On March 18, 2016, the Libyan Investment Authority (LIA), a sovereign wealth fund set up by dictator Colonel Muammar Gaddafi in 2006, filed suit in London at The High Court of Justice’s Chancery Division against Goldman Sachs International.
The suit claims the fund paid Goldman approximately $350 million to set up trades the LIA says it didn’t understand, which lost the fund $1.2 billion, everything it invested.
Instead of fraud, the LIA claims its “causes of action” are “undue influence” and “unconscionable bargain.”
Goldman decided not to settle and believes it can beat the charges because, you know, there was never any undue influence and Goldman Sachs is not unconscionable.
The suit will be decided this October.
In short, the LIA claims the Great Vampire Squid’s blood-funnel bankers, traders, and especially one junior salesman, cozied up to the “nascent” sovereign wealth fund’s managers and traders, who all had “limited legal and financial expertise,” by entertaining them lavishly at expensive restaurants and hotels, plying them with gifts and prostitutes, training them enough to claim they should have known what they were buying, employing the deputy executive director of the fund’s younger brother, and finally inducing them into putting on leveraged derivatives trades that amounted to an unconscionable bargain.
Here’s the inside scoop on the case…
Libya gained its independence from Italy in 1951. Eight years later massive quantities of oil were discovered and Libya entered the world stage. In 1969, with Libya’s king out of the country, an upstart colonel in the Libyan army, Muammar Mohammed Abu Minyar Gaddafi, led a coup and took over the country.
By 2003, the “Mad Dog” dictator was feeling the pinch when fellow strongman, Iraq’s Saddam Hussain, was pulled from his hiding hole and paraded as a prisoner of war.
Gaddafi, only a few weeks later, renounced his country’s nuclear and chemical weapons programs and sought to have sanctions against his country lifted.
Twelve countries lifted sanctions in 2003. The United States in 2004, to reward Libya’s renunciation of weapons of mass destruction, lifted its sanctions. By 2006 full relations were restored.
Gaddafi established the Libyan Investment Authority, the country’s sovereign wealth fund, in 2006. Its operations were primarily conducted by a management committee set up in January 2007, which later became the fund’s board of directors.
Gaddafi appointed his friend, a traditional commercial banker, Mohamed Layas, as executive director. Mustafa Mohamed Zarti (38 years old), at the suggestion of Safir Al Islam Gadaffi, Zarti’s friend and the son of Moammar Gadaffi, became the fund’s deputy executive director. Zarti’s banking experience was limited to a stint on OPEC’s Fund for International Development. The directors set up two teams at the fund, the equity or direct investment team and an alternative investment team.
The LIA claims the fund’s twelve team members had “no legal expertise and no background in, or experience of complex derivative products.”
Enter the Dragon
In June 2007, Moroccan native Youssef Kabbaj (31 years old), an upstart Goldman securities salesman out of the firm’s London offices, who spoke English, French, and Arabic and had an engineering degree from MIT, cold-called the LIA and got a meeting.
The suit claims Goldman, in particular Youssef Kabbaj, befriended LIA managers, especially deputy executive director Zarti, who pulled the trigger on the fund’s trades and investments.
Not only did Goldman’s Kabbaj lavish gifts on LIA managers and team members, wine and dine them, send them to Goldman University in London for training, and pay for their travel with him to Marrakech, Casablanca, and Rabat in Morocco, he did deputy executive director Zarti the ultimate favor and got his younger brother, Haitem Zarti (25 years old) an internship at Goldman.
With the ball teed-up, Goldman swung at LIA as hard as it could.
Between January 2008 and April 2008, Goldman suggested and executed nine “disputed trades” on behalf of the LIA.
The LIA itself was interested in an investment in Citigroup, having been told by Gadaffi himself that Qatar had made a $7.5 billion investment in the American bank, and to look into it. Goldman was only too eager to move that trade along.
But, rather than have the fund buy shares in Citi, Goldman created a “cash-settled forward purchase agreement for Citigroup shares with downside protection in the form of a put option at the same price as the forward.”
Yeah, that’s what I said. And I understand derivatives.
According to a just-published Bloomberg Businessweek article, “More simply, if Citi shares rose, as the LIA was betting, the fund stood to gain many times its initial investment. If the shares fell by a certain amount, the fund could lose everything. The structure was potentially more lucrative than a conventional purchase of equity and also significantly riskier-while resulting in far higher profits for Goldman.”
Goldman teed-up two of these trades amounting to a $200,000,000 bet on Citi going up.
An investment decision that seems damning to Goldman, and to me, is revealed in the suits “Re-Re-Amended Particulars of Claim Dated 18 March 2016.”
The LIA wanted to take an equity position in France’s Electricite de France, and on February 19, 2008, it’s equity direct investment team bought $73,768,695 worth of EdF stock. But, Goldman, on the same day, “restructured” the position into another “cash-settled forward purchase agreement for shares with downside protection in the form of a put option at the same price as the forward.”
In other words, Goldman took the LIA’s shares and converted it to $73,768,695 in premiums to establish a derivative trade that would make more money if EdF went up, but could lose everything if it fell far enough.
In the end, the LIA lost $1.2 billion on the trades Goldman ushered it into when markets imploded during the fall of 2008. While the derivative contracts had three years to go, by expiration none of the positions had recovered enough to be worth anything.
So LIA sued.
What’s revealed in the suit is that before the fund’s investments were wiped out, in the summer of 2008, LIA hired the law firm of Allen & Overy to help it understand the Goldman trades.
Catherine McDougall, a 26 year-old Australian lawyer working for Allen & Overy was assigned to the LIA. She was dismayed, to say the least.
Goldman never had the LIA sign an ISDA master agreement, standard in derivatives transactions, only sent LIA trade confirmations months after trades were executed (some they never received) didn’t provide account statements, and apparently charged the LIA some $350 million in fees which otherwise should have been closer to $111 million.
According to Matthew Campbell and Kit Chellel’s excellent Bloomberg Businessweek article, McDougall “was astonished by how little the LIA’s junior employees seemed to know. The legal department’s level of competence in dealing with complex legal documentation was ‘zero,’ she wrote later in a witness statement. The problem was compounded by rudimentary English and basic paperwork that was missing. She described the setup as like ‘an advertising company having no TVs.'”
“She asked to see the due diligence the LIA had performed before committing to the deals. They responded, she wrote, ‘Due what?'”
But lawyer Robert Miles in the Bloomberg article said, “that’s not the bank’s problem; the Libyans entered commercial transactions, fair and square.” The LIA “understood at all times that Mr. Kabbaj was a salesman, and that his job was to sell investments to the LIA from which [Goldman] could make money,” Goldman’s lawyers said in closing arguments.
The bank’s official statement on the lawsuit reads, in part, “We have always disputed the LIA’s claim that it was financially illiterate and it is clear that they understood the disputed trades and entered into them of their own volition.”
The LIA claims “undue influence” which Campbell and Chellel say is “more commonly used by wives against husbands”- the idea being “that one party to a transaction can have so much power over another that a contract between them isn’t valid.”
The unconscionable bargain claim stems from the oppressive fees Goldman charged in a mostly one-sided bet the LIA claims they had no idea they were at risk for.
We’ll know in October what the court’s decision is.
But in the meantime – what do you think?
Did Goldman exert undue influence to make gross profits on an unsophisticated “elephant” client? Or are slickster salesman still a viable business tool?
During Monday night’s presidential debate, GOP nominee Donald Trump said that the Fed was being “more political” than his democratic counterpart Hillary Clinton, which sparked a national conversation about what the Fed actually does.
Shah stopped by a recent episode of Making Money with Charles Payne to talk about his position that the Federal Reserve is – and always has been – a political tool.
Not long ago, Shah called Deutsche Bank “The Most Dangerous Bank in the World.”
Now, as the stock has lost a whopping 60% of its value over the past 12 months, one big question has surfaced: Will DB get bailed out?
On a recent episode of Varney & Co., Shah argued that it would. With 60 trillion in derivatives on its books, if the bank were to collapse, counterparties to those derivatives – all the big banks around the world – would follow.
This would make the collapse of Lehman Brothers look like a day at the beach.
Speaking of Lehman… the other big question hanging over the markets: Are we back to 2007?
Republican Presidential Nominee Donald Trump blasted the Federal Reserve and Fed chair Janet Yellen for being more “political” than his Democratic counterpart Hillary Clinton in Monday night’s heated presidential debate.
Is he right? Is the Federal Reserve political in any way, shape or form?
Fed officials, the vast majority of political analysts, and “a wide range of independent observers,” according to the New York Times, “roundly rejected” Mr. Trump’s “accusation.”
But the truth is, the Federal Reserve is absolutely, positively political. It’s in their DNA.
I’ll prove it to you…
The Fed Began as a Political Tool
This isn’t about Donald Trump being right. And, it isn’t about Hillary Clinton telling reporters on her campaign plane on September 6, 2016, “You should not be commenting on Fed actions when you are either running for president or you are president. Words have consequences. Words move markets. Words can be misinterpreted.”
This is just the bare naked truth about the Federal Reserve and how it operates.
Most people, including the majority of politicians in the U.S., analysts and journalists covering politics and the economy, and overseas observers, don’t know what the Fed is.
They think as America’s central bank it’s a branch of the government. It isn’t.
An example of the ignorance of even respected news outlets like the New York Times was front and center yesterday.
In a Times article titled “Scant Evidence to Support Trump’s Attacks on the Fed,” author Binyamin Applebaum writes, “The Fed is not independent. It is an arm of the federal government, chartered by Congress to maximize employment and minimize inflation.”
The Federal Reserve System is privately-owned by shareholders. It is not an “arm” or branch of the U.S. government.
It was conceived in 1910 by a handful of rich and powerful men including Senator Nelson Aldrich of Rhode Island, well known as an agent of John D. Rockefeller, to whom he was related through a family marriage, J.P. Morgan & Co. partner Henry Davison, Paul M. Warburg the principal partner at Kuhn Loeb & Co., and American agent of Europe’s richest, most powerful banking family, the Rothschilds, and National City Bank president Frank A. Vanderlip, at a clandestine meeting at the secluded Jekyll Island Club off the tip of South Georgia, partly owned by John Pierpont (J.P.) Morgan.
The Senator and bankers designed the private central bank, which took three years to slide through Congress, to have the sole right to create Federal Reserve Notes (U.S. dollars), in other words they own America’s money supply, and to use their money to buy the government’s debt whenever it was necessary to support Federal operations and to support and backstop the big banks who were the shareholders in the new central bank.
The whole story of how the Fed was created, by who, for what purposes, and how it was greased to be twisted through Congress and institutionalized in law under the Federal Reserve Act of 1913 is one of America’s dirtiest secrets. But the truth is out there.
As conceived, the Federal Reserve System is a political tool. It couldn’t have come into being if political interests weren’t satisfied.
The Fed Is Political – Whether it Acts or Not
The Fed was meant to look to the outside world like it was above politics in order to be a “Reserve System” (not a bank, wink, wink) to backstop the financial system and maintain stable prices.
The so-called “dual mandate” which says the Fed has to “promote effectively the goals of maximum employment,” in addition to stable prices, was only inserted into the Federal Reserve Act when in 1977 Congress punted its fiscal responsibilities to the Fed because it was tired of being blamed for “stagflation” plaguing the country.
But that doesn’t mean the Fed isn’t political.
Politicians constantly threaten the Fed with audits, greater Congressional oversight and control, and on rare occasions threaten to abolish it.
Since Congress has the ability to legislate the Fed out of existence, successive Federal Reserve chairmen, FOMC members and Regional Bank presidents have had to play ball with whichever party’s administration is in power.
Donald Trump maintaining that, “They’re keeping the rates down so that everything else doesn’t go down,” and saying, “The Fed is being more political than Secretary Clinton” isn’t a stretch.
The Fed announced last December, when it raised the Federal Funds rate one quarter of one percent, its first rate hike in nine years, it was looking to hike four times in 2016.
After a hiccup through February when stocks and bonds fell sharply, stocks made multiple new all-time highs and bonds are booming again. And still there’s no rate hike.
No doubt, the Obama administration and Hillary Clinton remember when in October 1979, right before the presidential election between Jimmy Carter and Ronald Reagan, the new non-partisan Fed chair, Paul Volcker, changed the Fed’s policy objectives and rates soared.
Jimmy Carter lost hands down.
In terms of the metrics the Fed says it watches, there was no reason for it not to raise in September, unless of course, there were political motivations.
Of course there were. Especially in light of Donald Trump criticizing and threatening the Fed.
Saying the Fed isn’t political is like calling the Grand Canyon a ditch.
Starting October 14, 2016, institutional prime money market funds won’t be able to price themselves at a constant $1.00 a share.
New SEC rules will require these giant funds to value shares based on actual market prices for underlying assets in their portfolios.
That means their per-share prices will fluctuate on a daily basis.
While that’s not exactly good news, it gets worse.
The rules allow funds to charge up to a 2% redemption fee when investors want out.
But the killer is, funds can put up “gates” that prevent investors from selling shares.
Besides problems investors will have with the new rules, unintended consequences affecting companies and municipalities that rely on selling their commercial paper and other short-term debt instruments to these big funds could end up killing the market.
Here’s what you need to know, and what to do…
Why They’re Changing the Rules
Money market funds used to price their shares at a constant $1.00. It used to be “a dollar in and a dollar out.”
If the underlying assets in a money market fund rose above a $1.00 funds could pay the excess out as a dividend. If the underlying value of assets fell such that the pro-rata per share price was below $1.00, funds could use amortizing accounting methods to still maintain the fund’s constant $1.00 a share price.
In 2008 the oldest and largest money market fund in the U.S., The Reserve Primary Fund “broke the buck” and priced its shares at $0.97 when Lehman Brothers collapsed and the price of Lehman’s commercial paper The Reserve Fund held imploded.
The Reserve Fund breaking the buck panicked investors who immediately withdrew hundreds of billions of dollars from money market funds before they could lower their prices too.
That run on money market funds brought the financial system to a standstill.
Instantly, there were no buyers for the billions of dollars of commercial paper and other short-term debt instruments corporations and municipalities sold to money market funds on a daily basis to fund their payrolls and other short term cash needs.
In July 2014 the Securities and Exchange Commission handed down new rules to make some money market funds more transparent in terms of pricing their underlying assets and to temporarily steady funds during times of extraordinary financial stress.
Making institutional funds float their share price makes it more transparent to impacted investors so that they, and not the fund sponsors or the Federal government, bear the risk of loss.
By allowing these funds to charge up to a 2% redemption fee, under certain circumstances, the SEC hopes to slow redemptions when investors would normally head for the exits.
By allowing funds to put up “gates” to shut down redemptions altogether, the SEC expects to halt debilitating money market runs when the financial system can least afford them.
The Letter of the Law
Here’s how the SEC explains the new pricing requirements, the new redemption fees, or “liquidity fees,” and gates:
Showing Fluctuations in Price – Institutional prime money market funds would be required to price their shares using a more precise method so that investors are more likely to see fluctuations in value. Currently, money market funds “penny round” their share prices to the nearest one percent (to the nearest penny in the case of a fund with a $1.00 share price). Under the floating NAV amendments, institutional prime money market funds instead would be required to “basis point round” their share price
Liquidity Fees – Under the rules, if a money market fund’s level of “weekly liquid assets” falls below 30 percent of its total assets (the regulatory minimum), the money market fund’s board would be allowed to impose a liquidity fee of up to two percent on all redemptions. Such a fee could be imposed only if the money market fund’s board of directors determines that such a fee is in the best interests of the fund. If a money market fund’s level of weekly liquid assets falls below 10 percent, the money market fund would be required to impose a liquidity fee of one percent on all redemptions. However, such a fee would not be imposed if the fund’s board of directors determines that such a fee is not in the best interests of the fund or that a lower or higher (up to two percent) liquidity fee is in the best interests of the fund. Weekly liquid assets generally include cash, U.S. Treasury securities, certain other government securities with remaining maturities of 60 days or less, and securities that convert into cash within one week.
Redemption Gates – Under the rules, if a money market fund’s level of weekly liquid assets falls below 30 percent, a money market fund’s board could in its discretion temporarily suspend redemptions (gate). To impose a gate, the board of directors would find that imposing a gate is in the money market fund’s best interests. A money market fund that imposes a gate would be required to lift that gate within 10 business days, although the board of directors could determine to lift the gate earlier. Money market funds would not be able to impose a gate for more than 10 business days in any 90-day period.
What the Unintended Consequences Mean for Your Money
Now, let me be clear: not all money market funds are subject to the new rules.
Retail and government money market funds are exempt and can still price their shares at a constant $1.00 per share.
Retail funds cater to natural persons, individual accounts (brokerage or mutual fund), retirement accounts, including workplace defined contribution plans, college savings plans, health savings plans, ordinary trusts and accounts sold through intermediaries with the underlying beneficial ownership being a natural person.
Government money market funds only invest in government issued debt instruments and are exempt.
But these rules could still have a big impact on your investments.
Besides affecting the industry already, where almost $500 billion has exited institutional prime funds this year, there are sure to be unintended consequences from the new rules.
Big institutional investors who invest in prime money market funds, a lot of them whose companies issue the commercial paper held by prime funds, aren’t going to take kindly to being subjected to redemption fees when they want their money out of funds as prices are falling.
And they for sure aren’t going to want to be in prime funds if they can’t get their money out at all, while prices are plummeting.
That means there will be hundreds of billions of dollars, possibly more than $1 trillion, not available to banks, corporations and municipalities who borrow on an almost daily basis by selling their commercial paper and debt instruments to institutional prime money market investors.
Besides drastically choking short-term borrowers, who will have to find other ways to raise short-term funds, investors who would normally invest in money market funds are moving into government money market funds, who now have to find hundreds of billions of dollars of short-term Treasury bills to hold in their portfolios.
There’s already a shortage of T-Bills.
Between banks, hedge funds and institutional investors hoarding T-Bills for liquidity purposes, there’s very little supply in the $1.7 trillion T-Bill market. The Treasury plans to add another $188 billion to the T-Bill supply in anticipation of the new money market rules and the move by big investors out of prime funds and into government funds.
That’s not nearly enough supply. Any rush into Treasuries, which are across the yield curve in short supply because the Fed’s hoarding over $3 trillion of government notes and bonds, could result in severe liquidity problems if any kind of market selloff triggers a further rush into safe governments and there aren’t enough of them.
The new rules will undoubtedly spawn unintended consequences that regulators and investors haven’t considered but are likely because of the massive disruption to corporate borrowers and big investors we’re about to witness.
Whenever the market encounters huge unknowns, there’s likely to be disruptions, dislocations and possibly panic if something somewhere all of a sudden breaks or stops working.
Ahead of congressional hearings to discuss the recent price boost for the company’s, EpiPen product, Shah speculated that pharmaceutical company Mylan NV (NASDAQ:MYL) could be a buy.
On the morning before the hearing, Shah said that the bad news was already out there, and as a result the stock was hovering just above its 52-week low. He further said that the stock was likely to bounce back – and he would even be looking to buy if it dipped lower during the hearings.
Sure enough, the stock has tacked on 4.74% since.
Shah also discussed Microsoft Corp. (NASDAQ:MSFT), Tesla Motors Inc. (NASDAQ:TSLA), the Bayer-Monsanto deal, December’s likely rate hike, and the politicization of the Fed.
If you haven’t been paying attention, you could be forgiven for not understanding just how important tomorrow is for the markets.
Tomorrow is day two of two-day meetings being held by the Bank of Japan’s monetary committee and the Federal Reserve’s Federal Open Market Committee (FOMC).
Right now, it’s not what central bankers with god complexes say that matters – even though, yes, they move markets with what they say and even what they don’t say.
It’s what they’ve done and what’s going to happen – no matter what they say – that matters now.
Forget the gobbledygook, cryptic blathering spewing down from Mt. Olympus.
Here’s what going to happen tomorrow – and beyond…
Three Things You Need to Know About Central Banks
Before we dive in, there are three facts you probably don’t know – but you absolutely need to know – about central banks. Number one:
All central banks, in all their iterations, whether they’re a branch of government, quasi-independent institutions, or private corporations whose shareholders are big banks and elitist bankers, which is exactly what America’s Federal Reserve System is, are all in bed with their governments.
They couldn’t exist otherwise. They’re given the power to manipulate interest rates, mostly through “open market operations,” where they go into financial markets (without any capital to speak of) and buy and sell trillions of dollars’ worth of government bills, notes and bonds to move interest rates up and down, for two reasons:
They can buy all the government-issued debt they’re asked to buy so governments can run unlimited deficits without immediately adversely impacting interest rates;
They can be blamed by politicians if there’s no economic growth or high inflation due to too much government borrowing, relieving politicians of the blame for high unemployment or high interest rates.
All central banks, after glad-handing their political masters, serve their country’s big banks, providing liquidity when needed and bailing them out, if they can, at least up to the point that governments have to step in with bailout money they get from central banks. Central banks are big bank, backstopping, bailout machines.
There is no need for any central bank, anywhere. They only exist to be manipulated by governments, to bailout TBTF (too-big-to-fail) banks, and to enrich bankster oligarchs, their capitalist cronies, and political officers all feeding at the same dirty trough.
With that established, I want to take a close look at the Bank of Japan. In terms of modern-day manipulations, BOJ has been at it the longest.
Believe it or Not, the BOJ Is Worse Than the Fed
After the BOJ’s excessive easy money policies inflated Japanese real estate, which was used as collateral in the 1980s for margin loans to buy stocks, which rose exponentially and were themselves used as collateral with banks for mortgages to buy skyrocketing properties, all ended in the horrific crashing of Japan’s stock markets in 1990 and real estate markets in 1991, the BOJ stepped in. And it never left.
Thirty-five years later, the BOJ’s still manipulating rates, still pushing on a string, still trying to underpin stocks and real estate, still trying to turn deflationary realities into some kind of magical 2% inflationary panacea. It’s not working.
The BOJ’s pursuit of inflation by artificially manipulating interest rates lower, into negative territory as of this past January, by buying 38% of all Japanese government issued debt in the world, by buying corporate debt, and by buying stocks, hasn’t worked.
It’s not that the BOJ can’t see that their low interest rate policies haven’t worked. It’s not that the BOJ can’t see that Japan’s exporting juggernaut has been slam-dunked by rising emerging markets exporters, especially China. It’s not that the BOJ can’t see that productivity declines and demographic realities are working against Japan’s economy.
The BOJ sees all that. None of it matters to them because it’s just doing what it does, what central bankers with god complexes and their cheerleading state governments want them to do, step into the void and manipulate rates and financial markets.
Why? Because regardless of what’s working for the economy, or the population, there are financial asset renters, bankers, and politicians who benefit by the manipulation.
The same story holds true for the run-up in real estate prices in the U.S. and the stock market crash. The Federal Reserve’s low interest rate policies inflated bubbles that popped.
Just like in Japan, big banks were saved by a central bank and have all gotten bigger.
The haves have gotten wealthier and the middle class and lower socio-economic classes have tragically fallen backwards down a very slippery slope.
Savers have been punished. Retirees and pensioners have been devastated. And the capital they’d amassed, which fed bank lending and capital formation throughout free markets, has been replaced by central bank, master-of-the-universe funny money.
Here’s why tomorrow is so important…
Why Tomorrow Is Huge for Markets
Tomorrow, the BOJ’s going to say they’re going to do more.
They’re probably going to say they’ll take rates further into negative territory if they have to. They’ll buy more government bonds, more corporate bonds, and more equities if they have to. They’ll buy foreign government bonds to lower those rates to manipulate the yen down to spur export growth if they have to. And to help beleaguered savers and pensioners, they’ll even let longer-term rates rise, and buy even more shorter-term debt to “steepen the yield curve” if they have to.
And the Fed?
It’s unlikely they’ll raise rates tomorrow. Partly because they don’t want to let the world think Donald Trump, who called them out for being political (which of course they are) is going to goad them into raising rates before the presidential election (which, by the way, happened in October 1979 and cost Jimmy Carter the election).
They’ll probably say they’re data dependent and since things have slipped a little they’re on hold until December.
But the fact remains that the Fed could raise rates tomorrow. And that could disrupt markets that aren’t expecting a raise. The BOJ could say tomorrow that to help pensioners they’re going to let long-term rates rise. And that could disrupt markets even more than the Fed raising rates.
Or they both might take those unexpected courses and really double-whammy disrupt markets.
But it doesn’t matter. The disruption is coming. It’s either coming tomorrow or between now and the end of the first quarter of 2017. But it is coming.
It’s impossible to keep manipulating rates and blowing smoke into financial markets when there’s no earnings growth, when earnings have been declining for five quarters in a row, when there’s no meaningful economic growth anywhere.
Central bankers are not gods. Free Markets are the closest thing we have to capitalist heaven, and they eventually will break free from the massive manipulation, from the extraordinary decades-old manipulations.
Because that’s what happens when markets are manipulated too high for too long.
Starting today, get ready for bond market and stock market volatility.
We’re betting interest rates are going to rise and we’re betting stock market volatility is going to explode over at my subscription newsletters.
We’re shorting the bond market by buying inverse ETFs that go up when bond prices decline (and rates rise) and we’re buying call options on the VIX.
We covered the still-breaking story last week, and I told you how it sold its customers up the river by selling them accounts and services they never signed up for, how the once-cleanest big bank in America sold its soul for a tiny fistful of dollars.
It’s already old news that the bankster culture club bred another scandal of almost biblical proportions on account of 5300 Wells’ “team members” getting the stiff arm out of the bank for doing what they were pressured to do.
It’s old news that the bank paid $185 million in fines to settle civil charges with the Consumer Financial Protection Bureau (CFPB), the Office of the Comptroller of the Currency, and the L.A. city attorney.
And it’s old news that none of that money will do one ounce of good anywhere – it’s only going to be absorbed into the black hole of the federal government.
But there’s still plenty to be said about cross-selling at Wells Fargo.
In fact, it’s worse than we thought…
Too Little, Too Late
First, for those aggrieved customers who suffered ignominious identity theft, forgery and fraud at the hands of junior banksters executing orders from above, Wells set aside $5 million to pay them back the false fees they were charged.
Do you get that? This deep and wide-ranging scheme that included the creation of two million unauthorized accounts, perpetrated by some 5300 employees (including bankers, managers, and branch managers) in 8800 branches for a measly $5 million in fees!
And we’re not talking about one of the usual suspects here (I’m looking at you, Goldman Sachs, Deustche Bank, and HSBC). We’re talking about a well-admired bank with 70 million customers and $1.9 trillion in assets.
And to make matters worse, the Los Angeles Times unleashed an incendiary investigative piece by E. Scott Reckard titled, “Wells Fargo’s Pressure-Cooker Sales Culture Comes at a Cost” back on December 21, 2013 detailing most of what’s come to light two and a half years later.
It’s a great piece of investigative reporting, and if you have the stomach for it, you can read it here.
One question: What took the CFPB and other regulators and district attorneys so long?
If You’re Not Thoroughly Disgusted, You Will Be
The other bit of news that’s breaking is about Carrie Tolstedt, the 55-year-old senior executive vice president of Community Banking at Wells, who announced her retirement this past July, and was the driving force behind Wells’ phenomenal cross-selling binge.
Tolsted, a 27-year Wells veteran and senior executive vice-president of Community Banking, was ranked the 27th “Most Powerful Women” in the U.S. in 2015 by Fortune.
That Tolstedt’s $1.7 million salary was augmented in 2015 with $7.3 million in stock and cash bonuses, which was announced in a Wells Fargo proxy statement detailing executive pay, and said, “under her leadership, Community Banking achieved a number of strategic objectives, including continued strong cross-sell ratios, record deposit levels, and continued success of mobile banking initiatives,” is all too telling.
When she retires, she’ll leave with an additional $124.5 million courtesy of stock, options, and restricted Wells Fargo shares, which weren’t vested but eligible because she’s “retiring.”
Yep, another exit package that should get clawed back, but probably won’t.
The facts aside, it looks like high-pressure sales tactics and a win-at-all-costs mentality trickled down from the head of the Community Banking throughout the company and bred a culture within a culture.
This coming Tuesday, Well Fargo’s CEO John Stumpf has to address a Senate Banking Committee hearing, called in astonished anger to admonish the bankster in charge. They’ll no doubt will ask him why the hell the bank is paying Tolstedt $124.5 million on the way out the door.
This travesty of a mockery of a sham is not going away so quickly for Wells Fargo.
According to the Wall Street Journal, “Federal prosecutors are in the early stages of an investigation into sales practices at Wells Fargo & Co. that led to the bank being hit last week with a $185 million fine.”
The investigation is being conducted by the U.S. Attorney’s Offices for the Southern District of New York and the Northern District of California, and while prosecutors have yet to decide if any case can be brought, either civil or criminal charges could result.
The Journal says:
The investigation is focusing on whether someone senior within the bank directed employees to falsify documents in conjunction with the opening of accounts and products without consumers’ knowledge or authorization. Prosecutors are also focusing on whether there was willful blindness to sales practices on the part of executives at the bank.
Please! That’s a no-brainer.
It’s about the bankster culture club. We all know it. And Wells Fargo knows it too.
Upon Carrie Tolstedt’s retirement announcement, Wells’ chairman and CEO John Stumpf sang her praises and the bank’s culture saying,
A trusted colleague and dear friend, Carrie Tolstedt has been one of our most valuable Wells Fargo leaders, a standard-bearer of our culture, a champion for our customers, and a role model for responsible, principled and inclusive leadership. Because of her passion for serving our customers, wherever and however they chose to receive their banking services – online, in branches, or via mobile phones – Carrie leaves Wells Fargo uniquely positioned to continue to be a leader in retail banking, no matter how the future of banking evolves. We share in the pride that she has for the legacy, accomplishments and talent that she will leave behind.
I recently told you that volatility is about to come back to life.
In fact, it’s already happening.
From the close last Thursday through the close yesterday, markets have fallen 2.48%. That’s the power of volatility.
Sometimes it’s a seasonal phenomenon. Traders return from the summer doldrums and markets resume normal business – and volatility gets up of the floor and starts scaring traders again.
This year, though, the timing could not have been worse.
Right now, there’s a massive $400 billion cross-market bomb sitting there, waiting for something to set it off – and market volatility could be just the thing to blow it up.
Today I’m going to tell you where this bomb is planted and how a spike in volatility could light the fuse.
Here’s what you need to know…
The Portfolio Model That’s Threatening Markets
The more than $400 billion powder keg’s actually a portfolio management trend that’s been growing for years.
It’s called “risk parity” and it makes perfect sense.
Bridgewater, the largest hedge fund in the world, runs its $70 billion All-Weather Fund using this strategy. In fact, according to Bank of America reports, there’s probably more than $400 billion being managed using this popular portfolio allocation strategy.
Risk parity, according to ZeroHedge is a, “cross-asset allocation portfolio model that assigns weight inversely proportional to volatility.”
In other words, multi-billion dollar funds and monster macro-global portfolio managers who diversify (because diversification is supposed to reduce portfolio risk) across an array of asset classes and need an allocation model that mathematically or otherwise tells them how to spread their capital across those different asset classes, are using volatility to weigh how much money goes into which asset classes.
Often criticized for placing performance ahead of concerns that the management technique exacerbates market turbulence, risk parity strategies produced dismal results last year thanks to excessive volatility in too many asset classes, including commodity prices, currencies, and equity markets exhibiting crazy volatility by alternatively rising, falling and rising again into year-end 0f 2015.
But in 2016, risk parity’s making a comeback.
The Salient Risk Parity Index, which according to the firm’s website is a “quantitatively driven global asset allocation index that seeks to weight risk equally across four asset classes – equities, interest rates, commodities and credit. The Index is calculated daily, rebalanced monthly, and targets a 10% volatility level” is showing 2016 to be a banner year for the model, with an 18.57% annualized return using data through the end of June.
That said, there are three very big problems with the strategy…
Three (Big) Problems with Risk Parity
First, the amount of money following the strategy has gotten really big. That creates a herd that moves in the same direction, which can be off a cliff if something goes wrong.
Second, as correlation (the tendency for different asset classes to track each other, or move in the same direction – like a herd) increases, as it has been increasing lately, the diversification theory of holding different asset classes as an overall hedged strategy goes out the window. Or, we might say, over a cliff… like a herd heading the wrong way.
And third, volatility (the weighting measure used to allocate capital into different asset classes) had been coming down, and was in fact at cycle lows for equities, at yearly lows for bonds, and had been dropping steadily since April for commodities and other “hard” assets. As volatility comes down, leverage tends to go up where this strategy is used.
It gets worse. If you combine the facts that big portfolios have gotten too big to unwind gently if they’re all headed for the same exits at the same time, and that correlation is so high that all asset classes could selloff in a pure panic, with the fact that volatility has been dampened enough that historical and mathematically-driven allocation models haven’t seen this potential “tail” on their bell curves, things could go terribly wrong.
The fuse that’s been lit is volatility. The minute the calendar turned from August to September, previously tamped-down volatility across asset-classes woke up and is stretching its legs and arms outward and upward.
We’ve Been Here Before
Is this speculation on my part – that risk parity can be a bomb? Absolutely not. It’s fact.
We got a good and scary glimpse of exactly this phenomenon last August in 2015.
All it took that summer was for the Chinese to push down their currency, and BANG!
The bomb that went off, that knocked stocks down 10% in a heartbeat, and hit other asset classes, was the selling by risk parity managers when volatility, which started with currency volatility, exploded (for example: the VIX went from 13 to 40), which caused risk parity models to automatically sell as volatility weightings rose.
We’re there again.
While there are plenty of “black swans” that could trigger volatility spikes, the one I’m most concerned about is coming right at us.
The Federal Reserve’s interest rate decision-makers on the FOMC meet September 20-21. It’s unlikely that they’ll raise rates, because they presumably know that risk parity funds will react negatively (hence you hear that the Fed’s “trapped” into doing nothing) and the dreaded market selloff the Fed’s desperate to avoid might happen.
But they could raise. Because volatility’s been so subdued up until September, they might be fooled into believing that’s a trend and a good sign. On top of that, because equities are still near record highs, they might see that as a good reason to raise now. And because bond volatility has been remarkably subdued, excluding the recent fairly minor tantrum, they might think the bond market can handle a small raise.
They could raise for any or all of those reasons. In my betting book the chance of a raise is about 30% to 40%, which is very high. As far as the markets, they’re betting the chances of a hike are somewhere around 20%.
That’s scary because the markets are not pricing in a possible rate hike.
If we get one, it could get ugly.
The worst case scenario would be for the bond market to sell off, and hard.
The amount of money that would be lost if bonds tumble would immediately trigger cross-selling of other asset classes, instantly spiking volatility across the map and potentially causing risk parity funds to automatically rebalance out of increasingly volatile asset classes into cash.
We need to be prepared for that possibility.
So here’s what to do.
How to Play the $400 Billion Bond Market Bomb
First – make sure you have your stops in place when and if the bomb goes off. With volatility kicking markets back into gear, you should already be looking to tighten your stops in case a bad day knocks a few hundred points – or a thousand points – off the Dow.
Next, you’ll want to put on a play that will soar if Treasuries selloff.
I like the ProShares UltraShort 20+ Year Treasury ETF (NYSEArca:TBT), an inverse fund that goes up in price when Treasury bond prices fall (meaning yields are rising)
TBT is a leveraged ETF, which means it goes up twice as fast as the treasury market falls.
That means two things:
It’s better as a short-term play. You’ll want to hold it for a couple of weeks – any more than that and tracking errors can start to interfere with your returns.
It’s got plenty of juice.
We’ll hold this position for a couple of weeks, maybe longer if it’s going our way. TBT closed trading yesterday at $33.24 and its 52-week low is $29.45.
If you buy it at these levels, put a stop down around $29. That’ll get you out of the position with around a 12.75% loss, making this is a good risk-reward play.
If you’re more adventurous, and can stand some more risk, meaning possibly losing 50% to 100% of your bet, I recommend buying call options on TBT for even more leverage.
For my money, I’m always willing, when it comes to options, to risk a small amount of my capital (usually 1%) for a potential couple hundred percent gain on the position. If you want to play that way, buy the calls.