Tavakoli: Biggest Fraud in the History of the Capital Markets

Washington Post
'This is the biggest fraud in the history of the capital markets'
By Ezra Klein
10/8/2010

Janet Tavakoli is the founder and president of Tavakoli Structured Finance Inc. She sounded some of the earliest warnings on the structured finance market, leading the University of Chicago to profile her as a "Structured Success," and Business Week to call her "The Cassandra of Credit Derivatives." We spoke this afternoon about the turmoil in the housing market, and an edited transcript of our conversation follows.

Ezra Klein: What’s happening here? Why are we suddenly faced with a crisis that wasn’t apparent two weeks ago?

Janet Tavakoli: This is the biggest fraud in the history of the capital markets. And it’s not something that happened last week. It happened when these loans were originated, in some cases years ago. Loans have representations and warranties that have to be met. In the past, you had a certain period of time, 60 to 90 days, where you sort through these loans and, if they’re bad, you kick them back. If the documentation wasn’t correct, you’d kick it back. If you found the incomes of the buyers had been overstated, or the houses had been appraised at twice their worth, you’d kick it back. But that didn’t happen here. And it turned out there were loan files that were missing required documentation. Part of putting the deal together is that the securitization professional, and in this case that’s banks like Goldman Sachs and JP Morgan, has to watch for this stuff. It’s called perfecting the security interest, and it’s not optional.

EK: And how much danger are the banks themselves in?

JT: When we had the financial crisis, the first thing the banks did was run to Congress and ask for accounting relief. They asked to be able to avoid pricing this stuff at the price where people would buy them. So no one can tell you the size of the hole in these balance sheets. We’ve thrown a lot of money at it. TARP was just the tip of the iceberg. We’ve given them guarantees on debts, low-cost funding from the Fed. But a lot of these mortgages just cannot be saved. Had we acknowledged this problem in 2005, we could’ve cleaned it up for a few hundred billion dollars. But we didn’t. Banks were lying and committing fraud, and our regulators were covering them and so a bad problem has become a hellacious one.

EK: My understanding is that this now pits the banks against the investors they sold these products too. The investors are going to court to argue that the products were flawed and the banks need to take them back.

JT: Many investors now are waking up to the fact that they were defrauded. Even sophisticated investors. If you did your due diligence but material information was withheld, you can recover. It’ll be a case-by-by-case basis.

EK: Given that our financial system is still fragile, isn’t that a disaster for the economy? Will credit freeze again?

JT: I disagree. In order to make the financial system healthy, we need to recognize the extent of our losses and begin facing the fraud. Then the market will be trustworthy again and people will start to participate.

EK: It sounds almost like you’re saying we still need to go through the end of our financial crisis.

JT: Yes, but I wouldn’t say crisis. This can be done with a resolution trust corporation, the way we cleaned up the S&Ls. The system got back on its feet faster because we grappled with the problems. The shareholders would be wiped out and the debt holders would have to take a discount on their debt and they’d get a debt-for-equity swap. Instead we poured TARP money into a pit and meanwhile the banks are paying huge bonuses to some people who should be made accountable for fraud. The financial crisis was a product of our irrational reaction, which protected crony capitalism rather than capitalism. In capitalism, the shareholders who took the risk would be wiped out and the debt holders would take a discount but banking would go on.

Janet Tavakoli: Did Goldman Sachs Commit Fraud?

Highlights:

Yes. The only thing that was surprising how long the SEC took to do it.

The complaint does not go quite far enough. It was a blatant fraud, more than just a failure to disclose information.

And this may be the beginning of a lot of questions about a lot of investment banks. It has massive implications IF the SEC does its job right, which they have not done in the past.

Tavakoli Structured Finance

"How to Corner the Gold Market" By Janet Tavakoli

Janet Tavakoli wrote an interesting essay that was just posted over at the Huffington Post called "How to Corner the Gold Market" which can be read in its entirety from her website here. I started to comment at the HuffPost, but the system there limits comments to 250 characters, so I left a brief comment which is probably still being moderated (note: and still is five hours later - J) and will post my entire comment here while it is fresh in my mind.

First I wanted to thank Janet for dropping me a note about this piece. She knows I have an abiding interest on this topic of market imbalances and regulation in general. I find the US markets fascinating these days, in particular where they involve leverage and derivatives. And Janet is one of the most 'on the ball' and smartest people that I know who are looking at this, and making the good calls well in advance of the situation.

What struck me as odd is that I just wrote a blog piece along similar lines on the same topic today, raising many of the same issues, but that is from the opposite perspective. You can read The Case for Position Limits: What is the Spot Price and How Is It Set? here.

I think Janet and I come to the same conclusions but from a very different perspective, the other side of the table in fact, I wanted to reflect at length on her essay because I think it is important, and in some ways a good formula for manipulating a market from either the short of the long side. In the metals markets today, most of the 'gorillas' are the TBTF crowd, and they seem to be on the short side. That does not mean that they are not being sized up for a market showdown that could be destructive if there is a mispricing of risk and market imbalance.

First, and its not really a quibble, I think the Hunt Brothers attempt to corner the silver market back in the 1970's was overturned not only by a pre-emptive action by the Fed (and it was not an accident as I recall but a conscious response to inflation speculation) but also actions by the exchanges that broke the corner by altering the rules. I have not read the essay she references but I recall the situation first hand since my stock broker at Bache, Halsey Stuart was keeping close track of it, and liked to discuss it with me. Since I was not trading that market at such a tender age, it was a interesting voyeuristic experience, being in the stands watching the men in the arena. When I saw a spec silver trader in their office breaking out in hives during the trading day, being crushed and ruined lock limit down, I resolved to stay away from that sort of action.

This is important because today, having apparently learned their lesson, the exchanges are generally willing to increase the margin requirements when there appears to be undue speculation, especially on the long side of the trade by the speculators not in the in-crowd with the exchange. This is probably more common in the commodity markets, but most commodity traders are well aware these margin changes. They have to be since it requires them to put up more capital, and the specs are often thinly capitalized.

Second, I believe that the commodity exchanges already have the ability to force a cash settlement between counterparties in the event of a market imbalance. I think they even have the option to force a settlement in a commodity ETF, including some which Janet discusses as possibly being the objects of manipulation.

So think in sum that there is little evidence that anyone is willing to take on the exchanges, even the big players, and try and force a corner or even a squeeze against what they perceive as mispricing, such as Soros and so many other big players did with the British Pound , and most recently other big hedge funds did with mispriced products from the latest bubble in the debt markets, and financial stocks. They may be vilified after the fact, but they were right and served a valuable market function. Whether they did anything illegal is another matter.

The piece I wrote today and reference above is about a situation in the precious metals markets which has the potential to become another serious problem for almost the same basic reasons as the debt markets in our most recent financial crisis: excessive leverage concentrated in a few TBTF institutions, lack of transparency, regulatory laxity, and a mispricing of risk.

Janet alludes to the same thing. My prescription is position limits and accountability the collateral and any other deliverables backing the trade. If indeed there are excessively naked shorts, then not squeezing them is of course one resolution, but the other is to rein them in. I should add that the major players claim that they are not naked short, and reference hedges which I believe are undisclosed.

It was kind of odd to hear this story told in a conspiratorial way, referencing the Hunt Brothers. Anyone who would take on the government sponsored banks like JPM and HSBC at this point would have to be rather well-heeled and gutsy indeed. And what is most ironic is that a whistle-blower's testimony appeared at the recent CFTC hearing, and seemed to allege that JPM is manipulating the silver market. It was widely covered in the blogosphere, but very little of it in the mainstream media. I don't think it was covered at all at the Huffington Post, so Janet may not have seen it.

And of course there was the subsequent story about the man and his wife being struck by a hit and run driver the next day in London, and the usual fear of smears and intimidation that must accompany all those who testify against the vested interests. That story remains to unfold. I hope it turns out better than that of Harry Markopolos, who was widely ignored until the worst happened and the Madoff Ponzi scheme collapsed. As I recall he was subject to intimidation and fears for his safety, warranted or otherwise. It must be hard to come forward with this sort of knowledge.

But let's cut through the verbage. Here we are again, with TBTF institutions playing the excessive leverage games and possible naked shorting and mispricing of risk in under-regulated markets, and putting the 'global markets' stability at risk.

If Janet has any specific knowledge about a conspiracy to take advantage of this she should immediately contact the CFTC. I recommend Bart Chilton because I hear he is responsive and interested in this very topic, and just helped to sponsor hearings on this topic as I understand it. If I knew anything at all like this I would as well. So far all I see is a market relatively dominated by the usual TBTF suspects. If some longs are sizing them up there is certainly nothing wrong with that, and if they are vulnerable to a default, then we can either ban short selling (or I guess in this case it would be buying what they are short) or we can try and tighten up the market and correct any obvious imbalances that might exist now in an orderly manner.

But based on the last three years experience of financial misdeed exposed, I would hesitate to account for something by a criminal or even conspiratorial intent what can be attributed to short term greed and sheer reckless stupidity, crony capitalism and regulatory capture, and some intelligent market players seeing this and using legitimate means to confront it, and give it the market players a thrashing they may deserve. But there could be things happening well behind the scenes that I, a reasonably intelligent and trying-to-be-informed market participant cannot see. Is the squid on the hunt again? It is hard to imagine anyone big enough to take on the jokers that seem to be batting the US markets around at will these days. But therein lies the problem to my way of thinking - opaque and excessively leveraged markets that favor the big predatory trading desks.

As anyone who reads my blog knows, I do not think the contrarians are at the heart of our issues here, those who were shorting the mortgage bubble and the derivatives associated with them, although there is always that possibility. I am much more concerned about the establishment, those who are pulling the strings of power, and influencing the regulators, and I found a resonant chord in Janet's essay about this.

The markets are in need of reform. And as concerned as I was before, as shown by the blog which wrote earlier today, I am even more concerned now because Janet seems concerned, and we are coming at this from two very different perspectives: her from the possibility of an engineered short squeeze, and I from the dangerous condition I think I see in the market structure as it is today, with many of the same large institutions at the epicenter of the most recent crisis doing the same thing all over again, different day, different market. same players and modus operandi.

If there are elements trying to manipulate the markets from either side of the trade, then I agree with Janet, that I wish nothing to do with them, and want to see them exposed and prosecuted. But so far that does not seem to be happening very much, anywhere in the system except for some relative 'small fry.'

It feels like groundhog day.

Jesse

Guest Post: Ralph Cioffi's Acquittal for Fraud - Janet Tavakoli

By Janet Tavakoli of Tavakoli Structured Finance

Ralph Cioffi and Matthew Tannin, former hedge fund managers and co-heads of Bear Stearns Asset Management, were acquitted yesterday (November 10) of all six counts in their fraud trial” U.S. v. Cioffi, 08-CR-00415, U.S. District Court for the Eastern District of New York (Brooklyn).

"I worked at Bear Stearns in the late 1980s and remembered amiable newcomer Ralph Cioffi to be Bear Stearns’ most talented and successful salesman of mortgage-backed securities. He was usually even tempered, always hard working, and thoughtful. I headed marketing for the quantitative group run by both Stanley Diller, one of the original Wall Street “quants,” and Ed Rappa (now CEO of R.W. Pressprich & Co, Inc.), a managing partner. Ralph was a popular salesman with my colleagues and a heavy user of our quantitative research. In gratitude for analytical work that helped him make sales, Ralph presented our group with an $800 portable bond calculator purchased out of his own pocket. When I was lured away from Bear Stearns by Goldman Sachs, Ralph Cioffi tried to persuade me to stay, matching the offer. Around 20 years had passed and since then we occasionally stayed in touch, but we were not close friends.

Among other hedge funds, Bear Stearns Asset Management (BSAM) managed the Bear Stearns High Grade Structured Credit Strategies fund. By August 2006, the fund had a couple of years of double-digit returns. BSAM launched the Bear Stearns High Grade Structured Credit Strategies Enhanced Leverage fund taking advantage of the first fund’s “success.”

Both funds managed by BSAM included CDO and CDO-squared tranches backed in part by subprime loans and other securitizations (collateralized loan obligations) backed by corporate loans and leveraged corporate loans. In August 2006 when BSAM was setting up the Enhanced Leverage fund, other hedge fund managers (like John Paulson), shorted subprime-backed investments.

Investors in the two funds managed by BSAM had been getting double digit annualized returns on high-grade debt at a time when treasuries were yielding less than 5 percent. In fixed income investments, that usually means investors are taking risk.

Ralph seemed to have similar views to mine on CPDOs, the leveraged product that I had said did not deserve a AAA rating. Ralph told me he thought the AAA rating could “lull the unsophisticated investor to sleep,” and that for the purposes of his hedge funds, if he liked an investment-grade-rated trade he could have the same trade without paying fees and: “easily lever up … fifteen times.” To paraphrase Warren Buffett, if the price of your investments drops, leverage will compound your misery.

On May 9, 2007, Matt Goldstein called and asked me if I had a chance to look at the registration statement for a new initial public stock offering (IPO) called Everquest Financial, Ltd (Everquest). Everquest is a private company formed in September 2006, and the registration statement was a required filing in preparation for its going public. The shares were held by private equity investors, but the IPO would make shares available to the general public.

Everquest was jointly managed by Bear Stearns Asset Management Inc, and Stone Tower Debt Advisors LLC, an affiliate of Stone Tower Capital LLC. I was curious, but I was swamped. I told him no, I was very busy and had not even had a chance to glance at it. He called again asking if I had seen it, and again I said no, “Go away.” The next morning I ignored Matt’s voice mails, but finally took his call the afternoon of Thursday May 10 telling him that I still had not looked at the registration statement and had no plans to do so that day. My first call on the morning of Friday, May 11, 2007, was again from Matt Goldstein. He thought the IPO might be important.

I went to the SEC’s website, and as I scanned the document I thought to myself: Has Bear Stearns Asset Management completely lost its mind? There is a difference between being clever and being intelligent. As I printed out the document to read it more thoroughly, I put aside the rest of my work and said: “Matt, you are right; this is important.” I was surprised to read that funds managed by BSAM invested in the unrated first loss risk (equity) of CDOs. In my view, the underlying assets were neither suitable nor appropriate investments for the retail market.

I did not have time for a thorough review, so I picked a CDO investment underwritten by Citigroup in March 2007 bearing in mind that if the Everquest IPO came to market, some of the proceeds would pay down Citigroup’s $200 million credit line. Everquest held the “first loss” risk, usually the riskiest of all of the CDO tranches (unless you do a “constellation” type deal with CDO hawala), and it was obvious to me that even the investors in the supposedly safe AAA tranches were in trouble. Time proved my concerns warranted, since the CDO triggered an event of default in February 2008, at which time Standard & Poor’s downgraded even the original safest AAA tranche to junk.

The equity is the investment with the most leverage, the highest nominal return, and is the most difficult to accurately price. The CDO equity investments were from CDOs underwritten by UBS, Citigroup, Merrill, and other investment banks.

Based on what I read, Everquest’s original assets had significant exposure to subprime mortgage loans, and the document disclosed it, “a substantial majority of the [asset-backed] CDOs in which we hold equity have invested primarily in [residential mortgage-backed securities] backed by collateral pools of subprime residential mortgages.” Based on my rough estimates, it was as high as 40 percent to 50 percent.

I explained my concerns to Matt in a general way. Among other concerns: (1) money from the IPO would pay down Everquest’s $200 million line of credit to Citigroup; (2) the loan helped Everquest buy some of its assets including CDOs and a CDO-squared from two hedge funds managed by BSAM, namely the Bear Stearns High-Grade Structured Credit Strategies Fund that had been founded in 2003 and the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund (“Enhanced Leverage Fund”) launched in August 2006; and (3) the assets appeared to include substantial subprime exposure.

Matt Goldstein posted his story on Business Week’s site later that day. Initially it was called: The Everquest IPO: Buyer Beware, but after protests from Bear Stearns Asset Management, Business Week changed the title to Bear Stearns’ Subprime IPO. I hardly think that pleased Bear Stearns more.

Ralph Cioffi contacted me about the Business Week article. He said that dozens of IPOs like Everquest had been done—mostly offshore so as not to deal with the SEC. According to Ralph, BSAM’s hedge funds and Stone Tower’s private equity funds would own about 70 percent of Everquest stock shares (equity), and they had no plans to sell “a single share at the IPO date.” They planned to use the IPO proceeds to pay down the Citigroup credit line and possibly buy out unaffiliated private equity investors.

I responded that verbal assurances that there are no plans to sell a share at the IPO date are meaningless. Publicly traded shares can be sold anytime. But even if the funds kept their controlling shares, it was not good news. Retail investors would have only a minority interest which would be a disadvantage if they had a dispute with the managers.

Ralph claimed that subprime was “actually a very small percent of Everquest’s assets.” He reasoned that on a market value basis the exposure to subprime was actually negative because Everquest hedged its risk. Technically, Ralph might have been correct—but the registration statement for the Everquest IPO itself suggested otherwise: “The hedges will not cover all of our exposure to [securitizations] backed primarily by subprime mortgage loans.”

It is fine to talk about net exposure (left over after you protect yourself with a hedge), but one usually also discusses the gross exposure (of the assets you originally bought). Hedges cost money, so they can reduce returns.

Ralph Cioffi said CDO equity is “freely traded and easily managed.” I countered that CDO equity may be easy for Ralph to value, but investment banks and forensic departments of accounting firms told me they have trouble doing it.

I told him that if this were a CDO private placement, it would have to be sold to sophisticated investors and meet suitability requirements, but since it is in a corporation, it can be issued as an initial public offering (IPO) to the general public. It seemed to be a way around SEC regulations for fixed income securities, and it was not suitable for retail investors in my view.

Ralph said he would talk to his lawyers about changing the IPO’s registration statement to add a line about third party valuations. We seemed to be talking at cross purposes, since the registration statement already said that third party valuation would occur at the time of underwriting. The problem with that was that the assumptions for pricing would be provided by a conflicted manager, and assumptions are critical in determining value. Moreover, on an ongoing basis, one had to rely on a conflicted management’s assumptions for pricing.

Ralph did not seem to want to end the discussion, so I asked him if there was something he wanted me to do. He said it would be great if I issued a comment saying I was quoted “out of context,” that my being quoted in Business Week lent credibility to the article and was not helping me, and that I would be “better served” writing my own commentary. I ignored what I perceived to be a thinly veiled threat. I told him that if he wanted me to write a commentary, I would do a thorough job of raising all of the objections I had just raised with him. Ralph seemed unhappy but my thinking he was a hedge fund manager from Night of the Living Dead was the least of his problems."

Excerpted with permission from the publisher, John Wiley & Sons, from Dear Mr. Buffett, What an Investor Learns 1,269 Miles from Wall Street , by Janet Tavakoli. © 2009 by Janet Tavakoli.