Why the fed’s case against Standard & Poor’s matters to you

Federal prosecutors filed civil fraud charges against Standard & Poor’s for alleged wrongdoing in rating mortgage bonds. This is the first federal enforcement action against a major credit rating agency over alleged illegal behavior tied to the 2008 financial crisis.

For the uninitiated, Wall Street investment banking firms long ago woke up to the fact that their credibility as sellers of financial securities to private investors could be significantly enhanced if these securities were “rated for safety” by so-called independent and objective third parties.

This was especially true for debt securities like bonds, whose likely buyers were perceived as very conservative. Since the market for bonds and other debt securities is far larger than the market for common stocks, development of a third-party rating system for them became a priority for Wall Street.

Three private firms emerged as the most trusted “rating agencies” for debt securities: Moody’s Investors Services Inc., McGraw-Hill subsidiary Standard & Poor’s, and Fitch Inc.

These firms assign “investment ratings” to debt securities based on their analysis of relevant financial data about the issuers. They charge fees to the sellers for rating the debt securities.

The financial community accepted this approach for providing debt securities buyers with “objective” information about their relative safety and these rating systems became a popular shorthand way to categorize the securities. Investment banks routinely used favorable ratings as marketing tools.

Some institutional buyers of debt securities (like insurance companies with streams of premium income to invest) announced that they would only buy securities rated “A” or better. Government and private sector regulators often set minimum ratings for the securities firms they regulated (such as commercial banks) were permitted to buy.

During the run-up to the financial crisis, this business was quite profitable. From 2005 to 2007, Moody’s had a return on capital of 140 percent, the highest among all publicly traded corporations listed in the S&P 500 Index. Its operating profit margin was 53.6 percent. And the firm’s revenues from rating corporate bonds grew by 187 percent. In short, the rating agencies made out like proverbial bandits.

So it doesn’t take much imagination to picture how the relationship might have played out on a typical day in 2007 as the mortgage backed securities and derivative products boom was approaching its climax. Wall Street investment banks delivered risk-profile reports for their latest deals that included mathematical risk models.

Except the formulas and equations behind those models were proprietary, meaning that rating agencies’ reliance on them amounted to little more than “trust me.” The agencies happily made that leap of faith, which benefited their bottom lines to the detriment of those who purchased the securities.

In addition to consistently churning out strong ratings for highly questionable debt securities, they also regularly increased the fees they charged for doing so.

If you conclude that the interaction between big banks and the rating agencies was more like a criminal enterprise than an arms-length relationship between a commercial enterprise and an independent , objective third party, you’re not alone. Federal prosecutors feel the same way.

Now where do all the purchasers of those now-worthless debt securities go to get their money back?

originally published: February 19, 2013

Reality check: Myths cloud free-market debate

In the years since the 2008 financial meltdown, free markets have suffered a shattering loss of credibility, especially among Americans who have lost their jobs, homes and the money they saved for retirement and college for their children.

Since the days of Adam Smith, more nonsense has been written about free-market capitalism than any subject other than religion.

Beginning in the 1960s, ivory-tower economists started developing a host of “rigorous” quantitative models that claimed to show how markets actually work.

These models (expressed in obscure differential equations rather than clear English) focused primarily on markets for common stocks and other financial securities that were assumed to represent the closest real-world approximation of the free-market ideal.

They were all wrong.

But they still became mainstream thinking among 1980s and ’90s Wall Street rocket scientists and remained so right on into the 2008 collapse. Several of the models’ developers even won the Nobel Prize in economics, with its impressive gold medal and seven-figure check.

It may come as a surprise to some, but markets are by no means artificial entities invented in an ivory tower. They are entirely natural and instinctive products of human pragmatism.

Let’s look at some of the popular myths about markets that have brought us so much grief. The first is that the amount of goods and services consumers are willing to buy at the so-called “market price” always equals the amount producers are willing to sell.

The evidence indicates that real-world buyers and sellers are forever chasing transaction prices that coincide just long enough for them to strike deals. The price agreed upon for one deal may be different from that of a similar one struck at the same instant on the other side of the room.

This should come as no surprise to anyone who’s ever bought a knock-off Rolex wristwatch, Mont Blanc pen or Vuitton handbag at a bargain price from one of the sidewalk stalls that line Manhattan’s Canal Street, where the sweaty reality of free markets truly flourishes.

Another myth is that markets are perfectly efficient because decisions to buy and sell are made by coldly rational androids that seek only to maximize their personal satisfaction in objective ways, possess complete information and have absolute freedom to enter into transactions or to pass on them.

But real-world markets are usually chaotic, with the average buyer or seller trying to guess what every other average buyer and seller thinks is the right price. And what about situations like the one faced by a fisherman forced to sell his fresh fish at the end of the day for whatever price a restaurant chain offers, because it’ll spoil overnight?

Many economists claim that market-price changes are entirely random and independent of each other, like consecutive coin tosses. But normal people instinctively know that prices are determined by human beings who negotiate knowing what the last transaction price was. The real world is like an unbalanced roulette wheel, full of patterns and dependencies.

Still another myth is that markets work best when they’re not subject to any meddling by external institutions like government. But markets need regulation  as both President Obama and Governor Romney acknowledged in their first debate.

We can’t rely on the myth that a seller knows his economic success ultimately depends on his reputation among potential buyers. The argument that he has a powerful economic incentive to maintain a reputation for honesty can easily fall prey to natural instincts that may be those of a con artist.

Market myths like these provided justifications for the deregulation mania on Wall Street and elsewhere. If we want to recover from the Great Recession they helped cause and avoid a repeat of it, we’d better learn the difference between myth and reality.

originally published: October 13, 2012

White-collar organized crime

One, two, three strikes you’re out. The chairman, CEO and COO of Barclay’s all resigned in the wake of the bank’s manipulation of the London inter bank offered rate, or Libor. The bank agreed to pay a penalty of about $450 million.

The Libor rate is essentially how much interest banks pay to borrow money on a short-term basis from other financial firms, a process overseen by the British Bankers’ Association, an industry trade group.

Libor, a global benchmark based on a gentlemen’s agreement among major financial institutions, is a reference point for a whole range of securities, loans, mortgages and derivatives sold around the world. According to The Wall Street Journal, the total value of these financial products is as much as $800 trillion, which dwarfs the global gross domestic product of nearly $70 trillion. Libor’ s corruption means consumers, corporations and governments have been paying the wrong interest rate.

Government officials on both sides of the Atlantic are now investigating how many other big banks joined in attempts to manipulate this important interest rate for their own gain. The alleged behavior is similar to falsifying your net worth and salary on a loan application to secure a lower interest rate.

The number of banks participating in rigging the Libor ranges from 16 to 20. Their alleged behavior is reminiscent of the organized crime cartel put in place during the 1930s by managerial genius Charles “Lucky” Luciano (no one called him “Lucky” to his face) and his partners.

This cartel was based on ideas originally developed by advanced management thinkers like New York gambling impresario Arnold Rothstein and Chicago gang leader Johnny Terrio.

They believed the market for traditional criminal gang activities was so large and profitable that there was “room for everybody.” Wasteful competition between rival gangs was unnecessary, foolish and got in the way of maximizing profits.

The cartel was popularly known as the Mafia (which incorrectly implies that it was exclusively Italian). Its activities were based on the “Lansky Principle.”

Meyer Lansky grew up with Luciano on Manhattan’s Lower East Side and helped create the organized crime syndicate. His simple principle, which came from observing gambling rackets as a kid, was that the best way to make money gambling is to run the game yourself.

Isn’t that what the big banks allegedly did in conspiring to fix the Libor rate? We have a large number of firms (families) that roughly coexist within an environment of”mutual cooperation” and share broad common goals. Just like members of an organized crime cartel, these financial institutions understood how to manage a portfolio of various businesses to maximize their overall value.

Regulators are now dealing with the fallout from the alleged conspiracy. It turns out that the Federal Reserve Bank of New York learned about the rate rigging in the summer of 2007. The regulatory pursuit of this conspiracy was, to say the least, not put on the fast track.

This rate manipulation follows multibillion-dollar trading losses at JP Morgan Chase, the Facebook initial public offering debacle and the collapse of the Peregrine Financial Group just months after the failure of MF Global.

Now politicians and the Justice Department are tripping over themselves in hot pursuit of criminal wrongdoing in manipulating Libor. When it comes to pursuing the financial mafia, let’s hope they have more success this time.

Anyone with a library card knows that there have been very few recent prosecutions oflarge U.S. financial institutions and their senior executives. These days, this crowd is the untouchables.

Assuming they are successful, we should forget the tobacco settlement-sized fines, the handcuffs and multimillion-dollar settlements that represent a minuscule percentage of firm profits. The worst punishment you can inflict on these white-collar criminals is not a long prison term.

No, force them instead to spend the rest of their lives living on not more than say $75,000 a year. Too bad we don’t punish school teachers that way. But to crooked CEOs, that’s poverty. And with the multimillion-dollar lifestyles they’ve become accustomed to, it would be the worst punishment of all.

originally published: July 28, 2012

JPMorgan Chase shows how little we have learned

Just when you thought America’s megabanks were safe and sound, JPMorgan Chase disclosed that it had lost at least $2 billion in just six weeks. The loss was suffered on high-risk investments in a portfolio of complex financial instruments known as derivatives. Ironically , it was incurred by a trading group within the bank that was supposed to manage the risks the bank takes with its own money.

So goes life in the fast lane. We have been led to believe that speculating in credit derivatives was a thing of the past. Not to worry; it’s all under control.

This shocking loss at one of the better-managed financial institutions has revived the debate about whether megabanks can be trusted to handle risk in the era of “too big to fail.” It shows that megabanks like JPMorgan Chase with so many moving parts, too much leverage and too much risk taking may have become too big to be effectively managed. Put differently, megabanks may be too big to succeed.

The loss also shows the market for the complex financial instruments known as derivatives remains opaque. So much for the financial industry’s argument about the dangers of too much regulation.

This loss is a major embarrassment to a firm that came through the 2008 financial crisis in much better financial shape than its peers by steering clear of risky investments that hurt many other megabanks.

While the loss did not cause anything close to the panic that followed the September 2008 failure of Lehman Brothers, it did shake the financial industry’s confidence. Stock in the bank, which is the  nation’s largest, lost 8 percent of its value in minutes. Fitch Rating Agency downgraded the bank’s credit rating by one notch. Standard & Poor’s revised its outlook on the firm to “negative,” suggesting a credit rating downgrade could follow. Other American financial institutions have also suffered losses.

You all remember the fall of 2008, when the roof fell in because too many financial institutions discovered that their investment portfolios were stuffed full of monopoly money derivative securities that were impossible to value for balance-sheet purposes. The derivative boom spread to the nation’s housing markets, where the subsequent meltdown brought Wall Street’s troubles to Main Street – with a vengeance.

These derivative securities were designed by the bright young Ph.D.’s in math or physics who found that it was a lot harder to earn a decent living in academia than earning a fabulous living on Wall Street. Their technical backgrounds let them quickly master the intricacies of quantitative finance theory and engineer all kinds of wild new derivative securities that were too complicated for most people to understand but very profitable for their employers.

So are derivatives tools of the devil? Or as Warren Buffett says, “weapons of mass destruction”? Not inherently.

Rather, they are extremely useful tools for transferring risk between willing buyers and sellers at mutually agreeable prices. And since the world is full of people with very different risk tolerances, derivatives can serve a highly valuable economic purpose.

The catch is that buyers and sellers of derivatives must be more than merely willing. They must also understand what the risk is really all about and how transferring risk doesn’t make it go away, no matter how many times it’s transferred, or to whom.

It is astonishing how few so-called financial executives and regulators understand what risk is really all about. They get carried away by the excitement of trading, let themselves believe they are participating in a no-lose game of boosting profits with no downside.

Until they wake up one morning to find themselves drowning in huge losses, while the rest us are left holding the bag amid a shattered economy. Let’s hope that isn’t what happens again this time.

We need to implement the Volcker Rule immediately to eliminate proprietary trading at commercial banks, and federally backed banks should be forbidden to engage risky trading practices. Of course, it may not be a bad idea to consider making the financial system less dependent on regulators and make banks small enough to fail.

originally published: May 15, 2012