A Bit of History

I asked one of my smart buddies about his thinking on the AIG bonus brouhaha.  Here's what he said:

If you want to understand why AIG awarded derivative traders in its Financial Products Group $165 million in bonuses, don’t be distracted by the on-going  morality play staged by politicians about the misuse of Federal funds, the blame-shifting game played by AIG executives, or even the disingenuous hand-wringing about the  sanctity of contracts.  The real decider here is money, specifically, $1.6 trillion worth of volatile derivative contracts.   This portfolio,  managed by 400 or so derivative traders that work for a London-based subsidiary ,  mainly consists of  credit default swaps that has the potential of inflicting hundreds of billions of dollars of losses on AIG– and, its de facto partner, the US tax payer.

How did the world’s largest insurer become a hostage to its subsidiary?  In 1998, this tiny group got into the newly-created credit default swap business when JP Morgan Chase came to it with a proposition to transform  debt on its books into security packages that could be sold off its books.  To make these bank debt packages salable to other institution, they needed credible insurance against default to get  Triple-A rating. So the AIG financial product group, seeing no risk of default, sold it in the form of credit default swaps.   Soon afterwards, with the support of Treasury Secretary Lawrence Summers (now President’s Obama’s economic advisor), the Commodity Futures Modernization Act  was passed, which excluded credit default swaps from being considered a "security" under the jurisdiction of the SEC or any other government agency.  This act allowed these swaps to be deployed on a massive scale to convert all kinds of debt, including even subprime mortgages and car loans, into triple A securities and turned AIG’s arm, now headed by Joseph J. Cassano, an aggressive Brooklyn-born alumni of Drexel’s back office operations, into a multi-billion dollar profit center for the insurance behemoth.   Even though the unit’s  400 or so traders constituted less than one-third of one percent of AIG’s loyal employees, it produced close to twenty percent of its total operating profits.  While Cassano kept the list of his counter parties in the credit default swaps a closely held secret, he  bragged at a conference in 2007 that they included a global swath of  “investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities and sovereigns and supranationals.”   By 2006, his group was raking in nearly $4 billion in profits, and, as is the tradition in the derivative game,  he and his  traders got a rich cut of the loot, which on average amounted to roughly $1.1 million a trader.
   With the collapse in 2008 of the debt AIG  was insuring, came such massive losses that Cassano resigned, and AIG, unable to post collateral, faced bankruptcy. At this point in September 2008, the US government rescued AIG, pouring in $173 billion of tax payers’ money.   Even so, there remained a $1.6 trillion  in potential liabilities that could be triggered by thousands of the credit default swap contracts, many of  which would not expire until 2012.  To prevent hundreds of billions of losses, these custom-designed contracts had to be continually watched, and, if necessary hedged, by traders who understood each one’s particular vulnerability.

To perform this critical task, the remaining 370 or so remaining traders in the group wanted the same sort of guaranteed compensation in the form of retention bonuses as had in their two year contracts. The situation for AIG, and the US government that now owned 80 percent of it, was not unlike the  one in Mario Puzo’s Godfather in which an offer is made that cannot be refused.  In this case, even without a bloody horse head under the blankets, AIG and its federal overseers could not  risk  falling into a $1.6 trillion black hole by turning down the demands of the traders in the financial product group.  It was not  that these  traders had such unique skills in managing derivative contracts that they could not be replaced by other people but that they  knew the business’ crucial secrets, including the identities of  he counterparties to the credit default swaps and the vulnerabilities in their positions.  The implicit threat: they could use the secrets to which they were privy to trade against AIG’s positions as it attempted to unload its $1.6 trillion dollar portfolio.  Under these circumstances,  rather than risking immense losses from having  their secret book compromised, AIG paid to keep its traders from defecting.  Their compensation, when approved by the Fed and Treasury, would amount to  about $500,000 a trader a year ( less than half what they had been getting in 2008.)  The staff at the NY Fed, while Timothy Geithner was still its head, in fact  helped negotiate the terms for these retention bonuses. When Geithner moved on to become Treasury Secretary in January 2009, he presumably understood how financially dangerous it could be to do otherwise, since he intervened with the Senate Banking Committee Chairman in February to get a provision dropped from a bill that would have prevented AIG (and other recipients of federal money) from paying such huge bonuses.  In fairness to Geithner, the alternative to making these pay-offs  might have proven a thousand times more costly to AIG, and its defacto owner, the US Government. Washington, after all, is ruled by pragmatism, and what difference is there between AIG paying $165 million to the derivative traders who caused the havoc, and the Fed rewarding the rating services that made possible the proliferation of trillions of dollar of  toxic debt with $1.2 billion in fees to  rate the new debt under its TALP plan to restore the credit markets damaged by its old Triple A rated toxic debt?

The Lost Decade + 2

Here's a chart of the S&P. It closed Friday at 770. It also closed at 770 on Jan 20, 1997. More than 12 years ago. *sigh*

Stop Trusting Wall Street

The Frog And The Scorpion.

In the late 90s, Wall Street profited handsomely from the tech IPOs they handled. Many of the companies they took public never should have seen the light of day, and, as we now know, the same investment banks that were handling the IPOs were writing the research reports that were intended to inflate prices. Wall Street firms made tremendous profits by taking nascent tech companies public. Who lost? We did, of course, by believing the hype the investment banks generated and buying their product.

Not content just to profit on the fees they were generating from the IPOs, the investment banks made even more money by setting the IPO price below what they gauged the fair market price would be at the open, taking money from the pockets of the original investors and employees in the company by setting an artificially low IPO price. Who lost? The company that was raising funds to finance growth in sales, marketing, development, etc. by going public. The banks were happy to make more profit, at the expense of the firms on whose behalf they supposedly were acting.

Is it the role of government to protect us from Wall Street? Certainly if we can’t read a prospectus and determine the intrinsic value of the company that’s going public, it’s not up to the government to save us from ourselves. All the government should be required to do is to make certain that the company filings are accurate, and the appropriate laws (such as no frontrunning, not sharing insider information, etc.) are being obeyed. In response to the public outrage, the government threw us a bone and started enforcing a Chinese wall between the analysts and the bankers. But in reality, it’s likely that even with this restriction in place Wall Street would still have found a way to profit at the expense of the public.

Fast forward to the present, and we find ourselves in an even worse situation. Banks found that they could package up home loans into new products and get the ratings agencies to give these products AAA ratings. Technically, the banks probably did not violate any laws, although they knew that, as with the IPOs, they were materially misrepresenting the intrinsic value of the product they were selling. And once again, they’re making huge profits by selling the product to the public.

I saw Alan Greenspan being interviewed by David Faber of CNBC. To the question of “what could the Fed have done,” Mr. Greenspan’s reply was essentially that the Fed was powerless to stop the chain of events, even had it known what was happening. And that the Fed will be powerless to stop similar things from happening in the future. In essence, we should expect individuals on Wall Street to act in ways that will maximize their individual financial return. When their interests are aligned with that of the public, it’s good for us. When inversely aligned, caveat emptor. In fact, it's now clear that individuals inside the Wall Street firms are so focused on maximizing their own pay that they're even willing to risk the fates of their own firms in the process.

So why should we ever trust Wall Street again? We can expect the government to throw us some small concessions in an effort to show the public that they are working to ensure that this can never happen again, similar to the Chinese wall they legislated after the dot com bust. But it should be clear to us by now that in a few years, the innovative folks on Wall Street will concoct some new product that it can pawn off to us at wildly inflated prices. It’s in their nature.

"Welcome to the Republican Party"

I received an email last night from a well intentioned friend. The email is below. My response is below that.
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Father / Daughter Talk

A young woman was about to finish her first year of college. Like so many others her age, she considered herself to be a very liberal Democrat, and among other liberal ideals, was very much in favor of higher taxes to support more government programs, in other words redistribution of wealth. She was deeply ashamed that her father was a rather staunch Republican, a feeling she openly expressed. Based on the lectures that she had participated in, and the occasional chat with a professor, she felt that her father had for years harbored an evil, selfish desire to keep what he thought should be his.

One day she was challenging her father on his opposition to higher taxes on the rich and the need for more government programs. The self-professed objectivity proclaimed by her professors had to be the truth and she indicated so to her father.

He responded by asking how she was doing in school. Taken aback, she answered rather haughtily that she had a 4.0 GPA, and let him know that it was tough to maintain, insisting that she was taking a very difficult course load and was constantly studying, which left her no time to go out and party like other people she knew. She didn't even have time for a boyfriend, and didn't really have many college friends because she spent all her time studying.

Her father listened and then asked, 'How is your friend Audrey doing?'

She replied, 'Audrey is barely getting by. All she takes are easy classes, she never studies, and she barely has a 2.0 GPA. She is so popular on campus; college for her is a blast. She's always invited to all the parties and lots of times she doesn't even show up for classes because she's too hung over.'

Her wise father asked his daughter, 'Why don't you go to the Dean's Office and ask him to deduct 1.0 off your GPA and give it to your friend who only has a 2.0. That way you will both have a 3.0 GPA and certainly that would be a fair and equal distribution of GPA.'

The daughter, visibly shocked by her father's suggestion, angrily fired back, 'That's a crazy idea, and how would that be fair! I've worked really hard for my grades! I've invested a lot of time, and a lot of hard work! Audrey has done next to nothing toward her degree. She played while I worked my tail off!'

The father slowly smiled, winked and said gently, 'Welcome to the Republican party.'

If anyone has a better explanation of the difference between Republican and Democrat I'm all ears.

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And my response to my well-intentioned friend:

Hi xxx,

That email is scary. It's scary because I know that there are lots of people in this country that think that it's true.

The Republicans claim to be the fiscally responsible party, and they call the Democrats the "tax and spend" party. But since 2000, we learned what the Republican party would do when it had control of the white house and a majority in both houses of the Congress.

So how have the Republicans done over the past 8 years?

If you remember back to the Clinton (Democratic) campaign in 1992, they ran on the slogan "It's the economy, stupid." Clinton took office with a $236 Billion deficit (the government was spending $236B more than they were taking in each year. Similar to a family making 250K a year but spending 500K a year, and financing the rest by taking out loans). Over the next 8 years, true to their promise, the deficit decreased under the Clinton administration each year. When they left office in 2000, they left Bush with a $250B surplus (that is, the government was taking in MORE than they were paying out each year).

The Bush administration has taken that surplus and squandered it. This year, the budget deficit was projected to be $800 Billion BEFORE the current Wall Street bailout. Our national debt (the amount of money our government owes and must pay interest on each year) is almost $10 Trillion. That's an insane amount of money.

The Republicans believe that industries should be lightly regulated, if at all. Many of us think that can work, if done responsibly. But it's been way out of control, as lobbyists push Washington to back off on their businesses. As a direct result of the lack of oversight of the financial markets, the taxpayers (you and I) will now fund the bailout of the financial markets. That is the exact OPPOSITE of that email. All of America will now pay to bail out the excesses of a handful of gazillionaires on Wall Street.

There might have been a time in the past when the Republicans were fiscally responsible, and the Democrats wanted to increase federal spending on questionable social programs, but not any more.

I'm neither a Democrat or a Republican. I want fiscal responsibility. But at the same time, I am more than happy to pay my fair share so that the public schools have computers, and athletics, and honors programs, and programs for special needs kids. I'm happy to pay a little bit more so that college is affordable. Or so that someone who needs medicine or a doctor can get it. That's not a re-distribution of wealth. Those are basic services. And it's the government's responsibility to provide them to all citizens. That's their job. That's why we pay taxes. But now, much of our tax receipts will be going to bail out Wall Street instead, and there will be even less available to fund the programs we need.

The fox has been guarding the henhouse for the past 8 years. And this country is in big trouble right now. Don't believe it's as simple as that email you were sent.

Shouldn't the President be Able To Multi-Task?

http://www.huffingtonpost.com/2008/09/24/mccain-camp-wants-to-post_n_129079.html

What if they win? Will they put the presidency on hold when things get too crazy?

The fox is guarding the henhouse. Again.

Lifted verbatim from Paulson's proposal to Congress:

Sec. 8. Review. Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

The entire proposal is here:

http://seekingalpha.com/article/96820-the-treasury-s-bailout-proposal-and-its-faults

This just might make Hank Paulson the most powerful person in the world.