This is the Wizards of Money, your money and financial management series, but with a twist. My name is Smithy and I’m a wizard watcher in the Land of Oz. This is part 15 of the Wizards of Money series and it is entitled “Homeland Securitizations and Overseas Vacations”… A Journey Through the Financial Twilight Zone.
Introduction
In this, the fifteenth edition of Wizards, we are going to take a look at the adventures that financial institutions send their financial instruments on – both at home and abroad. On this journey through the “Financial Twilight Zone” we’ll look at some of the financial tricks receiving attention in today’s corporate and banking scandals, as well as the rescue packages available for homeland capital getting into trouble in its overseas adventures.
On the issue of “Homeland Securitization” we will first look at the process known as “Securitization”, whereby anything that has a stream of cashflows emerging in the future can be bundled up into a new financial security and sold for cash today. And that literally means anything with a future stream of cashflows – from home loan and credit card repayments, to David Bowie songs and football ticket sales, to health club membership fees, to insurance against bad weather, and to the delivery of oil and gas by the now famous energy companies. We will start with a look at the biggest Homeland Securitization market of all – that for home mortgages, and some of its biggest players, from the banks to the mysterious bodies known as Fannie Mae and Freddie Mac. We will look at the use of securitization and its associated “Special Purpose Vehicles” as tools for regulatory avoidance and enhanced returns, and as the catalysts for Urban Sprawl and daily Credit Card Solicitations. We’ll also study the generation of what is known as “Toxic Sludge” on federally insured bank balance sheets, the relationship between securitization and the secret Over-the-Counter Derivatives Casino, as well as the hidden systemic risks that don’t get much attention.
In studying “Overseas Vacations” we will see how a summer trip to a Caribbean Island or a Swiss chalet for the snow season can provide great regulatory relief for stressed-out financial instruments securitized in the homeland. We take a critical look at the additional risks all this regulatory avoidance poses for each of us as bank depositors and taxpayers.
The Twilight Zone … the “Other Dimension” of Financial Transactions
To get started we need to cross into a whole new dimension – the world in between the two end points of a financial instrument or transaction. Just like the twilight zone wedged in between day and night, this strange world in between a debt on my balance sheet and an asset on somebody else’s books, is occupied by a cast of characters the majority of people just quite can’t see. You might have heard some of the names, or some rumors about them, but you can never quite see them clearly.
Before crossing into this “other world” underlying the financial system let’s just get a taste of how the regular daytime world we are used to interacts with this other dimension we can’t see.
We all interact with financial instruments at one end or another of this mysterious twilight zone of financial transactions. We do this by buying a home, shopping with a credit card, buying an insurance policy, having a pension fund, or even going to watch a movie, or buying a book or a CD. But few are aware that each such “every-day” action triggers a complex chain of events rippling through the financial ether world.
For example, your home mortgage may have got bundled up with thousands of others, packed in to a Special Purpose Vehicle and shuttled off to some remote island, split into 5 different tranches, four of which have been bought and sold at least ten times in the market and one of which ended up in the pension fund of your cousin in Chile. Layered on top of these five tranches are hundreds of derivatives contracts, swapped over and again throughout the global financial markets, one of whose positions was, quite by coincidence, taken by the insurance company you bought a policy with when you took out your mortgage. In addition, you might be interested to know that this insurance policy is actually no longer with the insurer you bought it from. It’s already off on a European vacation after being passed to a pool of European reinsurers and, in the process of crossing the Atlantic Ocean, managed to drop the extra baggage of “safety nets” required by US regulators to ensure the security of your future claims.
So … what’s going on? To get started in understanding this “other dimension” you need to get into a Special Purpose Vehicle to cross into the Financial Twilight Zone.
A Trip to the Financial Twilight Zone in a Special Purpose Vehicle
Having passed into the Twilight Zone in the only vehicle that can get you there, now you are going to have a look around at the scenery and at the main players.
Entering the Twilight Zone, the first thing you will notice is that the atmosphere is thick with financial securities and this takes the place of the regular air we are used to in the regular daylight world. The quality and quantity of this twilight zone atmosphere is regulated by the characters known as the investment bankers, who seem to be everywhere.
Traveling around the Twilight Zone you see some familiar faces … they look like the federally insured banks that we are used to seeing during our daily lives, except that they are dressed a bit differently and look very relaxed. Some – saying they are on a trip to Bermuda or the Bahamas – are dressed in their shorts and swimming outfits. Others, dressed up in their skiing gear, say they are touring the Swiss Alps. All in all, they say that the paths through places like the Caribbean Islands and Switzerland make travel through the Twilight Zone a lot smoother. And certainly one can easily see that, in this environment, the bankers are much more friendly and easy to get along with than when you come across them in broad daylight. One thing that’s a bit unsettling about them though … When you look behind their banking houses you see piles of “Toxic Sludge” that nobody in the Twilight Zone wants to talk about. When you question the bankers about whether it’s going to get cleaned up, the cheerful disposition suddenly vanishes and they give you a look that clearly says “If you keep asking questions like that, you’ll never make it back out into broad daylight.”
Excerpt: Closing Statements, Twilight Zone Episode 52 1961. Rod Serling
Quickly moving on from that tense situation, you come across the insurers you are also used to seeing in your daily life. They are dressed up in a similar fashion to the bankers though they are not exactly as happy, they say, since they don’t have the support of the federal deposit insurance. However, it’s the good deals from their mentors, the global reinsurers, that seems to cheer them up a lot.
Over on the horizon you see two huge bodies, actually bigger than most of the bankers and insurers dotting the landscape. You can’t quite make them out, even when you get up close, but they introduce themselves anyway as Fannie Mae and Freddie Mac. It’s hard to tell what they really are and the information you get from them is confusing. You ask them “Are you private bodies or are you government bodies?” And you never get a straight answer. In fact every time you ask, Freddie says private and Fannie says government. Then the next time you ask it’s the other way around! As always, in travel throughout the twilight zone, investors are always whizzing by, but when you ask them, they seem just as confused about the status of Fannie and Freddie. So its best just to give up and move on.
Usually, if you are confused about the atmosphere of securitizations you can go ask one of the investment bankers. For example, if you are confused about a certain type of financial instrument you can ask them “Is that a debt, or equity, or maybe even a trading liability?” They’ll usually respond with something like “Well, that depends … What would you like it to be?” And they can make exactly what you wish for – Just like Magic!
Excerpt: Closing Statements, Twilight Zone Episode 48 1961. Rod Serling
Moving along … we can just make out the outlines of some very dark objects, never seen in broad daylight, called the Hedge Funds. They seem to congregate in and around a great big dark building, also never seen in the daytime, called the Derivatives Casino. The car park at the Casino is packed full with Special Purpose Vehicles. The bankers and insurers are often seen coming and going into and out of this building – but only in the twilight zone, never in broad daylight, of course, since the Casino doesn’t exist in broad daylight.
At the center of the Twilight Zone is a complete black box, almost like a black hole. But instead of everything being pulled towards it, what happens is that every time there is but a little ripple emanating from the black box, it seems to cause a much bigger effect throughout the rest of the twilight zone – first hitting the banks and then jolting Fannie and Freddie so that they sometimes lose their balance. In this way, a little ripple from the black box, once it passes through the banks and Fannie and Freddie, gets much magnified in its impact on the rest of the players. They call this black box, of course, the Central Bank, or sometimes the Federal Reserve.
Such ripples that get magnified many times over can also come from other parts of the Twilight Zone. Lots of times you can even see the implosion of one of the dark objects known as the Hedge Funds or the crash of one of the larger speeding investors cause massive waves throughout the Twilight Zone. Interestingly, ripples can also come from the daylight world that we all live in, cross into this other dimension to cause massive destabilization then ripple back out to the daylight world.
Well, I think that’s enough of our visit for now. Once you get back in your Special Purpose Vehicle and travel back into the regular daylight world where the regular people live, this amazingly intricate “other world” known as the Financial Twilight Zone completely disappears from view … but you know its still there.
Now that we are back out and can think clearly, lets talk in some detail about what we’ve just seen … starting with the composition of the atmosphere – or the securities. But we can’t do that without first discussing those confusing objects called Fannie Mae and Freddie Mac that we just met in the Financial Twilight Zone.
The Birth of the Mae Sisters and Cousin Freddie
Securitization in its modern form was, like many a financial invention, initially born out of desperate times. Recall that in Wizards Part 10 we spoke of the regulatory blitz of the 1930’s during the Great Depression that brought in many new banking and stock market rules, such as the Glass-Steagall Act and the Securities and Exchange Commission. Such regulatory blitzes really only come along in times of utter desperation, like a complete financial and economic collapse, and they only come along because they have to. Because you can’t get the economy up and running unless you bring in some regulations to bring back confidence – the main ingredient for a functioning economy. Restoring confidence in the financial system and stimulating credit creation was a primary aim of the banking rules and federal deposit insurance implemented during the Great Depression that was discussed in Wizards Part 10.
This was also the primary aim of another act we did not get to speak about in Wizards Part 10 – that is, the National Housing Act of 1934. The National Housing Act saw the introduction of the Federal Housing Administration, or FHA, whose primary function was to provide insurance of home mortgage loans made by private lenders. This insurance meant that a lender would be repaid by the government in the event of loss on default by mortgagees. During such hard economic times this mandate of the FHA would stimulate credit creation by banks and other lenders for investment in home building which, in turn, would provide more affordable housing and create jobs and stimulate further economic growth. Simultaneously, the government insurance backing would shore up confidence in the now shaken and much mistrusted financial sector.
The practical implementation of this federal mortgage insurance took the form of the chartering of a government corporation to buy and sell the mortgages that the government would insure. The first such corporation was set up in 1938 and called the Federal National Mortgage Association, also known simply as “Fannie Mae”.
In 1968 they split Fannie in two and made a twin sister out of her that they called Ginnie Mae (short for Government National Mortgage Association). Ginnie stayed with the government doing what Fannie used to do and Fannie ventured off into the private markets. Fannie became fully owned by private shareholders, yet with a Charter and Mandate specified by Congress. Instead of complying with SEC rules and other rules that apply to private enterprises, Fannie is instead regulated by the Department of Housing and Urban Development (or HUD) who tells her basically what business to be in, and also by the Office of Federal Housing Enterprise Oversight who monitors her financial stability. Occupying that special area of the Financial Twilight Zone that is not quite government, not quite private enterprise, Fannie Mae is instead referred to as a Government Sponsored Enterprise or GSE.
Before long it was thought that the Mae sisters were lonely and so they made up a cousin officially called the Federal Home Loan Mortgage Corporation, but known as Freddie Mac, who looks a lot more like Fannie than Ginnie. Freddie is another GSE or Government Sponsored Enterprise, owned by private shareholders but regulated by HUD.
The job of Fannie and Freddie has been to provide an active secondary market for the home mortgages of low to middle income families. That is, while they don’t make home loans directly themselves, they buy individual home mortgages from primary lenders such as banks and mortgage companies, package together bunches of these loans and sell them back into the capital markets as mortgage-backed securities. The primary objective of creating such active secondary markets for these mortgages is to make sure that enough capital is available for affordable mortgages for families with low to moderate incomes. Without the ability to sell off such mortgages for cash to another party, banks and other lenders would make less loans in the low to moderate income groups and/or charge higher interest rates for fear of default and burdensome foreclosures.
Up until the 1980s the mortgage-backed securities issued by these entities looked more like what is known as simple “passthroughs”, whereby an investor in a security issued by Fannie or Freddie simply got a share of the interest and principal paid by the underling group of mortgagees, with a guarantee on repayment provided by Freddie Mac or Fannie Mae. But the deregulatory blitz of the 1980s ushered in the rise to power of the investment banking class and the corresponding rapid development and population of that parallel world known as the Financial Twilight Zone we got to visit earlier. And so began a totally new world of asset securitization, the very stuff underlying this parallel financial universe…
Excerpt: Closing Statements, Twilight Zone Episode 51 1961. Rod Serling
The Securitization Atmosphere of the Investment Bankers
One of the problems with the “passthrough” type securities mentioned earlier is that the cashflow stream is uncertain. It can be very long, with long fixed rate mortgages, and can also change suddenly if interest rates drop and mortgagees decide to prepay their loans. This can make such investments quite unattractive to say, long term investors such as pension funds and insurance companies who are looking for guaranteed payments long into the future. Furthermore, shorter-term investors might find these instruments altogether unattractive.
Investment bankers of the 1970s and 1980s invented a different type of mortgage backed security to get around these problems. Basically, given a pool of home mortgages, you could come up with a series of different tranches of securities or bonds or notes that you would issue against that pool. The first, or senior, tranche from the pool would have a fixed interest rate and set principle repayments and be the first set of cashflows to be paid out of the pool. The next tranche might only get interest payments and then start getting principle only when the senior tranche is fully paid off, and so on all the way down to the Z-tranche or the “toxic sludge” of leftovers that only gets repaid once ever other tranche is repaid. The senior tranche is the most secure instrument and so gets the lowest interest rate. The toxic tranche is more like a speculative investment and has a high potential yield but also high risks associated with it. In this way, a pool of pretty unglamorous and ordinary mortgages could give birth to a smorgasbord of different financial instruments to suit anyone’s tastes.
The wild capital markets of the 1980s thought this was just about the most fantastic monetary invention since fractional reserve banking and they were wild about it! Fannie and Freddie alone have grown to have trillions of dollars of home loans under their belts using this new wizardry. Not only has this invention helped the GSEs – Fannie Mae and Freddie Mac – provide ever more capital for home financing, it has also facilitated secondary markets in mortgage-backed securities issued by various other bank and non-bank entities. This invention that was able to turn the humdrum home mortgage into a slew of fancy securities to match anyone’s desires multiplied the attractiveness of mortgage-back securities many times over and, consequently, capital has been flooding in to the mortgage market ever since. In retrospect then, you might put more blame for the phenomenon of urban sprawl on the investment bankers than anyone else!
But the growth of the Financial Twilight Zone did not stop there! For it was soon realized that anything with a future stream of cashflows could be bundled up in such a fashion and have a set of designer financial instruments issued against that bundle. By the late 1980’s auto loan and credit card receivables were being bundled up in such a fashion. By the 1990s the securitization market was extended to cover future record and movie sales, health club membership fees, tax liens, life insurance policies and catastrophe insurance, to name a but a few. Name anything with a future stream of cashflows, and it can be securitized! Notably, in the late 1990s we also saw securitization become used more and more by banks to sell corporate loans off to the capital markets. Citigroup and JP Morgan Chase’s activities in this area have recently received a lot of attention, as we shall discuss later.
Securitization is attractive to both the issuer and the investor in the new securities for various reasons. We already talked about how these instruments have been designed to be attractive to the investor. For the issuer – that is, the one who originated the mortgages or first hooked you on a credit card – securitization has several attractions. One, especially so for banks, is to free up regulatory capital, or the “safety net” for depositors that we spoke about in Wizards Part 2 and 11, so it can be used in the next Wizard adventure. It should be noted that the current rules specifying the level of “safety nets” that bankers must maintain in the form of shareholder capital, actually encourage banks to remove low risk assets from their books and retain the higher risk assets. Another attraction of securitization is the removal of undesirable assets from the balance sheet, and into “off balance sheet” vehicles. Other attractions include that securitiztions issued through an SPV can be a cheaper way of raising capital and increasing liquid assets, rather than having to go directly to the capital and debt markets.
What this explosion in securitization has done is to create an explosion in the availability of capital for investment in whatever is being securitized. Hence we have seen an explosion in credit card offers, home equity loans and basic home loans, auto loans, corporate financing, media and entertainment financing, and so forth. Like placing the blame for the explosion in urban sprawl in the past decade, you might also need to credit the innovative investment bankers for all the credit card solicitations you get every day, as well the design of transactions that have allowed corporations to hide debt, and construct other accounting wizardry.
So what does all this have to do with Special Purpose Vehicles and the fact that so many characters in the Financial Ether seem to be hanging out on Caribbean Islands and Swiss Alps? To understand this, we better get back to our Special Purpose Vehicle and look at the mechanics of it.
The Mechanics of the Special Purpose Vehicle
The more traditional Special Purpose Vehicles, or SPV Version 1, work as follows. The party with the loans or other receivables to be securitized is known as the originator and they transfer these loans or receivables into a Special Purpose Vehicle to isolate them from the originator. The SPV raises funds from the capital markets to pay for these transferred assets and this money goes back to the originator. The way these SPVs raise funds is by issuing notes or securities in the form of bonds to investors. Such notes or bonds then give these investors a claim on the assets held by the SPV and, in theory, the claim is supposed to stop there. That is, in a true transfer of risk via the securitization process there should be no extra claims on the originator. Part of the reason for Enron’s rapid demise last year was that, in this case, there was a contingent claim of the investors back on the originator (Enron) in many of their SPV’s. Based on recent regulatory rulings from the main bank regulators, there seems to be some hidden guarantees lurking behind bank securitizations, too – part of the “Toxic Sludge” we spotted earlier in the Twilight Zone.
The notes issued against the assets held in the SPV can be designed to give rise to the many types of varieties of instruments to suit different types of investor needs, as we spoke about earlier for mortgage back securities. But what’s interesting here is that the highest risk tranche, the equivalent of the Z-tranche for the mortgage-backed security, also known affectionately as the “Toxic Waste” of the securitization, is often retained with the originator. That is, even though it might look like the originator has gotten the assets and associated risks off of its balance sheet, they actually retain the most risky part! And this is in addition to the toxic sludge hidden guarantees we just spoke about that the bank regulators have recently issued statements on. The behavior of both of these rapidly growing poisonous piles has not yet been tested in an economic downturn, and it’s a hidden risk in the Financial Twilight Zone that nobody seems to want to talk about.
To avoid any extra taxes, regulations and disclosure rules associated with putting an SPV between the originator and investor, especially the more regulated originators such as banks, many SPVs are set up in favorable tax and regulatory jurisdictions. Hence the preponderance of them in places like the Bahamas, Bermuda, Cayman Islands, Channel Islands and so forth. In addition places like Switzerland and the Switzerland of Latin American, Uruguay, are favorite places for limited taxes, regulatory avoidance and bank secrecy.
Here are some interesting words from Senator Carl Levin of the Permanent Subcommittee on Investigations at the July 23, 2002 hearings on JP Morgan Chase and Citigroup’s use of such vehicles.
Excerpt: Senator Carl Levin “Wizards behind the Curtain” July 23, 2002 Hearing
We’ll hear more on this hearing and what happened there a bit later.
The Special Purpose Vehicles Parked at the Over-the-Counter Derivatives Casino
Recall on our journey through the Financial Twilight Zone we could just make out the figures of the shady Hedge Funds and the outline of the Over-the-Counter Derivatives Casino with a lot of Special Purpose Vehicles in the parking lot. What was that all about you might be wondering?
Recall that we spoke about the OTC Derivatives Casino in Wizards Part 11. There are several types of derivatives games that might be played in conjunction with securitization. Let’s just talk about a couple of them:
First are the derivatives that might be used in relation to interest rates. Take for example the huge pools of mortgages on the books at Fannie Mae and Freddie Mac. Fannie and Freddie are buying pools of mortgages from banks (who issue the regular mortgages to regular people like you and me) and then selling these cashflows off in the form of much different securities. The revenue from the mortgages will come in over the lives of these mortgages, but their dues back to the securities holders is often due in a different pattern, and often over a much shorter period than the mortgages. If interest rates suddenly change direction Fannie and Freddie could find themselves in a whole lot of trouble. So, they say, they hedge this risk by entering into some offsetting gambles at the OTC Derivatives Casino. An interest rate derivative contract basically says that your counter-party will reimburse you if interest rates move in a certain direction.
But how do we know that this hedging makes them safe and sound? They are not regulated by the bank regulators nor by the SEC because of their special status in between something that’s government and something that’s private. Furthermore the OTC derivatives market is not regulated. How well hedged are Fannie and Freddie, and who are their counterparties – the big US banks maybe? After all, they are the biggest players at the OTC Derivatives Casino. And what about credit risks – Fannie and Freddie basically stand behind all these mortgages and bear the risks of default of mortgagees. What potential risks does all this impose on the US bank depositor and taxpayer?
On this topic, one of the biggest concerns arises from Fannie and Freddie’s peculiar status of being mostly private but partly government bodies. Therefore there has been a perception among investors in their securities, and maybe their derivative counterparties (the banks) that Fannie and Freddie would get bailed out by the US Taxpayer if they ever got in trouble. This may have lead some “too-big-fail” players into risks they shouldn’t be taking – but we have no way of knowing with so much of these markets permanently operating in the Twilight Zone and never exposed to the daylight.
Excerpt: Closing Statements, Twilight Zone Episode 46 1960. Rod Serling
There is a whole array of other derivatives gambles going on that, recently, have been causing alarms to sound in the bank regulator circles. This includes the Toxic Sludge generated by hidden guarantees (sort of like hidden insurance or derivatives) that can only be seen in the Twilight Zone. Similar things reared their ugly heads in the Enron scandal, but we have heard much less about them in terms of what the banks are doing and what the bank regulators have lately been observing on the bankers’ books. Shocked by the recent scandals the four main US banking regulators issued a series of “Supervisory Letters” on May 23, 2002 about the so-called Toxic Sludge (though they didn’t call it that) they have found on the bankers books. The press generally seems to have missed this. I’ll post some links to the Supervisory Letters and explanations on the Wizards of Money web site.
To learn more about this aspect of the bankers backyard toxic sludge it is informative to read a May 23, 2002 Supervisory Letter issued by the Federal Reserve Board saying that over the past few months the bank regulatory bodies “have become aware of a number of instances in which a banking organization provided credit support beyond its contractual obligation to one or more of its securitizations”. The latter part means that these guarantees have been provided outside of legal contracts, and hence away from the view of regulators and completely in the Twilight Zone. What this means is that, while the banks are acting as if all risks underyling these securitizations have been completely removed from their balance sheets (and hence they hold NO associated safety net) they are in fact taking on invisible risks. In a way these hidden guarantees behave like derivatives or insurance on the assets being securitized, and as such hidden guarantees came back to haunt Enron, so they could the banks. Just what banks are taking these risks, why they are taking them, and how severe the problem is, cannot be ascertained from these Federal Reserve Supervisory Letters. But this issue should be watched closely.
The Special Purpose Vehicle – Deluxe Version and the Banking Scandals
In yet another type of derivative transaction, credit risk is the main focus. Not only have banks and others been using Special Purpose Vehicles to securitize their corporate bond and loan portfolios, but now they have come up with Special Purpose Vehicle Version 100 – the Virtual Special Purpose Vehicle – to “effectively” transfer credit risk. These “synthetic obligations” now come in many forms – from Synthetic Corporate Debt Obligations to Credit Linked Notes to Credit Default Swaps. Without going into how these work, we just note that this is a very new and rapidly growing area of the OTC derivatives market and has really caught worldwide financial regulators by surprise, and actually made them extremely nervous. This market is so new that it has not been tested in a down market and, already, we saw two such transactions blow up in the big banks’ face during the Enron Scandal.
Citigroup had set up a Credit Default Swap transaction through a Special Purpose vehicle called Yosemite that was a focus of the July 2002 US Senate Inquiry into the role of banks in the Enron Saga. At the end of the day the transactions through these vehicles which appeared to involve oil and gas trades, enabled Enron to disguise true debt as the more appealing trading liabilities, and thus made Enron look like they were in better financial shape than they actually were. Citigroup opted for the Yosemite vehicle structure to enable it to pass the credit risks (or risk of default) into the capital markets – they surely didn’t want to take such risks themselves! Perhaps they already knew too much. While the Senate investigations did a good job at revealing this accounting wizardry at Enron, so far neither the Senate, nor Congress as a whole, nor the general press, have gotten themselves worried about the broader risks underlying the credit derivatives market as a whole, and its total avoidance of the daylight in its five or so years of existence.
The following is an excerpt from the July 23, 2002 Senate hearing into Citgroup’s role in the Enron Saga. Included is a description of how the Yosemite vehicles were set up. What’s interesting here is that, while Senator Fitzgerald initially addresses his question to Maureen Hendricks, a managing director on the Investment Banking side at Salomon Smith Barney, it is in fact Mr Richard Kaplan, head of the Credit Derivatives division at Citigroup that has to step in and explain the structure. After all, as is explained early on, the Yosemites were his babies – this invention is only befitting of the deepest, darkest warps of the Twilight Zone.
Excerpt: Richard Kaplan, Head of Credit Derivatives at Salomon Smith Barney/Citigroup explains the Yosemite Structure. Initial comments by Maureen Hendricks of Salomon Smith Barney with some questions from Senator Fitzgerald. 5 minutes.
After hearing all this you might be wondering why investors would be wanting to take on this credit risk by buying the Yosemite Notes. Interestingly, one of the conditions specified in the offering prospectus was that investors WOULD NOT KNOW the details of the assets underlying the Yosemite Notes. And these investors turn out be our trusted banks, insurance companies and pension funds, with no doubt some big time hedge funds thrown in for good measure. It’s best to let the bankers tell this story about the so-called “blind trust” notes:
Excerpt: Kaplan and Hendricks of Salomon Smith Barney tell us about “blind trust” notes in the Credit Derivatives game and our pension funds not knowing what they’re investing in.
Not to be outdone, JP Morgan Chase offered similar debt-hiding transactions to Enron through a vehicle known as Mahonia based in the Channel Island Jersey and, as it turns out, owned by a Charitable Trust. First we’ll let Mr Delappina, Managing Director at Morgan Chase Bank NY gives us a little refresher on structured finance, securitizations and how this applies to their dealings with the Energy Companies.
Excerpt:Delappina of JP Morgan Chase Bank NY on Structured Finance
One of the conditions for Enron being able to treat these truly debt transactions as benign trading liabilities for oil and gas trades, was that the intermediary Mahonia had to be independent of the banks and independent of Enron. While Mr. Delappina dis a splendid job of painting us a picture that that actually was the case, Senator Carl Levin of the Senate Investigative Committee soon points out that this picture is not a very accurate one, and that in fact the Chase Bank did have control over Mahonia via the so-called “Charitable Trust”. Lets listen to this interesting exchange between Delpinna and Levin at the July 23, 2002 Senate Hearings.
Exerpt: Senator Levin and Mr Delapinna from JP Morgan Chase paint different pictures of the “Charitable Trust” involve in JP’s Enron dealings.
Note: Due to time contraints on the Audio File, the following did not make it into the audio version of Wizards Part 15 but will be covered in more detail later…
Securing Homeland Capital when Overseas Adventures Go Wrong
The July 23, 2002 Senate hearings into the involvement of the two largest US banks in financing various Enron scams rippled throughout the markets and placed the spotlight on the spookiest risks these banks are exposed to, not the least of which being their massive OTC derivatives exposures. Not to mention their exposures to emerging or developing countries, and large remaining exposures to the Telecos and Energy companies.
Weeks after this hearing the country of Brazil, dealing with a falling currency, looked like it may default on its debt. Given the almost $30 billion exposure of the biggest US banks to Brazilian borrowers its probable that confidence in these banks would have been dealt permanent harm if Brazil defaulted. According to an August 8, 2002 Wall Street Journal article, the banks put a lot of pressure on the US administration to push for an IMF bailout of Brazil. Soon enough a sizable $30 billion bailout package was offered to Brazil to help it stabilize its currency to prevent default on its debt linked to the “hard currencies”. These are the sorts of events that we spoke about in Wizards Part 5. As anticipated by the US banks this helped restore confidence in them.
Within days, downward pressure was already back on the Real, the Brazilian currency. It will be interesting to see if the big US banks reduced their exposure to Brazil following the IMF bailout announcement, hence helping themselves while compounding Brazil’s problems. It would also be interesting to know if the speculative hedge funds, and the trading arms of the banks themselves, are back to their usual tricks in the arbitrage game and attacking this weak currency. We spoke about this common play, or form of monetary attack, in Wizards Part 5 – called Monetary Terrorism. This arbitrage game basically drains out the bailout and other reserve funds from a country very quickly and is a primary catalyst for the collapse of currencies.
As we’ve discussed in earlier episodes of Wizards, these bailouts also pose significant moral hazard, whereby “too big to fail” banks take excessive risks with our deposits, knowing they will always get bailed out. Hence the systemic risks throughout the global financial system are increased with every bailout.
Whatever happens in Brazil and the rest of Latin America now, it certainly appears that much of the rationale for this IMF bailout was aimed at financial security for the US Homeland.
That’s all for Wizards of Money Part 15. Note the Wizards of Money has a website at www.wizardsofmoney.org.
