Blau & Malmfeldt

Massachusetts Secretary of State Charges Oppenheimer

William Galvin, Secretary of State of Massachusetts, announced charges this morning against Oppenheimer in connection with its sales of auction-rate securities.  This is the first such administrative action against a "downstream" seller of ARS (i.e. a brokerage firm that sold the securities but was not involved in the underwriting process).

From the press release: “Oppenheimer executives betrayed the trust of their clients by continuing to market these auction rate securities as safe cash equivalents when they knew this was not the case. They kept their clients, and their own advisors to those clients, in the dark, even as they, themselves, got out of that tottering market.”

Posted by Paul Malmfeldt on November 18, 2008.

Michael Lewis On Wall Street's Demise

Michael Lewis is an excellent writer and his latest piece on portfolio.com is well worth reading.  Lewis argues that Wall Street's demise has been due in large part to: (1) the bulge bracket firms' transition from partnerships to public corporations (a process that began in the 1980s); and (2) the development of collateralized debt obligations, swap contracts and other derivatives -- financial instruments that are dangerous when misused.  Lewis argues that the directors of the bulge bracket firms (as employees/shareholders) had inadequate incentives to manage the risks inherent to these new financial instruments.

Incredibly, a share of Salomon Brothers stock purchased in 1986 for $46 -- the share price when Lewis started on the Salomon bond desk -- would be worth only $25 today (as 2.26 shares of Citigroup stock).

Posted by Paul Malmfeldt on November 17, 2008.

Smart Regulation For Derivatives

In his WSJ article of October 22, Stanford Business School Professor Darrell Duffie sums up the problem with derivatives and proposes a regulatory solution: "[w]hen unconstrained by good regulation, derivatives can be financial weapons of mass destruction.  Our new regulations should be smart and surgical." 

The smart regulatory scheme that Duffie has proposed focuses on centralized clearing for credit default swaps and other derivatives that are presently traded over-the-counter.  Credit default swaps function as insurance policies for debt securities: the party long the swap pays a premium to the counterparty short the swap.  If the borrower (i.e. the issuer of the debt securities) defaults, then the swap seller must make payments to its counterparty.  AIG cratered largely because it was overexposed to credit risks, having written more insurance policies (i.e. sold more swaps) than it could handle in a volatile credit environment.  In the absence of centralized clearing, not only was AIG overexposed to risk but its exposure was non-transparent prior to its failure.

In the futures industry, clearing houses such as the Chicago Mercantile Exchange impose strict capital and margin requirements upon clearing firms and traders to ensure that contract parties meet their financial obligations.  Similarly, a well-regulated derivatives clearing house could prevent contract parties, such as credit default swap sellers, from taking on more risk than they can handle -- which would help to prevent another AIG or Long Term Capital Management fiasco.

Posted by Paul Malmfeldt on October 22, 2008

Regulatory Failure At Heart Of Financial Crisis

Back in September 1998, Long-Term Capital Management -- a hedge fund run by Harvard Business School Professors and Nobel Prize winners -- was hovering on the brink of failure. LTCM's managers had created a massively leveraged portfolio comprised largely of derivatives.  LTCM began suffering enormous losses and a decline in liquidity in September 1998; these problems were due to economic instability in emerging markets around the globe that caused many of its positions to plummet simultaneously.

The Federal Reserve Bank acted quickly and organized LTCM's bailout.  All of Wall Street's major investment banks (with the exception of Bear Stearns, ironcially) contributed  hundreds of millions of dollars to a fund that was used to unwind LTCM's positions.  The banks feared that LTCM's failure would put them in jeopardy since they were counterparties to LTCM's derivatives contracts.  And the Federal Reserve Bank feared that LTCM's failure would trigger a global financial meltdown.  Disaster was avoided.

Ten years later we find ourselves once again hovering on the brink of a global financial meltdown.  The cause of the problem is fundamentally similar -- too much exposure to risk.  But this time the problem originates from several investment banks and insurance companies rather than from a single hedge fund.  And this time the web of counterparties is much broader.  The problem is much worse than it had been in 1998.  The Federal Reserve Bank and the Department of the Treasury may not be able to prevent a meltdown this time. 

Our government apparently learned very little from the LTCM fiasco.  The government failed to enact legislation and regulations designed to prevent firms from endangering the financial system through their leveraged investments.  Instead of improving regulation since 1998, the goverment continued with its hands-off approach and actually relaxed regulation.  The government in effect placed Wall Street in charge of safeguarding the financial system; but firms lacked the incentive to manage even their own risk exposure prudently.

The securities industry is in dire need of smarter regulation.  Firms cannot be permitted to endanger the financial system through their risky investments.  Regulators must have the ability to recognize serious threats to our financial system, must be powerful enough to correct these problems through regulatory action, and must use their power sparingly. 

Posted by Paul Malmfeldt on September 17, 2008.

CFTC Report Shows That Speculators Not To Blame For Oil Spike

According to a recent CFTC report, index traders actually reduced their net long position by 11% between January and June of this year.  The CFTC's report was based upon a comprehensive analysis of futures market transactions during this period.  Index traders -- fund managers who make investments in commodity futures markets -- are the market players that many Congressional Democrats blamed for the spike in oil prices earlier this year.  According to the WSJ, the CFTC's report shows that index traders were actually driving down the price of oil futures contracts.

Posted by Paul Malmfeldt on September 15, 2008.

Auction-Rate Securities Sellers Blame Underwriters For February's Debacle

The Wall Street Journal reported today that the "downstream sellers" of auction-rate securities ("ARS") -- the brokerage firms that sold ARS but neither underwrote them nor ran the auctions -- are denying any responsibility for the ARS crisis.  Oppenheimer and Co. says that the investment banks that underwrote ARS are 100 percent to blame and should have to buy them back from Oppenheimer's own brokerage customers.  Firms like Oppenheimer argue that the underwriters concealed risks from them.  

I agree that the underwriters are largely to blame for the ARS debacle.  But it strikes me as absurd that firms like Oppenheimer and Raymond James are saying that they were completely in the dark.  Oppenheimer and Raymond James were not exactly babes in the wood -- these firms have investment banking divisions and Mathematics Ph.Ds on their staffs who analyze structured finance markets. It appears that firms like Oppenheimer and Raymond James purposefully ignored problems with these securities because they were receiving very large sales commissions.

Posted by Paul Malmfeldt on August 19, 2008.

Investment Banks Agree To Buy Back Auction-Rate Securities

Within the past month, Merrill Lynch, Citigroup, and Wachovia (among other major Wall Street firms) have agreed to buy back auction-rate securities ("ARS") at face value as part of settlements with the SEC and state regulators.  These investment banks, which underwrote the securities and built the house of cards, are largely to blame for February's ARS debacle. 

This is obviously great news, not only for the banks' brokerage customers (who are stuck with illiquid securites worth less than face value) but also for the banks' registered representatives.  Many of these representatives did not realize that they were selling snake oil and were facing angry customers and arbitration actions.  I had expected the banks to hang their representatives out to dry in the arbitration proceedings.

On the other hand, it is bad news for the investment banks; they are now facing billions in ARS write-downs on top of billions in write-downs relating to other structured securities on their books.  I imagine that their stock prices will continue to slide.  (It is also bad news for the class-action plaintiffs' firms that are pursuing ARS cases against the investment banks -- they appear to have bet on the wrong horses.)

The settlements with the investment banks will solve only part of the problem: the buy-backs that will result from these settlements account for less than half the ARS market.  It will be interesting to see what happens with respect to the brokerage firms that played no role in underwriting the securities or in running the auctions but that falsely marketed these securities to customers as money market equivalents.  Unless they agree to buy back ARS from their customers, these firms will continue to face scrutiny from the SEC and state regulators.  And brokerage customers will continue to file arbitration actions so long as their ARS remain illiquid.  

Posted by Paul Malmfeldt on August 18, 2008.

Are The Speculators Really To Blame?

Numerous Congressional Democrats have attempted to blame speculators who bet on oil and gasoline futures for the rise in gasoline prices in 2008.  Among these Congressional members are: Rep. Hill (Ind.), Rep. Larson (Conn.), Rep. Dorgan (N.D.), and Rep. Murphy (Conn.)  Rep. Dorgan has stated that "as much as 20 to 30 to 40 percent could be taken off if you got rid of excessive speculation," and Rep. Murphy has made anti-speculation a central theme of his campaign for re-election.

Speculators who trade oil and gasoline futures are convenient scapegoats, but what effect do they really have on the price of physicals?  It's plainly a question with no simple answer.  Rep. Dorgan and the others appear not to recognize the complexity of this question.  Do they understand that speculators bet both sides of the market?  Do they understand that a long bet must be met by a short bet?  And what about the obvious fundamental factors affecting prices?

Increasing oil prices has no doubt been a source of suffering for millions of Americans in 2008.  But when members of Congress point their fingers at speculators, they are simply engaging in a political witch-hunt.  This witch-hunt is distracting our government from achieving solutions to our energy problems.

Posted by Paul Malmfeldt on August 5, 2008.

Don't Mess With Texas -- One Approach To The Auction-Rate Securities Mess

On July 22, 2008, the Texas State Securities Board announced that it may suspend the licenses of some or all of UBS's Texas-licensed brokers who sold auction-rate securities ("ARS") to brokerage customers, until their customers have the ability to liquidate the ARS in their accounts at par.  A hearing is scheduled for September.  One would have to imagine that Texas's non-nonsense approach will be effective.  It will be interesting to see whether Texas takes the same approach with the other major broker-dealers.

Posted by Paul Malmfeldt on August 5, 2008.

Update: On August 11, 2008, UBS reached a settlement with Massachusetts, New York, and Texas. 

From the Texas State Securities Board press release:

Under the terms of the settlement, UBS will buy back, no later than October 31, 2008, all illiquid auction rate securities from all UBS retail customers, including charities, who have less than $1 million on deposit. In addition, no later than January 2, 2009, UBS will buy back all illiquid auction rate securities from all other UBS retail customers, charities, and small to mid-sized businesses. These customers, who number approximately 40,000 nationwide, have been unable to sell their securities since February 13, 2008.

UBS will also:

• Fully reimburse all retail investors who sold their auction rate securities at a discount after the market failed in February 2008;
• Consent to a special, public arbitration procedure to resolve claims of consequential damages suffered by retail investors as a result of not being able to access their funds, in which UBS will not contest its liability for the illiquidity of the auction rate securities and in which UBS will pay all forum fees;
• Undertake to expeditiously provide liquidity solutions to all other institutional investors, with regular progress reports and subject to an outside deadline of June 30, 2010; and
• Reimburse all refinancing fees to municipal issuers who issued auction rate securities through UBS since August 1, 2007, and who refinanced those securities after the market failed.

As part of the settlement, UBS will pay the State of New York a civil penalty in the amount of $75 million. UBS will also pay a separate civil penalty of $75 million to the other states collectively. 

Credit Suisse Broker Who Allegedly Misrepresented Auction-Rate Securities Flees to Bulgaria

In an unusual twist to a Federal criminal probe relating to February's auction-rate securities ("ARS") meltdown, a former Credit Suisse broker facing charges has fled to Bulgaria, the Wall Street Journal reported today.  It appears that the broker, Julian Tzolov, made misrepresentations to a number of corporate clients pertaining to various ARS issues.  Tzolov allegedly told these clients that the ARS were backed by student loans when they were actually backed by mortgages.  The corporate clients have recorded paper losses in the millions and are obviously unhappy.  Under a new extradition treaty between the United States and Bulgaria slated to go into effect in September, it appears likely that Tzolov will face extradition.

Tzolov was hardly alone: thousands of securities brokers appear to have misrepresented ARS (wittingly or unwittingly) and each of the major broker-dealer firms appear to have systematically defrauded investors for years in connection with ARS.  These Federal prosecutors had many targets to choose from. 

So why have the Federal prosecutors chosen to focus on Tzolov?  And is criminal prosecution really appropriate in this context?  Why are the Feds so sure that Tzolov understood that mortgage-backed securities are riskier than those backed by student loans?       

Posted by Paul Malmfeldt on July 31, 2008.