Sunday, May 24, 2009

Ponzi Schemes and Stress Tests

Original LinK:

By Janet Tavakoli

Now that we are stress testing banks that have merged with entities involved in the housing and municipal bond market debacles, we should also revisit the Ponzi scheme. But first, I'll digress to comment on how we will handle the results of the "stress test" , since that is how we will claim we have solved the banks' problems. While the government will convert preferred shares to voting common shares, this is otherwise simply an accounting game. Credit derivatives were used for this nonsense in Europe, and we have a name for it: regulatory capital arbitrage. This time the U.S. will dilute shareholder value and claim banks have new capital. Moreover, the "stress tests" are anything but that. The "stress" scenario used in the "test" is my probable base case.

You'll recall in August of 2007, Ben Bernanke said subprime losses would only be $50 billion to $100 billion, and I called for more than triple that amount. It turns out I was too optimistic. I was in the right direction then, and I am in the right direction now. Our government is in the habit of telling the truth much too slowly.

We need fiscal stimulus and need to strengthen banks. I believe, however, that we should experience more pain now to gain a better future. Specifically, we should put some banks into receivership and not continue to bail out bank creditors with public money. Likewise we need to enforce controls on securitization (shadow banking) to restore credibility to this powerful tool. Until we confront the fact that global confidence in securitization was shattered by a massive Ponzi scheme, we cannot fix the securitization industry and unfreeze the capital markets. Global investors are waiting for us to clean up our own backyard.

Pundits claiming this was merely a bubble or merely a case of bad models do the industry no favors. There were no black swans or swans of any other color. There were simply Black Barts imitating the highwayman that engaged in bloodless robbery. I just ran across this article in The Deal, which suggest I may be confusing a bubble with a Ponzi scheme. That is not the case. While there was a bubble, it was inflated by a Ponzi scheme. While apologists for our industry may wish otherwise, I explain it again in Dear Mr. Buffett for those who missed it the first time in my book for industry professionals, Structured Finance.

The Wall Street Journal missed a golden opportunity (“Top Broker Accused of $50 Billion Fraud,” December 12, 2008). It wrote that if Madoff’s alleged losses exceeded $50 billion, it would “dwarf past Ponzi schemes.” Yet, Madoff was a piker.

The largest Ponzi scheme in the history of the capital markets is the relationship between failed mortgage lenders and investment banks that securitized the risky overpriced loans and sold these packages to other investors—a Ponzi scheme by every definition applied to Madoff. These and other related deeds led to the largest global credit meltdown in the history of the world.

Investment banks raised money from new investors to pay back old investors (mortgage lenders' dividends to shareholders and investment banking creditors of mortgage lenders which often included themselves). When mortgage lenders imploded, investment banks sped up opaque securitizations to offload worthless tranches of CDOs mixed in with others to careless so-called sophisticated investors along with naive investors. Raising money from new investors to pay back old investors, even if you are the old investor covering up losses, is a Ponzi scheme.

Bernard Madoff confessed—not the securitization “professionals” who work or worked for famous investment banks, certain CDO managers and certain hedge funds. One securitization professional gave an interview to Reuters in which he tried to claim that shady activity was not a Ponzi scheme since CDOs are legal. But using a legal financial instrument to commit fraud is still fraud. If you pawn off product by mixing it into a CDO portfolio, and you know or should know it is worthless (or even simply misrepresented), you must disclose that fact. But that is not what happened. Overpriced and overrated tranches of RMBS, CDOs and even CDO-squared, that on their own wouldn't get a decent bid from any knowledgeable securitization professional, were repacked to sell on to other investors. When new investors dried up, these products were held on the books as if the irresponsible ratings had meaning. This delayed the recognition of losses long enough to get through another bonus cycle.

The SEC has been silent on the dodgy securitization activities it “regulated’ over the past several years. Congress and others agree claiming there will be time to find out who is responsible later. Bail now, scapegoat later.'

Legacy investment banks and other bailout recipients have hundreds of billions of dollars worth of assets in opaque accounting buckets known as Level 2 (mark-to-model) and Level 3 (mark-to-management assumptions). Good luck trying to find details. This makes the "stress tests" less meaningful than they already are.

Self proclaimed sophisticated investors like bond insurers are responsible for their own due diligence, and they may not be able to press claims against errant banks and investment banks. But now that the taxpayer has bailed out these entities, and now that the Fed is using taxpayer money to subsidize the funding costs of the banking system, the situation has changed. The U.S. housing market has been damaged along with the municipal bond markets. The net effect is a massive crime on the U.S. economy, and taxpayers, at least, may wish some form of satisfaction in the form of greater regulation and economic clawback.

Some pundits want to claim the problem was mathematical outliers. The real problem is there were too many outright liars hiding behind the curtain of structured finance. Until we squarely face our problems, we cannot fix them. We had a financial Pearl Harbor, but investment bankers piloted many of the planes. We need to face that problem to restore confidence in the financial system. Once-over-lightly stress tests combined with regulatory capital window dressing will not solve our problem. What we need now is financial military police action combined with a financial Marshall Plan to restore our devastated financial system.

Janet Tavakoli explains to CNBC May 8, 2009 why the stress tests will neither restore confidence in the banks nor unfreeze demand for securitized financial products.

Janet writes today to "The market hit its high in Oct 2007, well after I and a few others were sounding warning alarms. Don’t look to current market price action for information about future outcomes."

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