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
Alrosa.
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
shattered.
Part II- What Happens If The Russians Fail
Edward Jay Epstein is the author of The Rise and Fall Of Diamonds

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)

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."

Ruling The Secret World Of Money

The Bank of International Settlements, better known as the BIS, is now calling for a global currency to replace the dollar as a reserve currency. Such a change would upend a financial system that has been in place since the Great Depression. As I reported well before the current crises, the power of the BIS, though cloaked in secrecy, should not be underestimated. It is, after all, the private club of the world's central bankers.

Is The car Czar Due For a Recall?

On March 29th 2009, Steven Rattner, President Obama’s newly-appointed car czar, met with Rick Wagoner, the chairman of General Motors, in Rattner’s new office in the Treasury Department, and in one of the most dramatic confrontations of the Obama administration in its first 100 days told him he would have to resign because he had lost the confidence of the Obama Administration. Wagoner, a 30-year veteran of GM, fell on his sword. Now, Less than a month after disposing of Wagoner, Rattner may confront a similar decision about his own tenure.
Up until leaving Wall Street for Washington in, Rattner, a 56-year-old former New York Times reporter, had a golden career in investment banking, working first at Morgan Stanley, then becoming a senior partner at Lazard Freres, and finally, in 2000, co-founding his own firm, Quadrangle Group, which specializes in raising money for leveraged buy-outs in the communications industry. The largest source of money for such buy-out funds was pension funds, which collectively manage about $2.3 trillion, and so he actively recruited money from state and municipal pension funds.
What brought Rattner into the investigative cross-hairs was that he had employed Henry "Hank" Morris, a top advisor for then-New York State Comptroller Alan Hevesi, to act as its placement agen. In March 2009, Morris was arrested and charged in a 123-count criminal indictment for, among other things, "enterprise corruption" and "money laundering" in regard to selling access to the New York State Common Retirement Fund. Quadrangle had received $100 million from this pension fund just after paying Morris’s firm a placement fee. It also paid Morris for his help in getting money from the Los Angeles pension fund, the New York City pension fund and the New Mexico pension fund.
It is perfectly legal in these states for a private equity fund to pay fees to placement agents for this service so long as it discloses them. Such disclosures are necessary to identify possible conflicts of interest. Rattner presumably was familiar with these requirements since he had himself worked as a placement agent while at Lazard Frere. However, in garnering investments from the Los Angeles and New York City pension funds, Rattner’s firm reportedly failed to disclose the placement fees that went to Hank Morris. In the case of the Los Angeles pension fund, Quadrangle identified two other placement agents it used, but not Morris’ firm. One of the key issues New York’s attorney general is now investigating is whether the New York City Pension Fund was "intentionally misled or deceived" in 2005 by Quadrangle’s failure to disclose paying finder's fees to Hank Morris’s firm.
Further increasing Rattner’s exposure to the so-called pay For play scandal, the New York attorney general’s office is also investigating whether Quadrangle might have evaded crucial reporting requirements with New York State Common Retirement Fund in 2005 by having its subsidiary buy DVD rights to movie that was co-produced by David Loglisci, New York’s deputy comptroller. Loglisci, a close associate of Morris, was also indicted with Morris on corruption charges. The low budget movie entitled "Chooch," an Italian expression for a bumbling idiot, had failed at the box-office, taking in less than $40,000, before Quadrangle bought the DVD rights for $88,000. According to a studio executive who deals with DVD distribution, the DVD rights to a movie like "Chooch" would be worth "zilch" since it would "cost more to manufacture the DVDs than a distributer could realistically hope to make from their sales." So was there another benefit to investing in Chooch? About three weeks after buying these DVD rights, Quadrangle got its $100 million from the New York State Common Retirement Fund for which Loglisci was the top investment officer. Adding to the intrigue, a top executive of the CarlyleRiverstone Fund, a joint venture of the Carlyle Group, which also used Morris’ firm to get money from the New York State pension fund, made a similar investment in Loglisci’s "Chooch." Among the charges against Loglisci (as well as Morris) is "money laundering."
To be sure, Rattner himself may be innocent of any wrong doing in making payments to Morris’ placement agent company and having a subsidiary invest in Loglisci’s "Chooch" venture. But with SEC ans New York Attorney General Andrew Cuomo investigating these charges, with law officers in California, New Jersey, and New Mexico preparing their own investigations, and Morris and Loglisci due to go on trial in New York, Rattner needs to weigh whether, like Caesar’s wife, the car czar needs to be above suspicion. If so, just as he had the courage to ask Wagoner to retire for the good of General Motors, he might be prompted to consider the same course of action for himself.

The Placement Agent Scandal

Is it Placementagent Gate? The placement agent scandal continues to unfold today with Steven Rattner, Obama’s car czar, more and more in the cross-hairs. This afternoon New York Attorney General office announced that it is investigating whether Rattner’s firm Quadrangle Group "intentionally misled or deceived" New York City Pension Funds in 2005 by failing to disclose money paid to a politically-connected placement agent (since indicted.) Meanwhile New York State announced a permanent ban on the use of placement agents. The real scandal here is how these agents of influence are used to corrupt pension funds, as well as college endowment funds, which put over 130 billion tax-free dollars in leveraged buy outs in 2008. For the implications, see my Clog in yesterday’s Daily Beast.

The AIG Bail-Out: A Necessary Conspiracy?

AIG was a death star on September 15th 2008. One does not need a conspiracy theory to understand why the Fed intervened to prevent financial Armageddon. See my article in the Daily Beast.

Diamonds Are No Longer Forever

Responding to the global recession in late February, De Beers’ once mighty diamond cartel closed down about half its global production, including Orapa Number 1 in Botswana, the world’s biggest diamond mine. The immediate problem was a nearly 25 percent drop in prices in December. But De Beers’ fear is not just that retail prices will continue to decline - it has managed that problem before - but that the public will begin to sell its hoard of diamonds, or what is called at De Beers "the overhang."
At the heart of this concern is the reality that, except for those few stones that have been permanently lost, every diamond that has been found and cut into a gem since the beginning of time still exists today. This enormous inventory, which overhangs the market, is literally in - or on - the public's hands. Some hundred million women wear diamonds, while millions of other people keep them in safe deposit boxes as family heirlooms.
De Beers executives estimate that the public holds more than 500 million carats of gem diamonds, which is more than 50 times the number of gem diamonds produced by the diamond cartel in any given year. The moment a significant portion of the public begins selling diamonds from this prodigious inventory, the cartel would be unable to sustain the price of diamonds, or maintain the illusion that they are such a rare stone that their value is, as the ad slogan claims, "forever."As Harry Oppenheimer, who headed the cartel for more than a quarter of a century, pointed out, "wide fluctuations in price, which have, rightly or wrongly, been accepted as normal in the case of most raw materials, would be destructive of public confidence in the case of a pure luxury such as gem diamonds, of which large stocks are held in the form of jewelry by the general public."The genius of the cartel was creating this "confidence" in the myth that the value of diamonds was eternal. In developing a strategy for De Beers in 1952, the advertising agency N.W. Ayer noted in a report to De Beers: "Diamonds do not wear out and are not consumed. New diamonds add to the existing supply in trade channels and in the possession of the public. In our opinion old diamonds are in 'safe hands' only when widely dispersed and held by individuals as cherished possessions valued far above their market price."In other words, for the diamond illusion to survive, the public must be psychologically inhibited from ever parting with their diamonds. The advertising agency's basic assignment was to make women value diamonds as permanent possessions, not for their actual worth on the market. It set out to accomplish this task by attempting through subtly designed advertisements to foster a sentimental attachment to diamonds that would make it difficult for a woman to give them up. Women were induced to think of diamonds as their "best friends."This conditioning could not be attained solely by magazine advertisements. The diamond-holding public, which included individuals who inherited diamonds, had to remain convinced that the gems retained their monetary value. If they attempted to take advantage of changing prices, the retail market would be chaotic.
Even during the Great Depression of the 1930s, there was only a limited overhang, since the mass-marketing of diamonds had begun only a single generation before the crash. So even though demand for diamonds almost completely abated, De Beers, by shuttering all its mines and borrowing money to buy up the production of the small number of independent mines that still existed, was able to weather the crisis.Today, however, with many generations of the diamonds it mass-marketed overhanging the market, and most of global diamond production in independent hands, it no longer is in a position to bring supply and demand into balance. Adding to this precarious situation, diamond cutters, manufacturers and dealers, have, as of Feb. 15, an estimated $40 to $50 billion worth of diamonds in mines in the pipeline that will intensify the downward spiral when the gems reach the market later this year.If the current recession so deepens that the desperate need for money trumps the tenacious grip of sentiment, and the public begins selling even part of its hoard, it could finally shatter the brilliantly nurtured illusion that the value of the glittering stones kept on fingers, in jewel boxes, and in vaults is eternal. As the overhang came pouring into the maket, De Beer's nightmare could become a reality.

Sympathy For The Devil: Why AIG Had No Choice But To Pay

If you want to understand why AIG awarded derivative traders in its Financial Products Group $165 million in bonuses, don’t be distracted by the on-going morality play staged by politicians about the misuse of Federal funds, the blame-shifting game played by AIG executives, or even the disingenuous hand-wringing about the sanctity of contracts. The real decider here is money, specifically, $1.6 trillion worth of volatile derivative contracts. This portfolio, managed by some 400 people in a London-based subsidiary , mainly consists of credit default swaps, interest rate swaps, and other exotic hedging swaps that have the potential of inflicting hundreds of billions of dollars of losses on AIG– and, its de facto partner, the US tax payer.
How did the world’s largest insurer become a hostage to its subsidiary? In 1998, this tiny group got into the newly-created credit default swap business when JP Morgan Chase came to it with a proposition to transform debt on its books into security packages that could be sold off its books. To make these bank debt packages salable to other institution, they needed credible insurance against default to get Triple-A rating. So the AIG financial product group, seeing no risk of default, sold it in the form of credit default swaps. Soon afterwards, with the support of Treasury Secretary Lawrence Summers (now President’s Obama’s economic advisor), the Commodity Futures Modernization Act was passed, which excluded credit default swaps from being considered a "security" under the jurisdiction of the SEC or any other government agency. This act allowed these swaps to be deployed on a massive scale to convert all kinds of debt, including even subprime mortgages and car loans, into triple A securities and turned AIG’s arm, now headed by Joseph J. Cassano, an aggressive Brooklyn-born alumni of Drexel’s back office operations, into a multi-billion dollar profit center for the insurance behemoth. Even though the unit’s 400-odd man group constituted less than one-third of one percent of AIG’s total employees, it produced close to twenty percent of its total operating profits. While Cassano kept the list of his counterparties in the credit default swaps a closely held secret, he bragged at a conference in 2007 that they included a global swath of "investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities and sovereigns and supranationals." One of his more complicated operations involved using a subsidiary called Banque AIG to provide the largest banks in France with custom-tailored swaps that effectively allowed them to evade regulatory capital requirements on hundreds of billions of debt on their books. By 2006, his group was raking in nearly $4 billion in profits, and, as is the tradition in the derivative game, he and his traders got a rich cut of the loot, which on average amounted to roughly $440 million (or about $1.1 million per employee)..
With the collapse in 2008 of the debt AIG was insuring, came such massive losses that Cassano resigned, and AIG, unable to post collateral, faced bankruptcy. At this point in September 2008, the US government rescued AIG, pouring in $173 billion of tax payers’ money. Even so, there remained a $1.6 trillion in potential liabilities that could be triggered by thousands of the credit default and other derivative contracts. To prevent hundreds of billions of losses, these custom-designed contracts, , many of which would not expire until 2012, had to be continually watched, and, if necessary hedged, by traders who understood each one’s particular vulnerability.
. To perform this critical task, key people in the group wanted the same sort of guaranteed compensation in the form of retention bonuses as had in their previous two year contracts. The situation for AIG, and the US government that now owned 77 percent of it, was not unlike the one in Mario Puzo’s Godfather in which an offer is made that cannot be refused. In this case, even without a bloody horse head under the blankets, AIG and its federal overseers could not risk falling into a $1.6 trillion black hole by turning down the demands of those in the financial product group. It was not that they had such unique skills in derivative contracts that they could not be replaced by other people since the managing of these contracts is not overly complex. It is that they knew a proprietary secret, to wit, AIG’s secret book, which included the identities of all the counterparties to the credit default swaps and the unhedged parts of the positions vulnerable to price fluctuations. In addition, replacing some of these operatives in the complex of arcane subsidiaries it had set up technically constituted a change of control and could trigger defaults. For example, as it explained in a secret memo to the staff at the U.S. Treasury in February 2009, just the resignation of two of its Banque AIG executives, Mauro Gabriele and James Shephard, could set in motion renegotiations, and possible defaults in $234 billion in its European derivative contracts with banks. So even key people who had resigned, such as Cassano, were kept on as consultants at fees of up to $1 million a month. The implicit threat was that, if they were simply let go, not only would it cause havoc with the status of the derivative contracts but that traders would be in a position to use the secrets to which they were privy to trade for others against AIG as it attempted to protect the positions in its $1.6 trillion dollar portfolio. Under these circumstances, rather than risking immense losses from having its secret book compromised, AIG paid to keep the key members of the group from defecting. Their compensation, when approved by the Fed and Treasury, would amount to about $500,000 per person a year ( less than half what they had been getting in 2008.) The staff at the NY Fed, while Timothy Geithner was still its head, in fact helped negotiate the terms for these retention bonuses. When Geithner moved on to become Treasury Secretary in January 2009, he presumably understood how financially dangerous it could be to do otherwise, since he intervened with the Senate Banking Committee Chairman in February to get a provision dropped from a bill that would have prevented AIG (and other recipients of federal money) from paying such huge bonuses. In fairness to Geithner, the alternative to making these pay-offs might have proven a thousand times more costly to AIG, and its defacto owner, the US Government. Washington, after all, is ruled by pragmatism, and what difference is there between AIG paying $165 million to the derivative traders who caused the havoc, and the Fed rewarding the rating services that made possible the proliferation of trillions of dollar of toxic debt with $1.2 billion in fees to rate the new debt under its TALP plan to restore the credit markets damaged by its old Triple A rated toxic debt?
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Buffet Versus The Hedge Funds

Warren Buffet’s holding company, Berkshire-Hathaway, finally released its numbers on Saturday (February 28, 2009) which showed that it had the largest decline in its book value in its history. But even before this bad news was announced, hedge funds were massively shorting not Berkshire Hathaway itself but the publicly-traded companies in its $50 billion portfolio. Their bet was that Buffet would be forced to dump the stock of these companies was based largely on his vulnerability to massive losses on derivative contracts, including credit default swaps. It turns out that even while Buffet was denouncing derivative contracts as "financial weapons of mass destruction" and " time bombs", he was amassing one of the world’s largest position in them. For example, he sold derivative contracts on four stock market indexes– the S&P 500 in America, the FTSE 100 in the U.K., the Dow Jones Euro Stats 50 index in Europe and the Nikkei 225 Stock Average in Japan– for $4.9 billion that expose his company to over $35 billion in losses. In 2008 alone these contracts had lost on paper nearly $10 billion and with the market in free fall in 2009, they lost another $3 billion. Indeed, each percent these indexes decrease adds another $350 million to the loss Berkshire Hathaway is liable for. He also sold more than $2/4 billion worth of the infamous credit default swaps, not unlike the ones that brought AIG down once it lost its triple A rating. Such contracts insure that companies will not default on their debt. In addition, Berkshire Hathaway subsidiaries sold derivative contracts on energy for "operational purposes."
Although even the multi-billion dollar paper losses on these derivatives don’t require Berkshire Hathaway to put up money to guarantee payment to its counterparts, they weaken its balance sheet. And since Buffet prides himself on maintaining a "Gibraltar-like financial position," the hedge funds are gambling Buffet will protect Berkshire Hathaway balance sheet– and its triple A rating– by selling part of Berkshire Hathaway’s portfolio. If that happens, they expect to profit in their short sales from the plummeting prices. Whether or not their play succeeds against Buffet, remains to be seen.

Madoff's Lucky Investors

Quick quiz: Would you be better off today if you had invested a half-million dollars a year ago in: a) Bernard Madoff’s infamous Ponzi scheme or b) AAA blue chips such as General Electric, AIG, Citibank or Bank of America?
The answer is, believe it or not, a). It was supplied last week by Irving Picard, the trustee liquidating Madoff's investment firm who, after examining Madoff’s records over the past 13 years, revealed that Madoff was a total fraud who. instead of buying any securities for his victims. swindled them out of their money. This is great news for his investors since it makes them eligible to collect 100 percent of their losses from the Securities Investor Protection Corp, an exchange-backed fund, which indemnifies investors against fraud up to $500,000 per investment account. So if our hypothetical investor was lucky enough to have invested $500,000 with Madoff, he would have zero loss. If on the other hand, he had been unlucky enough to invest this nest egg in the blue chip AAA blue chip selections, he would have lost at least 80 percent of his money (or up to 95% with AIG). So he would be out at least b$400,000. Making matters worse for our blue chip investor would be his tax situation. According to the U.S. tax code, a maximum of only $3,000 a year from an "investment capital loss" can be deducted against ordinary income. So if the unfortunate investor had no investment capital gains to offset the loss, it would take him over 133 years to fully deduct it from his taxes.
On the other hand, even if an investor put more that $500,000 an account with Madoff, the loss (beyond the $500,000 the investor gets back) is, thanks to an odd feature of the US tax code, a theft loss, and can be deducted dollar for dollar from his other non-investment income at present or for the past three years. So, under almost any scenario, an investor with taxable income he would be better off swindled by Madoff than having invested in General Electric, Citibank, AIG or Bank of America. Alas. as the Bonpartist Antoine Boulay de la Meurthe famously said of the assassination of the Duc d’Enghein. "It is worse than a crime, it is a mistake."

A De Beer's Nightmare

Diamonds, alas, are not forever. I explain in my article in the International Herald Tribune how De Beer's greatest nightmare is now unfolding.

The Oscar Deception

The 81 th Academy Awards, with its scripted speeches by stars, tearful acceptances, eulogies to the rich and the dead, red-carpet celebrity fashion show, and gold-dipped statuettes, has the same mission that it did when Louis B. Mayer convinced the other studio moguls to create the event in 1927 to: "establish the industry in the public's mind as a respectable institution." Now, televised by ABC in dazzling high-definition color, the evening-long informational will further the long-standing myth that Hollywood is in the business of making great—and original—movies.
This illusion, like all successful deceptions, requires misdirecting the audience's attention from reality of how Hollywood makes its money to a few brilliant aberrations. Take this year's Best Picture nominations: Milk, Frost/Nixon , The Curious Case of Benjamin Button ,The Reader , and Slumdog Millionaire . What all of these films have in common is that they have virtually little to do with the real business of the Hollywood studios, which is global openings on 3000 or more screen of youth-oriented movies that, after a few weeks in the multiplexes, can be mass marketed on DVDs. For the Hollywood elite to choose these atypically adult movies as a public display of its virtue is as absurd as the music industry giving its grammy awards to Mozart, Bach, and Verdim or international oil companies presenting awards to avant-garde artists who happen to paint in crude. While Hollywood studios, or their wholly-owned "independent" subsidiaries occasionally make or distribute artistic and social-commentary films, their principal business is no longer about making movies. It is about creating properties—including TV programs, cartoons, videos, and games—that can serve as licensing platforms for a multitude of markets.
The confusion proceeds from the fact that for the first 20 years of the Academy Awards, the movie business was entirely about movies. In those days nearly two-thirds of Americans went to a movie in an average week, and all the studios' earnings came from the proceeds of the tickets sold at movie houses. But that was before the advent of television in the late 1940s. Once people could watch sports, game shows, and movies at home for free, most of the habitual audience disappeared. By the late 1970s, U.S. movie theaters, which had sold 4.8 billion tickets in 1948, sold only 1 billion. Hollywood, on the verge of financial ruin, had little choice but reinvent itself.
The studios simply followed their audiences home. To do this, they first repackaged the movies shown at theaters Pied Piper-style by making movies that visually appealed mainly to children and teenagers and then recycled them into home products, including DVDs, TV shows, games, and toys, which, in 2008, produced some 80 percent of their revenues. In this business model, alas, art, literary, and social-commentary movies are marginalized, since they cannot be either turned into licensing franchises or used to lure huge opening-week audiences to theaters. And, as satisfying as these more artistic films may be to directors, writers, actors, and producers, they do not lend themselves to sequels, prequels, or other licensable properties. They do, however, perform one function very well: acting as decoys at Hollywood's annual celebration of itself.

The Myth Of The Lost Generation

"If you delay acting," President Obama warned Congress this month, "you potentially create a negative spiral that becomes much more difficult for us to get out of. We saw this happen in Japan in the 1990s… and as a consequence, they suffered what was called 'The Lost Decade' where, essentially… they did not see any significant economic growth." Actually, Japan’s GNP grew by nearly 10 percent during the 1990s. While such growth is meager, it was only part of the story. Before the United States rushes headlong into printing several trillion new dollars, with all the risks that entails of debasing the currency it is worth considering what was really lost in Japan’s "lost decade."

On the bleak side, Japan lost jobs. Its unemployment rate during these 10 years averaged 3.6 percent which, while high for Japan it was lower than any other country in the G-5 which, like Japan, had to compete with the surge in cheap-labor exports from China in the 1990s, In 1995, the midyear of the decade, while the unemployment rate was 3.2 percent in Japan, it was 5.6 percent in the US, and well over 8 percent in Germany, Britain France. Italy, and Canada.

What Japan did uniquely lose in the "negative spiral" was the incredible price froth that accompanied the 1980a bubble. At its height in 1989, real estate in Tokyo sold for as much as $139,000 a square foot– more than 350 times as much as choice property in Manhattan. Such valuation made the land under the Imperial Palace in Tokyo notionally worth more than all the real estate in California. The Japanese stock market, with some shares selling for a thousand times their earnings, similarly skyrocketed. Indeed. In 1989, the notional value of the stocks listed on the Tokyo exchange not only exceeded all the stocks in America, but represented 44% of the value all the equities in the world. When the bubble burst– as all bubbles do– real estate lost about 80 percent of their former value, and stocks plunged about 70 percent. As a result, the banking system that had extended virtually unlimited credit on pyramids collateral based on these assets, were left, if not insolvent, paralyzed. To the extent that the heady prices of the late 1980s proceeded from a wild flight from reality, their fall represented a cruel regression to the norm.

On the bright side, Japan had no inflation during this decade. So while the Japanese could no longer relish the fantasy that the land under their Imperial palace was worth more than the state of California, they could now more easily afford to buy homes, burial plots, and golf club memberships in Tokyo. The Japanese currency also was not debased in the crises, and a strengthening yen made vacations abroad and foreign imports (including fuel) far less expensive. The Japanese also continued to save. Unlike in America, in which the personal savings declined to a mere 5 percent in the 1990s (and became negative by 2005), Japan’s personal savings rate remained over 20 percent, providing some cushion of safety during this era. And Japan’s life expectancy rose in the 1990s to over 80 years, the highest of any major country, and 5 years longer than that of the United States.

Nor did Japan lose its advantage in international trade. Its automotive manufacturers, with the help of new hybrid and other fuel-efficient engines, gradually displaced their American competitors in world markets. Its electronic manufacturers, launching DVD players, digital camera, and high-definition TVs, changed the global face of home entertainment. Its state-of-the-art robotics and machine tool industry meanwhile provided China with the technological backbone for its economic boom. So even without "significant" growth in this decade, Japan remained the second largest economy in the world.

What was really lost in the crash was a popular delusion– the assumption that something as transient as the notional price of assets had enduring value. Once this illusion was brutally shattered, not even ten government stimulus packages, which totaled more than 100 trillion yen and caused public debt to exceed 100 percent of GDP, could resurrect it.
***

Harvard's Casino Investing

Harvard Management Corporation (HMC), which runs the world’s largest endowment fund, has had until recently an incredible record. Over the past six years, it succeeded in more than doubling the notional value of Harvard’s wealth to a $36.9 billion in fiscal 2008 (which ended on June 30th) even after paying for about one-third of Harvard’s operating expenses. So its recent loss of $8.2 billion between from July 1 through Oct. 31 2008 came as a stunning blow . This huge loss, as staggering as it sounds, may only be the tip of the iceberg of illiquid investments. According to a source close the Harvard Management Corporation, the damage, if the fund’s illiquid investment are realistically appraised, may be closer to $18 billion.
The lack of clarity as to size of the loss proceeds from the illiquid nature of the financial exotica in which Harvard is now heavily invested. Its team of highly incentivized money managers– who themselves earned $26.8 million in 2008– adopted a strategy aimed at taking maximum advantage of an inflationary global boom in the early 2000s by shifting the lion’s share of Harvard’s money from conventional endowment assets, such as bonds, preferred stocks, Treasury bills and cash, into more esoteric investments that would presumably rise as more money chased after scarcer goods. They bought, for example, oil in storage tanks, timber forests, and farm lands. While by the proliferation of trillions of dollars worth of sub-prime mortgages further expanded the bubble, driving up the price of oil, lumber and land rose, the notional value of Harvard’s portfolio soared. The price of oil, for example, which Harvard and other speculators were storing, more than quadrupled to $153 a barrel on commodity exchanges, allowing Harvard to hugely appreciate the notional value of its portfolio. So, between fiscal 2003 and 2008, Harvard’s "real assets" showed a gain of nearly 25% annually. But even after the subprime mortgage crisis began to unfold and a number of financial institutions. Including Bear Stearns had collapsed, Harvard’s money managers persisted in focusing on countering the risk of "continued longer term inflationary pressures - exacerbated by supply/demand considerations for various commodities."
Consequently, as late as June 2008 , the fund kept no reserve of cash or treasury bills and allocated a mere 6 percent of its money to fixed interest bonds. It also borrowed over one billion dollars to amplify the returns on its less conventional investments. So, by the time the bubble burst in the fall of 2008, only a small fraction of the endowment fund investment was even under the jurisdiction of the SEC. According to the 13F holding report it filed with the SEC in September 2008, Harvard had only $2.86 billion of its funds in exchange-listed stocks, options or other derivatives. What had happened to the rest of the more than $35 billion* it had allocated to investments at the start of Fiscal 2009 (in July) 2008?*
[*- From the $36.9 it had on June 30th, it had distributed $1.6 to the University which financed one-third of its budget, and another $200 million went to pay to HMC for the costs or administration and bonuses.]
Most of the balance had been allocated to investments, which if not totally illiquid, could not be valued by market activity. The breakdown that follows illuminates how far HMC had strayed from the path of traditional endowment investing.
More than a quarter of Harvard’s funds were still sunk in "real assets"; 8% in stockpiled oil, 9% in timber and other agricultural land, and 9% in real estate participation. Then came the financial crises, and prices plunged. Oil fell to under $40 a barrel. Lumber suffered almost as badly. And, with the drying up of bank lending, the value of its real estates holding became at best, problematic. One indication of how steep the loss may be is that CalPERS, the giant pension fund of the California Public Employees’ Retirement System, which owned even more real estate acreage than Harvard, reported in this period a 103% loss on real estate deals in which, like Harvard, it had borrowed to amplify its profits.
Another huge portion of Harvard’s endowment had been farmed out to hedge funds (18%) and private equity funds (13%). While these funds provided some diversification, many of them also impose restrictions on withdrawals, including ones, like Citadel, that suffered substantial losses. To get back its money under such circumstance, it was often necessary to sell at a steep discount to a "secondary" hedge fund. One major player in the private equity business tells me that Harvard had tried this Fall to sell its private equity stakes at 30 to 35 percent discounts but find no buyers even at those prices. Even worse, the typical private-equity fund has a provision for "capital calls," requiring investors to put up another 50 cents to 75 cents for every dollar they already have committed. If so with Harvard, the $4 billion it has allocated to private equity may not only o be drastically reduced in value, but might lead to a massive drain on its remaining capital.
Harvard also allocated nearly $4 billion, or 11% of its fund, to volatile emerging markets, such as Brazil, Mexico, and Russia. Here its money managers bet both that the stocks would go up and that the local currencies would at least hold steady against the dollar, but lost on both counts. First, the thin local stock markets, which had little liquidity, collapsed in the financial crises. For example, Russian stocks, lost almost 80%, of their value in a mater of days. Then, as banks and hedge funds, got out of their currency trades, the local currencies in many of these countries also lost heavily against the dollar. The Brazilian Real, for example fell about 40% . So the endowment fund took a double hit.
Aside from emerging markets, Harvard had invested another 11 percent if its portfolio in more established foreign economies, as those of Britain, Germany, France, Italy, Australia, and Japan. But here the stock markets declined, and, with the exception of the Japanese yen, so did their currencies.
Given the true cost of getting its money out of the hedge funds and other illiquid investments, my knowledgeable source finds the claim by Harvard’s money managers that the fund only lost 22 percent at best "purely pollyannaish." But while Harvard’s money managers may chose to look through rose color glasses at the value of their portfolio , Harvard University, which relies on the interest from distribution from its endowment to fund one-third of its operating budget, needs to be more realistic. As its President, Drew Faust, noted in letter to the Harvard faculty, "We need t\o be prepared to absorb unprecedented endowment losses and plan for a period of greater financial constraint."
To be sure, Harvard Management Corporation flight to illiquid assets strategy did not occur in a vacuum. Harvard’s money managers developed their ideas taking advantage of their "connections to Harvard University researchers and professors," as they say in the 2008 annual report. Up until mid 2006, Larry Summers, a former deputy secretary of the treasury (and now the head of Obama’s Economic Council, was Harvard’s President While it is not known what, if any, direct liaison Summers had with the Harvard Management Corporation,, he seemed to endorse its strategy in 2006 at a speech at the Reserve Bank of India in Mumbai when, citing the high returns that college endowment funds then had been achieving, argued that "By investing in a global menu of assets U.S. institutions have earned substantial real returns over the years."
Nor was Harvard alone in moving from traditional investments to a more"global menu". Yale’s endowment fund, which with $22.5 billion in assets in 2008 was second only to Harvard’s, followed a similar strategy of finding alternate investments including hedge funds, private equity funds, physical commodities, and emerging markets. Its longtime manager David Swensen indeed makes the argument in his book "Pioneering Portfolio Management" that diversifications of this kind are safer than just investing traditional stocks and bonds. And during the decade preceding the present financial crises his fund actually outperformed Harvard’s. But despite his efforts at diversification, Yale lost at least 25% of its fund in the fall of 2008 if one , takes into account the plunging value of its illiquid assets.
Up until the financial crises, comparative endowment fund performance became the financial equivalent of athletic rivalries, with Yale President Richard Levin, for example, pointing to the 2007 results (which beat Harvard), bragged, "The stunning thing is how much we outperformed other endowments," While Harvard, using other yardsticks, noted in its 2008 report that its "annual outperformance... easily places Harvard in the top five percent of all institutional funds." Hoping to match Harvard and Yale’s dazzling records of multiplying the notional value of their endowment funds other universities across the country, who, followed suite, plowing much of their endowment funds into financial exotica and other illiquid assets. In 1995, endowments had less than 10% of assets in these alternative type investments; by 2008, that average had climbed to more than 30%. Consider the plight of Columbia University. As oft June 2008, 41% of its $7 billion endowment fund was in hedge funds and 40% in private equity funds, and is liable for another $1.6 billion in capital calls up until 2012 (which would wipe twice over all its stock, bond , cash other liquid investments.) The collateral damage is yet to be fully reckoned, but the damage is beginning to show. In December 2008, Berkeley Chancellor Robert J. Birgeneau warned in a letter to students and faculty, "As of today, we are already seeing that the leading private universities have experienced significant drops in the value of their endowments and are engaging in severe budget cuts." So institutions of higher education, like other speculators seeking enormous profits in what is essentially a zero-sum game, learned the sad lesson that playing for high stakes in the casino economy inexorably entailed the risk of catastrophic losses.

Was Mike Milken Right?

Michael Milken, the financier who revolutionized corporate finance in the 1980s, based his entire concept of junk bonds, on what he claimed was a "fundamental flaw" in Wall Street’s financial structure: the trust it had in the ability of three ratings services– Standard & Poor’s, s Moody's and Fitch Ratings– to evaluate the relative risk of bonds. Since SEC rules prevented anyone else from supplying bond ratings, these rating services had (and still have) what is tantamount to a global monopoly on issuing bond ratings. When one or more of these services give a triple-A rating to a corporate bond, it certifies that there is virtually no risk of default, This seal of approval allows Wall Street underwriters to sell them to insurance companies, pension plans, college endowments, and other institutions, many of which are restricted by regulations from buying bonds with a lower rating that triple-A. In other words rating services determined which corporations are eligible for institutional bond financing.
When I interviewed Michael Milken back in 1987, he railed against the rating services, zeroing-in on Triple-A rated banks such as Citibank. His scathing analysis went as follows: "What is a bank?" he asked rhetorically. "It is nothing more than a bunch of loans." " How safe are these loans?" he continued.
"They are made mainly to three groups that may never repay them in a real
economic crisis-- home owners, farmers and consumers of big ticket items." "What
guarantees these loans?" "Very little since these banks usually have $100 in loans
for every dollar of equity." He pointed out that a number of states such as California required that all home loans be non-recourse loans, which means that the only collateral is the home itself (making them little better than what would later be called sub-prime mortgages.) "Yet,their bonds get a triple-A ratings from the bond rating services." ne continued. "This is crazy" because rating services measure "the past not the future" risk.
Soon afterwards, the financial establishment trounced on Milken. Faced with endless litigation. He pled guilty to the five counts of financial transgression, and went to prison for 22 months. But his downfall did not answer the critical issues he raised about the rating services.
That was two decades ago. Since then the rating services have extended their
Triple A ratings to debt packages, such as Collateral Debt Obligations (CDOs) that
included subprime mortgages and other questionable loans. Since they get much
higher fees for rating complex debt pools than for plain vanilla corporate bonds,
this expansion into CDOs has proved incredibly lucrative for them. Moody's,
which is partly owned by Warren Buffet’s Berkshire Hathaway, raked in over $3
billion in fees from 2002 until 2006 for providing these ratings. Standard &
Poor's meanwhile escalated this race into the abyss in 2000 by extending
their top ratings to "piggy-backed" CD0s. Appropriately named, piggy-backed CDOs multiplied leverage by allowing buyers to simultaneously take out a second loan to finance the first CDO. The logic was that if the initial loan was Triple A, and there could not default, so was the "piggy-back" based on it. Other rating services followed suit, so as not to lose the rich piggy-back rating business to Standard and Poor’s. The result that CDOs were leveraged over and over again, while maintaining the triple-A rating that made
them appear to be almost as safe as a Treasury bond.
Of course, there is an obvious conflict of interest in this enterprise: the rating services are paid by the companies who issue the securities they rate. Moreover, the rating services admit in their fine print that their ratings are based on the data supplied by the companies seeking the ratings. Nevertheless, wheelers and dealers in Wall Street, London, Dubai, and other financial ports of call so leverage these rated CDOs to such an extent that by late 2008 an estimated 18 trillion dollars in marketable debt hung over what remained of the global financial markets. As we all know now. the ratings proved to be wildly out of touch with reality, and the subsequent collapse of the house of cards built upon them, sapped the global financial system of the crucial confidence necessary for it to function..
If Milken’s critique of the rating services had been taken more seriously
in 1987, we might not now be staring into this back hole today,

Buffet's Darker Side

In the Presidential debates in October, both Barack Obama and John McCain, came up with the same name to save the reeling American economy: Warren Buffet.
Buffet is the chairman of Berkshire-Hathaway, a $120 billion holding company. Known in the media the "Oracle Of Omaha," he had condemned derivative contracts as early as 2003, describing them. "as time bombs, both for the parties that deal in them and the economic system." After derivative contracts on sub-prime mortgages had delivered a near death blow to the financial system in October 2008, he told Charlie Rose in an hour-long televised interview that such derivatives were nothing short of "financial weapons of mass destruction," saying, "They destroyed AIG. They certainly contributed to the destruction of Bear Sterns and Lehman." It light of his lucid explanation of their incredible perils, it seemed gratuitous for Charlie Rose to then ask Buffet if he himself had trafficked in derivatives, If he had asked, the Buffet’s answer might have been surprising since, at the time of that interview, Buffet’s holding company not only had multi-billion dollar positions in derivative contracts but it was the largest single shareholder in one of the principal enablers of the proliferation of sub-prime mortgage derivatives.
As subsequently revealed in Berkshire Hathaway’s third quarter 10-K filing with the SEC in 2008, the Oracle turned out to be one of America’s largest seller of derivative contracts. Not only had he sold over $2.5 billion worth of credit default swaps in 2008– the same notorious derivative contracts that had brought AIG to its knees– but he had sold over $6.7 billion worth of another type derivatives, called "index put option contracts" that essentially bet stock prices would not fall here and abroad. These contracts have a duration of as long as 20 year, and, as the disclosure notes, "generally may not be terminated or fully settled before the expiration dates and therefore the ultimate amount of cash basis gains or losses may not be known for years." Even for the first nine months of 2008, Berkshire’s losses from these derivative already were $2.2 billion.
But Buffet’s involvement in the derivative casino went beyond selling credit default swaps and put options. After Moody’s Corporation, the second- largest credit-rating company, went public in 2000, he had Berkshire Hathaway buy 48 million shares in it– approximately a twenty percent stake– making it by far Moody’s largest shareholder. The role Moody’s was to play in the proliferation of sub-prime mortgage , along with that of the two other rating agencies, Standard & Poor’s and Fitch Ratings, is lucidly described by Nobel laureate economist Joseph Stiglitz in an interview with Bloomberg News: "I view the ratings agencies as one of the key culprits, They were the party that performed that alchemy that converted the securities from F- rated to A-rated. The banks could not have done what they did without the complicity of the ratings agencies.''
The sad history of Moody’s race to the bottom began after it was spun off by Dun & Bradstreet Corp. in September 2000 and after Buffet had invested $499 million in it. Prior to that, Moody’s was a stodgy company in the low-profit business of evaluating credit data supplied to it largely by triple-A companies. The SEC had given it, along with S&P and Fitch’s, an effective lock on the issuance of credit ratings. So the giant corporations needed to get its top rating (AAA, meaning little or no risk) in order to sell their bonds to insurance companies, pension funds, and other regulated institutions. But with the mushrooming of mortgage-back securities, Moody's found a much more profitable business line: rating pools of mortgages called Collateralized Debt Obligations (CDOs). Working on the theory that if these CDOs were structured into different tiers, it could award Triple A ratings to the safer tiers, which, in turn, would allow underwriters to sell CDOs to institutions, Moody’s made additional money advising the underwriters how to structure their CDOs in such a way so that it could provide top ratings. Once they received these ratings they could leveraged them over and over again via so called "piggy back" loans.
Even though sub-prime mortgages accounted for about half of the collateral on CDOs, Moody's manage through this theory to assign triple A grades to nearly 75 percent of them. In August 2004, to get an even larger share of this business, it revamped its credit-rating formula in such a way that it could issue top-ratings to even a larger portion of sub-prime debt. Not to lose market share, Its chief competitor, S&P, followed suit the next week. By 2006, the market for rated CDOs had exceeded $3 trillion.
This enterprise entailed an obvious conflict of interest since Moody’s was being paid by very companies it was rating, but the profits were so enormous it was overlooked by everyone involved. By extracting almost three times the fees on structured CDOs than it got on conventional corporate debt, Moody’s took in an incredible $3 billion between 2002 and 2006. And since it had operating margins above 50 percent on its rating work, most of this new found El Dorado was profit. When Moody’s stock soared, it increased the market value of Buffet’s stake from $499 million in 2001 to $3.2 billion in February 2007. The Oracle of Omaha thus made $2.7 billion profit from the very "time bombs" he was at the time publically damning. Moody’s ratings meanwhile enabled these derivatives to spread like kudzu throughout the global financial pipelines until the entire house of cards collapsed in 2008. Moody's then had to downgrade more than 90 percent of all asset-backed CDO investments issued in 2006 and 2007, and Buffet, alas, lost a good part of the windfall
It is hardly conceivable that Buffet, who famously prides himself on the scrutiny he gives to companies in which he invests, could not have known that the heart of Moody’s money machine was certifying hundreds of billion dollars worth of CDOs for purchase by banks and other institution. If he didn’t know that, what kind of Oracle is he?

The Silver Lining To Madoff

"You can’t cheat an honest man. He has to have larceny in his heart in the first place."
– W. C. Fields, 1939

Don’t cry (yet) for investors in Bernie Madoff’s grand Ponzi scheme– or at least for those of them who pay taxes. As bad as they may have done in their calculated effort to beat the system by betting with one of the stock exchange’s major market makers, thanks to an odd feature of the US tax code they will probably wind up losing less money than ordinary investors had by buying shares in some of the largest companies on the New York Stock Exchange. If an investor has a net loss in legitimate srock investments, according to the tax code, it is considered an investment capital loss, and the maximum amount he can deduct from his other income is a piddling $3,000 annually. So if he loses a million dollars, it will take him 334 years to deduct it. If, on the other hand, an investor put that million with Bernie Madoff, he could deduct the entire million immediately from other taxes because, as far as the IRS is concerned, it proceeded from a theft, not an investment loss. If the investor was in a 50% bracket– with state and local taxes– and he had other taxable income, his bottom line loss from the million would be only $500,000. Consider, for example, if a prudent investor had bought $1 million worth of shares a year ago in such blue chip stocks as Citibank, Bank of America, AIG, Ambac, General Motors or Barclays Bank, which fell between 81 and 90 percent in value (as of January 19th), which, if he sold them, would leave him with an after-tax loss of over $800,000, or, much more than the loss he would have sustained if he had let Bernie madoff swindle him out of the million.
Even better, to the extent that Madoff’s investors paid taxes on false capital gains booked in their accounts during the prior five years, they are owed tax refunds– with interest. It also turns out that since virtually all hedge fund partners are limited partners, the entity's theft loss flows through to them, and they therefore can also take advantage of the Madoff tax credit for their personal tax returns. So as painful as it is to lose money in a Ponzi scheme is, it is more painful to lose it in a legitimate investments where the loss it is not tax deductible for centuries.
The US government stands to lose a vast amount of tax revenue through the Madoff tax credit– as investors may deduct billions of dollars worth of their loss against other income. But there is also a silver lining for the government. According to my knowledgeable source, Treasury department investigators are now discovering that a great many of Madoff’s investors funneled their money through off shore accounts without reporting them. The IRS thus will be able to level immense penalties on these tax-dodgers for hiding off shore income–even if it was fictive income. But are tax-dodgers really deserving of pity?
The real victims are the tax-exempt players, especially the legitimate philanthropies, that sunk their funds in Madoff’s Ponzi scheme. Alas, they cannot recoup any of their losses. The tragic flaw here was trust. Samuel Johnson adumbrated that danger more than two centuries ago when he wrote about the bankruptcy of merchants, that assumed the splendour of wealth only to obtain the privilege of trading with the stock of other men, and of contracting debts which nothing but lucky casualties could enable them to pay; till after having supported their appearance a while by tumultuary magnificence of boundless traffic, they sink at once, and drag down into poverty those whom their equipages had induced to trust them."

To Russia With Questions

In December, I went to Moscow to look further into the Litvinenko Affair. The Prosecutor General's office had set up a special unit, the National Investigative Committee, to handle that and other sensitive investigations. It took a resourceful research associate, and a few weeks of vexing paper work, to arrange an appointment. But, once in the door, its investigators proved surprisingly cooperative. See my 4000 word report in today’s New York Sun.

Ten Things We Don't Know About The Death of Litvinenko

1. We don’t where the Polonium 210 found in Alexander Litvinenko’s body came from.
Russia produces Polonium 210 for export to the US, but it is not the only state with the capability to produce it. Polonium 210 can be produced by any country with a nuclear reactor that is not subject to IAEA inspections. All that is required is the metal bismuth, which is readily available, and a nuclear reactor. In 2006, there were at least nine nuclear weapon states that had nuclear reactors not inspected by the IAEA, including China, Israel, Pakistan, India, and North Korea. ( Polonium 210 has been found in Iran in 2005)
2. We don’t know how the Polonium 210 got to London.

British authorities categorically deny that Polonium 210is produced in any reactor in that country. If so, it was smuggled into England from its country of origin. But no container for it was ever found.
3. We don’t know when the Polonium 210 was manufactured.

Polonium 210 half-life is about 134 days. During that brief period, half of it decays into daughter elements. So the date it was produced can be determined if the quantity of all the daughter elements is compared to that of the remaining Polonium 210. If the daughter elements are missing, which often happens outside the pristine conditions of a lab, the Polonium 210 cannot be dated. In the case of the radioactive corpse, the possible crime scenes were so compromised by weeks of repeated cleaning, vacuuming, and foot traffic that the traces found of Polonium 210 cannot be dated. The same is true of the Polonium 210 found in the corpse itself in the autopsy, since an unknown amount of the daughter elements would have been unable to get through the intestinal wall and would be expelled from the body.
4. We don’t know why the Polonium 210 was smuggled into England

Neither Litvinenko or any of the other men contaminated by the Polonium 210 admitted to having any knowledge of Polonium 210. Litvinenko believed he was poisoned by Thallium.
5. We don’t know when Litvinenko and his associates were first contaminated.
Traces of Polonium 210 was found in offices that Litvinenko and his two Russian associates, Lugovoy and Kovtun, had last visited on October 17th. But, since the Polonium 210 itself cannot be dates, the contamination could have been earlier.
6. We don’t know who contaminated who.

We know that four men were hospitalized with Polonium 210 in their bodies, Litvinenko, Scaramella, Lugovoy, and Kovtun. Scaramella could not have been the source of the cross-contamination since he arrived in London on the evening of October 31 and met only with Litvinenko. So he could not have contaminated (or been contaminated) by Lugovoy or Kovtun. But Litvinenko, Lugovoy, and Kovtun all met in offices that were contaminated by Polonium 210 on October 17th, so any of them– or anyone else present at that meeting or who visited those offices– could have been the proximate source of the cross-contamination.
7. We don’t know how anyone was contaminated?
Polonium 210 can be spread, as the Israeli investigation of a 1960s leak determined, by clothing fibers, dust, shoes, or even by shaking hands. In the case of the London Polonium cases, it remains a mystery how minute particles spread to the four men hospitalized.
8. We don’t know if the Polonium 210 was released by design or accident.
All the known Polonium 210 deaths in France, Israel, and Russia prior to the radioactive corpse in London resulted from an accidental leak. In the London case, since there were no witnesses to anyone deliberately poisoning Litvinenko and no since no aerosol sprayer, dispenser or other delivery device was found, the is no evidence that the contamination was intended.
9. We don’t know the findings of the autopsy examination .
The British authorities have not released these findings. So we don’t the amount of Polonium 210 found in Litvinenko’s body or the sites.
10. We don’t know the findings of the Coroner .
The British authorities have not released the Coroner’s Report, if it was completed. So there is no official cause of death.