Friday, February 12, 2010

Weekly Wrap

Judge Still Not Satisfied

Regulators lectured;
Bank execs sweating bullets.

Lawyers, the ones who get all the flak for adding costly friction to the system, will end up the heroes once the Global Financial Crisis runs its course. That's because they are taking names and assigning blame. Foremost among them is Federal District Judge Jed Rakoff (above), who is being petitioned to approve a settlement between the Securities Exchange Commission and the Bank of America over claims that the company withheld material information prior to a shareholder vote in December 2008 to corral the wounded bull, Merrill Lynch. In the weeks after the merger vote, Merrill reported a disastrous fourth-quarter loss while handing out hefty year-end bonuses to top-tier executives. BofA shareholders felt ripped off. After settling their stomachs with meds, they reached for their phones and speed-dialed their attorneys.

The SEC, established after the Crash of '29 to supervise the rascals playing in the Wall Street sandbox, swung into action. O.K., you got me--it slept through the alarm, rolling out of bed only after the New York State Attorney General had started his own investigation and only after a House panel told it to wake the hell up. The Commission puttered around for a few months, then offered Bank of America a $33 million wrist-slap, payable to the federal government. That was less than the janitor's bonus.

Rakoff was outraged. He found two things wrong with the settlement: one, it punished the wrong party (i.e. the shareholders, who were, like, the VICTIMS?!) and two, it failed to identify the perpetrators of the fraud. Other than that, it was a slick piece of work by the gub'mint. Rakoff threw out the settlement and told the commission to do the job right this time.

Five months later the SEC is back with a new settlement. The price tag has been increased to $150 million, and the proceeds now go to the shareholders. The Judge is still not happy. He thinks the payout should be doubled--and maybe doubled again--and should come out of the hides of the over-compensated executives who were so lax with due diligence and disclosure in the first place. Otherwise, shareholders would simply be paying themselves. In an order issued yesterday, Rakoff insisted that "the entire distribution be made to Bank of America shareholders who were harmed by the alleged non-disclosures, and that no distribution be made to to so-called 'legacy Merrill Lynch' shareholders of Bank of America, nor to Bank of America officers and directors who had access to the undisclosed information."

Moreover, the Judge wants further documentation concerning the dismissal by Bank of America of general counsel Timothy Mayopoulos prior to the December 2008 shareholder meeting. The New York AG alleges that Mayopoulos was fired for questioning the company's disclosure, or lack thereof. Rakoff wants to know what's up with that. If he does not get answers, the case will go to trial next month. Memo to BofA: courtrooms are all about disclosure. Of any and all wrongdoing.

Remember all those toxic securities that Congress was so eager to buy through TARP? You know, the ones no one else wanted? Well, there is a whole legion of lawyers trying to sort out exactly to whom those rightfully belong. Thankfully, they do not (yet) belong to us taxpayers. That's because then-Treasury Secretary Hank Paulson, having forced TARP through Congress, took a second look at the merchandise and had a brief moment of clarity: You know what? No one, not even we, can in good conscience push this crap onto the taxpayer. Instead, Hank opted for preferred stock in the banks holding the assets, giving us at least one degree of separation from the ooze.

Stuck with unwanted inventory--and knowing just how bad these mortgage-backed securities are--Wall Street lenders bought default insurance, just in case. Sure enough, distressed homeowners became delinquent on their mortgage payments. Now the insurers, as well as federally chartered guarantors Fannie Mae and Freddie Mac (yeah, we pretty much own them now), are pushing back in court. They claim that the loans were defective by design and were bundled into securities sold without proper--here's that word again--disclosure. The banks are being forced to take many of the loans back. In the words of Christopher Whalen of Institutional Risk Analytics, "The wave of loan repurchase demands on securitization sponsors is the next area of fun in the zombie dance party, namely the part where different zombies start to eat each other." When it comes to cannibalism, nobody does it better than lawyers.

Now let's enter the shadowy netherworld of credit default swaps. This is a whole 'nother universe parallel to the real one in which we live. Here you can buy default insurance for credit instruments that you do not actually own. And you can sell insurance without maintaining any reserves to indemnify buyers should a "credit event" actually occur. You can do these things because you are not regulated, thanks to the Commodities Futures Modernization Act of 2000, the act by which Congress essentially put the SEC into a Rip Van Winkle deep sleep (at least until Congressman Kucinich rang the alarm). You do all these things over the counter, without adult supervision.

By the end of 2007 the CDS market had a notional value of $45 trillion, and the biggest seller of this ghost protection was AIG. In 2008 "credit events" started happening in a big way, triggering massive liabilities at AIG. Unable to pay all the contract holders that came knocking (including Wall Street's biggest dealer banks), AIG tried to negotiate discounted payouts. That's when Timothy Geithner, then head of the New York Federal Reserve, stepped in, suspended negotiations, and ordered payouts at par for all his banking brethren. For that alone he should never have been confirmed as President Obama's Treasury Secretary.

Geithner and Paulson operated under the impression that CDS counterparties were at the top of the food chain in bankruptcy proceedings, senior to all other creditors and shareholders. But New York Bankruptcy Judge James Peck, handling the Lehman Brothers estate, has consigned counterparty risk back to the limbo world from whence it came. This delights Whalen, who views the judge's conduct as "the starkest condemnation possible of the AIG bailout, a hideous political contrivance that ranks with the great acts of political corruption and thievery in the history of the United States." As well, the Peck ruling will further embolden bond insurers and guarantors to seek relief from the sponsor banks who originated shoddy loans, then tried to lay off the risk by selling shady derivatives.

At least one profession has job security these days.

[ Peter Atwater of Minyanville summarizes in this posting, 02-16-2010:]

Where the securitization market once facilitated the movement of loan assets away from originators, the legal system is now moving financial claims the other way -- from investor to asset manager to underwriter or guarantor -- to “bundler” all the way back to the originator. And while we're just at the beginning stages of the litigation/warranty repurchase daisy chain, if the “settlements” so far are any indication, the final figures will be enormous.

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