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Courting Trouble

"There is such a feeling among people, among regulators, among the political system all over the world, against the banking system, and I don’t think that’s going to change so soon."
- Sanford Weill

A fish stinks from its head – but it swims from its tail.

The markets need leadership from the political class, but they will only thrive once they regain the confidence of their weakest participants. When the small retail investor trusts the market, the world trusts the market. This is something even Sandy Weill understands.

So why doesn’t Washington?

This nation continues to suffer a twin crisis of leadership in Washington, and of confidence on Main Street. Congress and President Obama both deserve a sound thrashing for their refusal to introduce sanity to the financial markets. Six years into the Financial Crisis (and counting…) we are no nearer to a level playing field, to a powerful and effective regulator, to actively extricating Bad Actors from the industry or to creating transparency in the markets. Like so much else on your television screen today, this will not end well.

In a legal case that may determine the future of capitalism, a federal appeals court in Manhattan was the scene of a hearing last Friday which produced the bizarre spectacle of a government regulator coming to the succor of a company it has just charged with a billion-dollar fraud.

Our recent book, Fixing A Broken Wall Street (http://tinyurl.com/cqgter9) lays out the history of Citibank and its current SEC case in lurid and angry detail, and spells out its implications for America’s credibility. As the next chapter in this nasty saga is played out, the future of capitalism hangs in the balance.

Judge Jed Rakoff (pronounced RAKE-off) of the Federal District Court in Manhattan has criticized the SEC. In 2009 he refused to approve a settlement between the SEC and Bank of America over alleged misleading proxy disclosures when BofA acquired Merrill Lynch. Judge Rakoff argued that the settlement did not disclose who was responsible for the misinformation, that the settlement did not cure the problems the SEC claimed existed at BofA, and that the amount of the fine was miniscule, compared to the financial damage suffered. Adding insult to injury, the Judge observed that the fine was to be paid by the shareholders – the putative injured party.

In November 2011, Judge Rakoff rejected a proposed $285 million settlement of SEC charges that Citigroup had committed a $1 billion fraud. Rakoff complained that the settlement provided no details of the alleged behavior, no indication of the profits Citi earned from the transaction in question – and thus no measure of reasonableness of the settlement amount – no indication of which Citi employees or executives were implicated, and no provision for a cure of underlying problems that gave rise to the SEC case.

Judge Rakoff ordered the SEC and Citi to prepare for trial, saying it was in the public interest that the case be heard in full. No sooner was the ink dry on the Order, than the parties filed for injunctive relief. The SEC and Citi joined forces seeking a court order to require him to stand down. On Friday they had their day in court – literally.

The SEC argued that Rakoff’s rejection of the settlement “conflicted with a century of judicial practice” (NY Times, 9 February, “Judge’s Rejection of Citigroup Deal Is Heard on Appeal”) and that “The court failed to give the SEC any deference.”

Regulatory agencies obtain court orders so they can enforce the terms of a settlement in the event of repeat infractions, and courts routinely sign off on settlements. In practice, though settlements contain language prohibiting repeat violations, those terms are never enforced. Firms can repeat the same violations and only have to pay another settlement. Since they settle “without admitting or denying” the allegations, you cannot say legally that a firm “committed fraud” and you especially can’t say they “committed the same fraud again.”

The theory behind settlements is judicial economy: court hearings drain taxpayer money and lengthy proceedings tie up critical legal resources. Outgoing SEC enforcement chief Robert Khuzami came to the Commission vowing to obtain more, and bigger settlements. Khuzami has won lots of settlements – and headlines. But the willy-nilly settling of every fraud case has gotten to the point where, far from preventing fraud or punishing crime, the government has become a partner in the questionable dealings of the world’s largest financial institutions.

Where’s the political will to force change? Look at another recent example and cringe.

HSBC bank is the third-largest publicly-traded bank, and the sixth-largest public company in the world (Forbes, 2012.) The bank recently agreed to pay a $1.9 billion fine and acknowledged that for years it permitted “narcotics traffickers and others to launder millions of dollars” throughout its global system. “Millions” is an understatement.

The Justice Department says HSBC took in more than $ 15 billion in unexplained cash deposits “in Mexico, Russia and other countries. In some branches the boxzes of cash being deposited were so big the tellets’ windows had to be enlarged” (The Guardian, 14 December 2012, “HSBC Money Laundering Fine.”) Entities for which HSBC is reported to have laundered funds include Colombian and Mexican drug gangs, and the Iranian Revolutionary Guard – the backers of Hezbollah (see our Screed of 23 July 2012, “50,000 Dead Mexicans Can’t Be Wrong.”)

The $ 1.9 billion settlement represents about 25% of HSBC’s annual profits, so it will have little effect on the bank’s operation. Senior HSBC executives said they were “profoundly sorry.”

There is a high likelihood that HSBC’s money laundering activities were implicated in the murder of US citizens. Mexican and Colombian drug gangs have killed tens of thousands of Mexicans and Colombians, but they also kill US citizens. Since the drug money in question originated in street sales in the US, there is an inevitable link, not merely to the killing of the odd DEA agent or border

police officer – and not only to Mexican-American gang members in Los Angeles – but to street violence here at home. We wonder why the politicians who are challenging the President’s drone memo are not calling for harsh measures against HSBC.

Oh – silly us! Now we remember.

Assistant US attorney general Lanny Breuer said the consequences of criminally prosecuting HSBC would be “dire” – it would cost jobs and risked destabilizing the global banking system.

As to the jobs issue, we are confident the FDIC could figure out a way to keep HSBC’s domestic US business humming – a perfect opportunity to bring Sheila Bair back as Treasury Secretary. As to the global piece, we are not sure how the government defines “destabilize,” when the global banking system is already the prime conduit for funneling cash to Iranian-funded terrorists and Mexican drug lords. This is no doubt a highly specialized use of the term, a degree of nuance known only to legal minds on the level of Mr. Breuer’s. What practitioners call “a term of art.” Where’s the political will to do something about failures in the system?

In 1998, Citigroup sprang whole into glorious, robust life, born from the mind of Sanford Weill like Botticelli’s Venus. It was ably midwived by Alan Greenspan and Robert Rubin, while the slap that started it breathing was administered by President Clinton. This entailed revoking the Glass Steagall Act and ultimately led to the Commodity Futures Modernization Act, making it illegal for the government to regulate the futures markets. It’s been Off To The Races ever since.

The judicial economy argument for settling cases is to keep court resources available for really important matters. Under this rubric, there can be no more important use of judicial resources than to determine whether Citigroup committed financial fraud. This is the entity for which major laws were uprooted, new laws brought into existence, and the entire structure of the marketplace and the economy turned on its head. The Citi case is a veritable laboratory of 21st-Century American Capitalism. The transaction that laid the foundation for the contemporary financial marketplace – and for the crisis that continues to plague us.

We say America is entitled to the full story on Citi. A full hearing should determine whether such an entity should – or even can – exist; whether it is possible to implement sufficient internal controls; how such an entity should be regulated – or whether it is ultimately not possible to oversee a marketplace dominated by behemoths. It would also reveal weaknesses in the current regulatory regime and help create a roadmap to restructuring the SEC. No wonder the unholy alliance of Citi and the SEC are desperate for a court-ordered stay.

Folks, it doesn’t get more important than this.

A strong decision in favor of Judge Rakoff will lay the groundwork for the incoming SEC chairman to get serious about restoring credibility to the markets, and should send the same signal to Congress. A decision against Judge Rakoff will be clear abdication – the regulatory equivalent of the Lehman bankruptcy.

Our lawyer friends think we’re overreacting. They say it will be tough to convince a court to push back against a federal judge. We hope they’re right. Until then, we seek in vain for a policy of Zero Tolerance.