Something to be Thankful for: The Kanjorski Amendment?

Ok, I admit I am a super-nerd on corporate governance and financial regulation. After all, compared to good health, family and friends, an African-American President, and general financial well-being in this age of financial strife, how else could I possibly suggest we give thanks for the Kanjorski Amendment. Well, I am thankful for much, but I am also truly gratified that someone, somewhere is willing to take on the financial elites and propose a reform that actually may help prevent future financial calamities.

I posted on the too-big-to fail problem months ago. At the time my proposal simply tried to make government bailouts unpleasant for financial titans, with a particular focus on CEOs and top managers, and the incentives they face. One element of this package was to give the regulators the power to order prudential divestitures if a firm threatened to become too-big-to-fail. Ultimately, I posted Subprime Bailouts and the Predator State, which formalized my thinking on the entire too-big-to-fail issue.

The Kanjorski Amendment provides the power for regulators to order divestitures if necessary to limit systemic risk.

Some have termed the Amendment a "trojan horse." I think this is ill-founded. The trojan horse argument has its basis in the provision of judicial review for arbitrary and capricious regulatory action. I can imagine nothing less. Regulators never have power to take arbitrary and capricious actions. This is, in fact, the lowest level of judicial review available. I would object if this review were not necessary before or shortly after a divestiture order.

I wish that there were sterner approaches out there. We need to take the profit out of being bailed out and even being too-big-to-fail. And, the political reality may preclude even Kanjorski's rather sensible proposal. Today, at least, I am thankful for the Kanjorski Amendment.

NASAA Enters into Historic $61 Billion Auction Rate Securities Series of Settlements with Financial Services Institutions

The North American Securities Administrators Association (NASAA) has reached settlements with more than a dozen financial services institutions regarding the inadequate disclosure of the auction rate securities (ARS) that were sold to public investors. The terms of the settlements require the financial services institutions to repurchase more than $61 billion in auction rate securities from investors. This is the largest return of funds to investors in history.

Numerous financial services institutions have entered into settlements with NASAA for failing to adequately disclose the risk of auction rate securities, misleading investors by falsely assuring them of the safety of ARS, and/or failing to supervise and train its sales agents. The financial services institutions that have entered into settlements with NASAA include: Wells Fargo Investments LLC, Wachovia Securities LLC, Merrill Lynch, UBS AG, TD Ameritrade, Inc., Bank of America Corp., Goldman Sachs Group Inc., Deutsche Bank AG, JP Morgan Chase & Co., Citigroup Inc., Morgan Stanley, Goldman Sachs, and Credit Suisse Group AG.

Auction Rate Securities (ARS) are long term, variable rate bonds tied to short term interest rates. ARS have a long term nominal maturity with interest rates that reset through a modified Dutch auction process, at predetermined short term intervals, usually 7, 28, or 35 days. They trade at par and are callable at par on any interest payment date at the option of the issuer. Interest is paid at the current period based on the interest rate determined in the prior auction period. Although ARS are issued and rated as long term bonds (20 to 30 years), they are priced and traded as short term instruments because of the liquidity provided through the interest rate reset mechanism. Frequent issuers of ARS include traditional issuers of tax-exempt debt such as municipalities, non-profit hospitals, utilities, housing finance agencies, student loan finance authorities and universities.

The interest rate on ARS is determined through a Dutch auction process. The total number of shares available to auction at any given period is determined by the number of existing investors who wish to sell or hold ARS only at a minimum yield. Existing investors and potential investors enter a competitive bidding process through broker-dealers. Investors specify the number of shares, in denominations of $25,000, they wish to purchase with the lowest interest rate they are willing to accept. Each bid and order size is ranked from lowest to highest minimum bid rate. The lowest bid rate at which all the shares can be sold at par establishes the interest rate, otherwise known as the “clearing rate.” This rate is paid on the entire issue for the upcoming period. Investors who bid a minimum rate above the clearing rate receive no ARS, while those whose minimum bid rates were at or below the clearing rate receive the clearing rate for the next period.

The Dutch rate mechanism makes ARS a form of derivative—that is, ARS derive their interest rate based on an underlying interest rate as determined by the Dutch auction process. There is often a derivative contracts intertwined with the ARS. The derivative contracts are supposed to reduce costs for the issuers by hedging their interest rate risks. Derivatives are not safe securities. I wrote an article on the riskiness of derivatives, and how average investors are often manipulated into investing in derivatives almost two years ago entitled Controlling a Financial Jurassic Park. Derivatives are one of the most sophisticated and riskiest investments amongst the array of financial products in which investors can invest. Yet the number of average investors that are manipulated into investing in derivatives is staggering. ARS investors are typically high net worth individuals (for tax-exempt issues) or corporations (for taxable issues). Not surprisingly, money market funds are ineligible to hold ARS due to Securities and Exchange Commission Rule 2a-7, which restrict money markets to securities with a final maturity of 397 days or less. This is a key indicator that ARS are not liquid securities that are easily convertible into cash.

Despite this data, financial service institutions involved in the NASAA series of settlements repeatedly told investors that auction rate securities were a “safe, liquid alternative to cash, certificates of deposit or money market funds.” Regulators alleged that ARS were marketed as safe, cash-like investments. In actuality, ARS are not cash-like investment as evidence by the freeze in the $330 billion auction-rate securities market last year. When the ARS market froze, in part due, to the lack of liquidity in the banking system, banks refused to allow investors to exchange their ARS for cash. Investors were dismayed at the financial institutions’ refusal to convert their ARS investment into cash, especially since their ARS had been marketed to them as nearly identical to cash.

The financial services institutions served as broker-dealers that operated the auction-rate market on behalf of municipalities, nonprofits, and closed-end mutual funds and were paid 0.25 percent of the security’s total issue for each year of its life. However, with the frozen ARS market, financial services institutions were and continue to earn servicing fees when 70 percent of the weekly auction rate securities are failing. Additionally, financial services institutions are earning banking fees when issuers redeem the securities, and financial services institutions make additional revenues when they assist issuers untangle from derivative contracts that are often intertwined with ARS.

All of the financial services institutions that have entered into settlements with NASAA have agreed to: (1) fully reimburse certain investors who sold these securities at a discount after the market failed, (2) consent to public arbitration to resolve other investor claims as a result of their inability to access their funds, and (3) pay millions in penalties to the various states whose residents were misled into purchasing the auction rate securities. NASAA President and Texas Securities Commissioner Denise Voigt Crawford stated that "we will continue to seek much needed relief for investors who have suffered from the collapse of the ARS markets."

Lydie Nadia Cabrera Pierre-Louis

Clearing Over-The-Counter Derivatives

Lost within the historical health care reform debate on Capital Hill is the quiet work in both the Senate and the House of Representatives where bills are being drafted and hearings are being held in connection with implementing new regulation on the over-the-counter derivatives trading market. One of the primary focuses in the proposed regulation is on reducing credit and systemic risk by requiring that over-the-counter derivatives be "cleared" through registered clearing organizations or agencies called "clearinghouses." The clearing of over-the-counter derivatives currently is addressed in three bills being debated in Congress, one from the House Financial Services Committee, one from the House Agricultural Committee and one from the Senate Finance Committee.

Many commentators believe that unregulated trading of over-the-counter derivatives, including credit default swaps and other complex vehicles contributed largely to the implosion of Lehman Brothers, Bear Stears, AIG and others precipitating the global economic meltdown.

As with all new regulation, in particular regulating an enormous over-the-counter derivatives trading market (measured in the hundreds of trillions), the "devil" is in the details. Many commentators, including my colleague Christian Johnson at the University of Utah S.J. Quinney College of Law, are dubious that Congressional adoption of legislation will reduce risk efficiently, rather worrying that such clearing will create legal uncertainty, loss of efficiencies, reduction of hedging effectiveness and increase costs, most of which will be difficult to measure and address.

Midwestern People of Color Legal Scholarship Conference Announcement

It is my pleasure to announce that the Midwestern People of Color ("MWPOC") Legal Scholarship Conference will be held in Chicago, Illinois from April 16, 2010 through April 18, 2010. The theme of the MWPOC Conference will be "Paradigms Lost: Outsider Scholarship, Insider Scholarship and the Economic Crisis." Professors Derrick Bell and Richard Delgado will be the keynote speakers.

As usual, this promises to be a very insightful and enriching event. This event is well worth your time and worthy of your attendance. As more registration details become available, I will keep you posted. I hope to see you in Chicago in April!

The Trickle Down Bailout, Foreclosures and Communities of Color

The chart at left shows the soaring delinquency rate for all mortgages in the US released yesterday by the Mortgage Bankers Association for Q3 of 2009. Delinquencies stand at a record high 9.64%. Foreclosures and delinquencies combined are now at a record high of 14.41 percent. These records go back to 1972.

“Despite the recession ending in mid-summer, the decline in mortgage performance continues. Job losses continue to increase and drive up delinquencies and foreclosures because mortgages are paid with paychecks, not percentage point increases in GDP. Over the last year, we have seen the ranks of the unemployed increase by about 5.5 million people, increasing the number of seriously delinquent loans by almost 2 million loans and increasing the rate of new foreclosures from 1.07 percent to 1.42 percent,” said Jay Brinkmann, MBA’s Chief Economist.

“Prime fixed-rate loans continue to represent the largest share of foreclosures started and the biggest driver of the increase in foreclosures. 33 percent of foreclosures started in the third quarter were on prime fixed-rate loans and those loans were 44 percent of the quarterly increase in foreclosures. The foreclosure numbers for prime fixed-rate loans will get worse because those loans represented 54 percent of the quarterly increase in loans 90 days or more past due but not yet in foreclosure."

The situation is more dire in communities of color: "Blacks and Latinos suffer in comparison to whites both in unemployment rates and having loans with higher interest rates. The nationwide unemployment rate is 10.2 percent. For blacks, it's 15.7 percent and for Latinos, 13.1 percent. As far as high-cost mortgages are concerned, blacks and Latinos were anywhere from two to nine times as likely as whites to have those kinds of loans."

Communities of color are now facing a historic destruction of household wealth: "If nothing is done then the foreclosures will continue disproportionately hitting blacks and Latinos," said UCLA professor Raul Hinojosa the author a study entitled The Continuing Home Foreclosure Tsunami. He also stated that continued foreclosures could destroy billions of dollars in housing wealth in communities of color. "Not only are you wiping out this generation of black and Latino families, but those neighborhoods go into serious decline."

Those following this blog are well-acquainted with my pessimistic outlook. I previously blogged about runaway debt and runaway unemployment. I have also decried the trickle down bailouts which have added to bank capital cushions but done little to help the economy at massive cost to the taxpayer. Right now the banks are hoarding over $1 trillion at the Fed while simultaneously starving the economy of capital.

We were not compelled by some iron rule of economics to give all our money to the banks to hoard so that they may be kept afloat while the middle class is vaporized by a mountain of debt, a collapsing economy, and no help in sight. I argued very early on in the bailout story that there were alternatives. In fact, I tried to persuade the Democrats to do an alternative bailout rather than stuffing money into the pockets of financial elites. After the election, I urged a Keynesian stimulus that would create jobs and I argued that the insolvency sponges at the center of our economy would suck up capital and hoard wealth.

What we are now seeing is the utter failure of the trickle down bailouts. I fear we are on the verge of runaway foreclosures.

Prof. Christopher Peterson on Fannie, Freddie: "Suckers"

Professor Christopher Peterson has a new article out entitled: "Fannie Mae, Freddie Mac, and the Home Foreclosure Crisis." Here is the abstract:

Following the Great Depression, the federal government was the primary architect of the secondary residential mortgage market. The foremost pillars of this federal involvement were the twin government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. In the public debate over the struggling American financial system, opponents of federal involvement in housing finance have persisted in asserting that Fannie Mae and Freddie Mac caused the home foreclosure crisis. This symposium essay attempts to provide a brief rebuttal to this surprisingly persistent oversimplification. It begins with historical context necessary for understanding the debate over the GSEs’ responsibility. Next it explains the development of the private, sub-prime home mortgage market, recounts the radical change in the GSEs’ investment and underwriting policies in the mid-2000s, and traces the events leading to the collapse and nationalization of the two companies. Although the GSEs began to engage in unacceptably risky investment decisions, the two companies were only one part of a larger more complex commercial and regulatory pattern that also included monetary policy, regulatory dereliction, judicial passivity, ill-advised borrowing, and reckless (or dishonest) brokering, appraising, lending, servicing, and securitizing by private financial services companies.

I found this quote compelling: "As soon as the GSEs abandoned direct monitoring, the profit-seekers (including the credit rating agencies) the GSEs relied on arranged to sell them garbage and harvest massive bonuses, commissions, and fees in the process. Like so many others, Fannie and Freddie's core failing was this: they were suckers."

So why the continued fury on the right regarding Fannie and Freddie? Here is Professor Peterson's take:

Although government minimalists hope to use the subprime crisis as evidence of President Reagan's mantra that 'government is not the solution to our problem; government is the
problem,' any fair appraisal of events demonstrates otherwise. It was the absence of a legislative response to shape and facilitate the rapidly emerging patterns of housing financial commerce. It was a sleeping judiciary that neglected to lay down a relevant common law in the absence of legislation. It was captive federal banking regulators that interpreted their 'consumer protection' obligations to mean protecting banks from consumers. It was the erosion of deposit insurance as a useful tool in preserving bank solvency. It was massive speculation in derivatives. It was media and scholarly academies that did not find a way to tell the stories and marshal the arguments to show what was about to happen. And, it was an indulgent, indifferent American public that that let itself be misled. Fannie Mae and Freddie Mac-part of the problem, rather than the solution-were but one factor in much larger and more genuinely disappointing picture of letdown.

In other words, the propaganda regarding Fannie and Freddie is simply "outdated demagoguery."

This is the most careful and balanced assessment I have seen on this issue. It fully recognizes that Fannie and Freddie both invested in much subprime product (under the bipartisan direction of two administrations) and guaranteed trillions of mortgages. Yet, in the end Fannie and Freddie were bit players compared to the long litany of causes. More to come on the long litany. . . .

Two More Bernie Madoff Associates Arrested And Charged With Fraud

Bernie Madoff is in jail for 150 years for pulling off one of the most massive Ponzi schemes in history. One thing is certain: Bernie Madoff could not have acted alone to perpetrate his fraud. In recent weeks and months many of the people around Bernie Madoff have begun to fall.

In the latest episode, two of Bernie Madoff’s computer programmers were arrested on Friday in New York on charges of falsifying books and records and helping Madoff to pull off his fraudulent scheme. Jerome O’Hara, 46, and George Perez, 43, were charged with criminal conspiracy and accused of producing false documents and trading records for Bernard L. Madoff Investment Securities LLC. “O’Hara and Perez were accused of knowing that the special computer programs they developed contained fraudulent information used in U.S. and European regulatory reviews.”

The Securities and Exchange Commission also filed civil charges against O’Hara and Perez. The arrest of O’Hara and Perez brings to five (5) the number of people criminally charged in the Madoff Scandal. Hopefully, more arrests should be forthcoming.

Fed's Lose Major Subprime Fraud Case: Bear Stearns Hedge Fund Managers Acquitted

On Tuesday of this week, the Department of Justice suffered a major set-back in the first trial stemming from the subprime and financial markets meltdown. Ralph Cioffi and Matthew Tannin, both former Bear Stearns hedge fund managers, were found not guilty on all charges by a U.S. District Court jury in Brooklyn, New York. Federal prosecutors alleged that Cioffi and tannin falsely inflated the value of their portfolios despite knowing that the mortgage-backed securities in their funds were at risk of collapse.

The Bear Stearns hedge funds managed by Cioffi and tannin collapsed in June of 2007. Investors lost $1.6 billion. Both Cioffi and Tannin were charged with numerous counts of securities fraud, wire fraud and conspiracy. Had they been convicted, both Cioffi and Tannin faced upwards of 20 years in prison. Additionally, Cioffi faced an added 20 years on an insider trading charge alleging that he shifted $2 million of his own money out of a poorly-performing fund to a separate fund that he oversaw. A number of jurors indicated that the government’s theory of the case and allegations just did not stick. Some jurors indicated that the government seemed to be trying to unfairly hold Cioffi and Tannin responsible for the impending collapse of financial markets, particularly at a time when even the best economists were uncertain about the direction of the markets.

Cioffi’s and Tannin’s defense attorneys argued that the two men were overly enthusiastic about the market and their funds performance. The defense also argued that the men had no way of knowing what lay ahead: namely, the subprime mortgage crisis and the housing market bubble burst of 2007.

In a political and economic climate where average everyday people want to draw “blood” from grossly overpaid executives, this is a tough set-back for the Department of Justice. This case was the first high-profile subprime mortgage case to go to trial. “The month-long trial was viewed as a barometer for future investigations of possible fraud at other firms that may have exacerbated last year’s financial meltdown.” Reportedly, former executives at AIG and Lehman Brothers are under investigation for their roles in the financial meltdown. Hopefully, the Department of Justice has learned a value lesson. If not, surely the defense bar will be taking notes of the arguments and theories put forward by the Cioffi and Tannin defense teams.

Seriously?

The Wall Street Journal and New York Times both reported this week that current A.I.G. Chief Executive Officer Robert Benmosche is loudly complaining ("boiling over") and threatening resignation over the efforts of the Obama Administration to curb executive pay at the troubled insurance giant. How can AIG recover and effectively regain its market position when the ability to lure or keep executives with outlandish compensation packages is not available?, seemingly wonders the AIG CEO.

According to the Wall Street Journal:

"The executive [Benmosche] is chafing under constraints imposed by AIG's government overseers, particularly a recent compensation review by the Obama administration's pay czar, Kenneth Feinberg, according to the people. AIG, 80% government owned since a rescue last year, is one of the companies under Mr. Feinberg's purview.

Last week, Mr. Benmosche and other AIG board members met with Mr. Feinberg in New York. During the three-hour meeting, board members discussed difficulties of complying with pay policies and retaining talent at the company. Mr. Benmosche's frustrations 'hit a crescendo,' said a person familiar with the matter."

Seriously? When the federal government with taxpayer money bails out an insurance giant for ridiculously reckless decision making (in the subprime and credit default swap markets), with dozens of billions of dollars, that government is not entitled to or supposed to provide compensation oversight? Really?

And Benmosche's primary argument is that the "talent" is leaving AIG for better pay elsewhere. Again, seriously? He cannot pay to keep the talent at AIG? Is this the same talent that torpedoed the company, which would be in receivership, but for the government bailout? Perhaps Benmosche and other corporate executives decrying the executive compensation limits, should reconsider what "talent" need be hired to revive the failures of the previous "talent."

Business-Related Changes During the First Few Months of Obama's Tenure

Business-Related Changes During the First Few Months of Obama’s Tenure

On October 20th, 2009, President Obama came to New York City where he made a speech at a Democratic National Committee fundraiser about all that he and his administration have done for our country in just nine months. I was at the speech, standing in the front row, just a few feet away from the President. (The VIPs were seated comfortably in a balcony section behind us.) It was obvious that the President wanted to be near the everyday people who elected him last November.

Here is some of what the President said. “…It’s important for all of us to remember what the situation was when we came in nine months ago, because there’s some people out there who seem to have a selective memory. There’s sort of a revisionist history about what was waiting for us when we began this presidency. We were facing an economic crisis unlike any we had seen in generations – losing 700,000 jobs a month; financial system on the verge of meltdown; economists of every political persuasion, they were fearful that we might fall into a Great Depression. You remember that?”

We all cried out – “yes!”

The President continued. “And that’s why we acted boldly and we acted swiftly to pass a Recovery Act that’s made a difference in the lives of families across America. People don’t, I think, remember where we were and where we are now. We put a tax cut into the pockets of small business owners….”

Then the President enumerated some of the accomplishments of the first nine months of his tenure as President. There are many, but I’ll mention only the business-related accomplishments that he described. His administration helped to create thousands of private sector jobs, and made over 30,000 loans to small businesses. The President also told us about his achievements that addressed the negative impact that some businesses have had on our society and citizens. He worked and achieved the passage of the Lilly Ledbetter Fair pay Act, ensuring that businesses pay women “the same as men for doing the same work.” The President continued. “We passed legislation to protect consumers from credit card abuse. We passed a law to prevent abuse in the mortgage industry. We passed a law that will protect our children from being targeted from big tobacco companies.” He has worked to fashion policy changes aimed at reducing greenhouse gas pollution by car manufacturers. And, of course, the President explained his ongoing efforts in dealing with insurance companies and health care reform, and the regulation of the financial industry.

Alluding to the intense criticism he has received, the President took credit for his many achievements, observing that he had a huge mess to clean up. “We understand exactly who and what got us into this mess. Now, we don’t mind cleaning it up – I’m grabbing my mop and my broom and we’re scrubbing the floors and trying to neaten things up. But don’t just stand there and say, “You’re not holding the mop right…. You’re not mopping fast enough. Don’t accuse me of having a socialist mob. Instead of standing on the sidelines, why don’t you grab a mop? Help us clean up this mess and get America back on track! Grab a mop!”, said the President.

The Audience, hundreds of us, responded by chanting the words – “Grab a mop! Grab a mop!” After the President finished his thirty-minute speech, he stepped down from the dais and shook the hands of those in the front row. I shook the President’s hand, happy to be a part of this historic gathering and optimistic about the nation’s future.

Fannie & Freddie: Conservative Mythology II

Controversy continues to swirl regarding the role of Fannie and Freddie in the subprime crisis. My thesis has been that most of those blaming Fannie and Freddie for the crisis (as a major causative element) do so for political reasons (or worse). A sub-thesis has always been that the conservative effort to blame Fannie and Freddie ultimately indicts the Bush Administration.

Let me explain. The argument that Fannie and Freddie acted as bit players is based upon the fact that neither originated nor securitized subprime loans. Further, their investment in subprime, while reckless and foolhardy, simply was not large enough to drive the crisis. Yes, both GSEs were politically co-opted, and yes both parties used them for partisan advantage. But all the data suggest their subprime investments were too modest to lay the cause at the door of the GSEs.

The panel to the left shows the Freddie and Fannie portfolio of private MBS over time. As you can see both Fannie and Freddie cut their subprime exposure by 2007. Even in 2006, however, their portfolio consisted of about half Alt-A or prime, not subprime. This picture is consistent with the data of Professor Alan White as well as a number of media reports. Basically, there is wide agreement that Fannie and Freddie invested in subprime to a significant degree, but they were cutting their investments by 2007, and much of their investment was higher graded product than subprime.


Any objective view of the source of problems shows that the real estate meltdown started in 2006 and 2007 in the subprime market. The panel to the left shows the very high delinquency rates associated with the 2007 and 2006 cohort of subprime mortgages. Those mortgages defaulted at a rate of 40% within months of origination. So there is a timing disconnect. Fannie and Freddie were cutting subprime investment just as it was getting rotten. Moreover they invested in Alt-A to a very significant extent. The numbers of subprime investments are just too small to lay much blame at the feet of the GSEs, and the timing is also out of kilter.

Which brings me to the Bush Administration. Continuing a policy starting in the Clinton Administration, the Bush Administration used the GSEs to further a political goal of expanding affordable housing. So, on November 1, 2004 the Bush Administration announced an expansion of efforts to get the GSEs to invest in subprime. The HUD press release trumpeting these efforts is available here. The effect of this effort was immediate. Whereas in 2001 Freddie bought $18.1 billion in subprime mortgages, the two GSEs bought $434 billion in subprime loans from 2004 to 2006. More specifically, according to the Washington Post: In 2003, the two bought $81 billion in subprime securities. In 2004, they purchased $175 billion -- 44 percent of the market. In 2005, they bought $169 billion, or 33 percent. In 2006, they cut back to $90 billion, or 20 percent." (Note how this data point dovetails with my timing point, above).

Why did the Bush Administration pursue this folly? The Federal Register gives the formal answer: the Bush Administration wanted the GSEs to be market leaders in the cause of affordable housing, expanded home ownership and expanded minority ownership. The GSEs actually objected to this effort.

Experts have castigated the effort:"That was a huge, huge mistake," said Patricia McCoy, who teaches securities law at the University of Connecticut. "That just pumped more capital into a very unregulated market that has turned out to be a disaster."

"For HUD to be indifferent as to whether these loans were hurting people or helping them is really an abject failure to regulate," said Michael Barr, a University of Michigan law professor who is advising Congress. "It was just irresponsible."

Despite its bi-partisan roots, clearly the Bush Administration put the pedal to the metal for GSE purchases of subprime mortgages.

But, for all the blame for the crisis that is out there, this cause continues to strike me as minor. Fannie and Freddie were bit players. As I mentioned in a recent comment post, however, I have no real dispute with those claiming this was a major cause, so long as that line of thinking recognizes that the Fannie and Freddie role was primarily driven by the Bush Administration in terms of numbers, with a hat tip to Andrew Cuomo and the Clinton Administration.

Finally, I am willing to wager that Wall Street lobbyists stood behind both the Clinton and Bush administration efforts for affordable housing. What CEO could resist the easy profits of packaging subprime, even predatory, loans for sale to the GSEs? Any help on this front would be appreciated.

Ex-AIG Chief is Back

Former deposed American International Group (AIG) CEO, Maurice "Hank" Greenberg, has recently reemerged on Wall Street quietly building up a family of insurance companies, C.V. Starr & Company, that seeks to compete with AIG. Greenberg has been hiring some of the individuals that he formerly employed at AIG. "Basically, he’s just starting ‘A.I.G. Two’ and raiding people out of ‘A.I.G. One,’ ” said Douglas A. Love, an insurance executive who has also hired A.I.G. talent for his company, Investors Guaranty Fund of Pembroke, Bermuda.

Greenberg was ousted as head of the insurance giant AIG in 2005 for allegedly engaging in accounting fraud (allegations were levied by former Attorney General and Governor of New York Elliot Spitzer). All the criminal charges were eventually dropped, though some civil claims remained unresolved. In August 2009, Greenberg agreed to a deal with the Securities and Exchange Commission to pay $15 million in penalties and disgorgement for overseeing fraudulent transactions at AIG. The transactions led to an accounting restatement by AIG of at least $2 billion, but Greenberg said the vast majority of the restatement "was unnecessary." Shortly after agreeing to settle, he issued a statement claiming he had "no responsibility" for the fraud.

From the New York Times: "While America generally loves stories of entrepreneurs making a comeback, Mr. Greenberg’s success may be at the expense of taxpayers. People who work in the industry say that if he is already luring A.I.G.’s people, he may soon be siphoning off its business and, therefore, its means to repay its debt to the government. “To me, it’s just going to be a matter of time before the valuation of what he’s building is greater than the valuation of A.I.G.,” said Andrew J. Barile, an insurance consultant in Rancho Santa Fe, Calif.

A.I.G., meanwhile, is struggling to regain its footing. The recipient of the biggest taxpayer bailout in history, it has been ordered by the government to restructure, unwind its complex derivatives and pay back the taxpayers."

To those that appear downright frightened by the thought that a deposed CEO of one of the Corporations responsible for nearly collapsing the global economy is restructuring and retooling, with a new company, note that Greenberg and his new C.V. Starr & Company just this month (October 2009), leased 141,000 square feet of space — three stories — on Park Avenue in Manhattan, in one of Lehman Brothers' old headquarters. Further, Greenberg has previously, expressed an interest in buying one of AIG’s prizes, a sprawling global insurance group, but only if he could buy the whole thing.

Also in 2009, AIG took Greenberg to court, accusing him of plundering $4.3 billion in stock from a trust that it says was set up to pay top performers. However, in July 2009, a federal jury ruled that Greenberg had not wrongly seized the stock and was therefore not required to reimburse the company.

Fannie, Freddie and the CRA: A Case of Conservative Mythology

I do not always agree with the Heritage Foundation, but I want to applaud their recent backgrounder Understanding the Great Global Contagion and Recession. It is a balanced, if conservative, overview of the key issues.

Here is their conclusion regarding the role of Fannie and Freddie in the crisis: "While the costs to the taxpayers are inexcusable and those responsible in and out of Congress should be held accountable, the two GSEs played at most secondary roles in the global financial contagion." I could not put it better. Fannie and Freddie did not originate nor securitize subprime loans. There was a bi-partisan effort to encourage the GSEs to invest in affordable loans and after 2004 in the wake of a Bush administration directive the GSEs tripled their purchases of non-prime loans. In 2000, as an example, Freddie bought $18.6 billion in subprime loans. By 2004, the GSE purchases peaked, but only constituted 33% of the market. Thereafter they cut back, and in 2005 their purchases amounted to just 20% of the market.

So, on this point, I concur with the Heritage Foundation: Fannie and Freddie were bit players in the financial crisis or in the exact words of the Heritage Foundation "they were at most incidental."

The Heritage Foundation also found that the Community Reinvestment Act (CRA) was "at most incidental" to the crisis. Here, the Heritage Foundation cites to a now famous Federal Reserve Study that found, according to the Heritage Foundation: "the Federal Reserve Board staff's research of 2006 mortgage originations strongly suggests that the CRA was likely only a minor or incidental factor. As Federal Reserve Governor Elizabeth Duke stated in February 2009, 'only 6 percent of higher-priced loans were made by CRA-covered lenders to borrowers and neighborhoods targeted by CRA.'" The Fed study that proves the irrelevancy of the CRA to the entire financial crisis is available here: http://www.federalreserve.gov/newsevents/speech/20081203_analysis.pdf. Six percent means that 94% of all subprime loans were not CRA loans!

There has long been a steady stream of media analysis demonstrating just how weak the case to pin blame on Freddie, Fannie and the CRA was. In late 2008, two experts stated: "It is not tenable to suggest that the Community Reinvestment Act, which was enacted more than 30 years ago, suddenly caused an explosion in bad subprime loans from 2002 to 2007. During the 1990s, enforcement under the reinvestment act was strong, prime lending to low-income communities increased and it was done safely. In 2000, a Federal Reserve report found that lending under the act was generally profitable and not overly risky."

Another report showed that Fannie and Freddie actually cut their subprime investments in half at the height of the subprime fiasco: "Between 2004 and 2006, when subprime lending was exploding, Fannie and Freddie went from holding a high of 48 percent of the subprime loans that were sold into the secondary market to holding about 24 percent, according to data from Inside Mortgage Finance, a specialty publication."

Over a year ago, Professor of Law Alan White stated: "Fannie and Freddie did play a role, albeit a minor one. As of 12/31/07, Freddie held $234 billion and Fannie held $112 billion in subprime securities, out of a total market of $2,116 billion (i.e. $2.1 trillion). Most of these purchases took place in 2005 and 2006. A significant chunk to be sure (about 15%) but if you took out the GSE purchases, there would still have been a huge subprime market, and there is no way to know whether other buyers might have purchased those same securities if Fannie and Freddie had not (i.e. their presence was probably not vital to the growth of subprime lending and securitization.) Other purchasers of subprime securities included banks and thrifts, foreign investors including sovereign wealth funds, mutual funds, hedge funds, insurance companies, state and local governments, private pension funds, and wealthy institutions and individuals. It is also worth noting that Fannie and Freddie started buying subprime securities late in the game, years after the subprime mortgage market had been launched and its dangerous products deployed."

So why do right wing extremists and other conservatives continue to circulate this myth that the crisis was caused by Fannie, Freddie and the CRA? I think the purveyors of this myth fall into three camps.

First, there is the principled laissez faire enthusiast. Basically these folks are against government involvement in the economy. Even the idea of a central bank is anathema. Fine, I disagree; but I respect the principled and consistent position.

Second, are the party ideologues. Here principle gives way to intellectual dishonesty. The point is to try to blame everything on the Democratic party. Even in the face of a manifestly bi-partisan crisis, generated by bi-partisan policies, the idea here is policy as boxing match. You pick a fighter and then root for him to bash the brains out of the other fellow. Truth is irrelevant as is the best interest of the country. I will call this the Krugman position, after the well-known Noble laureate in Economics, who is similarly dismayed by efforts to pin the blame on Fannie, Freddie and the CRA.

Finally, there are the hard core racists. Constituting perhaps 10-12% of the population, this group simply wants to blame the crisis on people of color. Ann Coulter's theories on the crisis have great appeal to this group because she casts her points in an overtly racial way. Obviously, there is no sign of intelligent life here, there is no point trying to reason with these extremists, and facts and numbers will not hold sway with this portion of body politic.

So, there is a conservative myth that the crisis was caused totally by Fannie, Freddie and the CRA. It is embraced by the 30% of the population that is more conservative than the Heritage Foundation. They tend to substitute heat for light in their arguments, so they make a lot of noise. Their main choice of argument is to hurl insults at those who disagree.

Thinking conservatives, like those at the Heritage Foundation have evolved to a point that their analysis is driven by fact rather than myth.

CEO Primacy and Unemployment

The new jobs report came out this morning and its very disconcerting. The headline unemployment number jumped to a 26 year high of 10.2%. It came on the heels of yesterday's news that productivity is surging. The surge in productivity means that US corporations are wringing more efficiency out of their labor force.

That may sound good, but what it means is that corporations are brutally cutting hours and slashing jobs to the bone to maintain profitability. As the Financial Times puts it "The US experience contrasts sharply with that in Europe. . .where companies cut back on employment and hours much less than their US counterparts, resulting in lower unemployment but worse productivity." In fact, hours worked is still in a free fall: "Total hours worked in the economy fell 0.2%. The average workweek was steady at a record-low 33 hours."

I previously highlighted the employment ratio, in my post "Runaway Unemployment?" That number too remains in a free fall. As the Brookings Institute states: "The current recession has also seen the steepest decline in the employment-to-population ratio in the modern era. Since the peak of the last economic expansion in December 2007 the percentage of Americans who hold jobs has fallen 4.2 percentage points, dropping from 62.7% to 58.5% of the population 16 and over." The upshot of this is that Americans are faced with a historic and rapid deterioration in the labor market.

This is consistent with my argument for years (starting in 2005 in the St. John's Law Review) that American corporate governance law devolved into a system of CEO primacy over the last two decades, as a result of CEO political power. I recently argued that CEO primacy drove the current subprime crisis by allowing CEOs to ring up profits and bonuses today at the expense of huge risks in the future. The last thing on the minds of CEOs was any concern at all for the well-being of the system that empowered them and allowed them to thrive.

Today, I posit that CEO primacy naturally leads to higher unemployment because CEOs can boost short term profits by brutally cutting employment which will enhance their "performance" compensation. The fact that cutting too much may lead to higher expenses down the road is irrelevant to CEOs. The fact that brutal employment cuts destroy the commons of consumption is even more irrelevant. As I wrote in 2006, without any effort to durably support consumption, CEO primacy will consume itself in a massive crisis of buying power.

CEO primacy is destroying American capitalism.

Holding Accountants Accountable for Securities Fraud (and Silliness)

Bernie Madoff’s, accountant, David G. Friehling, admitted in federal court that he had permitted Madoff to conceal his securities fraud scheme from regulators for nearly 20 years by never actually auditing Madoff’s operation. Friehling merely accepted “whatever figures he was given and plug[ged] them into independent audit” reports. For Friehling’s candid disclosure in federal court he faces a potential statutory maximum prison term of 114 years for nine criminal charges. The criminal charges include: (1) one count of securities fraud, (2) one count of aiding or abetting investment-adviser fraud, (3) four counts of making false filings to the Securities & Exchange Commission and (4) three counts of obstructing administration of the federal tax laws.

The Bernie Madoff fraud is one of the largest Ponzi schemes in history, with thousands of victims and approximately $50 billion in estimated losses. However, Friehling insisted that he had no knowledge about Madoff’s Ponzi scheme. “He had simply trusted Mr. Madoff.” Friehling also contends that he himself also invested $500, 000 with Madoff, and he had not idea that Madoff was engaged in a fraud. Besides the three tax charges, Friehling pleaded guilty to one count each of securities fraud and investment adviser fraud and four counts of making false filings to the Securities and Exchange Commission.

Additionally, Assistant U.S. Attorney Lisa Baroni stated that from 1991 through 2008 Friehling prepared false tax returns for Madoff and “other” Madoff family members, but declined to say who those others are. The false tax returns included individual income tax returns and returns for estates and trusts.

Earlier this year, Madoff admitted to operating the Ponzi scheme under the legitimacy of his Wall Street brokerage business. Frank DiPascali Jr., Madoff’s principle assistant, pleaded guilty to creating the fictitious paper trail of office records and customer accounts that helped deceive investors for almost 20 years. Yet, Friehling who “audited” Madoff’s brokerage firm operations, one of the biggest wholesale market-makers on Wall Street, and prepared Madoff’s personal taxes had not idea that there was fraud afoot. Hmmmmm? This really all sounds rather silly.

Friehling, a certified public accountant, created false and fraudulent certified financial statements from 1991 to 2008. Friehling knew that he failed to conduct independent audits of Madoff’s brokerage operations for almost 20 years. Friehling also knew that he failed to follow generally accepted accounting principles by merely accepting the information given to him by Madoff at "face value" without confirming the information. Friehling further knew that Madoff investors were relying on his “independent certified audits” in the mix of information that investors rely upon in deciding whether to invest in a particular investment. Friehling’s “independent certified audits” were material information that investors, federal regulators and taxing authorities relied upon for the truth and accuracy. Friehling futher stated that “in what is surely the biggest mistake of my life, I placed my trust in Bernard Madoff." In response to Mr. Friehling, I do not think that he made a mistake, I think he engaged in a crime for almost 20 years.

The Supreme Court, in TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, (1976), articulated a legal standard for materiality. The Supreme Court held that the materiality element is met if there is "a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the `total mix' of information made available." Additionally, SEC Staff Accounting Bulletin 99 - Materiality ("SAB 99") states that the FASB's Financial Accounting Concepts No. 2 defines materiality as “the omission or misstatement of an item in a financial report is material if, in light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.” When the Supreme Court’s materiality standard in TSC Industries, Inc. is juxtaposed against SAB 99, it is clear that Friehling’s failure to conduct any audit of Madoff’s investment firm and fraudulent filing of financial statement with the SEC for almost 20 years violated federal securities laws and is a crime. More importantly, it makes Friehling’s conduct given the legal and accounting standards under which he was required to conduct a full and complete audit of Madoff’s operations, almost silly. Silly in terms of the absolute absurdity of Friehling not even attempting to verify any of Madoff’s numbers given the enormity of Friehling’s duty under the federal securities regulation and accounting standards.

Therefore, it is not surprising that Friehling agreed to forfeit $3.18 million to the U.S. Attorney’s Office, as part of his criminal plea bargain and agreed to a partial settlement in the SEC's separate civil case. Friehling, further agreed to a permanent injunction restraining him or his accounting firm from violating securities laws. Friehling and his firm will be precluded from arguing that they didn't violate federal securities laws as alleged by the SEC for the purposes of determining disgorgement and any penalties. Friehling sentence is scheduled for late February 2010.