Regulatory

I know I keep talking about pieces of this (and in fact posted an earlier Ticker related to Sheila Bair), but I believe it is important to piece it all together.

First, the financial regulatory hearing had one of the most outrageous pieces of testimony that I have heard in a long time from the ABA:

Panics only happen when you first have financial bubbles caused by loose lending policies.

This is the worst sort of complaint from an arsonist who has managed to accidentally burn down his own house!  "But the fire was so unfair!" he protests, while hiding his own gasoline can - which he spread liberally around the neighborhood!

SIFMA also ignores the 900lb Gorilla in the room, refusing to accept their member's responsibility for creating the bubbles in the first place, then bleating about "fair value" in a panic of their own creation.  But the gist of the issue we now face is in fact that "fair value" is in fact zero for many of the instruments currently being held at or near "par".  As just one of many examples we have the HELOC exposure on all of the major banks - 70% of the dollar value is in the bubble states and by law these are subordinate loans - if the first mortgage balance is higher than market value this is an unsecured credit line and has zero recovery value in the event of default, yet there is absolutely no accounting recognition of this fact that I can find in quarterly reports over the last two years.

Interestingly enough the AFL/CIO has a very critical piece submitted to the panel; among their comments was this nugget:

Is there an explanation required?  Willful blindness is obvious in this instance.  So is the willful blindness that has trashed AFL/CIO (and other) pension plans who were investing in securities that ultimately were proved to be worth far less than represented (and in some extreme cases actually worthless) - all through a process of intentional obfuscation that was known to The Federal Reserve system and yet not only left alone but actively encouraged under Alan Greenspan's tenure, and ignored during Bernanke's.

The fact of the matter is that while "mark-to-market" may be imperfect, published, market prices are superior to all others, in that there is a reference - what a willing buyer will give you for a given asset right here and now. 

The function of the banking system is not, as often believed, to allow certain "favored sons" to get wealthy while everyone else gets screwed.

I have repeatedly documented that many of these so-called "securitzations" were the financial equivalent of claiming to have spun flax into gold, in that it is not possible to return more, in aggregate, on a risk-adjusted basis than was present in the original lending transaction.  Since nobody works for free the all-in return on any securitization must mathematically be significantly less than would be the case for the same basket of single loans held by the originators.  The primary means by which such "flax-spinning" occurred was by hiding risks - not clearly documenting, for example, that <X> percentage of the loans in the pool had no documentation of income or assets, and that HUD had found that those who took "stated income" loans tended to overstate their incomes by 50% or more.  By this bit of omission these securities were thought of as "safe", when in fact nothing was further from the truth.

The fact remains that until we force the schemes, intentional mis-valuations and lies out into the open, enforce existing law that makes fraudulent conduct illegal and start locking up the scammers up the down the line trust cannot return to the economy.

What the AFL/CIO needs to understand, along with the rest of America, is that these losses did not happen due to bad luck or a "bubble bursting" - they happened due to lies, intentional obfuscation and even fraudulent misconduct that resulted in the bubble's growth in the first instance, all fueled by making loans - creating credit growth - that the originators of said loans either knew or should have known could not, in aggregate and in the fullness of time, be paid back.

I continue to return to the mathematics because the math is never wrong and can never be debated.  Again, the GDP and Credit Growth chart:

From The Fed's own Z1 data the Compound Annual Growth Rate of debt since modern records have been kept (early 1950s) is 8.77%, while GDP has grown at 6.82%, a difference of 1.95%.

Since 1990 Debt has grown at a compound rate of 7.91%, while GDP has grown at 5.39%, a difference of 2.52%.

Since 2000 debt has grown at a compound rate of 8.49%, while GDP has grown at 5.22%, a difference of 3.27%.

The "spread" is and has been increasing and it is a mathematical fact that such cannot be maintained in perpetuity.

Yet the merchants of debt, including Bernanke and The US Congress, continue to refuse to deal with the mathematics - even when it screws major constituencies such as the AFL/CIO.

One wonders....

Oct. 29 (Bloomberg) -- Federal Deposit Insurance Corp. Chairman Sheila Bair, breaking with the Obama administration, said U.S. financial companies should prepay into a fund the government would use to unwind large failed firms.

Congress should set up a Financial Company Resolution Fund and force institutions with more than $10 billion of assets to pay before a firm collapses, Bair said in testimony prepared for a House Financial Services Committee hearing today. Investors in failed companies also should take losses, she said.

Getting a little religion here Sheila?

Let's review, however, history.  Recent history.

Preservation of the legal strictures of capital structure is very important in order for investors to have a reasonable expectation of consequence in the event of a failure - and thus be able to price risk.

But this foundational principle - the sanctity of contract and capital structure - has been roundly abused and flatly ignored by the government since this crisis began.

Chrysler, GM, a plethora of banks including Lehman, Bear and others - in exactly none of these circumstances has the capital structure remained unmolested.  The abuses in GM and Chrysler's cases, in particular, were ridiculously egregious that one simply can't make the argument that there is in fact a distinction between "Senior" or "Secured" and unsecured bondholders any more.

Never mind events such as Indymac Bank's failure - the bank holding company and bank itself were effectively asset-stripped by government fiat, leaving the supposedly-super-senior claims - those of depositors who had more than the insured limit on deposit with the bank - with absolutely nothing against which to recover.

The draft legislation creates a council of regulators, including the FDIC, to monitor companies and the economy for systemic risk. While Bair supports the concept, she said the proposed council “currently lacks sufficient authority to effectively address systemic risks.”

Congress should require a presidential appointee as the council’s leader to ensure its independence and set an odd number of members to avoid deadlocks, Bair said.

I agree.  That appointee needs to be a publicly-vetted and appointed person with Senate confirmation.  Since this is inherently a function of protecting the public purse, it must NOT fall to an unaccountable person such as Bernanke, who has shown repeatedly that he has not and will not enforce the regulatory strictures even when so demanded by black-letter law, and that Congress will not place him - or you - in the dock when you willfully and intentionally ignore the law.

Bair and lawmakers have said a lack of a mechanism for shutting large firms in an orderly way led to ad hoc programs, such as the $700 billion taxpayer bailout used by lenders including Citigroup Inc. and Bank of America Corp.

There is such a system - you just don't like it and therefore have willfully and wantonly ignored it.  It is called bankruptcy and in fact the regulation of same is one of the enumerated powers in The Constitution delegated to the Legislature (Art 1 Section 8)-

To establish a uniform rule of naturalization, and uniform laws on the subject of bankruptcies throughout the United States;

How can appointed Federal Officials manage to be installed in their offices without reading The Constitution, say much less understanding it?

This is a good start Sheila - now let's see you enforce "Prompt Corrective Action" and close each and every bank that has a negative ratio of assets to liabilities on a market-price basis, so that the disasters we've seen over the last two years with 20, 30, 40% or more losses to the Deposit Insurance Fund stop happening.

Oh wait - that would mean you'd have to close some of those "really big banks" here and now, wouldn't it?  It would also mean you'd have to take out that pile of trash called "GMAC", which after huge infusions of taxpayer capital is still trying to grab more to remain alive, while running national advertisements under their name "Ally Bank" for above-market rate CDs!

Hmmmmm...

Now comes Goldman with yet another pack of misdirection:

Goldman told the Securities and Exchange Commission that computer-driven trading and an increase in stock transactions that occur off public exchanges has reduced consumer costs, increased competition and brought more liquidity to markets.

“The investing community (especially retail) has benefited from the evolving market structure and industry competition,” Goldman Sachs said in a summary of the 55-page report submitted to the agency.

You have to love the general gist of this thing.

Let's break down what's really going on here, because it is both instructive and, in my opinion, necessary.

Dark pools and High Frequency Trading reduce transparency.  The argument raised by Goldman and others is that these venues "improve price" for retail investors (and others), such as mutual funds (held by many retail investors.)  The problem is that this is the wrong metric to apply.

Trading in established stocks is in fact a negative sum game.  That is, for every share I get a "better price" on as a buyer, the seller gets a lower price.  Worse, since there there are commissions and fees involved in all transactions, the net effect of each trade is to dilute the total capital base in the system.

An example will serve to show this:

$1,100 in total money in the system.
100 shares @ $10 "quoted".
Taxes, commissions and exchange fees of 1% of the transaction.

The buyer and seller transact all 100 shares.  There is now $1,090 in total money (the other $10 has been siphoned off in commissions and fees.)

Do it again.  There is now $1,080 (another $10 has been siphoned off.)

Perform 10 transactions and oops - there isn't enough money to transact an 11th time.

Now here's the rub - the amount of "spread" that the market maker, which would be Goldman (among many others) can make is entirely dependent on the ability to hide the actual bid and offer by real investors!

That is, let's assume that of the $10 in commissions and fees Goldman gets as a straight commission half of it.  The rest is exchange fees and taxes.  That is, off those 10 trades Goldman would make $50, the government would get perhaps $10 in taxes, and the exchanges would get the other $40 split among them in various service charges and such.

But what if the seller was willing to sell at $9.90, not $10, and yet that was in a "dark pool"?  That is, the buyer of those 100 shares saw only the $10 price on the public exchange, and not the $9.90 offer in the dark pool?

Well now Goldman could buy those shares for $9.90 and immediately sell them to the willing buyer for $10. 

Suddenly their $10 "commission" turns into $20 - a doubling of their profit on the trade, with essentially zero risk, since they will only execute this trade if they see both a bid at $10 and the "dark" (invisible to the retail investor) offer for $9.90.

The argument is often made that institutional investors would "dramatically" move the market with their entries or exits if they were required to be published on the exchanges in real-time. 

Well, yes.  And?  Exactly why is this bad?  Is not the price of a security supposed to reflect the supply and demand for that security?

Remember that for every buyer there is a seller, and for every seller (even if the seller is selling short!) there is a buyer.  Each and every trade that "advantages" one person through obfuscation and hiding of information disadvantages someone else by the exact same amount of money, and further allows someone to skim off a piece of the transaction without being detected.

Goldman's position on this is entirely self-serving.  They not only earn fees by operating one of these "dark pools" they also are given the opportunity to exploit the hidden nature of price to skim off part of the transaction stream for their own benefit.  That money always comes from one of the two parties - the actual buyer or seller - and if the "retail buyer" on one side benefits the retail seller on the other side is getting screwed.

All "Dark Pools" and other means of gaming the system - that is, asymmetrical information - are without exception working against transparency and open markets.  Ever since the markets went to "pennies" the market makers and brokers have been trying to find ways to skim that 1/8th or 1/16th they used to "earn" off the spread in transactions that was formerly theirs as a consequence of an enforced differential between bid and offer.

Goldman's argument that retail investors are "helped" or "benefit" from dark pools and other means of obscuring price discovery is a flat-out lie. 

The truth is that some retail investors "benefit" while others are screwed in an exactly equal amount, while at the same time the big broker-dealers exploit the hiding of information to skim off pieces of the transaction stream that radically increase their profits.

On-balance this is of net DETRIMENT to market participants, as the increase in skimming, whether through fees or exploiting the hidden nature of bids and offers, always must come from one of the participants in the market, as for each buyer there is a seller and vice-versa.

There is no free lunch.

Once again the "banksters" asymmetric information campaign strikes again, this time in New Jersey:

While New Jersey replaced the debt with fixed-rate securities in 2008 after the $330 billion auction-rate bond market froze, the swap, in which two parties typically exchange fixed payments for ones based on floating interest rates, isn’t scheduled to expire until 2019.

The state paid $940,000 under the agreement last month and a total of $11.4 million since the auction-rate bonds were redeemed. The expenditures come as the fund reaches its borrowing limit and Governor Jon Corzine, Goldman’s former chairman who was a U.S. senator when the contract was signed, seeks $400 million in budget reductions as tax receipts fall.

Goldman, of course, knew that there was a risk that the bonds would be redeemed or refinanced before the swap expired.

The State may not have understood that - but you can bet Goldman did.

This sort of game isn't unlawful, but it sure smells bad, and it points out the problem that information asymmetry poses to both consumers and municipal governments. 

Banks of course say (with some justification) that the rule is "caveat emptor."  Customers (including municipalities) say in return "but we didn't understand or know that", and they're right too.

I have a solution to this sort of game-playing: States must use their sovereign power to deny business licenses to those firms that pull this sort of crap.

Corporations must register as foreign corporations to maintain a business location ("nexus") in a given state.  Those who abuse consumers or the state itself should have that privilege withdrawn.

That too is legal, and since banks assert repeatedly (as also happened in Alabama) that such behavior is perfectly ok on their part, then I call for states to assert their rights to refuse foreign corporate registrations for these banks, and further to provide by statute that state agencies must do business only with firms holding proper foreign corporate registrations in the state involved.

This instantly deprives any firm that pulls this sort of crap all revenue from that state, and is the "balance of power" that is sorely needed.  It is also unquestionably legal.

Matt Taibbi once again writes in Rolling Stone, this time on naked short sales, and while he gets a good part of the issue right, he (and many others who have opined on this situation over the years) miss the forest for the trees.

Matt writes:

But the most damning thing the attack on Bear had in common with these earlier manipulations was the employment of a type of counterfeiting scheme called naked short-selling. From the moment the confidential meeting at the Fed ended on March 11th, Bear became the target of this ostensibly illegal practice — and the companies widely rumored to be behind the assault were in that room. Given that the SEC has failed to identify who was behind the raid, Wall Street insiders were left with nothing to trade but gossip. According to the former head of Bear's mortgage business, Tom Marano, the rumors within Bear itself that week centered around Citadel and Goldman. Both firms were later subpoenaed by the SEC as part of its investigation into market manipulation — and the CEOs of both Bear and Lehman were so suspicious that they reportedly contacted Blankfein to ask whether his firm was involved in the scam. (A Goldman spokesman denied any wrongdoing, telling reporters it was "rigorous about conducting business as usual.")

Matt gets so close, but fails in the closing.

See, there are two area of naked shorting that nobody wants to really deal with, yet both have to be if we are ever to make a difference.  Let's deal with them in turn.

The first, the writing of "naked" swaps, is one that I've written about before.  The essence of a "credit default swap" is a contract whereby the buyer of protection insures against the default of a credit instrument (usually a bond of some sort.)  If the bond issuer doesn't pay principal and/or interest, the buyer collects the face value of the bond from the seller of protection - but in turn must tender the defaulted bond to the seller. 

This "tender requirement" is due to the fact the most of the time a default bond is not worth zero - even in a bankruptcy most companies have some value, and the bondholders are entitled to that recovery.

This is pretty much like homeowners insurance if you think about it.  Your house might have a fire, but odds are it won't be worthless if there is.  Same with auto insurance - you buy insurance against a wreck, but if you have one, the insurance company can pay you the market value of the car prior to the crash and in turn they get to keep the (wrecked) car.

Now envision that we allow any number of people to buy fire insurance against your house.  There's only one house, but ten fire insurance policies.  Only one of those people (you) owns the house and only one of them (you) lives there, but ten people stand to collect whatever the damage amount is if there's a fire.

How likely would it be that someone would be sneaking around with a gas can at 3:00 AM were this to be allowed?

Now let's add another wrinkle to the mix - to collect on any of the insurance policies you must have possession of the house! 

Tonight, you have a real fire and the house burns to the ground.  The recovery value is zero; indeed, it might be negative (since you have to hire a bulldozer and cleanup crew to clear away the mess before you can rebuild.) 

But if there are ten insurance policies, suddenly that burned out smoking hulk has value that doesn't really exist, and a bidding frenzy is likely to develop for the (one) house.  See, without the (burned out) house to tender those insurance policies are worthless.

We don't allow this sort of thing in the insurance business because it both distorts the market and creates a reason for people to intentionally start fires.

Why do we allow it in the "credit default swap" business? 

Did a few people intentionally start some (financial) fires?

The same thing applies, ironically, when it comes to options.  See, if I buy a PUT option the market maker who sells it to me immediately hedges his exposure. If the market maker does not hedge and the price collapses, I will put the shares upon him at vastly more than their value and he will suffer a huge loss.  He has no reason to take that risk; his money is made on the bid/ask spread, and he has no reason to take a directional bet on the stock's price (he may, for that matter, agree with me on which way he believes the prices will move!)

Market makers are exempt from the prohibition on naked short sales.  They should not be.  To allow them to be is to remove one of the actual risks in an option transaction - execution risk.  That is, it is entirely possible to have more PUTs (or CALLs) outstanding than there is public float of the underlying issue!  It is also possible for those to go out in the money and be exercised, and if that happens then you have created exactly the same sort of counterfeiting fraud that exists with a raw naked short.

The same problem exists on the long side.  When a naked short has to be bought back, there are insufficient shares available to do so.  This creates a dislocation in price to the upside.  While everyone talks about "bear raids" nobody talks about synthetic and fraudulently-generated short squeezes - yet they are just as pervasive in impact as naked shorting, but in the opposite direction.

How many of the so-called "vertical" moves we have so often seen in stocks since last fall, in both directions, can be attributed to this? 

The answer?  Most of them.

The only check and balance on this is to not exempt market makers from the constraints that everyone else must follow - that is, you can't short shares you cannot actually borrow, and you can't buy something that nobody is willing to sell at the desired price.  Put more simply, the quantity of a given stock in "float" is in fact fixed, determination of the float is made by the corporation when they decide how many shares to issue, and nobody can be allowed to count a given share twice, no matter how that double-counting would otherwise occur.

Removing this pervasive fraud from the markets would cause option premium to rise a lot when the open interest began to approach a meaningful fraction of the float, and it would bar the writing of credit default swaps in amounts that exceed, in total value, the underlying reference.  That's how it should be, and it would have made the sort of bets placed last year uneconomic, as execution risk, which in fact exists, would have to be computed into the option's (or CDS') value.  Today, it is not.

Matt gets so close, but then fails in the end. 

The reality is that this sort of "counterfeiting" is in fact part and parcel of both the option and credit-default-swap markets, and in each and every case, including old-fashioned naked short sales, it is in fact an act of fraud.

We don't need new laws - we simply need the existing laws that deal with forgery and counterfeiting enforced across all investment products, and the "special exceptions" that legalize certain sorts of fraud must be removed.