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Market Crash Anniverary Edition – Monday, October 19th 2009


This Week in the Screed:

Springtime for Blankfein – It’s the Real Economy, Stupid!


Wall Street Forced To Share The Wealth – With Washington?


Ken Lewis, Meet Hester Prynne – Immaterial Girl



Springtime For Blankfein

Let me tell you about the very rich. They are different from you and me.

                   - F. Scott Fitzgerald, “The Rich Boy”

It has been a treat, watching the people of this great land as they twist and writhe and try like hell to dodge each gold-clad salvo from Wall Street.  Like peas hopping in a skillet, the Common Folk have been trying to find a place where they can set down, without being set off again by the scorching metal.

Maybe a better analogy is a cornered fox set upon by hounds.  What a thrill to watch the tiny animal as it yelps and leaps and twists and snaps and tries to save itself from being crushed and mangled when the dogs finally decide which of them will have first go at it.

Yes, that would be it.  A small, cornered beast trying desperately to find an escape – even a corner to hide in, small enough that the predators can’t rout it out.

A year ago there was no end of hand-wringing from Washington and the nation’s press as politicians and pundits prognosticated, columnists and commentators caviled, editorialists execrated, reporters ratiocinated, nabobs nattered and bloggers… uhm… blogged about the danger that “this” might spill over into “the real economy.”

There’s good news.  The Wall Street Journal, in an appropriately modest one-column headline (14 October, “Wall Street On Track To Award Record Pay”), reports that Wall Street is “on pace to pay their employees about $140 billion this year – a record high.”  The top 23 investment banks, hedge funds, and exchanges paid aggregate compensation of $130 billion in 2007 – the record so far.  Lucky for them, last year saw a market meltdown of Biblical proportions.  As has by now become excruciatingly clear to all – particularly excruciating to those who are still kicking themselves for missing perhaps the greatest one-two punch short-the-world to massive-short-squeeze trading opportunity in history – the markets have been rocked by successive tsunamis of volatility.  And, in case you still haven’t figured it out, Wall Street doesn’t get paid to make you money.  It gets paid to handle transactions.

Volatility = lots of transactions.

Lots of transactions = lots of transaction fees.

Lots of transaction fees = the biggest payday in Wall Street history.

We hope you made some money along the way, too.  Because your broker sure did.

The Journal reports the combined revenues of these firms are projected to hit $437 billion – an increase of some 27% over 2007’s all-time peak of $345 billion.  At these levels, we’re talking orders of magnitude.  And you used to chuckle when you teased them by calling them “Masters of the Universe”…

Banks and investment firms argue that they must continue to pay top dollar, otherwise their top talent will leave.  As witness the government forcing Citi to divest its Phibro trading unit, that prediction was dead on the money.

Are you shocked to read (Financial Times, 14 October, “AIG Staff Resist Pressure On Bonuses”) that Neil Barofsky, the SIGTARP (“Special Inspector-General for the Troubled Assets Relief Program”.  Sigtarp – it sounds so Star Wars, doesn’t it?) “found that AIG staff were resisting paying back part of the $168m retention payments” – the “stay bonuses” that were handed out to make sure that the people who understood how these ditzy instruments worked would stay on at AIG until a good portion of their positions were unwound – although we are not told who these instruments will  be sold to.  We bet the New York Fed is on the short list of potential bidders.

Today, we still don’t know who received the $700 billion of TARP money – indeed, we don’t even know whom to blame for the fact that we don’t know.  And Washington has no perceptible sense of urgency regarding either transparency or significantly enhanced capital requirements.

In our world, a surge in market averages is equated with an overall lift in global wellbeing (WSJ, 15 October, “Dow At 10000 As Crisis Ebbs”).  “Crisis Ebbs” as in, the Crisis was on Wall Street – not Main Street.  The definition of “global” is a bit narrower than you might think.

The Wall Street Journal reports (15 October, “Junk Is Hot, Except On Street”) “As investors have piled into high-yield bonds this year and shown a healthy appetite for risk and returns, one contingent has remained notably cautious: Wall Street.”  That opening sentence tells the whole story, and then some.  Curiously, the Journal column does not tie up the loose ends.

We at Research Edge have gone to pains to point out the obvious and fundamental conflict of interest inherent in the finance industry: that the Art of Managing Money is the Art of Having Other People’s Money to Manage.  OPM syndrome drives Wall Street.  Thus, the smart move is to look at what Wall Street is selling – then run the other way.

Read again that opening sentence from the Journal’s report.  Investors are buying high-yield bonds, Wall Street is selling them.  Which side of this trade would you like to be on?  The article quotes one high-yield fund manager as observing that buy orders have run seven to one over sell orders in recent weeks.  The same issue of the Journal (“Bond Ebullience Is Raising Eyebrows”) reports “the BofA Merrill Lynch US High Yield Index has gained nearly 49.4%” since January of this year. 

Put these two reports side by side and a picture of a feeding frenzy emerges, no doubt sparked by Wall Street’s sales force.  What it fails to point out is that Wall Street also has the opportunity to charge more for each transaction. 

Not holding junk bonds in inventory, bond desks have to source them from the street to fill customer orders.  According to regulation and practice, this means it is “harder” to fill these orders, thereby justifying a larger mark-up on each trade.  It also leaves a gap to be filled – and Wall Street abhors a vacuum.  Watch for significant new junk offerings to come flying down the pike, no doubt signaling the death of the sector.

As former World Heavyweight Champion Economist Hyman Minsky would likely point out, a feeding frenzy generally ends badly.  Or, as Marlin Perkins would observe in his fabled Wild Kingdom” television series, when the voracious carnivores have eaten the last scrap, they often turn on one another.

Those in government and the press who noisily worried about Wall Street infecting Main Street are guilty of spreading a pernicious lie.  The global financial crisis was sparked by problems in housing finance.  These problems spawned a human crisis of massive proportions, undercutting decades of wealth building and turning families out of homes in which they had long felt secure. 

Government processes, legal structures, and politicians at every level failed to exercise their legal or moral authority to protect their Main Street constituents in a rush to pander to the financial interests that pay for political campaigns.  Indeed, we suspect that a detailed review of decision failure would show significant instances where local officials attempted to intervene for the benefit of their constituents, only to be warned off by officials at the state level.  This is because of the stratification of sources of campaign monies.  We believe such a detailed study would be highly informative – and we are comfortable that such a review will never take place.

We suffered through what was fundamentally a housing crisis.  Proposals were put forward by academics.  Professor Luigi Zingales at the University of Chicago recommended a program to replace troubled mortgages with a combination of full-recourse financing and government-guaranteed non-recourse financing.  He argued that this would ease the pressure on homeowners who had taken zero-down mortgages by placing them on the hook for what they could actually pay, while limiting the cost to the government. 

FDIC Chair Sheila Bair had similar comments, focused on keeping families in their homes, while limiting the cost to the taxpayers.

But the powers that be weren’t having any of it.  The housing crisis was sold to the public as a banking crisis, and elected and appointed officials lined up to throw America under the bus.  Let there be no mistaking what constitutes the “Real” economy in this country – it’s Wall Street.  Main Street exists to buy our inventory. 

In case you find this troubling, don’t worry.  We will be OK.

Washington does not have the political will to force substantive change in our financial markets.  Which means that as far as Goldman Sachs, JP Morgan and the other 21 largest financial institutions are concerned, the United States of America is still Too Big To Fail.

Tax This

The beggars have changed places, but the lash goes on.

                   - W.B. Yeats

What’s all the fuss?  You would think that the unheard-of had just been broached when the weekend Wall Street Journal ran its piece on the notion of taxing Wall Street where they live (10-11 October, “Democrats Weigh Tax On Financial Transactions”). 

Those who have never been in the brokerage business – or who have never scrutinized their brokerage confirms – may not be aware of the processing fees that have long been part of the standard ticket charges for every retail transaction.  As successive waves of the bull markets surged over the past decades, commissions as a percent of total transaction cost were driven ever lower, even as volume was exploding.  Back in the 1990’s major brokerage firms – and quite a lot of minor ones – started tacking a “processing fee” onto their tickets.  Household name firms with global operations were billing their retail customers $25 per ticket, in addition to commissions.

The justification for this was that there were many costs associated with processing trades.  The real reason the brokerage firms did it was – they could.  Occasionally a customer would balk and sometimes the charge would be stricken or reduced.  But most customers didn’t even notice.

In the pre-emancipation plantation economy, there were two classes of slaves – Field Slaves and House Slaves.  According to popular street sociology, House Slaves saw themselves as superior to the Field Slaves, because they worked in the homes and interacted with the families of the masters.  While a slave is a slave is a slave, we suppose some may draw a modicum of comfort from the notion that they enjoy a unique position in the Great Chain of being – that of being able to look through the window onto large masses of folks who are far worse off.

Everything, of course, is relative.  The retail investors at the height of the bull market were, it turns out, the House Slaves of Wall Street.  Do you remember this television commercial advertising discount stockbrokerage services?  It featured a man being wheeled into the emergency room with frantic doctors racing the gurney down the corridors and shouting “He’s got money coming out the wazoo!”  Turns out what they were really selling was a Bill Of Goods.

Washington has caught on.  We’re all House Slaves now.

The Scarlet Letter

A pure hand needs no glove to cover it.

          - Nathaniel Hawthorne, “The Scarlet Letter”

Imagine the chagrin of Citigroup’s risk managers to see their peccadilloes revealed in the Wall Street Journal (16 October, “Muted Cheer As Citi Posts Profit”): “A person familiar with the matter said the lackluster performance wasn’t due to a single bad bet as much as “a collection of immaterial items that in the aggregate were material.”

If that doesn’t describe the global attitude that led to the implosion in the world’s financial markets, we don’t know what does.

By now it is trite to observe that senior management sets the tone in every firm.  It is our hallucination that the risk managers and compliance officers at Goldman Sachs or J.P. Morgan would not have considered those items “immaterial.”  Indeed, to a truly world-beating organization, nothing is ever immaterial.  The world is now reaping the fruits of a politicized global process which steadfastly supports institutionalized incompetence and unbridled avarice.  Entitlement has been substituted for performance, and excess for risk management. 

How else are we to explain, for example, a multi-billion dollar industry where the seller routinely performs the due diligence for the buyer?  We refer, of course, to the ratings agencies, who fell about in a frenzy, handing out triple-A ratings to illiquid interparty contracts like cigarettes in a prison.  CDS issuers all but dictated which issues would receive which ratings, nor did the buyers perform any diligence beyond determining what rating was slapped on the issues they were loading up on.

Everyone – sellers, buyers and raters – knew these contracts were illiquid.  But the sellers were getting paid to manufacture product, and – like taggers in a railyard at midnight – the raters were writing their great big “A” everywhere.  The managers were getting paid a percentage of assets under management.  And what better way to attract new money than by telling your investors you have access to a unique investment with a AAA rating? 

Just imagine the attraction to an investor of dealing with a money manager who has an exclusive in to an investment that provides a steady, above-market yield, and with no risk.  Shades of Bernie Madoff... 

What underlay this cycle of blatant irresponsibility?  The issuers are to blame – but perhaps the least.  They issued instruments for which there was demand.  And, when there was a new condition to that demand – the obtaining of an investment grade rating – they dutifully complied.  The raters are worthy of blame, but their business model was always predicated on conflict, as they sell ratings to the issuers themselves, and not to the end buyer.

So, as shameless as the conduct of the issuers and the ratings agencies was, it is the buyers who should get the biggest and reddest “A” of all.  As managers of OPM, their fiduciary duty was to perform due diligence on the instruments in their portfolios.  This they not only failed to do – we would go so far as to say they consciously refused.  And why?


By issuing a security bearing the AAA rating and by marketing it on the basis of the rating – and by the money managers buying it with their clients’ money – the parties to this transaction, while not particularly careful about the actual exposure to the investors, were certainly working to protect themselves against lawsuits. 

This gives rise to the Perfect Storm theory, where everyone gets to point a finger in a different direction, yet no one has to take responsibility for bad judgment born of willful negligence.

As we read about Citi, the entire world was beset by “a collection of immaterial items that in the aggregate were material.”  This is precisely the refrain we have heard from Pennsylvania Avenue, to Wall Street, to Main Street and back again.  And it doesn’t look set to get any better anytime soon.

In his response to well-informed questioning from Congressman Alan Grayson (D. Florida) earlier this year, Secretary Geithner said the answer to stabilizing the financial system is “Capital, capital, capital.”  Yet, last week Geithner told Maria Baritromo that “credit is the oxygen” of the financial system.  Want to have it both ways?  No problem.  Not only can we can get you that AAA rating, we also have a bunch of retired academics to tell you it’s OK.

By the way, the Obama Administration has gotten a triple-A rating of its own, in the person of Paul Volcker.  The former central banker, widely recognized as someone who actually knew what to do, and did it in the face of political odds, has now voiced (again) his concern that bank bailouts have created a situation of precisely the kind of moral hazard we have been clamoring against.  It turns out that Volcker is the Trophy Wife of the Obama economic team.  He gets trotted out before the press corps whenever the President needs to show off, but like other bimbos, Mr. Volcker is to be seen, but not heard.

And so we were swamped by a Perfect Storm of our own making. And having hit upon the formula, we appear to seeding the clouds for the next one.

Meanwhile, the current debate is astounding.  From Washington to the mainstream press – two well-known sources of inaccuracies, misdirection, and outright lies – we hear about nothing but lawyers.

The New York Times reports (16 October, “Bank Chief Forgoes Pay For 2009”) that Bank of America’s Ken Lewis has agreed to waive his compensation for this year.  The factor that appears to have weighed heavily in Ken Lewis’ decision was a change of opinion on the part of the law firm of Wachtell, Lipton, Rosen & Katz, who “initially advised Bank of America to withhold information about the perilous state of Merrill from the bank’s shareholders, but later advised it to alert federal officials to the growing losses.”

Here’s the bit that is missing from the ongoing debate:  The lawyers don’t make decisions.

We remember watching as members of Congress retreated during their grilling of Chairman Bernanke in the early stages of the BofA inquiry.  At key points in his testimony, Bernanke would reply by saying “we conferred with our lawyers.”  We were stunned at the passivity the word “lawyer” induced in the tight-lipped interlocutors.  As though under post-hypnotic suggestion, the questioners’ demeanor would instantly change and a look of helplessness would steal across their faces.  And when the questioning resumed, it was with a marked sense of lassitude. 

Oh, for the days of NYPD Blue!  We allowed ourselves to revel for a brief moment in a vision of Dennis Frantz smacking Bernanke across the back of the head and saying “Now I’m your lawyer, you son of a bitch!”

The debate has completely lost sight of the fact that it was Ken Lewis, his fellow executives (which ones, we may never find out) and – specifically – the board of directors who made the decisions to acquire Merrill Lynch, to hide the fact of the excess losses, and to cover up the whole process after the magnitude of the losses became public knowledge.  Even assuming cajoling and strong-arming from Messrs Paulson and Bernanke, it was still down to Mr. Lewis and his board to determine what course of action to take.  Lawyers give advice, based on what they believe they can justify in a court of law.  No law firm is beholden to BofA’s shareholders.  Buried in the inner page of this same story, the Times sees fit to report “Legal experts say the ultimate responsibility may lie with Bank of America, not its lawyers.”  Since when was there any question?

As to this current crop of disasters, no one in this sorry circle of negligence ever placed the investors’ interests first.  Rather, the guiding thought in everyone’s mind was, we will be all right if we are sued because the paper was rated AAA.  Thus has the world come to rely, not upon analysis and integrity, but upon the prophylactic use of third party advocates who, as Hamlet’s drunken porter says, “could swear in both the scales against either scale.”

Washington and Wall Street alike should note that even a drunken gatekeeper recognized that they could not equivocate their way into Heaven.

And there are some things that even your lawyers can not protect you from.

The New York Times (14 October, “E-Mail Shows Concerns Over Merrill Deal”) quotes an e-mail from Bank of America director Charles K. Gifford to another member of the board.  In the heat of a conference call where Ken Lewis revealed to the Board the egregious terms of the government bailout, and the staggering – and heretofore undisclosed – tally of losses on Merrill’s books, Gifford fired off an email saying “Unfortunately, it’s screw the shareholders!!” 

Thomas May, his fellow director, wrote back, “No trail.” 

So much for discretion.  Sending that “No trail” e-mail is the equivalent of posting a giant sign in the boardroom that says REMEMBER TO SHRED ALL INCRIMINATING DOCUMENTS.  With idiots like this on their board of directors, should any of us wonder at the position BofA finds itself in?