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We can share what we got of yours, ‘cause we done shared all of mine…
-         Grateful Dead, “Jack Straw”

It’s Friday the 13th, and Fed Chairman Bernanke is baaaaack, astride his battle-scarred helicopter.  Where foreign central bank officials used to suffer Chopper Envy, the measly purchases the Fed will be able to undertake going forward, as announced by a distinctly half-hearted Chairman Bernanke, make it clear the Chairman’s whirly-bird has been chopped down to size.
 
And while we’re on the subject, Happy Birthday to Secretary Geithner (born August 18, 1961).  In the spirit of the times, we wish the Secretary many extraordinary and extended returns of the day.
 
What will be the next shoe to drop?  And will it turn the perpetually youthful Secretary Geithner from a lean and mean 49 year-old into a suddenly decrepit semi-centenarian, or will he continue to tough it out?  His deluded and tenacious clinging to what are generally called “Keynesian” principles notwithstanding, we like Secretary Geithner and wish he were on our side.  (“If only he had used his genius for good…!”)

COMPLIANCE: The Birthday Boy of Last Resort - chart1

John Maynard Keynes was a highly successful currency trader, a self-made millionaire in a day when a million was actually… well… a million, and a man who honed his intestinal fortitude and grasp of human nature where it most counts: in the arena of putting one’s own money at risk.
 
We do not pretend to speak for Mr. Keynes, but we think his trader’s acumen would temper a bureaucrat’s blind urge to shovel good money after bad in the current scenario.  Indeed, as a currency trader, Keynes would no doubt recognize that today’s money is no longer so Good.  (Tim, maybe you should tell you friend Ben?)
 
One of the ways in which the yawing Helicopter is trying to stave off the Inevitable is by buying everything that is not bolted down.  And while it has become popular political sport to attack the likes of Congressman Barney Frank, he appears not to be to blame.
 
It is “Common Knowledge” today that Frank single-handedly trashed the American economy by “rolling the dice” on housing, letting Fannie and Freddie run wild with the public checkbook.  But while Freddie and Fannie enjoy “Most Favored Too Big To Fail” status, the fact is that the private sector issued far much paper, of far lower quality, than Fannie and Freddie combined.  Perhaps the biggest issuer of the worst paper was Lehman Brothers – probably the reason it was subjected to involuntary assisted suicide at the hands of the former Treasury Secretary while the Birthday Boy looked on.
 
The “real problem” with Fannie and Freddie, as everyone will tell you (but really… everyone.  We hear it from our barber, the guy at the pizzeria and half the cab drivers in town.) is that the government remains on the hook for its debts, but will not acknowledge it.  Indeed, even the steely-eyed Secretary Geithner had occasion to balk when asked outright whether GSE debt is sovereign debt of the United States.
 
Let’s get it straight: debt incurred by the government on behalf of poor citizens is not sovereign debt.  Debt incurred by powerful private corporations in the process of scamming poor citizens, and foreign investors – that is sovereign debt.  If you don’t think so, look at how much subprime paper has made it onto the Fed’s balance sheet.  TARP was designed to wall off toxic debt by buying it from the banks – a process which would have driven down prices to a less mythical level – but ended up giving money to the banks outright, while allowing them to not write down the worthless paper they continue to hold.  Now where does that paper go?  Behold Helicopter Ben, spinning his blades in reverse, sucking up all that nasty stuff, putting it on the public balance sheet.
 
Since it’s your birthday, Tim, we thought we’d show you the next tranche of toxic waste to grace the Fed’s balance sheet.  Call it our present to you.
 
With the ink on Dodd-Frankenstein barely dry, we read (Bloomberg, 9 August, “Structured Notes Are Wall Street’s Next Bubble, Whalen Says”) about the opaque and unregulated market in “structured notes.”  Christopher Whalen, of Institutional Risk Analytics, is credited with predicting the collapse of the mortgage backed market as early as March of 2007, so his insights may bear examination.
 
Whalen says the banks are using the same loophole that permitted the over-the-counter CDO and auction-rate securities markets to metastasize, and selling illiquid structured notes – one-off private contracts – often with little disclosure, and promising “enhanced yields that go well into double digits.”
 
The firms originating these contracts have no obligation to make markets in them.  Indeed, it is not clear what regulatory regime they may be brought under.  A spokesman for the Structured Products Association says they are “used by sophisticated investors to make tailored bets,” and “while it’s true that firms make clear in the prospectuses that they are under no legal obligation to provide liquidity, they have provided it over the last two decades without a single hiccup.”  But as we saw in the Goldman / Abacus hearings, “sophistication” is a concept open to a broad range of interpretations, and every new instrument created by Wall Street always worked fine – until it didn’t.  Retail sales of structured notes hit almost $30 billion this year, a 72% increase over last year.  Are all those people “sophisticated,” or are they blinded by nominal double-digit returns?  We can just hear Fabrice Toure saying “Dat’s de deal!”
 
Whalen writes that these investments are being packaged by the same firms now making an elaborate public show of the burden Dodd-Frankenstein represents for their business.  He says there are no standards for what must be contained in such a package, and that often they are “pure derivatives,” meaning no actual security underlies the projected return.  A bank could issue a note and make an offsetting bet.  Or it could just hope the market will trade in its favor, and that it can fill its own order to make payments to the investor when the time is right.  In short, an IOU.  Whalen says he is aware of two hedge funds being created “specifically to buy this crap from distressed retail investors” who will see the value of their holdings crushed when Treasury rates finally turn up.
 
For reasons beyond our meager ability to comprehend, structured notes are available to retail buyers, apparently without any regulatory requirement or standards of minimal disclosure, or a sophistication test.  Writes JP Morgan, “a principal protected note is backed by the firm that issued the note.”  They explain that the notes are not FDIC insured.  If an issuer goes bankrupt, the “principal protected” note is unsecured debt of the issuer.  Which means that the instruments underlying the note could be profitable, but the holder of the note might still receive nothing – exactly what happened to holders of notes issued by Lehman Bros.
 
JPM also clarifies that there is no aftermarket for the notes, that “will generally trade at a discount to their value at issuance” because of something called “distribution and hedging fees embedded in the original issue price.”
 
Allow us to point to two troubling usages here.  First, the instruments trade at a discount to their issue price, not to their value.  “Value,” as Marx points out in the early pages of Das Kapital, is a moral and spiritual concept, not to be confused with market price.  Second, the reason these notes trade at a discount is that the issuer takes hefty sales commissions (“distribution fees”) and banking and trading commissions (“hedging fees”) and builds them into the price to the buyer.  Like the structured derivatives offered to the likes of Jefferson County and the government of Greece, since there is no market quote for these notes, only the seller knows what price they should trade at.  What price is that?  How much can I get you to pay?
 
To JPM’s credit, they say the notes are “not intended to be actively traded instruments and are intended to be held to maturity.”  In common parlance, they are what we call “To who?” securities.  When the customer calls demanding to sell out a position, the broker asks, “Sell?  To who???”
 
When the debacle in unsecured structured notes hits, how many will end up on the Fed’s balance sheet?  The notes are unsecured obligations of the issuer, which will need to make a reserve based on their own internal calculation of the percentage likelihood of having to pay a projected dollar amount at maturity.  But this is an unregulated contract, so there appear to be no set standards for reserve computation.  This tips us off to two things.  First, when the “perfect storm” in these notes hits, the banks will not have the funds to pay out.  Bloomberg reported last month (16 July, “Bank of America Leads Sales of Structured Notes in What May Be Record Year”) “banks have sold $22 billion of structured notes to individual investors in the US this year,” with B of A accounting for $4.7 billion.  We sincerely doubt B of A has reserved $4.7 billion to pay off these notes.  Who is going to haul B of A’s chestnuts out of the fire if these IOUs actually come due?  Unlike Lehman, B of A has a huge percentage of Americans’ wealth in its deposit accounts.  And unlike Lehman, it is FDIC insured.
 
So our first question is answered: there is a good likelihood that a Perfect Storm will hit structured notes.  When it does, they will have to be sucked onto the Fed balance sheet, because FDIC insurance will not go far enough to cover the face amount outstanding.
 
So Happy Birthday, Tim!  Your BFF over at the Fed has launched a new party game called Pin the Tail on the Administration, where every toxic piece of financial excrement that no one has the political will to flush down the tube gets bought at inflated prices with the taxpayers’ money and socked away in the Secret Stash.  This game proceeds with all the players blindfolded and will only end when someone removes the blindfold and says out loud, “But these numbers are way overvalued!”  So, Tim, your Secret Birthday Question is: who’s going to buy from the Buyer of Last Resort?  In God we trust, indeed!
 
But here’s a better question.  The reason the banks have so little capital reserved against these notes is that they believe they will never have to pay out on them.  Buyer beware?  How about, buyer, be an idiot?

Moshe Silver

Chief Compliance Officer