Monthly Archives: October 2011

Bob Ivry, Hugh Son and Christine Harper have written anarticle that needs to be read by everyone interested in the financialcrisis. The article (available here) is entitled: BofA Said to Split RegulatorsOver Moving Merrill Derivatives to Bank Unit. The thrust of their story is that Bank of America’s holdingcompany, BAC, has directed the transfer of a large number of troubled financialderivatives from its Merrill Lynch subsidiary to the federally insured bank Bank of America (BofA). The story reports that the FederalReserve supported the transfer and the Federal Deposit Insurance Corporation(FDIC) opposed it. Yves Smith of Naked Capitalism has written an appropriately blistering attack on this outrageous action, which puts thepublic at substantially increased risk of loss.

I write toadd some context, point out additional areas of inappropriate actions, and adda regulatory perspective gained from dealing with analogous efforts by holdingcompanies to foist dangerous affiliate transactions on insureddepositories. I’ll begin by adding somehistorical context to explain how B of A got into this maze of affiliateconflicts.

KenLewis’ “Scorched Earth” Campaign against B of A’s Shareholders

AcquiringCountrywide: the High Cost of CEO Adolescence

During this crisis, Ken Lewis went on a buying spreedesigned to allow him to brag that his was not simply bigger, but thebiggest. Bank of America’s holdingcompany – BAC – became the acquirer of last resort. Lewis began his war on BAC’s shareholders byordering an artillery salvo on BAC’s own position. What better way was there to destroyshareholder value than purchasing the most notorious lender in the world –Countrywide. Countrywide was in themidst of a death spiral. The FDIC wouldsoon have been forced to pay an acquirer tens of billions of dollars to induceit to take on Countrywide’s nearly limitless contingent liabilities and toxicassets. Even an FDIC-assistedacquisition would have been a grave mistake. Acquiring thousands of Countrywide employees whose primary mission wasto make fraudulent and toxic loans was an inelegant form of financialsuicide. It also revealed the negligiblevalue Lewis placed on ethics and reputation.

But Lewis did not wait to acquire Countrywide with FDICassistance. He feared that a rival wouldacquire it first and win the CEO bragging contest about who had the biggest,baddest bank. His acquisition ofCountrywide destroyed hundreds of billions of dollars of shareholder value andled to massive foreclosure fraud by what were now B of A employees.

But there are two truly scary parts of the story of B of A’sacquisition of Countrywide that have received far too little attention. B of A claims that it conducted extensive duediligence before acquiring Countrywide and discovered only minor problems. If that claim is true, then B of A has beendoomed for years regardless of whether it acquired Countrywide. The proposed acquisition of Countrywide was hugeand exceptionally controversial even within B of A. Countrywide was notorious for its fraudulentloans. There were numerous lawsuits andformer employees explaining how these frauds worked.

B of A is really “Nations Bank” (formerly named NCNB). When Nations Bank acquired B of A (the SanFrancisco based bank), the North Carolina management took completecontrol. The North Carolina managementdecided that “Bank of America” was the better brand name, so it adopted thatname. The key point to understand isthat Nations/NCNB was created through a large series of aggressive mergers, sothe bank had exceptional experience in conducting due diligence of targets foracquisition and it would have sent its top team to investigate Countrywidegiven its size and notoriety. Theacquisition of Countrywide did not have to be consummated exceptionallyquickly. Indeed, the deal had an “out”that allowed B of A to back out of the deal if conditions changed in an adversemanner (which they obviously did). If Bof A employees conducted extensive due diligence of Countrywide and could notdiscover its obvious, endemic frauds, abuses, and subverted systems then theyare incompetent. Indeed, that word istoo bloodless a term to describe how worthless the due diligence team wouldhave had to have been. Given the manyacquisitions the due diligence team vetted, B of A would have been doomedbecause it would have routinely been taken to the cleaners in those earlierdeals.

That scenario, the one B of A presents, is not credible. It is far more likely that B of A’s seniormanagement made it clear to the head of the due diligence review that the dealwas going to be done and that his or her report should support that conclusion. This alternative explanation fits well with Bof A’s actual decision-making. Countrywide’s (and B of A’s) reportedfinancial condition fell sharply after the deal was signed. Lewis certainly knew that B of A’s actualfinancial condition was much worse than its reported financial condition andhad every reason to believe that this difference would be even worse atCountrywide given its reputation for making fraudulent loans. B of A could have exercised its option towithdraw from the deal and saved vast amounts of money. Lewis, however, refused to do so. CEOs do not care only about money. Ego is a powerful driver of conduct, and CEOscan be obsessed with status, hierarchy, and power. Of course, Lewis knew he could walk awaywealthy after becoming a engine of mass destruction of B of A shareholdervalue, so he could indulge his ego in a manner common to adolescent males.

AcquiringMerrill Lynch: the Lure of Liar’s Loans

Merrill Lynch is the quintessential example of why it wascommon for the investment banks to hold in portfolio large amounts ofcollateralized debt obligations (CDOs). Some observers have jumped to the naïve assumption that this indicatesthat the senior managers thought the CDOs were safe investments. The “recipe” for an investor maximizingreported income differs only slightly from the recipe for lenders.

Grow rapidly by
Holding poor quality assets that provide a premium nominal yield while
Employing extreme leverage, and
Providing only grossly inadequate allowances for future losses on the poor quality assets

Investment banks that followed this recipe (and most largeU.S. investment banks did), were guaranteed to report record (albeit fictional)short-term income. That income wascertain to produce extreme compensation for the controlling officers. The strategy was also certain to produceextensive losses in the longer term – unless the investment bank could sell itslosing position to another entity that would then bear the loss.

The optimal means of committing this form of accountingcontrol fraud was with the AAA-rated top tranche of CDOs. Investment banks frequently purport to basecompensation on risk-adjusted return. Ifthey really did so investment bankers would receive far less compensation. The art, of course, is to vastly understatethe risk one is taking and attribute short-term reported gains to the officer’s brilliance in achievingsupra-normal returns that are not attributable to increased risk(“alpha”). Some of the authors of Guaranteed to Fail call this processmanufacturing “fake alpha.”

The authors are largely correct about “fake alpha.” The phrase and phenomenon are correct, butthe mechanism they hypothesize for manufacturing fake alpha has no basis inreality. They posit honest gambles on“extreme tail” events likely to occur only in rare circumstances. They provide no real world examples. If risk that the top tranche of a CDO wouldsuffer a material loss of market values was, in reality, extremely rare then itwould be impossible to achieve a substantial premium yield. The strategy would diminish alpha rather thanmaximizing false alpha. The risk thatthe top tranche of a CDO would suffer a material loss in market value washighly probable. It was not a tailevent, much less an “extreme tail” event. CDOs were commonly backed by liar’s loans and the incidence of fraud inliar’s loans was in the 90% range. Thetop tranches of CDOs were virtually certain to suffer severe losses as soon asthe bubble stalled and refinancing was no longer readily available to delay thewave of defaults. Because liar’s loanswere primarily made to borrowers who were not creditworthy and financiallyunsophisticated, the lenders had the negotiating leverage to charge premiumyields. The officers controlling therating agencies and the investment banks were complicit in creating a corruptsystem for rating CDOs that maximized their financial interests by routinelyproviding AAA ratings to the top tranche of CDOs “backed” largely by fraudulentloans. The combination of the fake AAArating and premium yield on the top tranche of fraudulently constructed (andsold) CDOs maximized “fake alpha” and made it the “sure thing” that is one ofthe characteristics of accounting control fraud (see Akerlof & Romer 1993;Black 2005). This is why many of theinvestment banks (and, eventually, Fannie and Freddie) held substantial amountsof the top tranches of CDOs. (A similardynamic existed for lower tranches, but investment banks also found it muchmore difficult to sell the lowest tranches.)

Merrill Lynch was known for the particularly large CDOpositions it retained in portfolio. These CDO positions doomed Merrill Lynch. B of A knew that Merrill Lynch had tremendouslosses in its derivatives positions when it chose to acquire MerrillLynch.

Giventhis context, only the Fed, and BAC, could favor the derivatives deal

Lewis and his successor, Brian Moynihan, have destroyednearly one-half trillion dollars in BAC shareholder value. (See my prior post on the “Divine Right ofBank Profits…”) BAC continues todeteriorate and the credit rating agencies have been downgrading it because ofits bad assets, particularly its derivatives. BAC’s answer is to “transfer” the bad derivatives to the insured bank – transforming (alaIreland) a private debt into a public debt.

Banking regulators have known for well over a century aboutthe acute dangers of conflicts of interest. Two related conflicts have generated special rules designed to protectthe bank and the insurance fund. Onerestricts transactions with senior insiders and the other restrictstransactions with affiliates. The scamis always the same when it comes to abusive deals with affiliates – theytransfer bad (or overpriced) assets or liabilities to the insured institution. As S&L regulators, we recurrently facedthis problem. For example, Ford MotorCompany attempted to structure an affiliate transaction that was harmful to theinsured S&L (First Nationwide). Thebank, because of federal deposit insurance, typically has a higher creditrating than its affiliate corporations.

BAC’s request to transfer the problem derivatives to B of Awas a no brainer – unfortunately, it was apparently addressed to officials atthe Fed who meet that description. Anycompetent regulator would have said: “No, Hell NO!” Indeed, any competent regulator would havedeveloped two related, acute concerns immediately upon receiving therequest. First, the holding company’scontrolling managers are a severe problem because they are seeking to exploitthe insured institution. Second, thesenior managers of B of A acceded to the transfer, apparently without protest,even though the transfer poses a severe threat to B of A’s survival. Their failure to act to prevent the transfercontravenes both their fiduciary duties of loyalty and care and should lead totheir resignations.

Now here’s the really bad news. First, this transfer is a superb “naturalexperiment” that tests one of the most important questions central to thehealth of our financial system. Does theFed represent and vigorously protect the interests of the people or thesystemically dangerous institutions (SDIs) – the largest 20 banks? We have run a real world test. The sad fact is that very few Americans willbe surprised that the Fed represented the interests of the SDIs even though theywere directly contrary to the interests of the nation. The Fed’s constant demands for (andcelebration of) “independence” from democratic government, combined withslavish dependence on and service to the CEOs of the SDIs has gone beyondscandal to the point of farce. I suggestorganized “laugh ins” whenever Fed spokespersons prate about their“independence.”

Second, I would bet large amounts of money that I do nothave that neither B of A’s CEO nor the Fed even thought about whether thetransfer was consistent with the CEO’s fiduciary duties to B of A (v.BAC). We took depositions during theS&L debacle in which senior officials of Lincoln Savings and its affiliateswere shocked when we asked “whose interests were you representing – the S&Lor the affiliate?” They had obviouslynever even considered their fiduciary duties or identified their actualclient. We blocked a transaction thatwould have caused grave injury to the insured S&L by taking the holdingcompany (Pinnnacle West) off the hook for its obligations to the S&L. That transaction would have passed routinely,but we flew to the board of directors meeting of the S&L and reminded themthat their fiduciary duty was to the S&L, that the transaction was clearlydetrimental to the S&L and to the benefit of the holding company, and thatwe would sue them and take the most vigorous possible enforcement actionsagainst them personally if they violated their fiduciary duties. That caused them to refuse to approve thetransaction – which resulted in a $450 million payment from the holding companyto the S&L. (I know, $450 millionsounds quaint now in light of the scale of the ongoing crisis, but back then itpaid for our salaries in perpetuity.)

Third, reread the Bloomberg column and wrap your mind aroundthe size of Merrill Lynch’s derivatives positions. Next, consider that Merrill is only one,shrinking player in derivatives. Finally, reread Yves’ column in NakedCapitalism where she explains (correctly) that many derivatives cannot beused safely. Add to that my point abouthow they can be used to create a “sure thing” of record fictional profits,record compensation, and catastrophic losses. This is particularly true about credit default swaps (CDS) because ofthe grotesque accounting treatment that typically involves no allowances forfuture losses. (FASB: you must fix thisurgently or you will allow a “perfect crime.”). It is insane that we did not pass a one sentence law repealing theCommodities Futures Modernization Act of 2000. Between the SDIs, the massive, sometimes inherently unsafe and largelyopaque financial derivatives, the appointment, retention, and promotion offailed anti-regulators, and the continuing ability of elite control frauds toloot with impunity we are inviting recurrent, intensifying crises.

I’ll close with a suggestion and request to reporters. Please find out who within the Fed approvedthis deal and the exact composition of the assets and liabilities that weretransferred.

To keep up with Bill’s work follow on Twitter @WilliamKBlack and @deficitowl

1 Comment

Posted in Uncategorized, William K. Black

Tagged bank of america, countrywide, fraud, Ken Lewis, systemically dangerous institutions, William K. Black

Pavlina Tcherneva on At Issue with Ben Merens

Posted on October 18, 2011 by Pavlina Tcherneva | Comments Off

Ben Merens, of Wisconsin Public Radio’s At Issue, hosts Pavlina Tcherneva on how to address unemployment. Listen here.

Comments Off on Pavlina Tcherneva on At Issue with Ben Merens

Posted in Pavlina R. Tcherneva

Tagged job guarantee, unemployment, Wisconsin public radio

William K. Black: “Enforce the Laws for the 99”

Posted on October 18, 2011 by William Black | Comments Off

This segment of yesterday’s Dylan Ratigan show features William K. Black and David DeGraw of AmpedStatus.com. Black argues that we need, “fire Geithner, fire Holder, and demand Bernanke’s resignation, and … replace them with people who will actually enforce the laws for the 99[%].”

This meets with David DeGraw’s approval, who then enlists our favorite white-collar criminologist to serve as the Attorney General for the Occupy Wall Street movement. Watch the entire segment here.

http://www.msnbc.msn.com/id/32545640

Comments Off on William K. Black: “Enforce the Laws for the 99”

Posted in William K. Black

Tagged #econ4the99, #ows, david degraw, dylan ratigan, fraud

Two Billion Dollars Lost because the FDIC Ignored United Commercial Bank’s Frauds

Posted on October 17, 2011 by William Black | Comments Off

By William K. Black

The good news is that we finally have the second group ofindictments of senior bank officers. The prosecution involves officers of United Commercial Bank (UCB), a roughly $10 billion San Francisco bank that originally specialized in lending to Chinese-Americans and became primarily a commercial real estate (CRE) lender. The indictment deals only withthe cover up phase of UCB’s senior officers’ frauds. I will show in future posts that the reportedfacts on UCB’s loans were consistent with accounting control fraud. The UCB case is so rich in lessons that itwill take a series of articles to capture what the case reveals about thedegradation of regulation and prosecution of elite accounting controlfrauds.

Here are the most essential facts. In 2002,a court found that UCB’s senior managers had engaged in fraud to hide losses ona large loan for the purpose of fraudulently inducing another bank to bear thelosses. It found the senior officers’conduct so outrageous that it awarded substantial punitive damages. The FDIC, the SEC, and the Department ofJustice did nothing in response to the fraud.

Continue reading →

Comments Off on Two Billion Dollars Lost because the FDIC Ignored United Commercial Bank’s Frauds

Posted in William K. Black

Tagged accounting control fraud, DOJ, UCB prosecution, William K. Black

Creative Ways to Promote MMT

Posted on October 17, 2011 by admin | Comments Off

We always knew our readers were a smart bunch, but we had no idea how imaginative you are! Please keep sharing your creative endeavors with us (merchandise, animated videos, signs/slogans, etc.), and please keep spreading the word about MMT and NEP. Understanding the monetary system is the first step in a long journey toward creating a better world for us all.

Courtesy of Tschaff Reisberg

Comments Off on Creative Ways to Promote MMT

Posted in Uncategorized

Tagged Uncategorized

Today’s Modern Money Primer

Posted on October 16, 2011 by admin | Comments Off

Complications and private preferences. There are often two objections to the claim that government spending effectively takes place by simultaneously crediting the recipient’s bank account as well as the bank’s reserves: a) it must be more complicated than this; and b) what if the private sector’s spending and portfolio preferences do not match the government’s budget outcome?
Read More…

Comments Off on Today’s Modern Money Primer

Posted in L. Randall Wray, modern money primer, Uncategorized

Tagged L. Randall Wray, modern money primer

MMP Blog #20: Effects of Sovereign Government Budget Deficits on Saving, Reserves and Interest Rates, (continued)

Posted on October 16, 2011 by admin | Comments Off

By L. Randall Wray

The first of these objections has been carefully dealt with in a long series of published articles and working papers (by Bell (a.k.a. Kelton), Bell and Wray, Wray, Fullwiler, and Rezende who look at actual operating procedures in the US, Canada, and Brazil; I’ll provide references later as well as more details). In practice, the treasury cannot directly credit bank accounts when it wants to spend.

Rather, a complex series of steps is required that involve the treasury, the central bank and private banks each time the treasury spends or taxes. The central bank and the treasury develop such procedures to ensure that government is able to spend, that taxpayer payments to treasury do not lead to bounced checks, and—most importantly—that undesired effects on banking system reserves do not occur. While the end result is exactly as described above (treasury spending leads to bank credits, taxes lead to debits, and budget deficits mean net credits to both demand deposits and bank reserves), it is more complicated.

This often generates another question: what if the central bank refused to cooperate with the treasury? The answer is that the central bank would miss its overnight interest rate target (and eventually would endanger the payments system because checks would start bouncing). Readers are referred to the substantial literature surrounding the coordination (more details for the wonky coming up in a later blog). Nonspecialists can be assured that the simple explanation above is sufficient: the conclusion from close analysis is that government deficits do lead to net credits to reserves, and if undesired excess reserves are created they are drained through bond sales to maintain the central bank’s target interest rate.

The operational impact of bond sales is to substitute government bonds for reserves—it is like providing banks with a savings account at the central bank (government bonds) instead of a checking account (central bank reserves). This is done to relieve downward pressure on the overnight interest rate.

With regard to the second objection we first must notice that if the government’s fiscal stance is not consistent with the desired saving of the nongovernment sector, then spending and income adjust until the fiscal outcome and the nongovernment sector’s balance are consistent. For example, if the government tried to run a deficit larger than the desired surplus of the nongovernment sector, then some combination of higher spending by the nongovernment sector (lower nongovernment saving and lower budget deficit), greater tax receipts (thus lower budget deficit and lower saving), or higher nongovernment sector income (so greater desired saving equal to the higher deficit) is produced.

Since tax revenues (and some government spending) are endogenously determined by the performance of the economy, the fiscal stance is at least partially determined endogenously; by the same token, the actual balance achieved by the nongovernment sector is endogenously determined by income and saving propensities. By accounting identity (presented above) it is not possible for the nongovernment’s balance to differ from the government’s balance (with the sign reversed—one has a deficit and the other a surplus); this also means it is impossible for the aggregate saving of the nongovernment sector to be less than (or greater than) the budget deficit.

So, those are the general responses to those objections. I will do a wonky blog later with more details. But next week we look in more detail at the private saving decision.

Comments Off on MMP Blog #20: Effects of Sovereign Government Budget Deficits on Saving, Reserves and Interest Rates, (continued)

Posted in MMP, Uncategorized

Tagged MMP

The Message I Would Deliver from Zucotti Park

Posted on October 14, 2011 by admin | Comments Off

By Marshall Auerback

First, to the thin blue line: thank you and we ask for your protection rather than your discipline. Why should we expect that? Because the forces we are protesting are the very forces making it difficult for you and your families to save your wages and keep up with the cost of living. The Wall Street companies giving you contributions that are part of the problem, not the solution. They are bribing you to act against your own interests. So in protesting here, we are protesting on your behalf against a corrupted system, and we ask for your protection.

Second, to Brookfield Properties. This square produces little if any revenues for your shareholders. It is made of concrete and bricks. We have neither destroyed it, nor do we intend to. We cannot rationally understand your anxiety in letting us gather here, so we must conclude that your repeated demands for us to leave so you can clean it come from somewhere else. We will meet your demands with the more powerful force of massive non-violent resistance.

To the Board of Directors of Brookfield Properties, if you continue your demands for us to disband, we will scrutinize closely your contracts with the City of New York, past, present and in the future, to ensure that there is no evidence, explicit or circumstantial, of impropriety. We will deliberately hold your company specifically to the highest level of scrutiny.

Third, to Mayor Bloomberg. We see you and your business, Bloomberg LP, which caters specifically to the very same Wall Street banks and brokers whose practices we are protesting, as being in a violent conflict of interest. Thus, we do not respect your encouragement to leave and we will not obey and order for us to disband, which comes from your office.

Fourth, to the public at large: Brookfield Properties and Mayor Bloomberg do not have natural interests inserting themselves into this protest. To whomever it is whispering in their ears for us to disband, we say show yourself. If you are frightened that exposing the masses to the plutocratic status quo, consisting of our banking system and centrist politicians, we say you should be frightened. We will win because we have intelligence, moral clarity and because we are aggregating. You will lose because you are centralized only in systemic terms and there is no incentive for individuals supporting the status quo to fight to retain it.

And finally, we call out to the Tea Party, whom the mainstream media has artfully positioned as right-wing hard-headed idiots. We do not see you that way at all, but rather as every bit as idealistic as we are. When we strip out our social differences, the Tea Party and Occupy Wall Street movements have much in common, namely the recognition that the closed power system of the Washington/banking axis is suffocating 99% of the people of power. We both agree this power must be reversed and given back to the people. So join with us in support of this one issue, and we may then settle our social differences once power is restored to the people.