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Economics for the Totally Un-principled: A Study of Greed and Avarice at the Workplace

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20 March 2008

Economics for the totally un-principled; a Study of Greed and Average At The Workplace

Sam; what’s going on from an economic point of view?

News and views travel faster today as do economic twists and turns

What on earth is the real story about the world’s credit markets? Tell me the real story! What’s the low down? Is this just a plot? Are the Russians behind it or possibly the Chinese? The Iranians have never been up to any good any how about that guy Chavez in Venezuela, we out to punch him out! And why are my stocks going down? It is not too hard to answer that question but the more challenging issue is, what do we do about it? How do we stop the disease from becoming even more chronic? Lastly, how do we restore confidence in financial markets? Where has the liquidity gone? The Fed window is open, but where’s the money?

The answer to these questions is: subprime debt. The easiest way to find out if you have a subprime mortgage is to take the currently appraised value of your house and subtract what you owe. If the result is a negative number, you are a subprime debtor.

This product of American ingenuity has almost tanked the European Union and may wreck the American economic system for the next decade.

What’s the definition of your terms Charlie?

The ideal subprime borrower has a high debt to equity ratio, a questionable credit history or none at all; lenders perceive him as a n’ere-do-well or even worse. Because the subprime borrower’s credit is so poor, he has to pay an average of 200 basis points more for money. It took an ingenious criminal mind to determine that a 200 basis point spread would mitigate an appalling credit risk. Another approach was to use the arbitrary number of 620 on a personal Fair Isaac[1] (FICO) score to separate the real people from those that don’t pay their bills.[2]

Moreover, if the subprime borrower puts up substantial collateral along with his poor credit rating, the lenders elevate his character and rating to that of a “bank client.” When push comes to shove, collateral is more important than rating points any day of the week. That, incidentally, was the motto of famous Chicago historian and credit expert, Al Capone. The verbatim version, which has been memorialized in most books on economic theory, was “you always get some loans repaid with a good word but with a good word, a loaded gun, and substantial collateral you will never have to execute anyone to collect what you are legitimately owed.” Capone has often been ranked with Graham and Dodd in his evaluation of sophisticated modeling for the determination of credit risk and monetary theory.

All other causes of this subprime disaster overlaid in any direction are only figments of an overactive imagination. The theory of perfect markets clearly states that they should be allowed to find their own level of value determined by neutral forces within the operation of a free market. Calling a subprime loan a “guaranteed instrument” and then soupping it up by adding a redundant insurance policy does not make it anything other than what it is - a piece of red meat thrown to a naïve crowd engaged in a hysterical economic feeding frenzy.

a crime against nature itself

The artificially enhanced subprime mortgage was not only a crime against humanity but a crime against nature as well. No amount of due diligence could ever show that people that do not have a history of repaying loans (much less working for a living) will now pay their mortgage for literally any reason at all and certainly not because the loan has been insured by some unknown third party that has made a grave mistake. Most subprime borrowers we never even made aware of the fact that a third party has insured their ability to repay. Had they been polled on the subject, they probably would have thought that concept extremely amusing.

Why on earth would they care? And In truth, they don’t! Why would any rational human being insure someone who had never previously been known for repaying their debts in the past think that they have had some sort of economic epiphany. That is like thinking that a bear will use a toilet instead of defecating in the woods. Did the waving of some magic wand of securitization turn this into a more appetizing credit morsel or was just a plan to separate naïve investors from their hard earned money? We would certainly think that there later is more a more logical conclusion. The fact that this concept so denies any logical foundation that there are those that are convinced that it must be a latent plot invented by Communists seeking an immediate leveling of the world’s economic playing field in one startling redistribution effort. As best as our sources can confirm, Carl Marx has never died and has been hiding in Uruguay and invented the most painful methodology imaginable to magically separate the greatest number of people from their money and then took a copyright on the name, “The Subprime Loan.”

Nevertheless, a Communist plot is hardly the cause of this catastrophe. The most straightforward origin of much of this subprime disaster can be neatly laid at the feet of “derivatives” allowed to be carried off the balance sheet at major financial firms. That this group of extraterrestrial securities that while existing in a supposedly transparent environment seem to act as “heavy matter” and can avoid scientific detection. Derivatives are often so complex that not only do they defy description, they defy perceptive even from their maker. One can only be left in wonderment as to where the people were that were in charge of the Financial Accounting Standards Board (FASB); the Federal Reserve, GAAP and the Treasury Department when derivatives began to stealth-fully take control of the financial markets? Is the U.S. some third world country run by an economically and intellectually challenged dictator? However, the contrarian view is that they are instruments that originated on Mars during their so called “age of liquidity”.

However, the Martian inventors were right in step with what we now call the American Dream. Home ownership has always been important to the economy, and for decades politicians have relied on it as a ploy to attain public office. Moreover, they say that home ownership puts people to work, causes goods and services to be bought and sold, and enables the indigent to live in million dollar homes. This suited Washington and the politicians and anything that could forward this concept was pushed by the U.S. Government. The fact that it was absolutely unattainable was a closely guarded secret, the evidence of which is still locked in Bill’s library and will be released along with Hillary’s papers in the 25^th Century or later.

Of course, the very same folks that brought us home ownership, brought ploy have invited us the Four Horsemen of the Apocalypse (War, Conquest, Pestilence and Death) to dinner and we are not talking about the famous Notre Dame backfield.

A word about insurance

“And down in fathoms many went

The captain and the crew;

Down went the owners – greedy men

whom hope of gain allured:

Oh, dry the starting tear, for they

Were heavily insured.[3]

However, be all this as it may, times aren’t getting any easier. From an economic point of view there are camouflaged traps that have been set waiting to grab the unsuspecting. Some of us have not yet become knowledgeable about the fact that by calling something “insurance” does not make it insurance. Maybe they should have used another word referring to this farce, such as “Orange”. Wall Street bought insurance from the monolines (insurance companies specializing in single policy underwriting which turned out not to be hardly the case. The insurance was purchased to guarantee that the rating of the collateral would remain whatever it was at issuance throughout the period of the insurance.

”They could have easily stated that in order to guarantee your investment we have purchased an “Orange” which is included in your documentation. However, you cannot eat an Orange that part of a contract so this does not quite work. What was to happen if the rating collapsed was an open issue. What would happen if it both collapsed and the insurance company was insolvent was another unanswered issue. What would happen period seemed not to have ever been addressed?

The world is catching up

The world is catching up and the nouveau riche and they certainly are not interested in offering free lunch to another country simply attempting to siphon off their profits. For years, other than Lloyds of London and a precious few other insurance companies, the unusually state controlled structure of the United States insurance industry set the stage for the manner in which insurance was treated if you wanted to do business here. However, there is little question that having 50 different states independently making up individual laws controlling numerous anomalies of the insurance practice is at best a tad nuts. More pleasingly put, it is an economic nightmare, a logistical catastrophe and a regulatory freak. We are similar to the European Union with the exception that while they have 26 regulators to deal with and we have 50. Moreover, at least they are trying sort out the mess, under our regulatory environment there is little we can do.

The insurance industry’s American Council of Life Insurers along with the Society of Actuaries have at long last come to the conclusion that this system is broken and if not fixed will cause far ranging economic harm to the insurance business itself and to this country’s ability to compete on a worldwide basis. Thus, when is insurance, not insurance? We really don’t know, calling an orange, insurance hardly does the job. Insuring a ratings hardly cuts the ice. We have sold these folks what used to be known as “sleep insurance” which when taken with a sleeping pill allows you to sleep through your fears of insolvency. You are comforted in the fact that you have and may think that you have something that protects you but you are not sure what it is, or the conditions under which it operates. Sleep insurance and a strong sleeping pill will usually provide a good night’s sleep but you wake up with the same problem you went to bed with.

The Oil Guys

The Imperil King George Bush, who may well know a little relative to fighting wars, should have taken a few more courses on economics at Yale. George has shown surprising weakness Vis a Vis his friends at OPEC, who are showing a degree of intransigence never before encountered in the history of the United States. Falling in line with OPEC’s, intransigence are North Korea, Iran, Afghanistan, Venezuela, Ecuador and George’s best friend in Moscow, Putin; no longer fear U. S. economic or military retaliation. Lately, this country has acted more like an aged frump than a world class financial player, and too many of our national needs have been woefully overlooked. The American economy is being hit by what we would call the “Perfect Economic Storm”. Solutions are evasive for our number one financial watch dog, the Federal Reserve, as well as the Treasury, Congress and literally everyone else, including private industry.

Move it or lose it

Multinationals have the option of just picking up and moving either to another country or creating a country of their choosing. Why should they hide behind an American domicile when their tax dollars are being exhausted by pork barrels, waste, fraud, war and other nonsensical ill-conceived projects? Why on earth couldn’t any one of the big multinationals pull up stakes and create the United States of IBM; the GE Republic or the State of Microsoft? Taxes are paid in lieu of defense, infrastructure, trade protection and security. What exists if those potential trade-offs no long exist.

An interesting example of what is stirring world-wide is a particularly obscure problem in the insurance industry. Europe has had enough of our taking the cream off the top and then leaving them with the leavings. The European Union has created a solution to this perceived problem and given it the name, “Solvency II”. Frank Keating the president and chief executive officer of the ACLI put America’s problem into extraordinary perspective:

“There is an attempt to penalize the U.S. because of a lack of movement by the NAIC (National Association of Insurance Commissioners) to back Solvency II. If a company is forced to raise capital levels because the U.S. does have compatible standards with the European Union, how many would have to move their headquarters to Europe, to be under the jurisdiction of the regulator with more principles-based regulatory requirements. Moreover, the government’s need for money in light of a $1 trillion deficit, a $150 billion tax rebate scheme, the call for universal health care and the expense of waging a war campaign in Iraqis massive to say the least. We live in a world that needs money and are an industry that must show that the products we offer are for public policy reasons.” Congress is dead in the water and the U.S. Government has been asleep at the switch. There is little time to save this massive industry and nobody seems even to be aware of the problem.

Thus, the non-synergistic relationship created by numerous competitive regulators covering the 50 states, make us subject to reverting to the theory of the weakest link. Each state has its own theory of insurance survival and they all have unique statutory financial requirements. These states as a group look like the “gang that couldn’t shoot straight.” You can’t rob a bank if you don’t have a plan. New York wants to recreate a copy of the unregulated floor of Lloyd’s of London; Vermont thinks that there future lies with a prototype of offshore insurance and Texas doesn’t know how to read an insurance statement showing insolvency if it is placed directly in its face.

Living the Dream!

However, the fact that universal home ownership in this country was only a government generated sham that’s reality was only made possible to the avid readers of “Alice in Wonderland”. This in no way diminished the theoretical dependability of the complex transactional economics that went into the government’s ill conceived conclusions, flawed statistical analysis and dreadfully erroneous suppositions. Nonetheless, the obviously disturbed mental condition of those that created this unshapely mutation also had another trick up their sleeves. Suppose, the interest rates drop that are available to subprime borrowers or worse yet, assume the loan to value equation drops to negative due to inflation in housing market. In either case, the indigent borrower could well have no known reason to want to refinance his loan. That wasn’t really the American way. It just wouldn’t work for the lenders so they also included prepayment penalties so that the borrower could never come out whole no matter what occurred[4] or found work, which would naturally convert to the borrower having no interest in continuing to make monthly payments on a loan that was rapidly decreasing in value.

It is most interesting to note that while Wall Street and the Money Center banks had literally no particular desire to help American’s fulfill their dreams of universal home ownership until they found a way to make bundles of money in the process. Who better to do the public relations for Wall Street’s trap than the bureaucrats in Washington who fell for this rouse, hook, line and sinker?

Government officials fell into line as they seemed to conclude that the Wall Street imperialists had indeed gone soft and were now Hell bent to correct their malevolent ways of the last 200 years. The Federal Reserve with all of the resources it had at its disposal should have figured something was in the air when Secretary Greenspan relinquished the best job in the world that had been his for life. Greenspan did the natural thing and hurriedly wrote a book about his experiences explaining in intimate detail what a wonderful job he had done. His successor was at best a rookie and was thrown into a world where things just weren’t all that pleasant. Bernanke walked naïvely into a trap and is now paying an extreme price of the catastrophe that Greenspan created for him. A little like the spider inviting the fly to join him for tea.

a zero sum game at best for the bankers

However, this conundrum had a way out for our now underwater breadline borrower. If by the most unlikely of events he had achieved the potential windfall of having his property increase in value, he may been assuaged from the embarrassment of having to ultimately find work. In this scenario, this could even remain a fact even if his unemployment insurance runs out. Moreover, this state of affairs could well lead to alternatives such as refinancing and live off the increased principal for years to come. However, there is the small issue that he would have to pay the substantial new fees contained in the small print before he could do so. However, that would not be a particularly trying problem as the friendly bankers would be standing in line to service is increasingly valuable account, with the proviso, of course that he pay increased fees along with additional higher interest charges and loan application fees along with all of the other lovely bells and whistles that are necessary to keep the economy chugging along smoothly[5].

Nevertheless, he would always have the eventual alternative possibility to increase the size of his family and use his increased assistance payments as collateral, but that’s a tad more complex for the model we are looking at. Thus, if he lost his home to creditors and had put up nothing, he would have lived rent free and if the loan was called he would also have lived rent free.

The silly season when facts are not necessarily facts

The Wall Street Journal recently carried a letter to the editors by Holman W. Jenkins, Jr. of Business World and it speaks of former SEC chief, Richard Breeden’s concepts in the early ‘90’s and how he believed that the problem of subprime lending could be solved by an intricate “mark to market” system. Over the years in whatever Breeden has taken on, we think he has been a blazing success. His record is indeed extraordinary and his idea was obviously on the “mark”. While before its time, no one seemed to pay it much attention and the lending banks are now paying the price.

“…Still, accounting rules should not be doctored up as a way to prejudge various business decisions making, (this is regarding the fact that John Thain may have over reserved when he took the gigantic write-off for Merrill when he took over) through punishing practices they don’t like is often the agenda of accounting change advocates. Mark to market was a gift to the world from SEC Chief Richard Breeden in the early ‘90s. With the help of accounting mavens, he argued that requiring banks and other companies to account for financial assets at current market prices, as if the institutions were being sized up for liquidation, would provide a rough-tough discipline for the edification of investors, regulators and managers.

A rose would smell as sweet if it were called skunk cabbage – so we always maintain when somebody predicts either dire or utopian results from a mere accounting change. Still many questioned Mr. Breeden’s initiative at the time among them was Federal Reserve Chairman Alan Greenspan and Bank of America’s Richard M. Rosenberg. Particularly notable were their warning that new rule, when combined with risk-based capital standards, might lead banks to hold fewer loans on their own books, packaging more of them as complex securities for sale to investors. (The failure here is not properly regulating those upstream of the loan and improper disclosures to the public, not the mark to market which created new methods of providing liquidity)

Overlooked, too, was a phenomenon we perhaps understand better today – the propensity of the speculators who provide much of the market’s day-to-day liquidity to go on strike during moments when their services are most needed. (This was observable when there is no obligatory buyer of last resorts today in the securities markets. For all of its shortcomings, the specialist system contained immeasurable assets as pointed out by the SEC study market crash of 1987. “Mark to market” then becomes something else, because markets no longer exist for many of these abstruse securities. Banks are left oxymoronically trying to estimate what market prices would be if indeed markets existed at all.”

The chain of command

There are enough interesting legal points here for the purposes of discussion. First, if the issuer created what the underwriter would label an abstruse security, (supposedly one with little or no market or understanding) they should either have warned the investors of the risks within the offering memorandum or at worse, tried to make the product less abstruse. This statement is in itself a contradiction of terms. Furthermore, if the buyers decide to go on strike and prices cannot be estimated, this is also a disclosure that must be listed within the memorandum’s risk transactions. On the other hand, the author forgets that there were numerous buy backs and other protections inherent in the nature of these transactions. The fact that numerous broker dealers and investment bankers were overwhelmed by the cascade of problems that had been caused by their inventions and the innovative psychological problem that caused a collapse of liquidity in these instruments. Mr. Breeden’s mark to market proposal hardly failed, the regulators, the issuers, the underwriters, the Trustees, the servicers, the lenders, the brokers and the rest of the ladder of greed were out to lunch while the investment bankers had already been hoisted their on their own petard.

In addition, the Wall Street Journal seems to assume that by an over establishment of reserves by Investment Bankers plagued by this event might ultimately prove helpful. However, overestimation is just as much part of the disease as underestimation. Overestimation temporarily steals money from the Internal Revenue Service and is a crime, underestimation is probably just plain stupidity unless you are selling your own stock on the sly, and there is no other personal benefit. Moreover, we would have thought that managing earnings went out with the W. R. Grace investigation of several years ago. I think they called this tactic “big box” reserves which would be incentivized by the opportunity of growing earnings by stealth and not by sales.

Securitizing the little rascals!

In order to securitize these little rascals, the loans had to be uniform and were literally always based on a thirty year payback. Most of the subprime instruments were of the adjustable-rate variety (ARM)[6]. However, the alternative loan could be of the fixed rate garden variety, but that wouldn’t work best for the purposes gouging additional money from the indigent subprime recipient. Thus, the lenders would more often than not issue a variation of the ARM called a “Teaser” which offered the borrower a rate that even he could afford by using his disability insurance check. The down side to this tactic was in the small print, eventually when the small print came into play, the lender would raise the monthly payments to an exorbitant amounts at the end of the teaser period from two or three years.

In the meantime, the lender would have to go to the annoyance of foreclosing on the property; however in exchange for his troubles he would receive the opportunity of glomming onto the increased appreciation and the down payment along with whatever fees would have been collected. On a two year mortgage, this could be a substantial profit. For the most part, the American Dream of home ownership was really a nightmare waiting to happen, disguised under the guise of facilitating home ownership. These people could have never come out in one piece they were condemned to lose everything they had to a string of heartless Wall Street vultures. At least when they started they had a roof over their heads. Wall Street and the government had entered into a conspiracy to steal the roof itself and they have indeed done a yeoman like job of doing exactly that. The only difference is that of definition, in one instance the government had created the crime of omission; Wall Street’s activities were that of active commission.

If this wasn’t torture enough, the lenders invented an instrument akin to “the rack” or stretching torture used to great advantage during the Dark Ages for garnering information and money that under normal circumstances would not have been readily available. This tortuous device was also used for forcing unlimited tithing and collecting taxes simultaneously. This device is called a “negatively amortizing mortgage” and with those in a certain strata of society it is called “NegAms”[7]. You pay the interest, but not the entire normally required principal each month. This whole process saves the financial institution the trouble of dealing with refinancing after the “Teaser” period has ended. What a surprise these people were in for when they were informed of what was contained in the fine print.

Siphoning everything from the indigent back to Wall Street and into taxes simultaneously

Each month that you goes by, you manage to owe more money until eventually you are just plain drained of all your assets. Interestingly, Sixty-six percent of all subprime loans are originated by mortgage brokers. Moreover, they are uniquely successful in what they do and some of these folks are extremely helpful in counterfeiting your data to lend a helping hand to aid you in qualifying for a loan which you are unqualified to receive. Without these hard working folks, you probably would never have been able to qualify for the opportunity to lose your home to the bank. You would never have had the opportunity to share the American Dream of home ownership even for the short time that they provide. These are indeed wonderful people.

These are the sort of citizens that can add zeros to a balance sheet faster than the speed of light; however, it’s always just a mistake when they get caught, or was the fact that it a mistake that they got caught? Well either way, the result isn’t all that dissimilar. These are artists of the highest order have almost the sole responsibility for counterfeiting your application, helping you fraudulently apply for credit and, they are artistically capable of providing you with all of the necessary documentation to defraud both the lender and the rating agency. These fellow Americans are the sort of people that are being still being wined and dined by our friends at Countrywide, ne, Bank of America. There will be more about this later.

Reversing the mortgage is another form of torture

The “reverse mortgage” is also a comparably twisted concept but it is normally restricted for purposes of torturing people over 61 years of age. Every con man in the country has gravitated to the later as older people are gradually having everything they own drained away by this bastardized alternative to Viatical insurance. There are many correlations between this form of larceny and that of selling someone the rights to a Viatical Insurance Policy. Yet the reverse mortgage is a little more of the garden variety “Iron Maiden”. When the casket has been closed, the spikes drive through the debtor’s body in order to end their misery as quickly as possible. This form of torture is much more humane than the siphoning system we discussed earlier but has the same ultimate consequence.

This mechanism has been widely utilized as a particularly interesting variation on the old wealth transference scheme. Nevertheless, in “the sucking up the assets approach” the beneficiary is able to legally avoid creating an estate problem for his next of kin by carelessly utilizing this vehicle. Ultimately form of wealth transfer is much quicker than in utilizing the tried and true Iron Maiden approach, as the money is handed to the infirmed home owner in a lump sum and then taken back in a series of phony investments proposed by the lender at the time of the closing. By this time the lender has gained the elderly victim’s confidence and when the smoke has cleared you do not need to “pass go” at all to be totally bankrupt. Moreover, these friendly brokers usually do not have to be licensed to ply their trade, they are allowed by most states to fleece anyone they choice to do.

The beat goes on!

While these are variations on the subprime theme, let’s deal with the process as it exists within the normal chain of events. Thus, this is only the beginning of what in the trade is fondly called the “separation process”. The lender of the first part clearly understands that this loan and the accompanying documentation is virtually worthless for anything but bathroom tissue and wants to rid himself of this viral paper as soon as possible. The overall process is known as “risk transference” and is said to operate quicker than the person’s automobile horn going off in back of you when the stoplight turns from red to green. For simplicity, the process is called “securitization” and in real terms it means, playing the game of musical chairs with only one place to sit or more to the point, a game of hot potato utilizing a bar of molten steel.

The lender packages similarly structured mortgages and re-sells them to the securitizing entity which then insurers the paper usually with a monoline insurance company. The insurance does not affect the borrower in any way whatsoever but it does tend to facilitate the transfer a wad of money from the home owner to the insurer.

The friendly ratings folks down the street and Their Agenda

Once the insurance is firmly in place, the underwriter walks the documents over to the rating agency. In reality the deed has already been previously worked out before he gets there because the rating agency has for all intents and purposes been advising the issuer from the very beginning as to what is necessary in the package to arrange for the highest possible rating. In some instances this may smack of a collusion to “insure” the separation of borrowers from their cash with the significant alacrity. By granting of the old triple “A” rating, the underwriter can now foist the paper unto them onto customer, usually an unsuspecting institution that can’t walk and chew gum at the same time. The foisting process is called the creation of “Mortgage backed securities” (MBS). Alan Greenspan put into perspective the problem he visualized with this process:

“The crisis will leave many casualties. Particularly hard hit will be much of today’s financial risk-valuation system, significant parts of which failed under stress. Those of us who look to the self-interest of lending institution to protect shareholder equity have to be in a state of shocked disbelief. But I hope that one of the casualties will not be reliance on counterparty surveillance, and more generally financial self-regulation, as the fundamental balance mechanism for global finance.” (Financial Times, March 17, 2008)

Once the loan has become part of an MBS pool[8] you have become a missing person, never to be found again even by the FBI. Your loan has just been dehumanized. You have now become demonetized, only your uncompleted loan application form and approval along with various and sundry other papers that will never see the light of day again.

The process of making you vanish entirely is now nearly completed and the issuer through a series of confederates has taken what amounts to “contaminated meat” and passed it off medium rare filet mignon. It is part of an essential investment process that ends with a guaranteed income stream for each party in the chain. The lender has separated himself from the loan itself probably, causing him to want to take his money and disappear from the face of the earth before the indictments are issued. I mean this guy really wants no part of any of this transaction due to the fact he is well aware of from whence it came.

For the borrower, although the chickens have come home to roost when they have readjusted his loan upward and there is now no chance that he can make his payments. All this pathetic schnook wants to do is renegotiate an appropriate solution. Naturally, he goes back to deal with his lender and now finds out about the facts of life; “Elvis has left the building and he isn’t coming back,” he is told by a cleanup crew fumigating the lender’s premises. Who does this legitimate indigent now turn to work out a new repayment schedule? I am not sure I know. After analyzing the entire process, this transaction is unbelievably complex; many of the underlying documents have disappeared or never existed. How do you renegotiate something that only exists in the mind of the underwriter? I don’t think that there is an answer to this question. Our negotiable borrower has been computerized out of this universe onto another planet.

Seriously, he has now become a number in a portfolio of loans without faces and that is just what has occurred on the borrower’s side of the transaction. The lender now only has an answering machine that has long ago run out of space in the message that says, “Please leave your message and we will get right back to you.” If you think that message will ever be returned you are probably still waiting from a visit from the tooth fairy.

There is little or no way of renegotiating the transaction as it has become tragically impersonal and it is now part of a jumbled package where an individual loan probably means little or nothing. For example, let’s assume the MBS package was a billion dollars and our average problem mortgage is $200,000 which is probably in the ballpark. That makes this loan, statistically one out of 5,000 and probably is not even worth the price of admission for the trustee to work on. Moreover, in preparation for this eventuality, the trustee has undoubtedly assigned his job to a company that takes care of this sort of thing for a fee. In the long run, throwing the property into foreclosure would probably be cheaper. However, that is something that can only happen in conjunction with other players and is unlikely.

If it was possible, the foreclosure could be accomplished by the fund putting a local attorney on retainer to deal with these defaults en masse and then turning the property over to Century 21 or Goodwill auctions for liquidation. This property has indeed become a piece of stale meat. The American dream has just become a nightmare and the creditors are only inches away from your new residence in the trailer park for indigent citizens. Your loan, your house, your credit and your life is now just a statistic and no longer exists within this continuum. However, there is more to the process than meets the eye.

Finishing the process

Before the particular loan is taken into the pool, the entity usually legally becomes a trust which seemingly insulates it from regulatory supervision. Underwriters have to do this process on the fly because subprime originators usually have a half life of days. Literally hundreds have already down the drain and many more are what we call “walking Zombies” they are dead but either not aware of it or refuse to admit it. Most of these folks have been able to slink aware under the cover of darkness, but a few have been apprehended, some traveling to foreign countries carrying bags of diamonds out of the country with one way charters on rented jets. This management objective is geared to move the collateral into a safe place before the subprime initiator collapses under the mounting pressure of bad loans. This is hardly a business for “Old Men” as they have stated in the movie.

The trust insulates the investors from the legal problems of the originator and the issuer while also providing a tax free vehicle to pass through the returns. The trust administers the operation, scams off part of the money for expenses and salaries, and then distributes the residual funds to the investors. Yet, even the trustees do not want to Sheppard the loans due to the liability and time involved so the trust more often than not hires a “servicer” that is responsible for the collection and distribution of proceed, dealing with the unpleasantry of defaults and handling liquidations. In many cases any party in the chain can play that role but from a legal point of view, this is probably the same thing as playing catch with a jar of nitro glycerin. The thing can go off if it slips and even the slightest misstep can bring on a disaster.

The folks that take up the rear of the daisy chain

Other people that join the handout daisy chain are the ratings people and the “credit enhancement folks” (usually the monolines[9]). With all these hands in the pie it is a miracle that anything is left for the investor, but with the situation as it now stands we will eventually have add a bankruptcy attorney, the bankruptcy trustee, along with the forensic accountant and the debtor in possession into the of those in the feeding chain. Can you conceive of the convolution that the Wall Street financial engineers had to put themselves through just to glom onto a few bucks from literally folks living so far down the economic chain that they could not even be found once they had achieved this nebulous substitute for of home ownership?

more complexity than working for a living

However, we are not finished with all the pieces of the puzzle yet; it gets a tad more complex. This thing is similar to going all the way through a Medieval Labyrinth only to find a three headed, fire breathing tyrannosaurus waiting for you instead of the beautiful maiden. It was hardly worth solving the riddle with that outcome. However, this silly contrivance now has to be “layered” so that ever more players can get their hands on their share of the bounty. This process is called “credit tranching”. Each level of the pie must be carefully structured in order to maximize the return to the underwriters. The higher you climb in the structure the higher the rating of the debt, or in another way, the lower you go, the nearer you get to being totally wiped out. However, the lower you go the more equity has to be issued to investors and by over-capitalizing this class you have watered the investment. On the upper side, by giving up too much collateral at the Senior Debt level, you are leaving no collateral at the bottom if things get deadly. This is the ultimate tightrope and missteps are often fatal.

Putting the senior debt level into perspective we have the credit enhanced triple “A” bonds or at least that is what they were before the world suddenly came to an end. These contained a guaranteed income stream but not the documentation itself. That is found one notch further down the credit ladder. This is a very interesting structure due to the fact that by removing the collateral, from the income stream, there may well be state laws that have been violated. However, that is not the real problem, should the loan be called, it would appear that the senior debt could not do it unilaterally and cooperation of some sort would be required of both levels. This concoction of pieces of a pie has been cut up so disastrously, it would seem no one has direct access to a defaulted loan and there is almost no way this can occur.

As we descend further into the inner circle of Hell, we descend into the third concentric circle and we start to perspire from the increasing heat and can now visualize fires burning very close to where we are. We are approaching the area that contains preferred stock, sort of confluence of both debt and equity. The preferred is part of the transaction’s equity base but until these shareholders have been satisfied, the equity holders will receive nothing. The chances of them seeing anything ever from the lower levels of these transactions are about the same as winning the Irish Sweepstakes without a ticket. Due to the fact that the structures of these transaction fall from their own internal weight probably means that little or nothing will be recovered for the senior levels of debt as well.

The lowest level looks somewhat similar to our vision of like the inner circle of hell as depicted in Dante’s Inferno. Whatever they want to call this lowest level of financial life doesn’t much matter, but Hell and equity in this deal are synonymous. Although the “Underwriter” never assumed that it would be any different. He was betting on success but insuring himself against failure, something no one else in the chain seemed to have the brains to think about.

The remaining nuances of the transaction once again bear the earmarks of the writings in the Communist Manifesto by Carl Marks. He was a big fan of the redistribution of wealth throughout the system. The end result of this fiasco will not necessarily make the poor any worse off but will certain level the playing field for the rich, the banks and the monolines. The poor folks had nothing to lose and therefore had little or no downside.

This concept is obtuse to say the least. However, when viewed in its entirety, who ever thought up this misfit must have been a joking when he originally kicked around the structure with his colleagues. For some reason that we are unable to fathom, a local idiot savant must have taken this practical jokes seriously, however, whenever something becomes just too complex they will tend to break at rule, regulation or law somewhere. This was a bit of luck that the insurance companies (non-monolines) fell into. While begging to get into the transaction it was discovered that there were certain built in glitches in the transaction that would ban ownership in most insurance company portfolios. The insurance companies that have historically been among the worst investors in the world avoided the biting of the bullet this time.

what happened next Charlie?

Primarily, the insurance companies were allowed to guarantee the rating but for the most part were not allowed to participate in the funding. This probably permanently saved their bacon. The suckers that were left in the deal when the smoke had cleared were the mutual funds, the hedge funds and, to a more limited degree, the pension funds. Nevertheless, these folks aren’t fools and they know that everything that glistens is not gold. They figured out that that a shifty originator can always sneak some sub-sub-subprime loans into this package, get paid for his contribution and then the first day after the issue comes out it goes into default. These folks weren’t born yesterday. Or for that matter, why not throw in a couple of non-existing transactions which did not contain real people and were built around imaginary real estate. These were the go-go years of investment banking and getting the product out the door had become more important than proper due-diligence or the protection of investors.

Thus they demanded what they termed to be “sell back” or a collateralized “put” called “a repurchase agreement”. The point of this that the underwriters were trying to deal with is the danger that they were buying a package of junk and that could possibly tank before they had finished issuing the paper or cashing the check. In order to determine how to create this sophisticated model they again turned to the inventor of this disorganized ill-conceived collection of non-negotiable securities. Should the package return less than the model the package had been predicated on; certain escrowed funds are returned to the transaction to cover these anomalies. That is if they have been escrowed and the packager hasn’t left town. However, factually speaking most of these packagers have all almost universally gone down the drain or unable to repurchase their obligations or have hurriedly left the country. My guess is that these escrows were handled as perfunctory as the entire deal and at best there will be enough left to possibly get a free one-way ride out of Manhattan on the Staten Island Ferry. (Free)

What are the possibilities?

On the other hand, in spite of everything stated above and the obtuse number of fingers in the pot the situation would sort of shape up a little like this; the subprime borrower buys his house and hits the housing lottery jackpot and decides to pay off his loan because rates have collapsed and he can refinance under better terms. This sort of behavior would tend to screw up all the plans outlined previously, the Wall Street underwriters created another new term, with entitled, “negative convexity” which described their possible plight under this scenario.

This fancy phrase means simply that the borrowers can theoretically keep the mortgage if rates go up or refinance if they go down. No wanting to give the suckers and even break would not be in the best traditions of the “Street.” It would also have a tendency of unbalancing the transaction and could substantially affect overall returns. They solved that problem rather simply by not allowing subprime borrowers to refinance without enormous penalties and charges. They created an impasse’ so severe that the market for mortgages would have to fall into the area of fractions of 1 point in order for the buyer to come out ahead on a thirty year ARM. This problem had almost slipped by and ruined then entire fabric of the transaction if it hadn’t been nipped in the bud by creative foresight. Wall Street has seen the enemy and found it to be destitute.

Where have all the regulators gone?

The latest figures published by UBS seem to indicate that the subprime loses were now headed toward a total loss of over $600 billion and that the loss of $150 billion already had evaporated. Robert Herz, the chairman of the Financial Accounting Foundation Board (FASB) seemed to agree with the fact that $150 billion of the money was irreparably gone. FASB has allowed the derivative to sink further into the obscurity of an opaque balance sheet. However, Mr. Herz seems to think that oversight is akin to working with the devil and that derivatives are as pure as Ivory Soap. These are indirectly the folks that allowed this disaster while “out to lunch.”

How on earth can the regulators even have a clue relative to what is going to happen next when more often than not, the financial institution owning the derivative can’t define exactly what they own, where their collateral is, and what if anything is covered by an insurance policy that guarantees a rating but not the funds and what they would do if they had to liquidate their loan without the attendant collateral or full ownership of the security? Derivatives continue to be clearly devilish instruments that have already played an integral role in the catastrophe that destroyed Morgan Guarantee Bank, Bankers Trust and Continental Bank of Chicago. As the usage of this sort of instrument is only created to disguise black holes in the balance sheet and is a message that an accident is going to happen soon.

Now that the horse has long ago escaped the barn, Mr. Herz thinks the time has come to revisit the logic that has allowed this inconceivably economically catastrophic policy to persist where balance sheets are no longer worth the paper they are written on. Now that Citibank has had to have gone back to the financial well on several occasions, and Bank of America had to buy Countrywide literally in order to stay afloat, now that the regulated companies such as UBS and AIG have almost drowned into financial quicksand due to the crap shooting environment promulgated by a void in regulation; FASB is seemingly waking up to the fact that it may have are becoming a victim of their own negligence that have wrecked the organizations under their aegis. FASB had a mandate and while out to lunch, set the country up for disaster. As a primer to how this vacuum has caused rampant dislocations within the investment banking industry there are some limited facts worth reviewing, Citibank’s balance sheet currently shows $1.1 trillion in assets of which fully 50% are not visible to the naked eye. Simply put we would raise the question, why would any legitimate institution want o hide the nature of their assets; the answer is rhetorical; either they can’t disclose an empty pocket or they are unable to define the assets they are holding. This is really some fine state of affairs.

When the Regulators are away, guess what happened?

There is any number of examples of can occur when regulators refuse to regulate. Clearly investment bankers are in the business to make profits, accountants are looking to rake in the dough by assuaging their clients and trying to “help” no matter how “complex” the problem; other professionals that work in the chain of command are not much better and one would think that most lawyers should reread the ethically code before each and every case they take on. I think the following story of a famous company gone sour gives you a living and breathing illustration of what happens when only one bad apple starts cluttering up an unsophisticated financial landscape. However, this sort of thing can only occur when the regulators are asleep and the leader of the pack, has screw coming loss, is crazy and has a criminal orientation all at the same time.

When the regulators are at play, the worst things occur.

Please keep in mind as we run through one of the great disasters of American Business the fact that regulators at the top of the feeding chain are more often than not, political hacks that have been appointed to their jobs not because of any history of professionalism in their field but because of political donations and need for a job. What happened with E. F. Hutton happened only a decade or two ago is exemplary of describing the ineptness of current regulatory oversight. This particular crime in which hundreds of white collar people were involved was not discovered by any of Hutton’s regulators and if wasn’t for a small bank on the East coast, these folks would probably still be around. For its day, it was easily the single largest fraud in American history with all of the regulators, caught asleep at the switch. The criminal transactions came into the light of day, not because they had pilfered too much money but because they were running an unprofitable business and propping it up by stealing funds as their primary business. Too many unsophisticated folks were involved in the creation of this massive rip-off for it to remain in Pandora’s Box very long.

Everyone listens when E. F. Hutton speaks except the regulators! They are having lunch

Edward F. Hutton the investment banker that founded the brokerage firm that bore the same name was born in New York City in 1877. His family was poor and his father died when he was just ten. He was forced to drop out of school to help support his family and started his business life as a mail boy. Ultimately, Hutton became a stockbroker, married well, and began a small brokerage house with his father-in-law’s help. His big break came when he opened up an office in San Francisco at the time of the 1906 quake. Interestingly enough, Hutton had a direct telegraph line to New York when else really knew what these contraptions were about. However, when San Francisco quake hit; he was able to rack up big profits by reporting the fact before the disaster had ended. So the brokerage firm got its start not because of a successful approach to the industry but because Hutton had the foresight to be technologically a step ahead of this competition and he knew what to do with his knowledge when faced with disaster.

However, Hutton ran an open-shop at the brokerage house and encouraged each and every employee to let him know directly if they had any ideas for improving the firm. Paradoxically, Hutton’s shop was almost anarchistic; if you were not mature enough to go with your own decisions, you really were not made of the stuff for which Hutton desired. Whatever the logic of this business model, E. F. Hutton, the brokerage company grew until it was one of the largest firms of its kind in the United States, and for a time stood second only to the mighty Merrill Lynch.

Hutton had worked himself up through the ranks, ultimately becoming the Chairman of General Foods as well as the head the brokerage company. E.F. Hutton which was ultimately merged into Shearson Lehman Brothers in 1987 and entered into financial oblivion as their name disappeared. The successor firm is now called Salomon Smith Barney (part of Citigroup). The brokerage house became widely known for the slogan: “When E. F. Hutton speaks, people listen.” The commercial was a stroke of genius and gave it name recognition far beyond the firm’s own standing within the industry. However, the commercial was true only to the degree that the only people that were listening to what E. F. Hutton had to say were a tad out of step.

Hutton’s management remained aggressive even after their leader’s (D. F. Hutton’s) death in 1962. This aggression manifested by Hutton honing the art of internal money management to a degree that went well beyond the limits of legality or propriety. Their actions were clearly visible due to the fact that the refutation rate of Hutton checks from Bank of America’s data processing equipment was becoming overwhelming. Bank of America had noticed that easily 50% of the checks that Hutton wrote could not be processed by computer at a time when manual processing was no longer in vogue. The bounced checks were caused by small errors in the making of the checks which caused them to be rejected out of the electronic system. While this was originally chalked up to sloppy booking, the only apparent harm was the fact that the check in question had to be reentered into the system manually to be taken in thus causing a substantial time delay.

However, there was a method to the madness; the rate of rejection of Hutton checks ran an inconceivable 50 times the average in the system, allowing Hutton to profit from a much longer than average float on their checks. Hutton was thusly able to take advantage of a much longer float on their checks. This little trick was consummated in a number of ways but the mother of all of this invention was the simple routine of the rubbing grease into the fibers of the check before it was processed. When a greasy substance was rubbed into the check, it would slide through the electronic counting device unnoticed and for that reason had to be pulled out and re-entered by hand.

“Greasing the check” as it became known at Hutton worked well but if the brokerage firm always played the same game at some point regulators would get wise and cut off the illegal cash flow. Thus, the executive committee wanted to prepare for that contingency; they had to become creative and have a few other tricks up their sleeves so that they could claim that their check writing fraud was just an accident. The so called “Hutton Department of Criminal Activities” went to work to create an alternative check defrauding device and brilliantly soon came up with the simple solution of putting a staple that appeared to be placed at random in the bar coding which would totally made the offending document unreadable. As the merry “Hutton Criminal Team did additional research on the matter, they came up with the ultimate "Fed Con", a folded check, the check would not make it through the data processing equipment and get bounced every time. Hutton rewrote their manual for forgery and used this latest scheme to conduct their business from this point on.

Having an arsenal of formats for criminalizing the system and increasing their float Hutton was now able to put in motion one of the great muggings of all time. However, that worked for a time but as the greed factor increased dramatically; Hutton’s shenanigans were causing a massive backup at the Bank of America (B of A) check clearing facility. B of A performed a full evaluation of what was causing this expensive back up. It did not take much time to identify a road clearly leading right back to Hutton and the suspicion of foul play was voiced. In clear terms the bank acknowledged to Hutton its suspicions and stated that Hutton’s checks were being deliberately doctored. In spite of the fact that Hutton was a large client, Bank of America was in no mode to screw around with this messy situation and gave Hutton two choices: either they would stop playing with the checks, or the Bank would close their account and report them to the Treasury. Hutton complied. Bank of America had indeed put a stop to a massive criminal activity and went back about doing their business.

However, the Hutton criminal research went back to the drawing board and never stopped trying to find the ultimate answer that would allow them to screw all the banks they dealt with and believe it or not that had come with a forth with the ultimate plan to beat the system.

The geeks at Hutton devised a “use of funds” system that predicted almost exactly how much money E. F. Hutton would need in a particular branch on any given day. Whatever was in excess would be bundled up and wired out by 1:00 PM so that it hit and was credited to Hutton’s money center account on the same day and started to pay interest immediately. However, this semi-legitimate money management device required top flight managers to insure that the scheme was carried off like clockwork.

Hutton’s top management felt that in order for the system to work properly, they needed the total co-operation of all of their branch managers. Understanding this problem, they rounded up their key people, proposed a joint venture, creating an internal criminal operation in conjunction with the hired help and for their assistance in what Hutton claimed was a “noble cause”; the managers would be blessed with 10% of the interest by Hutton that was earned by the particular office as a bonus. Now Hutton had indeed created a large internal criminal network that was clearly incentivized. It was a hard working crew and they were joined at the hip in a criminal operation of massive proportions. However, the managers were making big books and no one seemed to care anymore as to whether they ever bought or sold a security of their customers. “Just kite the check and forget the business” became the Hutton slogan.

This has all happened before and not that long ago. You can see yourself both coming and going at the same time.

This was not a bad idea as far as it went. When funds could be packaged to hit the bank before 1:00 pm, credit appeared on that day and office profitability sprang through the roof. Managing money that had been deposited in the bank was a great trick; however, the brokerage business had been left in the dust and in spite of the system working like a well-oiled- machine, the business was wallowing in the mud. Management once again called in the criminal unit along with the geek. “We need another shot in the arm that lets us steal even a tad more” they claimed to all concerned.

Management was well prepared to give the managers a lesson in basic economics. They were told that by drawing down excessive amounts of money, the manager created excess in the interest account against uncollected funds in his local account. This was now a mandated system requiring special dedication by the managers and they were informed that they would be well rewarded for their diligence. Clearly, small town banks did not have the necessary oversight systems in place to figure out what was occurring; indirectly they were unquestionably being nickel and dimed into bankruptcy by hundreds of white collar criminals all collaborating on the most massive theft ever to take place in American business. However, they couldn’t exactly identify how the sham was being carried out.

By 1978, Hutton’s management had become increasingly more displeased by its bottom line. The firm had become a money-eating machine. But profits had totally vanished and this firm was only holding on by the thinnest of thread. Numerous meetings were held to discuss how to unravel the looming insolvency. After giving thought to numerous ideas of a mostly criminal variety, one possibility seemed to hold out the most hope among Hutton’s most senior officials. It was suggested that the firm transport itself into an overdraft criminal conspiracy and subsist on customer’s float. The conspirators thought the situation out very carefully and concluded that even if they were caught, the banking regulators had no regulatory control over a brokerage firm, and Hutton would get off Scott-free under almost any scenario. However, Hutton’s legal analysis was extremely flawed. When regulators finally got wind of the scheme, they concluded that it actually constituted a radically illegal mail fraud.

No more small time stuff for us was the rallying cry that went up from the Hutton meeting and by 1980, the checks which heretofore had been written for a thousand dollars or more were being replaced with multi-million dollar overdrafts, literally an act of theft against the banks that were clearing the transactions. Hutton was now going for the heart and if they could get this scheme under control, the world would become their oyster.

The execution was well thought out and the plan became a startling success, and in that year, Hutton was able to cut its bank borrowings on a daily basis from almost $400 million to a more manageable $200 million per day. Assuming that Hutton was paying 10% interest on the money, a figure that would probably have been conservative for that time of high rates that existed during that period, they would have conceivably saved almost $20 million in 1980 alone, a very pretty penny indeed.

However greed breeds greed!

Exhilarated by their early success, upper management pushed their branch managers vigilantly kite more checks and return higher rates on their illegally dominated float. Those managers that underperformed were given a work sheet, which carefully denoted the difference between the monthly commission that they actually received and the one that they would could have received if they had cooperated and become more productively involved in the plot. However, Hutton Officials were not entirely with the incentivization, one of the public relations oriented conspirators determined, that in each pay check, they would receive a check for what they were owed by Hutton for their conspiracy oriented profits as well as a hoard of monopoly money indicating the additional amount that they would have earned had they been more earnestly involved.

An unlikely New York State Corporation owned the Genesee County Bank, a small upstate bank at which E. F. Hutton had just opened an account. The management at the bank soon noticed that Hutton was writing checks for millions of dollars that could not possibly be covered by their funds. Hutton was depositing uncollected funds from the United Penn Bank in Wilkes-Barre, Pennsylvania into Genesee County Bank and trying to use them as “good funds”. Genesee Bank Officials wasted little time in contacting the New York State Corporation officials who in turn called the United Penn Bank asking whether or not there were good funds behind the checks. The response went, something like, “Hutton never has good funds.” United Penn Bank told the caller that the check that they had issued to Genesee was indirectly backed by a third bank-check probably issued by Manufacturers Hanover, Hutton’s primary bank. Crunch time had occurred.

New York State Corporation officials told the Genesee Bank to bounce the Hutton check. They then called upon the manager responsible for the check at Hutton. He indicated that his orders were coming from higher up and he was only a small cog in the chain. He gave them his superior’s phone number and up the daisy chain they went. The buck stopped at a very senior level, and the seriousness of what had just transpired was impressed upon the executive with whom they spoke. Hutton offered to deposit $30 million to its Genesee Bank account to cover any inconvenience that Hutton may have put them through. Genesee officials accepted the funds an hour later, and then promptly froze the account. Thus, $30 million of Hutton funds was tied up in the small bank for over 90 days causing Hutton endless pain.

In late December of 1991 Genesee officials wrote to “the state and federal banking regulators, the FBI, and the Secret Service describing everything Hutton was doing. A few days earlier, United Penn had notified the Federal Deposit Insurance Corporation, a federal banking regulator. As the complaints started flowing in, the banking regulators realized they had a potentially very significant problem on their hands. They had to investigate.” They were literally forced to get out of their easy chairs and to do something about what appeared to be a massive fraud. It turned out that they were totally right.

Simultaneously a possibly unconnected but dangerous event occurred. As though Hutton didn’t already have enough problems, a new account opened at Hutton started depositing astronomical amounts of money in the firm on a daily basis. The U.S. Government which was already all-over Hutton conducted an examination purportedly with Hutton’s offer to be cooperative. Just as the Government was about to close in for the kill, they found out that the accounts in question had been closed and the money had been removed. Worst yet, it was based on a tip that was conveyed directly to the account from senior Hutton management. Government investigators, which included FBI chief Louis Freeh, were incensed with Hutton’s backstabbing. Hutton had indeed had made a very treacherous enemy.

In 1983, Hutton’s overdrafts totaled one-half billion dollars and its bottom line effect on the brokerage firm was that this form of interest income accounted for 75 percent of the retail brokerage division’s profits. The Justice Department of the U. S. Government soon confirmed discovered this intricate system and began an extensive inquiry. The conclusion of the government’s investigation was released in 1985 when Hutton “pled guilty to 2,000 counts of mail and wire fraud, charges stemming from the use of the nation’s postal service and telecommunications networks by Hutton to defraud its banks via the draw down system. The firm teetered on the brink of insolvency until 1988, when it was purchased by Shearson Lehman Brothers, one of its major competitors.

Andersen does the tango, but is dangerously out of step

Congressional investigators were particularly galled in the way Hutton’s auditors mischaracterized the overdrafts appearing on Hutton’s financial statements. There was no “overdraft” item on Hutton’s balance sheet; Hutton’s accountants used the term “Drafts & checks payable” instead. The government determined that the two terms meant entirely different things, and Congress in their ultimate wisdom correctly concluded that this language was merely a smokescreen covering up a much more serious situation. Congress was also not too happy with the fact that while Arthur Anderson, the accountants for Hutton had sent a memorandum asking Hutton senior management for the files outlining and explaining in detail Hutton’s management procedures. In spite of their aggressive approach, Andersen’s letter became lost in the shuffle and it was never followed. Congressman Hughes had a little discussion with Andersen’s audit partner regarding this matter:

Congressman Hughes: Mr. Miller, what did you do after the meeting that took place on March 7, to check the accuracy of what was related to you?

Mr. Miller Well, after the meeting, sir, I reflected on the entire meeting; the fact that I had a hundred bank confirmations with no exceptions noted…the fact that I found no evidence of checks bouncing; I found no unusual fees being charged by the banks to Hutton.

Congressman Hughes: That’s not my question. My question is: what did you do after the meeting? Because, frankly, to your credit, you did see that there were some problems…Did you ever get to the bank’s point of view on the system?

Mr. Miller: No, Sir.

Congressman Hughes: Well, here’s what you say, “Joel Miller then stated that he would discuss the matter with other partners at Arthur Andersen and Company whose clients include major money-center banks, to ascertain what the banks’ point of view is regarding these transactions.”

Mr. Miller: Sir, I had a hundred confirmations from the banks. When I got back to my office and reflected on the entire meeting, I concluded that none of the banks had notified me of any problems—

Congressman Hughes: So you didn’t follow through.

Mr. Miller: Well, I followed through in that I reflected on the entire problem and I concluded I would stick by the opinion that I believe Mr. Rae gave me.

Andersen Dumbs Down, not a exactly hard for them to do

Congressman Hughes was not all that assuaged by Miller’s testimony or lack thereof. Hughes called Abraham Brilloff[10] to discuss the fact that in spite of the fact that the Justice Department had been examining Hutton with a fine tooth comb for over two years, there was not a peep about that matter from the usually ebullient Andersen other than an obscure footnote:

“The company and its subsidiaries are defendants in legal actions relating to its securities, commodities, investment banking, insurance and leasing businesses. Certainly these actions purport to be brought on behalf of various classes of claimants and seek damages of material [sic} for indeterminate amounts. In the opinion of management, these actions will not result in any material, adverse effect on the consolidated financial position of the company”;

Congressman Hughes: In your opinion, was this disclosure adequate, given that it was a little more than a month before Hutton pleaded guilty to 2,000 counts of mail and wire fraud, that obviously, at this time, Andersen was on notice of the ongoing grand jury investigation, and, in fact, had been subpoenaed?

Professor Brilloff: This disclosure was very much like a bikini-bathing suit, what it revealed was interesting, what it concealed was vital.

Whatever Andersen tried to do to have the matter corrected was largely wasted effort. For example, they did the right thing by going to the audit committee and pointing out several of the problems that they saw. However, the audit committee was more or a rest home than anything else. Hutton’s management did not consider that the committee was worth dealing with and considering their makeup, everyone was correct. None of the members had the slightest idea of what was going as they were apparently picked for that job solely based on their lack of expertise on the subject. One of the more auspicious members was a movie actress that was a granddaughter of Edward F. Hutton. In essence, Andersen’s words were completely wasted on the committee.

The Government was never able to affix the blame for this fiasco on any one person or group of people. The branch managers blamed the executives, the executives blamed the internal auditing staff, and they in turn blamed the outside auditors, who blamed the branch managers. There was no particular paper trial for the government to follow. Out of frustration, the Justice Department literally indicted the whole firm. In spite of that fact, there was a hearing before a congressional subcommittee to look into the matter. The committee asked the famous accountant, Abraham Brilloff to look into the matter and give the committee some insight into what he discerned:

An indictment against the accountants, But nobody was watching

Brilloff stated as follows: “Where has Arthur Andersen failed?…At the outset and most importantly, they failed to follow through on what they absolutely saw and understood were questionable transactions, as early as 1980. They questioned counsel and counsel said, “Go away, we’re too busy to respond.” It is my view that had Arthur Andersen really fulfilled its responsibilities under the circumstances, the Hutton money-management excesses would have been stopped dead no later than 1980 or 1981.” But we know Arthur Andersen, they were always interested in getting involved in the dirty side of the business as this was about as bad as it gets. Andersen pitched with vigor they had not showed for decades to help their clients deceive everyone in sight including the bank regulators.

Edwin Meese was the attorney general of the United States in 1985. The Hutton case was so egregious that he personally took charge of the announcement of its disposition, which read:

“The Department of Justice today filed a criminal information charging E.F. Hutton & Company, one of the nation’s largest securities dealers, with two thousand counts of mail and wire fraud. The essence of the charges was that Hutton obtained the interest-free use of millions of dollars by intentionally writing checks in excess of the funds it had on deposit.”

Congressman Mazzoli put Andersen’s roll in the Hutton scheme into perspective:

“Maybe some of the newer practitioners of accountancy have lost sight of the traditions and lofty history of the profession because they walk into firms now that are groveling for money just like the most mercantile of companies. Maybe they are incapable of having this high fiduciary standard that we, at least in my generation, grew up with in law, accountancy and in medicine.”

With 2,000 different counts against it and substantial fines to pay, the firm Hutton enterprise eventually merged itself out of business. Arthur Anderson had done the accounting for Hutton and knew all about what was going on. They had indicated that the overdraft scheme was highly questionable. They did not resign, nor did they go to the authorities or qualify their opinion. Seems to me s though this just another average day in the life of the accounting firm of Arthur Andersen; at the rate they were going, if they had stayed in business much longer, the whole world would have come to an economic standstill. There is little question that Edward F. Hutton probably turned over in his grave regularly.

Today however, the use of off-balance sheet vehicles has allowed lending institutions to leverage their loans substantially more than if they were part of a transparent structure. Hutton had achieved their black belt in financial deceit in a world that had more transparency than exists today. Had Hutton attempted to pull of the same trick today, under yesterday’s rules, with new literally wartime banking regulation in place, the world would now be in a state of total collapse.

However, what is bad for the public is often very good for others. This system of dealing with mirrors and subterfuge could potentially make the government more money from tax receipts; however, one would think that if you earn the money using Mafia type transactions, you will probably want to cheat the government as well. However, lawyers usually receive higher fees when they opine on transactions that are questionable at best. Either the accountant are total fools or they are also being paid a tad more to look the other way when their client has been caught by the accountants having been caught with their hands in the virtual cookie jar. The accountants also opine on a hopelessly opaque balance which states a bunch unreadable or immeasurable costs, expenses and primarily assets and liabilities along with out-of-sight projections created by management.

Another non-event

“Backstop financing” which is part of the fundamental and rickety foundation of off-the-balance sheet business transactions works well under healthy global economic systems and totally falls apart the second anything goes wrong. What good is something that only protects you when you have no problem? This lose – lose strategy is what is happening today as the banks were forced by buybacks to bring poorly performing assets back onto their balance sheets, thus, in turn causing these massive write downs. Backstop financing is at least a realistic insurance policy that offers a modicum of protects.

a tax on extreme dumbness

However, with further analysis; let us assume that a hedge fund using substantial leverage and has received a backstop agreement for their subprime investment as well. Any chink in the hedge fund armor can cause multiple hit. The collateral loses value that has been submitted by the hedge fund and the bank must also pay the loss on the subprime debt. They could well be paying this money to a bankruptcy, another lose – lose situation. The excess taxes collected by the government at the height of this folly will be returned to the investment banks in terms of refilling previous returns or a future right-off for future years. If the figures that are now predicated of the losses attributed to the so called subprime loan situation, all the major players involved will either be receiving substantial money back for previous years or not pay much in taxes for the distant future. This is going to have a substantial affect upon the Department of Treasure projection on forthcoming tax receipts.

There ought to be a dumbness tax that kicks in when you have either entered into or created a transaction that is sub-mindless. Why should the taxpayers pay large institutions for screwing up by lending to off-shore funds money on ill-conceived deals that will have no American tax implications no matter what Moreover, a hierarchy of dumbness should be created with ratings of 1 to 10? We would view, investing in a Nigerian scheme or the Irish Derby as a 10, just about the stupidest conceivable investment known to man. As the transaction became more complex and opaque, along with the necessary endorsement by supposedly legitimate lawyers and accountants; real Wall Street Underwriters sponsoring the transaction; and white shoe banks acting as trustees the higher the chance an unsophisticated entity could get caught.

Thus, the dumber the idea the increased chance of it not being discovered, the lower the stupidity tax would go. That would be the first half of the alternative tax transaction; the second would be a hierarchical surtax on those professionals that were paid to participate and endorse a scheme that they know was iffy at best without issuing a statement of palliation. The greater the disaster the higher the alternative minimum dumbness tax would rise. In either case the limit to the ignorance tax would stand at 10. So if the investor made a purchaser bought a ticket on the Irish Sweepstakes and later found out that he had been zonked in a phony, he would be a 10 and in this receive no deduction for his stupidity.

If he bought into a subprime deal that had constructive opinions attesting to its legitimacy and the other accoutrements, he would be a zero and the professionals that attested to the transactions legitimacy would be a 10. Under the “dumbness rating hierarchy” (DRH), every bad deal would of necessary need 10 points once it had been rated too stupid to have legitimately existed in this universe. Clearly the law of diminishing returns is clear in this instance: the more over-reaching its, affects the higher the tax and the more poorly thought out the project the greater amount that should be paid. Thus the cost of investing in these schemes will at least be thought out more carefully and the economic affect upon the national economy will start to decline. The money should go to support financial fraud education, in order that they stop listening to every stupid deal thought up by people with white shoes living in ivy towers.

It would appear that we have wondered into a mole hole and have traveled backward into time and are back into the Wild West times of the Savings and Loan crisis. It was a world where money was being raised for a series of off-the-wall transactions right out of the bank’s branch offices. The horrific part of these times were the fact that unregistered securities were being pushed by unlicensed brokers who were given a feeling of legitimacy by a fancy office, elegant cards and the cover created by the up-to-this point unsullied reputation of the S& L.

In order to bring back those good old days, there is proposed legislation in Congress which if passed will force the banks to revert to one of the tools created by Darth Vader (and others living on the dark side) to conquer other planetary bodies by creating economic catastrophes that would throw entire galaxies into financial panic. These “Darth Vader” instruments are given the horrifying name of “qualified special-purpose entity” (QSPE), which is really a synonym for selling mortgages within the banks portfolio directly to investors with warrantees squirreled away into a corporation that our research indicates is located, in a galaxy far, far away. These pathetic instruments are being created within the inner circle of hell.

Upon the default of this collateral, the warranty will be called upon but be returned with an addressee unknown from the dead-letter office. The ultimate guarantor is still the S & L and upon the warrantee “kickback”, these banks will once again have to write-off the underlying risk of guarantee putting the institution into worse condition than it was originally. This type of transaction is at the very heart of the extraordinary and may well form the venue in creation of a future loss for our banking systems of hundreds of billions more that will have to be absorbed into the system. Just as Mr. Vader creates a galactic fear by threatening his adversaries, this product could well be a preamble to the end of the world as we know it.

Under these circumstances, who can you trust?

The speed of light times a tad!

Simply put, in today’s economy, when international credit lines dry up it is no longer an event only crossing a limited number of borders. Historically, from World War I until World War II, the United States had economically insulated themselves from international, political and monetary involvements. The order of the day was absolute isolationism and as evidence of how bad it became was clearly the fact that Woodrow Wilson’s dream, the League of Nations never became a reality at least as far as this country was concerned. Moreover, its feebleness to accomplish anything could probably lay right at the lap of the attitude put forth by the United States Congress. Had this country become more involved, the course of the rise of Hitler and Mussolini could have possibly never have occurred. The situation in the Pacific Rim was something different and requires analysis from a totally different viewpoint.

However, our country received a wake-up call in the period immediately preceding World War II and as technology advanced over the next six decades, various countries became increasingly economically bonded at the hip. The number of countries making up this electronically connected bloc, continued to enlarge exponentially and today all of the world’s nations have become networked into the process. This has created a leveling of the playing field as cheap labor became attraction enough for businesses to expand their scope into underdeveloped nations. Moreover, new customers were created by this process as well.

Thoughts of economic warfare replaced the dangers of physical confrontations as the Soviet Union collapsed. Moore’s Law seemed to replace Einstein’s Theory of Relativity as the time between invention and utilization telescoped into an ever diminishing periods of time. Simultaneously, as more people are added to the earth’s intellectual pool, there has become a geometric amplification to human computing power that will continue to grow over at least the next five decades. Sometimes the rules change and we are left out of the loop. The below story can illustrate the economic repercussions of such an event.

In the 17th Century, merchant ships would be out calling on the world's ports in voyages lasting for up to two years at a time. As the story goes, one of these ships had left Holland for parts unknown and during the two-years that it was under sail, that country became involved in a tulip craze. It seems that everyone had gone Tulip crazy at the same time. The price of so-called valuable and rare bulbs shot up to stratospheric prices.

It was during this time that the sailors returned after two years at sea but they had not had any vegetables to eat for weeks and many were suffering from the then dreaded disease of scurvy. As the sailors walked through the dock's warehouse, another ship was unloading a prized cargo of tulip bulbs that had been imported from the far-east at great cost. As one of the sailors passed the table where they were inventorying their precious cargo, one of the scurvy ridden crewmen mistook the tulip bulb for an onion, picked it up and devoured it before he could be stopped. Sadly the sailor was convicted of stealing valuable merchandise and confiscating with his stomach. He was sentenced and served over two years at hard labor his lack of knowledge of a rather silly event that had occurred while out to sea. The moral of this story is that today, if tulips went up in price in Holland at 3:00PM, we would be aware of it at 3:01PM or earlier. Big economic bets turn bad faster and there is very little time to salvage a badly placed wager.

Behind this backdrop; economic and political events now send shockwaves that are felt in nanoseconds rather than in months and years; a far cry from the time, not so long ago in which people could be out of touch with reality, civilization and financial machinations for years. The time of the occurrence from the time of the occurrence of an unanticipated financial event, to the time that a hurried analysis is completed relative to all of its relevant implications. Moreover there is a telescoping of the moment in time between the realization that this may lead to catastrophic panic and whether it becomes a self fulfilling prophecy or not. We worry about more things simply because we are markedly better wired that before. In early times, we could worry about war, or a depression or sickness. Today we have the luxury of more import problems with which to expend our anxieties, such as the day-to-day psychological state of Brittany Spears, who will be tomorrow’s top model and who will win out in the latest Dancing With the Stars’ competition.

The news services stir us up about things that we shouldn’t even care about, but then again it is only that they are paid to be sensational and not depressing[11]. Who’s doing what to who has become critical information for us to know before we begin each day? We used to care about the weather but times have indeed changed and it is also important to see yesterday’s fashion show news in Paris so we know how to prepare for the coming season. We are not even certain whether our biggest concern is for what will occur today or what we should be worrying about tomorrow. This anxiety is now known as “future anticipation anxiety”.

We used to care about everything, but now we care about the better things in life, gossip, fashion and sex instead of children, having a coat and food. Possibly this is caused by the fact that the news travels faster and additionally the fact that people are more aware of the implications. In addition, today’s money is hotter and moves by wire to places of interest. In more civilized times, it took a substantial amount of time before thoughtless herd instincts came into play; today we are constantly concerned about having the right things to be worried about. The logic of reacting too quickly to a situation that has not been thoroughly thought out is exemplified by the following story written by G. W. Hanson way back in 1887 and is simply the story of two rats, one of which had experience on Wall Street:

“An old rat, whose long residence in the city had given him great knowledge of the wiles of civilized life, observed one evening a tempting bit of cheese close by his favorite hole in the wall. Instead of greedily rushing at it, he called a young friend, saying, “Whiskerando, some kind person has prepared a feast for us. Help yourself.” The guileless innocent rushed on the cheese, which he devoured voraciously: but, alas! In a few minutes, he rolled over on his back, stone dead. The dainty was poisoned. “My experience in Wall Street has stood me in well,” mused the old rat as he turned into his hole: “it is safer to give other folks pointers, and pocket your commission, than to risk your all on a wildcat investment.”

Interestingly enough some of the greatest fortunes were made at the expense of others during times of panic. Such is the era we are heading into once again. Uniquely, today highly complex economic factors are seemingly moving in unison to form a “perfect storm of economic disaster”. While this is simply a case of cause and effect, as is usual in these situations, the economic results can be made better or worse depending upon the psychological factors involved and the conclusions that are drawn.

It is interesting to note that all economic melt-downs have been brought about almost exclusively by panic, which was a tool by which the infamous Robber Barons used to splendidly enrich themselves. The more access to erroneous information, the more likely we are to trip on your shoe laces. The news services are so anxious to get our attention that they are willing to provide half-baked analysis and facts to a somehow energized audience. The smart ones know how to control the facts that work well for their financial dealings and are willing to provide red-herrings to the rest.

These folks used their control of the media and the government to increasingly enrich themselves and they were particularly adept to creating panics that didn’t exist. Misinformation spread by the paid media, the gossips, the informed and ignorant alike is thrown into a broth of theoretically reliable facts and that may be the last truth that comes as part of the resultant mix. Sadly, inaccurate information travels at the speed of light, just as do the facts. When that information is planted in order to provide a predictable outcome it is probably somewhat ingenious but dangerous for the slow of foot.

The English Branch of the Rothschild family probably created the greatest coup ever seen in the financial industry during the battle of Waterloo. The legend has it that Wellington (The English Commander) known as The Iron Duke, was about to engage Napoleon and his armies at Waterloo. Moreover, it was an acknowledged fact among the English gentry that if the Duke was vanquished or even bloodied, England would be set back a number of centuries in terms of progress and their stock market would wind up in shambles or worse.

However, conversely if Wellington won, the economic state of affairs for England would have turned spectacular to say the least. There was no question in Rothschild’s mind that this uncertainty offered the prospect of his making a humongous financial killing and he armed one of his observers with his trusty, family trained homing-pigeon and bought him a first-class ticket to the battle as an observer private observer. When it became evident to Rothschild’s agent that the Duke of Wellington had been victorious, he released the pigeon carrying the intelligence of England’s victory back to England and the Rothschild’s literally weeks before anyone else would receive the intelligence that the battle had even commenced.

However, Rothschild was not only interested in getting the news ahead of his competitors but was interested in making a lot of money. When he got the message he went onto the exchange floor and began furiously and opening selling his stocks. The other traders, seeing the Baron and his brokers engaging in massive selling mad the assumption that he had inside information relative to the outcome of the Battle of Waterloo. They came to the natural supposition that Baron Rothschild had somehow gotten word that the Iron Duke has lost had been vanquished. Everyone on the floor began selling and soon a full blown panic ensued. However, the Baron had confederates sprinkled throughout the floor of the exchange that were simultaneously buying up not only the stocks that he had dumped but were surreptitiously purchasing a substantially bigger position at the now highly depressed prices.

Rothschild had sent two messages that were carried out by actions, not by word of mouth; that he knew England had lost the battle and that the market would crash when everyone else found out the news. His action conveyed the event and they were misinterpreted only due to the fact that he had plotted well and was considered to have great financial acumen.

Our world has become akin to a massive tsunami spreading economic panic in ever increasingly large chunks of the planet within a series of ever more widening circles. The good news is that we are facing religious wars, local battles, internet invasions, and intransigent countries with large weapons. Also in the mix are farm prices that have gone off the wall, energy prices that are higher yet paired with an inconceivable impaired problem with ethanol which has become the problem not the cure. Even a third-grade student could have realized that the more we utilize ethanol, the less economic it becomes and the higher the price of the feed stock becomes. Seasoning the mix, along with intransigent friendly governments that either don’t want to be involved, or that are pursuing their own self interests in order to squeeze a tad more out of the panic.

However, the pure economic menace presents a larger package of disturbances which have become as dangerously more perilous as the economic firestorm gathers gains speed while rolling downhill. What started out as an overdue real estate price readjustment, caused an over- reaction and has brought with it a series of enormous multi-billion dollar bank failures, bailouts and thefts that have almost become an accepted part of economy of the United States? The villains of this episode that had been predicted for some time, were given too much credit, not enough regulation, the invention of securities that were ill-defined and not understandable to even their makers and a gullibility that prices would only rise.

However, the devil you know may be a bit better to deal with than the devil you don’t. Today, in this uncertain environment, financial institutions have become unwilling to do business with each other due to the fact that they just plainly either don’t trust each other or far more dangerously, don’t trust their regulators. Every player has books that are opaque and balance sheets that are unreadable and written to order. This free fall of confidence is being accompanied by a plunging dollar, rising unemployment, a falling stock market, and a sick housing market helping to round out what appears to be a rather dreary picture. Unless the unreasonable use of leverage and a return to transparency occurs, we will never be able to go back to the days when “your word was always your bond.”

When we look at the events that are unfolding, almost all we can visualize is one seemingly insurmountable predicament after another. On the sidelines are highly subsidized farmers becoming millionaires due to the fact that subsidized commodity prices hitting historic highs every day. Billions of dollars are still being thrown at these people to buy votes, not economic stability. The tax sheltered oil companies along with their despotic partners in the Middle-east are engaged in greasing the wheels of the fastest shift of worldwide wealth ever known in the history of man. It took the Roman Legions scores of years to loot each country that they conquered but the economics of change which dictate rapidity of movement. When you rob the bank it is necessary to leave the scene of the robbery as quickly as possible.

As in agricultural prices and in energy, depressions are not good for anyone, and it is a requirement of a good scam that the money be removed from the scene before it depreciates or the police find you. While we are being systematically raped and pillaged by the oil cartels, they are using their new found riches to both spread religious hatred while acquiring what is left of the industrial complex that was our legacy. The ultimate result of this is our resultant push back into isolation and away from the idealism of NAFTA, WTO and the United Nations. Isolationism is cheaper and less demanding; why create a better world that is intrinsically worse for our own people. This form of idealism is only a black nightmare that will eventually destroy us, especially in the totally energized environment that we have created.

These were really only useless dreams financed by a country grown rich, egotistical, lazy and aged while naively believing that they still controlled the known universe. We are looking into the teeth of uncontrollable inflation, currency devaluation, and commodity replacement of the value of goods, services, currency and most everything that glistens, powers engines, or you can eat. The popular solution could well force our country back into the isolation that followed World War 1, and will probably cause rationing of energy and send food costs spiraling out of control. Bread lines are a very potential possibility down the line and many NGOs are no longer able to afford the cost of even the most basic foods to feed the poor. Farmers will become king of the hill as they band together to control food prices and a bushel of wheat could then approach the price of a barrel of oil. As the old expression goes, you can’t eat oil.

However, the fault is ours, in our ego driven belief in some self anointed right to rule the world, we have tried to create democratic principles that would work in a despotic environment. These are hardly the best of bedfellows. However, this philosophical carelessness was not our only misstep; we blindly over extended our logistical supply lines and attempted to make inroads into arenas in which commerce was practiced entirely in a different way than our mandated self indulgent rules would allow. Our corporations were inelastic, our economic products created disasters and our intransigence was readily transparent. With our communication lines over extended we started to lose our economic vigor. This was nothing different than what happened to Rome, Athens, Alexander and Napoleon. Every war, economic or physical has a simple rule, “beware of the logistics”. Our banking system has been the heart of system and it is now in shreds.

Historically speaking

Trying to accomplish too many things all at once, in various parts of the world takes substantial planning and requires, financial resources, an experienced team along with a sensible plan. This is a story of having failed in every single instance of the plot.

The DeLorean, Cars, Coke, and Con

John DeLorean was the heir apparent at General Motors, then the largest company in the world. He was the ideal executive, highly respected, an excellent manager and socially accepted by one and all. However, things didn’t quite work out the way John wanted at General Motors for a number of now obscure reasons, but when he saw the top spot was not going to be his, he determined to open a company that would compete toe to toe with GM’s most profitable line, the Corvette, a car that had taken the upscale yuppie market by storm and a niche which DeLorean thought could stand a lot more competition.

DeLorean wasn’t much of a historian of the automobile business. He should have known that the odds were very much against a new, independent automobile company succeeding. It may well be that DeLorean didn’t care a lot one way or the other whether his venture was successful, and may have only been looking for a method of maintaining a lifestyle appropriate to a person of his self convinced social charms. The fact that Tucker, Crosley, Bricken, Cimarron Corvair, Kaiser-Frazer, American Motors, Studebaker, Edsel and LaSalle had bitten the dust along with additions to the list that are too long to count had nothing to do with Delorean’s decision. Ego and greed were the compelling factors.

DeLorean determined to build a gull-winged, stainless steel sports car in Northern Ireland where the British government was interested in making a substantial investment to alleviate persistent unemployment which at that time was linked to social unrest. Many have compared DeLorean to his predecessor Preston Thomas Tucker, who in 1948 built a rear-engine sedan with disc brakes, seat belts and an independent suspension system. What the two had in common is that both of these car-makers were charismatic, they were both indicted by the United States Government for fraud on numerous counts, they were both ultimately found to be not guilty ([50]) and both were way ahead of their times in terms of what they tried to produce. ([51]) They differed in that Tucker was attempting to build a sports car that would appeal to the masses and saved lives whereas DeLorean was attempting to deliver an overpriced automobile that not only couldn’t be accurately produced and which car had bugs that begotten bugs.

DeLorean raised or attempted to raise money from anyone and everyone. His presentations were public relations dreams, technically correct and extremely convincing. Like Ponzi’s schemes before him, everyone wanted to get in on Delorean’s unbelievably good thing. DeLorean was well prepared to accept their money. He set up a Panamanian Company, which was to do miscellaneous work for DeLorean but basically wound up only becoming a conduit leading only to a Swiss post office box. It seems that over seventeen million dollars found their way directly from DeLorean Motors to Panama, from there to Switzerland and from there to Swiss and Dutch banks. The next step in this highly sophisticated money laundering operation said to be directly back to DeLorean’ s personal account in the United States which was used to improve his life style and also to purchase drugs for resale.

DeLorean went first class in everything he did and in line with that, he hired the prestigious accounting firm of Arthur Anderson to fix his books. Anderson saw DeLorean as a super-charged customer who would always be in the public view. Because of their anxiety to please DeLorean, they were not as careful in auditing the books, as they perhaps should have been. However, historically speaking Andersen became known as an accountant that was overly sympathetic to its clients needs in spite of regulation.

Courts in both Great Britain and the United States found Anderson’s audits overlooked what appeared to be a number of instances of fraud with particularity concentrated on the Panamanian money laundering fiasco. In addition, an Anderson memorandum was uncovered that indicated that some of the regulators were on to DeLorean project and that the whole venture would collapse if the sensitive material involved ever became public. Anderson, for its part, lamely explained the memo away with the strange story that they memo represented some unknown business practice that was relative to DeLorean and had recently seen a resolution to the issue and had nothing to do with the point in question. Whether it was or was not, the memo itself would certainly indicate that in order to protect the public trust, Anderson should have dug deeper into the books. When they didn’t, they ultimately they got hammered for their failure to follow “good accounting principles” and to make the appropriate public disclosures that would have been required under the circumstances.

All of these things became almost secondary when the U.S. Government took pictures of DeLorean making a huge drug buy. While he looked like a movie star, if anybody had any doubts before about the fact that something outlandish was going on with the ex-General Motors honcho, this certainly should have put the matter into a very unambiguous focus. However, John DeLorean was not just making a drug buy. He was making a world-class drug buy that probably set the standard for that era. This spelled the death knoll for DeLorean Motors and certainly didn’t do their accountants any good either.

The DeLorean experience has cost Anderson $100 million ([52]), including both the American and British settlements not including a decade of attorneys’ fees and costs. The courts both here and abroad did not seem even to think twice about the issue of Anderson’s dereliction. When this fund raising gone wrong is put into perspective, the amount of the loss to investors becomes even larger. Probably $160 million was the total that was raised for DeLorean from all sources. The fact that Anderson received as salary of over 60 percent of the total amount raised is probably a record even within the world of accounting litigation where conflicts and lawsuits seem to be as normal as a stroll in the park.

DeLorean fought tooth and nail to avoid jail and bankruptcy. While he was successful in the former due to a law firm that argued the entrapment defense, he was declared bankrupt several years ago. In a fitting end to the strange tale of John DeLorean, his home of many years is no longer part of has assets and is in the process of becoming a golf course and little of his empire remains.

We are in a different time and a different place.

All of the economic downturns in history, no matter how disastrous cannot compare with the economic disaster that looms directly ahead of us. It is somewhat analogues to the anecdotal fables concerning the dikes in Holland. If you happened to be walking by and saw a leak, all you had to do was to simply put your finger into the hole in the dike and wait until help came along with someone arriving with either bubble gum or airplane cement. However, with numerous simultaneous problems cropping up with painful regularity, the immediate solution to these issues became increasingly difficult to deal with. We believe that the Fed can stand on its head and spit wooden nickels and not figure out a solution to this regulatory lax which is like a tornado that has gone out of control The unfortunate new guy at the FED still hasn’t gotten his seat warm and is already inundated with problems that had not evolved were not created under his aegis. We are all electronically interconnected so that their problem quickly became our problem or should we more accurately claim; our problem became theirs.

The central banks of the world no longer have the regulatory right, the time or credibility to advise their domestic industries that certain problems “do not concern them”. Only in Siberia does that line still have cache’. In the old days, these issues were dealt with by a wave of the hand and the simple disclaimer that caused this issue to be simplified into “this is not our problem.” We only have to look at the George Soros’ attack on and victory over the Bank of England to drive home the lack of tools available to the central banks that give them any control over potential economic problems. In many countries, multinational industries dwarf the economic power of central banks, and literally may have better credit than the bank itself. Thus, who is controlling whom?

Currently there are more corporations occupying the top Gross Domestic Product (GDP) spots in the upper range of the world’s top 100 economies than there are countries and in spite of uncontrolled growth, the disparity of power by the private sector is growing exponentially faster than the dependency of the Company to its domicile. Moreover, each central bank has to deal with its own real or imagined fears of global collapse independently of each other due to conflicting national interests and various degrees of election jitters. In the heady days of gold and silver backing of international currencies, there was a tad more confidence that what you saw is what you got. This is no longer the fact and as confidence in the Central Bank not be up to snuff, the value of currency depreciates at geometric rates when problems transpire.

Our economics bottom line has become literally impossible to comprehend with the advent of CDOs, derivatives, synthetics, calls, puts, straddles and off the balance sheet bookkeeping. However, when things become so complex that most people find it a disjointedly morass laden configured to become incomprehensible to evaluate. I thought I heard somewhere that the Securities and Exchange Commission (SEC) created regulations that offering regulatory memos as well as fillings in general in readable English. This was supposed to put an end to the historically magnetic Ponzi Scheme and those transactions built around an elaborate pyramid scheme.

In the United States, we are all familiar with Boston’s, Mr. Charles Ponzi, who under the guise of doing an extremely sophisticated arbitrage between U. S. Dollar and higher yielding convertible International Postal Union Coupons, offered to pay investors unbelievable returns in exchange for investment in his program. On the surface to the untrained eye, this concept seemed plausible. However, while it seemed to pass the sniff test, the volumes necessary to pull it off were astronomically impossible and did not even come close to existing other than in Ponzi’s imagination.

By remunerating early investors with handsome profits and extensive advertising, the word spread and Ponzi had attracted almost $10 million and 10,000 investors before the scheme imploded. Later it turned that Mr. Ponzi had previously served time in Canada for forgery and within ten days of his release from jail, was again arrested for smuggling aliens into the United States. Before his career ended in Brazil where he died in 1949 leaving an estate of $75, he became involved in a Florida Real Estate Pyramid scheme and ultimately jumped bail to avoid prison for larceny. However, he had probably created the world’s first hedge fund doing derivative business. The fact that it existed only in his mind quite possibly will mirror many of the economic magic tricks in play today.

A Real Concern

It would seem that those marketing subprime mortgages to people that couldn’t possibly repay their loans was recreating a theme based upon the same trick that Mr. Ponzi pulled in Boston. And just like lighting a stick of dynamite; you don’t want to hold on to it too long because it may go off in your hand. Clearly when you are doing something underhanded, do what you will and then get out of there fast before it becomes crystal clear of what you have pocketed. That was one of the prime sayings of John Dillinger when asked about robbing banks. “Don’t steal the banks change as well because it will only slow you down and you run a greater risk of getting caught”.

In the case of the subprime mortgages, clearly people would not survive the inevitable re-pricing that followed the short-term, highly discounted initial, get-acquainted offer (teaser). There is little question that many of these folks were over their heads to begin with, but indeed a great majority of these folks owed more money after the “teaser” period was over than when that began. We would wonder at the closing what these people thought when they were well aware that their interest costs would be reset and the payments would then become literally impossible to handle. A home is generally the largest and most important investment a family makes in a tangible product over their lifetimes. To think that they didn’t understand what they were getting into is beyond ridiculous unless we were dealing with indigent flippers. It would seem that not to be fully informed of their potential liabilities by professionals at closing may certainly have transferred to these homeowners a put and would undoubtedly subject the lenders to very damaging RICO charges.

However, it became very clear that very few of the players in this game were doing all that well when we looked under the usually distorted the balance sheet. The bankruptcies of the lenders began with Ownit Mortgage Solutions in December of 2006. This was followed with some amount of rapidity by Mortgage Lenders Network USA, ResMae Mortgage Corporation, People Choice, New Century Financial, and SouthStar Funding. Among the Lenders that have been closed or acquired in the last year or so also include, Option One Mortgage, EquiFirst Corporation, Fieldstone Mortgage, Rose Mortgage, Investaid Corporation, Popular Financial Holding, ECC Capital Corporation, Lenders Direct Capital, Secured Funding, Bay Capital, Champion Mortgage, Habourton Mortgage, Sebring Capital Partners, First Financial Equities, and Centex home Equity. Then we have the list of lenders attempting to get escape catastrophe by merger, sale or joint venture which include NovaStar Financial, Ameriquest/Argent Mortgage, Accredited Home Lenders, First NNL Financial Inc and Fremont Investment and Loan.

Interestingly enough, of the 27 lenders listed previously that were either bankrupt, closed or acquired, almost half are located in the State of California. However, this is merely a sampling of the overall list of casualties within this industry. Interestingly enough, by taking a look at the figures presented by MortgageDaily.com, it clearly shows that 2007, was a banner year for Lender catastrophe. Almost 150 companies went out of business and 42 more were so crippled that they had to be acquired. This is a total of nearly 200. The next most troubled year since 2000 was in 2006 when 37 lenders either failed or were acquired. As a matter of fact, a total of only 44 lenders went caput during the previous 7 years previous to 2007.

Moreover, 2008 promises to surpass the previous year in flying colors, probably creating a high water market in failed enterprises in this arena thanks in part to lack of either oversight or regulation. Sort of a double header, some at the Fed seemed more interested in giving speeches and cleaning up on book sales than watching the store. The Treasury was totally out to lunch and the accounts were happy to help their clients cover up gaping holes in their balance sheets by creating off-the-balance sheet apparitions that could not materialize without black magic. However, when the facts are not clear and the regulators do not want to regulate, the truth often vanishes as a result.

Never the Twain Shall Meet

While newspaper publishers are always out to smash the competition in a fight to the death, a literally no holds barred contest for survival, reporters also come under immense pressure to produce awesome headlines from their bosses, the publishers, to come up with stories that will hype circulation. In the early days of American publishing, there was not a substantial concern as to the real facts, as long as the story seemed believable, interesting and one the competition could not argue that it was fabricated. In those years, journalists were able to make the public believe almost anything and when one newspaper came up with something inconceivable their competition had to top it no matter how outrageous it might appear.

Petrified men were always good newspaper fodder and there was a newspaper by the name of Territorial Enterprise out of Virginia City that had become a force to be reckoned with in Western U.S. just before the Civil War started. People were hungry for news and the more outlandish it was the more they would devour it. Joseph T. Goodman was the editor of Territorial Enterprise and he encouraged his reporters to bring in material that would sell papers no matter whether it was true or not. There was a cub reporter that had just joined the paper’s staff by the name of Mark Twain who wrote the following tale on October 4, 1862:

“A petrified man was found some time ago in the mountains south of Gravelly Ford. Every limb and feature of the stony mummy was perfect, not even excepting the left leg, which has evidently been a wooden one during the lifetime of the owner – which lifetime, by the way, came to a close about a century ago, in the opinion of a scientist who has examined the corpse. The body was in a sitting posture, and leaning against a huge mass of stone out-cropping; the attitude was pensive, the right thumb resting against the side of the nose; the left thumb partially supported the chin, the fore-finger pressing the inner corner of the left eye and drawing it partly open; the right eye was closed, and the fingers of the right hand spread apart. This strange freak of nature created a profound sensation in the vicinity, and our informant states that by request, Justice Sewell or Sowell, of Humboldt City, at once proceeded to the spot and held an inquest on the body. The verdict of the jury was that “deceased came to his death from protracted exposure,” etc. “

“The people of the neighborhood volunteered to buy the poor unfortunate, and were even anxious to do so; but it was discovered, when they attempted to remove him, that the water which had dripped upon him for ages from the crag above, had coursed down his back and deposited a limestone sediment under him which had glued him to the bedrock upon which he sat, as with a cement of adamant, and Judge Sewell refused to allow the charitable citizens to blast him from his position. The opinion expressed by his Honor that such a course would be little less than sacrilege was eminently just and proper. Everybody in the region goes to see the stone man, as many as three hundred having visited the hardened creature during the past five or six weeks.”

We can almost visualize Twain revving up to the task as his writing meanders ever further from anything that could remotely be considered the truth. In reality there was considerable method to Twain’s madness. There was a man named Sewall in town that had the position of both coroner and Justice of the Peace. Twain considered him a moron and wanted to portray him in the worst possible light, as a bumbling idiot and purposely spelled his name wrong in his story. Moreover, Twain had noted that almost every day, papers in the territory were carrying stores in their bylines about petrified this and petrified that. Twain believed that if he made up a story that was beyond absurd, it would put a stop to those hoaxes. All he accomplished though was adding to the belief that these petrified folks did exist as literally everyone that read his piece, believed it. However, economic stories of the times were just as inventive as long as the contained some reality.

Suits to Suit!

Everyone is a loser it going to have a gripe as bad losers always do and then again, who isn’t a bad loser? A bad loser in my terms has always been an easy mark. Law suits are springing up like ragweed in the fall and the subprime fiasco promises to make the Savings and Loan fiasco look like a walk in the park. The losses already incurred in the amount of approximately 10 times the losses incurred by all parties that were concerned in the S&L crisis, but in those cases the Government was primarily the Plaintiff and the S&Ls, the defendant. This time around the lawyers will have a field day and you won’t be able to tell the defendants from the plaintiffs without scorecards. When the dust settles, the subprime crises will have made the asbestos litigation appear literally as a non-event. Everyone that is even tangentially involved in this matter will have numerous actions filed against them; the conduits, issuers, ratings services, monolines, banks trustees and underwriters will be sued by the homeowners’ and investors for predatory lending and illegal activity in both Federal and State Courts as well as in class actions and individually.

In parallel, actions will be taking place by regulators for additional criminal and civil actions. More of a layup will be the actions brought under common law fraud as well as Section 10b-5 of the Securities Code. Probably an easy victory could be available to plaintiffs relative to the issues of suitability. Investors and homeowners will probably both have that offense available to them. Obviously, there were conflicts of interest from the beginning to the end of the daisy chain with all the players wearing two sets of headgear at the same time.

The wily hedge-funds apparently eventually were long one class of same security and short the other. This in most cases was non-disclosed but critical to the offering memorandums. It is interesting to note that “the hedge fund industry’s use of multiple prime brokers to disguise their intentions could pose risk to the economy.” Essentially what the Government Accountability Office is saying is, simply put, when you are diversifying your trading in order to disguise the nature of your wager, you are also leaving your lenders in the dark as to their and your real exposure. This seems to defy the Truth in Lending Laws. Calling something that is an apple, an orange, doesn’t change what it is, it only tends to confuse the definer’s credibility or possible his eyesight.

The Commodities Future Trading Commission seemed to mimic the Accountability Office; it stated that “they remained concerned relative to hedge funds relative to Wall Street companies’ reliance on “counterparty credit risk management” to control hedge fund risk. They ominously mentioned the near economically fatal trading in Long Term Capital Management in 1998 which literally took the New York Federal Reserve along with some blue ribbon Wall Street firm’s utmost economic efforts to keep Mr. Humpty Dumpty in one piece after a severe contusion caused by slipping off the wall at a party where serious drinking occurred.

The creation of stories to push your particular point is a way of life. Every religion on earth has created their own visions of the basic elements of their belief in order to insure a highly motivated following. The stories that have been created to create various illusions have become legendary and as scientific advances move ever rapidly forward. Reading the bible will obviously create a problem with dubious fairy tales but in the end result they make good read and the bubbles they create are often not worth breaking:

The Shroud of Turin

There is little question that religion is to a great degree a lot of pomp and circumstance. The more godlike your particular church appears, the closer that you will think you could well believe that you were getting a tad closer to the true belief. In order to convince the faithful that certain things really occurred, in some instances it is necessary to preserve fables. It has been said that Christ was covered with a shroud after he died. This covering became known as the Shroud of Turin and some fourteenth century slicker sold the church a bill of goods that he had found it and bought the story, hook line and sinker.

While time did not treat the Shroud well, the faithful would come to visit the religious artifice; leaving with the thought that they had indeed found themselves a tad closer to god himself for having the experience. However, modern technology as it advances is often a factor in destroying these ancient legends. When scientists tested the cloth with process was described as “carbon-14 dating they discovered to the chagrin of the believers that the garment had been created some 1300 years after Christ had died. Thus it became highly unlikely to have ever covered his body. The Church which probably had paid a pretty penny for the cloth are now left without a good story that had been retold for centuries. However, in retrospect they may have certainly gotten their money’s worth. What you see is not necessarily what you get in either business or religion.

The brokers although appearing to have risk, in reality had surreptitiously created various safety valves to avoid having jeopardy. The Trustees in most cases did not carry out the letter of the agreement and may have not even read the document therefore not being able to address the small print. Clearly, the brokers took undue markups on the securities in contravention of National Association of Securities Dealers (NASD) regulations. The failure by underwriters to provide purchasers in due course with complete documentation will be a strategy to be utilized by both investors and homeowners gain an advantage in litigation.

However, shareholders of the underwriters will have actions against the public investment bankers for attenuation of corporate assets, as their securities continue to tank. Those that panicked early and were insiders and then sold out ahead of the bad news will be hit with insider litigation from the SEC and by shareholder’s attorneys. The SEC has already expressed substantial interest in these folks and the FBI has been all over this foolish panic oriented action. Rating agencies have totally dropped the ball, especially in the case of their analysis of the monolines ability to make good on their ratings insurance. They were late in almost all cases in reacting to downgrading some of these securities and have left others with an impossibility of paying off even a fraction of their potential liabilities in spite of various Wall Street provided refunding. These people have offered only lip service to the public and are no longer to be considered serious keepers of the flame.

Naturally some of these cases are more interesting than others but in a recent filing, HSH Nordbank AG charges that UBS dumped some of the most toxic pieces their CDO portfolio into the accounts of its clients. In particular, they allege that UBS sold it $500 million in complex investments that UBS’s now-defunct hedge fund, Dillon Read Capital Management, later used as a receptacle for troubled subprime-mortgage securities. The German bank says UBS’s actions led to a loss of at least $275 million. This would seem to be an act of desperation not a realistic approach to trying to maintain a sense of financial integrity. Moreover, UBS has other problems, the Securities and Exchange Commission and Department of Justice are looking into whether UBS and Merrill Lynch & Company properly assed the value of trouble securities they held.

In another case, Luminent Mortgage Capital Inc filed an action against Barclays PLS and Bear Stearns alleging that it had been misled about the investment and in written communications.

The principal quandary with the rating services is the fact that they had conflicts of interest that in turn created additional conflicts of interest. They were compensated by the monolines to rate their paper and then they helped them design their balance sheets so that they would obtain the required rating. Once having the rating, they could make the sale and start the entire process all over again. Moreover, the ratings people unrelentingly continued to be obstreperous in not lowering their public opinion of the securities in spite of the market prices having their bottom fall out clearly before their eyes. It would seem to be a time for an independent ratings agency that is neither in the pocket of the underwriter, the insurer, the Federal Reserve or anyone else. This is one of the roles of the rating service and it cannot be abdicated by extraneous influences that tend to pervert the facts for economic or political reasons.

Too cute to believe!

No one has ever said that the Hedge funds weren’t smart. They are constantly trying to stay one step ahead of both the regulators and their competition. The same can be said for the large Wall Street Investment Bankers. Some of the financial products that they have engineered are literally mind boggling in being totally diminimus in their nature. The fact that, between the underwriters and the hedge funds, they are throwing new products onto the “Street” with almost a reckless abandon giving all their supplies of investment chain, marching order that have not been carefully thought out. The fact that they have an insurance rap of some sort hardly gives the investor comfort that was available in the past. In the old days when the guarantee was rated triple “A”, you were able to sleep at not but this is no longer the case.

By making the players in the line of command push thoughtless products up the chain, they have allowed fraudulent securities, frivolous insurance, poorly thought-out buybacks, collusive ratings, amateur trustees and layered securities that are so flawed that the underwriters will be in court for the next decade. The products are hastily shoved out the door, layered to provide the underwriter absurd profits and little comfort that their insurance is either viable or has been realistically vetted. Very often these products are not thoroughly research and are released to the unsuspecting institutional buyers and the ratings services without straightening out all of the kinks.

While indulging themselves within the subprime environment they put the entire system into peril by jeopardizing solid ratings along with any semblance of insurance. In particular the nearly totally obliteration that the Investment Banks created within municipal bond market, we believe that the industry has been so damaged that it may never again be the vital market it once was. We believe that the damage is far reaching and there are going to be severe restrictions placed upon the underwriters and hedge funds when the regulators figure out who did what to whom. However, regulators are always late for the party and they are an incremental party to this destruction. Moreover, this will cause dislocations within the municipal finance industry far beyond the problems faced if only what has happened to the monolines which literally sacrificed the Municipal Bond Market to sail into unchartered waters of writing insurance on corporate debt.

The sophistication of this strategy is usually unavailable to any but the most sophisticated investors although that has to some degree changed as limited number individuals have taken advantage of its implications. Beyond the monetary problems that this sort of investment has created is the disastrous problem created by the tax ramifications of what has happened. This works by the process of setting up a series of special entities in order to take advantage of the transmutation of one type of instrument into that of another as if by black magic. Hedge funds are able to use leverage to purchase highly rated municipal securities at a total cost of substantially less than their eventual net yield.

Historically, due to tax ramifications, highly rated municipal bonds have traded at their tax differential (from equally rated government securities) plus a nominal number of basis points. In theory, if you could borrow money to purchase the municipals at a bargain price relative to the price of Governments or Corporate bonds, you could buy them, put them up as collateral on triple guaranteed collateral and substantially offset your risks on the newly purchased assets against your loan. Even with a nominal return; with high enough leverage, the hedge or arbitrage would return a substantial profit to the fund. The banks thought that this was a really capital idea and soon found their collateral boxes filled with monoline guaranteed municipal bonds. When visited by their auditor, the banks could explain that the collateral they were getting was just about the best there is next to a government bond and they were lending on riskless securities. That turned out to be hypothesis, not a fact.

However, the whole plan started backing up when the hedge funds ran into either unrelated problems due to market conditions or the related problems created by the monoline collapse. As the collateral value of either the Muni or the other collateral fell, they borrower or the banks had to hurriedly dump this collateral and the amount of securities that hit the market by drowning hedge funds became something more than the market could possibly digest. The market had never been hit by such concerted selling in history and not only collapsed but simultaneously became comatose. Nobody would touch the Muni market with a ten foot pole because no one knew when the next shoe would drop, whatever that may be. As if the monoline problem wasn’t enough, the fact that a change in price in no way reflected a change in ratings in these unusual and highly unexplained phenomena. The real relationship between the monoline collapse and the muni (municipal) collapse is only psychological at best, at best this was insurance that in real life could not exist under the strange underwriting circumstances.

You don’t go from a "CCC" rating to an "AAA" rating no matter what price you agree to pay unless one or more of the parties has lost their marbles. The exposure would just make the transaction too expensive to deal with. Moreover, cities didn’t stop paying their interest because investment banks were buying insurance protection on their portfolio and when put into perspective, all that the ratings industry was guaranteeing was a rating and not an interest payment nor anything else. No municipal entity stopped paying because of a change in rating or the failure of a monoline. The prices of munis collapsed when they were subjected to forced liquidation in the open market, first creating a small affect on prices but then creating an investment panic as trading in them literally ceased to exist. Collateral coverage was collapsed and now was no longer enough to cover loans and the market caused portfolio related margin calls. Banks were already reeling under the weight of what they believed to be more serious problems. However, in retrospect we will soon see that this is the most serious economic issue that this country has faced since the Gold Panic.

An interesting study in this matter that can explain exactly what has occurred is discussed in the following article by John Ferry entitled Munificent Arbitrage in Worth Magazine. We are quoting this article directly and we must warn you in advance, understanding these ramifications are not a trick for the faint at heart:

“Municipalities typically issue long-maturity debt, anywhere from 10 to 40 years.”They don’t issue a lot of seven-day paper, so there is an issue of supply and demand imbalance," Williams explains. Arbitrageurs cannot fund their long-term investments at short-term rates without short-term paper. Investment banks noticed this imbalance some years ago and saw an opportunity to act as an intermediary, filling the gap in short-term demand. They created a product called a "tender option bond program," an arrangement whereby the bank holds a fixed-rate, long-dated bond in trust and splits the underlying economic components into two distinct parts: a floating rate municipal security and a residual long-dated investment certificate. Hedge funds buy these, retain the long certificate and sell the floating-rate part to money market funds. The funds are then left with some interest rate risk, which they hedge using interest rate swaps. "With the swap, you’re making it duration [the measurement of a bond’s price sensitivity to changes in interest rates] neutral," Williams says.

The result is a long-term investment with minimized short-term exposure. For example, the hedge fund might get a 5 percent return from the very long-dated municipal debt that it owns, while, at the short end, it might pay out just 3 percent on the floating-rate notes that it sold to receive money market funds. That leaves a 2 percent profit, which is leveraged by putting the trade in place borrowed money. However, when there is a crossover between the rates earned on the differentiated rates, the problems are no long ones of profit, they become issues of survival.

McGuirk (just a quoted name) gives a real-money example: "Today they’ll get 3 percent for the short-term paper issued to money market funds, so that is their cost of funds. Then they buy long-term munis at 4.8 percent. Then they take out the interest rate risk using a combination of Libor or BMA swaps [those based on the Bond Market Association’s BMA index] to take the duration of the portfolio down to as close to zero as they can get it. And then they leverage it up to 10 times."

The strategy has grown so prevalent that it began having repercussions throughout the muni market. "For someone like me, who doesn’t use that type of strategy, it affects the types of bonds I buy or sell, because I’m competing with large, leveraged hedge funds for the same names," says Abner Herrman’s Klein. "With the amount of control that they have at the moment, they’re actually moving the market in ways that my portfolio could never move it."

We have little to quibble about relative to the facts within the article but full understanding of what is involved in this strategy will make one’s hair turn grey overnight. It would seem that the hedge funds are creating a moving target for the short sellers. Reversing the transaction is only an interest rate risk and is probably going to be more profitable than the alternative in the long run.

However, the first causality of this problem from the Muni point of view did not take long to appear. Jefferson County, Alabama had their rating slashed on their sewer-revenue debt by a sterling six notches in one revision and sent the debt into sub junk category. The county unfortunately is now underwater to the tune of $360 million according to S & P’s release. The poor folks in the county had no clue about what they were getting themselves into and it seems as though they are taking a page of the book written by Orange County when Merrill Lynch almost talked those folks into investing in oblivion a few years ago. For some obscure reason it seems that most of these municipalities were heavy into the Variable-rate demand obligation market. (VRDO) What that was supposed to do was to make long term muni debt mirror short term paper. However, when that market literally ceased to exist several weeks ago, it became readily obvious to country officials that they had a very serious problem on their hands. Jefferson County now has to put up additional collateral to the contra-parties of the swaps to at least stay above water; however, they don’t have a clue of where to get it.

This problem creates a two way hit due to the fact that on the other side of the swaps are Bank of America, Bear Stearns, J. P. Morgan and Lehman Brothers, who are into the transaction for big numbers; over $5.4 billion. These folks are not particularly flush at the moment and if Jefferson doesn’t come through this crisis, it could mean additional problems for the investment banking industry. And talk about tough agreements, the money is literally due now and it may be that the first to file a Chapter 9 bankruptcy petition as opposed to the much heralded predicted demise of La Jolla, California. There are possible solutions which all seem worse than the disease itself and many of them are not even worth mentioning here as they clearly seem to be inoperable.

Lehman Brothers is in a particularly tight situation having been overly involved in the subprime crises. Whereas Bear Stearns couldn’t get directly to the Fed window because of the non-commercial model that they follow, the Fed apparently felt they could do even better by being directly reactive. Apparently they felt that job that was done for Bear Stearns was imperfect and by openly standing behind the Investment Banks as well as the Commercial Banks, it would calm public sentiment.

After they Bear Stearns was taken over by JP Morgan, the Fed stretched a point and opened the window directly for Investment Banks as well as those of the commercial variety. This is any change in the Feds thinking that major players should be saved instead of taken over by third parties using Government guarantees. However, while the Fed has that power, they may also have waited a tad too long to act. The Federal Reserve Bank of New York urged leading US financial institutions to support Lehman Brothers in order to preserve financial stability, according to a report in the Daily Telegraph, citing unnamed sources. This activity occurred on the weekend of March 15 -16 at the same time that JP Morgan and they were working into midnight hours to save Lehman as well. Employees of the New York Fed are believed to have manned the phones calling senior Wall Street executives telling them that the Lehman’s mess should not be discussed and everything could be done should be done to help them through this mess.

I’ve Got to pick a pocket or two

As if that wasn’t enough, the Muni industry has other problems to deal with. Municipal funds are frequently raised on long-term projects in advance of needs due to the fact dramatic interest rate changes or dramatic economic modifications in economic conditions can have frightening affects on the projected costs of the project or the ability to have enough funding to complete the project. Usually the municipality purchases a Guaranteed Investment Contract (GIC) more often than paying a higher rate than that at which they are borrowing. This process usually consists of the municipality hiring a third party to negotiate the rate and timing of collateral and interest. However, it has recently come out that many of the people engaged in this third party work on behalf of the municipality have been engaging in collusion and price fixing; thus substantially increasing the borrowing cost of the project. Federal actions regarding to come to grips with this matter have been issued and the facts will shortly be released and incitements most probably issued.

For a fee these kindly folks would manage the escrow of the monies earmarked for later use by the municipal government. During the middle of 2006 the United States Government became concerned that there was substantial hanky-panky occurring with those third party managers and their questionable associates. As is usually the case, if you think something smells like the city dump, it usually is the city dump. In this case Federal Authorities have finished their investigation and UBS AG, Bank of America Corp, Financial Security Assurance Holdings and product developer CDR Financial Products have been invited to explain themselves by way of Wells notices from the SEC. However, Wells notices sent by the SEC are usually civil in nature because it is rare when an entire company is criminally indicted for the acts of a few bad apples within their corporate culture.

However, the Justice department’s antitrust division has served more serious notices to 30 individuals and that means that one way or the other, criminal charges will probably be in the offing. Wachovia Bank has already indicated that two of their employees have already received the lethal missives, Bank of America is cooperating with the government in exchange for the dropping of criminal charges and has already paid a fine of $14.7 million to the IRS; J. P. Morgan has been cooperating with the government, providing documentation and has already fired two employees. Others involved in the more deadly side of this deal are Sound Capital Management, Investment Management Advisory Group, XL Capital Ltd and AIG.

The issue is simply one of collusion; these folks joined together in a conspiracy jack up the price that municipal governments would have to pay for these services. Simply put, the muni government issues an RFP requesting a rate that they will receive from the servicer, trustee or what have you in exchange for the deposit of their funds with that service. The returns take the form of Guaranteed Investment Contract (GICs) which usually are geared to pay a fixed rate for the life of the funds.

However, if in reality there is a conspiratorial bid placed which no one is seriously going to top by previous arrangements, this collusive action substantially increases the municipality’s cost or alternatively, reduces its income stream raising the transactions cost. In this case, this would result in an act of collusion. This pre-arranged attempt to steal funds from the transaction would result in complicity, an action punishable by a jail term for individuals. However, this situation is far worse than it would appear to be on the surface; each municipality that has been hosed probably could join in a triple damage Rico case thus increasing the downside for the above list of potential criminals.

A recent SEC report stated that disclosure and accounting practices within the Municipal industry had to be tightened severely; oversight was largely elusive at the very least. Municipal Securities Rulemaking Board (MSRB) an aged creation of Congress harking back to early 1960s when times were somewhat different. This agency has no authority to do anything of value and attempts to live up to mandate. Without enforcement capabilities and with the regulators political hacks, the Municipal Industry has the Wild West of the securities industry. It is only a short time ago that we were forced to deal with the wide spread results of the pay-to-play disaster[12] of only a few years ago along with the infamous “yield burning” disasters[13].

However various forms of Pay-to-pay do not have anything to do with politics; for example, the SEC concluded on February 6, 2008 that fidelity Investments, the world’s largest mutual-fund company would have to pay an $8 million fine to settle U.S. Regulatory claims that it let staff members accept Super Bowl tickets, private-jet travel and other gifts from brokers. In addition the SEC claimed that “Fidelity failed to seek the best terms for mutual-fund trades because of “family and romantic relationships influenced its employees”.

Moreover, the SEC stated that this “misconduct created caused a serious risk of investor harm and violated Fidelity’s duty of allegiance and loyalty to investors. Moreover, Peter Lynch former portfolio manager and 12 other current and former employees got “numerous free tickets to concerts, theater and sporting events.” Moreover, Fidelity didn’t argue with the decision and stated “We do recognize the seriousness of the misconduct.” Pay-to-Play is not just a political payoff; it is an inherent part of the system which over the years does not become addressed, except when the dike bursts. Peter Lynch a well known Wall Street figure was ordered to repay the cost of his illegally purchased goodies.

An Insurance industry gone bad

In the United States one of the most promoted plans for bailing out the monoline industry which is now the expired monoline industry has turned into a farce. By the way, a monoline really means, one line of insurance, but has been bastardized into a phrase for companies that have been started out by insuring municipal debt and then went terribly wrong. Essentially, monolines are no longer monolines due to the fact that they went astray from their practical business models and somehow got into the much trickier business of literally insuring corporation’s ability to succeed (sounds like venture capital not insurance). This is particularly absurd due to the fact that they were betting essentially that Wall Street ratings and underwriters were all wet in their pricing and interest rates that they were assigning to various issues.

These amateurs had no investment banking departments and were actually bookmakers betting against or making bets against the pros, usually a suicidal undertaking and that has proven to be right once again. This hardly sounds like a sensible way to earn a living. They should have hired Sky Masterson (from the movie Guys and Dolls) to do their handicapping is forwarding the concept of dividing these credit insurer’s portfolios into good and bad loans. By analysis, Municipal Bonds (their original business) have a statistically very low default rate (probably substantially less than ½ of 1 percent. While certain corporate debt may have a rate of default over 1 ½ percent and that is in good times; not exactly what we are facing. As a matter of fact, short the monolines is a bet for a severe recession or depression and we are certainly headed into something isn’t so good. The history of betting against the house would have a similar outcome to a vacationer visiting Vegas and playing against a marked deck and in this case there is no possible layoff, only those with a vested interest in prolonging the economic agony created by this monster can have an interest in seeing this unwieldy vehicle survive. Even if they get through this by crippling the banking industry with the constant cash drain, the next time around it will probably be a lot worse.

The banks that used these folks to prop up their portfolios were trying to get a small edge that has now turned out to possibly be causing these folks the demise of their institutions. Neither Wall Street nor this institution will ever be the same again. However, with international competition such as it is, there will be another silly game invented by the “Street” and players will flock to a crooked table trying to grab as much money as they can until the place gets raided.

However, the rates for the two are the same from the insurance point of view and point up an obvious subsidizing of the bad companies by the good ones. However, Election Day decision is not necessarily logical or economically feasible; yet in spite of that the beat goes on. It is felt that the separation of the two groups into two sets of debt will cause little negative fallout into the municipal arena, the not bringing into play issues that could enrage the voters. However, many voters are involved in corporations and many more are employees of these companies.

This decision will amount to a disaster for corporate debt instruments, literally creating a calcification of the system. However, investors and insurance companies are not waiting for politically motivated suicidal tinkering and rates on guarantees in the corporate world have flown off the chart into record pricing areas just in the last several days. Moreover, as the bailout strategy continues to be worked on, which will require both political and commercial interests being satisfied, any measure adopted cannot possibly be correctly structured to substantially damage the marketplace, the borrowers, lenders and stockholders. Other than sacrificial cash donations for no particular reasons to the monolines that went far astray from their mandate, dealt in economic areas that their management had no ability to even understand nonetheless put into place.

To put into perspective the size of the potential problem one only has to gaze at the figures. Municipal Securities in the United States guaranteed by the monoline insurance industry most recently stood at $1,320 billion dollars as opposed to its exposure in the U.S. and International Structured Finance (primarily corporate) stood at $900 billion. These are massive amounts and leave little room for compromise neither of these numbers is something particularly easy to digest and as you can see any form of compromise in this regard will dramatically affect the local and international financial communities severely. Against these prodigious amounts of good and bad paper, the monolines only have somewhat under $50 billion in capital on hand as coverage.

However, some of their capital may be questionable and there is no room for error in these figures. It is insurance issued in a wind tunnel filled with confetti about to be hit by tornado. We would wonder where the rating agencies were when all this insanity was being assembled and worse yet where are they today? It cannot be that everyone is sleeping through this, Congress has gone apoplectic, the banks are hysterical over the bind they have put themselves into, the Fed acted like a bear waking from hibernation and needing a fix, and the various State Banking and Insurance Commissioners (“could be a financial tsunami that causes substantial damage throughout our economy”) are proclaiming literally, international disaster if this situation is not addressed on a permanent basis.

Cort and Company; National Student Market set the standards long ago

At this point it would be timely to take a look back in history at the origination of DMOs, subprime, layering, flipping and all the ills that have been brought together to make our economy sick. A criminally stupid game :

So if you think the subprime business was invented by greedy Wall Streeters that were only trying to take investors for a ride, let me tell you the story of Cortes Wesley Randell and as I run through his background, let me substitute today’s wording for what happened then. Mr. Randell was fraudulently in charge of a company by the National Commercial Credit Company of Washington D.C., he became the largest stockholder of that company while awaiting sentencing on another crime he had committed. Cortes, early on, was in the NCCC business of buying homes, fixing them up and then reselling (flipping) them to poor people (subprime) that could not afford a legitimate down payment. He would then issue what he called “Second Trust Notes” (layering) and sold them at a discount (lower rated paper in the layering process) and then raising money on the Notes from banks, investors and insurance companies (leveraging).

So fundamentally that is just the flavor, let me tell you the history of the Washington Consultant, turned Christian Prayer Leader, turned serial criminal, turned Jail Bird turned financial engineer. This is one of the most famous frauds in the history of Wall Street and Mr. Randell will show you how much ahead of his time he was. Wherever he went he created a buzz. He had Washington politicos eating out of the palm of his hand; he was debonair, handsome, well mannered and rich. A theoretically, “can’t miss combination.”

National Student Marketing was incorporated in the District of Columbia in 1966 and for a short time, it enjoyed almost unparalleled success. The company as its name implied, was in the business of marketing products to students, mainly those going to college. The theory was that one of the most dynamic markets in the country was that of kids going to college. If you could hook them early enough, they could possibly remain loyal to particular brand name oriented companies client for life but the critical issue was indoctrinating them as early as possible.

Cortes was always an accident waiting to happen.

Cortes Wesley Randell; the company’s CEO had about as much business background as a frog, but he was a great promoter and believed he could overcome that obstacle by staffing the company with business school graduates from his alma mater, the University of Virginia. The theory was that people selling into the scholastic market were both local and disorganized. If they could be brought together in a more homogeneous pot, every one of them could benefit from increased sales and lower costs. The students themselves would come out ahead because with central purchasing, the prices of these products being sponsored by these vendors would probably drop.

The concept on the surface made a lot of sense and National Student Marketing determined to expand its operations after it successfully gone public. They earmarked companies in similar businesses for acquisition and were soon buying everything in sight. Wall Street for some strange reason believed that the company’s management was capable and early on it developed an undeserved reputation for integrity and honesty. Randell had surrounded himself with “white shoe” firms in both the legal community, (having hired White & Case) and in the accounting community (by bringing aboard Peat Marwick who suddenly replaced Arthur Anderson who had resigned under very strange circumstances). Cortes, National Student Marketing’s CEO, and James F. Joy, SVP of NSMC, were both highly regarded by Wall Street and enjoyed good reputations. Furthermore, Randell had been an international-business consultant; his father was the company’s Chairman of the board and brought a wealth of business experience to the company. Another board member was Dr. Frank G. Dickey whose major sideline was being the Executive Director of the National Commission on Accrediting. This organization could give or withhold university accreditation. This certainly was an interesting guy to have around when you are in a business trying to get schools to sign on the dotted line.

Cortes was known as Cort to his friends, which consisted of just about everyone around the office. No one could have ever criticized Cort’s spending habits; he was just your average American six foot three inch, 30 year old multi-millionaire that had his very own castle with a private dungeon and mote on the Potomac, a fifty-five foot yacht that could sleep twelve and a world class hydrofoil. He also had one of the largest collections of radio-controlled model boats, quite a feat in the late 1960’s along with apartments at the Americana and the Waldorf Hotel in New York and of course the obligatory, Lear Jet with two full time pilots. It was believed that he was a combination of Clark Gable and Howard Hughes but it later turned out that he was really Elmer Fudd wearing elevator shoes.

Hard work doesn’t help when you don’t know what you are doing or where you are going.

However, Cort put in prodigious hours in much the same fashion, as did the merry-women at Equity Funding who while drinking Champaign and taking Quaaludes while turning out phony insurance policies during their long nights. The only difference between the two was that with Equity Funding, the midnight workers were toiling over the creation of phony new insurance policies for which they could get ready cash from the re-insurers. While in the case of National Student Marketing, the only people that they were trying to deceive were the accountants, lawyers, investment bankers, the students and the public with contracts that had been forged or hastily reconstructed with grander numbers contained therein. For these and other reasons, Cort certainly deserved all of the perquisites that the company could heap on him. If that was his job description, he certainly was at the right place at the right time.

Favorable articles about the company were appearing throughout the media and Business Week did an especially favorable piece on the company. Ad Age started talking to National Student Marketing because the NSMC was hitting the advertising market exactly a spot where all the agencies and their clients wanted to concentrate the business. The younger people that were the trendsetters were literally the company’s own back yard. They soon began saying in the agency business that, “If you wanted to get to these folks, you had better be on good terms with National Student Marketing.” It was a little like the Wal-Mart is today’s Mecca for marketing salespeople.

Early on, NSMC had almost six hundred part time campus representatives selling everything including the kitchen sink. Paper dresses were a big cash items as were psychedelic wall posters, freshman photo books, Summer employment guides, campus telephone directories, calendar desk pads with campus events and advertising, Cliftex, a manufacturer of men’s sport jackets, Transplex mobile units set to advertise existing products, American Airlines Youth Fare Cards, wire bound notebooks with advertising and beer mugs were all big things among college students of the era. In the meantime, National Student Marketing also was distributing at no charge, voluminous copies of student school guides, and a thing called Campus Pacs that contained razors, blades, soap, toothbrushes, and other assorted items. These were paid for by advertisers or by free ads that the company received an override on. This was certainly a cute marketing gimmick and was appreciated by all recipients.

In addition, the company had developed a computerized resume’ service, which although it lost substantial money, it received accolades for its inspirational qualities. Cort even bought a book cover manufacturer for the sole purpose of being able to sell advertising on its inside bindings. Logically, when the company acquired a company already in the business of manufacturing college-student-oriented products, it would certainly seem that there was some chance of success, but without fail, nearly every single product that was dreamed up by National Student Marketing became an abject failure. One would have thought that they would have cut their losses and run, but part of their dismal corporate philosophy was the “invented here” syndrome. They badly wanted Wall Street to believe they were producing something of value so they could trumpet the inauguration to the skies but this was just not the case. However, the beat went on and the public relations people kept the world thinking that Cort and his Virginia aluminizes were setting the world on fire; however it turned out that the only thing burning was National Student Marketing.

Unhappy Campers Join The Jeering Section

Moreover, the college bookstores were not very happy campers with this upstart that was putting their own representatives into direct competition with them. As a matter of fact, National Student marketing was caught between a rock and hard place. In reality, their student sales representatives were a fiasco and they could not have made money no matter what and how much they sold because of the extraordinary logistic baggage that came with the package. As a matter of fact, this may have been the first company in history that would have done best if it sold nothing and came up with no ideas. In the meantime, these obnoxious representatives were driving campus bookstores to the point of banning the products of National Student Marketing do to intellectual and attitude problems. A collapse of this end of the business would have caused a major problem because the companies that NSMC was buying for were for the most part their own suppliers. Luckily, the company folded before they had to deal with the issue.

In spite of this unknown internal disaster, National Student Marketing was the top performing stock of 1968 rising having Wall Street’s best performance. It was growing by leaps and bounds through acquisitions and non-existent sales. Amazingly for a company going down the tube, National Student Marketing had closed the year with twenty-two acquisitions bested only by the ubiquitous Dolly Madison Ice Cream with thirty-five. The company’s shares were purchased by Morgan Guaranty, Donaldson, Lufkin & Jenrette, as well as the prestigious Harvard Endowment Fund. The company’s stock was flying high having come out at $6 per share in the spring of 1968 and was trading at $144 by mid-December 1969.

Management was undaunted by failure and believed that if they could exchange appreciated paper for substantive acquisitions, they could keep everything in motion. Not wasting any time, according to court documents, “At a stockholders meeting held October 8, 1969, National Student Marketing (NSMC) shareholders approved an increase in the company’s authorized shares and approved a merger with Interstate National Corporation (which sold insurance to students) and five other companies.” Well, not exactly, that went out in the press releases to show that the company was continuing to make synergist transactions in their acquisition program. The fact is that the main lines that the company wrote were, for insuring race tracks and greenhouses. Sure, they wrote an occasional policy to a student but it was more a sideline than a business. Not that race tracks were bad business but it was not exactly providing the synergy that was expected of the company.

This was also a period when the word conglomerate had fallen on disfavor because literally every company that had advertised itself as such had suffered dramatic problems and the entire group had become an anathema to the “Street.” From infinite price-earnings ratios, now, even the best of the conglomerates were going for about 10-times earnings. It was important to Cort that a distinction is made between the acquisitions that he was making and the non-symbiotic acquisitions of other “conglomerates”. He came up with the declaration that while run of the mill conglomerates on Wall Street had merged in non-synergistic companies in the hopes of creating cost savings and financial homogenization, National Student Marketing specialized only in taking over only companies within the industry that dealt with students. Wall Street bought the story hook, line and sinker and nobody ever bothered to analyze the fact that literally everything that Cort was acquiring had seen better days, was not in the student business or was a fraud.

If anyone had taken the time to look they would have soon figured out that not only was the basic premise all wrong, but fully half of NSMC’s gross sales and probably the great majority of the profits came from non-student type of enterprises. On the other hand, Cort was always trying to make the left shoe fit on the right foot. As an example of his insanity, he took over a company that was solely in the business of supplying socks to wholesalers. What this would have to do with students no one could figure out until the every pervasive Cort came up with the answer everyone had been looking for. The company would start a student hosiery club that he would get off the ground with 250,000 members. The story had legs and achieved its purpose but the students didn’t gravitate to the concept at all and we know of no one that signed up for this gruesome idea. Being in the manufacturing, the wholesale distribution and the retail sales of a product literally was a logistical nightmare, because in each part of the economic sock chain you were competing with yourself. However, the research geniuses on the “Street” either didn’t want to see it or didn’t want to know about it. After all they had paid dearly for the stock and prayer was about the only way to get through the disaster Cort had created.

Rolling downhill with reckless abandon and worse

However, Cort was really on a negative role and his disastrous move in the direction of bankruptcy was the retail acquisition of school buses. This probably set the standard for disaster that the company will be remembered for when they go to business school. The problems that soon appeared were two-fold; the first was that the average users of the buses were either in nursery school or kindergarten, thus substantially bringing down the average age of his target market. To put it mildly, his demographics had tanked. This did not make the NSMC advertisers very happy but ultimately became enraged when they found that Cort was trying to sell them advertising on school buses ridden by children that could not read. It may also be the fact that these passengers did not have a substantial amount of discretionary income and that seemed to bother the ad people even more.

But Cort was on a roll and soon came up with the grandfather of disastrous acquisitions by purchasing Arthur Frommer's (the people that can send you around the world on $5 a day). There was not much question that the school kids liked the books, but they weren’t really about to start traveling around the world of 1968 and 1969 no matter what the price. This was the sixties and they just didn’t have the money to travel to the places that Frommer was pushing. Frommer and National Student Marketing were hoping for a big splash at the Frommer Affiliated Hotels from the acquisition but, in spite of the advertising to the contrary, these guys weren’t renting any rooms in them at $5 a day and the college crowd returned no business whatsoever to the company. Arthur was not a bit happy about the situation as he had made his own company his life’s work and that pretty much went up in flames when NSMC stock tanked.

One of the few decent ideas that National Student Marketing had was the renting of refrigerators to students for their dorms. While this idea made a lot of sense, most of the available outlets in dormitories did not allow for enough energy to power a machine and therefore, the refrigerators were considered a fire hazard by most college administrators. Cort panicked but luckily was able to find a refrigerator manufacturer that had a machine that used far less current. This was a break-though and with a massive major public relations campaign was able to get the devise onto many campuses. The problem with the refrigerators was, that while they were able to safely operate from just about any wall outlet, they made a prodigious amount of noise which totally eliminated the students ability to study or talk on the phone while they were plugged in. Even the few things that Cort did that seemed to work were inconceivable disasters.

The world was failing apart National Student Marketing and they had to come up with something quickly or face the consequences which by this time would have been fatal to say the least. They arranged a carnival of acquisitions that when simultaneously consummated should produce a sales increase of the Student company. However, the world of finance was beginning to smarten up and many of the companies to be acquired asked Peat Marwick for a comfort letter concerning NSMC’s unaudited interim financials. Normally, this shouldn’t have represented any big deal because the quarter had ended literally five months earlier. When Peat Marwick went to work on the comfort letter in earnest, they determined that contrary to previous representations, various amounts should be adjusted to deferred costs. There were receivables that should be written off and a substantive adjustment to paid-in capital be made retroactively and therefore, it should be reflected in the comfort letter delivered to the companies being acquired.

Now all that was well and good, but Cort knew that what the accounting firm wanted to do would have caused National Student Marketing to have to show a deficient for this period as opposed for the substantial profit that the company had projected. All of the transactions were an exchange of shares on a polling of interest basis and there would be a blood bath following the announcement of the readjustment. The closing was scheduled for Friday, October 31, 1969 and when all had been gathered at White and Case’s offices and the comfort letter was not part of the closing documents, many in the crowd developed stomach disorders which became highly evident.

Leave it to the lawyers to always screw up something that isn’t broken

The deal could not be consummated without the comfort letter and a hasty call was made from the law office to Peat Marwick’s Washington office to inquire about it. The partner in charge of the account, Anthony M. Natelli, dictated to Eplye’s (White & Case Senior Lawyer) secretary the comfort letter. This was along the lines that Peat Marwick had originally gone over with NSMC but of course, no one else in the room had ever seen it. There were substantial discussions about whether the mergers should be concluded, but more assuaging by both White & Case, National Student Marketing Executives and Peat Marwick seemed to carry the day. Because of the fact that the announcement had already been made as to the acquisition, the shareholders vote had already taken place in both companies and the people in the room only had an hour to agree to the deal, it was signed with some serious regrets.

The only way the projections came close to being met was by selling the Canadian subsidiary, CompuJob back to the original owners. They only had received stock when NSMC bought the company from them so that they had no cash to pay for the repurchase. It was determined that the Canadian’s would pay a price, substantially more than what the company had been purchased for by NSMC with the collateral for the sale to be some of the National Student Marketing stock that the principals had been received in the original deal. Holy Toledo!!

In a believe it or not story fit for Ripley, these transactions were concluded a full ninety-days after the fiscal year had ended on August 31, 1969 yet, consul gave an opinion that the transactions indeed had been closed in time to qualify for inclusion in the previous audit. “In the opinion of counsel in both transaction negotiations and agreements of sale were in effect consummated prior to August 31, 1969…” Thus, the company was able to come close to their target numbers, but a couple of more deals like this and National Student Marketing would be a thing of the past. Obviously they were playing a little too much Alice in Wonderland and Cort had become the Mad Hatter.

Moreover, late in 1969, a new item appeared on the balance sheet, deferred product development costs and the footnote indicated that this item, which included expenses, incurred during the year for products that would make it to market at some later date. Apparently, a lot of salaries and other items were added to the deferred number to beef it up. This created additional earnings because costs associated with the nebulous products would now be amortized over the useful life of the new products rather than to have employees salaries expensed as they should have done. One of the problems with this little accounting item is the fact that there were no products that would be coming to market to offset the charge. This indeed was a very creative way for the accountants to have handled the matter. With law firms and accountants such as these you don’t really need much of a company, but those were the days of the Wild West.

Additionally, the balance sheet showed hefty increases in the “unbilled receivables” column. Once again, the balance sheet neither states or explains what the statement means or why the figure for 1967, two years earlier had mysteriously changed without footnotes and of even greater magnitude, why it no longer appeared in the original financial figures. In addition, losses from “unamortized cost of prepared sales programs” rose substantially, avoiding a deduction from income, which would have been fatal for the company on the spot. Moreover, the footnotes went even further to point out the included in the 1969 results were acquisitions that had been agreed to in principal and not yet consummated. Arthur Anderson who had resigned had indeed avoided biting the bullet on this one, but there would be many more down the road.

Are the auditors born that way?

We don’t understand all of the bizarre accounting gimmicks that were used to get this one through the auditors, but if it hadn’t, the company’s profit would have been negligible and the stock would have tanked. Moreover, the fact that these acquisition were made three months after the accounting year had ended seemed like a piece of cake to the auditors. “No Problemo!” When shareholders raised that as an issue, “the Chairman of Peat, Marwick, Mitchell’s Ethics Committee who was present at the NSMC annual meeting, strangely seemed to opine as to the ethical nature of these bizarre machinations. The SEC and the GAAP people did not see things the same way as the Chairman of the Peat Marwick Ethics Committee and rescinded the regulations that had allowed this carry-over combination in earnings. Heretofore, financial affairs happening in one quarter would be reported in that quarter and only in that quarter.

However, Cort had once again had escaped with his life. In February 1970, at a meeting of more than 2,000 top money managers gathered at the New York Hilton for the Institutional Investors Conference an impromptu poll was taken of what the best performing stock in 1970 would be. The consensus choice was National Student Marketing that was then trading at more than $140 per share. However, it wasn’t too long after that meeting when the press started raising some serious questions about the financial data that National Student Marketing and their auditors were feeding the “Street”. Barron’s was the first to call into question literally all of the accounting magic that the company was using. The day after the report hit the street, National Student Marketing stock dropped twenty-points and the rout was on. Barron’s, Abelson who had written the story, had pretty good credibility and there seemed to be some truth to that and other negative stories circulating in the financial press. The stock started to plummet. Cort was no longer welcome on the “Street” and many people began looking for him with evil intentions.

Keep in mind that the Institutional Investor Conference thought the National Student Marketing was "all world" in early February of 1970. Well right about that time, February 24, 1970, Cort had lined up some substantial deals and their closing would certainly promulgate the National Student Marketing myth for a few more years. Champion Products with $50 million in sales was going to be acquired as was National Tape with $60 million and Josten’s, a New York Stock Exchange listed company with $70 million in sales. The only problem was that just as the deals were about to be concluded, the Peat Marwick folks finally got cold feet. They announced that the first quarter, which had been touted as a triple was actually going to be a great big loss. As if this wasn’t bad enough, several days later the loss was increased substantially.

Nevertheless, one way or the other, this cooked the NSMC goose. During this period of time as more acquisitions had been made, more and more of the voting stock was getting into the hands of people that had exchanged their stock for stock in National Student Marketing. They now controlled the company from a voting point of view. For the most part, these had been hard working folks who had devoted their lives to making their own companies work and had worked earnestly to fit into the corporate structure of NSMC. They were no longer happy campers. It was determined that Cort’s leadership was illusionary, his Virginia Mafia was a sham and their dream was a conspiracy. It was now time to produce results and that could best be accomplished with different leadership. Cort told the troops that he was resigning for medical reasons and left the company that he had created forever under a black cloud.

The damage had already been done and the company started going through new CEO’s like a duck goes through water. Reorganizing the company was becoming more of a horror as none of the facts held up. All the subsidiaries that had been recently, acquired demanded a rescission (they wanted their acquisition undone). Shareholders were filing lawsuits all over the place, the SEC was investigating the Company under every rock, the stock was now three bucks a share, and word came from the Post Office Department, that a mail-fraud investigation had been launched against way back Cort in 1964 and had never been disclosed. The banks pulled their lines, Wall Street had no additional interest in funding a reorganized National Student Marketing, and the rescinding subs didn’t want to upstream money into a parent that may have illegally acquired them in the first place. After it had been in free-fall for a while, investor’s lawsuits were brought against the company and the Securities and Exchange Commission announced that they would be taking a closer look at the company’s affairs.

When the smoke had cleared, the SEC named everybody involved including the lawyers and accountants for violating the antifraud provisions of the Securities Act of 1933. Held out by the SEC for particular hostility was Peat Marwick and in Accounting Series Release (“ASR”) No. 173 directed entirely at Peat Marwick burned their hide for sins of omission and commission committed in connection with National Student Marketing, Republic National Life Insurance Company, Penn Central, Stirling Homex and Talley Industries. Sanctions were instituted against the accounting firm in probably one of the most telling actions ever taken by the SEC against a large accounting firm.

Additional complications were added to the merger when various people from Interstate and the senior officers demanded the right to sell as part of their agreement. While that agreement was only partially kept, it was done in a vacuum as the shareholders of neither company were yet aware of the changes in the earnings projections contained in the “comfort agreement.” The law on the matter was fairly simple,

“President and counsel of merging corporation (Interstate) violated the antifraud provisions of the federal securities laws through their participation in the closing of the merger and through their sales of stock of the surviving corporation immediately following merger, in each instance without first disclosing the material information contained in unsigned “comfort letter” which revealed that the surviving corporation’s interim financial statements, used in securing shareholder approval of the merger, were grossly inaccurate.”

I guess that the moral of the story is that analysts’ projections are for the most part, follow the leader and don’t makes waves, the most investment bankers don’t do a proper amount of due diligence, that accountants are only partially to be believed, that lawyers represent their clients and not the public at large, that for the right price anything can happen, and once you get in to deep, you can’t get out with the help a derrick. That honesty is not an essential part of the investment mystic, that management at times will do just about anything to succeed or to avoid jail whatever is to come earlier. Those ratings services are great to have around only retrospectively and they are able to predict what they should have done with alarming accuracy. Those regulators more often than not fall asleep at the switch when the chips are down and the government is not necessarily your best friend.

Guilty as charged with a lot left over

While awaiting sentencing, Cort founded what we think if the first major subprime loan scheme we alluded to above under the aegis of National Commercial Credit Company of Washington, D.C., he preyed on poor people and stole their money, their credit and their lives. He stole all of the money from NCCC, bankrupting it and left all of the lenders high and dry when their paper proved to be worthless. For his efforts in this regard he was convicted of five counts of securities fraud, seven counts of mail fraud, four counts of interstate transportation of funds obtained by fraud and perjury to the government. He received a seven year sentence and five years probation for his troubles.

However, because Cortes was a good Christian and led a bible study group he received letters of commendation from various Republic Officials in the Nixon Administration and Congress. They were Charles Colson, Dean Burch, Senator William Armstrong, Nixon aid Fredric Malik and Congressman Jack Kemp. They apparently said in their notes to court that they often attended prayer meetings at his home in Florida and that he was a good Christian. Thankfully the court didn’t take these mindless recommendations seriously.

In any event Cort eventually was released from jail. He soon was back in business in partnership with the owner of Federal News Services, Robert Lee Boyd. Only a few months went by and a lawsuit was filed by Boyd against Cort for the fraudulent theft of $4 million.

Cort bounced back from this temporary reversal and became the president of eModel Agency while opening his home to additional advocates of prayer. The Federal Trade Commission in spite of his effort to communicate with God sued him for price fixing and after that he was caught forging documents and lying to a Federal Court.

Cort was not too good to his professional friends as well. Lawyers, accountants and bankers were sentenced to varying terms in prison or lost their licenses over his association with. Everyone who has crossed his path has been demonized and he was merely the first subprime lender in the world. This is a man that had the audacity to claim income from companies that didn’t even exist. He is still around today using his real name, and if you run across the guy, you can thank him for his creation of layered subprime debt along with flipping, bank fraud, and a pinch of greed.

What’s the price of stupidity in current dollars?

Subprime loans problems create an affect that we are going to have to deal with for some time. Because of the fact that it has created an economic storm that seems to be approaching from almost every direction and there are no blanket solutions. Moreover, due to the increased sophistication (not intelligence) of the instruments involved, there are extraordinary issues when trying to put out the fire. And the transactions can’t necessary be solved with money, rescission or any other quick fix. The collateral is no longer bundled to the transaction; someone has sold the stock but has lost the certificate.

Increased complexity of securitized transactions pushes the transaction into a document abyss and it seems to be in a hole that extends to the very bowels of the earth. Due to the unbundled nature of this transaction, the price the economy will pay is going to be substantially higher than what is currently within the framework of this country’s ability to pay. The fact is that the very underpinnings of the world’s banking system are at the very root of the problem due to the reality that there have recently been so many inconceivably stupid and avoidable excesses that not only they never should have existed but have due to extreme regulatory dereliction, they have remained unattended for much too long a time. Moreover, it wasn't that we couldn't see the coming storm approaching, it was the fact that we were certain that if we hid in a dark corner and sucked our thumbs long enough, the bogyman would somehow go away.

We did not face the crisis head-on and the results seem to be the unraveling of everything that has been put in place over the last 100 years. To believe that a monocline insurance company having a couple of billion dollars could overcome a major economic downturn intact where literally trillion were involved was inconceivable from every economic principal ever written in Graham and Dodd or ever taught in a Master’s class on economics. To further believe that we could overcome a 1500 basis write-down of municipal and corporate assets without paying a huge price was equally naïve. However, these will not necessary be the big losers in this game economic chess. Those will be the rating services which will be facing lawsuits as a result of being reactive about the realities into the 22^nd century and their partners in crime, the inventors of securities that just plain didn’t work.

A ripple affect

The fact that the affiliate of the enviable KKR or Carlyle finally ran out of money is not unique or disquieting on its surface. Theoretically, the endemic growth of the buyout firms or the hedge funds which were obscene over abusers of leverage kept raising the odds that one of the players would eventually have to stumble. However, when two of the most sophisticated funds in Wall Street history both collapse simultaneously we can become overly aware that something has clearly gone wrong with the infrastructure itself. Both KKR and Carlyle’s died of over-sophistication into a market that collapsed not because they guessed wrong but failed to input into their models the risk created by credit concerns by major institutions. In a market that is devoid of trust, no transaction can take place the markets cease to function. KKR had too many eggs in the extreme, short term financial marketplace and had their heads handed to them when that market literally closed for business until sense could be made out of who was doing what to whom and what that would mean to me. Carlyle was guilty of taking an indefinable instrument public and when people ultimately determined that they could not begin to understand it, the securities collapsed in a pile of rubble.

Carlyle simple overreached, however KKR had been dealing in a tried and true strategy that had become part of their business mode. They were playing in the auction-rate securities market (ARM) that has been estimated to sustain $330 billion in business. This market’s mandate is to provide a market for folks that like to take their rate chances on their perception of what the short debt market will do. This game of “chicken” worked well for all the participants for a time but when the monolines began showing signs of wear; and many of the securities in these auctions being guaranteed by the soon to be unreliable insurers, didn’t draw bids the system was literally shut down. With the banking system in disarray and Wall Street underwriting hitting a wall, as they say, “you can run, but you can’t hide.” In plainer words, “The fat lady had sung,” and had now left the building.

A wakeup call to the regulators is now too late; they’ve slept past noon!

Everyone was asleep at the switch but the monolines became bolder. As the folks at Creditsights have commented, “the regulatory capital bases of the monolines grew by 29 per cent between 2003 and 2006 to $22 billion. However, guarantees of structured finance – much riskier than the traditional municipal bond business – grew 175 per cent in that period to $1,600 billion.” There are even those that believe that should this arena continue to be unaddressed as the ratings collapse, even some of the more conservative hedge funds will start to topple. That would write the final chapter on banking as we know it and send the United States financial creditability into that of a third world country. We do hope that someone is watching the store, but we see pontification trumping activism. Thankfully, I am not sitting in the catbird seat overseeing this debacle as I have no reasonable solution to the mess.

It has been estimated that at least 25% of all mortgages written in the last several years will not be repaid. If these folks don’t pay and the building industry doesn’t turn around (which certainly can’t occur in the near future) we will soon have skeletal subdivisions rusting out while reminding us of our proven fiscal irresponsibility. Although this is a natural occurrence as we attempt to vie with other countries that are beginning to compete with our investment banking expertise. London became the prime competitor of Wall Street and got the city of New York so nervous that proposals for a Lloyds of London type insurance exchange were being set up in that city which would no oversight whatsoever. Without a regulator, the world seems to go nuts and usually precedes economic kamikaze missions. Perhaps the City Fathers are rethinking the proposal now that Northern Rock has totally dissipated London’s appetite for risk and the monoline disaster has addressed issues regarding negative oversight once and for all. We would predict that the clumsy and financially intolerable individual state governance of the insurance industry will be willed into extinction by an understanding Congress.

As is obvious from the foregoing, the regulators are out-to-lunch more often than not and probably believe in the integrity of their congregation to let them enjoy life at the top rather than worry that the world may be coming apart at the seams. We all recall Diogenes the man that spent his life searching for an honest man. Well that may or may not be true but Diogenes and his dad were really into other more interesting hobbies. They were counterfeiters of the first order and were convicted and jailed for their various unsavory pursuits. However, there is more than one principal to this piece of history, not only was Diogenes looking for an honest man (probably to steal his money) and not only was he caught red-handed and jailed but he stated that he had done all this in order to protect himself from the world’s criminality and financial irresponsibility and ordered his family on his death to bury him with his head pointed straight down because of the topsy-turvy nature of what he had observed. He had some point of view!!

It was Diogenes who was the nut job, not necessarily everybody else. However, seems a bit like today’s regulators; trusting in their fellow men while the world’s pockets are being picked.

Competing with the nueve riche’ economic proletariat

The London problem may well be a blessing in disguise as we continue losing our edge in regulatory securities oversight. It became a matter of economic life or death to be able to prolong New York’s dominance in the securities industry. The name of the game, became, let them do it their way. Everything was loosening up in order to compete with the folks across the pond. However, fundamentally the allowance for hedge funds to literally do whatever they wanted seems almost un-American and turned out to be just plain stupid.

The American Banks have found the hedge funds a great source of putting to work excess capital and will lend them almost any amount no matter what the leverage due to the fact that they have historically been willing to provide very high rated collateral, or fully hedged transactions. The problem of what has become blind lending to a credit worthy borrower is the fact that under conditions of economic stress, historically successful models begin to fail. Not Necessary due to the fact that someone made a mistake, but because of the economic pressures caused by uncertainty and mistrust.

Off the hook and gives them the accolades for their work with indigenous people throughout the world.

I got my tongue in back of my eye tooth and couldn’t see what I was saying.

Goldman Sachs is a different kind of place. Their managing partners usually become Secretaries of the Treasury or better and they seem to be able to avoid biting the bullet when there is a crisis. However, it may be that they are in for a minor fall. This is a story from the "Dailyreckoning.” “In 2006, Goldman Sachs’ mortgage-bond division – Alternative Mortgage Products (GSAMP) issued 83 home-loan-backed bonds, valued at $44.5 billion. In the subprime sector, it grew its business by 59% from 2005, unloading some $12.9 billion on unsuspecting, stupid and/or greedy investment fund managers (pros) who thought a bond under-pinned by home-buyers who had no conceivable hope of repaying.”

According to Inside Mortgage Finance, that made GSAMP the 15^th biggest issuer of subprime-backed bonds in 2006. In the third quarter of 2007, those securities were being downgraded by the credit ratings people literally faster than anyone else’s.” (Could this have anything to do with the fact that Goldman stated that they never bought monoline insurance; possibly their brilliance bit them in the behind) Research from Citigroup, dated 22^nd June, found that “portions of Goldman’s GSAMP-issued bonds which included subprime loans from a variety of lenders, have been downgraded a combined 69 times by Standard & Poor’s and Moody’s Investors Service in the year through June 15, 2006,” as Reuters reported. “Sixty of the GSAMP downgrades refer to classes from 2006 bonds,’ Citigroup added, and one of Goldman’s 2006 crop – the GSAMP Trust 2006-S3 – may actually be “the worst deal…floated by a top-tier firm,” reckons Allan Sloane in the Washington Post.

In spring 2006, “Goldman assembled 8,274 second-mortgage loans originated by Fremont Investment & Loan, Long Beach Mortgage, and assorted other players,” explains Sloane after studying the public record. “More than one-third of the loans were in California, then a hot market. It was a run-of-the-mill deal (face-value $494 million), one of the 916 residential-mortgage-backed issues totaling $592 billion that were sold last year. (Pretty much, they were the market) It would appear at least superficially that these loans were picked for their inadequacy. “The average equity (these) borrowers had in their homes been 0.71 %...( meaning) the average loan-to-value of the issue’s borrowers was 99.29%. Hypothetically let us take the case of this red necked couple down in Alabama that wants to buy a home. They pick a $500,000 palace out there in the hills and ask the mortgage company how much they have to put down on their dream house. The mortgage lender studies the ceiling for a time and says to Luke and his pregnant 15 year old bride.

“Luke, you got a job?”

“Sure Mr. Lender, I work as a sharecropper over at the John Smiths cotton farm.”

“What’d ya make workin' there Luke?”

“Well the work isn’t too regular in the winter time like it is now but so go bear hunting and catfish fishing ta rest of the time.”

“Luke, how many weeks do you work and what is your gross income.”

Luke: “Well I don’t rightly know what gross means, but Mr. Smith lets me have a bale or two of cotton now and again so that Edna here can make the baby’s clothes. Then, Mr. Smith lets me go over to the fruit trees and take whatever I need for lunch. He’s such a nice guy.” I guess with all the benefits I make about $70 a year.” Mr. Lender:

“Well you aren’t really a good quality loan so you gonna have to sell the still back in the woods, I know someone who’ll give you almost $4,000 and we can call that the down payment. Just put an “X” on these papers here. No need to ask you to read them, because you never did learn how ta read and congratulations you will be able shot them quail you like so much right from the porch. Luke:

“Thank your grandpa Lender Edna. “ Edna: Thank you grandpa.

According to Washington Post’s Allan Sloane, “It gets even weirder; some 58% of the loans that Goldman was involved in were no-documentation or low-documentation. This means that though 98% of the borrowers said they were occupying the homes they were borrowing on – “owner-occupied” loans are considered less risky than loans to speculators – no one knows if that was true. And no one knows whether borrowers’ income or assets bore any serious relationship to what they told the mortgage lenders.”

Whatever the truth, one in every six of the 8,274 mortgages bundled together in GSAMP Trust 2006-S3 was already in default 18 months later. Whoever bought those bonds will have taken a 100% loss, or they’re now anxious waiting – and hoping against hope – for some other schmuck to turn up and take this toxic was off their hands at a very heavy discount. Meantime at Goldman Sachs, the profits made by shorting the subprime market flipped Q3 ’07 from “significant losses” to “significantly higher” net revenues. Goldman creamed it by selling their client’s investment shore. They had first made the loan and then bet against it.

People are more than a little annoyed at what has happened to them and you certainly can’t blame them. Take the story of Cecilia L. Fabos-Becker which on the site of the dailyreckoning.com. She states in part “…Go look up on the SEC Edgar site the following: GSAMP Trust, GS Mortgage, and GSR Mortgage. You’d be surprised at how many subprime mortgages they own and securitized. Also they didn’t bother to record the ownership of the notes properly, or the assignment of deeds of trust, which is starting to be discovered as they try to foreclose on some of the older loans. My husband and I are in Chapter 13 bankruptcy…and in foreclosure, and discovered that not only had they not accurately conducted and filed required reports on chains of conveyance of assignments of deeds of trust, etc. but they lied to us about who the lenders were and their selected servicing agent, Ocwen Federal Bank FSB (later reorganized to ex\escape federal regulation as Ocwen Financial Corporation) never forwarded any of our appeals to them, or proposals for renegotiation or restructuring on the basis of hardship after experiencing several bona fide disasters (our business was twice in a FEMA declared disaster area and once in a State declared emergency area, etc.).

Betting against your clients would seem immoral at best and these don’t seem to be the sort of folks that are interested in helping the “little people,” a philosophical school founded by the great humanitarian, Leona Helmsley.

We’ve documented at least two dozen violations of RESPA and other federal codes in the handling of our mortgages. It’s not likely they were doing this all just to us. There were 3,086, mortgages whose securities were all bundled under “GSAMP Trust 2002-WMCI” (found under GS Mortgage in the Edgar listings). So, stay tuned, folks, and watch what happens in various types of U.S. Federal court, as more victims—and their attorneys come to the realization just how badly they have been damaged by Goldman Sachs and their lack of disclosures, response, etc. What’s really amusing, however is that the current U.S. Secretary of the Treasury, President Bush’s publicly designated “point man on the subprime mortgage crisis” was until 2006, the CEO of Goldman Sachs Group, Inc. So the President of the U.S. – and the majority of U.S. Senators rewarded the former CEO of Goldman for indirectly defrauding and raping investors worldwide… Where’s the International Court and international plaintiffs on this one?

Doesn’t ruining this many investors – not to mention God knows how many thousands, tens of thousands, or more, homeowners – somehow qualify for “crimes against humanity?” Even China has a “human right” that guarantees their citizens of a decent home – something with which our previously good friend, Mr. Paulson doesn’t seem to agree.

Clearer than mud

Clearly it was the unrestricted lending by brokers and banks that preceded and caused the 1929 debacle which was only corrected by the funneling of assets during World War II itself. They can say that the hedge funds are unregulated borrowers and thus are exempt from these rules but while that may be correct it would not diminish the responsibility when banks under the Fed’s aegis are loaning money to these opaque funds as quickly as they can push the money out of the window. Moreover, only a decade ago, the New York Federal Reserve had to deal with the catastrophic problems created by Long Term Credit. They had borrowed over 99 percent on a series of what they believed to be sure bets; that was only until the margin calls went out and couldn’t be met. As I recall it, if the money hadn’t been put up that night on an enforced basis, we would all have been in the bread lines by the next day. However, the Fed had more power at that time than it does today. It has allowed banks to operate in some nether world not encompassed by any regulation whatsoever. The folks have leaned back and knowingly allowed accounting that does not account for anything and derivatives that are incomprehensible even too there maker.

So we have lenders who have their own secret repositories of bad debt hiding within their balance sheets are lending money hand over fist to borrowers that won’t disclose what they are doing with the funds. J. P. Morgan recently ceased to exist as an independent bank due to the fact that they couldn’t even understand whether they were bankrupt or not. Bankers Trust wrote derivatives that seemed to be directed at offending even their biggest clientele and Continental Bank of Chicago which literally ceased to operate and became one of the biggest bailouts in U. S. History.

Perhaps we are so far into the game that the economic apparitions that have been foolishly released from the bottle can never be put back in again. However, there is no question that no mandated correction is even achievable until this disaster has run its course. The SEC has been taking a break from regulating, the GAAP people are out to lunch or don’t care, and the banks are cleaning up their balance sheets by selling their birthrights to foreign nationals. Moreover, the International commercial expansion has created a cadre’ of unsophisticated players with too much money and too little experience, moving into responsible positions, but not having a clue how to run anything other than a camel convey. These folks are now forcing their elders to play by a game containing unrealistic and uneconomic rules invented by others. We are being bamboozled by proxy in a sport where the house is gradually being taken over by amateurs. While no one has been looking, the bad guys are gradually taking it over.

One of the great thefts of all time was committed in Argentina some years ago when a group of inventive thieves who noted that the price of steel scrap had gone up substantially in price, waited until late at night and totally dismantled and absconded with an iron bridge spanning the Rio Parana River. The following morning’s rush hour produced an awakening that the bridge was no longer there as traffic backed up into the shopping district. Everything came to a jolting halt, due to the fact that the infrastructure had been hijacked while the regulators were asleep at the switch.

What does a bear do on wall street?

Moreover, the crunch that could have been created by Bear’s direct demise would have left repercussions that would have been felt throughout the investment universe. Thus, indirectly for the first time in recent memory the Fed indirectly opened its window to a non Federal Bank. This action was facilitated by J. P. Morgan, a bank that had remained reasonable solvent due to their avoidance of the subprime market and probably wouldn’t mind Bear Stearns at the right discount if they were able to check the inventory. Sadly Bear’s inventory is concentrated in collateral that there is not a big demand for; in some cases none at all. Moreover, Bear Stearns acted as a clearing agent for numerous hedge funds, and if Bear went down without some arrangement, this could create a clearly problem that would make 1929 look like a fantasy game of tiddlywinks.

This is a great calamity for Wall Street especially when you consider that the firm had apparently remained profitable over its entire existence, and believe it or not could well be profitable in receivership. The J. P Morgan proposed bailout would not include anything for the shareholders and other than turning back to Fed there is absolutely no hope of any sort of reasonable return to the shareholders. Bear Stearns continues to show a book value of approximately $80 per share with a stock that is selling at 30 and going south.

There are not many people that will have a lot of remorse over Bear’s demise although they all would have suffered if the Fed had not stepped. Wall Street is really a Street that is about three blocks long and the players all are inter-related in one way or another. However, the management teams at Bear were hard hitting people that never quite fit into the same social circle with other firms. They would be considered mavericks anywhere else but on the “Street”. Some of Bear’s more infamous customers include Stratton Oakmont and A. R. Baron whose principals would be complimented if you called them, bucket shops. Bear had a habit of trying to make money at any cost and had several instances of less than honorable financial dealings.

Hard charging Jimmy Cayne the fearless leader of Bear never gave an inch and neither did his mentor, Ace Greenberg who had denied that the company had a financial problem until the end. But he wasn’t the only one, Schwartz He had hired Cayne when he learned that he was a bridge player and between them they have won numerous tournaments. However, when the fire got really hot, Cayne started playing Bridge full time and was for the most part, not around for the finale. When he wasn’t at a bridge tournament he was on the links playing golf. Cayne’s loss on Bear stock is currently down over $800 million and the stock will probably go much lower.

However, Bear Stearns did have the foresight to build a $500 million 43 story castle on in close proximity of Grand Central Station at 383 Madison Avenue in the heart of the world’s most valuable real estate. Today’s value of the property could net close to $1 billion but real estate is usually not an admitted asset for regulatory purposes and should remain available to either creditors or shareholders after the smoke has cleared.

Not only did Bear play large in the arena of subprime loans, but they also created their own rules. Usually when an Investment Bank is pricing their portfolio they mark it to market; that is the price that the instrument is trading for as its value. However, it is difficult to mark to market something that has no perceived value. Thus Bear Stearns invented their own rules in order to stay solvent; so they used internal computer models “derived from or supported by some kind of observable market value.” Moreover, the inventory that remains on the books is an estimate based on “internally developed models or methodologies utilizing significant inputs that are generally less readily observable.” This makes sense to me but I don’t understand a word of it.

ESM Government Securities Shell Game

Not every business is obligated to have an outside accountant. Those that are public companies are usually required to do so (if they are reporting companies) and those institutions that are regulated as well as those who regularly deal with the public also have that obligation. Brokerage firms fall under the later and even if they are dealing in what were once called exempt securities (i.e. government bonds), the public trust is involved and they are regularly audited by an outside auditor.

ESM Government Securities Inc was founded in late 1975 and capitalized at less than $100,000. When it opened for business, the three partners were Ronnie Ewton, George Mead and Bobby Seneca with Ewton who had a somewhat checkered history assuming the top job. They brought in Alan Novick to handle the firm’s proprietary trading account. ESM was one of a group of brokerage firms that sprung up during the late seventies that for the most part indicated that they were in the business of attempting to improve their client’s overall portfolio yield.

This optimistic note indicated that this magic could be accomplished by a complex system of lending and re-borrowing of different but similar securities called a “repo” (a repurchase agreement) or it’s more complex cousin, the “reverse repo.” (Reverse repurchase agreement) Interest rates were sky-high at this time and savings banks had numerous restrictions relative to the interest rates that they could pay on CDs, which was virtually the only way in which they could attract money. Thus, they were in a position of always lending long and borrowing short and in situations where rates were going against them the institution could potentially fail. There was literally no lifeline available for them, mortgages were fixed and rates were going up like a hot air balloon.

One of the numerous problems with the industry was the fact that it was basically unregulated. Because of America’s growing internal debt, Uncle Sam wanted to make owning Government securities and would allow these shadowy people to exist in dark alleys or other dark corners. Liquidity was their rallying cry and in spite of shoddy practices, firms such as ESM provided the government exactly what they were looking for.

ESM came up with the theory that you literally can’t lie when talking about a government instrument. They were pretty close to correct, at the time this security was exempt and not subject to any of the rules normally reserved for securities of any type. In theory, no matter what you would say about its safety would be an understatement, and on a relative basis, this probably was very true at the time. The second methodology that the federal government used to move their paper was allowing government dealers and their clients the opportunity of literally unlimited leverage. You could borrow any amount that someone is willing to lend you if you use government securities as collateral. While margins on stocks have been set by the Federal Reserve at 50% and have remained at that level for decades, you could leverage government instruments at whatever the traffic would bear. This became the undoing of many small brokerage firms specializing in this business. More recently this became the undoing of the infamous Long Term Credit.

However, interest rates would rise and fall and due to margin calls many of the ESM type entities were not going to go down quietly. They started to innovate by attaching as the purchase of “junk bonds” and using the magic of the Repo market to collateralize themselves. Thus, ESM was able to earn enough to temporarily get by. During their period of significance, many of these brokerage firms failed and when they did, they more often than not took their clients whose securities they were holding, down the drain with them. Most of the people running the firms were heartless inveterate gamblers and they were more interested in providing themselves with a substantial livelihood than helping their clients. Names like Beville Bresler & Schulman and Lombard Wall all flourished and collapsed during this period of time bringing down many clients with them. Strangely, these Government Securities dealers that were offering their clients a form of “Black Magic” all had their beginnings in Memphis, a city that seemed to have the right climate for securities fraud.

Being an outside auditor for these types of companies was not an easy task as the firms were able to construct inconceivably complex products at the drop of a hat that only their makers seemed totally able to comprehend. (Probably best described as a forerunner of the derivative) This made accounting for the portfolio’s current value a job and a half. In derivatives, accounting firms and the products makers seem to have found a way around accounting for these products by hiding behind the accounting term, materiality. Materiality which literally means that if the investments do not account for more than five percent of a firms assets, they don’t have to individually accounted for and can be bundled. (Very general definition)

Materiality was not part of the accounting code that could be used at that time but other equally disturbing tricks of the trade were regularly dusted off the shelves. Thus, the auditors became engaged in internecine warfare just to find out the facts and for the most part, they lost. These so-called government brokers were dealing in anything that could make them a buck or disguise what they were doing from their own accountants. They were into leasing, purchasing, "repo-ing,” and trading in government securities. The ultimate question that could would regularly arise was that was smarter, the accounting firm of the government dealer.

Into this black magic environment stepped Jose Gomez, the son of Cuban emigrants who started his life in what then was called “Little Havana” in Miami. His first job was as a bag packer in a supermarket which he stuck with for quite awhile. He stayed in the same industry while he attempted to earn enough money for college and then became a buyer for another grocery store. Simultaneously he went to school at the University of Miami where he obtained a degree in accounting.

Jose was intelligent and persuasive and was soon hired by the then sixty-year old accounting firm of Alexander Grant & Company (Now Grant Thornton) to handle the audit for ESM a government dealer. In what he later described as an act of faith, he was assigned to them in 1977 and not only carried out his assignment but because close friends with the firm’s principals. Gomez became a super-lackey for ESM very early in his assignment when the firm’s principals found that they could bury odious accounting items from his prevue almost at will. Alan Novick, an ESM principal and bond trader became particularly adept at moving his loses into crannies that Gomez would not think of looking in.

In spite of Gomez acting as Alan Novick’ s unpaid Huckleberry, in 1979 he Gomez became a partner at 31 years of age at Grant and as such was certainly one of the youngest to ever achieve that position. Gomez was an extraordinary go-getter and was on the boards of many fabled charities located in the Miami area. His theory was that in order to succeed in accounting, you had to go where the money was; a splendid idea. However, not everything was so straightforward in Gomez’s life. Gomez confided in his newfound friend, Alan Novick that his credit card debts were squeezing the life out of him. This of course was about all Novick had to hear to spring into action. Gomez took $20,000 in cash from Novick at the end December in 1979 and got rid of some of his more pressing problems. However, poor Gomez had just bought the farm.

Credit card debt was not the only thing strangling the young accountant, he seemingly owed everyone for just about everything and set up numerous meetings with his benefactor, Alan Novick, to convince him to have ESM, his client take care of the remaining indebtedness. In a deal with the Devil, Gomez facilitated the ESM cover up of close to a fifty million dollar hole in their balance sheet. Had this hit the books at the close out the year 1979 the firm would have immediately become toast. This was in exchange for additional assistance on his never ending string of debts. Gomez later confessed the reasons for his foolishness:

“I was a young man in a hurry. I needed more money than I was making. I wanted nice clothes for my wife. I had to have a nice home, be seen at the right places. Take a trip to the Super Bowl. Do whatever was necessary to further my career. Use the plastic, the credit cards. When the plastic limit was reached, borrow and pay off the balances. Then use the plastic again.”

In the meantime, one of the most bizarre events in financial history occurred and as quickly as it had happened it once again disappeared. As we said at the onset, one of the senior partners at ESM was named Bobby Seneca. He had recently unloaded his wife in a divorce matter but she decided that her settlement was not nearly adequate. After all, “The loans, piled on top of the generous salaries, were feeding a lifestyle that was increasingly ostentatious. There was the luxury home, the lavish parties, the Mercedes and Jaguars, lots of jewelry for the wives. She saw how the other ESM wives were living, and she remembered the $70,000 Vatican wedding, the countless grams of cocaine, the mink capes, and the $8,000 Rolex watches”

In the court trial, Bobby Seneca was represented by Gene Strearns of Arky; Freed who peculiarly “confessed” in court that ESM and its principals were essentially broke. Furthermore, Stearns argued in court, “if news of the facts that he was enumerating in court ever got out, countless people would be wiped out, and the firm would collapse in a heap.” Seneca won the issue relative to his wife’s support and ESM was the beneficiary of a true miracle when the judge bought Strearns' argument about secrecy, hook, line and sinker. This had to be one of the extraordinary court decisions in American legal history. Thus, the conspirators had been saved to continue their pillaging of their client’s money, and were allowed to do it, essentially under the good graces of the American Court System.

Besides all of the first-rate playthings that the partners were buying for themselves, the firm was taking in a substantial amount of customer money and re-investing it in energy oriented transactions. They believed that the investments that they were making were so solid the even if everything continued to go wrong with ESM, the investments would unquestionably bail them out eventually. Gomez by this time was now a more than willing “worker bee” and was actively running a clinic at ESM on black-art accounting principles. Showing “the boys” how to falsify their records in ways that Alexander Grant would never think of investigating was no a critical part of his job description at ESM.

However, Novick was not happy with this nickel and dime stalemate that he found himself and determined to get even all at once. He bet over a billion dollars (A humongous sum at that time) that interest rates would decline. Either Novick was the worst trader that ever lived or just plain unlucky is not an issue for now, but unsurprisingly, as with everything else he was doing, he should have stayed in bed in bed that day. Novick’s “bad hair day” bet literally opened Pandora’s Box and the firm wound up the year of 1980 with a $13 million loss. When this amount was added to his previous bad bets it brought ESM into an insurmountable $144 million hole. Interest alone was running ESM $20 million per year. However, the now debt-free Gomez was rock solid during this period when he was desperately required and imaginatively produced an illusionary $12 million profit for ESM for the year 1980.

Pete Summers, a senior officer and shareholder of ESM decided that the game was getting a little too rough for him and wanted out. He would sell his stock back to the company for the inflated book value and keep his mouth shut. In order to make his point, Summers’ lawyer composed a scenario for the folks at ESM to read and it went this way in part:

“Example: Customer owns $50 million worth of collateral. ESM tells them they will give him $25 million for the collateral. ESM in turn puts the collateral out and receives $40 million. ESM nets out $15 million which they use to cover the loss ESM Government Securities took.”“They do this example three times to raise money to cover losses taken in the market. “

You may ask why any legitimate Savings Bank would give up $50 million in collateral in exchange for $25 million? In reality, there is no problem; as long as management of the Savings Banks was receiving enough money “under the table” from ESM, and they took the bait hook, line and sinker. Summers was on the mark with his example and was quickly paid out by ESM management in exchange for a non-disclosure agreement and the promise to let them alone and to go bother someone else.

The rest of the news for ESM was both good and bad. They had dodged the bullet in a problem with the Federal Home Loan Bank Board and another with the Securities & Exchange Commission through the black magic that Gomez was able to construct with his paranormal juggling of the pathetic ESM numbers. However, these were nervous times for Novick who was seemingly now putting out one fire after another. On the other hand, when he left the office, there was a lot to go home to. Novick had a devoted wife and three children that he adored waiting for him when he arrived from work every day. He owned race horses; show dogs and an imperial, castle like house in Fort Lauderdale. The horses were an expensive hobby and for the most part a Novick’s ponies could usually see all of the other horses when they raced in their usual position in the rear of the pack. On the other hand, his dogs were world-beaters while one; Ch. Braeburn’s Close Encounter won the best of the show award at Madison Square Garden making the dog, the world’s best that year. However, when you win a horse race you win real money and when your dog wins, you get a trophy.

Sadly for his family and partners, Novick died at the age of 44 from a heart attack just three months before ESM was officially closed. Some say he died from nervous agitation but it came at an inconvenient time for his partners. “Close Encounter”, the show dog won the best of the show six months after Novick had died. It was probably Novick’s death more than anything that caused the ultimate unraveling of ESM, due to the uncontroversial fact that he was the glue that was holding the firm together and when the glue was no longer accessible, the unraveling occurred rather quickly.

Eventually, everything went down the tube at once and because of Gomez’s fancy accounting work on behalf of Alexander Grant, the accounting company became the logical choice by creditors to repay everyone who had lost anything. There were four-hundred-seventy partners in Alexander Grant at the time and each one of which was jointly & severely liable to both each other and to the creditors. On the other hand, Grant had the foresight to have purchased a $500,000 deductible policy with a topside amount of $190 million. Caught with their hands in the till, there was never much question about how much Grant would pay, and ultimately by a series of shrewd negotiating maneuvers, the partners were let off the hook for their $1000 per man, deductible amount.

George Mead and Nick Wallace, two principals of ESM had seen enough and hired legal counsel for protection. It was soon evident what had occurred at ESM and that $300 million was missing. The ESM principals were advised to cooperate with the regulators and close down the firm because when the nature of what had occurred became known, there well could have been a major panic within the financial markets in this country. The biggest creditor was a New York Stock Exchange listed company (a savings and loan) and there were still billions of dollars in open positions that had to be prudently unraveled.

ESM had set a number of standards when they were closed up for good. It was probably the largest financial crime that had ever been committed up to that date. The accountants were so involved in the deception that they were created by their spurious audits that they had to be restated for 1978, 1979, 1980, 1981, 1982, 1983, and 1984. This was probably the mother of all restatements. The ESM crusaders had avoided biting the bullet on numerous occasions and were only living on borrowed time anyway. In numerous cases, the entire fraud had been hung out to dry and yet no one had ever thought of blowing the whistle.

Possibly the most interesting aspect of this affair was the fact that all reports to the IRS were essentially correct and through the use of subsidiaries and the like, the numbers were clearly available as to what was occurring should anyone desire to take a closer look. Obviously, Grant Thornton was also doing the IRS returns as well as the company’s financial statements which were showed dramatically varying sets of numbers. In spite of the fact that the information was available in Alexander Grants’ records, no senior person thought to bother to look. Lastly, the entire sordid affair was specified to a divorce court when the issue of increased support had been raised. In one of the most bizarre decisions in American jurisprudence history, the court sealed the verdict and the information due to the fact that its release would have been adverse to ESM. I guess we should ask the judge; what about the interests of creditors and the depositors?

Congress opened an entire subcommittee hearing on the matter and the words of Congressman Ron Wyden probably expressed the feelings of the committee as a whole after they had gotten a dose of what occurred:

“The auditors tell us that they had no choice but to rely on second-party confirmations—in this case, the word of Mr. Gomez—that the collateral for these large loans did exist and did adequately secure their clients’ interest. What disturbs me is that the system literally breeds this kind of buck-passing. If the auditors went as far as the system and the rules of their profession require in confirming the collateral, any reasonable person would conclude that once again, the auditing system has failed…it is my view that the only watchdogs throughout this sorry spectacle were either asleep, forgot how to bark, or were taking handouts from the burglars.” ([139])

Ewton got a 24-year sentence for his efforts, Novick died of a heart attack, Arky and one of the accountants who was convicted and sentenced to jail, both committed suicide. Grant was sanctioned by the Florida Board of Accountancy, received a 60-day suspension from accepting new clients and was absorbed by Grant Thornton never to be seen again.

What had occurred was theft and greed in the highest sense. The result of these efforts by ESM management to despoil their company and steal from their clients is listed below:

“The ESM merry-go-round screeched to a halt and devastation followed when the firm declared bankruptcy in March 1985. Its collapse caused pain and hardship to clients throughout the U.S., from Washington and Nevada to Texas and Pennsylvania. Ohio was hit hardest; ESM lasses bankrupted the state’s second largest S & L, Home State Savings of Cincinnati. A frightening panic followed, and a week later Governor Celeste was forced to shut down 68 other S & Ls. Half a million depositors endured agonizing weeks worrying if they’d ever see $4 billion of their money again.”

“True tragedy struck when two of the ESM players committed suicide. Another died at his desk. Marvin Warner, Home State’s owner who was once worth $100 million and who had served as Ambassador to Switzerland, was forced into bankruptcy. He and an associate recently had criminal convictions overturned on technical legal issues, but further appeals and retrial loom for the in the months and years ahead.”

“In the end, a large measure of justice was brought to the victims. The system creaked and groaned, it moved in fits and starts; but the thieves are in jail and the victims with the help of a very able lawyer of Ohio’s elected officials, have recovered almost all their money.” ([138])

Kamikaze central

The Japanese have played the international game of chicken, “we know game theory better than you” several times but the most catastrophic was their no interest policy for loans created in the early 80’s. It was designed for the Japanese to do from an economic point of view what they couldn’t do militarily; take over the world. This time they thought it could be accomplished simply by purchasing all of it. And they began executing this ill-thought out program of conquest. They bought up most of the choice real estate in the United States at unsustainable prices but to them it appeared a bargain because they were paying nothing to borrow money. Who could compete with that? They controlled the art world in spite of the fact that in many instances they bought the masters at auctions and couldn’t take delivery, they bought properties such as Rockefeller Center and the great golf courses which soon came back into the market at substantially lower prices as did the art. There second attempt at world domination in forty years had again ended in failure.

an ogre a day keeps markets on the toes

Concepts geared to separate investors from their money sprung up like weeds in the summertime. Everyone had created a can’t fail technique for investing and more often than not, in lemming like precision, the public followed the leader over the edge. Hedge Funds came up with a new variation on the theme. They would not steal all the money outright, they would only transfer money from the poor to the wealthy; sort of a reverse Robin Hood syndrome. This was helpful in widening the chasm separating the rich from the poor and for what it was, it became exceedingly successful. However, too many people wanted to join the wealthy elite and the money piled in so quickly that the hedge funds began to cannibalize each other looking for investments that would continue to provide absurd yields. In this feeding frenzy; the law of diminishing returns which had performed like clockwork for over 6,000 years showed its ugly head once again. The quality of the available investments dropped like a ships anchor in outer space and yields of these transactions went disgustingly negative. Enter the era of subprime loans.

But that wasn’t all that had happened. Along with the complete lack of enough deals to spread the wealth, the hedge funds could not resist accepting the manna that was floating from the sky. Hedgies began to compete in a competition to see if they could recycle as much of the public's money from high grade to garbage in an ever shorter period of time. In some cases full disclosers were not made and most of the debt securities that were sold during the period of 2006-7 were literally an attempt to rip off the public. Eventually, the public was driven to these securities as though they were breathing the perfumed essence of female hormones. The more the public put in, the more the eventuality of the house of cards grew. Before the frenzy had ended a catastrophe at least 10 times the size of the Enron disaster and as more money came in, the situation only became worse. In other words the house of cards was growing larger by the minute. We emerged into a new age, the age of “black magic of securitization”.

The banks and underwriters became active participants in this game foolishly believing that the list of suckers was endless. Picture the scenario of the mortgage of a worthless loan placed in a large package of like collateral insured by a monocline insurance company and then repackaged to be sold to investors living in almost every country on earth. It has some similarity to the infamous Toshio Shimizu who while not well known in his day job as a Tokyo welder, made a mark criminally and socially by attending almost every available wedding as a member of the bride’s family. While everyone else was at the ceremony he would offer to guard the wedding presents. By the time the wedding was over, most of the valuable gifts had disappeared into Toshio’s ditty bag. He went on with this pursuit for literally years before he was caught. The food was good, he met a lot of nice people and it was a living and if something went wrong, he still had his day job. He was the ultimate case of the cat guarding the canary cage, which is what regulation currently encompasses.

Throw in a bunch of fraud and sprinkle lightly with salt and simmer

This in itself represents self dealing, non-disclosure, and deceit of the highest order. The fraud occurred when certain brokerage firms, unable to stay in regulatory compliance by writing down the value of the securities, claimed that their values were holding up in spite of the fact that defaults were internally popping up regularly. This fact became interestingly visible, it had become absurdly obvious when Countrywide announced that it was in dire straits but by admitting a problem of this sort on Wall Street you would be creating a piranha like feeding frenzy of competitors attacking your lunch. That couldn’t happen without incredible erosions in the subprime market. The naivety that corporate leadership both in banking and the brokerage side thinks the public is guilty of is beyond conceit. There is not a chance that Countrywide would be taking a billion dollar write-off on uncollectable collateral while the Bear Stearns, one of the kings of the subprime business remains fiscal secure. It is mathematically and economically totally impossible. It strains any rational thought process. Moreover, it would seem that the boss man of Countrywide is has not been dealing from a full deck. In an internal e-mail that wound up in Congressional investigators hands. Mr. Mozillo who will go down in history as the CEO of the largest Mortgage Company in the world to ever collapse while taking out over $250 million in compensation in the last several years stated: This process is no longer about money but more about respect and acknowledgment of my accomplishment…Boards have been placed under enormous pressure by the left-wing anti-business press and envious leaders of unions.” This is the most egotistical, statement of all time and clearly adds transparency to his internal makeup. This is the stuff that wacko’s are made of.

With leadership such as this guy who apparently has a permanently bad hair day on Mondays through Fridays and on weekends as well. He has certainly not played well to the regulators who will also have some additional input into his next residence.

The following story takes a peek at executive arrogance that you cannot err along with where people that take that position windup:

Anthony De Angelis and His Magic Water Tanks

Anthony De Angelis had been around for a while. He was an elderly guy who over time has been credited with stealing a $1 billion dollars from folks at a time when that was real money, back in the early sixties. De Angelis knew a little about salad oil because he cut his teeth on the stuff as a commodity trader and one of the bits of obscure information that he was aware of was the fact that when you place water and salad oil together, the later will float to the top. De Angelis, never much of an angel, thought to exploit this anomaly and rented some of American Express’s storage tanks in New Jersey. In them, he placed approximately 1% salad oil and about 99% water. As we have previously explained, the salad oil popped to the top and unless someone was wearing a scuba diving suit they really would think that the tank was full was full of this valuable product.

The swindle was not created in vacuum. De Angelis was using the American Express warehouse receipts to guarantee the purchase of soybean-futures. Soybeans were an integral part of salad oil and by running up the price on the beans; Tino thought that he could make a large enough profit on the futures to cover any deliveries that he may chose to make on the salad oil. When the fraud was discovered, De Angelis’s position in soybeans was liquidated also causing the old-line commodity firm of Ira Haupt to collapse into an irrecoverable heap. The damage that had been done by De Angelis for its time was probably greater than any single incident in history preceding it.

American Express was acting as both the leassor of the tanks and the guarantor of the salad oil or the supposed contents of the tank as well. Once American Express was satisfied that the salad oil was in place, it would issue a warehouse receipt guaranteeing that the salad oil that was purchased by a third party was held by American Express and its existence was further guaranteed by an irrevocable bond. In this case there was no one to blame beyond whoever had been assigned to do the due-diligence for the credit card company. There was no accounting firm to blame. American Express had only one job to do and they jeopardized their entire company by bungling it.

One of the most interesting sidelights of the affair was the fact that the losses run up on the disappearing salad oil were actually more than the net worth of American Express itself. The American Express stock tanked and people were not sure whether the company would be able to stay survive or not. Then, even worse news hit. It turned out that American Express when it was formed began existence as a bank. Its charter was a bank charter and strangely even though banking was only a small part of its then existing business, the charter remained the same. Banking laws had been altered after many banks had disappeared during the 1929 crash and one of those changes made shareholders of banks liable for two-times the stock’s par value.

As we recall, American Express had a par value of $100 per share, which was substantially more than the stock was selling for. Shareholders panicked when they learned that they could be liable for stocks par value which was substantially more than the price of the stock which was not only what they paid for the stock but up to four-times what it was then priced at.

Luckily, American Express survived by tanking the subsidiary and having a team of very creative lawyers invent some new laws, but until the matter was negotiated out, it was touch and go for one of Americas premier, blue chip companies. On the other hand, at least two major brokerage firms bit the dust, one of them, J.R. Willliston Beane who had as its name partner, the one and only Beane that originally adorned the masthead at Merrill Lynch. Thinking he could do better with his own firm than he could at Merrill he pulled up stakes and lit down at Williston, just in time to be clobbered with the Salad Oil Disaster created by the elderly, Tino DiAngeles who according to the Wall Street Journal had created was called by the Wall Street Journal, one of the “all-time financial crimes.”

DeAngeles had created a unique commodity through criminal brilliance. He conceivably could not have been caught for decades. American Express had bet their company’s existence on a grizzly trader who in many ways was smarter than they were. The regulators were once again sleeping at the switch while DeAngeles was fleecing the market and came close to breaking American Express and bankrupting his fellow commodity traders on the New York Mercantile Exchange. However, Williston Bean and Ira Haupt never were heard of again.

Countrywide will see you through your ordeal

Moreover, with Countrywide having proven themselves as a tad light on management skills, introspective thinking, heavy on marketing and short on controls; why then would Bank of America agree to throw perfectly good money after bad by acquiring this permanent anchor on their management and earnings. We do not believe that this inconceivably dyslectic choice was brought on by any investment opportunity as the Bank claims but was clearly created due to the fact that the Bank could not afford, from a regulatory point of view to write down the investment they had already thrown in to this disaster. When the smoke fully clears there will be little question that Countrywide was worth less than nothing and will cause Bank of America to operate while simultaneously carrying a lead weight around their necks in order to work their way out of this mess. Do they take investors for fools? The arrogance of these folks is beyond comprehension. At best, B of A’s lawyers will be working around the clock to deal with the law suits for the next twenty years.

Moreover, if this is so clear to someone that really doesn’t have an axe to grind, where are the regulators who have staffs of investigators, lawyers, forensic accountants and research capabilities that are handsomely paid for with taxpayer’s dollars? The statements that Countrywide was issuing were plainly substantially misleading at best. They should have found a way to limp through this economic anomaly without taking on some of the most onerous baggage in financial history. Better to walk away wounded then not to be able to walk away at all. The decision made at the upper levels of many in the industry could well lead to time behind bars for those that were fundamentally attempting to deceive the public.

One stingingly clear and publically available example of the audacious manner in which Countrywide ran its business came out in a bankruptcy petition filed by the U.S. Bankruptcy Court for the Northern District of Georgia, A quote from court documents revealed the following: “Countrywide’s failure to ensure the accuracy of its claims and pleading has resulted in an abuse of the bankruptcy process.” Moreover Donald F. Walton is seeking sanctions against Countrywide for its inconceivably appalling behavior in any number of instances. The way I read this and I am indeed an amateur tells me that Countrywide was lying in court and did that and a sundry list of other evil things on a recurring basis.

Walton, went on to say, that he would like the courts to enjoin Countrywide for its “sustained bad faith conduct” in the treatment of distressed consumers trying to salvage their homes in bankruptcy court. There doesn’t seem to be a lot of constructive public relations value or a possibility of Bank of America to attract a lot of potentially happy new customers from this disaster. We would predict that the deal will ultimately tank and that Bank of America will wind up suing Countrywide for fraud, failure to disclose and other unseeingly acts. The write down on this ghastly transaction could possibly additionally cost Bank of America their charter. We are talking about seriously bad people here. However, Bank of America states that the transaction will not close until the third quarter of 2008. By that time, unless Bank of America wants to be in the same shape that Countrywide is in, there is little question that bankruptcy is the only way out of this mess.

But that isn’t all, in a most unusual action the Trustee in Bankruptcy who had previously had numerous problems with Countrywide in Florida, Pennsylvania and Texas has recently stated that in recent years, “Countrywide and its representatives have been sanctioned for filing inaccurate pleadings and other similar abuses within the bankruptcy system. Furthermore, Country wide “By accepting the plan payments to which it knew it was not entitled, and failing to promptly return such payments, Countrywide has acted in bad faith in the conduct of litigation before the court and have not been adequately sanctioned. ” Lawyers that ply the bankruptcy industry believe that this is just a preamble to seeking a national remedy against Countrywide, and Bank of American could go down if they don’t pull the plug on this transaction. The problems that seem to be clearly visible would be bankruptcy fraud, perjury and theft added to all the other grandiose problems Countrywide management has created for itself.

In a letter to Bank of America chief honcho Kenneth Lewis, Senator Schumer stated that Mr. Sambol (head of Countrywide) “was integral in Countrywide’s decisions to pursue potentially predatory lending practices and lax underwriting of risky loan products resulting in foreclosures and hurting the housing market.” Can you imagine the litigation expense that the Bank will have to buy into along with the time and effort of salvaging this hopeless mess? Your first write-off is your best and when you don’t know the territory, it is not good to hunting for elephants with a pop gun. I guess it’s not good to hunt elephants with a pop gun even if you know the territory.

Having said that, no more than two months after Bank of America had bitten hard on the Countrywide bullet and bought them out at a price that was only 20% of its book value previous year’s book value[14]; Countrywide set up a ski trip at the $750 a day Ritz-Carlton Bachelor Gulch ski resort in Avon, Colorado. The guests were brokers for the correspondent mortgage banks that sell home loans to Countrywide. “The event which was to include skiing, cocktail and dinners at swank restaurants, including Spago whose menu include Kobe steak with wasabi potato puree for $105.00.”[15]

Moreover, Angelo Mozilo was invited to the House Oversight and Government Reform Committee hearing and discussed compensation packages of senior executives involved in the subprime mess. While in essence, entertaining happens in every business, Kobe Steak isn’t always on the menu, the same day you are testifying in front of Congress. Kind of like sticking it in someone’s face, but it sure looks like Mozilo may have taken Bank of America to the cleaners as well. By the way, if you haven’t noticed, Countrywide has also laid off 19% of their employees representing almost 20% of their workforce while simultaneously having 90,000 loans in foreclosure. Not a pretty picture.

No one ever sad that this was a town for old men

However, as the movie said, this isn’t a game for old men. Both the Securities and Exchange Commission and Federal Prosecutors are looking into the value at which Merrill Lynch, UBS Ag and Bear Stearns were carrying their portfolio of mortgage backed securities. The two funds at Bear Stearns along with the Merrill and UBS all had extraordinary write-offs which certainly did not occur in the dead of night. When the smoke clears it should become apparent the required focus reports that were filed with the NASD, reporting capital ratios were not exactly in compliance to say the least. Interestingly enough, if something like this happened at a smaller firm than these; the principals would probably have gotten a job breaking up rocks for the next 20 years, the firms themselves would be out of business, the shareholders would have lost their investment and principals would probably be banned from the industry for life.

Merrill left a permanent stink on Wall Street due to their conspiring with Enron essentially defraud shareholders that one only can see a little of history repeating itself. We believe that when the going gets tough, true colors of an investment bank finally become transparent. Merrill should be ashamed of its actions but that won’t be much solace to those they have destroyed.

Wall Street has been getting away with this sort of stuff for years and it is only the critical fact that the investment banking industry pays substantial portions of the tax bill of the City, Country and State of New York along with that of the United States of America that this sort of behavior is not criminalized. Wall Street donations fund massive political campaigns while the chiefs of major Investment Banking firms often achieve cabinet status for their efforts including the current Secretary of United States the Treasury. The legislators are certainly aware of what is occurring and for the most part they have universally turned a blind eye when one of the big guys gets his hands caught in the till. The House has had ongoing investigation of baseball players who may have used a substance that could have done them harm, but was not illegal. However, having nowhere else to go, they will burn taxpayer’s dollars on perjury charges while the economy is going up in flames. I couple of fairly substantial jail sentences would probably restore morality back into the system. Remember, morality requires a social sensitivity and is learned behavior, not part of the human makeup.

It is beyond any reasonable comprehension that the SEC was unaware if the shenanigans taking place on Wall Street but assiduously turned a blind eye to the facts because it was creating liquidity. These folks were apparently unaware that too much liquidity flowing through a system can cause mental lapses, criminal behavior and tends to be obsessive. However, Wall Street fines have become a big portion of the Securities and Exchange Commission’s gross revenues and without them; Congress would have to find another way to compensate the regulators. However, we have a non-invasive way of correcting this problem: the first time an investment bank is found guilty of not acting in the best interests of the investors to pay X amount of dollars in fines but starting at a reasonably high plateau. The next time they are found guilty, make the fine 10X and so on; we understand that these folks are too big to fail and would affect our overall economy if they were put out of business. Deal with it in a way Wall Street will understand, fine them geometrically increasing sums until they learn that the shareholders interests are sacrosanct and that they have an obligation to investors ahead of any private interests. Enough of this tip toeing around what is really the issue?

When does a privatization become a private company?

It is rather interesting that this isn’t the only area where the Federal Government plays fast and loose with their own regulations. Take for example the case of Freddie Mac, Fannie Mae and Sallie Mae. These were originally government agencies that were mandated by the Government to responsible for keeping the mortgage and college loan businesses liquid. While Sallie Mae may be a slight exception to the following, we will deal with those issues shortly.

These folks were empowered by the Government to buy loans from brokers, thus pumping money back into the system to allow our well-oiled economic engine to continue to function efficiently. Eventually, the U.S. Government saw an opportunity of cutting these agencies loose and privatized them. For whatever reason they had, these companies soon became public and had shareholders. For some period of time, the shares performed well. The companies had a great deal; they had the U.S. Treasury as their piggy bank and we able to deal in leverage that was not available to competitors. They could also spread the wealth to their favorite loan providers.

However, this lasted only until it was discovered that for some unknown reason that the executives of Fannie Mae were managing their earnings and filing totally fictitious accounting documentation. When the smoke had cleared, the loss required a staggering readjustment of over $6 billion. New management was installed but when the subprime mortgage disaster hit, Freddie and Fannie were the only ones that had access to literally unlimited funds to pump into the system. However, in an era of rapidly failing real estate prices, was this an intelligent type exercise to perform on behalf of the public shareholders? It would seem logical to assume that a home buyer that puts up a 30% down payment is a pretty good credit risk, all other nuances aside. However, should the house decline in value by 40% which has happened in numerous localities throughout the country, we would find that our excellent credit risk might now possibly have turned into a deadbeat?

Today’s hero is often tomorrow’s villain or vice versa. This country has not been faced with falling home prices since 1930 and is hardly equipped to deal with something of this nature with no one in government having any prior experience in this distortion. All of our mortgage lending has become literally a bet against falling prices and the U.S. Government with their printing presses have been able to keep inflation at a high enough level to create bracket creep (keeping tax brackets unchanged while wages go up moving folks from one bracket to another when more taxes are needed) which also has the affect of increased taxation according to Government needs. Thus, there has never really been a time when homes have particularly dropped in value other than for a short time during the Carter years when this Georgia amateur show brought inflation and interest rates to peak never touched again either before or afterward in the 20^th century. Even in spite the economic machinations that Carter’s people foisted upon us, housing prices stayed relatively strong throughout the years. However, our lending practices in this country became skewed early in the 21^st century when mortgage brokers and investment bankers determined that home loans should be based on a perfect world perception of continually increasing land and home values. This is hardly a model to write home about. If you are going to create an imaginary scenario, it would have seemed logical to create an imaginary solution as well. Thus, like the dikes breaking in Louisiana, at least we would know what to do and who to best put the problem behind us.

Instead of the government letting management of Freddie Mac and Fannie Mae make a logical decision as to the right direction to go, the sequence of events seemed to be as follows, Fannie Mae came out with an awful earnings report for the year 2007 and especially for the year’s last quarter. The Government then applied new rules restricting their ability to buy mortgages because they had lost faith in their decision making result. This was followed by the subprime bubble bursting and in short order, the government unilaterally rescinded their rescission of any restriction on Fannie Mae. You could say in contradiction to this scenario that, “well that occurred over a substantial period of time and times create necessities that can’t always be foreseen”.

Wrong Bunkie! This whole affair took place in a period of a month.

However, that is not really the issue in question. Obviously, the management of all the privatized government agencies requires a lot of readjusting but in these cases the higher ranking jobs have very little relationship with that person’s ability to run anything. The real question would seem to be, who indeed is pulling the strings? If the company at the request of the government made a decision that was possibly the right choice for government but the wrong choice for the private sector, what is the obligation of the company’s management to good management and the shareholders? How are they indemnified against not dealing in the best interests of the shareholders? Will they get a pardon when the President leaves office and what if they haven’t been indicted by that time but are held to task by another administration? Why, if there is not a get out of jail free card available, would anyone want a job that can have a built in grand jury summons as its ultimate conclusion? There must be more to this than meets the eye, but it is not apparent. It would seem to me that in order to take one of those jobs I would want a massive D&O policy, comprehensive E&O, a gigantic salary, a get out of jail card, an offshore bank account and a one way ticket for myself and my family to an unknown destination.

There is a pretty wide gulf between perception and reality especially when the government enters into the picture. The government constantly makes the mistake of nominating political hacks that are owed favors to rune newly privatized companies. This makes about as much sense as asking a blind man to tell us what an elephant looks like from his sense of feel. Think about the standard unqualified political hack running a multibillion dollar publically owned corporation. These bureaucrats folks that have worked in the backrooms of political intrigue for all of their lives are now being asked to become transparent, a concept nearly beyond comprehension. This reminds us a story of how public perception can differ with reality.

A Different View of the Moon

Newspapers around the world are constantly trying to scoop one another, with the big enchilada being the first to expose a great story. Many papers have found that the preeminent way to increase their circulation was to create a total hoax that could grab the public’s imagination and then play it as though we are dealing with an unending old fashioned serial such as the “Perils of Pauline” who was last seen tied to a railroad track with the train’s engine pulling twelve cars at ninety miles an hour literally yards away. There was clearly no hope for Pauline but if you tuned in the following week, someone natural event had occurred to save her lunch.

In those days this ploy would work because news traveled slowly, science was not where it is today and lawsuits have made this sort of reporting rather dangerous. However, then is then and now is now; and then readership was survival and people thought that whatever appeared in the press was the word of God. Indeed a much simpler time.

Such was the well-planned connivance of the New York Sun in 1835. There were a number of critical elements to a totally fabricated story, the first was that it had to have real people that could be checked out. Second, it had take place where the activity involved would jib with the fabrication, third it had to be far away so that it would take a long time for the truth to be really known which in those days was not very difficult. Two parts of this story were true and that is what made this hoax both so elegant and so elusive check out.

The first element pertained to British Astronomer, Sir John Herschel who had received knighthood due to his startling and factual discoveries. The other ingeniously devised contrivance was by utilizing the credibility of the fabled Edinburgh Journal of Science, for confirming stories relative to a masterful hoax. This part was a so ingenious that only a mad scientist working within a medieval conjuring lab could have even began to think it up. The fact is that Edinburgh Journal of Science and quietly gone bankrupt and ceased publication without any fanfare or announcement.

Moreover, the New York Sun spiked the news story with a startling number of actual facts making it all the harder to refute. The ploy went something like this. On a story in the second page of the Sun on the August 25, 1835, it stated: “We have just learnt from an eminent publisher in this city that Sir John Herschel at the Cape of Good Hope, has made some astronomical discoveries of the most wonderful description, by means of an immense telescope of entirely new principle.” While the article was untrue, it was a fact that Herschel did go to South Africa a year earlier and had set up a sophisticated solar observatory in Cape Town.

There was not a lot of interest in the fact that Herschel had been looking at the stars in Cape Town which could certainly differ with the sky that would be viewable from New York City. This rather neutral news story was not intended to receive any controversy and as planned, it did not raise controversy or sell any newspapers. However, the next issue hit readers like an atomic bomb; it contained a description of what Herschel had seen through this new and powerful telescope while looking at the moon, which included a description of animals, vegetation and furry men with wings:

“We counted three parties of these creatures, of twelve, nine and fifteen in each, walking erect towards a small wood…Certainly they were like human beings, for their wings had now disappeared and their attitude in walking was both erect and dignified… About half of the first party had passed beyond our canvas; but of all the others, we had perfectly distinct and deliberate view. The average four feet in height, were covered, except on the face, with short and glossy copper-colored hair, and had wings composed of a thin membrane, without hair, lying snugly upon their backs from the top of the shoulders to the calves of their legs.

The face, which was of a yellowish color, was an improvement upon that of the large orangutan…so much so that but for their long wings they would look as well on a parade ground as some of the old cockney militia. The hair of the head was a darker color than that of the body, closely curled but apparently not woolly and arranged in two circles over the temples of the forehead. Their feet could only be seen as they were alternately lifted in walking; but from what we could see of them in so transient a view, they appeared thin and very protuberant at the heel… We could perceive that their wings possessed great expansion and were similar in structure of those of the bat, being a semitransparent membrane expanded in curvilinear divisions by means of straight radii, united at the back by dorsal integuments. But what astonished us most was the circumstance of this membrane being continued from the shoulders of the legs, united all the way down, though gradually decreasing in width. The wings seemed completely under the command of volition, for those of the creatures whom we saw bathing in the water spread them instantly to their full width, waved them as ducks do theirs to shake off the water, and then as instantly closed them in a compact form.”

Naturally, this story created an upheaval. Its publisher, Benjamin Day, had achieved what he was after, massively increased circulation and the New York Sun indeed became the most circulated newspaper in the world, a spot it held long after interest in this hoax had waned. Later issues elucidated on the original fairy tale and talked of sumptuous temples constructed with precious stones, marble pillars and fantastic forests. The public was breathless over the story when Day figured he had accomplished his goal and it was now best to lay it to rest. Somehow the newspaper had to find a way for Herschel’s experiment abruptly to come to an end. This was worked out when one of the reporters involved in the creation of this fraud wrote about the fact that because the giant telescope had been mistakenly faced in the wrong direction, the sun’s rays had entered its frame through the highly magnifying glass at its protuberance. This of course set off a massive explosion that destroyed the entire observation facility. However, the New York Sun indicated that luckily no one was killed in the massive explosion. Sadly this scientist that had created this highly intricate device had died of natural causes without sharing the nuances of the telescope with anyone; a fitting ending for an imaginary story.

In the meantime, the Sun was eating its competitors alive. All of the journals and newspapers were clamoring for the story. Many of the other newspapers, when the Sun wouldn’t give them editorial rights just plagiarized the stories from the Sun’s accounts. Scientists were anywhere and everywhere trying to get addition confirmation of the events described while numerous missionary societies organized conversion parties to land on the moon and redeem these obviously intelligent bat-like creatures. On September 16, 1835, almost three weeks to the day after the fraud had begun; Day admitted in a cute little article that the whole thing had been fabricated. Imagine the egg on the faces of competing journalists, who in their frenzied efforts to compete had copied the Sun’s story verbatim. When the affair had ended and the competition found out that they had been hosed to the maximum, the affair became even an unbelievable embarrassment to them. The public took the New York Sun’s apology for spoofing them in nice way but condemned their completion for plagiarism and unprofessional reporting. The New York Sun remained on top of the heap because of this experience for years to come.

Wall Street has been known to weave a legend around a type of security or a potential trend a make customers believe that if they don’t get in on the gravy train, now they will be just plain out of luck. We saw that herd instinct with the story weaving that went on with National Student Marketing, but Cort was an amateur when compared with the hero of our next tale.

ZZZZ Best Plan For Cleaning Up In The World

Barry J. Minkow’s mother was a telephone solicitor for a cleaning company and that was how, at twelve years old he started learning about the restoration business. While not yet in his twenties, he sensed an opportunity to become wealthy from that business and became what is known as a rug sucker, someone that goes into, usually a home, makes a lowball estimate on a cleaning job, takes the rug upon striking a deal and when the price is jacked up later the customer either has to pay or is out one rug. The lad was already involved in all the niceties of life, check kiting, forgery and theft from insurance companies by making phony claims. This was a dangerous way for a kid to be making a living and Barry believed that there had to be a something better.

Barry gravitated to a derivative of that business. By specializing in rug cleaning and insurance restoration (after fire or flooding had substantially damaged substantial portions of a building), he would be satisfying a more lucrative niche. He needed credibility, someone of standing that would vouch for his business acumen and success. He found the sucker he was looking for at his Los Angeles health club; his name was Tom Padgett an insurance claims adjuster who Minkow agreed to put on his payroll at $100 per week if he would confirm that ZZZZ Best was legit.

While still in high school, his vision flourished. Minkow already had hundreds of employees within a company with over $5 million in gross revenues. Minkow had named the company ZZZZ Best and he was the youngest chief executive officer of a major company in the United States, and soon had a luxurious home in a Los Angeles Suburb and naturally, a shiny new red Ferrari. Already on a roll and with the motto, “The sky is the limit”, Minkow became a much in demand regular on the nation’s talk show circuit where he chided people to try and accomplish more. Little did they know how he had achieved his success?

Minkow’s next move was to take the company public but he had to establish credibility in stages. Although he did not think of it at the time, Minkow was making himself subject to the security laws of the United States Government and soon things started to become more complex. According to the rules he needed an independent auditor to audit his books and hired an accountant by the name of George Greenspan to do the work.

When Greenspan naively called Padget to confirm that ZZZZ Best indeed had restoration contracts the circle imaginatively been closed. Now the kid had a set of books that would stand up to a degree of scrutiny, but he needed somebody eventually he came to believe that he needed some more prestigious than George Greenspan if he was really going to make a major score. With that in mind hired the prestigious New York Law Firm of Hughes, Hubbard and Reed and dumped Greenspan for the Big Eight accounting firm of Ernst and Whiney to give his young company the additional cache that he believed, white shoe, top drawer professionals on your payroll has a tendency to do.

ZZZZ Best’s offering memorandum indicated that in 1986, he already had almost $25 million in "insurance restoration" business on the books scheduled for early completion, from thirteen projections ranging from hundreds of thousands of dollars to over $7 million. Minkow offered the public $13 million worth of stock, which was sold as a unit containing three shares of common stock and a warrant to buy and additional share. The offering went public at $12 bucks, which valued each of the shares at a tad less than four dollars if you assume the warrant had some nominal value.

By 1987, the company’s earnings from these projects were estimated by internal ZZZZ Best auditors at $40 million, and Minkow was being favorably compared to Watson (IBM) and Land (Polaroid) in terms of business acumen. His company became known as the General Motors of the cleaning business. As his success seemed to continue unabated, Wall Street embraced Minkow. The price of ZZZZ Best stock soared, increasing Minkow’s net worth at one point to over $100 million.

The problem with this story is that although Minkow was only real in his own small way, his company was almost a total fabrication. The preliminary prospectus that he issued made the claim that: "The Company began its significant insurance restoration business in April 1985 and since then has performed restoration service for buildings ranging in size from 100,000 to 750,000 square feet. Restoration contracts, all of which are performed on a fixed price basis, have ranged from approximately $150,000 to $7,000,000. The Company has restored buildings located throughout California and in Arizona, with the majority being in Southern California. As of September 30, 1986, there were 13 insurance restoration projects in progress, under contracts aggregating $24,362,000 (including seven aggregating $15,068,000 through joint ventures), all of which are scheduled for completion within six months."

This totally illusionary restoration business played great on Wall Street and investors loved the concept. There was not one iota of evidence that anything the Minkow had said was true, but people wanted badly to believe. He had been able to convince both his lawyers and his accountants that a thriving business existed when in reality; it was totally a figment of Minkow’s fertile imagination. Statements of Wall Street brokerage houses like Ladenburg, Thalmann & Company were repeated everywhere; "ZZZZ Best meets the criteria of a company that has the same potentially explosive sales and earning characteristics and market opportunities that permitted McDonald's and 7-11 to reach the success each has achieved--sales of over $1 billion in a relatively short time from inception." He was given their highest honor by the prestigious association of Collegiate Entrepreneurs calling him one of the leading young business founders in the United States.

Eventually, his fraud cost the public over $70 million and Minkow was sentenced to 25 years in jail and fined $26 million. When accountants (at the time a big eight firm) Ernst & Whinney required on-site investigations of the restorations in progress, Minkow arranged for them to inspect buildings that had zilch to do with ZZZZ Best. He would bribe workers on the premises to go along with his fabrications or in the alternative; he would rent empty buildings and create literally a “Hollywood set” of restoration work in process.

On one occasion, he was told by the attorneys and accountants that they would be examining a work in process at a restoration site in Sacramento. Not having any restoration sites available because they didn't exist, it was no big deal for him to rent an old building for the day and bring in a number of people to act as though they were doing some work. He dressed them up in cute little ZZZZ Best uniforms and the scam went so well that a totally naïve Larry Gray, a senior auditor with Ernst & Whinney gave the following report:

"We were informed that the damage occurred from the water storage on the roof of the building. The storage was for the sprinkler systems, but the water somehow was released in total, causing construction damage to floors 18 and 17, primarily in bathrooms which were directly under the water holding tower; then the water spread out and flooded floors 16 down through about 5 or 6, where it started to spread out even further and be held in pools."

"We toured floor 17 briefly (is currently occupied by a law firm), then visited floor 12 (which had a considerable amount of unoccupied space) and floor 7. Morze pointed out to us the carpet, painting and cleanup work, which had been ZZZZ Best's responsibility. We noted some work not done in some other areas (an in unoccupied tenant space). But per Mark, this was not ZZZZ Best's responsibility; rather it was work being undertaken by tenants for their own purposes"

"ZZZZ Best's work is substantially complete and has passed final inspection."

Compare the pathetic report by Gray who had examined a building that had literally nothing to do with ZZZZ Best. Then looked he observed work that ZZZZ Best had nothing to do with and wrote a glowing report on a building that was hired for the day; with the report given in Congress by Mike Brambles a detective with the organized-crime intelligence division of Los Angeles Police Department on the same building. He is being interrogated by Representative Ron Wyden who is a member of a subcommittee investigating the affair:

Wyden: Did the building ever have any damage, or could they found that out?

Brambles: The building did not sustain any fire or waste damage. We ascertained that by checking with the building department of Sacramento in determining that in the previous two to three years there had been a very minor amount of construction work, that being only cosmetic in appearance and not involving fire and water restoration work.

Wyden: How long did it take your people to find out about the condition of the building?

Brambels: Approximately ten minutes at the building department and then roughly one or two hours at the restoration site.

In some instances, Minkow and his associates even gave the addresses of empty lots to Ernst and Whinney, believing that based on recent history they would not show up. Luckily for Minkow they didn’t.

Outsiders were soon tipping Ernst & Whinney and local newspapers that ZZZZ Best was a fraud. However, with the first commandment of accounting being "hear no evil, see no evil, speak no evil," they did nothing about it. Even worse, one Norman Rothberg told Ernst and Whinney in no uncertain terms that the ZZZZ Best Sacramento restoration site was a total fraud. Shortly thereafter, Rothberg had been properly paid off by Minkow to the tune of $25,000, he recanted his story. This incident did not cause Ernst & Whinney to blink an eye.

Ultimately, the evidence could no long be denied and even the accountants finally saw a massive fraud looming. Ernst realized that it had been taken and resigned. Congress put Ernst and Whinney's Gray on the grill and Representative Lent had an interesting experience in interviewing him.

Lent: It came to your attention that Rothberg was talking about a certain company, namely ZZZZ Best.

Gray Yes, sir. Yes, sir.

Lent: He was talking about fraud at ZZZZ Best and he mentioned that the Sacramento job was a phony job?

Gray: That is correct. We heard that on May 19.

Lent: You had been out there and you had walked that job, had you not?

Gray: That is correct, sir.

Lent: So you must have wondered whether you had been taken for a ride, whether you had been deceived, and it is logical to assume that you might have gone back there and looked at it over again, or made some further inquiry of the building department, the property owner, the contract, or other contractors, et cetera? You did none of those things?

Gray: No, sir.

In easily the most bizarre event in the annals of accounting, when Whinney resigned, Minkow replaced them with prestigious Price Waterhouse, which, contrary to every accounting tenet, made no concerted effort to determine the reasons for their predecessor’s resignation. ZZZZ Best indicated that the auditors found no fault with the company's securities filings. Ernst and Whinney added insult to injury by failing to disclose their reasons for resigning.

Worse still, once they were hired, Ernst & Whinney signed non-disclosure agreements that would have prevented any successor accounting firm or anybody else, for that matter, from finding out the location of ZZZ Best projects that they had visited. Moreover, they gave written promises not to "… make any follow-up visits to the Project…."

"We will not disclose the location of, or any other information with respect to, the Project or the Warehouse, to any third parties or to any other members or employees of our firm; We will not make any follow-up telephone calls to any contractors insurance companies, the owner of the Project or of the Warehouse, or other individuals involved in the restoration projection;

We will not make any follow-up visits to the Project or the Warehouse, unless specifically authorized by the Company and Interstate Appraisal Services ("Interstate") [company set up to appraise ZZZZ Best renovation projects]."

The confidentiality letter raised more questions than it answered. One would wonder how you could check out whether something is real or not if you could only visit the site with the permission of your client. An independent accountant cannot do his job and keep the public faith at the same time. If no follow up calls can be made to contractors, insurance companies, the owner of the Project or the Warehouse unless authorized by ZZZZ Best, the practice of accounting is laughable.

Another dialog between Congressman Wyden and Mr. Gray of Ernst and Whinney, which should have embarrassed the accounting firm so badly that Ernst, should have closed their doors on the spot:

`Wyden: "We go back to these confidentiality letters. They were signed by you personally, Mr. Gray, and they were signed also on behalf of Ernst and Whinney regarding the visits to phony insurance restoration jobs, one in Sacramento and San Diego. You mention personally in these letters on behalf of the firm that you won't disclose the location of the job sites to any third parties including other members and employees of the firm. You go on to proposals that you won't make any follow-up phone calls to any contractors, insurance companies, building owners, or other individuals involved in restoration projects. "

"I guess what raised my curiosity about these confidentiality letters is that I wonder how, after you signed them, you could then go out and independently verify material information given to you by ZZZZ Best management".

Gray: "The signing of the letters does nothing to restrict what I wanted to perform. We--in fact it was done at the client's request. We get requests from our clients many times to confirm our confidentiality relationship. As I stated earlier, we have the overriding responsibility to keep our clients' information confidential. So them asking me to do this, my purpose was to go on the site and see the work done. It did not restrict me being able to perform that and I did go on site to see the work done, and Congressman, if I would have had any questions that came up in the course of that review, I would have pursued those questions and gotten answers to satisfy myself, or I would have quit".

It is most interesting to listen to this total bilge coming out of Gray's mouth. We are not talking about trade secrets or a list of confidential customers, we are talking about imaginary insurance restoration projects that in their magical state have been for the most part completed. What were the odds of another restoration job occurring on the exact spot of the previous one? In addition, there is only a one out a million chances that the place flooded again; do you think for one minute that ZZZZ Best would stand a chance of getting the work after screwing things up the first time? At that point, the odds would stand directly at zero. Gray must have held a very low opinion of the intelligence of the Congressional investigators.

Wyden brought in Brambles once again to refute Gray's fabrications.

Wyden: "I just want to pin down that in San Diego, as at Sacramento, we had a situation where the building really didn't have any damage, and it wouldn't have been hard, as you said your own people could do, to determine that, is that correct?"

Brambles: "Yes sir, what we did was, we went again to the building department of San Diego and checked their construction permits on file. What our investigation determined was basically that the application for cosmetic construction had been applied for and granted by the city of San Diego. Their permit was paid for, but it was never inspected by the building inspectors, it was never finalized. That took us approximately ten minutes to do that. We also checked to determine whether or not the building had received damage in the area of fire and water, and that turned up negative results as well."

Wyden: "…what you have told us is that essentially in just a few minutes your own people could determine the job was a fake. But somehow the auditors didn't discover it, and it seems amazing…"

In Dallas, ZZZZ Best and Minkow’s merry man did an even better job of confusing the auditors. They told the accountants they were getting a lot of business in Texas and needed a warehouse in Dallas. When ZZZZ Best advised them that the warehouse was open, the auditors expressed an earnest desire to check it out. In typical fashion, the company rented an empty building for the day and then shipped a bunch of recently designed ZZZZ Best uniforms and other items with which to stock the warehouse. A telephone switchboard was installed, and when the people from the accounting firm were brought in to visit, everyone tried to look busy. Vehicles were in motion, products were being moved, trucks arrived and departed and the switchboard lit up like a Christmas Almost all of the calls were meant to be from potential customers inquires from companies in the area wanting to use the services of ZZZZ Best for their insurance restoration work.

The scene had all of the earmarks of Class B Hollywood movie. Embarrassingly, Larry Gray was once again the fall guy for this cheap stunt and as usual, he fell for it hook, line and sinker. He even reported back to Ernst and Whinney the warehouse would have to be expanded due to the increased business.

Although it was hardly possible, Gray had pulled the wool over his own eyes even further when ZZZZ Best gave him the unconscionable story that he could have the address where work was currently being conducted on a restoration, but they indicated that he couldn't visit it because it was a hardhat area. You would think that these guys were working with atomic bombs, not with paint, brushes and brooms, in reality; the address was that of an empty lot that ZZZZ Best had once again rented for the day. Gray, who had screwed up every other portion of his due diligence campaign, once again fell for the ZZZZ Best "Red Herring".

Gray was so incompetent in his investigation of ZZZZ Best that he should have been arrested for criminal stupidity. Not only did he set the all time record for negligence but, in addition, everything that occurred was theoretically a red flag that should have caused him realize that additional checking of the client should be in order.

I mean, a hardhat area in the rug cleaning business. We believe that Gray deserves the "Millennium Incompetence Award". This, too, is a great honor, as it is only given once every hundred years. There have been centuries where there has not been anything done that was stupid enough to qualify for the prize and the committee chose not to nominate anyone. Gray's incompetence was not even open to question and we are proud of the fact that he was the first candidate since Pontius Pilot to win a unanimous election.

This puts Gray in the same league as previous winners. You are all aware of their names; they are legion, but for posterity's sake we will remind you of some of the recent winners. The most recent was the U.S. Senator who, in the later part of the 19^th century, wanted to close the patent office because in his opinion it had become a white elephant due to the fact that everything that had ever or would ever be invented had already been patented. He simply felt that there was nothing left to invent. Marie Antoinette won the award in the previous century for her famous slogan, "let them eat cake". This was done when a starving population was begging for food because they had not had a square meal in months. This award had been given because it shows how close Marie was to her subjects and what a caring person she really was. The previous award was a one-time situation and uniquely, we gave a global award for those that wanted to burn Copernicus at the stake for his concentric theory of the universe. Although Gray has never achieved the notoriety that his predecessors received, we feel certain that time will reward Gray with fame as word of his complete accounting incompetence spreads.

ZZZZ Best did not go quietly. Many Congressional investigations were launched into the question of how this fairytale could have been constructed by an illiterate prepubescent, teenager. Moreover, the even more burning issue was how this juvenile delinquent could foil the due diligence process of the regulators, the accountants, the lawyers and the stock brokerage community? The verdict seemed to be that without the incomprehensible ineptness of the accounting firm (Ernst and Whinney), the fraud couldn’t have gotten off the ground and that Ernst & Whinney had failed in their role of independent outside accountant and their successor, Price Waterhouse compounded the worst job of accounting since the dawn of time.

John Dingell, who headed a House committee charged with looking into this type of fraud, literally couldn't believe his ears when the people from Ernst and Whinney started to testify. He already knew that someone had blown the whistle on ZZZZ Best by informing the accountants that the company was riddled with fraud. The newspapers had taken up the cudgel and the company was springing leaks all over the place. Dingell was trying to get a handle on whether the outside auditor, Ernst & Whinney, was representing the interests of the company or those of the public. He was interviewing Larry Gray who we have seen in action previously and Leroy Gardner, another principal of Ernst & Whinney, and seemed to get a lot more than he bargained for. You can see how the scenario unfolds;

Dingell: What happened to the stock during this period between June 2 and the date of bankruptcy on July 11? Did it go up or down?

Gardner: I didn't follow the stock.

Gray: It declined with the adverse publicity that was coming out.

Dingell: As a matter of fact, it lost about fifty percent of its value?

Gray: That may be the figure. I cannot recite the figures.

Dingell: The price per share on June 2, when you resigned, was around six or seven dollars. When the bankruptcy took place, which our colleague indicates was July 11, the stock fell to less than one dollar, something on the order of fifty to seventy-five cents; is that right?

Gray: I assume.

Dingell: I am wondering, it there some responsibility on the part of Ernst & Whinney to shareholders and other investors in this firm, or do you just have a peculiar special relationship with the firm?

Gardner: No, no. Our responsibility is to the public, to the investors.

Dingell: To the public and to the investors. How did you exercise that here? You initiated no contact with the SEC until July 16.

Gardner: No, no.

Dingell: Your contacts with the SEC on the seventeenth and nineteenth were initiated by the SEC. You did not initiate that contact…

Gardner: I am sorry.

Dingell: The SEC initiated the contact with you on the seventeenth to the nineteenth. You were sitting tranquilly by, informing your former client, during that period of time?

Gardner: That is not correct, sir.

Dingell: Your first communication to the SEC was on July 18?

Gardner: After we talked with the SEC in early July, there was no point ---

Dingell: They initiated that discussion; you did not?

Gardiner: That is correct. We knew at that point what they knew.

Dingell: Happily they called you up. But your first communication to the SEC was on the sixteenth. If the SEC hadn't called you on the seventeenth or nineteenth, would you have called the SEC?

Gardner: Well, the fact is they did call us and they already knew the allegation.

Dingell: I know they called you. We are in agreement on that. That point is not in controversy. If they, however, had not called you on the seventeenth or nineteenth, would you have called them?

Gardner: I can’t speculate about that.

As we can see from the above, one way that independent auditors can screw up is by not specifically identifying all of the assets that are referred to in the company’s financial data, thus it is as if the asset supplying the income does not exist, the income cannot exist either. Failing to consider all of the diverse sources of revenue and adapting accounting procedures to pasteurize the data so that it remains in balance becomes a product of consistent practice. However, unreasonably changing the form of the data also distorts the ultimate product by putting it into a form that is not realistically consistent with the general business of the account being audited. This lack of consistent product tends to distort the facts.

What was particularly grating in this case was the total indifference of the accounting firm to the public interest.

Once again, Congressman Dingell gets the last word with the accountants and our kudos as well:

"…we keep seeing this tremendous number of cases where supposedly men of goodwill are diligently watching and doing their job, but the public is being skinned, corporations are going under, rascals are prospering, honest men are suffering and the situation seems to be not improved…We have this wonderful relationship that seems to exist between the accountants and the corporations."

Within a short time, ZZZZ Best was hit with shareholders derivative actions, which named the accountants, the lawyers, the brokers and the company. Everyone coughed up a chunk of money to make a non-public settlement, which totaled approximately $35 million.

The company was a sham and an interesting observation showed that while the company had a market capitalization of $220 million in July of 1987, an auction of its assets brought only $62,000. As for Minkow, he was convicted on 57 counts of securities fraud and received a twenty-five year prison sentence for his trouble. While in prison, Minkow through a correspondence course received a bachelor’s and master’s degree in religion from the university founded by Jerry Farwell. He was released for good behavior and soon married a young lady that he met through an associate of Charles Keating who was doing time for his part in the Lincoln Savings debacle. Minkow now give lectures on Religious Based Social Integrity, he helps the FBI deal with criminals and advises CPAs on how to ferret out financial fraud.

In his lectures he makes an interesting point. “The average restoration job is $1,000 with a profit margin of 8 or 9 percent. “We were reporting an average job of $3 million with margins of 30 to 40 percent…and we got three clean opinions.”

I guess the above story speaks for itself. However the accountants only seem to act as hired hit men for their clients. Thus, there is plenty of room for companies to take “big bath” write offs- when times are bad, allowing them to “manage” earnings to show an artificially inspire growth rate. Moreover, this is the time that offers the maximum opportunity to add to reserves and issue poor earnings reports. This is called “pilling on” and historically when the economic conditions are universally critical are the best time to join the crowd and build reserves; everyone knows that your earnings are going to stink anyway. From an accounting point of view, it is less than truth-full and it creates some extra bad news that tends to drive the market a tad further down.

We believe that this is deceptive activity is opaque to investors that are unaware of what is going on. We think that during this period, there is a little of both happening. It may well be that Merrill Lynch has over-reserved thrusting a panic mode on investors not knowing when the next axe may fall. However, others are in more trouble that they care to admit. This may well include Citigroup, AIG and UBS all of which are issuing statements that are beyond comprehension. They well may be underestimating their problem in order to suck in additional tranches of money before they really have to deal with the facts. The Mid-East money people seem to have telegraphed a much dimmer view of Citigroup’s situation than the novice management team just brought aboard.

A Saving Grace, Not!

In 1846, a young Irish lad of thirteen from a named William R. Grace went to the sea and never once looked back. From an economic viewpoint, during the next half-century, Grace had literally conquered South America and when he died he left a legacy which has carried over almost until today. The Grace history almost deserves the word astounding when referring to what he accomplished. Grace became the first Catholic mayor of New York and performed his job in stunning fashion. And during the latter half of the 19^th century he also served as Grover Cleveland’s right hand during the time that Cleveland was President of the United States. While occupied with politics, he also assembled one of the greatest merchant fleets in world history. This is the legacy that was left by the W. R. Grace founder and his name was carefully nourished and esteemed over the ensuing generations. The last Grace that will ever run W. R. Grace and Company, Peter Grace, through a combination of the better things in life, greed and avarice, totally broke the mold. He mucked up the Grace name and history eventually may well forget William's astounding accomplishments and only remember Peter's shame. We believe that both acts should be remembered for posterity, William's for his empire building and Peter for milking the loyal shareholders that had faith in him out of everything that he could squeeze out.

We have seen companies do just about everything to boost their earnings including the innovation of completely spurious transactions. However, we have not yet dealt with a company that had an unusually good year and wanted to reserve part of its good fortunes so that it could continually show an increase in revenues over a longer period of time. Smoothing of W. R Grace’s earnings was designed to make it appear to be a solid growth company in Wall Street’s eyes. Moreover, we have also not dealt with a situation where the former chief financial officer became a “whistle blower” because he was removed from his job for questioning this illegal management of earnings. Moreover, we also do not think that we have ever seen such a clear cut case of an accounting firm catching their client in the act of doing something totally illegal, bringing it to the attention of management not once but a number of times, and then act as though the event never occurred, certifying the numbers that they themselves have found to be inaccurate.

In this case they gave the company a clean bill of health along with an unqualified opinion without even footnoting the matter. But then again, Pricewaterhouse Coopers seems to make its own rules when it comes to decisions of this sort.

When a company continually shows exceptional growth, the market has a tendency to place a higher premium on the company as well. Thus, many regulators point out that this action is every bit as criminal, due to the fact that the management of earnings gives the company a cache that would only be attributed to the kind of concern that had that type of growth. Thus, the stock instead of selling at ten times earnings that the normal cycle company would command, it would instead trade at thirty times earnings which historically been a stratospheric pinnacle usually reserved for only those with breakthrough products that have a lock on a perceived critical market niche which will take years to fill.

Assuming the company had 100 million shares outstanding; this earnings management would create a multibillion dollar loss once the company ultimately returned to their more established earnings pattern. By this time, company executives would have exercised all of the stock options that grateful shareholders had bestowed upon them in the belief that they were extraordinary corporate managers, not nefarious earnings administrators. When push came to shove, total earnings over the aggregate period would not be modified one wit, but those buying the stock as it rose based on criminally skewed numbers would have been totally defrauded, just as though the earnings had been 100% make-believe.

W. R. Grace was just another company in the overcrowded and mostly lackluster packing and specialty chemical industry for generations when it acquired an interest in a company in the health care business ([16]). Its politically well-placed Chief Executive Officer, Peter Grace, had run the company for what had seemed like an epoch. As Peter grew older, new management came onboard. However, Peter did not really want to leave the company and as he thought of all of those wonderful perks ([17]) that he had been getting over the years going up in smoke; he became more resistant to packing it in.

He formulated a plan that would allow him to keep everything that he had accumulated and for good measure, add a few supplementary benefits without working for them. Even Peter realized that it would be looked at sternly by the regulators and the shareholders if he appeared to be earning more money in retirement than he had when serving as a full time officer of the company so he determined to withhold knowledge of the entire matter from the shareholders. The Securities and Exchange Commission after an investigation came to believe that allowing this nefarious action by the new management was in rather poor taste, to say the least. First of all, shareholders are entitled to know what the retirement benefits of a former officer are and beyond that, how is it possible that his payout can possibly improve while the retiree is sunning himself on a tropical beach. ([18]). What’s more, there just seems to be a tad of transparency mislaid in this scenario and the SEC seemed to agree:

“On September 30, 1997, the Securities and Exchange Commission issued a Report of Investigation Pursuant to §21(a) of the Securities Exchange Act of 1934 concerning the Conduct of Certain Former Officers and Directors of W.R. Grace & Co. The Grace report is significant in that it purports to impose on corporate officers and directors, including outside directors, an obligation to question and take affirmative steps to ensure that the corporation's public disclosures are complete and accurate in compliance with federal securities laws. Under the policy articulated in Grace, outside directors may no longer be permitted to rely in certain circumstances on the existence of internal corporate procedures and on determinations made by securities counsel as to the propriety of such disclosures.’ ([19])

When Peter Grace ultimately retired ([20]), the aggressive new management headed by CEO Jean-Paul Bolduc and CFO Brian J. Smith took the reins and immediately got into trouble by accepting as true that putting excess earnings in a “rainy day reserve” was a neat thing to do. Beyond tinkering with the Grace Retirement program, they were also involved in the matter of some windfall profits derived from a kidney dialysis division that was in the process of being divested. The management determined to under-report the subsidiary’s earnings and to reserve the remainder conceptualizing that by under-reporting earnings in that matter, they could control when the stock would over-perform the market, thus, taking advantage of recently granted stock options.

Once again, the U.S. Securities and Exchange Commission didn’t see things quite that way. As a matter of fact, Richard Walker, the enforcement director of the SEC, said, “Extra earnings were put into a reserve to save for a rainy day so they could use it when they wanted to goose up the numbers.” Testimony was given by the people at Grace that Wall Street seemed super happy with 24% growth per year and that the difference could well be salted away for a rainy day.

There was a lot of logic in what these conspirators were trying to do. They were not naïve and believed that their kidney division could not sustain anywhere near the 30% per year growth rate that it was miraculously achieving. Thus, in their ultimate wisdom they came up with the formula for hiding the earnings which would give Grace an overall growth rate of 24% for the foreseeable future, a lot of which would be coming from the hidden reserve. Well as we said before, the conspirators had a lot of eyes and ears watching their movements, including our friend the whistleblower, who reported them to the SEC at his first opportunity.

In exchange for their indiscretions, the Securities and Exchange Commission is seeking civil fines and injunctions against seven former officers of the Grace Company:

“The commission has also filed cease-and-desist proceeding against seven former Grace Officers (among them CEO J.P. Bolduc), of whom three get special attention. These three, who include Grace’s former chief financial officer, Brian Smith, are licensed CPAs whom the SEC views as having engaged in “inappropriate professional conduct.” So the commission wants an administrative judge to bar them practicing before the SEC. That means that could not play any part in preparing the financial statements of publicly owned companies or any other SEC registrants.” ([21])

Once again we find that our friends at Pricewaterhouse Coopers were willing to blaze new trails in their ground-breaking approach to new and revolutionary management theories on the subject of reserving of earnings. Pricewaterhouse announced that they stood by the financial reports and wouldn’t comment further on a customer’s affairs. This particular accounting firm, uniquely creative in separating investors from their hard earned dollars, should have been more forthcoming at least once they had gotten caught deceiving shareholders.

Pricewaterhouse’s sorted record, which has caused so many problems in past audits of a multitude of companies, was given a chance to partially redeem themselves with the investing public by openly admitting an error. However, they played hardball once again and in doing so snatched defeat from the jaws of victory just as they had closed in on the gold ring. For their troubles, The SEC got two partners of the accounting firm to agree to cease-and-desist orders. “At least six Pricewaterhouse auditors and Norman Eatough, Grace’s former in-house audit chief, questioned the propriety of Grace’s accounting maneuvers. Mr. Eatough even took the bold step of complaining to the board’s audit committee – to no avail”

New management, which at this point does not include any of the rogues who were charged with cooking the books, made an interesting settlement on June 30, 1999, of the outstanding accounting problem. “Grace consents to a cease and desist order without admitting or denying the SEC’s findings. Grace also agrees to establish a $1 million fund to be used for programs in the public sector to further awareness and education relating to financial statements and generally accepted accounting principles.” ([22]) In any event, rumor has it that the SEC may give Pricewaterhouse something more to think about relative to certifying audits that they believed were fraudulent.

We are certainly hopeful that a little of that money can be used to educate Pricewaterhouse-Coopers as well. They seem to need more indoctrination than anyone else. But maybe they didn’t really need it. Last year PricewaterhouseCoopers received $11.3 million for their accounting of Grace’s books. I guess justice is never really served.

The Thundering Herd

However, one has to wonder about the previous statement when put into the perspective that:

“Merrill Lynch said yesterday it will eliminate 650 jobs as it stops making subprime mortgages through its First Franklin Financial Corp Unit, Merrill said it is quitting the subprime lending business because of the deteriorating market for home loans which to go people with poor credit…Merrill bought First Franklin and much of its loan portfolio from Cleveland-based National City Corporation for $1.3 billion in December, 2006. First Franklin had employed 2100 people as recently as last may.” [23]

Simply put, this is a catastrophic write off for Merrill and it would appear there are only so many that can be absorbed even under Thain’s guidance that would insurance Merrill’s continued existence.

As to UBS, while they have committed untenable acts and run their company like a one man funeral procession; the information that we have analyzed only seems to show criminal stupidity and this place should probably out to be closed down summarily before they commit more damage to themselves. They have obviously grown too fast and were not watching the subprime store as well as just about everything else they have done.

Another Party heard from!

There are various government agencies that have been privatized but still exist with their original mandate. In these pages we will discuss, Sallie Mae, Freddie Mac and Fannie Mae. For the moment we will deal with the other Mae, Sallie (SLM) is in a tad of hot water. It seems that they are selling a product called the “Tuition Answer Loan (TAL).” These loans are somehow blithely sold directly to students who may not even be of age to enter into a binding contract (under the law) for the most part by unregistered brokers. This devious device also avoids the necessity of having to answer to parents and school advisors relative to the merits of Sallie’s program (which is part of the pitch). This is a web based loan arrangement and has already created $3.3 billion in potential bad debts and is adding to the total at an almost geometric rate as the months go by. Sallie Mae has a total portfolio of a whopping $164 billion.

Sallie Mae was begun as a government agency in 1972 to promote loans for higher education and now owns or manages nearly 10 million student loans[24], more than any other lender. Recently, Sallie Mae built up the company's debt management operations unit -- from one that focused on collecting money from student loan debtors to one that also collects on consumer and mortgage debt, usually the hard way. There seems little or no relationship between the two but that’s the government for you.

The company was brought public several years ago for $25 billion and today is a public corporation which is subsidized to at least to some degree by the U.S. Government. Since 2000, Sallie Mae has purchased a series of smaller debt collection and debt-management companies including a majority of a larger company by the name of Arrow in 2004.

While all that sounds great, Sallie Mae (SLM) has built a reputation for their sucker punch collection techniques and has been become successful through the Arrow subsidiary of harassing people unnecessarily that owe them no discernable money but that doesn’t seem to matter. For this and other creative loan problems they are under investigation in both Illinois and Massachusetts. SLM has 529 college-saving plans that they administer that total $19 billion dollars and is the largest private source of college funding contributions in America. However, in spite of the size and in spite of their government affiliation, their collection department could just as easily be entitled “Mafia Credit and Lending” justice. The only threat that SLM does not regularly use is “Pay us or die.”

Moreover, this quasi government agency is so out of step that it only reports you to the credit bureau when they think you are a dead beat. However, if you pay on time, they don’t want any of their creditors to have a clue as to your identity. You represent red meat to them and not having to share your positive credit rating with competition not only has a life scaring affect upon the student but its bias against those with good credit is patently illegal. Possibly even more importantly, reporting the dreadful and not reporting the superior jars any statistical ability for discerning the genuine demographics of student lending. For the U.S. Government to purposely create skewed numbers in matter of considerable interest to our economic underpinnings is hardly in the best interest of commerce, trade, or any other department of the government or anywhere else for that matter.

It would stand to reason that down the road, anyone being turned down for a loan whose credit rating is reasonably good due to these sorts of inactions on the part of Sallie Mae. It would seem that they would have a huge defamation of character lawsuit against the agency. Moreover, one would think that there is a class action sitting in the wings waiting to crush this wayward group of hot shot lenders who are going well beyond their mandate.

Interestingly enough, one would even think that any executive officer that gave instructions to purposely tarnish a client’s credit could be personally liable for those actions, and that the knowing commission of a fraud could also well be exempted from Directors and Officers Liability Insurance Coverage. Moreover, I would imagine that fraudulent activities cannot be covered by corporate fiat as well. This would certainly seem to be a violation of the Fair Credit Reporting Act and the Senate thought enough about the issue under the aegis of Dick Durbin to propose an amendment making fair reporting mandatory. Dick was thinking about Sallie Mae when he proposed the bill. They have certainly not acted in the best interests of the government and certainly have reflected a negative image of where government stands on this issue.

This agency just like its siblings can hide under whatever tree is convenient depending on the weather. It is a public company and liable to its shareholders but is also beholden to the U.S. Government for certain monies and leverage. It is part of the Federal System when the loan faucet has to be turned on and that would seem hardly in the best interests of the shareholders. A lot of fraud lawsuits and defamation of character actions could dampen anyone’s ardor for the company pretty quickly.

However, there seem leave little doubt that collections would benefit greatly if a hit man, or at least someone that looked and acted like one was brought in to deal with the youngster’s debts. Nevertheless, in the long run, this may not only be opposed to the best interests of the shareholders, but super dangerous to students that are caught up in a financial conspiracy. You cannot privatize and then maintain control without serious legal implications that can affect free enterprise and the economic system itself. This formerly was historically called a rubber-band company; where the ownership would change but for intense and purposes, control had never left the spot from whence it began. This is certainly the case with Sallie Mae and when the government beckons, the company’s management is ready to do their bidding such as either making loans tighter or looser. This is about as close to a Ponzi scheme as you can get without paying a very large price. By shaking the youngsters down for payments they are certainly getting an early lesson in criminally oriented business economics, but most of the people we talked to never signed up for the course, it must have been a non-required elective.

Moreover, these are moves afoot to investigate the agency for unfair collection practices, failure to timely disclose terms of their loans, no option in the choice of your student loan lender (This is like being obligated to report on a daily basis to Attila the Hun for social science instructions), high or excessive interest rates, discrimination against minorities, unexplained fees assessed on student loan and, unexplained increases in the balances. The relationships between Sallie Mae and school officials are sometimes a little too friendly for comfort. They are wined and dined, put on ad hoc advisory boards which hold pseudo meetings at high-end resorts, cruises, gold outings and the like to make sure that Sallie Mae is are the company that get the loans. Furthermore, in exchange for that Sallie Mae offers what they call “opportunity loans” to schools that sign up to offer federal loans through their company. This is a pure and simple bribe. Many of these loans wind up in the pockets of the school board members and can be construed as payoffs in exchange for business (Hardly the American way). One would think that this practice is in violation of the federal law that “prohibits lenders from offering direct or indirect inducements to educational institutions to obtain federally backed loans.” However, its misuse would definitely be a crime.

Additionally, the fact that the people at Sallie Mae are not the nicest in the world has little to do with the state of the economy today, or does it? As the economy proceeds to tank, students will be the first to be laid off from their jobs, or not be able to find jobs, or it will take substantially longer time to reach a full employment. This will naturally hamper the repayment of their loans. Without payments, the principal and interest payments rise regularly and when compound interest is added into the mix it has caused some reports of extortion and loan sharking. Reputations are intangibles that are difficult to replace once they have been lost. We believe that the litigation in this arena will eventually explode when the conflicts clearly show that management is attempting to wear two hats at the same time. On one hand doing the bidding of the government while expanding and contracting loan availability as though they are playing an accordion. The other hat is representing the shareholders and churning out great earnings. How do these issues jib, the government may want to turn on the money facet when the economy is slowing down to give it a shot and conversely relatively represent simultaneously two groups with converse interests. This may well turn out the same sort of boondoggle as subprime loans.

As an ominous predictor of things to come, the New York Attorney General Andrew Cuomo has announced his investigation into Sallie Mae’s “Tuition Answer Loan”. God help us to protect our children from folks like these. Moreover, just to stir the pot a little more, Cuomo sent 33 subpoenas to others making direct loans to college students. There ought to be some system in place that when the economy acts poorly, there should be an automatic semi-freeze on payments. For example we could start at a bass of 5% which will call semi full employment. Should the figure drop to four percent the principal amount due raises by 10%. The repayment of the principal repayment can be raised with each decrease in unemployment and go higher with each lowering of the unemployment figures. Conversely, should these principal payments go down by 10% etc? We may or may not solve a lot with these concepts but it will certainly avoid a strange man in a dark suit weighing 400 lbs, six foot three inches tall having to visit a seventeen year girl in her bedroom whose main contact with the outside world is her gym class.

We want all of our kids to have the same opportunities that the legendary Horatio Alger achieved in spite of hardship. While Mr. Alger made a couple of highly publicized bucks on occasion but died absolutely flat broke. Maybe we should give a better example but we are stuck with Horatio for the moment. Instead of Alger, perhaps we should use Diogenes, the Cynic as a better example; he didn’t necessarily want to be an honest man, he wanted to find one. Why he looked so hard has been one of the best mysteries of the times. However, we may not know his strange motivation but we do know that he was convicted for counterfeiting and was run out of his town on a rail. After a life of crime, Diogenes asked in his will to be buried with his head pointed straight down as he was convinced that the world was going to be upside down sooner rather than later. Certainly a good point!

Statistically speaking, both Freddie and Fannie are both skating on thin ice. If a hedge fund was found by their bankers to be carrying this sort of leverage, they would have their loans foreclosed by the banks without even passing go. At last reading, Fannie was trading at 81 times its fair-value net worth and Freddie’s stood at 167 times its value. There is certainly not much room for error in these numbers and lot of room for concern relative the sanity of the people running the asylum. Using this approach, the U.S. banks look like fortresses when compared to these will-of-wisp structures.

Just plain out of control and who cares?

The accounting office in February of 2008 stated that fundamentally Fannie Mae was out of control and could not adequately manage its own affairs and due to that fact they would be restricted in various avenues of pursuing their business. No more than one month later, when it became clear that the subprime mess was a lot worse than anyone had thought, the government reversed itself but in an unfortunate result of bad timing, the day they revised their governance, literally at the same time they reported an astounding loss of $3.4 billion.

This at least, as far as my understanding, is a matter of record. However, what does not seem to be of record is the fact that Fannie Mae is a public company listed on the New York Stock Exchange. They never put up a whimper when the Government said they couldn’t manage their own affairs which one would think would have caused animosity toward in incapable management. Then suddenly after things get even more mired down in the mud, the boys in Washington changes Fannie’s mandate again and tell them that they are easing the just created restriction and their mandate is now to buy more mortgages than ever in order to add liquidity to the market. This is a noble concept but what of the officers of this public company, who indeed do they represent? Moreover, these same people that have proven their incompetence to both the public and private sectors are now literally told that they are now free to screw up with even greater leverage.

Think of this, the Government themselves reported that these folks couldn’t manage their way out of a paper bag and yet simultaneously with reporting one of worst earning reports in the history of American business history, they are turning over the keys to the candy store. What on earth happens if the company just plain runs out of money and becomes a ward of the state or the state just plain walks away from the mess that they have created? What about the liabilities of the directors and officers who are not government officials but representatives of the shareholders? Who indeed is their duty to? Time will sort this out but meanwhile things must be getting awfully choppy in Washington when the politicians start talking out of three sides of their mouths instead of the usual two.

The lower it goes, the worst it gets!

As of this writing, 363 high yield issues are under water and that number rose 22% in February of 2008. That figure compares rather poorly with the figures just seven months earlier of 22 issues that hadn’t made the grade (or a climb of 1600 percent) for such issues. For the uninitiated, distressed debt is a bond with a yield of 10 Percentage points above the comparable U.S. Treasury Bond yields. That along with the fact that the cost of insuring investors against corporate default has risen to an all time high is either disconcerting or terrifying depending upon your given psychological state at the time.

The sectors that seem to be most affected by an inability to pay interest on their borrowings would be corporate issues in the field of publishing, gaming and media. It would seem that if we are in a recession, the advertisers and the gambling casinos would be the first to suffer. One could wonder about how Sam Zell is fairing with his recent investment in the Chicago Tribune or the Rupert Murdoch of News Corporation investment into Dow Jones. However, these are quite smart fellows and I am sure that they are aware of contra cyclical facts that betray my lack of knowledge.

Nonetheless, the political climate is becoming so fearsome that should the monoline industry be allowed to tank, probably no one would be re-elected in this Congress (Tongue in cheek, probably someone). Currently and to some degree due to this problem, The National Association of State Retirement Administrators estimates that although their funds have $3 trillion in assets, but they also have $440 billion in underfunded liabilities. One could make the claim that; if they couldn’t make enough money up till now to pay their bills, they sure aren’t going to do very well in the next several years. Cities have seen local industries exporting their businesses overseas and after a time realize that they have sold their birthright for a bowl of porridge. The only tax base that they historically turned to for raising infrastructure funds to fix streets, pipes, lights, collect garbage and run the police, fire and emergency units has now been exported overseas. Thus, we have foolishly become much more dangerously tied to real estate prices to inflate us out of our tax problems; but that single trick pony is carrying too much of a load and is no long working.

You can almost feel the stirring of the horrifying "gobblehome" monster that usually lives seventy stories under the basement of the New York Fed. This monster has a vicious appetite for digesting chewy homes. However, for the last several years he has been dinning on the obliteration of the World Trade Center for so long that he has built his nest there. But now that the World Trade Center waste has been digested, he has again shown an appetite for more delectable morsels located in the greener suburbs. He usually prowls around areas with little industry combined with are large concentration of home ownership. A critically important part of this strange animal’s diet is the fact that he does not necessarily feed on subprime delicacies, but is equally fond of homes that have been inhabited by wealthier folks. Because of their tax base, the municipality has been raising taxes high enough to provide even the most basic critical services needed by the community but at some point the law of diminishing returns starts to kick in. There is only so much that is available before the economic bubble starts to kick in.

The owner has very few choices; pay the higher rate and live with it or move elsewhere, but taxes also have a way of culling a community. At some point, with constantly increasing bills for municipal services pushing tax rates increasingly higher; either one of two things will happen, the municipality could go bankrupt or the homeowner will or both. The price of the home starts to slip and as the value of the home decreases this minor blip becomes a plague, when fewer services can be offered because of the inverse community growth. Eventually, you have ghost town that has gone bankrupt and the home owners have pulled up stacks. Passing the bills for municipality on to future generations only can work for so long as the credit rating of the city drops and borrowing becomes increasingly expensive.

Even if he pays the high taxes some of his neighbors may not be able to stretch that far and will move out leaving their house to the gobblehome monster which soon turns the once lovely home into rubble. As the house begins to decay, so does the neighborhood and what may have been one of the quaintest villages in the county is now blight. Should this subprime mess continue unabated, this problem could well become endemic. For example, in Nassau country that would be classic, Nassau County is a bedroom community of the first water. Their industry left long for greener pastures long ago and the local fathers did not have the foresight to find replacement jobs for their citizens. There has always been a delicate balance between tax bills and the home owner’s ability to pay, and Nassau County for one is in no position to cope with a long battle with the gobblehome monster.

Whole cities are now looking at regulations that have been on the books nearly forever; Chapter 9 of the Bankruptcy Code which deals with the entire city filing for bankruptcy protection en mass. Unusual activities are taking place in cities that are dependent upon home taxes to get by. As a rule of thumb, the statistical mavens have made projections when the scale starts to tip to the danger side of the ledger. The tipping point comes when a city’s tax burden is provided by over 50% of tax income being provided by home owners in a community. The problem becomes geometrically more intense for every point that it raises the risk of community collapse rises geometrically.

Most bedroom communities have socially similar people living in a community of comparable valued dwellings. Due to the fact that their economic and probably their social backgrounds are somewhat similar, any dislocation relative to taxes has an inelastic point at which it affects literally everyone. As we have stated, ultimately whether everyone has been affected or not on the first round of the attack, those that close up shop make the neighborhood look spooky and gradual atrophy lies not far behind. Moreover, when the valuation of a property drops, it would be expected that its value of taxation purposes drops as well.

The bottom has dropped already in Vallejo, California’s where property values have sunk and the city appears to be opting for a bankruptcy filing under Chapter 9 of the Bankruptcy code. Can you imagine a city of 120,000 just not paying its bills? However, the city of San Diego may not be far behind.

Not only that but housing very often is tied to retirement income which is rapidly becoming less certain than it has ever been previously as pension funding coverage within States has dropped from 100% to 82% within a few short years. This has come about primarily due to the fact that lower tax collections impact actuarial projections and payments. Moreover, for the most part during this drop, home prices were flying and evaluations were rising. With the real estate market’s collapse, industry leaving town, evaluations dropping like an anvil; mortgage payments including increased taxes become much iffier. Talk about Social Security being a drag, this seems to make the Federal System look like the Second Coming.

The old variable demand note ploy

Then again, how many of you have owned a variable-rate demand note. This can take a number of forms but primarily, pay your mortgage interest principal or not, but for each missed payment the note becomes automatically restructured upward. This sort of collateral would be given to holders of rate sensitive debt instruments. As the cost of debt increases, the rate that has to be paid on it tends to move in tandem thus, providing a hedge against inflation and rising interest rates. However, this type of note has literally stopped functioning as the concept behind it was ill conceived from the beginning. This collateral is a tad below a subprime mortgage due to the fact that what you see is not what you get. Folks that on the debtor end of these tricky little monsters would only want to be in this position to find breathing time to get real financing.

However, the fact that no one trusts anyone else anymore on Wall Street and most of all they don’t trust the credit rating agencies or the monolines. While there is a market for about $330 billion of auction-rate out there that has trouble finding any bid at all, the variable-demand note market is a tad larger at over $500 billion. The way these things work is that they represent a reasonable return for purchasers looking for ebb and flow with of interest rates. However, lately there has not been ebb and certainly not flow. The big holders of this stuff are the same big brokerage firms that are up to their eyeballs in auction-rate debt for which there is scarcely a bid. When a broker deal has to write down his portfolio value it is almost the same as writing down cash.

They are obliged to only do their business when they are in ratio and prime assets or even insured assets are determined to be very close to the equivalent amount of cash. However, that was only true when an insured instrument meant that it was really insured or when a rating is not a state of mind that you wake up with in the morning but after a day’s being beat up at the office you change your mind. When their ability to do business starts to diminish, the brokers returns tend to collapse faster than a hotdog being digested at the Nathan's eating contest at Coney Island. The only similar time that I can recall when we actually went through this torturous economic hysteria was in 1987 on the day when the market literally dropped 33%, the largest one day percentage drop in history. This was brought on simply by What the University of Melbourne called a total lack of liquidity however that wasn’t the cause, it was the result.

For an unknown reason, sell order started to flow into the market early in that day and “trading mechanisms in financial markets were not able to deal with such a large influx of sell orders. Many common stocks in the New York Stock Exchange were not traded until late in the morning of October 19 because the specialists could not find enough buyers to purchase the large amounts of stocks that sellers wanted to get rid of at lower prices. As a result, trading was terminated in many listed stocks. This insufficient liquidity may have had a significant effect on the size of the price drop, since investors had overestimated the amount of liquidity.”

However, negative news to investors about the liquidity of stock, option and futures markets cannot explain why so many people decided to sell stock at the same.” By the middle of the day the bank’s had called the New York Specialists loans and stripped them of regulatory capital with which to do business. What started out as an orderly liquidation session ended up a massive panic probably unlike any stock market collapse in history. For the most part, the traders on the Exchange Floor did their job, but the banks turned into cowardly halfway into the battle and fled into the hills leaving only a motley group of fiscally wounded survivors in their wake.

Thus the literal “run on” the auction rate market was caused by a substantial decrease in the regulatory capital of many investment bankers, thus impairing their ability to engage in their money making opportunities. In the case of the Crash of 1987, the reneging by the banks of funding commitments added fuel to an already furiously burning fire. People sought liquidity wherever they could however, there was just nowhere to go, so they started running around in ever smaller circles bumping each other as they passed. Panic selling creating massive jolts to securities from one end of the spectrum to the other. In this sort of scenario, the panic spreads from the bottom up as people seem to try to climb the ratings ladder to escape the economic collapse. Moreover, this sort of thing affects regulatory capital throughout the system no matter how strongly the rating of an instrument, with the possible exception of Treasury Guaranteed instruments.

For example, an Investment Banker, let’s say Bear-Goldman has a portfolio of stocks that run the gambit from good to bad. Some of these are investments, some are speculations, some are trading residues and some are the other side of a derivative transaction[25]. They are carrying approximately 5 to 10 times their fundamental equity within these various classes and naturally are able to absorb differing multiples of leverage from their regulators based upon the perception of the collateral and restriction agreements. However, their portfolios will be weighted in one direction or another depending on the current bias of the broker’s market analysis.

Let us assume that the unusual happens and that the usually triple "A" municipal portfolio stops trading altogether and it becomes impossible to price the issues based upon a trading market. These securities are just not trading and the market has lost its liquidity at least in this issue. While this might not represent the same severe problem in the insurance industry due to different approaches to evaluating these contingencies, the portfolio of Bear-Goldman has now slipped under regulatory compliance. Two things must now occur in rapid succession; they must report the fact that they have become legally undercapitalized according to regulations issued by the NASD. Additionally, more importantly they must move to rectify the problem without delay.

If the problem cannot be solved by the use of external funding (which usually takes too long) they must liquidate other securities to move back into ratio again. This might not work if the firm has “concentration” within certain classes of securities that have all been crucified in the process of market collapse. However, Bear-Goldman couldn’t have been the only firm hurt by the write down, and the cumulative effect of this happening over and over again frightens the markets and shuts them down. This is pretty much where we stand in many areas today.

The cause of the 1987 panic is not particularly identifiable and probably was more the result of margin calls in an unfriendly environment. What will become known as the “liquidity crisis of 2008” has occurred for more discernable reasons. The Iraq War, hedge funds trying to out-perform each other, sophisticated products that were not understood, ratings agencies that fell asleep and did not do their job, insurance companies that were undercapitalized writing worthless indemnifications on ill conceived transactions; real estate prices dropping in a much needed readjustment and a failing dollar created by falling interest rates. This is clearly the perfect economic storm with affects that could not even have existed in previous markets due to the fact that many of these vehicles were not even in existence until recently.

But panic is panic; thus, folks are trying to become liquid by jumping out of the variable-demand notes to create cash or for regulatory needs. The problem is that everyone says this disaster coming in from all directions and it became somewhat like the building burning down and hundreds of inhabitants trying to get into the only elevator available simultaneously. It just couldn’t work. However, there is a little more to this instrument than meets the eye. Built into this “dirt devil” is a double guarantee or a double whammy depending on your philosophically reflective mode at the time. The guaranteed notes are first in line and carry both the credit of the issuer and secondarily folks that specialize in guarantying to buy these little buggers back whenever it is required[26]. The underwriters have been Bear Sterns, Lehman and Morgan Stanley according to the Wall Street Journal while the guarantors of the buy backs are the usually cast of characters, the already well beaten up banks; Citibank, J. P. Morgan Chase and Bank of America along with newcomer, State Street Bank in Boston which is also engaged in a resource draining litigation, as Trustee for some subprime debt that seems to have gone bad on their watch.

Conversely, that may become the rule as opposed to the exception if Mike Mayo (New York based credit analyst) is correct. He has stated that “subprime borrowers are likely to default on 30 percent to 40 percent of debt with losses on loans to people with poor credit histories, being as much as half the sum lent. “ Thus, extrapolation becomes rather simplistic. There are approximately $10 trillion home loan mortgages of which $1.2 trillion are subprime. Thus the conservative end of Mayo’s figures would show a $340 billion write down. However, that does not include Europe which is far from immune as well as other classes of loans mortgages which are now starting to collapse as home prices lose equity. Goldman Sachs has recently come out with substantially higher estimates, but then again they have sold the market short. The market had invented a product that no one understood and that had no market. It’s a good way of making money if you can do it.

However, selling something that either doesn’t exist or is not what it was intended to be is an old trick most recently accomplished by one of our most famous rogues; Billy Sol Estes and he didn’t even need an investment bank for a front to his operations. This guy had class.

Billy Sol Estes We Are Proud of You, The Boy’s In Fertilizer You Know

They brought this elderly 70-year old into the court and some thought that they had heard the name. “What’s he being tried for?” asked a local wag. “Oh, I’m not sure; I think something about tax evasion.” Replied another onlooker: “A guy that old, still hustling on his taxes, I can’t believe that.” Replied the first: Another bystander rejoined, “Guys, that’s Billy Sol Estes, the biggest crook ever produced in West Texas and that guy don’t know how to do anything but steal.”

This case was not a major event in Estes’ life, if what the family said is true, he may not even know that it happened. His lawyer pleaded insanity as a defense against the eight-count indictment on tax fraud that Estes was facing in the District Court in Brownwood, Texas. Relative to some of Billy Sol’s other exploits, this one was pretty tame. Billy and some of his cohorts started a charity, an alcoholism halfway house, and then treating it as a for-profit company, at least as far as the partners being able to siphon funds out of the company and pocketing the money. Many had pointed to Billy’s more charitable ways but they didn’t know the truth. In reality, this was minor league stuff and Estes was a major leaguer.

Billy Sol, who lived in Pecos Texas, had done bigger things in his life and stealing from a halfway house charity is hardly fitting for a criminal with such outstanding credentials. Years ago, Estes was an influential cotton grower who made a fortune by using his neighbors’ acreage to grow cotton during the years when the U.S. Government was paying a fancy premium for those sorts of things. He was always politically plugged in, which certainly helped a lot when it came to getting the big government subsidies. However, some genius at the agriculture department determined that there must be something wrong with being paid government money to raise cotton on some else’s land on a fully subsidized basis. When the inquiries started coming in droves, Estes decided that he was getting bored with producing cotton and determined to get into a new line in which he could make money without even having to have a product. After substantial research he determined that this non-product would be an imaginary liquid fertilizer tank farm.

Estes and DeAngelis came upon the same sort of scam thousands of miles from each other, almost simultaneously. Estes as opposed to DeAngelis had always been successful and had accumulated a substantial poke, most of which came from dealings with many of his political friends in Texas who he supported with a flourish when they were running for office. Tino DeAngelis, the instigator of the so called “salad oil scandal” was a nickel and dime crook that was always getting into trouble with the law if for no other reason than the fact that he just didn’t have Estes’ influence with the right people. Both used tank farms to create assets that were non-existent. Both convinced sophisticated institutional suckers to throw money at their schemes, both made a fortune in their illegal activities, and both caused a substantial number of people to suffer extreme financial hardships. Both were approximately the same age. The only difference between the two was DeAngelis made every effort to fill every one of his tanks no matter what they contained; Estes never put anything in the tanks nor were most of them ever built. He couldn’t have filled them because the tanks themselves didn’t exist.

His theory was that big institutions did lousy due diligence and that making the scheme work would not represent any problem. Estes went to the finance companies and told them that he had acres of tanks filled with fertilizer. If they would lend him money, he would segregate the tanks’ contents with a seal and a cast-iron imbedded nameplate, permanently bearing the name of any institution that would finance him on the basis of the tanks’ purported contents. He offered his lenders the right to send inspectors of their choice to scrutinize the tanks without advance notice to verify Estes’ assignment of rights to them.

Many institutions considered this great collateral; Estes was able to borrow real money on the liquid fertilizer that he claimed filled his tanks. The trouble was that while a few tanks contained the liquid fertilizer, the ratio between these tanks and the empty tanks was immense. As expected, the institutions regularly did attempt to verify their collateral’s existence. However, what Billy Sol knew and what they didn’t was that in West Texas, where the tanks were supposedly were located had only one airport that could logically be used to get to his tank farm to do an inspection. That airport had a handful of rental car facilities, whose employees all worked on Billy Sol’s payroll as a sideline. When an Eastern auditor showed up with a corporate credit card, they called Billy or one of his people. As soon as they could be sure that the traveler was a creditor of Billy’s, they trotted out the shiny new nameplate bearing that creditor’s name, removed the old creditor’s plate, and soldered the new one onto the tank. When the due diligence auditor came calling, naturally he found his company’s name embossed on the tank just as Mr. Estes had promised. Moreover, he found that it contained exactly what it was supposed to include.

The result of this magnificent scam made every inspector a salesman for Billy Sol. They all went back and told their constituents that everything was as advertised and for the most part, this herd industrial sheep were more than happy to have Mr. Estes load another non-existent tank with imaginary liquid fertilizer and give him a little more money.

Ultimately, Estes’ secret was revealed, and banks and finance companies all over the country went into a period of mourning. Estes had stolen them blue. The problem in this instance had been the fact that the tanks purportedly belonged to Estes and thus, there was no independent warehouse receipt. In the DeAngelis case, victims would have recourse against the issuer of the warehouse receipt, American Express. In this case there was no third party receipt, no insurance, and the money had vanished into thin air. Estes went to federal prison for his trouble and once again he went to the big house in 1979 for income-tax evasion. It appears that unless his insanity plea falls upon friendly ears he will have the government as his host for the third time at an age where a rest home would have been much more fitting, the tender age of seventy-two.

As a sidebar, Estes never quite knew when to let well enough alone. He gave an interview with VSD, a big French Weekly in April of 1999 in which he claimed that Lyndon Johnson ordered the assassination of Kennedy. In addition, he brought up a point in that article a point that he did not bring up when the U.S. Government went after him when he pled insanity. The point is that he indicated that the reason for this astounding statement was the fact that he is dying of prostate cancer and wants to “set the record straight before he dies.”

He went on to say that one Cliff Carter, a crony of Johnson and Malcolm “Mack” E. Wallace were also involved with Johnson in all kinds of nefarious stuff. The story in the French magazine gets crazier and crazier so we won’t honor it with anything further except to say that Estes indicated that “He also has recording of all of his conversations with Wallace, Carter and Johnson.

After Estes got out of prison the second time, he had a message waiting from God or somewhere else, in which he was told to clear the air. Estes told the world about his relationship with LBJ and a slush fund that he had personally set up for him. He went on to recount chapter and verse of murders, pillaging and other strange and bizarre experiences, which the former President was involved in. On the other hand, everyone that he was talking about had died and even the fact that he had told this story to a Texas Grand Jury had little effect on the world at large.

The U.S. Justice department hearing about this testimony asked Mr. Estes to visit them. Estes said that he would tell them about seven murders that Johnson was directly or indirectly involved including President Kennedy if they would give him immunity. No deal was ever reached and so we are unaware of what could or would have happened had they worked something out. It appears to us that Mr. Estes should have used the defense of insanity a little earlier in his career. This guy is certainly one strange dude.

a run on puts

So this sort of security allows the holder to sell it back at their convenience. This was a flaw built into the transaction in order to make it liquid. However, no one ever figured out that liquidity comes from buyers and sellers, not from guarantees. This was a small market play in by professionals for large numbers. It was not a market place where speculators or individuals would dare play. In this instance the large money center banks would guarantee a buy back not the insurance company. Essentially, the banks thought that they could pick up a couple of easy bucks at the by cutting the more sophisticated insurance companies out of a transaction that they believed could not go wrong.

The way these things worked,

The banks got clocked in subprime and were almost mortally wounded and on top of that saw a landslide of guaranteed debt coming back to them at the least advantageous time in their history. However, it appears to be a sink or swim proposition and at times such as these, it is clearly survival of the fittest. The players in this lottery of interest rates were the primarily the hedge funds at once side that were borrowing short and selling long and on the other were the municipalities that had excess cash from bonds issued projects where the money was taken down only when completion of a particular project was completed. Both sides had other alternatives but for whatever reasons choose this forum to throw the dice in. When the market ceased to exist, two things happened; the borrowers were left holding a bag that had no money in it and the sellers of money had no where to put their investments. This caused borrowing rates on a short term basis to explode and with it many of the best laid plans of municipalities.

This duality simultaneously raises the cost of issuing these sorts of instruments by municipalities and we are not talking about a little bounce; a 200 basis point uptick can knock the best laid plans of mice men astray especially when the city council is working on a tight budget. This problem seems to be the ill-wind which blew no one any good stuff at all. However, the worst news is that there may not be any market out there at all until the panics calm.

Even though such stalwarts as Bear Stearns still continued with the attitude that nothing had gone wrong and their portfolios were intact, clearly, they eventually had to bite the bullet and admit that two of their funds were literally worthless and worse yet, one of the fund's officers had sold out a substantial amount of his investment while telling the world, "all is well." Obviously, down the road the SEC will have to address this problem if they can do it without blowing up the baby any more than it has been already. They may now be damned if they do and damned if they don’t. If the same actions had been tried by small brokerage firms, their partners would be jailed, the firms closed, and the brokers suspended for life. Fines would have been had by all. Large firms committing the same crimes against humanity would get off with a small relative slap on the wrist and a “get out of jail free” card. Then again, nobody ever said that life was fair. However, the cat has left the bag and it is now an issue for the regulators will have to deal with.

I’m from Bear Stearns and I only want to help you with your investments

While for the most part, nothing Bear Stearns ever did had been much of a major regulatory problem. Bear Stearns certainly never had to create substantial falsehoods to get out of a tough spot and they have certainly been in them. For example, when they were clearing for Mafia-like small brokerage firms, there were numerous law suits filed against them for not advising the ultimate client of these firms that they were not dealing with nice people to say the least. Their little white lie in order to move this behind them was that they did not know who they were dealing with thus, they were not liable. Of course that flies in face of the “know your customer rules of the New York Stock Exchange” something that had been a critical part of the industry for decades. This could have been both a public relations and financial disaster for Bear, but they were able to gently side step the issue without becoming overly tarnished. However, they also may have been too big to fail as they had hundreds of small firms clearly through them and any impairment of Bear would have had national economic repercussions.

They stood behind previous regulations that stated that clearing firms (this is the fact of printing confirmations, executing of trades, providing a trading desk and supplying capital) not only did clearing and had nothing to do with the brokerage business practiced by the offending firm. While this seemed to work for Bear, it left a rather bad feeling on the parts of investors who believed that they were hosed and that Bear had been responsible. For example; someone hands you $100,000 as you get on an airline from Mexico to the United States and gives you a package to deliver to “Big Louie” in Detroit and you can keep the money once the delivery is made. You deliver the package and just as “Big Louie” begins to examine the contents which turn out to be heroine, the FBI, FDA, and the Police all show up and arrest everyone. Your defense is that I never knew that guy at the airport, I wasn’t ever introduced to “Big Louie”, I didn’t know what was in the bag and I am clearly an innocent victim.

Hold on now Bunkie, you received $100,000 cash which you brought into the country illegally; you took the package from a man you didn’t know and were told to deliver it to a part of Detroit that is inhabited only by drug dealers. You have lived in Detroit all of your life and couldn’t avoid knowing it if you tried. You were traveling to Detroit anyway and yet were given $100,000 for this delivery. Did you think that the package contained Angel Food Cake for Grandma?

However, for the most part, “Bear” won the battle but lost the public relations war. They obviously knew exactly what was going on and were just profiteering or “increasing shareholder value”. However, this was at a gigantic cost to thousands of investors whose accounts were carried by “Bear”.

In the case of the Bear Funds, The investors were offshore, Bear Stearns were onshore and the funds were based out of the Cayman Islands and apparently the lawyers for the prominent Wall Street broker dealer felt that they had insulated themselves down to their shoestrings.[27] There was no one that could hold them liable other possibly than the “front running” indulged in by a senior officer of the fund who sold his stock before other investors even got wind that something had gone badly wrong.

However, on February 28^th, a legal invasion took place spearheaded by the lawyers for the now rebellious investors who were by this time blazing mad due to the failed Bear Stearns High Grade Structured Credit and Enhanced Leverage funds. Sounds like they still have pirates in the islands, but this attack was probably of the legal variety and carried out mostly in a stealthy manner before Bear could react. The investor’s lawyer had prepared well and moved in a Cayman Island Court for “standing”. The judge listened to the allegations which included the fact that testified that Bear Stearns had used erroneous calculations to determine net asset value and that Bear warehoused or dumped unrealizable subprime debt into the feeder funds. In addition, Bear was charged with using their own liquidator (KPMG) to analyze the residual and past values and to proceed with the unraveling of the fund’s assets and name. Not playing the part of Mr. Nice Guy for sure.

This move in the Cayman’s which is rather sophisticated was taken because the offshore investors (supposedly) did not want their names publicly proclaimed for privacy reasons. By taking over the funds, the company itself would be in a position to commence action against Bear Stearns[28]. This probably was not in the Bear play book when they set up this convoluted methodology to keep the investors away from the parent. The Cayman Island Judge was extremely friendly to the position of the investors and ruled that KPMG (Bear’s anointed accountant) was also the liquidator of the main fund into which the feeders invested and therefore had a potential conflict of interest.

The judge stated unequivocally that it was “understandable that the investors would want investigations carried out “in an entirely independent, impartial and unfettered manner.” Moreover, the Judge also held that the broker should bear a share of the costs because it was “perfectly clear” that the Bear was behind the decision to put the funds into liquidation ahead of a petition by investors to take control by electing their own directors.

It would appear that Bear Stearns had not made too many friends either offshore, in the Cayman Islands or in the Caribbean judiciary. Should they be able to prove their charges along with the fact that it is clear that the Bear Stearns employee that was running one of the funds liquidated some of his interest without notice to other investors, could also potentially give Bear Stearns some severe headaches? We would think that these charges will certainly move the SEC into a more thorough investigation of the various 10 (b) (5) charges. This is not something that Bear Stearns and the former CEO, Jimmy Cayne, who seemed to be enjoying his bridge game and was working on his golf handicap while the firm was on fire, would relish. Makes Cayne sound a tad like Nero only you have to add the fiddle.

As we know, the short term debt market had literally collapsed. Firms not wanting to have Bear Stearns on the other side of their trade stopping taking orders from anyone that would be using them as a clearing bank or charged a stiff premium. Adding to its problems, Bear had to refinance over $100 billion in short term loans every morning and without any market a liquidity crisis soon ensued. A separate market existed for insurance on brokerage transaction and on March 13, 2008; insurance on Bear Stearns transactions hit an improbably $730,000 per million of insurance. We believe that to be the all-time high since the inception of this service. That figure was $100,000 higher than the previous record set by Countrywide.

As our guru from Morgan put it; "One reaction is shock that a company (Bear Stearns) that reaffirmed its book value at around $84 on (Wednesday) can be worth $2 per share four days later on Sunday," Deutsche Bank analyst Mike Mayo said in a note to clients on JPMorgan.

Bear Stearns also created some problems for itself in other areas of the market. According to the Wall Street Journal[29]…”Some other hedge-fund managers say they’ve been bullied by securities firms when they’ve tried to cash out on profits from such positions. When one hedge-fund manager considered selling out of a credit-default swap—in which his fund bought protection on $10 million of bonds of Countrywide Financial Corp. – He says the firms – Bear Stearns Cos., which sold him the swap, and Morgan Stanley – told him they would cash him out of his profitable position, only if he would simultaneously enter into another swap-selling insurance protection on the bonds equal to his fund’s $3 million profit. Eventually, he says, his fund sold the position through Goldman Sachs Group Inc. and Lehman Brothers Holdings Inc., allowing him to book the $3 million profit. Representatives for Bear Stearns, Morgan Stanley, Goldman and Lehman all were asked to comment on this bizarre incident, declined to comment.

Bear Stearns was not the first Investment Bank to collapse and it certain won’t be the last. However, people will be looking for the next shoe to fall and it will not be hard to identify the next candidate for failure. Wall Street is a Street of vultures. When they start smelling dying meat in the air, they start circling the playing field looking for their next meal. These meals can come in two sizes, the ones that fall of their own incompetence or they can be made to fail if Wall Street does not extend credit, or trade with them or spread rumors about them. This was George Soros’ strategy when he went after various international currencies. He created a self fulfilling prophesy that was more powerful than the central bank backing the currency themselves.

This one is going to be much easier to accomplish. Several hedge funds get together and short colossal numbers of shares and then spreading the rumor that the company is going under. This will cause an almost immediate collapse under the economic conditions in place today. This scenario can be easily addressed by temporarily banning short sales until the air clears. The solution may set a bad precedent but if you can’t make money on declining values there is no longer a benefit to spreading rumors that are honed to spread panic.

Bear Stearns isn’t the first troubled investment bank to seek a buyer, and it likely won’t be the last. The Wall Street Journal on March 17^th 2008, took a not-so-random walk through the Street relative to previous large failures and how they fared when trouble hit them.

“Drexel Burnham Lambert: Drexel was hit by the unexpected downturn in the junk-bond market in the late 1980s, just as Bear Stearns has been hit by the downturn in the subprime-mortgage markets. Drexel, like Bear, also faced rumors of a liquidity squeeze. In 1989, Drexel’s troubles caused it to post the first operating loss in its 54-year history; in 2007 Bear posted the first loss in its 83-year history.”

“Then there is the market karma: Drexel racked up many resentful counterparties and such powerful enemies as former Dillon Read banker Nicholas Brady, who later became Treasury Secretary. Similarly, many in the trading community were resentful that Bear didn’t put money into its two collapsed hedge funds last year—and that Bear refused to pitch in on the bailout of Long-Term Capital Management in 1998. Drexel faced a dark future when its civil liabilities and its problems with solvency scared buyers away, and the Fed rejected Drexel’s own restructuring plan for its business. Mr. Brady, who eventually became Treasury Secretary, rejected a government bailout of the firm and advised Drexel to file for bankruptcy protection.”

From an historical perspective, Drexel did file for Chapter 11 and was put into a runoff mode called NewStreet. .A trustee (actually four trustees who came from bankers that were formerly from Drexel) was appointed and the liquidation handled by distressed credit managers. The trustees gave back Drexel’s interest in various partnerships along with some private equity funds along with miscellaneous vesting benefits. The unraveling was successful and the unsecured creditors we repaid in full, which was the best possible outcome.

“Kidder Peabody: One of the vaunted securities firms of the Northeast, Kidder Peabody was bought by General Electric in 1986. Thereafter, it was plagued by scandals, including insider-trading cases involving Martin Siegel, head of arbitrage Richard Wigton (charges were later dropped), and trader Joseph Jett (who a judge originally found not guilty of securities fraud but, in 2004, the SEC reversed that decision and upheld the charges). Jett wrote a book about his experiences, “Black and White on Wall Street: The Untold Story of the Man Wrongly Accused of Bringing Down Kidder Peabody.” In 1994, General Electric sold Kidder to PaineWebber for $70 million. That was the effective death of the Kidder Peabody legacy; the 129-year-old PaineWebber was sold to UBS.”

“Salomon Brothers: The firm was forced to pay a huge regulatory fine for allegedly submitting false bids on Treasury bonds. Warren Buffett took over the firm for 10 months and saved Salomon when it was briefly banned from trading Treasury’s by intervening with regulators. Mr. Buffett later said he believed Salomon might have gone bankrupt and brought the world’s financial system to a standstill—as many believe might happen were Bear to fall. Buffett sold Salomon to Sanford I. Weill of Travelers Group for $9 billion. Salomon’s name survived for a time as Salomon Smith Barney. Though some veterans still work there, they have been subsumed into Citigroup’s investment bank.”

meanwhile back at the ranch

The FBI has now been brought in to attempt to determine exactly who did what to whom and when and why did they do it. Countrywide along with fifteen other subprime companies (whatever that means) are being looked at under a microscope regarding misrepresentations about the quality of tits packages of mortgage loans in securities filings. Moreover the regulators are examining mortgage-origination fraud, conflicts of interest and undisclosed relationships within the industry. Furthermore they are looking at and the practices used to package mortgage-backed securities for sale to investors. Naturally Countrywide takes center stage as during the years 2004 and 2007 they were gleefully churning out over $100 billion of these little devils, neatly tied up with a ribbon.

It is charged that they were aided and abetted by more than a dozen Wall Street firms that needed to poke their fingers into the mix in order to insure that they received their fair share of the proceeds or more. However, this sounds like Wall Street business as usually, not an attempt to steal more than they could carry. Federal investigators according to the Saturday/Sunday Wall Street Journal of May 8 and 9 states: Federal investigators are looking at evidence that may indicate widespread fraud in the origination of Countrywide mortgages, said one person with knowledge of the inquiry. If borne out, that could raise questions of whether company executives knew about the potential prospect of Countrywide’s mortgages going bad as it moved down the conveyor belt toward the end buyer. The Government now seems to believe that substantial amounts of this paper were earmarked for failure before it left Countrywide’s warehouse. The only question that seems left to answer is, “How far up the chain did that knowledge go” There is no issue that there was a lot of crap was packaged along with these awful subprime loans. Possibly forgeries or even worse, whatever that would mean.

However, there seems to be no questions that have arisen from the FBI’s seemingly on-target witch hunt. It would appear that it is based on information from informed sources that the folks at Countrywide were not all that forthcoming in accounting for their massive losses. This would add substantial seriousness to these matters that are subject to this ongoing investigation. However, charges are already out there regarding improper accounting. Countrywide is already being probed in Illinois and the city and state of New York on criminal charges. These are both publicly more far ranging than the FBI investigations mandate. The look-see includes Goldman Sachs Group Inc., J.P. Morgan Chase Co and Lehman Brother Holdings Inc. Where there is a little smoke, there is often a lot of fire.

More to the point Countrywide is charged with misleading investors by falsely representing that Countrywide had strict and selective underwriting and loan origination practices, ample liquidly that would not be jeopardized by negative changes in the credit and housing markets and conservative approach that set it apart from other mortgage lends.

Countrywide at its peak was writing an amazing 20 percent of home loans in the United States. Their servicing account still exceeds $1 billion and recently last month Countrywide lost in the fourth quarter of 2007 alone, $422 million.

I would say that this stuff is getting a little hairy.

Where’s the beef?

From a general point of view, making money has become the avocation of infinitely more folks as the world’s commerce has expanded. Thus, small triangular piece of land on the very top of the pyramid of life (successful people) began to flatten as available wealth scattered among the expanding list of the richest people on the planet. A billion is no longer what it used to be. It has been said that if you took the top 1000 richest people on earth, their resources could buy everything on the planet. However, they are not the only people with money and everyone is chasing the good life. I believe that there is more money available than there are resources available for purchase which will eventually cause mass economic dislocations, inflation and devaluation of currencies. This is not something that will only affect the United States but will have to adjust to some sort of new world order. The gap between rich and poor is already becoming alarming and we are possibly looking forward to actual revolution should there not be an adjustment. This usually happens with economic catastrophes leveling the playing field. One only has to look at the raison d'être for the French and Russian Revolutions to realize that this economic boondoggle must deal with this adjustment one way or the other.

That is when the winds of economic impossibility started blowing over the cards and due to a lack of having any foundation at all, the end came quickly. Becoming infinitely rich historically required some royalty in one’s background, the creation of a product such as DOS; having a large army at your disposal or discovering a major oil field where various ways to become instantly wealthy. When this group began to include people having none of the previous attributes other than the guts to play Ponzi with other people’s money, the game had obviously changed for the worst rather dramatically. It now wasn’t only oil rich princes of tyrannical states wishing evil upon the world that had the wherewithal but those that were entrepreneurs as well. Separating oil from the ground and people from their money seemed to be part of the fundamental MBA degree taught in the Ivy League.

Reckless expansion and easy credit are clearly the principal villains of this scenario, aided and abetted by high stakes poker players that were put in charge of lending money at the banks. To think that someone such as Jérôme Kerviel of Société Générale could invest and lose an amount of money substantially larger than the GDP of most countries within an international bank and then spend his days gambling with the proceeds over a substantial period of time is beyond our belief. This man was playing with a sum of money that is close to the combined wealth of Bill Gates and Warren Buffett combined and yet the bank never saw it coming. $60 billion is still a lot of money and for an untrained low level bank trader to be able to throw it around like popcorn is beyond conception. However, it is not only the rogue trader that causes havoc within an organization. Merrill Lynch, UBS[30] and Citibank became suicidal during this period and continued to bet the house on securities only an idiot savant would think acceptable. Though I would not want to anger the Idiot Savants community so, perhaps they wouldn’t commit these suicidal practices at all. Then if not them, who?

“Société Générale said Thursday that the rogue trading scandal uncovered last month, combined with significant write-offs of U.S. subprime mortgage investments, had pushed it to a record quarterly loss. The French bank declared a €3.35 billion, or $4.95 billion, net loss for the fourth quarter of 2007, compared with a gain of €1.18 billion a year earlier.

Société Générale - which has blamed the bulk of its troubles on an "exceptional fraud" by a 31-year-old junior trader, Jérôme Kerviel - reported an 82 percent plunge in net profit for the year, to €947 million. The bank also said it had booked write-downs and provisions worth €2.6 billion linked to its holdings of collateralized debt obligations and mortgage-backed securities. The results followed the publication late Wednesday of an independent report that found that Société Générale had failed to follow up on at least 75 alerts raised by its risk control officers, compliance officers and accountants over the course of two years.