The devil's in the details in the deal with the devil
by bobswern, Mon Mar 23, 2009 at 01:54:34 AM EDT
This post is about the many ways in which Wall Street is about to do what they've always done to us: game the system for their own advantage.
It's what they do. As the old question goes: "Why do you think they get the big bucks?"
But, first, a little background...
There are a ton of extremely valid reasons why our government is engaging in the biggest giveaway of all time to the status quo (a/k/a Wall Street).
I get it. Believe me, I do. (I have been blogging about the economy going on two years. I've been addressing it on behalf of fellow Democrats, professionally, for three decades.)
Expediency in an emergency--in light of crashing markets and dramatically rising unemployment and real and potential domestic and international social unrest--is about as legitimate of a reason as there is to act swiftly, right now.
President Obama--who is certainly addressing this expediently--pointed out the obvious "too-big-to-fail" meme tonight on 60 Minutes: "Obama Says Risks Still in System, Questions Bonus Tax."
"There are certain institutions that are so big that if they fail, they bring a lot of other financial institutions down with them," Obama said in an interview for the CBS program "60 Minutes" broadcast tonight. "And if all those financial institutions fail all at the same time, then you could see an even more destructive recession and potentially depression."
When your house is on fire, you don't hunt down the arsonist first; you put the fire out first; then you hunt down the sucker that started the fire and you hang them out to dry.
My fears (sorry Larry Summers, but if you're going to use "fear" to further your agenda and then simultaneously admonish the rest of us for talking about our legitimate fears--which happen to be heavily supported by a myriad of Obama-supporting authors and economists as well as two folks whom you won't even give the time of day: former Federal Reserve Chair Paul Volcker and Nobel Prize Winner Joseph Stiglitz), however, which also happen to be the shared concerns of even Obama's and Biden's closest economic advisors, Austan Goolsbie and Jarred Bernstein, respectively, as well as Office of Management and Budget Director Peter Orszag, are that we may be putting out this fire with gasoline. (NOTE: Austan Goolsbie actually pointed out this article to me--the link for which is provided in the previous sentence--a couple of weeks ago.)
If you think we're not making a deal with the devil--Wall Street--to dig ourselves out of this mess that risks haunting (and maybe even tragically undermining) both this administration, the Democratic Party, the public and at least one or two generations to come, then you're totally unprepared for what lies ahead.
It's not just important, it's imperative that we get this right the first time. Stating the obvious, there really might not be a second chance.
The biggest reason why we may not get a second chance to address these matters, effectively, relates to the reality that there's only so much money to go around, as DKos diarist gjohnsit brilliantly illustrated in their diary the other day: "U.N.: It's time for the world to ditch the dollar."
Then, on queue, almost simultaneously, the following two stories (and many more that were similar) appeared:
But, apart from this coming week, this diary isn't about what lies ahead; it's about right now.
More importantly, it's about being prepared right now for what lies ahead.
Throughout this economic crisis, there's been an ongoing pattern of the government acting (or, at least acting like it's acting) quickly, and then doubling-back and dealing with the fallout (both politically and economically) from its actions, afterwards.
In many respects, this same behavior is repeating itself this upcoming week as Treasury Secretary Tim Geithner announces his multi-faceted bailout plan for Wall Street.
There are massive black holes to be navigated around throughout this undertaking, now and going forward, and many of them relate to a matter that many members of the Obama administration have already totally wrapped their collective minds around, and that's implementing better regulatory oversight of Wall Street and the shadow banking sector. This weekend, Stephen Labaton wrote a very good piece on how the Obama administration is clearly focused on this matter, going forward, entitled: "Administration Seeks Increase in Oversight of Executive Pay ."
The only problem here is that they're formulating regulatory strategy relating to legislation that may not be written (and, hopefully, passed) until many weeks, months or years from now. Meanwhile, the cash spigot is turned on full-blast, and the money is spent now.
WALL STREET: "How will I game thee? Let us count the ways."
Just as sure as the sun will shine and the moon will rise, once again, Wall Street--known far and wide for doing just about whatever it takes to make a buck--prepares to game the government and the U.S. taxpayer for all they're worth.
The one thing you can take to the bank today, even if you don't have a pantload of cash to deposit there, is that truth.
FIRST, THERE WAS THIS...
Last night, I posted a diary which discussed the reality that at least some--if not all--of the collateral covered in the first iteration of TARP, back in the last quarter of 2008, was never collected by our government when payments were made to the various entities that needed to cover counterparty derivative debt.
In AIG's case, it appears (based upon the quote below) that this was/is the disposition of all of their counterparties. AIG's counterparties were allowed to keep the underlying derivatives and securities even though our government covered AIG's counterparty obligations.
The truth remains that the public knows very little about all of this, even now. Here's something we do know:
On December 28th, 2008, the stock market website, Seeking Alpha, in a post entitled, "AIG Becomes the Fed's Vehicle to Buy Toxic Assets," enlightened us to the reality that AIG's counterparties were being compensated for their losses but, simultaneously, they were also enabled by the government (via AIG) to actually hold onto their toxic trash while pocketing taxpayer-backed bailout money for it.
AIG Becomes the Fed's Vehicle to Buy Toxic Assets
by: Michael Steinberg December 28, 2008
The Washington Post (from Bloomberg News) "With Fed's Help, AIG Unloads $16 Billion in Credit Default Swaps" reports that American International Group (AIG) retired another $16B face value of credit default swaps for $6.7B by purchasing the underlying securities and canceling the contracts. The insured (counterparties) were able to keep the more than $9B in collateral that AIG posted. The counterparties were taken out at par. So far, the Fed's Maiden Lane III special purchase fund has purchased $62.1B face value of CDOs from AIG's counterparties. The Fed has committed to purchase up to $70B face value of CDOs from AIG's counterparties at roughly 50% of par. Each time the Fed is allowing the counterparties to keep all collateral.
Why has the Fed completely removed the risk of AIG as a counterparty in CDS transactions? Perhaps the Fed views moral hazard as a foreword looking constraint and AIG is just trying to unwind past regrettable activities. More likely the Fed is viewing AIG as a conduit to funnel capital into favored financial institutions. By forcing counterparties to sell the underlying CDO securities in order to receive full recovery, the Fed is liquidating toxic assets and preventing pure speculators from participating. But by paying close to par, when posted collateral is included, the benefit of price discovery is missing.
AIG told shareholders that the Fed would negotiate the CDO purchases on AIG's behalf and AIG's participation in any price appreciation would be limited. The implication was that the Fed would use its strength to be an advocate for AIG. Quite the opposite turned out to be true. Instead the Fed used its strength to force a weakened AIG to make whole its stronger counter parties.
Diarist emphasis is in bold.
What we're being told in this article is that all this toxic paper is still in the hands of the folks that have already been compensated for it by our government! How could that be? Apparently, we've knowingly let these AIG counterparties (and, perhaps other recipients of other bailout funds) keep it.
This week, per news articles throughout Saturday's MSM quoted above, Treasury Secretary Geithner will formally announce a series of federal programs to subsidize the private sector's purchase of all of this toxic paper--and more--from these very same entities.
Now, with the advent of new Financial Accounting Standards Board regulations that redefine the meaning of "Net Income," along with the Treasury Department's and the Fed's new TALF, TLGP and related programs, it would appear that these same counterparties may be enabled to:
a.) place those same derivatives and underlying securities--derivatives and securities for which they've already been compensated once by U.S. taxpayers--on their books as assets at mark-to-model valuations (i.e.: 100 cents on the dollar or more, for garbage that's only worth pennies on the dollar); and/or
b.) repackage them and offer them through to the shadow banking sector via TALF and a few other programs, collecting more government-sponsored subsidies--equivalent to possibly much more than the derivative's original value--in the process of doing so, thus...
c.) earning upwards of 150% in taxpayer-subsidized returns on paper that's actually worth only cents on the dollar.
But, there really isn't much deviousness here. The truth is, if the government even has an inventory of what they were supposed to obtain--and didn't--we don't even know if it exists. So, the likelihood that it may/will be sold within the upcoming program offerings remains very real.
BUT, THAT WAS JUST A PRELIM FOR THIS...
Tonight, I spent some time over at the Naked Capitalism blog, a left-leaning site that focuses on all things related to business and our economy--and one that's frequented by a lot of market professionals too--and let me tell you, it was an eye-opener!
Apparently, I was just scratching the surface.
If you have any doubt about what's about to go down this week on Wall Street, I would strongly, strongly suggest you take a gander at the ongoing discussions between host Yves and fellow bloggers there to understand just how simply and readily our government is about to get the shit gamed out of it.
Here are just a couple of examples of what I'm talking about--fellow professional Dem's explaining in great detail how this will all go down in coming days--and you may link to it all in real time, right here: Naked Capitalism.
There is a much simpler way to play this game than buying the CDS contract mentioned before.
Let's say ABC bank has $100m nominal value of debt that they have marked down to $90m on their books. But ABC knows it will really only net out to $60m if held to maturity. So they have another $30m in losses to recognize.
The easy way to game the system is for ABC to coordinte with Hedge Fund XYZ and simply loan XYZ the 3% of the $90m, or $2.7m with a two year term. This allows XYZ to bid and win the debt at full book value. Of course the debt could be spinning off $4-$7m annually depending upon your assumptions.
The bank beneifts in several ways: 1) they have a $2.7m risk-free loan that they know will be money good and paid in full in two years, ABC has a worst case loss of $2.7m instead of $30m. Of course the chances of losing anything are almost non-existent.
2) Their capitalization ratios are repaired immediately.
3) They don't have to take an additional mark down and the associated hit to earnings.
XYZ will get a healty portion of the spin off of cash in the mean time, that far exceeds the $2.7 million loan, and XYZ garners considerable goodwill with bank for future deals.
Since the Treasury sponsored loan is non-recourse, XYZ gets to walk away free and clear. XYZ has a huge potential to make money and Treasury is left holding the bag for the $30m that doesn't pay off.
To make matters worse, it would be almost impossible to stop this sort of deal from occuring. Even if the program forbade the bank from financing the purchase of their own debt it would be difficult to discover an agreement between two banks to cross fund other investors. Not surprisingly the XYZ fund always wins the bid because he intentionally overbids.
It is my guess that in the end this is the shell game that has been designed by the Fed, Banks, Treasury, Pension Funds, and Hedge Funds in order to hand the bill to the taxpayer a piece at a time without them knowing it.
And, something from Yves...
Saturday, March 21, 2009
Investor on Private Public Partnership: "One would have to be a criminal to participate in this"
Hoisted from comments:
Say I am SAC Capital. I get to be one of the bidders on bank assets covered by the program
Citi holds $100mm of face-value securities, carried at $80mm.
The market bid on these securities is $30mm. Say with perfect foresight the value of all cash flows is $50mm.
I bid Citi $75mm. I put up $2.25mm or 3%, Treasury funds the rest.
I then buy $10mm in CDS directly from Citi [or another participant (BOA, GS, etc)] on the bonds for a premium of $1mm.
In the fullness of time, we get the final outcome, the bonds are worth $50mm
SAC loses $2.25mm of principal, but gets $9mm net in CDS proceeds, so recovers $6.75mm on a $2.25mm investment. Profit is $4.5mm
Citi writes down $5mm from the initial sale of the securities, and a $9mm CDS loss. Total loss, $14mm (against a potential $30mm loss without the program)
U.S. Treasury loses $22.75mm
It's just a scheme to transfer losses from the bank to the taxpayer with an egregious payout to a middleman (SAC) to effectively money launder the transaction.
You've also transmuted a $30mm economic loss into a $36.75mm economic loss because of the laundering. So its incredibly inefficient.
How did fraud and money laundering become the national economic policy of the US?
There are actually much better illustrations on the site than what I have posted here. But, it's certainly proof positive that there are, literally, dozens of loopholes--many of them discussed over there in detail--which provide plenty of initiatives for anyone wishing to make a buck at the taxpayer's expense to do just that.
One of the examples I found especially amusing was how banks simply work with a favored hedge fund to move toxic paper from the bank's books to the hedge fund's ledgers...just to remove the loss from their ledges and to establish a much higher value for the paper as recorded in the new transaction, itself. Once the new, higher value (which has nothing to do with the actual market value of the paper) is recorded, the bank then "buys" the paper back from the hedge fund; and they book a "defined asset" with "real value" (as recorded by the previous transaction which establishes a benchmark for same), and therefore has a much higher-valued asset on its own ledger sheet! (And, that's an easy one that even I can understand!) Oh, yes, one more detail: the taxpayer ends up eating a multimillion dollar bill, too.
The long and the short of it is that if there's a way for a bank to semi-legitimately (and I'm really stretching the use of the word, "legitimately") pawn off bad paper, and at the same time enable a hedge fund to make a pile of money in the process, no matter how much it costs the taxpayer, it's all but definitely going to happen in the next few days, thousands and thousands of times over.
If you think these entities aren't experts at obfuscating transaction issues to make billions and billions of dollars, then you're in serious denial.
But, don't take my word for it, click on the links above and see for yourself what I'm referencing herein.
Now, we know the Obama administration is going to focus on regulating a lot of this stuff going forward, but it's safe to say it's not going to happen until long after the bad guys have made their getaway and the taxpayers are out trillions more in increasingly scarce cash...cash that could be going to Main Street instead of Wall Street.
Do you, honestly, in your heart of hearts think anything other than this is going to happen over the next few days? (Again, check out http://www.nakedcapitalism.com for much more conniving illustrations than what I'm showing you here.)
Inherently, within these programs, there are scores of ways to play the system and game the government. And, when it comes to Wall Street, it's what they do!
As much as two trillion--or more--taxpayer dollars are at stake. Do you think there'll be any other outcome other than what I'm discussing herein?
If you do, I've got a really nice bridge overlooking the East River that I'd like to sell you.
Tags: Austan Goolsbie, bailout, Barack Obama, depression, devaluation, Dollar, Euro, gjohnsit, Hedge Funds, Henry Paulson, Jared Bernstein, joe biden, Joseph Stiglitz, Peter Orszag, Recession, shadow banking industry, shadow banks, TALF, TARP, Tim Geithner, TLGP, US Treasury Department, Wall Street, yen (all tags)