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  • Ponzi Schemes and Stress Tests

    Ponzi Schemes and Stress Tests

    May 8, 2009

    by Janet Tavakoli, president of Tavakoli Structured Finance

    Now that we are stress testing banks that have merged with entities involved in the housing and municipal bond market debacles, we should also revisit the Ponzi scheme. But first, I'll digress to comment on how we will handle the results of the "stress test" , since that is how we will claim we have solved the banks' problems. While the government will convert preferred shares to voting common shares, this is otherwise simply an accounting game. Credit derivatives were used for this nonsense in Europe, and we have a name for it: regulatory capital arbitrage. This time the U.S. will dilute shareholder value and claim banks have new capital. Moreover, the "stress tests" are anything but that. The "stress" scenario used in the "test" is my probable base case.

    You'll recall in August of 2007, Ben Bernanke said subprime losses would only be $50 billion to $100 billion, and I called for more than triple that amount. It turns out I was too optimistic. I was in the right direction then, and I am in the right direction now. Our government is in the habit of telling the truth much too slowly.

    We need fiscal stimulus and need to strengthen banks. I believe, however, that we should experience more pain now to gain a better future. Specifically, we should put some banks into receivership and not continue to bail out bank creditors with public money. Likewise we need to enforce controls on securitization (shadow banking) to restore credibility to this powerful tool. Until we confront the fact that global confidence in securitization was shattered by a massive Ponzi scheme, we cannot fix the securitization industry and unfreeze the capital markets. Global investors are waiting for us to clean up our own backyard.

    Pundits claiming this was merely a bubble or merely a case of bad models do the industry no favors. There were no black swans or swans of any other color. There were simply Black Barts imitating the highwayman that engaged in bloodless robbery. I just ran across this article in The Deal, which suggest I may be confusing a bubble with a Ponzi scheme. That is not the case. While there was a bubble, it was inflated by a Ponzi scheme. While apologists for our industry may wish otherwise, I explain it again in Dear Mr. Buffett for those who missed it the first time in my book for industry professionals, Structured Finance.

    The Wall Street Journal missed a golden opportunity (“Top Broker Accused of $50 Billion Fraud,” December 12, 2008). It wrote that if Madoff’s alleged losses exceeded $50 billion, it would “dwarf past Ponzi schemes.” Yet, Madoff was a piker.

    The largest Ponzi scheme in the history of the capital markets is the relationship between failed mortgage lenders and investment banks that securitized the risky overpriced loans and sold these packages to other investors—a Ponzi scheme by every definition applied to Madoff. These and other related deeds led to the largest global credit meltdown in the history of the world.

    Investment banks raised money from new investors to pay back old investors (mortgage lenders' dividends to shareholders and investment banking creditors of mortgage lenders which often included themselves). When mortgage lenders imploded, investment banks sped up opaque securitizations to offload worthless tranches of CDOs mixed in with others to careless so-called sophisticated investors along with naive investors. Raising money from new investors to pay back old investors, even if you are the old investor covering up losses, is a Ponzi scheme.

    Bernard Madoff confessed—not the securitization “professionals” who work or worked for famous investment banks, certain CDO managers and certain hedge funds. One securitization professional gave an interview to Reuters in which he tried to claim that shady activity was not a Ponzi scheme since CDOs are legal. But using a legal financial instrument to commit fraud is still fraud. If you pawn off product by mixing it into a CDO portfolio, and you know or should know it is worthless (or even simply misrepresented), you must disclose that fact. But that is not what happened. Overpriced and overrated tranches of RMBS, CDOs and even CDO-squared, that on their own wouldn't get a decent bid from any knowledgeable securitization professional, were repacked to sell on to other investors. When new investors dried up, these products were held on the books as if the irresponsible ratings had meaning. This delayed the recognition of losses long enough to get through another bonus cycle.

    The SEC has been silent on the dodgy securitization activities it “regulated’ over the past several years. Congress and others agree claiming there will be time to find out who is responsible later. Bail now, scapegoat later.'

    Legacy investment banks and other bailout recipients have hundreds of billions of dollars worth of assets in opaque accounting buckets known as Level 2 (mark-to-model) and Level 3 (mark-to-management assumptions). Good luck trying to find details. This makes the "stress tests" less meaningful than they already are.

    Self proclaimed sophisticated investors like bond insurers are responsible for their own due diligence, and they may not be able to press claims against errant banks and investment banks. But now that the taxpayer has bailed out these entities, and now that the Fed is using taxpayer money to subsidize the funding costs of the banking system, the situation has changed. The U.S. housing market has been damaged along with the municipal bond markets. The net effect is a massive crime on the U.S. economy, and taxpayers, at least, may wish some form of satisfaction in the form of greater regulation and economic clawback.

    Some pundits want to claim the problem was mathematical outliers. The real problem is there were too many outright liars hiding behind the curtain of structured finance. Until we squarely face our problems, we cannot fix them. We had a financial Pearl Harbor, but investment bankers piloted many of the planes. We need to face that problem to restore confidence in the financial system. Once-over-lightly stress tests combined with regulatory capital window dressing will not solve our problem. What we need now is financial military police action combined with a financial Marshall Plan to restore our devastated financial system.



    Janet Tavakoli explains to CNBC May 8, 2009 why the stress tests will neither restore confidence in the banks nor unfreeze demand for securitized financial products.

    Janet writes today to iTulip.com: "The market hit its high in Oct 2007, well after I and a few others were sounding warning alarms. Don’t look to current market price action for information about future outcomes."

    Note: Eric Janszen is scheduled to interview Janet Tavakoli next week. Subscribers may submit questions they'd like Janszen to ask her here.

    Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting to financial institutions and institutional investors. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct professor of derivatives at the University of Chicago's Graduate School of Business. She is the author of: Credit Derivatives & Synthetic Structures (John Wiley & Sons, 1998, 2001), Structured Finance & Collateralized Debt Obligations (John Wiley & Sons, 2008), and Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street (John Wiley & Sons January 2009)

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    Last edited by FRED; 05-08-09, 02:10 PM.
    Ed.

  • #2
    Re: Ponzi Schemes and Stress Tests

    A year or so ago Meredith Withney was the first lighthouse warning, I think Janet Tavakoli is the second. This lady is one smart chemist ! This is the first internet 'fast world wide info' recession of note. Add this lady to Itulips list of American Heros who tried to save the common man wealth !

    Also..How can the financial police (SEC etc) control the 'securitization market' if they are not as smart as 'Tavakoli', until the SEC gets there Elliot Ness the Al Capones of 'securitization market' can enjoy the ride.
    Last edited by icm63; 05-08-09, 02:34 PM.

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    • #3
      Re: Ponzi Schemes and Stress Tests

      Me Thinks It Tis TOO SOON to be short the UST Market (will be better AFTER the next leg down has commenced) by which time the credibility of the FED and US Financial Authorities should TRULY be in the shitter. THAT will be the time to Short the UST, AFTER the next leg down.

      (Thanks to Lukester for pointing my thoughts in the right direction)

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      • #4
        Re: Ponzi Schemes and Stress Tests

        Random thought -- IF everyone starts shorting government bonds, would they not ban shorting them -- like they did with the banks when they were in crisis?

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        • #5
          Re: Ponzi Schemes and Stress Tests

          Originally posted by jpatter666 View Post
          Random thought -- IF everyone starts shorting government bonds, would they not ban shorting them -- like they did with the banks when they were in crisis?
          Good point, this brings up the question: who in their right mind would buy them if they were to do such thing? Would'nt this cause a (or at least a high risk of) collapse in government bonds?

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          • #6
            Re: Ponzi Schemes and Stress Tests

            I've seen a lot of Janet on TV lately. She is an intellectual "tour de force"; I suspect she and EJ may intellectually elope next week!;)
            Last edited by Chief Tomahawk; 05-08-09, 06:24 PM.

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            • #7
              Re: Ponzi Schemes and Stress Tests

              Way to sock it to them Janet! That was priceless watching those two CNBC women trying to throw a positive spin on the stress tests, and Janet slapping them back to reality. I literally LOL'ed.
              Warning: Network Engineer talking economics!

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              • #8
                Re: Ponzi Schemes and Stress Tests

                Wonderful. At last someone who understands this stuff and is a straight shooter. I am impressed. There is hope after all.

                I had rather written off Wall Street as a bunch of over excited incompetents and crooks. Intelligent criminals if you will.

                Janet suggests it need not be this way. That Wall Street can add real value.

                Good on you Janet.

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                • #9
                  Re: Ponzi Schemes and Stress Tests

                  Originally posted by icm63 View Post
                  A year or so ago Meredith Withney was the first lighthouse warning, I think Janet Tavakoli is the second. This lady is one smart chemist ! This is the first internet 'fast world wide info' recession of note. Add this lady to Itulips list of American Heros who tried to save the common man wealth !

                  Absolutely. Calling it a Ponzi scheme, and explaining why was perfect. Then in the interview, she said it all. The game is:

                  Dilute shareholder value. Do a capital arbitration game. Hope banks can earn their way out of, it with taxpayer funding and high spreads.
                  Put up a poll for the single gentlemen. Which of those three would you like to go on a date with.

                  Look forward to the interview. Too bad EJ:cool:

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                  • #10
                    Re: Ponzi Schemes and Stress Tests

                    Originally posted by Adeptus View Post
                    Way to sock it to them Janet! That was priceless watching those two CNBC women trying to throw a positive spin on the stress tests, and Janet slapping them back to reality. I literally LOL'ed.
                    Yeah, the expressions on the face of the CNBC hosts were priceless. Reminded me of when Overstock CEO Patrick Byrne was on CNBC in December 2007 saying we were "living at the edge of a 1929 kind of disaster" while the talking heads tried desperately to get him back on script. Man, that turned out to be prescient.

                    Jimmy

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                    • #11
                      Re: Ponzi Schemes and Stress Tests

                      Originally posted by FRED View Post
                      Our government is in the habit of telling the truth much too slowly.
                      Truth is not slow. Our government is in the habit of telling lies and covering them up. Like a repeat petty criminal our leaders find the smallest slice of fact that will suffice as truth and repeat it a thousand times.

                      Specifically, we should put some banks into receivership and not continue to bail out bank creditors with public money.
                      This is simple but nicely said. The bailout is for creditors, for counter parties.

                      Pundits claiming this was merely a bubble or merely a case of bad models do the industry no favors. There were no black swans or swans of any other color. There were simply Black Barts imitating the highwayman that engaged in bloodless robbery.
                      Arrests? If they don't start coming soon, when they do they may be in the form of public executions. I'm concerned about the level of denial we're still working though. It's not a healthy way to deal with this level of avarice.

                      Madoff was a piker.
                      The only thing I don't like about this sentence is that Madoff is a piker. To say was is to frame our situation as a thing in our past.

                      This delayed the recognition of losses long enough to get through another bonus cycle.
                      Sure, that's American business. For anyone who's been out of school long enough to work though 10-20 quarters of American business, you'll know that this is how it works. I'm not judging, but wondering why anyone would bring this up without pointing out that the lack of regulation guaranteed this outcome.

                      Legacy investment banks and other bailout recipients have hundreds of billions of dollars worth of assets in opaque accounting buckets known as Level 2 (mark-to-model) and Level 3 (mark-to-management assumptions).
                      Yup, mark to magic, mark to make believe there was no reason to chance as long as no one was paying attention.

                      Some pundits want to claim the problem was mathematical outliers.
                      Spreadsheet logic. Great stuff if you've got a very short time horizon. You can mark to magic with a 1-2 year timeline.

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                      • #12
                        Re: Ponzi Schemes and Stress Tests

                        Whats with all the money honeys? I don't mind eye candy, but it's distracting when your trying to engage critical thinking. Also the general tenor of the newscasters borders on hysterical in their attempt to convince you that everythings alright. I guess I like my news more dry, more "Bloomberg-esque".

                        That aside. This woman Janet Tavakoli is partly responsible for these "structured finance vehicles" as a paid consultant to the whos, whos of financial crookery, where she showed them the brave new world of CDS, CDOs and other financial fluff. So, I find it slightly ironic that she now is the siren song for banking malfeasance considering she was dancing all along with the others till the music stopped.

                        Also, this is more than a "crisis of confidence". There are very sound priniciples working to liquidate a system that is overleveraged and poorly managed. I do agree that the opaqueness of the financial system does it more harm than good, but if people think this is a problem just with the banking system then they're missing the point. The economy is having a systemic reaction and the banking sector is just a symptom of a greater illness.

                        Finally, I wouldn't short treasuries when you have the government acting as the "alpha and omega" of the economy. The opaqueness is metastasizing from the private financial sector to the public sector, there is no way to gauge prices of ANYTHING in this environment. With the FED monetizing debt in any number of ways, I think its a suckers bet to gamble against the house especially when the house holds all the cards.

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                        • #13
                          Re: Ponzi Schemes and Stress Tests

                          Below is an noteworthy interview on May 8, 2009 with William Black on Yahoo's Tech Ticker regarding the Stress Test:

                          "It is in the interest of the financial community to send this Propaganda out and it is remarkable that its still works"
                          - William Black

                          I apologize, but I do not know how to embed this one, but here is the html link for those of you interested in the video clip (6min.):
                          http://finance.yahoo.com/tech-ticker...gulator%20Says

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