Rx for Cleaning up Wall Street

Wall Street is finally getting its comeuppance judging by all the calls for more regulation. As a sign of how big an issue it has become, the Presidential candidates have announced reform-minded plans. But I wonder if they are truly keyed-in with all these supposedly "sophisticated" instruments that are commonplace on Wall Street, many of which precipitated the current economic malaise.

However sophisticated Wall Street shenanigans have become, the crisis itself is quite easy to comprehend: Wall Street these past few years has quietly created largely unregulated shadow markets that even the brightest minds in the universe can't value. Lest you think I'm spouting mere hyperbole, consider the following admissions:

• Alan S. Blinder, a former vice chairman of the Federal Reserve and an economics professor at Princeton, admits that even he has only a "modest understanding" of complex derivatives and "if you presented me with one and asked me to put a market value on it, I'd be guessing."


• Major Wall Streets banks use a metric known as value-at-risk (VAR), which measures how much money their traders could potentially lose on a given day. At the end of last year, Citigroup's VAR was $191 million, nearly double from a year earlier. But as noted by research firm Audit Integrity, Citigroup's VAR figures don't even include the bank's exposure to collateralized debt obligations – which the bank admits "are tough to value." CDOs were responsible for nearly $20 billion in investement-banking losses last year for Citi.


• Oppenheimer analyst Meredith Whitney lowered her earnings estimates for several major U.S. banks, including Citigroup, for the 30th time on Wednesday and warned "we are confident this will not be our last reduction in 2008."

It is almost beyond my comprehension how any company, particularly major financial institutions, took on such a dizzying degree of credit exposure they readily admit can't be quantified. Byron Wien, chief investment officer at hedge fund Pequot Capital, perhaps best explains how this came about. "These are ordinary folks who know a spreadsheet, but they are not steeped in the sophistication of these kind of models. You put a lot of equations in front of them with little Greek letters on their sides, and they won't know what they're looking at."

Some legislators are just now waking up to the magnitude of the problem and talk is brewing on Capital Hill about the need for regulatory reform. Senator Schumer's op-ed in the Wall Street Journal is indicative of Washington's reactive stance. Though I've been a critic of Mr. Schumer's in the past, his suggestions are all sound. Risk, regulatory consolidation, transparency and getting a handle on Wall Street's shadow markets (such as the $516 trillion global derivatives market) are all critical issues.

Even Jamie Dimon, J.P. Morgan's CEO, has grudgingly conceded there is a need for more regulation. "We have a terribly global world and, over all, financial regulation has not kept up with that."

However, couching recommendations with worry about global competition sets the stage for a classic Congressional cop-out. And simply creating more regulations and oversight won't protect investors from Wall Street's pervasive wrongdoings. There has to be a radical philosophical overhaul on the part of regulators in their oversight of the major Wall Street firms. America is badly in need of watchdogs that will bark with a vengeance and are willing to impose meaningful and painful punishments when Wall Street firms run afoul of regulations, as they frequently do.

Take the conflicted research scandal. Although Wall Street firms routinely peddled research to investors they knew was woefully bogus, they were allowed to settle the matter for a measly $1.4 billion. That didn't even amount to a wrist slap.

Or consider the collapse of the auction rate securities markets. The SEC uncovered considerable wrongdoing in this market as early as 1996, but imposed an insignificant $13 million penalty on 15 firms. Not surprisingly, the wrongdoing not only continued it actually escalated, and countless individual investors were left holding the bag.

In a letter to the nongovernmental Basel Committee of Banking Supervision, S.E.C. chairman Christopher Cox attributed the collapse of Bear Stearns to "a lack of confidence, not a lack of capital." That may be true. But had the S.E.C. intervened more aggressively when Bear Stearns' mortgage-backed hedge funds began imploding last June, regulators could have imposed measures that perhaps could have ensured a measure of confidence and staved off the firm's collapse.

Wall Street is dominated by some of the smartest people in the world. Regretfully, most of these people are driven by unadulterated greed and typically put their own interests ahead of the clients. This greed is now wreaking havoc on the lives of ordinary Americans and has badly hurt our economic standing in the international community. Its high time Wall Street was held accountable for their actions.

It's Time Wall Street Answered to Main Street

Ever since the Curbstone Brokers traded stocks outside the NYSE in the 1800s, its always been a dog-eat-dog world on Wall Street. In today’s market where thousands of hedge funds managed by glorified day traders are answering to sophisticated investors craving alpha, eating one’s own is as common as it ever was.

And today the financial press is full of articles covering investigations into whether false rumors spread by short sellers caused catastrophic damage to major financial institutions...sometimes the very same institutions that executed their trades. Bear Stearns stock price has been on a roller coaster ride and extremely aggressive put options are being investigated by the SEC:

Betting on a 57% decrease in Bear Stearns stock in nine days is very unusual, Todd Salamone of Schaeffers Investment Research told the Wall Street Journal. The Wall Street Journal claims that over 25,000 of such contracts as of last Thursday. The insinuation is the traders were manipulating the market either through insider trading or spreading false rumors.

It’s not illegal for traders to talk amongst themselves, but it is if the information is knowingly false. Regulators will have a hard time proving their case especially because well-lawyered hedge fund managers can expertly operate on the edges of legality.

The persistence of rumors however, should not be remembered as the only reason for Bear Stearns’ collapse. More likely, Bear Stearns is a case of managerial hubris, an utter failure to manage risk multiplied by unreasonable leverage and a culture of greed perpetuated from the top down. How else to explain the firm’s bulls-eye position among the myriad of Wall Street scandals of the past 20 years?

Bear Stearns is a scandal. Market manipulation by hedge funds is a scandal. In my mind, the potential intersection of the two underscores the need for regulatory consolidation, which Barney Frank (D-MA) has put on the table. It remains to be seen what shape the regulatory landscape may take given Wall Streets highly paid and effective lobbyist. But our current system of self-regulation, the light-touch of the SEC and forcing competitors to play by different rules has proven ineffective. The wave of greed on Wall Street and its tornado effect on Main Street is too strong for such a hands-off approach.

Consolidation may only be half the solution. The corporate scandals of Enron, WorldCom, etc. and the criminal trials in their aftermath sent a message to board members and CEOs alike: accounting fraud will not be tolerated. Thorough federal investigations should be next for Wall Street and if wrongdoing is found, perpetrators should be prosecuted to the fullest extent of the law.

The message would be clear: Wall Street exists for Main Street, not the other way around.

JP Morgan Buys Bears Stearns: Assets Less “Liabilities”

The shocking news that JP Morgan is buying Bear Stearns for the price of $2 per share has many people scratching their heads. Currently Bear Stearns stock isn’t even trading that low. However if you examine the amount of litigation costs and arbitration claims that JP Morgan inherits, it seems a little more reasonable. JP Morgan has announced it had to set aside $6 billion “pretax for litigation, losses on sales of Bear assets and back-office and other consolidation expenses.”

In my mind, Bear Stearns’ spectacular fall underscores the firm’s reluctance to cooperate with other Wall Street brokerages and its unreasonable treatment of investors. Bear Stearns famously neglected to cooperate with the bail out of Long Term Capital Management (LTCM). And more recently, after the firm’s two now collapsed hedge funds were discovered to be on the brink last summer, Bear Stearns stonewalled all attempts by its lenders to inject liquidity into the spiraling funds.

Ironically, it was J.P. Morgan Chase that encouraged Bear Stearns to act, according to a meeting recounted by a Wall Street Journal story from last June:

An hour and a half into the meeting, John Hogan, head of risk management for J.P. Morgan's investment bank, raised his hand. "With all due respect, I think you're underestimating the severity of the situation," he said to Mr. Cioffi and his boss, Bear Stearns Asset Management Chief Executive Richard Marin, according to people who were there. The funds "needed to figure out" how to meet their margin calls, he said, and if that meant bringing in funding from the parent company, "we recommend you do that."

Many attendees were puzzled by Bear's apparent unwillingness to bail out the struggling fund, according to people who were there. After the meeting, these people say, there was sympathetic talk about Mr. Cioffi, a loyalist to the firm who seemed to be getting no help in return, and grumbling over memories of the Long-Term Capital Management crisis.

That afternoon Steve Black, J.P. Morgan's co-chief of investment banking, put in calls to Bear co-presidents and chief operating officers, Mr. Spector and Alan Schwartz. "Is Bear going to stand behind your asset-management company?" he asked Mr. Schwartz, according to people who were briefed on the conversation. Mr. Schwartz said he'd get back to Mr. Black.

An hour later, he called and said that on the advice of Bear's lawyers, the firm wasn't going to get involved, these people said. A spokeswoman said Mr. Schwartz couldn't be reached for comment.

Given its historically self-interested approach to investor crises, this deal could be a positive for individuals with arbitration claims against Bear Stearns such as Zamansky & Associate’s clients. At the least the buyout avoids a Bear Stearns bankruptcy.

Perhaps at most, J.P. Morgan may not have the same motivation to impede investors from recovering losses due to the unscrupulous management of the hedge funds that we now look back at as the beginning of the end for Bear Stearns.

Carlyle Group and Wall Street Firms: Different Strokes for Different Folks

When the market for auction rate securities collapsed a few weeks back, not one of the big Wall Street firms offered to help their clients deal with the fallout. Although the clients were told that the securities were cash equivalents, they were in fact bonds that carried a significant amount of risk. Countless individuals and institutions are now experiencing a severe cash crunch.

So the attitude of David Rubenstein, co-founder of the Carlyle Group, provides a sharp study in contrasts. Mr. Rubenstein has announced his firm will compensate investors for losses sustained due to the collapse of its $22 billion mortgage-backed securities fund the firm launched just seven months ago.

“We have stood behind our products in the past and we are working on ways to address the losses that are being suffered by investors,” Mr. Rubenstein told the FT.

While it remains to be seen exactly what kind of compensation Mr. Rubenstein will offer investors to soften their financial blows, it’s commendable that he at least pays lip service to the idea of making his investors whole. That kind of talk is completely foreign to Wall Street firms.

Auction Rate Securities Taken Up By Congress

Tomorrow Barney Frank (D-MA), Chairman of the House Financial Services Committee, will hold hearings into the municipal bond market. After reading the press release, it appears most of the hearing will be dedicated to the “impact on state and local governments and other municipal bond issuers as the current credit crisis worsens.” It is my hope however that a significant portion of the hearing will be dedicated to questions pertaining to the financial services industry’s auction rate securities (ARS)-related conflicts of interest and the manner in which these instruments were peddled to investors.

On the third panel will be Martin Vogtsberger, Managing Director and Head of Institutional Brokerage, Fifth Third Securities, Inc. on behalf of the Regional Bond Dealers Association. Given the allegations against the industry, he is certainly in a hot seat.

One of the specific issues that Congress should raise is whether the industry is living up to its own “best practices” put out by the Securities Industry and Financial Markets Association, including Wall Street’s self-obligated promise to educate “investors as the material features” of auction rate securities including disclosure regarding auction procedures, conflicts of interest, liquidity and other risks. It seems clear the industry fell down and did not meet this minimum standard.

To wit, after Wall Street was caught rigging the ARS market the SEC conducted industry-wide enforcement action imposing fines upon the violators. And clearly this didn’t stop Wall Street from taking advantage of its conflicted position. For example Wall Street failed to disclose when they were making bids on ARSs, which would have provided investors an indication of the ARS market’s true liquidity and risk. Likely Wall Street propped up the market so that firms could continue to charge underwriting and auction fees to ARS issuers, which includes local government and municipalities. It was apparently typical for banks to charge a one percent underwriting fee to issuers then hit them up for a .25 percent fee to manage the auctions.

Furthermore, Wall Street pitched these instruments as “cash-equivalents,” a position not even corporate CFO’s can take, but as the New York Times aptly points out in Sunday’s business section, ARSs are far from cash.

The combination of Wall Street’s insatiable appetite for ARS fees coupled by a shameful marketing program to support the market blinded brokerages from their fiduciary responsibilities.

Chairman Frank, the ball is in your court.

When Wall Street Exploits A Charity

Having represented investors who have been wronged by Wall Street for more than three decades, I've seen a lot of scandalous activities. But nothing outrages me more when a brokerage firm seeks to exploit a charitable group. Sadly, I'm dealing with yet another egregious instance, this one involving the peddling of auction rate securities to a charitable foundation in Ohio.

The charity is called the Joffe Foundation, which was founded by Steven N. Joffe, a renowned Cincinnati opthamologist and a pioneer in laser-vision correction surgery. The foundation regularly makes donations and commitments to provide funds on an ongoing basis to support various charities and causes, including low-income patients in the US in need of laser vision correction; AIDS prevention; high school educations; and surgeries to correct cleft palates in children in South Africa and Ghana. Because of its ongoing funding commitments, the Joffe Foundation made clear to its broker at UBS Financial Services that it needed to keep its funds extremely safe and liquid.

But the foundation's UBS broker wasn't content having the organization park its money in a simple money market account. Instead, he encouraged it to purchase auction rate securities, which he assured Dr. Joffe were "the equivalent of cash" and could be liquidated within a few days if necessary.

Auction rate securities are long-term government or corporate bond instruments where the interest rates are set at weekly or monthly auctions. As long as there are investors willing to bid on the bonds, they are indeed liquid investments paying higher rates of interests than money market accounts. The problem is that if there aren't enough investors to buy the bonds, the auctions fail. Investors holding the paper are suddenly stuck with a long-term note with a "penalty" interest rate predefined by the bond's issuer.

Making a market for auction rate securities was a highly lucrative $330 billion market for the big Wall Street firms, including UBS. But the balance sheets of the big firms have been badly impaired because of the collapse of the mortgage-backed securities market (a crisis of their own doing), so they no longer have the wherewithal to support the auction rate market. That's why the market for auction rate securities has dried up.

Acting on his broker's insistence that auction rate securities were as good as cash, Dr. Joffe agreed to allow UBS to invest the foundation's entire $1.35 million. UBS invested all the money in various ARS series or issues of preferred stock in the Eaton Vance Limited Duration Fund, thereby increasing the Joffe Foundation's risk because all its auction rate securities investments were tied to that fund.

The auction for the Joffe Foundation's securities failed on Feb. 15, so all its cash is locked up indefinitely. Although the penalty interest rates of failed auction rate securities can sometimes go as high 17%, the penalty rate on the Joffe Foundation's paper is a measly 4.97%. That makes it incredibly unlikely that anyone will buy the paper before it matures. Moreover, the Eaton Vance fund itself carries enormous potential risk of principal loss.

As a result of this debacle, the Joffe Foundation cannot make a committed $100,000 donation to laser vision correction patients, nor fund its ongoing commitments. The foundation also needs cash to fund the salary of its administrative assistant.

Zamansky & Associates has already filed an arbitration claim on behalf of the Joffe Foundation, but it will take some time before it can be heard. You might think that UBS, which likely earned tens of millions of dollars peddling auction rate securities, would do right for a worthy charity and rescind the fraudulent and unsuitable investments so the foundation can honor its donation commitments, but unfortunately you would be badly mistaken.

Merger Meltdown: $29.5 billion!

That is the amount Sprint Nextel wrote down in the fourth quarter largely because of the failed melding of Sprint and Nextel Communications three years ago. It turns out the merger news release headline touting the “unmatched asset mix” was an unusually prescient investor warning: the companies have struggled mightily merging their technologies, according to the New York Times.

Another dozy from the merger’s announcement: “We will have the resources to develop and deploy compelling, differentiated services by unleashing the combined strengths of the two companies, each of which is recognized as a product and network innovator. This is a pro-competitive combination that will provide customer choice and create exciting new opportunities for all of our constituencies."

Guess what? All that unleashing did indeed spark lots of customer choice. Sprint Nextel expects to lose 1.2 million subscribers this quarter and possibly more in the second quarter. It lost more than 1 million customers in 2007.

Sprint Nextel’s write down comes just weeks after Alcatel-Lucent’s staggering $3.8 billion write-down relating to the merger of Alcatel and Lucent just one year ago. According to the Wall Street Journal, Alcatel and Lucent “underestimated the cost of ripping out and replacing customers' old equipment as it combined two overlapping product lines.”

Here’s what’s bothering me: Media stories announcing mergers dutifully mention the investment bankers involved in the deals, often a quid pro quo for the bankers leaking news of the deals in the first place. But when problems with these deals begin to surface, there is nary a mention of the investment bankers responsible.

So what exactly do investment bankers do to warrant the tens of millions of dollars in fees they command? For starters, one would expect that as part of their due diligence reviews they help determine whether there might be formidable problems merging the operations of competing technology companies. Okay, maybe it’s unreasonable to expect them to understand the underlying technologies of their clients. They might also be expected to gauge whether the managements responsible for making the deals work have the requisite competence, but you know what they say about biting the hand that feeds you.

The sad truth is that no one really knows exactly what value investment bankers add because the reality is that ultimately they don’t really add value. As Andrew Ross Sorkin noted in his column last week, it’s generally taken as a given that most mergers fail. So it really doesn’t matter what investment bank conducts an M&A due diligence review because all the optimistic assumptions invariably prove to be wrong anyway.

As an aside, I don’t understand the obsession over the so-called League Tables, which focuses on which investment bankers do the biggest or the most deals. A more valuable table would be the investment banks responsible for doing the worst deals. As a public service, I’ve put together a representative list:

1991: AT&T and NCR Corporation

Goldman Sachs and Dillon Read advised NCR and Morgan Stanley advised AT&T

1998: Daimler-Benz and Chrysler

Goldman Sachs and Deutsche Bank advised Daimler-Benz and Credit Suisse First Boston advised Chrysler

1999: Mattel and The Learning Company

Goldman Sachs advised Mattel and Merrill Lynch advised The Learning Company

2001: AOL and Time Warner

Salomon Smith Barney advised AOL and Morgan Stanley advised Time Warner

2001: Hewlett-Packard and Compaq

Goldman Sachs advised HP and Salomon Smith Barney advised Compaq

2005: Sprint and Nextel

Lehman Brothers Inc. and Citigroup Global Markets advised Sprint and Goldman Sachs & Co., Lazard Freres, and JP Morgan advised Nextel

2006: Alcatel and Lucent

Goldman Sachs advised Alcatel. And JPMorgan and Morgan Stanley advised Lucent