[Below, I have used the Mike Whitney article as an introduction to Henry C.K. Liu's two-part Liquidity Bust Bypasses the Banking System . -FNC]

"The new capitalist gods must love the poor -- they are making so many more of them." Bill Bonner, "The Daily Reckoning"

"The hope of every central bank is that the real problem can be kept from public view. The truth is that the public -- even professionals on Wall Street -- have no clue what the real problem is. They know it has something to do with derivatives, but none of them realize that it"s more than a $20 trillion mountain of unfunded, unregulated paper that has just been discovered to not have a market and, therefore, no real value . . . When the dollar realizes the seriousness of the situation -- be that now or sometime soon -- the bottom will drop out." --Jim Sinclair, Investment analyst

About a month ago, I wrote an article "Stock Market Brushfire: Will there be a run on the banks?" which showed how the collapse in the housing market and the deterioration in mortgage-backed bonds (CDOs) in the secondary market was creating difficulties for the banking system. Now these problems are becoming more apparent.

From the Wall Street Journal: "The rising interbank lending rates are a proxy of sorts for the increased risk that some banks, somewhere, may go belly up." (Editorial; WSJ, 9-6-07)

Ironically, the WSJ editorial staff -- which normally defends deregulation and laissez faire economics "tooth-n-nail" -- is now calling for regulators to make sure they are "on top of the banks they are supposed to be regulating, so we don"t get any surprise bank failures that spook the markets and confirm the worst fears being whispered about."

"Surprise bank failures?"

Henry Liu sums it up like this in his article, "The Rise of the non-bank system" -- required reading for anyone who wants to understand why a stock market crash is imminent: "Banks worldwide now reportedly face risk exposure of US$891 billion in asset-backed commercial paper facilities (ABCP) due to callable bank credit agreements with borrowers designed to ensure ABCP investors are paid back when the short-term debt matures, even if banks cannot sell new ABCP on behalf of the issuing companies to roll over the matured debt because the market views the assets behind the paper as of uncertain market value.

"This signifies that the crisis is no longer one of liquidity, but of deteriorating creditworthiness system-wide that restoring liquidity alone cannot cure. The liquidity crunch is a symptom, not the disease. The disease is a decade of permissive tolerance for credit abuse in which the banks, regulators and rating agencies were willing accomplices." (Henry Liu,"The Rise of the Non-bank System," Asia Times)

That's right; nearly $1 trillion in worthless paper is clogging the system, putting the kibosh on the big private equity deals and spreading panic through the money markets. It's a slow-motion train wreck and there's not a thing the Fed can do about it.

This isn't a liquidity problem that can be fixed by lowering the Fed's fund rate and creating more easy credit. This is a solvency crisis; the underlying assets upon which this world of "structured finance" is built have no established market value, therefore -- as Jim Sinclair suggests -- they're worthless. That means that the trillions of dollars which have been leveraged against these shaky assets -- in the form of credit default swaps (CDSs) and numerous other bizarre-sounding derivatives -- will begin to cascade down wiping out trillions in market value.

How serious is it? Economist Liu puts it like this: "Even if the Fed bails out the banks by easing bank reserve and capital requirements to absorb that massive amount, the raging forest fire in the non-bank financial system will still present finance capitalism with its greatest test in eight decades."

Overview

Credit standards are tightening and banks are increasingly reluctant to lend money to each other not knowing who may be sitting on billions of dollars in toxic mortgage-backed debt. (Collateralized debt obligations) It makes no difference that the "underlying economy is sound" as Bernanke likes to say. When banks hesitate to lend money to each other; it shows that there is real uncertainty about the solvency of the other banks. It slows down commerce and the gears on the economic machine begin to rust in place.

The banks' woes have been exacerbated by the flight of investors from money market funds, many of which are backed by Mortgage-backed Securities (MBS). Wary investors are running for the safety of US Treasuries even though yields that have declined at a record pace. This is causing problems in the Commercial Paper market as well as for the lesser known SIVs and "conduits." These abstruse sounding investment vehicles are the essential plumbing that maintains normalcy in the markets. Commercial paper is a $2.2 trillion market. When it shrinks by more than $200 billion -- as it has in the last three weeks -- the effects can be felt through the entire system.

The credit crunch has spread across the whole gamut of commercial paper and low-grade debt. Banks are hoarding cash and refusing loans to even creditworthy applicants. The collapse in subprime loans is just part of the story. More than 50 percent of all mortgages in the last two years have been unconventional loans -- no down payment, no verification of income, "no doc," interest-only, negative amortization, piggyback, 2-28s, teaser rates, adjustable rate mortgages (ARMs). All of these reflect the shoddy lending standards of the past few years and all are contributing to the unprecedented rate of defaults. Now the banks are holding $300 billion of these "unmarketable" mortgage-backed CDOs and another $200 billion in equally-suspect CLOs. (Collateralized loan obligations; the CDOs corporate-twin).

Even more worrisome, the large investment banks have myriad "off-book" operations which are in distress. This has forced the banks to circle the wagons and reduce their issuance of loans, which is accelerating the downturn in housing. Typically, housing bubbles unwind very slowly over a five- to 10-year period. That won"t be the case this time. The surge in inventory, the financial distress of many homeowners and the complete breakdown in loan-origination (due to the growing credit crunch) ensures that the housing market will crash-land sometime in late 2008 or early 2009. The banks are expected to write-off a considerable portion of their CDO-debt at the end of the 3rd quarter rather than keep the losses on their books. This will further hasten the decline in housing prices.

The banks are also suffering from the sudden sluggishness in leveraged buyouts (LBOs). Credit problems have slowed private equity deals to a dribble. In July, there were $579 billion in LBOs. In August, that number shrank to a paltry $222 billion. In September, those figures will deteriorate to double digits. The big deals aren"t getting done and debt is not rolling over. More than $1 trillion in debt will have to be refinanced in the next five weeks. In the present climate, that doesn"t look likely. Something"s has got to give. The market has frozen and the Fed"s $60 billion repo-lifeline has done nothing to help.

In the first seven months of 2007, LBOs accounted for "$37 of every $100 spent on deals in the US."

Thirty-seven percent! How will the financial giants make up for the windfall profits that these deals generated?

Answer: They won"t. Just as they won"t make up for the enormous origination fees they made from "securitizing" mortgages and selling them off to credulous pension funds, insurance companies and foreign banks.

As Steven Rattner of DLJ Merchant Banking said, "It"s become nearly impossible to finance a private equity transaction of over $1 billion." (WSJ) The Golden Era of Acquisitions and Mega-mergers is coming to an end. We can expect that the financial giants will probably follow the same trajectory as the dot-coms following the 2001 NASDAQ rout.

The investment banks are also facing enormous potential losses from liabilities that "operate off their balance sheets" In David Reilly"s article, "Conduit Risks are hovering over Citigroup" (WSJ 9-5-07), Reilly points out that "banks such as Citigroup Inc. could find themselves burdened by affiliated investment vehicles that issue tens of billions of dollars in short-term debt known as commercial paper . . . Citigroup, for example, owns about 25 percent of the market for SIVs, representing nearly $100 billion of assets under management. The largest Citigroup SIV is Centauri Corp., which had $21 billion in outstanding debt as of February 2007, according to a Citigroup research report. There is no mention of Centauri in its 2006 annual filing with the Securities and Exchange Commission.

"Yet some investors worry that if vehicles such as Centauri stumble, either failing to sell commercial paper or suffering severe losses in the assets it holds, Citibank could wind up having [“having to”] to help by lending funds to keep the vehicle operating or even taking on some losses."

So, many investors don"t know that Citigroup could be holding the bag for "$21 billion in outstanding debt"? Or, perhaps, the entire $100 billion is red ink; who knows? (Citigroup"s stock dropped by more than 2 percent after this report appeared in the WSJ.)

Another report, which appeared in CNN Money, further adds to the suspicion that the banks" "brokerage affiliates" may be in trouble: "The Aug. 20 letters from the Fed to Citigroup and Bank of America state that the Fed, which regulates large parts of the U.S. financial system, has agreed to exempt both banks from rules that effectively limit the amount of lending that their federally-insured banks can do with their brokerage affiliates. The exemption, which is temporary, means, for example, that Citigroup's Citibank entity can substantially increase funding to Citigroup Global Markets, its brokerage subsidiary. Citigroup and Bank of America requested the exemptions, according to the letters, to provide liquidity to those holding mortgage loans, mortgage-backed securities, and other securities . . . This unusual move by the Fed shows that the largest Wall Street firms are continuing to have problems funding operations during the current market difficulties." (CNN Money)

Does this mean that the other large banks are involved in the same type of "hide-n-seek" strategies? Sounds a lot like Enron"s "off-the-books" shenanigans, doesn"t it?

Wall Street Journal: "'Any off-balance-sheet issues are traditionally poorly disclosed, so to some extent, you're dependent on the insight that management is willing to provide you and that, frankly, is very limited,' says Mark Fitzgibbon, director of research at Sandler O'Neill & Partners. ' . . . Accounting rules don"t require banks to separately record anything related to the risk that they will have to loan the entities money to keep them functioning during a markets crisis. . . . The vehicles [SIVs and conduits] are often established in a tax haven and are run solely for investment purposes as opposed to typical corporate activities.'"

Still think the banks are on solid ground?

"Citigroup, the nation's largest bank as measured by market value and assets. Its latest financial results showed that it administers off-balance-sheet, conduit vehicles used to issue commercial paper that have assets of about $77 billion.

"Citigroup is also affiliated with structured investment vehicles, or SIVs that have 'nearly $100 billion' in assets, according to a letter Citigroup wrote to some investors in these vehicles last month." (IBID)

Yes, and how many of these "assets" are in fact corporate debt, auto loans, credit card debt, and student loans that have been securitized and are now under extreme pressure in a slumping market?

In an "up market" loans can provide a valuable income stream that transforms someone else"s debt into a valuable asset. In a "down market," however, defaults can wipe out trillions in market capitalization overnight.

[Fact is, however, that these investment banks and financial shopping mall concerns like Citigroup are so in-bed with the government and so privileged and so market-manipulated and so Greenspan/Bernanke-Put'd and so removed from moral hazard that classical free-market discipline will not be operative and betting against them won't pay. -FNC]

How did we get into this mess?

More than 20 years of dogged lobbying from the financial industry paid off with the repeal of the Glass-Steagall Act, which was passed by Congress following the 1929 stock market crash. The bill was written to limit the conflicts of interest when commercial banks are permitted to underwrite stocks or bonds.

The financial industry whittled away at Glass-Steagall for years before finally breaking down its regulatory restrictions in August 1987, when Alan Greenspan -- formerly a director of J.P. Morgan and a proponent of banking deregulation -- became chairman of the Federal Reserve Board.

"In 1990, J.P. Morgan became the first bank to receive permission from the Federal Reserve to underwrite securities, so long as its underwriting business does not exceed the 10 percent limit. In December 1996, with the support of Chairman Alan Greenspan, the Federal Reserve Board issued a precedent-shattering decision permitting bank holding companies [and the Bank Holding Company (originally the “One-bank Holding Company”) was itself a breakdown of “obsolete” “depression-era” legislation] to own investment bank affiliates with up to 25 percent of their business in securities underwriting (up from 10 percent).

"This expansion of the loophole created by the Fed's 1987 reinterpretation of Section 20 of Glass-Steagall effectively rendered Glass-Steagall obsolete." ("The Long Demise of Glass Steagall, Frontline, PBS)

In 1999, after 25 years and $300 million of lobbying efforts, Congress, aided by President Bill Clinton, finally repealed Glass-Steagall. This paved the way for the problems we are now facing.

Another contributing factor to the current banking-muddle is the Basel rules. According to the BIS (Bank of International Settlements) website: "The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. It seeks to do so by exchanging information on national supervisory issues, approaches and techniques, with a view to promoting common understanding. At times, the Committee uses this common understanding to develop guidelines and supervisory standards in areas where they are considered desirable. In this regard, the Committee is best known for its international standards on capital adequacy; the Core Principles for Effective Banking Supervision; and the Concordat on cross-border banking supervision."

The Basel Committee on Banking (Basel 2) requires "banks to boost the capital they hold in reserve against the loans on their books."

Sounds like a good thing, doesn"t it? This protects the overall financial system as well as the individual depositor. Unfortunately, the banks found a way to circumvent the rules for minimum reserves by "securitizing" pools of mortgages (MBS) rather than holding individual mortgages. (which called for more reserves) This provided lavish origination and distribution fees for banks, but shifted much of the risk of default to Wall Street investors. Now, the banks are saddled with roughly $300 billion in mortgage-backed debt (CDOs) that no one wants and it is uncertain whether they have sufficient reserves to cover their losses.

By October, we should know how this will all play out. As David Wessel points out in "New Bank Capital requirements helped to Spread Credit Woes": "Banks now behave more like securities firms, more likely to mark down the value of assets when market prices fall -- even to distressed levels -- rather than sitting on bad loans for a decade and pretending they"ll be paid back."

The downside of this is that once that banks write off these toxic MBSs and CDOs; the hedge funds, insurance companies and pension funds will be forced to do the same -- dumping boatloads of this bond-sludge on the market, driving down prices and triggering a panic sell-off. This is what the Fed is trying to prevent through its $60 billion repo-bailout.

Regrettably, the Fed cannot hope to remove a half-trillion dollars of bad debt from the balance sheets of the banks or forestall the collapse of related financial institutions and funds which are loaded with these "unmarketable" time-bombs. Besides, most of the mortgage derivatives (CDOs) have been massively enhanced with low interest leverage from the "carry trade." When the value of these CDOs is finally determined -- which we expect will happen sometime before the end of the 3rd quarter -- we can expect the stock market to fall sharply and the housing recession to turn into a full-blown economic crisis.

Alan Greenspan: The Fifth Horseman?

So, who"s to blame? The finger pointing has already begun and more and more people are beginning to see how this massive economy-busting equity bubble originated at the Federal Reserve -- it is the logical corollary of former Fed chief Alan Greenspan's "easy money" policies.

Henry C K Liu sums up Greenspan"s tenure at the Fed in his Asia Times article, "Why the Subprime Bust Will Spread": "Greenspan presided over the greatest expansion of speculative finance in history, including a trillion-dollar hedge-fund industry, bloated Wall Street-firm balance sheets approaching $2 trillion, a $3.3 trillion repo (repurchase agreement) market, and a global derivatives market with notional values surpassing an unfathomable $220 trillion.

"On Greenspan's 18-year watch, assets of US government-sponsored enterprises (GSEs) ballooned 830 percent, from $346 billion to $2.872 trillion. GSEs are financing entities created by the US Congress to fund subsidized loans to certain groups of borrowers such as middle- and low-income homeowners, farmers and students. Agency mortgage-backed securities (MBSs) surged 670 percent to $3.55 trillion. Outstanding asset-backed securities (ABSs) exploded from $75 billion to more than $2.7 trillion."

"The greatest expansion of speculative finance in history." That says it all.

But no one makes the case against Greenspan better than Greenspan himself. Here are some of his comments at the Federal Reserve System"s Fourth Annual Community Affairs Research Conference, Washington, D.C., April 8, 2005. They show that Greenspan "rubber stamped" every one of the policies which have since metastasized and spread through the entire US economy.

Greenspan, Champion of Subprime loans: "Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country. With these advance in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers."

Greenspan, Main Proponent of Toxic CDOs: "The development of a broad-based secondary market for mortgage loans also greatly expanded consumer access to credit. By reducing the risk of making long-term, fixed-rate loans and ensuring liquidity for mortgage lenders, the secondary market helped stimulate widespread competition in the mortgage business. The mortgage-backed security helped create a national and even an international market for mortgages, and market support for a wider variety of home mortgage loan products became commonplace. This led to securitization of a variety of other consumer loan products, such as auto and credit card loans."

Greenspan, Supporter of Loans to People with Bad Credit: "Where once more marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately.

"These improvements have led to the rapid growth in subprime mortgage lending . . . fostering constructive innovation that is both responsive to market demand and beneficial to consumers.

"Improved access to credit for consumers, and especially these more-recent developments, has had significant benefits.

Unquestionably, innovation and deregulation have vastly expanded credit availability to virtually all income classes. Access to credit has enabled families to purchase homes, deal with emergencies, and obtain goods and services. Home ownership is at a record high, and the number of home mortgage loans to low- and moderate-income and minority families has risen rapidly over the past five years. Credit cards and installment loans are also available to the vast majority of households"

Greenspan, Big Fan of "Structural Changes" Which Increase Consumer Debt: "As we reflect on the evolution of consumer credit in the United States, we must conclude that innovation and structural change in the financial services industry have been critical in providing expanded access to credit for the vast majority of consumers, including those of limited means. Without these forces, it would have been impossible for lower-income consumers to have the degree of access to credit markets that they now have.

"This fact underscores the importance of our roles as policymakers, researchers, bankers, and consumer advocates in fostering constructive innovation that is both responsive to market demand and beneficial to consumers."

Greenspan"s own words are the most powerful indictment against him. They show that he played a central role in our impending disaster. The effort on the part of media pundits, talking heads, and so-called experts to foist the blame on the rating agencies, predatory lenders or gullible mortgage applicants misses the point entirely. The problems began at the Federal Reserve and that"s where the responsibility lies.

Mike Whitney lives in Washington state. He can be reached at fergiewhitney@msn.com.

Copyright © 1998-2007 Online Journal

Liquidity Bust Bypasses the Banking System

By
Henry C.K. Liu 

Part I: The Rise of the Non-bank Financial system

This article appeared in AToL on September 6, 2007

In a short period of weeks, the subprime time bomb that had been ticking unnoticed for half a decade suddenly exploded into a system-wide liquidity crisis which then escalated into a credit crisis in the entire money market dominated by the non-bank financial system that threatens to do permanent damage to the global economy.

As an economist, Ben Bernanke, the new Chairman of the US Federal Reserve, no doubt understands that the credit market through debt securitization has in recent years escaped from the funding monopoly of the banking system into the non-bank financial system. As Fed Chairman, however, he must also be aware that the monetary tools at his disposal limit his ability to deal with the fast emerging market-wide credit crisis in the non-bank financial system. The Fed can only intervene in the money market through the shrinking intermediary role of the banking system which has been left merely as a market participant in the overblown credit market.

Thus the Fed is forced to fight a raging forest fire with a garden hose. One of the reasons the Fed shows reluctance in cutting the Fed Funds rate target may be the fear of exposing its incapacity in dealing with the credit crisis at hand in the non-bank financial system. What if after the Fed fires its heavy artillery and the credit crisis persists or even further deteriorates?

Liquidity Crunch only a Symptom

Banks worldwide now reportedly face hitherto known risk exposure of $891 billion in asset-backed commercial paper facilities (ABCP) due to callable bank credit agreements with borrowers designed to ensure ABCP investors are paid back when the short-term debt matures, even if banks cannot sell new ABCP on behalf of the issuing companies to roll over the matured debt because the market views the assets behind the paper as of uncertain market value. This signifies that the crisis is no longer one of liquidity, but of deteriorating credit worthiness system wide that restoring liquidity alone cannot cure. The liquidity crunch is a symptom, not the disease. The disease is a decade of permissive tolerance for credit abuse in which the banks, regulators and rating agencies were willing accomplices.

Commercial Paper Crisis

Investment vehicles in the form of commercial paper that mature in one to 270 days which normally carry top credit ratings allow issuing companies to sell debt in credit markets to institutions such as money market funds and pension funds at rates lower than bank borrowing or standby bank credit lines.  Unlike non-financial companies which use the short-term debt proceeds to finance inventories, financial company debtors invest the proceeds in longer-term securities with higher yields for speculative profit from interest rate arbitrage.

Much of these higher yield securities are in the form of collateralized debt obligations (CDOs) backed by “synthetic” high-rated tranches of securitized subprime mortgages, which have been losing market value as the market seizes from subprime mortgage default rates that have risen to the highest levels in a decade and are expected to get worse, perhaps much worse than currently admitted publicly by parties who are in a position to know the ugly facts. At what level would such willful withholding of material information crosses over from serving the public interest by benign calming of market fear to criminal security fraud in disseminating false information is for the US Securities and Exchange Commission (SEC) and eventually the courts to decide.

SEC as Advocate for Investors

The professed mission of the SEC is to protect investors, maintain fair, orderly and efficient markets while facilitating capital formation.  Claiming to be an advocate for investors, the SEC proclaims on its website: “As more and more first-time investors turn to the markets to help secure their futures, pay for homes, and send children to college, our investor protection mission is more compelling than ever. As our nation’s securities exchanges mature into global for-profit competitors, there is even greater need for sound market regulation.” 

The SEC declares that “the laws and rules that govern the securities industry in the US derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it, and so long as they hold it. To achieve this, the SEC requires public companies to disclose meaningful financial and other information to the public. This provides a common pool of knowledge for all investors to use to judge for themselves whether to buy, sell, or hold a particular security. Only through the steady flow of timely, comprehensive, and accurate information can people make sound investment decisions.  The result of this information flow is a far more active, efficient, and transparent capital market that facilitates the capital formation so important to our nation’s economy. To insure that this objective is always being met, the SEC continually works with all major market participants, including especially the investors in our securities markets, to listen to their concerns and to learn from their experience. The SEC oversees the key participants in the securities world, including securities exchanges, securities brokers and dealers, investment advisors, and mutual funds. Here the SEC is concerned primarily with promoting the disclosure of important market-related information, maintaining fair dealing, and protecting against fraud.”

The Issue of Systemic Fraud

It is now clear that material information about the true condition of the financial system along with material information of the financial health of major banks and their financial company clients have been systemically withheld, over long periods and even after the crisis broke, from the investing public who were encouraged to buy and hold even at a time when they should have really been advised to sell to preserve their hard-earned wealth. The aim of this charade has not been to enhance the return on the public’s investment, but to exploit the public trust to shore up a declining market and postpone the inevitable demise of wayward institutions.

For example, Larry Kudlow, self-proclaimed “renowned free market, supply-side economist armed with knowledge, vision, and integrity acquired over a storied career spanning three decades”, host of the “Kudlow & Company” TV show on CNBC weeknights at 5pm EST with live broadcast on Sirius Radio and XM Radio, and on Saturday mornings WABC radio, is an intrepid evangelistic cheer leader for the debt economy. The logo for his program is “putting capital back into capitalism”. As an evangelist for free market capitalism who celebrates debt and voices loud calls for central bank intervention to re-inflate the burst debt bubble, having never called for central bank intervention to stop the bubble from forming, Kudlow sounds amazingly similar to the campaign of Christian evangelist Pat Robertson of the 700 Club to put God back into people’s lives while advocating assassination of Venezuelan President Hugo Chavez and proclaiming Israeli Prime Minister Ariel Sharon’s stroke as divine retribution for Israeli pullout from the Gaza Strip.

The problem of both evangelistic programs is that the declarations of faith are frequently countered by faithless calls for sinful responses to developing events. One is grateful that evangelists are not yelling fire in a theater crowded with believers, but to tell the audience to sit and finish watching the movie when fire has broken out is not exactly doing God’s work.

There is indeed need to put capital back into debt-infested finance capitalism. Until then, Kudlow’s evangelistic message that “capitalism works” are just empty utterances. While market capitalization of US equity reached $20.6 trillion at the end of 2006, the US debt market grew to over $25 trillion in trading volume. There is $5 trillion of negative capital in US capitalism, about 45% of GDP.

Debt Drives the Market

Hedge funds, which number some 10,000, commanding assets in excess of $2 trillion funded with debt, have become dominant players in the run-away debt market, particularly in complex market segments, trading about 30% of the US fixed income market, 55% of US derivative transaction, 80% of high-yield/high-risk derivatives, 80% of distressed debts and 55% of the emerging market bonds. Investors in hedge funds include mutual funds, insurance companies, pension funds, banks, brokerage house proprietary trading desks, endowment funds, even central banks.

When private equity firm acquire public companies to take them private, the acquisition is done mostly with debt. Much of corporate mergers and acquisition are funded with debt. Foreign wars and domestic tax cuts are funded with sovereign debt. Debt instruments are routinely traded as if they were equity. With structured finance, debt can be lent out repatedly without reserve in the debt market. The lack of reserve allow the slight market turmoil to lead inevitably to an insurmoutable credit crisis.

Banks and Off-Balance-Sheet “Conduits”

Since bank clients such as hedge funds and private equity firms are private entities that cater to supposedly “sophisticated” investors, neither the banks or their private clients are required by regulation to make full disclosures of their financial situations. Yet mutual funds and pension funds get the money they manage from members of the general public who do not qualify individually as “sophisticated” investors, these funds should be entitled to better disclosure requirements.

As banks only set up and run investment “conduits” as independent entities to help their risk-prone clients monetize their securitized assets, such as receivables from credit cards, auto loans or home mortgages, by selling ABCP, such conduits are kept off the balance sheet of banks.

The Rise and Decline of Collateral Management

When dealing in the arcane derivatives market in particular, collateral management is an indispensable risk-reduction strategy. The Enron implosion was caused by “special purpose vehicles” which were early incarnations of present-day “conduits” backed by phantom collaterals. Enron’s collapse was a high-profile event that briefly brought credit risk to the forefront of concern in the financial services industry. Collateral management rose briefly from the Enron ashes as a critical mechanism to mitigate credit risk and to protect against counter-party default. Yet in the recent liquidity boom, collateral management has again been thrown out the window and rendered dysfunctional by faulty ratings based on values “marked to theoretical models” that fall apart in disorderly markets.

Banks and SEC Regulation U

Kenneth Lay, the once high-flying chairman of collapsed Enron, before his untimely death faced securities fraud as well as bank fraud charges after Enron’s bankruptcy. The bank fraud issue revolves around an obscure Federal Reserve banking regulation from the Depression-era, called Regulation U, which sets out certain requirements for lenders, other than securities brokers and dealers, who extend credit secured by margin stock. Margin stock includes any equity security registered on a national securities exchange; any debt security convertible into a margin stock; and most mutual funds. The regulation covers entities that are not brokers or dealers, including commercial banks, savings and loan associations, federal savings banks, credit unions, production credit associations, insurance companies, and companies that have employee stock option plans. which limits the amount of credit a bank can extend to customers for buying on margin. The purpose of the law is to prevent banks from taking on unwarranted or excessive risk.

Prosecutors alleged that Lay signed documents at Bank of America, Chase Bank of Texas and Compass Bank in which he agreed that he would not use the $75 million in personal credit lines to buy or maintain stock on margin but then proceeded to do exactly that. Lay would have to face up to 30 years in jail for each count if convicted had he lived.

On Lay's official website, the Houston community leader, free enterprise icon and superstar in the energy business, denounced the charges as “based on arcane laws” and added that “my legal team can find no record during this law’s 70 year existence of these provisions ever being used against a bank customer [like me] until now."

The Role of Banks in the Enron Fraud

When speculation grew about the role Citibank played in the collapse of Enron, shares of Citigroup fell 12%.  The US Senate heard testimony from Senate investigators about the role US banks and their investment bank subsidiaries might have played in backing the specious accounting at Enron in a complex scheme known as “prepays” under which Enron booked loans as energy trades and thus as profits to make the firm look far more profitable than it really was.  The investigators contended Enron could not have shown such profitability but for the shady help of large commercial banks, such as Citigroup and JP Morgan Chase, and their investment banking arms. Under General Accepted Accounting Principles (GAAP), loans issued to Enron should have been booked as debt rather than revenue.

Both Citigroup and JP Morgan claimed that “pre-pay” transactions are entirely lawful

Each bank engaged in about a dozen deals that involved questionable transactions with the failed energy trader. Enron then illegally hid the loans by cloaking them in transactions that were booked as energy trades to show Enron was earning more money than it actually was. This in turned boosted not only Enron share price but also its credit rating, permitting it to continue to secure loans at preferential rates. The convoluted transactions involved the leveraged purchase of natural gas and other commodities over long periods with credit to look like sales and booked as present revenue to increase profits.

Outrageously, while Enron booked the transactions as profits from phantom revenue, it did not report them on its tax returns, electing instead to log them as loans in order to deduct interest payments. About $5 billion of such loan amounts remained outstanding when Enron filed for Chapter 11 bankruptcy protection in December, 2003, which allowed the company to operate as a debtor-in-possession to try to minimize loss to creditors. According to the Senate report, the transactions, which took place from 1992 to 2001, effectively hid part of Enron's mounting debt, which eventually bankrupted the doomed the energy-giant.

The University of California, whose pension fund invested in Enron stocks, led a shareholder class action suit against Enron and its banks, alleging that internal Enron documents and testimony of bank employees detailed how the banks engineered sham transactions to keep billions of dollars of debt off Enron’s balance sheet and create the illusion of increased earnings and operating cash flow.

The suit listed specifically that Merrill Lynch purchased Nigerian barges from Enron on the last day of 1999 only because Enron secretly promised to buy the barges back within six months, guaranteeing Merrill Lynch a profit of more than 20%. As a result of this fraud, Merrill Lynch ultimately paid $80 million to settle with the SEC.

Also listed as evidence was the fact that Barclays Bank entered into several sham transactions with Enron, including creating a “special purpose entity” called Colonnade, a shell company to hide Enron’s debt, named after the street in London where the bank is headquartered. Also on the list was investment bank Credit Suisse First Boston which engaged in “pre-pay” transactions with Enron, including serving as one of the stop-offs for a series of round-trip, risk-free commodities deals in which commodities were never actually transferred or delivered.

Although the three lead banks and others had settled with the Enron fraud victims for $7.2 billion, several huge banks named in this suit still had not paid a penny to the victims of the fraud.  After years of trial preparation and just a few weeks before the scheduled trial, a 2-to-1 Fifth Circuit Court of Appeals decision on March 19, 2007 let the banks off the hook and destroyed the hope of Enron victims for any further recovery.

Court of Appeals Let Banks Off the Hook

The US Court of Appeals for the Fifth Circuit acknowledged that the conduct of the banks was “hardly praiseworthy,” but they ruled that because the banks themselves did not make any false “statements” about their conduct, they could not be liable to the Enron victims even if they knowingly participated in the scheme to defraud Enron shareholders. The Court ruled that Enron Corporation shareholders cannot proceed as a class against three investment banks for allegedly participating in fraudulent behavior that led to Enron’s collapse.

The University of California asserts that the Fifth Circuit Appeals Court decision absolving the banks from liability is wrong because the banks were uniquely positioned to create contrived financial transactions to distort a public company’s financial statements. The ruling awards the banks “get out of jail free” cards to commit fraud without being held accountable, lawyers representing the University argued. The ruling, in essence, declares that the mastermind of the bank robbery who planned the heist, recruited the other robbers, provided the weapons, drove the get-away car and went back to the hideout to split up the loot is not legally responsible just because he did not show his face inside the bank.

As the sole dissenting judge summarized, the ruling “immunizes a broad array of undeniably fraudulent conduct from civil liability . . . effectively giving secondary actors license to scheme with impunity, as long as they keep quiet.”

The 2-to-1 Appeals Court split decision is inconsistent with the express language of the broad anti-fraud prohibition of §10(b) of the Securities and Exchange Act of 1934 and Rule 10b-5, which makes it unlawful for “any person, directly or indirectly”, to “employ any device, scheme, or artifice to defraud” or “to engage in any act, practice, or course of business which operates . . . as a fraud or deceit upon any investor.”

In an extraordinary admission, the Appeals Court’s two-member majority acknowledged that “We recognize, however, that our ruling . . . may not coincide, particularly in the minds of aggrieved former Enron shareholders who have lost billions of dollars in a fraud they allege was aided and abetted by the defendants at bar, with notions of justice and fair play.”

Units of Citigroup Inc. arranged an unusual financing technique for Enron that enabled the energy trader to appear rich in cash from trading rather than saddled with debt. In a series of deals known as Yosemite, Citigroup’s multifarious scheme helped Enron borrow money over a period of three years that was booked as proceeds from trades instead of loans. The deals involved bond offerings and trades with an offshore entity to help manipulate the company’s weak cash flow upward to match its growth in paper profits, at a time when the gap had grown to as much as $1 billion a year.

Enron would not have been able to defraud investors but for the willing participation of Wall Street banks. Evidence supports the allegation that Citigroup, the nation’s largest financial institution that also owned commercial bank and investment bank units, helped Enron disguise debt on its balance sheet through complex financial accounting arrangements at the company.

Although Citigroup actions technically might have been in accordance with then lax accounting principles, they raised questions over whether Citigroup helped shield important material information from Enron investors. Citigroup denied wrong-doing, noting that lenders should not be held responsible for how a client such as Enron accounted for the financing arranged by its bankers. In a statement, Citibank said: “The transactions we entered into with Enron were entirely appropriate at the time based on what we knew and what we were told by Enron. We were assured that Enron’s auditors had approved them, and we believed they were consistent with accounting rules in place at the time.” What Citibank was saying was that the problem was with the rules of the game and that it had only been a clever player. Pathetically, it was the only true statement in the whole sordid affair.

SEC Scrutiny of Banks

Citigroup rival J.P. Morgan Chase & Co. also faced after-the-fact SEC scrutiny for similar deals through a vehicle known as Mahonia, which was the subject of a page one story in The Wall Street Journal in January 2003. Mahonia drew wide scrutiny following a lawsuit with insurers who had guaranteed the transactions through surety bonds. The insurers refuse to pay Morgan, arguing that prepaid transactions effectively generated loans, not trades. Their view was confirmed by presiding US District Judge Jed S. Rakoff who wrote in an opinion that the Mahonia transactions “appear to be nothing but a disguised loan.”

The SEC investigated both Citigroup and J.P. Morgan on whether the banks helped Enron hide debt and artificially boost cash flow for regulatory violations, and the office of Manhattan District Attorney Robert Morgenthau also examined the deals for criminal offenses. Enron, which had a reputation of brow-beating its bankers, was accused of putting pressure on Citigroup to carry out elements of the deals.

As with the Mahonia arrangement, Citigroup’s Yosemite transactions also involved commodity “prepay” transactions, in which money is paid up front for commodities such as natural gas or oil to be delivered at a future date, a practrice common in the energy market. But Senate hearings documents showed that the Yosemite transactions were manipulated to make debt appear on Enron’s public disclosures as trades through a series of “round trip” prepaid transactions. In each of the four Yosemite deals, Citigroup set up a trust that raised money from investors in Europe and the US. Then the money moved to a Citigroup-sponsored special purpose vehicle in the Cayman Islands known as Delta which then sent the money in a circle through a series of oil trades, first to Enron then to Citigroup, and then back to Delta, each time moving the money through oil prepay contracts. Oil never actually changed hands, and the trades effectively canceled each other out in what amounted to financial manipulation.

Cash settlement is common in commodity transactions, but the round-trip nature of the trades is one uncommon aspect that drew the scrutiny of congressional investigators. So did the accounting effect of the circular trades, which allowed Enron to borrow money from the Yosemite investors but record it as cash generated from its operations -- because that prepay contracts were booked as trades rather than loans. The distinction was central because the company’s burgeoning debt levels were starting to raise red flags among shareholders well in advance of Enron’s final collapse.

The use of prepays as a monetization tool is a sensitive topic for both ratings agencies and institutional investors. Documents show that Enron routinely kept Yosemite transaction details in a “black box”. Only two participating parties would know the precise details: Enron and Citigroup. This type of “black box” opaqueness is present is [in] many over-the-counter derivate products, “conduits” and “special investment vehicles” (SIVs) that are causing the current ABCP credit crisis.

Enron would put into Yosemite an extra payment called a “magic note” that assured that Yosemite’s investors received promised interest on their investments. Those investors were led to believe they were buying assets from Enron that has revenue streams. In fact, Enron simply was paying -- out of its other revenues -- interest on its magic note, a bond with a yield of as much as 49% in one instance. The return was spread out among Yosemite investors to make sure they were paid the promised interest on their investment in the trust. All of this became a belated concern to regulators because the debt did not appear as such in Enron’s public filings.

Banks Blame Auditors

Citigroup put the blame squarely on Enron and its then-auditors at Arthur Andersen LLP. “I wish I'd never heard of Enron,” Citigroup Chairman and CEO Sanford I. Weill said in an interview. He might have added that he wished he had never heard of Jack Grubman.

Jack Grubman, star telecom analyst of Citigoup investment banking firm, Salomon, entered into a quid pro quo with Citigroup CEO Weill to upgrade his “independent” rating of AT&T to help Solomon land a huge deal AT&T was preparing in order to finance a spin-off of its wireless telephone unit. Grubman in a two-page memo to Weill titled: “AT&T and the 92nd Street Y”, offered that if Weill, a member of the AT&T board and a close associate of AT&T CEO C. Michael Armstrong, would help Grubman’s twin children get into a much sought after New York nursery school, Grubman would take on a more positive view on AT&T’s business model as Weill had suggested. Weill proposed a donation of $1 million to the school if the Grubman kids were admitted. The exposure of the Grubman-AT&T deal revealed an embarrassing picture of how Wall Street firms put their own interests well ahead of that  of the small investors they were supposed to be helping with independent research during the IT bubble years and eventually led the departure of both Grubman and Weill from Citigroup, with Grubman barred from the security industry for life. Weill personally survived the multi-billion dollar Enron fraud unscathed only to fall over the questionable donation of $1 million to help an employee put his children in a nursery school in return for a biased stock analysis. Immunity mounts in proportion to the scale of malfeasance.

On July 28, 2003, the SEC instituted and settled enforcement proceedings against J.P. Morgan Chase & Co. and Citigroup, Inc. for their roles in Enron’s manipulation of its financial statements. The SEC accused each institution of helping Enron mislead its investors by characterizing what were essentially loan proceeds as cash from operating activities. The proceeding against Citigroup also resolved SEC charges stemming from the assistance Citigroup provided Dynegy Inc. in manipulating that company's financial statements through similar conduct.

For J.P. Morgan Chase, the SEC filed a civil injunctive action in US District Court in Texas. Without admitting or denying the SEC allegations, J.P. Morgan Chase consented to the entry of a final judgment in that action that would (i) permanently enjoin J.P. Morgan Chase from violating the antifraud provisions of the federal securities laws, and (ii) order J.P. Morgan Chase to pay $135 million as disgorgement, penalty, and interest. The settlement suggested that J.P. Morgan Chase had not been enjoined from violating the antifraud provisions of the federal securities laws before the Enron collapse.

For Citigroup, the SEC instituted an administrative proceeding and issued an order making findings and imposing sanctions. Without admitting or denying the SEC findings, Citigroup consented to the issuance of the SEC Order whereby Citigroup (i) was ordered to cease and desist from committing or causing any violation of the antifraud provisions of the federal securities laws, and (ii) agreed to pay $120 million as disgorgement, interest, and penalty. Of that amount, $101 million pertains to Citigroup's Enron-related conduct and $19 million pertains to the Dynegy conduct.

The SEC enjoinment against the two errant banks is like using the disallowance of further bank robberies as punishment for a previous bank robbery.

The SEC intended to direct the money paid by J.P. Morgan Chase and Citigroup to fraud victims ($236 million to Enron fraud victims and $19 million to Dynegy fraud victims) pursuant to the Fair Fund provisions of Section 308(a) of the Sarbanes-Oxley Act of 2002. That amounted to a mere pittance of the billions in losses suffered by the victims.

History Repeats Itself in 2007

On May 10, 2004, Citigroup under new CEO Charles Prince said that it would pay $2.65 billion to investors who bought securities of WorldCom that had been highly recommended by its analyst Jack Grubman before the telecommunications company collapsed. It also said it would put aside several billions of dollars more in reserves for other legal claims, raising the total cost to over $10 billion to clean up its problems stemming from the failure of WorldCom and Enron, as well as questionable practices in the offering of new issues and the publishing of sham stock research during the highflying days before the tech stock market bubble burst.

The after-tax cost to Citibank would total $4.95 billion, or 95 cents a share against its second-quarter earnings. Prince emphasized that that was only about equal to its profit for one quarter, and bond rating companies said they would not lower their rankings of Citigroup's debt. In other words, it was no big deal.

Before taxes, Citigroup's total cost of settling the WorldCom suit, paying regulatory fines relating to Enron and research analysts, and setting aside reserves for other litigation came to $9.8 billion, with losses on loans to WorldCom and Enron adding another $500 million.

“These are historical matters,” Prince said in May 2004. “They arose in a different era.” It appears that history is repeating itself in August 2007.

SEC Tolerance

The Enforcement Division of the SEC commented on the settlement with the two errant banks that “if you know or have reason to know that you are helping a company mislead its investors, you are in violation of the federal securities laws.” It went on to say that it “intend to continue to hold counter-parties responsible for helping companies manipulate their reported results. Financial institutions in particular should know better than to enter into structured transactions where the structure is determined solely by accounting and reporting wishes of a public company.” It deflected attention from the fact that the disciplinary action was merely a gentle tap on the risk. [wrist? Pun intended?]

The SEC pointed out that J.P. Morgan Chase and Citigroup engaged in, and indeed helped their clients design and execute complex structured finance transactions. The structural complexity of these transactions had no business purpose aside from masking the fact that, in substance, they were loans. As alleged in the charging documents, by engaging in certain structural contortions, these financial institutions helped their clients: (1) inflate reported cash flow from operating activities; (2) underreport cash flow from financing activities; and (3) underreport debt.

As a result, Enron and Dynegy presented false and misleading pictures of their financial health and results of operations. Significantly, with respect to Enron, both financial institutions knew that Enron engaged in these transactions specifically to allay investor, analyst, and rating agency concerns about its cash flow from operating activities and outstanding debt. Citigroup knew that Dynegy had similar motives for its structured finance transaction.

As alleged by the SEC, these institutions knew that Enron engaged in the structured finance transactions to match its “mark-to-market” earnings (paper earnings based on daily changes in the market value of certain assets held by Enron) with cash flow from operating activities. As alleged, by matching mark-to-market earnings with cash flow from operating activities, Enron sought to convince analysts and credit rating agencies that its reported mark-to-market earnings were real, i.e., that the value of the underlying assets would ultimately be convertible to cash in full.

The SEC further alleged that these institutions also knew that these structured finance transactions yielded another substantial benefit to Enron: they allowed Enron to hide the true extent of its borrowings from investors and rating agencies because sums borrowed in these structured finance transactions did not appear as “debt” on Enron’s balance sheet. Instead they appeared as “price risk management liabilities”, “minority interest”, or otherwise. In addition, Enron’s obligation to repay those sums was not otherwise disclosed.

Specifically as to J.P. Morgan Chase, the SEC allegations stem from J.P. Morgan Chase’s participation in so-called prepay transactions with Enron which were loans disguised as commodity trades to achieve Enron’s reporting and accounting objectives. These prepays were in substance loans because their structure eliminated all commodity price risk that would normally exist in commodity trades. This was accomplished through a series of trades whereby Enron passed the commodity price risk to a J.P. Morgan Chase-sponsored special purpose vehicle, which passed the risk to J.P. Morgan Chase, which, in turn, passed the risk back to Enron. While each step of this structure appeared to be a commodity trade, with all elements of the structure taken together, Enron received cash upfront and agreed to future repayment of that cash with negotiated interest. The interest amount was set at the time of the contract, was calculated with reference to LIBOR, and was independent of any changes in the price of the underlying commodity. The only risk in the transactions was J.P. Morgan Chase’s risk that Enron would not make its payments when due, i.e., credit risk.

Citigroup prepay transactions with Enron, while structured somewhat differently than the Chase transactions, had the same overall purpose and effect. Like the J.P. Morgan Chase prepays, the Citigroup prepays passed the commodity price risk from Enron to a Citigroup-sponsored special purpose vehicle to Citigroup and back to Enron. As in the J.P. Morgan Chase prepays, Enron's future obligations under the Citigroup prepays consisted of repayments of principal and interest that were independent of any changes in the price of the underlying commodity.

Additionally, two other Citibank transactions with Enron, Project Nahanni and Project Bacchus, each of which was also a structure that transformed cash from financing into cash from operations. In project Nahanni, Citigroup knowingly helped Enron structure a transaction that allowed Enron to generate cash from operating activities by selling Treasury bills bought with the proceeds of a loan. Project Bacchus was structured by Enron as a sale of an interest in certain of its pulp and paper businesses to a special purpose entity capitalized by Citigroup with a $194 million loan and $6 million in equity. However, in substance, Project Bacchus was a $200 million financing from Citigroup, because Citigroup was not at risk for its equity investment in the project.

Citigroup structured a transaction with Dynegy, known as Project Alpha, which was a complex financing that Dynegy used to borrow $300 million. Citigroup knew that Dynegy implemented Alpha to address the mismatch between its mark-to-market earnings and operating cash flow, and that it characterized as cash from operations what was essentially a loan transaction. As Citigroup knew, Dynegy, too, was concerned that the mismatch between earnings and cash flow from operations would raise questions about the quality of Dynegy’s earnings and its ability to sustain those earnings.

Acting like a Marshal Wyatt Earp who had just cleaned up Dodge City, the SEC congratulated itself for cleaning up the Wild Wide West of structured finance by gracefully acknowledged [acknowledging] the assistance of the Federal Reserve Bank of New York, the Office of the Comptroller of the Currency, and the New York State Banking Department in connection with its Enron-related actions. The Federal Reserve Bank of New York and the Office of the Comptroller of the Currency entered into separate written agreements with Citigroup. The Federal Reserve Bank of New York and the New York State Banking Department entered into a written agreement with J.P. Morgan Chase. These agreements, between the institutions and their primary banking regulators, obligate them to enhance their risk management programs and internal controls so as to reduce the risk of similar misconduct. The regulator focused only on bank obligation to “reduce the risk of similar misconduct” not to eliminate the misconducts entirely. Zero tolerance was not the message.

With these two actions, the SEC raised to six the total number of separate actions it brought in connection with the Enron fraud in twenty months since Enron declared bankruptcy in December 2003. The various defendants and respondents include three major financial institutions, Enron’s former Chief Financial Officer, and eight other former senior Enron executives. The SEC garnered a pathetic $324 million for the “benefit” of the victims of the Enron fraud.

FleetBoston Financial Corp. and Credit Suisse First Boston arranged Enron “prepay” transactions totaling a little more than $1 billion in a decade. J.P. Morgan alone during roughly the same period arranged $3.7 billion. Citigroup provided Enron with $4.8 billion in 14 separate transactions through prepays in just the last three years before Enron filed for bankruptcy protection.

Despite the banks' denials of any wrongdoing, many investors say the banks had or should have had knowledge about the true state of Enron’s finances. The two banks, as well as other Wall Street firms involved in Enron, face lawsuits accusing them of pushing Enron securities on the public, when, as lenders, they should have had insights that Enron's finances were dodgy.

Enron’s use of prepays arranged by banks was so extensive that Arthur Andersen created guidelines it gave to banks about what was needed for these structures to appear on Enron's books as trades rather than debt. “For prepays to be treated as trading contracts, the following attributes must exist,” the brochure said, citing, among other things, that “the purchaser of the gas must have an ordinary reason for purchasing the gas.” A Houston federal jury convicted Andersen in June 2003 of obstructing justice after the government accused the accounting firm of destroying documents related to Enron.

An array of executives, lawyers, bankers and institutions were formally named in an amended class action complaint for their alleged role in the Enron scandal. Lawyers for the Regents of the University of California, the court-appointed lead plaintiff in the case, said the defendants “pocketed billions of dollars” while Enron investors were being defrauded. Among those on the list were: Andersen, Enron auditors; Enron’s banks, including JP Morgan Chase and Citigroup; and Enron’s lawyers, including Vinson & Elkins. Enron board members such as Wendy Gramm, wife of the influential Republican senator Phil Gramm, were also named. Gramm, an economist who had called for deregulation of the energy industry, headed the Commodity Futures Trading Commission from 1988 to 1993. After a heavy lobbying campaign from Enron, the CFTC exempted it from regulation in trading of energy derivatives. Subsequently, Gramm resigned from the CFTC and took a seat on the Enron Board of Directors where she was paid $1.85 million. This lack of CFTC oversight contributed to Enron’s accounting irregularities, and the failure of the hedge fund Amaranth Advisors from losses resulting from betting on the wrong side of natural gas prices in September 2006.

The Fall of Andersen

Arthur Andersen, Enron’s auditor, with 2001 revenue of $9.4 billion, offered to settle its part in the case for $300m, reduced from its initial $750m offer and indicative of its dire financial circumstances brought on by deserting clients and disintegrating worldwide structure.  But it failed to cut a deal in time to be removed from the suit. Joseph Berardino, Andersen’s chief executive who resigned over the issues, was named a defendant. Andersen was convicted on June 15, 2002 of obstruction of justice for shredding documents related to its audit of Enron. Since the SEC does not allow convicted felons to audit public companies, the firm agreed to surrender its licenses and its right to practice before the SEC on August 31, 2002. This effectively ended the company's operations.

The Andersen indictment also put a spotlight on its faulty audits of other companies, most notably Sunbeam, Waste Management and WorldCom. Sunbeam, a household appliances manufacturer, acquired three other companies: Coleman, Signature Brands and First Alert with $1.7 billion of debt, which it cited in court filing as leading to the bankruptcy.

In the late 1990s, Sunbeam CEO Al Dunlap used accounting tricks to paint a picture of a turnaround in earnings that didn't exist. With a pay package that included more than seven million shares and options, Dunlap stood to make more than $200 million personally if he could keep Sunbeam’s stock price flying. In the spring of 1998, when Dunlap and his team ran out of tricks, Sunbeam corrected its books, declared bankruptcy on February 6, 2001, and the stock price plunged from $53 at its peak to just pennies. In an ominous harbinger of the Enron scandal, the SEC discovered that Andersen accounting documents had been destroyed. In 2001, Andersen paid $110 million to settle (without admitting legal responsibility) a class action suit by shareholders of Sunbeam over wildly "misstated" corporate financial statements in the 1990s.

In the case of Waste Management which in 1998 issued the largest corporate restatement before Enron, the company had exaggerated its earnings by $1.7 billion. The SEC's investigation found a longrunning cover-up -- not just by Waste Management, but by Andersen as well. Andersen and Waste Management paid a steep price in stockholder settlements, but no one went to jail. The SEC fined Andersen $7 million in June 2001, and Andersen promised to shore up its internal oversight -- but by then they were already deeply enmeshed in new trouble at Enron. Andersen paid $7 million last June to settle fraud allegations arising from an audit it conducted of the huge Waste Management Inc., based in Houston. Andersen agreed to pay $7 million to settle federal charges it filed false and misleading audits of Waste Management in which the Houston-based waste services company overstated income by more than $1 billion.

Andersen examined Waste Management's books from 1993 through 1996, and issued audit reports that falsely claimed that the statements had been prepared using generally accepted standards, the SEC said.

The agency said that the Waste Management financial statements that Arthur Andersen blessed had overstated the Houston-based waste services company's pretax income by more than $1 billion.

The bankruptcy of WorldCom on July 22, 2002, one month after it revealed that it had improperly booked $3.8 billion in expenses. WorldCom surpassed Enron as the biggest bankruptcy in history led to a domino effect of accounting and other corporate scandals that continue to tarnish US business practices.

WorldCom, with $107 billion in assets, collapsed under its $41 billion debt load. Its bankruptcy dwarfed that of Enron which listed $63.4 billion in assets when it filed a year earlier. Immediately upon filling for bankruptcy protection, WorldCom lined up $2 billion in debtor-in-possession financing from Citigroup, J.P. Morgan and G.E. Capital that would allow it to operate while in bankruptcy.

The WroldCom bankruptcy was precipitated by the revelation on June 25 that it had incorrectly accounted for $3.8 billion in operating expenses. The admission cast WorldCom into the top tier of scandal-ridden companies alongside Tyco International, Global Crossing, Adelphia Communications and Enron. WorldCom was one of the success stories of finance capitalism in the 1990s. In 1998, WorldCom under CEO Bernie Ebbers bought MCI, the nation's No. 2 long-distance provider behind for $37 billion. The company was struggling with its $41 billion debt, $24 billion of which was in corporate bonds. When its problems came to light in June, 2002, its banks refused to provide the company with any credit unless it was secured with WorldCom assets. Within 30 day, after missing three interest payments totaling $79 million on July 14, the company filed for bankruptcy protection a week later. Andersen for 15 months had signed off on the telecommunications company’s overstated profit reports.

On May 31, 2005, the US Supreme Court unanimously overturned Andersen’s conviction on the ground of serious flaws in jury instructions. In the court's view, the instructions allowed the jury to convict Andersen without proving that the firm knew it had broken the law or that there had been a link to any official proceeding that prohibited the destruction of documents. The opinion, written by Chief Justice William Rehnquist, was also highly skeptical of the government’s concept of “corrupt persuasion”--persuading someone to engage in an act with an improper purpose even without knowing an act is unlawful.  The Supreme Court was in effect saying that common sense unethical business behavior can be technically legal. The Court seems to view Andersen’s destruction of incriminating documents as merely an attempt to manage public relations in opposition to the lower court’s view of criminal obstruction of justice.

The Enron Corporation on September 23, 2003 in turn sued a variety of banks, brokerage firms and their subsidiaries that financed its deals and partnerships, accusing them of participating in deliberately murky transactions for millions of dollars in fees and helping to create the failed energy company’s facade of success. Defendants in the suit filed in Federal Bankruptcy Court in New York include J. P. Morgan Chase & Company and Citigroup Inc., two of Enron's largest creditors. Others include Merrill Lynch & Company, the Canadian Imperial Bank of Commerce, Deutsche Bank and Barclays Bank. The suit contends that Enron executives conspired with the banks to inflate profits and hide debt.

Conduits Dispersed

The problem for the banks now is exacerbated when asset-backed commercial paper conduits are no longer issued by one issuer and sold to one investor. ABCP now combine a variety of debt categories from different issuers and are sold to a large number of investors, making full disclosure difficult to understand even by “sophisticate” [sophisticated] investors.  Notes from conduits now account for half of the $3 trillion global commercial paper market.

High public officials who are in the position to know, ranging from the Chairman of the Federal Reserve to the Secretary of the Treasury repeatedly gave assurances to the investing public that were not only at variance with discernable trends but turned out to be materially false within weeks. The “basic facts” about the market that the SEC claims as its mission to make available to all investors were systemically distorted and withheld from the investing public with denials by officials of distress firms and their regulators up to days before the adverse information surfaced as undeniable facts.

These officials can now rest at ease for misleading investors because the high court of the land has declared “corrupt persuasion” to be legal, that persuading someone to engage in an act with an improper purpose even without knowing an act is unlawful is not criminal behavior.

Next: Bank Deregulation Fuels Credit Abuse

Liquidity Bust Bypasses the Banking System

By
Henry C.K. Liu


Part I: The Rise of the Non-bank Financial system

Part II: Bank Deregulation Fuels Credit Abuse

This article appeared in AToL on September 6, 2007
 

Federal Reserve data show that the outstanding stock of US commercial paper has fallen by $255 billion or 11% over the last three weeks, a sign that many borrowers have been unable to roll over huge amounts of short-term debt at maturity. Asset-backed commercial paper (ABCP), which accounted for half the commercial paper market, tumbled $59.4 billion to $998 billion in the last week of August, the lowest since December. Total short-term debt maturing in 270 days or less fell $62.8 billion to a seasonally adjusted $1.98 trillion. The yield on the highest rated asset-backed paper due by August 30 rose 0.11 percentage point to a six-year high of 6.15%.

Some analysts are comparing the current collapse of the CP market to the sudden drain on liquidity that occurred at the onset of the 2001 dotcom bust. Others are comparing the current crisis to the 1907 crash when large trusts did not have access to a lender of last resort as the Fed had not yet been established. Still others are comparing the current crisis to the 1929 crash when the Fed delayed needed intervention.

Today, key market participants who dominate the credit market with unprecedented high level of securitized debt operate beyond the purview of the Fed in the non-bank fiancial system and these market participants do not have direct access to a lender of last resort when a liquidity crisis develops except through the narrow window of the banking system.

Banks Get No Respect from Non-Bank Debt Markets

Banks are now unhappy about capital and debt markets where they are no longer getting respect. Market analysts have been crediting capital and debt markets for the long liquidity boom, rather than bank lending. Banks’ share of net credit markets, according Fed data on flow of funds, dropped from a peak of over 62% in 1975 to 26% in 1995 and still falling rapidly, while securitization’s share rose from negligible in 1975 to over 20% in 1995 to over 60% in 2006 and still rising rapidly, with insurers and pension funds taking the rest.

Debt securitization in the first half of 2007 stood at over $3 trillion up from $2.15 trillion in 2006, $375 billion in 1985 and 156 billion in 1972.  About $1.2 trillion are asset-backed securities. The biggest issuers are:

• Countrywide, $55 billion;

• Washington Mutual, $43 billion;

• General Motors Acceptance Corporation (GMAC), $40 billion. 

Big bank issuers are:

• JPMorgan/Chase, $38 billion;

• Citibank, $29 billion;

• Barclays Bank, $29 billion.

Big brokerage issuers are:

• Lehman Brothers, $37 billion;

• Merrill Lynch, $31 billion,

• Bear Sterns, $31 billion;

• Morgan Stanley, $26 billion. 

Asia, including Japan, which still funds its economies mostly through banks, could not recover quickly from the 1997 Asian financial crisis primarily because of an underdeveloped debt securitization market.

The DOW and Interest Rates

In February 2000, the Dow closed below 10,000 - a psychological bench mark from a peak of 11,723 just 4 weeks earlier, and 10,000 was only a transitional barrier.  Some bears predicted lack of support until 8,000. It was the first retreat from the 10,000 mark in 10 months, off 14.22% for the year, while the broader S&P 500 lost 9.25%. On September 17, the DJIA fell 684.81 points to close at 8,920.70, largest dollar loss in history, down 7.13%. On October 9, the DJIA fell 215.22 points to close at 7,286.27.  The market had declined 4,436.71 points, or 38%, from January 14, 2000 when it rose 140.55 to close at all time high of 11,722.98, first close above both 11,600.00 and 11,700.00.

On May 16, 2000, the Fed Funds rate was raised to 6.5%. After that, the Fed began lowering it on January 3, 2001 thirteen times to 1% on June 25, 2003 and held it there below inflation rate for a full year, unleashing the debt bubble. On July 19, 2007, the DJIA closed at 14,000.41, reaching a new all time high. The DJIA rose 6,714 points, or 92%, since the low point of 7,286.27 on October 9, 2002, in 4 years and10 months. The GDP rose from $10.5 trillion in 2002 to $13.2 trillion in 2006, a rise of 30%. Asset prices outpaced economic growth by a multiple of 3 during that period.

This extraordinary divergence shows more than the different economic fundamentals of the old and new economy.  It shows the financial effect of a shift of importance from banks as funding intermediaries to the exploding capital and debt markets, in which with the advent of structured finance, the line between equity and debt has been effectively blurred.

Greenspan’s Forked-Tongue Policy Pronouncements

NASDAG companies rely less on banks for funds and were thus less affected by Greenspan’s threats of interest rate hikes.  Greenspan had been vocal in explaining that his monetary policy moves of rising Fed Funds rate targets were not specifically targeted towards “irrational exuberance” in the stock markets, but toward the unsustainable expansion of the economy as a whole.  But data show that the economy did not expand at the same rate as the rise of equity prices.  Economic growth would be more sustainable without irrational exuberance in the stock market.

With the same breath, Greenspan decried the dangers of the wealth effect if it ever ends up heavier on the consumption side than on the investment side. It was a curious position, as most Greenspans positions seem to be. The Greenspan gospel says asset inflation is good unless it is spent rather than used to fuel more asset inflation.  He continued to restrain demand in favor of supply in an already overcapacity economy.

The need for demand management was argued by post-Keynesian economists who had been pushed out of the mainstream in recent decades by supply-siders. In housing, Greenspan was trapped in a classic dilemma of not knowing if housing is consumption or investment. Homeowners have been living in an asset (thus consuming it) that rises in market value faster than the rise of their earned income. Home equity loans enabled homeowners to monetize their housing investment gains to support their non-housing consumption. It is hard to see how home prices rising higher than homebuyers can afford to pay for them can be good for any economy. Yet the Fed celebrates asset price appreciation for shares and real estate, but treats wage rise like a dreaded plague.

Bifurcated Markets

The so-called “bifurcated” market indexes of the tech boom of the early 2000s indicated clearly that the Fed, whose sole monetary weapon being the Fed Funds rate, lost control of the new economy which appears impervious to short-tem interest rate moves.  Under such conditions, the only way the Fed could restrain unsustainable economic expansion in one sector was to overshoot the interest rate target to rein in an impervious Nasdaq at the peril of the whole economy.  Interest sensitive stocks were battered badly in 2000, including banks and non-bank lenders, such as GE, GMAC and Amex. This forced to Fed to aggressively ease subsequently to keep Fed Funds rate at 1% for a whole year from June 2003 to June 2004 to create the housing bubble. With inflation rate at 2%, the Fed was in effect giving borrowers a net payment of $1,000 for every $100,000 borrowed between 2002 and 2003.

The Peril of Uneven Profit Sharing

Financial services companies, including commercial banks, brokerage firms and mortgage lenders, investment bank and non-bank financial companies such as GE and GMCC, had since produced some of the biggest profits in the recent bull market fueled by a liquidity boom. The trouble with the financial sector making the bulk of the profit in the debt economy is that when newly created wealth is unevenly distributed to favor return on capital rather than through rising wages, it exacerbates the supply-demand imbalance which can only be sustained by a consumer debt bubble. The public have insufficient income to consume all that the debt economy can produce from over investment except by taking on consumer debt and home equity debt.

Liquidity Crunch Only Early Symptom

In recent weeks, the combination of sudden rise in interest rates due to a liquidity crunch and the hefty leverage employed by businesses in the financial sector has proved to be fatally hazardous to company cash flow and stock prices. Money center banks and broker dealers, along with their hedge fund customers are most vulnerable because they are most exposed to interest-rate-related risks through products such as interest rate swaps, default swaps and securitized mortgages. But this was just an early symptom, like an initial wave of high fever.

Lipper TASS reports that institutional and wealthy private investors poured $41.1 billion into hedge funds in the second quarter of 2007, which through performance gains swelled industry assets to an estimated $1.67 trillion by the end of June. The aggregate hedge fund performance of 5.19% by June 30 did not surpass market indices rise for the period. The S&P 500 returned 6.28%, while the MSCI World TR returned 6.71%. The biggest inflows were for market-neutral long-short equity strategies, which gained $14.9 billion, followed by event-driven funds, which gained $12.2 billion. Multi-strategy funds gained $6.1 billion during the period. Strategies that posted net outflows included global macro funds, which bet on world currencies and sovereign debt and were down by $848 million, and managed futures, which were down by 686.7 million.  Losses of this scale are bound to have structural effects.

The Credit Derivatives Overhang

The most popular of all derivative products is the interest rate swap, which essentially allows participants to make bets on the direction interest rates will take. According to the Office of the Comptroller of the Currency, interest rate swaps accounted for three out of four derivative contracts held by commercial banks at the end of 1999. The notional value of these swaps totaled almost $25 trillion; 2-3% of that reflected the banks’ true credit risk in these products, or between $500 billion to $700 billion. The notional amount outstanding as of December 2006 in OTC interest rate swaps was $229.8 trillion, up $60.7 trillion (35.9%) from December 2005. These contracts account for 55.4% of the entire $415 trillion OTC derivative market. A 1% move in interest rate would alter interest payment in the amount of $4 trillion, albeit much the payments would be mutually canceling, unless in the case of counterparty default.

Comptroller of the Currency Quarterly Report on Bank Derivatives Activities shows that US commercial banks generated a record $7 billion in revenues trading cash and derivative instruments in first quarter of 2007, up 24% from the first quarter of 2006, which at $5.7 billion had been the previous record. Revenues in the first quarter were 82% higher than in the fourth quarter. Net current credit exposure, the net amount owed to banks if all contracts were immediately liquidated, decreased $5.3 billion from the fourth quarter to $179.2 billion. The data for the third quarter of 2007 are expected to be very negative to reflect market turmoil since July.

The notional amount of derivatives held by US commercial banks increased $13.3 trillion to $144.8 trillion in the first quarter of 2007, 10% higher than in the fourth quarter and 31% higher than a year ago. Bank derivative contracts remain concentrated in interest rate products, which represent 82% of total notional value. The notional amount of credit derivatives, the fastest growing product of the global derivatives market, increased 13% from the fourth quarter 2006 to $10.2 trillion in first quarter in 2007. Credit default swaps represent 98% of the total amount of credit derivatives. Credit derivatives contracts are 86% higher than at the end of the first quarter of 2006. The largest derivatives dealers continue to strengthen the operational infrastructure for over-the-counter derivatives through a collaborative effort with financial supervisors, the OCC reports calims. Still, counterparty risk remains problematic.

Derivatives of all kinds weigh heavily on banks' capital structures. But interest rate swaps can be especially toxic when interest rates rise. And since only a few business economists predicted a jump in rates for the first half of the year when 1999 began -- in fact, yields have risen 25% -- these institutions now find themselves on the wrong side of an interest rate gamble. Moreover, as interest rates rise, bank income diminishes from interest-rate-related businesses like mortgage lending. Interest-sensitive sources of income will be the revenue disappointments in 2008, as in 2000, and as trading was in 1999.

Hedging Feeds Risk Appetite

The impact of the demised of the Nasdaq index on the wealth effect was not total.  Investment banks pitched to high tech/internet founders and early shareholders to hedge capital gains by signing away future upsides.  For those high tech swimmers who took advantage of the offers, this amounted to second layer swimming trunks that allowed them to lose the top layer without risking being caught naked when the tide receded suddenly.  It was the financial version of a flat-proved tubeless tire that can get you to the next gas station or 30 miles (whichever is closer) in the event of a puncture.  It does not, however, guarantee the driver the existence of a gas station that has not been forced to close from operational losses within 30 miles.

Meanwhile, pension funds were forced to jettison their old fashioned balanced portfolios in favor of structured finance strategies to seek higher returns. What the Greenspan Fed did was to penalize the general public by devaluing their future pension cash flow for the sins of the aggressively investing rich who continue to add to their wealth with Greenspan’s blessing as long as the risks of high returns are passed on to the system as a whole. This is what American economic democracy has come to.

Investor Confidence Low

Investors worldwide are unconvinced that the US Federal Reserve could succeed in stabilizing the US commercial paper market, the latest and so far biggest shoe to drop in the spreading contagion from US sub-prime mortgages. Banks are suddenly exposed to unexpected risks as US asset-backed commercial paper shrank by its biggest weekly percentage since November 2000 as investors shunned debt linked to mortgages and opted for the safety of Treasuries.

This means that investors prefer to lend money to the US government despite historically high levels of fiscal deficit and national debt, than to financial institutions that seek profit from interest rate arbitrage.  Market preference for speculative investment has vanished. Banks are suddenly holding the bad end of a massive amount of speculative debt instruments. When new commercial paper is not sold to roll over the maturing debt, borrowers must draw on bank credit at higher interest cost to prevent default, leaving banks with riskier debts that the market has rejected.

Fed Accepts ABCP as Discount Window Collateral

In the week to August 22, after the Fed lower the discount rate by 50 basis points to 5.75% on August 17, banks borrowed a daily average of only $1.2 billion from the Fed discount window, suggesting that banks were still unsure how to use the facility to lend to distressed clients. Officials at the New York Fed, the central bank’s liaison with Wall Street, received inquiries from commercial banks in recent days on whether their clients' asset-backed commercial paper could be pledged as collateral at the discount window.

The New York Fed issued a statement “in response to specific inquiries” from money-center banks on Friday, August 24, that it “has affirmed its policy to consider accepting as collateral investment quality asset-backed commercial paper (ABCP)” for discount-window loans to ease the liquidity crisis faced by the banks to try to calm a essential part of the money market the orderly functioning of which is critically needed to lubricate financial markets. But the statement only trimmed slightly the abnormally high average ABCP yield to 6.04%, still roughly 80 basis points higher than normal even for those borrowers who could sell commercial paper at all, which normally would be at rates close to the Fed funds rate of 5.25%.

Fed Exempts Banks from Lending Limits to Broker Dealer Subsidiaries

On the same day, the Fed eased regulations governing the relationship between Citibank NA, the US bank subsidiary of Citigroup Inc, and its broker-dealer subsidiary, Citigroup Global Markets Inc. The regulatory exemption allows Citibank to lend up to $25 billion to customers of the broker-dealer. Bank of America Corp. received a similar ease.

Section 23A of the Federal Reserve Act and the Fed Board’s Regulation W limit the amount of “covered transactions” between a bank and any single affiliate to 10% of the bank’s capital stock and surplus and the amount between a bank and all its affiliates to 20%.

The two banks proposed to extend to market participants in need of short-term liquidity to finance their holdings of certain mortgage loans and highly rated mortgage-backed and other asset-backed securities (Assets).  The banks proposed to channel these transactions through their respective Affiliated Broker-Dealers in the form of either reverse repurchase agreements or securities borrowing transactions (collectively, “securities financing transactions or “SFTs”).  Because the banks proposed to engage in SFTs with their respective Affiliated Broker-Dealers in amounts that exceeded the banks’ quantitative limits under the statute and rule, the banks must receive exemptions from the Fed to engage in the proposed transactions. The banks have agreed to limit their lending under the exemption to $25 billion which will constitute less than 30% of each bank’s total regulatory capital.

The Fed has allowed Citibank and Bank of America exemption to exceed the level limited by banking regulations to 10% of the bank’s capital. Lending the full $25 billion represents close to 30% of Citibank’s total regulatory capital.  The Fed explained that it made the exemption in the public interest, because it allows Citibank to get liquidity to the brokerage in “the most rapid and cost-effective manner possible” which ironically contradicts the Fed’s earlier explanation on “restoring orderly markets” by changing discount window procedures.

The two banks, along with JPMorgan Chase & Co. and Wachovia Corp., borrowed a total of $2 billion two days earlier in a symbolic show of support for the Fed’s anemic actions, while noting they still had access to cheaper funding than the new discount rate of 5.75%.

Until the repeal of the Glass-Steagall Act, banking regulation prohibited banks with federally insured deposits from operating brokerage subsidiaries. In the early part of the last century, individual investors had been repeatedly damaged by banks whose overriding interest was to profit from promoting stocks held by banks, rather than to enhance the interest of individual investors or protect the security of its depositors. After the 1929 market crash, regulators sought to limit the conflicts of interest created when commercial banks underwrote stocks or bonds which contributed to abuses that caused market crashes. A new law, known as the Glass-Steagall Act, banned commercial banks from underwriting securities, forcing banks to choose between being a regulated lender of high prudence or an underwriter-broker with high risk appetite. The law also established the Federal Deposit Insurance Corporation (FDIC), insuring bank deposits, and strengthens the Federal Reserve’s control over credit.

Glass-Steagall

The 1933 Glass-Steagall Act became a key pillar of banking law by erecting a regulatory wall between commercial banking and investment banking. The law kept banks from participating in the equity markets, and equity market participants from being banks. The relevant measure of the Glass Steagall act is actually the Bank Act of 1933, containing the provision erecting a wall separating the banking and securities businesses. It also left a small lope hole to allow the Federal Reserve to let banks get involved in the securities business in a limited way to relieve otherwise cumbersome operation.

Glass-Steagall was born in the 1933 depression. The banking system was in shambles with over 11,000 banks having failed or had to merge, reducing the number of surviving banks by 40%, from 25,000 to 14,000. The governors of several states closed their state banks and in March, President Roosevelt closed briefly all the banks in the country. Congressional hearings conducted in early 1933 concluded that the trusted professional of the financial markets: the bankers and brokers, were guilty of disreputable and dishonest dealings and gross misuses of the public trust. Historians, while acknowledging the role of malfeasance, now understand that the chief culprit of bank failures was structural, with inadequate regulations that permitted market abuse to become regular practice. Unethical practices were legal and competition was conducted with the law of the financial jungle.

The Banking Act of 1933 was the newly-elected Roosevelt administration response to the perceived shambles of the nation’s financial and economic system. But the Act did not address the structural weakness of the US banking system: unit banking within states and the prohibition of nationwide banking. This structure is a key reason for the failure of many US Banks, some 90% of which were unit banks with under $2 million in assets. The Act instituted deposit insurance and the legal separation of most aspects of commercial and investment banking, the principal exception being allowing commercial banks to underwrite most government-issued bonds.

Carter Glass was then a 75-year-old senator who physically stood only 5 feet 4 inches but historically a towering figure. A former Treasury secretary, he was a founder of the Federal Reserve System and a vocal critic of banks that engaged the risky business of investing in stocks. He wanted banks to stick to conservative commercial lending, and he exploited traditional anti-bank sentiments to push through changes. Henry Steagall, a rural populist from Ozark, Alabama, was Democratic chairman of the House Banking and Currency Committee, signed on to the bill to attach an amendment which authorized bank deposit insurance.

Senator Glass was convinced that bank should not be involved with securities underwriting or investment as such activities violate basic rules of good banking. As intermediary custodian of money, bank involvement in equity markets will lead to destructive speculation, as evidenced by the Crash of 1929 with its bank failures and the subsequent Great Depression.

Curbing the natural monopolistic tendency of banks has been a common legislative theme throughout US history until the recent onslaught of economic neo-liberalism. During the 1930s and 1940s, banks stayed regulated to stay within the basics of taking deposits and making secured loans funded by deposits. Congress did not intervene until 1956, when it enacted the Bank Holding Company Act to keep financial-services conglomerates from amassing excessive financial power. That law created a barrier between banking and insurance in response to aggressive acquisitions and expansion by TransAmerica Corp., an insurance company that owned Bank of America and an array of other financial services businesses. Congress thought it improper for banks to risk possible losses from underwriting insurance. While many banks today can sell insurance products provided by insurers, banks are not permitted to take on the risk of underwriting.

TransAmerica and the 1956 Bank Holding Company Act

Transamerica began when a young entrepreneur named A. P. Giannini started a small bank known as the Bank of Italy, later to be known as Bank of America. Giannini acquired Occidental Life Insurance Company through TransAmerica Corporation in 1930. In 1956, Congress passed the Bank Holding Company Act, which prohibited a company from owning both banking and non-banking entities. The company decided to divest itself of its bank holdings and keep its core life insurance businesses and related services under the Transamerica name. As a financial conglomerate, it acquired motion picture studio and distributor United Artists, Trans International Airlines, and Budget Rent A Car.

The Rise and Fall of Conglomerate

As private equity is the rage today, conglomerates were the new trend in the 1960s exploiting a combination of low interest rates and recurring alternative cycles of bear/bull markets, which allowed the conglomerates to buy companies in leveraged buyouts at temporarily deflated values with loan at negative real interest rates. As long as the acquired companies had profits greater than the interest on the loans used to buy them, the overall leveraged return on investment (ROI) of the conglomerate grew spectacularly, causing the conglomerate’s stock price to rise sharply within short periods. High stock prices allowed the conglomerate to borrow more loans without altering its debt to equity ratio, with which to acquire even more companies. This led to a chain reaction that allowed conglomerates to grow very rapidly.

But when interest rates finally rose to catch up with inflation, conglomerate ROI fell when anticipated “synergies” from owning diversified businesses failed to live up to expectation and conglomerate shares fell in market value, forcing them sell off recently acquired companies to pay off loans to maintain required debt to equity ratio. By the mid-1970s, most conglomerates had been dismantled, as many private equity deals are expected to in coming months.

The Case of GE

During the 1980s, GE, traditionally an engineering and manufacturing company, moved into finance and financial services to become today the largest conglomerate with $400 billion in market capitalization. Finance in 2007 accounted for about 45% of the company’s net earnings. But in the 1980s, the GE business model was the opposite of the “typical” 1960s conglomerate in that it employed interest rate hedges to sell commercial paper so that when interest rates went up, GE was able to offer leases on equipment that were less expensive than buying using bank loans. In 2003, GE Capital acquired TransAmerica Finance from Aegon, which retained the rest of TransAmerica. In 2004, GE subsidiary NBC acquired the entertainment assets of bankrupt Vivendi Universal, excluding Universal Music, to form NBC Universal, of which General Electric owns 80%.

General Electric Capital Corporation (GE Capital) is a global, diversified financial services company that engages in commercial finance, consumer finance, equipment management and insurance. One of only seven non-financial companies to be rated “triple A” for credit worthiness, GE Capital is one of the worlds largest issuers of commercial paper.

GE Commercial Finance offers an array of products and services aimed at enabling businesses worldwide to grow. Its services include loans, operating leases, fleet management and financial programs with 2006 revenue of $23.8 billion and 17% profit margin, with 22,000 employees worldwide.

GE Industrial provides a broad range of products and services throughout the world, including appliances, lighting and industrial products; factory automation systems; plastics, and sensors technology; non-destructive testing and equipment financing; and management and asset intelligence services. 2006 revenue was $33.5 billion with a profit margin of 5% with 85,000 employees worldwide.

GE Money provides home loans, insurance, credit cards, personal loans and other financial services for more than 130 million individual customers. 2006 revenue was $21.7 billion with a profit margin of 15% with 50,000 employees worldwide. Product offered include corporate travel and purchasing cards, credit cards, debt consolidation, home equity loans, mortgage and motor solutions and personal loans to individual consumers and retail clients such as auto dealers and department stores.

NBC Universal is one of the world's leading media and entertainment companies in the development, production, and marketing of entertainment, news and information to a global audience. Formed in May 2004 through the combining of NBC and Vivendi Universal Entertainment, NBC Universal owns and operates a valuable portfolio of news and entertainment networks, a premier motion picture company, significant television production operations, a leading television stations group and world-renowned theme parks. NBC Universal is 80-percent owned by General Electric and 20-percent owned by Vivendi.

GE share repurchase program increased to $14 billion for 2007, with $12 billion expected to be completed between now and year end.

The Repeal of Glass-Steagall

Repeated unsuccessful attempts were made since 1933 by commercial bankers and sympathetic regulators to repeal or draft exceptions to those sections of Glass-Steagall Act that mandate separation of commercial and investment banking. As a result, the US and Japan, which was forced to adopt laws similar to the US Banking statues after the Second World War, alone among the world’s major financial nations, legally require this separation. Japanese banks can engage in many securities activities, however, including underwriting and dealing in commercial paper and ownership of up to 5 percent of non-bank enterprises.

Glass-Steagall commonly referred to those sections of the Banking Act of 1933 that deal with bank securities operations: sections 16, 20, 21, and 32. These four sections of the Act, as amended and interpreted by the Comptroller of the Currency, the Federal Reserve Board and the courts, govern commercial bank domestic securities operations.

Sections 16 and 21 refer to the direct operations of commercial banks. Section 16 as amended generally prohibits Federal Reserve System member banks from purchasing securities for their own account. But a national bank (chartered by the Comptroller of the Currency) may purchase and hold investment securities (defined as bonds, notes, or debentures regarded by the Comptroller as investment securities) up to 10 per cent of its capital and surplus. Sections 16 and 21 also forbid deposit-taking institutions from both accepting deposits and engaging in the business of “issuing, underwriting, selling, or distributing, at wholesale or retail, or through syndicate participation, stock, bonds, debentures, notes or other securities”, with some important exceptions. These exceptions include US Government obligations, obligations issued by government agencies, college and university dormitory bonds, and the general obligations of states and political subdivisions. Municipal revenue bonds (other than those used to finance higher education and teaching hospitals), which are now issued and traded in larger volume than general obligations, are not included in the exceptions, in spite of the attempts of commercial banks to have Congress amend the Act. In 1985, however, the Federal Reserve Board decided that commercial banks could act as advisers and agents in the private placement of commercial paper.

Section 16 permits commercial banks to purchase and sell securities directly, without recourse, solely on the order of and for the account of customers. In the early 1970, the Comptroller of the Currency approved Citibank’s plan to offer the public units in collective investment trusts that the bank organized. But in 1971, the US Supreme Court ruled that sections 16 and 21 prohibit banks from offering a product that is similar to mutual funds. In an often quoted decision, the Court found that the Act was intended to prevent banks from endangering themselves, the banking system, and the public from unsafe and unsound practices and conflicts of interest. Nevertheless, in 1985 and 1986 the Comptroller of the Currency decided that the Act allowed national banks to purchase and sell mutual shares for its customers as their agent and sell units in unit investment trusts.

In 1987, the Comptroller also concluded that a national bank may offer to the public, through a subsidiary, brokerage services and investment advice, while acting as an adviser to a mutual fund or unit investment trust. Since 1985 the regulators have allowed banks to offer discount brokerage services through subsidiaries, and these more permissive rules have been upheld by the courts. Thus, more recent court decisions and regulatory agency rulings have tended to soften the 1971 Supreme Court’s strict interpretation of the Act’s prohibitions.

Sections 20 and 32 refer to commercial bank affiliations. Section 20 forbids member banks from affiliating with a company “engaged principally” in the “issue, flotation, underwriting, public sale, or distribution at wholesale or retail or through syndicate participation of stocks, bonds, debentures, notes, or other securities”. In June 1988, the US Supreme Court, by denying certiorari, upheld a lower court ruling accepting the Federal Reserve Board’s April 1987 approval for member banks to affiliate with companies underwriting commercial paper, municipal revenue bonds, and securities backed by mortgages and consumer debts, as long as the affiliate does not principally engage in those activities. “Principally engaged” was defined by the Federal Reserve as activities contributing more than from 5 to 10 per cent of the affiliate's total revenue. In 1987, the DC Court of Appeals affirmed the Federal Reserve Board’s 1985 ruling allowing a bank holding company to acquire a subsidiary that provided both brokerage services and investment advice to institutional customers. In 1984 and 1986 the Court held that affiliates of member banks can offer retail discount brokerage service (which excludes investment advice), on the grounds that these activities do not involve an underwriting of securities, and that “public sale” refers to an underwriting.

Section 32 prohibits a member bank from having interlocking directorships or close officer or employee relationships with a firm “principally engaged” in securities underwriting and distribution. Section 32 applies even if there is no common ownership or corporate affiliation between the commercial bank and the investment company.

Sections 20 and 32 do not apply to banks that are not members of the Federal Reserve System and savings or loan associations. They are legally free to affiliate with securities firms. Thus the law applies unevenly to essential similar institutions. Furthermore, securities brokers cash management accounts, which are functionally identical to check accounts, have been judged not to be deposits as specified in the Act.

Commercial banks are not forbidden from underwriting and dealing in securities outside of the United States. The larger money center banks, against whom the prohibitions of the Glass-Steagall Act were directed, have been particularly active in these markets after World War II. Five of the top 30 leading underwriters in the Eurobond market in 1985 were affiliates of US Banks, with 11% of the total market. These affiliates include 11 of the top 50 underwriters of Euronotes.

Citicorp, for example, held membership in some 17 major foreign stock exchanges, and it offers investment banking services in over 35 countries. In 1988, it arranged for its London securities subsidiary to cooperate with a US Securities firm to make markets in US securities. The Chase Manhattan Bank advertised that it had offices in almost twice as many countries as ten major listed investment banks combined. Furthermore, commercial bank trust departments could trade securities through their securities subsidiaries or affiliates for pension plans and other trust accounts.

Commercial banks off shore could offer some aspects of investment advisory services, brokerage activities, securities underwriting, mutual fund activities, investment and trading activities, asset securitization, joint ventures, and commodities dealing, and they could offer deposit instruments that are similar to securities.

The generally accepted rationale for the Glass-Steagall Act is well expressed in the 1970 brief filed by the First National City Bank (FNCB) in support of the Comptroller of the Currency’s decision to give the bank permission to offer commingled investment accounts. For this case Investment Company Institute v. Camp, (401 US 617, 1971), which the Supreme Court decided in favor of the Investment Company Institute, FNCB attorneys described the rationale for the Act: “The Glass-Steagall Act was enacted to remedy the speculative abuses that infected commercial banking prior to the collapse of the stock market and the financial panic of 1929-1933. Many banks, especially national banks, not only invested heavily in speculative securities but entered the business of investment banking in the traditional sense of the term by buying original issues for public resale. Apart from the special problems confined to affiliation three well-defined evils were found to flow from the combination of investment and commercial banking.
(1) Banks were investing their own assets in securities with consequent risk to commercial and savings deposits. The concern of Congress to block this evil is clearly stated in the report of the Senate Banking and Currency Committee on an immediate forerunner of the Glass-Steagall Act.
(2) Unsound loans were made in order to shore up the price of securities or the financial position of companies in which a bank had invested its own assets.
(3) A commercial bank’s financial interest in the ownership, price, or distribution of securities inevitably tempted bank officials to press their banking customers into investing in securities which the bank itself was under pressure to sell because of its own pecuniary stake in the transaction.

The original and continuing reasons and arguments for legally separating commercial and investment banking include:
a) Risk of loses
Banks that engaged in underwriting and holding corporate securities and municipal revenue bonds presented significant risk of loss to depositors and the federal government that had to come to their rescue; they also were more subject to failure with a resulting loss of public confidence in the banking system and greater risk of financial system collapse.
b) Conflicts of interest and other abuses
Banks that offer investment banking services and mutual funds were subject to conflicts of interest and other abuses, thereby resulting in harm to their customers, including borrowers, depositors, and correspondent banks.
c) Improper banking activity
Even if there were no actual abuses, securities-related activities are contrary to the way banking ought to be conducted.
d) Producer desired constraints on competition
Some securities brokers and underwriters and some bankers want to bar those banks that would offer securities and underwriting services from entering their markets.
e) The Federal “safety net” should not be extended more than necessary
Federally provided deposit insurance and access to discount window borrowings at the Federal Reserve permit and even encourage banks to take greater risks than are socially optimal. Securities activities are risky and should not be permitted to banks that are protected with the federal “safety net”.
f) Unfair competition
In any event, banks get subsidized federal deposit insurance which gives them access to ‘cheap’ deposit funds. Thus they have market power and can engage in cross-subsidization that gives them an unfair competitive advantage over non-bank competitors (e.g. Securities brokers and underwriters) were they permitted to offer investment banking services.
g) Concentration of power and less-than-competitive performance
Commercial banks' competitive advantages would result in their domination or takeover of securities brokerage and underwriting firms if they were permitted to offer investment banking services or hold corporate equities. The result would be an unacceptable concentration of power and less-than-competitive performance.

Beginning in the 1960s, banks began lobbying Congress to allow them to enter the municipal bond market.  In the 1970s, deregulation allowed brokerage firms to encroach on banking territory by offering money-market accounts that pay interest, allow check-writing, and offer credit or debit cards. In December 1986, the Federal Reserve Board, which has regulatory jurisdiction over banking, reinterprets Section 20 of the Glass-Steagall Act, which bars commercial banks from being “engaged principally” in securities business, deciding that banks can only have up to 5 percent of gross revenues from investment banking business. The Fed Board then permits Bankers Trust, a commercial bank, to engage in certain commercial paper transactions. In the Bankers Trust decision, the Board concluded that the phrase "engaged principally" in Section 20 allows banks to do a small amount of underwriting, so long as it does not become a large portion of revenue< style="font-family: times new roman,times,serif;">.

In the spring of 1987, the Federal Reserve Board voted 3-2 in favor of easing regulations under Glass-Steagall Act, overriding the opposition of Chairman Paul Volcker. The vote legalized as policy proposals from Citicorp, J.P. Morgan and Bankers Trust to allow banks to handle several underwriting businesses, including commercial paper, municipal revenue bonds, and mortgage-backed securities. Thomas Theobald, vice chairman of Citicorp, argued that three “outside checks” on corporate misbehavior had emerged since 1933: a very effective SEC; knowledgeable investors, and very sophisticated rating agencies, to render the tight regulations unnecessary. Yet in the current liquidity crisis, it has become clear that all three of these “outside checks” failed in recent years to protect both the public interest and the orderly function of markets. The SEC has largely been ineffective in preventing corporate fraud and market abuse, investors have been unable to fully understand the risk of complex financial instruments pushed on them by confused if not unprincipled brokers and rating agencies fell far short in accurately rating the true risk imbedded in debt instruments they rate.  

Volcker Opposed Repeal

Paul Volcker, the Chairman of the Fed, was out-voted over his fear that banks would recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public. It was the financial equivalent of letting the camel’s foot into the tent.  Since then, the history of finance capitalism has been the triumph of the security industry’s aggressive culture of risk over the banking industry’s prudent culture of security.

In March 1987, the Fed approved an application by Chase Manhattan to engage in underwriting commercial paper. While the Board remained sensitive to concerns about mixing commercial banking and underwriting, it reinterpreted the original Congressional intent by focusing on the words “principally engaged” to allow for some securities activities for banks. The Fed also indicated that it would raise the limit from 5% to 10% of gross revenues at some point in the future to increase competition and market efficiency.

Greenspan Supported Repeal

In August 1987, Alan Greenspan, a director of J.P. Morgan and a proponent of banking deregulation, was appointed chairman of the Federal Reserve Board. Greenspan put the full power of his new position to advocate bank deregulation by asserting its necessity to help US banks become global financial powers in the context of US push for financial globalization. In January 1989, the Fed Board approved a joint application by J.P. Morgan, Chase Manhattan, Bankers Trust, and Citicorp to expand the Glass-Steagall loophole to include dealing in debt and equity securities in addition to municipal securities and commercial paper. This marked a large expansion of the activities considered permissible under Section 20, because the revenue limit for underwriting business was still at 5%. Later in 1989, the Board issued an order raising the limit to 10% of revenues, referring to the April 1987 order for its rationale.

JP Morgan Jumpstart

In 1990, J.P. Morgan became the first bank to receive permission from the Federal Reserve to underwrite securities, so long as its underwriting business does not exceed the 10% revenue limit. In 1984 and 1988, the Senate passed legislation that would ease major restrictions under Glass-Steagall, but in each case the more populist House blocked passage. In 1991, the Bush Sr. administration put forward a repeal of Glass-Steagall proposal, winning support of both the House and Senate Banking Committees, but the House again defeated the bill in a full vote. And in 1995, the House and Senate Banking Committees approved separate versions of legislation to repeal Glass-Steagall, but conference negotiations on a compromise fell apart.

Attempts to repeal Glass-Steagall typically pit insurance companies, securities firms, and large and small banks against one another, as factions of these industries engage in turf wars in Congress over their competing interests and over whether the Federal Reserve or the Treasury Department and the Comptroller of the Currency should be the primary banking regulator.

In December 1996, with the vocal public support of Chairman Alan Greenspan, the Federal Reserve Board issued a precedent-shattering decision permitting bank holding companies to own investment bank affiliates with up to 25% of their business in securities underwriting, up from 10%. This expansion of the loophole initially created by the Fed's 1987 reinterpretation of Section 20 of Glass-Steagall effectively rendered Glass-Steagall obsolete, in view of explosive growth of banking. Virtually any bank holding company wanting to engage in securities business would be able to stay under the 25% limit on revenue, since banks are much larger institutions as compared to security firms. However, the law remained on the books, and along with the Bank Holding Company Act, continued to impose other restrictions on banks, such as prohibiting them from owning insurance-underwriting companies.

In August 1997, the Fed further eliminated many restrictions imposed on “Section 20 subsidiaries” by the 1987 and 1989 orders. The Board stated that the risks of underwriting had proven to be “manageable,” and allowed banks the right to acquire securities firms outright. In 1997, Bankers Trust, now owned by Deutsche Bank, bought the investment bank Alex. Brown & Co., becoming the first U.S. bank to acquire a securities firm.

Traveler Insurance Bought Citibank

In the summer of 1997, Sandy Weill, head of Travelers insurance company, sought and nearly succeeded in a merger with J.P. Morgan, before J.P. Morgan merged with Chemical Bank, but the deal collapsed at the last minute. In the fall of the same year, Travelers acquires the Salomon Brothers investment bank for $9 billion to merge it with the Travelers-owned Smith Barney brokerage firm to become Salomon Smith Barney.

In February 1998, Sandy Weill of Travelers approached Citicorp’s John Reed on a merger. On April 6, 1998, Weill and Reed announce a $70 billion stock swap merging Travelers (which owned the investment house Salomon Smith Barney) and Citicorp (the parent of Citibank), to create Citigroup Inc., the world's largest financial services company, in what was the biggest corporate merger in history.

The transaction had to work around remaining regulations in the Glass-Steagall and Bank Holding Company acts governing the industry, which were implemented precisely to prevent a merger of insurance underwriting, securities underwriting, and commercial banking. The pending merger effectively gave regulators and lawmakers three options: end these restrictions, scuttle the deal, or force the merged company to cut back on its consumer offerings by divesting any business that fails to comply with the law.

Weill met with Alan Greenspan and other Federal Reserve officials before the announcement to sound them out on the merger, and later told the Washington Post that Greenspan had indicated a “positive response.” Weill and Reed carefully structured the merger to technically conform to the precedents set by the Fed in its interpretations of Glass-Steagall and the Bank Holding Company Act.

Unless Congress changed the laws and relaxed the restrictions, Citigroup would have two years to divest itself of the Travelers insurance business with the possibility of three one-year extensions granted by the Fed and any other part of the business that did not conform to regulation. Citigroup promised to divest on the assumption that Congress would finally change the law before the company would have to do so. Citicorp and Travelers lobbied banking regulators and government officials for support.

In late March and early April, Weill makes three heads-up calls to Washington: to Fed Chairman Greenspan, Treasury Secretary Robert Rubin, and President Clinton. On April 5, the day before the announcement, Weill and Reed make a ceremonial call on Clinton to brief him on the upcoming announcement.

The Fed gave its approval to the Citicorp-Travelers merger on Sept. 23. The Fed’s press release indicated that “the Board's approval is subject to the conditions that Travelers and the combined organization, Citigroup, Inc., take all actions necessary to conform the activities and investments of Travelers and all its subsidiaries to the requirements of the Bank Holding Company Act in a manner acceptable to the Board, including divestiture as necessary, within two years of consummation of the proposal. ... The Board's approval also is subject to the condition that Travelers and Citigroup conform the activities of its companies to the requirements of the Glass-Steagall Act.”

Following the merger announcement on April 6, 1998, Weill immediately launched a lobbying and public relations campaign for the repeal of Glass-Steagall and passage of new financial services legislation known as the Financial Services Modernization Act of 1999. Modernization was an euphemism for total deregulation for the brave new world of financial globalization.

The House Republican leadership wanted to enact the measure in the current session of Congress. While the Clinton administration generally supported Glass-Steagall “modernization,” there are concerns that mid-term elections in November could bring in new Democrats less sympathetic to changing the populist laws. In May 1998, the House passed legislation by a narrow vote of 214 to 213 that allowed the merging of banks, securities firms, and insurance companies into huge financial conglomerates. And in September, the Senate Banking Committee votes 16-2 to approve a compromise bank overhaul bill. Despite this new momentum, Congress was still not certain to pass final legislation before the end of its session.

As the final push for new legislation heated up around election time, lobbyists raised the issue of financial modernization with a fresh round of political fund-raising. Indeed, in the 1998 mid-term election, the finance, insurance, and real estate industries, known as the FIRE sector, built a bonfire of more than $200 million on lobbying and more than $150 million in political donations. Campaign contributions were targeted to members of Congressional banking committees and other committees with direct jurisdiction over financial services legislation.

After 12 attempts in 25 years, Congress finally repeals Glass-Steagall, rewarding financial companies for more than 20 years and $300 million worth of lobbying efforts. Supporters hailed the change as the long-overdue demise of a Depression-era relic. Opponents saw it as the root for a future depression.

On October 21, with the House-Senate conference committee was deadlocked after marathon negotiations. The main sticking point is partisan bickering over the bill’s effect on the Community Reinvestment Act, which sets rules for lending to poor communities when much of the current subprime mortgages had initially been written before the abuse spread to the general market through securitization. Weill called President Clinton in the evening to try to break the deadlock after Senator Phil Gramm, chairman of the Banking Committee, warned Citigroup lobbyist Roger Levy that Weill had to get the White House moving on the bill or he would shut down the House-Senate conference. Serious negotiations resume, and a deal is announced at 2:45 a.m. on October 22.

Clinton Signed the Repeal

A few hours later, Weill and Reed issue a statement congratulating Congress and President Clinton, including 19 administration officials and lawmakers by name. The House and Senate approved a final version of the bill on November 4, three business days before the election and Clinton whom some Democrats call the best president the Republicans ever had, signed it into law the Gramm-Leach-Bliley Act, the official name of the Financial Services Modernization Act of 1999 on November 12, two days after the election to replaced the repealed Glass-Steagall Act of 1933. 

Repeal of Glass-Steagall Led to the Current Credit Crisis

What nobody expected, not even the most fervent opponents to bank deregulation, was that the repeal of Glass-Steagall paved the road to the emergence of the non-bank financial system which took off like a fighter jet of the deck of an aircraft carrier with the advent of deregulated global financial markets, which eventually rendered both banks and their central bank lenders of last resort irrelevant in a brave new world of finance.

Just days after the Treasury Department signed on to support the repeal of Glass-Steagall, Treasury Secretary Robert Rubin, a former co-chairman of Goldman Sachs, accepted a top position at Citigroup as Vice Chairman. The previous year, Weill had called Secretary Rubin to give him advance notice of the upcoming merger announcement. When Weill told Rubin he had some important news, the secretary reportedly quipped, “You’re buying the government?” Rubin could have added: “With debt?” The answer, while never reported, could have been: “No, the whole world.”

The world that Weill bought with debt from the non-bank financial system is now in a severe credit crisis with an irrelevant banking system that needs to have $1.3 trillion put back into the banks’ balance sheets. Even if the Fed bails out the banks by easing bank reserve and capital requirements to absorb that massive amount, the raging forest fire in the non-bank financial system will still present finance capitalism with its greatest test in eight decades.

Cash may be king in a liquidity crisis, but in a credit crisis, a king may echo Shakespeare’s Richard the Third: “A horse, a horse, my kingdom for a horse.”