Heads I Win, Tails You Lose – Rules Of The Kleptocracy

It’s always a god idea to keep your eye on the news that comes out on a Friday before a holiday weekend because that is everyone’s favorite time to release some “inconvenient” news. Last Friday’s NY Times Business section has a nice foursome of stories about the wonderful ways of Wall Street.

Let’s start off with Deutsche Bank (DB) which announced that they were going to settle their dispute over toxic mortgages with the Department of Justice (DOJ) for a mere $7.2 billion. The case involved the bank’s misrepresentations about the quality of mortgages it sold before the financial crisis. The statement from DB pointed out that the settlement has not yet been approved by DOJ, so it is not final. Earlier stories had suggested the DOJ was looking to settle for over $14 billion, a total that was equivalent to the bank’s current market value and that some believed may have forced the bank to be bailed out by the German government. The fact that DB was willing to settle for just half that amount will not make investors any less nervous about the precarious state of this major bank, although its shares have risen after the election of Donald Trump. It is rumored that DB is the only Wall Street bank that would continue to do business with Trump – (that may change now that he will be President) – and that he was into the bank for over $300 million. That loan is backed by Trump’s person guarantee (whatever that is worth), but the bank is looking to restructure the loan and drop that guarantee. Now a skeptical person like myself may look at this statement from DB that notes that the DOJ has not signed off on the agreement and think that DB is sending a message to DOJ to settle for the $7 billion now or perhaps get far less when Trump becomes President. I’m pretty sure Trump’s DOJ will be far less aggressive in going after Wall Street banks going forward but I’m positive they will be even less interested in going after a bank that manages to let Trump wriggle out of a $300 million personal guarantee.

At the same time DB was announcing its proposed settlement, Barclays was sued by the DOJ for their role in selling toxic mortgages after months of negotiations apparently could not result in a settlement. For Barclays, the case involves over $30 billion in mortgagees, subprime to AAA rated, that Barclays sold from 2005 and 2007. Over half of these loans defaulted and even the AAA tranches suffered heavy losses. Barclays had been advised repeatedly by outside vendors that provided due diligence on these mortgages that the loans were overstated and, in some cases, the properties backing those loans were even underwater. Those vendors used standard economic terms like “craptacular” and “the distinct aroma of default” in describing the mortgages. In 2007, a Barclays executive who is named in the DOJ lawsuit sent a distressed email to a colleague saying, “I just don’t think we’re able to hide as much as we were last year, jam things in, you know, bob and weave and hope for the best. And I think those days are behind us.” In a statement put out by Barclays, the firm claimed, “We have an obligation to our shareholders, customers, clients and employees to defend ourselves against unreasonable allegations and demands. Barclays will vigorously defend the complaint and seek its dismissal at the earliest opportunity.” Again, a skeptical person like myself might think that Barclays is really saying that they would rather take their chances with Trump’s DOJ rather than settle today. That seems like a pretty good bet right now.

The Times has another article about Goldman Sachs (GS) and its involvement in the massive money-laundering and embezzlement scheme that went on at the 1Malaysia Development Fund (1MDB). Goldman has not been directly implicated in the fraud but it raised billions of dollars for 1MDB, earning enormous fees. These transactions were apparently tracked and signed off on by Goldman’s president at the time, Gary Cohn. 1MDB apparently funneled much of this money into the personal bank accounts of prominent Malaysians and those connected to the government. Malaysia has a history of corruption so it should not come as a great shock that its development fund would be misused. Now, Goldman purely provide the vehicles for supposedly sophisticated investors (one of the most misleading terms on Wall Street) to invest in the fund. But, considering that the president of Goldman was tracking and signing off on these deals, you would think that Goldman might have done some due diligence on these investments. Goldman, of course, claims it believed the money was going into legitimate Malaysian development and investment projects. And it is clear that at least one Goldman executive abetted the scheme. Tim Leissner, the Goldman banker for 1MDB, wrote a letter on Goldman stationery that allowed a close associate of Malaysia’s prime minister to transfer $3 billion to a Swiss bank account, alleviating the concerns of that Swiss bank and it lawyers. Leissner was fired by Goldman when the existence of that letter was revealed. Now a skeptical person like myself would wonder whether Mr. Leissner would write a letter like that without getting some sort of approval, especially when he knew that the president of Goldman was tracking the 1MDB deal. Unsurprisingly, Gary Cohn has been chose by Donald Trump to be the director of the National Economic Council and his top legal adviser. A skeptical person like myself might think that this article will be the last we will hear about Goldman’s involvement with 1MDB.

Finally, there is an article that describes the ultimate Wall Street world of “heads I win, tails you lose” – hedge fund fees. The story describes how hedge funds inflate their returns by leaving out the management fees when they tout those fabulous returns. And example of this is a hedge fund that announced returns of 20.5% in the four years the fund was doing business. When you are getting less than 1% interest on savings, that sounds like a pretty fantastic return. In fact, that is hardly spectacular, especially when you realize the S&P 500 gained around 67% in the same period (that S&P gain was, of course, driven by Donald Trump’s presidential candidacy). But even that mediocre 20% return is misleading because it does not include the funds 1.5% management fee and 16% cut of any gains. When including those fees, the actual returns come to about 5.7%, which is not much better than earning that pitiful 1% every year for four years. So, about three-quarters of this hedge fund’s gain went to its managers as opposed to its investors. More importantly, the managers only share in the gains, they have no share in the losses. Those losses are strictly borne by the sophisticated investors (there’s that term again) who invest in the fund. In addition, this fund’s fees are actually below the normal 2% fee and 20% of the gain. It’s a nice racket if you can convince enough people to give you their money.

In the story about Goldman Sachs, there is this one paragraph, “The 1MDB case has become a signature campaign in the global effort by prosecutors to crack down on kleptocracy and the relative ease with which the superwealthy move their money beyond the oversight of government authorities.” If US authorities are really looking to clamp down on kleptocracy, there is plenty of work to do right here in the USA. And with Trump himself and most of his cabinet as beneficiaries of our existing kelptocracy, it is going to take a brave and powerful prosecutor to do anything to stem the tide for the next four years. But maybe that kind of bravery and power won’t be necessary. Larry Kudlow, Trump’s potential head of the Council of Economic Advisers, (not to be confused with the National Economic Council), assures us that, once they have stolen enough money from us, “Wealthy folks have no need to steal or engage in corruption”.