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Greed on Wall Street

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24 interesting findings on how Wall Street destroyed itself.

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Greed on Wall Street (Introduction to Chapter 9)  

来自浪里行舟   2011-10-04 14:56:39|  分类: Greed on Wall Street |举报 |字号 订阅

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Greed on Wall Street

Your money is my money

 

 

 

The year 2008 financial tsunami is caused by business leaders who aim is to maximize short term gains at the expense of longer term risks.

 

 

Author: Eric Woon Chok Thin


 

Table of Content

 

Preface

About Author

Content

Introduction: On Wall Street, your money is my money

Chapter 1: Jackson Tai Resigns from DBS

Chapter 2: The Demise of Lehman Brothers

Chapter 3: Peddling Instruments of Financial Derivatives

Chapter 4: Funds Sold by Financial Planning Advisers

Chapter 5: Merill Lynch’s Investment in Subprime Mortgages

Chapter 6: How Did AIG Implode?

Chapter 7: Off Balance Sheet Transaction at Citigroup

Chapter 8: The Meltdown of Subprime Mortgages

Chapter 9: Madoff Ponzi’s Scheme

Chapter 10: Dell’s Financial Statement: Reinstated

Chapter 11: Tremendous Growth Potential

Chapter 12: Mergers and Acquisitions

Chapter 13: The Unspoken Expectations of Security Analysts

Chapter 14: The Rise and Fall of Harvard University Endowment Fund

Chapter 15: Oil Price Shot Up to US$147 per Barrel

Chapter 16: Wall Street is Blind to Financial Manipulations


 

Preface

Most businessmen operate according to the principle to turn your money into their money. Usually, this is achieved by pandering goods and services to you in return for your money.  Obviously, the goods or services are offered at a price higher than the production cost in order to derive a net profit.

Let’s assume a manufacturing business is a highly complicated black box where raw materials and resources go in to produce the finished product. You and I can see the change in the tangible goods produced in its form, fit and functions.

On Wall Street, it is slightly different. Money goes into a black box and out it produces two streams of money. One stream emerges as revenue for Wall Street and the other one as the money which remains with the company that seeks a service from Wall Street. This is how Wall Street makes money.

You may argue that there is a distinct difference in the way money is made on Wall Street. The financial services provided by Wall Street are used as a tool to take the money out from the organizations they work with instead of adding value to their client’s business output.  Yet, Wall Street was extremely successful. The driving force behind Wall Street is: "Your money is my money".

And it was also the same reason that caused the financial tsunami of year 2008. The excesses that brought down Wall Street were the result of the untold underlying principle: “Your money is my money”.

It began from the heavily-rewarded CEO, who will use all means to raise its company’s stock price and to report a strong growth in earnings way beyond the true facts. Even if it is to the extent of foregoing its core business and spending more time to use all kinds of financial engineering tools what the CEO wants is to make as much money as possible during his tenure.

One of the most powerful financial engineering tools is the creation of off-balance sheet items. For example, Charles Prince of Citigroup moved US$80 billions into just seven SIVs (structured investment vehicles). SIVs are off-balance-sheet entities that have invested heavily in sub-prime mortgage-backed securities.

Bear Stearns' holdings also posed a greater risk to the nation's financial institution than Lehman's. Bear Stearns had $9 trillion worth of financial instruments known as derivatives, much of it in sub-prime mortgage securities which it shared with the other financial institutions. Lehman Brothers had about a tenth of that much exposure. Lehman Brothers was allowed to fail but not Bear Stearns whose holdings posed a much greater risk to the nation's financial institutions.

AIG bet big on securities lending, a service for short-sellers giving a mere 0.2 percentage in yield. However, it can add up to serious numbers when you are running hundreds of billions of dollars or in other words, ‘risking hundreds of billions of dollars’.

Very few people recognized that the biggest fools among all are the investors who pumped billions of dollars into the hands of the hedge fund managers. Just take a look at how the hedge fund managers bid up the oil price from as low as US$60 per barrel in Jan 2007 to US$147 per barrel in July 2008. The world demand for oil was very stable and certainly could not be a reason for the spiraling of crude oil prices. 

Where does America's greatest university, Harvard, invest its endowment fund? The answer is, seventy percent of Harvard's money is run by outside managers such as Convexity Capital Management, the Boston firm started by one time Harvard endowment chief Jack Meyer. Until this seventy percent is properly accounted for, you’ll never know if Jack Meyer’s 15-year performance in raising the endowment fund to $22.6 billion from $4.7 billion was an epic or a pure fabrication of lies.

Bernard Madoff did it even better. He used the service of an auditing firm with just two people. This was how his Ponzi scheme laid undiscovered for two decades and swallowed up US50 billion of investors’ money.

What differentiates between a genius and an idiot is how he looks at things. On Wall Street, a genius seizes whatever opportunity to get other people’s money.  Since everyone on Wall Street masterfully structured his or her performance bonus to short term gains, risks are always thrown out of the window simply because they won’t occur within the near term.

So, why should I worry? Profits belong to me. Losses are the investors’ or shareholders’. Who cares if the risks lead to bankruptcy? I made my money now.

Wall Street never learns. It only remembers, "Your money is my money; my money is mine". “The danger with this mentality isn't just that it offends our morals, it's that it endangers our markets,” said President Barack Obama.


 

Introduction

On September 27, 2008, Greenboro: Senator Barack Obama said, “We meet here at a time of great uncertainty for America. The era of greed and irresponsibility on Wall Street and in Washington has led us to a financial crisis as serious as any we have faced since the Great Depression. They said they wanted to let the market run free but they let it run wild, and in doing so, they trampled our core values of fairness, balance, and responsibility to one another.”

On Sep 17, 2008, New York: Senator Obama prides himself on delivering tough messages directly to the source, and his address at the NASDAQ Marketsite was another example. He said a ‘what's good for me is good enough’ mentality has crept into parts of the business world while working men and women toil longer hours and still struggle to pay for health care, tuition and taxes.

“If we are honest, I think we must admit that those who have benefited from the new global marketplace - and that includes almost everyone in this room - have not always concerned themselves with the losers in this new economy,” the Illinois senator said.

“The danger with this mentality isn't just that it offends our morals, it's that it endangers our markets,” Obama said...

“I am asking you to join me in ushering in a new era of mutual responsibility in America,” he said. He said he believes Wall Street leaders want to be part of building a more just nation, but they haven't been asked before.

On January 30, 2009: President Barack Obama, who has ordered a pay freeze on six-figure White House aides, wants to talk to Wall Street executives about a report indicating payments of over $18 billion in bonuses as the economy was in virtual free fall.

“It is shameful,” Obama said from the Oval Office on Thursday. “And part of what we're going to need is for the folks on Wall Street who are asking for help to show some restraint, and show some discipline, and show some sense of responsibility.”

The president's comments, made with new Treasury Secretary Timothy Geithner at his side, came in swift response to a New York state comptroller's report saying that employees of the New York financial world garnered an estimated $18.4 billion in bonuses last year.

Obama's harsh criticism of Wall Street came just one day after he brought several well-paid chief executives to the White House and praised them for being on the "front lines in seeing the enormous problems in our economy right now".

Obama called the payment of the Wall Street bonuses "the height of irresponsibility" and said the public dislikes the idea of helping the financial sector dig out of a hole, only to see it get bigger because of lavish spending. The comptroller's report found such bonuses were down 44 percent, but at about the same level they were during the boom time of 2004.

What Obama fell short of saying is, “On Wall Street, you can see it, you can hear it, you can smell it, you can taste it, and you can feel it in the air.”  The driving force is: Your money is my money, my money is mine.


 

Chapter: 1

Jackson Tai resigns from DBS

Shu-Ching Jean Chen, a Hong Kong-based staff writer at Forbes.com wrote on September 25, 2007: Singapore’s DBS Group Holdings, the holding company for Southeast Asia’s largest bank, DBS Bank, has lost its top man. DBS on Monday announced the resignation of its chief executive, Jackson Tai, who trail-blazed a path of fast regional expansion in the last five years. Tai, a 57-year-old Chinese-American and a career investment banker, plans to leave at the end of the year.

But DBS’s shareholders, the largest among them Singapore’s government, will press the company to find new sources of growth, whether it be the area of investment banking or in commercial banking, now that it will have to do without Tai’s investment banking acumen in sewing together a skein of mergers and acquisitions. How DBS will reorient its strategy is unlikely to be evident until the conclusion of an extensive global search currently under way to identify Tai’s successor. In the meantime, DBS’s chairman, Koh Boon Hwee, immediately took an ‘active management oversight role’ to help steer the current transition.

DBS shares opened at 20.70 Singapore dollars (U.S. $13.78), down from the previous day’s close of S$20.90 ($13.92), but recovered to trade 0.96% up at S$21.10 ($14.05) by mid-day Tuesday.

In a hastily arranged press conference on Monday evening, Tai said he was resigning from his dual post as vice chairman and CEO ostensibly for "family reasons" to return to the United States, a reason commonly cited by DBS outgoing chief executives. Some market watchers linked his decision to a more timely cause: the surprise disclosure on August 28 of a S$2.4 billion ($1.598 billion) investment exposure to liquidity problems amid the global credit crisis. The amount was double the initial estimate by the bank itself only a month ago.

Tai has been known for his energetic, hard-working drive and attention to detail, as well as his much cited youth spent toiling as dishwasher and waiter to help out his family before joining JPMorgan as an investment banker, where he served for 25 years. After JPMorgan, at which he held various management positions in New York, Tokyo and San Francisco, he joined DBS in July 1999 as chief financial officer.

He received an M.B.A. from Harvard University in 1974 and a B.S. from Rensselaer Polytechnic Institute. In his private life, he is known for fondness for music, reportedly having mastered playing the drums, trumpet, tuba, as well as piano.

Why did he resign at the young age of 57 years old and for an unrevealed "family reasons" as the reason? It is really mind-boggling. I suspected something was amiss but could not figure it out.

A month later, I finally pieced the mosaic together:

1.      On October 30, 2007, Merrill Lynch & Co., the world's largest brokerage, announced that its embattled Chief Executive, Stan O'Neal 56 will retire.  This was days after leading the firm to its biggest loss since its beginning 93 years ago.

2.      On October 31, 2007, Citigroup Inc. Chief Executive Charles Prince 57 was planning to resign at a board meeting shortly as the bank faced huge losses from distressed mortgage assets. The SEC is reviewing how Citigroup accounted for certain off-balance-sheet transactions that are at the heart of a banking-industry rescue plan. The review is looking at whether Citigroup appropriately accounted for $80 billion in structured investment vehicles, or SIVs. SIVs are off-balance-sheet entities that have invested heavily in mortgage-backed securities.

It is remarkable in hindsight that Citigroup had US$80 billion in SIVs that were moved to off-balance sheet transactions items.

How much SIVs does DBS have?

Only Jackson Tai knows how much toxic assets he had accumulated for DBS. Thus, he resigned.


Chapter 2

The demise of Lehman brothers

Chris Isidore, CNNMoney.com senior writer wrote on September 15, 2008: Six months ago, the Fed put up $29 billion to help keep Bear Stearns out of bankruptcy. On Sunday, the government said no to similar help for buyers looking at Lehman. Here's why.

When Lehman Brothers filed for bankruptcy on Monday, the government essentially sat on the sideline. Six months ago, when Bear Stearns faced a similar fate, the Federal Reserve intervened with the Treasury Department's support.

Why did Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson change their tune?

Experts say the Fed's lack of action on Lehman wasn't as much a change in thinking as it was a change in circumstance. They simply said that the firms were very different - that Bear Sterns posed a greater risk - and that regulators were better prepared this time to deal with the consequences of a failure.

"The system wasn't ready for Bear to fail in March," said Jaret Seiberg, financial services analyst for policy research firm Stanford Group. "It couldn't have been unwound in an orderly fashion."

In the case of Bear Stearns, the Fed engineered a bargain-basement sale of the firm by JPMorgan Chase by agreeing to assume $29 billion of the risk of losses from Bear Stearns going forward.

But when other banks considering a purchase of Lehman over the weekend sought the same kind of assurances from the Fed, they were turned down. Without a buyer, Lehman had little choice but Monday's bankruptcy filing that is expected to lead to its liquidation. Lehman's liquidation is the biggest bankruptcy filing in U.S. history. It filed with assets of $639 billion and debt of $613 billion.

Seiberg said a Bear Stearns bankruptcy would have prompted a massive sell-off and hit the financial sector much harder than the Lehman bankruptcy did on Monday. The Dow Jones industrial average fell more than 500 points Monday - a very rough day but not as bad as many feared. Seiberg said that steps taken by the Fed to make more money available to Wall Street and banks since March means that "the market doesn't have the same liquidity fears about Lehman failing as it did about Bear."

Barry Ritholtz, CEO of Fusion IQ, said that Bear Stearns' holdings also posed a greater risk to the nation's financial institution than Lehman's. He said Bear Stearns had $9 trillion worth of financial instruments known as derivatives, much of it shared with other financial institutions such as its eventual buyer, JPMorgan Chase. He said Lehman had about a tenth that much exposure.

“Lehman was only incompetent enough to blow up and destroy itself, whereas Bear's degree of incompetence was enough to threaten the entire financial system,” Ritholtz said.

Jane Wardell, AP Business Writer wrote on November 14, 2008: Administrators of the European arm of failed investment bank Lehman Brothers Holdings Inc. said on Friday that untangling its financial dealings will be a much bigger -- and far lengthier -- task than dealing with the fallout of the collapse of energy company Enron Corp. Uncertainty over the consequences of the failure -- with thousands of counterparties on Lehmans' complex derivative contracts left potentially exposed -- dealt a severe shock to the financial system.

After meeting with more than 1,000 creditors of Lehman Brothers International (Europe), or LBIE, in London, administrators from accountancy firm PriceWaterhouseCoopers said that they had recovered around just $5 billion of a potential $550 billion of obligations to creditors on the bank's balance sheet.

There is also a sense that investors, financial regulators and Wall Street firms have a better handle on the problems in the financial markets than they did six months ago. The fact that Bear Stearns took place when there was so much more uncertainty is also a reason the Fed kept it out of bankruptcy then, but didn't step in to help Lehman now.

“We didn't know what we didn't know in March,” said Art Hogan, chief market analyst at Jefferies & Co. “We know much more now.”

And there is also the widespread belief that the Fed felt it needed to take a stand and not become the first and primary source of funds for every purchase of a troubled financial firm.

“The Fed did not want to be in the position of having to save everybody,” said David Wyss, chief economist with Standard & Poor's.

But experts said it's certain that the recent upheaval - the Lehman bankruptcy and the seizure of mortgage lending giants Fannie Mae and Freddie Mac by the Treasury Department - will cause more losses going forward.

“There was a lot of negative pressure about all these bailouts,” said Bob Andres, chief investment strategist for PMC. “They have to use the money they have, judiciously.”

“There's a possibility that this unwinds in a much more messy fashion than we're seeing right now,” said Hogan. He wouldn't rule out the aftershocks of Lehman even causing a failure of another major firm.

Lehman's unsecured creditors are owed an estimated $200 billion but are expected to recover only $20 billion, ten cents on the dollar, once the restructuring is complete. Bryan Marsal, co-chief executive of Alvarez & Marsal (A&M) found that most of the loss of value had occurred because the bankruptcy filing caused the bank to default on trading contracts with counterparties, cancelling about 900,000 derivatives contracts. These included contracts in which Lehman was owed money. In an orderly unwinding, at least $50 billion could have been saved, A&M found.

Further value was destroyed when the unplanned bankruptcy forced down prices for Lehman's assets in a market already artificially depressed by the shock collapse of the bank. This meant that the trading and investment banking businesses were sold for less than $500 million although they had made about $4 billion annual profits before the bankruptcy.

About 150 A&M liquidation experts are working at Lehman's New York, London and Hong Kong offices to ascertain what assets can be salvaged for creditors. Mr Marsal will take over as Lehman's chief executive when Mr Fuld stands down at the year-end.


 

Chapter 3

Peddling financial instruments

What kind of product was the DBS High Notes5[1]? How exactly were the Notes sold? How many vulnerable investors have DBS[2] agreed to compensate, and what is the bank going to do about those not seen as vulnerable?

These are among the many questions that aggrieved customers hope DBS can answer when they meet the bank today in a dialogue session initiated by the investors.

The session, to be held in Suntec Convention Centre, comes two days after DBS said on its website that the redemption value of the DBS High Notes 5 has been calculated to be zero, leaving 1,400 investors with nothing.

“Most investors who turn up for the meeting will be those who fall outside the ‘vulnerable’ category,” said Mr. Kenneth Tay, who gathered around 200 fellow investors into a group. For them, compensation will be on top of the agenda. “The forum is just for DBS to address all of us together. If they cannot provide satisfactory answers, it wouldn’t be the end,” said the 38-year-old businessman, who invested $75,000.

Mr. Tay added, “DBS is just playing a game, they are trying to appease the public by paying the vulnerable group, the lowly educated and above a certain age, but they do not want to be responsible for the non-vulnerable group.”

DBS earlier said that compensation will be paid out to customers who were “clearly unsuitable” for the product, assessed by factors such as income level, age, literacy, amount of liquid assets and investment experience.

Alternatively, they can be customers whose risk-tolerance, as captured by a financial need analysis, is found to be inconsistent with the product. Mrs. Tay, but who is not related to Mr. Kenneth Tay, said the criteria might discriminate against ‘younger people’.

What are the actual criteria for judging mis-selling?” she asked. “If you are mis-sold, you are mis-sold; this shouldn’t enter into the situation at all.”

Most investors TODAY (a Singapore tabloid) spoke to say they hope to bring the matter up with the Financial Industry disputes Resolution Centre if their compensation claims are not sorted out to their satisfaction.

Mr. Tay said legal advice was against pursuing a class action suit. The president of the Securities Investors Association of Singapore, Mr. David Gerald – a former litigation lawyer – agreed. “It’s an uphill task to prove mis-selling in a court of law. It’s your word against the relationship manager’s,” he said.

When contacted yesterday, a DBS spoke person said, “We wanted to reassure High Notes customers that all their cases will be reviewed. The bank will do the right thing and will take responsibility if indeed there are any cases that failed to meet our standards.”

Did the sales staff of DBS, a distributor of the Lehman Brothers-structured products acted responsibly?

According to some investors, the sales prospectus and pricing statement were given only after the point of sales when the customer was already convinced to buy.

Others say the risk of the worst case scenario happening was played down by the relationship managers who genuinely believed at the point of sale that the possibility of a credit event was close to zero.

The above statements offer strong evidence that the relationship managers were trained to tell the investors the product provides a very much higher interest yield, and is safe (with no mention) from downward risk. This is a classic example of the application of the veil of misinformation[3] by the peddlers of financial products. I strongly believe, none of the investors were told of the higher than normal risk associated with the Lehman Brothers-structured products.

What is more damaging in this case was when the Prime Minister of Singapore Lee Hsien Loong made this point (风凉话)[4]. “Ultimately, each person has to take responsibility for his or her own financial decisions,” said Lee last week in a media interview.

What do you think was in the Prime Minister’s mind?

Most probably, he was saying to himself, “I am the Prime Minister of Singapore. My government has always been pro-business in order to ensure a sustainable high growth rate of the country’s GDP.  These financial products offer a high commission rate to the banks who sold them to the undiscerning public. That brings good profit to the financial industry and therefore, contributes significantly to the economic growth of the country which I am being measured.”

DBS bank cares for itself to bring in the lucrative profit from selling these high risk financial instruments. Who bears the risk? Na?ve ordinary citizens who just want to make a safe deposit. Before they can renew their time deposit, they were ‘sweet-talked’ into putting their money into such risky investments with false misrepresentation of higher return with no risk.

In the minds of the DBS staff, their only thought was, “Your money is my money.”


Chapter 4

Funds sold by financial planning advisers

Most of you are familiar with the behavior of the stock market. It goes up and it comes down. This cyclical pattern is repeated many times over. The stock market indices are used as a proxy to measure stock market performance. Usually, the stock market indices are based on different baskets of stocks and they are closely interrelated. They move up and come down together, in the same cyclical pattern.

Unit trusts are a portfolio of stocks managed by a fund manager. To create more value to an invested fund, the fund managers’ aim is to beat the stock market’s performance by carefully picking a basket of stocks for his portfolio. However, the fate of the portfolio of stocks still follows the same cyclical pattern of all other stocks.

Should a fund manager manage to increase the value of his investments by buying shares when they are on an upward trend, he would have increased the value of his fund.

You should read a brochure from a financial planning adviser who represents the unit trusts carefully. The brochure would most probably indicate the dates where the value of the fund has increased by a huge margin. It does indeed show growth at a much higher rate than the stock market indices. You would then have formed the impression that this fund has outperformed the market. Investors who are holding this fund would be most happy, correct?

Of course, not everything is as simple as it seems. The veil of misinformation[5] is used skillfully in this industry.

The brochure is a crafted picture that shows you the good stuff. The growth rates presented do not tell you anything about the real growth rates of the fund since its inception. Perhaps, the fund’s overall growth rate is not as impressive as it was presented. If they had told you this, you would probably not even invest in this fund.

The people in marketing are very clever. They only present a good picture, and not the big picture. What you see is not an overview of the fund, but a snapshot of the good times experienced by the fund. This is the most commonly used form of information manipulation used in the fund-management industry.

From a financial advisor’s point of view, they are only interested in bringing in more funds to the unit trust that gives them a commission. If you are na?ve and believe that the marketing material presents the full story, then the problem is yours, not theirs. To them, “Your money is my money.”

2011年10月04日 - 老子下凡 - 老子下凡的博客
 
 Figure 4-1: Marketing brochure which shows only the recent rise

 

Chapter 5

Merrill Lynch investments in subprime loans

 The Associated Press wrote on Tuesday, October 30th 2007: Merrill Lynch & Co., the world's largest brokerage, said Tuesday its embattled Chief Executive Stan O'Neal, the second-highest paid Wall Street CEO in 2006 will retire, days after leading the firm to its biggest loss since its founding 93 years ago.

Despite that $2.24 billion loss, analysts consider the vast majority of Merrill's business to be in perfectly fine shape. However, whoever replaces O'Neal will have to clean up the segment that is not in good order - Merrill's investments in sub-prime mortgages and other risky types of debt.

O'Neal, 56, who rose to power five years ago, was known for shaking up top management and placed a greater emphasis on riskier bets, rather than the safety of just trading stocks.

That strategy - which gave Merrill Lynch record results during the market's peak - came with a heavy cost during the tumultuous third quarter.

O'Neal ultimately shouldered the blame for the earnings miss. With his retirement, he becomes the biggest executive casualty of the credit crisis that has swept global markets this summer.

“Mr. O'Neal and the board of directors both agreed that a change in leadership would best enable Merrill Lynch to move forward and focus on maintaining the strong operating performance of its businesses, which the company last week reported were performing well, apart from sub-prime mortgages and CDOs,” Merrill Lynch said in a statement.

CDOs, or Collateralized Debt Obligations, are complex instruments that package mortgages with different repayment risk levels as a structured financial instrument.  It was Merrill Lynch's bet on CDOs, and the sub-prime mortgages that underpinned many of them, that proved to be O'Neal's downfall.

Analysts have said this week that whoever replaces O'Neal may have to write down another $4 billion worth of bad investments in the fourth quarter.

It is not known how much O'Neal would receive as an exit package, though there have been some reports it would be nearly $200 million. He was paid roughly $48 million salary in 2006, and had $160 million in stock and retirement benefits, according to James Reda, founder of compensation consultancy James F. Reda & Associates.

Why did O'Neal shake up top management and place a greater emphasis on riskier bets, rather than the safety of just trading stocks?

The answer was obvious. Riskier bet meant higher returns. His remuneration was linked to the profitability of the company he led for 5 years. A higher return obtained from the sub-prime mortgages would allow him to report higher profits year after year.  This would affect his annual remuneration package.

By the time Merrill Lynch broke under the huge write-down of sub-prime mortgages and CDO’s, O’Neil walked away with a golden handshake of $161.5 million in stock, options and retirement benefits.

O’Neal loves the higher interest spread offered by the sub-prime mortgage loan market. To him, “Your money is my money.” Obviously, sub-prime mortgages give him a potential higher remuneration than other safer investments.


 

Chapter 6

How did AIG implode?

John Carney[6] wrote on February 5, 2009: Up until now the tales of AIG's near collapse have largely focused on the derivatives trades, mainly credit default swaps, built by the company's small Financial Products division. This morning, the Wall Street Journal directs our attention to the larger AIG Investment unit, which placed huge bullish bets on credit products in the quest to achieve $1 billion in annual profit.

The story is long and a bit complex. Here's what we think was going on with AIG's unit. It is easy to see how the kind of strategy AIG followed could produce such devastating losses.

AIG was a huge securities lender. The main purpose of securities lending is to facilitate short sales. Basically, a securities lender buys a security and lends it out to a short seller or someone who wants to hedge a long position in the market.  In exchange for lending out the security, AIG got a fee and some collateral. AIG would then turn around and use that collateral and fee to buy more securities, particularly mortgage backed securities. This means that AIG was institutionally long on mortgage backed securities.

Why were they so big? Securities lending is a low margin business. It started out as a service for settlement failure - when someone who was supposed to deliver a stock or a bond but did not. It grew into a service for short-sellers and those who hedge. In order to ramp up the profits, AIG had to do two things: bet the fees and collateral, and get big. It grew almost ten-fold in less than 8 years. Although betting the collateral might only increase the yield by a few basis points, it can add up to serious numbers when you are running hundreds of billions of dollars.

AIG ignored two huge risks in the strategy. Although AIG's top executives thought the strategy did not present undue risks, the strategy was very risky.

(1) AIG's long position in the mortgage backed securities market was essentially un-hedged.

(2) Investing cash collateral from short sellers meant that AIG was basically shorting cash, and investing with borrowed money. It is a form of leverage.  When the short sellers close their positions, you can get caught by having to liquidate your positions to raise the capital in order to return the cash.

(3) Because the strategy of betting collateral only squeezed an additional 0.2 percentage point in yield, it did not make sense to hedge this strategy.  The extra yield would be eaten up by the cost of the hedge.

As short interest in sub-prime grew, AIG's business brew. While short sellers like John Paulson started piling up short positions in the American residential real estate, basically betting that housing would come crashing down, AIG was facilitating this. Its business and size of its portfolio grew in direct proportion to the demand for short sales in these securities. All along, AIG kept doubling down on its positions, going even longer. For years, this strategy produced hundreds of millions in profits. Unfortunately, those hundreds of millions were made while taking on tens of billions of dollars in risk.

Despite internal warnings about sub-prime, AIG kept building its position. When the market began flashing warning signals about loose mortgage lending standards, managers of the separate AIG Financial Products decided to stop writing credit derivatives on securities backed by sub-prime collateral. AIG Investments, however, kept on building the position.  From a $1 billion portfolio in 1999, AIG ramped it up to almost $100 billion by mid-2007.

The ideology of dislocation kept them from selling. Like so many other financial disasters, AIG refused to believe the evidence of the markets. It could see that the real estate market had become distressed in the summer of 2007, but it didn't want to sell the mortgage backed securities at "dislocated market prices". Why were the prices "dislocated?" That is the technical term for the prices being below where AIG thought they should be. They had all these financial models that told them you couldn't have a national housing downturn but were facing one. Surely this market misbehavior would correct itself eventually.  All AIG had to do was hold firm, keeping borrowing and wait for that turn around. Unfortunately, the market stayed dislocated longer than AIG could stay solvent.

The short sellers come calling again. In the end, AIG's strategy of betting with borrowed money -the collateral their customers had put up to borrow mortgage backed securities from AIG became a fatal mistake. When short-sellers closed out their positions, they demanded back the collateral. When hedged credit funds decided to exit long positions in the MBS market, they also closed out their short-hedges. AIG had put the collateral into mortgage backed securities, some of which had lost half their value. AIG simply could not meet those obligations. *Ring! Ring! “Hello, Mr. Bernanke? This is AIG. We need to talk.”

If the previous paragraph was too technical for you to understand, John Carney wrote on February 5, 2009:  Still confused about how AIG lost its shirt by going into the securities lending business big time? We understand. It's terribly complex and full of words that make your eyes glaze over.  So we decided to break it down into the simplest terms Wall Street transactions can be explained: The two-cow story.

You have two cows.

John Paulson borrows one cow so he can sell it for $100. He gives you $10 as collateral.

You buy your neighbor’s cow for $100, which you finance by taking out a $90 loan from the bank and use John's $10 to make up the rest.

You brag to everyone about your financial health. You have assets--two cows you own, plus one Paulson owes you--worth $300, and liabilities of just $100.

Suddenly, a third of the country goes vegetarian.

You thought your two cows were worth $200, but now they are worth $140.

You express confidence in your financial health. Your assets are now worth only $200--your two cows plus the one John owes you--but your liabilities are still only $100. If necessary, you could sell the assets at this distressed price and pay off all your loans.

You hold onto your cows because you are sure the market is "dislocated." Some day someone will want to eat beef again.

The rest of the country goes vegetarian. Your two cows are now worth $2 each to guys who want to make dog food.

John Paulson buys a cow in the market for $2 and he gives it to you as repayment of the loan. You now have three cows worth six bucks.

John wants his $10 back.

The bank calls. It wants its $90 back.

You call the Federal Reserve and ask for a bailout.

The only difference between a genius and an idiot is how he looks at things.  A genius saw the bubble in the mortgage-backed securities market brewing. But he chose to turn into an idiot by assuming the “dislocated market price” would correct itself eventually. What a fine line it is between the two positions.

In September the U.S. government took a nearly 80 percent stake in American International Group Inc. The insurer is in talks with the government on obtaining new funds, perhaps involving a debt-for-equity swap, and could post a nearly $60 billion loss tied to write-downs, CNBC said.


 

Chapter 7

Off-balance sheet transactions at Citigroup

 ROBIN SIDEL, MONICA LANGLEY and GREGORY ZUCKERMAN at Wall Street Journals wrote on November 3, 2007: Citigroup Inc. Chief Executive Charles Prince was planning to resign at a board meeting on Sunday, according to people familiar with the situation, as the bank faces big losses from distressed mortgage assets.

The move would end the four-year tenure of Mr. Prince, a longtime lawyer and loyal lieutenant of former Citigroup head Sanford Weill, who assembled the financial giant that stands as America's largest bank by assets.

Mr. Prince, 57 years old, moved before the board declared his fate. His tenure has been rocky. He faced pressure to cut costs, and more recently, debt-market turmoil has taken a tremendous toll. Citigroup's stock is down 31% this year and almost 9% during the last week. People familiar with the matter said the Securities and Exchange Commission is looking into the bank's accounting for its off-balance sheet investment funds that have recently attracted scrutiny.

Citigroup may report further losses on Monday, reflecting continued declines in the value of some mortgage-linked securities since the third quarter ended Sept. 30; people familiar with the matter said.

The SEC is reviewing how Citigroup accounted for certain off-balance-sheet transactions that are at the heart of a banking-industry rescue plan, according to people familiar with the matter. The review is looking at whether Citigroup appropriately accounted for $80 billion in structured investment vehicles, or SIVs, these people said. SIVs are off-balance-sheet entities that have invested heavily in mortgage-backed securities. A plan pushed by Citigroup and other banks would set up a new "superconduit" to buy assets from SIVs.

News of Mr. Prince's planned departure capped a wild week on Wall Street that started with the ouster of Merrill Lynch's Mr. O'Neal. His exit followed Merrill Lynch's announcement that it would make a $7.9 billion write-down connected to hit on mortgage-backed securities and suffer a $2.2 billion loss for the third quarter.

Rumors of similar write-downs at Citigroup roiled markets as the week progressed. Investors sent the stock market sharply down on Thursday, a day after a quarter-percentage-point interest-rate cut by the Federal Reserve that was intended to buoy markets.

Mr. Prince has been struggling for years to revitalize Citigroup, which was weighed down by bloated costs. The mess involving sub-prime mortgages to borrowers with poor credit standing has hit Citigroup hard. The board is expected to discuss whether Citigroup should update the amount of write-downs that it has taken on certain securities to reflect their deteriorating value, according to people familiar with the matter.

Citigroup is the largest player in the $350 billion SIV market, managing seven of these off-balance sheet vehicles that hold a combined $80 billion in assets. SIVs have issued short-term debt to investors such as money-market funds while buying mortgage-backed securities and other assets that carry a higher yield.

“Citigroup is confident that its SIV accounting is proper and in accordance with all applicable rules and regulations,” said Christina Pretto, a bank spokeswoman.

The SEC's review of Citigroup is in the early stages, people familiar with it said. The result could range from no action to a referral to the agency's enforcement division. The SEC is also taking a broad look at how brokerage firms valued assets tied to high-risk mortgages and whether they were timely in their disclosure of losses to investors, people familiar with the matter say.

“I don't think Citigroup is broken,” said Ted Wolff, an executive at Solaris Asset Management, a New York investment manager that has more than $1.5 billion in assets and would consider buying the stock if it gets somewhat cheaper. “The real issue is what's on the balance sheet.”

Looking at Citigroup balance sheet for year 2007, its total shareholders’ equity was US$113.598 billion.  Its net tangible assets were valued at US$49.707 billion after deducting goodwill of US$41.204 billion and Intangible assets of US$22.687 billion.

If the US$80 billion SIV’s were to be halved in value, Citigroup’s net tangible assets would be totally wiped out. But why were there SIVs in the first place?

It is a no-brainer that there must be something to hide. Yet two factors existed to make this scheme work.

One, SEC which uses the General Accepted Accounting Principles (abbreviation, US GAAP) allows the use of Off-balance sheet transactions.

Two, the Wall Street security analysts ignored the Off-balance sheet transactions. They just want to hear the good news that the bottom line has increased steadily.

Quite naturally, Charles Prince and almost every CEO openly feel there is no need to refrain from using off-balance sheet accounting to hide undesirable transactions that will negatively impact its bottom line. As years go by, it shot up to US$80 billion in Citigroup.

Of course, in Prince’s mind, “Your money is my money.”  I must get as much remuneration out of the stock options which are directly linked to the share price of Citigroup Inc.

And Prince knows very well. “Nationalization is a trap that the U.S. government should avoid,” Fox-Pitt Kelton analyst David Trone wrote. “If Citigroup is nationalized, all bank stocks are likely to get crushed in fear.”

Citigroup declined to comment on talks with the government, but in an email said its capital base is very strong, despite $28.5 billion of losses in the last five quarters. However, how much of its net tangible assets valued at US$49.707 billion in 2007 remains? $21.2 billion?


 

Chapter 8

The meltdown of the sub-prime mortgage market

 

 

 

DANIEL HOFFMAN, a housing and urban policy consultant wrote on Oct. 7, 2008:With CITIGROUP and Wells Fargo battling over the carcass of Wachovia Bank, it is useful to recall the role that Philadelphia-area community organizations played in trying to prevent this disaster.

As many may remember, Wachovia, then operating as First Union Bank, greatly expanded its Pennsylvania and New Jersey operations in 1998 by buying CoreStates Bank. At that time and in accordance with federal procedure, a coalition of community groups urged the Federal Reserve to deny First Union approval for this purchase, arguing that First Union had extensively marketed subprime and perhaps predatory mortgages in lower-income communities in ways that appeared to be discriminatory and perhaps illegal.

To address this concern, First Union entered into an agreement with these critics to provide mortgage data that exceeded federal disclosure requirements. These groups, working with researchers at the Federal Reserve Bank and Penn, sought to use this information to create a model early warning system to alert communities to the kinds of problematic lending practices that have resulted in a wave of foreclosures.

First Union's willingness to provide this data was key to reducing community opposition to its purchase of CoreStates. But shortly after the purchase, First Union withdrew from the agreement and no lending data was ever provided. Federal regulators refused to require First Union to turn over this information and then-Senator Rick Santorum described the agreement as "extortion". The rest is history.

But there are broader lessons to be drawn, particularly in regard to future regulation of the mortgage industry.

One lesson is that community organizers and community-based organizations proved to be good early signalers of future trouble in the mortgage industry. These entities must be brought closer to the regulatory process through service on regulatory boards, by requiring other regulators to take greater account of their testimony when considering mergers and access to other regulatory advantages and by having them play a bigger role in the mortgage origination process.

Another lesson is that more and better disclosure of lending practices is needed. Banks and investors in mortgage-backed securities have demonstrated that their own self-interest isn't enough to prevent them from originating and buying toxic lending products.

Now, with fewer lenders, the possibility of the remaining lenders exercising even more monopoly power means that regulators need to better monitor mortgage product pricing, to whom and where mortgage products are being sold, where foreclosures are occurring and why and that homes are being accurately appraised and borrowers have a reasonable opportunity to repay their loans even if their incomes do not increase.

The "innovative" data sought from First Union should now be a standard regulatory requirement. Loans that don't meet strict underwriting standards shouldn't be permitted, or at least not be allowed to be sold onto national mortgage markets.

Lenders and borrowers got in trouble because they trusted real-estate appraisers and brokers and mortgage brokers to act in their interest.

Limited disclosure requirements haven't prevented insider dealing and other abusive practices. A new fiduciary responsibility to buyers of homes and mortgages must be established.

What is foreclosure in the first place?

Legal process by which a lender cancels (forecloses) a borrower's right of redemption of the mortgaged property through a court order (called foreclosure order). The court sets a date up to which the borrower can redeem the property by paying off the entire loan balance (including foreclosing expenses). Thereafter, the lender is free to sell the property and, upon the sale, applies the sale proceeds first to the due amount and pays the remainder (if any) to the borrower. The borrower remains liable for the due amount if the property remains unsold and for the shortfall if the sale proceeds are insufficient to pay off the entire debt. The lender is generally under an obligation to sell the property at or near its fair market value (FMV).

 

What is non-performing loan?

Non-performing loan on which interest is overdue and full collection of principal is uncertain. According to typical banking regulations, if interest has not been paid for 90 days the loan is put on a cash basis. Thus, its interest cannot be credited to the bank's revenue account until it has actually been received. Loans which have adequate collateral (such as home mortgages), and some types of consumer loans, are generally exempt from this requirement. It is also called doubtful loan.

How does the financial meltdown begin?

When a borrower of a mortgage loan use to purchase a house (which is the collateral) fails to pay the interest for 90 days, the lender has to decide whether the collateral is sufficient to cover the debt. If the value of the property were on the uptrend, general, the collateral is sufficient. The lender may not re-classify the loan as a non-performing loan.

However, if the value of the property were to go down, the collateral is short and the lender is forced to re-classify the loan as non-performing. With further non-payment of interest, the bank is forced to foreclose the property.

The sub-prime mortgage loans come with a much higher interest spread because of the unsoundness of ability of the borrower to repay. This is the reason for the added 2 to 3 percentage point above the prime lending rate. 

When the property price made U-turn and down south, Les Christie NEW YORK (CNNMoney.com) staff writer wrote on October 31, 2008 -- At least 7.5 million Americans owe more on their mortgages than their homes are currently worth, according to a real estate research firm's report released Friday. In other words: If they sold their homes today, they'd have to bring a check to the closing. Ouch.

Another 2.1 million people stand right on the brink, according to the report by First American CoreLogic. Their homes are worth less than 5% more than the mortgages they're paying on them.

The technical term for this phenomenon is negative equity; more colloquially, these borrowers are often referred to as being "underwater". “Being underwater leaves homeowners vulnerable to foreclosure,” said Mark Fleming, CoreLogic's chief economist.

That's because these borrowers are left with no home equity to tap - via refinancing or a home equity loan - if they run into financial trouble. Negative equity has contributed much to the soaring increase in foreclosures over the past year. On the other hand, anyone who runs into trouble paying their bills but has positive equity in their home can avoid foreclosure by either borrowing against their home or simply selling it.

Les Christie NEW YORK (CNNMoney.com) wrote on October 28, 2008: Home prices fell in August for the 25th consecutive month and prices in 10 major markets plunged a record 17.7% year over year, according to a key index of real estate values released Tuesday. Negative equity shot up and lending pressure to more foreclosure.

Les Christie, NEW YORK (CNNMoney.com) wrote on November 7, 2008: For years, bad loans and their aftershocks have been sending homeowners into foreclosure. Now it's lost jobs that are putting troubled borrowers over the edge. As the economy tanks, unemployment is the major factor driving a much larger proportion of foreclosures now than in the earlier stages of the mortgage meltdown. And that's a situation that more and more people are finding themselves in. Nearly one million Americans have lost their jobs in 2008.

In June, 45.5% of all delinquencies reported by Freddie Mac were due to unemployment or the loss of income, according to the company. That's an increase from 36.3% in 2006.

“The two economic factors that most contribute to foreclosures are falling home prices and rising unemployment,” said Richard DeKaser, chief economist for National City Corp. “It's hard to pay your mortgage when you don't have a job.”

The problem with the current crisis was the result of a combination of past excesses of at least two factors.

One, the lenders refuse to re-classify the collateral as non-performing loan. In order to hide the deteriorating interest yield, structured investment vehicles, or SIVs were created to move these non-performing loan into off-balance sheet transactions.

Two, the lenders tried to delay foreclosure of non-paying loans. Why? They want to reduce the impact of the foreclosure to the valuation of new borrowings so that they can give out more loans and earn more interests.

Why were these two actions so rampantly taken by all the lenders?

The annual remunerations to the CEO of the banks and financial institutions in Wall Street are directly tied to the profitability. Profitability in the sub-prime mortgage market produces the highest returns in interest income. Of course, the CEOs chose to delay the impact of the non-performing sub-prime mortgage loans. In their mind, “Your money is my money.” I want to make as much money now as possible.

Once the money (annual remuneration package) is in my wallet, the rest is history.


 

Chapter 9

Madoff’’s Ponzi scheme

The New Paper on Sunday February 8, 2009 wrote: After losing his entire life’s savings to disgraced fund manager Bernard Madoff, 90-year-old Ian Thiermann abandoned retirement and now works the aisles of a grocery store to make ends meet.

Handing out fliers hawking avocados and pork ribs at a supermarket in Ben Lomond, California, Mr. Thiermann is one of many facing dramatic lifestyle changes after losing their savings in Madoff’s suspected US$50 billion Ponzi scheme.

Mr. Thiermann wasn’t even aware he had invested with Madoff until Dec 15, 2008 when a friend who managed his investments called him on the telephone. He said, “I’ve lost everything and you have lost everything.” For Mr. Thiermann, that meant US$750,000 (S$1.1 million).

Mr. Thiermann, owner of a pest-control company in Los Angeles before retiring 25 years ago, enjoyed returns of 10 to 12 percent each year on his savings or about 15 years, regardless of whether markets rose or fell. He lived on those returns, devoting much time to non-profit work.

About 4000 km to the east in west Chester, Pennsylvania, Maureen Ebel has also surrendered a comfortable retirement, and works as a cleaner after losing her family savings of US$7.3 million to Madoff.

On Dec 17, 2008, six days after learning of her losses, the 60-year-old widow found work cleaning the home of a friend and caring for a 93-year-old woman. Ms Ebel’s husband, a doctor, died in 2000. The former nurse is also selling her luxury Lexus SUV and a winter home in Florida.

“On the first day I went to work, after pushing that vacuum cleaner around, I came home and said to myself, ‘this is what my life has come to,’ and I held onto my dog and I cried,” Ms Ebel said in a telephone interview.

In Pompano Beach, Florida, 73-year-old Irwin Salbe also expects to return to work after losing about 75 percent of his investment portfolio to Madoff.

Such schemes use money from new investors to pay distributions and redemptions to existing investors.

A general manager for a newspaper and magazine distribution company in New York before retirement in 1991, Mr Salbe inherited the Madoff investments when his father died in 1984. Over the years he poured in his own money and eventually parked his entire retirement savings with Madoff.

“I’m going to have to go back to a part-time job,” he said.

After losing money to Madoff, Lawrence Velvel, dean of the Massachusetts School of Law, said both the US Securities and Exchange Commission and the Financial Industry Regulatory Authority could be held liable for investors’ losses.

“The brokerage industry is responsible for this because these are the people that caused all of this,” he said.

Frank James wrote on December 15, 2008: SEC missed Madoff warning signs.

Investors who apparently lost billions of dollars in Wall Street broker Bernard Madoff's alleged $50 billion Ponzi scheme weren't the only big losers.

The Securities and Exchange Commission was staggered by the revelation, as it was once again exposed as an inadequate enforcement agency, unable to spot problems with Madoff others had observed and, ultimately, ineffective at protecting investors.

As The Wall Street Journal reported in a Dec. 13 2008 story, Madoff didn't fool everyone.

Harry Markopolos, who years ago worked for a rival firm, researched Mr. Madoff's stock-options strategy and was convinced the results likely weren't real.

"Madoff Securities is the world's largest Ponzi Scheme," Mr. Markopolos, wrote in a letter to the U.S. Securities and Exchange Commission in 1999.

Mr. Markopolos pursued his accusations over the past nine years, dealing with both the New York and Boston bureaus of the SEC, according to documents he sent to the SEC reviewed by The Wall Street Journal.

The same story mentioned that Jim Vos, who heads a company called Aksia LLC that advises investors did some investigating and found a huge red flag in the form of the auditor Madoff used.

Until at least November, 2006, the firm, which claimed to manage billions of dollars and be among the largest market makers in the stock market, used as its auditor Friehling & Horowitz, a small New City, New York firm.

Mr. Vos says his firm hired a private investigator and determined that the accounting firm had only three employees, one of whom was 78 and lived in Florida, and another was a secretary, and that it operated in a 13 foot by 18 foot office. His firm felt that was too small an operation to keep an eye on such a large firm operating a complicated trading strategy. A message left for the accounting firm was not returned.

So there were strong suspicions about Madoff. Even so, the SEC apparently was unable, even when being warned of questionable activities, to apply enough scrutiny to uncover the alleged fraud.

This clearly adds to doubts about the SEC's ability to police financial markets at a time when the markets can ill afford to have new doubts emerge about the federal government's oversight of those markets.

Those doubts were already high. The SEC and it's chairman Chris Cox have been blamed for lax oversight especially of the financial instruments called derivatives that financial institutions loaded up on which, after the mortgage crisis hit, wound up devastating their balance sheets. Indeed, under Cox, the SEC actually reduced enforcement.

As the New York Times reported in October that the SEC also eased requirements for how much cash Wall Street institutions had to keep in reserve which, when the crisis hit, made the institutions like Bear Stearns, Lehman Brothers and the rest far weaker than they might have otherwise been.

As the WSJ reports in a story on Dec 15, 2008:

An enforcement case 16 years ago gave the Securities and Exchange Commission its first shot at figuring out how Bernard Madoff could rack up favorable returns with such uncanny consistency. After that, it received repeated warnings from outside whistle-blowers and at least twice looked into Mr. Madoff's brokerage itself.

Each time, it blew its chance. It was only last week, when Mr. Madoff allegedly confessed to his sons that he was running what amounted to a "giant Ponzi scheme," that the apparent $50 billion fraud came to light.

“This is a debacle for the SEC,” said Joel Seligman, an SEC historian and president of the University of Rochester in New York. “The commission has a lot to answer for.”

The revelations are the latest blow to the reputation of an agency that has been criticized for insufficient enforcement and the failure to better monitor the dangerous risk-taking on Wall Street that triggered this year's financial crisis.

Madoff promised investors results. He is believed to have set up an illegal scheme that would help him fulfill that promise. Madoff himself became rich and admired while pursuing that goal. Now people are beginning to know the real Madoff - a man who wanted to shield his clients from reality. In a sense, we made Madoff. He is the result of a society and its desire for results and more results. The disease of: more.

The mechanism that helps us to verify the claims of individuals in any market place, to know what we need to know to function and to make the essential decisions, is called regulation. You have government agencies that are meant to ensure this. In the investment world, there are mechanisms in place to keep an eye on people. Everyone, including Madoff. Some people thought this would never happen to them. Some of these people voted for Bush, twice. The Bush legacy: the Chairman of Merrill Lynch, John Thain, just got paid $83 million with your bailout money. The company lost $7.8 billion in 2007. Merrill got $10 billion in bailout money.

The Bush legacy: No regulation; a free-for-all market anarchy. You could not assemble a worse group of public officials into one presidential administration.

The Bush administration knows the investments are your hard earned money. But it said, “It is your money. I don’t give a damn.”

Madoff too knew the investments you placed onto him are ‘your money’. But he added three words behind that phrase with ‘is my money’.  That completes the full sentence: “Your money is my money.”

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