Friday, December 27, 2013 - Fooled Again

Fooled Again

by Sinclair Noe

And now we present the curious case of Michael Steinberg. Not familiar? That's understandable; Michael Steinberg is a convicted felon, securities fraud and conspiracy, specifically insider trading. Steinberg is a close personal friend and former trader with Steven A. Cohen. You've likely heard that name. Cohen is the billionaire, stock picker who runs SAC Capital hedge fund; recently fined $1.2 billion by the SEC for insider trading and not maintaining adequate supervision of his employees. Cohen has not been charged as an individual.

Eight SAC employees have been criminally charged; six have pleaded guilty and are cooperating with the government; one faces trial in January; Steinberg just lost his trial, and when the verdict was announced, the fellow fainted. The other guy who faces trial in January fainted when he was arrested. It's a bit funny, a bit pathetic. Steinberg faces a maximum of 85 years but that won't happen. Still, it looks like a potential case against Cohen could gain traction.

The US Attorney's Office in Manhattan has secured 77 insider trading convictions since 2009, without losing a single case. Jurors are capable of understanding insider trading. It's a fairly simple form of cheating. Jurors are also capable of understanding more complex forms of cheating. The markets are rigged by cheaters, in the form of insider trading and other, more complex scams. There are many honest people who earn god livings in the markets, but there are plenty of cheaters. The prosecutors aren't even going after the folks on the other side of the insider trades; someone supplied information on Weight Watchers, Gymboree, Dell, Nvidia, and Intermune (and others). At some point, those people expected something for their information. There is an old saying: if you can't identify the “mark” at a poker table, it's you.

No need to actually sit at the table with big time hedge fund types – you're still the “mark”. Just look at what's happening in Detroit. I knew it was just a matter of time until we started hearing more about how the big banks bet against Detroit; slowly but surely the information is oozing out as the vultures fight over the carrion.

Detroit, of course, has many problems, long standing problems. Back in 2005, Detroit's pensions were underfunded to the tune of $1.44 billion. Then-mayor Kwame Kilpatrick and other city officials set up nonprofit entities and corporations to issue the debt, and bought interest rate swaps as a hedge against rising interest rates (more precisely, they were sold interest rate swaps). Interest rates then dropped to the lowest levels in history; they lost the bet. Detroit owes the holders of the swaps the difference between the interest rates, adding to the pensions' underfunding by as much as $770 million over the next 22 years. Essentially, the politicians and banks gambled with the city's debt, and that bet may have exceeded legal limits on the debt; raising the question of whether the illegal bet is valid. There will probably be lawsuits.

And now that Detroit is in bankruptcy, the unelected emergency manager of Detroit, Kevin Orr, worked out a tentative deal to pay the UBS AG and Bank of America Merrill Lynch Capital Services more than $300 million in “secured debt”. Those banks are considered secured creditors because Detroit put up revenue from three casinos as collateral for the loan; which is now the only stable source of revenue for Detroit. The initial settlement would given the banks about 80 cents on the dollar of what they are owed, compared to 16 cents on the dollar that Orr has offered to retirees for their pensions. The judge told attorneys for Orr’s team to renegotiate the casino money deal because every deal the city has made relating to the swaps “has been made with a gun to its head”.

And so they went back to the table, and they have come up with a new deal, an incrementally better settlement that leaves much of the original structure intact. If the deal is approved by federal bankruptcy Judge Steven Rhodes, Detroit would get out of the swaps deal for about 56 cents on the dollar, get $120 million in cash to bolster city services and free up casino revenues, crucial to the city’s ongoing operations, that were used to secure a previous renegotiation of the swaps deal in 2009. Detroit might be smart to argue that the two major issues with the swaps in the bankruptcy proceeding: whether the swaps are secured debt, and whether the deal was legal in the first place. A favorable ruling for the city on either matter could result in a far better outcome than what has been agreed to.

Over the past five years Detroit has reduced its salary expenses by 30 percent. More than 2,350 public jobs have been cut, accelerating the city’s already notable pace of deterioration. Far from uncontrollable, the cost of health benefits for the city’s public workers and retirees has risen more slowly than the national rate of 4 percent a year. Since 2008, Detroit has reduced its spending by more than $400 million. In the same period, city revenues have fallen by nearly $260 million, with a steep decline after 2011. This decline, rather than its pension obligations, more than accounts for the city’s projected deficit this year of $198 million.

One consequence of these cuts is that public services like transportation, infrastructure maintenance and education are barely functioning. And yet there is one expense that has, so far, been spared: service fees on derivatives that were sold to the city by banks backed by UBS and Bank of America. In fact, these fees are the only significant increase in spending over the past five years. There have been many numbers tossed about in the Detroit bankruptcy, including the claim that the pensions are underfunded by $3.5 billion, but by some calculations, if you strip out the wheeling and dealing, the actual underfunded amount may be closer to $800 million. The public sector pays for the mistakes of the financial sector, and observers are led to believe that the basic promise of retirement is the city’s problem.

This isn't the first time the “swaps” problem has hurt municipalities, we also have examples from Montgomery County, Alabama and San Bernardino, California, and at the core is the question of whether pensions, secured by 20, 30, or 40 years of work are more or less secure than bets by banks. A new report by the Center for Retirement Research at Boston College indicates that costly pension promises are not the major cause of municipalities weak financial conditions. The researchers compared 32 cities that have recently made headlines as they struggle with serious budget problems to a list of 149 other cities that are in relatively good financial shape. "When identifying the source of the problems, fiscal mismanagement leads the list," the study's authors found. "Economic problems, in large part a response to the financial crisis and ensuing recession, come in second." And, "In many cases pension were a contributing factor, but they weren't the driving factor in the fiscal challenges these cities are facing."

Our next story takes us to Switzerland, where 300 Swiss banks are working to meet Department of Justice year-end deadline to put a stop to tax evasion by American clients. Banks with reason to believe they violated tax laws can ask the DOJ to waive prosecution if the banks disclose how they helped Americans hide assets, and the banks will be required to hand over data on undeclared accounts, and pay penalties. If the banks don't apply for waivers and cooperate, then the banks and their customers could face criminal probes.

To gain the non-prosecution deals the banks must pay 20% of the value of accounts not disclosed by August 2008, 30% for accounts opened between August 2008 and February 2009, and 50% for accounts opened afterward. Fourteen Swiss banks are already part of criminal investigations. The crackdown on tax cheats really took off back in 2009, when the US charged UBS, the biggest Swiss bank, with aiding Americans in hiding some $20 billion in assets. UBS admitted it fostered tax evasion; they paid $780 million in fines; they avoided prosecution.

The banks are complaining, whining really, that the penalties are too high. Some Swiss banks may decide to opt-out of the non-prosecution deal, but that comes with a risk. Nearly 40,000 clients told the IRS all about their offshore accounts so that they might avoid prosecution. If it is later learned that some of those clients had accounts with banks that skipped the non-prosecution deal, it would seem like a slam dunk case against the bank. One area that still seems confusing is how to treat multinational corporations with headquarters in the US but offices in Switzerland.

You might think the decision to opt-in to the non-prosecution deal would be simple because the banks aren't really paying a penalty; the money comes from client accounts; it isn't really the banks' money; it is the clients' money. Of course this is not how banksters think. Once the money is in the banks' account, it becomes their money; it is capital they can leverage, and then use to trade.

Just a reminder, we're talking about tax evasion, the same crime that brought down Al Capone. Imagine some petty thief robs the local liquor store and steals a case of beer; he won't get a non-prosecution deal by just handing over a few beers to the cops. Meanwhile, two Swiss banks, Wegelin and Bank Frey, have already gone out of business; and UBS estimates several more will likely close in the coming year. Tax evasion is the business model of the Swiss banks; without it they really can't function. The practice has become institutionalized over time. There is a much older model for taxation: render unto Caesar.

We “celebrated” the Federal Reserve's 100^th anniversary on December 23. Of course, we could probably eliminate taxes if we could just come up with a better central bank. The government, if it and not the Fed was in control of its money supply, could spend as needed to meet its budget, drawing on credit issued by its own central bank (not the Fed); it could do this until price inflation indicated a weakened purchasing power of the currency. Then and only then, could the government need to levy taxes; and the need for taxes would not be to fund the budget but to counteract inflation by contracting the money supply.

In 1977, Congress gave the Fed a dual mandate, not only to maintain the stability of the currency but to promote full employment. The Fed also has another job, as a regulator of the banking system; and as a regulator, it is an abysmal failure; worse than an atheist priest.

There is a discipline in economics known as the “theory of repeated games” and the basic idea is that if you repeatedly cheat at a game, then it increases the likelihood that I will retaliate by trying to cheat you. Of course that is just a theoretical game. In the real world, I might just stop playing your game. When corruption and cheating permeates a society, everything starts to break down, fairness and trust turn to dust and the vacant, crumbling buildings of Detroit.

You have probably invested through Wall Street at some time or another, and yet we know that insiders rig the game; they cheat to fatten their own wallet at your expense. We know that the banks change the laws to make their wagers more “secure” than the pensions of retired cops and firefighters. Even the new deal for Detroit values banks bets at 56 cents on the dollar but pensioners would only get 20 cents on the dollar. Ah, but you might not have a public pension, so you are not concerned. Do you have a private retirement account? A 401k or IRA? The banksters have no more respect for private accounts than public accounts.

Political and economic inequality go hand in hand with a two-tiered justice system, and at the root of the rot are the banksters, cheating the system, lying on a grand scale, and doing it all with impunity. Maybe 2014 could be the year when we won't be fooled again. Best wishes for the New Year.