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Here Come Da Judge

It’s the oldest-established, permanent floating crap game in New York.

                   - “Guys and Dolls”

In a giggle-inducing wire-crossing of intercultural word-play, December of last year saw a $300 million settlement between the federal government and the founder of on-line poker phenomenon PartyGaming.  The co-owner of what was by far the world’s largest poker room had not been charged with any crime.  Nonetheless, he agreed to plead guilty to one count of violating the Federal Wire Act, and to forfeit $300 million, on the basis that he “could be charged with a crime in the future.”  Unusual as the settlement may have been, it was clearly the unusual name of the protagonist – A. Dikshit – that excited press coverage, as much as the legal fine points of the case.  The judge in charge of the proceedings was Jed Rakoff – pronounced “RAKE-off”, we were told – which is exactly what gaming parlours the world over have been doing since time immemorial.

Now Judge Rakoff finds himself assigned to a case in which the stakes are orders of magnitude larger.  At the heart of this case is a man perhaps even lass fortunate than the Judge’s previous defendant.  The poker entrepreneur had the misfortune to be named Dikshit – with the understandable consequence that the media mentioned him almost as frequently as the Democrats referred to the fact that Dick Cheney’s daughter is a lesbian. 

Judge Rakoff is now faced with a man whose name is not at issue, but who has the still greater misfortune to actually be Ken Lewis, the CEO of Bank of America who has managed to add insult to injury by not only spending his shareholders’ money in the acquisition of a multi billion-dollar black hole called Merrill, but has now managed to agree to buy off the SEC with $33 million of shareholder hush money.

Judge Rakoff, to his credit, isn’t having any of it.  He has given the parties – the SEC and Bank of America – two weeks to come up with the goods.  And, as the ads for the National Enquirer used to say: I want to know.  Inquiring minds want to know who actually lied to shareholders; who made the decision not to reveal the additional Merrill losses, which were known about before the closing of the transaction; who within Bank of America made the determination that the additional few billion in losses were “not material”; how the SEC and Bank of America arrived at the number of $33 million, and who at the SEC was responsible.  In refusing to sign off on the settlement, the Judge made reference to the fact that, having cost the shareholders a bundle, some persons inside the bank were now getting the shareholders to cough up another bundle to make these sins go away.

The speed with which the SEC pushed this matter to a close is disconcerting.  There was no information produced – not to the public, anyway, and especially not to BofA’s shareholders – even by Wall Street standards, it is pretty startling to watch the SEC sweep this under the rug.

What political agenda can Chairman Schapiro be running on now?

We understand that pursuing this in a thoroughgoing investigation might end up implicating former Treasury Secretary Paulson, current Secretary Geithner, Fed Chairman Bernanke, not to mention making the members of Congress who pushed for approval of the funding to backstop the BofA / Merrill transaction look stupid.

We understand that all of this would create turmoil in the Washington/Wall Street nexus and might even call into question, in highly public fashion, President Obama’s blithely fostering continuity of the Goldman Sachs dynasty in government, and the way in which he throws himself swooning at the bankers, all the while doing his pitchfork dance over things like “disgusting” bonuses.  It might make people question why, before the government had actually acquired its stake in GM, he felt ballsy enough to fire that company’s CEO, but didn’t even give UAW head Gettlefinger a public dressing-down.  It might even cause some folk to ask why President Obama has so far raised nary an eyebrow about Treasury Secretary Paulson inviting Goldman CEO Blankfein to participate in planning the euthanasia of Lehman.

Judge Rakoff will need to take his publicity where he can get it, and being mentioned in the same breath as some of those who have appeared before him is decidedly not a publicist’s dream.  The Judge’s actions in the present case indicate he is more interested in the law of the land, than in the SEC’s political aspirations.

Stay in there, Yer Honor!  We’re rootin’ fer ya.

Classical Gas

In the spirit of shameless self-promotion we wish to point out that the featured story in Friday’s Wall Street Journal (14 August, “ETF Looks To Escape US Reach”) was one we not only could have written – we essentially did write it.  Some months ago.

The Journal reports “US Natural Gas Fund, the giant exchange-traded fund, is exploring ways to avoid regulators’ cracking down on speculation.”  It has been clear that this showdown was coming. 

With the CFTC moving aggressively to curb speculation – and as we have previously reported, ETFs are by definition speculators – it was a no-brainer that natural resources ETFs would soon be under the gun.  Add to that the tightening in the natural gas market, as reported in the press – and as commented upon in these scrivenings – it should surprise no one that “the fund is considering moving to offshore energy exchanges or further into unpoliced over-the-counter swaps markets to avoid Commodity Futures Trading Commission rules that would limit the size of natural gas positions.”

The FT article quotes UNG Chief Investment Officer John Hyland as stating the ETF’s probable next step will be to increase its use of over-the-counter products.  “The fund already has about 5% of its assets in swaps,” and may diversify by buying crude oil, heating oil, or gasoline.

This points to two problem scenarios for ETFs in general.  We would call it the unintended consequences of government meddling – except that even we can not believe the government is so stupid they couldn’t have seen this coming.  This would make it, then, the intended consequence of government meddling.  What interest does the US government have in forcing ETFs to seek far and wide for hospitable trading venues?

To the extent natural resources ETF managers want to remain in their air-conditioned offices, they will need to find replacement trades.  We can envision a scenario where a successful ETF doesn’t want to just shut down and hand back investor cash – they don’t get paid for the money they return.  If the CFTC gets its way, it will clamp down on trading both of underlying physical commodities, and of certain futures contracts.  Shutting the door on near-month contracts, for example, will cause what the old Playtex Living Girdle ads used to call “an unsightly bulge” in far-month contracts, as the ETF managers synthesize new positions to replace the contracts they can no longer trade.  Trading in UNG has already breached the stability barrier touted as the benchmark of an ETF – demand for the shares themselves has outstripped the manager’s ability to do new creation trades, and the price of the shares has fluctuated based on actual demand for the shares, rather than benignly reflecting price movement in the underlying commodity.  We predicted this phenomenon some time ago, and we believe the UNG example should call into question the whole notion underlying ETFs, that ETF creation and liquidation trades somehow do not affect their underlying components.  As to the present political tug-of-war – do we think that forcing ETF managers to seek out new twists, different markets and queer synthetics to replace these instruments will disrupt pricing in the world’s energy markets?  It takes two to contango.

Next case: as more and more energy ETFs look for more and more places to do swaps, more and more firms will want to be on the other side of those contracts.  Somewhere along the line – trust us on this one – there will be some substantial ETF that will have some substantial position in some swap whose counterparty does not have the capital to unwind the transaction, and is betting on things to be the same tomorrow as they were today.  There will be some major disruption which, though brief, will cause enough displacement in the markets that the ETFs will have major liquidation-creation cycles.  Needing to husband the physical resources, the first place the ETFs will look for liquidity will be their swap contracts, and there will come a moment when one or more counterparties are unable to unwind.

The ETFs will try to keep their positions in the underlying and do all their liquidity maneuvering in the future and swaps markets, for fear that, once they let actual oil out of their grasp (or gas, or gold, or silver, or pork, or… ) they will be prevented by regulatory restrictions from ever getting their hands on it again.

This business will predictably be great for financial firms that can do the swaps – did we mention that CFTC Chairman Gensler is a former Goldman partner? – and will be deadly for firms that jump in without proper capital, and for the ETFs that, desperate to continue to grow their asset base, trade with them. 

Finally – or perhaps first, as the Journal article points out – as the CFTC tightens its grip on natural resources trading, more and more natural resources ETFs will look for less encumbered jurisdictions.  They are not likely to find succor in the EU – witness the rumblings from the French and the Brits about controlling the price of oil.  This means they will have to seek out more hospitable places to trade.

Where will a growing natural resources ETF go to trade its underlying commodity when the US and Europe no longer will permit it?

One obvious place to look is parts of the globe that are eager for business, and that have a vested interest in seeing the commodity in question trade actively.  We would hardly be shocked to see ETF managers heading off on global jaunts.  Did we mention that Russia is home to the world’s largest proven gas reserves?  Or that Kazakhstan, number eleven on the list, is kindly disposed to talking to the West?

Or that the country with the world’s second largest proven natural gas reserves is Iran?

Hedge Fund Of Last Resort

If the size of your bundle you want to increase,

He’ll arrange that you go broke in quiet and peace…

-         “Guys and Dolls”

The Financial Times ran a piece (10 August, “New York Fed In Hiring Spree”) describing the New York Federal Reserve Bank’s new expansion program.  The FT reports that the Bank “ is aggressively hiring traders as it seeks to manage its burgeoning securities holdings, making the central bank one of Wall Street’s most active recruiters of financial talent.”  Indeed, the plan is to add 400 new hires to its markets group by year end.

This is significant, as it is the markets arm of the New York Fed that actually implements monetary policy.  When Chairman Bernanke says “add liquidity to the system”, it is traders at the New York Fed who rush out and purchase Treasurys – or who sell gobs of them when the Chairman orders a tightening.

New York City officials estimate that the financial sector will end up shedding as many as 140,000 jobs, which makes the pickings particularly ripe for those looking to scoop up traders.

The article quotes a Fed official as saying they have implemented programs that are “clearly outside the traditional credit-easing tools” that have been the Fed’s normal course of operation.  In recognition of the Brave New World in which they find themselves, the determination was made that new people – and new skill sets – need to be brought in to better manage credit risk.  This is also in recognition of the sheer quantity of securities the Fed has purchased recently – the FT states their assets have more than doubled in the past year and now exceed two trillion dollars.

Who is going to ride herd on that bundle?

But there is another question – and the answer might be more disturbing even than you think.

New programs already implemented at the New York Fed range from “first-ever purchases of mortgage-backed securities to lending money to hedge funds to buy securities backed by loans.”

The entity that, if the Obamam / Geithner plan is approved, will become the Systemic Risk Supervisor is in danger of, itself, becoming one of the greatest sources of systemic risk.

How will the Fed manage its plethora of new programs?  The Fed looks like it will be funding just about everything.  And it will provide the liquidity to support a two-sided market in what it buys and sells.  From where we sit, it looks like the Fed will be trading against itself.

Perhaps Chairman Bernanke doesn’t really get that, because he reads lots of books about what happened under FDR.  And guess what?  The traders being hired now won’t tell anyone – because they will expect their compensation to be tied to how their desk does, and not to the overall robustness of the markets, which is actually the Fed’s job.

Oh, and one other thing.  The articles we have read about this hiring spree say nothing of oversight and surveillance.  The Fed is hiring people whose job will be to provide liquidity to hedge funds, so that the hedge funds can buy garbage.  They are hiring people to trade existing mortgage-backed securities, and to take the plunge in commercial mortgage debt.  For what our two cents may be worth, we think a lot of the price risk may be out of many of the instruments they are gearing up to buy, and there are decided advantages to being on both sides of the market.

At the same time, we have heard it reported anecdotally that good quality surveillance and compliance people are in short supply.  The professionals who recruit in the sector say the very best have kept their jobs, or were snapped up in short order as firms vanished out from under them.  As to the rest – yes, there are compliance professionals out of work in their hundreds, just as there are bankers, traders, brokers and research analysts contemplating forced career changes.  But it is not the very best ones. 

The SEC has created an internal compliance function – though it remains to be seen how seriously this will be taken.  No less important will be the in-house surveillance team charged with making sure the New York Fed’s new trading machine runs clean.  In the absence of ill will, there will be plenty to do just to make sure the transactional and record-keeping part of the business remain free of conflict. 

Never mind what will transpire when someone decides to do something improper.  The Fed’s brief will be to keep the wheels turning – that is, provide liquidity.  In order to do this, it clearly resides on both sides of the market.  Desks will throw positions over the transom as fast as they can.  In this environment, is there an opportunity for fraud?  Would you like a better price on that trade?  Is there something in it for me?

The Fed needs to take this new hiring spree rather carefully.  Many of the very best traders are, well, still trading.  Many of those who were good in the bull market will be found wanting if their job is to actually trade the current markets.  If their job is merely to shuffle around pieces of paper and electronic bits and bytes, then we need computer programmers, not traders.  We wonder what profile the Fed is actually looking at as their ideal trader.  We understand Jerome Kerviel is available.

Cutting The Herd

Thy thunder, conscious of the new command,
  Rumbles reluctant o'er our fallen house.
      -John Keats, “Hyperion”

“Bank of America’s Merrill Lynch unit is offering signing packages greater than those handed out in the bull market of 2006 and 2007” reports the Financial Times (14 August, “Merrill In Aggressive Hiring Push”).  Merrill’s sales force has dropped from 18,000, before the BofA acquisition, to 15,000 as of the end of June – to say nothing of the top executives who took the money and ran before Ken Lewis had even had his first public bout of petulance over those sneaky extra few billion in losses.

Merrill wants to reverse this trend by signing up to 450 new top producing brokers.  They have already brought in Sallie Krawcheck, who quickly showed her confidence in her new employer by laying out a million bucks to buy BofA stock.  Of course, if she leaves BofA in a snit, they will likely have to buy her out as part of her severance.  Indeed, given the deal-making acumen of Ken Lewis and his board, we would not be surprised to learn they had fronted Krawcheck the money, then guaranteed her against losses on the position… but we digress

New superstar stockbrokers are being wooed to Merrill with offers of signing bonuses of 140% of their trailing twelve months’ production, plus an additional 200% over five years.  The FT article quotes a recruiter as saying this is more than Merrill has ever offered new recruits.

And just who are they recruiting with these lavish payouts?

Says an anonymous Merrill veteran, “They’re bringing someone in from a firm most of us would never consider going to.  It’s not the Merrill Lynch it was and never will be.”

The herd has stampeded, leaving the stragglers behind.  Now, desperate to sell something – anything – to redeem what might still be salvageable of this transaction, BofA management has decided to go for aggressive salesmen with high production numbers.  This is a change from the Merrill we knew, that was paying people premiums for their money lines.  In today’s world, assets under management are of less value than the immediate generating of commission dollars.

As we say, the art of managing money is the art of having money to manage.  And that comes down to marketing.  Merrill used to be in the business of having money to manage.  Now it appears they are in the business of generating gross.  Trust us, these interests conflict.

“To those of us that lived it,” says the anonymous Merrill broker quoted by the FT, “it was Camelot.  It’s not any more.”

This push to hire aggressive producers is not limited to Merrill.  The FT article reports that Morgan Stanley has similarly raised the bounty – while apparently lowering the bar on bringing in new salesmen with proven track records.  This was a predictable outcome of the government backstopping gargantuan acquisitions of a failed business model. 

Speaking of “Camelot” – for brokerage customers, the days of receiving prudent investment advice from seasoned professionals may soon resemble another famous Broadway musical – “Brigadoon”, the tale of a magical place that appears for only one day every hundred years.

It used to be Buyer Beware.  Now it’s Buyer, be afraid.  Be very afraid.

Moshe Silver

Chief Compliance Officer