Thanks to Wall Street, America Has Growing Greek-Like Debt Bombs

By Pam Martens and Russ Martens: July 1, 2015

Greeks Line Up to Receive Their Daily Rations of Cash from ATM Machine

Greeks Line Up to Receive Their Daily Rations of Cash from ATM Machine

Greece has two things in common with bankrupt or teetering parts of the United States: it took advice and money from Wall Street while paying huge fees; now the catastrophic results of that bad advice is falling on the backs of the poor and most vulnerable citizens. In fact, we’re all Greeks now.

From the $1.2 trillion in student debt now on the backs of U.S. college students, a growing number of whom are turning to prostitution to keep up, to teetering Puerto Rico, the bankruptcy of Jefferson County, Alabama in 2011, Detroit’s bankruptcy in 2013, Wall Street was on hand to grease the skids or set the train wreck in motion.

As Greece pensioners line up outside of banks today to receive a fraction of their monthly pension, Puerto Rico has acknowledged it can’t pay its $72 billion in debt and has imposed a stunning 11.5 percent sales tax on its struggling citizens.

How did Puerto Rico, with a tiny population of just 3.6 million, get itself into such astronomical debt? In October 2013, the Wall Street Journal’s Michael Corkery and Mike Cherney reported that Wall Street banks, led by Citigroup and UBS, since 2006 had sold 87 Puerto Rico debt deals totaling $61 billion. For burying Puerto Rico under debt, the reporters note that Wall Street, its lawyers and related parties received $1.4 billion in fees.

And, of course, there were those wonderful swap deals along the lines of those Goldman Sachs sold to Greece and JPMorgan sold to Jefferson County, Alabama. Corkery and Cherney report that Puerto Rico paid “$690 million to Wall Street firms to cancel derivative contracts” that apparently had gone sour as had the ones in Greece.

Then there was the issuance of interest-bearing bonds by Puerto Rico to pay off the interest on other bonds. According to the reporters, in August 2013 Morgan Stanley led an underwriting on $673 million in bonds but “at least $110 million of the debt will be used for ‘capitalized interest,’ according to the bond offering documents. That amounts to raising money from bondholders and then using the proceeds to make interest payments back to those same bondholders. It will also result in larger debt payments down the road.”

If a retail stock broker attempted to bury his client under margin debt or allowed the client to commit financial suicide in the market, the broker would be on the wrong side of the law. A long line of arbitration cases and Security and Exchange Commission rulings mandate that a registered representative must guide the client on a course of suitable investing. But apparently, burying counties, cities, countries, and U.S. territories under debt has no legal barriers on Wall Street. One has to get caught bribing someone to get charged by a regulator.

Back on November 4, 2009, JPMorgan’s trading unit, JPMorgan Securities was charged with the following two years before Jefferson County, Alabama filed for bankruptcy:

“The SEC alleges that J.P. Morgan Securities and former managing directors Charles LeCroy and Douglas MacFaddin made more than $8 million in undisclosed payments to close friends of certain Jefferson County commissioners. The friends owned or worked at local broker-dealer firms that performed no known services on the transactions. In connection with the payments, the county commissioners voted to select J.P. Morgan Securities as managing underwriter of the bond offerings and its affiliated bank as swap provider for the transactions.”

The SEC notes that the payments were secret but JPMorgan “passed on the cost of the unlawful payments by charging the county higher interest rates on the swap transactions.”

Glenn S. Gordon, the Associate Director of the SEC’s Miami Regional Office, had this to say at the time: “This self-serving strategy of paying hefty secret fees to local firms with ties to county commissioners assured J.P. Morgan Securities the largest municipal auction rate securities and swap agreement transactions in its history.”

Jefferson County emerged from bankruptcy on December 3, 2013 but sewer ratepayers will be feeling the pain of the county’s debt binge for decades to come. According to a 2013 report by Bloomberg News, sewer rates are projected to rise by “7.9 percent each year for four years, starting in 2014, and by almost 3.5 percent annually through 2053.” The report notes further that the “sewer rate increases will disproportionately affect the poor. Seventy percent of the sewer system’s users reside in the commission districts with poorest residents.”

What we already know about these derivative debt bombs is indeed unsettling. What is far more dangerous, however, is what we don’t know. Many deals were written in secret and have confidentiality clauses.

Goldman Sachs Doesn’t Have Clean Hands in Greece Crisis

By Pam Martens and Russ Martens: June 30, 2015

Tens of Thousands Protest in Front of the Greek Parliament Against Austerity Plan for Greece, Evening of June 29, 2015

Tens of Thousands Protest in Front of the Greek Parliament Against Austerity Plan for Greece, Evening of June 29, 2015

Are Goldman Sachs executives Lloyd Blankfein, Gary Cohn and Addy Loudiadis losing any sleep over elderly pensioners waiting outside shuttered banks in Greece, desperately trying to obtain their pension checks to pay their rent and buy food? Are these Goldman honchos feeling a small pang of conscience over the humiliation by creditors of this once proud country? Perhaps Blankfein, who famously espoused that he’s “doing God’s work” might shed a tear or two for the small child clinging to her elderly Grandmother’s hand as she searches in Athens for an ATM that will give her $66 from her bank account – the maximum allowed per day under the newly imposed capital controls.

According to investigative reports that appeared in Der Spiegel, the New York Times, BBC, and Bloomberg News from 2010 through 2012, Blankfein, now Goldman Sachs CEO, Cohn, now President and COO, and Loudiadis, a Managing Director, all played a role in structuring complex derivative deals with Greece which accomplished two things: they allowed Greece to hide the true extent of its debt and they ended up almost doubling the amount of debt Greece owed under the dubious derivative deals.

A February 2012 BBC documentary on the Goldman Sachs deal provides a layman’s view of the dirty underbelly of the deal, calling it “a toxic import” from America that is “hastening” the downfall of Greece.

On March 5, 2012, Nick Dunbar, who appears in the BBC documentary on the Goldman Sachs deal and author of The Devil’s Derivatives, penned a revealing article for Bloomberg News with Elisa Martinuzzi. The writers describe the Goldman Sachs deal with Greece as follows:

“On the day the 2001 deal was struck, the government owed the bank about 600 million euros ($793 million) more than the 2.8 billion euros it borrowed, said Spyros Papanicolaou, who took over the country’s debt-management agency in 2005. By then, the price of the transaction, a derivative that disguised the loan and that Goldman Sachs persuaded Greece not to test with competitors, had almost doubled to 5.1 billion euros, he said…

“A gain of 600 million euros represents about 12 percent of the $6.35 billion in revenue Goldman Sachs reported for trading and principal investments in 2001, a business segment that includes the bank’s fixed-income, currencies and commodities division, which arranged the trade and posted record sales that year. The unit, then run by Lloyd C. Blankfein, 57, now the New York-based bank’s chairman and chief executive officer, also went on to post record quarterly revenue the following year…

“The revised deal proposed by the bank and executed in 2002, was to base repayments on what was then a new kind of derivative — an inflation swap linked to the euro-area harmonized index of consumer prices…

“That didn’t work out well for Greece either. Bond yields fell, pushing the government’s losses to 5.1 billion euros, according to an analysis commissioned by Papanicolaou. It was ‘a very bad bet,’ he said in an interview.”

The deal was restructured again in 2005 according to the Bloomberg article, this time locking in the 5.1 billion euro debt.

For the unschooled to the ways of Wall Street, one might jump to the conclusion that Greece and its finance officials were knowing participants in the deal. That would be a reasonable assumption were it not for counties and cities and school districts across America that were similarly fleeced and hoodwinked by investment banks on Wall Street.

In March 2010, the Service Employees International Union (SEIU) released a study showing that from 2006 through early 2008, Wall Street banks are estimated to have collected as much as $28 billion in termination fees from state and local governments who were desperate to exit abusive derivative deals. That amount does not include the ongoing outsized interest payments that were, and still are being paid in some cases. Experts believe that billions of these abusive derivative deals may still remain unacknowledged by embarrassed municipalities.

Back in 2010 when German Chancellor Angela Merkel first heard of these derivative deals to hide sovereign debt among European Union partners, she had this to say: “It’s a scandal if it turned out that the same banks that brought us to the brink of the abyss helped to fake the statistics.”

Well, that’s exactly what happened. Wall Street padded its profits with these deals in order to extort massive bonuses for its executives from its shareholders on the basis that it was “doing God’s work,” when in fact it was catastrophically leveraging up the global economy with secret, off-balance-sheet debt deals. Wall Street then crashed the global economy in 2008 to 2009, just as it had from 1929 to 1932. And the people who structured these deals not only still have their jobs but they’ve received promotions and ever higher compensation while the people of Greece struggle to buy medicine and food.

Given this undeniable set of facts, Merkel’s choice of the word “scandal” to describe the unfolding Greek tragedy seems perhaps a bit mild.

Greece: Why Is a Nation of 11 Million Causing Stock Market Losses Around the World Today?

By Pam Martens and Russ Martens: June 29, 2015

Alexis Tsipras, Prime Minister of Greece, Asks Parliament for Referendum on July 5, 2015

Alexis Tsipras, Prime Minister of Greece, Asks Parliament for Referendum on July 5, 2015

Greece has just a tad more population, at 11 million, than New York City and its boroughs. But this morning, it has caused hundreds of billions of dollars to be erased from stock and bond markets around the world.

The situation in Greece this morning is as follows: banks and the Athens Stock Exchange have been closed until at least July 6, following a breakdown in talks between Greek Prime Minister Alexis Tsipras and the country’s creditors. The July 6 date stems from the vote in the Greek parliament over the weekend to hold a July 5 referendum allowing Greek citizens to vote on the austerity program offered by creditors in exchange for extending more loans to Greece. As a result of a run on the banks as the talks disintegrated, capital controls have now been imposed in Greece, allowing Greek depositors to withdraw no more than just €60 a day (about $66). Moody’s is out with a report this morning indicating that private sector deposits in the Greek banking system have diminished to approximately $133 billion, a decline of approximately $49 billion since November of last year.

This Tuesday, a loan made to Greece by the International Monetary Fund comes due, totaling 1.6 billion Euros, and it is highly unlikely that Greece will be able to make the payment, putting it officially into debt default.

How Greece will climb out of this predicament is very much in doubt. This morning its two year notes have sold off sharply with yields at one point reaching 33 percent. Although the Athens Stock Exchange is closed, Greek bank stocks trade on other international markets and they are seeing significant losses. Bloomberg Business reported this morning that “The National Bank of Greece SA plunged 30 percent in early New York trading.”

The crisis in Greece is spilling over into foreign stock and bond markets for a number of reasons. An immediate impact has been investors backing away from the bonds of other weak Eurozone countries like Portugal, Spain and Italy, pushing their yields up and bond prices down. Heretofore, adopting the Euro was seen as a permanent, irreversible position. But should Greece decide to exit the Euro to save itself from massive economic dislocations, the permanency of the Euro is thrown into doubt should other weak countries have similar difficulties.

The spillover to New York markets comes in the wake of a front page report in the Business section of the New York Times today, alerting markets to the fact that two major hedge funds, David Einhorn’s Greenlight Capital Inc. and John Paulson’s Paulson & Co. Inc. “have collectively poured more than 10 billion euros, or $11 billion, into Greek government bonds, bank stocks and a slew of other investments.”

A quote from the article sums up the situation. A corporate lawyer for various hedge funds, Nicholas L. Papapolitis, is on the ground in Athens and reports that “People are freaking out.” Papapolitis adds: “They have made some really big bets on Greece.”

Hedge funds are notorious for herd mentality. If Einhorn and Paulson are on the wrong side of Greek trades, you can bet others are as well. The Times mentions additional exposure at the following hedge funds: “Japonica Partners in Rhode Island, the French investment funds H20 and Carmignac, and an assortment of other hedge funds like Farallon, Fortress, York Capital, Baupost, Knighthead and Greylock Capital.”

The potential for losses at hedge funds is spilling over into U.S. bank stocks like Citigroup, JPMorgan and Bank of America, all down 1 to 1.8 percent in early morning trading. U.S. banks are viewed as exposed to hedge funds in multiple ways: they frequently provide loans through facilities known as prime brokerage; and according to a worrisome report from the U.S. Treasury’s Office of Financial Research earlier this month, large U.S. banks are engaging with hedge funds and private equity funds in “capital relief trades,” to make their own capital appear stronger. Unfortunately, neither shareholders nor the U.S. public nor the U.S. Treasury has any visibility on who’s holding these trades and how big they are.

Adding to the global stock market turmoil is a continuing selloff in the Shanghai Composite index in China, which is now down more than 20 percent in the past two weeks. China attempted to preempt a major market crash by cutting interest rates over the weekend. Despite this effort at market reassurance, the Shanghai Composite ricocheted in Monday trading between a loss of more than 7 percent to a gain of more than 2 percent before closing down 3.3 percent. The index had dropped 7.4 percent last Friday.

Scaring markets further was a Lehman-esque spike in the closely watched Markit iTraxx Europe index which measures moves in credit-default swaps and takes the pulse of how the market perceives the credit worthiness of corporate debt issuers. The cost to buy insurance (a credit default swap) on the debt of banks and financial companies spiked in overnight trading.

A recurring sentiment heard throughout international markets is that the Greek people have been humiliated by their lenders. The UK Telegraph wrote the following over the weekend:

“…the humiliation now being heaped upon a proud and ancient country is a salutary lesson to all member states – that without the power to make their own decisions they are always at the mercy of the unelected bureaucrats and financiers who run the institutions. The democracy that was born in Greece more than two millennia ago no longer applies when control over the currency and economic policy is handed to a supranational body. The question of whether the price is any longer worth paying is not one for the Greeks alone to answer.”

Treasury Now Has Color-Coded Financial Terror Alerts

By Pam Martens and Russ Martens: June 25, 2015

OFR Financial Stability MonitorRemember when the Department of Homeland Security was issuing those color-coded terrorist alerts? Well, they don’t do that anymore.  They’re back to using plain ole black-and-white words to describe threats.

Apparently, however, the U.S. Treasury’s Office of Financial Research (OFR) thought it was such a cool idea that they’ve started color-coding threats to our financial security from the denizens on Wall Street: the gang that brought our country to its knees in 2008 while the most expensive military in the world was hunting down robed cave-dwellers in the Middle East.

OFR’s color-threat alert is called the Financial Stability Monitor. The monitor is based on approximately 60 indicators and organized as a heat map: The closer an indicator is to the red end, the more elevated the risks; the closer an indicator is to the green end of the spectrum, the lower the risks. The Monitor, released yesterday, says that “financial stability risks remain moderate.” Unfortunately, when we studied the accompanying chart, we found that it’s based on first quarter data, meaning it’s almost three months old. (Imagine Homeland Security issuing a terrorist alert, then telling you it might not be all that reliable because it’s based on stale intelligence.)

Nonetheless, there’s some very interesting takeaways from the Monitor. First, even though the OFR has characterized the financial stability threat as “moderate,” a close reading of the report suggests a heightened threat. These are some key points from the report:

  • Financial and economic risks have further decoupled, with financial risk-taking occurring against the backdrop of a tepid growth recovery.
  • Global monetary policies and economic growth continue to diverge. Central banks in some advanced economies, led by the European Central Bank and the Bank of Japan, are conducting highly expansionary monetary policies, while in the United States, the Federal Reserve is closer to embarking on a tightening cycle.
  • Foreign risks have increased, including intensified government financing risks in Greece and weakening economic fundamentals in key emerging markets.
  •  After a lengthy period of unusually low yields, long-term government bond yields in advanced economies have risen abruptly since April. The speed and volatility of the correction have been significant, demonstrating the fragility of market liquidity and the vulnerability of markets to shocks during periods of low volatility and extended bond duration…
  • Although low volatility previously contributed to excessive risk-taking, the recent increase in volatility has not been accompanied by a proportionate decline in risk-taking.
  • The migration of risks from banks to less-regulated sectors is a continuing concern. For example, non-bank institutions continue to increase their share of highly leveraged syndicated loans.
  • Some market liquidity measures — the ability of market participants to sell assets with limited price impact and low transaction costs — signal a deterioration in liquidity. These changes have occurred along with a decline in the provision of liquidity by primary dealers, which could potentially reduce their willingness to buffer intense selling pressure.

Reduced liquidity, migration of risks from banks to less-regulated sectors, and rising interest rates sound to us like the perfect financial storm potentially in the making.

Indeed, the one area flashing red on the chart is interest rate risk. Gary Cohn, President and COO of Goldman Sachs, took to the radio last week to share his two cents on what’s likely to happen when the Federal Reserve finally hikes interest rates (after talking about it since what feels like the Paleozoic era).

Jake Siewert, global head of Corporate Communications at Goldman Sachs asks Cohn, in regard to a Fed rate hike: “Do you think markets have fully priced in the risks?” Cohn responds:

“We’re probably less ready than people think. It always is uniquely interesting how it comes as a surprise to everyone when something happens that we’ve been talking about for a long period of time…The reality of something happening is always different than the dialogue of it’s obviously going to happen. And when it does happen, it’s usually not the first derivative event that people are caught off guard by. They’re caught off guard by the second, third and fourth derivative events.”

We believe Cohn is referring to exogenous events as opposed to actual derivatives like credit default swaps. But, of course, derivatives do have a nasty habit of blowing up at inopportune times.

One area of significant financial risk to the U.S. financial system which the OFR can’t color-code because it’s hiding in a black hole is the capital relief trades that major U.S. banks and their foreign counterparts are conducting with unknown counterparties that could, potentially, teeter under market stresses caused by a Fed interest rate hike or simply rising rates.

As we reported last week, these so-called capital relief trades are being conducted by the banks, with hedge funds and private equity funds as counterparties, to dress up the appearance of stronger capital while keeping the deteriorating assets on their books. On June 11, OFR released a report on these trades, noting: “Banks have significant incentives to reduce their required regulatory capital by transferring credit risk to third parties. But public data needed to analyze such activities are scant.”

If we can’t quantify the amount of these trades; if we have no transparency on the credit-worthiness of the counterparties, is OFR really on solid ground with its color-coded warnings?

When it comes to Wall Street, without the restraint imposed by the repealed Glass-Steagall Act, it’s always a red alert day for investors.

Big Bank Moral Hazard: A Look at Paul Volcker’s Fed and June 30, 1982

By Pam Martens and Russ Martens: June 24, 2015

Paul Volcker (right) Hobnobbing at a Group of 30 Event

Paul Volcker (right) Hobnobbing at a Group of 30 Event

By any measure, the taxpayer bailouts and Federal Reserve loans of more than $13 trillion infused into the banking system during and after the 2008 financial collapse eclipse any other period in U.S. history. A growing body of research now suggests that these bailouts have set us up for ever greater episodes of moral hazard.

Kartik B. Athreya, writing for the Richmond Fed, has described moral hazard this way:

“As for implicit guarantees as a source of systemic risk, the idea is this: Any belief among financial market participants especially creditors, that they will be made whole by the public in the event of the failure of the assets they finance (i.e., that they will be ‘bailed out’) will lead them, all else equal, to (i) take greater risks, even if that means becoming ever more opaque or interconnected, and (ii) grow too large.”

Frequently cited as prior misguided adventures into moral hazard by the U.S. government is the bailout of Continental Illinois National Bank in 1984 and the Federal Reserve’s intervention in the Long-Term Capital Management crisis in 1998, where high-risk gambles in derivatives by an obscenely leveraged hedge fund blew up.

There is another stunning example of moral hazard that is rarely discussed today; perhaps because it occurred on the watch of former Fed Chairman Paul Volcker who was intimately involved in fashioning financial reform after the 2008 crisis.

At the June 30, 1982 meeting of the Federal Open Market Committee (FOMC) of the Federal Reserve, Chairman Volcker asked the Board to approve a $700 million loan to Mexico. As a bit of background, according to Fed data, in 1982 the largest U.S. banks held Latin American debt amounting to 176 percent of their capital. Regulators allowed this hubris to occur and now the Fed was preparing to bail them out of their jaded actions.

The following incredible exchange among Fed Governors occurs according to the transcript of the FOMC Meeting:

FORD. Have we looked at the banks? That is another concern. The last time I looked at the major U.S. banks, many of them had half their capital committed in Mexico.

CHAIRMAN VOLCKER. Mexico has become the world’s largest borrower, exceeding Brazil in the past year. And what is the amount from American banks alone?

VICE CHAIRMAN SOLOMON. $20 odd billion.

CHAIRMAN VOLCKER. Well, that’s big.

TRUMAN. It’s $21-1/2 billion.

CHAIRMAN VOLCKER. And that is part of their problem–that the banks are nervous anyway. They have lots of reasons to be nervous both domestically and internationally. They are choked up to the back of the throat anyway and they feel a lot more choked up now than they did last year when they were getting there.

VICE CHAIRMAN SOLOMON. I don’t think we really have any alternative…

Prior to the above exchange, Chairman Volcker explained how the Fed had become the lender of last resort to Mexico, rather than banks. Volcker states:

CHAIRMAN VOLCKER: …They [Mexico] have obviously tried some borrowing in the private markets. They spent a lot of time negotiating a big loan of $2-1/2 billion and they signed up the lead banks well over a month ago as I recall. The banks went out and tried to syndicate it…The banks found out during this period in going out and syndicating the loan that there was very little response, which I think is symptomatic of banking attitudes toward Mexico at this point. So the leaders in the syndicate got stuck with most of the loan because they had agreed to underwrite it. The loan presumably went through today finally. It was going to be signed every week and never got signed. I presume it got signed today. But by this time there is no money left of the loan because half of it goes into refinancing short-term debt that these same banks had put on some time ago and the other half goes to repay a bridge loan that they had made when they agreed to make the loan in the first place. So, there isn’t any cash from the loan. And it’s all symptomatic of the international financial markets closing up pretty tightly on Mexico now.

Bloomberg News was forced to fight a multi-year court battle against the Federal Reserve to make former Fed Chairman Ben Bernanke reveal the borrowings through its discount window during the financial crisis of 2008 and years following. When Bloomberg News finally won that battle, here it what it reported:

“The biggest borrowers from the 97-year-old discount window as the program reached its crisis-era peak were foreign banks, accounting for at least 70 percent of the $110.7 billion borrowed during the week in October 2008 when use of the program surged to a record. The disclosures may stoke a reexamination of the risks posed to U.S. taxpayers by the central bank’s role in global financial markets.”

Instead of stoking a reexamination of the risks posed by the Fed’s secret actions, Congress gave the Federal Reserve vastly expanded bank regulatory powers under the Dodd-Frank financial reform legislation. It became the regulator of first resort and the lender of last resort.

If you want to attempt to understand how moral hazard has permeated the U.S. financial system, there is no better place to begin than the Federal Reserve.

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