By G.L.C., on October 22nd, 2008
An auction rate security generally refers to a debt instrument with a long-term nominal maturity for which the interest rate is regularly reset through periodic auctions. It allows issuers to borrow for the long-term but at lower, short-term interest rates.
The auction-rate securities market involved investors buying and selling instruments that resembled corporate debt whose interest rates were reset at regular auctions, some as frequently as once a week. They were sold as being safe as cash.
Over the years, auction-rate securities became popular among investors looking for cash-like options with slightly higher yields than money-market funds and certificates of deposit. The investments—in reality, long-term bonds—were considered more like short-term debt because they could usually be sold at weekly or monthly auctions.
In August 2007, investors began pulling out of the auction-rate-securities market. It seized up earlier this year when Wall Street firms who kept auctions from failing by stepping in to buy any unpurchased securities stopped supporting the market en masse, leaving millions of investors without access to investments they believed were nearly as liquid as cash. Tens of thousands of investors nationwide — including institutional and individual investors, cities and towns, charities and small businesses — were left holding damaged, illiquid securities when the market collapsed.
The U.S. Justice Department is now ramping up criminal investigations into the collapse of the auction rate securities market. Federal prosecutors in Brooklyn,New York , are looking at whether Lehman Brothers Holdings Inc. defrauded its clients by dumping auction-rate securities into their accounts before the market broke down despite knowing the market could collapse. The prosecutors are probing Lehman’s handling of investments for two brothers, Brian Maher and Basil Maher. The brothers sold their family’s billion-dollar shipping business and invested some of the proceeds with Lehman. They lost access to $286 million that was tied up in the securities when the auction-rate market collapsed. Another issue being probed is whether the firm used clients’ money to purchase the securities to prop up auctions that might otherwise fail.
Federal Prosecutors are also probing the role of UBS employee David Shulman to decide whether to charge him with insider trading for selling his own holdings of auction-rate securities ahead of that market’s collapse. Shulman ran the auction rate securities business for UBS. As the credit crisis began to scare away buyers for many types of securities, UBS began to buy up the securities so that the auctions, which the firm ran, wouldn’t fail. Shulman was under pressure from UBS executives to reduce the firm’s holdings of the product, and he allegedly helped mobilize UBS brokers to sell more of the securities to customers as safe cash alternatives, despite his knowledge that the market may not hold up. Around the same time, Shulman sold more than $6 million of his own inventory of auction rate securities.
So far, most investigations have been about the role played by institutions and banks. These investigations are among the first to look at whether individuals committed crimes as the market collapsed in the credit crisis – a step in the right direction.
By G.L.C., on October 20th, 2008
The high-profile advertising partnership between Google and Yahoo announced in June after merger talks between Microsoft and Yahoo collapsed could run into a challenge from the U.S. Justice Department. The Association of National Advertisers, the American Association of Advertising Agencies, and the International Advertising Association have expressed concerns about the deal and asked the Justice Department to investigate and block the deal. Many advertisers have warned that the deal will limit competition, raise prices, and reduce choices.
Last month the Justice Department hired veteran antitrust attorney Sanford Litvack to help assess the evidence gathered by its lawyers in what many see as the clearest indication that the Justice Department could be planning to mount a legal challenge to the deal which allows Google to sell ads alongside some Yahoo search results on some of its Web sites. Google dominates the search advertising market. It is feared that the deal will reduce competition in the search advertising market and lead to higher prices. The real concern of antitrust law is to protect consumers–-the advertisers. Investigators trying to build a lawsuit to block the deal worried are that it could give Google too much power.
The two companies have maintained that the deal does not violate antitrust law and recently agreed to delay implementing the deal until at least October 22 to give the investigators–-federal and state–time to scrutinize the deal and complete their investigations. According to them, the deal would serve advertisers and users more effectively.
Both companies are in talks with the Justice Department in an effort to prevent any challenge to the deal. The negotiations are at an early stage and both companies have discussed concessions including capping the volume of Google ads Yahoo would use, assurances that Yahoo would continue to compete in search ads, and a reporting mechanism to ensure compliance. A reporting mechanism could require the companies to disclose details about their closely guarded search advertising technology. The disclosure requirement could require disclosing more than what they really want to disclose. The Justice Department will try to impose measures to ensure that advertisers won’t have to pay prices that are significantly higher.
Any settlement reached would likely be laid out in a consent decree that would be filed in court allowing the deal to go ahead. If the deal does go ahead, many feel it will be a formal recognition of Google’s market powers constraining its future conduct. It could draw private antitrust suits–opponents of the deal including Microsoft have been provided with documents and depositions for use in possible litigation.
Some experts are looking at the appointment of Mr. Litvack as an effort by the Justice Department, which in the past has been criticized by some in Congress for its approach to antitrust enforcement, to deflect any political fallout from its ultimate decision.
By G.L.C., on October 17th, 2008
In recent history, governments have nationalized banks when the pressures of internationalized financial markets and international competition have made it difficult for them to control and stabilize their finances and currency. During the last couple of decades, countries as different as Mexico, France, Sweden, and Japan carried out partial or more or less complete bank nationalizations to regain control of the financial situation.
In an attempt to overcome the present credit crisis, the U.S. government is using taxpayer’s money to bail out large corporations. The government has already swapped its sovereign guarantee for equity in Fannie Mae and Freddie Mac, the mortgage finance institutions, and American International Group, the insurance giant.
Sweden faced a similar crisis in the early 1990s – a banking system in crisis after the collapse of a housing bubble, an economy hemorrhaging jobs, and a market-oriented government struggling to stem the panic.
Sweden was able to overcome the crisis. How did they do it? Can the United States learn something from the Swedish crisis?
Financial deregulation in the 1980s fed a frenzy of real estate lending by Sweden’s banks, which did not worry enough about whether the value of their collateral might evaporate in tougher times. Property prices imploded. The bubble deflated fast in 1991 and 1992. In 1992, years of imprudent regulation and shortsighted macroeconomic policy left its banking system almost insolvent. The Swedish government not only rescued the banks and financial companies by taking over the bad debts, it successfully extracted equity from the stock holders before writing the rescue checks in an attempt to keep the banks and financial institutions on the hook while returning profits to taxpayers from the sale of distressed assets by granting warrants that turned the government into an owner. The government took a hands-on approach, pumping cash into the banks deemed to only have temporary problems and letting the ones believed to have no prospect of viability go under. Two banks were taken completely over by the state, which in turn offered a blanket guarantee for all creditors, but not for share holders.
Once the crisis was over, the Swedish government sold off nearly all of the nationalized bank investments, getting back most of the money that had been pumped in to rescue the banks.
The Swedish government took over insecure loans during the crisis worth around $9.9 billion of taxpayer money, but eventually got most of it back through dividends and later reselling the nationalized bank assets.
There were proposals in the United States that the government extract equity from the bank for the bailout they receive. But the proposals did not get any serious consideration.
By extracting equity from the banks and financial institutions for the bailout packages, the government could swing the public opinion in its favor. Using taxpayer’s money for bailing out large corporations without offering anything in return is not likely to find much public support. The bailout package appears to favor stock holders without much prospect of the tax payer’s money ever being reimbursed. If the banks survive, the stock holders’ holdings will still be there but the tax payers will have to foot the bill.
By G.L.C., on October 14th, 2008
On September 19, the United States Securities and Exchange Commission (SEC) abruptly banned short sales of financial stocks to protect companies that had come under siege in the stock market. There have been concerns that short sales are behind the big price slides in the market. Many felt that short sellers had contributed to the declines by betting against the companies’ shares. The SEC also came out with a new set of disclosure rules for short sellers. The SEC lifted the ban last week, and short sellers were allowed back on Wall Street from October 9.
Some analysts argue that short-selling can be used to manipulate share prices and add to pressure on fragile companies. Others say it is a legitimate tool that helps markets function.
The ban originally applied to 799 companies, but the SEC allowed the stock exchanges to add other companies to the list. Before the ban was lifted, about 190 more had been added, including General Electric, General Motors, and CVS Caremark.
In a short sale, investors borrow shares and immediately sell them, hoping to profit by replacing them later at a lower price – a sell-high, buy-low strategy. Short sellers seek to profit from a stock’s decline by selling borrowed shares and replacing them at a lower price. During the ban, borrowing shares has become more expensive, in part because some big pension funds and endowments have stopped lending stock altogether.
Hedge funds were badly affected by the ban and blamed the new rules for pushing them deep into the red. Many trading strategies rely on short-selling, and investors may have sold off some of their long positions in the market, driving prices down, because they were not able to hedge their bets with a corresponding short position. Convertible bonds were also adversely affected because traders typically short a company’s stock when they invest in its preferred shares. The raw number of trades in financial stocks also dropped, as many investors simply sat on the sidelines.
It now appears that the ban probably did not do what it was supposed to do. Since the ban, financial shares have plunged 23%. The market plunge following the ban has started a debate on whether the ban actually worked and whether the short-sellers really played such a big role in the declines. Many feel that the real problem is the weakness of the financial institutions. The lifting of the ban by itself is unlikely to spark another precipitous plunge in the market; instead it could actually bolster stocks. Investors who wanted to exit short positions in recent weeks, which would have meant purchasing shares, did not do so because they feared they would not be able to borrow the stock again to short it later on.
By G.L.C., on October 13th, 2008
The Securities and Exchange Commission (SEC) was set up as a reaction to the stock market crash of 1929 to provide oversight of brokerage firms and protect investors. Last month, Morgan Stanley and Goldman Sachs Group, Inc., filed to become bank holding companies. Now with the sale of Bear Stearns, the bankruptcy of Lehman Brothers Holdings, Inc., and the sale of Merrill Lynch & Co. to Bank of America Corp., the SEC now has no large firms left to oversee.
A recent report by Inspector General David Kotz has concluded that the SEC missed numerous warning signs leading up to the shotgun sale of Bear Stearns Cos. Bear Stearns, one of the most aggressive investment banks, agreed to be sold to J.P. Morgan Chase & Co. According to the report, the SEC failed to require the investment bank to rein in its risk taking. It failed to carry out its mission in its oversight of Bear Stearns. Despite the SEC staff having identified in 2006 precisely the types of risks that evolved into the subprime crisis, the SEC did not exert influence over Bear Stearns to use this experience to add a meltdown of the subprime market to its risk scenarios. There are many who blame the present crisis on years of looser regulations that allowed Wall Street firms to take on greater risks without adequate oversight.
The report details how the SEC made no efforts to require Bear Stearns to reduce its debt or raise money, failed to take steps after identifying numerous shortcomings in Bear Stearns’ risk management of mortgages, and also missed opportunities to push Bear management to address the problems. The report criticized the SEC for allowing internal auditors at Bear Stearns, not external auditors who would presumably be more objective, to perform critical work in reviewing the firm’s risk management. The SEC also did not review Bears Stearns’ strategy for informing investors about its funding plans following the failure of two of its hedge funds in July 2007. The SEC took too long to review Bear Stearns’ 2006 annual report and seek more information from the firm, which would have resulted in Bear disclosing more information about its mortgage portfolio to investors.
The SEC maintains that the failure is a result of the SEC not having enough authority to effectively oversee the banks and that the SEC has already expressed its concerns to Congress. The SEC staff completed its review of Bear Stearns’ 2006 annual report after its collapse.
Another report found that the SEC conducted in-depth reviews for only six of the 146 brokerage firms registered with the agency. The failure to carry out the purpose and goals of the Broker-Dealer Risk Assessment program hinders the SEC’s ability to foresee or respond to weaknesses in the financial markets.
As lawmakers take a second look at financial oversight, these reports could be nails in the coffin for the SEC. The power of the SEC could be dispersed to other agencies, such as the Federal Reserve. These reports document the failure of the SEC to either make its oversight program work or seek authority from Congress so that it could work.
By G.L.C., on October 9th, 2008
The Federal Reserve was created 95 years ago to prevent banking crises as an independent agency whose Washington-based governors are appointed by the president of the United States and confirmed by the Senate. Its officials usually steer clear of the most heated political debates in a bid to protect their freedom to make the tough decisions required to keep inflation under control. There’s a good reason for giving the Federal Reserve so much independence. Decisions about the stability of the financial system often require quick decisions in times of crisis.
Ever since the credit crisis started in August 2007, the Federal Reserve has been engaged in a few political actions involving tax payer risks: asking Congress to approve Treasury Secretary Hank Paulson’s $700 billion bailout plan, agreeing to lend $85 billion to American International Group, taking on $30 billion in illiquid Bear Stearns assets to facilitate its take over by J.P.Morgan Chase, and helping engineer the federal takeover of Freddie Mac and Fannie Mae, which could cost the Treasury over $200 billion.
The political role being played by the Federal Reserve is setting a dangerous precedent: unelected officials deciding, without congressional votes, which companies and industries should be aided by its nearly $1 trillion balance sheet and which should be left hanging. The Federal Reserve is committing so much taxpayer money on its own rather than having Congress or the executive branch commit it. Its new roles of overseeing Wall Street investment banks and the AIG loan portfolio, among them, may bring it into conflict with the job of managing monetary policy.
The Federal Reserve has been using government funds and its credibility in its attempts to end the credit crisis. This increasing political role of the Federal Reserve could put its hard won independence at risk. Its independence is crucial to setting the interest rates that guide the economy.
The Federal Reserve probably did not want to be seen in a political role, but it had no choice – charged with maintaining the stability of the financial system and the economy, it had little choice but to take aggressive action in the face of a potentially devastating crisis. It was watching a falling knife and had to grab it before it landed on somebody’s chest.
Any proposals to change the Federal Reserve’s role would face fierce opposition. Because of the actions it has taken so far in trying to save Wall Street firms, if it comes under attack, Wall Street will be among its main supporters. It will also have the support of an army of loyal bankers around the country.
Everything depends on how the economy emerges from the present credit crisis. If it stages a steady recovery, it will increase the credibility of the Federal Reserve and there will be less concern about its political role.
By G.L.C., on October 6th, 2008
The Federal takeover of Fannie Mae and Freddie Mac has not put an end to the woes of these two companies. The two companies have now received subpoenas from federal prosecutors in New York seeking information on the companies’ accounting, disclosure, and corporate governance. The two companies have also received requests from the Securities and Exchange Commission that they preserve documents.
The investigation focuses on activities starting in 2007. The bookkeeping practices of the two companies have always been questioned by critics. In fact, a Fortune magazine story said new accounting procedures at Fannie Mae masked potential losses on bad loans.
Accounting irregularities are nothing new to Fannie Mae and Freddie Mac. Both have had to restate earnings in past years following discoveries by federal regulators of irregularities on the companies’ books. Few years back, both companies were forced to restate billions of dollars in earnings after federal regulators discovered accounting irregularities at both companies. The scandal led to the replacement of the companies’ top executives. Freddie’s former chief executive, Gregory Parseghian, was ousted in December 2003. Fannie Mae CEO Franklin Raines and Chief Financial Officer Timothy Howard were swept out of office a year later.
Fannie Mae has also paid a record $400 million to the SEC in 2006 to settle charges that senior executives fraudulently used “cookie jar” reserves and other accounting gimmicks to hide $10.3 billion in losses from 2002 to 2004 to maximize bonuses.
Freddie Mac paid $125 million in fines in 2003, while earnings between 2000 and 2002 were restated after it discovered derivative-related errors after replacing one of its former auditors, Arthur Andersen. At the time, regulators charged that the company manipulated its accounting to push about $5 billion in earnings to future quarters.
The two companies have been in the conservatorship of their regulator, the Federal Housing Agency, since the government seized them. There is increasing pressure on the administration to hold accountable the companies and top executives. Both companies have said that they will cooperate fully with the prosecutors. The Federal Housing Finance Agency, which controls the companies, said that it will work with the companies to assure a smooth and efficient process and will work with the government agencies as they undertake their inquiries.
The Federal Bureau of Investigation is already looking at potential fraud by these two companies and insurer American International Group, Inc. The inquiries will focus on the financial institutions and the individuals who ran them. A number of members of Congress, including several on the Senate Judiciary Committee, have urged the FBI to be more aggressive in pursuing possible criminal charges against major players in the crisis. If the top executives of these companies were cooking the books, manipulating, doing things they were not supposed to do, then every American taxpayer would want them held responsible.
By G.L.C., on October 2nd, 2008
There have been concerns that, beyond the rising cost of fuel and feed, a hidden factor may be driving food prices higher: collusion among farmers, food processors, or exporters. Federal prosecutors have opened separate criminal probes into possible price-fixing by major egg producers and California tomato processors. This is the latest in a series of U.S. investigations of alleged collusion in food and agriculture. Prosecutors are already pursuing criminal or civil inquiries in the markets for fertilizer, citrus fruit, cheese, and milk, examining whether suppliers worked in league to manipulate prices.
Under U.S. law, it’s a crime for competitors to collaborate on production or prices. Price-fixing is a criminal violation that can bring stiff fines and sometimes prison terms for executives. In recent years, U.S. antitrust enforcers have aggressively pursued such cases. Although federal law bars competitors from collaborating when setting their prices, Congress has created antitrust exemptions, like the 1922 Capper-Volstead Act, intended to help small farm groups and cooperatives bargain with large food processors. There are also exemptions for exports. Egg and tomato producers say their cooperation is shielded by these exemptions.
Egg prices have increased more than 40% in a year. Fresh-egg farmers acted together through a series of export shipments organized by United Egg Producers, an industry cartel whose 250-plus members include virtually all of the nation’s big egg producers. By removing a small fraction of eggs that would have been bound for U.S. sales and arranging instead for their export, United Egg helped tighten domestic supply and drive up the price of eggs across the country.
Tomatoes are among the big price gainers in the past year despite the salmonella scare. In the tomato industry probe, the prosecutors are trying to determine if dominant processors of tomatoes for canning, ketchup, salsa, and sauces conspired to fix prices. The investigation comes after allegations that a consultant to SK Foods, Inc., a big processor located in Lemoore, California, was working with SK to bribe buyers at six major food companies to pay inflated prices for tomato paste and chili peppers. In wiretaps and raids carried out as part of the bribery probe, investigators found evidence of the wider price-fixing conspiracy.
The big dairy cooperative Dairy Farmers of America is under investigation for alleged manipulation of cheddar cheese futures prices in the Chicago Mercantile Exchange in an attempt to restrict competition.
This is an election year. Farmers are a powerful political voice, and the exemptions aren’t likely to be repealed. But the latest food industry investigations show that antitrust enforcers are increasingly willing to challenge the co-ops they allege have overstepped the spirit of the law. If businesses are going to use narrow exemptions to engage in anti-competitive conduct, the government must take a hard look at that.
By G.L.C., on September 30th, 2008
In the late 1970s, the total compensation of chief executives in large American corporations was 35 times that of the average American worker. In 1993, Congress limited the tax deductibility of executive salaries to $1 million unless it could be demonstrated that the extra pay was linked to performance incentives. This contributed to the practice in later years of very generous grants of stock options, which helped drive executive pay to new heights. According to an estimate by the liberal research organization the Economic Policy Institute, in 2007, an executive’s salary was 275 times that of the average worker.
Wall Street executives, with their eight figure earnings, are at the top of the corporate pay range. Wall Street firms have a bonus system which rewards short-term trading profits. It acts as an incentive for executives to expand their highly profitable businesses in exotic securities and ignore the risks. The present financial crisis is a direct result of the compensation practices at these Wall Street firms, which encouraged executives to maximize profits and ignore risks. The salary levels at some Wall Street firms are appalling, given their performance. After news of the bailout plan spread on September 19, experts felt that it was only reasonable to impose limits on the salaries of executives of firms that would participate in the bailout. It was they who made those risky bets on behalf of their firms.
As Congress and the Bush administration (represented by Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke) deliberated the bailout plan before it was rejected by the House on Monday, lawmakers felt that executives should not be allowed to walk away enriched, especially since many have contributed to the present crisis by taking too many risks. There were calls to impose some limits or approval authority on salaries of executives whose firms seek help.
Presidential candidates Barrak Obama and John McCain have both called for limits on the salaries of such executives. There is a fear among many, including lawmakers, that Wall Street’s tarnished titans might walk away with tens of millions of dollars a year while taxpayers pick up the tab.
A Senate draft document calls for a ban on incentive payments that the Treasury deems “inappropriate or excessive” and a “claw-back” provision requiring an executive to give up pay or severance benefits if the firm’s financial results are later shown to be overstated. Other proposals call for a ban on severance payments and allowing large shareholders, with a stake of 3% or more, to propose alternative slates of board directors. This would be an effort to tackle excessive pay practices by opening up and strengthening corporate governance.
Opponents of the proposals say that pay restrictions will discourage hard work and innovation. It would have an overall impact on the financial sector and the economy. Some feel that it would be best to stretch out payments for several years, encouraging executives to pursue the long-term health and stability of the firms they head. However, the salaries are bound to fall. With consolidation, more people would be competing for fewer jobs, leading to lower salaries.
By G.L.C., on September 26th, 2008
The present financial crisis – probably the worst in decades – is making the lawmakers in Washington, D.C., strongly consider the need to dust off a 1980’s era plan to help save the banking industry and stabilize the economy.
The idea of setting up a government corporation to deal with toxic assets has invoked strong interest among both Democrats and Republicans. Lawmakers are eager to find some solution to the crisis. Eleven banks have already failed this year, and there are questions surrounding the major financial institutions. On September 6, the federal government took over mortgage lending giants Fannie Mae and Freddie Mac as they teetered near collapse. Lehman Brothers has filed for bankruptcy. Merrill Lynch & Co agreed to sell itself to Bank of America. And the government has just bailed out American International Group, Inc., a financial behemoth.
The bailout of AIG, one of the world’s biggest insurers, cost the government $85 billion. Doubts remain whether the bailout will effectively help stem the ripple effect that failing banks and financial institutions are having on the economy. AIG’s cash squeeze is driven in large by losses in a unit separate from its traditional insurance business – the financial products unit, which sold credit default swap contracts designed to protect investors against default in an array of assets including subprime mortgages.
The Treasury Department is planning to sell bonds for the Federal Reserve in an effort to help it deal with the unprecedented borrowing needs resulting from the present financial crisis. And lawmakers are now appearing open to the idea of creating a government entity akin to the Resolution Trust Corporation (RTC). The RTC was formed amid the savings and loan crisis in the 1980’s. The RTC resolved and liquidated the assets of 747 thrifts with total assets of $394 billion.
What is needed is an institution or a mechanism of a supertrustee to handle incredibly large financial institutions which may be allowed to fail and how those assets get managed and ensure they are handled in an expeditious manner. The absence of such an institution or mechanism could in the future result in one failure after another. The failures will keep blossoming. Many lawmakers are calling the creation of such a mechanism a legitimate idea that merits consideration.
The creation of a new federal agency would only put taxpayers at risk for billions of dollars in bad debts. The parallels with the 1980’s are inexact. The mission of the RTC was to dispose of the assets as quickly as possible for maximum value and reduce taxpayer exposure. Unlike now, the government had no choice but to acquire the assets from savings associations because they were backed by federal deposit insurance. The mortgages, which are at the heart of the present crisis, are not backed by federally insured deposits.
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