Coyote Blog

Or maybe it is more correct to say that the taxpayer is being set up to keep BofA counter-parties whole. From Bloomberg, via Zero Hedge:

Bank of America Corp. (BAC), hit by a credit downgrade last month, has moved derivatives from its Merrill Lynch unit to a subsidiary flush with insured deposits, according to people with direct knowledge of the situation.

The Federal Reserve and Federal Deposit Insurance Corp. disagree over the transfers, which are being requested by counterparties, said the people, who asked to remain anonymous because they weren’t authorized to speak publicly. The Fed has signaled that it favors moving the derivatives to give relief to the bank holding company, while the FDIC, which would have to pay off depositors in the event of a bank failure, is objecting, said the people. The bank doesn’t believe regulatory approval is needed, said people with knowledge of its position.

Three years after taxpayers rescued some of the biggest U.S. lenders, regulators are grappling with how to protect FDIC- insured bank accounts from risks generated by investment-banking operations. Bank of America, which got a $45 billion bailout during the financial crisis, had $1.04 trillion in deposits as of midyear, ranking it second among U.S. firms.

“The concern is that there is always an enormous temptation to dump the losers on the insured institution,” said William Black, professor of economics and law at the University of Missouri-Kansas City and a former bank regulator. “We should have fairly tight restrictions on that.”

Obviously I am not a huge fan of bank regulation, but if the taxpayer is going to insure deposits, then the government has got to set and enforce capital restrictions on how those deposits are invested.  How many times do we have to learn this lesson?  The S&L crisis and the Texas bank collapse of the 1980's was caused by the exact same BS, investing taxpayer insured deposits in increasingly risky investments.

Normally, in a free economy, we expect lenders to enforce rules and discipline on those to whom they lend, just as fire insurers in the 19th century developed the first building codes and inspections to protect their themselves.  But if depositors are insured, they are not going to get worked up too much about BofA -- I am a depositor but I know the Feds will make me whole if the bank crashes.  Deposit insurance provides comfort to depositors and pays some dividends in heading off bank panics, but at the same time it relieves the bank of any accountability for how the deposits are invested unless the US government takes on that role.  Of all the BS regulations financial firms have to put up with, this is the one that should actually exist, and the implication in this article is that despite thousands of pages of new regulation, these basic protections still don't exist.  Sure, they exist in law, but there seems to be nothing to stop an agency from issuing exemptions, and this Administration has shown itself to love giving exemptions.

This reminds me a ton of the AIG bailout.  For some reason, there are a group of Wall Street companies (cough Goldman cough) that seem to have immense political power to protect investments in which they are a counter-party.  To this point, people have been expecting that the BofA holding company might soon fail, but the underlying banks would be fine and just sold off in pretty good shape.  Most of the trash is apparently at the holding company level.

The losers in all this are the counter-parties to these various derivatives, who would rather have a better set of assets to grab if the ship starts sinking.  Of course, they don't have any right to this -- they didn't make these original deals with the depository banks, they made them with Merrill Lynch and other trash BofA has bought.  But never-the-less, the Fed seems fired up to give these guys a special deal.  It reminds me of the Solyndra deal where the Administration allowed certain private parties to move ahead of the US Government on the creditor list, though at least in Solyndra's case these parties actually put some money into the pot for the privilege.  This seems to be a straight giveaway, and it is no surprise that the FDIC is apoplectic.

Ken Lewis gets his payoff for knuckling under to Paulson and Bernanke on the Merrill Lynch acquisition

Kenneth Lewis, outgoing chief executive of Bank of America Corp., will get no salary or bonus for 2009, according to people familiar with the matter, the biggest Wall Street name thus far to come under the thumb of the government's pay czar.In fact, Mr. Lewis will have to repay the North Carolina-based bank more than $1 million in salary he has already earned.

The move was demanded by Kenneth Feinberg, the U.S. Treasury Department's special master for compensation, and was agreed to by Mr. Lewis and the bank.

After forcing Lewis to deal fraudulently with his shareholders, they cut his pay to zero. Nice. Lewis will do fine, he has a nice fat retirement, but it is still a pretty scary development for those of us who still care about contracts and individual liberty.  Just ask yourself - what objective standard did Feinberg apply?  Can't come up with one, can you?

I am just fine with prosecuting mortgage brokers for fraud  who deliberately misrepresented the payments and risks of the loan products they were selling.  However, to be fair, we must then also prosecute borrowers and home buyers who deliberately misrepresented their assets and income to lenders, actions that are equally fraudulent.

Or, we could just let the whole foreclosure and bankruptcy system sort everything out and let bygones by bygones. 

Interestingly, it seems to be advocates for borrowers who want to stir the whole fraud thing up and are reluctant to just let the system play itself out.  I find this odd, for a couple of reasons:

• Fraud by lenders will be hard to prove, since they all are covered by written disclosures that I am sure reveal all the terms of the loan.  The government itself has designed a number of written disclosures lenders must use  [by the way, if reformers want to start somewhere, they might begin with these government disclosures.  My experience is that they are silly and uninformative, and were put together by someone in the government who does not actually understand loans].  Fraud by borrowers, on the other hand, should be dead-easy to discover - they signed their name to an income statement and list of assets and liabilities which are quite easy to check.
• The current foreclosure and bankruptcy system is pretty fair to borrowers.  In particular, in the case of subprime loans where the borrower has little equity, foreclosure costs almost nothing in current dollars - all the loss is on the bank, with absolutely no come-backs on the borrower in the future.  The borrower must endure years of difficult credit and rebuilding trust in the system, but that is the kind of minimum cost we should expect a foreclosure or bankruptcy to carry.  We always seem to get worked up about foreclosures, because we have this picture of someone losing a home they have lived in 20 years and losing all their equity.   But in these subprime cases, where the buyer has been in the home only a few months and put in virtually no equity, I think our mental picture of the costs, at least to the borrower, of foreclosure are overblown.

As an aside, I am easily convinced that there were many mortgage brokers offering their customers atrociously bad deals and rates.  I can't imagine personally not shopping around for mortgage rates from multiple suppliers, but there are clearly people who want to walk into one guy's office and buy something from that first person.   And a number of these people chose to do business with firms that gave them really poor service (if service is defined as getting the best possible loan for the buyer).  Which gets me to the subject of branding.

I know that there are a lot of folks, particularly on the left, who hate large corporations and national brands, but to a large extent the uneven and unpredictable quality of mortgage brokers may be due to a lack of national players and national brands in mortgage brokering. 

Mortgage brokers, stock brokers, and real estate brokers are all licensed by the government.  By statist thinking, that should be enough to ensure quality.  But while stock brokers and real estate brokers can be independent, most of them have organized themselves into groups under a brand name (e.g. Merrill Lynch or Century 21).  Few such national brands, if any, exist in mortgage brokering.

These brands exist because they have proven themselves useful and valuable to consumers.  Presumably they communicate some form of quality or reliability or capability beyond the level that having a government license affords.  This is not necessarily a gaurantee of perfection, of course.  Certainly Merrill Lynch brokers, form time to time, have been accused of fraudulent behavior.  But Merrill has been very fast to act on these occasions, taking actions designed to save its brand from being tainted.  It is this incentive, plus the history such brands carry in the collective memory, that gives consumers extra confidence to use brokers with these brands rather than individual practitioners.

If I was a contrarian with a load of money and a knowledge of mortgage brokering, I might be thinking about building a Century 21 or Remax-type brand in mortgage brokering.

Tom Kirkendall has an update on the various Enron cases, starting with the Nigerian barge case where  the conviction of four Merrill Lynch executives was vacated by the Fifth Circuit.  In fact, the appeals court ruling was so damning that the DOJ has decided not to retry the executives, and the case may well be a leading indicator that other Enron-related prosecutions are in jeopardy.

Although expected, the DOJ's decision in the Nigerian Barge case
reverberates through several other pending Enron-related cases. The DOJ
can retry three of the four former Merrill Lynch executives, but that
would be petty by even the DOJ's standards given the eviscerated nature
of the original charges and the fact that each of the defendants has
already spent a year of their lives in prison based on a prosecution
that was based more on resentment than on true criminal conduct. The
Fifth Circuit's now final decision in the barge case casts doubt (see also here) on a substantial number of the charges upon which former Enron CEO Jeff Skilling was convicted, and dispositively blows away over 80% of the case against former Enron Broadband executive Kevin Howard. In addition, the re-trials of Howard's former co-defendants from the disaster that was the first Enron Broadband case are now in various states of disarray, as is the pressured plea deal of former mid-level Enron executive, Chris Calger. And don't forget the mess that is the DOJ's case against the NatWest Three (see also here).

I have been following the Lay/Skilling Enron trial fairly closely, if only because in a past life I worked briefly with the principles, having worked with Jeff Skilling at McKinsey & Co. before he went to Enron.  By the way, if this causes you to assume this makes me particularly sympathetic to the gentlemen, think again.  Jeff Skilling is one of the brightest and most detail-oriented people I have ever worked with, giving me near certainty that his testimony before Congress where he imitated Sargent Shultz (I know nothing... NOTHING) was perjurous.   So I am not entirely neutral, but maybe not in the way you might imagine.

However, all that being said, Tom Kirkendall (whose blog is here and is doing a great job keeping up with the trial) has a very interesting post on the fairly scary tactics the Enron prosecution task force has brought to bear on a number of Enron and Enron-related defendants:

In an unprecedented move, the Task Force has named over 100 co-conspirators
in the case. So, the potential definitely exists for substantial
testimony about out-of-court statements going to the jury without the
defense ever having an opportunity to cross-examine the persons who
made the alleged statements. Moreover, fingering unindicted
co-conspirators is an equally effective technique for the Task Force to prevent testimony that is favorable to the defense
because persons named as unindicted co-conspirators are likely to the
assert their Fifth Amendment privilege against self-incrimination and
thus, not be defense witnesses during the trial. Thus, the Task Force's
liberal use of the co-conspirator tag has a double-whammy effect -- not
only does it allow the Task Force to use out-of-court statements
against defendants without having the declarant of the statements
subjected to cross-examination, it has also effectively prevented
previous Enron-related defendants from obtaining crucial exculpatory
testimony from alleged co-conspirators who have elected to take the
Fifth and declined to testify.

The co-conspirator tactic has had a huge impact on two of the previous Enron-related trials. During the Nigerian Barge trial,
the Task Force used out-of-court statements of co-conspirators
regarding the key factual issue in the case -- that is, what was said
during a conference call between several Merrill and Enron executives,
including former Enron CFO Andrew Fastow -- without ever having to put
a witness on the stand who actually participated in the call.
Similarly, none of the dozens of unindicted co-conspirators testified
on behalf of the defendants during that trial, so the Task Force's use
of the tactic effectively prevented the Merrill Lynch executives in
that case from providing the jury with exculpatory testimony. Not
surprisingly, the Task Force's liberal use of the co-conspirator tactic
has become a key appellate point for the Merrill executives in the appeal of their convictions.

Similarly, the importance of the co-conspirator issue on freezing
out exculpatory testimony was brought into full focus during the trial
of the Enron Broadband case last year. In a trial that, at the outset, appeared to be a sure-thing for the prosecution, the Task Force's case unraveled quickly as witnesses Lawrence Ciscon and Beth Stier
both testified to a riveted jury about how the Task Force's threats of
prosecution against them gave them second thoughts about providing the
exculpatory testimony that they gave during the trial. That trial ended
in a disastrous mix of acquittals and jury deadlock on the prosecution's charges.

The ability to face and cross-examine your accusers is a fundamental part of the American legal system.  Even well-intentioned relaxing of this principle has in the past led to innocent people going to jail.

Update:  Kirkendall writes that the same issue is being addressed on appeal in the Worldcom trial of Bernard Ebbers.