Profiting From TARP: The Treasury Department Nets $1.5 Billion In Bank Of America Warrant Sale

On Wednesday, the Treasury Department completed an auction of warrants it received from Bank of America in exchange for emergency TARP loans. The government indicated that it netted $1.54 billion from the Bank of America warrant auction. By all indications, this is the most lucrative and profitable warrant auction for the Treasury Department since it began the warrant auction process in December. A warrant is a derivative security that gives the holder the right to purchase securities from an issuer at a specific price within a certain time frame. The Bank of America TARP warrants expire in 2018 and 2019 and have a strike price that is close to double Bank of America’s recent trading price ($16.42 as of the close of the NYSE on Wednesday).

Recall, Bank of America repaid $45 billion in TARP funds to the federal government late last year, in December. As reported earlier on this Blog, things are looking up for American banks. Last year, the Congressional Budget Office (“CBO”) estimated that the TARP program would cost taxpayers $356 billion. Recently, indeed in January, the CBO estimated that the TARP program would only cost taxpayers $99 billion over its lifetime. The Obama administration’s Office of Management and Budget produced a similar estimate. The stock market rally in recent months, and the fact that relatively few banks retain TARP funds has narrowed the original gap somewhat. Again, the estimates regarding the TARP program are just that—estimates—it may take a number of years to fully understand the impact of the program and see fully just how much it might end up costing taxpayers.

TARP recipients have two options: 1. to repurchase their own warrants; or 2. to allow the government to auction the warrants to others. Goldman Sachs spent $1.1 billion to repurchase its warrants in July, after repaying $10 billion in TARP loans. Morgan Stanley spent $950 million to purchase its warrants associated with a $10 billion TARP loan. The Treasury Department began its first warrant auctions in December of 2009. In these first auctions, the Treasury Department raised $950 million auctioning JPMorgan Chase warrants. JPMorgan had received and repaid $25 billion in TARP funds. Citigroup and Wells Fargo, the last two megabanks to receive and repay TARP funds, have not yet decided whether they want to repurchase their own warrants or have the Treasury Department auction off those warrants.

At the end of the day, for all the criticism of the TARP program, the Treasury Department has recouped some profit for taxpayers. From the taxpayer’s perspective, however, when it comes to TARP bailouts in the auto and housing industries we might not end up being so lucky. The jury is still out!

Citigroup Fined $600,000 for Implementing Tax Avoidance Strategies that Defrauded IRS of Billions in Taxes

Citigroup Inc. was fined $600,000 by the Financial Industry Regulatory Authority (FINRA) formerly known as the National Association of Securities Dealers, a private-sector regulator of U.S. broker dealers with supervisory authority over 4,800 U.S. brokerages, which determined that Citigroup Global Markets assisted their clients to avoid paying billions of dollars of U.S. taxes.

The recent fine against Citigroup is part of a larger U.S. Senate investigation regarding global tightening on tax evasion schemes as numerous governments attempt to close widening budget gaps fueled by economic weakness. At the center of the U.S. Senate investigation and tax recovery effort has been the U.S. Department of Justice’s case against UBS AG, a Swiss banking conglomerate. In October 2008, UBS AG agreed to pay $780 million to settle criminal claims that it helped U.S. citizens evade taxes.

In the case against Citigroup, FINRA determined that Citigroup employed two main trading strategies to help their clients avoid paying U.S. taxes. The first trading strategy Citigroup employed from 2000-2004 to help their clients avoid paying U.S. taxes, was designed primarily to enrich Citigroup. The strategy involved Italian stock trades and loaning the stocks to Citigroup’s Swiss affiliate to avoid paying U.S. withholding taxes.

The second strategy that Citigroup employed from 2002-2005 involved buying U.S. stocks from foreign broker-dealer, selling the U.S. stocks back to the foreign broker-dealers before dividends were paid. After a series of interim steps, including using a derivative contract commonly known as a total return swap, the foreign clients would receive an amount equal to the dividends as a “dividend equivalent” free of withholding taxes. The “dividend equivalent” is not subject to U.S. withholding taxes. In 2006, Citigroup paid approximately $24 million to the Internal Revenue Service for using this strategy.

FINRA’s Executive Vice President and Chief of Enforcement, Susan Merrill, stated that “Citigroup’s inadequate supervision resulted in improper trading… increasingly complex trading strategies must be governed by supervision that is equally sophisticated.” FINRA determined that Citibank lacked written procedures to govern total return derivative swap transactions. FINRA also determined that Citigroup employees deviated from the procedures that Citigroup did implement. Furthermore, Citigroup failed to report certain stock trades to the New York Stock Exchange, as required by securities regulators.

In an era of heightened corporate governance, in part due, to the adoption of Sarbanes-Oxley as result of corporate misconduct by former Wall Street darlings such as Enron, K-Mart, Adelphia Communications et cetera, it is shameful that corporate misconduct of this magnitude continues to proliferate in the markets. I find myself repeatedly asking why major corporations engage in such reprehensible conduct. Citigroup’s implementation of total return dividend swap-links, intentionally designed to deceive the IRS, is not only manipulative and fraudulent, it is also illegal. However, FINRA’s fine of a mere $600,000 seems grossly under representative of the magnitude of Citigroup’s conduct.

FINRA stated that the amount of the $600,000 fine was influenced by Citigroup’s willingness to report the violations to FINRA. Citigroup neither admitted nor denied wrongdoing in agreeing to settle the investigation.

Lydie Nadia Cabrera Pierre-Louis
St. Thomas University School of Law
lplouis@stu.edu

Remembering Lehman on the First Anniversary of Its Collapse: Part II

Lehman Brothers’ collapse exactly one year ago, on Sept. 15, 2008, ignited a massive contraction in the $3.6 trillion money market industry, which provides short-term loans often referred to as commercial paper, used by businesses worldwide to cover everyday expenses, including payroll and utilities. The panic left companies such as Goodyear Tire & Rubber Co., whose operations are a long way from Wall Street stranded with insufficient cash and ravaged the investment accounts of millions of unsuspecting average Americans.

Everyone knew that Lehman was too big to fail without dire consequences. Tim Geithner, Treasury Secretary, recently said in an interview with Fortune that regulators expected bad things from Lehman’s collapse, but things proved even worse than they expected. When Lehman filed for bankruptcy its commercial paper was transferred to the Reserve Primary Fund. As result, Reserve Primary Fund became the first big money-market mutual fund to have its net asset value fall below $1 per share. It was the first time in history that a money market mutual fund opened with less than $1 per share net asset value. The event scared millions of average investors and prompted the U.S. government to guarantee money fund accounts to avoid a deposit run that could have destroyed short-term financial markets. The U.S. government has been keeping the American financial system functioning every since because companies that were too big to fail, did fail.

Wall Street was aware that the unregulated subprime mortgage lending business and the securitization of such inferior loans into investment vehicles such as collateralized debt obligations (CDOs) had pushed the financial system to the breaking point. What the Wall Street bankers failed to calculate was that short term borrowing would be literally frozen and would throw the global economy into a tailspin. The failure of Wall Street bankers and regulators to understand the importance of commercial paper and how that market would be negatively affected by Lehman’s collapse was critical because its aftershocks came closest to destroying the world economy. The run on money market funds, considered the safest investments after bank deposits, and also the principal buyers of commercial paper, sent shockwaves through the global economy. World stock markets lost $2.85 trillion, or more than 6 percent of their value, within three days of Lehman’s bankruptcy filing. Worldwide the cost of banks borrowing overnight funds from other banks, as measured by the London Interbank Offered Rate, or LIBOR, jumped 4.29 percentage points between Friday, Sept. 12, 2008 and Tuesday, Sept. 16, 2008. “We did not expect how the Lehman Brothers' bankruptcy would transmit through the commercial paper market and cause all the stress in the money funds,” said David Nason, a former assistant Treasury secretary for financial institutions under Treasury Secretary Paulson.

The financial chieftains inclusive of Goldman Sachs and JP Morgan Chase tried desperately to unwind their derivatives trades and keep bank-to-bank loans flowing, but they ignored the commercial paper market, the lifeblood of the economy. It was an oversight that would flat-line the American economy. Within a week of Lehman’s bankruptcy filing, the U.S. government stepped in to halt withdrawals from money market funds and provided a $1.6 trillion backstop for the commercial paper market. With these first defensive measures, the U.S. government became committed to strengthening the American financial industry regardless of the cost. “They put the entire financial system at risk, and they didn’t have to,” said Harvey R. Miller, a partner at Weil Gotshal & Manges LLP in New York who represented Lehman in the bankruptcy. Miller stated that “[government officials] were warned. I told them, ‘Armageddon is coming. You don’t know what the consequences will be.’ Their response was, ‘We have it covered.’” Lehman’s problems stemmed from borrowing too much to finance too many hard-to-sell investments, such as mortgage-backed securities, that were rapidly declining in value as a result of the deteriorating real estate market. Lehman was different because the U.S. government let it declare bankruptcy rather than bail Lehman out, as it had bailed out Bear Stearns, Merrill Lynch and Long-Term Capital Management because no one, not even the U.S. government, wanted to be responsible for Lehman’s undeterminable losses, which could tally into the millions or even billions. As a result, Lehman’s creditors were wiped out as well as its stockholders and the aftershocks are still reverberating in the world economy.

On the one year anniversary of Lehman’s collapse, "policymakers haven’t learned the key lesson of Lehman’s collapse," said Richard Bernstein, CEO of Richard Bernstein Capital Management LLC in New York and former chief investment strategist for Merrill Lynch. Bernstein added “[by] designating certain institutions as too big to fail, and not having a thorough regulatory process to match, practically invites another catastrophe.” Perhaps the U.S. government should consider breaking up financial behemoths such as Bank of America Corp. and Citigroup Inc., or limit their expansion, instead the U.S. government has given them billions of dollars in tax incentives and loan guarantees that enabled them to grow even bigger and have created a factual predicate were it could all fall apart, again.

Lydie Nadia Cabrera Pierre-Louis
St. Thomas University

Proposed Legislation Will Allow CFTC and SEC to Regulate Derivatives Market

A few years ago, I wrote an article entitled Controlling a Financial Jurassic Park which analyzed the unregulated Forex market, derivative trades, and fraud. The article discussed the cause of Forex derivatives fraud, its rampant increase in the last 10 years, and recommended proposed legislation to regulate and prevent fraud in the Forex derivatives market. One recommendation was for Congress to provide the Commodity Futures Trading Commission(CFTC) and the Securities & Exchange Commission (SEC) expanded authority under the Commodities Exchange Act and the Securities Exchange Act to aggressively regulate and prosecute derivative traders that defraud the public.

Imagine my elation when the Obama administration formally proposed legislation to regulate derivatives. The administration proposed that most derivatives should be traded on regulated exchanges similar to the way stocks and bonds are currently traded. The legislation also proposed tightening the banking regulations that inter-connect with the proposed derivative trading regulations. Additionally, the SEC, the CFTC and the banking regulatory agencies would share responsibility for oversight of the derivatives market. Shared regulation is a crucial element for preventing fraud in the market. As various federal agencies work through complex and sophisticated derivative transactions their shared analysis will allow for a better understanding of the transactions, and will create a better synergy to prevent fraud in the future.