doors in Washington. This, in turn, was followed by additional bailouts for Citigroup, AIG, Bank of America, Citigroup (again), and AIG (again).

Some of these deals may have been reasonable responses to the immediate situation. But it was never clear (and still isn’t) what combination of interests was being served, and how. Treasury and the Fed did not act according to any publicly articulated principles, but just worked out a transaction and claimed it was the best that could be done under the circumstances. This was late-night, backroom dealing, pure and simple.

Throughout the crisis, the government has taken extreme care not to upset the interests of the financial institutions, or to question the basic outlines of the system that got us here. In September 2008, Henry Paulson asked Congress for $700 billion to buy toxic assets from banks, with no strings attached and no judicial review of his purchase decisions. Many observers suspected that the purpose was to overpay for those assets and thereby take the problem off the banks’ hands—indeed, that is the only way that buying toxic assets would have helped anything. Perhaps because there was no way to make such a blatant subsidy politically acceptable, that plan was shelved.

Instead, the money was used to recapitalize banks, buying shares in them on terms that were grossly favorable to the banks themselves. As the crisis has deepened and financial institutions have needed more help, the government has gotten more and more creative in figuring out ways to provide banks with subsidies that are too complex for the general public to understand. The first AIG bailout, which was on relatively good terms for the taxpayer, was supplemented by three further bailouts whose terms were more AIG-friendly. The second Citigroup bailout and the Bank of America bailout included complex asset guarantees that provided the banks with insurance at below-market rates. The third Citigroup bailout, in late February, converted government-owned preferred stock to common stock at a price significantly higher than the market price—a subsidy that probably even most Wall Street Journal readers would miss on first reading. And the convertible preferred shares that the Treasury will buy under the new Financial Stability Plan give the conversion option (and thus the upside) to the banks, not the government.

This latest plan—which is likely to provide cheap loans to hedge funds and others so that they can buy distressed bank assets at relatively high prices—has been heavily influenced by the financial sector, and Treasury has made no secret of that. As Neel Kashkari, a senior Treasury official under both Henry Paulson and Tim Geithner (and a Goldman alum) told Congress in March, “We had received inbound unsolicited proposals from people in the private sector saying, ‘We have capital on the sidelines; we want to go after [distressed bank] assets.’” And the plan lets them do just that: “By marrying government capital—taxpayer capital—with private-sector capital and providing financing, you can enable those investors to then go after those assets at a price that makes sense for the investors and at a price that makes sense for the banks.” Kashkari didn’t mention anything about what makes sense for the third group involved: the taxpayers.

Even leaving aside fairness to taxpayers, the government’s velvet-glove approach with the banks is deeply troubling, for one simple reason: it is inadequate to change the behavior of a financial sector accustomed to doing business on its own terms, at a time when that behavior must change. As an unnamed senior bank official said to The New York Times last fall, “It doesn’t matter how much Hank Paulson gives us, no one is going to lend a nickel until the economy turns.” But there’s the rub: the economy can’t recover until the banks are healthy and willing to lend.

The Way Out

Looking just at the financial crisis (and leaving aside some problems of the larger economy), we face at least two major, interrelated problems. The first is a desperately ill banking sector that threatens to choke off any incipient recovery that the fiscal stimulus might generate. The second is a political balance of power that gives the financial sector a veto over public policy, even as that sector loses popular support.

Big banks, it seems, have only gained political strength since the crisis began. And this is not surprising. With the financial system so fragile, the damage that a major bank failure could cause—Lehman was small relative to Citigroup or Bank of America—is much greater than it would be during ordinary times. The banks have been exploiting this fear as they wring favorable deals out of Washington. Bank of America obtained its second bailout package (in January) after warning the government that it might not be able to go through with the acquisition of Merrill Lynch, a prospect that Treasury did not want to consider.

The challenges the United States faces are familiar territory to the people at the IMF. If you hid the name of the country and just showed them the numbers, there is no doubt what old IMF hands would say: nationalize troubled banks and break them up as necessary.

In some ways, of course, the government has already taken control of the banking system. It has essentially guaranteed the liabilities of the biggest banks, and it is their only plausible source of capital today. Meanwhile, the Federal Reserve has taken on a major role in providing credit to the economy—the function that the private banking sector is supposed to be performing, but isn’t. Yet there are limits to what the Fed can do on its own; consumers and businesses are still dependent on banks that lack the balance sheets and the incentives to make the loans the economy needs, and the government has no real control over who runs the banks, or over what they do.

At the root of the banks’ problems are the large losses they have undoubtedly taken on their securities and loan portfolios. But they don’t want to recognize the full extent of their losses, because that would likely expose them as insolvent. So they talk down the problem, and ask for handouts that aren’t enough to make them healthy (again, they can’t reveal the size of the handouts that would be necessary for that), but are enough to keep them upright a little longer. This behavior is corrosive: unhealthy banks either don’t lend (hoarding money to shore up reserves) or they make desperate gambles on high-risk loans and investments that could pay off big, but probably won’t pay off at all. In either case, the economy suffers further, and as it does, bank assets themselves continue to deteriorate—creating a highly destructive vicious cycle.

To break this cycle, the government must force the banks to acknowledge the scale of their problems. As the IMF understands (and as the U.S. government itself has insisted to multiple emerging-market countries in the past), the most direct way to do this is nationalization. Instead, Treasury is trying to negotiate bailouts bank by bank, and behaving as if the banks hold all the cards—contorting the terms of each deal to minimize government ownership while forswearing government influence over bank strategy or operations. Under these conditions, cleaning up bank balance sheets is impossible.

Nationalization would not imply permanent state ownership. The IMF’s advice would be, essentially: scale up the standard Federal Deposit Insurance Corporation process. An FDIC “intervention” is basically a government-managed bankruptcy procedure for banks. It would allow the government to wipe out bank shareholders, replace failed management, clean up the balance sheets, and then sell the banks back to the private sector. The main advantage is immediate recognition of the problem so that it can be solved before it grows worse.

The government needs to inspect the balance sheets and identify the banks that cannot survive a severe recession. These banks should face a choice: write down your assets to their true value and raise private capital within 30 days, or be taken over by the government. The government would write down the toxic assets of banks taken into receivership—recognizing reality—and transfer those assets to a separate government entity, which would attempt to salvage whatever value is possible for the taxpayer (as the Resolution Trust Corporation did after the savings-and-loan debacle of the 1980s). The rump banks—cleansed and able to lend safely, and hence trusted again by other lenders and investors—could then be sold off.

Cleaning up the megabanks will be complex. And it will be expensive for the taxpayer; according to the latest IMF numbers, the cleanup of the banking system would probably cost close to $1.5trillion (or 10percent of our GDP) in the long term. But only decisive government action—exposing the full extent of the financial rot and restoring some set of banks to publicly verifiable health—can cure the financial sector as a whole.

This may seem like strong medicine. But in fact, while necessary, it is insufficient. The second problem the U.S. faces—the power of the oligarchy—is just as important as the immediate crisis of lending. And the advice from the IMF on this front would again be simple: break the oligarchy.

Oversize institutions disproportionately influence public policy; the major banks we have today draw much of their power from being too big to fail. Nationalization and re-privatization would not change that; while the replacement of the bank executives who got us into this crisis would be just and sensible, ultimately, the swapping-out of one set of powerful managers for another would change only the names of the oligarchs.

Ideally, big banks should be sold in medium-size pieces, divided regionally or by type of business. Where this proves impractical—since we’ll want to sell the banks quickly—they could be sold whole, but with the requirement of being broken up within a short time. Banks that remain in private hands should also be subject to size limitations.

This may seem like a crude and arbitrary step, but it is the best way to limit the power of individual institutions in a sector that is essential to the economy as a whole. Of course, some people will complain about the “efficiency costs” of a more fragmented banking system, and these costs are real. But so are the costs when a bank that is too big to fail—a financial weapon of mass self-destruction—explodes. Anything that is too big to fail is too big to exist.

To ensure systematic bank breakup, and to prevent the eventual reemergence of dangerous behemoths, we also need to overhaul our antitrust legislation. Laws put in place more than 100years ago to combat industrial monopolies were not designed to address the problem we now face. The problem in the financial sector today is not that a given firm might have enough market share to influence prices; it is that one firm or a small set of interconnected firms, by failing, can bring down the economy. The Obama administration’s fiscal stimulus evokes FDR, but what we need to imitate here is Teddy Roosevelt’s trust-busting.

Caps on executive compensation, while redolent of populism, might help restore the political balance of power and deter the emergence of a new oligarchy. Wall Street’s main attraction—to the people who work there and to the government officials who were only too happy to bask in its reflected glory—has been the astounding amount of money that could be made. Limiting that money would reduce the allure of the financial sector and make it more like any other industry.

Still, outright pay caps are clumsy, especially in the long run. And most money is now made in largely unregulated private hedge funds and private-equity firms, so lowering pay would be complicated. Regulation and taxation should be part of the solution. Over time, though, the largest part may involve more transparency and competition, which would bring financial-industry fees down. To those who say this would drive financial activities to other countries, we can now safely say: fine.

Two Paths

To paraphrase Joseph Schumpeter, the early-20th-century economist, everyone has elites; the important thing is to change them from time to time. If the U.S. were just another country, coming to the IMF with hat in hand, I might be fairly optimistic about its future. Most of the emerging-market crises that I’ve mentioned ended relatively quickly, and gave way, for the most part, to relatively strong recoveries. But this, alas, brings us to the limit of the analogy between the U.S. and emerging markets.

Emerging-market countries have only a precarious hold on wealth, and are weaklings globally. When they get into trouble, they quite literally run out of money—or at least out of foreign currency, without which they cannot survive. They must make difficult decisions; ultimately, aggressive action is baked into the cake. But the U.S., of course, is the world’s most powerful nation, rich beyond measure, and blessed with the exorbitant privilege of paying its foreign debts in its own currency, which it can print. As a result, it could very well stumble along for years—as Japan did during its lost decade—never summoning the courage to do what it needs to do, and never really recovering. A clean break with the past—involving the takeover and cleanup of major banks—hardly looks like a sure thing right now. Certainly no one at the IMF can force it.

In my view, the U.S. faces two plausible scenarios. The first involves complicated bank-by-bank deals and a continual drumbeat of (repeated) bailouts, like the ones we saw in February with Citigroup and AIG. The administration will try to muddle through, and confusion will reign.

Boris Fyodorov, the late finance minister of Russia, struggled for much of the past 20 years against oligarchs, corruption, and abuse of authority in all its forms. He liked to say that confusion and chaos were very much in the interests of the powerful—letting them take things, legally and illegally, with impunity. When inflation is high, who can say what a piece of property is really worth? When the credit system is supported by byzantine government arrangements and backroom deals, how do you know that you aren’t being fleeced?

Our future could be one in which continued tumult feeds the looting of the financial system, and we talk more and more about exactly how our oligarchs became bandits and how the economy just can’t seem to get into gear.

The second scenario begins more bleakly, and might end that way too. But it does provide at least some hope that we’ll be shaken out of our torpor. It goes like this: the global economy continues to deteriorate, the banking system in east-central Europe collapses, and—because eastern Europe’s banks are mostly owned by western European banks—justifiable fears of government insolvency spread throughout the Continent. Creditors take further hits and confidence falls further. The Asian economies that export manufactured goods are devastated, and the commodity producers in Latin America and Africa are not much better off. A dramatic worsening of the global environment forces the U.S. economy, already staggering, down onto both knees. The baseline growth rates used in the administration’s current budget are increasingly seen as unrealistic, and the rosy “stress scenario” that the U.S. Treasury is currently using to evaluate banks’ balance sheets becomes a source of great embarrassment.

Under this kind of pressure, and faced with the prospect of a national and global collapse, minds may become more concentrated.

The conventional wisdom among the elite is still that the current slump “cannot be as bad as the Great Depression.” This view is wrong. What we face now could, in fact, be worse than the Great Depression—because the world is now so much more interconnected and because the banking sector is now so big. We face a synchronized downturn in almost all countries, a weakening of confidence among individuals and firms, and major problems for government finances. If our leadership wakes up to the potential consequences, we may yet see dramatic action on the banking system and a breaking of the old elite. Let us hope it is not then too late.

Prophet and Loss
Brooksley Born warned that unchecked trading in the credit market could lead to disaster, but power brokers in Washington ignored her. Now we’re all paying the price.

Shortly after she was named to head the Commodity Futures Trading Commission in 1996, Brooksley E. Born was invited to lunch by Federal Reserve chairman Alan Greenspan.

The influential Greenspan was an ardent proponent of unfettered markets. Born was a powerful Washington lawyer with a track record for activist causes. Over lunch, in his private dining room at the stately headquarters of the Fed in Washington, Greenspan probed their differences.

“Well, Brooksley, I guess you and I will never agree about fraud,” Born, in a recent interview, remembers Greenspan saying.

“What is there not to agree on?” Born says she replied.

“Well, you probably will always believe there should be laws against fraud, and I don’t think there is any need for a law against fraud,” she recalls. Greenspan, Born says, believed the market would take care of itself.

For the incoming regulator, the meeting was a wake-up call. “That underscored to me how absolutist Alan was in his opposition to any regulation,” she said in the interview.

Over the next three years, Born, ’61, JD ’64, would learn first-hand the potency of those absolutist views, confronting Greenspan and other powerful figures in the capital over how to regulate Wall Street.

More recently, as analysts sort out the origins of what has become the worst financial crisis since the Great Depression, Born has emerged as a sort of modern-day Cassandra. Some people believe the debacle could have been averted or muted had Greenspan and others followed her advice.

As chairperson of the CFTC, Born advocated reining in the huge and growing market for financial derivatives. Derivatives get their name because the value is derived from fluctuations in, for example, interest rates or foreign exchange. They started out as ways for big corporations and banks to manage their risk across a range of investments. One type of derivative—known as a credit-default swap—has been a key contributor to the economy’s recent unraveling.
FRONT AND CENTER: Born became the first woman at Stanford Law School to be president of the Law Review. In this 1964 photo, she is pictured with senior editors and classmates (back row, from left) Bruce Gitelson, Robert Johnson and Paul Ulrich, and (front row) Richard Roth and James Gaither.

The swaps were sold as a kind of insurance—the insured paid a “premium” as protection in case the creditor defaulted on the loan, and the insurer agreed to cover the losses in exchange for that premium. The credit-default swap market—estimated at more than $45 trillion—helped fuel the mortgage boom, allowing lenders to spread their risk further and further, thus generating more and more loans. But because the swaps are not regulated, no one ensured that the parties were able to pay what they promised. When housing prices crashed, the loans also went south, and the massive debt obligations in the derivatives contracts wiped out banks unable to cover them.

Back in the 1990s, however, Born’s proposal stirred an almost visceral response from other regulators in the Clinton administration, as well as members of Congress and lobbyists. The economy was sailing along, and the growth of derivatives was considered a sign of American innovation and a symbol of the virtues of deregulation. The instruments were also a growing cash cow for the Wall Street firms that peddled them to eager takers.

Ultimately, Greenspan and the other regulators foiled Born’s efforts, and Congress took the extraordinary step of enacting legislation that prohibited her agency from taking any action. Born left government and returned to her private law practice in Washington.

‘History already has shown that Greenspan was wrong about virtually everything, and Brooksley was right. If there is one person we should have listened to, it was Brooksley.’

“History already has shown that Greenspan was wrong about virtually everything, and Brooksley was right,” says Frank Partnoy, a former Wall Street investment banker who is now a professor at the University of San Diego law school. “I think she has been entirely vindicated. . . . If there is one person we should have listened to, it was Brooksley.”

Speaking out for the first time, Born says she takes no pleasure from the turn of events. She says she was just doing her job based on the evidence in front of her. Looking back, she laments what she says was the outsized influence of Wall Street lobbyists on the process, and the refusal of her fellow regulators, especially Greenspan, to discuss even modest reforms. “Recognizing the dangers . . . was not rocket science, but it was contrary to the conventional wisdom and certainly contrary to the economic interests of Wall Street at the moment,” she says.

“I certainly am not pleased with the results,” she adds. “I think the market grew so enormously, with so little oversight and regulation, that it made the financial crisis much deeper and more pervasive than it otherwise would have been.”

Greenspan, who retired from the Fed in 2006, acknowledged in congressional testimony last October that the financial crisis, which he described as a “once in-a-century credit tsunami,” had exposed a “flaw” in his market-based ideology.

He says Born’s characterization of the lunch conversation she recounted does not accurately describe his position on addressing fraud. “This alleged conversation is wholly at variance with my decades-long held view,” he said in an e-mail, citing an excerpt from his 2007 book The Age of Turbulence, in which he wrote that more government involvement was needed to root out fraud. Born stands by her story.

Robert Rubin, who was treasury secretary when Born headed the CFTC, has said that he supported closer scrutiny of financial derivatives but did not believe it politically feasible at the time.

A third regulator opposing Born, Arthur Levitt, who was chairman of the Securities Exchange Commission, says he also now wishes more had been done. “I think it is fair to say that regulators should have considered the implications . . . of the exploding derivatives market,” Levitt told STANFORD.

In a way, the battle had the look and feel of a classic Washington turf war.

The CFTC was created in the ’70s to regulate agricultural commodities markets. By the ’90s, its main business had become overseeing financial products such as stock index futures and currency options, but some in Washington thought it should stick to pork bellies and soybeans. Born’s push for regulation posed a threat to the authority of more established cops on the beat.

“She certainly was not in their league in terms of prominence and stature,” says a lawyer who has known Born for years and requested anonymity to avoid appearing critical of her. “They probably thought, ‘Here is a little person from one of these agencies trying to assertively expand her jurisdiction.’”

Some of the other regulators have said they had problems with Born’s personal style and found her hard to work with. “I thought it was counterproductive. If you want to move forward . . . you engage with parties in a constructive way,” Rubin told the Washington Post. “My recollection was . . . this was done in a more strident way.” Levitt says Born was “characterized as being abrasive.”

Her supporters, while acknowledging that Born can be uncompromising when she believes she is right, say those are excuses of people who simply did not want to hear what she had to say.

“She was serious, professional, and she held her ground against those who were not sympathetic to her position,” says Michael Greenberger, a Washington lawyer who was a top aide to Born at the CFTC. “I don’t think that the failure to be ‘charming’ should be translated into a depiction of stridency.”

Others find a whiff of sexism in the pushback. “The messenger wore a skirt,” says Marna Tucker, a Washington lawyer and a longtime friend of Born. “Could Alan Greenspan take that?”

Greenspan dismisses the notion that he had problems with Born because she is a woman. He points out that when he took a leave from his consulting firm in the 1970s to accept a job in the Ford administration, he placed an all-female executive team in charge.

It was not the first time that Born, 68, had pushed back against convention.

Her doggedness over a career spanning more than 40 years propelled her into the halls of power in Washington. She was a top commercial lawyer at a major firm, as well as a towering figure in the area of women’s rights, and a role model for women lawyers. She was on Bill Clinton’s short list for attorney general.

One of seven women in the Class of 1964 at Stanford Law School, she graduated at the top of her class, and was elected president of the law review, the first woman to hold either distinction. She is credited with being the first woman to edit a major American law review.

In the early 1970s, at a time when women had few role models at major law firms, she became a partner at the Washington, D.C., firm of Arnold & Porter, despite working part time while raising her children.

She helped establish some of the first public-interest firms in the country focused on issues of gender discrimination. She helped rewrite American Bar Association rules that made it possible for more women and minorities to sit on the federal bench, and she prodded the group into taking stands against private clubs that discriminated against women or blacks.

She was used to people trying to push her around, or being perceived as a potential troublemaker. She remembers being shouted down during an ABA meeting in the 1970s when she proposed that the organization take a position supporting equal rights for gay and lesbian workers. A former ABA president stood up and said, “that the subject was so unsavory that it should not be discussed . . . and was not germane to the purposes of the ABA,” she recalls. She lost that fight, although the group reversed its stand years later.

“She looks at things not just from a technical perspective or the perspective of an insider. She looks at the perspective of outsiders and how people without power are going to be affected,” says Esther Lardent, a Washington lawyer who worked with Born on various ABA matters. “That is a theme constantly running through her life and career.”

“She is a very polite and low-key person but she is never somebody who steps back from a disagreement or a fight if it is a matter of importance to her,” Lardent adds. “Did that make people uncomfortable? Did that make the men who dominated the leadership fail to take her seriously enough? I am sure that was the case.”

SHE WAS BORN in San Francisco. Her mother, an English teacher, and her father, the head of the city’s public welfare department, were both Stanford graduates.

An early mentor was her mother’s best friend from Stanford, Miriam E. Wolff, JD ’40, who became a deputy state attorney general and judge and the first woman to ever head a major port.

Born entered Stanford with the thought of being a doctor, but switched majors after a career counselor interpreted her answers on a series of vocational tests. In those days, women were assessed for their interest in nursing or teaching, men for the professional jobs, including law and medicine. The tests were even color coded—pink for women, blue for men.

Born says she insisted on taking both. Her mother, who had a master’s degree in psychology, felt that was the only way her daughter’s professional interests could be evaluated properly.

She scored high on being a doctor—and low on being a nurse. But rather than suggest she pursue a career as a physician, the counselor said the test proved that her interest in medicine was not genuine and that she was really only interested in making a lot of money. Born quit premed and majored in English.

“It was a turning point. What can I say? I was 18 years old. I didn’t know any better,” Born says. “Unfortunately, I was, you know, a member of the society as it was then. I was hurt by the advice, and kind of believed in it. I don’t believe in it now. It is ridiculous in retrospect.”

A decade later, one of the public-interest firms she founded challenged the tests as discriminatory.

Law school was welcoming and intellectually stimulating, even if some people were still getting used to the idea of having women around. Male law students got their own dormitory; women were left to make their own housing arrangements in off-campus boarding houses or apartments. “I also had . . . one student in my class tell me I was taking the place of a man who had to go to Vietnam and was risking his life because of me, which was sobering to say the least,” she recalls.

Making a mark in the classroom could also be a challenge. Some professors refused to call on women, thinking it rude or unbecoming. She remembers an episode in her first year when her professor appeared to have the class stumped after quizzing several men about a problem. “The little girl has it!” she recalls the professor declaring, after she blurted out the right answer.

“I was very worried that I would not do well and that I would disgrace myself, and women,” Born says. “I worked very hard during my first year because I was afraid I would flunk out.” In those Darwinian times in law schools, that was not an idle concern: professors tried to weed out all but the most qualified students, and about a third were dismissed from school after the first year. That would not be her fate.

“She was off the charts,” says Pamela Ann Rymer, JD ’64, a judge on the federal appeals court in Pasadena. “Brooksley never wore it on her sleeve. She is not quiet, but she is a very unpretentious kind of person, just plainly and obviously with a brilliant mind.”

Despite her grades, Born was passed over for a clerkship on the U.S. Supreme Court, the most coveted opportunity for a young lawyer. Stanford’s top students were good candidates for the clerkships, but a faculty committee decided to recommend two men for the positions even though Born had a superior academic record. It was a bitter introduction to a gender-biased legal culture. “They were sure I would understand that it would be unseemly for women to be clerks on the Supreme Court,” she says of the committee members. “I felt very disappointed and angry.”

Undaunted, she headed to Washington, and arranged an interview on her own with Arthur Goldberg, then one of the most liberal members of the high court. Goldberg would not hire her either but recommended her to a judge on the federal appeals court in Washington. Henry Edgerton, who wrote an opinion that became a basis for the landmark Supreme Court decision in the Brown v. Board of Education school desegregation case, gave her a clerkship. (Law school professor emerita Barbara Babcock also clerked for Edgerton.)

A year later, taken with the Washington scene and its place on the front lines of the civil rights movement, Born scrapped plans to return to San Francisco. “I wanted in,” she says. Arnold & Porter, a firm with a liberal tradition of public service, offered her a job, and she started work the same day that a former name partner of the firm, Abe Fortas, was sworn in as a justice of the Supreme Court.

The firm was one of a few that were beginning to hire women and treat them on par with men. But there were challenges, especially for those interested in a career and a family. Many firms up to that point refused to hire women who were married or who were interested in children.

The lone woman partner at Arnold & Porter at the time was married to Fortas and was renowned for her “misanthropic toughness,” including a preference for “thick cigars,” according to Charles Halpern, an associate with Born at the firm in the 1960s. “Our swimming pool has two deep ends,” Halpern recalls her once saying, “so that people aren’t tempted to drop by with their small children for a swim on a hot summer day.”

Born soon faced a difficult choice. She took a one-year leave when her then-husband got a Nieman fellowship at Harvard, where her first child was born. Returning to Washington, she tried to juggle full-time work and child rearing but it quickly became apparent that the arrangement didn’t work.

“I went to the partner I was working with the most and said I just didn’t think I could do this,” she says. “I thought I had to resign.” To her surprise, the partner suggested she work three days a week with the understanding she would not be considered for partner until she returned full time.

In 1974, when she had a 4-year-old and a 2-year-old, she was still working part time. The firm promoted her anyway. The family-friendly development was a stunning breakthrough at a time when law firms were focused on billable hours and the bottom line, and little else. It further raised her profile.

“When I met her I was in awe of her because the idea that she could be a partner in that firm was just unbelievable,” says Tucker, her longtime friend. The women bonded after being asked to teach a course on women and the law at two Washington-area law schools, and being horrified at what they found during their research. “We were surprised to find the degree to which discrimination was embodied in the law,” Born says. “It was a real consciousness-raising experience.”

Lawyer Marcia Greenberger sought out Born in the 1970s when she was named to start a new women’s rights project in Washington. Born agreed to chair an advisory board for the project, and became a guiding force, mentor and opener of doors, leveraging her contacts and credibility, Greenberger says. One of the first broad-based challenges to how universities were implementing Title IX—the 1972 law requiring equal programs and activities for women and men—was brought after Born passed along the name of a colleague who was incensed at the poor athletic facilities his daughter was forced to use at her school. Born also helped win Ford Foundation grants that enabled the project to hire its second lawyer. What is now called the National Women’s Law Center today has a staff approaching 60 and a budget of almost $10 million. Born remains chair of its board of directors.

Clinton named her to head the CFTC in 1996. She was not without experience: at Arnold & Porter she had represented the London Futures Exchange in rule making and other matters before the commodities agency.

She also knew how markets could be manipulated, having represented a major Swiss bank in litigation stemming from an attempt by the Hunt family of Dallas to corner the silver market in the 1980s.

“Brooksley had the advantage of knowing the law and understanding the fragility of the system if it weren’t regulated,” says Michael Greenberger, her former adviser at the CFTC. “She could see that the data points, by lack of regulation, were heading the country into a serious set of calamities, each calamity worse than the one before.”

Under a Republican predecessor, the CFTC had in 1993 largely exempted from regulation more exotic derivatives that involved just two parties. The thinking was that sophisticated entities negotiating individually tailored derivatives could look out for themselves. More generic derivatives still had to be traded on exchanges, which were subject to regulation.

By 1997, the over-the-counter derivatives market had more than doubled in size, by one measure, reaching an estimated $28 trillion, based on the value of the instruments underlying the contracts. (It has now reached an estimated $600 trillion.)

And some cracks were already surfacing in the landscape. Several customers of Bankers Trust, including Procter & Gamble, sued for fraud and racketeering in connection with several OTC derivative deals. Orange County, Calif., had gone bankrupt in part because of an OTC derivative-trading scheme gone awry.

What is more, all the growth had taken place at a time of economic prosperity. Some people were beginning to ask what would happen if the market suffered a major reversal.

“The exposures were very, very big and if it was your job to worry about things that could go wrong, and I think it was, this is one of the things you couldn’t help but notice,” says Daniel Waldman, a Washington lawyer who was the CFTC general counsel under Born. “It was only your blind faith in the participants that could give you much comfort because you really did not know much about the real risks.”

‘There was no transparency of these markets at all. No market oversight. No regulator knew what was happening,” Born says. “There was no reporting to anybody.’

“There was no transparency of these markets at all. No market oversight. No regulator knew what was happening,” Born says. “There was no reporting to anybody.”

She chose what she thought was a middle ground, circulating a draft “concept release,” to regulators and trade associations, which was intended to gather information about how the markets operated. She and her staff suspected the industry was trying to exploit the earlier regulatory exemption.

But even the modest proposal got a vituperative response. The dozen or so large banks that wrote most of the OTC derivative contracts saw the move as a threat to a major profit center. Greenspan and his deregulation-minded brain trust saw no need to upset the status quo. The sheer act of contemplating regulation, they maintained, would cause widespread chaos in markets around the world.

“We would go to conferences and it would be viciously attacked,” Waldman says. “They would just be stomping their feet and pounding the tables.” With Born unlikely to change her mind, the industry focused on working through the other regulators.

Born recalls taking a phone call from Lawrence Summers, then Rubin’s top deputy at the Treasury Department, complaining about the proposal, and mentioning that he was taking heat from industry lobbyists. She was not dissuaded. “Of course, we were an independent regulatory agency,” she says.

The debate came to a head April 21, 1998. In a Treasury Department meeting of a presidential working group that included Born and the other top regulators, Greenspan and Rubin took turns attempting to change her mind. Rubin took the lead, she recalls.

“I was told by the secretary of the treasury that the CFTC had no jurisdiction, and for that reason and that reason alone, we should not go forward,” Born says. “I told him . . . that I had never heard anyone assert that we didn’t have statutory jurisdiction . . . and I would be happy to see the legal analysis he was basing his position on.”

She says she was never supplied one. “They didn’t have one because it was not a legitimate legal position,” she says.

Greenspan followed. “He maintained that merely inquiring about the field would drive important and expanding and creative financial business offshore,” she says. CFTC economists later checked for any signs of that, and came up with no evidence, Born says.

“It seemed totally inexplicable to me,” Born says of the seeming disinterest her counterparts showed in how the markets were operating. “It was as though the other financial regulators were saying, ‘We don’t want to know.’”

She formally launched the proposal on May 7, and within hours, Greenspan, Rubin and Levitt issued a joint statement condemning Born and the CFTC, expressing “grave concern about this action and its possible consequences.” They announced a plan to ask for legislation to stop the CFTC in its tracks.

At congressional hearings that summer, Greenspan and others warned of dire consequences; Born and the CFTC were cast as a loose cannon.

Reverting to a theme Born claims he raised at their earlier lunch, Greenspan testified there was no need for government oversight, because the derivatives market involved Wall Street “professionals” who could patrol themselves.

Summers, Rubin’s deputy (and now director of the National Economic Council), said the memo had “cast the shadow of regulatory uncertainty over an otherwise thriving market, raising risks for the stability and competitiveness of American derivative trading.”

Born assailed the legislation, calling it an unprecedented move to undermine the independence of a federal agency. In eerily prescient testimony, she warned of potentially disastrous and widespread consequences for the public. “Losses resulting from misuse of OTC derivatives instruments or from sales practice abuses in the OTC derivatives market can affect many Americans,” she testified that July. “Many of us have interests in the corporations, mutual funds, pension funds, insurance companies, municipalities and other entities trading in these instruments.”

That September, seemingly bolstering her case, the Federal Reserve Bank of New York was forced to organize a rescue of a large private investment firm, Long Term Capital Management, which was a big player in the OTC derivatives market. Fed officials said they acted to avoid a meltdown that could have impacted the wider economy.

But the tide of opinion that had risen up against Born was irreversible. Language was slipped into an agriculture appropriations bill barring the CFTC from taking action in the six months left in her term.

“I felt as though that, at least, relieved me and the commission of any public responsibility for what was happening,” she says. Clinton aides sounded her out about a second term, but she said she wasn’t interested and left the agency in June 1999.

A year later, Congress enacted the Commodity Futures Modernization Act, which effectively gutted the ability of the CFTC to regulate OTC derivatives. With no other agency picking up the slack, the market grew, unchecked.

Some observers say now the episode and infighting showed how even a decade ago a patchwork system of regulating Wall Street was badly in need of reform.

“The fact that the . . . issue created such a threat to the marketplace to me confirmed the fact that something was not right,” says Richard Miller, a lawyer and editor of a widely read newsletter on derivatives. “How could we have a system that hangs together by such a narrow thread?” Miller testified at the time that the idea Born proffered should at least have been considered.

The Obama administration has pledged an overhaul of the financial system, including the way derivatives are regulated. Worrisome to some observers is the fact that his economic team includes some former Treasury officials who were lined up in opposition to Born a decade ago.

Born, who retired from her law firm in 2003, is not playing a formal role in the process. An outdoor enthusiast, she was planning a trip to Antarctica this winter, as the Obama team was settling in. “The important thing,” she advises, “is that the new administration should not be listening to just one point of view.”

“Private sector?” The government had to intervene through no fault of its own to save several companies — we, the people, are the owners. If this wasn’t democracy and the people had no way of electing the public officials, who are “temporarily” “over sighting/chaperoning” their management, then it’d constitute socialism. Your sophomoric blather stems from lack of rudimentary understanding of simple social/economical concepts.

The take over of AIG and its subsequent capital injection was absolutely paramount to maintain an unfaltering financial system and avoid imminent fall out to “systemic risk”– if this requires further explanation, then all hopes are lost. I suppose being clueless, intentionally or otherwise, to how much the largest insurance company in the world contributed to rape of our nation is how you plan to spend your unexamined life.

And I suppose, it doesn’t trouble you when the AIG’s London and CT departments got involved in a cesspool of CDS to fallaciously spread the risk of insured underlying investment assets (i.e. CDO’s and the horror of them all, CDO Squard’s) that were not remotely assessed just so later on balloon these “infinite risk” liabilities into multiple of trillions toxic assets.

Now you are crying your eyes out for the government (read: us taxpayers) booting the CEO of a company we owned for his blood-soaked hands in being a part of a reason of our economical collapse! Are you even listening to yourself?

After several months of researching AIG, I have realized that the company’s literal plunder into CDS market wasn’t solely for a lucrative revenue but indeed they were thinly capitalized hence a venture into an “reinsurance” business (aka surplus renting) to meet the regulatory standards while in actuality the contracts were never meant to be paid. ARGH!

Enter the CDS market to inject more artificial hormone BGH into a cash-cow machine and the rest is history. But none of the aforementioned insidious business decisions contrived by the former AIG CEO’s does not make an iota of vexation in your conscious. Rather, torch in hand, pitch fork flailing while biting on a red meat tossed out of some right wing drive-by pundit’s circus caravan is more desirable than vital issues at hand.

No, no, rather than examining the events, suggestions, and implementations, you have to resort this gratuitous name calling, “SOCIALISM!’ We’ve gone overboard of “super-capitalism” now there is an attempt to tediously collect the “free and fair market” out of this flotsam of economical debauchery, yet the rabid crowd are crying “SOCIALISM!”

Don’t even bother examining Chrysler balance sheet and germane financial structure? If this is news to you, they are going to flatly bankrupt if they do not accept an acquisition. So your cry of foul is utterly ridiculous. Either merge or go out of business; which do you prefer? Take your pick.

And once again, missy here rather make comments without having an ensemble of intellectual perspicacity to realize the reason, then Secretary of Treasury, Paulson asked those banking institutions who were not in dire need of capital injection to accept the bailout money was because of sustaining the overall financial stability.

If Mr. Paulson was to pick who would have gotten a piece of pie, a psychological fallout would have ensured for those large entities that received the bailout for being categorically singled out and labeled as unstable. This would have indeed propagated into a real systemic risk because the market would have automatically shifted itself from the “perceived” failure (bailout recipients) to the ones with no bailout money.

As a matter of fact, his exigent action, which was in reality pushed by Bernanke, muzzled the collapse of institutions. I highly suggest spend your time educating yourself about the issues rather than being imprisoned in a simpleton ideological bubble.

Steve Keen’s DebtWatch No 31 February 2009: “The Roving Cavaliers of Credit”
Published in January 31st, 2009
Posted by Steve Keen in Debtwatch

“Talk about centralisation! The credit system, which has its focus in the so-called national banks and the big money-lenders and usurers surrounding them, constitutes enormous centralisation, and gives this class of parasites the fabulous power, not only to periodically despoil industrial capitalists, but also to interfere in actual production in a most dangerous manner— and this gang knows nothing about production and has nothing to do with it.” [1]

Ten years ago, a quote from Marx would have one deemed a socialist, and dismissed from polite debate. Today, such a quote can (and did, along with Charlie’s photo) appear in a feature in the Sydney Morning Herald—and not a few people would have been nodding their heads at how Marx got it right on bankers.F

He got it wrong on some other issues,[2] but his analysis of money and credit, and how the credit system can bring an otherwise well-functioning market economy to its knees, was spot on. His observations on the financial crisis of 1857 still ring true today:

“A high rate of interest can also indicate, as it did in 1857, that the country is undermined by the roving cavaliers of credit who can afford to pay a high interest because they pay it out of other people’s pockets (whereby, however, they help to determine the rate of interest for all), and meanwhile they live in grand style on anticipated profits.

Simultaneously, precisely this can incidentally provide a very profitable business for manufacturers and others. Returns become wholly deceptive as a result of the loan system…”[1]

One and a half centuries after Marx falsely predicted the demise of capitalism, the people most likely to bring it about are not working class revolutionaries, but the “Roving Cavaliers of Credit”, against whom Marx quite justly railed.

This month’s Debtwatch is dedicated to analysing how these Cavaliers actually “make” money and debt—something they think they understand, but in reality, they don’t. A sound model of how money and debt are created makes it obvious that we should never have fallen for the insane notion that the financial system should be self-regulating. All that did was give the Cavaliers a licence to run amok, with the consequences we are now experiencing yet again—150 years after Marx described the crisis that led him to write Das Kapital.
The conventional model: the “Money Multiplier”

Every macroeconomics textbook has an explanation of how credit money is created by the system of fractional banking that goes something like this:

* Banks are required to retain a certain percentage of any deposit as a reserve, known as the “reserve requirement”; for simplicity, let’s say this fraction is 10%.
* When customer Sue deposits say 100 newly printed government $10 notes at her bank, it is then obliged to hang on to ten of them—or $100—but it is allowed to lend out the rest.
* The bank then lends $900 to its customer Fred, who then deposits it in his bank—which is now required to hang on to 9 of the bills—or $90—and can lend out the rest. It then lends $810 to its customer Kim.
* Kim then deposits this $810 in her bank. It keeps $81 of the deposit, and lends the remaining $729 to its customer Kevin.
* And on this iterative process goes.
* Over time, a total of $10,000 in money is created—consisting of the original $1,000 injection of government money plus $9,000 in credit money—as well as $9,000 in total debts. The following table illustrates this, on the assumption that the time lag between a bank receiving a new deposit, making a loan, and the recipient of the loan depositing them in other banks is a mere one week.

This model of how banks create credit is simple, easy to understand (this version omits the fact that the public holds some of the cash in its own pockets rather than depositing it all in the banks; this detail is easily catered for and is part of the standard model taught to economists),… and completely inadequate as an explanation of the actual data on money and debt.
The Data versus the Money Multiplier Model

Two hypotheses about the nature of money can be derived from the money multiplier model:

1. The creation of credit money should happen after the creation of government money. In the model, the banking system can’t create credit until it receives new deposits from the public (that in turn originate from the government) and therefore finds itself with excess reserves that it can lend out. Since the lending, depositing and relending process takes time, there should be a substantial time lag between an injection of new government-created money and the growth of credit money.

2. The amount of money in the economy should exceed the amount of debt, with the difference representing the government’s initial creation of money. In the example above, the total of all bank deposits tapers towards $10,000, the total of loans converges to $9,000, and the difference is $1,000, which is the amount of initial government money injected into the system. Therefore the ratio of Debt to Money should be less than one, and close to (1-Reserve Ratio): in the example above, D/M=0.9, which is 1 minus the reserve ratio of 10% or 0.1.

Both these hypotheses are strongly contradicted by the data.

Testing the first hypothesis takes some sophisticated data analysis, which was done by two leading neoclassical economists in 1990.[3] If the hypothesis were true, changes in M0 should precede changes in M2. The time pattern of the data should look like the graph below: an initial injection of government “fiat” money, followed by a gradual creation of a much larger amount of credit money:

Their empirical conclusion was just the opposite: rather than fiat money being created first and credit money following with a lag, the sequence was reversed: credit money was created first, and fiat money was then created about a year later:

“There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly. (p. 11)

The difference in the behavior of M1 and M2 suggests that the difference of these aggregates (M2 minus M1) should be considered… The difference of M2 – M1 leads the cycle by even more than M2, with the lead being about three quarters.” (p. 12)

Thus rather than credit money being created with a lag after government money, the data shows that credit money is created first, up to a year before there are changes in base money. This contradicts the money multiplier model of how credit and debt are created: rather than fiat money being needed to “seed” the credit creation process, credit is created first and then after that, base money changes.

It doesn’t take sophisticated statistics to show that the second prediction is wrong—all you have to do is look at the ratio of private debt to money. The theoretical prediction has never been right—rather than the money stock exceeding debt, debt has always exceeded the money supply—and the degree of divergence has grown over time.(there are attenuating factors that might affect the prediction—the public hoarding cash should make the ratio less than shown here, while non-banks would make it larger—but the gap between prediction and reality is just too large for the theory to be taken seriously).

Academic economics responded to these empirical challenges to its accepted theory in the time-honoured way: it ignored them.

Well, the so-called “mainstream” did—the school of thought known as “Neoclassical economics”. A rival school of thought, known as Post Keynesian economics, took these problems seriously, and developed a different theory of how money is created that is more consistent with the data.

This first major paper on this approach, “The Endogenous Money Stock” by the non-orthodox economist Basil Moore, was published almost thirty years ago.[4] Basil’s essential point was quite simple. The standard money multiplier model’s assumption that banks wait passively for deposits before starting to lend is false. Rather than bankers sitting back passively, waiting for depositors to give them excess reserves that they can then on-lend,

“In the real world, banks extend credit, creating deposits in the process, and look for reserves later”.[5]

Thus loans come first—simultaneously creating deposits—and at a later stage the reserves are found. The main mechanism behind this are the “lines of credit” that major corporations have arranged with banks that enable them to expand their loans from whatever they are now up to a specified limit.

If a firm accesses its line of credit to, for example, buy a new piece of machinery, then its debt to the bank rises by the price of the machine, and the deposit account of the machine’s manufacturer rises by the same amount. If the bank that issued the line of credit was already at its own limit in terms of its reserve requirements, then it will borrow that amount, either from the Federal Reserve or from other sources.

If the entire banking system is at its reserve requirement limit, then the Federal Reserve has three choices:

* refuse to issue new reserves and cause a credit crunch;
* create new reserves; or
* relax the reserve ratio.

Since the main role of the Federal Reserve is to try to ensure the smooth functioning of the credit system, option one is out—so it either adds Base Money to the system, or relaxes the reserve requirements, or both.

Thus causation in money creation runs in the opposite direction to that of the money multiplier model: the credit money dog wags the fiat money tail. Both the actual level of money in the system, and the component of it that is created by the government, are controlled by the commercial system itself, and not by the Federal Reserve.

Central Banks around the world learnt this lesson the hard way in the 1970s and 1980s when they attempted to control the money supply, following neoclassical economist Milton Friedman’s theory of “monetarism” that blamed inflation on increases in the money supply. Friedman argued that Central Banks should keep the reserve requirement constant, and increase Base Money at about 5% per annum; this would, he asserted cause inflation to fall as people’s expectations adjusted, with only a minor (if any) impact on real economic activity.

Though inflation was ultimately suppressed by a severe recession, the monetarist experiment overall was an abject failure. Central Banks would set targets for the growth in the money supply and miss them completely—the money supply would grow two to three times faster than the targets they set.

Ultimately, Central Banks abandoned monetary targetting, and moved on to the modern approach of targetting the overnight interest rate as a way to control inflation.[6] Several Central Banks—including Australia’s RBA—completely abandoned the setting of reserve requirements. Others—such as America’s Federal Reserve—maintained them, but had such loopholes in them that they became basically irrelevant. Thus the US Federal Reserve sets a Required Reserve Ratio of 10%, but applies this only to deposits by individuals; banks have no reserve requirement at all for deposits by companies.[7]

However, neoclassical economic theory never caught up with either the data, or the actual practices of Central Banks—and Ben Bernanke, a leading neoclassical theoretician, and unabashed fan of Milton Friedman, is now in control of the Federal Reserve. He is therefore trying to resolve the financial crisis and prevent deflation in a neoclassical manner: by increasing the Base Money supply.

Give Bernanke credit for trying here: the rate at which he is increasing Base Money is unprecedented. Base Money doubled between 1994 and 2008; Bernanke has doubled it again in just the last 4 months.

If the money multiplier model of money creation were correct, then ultimately this would lead to a dramatic growth in the money supply as an additional US$7 trillion of credit money was gradually created.

If neoclassical theory was correct, this increase in the money supply would cause a bout of inflation, which would end bring the current deflationary period to a halt, and we could all go back to “business as usual”. That is clearly what Bernanke is banking on:

“The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. A little parable may prove useful: Today an ounce of gold sells for $300, more or less. Now suppose that a modern alchemist solves his subject’s oldest problem by finding a way to produce unlimited amounts of new gold at essentially no cost. Moreover, his invention is widely publicized and scientifically verified, and he announces his intention to begin massive production of gold within days.

What would happen to the price of gold? Presumably, the potentially unlimited supply of cheap gold would cause the market price of gold to plummet. Indeed, if the market for gold is to any degree efficient, the price of gold would collapse immediately after the announcement of the invention, before the alchemist had produced and marketed a single ounce of yellow metal.

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.

By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation…

If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.” [8]

However, from the point of view of the empirical record, and the rival theory of endogenous money, this will fail on at least four fronts:

1. Banks won’t create more credit money as a result of the injections of Base Money. Instead, inactive reserves will rise;

2. Creating more credit money requires a matching increase in debt—even if the money multiplier model were correct, what would the odds be of the private sector taking on an additional US$7 trillion in debt in addition to the current US$42 trillion it already owes?;

3. Deflation will continue because the motive force behind it will still be there—distress selling by retailers and wholesalers who are desperately trying to avoid going bankrupt; and

4. The macroeconomic process of deleveraging will reduce real demand no matter what is done, as Microsoft CEO Steve Ballmer recently noted: “We’re certainly in the midst of a once-in-a-lifetime set of economic conditions. The perspective I would bring is not one of recession. Rather, the economy is resetting to lower level of business and consumer spending based largely on the reduced leverage in economy”.[9]

The only way that Bernanke’s “printing press example” would work to cause inflation in our current debt-laden would be if simply Zimbabwean levels of money were printed—so that fiat money could substantially repay outstanding debt and effectively supplant credit-based money.

Measured on this scale, Bernanke’s increase in Base Money goes from being heroic to trivial. Not only does the scale of credit-created money greatly exceed government-created money, but debt in turn greatly exceeds even the broadest measure of the money stock—the M3 series that the Fed some years ago decided to discontinue.

Bernanke’s expansion of M0 in the last four months of 2008 has merely reduced the debt to M0 ratio from 47:1 to 36:1 (the debt data is quarterly whole money stock data is monthly, so the fall in the ratio is more than shown here given the lag in reporting of debt).

To make a serious dent in debt levels, and thus enable the increase in base money to affect the aggregate money stock and hence cause inflation, Bernanke would need to not merely double M0, but to increase it by a factor of, say, 25 from pre-intervention levels. That US$20 trillion truckload of greenbacks might enable Americans to repay, say, one quarter of outstanding debt with one half—thus reducing the debt to GDP ratio about 200% (roughly what it was during the DotCom bubble and, coincidentally, 1931)—and get back to some serious inflationary spending with the other (of course, in the context of a seriously depreciating currency). But with anything less than that, his attempts to reflate the American economy will sink in the ocean of debt created by America’s modern-day “Roving Cavaliers of Credit”.

How to be a “Cavalier of Credit”

Note Bernanke’s assumption (highlighted above) in his argument that printing money would always ultimately cause inflation: “under a fiat money system“. The point made by endogenous money theorists is that we don’t live in a fiat-money system, but in a credit-money system which has had a relatively small and subservient fiat money system tacked onto it.

We are therefore not in a “fractional reserve banking system”, but in a credit-money one, where the dynamics of money and debt are vastly different to those assumed by Bernanke and neoclassical economics in general.[10]

Calling our current financial system a “fiat money” or “fractional reserve banking system” is akin to the blind man who classified an elephant as a snake, because he felt its trunk. We live in a credit money system with a fiat money subsystem that has some independence, but certainly doesn’t rule the monetary roost—far from it.

The best place to start to analyse the monetary system is therefore to consider a model of a pure credit economy—a toy economy in which there is no government sector and no Central Bank whatsoever—and see how that model behaves.

The first issue in such a system is how does one become a bank?—or a “cavalier of credit” in Marx’s wonderfully evocative phrase? The answer was provided by the Italian non-orthodox economist Augusto Graziani: a bank is a third party to all transactions, whose account-keeping between buyer and seller is regarded as finally settling all claims between them.

Huh? What does that mean? To explain it, I’ll compare it with the manner in which we’ve been misled to thinking about the market economy by neoclassical economics.

It has deluded us into thinking of a market economy as being fundamentally a system of barter. Every transaction is seen as being two sided, and involving two commodities: Farmer Maria wants to sell pigs and buy copper pipe; Plumber Joe wants to sell copper pipe and buy pigs.

Money simply eliminates the problem that it’s very hard for Plumber Joe to find Farmer Maria. Instead, they each sell their commodity for money, and then exchange that money for the commodity they really want. The picture appears more complicated—there are two markets introduced as well, with Farmer Maria selling pigs to the pig market in return for money, Plumber Joe doing the same thing in the copper market, and then armed with money from their sales, they go across to the other market and buy what they want. But it is still a lot easier than a plumber going out to try to find a pig farmer who wants copper pipes.

In this model of the economy, money is useful in that it replaces a very difficult search process with a system of markets. But fundamentally the system is no different to the barter model above: money is just a convenient “numeraire”, and anything at all could be used—even copper pipe or pigs—so long as all markets agreed to accept it. Gold tends to be the numeraire of choice because it doesn’t degrade, and paper money merely replaces gold as a more convenient form of numeraire.

Importantly, in this model, money is an asset to its holder, but a liability to no-one. There is money, but no debt. The fractional banking model that is tacked onto this vision of bartering adds yet another market where depositors (savers) supply money at a price (the rate of interest), and lenders buy money for that price, and the interaction between supply and demand sets the price. Debt now exists, but in the model world total debt is less than the amount of money.

If this market produces too much money (which it can do in a fractional banking system because the government determines the supply of base money and the reserve requirement) then there can be inflation of the money prices of commodities. Equally if the money market suddenly contracts, then there can be deflation. It’s fairly easy to situate Bernanke’s dramatic increase in Base Money within this view of the world.

If only it were the world in which we live. Instead, we live in a credit economy, in which intrinsically useless pieces of paper—or even simple transfers of electronic records of numbers—are happily accepted in return for real, hard commodities. This in itself is not incompatible with a fractional banking model, but the empirical data tells us that credit money is created independently of fiat money: credit money rules the roost. So our fundamental understanding of a monetary economy should proceed from a model in which credit is intrinsic, and government money is tacked on later—and not the other way round.

Our starting point for analysing the economy should therefore be a “pure credit” economy, in which there are privately issued bank notes, but no government sector and no fiat money. Yet this has to be an economy in which intrinsically useless items are accepted as payment for intrinsically useful ones—you can’t eat a bank note, but you can eat a pig.

So how can that be done without corrupting the entire system. Someone has to have the right to produce the bank notes; how can this system be the basis of exchange, without the person who has that right abusing it?

Graziani (and others in the “Circuitist” tradition) reasoned that this would only be possible if the producer of bank notes—or the keeper of the electronic records of money—could not simply print them whenever he/she wanted a commodity, and go and buy that commodity with them. But at the same time, people involved in ordinary commerce had to accept the transfer of these intrinsically useless things in return for commodities.

“Therefore for a system of credit money to work, three conditions had to be fulfilled:

In order for money to exist, three basic conditions must be met:

a) money has to be a token currency (otherwise it would give rise to barter and not to monetary exchanges);

b) money has to be accepted as a means of final settlement of the transaction (otherwise it would be credit and not money);

c) money must not grant privileges of seignorage to any agent making a payment.” [11]

In Graziani’s words, “The only way to satisfy those three conditions is …:

“to have payments made by means of promises of a third agent, the typical third agent being nowadays. When an agent makes a payment by means of a cheque, he satisfies his partner by the promise of the bank to pay the amount due.

Once the payment is made, no debt and credit relationships are left between the two agents. But one of them is now a creditor of the bank, while the second is a debtor of the same bank. This insures that, in spite of making final payments by means of paper money, agents are not granted any kind of privilege.

For this to be true, any monetary payment must therefore be a triangular transaction, involving at least three agents, the payer, the payee, and the bank.” ( p. 3).

Thus in a credit economy, all transactions are involve one commodity, and three parties: a seller, a buyer, and a bank whose transfer of money from the buyer’s account to the seller’s is accepted by them as finalising the sale of the commodity. So the actual pattern in any transaction in a credit money economy is as shown below:

This makes banks and money an essential feature of a credit economy, not something that can be initially ignored and incorporated later, as neoclassical economics has attempted to do (unsuccessfully; one of the hardest things for a neoclassical mathematical modeller is to explain why money exists, apart from the search advantages noted above. Generally therefore their models omit money—and debt—completely).

It also defines what a bank is: it is a third party whose record-keeping is trusted by all parties as recording the transfers of credit money that effect sales of commodities. The bank makes a legitimate living by lending money to other agents—thus simultaneously creating loans and deposits—and charging a higher rate of interest on loans than on deposits.

Thus in a fundamental way, a bank is a bank because it is trusted. Of course, as we know from our current bitter experience, banks can damage that trust; but it remains the wellspring from which their existence arises.

This model helped distinguish the realistic model of endogenous money from the unrealistic neoclassical vision of a barter economy. It also makes it possible to explain what a credit crunch is, and why it has such a devastating impact upon economic activity.

First, the basics: how does a pure credit economy work, and how is money created in one? (The rest of this post necessarily gets technical and is there for those who want detailed background. It reports new research into the dynamics of a credit economy. There’s nothing here anywhere near as poetic as Marx’s “Cavaliers of Credit”, but I hope it explains how a credit economy works, and how it can go badly wrong in a “credit crunch”)
How the Cavaliers “Make Money”

Several economists—notably Wicksell and Keynes—envisaged a “pure credit economy”. Keynes imagined a world in which “investment is proceeding at a steady rate”, in which case:

“the finance (or the commitments to finance) required can be supplied from a revolving fund of a more or less constant amount, one entrepreneur having his finance replenished for the purpose of a projected investment as another exhausts his on paying for his completed investment.” [12]

This is the starting point to understanding a pure credit economy—and therefore to understanding our current economy and why it’s in a bind. Consider an economy with three sectors: firms that produce goods, banks that charge and pay interest, and households that supply workers. Firms are the only entities that borrow, and the banking sector gave loans at some stage in the past to start production. Firms hired workers with this money (and bought inputs from each other), enabling production, and ultimately the economy settled down to a constant turnover of money and goods (as yet there is no technological change, population growth, or wage bargaining).

There are four types of accounts: Firms’ Loans, Firms’ Deposits, Banks’ Deposits, and Households Deposits. These financial flows are described by the following table. I’m eschewing mathematical symbols and just using letters here to avoid the “MEGO” effect (”My Eyes Glaze Over”)—if you want to check out the equations, see this paper:

1. Interest accrues on the outstanding loans.

2. Firms pay interest on the loans. This is how the banks make money, and it involves a transfer of money from the firms deposit accounts to the banks. The banks then have to acknowledge this payment of interest by recording it against the outstanding debt firms owe them.

3. Banks pay interest to firms on the balances in their deposit accounts. This involves a transfer from Bank Deposit accounts to Firms; this is a cost of business to banks, but they make money this way because (a) the rate of interest on loans is higher than that on deposits and (b) as is shown later, the volume of loans outstanding exceeds the deposits that banks have to pay interest on;

4. Firms pay wages to workers; this is a transfer from the firms deposits to the households.

5. Banks pay interest to households on the balances in their deposit accounts.

6. Banks and households pay money to firms in order to purchase some of the output from factories for consumption and intermediate goods.

This financial activity allows production to take place:

1. Workers are hired and paid a wage;

2. They produce output in factories at a constant level of productivity;

3. The output is then sold to other firms, banks and households;

4. The price level is set so that in equilibrium the flow of demand equals the flow of output

The graphs below show the outcome of a simulation of this system, which show that a pure credit economy can work: firms can borrow money, make a profit and pay it back, and a single “revolving fund of finance”, as Keynes put it, can maintain a set level of economic activity. [13]

These stable accounts support a flow of economic activity in time, giving firms, households and banks steady incomes:

Output and employment also tick over at a constant level:

That’s the absolutely basic picture; to get closer to our current reality, a lot more needs to be added. The next model includes, in addition to the basic system shown above:

1. Repayment of debt, which involves a transfer from the Firms’ deposit account to an account that wasn’t shown in the previous model that records Banks unlent reserves; this transfer of money has to be acknowledged by the banks by a matching reduction in the recorded level of debt;

2. Relending from unlent reserves. This involves a transfer of money, against which an equivalent increase in debt is recorded;

3. The extension of new loans to the firm sector by the banks. The firms sector’s deposits are increased, and simultaneously the recorded level of debt is increased by the same amount.

4. Investment of part of bank profits by a transfer from the banking sector’s deposit accounts to the unlent reserves.

5. Variable wages, growing labour productivity and a growing population.

The financial table for this system is:

As with the previous model, this toy economy “works”—it is possible for firms to borrow money, make a profit, and repay their debt.

With the additional elements of debt repayment and the creation of new money, this model also lets us see what happens to bank income when these parameters change.

Though in some ways the answers are obvious, it lets us see why banks are truly cavalier with credit. The conclusions are that bank income is bigger:

* If the rate of money creation is higher (this is by far the most important factor);
* If the rate of circulation of unlent reserves is higher; and
* If the rate of debt repayment is lower—which is why, in “normal” financial circumstances, banks are quite happy not to have debt repaid.

In some ways these conclusions are unremarkable: banks make money by extending debt, and the more they create, the more they are likely to earn. But this is a revolutionary conclusion when compared to standard thinking about banks and debt, because the money multiplier model implies that, whatever banks might want to do, they are constrained from so doing by a money creation process that they do not control.

However, in the real world, they do control the creation of credit. Given their proclivity to lend as much as is possible, the only real constraint on bank lending is the public’s willingness to go into debt. In the model economy shown here, that willingness directly relates to the perceived possibilities for profitable investment—and since these are limited, so also is the uptake of debt.

But in the real world—and in my models of Minsky’s Financial Instability Hypothesis—there is an additional reason why the public will take on debt: the perception of possibilities for private gain from leveraged speculation on asset prices.

That clearly is what has happened in the world’s recent economic history, as it happened previously in the runup to the Great Depression and numerous financial crises beforehand. In its aftermath, we are now experiencing a “credit crunch”—a sudden reversal with the cavaliers going from being willing to lend to virtually anyone with a pulse, to refusing credit even to those with solid financial histories.

I introduce a “credit crunch” into this model by changing those same key key financial parameters at the 30 year mark, but decreasing them rather than increasing them. Firms go from having a 20 year horizon for debt repayment to a 6.4 year horizon, banks go from increasing the money supply at 10% per annum to 3.2% per annum, while the rate of circulation of unlent reserves drops by 68%.

There is much more to our current crisis than this—in particular, this model omits “Ponzi lending” that finances gambling on asset prices rather than productive investment, and the resulting accumulation of debt compared to GDP—but this level of change in financial parameters alone is sufficient to cause a simulated crisis equivalent to the Great Depression. Its behaviour reproduces much of what we’re witnessing now: there is a sudden blowout in unlent reserves, and a decline in the nominal level of debt and in the amount of money circulating in the economy.

This is the real world phenomenon that Bernanke is now railing against with his increases in Base Money, and already the widespread lament amongst policy makers is that banks are not lending out this additional money, but simply building up their reserves.

Tough: in a credit economy, that’s what banks do after a financial crisis—it’s what they did during the Great Depression. This credit-economy phenomenon is the real reason that the money supply dropped during the Depression: it wasn’t due to “bad Federal Reserve policy” as Bernanke himself has opined, but due to the fact that we live in a credit money world, and not the fiat money figment of neoclassical imagination.

The impact of the simulated credit crunch on my toy economy’s real variables is similar to that of the Great Depression: real output slumps severely, as does employment.

The nominal value of output also falls, because prices also fall along with real output.

This fall in prices is driven by a switch from a regime of growing demand to one of shrinking demand. Rather than there being a continuous slight imbalance in demand’s favour, the imbalance shifts in favour of supply—and prices continue falling even though output eventually starts to rise.

The unemployment rate explodes rapidly from full employment to 25 percent of the workforce being out of a job—and then begins a slow recovery.

Finally, wages behave in a perverse fashion, just as Keynes argued during the Great Depression: nominal wages fall, but real wages rise because the fall in prices outruns the fall in wages.

This combination of falling prices and falling output means that despite the fall in nominal debts, the ratio of debt to nominal output actually rises—again, as happened for the first few years of the Great Depression.

Though this model is still simple compared to the economy in which we live, it’s a lot closer to our actual economy than the models developed by conventional “neoclassical” economists, which ignore money and debt, and presume that the economy will always converge to a “NAIRU”[14] equilibrium after any shock.

It also shows the importance of the nominal money stock, something that neoclassical economists completely ignore. To quote Milton Friedman on this point:

“It is a commonplace of monetary theory that nothing is so unimportant as the quantity of money expressed in terms of the nominal monetary unit—dollars, or pounds, or pesos… Let the number of dollars in existence be multiplied by 100; that, too, will have no other essential effect, provided that all other nominal magnitudes (prices of goods and services, and quantities of other assets and liabilities that are expressed in nominal terms) are also multiplied by 100.” [15]

The madness in Friedman’s argument is the assumption that increasing the money supply by a factor of 100 will also cause “all other nominal magnitudes” including commodity prices and debts to be multiplied by the same factor.

Whatever might be the impact on prices of increasing the money supply by a factor of 100, the nominal value of debt would remain constant: debt contracts don’t give banks the right to increase your outstanding level of debt just because prices have changed. Movements in the nominal prices of goods and services aren’t perfectly mirrored by changes in the level of nominal debts, and this is why nominal magnitudes can’t be ignored.

In this model I have developed, money and its rate of circulation matter because they determine the level of nominal and real demand. It is a “New Monetarism” model, in which money is crucial.

Ironically, Milton Friedman argued that money was crucial in his interpretation of the Great Depression—that the failure of the Federal Reserve to sufficiently increase the money supply allowed deflation to occur. But he a trivial “helicopter” model of money creation that saw all money as originating from the operations of the Federal Reserve:

“Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated… [16]

When the helicopter starts dropping money in a steady stream— or, more generally, when the quantity of money starts unexpectedly to rise more rapidly— it takes time for people to catch on to what is happening. Initially, they let actual balances exceed long— run desired balances…” (p. 13)

and a trivial model of the real economy that argued that it always tended back to equilibrium:

“Let us start with a stationary society in which … (5) The society, though stationary, is not static. Aggregates are constant, but individuals are subject to uncertainty and change. Even the aggregates may change in a stochastic way, provided the mean values do not… Let us suppose that these conditions have been in existence long enough for the society to have reached a state of equilibrium…” (pp. 2-3)

One natural question to ask about this final situation is, “ What raises the price level, if at all points markets are cleared and real magnitudes are stable?” The answer is, “ Because everyone confidently anticipates that prices will rise.” (p. 10)

Using this simplistic analysis, Milton Friedman claimed that inflation was caused by “too many helicopters” and deflation by “too few”, and that the deflation that amplified the downturn in the 1930s could have been prevented if only the Fed had sent more helicopters into the fray:

“different and feasible actions by the monetary authorities could have prevented the decline in the money stock—indeed, produced almost any desired increase in the money stock. The same actions would also have eased the banking difficulties appreciably. Prevention or moderation of the decline in the stock of money, let alone the substitution of monetary expansion, would have reduced the contraction’s severity and almost as certainly its duration.” [17]

With a sensible model of how money is endogenously created by the financial system, it is possible to concur that a decline in money contributed to the severity of the Great Depression, but not to blame that on the Federal Reserve not properly exercising its effectively impotent powers of fiat money creation. Instead, the decline was due to the normal operations of a credit money system during a financial crisis that its own reckless lending has caused—the Cavaliers are cowards who rush into a battle they are winning, and retreat at haste in defeat.

However, with his belief in Friedman’s analysis, Bernanke did blame his 1930 predecessors for causing the Great Depression. In his paean to Milton Friedman on the occasion of his 90th birthday, Bernanke made the following remark:

“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” [18]

In fact, thanks to Milton Friedman and neoclassical economics in general, the Fed ignored the run up of debt that has caused this crisis, and every rescue engineered by the Fed simply increased the height of the precipice from which the eventual fall into Depression would occur.

Having failed to understand the mechanism of money creation in a credit money world, and failed to understand how that mechanism goes into reverse during a financial crisis, neoclassical economics may end up doing what by accident what Marx failed to achieve by deliberate action, and bring capitalism to its knees.

Neoclassical economics—and especially that derived from Milton Friedman’s pen—is mad, bad, and dangerous to know.

Debtwatch Statistics February 2009

My discussion of the most recent monthly data is abbreviated given the length of this Report, but it now appears that the debt bubble has started to burst. Private debt fell by $A$5 billion in the last month, the first fall since 2003, and the steepest monthly fall on record.

As a result, Australia’s Debt to GDP ratio has started to fall.

However, it might rise once more if deflation takes hold. This was the Depression experience when the debt to GDP ratio rose even as nominal debt levels fell. Leaving that possibility aside for the moment, it appears that Australia’s peak private debt to GDP ratio occurred in March 2008, with a ratio of 177% of GDP including business securities (or 165% excluding business securities).

[1] Marx, Capital Volume III, Chapter 33, The medium of circulation in the credit system, pp. 544-45 [Progress Press]. Emphases added.

[2] Notably the “labour theory of value”, which argues erroneously that all profit comes from labour, the notion that the rate of profit has a tendency to fall, and the alleged inevitability of the demise of capitalism; see my papers on these issues on the Research page of my blog under Marx.

[3] Kydland & Prescott, Business Cycles: Real Facts and a Monetary Myth, Federal Reserve Bank of Minneapolis Quarterly Review, Spring 1990.

[4] “The Endogenous Money Stock”, Journal of Post Keynesian Economics, 1979, Volume 2, pp. 49-70.

[5] Basil Moore 1983, “Unpacking the post Keynesian black box: bank lending and the money supply”, Journal of Post Keynesian Economics 1983, Vol. 4 pp. 537-556; here Moore was quoting a Federal Reserve economist from a 1969 conference in which the endogeneity of the money supply was being debated.

[6] This policy “worked” in the sense that Central Banks were successful in controlling short run interest rates, and appeared to work in controlling inflation; but it is now becoming obvious that its success on the latter front was a coincidence—the era of low inflation coincided with the dramatic impact of China and offshore manufacturing in general on consumer and producer prices—and it led to Central Banks completely ignoring the debt bubble that has caused the global financial crisis. As a result, interest rate targetting is also going the way of the Dodo now.

[7] see Table 10 in Yueh-Yun C. OBrien, 2007. “Reserve Requirement Systems in OECD Countries” , Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary A¤airs, Federal Reserve Board, 2007-54, Washington, D.C;. The US rule implies that the main reason for the “reserve requirement” these days is to meet household demand for cash.

[8] Bernanke 2002: Remarks by Governor Ben S. Bernanke Before the National Economists Club, Washington, D.C., November 21, 2002. Deflation: Making Sure “It” Doesn’t Happen Here. Emphasis added.

[9] “Microsoft resorts to first layoffs, cutting 5,000“, Yahoo Finance January 22nd 2009.

[10] And, for that matter, by Austrian economics, whose analysis of money is surprisingly simplistic. Though Austrians advocate a private money system in which banks would issue their own currency, they assume that under the current money system, all money is generated by fractional reserve lending on top of fiat money creation. This is strange, since if they advocate a private money system, they need a model of how banks could create money without fractional reserve lending. But they don’t have one.

[11] Graziani A. (1989). The Theory of the Monetary Circuit, Thames Papers in Political Economy, Sprin, pp.:1-26. Reprinted in M. Musella and C. Panico (eds) (1995). The Money Supply in the Economic Process, Edward Elgar, Aldershot.

[12] Keynes 1937, “ Alternative theories of the rate of interest” , Economic Journal, Vol. 47, pp. 241-252: p. 247

[13] The parameters were an initial loan of $100, loan rate of interest of 5%, deposit rate of 1%, 3 month lag between financing production and receiving the sales proceeds, 1/3rd of the surplus from production going to firms as profits and the remainder to workers as wages, a one year lag in price adjustments, a money wage of $1, worker productivity of 1.1 units of physical output per worker per year, and a one year lag in spending by bankers and a two week lag by workers.

[14] “Non-Accelerating Inflation Rate of Unemployment”, another one of Milton’s mythical constants.

[15] Milton Friedman 1969, “The Optimal Quantity of Money”, in The Optimal Quantity of Money and Other Essays, Macmillan, Chicago, p. 1.

[16] Milton Friedman 1969, pp. 5-6

[17] Milton Friedman and Anna Schwartz 1963, A Monetary History of the United States 1867-1960, Princeton University Press, Princeton, p. 301.

[18] Remarks by Governor Ben S. Bernanke At the Conference to Honor Milton Friedman, University of Chicago, Chicago, Illinois November 8, 2002 On Milton Friedman’s Ninetieth Birthday.

Bailout: It’s About Capital, Not Liquidity; Seeking Beta: Interview with Robert Arvanitis
September 29, 2008

Click here to download the “Emergency Economic Stabilization Act of 2008” draft released on September 28, 2008.

Click here to download a section by section analysis of the draft legislation.

The events of the past few weeks have been coming so fast and have inspired so much emotion and stress among all Americans, ourselves included, that it is time to step back from the heat of politics and refocus on the substance of risk and finance. That is, after all, why people read The IRA. We’re not giving up the fight for sanity in Washington by any means, but we’ve got clients to serve and real work to do. It is the duty of citizens in a free and democratic society to speak up when we believe that our elected and appointed leaders are getting it wrong. This we shall continue to do, looking at the world through a prism concerned first and foremost by the national interest. But we are going to turn down the volume and, to recall the words of our old friend Alejandro Junco at El Norte in Monterrey, Mexico, declare war on adjectives, especially when it comes to personalities.

Last week also made us very aware of the privilege and responsibility we have at IRA to have access to the Big Media. Our friends at CNBC, Bloomberg, the New York Times, and many other print and broadcast outlets have generously given us enormous visibility over the past few months. As we travel around the country, people now stop us on the street, the train, in the lobbies of office building and airports, to ask: “What the hell is going on with the banks?” We appreciate the fact that people care about our views and we will work to deserve such confidence.

Finally, we want to thank the hundreds of readers, new and old, that we have heard from in the past week, supporting many of the opinions we express about the financial assistance legislation being formulated in Washington. The few who did not support our views at least appreciate our efforts. Said one reader: “It would make your ideas more palatable if they were presented with a little humility and a recognition that you are not infallible.” Let us just state for the record that we are not sure of anything at the moment, but we put faith in first principles of individual freedom and responsibility to guide our efforts. And please do keep those cards and letters coming.

Memo to Ben Bernanke & Hank Paulson: Confidence is a Function of Capital, Not Liquidity

During the presidential debates on Friday, Senator John McCain (R-AZ) said that we are “at the end of the beginning” of the economic recession that is affecting the US and the entire world. We completely agree. So let us try to describe in financial terms why we believe that the legislation currently being finalized in Washington will be ineffective in achieving the stated goal of restoring liquidity to financial institutions and thereby make it possible for banks to begin to expand their balance sheets and lending books, both of which are currently contracting at an alarming and accelerating rate. In a soon to be published article by Alex Pollock and John Makin, both of American Enterprise Institute, “The RTC or the RFC: Taxpayers as Involuntary Equity Investors,” the two respected financial observers write:

“Do we need a ‘new RTC’ as the U.S. Treasury is proposing-or something else? We believe that an alternative framework is needed. Its key elements should be two: recognition of systemic risk embedded in the illiquidity of mortgage-backed securities and capture of the upside of a rescue for taxpayers, not for banks and (former) investment banks that created the bubble…. A better model for a fair solution to the incipient solvency problem is the Reconstruction Finance Corporation, or RFC, of the 1930s. This was one of the most powerful and effective of the agencies created to cope with the greatest U.S. financial crisis ever. When financial losses have been so great as to run through bank capital, when waiting and hoping have not succeeded, when uncertainty is extreme and risk premia therefore elevated, what the firms involved need is not more debt, but more equity capital.”

Pollock and Makin point out that simply buying bad assets from banks does not solve the most basic problem, naming restoring confidence in one another among financial institutions by ending questions regarding solvency. In this regard, click here to see a proposal circulated by and among individual members of Professional Risk Managers International Association over the weekend. The plan has two big virtues from our perspective: 1) it minimizes the outlays by the Treasury by keeping bad assets in private hands and 2) it provides a capital facility for solvent banks, a provision that is missing from the drafts we’ve seen of the assistance proposal now under consideration in Washington.

It is important for all Americans to understand that this financial crisis began more than a year ago with the collapse of liquidity in many types of mortgage assets, but the battle is quickly shifting to concerns about capital and solvency. The Federal Reserve System, Federal Home Loan Banks and the Treasury have already advanced huge amounts of liquidity in the form of debt to financial institutions in an attempt to help them stabilize their funding sources and slowly begin to re-liquefy. Click here to see a map of the balance sheet of the Federal Reserve Bank of New York maintained by our friends at Cumberland Advisers. But unfortunately neither these existing sources of funding nor the proposal to provide even more debt-financed support gets to the core issue that is undermining in the financial system, namely worries about solvency.

Consider two models for government assistance. The first is the Resolution Trust Corporation (“RTC”) model of the 1980s, which was used to buy up bad assets following the S&L crisis of the 1980s. The older model comes from the 1930s and the Reconstruction Finance Corporation (“RFC”), the most authoritarian federal agency that has ever existed in the United States. Directed by Jesse R. Jones, the RFC used its vast legal powers to test the solvency of banks and commercial companies and, when those institutions were proven solvent, they were allowed to re-open. Those financial institutions that were determined not to be solvent were closed by the FDIC and either sold whole or in pieces to other institutions.

Below are two very simplified numerical illustrations to highlight the failings of the current plan in Washington by way of a comparison between (1) the RTC/Paulson model and (2) the 1930s RFC model, which is conveniently illustrated by the purchase of WaMu by JPMorgan Chase (NYSE:JPM). Of note, in the WaMu resolution, equity and bond holders of the parent holding company were effectively wiped out – a significant landmark for bank investors that probably kills the private market for bank equity for the foreseeable future. Significantly, the advances from the FHLBs and the covered bonds issued by WaMu’s bank subsidiary were conveyed through the receivership and assumed by JPM. More on this in our next comment.

The RTC/Paulson Model

Suppose the Treasury’s bailout fund purchases $1 billion dollars worth of illiquid assets from a participating bank at par value, which for laymen is the face value of a loan or security. In that $1 billion, the bank actually receives $900 million of cash that was raised via deposits or other forms of debt and $100 million in its own capital, assuming a 10:1 leverage ratio. This is how bank operations work, a little bit of capital and a lot of leverage — as described in the Jimmy Stewart film “Its a Wonderful Life.” If the bank sells assets to the Treasury below par value (or the current, adjusted value if an adjustment or write-down has already been made), then the selling bank takes a capital loss and the other providers of liquidity, whether via deposits, debts or official sources of funding like the Federal Reserve System and Federal Home Loan Banks, are also taking an implicit if as yet unrealized loss.

In this first example, the overall solvency of the bank is actually hurt and the issues of confidence and safety and soundness are left unresolved or even worsened. This is why we believe the proposal being considered in Washington will be ineffective at best and may actually worsen the crisis of confidence in US banks. The RTC/Paulson model does nothing to arrest the de-leveraging of the commercial banking system and may even worsen the crisis of confidence. In our view, Senator Dick Shelby (R-AL), the House Republicans and the members of either party who want to have political careers in two year’s time are right to vote no on this proposal.

The RFC/WaMu Model

In the second example, imagine that Treasury takes a $1 billion preferred equity position in a solvent but illiquid bank. Instead of only receiving 10% of the amount of the cash infusion from the Treasury as capital, the bank receives the full $1 billion as new capital to absorb losses and then serve as a basis to re-lever the bank’s balance sheet and make new loans. By putting capital into solvent but illiquid banks, the Treasury can help them to offset losses of existing assets and provide new capital to use to make new loans to support the real economy. Remember, when new capital is invested in a bank under the RFC model, all of those funds are available to support the bank’s balance sheet, including deposits and bond holders.

If an insolvent bank is resolved by the FDIC, but its asset quality problems are too severe for a purchaser to assume the full burden of dealing with these assets (unlike the JPM/WaMu transaction), then the Treasury bailout fund could subsidize the transaction by purchasing preferred equity in the purchaser and providing a small but still significant option for the taxpayer to benefit from any recovery on the failed bank’s assets. This allows the FDIC to minimize the number of troubled institutions that it must operate as receiver and keeps the troubled assets in private hands, where the cost of resolution will be minimized in order to maximize profit. But as suggested by the proposal advanced by individual members of PRMIA mentioned at the top of this comment, the first goal is to keep as many banks and assets as possible out of government hands.

The difference between the current, RTC type model and the 1930s RFC model can be summarized succinctly: The bailout proposal now before Congress does not deal sufficiently with the issue of solvency and ensures that the US banking system will continue to deflate and de-lever, meaning that less and less credit will be available to the private economy and the recession is likely to be far longer and deeper. The present situation in the US economy is not nearly as bad as the 1930s, but if Ben Bernanke and Hank Paulson don’t soon refocus their attention from liquidity to solvency of depository institutions, the US economy could end up in a situation that is much worse that the 1930s given the huge inflation of asset values seen over the past decade. This situation is soluable and can be quickly repaired, but only if we make capital and the leverage it can support work for us, not aganst us as is now the case.

With the RFC model, on the other hand, by quickly moving to inject capital into solvent banks, we can actually reverse the process of deleveraging and deflation that is currently grinding the global banking system — and the world economy — into the ground. By using new leverage and private capital, we can not only re-liquefy the banking system but also decrease the length and severity of the now present recession. As we’ve said before and will no doubt say again, the roadmap for how to achieve this positive end is in Jones’ memoir, Fifty Billion Dollars: My Thirteen Years at the RFC. We know for a fact that the Library of Congress has many copies of this excellent book as well as copies of the congressional hearings regarding the creation of the RFC and Jones’ periodic reports to the Congress. But will anyone in Washington bother to read them?

Seeking Beta: Interview with Robert Arvanitis

Robert Arvanitis of Risk Finance Advisers is a Wall Street veteran who has managed to avoid some of the more spectacular disasters in recent financial history. An actuary by training and a member of PRMIA, he learned the reinsurance business from Hank Greenberg at AIG. Seeing the need to broaden the industry model, he moved into investment banking. At Merrill Lynch (NYSE:MER) he was managing director of Global New Derivatives, responsible for the very first “catastrophe” bond, among other innovations. Robert took the money off the table just in time, leaving MER before the bust. He now has the leisure to pursue the cross-sector arbs between insurance and banking, as we discuss below.

The IRA: Bob, we’ve been wanting to talk to you for some time about the current financial crisis. You have a unique perspective given your work in both the insurance and banking worlds.

Arvanitis: My first observation is that we do not learn from the past – we find new and more subtle errors to commit. History does not repeat itself, people repeat the same mistakes over and over. Second, in the case of the financial markets, they are perpetually slicing and dicing what they know because they cannot have access to or understand what they don’t know. They only way to break out of these well-worn paths, the familiar X/Y plane is go off in a different direction, call it Z. The insurance industry deals with wind and death and hurricanes, while Wall Street deals with what’s described in the Bloomberg terminal. BTW, I also have just described the difference between mark-to-market and buy and hold forever.

The IRA: Give us an example of the law of repetition.

Arvanitis: Back in the late ’80s, a interesting thing happened at Lloyd’s of London, the famous insurance marketplace. That venerable institution was driven by a host of forces to seek growth, find new revenue sources.

The IRA: Sounds like Wall Street post-deregulation.

Arvanitis: Oh yes. Since insurance only grows naturally with the overall economy, the clever brokers at Lloyd’s hit on a new scheme. When an insurer has too much risk, it often reinsures itself, or passes risk on to a reinsurer. Reinsurers do likewise to protect themselves, and retrocede risk on to another reinsurer. Well to keep revenues growing, the London brokers started a chain, call it the London Market Excess (“LMX”). They circulated risks ’round and ’round from insurer to reinsurer to retrocessionaire, each time taking out a commission bite, and at each step, losing details about the actual underlying risks. This “LMX Spiral” was a great game for a while. Eventually, of course, claims had to be settled. With the loss of detail at each turn of the spiral, that was hard. Even worse, after all the brokers’ commissions, there was no money left to actually pay claims.

The IRA: Why does AIG, MBIA (NYSE:MBI) and Ambac (NYSE:ABK) spring to mind? Also nicely describes securitization.

Arvanitis: Precisely. Roll forward twenty years. An interesting thing happened on Wall Street. The banks found themselves driven by a host of forces to seek growth, find new revenue sources. Since true investment and commercial banking only grows naturally with the overall economy, the clever bankers of Wall Street hit on a new scheme. When a bank has too much risk, it often sells assets, or borrows, or both, since that’s cheaper than raising equity. But then the bank needs to create new assets, for fee income, for market share, and not least to keep its origination channels busy and loyal.

The IRA: We call it “yield to commission.”

Arvanitis: Well to keep revenues growing, Wall Street started a chain, call it the CDO excess spiral. Package assets. Circulate them. Buy pieces, re-package and re-circulate, taking out a commission bite at each step. This CDO spiral was a great game for a while. Eventually of course, assets had to perform. With the same risks in every package, correlations soared to 1. In the end, there was no money in the smallest Matryoshka doll.

The IRA: Why do such spirals happen?

Arvanitis: Well, it happened at Lloyds because with insurance, the brokers who distribute are distinct from, and competitive with, the underwriters who take the risks. This came about because from the start in shipping, a sinking loss was far too big for any one underwriter, so all risks were syndicated. Distribution grew up as an independent function. Capital markets are more sophisticated. Distribution and underwriting are under one roof, albeit separated by a Chinese wall. So we don’t find one function merely cozening the other. No, in banking we must resort to more subtle errors, deeper flaws in the system.

The IRA: Why does this not make us feel good…

Arvanitis: Because you and Dennis are honest analysts who don’t work for broker dealers, at least in your case not any longer. I too am a refugee. The flaw in capital markets is the Rube Goldberg apparatus that passes for regulation. Whatever else history decides, the current financial contretemps did not result from lack of regulation. Rather, it arose from human weakness on both sides-industry and government. The amorality of industry is widely discussed. What is not so often recognized is the human weakness in government.

The IRA: Those weaknesses are very visible this week.

Arvanitis: Congress delegates to SEC, which delegates to PCAOB/FASB, which delegate to auditors, who hope that giving information to shareholders, on the theory that it will let them govern the boards, who in their own turn just may be able to rein in management. Meanwhile, Congress via ERISA tries to define “prudent.” They do this by delegating great power – but not accountability – to rating agencies. Yet the NRSROs are paid by the Buy and Sell Side interests to say “Yes.” Coming along after the fact, shareholder suits are a very blunt corrective. They increase uncertainty, and raise D&O premiums, but have no effect on management and emphatically do not discipline boards. This scheme is worse than no feedback mechanism at all for it deceives us into believing someone, somewhere, is responsible.

The IRA: As our friend Timothy Dickinson noted in an interview this year, the idea that institutions are led by people sufficiently informed to make rational decisions is an illusion (‘The Tyranny of Reason: Interview with Timothy Dickinson’, July 30, 2008).

Arvanitis: Precisely. With so many moving parts, no specific bureaucrat can ever be called to account. Being mortal, the bureaucrats desire to avoid pain is as dear to them as the desire by their counterparts in private industry to seek gain. And it is far more profitable to game the rules, for example, than to enforce them. And any system can be gamed. Witness the over-reaction of SarbOx, and the subsequent avoidance.

The IRA: So your answer is to focus on the Z axis, namely low beta transactions. Give our readers a clear, simple definition of the difference between Alpha and Beta.

Arvanitis: Alpha, to use the securities market example, is when an investor performs above the perceived level of risk. As risk goes to zero, if you have anything left, then you are making free money. Another way to put it is “I’m a genius.” Of course, in the markets some people lose money, thus others make money due to those mistakes. But I personally believe that there is no “free” alpha. That said, there is a way to earn returns that may look like alpha, especially if you are an astute student of human nature. You can make a bet when other people are behaving irrationally, as when you buy when there is blood in the street.

The IRA: Or Warren Buffet buying a chunk of Goldman Sachs (NYSE:GS) as it was pushed into the arms of the Fed?

Arvanitis: Yes, but that is not really alpha. It does not come from the market but instead from human fallacy and exploitation thereof, like being a good salesman. So that is alpha. Beta means correlation to the market. If it is correlated to the market, then you should get paid like anybody else, namely union wages. If you take X risk then you get Y return, that is the market rate. No better, no worse, just the average.

The IRA: But you have chosen to focus your firm on brokering “low beta” risks. What is that?

Arvanitis: Low beta is uncorrelated, non-market risk. This is the type of risk that insurers used to price, the sinking of ships, hurricanes. Non-market, uncorrelated risks. Now 300 years before Harry Markowitz, landed English gentry instinctively realized that their money came from land rents and crops, so they put some of their money to work by investing in Lloyds of London. If the crop was good this year, but a few ships sank, you made money on crops and lost on ships. The next year, the crops were lousy but no ships sank, so you made money on insurance. Lloyds was the insurance industry’s first effort at diversification and they stuck to their knitting and underwrote real world risk events like hurricanes and fires, which were uncorrelated to other markets.

The IRA: So what happened to the insurance industry? How did AIG, MBI and ABK get lured away from low beta into something as reckless and speculative as credit default swaps (“CDS”)?

Arvanitis: The insurance industry grew out of its crib and now does more and more underwriting in high-beta risks. They sell liability insurance, D&O coverage, surety, and, good lord, they even get into bond insurance. CDS is a bridge even further removed from the basic, low-beta model from which insurance comes. The risk taken by insurers is more and more high beta, and by doing so they spoiled a perfectly good racket.

The IRA: Precisely. Why on earth would AIG or the monolines leave a low risk, double digit rate of return business to gamble on municipal bond issuers or CDS? Makes no sense. Were they just chasing earnings growth?

Arvanitis: If they were chasing earnings they’d be smart. They were chasing revenue. D&O liability is very high beta and far, far removed from the relatively uncorrelated risks upon which the insurance industry was built. Now this is where a great opportunity exists to create a new class of assets to feed to the insurers, pension funds, etc, who don’t forget, still live largely in the world of buy-and-hold. By creating an asset based on whether there won’t be a hurricane or that the wind does not blow in the Midwest at the wind farm, or that there is not sufficient traffic on the toll road, we can created a counter-cyclical bet. There are numerous ways to carve counter-cyclical trades out of capital markets transactions.

The IRA: So what’s the problem? Why isn’t Wall Street all over these types of low-beta transactions?

Arvanitis: Because the data needed to construct these transactions is not found on the Bloomberg and, let’s face it, Wall Street rarely rewards imagination. If they did, you and I would be running Goldman Sachs or Morgan Stanley and those business models would be very different. It is hard to get a low beta transaction through the commitment or risk committee of a major bank because they cannot find a quote on wind or weather patterns on the Bloomberg terminal.

The IRA: Yes, we’ve been there. Back in the late 1990s, IRA co-founder Chris Whalen tried to get his colleagues at Bear, Stearns to look at a small, KS-based start up that wrote the original standard for the 802.11 wireless internet protocols. They said the opportunity was too small. We eventually showed the idea to Sony (NYSE:SNE), but they didn’t get it either. But back on track, how do we deal with the mess on Wall Street? What would you tell members of Congress if you were in Washington today?

Arvanitis: As you state in the comment above this interview, it is all about capital. Firms need capital to demonstrate that they CAN hold assets to maturity. Therefore, they do NOT need to liquidate assets at distressed levels, so those assets ARE valuable. This, in turn, means the firm’s equity is in good shape, so that it in fact HAS capital. The logic is quite circular. Capital is what you have in order that you do not ever need it.

The IRA: But now capital is in doubt because of the fear of insolvency, thus the need for new capital is infinite.

Arvanitis: Banks need capital against risk, but they also need new revenues to feed that capital. Hence the constant search for holes in the regulatory scheme, especially for wide margin assets. Of course the widest margins are in the most illiquid assets, and off we go. The FASB mark-to-market rule is truly an economists’ nightmare. How can mark-to-market possibly matter in a market filled with illiquid assets? It merely lines up the dominos!

The IRA: Sadly, yes. As we pointed out last week, the FASB pricked the structured asset bubble that has caused the meltdown on Wall Street. I doubt any of the members of the FASB board understood the significance of their actions at the time. But by next year, enraged politicians and business leaders are going to be calling for the abolition of the FASB. If we were SEC Chairman Christopher Cox, FASB Chairman Bob Hertz or the other members of the FASB Board who voted to implement FAS 157, immigration would be on the top of the list of priorities for 2009.

Arvanitis: Well, here’s the rub. We want to trade in the most illiquid assets, but can’t afford to capitalize them without getting back on the circular mark-to-market spiral. Take my experience at MER as an example. When we did the very first “catastrophe” bond for USAA, we had to agent, not underwrite. Risk management officials at MER had no way to capitalize the bond for less than 100% if we positioned it. To solve this seeming problem, we must stop dealing with the full spread (on credit, or the equivalent full premium for equity.) Instead, we parse the spread into component drivers.

The IRA: Sounds a lot like the proposal from several PRMIA members we included in the top of this comment. Do continue.

Arvanitis: Traditionally, the market considers alpha, or “I’m a genius” returns, separately from beta, or “everyone gets paid” returns. The idea that there is ever a real alpha has been debunked repeatedly. Think “survivorship fallacy.” So we’re left with beta. It’s in the low-beta markets that real value lies. But those are the risks which Wall Street finds so very hard to mark-to market or to capitalize.

The IRA: So is it an impossible task to reorient Wall Street to new opportunities?

Arvanitis: No. Enter the insurance sector, from above. Insurers emphatically do NOT price on blinking Bloomberg quotes. They use actuarial methods to price from first principles. And as hungry for revenue as they are, there is an enormous arbitrage opportunity between Wall Street’s reaction-“we don’t know what to do with this, so it’s 100% capital”- and the insurer’s price “We’ll take it for 7¢.”

The IRA: When the smoke clears from the meltdown on Wall Street, we’ll come back to the “how to do it” discussion regarding low beta. Thanks Bob.
AIG: Before Credit Default Swaps, There Was Reinsurance
by: Christopher Whalen April 02, 2009 | about stocks

What do many corporate buyers of insurance have in common with American International Group? Perhaps more than they would like to admit. Like AIG, many companies in the past few years have bought finite insurance, which transfers a prescribed amount of risk for a particular liability. What regulators now want to know is, how many companies, like AIG, have used finite insurance to artificially inflate their financial results?

“Infinite Risk?”
CFO Magazine
June 1, 2005

In the regulatory world, a ‘side letter’ is perhaps the most insidious and destructive weapon in the white-collar criminal’s arsenal. With the flick of a pen, underhanded executives can cook the books in enormous amounts and render a regulator helpless.

Fraud Magazine
July/August 2006

PRMIA Event: Market & Liquidity Risk Management for Financial Institutions

First, a housekeeping item. On Monday, May 4, 2009, in partnership with the Federal Deposit Insurance Corporation (FDIC) and the Office of Thrift Supervision (OTS), the Washington DC chapter of Professional Risk Managers’ International Association (PRMIA) is presenting an important day-long conference on managing liquidity and market risk for financial institutions. Speakers include some of the leading risk practitioners, investors, researchers, bank executives and regulators in the US financial community. PRMIA free and sustaining members may register on the PRMIA web site. Members of the regulatory community may register via the FDIC University. IRA co-founder Christopher Whalen will participate in the conference and serve as MC. See the PRMIA web site for more information on the program and speakers. And yes, our favorite bank regulator is making the opening remarks.

For some time now, we have been trying to reconcile the apparent paradox of American International Group (NYSE:AIG) walking away from the highly profitable, double-digit RAROC business of underwriting property and casualty (P&C) risk and diving into the rancid cesspool of credit default swaps (“CDS”) contracts and other types of “high beta” risks, business lines that are highly correlated with the financial markets.

In our interview with Robert Arvanitis last year, “‘Bailout: It’s About Capital, Not Liquidity; Seeking Beta: Interview with Robert Arvanitis’, September 29, 2008,” we discussed the difference between high and low beta. We also learned from Arvanitis, who worked for AIG during much of the relevant period, that the decision by Hank Greenberg and the AIG board to enter the CDS market was, at best, chasing revenue. No rational examination of the business opportunity, assuming that Greenberg and his directors were acting based on a reasoned analysis, could have resulted in a favorable decision to pursue CDS and other “high beta” risks, at least from our perspective.

In an effort to resolve this conundrum, over the past several months, The IRA has interviewed a number of forensic experts, insurance regulators and members of the law enforcement community focused on financial fraud. The picture we have assembled is frightening and suggests that, far from just AIG, much of the insurance industry has been drawn into the world of financial engineering and has thus become part of the problem.

Below we present our preliminary findings and invite your comments. One of the first things we learned about the insurance world is that the concept of “shifting risk” for a variety of business and regulatory reasons has been ongoing in the insurance world for decades. Finite insurance and other scams have been at least visible to the investment community for years and have been documented in the media, but what is less understood is that firms like AIG took the risk shifting shell game to a whole new level long before the firm’s entry into the CDS market.

In fact, our investigation suggests that by the time AIG had entered the CDS fray in a serious way more than five years ago, the firm was already doomed. No longer able to prop up its earnings using reinsurance because of growing scrutiny from state insurance regulators and federal law enforcement agencies, AIG’s foray into CDS was really the grand finale. AIG was a Ponzi scheme plain and simple, yet the Obama Administration still thinks of AIG as a real company that simply took excessive risks.

No, to us what the fraud Bernard Madoff is to individual investors, AIG is to the global financial community. As with the phony reinsurance contracts that AIG and other insurers wrote for decades, when AIG wrote hundreds of billions of dollars in CDS contracts, neither AIG nor the counterparties believed that the CDS would ever be paid. Indeed, one source with personal knowledge of the matter suggests that there may be emails and actual side letters between AIG and its counterparties that could prove conclusively that AIG never intended to pay out on any of its CDS contracts.

The significance of this for the US bailout of AIG is profound. If our surmise is correct, the position of Feb Chairman Ben Bernanke and Treasury Secretary Tim Geithner that the AIG credit default contracts are “valid legal contracts” is ridiculous and reveals a level of ignorance by the Fed and Treasury about the true goings on inside AIG and the reinsurance industry that is truly staggering.

Does Reinsurance + Side Letters = CDS?

One of the most widespread means of risk shifting is reinsurance, the act of paying an insurer to offset the risk on the books of a second insurer. This may sound pretty routine and plain vanilla, but what most people don’t know is that often times when insurers would write reinsurance contracts with one another, they would enter into “side letters” whereby the parties would agree that the reinsurance contract was essentially a canard, a form of window dressing to make a company, bank or another insurer look better on paper, but where the seller of protection had no intention of ever paying out on the contract.

Let’s say that an insurer needs to enhance its capital surplus by $100 million in order to meet regulatory capital requirements. They can enter into what appears to be a completely legitimate form of reinsurance contract, an agreement that appears to transfer the liability to the reinsurer. By doing so, the “ceding company” – an insurance company that transfers a risk to a reinsurance company – gets to drop that $100 million in liability and its regulatory surplus increases by $100 million. The reinsurer assuming the risk does actually put up the $100 million in liability, but with the knowledge that they will never have to actually pay out on the contract. This is good for the reinsurer because they are paid a fee for this transaction, but it is bad for the ceding company, the insurer with the capital shortfall, because the transaction is actually a sham, a fraud meant to deceive regulators, counterparties and investors into thinking that the insurer has adequate capital. Typically the fee is 6% per year or what is called a “loan fee” in the insurance industry.

When it operates in this fashion, the whole reinsurance industry could be described as a “surplus rental” proposition, whereby an insurer literally loans another insurer capital in the form of risk cover, but with a secret understanding in the form of a side letter that the loan will be reversed without any recourse to the seller of protection. You give me $6 million in cash today, and I will give you a promise that we both know I will never honor.

Does this sound familiar? What our contacts in the insurance industry describe is almost a precise description of the CDS market, albeit one that evolved in the reinsurance industry literally decades ago and has been the cause of numerous insurance insolvencies and losses to insured parties.

Or to put it another way, maybe the inspiration for the CDS market – at least within AIG and other insurers — evolved from the reinsurance market over the past two decades. As best as we can tell, the questionable practice of using side letters to mask the economic and business reality of reinsurance transactions started in the mid-1980s and continued until the middle of the current decade. This timeline just happens to track the creation and evolution of the OTC derivatives markets. In particular, the move by AIG into the CDS market coincides with the increased awareness of and attention to the use of side letters by insurance regulators and members of the state and federal law enforcement community.

Keep in mind that what we are talking about here are not questionable risk management policies but acts of deliberate and criminal fraud, acts that often result in jail time for those involved. As one senior forensic accountant who has practiced in the insurance sector for three decades told The IRA:

In every major criminal fraud case in which I have worked, at the center of the investigation were these side letters. It was always very strange to me that on-site investigators and law enforcement officials consistently found that these side letters were being used to mask the true financial condition of an insurer, and yet none of the state regulators, the National Association of Insurance Commissioners (NAIC), nor federal law enforcement authorities ever publicly mentioned the practice. They certainly did not act like the use of side letters was a commonplace thing, but it was widespread in the industry.

It is important to understand that a side letter is a secret agreement, a document that is often hidden from internal and external auditors, regulators and even senior management of insurers and reinsurers. We doubt, for example, that Warren Buffet or Hank Greenberg knew the details of side letters, but they should have. Just as a rogue CDS trader at a large bank like Societe General (NYSE:SGE) might seek to hide losing trades, the underwriters of insurers would use sham transactions and side letters to enhance the revenue of the insurer, but without disclosing the true nature of the transaction.

There are two basic problems with side letters. First, they are a criminal act, a fraud that usually carries the full weight of an “A” felony in many jurisdictions. Second, once the side letter is discovered by a persistent auditor or regulator examining the buyer of protection, the transaction becomes worthless. You paid $6 million to AIG to shift risk via the reinsurance, but the side letter makes clear that the transaction is a fraud and you lose any benefit that the apparent risk shifting might have provided. As the use of these secret side letters began to become more and more prevalent in the insurance industry, and these secret side deals were literally being stacked on top of one another at firms like AIG, the SEC began to investigate. And they began to find instances of fraud and to crack down on the practice. One of the first cases to come to the surface involved AIG helping Brightpoint (NASDAQ:CELL) commit accounting fraud, a case that eventually led the SEC to fine AIG $10 million in 2003.

Wayne M. Carlin, Regional Director of the SEC’s Northeast Regional Office, said of the settlements:

In this case, AIG worked hand in hand with CELL personnel to custom-design a purported insurance policy that allowed CELL to overstate its earnings by a staggering 61 percent. This transaction was simply a ’round-trip’ of cash from CELL to AIG and back to CELL. By disguising the money as ‘insurance,’ AIG enabled CELL to spread over several years a loss that should have been recognized immediately.

Another case involved PNC Financial (NYSE:PNC), which used various contracts with AIG to hide certain assets from regulators, even though the transaction amounted to the “rental” of capital and not a true risk transfer.

As the SEC noted in a 2004 statement:

The Commission’s action arises out of the conduct of Defendant AIG, primarily through its wholly owned subsidiary AIG Financial Products Corp. (“AIG-FP”), (collectively referred to as “AIG”) in developing, marketing, and entering into transactions that purported to enable a public company to remove certain assets from its balance sheet.

Click here to see the SEC statement regarding the AIG transactions with PNC.

The SEC statement reads in part:

In its Complaint, filed in the United States District Court for the District of Columbia, the Commission alleged that from at least March 2001 through January 2002, Defendant AIG, primarily through AIG-FP, developed a product called a Contributed Guaranted Alternative Investment Trust Security (“C-GAITS”), marketed that product to several public companies, and ultimately entered into three C-GAITS transactions with one such company, The PNC Financial Services Group, Inc. (“PNC”). For a fee, AIG offered to establish a special purpose entity (“SPE”) to which the counter-party would transfer troubled or other potentially volatile assets. AIG represented that, under generally accepted accounting principles (“GAAP”), the SPE would not be consolidated on the counter-party’s financial statements. The counter-party thus would be able to avoid charges to its income statement resulting from declines in the value of the assets transferred to the SPE. The transaction that AIG developed and marketed, however, did not satisfy the requirements of GAAP for nonconsolidation of SPEs.

In both cases, AIG was engaged in transactions that were meant not to reduce risk, but to hide the true nature of the risk in these companies from investors, regulators and the consumers who rely on these institutions for services. Keep in mind that while the SEC did act to address these issues, the parties involved received light punishments when you consider that these are all felonies that arguably would call for criminal prosecution for fraud, securities fraud, conspiracy and racketeering, among other things. Indeed, this is one of those rare cases where we believe AIG itself, as a corporate person, should be subject to criminal prosecution and liquidation.

Birds of a Feather: AIG & GenRe

Click here to see a June 6, 2005 press release from the SEC detailing criminal charges against John Houldsworth, a former senior executive of General Re Corporation (“GenRe”), a subsidiary of Berkshire Hathaway (NYSE:BRK.A), for his role in aiding and abetting American International Group, Inc. in committing securities fraud.

The SEC noted:

In its complaint filed today in federal court in Manhattan, the Commission alleged that Houldsworth and others helped AIG structure two sham reinsurance transactions that had as their only purpose to allow AIG to add a total of $500 million in phony loss reserves to its balance sheet in the fourth quarter of 2000 and the first quarter of 2001. The transactions were initiated by AIG to quell criticism by analysts concerning a reduction in the company’s loss reserves in the third quarter of 2000.

But the involvement of the BRKA unit GenRe in the AIG mess was not the first time that GenRe had been involved in the questionable use of reinsurance contracts and side letters.

Click here to see an example of a side letter that was made public in a civil litigation in Australia a decade ago. The faxed letter, which bears the ID number from the Australian Court, is from an insurance broker in London to Mr. Ajit Jain, a businessman who currently heads several reinsurance businesses for BRKA, regarding a reinsurance contract for FAI Insurance, an affiliate of HIH Insurance. Notice that the letter states plainly the intent of the transaction is to bolster the apparent capital of FAI. Notice too that several times in the letter, the statement is made that “no claim will be made before the commutation date,” which may be interpreted as being a warranty by the insured that no claims shall be made under the reinsurance policy. By no coincidence, HIH and FAI collapsed in a $5.3 billion dollar fiasco that ranks as Australia’s biggest ever corporate failure.

Click here to read a March 9, 2009 article from The Age, one of Australia’s leading business publications, regarding the collapse of HIH and FAI. In 2003, an insurer named Reciprocal of America (“ROA”) was seized by regulators and law enforcement officials. An investigation ensued for 3 years. According to civil lawsuits filed in the matter, GenRe provided finite insurance to ROA in order to make the troubled insurer look more solvent than it was in reality. Several regulators and law enforcement officials involved in that case tell The IRA that the ROA failure forced insurers like AIG and Gen Re to start looking for new ways to “cook the books” because the long-time practice of side letters was starting to come under real scrutiny. “These reinsurance deals made ROA look better than it really was,” one investigator with direct knowledge of the ROA matter tells The IRA.

They went into the ROA home office in VA with the state insurance regulators and law enforcement, and directed the employees away from the computers and records. During that three-year investigation, GenRe learned that local regulators and forensic examiners had put everything together and that we now understood the way the game was played. I believe the players in the industry realized that that they had to change the way in which they cooked the books. A sleight- of-hand trick that had worked for 25 years under the radar of regulators and investors was now revealed.

Several senior officials of ROA eventually were prosecuted, convicted of criminal fraud and imprisoned, but DOJ officials under the Bush Administration reportedly blocked prosecution of the actual managers and underwriters of ROA who were involved in these sham transactions, this even though state officials and federal prosecutors in VA were anxious to proceed with additional prosecutions.

AIG: From Reinsurance to CDS

While some reinsurers are large, well-capitalized entities that generally avoid these pitfalls, AIG was already a troubled company when it began to write more and more of these risk-shifting transactions more than a decade ago. It is easy to promise the moon when people think that they can deliver, but because AIG and their clients saw how easy it was to fool regulators and investors, the practice grew and most regulators did absolutely nothing to curtail the practice. It was easy for AIG to become addicted to the use of side letters. The firm, which had already encountered serious financial problems in 2000-2001, reportedly saw the side letters as a way to mint free money and thereby help the insurer to look stronger than it really was. AIG not only helped banks and other companies distort and obfuscate their financial condition, but AIG was supplementing its income by writing more and more of these reinsurance deals and mitigating their perceived exposure via side letters.

A key figure in AIG’s reinsurance schemes, according to several observers, was Joseph Cassano, head of AIG-FP. Whereas the traditional use of side letters was in reinsurance transactions between insurers, in the case of both CELL and PNC neither was an insurer! And in both cases, AIG used sham deals to make two non-insurers, including a regulated bank holding company, look better by manipulating their financial statements. Falsifying the financial statements of a bank or bank holding company is an felony. AIG-FP was simply doing for non-insurers what was common practice inside the secretive precincts of the insurance world.

The SEC did investigate and they did finally obtain a deferred prosecution agreement with AIG, which was buried in the settlement with then-New York AG Elliott Spitzer. The key thing to understand is that if you look at many of these reinsurance contracts between ROA and Gen Re, they look perfect. They appear to transfer risk and seem to be completely in order. But, if you don’t get to see the secret agreement, the side letter that basically says that the reinsurance contract is a form of window dressing, then you cannot understand the full implications of the transaction, the reinsurance agreement. Not, several experts speculate, can you understand why AIG decided to migrate away from reinsurance and side letters and into CDS as a mechanism for falsifying the balance sheets and earnings of non-insurers.

Several observers believe that at some point in the 2002-2004 period, Cassano and his colleagues at AIG began to realize that state insurance regulators and the FBI where on to the reinsurance/side letter scam. A number of experts had been speaking and writing about the issue within the accounting and fraud communities, and this attention apparently made AIG move most of its shell game into the world of CDS.

By no coincidence, at around this time side letters began to disappear in the insurance industry, suggesting to many observers that the industry finally realized that the jig was up. It appears to us that, seeing the heightened attention from regulators and federal law enforcement agencies such as the FBI on side letters, AIG began to move its shell game to the CDS markets, where it could continue to falsify the balance sheets and income statements of non-insurers all over the world, including banks and other financial institutions. AIG’s Cassano even managed to hide the activity in a bank subsidiary of AIG based in London and under the nominal supervision of the Office of Thrift Supervision in the US, this it is suggested to hide this ongoing activity from US insurance regulators. Even though AIG had been investigated and sanctioned by the SEC, Cassano and his colleagues at AIG apparently were recalcitrant and continued to build the CDS pyramid inside AIG, a financial pyramid that is now collapsing. The rest, as they say is history.

Now you know why the Fed and EU officials are so terrified about an AIG liquidation, because it will result in heavy losses to or even the insolvency of banks and other corporations around the globe. Notice that while German Chancellor Angela Merkel has been posturing and throwing barbs at President Obama, French President Nicolas Sarkozy has been conciliatory toward the US. But for the bailout of AIG, you see, President Sarkozy would have been forced to bailout SGE for a second time in two years. So long as the Fed and Treasury can subsidize AIG’s mounting operating losses, the EU will be spared a financial bloodbath. But this situation is unlikely to remain stable for long with members of the Congress demanding an investigation of the past bailout, a process that can only result in bankruptcy for AIG.

Are the CDS Contracts of AIG Really Valid?

The key point is that neither the public, the Fed nor the Treasury seem to understand is that the CDS contracts written by AIG with these various non-insurers around the world were shams – with no correlation between “fees” paid and the risk assumed. These were not valid contracts as Fed Chairman Ben Bernanke, Treasury Secretary Geithner and Economic policy guru Larry Summers claim, but rather acts of criminal fraud meant to manipulate the capital positions and earnings of financial companies around the world. Indeed, our sources as well as press reports suggest that the CDS contracts written by AIG may have included side letters, often in the form of emails rather than formal letters, that essentially violated the ISDA agreements and show that the true, economic reality of these contracts was fraud plain and simple.

Unfortunately, by not moving to seize AIG immediately last year when the scandal broke, the Fed and Treasury may have given the AIG managers time to destroy much of the evidence of criminal wrongdoing. Only when we understand how AIG came to be involved in CDS and the fact that this seemingly illegal activity was simply an extension of the reinsurance/side letter shell game scam that AIG, Gen Re and others conducted for many years before will we understand what needs to be done with AIG, namely liquidation. Seen in this context, the payments made to AIG by the Fed and Treasury, which were then passed-through to dealers such as Goldman Sachs (NYSE:GS), can only be viewed as an illegal taking that must be reversed once the US Trustee for the Federal Bankruptcy Court for the Southern District of New York is in control of AIG’s operations.

AIG trail leads to London ‘casino’
Since 1987 the American financier Joseph Cassano has divided his time between London and Connecticut, where AIG, the world’s largest insurance company, runs a subsidiary called AIG Financial Products.

By Peter Koeing
Last Updated: 10:29PM BST 18 Oct 2008

For most of those 21 years life has been good for the bespectacled, intellectual-looking Cassano.

The Wall Street veteran rose to run his part of the insurer, AIG Financial Products. When in London he commuted from a company flat behind Harrods to his unit’s office at 1 Curzon Street in Mayfair’s hedge fund alley.

Cassano’s pay over the past eight years, according to US Congressional records, totalled $280m (£162m).

Then at the end of 2007 Cassano’s fortunes changed. The company’s accountants changed the basis on which they valued much of the collateral held by its units. Some half a trillion dollars worth of credit default swaps written by AIG Financial Products were marked down.

Credit default swaps, or CDSs, are quasi-insurance products bought by investors seeking protection against defaults on mortgage-backed securities and other credits.

In contrast to the remarkable profits it had tallied until 2007, the AIG subsidiary headed by Cassano began to report quarterly losses. The unit went from being star performer to vortex of a gathering nightmare.

On April 1 Cassano was nudged into retirement. In keeping with the bubble-time executive compensation practises established in the City and on Wall Street, however, the blow was softened. Cassano was allowed to continue using the company flat behind Harrods. He was given a consultancy and, according to former AIG chief executive Martin Sullivan, testifying to the US Congress, helped AIG unwind the rapidly devaluing CDSs held by AIG Financial Products. Cassano’s pay for this work was $1m a month for nine months.

“The question,” said Henry Waxman, the US Congressman chairing an October 7 Washington hearing into AIG, “was whether AIG’s executive compensation practices were fair and appropriate.”

None of this would seem to be of particular concern to the British public beyond AIG’s role generally in the world financial meltdown.

On September 16 the American insurer suffered a liquidity crisis following the downgrade of its credit rating. AIG had to beg the Federal Reserve Bank for an $85bn credit facility in return for giving up 80 per cent of its equity to the US government. This poured fuel on the fire ignited by the bankruptcy of Wall Street investment bank Lehman Brothers a day earlier.

A Sunday Telegraph investigation has determined, however, that there is a row brewing between the scores of regulators responsible for AIG’s activities in 130 countries. In the forefront of this row stands Britain’s financial regulator, the Financial Services Authority.

The operations of Cassano and his colleagues at 1 Curzon Street are attracting the attention of government officials in Washington, New York and Paris as well as London. Bumbling by the FSA, according to regulators in other countries, may have played an instrumental role in sparking the credit crunch that brought the global financial system to the brink of collapse.

This is already making political waves. Distancing himself and his government from the bad news, the Prime Minister Gordon Brown has repeatedly contended the financial crisis was made in the USA – where poor Americans in Rust Belt cities like Cleveland and Detroit fell behind on mortgage payments.

The reality has always been more complex. A financial chain links American sub-prime mortgages to the packagers and sellers of those mortgages in the City, as well as on Wall Street.

Now the role of AIG’s London office, and the FSA in overseeing what went on inside it may change all that.

On Friday, the Conservative Party Treasury spokesman Philip Hammond called for a public inquiry into the FSA’s oversight of AIG Financial Products in Mayfair. “We must not allow London to become a bolthole for companies looking for a place to conduct questionable activities,” he said.

“This sounds like a monumental cock-up by the FSA,” said Lib Dem shadow chancellor Vince Cable. “It is deeply ironic,” he added, that Brown was in Brussels last week calling for tougher global financial regulation just as the scandal over the FSA’s role in one of the key regulatory failures at the root of the global panic emerged as an international issue.

“We need an inquiry to establish what happened with the FSA’s regulation of AIG’s London operation,” Cable said.

Since AIG’s collapse in September, insurance regulators in various jurisdictions have played pass the parcel, each regulator seeking to distance itself from the CDS firm’s London business, according to politicians in Washington, such as the US Congress’s Waxman, as well as here.

The spectacle is reminiscent of the regulatory response to the collapse in the early 1990s of BCCI, a bank with operations in London, Luxembourg and the Middle East. BCCI regulators in its multiple jurisdictions, including London, dodged responsibility for not spotting BCCI’s $10bn fraud by blaming each other.

On Friday, Adair Turner, the FSA’s chairman, declined to answer questions about AIG’s London operation.

Meanwhile, people close to the City regulator explained that AIG Financial Products, the unit responsible for the insurer’s failure, fell outside its jurisdiction.

Under FSA rules, these people said, AIG Financial Products was deemed an “internal treasury operation” and, like the internal treasury operations of other companies, was not regulated.

But the FSA does have regulatory oversight responsibility for a number of AIG units in London, including a company called AIG FP Capital Management registered at 1 Curzon Street.

People close to the FSA said AIG FP Capital Management is a separate company from AIG Financial Products and is not involved in the business of creating credit default swaps.

There is little doubt, nevertheless, that US lawmakers consider London an epicentre of the AIG Financial Products disaster. During the hearing into the causes and effects of the AIG bail-out on October 7, the US House of Representatives Oversight Committee, led by Congressman Waxman, politicians pmentioned London a dozen times. California Congresswoman Jackie Speier referred to AIG’s Mayfair business as “the casino in London”.

Testimonies by former AIG chief executives Martin Sullivan and Robert Willumstad, along with a New York Times article on September 28, sketch the story of the AIG Financial Products unit in London.

It was originally staffed by executives, including Cassano, from defunct Wall Street investment bank Drexel Burnham Lambert. Drexel’s legendary junk bond king, Michael Milken, was investigated for insider trading in the 1980s and pleaded guilty to six charges.

As New Labour came to power in 1997 and established the FSA with a mandate to avoid regulatory failures such as BCCI, Cassano rose to the top of the AIG subsidiary where he worked.

By the end of last year AIG held $562bn of CDS contracts on its books, and in their October 7 testimony before the House Oversight Committee company executives acknowledged that a cockpit for this business was 1 Curzon Street.

In contrast to standard practice, however, AIG Financial Products did not hedge its exposure to a possible fall in the CDS market. In a footnote to AIG’s 2007 accounts spotted by Forbes magazine, the company declared: “In most cases AIGFP does not hedge its exposures to credit default swaps it has written.”

Last November, when AIG’s accountants asked the insurer to change the way it valued CDS’s, the comparatively small base of capital on which AIG Financial Products had built a mountain of business became visible. This began the unravelling that led to AIG’s central role in sparking the global financial crisis.

To date, no British authorities have said anything about AIG. In the US, in contrast, there are multiple investigations. In addition to the October 7 Congressional hearing into AIG, the insurer’s London business is now under scrutiny by the Office of Thrift Supervision in Washington and the New York State Department of Insurance in Manhattan.

Last week New York State Attorney General Andrew Cuomo sent a letter to AIG informing the company it was under investigation for “irresponsible and damaging” expenditures, among other things, for executive compensation packages that were not cut even as AIG drew down on the Federal Reserve’s $85bn credit facility to keep itself afloat.

Although the FSA will not comment on AIG Financial Products, there are indications from America that it is belatedly looking into the unit’s operations.

“There have been meetings and conversations” between Washington’s Office of Thrift Supervision and the FSA,” said Janet French, a spokeswoman for the Washington agency.

A person close to the New York State Department of Insurance said: “You can be certain there have been talks with the FSA.”

AIG did not return phone calls to its New York headquarters. Cassano did not return a call to his Connecticut home.

In the weeks ahead the British public may hear more about the obscure AIG business at 1 Curzon Street – if only because it links the financial crisis to the Prime Minister by way of the City regulator he created when he became Chancellor in 1997.

“The Prime Minister has used the City as his milch cow,” said Tory Treasury spokesman Hammond.

“He borrowed from it. He taxed it. Now, it appears, he allowed it to operate without adequate regulation.”

Joe Cassano: The Man Who Brought Down AIG?

Moments ago, members of the House oversight committee concluded their hammering of the two most recent AIG chief executives. Topic: Joe Cassano, the man who some credit with bringing down the insurance giant.

Cassano was president of AIG’s financial products division, which trafficked in the credit-default swaps, or CDS, which we learned earlier proved so dangerous.

Rep. Bruce Braley (D-Iowa) angrily recited the tale of Cassano’s tape: He earned $280 million in cash — more than AIG chief executives — and for every dollar his financial products unit made, 30 cents came back to Cassano and other top execs.

After the unit lost $11 billion, Cassano was fired Feb. 29 of this year, Braley pointed out, and got to keep $34 million in bonuses and was kept on as an AIG consultant at a salary of $1 million per month.

Braley asked the witnesses, former AIG chief executives Michael Sullivan and Robert
Willumstad, if they had exercised their authority to fire Cassano from his consultant’s role, given all the damage he had brought to AIG.

“No,” both said.

Then oversight committee Chairman Henry Waxman (D-Calif.) really lit into them.

Asked why they didn’t fire Cassano, Sullivan said they needed to “retain the 20-year knowledge of the transactions.”

Waxman was impressed.

“When I retire I want to come work for you at $1 million a month,” he said, The Post’s Peter Whoriskey reports.

“What would he have had to have done for you to fire him?” Waxman asked rhetorically.

The Reckoning
Behind Insurer’s Crisis, Blind Eye to a Web of Risk

Published: September 27, 2008

“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”

— Joseph J. Cassano, a former A.I.G. executive, August 2007

Two weeks ago, the nation’s most powerful regulators and bankers huddled in the Lower Manhattan fortress that is the Federal Reserve Bank of New York, desperately trying to stave off disaster.

As the group, led by Treasury Secretary Henry M. Paulson Jr., pondered the collapse of one of America’s oldest investment banks, Lehman Brothers, a more dangerous threat emerged: American International Group, the world’s largest insurer, was teetering. A.I.G. needed billions of dollars to right itself and had suddenly begged for help.

One of the Wall Street chief executives participating in the meeting was Lloyd C. Blankfein of Goldman Sachs, Mr. Paulson’s former firm. Mr. Blankfein had particular reason for concern.

Although it was not widely known, Goldman, a Wall Street stalwart that had seemed immune to its rivals’ woes, was A.I.G.’s largest trading partner, according to six people close to the insurer who requested anonymity because of confidentiality agreements. A collapse of the insurer threatened to leave a hole of as much as $20 billion in Goldman’s side, several of these people said.

Days later, federal officials, who had let Lehman die and initially balked at tossing a lifeline to A.I.G., ended up bailing out the insurer for $85 billion.

Their message was simple: Lehman was expendable. But if A.I.G. unspooled, so could some of the mightiest enterprises in the world.

A Goldman spokesman said in an interview that the firm was never imperiled by A.I.G.’s troubles and that Mr. Blankfein participated in the Fed discussions to safeguard the entire financial system, not his firm’s own interests.

Yet an exploration of A.I.G.’s demise and its relationships with firms like Goldman offers important insights into the mystifying, virally connected — and astonishingly fragile — financial world that began to implode in recent weeks.

Although America’s housing collapse is often cited as having caused the crisis, the system was vulnerable because of intricate financial contracts known as credit derivatives, which insure debt holders against default. They are fashioned privately and beyond the ken of regulators — sometimes even beyond the understanding of executives peddling them.

Originally intended to diminish risk and spread prosperity, these inventions instead magnified the impact of bad mortgages like the ones that felled Bear Stearns and Lehman and now threaten the entire economy.

In the case of A.I.G., the virus exploded from a freewheeling little 377-person unit in London, and flourished in a climate of opulent pay, lax oversight and blind faith in financial risk models. It nearly decimated one of the world’s most admired companies, a seemingly sturdy insurer with a trillion-dollar balance sheet, 116,000 employees and operations in 130 countries.

“It is beyond shocking that this small operation could blow up the holding company,” said Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn. “They found a quick way to make a fast buck on derivatives based on A.I.G.’s solid credit rating and strong balance sheet. But it all got out of control.”

The London Office

The insurance giant’s London unit was known as A.I.G. Financial Products, or A.I.G.F.P. It was run with almost complete autonomy, and with an iron hand, by Joseph J. Cassano, according to current and former A.I.G. employees.

A onetime executive with Drexel Burnham Lambert — the investment bank made famous in the 1980s by the junk bond king Michael R. Milken, who later pleaded guilty to six felony charges — Mr. Cassano helped start the London unit in 1987.

The unit became profitable enough that analysts considered Mr. Cassano a dark horse candidate to succeed Maurice R. Greenberg, the longtime chief executive who shaped A.I.G. in his own image until he was ousted amid an accounting scandal three years ago.

But last February, Mr. Cassano resigned after the London unit began bleeding money and auditors raised questions about how the unit valued its holdings. By Sept. 15, the unit’s troubles forced a major downgrade in A.I.G.’s debt rating, requiring the company to post roughly $15 billion in additional collateral — which then prompted the federal rescue.

Mr. Cassano, 53, lives in a handsome, three-story town house in the Knightsbridge neighborhood of London, just around the corner from Harrods department store on a quiet square with a private garden.

He did not respond to interview requests left at his home and with his lawyer. An A.I.G. spokesman also declined to comment.

At A.I.G., Mr. Cassano found himself ensconced in a behemoth that had a long and storied history of deftly juggling risks. It insured people and properties against natural disasters and death, offered sophisticated asset management services and did so reliably and with bravado on many continents. Even now, its insurance subsidiaries are financially strong.

When Mr. Cassano first waded into the derivatives market, his biggest business was selling so-called plain vanilla products like interest rate swaps. Such swaps allow participants to bet on the direction of interest rates and, in theory, insulate themselves from unforeseen financial events.

Ten years ago, a “watershed” moment changed the profile of the derivatives that Mr. Cassano traded, according to a transcript of comments he made at an industry event last year. Derivatives specialists from J. P. Morgan, a leading bank that had many dealings with Mr. Cassano’s unit, came calling with a novel idea.

Morgan proposed the following: A.I.G. should try writing insurance on packages of debt known as “collateralized debt obligations.” C.D.O.’s. were pools of loans sliced into tranches and sold to investors based on the credit quality of the underlying securities.

The proposal meant that the London unit was essentially agreeing to provide insurance to financial institutions holding C.D.O.’s and other debts in case they defaulted — in much the same way some homeowners are required to buy mortgage insurance to protect lenders in case the borrowers cannot pay back their loans.

Under the terms of the insurance derivatives that the London unit underwrote, customers paid a premium to insure their debt for a period of time, usually four or five years, according to the company. Many European banks, for instance, paid A.I.G. to insure bonds that they held in their portfolios.

Because the underlying debt securities — mostly corporate issues and a smattering of mortgage securities — carried blue-chip ratings, A.I.G. Financial Products was happy to book income in exchange for providing insurance. After all, Mr. Cassano and his colleagues apparently assumed, they would never have to pay any claims.

Since A.I.G. itself was a highly rated company, it did not have to post collateral on the insurance it wrote, analysts said. That made the contracts all the more profitable.

These insurance products were known as “credit default swaps,” or C.D.S.’s in Wall Street argot, and the London unit used them to turn itself into a cash register.

The unit’s revenue rose to $3.26 billion in 2005 from $737 million in 1999. Operating income at the unit also grew, rising to 17.5 percent of A.I.G.’s overall operating income in 2005, compared with 4.2 percent in 1999.

Profit margins on the business were enormous. In 2002, operating income was 44 percent of revenue; in 2005, it reached 83 percent.

Mr. Cassano and his colleagues minted tidy fortunes during these high-cotton years. Since 2001, compensation at the small unit ranged from $423 million to $616 million each year, according to corporate filings. That meant that on average each person in the unit made more than $1 million a year.

In fact, compensation expenses took a large percentage of the unit’s revenue. In lean years it was 33 percent; in fatter ones 46 percent. Over all, A.I.G. Financial Products paid its employees $3.56 billion during the last seven years.

The London unit’s reach was also vast. While clients and counterparties remain closely guarded secrets in the derivatives trade, Mr. Cassano talked publicly about how proud he was of his customer list.

At the 2007 conference he noted that his company worked with a “global swath” of top-notch entities that included “banks and investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities and sovereigns and supranationals.”

Of course, as this intricate skein expanded over the years, it meant that the participants were linked to one another by contracts that existed for the most part inside the financial world’s version of a black box.

Goldman Sachs was a member of A.I.G.’s derivatives club, according to people familiar with the operation. It was a customer of A.I.G.’s credit insurance and also acted as an

Few knew of Goldman’s exposure to A.I.G. When the insurer’s flameout became public, David A. Viniar, Goldman’s chief financial officer, assured analysts on Sept. 16 that his firm’s exposure was “immaterial,” a view that the company reiterated in an interview.

Later that same day, the government announced its two-year, $85 billion loan to A.I.G., offering it a chance to sell its assets in an orderly fashion and theoretically repay taxpayers for their trouble. The plan saved the insurer’s trading partners but decimated its shareholders.

Lucas van Praag, a Goldman spokesman, declined to detail how badly hurt his firm might have been had A.I.G. collapsed two weeks ago. He disputed the calculation that Goldman had $20 billion worth of risk tied to A.I.G., saying the figure failed to account for collateral and hedges that Goldman deployed to reduce its risk.

Regarding Mr. Blankfein’s presence at the Fed during talks about an A.I.G. bailout, he said: “I think it would be a mistake to read into it that he was there because of our own interests. We were engaged because of the implications to the entire system.”

Mr. van Praag declined to comment on what communications, if any, took place between Mr. Blankfein and the Treasury secretary, Mr. Paulson, during the bailout discussions.

A Treasury spokeswoman declined to comment about the A.I.G. rescue and Goldman’s role. The government recently allowed Goldman to change its regulatory status to help bolster its finances amid the market turmoil.

An Executive’s Optimism

Regardless of Goldman’s exposure, by last year, A.I.G. Financial Products’ portfolio of credit default swaps stood at roughly $500 billion. It was generating as much as $250 million a year in income on insurance premiums, Mr. Cassano told investors.

Because it was not an insurance company, A.I.G. Financial Products did not have to report to state insurance regulators. But for the last four years, the London-based unit’s operations, whose trades were routed through Banque A.I.G., a French institution, were reviewed routinely by an American regulator, the Office of Thrift Supervision.

A handful of the agency’s officials were always on the scene at an A.I.G. Financial Products branch office in Connecticut, but it is unclear whether they raised any red flags. Their reports are not made public and a spokeswoman would not provide details.

For his part, Mr. Cassano apparently was not worried that his unit had taken on more than it could handle. In an August 2007 conference call with analysts, he described the credit default swaps as almost a sure thing.

“It is hard to get this message across, but these are very much handpicked,” he assured those on the phone.

Just a few months later, however, the credit crisis deepened. A.I.G. Financial Products began to choke on losses — though they were only on paper.

In the quarter that ended Sept. 30, 2007, A.I.G. recognized a $352 million unrealized loss on the credit default swap portfolio.

Because the London unit was set up as a bank and not an insurer, and because of the way its derivatives contracts were written, it had to put up collateral to its trading partners when the value of the underlying securities they had insured declined. Any obligations that the unit could not pay had to be met by its corporate parent.

So began A.I.G.’s downward spiral as it, its clients, its trading partners and other companies were swept into the drowning pool set in motion by the housing downturn.

Mortgage foreclosures set off questions about the quality of debts across the entire credit spectrum. When the value of other debts sagged, calls for collateral on the securities issued by the credit default swaps sideswiped A.I.G. Financial Products and its legendary, sprawling parent.

Yet throughout much of 2007, the unit maintained that its risk assessments were reliable and its portfolios conservative. Last fall, however, the methods that A.I.G. used to value its derivatives portfolio began to come under fire from trading partners.

In February, A.I.G.’s auditors identified problems in the firm’s swaps accounting. Then, three months ago, regulators and federal prosecutors said they were investigating the insurer’s accounting.

This was not the first time A.I.G. Financial Products had run afoul of authorities. In 2004, without admitting or denying accusations that it helped clients improperly burnish their financial statements, A.I.G. paid $126 million and entered into a deferred prosecution agreement to settle federal civil and criminal investigations.

The settlement was a black mark on A.I.G.’s reputation and, according to analysts, distressed Mr. Greenberg, who still ran the company at the time. Still, as Mr. Cassano later told investors, the case caused A.I.G. to improve its risk management and establish a committee to maintain quality control.

“That’s a committee that I sit on, along with many of the senior managers at A.I.G., and we look at a whole variety of transactions that come in to make sure that they are maintaining the quality that we need to,” Mr. Cassano told them. “And so I think the things that have been put in at our level and the things that have been put in at the parent level will ensure that there won’t be any of those kinds of mistakes again.”

At the end of A.I.G.’s most recent quarter, the London unit’s losses reached $25 billion.

As those losses mounted, and A.I.G.’s once formidable stock price plunged, it became harder for the insurer to survive — imperiling other companies that did business with it and leading it to stun the Federal Reserve gathering two weeks ago with a plea for help.

Mr. Greenberg, who has seen the value of his personal A.I.G. holdings decline by more than $5 billion this year, dumped five million shares late last week. A lawyer for Mr. Greenberg did not return a phone call seeking comment.

For his part, Mr. Cassano has departed from a company that is a far cry from what it was a year ago when he spoke confidently at the analyst conference.

“We’re sitting on a great balance sheet, a strong investment portfolio and a global trading platform where we can take advantage of the market in any variety of places,” he said then. “The question for us is, where in the capital markets can we gain the best opportunity, the best execution for the business acumen that sits in our shop?”

Joseph W. St. Denis
October 4,2008
Henry A. Waxman, Chairman
Thomas M. Davis III, Ranking Member
House of Representatives
Committee on Oversight and Govemment Reform
2157 Rayburn House Office Building
Washington, DC 205 | 5’61 43
Dea¡ Chairman Wacman and Ranking Member Davis:
I am providing this letter in resporu¡e to the Committee’s subpoena in lieu of a
deposition pr. ugr..rirnt with Commiitee staff. The staffhas provided questions’ which
are addressed below.
Ouestion l: Briefly describe your professional history’
I received a B.A. and M.B.A. from the university of colorado at Boulder, and
have been a licensed Certified Public Accountant in Colorado since 1993′ I began my
career as an auditor in the Denver offrçe of Coopers & Lybrand’ I served as a Staff
Accountant and later as an Assistant Chief Accóuntant in the Division of Enforcement of
the united states securities and Exchange commission from 1998 to 2004′
Ouestion 2: ll’hat was your position at AIG?
I served a ing Policy at AIG Financial Products
(,,AIGFp”) from t,2OOl. My responsibilities included
documenting the
around that proposed accounting with my a(
Financial Services Division (“FSD”) and Cc
(“OAP”). Additionally, I served initially as a reso
AIGFP’s Transaction’Review committee, which w¿N responsible for tl?l,YlTfl *d
documenting the accounting for proposed transactions by customers ot AlLiFr”
I My understanding was that the Transaction Review Committee, orîRC’ was formed in response to the
Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities’ The TRC
My understanding was that the position was created l) as part of an entity-wide
effort to address material weaknesses tit.d by desire on
tfr. putt of FSD and OAP for greater visibility perations
and accounting policy process-of AIGFP and, for
AIGFP busineis people as they developed proposed transactions’
Question 3: lh’hat were your duties as Vice President for Accounting Policy?
My duties as Vice President for Accounting Policy were to research and
documeniAlGFP’s accounting policy issues and conclusions through a rigorous process
of consens c”s Financial Services
consensus the Progression below
for material and/or unusual transactions:
a) Meet with business people at AIGFP responsible {o^r
the proposed transactions to
gainan understanding of the transactionänd identiff potential accounting and
financial rePorting issues :
b) prepare a memorandum describing the prop_osed transaction and documenting the ‘
ana-lysis and disposition of accounting and frnancial reporting issues;
c) Share the memorandum with the CFO of FSD. Discuss and clear any review
comments and resolve any new issues identified at this level of review, and
update the draft to reflect FSD’s review;
d) Share the updated draft with OAP’ Discuss and and
resolve any-new issues, and update the draft to r noff’
Upon signoff by OAP, the documentation was c . , , ot’ (“PwC”) identified new issues or suggested changes
that all the parties agreed should be made;
e) Provide relevant conclusions to appropriate operational personnel within AIGFP
for implementation;
Ð Share the final memorandum with the PwC auditors; and
g) Revisit previous conclusions arrived at through the above process and update
related documentation as necessary’
included Joseph cassano, President; Doug Poling, General counsel and later head of the Transaction
Development Group; Pieire Micottis, Chief Risk Officer; and others at various times’
The above process did not necessarily involve intermediate review of accounting
analyses by AIGFÈ personnel. The CFO of AIGFP generally did not review my work
product unl.r, he had specifically requested it, nor, to my knowledge, did Joseph
burruno, president otRlCf’p. lriy understanding of my role, as noted above, was in large
part to pióvide a control point aná window for FSD and OAP into the operations and
à..ouniing policy pro..r, for AIGFP transactions. This understanding was confirmed
through nume.orrs conversations with senior managers within FSD and OAP’
Ouestion 4: Wat dates were you employed by AIG?
I was employed at AIGFP from late June of 2006 through September 30,2007 ‘
During this entiie period, I worked out of the Wilton, CT office of AIGFP’
Ouestion 5: To whom did You rePort?
1 Balfan. Upon Mr. Balfan’s transfer to the consulting
position January 2007,I reported to William Kolbert, Executive
Vice pre trative Offrcer. Mr. Balfan’s successor as CFO started
on 10, 2007,and I reported to her briefly prior to my resignation on October
Functionally, I reported to the leaders of the Marketing and Transaction
Development groups at ¡GFP, and to the senior financial managers of FSD and OAP’
ouestion 6: what was your relationship with Joseph cassano?
My relationship with Mr. cassano was one of employer and employe.e. until the
late summe r of 2007,i hud .t .ry minimal contact with Mr. Cassano. Beginning in early
2007,I replaced trrtait Balfan ón AIGFP’s Transaction Review Committee, which met
briefly twice per month to, as noted above, review the accounting by AIGFP’s customers
in proposed tiansactions. Mr. Cassano also participated in this committee’
Ouestion 7: How was your perþrmance rated and when?
I received two “formal” performance evaluations at AIGFP. The f,irst was in mid-
December of 2006, in connection with the awarding of my 2006 bonus. This evaluation
2 As detailed below, I resigned on Septembe r 9,2007 , but withdrew that resignation on September l0′ My
final resignation was effective at 8 a.m’ on October 1,2007 ‘
was with Doug poling, then Chief Administrative Officer; and Mark Balfan, then CFO of
AIGFp. Duriig this ãvaluation I was told that senior management of AIGFP thought that
I was a “fantastic hire,” and they were “thrilled” to have me as an employee’ I was
awarded a bonus that ôxceeded the guaranteed amount by $50,000, or l5Yo. According to
Mr. Poling, “this [was not] ,,rppor.á to happen,” but my outstanding performance had
wananted it.
I received the second evaluation in June of 2006, from AIGFP President Joseph
Cassano and V/illiam Kolbert, then Chief Administrative Officer. During this evaluation,
Mr. Cassano told me that I was “doin g a greatjob,” and that I “should continue to work
closely with [FSD] and OAP.” Mr. Cassano told me that AIGFP’s relationship with AIG
was AIGFP’s “most important asset,” and that my position was “critical” to that
euestion 8: Prior to your departure, did AIG initiate a review of the valuation of AIG’s
îapt, Srrør Credit bt¡o”n Swaps portfotio? Ilhat was your role? Did you have any
concerns about this?
Historically, my understanding was that the Super Senior Credit Default Swaps
(“SSCDS”) portfoiio had been accounted for at m ty with
Statement of Financial Accounting Standards No’ rivatives and
Hedging Activities (“SFAS 133”), as amended’ P turbulence in
the iáte summer of à007, it was my understanding that AIGFP’s SSCDS portfolio was in
an aggtegate unrealized gain posit-ion. However, as there was no active market for these
bespote instrumentr, ,.cãgniiion of a day-one gain on these instruments would not have
been in conformity with fÁSg Emerging Issues Task Force Issue No’ 02-3,lssues
Involved in Accountingfor Derivative contracts Heldfor Trading Purposes and
Contracts Involved in-Energ Trading and Risk Management Activities (“EITF 02-3”)’
Therefore, no mark-to-rnur[ôt adjustments were made to these instruments through the
quarter ended June 30, 2007. My understanding was that the instruments were monitored
for signific ant deteriorationthrough the use of a “value at risk” (“vaR”) model that
tracked movements in credit ratings for the underlying collateral’
As the credit crunch began to unfold in July and August of 2007, and with the
planned implementation of SFÃS 157, Fair Va superseded
parts of EIiF 02-3),effective January 1, 2008, financial
.unug.rn.nt in AIó, Inc.’s FSD and OAP turn FP’s SSCDS
Upon returning from a vacation in early September of 2007,1 learned that AIGFP
had received a multi-billion dollar margin call on certain SSCDS. I was gravely
concerned about this, as the mantra at AIGFP had always been (in my experience) that
there could never be iosses on the SSCDS. I was questioning this mantra in light of the
margin call, as were the professionals in FSD and OAP, in my belief’ I am not an expert
in the valuation of derivatives, but I was concerned that the valuation model of at least
one of AIGFP SSCDS counterparties apparently indicated that AIGFP was in a
potentially material liability position.
Despite my position and FSD’,s and oAP’s interest in the issue, I had no
involvemenì with eiforts to value AIGFP’s SSCDS portfolio. This was, in my
understanding, due to the actions of Mr. Cassano to exclude me from the SSCDS
valuation pro..rr. During the final week of September of 2007, the final week of my
employmËnt at AIGFP, iã a meeting with Mr. Cassano, the newly hired CFO of AIGFP’
urrd- uo AIGFP quantitative risk expert, Mr. Cassano made the following statement to me:
,,I have deliberately excluded you from the valuation of the Super Seniors because
I was concemed that you would pollute the process.”
My belief is that the “pollution” Mr. Cassano was concerned about was the
transparency I brought to AIGFP’s accounting policy process.
My understanding is that sometime during the late summer or early fall of 2007,
AIGFp executive and Crãdit Risk personnel began an effort to develop a so-called
,,Binomial Expansion Technique” (“BET”; model to provide valuations for the SSCDS
portfolio that would reflec in
this process whatsoever, o
September of 2007, a few
discussed. My knowledge of the process war
meeting. AIG’s Controller, Director of Inter ls
meetin!, held at AIGFP’s Wilton office. During this meeting, Mr. Cassano had one of
the Risk Management people distribute a PowerPoint presentation that purported to show
the applicatioriof the ÉEl’model to AIGFP’,s SSCDS portfolio and represented to the
urr”-fl.d group that the SSCDS portfolio continued to be in an aggregate unrealized
gain position.
Question 9: What precipitated your resignation?
I resigned because on multiple instances beginning in the late summer of 2007,
Mr. Cassanolook actions that I believed were intended to prevent me from performing
the job duties for which I was hired. One such instance involved AIGFP’s investment in
Tenaska, a natural gas storage and distribution operation in Omaha, NE’
In Decemb er 2006,I traveled to Omaha to perform pre-transaction accounting due
diligence and immediately identifred effors in Tenaska’s hedge accounti¡g’ I
communicated these findings to AIGFP’s senior management, specifically Doug Poling
and Mark Balfan, and to Tenaska. Tenaska told me that it would fix these problems prior
to the effective date of the merger. In June of 2007,I went back to Tenaska and found
that it had not corrected the problems. Again I reported these findings to Poling and
Balfan. At the time I left AIGFP, it was my understanding that Tenaska had indeed
conected the issues, but I left before I was able to verify this’
During August of 2007 , Mark Balfan pulled me out of a meeting with Doug
poling and broughi into AIGFP’s HALO room where Mr. Cassano was on from London.
Mr. Cãssano berated me for several minutes for going to Tenaska and finding the
problems. He shouted obscenities at me, and seemed especially aî9ry with Elias
i{abayeb, the CFO of FSD, whom he repeatedly referred to in disparaging language. The
source of Cassano’s anger was, in my understanding, a list of “closing issues” that Mr’
Habayeb had prepared ielating to third quarter issues. At one point Mr. Cassang held up
the liit and shrieked, “I’ve bent over backwards for this fexpletive deleted] and still I get
these [expletive deleted] lists!!” Mr. Habayeb had expressed interest in my f,rndings at
Tenasla, which was nof surprising to me given that it was his job to make sure that
AIGFp’s accounting followèd GÀ¿.p, and an error in Tenaska’s financial results would
be carried through tó AIGpP’s flrnancial statements through the equity pickup’ Mr.
Habayeb had inðluded the item “Tenaska hedge accounting” on the list, apparently to
pro¡¡pt him to follow up. Mr. Cassano told me in no uncertain terms during this session
ihat I worked for him, not FSD or OAP. Doug Poling, Mark Balfan, and William Kolbert
also attended this meeting.
This was the first time Mr. Cassano had expressed criticism of any of my close
working relationships with FSD or OAP. As previously noted, during my evaluation
with Mi. Cassano in June of 2007 two months earlier, Mr. Cassano had told me that I was
.,doing a great job,” and that I should “work closely with [AIG].” He also volunteered
aurin[tnis *r.ting in June 2007,which was also attended by William Kolbert, that he
had,,io desire to bi promoted, because it would separate [him] from the money,” and
that AIG’s corporate management was “scared to death” of him’
Another instance occurred in early September of 2007. While on vacation in
puerto Rico, I began receiving emails from the credit traders in London asking me for
assurances that RlGpp would not have to consolidate the Nightingale structured
investment vehicle (“SIV”) if AIGFP were to purchase all of the outstanding debt of the
vehicle. This was the beginning of the Credit Crunch, and the SIV could not roll its
paper. I said no; I could not make such assurances’ as this would likely be a
ieóonsideration event under FASB Interpretation No. 46(R), Consolidation of Variable
Interest Entities (“F[N 46(R)”), and the èxpected gain/loss model, originally formulated
in late 2006,would have to be revisited. Upon return from my vacation,I began
conversations with one of the quantitative risk experts at AIGFP and an accountant in
OAP to evaluate this reconsideration event.
Also upon return from my vacation,I found a new organizational chart on my
desk. It indicáted that I would report to the controller of AIGFP going forward. I felt this
to be a change that was designed to isolate me from OAP and FSD accounting policy
personnel, ui I thatlhe controller would require all communications with OAP
änd FSD to go through him. The change also represented a substantial demotion, as I had
previously b-een a peõr to the controller. This, in addition to the episode described above
regarding Tenaska, placed me in a conflicted position in that I believed that there was a
iuõiáfy eîcahting iwel of interference in my communrcations with OAP and FSD’
furtnér, I believed that this interference repiesented a fundamental departure from the
terms of the position I had agreed to undertake in June of 2006.
on Sunday, September 9,2007 ‘ I was contacted on
that the organizational chart was the result of a
ort to the new CFO, who was to start on Monday’
september 10,2007.I was also told that no one was trying to control or interfere with my
communications with FSD and OAp. I agreed to meet and discuss potentially staying at
AIGFP on Monday morning, September 10′
I came into AIGFp on Monday morning and discussed the situation with Mr’
cassano, again in AIGFP’,s HALO room. Mr. Cassano assured me during this meeting
e going forward, although he insisted that
Elias Habayeb and go straight to OAP’
he said. I decided to give it one more
chance. I had moved my wife and myself from Washington, DC to Connecticut and now
had a substantial investment of time in AIGFP. I had also put a lot of effort into building
relationships with the business people at AIGFP P
and FSD. Given Mr. Cassano’s assurances that I
Inc. going forward, as well as the fact that by res
from a substantial guaranteed bonus (which was
morning of Tuesday, Septembet25,2007,I was at my
a sis,’was, and told me that he had been asking for it for
th¡ee weeks. I did not recall his ever having asked for the sIV analysis, although, as
indicated above, I had been working on it wittr the AIGFP business people and with
OAp. I indicated to Mr. Cassano that I was to have a conference call with an accountant
in AIG’,s OAP at t0:30 that moming to discuss it. Mr. cassano glared at me and walked
returned from vacation that AIGFP had alre
of the SIV.) At the time of my resignation,
event had not been signed off by OAP.
3 I spoke later in the day to Mark Balfan, who told me that he had “told those guys that when Joe sees the
orgiorganization] chaá, he’s going to resign.” This indicated to me that the organization chart was not a
“clerical error.”
The instant the call was over, Mr. Cassano burst into the conference loom we
were in. He appeared to be highly agitated. “What the [expletive deleted] is going on
here?,, he asked. I replied: “Ñe’ïe just finished a call with OAP, they agree with our
approach…,, Mr. Cassano cut me oif and shouted several expletives regarding the OAP
person we had sPoken to on the call.
This was after I had told him earlier about the call with this individual, one of the
highly experienced accountants in houted at me for several minutes’
and then said, as previously noted: excluded you from the valuation
of the Super Seniãrs because I was concerne, would pollute the process'”
I finished out a very busy week that included attending the meeting referenced
above with the controller ornla during which the topic of AIGFP’,s SSCDS valuation
was discussed.
Over the weekend I had time to reflect, and determined that I believed Mr.
Cassano,s actions to be inconsistent with the terms we had agreed to in.our. HALO room
meeting on september 10. I could not continue in light of what I perceived to be Mr’
Cassano,s efforts to isolate me from OAP and FSP personnel, and in light of Mr.
Cassano’s decision to exclude me from the valuation of the SSCDS portfolio’
On Monday morning, October I,2007,I called Bill Shirley, general counsel of
AIGFP, and re-submitteî my resignation. My message to Mr’ Shirley was that I had lost
faith in the senior-most manâgemãnt of AIGÉp and cóuld not accept the risk to AIG and
myself of being isolated from corporate accounting policy personnel, especially given the
situation with the SSCDS.
ouestion L0: Did you speak to anyone within AIG about the reasons for your departure?
D e s crib e the s e communic at i ons ?
Subsequent to my resignation, in October of 2007,AIG’s Chief Auditor, Michael
Roemer, contácted *.. Mr. Rõemer told me that he wanted to understand the reasons for
,ny J.párture, and that he would report tho ‘ I
had intended to write a detailed memorand
decided to speak to Mr. Roemer in lieu of w
telephonically to Mr. Roemer for approxima ber’
I related the events described above to Mr. R my
resignation – e.g. Cassano’s statement that he had excluded me from discussions relating
to the valuation of AIGFP’s SSCDS.
When I related this to him, Mr. Roemer stated that I had been “painted into a
corner,, by Mr. Cassano and had no choice but to resign. In addition to Mr. Roemer, the
PwC engagement partner on AIGFP also contacted me to inquire as to my. reasons for
leaving Árôfp. I had a similar, though much higher-level conversation with him’ I did
not get into specific conversations with the PwC engagement partner. I did, however,
relate to himihat I had left because of what I perceived to be Mr. Cassano’s efforts to
impede my communications with my counterparts at the parent organization.
Question 11: How were bonuses awarded in AIG Financial Products? What is your
,raÃtonairg of the aruangement between AIG Corporate and AIG FP regording the
calculation of AIG FP’s annual bonus pool?
I had no access to payroll records or any compensation-related materials. The
following is based on my èxperience and conversations with other AIGFP employees.
My undeistanding is thai bonuses were paid in cash in late December of each year, based
on results through November 30. For “highly compensated” employees, my
understanding is that salaries were capped at $125,000 per year, and that bonuses could
be substantiai- in some cases running to eight figures. It was also my understanding that
certain portions of some employee’s bonuses were deferred’
My bonus for 2006 was $375,000, and I never received my contractually
guaranteed bonus for 2007 of$325,000.
My understanding of the arrangement between AIGFP and AIG regarding the
bonus poól *ur derived *noUy from conversations with other AIGFP employees. This
undersìanding was that for euCh doilar of AIGFP’s operating earnings – which excluded
certain GAAP accruals, such as mark-to-market adjustments on derivative positions –
AIGFP received 30 cents, which went to AIGFP’s bonus pool’
euestion 12: Do you have any concerns about the accuracy of AIG’s public disclosures
regarding its swaps portfolio?
I have not reviewed all of AIG’s public disclosures regarding its SSCDS portfolio
subsequent to my departure from AIGFP, and do not feel that it would be appropriate to
comment on their accuracy.
That said I have been shocked at the speed at which the losses in AIGFP’s
SSCDS portfolio have apparently developed. There are two things that I would note:
l. In my understanding and experience, AIG has always been a staunch defender of its
assets. As an outside observer, it has struck me as odd throughout the SSCDS crisis
that A,IG,was apparently unable to defend itself from claims on those portions of the
SSCDS that were written on subprime collateral. It is common knowledge that
underwriting standards on subprime loans had deteriorated dramatically, even going
back to the ãarlier vintages. Given this, I have been surprised that AIGFP apparently
either did not write the SSCDS contracts to provide exclusions for collateral that was
non-compliant with prudent underwriting standards, o1]ras been ineffective at
enforcin[ such exclusions. Having never reviewed a SSCDS agreement, I cannot
answer the question, but I would aik munagement, “how did this happen?”
2. I believe that certain statements made by Mr. Cassano and other senior AIG managers
in the early stages of the SSCDS crisis were ill-advised. Specifically, statements
made at the December 5,2007lnvest ar
AIGFP had received from its SSCDS
especially given the apparent state of , that
I would not have made’or condoned. :lieved at the time of the Investor Meeting
and continue to believe that full disclosure of margin calls by, and resulting collateral
postings to, AIGFP’,s SSCDS counterparties was of critical importance.

A chronology tracing the life of the Glass-Steagall Act, from its passage in 1933 to its death throes in the 1990s, and how Citigroup’s Sandy Weill dealt the coup de grâce.


Glass-Steagall Act creates new banking landscape

Following the Great Crash of 1929, one of every five banks in America fails. Many people, especially politicians, see market speculation engaged in by banks during the 1920s as a cause of the crash.

In 1933, Senator Carter Glass (D-Va.) and Congressman Henry Steagall (D-Ala.) introduce the historic legislation that bears their name, seeking to limit the conflicts of interest created when commercial banks are permitted to underwrite stocks or bonds. In the early part of the century, individual investors were seriously hurt by banks whose overriding interest was promoting stocks of interest and benefit to the banks, rather than to individual investors. The new law bans commercial banks from underwriting securities, forcing banks to choose between being a simple lender or an underwriter (brokerage). The act also establishes the Federal Deposit Insurance Corporation (FDIC), insuring bank deposits, and strengthens the Federal Reserve’s control over credit.

The Glass-Steagall Act passes after Ferdinand Pecora, a politically ambitious former New York City prosecutor, drums up popular support for stronger regulation by hauling bank officials in front of the Senate Banking and Currency Committee to answer for their role in the stock-market crash.

In 1956, the Bank Holding Company Act is passed, extending the restrictions on banks, including that bank holding companies owning two or more banks cannot engage in non-banking activity and cannot buy banks in another state.


First efforts to loosen Glass-Steagall restrictions

Beginning in the 1960s, banks lobby Congress to allow them to enter the municipal bond market, and a lobbying subculture springs up around Glass-Steagall. Some lobbyists even brag about how the bill put their kids through college.

In the 1970s, some brokerage firms begin encroaching on banking territory by offering money-market accounts that pay interest, allow check-writing, and offer credit or debit cards.


Fed begins reinterpreting Glass-Steagall; Greenspan becomes Fed chairman

In December 1986, the Federal Reserve Board, which has regulatory jurisdiction over banking, reinterprets Section 20 of the Glass-Steagall Act, which bars commercial banks from being “engaged principally” in securities business, deciding that banks can have up to 5 percent of gross revenues from investment banking business. The Fed Board then permits Bankers Trust, a commercial bank, to engage in certain commercial paper (unsecured, short-term credit) transactions. In the Bankers Trust decision, the Board concludes that the phrase “engaged principally” in Section 20 allows banks to do a small amount of underwriting, so long as it does not become a large portion of revenue. This is the first time the Fed reinterprets Section 20 to allow some previously prohibited activities.

In the spring of 1987, the Federal Reserve Board votes 3-2 in favor of easing regulations under Glass-Steagall Act, overriding the opposition of Chairman Paul Volcker. The vote comes after the Fed Board hears proposals from Citicorp, J.P. Morgan and Bankers Trust advocating the loosening of Glass-Steagall restrictions to allow banks to handle several underwriting businesses, including commercial paper, municipal revenue bonds, and mortgage-backed securities. Thomas Theobald, then vice chairman of Citicorp, argues that three “outside checks” on corporate misbehavior had emerged since 1933: “a very effective” SEC; knowledgeable investors, and “very sophisticated” rating agencies. Volcker is unconvinced, and expresses his fear that lenders will recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public. For many critics, it boiled down to the issue of two different cultures – a culture of risk which was the securities business, and a culture of protection of deposits which was the culture of banking.

In March 1987, the Fed approves an application by Chase Manhattan to engage in underwriting commercial paper, applying the same reasoning as in the 1986 Bankers Trust decision, and in April it issues an order outlining its rationale. While the Board remains sensitive to concerns about mixing commercial banking and underwriting, it states its belief that the original Congressional intent of “principally engaged” allowed for some securities activities. The Fed also indicates that it will raise the limit from 5 percent to 10 percent of gross revenues at some point in the future. The Board believes the new reading of Section 20 will increase competition and lead to greater convenience and increased efficiency.

In August 1987, Alan Greenspan — formerly a director of J.P. Morgan and a proponent of banking deregulation — becomes chairman of the Federal Reserve Board. One reason Greenspan favors greater deregulation is to help U.S. banks compete with big foreign institutions.


Further loosening of Glass-Steagall

In January 1989, the Fed Board approves an application by J.P. Morgan, Chase Manhattan, Bankers Trust, and Citicorp to expand the Glass-Steagall loophole to include dealing in debt and equity securities in addition to municipal securities and commercial paper. This marks a large expansion of the activities considered permissible under Section 20, because the revenue limit for underwriting business is still at 5 percent. Later in 1989, the Board issues an order raising the limit to 10 percent of revenues, referring to the April 1987 order for its rationale.

In 1990, J.P. Morgan becomes the first bank to receive permission from the Federal Reserve to underwrite securities, so long as its underwriting business does not exceed the 10 percent limit.


Congress repeatedly tries and fails to repeal Glass-Steagall

In 1984 and 1988, the Senate passes bills that would lift major restrictions under Glass-Steagall, but in each case the House blocks passage. In 1991, the Bush administration puts forward a repeal proposal, winning support of both the House and Senate Banking Committees, but the House again defeats the bill in a full vote. And in 1995, the House and Senate Banking Committees approve separate versions of legislation to get rid of Glass-Steagall, but conference negotiations on a compromise fall apart.

Attempts to repeal Glass-Steagall typically pit insurance companies, securities firms, and large and small banks against one another, as factions of these industries engage in turf wars in Congress over their competing interests and over whether the Federal Reserve or the Treasury Department and the Comptroller of the Currency should be the primary banking regulator.


Fed renders Glass-Steagall effectively obsolete

In December 1996, with the support of Chairman Alan Greenspan, the Federal Reserve Board issues a precedent-shattering decision permitting bank holding companies to own investment bank affiliates with up to 25 percent of their business in securities underwriting (up from 10 percent).

This expansion of the loophole created by the Fed’s 1987 reinterpretation of Section 20 of Glass-Steagall effectively renders Glass-Steagall obsolete. Virtually any bank holding company wanting to engage in securities business would be able to stay under the 25 percent limit on revenue. However, the law remains on the books, and along with the Bank Holding Company Act, does impose other restrictions on banks, such as prohibiting them from owning insurance-underwriting companies.

In August 1997, the Fed eliminates many restrictions imposed on “Section 20 subsidiaries” by the 1987 and 1989 orders. The Board states that the risks of underwriting had proven to be “manageable,” and says banks would have the right to acquire securities firms outright.

In 1997, Bankers Trust (now owned by Deutsche Bank) buys the investment bank Alex. Brown & Co., becoming the first U.S. bank to acquire a securities firm.


Sandy Weill tries to merge Travelers and J.P. Morgan; acquires Salomon Brothers

In the summer of 1997, Sandy Weill, then head of Travelers insurance company, seeks and nearly succeeds in a merger with J.P. Morgan (before J.P. Morgan merged with Chemical Bank), but the deal collapses at the last minute. In the fall of that year, Travelers acquires the Salomon Brothers investment bank for $9 billion. (Salomon then merges with the Travelers-owned Smith Barney brokerage firm to become Salomon Smith Barney.)

April 1998

Weill and John Reed announce Travelers-Citicorp merger

At a dinner in Washington in February 1998, Sandy Weill of Travelers invites Citicorp’s John Reed to his hotel room at the Park Hyatt and proposes a merger. In March, Weill and Reed meet again, and at the end of two days of talks, Reed tells Weill, “Let’s do it, partner!”

On April 6, 1998, Weill and Reed announce a $70 billion stock swap merging Travelers (which owned the investment house Salomon Smith Barney) and Citicorp (the parent of Citibank), to create Citigroup Inc., the world’s largest financial services company, in what was the biggest corporate merger in history.

The transaction would have to work around regulations in the Glass-Steagall and Bank Holding Company acts governing the industry, which were implemented precisely to prevent this type of company: a combination of insurance underwriting, securities underwriting, and commecial banking. The merger effectively gives regulators and lawmakers three options: end these restrictions, scuttle the deal, or force the merged company to cut back on its consumer offerings by divesting any business that fails to comply with the law.

Weill meets with Alan Greenspan and other Federal Reserve officials before the announcement to sound them out on the merger, and later tells the Washington Post that Greenspan had indicated a “positive response.” In their proposal, Weill and Reed are careful to structure the merger so that it conforms to the precedents set by the Fed in its interpretations of Glass-Steagall and the Bank Holding Company Act.

Unless Congress changed the laws and relaxed the restrictions, Citigroup would have two years to divest itself of the Travelers insurance business (with the possibility of three one-year extensions granted by the Fed) and any other part of the business that did not conform with the regulations. Citigroup is prepared to make that promise on the assumption that Congress would finally change the law — something it had been trying to do for 20 years — before the company would have to divest itself of anything.

Citicorp and Travelers quietly lobby banking regulators and government officials for their support. In late March and early April, Weill makes three heads-up calls to Washington: to Fed Chairman Greenspan, Treasury Secretary Robert Rubin, and President Clinton. On April 5, the day before the announcement, Weill and Reed make a ceremonial call on Clinton to brief him on the upcoming announcement.

The Fed gives its approval to the Citicorp-Travelers merger on Sept. 23. The Fed’s press release indicates that “the Board’s approval is subject to the conditions that Travelers and the combined organization, Citigroup, Inc., take all actions necessary to conform the activities and investments of Travelers and all its subsidiaries to the requirements of the Bank Holding Company Act in a manner acceptable to the Board, including divestiture as necessary, within two years of consummation of the proposal. … The Board’s approval also is subject to the condition that Travelers and Citigroup conform the activities of its companies to the requirements of the Glass-Steagall Act.”


Intense new lobbying effort to repeal Glass-Steagall

Following the merger announcement on April 6, 1998, Weill immediately plunges into a public-relations and lobbying campaign for the repeal of Glass-Steagall and passage of new financial services legislation (what becomes the Financial Services Modernization Act of 1999). One week before the Citibank-Travelers deal was announced, Congress had shelved its latest effort to repeal Glass-Steagall. Weill cranks up a new effort to revive bill.

Weill and Reed have to act quickly for both business and political reasons. Fears that the necessary regulatory changes would not happen in time had caused the share prices of both companies to fall. The House Republican leadership indicates that it wants to enact the measure in the current session of Congress. While the Clinton administration generally supported Glass-Steagall “modernization,” but there are concerns that mid-term elections in the fall could bring in Democrats less sympathetic to changing the laws.

In May 1998, the House passes legislation by a vote of 214 to 213 that allows for the merging of banks, securities firms, and insurance companies into huge financial conglomerates. And in September, the Senate Banking Committee votes 16-2 to approve a compromise bank overhaul bill. Despite this new momentum, Congress is yet again unable to pass final legislation before the end of its session.

As the push for new legislation heats up, lobbyists quip that raising the issue of financial modernization really signals the start of a fresh round of political fund-raising. Indeed, in the 1997-98 election cycle, the finance, insurance, and real estate industries (known as the FIRE sector), spends more than $200 million on lobbying and makes more than $150 million in political donations. Campaign contributions are targeted to members of Congressional banking committees and other committees with direct jurisdiction over financial services legislation.

Oct.-Nov. 1999

Congress passes Financial Services Modernization Act

After 12 attempts in 25 years, Congress finally repeals Glass-Steagall, rewarding financial companies for more than 20 years and $300 million worth of lobbying efforts. Supporters hail the change as the long-overdue demise of a Depression-era relic.

On Oct. 21, with the House-Senate conference committee deadlocked after marathon negotiations, the main sticking point is partisan bickering over the bill’s effect on the Community Reinvestment Act, which sets rules for lending to poor communities. Sandy Weill calls President Clinton in the evening to try to break the deadlock after Senator Phil Gramm, chairman of the Banking Committee, warned Citigroup lobbyist Roger Levy that Weill has to get White House moving on the bill or he would shut down the House-Senate conference. Serious negotiations resume, and a deal is announced at 2:45 a.m. on Oct. 22. Whether Weill made any difference in precipitating a deal is unclear.

On Oct. 22, Weill and John Reed issue a statement congratulating Congress and President Clinton, including 19 administration officials and lawmakers by name. The House and Senate approve a final version of the bill on Nov. 4, and Clinton signs it into law later that month.

Just days after the administration (including the Treasury Department) agrees to support the repeal, Treasury Secretary Robert Rubin, the former co-chairman of a major Wall Street investment bank, Goldman Sachs, raises eyebrows by accepting a top job at Citigroup as Weill’s chief lieutenant. The previous year, Weill had called Secretary Rubin to give him advance notice of the upcoming merger announcement. When Weill told Rubin he had some important news, the secretary reportedly quipped, “You’re buying the government?”

The Rise And Fall Of AIG’s Financial Products Unit
By Zachary Roth and Ben Buchwalter – March 20, 2009, 9:36AM

As we delve into the back-story behind the collapse of AIG, we thought it might be useful to lay out some key factual information about the firm’s Financial Products unit, known as AIGFP, whose disastrous credit default swaps brought the company to its knees. How and when did AIG Financial Products get started? Who ran it, and from where? How did it get into credit default swaps, and what exactly are they, anyway? And how did this group of derivatives traders eventually wind up bringing down one of the most admired financial firms in the world?

So here’s a rundown of some of the key developments in AIGFP’s tumultuous history — many gleaned from a superb three-part December 2008 Washington Post series on the unit (parts 1, 2, and 3):

From a Humble Start, A Swift Rise

– AIGFP was founded on January 27, 1987, when three Drexel Burnham Lambert traders, led by finance scholar Howard Sosin, convinced AIG CEO Hank Greenberg to branch out from his core insurance business by creating a division focused on complex derivatives trades that took advantage of AIG’s AAA credit rating.

– In addition to his two partners, Randy Rackson and Barry Goldman, Sosin brought 10 other staffers from DBL with him — including future AIGFP CEO Joseph Cassano. The team of 13 set to work in a windowless makeshift room, at first without full-size desks and chairs, in an accounting office on Third Avenue. AIGFP’s first significant deal, made in July 1987, was a $1 billion interest-rate swap with the Italian government.

– In its first 6 month of existence, the unit earned more than $60 million. Under the agreement that Greenberg and Sosin had signed, 38 percent of that went immediately to AIGFP, with the remaining 62 percent going to AIG proper. Crucially, the agreement also called for AIGFP received its profits up front, even though its deals generally took years to play out. AIG itself, not AIGFP, would be on the hook down the road if things went wrong. This arrangement would be modified, but only partially, after Sosin left in 1993.

Picture Subject- AIGFP soon moved to a swanky Madison Avenue office. A few years later, it would relocate again to Wilton, Conn, which remains the unit’s headquarters today.

– By 1990, AIGFP had expanded, opening offices in London, Paris and Tokyo.

– In 1993, Sosin left AIGFP, in part thanks to a strained relationship with Greenberg. (He got a reported $150 million payout). Tom Savage — a Midwestern math whiz who had joined AIGFP in 1988, after beginning his career at First Boston writing computer models for collateralized mortgage obligations, the very instruments that would later help cause the current crisis — soon took over as CEO.

– By that year, AIGFP employed 125 people, and was consistently raking in more than $100 million each year.

– By 1998, the unit had a revenue of $500 million. But it still had never made a single credit default swap.

The Seed Of Ruin Is Planted

– That year, JP Morgan approached AIG, proposing that, for a fee, AIG insure JP Morgan’s complex corporate debt, in case of default. According to computer models devised by Gary Gorton, a Yale Business Professor and consultant to the unit, there was a 99.85 percent chance that AIGFP would never have to pay out on these deals. Essentially, this would happen only if the economy went into a full-blown depression, in which case, the AIGers believed, the counter-parties would be wiped out, and therefore would hardly be in a position to demand payment anyway. With the backing of Cassano, then the COO, Savage greenlighted the deals. Credit default swaps were born.

– In 2000, Congress passed the Commodity Futures Modernization Act, which further reduced the already weak regulation of derivatives like credit default swaps*.

– Later that year, Cassano, now based in London, who in addition to serving as COO had been running AIGFP’s Transaction Development Group, replaced Savage as CEO. Cassano, the scrappy son of a Brooklyn cop, was no expert in the sophisticated computer models that assessed risk, but he had a gift for credit and accounting, and a fierce drive to succeed. At this time, the unit brought in $1 billion a year, and had 225 employees. By 2005, it would have 400.

– In 2002, the Justice Department charged that AIGFP had illegally helped another firm, PNC Financial Services, to hide bad assets from its books. To do so, AIGFP had set up a separate company, known as a “special purpose entity” to take on the assets. It had violated securities law, the Feds alleged, by setting up sham “companies” to invest in the entities, making them appear real. In 2004, AIG settled the charges by paying an $80 million fine, and gave back over $45 million in fees and interest it had earned on the deal. By the terms of its “deferred prosecution” agreement, it was placed on a short leash by the Justice Department. There is no evidence that anyone at AIGFP was formally sanctioned as a result of the episode.

– In March 2005, Greenberg, who had run AIG since 1968, stepped down as CEO, amid an investigation by New York Attorney General Eliot Spitzer into questionable accounting practices at the firm. Though the issue was unrelated to AIGFP, the unit would soon feel the ripple effects: the credit ratings agencies responded to Greenberg’s departure, and the allegations of irregularities, by downgrading AIG’s rating from AAA to AA. That, in turn triggered provisions in some of AIGFP’s credt default swaps, requiring AIG proper to over $1 billion in collateral for the deals. It was the beginning of the end.

– Later that year, an AIGFP exec named Eugene Park took a close look at the firm’s credit default swaps portfolio, and became alarmed. Many of the CDOs that were being insured contained too large a proportion of sub-prime mortgages, meaning the risk of default was high if the housing market collapsed. And with AIG proper’s credit rating having been downgraded, there was an increased chance that it would have to come up with collateral to cover those bets. Park told Cassano and others about his concerns.

– In response, Cassano worked with researchers from the investment banks to assess the risk form subprime mortgages, and decided in late 2005 it was time to stop making credit default swaps. But he couldn’t undo the nearly $80 billion worth of collateralized debt obligations that AIGFP had made swaps on that were already on its books*.

– Still, as late as August 2007, Cassano was sanguine about the deals, telling investors on a conference call: “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions.”

Things Fall Apart

Picture Subject- But that same month, with the housing market collapsing and sub-prime assets plummeting in value, Goldman Sachs demanded $1.5 billion in collateral from AIG, to cover the mortgage-backed securities that AIG’s credit default swaps had insured. Under the terms of its contract, AIGFP was required to post more collateral than it would have had its credit rating remained at AAA. By October, it had posted almost $2 billion, and other counter-parties were beginning to make their own collateral demands.

-Between early October and mid November, AIG’s stock price fell 25 percent. That month, AIGFP reported that its swaps portfolio had lost $352 million. A month later, Cassano put the figure at $1.1 billion

– Late that month, Pricewaterhouse Coopers, AIG’s auditing firm, told AIG CEO Martin Sullivan that no one knew whether AIGFP’s valuation of its derivatives portfolio was accurate. That process had been led by Casssano, who, it appears, had shut out the firm’s internal accountant, Joseph St. Denis. (St. Denis would describe Cassano’s high-handed behavior and unwillingness to allow AIGFP’s transactions to be properly audited, in a letter (pdf) to congressional investigators sent the following year.)

– And yet, Cassano and Sullivan were continuing to paint a rosy picture for investors. At a December 5 presentation, Cassano declared: “It is very difficult to see how there can be any losses in these portfolios.” Sullivan added: “”AIG has accurately identified all areas of exposure to the US residential-housing market … we are confident in out markets and the reasonableness of our valuation methods.” This presentation is currently being scrutinized by the Feds as evidence of possible fraud.

– In February 2008, AIG announced estimated losses of $11.5 billion, and that it had posted $5.3 billion in collateral.

– The following day, Sullivan announced that Cassano would step down, effective March 31. Only later, during a congressional investigation, did it come out that Cassano would get a $1 million a month consulting contract (the contract was cancelled in September 2008). It was also revealed that Cassano had made $43.6 million in salary and bonuses in 2006, and $24.2 million in 2007.

– That summer, it was reported that the Justice Department was investigating AIGFP for possible criminal fraud. The UK’s Serious Fraud Office would later announced its own probe.

Picture Subject- In September 2008, AIG executives learned that the ratings agencies planned to downgrade the company’s rating again. That would trigger more collateral calls, which AIG knew it couldn’t begin to cover. Desperate negotiations to keep the company afloat — including a possible $75 billion bridge loan from Goldman and JP Morgan, both major counter-parties on the credit default swaps — ensued. Tim Geithner, then the head of the New York fed, called in. But in the following days, it became clear that AIG’s level of exposure to its credit default swap losses was higher than anyone had yet understood. On Sept 16, the Federal Reserve Board, announced that it would take a nearly 80 percent equity stake in AIG — effectively taking over the firm — and would provide an $85 billion “loan”.

– In October 2008, Gerry Pasciucco, a vice chair at Morgan Stanley, was brought in to wind down AIGFP. The unit, Pasciucco found, had $2.7 trillion worth of swap contracts and positions, and 50,000 outstanding trades with 2000 different firms, and 450 employees in six offices around the world.

– In March 2009, amid outrage over multi-million dollar bonuses for those employees, AIGFP would post armed guards outside Wilton headquarters.

AIG trail leads to London ‘casino’
Since 1987 the American financier Joseph Cassano has divided his time between London and Connecticut, where AIG, the world’s largest insurance company, runs a subsidiary called AIG Financial Products.

By Peter Koeing
Last Updated: 10:29PM BST 18 Oct 2008

For most of those 21 years life has been good for the bespectacled, intellectual-looking Cassano.

The Wall Street veteran rose to run his part of the insurer, AIG Financial Products. When in London he commuted from a company flat behind Harrods to his unit’s office at 1 Curzon Street in Mayfair’s hedge fund alley.

Cassano’s pay over the past eight years, according to US Congressional records, totalled $280m (£162m).

Then at the end of 2007 Cassano’s fortunes changed. The company’s accountants changed the basis on which they valued much of the collateral held by its units. Some half a trillion dollars worth of credit default swaps written by AIG Financial Products were marked down.

Credit default swaps, or CDSs, are quasi-insurance products bought by investors seeking protection against defaults on mortgage-backed securities and other credits.

In contrast to the remarkable profits it had tallied until 2007, the AIG subsidiary headed by Cassano began to report quarterly losses. The unit went from being star performer to vortex of a gathering nightmare.

On April 1 Cassano was nudged into retirement. In keeping with the bubble-time executive compensation practises established in the City and on Wall Street, however, the blow was softened. Cassano was allowed to continue using the company flat behind Harrods. He was given a consultancy and, according to former AIG chief executive Martin Sullivan, testifying to the US Congress, helped AIG unwind the rapidly devaluing CDSs held by AIG Financial Products. Cassano’s pay for this work was $1m a month for nine months.

“The question,” said Henry Waxman, the US Congressman chairing an October 7 Washington hearing into AIG, “was whether AIG’s executive compensation practices were fair and appropriate.”

None of this would seem to be of particular concern to the British public beyond AIG’s role generally in the world financial meltdown.

On September 16 the American insurer suffered a liquidity crisis following the downgrade of its credit rating. AIG had to beg the Federal Reserve Bank for an $85bn credit facility in return for giving up 80 per cent of its equity to the US government. This poured fuel on the fire ignited by the bankruptcy of Wall Street investment bank Lehman Brothers a day earlier.

A Sunday Telegraph investigation has determined, however, that there is a row brewing between the scores of regulators responsible for AIG’s activities in 130 countries. In the forefront of this row stands Britain’s financial regulator, the Financial Services Authority.

The operations of Cassano and his colleagues at 1 Curzon Street are attracting the attention of government officials in Washington, New York and Paris as well as London. Bumbling by the FSA, according to regulators in other countries, may have played an instrumental role in sparking the credit crunch that brought the global financial system to the brink of collapse.

This is already making political waves. Distancing himself and his government from the bad news, the Prime Minister Gordon Brown has repeatedly contended the financial crisis was made in the USA – where poor Americans in Rust Belt cities like Cleveland and Detroit fell behind on mortgage payments.

The reality has always been more complex. A financial chain links American sub-prime mortgages to the packagers and sellers of those mortgages in the City, as well as on Wall Street.

Now the role of AIG’s London office, and the FSA in overseeing what went on inside it may change all that.

On Friday, the Conservative Party Treasury spokesman Philip Hammond called for a public inquiry into the FSA’s oversight of AIG Financial Products in Mayfair. “We must not allow London to become a bolthole for companies looking for a place to conduct questionable activities,” he said.

“This sounds like a monumental cock-up by the FSA,” said Lib Dem shadow chancellor Vince Cable. “It is deeply ironic,” he added, that Brown was in Brussels last week calling for tougher global financial regulation just as the scandal over the FSA’s role in one of the key regulatory failures at the root of the global panic emerged as an international issue.

“We need an inquiry to establish what happened with the FSA’s regulation of AIG’s London operation,” Cable said.

Since AIG’s collapse in September, insurance regulators in various jurisdictions have played pass the parcel, each regulator seeking to distance itself from the CDS firm’s London business, according to politicians in Washington, such as the US Congress’s Waxman, as well as here.

The spectacle is reminiscent of the regulatory response to the collapse in the early 1990s of BCCI, a bank with operations in London, Luxembourg and the Middle East. BCCI regulators in its multiple jurisdictions, including London, dodged responsibility for not spotting BCCI’s $10bn fraud by blaming each other.

On Friday, Adair Turner, the FSA’s chairman, declined to answer questions about AIG’s London operation.

Meanwhile, people close to the City regulator explained that AIG Financial Products, the unit responsible for the insurer’s failure, fell outside its jurisdiction.

Under FSA rules, these people said, AIG Financial Products was deemed an “internal treasury operation” and, like the internal treasury operations of other companies, was not regulated.

But the FSA does have regulatory oversight responsibility for a number of AIG units in London, including a company called AIG FP Capital Management registered at 1 Curzon Street.

People close to the FSA said AIG FP Capital Management is a separate company from AIG Financial Products and is not involved in the business of creating credit default swaps.

There is little doubt, nevertheless, that US lawmakers consider London an epicentre of the AIG Financial Products disaster. During the hearing into the causes and effects of the AIG bail-out on October 7, the US House of Representatives Oversight Committee, led by Congressman Waxman, politicians pmentioned London a dozen times. California Congresswoman Jackie Speier referred to AIG’s Mayfair business as “the casino in London”.

Testimonies by former AIG chief executives Martin Sullivan and Robert Willumstad, along with a New York Times article on September 28, sketch the story of the AIG Financial Products unit in London.

It was originally staffed by executives, including Cassano, from defunct Wall Street investment bank Drexel Burnham Lambert. Drexel’s legendary junk bond king, Michael Milken, was investigated for insider trading in the 1980s and pleaded guilty to six charges.

As New Labour came to power in 1997 and established the FSA with a mandate to avoid regulatory failures such as BCCI, Cassano rose to the top of the AIG subsidiary where he worked.

By the end of last year AIG held $562bn of CDS contracts on its books, and in their October 7 testimony before the House Oversight Committee company executives acknowledged that a cockpit for this business was 1 Curzon Street.

In contrast to standard practice, however, AIG Financial Products did not hedge its exposure to a possible fall in the CDS market. In a footnote to AIG’s 2007 accounts spotted by Forbes magazine, the company declared: “In most cases AIGFP does not hedge its exposures to credit default swaps it has written.”

Last November, when AIG’s accountants asked the insurer to change the way it valued CDS’s, the comparatively small base of capital on which AIG Financial Products had built a mountain of business became visible. This began the unravelling that led to AIG’s central role in sparking the global financial crisis.

To date, no British authorities have said anything about AIG. In the US, in contrast, there are multiple investigations. In addition to the October 7 Congressional hearing into AIG, the insurer’s London business is now under scrutiny by the Office of Thrift Supervision in Washington and the New York State Department of Insurance in Manhattan.

Last week New York State Attorney General Andrew Cuomo sent a letter to AIG informing the company it was under investigation for “irresponsible and damaging” expenditures, among other things, for executive compensation packages that were not cut even as AIG drew down on the Federal Reserve’s $85bn credit facility to keep itself afloat.

Although the FSA will not comment on AIG Financial Products, there are indications from America that it is belatedly looking into the unit’s operations.

“There have been meetings and conversations” between Washington’s Office of Thrift Supervision and the FSA,” said Janet French, a spokeswoman for the Washington agency.

A person close to the New York State Department of Insurance said: “You can be certain there have been talks with the FSA.”

AIG did not return phone calls to its New York headquarters. Cassano did not return a call to his Connecticut home.

In the weeks ahead the British public may hear more about the obscure AIG business at 1 Curzon Street – if only because it links the financial crisis to the Prime Minister by way of the City regulator he created when he became Chancellor in 1997.

“The Prime Minister has used the City as his milch cow,” said Tory Treasury spokesman Hammond.

“He borrowed from it. He taxed it. Now, it appears, he allowed it to operate without adequate regulation.”
Doo Doo 32 Bank Drill Down 1.5: The Forensic Analysis of Wells Fargo

Written by Reggie Middleton
Wednesday, 11 June 2008

**************** Statistical arbitrage
From Wikipedia, the free encyclopedia
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In the world of finance and investments statistical arbitrage is used in two related but distinct ways:

* In academic literature, statistical arbitrage is opposed to (deterministic) arbitrage. In deterministic arbitrage a sure profit can be obtained from being long some securities and short others. In statistical arbitrage there is a statistical mispricing of one or more assets based on the expected value of these assets. (For a simple example, consider a game in which one flips a coin and collects $1 on heads or pays $0.50 on tails. In any single flip it is uncertain if one will win or lose money. However, in the statistical sense, there is an expected value of $1×50% – $0.50×50% = $0.25 for each flip. According to the law of large numbers, the mean return on actual flips will approach this expected value as the number of flips increases. This is precisely the way in which a gambling casino makes a profit.) In other words, statistical arbitrage conjectures statistical mispricings or price relationships that are true in expectation, in the long run when repeating a trading strategy.

* Among those who follow the hedge fund industry statistical arbitrage refers to a particular category of hedge funds (other categories include global macro, convertible arbitrage, and so on). In this narrower sense Statistical arbitrage is often abbreviated as StatArb. According to Prof. Andrew Lo, StatArb “refers to highly technical short-term mean-reversion strategies involving large numbers of securities (hundreds to thousands, depending on the amount of risk capital), very short holding periods (measured in days to seconds), and substantial computational, trading, and IT infrastructure”.

[edit] StatArb, the trading strategy

As a trading strategy, statistical arbitrage is a heavily quantitative and computational approach to equity trading. It involves data mining and statistical methods, as well as automated trading systems.

Historically StatArb evolved out of the simpler pairs trade strategy, in which stocks are put into pairs by fundamental or market-based similarities. When one stock in a pair outperforms the other, the poorer performing stock is bought long with the expectation that it will climb towards its outperforming partner, the other is sold short. This hedges risk from whole-market movements.

StatArb considers not pairs of stocks but a portfolio of a hundred or more stocks (some long, some short) that are carefully matched by sector and region to eliminate exposure to beta and other risk factors. Portfolio construction is automated and consists of two phases: in the first or ‘scoring’ phase each stock in the market is assigned a numeric score or rank that reflects its desirability; high scores indicate stocks that should be held long and low scores indicate stocks that are candidates for shorting. The details of the scoring formula vary and are highly proprietary, but generally (as in pairs trading) they involve a short term mean reversion principle so that, e.g., stocks that have done unusually well in the past week receive low scores and stocks that have underperformed receive high scores. In the second or ‘risk reduction’ phase the stocks are combined into a portfolio in carefully matched proportions so as to eliminate (or at least greatly reduce) market and factor risk. This phase often uses commercially available risk models like MSCI Barra/APT/Northfield/Axioma to constrain or eliminate various risk factors[1].

Broadly speaking, StatArb is actually any strategy that is bottom-up, beta-neutral in approach and uses statistical/econometric techniques in order to provide signals for execution. Signals are often generated through a contrarian mean-reversion principle, but can also be formed by lead/lag effects, extreme psychological barriers[citation needed], corporate activity, as well as short-term momentum. This is usually referred to as a multi-factor approach to StatArb.

Because of the large number of stocks involved, the high portfolio turnover and the fairly small size of the effects one is trying to capture, the strategy is implemented in an automated fashion and great attention is placed on reducing trading costs.

Statistical arbitrage has become a major force at both hedge funds and investment banks. Many bank proprietary operations now center to varying degrees around statistical arbitrage trading.

[edit] Other forms of statistical arbitrage

Volatility arbitrage is a form of statistical arbitrage in which options, rather than equities, are the primary vehicle of the strategy.

[edit] Risks

In the general sense, statistical arbitrage only is demonstrably correct as the amount of trading time approaches infinity and the liquidity, or size of an allowable bet, approaches infinity. To put it another way, it does not take into consideration the same problems as the martingale betting system. Over any finite period of time, a series of low probability events may occur that impose heavy short term losses. If those short term losses are greater than the liquidity available to the trader, default may even occur, as in the case of Long-Term Capital Management.

Statistical arbitrage is also subject to model weakness as well as stock-specific risk.

The statistical relationship on which the model is based may be spurious, or may break down due to changes in the distribution of returns on the underlying assets. Factors which the model may not be aware of having exposure to could become the significant drivers of price action in the markets, and the inverse applies also. The existence of the investment based upon model itself may change the underlying relationship, particularly if enough entrants invest with similar principles. The exploitation of arbitrage opportunities themselves increases the efficiency of the market, thereby reducing the scope for arbitrage, so continual updating of models is necessary.

On a stock-specific level, there is risk of M&A activity or even default for an individual name. Such an event would immediately end any historical relationship assumed from empirical statistical analysis.

[edit] Events of summer 2007

During July and August 2007 a number of StatArb (and other Quant type) Hedge funds experienced significant losses at the same time (which is difficult to explain unless there was a common risk factor). While the reasons are not yet fully understood, several published accounts blame the emergency liquidation of a fund that experienced customer withdrawals or margin calls. By closing out its positions quickly, the fund put pressure on the prices of the stocks it was long/short. (The fund is not identified in the published articles but is thought by some to be AQR or GSAM). Because other StatArb funds had similar positions (due to the similarity of their alpha models and risk-reduction models) the other funds experienced adverse returns.[2]

In a sense, a stock “heavily involved in StatArb” is itself a risk factor, one that is new and thus was not taken into account by the StatArb models.

These events showed that StatArb has developed to a point where it is a significant factor in the marketplace, that existing funds have similar positions and are in effect competing for the same returns. Simulations of simple StatArb strategies by A. Lo show that the returns to such strategies have been reduced considerably from 1998 to 2007 (presumably because of competition).

********* Deferred compensation

It is an arrangement in which a portion of an employee’s income is paid out at a date after which that income is actually earned. Examples of deferred compensation include pensions, retirement plans, and stock options. The primary benefit of most deferred compensation is the deferral of tax to the date(s) at which the employee actually receives the income.

********** Unfunded Obligations

Retiring Unfunded Obligations
by Ward Bower
October 2004

Unfunded obligations are off-balance sheet liabilities to departed partners secured by contract. In professional corporations they generally take the form of deferred compensation so they are deductible to the firm.

Unfunded obligations (UOs) are created for a variety of reasons:

* To reward founders and early partners for the entrepreneurial risk and investment in starting and growing the firm.
* To reward departing partners for the value of WIP and AR left with the firm (offset by working capital initially required until the lawyer became economically viable when joining the firm).
* To provide a source of income in retirement, especially in the era before tax deferred retirement funding schemes became available, with time to build a meaningful retirement fund.
* To give retiring partners reason to help ensure the ongoing success and survival of the firm after their departure.

Altman Weil survey data shows that fewer firms today have such arrangements than five or ten years ago, fewer than even three years ago. About 28 percent of firms participating in Altman Weil’s 2002 survey have such an arrangement. UOs are quantified in a number of ways, based on AR and WIP at date of retirement, compensation points. Final average earnings formulae, or ongoing revenues from the partner’s clients after retirement.
Impact on the Firm

The move to reduce or eliminate UOs comes from the economic burden on the “surviving” partners, as UOs are paid from then-current earnings of the firm, reducing partner incomes. UOs have caused some firms to dissolve rather than carry this burden. They also make merger difficult where the other firm does not have such an obligation.

Firms with a UO seek to reduce the one-year impact of the UO by “capping” the amount of UO payments in any given year to a percentage of either gross fee revenues (typically one to two percent) or net income (typically three to six percent). The delicate balancing act is to establish an UO which is bearable by the firm so its receipt is reasonably assured to the departed partner ¾ i.e., not so burdensome as to cause partners to withdraw or the firm to collapse.
Reducing/ Eliminating the UO

Many firms in recent years have reduced or eliminated altogether the UO. Generally that requires sacrifice on the part of individual partners who may view the UO as a contractual obligation on which they are relying as part of their retirement income. This issue is more sensitive the more senior the partner, so it is always best to address it sooner rather than later.

Reduction/ Elimination of the UO

Law firms in recent years have employed many schemes to reduce or eliminate the UO. They include:

* Use of life insurance with cash values applied to offset the UO, or to reimburse the firm for the UO previously paid to the partner on death, or to transfer to the retiree in place of his/ her UO.
* Use of annuities to fund the projected UO, even though the premiums are not deductible.
* Use of “rabbi trusts” as a funding vehicle.
* Considering “excess profits” (e.g., partner incomes in excess of 120 percent of prior year incomes, for example) as offsets against UOs ultimately due.
* Offsetting UOs by firm contributions (or a percentage of them) to tax-deferred retirement plans (401k’s, defined contribution plans, etc.), even though it is arguably the partner’s “own money” used for such a purpose.
* “Grandfathering” more senior partners and cutting off the UO entirely for more junior partners (easier where there is an age gap).
* Diminishing the benefit over time ¾ e.g. 100 percent of UO to partners retiring in the next two years, 75 percent in two to five years, 50 percent in five to ten years, etc.

The method selected will depend on the specific circumstances of the firm ¾ burden, amounts involved, economics, demographics, sources of tax-deferred retirement funds, etc. The key to reducing this burden is to obtain universal understanding of the issue and reasonable concessions by partners for the long term good of the firm, or even for its survival. In recent years some firms have chosen to recast their UO as a deciding percentage of fees received from clients of the retired partner, providing an incentive for partners to transition their client relationships so that clients remain with the firm.

(Lewin Group is) part of Ingenix, which is owned by United Healthcare Group, the insurance behemoth that has been buying up insurance companies left and right, expanding its reach into just about every segment of the health-insurance market. Its flagship, UnitedHealthcare, helps make it the largest health insurer in the country. It’s a safe bet that United is not too keen on a public plan that might shrink its business.

Ya! Very reliable source of “researched” study. The pinnacle of journalism is being practiced by Washington Times. You have lost the credibility that you never had.

Wall Street’s Near-Death Experience
With the implosion of Lehman Brothers, in September 2008, the realization dawned: Morgan Stanley and Goldman Sachs could be next. In an excerpt from his new book, the author reveals the incredible scramble that took place—desperate phone calls, seat-of-the-pants merger proposals, flaring tempers—as Washington got tough and Wall Street titans Lloyd Blankfein and John Mack fought for survival.
By Andrew Ross Sorkin
November 2009

Excerpted from Too Big to Fail, by Andrew Ross Sorkin, to be published this month by Viking, a member of Penguin Group (USA) Inc.; © 2009 by the author. This account is based on hundreds of hours of interviews with dozens of the participants, many of whom agreed to be interviewed on the condition that they not be identified as sources.
Day One
Wednesday, September 17, 2008: After Lehman and A.I.G.

When Tim Geithner, president of the Federal Reserve Bank of New York, began his run that morning along the southern tip of Manhattan and up the East River just after six, the sun had yet to come up. He was tired and stressed, having slept only several hours in one of the three tiny, grubby bedrooms in the New York Fed’s headquarters.

As he stared at the Statue of Liberty and the first of the morning’s commuter ferries from Staten Island gliding across the harbor, he tried desperately to clear his mind. For five days his brain had been trapped in a maze of numbers—huge, inconceivable, abstract numbers, ranging in the span of 24 hours from zero for Lehman to $85 billion for A.I.G. Eighty-five billion dollars was more than the annual budgets of Singapore and Taiwan combined; who could even begin to understand a figure of that size? Geithner hoped that the sum would be sufficient to rescue the insurance giant from bankruptcy—and that the financial crisis would finally be over.

Andrew Ross Sorkin on wrangling Wall Street’s C.E.O.’s. Plus: How did the economy get into this mess? Visit our archive “Charting the Road to Ruin.” Illustration by Brad Holland.

Those ferries, freighted with office workers, gave him pause. This is what it was all about, he thought, the people who rise at dawn to go to their jobs, all of whom rely to some extent on the financial industry to help power the economy. Never mind the staggering numbers. Never mind the ruthless complexity of structured finance and derivatives, or the million-dollar bonuses of those who had made bad bets. This is what saving the financial industry is really about: protecting ordinary people with ordinary jobs.

But as he passed the South Street Seaport and then went under the Brooklyn Bridge, he inadvertently began thinking about what fresh hell the day would bring.

Due to disastrous bets on Lehman paper, the giant Reserve Primary Fund had broken the buck a day earlier, causing an investor run on the money-market funds. Between that, Geithner thought, and billions of dollars of investors’ money locked up inside the now bankrupt Lehman Brothers, that meant only one thing: the two remaining broker-dealers—Morgan Stanley and Goldman Sachs—could actually be next.

The panic was already palpable in John Mack’s office at Morgan Stanley’s Times Square headquarters. Sitting on his sofa with his lieutenants, Walid Chammah, 54, and James Gorman, 50, drinking coffee from paper cups, Mack was railing: the major news on Wednesday morning, he thought, should have been the strength of Morgan Stanley’s earnings report, which he had released the afternoon before, a day early, to stem any fears of the firm’s following in Lehman’s footsteps. His stock had fallen 28 percent in a matter of hours on Tuesday, and he decided he needed to do something to turn it around. The quarterly earnings report had been a good one—Morgan had announced $1.43 billion in profits, down a mere 7 percent from the quarter a year earlier. But the headline on The Wall Street Journal was gnawing at him: goldman, morgan now stand alone; fight on or fold? And as the futures markets were already indicating, his attempt to show strength and vitality had largely failed to impress.

Apart from the general nervousness about investment banks, he was facing a more serious problem than anyone on the outside realized: at the beginning of the week, Morgan Stanley had had $178 billion in the tank—money available to fund operations and lend to its hedge-fund clients. But in the past 24 hours, more than $20 billion of it had been withdrawn by anxious hedge-fund clients, in some cases closing their prime-brokerage accounts entirely.

“The money’s walking out of the door,” Chammah told Mack.

“Nobody gives a shit about loyalty,” Mack complained. The question was: how much more could they afford to let go? “We can’t do this forever,” Chammah said.

While Mack was beginning to believe that the hedge funds were conspiring against the firm—“This is what they did to Dick [Fuld, of Lehman Brothers]!” he roared, referring to the Monday implosion of Lehman—there was fresh evidence that some of them actually did need the cash. Funds that had accounts at Lehman’s London office couldn’t get at them and came begging to Morgan Stanley and Goldman.

And Morgan needed to keep paying out the money. It was essential in the midst of a crisis that the firm not display even the slightest sign of panic, or the entire franchise would be lost. Under normal circumstances, Mack, 63, was unflappable, but he was starting to come unwound.

‘T his is an economic 9/11!” There was chilling silence in Treasury Secretary Hank Paulson’s office as he spoke. Nearly two dozen Treasury staffers had assembled there Wednesday morning, sitting on windowsills, on the arms of sofas, or on the edge of Paulson’s desk, scribbling on legal pads. Paulson was seated in a chair in the corner, slouching, nervously tapping his stomach. He had a pained look on his face as he explained to his inner circle at Treasury that in just the past four hours the crisis had reached a new height, one he could compare only to the World Trade Center attacks, seven years earlier, almost to the week. While this time no lives may have been at stake, companies with century-long histories and hundreds of thousands of jobs lay in the balance.

The entire economy, he said, was on the verge of collapsing. Paulson was no longer worried about just investment banks; he was worried about General Electric, the world’s largest company and an icon of American innovation. Jeffrey Immelt, G.E.’s C.E.O., had told him that the conglomerate’s commercial paper, used to fund its day-to-day operations, could stop rolling. Paulson had also heard murmurs that JPMorgan Chase had stopped lending to Citigroup; that Bank of America had stopped making loans to McDonald’s franchisees; that Treasury bills were trading for less than 1 percent interest, as if they were no better than cash, as if the full faith of the government had suddenly become meaningless.

Paulson knew this was his financial panic. The night before, chairman of the Federal Reserve Ben Bernanke had agreed it was time for a systemic solution; deciding the fate of each financial firm one at a time wasn’t working. It had been six months between the implosions of Bear Stearns and Lehman, but if Morgan Stanley went down, probably no more than six hours would pass before Goldman did, too. The big banks would follow, and God only knew what might happen after that.

And so Paulson stood in front of his staff in search of a holistic solution, a solution that would require intervention. He still hated the idea of bailouts, but now he knew he needed to succumb to the reality of the moment. “The only way to stop this thing may be to come up with a fiscal response,” he said.

‘It’s ridiculous that I can’t deal with Goldman at a time like this!” Paulson complained to his general counsel, Bob Hoyt. Paulson was supposed to take part in a three p.m. call with Bernanke, Geithner, and S.E.C. chairman Christopher Cox to discuss Goldman Sachs and Morgan Stanley, but unless he could get a waiver, he would be unable to participate.

With Morgan Stanley on the ropes, Paulson had been growing increasingly worried about Goldman, where he had worked for 30 years and where he was C.E.O. from 1999 to 2006. If Goldman were to topple, it would, he believed, represent a complete destruction of the system. He’d had enough of recusing himself. Part of him regretted signing the original ethics letter agreeing not to get involved in any matter related to Goldman.

Former Treasury secretary and Goldman C.E.O. Henry Paulson. By Nigel Parry/CPi Syndication.

Geithner had raised this very issue back in March after the Bear Stearns deal. “You know, Hank, if another one of these banks goes,” he said, “I don’t know who would have the ability to take them over other than Goldman, and we have to do something about your waiver-recusal situation because I don’t know how we can do one of these without you.”

Given the extreme situation in the market, Hoyt told Paulson he thought it was only fair that he try to seek a waiver; Hoyt had in fact already drafted the material needed to request one. Paulson appreciated that the “optics” of a waiver to engage with his former employer were problematic, but he hoped it would remain a secret and he and Hoyt discussed keeping it confidential. Hoyt reached out to Fred F. Fielding, counsel to the White House and a longtime Washington hand, who knew his way around the system, and to Bernard J. Knight Jr., the D.A.E.O., or designated agency ethics official, at Treasury. Given the gravity of the situation, they quickly accepted Hoyt’s recommendation. Unknown to the public, Paulson was now officially free to help Goldman Sachs.

Kevin Warsh, a 38-year-old governor at the Federal Reserve, whose office was a few doors down from that of his boss, Ben Bernanke, was having his own worries over Morgan Stanley. He had worked as an M&A banker there six years earlier. He could tell that his former firm was quickly losing the confidence of the marketplace. To him, there was an obvious solution to its problems: Morgan Stanley needed to buy a large bank with deposits. His top choice? Wachovia, a commercial bank with a large deposit base that itself was struggling. Wachovia’s 2006 acquisition of Golden West, the California-based mortgage originator, was turning into a catastrophe, saddling the bank with a giant pile of bad debt that was beginning to reveal itself. After getting clearance to make contact with his old employer, based on an “overwhelming public interest,” Warsh contacted Wachovia C.E.O. Bob Steel and instructed him to call Mack in 20 minutes.

“Very interesting times,” Steel said to Mack when they reached each other. “I imagine you’ve already heard from Kevin. He told me he thought we should connect.”

Steel went on, intentionally keeping the discussion vague until he gauged Mack’s intentions: “There might be an opportunity for us. We’re thinking about a lot of things. I think this could be the right time to talk. But we’d need to move fast.”

“I could see something,” Mack replied, intrigued but noncommittal. “What’s your timing?”

“We’re moving in real time,” Steel said.

For Steel, a Morgan Stanley deal happened to be both commercially and personally attractive. It could present an elegant solution to Morgan’s succession problems down the road and could be Steel’s big opportunity to finally run a top Wall Street firm.

After speaking with Steel, Mack called Robert Scully, his top deal-maker, and told him about the conversation. Scully had his doubts; he didn’t know much about Wachovia’s books, but what he did know alarmed him. He agreed, however, that at this point no options could be automatically ruled out. Scully in turn called Rob Kindler, a vice-chairman. In the relatively straitlaced banker culture of Morgan Stanley, Kindler was an outlier—loud, indiscreetly blunt, and predisposed to threadbare old suits. Despite his idiosyncrasies, when it came to deal-making, his advice was highly valued. Kindler didn’t initially like the notion of a Wachovia merger, either, he told Scully, and took a reflexively cynical view. “Let’s put this in context for a moment: Bob Steel comes from Goldman; Wachovia’s investment bankers are Goldman; Hank Paulson is obviously from Goldman. The only reason we’re having this meeting with Wachovia is because Goldman won’t do the deal!”

Scully had been thinking much the same thing, but he and Kindler got Jonathan Pruzan, co-head of Morgan Stanley’s financial-institutions practice, to start running the numbers on Wachovia. The obvious concern was its gargantuan subprime exposure, some $122 billion worth. As the Wachovia due diligence got under way, Mack got a callback from Citigroup C.E.O. Vikram Pandit, whom he’d telephoned earlier that morning after Citigroup’s vice-chairman, Stephen Volk, had hinted they’d be open to a merger. Pandit delivered what amounted to a soft no on the merger talks. “The answer is no. The timing isn’t right, but at some point we’d like to do something.”

Mack clicked off, exasperated. Wachovia was nobody’s idea of a dream date, but at the moment it was the only girl at the dance.

By midafternoon, Morgan Stanley’s stock had fallen 42 percent. The rumors were flying: the latest gossip had the company as a trading partner with A.I.G., with more than $200 billion at risk. The gossip was inaccurate, but it didn’t matter; hedge funds were now seeking nearly $50 billion in redemptions. John Mack was meeting with his brain trust. “It’s outrageous what’s going on here,” Mack almost shouted, arguing that the raid on Morgan Stanley’s stock was “immoral if not illegal.” Intellectually he understood that short-sellers kept the market more efficient—after all, many were his clients—but at risk now was his own survival.

Colm Kelleher, Morgan Stanley’s 51-year-old C.F.O., was more fatalistic—the short-sellers couldn’t be stopped, he believed, or even necessarily blamed. They were market creatures, doing what they had to do to survive. “They are cold-blooded reptiles,” he told Mack. “They eat what’s in front of them.”

Mack had just gotten off the phone with one of his closest friends, Arthur J. Samberg, the founder of Pequot Capital Management, then with $4 billion under management, who had called about withdrawing some money.

“Take your money,” Mack told him, “and you can tell all your peers to take their credit balances out.”

Mack believed negative speculation was purposely being spread by his rivals and repeated uncritically on CNBC. He was so furious with what he believed was “bullshit coverage” that he called to complain to Jeff Immelt. (G.E. owns CNBC as part of its NBC Universal unit.)

Tom Nides, Mack’s chief administrative officer, thought they needed to go on the offensive. He encouraged his boss to start working the phones in Washington and impress upon them the need to put in place a ban on short-selling. “We’ve got to shut down these assholes!” he told Mack.

Desperate for an ally, Mack contacted his most serious rival, Lloyd Blankfein, of Goldman. “Lloyd, you guys are in the same boat as I am.” He asked Blankfein to appear on CNBC with him, as a show of force.

While the 53-year-old Goldman C.E.O. kept a television in his office, he was so disgusted with what he believed was CNBC’s Charlie Gasparino’s “rumor-mongering” that he had turned it off in protest. “That’s not my thing,” he told Mack. “I don’t do TV.”

As Goldman wasn’t in total crisis mode, Blankfein explained, he was disinclined to join Mack in a war on the shorts until he absolutely needed to.

Making little progress, Nides had another, perhaps shrewder, angle to play. He could call Andrew Cuomo, the New York State attorney general. Nides had a hunch that Cuomo might be willing to put a scare into the shorts. It was an easy populist message to get behind: Rich hedge-fund managers were betting against teetering banks amid a financial crisis.

“If you do this,” Nides told Cuomo, “we’ll come out and praise you.” Nides knew Mack would be reluctant—he’d be assailing his own clients—but this was a matter of survival.

‘What’s wrong?” Mack asked in alarm as Colm Kelleher walked into his office later in the day, his face ashen. “John, we’re going to be out of money on Friday,” Kelleher said with his staccato British inflection. He had been nervously watching the firm’s tank—its liquid assets—shrink, the way an airline pilot might stare at the fuel gauge while circling an airport, waiting for landing clearance.

Current Treasury secretary Timothy Geithner. By Ben Baker/Redux.

“That can’t be,” Mack said anxiously. “Do me a favor: go back to the financing desk—go through it again.”

Kelleher returned to Mack’s office 30 minutes later, less shaken, but only slightly. After finding some additional money trapped in the system between trades that hadn’t yet settled, he revised his prognosis: “Maybe we’ll make it through early next week.”
Day Two
Thursday, September 18, 2008: Fortress Goldman Under Attack

The panic at Goldman Sachs could no longer be denied. Perhaps the greatest sign of anxiety was the fact that Gary Cohn, Goldman’s co-president, who usually remained perched in his 30th-floor office, had relocated himself to the office of Harvey M. Schwartz, head of global-securities-division sales, who had a glass wall looking onto the trading floor. The door was left open; Cohn wanted to see and hear exactly what was going on.

Goldman’s shares opened down 7.4 percent. Investors were quickly beginning to believe the unthinkable: that Goldman, too, could falter. In two days, its share price had dropped from $133 to $108.

Every five minutes a salesman would tear into Schwartz’s office with news of another hedge fund announcing its plan to move its money out of Goldman, and would hand Cohn a piece of paper with the hedge fund’s phone number so he could try to talk some sense into them. With Morgan Stanley slowing down its payouts, some investors were now testing Goldman, asking for $100 million just to see if it could afford to pay. In every case, Cohn would wire the money immediately, concerned that if he didn’t the client would abandon the firm entirely.

Nevertheless, Stanley Druckenmiller, a George Soros acolyte worth more than $3.5 billion, had taken most of his money out earlier that week, concerned about the firm’s solvency. If word got around that a hedge-fund manager of Druckenmiller’s reputation had lost confidence in Goldman, that alone could cause a run. Cohn called him and tried to persuade him to return the money to the firm. “I have a long memory,” Cohn, who was taking this personally, told Druckenmiller, in whose honor he had even once hosted a charity cocktail party. “Look, the one thing I’m doing is I’m learning who my friends are and who my enemies are, and I’m making lists.”

Druckenmiller, however, was unmoved. “I don’t really give a shit—it’s my money!” he shot back. Unlike most hedge funds, Druckenmiller’s consisted primarily of his own money. “It’s my livelihood,” he said. “I’ve got to protect myself, and I don’t really give a shit what you have to say.”

“You can do whatever you want,” Cohn said in carefully measured tones. But, he added, “this will change our relationship for a long time.”

‘Listen, [JPMorgan Chase C.E.O.] Jamie [Dimon] just called me fishing around for something,” Colm Kelleher told John Mack midday Thursday as he marched into Mack’s office. “He said he was calling to see if he could be of help. It was strange.”

James Gorman, the firm’s co-president, had just reported receiving a similar call, Mack replied, and Geithner had phoned earlier to suggest that he talk to Dimon as a possible merger partner, too.

“It’s clear that, for him to be calling us, he wants to do a deal,” Kelleher said. “Jamie is always hanging around the hoop.… You know Jamie’s saying, ‘Let’s make friends with these guys before I eat them.’”

Mack was irritated by these suggestions; he didn’t particularly want to do a deal with Dimon, as he believed it would involve far too much overlap. But he decided to stop guessing what Dimon might be up to and ask him directly.

“Jamie, Geithner says I should call you,” Mack said abruptly when he reached Dimon on the phone a few minutes later. “Let’s get this out in the open: do you want to do a deal?”

“No, I don’t want to do a deal,” Dimon said flatly.

“Well, that’s interesting,” Mack retorted. “You’re calling my C.F.O. and you’re calling my president—why would you do that?”

“I was trying to be helpful,” Dimon repeated.

“If you want to be helpful, then talk to me. I don’t want you calling my guys,” Mack said, hanging up the phone.

Lloyd Blankfein, his top shirt button undone and tie slightly askew, looked at his computer screen and saw in dismay that his stock price had dropped 22 percent over the past several hours to $89.29.

In his e-mail in-box was a message from one of his traders saying that JPMorgan was trying to steal his hedge-fund clients by telling everyone that Goldman was going under. It was becoming a vicious circle.

Blankfein had been hearing these rumors for the past 24 hours, but he had finally had enough. He was furious. The rumormongering, he felt, had gotten out of control. And he couldn’t believe JPMorgan was trashing his firm to his own clients. He could feel himself becoming as anxious as Mack had sounded when they spoke the day before.

He called Dimon, too. “We’ve got to talk,” Blankfein began, then tried to calmly explain his problem. “I’m not saying you’re doing it, but there are a lot of footprints here.”

“Well, people may be doing something that I don’t know about,” Dimon replied. “But they know what I’ve said, which is that we’re not going after our competitors in the middle of all this.”

Blankfein, however, wasn’t buying this explanation. “But, Jamie, if they’re still doing it, you can’t be telling them not to!” Trying to get his point across, Blankfein, a movie buff, started doing his own rendition of A Few Good Men: “Did you order the Code Red? Did you say your guys would never do anything?” Dimon just listened patiently, eager not to get Blankfein even more wound up.

“Jamie, the point is, I don’t think you’re telling them to do this, but if you wanted to stop them in your organization, you could scare them into not doing it,” Blankfein said.

Even in its panicked state, Goldman was still Goldman, and Dimon didn’t want a war. Within half an hour he had his deputies Steve Black and Bill Winters send out a companywide e-mail: “We are operating as business as usual with Morgan Stanley and Goldman Sachs as counterparties. While they are both formidable competitors, during this period, we do not want anyone approaching their clients or employees in a predatory way.”

The 50th-floor office of Goldman’s fixed-income trading unit, in Lower Manhattan, was in near meltdown by lunchtime on Thursday. No trading was taking place, and the traders themselves were glued to their terminals, staring at the GS ticker as the market continued its swoon. Goldman’s stock dropped to $85.88, its lowest level in nearly six years.

Jon Winkelried, Goldman’s other co-president, had been walking the floors, trying to calm everyone’s nerves. “We could raise $5 billion in an hour if we wanted to,” he told a group of traders, as if to suggest that nothing was amiss. But just then, at one p.m., the market—and Goldman’s stock—suddenly turned around, with Goldman rising to $87 a share, and then $89. Traders raced through their screens trying to determine what had been responsible for the lift and discovered that the Financial Services Authority in the U.K. had announced a 30-day ban on short-selling 29 financial stocks, including Goldman Sachs’s.

The squawk boxes on Goldman’s trading floor soon crackled to attention. A young trader found a recording of “The Star-Spangled Banner” on the Internet and broadcast it over the speakers to commemorate the moment. About three dozen traders stood up from their desks, placed their hands over their hearts, and sang aloud, accompanied by rounds of high-fives and cheers.

Goldman Sachs C.E.O. Lloyd Blankfein. By Michelle V. Agins/The New York Times/Redux.

At exactly 3:01 p.m. the market took off. Traders all over Wall Street turned up the volume on the trading-floor flat-screens when Charlie Gasparino reported what he was hearing from his sources on Wall Street: the federal government was preparing “some sort of R.T.C.-like plan” (referring to the Resolution Trust Corporation, formed in 1989 during the savings-and-loan crisis) that would “get some or all of the toxic waste off the balance sheets of the banks and brokerages.” Between the time Gasparino began his report and the segment ended, the market jumped 108 points.

But Blankfein was not mollified by the market’s late turnaround, with Goldman’s stock ending the day up at $108. Gary Cohn had been on the phone earlier in the day with Kevin Warsh at the Federal Reserve, brainstorming a way to get in front of the financial tsunami. Warsh had thrown out the idea that perhaps Goldman should be looking at a merger with Citigroup, a fit that could solve major problems for both parties. Goldman could get a huge deposit base, while Citigroup would acquire a management team that investors could support.

Cohn expressed his doubts about the suggestion. “It probably doesn’t work, because I could never buy their balance sheet,” he explained. “And the social issues would be enormous.” The expression “social issues” was yet more Wall Street code, for who would run the firm. Goldman’s management didn’t exactly have high regard for Pandit and his team.

“Don’t worry about the social issues,” Warsh told him. “We’ll take care of them.” That was a not-so-subtle hint that, if a deal was struck, Pandit might be out of a job.

But Blankfein wasn’t particularly interested in either alternative. Goldman’s lawyer Rodgin Cohen, from Sullivan & Cromwell, had been encouraging him to think about transforming the firm into a regulated bank-holding company, such as JPMorgan and Citigroup. That would give Goldman unlimited access to the Fed’s discount window, enabling it to borrow funds at the same cheap rate as the government and to raise capital more easily, among other things.

Blankfein had always resisted the idea, however, because it came with a hefty price tag in the form of increased regulatory oversight. But these were extraordinary circumstances, to say the least, and the C.E.O. sensed that the world might be moving inexorably in that direction.

John Mack was still at his office in Times Square when Tom Nides told him the good news: his sources at the S.E.C. had confirmed that the agency was preparing to finally put in place a ban on shorting financial stocks, affecting some 799 different companies.

Rumors of the pending action were already moving on the wires. James Chanos, perhaps the best known of the short-sellers, who had pulled his money from Morgan Stanley because of Mack’s support for the ban, was already on the warpath.

That day, Morgan Stanley’s stock had fallen 46 percent, only to turn around in the last hours of trading, ending up 3.7 percent, or 80 cents. Between word of the government’s intervention and the short-selling ban, Mack was hoping that he’d finally have some breathing room.

He knew, though, that beneath the surface the firm was hurting. Hedge funds continued to seek redemptions. What the firm needed most was an investor to step up and take a big stake in the company to shore it up. “I don’t know how this happened,” he confided in Nides.

Mack could think of only one investor that might be seriously interested in making a sizable investment in the firm: China Investment Corporation (C.I.C.), China’s first sovereign-wealth fund. Wei Sun Christianson, C.E.O. of Morgan Stanley China, a 51-year-old dynamo with close relationships throughout the Chinese government, had initiated discussions with Gao Xiqing, president of C.I.C., within the past 24 hours. She happened to be in Aspen at a conference with him hosted by Teddy Forstmann, the leveraged-buyout king. C.I.C. already held a 9.9 percent stake in Morgan Stanley, and Gao had indicated to Christianson that he’d be interested in buying up to 49 percent of the firm. Gao had a major incentive to keep Morgan Stanley alive: he had invested $5 billion in the firm in December 2007, which was now worth half that. If Morgan Stanley filed for bankruptcy, he might lose his job.

Mack and Nides discussed the deal, and while neither man was particularly interested, given their choices, they knew it might prove to be the only solution. Gao was planning to fly to New York Friday night to meet with them.

Earlier in the day, Mack had spoken with Hank Paulson, who prided himself on his extensive Chinese contacts, trying to persuade him to call the Chinese government and encourage them to pursue the deal. It was a tad unusual to ask the government to serve as a broker, but Mack was desperate. “The Chinese need to feel as if they are being invited in,” Mack explained. Paulson said he’d work on it and see if President Bush would be willing to call Chinese president Hu Jintao. “We need an independent Morgan Stanley,” Paulson affirmed.

Nides, however, had a more cynical view of Paulson’s desire to protect Morgan Stanley. “He’ll keep us alive,” Nides told Mack, “because if he doesn’t, then Goldman will go.”
Day Three
Friday, September 19, 2008: The Asians Are Coming

Hoarse and a little haggard, Paulson made his way to the podium in the pressroom of the Treasury Building to formally announce and clarify what he had christened earlier that morning as the Troubled Asset Relief Program, soon known as tarp, a vast series of guarantees and outright purchases of “the illiquid assets that are weighing down our financial institutions and threatening our economy.” John Mack had been watching CNBC on Friday morning when he received a phone call from Lloyd Blankfein. “What do you think of becoming a bank-holding company?” Blankfein asked Mack.

Mack hadn’t really studied the issue and asked, “Would that help us?”

Blankfein said that Goldman had been investigating the possibility and explained to him the benefits.

“Well, in the long run it would really help us,” Mack said. “In the short run, however, I don’t know if you can pull it off fast enough to help us.”

“You have to hang on,” Blankfein urged him, clearly still anxious about how punishing the markets had become, “because I’m 30 seconds behind you.”

Meanwhile, Jon Pruzan, the Morgan Stanley banker who had been assigned to review Wachovia’s $122 billion mortgage portfolio—to crack the tape—finally had some answers. A team of Morgan bankers in New York, London, and Hong Kong had worked overnight to sift through as many mortgages as they humanly could.

“Now I know why they didn’t want to give us the tape!” Pruzan announced dourly at a meeting before they headed over to Sullivan & Cromwell to begin due diligence on Wachovia. “It shows they’re expecting a 19 percent cumulative loss.”

“You’ve got to be fucking kidding me,” Robert Scully exclaimed. “We obviously can’t do this deal.”

To make it work, Morgan Stanley would have to raise some $20 to $24 billion of equity to capitalize the combined firms, a virtual impossibility under the current market conditions. Scully described Wachovia’s mortgage book as “a $40 to $50 billion problem. It’s huge. The junior Wachovia team is not disputing our analysis.”

Kelleher, who had been keeping a careful watch over the firm’s dwindling cash pile, had just taken a look at Wachovia’s numbers for himself and observed, “That’s a shit sandwich even I can’t get my big mouth around.”

It became increasingly clear to everybody that the only way this deal was going to take place was if the government provided a guarantee, which nobody thought would happen. Steel and Mack agreed they’d get back in touch, but before he hung up, Steel asked Mack for a favor. “It wouldn’t be helpful if it leaked out that we’re not talking,” he said.

Morgan Stanley C.F.O. Colm Kelleher. Courtesy of Morgan Stanley.

The waiter at Blue Fin had just brought several massive plates of sushi—spicy lobster rolls, pieces of yellowtail tuna, and tobiko—when Colm Kelleher’s cell phone rang. He had gone to get a late lunch with his Morgan Stanley colleagues, including James Gorman, Walid Chammah, and Tom Nides, and the group had been chatting about their plan to meet later that night with Gao Xiqing and his team. With Wachovia effectively out of the picture, the Chinese were now their sole prospect.

When Kelleher looked down at the caller ID, he saw it was a number in Japan and walked to the corner of the restaurant.

Jonathan Kindred, president of Morgan Stanley’s securities business in Tokyo, greeted him and said excitedly, “This is interesting. I just got a call from Mitsubishi. They want to do the deal.” Mitsubishi UFJ, Japan’s biggest bank, was interested in buying a stake in Morgan Stanley.

The call had come completely unexpectedly and was totally unsolicited. Earlier in the week Morgan Stanley’s management had actually ruled out calling Mitsubishi after its chairman, Ryosuke Tamakoshi, said publicly that following Lehman’s bankruptcy his firm would not be making any investments in the United States.

Kindred said he thought Mitsubishi was prepared to move quickly. But Kelleher, rolling his eyes, was skeptical. He had worked with other Japanese banks before, and in his experience, they had always lived up to their reputation as being slow, risk-averse, and deeply bureaucratic.

James Gorman’s eyes widened when Kelleher returned to the table with Kindred’s news. This could be exactly what they needed, he thought.

Kelleher only scoffed. “This is a waste of time—they’re never going to do anything.”

“Colm, I really feel they’re going to do something,” Gorman insisted. He thought the fact that Mitsubishi had initiated the call to express interest was an encouraging sign. “This stuff doesn’t happen by accident.”

Kevin Warsh had taken the US Airways shuttle to New York late on Friday to help Geithner think through how to handle the upcoming weekend. Just as important, he would be Bernanke’s eyes and ears on the ground. As his driver made his way from La Guardia Airport through traffic to the New York Fed, Warsh received a call from Rodgin Cohen, the Sullivan & Cromwell lawyer who by now was advising both Wachovia on its talks with Morgan Stanley, and Goldman Sachs on its bank-holding-company status. He told Warsh he had an idea—a potentially big one. It wasn’t an officially sanctioned plan by his clients, just a friendly suggestion from an old-timer in the business.

He suggested to Warsh that the government attempt a shotgun wedding between Goldman and Wachovia. He knew it was a long shot—the “optics,” he acknowledged, would be problematic, given that Paulson and Bob Steel were both former Goldman men—but it would solve everyone’s problems: Goldman would get the deposit base it had been seeking, and Wachovia would have its death sentence stayed.

Warsh listened to the proposal and, almost to his own surprise, liked it.

Gao Xiqing, dressed in a sporty turtleneck and blazer, arrived at Morgan Stanley with his team just after nine p.m., having flown into New York with Morgan Stanley’s Wei Sun Christianson on a private jet from Teddy Forstmann’s Aspen conference. Gao’s bad back was causing him so much pain that when James Gorman went to introduce himself he found Gao lying on the floor of a conference room on the 40th floor, in the middle of a telephone call. Mack, ever the accommodating host, had a couch brought from the executive dining room for his guest to lie on.

Over dinner, ordered in from Mack’s favorite restaurant, San Pietro, they discussed a possible transaction. Alternating between standing up and lying down, Gao reiterated his interest in buying 49 percent of Morgan Stanley. As he had told Christianson on the flight over, he was now prepared to provide the firm with a credit line of as much as $50 billion and a nominal equity investment—no more than $5 billion, maybe less.

Mack was stunned. He knew the price that would be offered might be low, but to him this was absurdly so—the company was worth nearly $40 billion. This offer was effectively just a loan. While it might help Morgan Stanley stay in business, Gao was clearly taking advantage of its weakened condition. To Gao, the offer presented a way to reset the price he had paid for the 10 percent stake he had acquired in Morgan Stanley, in 2007, which was now worth far less. Unlike deals that other sovereign-wealth funds had struck then, giving them the right to reset the value of the deal if the firms sold equity at a lower price later, C.I.C. hadn’t had the presence of mind to insist on that stipulation. For some inexplicable reason, Gao had convinced himself that the agreement did include such a provision until Morgan Stanley got him a copy to show him that it didn’t.

However insulting Gao’s proposal, Mack recognized that his situation was desperate. Despite the market rally, the firm had continued to bleed cash. Kelleher had given him the cash balances, and they were not good—about $40 billion left in the tank. A few bad days could wipe them out, and most days lately had been bad ones.

When Mack returned to his office and huddled with Christianson and his team, they were flabbergasted; Chammah initially thought he had misheard Christianson when she presented the offer.

“That’s a ludicrous ask,” Kelleher said. “They are being unreasonable.”

Gorman, trying to calm everyone down, said they should all hope it might just be an opening bid: “They ask for the moon and then maybe they get more reasonable?”
Day Four
Saturday, September 20, 2008: Shall We Dance?

Tim Geithner hadn’t slept well on Friday night, having again decided to stay in one of the grim rooms on the 12th floor of the Federal Reserve. By six a.m., he had returned upstairs to his office dressed in an oxford dress shirt and sweatpants.

In his mind, he was already making battle plans. He had made it safely to the weekend but was worried about what would happen on Monday.

“John’s holding on to a slim reed,” Paulson had told Geithner about John Mack’s perilous position on a phone call the night before. Paulson was also still anxious about Goldman Sachs, his former employer. “We’ve got to find a lifeline for these guys,” said Paulson, and they reviewed the possible options.

On note cards that morning, Geithner started writing out various merger permutations: Morgan Stanley and Citigroup. Morgan Stanley and JPMorgan Chase. Morgan Stanley and Mitsubishi. Morgan Stanley and C.I.C. Morgan Stanley and Outside Investor. Goldman Sachs and Citigroup. Goldman Sachs and Wachovia. Goldman Sachs and Outside Investor. Fortress Goldman. Fortress Morgan Stanley.

It was the ultimate Wall Street chessboard.

Lloyd Blankfein arrived at his office at just past seven on Saturday morning. On Friday, Gary Cohn had had another conversation with the Fed’s Kevin Warsh, who encouraged him to keep looking at merger options, especially at Citigroup. Initially Cohn’s notion was that Citi should buy Goldman; he had even established an asking price. But Warsh suggested that Cohn approach it the other way around: Goldman should be the buyer. To Cohn, that made no sense, given that Citi was so much bigger. But what Warsh knew—and hadn’t yet shared with Cohn—was that Citigroup’s balance sheet had so many holes that its value was likely a lot lower than its current stock price reflected.

Blankfein was reading an e-mail when John Rogers, Goldman’s chief of staff, arrived. As they were reviewing their own battle plans, Geithner called. In his usual impatient tone, he insisted that Blankfein immediately call Vikram Pandit, Citigroup’s C.E.O., and begin merger discussions. Blankfein, surprised at the directness of the request, agreed he would place the call.

“Well, I guess you know why I’m calling,” Blankfein said when he reached Pandit a few minutes later.

“No, I don’t,” Pandit replied with genuine puzzlement.

Citigroup C.E.O. Vikram Pandit. By Chip Somodevilla/Getty Images.

There was an awkward pause on the phone. Blankfein had assumed that the Fed had pre-arranged the call. “Well, I’m calling you because at least some people in the world might be thinking that combining our firms would be a good idea,” he said.

After another few moments of uncomfortable silence Pandit finally replied, “I want you to know I’m flattered by this call.”

Blankfein now began to wonder if Pandit was putting him on. “Well, Vikram,” he said briskly, “I’m not calling with any flattery towards you in mind.”

Pandit hurriedly ended the call: “I’ll have to talk to my board. I’ll call you back.”

Blankfein hung up and looked up at Rogers. “Well, that was embarrassing. He had no idea what I was talking about!” From Blankfein’s perspective, he had done what he was asked to do, only to be shown up.

Blankfein phoned Geithner back immediately. “I just called Vikram,” he said testily. “As I think about it, you never told me whether Vikram was expecting a call, but I inferred it. He behaved as if he wasn’t expecting the call, and he convinced me that he wasn’t expecting the call.”

Geithner had miscalculated—could Pandit not see the gift that was being handed to him? It defied all reason. But Geithner had no time to deal with anybody’s injured feelings. “O.K., I’ll talk to you later,” he said and then hung up. Blankfein sat there, wondering what the hell had just happened.

Bob Steel, of Wachovia, had considered canceling his appearance on the second day of Teddy Forstmann’s weekend conference, but flew into Aspen that morning, having left the East Coast at four a.m. to arrive on time. But as the moderator, Charlie Rose, got to the Q&A portion of the panel, “Crisis on Wall Street: What’s Next?,” Steel was nervously checking his watch because he knew he had to get to New York fast. Jumping into a red Jeep Wrangler that he had rented at the airport, he finally had a minute to check his BlackBerry and discovered that Kevin Warsh had sent him several e-mails urging him to contact him immediately.

“Listen, I have a call for you to make,” Warsh told Steel when he finally reached him. “We think you should connect with Lloyd!”

Steel, reading between the lines, was stunned: the government was trying to orchestrate a merger between Goldman Sachs and Wachovia! On its face, he knew that it could be a politically explosive deal, considering the two firms’ connections to Treasury. Paulson, he imagined, must be involved somehow. But, given Steel’s former role at Treasury, Paulson wasn’t allowed to contact him directly. Steel was immediately anxious about the idea. If Goldman had really wanted to buy Wachovia, he thought, it would have done so long ago. After all, up until this week, when he spoke to Mack, Goldman had been on Wachovia’s payroll as its adviser and, as such, knew every aspect of its internal numbers. So, if there was a bargain to be had, then Goldman hadn’t seen it. Still, Steel saw the merits in such a deal, and because it was being encouraged by the Federal Reserve, he imagined it might just happen.

“I spoke to Kevin, and he said to give you a call,” Steel began when he got through to Blankfein.

This call, unlike the Citigroup fiasco, had been pre-wired. “Yes, I know,” Blankfein said. “We’d be interested in putting a deal together.”

As his plane headed to New York, Steel mused how a deal with Goldman would be something of a homecoming, even if it had been the result of a direct order from the government. Perhaps he could even wrangle the chairmanship.

Jamie Dimon had been hoping to take his first day off in two weeks. That was until Geithner called him early Saturday morning and instructed him—the president of the New York Federal Reserve seldom suggested anything—to start thinking about whether he’d like to buy Morgan Stanley.

“You’ve got to be kidding me,” Dimon replied.

No, Geithner said, he was quite serious.

“I did Bear,” Dimon objected, referring to JPMorgan’s taking over Bear Stearns the previous March at Paulson’s behest. “I can’t do this.”

Geithner ignored the answer. “You’ll be getting a call from John Mack,” he said and hung up the phone.

Mack, who had had a similar peremptory call from Geithner, phoned Dimon five minutes later. Dimon reiterated that he didn’t want to buy Morgan Stanley, which he had already told Mack earlier in the week. But Dimon was under orders to try to help Mack, so the two rivals talked about whether JPMorgan could offer Morgan Stanley a credit line that might give it some breathing room. Dimon said he’d think about it and come back to him with a decision.

As soon as he got off the phone with Mack, Dimon called Geithner. “I talked to John,” he said. “We’re talking about getting him a credit line.”

“I don’t know if that’ll be enough,” Geithner said, frustrated at the news. He wasn’t the slightest bit interested in any temporary measures.

Dimon immediately shot off an e-mail to his operating committee summoning them to the office, and within an hour, dressed in golf shirts and khakis, they had assembled in a conference room on the 48th floor.

Dimon had a grimace on his face as he related the call he’d received from Geithner. On a whiteboard Dimon used a black marker to sketch out what he had been thinking. “We can either buy them, buy part of them, or give them some type of financing.”

But what, exactly, would they be buying? The overlap between the firms was enormous. And what were Morgan Stanley’s toxic assets really worth? These were all but unanswerable questions.

Geithner was by now seriously miffed. He had been trying to reach Pandit since eight in the morning and had just heard back from Blankfein, who had somehow actually managed to get through to Pandit again. The only problem was that Pandit had turned Goldman down, and Geithner hadn’t even had a chance to speak with him.

Finally, he got through.

“I haven’t been able to reach you for four hours,” Geithner barked into the phone. “That’s unacceptable on a day like today!”

Apologizing, Pandit explained that he had been talking to his team about the Goldman proposal, which they had ultimately rejected. “We’re concerned about taking on Goldman,” Pandit said, trying to explain his rationale for turning them down. “I don’t need another trillion dollars on my balance sheet.”

Geithner could only laugh to himself—Pandit should have been so lucky as to own Goldman. “This is a bank,” Pandit said. “And a bank takes deposits and a bank has a prudency culture. I cannot envision a bank taking its deposits and investing them all in hedge funds. I know that’s not what Goldman is, but the perception is that they’d be taking deposits and putting them to work against a proprietary trade. That can’t be right philosophically!”

Having dispensed with pushing Goldman and Citigroup together, Geithner moved on to his next idea: merging Morgan Stanley and Citigroup. Pandit had been considering that option, too, and while he was more predisposed to merging with Morgan Stanley, he still was reluctant. “It’s still not our choice to do this deal, but we could think about it,” he told Geithner.

By two p.m., John Mack had grown concerned that the talks with C.I.C. were going nowhere. Gao hadn’t budged on what Mack was describing around the office as an “offensive” offer. He had no idea what Jamie Dimon would come up with, and he hadn’t heard anything from Mitsubishi.

Downstairs, Paul Taubman, the firm’s head of investment banking, was experiencing much the same panic as Mack. A disarmingly young-looking 48-year-old, Taubman had worked his entire career at Morgan Stanley, rising to become one of the most trusted merger advisers in the nation, and could now only wonder if it was all going to come to an end this weekend.

Morgan Stanley chairman John Mack. By Michele Asselin/Corbis.

Taubman and his colleague Ji-Yeun Lee were on the phone to Tokyo, where it was past midnight, with Kohei Yuki, Morgan Stanley’s vice-chairman and director in Japan, who was trying to coordinate talks with Mitsubishi.

“I think they’ve gone to bed for the night—we’ll pick it up in the morning,” Yuki said.

“That’s not going to work,” Taubman answered. “You need to call them at home and wake them up.”

There was a long pause; this was certainly a breach of Japanese protocol.

“O. … K.,” he said.

Twenty minutes later, Yuki was back on the phone: “I got him.” Mitsubishi was going to wake up its entire deal team and get working.

Goldman co-president Gary Cohn had agreed to engage in talks with Wachovia only on the presumption the Fed would help Goldman off-load some of Wachovia’s most toxic assets; Warsh, in a bold gesture, made a commitment that the Fed would strongly consider it. Paulson had spoken with Blankfein and told him to take the talks seriously. “If you go into this looking for all the problems and how much help you’re going to get, it’s never going to happen,” he said, adding, “You’re in trouble, and I can’t help you.”

In the meantime, Warsh instructed Cohn to make sure they could work out the personal dynamics. “Let’s not waste our time on economics if you guys are never going to solve the social issues,” he said. “If you aren’t willing to accommodate them, if Bob [Steel]’s not willing to do whatever, this isn’t going to happen.”

Steel was scheduled to land at Westchester County Airport, in White Plains, a suburb of New York City, in only a few hours, and Cohn walked into Blankfein’s office and made a suggestion.

“Lloyd, you should go pick Steel up at the airport,” Cohn said, believing it would be a gracious gesture to kick off the merger talks.

Blankfein looked seriously annoyed. He felt that he had not gotten along with Steel particularly well ever since Paulson had made them co-heads of Goldman’s equities division years earlier. “Do I have to?”

“Yes,” Cohn said firmly. “I would go with you, but it would be awkward. You should go pick him up.”

Blankfein was still resistant. “Can you go by yourself?”

“No,” said Cohn, who considered Steel a friend. “I already have a very good relationship with him.”

Blankfein relented. He’d head to the airport. Wearing slacks and a button-down shirt, he was waiting in the parking lot when Bob Steel arrived. As he walked out of the terminal, Steel, always perfectly coiffed, nonetheless looked as if he could use some sleep. He had already been awake for 15 hours, and his day was hardly done.

“What a birthday present!” Blankfein said to Steel brightly when he saw him. Blankfein, who turned 54 that day, was still hoping to get to a birthday dinner later that evening at Porter House New York, a steak restaurant, with his wife, Laura.

As the two men drove into the city they delicately began discussing the outlines of a deal and discussing their history together. Neither knew what to make of the merger idea or, for that matter, each other.

When they reached Goldman headquarters, Steel went directly to the 30th floor, where he once had an office. As he stepped into the conference room, he saw Chris Cole, who had been his firm’s adviser for the past five months. Now Cole would be on the other side, trying to buy Wachovia. Meanwhile, Steel’s lawyer, Rodgin Cohen, was also Goldman’s lawyer. It had all become so confusing and rife with conflicts, but they agreed that if they were going to do a deal they’d have to reach an agreement by Monday morning.

Goldman’s biggest issue was, as it had been with Morgan Stanley, trying to determine the scope of the hole. Wachovia owned $122 billion of pay-option arms—adjustable-rate mortgages—which Goldman Sachs felt weren’t going to be worth much. They each agreed to put teams on it to work up the numbers; Steel said he’d have his group fly up from North Carolina by morning.

Before decamping for the night, Blankfein invited Steel back to his office. He wanted to talk about titles, perhaps the most sensitive issue for men who often measure themselves as much by their business cards as by their wallets. Blankfein said he was thinking of making Steel one of three co-presidents, along with Gary Cohn and Jon Winkelried; Steel would continue to manage Wachovia as the consumer arm of Goldman Sachs.

Steel was taken aback and slightly offended. He was already the C.E.O. of a major bank; he’d been a vice-chairman of Goldman and a Treasury undersecretary in Washington. And now he was being asked to become one of three co-presidents?

“I’m not sure I want to be at the same level with Gary and Jon,” he said diplomatically. “But we’ll figure this out.”

As the sun was setting, Hank Paulson was still in his office and had just gotten off the phone with Geithner. The news was not promising. Geithner told him that Morgan Stanley had no plan apart from what he called the “naked” bank-holding-company scenario. Geithner said he was uncertain whether any investor—JPMorgan, Citigroup, the Chinese, or the Japanese—would come through. And he was skeptical of the Goldman-Wachovia deal.

“We’re running out of options,” he told Paulson.

Paulson, who had been living on barely three hours of sleep a night for a week, was beginning to feel nauseated. Watching the financial industry crumble in front of his eyes—the world he had inhabited his entire career—was getting to him. For a moment, he felt light-headed.

From outside his office, his staff could hear him vomit.

Saturday night, John Mack returned to his Upper East Side apartment, nursing a persistent cold. His wife, Christy, who had driven into the city from their weekend house in the suburban town of Rye to console him, was waiting up.

He was quieter than usual, wondering yet again how he would manage to raise billions of dollars in capital in only 24 hours. “You know, there’s a chance I could lose the firm,” he said, despair in his voice.

He needed some air, he told Christy, and decided to go out for a walk. As he roamed up Madison Avenue, he realized that his entire adult life, his entire professional career, was on the line. But this was not just about his personal survival; it was about the 45,000 people around the globe who worked for him, and for whom he felt a keen sense of responsibility. Images of Lehman employees streaming out of their building the previous Sunday night carrying boxes of their possessions still haunted him. He needed to buck himself up. Somehow, he was going to save Morgan Stanley.

When he stepped into his living room a few minutes later, he admitted to Christy with a grateful smile, “I’d rather be doing this than reading a book in North Carolina.”

Even before the black Suburban had come to a stop in his driveway, in a leafy enclave of Northwest Washington, D.C., on Saturday evening, Hank Paulson was stepping out of the car door, his Razr at his ear. His Secret Service agent preferred that Paulson wait inside until he got out of the vehicle, but Paulson had long since abandoned such protocol.

He raced inside to get on a call with Vice Premier Wang Qishan in China. For the past day, he had been trying to coordinate the call to press his case for China to pursue an investment in Morgan Stanley. Originally, he had wanted President Bush to call China’s president personally and had spoken with Josh Bolten, the president’s chief of staff, about it. But Bolten had concerns about whether it was appropriate for the president to be calling on behalf of a specific U.S. company.

Paulson had scheduled the call with Wang for 9:30 p.m. He knew Wang well from his trips to China as the C.E.O. of Goldman, and they had a comfortable rapport. He also knew it was highly unusual to be orchestrating a private market deal with another country, in this case the largest holder of U.S. debt. Before placing the call, Paulson had reached out to Stephen Hadley, the national-security adviser, to get some guidance. The instructions: Tread carefully.

JPMorgan Chase C.E.O. Jamie Dimon. By Joshua Roberts/Bloomberg.

When Paulson was finally connected to Wang, he moved quickly to the topic at hand, Morgan Stanley. “We’d welcome your investment,” Paulson told Wang. He also suggested that one of China’s biggest banks, such as the Industrial and Commercial Bank of China, should participate, making the investment a strategic one. Wang, however, expressed his anxiety about C.I.C.’s becoming involved with Morgan Stanley, given Lehman Brothers’ bankruptcy.

“Morgan Stanley is strategically important,” Paulson said, suggesting he would not let it fail.

Wang remained unimpressed, asking for a commitment that the U.S. government would guarantee any investment. Paulson, trying to avoid making an explicit promise but also trying to assuage him, said, “I can assure you that an investment in Morgan Stanley would be viewed positively.”
Day Five
Sunday, September 21, 2008: The Last Stand

By midday, Goldman Sachs and Wachovia were making rapid progress toward completing a deal. Peter Weinberg, Bob Steel’s main adviser and a former Goldman man, had constructed the outlines of an agreement. Just then, Joseph Neubauer, a Wachovia board member and the C.E.O. of Aramark, who was on hand at Goldman, got a call on his cell phone. It was Paulson. “This is not just about Goldman Sachs,” Paulson said, pressing him to do the deal. “I’m concerned about Wachovia. Aren’t you concerned?”

When Neubauer put down the phone, he looked at his fellow directors. “You’re not going to believe this. That was Hank.”

Warren Buffett was at his home in Omaha when he received a phone call from Byron Trott, a vice-chairman at Goldman Sachs. Buffett, who dislikes most Wall Street bankers, adored Trott, a mild-mannered midwesterner based in Chicago. For the past several weeks Trott had been trying in vain to persuade Buffett to make an investment in Goldman, but he had now come up with a new idea. He disclosed to Buffett that Goldman was in talks to buy Wachovia, with government assistance, and wanted to know whether Buffett might be interested in investing in a combined Goldman-Wachovia.

At first, Buffett wasn’t sure he was hearing Trott correctly. Government assistance? In a Goldman deal?

“Byron, it’s a waste of time,” he said in his folksy way after considering the new configuration. “By tonight the government will realize they can’t provide capital to a deal that’s being done by the former firm of the Treasury secretary with the company of a former vice-chairman of Goldman Sachs and former deputy Treasury secretary. There is no way. They’ll all wake up and realize, even if it was the best deal in the world, they can’t do it.”

John Mack had received some promising news that afternoon: Mitsubishi looked like it would actually pull through and make a sizable investment in Morgan Stanley. A conference call had been arranged for Mack to speak with Mitsubishi’s chief executive, Nobuo Kuroyanagi, that evening.

Just as they were going over the details, however, Paulson called.

“John, you have to do something,” Paulson said sternly.

“What do you mean I have to do something?” he asked, his voice rising with impatience, explaining that he had just learned that the Japanese were inclined to do the deal. “You’ve been so supportive—you said we can get through this.”

“I know,” Paulson said, “but you’ve got to find a partner.”

“I have the Japanese! Mitsubishi is going to come in,” he repeated, as if Paulson hadn’t heard him the first time around.

“Come on. You and I know the Japanese. They’re not going to do that. They’ll never move that quickly,” Paulson said, suggesting that Mack focus more on the deal with the Chinese or JPMorgan.

“No, I do know them. And I know I don’t agree with you,” Mack answered angrily. He explained that Mitsubishi had used Morgan Stanley as an adviser during its hostile bid for a part of Union Bank in California earlier in the year. “Japanese rarely do a hostile,” Mack reminded him. “They hired us, they followed through and got it done, so they’ll come through for us.”

Paulson was still skeptical. “They won’t do it,” he said with a sigh.

“You and I disagree,” Mack sputtered.

Calling Kevin Warsh out of a meeting at the Fed to come to the phone, Gary Cohn outlined the preliminary Goldman-Wachovia terms for him. They had agreed to a deal at market—Friday’s closing price of $18.75—and considering that Wachovia’s stock had jumped 29 percent that day on the back of the tarp news, Cohn thought it was a generous concession.

But then he wound up for his big pitch: to complete the deal, he said, Goldman would need the government to guarantee, or ring-fence, Wachovia’s entire portfolio of pay-option arm mortgages—all $122 billion worth.

Warsh stopped Cohn in midsentence. “We’re just not prepared to do that,” he said. “We can’t look as if we’re just writing a blank check.” He suggested that if they structured it so that Goldman would take a first loss—in the same way that JPMorgan had agreed to accept the first $1 billion of losses at Bear Stearns before the Federal Reserve would step in and guarantee the next $29 billion—the government might well consider acting as a backstop.

At Treasury, Jim Wilkinson, Paulson’s chief of staff, was by now practically sleepwalking down the halls. Paulson had just updated him on the Goldman-Wachovia talks and asked him for his counsel. Should the government provide assistance? Wilkinson, in his stupor, said he thought that it sounded like a reasonable idea.

But a half-hour later, after a cup of coffee and further reflection, Wilkinson changed his mind. He realized that such a deal would be a public-relations nightmare at the worst possible time, just as they were trying to pass tarp. Paulson would lose all credibility; he would be accused of lining the pockets of his friends at Goldman; the “Government Sachs” conspiracy theories would flourish.

Wilkinson ran back into Paulson’s office. “Hank, if you do this, you’ll get killed,” Wilkinson said frantically. “It would be fucking crazy.”

Ben Bernanke was being piped in over the speakerphone in Geithner’s conference room, where Warsh was reviewing the new terms of the Goldman-Wachovia agreement. Cohn and Steel had come back to him with a slight revision to the previous proposal, allowing for Goldman Sachs to take the first $1 billion of losses, per Warsh’s suggestion. Cohn and Steel said they were committed to completing the deal that afternoon if the government would agree to provide assistance. The boards of both companies had been put on standby.

The general view in the room seemed to be that it was a good transaction, but Geithner was quick to point out its drawbacks. “Does it make Goldman look weaker than they are?” he asked—a question Blankfein had raised earlier in the day. Geithner also wondered whether the Fed should be the one lending the money. Since Wachovia’s regulator was the F.D.I.C., perhaps it ought to be the one to bear that burden.

Terry Checki from the New York Fed couldn’t believe the gall of Goldman’s request. “They’re still driving these negotiations as though they have leverage,” he said. But he opposed the merger for a different reason: he was concerned that neither side had enough time to make a thoughtful decision, referring to the situation as “the shotgun-wedding syndrome.”

Then the New York Fed’s Bill Dudley, a former Goldman man himself, who thought the deal was unattractive for the government, raised the same objection that Buffett had raised just hours earlier: it would prove a public-relations disaster for the government.

“What are we doing here?” Dudley asked. “Look at all of the connections you’ve got: Treasury and Steel and me. Goldman is everywhere. We have to be careful.”

After Geithner and Bernanke called Paulson, all three agreed: they just couldn’t support the deal.

When Warsh delivered the news to Steel and Cohn, both men were flabbergasted. They had spent the last 24 hours trying to formulate an agreement at the behest of the government and were now being told it could not be carried out.

How did the economy get into this mess? Visit our archive “Charting the Road to Ruin.” Illustration by Brad Holland.

“I’m sorry. I understand—I’m just as frustrated as you are. We just don’t have the money; we don’t have the authorization,” Warsh explained.

Steel, feeling particularly slighted, told Warsh that he felt as if he were running from one bride to another, trying to find the right marriage to save his firm. First Morgan Stanley, and now Goldman Sachs.

Cohn, realizing that the conversation was about to get testy, said, “I think I should step out.”

“No, you should listen to this,” Steel insisted, raising his voice for the first time. “You should sit here and listen to every goddamn word of this.”

Anxiously talking into the speakerphone in the center of the table, Steel became even more irate. “What do you want me to do? Tell me what to do? You can’t make this work, you don’t like this, you don’t like that. Do you want to do the Midtown deal?” he said, referring to Morgan Stanley. “Do you want me to call Citi? I’ve got to protect my shareholders. That’s my job. Just tell me what the fuck you want me to do because I’m tired of running in circles.”

Paulson had gotten word that the Goldman-Wachovia deal was off, which put even more pressure on him to find a solution for Morgan Stanley. To him, JPMorgan was the obvious answer. While Dimon may have been resisting Paulson’s overtures—Paulson had broached the subject with him several times already over the past day—Paulson felt he now needed to apply some serious pressure.

“Jamie,” Paulson said when he reached him, conferencing in Geithner and Bernanke, “I need you to really think about buying Morgan Stanley. It’s a great company with great assets.”

Dimon, who had been anticipating that the government might try to foist the deal on him, was adamant.

“You’ve got to stop. This is not doable,” he said intently. “It’s not possible. I would do anything for you and for this country, but not if it’s going to jeopardize JPMorgan.

“Even if you gave it to me, I couldn’t do it,” Dimon continued, explaining that he thought the deal would cost the bank $50 billion and countless jobs.

“I don’t want to do it, and John doesn’t want to do it,” Dimon told him.

“Well, I might need you to do it,” Paulson persisted.

A few moments of silence passed until Dimon relented, but only slightly. “We’ll consider it, but it’s going to be tough,” he said.

At about 3:30 p.m., John Mack’s assistant announced that Secretary Paulson was on the line. “Hi, John. I’m on with Ben Bernanke and Tim Geithner. We want to talk to you,” Paulson said.

“Well,” Mack said, “since you’re all on the line, can I put my general counsel on?”

Paulson agreed, and Mack hit the speakerphone button after the television was muted.

“Markets can’t open Monday without a resolution of Morgan Stanley,” Paulson told him in the sternest way he knew. “You need to find a solution—we want you to do a deal.”

Mack just listened, dumbstruck.

Bernanke, who was usually remote and silent in such situations, cleared his throat and added, “You don’t see what we see. We’re trying to keep the system safe. We really need you to do a deal.”

“We’ve spent a lot of time working on this and we think you need to call Jamie,” Geithner insisted.

“Tim, I called Jamie,” Mack replied, clearly exasperated. “He doesn’t want the bank.”

“No, he’ll buy it,” Geithner said.

“Yes. For a dollar!” Mack exclaimed. “That makes no sense.”

“We want you to do this,” Geithner persisted.

“Let me ask you a question: Do you think this is good public policy?” Mack asked, clearly furious. “There are 35,000 jobs that have been lost in this city between A.I.G., Lehman, Bear Stearns, and just layoffs. And you’re telling me that the right thing to do is to take 45,000 to 50,000 people, put them in play, and have 20,000 jobs disappear? I don’t see how that’s good public policy.”

For a moment, there was silence on the phone.

“It’s about soundness,” Geithner said impassively.

“Well, look, I have the utmost respect for the three of you and what you’re doing,” Mack said. “You are patriots, and no one in our country can thank you enough for that. But I won’t do it. I just won’t do it. I won’t do it to the 45,000 people that work here.”

The Morgan Stanley bankers were still waiting to find out if the Mitsubishi deal was a go. The Fed, they had learned, was going to grant them bank-holding-company status (and likely Goldman, too), but Geithner was still insisting the firm needed a big investment by Monday as a show of confidence in the company. Mitsubishi had sent over a proposal, a “letter of intent,” to buy up to 20 percent of the firm for as much as $9 billion. But all they were getting was a letter; it wouldn’t be an ironclad contract, as they couldn’t get a full deal turned around quickly enough. But they were just hoping investors in the market would take the Japanese at their word and have more faith in them than Paulson or Geithner did.

Upstairs, Mack was on the phone with Mitsubishi’s chief executive, Nobuo Kuroyanagi, and a translator trying to nail down the letter of intent. His assistant interrupted him, whispering, “Tim Geithner is on the phone—he has to talk to you.”

Cupping the receiver, Mack said, “Tell him I can’t speak now. I’ll call him back.”

Five minutes later, Paulson called. “I can’t. I’m on with the Japanese. I’ll call him when I’m off,” he told his assistant.

Two minutes later, Geithner was back on the line. “He says he has to talk to you and it’s important,” Mack’s assistant reported helplessly.

Mack was minutes away from reaching an agreement. He looked at Ji-Yeun Lee, who was standing in his office helping with the deal, and told her, “Cover your ears.”

“Tell him to get fucked,” Mack said of Geithner. “I’m trying to save my firm.”

‘Thank God. We’re out!” Jamie Dimon exclaimed as he ran across JPMorgan’s executive floor into his colleague Jimmy Lee’s office, where the management team had camped out waiting for their next orders, watching the Ryder Cup and the New York Giants game, chowing down on steaks from the Palm.

“Mack just called,” Dimon said, breathing a sigh of relief. “They got $9 billion from the Japanese!”

Purchase Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves on

Andrew Ross Sorkin is a financial columnist for The New York Times.


Taxpayers Help Goldman Reach Height of Profit in New Skyscraper
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By Christine Harper

Dec. 21 (Bloomberg) — In the first six months of 2010, about 6,000 employees of Goldman Sachs Group Inc. will take a break from their spreadsheets and move across the southern tip of Manhattan to a new 43-story, steel-and-glass skyscraper.

The building was a bargain — and not just because the final cost is expected to be $200 million less than the $2.3 billion price the company had estimated when construction began in November 2005. Goldman Sachs also benefited from the government’s determination to avoid losing jobs in lower Manhattan after the Sept. 11, 2001, terrorist attacks.

Building a new headquarters cater-cornered to where the World Trade Center once stood qualified the firm to sell $1 billion of tax-free Liberty Bonds and get about $49 million of job-grant funds, tax exemptions and energy discounts. Henry Paulson, then Goldman Sachs’s chief executive officer, threatened to abandon the project after delays in addressing his concerns about safety. To keep the plan on track, state and city officials raised the bond ceiling to $1.65 billion and added $66 million in benefits. The interest expense on the financing is about $175 million less over 30 years than if the company had issued corporate debt at the time, according to data compiled by Bloomberg.

“It was absolutely imperative that Goldman Sachs keep its world headquarters downtown,” says John Cahill, who took part in the negotiations as chief of staff to then-Governor George Pataki and now works at New York law firm Chadbourne & Parke LLP. “They had the financial resources to move anywhere.”

Unprecedented Aid

Goldman Sachs, which set a Wall Street profit record of $11.6 billion in 2007 and may have earned $11.4 billion this year, according to the average estimate of 15 analysts surveyed by Bloomberg, won new and larger concessions from taxpayers in 2008. This time it was the threat of a financial meltdown that prompted the U.S. government, with Paulson as Treasury secretary, and the Federal Reserve to supply an unprecedented amount of aid to firms deemed critical to the financial system, including Goldman Sachs.

The 140-year-old company received $10 billion in capital, guarantees on about $30 billion of debt and the ability to borrow cheaply from the Fed. The Fed’s bailout of American International Group Inc., and its decision to pay the insurer’s counterparties in full, funneled an additional $12.9 billion to Goldman Sachs.

“What was done was appropriate because the potential costs of not doing that were probably exceedingly high,” says Gary Stern, who stepped down in August as president of the Federal Reserve Bank of Minneapolis. “It certainly looked very threatening.”

‘Bad Deal’

That’s not how the Goldman Sachs rescue looks to William Black, a professor of economics and law at the University of Missouri-Kansas City and a former bank regulator. He says the government has been far too generous in allowing the firm to get federal backing without either seizing equity or curbing risks.

“It’s just an unbelievably bad deal,” Black says. “We could hire any middle-tier guy or gal at Goldman, and they would tell us within 15 seconds that the deal we have made as a nation with Goldman is underpriced by many, many orders of magnitude and that we are insane.”

During the past year, Goldman Sachs’s profits and compensation outstripped those of its rivals. The firm, now the nation’s fifth-largest bank by assets, reported a record $8.44 billion in earnings for the first nine months of 2009 after setting aside $16.7 billion to pay employees. That comes to $527,192 for each person on the payroll, almost eight times the median U.S. household income.

Public Anger

The company’s stock is up 93 percent this year, above its price before Lehman Brothers Holdings Inc. collapsed. Meanwhile, the U.S. unemployment rate hit a 26-year high of 10.2 percent in October before dropping to 10 percent in November.

The perception that Goldman Sachs has profited at the expense of taxpayers has fueled public anger — even jabs from the television comedy show “Saturday Night Live.” Rolling Stone writer Matt Taibbi described the firm this year as “a great vampire squid wrapped around the face of humanity.” Conservative television commentator Glenn Beck devoted a 10- minute segment in July to diagramming Goldman Sachs’s connections to the government and arguing that taxpayers were being spun in “a web of lies.”

Bonus Plan

“People are just really angry; you can see it on the left and the right,” says Andy Stern, president of the 2.1 million- member Service Employees International Union, who led about 200 protesters outside Goldman Sachs’s Washington office on Nov. 16 to demand that the firm cancel its year-end bonuses and repay taxpayers instead. Some carried “Wanted” posters with pictures of Chairman and CEO Lloyd Blankfein.

The firm has made attempts to placate critics. On Nov. 17, it announced a five-year, $500 million program to provide education, capital and other forms of support to small businesses. On Dec. 10, it promised to pay the bonuses of the firm’s top 30 executives only in stock that they can’t sell for five years.

To Blankfein, the 55-year-old postal worker’s son who earned $68.5 million in 2007, the firm’s ability to generate profits and reward employees is a boon to society.

“Our shareholders are pensioners, mutual funds and individual investors, and they’re all taxpayers,” Blankfein told investors at a Nov. 10 conference hosted by Bank of America Corp. in New York. “The people of Goldman Sachs are one of the most productive workforces in the world.”


What Goldman Sachs’s workforce produces is different from what employees do at other financial institutions, leading some people to question why the firm is entitled to taxpayer support. It doesn’t operate branches or automated-teller machines. Only millionaires can open checking accounts. Instead, Goldman Sachs exists to serve large corporations, governments, institutions and wealthy individuals.

It makes money for them and for itself by trading assets ranging from stocks and bonds to oil futures and credit derivatives. In the first nine months of 2009, more than 90 percent of the company’s pretax earnings came from trading and principal investments, which include market bets, stakes in corporate debt and equity, and assets such as power plants.

“People who know the industry and know Goldman Sachs know that it is a giant hedge fund, but it’s wrapped in an investment banking wrapper,” says Samuel Hayes, a professor emeritus of investment banking at Harvard Business School in Boston. The public “would be horrified to think that their tax dollars were going to a hedge fund.”

Repaying TARP

Goldman Sachs repaid the $10 billion it received in October 2008 from the U.S. Treasury’s Troubled Asset Relief Program, and taxpayers got a return: $318 million in preferred dividends and $1.1 billion to cancel warrants to buy company stock the government was granted. Goldman Sachs says that’s a 23 percent annualized return for U.S. taxpayers, according to the firm’s calculation.

Other forms of support linger. By the end of September, Goldman Sachs’s $189.7 billion of long-term unsecured borrowings included $20.9 billion guaranteed by the Federal Deposit Insurance Corp. under a program started in October 2008 to unfreeze credit markets, according to the firm’s most recent quarterly filing. Most importantly, the Federal Reserve agreed on Sept. 21, 2008, to allow Goldman Sachs and smaller rival Morgan Stanley to become bank holding companies, giving them access to the Fed’s discount window and granting them a cheap source of borrowing traditionally reserved for commercial banks.

Interest Expense

“The issue that people have focused on — TARP and the payback of TARP money — is insignificant compared with the way they’ve been able to use federally guaranteed programs and their access to the Fed window,” says Peter Solomon, founder of New York-based investment bank Peter J. Solomon Co.

Those benefits, along with a drop in the Fed’s benchmark borrowing rate to as low as zero, have slashed Goldman Sachs’s interest costs to the lowest this decade, though its debt was higher in the first nine months of 2009 than in any comparable period except the previous two years. For those three quarters, the firm’s interest expense fell to $5.19 billion from $26.1 billion a year earlier.

“You can’t give a small group of firms this privilege, where they get free money from the Fed and a taxpayer guarantee and they can run the biggest hedge fund in the world,” Niall Ferguson, a professor of history at Harvard University and author of “The Ascent of Money: A Financial History of the World,” said at a Nov. 18 panel discussion in New York.

‘Using Your Money’

That view is shared by Solomon. “Everybody thinks they’re a bank, but they’re a hedge fund,” he says. “The difference is that this year they’re using your money to do it.”

Lucas van Praag, the partner responsible for the firm’s communications and the only Goldman Sachs executive willing to comment for this story, denies any similarity to hedge funds, the mostly private and unregulated pools of capital that managers use to buy or sell assets while participating in the profits.

“The assertion that we’re a hedge fund displays a substantial misunderstanding of our business,” says van Praag, 59, a British-born former public relations executive who joined Goldman Sachs after it went public in 1999. “We are in business primarily to facilitate transactions for our clients, and over 90 percent of our revenue and earnings come from doing that.”

Proprietary Trading

Proprietary trading, in which Goldman Sachs employees make bets with the company’s own money, has contributed only 12 percent of the firm’s revenue since 2003, van Praag says. Still, fixed-income, currency, commodity and some equity trading that takes place off exchanges blurs the line between client-driven transactions and proprietary wagers, says Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York who rates Goldman Sachs stock “outperform.”

“It’s coming onto my balance sheet, I’m owning it and then I’m selling it,” Hintz says. “The fact that I’m taking a position means I’m taking risk, and if I’m taking risk, then I’m taking a proprietary bet.”

If Goldman Sachs agrees to buy $1 billion of mortgages that a client wants to sell and then decides to keep the mortgages, it’s not easy to determine whether that trade is aimed at helping a client or is a proprietary investment decision, Hintz says.

Van Praag says that Goldman Sachs, unlike some other banks, was never in imminent danger of going out of business during the financial crisis unless the entire system was allowed to implode.

‘We Didn’t Wait’

“We had cash and funding that would have allowed us to survive for quite a long time, even assuming that counterparties had decided to stop providing financing,” van Praag says. “When markets became very difficult, we didn’t wait for the government to act. We went out and raised money in the private sector.”

Two days after winning the Fed’s approval to become a bank holding company, Goldman Sachs sold $5 billion of preferred stock to billionaire Warren Buffett’s Berkshire Hathaway Inc. and then raised another $5.75 billion by selling common stock to the public. Those deals, plus a $5.75 billion public offering in April 2009, helped raise shareholder equity to $65.4 billion from $45.6 billion in August 2008.

Goldman Sachs also cut the amount of assets it owns to $882 billion from $1.08 trillion before the Lehman collapse. The firm holds $167 billion in cash or near-cash instruments, up from about $102 billion at the end of August 2008, which it can use to pay off debts if creditors stop making loans.

‘Classic Bank Run’

Treasury Secretary Timothy Geithner said in an interview with Bloomberg Television on Dec. 4 that no bank would have survived without the government’s help.

“The entire U.S. financial system and all the major firms in the country, and even small banks across the country, were at that moment at the middle of a classic run — a classic bank run,” he said.

Since the government stepped in, investors have been more willing to lend money to Goldman Sachs. The premium bondholders charge to own the firm’s bonds that mature in April 2018 instead of U.S. Treasuries of the same maturity has shrunk to less than 1.5 percentage points from as much as 6.8 percentage points on Nov. 20, 2008, according to data compiled by Trace, the bond- price reporting system of the Financial Industry Regulatory Authority. The spread isn’t as narrow as the 0.99 percentage point premium to Treasuries that Goldman paid on new 10-year bonds in January 2006, the data show.


At an Oct. 15 breakfast sponsored by Fortune magazine, Blankfein said that market prices prove that investors don’t think the bank has a government guarantee.

“We’re not exactly borrowing at the government rate,” he said. “The market isn’t behaving that way.”

Sean Egan — co-founder of Haverford, Pennsylvania-based Egan-Jones Ratings Co., which in October gave Goldman Sachs an AA rating, its third highest — has a different view.

“We’re in the business of doing credit analysis, and we’ve come to the conclusion that essentially Goldman Sachs is backstopped,” Egan says.

William Larkin, who manages about $250 million in fixed- income investments at Cabot Money Management Inc. in Salem, Massachusetts, says he owns Goldman Sachs bonds partly because he thinks the company won’t be allowed to go out of business.

“They would be bailed out” if anything went wrong, Larkin says. “Goldman right now is in a catbird seat because it’s very important to keep them healthy.”

Fewer Competitors

Chief Financial Officer David Viniar takes issue with the idea that the firm continues to benefit from an implied guarantee by the U.S. government.

“We operate as an independent financial institution that stands on our own two feet,” Viniar, 54, told reporters on an Oct. 15 conference call. “We don’t think we have a guarantee.”

The firm has grown more dominant in the past year, increasing its market share, Viniar told analysts on Oct. 15. It has benefited from having fewer competitors — Bear Stearns Cos., Merrill Lynch & Co. and Lehman Brothers were all subsumed into other banks during the financial crisis — while larger rivals such as Citigroup Inc. and UBS AG have been hobbled by writedowns and a lower appetite for risk.

“The crisis has created an oligopoly,” says Solomon, who founded his firm in 1989 after leaving Lehman Brothers.


Goldman Sachs has also increased the size of the bets it’s making. Its value-at-risk — an estimate of how much the trading desk could lose in a single day — jumped to an average of $231 million in the first nine months of 2009, a record for the firm. At the end of September, the company estimated that a 10 percent drop in corporate equity held by its merchant-banking funds would cost it $1.04 billion, up from $987 million at the end of June.

Revenue generated by trading and investing, the most unpredictable part of Goldman Sachs’s business, accounted for 79 percent of the firm’s revenue in the first nine months of 2009, up from 28 percent in 1998. Early the next year, before Goldman Sachs’s initial public offering, executives, led by Paulson, told investors the company would try to decrease the percentage.

The government is acting schizophrenically by arguing that Goldman Sachs needs taxpayer support because it poses a risk to the financial system at the same time as it’s failing to do anything to curtail that risk, says Nobel Prize-winning economist Joseph Stiglitz, who teaches at Columbia University in New York.

“We say they’re too big to fail, but we refuse to do anything about their being too big to fail,” Stiglitz says. “We say that they represent systemic risk, but we don’t regulate them effectively.”

‘Biggest Single Gift’

Stiglitz also points to the Fed’s $182.3 billion AIG bailout as an example of how policy has been tilted to support Goldman Sachs.

“The biggest single gift was the AIG rescue,” he says. “No one has ever provided a good argument for why we did it other than we were bailing out Goldman Sachs.”

On Sept. 16, 2008, a day after Lehman filed the biggest bankruptcy in U.S. history, the Fed authorized Geithner, then president of the Federal Reserve Bank of New York, to lend $85 billion to help AIG avoid a similar fate by allowing it to continue to post collateral owed on contracts and to settle securities-lending agreements. Geithner later told a Congressional Oversight Panel that the government acted because “the entire system was at risk.”

$12.9 Billion

In November, the Fed created two entities: Maiden Lane II to repurchase securities that had been lent out in return for cash, and Maiden Lane III to purchase collateralized-debt obligations so AIG could cancel the credit-default swaps, similar to insurance policies, it had written on them. In the latter program, the Fed allowed the counterparties to settle contracts at 100 percent of their value.

Goldman Sachs was the biggest beneficiary, receiving a total of $12.9 billion in cash, consisting of $5.6 billion to cancel insurance on CDOs, $4.8 billion to repurchase securities and $2.5 billion of collateral.

If Goldman Sachs and AIG’s other counterparties hadn’t been paid off in full by the Fed, they might have taken losses on their contracts.

Other bond insurers had canceled agreements by paying less than par. Merrill Lynch accepted $500 million from Security Capital Assurance Ltd. in late July 2008 to tear up contracts guaranteeing $3.7 billion of CDOs. On Aug. 1, 2008, Citigroup agreed to accept $850 million from bond insurer Ambac Financial Group Inc. to cancel a guarantee on a $1.4 billion CDO.

Barofsky Report

In a Nov. 16 report on the AIG bailout, Neil Barofsky, special inspector general for TARP, said the Fed tried for two days to negotiate with counterparties, an effort that failed because the Fed felt obliged to make any discounts voluntary and because French counterparties said they couldn’t legally be required to comply. Goldman Sachs refused to negotiate because it felt it was hedged if AIG failed to pay, Barofsky wrote.

“Notwithstanding the additional credit protection it received in the market, Goldman Sachs (as well as the market as a whole) received a benefit from Maiden Lane III and the continued viability of AIG,” Barofsky wrote. Goldman Sachs would have been saddled with the risk of further declines in the market value of about $4.3 billion in CDOs as well as some $5.5 billion of CDSs, he added.

‘Fascination With AIG’

Viniar, who held a conference call in March to answer questions about the firm’s relationship with AIG, said Goldman Sachs didn’t need a bailout because the firm’s hedges meant it faced no significant losses if AIG failed.

“I am mystified by this fascination with AIG,” he said in an interview in April. “In the context of Goldman Sachs, they’re one of thousands and thousands of counterparties, and the results of any trading with AIG are completely immaterial to what we do. Always have been, and always will be.”

Suspicions that the fix was in for Goldman Sachs have been fanned by the firm’s political connections.

Paulson worked at the company for 32 years, the last eight of them as CEO, before becoming Treasury secretary in 2006. Geithner selected former Goldman Sachs lobbyist Mark Patterson to serve as his chief of staff at Treasury. Stephen Friedman, a former senior partner who serves on the company’s board, stepped down as chairman of the New York Fed in May amid controversy over his purchases of the firm’s shares in December 2008 and January 2009 after it became a bank holding company regulated by the Fed. Geithner and Lawrence Summers, President Barack Obama’s National Economic Council director, worked earlier in their careers under former Treasury Secretary Robert Rubin, who was once co-chairman of Goldman Sachs. Geithner’s successor as New York Fed president is William Dudley, a former chief U.S. economist at Goldman Sachs.

Political Contributions

Goldman Sachs and its employees have donated $31.4 million to U.S. political parties since 1989, more than any other financial institution and the fourth-highest amount of any organization, according to the Center for Responsive Politics, a Washington research group.

Regulators and lawmakers are attempting to make changes that they say will protect taxpayers in the future. One proposal being considered by the U.S. Congress is to require financial institutions whose failure could cause a breakdown of the entire system to hold more liquid assets and a larger buffer of capital to help absorb losses.

The bill would also empower regulators to step in and liquidate a major financial institution, or merge it with another, rather than bail it out or let it collapse.

Safety Net

That’s not enough for Paul Volcker, the former Fed chairman who serves as an economic adviser to Obama. Volcker, 82, has argued that the government safety net should be limited to financial institutions that provide utilitylike services such as deposit taking and business-payment processing essential to economic functioning. All risk-taking functions should be done separately, he says.

“I do not think it reasonable that public money –taxpayer money — be indirectly available to support risk-prone capital market activities simply because they are housed within a commercial-banking organization,” Volcker said in a Sept. 16 speech at a conference in California.

Asked about Goldman Sachs in a Dec. 11 interview in Berlin, Volcker said, “They can do trading and do anything they want, but then they shouldn’t have access to the safety net.”

Black, the former bank regulator, agrees.

“The answer is not to give these guarantees but to make sure there are no more systemically dangerous institutions,” he says. “They shouldn’t be allowed to grow, and of course, that’s what they’re doing right now. They’re mostly growing like crazy.”

Ground Zero

On a cold, rainy morning in December, rust-colored beams poke above a fence that surrounds the construction pit at Ground Zero in lower Manhattan. Across West Street, workers in yellow slickers are landscaping the strips that separate the entrance to Goldman Sachs’s new headquarters from the highway. In the lobby, a brightly colored abstract painting by Ethiopian- American artist Julie Mehretu, which cost about $5 million, greets employees who have already relocated.

The new building has twice as much space and costs 14 times as much as Goldman Sachs’s old headquarters a half mile (0.8 kilometer) away. Two American flags the size of bed sheets dominate the stone and concrete facade of the 30-story building at 85 Broad St., constructed almost three decades ago when Goldman Sachs was a private partnership with about 2,700 employees in New York.

In 1983, the year the firm moved in, it had pretax earnings of $462 million, one-twenty-fifth of what it made in 2007.

While Goldman Sachs has outgrown its old headquarters, one thing hasn’t changed: It’s still getting subsidies to remain in lower Manhattan. When it built 85 Broad St., the company received about $9 million in incentives to stay, according to a press report at the time. Now, it’s getting $115 million — an amount dwarfed by the funds U.S. taxpayers provided in the heat of the 2008 financial crisis.

To contact the reporter on this story: Christine Harper in New York at
Last Updated: December 20, 2009 19:01 EST


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Banks Reorder Transactions & Consumers Pay Insufficient Fund Fees

Posted by: Micah Adkins
August 24, 2009
Several nationwide class actions have been filed against some of the countries largest banking associations. The named plaintiffs allege the banks’ practice of reordering electronic transactions is deceptive and illegal, despite the banks’ customer agreements that state they can process customers’ transactions in any order. So what’s the big deal?

The following is an example of how banks are making millions of dollars by reordering customer transactions. Johnny and his family live paycheck to paycheck. Johnny makes his money the old fashion way, hard work and sweat at the local factory, and he gets paid every two weeks when his employer electronically deposits his check with his bank, Bank X. Its tough for Johnny and his family to pay all of their bills and expenses, and more often than not, Johnny’s paycheck is not enough to make ends meet. Johnny’s bank, Bank X, on the other hand, makes money the easy way, insufficient fund fees. Its quick, easy, and sweat free! While Johnny makes $15 per hour, Bank X has found a way to make $35 in less than one second!

For example, its Thursday Johnny has a balance of $200 in his Bank X checking account. Johnny started his morning like he does every Thursday, gassed up his truck, $50, and picks up a sausage biscuit and coffee, $5, for breakfast on his way to work. Later that same day, while on lunch break, Johnny picks up a burger and soda, $8, the family’s laundry from the cleaners, $35, and a birthday card for his grandmother, $4. After Johnny gets home from work, he takes his wife and three kids out for dinner, $65, then to the movies, $60. All 7 transactions were made with Johnny’s Bank X debit card and all 7 transactions were made on Thursday.

The total charges for Thursday total $ 227.00. As a result, his account is overdrawn on Friday. One would think that Johnny might expect one $35 overdraft fee for the insufficient funds and have an ending negative balance of $-62 ($27 overdraft + 35 insufficient fund fee) for the day, but instead Johnny is shocked to discover he has $105.00 in insufficient fund fees and has an ending negative balance of $-132.00. In other words, his checking account was debited by Bank X for three $35 overdraft fees. How? After all, he expected his account to be overdrawn by $23.00, but not according to Bank X’s records.

While Johnny’s transactions were made electronically throughout the day in the following order: $50; $5; $8; $35; $4; $65; and $60, Bank X has reordered the transactions from largest to smallest. Here is the order in which Bank X reorders Johnny’s debit card transactions for the day: $65; $60; $50; $35; $8; $5; and $4. Johnny’s account is now overdrawn after the fourth transaction, and he incurs $35 in overdraft fees for the next three transactions. Had Bank X processed the transaction in the order in which they were actually made, Johnny would have been charged $35 for one insufficient fund fee. Instead, Bank X charged Johnny’s account $105.00 in overdraft fees!

Sound familiar? If your bank has reordered your transactions or your bank has delayed posting deposits to your account and you have incurred overdraft fees, you need to contact attorney Micah Adkins.

Banks Use Overdraft Fees to Fleece Customers
Computerized Traps Sniff Out Time and Amount Opportunities

Aug 14, 2008 Rosemary E. Bachelor

Read more at Suite101: Banks Use Overdraft Fees to Fleece Customers: Computerized Traps Sniff Out Time and Amount Opportunities
As the mortgage crisis heightens and bank profits tumble, bank attempts to get non-service based fees have increased to nearly fraudulent proportions and the Federal Reserve is questioning these practices.
Banks Charge from When the Slip Is Signed

Now an overdraft fee can be charged before the transaction overdraws the account. This is a current practice of Bank of America, TD Banknorth and SunTrust.

Here’s how it works: Someone stops at the mall on the way home, sees that Penney’s has a two-for-one bargain on tee shirts and buys four, paying with a debit card. Thinking that may overdraw the account, the customer swings by the bank and makes a $100.00 deposit.

These three banks—and others—have computer programs that noticed insufficient funds when the purchase was signed for. That’s an automatic overdraft. Once upon a banking time, customers didn’t get charged unless they were short when the signature debit transaction cleared a few days later.
Largest Purchase Debited First

Banks also manipulate customer funds by the order in which they process debits and credits. The bank computer looks at the day’s transactions and sees the client made purchases totaling $99.00. A $100.00 deposit was made. The balance before these transactions was $75.00.

Watch these numbers: Spending power appears to be $175.00. Six purchases were made. The biggest is $76.00. There were five totaling $23.00.

First, all debits are charged before the credit (deposit) is processed. The $76.00 is first charged against the account, putting it in overdraft. The other five purchases wouldn’t have put it into overdraft so were processed last; each carries an overdraft charge.

There was enough money to pay the five purchases under $75.00 and the deposit (processed last) covered everything. Yet, there were six overdraft charges totaling $180.00. Uh-oh, the $100.00 deposit doesn’t cover them and now it’s overload mode. A $99.00 trip to WalMart is a $279.00 nightmare..

JPMorgan Chase is among banks that change the order of purchases so large debts get paid first, increasing the likelihood of incurring fees on smaller purchases.

The Federal Reserve has proposed giving customers the right to demand that banks deny transactions that overdraw their account. The Fed is also looking at banks processing transactions from high-to-low dollar amounts.
Online Account Balances Not Accurate

A disturbing revelation is that online account balances often aren’t accurate. With electronic transfers, ATMs, check cards, holds on accounts from hotel and rental car reservations, etc., banking is more complicated than banks expect customers to understand. Banks also sit on check deposits while the computer orders overdraft fees. The message? Don’t trust an online balance. It’s a moving target for your “financial partner”.

In 2007, banks collected a record $45.6 billion in overdraft fees, up 50% from 2001.

If the supermarket charged extra money when you didn’t buy more groceries you would be furious. The one-armed bandit used to be the casino slot machine. Now it is the bank!

SOURCES: Center for Responsible Lending; Center for Consumer Financial Services, Rochester Institute of Technology; Moebs Services, a Lake Bluff, IL consulting firm (selected by Federal Reserve and Congress to provide data for the Annual Report on Retail Services and Fees); Federal Reserve Proposal (Federal Register, Vol. 73, No. 97, Monday, May 19, 2008, Proposed Rules)

Read more at Suite101: Banks Use Overdraft Fees to Fleece Customers: Computerized Traps Sniff Out Time and Amount Opportunities

November 03, 2008
Behind AIG’s Fall, Risk Models Failed to Pass Real-World Test

Gary Gorton, a 57-year-old finance professor and jazz buff, is emerging as an unlikely central figure in the near-collapse of American International Group Inc.

Mr. Gorton, who teaches at Yale School of Management, is best known for his influential academic papers, which have been cited in speeches by Federal Reserve Chairman Ben Bernanke. But he also has a lucrative part-time gig: devising computer models used by the giant insurer to gauge risk in more than $400 billion of devilishly complicated deals called credit-default swaps.

AIG relied on those models to help figure out which swap deals were safe. But AIG didn’t anticipate how market forces and contract terms not weighed by the models would turn the swaps, over the short term, into huge financial liabilities. AIG didn’t assign Mr. Gorton to assess those threats, and knew that his models didn’t consider them. Those risks have cost AIG tens of billions of dollars and pushed the federal government to rescue the company in September.

The global financial crisis is studded with tales of venerable financial firms failing to protect themselves against the unexpected. In the case of AIG, as with many other firms, the financial horrors were hidden in the enormous market for credit-default swaps, which are a form of insurance against defaults on all sorts of debts.

A close look at AIG’s risk-management operations, and the rapid-fire chain of events that crippled the firm, raises questions about the run-up to the financial crisis: Did firms like AIG plunge into lucrative but perilous new markets without thoroughly understanding the pitfalls? Had the sheer complexity of the financial products made it all but impossible to fully calculate the risk? And did firms put too much faith in computer models to assess

The turmoil at AIG is likely to fan skepticism about the complicated, computer-driven modeling systems that many financial giants rely on to minimize risk. As chief executive of Berkshire Hathaway Inc., which owns insurance companies, Warren Buffett has been sounding the alarm about the issue for years. Recently, he told PBS interviewer Charlie Rose: “All I can say is, beware of geeks…bearing formulas.”

Last December, at a meeting with investors, Martin Sullivan, then AIG’s chief executive officer, told investors concerned about exposure to credit-default swaps that models helped give AIG “a very high level of comfort.” Mr. Gorton explained at the meeting that “no transaction is approved” by the chief of AIG’s financial-products unit “if it’s not based on a model that we built.”

Now, a federal criminal probe in Washington is examining whether AIG executives misled investors at that meeting, and whether any of its executives misled its outside auditor last fall. AIG itself has been forced to post about $50 billion in collateral to its trading partners, largely to offset sharp drops in the value of securities it insured with the credit-default swaps. These payments have continued to balloon after the bailout — raising the specter that the government will eventually have to lend more taxpayer money to AIG.

This account of AIG’s risk-management blunders is based on more than two dozen interviews with current and former AIG executives, AIG’s trading partners and others with direct knowledge of the firm, as well as internal AIG documents, regulatory filings and congressional testimony. Mr. Gorton, who continues to be a paid AIG consultant, referred questions about his role to AIG. Mr. Sullivan declined to comment.

AIG’s credit-default-swaps operation was run out of its AIG Financial Products Corp. unit, which had offices in London and Wilton, Conn. In essence, AIG sold insurance on billions of dollars of debt securities backed by everything from corporate loans to subprime mortgages to auto loans to credit-card receivables. It promised buyers of the swaps that if the debt securities defaulted, AIG would make good on them. AIG executives, not Mr. Gorton, decided which swaps to sell and how to price them.

The swaps expose AIG to three types of financial pain. If the debt securities default, AIG has to pay up. But there are two other financial risks as well. The buyers of the swaps — AIG’s “counterparties” or trading partners on the deals — typically have the right to demand collateral from AIG if the securities being insured by the swaps decline in value, or if AIG’s own corporate-debt rating is cut. In addition, AIG is obliged to account for the contracts on its own books based on their market values. If those values fall, AIG has to take write-downs.

Mr. Gorton’s models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn’t attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG’s finances.

The problem for AIG is that it didn’t apply effective models for valuing the swaps and for collateral risk until the second half of 2007, long after the swaps were sold, AIG documents and investor presentations indicate. The firm left itself exposed to potentially large collateral calls because it had agreed to insure so much debt without protecting itself adequately through hedging.

The credit crisis hammered the markets for debt securities, sparking tough negotiations between AIG and its trading partners over how much more collateral AIG should have to post. Goldman Sachs Group Inc., for instance, has pried from AIG $8 billion to $9 billion, covering virtually all its exposure to AIG — most of it before the U.S. stepped in.

Such payments continued after the government bailout. AIG already has borrowed $83.5 billion from the Federal Reserve, a little more than two-thirds of the $123 billion in taxpayer loans made available to AIG so far. In addition, AIG affiliates recently obtained from the government as much as $21 billion in short-term loans called commercial paper. Much of the $83.5 billion has been used to meet the financial obligations of the financial-products unit. If turmoil in the markets causes prices of many assets to fall further, the government might have to cough up more money to help keep AIG afloat. Cutting it off would risk renewing the market upheaval the policy makers have struggled to tame.

Mr. Gorton, the son of a Phoenix psychiatrist, took a circuitous route to academia. He studied Mandarin, considered becoming an actor and briefly drove a cab in Cleveland, where he carried a gun for protection, he later told acquaintances. Eventually, he collected multiple degrees, including a Ph.D. in economics, and joined the faculty of the Wharton School of the University of Pennsylvania.

He drove an old Volkswagen Beetle, lived in a gritty North Philadelphia row house and accumulated a vast trove of jazz records, which he would cue up at night on two turntables to keep the music coming, recalls his wife at the time, Rachel Bliss.

He was passionate about mathematics, engaging in late-night conversations with fellow teachers, says Ms. Bliss. One of his academic interests was how banks could unload risk and sell loans to investors.

In 1987, AIG launched its financial-products unit with Howard Sosin, a math expert and former Drexel Burnham Lambert executive. Among his hires were Joseph Cassano, a former Drexel colleague. After Mr. Sosin left, Mr. Gorton joined as a consultant in the late 1990s. Mr. Cassano later took over the unit.

Early on, Mr. Gorton billed AIG about $250 an hour, which likely would have netted him about $200,000 a year, says a former senior executive at the unit. Eventually, his pay was far greater; another former colleague estimates it at $1 million a year.

Mr. Gorton collected vast amounts of data and built models to forecast losses on pools of assets such as home loans and corporate bonds. Speaking to investors last December, Mr. Cassano credited Mr. Gorton with “developing the intuition” that he and another top executive had “relied on in a great deal of the modeling that we’ve done and the business that we’ve created.”

AIG began selling credit-default swaps around 1998. Mr. Gorton’s work “helped convince Cassano that these things were only gold, that if anybody paid you to take on these risks, it was free money” because AIG would never have to make payments to cover actual defaults, according to the former senior executive at the unit. However, Mr. Gorton’s work didn’t address the potential write-downs or collateral payments to trading partners.

AIG became one of the largest sellers of credit-default-swap protection, according to a Moody’s Investors Service report last week. For years, the business was extremely lucrative. In a 2006 SEC filing, AIG said none of the swap deals now causing it pain had ever experienced high enough defaults to consider the likelihood of making a payout more than “remote, even in severe recessionary market scenarios.”

AIG charged its trading partners a fraction of a penny a year for every dollar of credit protection. The company realized, of course, that it might have to post collateral if the market values of the underlying securities declined. But AIG executives believed that such price moves were unlikely to occur, according to people familiar with AIG’s operation.

As the debt securities created by Wall Street became more complicated, so did the swaps AIG offered. Around 2004, it began selling swaps designed to provide insurance on securities called collateralized-debt obligations, or CDOs, that were backed by securities such as mortgage bonds. Merrill Lynch & Co., then a major seller of the CDOs, was a big client.

So-called multisector CDOs, in particular, were exceptionally complex, involving more than 100 securities, each backed by multiple mortgages, auto loans or credit-card receivables. Their performance depended on tens of thousands of disparate loans whose value was hard to determine and performance difficult to systematically predict. In assessing their risk, Mr. Gorton constructed worst-case scenarios that factored in the probability of defaults on the underlying securities.

In late 2005, senior executives at the unit grew worried about loosening lending standards in the subprime-mortgage market. AIG decided to stop selling credit protection on multisector CDOs, partly due to “concerns that the model was not going to be able to handle declining underwriting standards,” Mr. Gorton told investors last December. But by the time it stopped, in early 2006, its exposure to multisector CDOs had ballooned to $80 billion.

By mid-2007, as the housing slump took hold, the subprime mortgage market was weakening and many mortgage bonds were sinking in value. Ratings agencies began downgrading many mortgage securities, a departure from the historical pattern, Mr. Gorton later explained to investors. Concern began mounting about AIG’s credit-default swaps, even though AIG didn’t have large exposures to subprime-mortgage bonds issued in the worst years of 2006 and 2007.

AIG’s trading partners were worried. Goldman Sachs held swaps from AIG that insured about $20 billion of securities. In August 2007, Goldman demanded $1.5 billion in collateral, arguing that the assets backing the securities were falling in value. AIG argued that the demand was excessive, and the two firms eventually agreed that AIG would post $450 million to Goldman, this person says.

Late last October, Goldman asked for even more collateral, $3 billion. Again, AIG disagreed, and it ultimately posted $1.5 billion. Goldman hedged its exposure by making a bearish bet on AIG, buying credit-default swaps on AIG’s own debt, according to one person knowledgeable about this move.

When AIG’s outside auditor, PricewaterhouseCoopers LLP, learned about Goldman’s demands, it reviewed the value of the swaps, according to a Pricewaterhouse official cited in minutes of a meeting of the audit committee of AIG’s board. Last November, when AIG reported third-quarter results, it took its first major write-down on the swaps, lowering their value by $352 million.

That same month, collateral calls came in from Merrill and Société Générale SA, says the person familiar with AIG’s finances. It’s not clear how much those two banks asked for, or how much they got.

AIG decided to talk to investors last Dec. 5 about the financial-product unit’s exposure to the mortgage market. A Pricewaterhouse official said his firm told AIG’s then-CEO, Mr. Sullivan, and a deputy six days before the event that AIG might have a “material weakness” in its risk management, according to minutes of a Jan. 15 meeting of AIG’s audit committee. Pricewaterhouse declined to comment.

In his presentation to investors, held at New York’s Metropolitan Club, Mr. Sullivan praised the unit’s models as “very reliable” in analyzing many mortgages, saying they had helped give AIG “a very high level of comfort.”

Mr. Gorton was introduced. “The models are all extremely simple,” he said. “They’re highly data intensive.” He said he didn’t rely on the default-risk predictions of credit-rating services, and instead came up with his own estimates of what was safe enough for AIG to insure.

Mr. Cassano, the unit’s head, told investors: “We believe this is a money-good portfolio….As Gary said, the models we use are simple, they’re specific and they’re highly conservative.”

But the collateral calls kept coming. By the end of 2007, at least four other banks that had purchased swaps from AIG — UBS AG, Barclays PLC, Credit Agricole SA’s Calyon investment-banking unit and Royal Bank of Scotland Group PLC — had asked for money, according to people familiar with collateral calls. Deutsche Bank and Canadian banks CIBC and Bank of Montreal also have demanded collateral at various points, a person familiar with AIG’s finances says.

In February, AIG disclosed that Pricewaterhouse had found a “material weakness” in its accounting controls. Late that month, AIG announced a $5.3 billion fourth-quarter loss, its largest ever, driven largely by write-downs on the swaps. It also said it was “possible” that actual losses on the swaps could be material.

Mr. Sullivan told investors that Mr. Cassano, the unit’s head, was retiring. He remained a consultant, receiving, until recently, $1 million a month, according to a document later released by Congress.

In May, AIG announced another record quarterly loss, of $7.8 billion, largely driven by write-downs of the value of the swaps. That same month, Yale’s School of Management announced it had hired Mr. Gorton away from Wharton.

Mr. Sullivan was ousted in June. As of July 31, AIG had handed over $16.5 billion in collateral on its swaps, according to a regulatory filing.

By August, AIG had increased its estimates for what it might ultimately lose on the swaps in the case of defaults to as high as $8.5 billion. (The estimates are distinct from potential losses on write-downs and collateral calls.) That same month, Mr. Gorton attended the Federal Reserve Bank of Kansas City’s annual gathering in Jackson Hole, Wyo. He presented a 92-page paper, “The Panic of 2007,” which explained how the financial markets came unglued after a series of unexpected events, such as when clients of financial firms suddenly sought to reclaim assets put up as collateral. “It is difficult to convey,” he wrote, “the ferocity of the fights over collateral.”

Credit markets worsened in late August and September, and AIG’s trading partners demanded additional collateral. When Lehman Brothers Holdings Inc. filed for bankruptcy protection on Sept. 15, bond markets essentially froze. That same day, rating agencies slashed AIG’s credit ratings. Company executives figured the downgrade would require AIG to post more than $18 billion in additional collateral to its trading partners, according to a person familiar with the matter. Worried that a bankruptcy filing could roil markets world-wide, the government stepped in with a bailout.

The rescue didn’t stop the collateral calls, which have eaten up much of the government’s initial $85 billion loan commitment, which on Oct. 8 it boosted to $123 billion.

On a rainy morning last week, Mr. Gorton briefly discussed with his Yale students how perplexing the struggles of the financial world have become. About 30 graduate students listened as Mr. Gorton lamented how problems in one sector caused investors to question value all across the board. Said Mr. Gorton: “There doesn’t seem to be a fundamental reason why.”

Source: The Wall Street Journal
So What Exactly Caused the Financial Crisis?
* February 23, 2010, 5:00 AM ET

By David Wessel

Gary Gorton, a finance professor at the Yale School of Management, takes a stab at explaining one key aspect of the recent crisis — the rise of the shadow banking system and the role that securitization plays — in testimony he’ll deliver later this week to the Financial Crisis Inquiry Commission.

The story isn’t as simple as the black hats vs. white hats version that politicians, the press and the public favor. In question-and-answer format, he offers a step-by-step explanation.

It’s wrong to blame this crisis on subprime mortgage lending, he says. Rather, this crisis is best seen as the latest of a series of banking crises throughout history. Banks borrow (or take deposits) short-term, promising to give money to their customers if they want it. They invest that money long-term, lending to businesses and consumers. This “intermediation” process is vital to the smooth functioning of the economy. But if depositors or others from whom banks have borrowed short-term demand their money back — a demand often sparked by panic — banks can’t instantly respond, and bad things ensue. In the old days, these runs were prompted by anxious depositors. Deposit insurance helped solve that problem. In our time, banks were reliant on short-term borrowing known as repurchase agreements — and the folks who held those panicked.

Gorton writes: “Repo is money… But, like other privately created bank money, it is vulnerable to a shock, which may cause depositors to rationally withdraw en masse, an event which the banking system — in this case the shadow banking system — cannot withstand alone. Forced by the withdrawals to sell assets, bond prices plummeted and firms failed or were bailed out with government money. In a bank panic, banks are forced to sell assets, which causes prices to go down, reflecting the large amounts being dumped on the market. Fire sales cause losses. The fundamentals of subprime [mortgages] were not bad enough by themselves to have created trillions in losses globally. The mechanism of the panic triggers the fire sales. As a matter of policy, such firm failures should not be caused by fire sales.”

“The crisis was not a one-time, unique, event. The problem is structural. The explanation for the crisis lies in the structure of private transaction securities that are created by banks. This structure, while very important for the economy, is subject to periodic panics if there are shocks that cause concerns about counterparty default. There have been banking panics throughout U.S. history, with private bank notes, with demand deposits, and now with repo. The economy needs banks and banking. But bank liabilities have a vulnerability.”

Gorton also argues that securitization — the business of making loans and then selling them off as securities — was prompted by a simple fact of banking business life. “Holding loans on the balance sheets of banks is not profitable. This is a fundamental point. This is why the parallel or shadow banking system developed,” he says. “As traditional banking became unprofitable in the 1980s, due to competition from, most importantly, money market mutual funds and junk bonds, securitization developed. Bank funding became much more expensive. Banks could no longer afford to hold passive cash flows on their balance sheets. Securitization is an efficient, cheaper, way to fund the traditional banking system.”

In addition to being a scholarly analyst of finance, Gorton had a ringside seat during this crisis. He helped craft models that AIG used to assess the risk of its credit default swaps.
Best if viewed in color.
Questions and Answers about the Financial Crisis*
Prepared for the U.S. Financial Crisis Inquiry Commission
Gary Gorton
Yale and NBER
February 20, 2010
All bond prices plummeted (spreads rose) during the financial crisis, not just the prices of subprimerelated
bonds. These price declines were due to a banking panic in which institutional investors and
firms refused to renew sale and repurchase agreements (repo) – short-term, collateralized, agreements
that the Fed rightly used to count as money. Collateral for repo was, to a large extent, securitized
bonds. Firms were forced to sell assets as a result of the banking panic, reducing bond prices and
creating losses. There is nothing mysterious or irrational about the panic. There were genuine fears
about the locations of subprime risk concentrations among counterparties. This banking system (the
“shadow” or “parallel” banking system) — repo based on securitization — is a genuine banking system, as
large as the traditional, regulated and banking system. It is of critical importance to the economy
because it is the funding basis for the traditional banking system. Without it, traditional banks will not
lend and credit, which is essential for job creation, will not be created.
*Thanks to Lori Gorton, Stephen Partridge-Hicks, Andrew Metrick, and Nick Sossidis for comments and
“Unfortunately the subject [of the Panic of 1837] has been connected with the party
politics of the day. Nothing can be more unfavorable to the development of truth, on
questions in political economy, than such a connection. A good deal which is false, with
some admixture of truth, has been put forward by political partisans on either side. As
it is the wish of the writer that the subject should be discussed on its own merits and
free from such contaminating connection, he has avoided as much as possible all
reference to the political parties of the day” (Appleton (1857), May 1841).
“The current explanations [of the Panic of 1907] can be divided into two categories. Of
these the first includes what might be called the superficial theories. Thus it is
commonly stated that the outbreak of a crisis is due to a lack of confidence — as if the
lack of confidence was not itself the very thing which needs to be explained. Of still
slighter value is the attempt to associate a crisis with some particular governmental
policy, or with some action of a country’s executive. Such puerile interpretations have
commonly been confined to countries like the United States where the political passions
of a democracy had the fullest sway. . . . Opposed to these popular, but wholly
unfounded, interpretations is the second class of explanations, which seek to burrow
beneath the surface and to discover the more … fundamental causes of the periodicity
of crises” (Seligman (1908), p. xi).
“The subject [of the Panic of 1907] is technical. Opinions formed without a grasp of the
fundamental principles and conditions are without value. The verdict of the uninformed
majority gives no promise of being correct …. If to secure proper banking legislation now
it is necessary for a . . . campaign of public education, it is time it were begun”
(Vanderlip (1908), p. 18).
“Don’t bother me with facts, son. I’ve already made up my mind.” – Foghorn Leghorn
1. Introduction
Yes, we have been through this before, tragically many times.
U.S. financial history is replete with banking crises and the predictable political responses. Most people
are unaware of this history, which we are repeating. A basic point of this note is that there is a
fundamental, structural, feature of banking, which if not guarded against leads to such crises. Banks
create money, which allows the holder to withdraw cash on demand. The problem is not that we have
banking; we need banks and banking. And we need this type of bank product. But, as the world grows
and changes, this money feature of banking reappears in different forms. The current crisis, far from
being unique, is another manifestation of this problem. The problem then is structural.
In this note, I pose and try to answer what I think are the most relevant questions about the crisis. I
focus on the systemic crisis, not other attendant issues. I do not have all the answers by any means.
But, I know enough to see that the level of public discourse is politically motivated and based on a lack
of understanding, as it has been in the past, as the opening quotations indicate. The goal of this note is
to help raise the level of discourse.
2. Questions and Answers
Q. What happened?
A. This question, though the most basic and fundamental of all, seems very difficult for most people to
answer. They can point to the effects of the crisis, namely the failures of some large firms and the
rescues of others. People can point to the amounts of money invested by the government in keeping
some firms running. But they can’t explain what actually happened, what caused these firms to get into
trouble. Where and how were losses actually realized? What actually happened? The remainder of
this short note will address these questions. I start with an overview.
There was a banking panic, starting August 9, 2007. In a banking panic, depositors rush en masse to
their banks and demand their money back. The banking system cannot possibly honor these demands
because they have lent the money out or they are holding long-term bonds. To honor the demands of
depositors, banks must sell assets. But only the Federal Reserve is large enough to be a significant buyer
of assets.
Banking means creating short-term trading or transaction securities backed by longer term assets.
Checking accounts (demand deposits) are the leading example of such securities. The fundamental
business of banking creates a vulnerability to panic because the banks’ trading securities are short term
and need not be renewed; depositors can withdraw their money. But, panic can be prevented with
intelligent policies. What happened in August 2007 involved a different form of bank liability, one
unfamiliar to regulators. Regulators and academics were not aware of the size or vulnerability of the
new bank liabilities.
In fact, the bank liabilities that we will focus on are actually very old, but have not been quantitatively
important historically. The liabilities of interest are sale and repurchase agreements, called the “repo”
market. Before the crisis trillions of dollars were traded in the repo market. The market was a very
liquid market like another very liquid market, the one where goods are exchanged for checks (demand
deposits). Repo and checks are both forms of money. (This is not a controversial statement.) There have
always been difficulties creating private money (like demand deposits) and this time around was no
The panic in 2007 was not observed by anyone other than those trading or otherwise involved in the
capital markets because the repo market does not involve regular people, but firms and institutional
investors. So, the panic in 2007 was not like the previous panics in American history (like the Panic of
1907, shown below, or that of 1837, 1857, 1873 and so on) in that it was not a mass run on banks by
individual depositors, but instead was a run by firms and institutional investors on financial firms. The
fact that the run was not observed by regulators, politicians, the media, or ordinary Americans has made
the events particularly hard to understand. It has opened the door to spurious, superficial, and
politically expedient “explanations” and demagoguery.
Q. How could there be a banking panic when we have deposit insurance?
A. As explained, the Panic of 2007 was not centered on demand deposits, but on the repo market which
is not insured.
As the economy transforms with growth, banking also changes. But, at a deep level the basic form of
the bank liability has the same structure, whether it is private bank notes (issued before the Civil War),
demand deposits, or sale and repurchase agreements. Bank liabilities are designed to be safe; they are
short term, redeemable, and backed by collateral. But, they have always been vulnerable to mass
withdrawals, a panic. This time the panic was in the sale and repurchase market (“repo market”). But,
before we come to that we need to think about how banking has changed.
Americans frequently experienced banking panics from colonial days until deposit insurance was passed
in 1933, effective 1934. Government deposit insurance finally ended the panics that were due to
demand deposits (checking accounts). A demand deposit allows you to keep money safely at a bank and
get it any time you want by asking for your currency back. The idea that you can redeem your deposits
anytime you want is one of the essential features of making bank debt safe. Other features are that the
bank debt is backed by sufficient collateral in the form of bank assets.
Before the Civil War the dominant form of money was privately issued bank notes; there was no
government currency issued. Individual banks issued their own currencies. During the Free Banking Era,
1837-1863, these currencies had to be backed by state bonds deposited with the authorities of
whatever state the bank was chartered in. Bank notes were also redeemable on demand and there
were banking panics because sometimes the collateral (the state bonds) was of questionable value. This
problem of collateral will reappear in 2007.
During the Free Banking Era banking slowly changed, first in the cities, and over the decades after the
Civil War nationally. The change was that demand deposits came to be a very important form of bank
money. During the Civil War the government took over the money business; national bank notes
(“greenbacks”) were backed by U.S. Treasury bonds and there were no longer private bank notes. But,
banking panics continued. They continued because demand deposits were vulnerable to panics.
Economists and regulators did not figure this out for decades. In fact, when panics due to demand
deposits were ended it was not due to the insight of economists, politicians, or regulators. Deposit
insurance was not proposed by President Roosevelt; in fact, he opposed it. Bankers opposed it.
Economists decried the “moral hazards” that would result from such a policy. Deposit insurance was a
populist demand. People wanted the dominant medium of exchange protected. It is not an exaggeration
to say that the quiet period in banking from 1934 to 2007, due to deposit insurance, was basically an
accident of history.
Times change. Now, banking has changed again. In the last 25 years or so, there has been another
significant change: a change in the form and quantity of bank liabilities that has resulted in a panic. This
change involves the combination of securitization with the repo market. At root this change has to do
with the traditional banking system becoming unprofitable in the 1980s. During that decade, traditional
banks lost market share to money market mutual funds (which replaced demand deposits) and junk
bonds (which took market share from lending), to name the two most important changes. Keeping
passive cash flows on the balance sheet from loans, when the credit decision was already made, became
unprofitable. This led to securitization, which is the process by which such cash flows are sold. I discuss
securitization below.
Q. What has to be explained to explain the crisis?
A. It is very important to set standards for the discussion. I think we should insist on three criteria.
First, a coherent answer to the question of what happened must explain why the spreads on asset
classes completely unrelated to subprime mortgages rose dramatically. (Or, to say it another way, the
prices of bonds completely unrelated to subprime fell dramatically.) The figure below shows the LIBOROIS
spread, a measure of interbank counterparty risk, together with the spreads on AAA tranches of
bonds backed by student loans, credit card receivables, and auto loans. The units on the y-axis are basis
points. The three types of bonds normally trade near or below LIBOR. Yet, in the crisis, they spiked
dramatically upwards and they moved with the measure of bank counterparty risk. Why?
Source: Gorton and Metrick (2009a).
The outstanding amount of subprime bonds was not large enough to cause a systemic financial crisis by
itself. It does it explain the figure above. No popular theory (academic or otherwise) explains the above
figure. Let me repeat that another way. Common “explanations” are too vague and general to be of
any value. They do not explain what actually happened. The issue is why all bond prices plummeted.
What caused that?
This does not mean that there are not other issues that should be explored, as a matter of public policy.
Nor does it mean that these other issues are not important. It does, however, mean that these other
issues – whatever they are – are irrelevant to understanding the main event of the crisis.
Second, an explanation should be able to show exactly how losses occurred. This is a different question
than the first question. Prices may go down, but how did that result in trillions of dollars of losses for
financial firms?
Finally, a convincing answer to the question of what happened must include some evidence and not just
be a series of broad, vague, assertions.
In what follows I will try to adhere to these criteria.
Q. Wasn’t the panic due to subprime mortgages going bad due to house prices falling?
A. No. This cannot be the whole story. Outstanding subprime securitization was not large enough by
itself to have caused the losses that were experienced. Further, the timing is wrong. Subprime
mortgages started to deteriorate in January 2007, eight months before the panic in August. The red line
below is the BBB tranche of the ABX index, a measure of subprime fundamentals. It is in the form of a
spread, so when it rises it means that the fundamentals are deteriorating. The two axes are measured
in basis points; the axis on the right side is for the ABX. The other line, the one that is essentially flat, is
the LIBOR minus OIS spread – a measure of counterparty risk in the banking system. It is measured on
the left-hand axis. The point is this: Subprime started significantly deteriorating well before the panic,
which is not shown here. Moreover, subprime was never large enough to be an issue for the global
banking system. In 2007 subprime stood at about $1.2 trillion outstanding, of which roughly 82 percent
was rated AAA and to date has very small amounts of realized losses. Yes, $1.2 trillion is a large number,
but for comparison, the total size of the traditional and parallel banking systems is about $20 trillion.
Source: Gorton and Metrick (2009a). LIBOIS is the LIBOR minus Overnight Index Swap spread. ABX
refers to the spread on the BBB tranche of the ABX index.
Subprime will play an important role in the story later. But by itself it does not explain the crisis.
Q. Subprime mortgages were securitized. Isn’t securitization bad because it allows banks to sell
A. Holding loans on the balance sheets of banks is not profitable. This is a fundamental point. This is
why the parallel or shadow banking system developed. If an industry is not profitable, the owners exit
the industry by not investing; they invest elsewhere. Regulators can make banks do things, like hold
more capital, but they cannot prevent exit if banking is not profitable. “Exit” means that the regulated
banking sector shrinks, as bank equity holders refuse to invest more equity. Bank regulation determines
the size of the regulated banking sector, and that is all. One form of exit is for banks to not hold loans
but to sell the loans; securitization is the selling of portfolios of loans. Selling loans – while news to
some people—has been going on now for about 30 years without problems.
In securitization, the bank is still at risk because the bank keeps the residual or equity portion of the
securitized loans and earns fees for servicing these loans. Moreover, banks support their securitizations
when there are problems. No one has produced evidence of any problems with securitization generally;
though there are have been many such assertions. The motivation for banks to sell loans is profitability.
In a capitalist economy, firms (including banks) make decisions to maximize profits. Over the last 25
years securitization was one such outcome. As mentioned, regulators cannot make firms do unprofitable
things because investors do not have to invest in banks. Banks will simply shrink. This is exactly what
happened. The traditional banking sector shrank, and a whole new banking sector developed – the
outcome of millions of individual decisions over a quarter of a century.
Q. What is this new banking system, the “parallel banking system” or “shadow banking system” or
“securitized banking system”?
A. A major part of it is securitization. Never mind the details for our present purposes (see Gorton
(2010 for details); the main point is that this market is very large. The figure below shows the issuance
amounts of various levels of fixed-income instruments in the capital markets. The green line shows
mortgage-related instruments, including securitization. It is the largest market.
$ Billions
Issuance in US Capital Markets
Corporate Debt
Federal Securities
Sources: U.S. Department of Treasury, Federal Agencies, Thomson Financial, Inside MBS & ABS,
Of greater interest perhaps is the comparison of the non-mortgage securitization (labeled “Asset-
Backed” in the above figure) issuance amounts with the amount of all of U.S. corporate debt issuance.
This is portrayed in the figure below.
Sources: U.S. Department of Treasury, Federal Agencies, Thomson Financial, Inside MBS & ABS,
The figure shows two very important points. First, measured by issuance, non-mortgage securitization
exceeded the issuance of all U.S. corporate debt starting in 2004. Secondly, the figure shows the effects
of the crisis on issuance: this market is essentially dead.
Q. So, traditional, regulated, banks sell their loans to the other banking system. Is that the
connection between the parallel or shadow banking system and the traditional banking system?
A. Yes. The parallel or shadow banking system is essentially how the traditional, regulated, banking
system is funded. The two banking systems are intimately connected. This is very important to
recognize. It means that without the securitization markets the traditional banking system is not going
to function. The diagram below shows how the two banking systems are related.
$ Billions
Non-Mortgage ABS Issuance vs. Corporate Debt
Corporate Debt
Pension Co
Insurance Co
Global: $11T*
Bank Conduits : $1T
Auto loans
Specialist Credit
Managers $500B
Parallel Banking System Investors
“Greek woes revive seven-year-old swaps story.”

Well, are these swaps evil? To paraphrase Bill Clinton, it depends on what your definition of “is” is. They don’t look fabulous now that Greece is on the verge of default because it mismanaged its debt. But the swaps weren’t illegal, and Goldman was giving its client — Greece — what it asked for. The bank followed all the rules to do it. True, the swaps weren’t disclosed, but you can blame the Maastricht rules for that: No country has to disclose these swaps, and that’s partly why they’re so popular with politicians and also why you never hear about them in the popular media. The trend recently has been to slap down regulations on stuff that was okay before but looks bad now, and several countries including France have officials looking at these swaps for that reason.

So is this entire thing mostly political? Need you even ask?

Whew! Glad it can’t happen here. Don’t be so sure. Most countries like to avoid talking about the size of their deficits, and they like to make the deficits look smaller so that they can keep issuing government bonds without paying a lot to borrow the money from investors. Government bonds pay for things like infrastructure, schools, public transportation — and more recently, bailouts. In fact, the entire U.S. bailout of the financial system is funded by a weird government-bond-buying circle that makes it hard to track our debt: The Federal Reserve created the financial-system bailouts, then Treasury issues bonds to pay for the bailouts, and the Fed buys the Treasuries to pay for the bailouts, which, you’ll remember, the Fed created. Then there’s Fannie Mae and Freddie Mac, which are wards of the state. The Fed has been the biggest buyer of Fannie Mae and Freddie Mac bonds in order to prop up the housing market; banks, knowing this, spent much of the year buying up Fannie Mae and Freddie Mac bonds to sell back to the government at a higher price, knowing the Fed would pay through the nose if necessary. Almost certainly, the Fed has paid more than it has to for some of these bonds because it is the main buyer in the market. In addition, Fannie and Freddie keep sinking into debt, but our government has ruled to exclude the two disastrous companies from our national deficit — no small matter when Fannie and Freddie have something like $6.3 trillion in liabilities. Then there’s California, whose disastrous finances could bring the entire country down, according to an op-ed in the Los Angeles Times. Recently, Moody’s Investor Service warned the U.S. that its vaunted triple-A credit rating might slip. Treasury Secretary Tim Geithner had to assure everyone that America wouldn’t lose the valuable rating, which keeps our borrowing costs low. But even he can’t be so sure.
By: Heidi N. Moore

Betting on the Blind Side
Michael Burry always saw the world differently—due, he believed, to the childhood loss of one eye. So when the 32-year-old investor spotted the huge bubble in the subprime-mortgage bond market, in 2004, then created a way to bet against it, he wasn’t surprised that no one understood what he was doing. In an excerpt from his new book, The Big Short, the author charts Burry’s oddball maneuvers, his almost comical dealings with Goldman Sachs and other banks as the market collapsed, and the true reason for his visionary obsession.
By Michael Lewis•
Photograph by Jonas Fredwall Karlsson
April 2010

Excerpted from The Big Short: Inside the Doomsday Machine, by Michael Lewis, to be published this month by W. W. Norton; © 2010 by the author.

In early 2004 a 32-year-old stock-market investor and hedge-fund manager, Michael Burry, immersed himself for the first time in the bond market. He learned all he could about how money got borrowed and lent in America. He didn’t talk to anyone about what became his new obsession; he just sat alone in his office, in San Jose, California, and read books and articles and financial filings. He wanted to know, especially, how subprime-mortgage bonds worked. A giant number of individual loans got piled up into a tower. The top floors got their money back first and so got the highest ratings from Moody’s and S&P, and the lowest interest rate. The low floors got their money back last, suffered the first losses, and got the lowest ratings from Moody’s and S&P. Because they were taking on more risk, the investors in the bottom floors received a higher rate of interest than investors in the top floors. Investors who bought mortgage bonds had to decide in which floor of the tower they wanted to invest, but Michael Burry wasn’t thinking about buying mortgage bonds. He was wondering how he might short, or bet against, subprime-mortgage bonds.

Every mortgage bond came with its own mind-numbingly tedious 130-page prospectus. If you read the fine print, you saw that each bond was its own little corporation. Burry spent the end of 2004 and early 2005 scanning hundreds and actually reading dozens of the prospectuses, certain he was the only one apart from the lawyers who drafted them to do so—even though you could get them all for $100 a year from

The subprime-mortgage market had a special talent for obscuring what needed to be clarified. A bond backed entirely by subprime mortgages, for example, wasn’t called a subprime-mortgage bond. It was called an “A.B.S.,” or “asset-backed security.” If you asked Deutsche Bank exactly what assets secured an asset-backed security, you’d be handed lists of more acronyms—R.M.B.S., hels, helocs, Alt-A—along with categories of credit you did not know existed (“midprime”). R.M.B.S. stood for “residential-mortgage-backed security.” hel stood for “home-equity loan.” heloc stood for “home-equity line of credit.” Alt-A was just what they called crappy subprime-mortgage loans for which they hadn’t even bothered to acquire the proper documents—to, say, verify the borrower’s income. All of this could more clearly be called “subprime loans,” but the bond market wasn’t clear. “Midprime” was a kind of triumph of language over truth. Some crafty bond-market person had gazed upon the subprime-mortgage sprawl, as an ambitious real-estate developer might gaze upon Oakland, and found an opportunity to rebrand some of the turf. Inside Oakland there was a neighborhood, masquerading as an entirely separate town, called “Rockridge.” Simply by refusing to be called “Oakland,” “Rockridge” enjoyed higher property values. Inside the subprime-mortgage market there was now a similar neighborhood known as “midprime.”

But as early as 2004, if you looked at the numbers, you could clearly see the decline in lending standards. In Burry’s view, standards had not just fallen but hit bottom. The bottom even had a name: the interest-only negative-amortizing adjustable-rate subprime mortgage. You, the homebuyer, actually were given the option of paying nothing at all, and rolling whatever interest you owed the bank into a higher principal balance. It wasn’t hard to see what sort of person might like to have such a loan: one with no income. What Burry couldn’t understand was why a person who lent money would want to extend such a loan. “What you want to watch are the lenders, not the borrowers,” he said. “The borrowers will always be willing to take a great deal for themselves. It’s up to the lenders to show restraint, and when they lose it, watch out.” By 2003 he knew that the borrowers had already lost it. By early 2005 he saw that lenders had, too.

A lot of hedge-fund managers spent time chitchatting with their investors and treated their quarterly letters to them as a formality. Burry disliked talking to people face-to-face and thought of these letters as the single most important thing he did to let his investors know what he was up to. In his quarterly letters he coined a phrase to describe what he thought was happening: “the extension of credit by instrument.” That is, a lot of people couldn’t actually afford to pay their mortgages the old-fashioned way, and so the lenders were dreaming up new financial instruments to justify handing them new money. “It was a clear sign that lenders had lost it, constantly degrading their own standards to grow loan volumes,” Burry said. He could see why they were doing this: they didn’t keep the loans but sold them to Goldman Sachs and Morgan Stanley and Wells Fargo and the rest, which packaged them into bonds and sold them off. The end buyers of subprime-mortgage bonds, he assumed, were just “dumb money.” He’d study up on them, too, but later.

He now had a tactical investment problem. The various floors, or tranches, of subprime-mortgage bonds all had one thing in common: the bonds were impossible to sell short. To sell a stock or bond short, you needed to borrow it, and these tranches of mortgage bonds were tiny and impossible to find. You could buy them or not buy them, but you couldn’t bet explicitly against them; the market for subprime mortgages simply had no place for people in it who took a dim view of them. You might know with certainty that the entire subprime-mortgage-bond market was doomed, but you could do nothing about it. You couldn’t short houses. You could short the stocks of homebuilding companies—Pulte Homes, say, or Toll Brothers—but that was expensive, indirect, and dangerous. Stock prices could rise for a lot longer than Burry could stay solvent.

A couple of years earlier, he’d discovered credit-default swaps. A credit-default swap was confusing mainly because it wasn’t really a swap at all. It was an insurance policy, typically on a corporate bond, with periodic premium payments and a fixed term. For instance, you might pay $200,000 a year to buy a 10-year credit-default swap on $100 million in General Electric bonds. The most you could lose was $2 million: $200,000 a year for 10 years. The most you could make was $100 million, if General Electric defaulted on its debt anytime in the next 10 years and bondholders recovered nothing. It was a zero-sum bet: if you made $100 million, the guy who had sold you the credit-default swap lost $100 million. It was also an asymmetric bet, like laying down money on a number in roulette. The most you could lose were the chips you put on the table, but if your number came up, you made 30, 40, even 50 times your money. “Credit-default swaps remedied the problem of open-ended risk for me,” said Burry. “If I bought a credit-default swap, my downside was defined and certain, and the upside was many multiples of it.”

He was already in the market for corporate credit-default swaps. In 2004 he began to buy insurance on companies he thought might suffer in a real-estate downturn: mortgage lenders, mortgage insurers, and so on. This wasn’t entirely satisfying. A real-estate-market meltdown might cause these companies to lose money; there was no guarantee that they would actually go bankrupt. He wanted a more direct tool for betting against subprime-mortgage lending. On March 19, 2005, alone in his office with the door closed and the shades pulled down, reading an abstruse textbook on credit derivatives, Michael Burry got an idea: credit-default swaps on subprime-mortgage bonds.

The idea hit him as he read a book about the evolution of the U.S. bond market and the creation, in the mid-1990s, at J. P. Morgan, of the first corporate credit-default swaps. He came to a passage explaining why banks felt they needed credit-default swaps at all. It wasn’t immediately obvious—after all, the best way to avoid the risk of General Electric’s defaulting on its debt was not to lend to General Electric in the first place. In the beginning, credit-default swaps had been a tool for hedging: some bank had loaned more than they wanted to to General Electric because G.E. had asked for it, and they feared alienating a long-standing client; another bank changed its mind about the wisdom of lending to G.E. at all. Very quickly, however, the new derivatives became tools for speculation: a lot of people wanted to make bets on the likelihood of G.E.’s defaulting. It struck Burry: Wall Street is bound to do the same thing with subprime-mortgage bonds, too. Given what was happening in the real-estate market—and given what subprime-mortgage lenders were doing—a lot of smart people eventually were going to want to make side bets on subprime-mortgage bonds. And the only way to do it would be to buy a credit-default swap.

The credit-default swap would solve the single biggest problem with Mike Burry’s big idea: timing. The subprime-mortgage loans being made in early 2005 were, he felt, almost certain to go bad. But, as their interest rates were set artificially low and didn’t reset for two years, it would be two years before that happened. Subprime mortgages almost always bore floating interest rates, but most of them came with a fixed, two-year “teaser” rate. A mortgage created in early 2005 might have a two-year “fixed” rate of 6 percent that, in 2007, would jump to 11 percent and provoke a wave of defaults. The faint ticking sound of these loans would grow louder with time, until eventually a lot of people would suspect, as he suspected, that they were bombs. Once that happened, no one would be willing to sell insurance on subprime-mortgage bonds. He needed to lay his chips on the table now and wait for the casino to wake up and change the odds of the game. A credit-default swap on a 30-year subprime-mortgage bond was a bet designed to last for 30 years, in theory. He figured that it would take only three to pay off.

The only problem was that there was no such thing as a credit-default swap on a subprime-mortgage bond, not that he could see. He’d need to prod the big Wall Street firms to create them. But which firms? If he was right and the housing market crashed, these firms in the middle of the market were sure to lose a lot of money. There was no point buying insurance from a bank that went out of business the minute the insurance became valuable. He didn’t even bother calling Bear Stearns and Lehman Brothers, as they were more exposed to the mortgage-bond market than the other firms. Goldman Sachs, Morgan Stanley, Deutsche Bank, Bank of America, UBS, Merrill Lynch, and Citigroup were, to his mind, the most likely to survive a crash. He called them all. Five of them had no idea what he was talking about; two came back and said that, while the market didn’t exist, it might one day. Inside of three years, credit-default swaps on subprime-mortgage bonds would become a trillion-dollar market and precipitate hundreds of billions of losses inside big Wall Street firms. Yet, when Michael Burry pestered the firms in the beginning of 2005, only Deutsche Bank and Goldman Sachs had any real interest in continuing the conversation. No one on Wall Street, as far as he could tell, saw what he was seeing.

He sensed that he was different from other people before he understood why. Before he was two years old he was diagnosed with a rare form of cancer, and the operation to remove the tumor had cost him his left eye. A boy with one eye sees the world differently from everyone else, but it didn’t take long for Mike Burry to see his literal distinction in more figurative terms. Grown-ups were forever insisting that he should look other people in the eye, especially when he was talking to them. “It took all my energy to look someone in the eye,” he said. “If I am looking at you, that’s the one time I know I won’t be listening to you.” His left eye didn’t line up with whomever he was trying to talk to; when he was in social situations, trying to make chitchat, the person to whom he was speaking would steadily drift left. “I don’t really know how to stop it,” he said, “so people just keep moving left until they’re standing way to my left, and I’m trying not to turn my head anymore. I end up facing right and looking left with my good eye, through my nose.”

His glass eye, he assumed, was the reason that face-to-face interaction with other people almost always ended badly for him. He found it maddeningly difficult to read people’s nonverbal signals, and their verbal signals he often took more literally than they meant them. When trying his best, he was often at his worst. “My compliments tended not to come out right,” he said. “I learned early that if you compliment somebody it’ll come out wrong. For your size, you look good. That’s a really nice dress: it looks homemade.” The glass eye became his private explanation for why he hadn’t really fit in with groups. The eye oozed and wept and required constant attention. It wasn’t the sort of thing other kids ever allowed him to be unself-conscious about. They called him cross-eyed, even though he wasn’t. Every year they begged him to pop his eye out of its socket—but when he complied, it became infected and disgusting and a cause of further ostracism.

In his glass eye he found the explanation for other traits peculiar to himself. His obsession with fairness, for example. When he noticed that pro basketball stars were far less likely to be called for traveling than lesser players, he didn’t just holler at the refs. He stopped watching basketball altogether; the injustice of it killed his interest in the sport. Even though he was ferociously competitive, well built, physically brave, and a good athlete, he didn’t care for team sports. The eye helped to explain this, as most team sports were ball sports, and a boy with poor depth perception and limited peripheral vision couldn’t very well play ball sports. He tried hard at the less ball-centric positions in football, but his eye popped out if he hit someone too hard. He preferred swimming, as it required virtually no social interaction. No teammates. No ambiguity. You just swam your time and you won or you lost.

After a while even he ceased to find it surprising that he spent most of his time alone. By his late 20s he thought of himself as the sort of person who didn’t have friends. He’d gone through Santa Teresa High School, in San Jose, U.C.L.A., and Vanderbilt University School of Medicine, and created not a single lasting bond. What friendships he did have were formed and nurtured in writing, by email; the two people he considered to be true friends he had known for a combined 20 years but had met in person a grand total of eight times. “My nature is not to have friends,” he said. “I’m happy in my own head.” Somehow he’d married twice. His first wife was a woman of Korean descent who wound up living in a different city (“She often complained that I appeared to like the idea of a relationship more than living the actual relationship”) and his second, to whom he was still married, was a Vietnamese-American woman he’d met on In his profile, he described himself frankly as “a medical resident with only one eye, an awkward social manner, and $145,000 in student loans.” His obsession with personal honesty was a cousin to his obsession with fairness.

Obsessiveness—that was another trait he came to think of as peculiar to himself. His mind had no temperate zone: he was either possessed by a subject or not interested in it at all. There was an obvious downside to this quality—he had more trouble than most faking interest in other people’s concerns and hobbies, for instance—but an upside, too. Even as a small child he had a fantastic ability to focus and learn, with or without teachers. When it synched with his interests, school came easy for him—so easy that, as an undergraduate at U.C.L.A., he could flip back and forth between English and economics and pick up enough pre-medical training on the side to get himself admitted to the best medical schools in the country. He attributed his unusual powers of concentration to his lack of interest in human interaction, and his lack of interest in human interaction … well, he was able to argue that basically everything that happened was caused, one way or the other, by his fake left eye.

This ability to work and to focus set him apart even from other medical students. In 1998, as a resident in neurology at Stanford Hospital, he mentioned to his superiors that, between 14-hour hospital shifts, he had stayed up two nights in a row taking apart and putting back together his personal computer in an attempt to make it run faster. His superiors sent him to a psychiatrist, who diagnosed Mike Burry as bipolar. He knew instantly he’d been misdiagnosed: how could you be bipolar if you were never depressed? Or, rather, if you were depressed only while doing your rounds and pretending to be interested in practicing, as opposed to studying, medicine? He’d become a doctor not because he enjoyed medicine but because he didn’t find medical school terribly difficult. The actual practice of medicine, on the other hand, either bored or disgusted him. Of his first brush with gross anatomy: “one scene with people carrying legs over their shoulders to the sink to wash out the feces just turned my stomach, and I was done.” Of his feeling about the patients: “I wanted to help people—but not really.”

He was genuinely interested in computers, not for their own sake but for their service to a lifelong obsession: the inner workings of the stock market. Ever since grade school, when his father had shown him the stock tables at the back of the newspaper and told him that the stock market was a crooked place and never to be trusted, let alone invested in, the subject had fascinated him. Even as a kid he had wanted to impose logic on this world of numbers. He began to read about the market as a hobby. Pretty quickly he saw that there was no logic at all in the charts and graphs and waves and the endless chatter of many self-advertised market pros. Then along came the dot-com bubble and suddenly the entire stock market made no sense at all. “The late 90s almost forced me to identify myself as a value investor, because I thought what everybody else was doing was insane,” he said. Formalized as an approach to financial markets during the Great Depression by Benjamin Graham, “value investing” required a tireless search for companies so unfashionable or misunderstood that they could be bought for less than their liquidation value. In its simplest form, value investing was a formula, but it had morphed into other things—one of them was whatever Warren Buffett, Benjamin Graham’s student and the most famous value investor, happened to be doing with his money.

Burry did not think investing could be reduced to a formula or learned from any one role model. The more he studied Buffett, the less he thought Buffett could be copied. Indeed, the lesson of Buffett was: To succeed in a spectacular fashion you had to be spectacularly unusual. “If you are going to be a great investor, you have to fit the style to who you are,” Burry said. “At one point I recognized that Warren Buffett, though he had every advantage in learning from Ben Graham, did not copy Ben Graham, but rather set out on his own path, and ran money his way, by his own rules.… I also immediately internalized the idea that no school could teach someone how to be a great investor. If it were true, it’d be the most popular school in the world, with an impossibly high tuition. So it must not be true.”

Investing was something you had to learn how to do on your own, in your own peculiar way. Burry had no real money to invest, but he nevertheless dragged his obsession along with him through high school, college, and medical school. He’d reached Stanford Hospital without ever taking a class in finance or accounting, let alone working for any Wall Street firm. He had maybe $40,000 in cash, against $145,000 in student loans. He had spent the previous four years working medical-student hours. Nevertheless, he had found time to make himself a financial expert of sorts. “Time is a variable continuum,” he wrote to one of his e-mail friends one Sunday morning in 1999: “An afternoon can fly by or it can take 5 hours. Like you probably do, I productively fill the gaps that most people leave as dead time. My drive to be productive probably cost me my first marriage and a few days ago almost cost me my fiancée. Before I went to college the military had this ‘we do more before 9am than most people do all day’ and I used to think I do more than the military. As you know there are some select people that just find a drive in certain activities that supersedes everything else.” Thinking himself different, he didn’t find what happened to him when he collided with Wall Street nearly as bizarre as it was.

Late one night in November 1996, while on a cardiology rotation at Saint Thomas Hospital, in Nashville, Tennessee, he logged on to a hospital computer and went to a message board called There he created a thread called “value investing.” Having read everything there was to read about investing, he decided to learn a bit more about “investing in the real world.” A mania for Internet stocks gripped the market. A site for the Silicon Valley investor, circa 1996, was not a natural home for a sober-minded value investor. Still, many came, all with opinions. A few people grumbled about the very idea of a doctor having anything useful to say about investments, but over time he came to dominate the discussion. Dr. Mike Burry—as he always signed himself—sensed that other people on the thread were taking his advice and making money with it.

Once he figured out he had nothing more to learn from the crowd on his thread, he quit it to create what later would be called a blog but at the time was just a weird form of communication. He was working 16-hour shifts at the hospital, confining his blogging mainly to the hours between midnight and three in the morning. On his blog he posted his stock-market trades and his arguments for making the trades. People found him. As a money manager at a big Philadelphia value fund said, “The first thing I wondered was: When is he doing this? The guy was a medical intern. I only saw the nonmedical part of his day, and it was simply awesome. He’s showing people his trades. And people are following it in real time. He’s doing value investing—in the middle of the dot-com bubble. He’s buying value stocks, which is what we’re doing. But we’re losing money. We’re losing clients. All of a sudden he goes on this tear. He’s up 50 percent. It’s uncanny. He’s uncanny. And we’re not the only ones watching it.”

Mike Burry couldn’t see exactly who was following his financial moves, but he could tell which domains they came from. In the beginning his readers came from EarthLink and AOL. Just random individuals. Pretty soon, however, they weren’t. People were coming to his site from mutual funds like Fidelity and big Wall Street investment banks like Morgan Stanley. One day he lit into Vanguard’s index funds and almost instantly received a cease-and-desist letter from Vanguard’s attorneys. Burry suspected that serious investors might even be acting on his blog posts, but he had no clear idea who they might be. “The market found him,” says the Philadelphia mutual-fund manager. “He was recognizing patterns no one else was seeing.”

By the time Burry moved to Stanford Hospital, in 1998, to take up his residency in neurology, the work he had done between midnight and three in the morning had made him a minor but meaningful hub in the land of value investing. By this time the craze for Internet stocks was completely out of control and had infected the Stanford University medical community. “The residents in particular, and some of the faculty, were captivated by the dot-com bubble,” said Burry. “A decent minority of them were buying and discussing everything—Polycom, Corel, Razorfish,, TibCo, Microsoft, Dell, Intel are the ones I specifically remember, but was how my brain filtered a lot of it I would just keep my mouth shut, because I didn’t want anybody there knowing what I was doing on the side. I felt I could get in big trouble if the doctors there saw I wasn’t 110 percent committed to medicine.”

People who worry about seeming sufficiently committed to medicine probably aren’t sufficiently committed to medicine. The deeper he got into his medical career, the more Burry felt constrained by his problems with other people in the flesh. He had briefly tried to hide in pathology, where the people had the decency to be dead, but that didn’t work. (“Dead people, dead parts. More dead people, more dead parts. I thought, I want something more cerebral.”)

He’d moved back to San Jose, buried his father, remarried, and been misdiagnosed as bipolar when he shut down his Web site and announced he was quitting neurology to become a money manager. The chairman of the Stanford department of neurology thought he’d lost his mind and told him to take a year to think it over, but he’d already thought it over. “I found it fascinating and seemingly true,” he said, “that if I could run a portfolio well, then I could achieve success in life, and that it wouldn’t matter what kind of person I was perceived to be, even though I felt I was a good person deep down.” His $40,000 in assets against $145,000 in student loans posed the question of exactly what portfolio he would run. His father had died after another misdiagnosis: a doctor had failed to spot the cancer on an X-ray, and the family had received a small settlement. The father disapproved of the stock market, but the payout from his death funded his son into it. His mother was able to kick in $20,000 from her settlement, his three brothers kicked in $10,000 each of theirs. With that, Dr. Michael Burry opened Scion Capital. (As a teen he’d loved the book The Scions of Shannara.) He created a grandiose memo to lure people not related to him by blood. “The minimum net worth for investors should be $15 million,” it said, which was interesting, as it excluded not only himself but basically everyone he’d ever known.

As he scrambled to find office space, buy furniture, and open a brokerage account, he received a pair of surprising phone calls. The first came from a big investment fund in New York City, Gotham Capital. Gotham was founded by a value-investment guru named Joel Greenblatt. Burry had read Greenblatt’s book You Can Be a Stock Market Genius. (“I hated the title but liked the book.”) Greenblatt’s people told him that they had been making money off his ideas for some time and wanted to continue to do so—might Mike Burry consider allowing Gotham to invest in his fund? “Joel Greenblatt himself called,” said Burry, “and said, ‘I’ve been waiting for you to leave medicine.’” Gotham flew Burry and his wife to New York—and it was the first time Michael Burry had flown to New York or flown first-class—and put him up in a suite at the Intercontinental Hotel.

On his way to his meeting with Greenblatt, Burry was racked with the anxiety that always plagued him before face-to-face encounters with people. He took some comfort in the fact that the Gotham people seemed to have read so much of what he had written. “If you read what I wrote first, and then meet me, the meeting goes fine,” he said. “People who meet me who haven’t read what I wrote—it almost never goes well. Even in high school it was like that—even with teachers.” He was a walking blind taste test: you had to decide if you approved of him before you laid eyes on him. In this case he was at a serious disadvantage, as he had no clue how big-time money managers dressed. “He calls me the day before the meeting,” says one of his e-mail friends, himself a professional money manager. “And he asks, ‘What should I wear?’ He didn’t own a tie. He had one blue sports coat, for funerals.” This was another quirk of Mike Burry’s. In writing, he presented himself formally, even a bit stuffily, but he dressed for the beach. Walking to Gotham’s office, he panicked and ducked into a Tie Rack and bought a tie. He arrived at the big New York money-management firm as formally attired as he had ever been in his entire life to find its partners in T-shirts and sweatpants. The exchange went something like this: “We’d like to give you a million dollars.” “Excuse me?” “We want to buy a quarter of your new hedge fund. For a million dollars.” “You do?” “Yes. We’re offering a million dollars.” “After tax!”

Somehow Burry had it in his mind that one day he wanted to be worth a million dollars, after tax. At any rate, he’d just blurted that last bit out before he fully understood what they were after. And they gave it to him! At that moment, on the basis of what he’d written on his blog, he went from being an indebted medical resident with a net worth of minus $105,000 to a millionaire with a few outstanding loans. Burry didn’t know it, but it was the first time Joel Greenblatt had done such a thing. “He was just obviously this brilliant guy, and there aren’t that many of them,” says Greenblatt.

Shortly after that odd encounter, he had a call from the insurance holding company White Mountain. White Mountain was run by Jack Byrne, a member of Warren Buffett’s inner circle, and they had spoken to Gotham Capital. “We didn’t know you were selling part of your firm,” they said—and Burry explained that he hadn’t realized it either until a few days earlier, when someone offered a million dollars, after tax, for it. It turned out that White Mountain, too, had been watching Michael Burry closely. “What intrigued us more than anything was that he was a neurology resident,” says Kip Oberting, then at White Mountain. “When the hell was he doing this?” From White Mountain he extracted $600,000 for another piece of his fund, plus a promise to send him $10 million to invest. “And yes,” said Oberting, “he was the only person we found on the Internet and cold-called and gave him money.”

In Dr. Mike Burry’s first year in business, he grappled briefly with the social dimension of running money. “Generally you don’t raise any money unless you have a good meeting with people,” he said, “and generally I don’t want to be around people. And people who are with me generally figure that out.” When he spoke to people in the flesh, he could never tell what had put them off, his message or his person. Buffett had had trouble with people, too, in his youth. He’d used a Dale Carnegie course to learn how to interact more profitably with his fellow human beings. Mike Burry came of age in a different money culture. The Internet had displaced Dale Carnegie. He didn’t need to meet people. He could explain himself online and wait for investors to find him. He could write up his elaborate thoughts and wait for people to read them and wire him their money to handle. “Buffett was too popular for me,” said Burry. “I won’t ever be a kindly grandfather figure.”

This method of attracting funds suited Mike Burry. More to the point, it worked. He’d started Scion Capital with a bit more than a million dollars—the money from his mother and brothers and his own million, after tax. Right from the start, Scion Capital was madly, almost comically successful. In his first full year, 2001, the S&P 500 fell 11.88 percent. Scion was up 55 percent. The next year, the S&P 500 fell again, by 22.1 percent, and yet Scion was up again: 16 percent. The next year, 2003, the stock market finally turned around and rose 28.69 percent, but Mike Burry beat it again—his investments rose by 50 percent. By the end of 2004, Mike Burry was managing $600 million and turning money away. “If he’d run his fund to maximize the amount he had under management, he’d have been running many, many billions of dollars,” says a New York hedge-fund manager who watched Burry’s performance with growing incredulity. “He designed Scion so it was bad for business but good for investing.”

Thus when Mike Burry went into business he disapproved of the typical hedge-fund manager’s deal. Taking 2 percent of assets off the top, as most did, meant the hedge-fund manager got paid simply for amassing vast amounts of other people’s money. Scion Capital charged investors only its actual expenses—which typically ran well below 1 percent of the assets. To make the first nickel for himself, he had to make investors’ money grow. “Think about the genesis of Scion,” says one of his early investors. “The guy has no money and he chooses to forgo a fee that any other hedge fund takes for granted. It was unheard of.”

By the middle of 2005, over a period in which the broad stock-market index had fallen by 6.84 percent, Burry’s fund was up 242 percent, and he was turning away investors. To his swelling audience, it didn’t seem to matter whether the stock market rose or fell; Mike Burry found places to invest money shrewdly. He used no leverage and avoided shorting stocks. He was doing nothing more promising than buying common stocks and nothing more complicated than sitting in a room reading financial statements. Scion Capital’s decision-making apparatus consisted of one guy in a room, with the door closed and the shades down, poring over publicly available information and data on 10-K Wizard. He went looking for court rulings, deal completions, and government regulatory changes—anything that might change the value of a company.

As often as not, he turned up what he called “ick” investments. In October 2001 he explained the concept in his letter to investors: “Ick investing means taking a special analytical interest in stocks that inspire a first reaction of ‘ick.’” A court had accepted a plea from a software company called the Avanti Corporation. Avanti had been accused of stealing from a competitor the software code that was the whole foundation of Avanti’s business. The company had $100 million in cash in the bank, was still generating $100 million a year in free cash flow—and had a market value of only $250 million! Michael Burry started digging; by the time he was done, he knew more about the Avanti Corporation than any man on earth. He was able to see that even if the executives went to jail (as five of them did) and the fines were paid (as they were), Avanti would be worth a lot more than the market then assumed. To make money on Avanti’s stock, however, he’d probably have to stomach short-term losses, as investors puked up shares in horrified response to negative publicity.

“That was a classic Mike Burry trade,” says one of his investors. “It goes up by 10 times, but first it goes down by half.” This isn’t the sort of ride most investors enjoy, but it was, Burry thought, the essence of value investing. His job was to disagree loudly with popular sentiment. He couldn’t do this if he was at the mercy of very short-term market moves, and so he didn’t give his investors the ability to remove their money on short notice, as most hedge funds did. If you gave Scion your money to invest, you were stuck for at least a year.

Investing well was all about being paid the right price for risk. Increasingly, Burry felt that he wasn’t. The problem wasn’t confined to individual stocks. The Internet bubble had burst, and yet house prices in San Jose, the bubble’s epicenter, were still rising. He investigated the stocks of homebuilders and then the stocks of companies that insured home mortgages, like PMI. To one of his friends—a big-time East Coast professional investor—he wrote in May 2003 that the real-estate bubble was being driven ever higher by the irrational behavior of mortgage lenders who were extending easy credit. “You just have to watch for the level at which even nearly unlimited or unprecedented credit can no longer drive the [housing] market higher,” he wrote. “I am extremely bearish, and feel the consequences could very easily be a 50% drop in residential real estate in the U.S.…A large portion of current [housing] demand at current prices would disappear if only people became convinced that prices weren’t rising. The collateral damage is likely to be orders of magnitude worse than anyone now considers.”

On May 19, 2005, Mike Burry did his first subprime-mortgage deals. He bought $60 million of credit-default swaps from Deutsche Bank—$10 million each on six different bonds. “The reference securities,” these were called. You didn’t buy insurance on the entire subprime-mortgage-bond market but on a particular bond, and Burry had devoted himself to finding exactly the right ones to bet against. He likely became the only investor to do the sort of old-fashioned bank credit analysis on the home loans that should have been done before they were made. He was the opposite of an old-fashioned banker, however. He was looking not for the best loans to make but the worst loans—so that he could bet against them. He analyzed the relative importance of the loan-to-value ratios of the home loans, of second liens on the homes, of the location of the homes, of the absence of loan documentation and proof of income of the borrower, and a dozen or so other factors to determine the likelihood that a home loan made in America circa 2005 would go bad. Then he went looking for the bonds backed by the worst of the loans.

It surprised him that Deutsche Bank didn’t seem to care which bonds he picked to bet against. From their point of view, so far as he could tell, all subprime-mortgage bonds were the same. The price of insurance was driven not by any independent analysis but by the ratings placed on the bond by Moody’s and Standard & Poor’s. If he wanted to buy insurance on the supposedly riskless triple-A-rated tranche, he might pay 20 basis points (0.20 percent); on the riskier, A-rated tranches, he might pay 50 basis points (0.50 percent); and on the even less safe, triple-B-rated tranches, 200 basis points—that is, 2 percent. (A basis point is one-hundredth of one percentage point.) The triple-B-rated tranches—the ones that would be worth zero if the underlying mortgage pool experienced a loss of just 7 percent—were what he was after. He felt this to be a very conservative bet, which he was able, through analysis, to turn into even more of a sure thing. Anyone who even glanced at the prospectuses could see that there were many critical differences between one triple-B bond and the next—the percentage of interest-only loans contained in their underlying pool of mortgages, for example. He set out to cherry-pick the absolute worst ones and was a bit worried that the investment banks would catch on to just how much he knew about specific mortgage bonds, and adjust their prices.

Once again they shocked and delighted him: Goldman Sachs e-mailed him a great long list of crappy mortgage bonds to choose from. “This was shocking to me, actually,” he says. “They were all priced according to the lowest rating from one of the big-three ratings agencies.” He could pick from the list without alerting them to the depth of his knowledge. It was as if you could buy flood insurance on the house in the valley for the same price as flood insurance on the house on the mountaintop.

The market made no sense, but that didn’t stop other Wall Street firms from jumping into it, in part because Mike Burry was pestering them. For weeks he hounded Bank of America until they agreed to sell him $5 million in credit-default swaps. Twenty minutes after they sent their e-mail confirming the trade, they received another back from Burry: “So can we do another?” In a few weeks Mike Burry bought several hundred million dollars in credit-default swaps from half a dozen banks, in chunks of $5 million. None of the sellers appeared to care very much which bonds they were insuring. He found one mortgage pool that was 100 percent floating-rate negative-amortizing mortgages—where the borrowers could choose the option of not paying any interest at all and simply accumulate a bigger and bigger debt until, presumably, they defaulted on it. Goldman Sachs not only sold him insurance on the pool but sent him a little note congratulating him on being the first person, on Wall Street or off, ever to buy insurance on that particular item. “I’m educating the experts here,” Burry crowed in an e-mail.

He wasn’t wasting a lot of time worrying about why these supposedly shrewd investment bankers were willing to sell him insurance so cheaply. He was worried that others would catch on and the opportunity would vanish. “I would play dumb quite a bit,” he said, “making it seem to them like I don’t really know what I’m doing. ‘How do you do this again?’ ‘Oh, where can I find that information?’ or ‘Really?’—when they tell me something really obvious.” It was one of the fringe benefits of living for so many years essentially alienated from the world around him: he could easily believe that he was right and the world was wrong.

The more Wall Street firms jumped into the new business, the easier it became for him to place his bets. For the first few months, he was able to short, at most, $10 million at a time. Then, in late June 2005, he had a call from someone at Goldman Sachs asking him if he’d like to increase his trade size to $100 million a pop. “What needs to be remembered here,” he wrote the next day, after he’d done it, “is that this is $100 million. That’s an insane amount of money. And it just gets thrown around like it’s three digits instead of nine.”

By the end of July he owned credit-default swaps on $750 million in subprime-mortgage bonds and was privately bragging about it. “I believe no other hedge fund on the planet has this sort of investment, nowhere near to this degree, relative to the size of the portfolio,” he wrote to one of his investors, who had caught wind that his hedge-fund manager had some newfangled strategy. Now he couldn’t help but wonder who exactly was on the other side of his trades—what madman would be selling him so much insurance on bonds he had handpicked to explode? The credit-default swap was a zero-sum game. If Mike Burry made $100 million when the subprime-mortgage bonds he had handpicked defaulted, someone else must have lost $100 million. Goldman Sachs made it clear that the ultimate seller wasn’t Goldman Sachs. Goldman Sachs was simply standing between insurance buyer and insurance seller and taking a cut.

The willingness of whoever this person was to sell him such vast amounts of cheap insurance gave Mike Burry another idea: to start a fund that did nothing but buy insurance on subprime-mortgage bonds. In a $600 million fund that was meant to be picking stocks, his bet was already gargantuan, but if he could raise the money explicitly for this new purpose, he could do many billions more. In August he wrote a proposal for a fund he called Milton’s Opus and sent it out to his investors. (“The first question was always ‘What’s Milton’s Opus?’” He’d say, “Paradise Lost,” but that usually just raised another question.) Most of them still had no idea that their champion stock picker had become so diverted by these esoteric insurance contracts called credit-default swaps. Many wanted nothing to do with it; a few wondered if this meant that he was already doing this sort of thing with their money.

Instead of raising more money to buy credit-default swaps on subprime-mortgage bonds, he wound up making it more difficult to keep the ones he already owned. His investors were happy to let him pick stocks on their behalf, but they almost universally doubted his ability to foresee big macro-economic trends. And they certainly didn’t see why he should have any special insight into the multi-trillion-dollar subprime-mortgage-bond market. Milton’s Opus died a quick death.

In October 2005, in his letter to investors, Burry finally came completely clean and let them know that they owned at least a billion dollars in credit-default swaps on subprime-mortgage bonds. “Sometimes markets err big time,” he wrote. “Markets erred when they gave America Online the currency to buy Time Warner. They erred when they bet against George Soros and for the British pound. And they are erring right now by continuing to float along as if the most significant credit bubble history has ever seen does not exist. Opportunities are rare, and large opportunities on which one can put nearly unlimited capital to work at tremendous potential returns are even more rare. Selectively shorting the most problematic mortgage-backed securities in history today amounts to just such an opportunity.”

In the second quarter of 2005, credit-card delinquencies hit an all-time high—even though house prices had boomed. That is, even with this asset to borrow against, Americans were struggling more than ever to meet their obligations. The Federal Reserve had raised interest rates, but mortgage rates were still effectively falling—because Wall Street was finding ever more clever ways to enable people to borrow money. Burry now had more than a billion-dollar bet on the table and couldn’t grow it much more unless he attracted a lot more money. So he just laid it out for his investors: the U.S. mortgage-bond market was huge, bigger than the market for U.S. Treasury notes and bonds. The entire economy was premised on its stability, and its stability in turn depended on house prices continuing to rise. “It is ludicrous to believe that asset bubbles can only be recognized in hindsight,” he wrote. “There are specific identifiers that are entirely recognizable during the bubble’s inflation. One hallmark of mania is the rapid rise in the incidence and complexity of fraud.… The FBI reports mortgage-related fraud is up fivefold since 2000.” Bad behavior was no longer on the fringes of an otherwise sound economy; it was its central feature. “The salient point about the modern vintage of housing-related fraud is its integral place within our nation’s institutions,” he added.

When his investors learned that their money manager had actually put their money directly where his mouth had long been, they were not exactly pleased. As one investor put it, “Mike’s the best stock picker anyone knows. And he’s doing … what?” Some were upset that a guy they had hired to pick stocks had gone off to pick rotten mortgage bonds instead; some wondered, if credit-default swaps were such a great deal, why Goldman Sachs would be selling them; some questioned the wisdom of trying to call the top of a 70-year housing cycle; some didn’t really understand exactly what a credit-default swap was, or how it worked. “It has been my experience that apocalyptic forecasts on the U.S. financial markets are rarely realized within limited horizons,” one investor wrote to Burry. “There have been legitimate apocalyptic cases to be made on U.S. financial markets during most of my career. They usually have not been realized.” Burry replied that while it was true that he foresaw Armageddon, he wasn’t betting on it. That was the beauty of credit-default swaps: they enabled him to make a fortune if just a tiny fraction of these dubious pools of mortgages went bad.

Inadvertently, he’d opened up a debate with his own investors, which he counted among his least favorite activities. “I hated discussing ideas with investors,” he said, “because I then become a Defender of the Idea, and that influences your thought process.” Once you became an idea’s defender, you had a harder time changing your mind about it. He had no choice: among the people who gave him money there was pretty obviously a built-in skepticism of so-called macro thinking. “I have heard that White Mountain would rather I stick to my knitting,” he wrote, testily, to his original backer, “though it is not clear to me that White Mountain has historically understood what my knitting really is.” No one seemed able to see what was so plain to him: these credit-default swaps were all part of his global search for value. “I don’t take breaks in my search for value,” he wrote to White Mountain. “There is no golf or other hobby to distract me. Seeing value is what I do.”

When he’d started Scion, he told potential investors that, because he was in the business of making unfashionable bets, they should evaluate him over the long term—say, five years. Now he was being evaluated moment to moment. “Early on, people invested in me because of my letters,” he said. “And then, somehow, after they invested, they stopped reading them.” His fantastic success attracted lots of new investors, but they were less interested in the spirit of his enterprise than in how much money he could make them quickly. Every quarter, he told them how much he’d made or lost from his stock picks. Now he had to explain that they had to subtract from that number these & subprime-mortgage-bond insurance premiums. One of his New York investors called and said ominously, “You know, a lot of people are talking about withdrawing funds from you.” As their funds were contractually stuck inside Scion Capital for some time, the investors’ only recourse was to send him disturbed-sounding e-mails asking him to justify his new strategy. “People get hung up on the difference between +5% and -5% for a couple of years,” Burry replied to one investor who had protested the new strategy. “When the real issue is: over 10 years who does 10% or better annually? And I firmly believe that to achieve that advantage on an annual basis, I have to be able to look out past the next couple of years.… I have to be steadfast in the face of popular discontent if that’s what the fundamentals tell me.” In the five years since he had started, the S&P 500, against which he was measured, was down 6.84 percent. In the same period, he reminded his investors, Scion Capital was up 242 percent. He assumed he’d earned the rope to hang himself. He assumed wrong. “I’m building breathtaking sand castles,” he wrote, “but nothing stops the tide from coming and coming and coming.”

Oddly, as Mike Burry’s investors grew restive, his Wall Street counterparties took a new and envious interest in what he was up to. In late October 2005, a subprime trader at Goldman Sachs called to ask him why he was buying credit-default swaps on such very specific tranches of subprime-mortgage bonds. The trader let it slip that a number of hedge funds had been calling Goldman to ask “how to do the short housing trade that Scion is doing.” Among those asking about it were people Burry had solicited for Milton’s Opus—people who had initially expressed great interest. “These people by and large did not know anything about how to do the trade and expected Goldman to help them replicate it,” Burry wrote in an e-mail to his C.F.O. “My suspicion is Goldman helped them, though they deny it.” If nothing else, he now understood why he couldn’t raise money for Milton’s Opus. “If I describe it enough it sounds compelling, and people think they can do it for themselves,” he wrote to an e-mail confidant. “If I don’t describe it enough, it sounds scary and binary and I can’t raise the capital.” He had no talent for selling.

Now the subprime-mortgage-bond market appeared to be unraveling. Out of the blue, on November 4, Burry had an e-mail from the head subprime guy at Deutsche Bank, a fellow named Greg Lippmann. As it happened, Deutsche Bank had broken off relations with Mike Burry back in June, after Burry had been, in Deutsche Bank’s view, overly aggressive in his demands for collateral. Now this guy calls and says he’d like to buy back the original six credit-default swaps Scion had bought in May. As the $60 million represented a tiny slice of Burry’s portfolio, and as he didn’t want any more to do with Deutsche Bank than Deutsche Bank wanted to do with him, he sold them back, at a profit. Greg Lippmann wrote back hastily and ungrammatically, “Would you like to give us some other bonds that we can tell you what we will pay you.”

Greg Lippmann of Deutsche Bank wanted to buy his billion dollars in credit-default swaps! “Thank you for the look Greg,” Burry replied. “We’re good for now.” He signed off, thinking, How strange. I haven’t dealt with Deutsche Bank in five months. How does Greg Lippmann even know I own this giant pile of credit-default swaps?

Three days later he heard from Goldman Sachs. His saleswoman, Veronica Grinstein, called him on her cell phone instead of from the office phone. (Wall Street firms now recorded all calls made from their trading desks.) “I’d like a special favor,” she asked. She, too, wanted to buy some of his credit-default swaps. “Management is concerned,” she said. They thought the traders had sold all this insurance without having any place they could go to buy it back. Could Mike Burry sell them $25 million of the stuff, at really generous prices, on the subprime-mortgage bonds of his choosing? Just to placate Goldman management, you understand. Hanging up, he pinged Bank of America, on a hunch, to see if they would sell him more. They wouldn’t. They, too, were looking to buy. Next came Morgan Stanley—again out of the blue. He hadn’t done much business with Morgan Stanley, but evidently Morgan Stanley, too, wanted to buy whatever he had. He didn’t know exactly why all these banks were suddenly so keen to buy insurance on subprime-mortgage bonds, but there was one obvious reason: the loans suddenly were going bad at an alarming rate. Back in May, Mike Burry was betting on his theory of human behavior: the loans were structured to go bad. Now, in November, they were actually going bad.

The next morning, Burry opened The Wall Street Journal to find an article explaining how alarming numbers of adjustable-rate mortgage holders were falling behind on their payments, in their first nine months, at rates never before seen. Lower-middle-class America was tapped out. There was even a little chart to show readers who didn’t have time to read the article. He thought, The cat’s out of the bag. The world’s about to change. Lenders will raise their standards; rating agencies will take a closer look; and no dealers in their right mind will sell insurance on subprime-mortgage bonds at anything like the prices they’ve been selling it. “I’m thinking the lightbulb is going to pop on and some smart credit officer is going to say, ‘Get out of these trades,’” he said. Most Wall Street traders were about to lose a lot of money—with perhaps one exception. Mike Burry had just received another e-mail, from one of his own investors, that suggested that Deutsche Bank might have been influenced by his one-eyed view of the financial markets: “Greg Lippmann, the head [subprime-mortgage] trader at Deutsche Bank[,] was in here the other day,” it read. “He told us that he was short 1 billion dollars of this stuff and was going to make ‘oceans’ of money (or something to that effect.) His exuberance was a little scary.”

By February 2007, subprime loans were defaulting in record numbers, financial institutions were less steady every day, and no one but Mike Burry seemed to recall what he’d said and done. He had told his investors that they might need to be patient—that the bet might not pay off until the mortgages issued in 2005 reached the end of their teaser-rate period. They had not been patient. Many of his investors mistrusted him, and he in turn felt betrayed by them. At the beginning he had imagined the end, but none of the parts in between. “I guess I wanted to just go to sleep and wake up in 2007,” he said. To keep his bets against subprime-mortgage bonds, he’d been forced to fire half his small staff, and dump billions of dollars’ worth of bets he had made against the companies most closely associated with the subprime-mortgage market. He was now more isolated than he’d ever been. The only thing that had changed was his explanation for it.

Not long before, his wife had dragged him to the office of a Stanford psychologist. A pre-school teacher had noted certain worrying behaviors in their four-year-old son, Nicholas, and suggested he needed testing. Nicholas didn’t sleep when the other kids slept. He drifted off when the teacher talked at any length. His mind seemed “very active.” Michael Burry had to resist his urge to take offense. He was, after all, a doctor, and he suspected that the teacher was trying to tell them that he had failed to diagnose attention-deficit disorder in his own son. “I had worked in an A.D.H.D. clinic during my residency and had strong feelings that this was overdiagnosed,” he said. “That it was a ‘savior’ diagnosis for too many kids whose parents wanted a medical reason to drug their children, or to explain their kids’ bad behavior.” He suspected his son was a bit different from the other kids, but different in a good way. “He asked a ton of questions,” said Burry. “I had encouraged that, because I always had a ton of questions as a kid, and I was frustrated when I was told to be quiet.” Now he watched his son more carefully and noted that the little boy, while smart, had problems with other people. “When he did try to interact, even though he didn’t do anything mean to the other kids, he’d somehow tick them off.” He came home and told his wife, “Don’t worry about it! He’s fine!”

His wife stared at him and asked, “How would you know?”

To which Dr. Michael Burry replied, “Because he’s just like me! That’s how I was.”

Their son’s application to several kindergartens met with quick rejections, unaccompanied by explanations. Pressed, one of the schools told Burry that his son suffered from inadequate gross and fine motor skills. “He had apparently scored very low on tests involving art and scissor use,” said Burry. “Big deal, I thought. I still draw like a four-year-old, and I hate art.” To silence his wife, however, he agreed to have their son tested. “It would just prove he’s a smart kid, an ‘absentminded genius.’”

Instead, the tests administered by a child psychologist proved that their child had Asperger’s syndrome. A classic case, she said, and recommended that he be pulled from the mainstream and sent to a special school. And Dr. Michael Burry was dumbstruck: he recalled Asperger’s from med school, but vaguely. His wife now handed him the stack of books she had accumulated on autism and related disorders. On top were The Complete Guide to Asperger’s Syndrome, by a clinical psychologist named Tony Attwood, and Attwood’s Asperger’s Syndrome: A Guide for Parents and Professionals.

“Marked impairment in the use of multiple non-verbal behaviors such as eye-to-eye gaze … ” Check. “Failure to develop peer relationships … ” Check. “A lack of spontaneous seeking to share enjoyment, interests, or achievements with other people … ” Check. “Difficulty reading the social/emotional messages in someone’s eyes … ” Check. “A faulty emotion regulation or control mechanism for expressing anger … ” Check. “One of the reasons why computers are so appealing is not only that you do not have to talk or socialize with them, but that they are logical, consistent and not prone to moods. Thus they are an ideal interest for the person with Asperger’s Syndrome … ” Check. “Many people have a hobby.… The difference between the normal range and the eccentricity observed in Asperger’s Syndrome is that these pursuits are often solitary, idiosyncratic and dominate the person’s time and conversation.” Check … Check …Check.

After a few pages, Michael Burry realized that he was no longer reading about his son but about himself. “How many people can pick up a book and find an instruction manual for their life?” he said. “I hated reading a book telling me who I was. I thought I was different, but this was saying I was the same as other people. My wife and I were a typical Asperger’s couple, and we had an Asperger’s son.” His glass eye no longer explained anything; the wonder is that it ever had. How did a glass eye explain, in a competitive swimmer, a pathological fear of deep water—the terror of not knowing what lurked beneath him? How did it explain a childhood passion for washing money? He’d take dollar bills and wash them, dry them off with a towel, press them between the pages of books, and then stack books on top of those books—all so he might have money that looked “new.” “All of a sudden I’ve become this caricature,” said Burry. “I’ve always been able to study up on something and ace something really fast. I thought it was all something special about me. Now it’s like ‘Oh, a lot of Asperger’s people can do that.’ Now I was explained by a disorder.”

He resisted the news. He had a gift for finding and analyzing information on the subjects that interested him intensely. He always had been intensely interested in himself. Now, at the age of 35, he’d been handed this new piece of information about himself—and his first reaction to it was to wish he hadn’t been given it. “My first thought was that a lot of people must have this and don’t know it,” he said. “And I wondered, Is this really a good thing for me to know at this point? Why is it good for me to know this about myself?”

He went and found his own psychologist to help him sort out the effect of his syndrome on his wife and children. His work life, however, remained uninformed by the new information. He didn’t alter the way he made investment decisions, for instance, or the way he communicated with his investors. He didn’t let his investors know of his disorder. “I didn’t feel it was a material fact that had to be disclosed,” he said. “It wasn’t a change. I wasn’t diagnosed with something new. It’s something I’d always had.” On the other hand, it explained an awful lot about what he did for a living, and how he did it: his obsessive acquisition of hard facts, his insistence on logic, his ability to plow quickly through reams of tedious financial statements. People with Asperger’s couldn’t control what they were interested in. It was a stroke of luck that his special interest was financial markets and not, say, collecting lawn-mower catalogues. When he thought of it that way, he realized that complex modern financial markets were as good as designed to reward a person with Asperger’s who took an interest in them. “Only someone who has Asperger’s would read a subprime-mortgage-bond prospectus,” he said.

I the spring of 2007, something changed—though at first it was hard to see what it was. On June 14, the pair of subprime-mortgage-bond hedge funds effectively owned by Bear Stearns were in freefall. In the ensuing two weeks, the publicly traded index of triple-B-rated subprime-mortgage bonds fell by nearly 20 percent. Just then Goldman Sachs appeared to Burry to be experiencing a nervous breakdown. His biggest positions were with Goldman, and Goldman was newly unable, or unwilling, to determine the value of those positions, and so could not say how much collateral should be shifted back and forth. On Friday, June 15, Burry’s Goldman Sachs saleswoman, Veronica Grinstein, vanished. He called and e-mailed her, but she didn’t respond until late the following Monday—to tell him that she was “out for the day.”

“This is a recurrent theme whenever the market moves our way,” wrote Burry. “People get sick, people are off for unspecified reasons.”

On June 20, Grinstein finally returned to tell him that Goldman Sachs had experienced “systems failure.”

That was funny, Burry replied, because Morgan Stanley had said more or less the same thing. And his salesman at Bank of America claimed they’d had a “power outage.”

“I viewed these ‘systems problems’ as excuses for buying time to sort out a mess behind the scenes,” he said. The Goldman saleswoman made a weak effort to claim that, even as the index of subprime-mortgage bonds collapsed, the market for insuring them hadn’t budged. But she did it from her cell phone, rather than the office line. (Grinstein didn’t respond to e-mail and phone requests for comment.)

They were caving. All of them. At the end of every month, for nearly two years, Burry had watched Wall Street traders mark his positions against him. That is, at the end of every month his bets against subprime bonds were mysteriously less valuable. The end of every month also happened to be when Wall Street traders sent their profit-and-loss statements to their managers and risk managers. On June 29, Burry received a note from his Morgan Stanley salesman, Art Ringness, saying that Morgan Stanley now wanted to make sure that “the marks are fair.” The next day, Goldman followed suit. It was the first time in two years that Goldman Sachs had not moved the trade against him at the end of the month. “That was the first time they moved our marks accurately,” he notes, “because they were getting in on the trade themselves.” The market was finally accepting the diagnosis of its own disorder.

It was precisely the moment he had told his investors, back in the summer of 2005, that they only needed to wait for. Crappy mortgages worth nearly $400 billion were resetting from their teaser rates to new, higher rates. By the end of July his marks were moving rapidly in his favor—and he was reading about the genius of people like John Paulson, who had come to the trade a year after he had. The Bloomberg News service ran an article about the few people who appeared to have seen the catastrophe coming. Only one worked as a bond trader inside a big Wall Street firm: a formerly obscure asset-backed-bond trader at Deutsche Bank named Greg Lippmann. The investor most conspicuously absent from the Bloomberg News article—one who had made $100 million for himself and $725 million for his investors—sat alone in his office, in Cupertino, California. By June 30, 2008, any investor who had stuck with Scion Capital from its beginning, on November 1, 2000, had a gain, after fees and expenses, of 489.34 percent. (The gross gain of the fund had been 726 percent.) Over the same period the S&P 500 returned just a bit more than 2 percent.

Michael Burry clipped the Bloomberg article and e-mailed it around the office with a note: “Lippmann is the guy that essentially took my idea and ran with it. To his credit.” His own investors, whose money he was doubling and more, said little. There came no apologies, and no gratitude. “Nobody came back and said, ‘Yeah, you were right,’” he said. “It was very quiet. It was extremely quiet.”
Interview: Nessa Feddis

The people that we’ve talked to say that the industry — the banking industry, the financial services industry — is given a lot of credit for being able to control regulation by Congress. You’re almost batting 1,000 percent.

Seeing what’s just passed [Credit Card Accountability Responsibility and Disclosure (CARD) Act of 2009], I kind of find that to be a rather questionable conclusion.

Well, before this year, it seems like you’ve almost had a perfect batting average.

Back in 1988, [Congress] did pass a credit card disclosure bill [Fair Credit and Charge Card Disclosure Act]. The only bills that have come up since then, where there’s been much focus, has been one back in the early 1990s or something like that, an amendment that came up on the Senate floor to cap interest rates. Right after that, the market crashed, so they didn’t pursue it.

But other than that, there hasn’t been a lot of attention on credit cards. It’s a great product, and most people manage their credit card well. And it’s a reflection of that more than the fact that there needed to be any attention given to it.

I guess what I’m reflecting [on] are comments that the financial services industry is one of the biggest contributors to Congress and one of the biggest lobbyists, wealthiest lobbyists, and that that’s had a real effect over the years.

Members of Congress are driven by their constituents; they’re driven by voters. If voters are upset, Congress acts.

So maybe you could explain how this industry that’s been so successful over the years, how it works. It’s based on risk-based pricing. What is that?

Risk-based pricing is basically a way of adjusting interest based on the risk of whether somebody is going to pay the loan or not repay the loan. Just as riskier drivers pay more for car insurance, people who are at greater risk of not repaying their loan pay a higher interest rate.

What it really comes down to is the nature of lending. All borrowers, to some degree, pay for the loans that aren’t repaid by other borrowers in the form of interest. A lender who lends out $100 and only gets $90 back because somebody is not going to repay has to make up that difference through the interest they charge the other borrowers who do repay the loan.

So the greater the chance that somebody is not going to repay the loan, they’re going to be in a pool of a group who are in the same risky category, and their interest rates are going to be higher. It allows people to charge the interest rate that’s more suitable for that borrower, just as a driver who’s a riskier borrower will pay more on car insurance. …

Risk-based pricing — that sounds simple, but this industry has really gotten it down to an art.

What controls prices is really competition, because there’s so much competition in credit cards, and everybody knows that. Even now, people continue to get solicitations and applications filling their mailboxes. And if somebody is dissatisfied by their rate or they think that they deserve a lower rate, they have lots of options. You’re not married to your credit card. It’s very easy to move to another competitor, and that’s what keeps credit card companies charging the appropriate interest rate. …

How big is the credit card industry, and how profitable has it been?

Right now, the credit card companies are losing money. The first quarter of 2009, they lost about $1.7 billion. We expect for those losses to continue through 2009, probably into 2010.

The government did do a very intensive study of credit card companies, including their profits, a couple of years ago. Over a 20-year period, profits were remarkably stable at about 3 percent return on assets. And what does that mean? That means if they start out with $100 at the end of the year in December, they will get back $103.

So it’s been a steady, reasonable profit, but I don’t think it’s excessive. It’s certainly less than what the food and drug [companies] make, and even what the automobile industry has been making. …

… [Consumer credit expert] Robert McKinley told us that over the years, the credit card industry has been like the Wild West; that it basically became an industry that was out of control.

Most people manage their credit card well, and most people value their credit card. It’s something they use on a daily basis and something they value on a daily basis. There are some people who found their interest rates increase because over time, people’s credit profile, their finances change, and they may have found their interest rate go up because of that change in risk. But most people manage their credit well, and there’s a lot of competition. …

And from the ABA’s point of view, the current state of regulation of credit cards and consumer lending in general, with the Federal Reserve involved and sort of an alphabet soup of agencies like the OTS [Office of Thrift Supervision] and the FDIC [Federal Deposit Insurance Corp.] or the OCC [Office of the Comptroller of the Currency], that’s worked well? That’s considered to be a successful model?

As I said, most people manage their credit cards well, and that is a reflection on an industry that works.

But the federal regulators, the sort of potpourri of different alphabet soup of agencies, that’s worked really well?

The Federal Reserve has the primary jurisdiction for the rule making for credit cards. Several years ago, they began to update the disclosure, so there was a little bit of lag. The disclosures were dated, so the Federal Reserve … has updated the disclosures. …

But the OCC has the jurisdiction. The FDIC and the OTS don’t really have that much authority over credit card companies. It’s primarily the OCC. And a lot goes on behind the scenes with the OCC — you have to talk to them. But yes, they don’t necessarily go over it with a hammer; it’s a little bit more subtle than that. But there were many practices that they addressed. It wasn’t something that necessarily made it into the press.

But they have guidelines, which is sort of like your mother’s suggestion: You’d better do it or have a good reason not to. And things like zero percent balance transfers, they put rules around that. So it was regulated. It was more subtle than what people understood, and it wasn’t as public as people thought. …

Do you really understand that contract that comes in the mail with your credit card?

Well, that’s not really what people rely on. The teachable moment is the application. And since 1988, every application has had to include a summary box of the primary important terms. And that’s what people rely on when they make a decision on what credit card to select.

One thing I will add, though. Much of the information in the contracts relates to federally required information. For example, there are requirements to disclose important consumer protections: what to do when your card gets lost and stolen. That takes space. It’s important information. …

So you’re saying that, to you, the documents that are sent out with these credit cards over the years were quite clear and people could figure them out?

I think for the most part, the information on the application got dated, so in recent years it was —

Dated? What does “dated” mean?

Well, because the information on the application, the summary box was based on language that Congress put into place in 1988; we’re now 20 years later. The consumers evolved; credit cards evolved. Those disclosures are dated.

There are many different solicitations that come in the mail, and they say, “Zero percent,” and there’s an asterisk, and then if you look down below, it says, “Transfer fee,” you know? …

It’s funny you raise the idea of the zero percent transfer. That was one of the ones that the OCC adopted guidelines on to ensure that the zero percent balance transfer, for example, has to be in close proximity to what the rate will go to when it expires. So that’s an example of when the OCC did step in. …

Were you surprised this past spring when the Banking Committee reported out its legislation related to credit cards, that that got through committee? What was your reaction when that happened?

It was a little unusual sequence of events, because usually Congress passes laws, and then the regulators adopt rules. In this case, the regulators adopted rules, and then Congress acted, so in that sense, it was a bit surprising.

Do you remember your reaction when you heard that it got through committee? It only got through by one vote, as I understand it, through the Senate committee.

I don’t remember. Again, given the makeup of the committee, we weren’t surprised that it got over by one vote.

You weren’t? Why? If people valued their credit cards for so long and they were so useful, and the regulation has been effective, as you described, how do you explain this legislative loss, if you will?

Even though most cardholders manage their credit well and understand how their credit card works, you do have a vulnerable group who was confused. And that’s what Congress was addressing, and that’s what was getting all the attention. There were a lot of anecdotes out there, and it’s very tempting to use those anecdotes as though they’re representative. …

So you really weren’t surprised when this passed first out of the committee?

… Early in the following year, Congressman [Barney] Frank [D-Mass.] made it very clear he planned to pass a bill. And you just don’t disregard something that the chairman of the House Financial Services says he’s going to do.

And the president of the United States convened representatives of the credit card industry in the White House, right? That had never happened before.

That was toward the tail end of the process. I think by that time we knew there was going to be a bill. I mean, by that stage, everything was already sort of in order. …

What changed?

Obviously the election changed an awful lot. You had very big changes in the House and the Senate and a change in the White House.

And a change in the economy.

I don’t know whether that was so much the situation, because credit card companies and credit cardholders were doing fairly well in the early part of the economic turndown. It really wasn’t until the latter part of 2008 that the credit card companies began to suffer, and that was because of the unexpected double-digit unemployment. So I don’t know that it was so much the economy as it was so much the elections.

And double-digit unemployment, which is part of the economy, mirrors the default rate with credit cards, right?

Absolutely. They follow each other very closely. And that’s because [it’s after] the first bill — not even the first loan — that people stop paying.

You were saying that the way risk-based pricing works is it’s based upon the ability of people to pay back the loan. But there are many people who believe that the whole industry is based on the idea that you don’t want people ever to pay it back, because you make a lot more money if they keep paying. Let me tell you what [Self-Help Credit Union CEO] Martin Eakes — whose name I’m sure you know — said to us. He said what risk-based pricing and democratized credit really means “is that we want to provide debt to people who we know cannot pay it back. It’s a fraud. You’re therefore keeping people in debt forever because they can’t pay it off. …”

It makes no sense for a bank that wishes to stay in business to lend out money that its customers can’t repay. It doesn’t help their customer, and it doesn’t help them.

Doesn’t it help the bank’s bottom line for someone to pay back a lot more than what they originally borrowed?

If they’re going to struggle to repay that loan, it doesn’t help the bank.

Then how do you account for their profits over the years, if most of their profits came from the people who were paying the highest interest rates and the most fees?

Card companies rely on a variety of different cardholders in their portfolios. On one end of the spectrum there are people who are at high risk of not repaying their loan, and that means they’re in a group where the losses are going to be higher. For that reason, the interest is higher for the people in that category. If losses aren’t as high, the returns will be higher.

At the other end of the spectrum there are people who are at very low risk. They are very likely to repay their loan. They’re in a group where their losses are going to be low. And that means … their prices are going to be lower, and their returns may not be as high. They’re steady, but they may be more modest. And then you’ve got everything in between.

And cardholders will balance their portfolios much as anybody might balance their 401(k) with regard to risks. And depending on the strategy of each individual cardholder, they’ll have different percentages among the various categories of customers.

Before we get to the proposed agency, what are the consequences of the legislation that has been passed for the consumer?

Congress understood when they adopted the rule that credit cards would be more difficult to get, limits would be lower, and interest rates would be higher for everyone. But they made the decision that that result was an acceptable consequence, an acceptable trade-off, for the sake of the consumers. …

Even before Aug. 20, when some of the rules went into effect, interest rates were being raised. People were feeling the pinch in the wake of this legislation.

… You saw that in the press, but in fact the data didn’t support that. Interest rates for existing customers went up a bit, about a point, in the 12-month period ending in May — and that’s from the Federal Reserve — of what people actually pay.

So interest rates on existing customers didn’t really go up in anticipation of the Aug. 20 new regulation. What we are seeing is that new accounts will be more expensive. And again, Congress understood that that would be the result.

So we can expect tighter and tighter lending?

Between the new rules and the economy, we expect that it will be harder for people to get credit cards. …

One of the people we interviewed said that, in fact, it is the economy that’s affecting all of this and that the legislation is really just piling on.

It’s both, and it’s hard to tease exactly what proportion, but there’s no question that the new rules make it more difficult to adjust to changes in the economy, to changes in customers’ financial situations and their credit profile. That means those risks, which are really costs, have to be spread across to everyone.

It also means that the inability to be able to make those adjustments means that people will find it harder to get credit cards, but also that they will lower the limits, because they have to manage the risk.

There’s a reaction that we got from a number of people that here’s the credit card industry, the banking industry, which is in part in business because of taxpayers. For instance, the taxpayers are buying the securities that this money is lent out from, right? The securitization is being financed by the Treasury. And here you are, still lobbying Congress and squeezing the consumers all at the same time.

Well, at this point the money from the government was something the banks did not want. They were “encouraged” to take the money for the sake of the economy. They have repaid it.

The current Treasury program to buy lending instruments, securities, to help finance the credit card industry is something the banking industry doesn’t want?

I don’t know that I can talk about the difference between CPP [Capital Purchase Program] and TARP [Troubled Asset Relief Program]. But we do know that the banks have repaid much of that money with a return of about 16 percent, and that’s a pretty good return in this day and age.

What’s the American Bankers Association’s position on the Consumer Financial Protection Agency [CFPA]?

Quite simply, it’s unnecessary; it’s going to delay needed improvements; it’s going to limit people’s choices; and it’s going to be very costly. We think that you can accomplish the improvements needed by fixing what needs to be fixed. It’s not necessary to create one more duplicative, costly bureaucracy, because at the end of the day, one way or the other, consumers pay. …

What the proponents of the Consumer Financial Protection Agency say is that this will be a taxpayer-financed consumer agency taking care of the needs of consumers. That hasn’t happened yet to this date, because the agencies that are primarily responsible are really concerned about the safety and soundness of the banks, not what’s going on with their customers.

I guess what you’re saying is that then customers and consumers are going to pay for this very costly duplicative agency. That’s what it sounds like you’re saying.

Well, taxpayers are going to pay for it.

One way or the other, customers are going to pay. Consumers are going to pay either directly or indirectly.

And if their rights are protected, if they’re not gouged, if they feel that it’s a fair agency that actually takes care of their problems, what’s the matter with that?

All the issues that this agency is intended to address can easily be addressed by improving the effectiveness of the existing agencies. It’s not necessary to reinvent the wheel. Fix what needs to be fixed.

So the position is that the agencies have actually done a good job over the last 20 years regulating the credit card industry, and we don’t need a new agency to take care of what’s happened?

In fact, we’ve seen that Congress and the regulators have addressed the credit card issue, and so arguably, no, an agency is not needed; it’s already been done. All the issues have been addressed on the credit cards. The mortgage issues are being addressed, and so mortgage and credit card will have already been addressed.

Let me read to you what one observer said: “Congress had the chance to do much more meaningful credit card legislation, and Congress focused on a few really egregious practices. The problem is that just saying you can’t do bad practices A, B and C doesn’t stop the card industry from coming up with new practices D, E and F.”

Or, as he put it, “It’s like Whack-A-Mole; that your industry is smart enough to figure out ways to make money off consumers unless there’s some overall agency that’s watching out for the consumers.”

First of all, the Federal Reserve had already reacted and addressed the primary concerns raised, and then Congress acted. So the Federal Reserve, at the signal of Congress, did respond. So it was the agency acting first and then Congress responding. …

What’s wrong with limits on interest rates? Credit unions live with an 18 percent interest rate.

History has shown that government controls, interest rate caps, don’t work. It means that a lot of people who need to have loans don’t get them, and it means that there are distortions in the price, and it becomes inefficient, so at the end of the day, customers pay more.

Customers pay more for belonging to a credit union?

No, they pay more if you restrict interest rates, and the interest rates don’t cover the expenses. And then it pushes out someplace else, so they’ll charge another fee, a transaction fee or an annual fee.

But when we looked at credit unions, for example, one in North Carolina that we looked at carefully, not only do they have an 18 percent interest rate cap, but for something like the equivalent of a payday loan, they charge only 12 percent.

… I don’t know about that particular credit union, but they’re probably more restrictive on who can have a credit card. And also, there may be other accounts that that person has a relationship with. By definition, a credit union is going to have other accounts with that customer, a checking account that may be subsidizing that.

That’s what happened back in the years when there were state usury laws. Arkansas was one where the interest rate has historically been very low, and what they found is that very few people could get [a] credit card. But also, they tended to have to have another relationship with that institution, a checking account or a mortgage. So it subsidizes it one way or the other. You can’t push down one place and not have it pop out someplace else.

You’re saying that there’s no logical limit to how much interest should be paid.

As I said, history has shown that when you cap interest rates, fewer people and [fewer] small businesses have access to loans, and the prices get distorted, and at the end of the day, customers pay more. …

The ABA sees no problem with, for example, the setting of overdraft fees by banks, in terms of their ranging from $12 to $39, depending upon the bank.

Overdraft fees are intended as a penalty to encourage people to manage their checking accounts. And a nominal fee doesn’t work.

A nominal fee doesn’t work? … Does a $40 cup of coffee work? …

If the penalty for parking in a fire lane were $5, I think you’d find a lot of fire trucks not able to get through. The purpose of the overdraft fee is to encourage people to manage their accounts, to keep track of their spending.

And your members who will organize, for instance, debits that come in on a particular day so that the biggest debit goes first, as opposed to the number on the check or the time that it comes in, and therefore drives the rest of the debits that come in into the overdraft area, you find that to be an acceptable practice?

Customers have said that they want their important payments made. The important payments tend to be the large payments — the mortgage, the rent — and so —

Do you really think that they would do that if they knew they were going to then incur five overdraft fees for all kinds of other minor things?

In fact they do, because the banks have been sued for paying low to high. One of the large institutions a number of years ago got sued because it paid the low dollars first, and some high payment wasn’t paid. So the payment order is something that people’s preferences vary depending on the individual. And their individual preference on an individual transaction will vary depending on the nature of that transaction.

Haven’t overdraft fees, particularly debit card fees, become a profit center for the banks, particularly in these hard times?

Banks make income from overdraft fees, just like they make income from any fee, and on checking accounts there are practically no fees left. The Government Accountability Office [GAO] found a couple years ago that the vast majority of banks offer free accounts. There are no fees left other than overdrafts [and] the occasional stop-payment fee.

But you know what I’m talking about. I could give you the anecdotal evidence that’s all out there, you know? We found one person who was charged seven different overdraft fees in a day because he was using his debit card to pay into a parking meter.

The vast majority of people avoid overdraft fees because they’re very simple to avoid.

The vast majority? Again, as we understand it statistically, about 10 percent of the people pay for 70 percent of the so-called free checking in America. Is that correct?

No. The greatest income from checking accounts is from the interest that banks make on the balances. So they make more money on the checking accounts with the higher balances than they do [on] the accounts with the low balances. The primary source of income for checking accounts is the interest they make.

Is it true that they make tens, maybe $20 billion in overdraft fees a year?

I don’t know. We don’t have that number.

According to the FDIC, they tell us that they make $20 billion a year.

I did see [this]. I don’t remember the number. That may be. …

When we go to talk to payday lenders, they say: “Look at our operation. We have the APR [annual percentage rate] posted right here. Everyone can see it.” Go to the bank, and when somebody does an overdraft, which is in some ways a bank version of a payday lending operation, there’s nothing posted. It’s not covered by Truth in Lending. Why is that?

Well, because you’d end up with a ridiculous result, because if you applied an APR to an overdraft, the APR would be higher the sooner the customer paid it off. That would be a very confusing message.

Well, it would be in the thousands of percent.

No. … I don’t know if you understood what I said. If you apply an APR to an overdraft, … the sooner the customer repays that overdraft, the higher the APR. If they don’t pay it back immediately, the APR goes down. So they’re getting the message that it’s cheaper for them not to repay the overdraft as quickly. That’s a very confusing message.

You mean it’s impossible for the banks to tell the customer how much it would cost?

They do. They tell them: “This is the fee. If you overdraw, it’s X dollars.” You cannot know in advance how long the person is going to take before they repay their loan. You cannot know in advance what the amount is going to be. So you can’t do a calculation up front. That’s impossible.

It sounds to me [like] one of the confusing parts of all this is when it’s a credit card, we get this agreement, a contract that’s almost impossible to decipher. We’ve had law professors say they don’t understand it. On the other hand, when we went to find out about debit card fees, we’re told: “Well, this is not a contract. In fact, it’s a noncontractual discretionary privilege.” …

The fees are disclosed. People understand it. It’s been something that’s been around since the beginning of checking accounts.

I actually went to the bank myself, because I didn’t know if I had check overdraft or not. I had never read the disclosures. And I was told that I did. But when I asked, “Would you cover my overdraft at the ATM machine?” if I went and asked for more money than I had in my account, I was told they can’t tell me because that’s part of the agreement.

And then I asked: “How much would you cover? How high? How far over could I go?” And they said they couldn’t tell me that either. So it sounds like a game with cards. On the one hand, it’s a contract that I can’t understand, and on the other hand there is no contract, and they can’t tell me how much money is involved.

Banks have been paying overdrafts on checking accounts since the beginning of checking accounts. It’s been a discretionary basis, an accommodation to their customers on the basis that they want transactions paid. All this is a modern version of it based on an automated system so that it is more uniform; it’s more fair. It’s not that you have to know somebody at the bank for them to ensure that your payments are made even though you don’t have money in the account.

My understanding is that five years ago, 80 percent of your members [were] denied transactions with debit cards when there weren’t sufficient funds in the account. And now it’s reversed: Eighty percent now do cover the withdrawal and/or the debit, but then they charge the fee.

Debit cards have somewhat replaced checks. People want their transactions paid. If they’ve just finished a meal at a restaurant, they want the transaction to go through, and that’s what the banks are responding to.

Without asking them. You’re not asked; they just do it.

It has to be disclosed in the original agreement that we may reserve the right to go ahead and pay transactions that you’ve authorized. …

Or not. “It’s up to us.”

Or not. But traditionally, all banks have paid overdrafts. Most banks have paid overdrafts on a discretionary basis. That’s been around since checking accounts have been around.

So it’s a privilege; it’s [at the] discretion of the bank.

It’s an accommodation. …

The complaint that led to this legislation is that the credit card industry was abusing its customers. …

The vast majority of cardholders manage their credit well, but there was a group that was confused, and that’s what Congress and the press were reacting to. …

And those people — how many of them are there, millions, the confused? Are those the people going bankrupt?

Most of the people who end up in bankruptcy or who end up with credit card problems, the underlying problem isn’t the credit card; the underlying problem is some sort of life crisis — a medical expense, a divorce, a job loss. And the credit card helps them bridge that gap. It gets them through the crisis. In most cases, they do make it through the crisis, but some of them don’t. But the underlying problem was another life crisis, not the credit card. …

A number of bankers complained to us about the non-banks, and one of them is the payday lenders. So we went to interview the payday lenders, and they told us check overdraft, debit card overdraft, is much more expensive than the service they offer.

Well, payday loans — if it’s just a single payday loan — probably isn’t the problem. The big problem with payday loans is people get into a cycle of debt. They start out with one loan, but then they don’t repay it. They get hit with a fee. They take out another loan, and that cycle continues, and it’s a downward cycle.

With overdrafts, the overdraft has to be paid immediately. And additional overdrafts over the limit are not permitted. It stops. If that overdraft isn’t paid within 60 days, the account is closed. So it stops. There’s no cycle. And that’s really the egregious part of the payday lending. It’s a cycle of debt.

But aren’t the overdraft fees also a cycle? Don’t most people who get one overdraft a year get two or three or four? They can get as many as they want as long as they stay in that cycle.

They don’t end up having debt that they can’t repay. The fact that they repay, that means it’s not a cycle of debt. They have to come positive. That means the debt is paid. With payday loans, they never pay it off. It’s an unending debt. That’s not true with overdrafts. …

Payday lenders say in most states they are forced to have one loan at a time. Now, they can’t stop somebody from going to another payday lender, but one payday lender can only give one person one loan until that’s paid off.

Right. But then they come in, and they have to get another loan, and all the other fees are added on, and they come in the next month, and they do the same thing. And pretty soon you’ve got a pretty big debt that the customer can’t pay it off.

And that’s not true for overdrafts. Once the customer has an overdraft, they’re required to bring that balance into a positive status immediately. If they don’t do it within 60 days, the account is closed. There are no more loans. There’s no cycle of debt. The debt is gone.

I believe Bank of America, at least, will give you seven overdraft fees in one day before you pay anything off.

But you have to pay it off, and if you don’t, then the account is closed. You don’t get more overdrafts. The account is closed. Within 60 days it stops. It’s not a cycle of debt. …

Sen. [Chris] Dodd [D-Conn.] and others have said to us, “The industry got arrogant.” You started using all these practices that created this problem. …

Well, once Congress and the regulators identified the problems, they’ve addressed it, and the industry is moving on. End of story.

One of the things that surprised me … is so many of the people that we’ve interviewed — consumer lending advocates, bank officials, many government officials — have said to us, “Disclosure doesn’t work.”

I think people are smarter than that. That’s interesting you bring that up, because if there’s a vulnerable segment that needs extra protection, there are two ways you can address that. You can limit everybody to the kind of product that the least sophisticated customer can manage and select, or you can try to identify that vulnerable group and protect them and then allow everyone else to continue to have the flexibility and choice of what they want in their financial product.

But the products in this case are really not substantially different. They provide you with cash. They’re convenient. It’s a piece of plastic; you don’t need to carry around a lot of cash with you.

That’s huge value.

There are all kinds of great utility value, but it’s sold on the basis of what kind of picture is on the card, what kind of points you get, what kind of rewards you might get, a zero percent come-on, all kinds of different things. And you don’t think that’s confusing to people, that that’s why this is happening?

No-frills basic credit cards are provided by large institutions and small institutions. They’re widely available, and many customers are perfectly happy with them. Other people want the perks. They want the rewards. They like the car rental insurance, and they have that choice. If there is a group that is more vulnerable and needs extra protection, then let’s provide them that protection, but allow other people who like the perks to have that option.

But nobody in any of the things that we’ve read about this Consumer Financial Protection Agency or otherwise is saying: “Don’t offer that. Just make sure everyone has a chance to get what they call a ‘plain vanilla’ product.”

… Under this agency, it’s not just that people will have fewer choices; they will practically have no choice.

The cornerstone of the proposal is to require this agency to design a government product based on what the least sophisticated customer might be able to handle. And everybody will get the same cookie-cutter, one-size-fits-all checking account, credit card account or mortgage loan.

And the agency may require not just that the entity offer the product, but they promote it as a superior product. And any entity who wants to offer something else takes a great risk of substantial penalty that down the road, with 20/20 hindsight, somebody is going to say, “That wasn’t suitable; that was too confusing.” So there’s not going to be a lot of incentive to offer something other than the government-designed product.

Are you against safety rules?

No. But if this agency had been in effect 30 years ago, 40 years ago, we wouldn’t have ATMs, we wouldn’t have debit cards and online banking, because the basic program, the basic checking account that everybody could have, would be one that’s accessible only by checks. And offering something beyond that, like a debit card, which would have been unfamiliar initially, would have been too risky.

There are ATM cards, there are ATM machines, there are checking accounts and all of these financial conveniences in plastic in countries that never had a credit card system like ours.

I’m talking about the agency, the power of this agency to basically get us stuck in 2009. Like your consumer products now, because they’re not going to get better. There’s not going to be anything new.

President Dubya, speaking on June 18, 2002, 10:30 A.M. EDT:
We are here in Washington, D.C. to address problems. So I””ve set this goal for the country. We want 5.5 million more homeowners by 2010 — million more minority homeowners by 2010. (Applause.)

And so I””ve asked Congress to fully fund an American Dream down payment fund which will help a low-income family to qualify to buy, to buy. (Applause.)

It is essential that we make it easier for people to buy a home, not harder.

Finally, we want to make sure the Section 8 homeownership program is fully implemented. This is a program that provides vouchers for first-time home buyers which they can use for down payments and/or mortgage payments. (Applause.)

And I””m proud to report that Fannie Mae has heard the call and, as I understand, it””s about $440 billion over a period of time. They””ve used their influence to create that much capital available for the type of home buyer we””re talking about here. It””s in their charter; it now needs to be implemented. Freddie Mac is interested in helping. I appreciate both of those agencies providing the underpinnings of good capital.

Fannie / Freddie Acquitted

Friday ~ August 27th, 2010 in Economics | by Karl Smith

The Conservator’s Report on Fannie and Freddie is out.

Fannie Mae and Freddie Mac are members of a long list of individuals and entities including Gary Condit, Tom Delay, Michael Jackson, Rod Blagojevich and JonBenet Ramsey’s parents. These are folks who were unjustly tried and convicted in the popular press essentially on the grounds that they were creepy or otherwise unsavory characters.

As I hope to continue to argue, being creepy, a bad person, or even a usual suspect does not make one automatically guilty of any particular crime. In this case government subsidies in the housing market are a bad idea for a host of reasons and have been for years. I will testify to this with vigor and passion.

However, that does not mean that Fannie or Freddie caused the housing bubble. Indeed, by my count they were among the biggest victims of it.

The proper question is not: What story is consistent with my general philosophy or worldview?

The proper questions is: What story is consistent with the facts?

Fact One: Fannie and Freddie’s primary business of subsidizing conventional loans was not a driver of the housing the bubble. Indeed, conventional loans represented less than a third of all mortgage originations during the peak price acceleration years.

This was a phenomenon of private-label non-conventional loan securitization.

1.1 Peaking in 2006 at a third of all mortgages originated, the volume of Alt-A and subprime mortgages was extraordinarily high
between 2004 and 2007. In 2005 and 2006, conventional, conforming mortgages accounted for approximately one-third of all
mortgages originated

[ . . .]

1.2 Private-label issuers played a large role in securitizing higher-risk mortgages from early 2004 to mid-2007 while the Enterprises
continued to guarantee primarily traditional mortgages.


Fact Two: Fannie and Freddie lost market volume during the boom. That is, during the boom not only did the fraction of loans securitized by Fannie and Freddie fall, but the absolute number fell. At the same time the absolute number of private-label securitizations rose.

There is a simple and obvious reason for this. The development of structured products meant that for many consumers the free market offered a more attractive loan than the government subsidized one.


Fact Three: The major losses to Fannie and Freddie came through their expansion into guaranteeing non-traditional loans, not through their portfolio. That is, yes like every other financial entity Fannie and Freddie were buying subprime packages in the secondary market. However, these losses were relatively mild.

The Investments and Capital Markets segment accounts for $21 billion, or 9 percent, of capital reduction from the end of 2007 through the second quarter of 2010. Losses in the Investments and Capital Markets segment stemmed from impairments of private-label securities, fair-value losses on securities, and fair-value losses on derivatives (used for hedging interest rate risk).

Fact Four: The key change in the Fannie / Freddie business model was their expansion in the types of loans they willing to guarantee. In particular moving into the Alt-A and Interest-Only categories.

As we can see these loans began to seriously underperform as the economy deteriorated. These loans were not a part of the original “crap hidden by structure” subprime business. Fannie / Freddie borrowers on had on average credit scores above 710 and equity (or down payment) of above 25%.


Also notice how loans with low credit scores and high loan-to-value had the largest delinquency rates in the beginning but then were eclipsed by Alt-A and Interest-Only loan categories as the economy deteriorated.


Fact Five: The higher number of Alt-A and Interest Only loans combined with ultimately higher delinquency rates have meant that a plurality of losses have come from these two categories. These loans were vulnerable not because the borrowers were poor low-credit individuals that the government was taking pity upon but because the loan concepts were predicated on rising or at least stable housing prices.


Fact Six: Areas with the largest collapse in home prices have accounted for most of Fannie and Freddie losses. Refer to the same graph above.

This is further evidence that it was the collapse of the bubble and not betting on people who were poor credit risks that induced major losses at Fannie and Freddie.

My Conclusion

The wave of housing price increases was kicked off by changes in private label securitization. These changes left Fannie and Freddie with a smaller market share and lower absolute level of securitizations. Fannie and Freddie attempted to adjust their basic business practices to stay competitive in bubble markets and among aggressive borrowers.

These adjustment left Fannie and Freddie exposed to a large decline in housing prices. This is exactly what happened and Fannie and Freddie reaped enormous losses because of their exposure.

Had Fannie and Freddie stuck to their traditional role of guaranteeing low value traditional loans rather than trying to stay competitive in bubble areas their losses would have been substantially less.

In short, attempting to subsidize the American dream for low and moderate income families may be a fundamentally bad policy. However, it does not appear to be either the origin of the housing bubble or the source of Fannie and Freddie’s trouble.
For Immediate Release Contact: Corinne Russell (202) 414-6921
August 26, 2010 Stefanie Mullin (202) 414-6376
FHFA Releases First Conservator’s Report on the
Enterprises’ Financial Condition
Washington, DC – The Federal Housing Finance Agency (FHFA) today released its first
Conservator’s Report on the Enterprises’ Financial Condition. The Conservator’s Report
provides an overview of key aspects of the financial condition of Fannie Mae and Freddie Mac
(the Enterprises) during conservatorship. The report will be released on a quarterly basis
following the filing of the Enterprises’ financial results with the Securities and Exchange
Commission (SEC).
“FHFA initiated the Conservator’s Report to enhance public understanding of Fannie Mae’s and
Freddie Mac’s financial performance and condition leading up to and during conservatorship,”
said FHFA Acting Director Edward J. DeMarco.
The report includes information on Enterprise presence in the mortgage market; credit quality
of Enterprise mortgage purchases; sources of Enterprise losses and capital reductions; and
Enterprise loss mitigation activity. Information presented in the report includes:
• The key driver in the decline of the Enterprises’ capital from the end of 2007 through the
second quarter of 2010 was the Single-Family Credit Guarantee business segment, which
accounted for 73 percent of the capital reduction over that period. The bulk of this capital
reduction was associated with losses from mortgages originated in 2006 and 2007.
• The Investments and Capital Markets business segment (which includes the retained
portfolio and credit losses associated with private-label mortgage-backed securities)
accounted for 9 percent of the capital reduction over the same period.
• Since the establishment of the conservatorships, the credit quality of the Enterprises’ new
mortgage acquisitions has improved substantially. Single-family mortgages acquired by the
Enterprises during conservatorship have, on average, higher credit scores and lower loanto-
value ratios, resulting in lower early cumulative default rates.
The Federal Housing Finance Agency regulates Fannie Mae, Freddie Mac and the 12 Federal Home Loan Banks.
These government-sponsored enterprises provide more than $5.9 trillion in funding for the U.S. mortgage markets
and financial institutions.
Federal Housing Finance Agency
Conservator’s Report
on the Enterprises’ Financial Performance
Second Quarter 2010
Federal Housing Finance Agency Conservator’s Report on the
Enterprises’ Financial Performance
Second Quarter 2010
Executive Summary………………………………………..….………….…… 3
1. Mortgage Markets and the Enterprises’ Market Presence….……………… 4
2. Credit Quality of New Single-Family Business……………………….……… 6
3. Capital………..…………………………….…………………………………….. 9
4. Single-Family Credit Guarantee Segment Results………..……………….. 10
5. Investments and Capital Markets Segment Results……………….……….. 13
6. Loss Mitigation Activity..………………………………………………..……….. 15
The purpose of this report is to provide an overview of key aspects of the financial condition of Fannie Mae and Freddie Mac during conservatorship. The
data in this report are derived primarily from the Enterprises’ SEC filings and other publicly available sources. In some cases, FHFA adjusted the
classification of certain data to provide comparability between the Enterprises. In other cases, the Enterprises’ reporting methodologies changed over time.
Therefore, the data in this report may not match exactly published figures.
Federal Housing Finance Agency Conservator’s Report on the
Enterprises’ Financial Performance
Second Quarter 2010
Executive Summary
Mortgage Markets and the Enterprises’ Market Presence
Originations of nontraditional and higher-risk mortgages grew dramatically between 2004 and 2007. Private-label issuers played a large
role in securitizing these mortgages. While the Enterprises acquired primarily traditional mortgages, they also acquired an increased
amount of nontraditional and higher-risk mortgages such as Alt-A, subprime, and interest-only loans, and invested in senior tranches of
private-label mortgage-backed securities. The Enterprises lost market share of mortgage-backed securities issuance between 2004 and
2007. After private-label issuers exited the secondary mortgage market in 2007, the Enterprises’ market presence increased, and they
have constituted the majority of secondary market issuance since.
Credit Quality of New Single-Family Business
Starting in 2008, the Enterprises tightened credit underwriting standards for new mortgage acquisitions and largely ceased acquiring
nontraditional and higher-risk mortgages. Mortgages acquired since 2008 have, on average, higher credit scores and lower loan-to-value
ratios and include few higher-risk products.
At the end of 2007, the Enterprises had $71 billion of combined capital. From the end of 2007 through the second quarter of 2010,
capital was reduced by $226 billion. Of the three business segments (Investments and Capital Markets, Single-Family Credit Guarantee
and Multifamily) the largest contributor to capital reduction to date has been the Single-Family Credit Guarantee segment, accounting for
$166 billion, or 73 percent, of combined capital reduction over that period.
Single-Family Credit Guarantee Segment Results
Credit-related expenses have been the primary driver of losses in the Single-Family Credit Guarantee segment. Nontraditional and
higher-risk mortgages concentrated in the 2006 and 2007 vintages account for a disproportionate share of credit losses. However, house
price declines and prolonged economic weakness have taken a toll on the credit performance of traditional mortgages.
Investments and Capital Markets Segment Results
The Investments and Capital Markets segment accounts for $21 billion, or 9 percent, of capital reduction from the end of 2007 through
the second quarter of 2010. Losses in the Investments and Capital Markets segment stemmed from impairments of private-label
securities, fair-value losses on securities, and fair-value losses on derivatives (used for hedging interest rate risk).
Loss Mitigation Activity
Since 2008, the Enterprises have enhanced their standard loss mitigation programs to address the needs of delinquent borrowers in this
credit cycle. Implementation of the Making Home Affordable program in 2009, together with the Enterprises’ enhanced loss mitigation
programs, expanded the options available to delinquent borrowers to retain or give up their homes while avoiding foreclosure.
Federal Housing Finance Agency Conservator’s Report on the
Enterprises’ Financial Performance
Second Quarter 2010
Mortgage Markets and the Enterprises’ Market Presence
1.1. Primary Mortgage Market Trends—Mortgage Originations
• Peaking in 2006 at a third of all mortgages originated, the volume of Alt-A and subprime mortgages was extraordinarily high
between 2004 and 2007. In 2005 and 2006, conventional, conforming mortgages accounted for approximately one-third of all
mortgages originated.
Originations $3,945 $2,920 $3,120 $2,980 $2,430 $1,500 $1,815 $320
$ in Billions
Inside Mortgage Finance, second quarter 2010 data not available.
Figure 1.1. Mortgage Originations by Product Type
41% 35% 33%
62% 65% 63%
20% 20%
7% 12% 13% 11%
11% 12% 14% 14% 6% 8% 4% 3%
2003 2004 2005 2006 2007 2008 2009 1Q10
Home Equity
Federal Housing Finance Agency Conservator’s Report on the
Enterprises’ Financial Performance
Second Quarter 2010
1.2. Secondary Mortgage Market Trends—Mortgage-Backed Securities Issued
• Private-label issuers played a large role in securitizing higher-risk mortgages from early 2004 to mid-2007 while the Enterprises
continued to guarantee primarily traditional mortgages. Consequently, the Enterprises lost market share of mortgage-backed
securities (MBS) issuance. After private-label issuers exited the secondary mortgage market in 2007, the Enterprises’ market
share increased. Their combined market share of MBS issued in the first half of 2010 was 66 percent.
2001 2002 2003 2004 2005 2006 2007 2008 2009 YTD
Enterprises 67% 68% 70% 47% 41% 40% 58% 73% 72% 66%
Ginnie Mae 13% 9% 8% 7% 4% 4% 5% 22% 25% 29%
Total Agency 80% 77% 78% 54% 45% 44% 63% 95% 97% 95%
Inside Mortgage Finance, Enterprise Monthly Volume Summaries.
Issuance figures exclude MBS issued backed by assets previously held in the Enterprises’ portfolios.
MBS Issuance Volume ($ in billions)
$300 Fannie Mae Freddie Mac Ginnie Mae Private-Label
Figure 1.2. Enterprises’ Market Share
Federal Housing Finance Agency Conservator’s Report on the
Enterprises’ Financial Performance
Second Quarter 2010
2. Credit Quality of New Single-Family Business
2.1 Credit Characteristics of the Enterprises’ New Single-Family Business
• Pre-conservatorship: As the mix of mortgage originations in the primary market shifted toward higher-risk mortgages, the
Enterprises guaranteed and purchased an increased amount of nontraditional and higher-risk mortgages. However, during this
period, the Enterprises continued to guarantee primarily traditional mortgages.
• Post-conservatorship: Purchases of nontraditional and higher-risk mortgages are down dramatically and the average FICO credit
score and loan-to-value ratio (LTV) of new single-family business has improved. While the percentage of new business with
LTVs greater than 90 percent increased in 2010, the bulk of this relates to the Home Affordable Refinance Program.
Percent of New Single-Family Business1
(Categories overlap and are not additive)
Fannie Mae YTD Freddie Mac YTD
2006 2007 2008 2009 Jun ’10 2006 2007 2008 2009 Jun ’10
Alt-A2 22% 17% 3% 0% 0% 18% 22% 7% 0% 1%
Interest-Only 15% 15% 6% 1% 2% 17% 21% 6% 0% 0%
Credit Score 90 Percent 10% 16% 10% 4% 8% 6% 11% 9% 4% 9%
Average LTV 73% 75% 72% 67% 69% 73% 74% 71% 67% 70%
Average Credit Score 716 716 738 761 758 720 718 734 756 750
1 New business is defined as issuance of MBS plus purchases of whole loans and does not include purchases of
mortgage-related securities.
2 Refer to sources for Alt-A definitions. Freddie Mac’s year-to-date figures include Alt-A purchases of $1.5 billion due to a
long-term standby commitment termination and a subsequent PC issuance. There was no change to the Alt-A
exposure on these mortgages as a result of these transactions.
Enterprises’ Forms 10-K, credit supplements to SEC disclosures, and management reports.
Figure 2.1. Characteristics of Single-Family Mortgage Acquisitions
Federal Housing Finance Agency Conservator’s Report on the
Enterprises’ Financial Performance
Second Quarter 2010
2.2 Performance of Nontraditional and Higher-Risk Mortgages (mostly purchased pre-conservatorship)
• Declines in house prices and weakness in the broader economy over the past few years have contributed to deteriorating credit
performance of mortgages in general and of nontraditional and higher-risk mortgages in particular.
Fannie Mae Freddie Mac
4Q07 4Q08 4Q09 2Q10 4Q07 4Q08 4Q09 2Q10
Product Type1
Alt-A 2.2% 7.0% 15.6% 15.2% 1.9% 5.6% 12.3% 12.4%
Interest-Only 2.0% 8.4% 20.2% 19.4% 2.0% 7.6% 17.6% 18.4%
Credit Score
90 Percent 3.0% 6.3% 13.1% 11.6% 1.9% 4.8% 9.1% 8.5%
Credit score 90 Percent
Total Single-Family 1.0% 2.4% 5.4% 5.0% 0.7% 1.8% 4.0% 4.0%
1 Loans with multiple product features may be in more than one category. Refer to sources for Alt-A definition.
Enterprises’ Form 10-Ks, Credit supplements to SEC disclosures, and management reports.
Figure 2.2. Single-Family Serious Delinquency Rates
Federal Housing Finance Agency Conservator’s Report on the
Enterprises’ Financial Performance
Second Quarter 2010
2.3 Performance of Post-Conservatorship Business
• While not necessarily indicative of the ultimate performance, the improved credit characteristics of new post-conservatorship
business is reflected in substantially lower cumulative default rates for the 2009 vintage compared to the years leading up to
Fannie Mae (data in basis points)
Yr1-Q1 Yr1-Q2 Yr1-Q3 Yr1-Q4 Yr2-Q1 Yr2-Q2
Freddie Mac (data in basis points)
Yr1-Q1 Yr1-Q2 Yr1-Q3 Yr1-Q4 Yr2-Q1 Yr2-Q2
Figure 2.3. Cumulative Default Rate by Origination Year
Cumulative Default Rate by Origination Year (data in basis points)
Time Since Beginning of Origination Year Time Since Origination
Fannie Mae1 Freddie Mac2
Vintage Yr1Q4 Yr2Q2 Vintage Yr1Q4 Yr2Q2
2002 0.35 3.09 2002 0.31 2.65
2003 0.36 2.52 2003 0.16 1.22
2004 0.70 4.56 2004 0.35 2.04
2005 0.66 4.81 2005 0.21 1.82
2006 1.28 11.58 2006 0.57 5.97
2007 3.01 28.68 2007 2.30 22.29
2008 2.17 12.61 2008 2.12 13.65
2009 0.09 1.21 2009 0.12 1.07
1 Defaults include loan liquidations other than through voluntary pay-off or repurchase by lenders and include loan foreclosures, preforeclosure sales, sales to third parties
and deeds-in-lieu of foreclosure. Cumulative Default Rate is the total number of single-family conventional loans in the guarantee book of business originated in the identified
year that have defaulted, divided by the total number of single-family conventional loans in Fannie Mae’s guarantee book of business originated in the identified year.
2 Rates are calculated for each year of origination as the number of loans that have proceeded to foreclosure transfer or short sale, divided by the number of loans in
Freddie Mac’s single-family credit guarantee portfolio relative to origination.
Enterprise quarterly credit supplement.
Federal Housing Finance Agency Conservator’s Report on the
Enterprises’ Financial Performance
Second Quarter 2010
3. Capital
• At the end of 2007, the Enterprises had $71 billion of combined capital. From the end of 2007 through the second quarter of 2010,
the Enterprises’ combined capital reductions have totaled $226 billion, requiring Treasury support of $148 billion through draws
under the Preferred Stock Purchase Agreements. The Single-Family Credit Guarantee segment has been the largest contributor to
capital reduction, accounting for $166 billion, or 73 percent, of capital reduction to date.
Figure 3. Capital Changes: January 1, 2008 – June 30, 2010
$ in billions Fannie Mae Freddie Mac Combined
Beginning Capital1 $44 $27 $71
Equity Issuance2 7 0 7
Available Capital $51 $27 $78
Capital Erosion
Single-Family Guarantee Earnings ($109) ($58) ($166) 73%
Multifamily Earnings (11) (0) (11) 5%
Investments Contribution3 (11) (11) (21) 9%
Consolidation Accounting Adjustment 3 (12) (8) 4%
Other (3) (3) (6) 3%
Senior Preferred dividends (6) (7) (13) 6%
Total Capital Erosion4 ($136) ($90) ($226) 100%
Capital deficit ($85) ($63) ($148)
Treasury Senior Preferred draw5 $85 $63 $148
Totals may not sum due to rounding.
1 Capital is defined as stockholders’ equity.
2 Fannie Mae’s figure includes common and preferred stock issuance pre-conservatorship.
3 Investments contribution equals the sum of investments segment earnings, the change in the accumulated other comprehensive income (AOCI) component of stockholders’ equity (excluding the
consolidation adjustment related to AOCI), and the impact of accounting changes for securities impairments.
4 Included in total capital erosion for both Enterprises are losses attributable to the writedown of low income housing tax credits (LIHTC) investments to zero in the fourth quarter of 2009.
$5 billion of these LIHTC losses for Fannie Mae are included in Multifamily Earnings and $3 billion of losses for Freddie Mac are included in Other.
Also included in total capital erosion but spread among the business segments is the establishment of a deferred tax asset valuation allowance which reduced capital by $21 billion for Fannie Mae and $14 billion
for Freddie Mac in 2008.
5 Total draws include amounts relating to the second quarter of 2010.
Fannie Mae segment earnings per Fannie Mae SEC disclosures for the relevant time periods.
Freddie Mac’s 2008 and 2009 segment earnings revised to reflect methodology effective in the first quarter of 2010 SEC disclosure.
Federal Housing Finance Agency Conservator’s Report on the
Enterprises’ Financial Performance
Second Quarter 2010
4. Single-Family Credit Guarantee Segment Results
4.1 Single-Family Credit Guarantee Segment Results
• Losses from the Single-Family segment have been driven by substantial provisions for credit losses as rising delinquencies
caused the Enterprises to build their loan loss reserves.
$ in billions Fannie Mae Freddie Mac Combined
YTD YTD 2008 –
2008 2009 Jun ’10 Total 2008 2009 Jun ’10 Total YTD Jun ’10
Revenue1 $9 $9 $0 $19 $5 $4 $2 $12 $30
Provision for credit losses2 ( 26) ( 50) ( 16) (92) ( 16) ( 29) ( 11) (57) (149)
Foreclosed Property Expenses (2) (1) (0) (3) (1) (0) (0) (1) (5)
Credit-related expenses (28) (51) ( 17) (95) (17) ( 29) ( 11) (58) (154)
SOP 03-3 Losses3 (2) (20) (0) (23) (2) (5) (0) (6) (29)
Other expenses4 (2) (3) (1) (6) (1) (1) (1) (3) (9)
Pre-tax income (loss) (22) (65) ( 18) (105) (15) ( 31) ( 10) (56) (161)
Provision (benefit) for taxes (5) 1 0 (3) (5) 4 0 (1) (5)
Net income (loss) ($27) ($64) ($18) ($109) ($20) ($27) ($10) ($58) ($166)
Totals may not sum due to rounding.
1 Consists of guarantee fee income, trust management income, net interest income, and other income. Guarantee fee revenue of $3.6 billion for
Fannie Mae year-to-date was offset by net interest expense of $3.3 billion related to forgone interest on nonperforming loans.
2 The provision for credit losses is the recognition of estimated incurred losses and increases the loan loss reserve. Fannie Mae’s figures have been
adjusted to exclude losses on credit-impaired loans acquired from MBS trusts.
Effective January 1, 2010, Freddie Mac’s provision for credit losses for segment earnings includes nonaccrual expense that is part of net interest
income for GAAP-basis earnings.
3 Losses on credit-impaired loans acquired from MBS/PC Trusts.
4 Consists of investment gains (losses), administrative expenses, and other expenses.
Fannie Mae segment earnings per Fannie Mae SEC disclosures for the relevant time periods. Effective in the first quarter 2010, Fannie Mae
changed the presentation of segment financial information; prior periods were not revised.
Freddie Mac segment earnings for 2008 and 2009 revised to reflect business segment reporting methodology effective in the first quarter of 2010
SEC disclosure.
2010 segment results for both Enterprises are not comparable with prior periods due to the adoption of new accounting standards for consolidations.
Figure 4.1. Single-Family Credit Guarantee Segment Results
Federal Housing Finance Agency Conservator’s Report on the
Enterprises’ Financial Performance
Second Quarter 2010
4.2 Loan Loss Reserves
• The Enterprises have increased loan loss reserves substantially since the end of 2007, with the bulk of the increase attributed to
the single-family book. Charge-offs have been low compared to provisions for credit losses, but their relative magnitude
continues to increase.
$ in billions Fannie Mae YTD Freddie Mac
Single-Family Loss Reserve 2008 2009 Jun ’10 2008 2009 Jun ’10
Beginning balance1 $3 $24 $62 $3 $15 33
Provision for credit losses2,3 26 50 16 92 16 29 11 57
Charge-offs, net3 (5) (13) (12) (29) (2) (7) (6) (16)
Adoption of New Accounting Standards1 – – (11) – – (0)
Other – – 3 (1) (4) (0)
Ending balance1 $24 $62 $59 $15 $33 $37
Credit Losses – Single-Family
Charge-offs3 $5 $13 $12 $29 $2 $7 $6 16
Other4 – – – – 0 0 0 1
Foreclosed Property Expense 2 1 0 3 1 0 – 1
Total3 $6 $13 $12 $32 $4 $8 $7 $18
Totals may not sum due to rounding.
1 Fannie Mae’s loan loss reserve excludes amounts related to the allowance for accrued interest receivable and allowance for preforeclosure
property taxes and insurance. Freddie Mac’s loan loss reserve excludes amounts related to the allowance for accrued interest receivable.
2 Freddie Mac’s figures include nonaccrual expense for segment reporting purposes.
4 Freddie Mac’s figures include charge-offs related to certain loans purchased under financial guarantees.
SEC disclosures for the relevant time periods.
Jan ’08 –
Jan ’08 –
Fannie Mae’s provision for credit losses have been adjusted to exclude losses on credit-impaired loans acquired from MBS trusts. Additionally,
the effect of losses from credit-impaired loans acquired from MBS trusts on charge-offs and foreclosed property expense has been reflected as
an adjustment to total credit losses and charge-offs, net.
Figure 4.2. Loan Loss Reserves
Federal Housing Finance Agency Conservator’s Report on the
Enterprises’ Financial Performance
Second Quarter 2010
4.3 Credit Losses
• Nontraditional and higher-risk mortgages concentrated in the 2006 and 2007 vintages account for a disproportionate share of
credit losses (charge-offs and foreclosed property expenses). However, house price declines and prolonged economic weakness
have taken a toll on the credit performance of conventional mortgages.
• Mortgages originated in California, Florida, Arizona and Nevada also account for a disproportionate share of credit losses. Those
states had some of the highest increases in house prices through 2006 and 2007 followed by the steepest declines to date.
(Percent of Total Credit Losses) Fannie Mae Freddie Mac
% of UPB
as of Dec
31, 20081 2008 2009
% of UPB
as of Dec
31, 20081 2008 2009
by State
California 16% 25% 24% 23% 14% 30% 32% 26%
Florida 7% 11% 16% 19% 7% 10% 15% 19%
Arizona 3% 8% 11% 10% 3% 9% 11% 11%
Nevada 1% 5% 7% 5% 1% 4% 6% 5%
by Product2
Alt-A 11% 46% 40% 36% 10% 50% 44% 40%
Interest-Only 8% 34% 33% 30% 9% 50% 47% 39%
by Vintage
2006 14% 35% 31% 30% 15% 41% 35% 30%
2007 20% 28% 36% 37% 19% 25% 36% 34%
2008 16% 1% 5% 7% 15% 0% 5% 6%
2009 n/a n/a 0% 0% n/a n/a 0% 0%
1 Represents each category’s share of the respective Enterprise’s single-family book of business, which is based on the unpaid principal balance
of all single-family mortgages held by the Enterprises and those underlying MBS/PCs as of December 31, 2008. Freddie Mac’s figures include
loans held by the company underlying structured securities less structured securities backed by Ginnie Mae certificates.
2 Product categories overlap.
Enterprises’ Forms 10-K, credit supplements to SEC disclosures, and management reports.
Figure 4.3. Credit Losses
Federal Housing Finance Agency Conservator’s Report on the
Enterprises’ Financial Performance
Second Quarter 2010
5. Investments and Capital Markets Segment Results
5.1 Investments and Capital Markets Segment Results
• Losses in the Investments and Capital Markets segment stemmed from impairments of private-label securities and fair-value
losses on securities. Fair-value losses on derivatives used to hedge interest rate risk contributed to investment segment losses,
however certain offsetting changes in the fair value of hedged assets and liabilities are not reflected in earnings or equity.
$ in billions Fannie Mae Freddie Mac Combined
2008 2009 Jun ’10 Total 2008 2009 Jun ’10 Total Jun ’10
Revenue1 $8 $13 $6 $27 $3 $8 $3 $14 $41
Derivatives gains (losses) (15) (6) (3) (25) (13) 5 (5) (13) (38)
Trading gains (losses) (7) 4 3 ( 1) 1 5 (1) 5 4
Other gains (losses)2 2 1 1 4 2 ( 0) 1 3 7
Other-than-temporary impairments ( 7) (10) (0) (17) (17) (10) (1) (28) (45)
Other expenses3 (1) (1) (0) (1) (2) (1) 1 (2) (3)
Pre-tax income (loss) (21) 1 7 (13) (26) 7 (2) (21) (34)
Provision (benefit) for taxes4 (9) (0) 0 (9) (2) (1) 0 (2) (11)
Net income (loss) ($29) $1 $7 ($22) ($28) $6 ($2) ($23) ($45)
Unrealized gains (losses) on AFS5 (6) 11 3 8 (20) 19 9 7 16
Accounting change for Impairments 0 3 0 3 0 5 0 5 8
Investments Contribution ($36) $15 $10 ($11) ($48) $30 $7 ($11) ($21)
Totals may not sum due to rounding.
1 Consists of guarantee fee expense, trust management income, net interest income, and other income.
2 Figures consist of debt extinguishment losses, debt foreign exchange gains (losses), debt fair-value losses, investment gains (losses),
and hedged mortgage assets gains, net.
3 Consists of administrative expenses and other expenses.
4 Includes extraordinary losses/noncontrolling interest.
5 Includes unrealized gains (losses) on available for sale securities and adjustments for other-than-temporary impairments included in
accumulated other comprehensive income.
Fannie Mae segment earnings per Fannie Mae SEC disclosures for the relevant time periods. Effective in the first quarter 2010, Fannie Mae
changed the presentation of segment financial information; prior periods were not revised.
Freddie Mac segment earnings for 2008 and 2009 revised to reflect business segment reporting methodology effective in the first quarter of
2010 SEC disclosure.
Figure 5.1. Investments and Capital Markets Segment Results
Federal Housing Finance Agency Conservator’s Report on the
Enterprises’ Financial Performance
Second Quarter 2010
5.2 Security Impairments
• Alt-A and subprime securities acquired in 2006 and 2007 account for the bulk of security impairments.
$ in billions
Fannie Mae 2008 2009
Vintage1 2006 &
vintages Total
2006 &
vintages Total
2006 &
vintages Total
Alt-A/Option ARM Alt-A $3.0 $1.8 $4.8 $1.7 $2.3 $4.0 $0.1 $0.0 $0.2 $9.0
Subprime 1 .9 – 1.9 5.6 0 .1 5.7 0.2 – 0.2 7.7
Other – 0.2 0.2 0.0 0.2 0.2 – – 0.0 0.5
Total2 $4.9 $2.0 $7.0 $7.3 $2.6 $9.9 $0.3 $0.0 $0.4 $17.2
Freddie Mac 2008 2009
Vintage1 2006 &
vintages Total
2006 &
vintages Total
2006 &
vintages Total
Alt-A $2.1 $1.8 $4.0 $0.9 $0.8 $1.7 $0.0 $0.0 $0.0 $5.7
Subprime 3 .4 0 .2 3.6 6.4 0 .1 6.5 0 .3 0 .0 0.3 10.4
CMBS – – – 0.1 0.0 0.1 0.1 0.0 0.1 0.2
Option ARM 6 .0 1 .6 7.6 1.4 0 .4 1.7 0 .1 0 .0 0.1 9.4
Other 1.1 0.4 1.4 0.8 0.1 0.9 0.3 0.0 0.3 2.7
Total2 $12.6 $4.0 $16.6 $9.6 $1.5 $11.0 $0.8 $0.1 $0.9 $28.5
Totals may not sum due to rounding.
1 Vintage of private-label securities is based on security issue date.
2 The adoption of FSP FAS 115-2 in April of 2009 required the Enterprises to begin recognizing only the credit portion of impairments in their statement
of operations. This new accounting standard did not require the Enterprises to revise previously recorded amounts in their statements of operations
but did result in an equity increase of $5 billion and $3 billion for Freddie Mac and Fannie Mae, respectively, which is not reflected in Figure 5.2.
Fannie Mae and Freddie Mac management reports.
YTD Jun ’10
YTD Jun ’10
Figure 5.2. Security Impairments
Federal Housing Finance Agency Conservator’s Report on the
Enterprises’ Financial Performance
Second Quarter 2010
6. Loss Mitigation Activity
• The Enterprises have traditionally worked with delinquent borrowers to mitigate credit losses in situations where the borrower
demonstrates the willingness and ability to cure the delinquency. Loss mitigation actions include loan modifications, repayment
plans, forbearance plans, short sales and deeds-in-lieu.
• As the volume of delinquencies increased in 2008 and 2009, the Enterprises enhanced their standard loss mitigation programs to
address the needs of delinquent borrowers in this credit cycle.
• Implementation of the Making Home Affordable program announced by the Administration in early 2009, together with the
Enterprises’ enhanced loss mitigation programs, expanded the options available to delinquent borrowers to retain or give up their
homes while avoiding foreclosure.
• At the end of the first quarter of 2010 approximately 448,000 of the Enterprises’ loans were in the trial period of the Home
Affordable Modification Program (HAMP). (Note, this is not reflected in Figure 6.)
• More information on the Enterprises’ loss mitigation activities can be found in FHFA First Quarter 2010 Foreclosure Prevention &
Refinance Report.
* Consists of HomeSaver Advance (Fannie Mae), charge-offs in lieu and deeds-in-lieu.
** Include loans that were 30-plus days delinquent at initiation of the plan. Completed forbearance plans exclude Home Affordable Modification Program Loans.
Enterprises’ Foreclosure Prevention Actions
16 15 13 24 37 32 37
18 16 15
17 27
1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10
Short Sales &
Other *
Number of loans in thousands
Figure 6. Loss Mitigation Activity

by Jake Bernstein and Jesse Eisinger
ProPublica, Aug. 26, 2010, 9:09 p.m.

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Oct. 20: This text has been corrected [1].

Over the last two years of the housing bubble, Wall Street bankers perpetrated one of the greatest episodes of self-dealing in financial history.

Faced with increasing difficulty in selling the mortgage-backed securities that had been among their most lucrative products, the banks hit on a solution that preserved their quarterly earnings and huge bonuses:

They created fake demand.

A ProPublica analysis shows for the first time the extent to which banks — primarily Merrill Lynch, but also Citigroup, UBS and others — bought their own products and cranked up an assembly line that otherwise should have flagged.

The products they were buying and selling were at the heart of the 2008 meltdown — collections of mortgage bonds known as collateralized debt obligations, or CDOs.

As the housing boom began to slow in mid-2006, investors became skittish about the riskier parts of those investments. So the banks created — and ultimately provided most of the money for — new CDOs. Those new CDOs bought the hard-to-sell pieces of the original CDOs. The result was a daisy chain [2] that solved one problem but created another: Each new CDO had its own risky pieces. Banks created yet other CDOs to buy those.

Individual instances of these questionable trades have been reported before, but ProPublica’s investigation, done in partnership with NPR’s Planet Money [3], shows that by late 2006 they became a common industry practice.
Click to see how frequently the banks turned to their best customers — their own CDOs. [4]

Click to see how frequently the banks turned to their best customers — their own CDOs.

An analysis by research firm Thetica Systems, commissioned by ProPublica, shows that in the last years of the boom, CDOs had become the dominant purchaser of key, risky parts of other CDOs, largely replacing real investors like pension funds. By 2007, 67 percent of those slices were bought by other CDOs, up from 36 percent just three years earlier. The banks often orchestrated these purchases. In the last two years of the boom, nearly half of all CDOs sponsored by market leader Merrill Lynch bought significant portions of other Merrill CDOs [4].

ProPublica also found 85 instances during 2006 and 2007 in which two CDOs bought pieces of each other. These trades, which involved $107 billion worth of CDOs, underscore the extent to which the market lacked real buyers. Often the CDOs that swapped purchases closed within days of each other, the analysis shows.

There were supposed to be protections against this sort of abuse. While banks provided the blueprint for the CDOs and marketed them, they typically selected independent managers who chose the specific bonds to go inside them. The managers had a legal obligation to do what was best for the CDO. They were paid by the CDO, not the bank, and were supposed to serve as a bulwark against self-dealing by the banks, which had the fullest understanding of the complex and lightly regulated mortgage bonds.

It rarely worked out that way. The managers were beholden to the banks that sent them the business. On a billion-dollar deal, managers could earn a million dollars in fees, with little risk. Some small firms did several billion dollars of CDOs in a matter of months.

“All these banks for years were spawning trading partners,” says a former executive from Financial Guaranty Insurance Company, a major insurer of the CDO market. “You don’t have a trading partner? Create one.”
Get ProPublica’s latest headlines and major investigations delivered to your inbox. [5]

The executive, like most of the dozens of people ProPublica spoke with about the inner workings of the market at the time, asked not to be named out of fear of being sucked into ongoing investigations or because they are involved in civil litigation.

Keeping the assembly line going had a wealth of short-term advantages for the banks. Fees rolled in. A typical CDO could net the bank that created it between $5 million and $10 million — about half of which usually ended up as employee bonuses. Indeed, Wall Street awarded record bonuses in 2006, a hefty chunk of which came from the CDO business.

The self-dealing super-charged the market for CDOs, enticing some less-savvy investors to try their luck. Crucially, such deals maintained the value of mortgage bonds at a time when the lack of buyers should have driven their prices down.

But the strategy of speeding up the assembly line had devastating consequences for homeowners, the banks themselves and, ultimately, the global economy. Because of Wall Street’s machinations, more mortgages had been granted to ever-shakier borrowers. The results can now be seen in foreclosed houses across America.

The incestuous trading also made the CDOs more intertwined and thus fragile, accelerating their decline in value that began in the fall of 2007 and deepened over the next year. Most are now worth pennies on the dollar. Nearly half of the nearly trillion dollars in losses to the global banking system came from CDOs, losses ultimately absorbed by taxpayers and investors around the world. The banks’ troubles sent the world’s economies into a tailspin from which they have yet to recover.

It remains unclear whether any of this violated laws. The SEC has said [6] that it is actively looking at as many as 50 CDO managers as part of its broad examination of the CDO business’ role in the financial crisis. In particular, the agency is focusing on the relationship between the banks and the managers. The SEC is exploring how deals were structured, if any quid pro quo arrangements existed, and whether banks pressured managers to take bad assets.

The banks declined to directly address ProPublica’s questions. Asked about its relationship with managers and the cross-ownership among its CDOs, Citibank responded with a one-sentence statement:

“It has been widely reported that there are ongoing industry-wide investigations into CDO-related matters and we do not comment on pending investigations.”

None of ProPublica’s questions had mentioned the SEC or pending investigations.

Posed a similar list of questions, Bank of America, which now owns Merrill Lynch, said:

“These are very specific questions regarding individuals who left Merrill Lynch several years ago and a CDO origination business that, due to market conditions, was discontinued by Merrill before Bank of America acquired the company.”

This is the second installment of a ProPublica series about the largely hidden history of the CDO boom and bust. Our first story [7] looked at how one hedge fund helped create at least $40 billion in CDOs as part of a strategy to bet against the market. This story turns the focus on the banks.

Merrill Lynch Pioneers Pervert the Market

By 2004, the housing market was in full swing, and Wall Street bankers flocked to the CDO frenzy. It seemed to be the perfect money machine, and for a time everyone was happy.

Homeowners got easy mortgages. Banks and mortgage companies felt secure lending the money because they could sell the mortgages almost immediately to Wall Street and get back all their cash plus a little extra for their trouble. The investment banks charged massive fees for repackaging the mortgages into fancy financial products. Investors all around the world got to play in the then-phenomenal American housing market.
Click to see how the CDO daisy chain worked. [2]

Click to see how the CDO daisy chain worked.

The mortgages were bundled into bonds, which were in turn combined into CDOs offering varying interest rates and levels of risk.

Investors holding the top tier of a CDO were first in line to get money coming from mortgages. By 2006, some banks often kept this layer, which credit agencies blessed with their highest rating of Triple A.

Buyers of the lower tiers took on more risk and got higher returns. They would be the first to take the hit if homeowners funding the CDO stopped paying their mortgages. (Here’s a video explaining how CDOs worked [8].)

Over time, these risky slices became increasingly hard to sell, posing a problem for the banks. If they remained unsold, the sketchy assets stayed on their books, like rotting inventory. That would require the banks to set aside money to cover any losses. Banks hate doing that because it means the money can’t be loaned out or put to other uses.

Being stuck with the risky portions of CDOs would ultimately lower profits and endanger the whole assembly line.

The banks, notably Merrill and Citibank, solved this problem by greatly expanding what had been a common and accepted practice: CDOs buying small pieces of other CDOs.

Architects of CDOs typically included what they called a “bucket” — which held bits of other CDOs paying higher rates of interest. The idea was to boost overall returns of deals primarily composed of safer assets. In the early days, the bucket was a small portion of an overall CDO.

One pioneer of pushing CDOs to buy CDOs was Merrill Lynch’s Chris Ricciardi, who had been brought to the firm in 2003 to take Merrill to the top of the CDO business. According to former colleagues, Ricciardi’s team cultivated managers, especially smaller firms.

Merrill exercised its leverage over the managers. A strong relationship with Merrill could be the difference between a business that thrived and one that didn’t. The more deals the banks gave a manager, the more money the manager got paid.

As the head of Merrill’s CDO business, Ricciardi also wooed managers with golf outings and dinners. One Merrill executive summed up the overall arrangement: “I’m going to make you rich. You just have to be my bitch.”

But not all managers went for it.

An executive from Trainer Wortham, a CDO manager, recalls a 2005 conversation with Ricciardi. “I wasn’t going to buy other CDOs. Chris said: ‘You don’t get it. You have got to buy other guys’ CDOs to get your deal done. That’s how it works.'” When the manager refused, Ricciardi told him, “‘That’s it. You are not going to get another deal done.'” Trainer Wortham largely withdrew from the market, concerned about the practice and the overheated prices for CDOs.

Ricciardi declined multiple requests to comment.

Merrill CDOs often bought slices of other Merrill deals. This seems to have happened more in the second half of any given year, according to ProPublica’s analysis, though the purchases were still a small portion compared to what would come later. Annual bonuses are based on the deals bankers completed by yearend.

Ricciardi left Merrill Lynch in February 2006. But the machine he put into place not only survived his departure, it became a model for competitors.

As Housing Market Wanes, Self-Dealing Takes Off

By mid-2006, the housing market was on the wane. This was particularly true for subprime mortgages, which were given to borrowers with spotty credit at higher interest rates. Subprime lenders began to fold, in what would become a mass extinction. In the first half of the year, the percentage of subprime borrowers who didn’t even make the first month’s mortgage payment tripled from the previous year.

That made CDO investors like pension funds and insurance companies increasingly nervous. If homeowners couldn’t make their mortgage payments, then the stream of cash to CDOs would dry up. Real “buyers began to shrivel and shrivel,” says Fiachra O’Driscoll, who co-ran Credit Suisse’s CDO business from 2003 to 2008.

Faced with disappearing investor demand, bankers could have wound down the lucrative business and moved on. That’s the way a market is supposed to work. Demand disappears; supply follows. But bankers were making lots of money. And they had amassed warehouses full of CDOs and other mortgage-based assets whose value was going down.

Rather than stop, bankers at Merrill, Citi, UBS and elsewhere kept making CDOs.

The question was: Who would buy them?

The top 80 percent, the less risky layers or so-called “super senior,” were held by the banks themselves. The beauty of owning that supposedly safe top portion was that it required hardly any money be held in reserve.

That left 20 percent, which the banks did not want to keep because it was riskier and required them to set aside reserves to cover any losses. Banks often sold the bottom, riskiest part to hedge funds [7]. That left the middle layer, known on Wall Street as the “mezzanine,” which was sold to new CDOs whose top 80 percent was ultimately owned by … the banks.

“As we got further into 2006, the mezzanine was going into other CDOs,” says Credit Suisse’s O’Driscoll.
Get ProPublica’s latest headlines and major investigations delivered to your inbox. [5]

This was the daisy chain [2]. On paper, the risky stuff was gone, held by new independent CDOs. In reality, however, the banks were buying their own otherwise unsellable assets.

How could something so seemingly short-sighted have happened?

It’s one of the great mysteries of the crash. Banks have fleets of risk managers to defend against just such reckless behavior. Top executives have maintained that while they suspected that the housing market was cooling, they never imagined the crash. For those doing the deals, the payoff was immediate. The dangers seemed abstract and remote.

The CDO managers played a crucial role. CDOs were so complex that even buyers had a hard time seeing exactly what was in them — making a neutral third party that much more essential.

“When you’re investing in a CDO you are very much putting your faith in the manager,” says Peter Nowell, a former London-based investor for the Royal Bank of Scotland. “The manager is choosing all the bonds that go into the CDO.” (RBS suffered mightily in the global financial meltdown, posting the largest loss in United Kingdom history, and was de facto nationalized by the British government.)
Source: Asset-Backed Alert

Source: Asset-Backed Alert

By persuading managers to pick the unsold slices of CDOs, the banks helped keep the market going. “It guaranteed distribution when, quite frankly, there was not a huge market for them,” says Nowell.

The counterintuitive result was that even as investors began to vanish, the mortgage CDO market more than doubled from 2005 to 2006, reaching $226 billion, according to the trade publication Asset-Backed Alert.

Citi and Merrill Hand Out Sweetheart Deals

As the CDO market grew, so did the number of CDO management firms, including many small shops that relied on a single bank for most of their business. According to Fitch, the number of CDO managers it rated rose from 89 in July 2006 to 140 in September 2007.

One CDO manager epitomized the devolution of the business, according to numerous industry insiders: a Wall Street veteran named Wing Chau.

Earlier in the decade, Chau had run the CDO department for Maxim Group, a boutique investment firm in New York. Chau had built a profitable business for Maxim based largely on his relationship with Merrill Lynch. In just a few years, Maxim had corralled more than $4 billion worth of assets under management just from Merrill CDOs.

In August 2006, Chau bolted from Maxim to start his own CDO management business, taking several colleagues with him. Chau’s departure gave Merrill, the biggest CDO producer, one more avenue for unsold inventory.

Chau named the firm Harding, after the town in New Jersey where he lived. The CDO market was starting its most profitable stretch ever, and Harding would play a big part. In an eleven-month period, ending in August 2007, Harding managed $13 billion of CDOs, including more than $5 billion from Merrill, and another nearly $5 billion from Citigroup. (Chau would later earn a measure of notoriety for a cameo appearance in Michael Lewis’ bestseller “The Big Short [9],” where he is depicted as a cheerfully feckless “go-to buyer” for Merrill Lynch’s CDO machine.)

Chau had a long-standing friendship with Ken Margolis, who was Merrill’s top CDO salesman under Ricciardi. When Ricciardi left Merrill in 2006, Margolis became a co-head of Merrill’s CDO group. He carried a genial, let’s-just-get-the-deal-done demeanor into his new position. An avid poker player, Margolis told a friend that in a previous job he had stood down a casino owner during a foreclosure negotiation after the owner had threatened to put a fork through his eye.

Chau’s close relationship with Merrill continued. In late 2006, Merrill sublet office space to Chau’s startup in the Merrill tower in Lower Manhattan’s financial district. A Merrill banker, David Moffitt, scheduled visits to Harding for prospective investors in the bank’s CDOs. “It was a nice office,” overlooking New York Harbor, recalls a CDO buyer. “But it did feel a little weird that it was Merrill’s building,” he said.

Moffitt did not respond to requests for comment.

Under Margolis, other small managers with meager track records were also suddenly handling CDOs valued at as much as $2 billion. Margolis declined to answer any questions about his own involvement in these matters.

A Wall Street Journal article [10] ($) from late 2007, one of the first of its kind, described how Margolis worked with one inexperienced CDO manager called NIR on a CDO named Norma, in the spring of that year. The Long Island-based NIR made about $1.5 million a year for managing Norma, a CDO that imploded.

“NIR’s collateral management business had arisen from efforts by Merrill Lynch to assemble a stable of captive small firms to manage its CDOs that would be beholden to Merrill Lynch on account of the business it funneled to them,” alleged a lawsuit filed in New York state court against Merrill over Norma that was settled quietly after the plaintiffs received internal Merrill documents.

NIR declined to comment.

Banks had a variety of ways to influence managers’ behavior.

Some of the few outside investors remaining in the market believed that the manager would do a better job if he owned a small slice of the CDO he was managing. That way, the manager would have more incentive to manage the investment well, since he, too, was an investor. But small management firms rarely had money to invest. Some banks solved this problem by advancing money to managers such as Harding.

Chau’s group managed two Citigroup CDOs — 888 Tactical Fund and Jupiter High-Grade VII — in which the bank loaned Harding money to buy risky pieces of the deal. The loans would be paid back out of the fees the managers took from the CDO and its investors. The loans were disclosed to investors in a few sentences among the hundreds of pages of legalese accompanying the deals.

In response to ProPublica’s questions, Chau’s lawyer said, “Harding Advisory’s dealings with investment banks were proper and fully disclosed.”

Citigroup made similar deals with other managers. The bank lent money to a manager called Vanderbilt Capital Advisors for its Armitage CDO, completed in March 2007.

Vanderbilt declined to comment. It couldn’t be learned how much money Citigroup loaned or whether it was ever repaid.

Yet again banks had masked their true stakes in CDO. Banks were lending money to CDO managers so they could buy the banks’ dodgy assets. If the managers couldn’t pay the loans back — and most were thinly capitalized — the banks were on the hook for even more losses when the CDO business collapsed.

Goldman, Merrill and Others Get Tough

When the housing market deteriorated, banks took advantage of a little-used power they had over managers.
Source: Thetica Systems

Source: Thetica Systems

The way CDOs are put together, there is a brief period when the bonds picked by managers sit on the banks’ balance sheets. Because the value of such assets can fall, banks reserved the right to overrule managers’ selections.

According to numerous bankers, managers and investors, banks rarely wielded that veto until late 2006, after which it became common. Merrill was in the lead.

“I would go to Merrill and tell them that I wanted to buy, say, a Citi bond,” recalls a CDO manager. “They would say ‘no.’ I would suggest a UBS bond, they would say ‘no.’ Eventually, you got the joke.” Managers could choose assets to put into their CDOs but they had to come from Merrill CDOs. One rival investment banker says Merrill treated CDO managers the way Henry Ford treated his Model T customers: You can have any color you want, as long as it’s black.

Once, Merrill’s Ken Margolis pushed a manager to buy a CDO slice for a Merrill-produced CDO called Port Jackson that was completed in the beginning of 2007: “‘You don’t have to buy the deal but you are crazy if you don’t because of your business,'” an executive at the management firm recalls Margolis telling him. “‘We have a big pipeline and only so many more mandates to give you.’ You got the message.” In other words: Take our stuff and we’ll send you more business. If not, forget it.

Margolis declined to comment on the incident.

“All the managers complained about it,” recalls O’Driscoll, the former Credit Suisse banker who competed with other investment banks to put deals together and market them. But “they were indentured slaves.” O’Driscoll recalls managers grumbling that Merrill in particular told them “what to buy and when to buy it.”

Other big CDO-producing banks quickly adopted the practice.

A little-noticed document released this year during a congressional investigation into Goldman Sachs’ CDO business reveals that bank’s thinking. The firm wrote a November 2006 internal memorandum [11] about a CDO called Timberwolf, managed by Greywolf, a small manager headed by ex-Goldman bankers. In a section headed “Reasons To Pursue,” the authors touted that “Goldman is approving every asset” that will end up in the CDO. What the bank intended to do with that approval power is clear from the memo: “We expect that a significant portion of the portfolio by closing will come from Goldman’s offerings.”

When asked to comment whether Goldman’s memo demonstrates that it had effective control over the asset selection process and that Greywolf was not in fact an independent manager, the bank responded: “Greywolf was an experienced, independent manager and made its own decisions about what reference assets to include. The securities included in Timberwolf were fully disclosed to the professional investors who invested in the transaction.”

Greywolf declined to comment. One of the investors, Basis Capital of Australia, filed a civil lawsuit in federal court in Manhattan against Goldman over the deal. The bank maintains the lawsuit is without merit.

By March 2007, the housing market’s signals were flashing red. Existing home sales plunged at the fastest rate in almost 20 years. Foreclosures were on the rise. And yet, to CDO buyer Peter Nowell’s surprise, banks continued to churn out CDOs.

“We were pulling back. We couldn’t find anything safe enough,” says Nowell. “We were amazed that April through June they were still printing deals. We thought things were over.”

Instead, the CDO machine was in overdrive. Wall Street produced $70 billion in mortgage CDOs in the first quarter of the year.

Many shareholder lawsuits battling their way through the court system today focus on this period of the CDO market. They allege that the banks were using the sales of CDOs to other CDOs to prop up prices and hide their losses.

“Citi’s CDO operations during late 2006 and 2007 functioned largely to sell CDOs to yet newer CDOs created by Citi to house them,” charges a pending shareholder lawsuit against the bank that was filed in federal court in Manhattan in February 2009. “Citigroup concocted a scheme whereby it repackaged many of these investments into other freshly-baked vehicles to avoid incurring a loss.”

Citigroup described the allegations as “irrational,” saying the bank’s executives would never knowingly take actions that would lead to “catastrophic losses.”

In the Hall of Mirrors, Myopic Rating Agencies

The portion of CDOs owned by other CDOs grew right alongside the market. What had been 5 percent of CDOs (remember the “bucket”) now came to constitute as much as 30 or 40 percent of new CDOs. (Wall Street also rolled out CDOs that were almost entirely made up of CDOs, called CDO squareds [12].)

The ever-expanding bucket provided new opportunities for incestuous trades.

It worked like this: A CDO would buy a piece of another CDO, which then returned the favor. The transactions moved both CDOs closer to completion, when bankers and managers would receive their fees.
Source: Thetica Systems

Source: Thetica Systems

ProPublica’s analysis shows that in the final two years of the business, CDOs with cross-ownership amounted to about one-fifth of the market, about $107 billion.

Here’s an example from early May 2007:

* A CDO called Jupiter VI bought a piece of a CDO called Tazlina II.
* Tazlina II bought a piece of Jupiter VI.

Both Jupiter VI and Tazlina II were created by Merrill and were completed within a week of each other. Both were managed by small firms that did significant business with Merrill: Jupiter by Wing Chau’s Harding, and Tazlina by Terwin Advisors. Chau did not respond to questions about this deal. Terwin Advisors could not reached.

Just a few weeks earlier, CDO managers completed a comparable swap between Jupiter VI and another Merrill CDO called Forge 1.

Forge has its own intriguing history. It was the only deal done by a tiny manager of the same name based in Tampa, Fla. The firm was started less than a year earlier by several former Wall Street executives with mortgage experience. It received seed money from Bryan Zwan, who in 2001 settled an SEC civil lawsuit over his company’s accounting problems in a federal court in Florida. Zwan and Forge executives didn’t respond to requests for comment.

After seemingly coming out of nowhere, Forge won the right to manage a $1.5 billion Merrill CDO. That earned Forge a visit from the rating agency Moody’s.

“We just wanted to make sure that they actually existed,” says a former Moody’s executive. The rating agency saw that the group had an office near the airport and expertise to do the job.

Rating agencies regularly did such research on managers, but failed to ask more fundamental questions. The credit ratings agencies “did heavy, heavy due diligence on managers but they were looking for the wrong things: how you processed a ticket or how your surveillance systems worked,” says an executive at a CDO manager. “They didn’t check whether you were buying good bonds.”

One Forge employee recalled in a recent interview that he was amazed Merrill had been able to find buyers so quickly. “They were able to sell all the tranches” — slices of the CDO — “in a fairly rapid period of time,” said Rod Jensen, a former research analyst for Forge.

Forge achieved this feat because Merrill sold the slices to other CDOs, many linked to Merrill.

The ProPublica analysis shows that two Merrill CDOs, Maxim II and West Trade III, each bought pieces of Forge. Small managers oversaw both deals.

Forge, in turn, was filled with detritus from Merrill. Eighty-two percent of the CDO bonds owned by Forge came from other Merrill deals.

Citigroup did its own version of the shuffle, as these three CDOs demonstrate:

* A CDO called Octonion bought some of Adams Square Funding II.
* Adams Square II bought a piece of Octonion.
* A third CDO, Class V Funding III, also bought some of Octonion.
* Octonion, in turn, bought a piece of Class V Funding III.

All of these Citi deals were completed within days of each other. Wing Chau was once again a central player. His firm managed Octonion. The other two were managed by a unit of Credit Suisse. Credit Suisse declined to comment.

Not all cross-ownership deals were consummated.

In spring 2007, Deutsche Bank was creating a CDO and found a manager that wanted to take a piece of it. The manager was overseeing a CDO that Merrill was assembling. Merrill blocked the manager from putting the Deutsche bonds into the Merrill CDO. A former Deutsche Bank banker says that when Deutsche Bank complained to Andy Phelps, a Merrill CDO executive, Phelps offered a quid pro quo: If Deutsche was willing to have the manager of its CDO buy some Merrill bonds, Merrill would stop blocking the purchase. Phelps declined to comment.

The Deutsche banker, who says its managers were independent, recalls being shocked: “We said we don’t control what people buy in their deals.” The swap didn’t happen.

The Missing Regulators and the Aftermath

In September 2007, as the market finally started to catch up with Merrill Lynch, Ken Margolis left the firm to join Wing Chau at Harding.

Chau and Margolis circulated a marketing plan for a new hedge fund to prospective investors touting their expertise in how CDOs were made and what was in them. The fund proposed to buy failed CDOs — at bargain basement prices. In the end, Margolis and Chau couldn’t make the business work and dropped the idea.

Why didn’t regulators intervene during the boom to stop the self-dealing that had permeated the CDO market?

No one agency had authority over the whole business. Since the business came and went in just a few years, it may have been too much to expect even assertive regulators to comprehend what was happening in time to stop it.

While the financial regulatory bill passed by Congress in July creates more oversight powers, it’s unclear whether regulators have sufficient tools to prevent a replay of the debacle.

In just two years, the CDO market had cut a swath of destruction. Partly because CDOs had bought so many pieces of each other, they collapsed in unison. Merrill Lynch and Citigroup, the biggest perpetrators of the self-dealing, were among the biggest losers. Merrill lost about $26 billion on mortgage CDOs and Citigroup about $34 billion.

Additional reporting by Kitty Bennett, Krista Kjellman Schmidt, Lisa Schwartz and Karen Weise.

Correction: This story previously reported that there were 85 instances during 2006 and 2007 in which two complex securities known as collateralized debt obligations bought pieces of each others’ “unsold” inventory. In fact, there were some instances when this cross-exposure occurred through later transactions. The banks sometimes used such transactions to minimize their own exposure to CDOs they had created.

An interactive graphic we published includes at least one example of cross-exposure that did not involve “unsold” inventory. A CDO called Tourmaline III made a sidebet in 2007 that mirrored the performance of a piece of a CDO called Zais Investment Grade 8; that same year Zais 8 bought a piece of Tourmaline III. Both CDOs were underwritten by Deutsche Bank.

Capital structure
In stories about the auto companies and the banks, we’ve been hearing a
lot about debt-to-equity swaps, and exchanging preferred shares for
common stock. To get how those swaps work, you first need to understand
a company’s capital structure.

Credit default swaps? Theyre complicated — and scary! The receipt you get when you pre-order your Thanksgiving turkey? Not so much. But they have a lot in common: Theyre both derivatives. Senior Editor Paddy Hirsch explains

Fannie, Freddie and the Fed
The Federal Reserve said this week it will no longer buy mortgage backed securities from Fannie Mae and Freddie Mac. Some people worry mortgage rates could rise as a result.

Dark pools are exchanges where people trade stocks anonymously. Senior Editor Paddy Hirsch explains how they work, and why the SEC is considering regulating them.

What is a Futures Contract?
A futures contract is an agreement to buy or sell in the future a specific quantity of a commodity at a specific price. Most futures contracts contemplate actual delivery of the commodity can take place to fulfill the contract. However, some futures contracts require cash settlement in lieu of delivery, and most contracts are liquidated before the delivery date. An option on a commodity futures contract gives the buyer of the option the right to convert the option into a futures contract. Futures and options must be executed on the floor of a commodity exchange—with very limited exceptions—and through persons and firms who are registered with the CFTC.

Who Uses Futures and Options Markets?
Most of the participants in the futures and option markets are commercial or institutional users of the commodities they trade. These users, most of whom are called “hedgers,” want the value of their assets to increase and want to limit, if possible, any loss in value. Hedgers may use the commodity markets to take a position that will reduce the risk of financial loss in their assets due to a change in price. Other participants are “speculators” who hope to profit from changes in the price of the futures or option contract.

A futures contract is an agreement to buy or sell a commodity at a date in the future. Everything about a futures contract is standardized except its price. All of the terms under which the commodity, service or financial instrument is to be transferred are established before active trading begins, so neither side is hampered by ambiguity. The price for a futures contract is what’s determined in the trading pit or on the electronic trading system of a futures exchange.

Speculators are people who analyze and forecast futures price movement, trading contracts with the hope of making a profit. Speculators put their money at risk and must be prepared to accept outright losses in the futures market. Speculators earn a profit when they offset futures contracts to their benefit. To do this, a speculator buys contracts then sells them back at a higher (contract) price than that at which they purchased them. Conversely, they sell contracts and buy them back at a lower (contract) price than they sold them. In either case, if successful, a profit is made.

Speculators enter the futures market when they anticipate prices are going to change. While they put their money at risk, they won’t do so without first trying to determine to the best of their ability whether prices are moving up or down. Speculators analyze the market and forecast futures price movement as best they can. They may engage in the study of the external events that affect price movement or apply historical price movement patterns to the current market. In any case, the smart speculator doesn’t operate blind.

People who buy and sell the actual commodities can use the futures markets to protect themselves from commodity prices that move against them. They’re called hedgers. Speculators assume risk for hedgers. Speculators accept risk in the futures markets, trying to profit from price changes. Hedgers use the futures markets to avoid risk, protecting themselves against price changes.

There’s a futures contract for a commodity or financial product because there are people who conduct an active business in that commodity. For example, there’s a Lumber futures contract because there are lumber producers who sell lumber and companies that buy lumber. The hedger plans to buy (sell) a commodity, such as lumber or live cattle, and buys (sells) a futures contract to lock in a price and protect against rising (falling) prices. The need for risk management that futures can meet holds true for all markets, including financial markets.

The producers and users of commodities who use the futures market are called hedgers. Buying and selling futures as a risk management tool is called hedging. Suppose a meat packer needs to buy cattle in October. Today’s cash price is okay, but what if prices rise? The meat packer can lock in a price on the cattle today, just in case the cash prices do go up between now and October. Protecting an October purchase price can be done by buying October Live Cattle futures contracts. This is called a long hedge.

What’s Already Determined?
delivery date
delivery point or cash settlement

Here’s an interesting point to remember. Most people who buy and sell Random Length Lumber futures don’t deliver or pick up a load of lumber when the contract matures. They usually offset the trade and get out of the market before that point. They don’t really want the lumber. They’ve traded the futures contracts for other reasons, such as protection against rising or falling lumber prices or simply to earn a profit on the trade.
Historical Futures Commission Merchants Financial Reports

Excess Net Capital: This is the amount by which the adjusted net capital exceeds the net capital requirement.

Customers’ 4d(a)(2) Seg Required: This is the sum of all accounts that contain a net liquidating equity.
2002 45,660,057,887 52,244,295,812
2003 50,114,476,356 56,243,176,059
2004 49,628,459,814 70,820,967,650
2005 55,322,525,530 80,368,083,706
2006 99,647,125,233
2007 110,540,901,561
2008 157,701,103,068
The filthy rich: Forbes lists America’s top 400 for 2007
By Hiram Lee
27 November 2007

World Billianoiars
2007 900B -> 4.4T

American Billioniars

2007 300B -> 1.54T
2006 120B -> 1.25T
2005 125B -> 1.13T
2004 45B -> 1T
2003 B -> 955T


Written by thisismylastbreath

May 4, 2011 at 8:14 pm

Posted in Uncategorized

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