Pam Martens and Russ Martens published a mind-boggling expose yesterday on how the SEC is refusing to stop an abuse by major banks that increases systemic risk. Large banks are continuing to fake their capital levels, via a ruse called a “capital relief trade” with hedge and pension funds. And Mary Jo White, the chairman of the SEC, is aware of this practice, which undermines the safety and soundness of financial institutions, and has done squat about it.
White is not just head of the SEC but also a member of the Financial Stability Oversight Council. She is undermining it and financial reform generally by her failure to take on this practice. Pam Martens and Russ Martens also charge the SEC chairman and her director of enforcement, Andrew Ceresney, with cronyism, since they both hail from the law firm Debevoise, which is an active player in this practice.
As much as there has been considerable consternation over Mary Jo White’s numerous lapses, like hiding behind the need for more data as an excuse for doing nothing about high frequency trading, her failure to secure more admissions of wrongdoing in SEC settlements, and her refusal to comply with Dodd Frank by virtue of too freely issuing waivers for mandatory sanctions, even to recidivist bad actors, this dereliction of duty is considerably more serious, because it increases systemic risk in a direct, tangible way.* Remember that technically permissible balance sheet fakery at Lehman, also known as Repo 105, allowed it to mask how sick it was.
One of the excuses for the weakness of Dodd Frank was that if financial firms had high enough equity levels, all the other ways of reducing risk became less important. The Wall Street Journal quoted Geithner’s reform approach that he set forth in 2009:
“The most simple way to frame it is: capital, capital, capital,” Treasury Secretary Timothy Geithner told Congress last year. “You want capital requirements designed so that, given how uncertain we are about the future of the world, [and] given how much ignorance we fundamentally have about some elements of risk, that there is a much greater cushion to absorb loss and to save us from the consequences of mistaken judgment.”
Thus capital relief trades undermine the government’s chosen first line of defense against bank failure. From the Martens’ article:
For more than two years now, SEC Chair Mary Jo White has been aware that the most dangerous banks on Wall Street, which are publicly traded securities, have been engaging in “capital relief trades” with hedge funds and private equity firms to dress up the appearance of stronger capital while keeping the deteriorating assets on their books. But neither White nor her Director of Enforcement, Andrew Ceresney, have put a halt to the practice.
And it provides an example of how one of the weakest too big to fail banks, Citigroup, has engaged in this practice. Recall that Citi was the only one of the five largest banks to fail the stress test twice in three years and have its plans to increase dividends and buy back stock rejected. Again from the Martens’ account:
In February 2013, Bloomberg News reported one of these eyebrow-raising trades between Citigroup – the bank that blew itself up in 2008 with hidden derivative deals – and Blackstone Group, a private-equity firm. Blackstone had insured Citigroup against initial losses on $1.2 billion of shipping loans, allowing Citigroup to lower the amount of capital the bank had to set aside by 96 percent. The problematic loans remained on Citigroup’s balance sheet according to Bloomberg News.
Mind you, $1.2 billion is small beer compared to the $50 billion in Lehman Repo 105 trades at its peak. But the flip side is that this is the one of the very few examples of this type of transaction that has come to light. How much more risk has been shifted to unregulated entities like private equity and hedge funds? Recall that AIG has an AAA balance sheet and was considered a financial powerhouse. By contrast, these risks presumably sit at specific private equity and hedge funds, and a $1.2 billion risk is certain to loom large relative to total fund size. These entities aren’t supervised for safety and soundness and thus aren’t held to any requirement that will assure that they can meet liquidity demands in the event that Citigroup or one of its peers that has entered into similar trades hits a financial iceberg yet again. Recall one of the lessons of the crisis: when a hedge fund is hit with losses, it also receives investor redemptions, which put many once high-flying funds into a death spiral. And the icing on the cake is that retirees and endowments are major investors in these “alternative” investments and thus the main ultimate risk bearers.
The article describes the undisclosed, glaring conflict of interest:
While White and Ceresney have allowed these risky capital relief trades to proliferate in the dark, their former law firm has been gushing over the trades and drumming up business for the murky area. In a Debevoise publication sent to clients in 2013, the law firm indicated it had experience in these deals and said they “appear to be particularly good opportunities for funds to generate revenue by providing targeted credit support, while retaining the ability to actively deploy capital as needed.”
Debevoise added further: “While it remains to be seen if transactions of this type can be structured in ways that are appropriate and attractive for a traditional private equity fund, it is yet another example of the innovative emerging opportunities for capital providers to make effective use of balance sheet capital as banking organizations adjust to the post-crisis regulatory paradigm.”
Please sign the Credo petition, Tell President Obama: Time for Mary Jo White to go. More important, call or e-mail your Senators and Representative and tell them about the Martens’ bombshell. You can find Senate contact information here and House contact details here.
Mary Jo White has done nothing to stop the type of bad practices that blew up the financial system in 2008. She is so clearly unwilling to do her job that she needs to be fired.
Update: My bad (failure of early AM drafting) to not say that the President cannot fire White. However, I also cannot imagine that if she were to hit a firestorm of criticism and the President were to call her in and say that the public had lost confidence in her, the odds are high that her resignation would be forthcoming.
* As much as HFT and dark pools have produced the worst possible market structure for public equities, the low use of borrowing in the US stock markets means it is not a source of systemic risk.