bank investigations finally beginning

Until recently, one of the key aspects of the financial wrongdoing that led to the Great Recession, one bemoaned by mid-level investigators/regulators, has been that virtually no one has been prosecuted.  This contrasts sharply with what occurred during the savings and loan collapse of the early 1980s and the junk bond debacle later in that decade.

One obvious difference between the latter and today is that the perpetrators in the former instances were tiny fish in the financial pond–either owners of small S&Ls or the rogue financier Michael Milken, who worked for the US subsidiary of a Belgian bank.  No one systematically important.  No big sources of political patronage.

Just what any cynic would have thought.

But what appears to be proving most important, in my view, is who is serving as head of the SEC.

President Obama’s appointment in 2008 to chair the regulatory agency was Mary Shapiro. Her previous job?   …head of the National Association of Securities Dealers, now known as FINRA (Financial Industry Regulatory Authority), the trade group representing the investment banking industry.  In other words, Ms. Shapiro was the chief publicist/lobbyist for the big commercial/investment banks.  According to Wikipedia, FINRA paid her $9 million in her final year in that post.  Talk about the fox guarding the henhouse.

Now that Ms. Shapiro has been replaced by a tough veteran prosecutor, Mary Jo White, investigations are suddenly far more extensive.  And the SEC efforts now have teeth.  No more consent decrees without admission of criminal behavior.  And it’s finally ok to investigate the systematically important banks.

I think this new effort to clean up Wall Street is a huge plus for all portfolio investors, and particularly for individuals like us.

A perverse part of me just can’t accept a gift horse, though.  I keep wondering what led to Mr. Obama’s change of heart.  I’m thinking that the contrast between Shapiro and White (Elisse Walter, another FINRA alumna, served as SEC chairperson for a few months between the two) is so great that there must have been a reason.  Could Mr. Obama just have been that clueless?  Does he no longer need political donations?  I can’t imagine what.  Any thoughts?


the SEC says issuers of private securities, like hedge funds, can now advertise their wares

SEC disclosure 

The SEC has very specific rules that limit what a company can say, either about itself or about the securities it’s selling, when it’s in the process of issuing stocks or bonds.

The securities of some companies aren’t subject to general SEC oversight,  either because the firms are tiny or the securities are being sold only to a small group of supposedly savvy buyers.  In such cases, the SEC rules have been, basically, that the firm can say nothing publicly.  In particular, the issuing company can’t solicit interest from the general public or advertise its offerings in ways the general public might see–like in newspapers or on the internet.

a rule change

That changed last year when Congress passed the JOBS (Jumpstart Our Business Startups) Act.  This legislation requires the SEC to take back the regulations that bar solicitation and advertising by issuers of non-regulated securities.  Mary Shapiro, former head of the SEC, decided this was a bad idea and didn’t comply.  The current chairman, Mary Jo White, has followed the Congressional directive and removed them.

Yes, Ms. White had no legal choice…

…but is this a good idea?

At first blush, it would seem that it isn’t.  After all, the consensus is that the JOBS Act, by eliminating the requirement for many issuers to offer audited financial statements to potential buyers, is an open invitation to fraud.

Washington is the same crew that repealed the Glass-Steagall Act in the late 1990s, allowing commercial banks to reenter businesses they helped cause the Great Depression with–and which they promptly used to help cause the Great Recession that we’re still digging ourselves out of.

In this case, the glaring issue is that there’s lots of evidence that significant numbers of hedge funds misstate in their marketing materials their investment performance, their professional qualifications and the size of their assets under management.  It doesn’t take a genius to guess what side of the ledger the misstatements fall on.  (Search PSI for my posts on hedge funds.  If you read one, maybe it should be about an NYU study.)

Why would hedge funds change their stripes when selling to a much wider group of individual investors.

accredited investors

Yes, issuers are supposed to sell the bulk of their offerings to “accredited” investors.  But that only means that buyers are supposed to have either:

–net worth of at least $1 million, excluding the value of a primary residence, or

–income of $200,000 in each of the past two years, with prospects of the same in the current year ($300,000 for couples).

That doesn’t mean they know anything about finance.

maybe it is

But there may be a method to the apparent madness.

Ms. White seems to be drawing a sharp distinction between the character of the buyer of a private offering (supposedly sophisticated parties, who are outside SEC purview) and the disclosure materials relating to it.

Because the offering documents have so far been disseminated only to qualified buyers, the SEC had no say over their accuracy. That was up to the buyer to judge.  Now, thanks to the JOBS Act, these materials can be disseminated to everybody, whether “accredited” or not.  The issuer subsequently screens potential buyers to ensure they meet the accreditation criteria before he allows them to purchase.

The SEC is asserting that the wider dissemination gives the agency jurisdiction over the accuracy of the materials.  It is preparing rules it intends to have issuers of private securities follow.

It may turn out that the JOBS Act has accidentally given the SEC another weapon in addition to prosecution for illegal insider trading in its fight to clean up the hedge fund industry.

the SEC, Citigroup and moral hazard

This is an update and elaboration on my November 11th post about Judge Jed S. Rakoff, the SEC and Citigroup.

moral hazard

Moral hazard in finance is the situation where the existence of an agreement to share risks causes one of the parties to act in an extra-risky manner, to the detriment of the other.   In a sense, the willingness of the party who ultimately gets injured to enter into the agreement causes, or at least allows, the bad behavior by the other to occur.  He inadvertently sets up a situation where the bad behavior is rewarded, not punished.


–Systematically important banks have been able to take very big proprietary trading risks, knowing that they are “too big to fail” and will ultimately be bailed out by the government if their risky bets don’t pan out.  The rewards of such risk-taking go as bonuses to the bankers; the cost of bets gone bad is borne by the general public.

–One of the reasons Germany is so hesitant to bail out Greece is that doing so rewards the latter country’s reckless borrowing behavior over the past decadeand shifts the costs of cleaning up the resulting economic mess onto the citizens of the rest of the EU.

the Rakoff case and moral hazard

Judge Rakoff has just rejected a proposed settlement of a case involving Citigroup and the SEC, on what appear to me to be similar moral hazard grounds.

The settlement involves Citi’s creation and sale of $1 billion in securities ultimately tied to a pool of sub-prime mortgages selected by the bank.  Citi neglected to tell the buyers of the securities that it wasn’t simply an agent.  It was making a $500 million bet that the securities would decline in value sharply–which they subsequently did.  Investors who bought the securities from Citi lost $700 million.

I don’t know precisely how much money Citi made on this transaction.  But I think I can make a good guess.  To make up rough numbers, collecting a 2% fee for creating and selling the issue would bring in $20 million or so.  A 70% gain on its negative bet on the issue would yield $350 million.  If so, the much more compelling reason for creating the issue would be to design it to fail and then short it.  In any event, let’s say Citi cleared $370 million before paying its employees who thought up and executed the total deal.

The proposed settlement?

–fines and penalties totaling $285 million

–Citi doesn’t admit or deny guilt, which means

——the settlement doesn’t create any evidence to support a lawsuit by the investors who lost money, and

——the settlement doesn’t trigger the sanctions against future illegal conduct that are contained in prior settlements with the SEC.

–only low-level Citi employees are reprimanded.

Assume the SEC allegations are all true.

If so, what a deal for Citi!  The SEC “punishment” is that the bank keeps $85 million in profits and gets a slap on the wrist.  Who wouldn’t agree?

What would make this moral hazard is that this is is the worst case outcome for Citi.

And, if you figure that the SEC looks at one suspicious deal out of ten, the situation is even less favorable for investors.  The decision whether to create another issue like this one is a layup.

Would it be so easy if Citi stood a chance of losing money?  …or of triggering clauses in prior settlements prohibiting illegal behavior?

What about the legal team that decided what he minimum disclosure in sales materials should be?  Would they have insisted that Citi must reveal its proprietary trading position in those materials if fines were larger, or if they could be held professionally liable for the information’s exclusion?

What if the Citi executives that okayed everything risked being barred from the securities business for a period of time–would they have acted in the way they did?


I don’t think critics are correct that Judge Rakoff is trying to raise his public profile by insisting that the SEC either obtain a better settlement or go to trial with its case.  Others are saying that the SEC takes settlements like this because it doesn’t have the legal skill to get anything better.  But these are ad hominem arguments  –like saying the parties are wearing ill-fitting clothes, they’re distracting, but irrelevant.

But it is true that this case comes at a time of growing public anger that bank executives are showing few ill effects from the devastating economic damage they helped cause.

It will be interesting to see what new settlement the SEC and Citi come up with.

Stay tuned.

Citigroup, Jed Rakoff, MF Global and the SEC

There’s an odd asymmetry to the way the SEC works.

For example, it put Martha Stewart in jail but ignored Bernie Madoff.   It pursued Michael Milken vigorously after the junk bond market collapsed.   But it has, so far, left the heads of the major commercial and investment banks untouched, despite the fact that the toxic derivative securities they created were much more widespread and–as we continue to see–have damaged the world financial system much more severely than anything Milken did.

Raj Rajaratnam’s insider trading recently drew an 11-year prison sentence and a $93 million fine.

But the other side of the SEC has come to light again recently in the court of gadfly judge Jed Rakoff.  Judge Rakoff is being asked to approve a settlement of a case in which buyers of a Citigroup mortgage product lost $700 million.

The deal the SEC is offering?

–pay back $160 million, plus $30 million in interest and a $95 million fine;

–Citi doesn’t admit it did anything wrong;

–only low-level Citi employees are sanctioned.

–oh  …and the SEC wants to include an admonition to Citi not to do stuff like this again.  But, as Judge Rakoff points out, Citi appears to have violated such orders issued in prior settlements at least twice in the past decade and the SEC has done nothing.

You’d take a deal like that all day long.

A cynic might say that this behavior is related to the fact the current head of the SEC used to be in charge of the brokerage industry trade association.  On the other hand, I believe much of the toxic derivative activity was deliberately organized by the banks out of London because that put them out of the reach of US prosecutors.  So there’s not much the SEC can do.

…which brings me to MF Global.

There’s certainly a danger to generalizing from a small number of instances.  But, to me, what connects Martha Stewart, Michael Milken and Raj Rajaratnam is tha: t the issues are easy to understand, the names are high-profile, none were deeply plugged into the financial industry establishment and, although wealthy, none had the near-infinite resources of the large investment and commercial banks.

One of the issues that the Occupy Wall Street movement gives voice to is that after nearly destroying the world economy and forcing a high-cost financial rescue that all of us will be paying for for many years, no high-level financial commercial bank or brokerage executive has been prosecuted for anything.

What this adds up to, I think, is that the SEC will be scrutinizing the role Jon Corzine played in the demise of MF Global very carefully.  He’s a former head of Goldman Sachs but no longer an industry insider;  he’s an ex-senator and ex-governor; he’s wealthy–but not Bill Gates.   And, the question of whether the firm illegally took money out of customer accounts and used it to stave off margin calls is pretty clear-cut.  It may also be hard to say you didn’t notice an extra $600 million plopping into a portfolio you manage–especially so if you really needed it.

It will be interesting to see what happens–both whether the SEC finds a reason to prosecute and whether that will satisfy OWS.  My guess on the second count is that it won’t.

insider trading and ETF stripping

insider trading

Over the past couple of months there has been a constant drip, drip, drip of news conferences by the SEC on the topic of its ongoing investigation of insider trading.   Most have been to announce arrests of hedge fund-related professionals accused of this white-collar crime.  The “timed release” nature of the news flow has several objectives that I can see:

–it unsettles as yet uncaught lawbreakers, perhaps causing them to make foolish mistakes that will make their apprehension easier,

–it discourages anyone tempted to trade on confidential company information,

–it burnishes the reputation of the SEC as guardian of the securities markets, and, of course,

–it keeps unflattering stories, such as the one that the agency’s own financial statements have chronically failed to meet minimum government standards, off the front page.

ETF stripping

One the of the latest SEC announcements involves something new to me–ETF stripping. What is it?

The securities exchanges and their regulators maintain continual computer surveillance of public market trading, both of securities and derivatives.  They look for unusual patterns in volume or price movement that may indicate insider trading.   For example, three days before a merger announcement, trading in near-term call options of the target firm spikes to 5x normal volume; or the day before a surprisingly bad earnings report, puts for the stock of the company in question do the same thing.  Such deviations from the norm ring alarm bells and prompt the regulators to investigate who was trading and why.

According to the SEC, one way traders on inside information have been able to outwit this surveillance has been by buying shares in a sector ETF that contains their target stock, and shorting all the other names the ETF contains.  They end up owning only the name they want to.  But they don’t show up on the regulators’ screens as owning the target stock at all.  Instead, they’re seen as holding an index security (the ETF) and a bunch of short positions.

my thoughts

I have several thoughts:

–Most traditional investors can’t short stocks.  For those who can, there’s a very good chance that clients would notice and question the synthetic construction of a long position through ETF stripping.  So the SEC is talking about hedge funds here.

–Hedge funds would presumably piece the trading out to several brokers so that no one counterparty sees the entire picture.

–ETF stripping would be particularly hard to find if it were done by the trading desks of brokers, particularly those who act as intermediaries for ETFs and are constantly buying and selling both ETFs and their component securities.  Trading costs would be the lowest for such brokers, as well.

–There’s no reason to go to the trouble of ETF stripping other than to try to evade regulatory scrutiny.  So the practice seems to me to be a two-edged sword.  On the one hand, the chances of being detected are lessened.  On the other hand, the ETF stripper is like the burglar caught in the bank after hours with safe-cracking tools.  If caught, he can’t claim he’s there by accident.

–I can’t imagine the SEC figured this out by itself.  Instead, I presume the agency learned about ETF stripping through an arrested inside trader who offered information in exchange for a lesser sentence.

It will be interesting as this story develops to see how widespread the practice has been.


the SEC inspector general is investigating the agency’s office leasing practices–again

a new lease

The point at issue:  the SEC, which has been leasing office space for itself for the past twenty years, inked a ten-year contract last July for 900,000 square feet of prime office space in downtown Washington.  According to the Financial Times, rent for the new space in Constitution Center amounts to $51.8 million annually.

unusual or not?

What’s unusual about the signing?  For the SEC, a critic might say it’s just business as usual.  Anyway:

1.  It comes at a time when the agency is cutting back on investigations for lack of resources

2.  The SEC bypassed government competitive bidding requirements for leasing office space, by declaring this situation was an emergency

3.  Normally, government agencies wait for Congress to appropriate the money before spending it.   The SEC didn’t in this case.  And it now appears the extra funds will not be coming any time soon,

4.  The SEC doesn’t need the space.  It’s moving a bunch of people from the suburbs, where rents are presumably much cheaper, to fill some of it up.  And it’s trying to get out of its obligation for two-thirds of the space it just signed up for.  My guess is that it will end up subletting the space at a loss to some other arm of the Federal government.

the lease expense is huge

Two other factors make this deal stand out:

1.  If you take the $51.8 million and add to it the $83 million the SEC already spends each year on real estate, the SEC was committing a whopping 15% of its budget to real estate.

2.  According to the Wall Street Journal, the SEC’s offices are 2.5x the size that’s the norm for the federal government.

What’s also noteworthy is that this isn’t the SEC’s first office snafu–though arguably the largest.  Of the incidents we know about, in 2005-06 it had to cut back on investigations to fund a $48 million cost overrun on office construction expenses.  The agency is reported to have paid for years for office space in New York that it wasn’t occupying.  Recently, its leasing practices in San Francisco have also come in for criticism.

Where do they get these people?

insider trading, hedge funds, expert networks and skilled securities analysis (l)

News reports over the past day or indicate we may be in the early days of what could prove a widespread regulatory crackdown on insider trading.  The FBI has raided the offices of several hedge funds, a number linked with SAC Capital.  A west coast independent technology analyst has publicized a failed attempt by the federal police agency to trade more lenient treatment for alleged offenses in return for recording (presumably incriminating) conversations with a client, hedge fund SAC Capital.  “If felt like a street mugging,” he’s quoted as saying.  The analyst reported this encounter by email to his customers, instead.  They, in true Wall Street fashion, immediately ceased doing business with him.

All this prompts me to write about four loosely linked topics:  insider trading, expert networks, hedge fund information gathering and issues that the fuzzy nature of what constitutes insider trading create for professional securities analysts.

Two posts, today and tomorrow.

insider trading

First, a pedantic point.  Insiders, like the top managements of publicly traded companies, can trade legally.  There are, however, clear restrictions on what they can do and when.

But that’s not what people usually mean when they talk about insider trading.  They’re referring to illegal insider trading.  There’s actually a good, if a bit dated, survey of insider trading regulations and their purpose on the SEC website.

Here’s my take on what insider trading is.  Remember, though, that despite the fact I’ve sat through 25 years+ of mandatory compliance training that included a heavy dose of insider trading information, I’m not a lawyer.  As you’ll see below, this can be a pretty fuzzy concept, with lots of gray area, border line cases.

The standard definition of insider trading is that it is based on material, non-public information.  Doing so is illegal for two reasons:

1.  It’s like stealing.  It’s taking information that is supposed to be used only for a corporate purpose and using it for personal benefit instead.  For the corporate employee who has such information, trading on it is a violation of the duty of trust and care he is expected to have for his employer.

2.  It’s like fraud.  That’s because the inside information trader is taking advantage of the fact he knows the person on the other side of the trade can’t possibly be aware of the material information he is acting on.

That’s straightforward enough.  But inside information also has a viral or fungal quality to it.  Today’s rules maintain that anyone, whether employee of the company involved or not, becomes a “temporary” or “constructive” insider the minute he reads/hears the information.  This means he has the same fiduciary obligation that a company employee would have.  He can’t trade on the information, even if he had figured out 95% of it on his own already.

It also means that the last thing any securities analyst worth his salt wants is inside information.  It’s like a runner getting a knee injury.  It puts him out of the game and on the sidelines.

Another modification to the rules concerns selective disclosure, which under Regulation FD (Fair Disclosure) is no longer allowed.  At one time, companies routinely disclosed information to sell side analysts but not to shareholders or their representatives.  Or they gave extra information to favored institutional shareholders in private meetings.  I remember vividly once being asked to leave a briefing by Sony about its video game strategy, even though I was representing owners of the company’s stock, because I didn’t work for an investment bank.  That’s crazy, to tell company secrets to strangers but not the owners, but it happened.  (I refused, by the way, and wasn’t thrown out.)

expert networks

Analysts and expert networks are different.

Most sell side analysts specialize in a single industry.  Their buy side counterparts usually cover several industries, sometimes closely related, sometimes not.  Both kinds read industry literature, attend trade shows, go to company analyst days (where top management explains how the company in question makes its money and where it stands among its competitors), read company SEC filings, listen to earnings conference calls.  They also produce detailed spreadsheets modeling company operations, hoping to project future earnings with a high degree of accuracy.  Gradually, even if they have no prior industry background, they become extremely knowledgeable about the areas they cover.

Expert networks, in contrast, are collections of industry consultants who are assembled by a middleman and whose services–usually a one- or two-hour meeting–are offered to professional investors for a fee, most often paid in soft dollars.

Say a company wants to find out about communication networking equipment and doesn’t have an experienced analyst who covers the area.  Or maybe the company does but a portfolio manager wants an especially detailed or technical question answered.  Then he calls the expert network organizer to say what he needs.  What he probably gets is a middle-level manager or technical employee from, say, Cisco, who is willing to talk for two hours for $1,000 (the payment to the network organizer may be $2.000-$3,000).

The legal issue is that the guy from Cisco may have no idea how much of what he knows is inside information.  So the result of the meeting may be that inside information is passed from the expert network consultant to the investor.  If so, it’s the functional equivalent of whacking every investor at the meeting in the knee with a crowbar.  What the SEC is investigating is whether obtaining inside information is the intent of the meeting and, in particular, if some hedge funds use these networks as conduits to get illegal information that they can trade on.

Back to analysts, for a minute.  I don’t John Kinnucan, the analyst the FBI tried to wire, and I’ve never seen his work.  The Wall Street Journal description of his business suggests he operates in a gray area.  According to the article, his specialty is “channel checks.”  That is, he schmoozes with tech company salesmen and with distributors, to see what’s selling and what isn’t.  He then synthesizes the information he gets and passes it on to clients.  It’s also possible that clients ask for specific items of information–I don’t know whether they do or not, but I think it’s a reasonable supposition that they do.

The big question is whether Mr. Kinnucan’s sources of information tell him very specific things that they have an obligation not to reveal to people outside the company.  In other words, is this activity like #1 above, a use of confidential company information for personal benefit.  If so, Mr. Kinnucan and any of his clients who receive his reports are infected.  They’re insiders and can’t trade on the information.  The FBI appear to have waned Mr. Kinnucan’s taped conversations with SAC Capital to build/buttress an insider trading case against SEC.  So they must either think, or hope, that the information in the reports do contain inside information.

That’s it for today.  Tomorrow:  why I think hedge funds use expert networks and highly specialized analysts like Mr. Kinnucan; and practical issues for any securities analyst.