Slouching Towards Wall Street… Notes for the Week Ending Friday 23 September 2011
Brazil is a founding member nation of the United Nations. Its foreign minister chaired the first special session of the General Assembly in 1947, and Brazil is traditionally first to speak in the General Debate. Brazil has also been elected ten times to the Security Council, tied with Japan for most years served as an elected member. Lately, Brazil has been pushing for permanent status on the Council, a position that some members have supported, others have remain silent on, but none has challenged publicly. Last week Brazil’s President Dilma Rousseff became the first woman to open a General Assembly.
UN records reflect an odd parallel: the debate in the 1947 Special Session included Resolutions 104-107, titled “Hearing for the Jewish Agency in Palestine,” “Hearing for the Arab Higher Committee,” “Special Committee on Palestine,” and “Threat or Use of Force,” which “calls upon all governments and peoples… to refrain… from the threat or use of force or any other action which might create an atmosphere prejudicial to an early settlement of the question of Palestine.” Without espousing any particular point of view, we think reasonable people should agree that the time for “an early settlement of the question” has come and gone.
The can containing the Israel-Palestine question has been kicked as far as possible down the road, and with the most ferocity, and by the largest number of participants in the international community of any issue before this august body, a point made by President Rousseff as she declared her nation’s support of the bid for Palestinian statehood. As to kicking other cans, President Rousseff spared no niceties on her US opposite number, saying “the problem is not money,” but that “the greatest difficulty facing the US currently is the lack of political decision.” Touche, Senhora Presidenta.
Those inclined to dismiss Rousseff’s words as rodomontade should note that she has defied her own political base, firing five cabinet ministers in her first nine months in office and overseeing the arrest and indictment of scores of other government functionaries on charges of corruption. The sole exception was Defense Minister Nelson Jobim, a holdover from the administration of former president Lula. Jobim pulled the highly impolitic move of bashing President Rousseff publicly, saying he had voted for her opponent in the last election. Referring pointedly to two new women cabinet-level appointees, Jobim complained that he was “surrounded by idiots” in the Rousseff administration. Having unmasked himself as both the Judas and the Lawrence Summers of Brazil, he was also promptly dumped by the president.
Rousseff’s “clean sweep” policy has shaken her own constituency. She is set on rooting out corruption and has taken the decidedly non-Brazilian position that she will not tolerate corruption in her government, even when they are on her side. Brazilians have a word — jeito — that translates as “knack,” but that means so much more. Jeito means the ability to make something happen, to fix things. In short, to maneuver around the rules. Soccer players who are adept at evading their adversaries as they drive towards the goal have jogo de cintura, or “hip action.” They are adept at driblando — dribbling, meaning they can work the ball to dance around defending players. All these expressions are applied in daily life and refer to ways of getting around Brazil’s famously atrocious bureaucracy. Brazil ranks 129th out of 183 countries in the World Bank’s ease of doing business survey, and it can take as long as two years for a new company to receive approvals to operate. The average Brazilian company spends more than 2600 hours a year on bureaucratic processes relating to taxes. Brazilians also apply the jeito to everyday affairs, everything from using family connections to get jobs, to paying bribes to avoid traffic fines. One reason the jeito is so prevalent is the mind-numbing bureaucracy makes simple daily activities impossible. Before the proliferation of cell phones in the 1990’s Brazilians had to wait up to a decade to have a home telephone installed. A thriving black market in phone lines developed. When a person died, their heirs would auction off their phone line at prices up to US$ 1000. Private citizens are used to employing the jeito to get police detectives to investigate theft — with so much crime in Brazil they often don’t bother — and insurance companies find it cheaper to pay a small tip to have the police “find” stolen property than to have to pay out on insurance claims when homes or businesses are broken into.
Observers of Brazilian society claim the development of the country from the time of the first Portuguese colonization was rooted in a system of doing favors. This led to a culture of corruption where it is not only easier, but preferable to pay a bribe rather than wait for the government to do its job. President Rousseff seems determined to overturn this image of Brazil and has shaken up her own party by her even-handed trashing of corrupt politicians. Where, they ask, will it all end? If she throws out all the corrupt politicians, then what? Indeed.
President Rousseff has identified a slew of rogues that clearly needed fingering. And they are not all in her own government. Alas, we doubt President Obama is open to her message. It is, after all, an election year.
Speaking of rogues, what exactly makes a person a “rogue”? We checked at thefreedictionary.com and found the first definition as “an unprincipled, deceitful, and unreliable person.” Using this definition, we are not sure that Kweku Adoboli, the UBS employee alleged to have fumbled some $2.3 billion of the bank’s money, would be the only employee on his desk to merit the characterization. Clearly, what makes Adoboli’s actions “rogue” activity is not the fact that he allegedly lost over $2 billion, but that he lost the bank’s own money. Lest you think us unnecessarily cynical, we offer the following.
Last year the World Federation of Exchanges did a study of same-day affirmation (SDA) by country. Trade affirmation is a small furry rodent that inhabits the musty shadows of an un-sexy corner of Wall Street known as Operations and Back Office. This is the part that, as people are only now finding out, is held together by paper clips and rubber bands, while the high frequency traders run computer arrays that would make the chief weapons officer of Battlestar Galactica drool.
The revenue generating part of the business — sales and trading — has glommed all the glamour, all the publicity, and all the assets. The transaction processing piece, meanwhile, has almost always had to play catch-up. The UBS scandal has brought the post-trade piece of the business to public attention (Financial Times, 23 September, “Back Office Upgrades Confirmed As Still Lacking”). The FT points out that accused UBS trader Kweku Adoboli had intimate knowledge “of how confirmation that trades have been done… can happen after settlement.” It is possible for a firm to receive payment for a trade before the seller has confirmed the transaction to the buyer. And while it is not so simple to take the buyer’s cash out before seller’s the securities have been delivered, the seller can show the cash on their own books as having been received, and can even spend it in further transactions.
The FT explains that this risk is particularly prevalent in over the counter markets, where ETFs, foreign exchange options and a number of commodity derivatives trade. It is also where money market instruments trade, and we do not fancy the notion of a fail to deliver on a few hundred billion dollars’ worth of short term commercial paper in what our brokerage statement misleadingly calls our “cash” balance. One way to mitigate this risk is to require both sides to affirm a trade same day, even if the formal trade confirm document — paper or electronic — is not issued until a day or two later. The industry group review found the highest rates of SDA were in Japan, India and Hong Kong, all well above 90%. A second tier — in the 80 percent-plus range — includes Germany, France, the UK and China. Among leading global markets, the US ranked dead last, with only 46.9% of trades being same day affirmed. One could argue that this is still a larger number of actual trades than the other markets process, but the fact remains that we rank dead last among the ten leading markets in the world — fifteen percentage points behind Brazil, fans of President Rousseff will note. There is an initiative afoot to harmonize settlement practices among some thirty different nations, each with different regulatory regimes, bank and market conventions, and different current back-office practices. We wish them luck.
Shortly before the UBS scandal broke the FT reported on a phenomenon known in the industry as fails to deliver (7 September, “Delivery Failures Turn Spotlight On Settlements”). The FT reports that fails — when the buyer does not deliver cash on settlement date, or the seller does not deliver the securities — have spiked in recent months and now average $200 billion a day in the US market alone. At least in the US the number is known. There is no equivalent data available for Europe.
Some observers are convinced that banks are deliberately failing “as a way of dealing with financial stress.” For a period of time — say the time between accounting cycles, or between departmental audits — fails permit a trader, a trading desk, or even an entire institution to carry on its books both the value of the securities it has sold, but not delivered, and the value of the cash it has booked, but not received. Margin rules and trading system conventions generally allow the proceeds of a sale to be used for new purchases before the cash is actually delivered, so a fail on a cash payment may go unnoticed if it is resolved before too many downstream transactions settle. Or it can set off a cascade where successive trades have to be broken, with the firm eating both its own losses, and those of its counterparties on the trades in question. This appears to be roughly the case facing UBS.
In the US, there is a further Never-Never-Land called “ex clearing,” where aged fails go into permanent limbo. They become an off-book contract between the counterparty brokers, who agree not to pursue the matter. There is no way of knowing the dollar value of fails that have been thus dispatched, and consequently it is impossible to know what amounts of money on bank balance sheets are actually phantom capital that will never be recovered.
The FT reports that only in May 2009, after the Lehman collapse, was a fail penalty introduced in the US Treasurys market. In that month alone daily Treasury fails reached $569 billion. The US now plans to introduce fails charges for mortgage backed securities, which traders say will force fails into other segments of the market. The FT reports for example that ETFs are now more likely to fail than are normal equity trades.
This brings us back to our rogue trader. Mr. Adoboli worked in UBS’s equities division where he was charged with running a rather “sedate trading book” (WSJ, 19 September, “Details Emerge Behind UBS’s $2.3 Billion ‘Rogue’ Trader”). The losses reportedly stemmed from one-way bets on the direction of the market, using unhedged index futures. The losses were reportedly masked with falsified entries showing offsetting trades. Mr. Adoboli reportedly created fictitious trades using ETFs, which settle over a longer cycle than the instruments on which he was actually losing money, recording them with European counterparties who were not obligated by market rules to confirm ETF trades.
In a revealing comment, the Journal article said UBS’s internal risk monitoring focuses on proprietary trading in fixed income — because that is where the bank took a $50 billion write-down in 2008-2009, partly because of heavy concentration in one class of securities. “The overhaul of its risk-control system didn’t address the danger of a back-office employee finding a way to fake trades.” Fair enough. If an employee is determined to break the law, they will figure out a way to do it. But the equities business is in general not closely monitored “because it had typically been a client business that carried less risk.” Losing a client $2 billion is called a streak of bad luck. Losing the bank $2 billion is called fraud.
Mr. Grubel has resigned as head of UBS. Mr. Adobli sits in a British jail as he waits for his fate to be decided. Unlike SocGen’s Jerome Kerviel, he does not yet appear to have taken the position that his superiors knew of his activities. We doubt there is another major shoe to drop in this matter. The bank did not have adequate controls. In retrospect everyone will clamor that it was idiotic not to anticipate employee fraud. On the UBS trading desk, a trading book was handed over to an idiot who got in well over his head, and who was apparently overseen by idiots whose risk management process consisted of initialing reams of printouts every day, rather than getting to know the trading style of their employees. The best advice we can give to UBS: don’t hire any more idiots.
Cain kills his brother, Abel, in the fourth chapter of the Book of Genesis. But it is not until halfway through the Book of Exodus — sixty-six Biblical chapters later — that God gets around to issuing a commandment against murder. If the Divinity could overlook such an obvious fact for so long, we suppose we should give SEC Chairman Mary Schapiro some wiggle room in the matter of David Becker. Ms. Schapiro is already wiggling in this matter, and very adroitly at that.
Along the lines of “Why Didn’t Anyone Think Of This Sooner?” we note the SEC put out two related proposals at its 19 September open meeting. Chairman Schapiro spoke about Conflicts of Interest Relating to Certain Securitizations, considering a new rule to “ensure that those who create and sell asset-backed securities cannot profit by betting against those same securities at the expense of those who buy them.” This is along the lines of rules requiring issuers of asset-backed securities to retain at least a 5% interest and requiring certain clarity in the statements made in connection with the issuance of such securities.
SEC Commissioner Luis Aguilar spoke at the same meeting. Invoking Senator Levin’s simile of selling someone a car with no brakes, then taking out a life insurance policy on the buyer, commissioner Aguilar proposed a rule designed to prohibit firms from purposely designing an asset-backed transaction to fail, “selling it to customers, and then betting on its failure.”
Speaking of things they just told us, former SEC General Counsel David Becker is maintaining that he did nothing wrong — indeed, that he did everything right when he disclosed his family’s Madoff connection to Chairman Schapiro. It is as though someone left a bucket of vomit standing in the middle of the floor. People continued working, not even knowing it was there until someone inadvertently kicked it over. Suddenly, the whole place stinks and people are running for the exit.
David Becker recently returned to his position as a senior partner at the law firm of Cleary Gottlieb, after spending two years as SEC General Counsel. Facts not in dispute include a $2 million portfolio in his parents’ name managed by Bernard Madoff, and the fact that, upon his mother’s death, Becker and his two siblings stood to share that asset. It is also not disputed that, when Becker came to the SEC in the midst of the Madoff brouhaha, he informed Chairman Schapiro of his family’s Madoff connection. Schapiro referred Becker’s disclosure to the SEC’s ethics counsel, who ruled Becker should be given free rein to be involved in Madoff-related matters.
While Becker was diligently disclosing his potential conflicts, Chairman Schapiro was rather less forthcoming (NY Times, 20 September, “SEC Hits Its Lawyer’s Madoff Ties”). She not only did not inform any other SEC commissioners of Becker’s Madoff connection. According to the report of the SEC Inspector General, Schapiro also participated in a decision not to have Becker testify before Congress, where he would have to reveal the Madoff investment. Becker took an active role in the Madoff case, challenging the general consensus at the Commission on how Madoff victims should be compensated. Becker’s position, according to the IG report, would have netted his mother’s estate some $130,000 more than it otherwise stood to receive. The report also states that the SEC ethics officer who approved Becker’s work on Madoff — he has resigned and is represented by lawyer Harvey Pitt, yes that Harvey Pitt, the former SEC Chairman — reported directly to Becker. Becker wrote performance reports praising the work of the ethics office. Based on his review, Inspector General David Kotz has referred Mr. Becker to the Justice Department criminal division.
In a further bizarre turn of events, Ms. Schapiro has been broadly praised — addressed in deferential, nay, all but apologetic tones by her Congressional interlocutors. House Oversight panel chairman Patrick McHenry positively oozed treacle as he told Schapiro “you have a wonderful reputation,” and praised her handling of the IG report disclosures saying “you did make a mistake — and you admitted as such.” With this statement Congressman McHenry ties more than simple English usage in knots.
Whether or not Becker had improper intent in the Madoff case — and we are convinced he did not– the IG report seems misplaced in damning Becker, but not Schapiro. We certainly question Becker’s judgment in not recusing himself. In the wake of the IG report on the SEC’s mismanagement of the Madoff case, it beggars the imagination that anyone thought he could get involved and not come out covered in filth. We can speculate no end — that Schapiro begged Becker, a man of sterling reputation and credentials, to help bail out the Commission at its Darkest Hour; that Becker’s faith in his own integrity blinded him to the stupidity of going near the Madoff slop bucket; that Becker’s faith in his own stature blinded him to Chairman Schapiro’s need for scapegoats. As poor as Becker’s judgment was in this case, we are utterly baffled that Congress is not seething for Schapiro’s head. She was the one who decided not to inform anyone else — who may have deliberately hidden Becker’s Madoff connection from others once it became clear that the original ethics decision was the wrong one. Not only does Chairman Schapiro appear only too ready to throw Mr. Becker under the bus, but why the IG does not refer Ms. Schapiro for disciplinary review is beyond us, and we have to wonder at a Congressional panel that praises her after she apparently covered up a potentially serious ethics matter. The only answer that comes to mind is that Congress, being so full of highly incompetent people of low moral character, have now found cause to embrace Ms. Schapiro as one of their own.
Chairman Schapiro waltzed into the SEC with a white plume waving from her helmet, her mission to re-energize the agency and set it back on course. The Madoff affair, blamed on prior incompetence, was not “hers.” Oh no? Lest we forget, during the years that the SEC was bungling its handling of Bernie Madoff, Mary Schapiro was head of NASD and then of the merged FINRA, in which capacity she oversaw a parallel failure of the financial markets’ self-regulatory body to catch Madoff. Madoff’s firm became registered with the NASD in 1960. Bernard Madoff served for many years on the NASD board — including a stint as vice chairman — and was instrumental in an advisory role to the organization. Clearly he and Ms. Schapiro got on well. She never for a moment suspected he might be up to no good.
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