Bethany McLean Mon, 02 Jun 2014 21:45:27 +0000 en-US hourly 1 How corporate jets fly under shareholder radar Wed, 28 May 2014 13:40:11 +0000 F

Men’s apparel retailer Jos. A. Bank may be best known for its incessant advertisements of all the merchandise it has on sale. “Could they advertise more? Could they sell less?” quipped Jerry Seinfeld. “We’ll give you three suits for $8! Just take it! Get it out of here!”

So in a twisted kind of way, it’s perfect that the company and its chairman of the board, Robert Wildrick, have recently pulled off a different kind of super sale. In March, competitor Men’s Wearhouse agreed to buy Jos. A. Bank — for $65 a share, about a 55 percent premium to its share price last fall. Wildrick served as the chief executive officer until 2008, and is often given credit for growing the business from a struggling retailer into a national brand. He now has a consulting agreement with the company that pays him $825,000 a year, and has earned over $200,000 a year in his role as chairman.

Seinfeld might be surprised to hear it, but there is a piece of merchandise that Jos. A. Bank doesn’t advertise. According to Federal Aviation Administration records, Jos. A. Bank leases a private plane, and not just any private plane — a high-end Dassault Falcon 2000EX. A reader of Jos. A. Bank’s financial statements would almost certainly not be aware of the existence of the plane.

What’s interesting is that despite all the furor about corporate jets, and the complaints about executive compensation, experts say this situation is not uncommon. “It’s entirely possible that a company could have a jet and not have it be disclosed in the proxy statements,” said Andrew Liazos, a partner at law firm McDermott Will and Emery, who heads the firm’s executive compensation group. Indeed, Jos. A. Bank is a perfect example of how a company can thread the needle of the disclosure rules about jets — without breaking any laws.

Jos. A. Bank’s plane is not identified in the company’s financial statements. I searched its proxy statements and 10Ks going back to 2003 for the terms “jet,” “personal use,” “aircraft,” and “airplane,” and found nothing related to this aircraft. And this is technically proper — if the plane is being used entirely for business purposes. If its executives or directors are allowed personal use, and that use exceeds a certain dollar value, it must be disclosed in the proxy statement. According to the SEC, a company is required to report as “’All Other Compensation’ perquisites and personal benefits if the total amount exceeds $10,000, and to identify each such item by type, regardless of the amount.” It wouldn’t take much flying on a Falcon 2000EX for the benefit to exceed $10,000. According to Jos. A. Bank spokesman Tom Davies, its plane is used entirely for business purposes, so no disclosure is necessary.

But here’s where things get a little more contorted. Jos. A. Bank is headquartered in Hampstead, Maryland. Yet the jet’s lease says the jet is hangared in West Palm Beach, Florida — which is where board chairman Wildrick lives. The company’s director of aviation, Jeff Michlowitz, also lives in Florida, according to property records. A now-expired advertisement for a second pilot included in its job description “some weekend flying and occasional Sunday relocations” and read “MUST LIVE WITHIN 1 HOUR FROM PALM BEACH INTERNATIONAL AIRPORT.”

If the chief executive officer of a company — which Wildrick was until 2008 — were using a jet to commute from home to the office, that would qualify as personal use. (According to the FAA, the first payment on the lease was due in May 2004.) In such circumstances, the jet should have been disclosed. Aha!

Yet a 2001 amendment to Wildrick’s employment agreement established “additional executive offices at a location in the Palm Beach, Florida metropolitan area” and specifically allowed Wildrick to “conduct the affairs of the company from the Palm Beach office.” Given that, the travel between Florida and the company’s Hampstead, Maryland headquarters would be considered a business expense, and wouldn’t have had to have been disclosed — even when he was CEO. Now that he’s a director, travel between Palm Beach and Hampstead would still qualify as business use.

This strikes some corporate governance experts as odd. “It’s highly unusual to have a corporate jet based where the directors are, and not where the executives are,” says Lynn Turner, the former chief accountant of the SEC, and a former board member at both public companies and institutional investors. “It would be significant information for the investors in that company.” It also seems strange that a company would have a jet that was just for the use of the chairman of the board.

FBut Michlowitz, the company’s director of aviation, says the plane is not just for Wildrick’s use. He says that other executives also use the plane to visit the stores and scout out new real estate. He adds that Wildrick barely uses it at all anymore. Asked why, given those circumstances, the plane is still kept in Palm Beach, he responds that inclement weather and increased difficulty of maintenance at facilities near cold, snowy Hampstead make Palm Beach a sensible decision. He adds that the other executives fly commercially down to Palm Beach, and then use the plane from there. He also reiterated Davies’ point, which is that the plane is used entirely for business.

Putting all this aside, doesn’t the cost of a plane still have to show up somewhere in the financial statements? Well, yes, sort of. Many corporate aircraft are leased, rather than owned, and Davies confirms that this is the case with Jos. A. Bank’s plane. Since the plane is classified as an operating lease, the payments are a form of off-balance-sheet financing — which must be disclosed, according to the SEC, albeit not in granular enough detail to tell that they are for a plane.

In its financial statements for the year ending in January 2005, Jos. A. Bank says that its “principal commitments are non-cancelable operating leases in connection with its retail stores, certain tailoring spaces, and equipment.” The plane, according to Davies, is part of that “equipment.” Would you ever have guessed?

At the time of that first lease payment, Jos. A. Bank’s stock was selling for about $13 per share. In fiscal 2004, the company’s net income was just $24.5 million — close to the $24 million price of the plane! Back then, and even before the sale to Men’s Wearhouse, shareholders might have wanted to understand what benefit they were getting from the use of the plane. But given the deal — which means that anyone who bought at the time the company got its jet has just about quadrupled her money — it would be hard to find a shareholder who would complain now. (Calls to two Men’s Wearhouse spokespeople were not returned.)

Maybe the larger question is this: Would Jerry Seinfeld still call what Jos. A. Bank is selling “cr*p” if he knew it included a Falcon 2000EX?

PHOTOS: Dassault Falcon 2000LXS (Source: REUTERS/Courtesy Dassault Aviation)

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Fannie and Freddie are more complicated than that Fri, 21 Feb 2014 18:11:16 +0000 This article was written in response to “How Ralph Nader learned to love Fannie and Freddie” (February 18) by Bethany McLean.

Bethany McLean’s article deserves a number of clarifying responses.

McLean injects an air of complexity and confusion with regard to my positions on a number of separate issues in what seems to be an attempt to imply a more interesting narrative for her article than exists in reality. Some clarifications are in order:

In the 1990s and early 2000s I opposed corruption in the government-sponsored enterprises (GSEs). I was clear about my admonition of the government subsidies they received in the form of an implicit government guarantee without meeting their obligations to advance affordable housing. I was clear that their drive for profits could tempt them deeper into murky legal waters. My opposition to their management compensation packages and questionable accounting practices were made plain.

Now I am advocating for the GSEs’ shareholders’ rights. This is an issue separate from the previous transgressions and corruption.

In its conservatorship of the GSEs, the federal government has used and abused GSE shareholders. It has unfairly treated the GSEs differently than other bailed-out corporations that were equally -- or more -- at fault for the financial crisis.

For example, AIG and Citigroup shareholders were given a chance to share in their companies’ recovery. In the Treasury Department’s unilateral amendment of the preferred stock purchase agreements in 2012, the federal government unlawfully changed the terms of its initial investment to its own benefit.

I have long been an advocate for shareholder rights. This is not an issue of supporting Fannie Mae and Freddie Mac in their previous incarnations, but an issue of the rule of law.

There exists a more nuanced position than one of the two extremes of proposing that we either completely eliminate the GSEs or that we maintain them without any reform, warts and all.

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How Ralph Nader learned to love Fannie and Freddie Tue, 18 Feb 2014 21:34:58 +0000

Corrects story issued February 18 in third-to-last paragraph regarding efforts to contact Ralph  Nader.

“It is time for [government-sponsored enterprises] to give up ties to the federal government that have made them poster children for corporate welfare. Most of all, Congress needs to look more to the protection of the taxpayers and less to the hyperbole of the GSE lobbyists. –Ralph Nader, testimony before the House Committee on Banking and Financial Services, June 15, 2000

“Fannie Mae and Freddie Mac should be relisted on the NYSE and their conservatorships should, over time, be terminated. –Ralph Nader, letter to Treasury Secretary Jacob Lew, May 23, 2013

People certainly do change.

Right now, one of Ralph Nader’s key projects, Shareholder Respect, is supporting a group called Restore Fannie Mae. They are fighting for “an end to the unconstitutional conservatorship of Fannie Mae and Freddie Mac by the U.S. government.”  To that end, Nader has written an op-ed in the Wall Street Journal, “The Great Fannie and Freddie Rip-Off” and sent the above letter to Treasury Secretary Jack Lew, as well as one to the new Federal Housing Finance Authority director, Mel Watt. Nader also held a roundtable to drum up support for the cause, which largely seems to be about making sure shareholders get paid–but which seems an argument for a return to the status quo.

For most of their existence, Fannie and Freddie have been controversial.  Critics argued that their gains during good years would go to shareholders and executives, while taxpayers would be saddled with any losses, thanks to an implicit government guarantee. That’s indeed what happened during the 2008 economic crisis.

Critics soon began to assert that the government-sponsored enterprises were largely responsible for the financial calamity. The more extreme critics, like Representative Jeb Hensarling (R-Tex.), now want the GSEs wiped out and the government completely out of the housing market. Even former Representative Barney Frank, once one of the GSEs’ strongest defenders, now says they should be abolished. In polite society, you do not dare say that the GSEs should be restored to their old selves.

The funny thing is, as his 2000 testimony shows, Nader was once among these GSE critics. You have to go back to the late 1990s, when what became an underground war against the GSEs had barely gotten started. Louisiana Representative Richard Baker was, at that point, one of the few people willing to get bruised trying to rein in the then very powerful housing giants. Baker tried to pass a bill that would tighten regulation of GSEs.

Nader’s congressional testimony was in support of Baker’s bill. He was vehement, warning that the GSEs would cause a taxpayer bailout similar to the late 1980s savings and loan crisis if the rules weren’t changed. (“Ralph Nader Predicted Wall Street Meltdown 8 Years Ago” read the headline on a Nader press release during his 2008 presidential campaign.)

“We are obviously not talking about GSEs interested only in providing the American dream of home ownership,” Nader said.  “They have a big appetite that grows bigger as they saturate the mortgage market. They will reach out for more to maintain their high level of profits and shareholder dividends.”

It’s unclear how Nader got involved in the anti-GSE crusade. One longtime GSE watcher says that a guy named Jake Lewis, who worked as Nader’s spokesman around that time, previously had been a spokesman for the old House Banking Committee (now known as the House Committee on Financial Services). Armando Falcon, who became the head of Fannie and Freddie’s regulator and a huge opponent of the GSEs, was counsel to the House Banking Committee around that time. The longtime GSE watcher speculates that Falcon sparked Lewis’s interest, and maybe Lewis, in turn, sparked Nader’s.

Whatever the case, Tim Howard, Fannie Mae’s former chief financial officer,  recalls in his new book, The Mortgage Wars: Inside Fannie Mae, Big-Money Politics, and the Collapse of the American Dream, that Nader helped to organize a 1999 conference where anti-GSE types could complain.  (Ironically enough, Restore Fannie Mae calls The Mortgage Wars a “fantastic read,” which it is.)

It wasn’t long after this that the war got started in earnest. The big lenders and mortgage insurers started an organization called FM Watch, with the goal of curtailing Fannie and Freddie’s power. Then, in the wake of Enron, the George W. Bush White House, terrified of another scandal on its watch, decided to take on the GSEs. Both Fannie and Freddie had to do multibillion-dollar accounting restatements, and the chief executive officers and other top execs at both firms resigned. (At one point, I was sure that Fannie and Freddie were the bad guys. I’m less sure today. There are certainly two sides to the story, and if you want to understand the other one, read Howard’s book.)

Even after the denouement, Nader stayed involved. In 2006, he wrote a letter to then Securities and Exchange Commission Chairman Christopher Cox. “As you continue to investigate the Fannie Mae accounting debacle,” Nader wrote, “we are writing to urge you to seek civil sanctions, including disgorgement, from senior executives who profited directly from the misconduct at Fannie Mae, and that you urge the Department of Justice to give careful consideration to criminal prosecution of these individuals.”

Perhaps the most surprising thing is that despite his prescient warnings and his dislike of the GSE business model, somewhere along the way Nader bought stock in Fannie and Freddie.

As it turned out, the mid-2000s victory over the GSEs was small in comparison to what came later. When Fannie and Freddie were put into conservatorship in September 2008, the Treasury took 79.9 percent of their common stock and $1 billion in preferred stock. Which meant the Treasury had to be paid in full before any other shareholders realized anything.  The Treasury also charged the GSEs a 10 percent interest rate on funds advanced to cover their capital shortfalls, double the rate the big banks had to pay on the money they took. Then, in 2012, Treasury replaced the 10 percent dividend with a “net worth sweep,” which in essence meant that Treasury would take every dollar of profit the GSEs made. In other words, it was now impossible for Fannie and Freddie ever to pay back the government.

In Nader’s Wall Street Journal op-ed, he wrote that even after the conservatorship, “some faithful shareholders, including me, held on, believing that they might have a chance to recover something–as did their counterparts in Citigroup, AIG and the rest of the rescued.” He also writes that the “mistreatment of the Fannie Mae and Freddie Mac shareholders, including me, is uniquely reprehensible.” He wants shareholders (and taxpayers) to recoup some of the benefits of profitable GSEs.

Nader is right. At one point, you could have argued that the disparate treatment of the GSEs and the big banks was warranted because the GSEs required a lot more money. At the peak of the crisis they required $188 billion in total from the government, versus the $10 billion to $25 billion that the big banks each took as part of the 2008 Troubled Asset Relief Program.

Then again, there are lots of other ways in which the government financially supported the banks. At one point there was also an argument that the GSEs, unlike the banks, would always be a black hole, draining money from taxpayers. But that hasn’t turned out to be true either: The GSEs will soon have sent more to the Treasury than they took.

In addition to Nader’s past opposition to the GSEs, there’s another irony here. Restore Fannie Mae describes itself as a “group of concerned taxpayers, students, families, shareholders and citizens who are dedicated to establishing fairness in America’s housing market.” But it is also aligned with the interest of powerful financial firms–not Nader’s usual pals!–including hedge fund Perry Capital and mutual fund Fairholme Capital.

Both Perry and Fairholme have sued the government, arguing that the 2012 restructuring of the conservatorship was illegal. Theodore Olson, the former U.S. solicitor general turned Gibson & Dunn lawyer who is representing Perry Capital, spoke at Nader’s Feb. 5 roundtable, discussing the impact of conservatorship on the GSEs.

Maybe it’s fitting that the topic of housing makes for interesting bedfellows. This past weekend, New York Times columnist and long-time GSE critic Gretchen Morgenson also wrote a piece sympathetic to the shareholder point of view.

Apart from getting his money back, it isn’t clear what Nader’s goal is.  What he doesn’t want is to see the housing market handed to the banks, which would be the result of most of the GSE reform bills now circulating around Congress. Restore Fannie Mae makes a point of saying that “responsible lending standards” should be enshrined in the GSEs’ charters. But if Nader wants a fundamental change in their structure from the pre-2008 days, I can’t find a clear overview of what that is.

Messages seeking comment sent to Nader’s organization and Restore Fannie Mae through their websites received no response from Nader. Nader was not contacted directly. Nader didn’t return messages to his organization or to Restore Fannie Mae asking for comment. So we have no answer as to why he seems to have changed his mind on the GSEs.

Is it just a story of pure hypocrisy, the way we can all change our minds when our own money is at stake? Or did the 2008 fiscal crisis, along with the right’s highly politicized efforts to blame it on the GSEs, make Nader realize that the alternative of the big banks might be worse?

Has Nader come to believe, in a twist on Winston Churchill’s famous saying about democracy, that the GSEs might be the worst possible way to finance housing–except for all the others?


PHOTO (TOP): A sign advertising bankruptcy filing hanging off a road sign in San Bernardino, California, September 11, 2012. REUTERS/Lucy Nicholson

PHOTO: Ralph Nader at the National Press Club in Washington, February 28, 2008. REUTERS/Molly Riley

PHOTO: The Fannie Mae headquarters is seen in Washington, November 7, 2013. REUTERS/Gary Cameron

PHOTO: Treasury Secretary Tim Geithner participates in the Obama administration’s Conference on the Future of Housing Finance in the Cash Room of the Treasury Building in Washington, August 17, 2010. REUTERS/Jason Reed


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Is Steve Cohen the real target in this trial? Wed, 05 Feb 2014 22:11:25 +0000

The fate of Mathew Martoma, the former SAC Capital portfolio manager charged with the biggest insider trade in history — more than $275 million in profits and avoided losses, says the government — is now in the hands of a 12-person jury, which began deliberations in a Manhattan courthouse Tuesday afternoon.

But whatever the verdict for Martoma, the trial has been bad news for someone else: Martoma’s former boss, SAC head Steve Cohen. Given the slow, but relentless, nature of the government’s actions against Cohen, it might be worth remembering the old adage: It ain’t over til it’s over.

Cohen has, to date, famously avoided any criminal charges personally — despite a string of other government actions against both him and his firm. Last March, SAC agreed to pay more than $600 million to settle civil insider trading charges, brought by the Securities and Exchange Commission, involving Martoma’s trade. Then, on July 19, the SEC charged Cohen with failing to supervise his employees, alleging that he “received highly suspicious information that should have caused any reasonable hedge fund manager to investigate the basis for trades” made by Martoma and another manager.

SAC quickly fired back. A 43-page internal white paper rebutting the SEC’s charges was leaked to the press. In it, SAC claimed that its compliance efforts were so fantastic that the SEC was just wrong, wrong, wrong in accusing Cohen of failing to supervise his employees.

Among other things, the firm’s lawyers wrote, “SAC’s compliance team, with Cohen’s full support, deploys some of the most aggressive communications and trading surveillance in the hedge fund industry.” That included a “review of trading made around market moving events and corporate access events” along with “regular reviews of the firm’s most-profitable trades.” SAC lawyers also asserted, “Cohen has frequently forwarded to compliance staff communications he receives that caused him concern.”

It’s long been clear that the government doesn’t agree with that picture of righteousness. The very next day, the Justice Department filed a criminal case against SAC, though not against Cohen, alleging that his firm “failed to employ effective compliance procedures.” Prosecutors noted that six former SAC employees had pled guilty to insider trading, yet SAC’s vaunted compliance department had “contemporaneously identified only a single instance of suspected insider trading by its employees in its history.”

Last fall, SAC paid more than $1 billion to settle the charges.

At that time, there was a lot of commentary, and rage, that Cohen himself had pretty much walked away. But that was never true.

If the SEC wins its failure to supervise case against Cohen, there could be more fines. More importantly, the SEC could try to limit his ability to be involved with public companies, and could seek to bar him from managing other people’s money for a long time. In addition, in December, a close Cohen lieutenant named Michael Steinberg was convicted of insider trading. It is wrong to think that the feds are done with their investigation of Cohen.

Fast forward to the Martoma trial, which has featured testimony from current SAC employees, including top traders Chandler Bocklage and Phillip Villhauer, and Peter Nussbaum, the longtime general counsel. At times, the thrust of testimony has veered dangerously toward Cohen — and not in a totally flattering way.

At one point, Bocklage called Cohen the “greatest trader of all time,” and a defense lawyer began to ask what made Cohen so great. Judge Paul Gardephe warned, “General questions about how Steve Cohen conducted his trading I think are very dangerous — dangerous in the sense that they represent a risk of opening the door to a broader examination of how Steve Cohen did business.”

But more important, Martoma’s defense has undercut some of the assertions in that strident white paper. Martoma is charged with using inside information to first help SAC amass big positions in two pharmaceutical companies, Elan and Wyeth, heading into a big meeting where critical data would be released, and then persuading Cohen to sell, and also short, the stocks based on confidential information that the data would be negative.

When SAC sold its shares in Elan and Wyeth, Cohen had the traders use “dark pools” and algorithms to limit how many people both inside and outside SAC were aware of the trade. In its white paper, SAC said that this was a “customary trading practice” and was “reasonable” — given how leaks about SAC unloading a large position could cause the stocks to fall.

Those are totally fair points.

But what no one said was that to limit visibility into the trades even more, they weren’t done in Cohen’s or Martoma’s account. Instead, Villhauer had the operations people use two additional accounts that even fewer people could access. The sales were done there. Later, they were transferred back into Cohen’s and Martoma’s accounts.

This does not seem to have been customary.

“Mr. Villhauer,” one prosecutor asked, “can you recall another instance prior to July of 2008 in which the firm sold a large position using firm accounts and then transferred the sales later to the accounts that held the long position?” “I cannot,” Villhauer responded. Bocklage also testified that he did not learn about the sales until afterwards — and said that he could not recall any equivalent experience during his decade-plus at SAC.

That’s not all. The white paper also claims, “Cohen has frequently forwarded to compliance staff communications he receives which cause him concern.” Yet on the Elan and Wyeth trades, it does not appear that Cohen ever sought compliance’s input.

Prosecutor Arlo Devlin-Brown asked Nussbaum, “And compliance wasn’t informed that SAC sold $700 million of Elan and Wyeth in the week leading up to the ICAD announcement [where the pivotal data was released], was it?” “Not by a special notice, no,” Nussbaum answered. He continued, “I don’t think they were [aware of the trades]…because nobody came by and mentioned anything.” Devlin-Brown emphasized, “Nobody came by and mentioned anything?” Answered Nussbaum, “Correct.”

From that testimony, it does not appear that SAC’s compliance programs, including surveillance supposed to pick up SAC’s most profitable trades and flag big trades around market-moving events, picked up on the Elan and Wyeth trades. Which is shocking, given not just the size of the trades, but the fact that Elan’s shares lost more than 40 percent of their value after the release of the negative data, and Wyeth’s shares lost 12 percent.

There may be an explanation as to why these huge trades were missed. But the argument that SAC’s compliance regime is so rigorous that it by definition exonerates Cohen is looking a little more suspect.

The irony of this is that SAC is paying for Martoma’s defense — standard company policy. Which might be a twist on another old adage: Be careful what you pay for.


PHOTO (TOP): Former SAC Capital employee Mathew Martoma exits the Manhattan federal court following an appearance on insider trading charges in New York, November 26, 2012.  REUTERS/Brendan McDermid

PHOTO (INSERT): Hedge fund manager Steven A. Cohen, founder and chairman of SAC Capital Advisers, responds to a question during a one-on-one interview session at the SkyBridge Alternatives Conference in Las Vegas, Nevada, May 11, 2011. REUTERS/Steve Marcus



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Where is the political accountability for America’s pension disasters? Wed, 11 Dec 2013 22:03:53 +0000 Five years after the financial crisis, there’s still a hue and cry about sending people to jail. After all, financiers were, at best, self-servingly optimistic about the future. At worst, they said things that weren’t true, and made promises they couldn’t keep. Investigations are still ongoing, and although it’s doubtful, maybe some big guys will go to jail. But there’s another group of people who have injured, and are continuing to injure, millions of Americans with purposefully blind optimism and false promises. Those are politicians in every city and state that is facing a pension shortfall.

You can’t read the news without hearing about the pension problem. Last week, federal judge Steven Rhodes ruled that Detroit can proceed with the largest municipal bankruptcy in history, thereby allowing the city to cut billions of dollars in payments that are owed to city employees, retirees, investors and other creditors. In Illinois, Governor Pat Quinn signed into law a plan that will trim Illinois’s pension hole, which is viewed as being one of the deepest and darkest in the country. (Labor unions say they will challenge the plan in the courts; credit rating agencies have pointed out that the legal protection of pension benefits is particularly strong in Illinois, so it remains to be seen what will happen.)

Inevitably, there is more to come. Rhodes’s ruling could have implications for California cities, like San Bernardino and Vallejo, that are wrestling with bankruptcies. In Chicago, the pension hole is estimated at $20 billion, and according to the New York Times, payments to the local pension fund are expected to increase by $590 million in 2015 to a total annual contribution of almost $1.4 billion. “Should Chicago fail to get pension relief soon, we will be faced with a 2015 budget that will either double city property taxes or eliminate the vital services that people rely on,” Mayor Rahm Emanuel told the Times.

There is disagreement about the size of the problem — it depends on how optimistic you are about the future, and how you truly account for pension liabilities — but most people agree that a problem exists. Estimates of the size of the hole range from almost $1 trillion to well over $4 trillion, according to a 2012 paper by the Kennedy School. In a recent report, the credit rating agency Moody’s, which calculates the pension hole using something called adjusted net pension liability — basically, the difference between the value of a pension plan’s assets and its future benefit payments adjusted for a present-value calculation — wrote that “several large local governments have pension burdens large enough to cause material financial strain.” For instance, in Chicago, the adjusted net pension liability is 678 percent of its annual revenue; 28 other local governments in Moody’s list of the top 50 (based on the amount of debt outstanding and whether or not Moody’s rates them) have an adjusted net pension liability that is greater than their annual revenue. Four of the top 50 local governments have actuarial contribution requirements in excess of 15 percent of operating revenues. In fiscal 2011, 33 of the top 50 local governments contributed less than what was actuarially required. And so on.

The argument generally centers on whose fault it is. You can pick your villain: Labor unions, Wall Street, the rich, the recession, an uncooperative market that can’t deliver the ridiculous 8 percent returns that many plans have counted on, the politicians. In simple terms, the right wing generally blames the unions for negotiating what some view as overly generous packages, while the unions have mostly argued that their benefits are legally protected by the state, and therefore cannot be cut back. Both miss the point. The unions should be angry about the underfunding of their pension benefits, while no one should be angry at the unions: it was their job to get the absolute best deal for their constituents that they could, and so they did. It doesn’t really matter if the promises were too generous or not generous enough: they were promises, and people relied on them.

There’s only one group whose job it was to navigate a course between different groups with different interests, and not to make promises that couldn’t be kept. That’s the politicians. And they have repeatedly failed.

Take Detroit. The Detroit Free Press, which analyzed the city’s history back to the 1950s, says that “its elected officials and others charged with managing its finances repeatedly failed — or refused — to make the tough economic and political decisions that might have saved the city from financial ruin.” The paper concluded, “When all the numbers are crunched, one fact is crystal clear: Yes, a disaster was looming for Detroit. But there were ample opportunities when decisive action by city leaders might have fended off bankruptcy.” The story quoted Bettie Buss, a former city budget staffer who spent years analyzing city finances for the nonpartisan Citizens Research Council of Michigan, and who said, “That was the whole culture — how do we get what we want and not pay for it until tomorrow and tomorrow and tomorrow?”

Indeed. That seems to be the culture in lots of places. “For years, cities have promised rock-solid pensions without setting aside enough money to pay for them, aided by lax accounting practices, easy borrowing and sometimes the explicit encouragement of labor unions,” wrote the New York Times last week. “Officials were counting on rich investment gains to fill the holes; unions and their retirees were counting on legal provisions — like Michigan’s Constitution — that said pensions were unassailable and that benefits would always be paid, whether through higher taxes or budget cutbacks elsewhere.”

Doesn’t that sound just like bankers counting on home prices going up forever, and investors believing that a triple A rating was invincible? Maybe you can argue that the politicians didn’t know any better. But they’ve certainly gotten warnings, just as bankers did. According to the New York Times, way back in 1978, an actuary named Russell Mueller filed a report. He quoted a Michigan state representative, Dan Angel, complaining about the way pensions in his state were being granted. “This takes place in a totally political atmosphere, without any regard for how the bill will be paid, by whom, and when,” Angel said in the report. “Employees had better get concerned that there is enough cash on hand to meet retirement needs, and taxpayers had better get concerned with these massive and increasing debt obligations.” “Public pension legislation is inevitable,” Mr. Mueller concluded in his report. But as the Times reported, state and local officials shot down the proposed federal funding requirements. Let’s remember that the next time we complain about bankers lobbying against new regulations.

I certainly don’t know what the solution is, and I don’t envy anyone who has to grapple with these intensely difficult issues. But especially at this point, there’s just one word that describes politicians who promise to pay that which cannot be paid: Fraud.

PHOTO: Detroit firefighter Darrell Tucker holds a sign in front of the Federal courthouse as he rallies against cuts in their city pensions and health care benefits during a protest against the city’s municipal bankruptcy filing, in Detroit, Michigan October 23, 2013.    REUTERS/Rebecca Cook

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The top five unlearned lessons of the financial crisis Tue, 24 Sep 2013 15:20:35 +0000 In capital we trust. Capital is our savior, our holy grail, our fountain of youth, or at least health, for banks. Seriously, how many times have you read that more capital will save the banks from another Armageddon? Even the banks point to capital as a reason to have faith. “Financial institutions have also been working alongside regulators to make themselves and the financial system stronger, more transparent, more resilient and more accountable,” wrote Rob Nichols of the Financial Services Forum, which is made up of the chief executive officers of 19 big U.S. financial institutions. “Specifically, capital, which protects banks from unexpected losses, has doubled since 2009.” If you were a cynic — who, me? — you might say that the mere fact that the banks are pointing to capital is proof that capital is not all that.

Everyone seems to be ignoring the basic fact that capital isn’t a pile of cash. It’s an accounting construct. On his Interfluidity blog (which I found courtesy of Naked Capitalism), Steve Waldman writes, “Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much ‘capital,’ we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely ‘true’ model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank.” In other words, even if you give bankers credit for good intentions, the accounting that would truly capture “capital” may not exist. Or as Waldman writes, “Bank capital cannot be measured.” Layer in some real world realities. The next time things get tough, will regulators once again practice forbearance and allow firms to overstate their capital, which has the perverse effect of making no one trust reported capital? Let’s not forget Lehman, which according to Lehman had a very healthy Tier 1 ratio of 10.7 percent on May 31, 2008 and a total capital ratio of 16.1 percent. This didn’t matter, because no one believed Lehman’s capital was real.

On the list of cures for the sick financial system, the concept of “risk retention” ranks right behind capital — but there are a couple of neat little twists here. The narrative of the crisis is that because mortgages could be sold off to banks, who would turn them into securities and sell those on to investors, who thought they were buying triple-A paper courtesy of the rating agencies — well, no one had any incentive to care about credit quality. In a piece in the Wall Street Journal entitled “How to Create Another Housing Crisis,” MFS Investment Management’s former chairman Robert Pozen writes, “With ‘no skin in the game,’ the originators had little incentive to determine whether the borrower was likely to default.” As a result, one provision of Dodd-Frank requires securitizers of any asset, not just mortgages, to retain 5 percent of the risk of loss. Barney Frank has said that the risk retention rules are the “most important aspect” of the legislation that bears his name.

The first twist is how risk retention became risk liberation. The housing-industrial complex went to work. Into Dodd-Frank went a provision that certain “safe” mortgages, called qualified residential mortgages, or QRMs, would be exempt from the risk retention requirement. “Safe” was left to the regulators to define. Cue more lobbying. The rules finally proposed in late August would exempt, according to a Wall Street Journal piece by Alan Blinder, some 95 percent of mortgages from the risk retention requirement. In other words, the very asset that most people believed led to the credit crisis is also the asset that is pretty much exempt from the new rules! Classic. In the joint announcement on August 28, the regulators wrote, “The Commission acknowledges that QM does not fully address the loan underwriting features that are most likely to result in a lower risk of default. However, the agencies have considered the entire regulatory environment, including regulatory consistency and the possible effects on the housing finance market.” (That last bit is super scary.)

That said, the real twist here is that risk retention is no silver bullet. After all, firms like Countrywide, Washington Mutual, Merrill Lynch, AIG and Citigroup went under or almost went under precisely because they retained so much risk on their own balance sheets. Malevolence is only part of the problem with our financial system. The other problem is sheer stupidity.

Which leads to the next issue. So much of the safety of the financial system still depends on the Street’s ability to manage risk. But if the last years have taught us anything, it’s that risk management might be an oxymoron: Maybe risk is risk precisely because it can’t be managed. Just for the fun of it, I searched Merrill Lynch’s 2007 10K. They used the phrase “risk management” 76 times. “Subprime” was mentioned 11 times.

Next, I searched JPMorgan Chase’s 2012 10K and found 166 mentions of risk management. (Give or take — I got a bit dazed.) But while JPMorgan was busy talking about how great they were at risk management during the crisis, and while we were busy listening, the bank’s chief investment office was busy making crazy bets that ultimately cost the company more than $6 billion — bets that the CIO was valuing at different prices than the same positions were being valued in the investment bank, thereby violating a cardinal rule of Risk Management 101. And no one inside the bank seems to have noticed!

So now, JPMorgan is spending $920 million to settle civil charges brought by a host of regulators. A criminal probe is ongoing. As part of its settlement with the SEC, JPMorgan agreed that its trading losses “occurred against a backdrop of woefully deficient accounting controls” in its chief investment office; the OCC said in its consent order that the bank’s oversight “did not provide an adequate foundation to identify, understand, measure, monitor and control risk.” And according to the Wall Street Journal, JPMorgan is spending an additional $1.5 billion and committing 500 extra employees to get better at what it was supposedly already great at. “Fixing our controls issues is job No. 1,” CEO Jamie Dimon told the Journal. “This is a huge investment of people, time and money … but it will make us stronger in the long run.” Oh, I sure do hope so. But big banks are very subversive places.

Speaking of subversive, I think that both risk management and new regulations are set up to be subverted if the incentives aren’t right, too. (Put rules, regulations and incentives in a 2 on 1 Ultimate Fighting Championship, and incentives will score a knockout every time.) Yes, there have been lots of changes to incentives after the crisis. There’s more disclosure, and firms often have “clawback” provisions, meaning that bankers who do bad things have to give the money back. (Three JPMorgan traders were hit by this.) And bankers are getting a smaller percentage of their pay in upfront cash. A chunk, which is often in the firm’s stock, is held back, or deferred.

This is all well-intentioned and I’m trying to be optimistic. But the history of attempts to align individual compensation with a firm’s results is a case study in unintended consequences. (See stock options.) And there are warning signs about the current “fixes.” Take deferred compensation, which often means that bankers get a small part of their bonus in upfront cash, and the rest in stock, which can only be cashed out over a period of years. One problem is that for bankers to cash out their deferred stock, they often have to remain employed at the same place. One of the good things about the old system was that people moved on. Now, people are encouraged to stick around even if they’ve already checked out, thereby clogging up the system. “The inefficiency generated by the current illiquidity of people moving now can not be underestimated,” a former senior banker tells me.

While we’re on the subject of inefficiency, let’s talk about our regulatory system. In 2007, before most people realized there was a crisis brewing, Hank Paulson, then the Secretary of the Treasury, released the Blueprint for a Modernized Financial Regulatory Structure. You can dismiss this as writing reports while housing burned. Fair enough. But one of Paulson’s key ideas was to streamline the regulators, and he was right. As he later wrote about regulators in a Financial Times piece, “It is clear that their overlapping jurisdictions, gaps in jurisdictions and authorities, uneven capabilities and competition among themselves created the environment in which excesses throughout the markets could thrive.” We did get rid of the worst regulator, which was the Office of Thrift Supervision. But if you think the problem has been solved, just read the Wall Street Journal’s excellent piece on the skirmishing over the Volcker Rule (which seeks to ban proprietary trading by banks). According to the Journal, Treasury department officials had to bribe staffers from other agencies like the SEC with Bojangles fried chicken to get them to make the trek across D.C. History repeats itself, first as tragedy, second as farce.

PHOTO: People stand next to windows, above an animated sign, at the Lehman Brothers headquarters in New York September 16, 2008. REUTERS/Chip East (UNITED STATES)

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Taking government out of the mortgage business is harder than it looks Tue, 20 Aug 2013 15:42:05 +0000 Limbo. That’s the word most people use to describe the state of affairs in a critical part of our economy — housing finance. The government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, which were nationalized almost five years ago with the seemingly noble goal of eventually getting rid of them, now back some 90 percent of American mortgages. So much for good riddance!

But talk of reform finally seems close to action. Senator Bob Corker (R-Tenn.) and Senator Mark Warner (D-Va.) have proposed a bipartisan bill called, appropriately enough, Corker-Warner. Meanwhile, the House Financial Services Committee, led by Representative Jeb Hensarling (R-Texas), has produced its own bill, the more grandiosely entitled Protecting American Taxpayers and Homeowners, or PATH Act. Last Tuesday, during a speech in Phoenix, President Barack Obama weighed in. “Private lending should be the backbone of the housing market,” the president said. That same day there was also a housing policy forum at the George W. Bush Presidential Center in Texas, where, among others, Hensarling spoke.

Everyone (well, almost everyone) seems to agree with the president: Private lending should be the backbone of the housing market. But just how much private capital does that entail? Hensarling and most of the Republicans think the government should get out of the game entirely. American Enterprise Institute scholar Peter Wallison, a long-time critic of the GSEs, recently wrote a piece in the Wall Street Journal entitled “Competing Visions for the Future of Housing Finance,” in which he called any remaining government presence “faux reform.”

Corker and Warner (and Obama) want the government somewhat out of the way — but still there as a backstop. Then there’s the liberal Democrat wing, personified by Senate Majority Leader Harry Reid (D-Nev.), who announced in a radio interview that he fears Obama’s proposal will crimp home ownership. Unfortunately, these stances are too often vague stakeouts of ideological positions about the role of government — and too rarely about the very basic math of housing finance.

Right now, there is about $10 trillion of mortgage-related debt outstanding. Fannie and Freddie securities make up roughly $4.4 trillion — slightly less than half — of that. The largest holder, in turn, of these Fannie and Freddie securities are U.S. commercial banks, which in the first quarter of 2013 held roughly $1.6 trillion of them. Another huge chunk — more than $1 trillion — is held by the Federal Reserve. About the same amount is held by “the rest of the world” — often foreign central banks and sovereign wealth funds — and another chunk about that size is held by mutual funds. 

These buyers are often looking for particular things — things that they get because Fannie and Freddie guarantee the timely repayment of principal and interest on their securities. First off, that means the buyers don’t have to think about credit risk, but only interest rate risk. Indeed, so-called rates buyers, who arguably supply more than half of the mortgage credit outstanding (it is rates buyers who now purchase GSE securities) not only don’t want credit risk, but in some cases — for institutional, legal or regulatory reasons — they can’t take it. Therefore, they only want to own mortgages that are backed by Fannie or Freddie.

Among other things, they also want their investment to be liquid, meaning it can be traded easily. By contrast, private-label securities (shorthand for securities that aren’t backed by Fannie or Freddie) aren’t easily tradeable, because it’s complicated to analyze the credit underlying a huge package of mortgages.

Nor are new rules always designed to encourage investment in private-label securities. Under the final Basel III rules that will determine how much capital banks have to hold, banks will have to do their own due diligence, to the satisfaction of their regulator, on mortgage-backed securities that don’t have a Fannie or Freddie guarantee in order to determine the appropriate amount of capital that must be held against them. Securities backed by a GSE, on the other hand, automatically get favorable capital treatment.

So in Hensarling’s vision, which does not see any role for government in the mortgage market, you basically have to replace the investor base for the $4 trillion-plus in GSE securities with investors who want and can take credit risk, and are willing to invest in a far less liquid instrument. Four trillion dollars is lot of money; in a late 2010 article, CSFB analyst Mahesh Swaminathan estimated that a private-only solution would remove between $3 trillion and $4 trillion of funding from the U.S. mortgage market.

The Corker-Warner bill, to which Obama is closer in spirit, calls for a system where, in essence, mortgages will be bundled up and sold as securities, and private capital will absorb the first 10 percent of losses on those securities. After that, a government guarantee will kick in. But it’s not obvious that there’s enough capital market demand in the world even for this “first loss” piece. For the entire $4.4 trillion of existing GSE securities to be covered up to 10 percent first loss, you would need $44 billion $440 billion in capital.*

It’s also worth thinking about this on a monthly basis. Investors have been buying some $100 billion of Fannie and Freddie mortgage-backed securities a month. Issuance is likely to decline as rates rise, so let’s say it’s $80 billion a month. So you’d need to sell $8 billion a month in credit risk in order to securitize the entire $80 billion of mortgages.

Another idea is for a new breed of mortgage insurers — existing mortgage insurers mostly insure individual mortgages, not pools — to provide insurance for the pooled securities. If you assume the new insurers had to be capitalized at 10 percent, then they’d need a more manageable $9.6 billion in capital each year.

Those who argue for no government involvement in the housing market say that the current numbers are beside the point. In congressional testimony, Wallison said that the only reason the buyers of GSE paper didn’t want to take credit risk was because “these government-backed securities attract investors who do not want to take risks.” In his view, there are plenty of other investors who would step forward. After all, the private market finances lots of other stuff.

Others disagree, sometimes violently. A source of mine who is a big investor in GSE securities sniffs, “This is what you would expect to hear from someone who has never bought or sold a bond in his life, or managed according to investment guidelines, or had to defend an investment decision to an investment committee or fund’s board of directors. It is a think tank answer to a real world problem. Asset allocations do not change in the way he describes. Dollars that are invested in something with zero credit risk don’t get re-allocated into something that has credit risk, at least not in the same size and at the same price.”

And then, there are those in the middle, like Mark Zandi of Moody’s Analytics. According to the Wall Street Journal, Zandi thinks the capital will be there — but it will come at a higher price. Under the PATH bill, he estimates that mortgage rates would rise significantly and availability would decline. Even under Corker-Warner, he thinks rates would rise. As Journal columnist William A. Galston put it, “There are real trade offs, and the public deserves to know what they are.”

But there is another concern. The question isn’t just whether private capital would step up, but where it could come from. Remember, right now, U.S. commercial banks own $1.6 trillion of GSE securities. Theoretically, they could step up and own that plus more, all with credit risk. But does that accomplish the stated goal of removing risk from the taxpayer? Well, no: You’re just shifting risk from government-sponsored enterprises to government-sponsored banks. And as another source says, “If all the risks in real estate get shoved back into the banking system, the big smart guys will dictate the first time a panic occurs. Do you want Jamie [Dimon of JPMorgan Chase] or Lloyd [Blankfein of Goldman Sachs] determining who will get bailed out the next time there is a crisis?”

My new favorite quote comes courtesy of Hensarling, who in his prepared remarks for the Dallas forum said, “If, at the end of the day, taxpayers are still on the hook, then I fear all you’ve done is put Fannie and Freddie in the Federal Witness Protection Program, given them cosmetic surgery and a new identity and released them on an unsuspecting public.”

He’s right. If mortgage credit risk is shifted into the banking system, taxpayers are still on the hook. Fannie and Freddie may be better hidden — they’ll be camouflaged as banks — but they’re still lurking out there!

So the conversation, in the end, shouldn’t be about competing visions, because vision doesn’t have anything to do with how the market works. It should be about this beast (which can trick us into believing it’s been tamed) called mortgage credit risk. How much demand for it does a reform plan require? Is that demand likely to materialize, and if so, what is the source? And are the costs, whether they are on the backs of taxpayers or homeowners, acceptable to all of us? It’s math, not politics.

*CORRECTION (Aug. 23, 2013): This piece originally miscalculated how much capital would be needed to cover 10 percent of security loss. It is $440 billion, not $44 billion.

PHOTO: A sign in front of the Fannie Mae headquarters is photographed in Washington  February 11, 2011. REUTERS/Molly Riley

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The crackdown on bank misbehavior masks a troubling reality Wed, 07 Aug 2013 19:45:33 +0000 “Ex Goldman Trader Found Guilty for Misleading Investors.” “Bond Deal Draws Fine for UBS.” “JPMorgan Settles Electricity Manipulation Case for $410 million.” “Deutsche Bank Net Profit Halves on Charge For Potential Legal Costs.” “US Sues Bank of America Over Mortgage Securities.” “Senate Opens Probe of Banks’ Commodities Businesses.” “US Regulators Find Evidence of Banks Fixing Derivatives Rates.” “Goldman Sachs Sued for Allegedly Inflating Aluminum Prices.”

So goes a sampling of headlines about the banking industry from the past week — yes, just one week. We seem to be living in an era where bankers can do no right. I can’t put it any better than a smart hedge fund friend of mine, who upon reading the news about the $410 million that JPMorgan paid to make allegations that it manipulated energy markets go away, sent me an email. “I am a bank friendly type,” he said. But, he added, in typically terse trader talk, “Something structurally amiss when so much financial activity is borderline.”

By one measurement, the problem has gotten worse by an order of magnitude in recent years. In the annual letter he writes to shareholders, Robert Wilmers, the chairman and CEO of M&T Bank, has started keeping track of the fines, sanctions and legal awards levied against the “Big Six” bank holding companies. In 2011, those penalties were $13.9 billion. In 2012, they more than doubled to $29.3 billion. Wilmers writes that the past two years represent the majority of the cumulative $52 billion in charges, from 236 separate actions in eight countries, over the past 11 years. Wilmers also cites a study done by M&T, according to which the top six banks have been cited 1,150 times by the Wall Street Journal and the New York Times in articles about their improper activities. Perhaps not surprisingly, the biggest bank, JPMorgan, accounts for a sizable chunk of all this. According to a report by Josh Rosner, a managing director at independent research consultancy Graham Fisher & Co, JPMorgan has paid $8.5 billion in fines between 2009 and 2012, or about 12 percent of its net income over that period.

The results aren’t in for 2013 yet, but so far, the tune is more of the same. In addition to all of last week’s news, there’s the $8.5 billion that 13 banks agreed to pay to address allegations of robo-signing. Barclays, while not a “Big Six” bank, was also ordered to pay $488 million by FERC; that bank, along with RBS and UBS, has also agreed to pay a combined settlement that is well over $1 billion to settle charges that they manipulated the key interest rate called Libor.

How you explain those numbers depends on where you sit. In his letter, Wilmers embraces the argument that a predisposition to wrongdoing is now built into the system, in part because of the decline of traditional banking and the merger of commercial and investment banking. Money center banks, which are desperate to pump up their profits, have increasingly invested in things they know nothing about, whether it be emerging market debt or subprime mortgages. At the same time, Wall Street firms have pushed the envelope in developing newfangled ways for their customers to lose money. (Oops — I meant newfangled ways to help “markets remain efficient and liquid.”) Then, commercial banks have used their balance sheets to inject steroids into Wall Street’s products. Or as Wilmers writes, “One’s cash from deposits and the other’s creativity led to a symbiotic relationship, enhanced by the closeness of geography.”

Another way to think about this is that the combination of investment and commercial banking has brought a tidal wave of government-backed money to businesses that should be purely risk-based. There’s too much money chasing too little return, and the winner takes all. Toss in some rules that are oftentimes too stupid to be respected, therefore inviting gaming, and what do you expect? Banks are constantly going to be right up against the line of wrongdoing, if not over it. Or as my friend writes, “You know it is because some combination of competition, over capacity, resource misallocation, too much money dangled too easily in front of kids. Leads to cutthroat, childish and sometimes borderline behavior.”

If you’re a regulator, the story is simpler. You’ve gotten tired of reading that you kowtow to your banking clients. (Hell hath no fury like a regulator scorned.) You know you screwed up in the financial crisis, or in FERC’s case, back in the Enron years. Funding is tight. There’s a need and a desire to show that you’re an enforcer. That said, you don’t want to risk putting your clients out of business. So you don’t charge individuals, and you allow banks to neither admit nor deny guilt, and shareholders pay the big fines. Everyone seems happy.

Of course, if you’re a bank, you think the numbers are B.S. You think you’ve been unfairly blamed for the financial crisis, that the spate of enforcement actions are to some degree political, and that regulators have gone wild. They’ve lost their collaborative attitude. But because your overseers allow you to neither admit nor deny guilt, as well as to spend shareholders’ money to make the problem go away — and not incidentally, the fines don’t appear to impact executive compensation — pay you do. (See Goldman Sachs, Abacus.)

There’s probably some truth to all these points of view. Look at JPMorgan’s recent settlement with FERC. Banks are in the energy business (pause to think about how weird that is) thanks in part to rulings by the Federal Reserve, which has always believed, often mistakenly, that allowing banks new ways to make money would strengthen the system. Less-regulated investment banks like Goldman Sachs, which turned into bank holding companies during the financial crisis, have been trading energy for a long time. But can today’s banks be trusted with playing a role in what we all pay for power? (This is all now in flux.) As for the regulator, there’s no question that FERC, which was humiliated by the events in California at the turn of the century, is determined to be more aggressive.

JPMorgan, for its part, wants to make money. There’s nothing wrong with that. But in a highly competitive, rules-driven world, especially when the rules seem to invite bad behavior, that can lead to problems. As blogger Matt Levine put it, “FERC built a terrible box, and the box had some buttons that were labeled ‘push here for money,’ and JPMorgan pushed them and got money.” According to newspaper reports, FERC originally wanted around $1 billion in fines and the traders’ heads on a platter. In the end, it was business as usual: JPMorgan paid about half that, no individual traders were charged, and the firm didn’t have to admit or deny any guilt.

On the surface, everyone seems willing to live with the current state of affairs. But the apparent calm masks how seriously messed up this all is.  Look again at the JPMorgan settlement. According to the New York Times, FERC accused the bank of  “turning money-losing power plants into powerful profits centers,” and alleged that a senior executive gave “false and misleading statements under oath.” But the end result — a mere fine — is totally out of synch with that damning language. This makes people cynical about the system. How can you have these apparently bad actors be somehow immune from any serious repercussions? It “smells of cronyism, which is third world stuff,” writes another friend of mine, who, by the way, is not an Occupy Wall Street type, but rather a somewhat buttoned down professional investor. “Scares me.”

Supporters of the banks offer an easy answer to the lack of charges (and it might occasionally be true), which is that the actions aren’t actually that bad. The whole thing is just a show, meant to make the regulators look tough and capable and the banks look contrite. But that’s not OK either, because a functioning economy needs a functioning financial system, one in which people have a basic degree of trust. A constant flood of news about supposed malfeasance does not inspire trust.

In a recent piece in the New York Review of Books, former Federal Reserve chair Paul Volcker weighed in on the incredibly slow implementation of financial reform. “The present overlaps and loopholes in Dodd-Frank and other regulations provide a wonderful obstacle course that plays into the hands of lobbyists resisting change,” he wrote. “The end result is to undercut the market need for clarity and the broader interest of citizens and taxpayers.” I worry that the end result of Volcker’s “wonderful obstacle course” will be a wonderful playground, chock full of badly designed buttons that banks can press to make money. The regulators will bring charges, no one will pay in any meaningful way, we’ll all get more and more cynical and distrustful, and the show will go on. That is, until all the banks press the buttons at the same time, at which point we’ll have another financial crisis. Come to think of it, maybe that wouldn’t be such a bad thing: It might inspire us to think about a financial system that actually makes sense.

PHOTO: Former Goldman Sachs bond trader Fabrice Tourre leaves the Manhattan Federal Court in New York August 1, 2013. REUTERS/Keith Bedford

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The folly of trying to level the investment playing field Thu, 25 Jul 2013 17:16:28 +0000 The government is cracking down on insider trading; isn’t that great news for you? Last Friday, the Securities and Exchange Commission charged hedge fund mogul Steve Cohen with failing to supervise two employees who themselves face insider trading charges; on Thursday morning the Justice Department filed criminal charges against his firm, SAC Capital. Earlier this summer, the news broke that New York’s attorney general, Eric Schneiderman, was investigating the early release (by Thomson Reuters, which publishes this column) of the University of Michigan’s widely-watched index on consumer sentiment to a group of investors. Faced with a court order, Thomson Reuters agreed to suspend the practice, while asserting that “news and information companies can legally distribute non-governmental data and exclusive news through services provided to fee-paying subscribers.”

In a statement, Schneiderman said that “the securities markets should be a level playing field for all investors.” Preet Bharara, who is the U.S. Attorney for the Southern District of New York, has also invoked the notion of fairness. He told CNBC’s Jim Cramer, “I think people need to believe that the markets are fair, and that the same rules apply to everyone…I don’t want to buy a stock because I have a feeling that someone knows more than I do.”

Let’s give both Schneiderman and Bharara credit for good intentions. What could be more desirable than a level playing field in the all-important game called our financial security? But the playing field isn’t level, it never has been, and I’m not sure it can ever be. If history is any evidence, attempts to level it have only tilted it all the more. So, maybe the real problem is the pretense of fairness.

The notion that individual investors could compete with big institutions in the stock market began, according to my friend, co-author, and New York Times columnist Joe Nocera, on May 1, 1975, which was when commissions were deregulated. That gave rise to discount brokerages like Charles Schwab, which catered to individual investors. The movement gained currency (no pun intended) as the first dot-com bubble made investing seem easy, and brokerage moved online. Technology democratizes everything! Information is free! A veritable flood of ads, including those featuring stock-trading teenagers with their own helicopters and tow truck drivers with private islands, all preached “some version of the mantra that you can get rich faster if you take charge of your own investments,” as the New York Times put it in an October 1999 piece — which, not incidentally, noted that the top 10 online brokers were budgeting about $1.5 billion in the coming year for advertising, more than Walt Disney and Coca-Cola combined. Old line brokers like Merrill Lynch and Morgan Stanley Dean Witter got into the game too, offering low-priced trades with the perk of access to their stock research, which was supposed to help guarantee your success. In a message meant to scare people away from operating without access to the firm’s research, Morgan Stanley warned investors, “Life’s not fair.”

No, life isn’t fair, and as we all know now, the playing field hadn’t been leveled. Individual investors, whether operating via discount brokerages or with the dubious benefit of Street research, were just cannon fodder for the so-called smart money—including, not surprisingly, Cohen’s SAC Capital — which made fortunes by shorting dot-com stocks ahead of the crash. (The “smart money” isn’t necessarily smart, but it is well-connected.) Nocera has argued that without fixed commissions, research was less profitable, so research became a subsidiary of the investment banking division — oh, the law of unintended consequences. Along came Eliot Spitzer (I’m hitting all of the summer’s headlines!), who documented that research analysts, far from providing investors with objective advice, were basically shills for the investment bankers. A buy rating bought investment banking business, instead of paying for your retirement. Ten big firms jointly paid $1.4 billion to settle charges, and agreed to changes in how they did business, such as putting a wall between research and investment banking, and compensating analysts based solely on their performance.

Just as commission deregulation may have backfired in some ways, so did Spitzer’s reforms. Analysts went from being stars, whose compensation was juiced by rich investment banking fees, to mere grunts. As a result, the quality of Wall Street’s research — which smart people relied on for information, not for the tainted recommendation — has declined dramatically. I emailed two longtime sources who are professional investors to make sure I was right about the decline in the quality of research. Both wrote back YES in all caps.

Then came the rise of hedge funds, who will pay almost anything for even a shred of information. That’s led to the growth of all sorts of exclusive services. Most prominent are so-called expert network firms, which match investors who are willing to pay hundreds of dollars an hour with “experts” in a given field. In addition, hedge funds swap ideas and insights with each other at exclusive dinners and charity conferences. The big investment banks sponsor their own exclusive dinners and conferences where their top clients can sit down with company management or other particularly compelling experts. A few years ago, a controversy broke out over Goldman’s “trading huddles,” where favored clients — including SAC, natch — got access to analysts’ ideas. Goldman paid $22 million to settle charges that it failed to supervise research analysts’ communications adequately, which is utterly absurd due to the pretense that communications can be supervised: Important investors can have a private conversation with an analyst, or with company management, whenever they want.

In the wake of Enron, I remember being struck by how tightly closed the circles of information really were. Plenty of people were skeptical about Enron, but their skepticism never made it to the ears of your average investor. If anything, the circles might be even more closed today. Hedge fund managers — unlike mutual fund managers, who were usually trolling for new clients and wanted their names in the press — can’t take money from your average investor, have little incentive to talk, and the best ones often don’t, meaning their ideas don’t leave their circles.

It was an expert network, Primary Global Research, or PGR, that became central to the government’s insider trading investigations. It turned out that PGR consultants were getting their hands on inside information, either because they themselves worked in critical areas of companies or via other friends, and feeding it to hedge fund clients. The government’s investigation into PGR helped point to a group of friends at different hedge funds that shared inside information from a variety of technology companies, including Dell. “I have a 2nd hand read from someone at the company,” an SAC analyst named Jon Horvath — who has pled guilty to insider trading — told his boss, Michael Steinberg, before Dell’s earnings in the summer of 2008. Steinberg, who is one of Cohen’s lieutenants, has been criminally charged over that trade too, and the SEC alleges that Cohen got Horvath’s email, too. (SAC says Cohen didn’t read it, and that neither he nor the firm has done anything wrong.)

But the line between what’s insider trading and what isn’t is most definitely not the line between what information an average investor can access, and what information a hardworking hedge fund manager who can spend thousands of dollars and hundreds of hours on expert research can access. “I shudder to think how much of my alpha comes from failed individual investors,” one hedge fund manager tells me. The group of analysts could have done almost everything short of getting a source inside Dell. They could have worked Dell’s investor relations department, used sources at other companies, called customers to do so-called “channel checks” — research on what’s selling — set up meetings with management and industry analysts and pooled all their information. That’s all legal. “Edge,” as they call it in the hedge fund community, can refer to inside information, but it can also be that little bit of knowledge gleaned from incredibly hard work. And within those circles, “edge” gets shared — but not with you.

I don’t know if there’s any way to fix this, or for an individual investor to deal with it effectively. (Your run of the mill mutual fund manager isn’t that much more plugged in than you are.) You can buy index funds or ETFs, which you probably should do anyway. You can stay away from short-term trading, which is where edge matters most. Or you can play the game. You might even win sometimes, because edge is just edge — it isn’t a guarantee. But if you choose to play the game, know what you don’t know, and when people tell you that they’re leveling the playing field for you, don’t thank them.

PHOTO: People walk past a building that includes SAC Capital as a tenant in New York, July 25, 2013. REUTERS/Carlo Allegri

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How much does Jamie Dimon matter? Tue, 21 May 2013 17:26:42 +0000 So today is the day.  After weeks of near-constant coverage of the big decision — will JPMorgan Chase shareholders keep Jamie Dimon as chairman and CEO or relegate him to just CEO? — the verdict came at JPMorgan’s annual meeting in Tampa, Florida:  Dimon gets to keep both titles. The next question is whether the result will get as much press as the original question did.

The subject has gotten so much coverage in part because Dimon is so divisive. To his supporters, he’s the personification of everything that’s best about the financial system. Those who defend Dimon, like New York Times columnist Andrew Ross Sorkin, point out that JPMorgan Chase hasn’t lost money in any quarter while Dimon has been in charge. Others, including Warren Buffett, Jack Welch, Michael Bloomberg and Rupert Murdoch, praise Dimon, who is often called “America’s most famous banker,” for his management skills. But to detractors, he’s the personification of all that’s wrong with modern banking — the arrogance, the resistance to new regulation, the astronomical pay in the face of obvious mistakes. The way he acted — threatening to resign entirely if his chairmanship was taken away — is proof that he’s no more than a spoiled child.

But I wonder if the vote has gotten so much attention for another reason, which is that it’s easier to chew over Jamie Dimon than it is to think about the right structure for our financial system. Sure, the management, and the structure of that management, at JPMorgan matters.  But if I were a conspiracy theorist ‑ and really and truly, I’m not! ‑ I might even suspect that all the fuss about Dimon is supposed to make us “watch the birdie.”  It’s a distraction, meant to deflect attention from the real point, which is how we structure a financial system that best serves the needs of consumers and businesses in as safe a way as possible.

We’ve been getting close to having that conversation lately.  In late April, Senators Sherrod Brown (D-Ohio) and David Vitter (R-La.) rolled out the Brown-Vitter bill, which some have called the “break up the big banks” bill because the capital requirements it would impose on large banks, those with over $500 billion in assets, are so onerous as to force a breakup. At the least, the bill is a start to a much-needed conversation — or it was until Dimon began to dominate the headlines.

JPMorgan, which is the nation’s largest financial holding company with $2.4 trillion in assets, is not only one of the central targets of Brown-Vitter, it’s also a cause of the bill.  That’s not just because JPMorgan is big. Last summer, as most people know, JPMorgan lost more than $6 billion because of a trade in credit derivatives gone wrong. (The bank still made money that quarter.) Dimon, who initially and famously dismissed rumors as a “tempest in a teapot,” was forced to testify twice in Washington, and to offer a rare mea culpa, not once but repeatedly, for what he called a “terrible mistake.”

Just before Brown and Vitter produced their bill, in mid-March, the Senate Permanent Subcommittee on Investigations finished a report on JPMorgan’s big loss.  The trades “provide a startling and instructive case history of how synthetic credit derivatives have become a multi-billion dollar source of risk within the U.S. banking system,” wrote the PSI. “They also demonstrate how inadequate derivative valuation practices enabled traders to hide substantial losses for months at a time; lax hedging practices obscured whether derivatives were being used to offset risk or take risk; risk limit breaches were routinely disregarded; risk evaluation models were manipulated to downplay risk; inadequate regulatory oversight was too easily dodged or stonewalled; and derivative trading and financial results were misrepresented to investors, regulators, policymakers and the taxpaying public who, when banks lose big, may be required to finance multi-billion-dollar bailouts.”  OK, then!

Around the same time, Joshua Rosner, a managing director at independent risk consultancy Graham Fisher & Co., wrote a report called “JPMorgan Chase: Out of Control.”  He noted that since 2009, JPMorgan has paid more than $8.5 billion in settlements for various regulatory and legal problems.  That amount represents almost 12 percent of the net income the firm has produced from 2009 to 2012, according to Rosner, who also alleges that “many of JPM’s returns appear to be supported by an implied guarantee it receives as a too-big-to-fail institution.”

These are huge issues that everyone should be concerned about. But inadequate risk management, derivatives exposure, incentives to put excess money to work by making trades rather than loans and a torrent of legal issues aren’t — unfortunately — unique to JPMorgan Chase. We’ve created a Frankenstein of a financial system, one that is manmade but often so complex that it can eclipse our ability to measure or manage it. Add to that the constant pressure for profits and the opportunities to arbitrage an increasingly prescriptive, expensive set of rules and regulations.  It’s a toxic combination.  Plus, we live in a world where size and money equals political power, making effective oversight difficult. Would replacing Jamie Dimon as chairman help? A Wall Street Journal story quoted Michael Garland, who is an assistant comptroller for New York City and a co-sponsor of the shareholder resolution to split the roles, saying that an independent chairman would have more time than Dimon to deal with unhappy regulators. Great: more placating and handholding. Garland also says that it would send a strong message to the bank that the board needs to strengthen its oversight. Raise your hand if you think there’s a board out there that truly can oversee a modern financial institution.

It would be nice if all of this were fixable by adding or swapping the players at JPMorgan. But does anyone believe that if JPMorgan had had another chairman during this period — say, Bill Harrison, who was the bank’s CEO before Dimon — that last summer’s derivatives losses wouldn’t have happened? If JPMorgan had a different CEO, that wouldn’t make the issues go away. Arguably, it would make things worse.

Dimon certainly hasn’t navigated the fraught world of big banking perfectly. But name one person who has. The world’s next great banker might be being groomed inside or outside JPMorgan, but for now, if we’re going to live with the banks we’ve got, I’ll take Dimon over Dimon-lite.

The problems with JPMorgan aren’t a result of who the people are or aren’t at JPMorgan. They’re a result of the system. And while it may or may not make sense to change the people, don’t be deluded:  That’s not changing the system.

PHOTO: JPMorgan Chase & Co CEO Jamie Dimon speaks about the state of the global economy at a forum hosted by the Council on Foreign Relations (CFR) in Washington October 10, 2012. REUTERS/Yuri Gripas

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