Felix Salmon

Where’s today’s hellhound of Wall Street?

Felix Salmon
Oct 14, 2010 23:00 UTC

My review of Michael Perino’s new book about Ferdinand Pecora, The Hellhound of Wall Street, is up now chez B&N. I liked the book a lot, and learned a lot from it, and ultimately came away saddened that history can’t and won’t repeat itself this time round. In 1933, Pecora was the hero of the financial crisis: the man who brought the banksters to book. Today, there’s no such hero. And while Dodd-Frank and Basel III are all well and good, they’re not remotely as far-reaching and revolutionary as the Securities Act, and the Exchange Act, and the creation of entities like the SEC and the FDIC.

Of course, it’s thanks largely to Pecora that we don’t need anything so far-reaching and revolutionary. It’s great that Perino has rescued Pecora from the dusty reaches of history, and is showing what an aggressive prosecutorial lawyer can do, given subpoena power and the moral high ground. I’d love to see one of those in the Senate today, or even in an AG’s office somewhere, or at the SEC. But ever since Eliot Spitzer became governor of New York, that job has seemed to be vacant. It looks very much as though there will be precious few prosecutions coming out of this crisis. Unless, of course, I’m right about the degree to which the mortgage scandal could explode.


Acutally, midasw, the high point of Pecora’s examinations was during the Hoover administration. After the election, to be sure — after FDR was elected — but before he took office.

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The law that was broken in the mortgage scandal

Felix Salmon
Oct 14, 2010 20:32 UTC

Update: Thanks to Economics of Contempt. This turns out not to be the cut-and-dried breaking of the law that it looks like. Because it turns out that Section 15E(s)(4)(A) of the Exchange Act is very new: it was only inserted into the Act by Dodd-Frank (page 1,376, if you’re following along at home). So it wasn’t in force when these bonds were issued. You couldn’t do this kind of thing any more — it would be illegal. But Section 15E(s)(4)(A) isn’t enforceable retroactively.

After my post yesterday on the mortgage bond scandal, a lot of commenters said that it looked like a violation of Rule 10b5-1 of the Exchange Act — the bit that prohibits trading on material nonpublic information. Well, it may or may not be a violation of 10b5-1. But that might be beside the point, because this looks like an absolutely textbook violation of Section 15E(s)(4)(A).

This rule is not dense legalese at all. In fact Section 15E(s)(4)(A) is written in very plain English. Here it is in full (see page 231 of the PDF):

The issuer or underwriter of any asset-backed security shall make publicly available the findings and conclusions of any third-party due diligence report obtained by the issuer or underwriter.

I can’t for the life of me work out how every single mortgage bond that Clayton taste-tested didn’t violate this rule.

And in fact, the SEC has now proposed its own additional rule, which would mandate this kind of due diligence, and would also mandate that the issuer disclose the nature, findings and conclusions of any such taste test.

Up until now, underwriters have not been obliged to do this kind of due diligence. But the fact is that they did it, and that Clayton, in particular, made good money from performing such due diligence for just about every major investment bank in the world. As far as I know, not a single one of those banks disclosed Clayton’s results when they sold their bonds. And that looks to me like a blatant violation of Section 15E(s)(4)(A).

Or is there something I’m missing here? (Obviously, yes, there was.)

Update 2: If Section 15E(s)(4)(A) doesn’t do the job, what are we left with? Well, there’s still 10b5-1, of course. That prohibits the sale of any security on the basis of material nonpublic information. And there’s also Section 17 of the Securities Act:

It shall be unlawful for any person in the offer or sale of any securities… to obtain money… by means of any untrue statement of a material fact or any omission to state a material fact.

Which still does the job, I think.


10b statute of limitations has probably run at this point. I’m not sure what state law these are typically governed by, but they might have something if it’s NY state, where it’s six years.

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Mortgage mess TV

Felix Salmon
Oct 14, 2010 19:09 UTC

I’ve been getting a lot of good feedback about my post yesterday on the way in which just about every major investment bank in the world might have huge legal risk surrounding the way that they built their mortgage bonds. The stock market in general might be relatively sanguine about the mortgage mess, but bank stocks are falling, and I suspect that the worst is yet to come. Certainly the tail risk to the banking industry as a whole is as high as it’s been since TARP was first unveiled.

In any case, if the post was a bit tl;dnr for your tastes, here’s a jerky video version, complete with libel-conscious bleepage. You’ve heard of the foreclosure mess. Here’s a mortgage-bond mess to layer on top:


Hey Felix,

Loved the video, perfect example of asymmetric information. I am currently a student studying Banking and Finance with the LSE internation program. I had thought of re doing your skit in class for a presentation of asymmetric info, but would honestly believe that would not be doing justice. I would like permission to play this clip and is there anyway I can download it?.

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Hindsight and investment advice

Felix Salmon
Oct 14, 2010 15:00 UTC

Cullen Roche today revisits his advice from a year ago, which was published in New York Magazine, on how to buy toxic assets. He says that he “received a pretty substantial backlash from the article”, which is true: I wrote about it under the headline “Awful investing advice of the day, distressed-mortgages edition”. But now he’s defending himself:

First of all, I wasn’t making, nor do I ever make recommendations for anyone. That should be ABUNDANTLY clear to any and all readers of everything I write. I was simply brainstorming about the ways that small investors could gain access to toxic assets because it’s a relatively closed space to the small investor if you don’t have certain connections…

Even though these ideas were generated well after the market bottom the one year results prove that we were indeed in the midst of a once in a lifetime opportunity…

Unfortunately, the once in a lifetime opportunity is likely gone as the risk/reward environment has altered dramatically… In fact, distressed debt looks more crowded by the minute.

So does that mean, pace Joe Weisenthal, that I’ve been proven wrong?


Firstly, of course Roche was making investment recommendations — he was citing specific ticker symbols, ferchrissakes, and the first line of the piece (headlined “The Beginner’s Guide to Toxic Assets”) was this:

So how can you consider joining Michael Osinski and invest in toxic assets?

The entire piece, in other words, was presented as a way to give those “beginners” a “guide” for how to “invest in toxic assets”. You can reiterate until you’re blue in the face that you’re not giving investment recommendations, but a guide like this — especially if it comes with ticker symbols — is exactly that.

Secondly, the one year results are not particularly convincing. Roche’s own numbers say that his recommendations went up by 21% on average, compared to a rise of 11.45 percent in the S&P 500. But the 21 percent return figure doesn’t include transaction costs, and it certainly doesn’t make any attempt to account for the the fact that these stocks are inherently riskier than a big index of the largest companies in America.

Does the excess 955bp of return make up for that risk? Maybe it does — but it would be nice if Roche had told us in advance what kind of outperformance would constitute proof that his “once in a lifetime opportunity” thesis was true. Personally, I would expect that a once-in-a-lifetime opportunity would generate rather more than 955bp in excess returns, but maybe that’s just me.

Finally, and most importantly, the initial story didn’t give any kind of exit strategy. I’ll give Roche some small credit for posting exit advice on his blog today. But 99% of the people who read his original article on nymag.com will never see that blog post. And so if you took his advice a year ago, right now you’re just sitting on paper profits. And there’s no indication at all, in his original article, that you should sell after one year, or sell when the portfolio has risen by 20 percent, or even sell at all, really.

Every article saying that now’s a good time to buy X should be ignored automatically if it doesn’t say when you’re meant to exit that trade. (“Never” is a reasonable answer to that question, but if you’re giving buy-and-hold-forever advice, be explicit about that.) Given that NY Mag is unlikely to run a piece saying “hey, those stocks we recommended, now would be a good time to sell them”, it should never have run the article saying that it was a good time to buy them a year ago.

But hey, if someone at NY Mag is reading this, maybe a little blog entry might be in order. It can’t hurt, and it might save a few readers from following these stocks down after riding them up.


I see your point, Greycap. If I read the original recommendation at the time (don’t remember), I would definitely have discarded it on the basis of risk — not over the valuation.

Very hard to fairly price something if you can’t determine (and bound) its risk.

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Felix Salmon
Oct 14, 2010 07:57 UTC

Bloomberg TV host: “Are you buying? Adding more gold to the collection?” Mr T: “The highest weight I carry is 45lbs” — YouTube

When asked if their food was not biodegradable, McDonald’s said: ‘This is an outlandish claim and is completely false.’ — Daily Mail

States probe mortgage industry practices — Reuters

“I know Arianna doesn’t like it,” Obama said lightly. “But I like taupe.” — NYT


Interesting, hsvkitty, especially the two-week results. The Big Mac shows surprisingly little decay.

I’m less surprised by the permanent french fries.

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SEC unblasted on Goldman

Felix Salmon
Oct 14, 2010 07:46 UTC

Remember the WSJ front-page headline saying “SEC Blasted on Goldman“? It was based on a few comments from the SEC inspector general, David Kotz, who has now released his official report on Goldman. And there ain’t no blasting here:

The OIG investigation did not find that the SEC’s investigation of, or its action against, Goldman was intended to influence, or was influenced by, financial regulatory reform legislation. The OIG found that the investigation’s procedural path and timing was governed primarily by decisions relating to the case itself, as well as concern about facts about the investigation’s subject matter being publicized prior to the SEC filing an action and concerns about press coverage and maintaining a relationship with the NY AG.

The OIG also did not find that the settlement between the SEC and Goldman was intended to influence, or was influenced by, financial regulatory reform legislation. The settlement’s timing was driven primarily by factors relating to the civil action against Goldman and Goldman’s quarterly earnings release.

The OIG did not find that anyone at the SEC shared information about its Goldman investigation with any journalists or members of the media prior to the filing of its action against Goldman on April 16, 2010.

In fact, pretty much the only negative thing that the OIG did find was that the SEC, according to its own rules, should have given Goldman a heads-up before announcing the suit. As a result, the OIG recommends that the SEC… take another look at those rules.

The report isn’t wholly believable. Of course the New York Times had a heads-up about the case: you can’t read a complaint, write a long, detailed story about it and publish that story, all within five minutes of the SEC press release going out. But then again, the OIG somehow wasn’t able to get his hands on that story:

The New York Times Company represented that it was unable to retrieve the version of its article about the SEC’s action against Goldman as it was first published at 10:38 a.m. As a result, the level of detail concerning the SEC’s action contained in this first iteration of the article could not be reviewed by the OIG.

Well, you can see the final version of the story here; it doesn’t differ substantially from the story as first published and it’s over 1,700 words long. It clearly wasn’t written in five minutes.

I’m also unsure how much of this to take at face value:

Chairman Schapiro testified that she was “quite surprised” at how much media coverage the Goldman action received… Cohen testified that he and others at the SEC were surprised at the attention given to the Goldman case once it was announced… Many other witnesses in this investigation testified that they were surprised or “shocked” at the extent of the media attention given to the Goldman action.

Certainly there was a lot of press coverage given to the case and Goldman’s share price went down more than I think anybody at the SEC or even Goldman would have expected. In hindsight, it’s easy to see why the case got so much attention, but at the same time I can maybe believe that the SEC didn’t anticipate the full extent of the media firestorm. (Here’s one datapoint: it’s the only occasion I’ve been asked to write an op-ed for the Washington Post.)

But all those are quibbles. The OIG report is clear and it’s a full exoneration of the SEC both in terms of whether the case was political from the start and even in terms of whether its timing was political. Kotz concludes in both cases that it wasn’t. I’ll be fascinated to see how much prominence the WSJ gives this story.

USAID’s PR problem

Felix Salmon
Oct 13, 2010 20:33 UTC

Foreign aid is a much cheaper way of conducting a country’s foreign policy than the military — and in many cases it can be much more effective, too. The Obama administration is very keen on this: a recent roundtable discussion on its new Global Development Policy, for instance, featured not only secretary of state Hillary Clinton but defense secretary Bob Gates and treasury secretary Tim Geithner as well.

At one point in the discussion, Clinton explained that the U.S. was running into an unexpected problem:

We have to fight to get the U.S. Government’s label on our material because a lot of our aid workers and our NGO partners are afraid to have association with the U.S. Government, whereas China, Japan, everybody else, emblazoned across all that they do, “Gift from the people of China,” that – “From the generosity of the people of Japan,” or you name it. So the American taxpayer is looking at this and saying, “We want to help those people. That’s a terrible disaster. But they don’t even want to admit that it’s coming from us?”

Philanthropy is a very public thing in the U.S.: if you give a lot of money to a certain cause, you can often demand your name emblazoned across it somehow. The problem is that when the US makes similar demands, it puts lives at risk. Here’s Rob Crilly:

if you were, say, a Western aid worker you might a few reservations about delivering goods with a nice red, white and blue logo with a row of stars and stripes on it…

Anyway this is what the good people at USAID are insisting on. Inevitably, charities tried to avoid displaying it too prominently – and maybe US officials were prepared to turn a blind eye – but that was until Richard Holbrooke visited and expressed his concern that the US was not getting sufficient credit for the hundreds of millions of dollars in aid being poured into Pakistan…

Such is the strong feeling among aid agencies that some – including, I understand, Oxfam – are prepared to give up millions of dollars in funding rather than risk more lives…

It is not a question of courage. The aid workers I know are aware of the risks they face. Many here in Pakistan here now knew Linda Norgrove, who was kidnapped and killed in Afghanistan. It is a question of knowing the limits of acceptable risks. Using a stars and stripes logo lies on the wrong side of stupid.

It’s one thing to espouse a generous foreign-aid policy on the grounds that you will ultimately do well by it in terms of domestic security. But it’s something else entirely to try to squeeze every last ounce of PR value out of that foreign aid, even if doing so puts the lives of aid workers at risk. (Many of them won’t even display their own logos in places like Afghanistan, let alone the stars and stripes of USAID.)

Let’s hope that Clinton and Holbrooke back down on their hard line here, especially since the value of the U.S. branding is so anecdotal and fluffy, while the cost is clear and harsh. It might not be particularly American, but sometimes the most noble kind of aid is the aid you’re not always rushing to take credit for.


This is why the Red Cross is aggressively neutral, and does not carry guns. This is also why using military means to secure areas for development is a terrible, terrible idea.

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Geithner’s bizarre foreclosure logic

Felix Salmon
Oct 13, 2010 15:56 UTC

Politico has the transcript of Tim Geithner’s appearance on Charlie Rose last night:

I think it’s important to recognize, Charlie, that if you — a national moratorium would be very damaging to exactly the kind of people we’re trying to protect, because the consequence of that would be in neighborhoods that have been most affected by the foreclosure crisis, where you see lots of houses on the block empty, unoccupied, what it means is those communities will be living longer with houses unoccupied, with more pressure on their house price with the people still in their houses. That would be very damaging.

I don’t follow this logic at all. Geithner is absolutely right that empty houses are a Bad Thing. But he seems to think that a foreclosure moratorium would cause empty houses. Isn’t it foreclosures which cause empty houses?

I feel I’m missing something obvious here — but as I understand it, when a bank forecloses on a house and sells that house, it evicts the previous owners as part of that process. One the old owners are evicted, the house is empty — until the bank manages to sell it. If the foreclosure doesn’t happen, the eviction doesn’t happen, and the house isn’t empty.

Is Geithner implying that banks will continue to evict homeowners even without foreclosing on those properties? Is that even possible?

Update: Treasury responds, via email.

First, at least 40 % of all homes in foreclosure are vacant.  Delaying conveyance of title and resale has devastating impacts on neighborhood values
and increases demand for municipal services.

Also, a blanket moratorium equally impacts the banks that are acting in accordance with the law increasing costs for servicers and investors.
This threatens the safety and soundness of smaller community banks that are not part of the document problem and ultimately limits market
liquidity preventing low and moderate income borrowers from refinancing or buying a house as investors are ever more hesitant to lend to all
but the most pristine credit borrowers.


Geithner or as I affectionately call him, Capt Transparency is at it again does anyone think this guy is working for the American Home Owner at risk. He is gonna close the conference room door and cook the books into a nice big cake for the American homeowner to eat instead of bread after they are evicted. Felix, Thanks for keeping an eye on the Hypocrisy that currently rules The fact that the issues are so wide spread and specifically documented may not be enough. Hopefully individual Americans will question the authority and make these alleged Bankers pay… http://diligencegroupllc.net/

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The enormous mortgage-bond scandal

Felix Salmon
Oct 13, 2010 15:21 UTC

You thought the foreclosure mess was bad? You’re right about that. But it gets so much worse once you start adding in a whole bunch of parallel messes in the world of mortgage bonds. For instance, as Tracy Alloway says, mortgage-bond documentation generally says that if more than a minuscule proportion of notes in a mortgage pool weren’t properly transferred, then the trustee for the bondholders can force the investment bank who put the deal together to repurchase the mortgages. And it’s looking very much as though none of the notes were properly transferred.

But that’s not even the biggest potential problem facing the investment banks who put these deals together. It also turns out that there’s a pretty strong case that they lied to the investors in many if not most of these deals.

I mentioned this back in September, and I’ve been doing a bit more digging since then. And I’m increasingly convinced that the risk to investment banks isn’t only one of dodgy paperwork; there’s also a serious risk of massive lawsuits from the SEC or other prosecutors, as well as suits from individual mortgage investors.

The key firm here is Clayton Holdings, a company which was hired by various investment banks — Goldman Sachs, Bear Stearns, Citigroup, Merrill Lynch, Lehman Brothers, Morgan Stanley, Deutsche Bank, everyone — to taste-test the mortgage pools they were buying from originators.

Here’s how it would work:

First, the bank would put in a winning bid for the pool of mortgages, with the intention of slicing it up into mortgage bonds and selling those bonds off to investors at a profit.

After submitting the winning bid, the bank would commission Clayton to take a closer look at a representative sample of loans in the pool. Clayton controlled as much as 70% of the market for this service, which is known as third-party due diligence. But Clayton’s not at fault here, and the problem is likely to apply no matter who performed this service.

The size of the representative sample would vary according to the size of the loan pool; it could be anywhere between 5% and 35% of the loans in the pool. Essentially, Clayton would go back to the loans, one by one, and re-underwrite them after the fact, checking that the originator’s underwriting standards were in fact being upheld.

Clayton would either accept or reject the loans it was looking at, according to whether or not they met underwriting standards. Here’s the results of what it found for one bank, Citigroup; the chart comes from this document filed with the Financial Crisis Inquiry Commission. I’m just using Citi as an example, here; all banks behaved in basically exactly the same way.


Look at the first line. Clayton reviewed 1,280 loans on behalf of Citigroup in the first quarter of 2006. Of those, it accepted 554 outright: they lived up to the originator’s underwriting standards. It also waived another 144, on the grounds that there were mitigating factors (a large downpayment, say). And it rejected 582 for a rejection rate of 45%.

This kind of information was valuable to Citigroup: it showed them that the quality of the loan pool was much lower than you’d think just by looking at the ostensible underwriting standards.

Armed with this information, Citigroup would do two things. First of all, it would take those 582 rejects and put most of them back to the underwriter. Essentially, they said, the loans weren’t as advertised, and they didn’t want them. But Citi would still keep some of them in the pool.

But remember that Clayton had tested only a small portion of the loans in the pool. So Citi knew that if there were a bunch of bad loans among the loans that Clayton tested, there were bound to be even more bad loans among the loans that Clayton had not tested. And those loans it couldn’t put back to the originator, because Citi didn’t know exactly which loans they were.

If there had been any common sense in the investment banks, that would have been the end of the deal. But there wasn’t. Rather than simply telling the originator that its loan pool wasn’t good enough, the investment banks would instead renegotiate the amount of money they were paying for the pool.

This is where things get positively evil. The investment banks didn’t mind buying up loans they knew were bad, because they considered themselves to be in the moving business rather than the storage business. They weren’t going to hold on to the loans: they were just going to package them up and sell them on to some buy-side sucker.

In fact, the banks had an incentive to buy loans they knew were bad. Because when the loans proved to be bad, the banks could go back to the originator and get a discount on the amount of money they were paying for the pool. And the less money they paid for the pool, the more profit they could make when they turned it into mortgage bonds and sold it off to investors.

Now here’s the scandal: the investors were never informed of the results of Clayton’s test. The investment banks were perfectly happy to ask for a discount on the loans when they found out how badly-underwritten the loan pool was. But they didn’t pass that discount on to investors, who were kept in the dark about that fact.

I talked to one underwriting bank — not Citi — which claimed that investors were told that the due diligence had been done: on page 48 of the prospectus, there’s language about how the underwriter had done an “underwriting guideline review”, although there’s nothing specifically about hiring a company to re-underwrite a large chunk of the loans in the pool, and report back on whether they met the originator’s standards.

In any case, it’s clear that the banks had price-sensitive information on the quality of the loan pool which they failed to pass on to investors in that pool. That’s a lie of omission, and if I was one of the investors in one of these pools, I’d be inclined to sue for my money back. Prosecutors, too, are reportedly looking at these deals, and I can’t imagine they’ll like what they find.

The bank I talked to didn’t even attempt to excuse its behavior. It just said that Clayton’s taste-testing was being done by the bank — the buyer of the loan portfolio — rather than being done on behalf of bond investors. Well, yes. That’s the whole problem. The bank was essentially trading on inside information about the loan pool: buying it low (negotiating for a discount from the originator) and then selling it high to people who didn’t have that crucial information.

This whole scandal has nothing to do with the foreclosure mess, but it certainly complicates matters. It’s going to be a very long time, I think, before the banking system is going to be free and clear of the nightmare it created during the boom.

Update: KidDynamite asks a good question in the comments: were the bond investors able to do their own due diligence on the loan pool? The answer is no, they weren’t — the prospectus did not include the kind of loan-level information which would enable them to do that.


Hope you don’t mind but as I read news stories that pertain to blogs I was interested in, I feel compelled to add them . If it ticks you off, just say so and I’ll stop.

http://www.bloomberg.com/news/2011-01-18  /jpmorgan-s-emc-mortgage-sued-over-mort gage-loan-documents.html

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