Monday, June 25, 2012 – Spain and Cyprus Fall – US Banks Insure Bets – Goldman Behaves Badly – Congressional Insider Trading – by Sinclair Noe

DOW – 138 = 12,502
SPX – 21 = 1313
NAS – 56 = 2836
10 YR YLD -.06 = 1.61%
OIL -.06 = 79.15
GOLD + 13.00 = 1585.30
SILV +.64 = 27.64
PLAT + 9.00 = 1450.00

So, the good news is that the Dow only dropped 138.

It could have been worse; or better, depending on your perspective. Back in April we advised heeding the old advice to sell in May and stay away. May was a horrible month. The first couple of weeks in June, we bounced back just a little, then we continue the declines.

This Euro-problem just never dies. There will be another emergency two day Euro-summit starting Thursday.  This appears to be the one area of relentless growth in Europe – the emergency summit business. I’m guessing that the caterers and event planners in Brussels are posting nifty profits. Expectations are low after Germany resisted pressure for common euro zone bonds or a flexible use of Europe’s rescue funds at a meeting of the region’s four biggest economies last week. Austerity measures pushed forward by Germany have tested the patience of the Greeks. The Greek government had to begin a search for a new finance minister after the nominee for the post said he could not serve because of health reasons. The situation in Greece sometimes seems it is never-ending. 

Cyprus announced it was seeking a bailout for its banks and its budget. Cyprus joins Greece, Ireland, Portugal and Spain in seeking EU rescue funds, meaning more than a quarter of the 17 euro zone members are now in the bloc’s emergency ward. Italy’s funding costs have soared too, which means it could be next. 

 Cyprus suffered a further sovereign credit rating cut on Monday by Fitch, to the junk BB+ grade. It is already shut out from raising new funds on capital markets, with yields on existing bonds well into double digits.  An island with just 1 million residents, Cyprus has a disproportionately large financial sector that is heavily exposed to Greece, a neighbor more than 10 times the size with which it shares a language, culture and close political links. Cyprus will find the bailout money. The reason? A few months back they found huge deposits of natural gas. 

Meanwhile, Spain is running on fumes. Moody’s Investors Service downgraded the long-term debt and deposit ratings for 28 Spanish banks and two issuer ratings, following on the heels of a cut to Spain’s sovereign rating to just above junk status earlier this month. Spain formally submitted its request for up to 100 billion euros of funds to bail out its banks, agreed on June 9. Spanish government bonds came under pressure with the 10-year bond yield up almost 30 basis points at 6.64 percent, near the 7-percent mark that forced other indebted European countries to ask for bailouts. 

Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America and Citigroup all suffered credit ratings cuts on Thursday. The rating agency Moody’s Investors Service said the banks had moved to strengthen their operations, but their core trading businesses contained structural weaknesses. And some of the problems that lead to the credit downgrades may actually be exacerbated by the cuts. 

One of those trouble spots is short-term borrowing. Wall Street firms need to finance their operations at a low cost to make profits, so they make heavy use of short-term loans that last from a few days to a few months; the downgrades could push up the costs of these loans. 

Another trouble spot is their derivatives business. Derivatives can be a lucrative for banks, but derivatives clients, to protect themselves, may now demand better terms with downgraded banks, like increased collateral. A derivative is less appealing when the counterparty looks weak. Wall Street banks would then have to decide whether to give up the business, or go along with client demands and face weaker profits. Some banks may have to relax their terms in order to win business.

To help insulate their profits from a downgrade, many Wall Street banks locate derivatives trades in bank subsidiaries backed by government-insured deposits. So, the units that took the risks messed it up so bad that their credit rating is cut, the banks just shift the risk of bets in derivatives over to the FDIC insured side of the ledger, and since they are FDIC insured, these subsidiaries have higher credit ratings than the parent companies. Citigroup, Bank of America and JPMorgan Chase have more than 90 percent of their derivatives in such subsidiaries. Morgan Stanley only has 5 percent. 

Incredibly, there has been very little mention of this by the bank regulators. I think the FDIC should be screaming bloody murder, but they are not. The banks are now lumping together massive bets on derivatives with deposits from widows and orphans, and if the bets fail (and really given enough time, all gamblers are bound to hit a losing hand), when the bets fail, the first payoff comes to the gamblers. You may not want a bank bailout, but you probably want to guarantee FDIC insured deposits. This is the banksters sneaky new backdoor bailout. You’ve been warned.

Moody’s didn’t warn of possible future downgrades for these bank holding subsidiaries, but it did say the parent companies had a negative outlook, the agency’s way of saying it still had doubts about their creditworthiness. Given that threat, the banks may try to do as much business as they can in these higher-rated subsidiaries. That could face resistance from regulators, if the regulators ever wake up and smell the rot. 

Goldman Sachs lost a bid to dismiss a shareholder lawsuit alleging it made material misstatements in its own securities filings about its conflicts of interest in several complex securities transactions, including the now-infamous Abacus 2007 deal.

Every now and then a Judge wakes up and sees the light, and so we must say hallelujah and recognize a new convert: In a 27-page opinion, Hon. Paul Crotty of the U.S. District Court in the Southern District of New York said the shareholders, led by the Arkansas Teacher Retirement System and other pensions, sufficiently argued that Goldman made material misstatements about its business practices and conflicts in its roles in collateralized debt obligations like Abacus, and similar deals named Hudson, Anderson and Timberwolf.

Goldman’s arguments are “Orwellian,” the judge wrote in the opinion. “Words such as ‘honesty,’ ‘integrity,’ and ‘fair dealing’ apparently do not mean what they say; they do not set standards; they are mere shibboleths.”

At issue are disclosures in Goldman’s annual securities filings and its annual report related to how it addresses conflicts of interest, and more generally, how it conducts its business, including a line that it is dedicated to complying with the letter and spirit of the laws. Fraudulent conduct hurts a company’s share price, the judge wrote in his opinion; and concealing such conduct caused Goldman’s stock to trade at artificially high prices, the opinion said.

A spokesman for Goldman declined to comment.

In the Abacus deal, for which Goldman paid a $550 million SEC enforcement settlement two years ago, Goldman allegedly allowed hedge fund Paulson & Co. to select assets for the security that would perform badly or fail and hid the hedge fund’s role from investors.  In the Anderson, Hudson and Timberwolf 1 deals, Goldman said it held a long position in the equity portions without disclosing its substantial short positions in each, the shareholders allege.

The judge wrote that the shareholders have plausibly argued that Goldman knew its statements about holding long positions and being aligned with investors were inaccurate because of its substantial short positions. The judge also wrote: “If Goldman’s claim of ‘honesty’ and ‘integrity’ are simply puffery, the world of finance  may be in more trouble than we recognize.”

A new investigation from the Washington Post reveals 130 members of Congress or their families have traded stocks collectively worth hundreds of millions of dollars in companies lobbying on bills that came before their committees, a practice that is permitted under current ethics rules.

The lawmakers bought and sold a total of between $85 million and $218 million in 323 companies registered to lobby on legislation that appeared before them, according to an examination of all 45,000 individual congressional stock transactions contained in computerized financial disclosure data from 2007 to 2010.

Almost one in every eight trades — 5,531 — intersected with legislation. The 130 lawmakers traded stocks or bonds in companies as bills passed through their committees or while Congress was still considering the legislation. The party affiliation of the lawmakers was almost evenly split between Democrats and Republicans.

Earlier this year, Congress responded to criticism of potential conflicts of interest by passing the Stock Act, which bars lawmakers, their staffs and top executive branch officials from trading on inside information acquired on Capitol Hill; but the act failed to address the most elemental difference between Congress and the other branches of government: Congress forbids top administration officials, for instance, from trading stocks in industries they oversee and can influence. The lawmakers, by contrast, can still invest in firms even as they create laws that can affect the bottom line of the companies.

It sounds like common sense and basic propriety that if you have major responsibility for drafting legislation that directly affects particular companies, then you shouldn’t be trading in their stock. Your wife isn’t a blind trust. Your financial adviser isn’t either. At some point the lawmakers need to learn how to just say no.

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