Pie in the Sky By and By

It is a criminal offence almost everywhere to advertise and sell an article that claims to be made of gold or studded with diamonds but in reality is base metal or glass. So is it not time for some criminal prosecutions against some of the world’s top bankers for doing likewise with financial products?

That is the kind of products sold in such volume as to fund the multi-million dollar bonuses received by the likes of US Treasury Secretary Henry Paulson as recent head of Goldman Sachs, or payouts to sacked chief executives — US$160 million to Stan O’Neal of Merrill Lynch and US$29 million to Citigroup chief Chuck Prince.

The bulge-bracket institutions told the world and their shareholders that they had a low-risk way of making lots of money. They originated mortgages and other loans, and/or they packaged them into Collateralized Debt Obligations (CDOs) which were then sold onto other parties ranging from school boards to pension funds, hedge funds and assorted other financial institutions, including in China and other cash rich parts of the developing world.

This was profitable because of the scale and apparently low risk as the new paper was quickly off the banks’ balance sheets and onto someone else’s. As a result profits soared much faster than bank balance sheets. Meanwhile most that stayed with banks, either in-house or sold to other banks, was deemed Triple A by the rating agencies, thus enabling capital to risk asset ratios remain looking healthy.

This whole process allowed shares of banks to rise to record levels even as their traditional businesses seemed to be increasingly undermined by securitization, non-bank intermediation and a flat yield curve which squeezed lending margins.

The reality however turns out to be rather different. In some cases banks have had throw money after structured investment vehicles (SIVs) to prevent them from collapsing and giving the institutions a bad name. That can be regarded as a misfortune. What goes beyond misfortune to deliberate deception are the cases where it turns out that the buyers of the “sold” paper and SIVs had undisclosed buy-back agreements which the buyers are naturally been keen to exercise now that the market has been exposed for the smoke and mirrors that it always was. In the case of Bank of America, such buy-back commitments were the main reason for a US$3 billion write-off that it has just admitted.

No sale with a one way buy-back arrangement can ever be classed a real “sale”. It was a fraud on the investors in the vending banks to have claimed it as such, and to have announced profits based on those sales. It also is extraordinary that, according to most reports, many of these buy-back arrangements were kept off the balance sheets, with no sign of them as the contingent liabilities they really were.

This looks suspiciously like Enron all over again. And it merely goes to show not only the greed of the financial institutions but the ease with which new-era financial products supposedly dreamed up by the brightest of minds have in reality been a useful cover for the familiar snake oil salesmen and Penza scheme promoters of old.

Again it looks very much as though the auditing cartel remains the creature of big finance rather than the protector of investors, which was the raison d’etre of compulsory auditing by professionals. Not even Enron and the demise of Arthur Andersen has been enough to stop greed trumping professional standards. In auditing you get what you pay for.

Of course not all the toxic rubbish sold by the banks to enrich the bankers personally ended up hitting their shareholders. Much ended up in the hands of complete innocents who had little idea of what really motivates bulge-bracket bankers. These are innocents such as those who bought a much touted variant of the CDO known as the Constant Proportion Debt Obligation. In their simplest terms, they are essentially a leveraged bet on the credit quality of investment-grade companies. One issued by ABN-Amro in July and given a Triple A credit rating by those accomplices in the scammery, the ratings agencies, has fallen to 41 percent of its face value. Even a Bloomberg columnist equated CPDOs to the Nigerian scams which still trap a few innocents.

The bankers will say that none of this was deliberate. They “didn’t understand” their own products. Or were just “following orders,” or this was “market practice” or was “approved by lawyers and accountants”. They were not really to blame so not only should they not be prosecuted but they should keep the multi-million dollar bonuses written into their contracts. That will doubtless be the result and the west will continue to reward and promote financial manipulators at the expense of those who create new industries, new jobs and planet saving technologies.