The Occupy Finance Book – Chapter 5: “The Dirty Dozen Legal Outrages”

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Chapter 5.  "The Dirty Dozen Legal Outrages"

Chapter 5.
“The Dirty Dozen Legal Outrages”

NL: My name is Nicholas Levis, I am a writer and a translator.I’ve studied sociology and I have been very interested in the sociology of the financial sector, especially insofar as it caused the biggest economic crash since the Great Depression.

OPR: What do you mean by the sociology of the financial sector?

NL: Well, I think it’s very important. The level of social relations is really where people become who they are and make the kind of decisions that they make. I think if you really want to understand what’s happened in the financial sector, it [is] important to know the economics and the finance and the numbers, but perhaps it’seven more important to know the psychology and the social relations, the incentives that the traders and the executives and the decision-makers in the sector have. For example, one incentive, the rewards that they make, are the bonuses. There’s a bonus system that’s based on how many deals theymake and what the volume of the deals are. Therefore they have an incentive to make deals no matter what, because they will not be punished if the deals go wrong. Whatever deal they make, they get a cut, whatever volume it has, they get a bonus at the end of the year. So there’s really nothing to stop them. The only incentive is to keep making deals, keep making deals, and to make up reasons in their mind to deny the risks. Because in the end, the risks are only to the institutions and not to them personally. They will still make millions of dollars, even if the institution burns down. Even if the city burns down, the whole world economy crashes, it doesn’t make a difference, they still made their bonuses, so why should they care? That’s one side.

The other side is, they have nothing to fear because every time they are caught committing a crime some settlement will be made, that’s a civil-suit settlement. Some penalty will be paid by the institution, but not by the person. Nobody pays personally, so why should they care? They are never gonna go to prison, or that’s the lesson they’ve learneduntil now. Just twenty years ago they might have gone to prison for some of the frauds they committed, for example [as happened in the 1980s] during the Savings and Loans scandals. But in this latest round,of the mortgage backed securities frauds, nobody went to prison. Noneof the architects, none of the big players of the Wall Street banks, noneof the executives, no Mozilos (Countrywide Financial) or Richard Fulds (Lehman Brothers) or Jaime Dimons (JP Morgan Chase) had to fear. So why shouldn’t they continue acting exactly as before?

OPR: But they created the circumstances in which they can act this way, namely the laws. They changed our democratic system.

NL: Yes, that’s one of the most infuriating things about it, which is that Wall Street in the 2000s played entirely by the rules that Wall Street had written. Wall Street was able to get almost complete deregulation starting from the 1980s and especially towards the end of the 1990s with the repeal of the Glass Steagall limits that allowed investment banks to also be commercial banks, so that banks that hold deposits ofregular people can also speculate in these high-risk deals. By breaking down all the rules they were able to take much higher risks and make a lot more money for them personally, for the executives and the traders, and see no consequences in the end. And it’s really infuriating that playing by their own rules, they committed these frauds, they crashed the world economy, they set up a situation where they had to be bailed out because they were too big to fail, or so they said. They were bailed out, the institutions were bailed out, and the people who were responsible, the decision makers, weren’t punished. They actuallyremained in place. Some of the same people who crashed the world economy, like Jamie Dimon, or like Lloyd Blankfein at Goldman Sachs, are still exactly where they were in 2008. That is infuriating, and not only [because they crashed] the world playing by their own rules, the rules that they had written, but that afterwards they got to blame it on government, oron irresponsible borrowing by the public sector. Now they are blaming it on pension funds, so that is truly infuriating.

OPR: So we are talking about Chapter Five from the Occupy Finance Book and Chapter Five is titled: The Dirty Dozen Legal Outrages. This is basically a chapter how they got away with it and the chapter starts with HSBC. What is the scandal surrounding that?

NL: Well, the business model for Wall Street is becoming increasingly indistinguishable from crime. We picked a dozen really enormous crimes or cheats to discuss, but we could have picked another dozen you know. That’s the hilarity of it, the dark humor of it. HSBC, the Hong Kong and Shanghai Banking Corporation, was founded in 1846 after the opium wars. The British actually fought a war in Chinato force China to accept opium. China wanted to make opium illegal and the British fought against the Chinese and as a consequence of this war, they got Hong Kong, so they started up this bank. So from thebeginning of its history, HSBC has specialized in laundering the money from the illegal drug trade. That is what HSBC actually does historically, since its foundation.

Now, if we fast forward 150 years, in the 2000s evidence was constantly coming out in congressional hearings and various investigations in the press that HSBC was laundering billions of dollars for the Mexican and Colombian drug cartels, and they were finally caught, and in 2012 they were forced to admit to having laundered at least $821 million for the drug cartels. Now let’s keep in mind the US finances and fights this enormous so-called “drug war” in which peoplemight go to prison for possession of a single ounce of marijuana. This isliterally a war in Mexico and Colombia, where the US pays those governments to have gun battles with the cartels. So it’s kind of crazy that it’s discovered that HSBC launders the money for the Colombian and the Mexican drug cartels, and there’s no punishment. The people who decided to do this do not have any criminal consequences, they remain in place, they get to stay there, they learned that crime pays. HSBC, the institution, the bank, is forced to pay a penalty. There’s a settlement with the Justice Department in December 2012. The settlement is for $2 billion, that sounds like a lot of money, but it’s onlysix weeks of HSBC’s profits and again, it’s only institutional, there are no personal consequences. If there are no personal consequences thenthe actual human decision-maker has no reason not to do it again. So we actually had a whistle blower come to us, Everett Sloane, who was an investigator and auditor inside HSBC, responsible for looking for drug money laundering, and he quit because he was being discouragedfrom investigating it and he knew that it was continuing, so he came toAlternative Banking. They’ve actually held press conferences with him and taking him to our protests at HSBC. So of course [HSBC] will continue doing this. Until there is personal punishment of these white collar criminals, there’s absolutely no incentive for them not to do it. All they learned from these “settlements,” so-called, is that crime pays.Because again, settlements only hit the institution, no decision makers,no humans are affected by it

OPR: What do we need to do?

NL: What do we need to do? Well first of all…it’s funny because some of these settlements, JP Morgan Chase for example just had a settlement for $13 billion for fraud on the mortgage-backed securities with the Justice Department. That sounds like an enormous sum, but again it only represents only about a quarter of their annual profits. The problem is that these settlements basically put a price on crime and they only put a price on the institution rather than the people. People have to actually be prosecuted and there are means to prosecute people. There is such a thing as conspiracy law and there is such a thing as fraud law but is not applied to these people. They always try to apply some obscure banking regulations that are extremely hard to prove and why is that? Because they don’t treat them like gangsters even though they are gangsters. They are a mafia,they are a criminal conspiracy, they are exactly like John Gotti. They should be hit with the Racketeering Act (RICO) for criminal conspiracy, like gangsters are, but instead these people are invited to speak to theSenate and celeebrated as the most wonderful people who create all thewealth. There’s the insanity of it. While they plunder with every means they can possibly come up with. That’s financial innovation what they call that… plunder…

OPR: So what do we do?

NL: So what do we do? I think the easy answer is to say these people should be investigated and prosecuted. The easy answer is to say these banks need to be broken up. We cannot tolerate institutions, private for-profit institutions, that claim to be too big to fail because if one of them fails then all of them fail because they’re so interconnected and there’s a huge financial disaster for the world. This cannot be tolerated. These institutions need to be broken up and the people responsible for crime need to be prosecuted but it’s not happening because the government basically is in bed with them. Theyhave captured the regulatory agencies.

One of the funny things about the HSBC story is that the guy at the Treasury Department responsible for terrorist financing, the guy at the Treasury Department who was the main official in charge of investigating drug money laundering, was Stuart Levey (for details on the following, see NL article in">Naked Capitalism). When Levey retired from the Treasury Department in 2011, he went to work for HSBC as their Chief Counsel. So they hired the chief investigator of drug money laundering from the Treasury Department as soon as he leaves the Treasury Department. He’s probably making ten times the salary at HSBC and not only that, the new guy at the Treasury Department, David Cohen, used to be in the same law firm as this Stuart Levey, so it’s a very nice arrangement.

So what am I trying to get at? The point is, they should be prosecuted and the banks should be broken up and it’s obvious that this needs to happen, but it’s not happening. Why is it not happening? Because they captured the government, they captured the politicians, they control the lobbies, they pay for the campaign contributions, they control the politics. Therefore what needs to happen is democracy on the street.

We, the people, need to express ourselves and until we do, none of thisis going to change. There are two kinds of power in the US, there’s money power and there’s people power, and if the people don’t get outon the street and say ‘no business as usual’, you know, this cannot be tolerated anymore that the 1% are benefitting so enormously, all the wealth gets sucked into them so they control 40% of the wealth and 20% of the income, just 1% of the people, this ruling class, and they act with such impunity. If they commit crime they don’t have to worry about it. I mean, they can’t murder someone on television live, but they can steal billions of dollars. They can crash the economy, they cantake unacceptable risks, they can do all these things, and that’s only going to change through a peaceful revolution of the people. We need to get out onto the street, we need to organize for strikes, we need to organize consumer boycotts, we need by every means possible, by civil disobedience, by creative protests, every peaceful means possibleI would say, because there’s no point in any kind of violent protests. They have the monopoly on violence, they will win any violent confrontation. Therefore this needs to be creative and peaceful and educational at the same time because unfortunately many of our fellow citizens are simply not aware of these issues. They are being skinned themselves, or they are apathetic about it because they think they are powerless. That’s not true. They are not powerless, dictatorships get overthrown, this is not quite a dictatorship. We have a lot of freedom in this countrystill, to organize, to speak out, so we should be using it or we will lose it.

OPR: yes, I was just gonna ask, what if we don’t rise up, what is gonna happen in the next 5-10 years?

NL: Well that’s a very good question. I think it’s only going to get worse. I think we’re gonna gradually lose the ability to rise up because at the same time these institutions, like I said, they own the politicians,they own the regulatory agencies, well guess what, they also own the law enforcement. Right here in this city, somewhere downtown at an undisclosed location, there is a central police surveillance office that brings together the police, the FBI, the CIA, agencies that shouldn’t be doing any kind of domestic surveillance at all, presumably the NSA, thestate [agencies of law] enforcement, but also there’s a desk there for the Federal Reserve, for Goldman Sachs, for Pfizer, for Monsanto, for JPMorgan Chase, all the Wall Street banks and several major corporations in the city… all of these private and quasi private-public entities share one giant surveillance and command center with the New York Police Department. This is what was activated during OccupyWall Street, during the occupation of Zuccotti Park.
This is not a secret, it’s just not reported, because the media are too busy talking about I don’t know what today, sports or Kim Kardashian or anything but the reality of this police state that’s being built here.

So the NYPD unfortunately, it should exist to protect and serve the people and really it should be raiding the offices of Goldman Sachs andarresting them and they should be arresting the executives at HSBC the same way they would arrest drug lords. If they found out that therewas a house with drugs in it, then they would go and raid that. Well you know, there’s a house with drug money laundering going on and that’s the HSBC office, but instead of that the NYPD meets with these very same criminal organizations who control the finances in this country and they talk about what to do with peaceful protesters. That’sthe threat, peaceful protesters, and increasingly we have a situation in the rhetoric, and increasingly within the laws, that protest is being equated with terrorism. All crime is being equated with terrorism. It’s just been getting worse and worse in the last twelve years since 9/11, it really opened the way to allow this increasing definition of everything that is deviant, anything that might be criminal, anything that might be protest, is increasingly defined as terrorism. They really opened up the laws so that practically any political activity is potentially defineable as terrorist. This is where we have to stand up and say ‘enough’! The Snowden revellations for example, that should be a signal and I wonder if that signal is not like they’re doing crash-cart on a dead patient… They are saying “clear’, is the patient dead or will the patient rise again? Is there still a live democracy in this country? Because democracy is not a constitution or a set of laws, or regulations in theory. Democracy is a living practice of a living people, or it is nothing. You use it or you lose it.

OPR: So do you thing we have a living democracy right now? Still?

NL: That’s the question. The patient is on the table and they are saying “clear” and they are giving a shock and seeing if the patient is gonna wake up, you know? I think yes we do still have a living democracy amongst millions of people in this country who are organized in many movements for change and who have really gotten an understanding in recent years that business as usual cannot go on, you can’t just picket politely in front of some office or write a letter to your congressman or write a letter to the editor and think this is going to get results anymore. We are really way past that point. We need civil disobedience, creative protest, we need permanent protest, we need strikes, we need a general strike eventually, we need to organize in the workplace and as consumers and by every means, because this is going to be a long struggle to regain some measure of democracy in this country. It’s not going to come about just because we wish it to be so because or because it is the right thing.

OPR: Thank you.

Chapter 5. The Dirty Dozen Legal Outrages

“If serious prosecutions of fraud by Wall Street firms are never brought, the public’s suspicion about Washington’s policies toward bankers will only grow, as will cynicism about the rule of law as it is applied to the rich and powerful.”(1)
Jeff Madrick and Frank Partnoy

The past decade has seen a broad assortment of legal outrages. Wall Street firms have flagrantly violated the law. Often they are not prosecuted at all. When they are, they typically receive a slap on the wrist that will not deter future wrong-doing. At the same time, Congress has passed laws and regulators have written regulations that further entrench Wall Street’s interests. The following are some of the worst.

1.HSBC Laundering Money for Terrorist Organizations and Drug Cartels
Hongkong and Shanghai Bank Corporation (HSBC) laundered billions of dollars for Al Qaeda, Iran, Mexican drug cartels and similar “clients.” When warned by regulators or reported by news media, HSBC alternately denied the activity or said they would stop it. Instead, they allowed it to continue for at least a decade. In fact, an HSBC whistleblower claims it is still going on.(2)(see Chapter 2).(3)

2. 2005 Bankruptcy Law
In 2005, Congress revised the bankruptcy law to make it much more “creditor-friendly.” This is to say, good for the banks, bad for the borrower. To give one example, judges are no longer allowed to reduce amounts owed on student loans to private lenders, even if the schools are scamming,for-profit “degree mills”.(4) Lo and behold, in 2010, student loans pulled ahead of credit-cards as a form of 99% indebtedness. (5)

3. LIBOR Manipulation
Although it is obscure, the London Interbank Offered Rate (LIBOR) is crucial to trillions of dollars of financial instruments —quite possibly including your mortgage, your credit card or your city’s borrowing. Despite its incredible importance to rates around the world, LIBOR is set through casual communications among banks, and traders routinely adjusted these “communications” to benefit one another. They basically skewed the entire international financial system for personal gain.

This episode epitomizes two things about Wall Street. First of all, this was done by traders without apparent oversight. It is not clear that the banks involved actually benefited. But, the traders did increase their own bonuses. A trader has even been quoted as saying, “It’s us against the bank.”(6)The bank in question was his employer. Clearly, the megabanks are unable to govern themselves. Second, this behavior happened at many banks in several countries. It was so common that traders felt no compunction about putting damning statements in e-mail messages. For traders, their bonus is paramount, obligations to their employer are secondary, and consideration of other people is not even on the radar screen.

4. Repeal of Glass-Steagall
After the Great Depression, reforms were put in place to restrict banks from taking risky positions with depositors’ money or with funds borrowed from the Federal Reserve. This reduced the frequency of bank failure for fifty years. But beginning in the 1980s, many of these restrictions were removed, with the capstone being the Gramm-Leach-Bliley Act of 1999. More specifics of this sad history are discussed in Chapter 4.

5. Too Big to Fail / Too Big to Jail
There is a widespread belief that failure of one of the largest banks or other financial institutions could have catastrophic consequences for the economy. Rather than trying to address this threat, the fear of these consequences has been used as justification for bailing out these institutions when they get into trouble (see Chapter 2). President Obama and his administration will claim that this problem was addressed by the Dodd-Frank Wall Street Reform Act. But even the Fed does not believe it. In a major speech on the topic, Federal Reserve Board member William Powell noted, “Success is not assured.”(7) This is Fed-speak for “we have our fingers crossed.” Richard Fisher, President of the Dallas Federal Reserve Bank, is more forthright; he says the banks are still too big, practice crony capitalism, and need to be broken up.(8)

Even worse, too big to fail has been used as an excuse not to prosecute banks even when they admit to a long history of criminal activity (see point 12below, “Lack of Accountability”).(9)

In addition to the injustice of all that, because the megabanks are deemed too big to fail, they can borrow at lower interest rates —in essence, this is a subsidy worth tens of billions of dollars to the banks every year.(10)

6. Special Tax Break for Hedge Fund and Private Equity Managers
Hedge fund managers and private equity executives get a big break on their personal income tax. They pay about half of the ordinary tax rate because their income is deemed to be long-term capital gains subject to a preferential rate —even if it really isn’t.(11)

This is called “carried interest” treatment.(12)

7. Commodity Futures Modernization Act of 2000
In the 1990s, instruments called “derivatives” were traded outside of public view and often without regulatory oversight,in volumes representing more money than the entire world economy. Brooksley Born, then head of the agency with authority to regulate most derivatives, tried to include these within the agency’s scope. This effort was squashed first through the combined efforts of Treasury Secretary Lawrence Summers and Fed Chairman Alan Greenspan, and then by Congress in this so-called “Modernization” Act (see Chapter 4).

8. Privatization of Fannie Mae and Freddie Mac
Fannie Mae was created as a government agency in the 1930s to foster the issuance of long-term fixed-rate mortgages. It served this purpose well for nearly 50 years. But in the 1970s, Congress decided to privatize it. They did the same with Fannie’s brother “Freddie Mac” shortlyafterward. As private companies, they paid their shareholders tens of billions of dollars in dividends by taking enormous risks. But, when the risks turned sour, Fannie and Freddie were deemed “too big to fail” and considered “government sponsored enterprises” and so we, the taxpayers, got to absorb their hundreds of billions of dollars in losses.

9. Fiduciary Obligations of Pension Trustees
Trustees of pension funds might appropriately be concerned not just about the financial returns on investments they secure for participating employees —but also on whether the industries the employees work in survive, or for that matter, whether the world they live in survives. Which means the trustees may want to avoid investing in companies that are engaging in unsavory labor practices, war profiteering, or are contributing to climate change. The plan beneficiaries might in fact agree with these criteria. But, fiduciary obligations have been interpreted to pretty much prevent trustees from considering such “non-financial” factors. This means that the financial criteria that are generated by Wall Street to evaluate investments are effectively all the trustees are allowed to consider when investing trillions of dollars of the 99%’s savings. The harm that may be done by the companies invested in is considered irrelevant.(13)

10. Robo-Signing and the Settlement
After the collapse of the housing market, banks had many mortgages in default. When they took the bail-out money, the banks assured the government that they would work with the borrowers to make the best of the situation. Working with the borrowers would also have been good for banks, in many cases, because it is often more profitable to adjust a mortgage of an existing borrower who is behindthan to try recouping the money on the delinquent loan by selling the house in foreclosure.

Because of the extensive securitization of mortgages, it often wasn’t clear which institution had title to the loans. The law required the banks to work through the documentation and figureit out. But many banks decided neither to work with borrowers nor to go through the pains-taking process of lawfully foreclosing on them. Instead, they hired unqualified people to sign documents without reading them so that foreclosures could proceed quickly. This came to be called the robo-signing scandal.

When the robo-signing scandal came to light, the banks were let off with light settlements and no prosecutions.

11. Companies Are Just Like People … Until They Owe Money
Another not sufficiently discussed, but sadly entrenched, outrage in the law is the use of corporations as a means to run from commercial debts. In a very real sense, that is what the law understands corporations are for. As we have discussed, especially since the 2005 bankruptcy amendments, the ability of human beings to get out from under their debts, especially loans to pay for college, is almost non-existent. Mitt Romney (and the Supreme Court in its Citizens United decision), have told us that “corporations are people,” but it turns out that this is not entirely true. People get stuck with the consequences of their promises (at least the 99% does); corporations do not.

Consider, for example, the fact that a human (as opposed to a “corporate”) person can pretty much give away all of his future earnings by signing papers that obligate him to pay a huge student loan or a home mortgage that he can’t really afford. Say what you may about whether someone should sign such documents, a signature on a loan or a mortgage means what it means: you are obligated to repay. This is not so for corporations.

Because they are really not things at all, but just names on registries, they can easily go out of business, leaving whomever they owed money to, such as their workers, in the lurch. Indeed, when principals of companies (in rare cases) try to back up the promises of the companies they create by saying they will be personally liable for the corporate debt —courts often won’t let them even when the language they have signed agreeing to do this is crystal clear.

Similarly, companies will almost never be found responsible for one another’s debts even if it is overwhelmingly clear that they are run by the same people, using the same phone numbers, and sharing the same office. Again, the motivation here is that companies are entities that are designed to run up debts. Absent extraordinary circumstances, courts will not undermine that purpose by doing something so “inefficient,” so “socialistic,” as holding the humans behind the companies responsible for the damage to society that their corporate creations inflict, even though we know it is these same human principals who stand to benefit on the upside if their companies succeed. If only it were so easy for the broke students who never got the benefit of a good job after graduation to get out of the bet they took in going to college.(14)

12. Lack of Accountability and Prosecution
After running up billions of dollars in losses in their companies and trillions of dollars in “collateral damage” to the economy, the megabanks were not required to replace their CEOs or other senior executives. Not only did the CEOs keep their jobs, they even kept their bonuses, their stock options, and their corporate jets.

In many cases, the CEOs should have been prosecuted. Although some people admit that there were regrettable acts, they still argue that few of these acts were actually illegal. This is not true. We provide a list of some of the crimes below. Despite this extensive law-breaking, there were actually fewer criminal prosecutions after 2008 than after the comparatively tiny 1980s savings and loan scandals (see Chapter 4). In many cases since 2008, no prosecution was brought at all. In others, there was a settlement on terms that amounted essentially to a slap-on-the-wrist. What’s worse, noneof the senior executives was prosecuted.

Although some try to justify the inaction or light penalties by arguing it would have been hard to prove the crimes, this is not an adequate excuse. First of all, as former prosecutor Neil Barofsky noted when he met with Alternative Banking, it is a prosecutor’s job to try hard cases. But secondly, it shouldn’t have been so hard. After the bubble in Internet stocks of the 1990s, Enron’s massive book-keeping fraud, and other corporate accounting scandals, Congress passed the Sarbanes-Oxley Act specifically to make senior executives liable for crimes committed by their companies.(15)

The salt in the wound has been that after seeing the bankers get away with all this, we now get to hear the U.S. Attorney General, Eric Holder, explain why. Holder noted that “I am concerned that the size of some of these institutions becomes so large that it does become difficult for us to prosecute them”(16), specifically because their immensity means any harm to them will harm the economy. They are just too big and too important to be bothered with having their crimes punished. They are literally “too big to jail.” Lack of prosecution, or inadequate prosecution, only encourages continued law-breaking.

1 Jeff Madrick and Frank Partnoy, “Should Some Bankers Be Prosecuted”, New York Review of Books, November 10, 2011

2 Marni Halasa, “Is Anybody Listening? HSBC Continues to Launder Money for Terrorist Groups Says Whistleblower” Huffington Post, August 28, 2013

3 “HSBC money laundering report: Key findings”, BBC News, December 11, 2012

4 Kayla Webley, “Why Can’t You Discharge Student Loans in Bankruptcy?” Time Magazine, February 9, 2012.
Maureen Tkacik, “Student Debt: The Unconstitutional 40-Year War on Students”, Naked Capitalism, August 15, 2012

5 Mark Kantrowitz, “Total College Debt Now Exceeds Total Credit Card Debt”,, August 11, 2010.
Linda E. Coco. “Debtor’sPrisonintheNeoliberalState: “Debtfare” and the CulturalLogicsof the BankuptcyAbusePreventionandConsumerProtectionActof2005” California Western Law Review,2013.
Available at:

6 John Lanchester, “Let’s Consider Kate”, London Review of Books, July 18, 2013

7 Speech by Governor Jerome Powell, “Ending ‘Too Big to Fail’”, Institute for International Bankers2013 Washington Conference, March 4, 2013

8 Pedro Nicolaci da Costa, “Richard Fisher Says Too-Big-To-Fail Banks Need to Be Broken Up”, Huffington Post, March 16, 2013

9 “The Untouchables”,PBS Frontline, January 22, 2013

10 Dean Baker and Travis McArthur, “The Value of the ‘Too Big to Fail” Big Bank Subsidy”. Center for Economic and Policy Research, September, 2009.

11 Jacob Goldstein, “Carried Interest: Why Mitt Romney’s Tax Rate Is 15 Percent”, Planet Money on NPR,January 19, 2012.

12 The preferential treatment of capital gains should not exist at all. It is not at allclear why capital should be taxed less than labor. What’s more, it creates opportunities for tax gimmicks. Reagan abolished in 1986 with no ill effects. Unfortunately, it was brought back under Bush I. But, even if there is a preferential rate for capital gains, it is clear that carried interest should not qualify.

13 Mason Tenders Dist. Council Welfare Fund v. Thomsen Constr. Co., 301 F.3d 50, 52 (2d Cir. N.Y. 2002)

14 See Donovan v Bierwirth 680F.2d 263 (2d Cir. 1982)

15 Marian Wang, “Why No Financial Crisis Prosecutions? Ex-Justice Official Says It’s Just too Hard”,ProPublica, Dec. 6, 2011“Prosecuting Wall Street”, 60 Minutes, December 4, 2011 Jeff Madrick and Frank Partnoy, “Should Some Bankers Be Prosecuted”, New York Review of Books, November 10, 2011

16 Mark Gongloff, “Eric Holder Admits Some Banks Are Just Too Big To Prosecute”, Huffington Post, March 6, 2013


CDOs, CDSs, and Magnetar Capital

Manipulating internal risk models
One way people make money in the finance industry is by taking intelligent risks. You get your “edge” through figuring out that things are mispriced and betting on that knowledge.

Of course, every bet involves risks, and not all bets will be correct. You will sometimes get burned, but over time, you hope, the wins will exceed the losses, and what really matters is that, relative to the risk you take on, your profits are good. That is in fact how traders are measured and how bonuses are awarded, so there’s a lot on the line.

Instead of understanding each bet individually, a bank or hedge fund, generally speaking, tries to keep track of only the risk that each of their trading groups is takingon as a whole. Each group is required to have a risk model which measures their risks in various ways. Each group is also given a “risk limit” which they are expected not to exceed and which they divvy up among individual traders inside the group. All of this is a way to keep things reasonably safe for the firm. But since there’s such a strong connection between risk and reward, the individuals in each trading group always want the group’s risk limits, and their individual risk limit, to be higher.

Leading up to the financial crisis in 2008, there was a pretty well-known (and widely-used) method of working around the pesky requirements for having a risk model and paying attention to risk limits in one’s group.Namely, the group would let a “risk guy” into the group for a while, just long enough to for him to create a half-decent risk model, and then the group would say, “Thanks but we don’t need you anymore, we’ll run with this”. Then the risk guy would be kicked out of the group. The group would then spendthe next few years learning how to “game”, or manipulate, the risk model.

For instance, traders would figure out exactly what kind of trades to make so that the risk model wouldn’t be able to “see” them. No model is perfect so every model has blind spots,namely risks that are ignored, overlooked, or underestimated. By taking these positions, they could potentially make more money while remaining technically within the risk limit. Even better for risk takers and common at the time, the market would change and new instruments would be created. So the risk model would be applied to instruments it wasn’t even meant to measure.

The game went like this: it was important to always stay within the preset risk limits –as measured by the risk model –even while thegroup took larger and larger bets on things that were invisible to the risk model. As long as the world didn’t blow up, this method returned higher-than-expected profits, so the group’s profit versus its stated (but not actual) risk looked great.

Individual members of the group would get rewarded for this. In the meantime the company they worked for took on the risk and, typically, didn’t see it as coming from any specific trading group but rather as some type of systemic risk. Or, because the instrumentsdidn’t have publicly available prices, the traders would make up prices or get their friends at dealers to make up prices that made the positions look less risky than they really were or that were more stable than they should be, so the risk wouldn’t showup at all.

It’s not clear how many people or how high up were those who participated in this scam, but it seemed pretty clear that they enjoyed the ride as long as it lasted. As Citigroup CEO Chuck Prince said in July 2007, as things were starting to fall apart, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” (1)

The Collateralized Debt Obligation (CDO) market
One really enormous and tragic example of how people can game the risk model is described in Yves Smith’sbrilliant book Econned2, in the chapter describing theCDOmarket andMagnetar Capital’s involvement. One can argue that CDOs were the reason the housing bubble turned into a full-blown global economic crisis, so it’s important to understand them at least at a basic level.

What are CDOs anyway? The CDO market is complicated, and you can learn a lot about it by reading Smith’s book. What follows is a very simplified version.

In the late 1980s through the mid-to-late 1990s, there were not that many securitizations outside of the federal arena (namelyFreddie Mac, Fannie Mae,and Ginnie Mae), and they were pretty useful because they made pools of mortgages more predictable and tradable than individual mortgages.

Recall from the previous insert titled What is Securitization?that, after being created, securities were sliced into groups called “tranches” depending on how they would be treated if the underlying mortgages defaulted. Back in the 1980s, the pieces at the top of the securitization pile were given the highest possible rating, AAA, by Moody’s and S&P (later joined by Fitch and dubbed the “big three rating agencies”), because they had a big cushion of loss protection beneath them. The lower tranches had lower ratings such as BBB and were harder to sell, which limited the size of the overall market.

Starting around 2003 the lower-rated, harder-to-sell tranches started getting re-securitized into new instruments, which were called Collateralized Debt Obligations, otherwise known asCDOs.

So, just as the mortgage-backed securities took questionable mortgages and converted them into securities that people were willing to buy, CDOs were the next step: they took the very worst mortgage-backed securities and repackaged them into new securities. To sell these profitably, they needed the stamp of approval from the rating agencies who are supposed to be independent, objective evaluatorsof the credit-quality securities. However, as securitization became widespread, theagenciesbecame severely compromised. Issuers pay the rating agencies to rate their securities. This creates a conflict of interest,but it wasn’t too harmfulwhen they were rating bonds from many different companies and no one set of issuers were dominant. But with securitizations, massive amounts of securities were being issued by the banks.

In addition, rating agencies are low in the food chain and so pay less compensation than the banks and hedge funds. So employees of rating agencies would see the banks aspotential employers and so would be particularly disinclined to ask questions. Everyone at the rating agencies had large incentives to please the banks by putting the highest ratings on the securities.

They were convinced that because many mortgages, or CDOs,were being pooled together, they would benefit from the magic of diversification and the risk would go away. If it seems that they really believed this, remember Upton Sinclair’s dictumthat “It is hard to get a man to understand something when his livelihood depends on his not understanding it.”

Once the securities had gotten the rating agencies’ stamps of approval, the banks could find willing buyers of them who were happy to buy AAA-rated securities that yielded morethan others. If this again seems naïve, it was. But the decisions were being made by people who were managing other people’s money. They would not personally take the losses. And AAA-rated securities had been safe in the past.

In fact there were even riskier CDOs, called mezzanine CDOs, which consisted mainly of the BBB tranches, and so-called “high grade” CDOs consisting mostly of old A and AA tranches. These mezzanine CDOs were again securitized, with around 75% of them getting anAAA rating.

Yes, you read that right: if you bundled together a bunch of easy-to-imagine-they’d-fail low-rated mortgage bond tranches –even though you knew the terms of those mortgages and how much they depended on the housing market to continue its climb—most of the resulting package would be deemed AAA. The riskiest securities received the highest rating.

It made no sense then and it makes no sense now.

The Credit Default Swap (CDS) market
Enter the credit default swap (CDS) market.

First, what is a CDS? People have correctly described it as an insurance contract on a bond. So, for some quarterly fee, you can insure the value of a bond you purchased against the risk of default.

Say, for example, that you own a 5-year bond issued by a large company like Sears. Then you might be worried about the possibility of Sears having financial problems and defaulting on this bond. If you buy a 5-year CDS to protect your bond, then if Sears does default, you’ll get back your lost money from whoever wrote the CDS –as long as that insuring entity hasn’t gone bankrupt itself.

But the amazing thing is that, unlike normal homeowner’s insurance, you don’t actually need to own the Sears bond (the “underlying bond”) to buy CDS “protection” on it. In other words, you can buy insurance on a bondyou don’t own. That is, you can bet that Sears will default on its bond, since you can pay a quarterly fee for the chance to make a bunch of money in the case of default.

Also, you could buy CDSs for financial instruments other than bonds. It was also possible, and common, to buy CDSs to protect the tranches of securitized products, like mortgage-backed securities or CDOs.

Remember the discussion about how risky these investments were, standing by themselves? Now a product had been invented to remove the risk from these financial time bombs. Well, actually not to remove it but to pass it on to someone else. Who ended up with this risk? Read on.

So how did traders use CDSs in their bets surrounding the mortgage market?

Hedge fund tradersbought CDS protection on higher, less risky trancheswhile selling protection on a lower tranche of that same CDO. Because the higher tranche was supposed to be less risky, protection on it was cheaper and so they could buy more protection than they sold without actually having to pay any money. The traders were betting that “if things go bad, they will go really bad”, while limiting their overall exposure.

In other words, if all the tranches failed,then the traders would be paid more money on the higher tranche than they lost on the lower tranche, so they would end up far ahead. The only situation where they lost money is when the lower tranche went into default but the higher tranche didn’t, which they thought unlikely. Remember, all those tranches were made from super shaky mortgages, so there’s no reason to think some of them would go bad but others wouldn’t —they’d probably all go down together.

Moreover, the income on the lower rated tranche, i.e. the money coming from those risky mortgages, would be sufficient to pay for the CDS fees on the higher rated tranche. In finance this is called a “self-financing bet,” which means that traders at banks and hedge funds could do this a whole lot. Which they did.

The synthetic CDO market
Recall that a CDO is a re-securitized security. The money paid out from a mortgage-backed CDO comes from a bunch of mortgages somewhere, even though it takes a few twists and turns to get there.

But what if the demand for CDOs outstrips the supply? In the mid 2000’s, investors became hungry forever more bets on the mortgage market. In fact there was more demand than could be sustained by the large but finite mortgage market at the time.

The demand for more CDOs (and for more CDSs to play the game described above) led some clever traders to figure out that they could create CDO-like instruments, which they called “synthetic CDOs,” from credit default swaps rather than from actual bonds. The money coming from synthetic CDOs wasn’t paid by mortgage holders, but rather from premiums the traders werepaying on the CDS contracts.

Once synthetic CDOs were invented, the banks could create more CDOs (synthetic ones) without even going to the trouble of issuing more mortgages. Moreover, traders could bet against the same crappy BBB bonds again and again and have them packaged up with most of the value of the “synthetic” CDO rated AAA, again with the collusive help of the ratings agencies.

The first mortgage-backed synthetic CDO was issued in 2005. By 2006, the synthetic CDO market was by some estimates bigger than the actual CDO market.

Who was doing this stuff?
At first, the big protection sellers in the CDS market were insurance behemoth AIG and other insurers. This makes sense since CDSs are like insurance. But the insurers only wrote CDSs on the least risky AAA CDO tranches.

Later, after AIG stopped being involved –not soon enough, as we later saw –that side of the CDS market was entered into by all sorts of unsophisticated investors with help from the complicit ratings agencies who kept awarding AAAratings because they were being well paid to do so.

Even so, there was still a problem for this re-re-bundled heavily synthetic CDO market. Namely, it was hard to find people to buy the so-called “equity tranche”, which was the tranche that would disappear first, as the first crop of the underlying loans defaulted. This tranche contained mortgages that no sane person expected to pay out, which is why it was considered toxic.

That’s when hedge fund Magnetar Capital, and others, got into the act. They set up deals that were designed to fail so they could profit by betting against them. Banks were willing to allow anyone willing to buy the equity tranche to design the synthetic CDO themselves. By agreeing to buy the equity tranche, Magnetar got to create CDOs designed to fail. Why would they do this? Because they could make much bigger bets against the AAA-rated tranches. Also, the equity tranche, because it was risky, paid out a lot of cash quickly. If they were lucky, they could get enough cash out to pay for theirbets. In any case, they would win big as long as the CDOs failed catastrophically —which they did —exactly as they had been designed to do.

The CDOs that Magnetar designed to fail were then sold by banks to pension funds and other global investors. The banks selling them did not consider it relevant to tell the buyers that the deal was designed by a hedge fund that was making a huge bet on their failing.How big was this? Magnetar Capital accounted for the majority of the synthetic CDO issuance in 2006, which was one of the biggest years in this market. And everything they did was legal, although the banks committed fraud when they sold the deals without mentioning who designed them and why.

If this seems immensely complicated and confusing, it’s because it is, and it was designed to be that way.

Let’s go back to the groups manipulating their internal risk models from the beginning of this insert. The same thing happened here, except instead of individual traders fooling the company they were working for, Magnetar was fooling the entire market. Instead of one risk guy, there was a combination of the rating agencies, AIG and naïve investors.

In the end, it was the investors who’d been duped into buying this stuff and ultimatelythe United States and various European governments who were on the hook, which is to say, us.

How predictable was this whole scheme? Some people at Goldman Sachs and Deutsche Bank knew exactly what was happening and what was likely to happen. They made a very intelligent bet that if and when the housing market went under, AIG would be backed by the government.

In essence this entire market was an enormous bet on a government bailout. Not everyone knew this, of course, especially the guys who were still betting on the mortgage market when it collapsed, but lots of people knew. These are some of the same people who, right now, are lobbying against reasonable financial regulation.

This story argues for, at the very least, the treatment of CDS as insurance with the associated regulations. Any thinking human being should recognize that you first need to own something in order to buy insurance protection on it, just like with home and fire insurance. Imagine it this way: Magnetar identified buildings they didn’t own, where they saw arsonists enter with gallons of gasoline and matches, and then bet everything on the probability of fires in those buildings.

1 Michiyo Nakamoto in Tokyo and David Wighton, “Citigroup chief stays bullish on buy-outs”, Financial Times, July 9, 2007

2 Yves Smith, ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism, Macmillan201

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