of negligent, unethical and outright criminal behaviour, ranging from high crimes to misdemeanours

From Willem Buiter:

Moral hazard - lite and strong

March 26, 2009 10:44pm

I have always been a believer in the screw-up theory of history (and particularly of disasters) rather than of the conspiracy theory of history (disasters). The financial crisis that has engulfed the world certainly offers massive evidence for the importance of screw-ups - errors, mistakes, misunderstandings, singular stupidity verging on idiocy, misjudgements and missed opportunities. I am, however, as more detailed evidence accumulates about the genesis of the financial collapse, becoming more and more impressed with the importance of misfeasance and malfeasance - of negligent, unethical and outright criminal behaviour, ranging from high crimes to misdemeanours.

Three representative examples:

(1) UBS agrees to pay $780m (£548m) in fines and to turn over a yet-to-be-determined number of US customer names to the US government as part of a settlement in which the Swiss bank admitted it helped thousands of clients evade taxes. I don’t understand why a bank that systematically and over many years promotes, aids and abets tax evasion, tax avoidance and tax fraud should be allowed to continue to exist. Why aren’t all those involved stamping license plates? Surely, these are criminal as well as civil offences?

(2) Bernie Madoff runs a $50 bn Ponzi scheme over many decades, right under the noses of the regulators in one of the two financial co-centres of the universe. It is possible Bernie Madoff was the only crook involved. Possible, but unlikely.

(3) Why is Barclays sufficiently desperate to avoid even partial UK government ownership, that it is willing to accept £7 billion of capital from the Middle East at a price well in excess of what was available from the UK Treasury? Is this not a clear breach of the fiduciary duty of the management and the board? Why is Barclays now even actively considering selling one one of its crown jewels, iShares, rather than accepting a public sector capital injection when this was on offer? Could it be related to the fact that Barclays runs one of the world’s largest ‘tax efficiency’ units, which it does not wish to be subject to closer scrutiny by a shareholder who is supposed to speak for the British tax payer?

On March 17, 2009, Barclays Bank obtained a court order banning the Guardian from publishing documents which showed how the bank set up companies to avoid hundreds of millions of pounds in tax. The gagging order was granted by Mr Justice Ouseley after Barclays complained about seven documents on the Guardian’s website which had been leaked to the Liberal Democrats’ deputy leader, Vince Cable.

I am sure there is some legal peg that Mr Justice Mousey can hang this gagging order on, but to me this is an extraordinary interference with the freedom of the press and the public’s right to know something that is clearly of significant public interest. I tend to forget that justice and the law are two quite unrelated concepts.

The internal Barclays memos showed executives from SCM, Barclays’s structured capital markets division, seeking approval for a 2007 plan to sink more than $16bn into US loans. Tax benefits were to be generated by an elaborate circuit of Cayman islands companies, US partnerships and Luxembourg subsidiaries.

These documents were leaked to Dr. Cable by a former employee of the bank, who also wrote a long account of how the bank works. It included the following telling paragraphs: “The last year has seen the global taxpayer having to rescue the global financial system. The taxpayer has already had a gun put to their head and been told to pay up or watch the financial system and life as we know it disappear into a black hole.

“It is a commonly held view that no agency in the US or the UK has the resources or the commitment to challenge SCM. SCM has huge amounts of resources, the best minds rewarded by millions of pounds. Compare this with HMRC [Her Majesty's Revenue & Customs] recently advertising for a tax and accounting expert with the pay at £45,000.”

“Through the use of lawyers and client confidentiality SCM regularly circumvents these rules, just one example of why HMRC will never, in its current state, be up to the job of combating this business.” ...

Financial nonfeasance, misfeasance and malfeasance thrive on opaqueness, complexity and lack of transparency

Another reason why banks (although quite willing to take the King’s shilling in the form of guarantees for assorted assets and liabilities; indeed Barclays is considering joining the UK government’s asset protection programme) may be reluctant to accept the state as a major shareholder is the more intense scrutiny of what the bank has on its balance sheet that this is likely to imply.

It is clear that the vast majority of the large border-crossing banks are continuing to exploit every accounting trick in the book to avoid recognising the marked-to-market losses on their dodgy assets. With most banks cursed with paper-thin equity cushions in relation to their assets, a more intense, let alone a quasi-forensic scrutiny of the balance sheet by a nosy expert paid for and acting on behalf of the government shareholder could easily precipitate a move from partial to full state ownership and thence into insolvency and an orderly restructuring or liquidation.

Too many bank insiders have exploited their monopoly of information and the control it bestows on them, to enrich themselves by robbing their shareholders blind. There has been a spectacular failure of corporate governance. Boards have foresaken their fiduciary duties. Surely, even the liability insurance taken out by board members ought not to shelter those who are guilty of, at best, such willfull negligence and dereliction of duty? Where are the class actions suits by disgruntled shareholders? Where are the board members in handcuffs?

Now that there is no meat left on the shareholder drumstick, the rogue managers and employees are going after a piece of the really juicy bird - the ever-patient tax payer. I hope they choke on it.

Moral hazard refers, in insurance parlance, to a situation where the likelihood of an insured event occurring can be influenced by the insured party, without the insurer being able to observe accurately the actions of the insured party that influence the outcome. So anything that creates incentives for excessive risk taking, like limited liability and investments in toxic assets that benefit from leverage in the form of non-recourse lending by the Fed, would create moral hazard in the insurance sense of the word - moral hazard lite.

What we have seen and continue to see in much of the border-crossing financial sector, however, is a rather more literal form of moral hazard: a lack of morals in some key participants in the financial system dance causing major hazards to the financial well-being of millions of powerless victims. Corrupted morality putting at risk genuine, wealth-creating financial intermediation, innovation and risk-taking. This is moral hazard strong.

Finance is one of the great social inventions of humanity; the division of labour and specialisation in effort and activity that are at the root of all prosperity depend on it. It makes me sick to see an entire branch of human endeavour brought into disrepute by the actions of a relatively small (but still far too large) number of masters of the universe. There will have to be a reckoning, and not just in the court of history."

Me:
"I am, however, as more detailed evidence accumulates about the genesis of the financial collapse, becoming more and more impressed with the importance of misfeasance and malfeasance - of negligent, unethical and outright criminal behaviour, ranging from high crimes to misdemeanours."

I agree. To me, Fraud, Negligence, Collusion, and Fiduciary Mismanagement, form the second most important cause of this crisis. Just think subprime. Yesterday, Secretary Geithner said the following:

" We saw huge gains in increased access to credit for large parts of the American economy, but those gains were overshadowed by pervasive failures in consumer protection, leaving many Americans with obligations they did not understand and could not sustain. The huge apparent returns to financial activity attracted fraud on a dramatic scale."

"The rising market hid Ponzi schemes and other flagrant abuses that should have been detected and eliminated."

"Consumer and investor protection is a critical component of the President's regulatory reform plan. We are developing a strong, comprehensive plan for consumer and investor regulation to simplify financial decisions for households and to protect people from unfair and deceptive practices."

These sound like a good beginning.

To me the most important cause of this crisis falls into this category as well. It is Looting:

http://www.nytimes.com/2009/03/11/business/economy/11leonhardt.html?ref=business

And “Looting” provides a really useful framework. The paper’s message is that the promise of government bailouts isn’t merely one aspect of the problem. It is the core problem.

Promised bailouts mean that anyone lending money to Wall Street — ranging from small-time savers like you and me to the Chinese government — doesn’t have to worry about losing that money. The United States Treasury (which, in the end, is also you and me) will cover the losses. In fact, it has to cover the losses, to prevent a cascade of worldwide losses and panic that would make today’s crisis look tame.

But the knowledge among lenders that their money will ultimately be returned, no matter what, clearly brings a terrible downside. It keeps the lenders from asking tough questions about how their money is being used. Looters — savings and loans and Texas developers in the 1980s; the American International Group, Citigroup, Fannie Mae and the rest in this decade — can then act as if their future losses are indeed somebody else’s problem."

And:

http://www.bankofengland.co.uk/publications/speeches/2009/speech374.pdf

"No. There was a much simpler explanation according to one of those present. There was absolutely no incentive for individuals or teams to run severe stress tests and
show these to management. First, because if there were such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that
event the authorities would have to step-in anyway to save a bank and others suffering a similar plight.
All of the other assembled bankers began subjecting their shoes to intense scrutiny. The unspoken words had been spoken. The officials in the room were aghast. Did
banks not understand that the official sector would not underwrite banks mismanaging their risks? Yet history now tells us that the unnamed banker was spot-on. His was a brilliant articulation of the internal and external incentive problem within banks. When the big
one came, his bonus went and the government duly rode to the rescue. The timeconsistency problem, and its associated negative consequences for risk management, was real ahead of crisis. Events since will have done nothing to lessen this problem, as successively larger waves of institutions have been supported by the authorities"

Finally, I hope that everyone noted this:

Treasury Proposes Legislation for Resolution Authority

"Treasury Secretary Timothy Geithner on Monday called for new legislation granting additional tools to address systemically significant financial institutions that fall outside of the existing resolution regime under the FDIC. A draft bill will be sent to Congress this week and several key features are highlighted below.

The legislative proposal would fill a significant void in the current financial services regulatory structure and is one piece of a comprehensive regulatory reform strategy that will mitigate systemic risk, enhance consumer and investor protection, while eliminating gaps in the regulatory structure. "

The power and ability and funds to seize large banks or financial concerns could soon be law. I said "could". Posted by: Don the libertarian Democrat"

JJ, Thanks for the comment. I saw that story :

http://www.spiegel.de/international/business/0,1518,druck-614539,00.html

I didn't know about Flowers. On Mr. Buiter's topic:

http://www.spiegel.de/international/business/0,1518,598499,00.html

"Yet again, dozens of investigators mounted simultaneous raids on numerous locations. But this time the investigations aren't into corruption. Investigators are looking into charges of speculation, market manipulation, breach of trust and deception, insider trading and incompetence among greedy finance managers at the Munich-based Hypo Real Estate, one of the German banks that has been the most deeply entangled in the finance crisis. The sums of money involved in this scandal far exceed those in the Siemens affair."

This has been going on, but not much noticed in the US:

"Subprime Swindlers Reconnect to Homeowners in Foreclosure Scams "

http://www.bloomberg.com/apps/news?pid=20601109&sid=aUL_Qh8cOzv8&refer=home

It also goes to Mr. Buiter's point. Posted by: Don the libertarian Democrat

We have existing laws that make that conduct illegal. Investigate the activity, charge the wrongdoers, prosecute them, get your convictions

TO BE NOTED: From The Market Ticker:

Posted by Karl Denninger in Editorial at 18:10

"Had Enough FRAUD America?

Let's expand a bit on a couple of Tickers from the last couple days; "AIG: More Samurai Swords Please" and "What SCHEME Is AIG", specifically.

This is what I said in May of 2008:

The solution to this entire mess is the same that it was (but not taken) back when the Bank of England was essentially looted, and when our banking system was looted in the early 1900s - find the market participants who have engaged in fraud via various forms, whether they be mortgage bankers handing out liar loans and misrepresenting them as "AAA Prime" paper or whether they be people in the marketplace who initiated the plethora of (false) rumors over the last many years about various companies, irrespective of whether the intent was to drive prices up or down, and prosecute them.

We have existing laws that make that conduct illegal. Investigate the activity, charge the wrongdoers, prosecute them, get your convictions and toss the lot of 'em in prison with a bunch of 7' tall rapists in the exercise yard, no guards, and a $100 video camera in the guard shack.

Then post the "results" on YouTube as a warning to the world - try that again in this country and this is the consequence you will receive.

That will be the last time it happens.

But until we take that sort of step and hold people to account, this sort of "looting operation" will continue, and we the people will continue to get screwed.

And specifically with regards to CDS, in the same article:

The entire claim and chain of events rests on the fact that market participants, up to and including Ben Bernanke at The Federal Reserve, were and are aware that these CDS contracts are in fact fraudulent in that there is no way performance can take place, yet everyone up and down the line is allowing these "assets" to be counted as "money good" on the books of banks and other financial institutions!

THIS is the key item in the debate folks.

The rest of this noise making is mental masturbation and intentional misdirection intended to keep you from asking the tough questions and demanding that existing law be enforced.

Congress and prosecutors across the board, both State and Federal, need to start bringing indictments, starting with the fraudulent accounting.

You can't value something at "par" when you are well-aware that the underlying credit quality has gone straight in the toilet and that there is not a snowball's chance in hell that the "insurance" you bought to protect yourself has no chance of being "money good." As soon as you become aware of the impairment under the law you are required to reserve against it!

While any one company could claim that its insurance is "money good" that's not the point.

Everyone in the marketplace today now has proof that these swaps in aggregate are worthless, with proof of this found in the fact that The Fed claimed under oath exactly that as justification for the Bear Stearns bailout!

So you have a situation here where the entire banking regulatory system has declared these contracts worthless in the aggregate and yet company after company continues to claim in their financial statements and results that these contracts are "money good"!

This is out and out fraud and must be stopped.

We the people are being systematically looted by these people and our prosecutorial apparatus sits on its butt and sips Starbucks Lattes instead of doing their job!

It is time for we the people to say ENOUGH.

Call Congress and demand that they stop this charade here and now. Every firm that has claimed their paper is "protected" by these wraps must be forced to identify the counterparty that currently holds the risk and those parties must be forced to prove that they can pay any and all claims against those policies.

If they can't (and the default case must be "they can't", since that was in fact Bernanke's and Geithner's position under oath!) then those wraps must be considered "doubtful" and reserves must be taken against the underlying credit quality.

Do this and we immediately identify who is broke and who is not, the market finds its proper price for these assets, and as a consequence the market will clear.

Everyone wants to make this whole mess complicated.

Its not.

It is in fact very simple.

The only "complication" is that there are thousands of people who are ripping the American People off wholesale, waving their arms around in the hope that you'll let them get away with it.

Don't fall for it.

Nearly a year ago folks.

There it was, laid out for everyone both in government and here.

In plain, black (digital) ink.

Now I want answers. You should want answers. And if you think that the answer is to flood AIG's derivatives desk with threatening calls, it is not.

It is to flood CONGRESS with calls demanding that this crap STOP.

Right now.

Specifically, we must insist that:

Every person involved with an identifiable criminal offense embedded in here (and I bet we can find plenty) be investigated, indicted, prosecuted AND if found guilty IMPRISONED.

Every firm that was unjustly enriched be told that they either return the funds or face a suit for that unjust enrichment and, in the case of a bank (or bank holding company) immediate confiscation by the FDIC and decertification of their federal banking charter.

The Federal Reserve be told that either IT cooperates in this matter and both disgorges its garbage on the balance sheet back to its originators, ceases all non-lending actions and opens its kimono here and forward or its charter will be revoked by Congress and The Fed's function will be subsumed by Treasury.

What I laid forth as my postulate has now been proved correct in the fullness of time.

Gee, Eliot Spitzer is back and says the same thing:

The appearance that this was all an inside job is overwhelming. AIG was nothing more than a conduit for huge capital flows to the same old suspects, with no reason or explanation. (No really? - me)

So here are several questions that should be answered, in public, under oath, to clear the air:

What was the precise conversation among Bernanke, Geithner, Paulson, and Blankfein that preceded the initial $80 billion grant?

Was it already known who the counterparties were and what the exposure was for each of the counterparties?

What did Goldman, and all the other counterparties, know about AIG's financial condition at the time they executed the swaps or other contracts? Had they done adequate due diligence to see whether they were buying real protection? And why shouldn't they bear a percentage of the risk of failure of their own counterparty?

What is the deeper relationship between Goldman and AIG? Didn't they almost merge a few years ago but did not because Goldman couldn't get its arms around the black box that is AIG? If that is true, why should Goldman get bailed out? After all, they should have known as well as anybody that a big part of AIG's business model was not to pay on insurance it had issued.

Why weren't the counterparties immediately and fully disclosed?

No kidding.

These bonuses aren't "news" to Geithner (who was at the NY Fed, remember, when this entire AIG mess started) or to anyone else:

WASHINGTON (AP) — Cue the outrage. For months, the Obama administration and members of Congress have known that insurance giant AIG was getting ready to pay huge bonuses while living off government bailouts. It wasn't until the money was flowing and news was trickling out to the public that official Washington rose up in anger and vowed to yank the money back.

Cut the crap Mr. President, Mr. Geithner and Congress. You are lying and this entire "bonus" game is a smokescreen to try to divert attention from the real theft - nearly $100 billion dollars of taxpayer money that has gone to Goldman and other banks, including foreign banks, to pay off Credit Default Swaps written by AIG that were worthless as the company had no capital behind them. This in turn means that the accounting of these firms has in fact fraudulently overstated earnings - perhaps for years - and still is!

The Fed, OTS and OCC have and had jurisdiction over American banks that bought these products, and were clearly derelict in their duty to prevent these regulated entities from purchasing these CDS from a firm that was unable to prove capital adequacy to cover its bets.

The European regulators have similar jurisdiction over those institutions and similarly have been derelict in their duty.

What the hell are we doing bailing out FOREIGN REGULATORS AND GOVERNMENTS who were derelict in their duty with regards to the institutions under their control?

Finally, TurboTimmy, it is not acceptable for you to simply "deduct" the amount of the bonuses from AIG's "aid package". Uh uh. This entire bonus question is a smokescreen for the massive conflicts of interest where an investment bank buys billions of dollars of "credit protection" from a company, then the CEO goes to work for Treasury and makes sure those contracts are good by siphoning off money from the taxpayer to cover them when the seller turns out to be insolvent.

It is time to hold people to account, here and now, for what certainly looks to me like an intentional and outrageous looting operation conducted against the American Taxpayer for the benefit of covering up the outrageous malfeasance and misfeasance by both American and foreign governments and regulatory bodies.

I refuse to believe this has all been some big accident.

I firmly believe it has been an intentional series of actions and it is time for America and stand up and say NOT THIS TIME YOU WON'T.

How long will you sit for this America before you either obtain proper redress for these actions or go purchase these two items

and prepare to use them?

No more excuses Mr. President, Mr. Bernanke, Mr. Geithner and Mr. Summers.

It is time to cut the crap, because if we don't do the right thing here and now foreigners will do it for us:

Foreigners sold a net $60.9 billion in long-dated U.S. securities in January, after buying $24.3 billion in December. Including changes in banks' dollar holdings, short-term securities and nonmarket transactions, net foreign capital outflows totaled a record $148.9 billion in January, compared with $86.2 billion in inflows in the previous month.

Michael Woolfolk, senior currency strategist at the Bank of New York Mellon Corp., said the big outflows are a concern and could represent a trend away from the flight to quality that has boosted purchases in U.S. assets in recent months.

"This was a truly awful report, throwing into question the funding of the U.S. current-account deficit," he said in a statement.

Mr. Woolfolk misses the essence of this signal from foreigners. That signal is, quite simply, one of disgust with what is happening over here in the realm of outright theft and fraud, and is best summarized thus:

Stop the looting and start the prosecuting right now or we will take our ball and bat and depart, leaving you with an un-fundable government budget that will be forced to contract by more than 75% within days, along with a smoking hole where your capital markets and economy once were.

Need I remind Ticker readers that I predicted exactly this potential course of action by our government and the potential outcome back when these "bailouts" and "handouts" first began over a year ago?

Time's up folks."

And to Black's point, the real issue is fraud. Why is no one at Treasury willing to use the F word?

From Naked Capitalism:

"Wiliam Black Savages Treasury's Conduct on AIG

William Black, now a professor of economics and law at the University of Missouri (Kansas City) was a senior bank regulator during the savings loan crisis (his claim to fame was his pursuit of Charles Keating of Lincoln Savings, in which he was removed from the initiative and more management friendly investigators were assigned, and events later proved Black correct). Black has seen a lot of bad behavior at close range.

He is not at all impressed with how the Treasury has handled AIG. Via e-mail:

This is the consequence of six things on the Treasury end of things:

(1) the failure to use Chapter 11 bankruptcy/pass-through receivership to deal with deeply insolvent financial institutions

(2) the failure to expose, and to the extent possible, remedy through restatements the massive accounting fraud that AIG was/is engaged in that triggers the bonuses

(3) the failure to bring criminal charges against the control frauds

(4) the failure of Treasury as negotiators -- they had all the leverage when they bailed out AIG and could have conditioned the aid on at least the VP tier and above giving up their bonuses

(5) the weakness of Treasury's current lawyers who, if press reports are accurate, couldn't think of any way for the U.S. government to take effective action against what it reportedly views as a scandal,

(6) (and I haven't seen this discussed) why was Treasury blind-sided by this? It confirms that they did not conduct even the most obvious due diligence on AIG's assets and contingent liabilities

Given what we know about the lack of due diligence by AIG on underlying assets, particularly nonprime paper, this confirms exactly how dangerous Treasury is to the the nation. It is also consistent with the concern that it faces such a critical staff shortage, particulary in the relevant skills (which the folks it hires from Wall Street lack). I doubt that they have five senior officials that have ever reviewed loan files for a living or conducted meaningful due diligence (which requires cracking the loan files).

On the AIG end we see the perverse incentives of keeping the senior level folks on that caused the crisis. They have every incentive not to be honest about the true extent of the losses. They know the place is dead (hopelessly insolvent) and have strong incentives to loot the corpse, e.g., through bonuses. They do not alert Treasury sufficiently in advance even to bonuses that they should know will be perceived as scandalous (though another problem with keeping these failed elites in power is that they are clueless about the reaction of normal people). They do not work to limit bonuses, e.g., by being honest about past accounting fraud. I believe when the facts come out that we will find that they did not make criminal referrals on the prior senior officials that led AIG's accounting fraud (which would have given AIG and the Treasury a far stronger legal basis for refusing to pay bonuses that were "earned" via accounting control fraud.

I don't oppose bonuses that are actually earned through long term performance. That is not the case with the AIG bonuses. We can offer well designed performance pay if we use bankruptcy or receiverships.

We see tonight another lame defense that the Treasury is trying really hard to claw back the bonuses. Please. Even if Treasury consulted outside counsel, I would strongly suspect it would be a large firm with a big corporate clientele.

Guess what? At those firms, HR is a backwater. The best HR lawyers are typically at boutiques or solo operators because they sue large corporations (that would represent a rather insurmountable conflict of interest for any firm seeking to represent those nice big meal ticket clients). I'm not current, but a decade ago, there was a woman lawyer (I cannot recall her name to save my life) who was an absolute killer, When a wronged executive or employee walked in with her at their side, BIg Co. knew they had a very serious problem on their hands. I am told by people who used her she was also a phenomenal negotiator on deals. It's certain that Treasury did not attempt to secure advice from that sort of attorney.

And to Black's point, the real issue is fraud. Why is no one at Treasury willing to use the F word? Who would it embarrass? There is not reason for NOT pursuing that angle, save that AIG must have the 5x7 glossies on some pretty influential people, or that pursuing fraud at AIG would, via a daisy chain of connections, reveal that fraud was pervasive, and the Treasury is desperate to preserve the false image that the system has integrity.

Posted by Yves Smith at 11:24 AM"

Me:

Don said...

"And to Black's point, the real issue is fraud. Why is no one at Treasury willing to use the F word? Who would it embarrass? There is not reason for NOT pursuing that angle, save that AIG must have the 5x7 glossies on some pretty influential people, or that pursuing fraud at AIG would, via a daisy chain of connections, reveal that fraud was pervasive, and the Treasury is desperate to preserve the false image that the system has integrity. "

I agree. A terrific post. People should read Pizzo's "Inside Job" about the S and L Crisis. It will at least teach them what to look for.

Don the libertarian Democrat

March 16, 2009 11:35 AM

“Rules don’t work if people have no fear of them,”

From the NY Times:

Spurred by rising public anger, federal and state investigators are preparing for a surge of prosecutions of financial fraud, The New York Times’s David Segal reports.

Across the country, attorneys general have already begun indicting dozens of loan processors, mortgage brokers and bank officers. Last week alone, there were guilty pleas in Minnesota, Delaware, North Carolina and Connecticut and sentences in Florida and Vermont — all stemming from home loan scams.

With the Obama administration focused on stabilizing the banks and restoring confidence in the stock market, it has said little about civil or criminal charges at the federal level. But its proposed budget contains hints that it will add to this weight of litigation, including money for more F.B.I. agents to investigate mortgage fraud and white-collar crime, and a 13 percent raise for the Securities and Exchange Commission.

Officials at the Justice Department have said little in public about their plans. But people who have met with Attorney General Eric H. Holder Jr. say he is considering a range of strategies.

“It’s clear that he and other top-level members of the Obama administration want to seize the opportunity to send a message of zero tolerance for mortgage fraud,” said Connecticut’s attorney general, Richard Blumenthal, who attended a meeting with Mr. Holder and a number of state attorneys general last week in Washington. “The only question is when and how they will do it.”

One person who had discussed the matter with Mr. Holder, but declined to be identified because he was not authorized to speak for the Justice Department, said that the attorney general was deciding whether to form a task force to centralize the effort or allow state attorneys general to develop cases on their own.

A Justice Department spokesman, Matthew A. Miller would not comment, other than to write by e-mail, “It will be a top priority of the Justice Department to hold accountable executives who have engaged in fraudulent activities.”

At the low end of the mortgage transaction ladder, state prosecutors have had a relatively easy time prevailing, but recent history suggests that the government’s odds of winning drop when they go after Wall Street executives. Some high-profile convictions have been won in the last decade, but several of the Enron prosecutions and some cases brought by Eliot Spitzer when he was New York’s attorney general fell apart or were overturned on appeal.

As federal authorities decide on a course of action, members of Congress are becoming impatient. Representative Barney Frank, chairman of the House Financial Services Committee, announced plans last week for a hearing on March 20, inviting Mr. Holder, bank regulators and leaders of the S.E.C. to answer questions about their enforcement plans.

“Rules don’t work if people have no fear of them,” Mr. Frank, Democrat of Massachusetts, said at a news conference last week.

State and local prosecutors, it seems, do not need the nudge. Last week, the district attorney’s office in Brooklyn announced the creation of a real estate fraud unit, with 12 employees and a mandate to “address the recent flood of mortgage fraud cases plaguing New Yorkers.” In late February, Maryland unveiled a mortgage fraud task force, bringing together 17 agencies to streamline investigations.

With all the state activity and portents of a new resolve at the federal level, lawyers who defend white-collar clients sense growing momentum to perp walk and prosecute executives involved in the mortgage meltdown.

“It’s going to be open season,” says Daniel M. Petrocelli, a defense lawyer whose clients include Jeffrey K. Skilling, the former chief executive of Enron. “You’ll see a lot of indictments down the road, and you’ll see a lot of prosecutions that rely on vague theories of ‘deprivation of honest services.’ ”

Many financial executives have hired lawyers in the last few months, either through in-house counsels or, more discreetly, on their own, several lawyers who defend white-collar clients said. While assorted Wall Street executives have been prosecuted over the years, any concerted legal attack on the financial sector would have little precedent.

After the Depression, Congress formed what became known as the Pecora Commission, which grilled leading financiers. But the point was mostly to embarrass them, and the upshot was to set the stage for stricter regulations. The most indelible image of the commission’s hearings was a photo of J.P. Morgan with a midget who had been plopped in his lap by an opportunistic publicist.

The question behind any cases brought against Wall Street will boil down to this: Was the worst economic crisis in decades caused by law-breaking or some terrible, but noncriminal, combination of greed, naiveté and blunders? The challenge for the Obama administration will be to prove that it was the former, said Michael F. Buchanan, a partner at Jenner & Block and a former United States attorney in New Jersey.

“We punish people for intentional misconduct, we don’t punish them for stupidity or innocent mistakes,” Mr. Buchanan said. “If you’re a prosecutor, you want evidence that shows real dishonesty. You want something that shows that these people were doing something wrong, and they knew it.”

That nearly the entire banking industry acted in the same, possibly reckless, way could actually help any executive who winds up in court, lawyers said.

The herdlike nature of the behavior suggested that bankers were competing for business using assumptions that were widely shared, rather than trying to get away with a crime. And it would be hard to prove that anyone broke the rules, these lawyers said, given that regulations in the riskiest parts of the mortgage industry were so lax.

One defense lawyer said he expected to argue that either his clients did not understand the financial instruments they were marketing, or were not adequately warned of the dangers by underlings.

“We’ll all sing the stupidity song,” said the lawyer, who said he feared that speaking publicly by name would deter potential clients. “We’ll all sing the ‘These guys never told me’ song.”

But for government lawyers, the environment for corporate fraud cases could scarcely be more inviting. It is not just that the public’s zeal for Wall Street pelts is high. The resources are there, too, because some of the money once used to fight terrorism is being shifted to fighting financial fraud.

And in recent years the use of wire fraud statutes has expanded, allowing prosecutors to turn virtually anything said or sent by e-mail in private into a federal crime, if it contradicts what investors were told in public disclosures.

Wire fraud charges were among those brought against two former Bear Stearns managers, arrested in June, who are accused of praising their hedge fund to clients as they worried about its future to others in the company. The cases have yet to go to trial.

Federal sentencing guidelines also link the length of a prison sentence to the size of the financial loss to the public. Given that so many billions have vaporized in recent months, convictions could easily lead to life sentences, defense lawyers said, and the mere threat of such sentences gives prosecutors enormous leverage in settlement talks.

“There are executives now getting sentences longer than murderers and rapists,” said Mr. Petrocelli, the lawyer, referring to white-collar prosecutions in recent years, including that of Mr. Skilling of Enron, who is now serving a 24-year sentence for securities fraud and other crimes.

Why has there not been a batch of subpoenas at the federal level already? The Department of Justice is settling in and is missing important staff members, says Reid H. Weingarten, a defense lawyer and former trial lawyer for the Justice Department. In addition, former members of the Justice Department say that prosecutors and regulators are reluctant to act while the markets are in such disarray for fear of further unnerving investors and the public.

Lawyers for white-collar clients say they expect to be busy, but not all of them predict that means they will be earning huge fees. In the past, the legal bills of Wall Street higher-ups were paid by insurers that indemnified them. But that is not necessarily the case with banks that have gone bankrupt or disappeared.

“I know bankers are not now evoking much sympathy from the public at large,” Mr. Weingarten said. “But these days many Wall Street types are struggling mightily with mortgage payments, tuition bills and health insurance. It’s a very different world out there now.”

Me:

Add this to Leonhardt’s piece about looting, and you have the two main causes of this crisis. What’s interesting to me is that people seem to be missing the irony that so-called free market reforms were supported by a government guarantee. That’s the point about looting. It was not free market, and the actors didn’t think that it was. They assumed government backing.

Then this:

“One defense lawyer said he expected to argue that either his clients did not understand the financial instruments they were marketing, or were not adequately warned of the dangers by underlings.

“We’ll all sing the stupidity song,” said the lawyer, who said he feared that speaking publicly by name would deter potential clients. “We’ll all sing the ‘These guys never told me’ song.”

How many stories have we read about how complex these investments were? They drank their own Kool-Aid? They didn’t understand? Please.

It was Fraud, Negligence, Fiduciary Mismanagement, and Collusion. Now that we have these two stories, maybe we can get rid of all the systemic excuses meant to cover this up.

Without Fraud and Looting, this crisis wouldn’t have occurred.

— Posted by Don the libertarian Democrat

Spurred by rising public anger, federal and state investigators are preparing for a surge of prosecutions of financial fraud.

TO BE NOTED: From the NY TIMES: Cause Number 2:

"Financial Fraud Is Focus of Attack by Prosecutors

By DAVID SEGAL

Spurred by rising public anger, federal and state investigators are preparing for a surge of prosecutions of financial fraud.

Across the country, attorneys general have already begun indicting dozens of loan processors, mortgage brokers and bank officers. Last week alone, there were guilty pleas in Minnesota, Delaware, North Carolina and Connecticut and sentences in Florida and Vermont — all stemming from home loan scams.

With the Obama administration focused on stabilizing the banks and restoring confidence in the stock market, it has said little about federal civil or criminal charges. But its proposed budget contains hints that it will add to this weight of litigation, including money for more F.B.I. agents to investigate mortgage fraud and white-collar crime, and a 13 percent raise for the Securities and Exchange Commission.

Officials at the Justice Department have not said much in public about their plans. But people who have met with Attorney General Eric H. Holder Jr. say he is weighing a range of strategies.

“It’s clear that he and other top-level members of the Obama administration want to seize the opportunity to send a message of zero tolerance for mortgage fraud,” said Connecticut’s attorney general, Richard Blumenthal, who attended a meeting with Mr. Holder and other state attorneys general last week in Washington. “The only question is when and how they will do it.”

One person who had discussed the matter with Mr. Holder, but declined to be identified because he was not authorized to speak for the Justice Department, said that the attorney general was deciding whether to form a task force to centralize the effort or allow state attorneys general to develop cases on their own.

A Justice Department spokesman, Matthew A. Miller, would not comment, other than to write by e-mail, “It will be a top priority of the Justice Department to hold accountable executives who have engaged in fraudulent activities.”

At the low end of the mortgage transaction ladder, state prosecutors have had a relatively easy time prevailing, but recent history suggests that the government’s odds of winning drop when they go after Wall Street executives. Some high-profile convictions have been won in the last decade, but several of the Enron-related prosecutions and some cases brought by Eliot Spitzer when he was New York’s attorney general fell apart or were overturned on appeal.

As federal authorities decide on a course of action, Congress is becoming impatient. Representative Barney Frank, chairman of the House Financial Services Committee, announced plans last week for a hearing on March 20, inviting Mr. Holder, bank regulators and leaders of the S.E.C. to answer questions about their enforcement plans.

“Rules don’t work if people have no fear of them,” Mr. Frank, Democrat of Massachusetts, said. State and local prosecutors, it seems, do not need the nudge. Last week, the district attorney’s office in Brooklyn announced the creation of a real estate fraud unit, with 12 employees and a mandate to “address the recent flood of mortgage fraud cases plaguing New Yorkers.” In late February, Maryland unveiled a mortgage fraud task force, bringing together 17 agencies to streamline investigations.

With all the state activity and portents of a new resolve at the federal level, lawyers who defend white-collar clients sense growing momentum to perp walk and prosecute executives involved in the mortgage crisis.

“It’s going to be open season,” says Daniel M. Petrocelli, a lawyer whose clients include Jeffrey K. Skilling, the former chief executive of Enron. “You’ll see a lot of indictments down the road, and you’ll see a lot of prosecutions that rely on vague theories of ‘deprivation of honest services.’ “

Many financial executives have hired lawyers in the last few months, either through internal counsels or, more discreetly, on their own, several lawyers who defend white-collar clients said.

While assorted Wall Street executives have been prosecuted over the years, any concerted legal attack on the financial sector would have little precedent. After the Depression, Congress formed what became known as the Pecora Commission, which grilled top financiers. But the point was mostly to embarrass them, and the upshot was to set the stage for stricter regulations. The most indelible image of the commission’s hearings was a photo of J. P. Morgan Jr. with a midget who had been plopped in his lap by an opportunistic publicist.

The question behind any cases brought against Wall Street will boil down to this: Was the worst economic crisis in decades caused by law-breaking or some terrible, but noncriminal, mix of greed, naïveté and blunders? The challenge for the Obama administration will be to prove that it was the former, said Michael F. Buchanan, a partner at Jenner & Block and a former United States attorney in New Jersey.

“We punish people for intentional misconduct, we don’t punish them for stupidity or innocent mistakes,” he said. “If you’re a prosecutor, you want evidence that shows real dishonesty. You want something that shows that these people were doing something wrong, and they knew it.”

That nearly all of the banking industry acted the same, possibly reckless, way could actually help any executive who lands in court, lawyers said. The herdlike behavior suggested that bankers were competing for business using widely shared assumptions, rather than trying to get away with a crime. It would be hard to prove that anyone broke the rules, these lawyers said, since regulations in the riskiest parts of the mortgage industry were so lax.

One defense lawyer said he expected to argue that either his clients did not understand the financial instruments they were marketing, or were not warned of the dangers by underlings.

“We’ll all sing the stupidity song,” said the lawyer, who said he feared that speaking publicly by name would deter potential clients. “We’ll all sing the ‘These guys never told me’ song.“

But for government lawyers, the environment for corporate fraud cases could scarcely be more inviting. It is not just that the public’s zeal for Wall Street pelts is high. The resources are there, too, because some of the money once used to fight terrorism is being shifted to fighting financial fraud. And in recent years the use of wire fraud statutes has expanded, allowing prosecutors to turn virtually anything said or sent by e-mail in private into a federal crime, if it contradicts what investors were told in public disclosures.

Wire fraud charges were among those against two former Bear Stearns managers who were arrested in June, accused of praising their hedge fund to clients as they worried about it to colleagues. Federal sentencing guidelines also link the length of a prison term to the size of the financial loss to the public. Given that so many billions have vaporized recently, convictions could easily lead to life sentences, defense lawyers said, and the mere threat of such sentences gives prosecutors enormous leverage in settlement talks.

“There are executives now getting sentences longer than murderers and rapists,” said Mr. Petrocelli, the lawyer, referring to white-collar prosecutions in recent years, including that of Mr. Skilling of Enron, who is now serving a 24-year sentence for securities fraud and other crimes.

Why has there not been a batch of subpoenas at the federal level already? The Department of Justice is missing important staff members, says Reid H. Weingarten, a defense lawyer and former trial lawyer for the Justice Department. Former members of the Justice Department say that prosecutors and regulators are reluctant to act while the markets are in such disarray for fear of further unnerving investors and the public.

Lawyers for white-collar clients say they expect to be busy, but not all of them predict that means they will be earning huge fees. In the past, the legal bills of Wall Street higher-ups were paid by insurers that indemnified them. But that is not necessarily the case with banks that have gone bankrupt or disappeared.

“I know bankers are not now evoking much sympathy from the public at large,” Mr. Weingarten said. “But these days many Wall Street types are struggling mightily with mortgage payments, tuition bills and health insurance. It’s a very different world out there now.”

in most cases, we won't be able to hold the board and officers criminally liable

From Justin Fox:

"Making the financial miscreants pay (it's harder than you might think)

Posted by Justin Fox | Comments (6) | Permalink | Trackbacks (0) | Email This

In a comment to my rambling attempt to explain the mess that is AIG, curmudgeon57 asked:

At what point can we hold the board and officers criminally liable for running a scam? (if you sell something you can't deliver, you either have to return the money or go to jail. It's that simple, right?)

My friend Roger Parloff took a valiant stab at answering this—for Wall Street in general, not just AIG—in a Fortune cover story in January. His answer was that, in most cases, we won't be able to hold the board and officers criminally liable.

[B]ad business models - even business models that in retrospect look like prescriptions for disaster - are not crimes as long as they are fully disclosed to investors. And the fact that lenders were hawking outlandishly risky mortgages to people who were terrible credit risks was, in fact, no secret in America: It was bipartisan national policy. The fact that exotic mortgages (like "pick a payment option" ARMs and "Alt-A" loans with no documentation of the buyer's assets or income) were then being packaged into complex derivative securities - some rated AAA by Moody's, S &P, and Fitch - was not just well known but also hailed as ingenious by some of the putatively best financial minds in the country.

If CEOs did not foresee the imminent train wreck that, looking back, seems so inevitable, neither did former Federal Reserve chairman and erstwhile "maestro" Alan Greenspan, who has recently, if self-servingly, termed our predicament a "once-in-a-century credit tsunami."

A little further on, Roger writes:

The job of the prosecutors is not to ferret out the root causes of what went wrong with the economy. That's a task for historians. The prosecutors are to look for unambiguous, intentional wrongdoing - and since a lay jury will be the official scorer here, the simpler the wrongdoing, the better. While it might be true, for instance, that investors were misled by the way companies handled mark-to-market accounting of derivatives, a prosecutor who makes that the centerpiece of his case will end up with a swearing contest between opposing accounting experts - a morass in front of a jury.

So my answer to curmudgeon57 is, I dunno. There will be prosecutions of those who ran what seem to be obvious scams, such as Bernie Madoff. There will be many attempts to nail other Wall Streeters for crimes only tangentially related to their role in causing the financial collapse, because prosecutors at least stand a chance of winning those cases. But holding most of the people who got us into this mess criminally liable for doing so just isn't going to happen. And maybe we don't want it to: The former Countrywide president who is now running a company (PennyMac) that buys up delinquent mortgages and renegotiates the terms is providing a valuable service and helping clear the way for better days for all of us. Do we really want him behind bars? At the same time, his smug conviction that he's not in any way to blame for the housing mess is awfully hard to take. These people need to pay, somehow. But how? I've been struggling with this for a while. Here are the options I can think of:

1. Claw back the cash. Millions of Americans made big financial mistakes over the past five years. Only a few got paid millions of dollars (or hundreds of millions) for making them. Ever since Congress passed the Superfund law in 1980, polluting corporations have had to pay to clean up the messes they make. There are no punitive charges assessed. Just the cost of the cleanup. Why not demand the same financial polluters? I've written about this before, and the answer is that it's hard. There will be attempts—by plaintiffs' attorneys and by corporate boards of directors—to confiscate big executive paychecks that preceded implosions. But I don't see a lot of them succeeding except in cases of outright fraud. Congress could change the law to make clawbacks easier, but doing that retroactively seems awfully problematic. So does determining exactly who has to give their money back. For example: Is Hank Greenberg at fault for building AIG into such a monstrosity? Or would everything be okay now if Eliot Spitzer hadn't hounded Greenberg out of office in 2005 and left the company in the hands of lesser men? (I, like John Gapper, lean toward the former explanation, but it's not really up to me.) Morally, a well-targeted clawback is exactly what the financial world needs right now (the cash would come in handy, too). Practically, though, it's just not gonna happen.

2. Embarrass them on Capitol Hill. The 20th century saw two great Congressional inquiries into financial misbehavior—the Pujo hearings of 1912-1913 and the Pecora hearings of 1933-1934. The essential characteristic that both shared, other than their names begin with "P," was that the questioning was done not by blowhard members of Congress but by very smart New York lawyers hired by Congress: Samuel Untermyer in 1912-1913 (Arsene Pujo of Louisiana was the chairman of the subcommittee that held the hearings, but he let Untermyer do the talking) and Ferdinand Pecora in 1933-1934. So far all we've gotten from this crisis are some disappointing hearings where elected officials—most of them with little knowledge and no prosecutorial skills—ask the questions. But both the Pujo and Pecora hearings did come several years after the financial collapses they were meant to investigate (the Panic of 1907 in Pujo's case, in case you were wondering), meaning that we've still got lots of time.

3. Raise taxes on high earners. The financial crisis (and subsequent government bailouts) and the years of plenty on Wall Street that preceded it together constitute a pretty appalling case of socializing risk and privatizing reward. So why not socialize the reward a bit more, by raising taxes on the biggest earners, many of whom are Wall Streeters? That's already the direction the Obama administration is headed in, but there are limits to this approach. For one thing, it's a pretty blunt instrument: There are lots of high earners who aren't engaged in activities that pose major systemic risks (for some reason, LeBron James keeps springing to mind). For another, if you take the whole socializing reward thing too far you risk strangling the economy. Although ... we had a 90%+ top tax rate in the 1940s and 1950s, and the economy didn't act particularly strangled.

4. Let them fail. Another way to remedy the mismatch of socialized risk and privatized reward would of course be to privatize risk. Financial sector risk has a bad habit of not staying in the financial sector, though, which is why we've been doing all these bailouts. I do think we've reached a point where we need to move from bailouts to workouts. But even those will still probably end up costing taxpayers a lot. And in most cases the people most to blame for the mess are already gone from the banks/insurance firms/etc. in question.

5. Wait for the historians, or at the very least for Bethany McLean and Joe Nocera's book. (Or Roger Lowenstein's or Andrew Ross Sorkin's or Barry Ritholtz's or somebody else's—I've got a book of my own coming out soon so I'd better not tick these people off. And while I really don't think Dan Gross's new ebook makes any pretense of being the definitive account of the crisis, I feel strangely compelled to inform you that it's available now on Kindle and the Sony Digital Book) The best post-crisis chronicles usually tarnish their chosen villains for decades to come, meting out justice in a way that the judicial system cannot. Until of course the revisionist histories come along decades later and turn everything upside down.

6. Something else. Tarring and feathering? Humanely administered flogging? Maoist self-criticism? If you have better ideas, let's hear them."

Me:

1. donthelibertariandemocrat Says:
   Friday, March 6, 2009 at 2:34 pm

   Through this crisis, I have been remembering this book:

   "Inside Job: The Looting of America's Savings and Loans (Paperback)
   by Stephen Pizzo (Author), Mary Fricker (Author), Paul Muolo (Author)

   From Publishers Weekly
   Bound to be controversial, this impressive expose by three journalists charges that the S & L industry was taken over by a national network of Mafiosi, corrupt thrift officers, appraisers, auditors and arms- and drug-dealers laundering money, all of whom exploited opportunities provided by the 1982 deregulation. Fortified with unlimited broker deposits, the network plundered hundreds of federally insured thrifts. The authors discount the role of high oil prices, the Sunbelt recession and other factors as catalysts in the S & L disaster. Excepting Federal Home Loan Bank Board chairman Erwin Gray, who fought to limit deposit brokerage, Pizzo, Fricker and Muolo accuse the Justice Department, the courts and other federal and state agencies for ignoring or covering up four years of fraud. They also maintain that the guilty have not been punished and little of the loot has been recovered out of official fear of revelation.
   Copyright 1989 Reed Business Information, Inc. --This text refers to an out of print or unavailable edition of this title. "

   I draw a pretty direct line from the S and L Crisis to where we find ourselves today. Even if it's hard and it doesn't always work, we need to have criminal and civil investigations, as well as congressional investigations, into these businesses. If we don't, I expect to be thinking about this book again in the not to distant future.

This story is almost beyond belief, but I suppose nothing really is anymore.

From Paul Kedrosky:

"Stanford International’s “Incredible” Returns Under Scrutiny

This story is almost beyond belief, but I suppose nothing really is anymore. The gist: An $8.5-billion investment firm has been offering certificates of deposit with anomalously high rates of return for more than a dozen years, and concerns are growing that this can’t be real.

The [Federal] agencies are investigating Stanford’s sales of certificates of deposit issued by its Antigua-based affiliate, Stanford International Bank Ltd., according to the former employees. The agency has asked former employees about the bank’s stated returns on investment, between 10.3 and 15.1 percent every year from 1995 until last year, according to documents and annual reports on the bank’s Web site. SIB has $8.5 billion in assets and 30,000 clients, according to the site.

“That type of return ignores the business cycle,” said L. Burke Files, principal of Financial Examinations & Evaluations Inc., a Tempe, Arizona-based financial investigation firm. “His returns fall outside the bell curve of probability.” [Emphasis added]

More here."

Me:

At some point, people are going to start taking my second main cause of the crisis:
Fraud, Collusion, Negligence, and Fiduciary Mismanagement
seriously. I predict that it will happen just after the statute of limitations on all these causes runs out.

"We have to start taking accounting fraud seriously. It is a crime. It is a felony. It is the "weapon of choice" among financial control frauds."

Yves Smith:

"Obama's Financial Reform Proposals: Less Than Meets the Eye

Team Obama has started to preview some of its financial reform proposals. And if the New York Times has represented it accurately, it falls far short of what is called for.

Consider the opening sentence of the article:

The Obama administration plans to move quickly to tighten the nation’s financial regulatory system.

If all the Obama administration intends to do is tinker around( MY FEAR AS WELL ) the margins of our existing framework, the US will make perilous little headway in cleaning up the financial system. In the Great Depression, the Securities Act of 1933 and the Securities and Exchange Act of 1934 were bold, root and branch reforms that proved to be remarkably effective and lasting.

That isn't to say we have to start from a blank sheet of paper, but the powers that be need to be willing to question and probe our existing institutional arrangements more deeply than they seem willing to.

Let's go through some relevant sections of the Times' story:

Officials say they will make wide-ranging changes, including stricter federal rules for hedge funds, credit rating agencies and mortgage brokers, and greater oversight of the complex financial instruments that contributed to the economic crisis....

A theme of that report [by an international committee headed by Paul Volcker], that many major companies and financial instruments now mostly unsupervised must be swept back under a larger regulatory umbrella, has been embraced as a guiding principle by the administration, officials said.

Yves here. So far, motherhood and apple pie circa 2009, but look at the particulars:

Officials said they want rules to eliminate conflicts of interest at credit rating agencies ...The core problem, they said, is that the agencies are paid by companies to help them structure financial instruments, which the agencies then grade....

Yves here. Notice the problem has been defined narrowly: rating agency conflicts. No consideration of rating agency competence( I WOULD SAY THAT THE NATURE OF RATING IS WHAT NEEDS TO BE STUDIED.) (they were unduly dependent on issuer input for some structured products), or the depth of the conflicts (even if you change the pay arrangements, rating agencies have long been a revolving door, with the best staff going to Wall Street. Even in a brave new world of lower financial firm pay, that pattern will still persist. And staff will therefore still have an incentive not to be as tough as they might need to be.

Back to the article:

The administration is also preparing to require that derivatives like credit default swaps, a type of insurance against loan defaults that were at the center of the financial meltdown last year, be traded through a central clearinghouse and possibly on one or more exchanges. That would make it significantly easier for regulators to supervise their use.

We have long been in favor of getting as many OTC products as possible traded on exchanges. But thee is a second issue with credit default swaps. The size of the market is so large relative to the size of the underlying volume of bonds that it has produced significant distortions in the pricing of bonds in new issues (there was a period last summer when the correlation models were blowing up, and one of the side effects was that AAA issuers were suddenly facing insanely high spreads if they financed due to the arbitrage the cash and derivative markets (see here and here for more detail). Similarly, the financial press too often last summer took up financial firm CEO claims that evil stock short sellers were driving down the prices of their stocks, when in fact, CDS were a better vehicle and the cognisenti argued were a far more likely culprit( GOOD JOB YVES ).

The justification for financial "innovation" is that it lowers the cost of financing, improves liquidity, and produces other benefits to the real economy. But there are numerous examples of CDS creating distortions to the detriment of the real economy. Thatt suggests that some thought should be given as to whether and how measures might be put in place to reduce the size of the CDS market (personally, I think the justifications for its existence are weak, but I see no willingness in the Obama crowd to make bold moves in this arena).( I OF COURSE BLAME PEOPLE )

Another reason to rein in the CDS market is that the scale of the risks involved may be too large even for an exchange. As we noted last fall:

The most valuable element of moving CDS to an exchange, as far as lowering systemic risk is concerned, is centralized clearing, since if anyone defaults, the counterparty is the exchange, not an individual firm. Thus regulators have been moving forward as quickly as possible to set up a central clearinghouse. In particular, the CME Group proposed acting as a clearlinghouse, which means that its members would absorb the losses if any counterparty failed. Some rival proposals suggested setting up a new clearinghouse, which is a much sounder design, but would take longer to implement.

However, some savvy and influential and savvy CME members are now objecting to the idea, arguing that the additional risk of CDS clearing on top of their existing CME obligations is more than the members can realistically support. Moreover, they contend that putting together CDS and futures under the same umbrella is too much risk in one venue, and will increase, not reduce systemic risk.

The article recites a host of rather conventional ideas that have been bandied about that Team Obama has latched on to, such as requiring hedge funds to register with the SEC. Bernie Madoff was registered; the SEC skipped his normal inspection and ignored a detailed letter by one Harry Markopolos ("The World's Largest Hedge Fund is a Fraud") that concluded that the Madoff funds were most likely a Ponzi scheme. So exactly what is this going to accomplish? Eliot Spitzer in an article at The Big Money tells us that the SEC is not serious about enforcement:

The traditional critiques of the SEC have been that it was underfunded and didn't have up-to-date laws needed to regulate sophisticated financial transactions in evolving markets. That's not accurate. The SEC is a gargantuan bureaucracy of 3,500 employees and a budget of $900 million—vast compared with the offices that actually did ferret out fraud in the marketplace. And the general investigative powers of the SEC are so broad that it needs no additional statutory power to delve into virtually any market activity that it suspects is improper, fraudulent, or deceptive. After each business scandal (Enron, Wall Street analysts, Madoff …), the SEC claims a need for more money and statutory power, yet those don't help. The SEC has all the money and people and laws it needs. For ideological reasons, it just didn't want to do its job, and on the rare occasions when it did, it didn't know how.

Now in theory, with a new SEC chief, the SEC might get a bit more aggressive, but even in the Clinton era, reform minded Ted Levitt was reined in by Congress that threatened to SEC budgets if it made life too hard for Wall Street (and Democrat Joe Lieberman was the biggest perp). So aside from some cosmetic moves, I doubt much will change here.
Now let us return to the Times article, which illustrates that the underlying problem:

Officials said that the proposals were aimed at the core regulatory problems and gaps that have been highlighted by the market crisis. They include lax government oversight of financial institutions and lenders, poor risk management efforts by banks and other financial companies, the creation of exotic financial instruments that were not adequately supported by their issuing companies, and risky and ill-considered borrowing habits of many homeowners whose homes are now worth significantly less than their mortgages.

In other words, this is a symptom oriented, patchwork approach( TRUE ). And it misses some of the underlying drivers: the opaqueness and complexity of many of the new instruments, texcessive leverage (oh wait, the powers that be think excessive leverage is the solution) and widespread accounting fraud.( TRUE. BUT, IN REALITY, ONLY SUPERVISION AIMED AT COMPREHENDING THESE INNOVATIONS WILL WORK. )

For instance, how could Lehman have collapsed with what turned out to be a hole in its balance sheet of in excess of $100 billion when its financial statements gave no clue of problems of that size? And as we noted at the time, its executives were claiming, forcefully, that everything was OK, the converse of what was actually the case (see here, here and here for examples).( THIS IS FRAUD )

Or consider the views of William Black (a bank regulator during the S&L crisis who went after Lincoln Savings, owned by the powerful Charles Keating. Black's efforts were thwarted but he was eventually vindicated) on Merrill:

Thain portrayed himself as a hero of capitalism and the embodiment of a successful CEO deserving of millions of dollars in bonus compensation because he "sold" Merrill to B of A -- minimizing the losses of Merrill's shareholders. There was, of course, criticism of the scale of these bonuses, but no fundamental rejection of his claim to be a hero.

The lack of rejection illustrates why we are in crisis. We need to be blunt. Thain transferred a loss that risk capital is supposed to bear to the taxpayers of the United States (not B of A). He was able to transfer that loss to the taxpayers because Merrill, under his leadership, engaged in monumental accounting fraud (which means it also engaged in securties fraud)( I AGREE ). We have to start taking accounting fraud seriously. It is a crime. It is a felony. It is the "weapon of choice" among financial control frauds. It causes staggering direct losses and indirectly, by eviscerating trust, it causes entire markets to shut down. This should not surprise economists. We make things crimes in large part because they produce material negative externalities. ( THIS IS MY POSITION )

So, Thain "was part of the problem." The fact that he could (A) lead such a massive fraud and (B) think that he should be rewarded with many billions of dollars for defrauding the citizens of the United States shows two key reasons why the crises keep getting worse( SPOT ON. ). Our most elite business leaders now embody traits we used to understand were loathsome. The fact that this is not obvious even to skilled, sceptical financial reporters shows how serious a problem we face.( I COULDN'T AGREE MORE )

Until we start talking addressing the root causes, these financial "reforms" will prove as effective as trying to treat gangrene with antibiotics. "( I AGREE )

"there was no confusion on wall street and investment banks were not at all duped by rating agencies"

From the Skeptical CPA:

"J'accuse

"first, late-stage receivables securitizations were a criminal fraud perpetrated by the investment banks in conjunction with mortgage lenders. tavakoli asserts there was no confusion on wall street and investment banks were not at all duped by rating agencies--indeed, they knowingly exploited the conflicted interests and moral weakness of those agencies to sell trillions of loss-making loans onto unsophisticated investors. they did so in an effort to pass off investment bank losses while collecting fees on the packaging and distribution of those losses. ... nail not only their bankrupt leadership but these outfits themselves to a tree and light it on fire. i'll more than gladly accept permanently lower growth as the price paid for the modest semblance of moral rectitude, culpability and worthiness that might ensure that 'banker' is not merely another euphemism for 'parasite'," gaius marius (gm), 9 January 2009 at: http://declineandfallofwesterncivilization.blogspot.com/2009/01/start-with-indictments.html.

( THIS IS BASICALLY MY POSITION, AND WHY I SAY THAT FRAUD, NEGLIGENCE, FIDUCIARY MISMANAGEMENT, AND COLLUSION, ARE THE SECOND LEADING CAUSE OF THE CRISIS. )

gm has a link to a 6-minute interview with Janet Tavakoli (JT) of Chicago who says things like "there were no black swans, but black barts". See it. She's wonderful! I love you JT! JT is as critical of investment bankers (IB) who sold MBSs and CDOs as I've been. JT contends IBs knowingly packaged garbage which they sold to investors. The scheme was something akin to what I call a "secured debt, unsecured debt swap" prior to bankruptcy of an insolvent company. gm is more hostile to the IBs, than me. Imagine, he wants them burned at the stake. I'll settle for their merely visiting GSG's CNC guillotine! Chop, chop! For an explanation of what's going on see:

http://skepticaltexascpa.blogspot.com/2007/09/are-tehy-really-this-stupid.html.

http://skepticaltexascpa.blogspot.com/2007/12/of-quants-faith-and-alcoholics.html.

http://skepticaltexascpa.blogspot.com/2008/12/deprizio-doctrine-and-aig.html."

The Black Swan was the inability of the government to easily and effectively deal with the mess created. Most of the Investor Class believed that the government could. They were wrong.

"...the way an entire market has operated for years."

Gee. More Collusion and Fraud. From the NY Times:

"Nationwide Inquiry on Bids for Municipal Bonds

By MARY WILLIAMS WALSH

The federal investigation that prompted Gov. Bill Richardson of New Mexico to withdraw his nomination as commerce secretary offers a rare glimpse into a long-simmering investigation of possible bid-rigging, tax evasion and other wrongdoing throughout( HOW BIG? ) the municipal bond business.

Three federal agencies and a loose consortium of state attorneys general have for several years been gathering evidence of what appears to be collusion( COLLUSION ) among the banks and other companies that have helped state and local governments take approximately $400 billion( $400 BILLION ) worth of municipal notes and bonds to market each year.

E-mail messages, taped phone conversations and other court documents suggest that companies did not engage in open competition for this lucrative business, but secretly divided it among themselves, imposing layers of excess cost on local governments, violating the federal rules for tax-exempt bonds and making questionable payments and campaign contributions to local officials who could steer them business. In some cases, they created exotic financial structures that blew up.( NOT A CAUSE OF OUR CRISIS YOU SAY. )

People with knowledge of the evidence say investigators are not just looking at a few bad apples, but also at the way an entire market( HOW BIG?) has operated for years( HOW LONG?).

“It’s rare to sell a Senate seat, but it’s not rare( NOT RARE ) to sell a bond deal,” said Charles Anderson, who retired as manager of tax-exempt bond field operations for the Internal Revenue Service in 2007. “Pay-to-play in the municipal bond market is epidemic( THAT LARGE EH).”

Michael D. Hausfeld, an antitrust lawyer in Washington, who is representing some of the cities, counties and states entangled in the federal dragnet, called it “one of the longest-running, most economically pervasive antitrust conspiracies ever( HOW BIG?) to be uncovered in the U.S.” Many of these municipalities say they did nothing wrong and were duped by financial firms, which they are suing.

The possibility of a vast web of collusion would be sobering in any case, but the issue is of particular concern now, as Congress and the incoming Obama administration prepare a big fiscal stimulus package that may spawn infrastructure projects( LIKE THE BIG DIG AND BAY BRIDGE? ) carried out and financed at the state and local level. States and cities issue bonds to raise money to pay for things like schools and road construction, and are supposed to follow( I GUESS THAT THEY DON'T ) strict rules on how the proceeds are handled for investors to receive a tax exemption on the interest.

Mr. Anderson estimated that as much as $4 billion a year was vanishing into the system, based on the volume of problems he saw before retirement.

Christopher Cox, the chairman of the Securities and Exchange Commission, has said oversight of the municipal bond markets is inadequate, and has urged Congress to take steps to protect both investors and taxpayers. Congress has not taken up the initiative( OF COURSE NOT. THEY'RE INVESTIGATING HEDGE FUNDS. ).

The S.E.C. and the Justice Department declined to discuss the details or status of their investigations, including in New Mexico, where work on municipal bonds is part of a federal grand jury investigation. Officials at the I.R.S. said they were giving the matter high priority and had challenged the tax-exempt status of municipal bonds in a number of places but declined to describe individual cases.

Christopher Taylor, who retired in 2007 as executive director of the Municipal Securities Rulemaking Board, said the evidence amassed so far included tape-recorded phone calls, in which the independent specialists who are supposed to help local governments pick their bankers could be heard telling bankers: “We want you to bid on this deal, but you’re not going to get it — you’re going to get the next one. We want you to submit a sloppy bid.”( COLLUSION )

Unsuspecting governments then accepted the recommended bids, and paid too much, he said. Mr. Taylor also cited evidence of banks( NO! ) being paid in cities where they did no work at all, apparently to reward them for throwing the business to their rivals.

The business is lightly regulated, with rules governing the conduct of companies set by the municipal securities board. Municipal bond underwriters are prohibited from making campaign contributions to “buy” the business of bringing bonds to market. But no such rules govern the conduct of a type of professional who appeared in the industry about a decade ago — specialists who work with financial derivatives, like swaps and options.

In the last few years, the use of such derivatives in combination with municipal bonds has grown rapidly, market participants say. And so, it appears, has the interest of federal agents.

The federal inquiry appears to have started at the I.R.S., which was concerned that the rules for tax-exempt bonds were being trampled.

“We saw this coming and went to the Department of Justice and said, ‘Hey look! It looks as if there’s been price-fixing and bid-rigging on a major scale( HOW BIG? ) here,’ ” said Mr. Anderson, the retired I.R.S. manager.

The efforts have broadened into what investigators and lawyers described as a coordinated effort among the federal agencies broken down by jurisdiction.

The S.E.C. polices fraud in the municipal bond markets and is looking into whether municipal bonds are routinely certified for tax-exempt treatment, by people who perhaps know or should know they do not qualify.

The Justice Department’s criminal antitrust division has authority over bid-rigging, and that part of the investigation is being led by federal prosecutors in Manhattan. At the same time, various regional U.S. attorneys’ offices around the country are looking at whether campaign contributions and other gifts to state and local politicians were used improperly to “buy” ( COLLUSION )bond-related business.

More than 30 financial services companies have been subpoenaed, including JPMorgan Chase, Merrill Lynch and the American International Group, which have recently received government assistance and in the case of A.I.G., an outright federal bailout. Several have disclosed in corporate filings that their employees have been called to testify before grand juries or have received “Wells notices” from the S.E.C. warning that an enforcement action is looming( REALLY? THESE PEOPLE? ).

The disclosures follow raids by the F.B.I., in 2006, of the offices of three specialized firms that bring together local officials and the banks and other companies that seek business working on municipal bond sales.

One of the three, CDR Financial Products, of Beverly Hills, Calif., is at the heart of the federal investigation in New Mexico. Investigators there are looking at how CDR Financial came to be selected as the “swap adviser” for a $1.5 billion program — called Governor Richardson’s Investment Program, or GRIP — to raise money for road and rail construction in New Mexico.

CDR Financial and its founder, David Rubin, gave $100,000 to two of Governor Richardson’s political action committees in 2003 and 2004, and the company earned $1.5 million for advising GRIP in 2004. A Colorado political consultant, Michael Stratton, lobbied on behalf of CDR Financial, and was paid $269,000 by JPMorgan Chase during the same period, according to regulatory filings. JPMorgan was the lead underwriter on about $1.1 billion of bond sales for GRIP.

Mr. Stratton did not respond to messages requesting comment, and a JPMorgan spokesman said the bank would have no comment.

Allan Ripp, a spokesman for CDR Financial, said that Mr. Rubin had made the contributions because he supported Governor Richardson’s efforts to register people likely to vote Democratic in the presidential election. He said CDR Financial had competed fairly for the bond business and won its assignment on the merits.

Governor Richardson has said that he and his aides acted correctly at all times, and that he withdrew his nomination as commerce secretary only out of concern that the investigation might cause a long and distracting confirmation battle.

CDR Financial and the other two firms raided by the F.B.I. — Investment Management Advisory Group, known as Image, of Pottstown., Pa., and Sound Capital Management of Eden Prairie, Minn. — had attracted unfavorable attention even before the F.B.I. raids, in some cases because of campaign contributions.

In Philadelphia, Image and CDR Financial were described as “Company No. 1” and “Company No. 2” in the indictments of the former city treasurer, Corey Kemp, and other officials in 2004. CDR Financial had made political contributions and earned $415,000 for helping Philadelphia link a type of derivative called a “swaption” to its bonds. Image squired the city treasurer around by limo, and was in the running to participate in a school bond sale, but the deal fell apart when a local newspaper, The Daily News, questioned Image’s involvement( NO! ).

Mr. Kemp is serving a 10-year prison sentence for accepting illegal payments in exchange for steering city bond business and other contracts to selected companies. Neither CDR Financial nor Image was formally accused of wrongdoing.

The use of derivatives in connection with municipal bonds has grown rapidly in the last five years. The packages are presented as money-savers to the municipalities, which may want to protect themselves against interest rate changes. But over the last year, as turmoil spread through the credit markets, some of the derivatives have blown up, leaving local governments stuck with unexpected costs.

That happened in Alabama, where Jefferson County linked an extraordinary number of derivatives, called interest-rate swaps, to its bonds, in some cases with the help of CDR Financial. Despite publicized concerns about whether improper payments( A CRIME ) to certain officials were behind the swaps, the county insisted the swaps were saving money( THIS IS A RESULT OF NOT TAKING THIS KIND OF CRIME SERIOUSLY ). Last year, the derivatives failed, leaving the county with vast bills. Jefferson County is now at risk of declaring what would be the biggest governmental bankruptcy in United States history.

Even in places where the bonds and derivatives are performing as expected, irate government officials are finding they may have overpaid for various services and have inadvertently broken federal tax rules. Again and again( HOW OFTEN? ), proceeds from tax-exempt bonds appear to have improperly generated investment income for banks and insurers.

Among the governments that have sued these financial firms are the cities of Chicago and Baltimore; Oakland and Fresno, Calif.; the state of Mississippi; and a number of counties, school districts and at least one water and sewer district. The lawsuits were consolidated in November, in Federal District Court for the Southern District of New York. Chicago has since abandoned that litigation."

As I keep saying, Fraud, Negligence, Fiduciary Mismanagement, and Collusion as a class form the second most important cause of this crisis. Of course, it was really Complexity.