The Market Ticker - Regulatory

NOW FASB Wants To Do The Right Thing?

nospam@example.com (Karl Denninger) — Sun, 14 Mar 2010 22:20:00 -0400

The war over mark-to-market accounting is about to get hot, again. In coming weeks, the Financial Accounting Standards Board is likely to propose that banks expand their use of market values for financial assets such as loans, according to people familiar with the matter. That departs from current practices in which banks hold loans at their original cost and create a reserve based on their own view of potential losses.

Let's cut the pump-monkey crap and recall for everyone exactly how that "current practice" came to be, shall we?

Back last spring as I have written about more than once, the dishonorable Mr. Kanjorsky, Barney Frank's stooge, held a hearing in which he basically put a gun to FASB's head and informed them that they would allow banks to mark their loans to model - or Congress would introduce a law overriding FASB.

FASB objected, but it didn't matter. In the end they relented.

This was the catalyst for the huge rally in the stock market. It was a declaration of legalized accounting fraud from the people who oversee financial accounting matters.

Now, a year later, after Barney Frank comes to realize that it was precisely this "gun up your butt" approach to financial regulation that has made all efforts to modify home loans (including cramdowns) worthless, we see some effort to change things.

Why does it make modifications worthless? Simple - a second loan behind an underwater first (e.g. a HELOC) is worth zero if the first is underwater and forecloses. That's because it is a subordinate lien and is only entitled to be paid (at all) if the first is fully recovered. In a case where the first is underwater, it won't be recovered; ergo, the second is worth exactly nothing.

But "mark to fantasy", otherwise known (by me anyway) as legalized accounting fraud, has these banks carrying the loan on their books at or near 100 cents on the dollar. That's because "the loss hasn't happened yet", so since they're entitled to "model" a potential outcome 30 years in the future, they can say "well property prices won't stay down for that long, so we don't have to take the loss!"

It's bogus of course as the odds of someone paying on an underwater loan for a decade are close to zero. Anything that interrupts the borrower's cash flow - a loss of job, a medical problem, or simply being tired of taking it in the cornhole month after month while they could buy a house across town for half the price - results in a foreclosure, because the property isn't worth enough to sell and extinguish the mortgage.

Under mark-to-market rules banks had to price these loans at the current market's appraisal of their worth. Thus, as home prices declined and people were more and more underwater the market price would fall toward the zero that would be recovered if the foreclosure happened. This would in turn make the foreclosure no more damaging to the bank balance sheet than not foreclosing, and thus, the market would tend to clear.

But no! We can't have that! So instead we have this fantasy. The consequence is banks letting people live in a house that they haven't made a payment on in a year - and sometimes two. Nobody cares if the loan is performing or not, because it was probably sold to some poor bastard and the servicer is advancing interest payments anyway! Moody's, S&P and Fitch keep downgrading these bonds in a furious fusillade, but nobody cares at the bank, because the bank doesn't hold that paper - some fool pension fund does.

(What's left unsaid there, of course, is that said pension fund might be getting their interest payments now, but they sure as hell will not get the principal at maturity - because it doesn't exist. What that will do to the pension funds is obvious, but heh, so long as the banks get to lie, it's all ok that pensioners get screwed, right?)

What the bank holds is the HELOC and they are often the servicer as well. They have a terrible conflict of interest in this regard because if they foreclose then the HELOC is worth nothing, and they take the full dollar hit right here and now. If that was to be done across the board with these delinquent loans my analysis shows that many banks Tier 1 common equity levels would be forced below regulatory minimums and in some cases would be destroyed altogether. The latter would force immediate FDIC seizure. It is thus cheaper to advance the interest payment to the bondholder and pretend, even though the payments aren't coming in, praying that somehow the borrower who hasn't made a payment in a year will suddenly come up with $25,000 to "come current." (Yeah, right.)

Let me be absolutely crystal-clear - this is an outright scam promulgated by the same jackassery in The Government (SEC, Treasury and Congress) and The Fed that led to the destruction of Lehman. Instead of forcing these institutions to take their marks and admit to their losses they were allowed to put forward abjectly false and misleading financial statements. In the case of Lehman it appears the law was broken. But in the case of the big banks today Congress got the rules changed by shoving a gun up FASB's nose so as to make the INTENTIONAL false reporting of asset values a lawful act.

This should have absolutely never, ever happened and those dishonorable knaves in Congress responsible should resign NOW.

These banks should have been taken into receivership by the FDIC and closed. We would still have the $3 trillion we have blown trying to prop up the economy - well more than enough to pay off the depositors when the assets were liquidated. Deposits would have been dispersed to strong community banks, lending them further strength and ability to lend to qualified borrowers. The scam-meisters on Wall Street would have lost their jobs and been closed down, we would have taken a horrific hit in the market but it would now be over and the economy would truly be on the mend.

Instead we lied and pretended, creating a false dawn and a market rally based on nothing more than a scam. This cannot hold indefinitely, and yet the conditions for a true recovery in those asset prices will not happen for over a decade - if ever. If we do not stop this insanity cash flow will force the issue eventually and by then The Government will have blown its wad furiously trying to replace 10% of GDP in the private market, as it has for the last two years, and thus be unable to fund the FDIC deficiency.

The simple fact of the matter is that as I have written about for over three years I absolutely believe that if valued on market prices these banks were insolvent then and are today. Hiding the fact of that insolvency with bogus accounting fictions does nothing to solve the problems that face us and in chokes off lending, prevents markets (especially housing and commercial real estate) from clearing and will absolutely prevent any durable economic recovery from occurring.

Oh yes, it has pumped the stock market to the moon, but the test is not whether the stock market goes to the moon - it is whether the market price reasonably reflects underlying fundamental value, and there the evidence is clear - it does not.

The danger here from continued obfuscation could not be more grave. We may have already passed the point where the government is capable of funding the deficiency to come in the FDIC accounts, but if we do not stop this crap, it is a certainty that such will occur, exactly as did in Iceland.

Is That Fear I Sense? (CDS Regulation)

nospam@example.com (Karl Denninger) — Thu, 11 Mar 2010 11:38:00 -0500

Amusing how Bloomberg comes out pumping the CDS monster:

March 11 (Bloomberg) -- European politicians and regulators could initiate a continent-wide ban on speculative trading of sovereign credit-default swaps tomorrow. Making it stick without the Americans won’t work.

Oh there you're simply wrong, my friends. The assertion is made:

“You need to get the U.S. on board, otherwise the effect will be minimal because trading will simply move elsewhere,” said Jan Hagen, head of the financial services group at the European School of Management and Technology in Berlin. “A ban would allow European politicians to tell voters at least they’re doing something.”

On the contrary.

EU nations can pass laws and regulations that make the collection of bets placed in this fashion unenforceable. That is, you're free to write all the swaps you want over in London, but you can't force anyone in the EU to pay when the bet goes against them.

This, incidentally, is exactly what the Dutch did when Tulip Mania blew up. They declared all the contracts that had been written against Tulip Bulbs (which were an awful lot like a CDS!) to be unenforceable gambling contracts and thus void.

POOF!

Such a law, if passed EU-wide would make the European Union a haven for corporations and even banks. No longer could you be attacked within the EU - and frankly, who gives a tinker's damn what London or Wall Street thinks if they can't reach into your firm if and when their contracts go bad!

Oh, and if you think the Europeans don't have a real solid reason to do this either individually as nations or collectively, you're wrong. Italian cities, for example, appear to have been scammed with swap contracts written in English rather than their native language by a bunch of High Street shysters. They're now bleeding from all orifices on these "deals" and looking for a clean way to stop it.

This is the way to do it and it's entirely within their rights as sovereign nations to do so, just as it is ours.

Should the EU do so America would be forced to go along, lest it be effectively depopulated in terms of large financial and industrial concerns. Same with Britain.

So go ahead and put forward this sort of BS "firebreak" kind of argument, Bloomberg. It's abject nonsense.

The creation of a "safe haven" where fraudulent swaps are no longer enforceable would be of tremendous benefit to the western world.

If London and Wall Street have managed to bribe their respective governments to a degree that makes banning fraudulent conduct impossible, then we will simply have to look to the Europeans to take the proper - and long overdue - step forward in fixing this problem, and suffer the consequences in the loss of both jobs and companies that come from the "big banks" obfuscation and BS.

Barney Frank: The Liar Is (Again) In The House

nospam@example.com (Karl Denninger) — Mon, 08 Mar 2010 08:07:00 -0500

Will this man ever take responsibility for what he does?

Many second liens have little value because of the plunge in home prices, Rep. Frank wrote, adding: "Yet because accounting rules allow holders of these seconds to carry the loans at artificially high values, many refuse to acknowledge the losses and write down the loans."

How did that happen Mr. Frank?

Oh yeah, I remember! Your committee pressured FASB to drop "mark to market" accounting requirements last year!

That is, YOU were personally responsible for this crap.

Remember the subcommittee hearing chaired by your fool-in-chief Mr. Kanjorski? I remember that circus show of horrors well. In case you've forgotten, let me help jog your memory:

Washington, DC – Congressman Paul E. Kanjorski (D-PA), Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, today announced that the Subcommittee will hold a hearing to examine the mark-to-market accounting rules that many contend have exacerbated the current troubles in the financial industry and in the broader economy. The standard requires companies to value assets they hold at current market values. For assets that are frozen and have a diminished current market value but may recover value in the future, the standard has proven problematic. Companies are then forced to write-down billions in assets, which can lead to further write-downs elsewhere.

Like second mortgages, for instance?

Yeah.

This hearing was what prompted those banks to mark those loans to fantasy values, a practice they are still continuing to this day, even though if the first is underwater and goes into foreclosure the second is in fact worth zero.

Therefore, a first that is both underwater and is late by 60 days or more is almost certain to either short sale or foreclose ultimately, and under mark to market rules the second would have to be written off.

But your committee, which sits over the subcommittee on Capital Markets, effectively bludgeoned FASB into legalizing the accounting fictions that you now complain about.

Indeed, the testimony of FASB was that:

The fact that fair value measures have been difficult to determine for some illiquid instruments is not a cause of current problems, but rather a symptom of the many problems that have contributed to the global crisis, including lax and fraudulent lending, excess leverage, the creation of complex and risky investments through securitization and derivatives, the global distribution of such investments across rapidly growing unregulated and opaque markets that lack a proper infrastructure for clearing mechanisms and price discovery, faulty ratings, and the absence of appropriate risk management and valuation processes at many financial institutions.

None of which, I might add, your Committee has bothered to address.

Having done nothing but bleat and ram down the throat of FASB changes in accounting standards that have legalized outright balance sheet fraud, you now have the temerity to complain about the results, when I and many others said at the time this would be precisely what would happen.

The solution to the problem is, of course, to reverse the outcome of that idiotic hearing and restore mark-to-market accounting forthwith for all bank assets.

Go look in the mirror Mr. Frank - you made this mess yourself, and while you're at it drag that clown-car occupant Kanjorski with you.

IRA Goes Off The Rails - Mark To Market

nospam@example.com (Karl Denninger) — Sun, 07 Mar 2010 13:41:00 -0500

In what I can only describe as a self-serving piece for keeping banking "exactly as it is" (which is inherently unsustainable and thus can't be) IRA tries to refute the value of mark-to-market with a stunning piece.

Finally, on April 2, 2009, FASB allowed banks to use "cash flow" to value bonds when the market was illiquid - exactly like Bernanke said last week. This fixed the immediate problems in the system, and the economy and financial markets have been on the mend ever since. In fact, the stock market bottomed on March 9, 2009 - the very day markets found out that Representatives Barney Frank and Paul Kanjorski would hold a hearing to force FASB to change the misguided accounting policy.

No it didn't.

Remember FHLB Seattle again? Their "at market" losses on a portfolio of trash, er, loans was some $300 million. They claimed that the real loss to be realized over time was in fact $12 million, using model-based accounting. After all, these loans, while deeply underwater, weren't really impaired.

Or so they told Congress. I remember the testimony well.

But now, one year later, they are suing the banks that packaged up all this dog squeeze. Among the pieces of trash being sued over are the very same securities against which they said that a model-based valuation system showed a tiny $12 million loss.

Are they suing for $12 million?

No.

That "tiny $12 million loss" in fact is some $311 million - almost exactly what the market price predicted it would be.

Remember, this was in the "depths of hell" time period too - March of 2009. It was when the entire world was coming apart, Satan was chortling at the fate of our financial system and the S&P 500 traded - literally - at 666.

Yet that view - that market view - was correct.

To the regulators, it does not matter if the loan is still being paid on time. And it does not matter if the lower valuation of the collateral will force an already stressed borrower to come up with more cash. Regulators have decided that they want banks better capitalized and the way they can do that is to reduce the value of a bank's assets and then force these banks to raise money from shareholders.

It shouldn't matter to the regulators.

As I wrote months ago, the solution to this problem is One Dollar of Capital:

The solution is very simple, but you will notice that Jamie doesn't bring it up. That's because he finds it unacceptable.

What's that solution?

Prohibit as a matter of Federal Law, and enforce it vigorously under pain of immediately dissolution, THE LENDING OF MONEY UNSECURED THAT EXCEEDS THE FIRM'S CAPITAL.

This is in fact the only way you can both end "too big to fail" and not constrain size or influence.

It is also the definition of sound lending.

It is also how lending was done prior to the banksters corrupting the government and literally usurping the sovereign credit of The United States.

This is what the regulators are trying to back into.

It is the right thing to do, because it is the definition of sound banking.

ONE DOLLAR OF (EXCESS) CAPITAL FOR EACH DOLLAR OF UNSECURED LENDING.

You enforce this, the problem with systemic risk disappears. Banks can fail without harm to anyone else. Banks can take all the risk they want - with their shareholders and subordinate bondholders money - but never with depositors or secured bondholders money. At the point those bets go bad and deplete their excess capital the bank is closed - right then and there.

All secured lenders to the bank get their money back.

All of it.

All depositors get their money back.

All of it.

The shareholders and unsecured lenders to the bank take a haircut, which is determined by the actual over-time performance of the outstanding unsecured lending.

The FDIC Deposit Insurance Fund loss, if this regulatory framework is applied and enforced, is always zero.

This regulatory regime exactly matches the bank's lending risk with the expected risk of lending money to the bank. Those who lend unsecured (e.g. shareholders and subordinate bondholders) have lent money with the expectation that they might lose it. The bank in turn has lent out capital with the expectation that it might not be repaid.

The secured lenders to the bank - senior bondholders and depositors - lent their money with the expectation that it was a secured loan. The bank in turn lent that money out secured by an asset that is valued (each and every day) at or above the loan balance.

Statutory law sets a reserve ratio (cushion) between secured lending out and secured capital in. This gives the market room to move against the bank on the valuation of those secured loan assets without causing the bank to fail. Management is free to increase that ratio should it desire, but not to dip under it (if they do, the bank gets closed.)

But for each dollar of unsecured lending that is out there from the institution, that bank must hold one dollar of excess capital beyond statutory requirements.

If it does not, at any time, then the bank is closed, haircuts may happen, and the bank's management loses their jobs.

This is the only stable fractional lending system that can be constructed folks.

It remains difficult or impossible to find support for it precisely because it is so simple and yet it absolutely prevents the playing of "Heads Management Wins, Tails Taxpayers Lose."

If we want a stable financial system, we must impose this, and I call upon IRA, along with the other folks in the private and government sector, to wake up and smell the math.

All You Need To Know About Bank Balance-Sheet Fraud

nospam@example.com (Karl Denninger) — Sat, 06 Mar 2010 13:17:00 -0500

I am constantly amused by those people who claim there is some vast "conspiracy" in this country when it comes to banks, balance sheets, and fraudulent lending and accounting.

There is no conspiracy.

It is, in fact, "in your face" fraud.

The FDIC does us the courtesy of explaining it virtually every Friday night, right on their web page.

I am simply going to take last night's bank closures, which numbered four. One of them has no "deposit insurance fund" estimated loss available, because they didn't find someone to take the assets - they're just mailing checks. But the other three do.

Waterford Bank, Germantown MD: $155.6 million in assets, $156.4 in insured deposits. They were "underwater" by $800,000, right? Wrong: Estimated loss, $51 million. That is, the assets of $155.6 million were overvalued by approximately 30% at the time of seizure.
Bank of Illinois, Normal IL: $211.7 million in assets, $198.5 million in deposits. They were "underwater" by $13.2 million (which is why they were seized), right? Wrong: Estimated loss $53.7 million. That is, the the assets of $211.7 million were overvalued by more than 25% at the time of seizure.
Sun American Bank, Boca Raton FL: $535.7 million in assets (so they claimed anyway), $443.5 million in total deposits. Heh, why did you seize them - they have more assets than liabilities? Oh wait: Estimated loss: $103.8 million, so the actual assets are worth $443.5 - $103.8, or $339.7 million. That is, the assets of $535.7 million were overvalued by a whopping 37% at the time of seizure.

This isn't new, by the way. In August of 2009 I went through Colonial Bank's failure based on BB&T's presentation to its shareholders on the "merger" - and gift it was given by the FDIC. It too showed that Colonial had been carrying assets on their books at a ridiculous 37% above where BB&T ultimately marked them as a whole.

Folks, your bank is being assessed deposit insurance premiums to pay for these losses. You are paying these losses through increased fees and interest expense on your credit cards and all other manner of borrowing.

You are paying for outrageous, pernicious and endemic balance sheet fraud.

There is no conspiracy. It is right under your nose. One of these three banks, based on their balance sheet, wasn't even underwater - it was "to the good" by nearly $100 million dollars.

The balance sheet was a flat, bald-faced lie.

You want to sit for this?

Why should you?

Now let's ask the inconvenient question:

Are the big banks - specifically, Citibank, Bank of America, Wells Fargo and JP Morgan - all similarly overvaluing their assets?

Why should we believe they are not? You can go through more than a year's worth of FDIC bank seizure information and in essentially every single case you will find that overvaluations of somewhere from 20-50% have in fact occurred, yet not one indictment for book-cooking has issued.

So let's be generous and assume that the "big banks" are over-valuing their assets by 25% - the lower end of the range of what the FDIC says is, through actual experience, what's going on, and add it all up.

Bank of America shows $2.25 trillion in assets.

Citibank shows $1.89 trillion in assets.

JP Morgan/Chase shows $2.04 trillion in assets.

And Wells Fargo shows $1.31 trillion in assets.

This totals $7.49 trillion smackers.

The FDIC's experience with seizing banks thus far suggests quite strongly that all four of these entities are lying about these valuations, and that were they to be seized the loss embedded in them (and for which you, the taxpayer would be responsible) is somewhere between $1.49 and $2.99 trillion dollars.

Incidentally, neither the FDIC or Treasury happens to have either $1.49 or $2.99 trillion laying around, and it is highly questionable if they could raise it, should that become necessary.

Now of course neither you or I can prove this is correct. However, we can look at the FDIC's own published bank closing statements, and derive from them a pattern stretching back more than a year now that has disclosed that in essentially each and every case the banks in question have overvalued their assets by anywhere from 20-40%, and that as of the day of the seizure such an overvaluation was in fact a continuing and ongoing practice.

Back in the beginning of 2009 we had people argue that "mark to market" was invalid - that in fact the market-based pricing losses that were being claimed were ridiculous and would never happen. One of the claimants was the Federal Home Loan Bank of Seattle, which said that the $300 million in mark-to-market losses would not actually happen - that the real loss was only going to be $12 million dollars.

FHLB Seattle recently filed suit against the bundlers of this trash, claiming, surprise-surprise, that the real loss is not $12 million, not $300 million, but $311 million - on that bundle of trash alone. In all they are seeking $2 billion in damages.

We have now learned, a year into this "experiment" with mark-to-model promulgated at gunpoint by Congress that:

The banks indeed have been lying about asset valuation and the proof comes in the form of the FDIC seizures, which in essentially case have documented massive and outrageous overvaluation of assets on bank balance sheets.
The claimed "mark to model" losses, which were tiny compared to the market-price losses, were in fact fictions, to the point that the poster child of the "mark to model" argument is now suing the purveyors of the instruments supposedly not to be marked to the market for losses that exceed what the market-based loss was back in March of 2009.

If you wish to argue that the economy and banking system are recovering their health, you must deal with this. If indeed large bank balance sheets are concealing a deficiency of somewhere between $1.5 and $3 trillion in losses not only will the economy and lending environment not recover it can't as the large banks all know the truth.

I believe this is why those very same banks are hoarding cash. I believe they know that at some point in the future - a point not under their control - the truth may come out and if it does an instantaneous run would occur - not just on their bank, but on all banks. Such an event could be defended against only with a huge cash hoard - a hoard that, if they lend out said cash, would not be available to them.

The Federal Reserve knows this too. I believe this is why there is nearly $1 trillion of "excess reserves" sitting at The Fed, up from nearly zero prior to the crisis - it is these large banks' "backstop" against a potential run should the truth of their balance sheets reach public conscience.

The political and regulatory bottom line is simple: As I have repeatedly maintained for nearly three years, we now have the facts from our own government agencies, most particularly the FDIC: The banks have been and still are cooking their books in a manner that intentionally overstates their asset valuations - an act that is exactly identical to that which brought down ENRON.

Something to think about on this fine weekend.

More CDS: Refusal To Prove Capital Adequacy

nospam@example.com (Karl Denninger) — Thu, 25 Feb 2010 09:19:00 -0500

This is simple folks:

Feb. 25 (Bloomberg) -- The biggest credit-default swaps investors oppose targets for clearing trades as regulators attempt to curb risk in the $25 trillion market.

Pacific Investment Management Co., BlueMountain Capital Management LLC and AllianceBernstein LP are among asset managers and hedge funds that won’t agree to specific goals before the Federal Reserve Bank of New York’s March 1 deadline requiring them to outline the industry’s next steps to move swaps through clearinghouses, according to people familiar with the matter who declined to be identified because the talks are private.

NOT CLEARINGHOUSES FOLKS, CENTRAL COUNTERPARTIES.

And further, if these firms don't like it, tough crap. Declare any contract over which nightly margin and capital supervision is not available TO THE PUBLIC to be void as an unlawful gambling instrument, contrary to national security, and a demonstrably-fraudulent inducement as the writer is refusing to demonstrate ability to pay.

That ought to do it.

I'm tired of this crap. We simply cannot afford to have people writing contracts they can't cover. That's how we got the blowup in 2008 and now we're threatening to destroy sovereign nation credit (see my other Ticker of today) over the same bogus and fraudulent garbage.

Give them 30 days. Either they get moved onto a regulated exchange where we have nightly margining and publication of bid, offer, last trade and size (open interest) or the contracts are declared void due to lack of consideration - that is, due to the firm's blanket refusal to prove ability to cover the position.

CONgress and President Obama need to stop fellating the banks, brokers and hedge funds and instead bite down - while we still have an economy and financial system left.

You Had Better Cage The Monster CONgress (AIG/GS/CDS)

nospam@example.com (Karl Denninger) — Sat, 06 Feb 2010 21:56:00 -0500

I've been writing about this now over a year in regard to the mess that became of AIG, their "financial products" unit, and what I believe is culpability not only of certain financial parties but more importantly our regulators of these firms.

Now The NY Times has published a new article that makes clear that my clarion call for major changes in these areas of the market were not only spot-on, but are even more necessary today than they were back then.

A.I.G. had long insured complex mortgage securities owned by Goldman and other firms against possible defaults. With the housing crisis deepening, A.I.G., once the world’s biggest insurer, had already paid Goldman $2 billion to cover losses the bank said it might suffer.

A.I.G. executives wanted some of its money back, insisting that Goldman — like a homeowner overestimating the damages in a storm to get a bigger insurance payment — had inflated the potential losses. Goldman countered that it was owed even more, while also resisting consulting with third parties to help estimate a value for the securities.

Read that carefully. The NY Times is making this sound like AIG had insured losses against securities Goldman was holding. That's what insurance is, right?

Here's the problem: Goldman didn't own the securities.

In addition to offering to cancel its own contracts, Goldman offered to buy all of the insurance A.I.G. had written for several other banks at severely distressed prices, according to three people briefed on the discussions.

Negotiating with Goldman to void the A.I.G. insurance was especially difficult, Federal Reserve Board documents show, because the firm did not own the underlying bonds. As a result, Goldman had little incentive to compromise.

Now do you see the outrage in these so-called "protection devices"?

They aren't. They were raw bets. Very highly-leveraged gambling instruments that had a very low cost at origination - a cost all out of proportion to their eventual potential return.

We do not let "just anyone" buy insurance. You must have an insurable interest. That is, I can't buy fire insurance on your house. If I could, I might - and so might 20 of my best friends. We might even target those homes we think might have fires. We could even bribe the folks doing a controlled burn nearby to be a little less careful than they ordinarily would. Or, in the extreme case, one of us might just set a fire on purpose!

None of this is allowed in the insurance marketplace because it creates too many incentives for people to set fires and otherwise cause calamities, whether through outright unlawful conduct or helping along "a series of unfortunate events."

In the regulated options, futures and stock markets we have controls on this sort of thing as well. To short a stock (legally) you have to be able to borrow it. That is, someone who owns it must lend it to you first (perhaps in exchange for money.) As more people short the cache of people willing to lend out that stock for free will evaporate, and you'll have to start paying up for the privilege of borrowing it. This is a natural check and balance on placing negative bets via shorting.

Buying PUTs or transacting in the futures market has costs too. Those regulated markets have defined margin requirements and they are enforced - nightly. The cost of buying a PUT includes something for the guy who sells it to you, as he is going to hedge his bet by being short the stock. Thus, as the number of PUT buyers increases the premium demanded rises - precipitously so as the demand for those PUTs goes up. Finally, buying a PUT doesn't come with the right to demand anything more from the seller - his margin requirements are enforced by the exchange and you don't get to hold the money.

These OTC CDS contracts had another insidious feature: They apparently included a clause that not only would a downgrade of the security trigger margin requirements but so would a downgrade of AIG.

The terms, described by several A.I.G. trading partners, stated that A.I.G. would post payments under two or three circumstances: if mortgage bonds were downgraded, if they were deemed to have lost value, or if A.I.G.’s own credit rating was downgraded.

The perversity of incentives here is that if you can demand that your counterparty hand over more and more "margin" to you it is possible to actually force a downgrade by your actions and thus cause even more margin to have to be posted! This, of course, harms the firm's liquidity and makes a further downgrade more likely.

Rinse and repeat to destruction - which, incidentally, is exactly what happened.

This is dramatically different than the regulated markets, where valuations are determined by the market, not by one of the parties at interest and the margin requirement is fixed by the deficiency (if any) against the final strike price and the market's price - the person who happens to be short gets no benefit (or harm) due to his or her credit rating. If you're underwater, you post margin. If not, you don't, but in neither case does the person on the other side of the trade get to hold the margin funds! He gets your money only when he closes his position or the option expires (if it's in the money.)

These "synthetics" (such as the Abacus CDOs) are an outrage on their face. These are not created from the purchase of actual physical asset (e.g. a mortgage security) but rather by someone writing a credit-default swap against a reference. These are then bundled up and sold. When a credit-default swap is then written against a synthetic CDO it is equivalent to writing a gambling contract on a gambling contract as nobody in the chain owns an actual physical asset (such as a loan)!

The simple fact of the matter is that "naked" CDS exposures need to be prohibited right now. They never should have been allowed and not a damn thing has changed. Purely synthetic instruments need to be traded on an exchange in each and every case as a means of preventing chicanery, where margin can be enforced transparently on a nightly basis by a neutral third party in the middle of all transactions - the nominal buyer for every seller, and seller for every buyer. This third party (the exchange), having no skin in the game either way, will not permit the abuses that are too easily committed when you have over-the-counter transactions of this type.

The article referenced makes a decent case that AIG didn't fall off the cliff, it was pushed. There are even allegations raised of collusive conduct which, if true, add an even more serious angle to this entire story.

But at the end of the day the problem boils down to the same basic facts I have been harping on since the beginning:

Writing "insurance" on something the purchaser doesn't own isn't insurance, it's a gambling contract.
When such gambling contracts stack up to a great degree there are huge incentives for someone to commit financial arson. Whether they did or did not is a matter for debate, but that the incentives exist to structure deals in a way that are easily detonated so you can profit from them as exposure increases is not open to debate. Such incentive does absolutely exist - and we must eradicate it.
To prevent fraud and gaming of the system, such contracts must be on a regulated exchange where each buyer and seller deals with a neutral third party (the exchange itself) that is responsible for nightly margining, trade reporting, open interest and bid/offer maintenance. These facts must be exposed at all times to the public so that the market operates in a transparent fashion and neither side of the transaction can be "pushed".
The exposure of these contracts on said exchange will also prevent disasters like AIG from occurring, as the fact that they are short "X" will become instantly visible to everyone, including their regulators. The precise exposure they are taking on will thus be known at all times.
We must bar backstopped entities (such as banks and insurance companies) from trading in or creating synthetic instruments such as this in the first place. These are not hedges as by definition there are no actual hard assets behind them. The argument that they are created to fill a demand from the market is true but irrelevant - the fact remains that with no actual hard asset acquisition behind them they serve no fundamental credit intermediation purpose which is the purview of banks and insurance companies - they are, instead, pure speculative instruments. Let the hedge funds, operating without any sort of financial backstop, create these all they want - and trade them on a regulated exchange - but keep the banks and insurance companies out of it.

We have not neutered this monster in the slightest. Indeed, the latest rabble in the market with regard to Greece, Spain and Portugal is, not surprisingly, about (once again) credit default swaps blowing out.

And again I ask - who wrote those CDS naked on these nations to people who didn't actually hold underlying positions in the bonds without them being traded on a central exchange, and why, after 2008 and 2009, do we still let that crap go on?

Shelby: When You Close Your Eyes You Cannot See

nospam@example.com (Karl Denninger) — Wed, 03 Feb 2010 07:48:00 -0500

Have a listen and pay close attention starting about 2:00 into the clip.

Shelby: "What were the root causes and how to prevent them in the future?"

That's simple - it's called willful blindness.

By you. By Dodd. By Frank. By Bernanke. By OTS. By OCC. By Paulson. By Geithner.

Willful, intentional blindness to the outright scams that all of the above and more have been willfully and intentionally ignored over the space of more than two decades, including while Shelby was the Chair of The Banking Committee.

Never mind the outright lie that "prop trading didn't take down any of these companies." Oh really? What was Merrill Lynch? What was "Hvol4"? That was a prop desk basis trade that blew up in Merrill's face and literally killed the bank, forcing them into a shotgun marriage with a subsidized (by the taxpayer) Bank of America. They weren't alone either - Deutsche Bank took a huge loss on pretty much the same bet gone bad. The FT said this about the "final nail in the coffin" with regards to that prop trade that detonated:

Mr Cotty also gave his blessing to a $1bn writedown of credit default swaps involving investment grade companies. The markdown of a position on the “high vol 4” index transformed a gain of $100m into a loss of $900m, said a source familiar with the matter.

In short Shelby (and Corker!) you need to quit trying to run in an attempt to derail what should be a complete and total ban on ALL proprietary trading by US banking interests that have access to the government backstop.¹

Why?

Because these abuses killed one of them dead and nailed several others for huge losses during 2008. Any claim otherwise are a bald lie.

There are rather simple ways to put a stop to the crap that led to this mess, and to prevent it in the future:

Prosecute fraud and claw back "gains" made on false claims. Everywhere. Start at the top and work down, simply because fraud at the top costs more people more money. If you securitized something and didn't disclose the fact that these "securities" were comprised of loans where incomes were overstated by 50% or more in half or more of the notes, you go to prison - because you either knew or could have checked (but didn't) and represented these loans were of "prime" quality. If you were shorting what you were selling then obviously you didn't believe that the price at which you were selling represented good value, right? Go join Bubba over there. Keep going but start from the top.
Put an immediate stop to institutions that cannot cover their own mistakes. The poster child for this is the disclosure that Blackrock filed some 1800 13-G disclosures - because they took over a Barlcays unit. No big deal as those are all customer funds in segregated accounts - they just manage it - right? Wrong. Blackrock (according to Yahoo finance) has some $3.5 billion in cash but is managing nearly 1,000 times as much in assets. Their market cap is a mere $40 billion. Should they screw up in some fashion, get sued, and get a judgment against them that comprises a mere 1/10th of 1% of their assets under management their entire cash account would go up in smoke, leaving a debt hole (which they also have) of the same size! At less than 1% the entire company's market cap would go up in smoke and the firm would likely fail. This is a company that makes a literal handful of basis points (4.7 billion in revenue?!) across their asset base. Who among us has never made a mistake and been forced to eat it? They're not alone by the way - not only has Blackrock gotten much bigger but so has JP Morgan, Bank of America and Wells Fargo during this mess. Every one of these firms and dozens more have dramatically too much under management for their capital base. We have a 6% Tier 1 Capital ratio for banks and frankly I believe it should be 10%, held in cash, no exceptions if you want to run customer money. You have to be able to survive an adverse event without a government backstop. Give all these firms one year to either raise that capital or break themselves up - period.
No more mark to myth. The whole point of mark-to-market is that if you have to sell it you know what you can sell it for. You avoid capital crunches during asset devaluation by holding more in Tier Capital, in cash, than you need from a regulatory point of view and you unload early and often as prices deteriorate. Yes, I know, people want prices high for various reasons, but the fact of the matter is that if you're a buyer (of houses, of cars, of anything) you want prices low, not high. Prices seek equilibrium and when there's a crunch you find out what utility value actually is. This is not a bad thing, it's a good thing!
No more securitization. All securitization accomplishes is obscuring reality and generating false "profits" that never actually existed. Securitization doesn't transfer risk it hides it on purpose and by doing so is an act of robbery and fraud. Portfolio every loan. Lenders can sell undifferentiated bonds to raise funds which they can then loan to borrowers, holding the paper. This preserves the intermediation function but stops the lies and obfuscation, since if you lent it you own it. Allow the trading of whole loans, but no bundles or securities based on them. If an insurance company or other "stable" investor wants to loan someone money for 5, 10, 20 or 30 years they can buy a bond issued by "Bank #1" who can then make a loan with that money and portfolio it. Levels of indirection? One. Skimmed funds? Minimal. The economy benefits from lower costs for productive borrowers while shutting down the scammers.
No more capital market activity for lending and depository institutions - that is, those with access to the federal teat in the form of deposit, loan, investor or bond insurance. Period. And none means none. It means if you want to act as a custodian of customer money (e.g. like a stock brokerage or bank) and have a lending function (e.g. margin accounts or a loan book) you cannot trade your own book - your first and only responsibility is to the customer. If you're a bank you cannot be in the markets at all. You can clear a customer order but you can't trade yourself - irrespective of why. I know all about the arguments related to hedging one's own positions - the solution to that, of course, is to bar these institutions from taking their own positions in the capital markets in the first place! There's no reason for a bank to be "hedging" a customer position - only their own. Make the banks and brokerages choose - if they want to earn commissions that's fine but then they're fiduciaries of their customers - not combatants in the market who are acting with superior information against customer interests. Those firms that wish to be present in the markets for their own purposes must be fully legally and operationally distinct (that is, not subsidiaries or owned by the same corporate parent) from any customer clearing activity, as to fill both roles is an inherent conflict of interest that simply cannot be resolved. Trade with your own money, not your customer's and definitely not with the US Taxpayer's!

If you surmise that this proposal looks a lot like Glass-Steagall, that's because it does.

It also solves the problem.

I would like to see things like "credit default swaps" all traded on exchanges and argue that they should be, as that's the only way to guarantee margin supervision and mark to market, but if you do the above it doesn't matter. No regulated entity can write, buy, or trade in them - so it no longer matters what unregulated folks do. Who cares if two hedge funds want to blow each other to bits with these things? Not I, so long as they can't infest the regulated insurance and banking landscape. Have at it boyz but if you find your "counterparty" doesn't have any money go tell the judge when you sue your counterparty for fraud - the rest of us will sit back and laugh at you both.

^1. For a full dissertation on the basis trade that blew Merrill to bits, see Zerohedge, which did a nice piece on it.

Dodd, Shelby, Perhaps More? (Volcker Rule)

nospam@example.com (Karl Denninger) — Tue, 02 Feb 2010 14:43:28 -0500

Quick drive-by: Now apparently these guys are both for "The Volcker Rule."

Has someone felt a bit of heat for their "oh no, that's dead on arrival" viewpoint as was "leaked" to the media previously?

Hmmmmm....

Volcker up now in a Senate Banking Committee hearing - this should be good. I'm recording it if anything of particular note warrants a Ticker later.

AIG: The Idiocy That Will Not Die

nospam@example.com (Karl Denninger) — Fri, 29 Jan 2010 08:33:00 -0500

Why do I smell a Fannie/Freddie debacle in here?

AIG owes $25.8 billion on the line, about $2.4 billion more than last week, according to Fed data released yesterday. The draw has increased for six straight weeks. The company said in November that it may borrow additional funds from its five-year Fed credit line to make payments on maturing commercial paper.

Wait a second.... payments on maturing commercial paper? Why would they owe payments on maturing commercial paper that they purchased? I thought that companies paid to borrow, not the other way around?

Oh wait - perhaps it's their commercial paper? Exactly what are they paying to borrow? And if it's expiring, does this mean they can't roll it over? How are these clowns funding themselves?

Hmmmm..... so AIG borrowed a bunch of money, perhaps from the Fed Alphabet Soup program) to support the commercial paper market, which they are now shutting down (as of February 1st), and they have a problem rolling it over in the private market? That would make sense. But if they can't roll it over in the private market how is AIG going to be handling it's ongoing short-term financial needs?

These sorts of arcane things may not pique the interest of most Americans, but it should. AIG is now a ward of the state, with some $180 billion in money pumped into or through them. And while their AIGFP (financial products) division was at the center of this mess, writing credit-default swaps against CDOs that couldn't be reasonably valued in the market (due to their thin trading and no agreement on their value) with no money to back it up, the question remains - had AIGFP gone bankrupt along with the holding company would it have mattered to the regulated insurance subsidiaries?

Indeed, the entire point of structuring insurance businesses this way (every state has its own separate subsidiary) is to allow the firm to take one of their subsidiaries through bankruptcy if necessary without destroying policyholder interests in other states! Just go ask all the "Pup Company" insurance structures in Florida, for example, where you have "Joes Insurance of Florida" that is legally and financially distinct from "Joes Insurance" - very handy when a Cat 5 hurricane comes roaring across the state and lays a couple of cites waste!

I have seen nothing other than a bare assertion that we "had to" rescue AIG to prevent these policyholders from getting screwed. Indeed, over the years we have seen multiple instances where insurance company subsidiaries "blow up" and yet the impact remains contained to that specific subsidiary. This is not an accident, it is in fact by design!

So now with AIG as a ward of the state one has to, I believe, ask one simple question - how do we get out of this, and why are we continuing to pump money into AIGFP instead of severing the cord so the remainder of the company is protected?

IRA: Volcker Criticism Only Partly Justified

nospam@example.com (Karl Denninger) — Tue, 26 Jan 2010 12:39:00 -0500

Out from the IRA is an interesting piece taking a shot at Volcker's reform proposals:

If you accept that situations such as AIG and other cases where Buy Side investors (and, indirectly, the US taxpayer) were defrauded through the use of OTC derivatives and/or structured assets as the archetype "problems" that require a public policy response, then the Volcker Rule does not address the problem. The basic issue that still has not been addressed by Congress and most federal regulators (other than the FDIC with its proposed rule on bank securitizations) is how to fix the markets for OTC derivatives and structured finance vehicles that caused losses to AIG and other investors.

Well, actually it does partly fix the problem.

IRA gets the cause correct: we got into this mess as a consequence of intentionally-opaque financial instruments that were less-than-honest in both their intentions and disclosures.

But where IRA misses the market is that they have not discussed who was it that came up with these structured financial instruments, who assembled them, who wrote the prospectuses, and who bought ratings for them from the ratings agencies?

Why that would be "the big banks", right?

Remember, Wachovia wrote off-balance-sheet swaps against their own securitized mortgage deals when they found them unmarketable "as written."

Goldman, Merrill, Morgan, Bank of America, Lehman, Bear and others created the securitized mortgage conduits and structures for non-agency paper and in fact stuffed into Fannie and Freddie securitized loans that did not meet the GSE's actual mandate in terms of disclosure and underwriting - that is, they sold them purely on the basis of a rating.

Despite warnings from the FBI in 2004, Comscore in 2006 and HUD in 2007, all of which warned of extraordinary levels of fraud in these instruments and two of them - Comscore and HUD - making the claim that as many as nine in ten ALT-A loans were made to people who did not have the income and/or assets they represented, there was no disclosure of these facts in the offering prospectuses for the securitized debt generated from these "loans."

IRA points out:

A decade since the Enron-WorldCom scandals, we still have the same basic problems, namely the use of OBS vehicles and OTC structured securities and derivatives to commit securities fraud via deceptive instruments and poor or no disclosure. Author Martin Mayer teaches us that another name for OTC markets is "bucket shop," thus the focus on prop trading today in the Volcker Rule seems entirely off target -- and deliberately so. The Volcker Rule, at least as articulated so far, does not solve the problem nor is it intended to. And what is the problem?

Not a single major securities firm or bank failed due to prop trading during the past several years. Instead, it was the securities origination and sales process, that is, the customer side of the business of originating and selling securities that was the real source of systemic risk. The Volcker Rule conveniently ignores the securities sales and underwriting side of the business and instead talks about hedge funds and proprietary trading desks operated inside large dealer banks. But this is no surprise. Note that former SEC chairman Bill Donaldson was standing next to President Obama on the dais last week when the President unveiled his reform, along with Paul Volcker and Treasury Secretary Tim Geithner.

The argument that we have not solved these issues is a good one, but again misses the mark in that one must ask: why would an institution create these things unless they were able to force someone else to eat them when they go bad?

I would argue that while IRA certainly has the "long view" correct (and in fact it is almost exactly what I've been arguing for since I began publishing The Market Ticker) in point of fact separating securities businesses from deposit and loan -making in all of its forms is in fact a positive change, in that it will remove the backstop that these firms otherwise immediately run to whenever someone proposes to do something (like make them eat their fraudulently-created securities) that might threaten their survival.

As such while "The Volcker Rule" certainly won't fix the world, it will in fact change the landscape in a fashion that will make possible the imposition of strict liability for the creation of fraudulent securities in all their forms, including the "corporate death penalty" sanction that, at present, we are told cannot be applied without destroying both the banking system and economy.

So Much For FASB (Wells And Others)

nospam@example.com (Karl Denninger) — Fri, 22 Jan 2010 07:49:00 -0500

Well, so much for the FAS 166/167 announcement that was supposed to end the off-balance-sheet games.

The new accounting standard requiring banks to bring assets back on balance sheet had a negligible impact on Wells Fargo. Despite having over $2.0 trillion of off-balance sheet assets, Wells consolidated just $10 billion of risk-weighted assets when the new standard took effect January 1. (See slide 17 in the bank’s supplemental earnings release)

Grrrrr.....

The "Volcker Rule" is a good thing, and we should (and must) stand behind President Obama in implementing it.

But if the games with off-balance sheet "assets" are not addressed we will be right back where we started in short order.

We still have not learned a damn thing from ENRON have we? Off-balance-sheet "assets" are always a means of deceiving investors and regulators as to exactly what the exposure might be (and thus how much CAPITAL should be behind those alleged "assets".)

There is no other reason to run an entity off the balance sheet - other than to keep from having to properly reserve and capitalize against a potential bad outcome for that "asset"!

The banks are all whining about "risk retention" and claiming that it will "effectively shut down" mortgage underwriting (except by the few "huge banks.") Oh really? How come it didn't shut it down for the preceding 50 years after The Depression - before securitization became all the rage?

The reason is simple - banks love it when they can find some sort of SCAM to allegedly "transfer risk" to someone else but keep their chunk of the deal. If they were underwriting mortgages (for real, not the "automated crap" they use today) and thus were confident that they had actually made a good loan they'd be more than happy to portfolio the paper and earn the income stream - all of it!

The scam of faux "risk transfer", of course, allows them to not give a good damn about the performance of that "deal" - and yet performance is, in point of fact, what should be the central concern when a deal is structured!

Let's be frank: Securitization fraud and OTC Derivatives fraud in all of their forms is why we had both the bubble and the bust. Without those crucial capabilities there would have been no bubble - and no bust.

For more than two years I have advocated that there must be NO off-balance sheet exposures permitted (by anyone) and NO OTC derivatives. If you want to write derivatives you should be forced to do so on a public exchange with a central counterparty. Such a structure inherently forces proper margin supervision since the exchange is the buyer for every seller and the seller for every buyer - and as their only fee income is from trade volume, they will never allow people to cheat on margin or capital adequacy.

Has such come to the fore as "the" goal of regulatory reform?

Not yet.

If it does not we will suffer another collapse. It is inevitable and all we are left to argue over is when it will occur.

To President Obama: FOLLOW THROUGH NOW!

nospam@example.com (Karl Denninger) — Thu, 21 Jan 2010 15:33:00 -0500

So Bwarney "I never met a banker I wouldn't blow" Frank said:

Oh, so Bwarney doesn't like the bank reform eh?

He got suitably "informed" (are they down to rank bribes with $100 bills - out of sequence - in envelopes yet?) I'm sure by the banksters lobby about 30 seconds after President Obama showed up on TV this morning.

Well I have an answer for that problem if Bwarney doesn't want to play ball.

See, President Obama doesn't need him to.

He can fire Turbo "I cheated on my taxes" Timmy - after all, the recently-announced rules should prohibit him from receiving his paycheck anyway - and replace him with Paul Volcker.

Mr. Volcker can then do what Congress won't through the back door.

You want to be a Primary Dealer and bid on Treasury Auctions? Cool - divest first, then come talk with us. Until then we'll run our auctions directly and you won't make the FICC revenues off your arbitrage (which is a huge, captive, and virtually guaranteed "free money" source.)

If the banks still don't like the rules that President Obama wants then how about if our new Central Banker is PAUL VOLCKER of Treasury who then issues non-debt-based currency directly?

And don't tell me he can't. He most certainly CAN without passing one new law:

United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes, and dues. Foreign gold or silver coins are not legal tender for debts. (31 USC Sub IV Ch 51 Sub 1 Sec 5103)

Unfortunately for The Fed they screwed up when they passed The Federal Reserve Act and failed to void the ability of Treasury to issue its own non-debt-bearing currency which is also legal tender. It requires only an executive order to implement this and there is nothing Bwarney Frank can do about it.

Doing that would effectively emasculate both The Federal Reserve and the big banks that have all sorts of credit outstanding through The Fed, as it would destroy the backstop that The Fed enjoys. Suddenly The Fed would be "just another bank" with a metric crapload of used dogfood on its balance sheet in the form of Freddie and Fannie MBS that also don't have a full faith and credit guarantee!

IF President Obama is serious about fixing these problems, this is how he addresses it. Either play ball - right here and now - "OR ELSE."

Oh, and start using the words "indictment", "prosecution" and "prison" too - or just perp-walk a few of those banking executives on Wall Street.

THAT will convince me that our President is serious.

Did The President FINALLY Wake Up?

nospam@example.com (Karl Denninger) — Thu, 21 Jan 2010 11:51:00 -0500

I'm not sure I believe what I'm hearing on CNBC coming out of The President's mouth.

Is he really listening to Paul Volcker? Finally?

Here's what I heard that I liked - a lot.

1. Limit the Scope - The President and his economic team will work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.

Did I really read that? REALLY? I've been saying this for more than two years, and FINALLY we are hearing it out of the administration.

IF YOU WANT TO TRADE FOR YOUR OWN ACCOUNT THEN DO SO WITH YOUR OWN CAPITAL IN A FASHION THAT CANNOT BE SUBJECT TO A TAXPAYER BACKSTOP!

This is EXACTLY what Paul Volcker, myself and a few others have been calling for. It is the essence of Glass-Steagall. It is the proper role of government to grant permission to use the sovereign credit only for the purpose of regulated lending and deposit-taking with strict supervision to prevent lies, scams, schemes, evasion of reserve requirements and fraud.

As I have said repeatedly with taxpayer guarantees come responsibility to act in a responsible fashion and this means no proprietary trading with taxpayer backstops.

2. Limit the Size - The President also announced a new proposal to limit the consolidation of our financial sector. The President’s proposal will place broader limits on the excessive growth of the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits.

YES! Look, AIG was not gambling with sovereign credit - but it was "too big to fail" precisely because it was permitted to write liabilities against which it held insufficient capital. If it had been a small company nobody would have cared.

But it wasn't a small company. It was a freaking huge monstrosity that threatened the stability of the system as a whole.

Now here's my message to Congress:

PASS THIS, PASS IT NOW, AND PASS IT FAST. NO DAMN EXCUSES - OR YOU'RE FIRED!

There remains one further critical step that must be taken:

We must INSIST as citizens that those in the financial industry - top to bottom, starting at the top (including The Federal Reserve) - who intentionally concealed the risks of these "products" and the "credit quality" (or lack thereof) in them are investigated and when appropriate indicted and prosecuted.

EACH AND EVERY FINANCIAL FIRM MUST BE SUBJECT TO A FULL FORENSIC AUDIT WITH ALL MISDEEDS DISCOVERED THEREIN TURNED OVER TO A GRAND JURY - PERIOD!

THIS INCLUDES "MARK TO FANTASY" ACCOUNTING BS, OFF BALANCE SHEET GAMES AND ALL OTHER FORMS OF DISTORTION AND LIES!

STOP THE LOOTING AND START PROSECUTING!

To the Citizens of this nation: You have just been given the MEANS to stop the crap that got us into this economic mess.

GET OFF YOUR ASS, PHONE, FAX AND PROTEST IN PERSON DEMANDING ALL OF THE ABOVE HAPPEN RIGHT NOW - OR SHUT THE HELL UP NOW AND FOREVER MORE ABOUT THE ECONOMY SUCKING!

More On Forex Trading and Brokerages

nospam@example.com (Karl Denninger) — Thu, 21 Jan 2010 08:52:00 -0500

My "Reform to Kill Retail F/X" article got a few people's blood pressure up...

It appears that my central point wasn't well-communicated based on the comments I've received (including in places that I don't have "commenting" accounts), so I'll try again.

Here's the central point:

The brokerages all claim to be "commission-free" but this is not really true - the fees charged, instead of being in the form of a traditional commission, are in the form of "pips" or a spread, and on a position held open the spread is charged again and again as a "rollover fee."

The key item is that since this is an over-the-counter market you do not know what the actual market price is at any given point in time, and therefore you do not know what the commission is that you're being charged as it is (intentionally) hidden from you.

The number of people who said "oh you only pay the spread once" are sadly delusional. In a regulated exchange market where national best bid and offer (NBBO) is visible to you you can typically "split the baby" between bid and offer, or even occasionally get filled "wrong way" in the spread as someone will occasionally "pick off" your bid or offer. Further, your broker is typically either restricted or prohibited entirely from taking the other side of the trade internally with you. In the case of Globex futures the rule is that before your broker can "cross" your order internally (e.g. for another client) they must expose your order to the market for a minimum period of time.

In other words, the broker doesn't get the spread, the guy on the other side of the trade does! Half the time (on average) that's you.

This is not true if you can't see the market depth and are in fact buying or selling on whatever spread you're presented by the broker instead of the market itself - he may be (and probably is) padding the actual market spread materially on both sides.

These rules, along with the inherent characteristics of an exchange (that is, the visibility of the bid and offer stack at any given point in time) means that a brokerage has to expose their commission and fee structure - how they actually make money - in a form you can see it.

Again: In an OTC market this is not true as what you are provided as a bid and offer is only what the broker wants you to see and may have no relationship to the best bid and offer they can find in the marketplace.

This is the inherent screw job in OTC derivative contracts - OTC Forex - or OTC anything. The lack of a regulated, public exchange where you as a customer can see the various bids and offers in the marketplace means that you as a customer will always be disadvantaged as the broker you're doing business with has every incentive to skim from you by concealing the actual market depth.

Of course the Forex Dealers don't want this to change. They don't like the idea of a regulated exchange for the same reason that the banks don't like that concept for CDS. Their business model depends on obscurity to maximize their profit, and it is extremely difficult if not impossible for a customer to know whether they're getting a good deal or literally bent over the table in any particular instance. Further, it is entirely possible for one client to get a "good deal" and another "be screwed" - and again, the lack of an exchange and thus central posting of bids, offers and trades makes it essentially impossible for you as a customer to know if you're being treated fairly or not.

There is no such thing as a free lunch in lending, brokerage or anything else.

My central point by weighing in on this issue is that the customer is never in a better position when one has an OTC market with no public visibility versus an open, exchange-traded market and that as I have noted nobody ever works for free.

The bottom line is this: If you can't figure out how someone's making their cut of the transaction your most-reasonable assumption is that the means by which they make their money, and the amount they're skimming off your transaction, is being concealed from you for the express purpose of allowing them to maximize their take.

That is, when you look around and can't find a sucker you need only find the closest mirror to locate the person who's on the short end of the stick.

CFTC "Reform" To Kill Retail FX?

nospam@example.com (Karl Denninger) — Wed, 20 Jan 2010 09:50:00 -0500

Slithering along in the proposed rule bin is a nasty little ditty from the CFTC that will fundamentally change how retail FX (forex) business is conducted - and, likely, end its appeal.

The proposal does a number of things, not all of them bad. Retail FX shops have been subject to massive abuse and near-absent enforcement, including front-running. While "bucket shops" ("dealers" that don't actually trade but rather have you betting against the house) have been broadly illegal whether it goes on these days or not is difficult to discern.

In addition you've all seen the ads - both online and on ToutTV - pumping OTC Forex trading as a means to "make money" in a trading market that is open nearly 24x7.

Chief among the risks is the fact that these products are in fact an over-the-counter market - that is, there is no central party exchange and counterparty. As a consequence counterparty risk exists in these accounts along with the risk of business failure of your broker. These accounts are often marketed and sold to people who have little appreciation for the risk that the extreme leverage (in many cases 100:1 or higher!) offered to clients can pose. The brokerages all claim to be "commission-free" but this is not really true - the fees charged, instead of being in the form of a traditional commission, are in the form of "pips" or a spread, and on a position held open the spread is charged again and again as a "rollover fee." As such, unlike a stock, option or futures trade where one pays to enter and again to exit (but not to hold) a FX position is inherently a short-term trade, as you will be charged simply for the privilege of holding your position open over a period of time.

Indeed, while nearly all OTC Forex brokers use language in their advertising that suggests very low (or absent) commissions in point of fact commissions can be quite high and in order to control those costs you MUST trade on very short time frames. If you short the Euro/USD cross, for example, and expect a 100 pip (one cent) move on your trade, you might pay three pips of spread to enter and another three to exit, for a total "vig" of six pips. That's a 6% commission! Worse, if you hold over a rollover you will get hit with another spread and your commission goes up even more. To put this in perspective I can buy or sell 1,000 shares of a $100 stock (total "notional" value of $100,000) for $10 at many discount brokerages. If I'm playing for a $1 move on that $100 stock I pay $20 (round trip) in an attempt to make $1,000 - a commission of 2% on the expected move. In the futures market I can put on a single /6E contract (Euro/Dollar futures) for under $3 in commissions (each way) with an initial margin of $4,050 and a move per-pip of $12.50. This means I can trade for the same 100 pip move for a cost of $6 on a potential profit of $1,250, or ONE TENTH the percentage cost of commission of a retail FX shop! Most brokerages of course try to quote commissions on the "notional value" of the position you buy or sell - that's an intentional misdirection as the correct way to compute the "vig" (or cost of your action) is the percentage cost on the anticipated profit on the trade. The bottom line: RETAIL FX COMMISSIONS ARE QUITE HIGH COMPARED TO OTHER FORMS OF TRADING AND THOSE COMMISSIONS MAKE IT DIFFICULT TO CONSISTENTLY PROFIT AS A TRADER IN THIS MARKET.

As such OTC Forex trading is NOT suitable for virtually ALL persons. Indeed, it is the ultimate "day trading" vehicle, both due to the severe cost disadvantages that apply to positions that are held open along with the fact that most "FX brokerages" offer leverage of 100:1 or more. That is, a 1% move in the currency pair you're trading can and will, if it goes the wrong way, wipe you out.

In addition to all of the above there is margin risk that is often unappreciated. While all brokers (in all markets) will typically try to protect themselves by reserving the right to close a position that reduces your account equity to zero (rather than generate a margin call and wait for you to meet it) there is no guarantee that a rapid and/or disorderly move will not gap over the "zero line" and leave you with negative equity. This can lead to a situation where you can easily lose more money than you have deposited with the brokerage. Large, unexpected and violent moves in FX markets are relatively common, especially around news events, and even though such moves often reverse quickly they frequently result in accounts being destroyed and liquidated unexpectedly. This risk goes up dramatically as offered leverage increases.

Now you might think from the above that I "hate" Forex.

You'd be wrong.

Forex is a very difficult market to consistently make money in, mostly due to the "pip spread" form of commissions. The spread looks small but in fact when combined with the high degree of leverage offered it is quite large and it is also charged on a recurring, not only on a trade entry and exit, basis.

Nonetheless for those who wish to speculate on an intraday basis, using very high degrees of leverage and accepting the sizable risk associated with this sort of trading, OTC Forex is a reasonable way to speculate on currency moves and, if one has a full and fair understanding and acceptance of the risks I have no quarrel with it.

The CFTC's proposal will tighten up regulatory supervision substantially and to the degree that it stems the abuses, including irresponsible marketing practices, improving capital adequacy supervision and providing a means of addressing the "shark" problem (misleading, abusive and unreasonable acts by some retail FX brokerages) it is a good thing.

The retail FX industry is rather aghast at the regulatory requirements including assigning liability for improper actions or business practices. To this I say "Awwwwwwwww!" The retail FX marketplace has for years been rife with complaints about various FX brokerages with allegations including soliciting people who have no business trading in this market, front-running, spread manipulation and even blatant bucket shop operations. How much of this is true I have no means to determine (I don't trade FX with the "retail folks", preferring instead to use an established real broker that deals in other products and therefore has some generalized skin - and a reputation - to protect) but that some of these abuses have happened is a matter of record. (With that said, many who put on a bad trade and lose due to their own overuse of leverage or simply making a bad decision look for someone to blame other than themselves for their losses, so I am typically skeptical of such claims absent evidence.)

But buried in the proposal is one item that has the potential to kill retail FX as we know it today:

Proposed Regulation 5.9(a) would require each RFED and each FCM that engages in retail forex transactions, in advance of any such transaction, to collect from the retail forex customer a security deposit (in cash or in financial instruments that meet the requirements of Regulation 1.25) equal to ten percent of the notional value of the retail forex transaction, ten percent of the notional value of short retail forex options in addition to the premium received, or the full premium received for long options, as the case may be. Pursuant to proposed Regulation 5.9(b), the RFED or FCM would be required to collect additional security deposit or to liquidate the retail forex customer’s position if the amount of security deposit collected fails to meet the requirements of paragraph (a).

That paragraph effectively limits leverage to 10:1 by imposing a hard margin cap of 10% on cash positions (long or short) - or a net leverage reduction of 90%.

Now I'll go out on a limb here and say that most Forex traders, if limited to 10:1 leverage, will leave. They will either trade something else or go somewhere else. Of course the bleating has begun already, with people claiming that traders will move to Europe where they can obtain leverage as high as 400:1.

Well folks, frankly, if you're playing with 400:1 leverage you're juggling nuclear balance sheet destroyers and sooner or later one will explode and blow your fool head off. I simply cannot countenance such a thing.

Is 10:1 a reasonable limit? We seem to think it is in other parts of the market - in commodities and futures generally, most of which offer somewhere between 6:1 and 10:1. As such the CFTC's proposal appears to be in line with other regulated markets, and on its face appears reasonable.

But there's no doubt that this has (and will) anger a huge number of retail FX traders and dealers and will, without a doubt, engender more calls of "you're going to destroy us if you limit things like this!"

Indeed, some of that has already come, including this article from Turnkey Trading Partners (who alerted me to the proposal - it had flown under my radar originally.)

My view on the regulatory proposal is that there is both good and bad contained herein. I believe:

Regulation of business practices and demanding capital adequacy tests and strict liability for business practices (especially when it comes to solicitations and/or things like front-running and other abusive practices) is a good thing. The Retail FX market has been a shark tank since its inception and muzzling some of the sharks will make the market more fair for everyone.
Few people truly understand the commission structure and how much it actually costs to trade FX. I have seen NO retail FX shop that explains the commission structure in a fashion that I consider adequately clear - and that's being polite.
The leverage limit may be overbearing. The need for some sort of leverage limit isn't really open to question - there is such a need. Whether 10:1 is the right number is another question.

On balance I agree that it is long overdue to clean up the FX market shark tank and shoot some of the Tiger Sharks that have been devouring retail customers who have an inadequate understanding of the risks they are accepting by playing in this market, the fee and commission structure and its implications, and how this, along with the rollover format of fees and commissions make it very difficult to consistently profit in this marketplace.

Perhaps the leverage limits will trash the retail FX market and drive it offshore. But I believe there's an argument to be made that with the alternatives available for the most-common currency crosses already (e.g. the /6E Euro/Dollar cross futures contract) there are alternative products that have significantly lower costs embedded in their trading and as such the impact of these regulatory changes could be to bring in line with regulated futures contracts the fee and cost structure found in the OTC marketplace. If it instead drives the market overseas or destroys it entirely what have we lost as traders when I can get the same exposure to the market for one tenth of the commission expense?

Finally, why is the retail FX brokerage community whining about this proposal instead of adjusting their cost and business models to bring commissions more in line with the regulated marketplace that consistently provides users with the same exposure to the market at a fraction of the cost? If you trade retail FX maybe it's time for you to investigate the regulated /6(x) futures contracts instead and cut your transaction costs down to a more reasonable percentage of your anticipated profits. Yes, you'll have to post margin and if you're a "very small" trader you probably won't be able to participate. But if you can't post margin on even one contract in that market the better question is "can you really afford to be trading these products - a highly-speculative instrument in which you can lose everything you put up and then some - at all?"

Now there's something to think about.

Sheila Is "Concerned": She Should Be!

nospam@example.com (Karl Denninger) — Tue, 15 Dec 2009 08:05:00 -0500

The latest piece of stupid to come out of Ms. Bair's mouth was this morning on CNBS and summarized on Bloomberg:

Dec. 14 (Bloomberg) -- Federal Deposit Insurance Corp. Chairman Sheila Bair said she’s “concerned” that U.S. banks are making only the safest loans, and encouraged the companies to step up their pace of lending.

“There needs to be well-managed risk-raking to get the economy going again,” Bair said today in a Bloomberg Television interview at the White House, prior to a meeting of bank chief executive officers with President Barack Obama.

Right. But here's the problem, in a nutshell - the banks are still hiding losses - big losses.

Where? Well, among other places, as I noted in The Ticker on the 8th:

However, as Laurie has said, the choice is between forced cramdowns and workouts within the current loan structures or continued foreclosures. Both end in the same place for home values, but the latter results in larger losses, as a loss delayed is a loss that grows larger for multiple reasons. Some of those include "homeowners" who trash their foreclosures on the way out the door, vandalism and simple rehab-and-resale expenses.

Today, a week later, she suddenly "gets some press" - for what I've been writing about for over two years, and what others have been opining on as well: The second mortgages are sitting on bank balance sheets and they are, for loans that are underwater on the first, worth exactly zero!

“It’s important to realize the largest second-lien holders are the largest banks, and there’s going to have to be some very substantial writedowns if you go to a principal-reduction program,” Goodman said. “And this is going to have to be addressed head-on.”

How do you intend to "address" this Sheila?

Let's count the ways:

You can stop allowing banks to lie! That would be a great idea. Force them to go through their second line portfolio line by line, and reserve against all loans that have a subordinate position and for which the collateral value is less than the total of the first and all seconds combined. For those who are not paying today, that means writing those loans off entirely, as the capital structure says they are worth zero. For loans that are currently performing a provision for doubtful collection should be established.
You can find a way to "bail out" the second line holders. How much is involved here? Good question - but it's not small! Several of the large banks have tens of billions of dollars of this trash on their balance sheets and it infests basically all of them. This is a roughly $1 trillion dollar mess. Since these were the "ATM Machines" of housing and were both most popular in bubble areas and were drawn down in those areas heavily, the losses are likely to be enormous - hundreds of billions worth. (Estimates are that 70% of all outstanding HELOC balances are in bubble states - specifically, California, Arizona, Nevada and Florida.)

So which is it going to be Ms. Bair? You say you want banks to take "prudent risks" but those were the same "prudent risks" that caused all the trouble in the first place. These so-called "prudent risks" include writing second lines (including HELOCs) that were immediately tapped and spent - not on household improvements that increase the value of the home, but on boats, cars, exotic vacations and credit-card balances.

Now you want "small business" to be able to get loans. There's a major problem here: Small businesspeople have no collateral to pledge!

I know - I have been a small businessperson most of my adult life. I have interacted with banks most of my adult life too. And in each and every instance for a small business loan I have been asked to pledge my personal assets as collateral for that loan. As I was either unwilling to do so or unable (I had no material personal assets as I lived in an apartment at the time) I did not "avail" myself of the moneychangers financial abuse (fortunately.)

With most homes underwater, most small businesspeople have no assets to pledge as collateral. Therefore, you are asking for the impossible - prudent lending does not take place unsecured, and yet small businesspeople are, largely, without collateral as a direct and proximate cause of the outrageous housing bubble that your agency, along with the rest of the Federal Government and Federal Reserve, willingly and knowingly allowed to be blown (and which is now collapsing.)

The fraud machine on Wall Street and in DC continues to roll on, with pointless bleating from administration officials on a regular basis about how we "must increase lending" - when in truth it was too much lending to people who simply couldn't pay that caused the trouble in the first place, destroying the collateral value that would, in normal economic times, be used as security for such lending.

We will eventually stop trying to drink ourselves sober, but I fear that it will only happen when we start puking up blood - or worse, suffer liver cancer.

Now We're Talking! Glass-Steagall

nospam@example.com (Karl Denninger) — Tue, 08 Dec 2009 08:17:00 -0500

I can't believe this is coming from five Democrats:

Five House Democrats will call this week for a return to a Depression-era law that separated Wall Street investment banking from Main Street commercial banking.

If adopted, the measure would give banks one year to choose between being commercial banks or investment banks. The nation's biggest -- those now commonly referred to as "too big to fail" -- would be broken up. The Obama administration opposes the measure.

The amendment's five co-sponsors -- Maurice Hinchey of New York, John Conyers of Michigan, Peter DeFazio of Oregon, Jay Inslee of Washington, and John Tierney of Massachusetts - want to restore the Glass-Steagall Act of 1933, which prohibited commercial banks from underwriting stocks and bonds. The act was repealed in 1999 at the urging of, among others, Larry Summers, now President Barack Obama's chief economic adviser.

Gentlemen, you're on the right side of this.

You can start reading here, then page back. There's a lot of reading for you to do..... (this is the search results for all of my Tickers that have mentioned Glass-Steagall, of course.)

http://market-ticker.org/search/glass-steagall/P12.html

A FULL re-instatement of Glass-Steagall - not some watered-down piece of legislative trash, but the real deal - will prevent the economic meltdown we are in the middle of from ever happening again.

The key to such a fundamental re-balancing of our economy would be the restoration of the balance of credit, by making it impossible for those banks with access to the sovereign's fractional reserve privilege to speculate with it.

Instead, lending would shift primarily to productive investment.

Glass-Steagall, in point of fact, was one of the primary reasons post-WWII that we came roaring forward with our economy. Lending went to finance productive assets (e.g. factories, machines, tractors, combines, etc) instead of financial speculation as it had in the 1920s.

It was that financial speculation that led to the asset bubbles in the 1920s - and that, in turn, resulted in the malinvestment that was responsible for The Great Depression.

It was that very same financial speculation in the 1990s and 2000s that led to the current bust, and contrary to the claims made by Bernanke, Geithner and others, the pain is not over, nor can it be until and unless the banks' abuse of sovereign credit for financial speculation is prohibited.

If this amendment passes it will eviscerate Wall Street's "profit gravy train", but it will also usher in a productive explosion in America that we have not seen in the last 50 years.

You want to see jobs created by the millions and Americans return to work?

Pass this amendment.

Heh Bair! Stick This In Your (Censored)

nospam@example.com (Karl Denninger) — Thu, 03 Dec 2009 09:05:00 -0500

If Bair won't do the right thing with the FDIC (and OTS/OCC), seizing banks when she should, it appears they will stop the BS games that they DO play when they come in:

When AmTrust Financial Corp. filed for bankruptcy protection this week, it may have been trying to avoid what happened to Washington Mutual last year.

Federal regulators seized WaMu in September 2008 and sold it to JPMorgan Chase, leaving WaMu shareholders without a dime. Never mind that WaMu's parent company had $4 billion in the bank. Regulators took it all and gave it to JPMorgan.

Exactly. These deposits, of course, are well beyond the FDIC insurance limits, and simply "disappear" when the FDIC comes-a-knocking.

But not if you file bankruptcy first! Then you get to throw a padlock on the safe - before Sheila can come in there and rob your bank (almost literally.)

In all fairness if you're over the FDIC maximum there's really not a lot you can do about it. Which is why you should never be, and why the Transaction Account guarantee program (now ending) has been such a big deal for businesses.

Try running a payroll for a business of any size without being over $250,000 in your account - ever. Good luck.

Sheila, I'm sure, will be pissed off about this - that's a few million (and maybe tens of millions) she's been "foreclosed" on being able to use to help cover what will, I'm sure, be huge FDIC losses if and when this bank is seized.

Of course if The FDIC had ever bothered with this silly law called "Prompt Corrective Action" - USC Title 12, Ch16, Sec 1831o - there would have never been a problem in the first place. This bank, and the more than a hundred others thus far (and likely more than 2,000 to come) would have been seized before there was a risk of actual loss of materiality to the deposit insurance fund.

But Sheila has played "extend and pretend", just like Treasury. Unfortunately extending and pretending is really all about the pretending, and when the cash flow will no longer support the light bill, you're done and the lies are exposed.

Any angst that Sheila has is the result of her own actions, and as a consequence I applaud boards that are willing to take this bull by the horns and shove it where Sheila won't appreciate it.

Maybe - just maybe - it will wake up our regulators if done often enough to hurt, and cause them to start enforcing the law instead of willfully turning a blind eye to it.

It's Called "Precedent" (Bair)

nospam@example.com (Karl Denninger) — Tue, 24 Nov 2009 21:28:00 -0500

When GM and Chrysler were bailed out, I wrote on the foolishness of setting forth precedent allowing secured creditors to get screwed so the UAW could "get theirs."

Apparently people didn't bother to listen, because now Bair of the FDIC has endorsed an amendment to the Regulatory Overhaul Bill that would require "secured" creditors to take a haircut if a "systemically significant" firm fails - at the discretion of the government.

At first this sounds reasonable - demand that people investigate risk, basically, by demanding that they eat the cost if they don't.

There's a problem with this approach, however: the issue that arises with secured collateralized lending on a short-term basis shouldn't exist.

Why not?

Because if collateral is posted on a transaction it should be removed from the firm's list of assets, since it is no longer available to that firm until the loan is paid back.

As such only excess assets (beyond liabilities) should be eligible for this sort of thing. And if so, why should that be subject to a haircut?

Further, shouldn't all of the creditors junior to those get wiped out - 100% - first?

Yes - but they didn't in the case of GM and Chrysler, did they?

The real problem is the accounting games that are played by these institutions. How can you tell what sort of exposure you've got lending to any of these companies? As I've repeatedly said, I can't buy anything in the financial space as an investment today - not even "big conglomerates" like GE - because it is impossible for me to evaluate their balance sheet and believe what I am reading.

The solution is, as I've said: One dollar of capital for each dollar of unsecured lending outstanding.

That's the right answer.

It removes all the accounting games.

It forces banks to hold capital for unsecured lending - dollar for dollar - irrespective of what form the so-called "lending" takes.

It stops the BS games with derivatives.

It removes systemic risk - all of it.

And it protects depositors and taxpayers - all of them, all the time, absolutely and without exception.

Quit playing with the Vampire Squid Sheila.

The correct response to the appearance of one or more Vampire Squid is not to appease, but rather to lock and load a magazine full of silver bullets, then provide them with lots of ventilation.

There is no solution to these problems that involves tinkering or appeasement. There is only sound banking or what we have now: kleptocracy.

Sound banking must return to The United States Ms. Bair.

Either you stand for sound banking or you stand with the kleptocrats.

There is no middle ground.