In this issue of The Institutional Risk Analyst, we reflect on some reader comments about the growing number of financial frauds littering the global landscape, particularly in Europe. And we can’t help but notice the number that have ties back to those savvy investors at Softbank.
Alan B on the Left Coast reflects that this near-bank called Greensill bears a striking resemblance to Penn Square Bank, an Oklahoma-based lender with offices in a shopping mall that failed in July 1982.
“That crappy bank was funded by brokered deposits, ended up taking down some bigger banks and causing a bit of embarrassment among regulators,” notes Alan, who always tends toward understatement. In fact, when the Federal Deposit Insurance Corporation repudiated the loan participations sold by Penn Square, it caused five other banks to fail because of – wait for it – participations in leveraged loans.
We wrote in American Banker in May 2016:
“The investor exodus away from leveraged loans with exposure to the petroleum sector brings back memories of the 1970s oil bust, an economic shock that led to the failure of Penn Square Bank in 1982, the subsequent failure of Seafirst Bank later in that year, followed by Continental Illinois Bank in 1984. Before its failure, Penn Square technically continued to "own" — and service — loan interests held by other banks with participations. As receiver for the failed bank, the Federal Deposit Insurance Corp. deemed those investors to be nothing more than general creditors of the failed bank's estate. Those participating banks lost their entire investment.”
Aside from the lack of stable funding, Greensill was doomed to fail for the same reason that most nonbank finance companies fail, namely that the originate-to-sell model for private loans is inherently unstable and often unprofitable.
Only by adding more risky assets to the mix of “supply chain” finance was Greensill able to construct the appearance of profitability and then only temporarily.
“Time to turn on the lights and find the rest of the cockroaches,” notes Alan B, reflecting the judgement, which we share, than more revelations will be forthcoming in this latest Softbank project. There is never just one cockroach in a financial mess this large. As more counterparties of Greensill acknowledge their error, the financial loss is likely to grow.
The fact that the folks at Softbank reportedly injected $2 billion into Greensill should come as no surprise. Another famous fraud that exploded all over EU regulators last year, Wirecard AG, also featured a large investment by Softbank. Indeed, the Japanese investment fund seemingly facilitated the earlier fraud. The $1 billion invested by Softbank in 2020 allowed Wirecard to raise almost $4 billion in debt leading up to its eventual declaration of insolvency last year.
Revelations that the individual principals of Wirecard stood to benefit financially from the Wirecard deception has caused EU officials to start an investigation. But given that the government of Angela Merkel has allowed multiple frauds to flourish during her tenure, led of course by the ongoing fiasco at Deutsche Bank AG (NYSE:DB), we’d be surprised to sere any actual penalties imposed on Softbank and its shadowy leader, Masayoshi Son.
Aside from regulatory incompetence, the reason that frauds such as Greensill and Wirecard are able to flourish is that central banks, by lowering interest rates to unnatural levels, enable dishonest people to lure gullible investors into a trap. Both in terms of market prices and credit quality, volatility is the operative term.
“In a ZIRP/NIRP world, every asset feels like a [principal only] PO, and there are scant [interest only] IO assets,” notes our old pal Nom de Plumber, a senior risk manager with a penchant for suing federal agencies. “So, assets generally behave in a digital manner, ping-ponging between 0:00 (extension and default) and 100:00 (prepayment), as you illustrate via accounting treatment. And market volatility and illiquidity go in tandem. Thank you.”
By driving interest rates down, central banks not only increase volatility, but provide fertile ground for fraud as investors desperately search for yield in a market denuded of duration. Even the ridiculously thin loan margins offered by Greensill were attractive to investors for a time, but as soon as one investor backed away from buying loans from the nonbank it collapsed into bankruptcy.
The key piece in the puzzle in the case of both Wirecard and Greensill is the tendency of EU regulators to outsource basic supervisory tasks. The German regulator BAFIN, for example, is located in Bonn, away from the financial center of Frankfurt. The German regulators actually outsource a lot of the supervision work to external auditors, which was also the key issue in the case of the Wirecard fraud.
In Germany, it seems, there are more than enough lawyers to ensure that everyone is following the letter of the law, but few regulators to actually oversee the substance.
Meanwhile, below the surface, Europe has become a Wild West of financial chicanery and money laundering. Recall that global audit firm Ernst & Young dropped the ball with respect to the Wirecard fraud, leaving investors defenseless.
We note with some astonishment that the bankers at DB just voted themselves higher bonuses even as shareholder dividends remain frozen. But a backlash is forming against the bank’s bonus pool of €1.9bn, which is 16x Deutsche’s net profit in 2020, according to its annual report. About half of that amount is allocated to investment bankers, reports the Financial Times.
When outside monitors put in place by US regulators suggested to DB’s US unit that it needed to curtail activities in Vladimir Putin’s money laundering empire, the German Bank rejected the guidance and instead announced that it intended to expand operations in Russia. So much for prudential regulation on either side of the Atlantic.
Readers of The Institutional Risk Analyst will recall that DB used “mirror trades” to disguise illegal transactions that helped major criminal organizations, terrorist groups, and drug cartels launder and transfer billions in dirty money. We wrote in our review the important book by David Enrich, “Dark Towers: Deutsche Bank, Donald Trump, and an Epic Trail of Destruction,” officials at the Fed and other agencies have never been called to account for DB.
Likewise, at Credit Suisse (CS), bankers have just reported losing $10 billion in client money in the Greensill fraud, but will still apparently receive enhanced bonuses for their fine work in 2020.
“Deutsche’s payouts would have been even higher without intervention from the European Central Bank,” notes the FT’s Lex column. “Banking’s social contract is constantly rewritten. Paymasters should proceed warily.” But, in fact, the bankers operate with impunity as governments from Washington to Berlin lose the will to enforce the rules.
But if we are to hold investment professionals to a higher standard, then what about central bankers? Should we ask the Federal Reserve to provide a cost benefit analysis of monetary policy and financial deception? And maybe, just maybe, somebody in Congress ought to ask Fed Chairman Jerome Powell why DB is still allowed to operate in the US?
How much fraud and financial market instability should voters in the US and EU tolerate as a result of low interest rate policies? Perhaps it is time to ask Federal Reserve Chairman Jerome Powell how much fraud and financial abuse the US should tolerate as it travels the road to full employment.
As Ed Caeser wrote in The New Yorker last year of the DB bankers who were sanctioned for the Russia activities: “Those who worked above him at the bank continue to thrive, however, and their incompetent, unethical, or simply illegal behavior has gone unpunished. Meanwhile, dirty money continues to pump around the financial system like a pathogen. The FinCEN files, while revelatory, are also dispiriting. It’s hard to escape the conclusion: crime pays.”
ABOUT CHRISTOPHER WHALEN
Christopher Whalen is the author of the book Ford Men and chairman of Whalen Global Advisors. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington.
This piece does not necessarily reflect the opinion of Hedgeye.