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Bye-Bye, Bernie

It is the end that crown us, not the fight.

- Robert Herrick

Bernie Madoff must be upset.  Here he went to the trouble to make sure everyone knows he perpetrated the greatest financial fraud in history, and he doesn't even come close to the all-time record sentence.

As reported in the Wall Street Journal (29 June, "Madoff's 150-Year Sentence: Long, But Not Longest") "Sholam Weiss received an 845 year sentence for a fraud scheme that took $450 million from an insurance company... In 2008, Norman Schmidt was sentenced to serve 330 years in federal prison for his role in a fraudulent 'high yield investment scheme.'"

Weiss' 845 years, amortized over $450 million, works out to over half a million dollars per year - more than $530,000.  At that rate, Madoff's declared $65 billion fraud should have brought him over 130,000 years in the slammer.  Now that's what we call something To Write Home About!

Compared to Schmidt and Weiss, Madoff hardly even qualifies for the Hall of Fame.  Why did he do it?

What really sparks our interest is: why, when he saw it all crashing around his ears, did Madoff not throw a few hundred million dollars into a duffel bag and travel to some part of the world where they would neither find, nor extradite him?

He is not protecting his family - at least not from legal action.  His guilty plea means he will not have to testify, but there will be intense scrutiny on every aspect of his business - and every person involved - as the civil suits start to unfold over what promise to be a chock-full several years.

So we repeat: why did Bernie cop a plea?

One tale making the rounds is that Bernie lost a few hundred million dollars belonging to some high-profile Russian mobsters.  We find this believable for several reasons.  One is that we have worked on Wall Street long enough to know that there is no type of nasty person who does not have a finger or two in a pie.  Typically, the nastier the pie, the nastier the fingers.  It is crystal clear that everyone who understands the markets even a little recognized that Bernie was violating the rules - if not breaking the law.  There was no other way he could have delivered steady returns year in, year out.  And bad guys like dealing with bad guys - their secrets are safer with someone who has significant secrets of his own to protect.

Another reason - circumstantial, to be sure - is Harry Markopolous' statement, buried in his now-famous correspondence with the SEC, that he feared for his safety and the safety of his family if his work on Madoff's dealings became widely known.  Another is that we have heard this story from people who invested with Madoff.  And don't forget, the unspoken reason the judge permitted Madoff to show up in court in a suit, instead of his prison jumpsuit, is he was wearing a bulletproof vest and could keepit out of sight under his coat.

Judge Chin's sentence of 150 years guarantees that Bernie Madoff will die in prison.  Now it looks to us like the only question is: how soon?

Fighting the Good Fight

Will no one rid me of this meddlesome priest?

Pity poor Sheila Bair.  She is getting kudos from the public - including a smart piece praising her in the current New Yorker magazine (28 June, "The Contrarian: Sheila Bair and the White House Financial Debate").  Bair was just honored with the Profile in Courage Award from Boston's Kennedy Library Foundation - awarded annually to public officials that the Foundation deems to have "exhibited political bravery."  Bair, the article reports, "was recognized for her early, though ultimately futile, attempt to get the Bush Administration to address the subprime-mortgage crisis before it became a threat to the entire economy." 

Bair is on the move.  She has started laying down the law to newcomers, letting them know in no uncertain terms whose territory they are now on (WSJ, 3-5 July, "FDIC Proposes New Bank Rules").  Bair is proposing new standards for firms that want to buy into the banking business, including greatly increased capital reserve requirements, and what many are calling an unreasonable proposal that buyers from outside the banking industry not be given a green light to buy banks merely to flip them.

Bair is struggling to maintain her balance atop a stack of shifting tectonic plates.  As private equity discovers banking, Chairman Bair is trying to create rules that will protect the remnants of the banking system from the worst of the private equity abuses.  Who would have thought that a US regulator would attempt to inject a note of caution into the business of banking?

As the New Yorker article points out, Bair is hardly your typical Washington Insider, and is that much more of an outsider in the current administration.  The political process that continues to unfold is highlighted by recent stories about the promotion of William Dudley to the position of president of the New York Fed, the post vacated by Timothy Geithner when he became Secretary of the Treasury.

As reported in the Wall Street Journal (2 July, "Fissures Appear At The New York Fed"), a number of New York Fed directors were not pleased with Geithner's obvious efforts to push Mr. Dudley into the role.  Dudley, it should be noted, is a former Goldman Sachs economist.  He stepped into his new role shortly before the eruption of publicity surrounding New York Fed board chairman Stephen Friedman, who had not disclosed his trading in the stock of his former employer - Goldman Sachs - despite requirements that he do so.  "Some are calling for more oversight of both the reserve banks and the central bank," reports the WSJ article.  We wonder who shall do this overseeing.

It is clear that Tim Geithner has been given the go-ahead to create a new financial system.  Nor do we perceive the influence of Goldman on the wane in the Business As Usual initiatives of the current administration.  (Business As "Use You All"?).

In short, FDIC Chairman Bair is facing extremely long odds.  She is being set up by the Old Boys' Network.  The Journal article quotes billionaire investor Wilbur Ross as saying Bair's proposed new requirements are "harsh and discretionary."  Ross, part of the consortium that acquired Florida's failed BankUnited, now says "I think it could guarantee that there will be no more private equity coming into banks."

First, given the current model and primary players in the private equity business, we fail to see that as an unmitigated disaster.  Add to that the reality that the government is handing out incentives to buyers who neither come from, nor care to understand the banking business, merely to get someone to take the liability off their hands.  Finally, the incentives come with a powerful precedent and an implicit guarantee that, if the bank fails again, there will be a bailout.

Which lands these future disasters right in the lap of the FDIC.  We note that the Journal article is flanked by a column headed "Tally Hits 52 As Regulators Close 7 Banks."

In the world of things that ain't over till they're over, this ain't anywhere near over.  Chairman Bair is collecting bids to acquire failed banks, and she has already seen a few that didn't pass the smell test.  We are rooting for her to stick to her guns - we just wish the President would give her a much bigger arsenal.  We fear Chairman Bair will be beaten from all sides by the fairy tale that she is single-handedly impeding the recovery.  That, if not for This Meddlesome Regulator, the billions sitting idle in private equity coffers would come charging in off the sidelines and win the day.

The fact is that private equity is not the gem of the investment world it once was.  There is idle cash lying around because deals are going too cheaply, or because investors are clamoring for the managers to stop screwing up with their money - all while demanding greatly reduced fees.  Is it any wonder the private equity guys are looking for new fields to furrow?

The final paragraph of the Journal story tells us "Ms. Bair said she remained open to make changes on most parts of the proposal."  We would hate to think that, now that the crush is coming, Sheila Bair is preparing to bend in the political wind.

The Long And The Short Of It

The New York Times (3 July, "SEC May Reinstate Rules For Short-Selling Stocks") reports that the Commission looks set to bring back the Uptick Rule, abolished by the Commission under Chairman Cox in 2007. 

The Rule, voted out based on studies that seemed to show it had no effect on market stability, is on the political agenda.  According to the Times, House Financial Services Committee Chair Barney Frank is pushing SEC Chair Schapiro on the issue, as is Delaware Senator Edward Kaufman, who has introduced a bill to reinstate the Rule.

It appears that reinstating the Uptick Rule will end, at least temporarily, the long-winded discussion over short selling circuit breakers.  This is presumably good news on many fronts - not least for the politicians themselves.  It will enable Frank, Kaufman and others to show instant action on a subject that they have made sure is uppermost in the minds of their constituents - even those who do not know what short selling is. 

Underlying the battle over short selling is the fairy tale about unfettered growth.  "Think and grow rich," wrote Napoleon Hill.  The mantra of both Wall Street and Washington is, "Let us do the thinking - and you'll grow rich."

Under the mysterious machinations of the Maestro - Alan Greenspan - the nation was lulled into a sense of entitlement.  All we had to do was buy stuff, then sit back and wait for it to go up in price.  Then we bought more stuff.  Then we used that as collateral and leveraged it to buy still more.  Irrational exuberance - shamelessly promoted by the most irrational of them all - led us to where we are today.

Short sellers have long been seen as un-American.  As a balance, we offer a piece from this weekend's Wall Street Journal (3-5 July, "New Evidence On The Foreclosure Crisis"), in which Stan Liebowitz, of the University of Texas, Dallas, argues that the greatest single contributing factor to the foreclosure crisis was not subprime loans, but zero money-down mortgages.  The incidence of defaults among zero money-down mortgages far outweighs those among subprime, NINJA ("No Income, No Job or Assets"), or "liar" loans.  The Mortgage Bankers Association's own statistics show "that 51% of all foreclosed homes had prime loans. Not subprime, and that the foreclosure rate for prime loans grew by 488%, compared to a growth rate of 200% for subprime foreclosures."  What, then, is determinative?  In the figures quoted by Professor Liebowitz, the twelve percent of homes having negative equity accounted for 47% of all foreclosures. No skin in the game.

This is the new American Dream: working for what you want, and keeping what you build, has been replaced by Something for Nothing.

Something for Nothing became the driving force behind Wall Street.  In the 1980's and 90's, tens of thousands of young men flocked to Wall Street where the business was fueled by OPM - Other People's Money.  No one has had skin in the game for a generation.  No one except the customer.  And now - as a result - the taxpayer. 

Regulators and brokerage managements insisted that financial salespeople not invest in the same instruments they pitched to their customers.  Under the guise of Conflicts of Interest, the purveyors of investments were insulated from the negative effects of owning them.  Investment banks, meanwhile, created product - in the form of deals and public offerings - promoted them through their own in-house advertising agencies - research departments - and pumped them through their own distribution pipeline - the brokers.

Ultimately, that model caused a global crash - because not everyone can get out the exit at the same time.  Short sellers, dubbed unpatriotic because they take up permanent residence outside the exit, are our society's Mark of Cain.  In a culture that has confused Owning with Creating, it is virtuous to possess.  It hardly matters what - just go out and obtain something.  If you can not afford it, we will arrange for you to borrow the money.  Or you can buy it with OPM.  Or, as Professor Liebowitz' research indicates, if you can not afford it, we will give it to you anyway.

In a seemingly unrelated story, the Wall Street Journal had a front-page item (1 July, "Finance Lobby Cut Spending As Feds Targeted Wall Street") saying political contributions from Wall Street to Washington are down a whopping 65% in 2009, as compared to 2007.  Also, there has been an upward trend in giving to Democrats over Republicans - which only makes sense when you consider a random list of Dems in a position to exert influence on Wall Street: Barney Frank, Chuck Schumer, Chris Dodd, Henry Waxman and Barak Obama come to mind, just to name a few.  By making the fuss about short selling go away, Frank and his cronies hope to emerge as the good guys in this debate.

Clearly, the outcome most devoutly wished by all is a return to Business As Usual - investment bankers will return to doing deals, private equity will gobble up banks, brokers will go back to cramming deals in their customers' accounts, and the money will flow back from Wall Street to Washington. 

Folks, short sellers are not the heart of the problems facing the world's economies today.  The real question is, who will rein in the Long Buyers?

Coded Messages

Just walk 'round like you own the place.  Always works for me.

- Dr. Who, "The Shakespeare Code"

First, do no harm.  Then, when they're not looking - f*** 'em where they breathe!

This was the text first considered for the new Code of Ethics for new MBA graduates.  After due consideration, it was shelved in favor of a somewhat more flowery text that includes such notions as protecting the interests of shareholders, managing one's enterprise in good faith, and taking responsibility for one's own actions.  We especially like the undertaking to "understand and uphold, both in letter an in spirit, the laws and contracts governing my own conduct and that of my enterprise."  Considering how many folks get to squirm out of a tight spot by pointing to inconsistencies in the black letters of law or contract, it would be a welcome breath of fresh air to have managers one could actually rely on to interpret such documents for the benefit of the enterprise.

Now (WSJ, 2 July, "Adviser Adopts Cuomo's 'Code Of Conduct'") Pacific Corporate Group Holdings LLC has voluntarily signed on to NY Attorney General Cuomo's new document, the Code of Conduct.  In so doing, PCG "also will return $2 million in fees it received from the New York State Common Retirement Fund."  As has been earlier reported, both the Carlyle Group and Riverstone Holdings have signed this documents and made payments to the State of New York.

The Code of Ethics is now a requirement for investment advisory firms, and brokers and hedge funds have long wrestled with the compliance manual, endlessly supplemented by memoranda and addenda.  This cumbersome document is almost never read by any person to whom it pertains, but read in meticulous detail by examiners who pick apart every sentence and now actually quiz employees on its content, and on how the prescribed procedures are implemented.

The Code of Ethics is a sort of pre-consent decree.  Regulators often have a hard time proving a case, but at a certain point it becomes compelling for both sides to seek a settlement. So the firm, or individual, pays a fine and enters into an agreement "without confirming or denying" the charges.  They then promise that, even though they do not admit that they violated a rule or broke a law, they will not violate that rule or break that law in the future.

This has now led to the Code of Ethics, where firms and employees sign a document in advance of engaging in any business, affirming that they will not break the law.

This process of regulatory creep goes on constantly.  In an ideal world, it would be a positive.  Regulators who were well versed in the industry would fine tune their approach as the industry evolved.  Over time, regulators in the field would report a consensus that the industry had changed, and the commissioners and senior staff would review rules and procedures accordingly.  From this process would evolve Best Practices.  New rules would be drafted, and old ones scrapped or modified to keep pace with reality.  This would keep the rule books lean, and the rules and practices current.  It would achieve buy-in and self policing from the industry and would benefit all.

Until the SEC and FINRA drop the pretense of knowing what they are doing and actually hire large numbers of people with real industry experience, regulatory creep will ensure that old rules stay in place - and stay old - while new rules will continue to display a tin ear with respect to the marketplace.  In the current political environment, the regulators are too busy appeasing special interests. Ditto the White House and Capital Hill. 

Check out this howler from the Wall Street Journal (2 July, "SEC Plan Aims To Better Foretell Risks") in a description of new rules proposed to regulate executive pay.  "The proposed compensation rules would require public companies to disclose information about how compensation policies can lead to increased risk-taking and explain how those risks are managed.  Companies would only need to provide this information, however, if the risks could have a material effect on the business."

When is disclosure not disclosure?  When it's not material.  Who gets to decide when an item is material?  Well, since the company itself will not have to make a disclosure unless it is material, logic dictates that the company itself makes the determination as to materiality.  After all, no one but the company itself will ever have access to this information.  Why did we just bother using taxpayer resources to discuss and propose a rule designed to enshrine in statute a company's prerogative to scam its shareholders?

MBA students are lining up to swear an oath of morality, integrity, and good business practices.  Why aren't their professors telling them that it puts them at an immediate disadvantage in the careers they are preparing for?

Moshe Silver

Chief Compliance Officer