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Swiss Cheese
We notice that Swiss banks are suddenly buying US Treasury bonds by the cartful. Could this be a sop to get the US to back off the UBS client list?

Chief Anti Money Laundering Compliance Officers take note: The US authorities pushed for the establishment of offshore relationships for major money center US banks in the 1960’s. The unstated, but very real purpose was to create a captive market for US Treasury debt. Illicit funds that domestic US banks could not take in as deposits, could go to these arms-length relationship banks. Laundered proceeds of arms dealing, drug dealing, and other Dark Arts could safely go to banks in certain Caribbean nations. Those local banks, in turn, through their New York correspondents, would buy up Treasurys for their portfolios.

If you wonder why certain dicey jurisdictions are treated with kid gloves, while the Swiss are suddenly Public enemy Number One, you might look at the Treasury Department’s list of Treasury Bond holdings by country. As of year-end 2008, the Chinese held $727 billion of our debt, the Japanese $626 billion. Third on the list is an entry that reads “Caribbean Banking Centers”, with $197 billion. Switzerland ranks eleventh, after Taiwan, and with half of the Treasury holdings of Russia ($116 billion) or Brazil ($127 billion), clearly, the Swiss can do more.

Switzerland’s holdings of US Treasurys went from under $44 billion in June of 2008, to above $62 billion at year end. This 50% increase is still a rather small percentage of total assets on their books. US authorities appear not to care that the Swiss Franc is itself a reserve currency. With the top ten Swiss banks holding assets on the order of three trillion US dollars, having the entire Swiss banking system hold only $62 billion looks downright… un-American.

The US push to shake loose tens of thousands of confidential account relationships looks like extortion designed to force the Swiss to put more assets at work in our marketplace. After all, we can’t count on the Chinese to do all the heavy lifting. In addition to all the other wonderful financial things our Government is doing, are we now vying to be the Money Launderer of Last Resort?

Swiftian Justice
Laws are like cobwebs, which may catch small flies, but let wasps and hornets break through.
- Jonathan Swift
On March 4, the SEC announced a success in a long-running litigation against 14 specialist firms. The firms in question have collectively agreed to pay $70 million in disgorgement and fines, versus alleged customer harm on the order of $58 million or more.
The SEC’s complaint charges these firms with Trading Ahead – which is filling a customer order from the firm’s proprietary account while holding matchable customer agency orders; Interpositioning – which is filling the outstanding matchable agency order from their own account, after having traded ahead; and Trading Ahead of Unexecuted Orders – which is not filling the customer order and taking the trade for the firms own account.
In addition, the regional specialist firms in the inquiry were alleged to have traded against their customer orders by executing trades on the NYSE that, since they were not recorded in a customer trades blotter, looked like firm proprietary trades. It’s not Bernie Madoff, but it ain’t good.
The activities took place during the period 1, which means that it has taken ten years, since the initial infractions, to build and prosecute this case through to its conclusion. We are not sure whether this qualifies as Swift Justice, but the irony is not lost on us that customers are not being protected by the agency.
But it gets better.
The $70 million that the SEC collects will go into their coffers. Face it, how complicated is it to figure out, customer by customer, trade by trade, who lost what? The firms will pay out, the SEC will add $70 million to its bankroll for the year, and in their year-end report for 2009, they will point to this as a significant achievement.
It is a signal irony of the regulatory process that people never get punished, but only told they must share the wealth. The Consent Decree in the case means that, even though they are paying out millions, the firms in question are neither affirming nor denying their guilt. And their further punishment? An order will be entered saying that, in the future, these firms are not allowed to break the law.
We will bet a very large nickel that, even after paying out on this consent decree, the firms all booked substantial profits on the practices in question.

Regulatory problem – why this happened, and why it will happen again: the exchanges do not share information with each other. We have been given to understand that the SEC will close the matter after taking the Specialists’ money. It should not stop there, because the regulatory mechanism that permitted this to occur has not been remedied.

We do not need to fault the exchanges individually, but we observe that, despite having the same market participants trading across multiple exchanges, the exchanges do not share oversight information. Specialists executing improper trades on the regional exchanges were doing closing, or layoff trades on the NYSE. Since neither exchange saw the entire transaction, these illegitimate transactions looked like proprietary trades. Had the exchanges matched their blotters and the customer orders on the specialist books, many of these illicit practices would have been run down and the firms disciplined.

So far, the SEC has not required the exchanges to share this information. This looks like a typical – and major – lapse on the part of the regulators. Closing this gap would eliminate the loophole that made this abuse possible in the first place.

Are we missing something?

Too Big To Regulate
It is a maxim among these lawyers, that whatever hath been done before, may legally be done again: and therefore they take special care to record all the decisions formerly made against common justice and the general reason of mankind.
- Jonathan Swift

We have been eavesdropping on the global jaw-jaw over introducing a new financial regulatory regime. We would not characterize this as a Dialogue. It is more a cacophony of monologues, with each group, political party, and government telling everyone else why We are Right and You are Wrong.

We do not pretend to have the global solution for the ills that have beset our markets. We are mildly amused at, for example, Senator Schumer – a longtime Wall Street groupie – who is shocked to find rampant greed-fueled speculation driving the financial industry. So far his major overhaul of the system appears to consist of merging the SEC and the CFTC (an awful idea that will leverage the inefficiency of the SEC and extend it to a market they have heretofore not been able to neglect); to adding one hundred junior-level lawyers to the SEC staff (giving the incompetent senior lawyers fresh meat to train in all the tried-and-untrue methods of not following up on leads and tips); and moving the SEC from Washington to New York City (now that DC has a voice in Congress, let’s not let this crisis go to waste).

We will make one fundamental observation, and we hope those who make laws and rules will bear it in mind.

In the 1980’s and 1990’s, large brokerage firms beefed up their compliance departments to keep the regulators at bay. Many of the largest and most successful firms of that era, all household names at the time, no longer exist. Many were absorbed into Citi – itself teetering on the brink of a black hole. Then, there were whole floors in major Manhattan office buildings staffed with lawyers and paralegals. A typical day for a typical mid-level compliance attorney at these firms included multiple Trades Reviews. The reviews would consist of a computer printout being placed on the lawyer’s desk first thing in the morning. These printouts were often a thousand pages or more, each page would have scores of customer trades. The evidence of the review consisted of the attorney signing the cover sheet. The blotter would then be packed up at the end of the day and shoved into a file drawer. After two years, it would be taken from the drawer, packed into a Banker’s Box and sent to a warehouse in Jersey City.

The sheer volume of transactions, by its nature, overwhelmed the human capacity to know what was going on. Permit your correspondent to step out of the Editorial We for a moment and explain a bit about my background.

As a branch manager and compliance officer for retail brokerage firms, my daily routine focused on the blotter. I started my day with the prior day’s trades before me – when I ran compliance for a retail firm with 350 producers, doing over $100 million in commission business a year, I nonetheless made it my business to look at every trade in every account, every day. To be sure, there were things I missed. But it was not for not looking for them.

These hands-on, close to the ground daily reviews are what give supervisors the ability to know when something is wrong. The supervisor gets to know the patterns of trading by broker, by customer, by trading desk, and by security. When the brokerage firms got so large that the reviews were taken off the branch manager’s desk and shifted upstairs to the attorneys, it was the signal that things would never again work properly. You can not tell when something looks wrong if you don’t know what it looks like when it is right.

Today’s failed financial institutions are not Too Big To Supervise. And since the regulatory system runs on a daisy-chain of Reliance, they are Too Big to Regulate. If there were ten times – or fifty times – or a hundred times the supervisory personnel in these institutions, and if they took the trouble to get to know what really went on on their watch, these organizations could be viable. The morphing of the format of business data from individual transactions – be they stock trades, investment banking mergers, or negotiating asset-backed contracts – to computer runs that are checked by upstairs staffers, takes the oversight out of the hands of those who understand how the transaction work. There are very few problems or conflicts that can not be addressed, once you have full information and seasoned managers to process that information. When the ratio of a firm’s information to its managers’ ability to digest that information gets out of whack, the firm is a prime candidate for implosion, regardless of its business mix.

Industries whose major players all grow on this model will collapse sooner or later, as will the societies that stand upon them. There is no substitute for Hands-On oversight.

Of Pots And Kettles
Wall Street indices predicted nine out of the last five recessions.
- Paul A. Samuelson
Latest in the category of Why Are They Reporting On This As Though It Were News? – The Wall Street Journal (11 March, “Obama, Geithner Get Low Grades From Economists”) reports “A majority of the 49 economists polled said they were dissatisfied with the administration's economic policies.”

Showing that even the Wall Street Journal can be fair to Messrs Obama and Geithner, the article also says “The economists, many of whom have been continually surprised by the depth of the downturn, also pushed back yet again their forecasts for when a recovery would begin.” In other words, their predictive acumen has not sharpened measurably since Professor Samuelson made the above observation.

This is a bunch of guys who – like Jim Cramer – get paid not to guess correctly, but just to guess. Forty-nine professional economists criticizing President Obama’s economic policy is like Alice Cooper critiquing Boy George’s wardrobe.

The Wall Street Journal paid someone to write this story, and ran it with a headline that seems to imply a group of experts are telling us we voted for the wrong President. You paid two dollars to buy the paper and spent several minutes of your time reading it. People discussed it all weekend as though it has meaning, and some are now lamenting the day they voted for Barack Obama. The Journal will, no doubt, be able to reference it as it gloats over President Obama’s declining poll figures. None of which has any bearing on whether or not this Administration’s policies will be effective.

With articles like this, the media tread ever closer to the Event Horizon of the Black Hole of meaninglessness. At least they can still sell newspapers. Of such things are public opinion made.