Slouching Towards Wall Street… Notes for the Week Ending Friday 9 December 2011
Business — And Suspects — As Usual
I’m shocked — shocked — to find that gambling is going on in here!
- Claude Raines in “Casablanca”
The Book of Ecclesiastes counsels us that beauty fades but — to paraphrase the words of King Solomon — bons mots live forever. “Casablanca,” many people’s candidate for greatest movie of all time, features not only one of the screen’s great enduring beauties, but many of the most memorable lines in the history of film.
The above-quoted line is now making the rounds, even though it is not actually what Jon Corzine said. We have heard it repeated enough this week and we offer it, not as evidence of our own cleverness, but in recognition of what happens when everyone knows something to be true, even if it is not. “Play it again, Jon.”
This week we watched as Jon Corzine expressed himself “stunned” when he was told “MF Global could not account for many hundreds of millions of dollars of client money.” Not so stunned, perhaps, as the owners of those hundreds of millions, but as a former public servant Corzine should sympathize with those who suffer unexpected reversals. We remember the palpable sympathy he expressed — six million dollars’ worth — for former girlfriend Carla Katz who was bounced from her job as head of a New Jersey union local after she was charged with suppressing dissent among more than 10,000 state workers during her beau’s governorship.
We get the feeling that Mr. Corzine approached his position as Governor of New Jersey much the same way we approach balancing our checkbook. The number we arrive at with pencil and paper is never the same as the one the soothing female voice announces over the telephone. We trust this anonymous goddess of the bank accounts rather than our own calculation, because her number is consistently larger than the one we arrive at — which appears to be the way the State of New Jersey traditionally balanced its finances. We also note this anonymous siren’s penchant for being everywhere at once and the fact that she seems to know everything. The same voice that announces our bank balance also tells us what time to catch our train and patiently announces alternate routes when we miss our turnoff. (Which always makes us think of the line from the Grateful Dead song “Sugar Magnolia” — “Takes the wheel when I’m seeing double / Pays my ticket when I speed.”)
Alas for Stunned Jon, the Diaphanous Voice Without A Name was not available to recalculate when he drove MF Global off a cliff. Apparently he thought he was still at Drumthwacket. Corzine was all deference and gravitas before a Congressional hearing this week as he solemnly stated over and over that he did not have all his papers and so would not be able to give meaningful answers to the panel’s questions.
We have long given up commenting on the disingenuousness of such testimony. Indeed, one former SEC attorney called the performance “phenomenal,” saying Corzine selected his words with utmost care and managed not to even stub his toe. We note that Corzine did not take the opportunity offered to set the record straight on the dispute between him and current New Jersey Governor Chris Christie, who alleged he inherited a $1.3 billion shortfall from his predecessor after being assured there was a half-billion dollar surplus. One point two billion, one point three billion. What’s one-tenth of a billion dollars between governors? In fact, it is $100 million, which we still think quite a lot of money. Charlie Gasparino, senior financial correspondent for Fox Business, quotes unnamed sources (8 November, “Corzine’s Wealth Is Eroding Along With His Reputation”) saying Corzine “is worth far closer to $1 million than he is to $1 billion,” and that his troubles are far from over.
Mr. Corzine is like your teenage son who repeatedly goes joyriding with the family car when you are out of town. Indeed, his own reckless backseat driving very nearly killed him and two other people. The man who apparently could not operate within the framework of Goldman’s robust risk management process also could never quite get New Jersey’s finances cleaned up, leading us to wonder how in the world he was ever granted regulatory approval to be in charge of an organization that handles billions of dollars of other people’s money.
We think “stunned” is a good choice of words. We also liked Mr. Corzine’s repeated deadpan declarations that he “didn’t intend to break the rules.” Corzine has gone on record as sort of kind of, well, in so many words we suppose you could say taking responsibility for the trading decisions that sunk MF Global. We would like to remind Mr. Corzine that, as head of the firm, he actually is responsible. Certainly according to the capitalist’s moral code, whereby the boss gets the lion’s share of the profits, and has to shoulder all the blame. (Even if the sinking is the fault of the first mate, it is always the captain who goes down with the ship.)
Mr. Corzine is also legally responsible, as CEO of MF Global, regardless of what he may have “intended,” and notwithstanding his stunned status. No trader worthy of the name ever leaves his desk at the close of business without knowing the exact value of his book, the exact structure of his positions, and the half dozen or so major things that might go wrong if the market fails to cooperate on the morrow. By all accounts, Mr. Corzine is rather more obsessive than most, and we submit that one does not get to be CEO of Goldman Sachs — even a failed one — without being a pretty extreme control freak. Corzine lost his footing at Goldman when he got the firm involved in bailing out Long Term Capital Management. One would think he would have learned a lesson. In fact, he did: it pays to be Too Big To Fail, because then they have to bail you out.
As CEO of MF Global, Corzine is responsible for everything that happened — whether or not he “intended” any violation or whether or not he is “stunned.” That liability proceeds from Sarbanes Oxley, a piece of legislation Corzine helped to write.
The Wall Street Journal reports (6 December, “Corzine Rebuffed Internal Warnings On Risks”) in the wake of an internal trading scandal that cost MF Global $140 million, the firm hired Michael Roseman, a seasoned and effective manager, as its chief risk officer. This was before Corzine came to the firm. Other MF Global traders criticized Roseman as being too risk averse. “He would stand in people’s face,” one said, which is actually the only way a risk manager ever gets anyone’s attention, since risk managers only have authority to the extent management backs them up. Roseman expressed concerns about Corzine’s trading almost from the start, voicing his discomfort to members of the board as early as September 2010, by which time Corzine’s European position was already $1.5 billion, busting through size and concentration limits Roseman had been hired to implement.
Roseman resigned in March, after failing to either rein in Corzine, or get the board to curtail his trading. This raises a simple question: why does the resignation of a chief risk officer not trigger an automatic regulatory inquiry?
Compliance and risk personnel are Wall Street’s necessary evils. “Necessary,” because they are required by regulators, not because the owners of firms believe it prudent to maintain internal checks and balances. Executives of a firm will never know if a risk officer or compliance officer is doing a splendid job. A firm either stays in business, or it blows up, and owners tend to grab the credit when there are no problems, and blame others when things go bad. Compliance and risk departments are overhead, and firms do not develop performance metrics for cost centers. They just grit their teeth and keep staff and resources to a minimum. John Meriwether steered Long Term Capital Management to a $4.6 billion loss in 1998 that endangered, and ultimately pulled in, the entire US banking system. Yet within a year Meriwether was operating a new hedge fund that went on to raise $3 billion. Folks who make transactions happen are always in demand. What’s a little losing streak? Any idiot can lose a million dollars on a trading desk, but it takes a rare combination of genius and guts to lose four billion. Compliance officers of failed firms have a harder time landing on their feet than the head traders who blew up their books.
Brokers and traders famously call their compliance divisions the “sales prevention department.” In recent years the regulators have issued warnings and disciplinary actions to compliance and risk personnel for the actions of their firms. This is significant because the surveillance and risk functions are not decision making ones. A compliance officer can not force people to obey the rules, nor can a risk officer force a trader to curb his positions. The decision ultimately comes from the owners or the board of the firm. At Goldman, the culture of risk management was taken seriously, which resulted in Corzine being edged out. At MF Global, in contrast, Corzine was unstoppable.
When a registered employee leaves a firm, the firm makes a filing of the termination with FINRA. FINRA, which collects fees for registering financial industry personnel, seems to do little with the information it gathers. We suggest that the departure of a compliance or risk officer should be seen as a red flag and worthy of a mandatory regulatory inquiry. The resignation or termination those charged with keeping the business out of trouble should trigger an inquiry. Compliance officers leave a firm either because management is taking a course of action the compliance officer can not possibly defend, or the compliance officer screwed something up massively and wants to get out before it is uncovered. Either way, regulators should automatically inspect a firm upon the departure of risk or compliance personnel.
Would the MF Global meltdown have been avoided if FINRA and the CFTC had a process for examining firms when risk and compliance personnel left? All we can say is that most people drive slower and more responsibly when they see a state trooper in their rearview mirror. FINRA and the CFTC combined their respective inadequacies and incompetences to allow MF Global to go down in rather spectacular fashion, incomparably exacerbated by the idiotic form of cross-mis-regulation that deliberately leaves huge gaps in oversight.
Regulators are not in the business of following up on the obvious. Instead, they compile large stacks of printouts and sign out to the field at 3:30 so they don’t have to go back to their offices and do another hour or two of work before they go home for the night.
When the regulators start looking at what actually goes on inside the industry, there might be a chance things will change. Until then, the Corzines of the world will continue to write corporate governance legislation using disappearing ink, and to pay themselves million dollar bonuses with disappearing funds. Given the combination of stupidity, cupidity and duplicity in Washington, we are not holding our breath.
As Humphrey Bogart might have said, “Here’s not looking at you, kid!”
Speaking of regulators and scam artists, the ruckus in the rotunda about Congressional insider trading recalls a murky dossier that still leaves open questions about oversight in the securities markets.
In the spring of 2007, FINRA did some repositioning in its own endowment portfolio. It liquidated its holdings in auction rate securities, selling its entire position valued at over $862 million, or over half its $1.5 billion portfolio. The FINRA endowment is managed by FINRA — opaquely — for the benefit of its members, which is every brokerage firm in America, as well as every individual stockbroker, registered adviser, and trader. According to FINRA’s own website (www.finra.org) the self-regulatory body oversees “nearly 4,490 brokerage firms, 163,640 branch offices, and 635,405 registered securities representatives.” That’s a lot of registered entities and people. How do they manage it? you ask.
It’s not all their fault. Many of the abuses FINRA is unable to curtail arise because they do not have jurisdiction. In the MF Global meltdown, for example, FINRA and the CFTC appeared to be locked in a turf war — specifically, a battle to prove that what happened was not their responsibility, but was some other agency’s bailiwick.
FINRA does not regulate banks, so when Merrill Lynch was bought by Bank of America, FINRA claimed they had no authority over tens of billions of dollars in losses that ended up on the books of B of A. Oddly, the depth of the losses did not emerge until after the brokerage firm had become part of the bank holding company. In the event, no one challenged FINRA to explain this lapse in their surveillance of Merrill Lynch before the B of A transaction.
Madoff is, of course, everybody’s case in point. FINRA says they could not be expected to catch Madoff’s fraud, because it was hedge fund fraud, and FINRA only regulated Madoff’s broker dealer. Never mind that FINRA audited Madoff Securities many times and failed to identify fictitious trades, falsified customer statements, and massive amounts of money that just was not there in the fund’s brokerage accounts.
According to FINRA’s own disclosures, most of the $700 billion or so of FINRA money that was not in auction rate securities was in “alternative investments” — broker-ese for “hedge funds.” It was not disclosed which funds those might be, though given Bernie Madoff’s close relationship with the NASDAQ stock market, the NASD and later with FINRA, a reasonable person would conclude there was at least motive, means and opportunity for a nepotistic investment of half a bil or so with Uncle Bernie.
Auction rate securities were instruments backed by a variety of assets. The liquidity and pricing in the market was predicated on a series of auctions, through which the securities could be resold, and new price levels established. By 2007 some of these auctions had already failed, and by the time FINRA sold out its entire position, the SEC and a number of states attorneys general had already gone after firms for abuses in the auction rate market. In February of 2008 the ARS market shut down as investors stopped bidding entirely, and banks ceased acting as bidder of last resort. Exercising its customary perspicacity, the month after the entire auction rate market froze up, FINRA issued guidance to investors warning about the risks of investing in ARS. There was no fine print on the notice indicating that FINRA had liquidated its own ARS portfolio at the first scent of trouble the year prior. By 2009 FINRA was handling over 340 ARS-related arbitrations. No one ever seems to have been called to account for FINRA’s seeming trading on its own knowledge of market sensitive information.
What is in the news now, though underreported, is the case of Standard Investment Chartered v. FINRA in which a small brokerage firm is trying to get the Supreme Court to review allegations that the NASD lied to its members to coerce them into approving the merger of the NASD and NYSE that resulted in FINRA.
This issue has been kept alive, largely thanks to the efforts of Larry Doyle, whose blog “Sense on Cents” (senseoncents.com) is required reading. Doyle first wrote about the case in 2009, and has long been the lone voice crying in the wilderness. Now the story has gotten out, but we think not widely enough.
The merger that created FINRA entailed the sale of the Nasdaq stock exchange for about $1.5 billion. In its de-mutualization, FINRA paid $35,000 apiece to its approximately 5100 member firms, for a total of $175 million. The Standard Investment Chartered suit alleges that NASD Chair Schapiro and other NASD officers lied to their members when they told them $35,000 was the maximum they could receive in the sale and still have FINRA retain its not-for-profit status. Standard alleges that the IRS did not complete its review until well after the vote was over, and FINRA and its executives lied to their members “so that the Officer Defendants could line their pockets.”
If someone like Oliver Stone were making a fictionalized movie version of these events, here’s where Schapiro and her co-conspirators would have a clandestine late-night sit down with the NASD’s investment portfolio, terrified that they might have to reveal to the NYSE how much money they lost with Bernie Madoff. They just managed to squeak by and get out of their auction rate preferreds on time. But the Madoff investment, well, the only way to make that up was to find a fresh source of cash. We are not privy to what representations were made regulator to regulator as part of the terms of the merger, but we assume that, as with every other business merger, there was a comparison of assets that went into the final calculation. We assume the billion dollar windfall was in the mix, perhaps as the price of getting the merger through. The officers of the NASD also received millions of dollars in bonuses for successfully consummating the deal.
Standard filed its suit in 2009 and the case made it to the Second Circuit, which rejected the suit, ruling that the NASD and its officers had sovereign immunity because they are quasi-government actors. Significantly, the court ruled that immunity was not tied to the NASD’s exercise of its regulatory duties.
The SEC is a government agency, created and empowered by Act of Congress. In its capacity as overseer of the nation’s securities markets, the SEC grants oversight responsibility to a series of self regulatory organizations (“SROs”) including FINRA and the stock exchanges. In their capacity as private proxy for government oversight, the court found the NASD and its executives, as well as its successor FINRA, immune to lawsuits for actions “incident to” their regulatory duties.
An amicus brief filed jointly by the Cato Institute and the Competitive Enterprise Institute says the judiciary is the only institution capable of “ensuring that SROs remain faithful to their delegated duties of protecting investors and the public. Because the SROs are quasi-private actors, they have incentives to act in their own best interests — rather than in the public interest — and they do not have to be as transparent as fully public agencies. Further, the executive branch, including the SEC, has failed to hold SROs accountable for their self-serving behaviors.”
This is strong stuff. Considering how extensively the SEC covered up its own failures, notably in Madoff — and where else, we may never know — the amicus brief alleges the government is even worse at holding FINRA to account. A number of other entities have filed in behalf of Standard’s case asking the Court to grant certiorari. Notably, no one seems to have filed a brief in support of FINRA, asking the court not to hear the case.
We fear the court may agree to hear the case, only in order to establish that the courts do not have jurisdiction over self-regulatory bodies when duly sanctioned by federal agencies. This would be a sharp stick in the eye to the public trust in the markets, which is shaky enough already. The odds do not look good. Something like one per cent of all cases appealed to the Court are actually heard. And the Court already has a precedent of sending regulatory matters back whence they came without opining on the merits of the case. Says Standard’s lawyer, “the issue of accountability at FINRA is not a right or left thing. It’s a right or wrong thing.”
Let’s hope the Court deems allegations of billion-dollar abuse by a regulatory body important enough to hear. Even the Supreme Court should have an interest in distinguishing between Right and Wrong.
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