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And Now It’s Time To Play ‘You Bet Your Life’!

O Death, where is thy sting?  O Grave, where is thy victory?

                             - 1 Corinthians (15:55)

We Couldn’t Make This Up If We Tried.  A story in the New York Times (5, September, “Wall Street Pursues Profit In Bundles Of Life Insurance”) describes the latest hot trend in investment banking: securitizing life settlements.

This is viaticals on steroids.

Viaticals were a form of investment that sought to combine the profit motive with compassionate humanitarianism.  In a classical transaction, a viatical broker gets paid a commission for selling to an investor the life insurance policy of a terminally ill person.  The patient, with a medically pronounced short life expectancy, needs cash now to pay for drugs, home care, and mounting expenses occasioned by the miseries surrounding the end of life.

The investor pays a discount and receives the full death benefit when the patient dies and the policy pays out.  Viatical settlements companies have historically paid between 60-80% o the face value of the life insurance policies they acquire, but the example quoted in the Times article is a mere $400,000 cash for a policy with a $1 million death benefit.  This is a reflection of supply and demand: the supply of aging, sick baby boomers and their parents – an increasing number of whom are suddenly out of work, have found their compensation cut by 10%-30%, or are just plain scared they will soon lose their job and never be able to work again – is growing, while the supply of available cash is dwindling.

It looks like Wall Street has timed this market perfectly and is offering the largest group of sick, scared old people in the history of capitalism just enough money to get them to sign over their heirs’ inheritance.  Note that by the time the viator – the person who is terminally ill – signs over the insurance policy, it is a good bet that all other family assets have been used up, and there’s nothing left in the estate.

Viaticals used to be – you will excuse the term – a thriving niche business, and they represented a healthy chunk of change.  It is estimated that by the year 2000, viatical settlements companies in America did $4 billion in business.

The AARP quotes the North American Securities Administrators Association (NASAA – the umbrella group for state securities regulators) as calling viaticals “one of the top ten investment scams,” and reports that “a Florida grand jury in 2000 found as much as 40-50% of the life insurance policies viaticated by viatical settlement providers may have been procured by fraud.”

Viaticals fraud includes faking terminal conditions – which leads to the purchaser having to keep up premium payments or lose their investment altogether – and the risk that a broker may have sold the same policy multiple times.

But even without fraud, there are risks to these transactions.  With improving medical care, people are living longer, and the investor who thought he bought a Dead Man Walking may be dismayed to see that man walking back, very much alive, as he returns from his latest treatment or surgery – a drug or procedure that was not available when the policy was viaticated.

But of all the risks in the viaticals business, here’s the one we like best of all.

Wall Street firms collude to drive down the prices paid for viatical settlements.  Where legitimate viatical settlements companies historically paid as much as 80% of the value of a life insurance policy, the power of the investment banks drives viatical payments down to less than half the face value of the policies bought.  

Our scenario has the makings of a Perfect Storm: a cocktail that blends the despair of a broad swathe of the American public, with the greed and mind-numbing technologism of Wall Street’s whiz kids, with the desperation of global investors to find the Next Big Thing in the US Dollar – with a profound failure of regulation.

We make our prediction now: you will see the day when shocked and outraged members of Congress will pronounce themselves “horrified” and state that “no one could have predicted this disaster.”

The investment banks will be given the regulatory green light to package trillions of dollars in life insurance policies.  They will sell the resulting securities to the Chinese.  In this they will be aided and abetted by Congress, who will put hurdles in front of nascent insurance reform. Recall that the abuses of Credit Default Swaps, which led to the implosion of AIG and much of the rest of the world, were largely tied to speculative trading.  CDS were created to serve a specific function relating to capital requirements.  A regulatory carve-out was granted – the wisdom of this act may be questioned, in view of subsequent events – but regulation never foresaw that the market would metastasize. 

CDS resembled insurance policies.  Indeed, they were described as such.  But insurance policies are not speculative instruments, and the law requires that a policy holder must have an “insurable interest” in the insured.  Otherwise speculators would be lining up outside old-age homes and taking out policies on the residents by the hundreds. 

The viatical settlement companies serve a legitimate niche.  By bringing financial relief to the hopeless, they provide a capitalist solution to human suffering.  It is far from pretty, but in our hearts we can see the logic in permitting someone to advance money to a dying stranger, and be compensated for the use of those funds.

At the Wall Street level, though, how do we reconcile packaging life insurance policies on this scope with the notion of “insurable interest” on which insurance regulation is predicated?  This fits nicely with pending health reform legislation.  CEOs of Wall Street banks will clamor for a seat on the Death panel, knowing their clients’ income stands to be affected adversely if too many people are allowed to live too long.  We remember that Lloyd Blankfein was in the room when Treasury and the Fed pulled Lehman from life support.  Will he be standing at her bedside in St. Barnabas too?

Or how about the insurance industry itself?  Will it be a major buyer of these securities?  After all, who knows better than they when these people are really expected to die?

It is still early days.  No securities have been issued yet, and it looks like the press is serving as the beard for this new concept – the Times article makes it seem that firms are reluctant to lend their names to this just yet, though Credit Suisse is mentioned by name.  And “one investment banker not authorized to speak to the news media” is quoted as saying “we’re hoping to get a herd stampeding after the first offering” of these Death Swaps.  We understand why this banker was not authorized to speak to the media.  We wonder what firm he works for?

Imagine what it will look like ten years from now, when several trillion dollars in Death Swaps have been sold.  When the investment banks have taken in a few billion in fees, and the Chinese government has been paid tens of trillions of dollars in death benefits.  By then, millions of American families will have lost not only their loved ones, but every penny of their inheritance.  The fat banking fees will be paid to American investment bankers, while the real money – trillions of dollars – will be paid to foreign governments who will buy these things by the boatload.  Just as they bought our mortgage-backed paper, the Europeans and the Chinese will scoop up our death-backed securities (“DBS” – or will they call them MBS – “Mortuary-Backed Securities”?) like there’s no tomorrow (darn! There we go with those unfortunate metaphors again!)

Finally, after a generation has seen their patrimony wiped out, the lawyers will jump into the fray.  And probably the states’ attorneys general too.  There will be a multi billion-dollar settlement, and Wall Street will ride off into the sunset, looking for fresh fields to plunder.

Where there’s life, there’s hope. 

The Full Madoff 

We have stolen from the People of Israel, and from the Nations.  We have repaid Evil for Good. 

          - “The Great Confession”, Yom Kippur liturgy

Now it can’t be told.

After announcing it could be some weeks before we saw the document, the SEC Office of the Inspector General dished up its full report on the Madoff matter late on Friday, right before the long Labor Day weekend.  This is an odd regulatory bootleg play.  It can’t be that the SEC thought no one would notice it.  Perhaps it was their effort to provide that last bit of beach reading for those who have already polished off the last Harry Potter novel.

After reading the Executive Summary we thought seriously about hanging up our scrivener’s spurs.  We have re-convinced ourselves that the relentless persistence of Mediocrity and Evil in the world is not sufficient cause to cease trying to do Good.  We despair of ever being able to Speak Truth to Power – because no one wants to know the Truth, and Power doesn’t listen by definition.  But we can at least voice an opinion contrary to what the world is being force-fed by government and media alike.

We are tempted to embark on a line-by-line dissection of the OIG report, but we will confine ourselves to two observations.  We can not stress how important it is that you read this document for yourself.

First: SEC staffers are garbage.

This is not our opinion.  Nor is it the opinion of major news media or financial commentators.  We believe it is largely the opinion SEC staffers hold of themselves.

When a group of over-educated and under-motivated people persistently fail at everything they undertake, are never allowed to bring a project to completion, and are always staring at an insurmountable pile of work for which they have no expectation of receiving reward or praise, this fosters a case of collective depression.  And we can think of few things more depressing than being a career SEC employee.

It’s pretty depressing to go through four years of college, three years of law school – four, if you work full time while taking classes at night – put in five, six, seven years of 14-hour days, seven-day weeks as an associate at a law firm, being tied to cell phone and blackberry every moment of your vacation or days off, only to be told that you are “not partner material”.

The law firm model is not a complete scam – does it make sense to tell a second-year associate you already know they will never make partner, when they are competent and effective in the niche you have designated for them? 

In fact, the way our national mentality shapes dialogue is inherently flawed, and unrealistic expectations lie at the heart of our national self image.  How often have we heard that in America, “everyone can grow up to be President”?  And while the election of Barak Obama seems to finally have proven that to be almost true (we note that the Democrats were Uncomfortable With Hillary – America is ready for a half-white President, but not yet for an all-woman one) the reality is: only one person grows up to be President.

But some of the others grow up to be investment bankers.

Lord Turner, chairman of the UK Financial Services Authority, recently remarked (FT, 3 September, “Regulators And Bankers Must Share The Blame”) that the industry he oversees has grown ”beyond a socially reasonable size” and that most of what bankers do is “socially useless activity.”

If you are an investment banker earning four hundred thousand dollars your first year out of B-school, it will be hard to convince you your are engaged in a socially useless activity.  Now imagine being an SEC staff attorney, three years out of law school, sipping nasty office coffee, taking orders from a career bureaucrat, being treated like doggy-doo by investment bankers, and earning $85,000 a year.

Who says SEC employees are garbage?  Everybody.  It’s the way the system is structured.

These are the people charged with policing our securities markets.  The junior grunts, already jaded by their third year at the Commission, are the ones who failed to catch Bernie Madoff with his fiduciary pants down.

It can not fail to resonate with anyone reading the OIG report that the SEC received numerous highly detailed, highly specific tips and complaints – including a detailed analysis provided by a hedge fund of funds at the request of the SEC – and did absolutely nothing about them.  Is it really possible that the watchdog of the global securities marketplace doesn’t care?

An item in the NY Times (13 September, “But Who Is Watching The Regulators?”) points out that there is essentially no consequence to a regulator of failure to exercise due diligence.  Indeed, we can fairly say that, for most regulatory employees, the consequence of failure to fully carry out their job is… longevity in that very job.

Imagine yourself as a second-year SEC attorney, listening to Bernie remind you that he is in his second term as Chairman of Nasdaq and being considered to be the next SEC chairman.  You know that Bernie lied to you, that his answers to your questions didn’t make any sense, and that he is withholding information.  Are you going to lay your $85,000 a year job on the line to charge Bernie Madoff with wrongdoing?  Put differently: if you, a second-year drudge, have already figured out that Bernie is pulling a scam, then surely those above you in the organization must already know it.  When they tell you to “keep you eyes on the prize” and look, not at the evidence of fraudulent activity, but at the lack of evidence of front running, you read between the lines and elaborately do nothing.

Go after Bernie Madoff?  That’s above my pay grade.

Our second observation is that we don’t believe the major conclusion underlying the OIG report.  The report states blandly that the OIG found no evidence of any conflictual relationships between SEC staff and Madoff.  The report concludes that “senior officials at the SEC” did not try to influence or interfere with any of the probes of Madoff’s business.

We don’t buy it. 

There are too many instances of examiners being put off, pulled off, and pushed off the scent.  Too many instances where even the junior SEC grunts knew something was wrong.  We remain convinced that folks inside the Commission were running interference for Madoff – perhaps without even knowing why.

Or perhaps it was not “senior officials,” as some of the clear instances of examiners being called off were from staffers who might be characterized as “mid-level.”  If the OIG is weaseling out of pinning blame by defining the miscreants out of the game, this is a pretty poor, if highly predictable, gambit.  What do you call a cover-up of a cover-up?  Watergate-gate?

When Linda Thomsen abruptly closed the single most important review undertaken by the Commission in years, the only tangible results were a highly suspicious termination of a senior SEC attorney, and the totally improper passing of a tip to Morgan Stanley’s counsel that John Mack was not going to be charged.  How was Thomsen disciplined for trashing this key docket?  She got to stay on for the duration of Chairman Cox’s term, then left to become a partner at the law firm of Davis Polk.

No sooner does Mary Schapiro take over than the SEC announces they are re-opening the Pequot matter.  Then Pequot abrptly closed down, and now Mack has announced his retirement from Morgan.

But this just scratches the surface, similar to the raft of Ponzi cases the SEC has brought recently.  The SEC is gunning for the low-hanging fruit – as well they should.  But it appears that the low-hanging stuff is all they ever capture, and a steady diet of this stuff is not good for the digestion of the Body Politic.  Remember too, this is the Agency that fined BofA’s shareholders $33 million for what look like deliberate lies and cover-ups on the part of management, abetted by complete incompetence on the part of the Board of Directors. 

By constantly caving in to the bureaucratic pissing contest within its own walls, by focusing on turning out files and memos rather than preventing criminal activity, by pandering to politicians rather than policing the markets – and with less than a billion dollars to spend on all their efforts – it is no wonder the SEC is largely staffed by the Dullest and Worst, those who can’t find work anyplace else.

Chairman Schapiro has to acknowledge that there is plenty of dead wood at the Commission.  She has to acknowledge that there are bad people at the Commission.  More important, she has to actually do something to clean house.  The Commission still has plenty of work and lots of explaining to do to get Madoff-gate behind them.

Being Academically Right Means Never Having To Say You’re Sorry

For the sin that we have sinned before You without knowledge; and for the sin that we have sinned before You with the utterance of the lips.

          - Confession of Sins, Yom Kippur liturgy

It must be that time of year.  First, Sam Antar rats out his community (see last week, “Insaaaaane!”).  Now, Nobel Prize-winning economist Paul Krugman rats out his whole profession (Sunday New York Times Magazine, 6 September, “How The Economists Got It So Wrong”)

As Krugman’s account of the dismal performance of the Dismal Scientists makes clear, no group of people have greater cause than the economists to beg forgiveness for the sin of ignorant utterings.  Or of utter ignorance.

Examples abound of brands which, once known for quality, innovation and efficacy, fell victim to their entrenched distribution network and the easy buck.  Second-rate innovations were pumped out to existing customers to generate revenue, and it often takes a generation – coupled with a major technology revolution – for users to recognize thatthey have been victims of inferiority.

“No one ever got fired for buying a ____”  is a fiction to which everyone subscribes.  It is the technological equivalent of Plausible Deniability.  Keeping the job has become more important than doing the job, not just at the SEC, but across the board in Corporate America.

The tyranny of Ivy League PhD economists is one of the most destructive manifestations of the Legacy Mediocrity that affects our consumer society.

Speaking a language of numbers and algorithms that gut traders and market makers – many who earned their PhD in the University of Hard Knocks – could neither emulate nor comprehend, they wowed managers and investors alike with science.  Soon they were running the show.  A generation of the most important business, social and political decisions have been made by people who never actually held positions in business, or hands-on positions in dealing with social or political issues.

Worse, like the economists who were their professors and mentors, they refused to believe their science could get it wrong.  If the outcome did not match theory, there must be something wrong in the implementation.  Another run would surely get it right.  Who are their laboratory rats?   Why, We The People.

Generations of highly intelligent young people went into the world’s finest universities and obtained a theoretical grounding in how the world is supposed to work.  Now our world has been their post-doctoral laboratory.  Sorry if they got it wrong.

Princeton.  Wharton.  Stamford.  Harvard.

There is plenty to atone for.

In memoriam – all victims of terror.

Moshe Silver

Chief Compliance Officer