Monday, August 5, 2013

Monday, August 05, 2013 - ISDAfix

by Sinclair Noe

DOW – 46 = 15612
SPX – 2 = 1707
NAS + 3 = 3692
10 YR YLD + .04 = 2.64%
OIL - .38 = 106.56
GOLD – 9.70 = 1304.80
SILV - .18 = 19.81

We've talked on several occasions about the various banking scandals that have cropped up over the past couple of years. It's a long list and includes everything from municipal bond rigging to robo-signing, predatory loans to insider trading, derivatives stuffing to energy price manipulation including oil markets and electricity markets. Last year we heard about what appeared to be the biggest scandal, at least in dollar volume; the Libor rate rigging scandal.

The scandal surrounding the London interbank offered rate (Libor), against which it's estimated more than $300 trillion worth of products are priced, everything from derivatives to mortgages to credit cards and … well almost everything that might be bought or sold, has become a symbol for the brazen arrogance with which some in the financial industry have pursued their own interests. Libor rate rigging has cost individuals as well as municipalities, including Baltimore, Houston, San Diego, Sacramento, and others; maybe even Detroit. The US municipalities claim that they lost money when they received lower interest rate payments than they should have, or had to pay artificially inflated rates because of the alleged manipulation. In other words, the banksters ripped them off coming and going.

In London, the Libor investigation is ongoing and they've recently announced plans to make charges, possibly criminal charges within a couple of months. The Serious Fraud Office, or SFO has leveled criminal charges at three relatively junior-level individuals in connection with the scam. Three banks, including Barclays, RBS, and UBS have agreed to pay around $2.6 billion to date to secure civil settlements with UK and US regulators; we don't yet have confirmation that the fines have been paid. More than a dozen more banksters were involved in Libor, including Citigroup, JPMorgan, Deutsche Bank, HSBC, Bank of America, Credit Suisse, Rabobank, ICAP, Teullet Prebon, and Royal Bank of Canada.

The prosecutors say it will be difficult;they are outmanned and outgunned; the banksters hit back with counter-suits against prosecutors. Plain and simple, the banksters have more money to spend on litigation. And we all know that justice isn't about justice, it boils down to who has the most money to push around the other party. Also, pushing beyond the judicial system, the banksters have managed to infiltrate the the legislative process, watering down regulations and laws; new efforts to toughen the laws since the Financial Crisis might be too late to find those culpable of causing the crisis to face criminal penalty. Also, much of the correspondence, such as emails, that can be admitted as evidence rarely makes it to the top floor of the corporate suites.

Still those emails reveal the  high pressure on brokers trying to win business from traders is a big incentive to curry favor in extraordinary ways. According to the Wall Street Journal, gifts of expensive dinners, ski trips, strip clubs, and prostitutes are particularly common in London where there is no regulation on the amount of money brokers can lavish on traders. “Some brokers appear to see entertainment as part of explicit favors-for-business exchanges. Such profits, however, have been at the expense of investors, retirees, taxpayers, regular bank customers, pension funds, cities, and public works programs; to the point where even a regular bus rider pays for the transgressions of the banksters.

You might imagine that it would be hard for the banksters to do much worse than manipulate the most widely used interest rate which affects hundreds of trillions of transactions, but then you'll recall that the Financial Crisis of 2007-2008 was not so much the failure of subprime mortgages as it was the failure of the derivatives written on mortgages. There would never have been the sheer volume of toxic loans in the first place, except that the banksters had figured out a way to package all the garbage and collect fees for doing so, and then bet against the very loan derivative packages they created and marketed to customers. Those derivatives were highly leveraged and ridiculously under-capitalized. When the derivatives failed, that is when Hank Paulson went begging on bended knee for bailouts to prevent a global financial meltdown. You might imagine the banksters had hit their bottommost with the Libor rigging, but wait there's more.

For all the interest rates determined by the rigged process that is Libor, there were side bets in the derivatives markets. And trading in those derivatives is largely conducted through the market known as the ISDAfix, which refers to the International Swaps and Derivatives Association and the fix part of the name is what they chose to describe their marketplace. Sure enough, the fix was in.

ICAP, a major London-based firm, is now being investigated by the US Commodity Futures Trading Commission for falsely reporting the benchmark known as ISDAfix, which provides the standard rates in the $379 trillion market for interest rate swaps. ICAP also maintained trading desks in New Jersey which they nicknamed Treasure Island. Fifteen other banks, including Bank of America, JP Morgan Chase and UBS, have been issued subpoenas for their role in submitting the bids and offers used by ICAP to create the benchmark.

Interest rate swaps refer to transactions that provide customers with greater security on loans, at least that's the theoretical claim. This might valuable if a city or company has a loan with a variable and unpredictable interest rate, which can be “swapped” for a fixed and more secure rate. The reality is that in many instances the swaps create greater risks. The price fixing on both interest rates and interest rate swaps is an example of price fixing corruption layered on price fixing corruption. Ultimately it means we all pay more and get less for everything from a mortgage to a bus ride to a glass of water, so the banksters can gamble in the derivatives casino.

Price fixing of the ISDAfix first came into focus in April. Last Friday, the Commodity Futures Trading Commission revealed that their investigation of the ISDA fix had produced recorded telephone calls and emails. And now Bloomberg is reporting that there is a growing trail of evidence showing price manipulation. The CFTC is sorting through more than one million emails; they are interviewing traders. Remember the guilty verdict last week against Fabrice Tourre, the junior level Goldman Sachs trader convicted of insider trading? You've got to believe the junior level traders in the ISDAfix are familiar with the fate of Fabulous Fab and how Goldman threw him under the bus.

CFTC investigators are piecing together evidence that shows swaption traders at banks worked with rate-swap traders at their own firms to manipulate ISDAfix. The swaption traders told their rate-swap colleagues the level at which they needed ISDAfix to be set that day in order to bolster the value of their derivatives positions before these were settled the next day.

The rate-swap trader would then tell a broker at ICAP, the biggest arranger of the contracts between banks, to execute as many trades in interest-rate swaps as necessary to move ISDAfix to the desired level by the close of trade; the price fixing went by the quaint name of banging the close.

It looks like a violation of the Dodd-Frank Act. The law defines the activity as demonstrating “intentional or reckless disregard for the orderly execution of transactions during the closing period” as to interfere with settlement prices.

Maybe you haven't heard of the ISDAfix price fixing scandal, but at more than $370 trillion, there is a strong probability that it is bigger than the Libor scandal. Just to provide perspective, the Gross Domestic Product of the United States, the measure of all goods and services produced each year is about $16 trillion. The GWP, or Gross World Product is the combined gross national product of all the countries in the world; so, the ISDAfix is more than five times bigger than the value of all goods and services produced in the entire world this year. And for all its size the ISDAfix and the derivatives traded do not produce any goods or services.

Over the years we've seen that when any sector of the economy grows too large, there is readjustment. Remember the energy bubble of 1980? The tech bubble of 2000? The financial bubble of 2007? An easy, though incomplete representation can be found by looking at S&P500 sectors over the years; for most of the time until the 1990s, the financial sector represented 5-10% of the S&P capitalization; the bubble burst at 22% in 2007 and now we are back to about 20%. So, the bubble is inflating and it seems inevitable it will eventually pop. The difference between 5% and 20% is the capital the financial sector sucks out of productive purpose; capital that could be used to produce a much healthier economy. We might consider the financial sector as the lubricant for the engine of commerce, but too much grease just gums up the works.

Unfortunately, when a bubble pops it creates a lot of damage, however that damage rarely falls on the people who created the problem, instead it destroys the 401Ks and pensions and home values and jobs of the middle class. Creative destruction may be effective but it is also painful; the “collateral damage” is real and I hope it can be avoided.

We are now five years past the last meltdown and we have not seen a single arrest or prosecution of any senior Wall Street banker for the systemic fraud that precipitated the 2008 financial crisis – a crisis from which millions of people are still suffering, so it comes as no surprise that we continue to report on one scandal after another. Almost nothing has changed, except the financial sector is growing back to dangerous dimensions.

It's never-ending. Today, BP, the oil company which made a mess of the Gulf coast, today they denied wrongdoing even as the Federal Energy Regulatory Commission (FERC) charged BP with manipulating gas prices in 2008. The scheme in question dates back to Hurricane Ike and how the gas traders tried to manipulate prices during the Hurricane. BP claims that's not what they were doing, that a trader-in-training made a mistake when he tried to explain the scheme to a senior BP official.

Remember last week when Steve Cohen faced all those troubles for insider trading at SAC Advisors, the nearly personal hedge fund run by Cohen. Cohen doesn't face criminal charges himself, but the firm might be shut down as the case proceeds. Well, new week, new hedge fund; this time it's George Soros facing allegations his fund management firm engaged in insider trading before the purchase of a large stake in nutritional supplement company Herbalife.

One of the billionaire investor’s top managers is alleged to have leaked details of Soros Fund Management’s purchase of a near-5% stake in Herbalife before the deal is believed to have been finalised last week.

The claim is part of a complaint reportedly filed with the Securities and Exchange Commission by Bill Ackman, who runs the Pershing Square hedge fund and holds a $1billion short bet on Herbalife.

Jeff Bezos, the CEO of has agreed to buy th Washington Post newspaper company. Bezos is making the deal as an individual and not as part of Amazon, the world’s biggest online retailer. Just thought he'd try his hand at the newspaper business, in the proud tradition of Citizen Cane; and what better place to have a newspaper than Washington DC.

The president of the Federal Reserve Bank of Dallas came up with a catchy name for his speech today: Let me articulate clearly: “Horseshift!” (there is an “f” before the “t”) As always, he is no fan of quantitative easing. Fisher says the Fed is closer to slowing its monthly bond buying. Excerpt: “A corollary of reining in this massive monetary stimulus in a timely manner is that financial markets may have become too accustomed to what some have depicted as a Fed `put.’ Some have come to expect the Fed to keep the markets levitating indefinitely. This distorts the pricing of financial assets, encourages lazy analysis and can set the groundwork for serious misallocation of capital.”

The second quarter reporting season is underway but at the end of the first quarter, according to FactSet, the S&P 500 companies, excluding the financial companies that have complicated balance sheets that would obscure our view, had $1.3 trillion in ready cash – and that's just S&P 500 companies; the corporate cash hoard likely tops $2 trillion. Meanwhile, capital expenditures (building new plants, starting projects, hiring people, leasing equipment) grew at its slowest rate in 3 years. No doubt, cash is nice to have in a storm and the Financial Crisis has hammered home the importance of a rainy day fund, but all of this cash will not sit idle forever.
One little-noticed item in the most recent jobs report is that the biggest jobs-gaining sector was "Financial Activities": banks, insurance companies, real estate companies and related financial services firms. These are the folks who will be making the big play for this money.
The other constituency after that cash are the shareholders who want dividends or for the company to buy their stock. Most big companies are already doing a bit of both. McDonald's, in the news because some of its low wage employees have walked out on strike last week, MickeyD says that, "after investing in our business we are committing to returning all free cash flow to shareholders over the long term." Then, they announce they are cutting expansion funds.

What you don't see, in page after page of earnings reports, is anyone talking about paying workers more. The word "salary" is referred to once by American Express executives saying that salary costs were flat year over year. The word "wage" shows up only in the McDonald's call, as a complaint about costs. The word "hire?" Google is hiring. The word "compensation" is mentioned only in Goldman Sachs' regulator disclosures.

The Transportation Department reports airlines collected $6 billion in fees for checked bags and reservation change penalties in 2012, compared with $1.3 billion in 2007. And that doesn't include what are known as ancillary fees for things like priority boarding. 

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