Felix Salmon

Some countries default on their performing debt because they no longer have the ability to pay it. Other countries default on their performing debt because they no longer have the willingness to pay it. Argentina has been in both situations: something of a serial defaulter, it defaulted on or restructured its obligations in 1828, 1890, 1982, 1989, 2001, and 2005.

And it’s going to default once again in 2013.

This time, however, is a little bit different. Argentina has both the willingness and the ability to pay its performing debt. It’s adamant, however, that it’s not going to pay $1.4 billion to Elliott Associates, a hedge fund which has been prosecuting a highly-aggressive litigation strategy against the country, based on the fact that it holds defaulted debt and refused to exchange that debt for performing bonds. Depending on where you sit, Argentina’s refusal to pay off Elliott is either noble or foolish. But after two and a half hours of highly contentious oral testimony in federal appeals court today, it’s pretty clear that the US courts aren’t going to allow Argentina to stay current on its performing debt — not unless the country also writes a ten-figure check to Elliott. Which means that we’re headed straight for default, with almost no realistic chance of avoiding it.

You didn’t really need me to tell you that: one look at Argentina’s 12-month credit default swap (current spread: 5,266bp) will tell you everything you need to know. But this is a pretty big deal all the same — not least because the Second Circuit seems certain to hand down a judgment which is pretty bad law.

That’s nothing new: in its first decision, the Second Circuit happily ignored lots of settled law about sovereign immunity, among other things, and was downright wrong about pari passu. This time around, the law preventing the Second Circuit from upholding the lower court’s orders is much weaker, and mainly comprises something called Rule 65(d)(2)(C), which is even more obscure than pari passu. Essentially, the Second Circuit has proved itself more than capable of taking a steamroller to formidable legal obstacles; this one should present no real problems at all, by comparison.

The questioning was led, aggressively, by Judge Reena Raggi, who barely let a sentence get finished and who made it clear from the very beginning that she is if anything even more fed up with Argentina’s antics than the district court judge, Thomas Griesa, whose verdict was being appealed. The fact that Argentina’s vice president and economy minister were sitting right in front of her didn’t faze her for one second: this was her courtroom, she was in charge, and it took her no time at all to accuse Argentina of being “contumacious”. (Which is fair enough, even Argentina’s counsel didn’t really disagree on that front.) In Raggi’s eyes, clearly, there’s nothing worse than a contumacious defendant: it doesn’t matter how many footnotes you have or how much precedent you cite, if you’re thumbing your nose at her she’ll find against you.

What’s more, Raggi really doesn’t like being blackmailed. Both Argentina and David Boies, acting on behalf of the bondholders who are currently being paid by Argentina, made the point multiple times that if Griesa’s order was upheld, the certain result would be another Argentine default, a whole new set of cases on Griesa’s docket, and, essentially, a loss for everybody, including Elliott Associates, which still wouldn’t actually get paid. Raggi was unimpressed: “Is that really this court’s concern?” she asked Boies, saying that it was not her job to wonder about “whatever the market might do” as a result of her ruling.

Boies, in truth, was unimpressive: he never seemed entirely on top of his brief, and there was one excruciating episode where he had to go scurrying off to ask Bank of New York’s lawyer to find out the answer to a question which everybody else in the courtroom knew the answer to. Argentina’s tactic today was to spend less time arguing its own case, and to outsource the job of fighting Elliott to Bank of New York and to David Boies, in the hope that they would be more sympathetic and less contumacious. But Raggi made mincemeat both of BoNY’s lawyer — telling him in as many words at one point that he was giving very bad advice to his client — and of Boies, who was clearly out of his depth. Remarked one lawyer, observing the proceedings: “If you’re going to bring in a hired gun, at least make sure it’s fully loaded.”

Argentina’s own lawyer, Jonathan Blackman, started off rockily yet actually finished quite strongly, warning of the practical consequences of what everybody in the courtroom could quite clearly see coming at that point. “You’re making it worse!” he said. “Do no harm!” It was an argument with no legal weight, and it won’t change the final result. But he did give Argentina the use of a “don’t say we didn’t warn you” card at any time the US or anybody else criticizes it for defaulting yet again.

But the clear winner was Ted Olson, representing Elliott, who stayed calm and masterful throughout. In contrast to Boies, he knew exactly what he was talking about, was sure of the merits of his own case, and didn’t feel the need to appeal to Learned Hand precedent every few minutes. In front of more impartial judges, he might have had a harder time of it. But oral arguments aren’t the time or the place for jurisprudential nit-picking: that’s what detailed briefs are for. Rather, Olson’s job was to reassure the three appeals-court judges that they should feel perfectly comfortable upholding their colleague’s decision and standing up for legal rights enshrined in New York-law documentation. And he did that extremely well.

Or maybe the real winner was pretty much everybody in the courtroom, since the one thing that seems certain is that the amount of litigation and dealmaking surrounding Argentine sovereign debt — which has already been enormous — is going to become positively stratospheric. It’s hard to look too far into the future, here, but one likely scenario is that the appeals court will uphold Griesa’s decision at some point in April or May, forcing a big default in June. At that point, Argentina will probably launch an exchange offer under Argentine law, under which anybody holding currently-performing bonds would be able to swap them into bonds with substantially identical terms, just payable in Buenos Aires rather than New York. Given that Argentine-law bonds have been trading at tighter spreads then US-law bonds for some months now, one can assume that nearly all bondholders would jump at the opportunity to keep on getting their coupons.

Argentina might even take the opportunity to give its holdouts a third bite at the cherry, offering them some kind of option to take a haircut and get performing Argentine-law bonds in exchange for their defaulted debt. But many holdouts would still remain, and will surely continue to pester New York courts for the foreseeable future.

All of which helps explain why Argentina’s credit default swaps are trading so much wider than Argentina’s bonds. The bonds will probably default, but bondholders are unlikely to suffer huge losses if they just have a bit of patience for a couple of months — eventually, Argentina will surely give them the opportunity to swap their debt into a slightly different instrument, one which is less susceptible to New York jurists. That said, the credit default swaps will be triggered, and Argentina will probably drop out of key emerging-market indices like JP Morgan’s EMBI.

This is emphatically not what Argentina hoped for when it entered into its exchange offers in 2005 and 2010. Back then, the idea was that it could cure its default, mop up its holdouts somehow, or at least render them irrelevant, and ultimately make it back into the good graces of the international capital markets. Instead, Argentina remains a capital-markets pariah, it can’t really do business anywhere in the world without worrying that Elliott or someone like it is going to attach its property, and pretty soon it will probably have to give up on issuing any foreign debt at all, retreating instead to its own small South American world.

Argentina is a unique and special case on many levels: the failure of its 2005 and 2010 debt restructurings does not mean that debt restructurings in general don’t work, or that we need to resuscitate the idea of a sovereign bankruptcy regime. Still, the precedent being set here is not a happy one — not for international bondholders, probably not even for Elliott Associates, which is still a long way from getting paid, and definitely not for Argentina. This is looking very much like one of those court cases which absolutely everybody ends up losing.

Update: There is one way that Argentina can prevent a default in 2013: by prepaying all its 2013 coupons now, before the ruling comes down. Don’t rule it out: in this case, anything is possible.

There’s a very simple and cost-free thing that all news organizations can do to make their news better: every time you write about a court filing or judgment, link to it. (And, ideally, make sure it’s been uploaded to Recap, too.) For instance, consider Patricia Cohen’s NYT article about David Mirvish’s lawsuit against the Knoedler gallery. (See what I did there? You’re welcome.)

Cohen’s article is a very interesting view of the lawsuit and its context, but it doesn’t come close to capturing the barminess of the complaint. And because Cohen understands the bigger picture, she actually ends up misrepresenting the suit itself, in which Mirvish is seeking to take possession of two paintings on the grounds that Knoedler, which has now closed, isn’t selling them. Here’s Cohen:

While most of the suits have argued that the paintings Ms. Rosales brought to market were fakes, Mr. Mirvish says his are Modernist masterpieces and that he lost out on millions of dollars in profits when Knoedler failed to sell them.

In reality, Mirvish isn’t suing for “millions of dollars in profits”: he just wants the paintings, is all. Which is pretty aggressive, seeing as how he’s only paid for a 50% share in them.

The case is fascinating because Mirvish was acting as an unabashed speculator in this case: he bought the Pollocks low, knowing that they had dubious provenance, and hoped, with Knoedler’s help, to be able to sell them high and make a tidy profit. Call it provenance arbitrage: Knoedler was a storied and highly-respected gallery, and a painting being represented as genuine Pollock by Knoedler is worth a lot more than a painting being represented as genuine Pollock by a sketchy Long Island dealer by the name of Glafira Rosales.

In the beginning, everything worked out great for both Knoedler and Mirvish, even if Mirvish’s lawyer, Nicholas Gravante, seems to find it incredibly difficult to explain what actually happened. For instance, he writes:

Knoedler purchased the Silver Pollock from Rosales for $950,000 in 2002.

Knoedler paid $475,000 to Rosales from its own funds and contemporaneously sold Mirvish a 50% investment interest in the Silver Pollock for $1.6 million. Thus, the end result of the transaction was that Knoedler held title to the Silver Pollock, and Knoedler recorded a profit of $1.125 million.

This is not easy to understand. On a cashflow basis, if Knoedler buys the painting for $950,000 and then sells a 50% stake in the painting for $1.6 million, then the profit to the gallery is $650,000, not $1.125 million. And on a mark-to-market basis, if the Mirvish deal ratifies a $3.2 million valuation on the painting, then Knoedler has made $650,000 in cash, plus $1.6 million for the value of its own 50% stake, for a total profit of $2.25 million. The only way to get to $1.125 million is to think of the painting in two halves. Knoedler bought both halves for $475,000 apiece, and then sold one of the halves for a profit of $1.125 million, while holding on to the other half for itself.

Now this may or may not be the way that Knoedler thought about the deal; the whole thing is massively complicated by the fact that, as Cohen reports, Gravante also represents Knoedler’s former president, Ann Freedman. Why on earth would Mirvish hire the lawyer who represents the president of the gallery he’s suing?

What’s more, the public version of the lawsuit omits what happened next to the Silver Pollock: Freedman sold it to a London hedge fund manager, Pierre Lagrange, for $17 million, and, according to Cohen, “for four years, the sellers, including Mr. Mirvish, enjoyed the gains from their commercial coup”. Presumably, Mirvish received half of that $17 million, and made a personal profit of $6.9 million; Knoedler also made $6.9 million, plus the $1.125 million it had already made on the Mirvish deal, for a total of $8.025 million.

There is one short paragraph of the lawsuit which has been redacted, which may or may not explain some of what happened after Lagrange declared the painting to be a fake and asked for his money back; it certainly doesn’t seem long enough to explain the whole story. Still, the upshot, at least in Mirvish’s mind, seems to be that Knoedler now possesses the painting; that it’s not attempting to sell the painting; and that if Knoedler isn’t going to try to sell the painting, then Mirvish wants his $1.6 million back.

All of this seems to hinge on a “contract” between Mirvish and Knoedler, under which Mirvish’s payment of $1.6 million was not a once-and-for all purchase of 50% of the painting, but was rather a revocable deal, under which Knoedler had the right to retain the $1.6 million only if it was “marketing and attempting to sell” the painting. Naturally, Mirvish can’t produce a copy of this “contract”. But never mind that: it’s just not fair, what Knoedler did. In probably the most astonishing sentence in the entire complaint, we’re told that

Mirvish’s investment in the Silver Pollock was worthless absent Knoedler’s agreement to market and sell the painting.

Worthless! Remember, here, that Mirvish still believes the Silver Pollock to be a timeless masterpiece. But he, like the White Queen, is clearly one of those people capable of believing six impossible things before breakfast, since he also seems to think that a 50% ownership stake in a significant Pollock painting is worthless — unless, that is, an Upper East Side art gallery is attempting to sell the thing.

Now Mirvish used to be an art dealer in his own right, and I’m sure he never told people buying a painting that their painting would be worthless unless it was consigned for sale somewhere. But for the purposes of this complaint, the money that Mirvish spent on his 50% of the painting amounts to “unjust enrichment” of Knoedler, just because Knoedler (which is no longer operating) isn’t actively trying to sell the thing.

All of which is to say that in this lawsuit, Mirvish has taken the idea of art-as-an-investment to a particularly bonkers extreme. In Mirvish’s world, it seems, artworks have no inherent value, just by dint of being beautiful or genuine or unique. Instead, an artwork is only an investment if it’s being shopped around — if someone’s trying to make a profit on it, by selling it.

Similarly, in Mirvish’s world, if a gallery has a claim to 50% of the value of a painting, but again isn’t actively shopping that painting around, then the gallery’s claim is worthless. That’s basically what Mirvish is saying with respect to the other two Rosales Pollocks he took a 50% stake in.

The deal with these two Pollocks — which are rather hilariously referred to in the complaint as “the Greenish Pollock” and “the Square Pollock” — was slightly different than the deal with the Silver Pollock. The basic facts are similar: Knoedler bought the Greenish Pollock from Rosales for $750,000, and then sold a 50% stake in it to Mirvish for $1.25 million. And after buying the Square Pollock from Rosales for $2.25 million, Knoedler sold a 50% stake in that painting to Mirvish for $2 million.

But these two paintings weren’t split into conceptual halves, in the way that the Silver Pollock was. Instead, a rather complicated arrangement was worked out. Mirvish contracted to buy both paintings in full, outright — but he only paid half of the total purchase price. The other half of the purchase price was lent to Mirvish by Knoedler, in the form of “a non-recourse, non-interest bearing loan”. And just as with the Silver Pollock, Knoedler kept physical possession of the painting, with an eye to flipping it for a profit. Under the terms of the loan, 50% of the sale proceeds would go to Knoedler, and 50% to Mirvish; if all went according to plan, Knoedler’s 50% would be more than enough to pay off the loan and to keep a healthy profit for itself.

This is not easy to follow, but the key word here is “non-recourse”. What it means is that although Knoedler had technically lent Mirvish $3.25 million, Mirvish personally has no legal obligation to ever pay Knoedler that money. If Mirvish ever gets possession of the paintings, then he has title to them already, and never needs to pay the $3.25 million that Knoedler is owed. Economically, the deal is the same as with the Silver Pollock: Mirvish paid a certain amount of money for a 50% economic stake in the artwork, on the understanding that he would receive 50% of the eventual sale proceeds. But legally, at least according to this complaint, Mirvish owns these artworks outright — he has title to both of the paintings in full, rather than just to some kind of 50% investment stake.

In a weird way, the tables are turned, with the Greenish and Square Pollocks: it’s Knoedler, rather than Mirvish, which has the speculative investment interest. And so by the logic of the Silver Pollock, now that the works aren’t being actively shopped any more, Knoedler should be able to retrieve from Mirvish the $3.25 million it lent him, and zero out the whole deal. Except, of course, Mirvish doesn’t see it that way: he has no interest at all in repaying those loans. In fact, he wants to take possession of both paintings without repaying the loans.

Once again, Mirvish conjures up an invisible contract, under which Knoedler was obliged to hand over the paintings to Mirvish if it ever stopped trying to sell the paintings. It’s hard to see why Knoedler would ever enter into such a contract while also being owed $3.25 million in non-recourse loans: after all, the minute it gives Mirvish the paintings, it can basically kiss that $3.25 million goodbye.

Indeed, if there was some kind of implied contract between Mirvish and Knoedler, it was surely that Knoedler would never just hand the paintings over to Mirvish and receive nothing in return for its 50% economic stake in the works. Both parties entered into this deal in a spirit of financial speculation, and both parties thought of themselves as having an equal share in the works. The complaint says that “equity and good conscience require that Knoedler deliver the Greenish Pollock and Square Pollock to Mirvish” — but there’s nothing equitable about that outcome whatsoever, where Mirvish ends up with 100% of the paintings, and Knoedler ends up in the hole to the tune of $3.25 million.

Knoedler is bust, now; it will never reopen. Its liabilities exceed its assets, but among those assets is a 50% economic stake in two Mirvish Pollocks. Those Pollocks are basically unsellable at this point, given their Rosales provenance, and in Mirvish’s eyes, that means the 50% economic stake is worth zero, even though (he says that ) he’s convinced the paintings are genuine.

The whole thing would stink of Mirvish trying to kick Knoedler and Freedman while they’re down — an investor trying to take advantage of their misfortunes by getting 50% of two (alleged) Pollocks for free. Except, that is, for the fact that Mirvish is using Freedman’s lawyer. Which means that the real story is more complicated still.

In any event, this lawsuit is a rare glimpse into a side of the art world which is very rarely seen — a purely mercenary world of co-investments and speculative bets, where stakes in artworks are bought and sold with an eye to making many millions of dollars in profit should a convenient hedge-fund manager turn up brandishing a $17 million check. It’s a world which is deliberately kept very secret from the buyers of the art: if you’re a gallery trying to sell a painting for $17 million, you’re not exactly going to advertise the fact that you bought it for $950,000 just five years earlier. But that’s the thing about the art world: there is literally no limit to how big the mark-ups can get. And it’s a world where the most successful dealers are the ones who can deal in established names like Pollock, and still try to lock in a sale price at a double-digit multiple of what they paid.

Andrew Ross Sorkin and Peter Lattman have uncovered an interesting wrinkle in the SEC’s case against Mathew Martoma, the most promising part of its huge investigation into Stevie Cohen. The SEC made quite a big deal of the fact that Martoma didn’t just sell his position in two pharmaceutical companies ahead of a big negative announcement; he even kept on selling after that, building up a substantial short position.

But as Sorkin and Lattman have worked out, that’s not really the case: SAC was flat going into the announcement, rather than being short.

The NYT’s spin on this news is that it suggests “a possible line of defense for the portfolio manager”, but it’s not entirely obvious from the report what that possible line of defense is, so let me spell it out.

First, it’s worth stating quite clearly that profits are the same as avoided losses in the eyes of the law. The SEC says that Martoma made $75 million in profits and avoided $194 million in losses as a result of the trading, for a total of $269 million; in the light of the NYT’s new information, that should probably just be $269 million in avoided losses, and nothing in profits. The total amount of money is the same, so the severity of the charges is unchanged.

But here’s the thing: if your trading book is long ahead of a big announcement, you’re basically making a bet on that announcement. Similarly if you’re short. But if you’re flat, that’s the one way of not betting on the announcement. And it now seems that SAC was flat, rather than short.

Of course, if Martoma traded on inside information, then he’s guilty whatever the final position of SAC’s trading book was. But if that position was flat rather than short, it’s no longer circumstantial evidence that SAC thought the announcement was going to be negative.

And there’s another line of defense here, too. As the NYT says, “SAC is well known for its aggressive, rapid-fire trading style, and several former employees say that there is nothing unusual about the fund’s exiting a large position over just a few days.” And this is the defense that has now been opened up. SAC was sitting on substantial paper profits, on its position in Wyeth and Elan. It knew an announcement was coming, and it knew that announcement could move the stocks substantially. If it made the sensible determination that the downside was bigger than the upside, there was every reason for the fund to move to a flat position ahead of the announcement, whether it had any inside information or not.

If I were a defense lawyer here, I’d be coming up with hundreds of previous cases where SAC exited a large position in a short amount of time, ideally ahead of some big announcement. Some of those exits will have been smart, in hindsight, while others will have been silly: SAC would have been better off holding onto its position rather than going flat. But the decision to go flat and take profits (or cut losses) is a common one within SAC, and can happen at any time for any of a million reasons. And as a result, SAC’s trading activity is not in and of itself prima facie evidence of insider knowledge.

Frankly, this isn’t much of a defense. Trading activity is what the SEC uses to try to find possible abusers of inside information; it’s not what the SEC uses to try to prove such cases. In this case, the SEC is relying on the testimony of Sid Gilman, the doctor who leaked the trial results to Martoma before the official announcement.

But the news does help insulate Cohen, even if it doesn’t help Martoma very much. No one knows what Martoma told Cohen before Cohen made the decision to go flat, but SAC’s trading action is entirely consistent with a simple declaration that Martoma wasn’t comfortable being long any more. (The rest of SAC was already making a strong case against being long at this point.) If Cohen knew that an announcement was imminent, and that the one person who wanted to be long no longer wanted to be long, then it would have made sense for him to go flat ahead of the announcement, even if he had no inside information at all. And there’s no particular reason to believe that Martoma would have admitted to Cohen that he had illegal insider information.

As Sorkin and Lattman say, the statute of limitations on this trade is rapidly running out: if the SEC will have to either bring charges against Cohen soon, or not at all. And so long as Martoma is refusing to cooperate with the SEC, it increasingly seems as though the SEC’s best chance yet to nail Cohen is going to slip through its hands.

If you want to stay on top of what’s going on in the case of Elliott vs Argentina, here’s your one-stop shop: Shearman & Sterling’s invaluable page on the subject, with links to all the briefs and filings you could possibly ever want to read on the subject, plus Shearman’s own detailed and useful summaries of what they say and mean.

The latest news in the case is quite important. A group of Argentine bondholders — real bondholders, not the vultures holding defaulted debt — were understandably unhappy at the Second Circuit’s interpretation of the pari passu clause in New York law bond documentation. That interpretation is, for the time being, the last word on what the pari passu clause means — but the problem is that a majority of observers, including myself, don’t actually believe that the pari passu clause means what the Second Circuit says it means.

So Argentina’s creditors had a bright idea. New York courts are the ones in charge of determining what contracts mean when they’re written under New York state law. So they asked the appeals court to send the case over to the New York Court of Appeals, for a new ruling on the meaning of the pari passu clause.

They lost: the appeals court just said no to that idea. As a result, the world has already changed dramatically: from here on in, settled law is going to say that pari passu boilerplate can and should be read to mean that debtors should make a “ratable payment” to all equally-ranking creditors, and that they can’t pay Peter without paying Paul. This is an important precedent in the world of sovereign debt, and is almost certain to make debt restructurings that much more difficult, at the margin. Indeed, the FT ran an article last week saying that the ruling is so important we should maybe try to resuscitate the IMF’s doomed Sovereign Debt Restructuring Mechanism proposal from 2002. Please, anything but that.

The Second Circuit’s ruling is almost certainly here to stay; there are a couple of appeals going on, one to the whole circuit sitting en banc, and the other to the Supreme Court. But the chances of either appeal succeeding are vanishingly slim. But let’s not overemphasize the importance of the precedent here. There is a very real chance that Argentina could wind up in technical default as a result of this ruling, but it’s far from clear that the ruling is going to prove particularly important to any country that’s not called Argentina.

The reason is that the Second Circuit’s interpretation of the pari passu clause ultimately boils down to “hey Argentina, if you’re paying these guys, then you have to pay those guys too”. But there was never any doubt that Argentina had a legal obligation to pay those guys. Even Argentina itself doesn’t dispute that. Anybody holding defaulted Argentine bonds can very easily go to just about any court they like, and get a judgment saying that they have to be paid, whether or not anybody else is being paid at the same time.

So really, the interpretation of the pari passu clause is neither here nor there. What’s important — what’s absolutely crucial, in this case — is the remedy that Judge Griesa has come up with in retaliation against Argentina for not paying NML Capital (a/k/a Elliott). I explained that remedy using Lego last month; the important thing is that Griesa isn’t just delivering judgments against Argentina, but that he’s also binding intermediaries like Bank of New York Mellon and generally the entire financial clearing system.

That’s what all the briefs in front of the Second Circuit are now litigating: not the meaning of the pari passu clause, but rather what courts can and can’t do if they determine that the clause has been breached.

There’s a huge spectrum of possible rulings from the Second Circuit on that front, ranging from a full affirmation of everything that Griesa has done, all the way to a declaration that while Argentina has indeed violated the law, innocent third parties can’t be enjoined or punished for its actions. But whatever the Second Circuit rules, the ruling will only affect Argentina, and won’t be a particularly useful or important precedent for anybody else: remedies aren’t precedents in the same way that rulings are. In future, any judge finding a debtor guilty of violating a pari passu clause will still have full discretion in terms of the remedies she can impose, and will never be impelled to follow in Griesa’s footsteps. And even Griesa only started getting this harsh on Argentina after a full decade of Argentina cocking its sovereign nose at his court.

So while a lot of sovereign-restructuring geeks will breathe easier if the Second Circuit strikes down the most extreme part of Griesa’s ruling, nothing the court can do would be enough to justify broad-based panic about sovereign restructurings more generally, and very few investors would consider an Elliott victory here to be a green light encouraging them to try the same tactics in future restructurings. The Argentina case is unique on many levels, and is likely to stay that way — no matter how the Second Circuit rules.

Mark Gongloff is not a fan of the idea that corporations are people. Except, that is, when the corporation in question is HSBC: he’s extremely angry at the fact that the UK bank won’t face criminal prosecution as a result of its money-laundering shenanigans.

Gongloff’s take is pretty mainstream: the NYT editorial page said that the decision is “a dark day for the rule of law”, adding that “clearly, the government has bought into the notion that too big to fail is too big to jail”.

But here’s the thing: you can’t jail a bank, or any corporation; a criminal indictment of a corporation is a bit of a peculiar fish at the best of times. Even if the bank survived, which Gongloff thinks is possible but no one knows for sure, there would certainly be massive job losses — and we can be sure that somewhere between 99% and 100% of those job losses would fall on people who had absolutely nothing at all to do with the money laundering that HSBC was getting up to.

What’s more, it’s important to put HSBC’s crimes in context. The United States, in its role as global hegemon and guardian of the world’s only real reserve currency, has unapologetically taken the opportunity to use its economic power to push its geopolitical agenda. For instance, if you’re an Iranian business and you want to do business in dollars, the US is determined to make your life as difficult as possible. The US might have no jurisdiction over Iranian businesses, but it does have jurisdiction over nearly all the important banks in the world, since it’s impossible to be a global bank without having some kind of presence in the US. And — as Argentina is finding out right now in its court case against Elliott Associates — if you want to send dollars around the world, you basically have to send them through the USA.

To put it another way, the laws that HSBC broke were laws designed to bolster the international standing of the US relative to Iran and other countries: they were geopolitically motivated, and the intended target was not the international banking system, with which the State Department has no particular beef, but rather countries the State Department doesn’t like.

In general, the laws have had their intended effect: they have depressed commerce in the relevant countries. But after HSBC has been caught breaking the laws, is there really any point in then pursuing a scorched-earth criminal prosecution against the bank? Remember, the bank was not the real target of the laws in the first place — and what HSBC did was perfectly legal in, say, the UK.

The US certainly has the ability to criminally prosecute HSBC. But doing so would not particularly hurt Iran or any of America’s other state enemies. And the laws which HSBC broke were not laws against bad banking, they were laws against bad states.

Or, to put it another way: the US is the most powerful sovereign nation on the planet. With a flick of its Justice Department finger, it could wipe a globe-spanning bank off the face of the financial system. It has truly awesome power. And every single bank in America is well aware of just how much power the US has in this regard. The question isn’t whether to use that power, it’s why. To do so would be bullying, and capricious, and would punish thousands of innocent individuals, and would destroy hundreds of billions of dollars of value, all for the purpose of nothing much in particular. Just because the US can prosecute HSBC doesn’t mean that it should prosecute HSBC. And sometimes, forbearance isn’t a sign of weakness, it’s a sign of maturity.

Update: Contra EJ Fagan, this is not an argument against prosecuting individuals at HSBC who broke the law. And in the comments, a lot of people are making the point that HSBC’s crimes centered not on Iran but rather on Mexican drug cartels; again, the laws broken are all part of the US war on drugs. The question here is: do you destroy a bank as collateral damage in that war?

Now that the election is over, there’s a bit of time to revisit that very important CPDO decision I wrote about on Monday. There’s a lot of material to be mined here, and the Internet is slowly delving its way into it: I particularly love, for instance, the way that Daniel Davies started tweeting out noteworthy paragraphs.

But first there’s Paul Davies, who does a great job of explaining the revolving-door aspect to the case. You know how banks will hire regulators, at multiples of their former salary, and turn the former gamekeepers into poachers? Well, exactly the same thing happens to S&P: it pays better than the US government, but not nearly as well as the structured-credit department at ABN Amro. And thus a whole slew of S&P alumni ended up at the Dutch bank, putting together deals precisely designed to be the absolutely worst possible product in the world which could still, somehow, get a triple-A rating. In order to do that, you need people who know how the ratings sausage is made — and the easiest way to do that is to simply hire them.

S&P was well aware of what ABN Amro was doing, of course, but they had no incentive to frown on its behavior. For one thing it was good news for staffers that there was a healthy bid out there for their services; for another, ABN Amro paid S&P itself huge amounts of money to rate these deals. Everybody won — except the credulous investors who thought that ratings were honest, arm’s-length things.

Matt Levine points out that conceptually, the CPDO is “the perfect ratings arbitrage”, because the rating just tries to calculate the probability of default, without regard to the recovery value given default. As a result, the CPDO was specifically designed to have a recovery given default of very near zero, since that would increase the yield on the instrument without increasing the default rate. (This is exactly the same reason why it was S&P, rather than Moody’s, which downgraded the US from triple-A last year.)

Louise Bowman, meanwhile, finds this email exchange, between a couple of S&P quants:

Mr Venus: I am done with the whole CPDO – wish I was never involved in that whole mess that was made.

Mr Ding: What a wuss.

Mr Venus: That thing is done by 3 people: Cian, Sriram and you. I am not responsible, I just helped build an internal model. You are the wuss for bending over in front of bankers and taking it.

Mr Ding: primarily me and the banker…so what? I would not mind if they put my name on that article, grow up kid.

Mr Venus: You rate something AAA, when it is really A-? You proud of that little mistake? It’s nothing to do with growing up, it’s about doing your job to a high standard. If you want to talk about growing up, you should admit to Perry [Inglis] that you made a mistake with your analysis.

But the smartest lines, still, come from the judge, Jayne Jagot. For instance, she spends a lot of time demolishing the S&P argument that the investors didn’t understand what they were buying, and therefore that it was the investors’ fault, not S&P’s fault, that the investors lost money. Jagot demonstrates clearly that the investors knew full well that they didn’t understand the CPDOs, and that it wasn’t necessarily stupid of them to invest anyway:

The notion that it was necessarily imprudent of the councils to invest in a product they did not understand, on analysis, is specious. It is a superficially attractive catchphrase which does not withstand scrutiny. An investor who obtains expert advice and relies on an expert rating is not imprudent merely because the investor does not understand the investment. So in this case the councils’ lack of understanding and their knowledge of their own lack of capacity to understand was the reason for relying on the expert advice and recommendations of LGFS and the expert opinion of S&P embodied in the rating.

The fact is that in the fixed-income world, investors almost never understand what they are buying. A bond is a set of predictable cashflows, with a sting in the tail: it has some unknowable probability of default. Different analysts can try to calculate that probability by different means, but in reality bond investors simply don’t have the time or the expertise to do that for every bond they buy. That’s where ratings come in handy: they’re a way for bond investors to outsource a lot of the hard work they don’t have the time or the human capital to do themselves. And the ratings agencies know it: as Jagot says, “S&P is paid to assign a rating for a structured financial product for one purpose only.”

And then there’s the bigger picture: the fact that Jagot was able to deliver this magnum opus of an opinion at all. It’s clearly the product of vast amounts of work, and a positively enormous amount of lawyering on both sides. The victims, in this case, were relatively small Australian municipalities: how did they manage to afford to fight this court case this far?

The answer is, they didn’t: all of the legal fees were paid by a litigation funder called IMF (Australia), which will take a cut of any proceeds. They write:

Litigation finance is a critical mechanism to enable cases to be brought and litigated against large corporations, banks and other powerful institutions, often by small and mid-sized companies and entities.

The Australian Federal Court’s finding yesterday — in favor of local municipalities — that S&P’s AAA ratings were “misleading and deceptive” could never have been achieved without litigation funding support from IMF (Australia), Bentham’s parent.

I have no problem at all with companies like IMF funding these lawsuits. It’s incredibly hard for investors to successfully sue big financial-services companies like S&P, and litigation funders help to level the playing field. Even if they end up getting paid no money at all, they have at least caused Jagot’s wonderful opinion to see the light of day. And that alone is a massive public service.