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Generational Dynamics Web Log for 14-Oct-07
Financial firms increasingly hide losses through deceptive or fraudulent practices

Web Log - October, 2007

Financial firms increasingly hide losses through deceptive or fraudulent practices

According to an article in Friday's Wall Street Journal, banks and other organizations are going to extraordinary lengths to hide the real values of mortgage-backed securities (MBSs) in their asset portfolios.

Techniques include: refusing to reveal prices of assets to investors; hiding at-risk securities in separate "black-box" corporations known as SIVs (structured investment vehicles); deceptive or fraudulent sweetheart deals with other financial firms to establish artificial "market values" for assets.

In addition, some of these techniques appear to have been designed to illegally avoid tax consequences on certain kinds of income. On Friday, the IRS announced an inquiry into a particular kind of SIV known as "remics" (real estate mortgage investment conduits). A financial firm transfers its mortgage-backed securities to a remic, which can then sell slices of the MBSs to investors. The IRS is examining whether financial firms controlling these remics are underreporting the income they earn.

The use of SIVs is the latest twist to come under scrutiny following the "Bear Stearns disaster" that became public in June. At that time, Stearns bailed out its defaulting hedge funds rather than have to sell some of the assets in their portfolios.

These assets were collateralized debt obligations (CDOs), a kind of synthetic security created by slicing and dicing mortgage loans at various risk levels. Stearns had given these synthetic securities a certain value, or notional price, based on computer programs designed to valuate these kinds of synthetic securities. Unfortunately, no one was willing to purchase the CDOs at the notional prices that the Stearns computer programs had computed.

Finally, in mid-July, the firm announced that its hedge funds were almost totally worthless.

This led, in August, to the "liquidity crunch" or "credit crunch" and the worldwide banking crisis. Companies around the world were no longer able to sell "asset-backed commercial paper" (ABCP), where the assets were CDOs, because investors had no way of knowing whether the notional prices had any validity.

Various central banks -- the Fed, the Bank of England, the European Central Bank -- provided a temporary solution by shocking investors with a large monetary loosening, much more generous than investors had expected. They lowered interest rates (by a full ½ point in the US), and perhaps even more important, the central banks accepted some of this asset-back commercial paper as collateral for central bank loans.

However, the commercial paper crisis is far from over. The Fed itself said as much in the Open Market Committee meeting minutes, published last week, which said, "Given existing commitments to customers and the increased resistance of investors to purchasing some securitized products, banks might need to take a large volume of assets onto their balance sheets over coming weeks, including leveraged loans, asset-backed commercial paper, and some types of mortgages."

What the Fed is referring to is the fact that market exigencies are forcing one institution after another to place their mortgage-backed securities on the market, to test what prices they can sell for.

This is an ongoing process. In the past month, eight major financial firms -- UBS, Merrill Lynch & Co., Citigroup Inc., Deutsche Bank AG, Morgan Stanley, Goldman Sachs, Lehman Brothers Holdings Inc., and Bear Stearns Cos. -- have written down $20 billion in asset values. There's a lot more to come.

How big is the problem? In times past, an investment portfolio might have contained stocks that trade on the stock market, the WSJ reports that substantially more than 50% of the assets in most portfolios are now securities that DON'T trade on exchanges.

In order to prevent a market for these securities from developers, financial firms are refusing to providing pricing information to investors in the overwhelming majority of cases.

The article provides the following "Percentage of investors who reported problems getting price quotes this summer in various markets:"

	Corporate bonds                         62%
	Commerical mortgage-backed securities   63%
	High-yield bonds                        65%
	Mortgage-backed securities              66%
	Leveraged loans                         69%
	Collateralized loan obligations         78%
	Asset-back securities                   82%
	CDOs / Structured credit                83%

Besides refusing to divulge prices, financial firms are resorting to other methods to "protect" themselves at the expense of the public:

A hedge fund manager in a subsidiary of UBS AG was disciplined and relieved of his duties for marking down the price of his portfolio of securities "to where I could reasonably sell them."

One company, Ellington Management Group, has suspended investor redemptions, because the firm doesn't know how much its assets are worth.

Some firms have been setting asset prices by offering them for sale at the notional price, and then claiming that the mere offer to sell is a valid "mark to market" exercise for valuating securities.

A group of firms may sell securities to one another in order to establish an artificially high market price for all the firms' securities.

One firm will sell a securities portfolio to another firm, with a commitment to buy them back at a later time at a minimum price. Bear Stearns is known to have used this technique.

I'm not a lawyer but these practices sure look like fraud to me. If a firm uses deceptive practices to claim unrealistically high asset values in sales to investors, then the investor is being defrauded.

What we're seeing are two growing trends, both of which I've described several times before:

First, the size of the problem is growing. Investors, mutual funds, investment trusts, hedge funds, savings banks, pension funds, college endowments, money market funds, insurance companies, and so forth have all invested HUGELY in securities that have no credible value.

And second, the net is spreading for people who are going to be blamed for the coming financial crisis. When everyone was making money, no one cared about a little cheating or a little fraud or a little embezzlement. But once people start losing money, the desire for revenge will be enormous, and repercussions will be felt in every corner of the world.

In the meantime, here are your Sunday comics:

Stocks at all time highs! <font face=Arial size=-2>(Source: stockmania.com)</font>

Stocks at all time highs! (Source: stockmania.com)

(14-Oct-07) Permanent Link
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Generational Dynamics Web Log for 14-Oct-07 Financial firms increasingly hide losses through deceptive or fraudulent practices

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Generational Dynamics Web Log for 14-Oct-07
Financial firms increasingly hide losses through deceptive or fraudulent practices