The Market Ticker - Regulatory

SUPPORT REP SPEIER!

nospam@example.com (Karl Denninger) — Thu, 19 Nov 2009 09:23:55 -0500

An amendment offered by Representative Speier to the FSIA bill currently under markup:

Page 28, after line 8, insert the following new paragraph:

1 (4) LEVERAGE LIMITATION.—The Board shall require each identified holding company to maintain a debt to equity ratio of no more than 15 to 1, and the Board shall issue regulations containing procedures and timelines for how an identified holding company with a debt to equity ratio of more than 15 to 1 at the time such company becomes an identified holding company shall reduce such ratio.

Oh my God, she gets it.

GET ON THE PHONE FOLKS!

Washington D.C. Office
211 Cannon House Office Building
Washington, DC 20515
Phone: (202) 225-3531
Fax: (202) 226-4183

"Financial Stability" Bill: A Chimera?

nospam@example.com (Karl Denninger) — Mon, 16 Nov 2009 08:54:00 -0500

One wonders about this 1136-page behemoth......

First, some general observations:

It does not ban off-balance sheet exposures. Why not, given their history both in ENRON's collapse and the panic of 2008? How many times do we have to see these entities abused for the explicit purpose of hiding risk?
It draws a distinction between "regular" and "too big to fail" companies, putting the second into a putative "more supervised" bucket.
It lists requirements that allegedly already exist - including for capital, leverage and "prompt corrective action." But nowhere in the proposed Title does it appear to contain either civil or criminal penalties for the new agency if it fails to discharge its responsibilities. As we have repeatedly seen under existing "Prompt Corrective Action" you can have all the laws you want but if nobody will enforce them they are meaningless.
The contingent capital - that is, hybrid debt that is automatically convertible to equity upon failure to meet a standard set by the agency - sounds good. But is it good? Well, maybe. More on that later.
It does not appear that this act prevents "large" companies from restructuring as a group of bank holding companies to evade supervision. I may have missed it, but if there is a clause or title in there that prevents cross-ownership evasion (by treating any such cross-ownership as one firm for the purpose of classification) I didn't see it.
The leverage limits specified in the act (the "floor", p56) is ridiculously low. 2% capital in tangible equity? That's 50:1 leverage! What are these people smoking? Remember - Bear and Lehman both failed at about 30:1. Prudential eh? Like hell. Realize that with a 2% tangible equity floor a mere 2% loss on assets results in bankruptcy. How many times have we seen traded securities lose 2% or more in a single day? Many. How does one call this "prudential"?
Credit exposure: There goes the need for "23A" exemptions. The putative limit of affiliated and unaffiliated firms is 10% to any single firm, although The Fed has handed out exemptions to that limit like candy on Halloween. This bill puts a 25% limit (!) on unaffiliated credit exposure - a more than doubling of the previous limits. This is a tightening of risk controls? Like hell. In addition allowing more than ten times the credit exposure to an entity than the equity capital requirement is asinine - this would theoretically allow a single counterparty failure to wipe out the firm's capital by that same ten times! A firm should not be allowed to have more exposure to a given counterparty than its equity cushion to prevent any single failure from cascading through to the regulated entity and taking it out.
The putative "resolution authority" allows the assumption of literally any risk, putative "asset" or liability of a failing firm with the full faith and credit of The United States. This is effectively the provision of a blanket guarantee of any large financial firm's assets and liabilities by The US Federal Government. I thought we were getting rid of moral hazard (or is that "mortal hazard" - to the government?)
The putative "resolution authority" creates an explicit right to do what The Administration did with GM, Chrysler and others - to insert the government in front of Senior Creditors. Over the last year or so the sanctity of the capital structure has been essentially destroyed - this act makes that destruction a matter of formal federal law. Blech.
The putative "resolution authority" specifically bars judicial review for those creditors who claim they were screwed by the imposition of modified claim priority. This codifies in black letter Federal Law what was done to Chrysler and GM bondholders.
Ridiculous shortening of statutes of limitations. There are peppered all over this legislation unbelievably short periods of time to file claims, from 30 to 90 days - dramatically shortening the time to bring suits. This appears to be intentionally designed to limit the ability of those who believe they were abused by these processes to obtain judicial relief.
The supposed "strengthening" of regulation of OTC derivatives contains a very important weasel provision on page 385. Specifically, it says ".... MAY jointly prescribe rules defining the term "swap" or "security-based swap" to include transactions that have been structured to evade this title." Note the word MAY. It is not SHALL, meaning that just as has occurred to date, the CFTC and SEC can willfully and intentionally allow firms to evade all of these "reforms" - and you can bet they will, since this is entirely within their discretion. Oh, and the byzantine definition of these products has enough holes to drive a truck through - sideways.
This act specifically preempts state "bucket shop" laws relating to swaps and OTC derivatives. This is a serious problem folks - the issue with "bucket shops" is that the putative "dealer" isn't really dealing at all - you're betting against him and he controls the bid and offer, thereby making it trivially easy to guarantee that you lose. While there hasn't been much in the way of attention paid to this, I am deeply troubled by inclusion of explicit federal preemption of these laws - who in the financial industry wants to be able to evade these important protections in state law, and why?

This act effectively transfers and consolidates the OCC and OTS into this new agency, deleting them. There may be some good that comes from this, in that OCC and OTS have been accused of both malfeasance and misfeasance - and in the case of OTS, specific allegations of conspiracy to cook the books (e.g. Indymac) have been made. Nor is this a new problem - it featured prominently in the S&L crisis as well with some of the same actors. But putting a different name on the door doesn't change the agency. What's missing here is the same thing that has been missing up until now - an "or else" putting criminal and/or civil penalties into the law so that those who have or do commit this sort of accounting fraud can and will face the music.

Contingent capital sounds like a great idea, and it might even be a great idea. But who had the idea to set the bar on leverage at 50:1 (a 2% equity requirement)? That's insane. What's wrong with the former 12:1 standard? Oh, I know, these so-called "too big to fail" companies can't make as much money. I thought the purpose of this act was to impose stronger leverage limits and prudential regulation, not loosen standards further? Why are we going from 40:1 (today) to 50:1 (in this act) if that is the case?

There is a fair bit to like in this act. The explicit statement of support for state laws in the consumer protection realm that are stronger than federal protections is one of these areas. The abolishment of "venue shopping" when it comes to regulators (e.g. OCC .vs. OTS) is long overdue.

But the above bullet points are troubling, and this act reeks of having intentional loopholes written into it via obfuscation, along with no statutory demand that the new FIRA agency actually stomp on such abusers. There are too many "mays", not enough "shalls", and an absolute lack of "or else's" - making this one of those acts that says more by its absence than presence.

Add to that the further loosening of leverage limits and you have what is obviously a lobbyist-written "bill" that totals 1136 pages primarily as a means to dissuade anyone from reading it.

Well, it didn't stop me.... and what I see in there, despite the gloss of some improvements (especially in consumer protection) is a big fat stinking piece of used dog food when it comes to financial stability and prudent regulation.

Too Big To Exist

nospam@example.com (Karl Denninger) — Tue, 10 Nov 2009 09:01:00 -0500

Senator Sanders has filed a bill called "Too Big To Fail, Too Big To Exist."

Unlike the 1900 page monstrosities, this one will take you just minutes to read. It is two whole pages.

It should become law tomorrow.

There will be those who argue that this is "anti-capitalist."

On the contrary; by refusing to force banks and other institutions to adhere to the fundamental principle of sound fractional lending - that is, insisting that for each dollar of unsecured lending outstanding at any instant in time the institution hold one dollar in actual capital we have extended the credit of the sovereign (in this case The United States) through allegedly-private institutions.

This is the sin upon which all the screaming for "bailouts" rest, for without violating this fundamental banking principle there would never be a need for a bailout, as each institution would always, at any instant in time, be able to cover every withdrawal through both asset sales at the market and excess capital held.

I therefore fully support Senator Sanders' bill and urge you to head to his petition site and sign it.

Those who argue that banks and other firms should be able to grow as large as they like cannot get past the above italicized paragraph. No firm is limited in size, but no firm should be able to leverage the government's credit for it's own private purposes, as we have seen that each and every time it is allowed these institutions use that leverage to screw the consumer and then force the taxpayer to bail out their bad lending decisions.

Senator Sanders has the right solution - one that allows firms that do not wish to be broken up to raise sufficient capital so that each dollar of unsecured lending is backed by one dollar of capital.

Such a firm, irrespective of size, would not be "too big to fail"; as such this bill would impose market discipline - not, as I'm sure detractors will argue, "socialism."

Sheila Bair: All Bark, No Bite

nospam@example.com (Karl Denninger) — Mon, 02 Nov 2009 14:11:00 -0500

Sheila is apparently upset at the banks "pushing back" against reform:

Sheila Bair, chairman of the Federal Deposit Insurance Corp, said on Monday that some in the financial services sector are trying to argue that regulatory reform would stifle innovation and impede economic growth.

"That makes me angry," Bair said in a text of remarks prepared for a lecture at Kansas State University.

It does? You're not showing it.

How hard is this Sheila? You have the authority, along with the OTS and OCC, to walk into any bank in the United States with your examiners, look at every asset they hold, compare it against your standards of a "reasonable" mark and take action if you find that the bank could not be liquidated "at or above par."

You not only can do this but Prompt Corrective Action, US Code Title 12, Chap 16, Section 1831o mandates that you do, as that law is liberally peppered with "SHALL"s and has precious few "MAY"s.

Sheila is being gamed because the FDIC has shown over the last two years that whenever the banking industry say "Bark" the response from Sheila is "YIP!" Indeed, when I looked up "lapdog" in an online dictionary I got the following back:

lap*dog
Function: noun
Date: 1645

a small dog that may be held in the lap

a servile dependent or follower

Sheila Bair

Oops, did I make that last one up? Well....

There is already plenty of law on the books to cover what's been going on here, especially when it comes to banking regulation.

The examiners can have their mandate set by Sheila, along with the OTS and OCC. Their job, after all, is to determine what the odds are of loss to the deposit fund and whether a bank is safe and sound (for depositors), not whether the numbers will look good for Wall Street's quarterly parade.

Yes, I'm sure the banks would grouse if the examiners were to show up and demand that banks hold capital against the underwater portion of Home Equity loans, subprime CDOs and similar garbage. They'd also squeal if the examiners decided that any loan that was 60+ had to be reserved against at recovery value.

So what? The response ought from them to be "Talk to the hand."

Those banks that don't like these rules don't have to take FDIC insurance! They can run without it if they're so "safe" - let's see how many depositors they retain without it.

If Sheila doesn't like being the hard-nosed enforcer of capital adequacy and marking assets at recovery value as soon as loans fail to be paid on time then she should resign and cede the office to someone who has no problem getting on the phone - or showing up in person - and raising hell.

I'll volunteer, and suggest that anyone wondering if I have the "sack" for the job should find Mory Ejebat (formerly of Ascend) and mention my name.

Bring a tape recorder and post the result on YouTube.

Alternatively, just read a few Tickers.

You Can't Possibly Be Serious (CRE)

nospam@example.com (Karl Denninger) — Sat, 31 Oct 2009 10:03:00 -0400

I am speaking of the notion that went up the flagpole on allowing banks to refinance commercial real estate loans at more than 100% LTV - and having this "overlooked" by regulators.

Oh, but they are!

Regulators, in a significant step, also said they won't penalize banks for performing loans where the value of the underlying property is now worth less than the loan balance.

Who did this?

The guidelines, released on Friday by agencies including the Federal Deposit Insurance Corp., the Federal Reserve and the Office of the Comptroller of the Currency, provide guidance for bank examiners and financial institutions working with commercial property owners who are "experiencing diminished operating cash flows, depreciated collateral values, or prolonged delays in selling or renting commercial properties."

Their comment?

"Financial institutions that implement prudent [commercial real estate] loan workout arrangements after performing a comprehensive review of a borrower's financial condition will not be subject to criticism for engaging in these efforts," the agencies said in a policy statement.

One of the definitions of "prudent lending" is not to lend beyond the current value of a given asset, with any such "excess amount" requiring a dollar-for-dollar reserve of the bank's own capital.

Of course the others are knowing that the borrower can pay, which they appear to be covering.

But just as in residential real estate when you lend in commercial real estate beyond asset value you're doomed, because it is not possible to have a reasonable expectation that the borrower will continue to perform!

Why?

Primarily because demanded rents cannot be maintained.

Take two strip malls across the street from one another. Both started with a "value" of $10 million. Both now have a "present value" of $5 million. Both are identical - in the same location, on opposite sides of the same road, both have the same square footage and amenities.

One loan is foreclosed and the property sold - for $5 million. That buyer finances the $5 million purchase.

The second is "worked out" instead of demanding that the borrower either be foreclosed or pony up the other $5m (which he doesn't have), and the bank rolls the note at a negative equity position of $5m.

What happens?

Tenants start to go out of business. As space opens in the $5m note mall, those in the $10m note mall see the open space. So do potential new tenants.

Is the rent in the $5m note property going to be higher or lower than the rent in the $10m note property?

How many of the $10m note property spaces will be rented one, two, three or five years from now, compared to the $5m property?

What is going to happen to that $10m loan?

This is an out-and-out scam that is simply going to end up costing the FDIC even more money, because the banks will be even further underwater when the note on that "worked out" property inevitably blows up.

Every time I see the government come up with some hair-brained scheme that will (1) never work and (2) will explode in the taxpayer's face, I maintain that I've seen the dumbest thing yet.

Unfortunately the FDIC and other regulators keep outdoing themselves.

Financial Reform: Other Testimony

nospam@example.com (Karl Denninger) — Thu, 29 Oct 2009 13:09:27 -0400

I know I keep talking about pieces of this (and in fact posted an earlier Ticker related to Sheila Bair), but I believe it is important to piece it all together.

First, the financial regulatory hearing had one of the most outrageous pieces of testimony that I have heard in a long time from the ABA:

It is critical that banks remain committed to the long-term. For banks to provide long-term loans to, and investment in, businesses, communities, and consumers’ futures, banks must not have their loans and investments marked to prices set in markets that are panicked or are over-exuberant. These are long-term investments, not day-to-day trades. Simply put, if FASB continues its effort regarding mark-to-market, the lesson learned from this financial disaster will be that long-term loans and investments will have their valuations destroyed, and therefore the bank will be destroyed, by mark-to-market accounting during financial panics.

Panics only happen when you first have financial bubbles caused by loose lending policies.

This is the worst sort of complaint from an arsonist who has managed to accidentally burn down his own house! "But the fire was so unfair!" he protests, while hiding his own gasoline can - which he spread liberally around the neighborhood!

SIFMA also ignores the 900lb Gorilla in the room, refusing to accept their member's responsibility for creating the bubbles in the first place, then bleating about "fair value" in a panic of their own creation. But the gist of the issue we now face is in fact that "fair value" is in fact zero for many of the instruments currently being held at or near "par". As just one of many examples we have the HELOC exposure on all of the major banks - 70% of the dollar value is in the bubble states and by law these are subordinate loans - if the first mortgage balance is higher than market value this is an unsecured credit line and has zero recovery value in the event of default, yet there is absolutely no accounting recognition of this fact that I can find in quarterly reports over the last two years.

Interestingly enough the AFL/CIO has a very critical piece submitted to the panel; among their comments was this nugget:

These arrangements may explain why the Federal Reserve has never given any account of how it allowed bank holding companies like Citigroup and Bank of America to arrive at a point where they required tens of billions of dollars of direct equity infusions from the public purse to avoid bankruptcy.

Is there an explanation required? Willful blindness is obvious in this instance. So is the willful blindness that has trashed AFL/CIO (and other) pension plans who were investing in securities that ultimately were proved to be worth far less than represented (and in some extreme cases actually worthless) - all through a process of intentional obfuscation that was known to The Federal Reserve system and yet not only left alone but actively encouraged under Alan Greenspan's tenure, and ignored during Bernanke's.

The fact of the matter is that while "mark-to-market" may be imperfect, published, market prices are superior to all others, in that there is a reference - what a willing buyer will give you for a given asset right here and now.

The function of the banking system is not, as often believed, to allow certain "favored sons" to get wealthy while everyone else gets screwed.

I have repeatedly documented that many of these so-called "securitzations" were the financial equivalent of claiming to have spun flax into gold, in that it is not possible to return more, in aggregate, on a risk-adjusted basis than was present in the original lending transaction. Since nobody works for free the all-in return on any securitization must mathematically be significantly less than would be the case for the same basket of single loans held by the originators. The primary means by which such "flax-spinning" occurred was by hiding risks - not clearly documenting, for example, that <X> percentage of the loans in the pool had no documentation of income or assets, and that HUD had found that those who took "stated income" loans tended to overstate their incomes by 50% or more. By this bit of omission these securities were thought of as "safe", when in fact nothing was further from the truth.

The fact remains that until we force the schemes, intentional mis-valuations and lies out into the open, enforce existing law that makes fraudulent conduct illegal and start locking up the scammers up the down the line trust cannot return to the economy.

What the AFL/CIO needs to understand, along with the rest of America, is that these losses did not happen due to bad luck or a "bubble bursting" - they happened due to lies, intentional obfuscation and even fraudulent misconduct that resulted in the bubble's growth in the first instance, all fueled by making loans - creating credit growth - that the originators of said loans either knew or should have known could not, in aggregate and in the fullness of time, be paid back.

I continue to return to the mathematics because the math is never wrong and can never be debated. Again, the GDP and Credit Growth chart:

From The Fed's own Z1 data the Compound Annual Growth Rate of debt since modern records have been kept (early 1950s) is 8.77%, while GDP has grown at 6.82%, a difference of 1.95%.

Since 1990 Debt has grown at a compound rate of 7.91%, while GDP has grown at 5.39%, a difference of 2.52%.

Since 2000 debt has grown at a compound rate of 8.49%, while GDP has grown at 5.22%, a difference of 3.27%.

The "spread" is and has been increasing and it is a mathematical fact that such cannot be maintained in perpetuity.

Yet the merchants of debt, including Bernanke and The US Congress, continue to refuse to deal with the mathematics - even when it screws major constituencies such as the AFL/CIO.

Bair Starting To "Get It"?

nospam@example.com (Karl Denninger) — Thu, 29 Oct 2009 09:16:00 -0400

One wonders....

Oct. 29 (Bloomberg) -- Federal Deposit Insurance Corp. Chairman Sheila Bair, breaking with the Obama administration, said U.S. financial companies should prepay into a fund the government would use to unwind large failed firms.

Congress should set up a Financial Company Resolution Fund and force institutions with more than $10 billion of assets to pay before a firm collapses, Bair said in testimony prepared for a House Financial Services Committee hearing today. Investors in failed companies also should take losses, she said.

Getting a little religion here Sheila?

Let's review, however, history. Recent history.

Preservation of the legal strictures of capital structure is very important in order for investors to have a reasonable expectation of consequence in the event of a failure - and thus be able to price risk.

But this foundational principle - the sanctity of contract and capital structure - has been roundly abused and flatly ignored by the government since this crisis began.

Chrysler, GM, a plethora of banks including Lehman, Bear and others - in exactly none of these circumstances has the capital structure remained unmolested. The abuses in GM and Chrysler's cases, in particular, were ridiculously egregious that one simply can't make the argument that there is in fact a distinction between "Senior" or "Secured" and unsecured bondholders any more.

Never mind events such as Indymac Bank's failure - the bank holding company and bank itself were effectively asset-stripped by government fiat, leaving the supposedly-super-senior claims - those of depositors who had more than the insured limit on deposit with the bank - with absolutely nothing against which to recover.

The draft legislation creates a council of regulators, including the FDIC, to monitor companies and the economy for systemic risk. While Bair supports the concept, she said the proposed council “currently lacks sufficient authority to effectively address systemic risks.”

Congress should require a presidential appointee as the council’s leader to ensure its independence and set an odd number of members to avoid deadlocks, Bair said.

I agree. That appointee needs to be a publicly-vetted and appointed person with Senate confirmation. Since this is inherently a function of protecting the public purse, it must NOT fall to an unaccountable person such as Bernanke, who has shown repeatedly that he has not and will not enforce the regulatory strictures even when so demanded by black-letter law, and that Congress will not place him - or you - in the dock when you willfully and intentionally ignore the law.

Bair and lawmakers have said a lack of a mechanism for shutting large firms in an orderly way led to ad hoc programs, such as the $700 billion taxpayer bailout used by lenders including Citigroup Inc. and Bank of America Corp.

There is such a system - you just don't like it and therefore have willfully and wantonly ignored it. It is called bankruptcy and in fact the regulation of same is one of the enumerated powers in The Constitution delegated to the Legislature (Art 1 Section 8)-

To establish a uniform rule of naturalization, and uniform laws on the subject of bankruptcies throughout the United States;

How can appointed Federal Officials manage to be installed in their offices without reading The Constitution, say much less understanding it?

This is a good start Sheila - now let's see you enforce "Prompt Corrective Action" and close each and every bank that has a negative ratio of assets to liabilities on a market-price basis, so that the disasters we've seen over the last two years with 20, 30, 40% or more losses to the Deposit Insurance Fund stop happening.

Oh wait - that would mean you'd have to close some of those "really big banks" here and now, wouldn't it? It would also mean you'd have to take out that pile of trash called "GMAC", which after huge infusions of taxpayer capital is still trying to grab more to remain alive, while running national advertisements under their name "Ally Bank" for above-market rate CDs!

Hmmmmm...

Goldman's Dissembling (Dark Pools .et.al.)

nospam@example.com (Karl Denninger) — Tue, 27 Oct 2009 08:13:00 -0400

Now comes Goldman with yet another pack of misdirection:

Goldman told the Securities and Exchange Commission that computer-driven trading and an increase in stock transactions that occur off public exchanges has reduced consumer costs, increased competition and brought more liquidity to markets.

“The investing community (especially retail) has benefited from the evolving market structure and industry competition,” Goldman Sachs said in a summary of the 55-page report submitted to the agency.

You have to love the general gist of this thing.

Let's break down what's really going on here, because it is both instructive and, in my opinion, necessary.

Dark pools and High Frequency Trading reduce transparency. The argument raised by Goldman and others is that these venues "improve price" for retail investors (and others), such as mutual funds (held by many retail investors.) The problem is that this is the wrong metric to apply.

Trading in established stocks is in fact a negative sum game. That is, for every share I get a "better price" on as a buyer, the seller gets a lower price. Worse, since there there are commissions and fees involved in all transactions, the net effect of each trade is to dilute the total capital base in the system.

An example will serve to show this:

$1,100 in total money in the system.
100 shares @ $10 "quoted".
Taxes, commissions and exchange fees of 1% of the transaction.

The buyer and seller transact all 100 shares. There is now $1,090 in total money (the other $10 has been siphoned off in commissions and fees.)

Do it again. There is now $1,080 (another $10 has been siphoned off.)

Perform 10 transactions and oops - there isn't enough money to transact an 11th time.

Now here's the rub - the amount of "spread" that the market maker, which would be Goldman (among many others) can make is entirely dependent on the ability to hide the actual bid and offer by real investors!

That is, let's assume that of the $10 in commissions and fees Goldman gets as a straight commission half of it. The rest is exchange fees and taxes. That is, off those 10 trades Goldman would make $50, the government would get perhaps $10 in taxes, and the exchanges would get the other $40 split among them in various service charges and such.

But what if the seller was willing to sell at $9.90, not $10, and yet that was in a "dark pool"? That is, the buyer of those 100 shares saw only the $10 price on the public exchange, and not the $9.90 offer in the dark pool?

Well now Goldman could buy those shares for $9.90 and immediately sell them to the willing buyer for $10.

Suddenly their $10 "commission" turns into $20 - a doubling of their profit on the trade, with essentially zero risk, since they will only execute this trade if they see both a bid at $10 and the "dark" (invisible to the retail investor) offer for $9.90.

The argument is often made that institutional investors would "dramatically" move the market with their entries or exits if they were required to be published on the exchanges in real-time.

Well, yes. And? Exactly why is this bad? Is not the price of a security supposed to reflect the supply and demand for that security?

Remember that for every buyer there is a seller, and for every seller (even if the seller is selling short!) there is a buyer. Each and every trade that "advantages" one person through obfuscation and hiding of information disadvantages someone else by the exact same amount of money, and further allows someone to skim off a piece of the transaction without being detected.

Goldman's position on this is entirely self-serving. They not only earn fees by operating one of these "dark pools" they also are given the opportunity to exploit the hidden nature of price to skim off part of the transaction stream for their own benefit. That money always comes from one of the two parties - the actual buyer or seller - and if the "retail buyer" on one side benefits the retail seller on the other side is getting screwed.

All "Dark Pools" and other means of gaming the system - that is, asymmetrical information - are without exception working against transparency and open markets. Ever since the markets went to "pennies" the market makers and brokers have been trying to find ways to skim that 1/8th or 1/16th they used to "earn" off the spread in transactions that was formerly theirs as a consequence of an enforced differential between bid and offer.

Goldman's argument that retail investors are "helped" or "benefit" from dark pools and other means of obscuring price discovery is a flat-out lie.

The truth is that some retail investors "benefit" while others are screwed in an exactly equal amount, while at the same time the big broker-dealers exploit the hiding of information to skim off pieces of the transaction stream that radically increase their profits.

On-balance this is of net DETRIMENT to market participants, as the increase in skimming, whether through fees or exploiting the hidden nature of bids and offers, always must come from one of the participants in the market, as for each buyer there is a seller and vice-versa.

There is no free lunch.

Asymmetric Information Strikes Again

nospam@example.com (Karl Denninger) — Fri, 23 Oct 2009 10:08:00 -0400

Once again the "banksters" asymmetric information campaign strikes again, this time in New Jersey:

While New Jersey replaced the debt with fixed-rate securities in 2008 after the $330 billion auction-rate bond market froze, the swap, in which two parties typically exchange fixed payments for ones based on floating interest rates, isn’t scheduled to expire until 2019.

The state paid $940,000 under the agreement last month and a total of $11.4 million since the auction-rate bonds were redeemed. The expenditures come as the fund reaches its borrowing limit and Governor Jon Corzine, Goldman’s former chairman who was a U.S. senator when the contract was signed, seeks $400 million in budget reductions as tax receipts fall.

Goldman, of course, knew that there was a risk that the bonds would be redeemed or refinanced before the swap expired.

The State may not have understood that - but you can bet Goldman did.

This sort of game isn't unlawful, but it sure smells bad, and it points out the problem that information asymmetry poses to both consumers and municipal governments.

Banks of course say (with some justification) that the rule is "caveat emptor." Customers (including municipalities) say in return "but we didn't understand or know that", and they're right too.

I have a solution to this sort of game-playing: States must use their sovereign power to deny business licenses to those firms that pull this sort of crap.

Corporations must register as foreign corporations to maintain a business location ("nexus") in a given state. Those who abuse consumers or the state itself should have that privilege withdrawn.

That too is legal, and since banks assert repeatedly (as also happened in Alabama) that such behavior is perfectly ok on their part, then I call for states to assert their rights to refuse foreign corporate registrations for these banks, and further to provide by statute that state agencies must do business only with firms holding proper foreign corporate registrations in the state involved.

This instantly deprives any firm that pulls this sort of crap all revenue from that state, and is the "balance of power" that is sorely needed. It is also unquestionably legal.

Short Sales: The Real Issue

nospam@example.com (Karl Denninger) — Wed, 21 Oct 2009 15:31:00 -0400

Matt Taibbi once again writes in Rolling Stone, this time on naked short sales, and while he gets a good part of the issue right, he (and many others who have opined on this situation over the years) miss the forest for the trees.

Matt writes:

But the most damning thing the attack on Bear had in common with these earlier manipulations was the employment of a type of counterfeiting scheme called naked short-selling. From the moment the confidential meeting at the Fed ended on March 11th, Bear became the target of this ostensibly illegal practice — and the companies widely rumored to be behind the assault were in that room. Given that the SEC has failed to identify who was behind the raid, Wall Street insiders were left with nothing to trade but gossip. According to the former head of Bear's mortgage business, Tom Marano, the rumors within Bear itself that week centered around Citadel and Goldman. Both firms were later subpoenaed by the SEC as part of its investigation into market manipulation — and the CEOs of both Bear and Lehman were so suspicious that they reportedly contacted Blankfein to ask whether his firm was involved in the scam. (A Goldman spokesman denied any wrongdoing, telling reporters it was "rigorous about conducting business as usual.")

Matt gets so close, but fails in the closing.

See, there are two area of naked shorting that nobody wants to really deal with, yet both have to be if we are ever to make a difference. Let's deal with them in turn.

The first, the writing of "naked" swaps, is one that I've written about before. The essence of a "credit default swap" is a contract whereby the buyer of protection insures against the default of a credit instrument (usually a bond of some sort.) If the bond issuer doesn't pay principal and/or interest, the buyer collects the face value of the bond from the seller of protection - but in turn must tender the defaulted bond to the seller.

This "tender requirement" is due to the fact the most of the time a default bond is not worth zero - even in a bankruptcy most companies have some value, and the bondholders are entitled to that recovery.

This is pretty much like homeowners insurance if you think about it. Your house might have a fire, but odds are it won't be worthless if there is. Same with auto insurance - you buy insurance against a wreck, but if you have one, the insurance company can pay you the market value of the car prior to the crash and in turn they get to keep the (wrecked) car.

Now envision that we allow any number of people to buy fire insurance against your house. There's only one house, but ten fire insurance policies. Only one of those people (you) owns the house and only one of them (you) lives there, but ten people stand to collect whatever the damage amount is if there's a fire.

How likely would it be that someone would be sneaking around with a gas can at 3:00 AM were this to be allowed?

Now let's add another wrinkle to the mix - to collect on any of the insurance policies you must have possession of the house!

Tonight, you have a real fire and the house burns to the ground. The recovery value is zero; indeed, it might be negative (since you have to hire a bulldozer and cleanup crew to clear away the mess before you can rebuild.)

But if there are ten insurance policies, suddenly that burned out smoking hulk has value that doesn't really exist, and a bidding frenzy is likely to develop for the (one) house. See, without the (burned out) house to tender those insurance policies are worthless.

We don't allow this sort of thing in the insurance business because it both distorts the market and creates a reason for people to intentionally start fires.

Why do we allow it in the "credit default swap" business?

Did a few people intentionally start some (financial) fires?

The same thing applies, ironically, when it comes to options. See, if I buy a PUT option the market maker who sells it to me immediately hedges his exposure. If the market maker does not hedge and the price collapses, I will put the shares upon him at vastly more than their value and he will suffer a huge loss. He has no reason to take that risk; his money is made on the bid/ask spread, and he has no reason to take a directional bet on the stock's price (he may, for that matter, agree with me on which way he believes the prices will move!)

Market makers are exempt from the prohibition on naked short sales. They should not be. To allow them to be is to remove one of the actual risks in an option transaction - execution risk. That is, it is entirely possible to have more PUTs (or CALLs) outstanding than there is public float of the underlying issue! It is also possible for those to go out in the money and be exercised, and if that happens then you have created exactly the same sort of counterfeiting fraud that exists with a raw naked short.

The same problem exists on the long side. When a naked short has to be bought back, there are insufficient shares available to do so. This creates a dislocation in price to the upside. While everyone talks about "bear raids" nobody talks about synthetic and fraudulently-generated short squeezes - yet they are just as pervasive in impact as naked shorting, but in the opposite direction.

How many of the so-called "vertical" moves we have so often seen in stocks since last fall, in both directions, can be attributed to this?

The answer? Most of them.

The only check and balance on this is to not exempt market makers from the constraints that everyone else must follow - that is, you can't short shares you cannot actually borrow, and you can't buy something that nobody is willing to sell at the desired price. Put more simply, the quantity of a given stock in "float" is in fact fixed, determination of the float is made by the corporation when they decide how many shares to issue, and nobody can be allowed to count a given share twice, no matter how that double-counting would otherwise occur.

Removing this pervasive fraud from the markets would cause option premium to rise a lot when the open interest began to approach a meaningful fraction of the float, and it would bar the writing of credit default swaps in amounts that exceed, in total value, the underlying reference. That's how it should be, and it would have made the sort of bets placed last year uneconomic, as execution risk, which in fact exists, would have to be computed into the option's (or CDS') value. Today, it is not.

Matt gets so close, but then fails in the end.

The reality is that this sort of "counterfeiting" is in fact part and parcel of both the option and credit-default-swap markets, and in each and every case, including old-fashioned naked short sales, it is in fact an act of fraud.

We don't need new laws - we simply need the existing laws that deal with forgery and counterfeiting enforced across all investment products, and the "special exceptions" that legalize certain sorts of fraud must be removed.

"Financial Autopsy" Amendment - CFPA

nospam@example.com (Karl Denninger) — Wed, 21 Oct 2009 08:10:00 -0400

Word comes from DC that there is now a "Financial Autopsy" amendment in the CPFA bill, courtesy of Grayson/Clay/Miller. The summary is:

Financial Autopsy Amendment:

- Requires the CFPA conduct a “Financial Autopsy” of each state’s bankruptcies and foreclosures (a scientific sampling), and identify financial products that systematically led to a large number of bankruptcies and foreclosures.

- Requires the CFPA report to Congress annually on the top financial products (the companies and individuals that originated the products) that caused consumer bankruptcies and foreclosures.

- Requires the CFPA take corrective action to eliminate or restrict those deceptive products to prevent future bankruptcies and corrections

- The bottom line is to highlight destructive products based on if they are making people “broke”. Thank you for your consideration, we hope you will join us in supporting this amendment.

Sincerely,
Alan Grayson Wm. Lacy Clay Brad Miller

This sounds good, especially at first blush, and is certainly a move in the right direction. But......

There is nothing preventing financial institutions from "tweaking" a product that causes trouble and reintroducing it. The general problem here is the same as what we've seen before with so-called regulation - the lack of an "or else.
There appears to be no financial sanction or clawback to compensate those who are harmed by these products.

I generally like the premise, but I don't like the lack of hard accountability. "Stop beating your wife" sounds good, but who pays for her medical treatment? More importantly, if you beat your wife with a baseball bat, simply removing the bat is insufficient so long as there is a kitchen full of knives and chairs available to you when she returns home!

This sort of "feel good" legislative amendment will of course be resisted, but it simply isn't enough. The basic principle of equity (better said as "fairness under the law") puts forward the premise that one cannot cheat and be allowed to keep the fruits of one's outrageous behavior.

So while I like the direction of this amendment, I would put forward the premise that the entirety of the gains "earned" from such toxic products, when found, are clawed back and distributed to the consumers so harmed, and that to the extent this does not fully compensate for that harm such a finding should give rise to a private, civil cause of action for the consumers who are bankrupted or foreclosed.

The key here is that in order for that cause of action to exist a finding must be made that systematically cause a large number of foreclosures and bankruptcies.

We do not simply bar people from creating toxic "foods" and "drugs", we expose them to legal liability if and when they do.

Pure logic dictates that screwing someone, no matter how you do it, should lead to legal sanction and exposure for your outrageous conduct. How we have managed to get to a place in this country where that is not the immediate and indisputable response to such ridiculously egregious conduct is something we must address - and resolve.

Bernanke Under Fire: Grayson / Paul

nospam@example.com (Karl Denninger) — Thu, 08 Oct 2009 08:39:00 -0400

In a letter to The Senate Banking Committee today Representatives Grayson and Paul demanded of Senator Dodd that Bernanke's reconfirmation hearing be suspended until The Fed provides answers to several questions, specifically:

Information that Bloomberg reporter Mark Pittman has requested via a Freedom of Information Act Request on the Bear Stearns rescue and that the Federal Reserve is contesting in the courts and which Manhattan Chief U.S. District Judge Loretta Preska has ordered by turned over by the Federal Reserve.
Information that Rep. Grayson requested in February at a hearing and by follow-up letter on which institutions received the $1.2 trillion added to the Federal Reserve’s balance sheet, how much each institution received, and what was promised in return.
All Federal Reserve documents that went to Attorney General Andrew Cuomo’s office relating to the Bank of America/Merrill Lynch merger in which potentially illegal and coercive activity might have occurred, as well all Federal Reserve documents relating to the lawsuit pursued by Merrill Lynch shareholders in the US District court for the Southern District of New York.
Transcripts of all Open Market Meeting Minutes up to and including that of June, 2009, transcripts which are normally withheld from the public for five years.
Full disclosure of all terms and conditions of all off-balance sheet Fed transactions in the past three years.

I have been sharply critical of Representative Paul over the previous two years in The Ticker, mostly due to the fact that he has refused to display evidence that he "gets it", including questioning directed to Fed Chair Bernanke in multiple hearings since this crisis began. "Hard money", his "all the time, every time" issue will no more solve the problems our nation faces than will wishing for The Easter Bunny or believing in Santa Claus.

But today I am forced to change my beliefs, at least in part. I don't know if Representative Grayson turned a light on or if Representative Paul simply woke up over the last couple of months, but what I see here before me is a substantive and welcome change.

Now I want to challenge both Representatives Paul and Grayson, as well as the rest of the House and Senate, to consider the following points:

This is not a Recession. It is a Depression. All credit-led economic downturns are. If you doubt that this is a Depression have a look at the article in The Detroit News today, chronicling a scene every bit as forlorn as was seen in the 1930s, every bit as poignant, and every bit as unnecessary. It was asked:

"This morning, I seen the curtain pulled back on the misery," he said. "People fighting over a line. People threatening to shoot each other. Is this what we've come to?"

It is what we will come to nationally if we do not stop the stupidity here and now.

Government created this Depression just as Government created the Depression of the 1930s by refusing to do its job of regulation. 75% of the people in the 1930s had jobs. 75% of people have jobs now. If you truly believe that unemployment is 9.something percent, you're delusional. If you believe it is the 16.x percent that is recorded in "U-6" you are likewise delusional as neither counts those who have given up trying to find work. Take a trip to Detroit, Michigan. It is not that different from any other major city today. If your perspective is limited to the Beltway of Washington DC or the sheltered parts of America where it all appears ok you need to get out more often. I have, I lived in the Detroit area in the 1970s and 1980s, and I have never - ever - seen anything like what happened at Cobo Hall as described in that article before today in America. Anywhere.
This Depression was caused by the same thing all others in modern times have been: banks lending unsecured beyond excess reserves. That is, banks lending in a speculative rather than secured manner. That is the primary sin. It is that simple. It has always been the primary sin that has led to this result, and it is the primary sin this time as well. This must end, now and forever, if we are to both stop this lunacy and prevent it from ever happening again. Our regulators, our Congress, and so-called "economists" have spent more than two years waving their arms claiming that this or that "tweak" to the regulatory structure will prevent systemic risk and set things right. They're either wrong or lying and the proof lies in mathematics, not political or philosophical dicta. If you need an explanation, read "Sound Banking: A Capitalist Imperative." Reality is that if you provide a business with a means to speculate with someone else's money (in this case, yours and mine through the credit of the sovereign) they will do so recklessly since the losses are not theirs. You can only prevent this outcome by barring the practice.
We have compounded that sin by refusing to force banks to admit to their insolvencies, and there are in fact many, even a majority, that are insolvent. They are not "mildly" or "slightly" insolvent either. Just last week Warren Bank failed and was seized by the FDIC. The loss to the deposit fund is estimated at $275 million out of an asset base of $538 million - that is, the bank was underwater by 51%. But it is, in fact, much worse than that since "well-capitalized" according to the government requires a Tier 1 Leverage capital ratio of at least 5%. To fail "adequately capitalized" you must have Tier 1 Leverage capital under 4%. To put this in perspective this bank failed 12.75 times before being seized. This is not an accident, it is willful, deliberate regulatory malfeasance or fraud on the part of examiners and institutions. There is no other possible explanation. This is also not an isolated incident; Colonial Bank was seized recently, a huge bank, and the assets were written down 39% - a nearly ten-fold failure before being seized.
The government cannot make up for the contraction in private credit. All the government is doing is risking its own insolvency. We cannot run trillion dollar+ deficits - Depression or no Depression. We cannot continue to take bad debt onto the balance sheet of Treasury or The Fed and we cannot make unsound FHA (and now USDA!) real estate loans. WE CANNOT LIE OUR WAY OUT OF THIS. Despite the fact that Washington DC politicians are known for lying whenever their lips are moving, mathematics never lies and always catches up with you - without exception.
The Government's continued mendacity in this matter is leading to the destruction of the Dollar and, potentially, our economy and government funding mechanisms. We now have an active "carry trade" going on using dollars as the funding currency - an unthinkable situation just a few months ago. The credit system is functioning only in places where tens or even hundreds of billions in printed money are being used to "purchase" worthless (or nearly-so) loans. Fannie, Freddie and now the FHA have become embroiled in a futile attempt to prop up residential property markets, which in turn has led banks to withhold foreclosure actions as a means of hiding losses. This in turn has trapped millions of homeowners in underwater property, preventing them from moving to seek better employment opportunities and creating artificial shortages of housing in some MSAs as inventory is "locked up" by banks as a means to avoid recognition of losses that have already occurred.
We cannot restore our economy to health until we force the bad debt out of the system. We must stop trying to layer on more debt to pay interest on existing debt, and we must stop playing shell games with the bad debt that exists. It is mathematically impossible for credit creation to continue at a rate exceeding growth in output on a continual basis. The fraudulent granting of credit with no assets or capital behind it (#2 and #3) is why we are here. The only path to a durable economic recovery is to stop doing that which led us into the mess in the first place.

Given these facts we have choices to make as a nation.

We can choose to continue that which has failed, or we can choose to reform the banking and financial system. We can insist that the banking and financial system face the following regulatory changes:

Mark all assets to the market, now and forevermore, on a nightly basis. If this results in firms becoming insolvent, then so be it. We need a banking system - we do not need the specific banks we have operating today.
Pass a federal law mandating that receiving deposits or transacting business while insolvent is a felony, as is the case in several states. Then enforce it. Strictly.
Define insolvency as the inability to pay all depositors at any point in time through ordinary business transactions. This implements the requirement that banks lend unsecured only to the limit of their excess capital and never beyond. Banks can lend to any degree they'd like provided they have capital or assets of at least the outstanding balance behind each loan. If a bank wishes to lend to you on a credit card, it must hold one dollar of capital for each dollar you have outstanding on your charge plate. If a bank wishes to write a 100% LTV home mortgage it may, but it must hold one dollar of capital for each dollar of loan balance beyond your home's recovery value - including resale expenses. It is a bank's decision how close it wishes to operate to the line of insolvency and forced closure and it is also a bank's decision as to how much capital it wishes to raise; the less "cushion" it wishes to maintain the greater the risk that its shareholders and unsecured bondholders will lose everything through an unexpected drop in the market value of the assets behind their loans. This removes all the nonsense and games about "leverage" and reduces it to one simple reality: you may not impugn the credit of the sovereign (The Federal Government) as a private enterprise. Period.
Force The Federal Reserve to disgorge all of its non-government-guaranteed paper. The Federal Reserve Act (Section 14) clearly does not permit the purchase of any such obligation. This is a monstrous problem as there could be hundreds of billions of dollars in losses embedded in that paper and it was acquired illegally. Such a loss, if and when it detonates on their balance sheet, will have severe and perhaps catastrophic consequences for our government, our banking system and the dollar. The entire essence of Mr. Paul's and Mr. Grayson's (very valid) complaint is that The Fed is preventing trash debt resolution by taking it onto its own balance sheet and refusing to disclose that it has done so and how it has valued those so-called "assets." Disclosure is laudable but requiring The Federal Reserve to actually live within the strictures of The Federal Reserve Act should be the standard we demand.

These four steps end the credit crunch tomorrow and prevent it from ever returning. They also end a number of large financial institutions tomorrow. That's ok - there are literally 330 million capitalists in this nation, some of whom will want to start new banks, and there are also thousands of community banks and credit unions that can operate within these rules.

No, these steps will not bring back the "free credit" world of the 2000s. That is gone forever whether we like it or not. Credit will be available to worthy borrowers at a risk-adjusted interest rate that reasonably reflects the probability of default and inflation, plus a fair, demanded profit. This is how credit should have been for the past 230 years of this nation's history, and how it can be going forward.

In addition The Federal Government must adjust its policies and operations, specifically:

The government cannot spend more than it makes. With the possible exception of a declared war, deficit spending is indefensible, especially when the deficit reaches 30, 40 or even 50% of the entire Federal operating budget. If government wishes to increase spending then it must increase tax revenues. This in turn requires that The Government take a long, cold, hard look at how we can couple tax revenues to growth. I am a personal advocate of The Fair Tax because it aligns Federal Revenue with GDP and thus provides a powerful incentive for the government to act in a manner that promotes economic prosperity, but there are undoubtedly other means of accomplishing this central goal.
The government must not bail people out. The essence of capitalism is that when you screw up you fail - and go bankrupt. Only the hand of the market provides disincentives to bad decisions - either prospectively or, if not heeded, retrospectively by clearing the playing field for new entrants in the place of failed enterprises. The US car companies are prime examples; "Cash for Clunkers" and the US Auto Bailouts have been dismal failures; the collapse in sales in September has made clear that Chrysler, for example, is almost certain to fail to survive more than another year, even when the billions given to Cerberus to "restructure." That was pure money down the drain that accomplished nothing other than suspending Chrysler's death sentence for a few months to a year, yet it has blocked the acquisition of those facilities by a potential competitor as-yet unknown. The economic damage done via these interventions is severe and irreversible.
Government must enforce laws against fraud in all areas of the market evenly and swiftly. Banks, as just one example, cannot be permitted to "re-order" transactions so as to generate the maximum in overdraft and other "junk" fees - a clearly unfair business practice. The practice of pretending that loans are performing when they are not by shuffling paper around between subsidiaries must bring prosecutions, not forbearance. When someone is cheated (for example by bogus "ratings" on securities or unlawful front-running in the markets) they need to be able to look to the government for help, rather than the bad actors taking cover behind willful regulatory blindness.

The rest of the world is passing judgment on our nation's willingness and even ability to rein in the rampant financial fraud and outrageous acts that led us to this precipice. These nations are, quite realistically, looking to diversify away from the dollar for international transactions and as a reserve currency as they perceive that our government and business environment has become nothing more than a giant looting machine operated for the benefit of a handful of firms and people on Wall Street who have been and will be allowed to siphon off whatever they desire at everyone else's expense.

Firms and individuals worldwide were sold well over a trillion dollars of worthless securities by these bad actors. Some of them, such as the Chinese and large foreign banks, appear to have received a "back door" bailout via unannounced and likely unlawful actions of The Fed, while others have been left to twist in the wind.

Lehman was permitted to co-mingle customer margin funds with their own operating capital, resulting in billions of dollars of customer wealth that should not have been at risk being tied up in the bankruptcy courts, possibly for years, with a very real risk that it will never be returned to its rightful owners. At the same time The NY Fed may have have received their funds back immediately after the filing in violation of bankruptcy preference laws.

Our banking system is currently hiding hundreds of billions in defaulted mortgage loans "off book" via exotic and undisclosed financial shenanigans. In the instances where these properties are being disposed of huge losses, often in excess of 50%, are being realized - yet this is not being recognized as the "mark" on similar securities held by other institutions as it should be. This is presenting a false view of financial institution health, but more importantly it is severely constraining credit as consumers trapped in these homes where banks are refusing to proceed to foreclosure are unable to proceed to rebuild their credit while the banks are stuck with an "asset" they are refusing to sell at its market price, clogging up their credit origination capacity. Worse, those institutions that are disposing of these "assets" have first put in place "loss-share" arrangements where the FDIC or Treasury is in fact "eating" 90 or 95% of the losses - meaning that the loss of value in these assets (houses) is being distributed as a tax to all Americans! The banks that distributed these "profits" to shareholders and executives on the way up have managed to set up a "heads we win and keep it, tails you lose and eat it" circumstance - but only for them. For the homeowner he's bankrupted by these shenanigans and those who refused to participate in the fraud get the tax bill.

We can choose to address these problems now or we can continue to march toward the abyss. The loss of confidence in our government, in our regulatory agencies and indeed in our currency is on the brink of becoming disorderly. Should that point be reached it will be too late to take remedial action and our nation will be forced to suffer the (well-deserved) consequences of our willful blindness to these outrageous acts of looting, all of which will come raining down on American consumer's heads.

We the people must insist on better and hold our lawmakers feet to the fire. If the Washington DC politicians will not do their jobs then we must in turn insist that our state lawmakers do so - including, if necessary, by enforcement of our State 10th Amendment rights.

Reform: One Central Banker That "Gets It"?

nospam@example.com (Karl Denninger) — Thu, 24 Sep 2009 08:57:00 -0400

One has to wonder, given this testimony to be given today by Paul Volcker:

The challenge is not to paper over or tinker around the edges of the broken system. We need to minimize the danger that the uncertainties and risks inherent in the functioning of a market-based financial system do not again jeopardize the functioning and foundation of our economy.

Actually, the challenge is to lock up the malefactors, liars and thieves, of which there have been and are many.

What would be the bank robbery rate were there no penalty for robbing banks? You need look no further than the so-called "regulatory framework" for the source of the problem - The Federal Reserve Act, the enabling legislation for the OTS and OCC, "Prompt Corrective Action" - all of these are great-sounding laws but none of them contain the critical clause in any law if you expect people to follow it: an "or else."

I particularly welcome the strong reaffirmation of one long-standing principle – the separation of banking from commerce – that has long characterized the American approach toward financial regulation.

Reaffirmation? Where?

The repeal of Glass-Steagall dropped the last pretense of any such thing - a law that had been wantonly and notoriously violated by the merger of Citibank and Travelers and which was clearly unlawful at the time it was contemplated and entered into. Instead of swiftly applying a boot to the head of both Boards of Directors and the Chairmen of both firms the law was instead changed to make retroactively legal that which was a blatant violation of United States Law.

As a general matter, I would exclude from commercial banking institutions, which are potential beneficiaries of official (i.e., taxpayer) financial support, certain risky activities entirely suitable for our capital markets.

Ownership or sponsorship of hedge funds and private equity funds should be among those prohibited activities. So should in my view a heavy volume of proprietary trading with its inherent risks. Some trading, it is reasonably argued, is necessary as part of a full service customer relationship. The distinction between "proprietary" and "customer-related" may be cloudy at the border. But surely by the active use of capital requirements and the exercise of supervisory authority, appropriate restraint can be maintained.

Right.

But left unsaid is that "participation" in these fancy instruments inherently lead to intentional obfuscation and even fraud.

Witness IndyMac Bank. We now know for a fact (because the OTS OIG office said so) that one of the OTS officials in active conspiracy with the bank back-dated deposits to make them appear more sound and secure than they were.

This resulted in a huge loss to the FDIC's deposit insurance fund when they subsequently failed.

Nobody was prosecuted for this - even though bank fraud is a felony, and so is, post-SarBox, issuing known-false accounting statements.

But this was not just an "abstract" problem for the deposit insurance fund and bank regulation. There were hundreds if not thousands of people who lost huge amounts of money in IndyMac, as they were over deposit insurance limits when the bank failed.

ALL OF THEIR UNINSURED FUNDS ARE GONE, and many of those individuals and businesses made those deposits after the fraud occurred - that is, but for the fraud they would not have lost their money as the bank would have been closed before they made the deposits.

This is not an isolated incident; Bloomberg noted yesterday:

“The examiners should have seen a lot of this coming,” said Gerard Cassidy, an analyst with Portland, Maine-based RBC Capital Markets, an investment bank owned by Royal Bank of Canada. “I shake my head when I look at some of these failures and ask, ‘Where were the regulators?’ We’re paying a lot more than we would if they had acted sooner.”

They failed to act because they have been effectively bribed, whether through actual money or whether through a revolving-door policy and lack of enforceable sanction in their enabling laws for willful blindness is not important. The outcome is the important factor, and there the evidence is beyond question. But back to Mr. Volcker:

Quite simply, it is the Federal Reserve that has (surely should have) the independence from political pressures, the prestige and the essential qualifications of experience to serve as overseer of the financial system.

The problem with Mr. Volcker's endorsement of The Fed as a continued systemic monitor and regulator is that The Fed has intentionally ignored outrageously predatory behavior, risk-hiding, loss-hiding and even UNLAWFUL activity by some of the banks and financial institutions under its supervision, including but not limited to IndyMac's deposit backdating.

It is not possible to make a logical argument for extending supervisory authority to an organization that has shown a repeated pattern of willful misconduct, has resisted audits of its activity and has in fact made bald threats to Congress in regard to statements of their intent to exercise their Constitutionally-granted authority to execute those audits in discharge of their responsibility toward the monetary supply.

The bottom line is that our regulatory system not only has failed it continues to fail, and this is no accident. These failures are intentional acts promulgated by those in Congress and other agencies such as The Federal Reserve that have written laws in such a fashion that they are mere suggestions.

Time has shown that in practice these alleged "laws" are notoriously and openly ignored at any time powerful people decide they would like to ignore them, and this willful thumbing of one's nose to the law extends to the present day. We have financial institutions that are intentionally hiding bad assets on their books at entirely-fictional values, and nearly 100 banks have failed with their books in this state. Not one indictment for accounting or bank fraud has been brought in connection with these falsehoods.

Since almost-literally every failed banking institution thus far has disclosed losses that are dramatically beyond the "zero remaining capital" line, prior to which the FDIC should have acted, it is only reasonable to assume that every remaining bank in the system is likewise carrying some amount of underwater securities at unrealistic and fictional values. They have survived to this point only due to the Federal Government's willingness to not only turn a blind eye to blatant and outrageous false statements of "value" in these securities but due to direct and indirect subsidizations in addition to enable them to "meet" the cash-flow requirements that these securities would otherwise demand.

This in turn has resulted in consumers being faced with 20, 25, even 30% interest rates on credit cards while Fed Funds stands at 0%, effectively forcing those who are carrying balances to subsidize the fraudulent accounting that has infested our banking system.

No reform will have meaning until and unless all can trust a balance sheet. This means the end of off-balance-sheet accounting, the end of fictional claims of asset value and the end of willful blindness within our regulatory structure.

It is my assertion that the only meaningful method to enforce such strictures is to guarantee that every regulatory pronouncement and law have a strict "or else" clause imposing criminal sanction for violations, and that when imprisonment would be called for in a statute for a personal actor, when a corporation is the violator the sanction be extended to the corporation as a suspension of the firm's corporate charter for a like term of years as would be imposed on a person.

It has been proved through decades of sociological study that only the certainty of punishment deters crime. Today there is no punishment at all for violating most of the regulatory code allegedly imposed on the financial system as there is no "or else" clause in essentially any of these regulations.

This must change.

BILL BLACK'S PROPOSAL FOR "SDI"s

nospam@example.com (Karl Denninger) — Wed, 23 Sep 2009 13:01:00 -0400

READ THIS CONgress: THIS IS ONE OF THE GUYS WHO WAS DOING FORENSICS ON THE S&L CRISIS - AND WHO KEATING ALLEGEDLY THREATENED WITH DEATH FOR DOING SO!

From "Washington's Blog", reprinted in full:

Wednesday, September 23, 2009

William K. Black's Proposal for “Systemically Dangerous Institutions”

William K. Black, Associate Professor of Economics and Law at the University of Missouri – Kansas City, and the former head S&L regulator, has written the following fantastic new proposal concerning the giant, insolvent banks. Posted/reprinted with Professor Black's permission.

William K. Black
Associate Professor of Economics and Law
University of Missouri – Kansas City

blackw@umkc.edu

September 10, 2009

The Obama administration is continuing the Bush administration policy of refusing to comply with the Prompt Corrective Action (PCA) law. Both administrations twisted a deeply flawed doctrine – “too big to fail” – into a policy enshrining crony capitalism.

Historically, “too big to fail” was a misnomer – large, insolvent banks and S&Ls were placed in receivership and their “risk capital” (shareholders and subordinated debtholders) received nothing. That treatment is fair, minimizes the costs to the taxpayers, and minimizes “moral hazard.” “Too big to fail” meant only that they were not placed in liquidating receiverships (akin to a Chapter 7 “liquidating” bankruptcy). In this crisis, however, regulators have twisted the term into immunity. Massive insolvent banks are not placed in receivership, their senior managers are left in place, and the taxpayers secretly subsidize their risk capital. This policy is indefensible. It is also unlawful. It violates the Prompt Corrective Action law. If it is continued it will cause future crises and recurrent scandals.

On October 16, 2006, Chairman Bernanke delivered a speech explaining why regulators must not allow banks with inadequate capital to remain open.
http://federalreserve.gov/newsevents/speech/bernanke20061016a.htm

Capital regulation is the cornerstone of bank regulators' efforts to maintain a safe and sound banking system, a critical element of overall financial stability. For example, supervisory policies regarding prompt corrective action are linked to a bank's leverage and risk-based capital ratios. Moreover, a strong capital base significantly reduces the moral hazard risks associated with the extension of the federal safety net.

The Treasury has fundamentally mischaracterized the nature of institutions it deems “too big to fail.” These institutions are not massive because greater size brings efficiency. They are massive because size brings market and political power. Their size makes them inefficient and dangerous.

Under the current regulatory system banks that are too big to fail pose a clear and present danger to the economy. They are not national assets. A bank that is too big to fail is too big to operate safely and too big to regulate. It poses a systemic risk. These banks are not “systemically important”, they are “systemically dangerous.” They are ticking time bombs – except that many of them have already exploded.

We need to comply with the Prompt Corrective Action law. Any institution that the administration deems “too big to fail” should be placed on a public list of “systemically dangerous institutions” (SDIs). SDIs should be subject to regulatory and tax incentives to shrink to a size where they are no longer too big to fail, manage, and regulate. No single financial entity should be permitted to become, or remain, so large that it poses a systemic risk.

SDIs should:

1. Not be permitted to acquire other firms

2. Not be permitted to grow

3. Be subject to a premium federal corporate income tax rate that increases with asset size

4. Be subject to comprehensive federal and state regulation, including:

a. Annual, full-scope examinations by their primary federal regulator

b. Annual examination by the systemic risk regulator

c. Annual tax audits by the IRS

d. An annual forensic (anti-fraud) audit by a firm chosen by their primary federal regulator

e. An annual audit by a firm chosen by their primary federal regulator

f. SEC review of every securities filing

5. A prohibition on any stock buy-backs

6. Limits on dividends

7. A requirement to follow “best practices” on executive compensation as specified by their primary federal regulator

8. A prohibition against growth and a requirement for phased shrinkage

9. A ban (which becomes effective in 18 months) on having an equity interest in any affiliate that is headquartered in or doing business in any tax haven (designated by the IRS) or engaging in any transaction with an entity located in any tax haven

10. A ban on lobbying any governmental entity

11. Consolidation of all affiliates, including SIVs, so that the SDI could not evade leverage or capital requirements

12. Leverage limits

13. Increased capital requirements

14. A ban on the purchase, sale, or guarantee of any new OTC financial derivative

15. A ban on all new speculative investments

16. A ban on so-called “dynamic hedging”

17. A requirement to file criminal referrals meeting the standards set by the FBI

18. A requirement to establish “hot lines” encouraging whistleblowing

19. The appointment of public interest directors on the BPSR’s board of directors

20. The appointment by the primary federal regulator of an ombudsman as a senior officer of the SDI with the mission to function like an Inspector General

TO CONGRESS: WAKE UP!

Games Banks Play (WFC)

nospam@example.com (Karl Denninger) — Thu, 17 Sep 2009 08:36:00 -0400

Jingle mail, Jingle Mail, Jingle all the way.....

This borrower couldn't pay and thus stopped doing so. This should generate a "NOD" (Notice of Default) and ultimately lead to foreclosure, right? It should result in an impaired asset which might be sold to some other company (at a discount), right?

It got sold all right - right at the "120 day" late point where Wells counts a loan as "defaulted."

But look at who it got sold to..... (click for a larger copy)

Yes, Wells bought the loan from.... itself?

Yep.

I have the original purchase documentation on the mortgage from July 21st 2008, when it was bought (by Wells in Frederick MD) from the original funding company in Tempe AZ.

Now, when the borrower defaults, Wells buys the loan from itself?

For what purpose?

The obvious questions that arise are:

Is this loan "suddenly new and thus not yet non-performing" after playing this shell game? And if so, how many more "performing" loans does Wells have now that they haven't been "non-paying" for at least 90 days (having "just been acquired")?
Was it sold at Par?
Was this accounted for as a "true sale" when it was in fact "sold" from and to the same company in a different office location?

You don't think there might be a little shell game going on here do you?

Doesn't anyone remember that the S&Ls did this same sort of crap (with the twist that in many cases they colluded with each other to shuffle them around between institutions) as they swirled the bowl?

Inquiring minds want to know the answers to the above three questions, and if we had honest regulators they'd be demanding answers to those questions too.