In case you didn’t catch the article titled “Guilty Pleas Hit the ‘Mark'” in yesterday’s Wall Street Journal, I’m here to make sure you don’t miss it.
This is too good.
Three former employees of Credit Suisse Group AG (NYSE:CS) were charged with conspiracy to falsify books and records and wire fraud. They were accused of mismarking prices on bonds in their trading books by soliciting trumped-up prices for their withering securities from friends in the business.
By posting higher “marks” for their bonds in late 2007, they earned big year-end bonuses.
What a shock!
What’s not a shock is that, after a bang-up 2007, Credit Suisse had to take a $2.85 billion write-down in the first quarter of 2008. No one knows how much of that loss was attributable to the three co-conspirators, who were fired over their “wrongdoing.”
Two of the three accused pleaded guilty. Also not shocking is the reason David Higgs – one who pleaded guilty – gave for his actions. He said he did it “to remain in good favor” with bosses, who determined his bonus, and who profited handsomely themselves from his profitable trading and inventory marks.
As for Salmaan Siddiqui, the other trader who pleaded guilty? His attorney Ira Sorkin, the former SEC enforcement chief, said of his client, “What he did was the result of his boss and his boss’ boss directing him to do it.”
You know what else is shocking?
Everyone was dong this at all the brokerages, investment banks and commercial banks that had trading desks… and only three people have been charged.
What’s even more shocking (though not to me) is that the “system” has been engineered over years to allow banks to hold riskier and riskier securities, with more and more leverage, and, in the most egregious affront to sense and safety, be allowed to mark their inventories (including exotic instruments that no one really knew how to price) based on internal “models” and extrapolated scenarios. Whatever that means.
Everyone up the chain, from the trader making bets to his boss, his boss’ boss, all the way up to the chairman, eats off the same plate.
And you know what they say about where you eat…
Marking your trading book within the bounds of what you can get away with isn’t exactly condoned, but neither is it frowned upon – especially at year-end, when bonuses are being calculated. After all, you’ll always have next year to trade out of losses or turn them into winners.
It’s about getting paid and how much.
But don’t just blame the traders and their bosses. Blame the politicians and the regulators who tore up sound Depression-era banking laws and coddled big banks by “desupervising” them when deregulation didn’t deliver the whole train to the station.
Find out where the mortgage-backed securities boom really started, who greased some of the steepest slopes, and why and how everything leads back to bonuses.
How Deregulation Ended Honesty in the Banking Sector
Here’s what happened, in broad strokes (borrowed from articles I’ve written for MoneyMorning.com).
In 1988, the Basel Accord established international risk-based capital requirements for deposit-taking commercial banks. In a byproduct of the calculations of what constituted mortgage-related risk (traditional mortgage loans have long maturities and are illiquid), lenders were expected to set aside substantial reserves; however, “marketable securities” that could theoretically be sold easily would not require much in the way of reserves.
To free up reserves for more productive pursuits, banks made a wholesale shift from originating and holding mortgages to packaging them and holding mortgage assets in a securitized form.
That lessened asset-quality considerations and ushered in the new era of asset-liquidity considerations.
Meanwhile, over at the U.S. Commodities Futures Trading Commission (CFTC), the appointment of free-market disciple Wendy Gramm (wife of then-U.S. Sen. Phil Gramm (R-Tex.)) as chairman would result in her successful 1989 and 1993 exemption of swaps and derivatives from all regulation.
These actions would turn out to be consequential in the reign of terror that was to come…
In 1993, with her agenda accomplished, Wendy Gramm resigned from her CFTC post to take a seat on the Enron Corp. board as a member of its audit committee. We all know what happened there. (Wait a minute; I did say she was on the audit committee, right?)
Of course, Enron’s fraud and implosion became the poster child for deregulation run amok.
It ultimately helped spawn Sarbanes-Oxley legislation, which has its own issues, but nonetheless has prevented all kinds of fraud and inappropriate behavior on account of the fact that top executives have to attest to the veracity of, and sign off on, all financial documents and other “stuff.”
Now, don’t lose any sleep over the fact that of all the CEOs and CFOs and other muckety-muck multi-multi-millionaire executives that ran and still run the too-big-to-fail banks and the banks and investment banks that did fail or were merged (because they failed but were valuable to banks who wanted to make themselves bigger so they would never be allowed to fail) ever were charged with any crime under Sarbanes-Oxley.
Why shouldn’t you worry? Because, silly, there’s a concerted effort to do away with the law. After all, don’t you know, it hampers business from creating jobs, which we desperately need?
Sorry. I just returned from the bathroom, where I was getting sick.
Anyway, the constant flow of money to lobbyists and into legislators’ campaign coffers was paying off for banking interests.
The Fed, under Chairman Greenspan, along with Robert Rubin and Larry Summers, was methodically deconstructing the foundation of the Depression-era Glass-Steagall Act.
The final breaching of the wall occurred in 1998, when Citibank was bought by Travelers.
The deal married Citibank, a commercial bank, with Travelers’ Solomon, Smith Barney investment bank, and the Travelers insurance business.
There was only one problem: The deal was clearly illegal in light of Glass-Steagall and the Bank Holding Company Act of 1956. However, a legal loophole in the 1956 BHC Act gave the new Citicorp a five-year window to change the landscape, or the deal would have to be unwound.
Phil Gramm – the fire breathing free-marketer, Texas senator, and then-chairman of the U.S. Senate Committee on Banking, Housing and Urban Affairs (and loving husband of Wendy) – rode to the rescue, propelled by a sea of more than $300 million in lobbying and campaign contributions.
In 1999, in the ultimate proof that money is power, U.S. President Bill Clinton signed into law the Gramm-Leach-Bliley Financial Services Modernization Act, at once doing away with Glass-Steagall and the 1956 BHC Act, and crowning Citigroup Inc. (NYSE:C) as the new “King of the Hill.”
From his position of power, Sen. Gramm consistently leveraged his Ph.D. in economics and free-market ideology to espouse the virtues of subprime lending, where he famously once stated: “I look at subprime lending and I see the American Dream in action.”
If helping struggling borrowers pursue their homeownership dreams was such a noble cause, it might have been incumbent upon the senator to not block legislation advocating the curtailment of predatory lending practices.
Oh well. Let’s not quibble with a Senator.
From 1989 through 2002, federal records show that Sen. Gramm was the top recipient of contributions from commercial banks and among the top five recipients of campaign contributions from Wall Street. (See my article “How Subprime Borrowing Fueled the Credit Crisis.”)
Since moving on from the Senate in 2002 to mega-universal Swiss banking giant UBS AG (NYSE:UBS), where he serves as an investment banker and lobbyist, Gramm makes no apologies.
“The markets have worked better than you might have thought,” he has been quoted as saying. “There is this idea afloat that if you had more regulation you would have fewer mistakes. I don’t see any evidence in our history or anybody else’s to substantiate that.”
On April 28, 2004, in a fitting (and perhaps flagrant) final act of eviscerating prudent regulation, the SEC ruled that investment banks could essentially determine their own net capital.
The insanity of that allowance is only surpassed by the fact that the SEC allowed the change because it was simultaneously demanding greater scrutiny of the books and records of what were the holding companies of investment banks and all their affiliates.
The tragedy is that the SEC never used its new powers to examine the banks.
The idea was that Consolidated Supervised Entities (CSEs) could use internal “models” to determine risk and compliance with net capital requirements.
In reality, what the investment banks did was essentially re-cast hybrid capital instruments, subordinated debt, deferred tax returns, and securities with no ready market into “healthy” capital assets, against which they reduced reserve requirements for net capital calculations and increased their leverage to as much as 30:1. (Here’s “How Wall Street Manufactures Financial Services Products,” an insider’s look at how greed on Wall Street results in unscrupulous investment instruments.)
When the meltdown came, the leverage and concentration of bad assets quickly resulted in the shotgun marriage of insolvent Bear Stearns Cos. to JP Morgan Chase & Co. (NYSE:JPM), the bankruptcy of Lehman Brothers Holding, the sale of Merrill Lynch to Bank of America Corp. (NYSE:BAC), and the rushed acceptance of applications by Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) to convert to bank holding companies so they could feed at the taxpayer bailout trough and feast on the Fed’s new smörgåsbord of liquidity handouts.
There are no more CSEs (the SEC announced an end to that program in September). The old investment bank model is dead.
The motivation for bankers to undermine and inhibit prudent regulation is inherent in banker compensation incentives.
The Journal of Financial Research sums up the problem on compensation by concluding: “Firm characteristics that influence managerial compensation include leverage (as a measure of observable risk) market-to-book ratio of assets, size and shareholder return. Evidence suggests that Bank Holding Companies may be exploiting the deposit insurance mechanism because leverage is a significant factor in their results for incentive-based components of compensation. Our results strongly support the view that fundamental shifts in business activities of Bank Holding Companies have influenced their compensation strategies.”
And we wonder if bankers are good people or merely compensation and bonus whores…
You do the math.
As far as telling you what’s wrong with America – a lot of you wrote in to say you DO want to know – this is part of it. But we can see this part clearly.
What we can’t see is how we really got here, where here is, and where we’re going next.
You’ll get that on Sunday.
Not because I want to ruin your Super Bowl Sunday. But because I hope you pass it along to the friends you’ll gather with later in the day, and before the beer flows and the game starts, maybe you’ll ask yourself and ask your friends… is this really happening?