Wall Street Law Blog

How a neighbor in Crawford Texas might explain financial crisis to Bush

Lessons in liquidity, insolvency, mark to market accounting, risk management, and the big difference between luck and skill.

Liquidity, Insolvency, and the financial crisis - 

By "Executive" Analogy...

***

Deep in the heart of Texas:

Your neighbor, George, recently lost his job.  

One Saturday morning at nine o'clock, George knocks on your door.   "Morning neighbor, he says.  Want to watch some of them hunting and fishing shows on ESPN 2?

You say ok, and invite him in.  George has been away a while, and besides, he has always been good for a few laughs.  

George pulls a can of Schlitz from his pocket, pops the tab, and takes a few big gulps.  He narrows his eyes.  "Heck, you're one of thos economist fellas, aint ya? "  You respond that you are indeed an economist.  "Riddle me this, then," he says.

Curious, you take the bait, "I'll try."

"Tell me about this mortgage, financial crisis, subprime..."

"You want me to explain the financial crisis to you?"

"Bingo!" 

You can see he is serious.  Well, George, we need to start with a few concepts first."

"Great.  I'm a concept guy. Know what I mean?"  He smiles; punches you in the arm.  "Call me Doubayuh.  George is my daddy."  He giggles.

You clear your throat.  "Ok, uh, Doubayuh.  Well, at the most basic level, I think we need to start with liquidity, then maybe insolvency, risk management maybe - then we'll take it from there."

"Sweet."  He guzzles his Schlitz.

You take a deep breath.  "Ok, well, absent umm government price regulation, the value of any asset is generally set by supply and demand - which basiscally comes down to how many people want it and how bad do they want it." 

Your neighbor interrupts - "Right, right... Supply and demand.  Heard of it.  Go on, Professor."  

You continue.  "Well, if demand is high, you should be able to convert whatever you are selling into cash rather easily.  In other words, you can liquidate your asset for real money.  So that is they mean when they talk about liquidity."

Your neighbor smiles at you.  Then he squints and nods his head.  "That's what who, means, err - I'm afraid you lost me there Professeroooney."  He punches your arm playfully.

"You can call me Mike, sir."  

Course I can call you Mike.  But I like nicknames, if you get me, err, get my drift."  He chuckles. "You know, like Brownie."

"Yes, whatever you want George.  So, I was talking about the folks who set monetary policy.  You asked me who they were."

"Go on, Brownie.  Just kidding.  Go ahead Mike."

"I was talking about the Secretary of the Treasury, the Fed Chairman, bankers, the guys on CNBC..."

"Treasury.  Wait, that rings a bell.  That Paulsen guy, right?  I call him Goldy, cause he used to work at-"

"Mr. Pre- uh, George.  Hank Paulsen isn't the Secretary anymore."

"Really?  I had no idea. I really liked that guy.  Real strong sense of right and wrong, ya know? Goldy - umm Hank Paulsen - The guy was always talking about how we need to avoid moral hazards.  Great family values..."

"Ok.  We need to back up a little bit here George.  You a football fan?"

"How bout them Cowboys!  Course I am.  This is Texas.  Friday night lights is the best book I ever read.  Ok, I didn't read it.  Hell of a good movie.  Go Panthers!"  George pulls a new can of Schlitz out of his other pocket, pops the tab, and pours in a mouthful.

"Great," you say.  "Let's try this with a football example.  I think you'll have an easier time relating to the concepts."

"Go on."

"Let's say you need to come up with two thousand dollars in 48 hours to pay off your losses from a bad bet on the Dallas Cowboys.  Your bookie, let's call her Tipper, has threatened to break your thumbs if you don't pay up.  No problem, you think to yourself.  You're always telling everyone that your, umm, "stuff",  is worth at least ten thousand bucks.  You decide to have a yard sale.  You put an add in the Dallas Morning News. The next day, your ranch is flooded with potential customers."  You with me, George?"

"Heck yeah."

"Ok.  Now, let's say you get offers below what you had hoped.  You sweat it out, but in the end your proceeds are $2,005."

"My thumb is safe, right?"

"Yes.  Your thumb is safe. Anyway, you've just had a liquidity crisis because your assets weren't worth nearly what you thought.  But the crisis didn't kill you because you ultimately were able to raise the money you needed, if just barely."

"Hey now!"

"On the other hand, if you think your stuff is worth ten grand, and you need at least two to pay Tipper, but you raise less than a thousand dollars, then you have a bunch of problems.  First of all, you have a liquidity problem that has evolved into an insolvency problem.  You have nothing to sell, and not enough money to pay your debt.  You are in the hole, sir, and you may need some bankruptcy protection."

"Ouch."

"I know.  Also, you have some serious accounting issues.  You have apparently been inflating the value of your assets by more than 90%."

"Maybe I did it on purpose." He squints again, and cracks up laughing.  His shoulders bounce up and down under a denim jacket.  "Oh man.  No, seriously, how was I supposed to know what the junk was worth? I never tried to sell it before."

"And that is a very good point.  You don't know what the stuff is worth until you try to liquidate it.  However, you've been strutting around town telling bankers, bookies, and whoever else you know that you have more than ten thousand dollars in liquid assets.  The truth is that you have less than one thousand.  And that is the problem with thinly traded assets like CDOs."

"Thin CD who?"

"Forget it.  That's for another day.  The point is that your actual liquidity was less than 10% what you said it was.  Translation, you bet on the Cowboys with money you don't have.  That, my friend, is bad risk management."

"I'm sorry."

"This is just an illustration, George.  You don't need to apologize." 

"I know.  But role-playing is more fun if you really get into it."  He winks.

"Ok. Well then, unfortunately for you, the Philadelphia Eagles crushed the Cowboys.  Next comes the painful consequences of your high-risk behavior."  

"You mean?"

"Yes George, Tipper is gonna come break your thumb."

"Hah - fat chance - She'll never catch me."

"Probably not, sir.  Now, here is the really interesting part - for me at least.  You could have gotten lucky and won your first bet.  Maybe you accidentally bet on the Eagles or something like that.  Point is, if you won that first bet, you would not have had any reason to liquidate your stuff.  Nobody would know that you overvalued your assets. And nobody would know how poorly you manage risk."

"Now that sounds good to me."

"That's what the banks thought."

"Which banks?"

"Uh, we'll save that for next time too."

"Good."

"All right. So maybe you win the first bet, and then go on a nice streak, winning bets for 6 weeks in a row.  Even better, let's say you let all the winnings ride each week and keep right on winning.  Everyone would be impressed at your obvious skill.  You also would have made a small fortune.  There's no reason to stop, you think.  You are damn good at this football betting.  Its easy money. How bout them Cowboys, indeed."

"Professor, this sounds too good to be true."

"I'm impressed, George.  Ok. So you know you are taking too many risks.  But you do it anyway. You let it all ride on week 7.  The game happens to be a a rematch with Philly.  The Eagles smoke the Cowboys again.  You lose it all.  Every penny.  Nobody thinks you are so smart anymore.  How could you lose so badly.  Haven't you heard of hedging your bets? In the end, people correctly judge you as just another risk-taker that had a lucky streak and blew up."

"Wow."  George finishes his beer and then checks his watch.  "I've got to go Professor.  But that was one wild roller coaster ride.  Thanks for the lesson on liquidity, insolvency, and gambling.  Next time maybe we can talk about the notional value of credit default swaps."  He stands, smiles, and winks.  "Adios amigo." He says.

"Goodbye sir."

By Brett Sherman, The Sherman Law Firm

Lessons in liquidity, insolvency, mark to market accounting, risk management, and the big difference between luck and skill.

Liquidity, Insolvency, and the financial crisis - 

By "Executive" Analogy...

Game On! SEC Says Bear Stearns Subprime Hedge Fund Case Will Go Forward

In a recent post, Fortune Magazine reported that the SEC intends to press forward with a civil lawsuit against ex-Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin. See tinyurl.com/3b6a7cs

By Brett Sherman; Wall Street Law Bog, The Sherman Law Firm

CHANCE TO SAVE FACE?

Federal Prosecutors Have Been Criticized For Rushing Their 2008 Indictment in a complex criminal fraud case against former Bear Stearns Hedge Fund Managers Ralph Cioffi and Matthew Tannin.

That Case Ended In Acquittal.

Lawyers for the SEC Have Taken Their Time. But Will The Civil Trial End With A Better Reult For The Government?   Maybe so.

Double Jeopardy is Not An Issue

First, the SEC lawsuit is NOT DOUBLE JEOPARDY.

Double jeopardy is all about the possibility of incareration.  Jail.  Unlike the failed 2009 criminal prosecution of Cioffi and Tannin, the SEC lawsuit cannot result in jail time for the managers of two Bear Stearns subprime hedge funds that went bankrupt in July 2007. Thus, no double jeopardy.

BACKGROUND

The only high profile criminal case about the subprime meltdown and financial crisis ended disastrously for the federal government.

Ralph Cioffi and Matthew Tannin, the now infamous managers of two Bear Stearns hedge funds that failed during the summer of 2007, were arrested and charged in with fraud-based crimes June 2008. The crux of the charges was that the two Bear executives deceived investors about the risks and performance of complex designer securities called collateralized debt obligations (and better known as CDOs).  The CDOs at issue were backed by subprime mortgages.   

Subprime mortgage defaults spiked when the housing bubble popped in 2006.  By 2007, mortgage defaults were so high that investors stopped buying subprime-backed CDOs.  As demand shrunk, the value of these securities plunged.  

 In 2009, a jury found Cioffi and Tannin not guilty of criminal fraud charges on all counts.

 

 

A CHILLING EFFECT?

Pundits have pointed to the acquittal, an embarrassment for prosectors, to help explain the complete absence of subsequent indictments against executives from Bear Stearns or other big players in the market for mortgage bonds.

"There is no doubt in my mind that the verdict in the Bear Stearns hedge fund trial has had a huge chilling effect on prosecutions," said retired judge and trial lawyer Lee Sherman.

It isn't exactly good for the careers of prosecutors to lose these kinds of high visibility cases."

 

Lee Sherman is a senior consultant to The Sherman Law Firm and a regular Wall Street Law Blog contributor.

WHY PUT CIOFFI AND TANNIN ON TRIAL AGAIN?

For many observers, the SEC's decision to press on with its case against Cioffi and Tannin is a surprise. The allegations are nearly identical to the failed Bear Stearns prosecution.

However, Mr. Sherman believes the move makes sense. 

"Remember," Sherman said, "Unlike federal prosecutors, who were bound by the Constitution's speedy trial requirement, the SEC has had years to investigate and prepare for this. Plus -- and I believe this is a major factor -- the SEC has a far easier burden of proof."

 

 

PREPONDERRANCE OF THE EVIDENCE

In 2009, federal prosecutors failed -- in the jury's view -- to prove the two former Bear Stearns executives guilty beyond a reasonable doubt. In the civil trial, SEC lawyers will try to prove civil liability rather than guilt and, therefore, the burden of proof is the preponderance of the evidence standard.

Under the preponderrence standard, jurors are typically instructed to find liability if they feel 51% sure that the evidence supports liability.  Obviously, with the preponderrence standard, the bar is set much lower than it is under the beyond a reasonable doubt required in criminal cases.

REDEMPTION?

Perhaps the biggest reason why the SEC chose to proceed against Cioffi and Tannin is to rehabilitate the Commission's severely damaged reputation.  Under the Bush administration, the SEC failed to detect and prevent fraud by Wall Street investment banks again and again and again.  The Commission has been rightly blamed for being asleep at the switch.     

Under President Obama, personnel and cosmetic changes at the SEC have been made. And there has been the predictable amount of tough talk.  Still, in terms of real change, the SEC still needs a major accomplishment before the public will believe there's a new sheriff in town.

Stay tuned... This may get interesting.

Wall Street Law Blog; A Publication of The Sherman Law Firm

*Information about SEC's decision to move forward via Fortune tinyurl.com/3b6a7cs