Monday, May 19, 2014

Springtime for Bankers By Paul Krugman

Springtime for Bankers

By Paul Krugman
New York Times
By any normal standard, economic policy since the onset of the financial crisis has been a dismal failure. It’s true that we avoided a full replay of the Great Depression. But employment has taken more than six years to claw its way back to pre-crisis levels — years when we should have been adding millions of jobs just to keep up with a rising population. Long-term unemployment is still almost three times as high as it was in 2007; young people, often burdened by college debt, face a highly uncertain future.
Now Timothy Geithner, who was Treasury secretary for four of those six years, has published a book, “Stress Test,” about his experiences. And basically, he thinks he did a heckuva job.
He’s not unique in his self-approbation. Policy makers in Europe, where employment has barely recovered at all and a number of countries are in fact experiencing Depression-level distress, have even less to boast about. Yet they too are patting themselves on the back.
How can people feel good about track records that are objectively so bad? Partly it’s the normal human tendency to make excuses, to argue that you did the best you could under the circumstances. And Mr. Geithner can indeed blame much though not all of what went wrong on scorched-earth Republican obstructionism.
But there’s also something else going on. In both Europe and America, economic policy has to a large extent been governed by the implicit slogan “Save the bankers, save the world” — that is, restore confidence in the financial system and prosperity will follow. And government actions have indeed restored financial confidence. Unfortunately, we’re still waiting for the promised prosperity.
Much of Mr. Geithner’s book is devoted to a defense of the U.S. financial bailout, which he sees as a huge success story — which it was, if financial confidence is viewed as an end in itself. Credit markets, which seized up after Lehman fell, mostly returned to normal during Mr. Geithner’s first year in office. Stock indexes rebounded, and have hit new records. Evensubprime-backed securities — the infamous “toxic waste” that was poisoning the financial system — eventually regained a significant part of their value.
Thanks to this financial recovery, bailing out Wall Street didn’t even end up costing a lot of taxpayer money: resurgent banks were able to repay their loans, and the government was able to sell its equity stakes at a profit.
But where is the rebound in the real economy? Where are the jobs? Saving Wall Street, it seems, wasn’t nearly enough. Why?
But fiscal austerity wasn’t the only reason recovery has been so disappointing. Many analysts believe that the burden of high household debt, a legacy of the housing bubble, has been a big drag on the economy. And there was, arguably, a lot the Obama administration could have done to reduce debt burdens without Congressional approval. But it didn’t; itdidn’t even spend funds specifically allocated for that purpose. Why? According to many accounts, the biggest roadblock was Mr. Geithner’s consistent opposition to mortgage debt relief — he was, if you like, all for bailing out banks but against bailing out families.
“Stress Test” asserts that no conceivable amount of mortgage debt relief could have done much to boost the economy. But the leading experts on this subject are the economists Atif Mian and Amir Sufi, whose just-published book “House of Debt” argues very much the contrary. On their blog, Mr. Mian and Mr. Sufi point out that Mr. Geithner’s arithmetic on the issue seems weirdly wrong — order of magnitude wrong — giving much less weight to the role of debt in holding back spending than the consensus of economic research. And that doesn’t even take into account the further benefits that would have flowed from a sharp reduction in foreclosures.
In the end, the story of economic policy since 2008 has been that of a remarkable double standard. Bad loans always involve mistakes on both sides — if borrowers were irresponsible, so were the people who lent them money. But when crisis came, bankers were held harmless for their errors while families paid full price.
And refusing to help families in debt, it turns out, wasn’t just unfair; it was bad economics. Wall Street is back, but America isn’t, and the double standard is the main reason.

Tuesday, April 15, 2014

Three Expensive Milliseconds By Paul Krugman

Three Expensive Milliseconds
By Paul Krugman
Four years ago Chris Christie, the governor of New Jersey, abruptly canceled America’s biggest and arguably most important infrastructure project, a desperately needed new rail tunnel under the Hudson River. Count me among those who blame his presidential ambitions, and believe that he was trying to curry favor with the government- and public-transit-hating Republican base.

Even as one tunnel was being canceled, however, another was nearing completion, as Spread Networks finished boring its way through the Allegheny Mountains of Pennsylvania. Spread’s tunnel was not, however, intended to carry passengers, or even freight; it was for a fiber-optic cable that would shave three milliseconds — three-thousandths of a second — off communication time between the futures markets of Chicago and the stock markets of New York. And the fact that this tunnel was built while the rail tunnel wasn’t tells you a lot about what’s wrong with America today.
Who cares about three milliseconds? The answer is, high-frequency traders, who make money by buying or selling stock a tiny fraction of a second faster than other players. Not surprisingly, Michael Lewis starts his best-selling new book “Flash Boys,” a polemic against high-frequency trading, with the story of the Spread Networks tunnel. But the real moral of the tunnel tale is independent of Mr. Lewis’s polemic.
Think about it. You may or may not buy Mr. Lewis’s depiction of the high-frequency types as villains and those trying to thwart them as heroes. (If you ask me, there are no good guys in this story.) But either way, spending hundreds of millions of dollars to save three milliseconds looks like a huge waste. And that’s part of a much broader picture, in which society is devoting an ever-growing share of its resources to financial wheeling and dealing, while getting little or nothing in return.
How much waste are we talking about? A paper by Thomas Philippon of New York University puts it at several hundred billion dollars a year.
Mr. Philippon starts with the familiar observation that finance has grown much faster than the economy as a whole. Specifically, the share of G.D.P. accruing to bankers, traders, and so on has nearly doubled since 1980, when we started dismantling the system of financial regulation created as a response to the Great Depression.
What are we getting in return for all that money? Not much, as far as anyone can tell. Mr. Philippon shows that the financial industry has grown much faster than either the flow of savings it channels or the assets it manages. Defenders of modern finance like to argue that it does the economy a great service by allocating capital to its most productive uses — but that’s a hard argument to sustain after a decade in which Wall Street’s crowning achievement involved directing hundreds of billions of dollars into subprime mortgages.
Wall Street’s friends also used to claim that the proliferation of complex financial instruments was reducing risk and increasing the system’s stability, so that financial crises were a thing of the past. No, really.
But if our supersized financial sector isn’t making us either safer or more productive, what is it doing? One answer is that it’s playing small investors for suckers, causing them to waste huge sums in a vain effort to beat the market. Don’t take my word for it — that’s what the president of the American Finance Association declared in 2008. Another answer is that a lot of money is going to speculative activities that are privately profitable but socially unproductive.
You may object that this can’t be right, that the invisible hand of the market ensures that private returns and social returns coincide. Economists have, however, known for a long time that when it comes to speculation, that proposition just isn’t true. Back in 1815 Baron Rothschild made a killing because he knew the outcome of the Battle of Waterloo a few hours before everyone else; it’s hard to see how that knowledge made Britain as a whole richer. It’s even harder to see how the three-millisecond advantage conveyed by the Spread Networks tunnel makes modern America richer; yet that advantage was clearly worth it to the speculators.
In short, we’re giving huge sums to the financial industry while receiving little or nothing — maybe less than nothing — in return. Mr. Philippon puts the waste at 2 percent of G.D.P. Yet even that figure, I’d argue, understates the true cost of our bloated financial industry. For there is a clear correlation between the rise of modern finance and America’s return to Gilded Age levels of inequality.
So never mind the debate about exactly how much damage high-frequency trading does. It’s the whole financial industry, not just that piece, that’s undermining our economy and our society.

Monday, January 13, 2014

Gangster Bankers: Too Big to Jail By Matt Taibbi

Gangster Bankers: Too Big to Jail


How HSBC hooked up with drug traffickers and terrorists. And got away with it

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February 14, 2013 8:00 AM ET

The deal was announced quietly, just before the holidays, almost like the government was hoping people were too busy hanging stockings by the fireplace to notice. Flooring politicians, lawyers and investigators all over the world, the U.S. Justice Department granted a total walk to executives of the British-based bank HSBC for the largest drug-and-terrorism money-laundering case ever. Yes, they issued a fine – $1.9 billion, or about five weeks' profit – but they didn't extract so much as one dollar or one day in jail from any individual, despite a decade of stupefying abuses.

People may have outrage fatigue about Wall Street, and more stories about billionaire greedheads getting away with more stealing often cease to amaze. But the HSBC case went miles beyond the usual paper-pushing, keypad-punching­ sort-of crime, committed by geeks in ties, normally associated­ with Wall Street. In this case, the bank literally got away with murder – well, aiding and abetting it, anyway.

For at least half a decade, the storied British colonial banking power helped to wash hundreds of millions of dollars for drug mobs, including Mexico's Sinaloa drug cartel, suspected in tens of thousands of murders just in the past 10 years – people so totally evil, jokes former New York Attorney General Eliot Spitzer, that "they make the guys on Wall Street look good." The bank also moved money for organizations linked to Al Qaeda and Hezbollah, and for Russian gangsters; helped countries like Iran, the Sudan and North Korea evade sanctions; and, in between helping murderers and terrorists and rogue states, aided countless common tax cheats in hiding their cash.

"They violated every goddamn law in the book," says Jack Blum, an attorney and former Senate investigator who headed a major bribery investigation against Lockheed in the 1970s that led to the passage of the Foreign Corrupt Practices Act. "They took every imaginable form of illegal and illicit business."

That nobody from the bank went to jail or paid a dollar in individual fines is nothing new in this era of financial crisis. What is different about this settlement is that the Justice Department, for the first time, admitted why it decided to go soft on this particular kind of criminal. It was worried that anything more than a wrist slap for HSBC might undermine the world economy. "Had the U.S. authorities decided to press criminal charges," said Assistant Attorney General Lanny Breuer at a press conference to announce the settlement, "HSBC would almost certainly have lost its banking license in the U.S., the future of the institution would have been under threat and the entire banking system would have been destabilized."

It was the dawn of a new era. In the years just after 9/11, even being breathed on by a suspected terrorist could land you in extralegal detention for the rest of your life. But now, when you're Too Big to Jail, you can cop to laundering terrorist cash and violating the Trading With the Enemy Act, and not only will you not be prosecuted for it, but the government will go out of its way to make sure you won't lose your license. Some on the Hill put it to me this way: OK, fine, no jail time, but they can't even pull their charter? Are you kidding?

But the Justice Department wasn't finished handing out Christmas goodies. A little over a week later, Breuer was back in front of the press, giving a cushy deal to another huge international firm, the Swiss bank UBS, which had just admitted to a key role in perhaps the biggest antitrust/price-fixing case in history, the so-called LIBOR scandal, a massive interest-rate­rigging conspiracy involving hundreds of trillions ("trillions," with a "t") of dollars in financial products. While two minor players did face charges, Breuer and the Justice Department worried aloud about global stability as they explained why no criminal charges were being filed against the parent company.

"Our goal here," Breuer said, "is not to destroy a major financial institution."

A reporter at the UBS presser pointed out to Breuer that UBS had already been busted in 2009 in a major tax-evasion case, and asked a sensible question. "This is a bank that has broken the law before," the reporter said. "So why not be tougher?"

"I don't know what tougher means," answered the assistant attorney general.

Also known as the Hong Kong and Shanghai Banking Corporation, HSBC has always been associated with drugs. Founded in 1865, HSBC became the major commercial bank in colonial China after the conclusion of the Second Opium War. If you're rusty in your history of Britain's various wars of Imperial Rape, the Second Opium War was the one where Britain and other European powers basically slaughtered lots of Chinese people until they agreed to legalize the dope trade (much like they had done in the First Opium War, which ended in 1842).

A century and a half later, it appears not much has changed. With its strong on-the-ground presence in many of the various ex-colonial territories in Asia and Africa, and its rich history of cross-cultural moral flexibility, HSBC has a very different international footprint than other Too Big to Fail banks like Wells Fargo or Bank of America. While the American banking behemoths mainly gorged themselves on the toxic residential-mortgage trade that caused the 2008 financial bubble, HSBC took a slightly different path, turning itself into the destination bank for domestic and international scoundrels of every possible persuasion.

Three-time losers doing life in California prisons for street felonies might be surprised to learn that the no-jail settlement Lanny Breuer worked out for HSBC was already the bank's third strike. In fact, as a mortifying 334-page report issued by the Senate Permanent Subcommittee on Investigations last summer made plain, HSBC ignored a truly awesome quantity of official warnings.

In April 2003, with 9/11 still fresh in the minds of American regulators, the Federal Reserve sent HSBC's American subsidiary a cease-and-desist­ letter, ordering it to clean up its act and make a better effort to keep criminals and terrorists from opening accounts at its bank. One of the bank's bigger customers, for instance, was Saudi Arabia's Al Rajhi bank, which had been linked by the CIA and other government agencies to terrorism. According to a document cited in a Senate report, one of the bank's founders, Sulaiman bin Abdul Aziz Al Rajhi, was among 20 early financiers of Al Qaeda, a member of what Osama bin Laden himself apparently called the "Golden Chain." In 2003, the CIA wrote a confidential report about the bank, describing Al Rajhi as a "conduit for extremist finance." In the report, details of which leaked to the public by 2007, the agency noted that Sulaiman Al Rajhi consciously worked to help Islamic "charities" hide their true nature, ordering the bank's board to "explore financial instruments that would allow the bank's charitable contributions to avoid official Saudi scrutiny." (The bank has denied any role in financing extremists.)
In January 2005, while under the cloud of its first double-secret­-probation agreement with the U.S., HSBC decided to partially sever ties with Al Rajhi. Note the word "partially": The decision­ would only apply to Al Rajhi banking and not to its related trading company, a distinction that tickled executives inside the bank. In March 2005, Alan Ketley, a compliance officer for HSBC's American subsidiary, HBUS, gleefully told Paul Plesser, head of his bank's Global Foreign Exchange Department, that it was cool to do business with Al Rajhi Trading. "Looks like you're fine to continue dealing with Al Rajhi," he wrote. "You'd better be making lots of money!"

But this backdoor arrangement with bin Laden's suspected "Golden Chain" banker wasn't direct enough – many HSBC executives wanted the whole shebang restored. In a remarkable e-mail sent in May 2005, Christopher Lok, HSBC's head of global bank notes, asked a colleague if they could maybe go back to fully doing business with Al Rajhi as soon as one of America's primary banking regulators, the Office of the Comptroller of the Currency, lifted the 2003 cease-and-desist order: "After the OCC closeout and that chapter is hopefully finished, could we revisit Al Rajhi again? London compliance has taken a more lenient view."

After being slapped with the order in 2003, HSBC began blowing off its requirements both in letter and in spirit – and on a mass scale, too. Instead of punishing the bank, though, the government's response was to send it more angry letters. Typically, those came in the form of so-called "MRA" (Matters Requiring Attention) letters sent by the OCC. Most of these touched upon the same theme, i.e., HSBC failing to do due diligence on the shady characters who might be depositing money in its accounts or using its branches to wire money. HSBC racked up these "You're Still Screwing Up and We Know It" orders by the dozen, and in just one brief stretch between 2005 and 2006, it received 30 different formal warnings.

Nonetheless, in February 2006 the OCC under George Bush suddenly decided to release HSBC from the 2003 cease-and-desist­ order. In other words, HSBC basically violated its parole 30 times in just more than a year and got off anyway. The bank was, to use the street term, "off paper" – and free to let the Al Rajhis of the world come rushing back.

After HSBC fully restored its relationship with the apparently terrorist-friendly Al Rajhi Bank in Saudi Arabia, it supplied the bank with nearly 1 billion U.S. dollars. When asked by HSBC what it needed all its American cash for, Al Rajhi explained that people in Saudi Arabia need dollars for all sorts of reasons. "During summer time," the bank wrote, "we have a high demand from tourists traveling for their vacations."

The Treasury Department keeps a list compiled by the Office of Foreign Assets Control, or OFAC, and American banks are not supposed to do business with anyone on the OFAC list. But the bank knowingly helped banned individuals elude the sanctions process. One such individual was the powerful Syrian businessman Rami Makhlouf, a close confidant of the Assad family. When Makhlouf appeared on the OFAC list in 2008, HSBC responded not by severing ties with him but by trying to figure out what to do about the accounts the Syrian power broker had in its Geneva and Cayman Islands branches. "We have determined that accounts held in the Caymans are not in the jurisdiction of, and are not housed on any systems in, the United States," wrote one compliance officer. "Therefore, we will not be reporting this match to OFAC."

Translation: We know the guy's on a terrorist list, but his accounts are in a place the Americans can't search, so screw them.

Remember, this was in 2008 – five years after HSBC had first been caught doing this sort of thing. And even four years after that, when being grilled by Michigan Sen. Carl Levin in July 2012, an HSBC executive refused to absolutely say that the bank would inform the government if Makhlouf or another OFAC-listed name popped up in its system – saying only that it would "do everything we can."

The Senate exchange highlighted an extremely frustrating dynamic government investigators have had to face with Too Big to Jail megabanks: The same thing that makes them so attractive to shady customers – their ability to instantaneously move money around the world to places like the Cayman Islands and Switzerland – makes it easy for them to play dumb with regulators by hiding behind secrecy laws.

When it wasn't banking for shady Third World characters, HSBC was training its mental firepower on the problem of finding creative ways to allow it to do business with countries under U.S. sanction, particularly Iran. In one memo from HSBC's Middle East subsidiary, HBME, the bank notes that it could make a lot of money with Iran, provided it dealt with what it termed "difficulties" – you know, those pesky laws.

"It is anticipated that Iran will become a source of increasing income for the group going forward," the memo says, "and if we are to achieve this goal we must adopt a positive stance when encountering difficulties."

The "positive stance" included a technique called "stripping," in which foreign subsidiaries like HSBC Middle East or HSBC Europe would remove references to Iran in wire transactions to and from the United States, often putting themselves in place of the actual client name to avoid triggering OFAC alerts. (In other words, the transaction would have HBME listed on one end, instead of an Iranian client.)

For more than half a decade, a whopping $19 billion in transactions involving Iran went through the American financial system, with the Iranian connection kept hidden in 75 to 90 percent of those transactions. HSBC has been headquartered in England for more than two decades – it's Europe's largest bank, in fact – but it has major subsidiary operations in every corner of the world. What's come out in this investigation is that the chiefs in the parent company often knew about shady transactions when the regional subsidiary did not. In the case of banned Iranian transactions, for instance, there are multiple e-mails from HSBC's compliance head, David Bagley, in which he admits that HSBC's American subsidiary probably has no clue that HSBC Europe has been sending it buttloads of banned Iranian money.

"I am not sure that HBUS are aware of the fact that HBEU are already providing clearing facilities for four Iranian banks," he wrote in 2003. The following year, he made the same observation. "I suspect that HBUS are not aware that [Iranian] payments may be passing through them," he wrote.

What's the upside for a bank like HSBC to do business with banned individuals, crooks and so on? The answer is simple: "If you have clients who are interested in 'specialty services'­ – that's the euphemism for the bad stuff – you can charge 'em whatever you want," says former Senate investigator Blum. "The margin on laundered money for years has been roughly 20 percent."

Those charges might come in many forms, from upfront fees to promises to keep deposits at the bank for certain lengths of time. However you structure it, the possibilities for profit are enormous, provided you're willing to accept money from almost anywhere. HSBC, its roots in the raw battlefield capitalism of the old British colonies and its strong presence in Asia, Africa and the Middle East, had more access to customers needing "specialty services" than perhaps any other bank.

And it worked hard to satisfy those customers. In perhaps the pinnacle innovation in the history of sleazy banking practices, HSBC ran a preposterous offshore operation in Mexico that allowed anyone to walk into any HSBC Mexico branch and open a U.S.-dollar account (HSBC Mexico accounts had to be in pesos) via a so-called "Cayman Islands branch" of HSBC Mexico. The evidence suggests customers barely had to submit a real name and address, much less explain the legitimate origins of their deposits.

If you can imagine a drive-thru heart-transplant clinic or an airline that keeps a fully-stocked minibar in the cockpit of every airplane, you're in the ballpark of grasping the regulatory absurdity of HSBC Mexico's "Cayman Islands branch." The whole thing was a pure shell company, run by Mexicans in Mexican bank branches.

At one point, this figment of the bank's corporate imagination had 50,000 clients, holding a total of $2.1 billion in assets. In 2002, an internal audit found that 41 percent of reviewed accounts had incomplete client information. Six years later, an e-mail from a high-ranking HSBC employee noted that 15 percent of customers didn't even have a file. "How do you locate clients when you have no file?" complained the executive.

It wasn't until it was discovered that these accounts were being used to pay a U.S. company allegedly supplying aircraft to Mexican drug dealers that HSBC took action, and even then it closed only some of the "Cayman Islands branch" accounts. As late as 2012, when HSBC executives were being dragged before the U.S. Senate, the bank still had 20,000 such accounts worth some $670 million – and under oath would only say that the bank was "in the process" of closing them.

Meanwhile, throughout all of this time, U.S. regulators kept examining HSBC. In an absurdist pattern that would continue through the 2000s, OCC examiners would conduct annual reviews, find the same disturbing shit they'd found for years, and then write about the bank's problems as though they were being discovered for the first time. From the 2006 annual OCC review: "During the year, we identified a number of areas lacking consistent, vigilant adherence to BSA/AML policies. . . . Management responded positively and initiated steps to correct weaknesses and improve conformance with bank policy. We will validate corrective action in the next examination cycle."

Translation: These guys are assholes, but they admit it, so it's cool and we won't do anything.

A year later, on July 24th, 2007, OCC had this to say: "During the past year, examiners identified a number of common themes, in that businesses lacked consistent, vigilant adherence to BSA/AML policies. Bank policies are acceptable. . . . Management continues to respond positively and initiated steps to improve conformance with bank policy."

Translation: They're still assholes, but we've alerted them to the problem and everything'll be cool.

By then, HSBC's lax money-laundering controls had infected virtually the entire company. Russians identifying themselves as used-car salesmen were at one point depositing $500,000 a day into HSBC, mainly through a bent traveler's-checks operation in Japan. The company's special banking program for foreign embassies was so completely fucked that it had suspicious-activity­ alerts backed up by the thousands. There is also strong evidence that the bank was allowing clients in Sudan, Cuba, Burma and North Korea to evade sanctions.

When one of the company's compliance chiefs, Carolyn Wind, raised concerns that she didn't have enough staff to monitor suspicious activities at a board meeting in 2007, she was fired. The sheer balls it took for the bank to ignore its compliance executives and continue taking money from so many different shady sources­ while ostensibly it had regulators swarming­ all over its every move is incredible. "You can't make up more egregious money-laundering that permeated an entire institution," says Spitzer.

By the late 2000s, other law enforcement agencies were beginning to catch HSBC's scent. The Department of Homeland Security started investigating HSBC for laundering drug money, while the attorney general's office in West Virginia snooped around HSBC's involvement in a Medicare-fraud case. A federal intra-agency meeting was convened in Washington in September 2009, at which it was determined that HSBC was out of control and needed to be investigated more closely.

The bank itself was then notified that its usual OCC review was being "expanded." More OCC staff was assigned to pore through HSBC's books, and, among other things, they found a backlog of 17,000 alerts of suspicious activity that had not been processed. They also noted that the bank had a similar pileup of subpoenas in money-laundering cases.

Finally it seemed the government was on the verge of becoming genuinely pissed off. In March 2010, after seeing countless ultimatums ignored, they issued one more, giving HSBC three months to clear that goddamned 17,000-alert backlog or else there would be serious consequences. HSBC met that deadline, but months later the OCC again found the bank's money-laundering controls seriously wanting, forcing the government to take, well . . . drastic action, right?

Sort of! In October 2010, the OCC took a deep breath, strapped on its big-boy pants and . . . issued a second cease-and-desist order!

In other words, it was "Don't Do It Again" – again. The punishment for all of that dastardly defiance was to bring the regulatory process right back to the same kind of double-secret-probation­ order they'd tried in 2003.

Not to say that HSBC didn't make changes after the second Don't Do It Again order. It did – it hired some people.
No. 3
In the summer of 2010, 25-year-old Everett Stern was just out of business school, fighting a mild case of wanderlust and looking for a job but also for adventure. His dream was to be a CIA agent, battling bad guys and snatching up Middle Eastern terrorists. He applied to the agency's clandestine service, had an interview even, but just before graduation, the bespectacled, youthfully exuberant Stern was turned down.

He was crushed, but then he found an online job posting that piqued his interest. HSBC, a major international bank, was looking for people to help with its anti-money-laundering program. "I thought this was exactly what I wanted to do," he says. "It sounded so exciting."

Stern went up to HSBC's offices in New Castle, Delaware, for an interview, and that October, just days after the OCC issued the second Don't Do It Again letter, he started work as part of HSBC's "expanded" anti­money-laundering program.

From the outset, Stern knew there was something weird about his job. "I had to go to the library to take out books on money-laundering," Stern says now, laughing. "That's how bad it was." There were no training courses or seminars on money-laundering­ – what it was, how to detect it. His work mainly consisted of looking up the names of unsavory characters on the Internet and then running them through the bank's internal systems to see if they popped up on any account names anywhere.

Even weirder, nobody seemed to care if anybody was doing any actual work. The Delaware office was mostly empty for a long while, just a giant unpainted room with a few hastily arranged cubicles and only a dozen or so people in it, and nobody really watching any of the workers. Stern and a fellow co-worker­ would routinely finish all their work by 10:30 in the morning, then spend a few hours throwing rocks into a quarry located behind the bank offices. Then they would go back to their cubicles and hang out until 3 p.m. or so, or until it was at least plausible that they'd put in a real workday. "If we asked for any more work," Stern says, "they got angry."

Stern earned a starting salary of $54,900.

Soon enough, though, out of boredom and also maybe a little bit of patriotism, Stern started to sift through some of the backlogged alerts and tried to make sense of them. Almost immediately, he found a series of deeply concerning transactions. There was an exchange company wiring large sums of money to untraceable destinations in the Middle East. A Saudi fruit company was sending millions, Stern found with a simple Internet search, to a high-ranking figure in the Yemeni wing of the Muslim Brotherhood. Stern even learned that HSBC was allowing millions of dollars to be moved from the Karaiba chain of super­markets in Africa to a firm called Tajco, run by the Tajideen brothers, who had been singled out by the Treasury Department as major financiers of Hezbollah.

Every time Stern brought one of these discoveries to his bosses, they rolled their eyes at him, if not worse. When he alerted his boss that a shipping company with ties to Iran was doing a lot of business with the bank, he blew up. "You called me over for this?" the boss snapped.

Soon after, the empty office started to fill up. What HSBC did in the way of hiring new staff was actually pretty clever. It liqui­dated its credit-card-collections unit and moved the bulk of the employees over to the anti-money-laundering department. Again, without really training anyone at all, it put hundreds of loud, gum-chewing, mostly uneducated, occasionally rowdy call-center workers on a new gig, turning them into money-laundering investigators.

Stern says his co-workers not only sucked at their jobs, they didn't even know what their jobs were. "You could walk into that building today," he says, "and ask anyone there what money­laundering is – and I guarantee you, no one will know."

When something fishy pops up in connection with a bank account, the bank generates an alert. An alert can be birthed by almost anything, from someone wiring $9,999 (to keep under the $10K reporting level) to someone wiring large sums in round numbers to someone else opening an account with a phony-sounding name or address.

When an alert gets generated, the bank is supposed to promptly investigate the matter. If the bank doesn't clear the alert, it creates a "Suspicious Activity Report," which is handed over to the Treasury Department to be investigated.

Stern then found himself in the middle of a perverse sort-of anti­compliance mechanism. HSBC had "complied" with the government's Don't Do It Again, Again order by hiring hundreds of bodies whom it turned into an army for whitewashing suspicious transactions. Remember, the complaint against HSBC was not so much that it had specifically allowed terrorist or drug money through, but that it had allowed suspicious accounts to pile up without being checked.

The boss at Stern's Delaware office gave his new team goals: Everyone was to try to clear 72 alerts a week. For those of you keeping score at home, that's nearly two alerts investigated and cleared every hour. According to Stern, almost any kind of information was good enough to clear an alert. "Basically, if a company had a website, you could clear them," he says.

Soon enough, HSBC's compliance executives were circulating cheery e-mails. "Great job by some Delaware professionals in the early part of the week," wrote Stern's boss on June 30th, 2011. The e-mail was subject-lined, "The 60-plus crowd," signifying accolades to employees who had cleared more than 60 suspicious transactions that week.

After trying in vain to convince his bosses to at least let him do his job and look for money-laundering, Stern decided to turn whistle-blower, telling the FBI and other agencies what was going on at the bank. He left work at HSBC in 2011, fully expecting that the government would drop the hammer on his former employers.

By that time, numerous agencies, including the Department of Homeland Security, had crawled all the way up HSBC's backside, among other things examining it as part of a major international narcotics investigation. In one four-year period between 2006 and 2009, an astonishing $200 trillion in wire transfers (including from high-risk countries like Mexico) went through without any monitoring at all. The bank also failed to do due diligence on the purchase of an incredible $9 billion in physical U.S. dollars from Mexico and played a key role in the so-called Black Market Peso Exchange, which allowed drug cartels in both Mexico and Colombia to convert U.S. dollars from drug sales into pesos to be used back home. Drug agents discovered that dealers in Mexico were building special cash boxes to fit the precise dimensions of HSBC teller windows.

Former bailout inspector and federal prosecutor Neil Barofsky, who has helped secure numerous foreign money-laundering indictments, points out that the people HSBC was doing business with, like Colombia's Norte del Valle and Mexico's Sinaloa cartels, were "the worst trafficking organizations imaginable" – groups that don't just commit murder on a mass scale but are known for beheadings, torture videos ("the new thing now," he says) and other atrocities, none of which happens without money launderers. It's for this reason, Barofsky says, that drug prosecutors are not shy about dropping heavy prison sentences on launderers. "Frankly, our view of money-laundering was that it was on par with, and as significant as, the traffickers themselves," he says.

Barofsky was involved in the first extradition of a Colombian national (Pablo Trujillo, a member of the same cartel that HSBC moved money for) on money­laundering charges. "That guy got 10 years," says Barofsky. "HSBC was doing the same thing, only on a much larger scale than my schmuck was doing."

Clearly, HSBC had violated the 2010 Don't Do It Again, Again order. Everett Stern saw it with his own eyes; so did the OCC and the U.S. Senate, whose Permanent Subcommittee on Investigations decided to target the company for a yearlong investigation into global money-laundering. The bank itself, in response to the Senate investigation, acknowledged that it had "sometimes failed to meet the standards that regulators and customers expect." It would later go on to say that it was even "profoundly sorry."

A few days after Thanksgiving 2012, Stern heard that the Justice Department was about to announce a settlement. Since he'd left HSBC the year before,­ he'd had a rough time. Going public with his allegations had left him emotionally and financially devastated. He'd been unable to find a job, and at one point even applied for welfare. But now that the feds were finally about to drop the hammer on HSBC, he figured he'd have the satisfaction of knowing that his sacrifice had been worthwhile.

So he went to New York and sat in a hotel room, waiting for reporters to call for his comments. When he heard the news that the "punishment" Breuer had announced was a deferred prosecution agreement – a Don't Do It Again, Again, Again agreement, if you will – he was flabbergasted.

"I thought, 'All that, for nothing?' " he says. "I couldn't believe it."

The writer Ambrose Bierce once said there's only one thing in the world worse than a clarinet: two clarinets. In the same vein, there's only one thing worse than a totally corrupt bank: many corrupt banks.

If the HSBC deal showed how much dastardly crap the state could tolerate from one bank, Breuer was back a week later to show that the government would go just as easy on banks that team up with other banks to perpetrate even bigger scandals. On December 19th, 2012, he announced that the Justice Department was essentially letting Swiss banking giant UBS off the hook for its part in what is likely the biggest financial scam of all time.

The so-called LIBOR scandal, which is at the heart of the UBS settlement, makes Enron look like a parking violation. Many of the world's biggest banks, including Switzerland's UBS, Britain's Barclays and the Royal Bank of Scotland, got together and secretly conspired to manipulate the London Interbank Offered Rate, or LIBOR, which measures the rate at which banks lend to each other. Many, if not most, interest rates are pegged to LIBOR. The prices of hundreds of trillions of dollars of financial products are tied to LIBOR, everything from commercial loans to credit cards to mortgages to municipal bonds to swaps and currencies.

If you can imagine executives at Ford, GM, Mitsubishi, BMW and Mercedes getting together every morning to fix the prices of aluminum and stainless steel, you have a rough idea of what the LIBOR scandal is like, except that in the car-company analogy, you'd be dealing with absurdly smaller numbers. These are the world's biggest banks getting together every morning to essentially fix the price of money. Low LIBOR rates are an indicator that banks are strong and healthy. These banks were faking the results of their daily physicals. In banking terms, they were juicing.
No. 4
Two different types of manipulation took place. In 2008, during the heat of the global crash, banks artificially submitted low rates in order to present an image of financial soundness to the markets. But at other times over the course of years, individual traders schemed to move rates up or down in order to profit on individual trades.

There is nobody anywhere growing weed strong enough to help the human mind grasp the enormity of this crime. It's a conspiracy so massive that the lawyers who are suing the banks are having an extremely difficult time figuring out how to calculate the damage.

Here's how it works: Every morning, 16 of the world's largest banks submit numbers to a London­based panel indicating what interest rates they're charging other banks to borrow money and what they themselves are charged. The LIBOR panel then takes those 16 different interest rates, tosses out the four highest and the four lowest, and averages out the remaining eight to create that day's LIBOR rates – the basis for interest rates almost everywhere in the world.

The fact that the LIBOR panel tosses out the four highest and lowest numbers every day is an important detail, because it means that it is difficult to artificially influence the final rate unless multiple banks are conspiring with each other. One bank lying its ass off and reporting that banks are lending money to each other basically for free doesn't move the needle much. To really be sure you're creating an artificially low or high interest rate, you need a bunch of banks on board – and it turns out that they were.

For perhaps as far back as 20 years, banks have been submitting phony numbers, often in concert with other banks. They did it for a variety of reasons, but the big one, typically, is that a bank trader is holding some investment tied to LIBOR – bundles of currencies, municipal bonds, mortgages, whatever – that would earn more money if the interest rate was lower. So what would happen is, some schmuck trader at Bank X would call the LIBOR submitter and offer him cash, booze, a blow job or just a pat on the back to get him to submit a fake number that day.

The scandal first blew up last year when the British megabank Barclays admitted to its part in the fixing of LIBOR rates. British regulators released a cache of disgusting e-mails showing traders from many different banks cheerfully monkeying around with your credit-card bills, your mortgage rates, your tax bill, your IRA account, etc., so that they could make out better on some sordid trade they had on that day. In one case, a trader from an unnamed bank sent an e-mail to a Barclays trader thanking him for helping to fix interest rates and promising a kickass bottle of bubbly for his efforts:

"Dude. I owe you big time! Come over one day after work, and I'm opening a bottle of Bollinger."

UBS was the next bank to confess, and its settlement – $1.5 billion in fines – was much the same, only the e-mails released were, if anything, more disgusting and damning. The British Financial Services Authority – equivalent to our SEC – discovered thousands of requests to fudge rates over a period of years involving dozens of different individuals and multiple banks. In many cases, the misdeeds were committed more or less openly, in writing, with traders and brokers baldly offering bribes in texts and e-mails with an obvious unconcern for punishment that later, sadly, proved justified.

"I will fucking do one humongous deal with you," begged one UBS trader who wanted a broker to fix the rate. "I'll pay, you know, $50,000, $100,000."

British regulators aren't hiding the size of the scandal. The UBS settlement demonstrated, without a doubt, that the LIBOR scandal involved more than just one or two banks, and probably involved hundreds of people at many of the world's largest and most prestigious financial institutions – in other words, a truly epic case of anti-competitive collusion that called into question whether the world's biggest banks are innovating a new, not-entirely capitalist form of high finance. "We have said there are five further institutions under investigation," says Christopher Hamilton of the FSA. "And there is a large number of individuals as well." (At press time, another bank, the Royal Bank of Scotland, also settled for LIBOR-related offenses.)

This dovetailed with what Bob Diamond, the former head of Barclays, told the British Parliament the day after he stepped down last year. "There is an industrywide problem coming out now," he said. Michael Hausfeld, a famed class-action lawyer who is suing the banks over LIBOR on behalf of cities like Baltimore whose investments lost money when interest rates were lowered, says the public still hasn't grasped the importance of comments like Diamond's. "Diamond essentially said, 'This is an industrywide problem,'" Hausfeld says. "But nobody has defined what this is yet."

Hausfeld's point – that Diamond's "industrywide problem" might be more than just a few guys messing with rates; it could be a systemic effort to pervert capitalism itself – underscores the extreme miscalculation of both recent no-prosecution deals.

At HSBC, the bank did more than avert its eyes to a few shady transactions. It repeatedly defied government orders as it made a conscious, years-long effort to completely stop discriminating between illegitimate and legitimate money. And when it somehow talked the U.S. government into crafting a settlement over these offenses with the lunatic aim of preserving the bank's license, it succeeded, finally, in making crime mainstream.

UBS, meanwhile, was a similarly elemental case, in which the offenses­ didn't just violate the letter of the law – they threatened the integrity of the competitive system. If you're going to let hundreds of boozed-up bankers spend every morning sending goofball e-mails to each other, giving each other super­hero nicknames while they rigged the cost of money (spelling-challenged UBS traders dubbed themselves, among other things, "captain caos," the "three muscateers" and "Superman"), you might as well give up on capitalism entirely and just declare the 16 biggest banks in the world the International Bureau of Prices.

Thus, in the space of just a few weeks, regulators in Britain and America teamed up to declare near-total surrender to both crime and monopoly. This was more than a couple of cases of letting rich guys walk. These were major policy decisions that will reverberate for the next generation.

Even worse than the actual settlements was the explanation Breuer offered for them. "In the world today of large institutions, where much of the financial world is based on confidence," he said, "a right resolution is to ensure that counter-parties don't flee an institution, that jobs are not lost, that there's not some world economic event that's disproportionate to the resolution we want."

In other words, Breuer is saying the banks have us by the balls, that the social cost of putting their executives in jail might end up being larger than the cost of letting them get away with, well, anything.

This is bullshit, and exactly the opposite of the truth, but it's what our current government believes. From JonBenet to O.J. to Robert Blake, Americans have long understood that the rich get good lawyers and get off, while the poor suck eggs and do time. But this is something different. This is the government admitting to being afraid to prosecute the very powerful – something it never did even in the heydays of Al Capone or Pablo Escobar, something it didn't do even with Richard Nixon. And when you admit that some people are too important to prosecute, it's just a few short steps to the obvious corollary – that everybody else is unimportant enough to jail.

An arrestable class and an unarrestable class. We always suspected it, now it's admitted. So what do we do?

This story is from the February 28th, 2013 issue of Rolling Stone.

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Saturday, November 9, 2013

Chase Isn't the Only Bank in Trouble by Matt Taibbi

Chase Isn't the Only Bank in Trouble


I've been away for weeks now on a non-financial assignment (we have something unusual coming out in Rolling Stone in a few weeks) so I've fallen behind on some crazy developments on Wall Street. There are multiple scandals blowing up right now, including a whole set of ominous legal cases that could result in punishments so extreme that they might significantly alter the long-term future of the financial services sector.

As one friend of mine put it, "Whatever those morons put aside for settlements, they'd better double it."

Firstly, there's a huge mess involving possible manipulation of the world currency markets. This scandal is already drawing comparisons to the last biggest-financial-scandal-in-history (the Financial Times wondered about a "repeat Libor scandal"), the manipulation of interest rates via the gaming of the London Interbank Offered Rate, or Libor. The foreign exchange or FX market is the largest financial market in the world, with a daily trading volume of nearly $5 trillion.

Regulators on multiple continents are investigating the possibility that at least four (and probably many more) banks may have been involved in widespread, Libor-style manipulation of currencies for years on end. One of the allegations is that traders have been gambling heavily before and after the release of the WM/Reuters rates, which like Libor are benchmark rates calculated privately by a small subset of financial companies that are perfectly positioned to take advantage of their own foreknowledge of pricing information.

A month ago, Bloomberg reported that it had observed a pattern of spikes in trading in certain pairs of currencies at the same time, at 4 p.m. London time on the last trading day of the month, when WM/Reuters rates are released. From the article:

In the space of 20 minutes on the last Friday in June, the value of the U.S. dollar jumped 0.57 percent against its Canadian counterpart, the biggest move in a month. Within an hour, two-thirds of that gain had melted away.
The same pattern – a sudden surge minutes before 4 p.m. in London on the last trading day of the month, followed by a quick reversal – occurred 31 percent of the time across 14 currency pairs over two years, according to data compiled by Bloomberg. For the most frequently traded pairs, such as euro-dollar, it happened about half the time, the data show.
The recurring spikes take place at the same time financial benchmarks known as the WM/Reuters (TRI) rates are set based on those trades…

The Forex story broke at a time when the industry was already coping with price-fixing messes involving oil (the European commission is investigating manipulation of yet another Libor-like price-setting process here) and manipulation cases involving benchmark rates for precious metals and interest rate swaps. As Quartz put it after the FX story broke:

For those keeping score: That means the world's key price benchmarks for interest rates, energy and currencies may now all be compromised.

Perhaps most importantly, however, there's a major drama brewing over legal case in London tied to the Libor scandal.

Guardian Care Homes, a British "residential home care operator," is suing the British bank Barclays for over $100 million for allegedly selling the company interest rate swaps based on Libor, which numerous companies have now admitted to manipulating, in a series of high-profile settlements. The theory of the case is that if Libor was not a real number, and was being manipulated for years as numerous companies have admitted, then the Libor-based swaps banks sold to companies like Guardian Care are inherently unenforceable.

A ruling against the banks in this case, which goes to trial in April of next year in England, could have serious international ramifications. Suddenly, cities like Philadelphia and Houston, or financial companies like Charles Schwab, or a gazillion other buyers of Libor-based financial products might be able to walk away from their Libor-based contracts. Basically, every customer who's ever been sold a rotten swap product by a major financial company might now be able to get up from the table, extend two middle fingers squarely in the direction of Wall Street, and simply walk away from the deals.

Nobody is mincing words about what that might mean globally. From a Reuters article on the Guardian Care case:

"To unwind all Libor-linked derivative contracts would be financial Armageddon," said Abhishek Sachdev, managing director of Vedanta Hedging, which advises companies on interest rate hedging products.

Concern over all of this grew even hotter last week with the latest Libor settlement, in which yet another major bank, the Dutch powerhouse Rabobank, got caught monkeying with the London rate.

Rabobank paid over a billion in fines to American, British, Dutch and Japanese authorities and saw its professorial CEO, Piet Moerland, resign as a result of the probe. The investigation revealed the same disgusting stuff all of the other Libor probes had revealed – traders and various other mid-level bank sociopaths laughing and joking about rigging rates and screwing customers all over the world. From the WSJ:

In a July 2006 electronic chat, an unidentified Rabobank trader was informed about the bank's plans to set Libor "obscenely high" that day, according to an exchange cited by the Justice Department. The trader responded, "oh dear . . . my poor customers . . . . hehehe!!"

Here at home, virtually simultaneous to the Rabobank settlement, Fannie Mae filed a suit against nine banks – including Barclays Plc (BARC), UBS AG (UBSN), Royal Bank of Scotland Plc, Deutsche Bank AG, Credit Suisse Group AG, Bank of America, Citigroup and JPMorgan – for manipulating Libor, claiming that the mortgage-financing behemoth lost over $800 million due to manipulation of the benchmark rate by the banks.

And virtually simultaneous to that, JP Morgan Chase disclosed that it is currently the target of no fewer than eight federal investigations, for activities ranging from possible bribery of foreign officials in Asia to allegations of improper mortgage-bond sales to . . . the Libor mess. "The scope and breadth of risky practices at JPMorgan are mind-boggling," Mark Williams, a former Federal Reserve bank examiner, told Bloomberg.

The point of all of this is that any thought that the potential Chase settlement might begin a period of regulatory healing for it and other Wall Street banks appears to be wildly mistaken. If anything, the scope of potential liability for all the major banks, particularly in these market-rigging furors, appears to be growing in all directions.

A half-year ago, it looked like the chief villains in the Libor mess at least were going to get away with writing relatively small checks. Back in March, a major private class-action suit filed by a gaggle of plaintiffs against the banks for Libor manipulation was tossed by a federal judge here in the southern District of New York on the seemingly preposterous grounds that a bunch of banks getting together to monkey with the value of world interest rates in this biggest-in-history financial collusion case was somehow now an antitrust issue.

The banks in that case humorously implied that the victims might have done better to sue for fraud instead of manipulation ("The plaintiffs, I believe, are confusing a claim of being perhaps deceived," one bank lawyer put it, "with a claim for harm to competition"), and the judge seemed to agree.

Moreover, when the plaintiffs' lawyers tried to make a point about the seemingly key fact that a series of governments had already concluded settlements with the banks for manipulating Libor, the judge – the Hon. Naomi Rice Buchwald – mocked the plaintiffs' lawyers for trying to ride to civil victory on a wave of government settlements:

Wait a second. Your job here, as plaintiffs' counsel, looking for whopping legal fees, is not to piggyback on the government. Indeed, the reason that there are statutes that provide plaintiffs' counsel with attorney's fees is a recognition that the government has limited resources.

The banks must have thought they'd hit the lottery, with this potentially deadly Libor suit suddenly stopped dead in its tracks by a grumpy federal judge with an apparent distaste for plaintiff lawyers who collect "whopping" legal fees. So the victims tried to take a different tack, appealing to a federal panel in an attempt to allow them to file their suits against the banks on a state-by-state level.

But then, in a seemingly fatal blow to the private claims, the U.S. Judicial Panel on Multidistrict Litigation ruled in favor of the banks, sending the case right back into the courtroom of the same judge who'd dumped on the plaintiffs' lawyers and their "whopping fees."

That was just a month ago, at the beginning of October, and back then it seemed like the banks might somehow escape the Libor mess with their necks intact.

Now, a month later, yet another bank has been forced to cough up a billion dollars for Libor manipulation, Fannie Mae has filed a major suit on the same grounds, and the Guardian Care Homes case is not only alive but looking like a threat to cancel billions of dollars' worth of Libor-related contracts. Not only that, many of those same banks are being sucked into what potentially is an even uglier scandal involving currency manipulation.

One gets the feeling that governments in all the major Western democracies would like to sweep these manipulation scandals under the rug. The only problem is that the scale of the misdeeds in these various markets is so enormous that even the most half-assed attempt at regulation will cause a million-car pileup.

There's simply no way to do a damage calculation that won't wipe out the entire finance sector when you're talking about pervasive, ongoing manipulation of $5-trillion-a-day markets. That's the problem – there's no way to do a slap on the wrist in these cases. If they're guilty, they're done.

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Wednesday, July 3, 2013

The Last Mystery of the Financial Crisis By Matt Taibbi

The Last Mystery of the Financial Crisis

It's long been suspected that ratings agencies like Moody's and Standard & Poor's helped trigger the meltdown. A new trove of embarrassing documents shows how they did it


By Matt Taibbi

June 19, 2013 9:00 AM ET
What about the ratings agencies?
That's what "they" always say about the financial crisis and the teeming rat's nest of corruption it left behind. Everybody else got plenty of blame: the greed-fattened banks, the sleeping regulators, the unscrupulous mortgage hucksters like spray-tanned Countrywide ex-CEO Angelo Mozilo.
But what about the ratings agencies? Isn't it true that almost none of the fraud that's swallowed Wall Street in the past decade could have taken place without companies like Moody's and Standard & Poor's rubber-stamping it? Aren't they guilty, too?
Man, are they ever. And a lot more than even the least generous of us suspected.
Everything Is Rigged: The Biggest Price-Fixing Scandal Ever
Thanks to a mountain of evidence gathered for a pair of major lawsuits by the San Diego-based law firm Robbins Geller Rudman & Dowd, documents that for the most part have never been seen by the general public, we now know that the nation's two top ratings companies, Moody's and S&P, have for many years been shameless tools for the banks, willing to give just about anything a high rating in exchange for cash.
In incriminating e-mail after incriminating e-mail, executives and analysts from these companies are caught admitting their entire business model is crooked.
"Lord help our fucking scam . . . this has to be the stupidest place I have worked at," writes one Standard & Poor's executive. "As you know, I had difficulties explaining 'HOW' we got to those numbers since there is no science behind it," confesses a high-ranking S&P analyst. "If we are just going to make it up in order to rate deals, then quants [quantitative analysts] are of precious little value," complains another senior S&P man. "Let's hope we are all wealthy and retired by the time this house of card[s] falters," ruminates one more.
Ratings agencies are the glue that ostensibly holds the entire financial industry together. These gigantic companies – also known as Nationally Recognized Statistical Rating Organizations, or NRSROs – have teams of examiners who analyze companies, cities, towns, countries, mortgage borrowers, anybody or anything that takes on debt or creates an investment vehicle.
Their primary function is to help define what's safe to buy, and what isn't. A triple-A rating is to the financial world what the USDA seal of approval is to a meat-eater, or virginity is to a Catholic. It's supposed to be sacrosanct, inviolable: According to Moody's own reports, AAA investments "should survive the equivalent of the U.S. Great Depression."
The Scam Wall Street Learned From the Mafia
It's not a stretch to say the whole financial industry revolves around the compass point of the absolutely safe AAA rating. But the financial crisis happened because AAA ratings stopped being something that had to be earned and turned into something that could be paid for.
That this happened is even more amazing because these companies naturally have powerful leverage over their clients, as they are part of a quasi-protected industry that enjoys massive de facto state subsidies. Largely that's because government agencies like the Securities and Exchange Commission often force private companies to fulfill regulatory requirements by retaining or keeping in reserve certain fixed quantities of assets – bonds, securities, whatever – that have been rated highly by a "Nationally Recognized" ratings agency, like the "Big Three" of Moody's, S&P and Fitch. So while they're not quite part of the official regulatory infrastructure, they might as well be.
It's not like the iniquity of the ratings agencies had gone completely unnoticed before. The Financial Crisis Inquiry Commission published a case study in 2011 of Moody's in particular and discovered that between 2000 and 2007, the agency gave nearly 45,000 mortgage-backed securities AAA ratings. One year Moody's doled out AAA ratings to 30 mortgage-backed securities every day, 83 percent of which were ultimately downgraded. "This crisis could not have happened without the rating agencies," the commission concluded.
Thanks to these documents, we now know how that happened. And showing as they do the back-and-forth between the country's top ratings agencies and one of America's biggest investment banks (Morgan Stanley) in advance of two major subprime deals, they also lay out in detail the evolution of the industrywide fraud that led to implosion of the world economy – how banks, hedge funds, mortgage lenders and ratings agencies, working at an extraordinary level of cooperation, teamed up to disguise and then sell near-worthless loans as AAA securities. It's the black box in the American financial airplane.
In April, Moody's and Standard & Poor's settled the lawsuits for a reported $225 million. Brought by a diverse group of institutional plaintiffs with King County, Washington, and the Abu Dhabi Commercial Bank taking the lead, the suits accused the ratings agencies of conspiring in the mid-to-late 2000s with Morgan Stanley to fraudulently induce heavy investment into a pair of doomed-to-implode subprime-laden deals, called Cheyne and Rhinebridge.
Stock prices for both companies soared at the settlement, with markets believing the firms would be spared the hell of reams of embarrassing evidence thrust into public view at trial. But in a quirk, an earlier judge's ruling had already made most of the documents in the case public. Although a few news outlets, including The New York Times, took note at the time, the vast majority of the material was never reported, and some was never seen by reporters at all. The cases revolved around a highly exotic and complex financial instrument called a SIV, or structured investment vehicle.
The SIV is a not-so-distant cousin of the special purpose entity, or SPE, which was the main weapon of destruction in the Enron scandal. The corporate scam du jour in those days was mass accounting fraud, in which a company would create an ostensibly independent corporate structure that would actually be controlled by its own executives, who would then move their company's liabilities off their own books and onto the remote-controlled SPE, hiding the firm's losses.
The SIV is a similar concept. They first started showing up in the late Eighties after banks discovered a loophole in international banking standards that allowed them to create SPE-like repositories full of assets like mortgage-backed securities and keep them off their own books.
These behemoths operated on the same basic concept as an ordinary bank, which borrows short-term cash from depositors and then lends money long-term in the form of things like mortgages, business loans, etc. The SIV did the same thing, borrowing short-term from investors and then investing long-term on things like student loans, car loans, subprime mortgages. Like banks, a SIV made money on the spread between its short-term debt and long-term investments. If a SIV borrowed on the commercial paper market at 3 percent but earned 6.5 percent on subprime mortgages, that was an easy 3.5 percent profit.
The big difference is a bank has regulatory capital requirements. A SIV doesn't, and being technically independent, its potential liabilities don't show up on the books of the megabank that created it. So the SIV structure allowed investment banks to create and take advantage of, without risk, billions of dollars of things like subprime loans, which became the centerpiece of the new trendy corporate scam – creating and then selling masses of risky mortgage-backed securities as AAA investments to institutional suckers.

atings agencies helped this game along in two ways. First, banks needed them to sign off on the bogus math of the subprime era – the math that allowed banks to turn pools of home loans belonging to people so broke they couldn't even afford down payments into securities with higher credit ratings than corporations with billions of dollars in assets. But banks also needed the ratings agencies to sign off on the safety and reliability of these off-balance-sheet SIV structures. The first of the two SIVs in question was dreamed up by a London-based hedge fund called Cheyne Capital Management (pronounced like Dick "Cheney"), run by an ex-Morgan Stanley banker duo who hired their old firm to build and stock this vast floating Death Star of subprime loans.
Morgan Stanley had multiple motives for putting together the Cheyne deal. For one thing, it earned what the bank's lead structurer affectionately called "big fat upfront fees," which bank executives estimated would eventually add up to $25 million or $30 million. It was a lucrative business, and the top dogs wanted the deal badly. "I am very focused on . . . getting this deal done to get NY to stop freaking out" and "to make our money," said Robert Rooney, the senior Morgan Stanley executive on the deal. A spokesman for Morgan Stanley, however, told Rolling Stone, "Our sole economic interest was in the ongoing success of the SIV."
But that wasn't Morgan Stanley's only motive. Not only could the bank make the "big fat upfront fees" for structuring the deal, they could also turn around and sell scads of their own mortgage-backed securities to the SIV, which in turn would be marketed to investors like Abu Dhabi and King County. In Cheyne, 25 percent of the original assets in the deal came from Morgan Stanley – over time, $2 billion of the SIV's $9 billion to $10 billion portfolio of assets came from the bank as well.
Internal Morgan Stanley memorandums show that the bank knowingly stuffed mortgages in the SIV whose borrowers were, to say the least, highly suspect. "The real issue is that the loan requests do not make sense," complained a Morgan Stanley employee back in 2005. He noted loans had been made to a "tarot reading house" operator who claimed to make $12,000 a month, and a "knock off gold club distributor" who claimed to make $16,000 a month. "Compound these issues," he groaned, "with the fact that we are seeing what I would call a lot of this type of profile."
No matter – into the soup it went! Morgan sold mountains of this crap into Cheyne's SIV, where it was destined to be sold off to other suckers down the line. The only thing that could possibly get in the way of the scam was some pesky ratings agency.
Fortunately for the bank and the hedge fund, these subprime SIVs were a relatively new kind of investment product, so the ratings agencies had little to go on in the area of historical data to measure these products. One might think this would make the ratings agencies more conservative. In fact, caution in the face of the unknown was supposed to be a core value for these companies. As Moody's put it, "Triple-A structures should not be highly dependent on untestable assumptions."
But when it came to the Cheyne SIV, Moody's punted on caution. In an e-mail sent to executives from both Morgan Stanley and Cheyne in May 2005, David Rosa, a Moody's senior analyst, admitted that when it came to this SIV, he had nothing to go on.
"Please note that in relation to assumed spread [volatility] for the Aa and A there is no actual data backing up the current model assumptions," he wrote. In lieu of such data, he went on, "We will for now accept the proposal to use the same levels as [residential mortgage-backed securities] given that this assumption is supported by the analysis of the Aaa data . . . and Cheyne's comments on their views of this asset class."
Translation: We have no historical data, so we'll just accept your reasoning for the time being, even though you have every incentive in the world to lie about the quality of your product.
At one point, a Morgan Stanley analyst even claimed that the bank had written, in Moody's name, an entire 12-page "New Issue Report" for the Cheyne SIV – a kind of ratings summary in which Morgan Stanley appears to have given itself AAA ratings for large chunks of the deal. "I attach the Moody's NIR (that we ended up writing)," yawns Morgan Stanley fixed-income employee Rany Moubarak in a March 2006 e-mail. The attached document came proudly affixed with the "Moody's Investors Service" logo. (Both Moody's and Morgan Stanley deny that anyone other than Moody's wrote that report.)
Morgan Stanley ended up getting both Moody's and S&P to rate the deal, and that was not only common, it was basically industry practice. There were many reasons for this, but a big one was a concept called "notching," in which the agencies gave ratings penalties to any instrument that had not been rated by their own company. If a SIV contained a basket of mortgage-backed securities rated AA by Standard & Poor's, Moody's might "notch" those underlying securities down to A, or even lower. This incentivized the banks to hire as many ratings agencies as possible to rate every investment vehicle they created.
Again, despite the fact that the ratings agencies enjoyed broad quasi-official subsidies, and despite the powerful market leverage that techniques like "notching" gave them, they still routinely chose to roll over for banks. And the biggest companies were equally guilty. In the case of the Cheyne deal, Standard & Poor's was every bit as craven as Moody's.
In September 2004, an S&P analyst named Lapo Guadagnuolo sent an e-mail to Stephen McCabe, the agency's lead "quant" on the Cheyne deal, who apparently was on vacation. The e-mail chain was mostly a bunch of office gossip, where the two men e-whispered about an employee who was about to quit. But sandwiched in the office banter was an offhand line about the Cheyne deal and how full of shit it was. "Hi Steve!" Guadagnuolo wrote cheerily, adding, "How is Australia and how was Thailand????Back to [Cheyne] . . . As you know, I had difficulties explaining 'HOW' we got to those numbers since there is no science behind it . . .
"Thanks and regards . . . have you heard that [redacted] has resigned . . . and somebody else will follow suit today!!"
McCabe, blowing off the "no science behind it" comment, answered eagerly, "Who, Who, Who????" The quadruple question mark must be an S&P-ism.
A month later, McCabe seemed more concerned about the lack of science in the Cheyne deal. He complained in an e-mail to his boss, Kai Gilkes, who was the agency's senior quantitative analyst in Europe.
"From looking at the numbers it is quite obvious that we have just stuck our preverbal [sic] finger in the air!!" he fumed.
Gilkes was experiencing his own crisis of conscience by mid-2005, complaining in an oddly wistful e-mail to another S&P employee that the good old days of just giving things the ratings they deserved were disappearing. "Remember the dream of being able to defend the model with sound empirical research?" he wrote on June 17th, 2005. "If we are just going to make it up in order to rate deals, then quants are of precious little value."
Frank Parisi, Standard & Poor's chief credit officer for structured finance, was even more downtrodden, saying that the model that his company used to rate residential mortgage-backed securities in 2005 and 2006 was only marginally more accurate than "if you just simply flipped a coin."

Given all of this, why would top analysts from both Moody's and Standard & Poor's rate such a massive deal like Cheyne without any science to back it up? The answer was simple: money. In the old days, ratings agencies lived on subscriptions sold to investors, meaning they were compensated – indirectly, incidentally – by the people buying the financial products.
But over time, that model morphed into the current "issuer pays" model, in which a company like Moody's or Standard & Poor's is paid directly by the "issuer" – i.e., the company that is actually making the financial product.
For Cheyne, for instance, the agencies were paid in the area of $1 million to $1.5 million to rate the deal by Morgan Stanley, the very company with an interest in getting a high rating. It's the ultimate in negative incentives, and was and continues to be a major impediment to honest analysis on Wall Street. Michigan Sen. Carl Levin, one of the few lawmakers to focus on reforming the ratings agencies after the crash, put it this way: "It's like one of the parties in court paying the judge's salary."
Thanks to this model, ratings-agency business soared during the bubble era. A Senate report found that fees for the "Big Three" doubled between 2002 and 2007, from $3 billion to $6 billion. Fees for rating mortgage-backed securities at both Moody's and S&P nearly quadrupled.
So there were powerful incentives to whitewash deals like Cheyne. The eventual president of Moody's, Brian Clarkson, actually copped to this awful truth in writing, in a 2004 internal e-mail. "To put it bluntly," he wrote, "the issuer could take its business elsewhere unless the rating agency provides a higher rating."
Both Moody's and Standard & Poor's employees described complex/exotic new financial products like CDOs and SIVs as "cash cows," and behind closed doors, executives talked openly about the financial pressure to give scientifically unfounded analysis to products the banks wanted to sell.
The minutes from a 2007 conference of Standard & Poor's executives show that the raters knew they were in way over their heads. Admitting that it was virtually impossible to accurately rate, say, a synthetic derivative loan deal with underlying assets in China and Russia, one executive candidly admits, "We do not have the capacity nor the skills in house to rate something like this." Another counters, "Market pressures have significantly risen due to 'hot money.'" The first retorts that bankers are pushing boundaries, asking the raters to help them play the highly cynical hot-potato game, in which bad loans are originated en masse and then instantly passed off to suckers who will take on all the risk. "Bankers say why not originate bad loans, there is no penalty," the executive muses.
Hilariously – or tragically, depending on your point of view – an S&P executive at the conference even tossed off a quick visual sketch of their company's moral quandary. The picture is atrociously drawn (it looks like a junior high school student's rendering of a ganglion cell) and comes across like the Wall Street version of Hamlet, showing the industry traveling down a road and reaching a "Choice Point" crossroads, where the two options are "To Rate" and "Not Rate."
The former – basically taking the money and just rating whatever crap the banks toss their way – is crudely depicted as a wide, "well marked super highway." Meanwhile the honorable thing, not rating shitty investments, is shown to be a skinny little roadlet, marked "Dark and narrow path less traveled."
Obviously, the ratings agencies like S&P ultimately decided to take the road more traveled, choosing profits over scruples. Not that there wasn't some token resistance at first. For instance, some at S&P hesitated to allow the use of a questionable technique called "grandfathering," in which old and outdated rating models were used to rate newly issued investments.
In one damning e-mail chain in November 2005, a Morgan Stanley banker complains to an S&P executive named Elwyn Wong that S&P was preventing him from putting S&P ratings on Morgan Stanley deals that used this grandfathering technique. "My business is on 'pause' right now," the banker complains.
Wong took the news that S&P was holding up deals over the grandfathering issue badly. "Lord help our fucking scam," he said. "This has to be the stupidest place I have worked at." Wong, incidentally, was later hired by the U.S. Office of the Comptroller Currency, our top federal banking regulator.
The purists, however, couldn't hold out for long. In the Cheyne case, when one of the "quants" tried to hold the line, Morgan Stanley went over their heads to someone on the business side at the company to get the rating it wanted.
In July 2004, for instance, analyst Lapo Guadagnuolo sent an e-mail to Morgan Stanley's point man on the Cheyne deal, Gregg Drennan, and told him that the best he could do for the "mezzanine capital notes" or "MCN" piece of the SIV – a piece that Drennan wanted at least an A rating for – was BBB-plus. Drennan responded in an e-mail that CC'd Guadagnuolo's boss, Perry Inglis, telling him that Morgan Stanley "believe[s] the position the committee is taking is very inappropriate."

Ultimately, the analyst committee agreed to give the dubious Mezzanine Notes an A rating, marking the first time these middle-tier investments in a SIV ever received a public A rating. For Wall Street, this was occasion to par-tay. In the summer of 2005, one of the Cheyne hedge-funders sent out a celebratory e-mail to Morgan Stanley execs, bragging about getting the ratings companies to cave. "It is an amazing set of feats to move the rating agencies so far," the hedgie wrote. "We all do all this for one thing and I hope promotions are a given. Let's hope big bonuses are to follow."
Later on, S&P caved even further, agreeing to allow Morgan Stanley to lower the "capital buffer" in the deal protecting investors without suffering a ratings penalty. As late as February 1st, 2006, Guadagnuolo was defiantly telling Morgan Stanley that the one-percent buffer was a "pillar of our analysis." But by the next day, Morgan Stanley executive Moubarak had chopped Guadagnuolo's knees out. He cheerfully announced in a group e-mail that the bank had managed to remove this "pillar" and get the buffer knocked down to .75 percent.
Tina Sprinz, who worked for the Cheyne hedge fund, sent an e-mail that very day to Moubarak, thanking him for straightening out the pesky analysts. "Thanks for negotiating that," she says. The ratings process shouldn't be a "negotiation," yet this word appears throughout these documents.
In the Cheyne deal, just the plaintiffs in the lawsuit invested a total of $980 million in "rated notes," and those who invested in these "MCNs" were completely wiped out. Analysts from both agencies would express regret and/or trepidation about their roles in unleashing the monster deals and their failure to stop the business-side suits running the companies from selling them out. Gilkes, the S&P analyst who worried about shunning real science in favor of just making things up, later testified that the subprime assets in such SIVs were "not appropriate."
"They should not have been rated," he said.
If the significance of Cheyne is that it showed how the ratings agencies sold out in an effort to get business, the significance of the next deal, Rhinebridge, is that it showed how low they were willing to stoop to keep that business.
Rhinebridge was a subprime-packed SIV structured very much like Cheyne, only both the quality of the underlying crap in the SIV and the timing of the SIV's launch were significantly more horrible than even Cheyne's.
Not only did Morgan Stanley insist that the ratings agencies allow the bank to pack Rhinebridge full of a much higher quantity of subprime than in the Cheyne deal, they were also pushing this massive blob of toxic mortgages at a time when the subprime market was already approaching full collapse.
In fact, the Rhinebridge deal would launch with high ratings from both agencies on June 27th, 2007, less than two weeks before both Moody's and S&P would downgrade hundreds of subprime mortgage-backed securities. In other words, both Moody's and S&P were almost certainly in the process of downgrading the underlying assets in the Rhinebridge SIV even as they were preparing to launch Rhinebridge with AAA-rated notes.
"It was the briefest AAA rating in history," says the plaintiffs' lawyer Dan Drosman. "Rhinebridge went from AAA to junk in a matter of months."
There is an enormous documentary record in both agencies showing that analysts and executives knew a bust was coming long before they sent Rhinebridge out into the world with a AAA label. As early as 2005, S&P was talking in internal memorandums about a "bubble" in the real-estate markets, and in 2006 it knew that there had been "rampant appraisal and underwriting fraud for quite some time," causing "rising delinquencies" and "nightmare mortgages."
In June 2007, the same month Rhinebridge was launched, S&P's Board of Directors Report talked about a total collapse of the market. "The meltdown of the subprime-mortgage market will increase both foreclosures and the overhang of homes for sale."
It was no better at Moody's, where in June 2007, executives were internally discussing "increased amounts of lying on income" and "increased amounts of occupancy misstatements" in mortgage applications. Clarkson, who would become president two months later, was told the week before Rhinebridge launched that "most players in the market" believed subprime would "perform extremely poorly," and that the problems were "quite serious."
Yet the two ratings agencies not only kept those concerns private, they both took outlandish steps to declare just the opposite.
In a pair of matching public papers, both Moody's and S&P proclaimed that summer that while subprime might be going to hell, subprime-packed investments like SIVs might be just fine. The Moody's report on July 18th read "SIVs: An Oasis of Calm in the Sub-prime Maelstrom," while an S&P report on August 14th, 2007, was titled "Report Says SIV Ratings Are Weathering Current Market Disruptions."
The S&P report was so brazen that it even shocked a Morgan Stanley banker involved in the SIV deals. "I cannot believe these morons would reaffirm in this market," chortled the banker in an e-mail the day after the paper was released.

Rhinebridge, cheyne and a hell of a lot of other subprime investments ultimately blew to smithereens, taking with them vast amounts of cash – 40 percent of the world's wealth was wiped out in the aftermath of the mortgage bubble, according to some estimates. 2008 was to the American economy what 9/11 was to national security. Yet while 9/11 prompted the U.S. government to tear up half the Constitution in the name of public safety, after 2008, authorities went in the other direction. If you can imagine a post-9/11 scenario where there were no metal detectors at airports and people could walk on carrying chain saws and meat cleavers, you get a rough idea of what was done to reform the ratings process.
Specifically, very little was done to change the way AAA ratings are created – the "issuer pays" model still exists, and the "Big Three" retain roughly the same market share. An effort by Minnesota Sen. Al Franken to change the compensation model through a new approach under which agencies would be assigned to rate new issues through a government agency passed overwhelmingly in the Senate, but in the House it was relegated to a study by the SEC – which released its findings last year, calling for . . . more study. "The conflict of interest still exists in the exact same way," says a frustrated Franken.
The companies by now are all the way back in black. In 2012, for instance, Moody's profits soared 22 percent, to $1.18 billion. McGraw-Hill, the parent company of Standard & Poor's, scored $437 million in profits last year, with the rating business accounting for 70 percent of the company's profits.
In February, the Obama Justice Department, in an action that seems belated, filed a $5 billion civil suit against Standard & Poor's, drawing upon some of the same data and documents that were part of the Cheyne and Rhinebridge suits. As part of that action, high-ranking officials at S&P were interviewed by government investigators and admitted that they had shaded their ratings methodologies to protect market share. In this deposition of Richard Gugliada, head of S&P's CDO operations, the government asks why the company was slow to implement updates to its model for evaluating CDOs:
Q: Is it fair to say that Standard & Poor's goal of preserving an increasing market share and profits from ratings fees influence the development of the updates to the CDO evaluator?
A: In part, correct.
Q: The main reason to avoid a reduction in the noninvestment grade ratings business was to preserve S&P's market share in that category, correct?
A: Correct.
Years after the crash, it's a little insulting to see industry analysts blithely copping under oath to having traded science for market share, especially since the companies continue to protest to the contrary in public. Contacted for this story, Moody's and S&P insisted many of the documents in this case were simply taken out of context, and that their analysis throughout has been rigorous, objective and independent.
It's a thin defense, but it's holding – for now. McGraw-Hill stock plunged nearly 14 percent when news of the Justice Department suit leaked, and dropped nearly 19 percent for February, but has since regained much of its value – its stock rose nearly 16 percent in March and April, as markets reacted favorably to, among other things, its recent settlement of the Cheyne and Rhinebridge suits. The markets clearly think the ratings agencies will survive.
What's amazing about this is that even without a mass of ugly documentary evidence proving their incompetence and corruption, these firms ought to be out of business. Even if they just accidentally sucked this badly, that should be enough to persuade the markets to look to a different model, different companies, different ratings methodologies.
But we know now that it was no accident. What happened to the ratings agencies during the financial crisis, and what is likely still happening within their walls, is a phenomenon as old as business itself. Given a choice between money and integrity, they took the money. Which wouldn't be quite so bad if they weren't in the integrity business.
This story is from the July 4 - July 18, 2013 issue of Rolling Stone

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