"The rise and fall of ponzi scheme mastermind Bernie Madoff" PBS NewsHour 4/14/2021
Excerpt
SUMMARY: Former financier Bernie Madoff, who organized the largest fraud in Wall Street's history, died Wednesday. He swindled major charities, universities and celebrities out of billions, and was serving 150 years in prison. Stephanie Sy has our report about his rise and fall.
SUMMARY: The startup WeWork set out to revolutionize the workplace -- leasing, renovating and subletting offices as shared coworking spaces. At the beginning of 2019, it was the single biggest private office tenant in London, New York, and Washington. But the company’s valuation has plunged $40 billion, and it’s now laying off 2400 employees. John Yang talks to The New York Times' Peter Eavis.
SUMMARY: The Federal Reserve cut a key short-term interest rate for the first time in a decade, lowering the federal funds rate a quarter point. It had raised that rate, which reflects what banks charge each other for loans, in December. But the news didn't satisfy Wall Street, where stocks fell significantly -- or President Trump. Judy Woodruff talks to the Brookings Institution's David Wessel.
SUMMARY: With a presence in 65 countries, ride-sharing company Uber has conducted about 10 billion trips in its lifetime -- about 15 million per day. Paul Solman looks at how economists are using this treasure trove of data.
SUMMARY: A financial storm sent stocks plunging to their biggest losses in eight months. The Dow Jones Industrial Average plunged 831 points. The NASDAQ fell 316 percent. Amna Nawaz talks about what may have prompted the selloff with Hugh Johnson, Chief Investment Officer at Hugh Johnson Advisors. Johnson says it’s a “severe correction.”
SUMMARY: The sell-off that hit Wall Street on Friday whipsawed the market again on Monday. In one furious, 15-minute stretch, the Dow dropped and recouped 700 points. What made markets plunge? John Yang gets analysis from Gillian Tett of the Financial Times and Diane Swonk of DS Economics.
SUMMARY: Global markets have been on a roller coaster ride for the past three days. The Dow Jones Industrial Average plunged more than 500 points Tuesday morning, but ended up more than 500 points. John Yang learns more from Neil Irwin of The New York Times.
SUMMARY: The stock market took another nerve-wracking ride on Thursday, with the Dow Jones Industrials dropping more than 1,000 points. One explanation of this week's jitters is the idea that market prices are out of whack. So how low could we go? Economics correspondent Paul Solman puts today's market in historical perspective -- and it isn't especially reassuring.
SUMMARY: Stocks plunged on Friday over fears that the Federal Reserve will accelerate interest rate hikes. The sell-off was driven by news that the economy added a net of 200,000 jobs in January, with wages rising at the fastest pace in more than eight years. Judy Woodruff gets analysis from Liz Ann Sonders, chief investment strategist of Charles Schwab.
SUMMARY: The job market and the economy are growing stronger and at a healthy pace, Federal Reserve Chair Janet Yellen told PBS NewsHour’s Judy Woodruff [on] Friday as she wrapped up her four-year term on a momentous economic day.
The day started with a solid jobs report showing 200,000 new jobs last month and better wage growth. But the Dow Jones continued plunging during a brutal week, finishing the day down more than 665 points or about 2.5 percent. It capped the worst week for the Dow in two years.
But Yellen was focused on the long-term picture, saying that for “almost all groups in the American economy … you’re seeing plentiful jobs and wages beginning to rise at a slightly faster pace.”
In the NewsHour interview, recorded before the stock market closed, Yellen also warned that stock market valuations are elevated beyond their usual historic levels, including the ratio of price to earnings. Yellen stopped short of characterizing the market’s rise in recent months as a bubble.
Even as the market was dropping, Yellen stressed that the financial system is more resilient now than it was during the financial crisis of 2008. Still, she said, “investors should be careful and, I would say, diversified in their investments.”
Yellen also struck a sober tone on other trends in the economy. She said productivity — a key barometer watched by the Fed — has been weaker than hoped. She also said the pace of new firms being created over the past decade was slower than usual.
SUMMARY: July was the second straight month of solid gains for U.S. employers, who added 209,000 jobs, according to the Labor Department. Mark Vitner of Wells Fargo joins Judy Woodruff to discuss what it means for the job market, the stock market and millions of Americans.
SUMMARY: The market value of Tesla, the high-end electric car manufacturer, has surpassed that of American automotive giants like Ford and General Motors, both of which sell millions more cars than Tesla does. James B. Stewart of The New York Times joins William Brangham to discuss Tesla's brand allure and the state of today's auto industry.
WILLIAM BRANGHAM (NewsHour): Here are some head-scratching numbers to consider.
Tesla's market value is $50 billion, yet Tesla may lose nearly a billion dollars this year, whereas, combined, Ford and GM are expected to earn more than $15 billion. Last year, Tesla sold just about 80,000 vehicles. Ford and GM? They sold nearly 17 million.
James Stewart is a business columnist for The New York Times and a staff writer for The New Yorker, and he's here to help us understand why Tesla's value is skyrocketing.
James Stewart, welcome to the NewsHour.
You know these numbers very, very well. What is going on here?
JAMES STEWART, The New York Times: Well, these numbers are pretty amazing. They make no rational sense, really.
But Tesla is what I call the sort of ultimate story stock, which means investors care about the story. They don't care about the numbers. They do not care that it's losing. They have lost over $500 million last year, may lose a billion this year. And they don't really care that GM and Ford are making billions of dollars in profit.
The story with Tesla is that they are going to dominate the auto market, that they are going to create the world's safest car, that they are going to take over the battery market, and that they are going to dominate and reinvent the electric grid.
I mean, these are all huge markets, and they think Tesla is going to dominate every one of them.
SUMMARY: At Zappos, an engaging work culture comes first; the company lavishly invests in morale. But what's the business rationale for spending generously to make employees happy? Economics correspondent Paul Solman visits the eccentric Las Vegas headquarters of Zappos, a company that's known for its devoted customer service and philosophy of self-management rather than hierarchy.
HARI SREENIVASAN (NewsHour): You might know retailer Zappos for the shoes it sells and its emphasis on customer service. What you may not know about is its quirky corporate culture, and why the company is banking on that for its long-term success.
Our economics correspondent, Paul Solman, reports, as part of his weekly series, Making Sen$e, which airs every Thursday.
WOMAN: Definitely the best port-a-potty experience I have ever had.
PAUL SOLMAN (NewsHour): From its Porta Party P.R. to its campus in downtown Vegas, Zappos, the online shoe monger, is devoted to different.
JASON BROWN, Zappos: Let me give you these three rules about wearing wallflowers, as we like to call them.
PAUL SOLMAN: Wallflowers?
JASON BROWN: Wallflowers, because you see we have got the wall? And we call them wallflowers.
PAUL SOLMAN: Front desk dress code enforcer Jason Brown gives visitors three options.
JASON BROWN: First one is to take it off if it holds sentimental value to you. The next one is to wear it around your head in a bandana, John Rambo-style. And then the last one is to cut, and it becomes part of the collection.
SUMMARY: The Dow Jones and other indexes were already doing well when Donald Trump won the presidential election. And the overall jump of recent weeks has accelerated mightily, rising from just above 18,000 on election day to breaking 21,000 this week. For analysis of what's happening with the markets, William Brangham speaks with Neil Irwin of The New York Times.
Right after the financial crisis, an SEC lawyer fought a lonely struggle to get his agency to crackdown harder on Goldman bankers. He lost.
This story was co-published with The New Yorker. It is not subject to our Creative Commons license.
In the late summer of 2009, lawyers at the Securities and Exchange Commission were preparing to bring charges in what they expected would be their first big crackdown coming out of the financial crisis. The investigators had been looking into Goldman Sachs' mortgage-securities business, and were preparing to take on the bank over a complex deal, known as Abacus, that it had arranged with a hedge fund. They believed that Goldman had committed securities violations in developing Abacus, and were ready to charge the firm.
James Kidney, a longtime SEC lawyer, was assigned to take the completed investigation and bring the case to trial. Right away, something seemed amiss. He thought that the staff had assembled enough evidence to support charging individuals. At the very least, he felt, the agency should continue to investigate more senior executives at Goldman and John Paulson & Co., the hedge fund run by John Paulson that made about a billion dollars from the Abacus deal. In his view, the SEC staff was more worried about the effect the case would have on Wall Street executives, a fear that deepened when he read an email from Reid Muoio, the head of the SEC's team looking into complex mortgage securities. Muoio, who had worked at the agency for years, told colleagues that he had seen the “devasting [sic] impact our little ol' civil actions reap on real people more often than I care to remember. It is the least favorite part of the job. Most of our civil defendants are good people who have done one bad thing.” This attitude agitated Kidney, and he felt that it held his agency back from pursuing the people who made the decisions that led to the financial collapse.
While the SEC, as well as federal prosecutors, eventually wrenched billions of dollars from the big banks, a vexing question remains: Why did no top bankers go to prison? Some have pointed out that statutes weren't strong enough in some areas and resources were scarce, and while there is truth in those arguments, subtler reasons were also at play. During a year spent researching for a book on this subject, I've come across case after case in which regulators were reluctant to use the laws and resources available to them. Members of the public don't have a full sense of the issue because they rarely get to see how such decisions are made inside government agencies.
Kidney was on the inside at a crucial moment. Now retired after decades of service to the SEC, Kidney recently provided me with a cache of internal documents and emails about the Abacus investigation. The agency holds the case up as a success, and in some ways it was: Goldman had to pay a $550 million fine, and a low-ranking trader was found liable for violating securities laws. But the documents provided by Kidney show that SEC officials considered and rejected a much broader case against Goldman and John Paulson & Co.
Kidney has criticized the SEC publicly in the past, and the agency's handling of the Abacus case has been previously described, most thoroughly in a piece by Susan Beck, in The American Lawyer, but the documents provided by Kidney offer new details about how the SEC handled its case against Goldman. The SEC declined to comment on the emails or the Abacus investigation, citing its policies not to comment on individual probes. In a recent interview with me, Muoio stood by the agency's investigation and its case. “Results matter. It was a clear win against a company and culpable individual. We put it to a jury and won,” he said.
Kidney, for his part, came to believe that the big banks had “captured” his agency — that is, that the SEC, which is charged with keeping financial institutions in line, had become overly cautious to the point of cowardice.
The Abacus investigation traces to a moment in late 2006 when the hedge fund Paulson & Co. asked Goldman to create an investment that would pay off if U.S. housing prices fell. Paulson was hoping to place a bet on what we now know as “the big short”: the notion that the real-estate market was inflated by an epic bubble and would soon collapse. To facilitate Paulson's short position, Goldman created Abacus, an investment composed of what amounted to side bets on mortgage bonds. Abacus would pay off big if people began defaulting on their mortgages. Goldman marketed the investment to a bank in Germany that was willing to take the opposite side of the bet — that housing prices would remain stable. The bank, IKB, was cautious enough to ask that Goldman hire an independent manager to assemble the deal and look out for its interests.
This is where things got dodgy. Unbeknownst to IKB, the hedge fund Paulson & Co. improved its odds of success by inducing the manager, a company called ACA Capital, to include the diciest possible housing bonds in the deal. Paulson wasn't just betting on the horse race. The fund was secretly slipping Quaaludes to the favorite. ACA did not understand that Paulson was betting against the security. Goldman knew, but didn't give either ACA or IKB the full picture. (For its part, Paulson & Co. contended that ACA was free to reject its suggestions and said that it never misled anyone in the deal.)
When SEC officials discovered this in 2009, they decided that Goldman Sachs had misled both the German bank and ACA by making false statements and omitting what the law terms “material details” — and that these actions constituted a violation of securities law. (The SEC oversees civil enforcement of U.S. securities law and can charge both companies and individuals with violations. Its work can often be a precursor to criminal cases, which are handled by prosecutors at the Justice Department.)
Kidney was a trial attorney with two decades of experience at the SEC, and had won his share of courtroom battles. But the stakes in this case were particularly high. Politically, it was a delicate moment. The global financial system was only just recovering, millions of Americans had lost their jobs, and there was growing public anger about the bailout of the banks and car companies in Detroit. When Kidney looked at the work that had been done on the case, he found what he saw as serious shortcomings. For one, SEC investigators had not interviewed enough executives. For another, the staff decided to charge only the lowest man on the totem pole, a midlevel Goldman trader named Fabrice Tourre, a French citizen who lived in London, and who was in his late twenties when the deal came together. Tourre had joked about selling the doomed deal to “widows and orphans,” and had referred to himself as “Fabulous Fab,'' a sobriquet that probably would not endear him to a jury. He was an easy target, but charging him was not likely to send a signal that Washington was serious about cracking down on Wall Street's excesses.
Kidney could not understand why SEC staffers were reluctant to investigate Tourre's bosses at Goldman or anyone at Paulson & Co. Charging only Goldman, he said, would send exactly the wrong message to Wall Street. “This appears to be an unbelievable fraud,” he wrote to his boss, Luis Mejia. “I don't think we should bring it without naming all those we believe to be liable.”
Kidney came to work at the SEC in 1986. He was thirty-nine at the time, having first worked a stint as a journalist. The “steam was elevated” at the agency when he started there, he said. Young lawyers were expected to go after the big names, and they did: the junk-bond king Michael Milken, the insider trader Ivan Boesky, the investment banker Martin A. Siegel.
As a trial lawyer, Kidney's job was to develop a compelling narrative that could be presented to a jury of laymen unfamiliar with the intricacies of finance. “Jim was a great attorney. A lawyer's lawyer. Sound legal mind, excellent writer, and a true trial lawyer,” said Terence Healy, the vice-chair of securities enforcement practice at Hughes Hubbard and a former colleague of Kidney's at the SEC. But Kidney also exasperated some staffers who thought he wasn't detail-oriented and didn't grasp nuances.
Soon after he joined the case, Kidney believed that the evidence the SEC staff had assembled justified charges against more people and he argued for, at the very least, an investigation of higher-level executives. The SEC team had not interviewed Tourre's direct superior, Jonathan Egol. Nor had they questioned top bankers in Goldman's mortgage businesses or any of the bank's senior executives. Even more surprising to Kidney, the agency had not taken testimony from John Paulson, the key figure at his eponymous hedge fund. It seemed to Kidney, as he reviewed the case materials, that the agency had spent more time and effort investigating much smaller insider-trading cases. Just two weeks after he joined the case, on August 14th, Kidney urged the team to broaden its investigation and issue key participants in the Abacus deal what are known as Wells notices — official notification that the SEC is considering charges.
Kidney's view of the case put him at odds with Muoio, who was widely respected at the agency for his analytical abilities. Kidney said that he was aghast when, in an email sent a month later congratulating his team on their work investigating Tourre, Muoio described potential targets of SEC charges as “good people who had done one bad thing,'' and he did little to hide his irritation.
“I am in full agreement that when we sue it can be devastating, and that we have sued little guys way too often on flimsy charges or when they have been punished enough,'' he wrote back. “But I'm not at all convinced that Tourre alone is sufficient here.”
Kidney later explained to Muoio that he was pushing for a more assertive approach because he believed that the SEC had grown too passive in its oversight of Wall Street. “The damage to the reputation of the [SEC] in the last few years and the decline of the institution are very troubling to me,” he wrote.
Kidney and Muoio battled for months. Kidney felt that the agency was overly dependent on the kind of direct evidence it had against Tourre. Part of the problem was that high-level Goldman executives had been savvier in how they communicated: when topics broached sensitive territory in emails, they would often write “LDL” — let's discuss live.
Kidney pressed the team to take what he thought were obvious investigative steps. He had been told by a staff attorney in the group that Muoio had vetoed the idea of calling Paulson to testify, and the agency hadn't subpoenaed Paulson's emails initially, relying mainly on the voluntary disclosure of documents. “We didn't get subpoena power until late in the investigation,” a staff attorney acknowledged to Kidney in an email sent late in August of 2009.
As the year ended, Muoio remained opposed to bringing charges against anyone but Tourre. In a December 30th email, sent to the entire group investigating the deal, Muoio offered an explanation for what had happened during the bubble years: “Now that we are gearing up to bring a handful of cases in this area, I suggest that we keep in mind that the vast majority of the losses suffered had nothing to do with fraud and the like and are more fairly attributable to lesser human failings of greed, arrogance and stupidity of which we are all guilty from time to time.”
Several days later, Kidney sent an email to Lorin Reisner, the SEC's deputy director of enforcement, in which he warned, “We must be on guard against any risk that we adopt the thinking of those sponsoring these structures and join the Wall Street Elders, if you will.”
Kidney also continued to push the agency to bring charges against Egol, Tourre's superior at Goldman, arguing that the SEC should at least interview him. According to Kidney, Muoio dismissed the idea, saying that the agency knew what Egol would say.
“That's a cardinal sin in an investigation,'' Kidney said that he told Muoio. “You can't assume what somebody will say.”
One reason for the reluctance from Muoio and others at the SEC was that they wanted to make the case about misleading statements and they didn't have that sort of evidence from Paulson & Co. employees or high-level Goldman executives.
Kidney told me that he thought the SEC could avail itself of a broader interpretation of securities law. He argued that the agency should file civil actions against top players at both the bank and the hedge fund under a concept called “scheme liability” — a doctrine of securities law that makes it illegal to sell financial products whose main purpose is to deceive investors.
In late October of 2009, Kidney circulated a long memo arguing that the SEC should consider charging Paulson & Co., John Paulson himself, and Paolo Pellegrini, who was the hedge fund executive who worked on the Abacus deal.
“Each of them knowingly participated, as did Goldman and Tourre, in a scheme to sell a product which, in blunt but accurate terms, was designed to fail,” Kidney's memo said. “In other words, the current pre-discovery evidence suggests they should be sued for securities fraud because they are liable for securities fraud.”
John Paulson and Pellegrini declined to comment for this article. Paulson & Co. and Goldman dispute that the deal was fraudulent. A spokesman for the Paulson hedge fund said that “there was no ‘scheme' nor was Abacus ‘designed to fail'” and that the hedge fund neither told Goldman what to disclose to investors nor knew anything about what the bank was telling investors. A Goldman spokesman said that the bank never created mortgage-related products that were designed to fail. He said the precipitous collapse in the value of Abacus, which fell to zero several months after it had been created, resulted from the broad decline in the housing market that afflicted all securities related to real estate, not because of flaws in the product.
Some of Kidney's colleagues initially supported his idea to pursue scheme liability, but Muoio seemed to think that doing so would hurt the agency's solid but narrower case against Goldman. “I continue to have serious reservations about charging Paulson on our facts,'' Muoio wrote. “And I worry that doing so could severely undermine and delay our solid case against Goldman.” Muoio's viewpoint, again, prevailed.
Muoio, in a recent interview with me, dismissed Kidney's complaints. “I cannot imagine any basis for claiming ‘regulatory capture,' given that I have never worked in industry or finance and given the cases I have made, including very significant cases against banks, auditing firms, companies and senior executives," he said.
Even after he lost the debate over scheme liability, Kidney continued to argue for charging Jonathan Egol with securities-law violations. One staffer wrote that the SEC had testimony, but little documentary evidence, proving that Egol had reviewed the Abacus documents. “The law surely imposes liability on others besides the literal scrivenor [sic], or we are in big trouble,” Kidney shot back in an email. “Why are we working so hard to defend a guy who is now a managing director at Goldman so we can limit the case to the French guy in London?”
“I am sure you are not suggesting we charge Egol because of his position within the company,” Muoio replied. “Nationality is also clearly irrelevant and I hope that's the last we hear from you on that subject. Tourre admits he was principally responsible for the problematic disclosures.”
Members of the SEC staff finally interviewed Egol in January. Muoio would later tell the SEC inspector general: “We didn't lay a glove on him.” But Kidney felt differently. As he saw it, Egol had acknowledged reviewing all the documents that the SEC had deemed misleading.
On January 29, 2010, after months of investigation and debate, the SEC provided a Wells notice to Jonathan Egol. Neither Egol nor his lawyers responded to repeated calls and emails seeking comment.
Things dragged on. In March, Muoio wrote an email arguing against charging Egol, saying that, among other reasons, he “will strike most jurors as nice, likable, down-to-earth family man.” On the afternoon of March 22nd, the team gathered in the office of Robert Khuzami, the SEC's director of enforcement, for a meeting. Kidney, Lorin Reisner, and one other lawyer present were in favor of suing Egol; Muoio remained implacably against, as did others. Most of the lower-level staffers stayed quiet.
The following day, Khuzami emailed the group with his decision: “I am a no on Egol. An extremely difficult call,” he wrote. “The lack of consensus among our group is itself, for me, confirmation of this conclusion.” Khuzami did not respond to a request for comment for this article.
Kidney had lost. He was offered the job of handling the expert witnesses for the trial but knew what that meant — that he was getting demoted. He declined.
On Friday, April 16, 2010, the SEC stunned the markets, suing Goldman Sachs and charging the firm with omitting information that would have been crucial to investors in Abacus. The agency brought a charge against Tourre, as well. Goldman's stock dropped thirteen per cent that day, erasing $10 billion of its market capitalization.
A couple of months later, on July 15, 2010, the SEC settled with Goldman for $550 million. Goldman Sachs did not admit any wrongdoing. The SEC wrung an apology out of the bank, which the agency perceived as scoring a victory that critics called inadequate.
It would be the only SEC action brought against the bank for its actions in this corner of the mortgage securities markets just before the meltdown, although a Senate investigation uncovered questionable behavior related to other Goldman mortgage securities. The Justice Department recently settled a case with Goldman that charged that the bank had misrepresented mortgage-backed securities. The bank had to pay on the order of $5 billion. The Justice Department did not charge any individuals.
In 2013, Fabrice Tourre was found liable in a civil trial and ordered to pay more than $850,000. He is now a Ph.D. candidate at the University of Chicago.
Kidney became disillusioned. Upon retiring, in 2014, he gave an impassioned going-away speech, in which he called the SEC “an agency that polices the broken windows on the street level and rarely goes to the penthouse floors.”
In our conversations, Kidney reflected on why that might be. The oft-cited explanations — campaign contributions and the allure of private-sector jobs to low-paid government lawyers — have certainly played a role. But to Kidney, the driving force was something subtler. Over the course of three decades, the concept of the government as an active player had been tarnished in the minds of the public and the civil servants inside working inside the agency. In his view, regulatory capture is a psychological process in which officials become increasingly gun shy in the face of criticism from their bosses, Congress, and the industry the agency is supposed to oversee. Leads aren't pursued. Cases are never opened. Wall Street executives are not forced to explain their actions.
Kidney still rues the Goldman case as a missed chance to learn the lessons of the financial crisis. “The answers to unasked questions are now lost to history as well as to law enforcement,“ he said. ”It is a shame.”
SUMMARY: The Obama administration has taken steps to rein in big businesses this week: New rules issued by the Treasury Department regarding tax loopholes ended a $160 billion deal between Pfizer and Allergan. Meanwhile, the Justice Department has filed an antitrust suit against a proposed oil giant merger, and more may follow. Gwen Ifill talks to Jim Tankersley of The Washington Post for more.
GWEN IFILL (NewsHour): The Obama administration took steps this week to rein in big businesses when it comes to taxes and mergers.
First, the Treasury Department issued tough new rules that make it harder for one company merging with another to lower its taxes by taking a foreign address. The President spoke out against the so-called inversions, saying they lead to one of the most insidious tax loopholes.
A day later, the drug companies Pfizer and Allergan called off a $160 billion deal. Plus, the Obama Justice Department is trying to block oil services giant Halliburton from merging with its rival Baker Hughes. Other proposed mergers may also be in trouble.
Jim Tankersley writes about this for The Washington Post.
Welcome, Jim.
JIM TANKERSLEY, The Washington Post: Thanks for having me.
GWEN IFILL: So, give me a sense of whether this is a conscious strategic use by the administration on tax policy to crack down on business.
JIM TANKERSLEY: Well, in this particular case, it’s absolutely the administration saying, this is a practice in the corporate world that we don’t like, and we’re going to use tax policy to stop it. It looks very tailored in particular to mergers like the Pfizer one, which, I mean, it’s very rare that you see a rule get announced on one day and a merger get called off the next, but that’s what they have pulled off here.
GWEN IFILL: So, one of the things that they — when we talk about this, though, for instance, the administration decided they wanted to make financial advisers more accountable to clients.
JIM TANKERSLEY: Yes.
GWEN IFILL: Is that part of that same strategy, or is that different?
JIM TANKERSLEY: I think what we’re seeing are two things.
Over time, we have seen the President sort of shed his inhibitions about taking positions that might be opposed by the business community. He doesn’t seem to really care too much anymore if he’s being called anti-business. So, we see like sort of string of decisions this week that we have mentioned that are all in that vein.
And the business community has howled, and he hasn’t really let that bother him. Shorter term, what we’re seeing, though, is the President, I think, is thinking about his legacy, and he knows right now we’re in a time, a very populist time, anti-corporate time in the America in the campaign.
And so by personally getting out and announcing details of the inversions rule, making the case for it, for example, this week, he’s trying to cement that rule in the public’s mind, so that the next President doesn’t change it or walk it back.
SUMMARY: It’s been a common theme this campaign season: Are our banks still too big to fail? Former treasury official Neel Kashkari and presidential candidate Sen. Bernie Sanders have both shared their concerns with the NewsHour. For another perspective on the argument, Jeffrey Brown talks to Barney Frank, former Democratic congressman and co-author of the regulatory Dodd-Frank bill.
JEFFREY BROWN (NewsHour): In our first conversation, we talked with Neel Kashkari, president of the Federal Reserve Bank in Minneapolis. As a Treasury official during the financial crisis, he helped oversee the bailout of the banks. He now argues that the system remains in danger and that giant financial firms should be broken up.
That’s a view being heard on the campaign trail from Senator Bernie Sanders.
In his interview with Judy yesterday, here’s how he described the problem and his plan for it.
SEN. BERNIE SANDERS (VT-I), Democratic Presidential Candidate: It will be important to point out that three out of the four largest banks in this country today are bigger than they were when we bailed them out because they were too big to fail, that you have the six largest banks in this country that have assets of 58 percent of our GDP.
I happen the believe that when you have a few financial institutions with unbelievable economic power, with unbelievable financial power, that what we should do is reestablish a modern Glass-Steagall legislation, and what we should do, in fact, is break them up, not only from a risk perspective of not seeing their greed and illegal behavior destroy our economy, as happened eight years ago, but also from creating a competitive financial system, where we don’t have so few financial institutions with so much power.
JEFFREY BROWN: And we get a response now from one of the leading players in the aftermath of the financial crisis.
Barney Frank served as a Democratic congressman from Massachusetts from 1981 until his retirement in 2013. As chairman of the House Financial Services Committee, he played a lead role in crafting the Dodd-Frank law, which enacted the most sweeping changes to U.S. financial regulation since the Great Depression.
A private equity mogul lauded for his patriotic donations has quietly worked to protect one source of his wealth — the carried-interest loophole.
On Aug. 23, 2011, a magnitude-5.8 earthquake shook the Washington Monument for about 20 seconds, sending tourists on the observation deck down eight hundred and ninety-seven steps. One of the two strongest quakes ever recorded east of the Rockies, it fractured two dozen of the stone protrusions that hold up the marble slabs at the monument's peak. That December, Congress appropriated half of the $15 million required to repair the obelisk, saying that the rest would have to be raised from private citizens.
Within weeks, David Rubenstein, the co-founder of the Carlyle Group, a private-equity firm, announced that he would provide the funds. On June 2, 2013, Rubenstein joined the Secretary of the Interior and the head of the National Park Service to inspect the progress, atop the scaffolding. In public appearances, he often tells what happened next, in a deadpan manner that he says is joking. As he recalled last year in a talk at Rensselaer Polytechnic Institute, he decided, while his hosts were looking away, to leave his mark: “I took a pen out and I wrote my initials at the very top.”
Rubenstein, with an estimated net worth of $2.6 billion, is one of the wealthiest people in Washington. He is an American-history buff, and practices what he calls “patriotic philanthropy,” on behalf of the national heritage. In 2007, he spent $21.3 million on a 710-year-old copy of the Magna Carta. He loaned it to the National Archives and, four years later, financed the construction of a new, $13.5 million gallery to house the document. He has bought two copies of the Emancipation Proclamation, signed by Abraham Lincoln, and loaned one to President Obama, who displayed it for a time in the Oval Office. He has made substantial gifts to Monticello, to James Madison's estate at Montpelier, to Robert E. Lee's mansion, to the Iwo Jima Memorial, and, last month, to the Lincoln Memorial. (Although he has also donated generously to hospitals, universities, and other traditional beneficiaries, more than half of the several hundred million dollars he has given away fits the “patriotic” theme.)
His role as a civic patriarch extends to other projects. He is the president of the Economic Club of Washington, which brings together the city's business élite for discussions with government and financial leaders, and he sits on the boards of the Kennedy Center, the Brookings Institution, and the Smithsonian. Every few months, he funds a bipartisan dinner salon for senators and representatives at the Library of Congress, where he interviews a prominent presidential historian, such as David McCullough, Ron Chernow, or Doris Kearns Goodwin.
In 1987, after a short career in politics, Rubenstein founded Carlyle, building it around his Washington relationships and those of his partners — “access capitalism,” Michael Lewis called it, in a critical 1993 profile of Rubenstein in The New Republic. For the most part, Rubenstein has received favorable press coverage, including widespread praise for his charitable work. In 2012, the Washington Post described him as the “generous repeat benefactor for Washington's endangered national icons,” and the magazine Washingtonian named him a Washingtonian of the Year. He is a frequent guest on Bloomberg Television and on CNBC. Last May, on a “60 Minutes” segment titled “All-American,” he said, referring to the Washington Monument, “The government doesn't have the resources it used to have. We have gigantic budget deficits and large debt. And I think private citizens now need to pitch in.”
Until recently, relatively little attention had been paid to one source of Rubenstein's wealth, which he has quietly fought to protect, the so-called carried-interest tax loophole. The tax break has helped private equity become one of the most lucrative sectors of the financial industry. Since the end of the recession, private equity has reported record profits, and at least eighteen private-equity executives are estimated to be worth $2 billion or more each. And during the current presidential campaign, with its populist themes, the loophole has become a target among Democrats and Republicans alike.
The notion of “carried interest” derives from the share of profits that twelfth-century ship captains received on the cargo they carried. It came into its modern usage in the 1920s, in the oil-and-gas industry, and was enshrined in the federal tax code in 1954. When a group of partners drilled for oil, a few would put up the money and others would invest only their labor, or “sweat equity” — finding land and investors, buying equipment, and so on. If the partners sold out, the IRS would tax the profits of all the partners at the lower rate for capital gains rather than as ordinary income.
Over time, partnerships in other industries, mainly real estate and venture capital, began taking advantage of the same form of taxation. Private-equity firms stretched the model to its breaking point. Their work is essentially a combination of investment banking and management consulting; they are compensated not for building new ventures from scratch, with the risk that entails, but for managing the investments of wealthy individuals and pension funds and other institutional clients. These funds are pooled, along with borrowed money, to acquire private companies or to take public companies private — before making improvements or cutting costs and selling at a big profit.
Even if no profits are realized, private-equity firms get paid: under the “2 and 20” compensation structure, they receive a two percent fee annually on assets under management, in addition to a 20 percent cut of profits beyond a given benchmark. The IRS characterizes the managers' cut of the profits as carried interest, taxing it as though it were capital gains made through the sale of a person's own investment. For most of the past fifteen years, long-term capital gains have been taxed at 15 percent, compared with 35 percent for ordinary income in the top bracket.
One name for the tax break is the “hedge-fund loophole,” but hedge funds benefit much less than private equity does, because their trades tend to be too short-term to qualify for the low capital-gains rate. At a Credit Suisse forum in Miami, in 2013, Rubenstein said of private equity, “Carried interest is really what the business has historically been about — producing distributions for your investors from good sales and IPOs … and getting 20 percent of the profits for yourself.” He went on, “That's how we've really grown our business.”
Barack Obama, during his first presidential campaign, pledged to reform the tax on carried interest and, in 2012, went after Mitt Romney for having enjoyed its benefits as the co-founder of Bain Capital. This year, Bernie Sanders, Hillary Clinton, and Donald Trump have all attacked the loophole, often using hedge-fund managers as the rhetorical target. As Trump put it in August, “They're paying nothing, and it's ridiculous. … These are guys that shift paper around and they get lucky.” Jeb Bush, who made a foray into private equity in 2014, also called for closing the loophole during his ill-fated campaign. Private-equity partners argue that their tax treatment is justified under the tradition of encouraging risky business partnerships and is necessary for their industry to flourish. So far, the partners have won out; despite the rise of anti-Wall Street sentiment after the 2008 financial collapse, the loophole has withstood every effort at reform.
SUMMARY: Another market plunge in China and plummeting oil prices -- which dropped to a staggering $30 a barrel -- fueled a tough week on Wall Street. Judy Woodruff talks to Bradley Olson of The Wall Street Journal and Liz Ann Sonders of Charles Schwab.
JOSH EARNEST, White House Press Secretary: There’s no denying that weakness in other markets with whom we do extensive business is going to be a headwind for the U.S. economy. We’re mindful of that, particularly as the international economy becomes more integrated, and we have to be sensitive to movements that we see in the economies of other countries.
JUDY WOODRUFF (NewsHour): The U.S. market was also hurt by disappointing reports on several major economic indicators. Industrial production fell for a third straight month in December. And retail sales unexpectedly dropped a 10th of a percent last month, partly because warmer weather hurt winter clothing sales.
For a closer look at the dramatic drops in both the stock market and world oil prices, we turn to Liz Ann Sonders. She’s chief investment strategist at Charles Schwab. And Bradley Olson, he’s national energy reporter for The Wall Street Journal.
And we welcome both of you to the program.
Liz Ann Sonders, what is behind this volatility today in the market?
LIZ ANN SONDERS, Charles Schwab: Many of the same things, actually, that contributed to the volatility that we saw last year.
You have touched on certainly oil, but it’s more broadly what’s happening in the commodity complex, and not just the huge plunge, in and of itself, but what that says about global growth. Of course, related to that is China, the weakness there, not only in its equity market, but its economy, its currency. That is tied into commodity prices.
And then even more importantly was the uncertainty regarding the Fed. We got past the uncertainty the defined 2015 in terms of will they, won’t they, and if they will, when? They got the first rate hike. Now it’s what are they going to do from here? Are they going to continue to raise interest rates? What will be the justification?
So, a lot of it really is unfinished business from 2015. It’s just conspired to occur in a condensed period of time, unfortunately, right at the beginning of the year, which I think adds to the angst for investors.
SUMMARY: The so-called carried interest loophole is a tax break used by hedge funds and other investment groups that lets wealthy money managers pay a relatively low investment tax rate. Economics correspondent Paul Solman takes a close look at the controversial tax break.
GWEN IFILL (NewsHour): Now, a tax break that is coming under fire, one used by hedge funds and money managers, controversial because of the way profits are taxed at a much lower rate.
Our economics correspondent, Paul Solman, explores what it’s all about, part of our weekly series Making Sen$e, which airs every Thursday on the NewsHour.
PROTESTERS: (NewsHour) Hey, hedge fund billionaires!
PROTESTERS: Pay your fair share!
Hey, hedge fund billionaires, pay your fair share!
PAUL SOLMAN (NewsHour): The Hedge Clippers, an activist group targeting hedge fund billionaires and especially their tax breaks. In the past few months, the Clippers have been taking their tools to their targets’ backyards, like their March field trip to Greenwich, Connecticut.
PROTESTERS: Hedge funds, pay your taxes! Billionaires, pay your taxes!
PAUL SOLMAN: Their July jaunt to The Hamptons, summertime playground of the 0.1 percent.
PROTESTERS: We can see your greedy side.
PAUL SOLMAN: And, earlier this month, to the Midtown Manhattan headquarters of Bloomberg, where a conference was taking place to — quote — “celebrate the leaders and innovators who shape economies.”
If there were ever a time not to bet the moon on the stock and bond markets, it’s now, with U.S. stocks at near-record highs and interest rates on quality bonds at near-record lows. But Wall Street is urging state and local governments to do just that — and they’re listening.
Despite the risks, governments are lining up to issue billions of dollars in new debt to replenish their depleted pension funds and, as a bonus, take some pressure off strapped budgets. In some cases, the borrowing makes their balance sheets look vastly better. Bankers, who make fat fees for raising the money, are encouraging this borrow-and-bet trend. Their sales pitch is that borrowing at today’s low interest rates all but guarantees a profit for the governments because they can invest the proceeds in their pension funds and for decades earn returns higher than the 5 percent or so in interest that they will pay on the bonds.
But there’s a catch: If the timing is wrong, these so-called pension obligation bonds could clobber the finances of the government issuers. Pension funds and beneficiaries will be better off because pensions will be more soundly financed. But taxpayers — present and future — might be considerably worse off. They will be running huge risks and could get stuck with a massive tab.
“It’s sold as a magic bean,” said Todd Ely, a professor at the University of Colorado at Denver who has studied pension bonds. “But when it goes bad, it’s not free. Then it isn’t really magic. If it could be counted on to work as often as it’s supposed to, then everyone would be doing it.”
Plenty of takers are bellying up to the borrowing bar. Governments sold $670 million worth of pension bonds through the first half of this year, more than double the $300 million raised for all of last year, according to deal-trackers at Thomson Reuters.
That total would more than double if Kansas completes a pending $1 billion deal, which would be its biggest bond issue. A $3 billion sale is under consideration in Pennsylvania, that state’s largest as well. Lawmakers recently rejected record multibillion-dollar deals in Kentucky and Colorado, but those proposals are expected to resurface. And new proposals are being pitched to other governments.
Pension bonds have waxed and waned since the 1980s, but the current boom is different. An examination by The Washington Post and ProPublica found that it’s being driven not only by the prospect of investment profits but also by a new accounting quirk that has largely escaped public notice while morphing into a major marketing tool for Wall Street banks.
The quirk stems from a rule change that was meant to force governments to more clearly disclose the health of their pension funds. But a side effect is to allow governments with extremely underfunded pensions to slash reported shortfalls by $2 or more for each $1 borrowed.
Here’s how: If a pension plan is so poorly funded that it is projected to run out of cash, the new rules require it to make less optimistic projections about future returns. That increases the reported pension shortfall. But if governments infuse a big slug of borrowed money into the fund, they can resume using optimistic projections, and the shortfall shrinks.
It’s like getting a new credit card, borrowing on it to pay off part of an existing loan, then having the total amount owed magically shrink by more than what is borrowed. Sounds impossible — but it’s true.
The impact can be dramatic. In March, the town of Hamden, Conn., reduced its unfunded pension amount by about $320 million with a $125 million pension bond and promises of future payments, according to an estimate by ProPublica and The Post. The Kentucky Teachers’ Retirement System said it estimates that a $3.3 billion bond issue plus payment promises could carve $9.5 billion off its unfunded liability.
Those figures don’t reflect the decades of debt and risk placed on taxpayers.
The rule change, from the Governmental Accounting Standards Board, has been in the making since 2006, but is only now starting to take effect — and to be noticed. So GASB is fast becoming a recognized acronym in state capitals.
“GASB is certainly a huge concern,” said Beau Barnes, deputy executive secretary of the Kentucky System. Until this year the term was unfamiliar to state legislators, he said, “but in 2015 when you say ‘GASB,’ most of them have an idea that it’s going to be bad.”
It’s not clear whether anyone involved in the long rulemaking process realized that the change would encourage governments to sell bonds to improve their balance sheets.
We asked GASB Chairman David Vaudt about this but couldn’t get a clear answer. His response was, “We follow our due process, and the input that we consider is from our stakeholders: the preparers, auditors and users” of governmental financial statements.
The question of whether governments will come out ahead in the real world — as opposed to the accounting world — with pension bonds is far from clear. In large part, it depends on governments’ willingness to make substantial payments to their pension funds after the bonds are sold.
A review by ProPublica and The Post of the 20 largest pension bonds issued since 1996 found that in three-fourths of the deals, governments did not make their full required contribution in the years after the bonds were sold. Those bonds account for nearly two-thirds of the pension debt issued since 1996, according to Thomson Reuters. In more than half the deals, some proceeds even went on to make annual pension contributions — borrowing from the future to pay today’s expenses. Because of the underfunding, most of the pension funds now are worse off than before the bonds were issued.
In all five recent or proposed bond sales examined — by Kentucky, Kansas, Pennsylvania, Colorado and the town of Hamden, Conn. — the issuers and potential issuers said they were planning to make less than full payments for many years.
“These bonds are pernicious,” said Alicia Munnell, director of the Center for Retirement Research at Boston College. “They discourage pension funding. They shift costs forward to future generations.”
SUMMARY: Anxiety over interest rates, the dollar and falling oil prices drove volatility in the financial markets this week; even good news seemed to upset investors. Judy Woodruff talks to Mark Vitner of Wells Fargo about what’s causing the turmoil and what it says about the global economy.
JUDY WOODRUFF (NewsHour): It was another tough day for the financial markets, capping a volatile week, one marked by anxiety over interest rates, the dollar, and falling oil prices, among other things.
More puzzling in some ways, there was good economic news earlier this week, and that still seemed to upset investors. What’s happening here? And does the volatility of recent weeks suggest the end of a bull market?
Well, Mark Vitner is a managing director and senior economist at Wells Fargo, and he joins me now.
So, Mark Vitner, how do you explain all this volatility and especially the downward move after this good news on jobs last week?
MARK VITNER, Wells Fargo: Well, I think it’s really just part of the adjustment process.
We have had interest rates stuck at zero for eight years now, and the economy has improved to the point where the Federal Reserve is likely to raise interest rates probably in June, but probably no later than September. They’re almost definitely going up this year.
And that causes people to reassess how they position certain investments. Companies that are interest-rate sensitive are now falling out of favor. And we have got a lot else going on in the world that’s unnerving the markets. The dollar has strengthened tremendously and has done it very fast. And we have had this incredible slide in oil prices, which you would think is a good thing, but it’s got some people questioning why on earth are prices falling so far so fast.
At a conference on housing finance last month, a collection of investors described their innovative "rent-to-own" products.
Rent-to-own schemes have long exploited the poor. Naturally, marketers address that problem with euphemisms. Today, it's called lease purchase. The arrangements work in myriad permutations, but the basic deal is that a person rents a home and pays for an option to buy it at a later date.
All the panelists hailed the product, calling it a "yield enhancer" that would increase profits. In a standard lease, one panelist explained, the owner covers costs like taxes, maintenance cost and insurance. With lease purchase, the renter pays those expenses. And it's easier to evict because the occupant has only a rental agreement. It's not a foreclosure proceeding against an owner, after all.
One went further. Eli Shaashua, of Red Granite Capital Partners, described it this way: "Basically, it's an added fee to the rent. For us, it instills pride in homeownership for some tenants who cannot currently when they rent a house own their own home."
Having pride in ownership means that the renter takes care of the property more carefully. So that's a good thing — for the owner, that is.
Shaashua went on to explain that his options last generally for two years. A renter pays a bit extra for the right to buy the house at a predetermined price, one above the current value.
Then Shaashua delivered the kicker to the roomful of would-be investment managers: "Most times, given the reality, tenants do take it, but it's hard for them to execute the option," he said. "Our experience is that most stay until the end and then they say they cannot come up with the down payment or decide not to stay in the property."
Voila, free money. This amounts to an admission that the product exploits consumers' lack of financial savvy. This shouldn't be surprising. Who are you going to bet gets the price right, an aspiring home buyer or analyst with access to oceans of data on prices and historic trends?
"I regret that my words at the panel were taken out of context and understood in a way which is completely different than the one I was intending to convey," Shaashua said in response to a request for comment. "Our firm actively engages, and incentivizes home ownership and community renewal, which, according to our experience and our opinion, constitutes a clear win-win scenario for all parties involved. However, despite our intention to encourage home ownership and the given incentives, we noticed that the conversion rate to home ownership does not meet the level we hope to achieve."
The country is facing a shortage of rental housing. At the same time, financial giants like the Blackstone Group have come into the market, raising worries that such investors would neglect the upkeep of the homes they bought or inflate another bubble. There may be some of that, but they have acted to stabilize plummeting prices. So the influx of financial firms hasn't been entirely malign.
The rent-to-own business appears to be a small, grubby niche of finance. People I spoke with said that the big players were not doing rent-to-own. And I couldn't find any serious Internet presence for Red Granite Capital Partners.
Yet even if rent-to-own is a small, dark corner, there are some important lessons to be drawn. The first, obvious one is that someone should look out for renters in markets where people might take advantage of them. That's where the Consumer Financial Protection Bureau comes in. As it happens, the very thing Republicans would like to do now that they control Congress is gut this fledgling agency.
This is another lesson. Today, we are having a debate about how to properly run a housing finance system. About seven in 10 new mortgages have government backing, mainly from Fannie Mae or Freddie Mac. On one side is pretty much everyone on the right, center and left-of-center. They argue that the government needs to have a much-reduced role. There are various positions, but the main one is that the market can deliver more mortgages more efficiently to more people.
But there is another side: That the top-down, dominant government role works. Melvin L. Watt, the Obama appointee who now heads of the Federal Housing Finance Agency, seems to hold a lonely position in this camp. He is pushing Fannie and Freddie to expand credit, widening the types of mortgages they will back from the private sector. In doing so, he is reversing direction from his predecessor, Edward J. DeMarco. Watt is staking out the position that the government can be a responsible steward for most of the housing market.
In recent months, Watt has pushed through changes to allow Fannie and Freddie to buy loans made to borrowers who made lower down payments on houses, loosened up the mysterious "credit box" at the giant mortgage companies and lowered fees.
Some critics argue that the real problem is not tight credit from banks but lack of demand, because the middle class is getting squeezed.
But both things can be true. The economy is certainly not producing high enough wages for people to be able to afford homes and that bears addressing. But credit is tight and can be loosened as the economy turns up.
Loosening credit naturally leads to a queasy feeling for people who well remember the excesses of the last decade. Conservatives and some Wall Streeters are criticizing Watt. They are doing so while still advocating "reform" for Fannie and Freddie — code for privatizing the mortgage market. They seem to have a point: Didn't we learn anything from the housing crash?
Actually, we did. We learned that the private sector ran amok, selling inappropriate loans to unqualified buyers. This is not what Fannie and Freddie will be doing under Watt's watch.
Watt is doing "all of the kinds of things we would have liked to have done at the peak of the crisis," said Christopher J. Mayer, a housing expert at Columbia University. "It's refreshing for people to say that homeownership is important for wealth accumulation. You have to do it responsibly, but government needs to play a role."
Doing it conscientiously, of course, is the key.
These Watt changes are an important test. Can the government do it when the private sector, with its rent-to-own sharks, cannot?
Correction: This column incorrectly said that about nine in 10 new mortgages have government backing. Recently, more than seven in 10 new mortgages have government backing, mainly from Fannie Mae or Freddie Mac.
Wall Street pressed S&P, Moody’s and Fitch to assign more favorable credit ratings to their deals and bragged that the raters complied. Now many of the bonds are headed for default.
When the economy nosedived in 2008, it didn’t take long to find the crucial trigger. Wall Street banks had peddled billions of dollars in toxic securities after packing them with subprime mortgages that were sure to default.
Behind the bankers’ actions, however, stood a less-visible part of the finance industry that also came under fire. The big credit-rating firms – S&P, Moody’s and Fitch – routinely blessed the securities as safe investments. Two U.S. investigations found that raters compromised their independence under pressure from banks and the lure of profits, becoming, as the government’s official inquiry panel put it, “essential cogs in the wheel of financial destruction.”
Now there is evidence the raters also may have succumbed to pressure from the bankers in another area: The sale of billions of dollars in bonds by states and municipalities looking to quickly cash in on the massive 1998 legal settlement with Big Tobacco.
A review by ProPublica of documents from 22 tobacco bond offerings sold by 15 state and local governments shows that bankers routinely bragged about having their way with the agencies that rated their products. The claims were brazen, the documents show, with bankers saying they routinely played one firm against its competitors to win changes to rating methods, jack up a rating or agree to rate longer-term, riskier bonds.
"Bear Stearns is the ONLY firm in two years to have negotiated new rating criteria pertaining to stress tests and tobacco sector fundamentals,” the now-defunct investment bank stated in a typical 2005 pitch for a deal led by Kym S. Arnone, who today chairs the Municipal Securities Rulemaking Board, the industry’s self-regulator.
“Fitch reached out to UBS for input so that they would fall in line with the other ratings agencies,” UBS said after it and other financial services firms dropped Fitch from deals because of its “constraining” stress tests. Following the conversation, “Fitch amended their stress criteria,” UBS told officials in Michigan as it readied a 2006 deal.
In 2007, JPMorgan promised to negotiate Fitch “to their knees” if Ohio hired the bank for a $5.5 billion deal that was the largest sale, or “securitization” of tobacco settlement payments.
The 140 documents, unearthed through public records requests, show that bankers from six Wall Street firms – UBS, Bear Stearns, Citigroup, Merrill Lynch, JPMorgan and Goldman Sachs – claimed they could persuade the rating agencies to make favorable changes to their criteria.
Garnering better grades for the tobacco bonds meant the bankers could sell more of them, get a leg up on their competition and win millions of dollars in fees from the governments issuing the debt. The state and local governments were trading their annual tobacco payments for up-front cash by making the bond deals. As ProPublica has reported in a series of stories, the bonds have proved much riskier than advertised, leading to fiscal headaches for the issuers and losses for investors.
While there are no indications that the bankers did anything illegal, their claims further undermine the argument by the raters that their opinions are only the result of independent analysis – something the firms will soon be required to attest to in writing under reforms enacted in the wake of the financial crisis.
Since the economy tumbled in 2008, the estimated $36 billion of bonds issued in the tobacco sector – like so many other corners of Wall Street – have proven to be founded on shaky assumptions. In this case, the unraveling was caused by weaker-than-expected cigarette sales, which drive the size of the settlement payments. The outlook is now so bleak that in September Moody’s estimated that 80 percent of the money owed on tobacco bonds it rates won’t repay on time.
The future may be even bleaker for a $3 billion sliver of the debt. Those securities, known as capital appreciation bonds, promised balloon payoffs so large – $64 billion, all told – that they are almost certain to default. The documents show bankers pressed rating agencies to ease criteria for evaluating those bonds as well.
ProPublica shared the tobacco bond documents with S&P, Moody’s and Fitch. All denied changing their methodologies, also known as rating criteria, in response to demands from bankers.
In an interview, Nicolas Weill, who oversees Moody’s rating methodologies for tobacco bonds and similar securities, said, “We don’t negotiate criteria.” Those criteria – such as stress tests that gauge how much cash is available to repay the bonds under various scenarios – are "never, ever" open to deal-by-deal changes. He said the firm may evaluate different deal structures but only if they meet those criteria.
In a statement, Fitch said: “With respect to every one of the examples provided to us by ProPublica, we can affirm that no banker or other outside party unduly influenced any of these ratings decisions … We determine our ratings – they are not open to negotiation with issuers and bankers.”
S&P said in a statement: “On the whole, the assertion that S&P’s cash-flow stress assumptions for tobacco settlement bonds were relaxed is false … credit ratings change because factors that affect credit risk change.”
ProPublica shared the documents with each of the banks. All declined to comment except UBS, which said the bankers involved no longer work for the firm, which exited the municipal bond business amid the 2008 market turmoil.
ProPublica also shared the materials with the Securities and Exchange Commission, which regulates rating agencies and has been working to reform the rating process since the abuses in mortgage-backed securities. In August, the agency adopted hundreds of pages of new rules it said will help prevent “conduct and practices that were central to the financial crisis.”
The SEC also has been investigating whether S&P bent its criteria to win ratings of commercial mortgage bonds. The regulator is now seeking to suspend S&P from that part of the business in what would be its toughest action yet against one of the big three raters, Bloomberg News reported this month.
The SEC declined to comment on the documents provided by ProPublica.
The documents give the bankers’ version of what happened, and some degree of exaggeration can be expected in any sales pitch. Nevertheless, former rating analysts, lawyers and regulatory experts who reviewed the documents said the consistency of the bankers’ claims across multiple years, deals and states, compared with known criteria changes and ratings, suggests the banks’ influence was real.
“Banks have a right to advocate for their clients – that’s normal,” said Mayra Rodriguez-Valladares, a financial regulatory consultant who reviewed the documents at ProPublica’s request. “What’s going on here is very different … this is the banks trying to convince rating analysts to make changes to their methodology, and that’s really crossing the line.”
