A Diary A Day – a Humongous Heaping Healthy Helping of FRAUD

(8 am. – promoted by ek hornbeck)

Yesterday I diaried about my understanding of how the meltdown happened, here. But there is part of the diary worthy of a diary on it’s own. The very important part played by Wall Street’s three biggest arbiters of credit. We will look at their part combined with how these instruments were allowed to be traded that may be the largest fraud ever perpetrated against the American people. We will discuss the illegal actions that can and MUST be pursued below the fold.

Years ago, in the 70’s my “was-band” worked as a commodities broker for Merrill Lynch. In those days Merrill’s biggest issue was their unwillingness to promote women to positions on the trading floor. It was during the time Nelson “Bunkie” Hunt and his brother tried to corner the silver market. Known as Silver Thursday, the very idea one person could come so close to cornering a global metals market, set Wall Street and much of the world back on their heels.

Beginning in the early 1970s, Hunt and his brother William Herbert Hunt began accumulating large amounts of silver. By 1979, they had nearly cornered the global market. In the last nine months of 1979, the brothers earned an estimated $2 billion to $4 billion in silver speculation, with estimated silver holdings of 100 million ounces. During the Hunt brothers’ accumulation of the precious metal, prices of silver futures contracts and silver bullion during 1979 and 1980 silver prices rose from $11 an ounce in September 1979 to $50 an ounce in January 1980. Silver prices ultimately collapsed to below $11 an ounce two months later. The largest single day drop in the price of silver occurred on Silver Thursday. Hunt filed for bankruptcy under Chapter 11 of the Federal Bankruptcy Code in September 1988, largely due to lawsuits incurred as a result of his silver speculation. In 1989 in a settlement with the United States Commodity Futures Trading Commission, Nelson Bunker Hunt was fined US$10 million and banned from trading in the commodity markets as a result of charges of conspiring to manipulate the silver market stemming from his attempt to corner the market in silver. This fine was in addition to a multimillion-dollar settlement to pay back taxes, fines and interest to the Internal Revenue Service for the same period.

Please read the aftermath from Time magazine, a lot of familar faces and familiar solutions. In the end laws were changed. Nelson Hunt lived a life of privilege, he had it all and it still wasn’t enough … “People who know how much they’re worth aren’t usually worth that much.”

Today we have another kind of meltdown still caused by greed compounded by an absence of or ineffective regulations. Problems started with SIV. Invented by Citigroup in 1988, SIV  is part of the shadow banking system and start as a SIV, a Structured investment vehicle. SIV and all their children like ABS represent a virtual bank.

Historically banks have instead of relying on depositor funds to cover monies loaned for short term cash flow issues, money is gotten by selling short term commerical paper. The interest on this paper is low and usually close to the LIBOR average. This paper is also rated by the big three of credit arbiter with the rating as the issuing bank. Commerical paper isn’t new, it has been used for years to cover things like payroll, not unlike any other business. Normally these notes have no collateral. Again from WIKI

As defined by American law, commercial paper is a financial instrument that matures before nine months (270 days), and is only used to fund operating expenses or current assets (e.g., inventories and receivables) and not used for financing fixed assets, such as land, buildings, or machinery. By meeting these qualifications it may be issued without U.S. federal government regulation, that is, it need not be registered with the U.S. Securities and Exchange Commission. Commercial paper is a type of negotiable instrument, where the legal rights and obligations of involved parties are governed by Articles Three and Four of the Uniform Commercial Code, a set of non-federal business laws adopted by each of the 50 U.S. States.

SIV and ABS is available to non-bank financial institutions. These institutions borrow and lend thru credit derivatives and in that way circumvent banking laws and regulations. The value of these credit derivatives are based on credit risk. There is a significant advantage in so much as it allows the issuer to package of assets they couldn’t easily borrow against otherwise. Unlike legitimate CP, ABS and SIV can be renewed over and over again.

From Investopedia: Structured Investment Vehicle – SIV

What Does Structured Investment Vehicle – SIV Mean?

A pool of investment assets that attempts to profit from credit spreads between short-term debt and long-term structured finance products such as asset-backed securities (ABS). Funding for SIVs comes from the issuance of commercial paper that is continuously renewed or rolled over; the proceeds are then invested in longer maturity assets that have less liquidity but pay higher yields. The SIV earns profits on the spread between incoming cash flows (principal and interest payments on ABS) and the high-rated commercial paper that it issues. SIVs often employ great amounts of leverage to generate returns.

Also known as “conduits”.

Investopedia explains Structured Investment Vehicle – SIV

SIVs are less regulated than other investment pools, and are typically held off the balance sheet by large financial institutions such as commercial banks and investment houses. They gained much attention during the housing and subprime fallout of 2007; tens of billions in the value of off-balance sheet SIVs was written down as investors fled from subprime mortgage related assets.  

Many investors were caught off guard by the losses because little is publicly known about the specifics of SIVs, including such basics as what assets are held and what regulations determine their actions. SIVs essentially allow their managing financial institutions to employ leverage in a way that the parent company would be unable to due to capital requirement regulations.  

Investopdia: What Does Credit Derivative Mean?

Privately held negotiable bilateral contracts that allow users to manage their exposure to credit risk. Credit derivatives are financial assets like forward contracts, swaps, and options for which the price is driven by the credit risk of economic agents (private investors or governments).

Investopedia explains Credit Derivative

For example, a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss by transferring the credit risk to another party while keeping the loan on its books.

From Investopedia What Does Asset-Backed Security – ABS Mean?

A financial security backed by a loan, lease or receivables against assets other than real estate and mortgage-backed securities. For investors, asset-backed securities are an alternative to investing in corporate debt.

Investopedia explains Asset-Backed Security – ABS

An ABS is essentially the same thing as a mortgage-backed security, except that the securities backing it are assets such as loans, leases, credit card debt, a company’s receivables, royalties and so on, and not mortgage-based securities.

So what does all this mean? It means banks are able to leverage to their heart’s content because they have a ready unregulated market for their poor judgement. And they can securitize virtually anything, including fees. These securities and their derivative children CDO, CLO and CDS etc. are rated without regard for the issuing bank. Moody’s Investors Service, S&P and Fitch Ratings gave us 80 percent  AAA rating on these securities, the same designation given to U.S. Treasury bonds.

Their ratings put toxic paper on the same investment plane as US Treasury notes, the gold standard, implying these investments couldn’t fail. What made them so insanely attractive and created the hottest capital market in the world is these securities paid 2-3 percent higher interest than Treasuries.

Rating agencies are supposed to be impartial, in fact they need to be for the system to work, they are the first and one of the most important check and balance. This expansion could not have happened without the aid of the rating agencies. Issuers of securitized investments were not only coached and given guidance by the rating agencies on how to shape these investments, but the rating agencies gave bankers the software to use to make it even easier to commit this fraud. Yet to this day the rating agencies contend they do not offer consulting services or have any part of the structuring of the instruments. The rating agencies charged the issuers for this service and the subsequent ratings. The software and the AAA rating for 98% of these securities say they are liars.

This isn’t the first time the rating agencies have betrayed our trust. In 2001 Moody’s came underfire and were sued by stockholders because of their failure to downgrade  ENRON in a timely manner. In 1994 the big three were criticized for keeping bonds sold by Orange County, Calif., at investment grade while the county filed the nation’s largest municipal bankruptcy. After ENRON, in September of 2006 Congress passed the Credit Rating Agency Reform Act, giving the SEC the power to investigate, designate and regulate these agencies. In January of 2007 the SEC made their recommendations regarding new regulations.  The SEC took action again in June of 2008 adding more regulation. The problem is the regulations are mostly toothless in addressing the real problems. The SEC after their investigation found insufficient disclosure between the issuers and the rating agencies and conflicts of interest. We know from testimony and emails that the rating agencies were fully aware they are giving a AAA rating to what was essentially junk bonds. The rules most needed were dropped from the final regulations after they came underfire from Wall Street. Because of laws regarding investments and what certain large buyers can purchase what the problem is far from fixed.

By law, certain investors must rely on the ratings of a handful of Securities and Exchange Commission designated “Nationally Recognized Statistical Rating Organizations” (NRSROs). For example, most state insurance regulators require that only assets rated in the top four ratings categories by NRSROs are eligible investments. Similarly, money market funds can only invest in securities with the highest NRSRO ratings. In fact, innumerable institutions – public and private, and domestic and international – mandate asset quality levels predicated on the major rating agencies’ due diligence.

Standard & Poor’s Ratings Services, Moody’s Investors Service (MCO) and Fitch Ratings Inc. are all SEC-designated NRSROs. They are the largest, best-known and most-profitable ratings firms in the tiny, $5 billion-a-year universe of ratings firms. S&P is a part of The McGraw-Hill Cos. Inc. (MHP), while Fitch is a subsidiary of France’s Fimalac SA.

Moody’s was spun out of financial publisher Dun & Bradstreet Corp. (DNB) as a public company in 2000. Warren Buffett’s Berkshire Hathaway Inc. (BRK.A, BRK.B), apparently having spotted a diamond in the rough, bought into D&B before the divestiture, and ended up with a hefty 19% stake in Moody’s after the spin-off was completed.

The problem with the business of rating the issuers of securities, and rating the securities they issue – such as mortgage-backed securities and collateralized mortgage-backed obligations – is that the rating agencies are paid by the issuers to rate them. Objectivity aside, ratings firms are in business not to rate but to make money for themselves by rating issuers and their securities. It’s like all the contestants in the Miss World pageant paying the judges with country funds … who’s not going to be judged beautiful?

It is interesting the SEC is addressing what they see as a conflict of interest between the issuers and the rating agencies, when the two clearly enabled the other in committing fraud. Apparently I’m not the only one who believes fraud was committed. In fact there are quite a few of us out there who think that this might be a case for an experienced Insurance Investigator. I have some friends in Canada who own an insurance company and they sometimes have to use private investigators if they suspect that a person or a business is making fraudulent claims, and we think foul play might be going on in this case.

March 11th 2009 A US District Court judge says Moody’s Corp. investors can go ahead in part with a lawsuit accusing the credit rating agency of securities fraud. The class action lawsuit accuses Moody’s of claiming it was an independent body that impartially published accurate financial instrument ratings when such misrepresentations artificially inflated its stock price (until media reports about its compromised objectivity caused the value of its stocks to drop).

And there were problems. Lots of them. According to a Feb. 15 “Review & Outlook” piece in The Wall Street Journal, Joseph Mason, professor of finance at Drexel University, studied collateralized debt obligations rated “Baa” by Moody’s and determined that they were 10 times more likely to default than equivalently rated corporate bonds. The article went on to say that an S&P spokesperson, when asked if they actually examined the underlying mortgages in the pools, answered: “We are not auditors; we are not accounting firms.”

While S&P – and to a lesser degree, Fitch – were just playing the game, Moody’s actually ran away with the ball. An eye-popping and brilliant April 11 Aaron Lucchetti article by Aaron Lucchetti exposed the unseemly underbelly of Moody’s greed. What stood out the most in the article was Moody’s willingness – under the direction of Brian Clarkson, who joined the firm in 1991 and became president and chief operating officer – to bend over backwards to accommodate issuers of mortgage-backed and structured finance paper. Clarkson was willing to switch analysts if clients complained, which several did, including Credit Suisse Group AG (ADR: CS), UBS AG (UBS), and Goldman Sachs Group Inc. (GS).

Under Clarkson, Moody’s expanded and grabbed a huge piece of the deal-ratings-market pie. By 2006, the company was rating $9 out of every $10 raised in mortgage securities. For all of that year, the firm’s structured finance group generated more than $881 million in revenue, about 43% of Moody’s revenue. And in 2007 it was estimated that the firm rated 94% of the approximately $190 billion in mortgage and structured-finance CDOs floated during the year.

Like any other stock or bond you can play/bet the come don’t come line. This is why in the casino know as Wall Street millionaires are made in down markets. Options are an important part of this model. You are betting on the future performance of a stock or bond, not unlike futures trading int the commodities market. For a small premium you can get a buy option at a certain price at sometime in the future. An option to  sell is essentially the same thing in the reserse, but the kicker is you don’t have to own the stock to offer to sell it in the future. Eventually if the day comes when to option to sell is exercized by the price asked then you have to scramble to buy and sell. If the day comes and the price has not been met, all you lose is the original premium paid on your buy option. Cheap fun and it gets better. “Naked Call Writing” is the term used when you own no part of the trade. While not illegal it is dangerous and many brokerage houses won’t write them. Options are derivatives, a thing made from the pieces of something else. The scarey thing as Cramer pointed out is they can be securitized. You can make and trade and investment based on parts of a thing, in this case stock and not even own it. If the deal works out and you guess the market correctly it is possible to collect billions in profits on the misery of others. There are books written about this being the future of investments. They teach you to ride it up and down, crashes and slow downs mean nothing if you are clever and greedy.

This is how Hedge Funds work. Because Hedge Funds limit their number and type of investors they are exempt from regulations governing short selling, derivative contracts, leverage, fee structures and the liquidity of interests in the fund. The funds are specialized each having its own strategy and areas of interest, they also dominate the high yield market. We have identified a literal alphabet soup of corruption that needs to be severely regulated or outlawed entirely. The idea bailing out AIG may also bail out Hedge Funds is repugnant.

I would suggest the people who brought us to this party and caused the headache ought to be paying for the cure. There needs to be an investigation if one isn’t currently underway along with prosecutions for at the very least fraud and conspiracy to commit fraud. And why not “tax” stock and bond trades? Why not add a little bit to each stock or bond? In 2008, 894.5 billion shares passed thru the NYSE. Just 10 cents added to each stock or bond could add at least $89 billion to a fund to pay back the bail out.  Once paid back with interest, the fund should continue, perhaps at a reduced amount to provide money for future bailouts if necessary.  


  1. Cross posted KOS

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