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Eye on Re-Regulation: Where There's Smoke. Notes for the Week Ending Friday, December 19, 2008

If the Shoe Fits…
This is like déjà vu all over again.
- Yogi Berra

Chairman Cox went public on Wednesday in the wake of l’affaire Madoff. We have obtained a copy of the speech, and we would like to play for you the tape of what he forgot to say:

“As Chairman of the Commission, I personally take full responsibility for any lapses in regulation that may have occurred during my tenure. You have my personal pledge that I will not rest until every aspect of this affair has been thoroughly analyzed. If there has been wrongdoing, we shall see to it that all guilty parties are punished to the fullest extent of the law. If we find that actions or negligence on the part of Commission staff contributed to the problems which are only now coming to light, you have my personal guarantee that I will correct any procedures, and discipline any individuals that may have been at fault.”

As the nation’s top Regulator overseeing the Financial Services industry, Chairman Cox should know better than anyone that the least costly thing to give is one’s Word of Honor. In keeping with the Research Edge Team Shout for the week – C’mon, Man! Cox. Bro’, you can do better than that!

For the record, it is impossible in the current political environment to run the SEC effectively. The lawmakers have cut the Commission’s budget down to the price of an ice cream cone. Congress has phumphered and waffled, and largely beaten the Sword of Justice into a Capitalist Ploughshare. There has been excess at the both the Liberal and Conservative ends of the spectrum, as exemplified in the Community Reinvestment Act, which compelled banks to loan money to insolvent borrowers, and the Commodity Futures Modernization Act, which made it illegal to regulate complex financial derivatives.

America, land of unimaginable plenty, is used to having it both ways. We want to be profligate wasters of natural resources – in what version of reality does a Hummer qualify as the soccer-mom’s reasonable alternative to a Dodge Caravan? – yet we take it as our eternal right to have God’s Pristine Country available to us.

The fact is, we want our markets to bubble with the froth of excess. It emerges that one of the reasons Bernard Madoff was so successful at raising investor dollars was that people were convinced he was breaking the law and making illicit profits. Many of the hedge fund-of-funds managers who shipped wads of investor cash over to Madoff Investments apparently believed he was front running his own brokerage orders as he traded through his own brokerage firm. Not merely self-dealing, but self-insider-trading. These same people are now shocked to learn that they were right about the illicit, but – oops! – wrong about both the mechanism and the beneficiary.

As Madoff’s firm was examined by the SEC over the years, one item that should have been obvious was the identity of Madoff’s auditor, the firm of Friehling & Horowitz. As reported by Fortune magazine (CNNMoney.com December 19, “Madoff’s Auditor… Doesn’t Audit?”) the firm whose audits Madoff presented to the SEC examiners was a three-person shop which had certified repeatedly to the American Institute of Certified Public Accountants (AICPA) that it did not perform audits. The Fortune story quotes the AICPA as stating that Friehling & Horowitz has certified in writing each year for the past 15 years that they do not perform audits. What is the purpose of having a national professional association if the Government agencies that rely upon the profession don’t cross check lists to see who is signed up and who is not?

Further, consider the structure of Madoff Investments: the firm acted as a money manager, as its own broker, its own custodian for investor funds, and its own administrator. We can assure you that only person with a serious drug dependency – or multiple alimonies and a death wish – would accept a job as a compliance officer under such conditions. A rookie examiner would see these red flags, literally printed on the Commission audit checklist: self-dealing through the captive broker dealer; no custodial third party to guarantee the safety of client assets; internally-generated statements with no outside oversight to ensure the integrity of client reporting. Add to this a no-name auditor – which is in print as not performing audits. Can Chairman Cox really say that the Commission acted properly in this matter?

The reality is that we cherish our two-tiered system of justice. We wanted Bernie to be a crook. Just as we wanted Linda Chatman Thomsen, Director of Enforcement, to tip off Morgan Stanley about the SEC investigation of John Mack, then a candidate for CEO of the investment bank (there was “smoke, but no fire”, said Chief Thomsen, the quote which gave this column its title).
The SEC found that she acted properly in light of the important place in the financial markets occupied by Morgan Stanley. We respond cynically when people and institutions behave as though they were above the law. But in our system, Equality Before the Law is stratified. When major market players are at risk, our current operating system requires that they be bailed out so as not to impede the flow of commerce. If you have ever been in favor of a tariff, a windfall profits tax, a farm subsidy – or a bailout of the automotive manufacturers and their union – you should think twice before criticizing the SEC’s findings in the matter of Director Thomsen.

Put another way: C’mon, Man – this is our elected government we’re talking about. Clearly, they are giving us what we want. Otherwise, we’d vote for someone else.

Oh, guess what – we just did.


A Shoe-In
President-Elect Obama has tapped Mary Schapiro to head the SEC. Ms. Schapiro has lots of street cred from the years she spent whipping the NASD into shape – and trust us, it needed a whipping. She may be just the person to oversee the transition from a do-nothing SEC to a Can-Do SEC. The leading indicator that will demonstrate the Obama Administration’s commitment to “Change We Can Believe In” is the size of the new SEC budget. Watch for large amounts of money to be pumped in. And if not – watch for the next Bernie Madoff. And the next.

Chairman Cox built his career at the Commission around working to forge consensus on every issue. What he – and Congress, at whose pleasure he serves – has overlooked is that this approach cannot work. The SEC is charged with overseeing a fast-paced world where gunslingers dominate, where slow and steady loses every race, and where the players sleep with loaded revolvers under their pillows. A successful Top Regulator in this environment must run an Ultimate Fighting Championship, not a Quaker meeting.

Chairman Cox played politics with the nation’s wealth – and ended up contributing to the downfall of our markets and with it, the Dollar and our global credibility. As the collapsing financial markets have graphically demonstrated, when complex structures crumble, the destruction is so rapid and pervasive that we are powerless to act. The same is true of the global credibility the US markets have enjoyed for so long. Building consensus is a valuable political exercise. But the Chairmanship of the SEC, though a political appointment, is not place for a politician.

We like Mary Schapiro for this job. She is genuinely tough and smart and understands the industry. She managed the merger of the NYSE and NASD and will be the right person to oversee the roll-up of the current goulash of agencies into the SEC-slash-whatever, as the future joint regulatory body will no doubt be. As CEO Schapiro herself has observed regarding the current regulatory structure: if this were proposed today, would you vote for it?

The excesses of Wall Street have always shared in the Manifest Destiny idea that America is made up of people who are strong enough, daring enough and brazen enough to reach out and grab. Deep down, we Americans love our rascals. Now, though, too many rascals are running too wild. The Greed that was Good has metastasized into an Excess of Excess. So many of these guys have appeared on the front pages so frequently that Americans are suffering Rascal Fatigue and finding them unappealing. All of which feeds into the general disgust with the Status Quo that led to the Obama victory.

We are pleased that the SEC has emerged as blatantly Part Of The Problem – because in reality, the problem is us. Maybe it took the Bernie and Christopher Show to finally bring it home to us all. And when there’s nothing left to like, nothing left to be jealous of, nothing left to envy, you have lost your audience. Wall Street, your season has just been canceled.

Finally, even though Ms. Schapiro “Gets It” with respect to the regulators’ job of protecting the investor, there remain serious stumbling blocks. One is the very process whereby investors who are wronged get compensated. FINRA does not have large or sharp teeth, and justice for investors who have been hoodwinked is neither swift, nor particularly sure. Look for her to address this gap in the Regulatory Agency of the Future.

But here’s the worst part of it: the one group we cannot regulate is the investors themselves. As CEO of NASD – now FINRA – Ms. Schapiro presided over the rollout of a comprehensive Investor Education Program, but this is a classic horse-to-water situation. Stockbrokers are required to pass a licensing examination before they are permitted to tout investments to the public. If only investors were required to pass a licensing exam before they could open brokerage accounts…


Not On Thy Sole, But On Thy Soul, Harsh Jew

I went looking for trouble, and I found it.
- Charles Ponzi

Here we go again with one of our favorite exercises:

$50,000,000,000.00

Whew! My fingers get tired just tapping out all those Zeroes. Imagine how tired Bernie’s must have gotten while counting them up – which he had to do in order to inform his sons just how big his crime was.

Prosaic as it may be to observe, the man who steals the proverbial loaf of bread would not be sitting in his Manhattan apartment sipping a martini while showing off his new electronic gear to his wife. (“Honey, does this ankle bracelet make me look fat?”) Our advice to President-Elect Obama: don’t close Gitmo just yet.

We are truly mesmerized by the psychology of a man who tells his own sons “I went through fifty billion dollars of other people’s money in a giant Ponzi scheme.” Right now, we have nothing more than their words, reporting his words, to indicate the magnitude of the scam perpetrated.

While we cannot Walk A Mile In His Shoes, we can speculate on Mr. Madoff’s inner processes. How prosaic to have squandered, say, a mere $137 million of investor money! How embarrassing, in this day and age, where hundreds of billions are tossed about like dwarves at a ‘90’s Wall Street watering hole, to have beaten investors for only a couple of billion. No, by his own admission, Bernie is The Biggest Of All Time. Judging by the reported state of his firm’s financial records, the actual amount may never be known. Which may be the beauty part of Bernie’s plan.

Bernie is going down, and he’s making sure it will be one for the record books. In a world characterized by excess, Bernie’s legacy is to be the most excessive of all. Bernie’s fraud, like any other, started at home, within his own community. Jewish institutions and charities across the globe have been destroyed by his actions. But the major achievement – what catapults Bernie into the ranks of the Great Scoundrels – is his ability to transcend the bounds of race, ethnicity, and social class. Bernie’s fraud was truly global in scope. It is indeed One For The Books.

As he lay dying in a charity hospital in Rio de Janeiro, Charles Ponzi granted one final interview. He spoke about his adventure as the greatest financier the city of Boston had ever seen.

“I had given them the best show that was ever staged in their territory since the landing of the Pilgrims!” Ponzi is reported to have said. “It was easily worth fifteen million bucks to watch me put the thing over." Charles Ponzi went out singing his own praises for the sheer magnitude of his accomplishment. He would have been bursting with pride to learn that the scam he copied from someone else (who had copied it from someone else, who copied it…) is now associated across the globe with his name.

Bernie is making his own play for Eternal Glory. We will bet a nickel (which is all we have left) that the term “Madoff Scheme” quickly finds its way into common usage, to differentiate a Wall Street pyramid scam from the garden-variety Ponzi Scheme. Alas, Charles Ponzi’s name may fade into oblivion. Yea verily – how are the mighty fall’n.

As Shelly wrote in “Ozymandias”, “Nothing beside remains. ‘Round the decay of that colossal wreck, boundless and bare, the lone and level sands stretch far away.”

He could have been writing about the world’s financial system.

Moshe Silver
Director of Compliance
Research Edge LLC

Keith R. McCullough
CEO & Chief Investment Officer

RESEARCH EDGE, LLC
111 Whitney Avenue
New Haven, CT 06



Quote Of The Week: Merry Christmas!

A Christmas Car-Oil

The Monarchs crept to Congress, crowns in hand,
All sniveling, slinking in on private jets.
Proud Gettelfinger meanwhile took his stand
And said “We shall not budge – off are all bets!”

Our President – who singly had invaded
Two sovereign states, with no mean loss of life –
‘Fore Dearborn now his impotence paraded
In guise of hovering above the strife.

Yet now, “’Gainst principle and judgment acting”
The W taxpayer cash distributes,
Rather than show the world his Bone has Backing.
For defense – nothing. Seventeen bil’ for tributes.

Detroit, the People wish Ye Merry Yule.
Of Last Resort, we’re now the Greater Fool.

Moshe Silver
Research Edge LLC

Chart of The Week: Volatility Breaks

While the hearts and minds of the obvious are getting all beared up, volatility continues to break down. This week’s crash in the VIX was a critical one in our macro model, and it should not be ignored.

The VIX was down -17% on the week, following its -9% week over week fall in the week prior, taking its 2-week crash to -26%. This is why the shorts are being squeezed most materially where they were making most of their money in the months prior – small caps.

This week alone the Russell 2000 had a +3.8% move. With the larger cap Dow being a proxy for “liquidity”, and closing down -0.6% on the week, the real liquidity needed in the US market place was that for the shorts to cover in illiquid small cap shorts.

Everything that matters in our macro models happens on the margin. On this margin, volatility is declining at an accelerating rate, while positive breadth continues to expand. If you add some volume to this Christmas cocktail, you have yourself a relative performance party that few can afford to miss.

Our breakdown level for the VIX is now $51.15 – see the chart below – that’s the bear hunter’s bulls-eye, where support has quickly morphed into stiff resistance for a growing community of consensus bears.
KM

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US Market Performance: Week Ended 12/19/08...

Index Performance:

Week Ended 12/19/08:
DJ (0.6%), SP500 +0.9%, Nasdaq +1.5%, Russell2000 +3.8%

DEC08’ To Date:
DJ (2.8%), SP500 (1.0%), Nasdaq +1.9%, Russell2000 +2.8%

Q408 To Date:
DJ (20.9%), SP500 (23.9%), Nasdaq (25.9%), Russell2000 (28.5%)

2008 Year To Date:
DJ (35.3%), SP500 (39.6%), Nasdaq (41.0%), Russell2000 (36.5%)

DELEVERAGING THROUGH BOND BUYBACK

ASCA, BYD, LVS, MGM, and PNK all have potential debt covenant issues in 2009. BYD and MGM are in the unique position of having the combination of sufficiently lenient credit facility covenants and significantly discounted subordinated debt. Both companies can de-lever by borrowing off their credit facilities to buy back discounted sub debt and retiring it. Both can also sell assets and use the proceeds to retire sub debt subject to certain conditions.

By way of example, MGM borrows $100 million from its credit facility and buys $154 million par value debt trading at 65. The company would have to pay taxes on the gain of $54 million at the ordinary rate, say 35%. Thus, on a net basis, MGM would be deleveraging at $35 million ($54 million less taxes of $19 million) for every $100 million in bank borrowing used to repurchase sub debt. Nobody likes to pay taxes but the penalties of a covenant breach are much more severe.


MACAU VISAS: NO MAJOR CHANGES

Galaxy and SJM, the Hong Kong listed Macau stocks, have been ripping as of late with the US listed Macau stocks doing quite well in their own right. Rumors of Beijing loosening visa restrictions have been the main catalyst. Unfortunately, those rumors are probably unfounded. We still believe visa restrictions will ultimately be loosened, but not until mid to late 2009 when the new Macau Chief Executive takes the wheel.

There is potentially a touch of good news on the visa front. Beijing appears to be allowing higher frequency visitation to high net worth players identified by the casinos. This should certainly help the direct credit business but is not the visa panacea sought by investors.

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