Today brought us news that federal prosecutors in Manhattan are sniffing Goldman over. Those would be pooches no one wants to get close to, because they bite with criminal charges. No investment bank has ever--repeat, ever--survived criminal charges.
It's also reported that Goldman is thinking hard about settling the recently filed SEC case. That would seem a striking change of heart, considering Goldman's jut jawed defiance at Congressional hearings on Tuesday. But there's a logical explanation for the apparent change of course--the shareholders are rumbling.
We mean the outside shareholders. They don't participate in the employee bonus pool, and receive their profits from share appreciation and dividends. They would take a longer term view of the firm--almost like the partners who owned Goldman before it went public in 1999. As with all investment banks, Goldman's reputation is its principal asset. That's been a depreciating asset in recent weeks, and the stock price has dropped a corresponding 15% or so.
Berkshire Hathaway may be Goldman's largest shareholder, having infused $5 billion in the fall of 2008 as a vote of confidence in the U.S. financial system. Berkshire Hathaway got about 7.6% of Goldman's beneficial ownership, according to Goldman's most recent proxy statement. Large mutual funds and money management firms are also major shareholders. Many of these institutional shareholders can't easily ditch GS stock, because they might hold it as part of an index fund or a basket of stocks needed for an investment strategy. Or else they might hold so much GS stock that they can't dump it all quickly without rippling the market big time. So they're stuck with this puppy, and every downward tick in its price probably ticks them off ever more.
Shareholders have been instrumental in fostering settlement in big government cases. In the late 1980s, the SEC and the U.S. Attorney's office in Manhattan squared off with Drexel Burnham Lambert Incorporated, the leading junk bond firm of its day. The SEC sued Drexel (and its junk bond star, Michael Milken) in September 1988, while a criminal investigation by the U.S. Attorney's Office in Manhattan moved forward. The prospect of indictment loomed for Drexel, and its largest shareholders, including a Belgian financial firm called Groupe Bruxelle Lambert, pressured Drexel's management into settling.
Some 23 years ago, Berkshire Hathaway acquired about 12% of Salomon Inc., another investment bank. Four years later, in 1991, a scandal over U.S. Treasury auction bidding blew up at Salomon. Warren Buffett, Berkshire Hathaway's CEO, became Salomon's Chairman, and steered the firm toward settlement with the U.S. government.
Goldman's large shareholders will likely avoid public comment. But surely they're thinking hard about how to save their investments. In just a couple of weeks, Goldman's legal problems have mushroomed to include not only the SEC lawsuit, but shareholder suits, investigations by foreign regulators, potential lawsuits by customers and now the possibility of criminal charges. A quick settlement with the SEC could reduce the incentive for the U.S. Attorney's office to press ahead. It might also staunch the flow of evidentiary revelations that bursts forth in tabloid fashion just about every day now (was the love life of a Goldman employee ever before so interesting?). While institutional shareholders in America generally maintain a lizard-like impassivity when it comes to corporate governance, a legal crisis that threatens a firm's viability is just the circumstance to inspire them to damage control. The recent past teaches that investment banks can't withstand the tsunami of bad publicity that seems to be engulfing Goldman. There's scarcely a chance that Warren Buffett will comment publicly about Goldman's situation. But you can bet dollars to doughnuts that he and other large GS shareholders aren't holding their peace behind the scenes.
Thursday, April 29, 2010
Why Goldman's Explanation Doesn't Work
They must have felt better after Tuesday's hearing, the Senators who got to ventilate their Kabuki outrage and the Goldman witnesses their defiant self-rationalizations. But in the end, Goldman lost ground.
In essence, Goldman argues that it served as an intermediary between long and short investors in ABACUS 2007-AC1, the first synthetic CDO ever to achieve tabloid fame, perhaps eclipsing, however momentarily, Kate Gosselin. Goldman claims it made extensive disclosure to sophisticated investors on both the long and short sides, and let these grownups decide for themselves if they wanted to invest. They should have to bear the risks that they voluntarily undertook, contends Goldman, perhaps overlooking the fact that it didn't bear any of the risks it voluntarily undertook in connection with AIG because the U.S. taxpayer (i.e., you) bailed out AIG, and therefore Goldman.
Synthetic CDOs are, on paper, pure bets. They don't actually hold any underlying investments and the payments investors make for them do not finance the building of factories or the development of advancements in computer memory chips. There is no intrinsic difference between a synthetic CDO and a sports bet. Both are wagers and nothing more.
But ABACUS 2007-AC1 wasn't analogous to an ordinary sports bet. It was like betting with someone who got to pick the lineups for the competing teams; in other words, someone who rigged the game. If you didn't know that--and it became indisputable from yesterday's hearing that IKB, one of the long investors in ABACUS 2007-AC1, didn't know about John Paulson & Co.'s role in choosing the collateral--you could get hosed. Which is exactly what happened to the long investors in ABACUS 2007-AC1.
So Goldman's explanation doesn't work. It wasn't just an intermediary between sophisticated investors that made informed bets on a fully disclosed investment. It was a promoter of a rigged bet that didn't disclose to everyone the playing field had been tilted.
Whether Goldman is legally liable remains for the courts to decide. However, it failed at the principal challenge it faced in yesterday's hearing, which was to diffuse the public controversy over the SEC's case. It had no appealing story for why Horatio Alger would want to grow up to be a synthetic CDO salesman. Goldman's witnesses offered only carefully crafted testimony that brought to mind some politician's line about the absence of controlling legal precedent or another politician's quibbling over the meaning of "is." Goldman couldn't bring even a scintilla of contrition to bear, apparently rejecting the notion that a little humility would come across better than polite arrogance. One thing that was loud and clear is that Goldman's management intends to litigate this case until Hell freezes over. But the SEC seems to have ended up with slightly improved litigation prospects, even though it didn't participate in the hearing. So it won't back down any sooner than Goldman. A long struggle in the courts bears greater risk for Goldman than it does the SEC. Goldman needs to be careful with the trade it just got into.
In essence, Goldman argues that it served as an intermediary between long and short investors in ABACUS 2007-AC1, the first synthetic CDO ever to achieve tabloid fame, perhaps eclipsing, however momentarily, Kate Gosselin. Goldman claims it made extensive disclosure to sophisticated investors on both the long and short sides, and let these grownups decide for themselves if they wanted to invest. They should have to bear the risks that they voluntarily undertook, contends Goldman, perhaps overlooking the fact that it didn't bear any of the risks it voluntarily undertook in connection with AIG because the U.S. taxpayer (i.e., you) bailed out AIG, and therefore Goldman.
Synthetic CDOs are, on paper, pure bets. They don't actually hold any underlying investments and the payments investors make for them do not finance the building of factories or the development of advancements in computer memory chips. There is no intrinsic difference between a synthetic CDO and a sports bet. Both are wagers and nothing more.
But ABACUS 2007-AC1 wasn't analogous to an ordinary sports bet. It was like betting with someone who got to pick the lineups for the competing teams; in other words, someone who rigged the game. If you didn't know that--and it became indisputable from yesterday's hearing that IKB, one of the long investors in ABACUS 2007-AC1, didn't know about John Paulson & Co.'s role in choosing the collateral--you could get hosed. Which is exactly what happened to the long investors in ABACUS 2007-AC1.
So Goldman's explanation doesn't work. It wasn't just an intermediary between sophisticated investors that made informed bets on a fully disclosed investment. It was a promoter of a rigged bet that didn't disclose to everyone the playing field had been tilted.
Whether Goldman is legally liable remains for the courts to decide. However, it failed at the principal challenge it faced in yesterday's hearing, which was to diffuse the public controversy over the SEC's case. It had no appealing story for why Horatio Alger would want to grow up to be a synthetic CDO salesman. Goldman's witnesses offered only carefully crafted testimony that brought to mind some politician's line about the absence of controlling legal precedent or another politician's quibbling over the meaning of "is." Goldman couldn't bring even a scintilla of contrition to bear, apparently rejecting the notion that a little humility would come across better than polite arrogance. One thing that was loud and clear is that Goldman's management intends to litigate this case until Hell freezes over. But the SEC seems to have ended up with slightly improved litigation prospects, even though it didn't participate in the hearing. So it won't back down any sooner than Goldman. A long struggle in the courts bears greater risk for Goldman than it does the SEC. Goldman needs to be careful with the trade it just got into.
Wednesday, April 28, 2010
Sovereign Debt Debacle in the Making
If you've ever wondered what it would have been like on the Titanic, take a look at the Euro bloc. Today's drop by the Dow Jones Industrial Average of 213 points only mildly foreshadows what could happen. Greece, as we all know, is in deep yogurt. But Portugal and Spain are also sliding into the vat. Current estimates of the bailouts needed by these three countries total around 500 billion Euros. (That would be around $650 billion.) The IMF might be able to cough up around 200 billion Euros. The other 300 just ain't happening. A large part would have to come from Germany, and the Germans are already struggling with the idea of contributing around 12 billion Euros to Greece's bailout. With the most recent developments, the German public might well conclude that even a small bailout for Greece would begin Germany's slide down the slippery slope, and clamor to depart the EU.
Neither the Federal Reserve nor any other part of the U.S. government can do much. Americans are fed up with bailing out each other; they won't stand for bailing out people overseas. To make things worse, Goldman Sachs appears to have played a significant role in certain aspects of Europe's sovereign debt problem. While its exposure to the sovereign debt mess remains unclear (no doubt GS has plenty of hedges in place), anything that might look like another bailout of Goldman, after AIG's nationalization, would be beyond the pale.
The European Union doesn't have a true governance structure. That's why it got into trouble and that's why it can't work its way out of trouble. Ten years ago, Argentina linked its currency to the dollar and got into a debt crisis not unlike Greece's current predicament. It had to delink from the dollar, and today is in decent shape. The Euro bloc will almost surely lose members--either the debtor nations that need the bailouts, or the wealthy nations that would be expected to fund the bailouts, will leave. The Euro may eventually be good only for buying its automotive counterpart, the Edsel.
Neither the Federal Reserve nor any other part of the U.S. government can do much. Americans are fed up with bailing out each other; they won't stand for bailing out people overseas. To make things worse, Goldman Sachs appears to have played a significant role in certain aspects of Europe's sovereign debt problem. While its exposure to the sovereign debt mess remains unclear (no doubt GS has plenty of hedges in place), anything that might look like another bailout of Goldman, after AIG's nationalization, would be beyond the pale.
The European Union doesn't have a true governance structure. That's why it got into trouble and that's why it can't work its way out of trouble. Ten years ago, Argentina linked its currency to the dollar and got into a debt crisis not unlike Greece's current predicament. It had to delink from the dollar, and today is in decent shape. The Euro bloc will almost surely lose members--either the debtor nations that need the bailouts, or the wealthy nations that would be expected to fund the bailouts, will leave. The Euro may eventually be good only for buying its automotive counterpart, the Edsel.
Sunday, April 25, 2010
SEC v. Goldman Sachs: Back to First Legal Principles
The Paleolithic quality of the derivatives markets takes us back to earlier times, when the courts and the SEC struggled to establish the basic ground rules of the securities markets. Although American lawyers, unlike their English brethren, tend to fixate over the most recent judicial decisions, it is can be instructive to go back to a time when the stock markets were more rudimentary, bearing interesting resemblances to today's derivatives markets.
In 1972, when french fries were still cooked in lard and tasted much better than they do today, the U.S. Supreme Court handed down its decision in Affiliated Ute Citizens v. United States, 406 U.S. (128). This case involved a company, Ute Distribution Corp., which was created to distribute certain assets of the Ute Native American tribe to its mixed-blood members. The original mixed blood shareholders were permitted to sell their stock, although sales involved a somewhat laborious over-the-counter process by the transfer agent, a bank called First Security Bank. Two employees at a branch office of the bank saw a profit opportunity and devised a scheme to buy stock from original shareholders at lower prices and resell it to non-Utes at higher prices. The result was a two-tiered market, in which stock sales by Utes were in the range of $300 to $700 per share, while transactions between white buyers and sellers were in the $500 to $700 range. The two bank employees, who themselves purchased some of the selling Utes's shares, did not disclose to the Ute sellers the existence of the higher priced white market. When some of the selling Utes found out, they sued the bank and its employees (and also the United States, arguing it had some responsibility to restrain the Utes from selling their shares; but the Court ruled in favor of the U.S.).
The Court decided that the bank and its two employees were liable under the SEC's antifraud rule, 10b-5, for failure to disclose the existence of the two-tiered market the two employees had created. The two employees had actively encouraged non-Utes to buy, and received commissions and other compensation for sales to non-Utes. The Court held them and the bank liable even though the two employees made no affirmative representations or recommendations to selling Utes. The bank employees were deemed responsible because they had "facilitate[d] the mixed-bloods' sales to those seeking to profit in the non-Indian market the defendants had developed and encouraged and with which they were fully familiar." 406 U.S. at 153.
In the Affiliated Ute case, the bank and its two employees were not formal underwriters or broker-dealers. But they informally structured transactions so that selling Utes were unknowingly at a disadvantage. That, in the view of the Court, made the defendants liable for failure to disclose as required by the antifraud requirements of Rule 10b-5. The Court's imposition of Rule 10b-5 liability on the bank and its employees for their actual conduct, and not their contractual status (as transfer agent), is in keeping with the rule's purpose as a catch-all provision to guard against the inventiveness and creativity of fraudsters.
While there are differences of fact between Affiliated Ute and the SEC's case against Goldman Sachs, the basic principle of Affiliated Ute is problematic for Goldman. It created ABACUS 2007-AC1, in a way that some evidence indicates was slanted to favor the short side because of the substantial role in selecting the collateral played by John Paulson & Co., the short seller that commissioned Goldman to created this synthetic CDO. Even though Goldman evidently did not recommend buying to the investors on the long side, the Court in Affiliated Ute did not require affirmative recommendation or representation before applying liability. Following the Court's reasoning, Goldman, as a key participant in creating the CDO, should have disclosed to long investors the information indicating that ABACUS 2007-AC1 could be rigged in favor of the short investor.
The derivatives market, circa 2007, was an opaque, informal, heavily negotiated market. Even sophisticated investors didn't have much in the way of objective reference points to measure potential investments. Specific information is always more important than sophistication. Lots of sophisticated people ripped off by Bernie Madoff wouldn't have invested if he had, as required by law, disclosed what he was really up to. The Great Recession began as a result of idiocy in the derivatives markets and we taxpayers, workers, homeowners and citizens are still struggling to recover. All of us have a stake in the integrity, fairness and soundness of the derivatives markets.
In 1972, when french fries were still cooked in lard and tasted much better than they do today, the U.S. Supreme Court handed down its decision in Affiliated Ute Citizens v. United States, 406 U.S. (128). This case involved a company, Ute Distribution Corp., which was created to distribute certain assets of the Ute Native American tribe to its mixed-blood members. The original mixed blood shareholders were permitted to sell their stock, although sales involved a somewhat laborious over-the-counter process by the transfer agent, a bank called First Security Bank. Two employees at a branch office of the bank saw a profit opportunity and devised a scheme to buy stock from original shareholders at lower prices and resell it to non-Utes at higher prices. The result was a two-tiered market, in which stock sales by Utes were in the range of $300 to $700 per share, while transactions between white buyers and sellers were in the $500 to $700 range. The two bank employees, who themselves purchased some of the selling Utes's shares, did not disclose to the Ute sellers the existence of the higher priced white market. When some of the selling Utes found out, they sued the bank and its employees (and also the United States, arguing it had some responsibility to restrain the Utes from selling their shares; but the Court ruled in favor of the U.S.).
The Court decided that the bank and its two employees were liable under the SEC's antifraud rule, 10b-5, for failure to disclose the existence of the two-tiered market the two employees had created. The two employees had actively encouraged non-Utes to buy, and received commissions and other compensation for sales to non-Utes. The Court held them and the bank liable even though the two employees made no affirmative representations or recommendations to selling Utes. The bank employees were deemed responsible because they had "facilitate[d] the mixed-bloods' sales to those seeking to profit in the non-Indian market the defendants had developed and encouraged and with which they were fully familiar." 406 U.S. at 153.
In the Affiliated Ute case, the bank and its two employees were not formal underwriters or broker-dealers. But they informally structured transactions so that selling Utes were unknowingly at a disadvantage. That, in the view of the Court, made the defendants liable for failure to disclose as required by the antifraud requirements of Rule 10b-5. The Court's imposition of Rule 10b-5 liability on the bank and its employees for their actual conduct, and not their contractual status (as transfer agent), is in keeping with the rule's purpose as a catch-all provision to guard against the inventiveness and creativity of fraudsters.
While there are differences of fact between Affiliated Ute and the SEC's case against Goldman Sachs, the basic principle of Affiliated Ute is problematic for Goldman. It created ABACUS 2007-AC1, in a way that some evidence indicates was slanted to favor the short side because of the substantial role in selecting the collateral played by John Paulson & Co., the short seller that commissioned Goldman to created this synthetic CDO. Even though Goldman evidently did not recommend buying to the investors on the long side, the Court in Affiliated Ute did not require affirmative recommendation or representation before applying liability. Following the Court's reasoning, Goldman, as a key participant in creating the CDO, should have disclosed to long investors the information indicating that ABACUS 2007-AC1 could be rigged in favor of the short investor.
The derivatives market, circa 2007, was an opaque, informal, heavily negotiated market. Even sophisticated investors didn't have much in the way of objective reference points to measure potential investments. Specific information is always more important than sophistication. Lots of sophisticated people ripped off by Bernie Madoff wouldn't have invested if he had, as required by law, disclosed what he was really up to. The Great Recession began as a result of idiocy in the derivatives markets and we taxpayers, workers, homeowners and citizens are still struggling to recover. All of us have a stake in the integrity, fairness and soundness of the derivatives markets.
Thursday, April 22, 2010
Did Goldman Sachs Really Lose $90 Million from the CDO It Constructed for Paulson?
Goldman Sachs claims it lost $90 million from holding a piece of the synthetic CDO that it constructed for John Paulson & Co., a transaction now famous as the subject of the SEC's recent enforcement action against Goldman. Can we take this claim of a $90 million loss at face value? Goldman has persistently asserted it was well-hedged against AIG risk, and didn't need the billions it garnered when the U.S. Treasury bailed out AIG's creditors for 100 cents on the dollar. One wonders why Goldman, if it were a good corporate citizen dedicated to doing God's work, didn't decline the money it didn't need, especially when so many middle class taxpayers are badly stretched. But on Wall Street, money talks and good deeds walk. It's fine if John F. Kennedy declined his presidential salary because of his family's wealth, but Wall Street isn't in Camelot.
Considering how well Goldman supposedly was hedged against AIG risk, it's hard to imagine it wasn't hedged against the decline in the mortgage markets. After all, e-mails quoted in the SEC's charges make clear that Goldman expected that decline. And Goldman evidently greatly reduced its overall exposure to real estate and mortgages even before and while it put together ABACUS 2007-AC1. From a risk management standpoint, one would expect that when Goldman unexpectedly got saddled with a piece of the ABACUS deal, it would have hedged itself. Certainly, it wouldn't have knowingly carved out a piece of its risk profile and left its interest in ABACUS 2007-AC1 naked long. So did Goldman really lose $90 million? Its accounting and risk management records might make for interesting reading in this regard.
If Goldman was in fact hedged against its ABACUS exposure, or was able to take advantage of general hedging in the mortgage and real estate sector to offset its ABACUS losses, then its claim of a $90 million loss could be false or misleading. Ordinarily, $90 million, more than lunch money to most people, ain't squat sit to Goldman Sachs. But Goldman's vaunted reputation is on the line. Claiming this $90 million loss as an indication of its innocence, if there really isn't such a loss, just might step over the line. The SEC has sanctioned a public company for making a misstatement in connection with its defense of an investigation. See SEC Press Release No. 2004-67 (May 17, 2004)(captioned, "Lucent Settles SEC Enforcement Action Charging the Company with $1.1 Billion Accounting Fraud"). Given how Goldman's stock has gyrated with the back and forth among news stories about the case, a misstatement by Goldman about the strength of its defenses could conceivably step over the line and itself be potential grist for the SEC's enforcement mill.
Back to hedging. A fun question might be to ask what Goldman, as a market maker, did with the RMBSs that related to ABACUS 2007-AC1. Goldman, like other large banks active in the mortgage business, might have made markets in those RMBSs. The SEC complaint alleges (and essentially all news sources agree) that the RMBSs underlying ABACUS 2007-AC1 dropped in value very quickly after the deal was done, hammering the long side of the deal. If Goldman was a market maker in some or all of these RMBSs and dropped its quotes muy pronto, one would have to wonder why it was so unafraid of imposing losses on its own holdings in the ABACUS deal. The answer could well be that it was well-hedged on ABACUS and dropped its bids because it didn't want to buy doggy RMBSs from someone else trying to hit its bids.
Although the derivatives markets were, and still are, murky on the best of days, records of Goldman's quotes may exist in documentation maintained by institutional investors who were seeking market valuations for accounting purposes. Big compilers of market data like Bloomberg and Reuters may also have relevant information. Of course, Goldman should have records of its own quotes. But independent verification would be de rigueur, now that the parties are dancing in federal court. The discovery process (i.e., the process in litigation of collecting and exchanging evidence) in SEC v. Goldman is likely to begin presently. Perhaps the SEC's litigation team will find some interesting stuff.
Considering how well Goldman supposedly was hedged against AIG risk, it's hard to imagine it wasn't hedged against the decline in the mortgage markets. After all, e-mails quoted in the SEC's charges make clear that Goldman expected that decline. And Goldman evidently greatly reduced its overall exposure to real estate and mortgages even before and while it put together ABACUS 2007-AC1. From a risk management standpoint, one would expect that when Goldman unexpectedly got saddled with a piece of the ABACUS deal, it would have hedged itself. Certainly, it wouldn't have knowingly carved out a piece of its risk profile and left its interest in ABACUS 2007-AC1 naked long. So did Goldman really lose $90 million? Its accounting and risk management records might make for interesting reading in this regard.
If Goldman was in fact hedged against its ABACUS exposure, or was able to take advantage of general hedging in the mortgage and real estate sector to offset its ABACUS losses, then its claim of a $90 million loss could be false or misleading. Ordinarily, $90 million, more than lunch money to most people, ain't squat sit to Goldman Sachs. But Goldman's vaunted reputation is on the line. Claiming this $90 million loss as an indication of its innocence, if there really isn't such a loss, just might step over the line. The SEC has sanctioned a public company for making a misstatement in connection with its defense of an investigation. See SEC Press Release No. 2004-67 (May 17, 2004)(captioned, "Lucent Settles SEC Enforcement Action Charging the Company with $1.1 Billion Accounting Fraud"). Given how Goldman's stock has gyrated with the back and forth among news stories about the case, a misstatement by Goldman about the strength of its defenses could conceivably step over the line and itself be potential grist for the SEC's enforcement mill.
Back to hedging. A fun question might be to ask what Goldman, as a market maker, did with the RMBSs that related to ABACUS 2007-AC1. Goldman, like other large banks active in the mortgage business, might have made markets in those RMBSs. The SEC complaint alleges (and essentially all news sources agree) that the RMBSs underlying ABACUS 2007-AC1 dropped in value very quickly after the deal was done, hammering the long side of the deal. If Goldman was a market maker in some or all of these RMBSs and dropped its quotes muy pronto, one would have to wonder why it was so unafraid of imposing losses on its own holdings in the ABACUS deal. The answer could well be that it was well-hedged on ABACUS and dropped its bids because it didn't want to buy doggy RMBSs from someone else trying to hit its bids.
Although the derivatives markets were, and still are, murky on the best of days, records of Goldman's quotes may exist in documentation maintained by institutional investors who were seeking market valuations for accounting purposes. Big compilers of market data like Bloomberg and Reuters may also have relevant information. Of course, Goldman should have records of its own quotes. But independent verification would be de rigueur, now that the parties are dancing in federal court. The discovery process (i.e., the process in litigation of collecting and exchanging evidence) in SEC v. Goldman is likely to begin presently. Perhaps the SEC's litigation team will find some interesting stuff.
Tuesday, April 20, 2010
SEC v. Goldman Sachs: What the Case Is Really About
The SEC's fraud case against Goldman Sachs, and Goldman's defense, reflect competing views of the way federal regulation of the financial markets should work. While we have no inside information about how either party plans to argue its side of the case, the information that's already public indicates the lay of the land. Goldman contends that it gave "extensive" disclosure to "sophisticated" investors and they should thereafter be held responsible for themselves. The SEC's argument is Goldman's defense doesn't address the way investments are sold in the real world and that, in reality, Goldman misled investors.
A central theme of the securities laws is disclosure--public companies, broker-dealers, mutual funds and a variety of other players are required to make disclosures prescribed by SEC rules. These disclosures can sometimes be extensive, and Goldman claims to have made extensive disclosures to its customers. The interests in the synthetic CDO in question (ABACUS 2007-AC1) were privately sold and it's unclear what disclosures were actually made. But Goldman claims that the investors pretty much knew what mortgage-backed securities the CDO would be based on and that an independent agent, ACA, selected those MBSs. It contends that the investors were sophisticated and able to decide for themselves how risky these investments were.
The SEC's case is that, however much Goldman may have spoken in its disclosures, it didn't speak the complete truth. Part of the SEC's version of the truth would be that John Paulson & Co. had a large role in the selection of the collateral, that Goldman slyly cultivated a contrary impression in the minds of investors, and that investors knowing the reality of Paulson's involvement would have been reluctant to buy the long side of the transaction.
The SEC's case appears to hark back to the 1930s, 40s, 50s and 60s, a foundational period of time in which the broad contours of the securities laws were shaped. This was a time when knowledge of investments and the financial markets was much more tightly held than is the case today. There was no Internet, no electronic trading systems and no electronic reporting of securities transactions (except the legendary but not terribly informative ticker tape, which was simply a very long telegram). Many stocks and bonds were traded by telephone, or in face-to-face transactions at bank counters (hence the term, "over-the-counter"). Investors relied heavily on financial professionals to deal fairly and squarely with them, because they had few, if any, other sources of information. When you think it about, it's similar to today's derivatives market.
It is axiomatic that the more opaque a market is, the easier it is to sell snake oil. The snake oil business was vibrant in the financial markets of the 1930s, with investors snake bit early and often. The SEC developed a doctrine of law called the "shingle theory." This theory postulates that when a broker-dealer hangs out its shingle to do business, it impliedly represents that it will deal fairly with its customers. An early decision affirming this theory is Charles Hughes & Co. v. SEC, 139 F.2d 434 (2d Cir. 1943), in which a broker-dealer was deemed to have violated the law by overcharging customers (by as much as 40% over market prices). The shingle theory has primarily focused on the pricing of securities, and limits the so-called "markup" a broker-dealer may charge a client. A more recent decision in this vein is SEC v. First Jersey Securities, Inc., 101 F.3d 1450 (2d Cir. 1996). In other words, the shingle theory isn't just a disclosure theory; it has substantive effect, limiting the pricing latitude of broker-dealers in the over-the-counter market. Although the SEC's case against Goldman isn't about prices, the shingle theory's premise--that a broker-dealer has a duty of fair dealing--provides support for the SEC's position that in an opaque market like the CDO market, Goldman isn't a mere intermediary, but has an obligation of fair dealing.
Another foundational case is United States v. Simon, 425 F.2d 796 (2d Cir. 1969). The president of a company called Continental Vending Machine Corporation borrowed a lot of the company's money in order to play the go-go stock market of the 1960s. He did not reveal to shareholders his use of the company's funds as a personal piggy bank, instead routing the funds through a corporation he controlled so that Continental's records did not show he was the true recipient of the money. The stock market of the 60s was every bit as volatile as today's stock markets, and the president's personal investments belly flopped. He had no other means to repay the loans and Continental was left insolvent. The way the president siphoned off the money allowed the company, under the accounting rules prevailing at the time, to present its financial condition as solid. Defendant Simon, an accountant who audited Continental's financial statements, knew of the president's hidden loans but didn't reveal them when he certified Continental's financial statements. Even though the company's financials complied with the applicable accounting rules, the court nevertheless held Simon criminally liable for his silence. It observed that " . . . it simply cannot be true that an accountant is under no duty to disclose what he knows when he has reason to believe that, to a material extent, a corporation is being operated not to carry out its business in the interest of all the stockholders but for the private benefit of its president." It described Simon's certification of Continental's financials as a "snare and a delusion." Thus, Simon, the auditor, was held to be a crook because he didn't disclose how the president had secretly ruined the company, even though the company had followed the accounting rules. In plain English, complying with the stated rules isn't enough when there's a larger truth that remains undisclosed.
Of course, there are differences between the roles of auditors and broker-dealers. But both serve as gatekeepers to the securities markets. Without auditors willing to certify their financial statements, companies could not go public. Without a broker-dealer willing to put together ABACUS 2007-AC1, John Paulson wouldn't have had an opportunity to take the short side of its collateral pool. He paid Goldman $15 million to put the deal together and played a large de facto role in choosing the collateral. Goldman evidently thought that the selection of the collateral had to appear objective to investors--the SEC complaint alleges that Goldman was very particular that ACA was necessary as the collateral manager to make the deal appear on the up and up. ACA wanted to know what Paulson's role was, and, according to the SEC, Goldman slyly implied that Paulson would take an equity position on the long side of the deal instead of revealing that Paulson was looking for a shorting opportunity. In essence, the SEC alleges that Goldman tricked ACA into acting as the collateral agent.
U.S. v. Simon indicates that even if Goldman made extensive disclosures to the investors, the fact that it did not reveal the larger picture of Paulson's role might have been improper. The SEC's allegations that Goldman made affirmative statements that misled ACA or investors would, if true, only compound Goldman's litigation risks, since they imply Goldman intentionally painted a false picture.
As to intentions, the SEC has an advantage. It charged Goldman and Fabrice Tourre with violations of Section 17(a) of the Securities Act of 1933, as well as violations of the SEC's all-purpose, utility infielder antifraud rule, 10b-5. To prove a violation of Rule 10b-5, the SEC must establish that Goldman and Tourre acted with scienter, a legal term for bad intent. The need to prove bad intent can sometimes be a challenge, depending on the facts of the case (although there seem to be colorful e-mails in the SEC's possession that will give it a shot at proving scienter in this case). Section 17(a) violations, however, can sometimes be established without the SEC having to prove any bad intent. See Aaron v. SEC, 446 U.S. 680 (1980). Even if the SEC cannot prove that Goldman and Tourre had bad intent, they may still found liable for securities fraud.
There is a thread in the SEC's Complaint indicating that Goldman itself believed that the mortgage market was, at the time it marketed ABACUS 2007-AC1, likely to tank. The facts here don't seem as extreme as those in the SEC's 2003 case against various underwriters for selling stocks that the brokers themselves thought were lousy investments. See the SEC's press release on April 28, 2003 (http://www.sec.gov/news/press/2003-54.htm). Goldman apparently didn't formally recommended ABACUS 2007-AC1. But if it is true that Goldman was negative on the mortgage market while selling the deal to long side investors, that would only add to the aura of cynical sleaze.
The case appears to be the SEC's effort to deal with the reality of the derivatives markets. These markets, circa 2007 when ABACUS 2007-AC1 was constructed and marketed, were understood in depth by only a small circle of cognoscenti, and perhaps not even all of them. The SEC alleges that Tourre in one e-mail referred [in translation] to " . . . standing in the middle of all these complex, highly leveraged, exotic trades he [i.e., Tourre] created without necessarily understanding all of the implications of those monstruosities [sic]!!!" (As an aside, Tourre could have legal liability if he marketed investments he didn't understand because brokers are supposed to understand the products they peddle to clients.) Most investors in this market likely relied, to varying degrees, on the perceived interests and reputations for integrity of the parties in the picture. However skillful and knowledgeable money managers and corporate treasurers may be, the fact is that detailed information about the esoterica of the derivatives market would not have necessarily been available to them, if only because they might not have even known what questions to ask. Thus, they would have been interested in the identities and roles of relevant players.
Remember, Bear Stearns and Lehman were sophisticated but they failed. Merrill Lynch and WaMu were sophisticated but they had to be sold in distressed circumstances. AIG was sophisticated, but it blew itself up. Even Fannie Mae and Freddie Mac were pretty sophisticated, but they are now wards of the state. Sophistication is no substitute for specific information. Lots of very intelligent people buy a stock because Warren Buffett bought the stock. Few would short it. And those decisions would be made without a whole lot of reference to the stock's "objective" merits. If you were a derivatives investor and learned that John Paulson was a de facto short side co-venturer with Goldman in ABACUS 2007-AC1, you might well have accidentally dropped the phone if Fab Tourre tried to pitch you the long side of the deal. Certainly, there are some people who wish they had.
A central theme of the securities laws is disclosure--public companies, broker-dealers, mutual funds and a variety of other players are required to make disclosures prescribed by SEC rules. These disclosures can sometimes be extensive, and Goldman claims to have made extensive disclosures to its customers. The interests in the synthetic CDO in question (ABACUS 2007-AC1) were privately sold and it's unclear what disclosures were actually made. But Goldman claims that the investors pretty much knew what mortgage-backed securities the CDO would be based on and that an independent agent, ACA, selected those MBSs. It contends that the investors were sophisticated and able to decide for themselves how risky these investments were.
The SEC's case is that, however much Goldman may have spoken in its disclosures, it didn't speak the complete truth. Part of the SEC's version of the truth would be that John Paulson & Co. had a large role in the selection of the collateral, that Goldman slyly cultivated a contrary impression in the minds of investors, and that investors knowing the reality of Paulson's involvement would have been reluctant to buy the long side of the transaction.
The SEC's case appears to hark back to the 1930s, 40s, 50s and 60s, a foundational period of time in which the broad contours of the securities laws were shaped. This was a time when knowledge of investments and the financial markets was much more tightly held than is the case today. There was no Internet, no electronic trading systems and no electronic reporting of securities transactions (except the legendary but not terribly informative ticker tape, which was simply a very long telegram). Many stocks and bonds were traded by telephone, or in face-to-face transactions at bank counters (hence the term, "over-the-counter"). Investors relied heavily on financial professionals to deal fairly and squarely with them, because they had few, if any, other sources of information. When you think it about, it's similar to today's derivatives market.
It is axiomatic that the more opaque a market is, the easier it is to sell snake oil. The snake oil business was vibrant in the financial markets of the 1930s, with investors snake bit early and often. The SEC developed a doctrine of law called the "shingle theory." This theory postulates that when a broker-dealer hangs out its shingle to do business, it impliedly represents that it will deal fairly with its customers. An early decision affirming this theory is Charles Hughes & Co. v. SEC, 139 F.2d 434 (2d Cir. 1943), in which a broker-dealer was deemed to have violated the law by overcharging customers (by as much as 40% over market prices). The shingle theory has primarily focused on the pricing of securities, and limits the so-called "markup" a broker-dealer may charge a client. A more recent decision in this vein is SEC v. First Jersey Securities, Inc., 101 F.3d 1450 (2d Cir. 1996). In other words, the shingle theory isn't just a disclosure theory; it has substantive effect, limiting the pricing latitude of broker-dealers in the over-the-counter market. Although the SEC's case against Goldman isn't about prices, the shingle theory's premise--that a broker-dealer has a duty of fair dealing--provides support for the SEC's position that in an opaque market like the CDO market, Goldman isn't a mere intermediary, but has an obligation of fair dealing.
Another foundational case is United States v. Simon, 425 F.2d 796 (2d Cir. 1969). The president of a company called Continental Vending Machine Corporation borrowed a lot of the company's money in order to play the go-go stock market of the 1960s. He did not reveal to shareholders his use of the company's funds as a personal piggy bank, instead routing the funds through a corporation he controlled so that Continental's records did not show he was the true recipient of the money. The stock market of the 60s was every bit as volatile as today's stock markets, and the president's personal investments belly flopped. He had no other means to repay the loans and Continental was left insolvent. The way the president siphoned off the money allowed the company, under the accounting rules prevailing at the time, to present its financial condition as solid. Defendant Simon, an accountant who audited Continental's financial statements, knew of the president's hidden loans but didn't reveal them when he certified Continental's financial statements. Even though the company's financials complied with the applicable accounting rules, the court nevertheless held Simon criminally liable for his silence. It observed that " . . . it simply cannot be true that an accountant is under no duty to disclose what he knows when he has reason to believe that, to a material extent, a corporation is being operated not to carry out its business in the interest of all the stockholders but for the private benefit of its president." It described Simon's certification of Continental's financials as a "snare and a delusion." Thus, Simon, the auditor, was held to be a crook because he didn't disclose how the president had secretly ruined the company, even though the company had followed the accounting rules. In plain English, complying with the stated rules isn't enough when there's a larger truth that remains undisclosed.
Of course, there are differences between the roles of auditors and broker-dealers. But both serve as gatekeepers to the securities markets. Without auditors willing to certify their financial statements, companies could not go public. Without a broker-dealer willing to put together ABACUS 2007-AC1, John Paulson wouldn't have had an opportunity to take the short side of its collateral pool. He paid Goldman $15 million to put the deal together and played a large de facto role in choosing the collateral. Goldman evidently thought that the selection of the collateral had to appear objective to investors--the SEC complaint alleges that Goldman was very particular that ACA was necessary as the collateral manager to make the deal appear on the up and up. ACA wanted to know what Paulson's role was, and, according to the SEC, Goldman slyly implied that Paulson would take an equity position on the long side of the deal instead of revealing that Paulson was looking for a shorting opportunity. In essence, the SEC alleges that Goldman tricked ACA into acting as the collateral agent.
U.S. v. Simon indicates that even if Goldman made extensive disclosures to the investors, the fact that it did not reveal the larger picture of Paulson's role might have been improper. The SEC's allegations that Goldman made affirmative statements that misled ACA or investors would, if true, only compound Goldman's litigation risks, since they imply Goldman intentionally painted a false picture.
As to intentions, the SEC has an advantage. It charged Goldman and Fabrice Tourre with violations of Section 17(a) of the Securities Act of 1933, as well as violations of the SEC's all-purpose, utility infielder antifraud rule, 10b-5. To prove a violation of Rule 10b-5, the SEC must establish that Goldman and Tourre acted with scienter, a legal term for bad intent. The need to prove bad intent can sometimes be a challenge, depending on the facts of the case (although there seem to be colorful e-mails in the SEC's possession that will give it a shot at proving scienter in this case). Section 17(a) violations, however, can sometimes be established without the SEC having to prove any bad intent. See Aaron v. SEC, 446 U.S. 680 (1980). Even if the SEC cannot prove that Goldman and Tourre had bad intent, they may still found liable for securities fraud.
There is a thread in the SEC's Complaint indicating that Goldman itself believed that the mortgage market was, at the time it marketed ABACUS 2007-AC1, likely to tank. The facts here don't seem as extreme as those in the SEC's 2003 case against various underwriters for selling stocks that the brokers themselves thought were lousy investments. See the SEC's press release on April 28, 2003 (http://www.sec.gov/news/press/2003-54.htm). Goldman apparently didn't formally recommended ABACUS 2007-AC1. But if it is true that Goldman was negative on the mortgage market while selling the deal to long side investors, that would only add to the aura of cynical sleaze.
The case appears to be the SEC's effort to deal with the reality of the derivatives markets. These markets, circa 2007 when ABACUS 2007-AC1 was constructed and marketed, were understood in depth by only a small circle of cognoscenti, and perhaps not even all of them. The SEC alleges that Tourre in one e-mail referred [in translation] to " . . . standing in the middle of all these complex, highly leveraged, exotic trades he [i.e., Tourre] created without necessarily understanding all of the implications of those monstruosities [sic]!!!" (As an aside, Tourre could have legal liability if he marketed investments he didn't understand because brokers are supposed to understand the products they peddle to clients.) Most investors in this market likely relied, to varying degrees, on the perceived interests and reputations for integrity of the parties in the picture. However skillful and knowledgeable money managers and corporate treasurers may be, the fact is that detailed information about the esoterica of the derivatives market would not have necessarily been available to them, if only because they might not have even known what questions to ask. Thus, they would have been interested in the identities and roles of relevant players.
Remember, Bear Stearns and Lehman were sophisticated but they failed. Merrill Lynch and WaMu were sophisticated but they had to be sold in distressed circumstances. AIG was sophisticated, but it blew itself up. Even Fannie Mae and Freddie Mac were pretty sophisticated, but they are now wards of the state. Sophistication is no substitute for specific information. Lots of very intelligent people buy a stock because Warren Buffett bought the stock. Few would short it. And those decisions would be made without a whole lot of reference to the stock's "objective" merits. If you were a derivatives investor and learned that John Paulson was a de facto short side co-venturer with Goldman in ABACUS 2007-AC1, you might well have accidentally dropped the phone if Fab Tourre tried to pitch you the long side of the deal. Certainly, there are some people who wish they had.
Sunday, April 18, 2010
SEC v. Goldman Sachs: Betting the Ranch
The New York Times reports that the SEC didn't give Goldman Sachs a chance to discuss settlement before filing its fraud case on Friday (4/16/10). http://www.nytimes.com/2010/04/19/business/19sec.html?src=busln. The SEC had notified Goldman last year that it might face charges, the Times reports, but Goldman didn't find out about Friday's lawsuit until after it was filed.
The SEC's normal procedure is to discuss settling before filing an enforcement action. Those discussions usually lead to settlement. Why would this time have been different? We don't have any inside information from either side. But here's our guess.
It's likely there were settlement talks of an informal nature before the case was filed. The notice last year that the SEC might bring charges was probably a so-called Wells notice, which gives persons that the SEC staff is thinking ought to be subjects of an enforcement action an opportunity to present their views before the Commissioners make a final decision. It almost always happens that the SEC staff and the potential defendants informally discuss the possibility of settlement at the Wells stage. There could have been an exchange of views between the SEC staff and Goldman in which Goldman indicated it would settle for a nonfraud charge if no individual Goldman employees were sued and if it didn't have to pay a painfully large amount of money. The SEC staff, however, may have made it clear that it would not recommend to the Commissioners any settlement that didn't include fraud charges, while reserving the right to pursue individuals (as the Commission in fact did on Friday). The Commissioners would have been informed, one way or another, of any settlement positions offered by Goldman. But if they agreed that the evidence required a fraud charge, they may well have authorized the staff to file the case promptly instead of engaging in fruitless attempts to persuade Goldman to accept fraud charges that Goldman had already rejected.
One indication that Goldman wasn't caught terribly off guard is the fact that, within hours after the lawsuit was filed, it began issuing public denials of certain factual assertions made by the SEC. Making those public denials is risky from a litigation standpoint, because those statements could be used as evidence against Goldman in the future. Many defense lawyers would recommend against such detailed denials except perhaps in court pleadings. That Goldman could pump out these factual assertions so quickly after supposedly being surprised by a lawsuit indicates that it probably was prepared for a battle, even if it didn't know the exact time of the opening bombardment.
The SEC did gain an advantage by filing without formal settlement talks. It was able to write the charging document (called the complaint) the way it thought was appropriate. Complaints filed in settled cases are meticulously negotiated by defense lawyers who try to make the charges appear as milquetoasty apologies by the SEC for having the temerity to disturb the tranquility of the defendants. This time, the complaint unequivocally charged the defendants with fraud.
The SEC's assertiveness tilts the playing field against Goldman in a number of ways. The principal victims in this case were European banks. European governments are making noise about investigating Goldman and recovering from it the losses their banks sustained. Investors on the losing end of other Goldman derivatives transactions are no doubt reviewing their files and reliving their losses in an effort to ascertain if they, too, can recover. Class action lawsuits by Goldman shareholders may be filed, as its stock has taken a beating. The SEC is probably investigating other deals that may be connected to Goldman, and further enforcement actions would be in the works. State regulators whose municipalities took losses in Goldman deals may become emboldened. In this vein, the case against Goldman may be the first since the Before Spitzer era that the SEC has upstaged the Attorney General of New York. It's not beyond the realm of possibility that the NY AG's office will be looking to run with the new big dog in the neighborhood.
On the regulatory reform front, this case strengthens arguments for major change in the derivatives markets. Even if Goldman and other Wall Street banks continue their furious lobbying offensive in Washington, they have probably lost some traction in Washington, and also in Europe, where the impetus for change was already great. It's one thing to argue that honest businesses shouldn't be burdened by costly and unnecessary rules. It's another to be an accused fraudster saying more regulation would be bad. The dynamics of regulatory reform are shifting.
Worst of all for Goldman, the U.S. Department of Justice may come under pressure to act. A criminal charge would be the worst possible development for Goldman. Financial firms never--repeat, never--survive federal criminal charges. Think of E.F. Hutton and Drexel Burnham Lambert. Younger readers may not recognize those firms because they were major investment banks that were criminally charged years ago and didn't survive. A civil fraud charge, such as the SEC filed, can fairly readily be crafted into criminal charges if the evidence is strong enough.
It's doubtful that DOJ has enough for criminal charges at the moment (or else it would have acted, too). But the individual defendant, Fabrice Tourre, will surely come under pressure to settle and become a cooperating witness for the government. The fact that he now lives in the UK and a British bank (Royal Bank of Scotland) wound up holding close to a billion dollars of the losses in this case, may prompt the British government to start clearing its throat in Mr. Tourre's direction. If Tourre does settle and cooperate, he perhaps could provide the government with details it doesn't yet have and point the finger up the chain of command. Tourre need not testify in the SEC's case because of his Fifth Amendment right against self-incrimination. But in a civil lawsuit such as the SEC's, a defendant's assertion of the Fifth can be used as evidence against him (yes, seriously, the courts have said so; the privilege against self-incrimination protects a defendant only in criminal prosecutions). So Tourre may hurt himself in the SEC case if he takes Five. But if he talks, he will have to answer tough questions about some e-mails and other documents that don't exactly cover him with glory. He might be damned if he does and damned if he doesn't. Defendants in that situation sometimes cut deals with the government.
This is a must-win case for the SEC. After years of horrendously bad publicity for a proud agency with a renowned heritage, the Commission marks a turning point by filing this case--but only if it wins or gets a good settlement. As much as it ever has, the SEC is betting the ranch. But it's done that before and prevailed. The SEC case against Michael Milken and Drexel Burnham Lambert in the 1980s was comparable. Drexel was perhaps the most powerful investment bank of the day and Milken was unequivocally its most powerful employee. Milken and Drexel fought tooth and nail, employing an army of defense lawyers that may have outnumbered the government's team by a ratio of 10 to 1. Most of the government lawyers were in their late 20s or early 30s. But they cared--tremendously--and the government (SEC and DOJ) carried the day, primarily by building a strong body of evidence. Both Drexel and Milken eventually settled, agreeing to criminal and civil charges. Don't sell the SEC short just because 18 months ago it was in the ICU. The staff working on this case are not the SEC's Madoff team, and Goldman's management and lawyers could be in for a surprise if they're banking on the presumed incompetence of their adversaries.
Goldman, too, is betting the ranch. We presume that at some point in its dialogue with the SEC staff it rejected the possibility of settling to fraud charges. Now, that position, assuming it is Goldman's position, is being put to the test. The only thing worse than agreeing to a fraud charge is being found liable for fraud after a trial. Goldman's only good outcome would be to go to trial and win. Perhaps it will. But will its management want to risk going to trial? If Goldman loses, the floodgates will opened for plaintiffs lawyers, state regulators and attorneys general, European regulators, and perhaps other claimants. And even if Goldman litigates this case for years, what about Goldman's other derivatives deals that went sour? They'll all now be assiduously scrutinized by armies of potential claimants. Fighting the SEC could be tantamount to manning the Maginot Line, while swarms of other claimants outflank Goldman from the left and the right.
Corporations generally don't like to litigate with federal regulators because the risks of losing usually outweigh the gains from winning. And the SEC, as painful as a loss could be in this case, has less to lose than Goldman. Goldman's top executives were once traders, where everything they did involved a deal. In a deal, you give up something to get something else. No doubt they will think about a deal. The terms for settlement are likely to be unpalatable at best. But what will Goldman's alternative be? Years of litigation and the accompanying uncertainty while competitors try to woo away its clients? Losses totaling many millions, and perhaps even billions in the end? A downside of doing leveraged deals is that if they become legal problems, the leverage works against you.
One thing to watch for is Goldman's earnings announcement on Tuesday, April 20, 2010. What will it say about the SEC case? What impact will the SEC case have on Goldman's litigation reserves? It's possible Goldman will delay its earnings announcement while it sorts out the fallout from the lawsuit. But these questions will remain whenever Goldman speaks.
The SEC's normal procedure is to discuss settling before filing an enforcement action. Those discussions usually lead to settlement. Why would this time have been different? We don't have any inside information from either side. But here's our guess.
It's likely there were settlement talks of an informal nature before the case was filed. The notice last year that the SEC might bring charges was probably a so-called Wells notice, which gives persons that the SEC staff is thinking ought to be subjects of an enforcement action an opportunity to present their views before the Commissioners make a final decision. It almost always happens that the SEC staff and the potential defendants informally discuss the possibility of settlement at the Wells stage. There could have been an exchange of views between the SEC staff and Goldman in which Goldman indicated it would settle for a nonfraud charge if no individual Goldman employees were sued and if it didn't have to pay a painfully large amount of money. The SEC staff, however, may have made it clear that it would not recommend to the Commissioners any settlement that didn't include fraud charges, while reserving the right to pursue individuals (as the Commission in fact did on Friday). The Commissioners would have been informed, one way or another, of any settlement positions offered by Goldman. But if they agreed that the evidence required a fraud charge, they may well have authorized the staff to file the case promptly instead of engaging in fruitless attempts to persuade Goldman to accept fraud charges that Goldman had already rejected.
One indication that Goldman wasn't caught terribly off guard is the fact that, within hours after the lawsuit was filed, it began issuing public denials of certain factual assertions made by the SEC. Making those public denials is risky from a litigation standpoint, because those statements could be used as evidence against Goldman in the future. Many defense lawyers would recommend against such detailed denials except perhaps in court pleadings. That Goldman could pump out these factual assertions so quickly after supposedly being surprised by a lawsuit indicates that it probably was prepared for a battle, even if it didn't know the exact time of the opening bombardment.
The SEC did gain an advantage by filing without formal settlement talks. It was able to write the charging document (called the complaint) the way it thought was appropriate. Complaints filed in settled cases are meticulously negotiated by defense lawyers who try to make the charges appear as milquetoasty apologies by the SEC for having the temerity to disturb the tranquility of the defendants. This time, the complaint unequivocally charged the defendants with fraud.
The SEC's assertiveness tilts the playing field against Goldman in a number of ways. The principal victims in this case were European banks. European governments are making noise about investigating Goldman and recovering from it the losses their banks sustained. Investors on the losing end of other Goldman derivatives transactions are no doubt reviewing their files and reliving their losses in an effort to ascertain if they, too, can recover. Class action lawsuits by Goldman shareholders may be filed, as its stock has taken a beating. The SEC is probably investigating other deals that may be connected to Goldman, and further enforcement actions would be in the works. State regulators whose municipalities took losses in Goldman deals may become emboldened. In this vein, the case against Goldman may be the first since the Before Spitzer era that the SEC has upstaged the Attorney General of New York. It's not beyond the realm of possibility that the NY AG's office will be looking to run with the new big dog in the neighborhood.
On the regulatory reform front, this case strengthens arguments for major change in the derivatives markets. Even if Goldman and other Wall Street banks continue their furious lobbying offensive in Washington, they have probably lost some traction in Washington, and also in Europe, where the impetus for change was already great. It's one thing to argue that honest businesses shouldn't be burdened by costly and unnecessary rules. It's another to be an accused fraudster saying more regulation would be bad. The dynamics of regulatory reform are shifting.
Worst of all for Goldman, the U.S. Department of Justice may come under pressure to act. A criminal charge would be the worst possible development for Goldman. Financial firms never--repeat, never--survive federal criminal charges. Think of E.F. Hutton and Drexel Burnham Lambert. Younger readers may not recognize those firms because they were major investment banks that were criminally charged years ago and didn't survive. A civil fraud charge, such as the SEC filed, can fairly readily be crafted into criminal charges if the evidence is strong enough.
It's doubtful that DOJ has enough for criminal charges at the moment (or else it would have acted, too). But the individual defendant, Fabrice Tourre, will surely come under pressure to settle and become a cooperating witness for the government. The fact that he now lives in the UK and a British bank (Royal Bank of Scotland) wound up holding close to a billion dollars of the losses in this case, may prompt the British government to start clearing its throat in Mr. Tourre's direction. If Tourre does settle and cooperate, he perhaps could provide the government with details it doesn't yet have and point the finger up the chain of command. Tourre need not testify in the SEC's case because of his Fifth Amendment right against self-incrimination. But in a civil lawsuit such as the SEC's, a defendant's assertion of the Fifth can be used as evidence against him (yes, seriously, the courts have said so; the privilege against self-incrimination protects a defendant only in criminal prosecutions). So Tourre may hurt himself in the SEC case if he takes Five. But if he talks, he will have to answer tough questions about some e-mails and other documents that don't exactly cover him with glory. He might be damned if he does and damned if he doesn't. Defendants in that situation sometimes cut deals with the government.
This is a must-win case for the SEC. After years of horrendously bad publicity for a proud agency with a renowned heritage, the Commission marks a turning point by filing this case--but only if it wins or gets a good settlement. As much as it ever has, the SEC is betting the ranch. But it's done that before and prevailed. The SEC case against Michael Milken and Drexel Burnham Lambert in the 1980s was comparable. Drexel was perhaps the most powerful investment bank of the day and Milken was unequivocally its most powerful employee. Milken and Drexel fought tooth and nail, employing an army of defense lawyers that may have outnumbered the government's team by a ratio of 10 to 1. Most of the government lawyers were in their late 20s or early 30s. But they cared--tremendously--and the government (SEC and DOJ) carried the day, primarily by building a strong body of evidence. Both Drexel and Milken eventually settled, agreeing to criminal and civil charges. Don't sell the SEC short just because 18 months ago it was in the ICU. The staff working on this case are not the SEC's Madoff team, and Goldman's management and lawyers could be in for a surprise if they're banking on the presumed incompetence of their adversaries.
Goldman, too, is betting the ranch. We presume that at some point in its dialogue with the SEC staff it rejected the possibility of settling to fraud charges. Now, that position, assuming it is Goldman's position, is being put to the test. The only thing worse than agreeing to a fraud charge is being found liable for fraud after a trial. Goldman's only good outcome would be to go to trial and win. Perhaps it will. But will its management want to risk going to trial? If Goldman loses, the floodgates will opened for plaintiffs lawyers, state regulators and attorneys general, European regulators, and perhaps other claimants. And even if Goldman litigates this case for years, what about Goldman's other derivatives deals that went sour? They'll all now be assiduously scrutinized by armies of potential claimants. Fighting the SEC could be tantamount to manning the Maginot Line, while swarms of other claimants outflank Goldman from the left and the right.
Corporations generally don't like to litigate with federal regulators because the risks of losing usually outweigh the gains from winning. And the SEC, as painful as a loss could be in this case, has less to lose than Goldman. Goldman's top executives were once traders, where everything they did involved a deal. In a deal, you give up something to get something else. No doubt they will think about a deal. The terms for settlement are likely to be unpalatable at best. But what will Goldman's alternative be? Years of litigation and the accompanying uncertainty while competitors try to woo away its clients? Losses totaling many millions, and perhaps even billions in the end? A downside of doing leveraged deals is that if they become legal problems, the leverage works against you.
One thing to watch for is Goldman's earnings announcement on Tuesday, April 20, 2010. What will it say about the SEC case? What impact will the SEC case have on Goldman's litigation reserves? It's possible Goldman will delay its earnings announcement while it sorts out the fallout from the lawsuit. But these questions will remain whenever Goldman speaks.
Friday, April 16, 2010
The SEC's Case: Goldman, Too, Danced to the Music
Today's enforcement case by the SEC against Goldman Sachs for allegedly making misrepresentations in the marketing of a synthetic CDO called ABACUS 2007-AC1 signifies many things. Goldman hasn't formally responded in court, but has denied certain assertions by the SEC. We won't attempt to predict the legal outcome at this early stage. But a few observations seem fair.
First, the case signals a return by the SEC and its Division of Enforcement to the big leagues, after a painful stint in Triple A. The agency will be on the front pages of newspapers tomorrow--this time in a positive light. Of course, the SEC needs to get a good result--victory at trial or a favorable settlement. But its willingness to take on the most imperious doyenne on Wall Street--which couldn't even get its CEO on the train from New York to Washington for a meeting with the President late last year (are they now rethinking that one?)--reflects pugnaciousness badly needed in the regulatory structure.
Second, the case will strengthen the movement toward reforming financial regulation, with a special nod in favor of the Volcker rule--there's really no good reason for insured deposits to subsidize this sort of behavior. Additionally, the two principal victims were European banks. The SEC charges will only fuel the already robust movement in Europe to rein in the Wild West antics of the derivatives markets--in part because the case broadly echoes Goldman's reported role in helping Greece pretty up its balance sheet, thus effectively increasing Greece's risk of overextending itself, and then creating a trading vehicle in London to short sell Greece.
Third, regardless of whether or not Goldman is legally liable, one has to wonder what on earth Goldman's management was thinking when they signed off on this deal? By early 2007, when the deal was done, Goldman was aware of the growing weakness in the mortgage markets. Certain e-mails were quoted in the SEC's complaint which make that clear and Goldman hasn't denied the contents of the e-mails. When a bank knows a market is poised for problems, why structure a deal that involves selling long positions in that market? Surely there are less problematic ways to make money. Goldman made $15 million in fees for structuring this deal (although it claims to have lost $90 million in the end). It could pay out a lot more than $15 million to injured investors if it loses at trial. And even if it turns out that Goldman didn't break any rules, why would it have benefited from putting clients in a position of significant potential for loss? These weren't dot com IPOs. These were interests in mortgages, supposedly a pretty safe investment. Clients would reasonably have expected that they wouldn't be put at major risk by a silk stocking firm like Goldman when they were looking for comparative safety.
The old Goldman Sachs (primarily, the firm before it went public), had a strong sense of self-awareness and propriety, turning away from many deals and their potential fees simply because they would have been too risky for clients and therefore too risky to Goldman's reputation and standing. Today's Goldman seems to have lost that sense of judgment and moderation.
What may have really been going on, we speculate, could be that Goldman wanted the fees. Although $15 million isn't much for an investment bank that makes billions a year, it is a lot to individual Goldman executives, like the man who was named as a defendant by the SEC, Fabrice Tourre. Tourre, alleged to be 31 today, was in 2007 exactly at the young age where ambitious investment bankers push extremely hard to climb the career ladder toward anticipated stardom--old enough to have significant responsibility and latitude, but frequently not enough experience to know that cents and sense--especially common sense--are very different things. Young, high powered execs will push, push, and push their deals because they're focused on bonus time. But a mature financial institution can't just knuckle under to its young guns. In a highly visible and highly regulated industry like financial services, how you generate revenues matters as much as how much you generate. Chuck Prince, former CEO of Citigroup, famously said (and we paraphrase) that as long as the music in the mortgage markets was playing, Citigroup had to get up and dance. It did, and it got clobbered. Now we have Goldman, by early 2007 seemingly aware of the growing difficulties in the mortgage markets, yet also wanting to dance while the music was playing.
The nightly cleaning crews at Goldman's offices surely earn modest wages. But those are honest wages earned in exchange for a fair night's work. With today's allegations about ABACUS 2007-AC1, we have Goldman, which has tried for decades to present itself as a cut above all those scumbags on Wall Street, not comparing well to its cleaning staff. Goldman was supposed to be smarter, a protector of clients' interests, a firm that took the long view and would forgo current income for the sake of propriety. Its elite, blue blood aura provided special entree in Washington, as well as on Main Street. People thought of Goldman as clever, very quick on its feet, highly profitable, yet thoughtful before it was greedy. That bubble has now burst, and GS is revealed to have feet of clay. On one level, that's reassuring, but on many others, it's not. Expect financial regulatory reform legislation to be enacted by the mid-term elections.
First, the case signals a return by the SEC and its Division of Enforcement to the big leagues, after a painful stint in Triple A. The agency will be on the front pages of newspapers tomorrow--this time in a positive light. Of course, the SEC needs to get a good result--victory at trial or a favorable settlement. But its willingness to take on the most imperious doyenne on Wall Street--which couldn't even get its CEO on the train from New York to Washington for a meeting with the President late last year (are they now rethinking that one?)--reflects pugnaciousness badly needed in the regulatory structure.
Second, the case will strengthen the movement toward reforming financial regulation, with a special nod in favor of the Volcker rule--there's really no good reason for insured deposits to subsidize this sort of behavior. Additionally, the two principal victims were European banks. The SEC charges will only fuel the already robust movement in Europe to rein in the Wild West antics of the derivatives markets--in part because the case broadly echoes Goldman's reported role in helping Greece pretty up its balance sheet, thus effectively increasing Greece's risk of overextending itself, and then creating a trading vehicle in London to short sell Greece.
Third, regardless of whether or not Goldman is legally liable, one has to wonder what on earth Goldman's management was thinking when they signed off on this deal? By early 2007, when the deal was done, Goldman was aware of the growing weakness in the mortgage markets. Certain e-mails were quoted in the SEC's complaint which make that clear and Goldman hasn't denied the contents of the e-mails. When a bank knows a market is poised for problems, why structure a deal that involves selling long positions in that market? Surely there are less problematic ways to make money. Goldman made $15 million in fees for structuring this deal (although it claims to have lost $90 million in the end). It could pay out a lot more than $15 million to injured investors if it loses at trial. And even if it turns out that Goldman didn't break any rules, why would it have benefited from putting clients in a position of significant potential for loss? These weren't dot com IPOs. These were interests in mortgages, supposedly a pretty safe investment. Clients would reasonably have expected that they wouldn't be put at major risk by a silk stocking firm like Goldman when they were looking for comparative safety.
The old Goldman Sachs (primarily, the firm before it went public), had a strong sense of self-awareness and propriety, turning away from many deals and their potential fees simply because they would have been too risky for clients and therefore too risky to Goldman's reputation and standing. Today's Goldman seems to have lost that sense of judgment and moderation.
What may have really been going on, we speculate, could be that Goldman wanted the fees. Although $15 million isn't much for an investment bank that makes billions a year, it is a lot to individual Goldman executives, like the man who was named as a defendant by the SEC, Fabrice Tourre. Tourre, alleged to be 31 today, was in 2007 exactly at the young age where ambitious investment bankers push extremely hard to climb the career ladder toward anticipated stardom--old enough to have significant responsibility and latitude, but frequently not enough experience to know that cents and sense--especially common sense--are very different things. Young, high powered execs will push, push, and push their deals because they're focused on bonus time. But a mature financial institution can't just knuckle under to its young guns. In a highly visible and highly regulated industry like financial services, how you generate revenues matters as much as how much you generate. Chuck Prince, former CEO of Citigroup, famously said (and we paraphrase) that as long as the music in the mortgage markets was playing, Citigroup had to get up and dance. It did, and it got clobbered. Now we have Goldman, by early 2007 seemingly aware of the growing difficulties in the mortgage markets, yet also wanting to dance while the music was playing.
The nightly cleaning crews at Goldman's offices surely earn modest wages. But those are honest wages earned in exchange for a fair night's work. With today's allegations about ABACUS 2007-AC1, we have Goldman, which has tried for decades to present itself as a cut above all those scumbags on Wall Street, not comparing well to its cleaning staff. Goldman was supposed to be smarter, a protector of clients' interests, a firm that took the long view and would forgo current income for the sake of propriety. Its elite, blue blood aura provided special entree in Washington, as well as on Main Street. People thought of Goldman as clever, very quick on its feet, highly profitable, yet thoughtful before it was greedy. That bubble has now burst, and GS is revealed to have feet of clay. On one level, that's reassuring, but on many others, it's not. Expect financial regulatory reform legislation to be enacted by the mid-term elections.
Wednesday, April 14, 2010
Mortgage Relief: the Principal Writedown Illusion
Both the Bush and Obama administrations have pursued the idea of writedowns of the principal balances of defaulting mortgages as a way of furnishing distressed homeowners relief. About 25% of all mortgages are now underwater. In spite of well over a year of effort, something like a few hundreds of thousands of borrowers, at most, out of the millions in trouble, have received permanent principal writedowns. They may be the most effective way to help struggling owners stay in their homes. They reduce payments to a level that will, long term, hopefully be manageable. At the same time, they keep houses off the foreclosure market, thereby reducing downward pressure on housing prices. If housing prices keep declining, the number of homeowners underwater on their mortgages will increase, thereby producing more pressure to default and repeat the downward cycle. Why, then, have principal writedowns been so strongly resisted by banks?
Here's our take. Fairness isn't the issue. Principal writedowns are unfair, benefiting in many cases the reckless and irresponsible at the expense of the conscientious and taxpaying. But the big banks don't give a rat's big toe about fairness (they didn't seem to have a problem taking a multi-trillion dollar bailout when their survival was on the line). The problem is that they can't dump the bulk of the costs of principal writedowns onto the federal government.
If banks were today to write down all underwater mortgages to the market value of the homes, they'd have to book losses somewhere around $600 billion (with perhaps a couple hundred billion more for federal agencies like Fannie Mae, Freddie Mac and the FHA). The Tier 1 capital (a commonly used measure of bank capital) of the 20 largest banks in the U.S. (which among banks hold the most mortgage assets) is probably in the range of $900 billion. Comprehensive principal writedowns could reduce Tier 1 capital by hundreds of billions and require a major recapitalization binge. The banks' existing shareholders would be displeased, to say the least. In addition, the federal government and the ever accommodative federal taxpayers would probably have to prop the banks up as they returned to the capital markets.
While not every underwater homeowner would seek a principal writedown, the attractiveness of the proposition would likely motivate a lot of people who aren't currently in default to volunteer for a bum's rush out of part of their monthly payments. After all, why pay full freight when the neighbor across street gets a break and comes up with enough cash for an annual vacation? You may recognize the moral ambiguity of not paying a loan you voluntarily undertook. But what will you say when the kids across the street can suddenly afford summer internships in Europe and your kid wants one?
The Obama administration is willing to toss principal writing down banks 10 to 21 cents per dollar written down for their trouble, depending on how far underwater the loan is. But with many loans tens of thousands or even hundreds of thousands of dollars underwater, the 79 to 90 cents on each dollar of write down the banks absorb hits their bottom line hard. Politically coerced changes to the accounting rules last year allow banks to waffle and delay on recognizing loss on mortgages, until they've been sold after foreclosure. It's only after the foreclosure sale that banks have to book a loss. Foreclosure rates have been rising, but banks have been dribbling out foreclosed properties, holding many off the market to prevent a downward price panic. They hope to get more than the current market price for the house, something that wouldn't be possible if they had to do an immediate principal writedown. So it makes more sense to foreclose, hide behind relaxed accounting rules, and hold onto the house while hoping for a better price in the future.
Another reason for waiting, which surely no banker will admit, is that political pressure on the Obama administration to expand the use of principal writedowns will probably grow. Just two weeks ago, the administration announced the 10 to 21 cents on the dollar offer. As the mid-term election approaches, those terms could improve. No administration, Democrat or Republican, has ever done anything except protect and advance the interests of homeowners and the housing industry. Even the Bush Administration's nationalizations of Fannie Mae and Freddie Mac only further entrenched those institutions' comprehensive grip on housing finance. The Obama administration may well up its bid before this fall's elections. And if it doesn't, the banks are under no additional pressure than what they face now--a moribund real estate market, but no need under the accounting rules to recognize that reality--to offer principal writedowns. It makes sense for the banks to stall and delay, until the feds to come through with more dinero.
Since the 1930s, housing has been a federal program, not a market. It doesn't operate in accord with market principles, and market forces in housing operate spasmodically and unpredictably. Struggling homeowners realistically have few or no good options. Potential buyers are mystified by a market where nothing makes sense. Transaction costs are indefensibly high, and closing processes are tortuous enough to extract full confessions from the most hard core terrorists. Because the real estate market isn't truly functional, the huge overhang of bad loans from the early and mid-2000s hasn't cleared the market, and we muddle along even after years of loss and stagnation. If you're going to buy a house, save up a big downpayment and buy only as much as you need. Good luck.
Here's our take. Fairness isn't the issue. Principal writedowns are unfair, benefiting in many cases the reckless and irresponsible at the expense of the conscientious and taxpaying. But the big banks don't give a rat's big toe about fairness (they didn't seem to have a problem taking a multi-trillion dollar bailout when their survival was on the line). The problem is that they can't dump the bulk of the costs of principal writedowns onto the federal government.
If banks were today to write down all underwater mortgages to the market value of the homes, they'd have to book losses somewhere around $600 billion (with perhaps a couple hundred billion more for federal agencies like Fannie Mae, Freddie Mac and the FHA). The Tier 1 capital (a commonly used measure of bank capital) of the 20 largest banks in the U.S. (which among banks hold the most mortgage assets) is probably in the range of $900 billion. Comprehensive principal writedowns could reduce Tier 1 capital by hundreds of billions and require a major recapitalization binge. The banks' existing shareholders would be displeased, to say the least. In addition, the federal government and the ever accommodative federal taxpayers would probably have to prop the banks up as they returned to the capital markets.
While not every underwater homeowner would seek a principal writedown, the attractiveness of the proposition would likely motivate a lot of people who aren't currently in default to volunteer for a bum's rush out of part of their monthly payments. After all, why pay full freight when the neighbor across street gets a break and comes up with enough cash for an annual vacation? You may recognize the moral ambiguity of not paying a loan you voluntarily undertook. But what will you say when the kids across the street can suddenly afford summer internships in Europe and your kid wants one?
The Obama administration is willing to toss principal writing down banks 10 to 21 cents per dollar written down for their trouble, depending on how far underwater the loan is. But with many loans tens of thousands or even hundreds of thousands of dollars underwater, the 79 to 90 cents on each dollar of write down the banks absorb hits their bottom line hard. Politically coerced changes to the accounting rules last year allow banks to waffle and delay on recognizing loss on mortgages, until they've been sold after foreclosure. It's only after the foreclosure sale that banks have to book a loss. Foreclosure rates have been rising, but banks have been dribbling out foreclosed properties, holding many off the market to prevent a downward price panic. They hope to get more than the current market price for the house, something that wouldn't be possible if they had to do an immediate principal writedown. So it makes more sense to foreclose, hide behind relaxed accounting rules, and hold onto the house while hoping for a better price in the future.
Another reason for waiting, which surely no banker will admit, is that political pressure on the Obama administration to expand the use of principal writedowns will probably grow. Just two weeks ago, the administration announced the 10 to 21 cents on the dollar offer. As the mid-term election approaches, those terms could improve. No administration, Democrat or Republican, has ever done anything except protect and advance the interests of homeowners and the housing industry. Even the Bush Administration's nationalizations of Fannie Mae and Freddie Mac only further entrenched those institutions' comprehensive grip on housing finance. The Obama administration may well up its bid before this fall's elections. And if it doesn't, the banks are under no additional pressure than what they face now--a moribund real estate market, but no need under the accounting rules to recognize that reality--to offer principal writedowns. It makes sense for the banks to stall and delay, until the feds to come through with more dinero.
Since the 1930s, housing has been a federal program, not a market. It doesn't operate in accord with market principles, and market forces in housing operate spasmodically and unpredictably. Struggling homeowners realistically have few or no good options. Potential buyers are mystified by a market where nothing makes sense. Transaction costs are indefensibly high, and closing processes are tortuous enough to extract full confessions from the most hard core terrorists. Because the real estate market isn't truly functional, the huge overhang of bad loans from the early and mid-2000s hasn't cleared the market, and we muddle along even after years of loss and stagnation. If you're going to buy a house, save up a big downpayment and buy only as much as you need. Good luck.
Sunday, April 11, 2010
Big Banks Make the Case for Continuous Disclosure
We learned late last week that 18 of the largest banks (including, among others, Goldman Sachs, Morgan Stanley, J.P. Morgan Chase, Bank of America and Citigroup) displayed a pattern of temporarily lowering their debt levels at the end of each quarter, just in time for their quarterly reports, and then ratcheting their borrowings back up at the beginning of the next quarter. (See Wall Street Journal, April 9, 2010, p. C1). Their reported debt levels averaged 42% below the intraquarter peaks. Thus, their quarterly reports understated the risks they carried.
As we know from the Lehman bankruptcy examiner's report, Lehman used a transaction called "Repo 105" to understate its leverage. While it is unclear that other major banks engaged in Repo 105 trades, they evidently have other ways to achieve a similar result.
Let us ask: who's in the dark? Not management of the big banks. They should be and hopefully are monitoring leverage levels on a continuing basis throughout market hours (which are basically 24 hours a day, five days a week, because trading is global). Certainly, they'd have the data at their fingertips.
Federal banking regulators can easily find out any time how leveraged the big banks are. They have examiners stationed at each of the major money center banks, who can get information on the spot. So there can be a continuous flow of information to the feds--and we hope there is.
That leaves (you've probably guessed it): you, the public investor. You're the chump. It's understandable why management wouldn't want you to know how risky their operations are. You might lower the price you're willing to pay for the bank's stock. That's not conducive to a brontosaurus size executive bonus. By reporting lower quarter-end leverage than they hold most of the time, the big banks can maintain a higher stock price. It's likely the big banks' lawyers have cleverly included language in their public filings saying that bank leverage levels fluctuate. But there's a distinct possibility they didn't disclose that they typically ease leverage levels down at the end of each quarter and pump them back up at the beginning of the next.
All this reinforces the case to require banks, and other public companies, to make continuous disclosure. We've advocated the idea before. See http://blogger.uncleleosden.com/2009/10/allow-insider-trading-why-not-reduce.html. Our earlier essay argued that with continuous disclosure, there would be less inside information and therefore probably less insider trading. Now, we can see that continuous disclosure would result in fairer pricing of stocks. It may well be that bank stocks are over-valued because investors didn't realize how risky they are.
Continuous disclosure isn't difficult. It's already made to management as a matter of course, and to federal banking regulators on demand. We're not talking about highly tentative or immaterial information; we're talking about the info management relies on to run the banks and keep them solvent. There is no technological impediment to continuous disclosure, and the cost is small, since the data is already collected, crunched and disseminated (to some). Certain accounting decisions tend to be made on a quarterly or annual basis. Asset writedowns, adding to or drawing down reserves, writing off bad debts, depreciation and depletion are examples. But that's because the current reporting regime requires quarterly and annual reports. There's no intrinsic reason why these decisions can't be made more frequently. Even if they can't be made every day, assets depreciate and deplete, reserves can be set aside or used, and bad debts become uncollectible all the time, not just at the ends of quarters or years.
The quarterly and annual reporting requirements evolved in the 1930s and 1940s, when accountants collected data and prepared financial statements using pencils, paper and mechanical desk calculators. With the enormous capabilities of modern computers, there is no reason except inertia to stick with a quarterly and annual reporting regime. Indeed, there already are continuous reporting requirements for a limited number of items on SEC Form 8-K. The agency recognizes the need for continuous reporting; the only question is how much information should be continuously reported.
Of course, public companies will oppose the idea. Financial reporting is all too often treated as a game, in which management tries to present the company in the best possible light without violating any controlling legal precedents. And sometimes management presents the company in a better light than that and goes to jail. With only a tiny handful of exceptions, public companies don't seem to think that giving the public investor the full picture is a priority. That's too bad, because many public investors--i.e., individual investors--are MIA from the current stock market rally. Numerous commentators have observed that the past year's bull market progressed on rather thin volume, with individual investors licking their 2007-08 wounds from the sidelines. Even though the market has gone up for something like seven of the last eight weeks, the individual investor still hunkers down.
Of course, revealing the higher actual leverage of banks would tend to push their stock prices down. Indeed, continuous disclosure could in the near term be a short seller's banquet. But let us remember that a small group of mostly anonymous short sellers were among the first to realize that the real estate and mortgage markets amounted to a greatly over-valued bucket of mashed potatoes. Management and federal banking regulators, who had much better access to the relevant data, stood right at the front bumper but failed to see the tractor-trailer bearing down on them.
Continuous disclosure would enhance market fairness and efficiency. When stock prices reach a truly fair level, investor trust can begin. If investors continue to feel the stock market is a casino where they're always betting against the house, they'll embrace federally insured bank accounts and money market funds that invest only in U.S. Treasuries. This is exactly what happened in Japan after its 1989-90 stock market cataclysm, and the favorite savings vehicle for the Japanese today is an account with their postal system. (As odd as it sounds, the Japanese postal system runs the largest bank in the world measured by deposits; but then again, the U.S. postal system offered savings accounts until 1967.) Numerous individual investors in Japan never found their way back to equities. Very possibly, for many Americans that will also be the road not taken.
As we know from the Lehman bankruptcy examiner's report, Lehman used a transaction called "Repo 105" to understate its leverage. While it is unclear that other major banks engaged in Repo 105 trades, they evidently have other ways to achieve a similar result.
Let us ask: who's in the dark? Not management of the big banks. They should be and hopefully are monitoring leverage levels on a continuing basis throughout market hours (which are basically 24 hours a day, five days a week, because trading is global). Certainly, they'd have the data at their fingertips.
Federal banking regulators can easily find out any time how leveraged the big banks are. They have examiners stationed at each of the major money center banks, who can get information on the spot. So there can be a continuous flow of information to the feds--and we hope there is.
That leaves (you've probably guessed it): you, the public investor. You're the chump. It's understandable why management wouldn't want you to know how risky their operations are. You might lower the price you're willing to pay for the bank's stock. That's not conducive to a brontosaurus size executive bonus. By reporting lower quarter-end leverage than they hold most of the time, the big banks can maintain a higher stock price. It's likely the big banks' lawyers have cleverly included language in their public filings saying that bank leverage levels fluctuate. But there's a distinct possibility they didn't disclose that they typically ease leverage levels down at the end of each quarter and pump them back up at the beginning of the next.
All this reinforces the case to require banks, and other public companies, to make continuous disclosure. We've advocated the idea before. See http://blogger.uncleleosden.com/2009/10/allow-insider-trading-why-not-reduce.html. Our earlier essay argued that with continuous disclosure, there would be less inside information and therefore probably less insider trading. Now, we can see that continuous disclosure would result in fairer pricing of stocks. It may well be that bank stocks are over-valued because investors didn't realize how risky they are.
Continuous disclosure isn't difficult. It's already made to management as a matter of course, and to federal banking regulators on demand. We're not talking about highly tentative or immaterial information; we're talking about the info management relies on to run the banks and keep them solvent. There is no technological impediment to continuous disclosure, and the cost is small, since the data is already collected, crunched and disseminated (to some). Certain accounting decisions tend to be made on a quarterly or annual basis. Asset writedowns, adding to or drawing down reserves, writing off bad debts, depreciation and depletion are examples. But that's because the current reporting regime requires quarterly and annual reports. There's no intrinsic reason why these decisions can't be made more frequently. Even if they can't be made every day, assets depreciate and deplete, reserves can be set aside or used, and bad debts become uncollectible all the time, not just at the ends of quarters or years.
The quarterly and annual reporting requirements evolved in the 1930s and 1940s, when accountants collected data and prepared financial statements using pencils, paper and mechanical desk calculators. With the enormous capabilities of modern computers, there is no reason except inertia to stick with a quarterly and annual reporting regime. Indeed, there already are continuous reporting requirements for a limited number of items on SEC Form 8-K. The agency recognizes the need for continuous reporting; the only question is how much information should be continuously reported.
Of course, public companies will oppose the idea. Financial reporting is all too often treated as a game, in which management tries to present the company in the best possible light without violating any controlling legal precedents. And sometimes management presents the company in a better light than that and goes to jail. With only a tiny handful of exceptions, public companies don't seem to think that giving the public investor the full picture is a priority. That's too bad, because many public investors--i.e., individual investors--are MIA from the current stock market rally. Numerous commentators have observed that the past year's bull market progressed on rather thin volume, with individual investors licking their 2007-08 wounds from the sidelines. Even though the market has gone up for something like seven of the last eight weeks, the individual investor still hunkers down.
Of course, revealing the higher actual leverage of banks would tend to push their stock prices down. Indeed, continuous disclosure could in the near term be a short seller's banquet. But let us remember that a small group of mostly anonymous short sellers were among the first to realize that the real estate and mortgage markets amounted to a greatly over-valued bucket of mashed potatoes. Management and federal banking regulators, who had much better access to the relevant data, stood right at the front bumper but failed to see the tractor-trailer bearing down on them.
Continuous disclosure would enhance market fairness and efficiency. When stock prices reach a truly fair level, investor trust can begin. If investors continue to feel the stock market is a casino where they're always betting against the house, they'll embrace federally insured bank accounts and money market funds that invest only in U.S. Treasuries. This is exactly what happened in Japan after its 1989-90 stock market cataclysm, and the favorite savings vehicle for the Japanese today is an account with their postal system. (As odd as it sounds, the Japanese postal system runs the largest bank in the world measured by deposits; but then again, the U.S. postal system offered savings accounts until 1967.) Numerous individual investors in Japan never found their way back to equities. Very possibly, for many Americans that will also be the road not taken.
Thursday, April 8, 2010
Demote GDP and Enhance Economic Well-Being
The most frequently used measure of economic well-being is Gross Domestic Product. Government and private sector leaders, economists, commentators and polemicists fixate over GDP. Its upward movements prompt celebrations and congratulations (usually, self-congratulations). Its downward movements provoke calls for resignation, electoral ouster, and tea parties, and fuel no end of tiresome cable TV commentary. Whether the country is in an economic downturn or upturn is defined by movements in GDP.
Whenever a numerical figure is used as an important benchmark, it can become a tail that wags the dog. A well-known example is corporate earnings per share. Public companies scheme and maneuver to make earnings per share large enough to cast management in a good light and boost the company's stock price. While there are legal ways to "manage" earnings per share, financial regulators' rap sheets are replete with public companies that lied and cheated in order to doll up their financial statements. Earnings per share as a benchmark drives behavior. It is a narrow, incomplete way of measuring a company's value, which diverts management's attention toward the next quarter and away from long term planning and investment.
The use of GDP to measure economic well-being may distort government behavior. GDP, as it's usually calculated, measures the amount of a nation's consumption and investment. It includes private consumption (ham, eggs, shoes, DVDs, cars, kiddie train sets, etc.), gross investment (basically, business investment plus new home sales), government spending (which doesn't include transfer payments like Social Security and unemployment compensation, but these tend to get picked up through private consumption), and net exports (gross exports minus gross imports, which can yield a negative number). Most of GDP consists of consumption (private consumption and most government spending, reduced by net exports (read, net imports)). Business investment, new home sales, and government investment account for a relatively small portion of GDP.
GDP does not differentiate between consumption financed with debt, as opposed to consumption paid for with earnings or savings. Thus, consumers indulging in home equity loans or cash out mortgage refinancings boost GDP by the full extent of the dollars they borrow and spend. The same is true when a government borrows money to pay for its spending. Thus, the government is incentivized to borrow and spend in order to boost GDP, as opposed to raising taxes to cover its budget (which would reduce private spending and perhaps business investment, thereby diminishing GDP). The government is similarly rewarded when it cuts taxes (providing more money for private consumption and business investment), and substitutes borrowed money to cover its budget. Either way, government borrowing can boost GDP and make the government look good.
Government subsidies of private borrowing, such as home mortgage and home equity loans, can also enhance GDP, because GDP is not adjusted for private consumption fueled by debt. If government policy inflates home prices, which in turn encourage more tax code subsidized borrowing to finance consumption, the larger GDP becomes and the better the government looks.
A major shortcoming of GDP is that it doesn't reflect the worst aspects of the current financially driven economic crisis. Instability and volatility in the stock and real estate markets have shaken the middle and upper middle classes. Increased unemployment levels don't show up in GDP. Wage and salary cuts, reductions in working hours, and other earnings losses aren't recorded in GDP. The hundreds of billions of dollars of interest income lost by savers, who can get barely a pittance for their hard earned savings, is not an input for GDP. Even the loss of home equity loans and generous credit card lines of credit, so important to fueling the boom of the early 2000s, doesn't enter into the calculation of GDP. All of these factors may be reflected indirectly in lower consumption and reduced business investment. But those statistical effects don't begin to reflect the insecurity gripping tens of millions of Americans. Government pronouncements and Wall Street boosterism that tout GDP growth clash with the daily experiences of typical Americans. A recovering GDP uplifts the stock market, disproportionately benefiting the wealthy and well-to-do. But this uneven impact fuels Tea Parties and other harbingers of discontent.
A number of readily available statistics can be used to create a more complete picture of economic well-being. Unemployment levels, median household income, per capita income, distribution of income, trends in asset values, volatility in asset values, savings rates, debt growth or reduction, business investment, and changes in worker productivity all help to round out the picture. There is no single measure of economic well-being that really works. We have to look at a basket of statistics to get the full picture. And getting the full picture would lead to more well-rounded government policies. GDP is a valid measure of an economy's size. But using it as the principal benchmark for the government's performance can distort government policy by encouraging borrowing, while reminding numerous Americans that they remain outside the Beltway.
Homeowners didn't become wealthier by embracing home equity loans and cash out mortgage refinancings. They simply frontloaded their consumption. Now, later in life, they are having to pay for their unwillingness to delay gratification. Borrowing to finance government spending is largely the same (with the exception of government investment in highways, bridges and other infrastructure, which may enhance future economic growth). A better balanced approach to measuring economic well-being would reduce the political reward to the government from borrowing to finance deficits.
The Euro zone sovereign debt crisis illustrates the dangers of outsized government borrowing. Greece's economy is about 0.6% of the world economy. But bailing it out has proven to be intractable. Imagine what could happen if a much larger economy overspent.
Whenever a numerical figure is used as an important benchmark, it can become a tail that wags the dog. A well-known example is corporate earnings per share. Public companies scheme and maneuver to make earnings per share large enough to cast management in a good light and boost the company's stock price. While there are legal ways to "manage" earnings per share, financial regulators' rap sheets are replete with public companies that lied and cheated in order to doll up their financial statements. Earnings per share as a benchmark drives behavior. It is a narrow, incomplete way of measuring a company's value, which diverts management's attention toward the next quarter and away from long term planning and investment.
The use of GDP to measure economic well-being may distort government behavior. GDP, as it's usually calculated, measures the amount of a nation's consumption and investment. It includes private consumption (ham, eggs, shoes, DVDs, cars, kiddie train sets, etc.), gross investment (basically, business investment plus new home sales), government spending (which doesn't include transfer payments like Social Security and unemployment compensation, but these tend to get picked up through private consumption), and net exports (gross exports minus gross imports, which can yield a negative number). Most of GDP consists of consumption (private consumption and most government spending, reduced by net exports (read, net imports)). Business investment, new home sales, and government investment account for a relatively small portion of GDP.
GDP does not differentiate between consumption financed with debt, as opposed to consumption paid for with earnings or savings. Thus, consumers indulging in home equity loans or cash out mortgage refinancings boost GDP by the full extent of the dollars they borrow and spend. The same is true when a government borrows money to pay for its spending. Thus, the government is incentivized to borrow and spend in order to boost GDP, as opposed to raising taxes to cover its budget (which would reduce private spending and perhaps business investment, thereby diminishing GDP). The government is similarly rewarded when it cuts taxes (providing more money for private consumption and business investment), and substitutes borrowed money to cover its budget. Either way, government borrowing can boost GDP and make the government look good.
Government subsidies of private borrowing, such as home mortgage and home equity loans, can also enhance GDP, because GDP is not adjusted for private consumption fueled by debt. If government policy inflates home prices, which in turn encourage more tax code subsidized borrowing to finance consumption, the larger GDP becomes and the better the government looks.
A major shortcoming of GDP is that it doesn't reflect the worst aspects of the current financially driven economic crisis. Instability and volatility in the stock and real estate markets have shaken the middle and upper middle classes. Increased unemployment levels don't show up in GDP. Wage and salary cuts, reductions in working hours, and other earnings losses aren't recorded in GDP. The hundreds of billions of dollars of interest income lost by savers, who can get barely a pittance for their hard earned savings, is not an input for GDP. Even the loss of home equity loans and generous credit card lines of credit, so important to fueling the boom of the early 2000s, doesn't enter into the calculation of GDP. All of these factors may be reflected indirectly in lower consumption and reduced business investment. But those statistical effects don't begin to reflect the insecurity gripping tens of millions of Americans. Government pronouncements and Wall Street boosterism that tout GDP growth clash with the daily experiences of typical Americans. A recovering GDP uplifts the stock market, disproportionately benefiting the wealthy and well-to-do. But this uneven impact fuels Tea Parties and other harbingers of discontent.
A number of readily available statistics can be used to create a more complete picture of economic well-being. Unemployment levels, median household income, per capita income, distribution of income, trends in asset values, volatility in asset values, savings rates, debt growth or reduction, business investment, and changes in worker productivity all help to round out the picture. There is no single measure of economic well-being that really works. We have to look at a basket of statistics to get the full picture. And getting the full picture would lead to more well-rounded government policies. GDP is a valid measure of an economy's size. But using it as the principal benchmark for the government's performance can distort government policy by encouraging borrowing, while reminding numerous Americans that they remain outside the Beltway.
Homeowners didn't become wealthier by embracing home equity loans and cash out mortgage refinancings. They simply frontloaded their consumption. Now, later in life, they are having to pay for their unwillingness to delay gratification. Borrowing to finance government spending is largely the same (with the exception of government investment in highways, bridges and other infrastructure, which may enhance future economic growth). A better balanced approach to measuring economic well-being would reduce the political reward to the government from borrowing to finance deficits.
The Euro zone sovereign debt crisis illustrates the dangers of outsized government borrowing. Greece's economy is about 0.6% of the world economy. But bailing it out has proven to be intractable. Imagine what could happen if a much larger economy overspent.
Sunday, April 4, 2010
The Devil's Casino: A Morality Tale of the Rise and Fall of Lehman Brothers
Apres le scandale, les livres. The latest on the collapse of Lehman Brothers is Vicky Ward's The Devil's Casino. The complimentary copy sent to me for review by the publisher, John Wiley & Sons Inc., comes in a dust jacket depicting a deck of cards with the joker face up. The imagery is a propos, and the book presents a gripping, page-turner of a tale. But there's much more to this book than a story about exceedingly wealthy bankers taking undue risks in the heedless pursuit of shameless self-aggrandizement. It presents a morality tale, not just about people, but also about organizations and their life cycles.
Here's an overview of the book. In the mid-1980s, Lehman, a proud and distinguished mid-sized investment bank, sold itself to Shearson American Express. The senior management of the old Lehman mostly left. Taking over as the management of the newly acquired subsidiary were Richard Fuld and his deputy, Christopher Pettit. In the middle of their careers, these two men were suddenly dislocated and had to adjust to new bosses and a new corporate culture. Pettit, a West Point graduate and decorated Vietnam War combat vet, had built up the highly successful commercial paper operation at Lehman, instilling in it the sense of solidarity found in elite military units. Apparently driven by loyalty to his people as well as the realization that his future success likely depended on keeping them together, Pettit risked his career by insisting to his new bosses that the commercial paper operation be kept together. Noting how profitable Pettit's operation had been, Shearson's management reluctantly acquiesced.
Fuld and Pettit joined together to maintain a de facto Lehman inside Shearson (with some personnel persisting in answering their phones "Lehman"). Fuld took on the difficult task of alternately staving off and then cultivating Shearson's management, a job for which the plainspoken Pettit had no appetite. Pettit, in turn, managed "Lehman's" day-to-day operations inside Shearson, with close friends from his early days at the firm reporting to him. The division of duties played to both Fuld's and Pettit's strengths, and "Lehman" prospered.
Even as "Lehman" prospered, Fuld and Pettit began to change. Fuld, successful as a hands-on trader, became isolated as a senior executive. One vignette recounted in the book has him ordering shirts from the L.L. Bean catalog during the work day. Fuld also sought to acquire the polish and poise of Wall Street's executive elite, taking self-improvement training and, most importantly, scrutinizing and learning from the most talented men around him. He let Pettit handle daily operations; Fuld's focus was upward, geared toward advancing his career.
It's less clear how and why Pettit changed. As the firm grew, he may have been frustrated by his inability to supervise thousands of employees with the close, personal style he had previously used in successfully overseeing hundreds. His marriage to his high school sweetheart deteriorated and he took up with another woman who worked at "Lehman." This affair grated with the family-oriented culture at the "firm," which Fuld in particular sought to instill. It also marred Pettit's image, as the man who had symbolized the best in the "firm" revealed his feet of clay.
"Lehman's" pugnacious independence not surprisingly led Shearson American Express to spin it off, after ten years. But independence seemed to bring out the unattractive side of Lehman's senior executives. Fuld evidently saw the firm as the ticket, not only to wealth, but also the recognition that would come from being the CEO of a top tier Wall Street firm. He made the firm's growth a priority. He also became increasingly insecure about Pettit, whose charisma and leadership abilities Fuld could not match. Pettit was the one person in the firm who could compete with Fuld for the top job.
At the same time, Pettit's relationship with his lieutenants apparently frayed, perhaps because of his affair, and in part because of the inevitable vicissitudes of the markets. One example recounted in The Devil's Casino is the Mexican peso crisis of 1995, for which Lehman had $5 billion of exposure, a significant amount for the recently spun off firm. Pettit held Joe Gregory, then the head of fixed income, responsible for the unexpectedly large size of this exposure (Pettit had known of $1 billion). Pettit took to dressing Gregory down on a weekly basis. Gregory had previously been one of Pettit's closest friends at the firm, but the now their friendship fractured. Exactly why Pettit was so angry isn't clear; perhaps it was Pettit's military background subconsciously influencing his perception of events. For a combat unit to survive and be effective, every member must do his job. Otherwise, the entire unit may be imperiled and wiped out. Excuses and explanations don't resurrect dead soldiers; performance of one's duties is essential. Friendship is subordinated this imperative, because failure on the battlefield can be so costly. Pettit may have overreacted, from the viewpoint of a civilian dealing with a firm's misguided investments. Gregory evidently bore scars from this castigation, and, as Ward tells the story, later served as the Judas Iscariot who engineered Pettit's downfall.
Whatever Pettit's motivation, he was losing support within the firm and there were plenty of people who thought they would benefit if he departed. Fuld, although nominally the CEO, seemingly did not have the gumption to force Pettit out. He acted only when pushed by a conspiracy, comprised of Gregory and others among Pettit's lieutenants. Pettit was demoted and soon departed, tragically dying shortly thereafter in a snowmobiling accident.
As described in The Devil's Casino, Pettit's departure marked the moment when Lehman became engulfed by the atavistic impulses of lesser men than Christopher Pettit. Fuld did not immediately replace Pettit, leaving the Chief Operating Officer position open for several years. Yet, he stayed aloof from daily operations, with the firm being managed through a committee composed of the heads of the major operational units. This structure may have been conducive to promoting profitability (Fuld's uppermost goal). But it left matters crucial to the organic health of the firm as a whole, such as risk management, at a disadvantage. When Fuld eventually selected a COO, it was Joe Gregory, whom Fuld did not regard as competition for the CEO position.
The rest of the story, told in substantial and engaging detail, is well-known in its overarching features. Lehman endeavored to be David among the Goliaths of Wall Street, scoring some successes that only fueled management's hunger for more favorable headlines. Risk management came to be viewed as tiresome, and risk managers received less of management's attention.
By the early 2000s, Lehman had fallen hard for the allure of real estate, betting more and more of its balance sheet on a seemingly golden goose of an asset that kept increasing in value. Fuld's sound instincts as a trader evidently abandoned him, and Lehman piled into real estate while the smarter firms were pulling back. As the mortgage crisis unfolded in 2007 and 2008, astute players, such as short seller David Einhorn, began questioning Lehman's strategy. The firm changed CFOs, installing the attractive but not well-qualified Erin Callan as the new CFO. Although she was remarkably poised and momentarily effective in presenting the firm as solvent, her short tenure ended after a few months when the firm had to report $2.8 billion in quarterly losses, its first publicly reported losses ever. What may have been the firm's last ditch effort to substitute image for substance failed, and the die was cast. Although Fuld belatedly realized that he needed to improve the quality of the firm's management, he could not undo the firm's gargantuan real estate exposure. Lehman's new management, which included alumni previously shoved aside by the prior management, couldn't save the firm when its short term funding fled, and it was forced to seek the protection of the bankruptcy courts.
The Devil's Casino covers familiar issues, such as the dependence of Lehman and other Wall Street on short term funding to make less than liquid investments, and the federal government's decision not deploy taxpayer money to bail out Lehman. However, the longer story it tells, of the late 20th Century Lehman's origins as subsidiary and then spin-off of Shearson American Express, illustrates issues that haven't received as much coverage.
Lehman's evolution, first as a unified upstart led by a charismatic leader, and then as an increasingly dysfunctional real estate investor, exemplifies how organizations become strong, grow, prosper, but then lose focus, weaken and fracture. This is a story seen many times in many organizations. But it's a singularly important problem when it happens to financial firms with wide-ranging exposures throughout the financial system. Ward's depiction of a distant CEO who drives out the most capable man in the organization belies Wall Street's claim to believe that its people are its real capital. Wall Street firms, like so many other organizations, are susceptible to the machinations of office politics, where the well-being of the organization is subordinated to the personal interests of a few at the top. When this happens at a money center bank with worldwide exposure, the potential consequences to society and taxpayers may be painful.
What does this imply? First, boards of directors of major financial institutions have to be more proactive about the quality and style of management. It is in fact true that people are a Wall Street firm's real capital. A CEO who can't maintain the quality of personnel, or even worse forces out the best, needs encouragement to pursue other interests. While most corporate boards wouldn't regard personnel management to be within their normal duties, directors of major banks should be more assiduous. Lehman's directors scarcely manage occasional cameo appearances in The Devil's Casino. Perhaps they played a larger role than depicted in the book. But as far as a reader of The Devil's Casino can tell, there was no meaningful check or balance on the way Fuld performed his job. Thus, Lehman's viability as a firm was exposed to Fuld's individual weaknesses.
Another consideration is that federal regulators need to be more attentive to the quality of management. This is not a new problem for the Federal Reserve. The Fed has the authority to remove officers of banks under its supervision for specified statutory reasons, and from time to time has exercised this authority. Typically, the Fed informally signals its displeasure with a particular banker, and the astute bank removes the offending individual before the Fed feels the need to take formal action. Under the systemic risk monitoring responsibility that may soon rest with the Fed, regulators must recognize that risk taking is often a matter of personality and ambition, not just employee incentives and trading strategies, and they should be prepared to remove any individual executive or group of executives who might, with the enormous resources of a major bank, put the financial system in jeopardy.
Ultimately, the responsibility for maintaining the vitality of an organization rests with management. In this respect, The Devil's Casino offers an in-depth study of a failed organization for executives elsewhere to ponder. Whatever Dick Fuld intended, he didn't intend for Lehman to fail so spectacularly. CEOs everywhere should view his fate as an object lesson. To make an organization succeed, the top executive must understand that the organization is greater than he or she, and its needs and welfare supersede his or hers. If you want to be a rock star, learn to play the guitar. If you think you can use an organization to reach the klieg lights, remember Dick Fuld.
The Devil's Casino is written in a readily accessible, fast-paced style that Vicky Ward likely honed as a contributing editor of Vanity Fair. While this is a serious book that tells a serious story, those inclined to indulge, perhaps just occasionally, in voyeuristic schadenfreude will not be disappointed by vignettes about a senior executive's wife having a walk-in shoe closet larger than a store, the sartorial conformity expected of senior executives, the ruthless pecking order among management's wives, and the Prussian discipline expected of Lehman wives when it came to the firm's interests. The book synthesizes an enormous amount of information in an impressively coherent way. We offer a minor suggestion that the three references to "Robert Rubin" be clarified to distinguish Robert S. Rubin, formerly a senior partner of Lehman who is mentioned twice (the first two times), from Robert E. Rubin, former Co-Chairman of Goldman Sachs, then Secretary of the Treasury and then a director of Citigroup, who is the third reference to Robert Rubin (and correctly identified as a former Secretary of the Treasury but not distinguished from the earlier references to "Robert Rubin").
Here's an overview of the book. In the mid-1980s, Lehman, a proud and distinguished mid-sized investment bank, sold itself to Shearson American Express. The senior management of the old Lehman mostly left. Taking over as the management of the newly acquired subsidiary were Richard Fuld and his deputy, Christopher Pettit. In the middle of their careers, these two men were suddenly dislocated and had to adjust to new bosses and a new corporate culture. Pettit, a West Point graduate and decorated Vietnam War combat vet, had built up the highly successful commercial paper operation at Lehman, instilling in it the sense of solidarity found in elite military units. Apparently driven by loyalty to his people as well as the realization that his future success likely depended on keeping them together, Pettit risked his career by insisting to his new bosses that the commercial paper operation be kept together. Noting how profitable Pettit's operation had been, Shearson's management reluctantly acquiesced.
Fuld and Pettit joined together to maintain a de facto Lehman inside Shearson (with some personnel persisting in answering their phones "Lehman"). Fuld took on the difficult task of alternately staving off and then cultivating Shearson's management, a job for which the plainspoken Pettit had no appetite. Pettit, in turn, managed "Lehman's" day-to-day operations inside Shearson, with close friends from his early days at the firm reporting to him. The division of duties played to both Fuld's and Pettit's strengths, and "Lehman" prospered.
Even as "Lehman" prospered, Fuld and Pettit began to change. Fuld, successful as a hands-on trader, became isolated as a senior executive. One vignette recounted in the book has him ordering shirts from the L.L. Bean catalog during the work day. Fuld also sought to acquire the polish and poise of Wall Street's executive elite, taking self-improvement training and, most importantly, scrutinizing and learning from the most talented men around him. He let Pettit handle daily operations; Fuld's focus was upward, geared toward advancing his career.
It's less clear how and why Pettit changed. As the firm grew, he may have been frustrated by his inability to supervise thousands of employees with the close, personal style he had previously used in successfully overseeing hundreds. His marriage to his high school sweetheart deteriorated and he took up with another woman who worked at "Lehman." This affair grated with the family-oriented culture at the "firm," which Fuld in particular sought to instill. It also marred Pettit's image, as the man who had symbolized the best in the "firm" revealed his feet of clay.
"Lehman's" pugnacious independence not surprisingly led Shearson American Express to spin it off, after ten years. But independence seemed to bring out the unattractive side of Lehman's senior executives. Fuld evidently saw the firm as the ticket, not only to wealth, but also the recognition that would come from being the CEO of a top tier Wall Street firm. He made the firm's growth a priority. He also became increasingly insecure about Pettit, whose charisma and leadership abilities Fuld could not match. Pettit was the one person in the firm who could compete with Fuld for the top job.
At the same time, Pettit's relationship with his lieutenants apparently frayed, perhaps because of his affair, and in part because of the inevitable vicissitudes of the markets. One example recounted in The Devil's Casino is the Mexican peso crisis of 1995, for which Lehman had $5 billion of exposure, a significant amount for the recently spun off firm. Pettit held Joe Gregory, then the head of fixed income, responsible for the unexpectedly large size of this exposure (Pettit had known of $1 billion). Pettit took to dressing Gregory down on a weekly basis. Gregory had previously been one of Pettit's closest friends at the firm, but the now their friendship fractured. Exactly why Pettit was so angry isn't clear; perhaps it was Pettit's military background subconsciously influencing his perception of events. For a combat unit to survive and be effective, every member must do his job. Otherwise, the entire unit may be imperiled and wiped out. Excuses and explanations don't resurrect dead soldiers; performance of one's duties is essential. Friendship is subordinated this imperative, because failure on the battlefield can be so costly. Pettit may have overreacted, from the viewpoint of a civilian dealing with a firm's misguided investments. Gregory evidently bore scars from this castigation, and, as Ward tells the story, later served as the Judas Iscariot who engineered Pettit's downfall.
Whatever Pettit's motivation, he was losing support within the firm and there were plenty of people who thought they would benefit if he departed. Fuld, although nominally the CEO, seemingly did not have the gumption to force Pettit out. He acted only when pushed by a conspiracy, comprised of Gregory and others among Pettit's lieutenants. Pettit was demoted and soon departed, tragically dying shortly thereafter in a snowmobiling accident.
As described in The Devil's Casino, Pettit's departure marked the moment when Lehman became engulfed by the atavistic impulses of lesser men than Christopher Pettit. Fuld did not immediately replace Pettit, leaving the Chief Operating Officer position open for several years. Yet, he stayed aloof from daily operations, with the firm being managed through a committee composed of the heads of the major operational units. This structure may have been conducive to promoting profitability (Fuld's uppermost goal). But it left matters crucial to the organic health of the firm as a whole, such as risk management, at a disadvantage. When Fuld eventually selected a COO, it was Joe Gregory, whom Fuld did not regard as competition for the CEO position.
The rest of the story, told in substantial and engaging detail, is well-known in its overarching features. Lehman endeavored to be David among the Goliaths of Wall Street, scoring some successes that only fueled management's hunger for more favorable headlines. Risk management came to be viewed as tiresome, and risk managers received less of management's attention.
By the early 2000s, Lehman had fallen hard for the allure of real estate, betting more and more of its balance sheet on a seemingly golden goose of an asset that kept increasing in value. Fuld's sound instincts as a trader evidently abandoned him, and Lehman piled into real estate while the smarter firms were pulling back. As the mortgage crisis unfolded in 2007 and 2008, astute players, such as short seller David Einhorn, began questioning Lehman's strategy. The firm changed CFOs, installing the attractive but not well-qualified Erin Callan as the new CFO. Although she was remarkably poised and momentarily effective in presenting the firm as solvent, her short tenure ended after a few months when the firm had to report $2.8 billion in quarterly losses, its first publicly reported losses ever. What may have been the firm's last ditch effort to substitute image for substance failed, and the die was cast. Although Fuld belatedly realized that he needed to improve the quality of the firm's management, he could not undo the firm's gargantuan real estate exposure. Lehman's new management, which included alumni previously shoved aside by the prior management, couldn't save the firm when its short term funding fled, and it was forced to seek the protection of the bankruptcy courts.
The Devil's Casino covers familiar issues, such as the dependence of Lehman and other Wall Street on short term funding to make less than liquid investments, and the federal government's decision not deploy taxpayer money to bail out Lehman. However, the longer story it tells, of the late 20th Century Lehman's origins as subsidiary and then spin-off of Shearson American Express, illustrates issues that haven't received as much coverage.
Lehman's evolution, first as a unified upstart led by a charismatic leader, and then as an increasingly dysfunctional real estate investor, exemplifies how organizations become strong, grow, prosper, but then lose focus, weaken and fracture. This is a story seen many times in many organizations. But it's a singularly important problem when it happens to financial firms with wide-ranging exposures throughout the financial system. Ward's depiction of a distant CEO who drives out the most capable man in the organization belies Wall Street's claim to believe that its people are its real capital. Wall Street firms, like so many other organizations, are susceptible to the machinations of office politics, where the well-being of the organization is subordinated to the personal interests of a few at the top. When this happens at a money center bank with worldwide exposure, the potential consequences to society and taxpayers may be painful.
What does this imply? First, boards of directors of major financial institutions have to be more proactive about the quality and style of management. It is in fact true that people are a Wall Street firm's real capital. A CEO who can't maintain the quality of personnel, or even worse forces out the best, needs encouragement to pursue other interests. While most corporate boards wouldn't regard personnel management to be within their normal duties, directors of major banks should be more assiduous. Lehman's directors scarcely manage occasional cameo appearances in The Devil's Casino. Perhaps they played a larger role than depicted in the book. But as far as a reader of The Devil's Casino can tell, there was no meaningful check or balance on the way Fuld performed his job. Thus, Lehman's viability as a firm was exposed to Fuld's individual weaknesses.
Another consideration is that federal regulators need to be more attentive to the quality of management. This is not a new problem for the Federal Reserve. The Fed has the authority to remove officers of banks under its supervision for specified statutory reasons, and from time to time has exercised this authority. Typically, the Fed informally signals its displeasure with a particular banker, and the astute bank removes the offending individual before the Fed feels the need to take formal action. Under the systemic risk monitoring responsibility that may soon rest with the Fed, regulators must recognize that risk taking is often a matter of personality and ambition, not just employee incentives and trading strategies, and they should be prepared to remove any individual executive or group of executives who might, with the enormous resources of a major bank, put the financial system in jeopardy.
Ultimately, the responsibility for maintaining the vitality of an organization rests with management. In this respect, The Devil's Casino offers an in-depth study of a failed organization for executives elsewhere to ponder. Whatever Dick Fuld intended, he didn't intend for Lehman to fail so spectacularly. CEOs everywhere should view his fate as an object lesson. To make an organization succeed, the top executive must understand that the organization is greater than he or she, and its needs and welfare supersede his or hers. If you want to be a rock star, learn to play the guitar. If you think you can use an organization to reach the klieg lights, remember Dick Fuld.
The Devil's Casino is written in a readily accessible, fast-paced style that Vicky Ward likely honed as a contributing editor of Vanity Fair. While this is a serious book that tells a serious story, those inclined to indulge, perhaps just occasionally, in voyeuristic schadenfreude will not be disappointed by vignettes about a senior executive's wife having a walk-in shoe closet larger than a store, the sartorial conformity expected of senior executives, the ruthless pecking order among management's wives, and the Prussian discipline expected of Lehman wives when it came to the firm's interests. The book synthesizes an enormous amount of information in an impressively coherent way. We offer a minor suggestion that the three references to "Robert Rubin" be clarified to distinguish Robert S. Rubin, formerly a senior partner of Lehman who is mentioned twice (the first two times), from Robert E. Rubin, former Co-Chairman of Goldman Sachs, then Secretary of the Treasury and then a director of Citigroup, who is the third reference to Robert Rubin (and correctly identified as a former Secretary of the Treasury but not distinguished from the earlier references to "Robert Rubin").
Thursday, April 1, 2010
Benefits of Federal Health Insurance Reform
2010's federal health insurance reform includes a wide-ranging panoply of programs, credits and other measures. Folks currently covered by employer sponsored health insurance plans won't experience much immediate change. But over the next year and later, they'll see improvements.
Those having trouble getting coverage will find the new law a big improvement. The recent legislation isn't Internet-friendly--it can't be summarized to two paragraphs or less. But there are a number of provisions that could soon change things for millions of Americans. Here they are, with those taking effect sooner listed first.
Small Business Tax Credit. Small businesses may get a tax credit of as much as 35% of their employee health insurance premiums, depending on how large they are, starting immediately and running through 2013. Small, in this case, means small (as in no more than the equivalent of 25 full-time employees). These companies, which may number as many as 4 million, are perhaps the most likely not to offer health insurance to employees, so the credit could bring more people under the umbrella of employer-sponsored coverage. The credit will increase to 50% of premiums beginning in 2014 and is available for any two consecutive years at the 50% level.
Closing the Medicare D Doughnut Hole. Those covered by Medicare D policies who in 2010 hit the gap in coverage called the "doughnut hole" will be eligible for a $250 rebate. Beginning in 2011, a 50% discount (instead of the rebate) will be available for prescriptions filled in the doughnut hole. The doughnut hole will be closed in 2020.
Federal High Risk Pool. By the end of June, 2010, a federal high risk insurance pool will become available for persons with pre-existing conditions who are having trouble getting coverage otherwise. This pool is temporary, and will operate until federally established health insurance exchanges provide a permanent source of coverage beginning in 2014. At that point, persons with pre-existing conditions can purchase health insurance through the exchanges or some other way, such as individually acquiring coverage. You can more information and application options at https://www.pcip.gov/.
Federal Assistance for Employers Covering Early Retirees. By the end of June 2010, a temporary federal program will begin offering reinsurance to employers providing early retirees (i.e., those between the ages of 55 and 64) with health insurance during retirement. Reinsurance is an indirect way of subsidizing retiree health insurance coverage, and should make it easier for employers to maintain coverage for early retirees. (Retirees 65 and older are eligible for Medicare coverage, so the reinsurance program doesn't extend to them.) The reinsurance program will be superseded in 2014 by the health insurance exchanges.
No More Punishing the Sick. Just as banks are notorious for denying credit to those who need it the most, sometimes insurance companies drop customers because they fall ill. Beginning at the end of September 2010, insurance companies will be prohibited from engaging in this practice. Some Tiny Tims will enjoy Christmas early this year when their Scrooge-like health insurers can no longer ax them.
Children Under 19 Cannot Be Turned Down for Pre-existing Conditions. By the end of September 2010, insurers won't be able to turn down children under 19 because of pre-existing conditions. (By 2014, insurers won't be allowed to turn anyone down for pre-existing conditions.) The high risk pool mentioned above could cover children who aren't protected by this provision.
Young Adult Dependents Up to Age 26 Can Be Covered by Parents. By the end of September 2010, young adults up to age 26 who are dependents of their parents will be eligible for coverage under their parents' policies (unless they live in a state that mandates coverage to an older age, such as 28 or 29).
No Lifetime Caps on Coverage. By the end of September 2010, insurers won't be allowed to impose lifetime limits on coverage.
Phaseout of Annual Limits on Coverage. By the end of September 2010, insurers will face greater restrictions on their ability to place annual limits on coverage. By 2014, annual limits will be eliminated.
Free Preventive Care. By the end of September 201o, new private insurance plans will have to cover preventive care without co-pays or deductibles. Beginning in 2011, Medicare will provide the same free preventive care coverage.
Increased Funding for Community Health Centers. Beginning in October 2010, community health centers--clinics that provide primary care to mostly low income patients--will receive increased federal funding in order to almost double over the next five years the number of patients they treat. This should help alleviate the shortage of primary care throughout much of America.
Independent Appeals Process. By the end of September 2010, new health plans will be required to have independent appeals processes for customers denied claims or coverage. This could be very important if you or a family member have a major health issue.
This year's health insurance reform affects many other aspects of the health care system, and will be implemented over the next decade or so. A more permanent system with health insurance exchanges should be in place by 2014. The number of primary care practitioners should increase. The patchwork health insurance system of the past will gradually be phased down, and near universal coverage should result from the federal programs. In the meantime, if you want information about current health insurance resources, take a look at http://blogger.uncleleosden.com/2007/06/how-to-find-health-insurance.html. Illegal immigrants cannot participate in the federally sponsored system, and may have to fall back on the remnants of the old health care system. This limitation is understandable from a political standpoint. However, if an illegal immigrant has, for example, tuberculosis, meningitis or some other transmissible illness, we all benefit if that person gets good health care.
Those having trouble getting coverage will find the new law a big improvement. The recent legislation isn't Internet-friendly--it can't be summarized to two paragraphs or less. But there are a number of provisions that could soon change things for millions of Americans. Here they are, with those taking effect sooner listed first.
Small Business Tax Credit. Small businesses may get a tax credit of as much as 35% of their employee health insurance premiums, depending on how large they are, starting immediately and running through 2013. Small, in this case, means small (as in no more than the equivalent of 25 full-time employees). These companies, which may number as many as 4 million, are perhaps the most likely not to offer health insurance to employees, so the credit could bring more people under the umbrella of employer-sponsored coverage. The credit will increase to 50% of premiums beginning in 2014 and is available for any two consecutive years at the 50% level.
Closing the Medicare D Doughnut Hole. Those covered by Medicare D policies who in 2010 hit the gap in coverage called the "doughnut hole" will be eligible for a $250 rebate. Beginning in 2011, a 50% discount (instead of the rebate) will be available for prescriptions filled in the doughnut hole. The doughnut hole will be closed in 2020.
Federal High Risk Pool. By the end of June, 2010, a federal high risk insurance pool will become available for persons with pre-existing conditions who are having trouble getting coverage otherwise. This pool is temporary, and will operate until federally established health insurance exchanges provide a permanent source of coverage beginning in 2014. At that point, persons with pre-existing conditions can purchase health insurance through the exchanges or some other way, such as individually acquiring coverage. You can more information and application options at https://www.pcip.gov/.
Federal Assistance for Employers Covering Early Retirees. By the end of June 2010, a temporary federal program will begin offering reinsurance to employers providing early retirees (i.e., those between the ages of 55 and 64) with health insurance during retirement. Reinsurance is an indirect way of subsidizing retiree health insurance coverage, and should make it easier for employers to maintain coverage for early retirees. (Retirees 65 and older are eligible for Medicare coverage, so the reinsurance program doesn't extend to them.) The reinsurance program will be superseded in 2014 by the health insurance exchanges.
No More Punishing the Sick. Just as banks are notorious for denying credit to those who need it the most, sometimes insurance companies drop customers because they fall ill. Beginning at the end of September 2010, insurance companies will be prohibited from engaging in this practice. Some Tiny Tims will enjoy Christmas early this year when their Scrooge-like health insurers can no longer ax them.
Children Under 19 Cannot Be Turned Down for Pre-existing Conditions. By the end of September 2010, insurers won't be able to turn down children under 19 because of pre-existing conditions. (By 2014, insurers won't be allowed to turn anyone down for pre-existing conditions.) The high risk pool mentioned above could cover children who aren't protected by this provision.
Young Adult Dependents Up to Age 26 Can Be Covered by Parents. By the end of September 2010, young adults up to age 26 who are dependents of their parents will be eligible for coverage under their parents' policies (unless they live in a state that mandates coverage to an older age, such as 28 or 29).
No Lifetime Caps on Coverage. By the end of September 2010, insurers won't be allowed to impose lifetime limits on coverage.
Phaseout of Annual Limits on Coverage. By the end of September 2010, insurers will face greater restrictions on their ability to place annual limits on coverage. By 2014, annual limits will be eliminated.
Free Preventive Care. By the end of September 201o, new private insurance plans will have to cover preventive care without co-pays or deductibles. Beginning in 2011, Medicare will provide the same free preventive care coverage.
Increased Funding for Community Health Centers. Beginning in October 2010, community health centers--clinics that provide primary care to mostly low income patients--will receive increased federal funding in order to almost double over the next five years the number of patients they treat. This should help alleviate the shortage of primary care throughout much of America.
Independent Appeals Process. By the end of September 2010, new health plans will be required to have independent appeals processes for customers denied claims or coverage. This could be very important if you or a family member have a major health issue.
This year's health insurance reform affects many other aspects of the health care system, and will be implemented over the next decade or so. A more permanent system with health insurance exchanges should be in place by 2014. The number of primary care practitioners should increase. The patchwork health insurance system of the past will gradually be phased down, and near universal coverage should result from the federal programs. In the meantime, if you want information about current health insurance resources, take a look at http://blogger.uncleleosden.com/2007/06/how-to-find-health-insurance.html. Illegal immigrants cannot participate in the federally sponsored system, and may have to fall back on the remnants of the old health care system. This limitation is understandable from a political standpoint. However, if an illegal immigrant has, for example, tuberculosis, meningitis or some other transmissible illness, we all benefit if that person gets good health care.
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