Wednesday, December 28, 2011

Volatility Lurks

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

The European Union is putting its money where its mouth is. Never taking the slightest blame for euro woes, its New York employees are moving to new offices at 666 Third Avenue. The EU's United Nations delegation will "take about 45,000 square feet .... and pay about $60 a square foot annually for 15 years...." reported Bloomberg on December 23, 2011. Negotiations with its prospective new landlord, Tishman Speyer Properties L.P., are nearing completion. The real estate company should consider an anti-EU hedge at the moment the EU signs up.

Sixty Euro employees will occupy the space (per
Bloomberg). This works out to a 25-by-30 square-foot office for each. "Austerity" is imposed on the lower 99%, but not yet in Brussels, Strasbourg, or points west.

The potential break up of the European Union is more a consideration for a landlord holding a fifteen-year lease agreement than for the average investor. Yet, current havoc and future bedlam are clearly underpriced in all markets. European and U.S. mispricings will be discussed here.

The S&P 500 volatility index - the VIX - is a measurement of volatility expectations. It has fallen 50% since the (latest) agreement to save the euro was announced. From 30.59 on December 8, 2011, (the Eurocrats trumpeted their fiscal union pact on December 9, 2011) the VIX fell to a 20.72 close on December 23, 2011.

Whether or not fiscal continence is the route to euro salvation does not seem to matter. As discussed in
The Rotten Heart of Europe, the Euro establishment (Brussels, banks, and bond markets) vectored towards that conclusion. Having done so, the implied volatility of markets is a derivative of what negotiators accomplished on December 9th.

European Voice
, a Brussels-based, English-language newspaper "maintains an independent stance regarding the affairs of the European Union." So it claims. It is owned by the Economist Group. This disabuses the notion of neutrality. The Economist's heart, soul, liver, and spleen promote the European Union over national sovereignty.

Van Rompuy Sends European Leaders Draft of Fiscal Union Pact, published on December 14, 2011, distills the best efforts of euro fans to promote the fiscal union pact. We learn that Herman Van Romney, the president of the European Council, has (on December 14) sent a draft of an inter-governmental treaty that will seek to boost economic discipline in the eurozone. It will enter into force once nine of the 17 eurozone member states have ratified it. It contains tougher rules on economic discipline. [Underlined words to be explored - FJS]

Since the purpose of the pact is to convince skeptics of the euro's stability, Van Rompuy must be planning an early retirement. Maybe next week.

The "draft" will transmogrify into a treaty by March 2012. (This and what follows is gathered from
European Voice.) How many of the still (somewhat) sovereign states will sign is unknown. We do know that most countries "have shown interest." Whether any more is expected of countries is not clear: "If a eurozone country does not ratify it, it will not be bound by the new rules." That's the problem with the euro today.

However, an EU official told
European Voice that rejection by a country would "make life politically very uncomfortable for a non-ratifying member." Here is the mailed fist of the lifetime bureaucrat. The EU official continued: "It ["It' seems to mean the state's sovereignty - FJS] would not be durable for long." The second decade of the 18th, 19th, and 20th century were marked by continental European skirmishes. Four-in-a-row looks plausible.

European Voice
reports there are references in the treaty to "work jointly towards an economic policy fostering growth through enhanced convergence and competitiveness." Yet, these references - "remain vague." Please recall that markets, by and large, believe the Eurocrats will prevent a euro breakdown.

"Once adopted, the treaty will force countries to run a balanced budget and enshrine that rule in
their constitutions." This is the out-to-lunch attitude of the bureaucrat: expecting, by the beginning of March 2012, the parliaments of nine - or is it 17? - European countries to cede their parliamentary authority (and the opportunity to hand out vote-gathering favors) regarding respective national budgets, at a time voters are ready to lop off parliamentary heads.

Standards to enforce fiscal discipline were ignored in 2005 when "Germany and France helped loosen the rules when they forced through the relaxation of the anti-debt stability pact..." (From:
The Rotten Heart of Europe.) That was during a time of relative prosperity. Actually, it was a time when all countries could borrow and spend with abandon, the very problem that has caused the euro's decline.

In any case, an
inter-government pact is unenforceable since "the European Commission cannot take member states to court when they breach budget rules." This is worth $60 a square foot?

Amidst this incoherence, gold and silver wallow. The VIX rose from a fat, dumb, and happy 17.56 on July 22, 2011 to 48.00 on August 8, 2011. It was during that time Standard & Poor's cut the credit rating of the U.S. government and the debt ceiling terrified the nation. Should another rating agency do so (Fitch has been making noises) one should expect volatility.
(Washington Post headline, December 27, 2011: "Obama to Ask for Increase in Debt Ceiling")

Jim Bianco
[], president and television star at Bianco Research, explained the potential problem in an interview with Kate Welling (Welling@Weeden). When a country loses its AAA-rating, Basel III capital requirements and central bank rules require banks to apply haircuts against the downgraded bonds. This would create a problem in repo markets, among others. Borrowers in the repo market (somewhere around $4 trillion for U.S. banks) would need to find additional collateral. (Here is the problem of falling standards of collateral leading to demands for more collateral, again.)

Bianco explained the potential rumpus: "Since [Moody's and Fitch] are still at triple-A, we can pretend S&P did nothing. The next downgrade, if Moody's or Fitch were to follow S&P's lead, would actually matter a lot.... The next one that issues a downgrade would make the U.S. a split-rated double-A-plus, which would change some of the rules."

If the VIX falls to 18, call options are worth considering.

Thursday, December 15, 2011

U.S. Exposure to Europe - Unknowns Unknowns

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

[T]here are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns - there are things we do not know we don't know. "

-Former United States Secretary of Defense Donald Rumsfeld, February 12, 2002

There were reasons to criticize Donald Rumsfeld's turn as Defense Secretary but this was not one of them, even though the media quoted and re-quoted this most sensible approach to uncertainty as proof of a retarded intellect.

As Eurocrats dissemble (see: The Rotten Heart of Europe), ratios that quantify U.S. financial system exposure to European insolvency are dated, even as they are published. Credit default swaps or loans may have been traded in the interim, may have been hedged, or may have slithered from For-Profit-or-Bailout Banks onto the Federal Reserve balance sheet (i.e., nuclear-waste securities). Aggregate bank balance-sheet figures may be gross or net (and we debate whether gross or net is the more consequential measure), may be the tip of an iceberg compared to submerged, off-balance-sheet liabilities, and ultimately, we do not know the timing of the Fed's $5 trillion academically certified money dump into the banking system.

These limitations have been compounded by a recently revealed "unknown unknown," at least to most of us. On December 7, 2011, Reuters published "MF Global and the Great Re-Hypothecation Scandal." Reuters' reporter Christopher Elias opened: "A legal loophole in international brokerage regulations means that few, if any, clients of MF Global are likely to get their money back." (Re-hypothecation will be described below.)

Some lessons here: First, if not for the money stolen from MF Global's customers, Reuters probably would not have set Elias on the trail to re-hypothecation. Second, it is when good credit is receding that such scandals come to light. (Madoff.) If not for the slide in European sovereign bond prices (the route by which MF Global's CEO leveraged and bet the solvency of his firm), MF Global would not have disappeared. Third, and very much related to the previous point, the world's good collateral shrinks by the hour. Fourth, the supposed bond "guarantees" that authorities bray about are a chimera. Quoting Elias: "Backed by the European Financial Stability Facility (EFSF), it was a clever bet (at least in theory) that certain Eurozone bonds would remain default free whilst yields would continue to grow." The EFSF is backed by words, not assets. The more that governments and international bodies vote to back spiraling guarantees, the less their guarantees are worth. Thus: good collateral as a percentage of paper and paper promises shrinks. Fifth, and very much related to points two through five, it is only the spiraling of financial leverage that prevents the financial economy from collapsing.

Re-hypothecation is a revelation in financial leverage. Most readers understand "hypothecation," even if they never heard the word. Elias explains: "By way of background, hypothecation is when a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral but is 'hypothetically' controlled by the creditor, who has a right to seize possession if the borrower defaults." An example would be an investor who holds a margin account with a broker. If the value of the assets (shares of IBM) fall to a certain point, the broker requires that the investor put more money into the account. If the client does not put the required money into the account, the broker has the right to sell shares of IBM. The cash received in the sale restores the minimum level of equity required by the broker.

Elias explains the process as follows: "In the U.S., this legal right takes the form of a lien.... A simple example of a hypothecation is a mortgage, in which a borrower legally owns the home, but the bank holds a right to take possession of the property if the borrower should default."

Now we get to the scary part. Re-hypothecation, explains Elias: "occurs when a bank or broker re-uses collateral posted by clients... to back the broker's own trades and borrowings. The practice of re-hypothecation runs into the trillions of dollars and is perfectly legal." He quantifies the legal scam: "Prior to Lehman Brothers collapse, the International Monetary Fund (IMF) calculated that U.S. banks were receiving $4 trillion worth of funding by re-hypothecation, much of which was sourced from the UK. With assets being re-hypothecated many times over (known as 'churn'), the original collateral being used may have been as little as $1 trillion - a quarter of the financial footprint created through re-hypothecation.

ot off the press (dated December 2011) is an IMF report: The-Non-Bank-Bank Nexus and the Shadow Banking System. Authors Zoltan Pozsar and Manmohan Singh give an example of how re-hypothecation works (on page 11 of the paper). A dealer holds a Treasury security as collateral which "comes with the rights for the dealer to repledge it." The dealer uses this collateral as his (the dealer's) collateral with an asset manager. The asset manager "may re-use the Treasury security to post collateral with another dealer..." On it goes, each party in turn using the same Treasury security as collateral. The IMF authors proffer: "Since these transactions are underpinned by a single piece of collateral, such daisy-chains may be referred to as dynamic chains." They may also be referred to as an illusion of credit that nonetheless has inflated asset prices from Shanghai apartments to Apple common stock to European and U.S. Too-Levered-To-Die Banks. Pozsar and Singh write the traditional thinking of how banks fund themselves "ignores the significant funding that banks receive from the asset management complex" that permit "both individual banks and the banking system as a whole [to] quickly lever up."

Understanding this lends credibility to MF Global Chief Executive Officer Jon Corzine's statements before Congress that he does not know where his clients' money is. Pozsar and Singh write: "The securities that asset managers invest on behalf of households are seldom left lying around passively in portfolios. In order to capture their value as collateral, securities are routinely lent out for use in the shadow banking system, a fact few households, whose securities are ultimately being lent, are oblivious to." [My italics, should you have nodded off during all the IMF talk. - FJS]

It is generally believed that U.S. banks are in much better shape than European banks today. Of what value is this? Back to Pozsar & Singh: "The repeated use of... collateral facilitates system-lubrication [and] also the build-up of leverage-like collateral chains between banks and managers."

A down drift of collateral values, which should be expected since there is no value to the compounded layers, may be a reason European banks are in such dire straits. (European Central Bank President Mario Draghi to the European Parliament on Thursday, December 1, 2011: "We are aware of the scarcity of eligible collateral.")

reported on December 13, 2011: "EU Banks Selling 'Crown Jewels'..." The banks are selling some of their most profitable arms (lines of business) to raise cash. Is this the fire sale of the century? Probably not. Selling profitable lines at discounts to their fair value today drags down prices which may lead to another round of discount sales, at even lower prices tomorrow.

Distorted pricing of assets by a leveraged financial system with few real assets has led to some strange observations. Izabella Kaminska reports in the Financial Times (alphaville) that it is not regulators or authorities, but "the markets themselves... [that] are demanding a re-collateralization in all funding areas." She notes: "[T]he latest trend towards gold collateralized bank loans shows in some ways the market is demanding the recollateralization of credit with gold." Kaminska notes: "Gold is switching places with [U.S.] Treasuries as the ultimate form of security."

It is surprising U.S. Treasuries still hold that princely position. The FDIC is now guaranteeing $53 trillion (not billion, but: trillion) of Bank of America's (transferred from its Merrill Lynch subsidiary) credit default swaps. This maneuver was executed by the Federal Reserve. This is both reprehensible and meaningless. Assume a 25% default rate on the credits and that Bank of America also defaults. A $13 trillion tax on Americans to make good on our guarantee is meaningless, other than to induce an immediate credit downgrade to F-.

Speaking of the Fed, specifically of Federal Reserve Chairman Ben Bernanke, he told Congress on November 2, 2011, that MF Global had been approved as a primary dealer by the New York Federal Reserve, "but we are not the regulators of MF Global," nor is there any reason the Fed should be overseers or regulators to such a firm. Authors Poszar and Singh placed dealers at the heart of the re-hypothecation racket. Oh, Ben! Aggressively stupid to the end.

From the close on November 30, 2011, to December 12, 2011, (when Kaminska wrote), the spot gold price fell about $90, from $1,746 to $1,659. Kaminska explained why: Right now: "Banks don't need gold as much as they need cash." (This relative lack of need for gold is what she refers to below as "surplus gold.")

As has been written many times "gold is the ultimate form of payment," and so it is being lent by banks "for its use as a funding instrument: collateral." Gold now is being lent by banks (repoed) at a negative rate. "The more negative the rate, the higher the cost of funding using the collateral." Kaminska concludes: "With surplus gold being put into the system, the price of gold has no choice but to stall."

Maybe Kaminska should have considered another possibility: as the panic for collateral worsens, the price might continue to fall. In fact, over the past two days (December 12 to December 14), gold has fallen another $90, to $1,567 (as this is written). If Kaminska's analysis is correct, the price of gold could spring back up, with alacrity.

With the European banking system near collapse, we may soon find just how exposed is the U.S. banking system to continental credit, credit default swaps, and "repeated use of... collateral facilitates system-lubrication [and] the build-up of leverage-like collateral chains between banks and managers."

There is no question that, if it was within their power, the Eurocrats would have absorbed every last bond and bank loan on a bank balance sheet that is trading at a discount. "Oh," they must be wishing "if only we had the arrogated authority of Federal Reserve Chairman Ben Bernanke." They know that when (not if) the Federal Reserve chairman is in a similar position to theirs, he will beckon $5 trillion of funny money into existence. This would exceed his authority, but after members of a Congressional committee read him the riot act, they will thank him for saving the system, even as the inflation rate passes 30% during the hearing, and he will be Time magazine's Hero-of-the-Year again.

As for the Eurocrats, they will find a way to do the same. They must: otherwise the pampered satraps in Brussels will have to move home and pay taxes.

But could this "known known" (speaking of both the U.S. and Europe) be a miscalculation? That is to say, could the parties mentioned miscalculate and not act in time to pump up the sinking structure of leveraged ether?

Possibly so. There is precedence. Benjamin Anderson, economist at the Chase Bank from 1920 to 1939, wrote about two such misjudgments in the 1930s, in his highly recommended book, Economics and the Public Welfare: A Financial and Economic History of the United States, 1914-1946.

On May 12, 1931, "there came an unexpected run on Oesterreichische-Credit-Anstalt," a large Austrian bank. To be noted: (1) Oesterreichische-Credit-Anstalt was forced into a merger with a weaker bank in 1929. This might be analogous to Bank of America's acquisition of Countrywide Financial, and, (2) quoting Anderson: "The Austrian government guaranteed certain of the investments." (Oh, those government guarantees again!), but "the merged bank had been inadequately financed... the big merged institution was still insolvent." Just as in Europe today: how good is the credit (collateral) of the guarantor? The bulk of a sovereign state's collateral is future tax revenues. From Greece to the United States, this does not inspire confidence today.

On May 14, 1931, the Bank for International Settlements coordinated support by central banks. "This made a great show of international cooperation... but the effect was bad when eleven central banks were providing among them only $5.6 million. Creditors grew more frightened, rather than less. If the thing were to be done at all, it should have been done adequately. The first principal of bank loans in a crisis is that if the borrower needs $100,000 to save him, you give him $100,000 or you give him nothing at all. You don't give him $20,000."

Here, as described above, is where the U.S. (today) can hyper-inflate at will, while Europe is encumbered. Back to Anderson and 1931: "Panics are not dealt with effectively through delay, through public discussion, and through fighting for position. A loan of $25 million made promptly at the first sign of panic would probably have stopped it. There came a time when $100 million would not stop it. By the time the Austrian government on May 29, [1931], voted the guarantee of $150 million, the credit of the Austrian government was so shaken that no one cared about the pledge. When on June 6, 1931, the Bank for International Settlements arranged to give a... 100 million shilling credit [$14 million - FJS] to Austria, the Austrian financial disaster was very little helped thereby."

German banks endured a run on June 1, 1930. "In the beginning of the run on Germany, again the effort of international banking cooperation was made. Again $100 million promptly provided by concerted action of British, American, and French banks, publicly announced and instantly made available, could have stopped the crisis. A month later $500 million would not have been sufficient."

There were squabbles: It is "in the French character and the French tradition that immediate acceptance of a contract proposed by another party is out of the question.... France delayed, and France delayed to long.... The German people, as well as foreign creditors, were engaged in the run on German banks." France was not the only culprit. Anderson criticizes New York bankers for being too timid and too late.

This was not the end for German banks. Publicized meetings among government authorities and official proclamations dragged into 1932: the Euro summits of the day. Hope sprang eternal that a reconstruction of German debts (and war repatriations) could be managed, but it was not to be. Anderson observed (literally: he was confidant to participants) that "governments move slowly and politicians look to the next election." He concluded: "If the governments had acted that winter, Hitler would never have come to power, and we should have saved the democratic regime of Germany." This was an unknown unknown.

Thursday, December 8, 2011

The Rotten Heart of Europe

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

To Americans, European problems may seem as remote as they did in 1939. There is a good chance, though, that the crumbling financial structure will not be "contained" or "ring-fenced": the latter being the common description of how Europe had isolated itself from Italy's difficulties. That lasted a week or so. We may soon discover the extent of American exposure to European financial insolvency.

The catalyst for this coming weekend's European Union meeting is the failure of Europe's daisy-chain finance. On Monday, December 5, 2011, Bill King (The King Report) wrote of the latest: "European solons are proposing another Daisy Chain Bailout scheme - bankrupt and near-bankrupt European nations will inject money that they must borrow from the IMF so they can in turn borrow the money that they borrowed and then lend to themselves." Wendy's toes are curled around the end of Captain Hook's gangplank.

The creditworthiness of the fractured institutions is not trusted: the commercial banks, the national central banks, the ECB, the EFSF, and most importantly, the Bundesbank. On November 23, 2011, the Bundesbank attempted to auction €6 billion of 10-year German government bonds. It received bids for €3.8, or 61% of the total. Neil Jones at Mizuho Corporate Bank Ltd. in London told Bloomberg: "If investors do not wish to buy bunds, they do not wish to buy Europe." Right-ho.

The purpose of this dispatch is to dispel rumors that current front-page treaty talks have any economic meaning. The European and U.S. stock markets react with a 3% or 4% gain after vague announcements, but we are getting closer to a day when the false prophets are stripped bare.

The euro cannot survive in its current form. To understand this, we will return to its introduction. Some dates: The 1992 Maastricht Treaty formally established the intent of a single currency. The euro acquired electronic legitimacy on January 1, 1999. For instance, it was henceforth used in electronic bank transfers. The national currencies were locked at a specific rate to the euro on that date. On January 1, 2002, euro coins and bills became legal tender.

The euro was introduced after the finances of 10 (or 11, we'll skip over this) countries had "converged," meeting such criteria as national budget deficits less than 3% of GDP and a debt ratio less than 60% of GDP. It is now the currency of 17 European countries. Most, if not all, played games to meet these requirements. This was not a secret.

The preferred method of cheating has been to fabricate or ignore. On June 5, 2000, when Greece was admitted into the not very exclusive euro club, Austrian Finance Minister Karl-Heinz Grasser told reporters: "Greece will become a member for sure. It meets all the requirements for membership." A leading requirement was to not tell reporters the truth. French Finance Minster Laurent Fabius offered a more discreet assessment, as would be expected from a graduate of the École Nationale d'Administration (the training ground for advanced French bureaucrats): "Greece has made a huge improvement."

The euro, and more generally, the European Union, has been a bureaucratic racket from the beginning. Brussels protects its own interests first. It does not weigh the success of its ventures by how the masses subject to its mandates fare. The euro had its flaws, but the paper pushers never answer for mistakes. Like the Federal Reserve or the Gang of Four, they are unaccountable. (The latter offers some hope.) Human tissue is Play-Doh in their hands to be molded into what Superior Persons call their "European Project.

When trouble loomed, the Eurocrats looked the other way: "
Except for being told by the EU and ECB to get its financial house in order, Greece was not punished for cheating. In 2005, Germany and France helped loosen the rules when they forced through the relaxation of the anti-debt "stability pact," despite knowing that Greece had been above the 3% threshold for the previous three years." (Gold Alert, May 27, 2011)

The great flaw was already evident: countries could spend and tax as they wished (or didn't wish) while issuing bonds as if they were as creditworthy as the Bundesbank. It is only natural that Italy shoveled out bonds, borrowing and spending, until its debt grew to be the third largest sovereign bond market in the world, without a chance now of repayment at par.

Former European Central Bank Chief Economist Otmar Issing was quoted by Bloomberg on May 26, 2011: "Greece cheated to get in, and it's difficult to know how we should deal with cheaters." In fact, this is a matter of character, not law: "The grand plan outlined by France and Germany on Monday for European Treaty change breaks no new ground in terms of ideas - all the proposals already exist in various legal acts, the only problem is they have never been observed in practice." (Reuters - December 5, 2011)

The Eurocrats are meeting this weekend to discuss a treaty that will - do nothing, even in today's frantic quest to sign a scrap of paper that will satisfy potential bond buyers. A carrot was dangled, but quickly withdrawn. From Ambrose Evan-Pritchard in the Daily Telegraph: "[German Chancellor Angela] Merkel seems to have backed off on demands that budget breaches will be justifiable before the European court, so the Treaty chatter is mostly Quatsch, betises, and eyewash.

By the way, the effectiveness or necessity of rules is not discussed nearly as much as whether they are breached. The rules seem to be an end in themselves. The real problem, of divergent national economies operating in a single financial system, while countries spend and tax with very different priorities, has not changed. It remains - just talk.

Recall that the catalyst is disintegrating finance. Aside from the Bundesbank auction, an unknown number of banks cannot borrow from each other, so are drawing on the European Central Bank, which, itself, is highly leveraged, is holding Greek and Italian bonds at par, and is cheating on its constitutional restriction that it cannot bail out nations. Europe has begged around the globe for capital investment, to no avail. Portugal carried its tin cup to Angola, a former colony. The Angolans responded "nyet." Thwarted by its African sidekick, Lisbon officials validated Angola's wariness by confiscating €5.6 billion from Portuguese pension funds to fill its budget gap. Isn't technology wonderful? Tanks and troops slogging across continents warned of such heists in the past. Americans beware.

Of importance: the financial woes are REAL; the advertised solution is pretense. There is no financial "solution" as the loungers and idlers at European Union cocktail parties would define solution. They want a "fix" under the assumption the European Project could not possibly suffer from a design flaw. They designed it.

The Belgian bureaucrats expect the ECB to deploy enormous monetary firepower (€2 to €5 trillion) to relieve them of all this financial talk. To do so would break the law, not a consideration eurocrats or eurocratic periodicals mention. Bernard Connolly, in The Rotten Heart of Europe: The Dirty War for Europe's Money (1995), wrote that monetary union "is not only inefficient but undemocratic. A danger not only to our wealth but also our freedoms, and ultimately, our peace. The villains of the story... are bureaucrats and self-aggrandizing politicians." Monetary union "is a mechanism for subordinating the economic welfare, democratic rights, and national freedom of the European countries to the political and bureaucratic elites whose power-lust, cynicism, and delusions underlie the actions of the vast majority of those who now strive to create a European superstate."

Connolly is now an economic consultant (Connolly Insight) who wrote this book after his eye-opening experience inside the Eurocracy. There is a single copy available on Abebooks, for $1443.52.

It was 97 years ago when German Chancellor von Bethmann-Hollweg asked the British ambassador in Berlin, Sir Edward Goschen, why England would defend Belgium's neutrality. His Majesty's Government had signed a treaty to do so, in 1839. Bethmann-Hollweg replied this was a "scrap of paper."

It has been a deplorable century for the law, agreements, and treaties since that confrontation in 1914, the same year the International Gold Standard unraveled. Now, the stellar leadership mentioned above and in the United States are worming their way to a poetic conclusion. Currencies will not be worth the money they are printed on.

Thursday, December 1, 2011

The SEC's Day in Court

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (, 2009)

Mists gather over dubious government practices. The collapse of MF Global should have scared the wits out of U.S. investors. If you haven't panicked yet, there is still time. Since public discussion of its demise lasted about 45 minutes, we are left to speculate. A possible, but sketchy summary might run: a securities firm, run by the former senior partner at Goldman Sachs, took a leveraged position in speculative bonds that caused the eighth largest bankruptcy in U.S. history. Thousands of brokerage customers, who believed their accounts were segregated from MF Global's account, are left to conclude (given the silence of government agencies), that their money is gone. And, MF Global may have done nothing illegal (protected within the boundaries of CFTC Rule 1.29).

Now, the good news: a government employee - a judge - who is fighting for the common man.

Judge Jed S. Rakoff of the United States District Courts of the Southern District of New York struck a blow against the Securities and Exchange Commission and in support of the "public interest." The Securities and Exchange Commission had asked the Court to approve a Consent Judgment between Citigroup and the S.E.C. Judge Rakoff (cutting to the chase) wrote he could not do so: "An application of judicial power that does not rest on facts is worse than mindless, it is inherently dangerous. The injunctive power of the judiciary is not a free-roving remedy to be invoked at the whim of a regulatory agency, even with the consent of the regulated. If its deployment does not rest on facts - cold, hard solid facts, established either by admissions or by trials - it serves no lawful or moral purpose and is simply an engine of oppression."

Judge Rakoff summarized the lawsuit of
U.S. Securities and Exchange Commission vs. Citigroup Global Markets: "According to the S.E.C.'s complaint, after Citigroup realized in early 2007 that the market for mortgage-backed securities was beginning to weaken, Citigroup created a billion-dollar Fund (known as "Class V Funding III") that allowed it to dump some dubious assets on misinformed investors. This was accomplished by Citigroup's misrepresenting that the Fund's assets were attractive investments rigorously selected by an independent investment adviser, whereas in fact Citigroup had arranged to include in the portfolio a substantial percentage of negatively projected assets and had then taken a short position in those very assets it helped select." There is more, but this gives a sense of Citigroup's conduct.

The settlement required Citigroup to disgorge its ill-gotten profits and to pay the S.E.C. a $95 million civil penalty. This is pocket change for a bank that makes or loses $10 billion a quarter. Judge Rakoff said as much: "If the allegations are true, this is a very good deal for Citigroup; and, even if they are not true, it is a mild and modest cost of doing business."

Judge Rakoff's rejection of the Consent Judgment is in contradiction to past and current practices: the securities firm under investigation (all of the big ones, all of the time) engages in a questionable practice; the SEC investigates; the parties agree to a settlement, the defendant neither "admitting nor denying the allegations of the complaint..." (All quotations are from Judge Rakoff's Opinion and Order, unless otherwise noted.) The November 29, 2011,
Financial Times addressed the context: "Citigroup did not admit or deny wrongdoing - a standard practice for four decades in SEC settlements."

These side deals are rubber-stamped by the Court even though it "has not been provided with any proven or admitted facts upon which to exercise even a modest degree of independent judgment.... [T]he court has become a mere handmaiden to a settlement privately negotiated on the basis of unknown facts."

Judge Rakoff hints such agreements are privately negotiated within the White Shoe Club: "Although [the charges against Citigroup] would appear to be tantamount to an allegation of knowing and fraudulent intent... the S.E.C., for reasons of its own, chose to charge Citigroup only with negligence...."

This "deals a double blow to any assistance the defrauded investors might seek to derive from the S.E.C. litigation, in attempting to recoup their losses through private litigation, since private investors not only cannot bring securities claims based on negligence... but also cannot derive any collateral estoppel assistance from Citigroup's non-admission/non-denial of the S.E.C.'s allegations." ["Collateral estoppel assistance": The S.E.C. structured the settlement so that private litigants cannot use any admissions/statements Citigroup made during this S.E.C. action.]

This helps explain why every bank CEO and director sat in front of post-meltdown, Congressional committees and pleaded idiocy. They "never saw it coming." That was negligent, which cannot be litigated. The dumbbells have escaped (at least, until now) charges of "knowing and fraudulent intent" since it was beyond their comprehension that mortgages on which the buyer never made a single payment (common by early 2007) should not be bundled and sold to the public. It was quite a sight to watch Bob Rubin, former partner (and certified genius) at Goldman Sachs, testify he was denser than Wall Street shoe shine boys.

Judge Rakoff chastised the S.E.C. for abusing the public interest: "[I]n any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth. In much of the world propaganda reigns, and truth is confined to secretive fearful whispers." If Heaven were on Earth, the Bureau of Labor Statistics would face off against Judge Rakoff and defend its unemployment, inflation, and G.D.P. propaganda.

Like other failing, doddering, American bureaucracies, the S.E.C.'s counter-argument hurt more than it helped: "[T]he S.E.C. suggests that, if the public interest must be taken into account, the S.E.C. is the sole determinant of what is in the public interest..." This shows an organization that is so accustomed to reigning outside the law that it could only muster a nonsensical, circular, self-aggrandizing argument in front of a judge who is determined that the S.E.C. must operate according to the laws of the United States: "[T]he S.E.C.,
of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges.... [T]his court must not... grant judicial enforcement to the agency's contrivances." [My italics - FJS]

If only the bankrupt customers of MF Global can find such an advocate.