On the importance of Excel

Four years ago, when global markets were going completely haywire, one of the more important events that helped "turn things around" was FASB's relaxation of mark-to-market accounting standards, a decision that allowed banks to value many of their "distressed" assets based on, basically, whatever their internal models said they were worth. We can argue all day about the long-term costs and benefits of this decision (as you might imagine, I'm pretty aggressively negative on the decision), but ultimately the short-term impact was to place a significant amount of the world's financial stability on the shoulders of one computer program—Microsoft Excel.

We'll turn things over to Baseline Scenario's James Kwak for some more color on the topic (all emphasis mine):

I spent the past two days at a financial regulation conference in Washington... In his remarks on the final panel, Frank Partnoy mentioned something I missed when it came out a few weeks ago: the role of Microsoft Excel in the “London Whale” trading debacle (note: read more about it here)...

To summarize: JPMorgan’s Chief Investment Office needed a new value-at-risk (VaR) model for the synthetic credit portfolio (the one that blew up) and assigned a quantitative whiz (“a London-based quantitative expert, mathematician and model developer” who previously worked at a company that built analytical models) to create it. The new model “operated through a series of Excel spreadsheets, which had to be completed manually, by a process of copying and pasting data from one spreadsheet to another.”

The internal Model Review Group identified this problem as well as a few others, but approved the model, while saying that it should be automated and another significant flaw should be fixed. After the London Whale trade blew up, the Model Review Group discovered that the model had not been automated and found several other errors. Most spectacularly,

“After subtracting the old rate from the new rate, the spreadsheet divided by their sum instead of their average, as the modeler had intended. This error likely had the effect of muting volatility by a factor of two and of lowering the VaR ...”

Microsoft Excel is one of the greatest, most powerful, most important software applications of all time... it provides enormous capacity to do quantitative analysis, letting you do anything from statistical analyses of databases with hundreds of thousands of records to complex estimation tools with user-friendly front ends. And unlike traditional statistical programs, it provides an intuitive interface that lets you see what happens to the data as you manipulate them.

As a consequence, Excel is everywhere you look in the business world—especially in areas where people are adding up numbers a lot, like marketing, business development, sales, and, yes, finance...

But while Excel the program is reasonably robust, the spreadsheets that people create with Excel are incredibly fragile. There is no way to trace where your data come from, there’s no audit trail (so you can overtype numbers and not know it), and there’s no easy way to test spreadsheets, for starters. The biggest problem is that anyone can create Excel spreadsheets—badly. Because it’s so easy to use, the creation of even important spreadsheets is not restricted to people who understand programming and do it in a methodical, well-documented way.

This is why the JPMorgan VaR model is the rule, not the exception: manual data entry, manual copy-and-paste, and formula errors. This is another important reason why you should pause whenever you hear that banks’ quantitative experts are smarter than Einstein, or that sophisticated risk management technology can protect banks from blowing up. At the end of the day, it’s all software. While all software breaks occasionally, Excel spreadsheets break all the time. But they don’t tell you when they break: they just give you the wrong number.

Yikes. As Kwak later points out, this is likely a systematic problem, and not just an unfortunate one-time mistake. If the modeler's error had served to increase the amount of risk at the end of the day, then the mistake no doubt would have been caught, since it would have affected the bank's bottom line. But because senior executives and traders were explicitly hoping for a model that underestimated the risk profile of their portfolios, the "mistake" here went unnoticed and uncorrected, which is so absurd that it's almost comical.

If a mortgage officer at a small regional bank made a similar mistake—say, inadvertently doubling the annual income number for a loan applicant, and then approving said applicant for a number of low-interest loans—that officer would undoubtedly be fired at the end of the day. But here, at JPMorgan, we have a guy who made a similar error on a much larger scale, with much riskier assets and a whole lot more money on the line, and the whole world shrugs its shoulders and goes on about its business. That's scary.

What are some of the other bank models out there telling us about banks' risk profiles and the strength of their capital bases? Should we expect those models to be any better than this one? I suspect not, and I think the (over)reliance on Excel will likely lead us to some very negative outcomes down the line. Of course, as I've said before, this doesn't mean that we should blame the model if and when things go horribly wrong—models, at the end of the day, are only as good as the people who write (and monitor) them. Instead, we need to start blaming the people who write and implement these models, and then holding them accountable for their errors.

[Baseline Scenario]

Quote of the Week (Brockton edition)

Whoa, it's Thursday already? And I haven't written a single blog post yet this week? And there's seriously football on tonight? Like, real actual football? Man, what happened to my summer? And why do I have 38 unfinished blog drafts sitting in my queue? I mean seriously, 38?

Alright, it's time to get back to work around here, starting with your belated Quote of the Week. This one comes from an article that I came across while I was on vacation, and it follows in a theme that I first teed up in this blog post, and then briefly followed up on at the end of this blog post. On multiple occasions I've called for people to boycott the big banks because of their continued criminal behavior, because the banks won't get the message until we hit them in the pocket with it.

There have been a few consumer-led move-your-money campaigns over the past few years, but the simple fact is that large institutions (governments and corporations) can single-handedly keep these banks in business even if the consumer depositors don't. Not only can they do so, but they're almost guaranteed to do so, in large part because they need the banks in order to remain solvent (who else is going to finance their ever-increasing debts?).

But sooner or later, even those governments and corporations are going to say "enough is enough" (whether as a result of taxpayer pressure or their own decision-making process), and we may be nearing that tipping point. The LIBOR-fixing scandal and the bid-rigging scandal were both instances where banks boldly conspired to effectively (or directly) steal money from local governments, indicating a brash assumption on their parts that they are completely above the law and have governments in the palms of their hands (not a bad assumption, frankly, but almost certainly taken too far).

This is a severe miscalculation on the banks' part, a banking equivalent to biting the hand that feeds them. City and local governments are seriously pissed, and they're starting to fight back. How appropriate, then, that one of the first cities to come out swinging was Brockton, Massachusetts, the so-called "City of Champions", home to Rocky Marciano and Marvin Hagler. From The Boston Globe, via Naked Capitalism's Yves Smith:

This week's QUOTE OF THE WEEK

"Brockton will move its $170 million payroll account out of Bank of America, a move the city says makes good business sense but which advocates for residents facing foreclosure see as a just response to the national lender’s role in the subprime mortgage crisis."
                                        - The Boston Globe

For what it's worth, Brockton's City Treasurer went out of his way to stress that this was a strictly business decision, motivated by a better offer from local bank Eastern Bank. But he also admitted that he was sending a message to Bank of America with this move, and that he is revisiting the city's other working relationships with the bank (including school lunch accounts and health care trust funds) to see if they might be better served elsewhere.

Politicians and governments are funny beasts, and they have a tendency to change their tunes very quickly when public opinion shifts. Banks have been able to count on the support of government policies for many decades now, but it's clear that they've taken advantage of that support and in many cases betrayed the governments' trust. If at any point in the future any city government believes that there is more to be gained politically from leaving a bank than from continuing to support it, you can bet that those governments will make the politically popular move, banks' bottom lines be damned.

Might this Brockton decision be just an isolated incident in an otherwise unchanged environment? Quite possibly. But I'm wondering if this might be a warning shot, and if a tipping point might be nearer than many people (and banks) think. We'll see.

[Boston Globe]
(h/t Naked Capitalism)

"Inside Job" and bank criminality

A little over a year ago, I posted a Quote of the Week (and also this follow-up) from Charles Ferguson, the director of the Oscar-winning documentary "Inside Job". Ferguson was complaining about the lack of prosecutions of fraud committed by financial executives, a topic I've also discussed here more times than I can remember.

However, until this week, I hadn't actually watched the documentary—not until Barry Ritholtz tipped me off to the presence of the entire movie on Vimeo. I'd avoided "Inside Job" in part because I (arrogantly and incorrectly) thought that I had read and learned everything there was to know about the financial crisis already, and figured that the film probably didn't have much new to add to the discussion. How wrong I was.

The greatest compliment I can give to any non-fiction piece is that it's worth reading even if you think you already know everything about the topic in question—that certainly applies here. "Inside Job" provides incredible access to a who's who of characters in the mess that is our financial system, from economists to bankers to politicians and everyone in between. Ferguson pulls few punches, and he is particularly harsh with respect to the (role of the) academic world, including my alma mater.

Like many pieces on the topic, I think "Inside Job" is a little too forgiving of the borrowers who made the real estate bubble possible, but that's certainly nothing new here (and I've discussed that dynamic before as well). All in all, though, if you haven't yet watched the doc, I highly recommend it. It does a great job of showing just how ugly things have been behind closed doors at our banks, and also how this financial crisis is far from over—in fact, it may still be in its early stages.


Inside Job, Narrated by Matt Damon (Full Length HD) from jwrock on Vimeo.

But if you don't have the time to watch the film, and you somehow still doubt my assertions that banks continue to commit crimes that have systematically gone unpunished... just read this little post (also courtesy of Barry Ritholtz) and be done with it. In fact, I'll just go ahead and reproduce the whole thing right here.

Here are some recent improprieties by the big banks:

- Laundering money for drug cartels. See this, this, this and this (indeed, drug dealers kept the banking system afloat during the depths of the 2008 financial crisis)

- Laundering money for terrorists

- Engaging in mafia-style big-rigging fraud against local governments. See this, this and this

- Shaving money off of virtually every pension transaction they handled over the course of decades, stealing collectively billions of dollars from pensions worldwide. Details here, here, here, here, here, here, here, here, here, here, and here

- Charging “storage fees” to store gold bullion … without even buying or storing any gold. And raiding allocated gold accounts

- Committing massive and pervasive fraud both when they initiated mortgage loans and when they foreclosed on them (and see this)

- Pledging the same mortgage multiple times to different buyers. See this, this, this, this and this. This would be like selling your car, and collecting money from 10 different buyers for the same car

- Cheating homeowners by gaming laws meant to protect people from unfair foreclosure

- Committing massive fraud in an $800 trillion dollar market which effects everything from mortgages, student loans, small business loans and city financing

- Engaging in insider trading of the most important financial information

- Pushing investments which they knew were terrible, and then betting against the same investments to make money for themselves. See this, this, this, this and this

- Engaging in unlawful “frontrunning” to manipulate markets. See this, this, this, this, this and this

- Engaging in unlawful “Wash Trades” to manipulate asset prices. See this, this and this

- Otherwise manipulating markets. And see this

- Participating in various Ponzi schemes. See this, this and this

- Charging veterans unlawful mortgage fees

- Cooking their books (and see this)

- Bribing and bullying ratings agencies to inflate ratings on their risky investments

The executives of the big banks invariably pretend that the hanky-panky was only committed by a couple of low-level rogue employees. But studies show that most of the fraud is committed by management.

Indeed, one of the world’s top fraud experts – professor of law and economics, and former senior S&L regulator Bill Black – says that most financial fraud is “control fraud”, where the people who own the banks are the ones who implement systemic fraud. See this, this and this.

But it's all okay, because Wall Street is our Main Street, love 'em or hate 'em, right? Bullshit.

That list should just about do it for the "banks never committed any crimes" line of argument, forever. So, watch "Inside Job" if you haven't already—and even if you have, watch it again. It's worth it.

[Barry Ritholtz]
[Max Keiser]

How JPMorgan profited from its massive trading loss

Yes, the title of this post is intentionally nonsensical. That's because we have clearly crossed over from the bizarre into the downright absurd, as was pointed out in this item on the Sober Look blog.

For those in need of a primer, on Thursday evening JPMorgan disclosed a massive $2B trading loss in a portfolio whose ostensible purpose was to "hedge" underlying bank risk, though it clearly does nothing of the sort (read Barry Ritholtz for more on that point). The bank's stock price plunged nearly 10% on Friday, and its bonds were hit hard as well. That last part is where the crazy comes in.

With all the talk about JPMorgan's losses out of the CIO's office, nobody is discussing the money the firm made on Friday due to the accounting magic called DVA. After all, CIO's positions were (at least in principle) meant to act as an offset to this earnings volatility. 

As an example the chart below shows the price action for JPM's newly minted bond (issued just last month). It's a 4% coupon bond maturing in 20 years. 

Source: Bloomberg

With roughly $12bn of this bond outstanding, JPMorgan will record a gain of some $350MM based on Friday's price move just for this bond. It's important to note that this bond represents only a fraction of the $2.3 trillion balance sheet funding. Since the firm's long-term debt is some 12% of total liabilities, one can do a quick back of the envelope estimate. A two point drop (which is lower than the bonds above moved on Friday) in JPMorgan's long term bonds results in roughly $5bn in DVA gains. This more than offsets the reported losses on the CIO's portfolio. Welcome to accounting magic.

That is absolutely amazing. By disclosing a $2B trading loss and sending its own outstanding debt to the woodshed, JPMorgan will actually get to disclose a paper profit as a result (as they did last fall, along with just about every other bank).

The concept of DVA is simple, but also completely retarded. Essentially, the downward movement in the bond price is interpreted as reflecting an increased likelihood that JPMorgan will default on its outstanding debt. In bank accounting land, that means that it won't have to pay back money that it previously expected to have to pay... free earnings!

Of course, in order to ACTUALLY realize these "earnings", JPMorgan will have to actually default on its debt, which would tank the company in every way imaginable. But in the magical short-term world of bank accounting, a $2B trading loss can instantly transform itself into a big-time profit.

And hey, that $5B DVA gain that was calculated in the blog post assumed only a 2-point decrease in bond prices (i.e. from 100 to 98). Just imagine what JPMorgan's earnings would look like if their bond prices REALLY got whacked, like... oh, I don't know... Spain?

So remind me again, how exactly am I supposed to know when a bank is actually making money these days? And why should I ever trust a bank earnings report? Shaking my head...

[Sober Look]

On Goldman, "asymmetric service", Apple, and (the lack of) jail time

It's been a little while since I ranted about the rampant and blatant illegality that is allowed to persist on Wall Street ever since the bailout (because, remember, Wall Street is our Main Street), but I simply can't let the events of the last week go by without mention. I'll present to you three separate news items, all of which... ahem... may or may not be related.

First up, directly from our friends at the SEC (dated April 12th, emphasis mine):

The Securities and Exchange Commission today charged that Goldman, Sachs & Co. lacked adequate policies and procedures to address the risk that during weekly “huddles,” the firm’s analysts could share material, nonpublic information about upcoming research changes. Huddles were a practice where Goldman’s stock research analysts met to provide their best trading ideas to firm traders and later passed them on to a select group of top clients. 

Goldman agreed to settle the charges and will pay a $22 million penalty. Goldman also agreed to be censured, to be subject to a cease-and-desist order, and to review and revise its written policies and procedures to correct the deficiencies identified by the SEC. The Financial Industry Regulatory Authority (FINRA) also announced today a settlement with Goldman for supervisory and other failures related to the huddles. 

“Higher-risk trading and business strategies require higher-order controls,” said Robert S. Khuzami, Director of the Commission’s Division of Enforcement. “Despite being on notice from the SEC about the importance of such controls, Goldman failed to implement policies and procedures that adequately controlled the risk that research analysts could preview upcoming ratings changes with select traders and clients.” 

The SEC in an administrative proceeding found that from 2006 to 2011, Goldman held weekly huddles sometimes attended by sales personnel in which analysts discussed their top short-term trading ideas and traders discussed their views on the markets. In 2007, Goldman began a program known as the Asymmetric Service Initiative (ASI) in which analysts shared information and trading ideas from the huddles with select clients. 

According to the SEC’s order, the programs created a serious risk that Goldman’s analysts could share material, nonpublic information about upcoming changes to their published research with ASI clients and the firm’s traders. The SEC found these risks were increased by the fact that many of the clients and traders engaged in frequent, high-volume trading.

Okay, so for those of you keeping score at home, Goldman admitted to engaging in a blatant insider trading scheme (with a very catchy name, the Asymmetric Service Initiative) for several years before and after the bailout, and paid a paltry $22 million fine as a result. Similar behavior by you or me would land us in jail for several years, but that's beside the point.

Up next, from last night, per Reuters (again, emphasis mine):

U.S. stocks scored their biggest gains in a month on Tuesday after Coca-Cola led a round of strong earnings and as concerns about Europe's debt crisis eased as Spanish bond yields fell. 

Apple Inc shares ended a five-day losing streak with a rally of 5.1 percent, helping the Nasdaq Composite close above 3,000. The stock closed at $609.70 and booked its best day in almost three months after it dropped 8.8 percent in the previous five sessions.

Wow, that's a pretty strong rally after a pretty ugly sell-off. I wonder who was buying... NEXT! From this morning...

In a research note this morning Goldman Sachs is not only sticking with its its “conviction” buy rating on Apple, but it also boosted its 12-month price target on the stock to $750 from $700. 

“Despite recent volatility, we continue to believe Apple’s shares are very attractive at current levels,” said Bill Shope, an analyst at Goldman. “It remains our top pick, and we’d be buyers ahead of March-quarter results.”

Oh, really? You "would be" buyers? Ahead of "March-quarter results"? YOU ALREADY WERE the f*%$^&cking buyers, ahead of your own freaking upgrade, you scumbags (ahem, allegedly).

This is truly epic. The week after Goldman admits to the SEC that it's been kinda, sorta, possibly, illegally leaking info regarding its rating calls to its own traders and top clients for years, it goes ahead and (ahem, allegedly) does the exact same thing with Apple, the largest market-cap company in the world (and therefore also one of the most watched and most heavily traded). That's... bold.

Not surprisingly, Apple stock opened up higher this morning, then began to sell off after the initial pop. What do I think happened? Privileged clients got the leaked info, bought ahead of the news (along with Goldman's traders), then sold some or all of their shares back out today to the suckers on the street who waited for the news to become public. It's a cute trick, and it's also viciously illegal (it's basically a variation on the old "pump and dump", but nobody was ever bold enough to try to pull it off on a huge company on this kind of scale... until Goldman). But no worries, just pay a small token fine and all is well. Move along, folks.

"Asymmetric service", indeed. I'll tell you what, I'm going to start a bank robbery scheme, but I'm going to refer to it as my "Selective Wealth Redistribution Program"... think I'll be able to get away with that one by just agreeing to pay back a small portion of what I stole? Yeah... I didn't think so.

[SEC]
[Reuters]
[WSJ]

The blight of interest rate swaps

It's no secret that state budgets (not to mention their public pension funds) have been under intense pressure lately, a problem made significantly worse by perpetually accommodative Fed policy. Much like our federal budget, these state funding crises have stemmed from both the revenue side and the spending side, caused by decades of politicians who habitually promised the world to their constituents without bothering to do any contingency planning at all.

But a recent report from SEIU sheds light on yet another drag on state and municipal budgets at a time when they can least afford it, once again aided and abetted by Fed policy--and, of course, benefiting banks everywhere at the expense of taxpayers. To summarize...

Big banks are profiting at state and local governments’ expense using the same toxic financial instruments that helped crash the economy.  These derivatives known as interest rate swaps, were sold to governments with a promise that they would lower their borrowing costs but have now become a huge liability. The banks have already taken as much as $28 billion from state and local governments.  Now, during the worst public budget crisis in memory, the big banks seek to collect billions more from toxic deals that local and state governments are trapped into and are forcing layoffs and cuts to services to cover payments to banks.

I do take issue with the assertion that these are "the same toxic financial instruments that helped crash the economy", but that disagreement is immaterial to this discussion. The quick and dirty of it is that banks enticed state and local governments everywhere to "lock in" their interest rate costs--both pre-existing and projected--at what were at the time multi-decade lows. Those governments were effectively borrowing money in advance, often paying interest to the banks on loans never made (for projects not yet approved or begun). When the economy tanked and interest rates went even lower, the governments were still on the hook for the higher interest rate expense.

Adding insult to injury, the weakened economy meant that those not-yet-approved projects would in fact never begin (as spending measures were reined in), meaning that the governments had "locked in" interest rates on non-existent borrowing needs--without a project to fund, the swaps became naked bets on interest rate movement, bets that the governments had no way of winning in the face of loosening Fed policy.

The governments therefore were (and still are) left paying an insane tab to the banks for no reason whatsoever. If this whole scenario sounds familiar, that's because it is--I wrote several months ago about a similar scenario involving Bobby Bonilla and the Mets, in which case Bonilla was effectively playing the role of the bank. These interest rate swaps also cost the Port Authority of New York/New Jersey vast sums of money, sums that they are now trying to recoup via increased tolls and fees (as though they weren't high enough to begin with).

While the states should have known better than to get into these arrangements to begin with, the fact that these local budgets are now suffering so badly as a result shows yet another side effect--an unintended consequence--of the Fed policy that I have spent so many words on this blog deriding. The only way to solve the problems that these governments--state and otherwise--now face is, of course, through more monetary stimulus!! And round and round and round we go... aren't centrally planned economies fun?

[SEIU]

Who funds the fine arts (and does it matter)?

Yves Smith of the Naked Capitalism blog tipped me off to an interesting blog post regarding the funding sources of the fine arts (specifically, orchestras), and whether orchestras and other organizations should accept funding from "tainted" corporate sources. The article centers around a discussion as to whether banks are now, in the wake (eye?) of the financial crisis, affected with the same stigma as are tobacco companies. However, I think the piece may actually miss a bigger picture question, as I'll address later.

Exclusive Overgrown Path research shows that 45% of corporate sponsorship for ten leading orchestras in Europe and North America comes from the banking and financial services sector. This is more than five times greater than from any other corporate funding source. 

A second funding tier comprises companies from the automotive and media industries, with each sector accounting for around 8% of sponsorship. Below that a third tier is made up of companies from the aerospace & defence, pharmaceutical, retail, utility and law sectors. As the research analyses source rather than revenue (see explanatory note below) it is likely that the fiscal contribution of the banking and financial services corporations is considerably greater than 50%. 

A number of the corporate funders, both in the banking sector and elsewhere, have been linked to ethical issues, some of which are noted in the supporting material below. This raises the important but little-explored question of what price classical music is prepared to pay for funding.

The author goes on to cite specific examples of unethical behavior from Deutsche Bank, which largely funds both the Berlin Philharmonic and the London Philharmonic. This is all well and good, and we could easily have an extended ethical discussion over whether or not any organization should accept money from anyone who does anything unethical or illegal (Does accepting money from a criminal make you a criminal? Is everyone who attended Penn State somehow liable for the alleged actions of Jerry Sandusky, or is every Republican a sexual harasser because they share a party with Herman Cain?), but I definitely think it misses the point.

You see, down in the comments section of that post, one reader made a particularly astute observation. In noting that the blog author had neglected to consider those orchestras that received primarily state funding--focusing only on those that relied on corporate sponsorships--the commenter remarked the following:

I note your point... above, but let's not forget that all government funding is ethically compromised. 

Government money comes from tax, including that on the profits and wages earned in such industries as pornography, junk food, oil, armaments, gambling, tobacco, alcohol etc. 

The state is often an active participant in dodgy industries like armaments and gambling. For example, in the UK, the government's huge gambling operation, the National Lottery, is used to fund 'good causes'. 

Does ethically compromised money conveniently become ethically cleansed when it has passed through the hands of the state? 

In the opinions of those who are given it I suspect so.

That commenter makes some fantastic points, especially when he brings up the National Lottery. I've long been uncomfortable with the double standard that exists--both in the United States and elsewhere--whereby gambling is illegal and condemnable, unless it is explicitly sponsored by and supporting local governments. We go out of our way to pretend that our state lotteries are somehow virtuous because they are (often) used to fund public schools, while we are asked to kindly ignore the fact that this funding often comes on the backs of degenerate gamblers whose lives are compromised or ruined by their gambling addiction. Why does that double standard make sense?

In my estimation, any government is simply a reflection of all the elements of a society--both virtuous and nefarious--put together into one big bucket. If you accept money from a government agency of any kind, you are by proxy accepting money from a bank, a tobacco company, a railroad, a strip club, a sex shop, and, thanks largely to California, a medical marijuana dispensary--all of these and more, without any way of distinguishing one dollar from another. If the trend toward moral relativism with regard to state budgets continues (and it's almost certain to), this dynamic will only become more pronounced, further blurring the line between unethical companies and government agencies.

The only remaining question is, do we care? Personally, I don't. If a company takes liberties with its customers or the taxpayers, and we are all collectively naive (or stupid) enough to continue doing business with them, then we are legitimizing their business practices by proxy, and we in large part lose our right to cast moral judgment in their direction.

We may find banks and tobacco companies to be distasteful, but as a collective unit we continue to support them as customers. If they feel like re-channeling some of this "dirty money" into more virtuous areas in the name of image enhancement, I say we let them do so. That goes for corporations, governments, and individuals alike--if we don't like what they're doing, we should stop giving them our own money in the first place. Refusing to take it back from them later is simply stupid and self-defeating.

[On An Overgrown Path]  
(h/t Naked Capitalism)

Update to SEC post

In writing my SEC rant this morning, I forgot to include a reference to a very interesting post from Naked Capitalism's Yves Smith, which pointed out a dynamic of which I wasn't yet aware. Here it is:

Alison Frankel at Reuters highlights a new New York appellate court decision where JP Morgan is being hoist on the Rakoff petard. Bear Stearns, which is now owned by JP Morgan, entered into a $250 million settlement in 2006 over allegations that it cheated customers by engaging in impermissible market timing. The agreement contained standard SEC “without admitting wrongdoing or denying” language. The payment broke down into $160 million of disgorgement and $90 million of penalties.

What may surprise many readers is that the $160 million disgorgment was covered by insurance, or at least JP Morgan thought it was. Per Frankel:

The insurance agreements said the bank was covered for damages awards and charges incurred by regulatory investigations, with one catch: The policies excluded claims “based upon or arising out of any deliberate, dishonest, fraudulent, or criminal act or omission,” if there were a final adjudication reflecting that wrongdoing.

The insurers said no dice, and JP Morgan took them to court to try to force them to pay. The lower court decided in favor of JP Morgan, but the appeals court reversed. And the logic is revealing:

But a ruling Tuesday by the New York state Appellate Division, First Department, suggests the boilerplate language that Ramos cited — and Rakoff has derided — may no longer offer defendants much benefit even without judges specifically rejecting it….

But the decision’s implications may be broader than that. In an opinion written by Justice Richard Andrias, the state judges simply didn’t pay much heed to the SEC “neither admit nor deny” boilerplate. “Read as a whole,” the decision said, “the offer of settlement, the SEC Order … and related documents are not reasonably susceptible to any interpretation other than that Bear Stearns knowingly and intentionally facilitated illegal late trading for preferred customers, and that the relief provisions of the SEC Order required disgorgement of funds gained through that illegal activity.” Moreover, in a footnote, the opinion referred explicitly to Rakoff’s criticism of SEC boilerplate in SEC v. Vitesse Semiconductor.

Putting on a public policy, rather than a legal hat, insurance that has the effect of letting companies and boards buy their way out of the economic consequences of bad conduct is a terrible idea.

While it doesn't exactly surprise me, I officially had no idea that banks held (or even had the capability to hold) insurance policies to protect them against penalties arising from SEC enforcement actions. This fact only lends credence to the concept that banks are internalizing fraud-based fines as a general cost of business, and it only makes Rakoff's ruling that much more critical. More importantly, it adds another judge--Judge Richard Andrias--to the ever-growing roster of justices who are fed up with the way that the financial watchdogs treat bank fraud.

The SEC has been played as puppets here, as the banks have simply purchased insurance against anything the SEC might do. This plan only works as long as the SEC continues to allow “without admitting wrongdoing or denying” language to be a standard part of its settlements, and this is exactly what must stop.

Judge Andrias and Judge Rakoff are onto something here, and the SEC therefore has a choice--assemble a legal team that will actually prosecute instances of bank fraud, or else assemble a similar team that will appeal every like-minded judicial ruling in the Andrias-Rakoff vein. Only one of these options is consistent with the SEC's mandate, and only one of them is an acceptable use of taxpayer dollars. I think you know which one.

[Naked Capitalism]

The SEC and the politics of intimidation

Just two days ago, I posted a chart detailing the serial fraud that has been perpetrated by our largest financial firms--and allowed to continue by an apparently disinterested SEC. In my conclusion, I opined that we need "more Eric Schneidermans and Jed Rakoffs," the latter referring to the judge who threw out a proposed settlement between the SEC and Citigroup.

I had previously written that Rakoff's ruling was an incredibly important one, while noting that Rakoff had "faced a significant amount of scrutiny from people who think that the SEC 'can't afford' to prosecute cases like these, because the cases are too expensive and the banks have such amazing legal resources". Still, I was hopeful that Rakoff's rebuke might force the SEC into action, as public pressure mounted and opinion coalesced against the banks. No such luck.

Judge Rakoff got to have his insurrection when he rejected the SECs $285 million settlement with Citigroup last month.

Now it's the SECs turn. According to the Wall Street Journal, the agency is planning an insurrection too — against Judge Rakoff. The agency will expend its resources creating a five person panel to appeal the Judge's decision.

You'll recall that instead of allowing the agency to take Citi's money and be done with its mortgage-backed security suit against the bank, Judge Rakoff asked both parties to go back to the drawing board.

In doing so, Judge Rakoff bucked a practice that's been in play since the 1970s. The SEC has allowed banks to pay small sums ('pocket change," in Rakoff's words) and neither confirm nor deny their guilt in civil suits against the agency. Rakoff thinks that practice is unjust.

So given the Judge's order, you would think the SEC might prepare itself to go to trial with Citi so the bank could maintain its innocence (a scary prospect for both parties). Or that both parties, at the very least, would get their calculators out to tabulate a sum that might make the Judge happy.

Not so. The SEC would prefer to create a 5 person commission to appeal the Judge's ruling and nip this problem in the bud.

Right. So the SEC "can't afford" to prosecute cases against banks that consistently and repeatedly perpetrate fraud against the American public, but it can afford to mount appeals against judges who stand in their way. Sounds great.

What's so disheartening about this turn of events is that it's seemingly indicative of a new way of doing business in Washington, that of the politics of intimidation. The first clear example of this wave of bullying came after S&P's well-publicized downgrade of U.S. sovereign debt in August--rather than humbly taking their lumps and acknowledging some flaws in the way that they did business, Washington instead elected to turn their ire on S&P with a clearly retaliatory investigation of the agency's business practices.

The message to S&P was clear, as is the message here to Judge Rakoff--we don't care who you are, or what you think. If you disagree with the way we do business, we will do everything we can to make your life miserable, or at least marginalize your voice. That's not the America that I know and love, and I think it's a very sad turn of events for all Americans. Our political system and democratic process must be respected, even when that means that government bodies may (on occasion) face steep criticism for their actions.

While you may not agree with the assertion that "dissent is the highest form of patriotism" (or, as some have reminded us, "descent the highest form of patriotic"), you must certainly acknowledge that the politics of intimidation lead us down a very dangerous path. A government that bullies its opponents into silence is not a democracy at all--it's a thinly veiled dictatorship, with "free speech" a mere mirage.

If there is any hope for our democracy going forward, here's hoping that whichever judge hears the SEC's appeal affirms Judge Rakoff's decision. It's the only way that we can ensure that equality under the law persists (or returns) in our country--without equality under the law, there cannot be a true democracy at all.

Of course, even with an affirmation of Rakoff's ruling, the SEC can still simply begin making its settlements outside of the court system entirely, which still misses the point. I yearn for a time that government bodies treat dissent as an opportunity for soul-searching and reform, rather than as an opportunity for chest-pounding and muscle flexing. In my opinion, the tighter these agencies try to hold onto their power and preserve their existing processes, the more they lose credibility altogether. And a government without credibility cannot survive.

[Business Insider]

Ugh

If you've been reading me long, you'll know how I feel about the big banks, and you'll also know that I think the banks have been the recipient of many more government-sponsored bailouts than we could possibly imagine--TARP was just the tip of the iceberg.

Bloomberg (and, more hilariously, Jon Stewart) broke the news of one of these backdoor bailouts last week, in the form of trillions of dollars in secret loans from the Fed, many of which were then lent back to the Federal government for a profit (borrowing from the Fed, lending to the government, and taking a profit on the difference--uh yeah, that's a bailout).

But I've always been more interested in the non-financial type of bailouts--namely, the crimes that banks are allowed to perpetrate without facing anything more than a fine when the crimes are discovered. That they can internalize these fines as a cost of business only ensures that for banks, crime does indeed pay. For evidence of this dynamic, look no further than this New York Times infographic (brought to my attention by Barry Ritholtz), detailing the so-called "Wall Street Recidivists".

You'll notice that my favorite company Bank of America shows up on there multiple times, as does Merrill Lynch, which is now wholly owned by BofA. I'm absolutely shocked.

It's clear that this world needs more Eric Schneidermans and Jed Rakoffs, and fewer bankster criminals. The prevailing attitude in Washington seems to be that if we prosecute the banks fully, it will "upset the markets", or that the banks will scale back lending and devastate the economy. That line of reasoning is insulting to our intelligence. If we allow different people to have different treatment under the law, the whole nation suffers immensely. Equality under the law is the only thing keeping our democracy (and, frankly, our economy) intact. It must be preserved at all costs.

The banks have been lying, cheating, and stealing for over a decade, and it's about damn time we put a stop to it. Fines aren't enough--they're just a thinly veiled bailout. We need handcuffs and bank closures, and if the markets suffer in the time being, so be it. Anyone actually feel like stepping up and doing it?

[NY Times]
(h/t Barry Ritholtz)

MF Global and moral hazard

I've been sitting on this post for nearly a month now, ever since ex-Goldman Sachs CEO (I told you, these guys are everywhere) and ex-New Jersey Governor Jon Corzine's firm, MF Global, went belly-up--and "misplaced" a bunch of client funds in the process. The repercussions of this collapse are widespread and still being felt throughout the financial markets, and it cannot be so easily dismissed as an isolated incident. 

There are two primary reasons that the collapse of MF Global is so important. First, the apparent theft of client funds threatens to undermine the confidence of a large set of players in financial markets, players who have a significant amount of leveraged capital at their disposal, and who therefore possess great power in the markets. If they no longer think their money is safe in their managed accounts, the effects of that confidence loss could be devastating.

But second, and perhaps more importantly, MF Global is the first major sign that the bank bailouts of 2008-09--whether through TARP, emergency Fed loans, or myriad other backdoor bailouts like failing to prosecute bank fraud of various sorts--didn't end the concept of "Too Big To Fail", but rather institutionalized it.

When TARP was first being considered, one of the chief concerns among those who opposed it (myself included) was that they would create massive moral hazard in the future, and that banks would continue to take outsized risks that threatened to harm our economy, knowing that the government would have their backs if those bets went wrong. By failing to punish the bad bets of the big banks, the government would only ensure more bad bets in the future, in essence guaranteeing that the financial crisis of 2008-09 would be repeated.

Until now, those concerns have been mostly theoretical, with no empirical evidence to support them. But now, with MF Global, we critics have our first piece of hard data to support our moral hazard argument. As evidence, consider the fact that MF Global, at the time of its collapse, was operating with a staggering 40-to-1 leverage ratio--even greater than that of Lehman Brothers at the time of its implosion in 2008.

The politically-connected Corzine (a top Obama fundraiser) clearly expected that the government would have his back if things went wrong at MF, and why wouldn't he? By bailing out the banking sector, it's clear that the government in essence rewarded the bad behavior, and that broker-dealers became even more bold in response. Corzine may have erred in his judgment (time will tell, but his judgment is pretty clearly lacking), but that doesn't make his actions or decisions any less important in a macro sense.

Think MF Global's high leverage ratio is a coincidence, or just one bad player? Think again--a recent study from the University of Michigan confirmed that bailed-out banks took on more risk than those that did not, showing that they failed to learn the lessons of their previous failures. Of course, that's realistically exactly what the Fed and Congress wanted--a rebubbling of the previous bubble, a resumption of the world "the way it was", rather than "the way it should be".

We may hear people here and there in the banking world bellyaching about Dodd-Frank and the "crazy" regulations that they're now subject to, but the truth is that nothing about our government's response to the financial crisis has done anything at all to prevent the next one. If anything, it's done everything possible to ensure the next financial crisis, and MF Global is Exhibit A in that case.

Dismiss the MF Global collapse as an isolated incident if you wish--many people did so with Bear Stearns in March of 2008, foolishly ignoring the risks until they smacked them upside the head in the fall of that same year. But for any who care in the least about the future financial security of our nation, you must recognize that MF Global has the federal government's fingerprints all over it. Thanks, TARP.

Goldman rules the world

I've never exactly tried to hide my feelings about Goldman Sachs (see here, here, here, and... you know what, there's a lot of it), but I've gotta hand it to them--they're experts at expanding their global domination. While you were sleeping, it turns out Goldman's been busy completely taking over Europe.

I've already mentioned here before (in this blog post) that there's a ridiculous revolving door between Goldman Sachs and Washington, to the point where it's literally impossible to determine where Goldman ends and the federal government begins. Now, it seems that the revolving door dynamic has jumped across the Atlantic, and gone to work on the European governments, one by one. Per The Independent:

The author (Stephen Foley) goes on to write that:

Even before the upheaval in Italy, there was no sign of Goldman Sachs living down its nickname as "the Vampire Squid", and now that its tentacles reach to the top of the eurozone, sceptical voices are raising questions over its influence. The political decisions taken in the coming weeks will determine if the eurozone can and will pay its debts – and Goldman's interests are intricately tied up with the answer to that question.

Simon Johnson, the former International Monetary Fund economist, in his book 13 Bankers, argued that Goldman Sachs and the other large banks had become so close to government in the run-up to the financial crisis that the US was effectively an oligarchy. At least European politicians aren't "bought and paid for" by corporations, as in the US, he says. "Instead what you have in Europe is a shared world-view among the policy elite and the bankers, a shared set of goals and mutual reinforcement of illusions."

This is The Goldman Sachs Project. Put simply, it is to hug governments close. Every business wants to advance its interests with the regulators that can stymie them and the politicians who can give them a tax break, but this is no mere lobbying effort. Goldman is there to provide advice for governments and to provide financing, to send its people into public service and to dangle lucrative jobs in front of people coming out of government. The Project is to create such a deep exchange of people and ideas and money that it is impossible to tell the difference between the public interest and the Goldman Sachs interest.

Now, I'd be going a little too far if I were to suggest that Goldman deliberately brokered deals that saddled these incompetent governments with too much debt so that they could later roll into town when the inevitable crisis hit and "save" the governments with their financial genius, thereby ensuring that their devilish plan of taking over the world would proceed on schedule... wouldn't I? That is far-fetched, right? Wait, is it? Jesus, I don't even know anymore...

I've gotta say, if this is indeed all part of an evil master plan (and you know what, even if it isn't), I really just have to hand it to them--these guys are good. Welcome to the Goldman universe.

[The Independent]

Boycott Bank of America

I've had it. Trying to hijack the rule of law (via our state AGs) was bad enough. Initiating a back-door TARP (via state-owned Fannie Mae) was even worse. But a third stealth taxpayer-funded bailout is just too many. Three strikes, you're out.

Bank of America Corp. (BAC), hit by a credit downgrade last month, has moved derivatives from its Merrill Lynch unit to a subsidiary flush with insured deposits, according to people with direct knowledge of the situation.

The Federal Reserve and Federal Deposit Insurance Corp. disagree over the transfers, which are being requested by counterparties... The Fed has signaled that it favors moving the derivatives to give relief to the bank holding company, while the FDIC, which would have to pay off depositors in the event of a bank failure, is objecting, said the people. The bank doesn’t believe regulatory approval is needed, said people with knowledge of its position.

Three years after taxpayers rescued some of the biggest U.S. lenders, regulators are grappling with how to protect FDIC- insured bank accounts from risks generated by investment-banking operations. Bank of America, which got a $45 billion bailout during the financial crisis, had $1.04 trillion in deposits as of midyear, ranking it second among U.S. firms.

“The concern is that there is always an enormous temptation to dump the losers on the insured institution,” said William Black, professor of economics and law at the University of Missouri-Kansas City and a former bank regulator. “We should have fairly tight restrictions on that.”

In the words of Bruce Wayne, the details of this ridiculous bailout attempt are "a bit technical," so I'll put it in layman's terms for you--Bank of America just backed a pickup truck full of toxic horseshit from its investment bank into your backyard, and dumped it all there. Now it's your job to clean it up.

This is an absolute joke, and it's not even close to legal. The FDIC does not exist in order to backstop failed bets from investment banks and trading desks. Attempting to use the taxpayer-backed institution that way is nothing short of theft, and all Americans (not just BofA account holders) should be furious--the FDIC itself already is.

The fact is, the "toxic assets" that caused the financial crisis of 2008-09 never actually went away--they were simply hidden from the public view via a suspension of mark-to-market accounting (itself a borderline crime via accounting fraud). These assets have bounced around for a couple of years, never regaining value, and now the banks are trying to park them in your backyard--if you still have one.

The banks (and their cronies at the Fed, and the politicians whose campaigns they've funded) have consistently gambled that you won't understand the technical details of the fraud, and therefore won't be upset. So far, they've been disturbingly correct, and they've gotten away with pointing a gun at the head of the taxpayer time and time again by threatening "financial Armageddon". But things are changing, and Occupy Wall Street (OWS) is the result--these people may not now exactly how they've been robbed, but they certainly know the results, and they're fed up.

Of course, there are those who have tried to brand the OWS people as "socialists" or "Marxists". I can hardly conceive of a more offensive (and flagrantly false) depiction. While there may be pockets of whackos involved here (just as there were in the Tea Party--eventually, the fringe hijacked that movement), the core values of the movement are anything but socialist. At the center of OWS is a demand that these socialized institutions be held responsible for their losses, and not be backstopped by the government or taxpayers. How is it socialist to demand equality under the law, and to demand that bad banks be allowed to fail?

Occupy Wall Street is, ultimately, a revolution against the concept of "Too Big To Fail"--that very concept is, indisputably, anti-capitalist. A system that does not allow an institution to fail even when the market has said that it must is hardly capitalist--it's socialist. It requires an amazing act of mental gymnastics to suggest that opposing socialist acts... is somehow Marxist. But this is what our banks and politicians are trying to do.

If you've got assets with Bank of America, don't wait until November 5th. Pull them now. No, don't pull it for the traditional "is my money safe?" reasons. Pull it to send a message that you refuse to backstop bad bets by investment bankers, that you refuse to subsidize their ridiculous salaries, and that you refuse to continue to be a part of this badly broken system.

Bank of America put themselves in this situation. It's not your job to save them, and if you do, you're only paving the way for more bailouts (and $5 debit card fees) in the future. The extortion must end now.

[Bloomberg]

Quote of the Week

This week, as I often do, I'm going to cheat a bit on Quote of the Week, and use it as an excuse to post a pretty clever cover from the New Yorker, pertaining to Occupy Wall Street.

For Quote of the Week, we'll just go with the guy in the background with the "I'm good, thanks" poster. He's my favorite.

I think I'm gonna start to walk around carrying a sign that says "I'm good, thanks," just to see how people respond to me. Actually maybe I'll just print up some t-shirts. Who wants one?

Interesting related graphics (and how they relate to Occupy Wall Street)

I've already posted Jon Stewart's terrific take on Occupy Wall Street here, and if you're looking for an equally well-executed (albeit much less humorous) summary of the situation, I'd suggest you read this piece from Barry Ritholtz. He correctly points the finger not only at Wall Street execs, but also at Washington, the mainstream media, and even the Supreme Court.

Ritholtz also warns that if the Occupy Wall Street movement isn't careful, it could suffer the same fate as the Tea Party--that is, being co-opted by a partisan political message that over-simplifies and distorts the original themes of the movement for the benefit of an established political party. In the initial stages of a movement or protest, disorganization doesn't really matter, but eventually it does--people (especially those in the media) are always looking for a coherent narrative, and they'll find it wherever they can.

At any rate, in that vein, I was struck by a couple of charts (appropriately enough, all brought to my attention by the very same Barry Ritholtz) that I came across this weekend, and they seemed both related and relevant. I'll leave the conclusions to you.

The first is a series of charts showing the changing distribution of income gains in the U.S. over the past century (culled from this interactive graphic).

Between 1917 and 1981, the bottom 90% received 69% of income gains.

Between 1982 and 2000, the bottom 90% received just 23% of income gains.

Since 2001, incomes for the bottom 90% have declined. The top 10% have still gained.

Related to that is a graphic showing which Presidents were responsible for the majority of our country's debt accumulation. (Note: I always take these "debt by President" charts with a massive grain of salt, because it's always difficult--if not impossible--to properly assess "blame" to one President or another for certain long-standing projects or proposals. If TARP was passed by Bush but enacted under Obama's watch, who bears the brunt of that debt hit? What about tax cuts, and then the extension of those tax cuts? And do we give Obama a free pass for certain of his policies that are certain to create debt in the future, even if they haven't officially done so yet? As a result, the findings of these types of charts have a tendency to be... a bit inconsistent. But they're generally consistent in a range--like, it's indisputable that George W. accumulated significantly more debt than Clinton--if not in specific numbers and percentages. They're far from statistically perfect, and therefore heavily prone to statistical manipulation to suit the artists' needs. But if you appreciate that fact, they can still be interesting.)

Alright, that's it for now. That should at least help explain why so many people are so angry, and why they're out in the streets (that and the fact that they're unemployed and really have nothing better to do). Good times.

Jon Stewart on "Occupy Wall Street"

I haven't really been able to piece together my thoughts on the growing Occupy Wall Street phenomenon, and I'm certainly not alone. The difficulty in assessing this situation/movement/protest is that we all want it to be some cohesive, coherent, easy-to-categorize group, when in reality it's anything but--and that's exactly what makes it so important.

The fact is, the people of the Occupy Wall Street movement are exactly what they say they are--the "other 99%". And since we know that 99% of people can rarely agree on anything (the closest we've been able to get is, ahem, 89%), it's unrealistic and frankly stupid to expect this group to have one consistent message. They're not anarchists, they're not Nazis (fuck the heck, Ann Coulter?!?), they're not lazy and uneducated, and they're not hippies--although some of them are probably all of these things. The only thing these people have in common is that they're unemployed (or underemployed), pissed off, and tired of not having their voice heard. And that much I can certainly get behind (well, not the unemployed part... whatever, you get my point).

So let's leave it to Jon Stewart to explain the rest, because he does a pretty terrific job of showing just how absurd things can become when we try so hard to categorize the un-categorizable.

The Daily Show
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Ignore these people at your own peril. I have a feeling this group won't be quite as easy to co-opt into a political party as was the Tea Party.