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.

Non-Farm Payrolls: US Economy Doing a Great Imitation of a Developing Double Dip

The September Non-Farm Payrolls report was not good news.

This is a remarkably unnatural US economic recovery, with gold, silver, and other key commodities soaring in price, the near end of the Treasury curve hitting record low interest rates, and stocks steadily rallying as employment slumps and the median wage continues to decline.

The US is a Potemkin Village economy with the appearance of prosperity hiding the rot of fraud,  oligarchy, and political corruption.

As monetary power and wealth is increasingly concentrated in fewer hands, the robust organic nature of the economy and the middle class continues to deteriorate.

This is what is happening, and monetary policy cannot affect it.   The change must come from the source, which is in political and financial reform.   And the powerful status quo is dead set against it.



The long term trend of employment has not yet turned lower which would make the second dip 'official' from our point of view. But the prognosis does not look good.

Federal Reserve Issues 'Cease and Desist' Order for HSBC North America

What could a TBTF bank possibly do to deserve an official reprimand from their friends at the Fed? Bank Secrecy Act and Anti-Money Laundering (BSA/AML) related it appears, protecting flows of secrets and cash.

I hope it is not related to HSBC's position as the primary custodian for GLD and helping to 'start of the gold rush' back in 2009 by kicking out all the small fry to make room for more unemcumbered and leaseable London-ready bullion.

"WHEREAS, the Federal Reserve Bank of Chicago (the “Reserve Bank”) reviewed and
assessed the effectiveness of HNAH’s corporate governance and compliance risk management
practices, policies, and internal controls, and identified deficiencies..."

Press Release
Federal Reserve
Release Date: October 7, 2010

The Federal Reserve Board on Thursday announced the issuance of a consent Cease and Desist Order between HSBC North America Holdings, Inc. (HNAH), New York, New York, a registered bank holding company, and the Federal Reserve Board. The order requires HNAH to take corrective action to improve its firmwide compliance risk-management program, including its anti-money laundering compliance risk management.

Concurrent with the Federal Reserve Board's enforcement action, the Office of the Comptroller of the Currency announced Thursday the issuance of a Cease and Desist Order against HSBC Bank USA, N.A., McLean, Virginia, for violating the Bank Secrecy Act and its underlying regulations.

A copy of the Board's order is attached.

Attachment (pdf)

SP 500 and NDX December Futures Daily Charts

There is not a lot of doubt in my mind that this action in the US stock indices is indicative of bubble liquidity, but unfortunately underpinned by weak, cynical hands and thin volumes, and unrelated to economic fundamentals. Some of this is the effect of the upcoming November elections.

You will know the economy is improving when the median wage and employment start increasing. There is no evidence of this yet. Jobs creation remains below the level of population growth.

The Fed created a monetary bubble in 2004-07 which resulted in a bull market in stocks, and spawned a massive housing bubble and bank fraud overhang, the latter of which remains unremediated and a serious impediment to genuine economic growth.

Any serious exogenous event can now lead to a significant correction without direct Fed intervention of a scale much greater than their current POMO activity. Fraud and insider dealing is pervasive, and the Congress is largely under the influence of the banks and corporations because of the existing process of campaign financing.

Gold Daily Chart

Gold corrected back to trend as we noted it might the other day, and said we were taking profits in gold and silver on the short term trades only.

This consolidation was predictable given the extension above trend. Long ago we said we expected gold to move to 1375 and consolidate after the breakout from the handle in the cup formation. This is of a common pattern. We may have already seen this consolidation off the spike up.

Gold will remain in a bull market until the fundamentals change in the real economy with regard to honest stores of value. If you do not understand this by now you may not do so until it is too obvious to do anything about it.

Gold Chart: A Time and Price Projection

It is important to keep in mind that this is a trend projection.

An exogenous event or a change in environment such as a liquidity crisis and equity market crash will test and can certainly alter this trend. As traders we must be mindful of what the market tells us.

As you may recall, I like to use these kind of charts as indications of the progress of a market, rather than hard and fast rules.

For example, the correction we see today in gold is to be expected as we ran well above trend over the past few days. Is this the consolidation we have been expecting around 1375? Very possibly.  That objective was set months ago and is more an indicative target than a hard buy or sell stop.   After a breakout from a cup and handle, price almost always gets ahead of itself and undergoes a consolidative correction.  So, there we may now be.

The equity market SP 500 December futures appear to be hesitating ahead of tomorrow's Non-Farm Payrolls report.  It was at the top of a short term trend channel at 1163 with its lower bound at 1136.  The breakdown of the NDX yesterday was indicative.  That range in the futures is 2025 to 1965.   A break of trend in the SP futures will set up a test of big support at 1120.  The Feds seem to be all over these markets, so I prefer to play it tight, light, and short term until we see a confirmed change in trend.

It is the relationship of the current price to the chart that is most important, with time as a factor.

Gold Daily Chart

Gold and Silver Daily Charts

Gold broke out of its trend channel today on the same monetary euphoria that seemed to drive US equities.

Prior resistance is now support, so we would look for the top of the trend channel to provide some level of potential lift in the case of a consolidation or pullback around the 1325-1330 level. Breakouts from cup and handle formations can be violent, and it would not surprise this chartist to see that run to the first target of 1375 before gold consolidates properly. I would hope gold would take a more leisurely route higher to that second target of 1455 and beyond, our long term minimum objective for the cup and handle, since the big parabolic peaks are almost always followed by deep corrections.

This gold chart gave us a 'buy or die' signal at 1,156 which was an almost perfect 50% retracement of the big rally off the bottom. That buy signal now shifts to 'neutral' as we approach the intermediate objective of the breakout which is 1375 before a consolidation or a pullback. Keep in mind that the minimum measuring objective of 1450 was set in May 2010 although the details are periodically revised as new data is obtained from the chart. It has been a long road since then. Now things get a little more complicated.

Ben Davies' Interview on King World News is a credible hypothesis into what may be happening over the next two years or so. I always assume these large macro changes take time, but there are periods when they reach a tipping point or a sea change and the progress of such changes can accelerate significantly. The markets may be signaling such a major development.

One thing I am sure of is that as this situation plays out and as gold and silver rally higher, the reasons given by some as to why the precious metals should not be doing what they are doing, rising higher in price, will become increasingly strident, insistent, and at times unintentionally funny because they are so disconnected and inappropriate compared to reality.

It requires intelligence and maturity to realize when you are wrong, but it is a mark of character to be able to admit it, gather yourself together, and go forward again successfully, dealing with things as they are. Self-deception is a powerful ally to failure, and rationalization can be remarkably inventive and seemingly inexhaustible. Everyone is admittedly wrong sometimes, except for the deluded, the naive, the con-man, and the narcissist.

Silver is 'taking no prisoners' from the bear camp in its own powerful breakout that continues to extend beyond our expectations. I am of a mind to take some profits off the table for the short term trades, but I certainly would not get in front of this juggernaut just yet, or more seriously hedge the long term positions. That time may come, and the market will let us all know when.

The Guardians of the Realm

How's Your Confidence Now?

 

How About Now?

SP 500 and NDX December Futures Daily Charts

The ISM Services Index came in at 53.2 versus an expected 51.8 and it was off to the races with a day long short squeeze in US equities.

Tomorrow is the ADP report, with expectations of 18-20,000 jobs added in the private sector, a possible peek ahead at the big non-Farm Payrolls Report for September which carries expectations of flat jobs growth.

Personally I think the markets are starting to price in a QE2 stimulus and a whiff of inflation to go with it, with additional inspiration from the example of Japan, which is approaching a level of debt to GDP that generally begins to approach the threshold of hyperinflation to come.

However it develops, I doubt this will end well and remain very cautious of equities, leaving the day with a new small short position. We all have to be mindful of the Fed's ability to blow another asset bubble, more generally in equities. Difficult times to be an investor or a saver indeed.