On Greed and Money

Chapter Eleven.

I have to integrate bonds and bond insurance into the over-all picture I've sought to create of what happened, especially in the US though we did all too good a job of then exporting it, in the period 2007-08. This requires backing up chronologically. It was in the world of quasi-public agencies that the notion of "too big to fail" got its start when Nelson Rockefeller and John Mitchell (before he was immotalized by the Watergate scandal) planned a novel way of financing affordable housing, although they didn't actually use that phrase.

1. Nelson Rockefeller and the "moral obligation" bonds of New York
2. The rise of the muni bond insurance industry
3. Who is really paying for this insurance? Third party payment as a regular matter is a common symptom of systemic trouble.
4. MBIA, accounting chicanery, and crack houses as collateral
5. Elliott Spitzer and rumblings in early 2008. (Valentines' Day)
6. Fall of Bear Stearns. Spitzer's fall served as comic relief.
7. The rest of that year from the bonds/insurer POV.

The material included under this heading in my book proposal can serve as the chapter's ending:

Where do we go from here? The credit crunch of 2007 and the stock crash of 2008 are in the history books and time travel is impossible, so we only work forward.

We should be wary of a “hair of the dog that bit us.” We should refuse to resolve this hangover by easy-money nostrums and loose-accounting remedies, or by making it easier for corporate managers to entrench themselves. That dog will only get more rabid and bite still more devastatingly if we indulge him further.

Two years ago

It was two years ago this week that the bigwigs of Wall Street and Washington were scrambling to answer the question, "What do we do about Bear Stearns," in a hectic prelude to the even graver crises of that autumn.

It was also on March 18, 2008, that Lehman Brothers put out an optimistic press release, reporting quarterly earnings of $489 million, or 81 cents per share. Investors loved that number. Lehman's shares went up $14.74 that day, to close at $46.49. Michael Hecht, an analyst with Banc of America Securities, called the quarterly results "all in all solid."

The commonality? The bad news on the Bear side was overstated (the $2 a share the Bear shareholders thought they'd be getting two years ago today was, in few days later, quintupled -- still, a devastating loss, but $10 per share was a mite better than $2.)

The good news on the Lehman side was also overstated. Indeed, "overstated" is kind. Hence the now notorious Examiner's Report to the bankruptcy court.

That's our brief anniversary lesson on the oldest of subjects: the difference between reality and appearance.

Of course, two years ago this week we were also learning -- at least New Yorkers interested in the goings-on in Albany were learning, about the world's oldest profession, at least the high-level variant of that profession patronized by the Spitzers of the world.

Bear Stearns: Venue???

After all the storm-and-stress of the last two years, the criminal trial of Tannin and Cioffi may all have come down to the discomfort the jury felt over the inappropriate venue.

Venue, by standard legal definition, is "the county (or geographical division) in which an action or prosecution is brought for trial, and which is to furnish the panel of jurors."

The Bear Stearns sponsored funds managed by Cioffi and Tannin dissolved in the spring and summer of 2007, an early sign of the severity of the subprime crisis. The two men were indicted in June 2008, in the federal district court for the eastern district of New York. Here we see the venue question.

Why were they indicted and later tried in the eastern district of New York? That district consists of Long Island, Staten Island, the Queens, and Brooklyn. Didn't Tannin and Cioffi work in Manhattan? Manhattan, along with the Bronx, constitutes the SOUTHERN DISTRICT of New York. Yes, they did. And there have been times when the US Attorney for the southern district was the big cheese in such matters, the sheriff of Wall Street (that's how Rudi Giuliani first became a national figure after all, back in the 1980s).

It appears that the prosecutors in Brooklyn wanted one of the sexy insider-trading cases for themselves. Here's a story about that general subject written with reference to cases you won't recognize, but which made quite a splash at the time the summer of 2000.

But back to the Tannin/Cioffi matter. Soon after retiring to deliberate, the jury sent the judge a brief note: "Please explain venue further." This kind of trans-district poaching it seems has costs.

Top Financial Stories 2008

I generally ask myself at this time of year what were the biggest stories of the past twelve months, in business/financial news.

By "stories," I don't mean themes, such as "Bear market in bank stocks" or "volatile crude oil prices." I mean stories, such as one might have seen in a particular newspaper on some specific day.

Of course, I choose the ones I do largely because they illustrate an important theme. But the theme itself isn't the story.

Further, I don't rank them, as in a top ten list. Usually, on this blog last year at this time and at my blog-city home for two years before that, I've simply given one "top" story from each of the twelve months of the year now ending.

This year has been so wild, though, especially its second half, that I haven't been able to stick to the one-a-month presentation. I've ended up with a list of 18 big stories, two per month starting with July.

All that understood, here we go!

January. Frenchman Jerome Kerviel loses 4.9 billion euros for Societe Generale. $7 billion. The story started off the year with a bang. Kerviel leap-frogged past Nick Leeson as the all-time most rogue-ish "rogue trader."

February. A jury in Hartford, Conn. convicts a former AIG exec of skullduggery.

The executive in question was Christian Milton, once AIG's vice-president for re-insurance. He was convicted of an effort to inflate AIG's loss reserve numbers.

March. The Federal Reserve backs a JPMorgan takeover of Bear Stearns. At one point, [i.e. the morning of March 17] the price was actually $2 a share for Bear's stock, although less than a week prior -- at the close of trading Monday afternoon, March 10, the market valuation had been $70.08 a share. It was hard not to think JP Morgan was making off with ill-gotten gains somnehow. In fact, the purchase price didn't stay down at $2. To resolve some problem in the documentation, it was eventually raised to $10. Bully. Still, the value-evaporation was breaktaking.

April. Food price increases cause riots, political crises, worldwide.

There would be a lot to discuss under this heading, were that my goal in this entry. Instead, I'll just ask about the use of foodstuffs as a surrogate for gasoline: what impact did that have in triggering the price increases or the result?

May. Yahoo successful in warding off acquisition attempt by MS.

A victory for Jerry Yang, the founder of Yahoo!, who remains its guiding spirit and has preserved its independence.

June. Voters in Ireland reject the Lisbon treaty, thus slowing Euro unity..

The world continues to wrestle with the whole idea of "sovereignty," in terms of nation-states or of broader or smaller units.

Hereafter we award two biggest-story prizes per month.

July. (a) Israel, of Bayou and Bear Mountain infamy, turns himself in.

The whole Bayou funds meltdown had more than a touch of the bizaare to it. Israel's effort to simulate a suicide on the Bear Mountain Bridge, the failure of authorities to discover a body in the Hudson, and his re-appearance and surrender just added the garnish to that meal of oddities.

(b) Crude oil prices peak near $150 barrel, head down.

Why did it get that high? Why has each barrel lost close to three quarters of that value in the months since? Which one is the anamoly, prices above $140 or around $40? which one will be the norm going forward? Reviewing this year just leaves me full of questions.

August. (a) Second circuit court hears arguments in CSX/TCI dispute.

This is fascinating litigation about proxy votes and the working of the equity swaps market. These aren't issues that will go away anytime soon.

(b) CME, Nymex agree to consolidation -- part of the much broader trend of the consolidation of exchanges worldwide.

September. (a) Bankruptcy of Lehman Brothers, all heck breaks loose re: bank stocks or, for that mnatter, US equities generally.
(b) SEC emergency order bans any short selling of bank stocks .

These two points rather adequately explain themselves. I'll only add that the ban later expired unlamented. Various restrictions of short-selling remain, but a simple ban on it is akin to a ban on pessimism. It is idiotic.

October. (a) Bush and 'leadership' put a TARP over troubles.
The acronym "TARP" stood for the "Troubled Assets Relief Plan," the keystone of the Emergency Economic Stabilization Act of 2008, which became law on OPctober 3, after a turtuous legislative process that re-defined the Presidential campaign to Senator McCain's disadvantage. That isn't all it has redefined.

(b) Waxman hearings excoriate the credit rating agencies I'll just leave a link to my contemporaneous explanation of this hearing and its bovine idiom.

November. (a) Geithner an early cabinet choice of President Elect.
The Republicans during the campaign had sought to tag Sen. Obama a "socialist" (while a President and Treasury Secy of their party were nationalizing industries -- how odd!) Anyway, the Prez-elect's choice of Timothy Geithner as his own Treasuiry Secretary should have re-assured anyone who needed re-assurance on this front.
(b) Paulson completes the bait-and-switch with the TARP.
The outgoing Treasury boss has advertised the TARP as a fund for purchasing troubled assets. Hence, the name. Those purchases were meant to stabilize, without taking over, the banking system. But by one month out, Paulson was acknowledging that the real use of the money would be to make "equity infusions." In other words, takeovers.

December. (a) Bernard Madoff is arrested Dec. 11, one day after his sons had apparently revealed his pyramid scheme to the authorities.

You can't really call Madoff a "rogue trader" in the manner of Kerviel, the rogue with whom the year began. A rogue is a trader who gets a firm in trouble by going behind the back of his bosses there. Madoff was the guy with his name on the door. Call him a "rogue principal" if you like. Still, his fall gives a nice sense of symmetry to the year.

(b) Dec. 16, Federal Reserve lowers federal funds rate to a range between 0% and 0.25%, record territory. Three days later, the Bank of Japan followed suit, lowering its benchmark rate to 0.10%.

Wow. Funds rates are dropping like crude oil prices.

Whew. I'm sooo happy this year is over.

Bear Stearns RIP

Cioffi/Tannin Discovery to Proceed: U.S. Attorney Rebuffed

Two former hedge fund managers, Ralph Cioffi and Matthew Tannin, have won a round in their resistance to enforcement actions both civil and criminal. The U.S. District Court for the eastern district of New York has denied a motion by prosecutors to stay discovery in the civil proceeding pending the completion of the criminal case.

Messrs Cioffi and Tannin managed the Bear Stearns High Grade Structured Credit Strategies Fund from October 2003 until July 2007 -- Mr. Cioffi was the senior portfolio manager, Mr. Tannin as portfolio manager reported to Cioffi. They created a related fund near the end of that period, calling it the Bear Stearns High Grade Structured Credit Strategies Enhanced Fund.

The U.S. Attorney, Benton Campbell, filed indictments against both men on June 18, 2008, alleging securities fraud, conspiracy, and wire fraud. The central charge is that they made fraudulent statements regarding the prospects of these entities. The Securities and Exchange Commission filed a civil action the following day on the same theory.

Mr. Cioffi (but not Mr. Tannin) is also accused of insider trading, because late in March 2007, according to the indictment, he transferred approximately $2 million of the money he had personally invested in one of these funds to another hedge fund.

The arguments over a discovery stay

The U.S. Attorney moved to intervene in the civil action in August, and asked for a stay in the SEC’s action -- and so in the defendants’ ability to conduct discovery in that context -- pending resolution of the criminal charges. His filings claim that this will protect the secrecy of grand jury proceedings and in general “prevent the broad civil discovery available in the Civil Case from circumventing the more limited discovery that will be available to the defendants who have been indicted in the Criminal Case.” The SEC has taken no position on this motion.

Each defendant has retained his own counsel. Mr. Cioffi is represented by Edward J.M. Little of the New York law firm Hughes Hubbard & Reed; Mr. Tannin by Susan Brune of Brune & Richard, also of New York. Both have vigorously opposed the motion for a stay.

Defense counsel argue that such a stay is extraordinary, and that under the applicable precedents the government is required to make a specific showing of how the public’s interests will be prejudiced by the continuance of civil discovery. Mr. Little describes the discussion of prejudice in the government’s memo as consisting only of “a few weak assertions [that] simply parrot the usual, generic, and worn claims of prejudice,” e.g. that the defendants would obtain material in the civil case to which, in the criminal context, they are not entitled.

Further, as Little's brief points out, it was the decision of the United States to bring nearly-simultaneous proceedings in the first case that led to the difficulty under which the government now claims to labor. “The government milked all the advantages of initiating simultaneous proceedings -- holding joint press conferences to laud their dual enforcement efforts -- yet now seeks to evade any of the obligations that come with that choice.”

Ms Brune makes much the same point. “If any party has had an unfair advantage it is the government, which has already obtained extensive discovery, including from Mr. Tannin, for use in the civil and criminal cases. At the crux of the [motion for a stay] is the government’s effort to preclude Mr. Tannin entirely from investigating the facts and from defending himself.”

In a reply brief October 8, Mr. Campbell tried to make the argument that he isn’t obliged to provide a specific accounting of possible harms from civil discovery, because “there is no precedent to deny a stay where the government agrees to provide broad discovery in the criminal case.”

There’s such a precedent now

The court’s decision, filed by Senior Judge Frederic Block October 23, sides firmly with the defendants.

Judge Blank denied the USAO's motion. At the very least, he indicates, it is premature. “Neither defendant has answered the civil complaint and no discovery requests have been proposed. In this context -- or, more accurately, absence of context -- the Court cannot engage in any meaningful balancing of the competing interests at stake.”

He also echoed the arguments of the defense counsel about the deliberate choice of tactic on the government’s part. “Courts are justifiably skeptical of blanket claims of prejudice by the government where -- as here -- the government is responsible for the simultaneous proceedings in the first place.”

Discovery will go forward. The decision to deny a stay is without prejudice to the prosecution’s right to object to particular discovery requests.

Investors in the two Bear Stearns funds were among the early victims of the bursting of the subprime bubble, and Messrs Cioffi and Tannin were the first managers accused of crimes as a consequence. But the nature of their allegedly deceptive behavior is less clear-cut than that of a more typical fraud case, such as that which arose out of the collapse of the Bayou funds in 2005. The government isn’t charging that Cioffi and Tannin, like Samuel Israel and Dan Marino in the Bayou affair, pretended to the investors that the returns were positive when they were in fact negative.

The charge, rather, is that the Bear Stearns defendants misrepresented to investors “the financial prospects of the funds [and] their opinions regarding the financial prospects of the funds.” That sounds a bit slippery.

What is especially worrisome is the government’s reliance upon email conversations between the two defendants in an effort to establish that they weren’t always as cheerful as they let on when communication to investors. A pertinent question has come from Tom Kirkendall, a Houston-area lawyer who maintains a much-read blog on business law, “Do we really want a marketplace in which people are afraid of being candid and analyzing the market with associates for fear of criminal liability?”

Given such questions, every step forward in these twinned enforcement proceedings will come under careful scrutiny.

Bankruptcy

Dysfunction of the corporate bankruptcy system in the US is, I feel certain, a good part of what ails us inboth micro and macro terms.

In a recent reveiw of Alan Greenspan's memoir, which I contributed to The Federal Lawyer, I said that debtor/creditor relations are a central theme in US history. That was the issue behind the fights over the first and second national banks. Regional disputes over debt and credit helped ignite a civil war, and the subsequent west-versus-east character of American populism. This was the issue behind the Bretton Woods negotiations of 1944, the subsequent unravelling of the system created there, and Greenspan's own present notoriety.

I didn't reference bankruptcy law in that review, but it is a branch on the same conceptual tree.

The kerfuffle over Bear Stearns last month renewed my interest in the whole subject. I suspect that the reason Bear melted down as quickly and unexpectedly as it did has a lot to do with contemporary bankruptcy laws, and the fact that Bear's counter-parties had to act in anticipation of the very possibility, even the mere rumor, that Bear might make such a filing.

I discussed related points in a blog entry here last August, and for today I'll just link you to that.

On a personal note: I'm going to be doing some travelling. You probably won't see another entry here for a week. I hope to see lots of comments when I return.

Fraudulent conveyances

A defunct New York based hedge fund named Manhattan Investment entered chapter 11 protection seven years ago.

Earlier this year, in a surprise move, a bankruptcy court judge ruled that giant brokerage firm Bear Stearns -- which was the "prime broker" for Manhattan -- might be on the hook for $121.5 million in money that this particular client transferred thereto shortly before the collapse. Bear with me whilst I try to explain this to myself.

There's a large and convoluted body of precedent and principles that deal with pre-bankruptcy transfers. There's good intuitive reason for concern. After all, think of this on a Mayberry Scale. Suppose Floyd's Barber Shop (or FBS Inc.) has fallen on hard times. Too many of the men of Mayberry have gone bald, or have gotten into the habit of going to Raleigh to get their hair cut in fashionable styles, and poor Floyd just can't make ends meet.

He has lots of creditors, but we'll focus on two, the North Carolina Scissor Sales Co. (NCSS) and the Greater Mayberry Hair Tonic Supplier (GMHTS).

The folks at GMHTS have always been buddies with Floyd. They've hung out together out in front of the sheriff's office and all that. But Floyd hardly knows the NCSS at all. They're just the name of the invoice to him.

So what does he do when he is facing insolvency? If he declares bankruptcy, then his barbershop as an "estate" is protected from all creditors until the court-appointed trustee can come up with a plan for who gets what. The strangers at the NCSS and Floyd's buddies at the GMHTS will be on an even basis here.

Suppose that he doesn't like that idea. Giving in to a natural human temptation, he might make a large payment -- all the cash he has left in the register, against the GMHTS bill. Then declare bankruptcy the following day.

The NCSS will naturally be unhappy when they discover this. Floyd isn't allowed to do that. The Trustee may seek to "avoid" that conveyance -- in other words, get the money back from the scissors' salesmen and put it back into the barbershop's cash register until a general plan is developed, wherein of course the NCSS and the GMHTS will be treated equally.

Which conveyances are avoidable and which aren't? Ah, there's the rub. The $121.5 million question for Bear Stearns just now.