Friday, May 29, 2009

The Russian Take Over The Diamond Cartel

De Beers Consolidated Mines, Ltd., whose mines up until recently produced over 40 percent the world’s diamonds, reduced its output of rough diamonds by about 90 percent in 2009. Moreover, in accordance with the new anti-trust laws of the European Union, it stopped buying diamonds from other producers for its stockpile. By doing so, it effectively relinquished control over the diamond prices to the Russia’s state-controlled monopoly, Alrosa, which is now the largest the world’s largest diamond producer.
For more than a century, De Beers had been the undisputed overlord of a global diamond cartel. Indeed it masterfully created and perpetuated the diamond invention, the idea that diamonds are rare and forever valuable. To be sure, until the late nineteenth century, diamonds were truly rare, found mainly in a few riverbeds in India and South America, and the entire world production of gem diamonds amounted to a few pounds a year. Then in 1870, huge diamond mines called “pipes”
because of their circular shape were discovered in South Africa, where
diamonds were soon being scooped out by the ton by steam shovels. As
these diamonds poured onto the market, the price dropped to loss than
$10 a carat, endangering the investments in these mines. Realizing that
the flood of diamonds from these pipes, if not abated, would destroy the
public’s perception that diamonds were scarce, and that without the
perception of scarcity diamonds would become at best only
semiprecious gems, the mine owners moved to limit the surfeit of
diamonds by merging their properties in 1888 into a single entity, De
Beers. This diamond cartel, which then came under the control of the
Oppenheimer family, maintained the “price security” crucial to the
illusion by releasing onto the market only the number of carats to satisfy
demand at the established price and stockpiling the excess diamonds in
its vaults in London and Johannesburg. When diamonds were found in
more and more countries, it worked through an intricate system of
bankers, shell corporations, and buying agents to keep them in a single
channel of distribution called the “Central Selling Organization.” By
acting as the buyer of last resort, De Beers proved be the most successful
cartel arrangement in the annals of modern commerce. Then, in the
1960s, it was confronted by a new challenge: a huge pipe mine
discovered outside in purview in Siberia. Even though the Russians had discovered it in 1955, the incredibly harsh conditions in Siberia delayed its development until 1962.
Concerned that these small, mainly quarter to half carat diamonds would
disturb the precariously balanced market, Sir Philip Oppenheimer, the
head of the Central Selling Organization, rushed to Moscow to negotiate
a 5 year deal to buy virtually all the Siberian diamonds. De Beers
considered it a good investment, even if had to stockpile all these
diamonds, because, based on the data, it had it could reasonably expect
the production from that Siberian mine to gradually diminish as similar
mine had done in South Africa. Instead, production accelerated at an
incredible pace, and by 1968, it was delivering nearly two million carats
a year to De Beers, most of which were added to its bulging stockpile.
In return, the diamond haul provided the Soviet Union with so much
hard currency that the head of the Mirny Diamond Administration said,
"We call ourselves the country's foreign exchange department."
When Russia delivered some 2.5 million carats in 1976– -almost onequarter of the world's supply– Sir Philip insisted on personally inspecting the mysterious Siberian mine before he would renew thecontract. He was accompanied by Barry Hawthorne, who was then De Beers' chief geologist in Kimberley. By the time they had completed the arduous journey to Mirny– fog delayed the flight for nearly a day–
they had very little time to inspect the mine. "We had about a twentyminute tour of the mine," Hawthorne later told me, and what he saw at the open pit site only deepened the mystery of how the Russians produced vast quantities of gem diamonds from the depth of the excavation he could calculate that less ore had actually been taken from
this mine since 1960 than would be able to produce anywhere near the
quantity of gem diamonds the Russians were shipping to De Beers– at
least by comparison to their South African state-of-the art mines.
Hawthorne theorized that Russia must have “secret mines” elsewhere.
The Siberian diamonds also intrigued the CIA since the hard currency
they provided could fund KGB operations. The CIA’s
counterintelligence staff even looked into the possibility that the
Siberian diamonds were man-made, or “grown”, in hydraulic presses– a
process which had been demonstrated experimentally by General
Electric but proved economically unfeasible (at least in the US)– though
it could not find any evidence to substantiate this theory. In any case,
for de Beers, the enigma became a moot issue: wherever these diamonds
came from– whether the Mirny mine or some other secret sources– they
could not be allowed to inundate the market and destroy the illusion of
scarcity. Whatever their origin, De Beers had to keep them in its
“single channel” of distribution. So though, the price was a matter of
tough negotiations, it continued to bear the burden of sustaining the
illusion of scarcity.
After the Soviet Union collapsed in 1990, De Beers still bought about
half of Russia’s diamonds (with the balance consigned to local
consumption or the Russian stockpile that had been created by the
Communists in 1917 to hold gems taken from the Czar.)
Since acting as buyer of last resort put enormous financial strains on
the company, and mew antitrust laws in Europe made it more difficult to
stockpile diamonds, De Beers sought a new strategy by moving to
establish its brand in the retail end of the diamond business. Then,
facilitating this change, the European Union in 2008 prohibited De
Beers from stockpiling Russian diamonds. Even though the Supreme
Court of the European Union later suspended that prohibition, De Beers
agreed to end its long-standing deal with the Russians by 2009. As a
result, the baton has been passed to the Russian diamond monopoly
The Russians are aware of the requisites of running the cartel. “If you
don’t support the price,” Andrei V. Polyakov, a spokesman for Alrosa
told the New York Times, “a diamond becomes a mere piece of carbon.”
The immediate problem confronting the Russians is the $5 to $7 billion
worth of diamonds in the so-called pipeline, which are the diamonds
bought by cutters, dealers, and manufacturers, mainly with bank
financing, that because of the collapse in retail sales, remain in their
inventories. On top of that, new pipe mines in Angola and Australia
threaten to further destabilize the market. So the new overlords of the
diamond cartel have their work cut out for them.
But while the Russians may share the motivation and even logic of
De Beers, the diamond invention is far more than a monopoly for fixing
diamond prices; it is a mechanism for converting tiny crystals of carbon
into universally recognized tokens of wealth, power, and romance. De
Beers managed this feat through the intangible but crucial element of
good will. For three generations, the Oppenheimer family built a
network of relationships with diamond cutters in Antwerp, brokers in
Tel Aviv, intermediaries in Africa, and bankers in London which was
based on a long-standing mutual trust. This network furnished, among
other things, much of the pricing intelligence, discipline and public
relations that allowed De Beers to control the diamond trade. If the
Russian monopoly lacks the necessary human capital to run this delicate
mechanism, the illusion at the heart of the diamond invention , along
with the diamond prices it has for so long sustained, may be forever
Part II- What Happens If The Russians Fail
Edward Jay Epstein is the author of The Rise and Fall Of Diamonds

Monday, May 18, 2009

Cuomo's Matrix Of Corruption

The corruption of pension funds by private interest is hardly a new phenomenon. Las Vegas after all was largely built with money from the Teamster’s Central States Pension Fund, with the intermediary Sidney Korshak, a mob- connected lawyer, channeling a large part of it to casino owners. Korshak himself was never conducted of any wrongdoing, but Jimmy Hoffa, the President of the International Teamster Union, was imprisoned on corruption charges in 1971, Then, after getting a pardon from President Nixon in 1974, he literally disappeared without a trace (his body, according to the latest FBI theory, had been cremated by his associates in organized crime). Today, Pension fund financing is a far more respectable and civilized industry. It is also vastly richer, with pension fund s holding over $2.7 trillion in assets, and providing private equity firms with the most of the capital they use for their leveraged buy-outs, real estate acquisitions and other ventures. In return for allowing pension funds to participate in their deals, the private equity firms exact lucrative fees, taking both a percent of their total investment– typically two percent per year– and part of the profits– usually 20 percent of each successful deal. In 2008, the ten largest pension funds had allocated $105 billion to such private equity deals, creating a veritable El Dorado. To mine this mother lode, private equity firm had to first access to the functionaries at the pension fund who controlled these allocations, and while there is no single powerful intermediary in the class of Sydney Korshak, there are legions of less visible intermediaries called, "placement agents," who use their political contacts, financial experience, powers of persuasion, and other means to extract pension fund money for private equity firms. Indeed, it is now a multi-billion dollar industry. In return for inducing pension fund officials to invest in such deals, they get a cut from the private equity firm of usually between 1 and 3 percent of the total commitment. Since placement agents gets nothing if they fails, they have a powerful incentive to do what is necessary to close the deal. The question currently concerning New York State Attorney-General Andrew Cuomo, the SEC, and some 36 other state attorneys general law is: how do they accomplish their amazing feat of inducement?
According to Cuomo, who is spearheading the investigation, there is " a matrix of corruption, which grows more expansive and interconnected by the day." So far six people have been charged criminally and two people have pleaded guilty. Among those charged with "enterprise corruption" are Henry "Hank" Morris, and his friend David J. Loglisci. Morris, a former top aide to former New York Comptroller Alan Hevesi, who was in charge of New York’s $122 billion pension, raked in at least $15 million dollars in "placement" fees from private equity firms. Former deputy comptroller Loglisci, the top investment officer of the state’s pension fund, allegedly got paid from Morris and also had private equity firms steer money into a curious movie venture called "Chooch he and his brother produced, and whose plot, aptly enough, concerns a bag of mystery money. Both Morris and Loglisci deny any wrong doing and are currently awaiting trial.
Cuomo’s game plan, according to one lawyer knowledgeable about the investigation, is "to work his way up the food chain." This strategy, as the lawyer explained, involves making deals with less-culpable parties in return for their cooperation and testimony against other private equity firms whose real exposure comes not from their making payments to placement agents, which is perfectly legal in most states, but from their failure to disclose them or, even worse. "disguising them" as sham transactions.
Consider the recent guilty plea of placement agent Julio Ramirez Jr. to a misdemeanor securities fraud violation. According to Cuomo’s office, Ramirez, , who worked for the placement agent Wetherly Capital Group in Los Angeles, entered into a "corrupt arrangement" with Hank Morris to get private equity firms $50 million in investments from New York's $122 billion Common Retirement Fund. Ramirez then split his fees with Morris, but did not disclose Morris’ involvement. Since that omission made him vulnerable to prosecution, he elected to cooperating with the Cuomo’s investigation, further tightening the prosecutorial vice on Hank Morris.
Cuomo also made settlements with the Carlyle Group, one of the nation’s largest private equity firms and Riverstone Holding a private equity company headed by David M. Leuschen. Their joint venture had paid $10 million to Hank Morris’ firm for its help in getting it $730 million in investments from the New York Pension fund. Leuschen, had also invested $100,000 of his own money in the movie Chooch, a movie venture that involved David Loglisci, the chief investment officer of that pension fund. Since the joint venture had fully disclosed its payments to Morris’s firm and could claim that it was not involved in Leuschen’s personal investment in the Chooch investment, Cuomo made a deal with both Carlyle and Riverstone in which each paid a fine– Carlyle $20 million and Riverstone $30 million and agreed not to use placements agents in any future deals and to fully cooperate in the ongoing investigation. In addition, Carlyle, issued statement saying that it "was victimized by Hank Morris's alleged web of deceit." It also moved to sue both him and his company for more than $15 million in damages, further racheting up the pressure on Morris to make a deal. The settlement did not include Leuschen, who is still, according to Cuomo, "under investigation." It also does not bode well the 20 other investment firms ensnared in Cuomo’s Matrix. The Quadrangle Group, for example, paid Morris placement multi-million dollar fees for assisting it get pension fund money in New York, New Mexico, and California and also invested money in the mysterious Chooch venture. But, unlike Carlyle and Riverstone, Quadrangle failed to disclose it’s the fees it paid Morris’ company to New York City Pension Fund and the Los Angeles Fire and Police Pensions Fund. Nor can it separate itself from its Chooch investment by, as Carlyle and Riverstone did, shifting responsibility to a personal investment, since it had one of its own private equity holdings buy the video rights to movie. One possible problem for Cuomo– as well as the SEC investigation is the prominence of Quadrangle’s then chairman Steven Rattner, who in 2009 became a key member of President Obama’s task force that is presently desperately working to save General Motors and the American car industry.
But Cuomo has pledged that "The investigation will continue until we have unearthed all aspects of this scheme." As he is both a tenacious– and ambitious investigator, he will undoubtedly topple more dominoes as he proceeds up the food chain . But will he break the matrix of corruption? Stay tuned.
(Updated June 12)

Friday, May 08, 2009

The Amazing Chrysler Trick

The latest casualty of the economic crises is the Rule of Law.
Consider the sad case of Chrysler. Its troubles became manifest in 2007,
when it was owned by the German auto giant, Daimler, and it was unable to come to terms with the United Auto Workers labor union (UAW). Rather than suffer more losses from an unfavorable union contract, Daimler decided to rid itself of Chrysler by handing over 80 percent of its ownership to Cerberus Capital Management, a private equity fund named after the mythical creature guarding the doors of hell. After Cerberus agreed to keep the car company going, Chrysler celebrated with a huge fireworks display and acrobats swinging on ropes from its roof at its headquarters in Auburn Hills, Michigan. Chrysler then borrowed $10 billion from a banking syndicate, led by J.P. Morgan Chase, Citigroup, and Goldman Sachs, to fund its operations. The loan was secured by mortgages on Chrysler's real estate,manufacturing plants, patents, and highly profitable brand licensing rights (Jeep alone earned $250 million a year licensing its name to toys, clothes,and other products.)
The lenders assumed (incorrectly, as it turned out) that their secured loan which was senior to any other Chrysler debt, would be protected even if Chrysler went bankrupt, since the iron rule of bankruptcy held that secured loans get fully paid before unsecured loans. Without this rule, financiers would be reluctant to lend money to corporations on their assets. What these lenders had not reckoned on was the political power of the UAW, especially after the 2008 Democratic landslide.
With automobile manufacturing shifting from the unionized factories of the Big Three– Chrysler, General Motors, and Ford– to the non-unionized factories owned by foreign manufacturers, including those of Toyota, the UAW was rightly concerned that it would lose its grip on the automotive industry. Already, in 2008, these non-union factories‹located mainly in traditionally Red, or Republican, states whose "right-to-work" laws prevented employees from being forced to join a union‹were selling almost as many passenger cars in America as the Big Three. So if Chrysler was allowed to collapse, the UAW stood to lose heavily. As
did the Blue states in the Midwest where its factories are located. So the
UAW had little difficulty in rallying massive support for a rescue among the Democratic leadership of both the House and Senate. By February. President Obama had appointed investment banker Steven Rattner to head his auto task force and come up with a plan.
The solution that Rattner (aka the car czar) endorsed involved dividing Chrysler into two companies‹an old Chrysler, which would be saddled with the debts, and disappear, and a new Chrysler, to which all the valuable assets would be assigned, including those that had been mortgaged to the senior secured creditors.
The new Chrysler would be owned by the UAW, which would get 55 percent of the shares; Fiat, the Italian manufacturer, which would be get 20 percent, with the option of increasing its ownership to 35 percent if it conformed to the targets imposed by the U.S. government; and the U.S. government, which would get most of the remaining shares. Fiat would essentially run the company, supplying its small-car technology and its management (even though, on previous occasions, its managerial efforts in America proved unsuccessful.) The new deal is a win-win for Fiat, since it is not investing any money in the new Chrysler, and can walk away without a penalty.
But what of the people who lent the old Chrysler money secured by its
assets? According to the rules of bankruptcy, they were entitled to be paid
the full $6.9 billion they'd lent the old Chrysler before those assets could be shifted to the new Chrysler‹and before the unsecured creditors, including the UAW's pension fund and auto-part suppliers could be paid a cent. That was not in the car czar's game plan, however, Instead, the creditors were confronted with a take-it-or-else offer of 29 cents on the dollar,
substantially less than the unsecured creditors would receive. (The UAW's
fund, for example, would receive an implied 55 cents on the dollar.) The "else" turned out to be what President Obama described as a "surgical bankruptcy" for Chrysler in a pre-selected U.S. bankruptcy court. Here the administration was able to play its ace in the hole. The four bank that held 70 percent of these loans, namely Citigroup, Goldman Sachs, Morgan Stanley, and JP Morgan Chase, all had received government bailout money, making them vulnerable to government reprisals. So while denouncing hold-outs as "speculators" and "obstructionists" or, as one Congressman from Michigan termed them, "vultures", it was not difficult for officials to strong-arm these banks into accepting the deal.
Using these tactics, Chrysler was able to secure the support of more than two-thirds of its creditors. Once that threshold had been crossed, U.S. bankruptcy judge Arthur Gonzales was within his rights to force the remaining creditors to approve the plan.
Whether or not this extraordinary intervention saves Chrysler, which lost a
staggering $16.8 billion in 2008, remains an open question. After all, even
Fiast's organizational skills may not be enough to persuade
American consumers to buy cars from a company emerging from bankruptcy, especially since its much-heralded small-car technology, meanwhile, will not appear until 2012.
But the consequences of upending the rule of law, even if it was done with
the best of intentions, may prove far more serious than whatever befalls
Chrysler in the Rustbelt. For one thing, it will undoubtedly become far more difficult for an American corporation to borrow money on its assets, since even a senior secured lender can no longer be sure his claim will take priority over those of labor unions and other unsecured creditors.
As one savvy investment banker told me, "Now that we live in a banana
republic, secured lending is anything but secure."