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"This is what you see all over the world.
The rules are not for the elite. The elite are always living above the law.”
Eva Joly: "J'accuse - Investigating Iceland’s financiers", Financial Times, Nov 14, 09, Stanley Pignal et al.

Birthday laudatio to a comrade-in-arms
  Auch für Dich gilt was Goethe in seinem Faust zum Ausdruck brachte:
"Du gleichst dem Geist den Du begreifst!"
   Wie verschiedentlich gezeigt, hast Du frühzeitig den Geist begriffen -
und meist einsam, und nicht selten contre vent et marée, auch nachhaltig erfolgreich umgesetzt.
    Für Dich, für Deine Familie, und für uns alle kann ich mir sodann nichts besseres wünschen,
als dass andere umso mehr diese Erkenntnisse und Erfahrungen teilen,
als sie sich auf hoher und höchster Ebene als verantwortlich erkennen,
sei dies nun in der Zivilgesellschaft, in der Wirtschaft oder im Staat.
    Das anspruchsvolle System der Demokratie
bedingt sowohl den selbst-verantwortlichen, solidaren und souveränen Bürger,
als auch den auf diesen Bürger ausgerichteten Rechtsstaat.
Der so verstandene, vorab den Freiraum des Bürgers zu schützende Rechtsstaat
verkommt zum Rechtsmittelstaat, wenn seine Regelungsdichte die kritische Masse übersteigt,
und wenn das ohnehin regelmässig auf den "Krämer" ausgerichtete Recht
auf der Makrostufe als Freibrief für ungezügeltes Wirtschaften verstanden und missbraucht wird.
Denn je höher die wirtschaftliche und politische Betätigungsebene,
desto grösser sind die Rechtslücken und Interessenkonflikte.
    Rechtslücken sind aber besonders dort keinesfalls zulasten des Gemeinwohls zu nutzen.
Auch die unvermeidbar auftretenden Interessenkonlikte sind besonders dort nicht zu verdrängen,
sondern mit Vernunft, Tiefgang und Weitsicht stets vorrangig zugunsten des Gemeinwohls zu lösen.
Daraufhin sind Ausbildung und Rechtsnormen auszurichten.
Und es gilt auch dort im obigen Sinne zu handeln, wo weder Wegweiser noch Pfade bestehen.
Denn besonders dort ist auf diese inneren Leitplanken zu achten, ist auf den inneren Kompass abzustellen.
So wie dies schon der spanische Dichter Antonio Machado mit den Worten vorgezeichnet hat:
"Traveller, there is no road, the road is made by the traveller!"
Iconoclast, 22 Sep 2010.

22 Aug 11    Wall Street Aristocracy Got $1.2 Trillion in Secret Loans, Washington Post, Bradley Keoun et al.
15 Aug 11    How Bad Is It?, The New Yorker, John Cassidy
28 Jun 11   US hypocrisy: A Little House of Secrets on the Great Plains, YAHOO.finance, Kelly Carr et al.
18 Jun 11   BARRONS: The world knows America can pay its debts. It doesn't know if America will. Thomas G.Donlan
13 Jun 11   US demands tax tolerance of foreign financial groups, Financial Times, Gillian Tett
12 Jun 11   Tax compliance bill drives expat to despair of US, Financial Times, Vanessa Houlder
1.Jun 11   Rechtsansätze für einen nachhaltigeren UBS-Kundenschutz, ASDI/SIPA
9 Nov 10    Bond buyers aren't fools: the Fed can't simultaneously raise inflation and lower interest rates, WSJ, Alan Reynolds
3 Nov 10   Leverage ratio 69 to 1: Fed balance sheet could look very ugly, very fast, WSJ, editorial, comments
20 oct 10   Dollar currency & pension funds: history's biggest Ponzi schemes, BILAN, Myret Zaki
18 Oct 10   Banks Shared Clients’ Profits, but Not Losses, NYT, LOUISE STORY
23 Aug 10   Too big not to fail, Wegelin comment #272, Konrad Hummler (DE, FR, IT)
30 Jun 10   In U.S. Bailout of A.I.G., Forgiveness for Big Banks, NYT, LOUISE STORY et al., AIG bailout docs
19 May 10   Clients Worried About Goldman’s Dueling Goals, NYT, Gretchen Morgenson et al., comments
19 May 10   Goldman’s Responses on Relations With Clients, NYT. Goldman insider documents
24 Apr 10   Rating Agency Data Aided Wall Street in Deals, NYT, Gretchen Morgenson et al.
7 Feb 10   Testy Conflict With Goldman Helped Push A.I.G. to Edge, NYT, Gretchen Morgenson et al.
24 Dec 09   Banks Bundled Bad Debt, Bet Against It and Won, NYT, Gretchen Morgenson et al.

December 24, 2009

Advantage: Product Design — Designing Products Then Betting Against Them
Banks Bundled Bad Debt, Bet Against It and Won

One former Goldman salesman wrote a novel about the crisis. A Deutsche Bank trader passed out T-shirts for investors hoping to profit on a housing bust. Right, William P. O'Donnell/The New York Times

In late October 2007, as the financial markets were starting to come unglued, a Goldman Sachs trader, Jonathan M. Egol, received very good news. At 37, he was named a managing director at the firm.

Mr. Egol, a Princeton graduate, had risen to prominence inside the bank by creating mortgage-related securities, named Abacus, that were at first intended to protect Goldman from investment losses if the housing market collapsed. As the market soured, Goldman created even more of these securities, enabling it to pocket huge profits.

Goldman’s own clients who bought them, however, were less fortunate.

Pension funds and insurance companies lost billions of dollars on securities that they believed were solid investments, according to former Goldman employees with direct knowledge of the deals who asked not to be identified because they have confidentiality agreements with the firm.

Goldman was not the only firm that peddled these complex securities — known as synthetic collateralized debt obligations, or C.D.O.’s — and then made financial bets against them, called selling short in Wall Street parlance. Others that created similar securities and then bet they would fail, according to Wall Street traders, include Deutsche Bank and Morgan Stanley, as well as smaller firms like Tricadia Inc., an investment company whose parent firm was overseen by Lewis A. Sachs, who this year became a special counselor to Treasury Secretary Timothy F. Geithner.

How these disastrously performing securities were devised is now the subject of scrutiny by investigators in Congress, at the Securities and Exchange Commission and at the Financial Industry Regulatory Authority, Wall Street’s self-regulatory organization, according to people briefed on the investigations. Those involved with the inquiries declined to comment.

While the investigations are in the early phases, authorities appear to be looking at whether securities laws or rules of fair dealing were violated by firms that created and sold these mortgage-linked debt instruments and then bet against the clients who purchased them, people briefed on the matter say.

One focus of the inquiry is whether the firms creating the securities purposely helped to select especially risky mortgage-linked assets that would be most likely to crater, setting their clients up to lose billions of dollars if the housing market imploded.

Some securities packaged by Goldman and Tricadia ended up being so vulnerable that they soured within months of being created.

Goldman and other Wall Street firms maintain there is nothing improper about synthetic C.D.O.’s, saying that they typically employ many trading techniques to hedge investments and protect against losses. They add that many prudent investors often do the same. Goldman used these securities initially to offset any potential losses stemming from its positive bets on mortgage securities.

But Goldman and other firms eventually used the C.D.O.’s to place unusually large negative bets that were not mainly for hedging purposes, and investors and industry experts say that put the firms at odds with their own clients’ interests.

“The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen,” said Sylvain R. Raynes, an expert in structured finance at R & R Consulting in New York. “When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”

Investment banks were not alone in reaping rich rewards by placing trades against synthetic C.D.O.’s. Some hedge funds also benefited, including Paulson & Company, according to former Goldman workers and people at other banks familiar with that firm’s trading.

Michael DuVally, a Goldman Sachs spokesman, declined to make Mr. Egol available for comment. But Mr. DuVally said many of the C.D.O.’s created by Wall Street were made to satisfy client demand for such products, which the clients thought would produce profits because they had an optimistic view of the housing market. In addition, he said that clients knew Goldman might be betting against mortgages linked to the securities, and that the buyers of synthetic mortgage C.D.O.’s were large, sophisticated investors, he said.

The creation and sale of synthetic C.D.O.’s helped make the financial crisis worse than it might otherwise have been, effectively multiplying losses by providing more securities to bet against. Some $8 billion in these securities remain on the books at American International Group, the giant insurer rescued by the government in September 2008.

From 2005 through 2007, at least $108 billion in these securities was issued, according to Dealogic, a financial data firm. And the actual volume was much higher because synthetic C.D.O.’s and other customized trades are unregulated and often not reported to any financial exchange or market.

Goldman Saw It Coming
Before the financial crisis, many investors — large American and European banks, pension funds, insurance companies and even some hedge funds — failed to recognize that overextended borrowers would default on their mortgages, and they kept increasing their investments in mortgage-related securities. As the mortgage market collapsed, they suffered steep losses.

A handful of investors and Wall Street traders, however, anticipated the crisis. In 2006, Wall Street had introduced a new index, called the ABX, that became a way to invest in the direction of mortgage securities. The index allowed traders to bet on or against pools of mortgages with different risk characteristics, just as stock indexes enable traders to bet on whether the overall stock market, or technology stocks or bank stocks, will go up or down.

Goldman, among others on Wall Street, has said since the collapse that it made big money by using the ABX to bet against the housing market. Worried about a housing bubble, top Goldman executives decided in December 2006 to change the firm’s overall stance on the mortgage market, from positive to negative, though it did not disclose that publicly.

Even before then, however, pockets of the investment bank had also started using C.D.O.’s to place bets against mortgage securities, in some cases to hedge the firm’s mortgage investments, as protection against a fall in housing prices and an increase in defaults.

Mr. Egol was a prime mover behind these securities. Beginning in 2004, with housing prices soaring and the mortgage mania in full swing, Mr. Egol began creating the deals known as Abacus. From 2004 to 2008, Goldman issued 25 Abacus deals, according to Bloomberg, with a total value of $10.9 billion.

Abacus allowed investors to bet for or against the mortgage securities that were linked to the deal. The C.D.O.’s didn’t contain actual mortgages. Instead, they consisted of credit-default swaps, a type of insurance that pays out when a borrower defaults. These swaps made it much easier to place large bets on mortgage failures.

Rather than persuading his customers to make negative bets on Abacus, Mr. Egol kept most of these wagers for his firm, said five former Goldman employees who spoke on the condition of anonymity. On occasion, he allowed some hedge funds to take some of the short trades.

Mr. Egol and Fabrice Tourre, a French trader at Goldman, were aggressive from the start in trying to make the assets in Abacus deals look better than they were, according to notes taken by a Wall Street investor during a phone call with Mr. Tourre and another Goldman employee in May 2005.

On the call, the two traders noted that they were trying to persuade analysts at Moody’s Investors Service, a credit rating agency, to assign a higher rating to one part of an Abacus C.D.O. but were having trouble, according to the investor’s notes, which were provided by a colleague who asked for anonymity because he was not authorized to release them. Goldman declined to discuss the selection of the assets in the C.D.O.’s, but a spokesman said investors could have rejected the C.D.O. if they did not like the assets.

Goldman’s bets against the performances of the Abacus C.D.O.’s were not worth much in 2005 and 2006, but they soared in value in 2007 and 2008 when the mortgage market collapsed. The trades gave Mr. Egol a higher profile at the bank, and he was among a group promoted to managing director on Oct. 24, 2007.

“Egol and Fabrice were way ahead of their time,” said one of the former Goldman workers. “They saw the writing on the wall in this market as early as 2005.” By creating the Abacus C.D.O.’s, they helped protect Goldman against losses that others would suffer.

As early as the summer of 2006, Goldman’s sales desk began marketing short bets using the ABX index to hedge funds like Paulson & Company, Magnetar and Soros Fund Management, which invests for the billionaire George Soros. John Paulson, the founder of Paulson & Company, also would later take some of the shorts from the Abacus deals, helping him profit when mortgage bonds collapsed. He declined to comment.

A Deal Gone Bad, for Some
The woeful performance of some C.D.O.’s issued by Goldman made them ideal for betting against. As of September 2007, for example, just five months after Goldman had sold a new Abacus C.D.O., the ratings on 84 percent of the mortgages underlying it had been downgraded, indicating growing concerns about borrowers’ ability to repay the loans, according to research from UBS, the big Swiss bank. Of more than 500 C.D.O.’s analyzed by UBS, only two were worse than the Abacus deal.

Goldman created other mortgage-linked C.D.O.’s that performed poorly, too. One, in October 2006, was a $800 million C.D.O. known as Hudson Mezzanine. It included credit insurance on mortgage and subprime mortgage bonds that were in the ABX index; Hudson buyers would make money if the housing market stayed healthy — but lose money if it collapsed. Goldman kept a significant amount of the financial bets against securities in Hudson, so it would profit if they failed, according to three of the former Goldman employees.

A Goldman salesman involved in Hudson said the deal was one of the earliest in which outside investors raised questions about Goldman’s incentives. “Here we are selling this, but we think the market is going the other way,” he said.

A hedge fund investor in Hudson, who spoke on the condition of anonymity, said that because Goldman was betting against the deal, he wondered whether the bank built Hudson with “bonds they really think are going to get into trouble.”

Indeed, Hudson investors suffered large losses. In March 2008, just 18 months after Goldman created that C.D.O., so many borrowers had defaulted that holders of the security paid out about $310 million to Goldman and others who had bet against it, according to correspondence sent to Hudson investors.

The Goldman salesman said that C.D.O. buyers were not misled because they were advised that Goldman was placing large bets against the securities. “We were very open with all the risks that we thought we sold. When you’re facing a tidal wave of people who want to invest, it’s hard to stop them,” he said. The salesman added that investors could have placed bets against Abacus and similar C.D.O.’s if they had wanted to.

A Goldman spokesman said the firm’s negative bets didn’t keep it from suffering losses on its mortgage assets, taking $1.7 billion in write-downs on them in 2008; but he would not say how much the bank had since earned on its short positions, which former Goldman workers say will be far more lucrative over time. For instance, Goldman profited to the tune of $1.5 billion from one series of mortgage-related trades by Mr. Egol with Wall Street rival Morgan Stanley, which had to book a steep loss, according to people at both firms.

Tetsuya Ishikawa, a salesman on several Abacus and Hudson deals, left Goldman and later published a novel, “How I Caused the Credit Crunch.” In it, he wrote that bankers deserted their clients who had bought mortgage bonds when that market collapsed: “We had moved on to hurting others in our quest for self-preservation.” Mr. Ishikawa, who now works for another financial firm in London, declined to comment on his work at Goldman.

Lewis Sachs, left, who oversaw C.D.O.’s before becoming a Treasury adviser, and John Paulson, whose company profited as the housing market collapsed. Left, Treasury Department; Kevin Wolf/Associated Press

Profits From a Collapse
Just as synthetic C.D.O.’s began growing rapidly, some Wall Street banks pushed for technical modifications governing how they worked in ways that made it possible for C.D.O.’s to expand even faster, and also tilted the playing field in favor of banks and hedge funds that bet against C.D.O.’s, according to investors.

In early 2005, a group of prominent traders met at Deutsche Bank’s office in New York and drew up a new system, called Pay as You Go. This meant the insurance for those betting against mortgages would pay out more quickly. The traders then went to the International Swaps and Derivatives Association, the group that governs trading in derivatives like C.D.O.’s. The new system was presented as a fait accompli, and adopted.

Other changes also increased the likelihood that investors would suffer losses if the mortgage market tanked. Previously, investors took losses only in certain dire “credit events,” as when the mortgages associated with the C.D.O. defaulted or their issuers went bankrupt.

But the new rules meant that C.D.O. holders would have to make payments to short sellers under less onerous outcomes, or “triggers,” like a ratings downgrade on a bond. This meant that anyone who bet against a C.D.O. could collect on the bet more easily.

“In the early deals you see none of these triggers,” said one investor who asked for anonymity to preserve relationships. “These things were built in to provide the dealers with a big payoff when something bad happened.”

Banks also set up ever more complex deals that favored those betting against C.D.O.’s. Morgan Stanley established a series of C.D.O.’s named after United States presidents (Buchanan and Jackson) with an unusual feature: short-sellers could lock in very cheap bets against mortgages, even beyond the life of the mortgage bonds. It was akin to allowing someone paying a low insurance premium for coverage on one automobile to pay the same on another one even if premiums over all had increased because of high accident rates.

At Goldman, Mr. Egol structured some Abacus deals in a way that enabled those betting on a mortgage-market collapse to multiply the value of their bets, to as much as six or seven times the face value of those C.D.O.’s. When the mortgage market tumbled, this meant bigger profits for Goldman and other short sellers — and bigger losses for other investors.

Selling Bad Debt
Other Wall Street firms also created risky mortgage-related securities that they bet against.

At Deutsche Bank, the point man on betting against the mortgage market was Greg Lippmann, a trader. Mr. Lippmann made his pitch to select hedge fund clients, arguing they should short the mortgage market. He sometimes distributed a T-shirt that read “I’m Short Your House!!!” in black and red letters.

Deutsche, which declined to comment, at the same time was selling synthetic C.D.O.’s to its clients, and those deals created more short-selling opportunities for traders like Mr. Lippmann.

Among the most aggressive C.D.O. creators was Tricadia, a management company that was a unit of Mariner Investment Group. Until he became a senior adviser to the Treasury secretary early this year, Lewis Sachs was Mariner’s vice chairman. Mr. Sachs oversaw about 20 portfolios there, including Tricadia, and its documents also show that Mr. Sachs sat atop the firm’s C.D.O. management committee.

From 2003 to 2007, Tricadia issued 14 mortgage-linked C.D.O.’s, which it called TABS. Even when the market was starting to implode, Tricadia continued to create TABS deals in early 2007 to sell to investors. The deal documents referring to conflicts of interest stated that affiliates and clients of Tricadia might place bets against the types of securities in the TABS deal.

Even so, the sales material also boasted that the mortgages linked to C.D.O.’s had historically low default rates, citing a “recently completed” study by Standard & Poor’s ratings agency — though fine print indicated that the date of the study was September 2002, almost five years earlier.

At a financial symposium in New York in September 2006, Michael Barnes, the co-head of Tricadia, described how a hedge fund could put on a negative mortgage bet by shorting assets to C.D.O. investors, according to his presentation, which was reviewed by The New York Times.

Mr. Barnes declined to comment. James E. McKee, general counsel at Tricadia, said, “Tricadia has never shorted assets into the TABS deals, and Tricadia has always acted in the best interests of its clients and investors.”

Mr. Sachs, through a spokesman at the Treasury Department, declined to comment.

Like investors in some of Goldman’s Abacus deals, buyers of some TABS experienced heavy losses. By the end of 2007, UBS research showed that two TABS deals were the eighth- and ninth-worst performing C.D.O.’s. Both had been downgraded on at least 75 percent of their associated assets within a year of being issued.

Tricadia’s hedge fund did far better, earning roughly a 50 percent return in 2007 and similar profits in 2008, in part from the short bets.

February 7, 2010

Advantage: Price Setting — Controlling the Marks on Investments, With Self-Interest in Mind
Testy Conflict With Goldman Helped Push A.I.G. to Edge

Billions of dollars were at stake when 21 executives of Goldman Sachs and the American International Group convened a conference call on Jan. 28, 2008, to try to resolve a rancorous dispute that had been escalating for months.

A.I.G. had long insured complex mortgage securities owned by Goldman and other firms against possible defaults. With the housing crisis deepening, A.I.G., once the world’s biggest insurer, had already paid Goldman $2 billion to cover losses the bank said it might suffer. A.I.G. executives wanted some of its money back, insisting that Goldman — like a homeowner overestimating the damages in a storm to get a bigger insurance payment — had inflated the potential losses. Goldman countered that it was owed even more, while also resisting consulting with third parties to help estimate a value for the securities.

After more than an hour of debate, the two sides on the call signed off with nothing settled, according to internal A.I.G. documents and an audio recording reviewed by The New York Times.

Behind-the-scenes disputes over huge sums are common in banking, but the standoff between A.I.G. and Goldman would become one of the most momentous in Wall Street history. Well before the federal government bailed out A.I.G. in September 2008, Goldman’s demands for billions of dollars from the insurer helped put it in a precarious financial position by bleeding much-needed cash. That ultimately provoked the government to step in.

With taxpayer assistance to A.I.G. currently totaling $180 billion, regulatory and Congressional scrutiny of Goldman’s role in the insurer’s downfall is increasing. The Securities and Exchange Commission is examining the payment demands that a number of firms — most prominently Goldman — made during 2007 and 2008 as the mortgage market imploded.

The S.E.C. wants to know whether any of the demands improperly distressed the mortgage market, according to people briefed on the matter who requested anonymity because the inquiry was intended to be confidential.

In just the year before the A.I.G. bailout, Goldman collected more than $7 billion from A.I.G. And Goldman received billions more after the rescue. Though other banks also benefited, Goldman received more taxpayer money, $12.9 billion, than any other firm.

In addition, according to two people with knowledge of the positions, a portion of the $11 billion in taxpayer money that went to Société Générale, a French bank that traded with A.I.G., was subsequently transferred to Goldman under a deal the two banks had struck.

Goldman stood to gain from the housing market’s implosion because in late 2006, the firm had begun to make huge trades that would pay off if the mortgage market soured. The further mortgage securities’ prices fell, the greater were Goldman’s profits.

In its dispute with A.I.G., Goldman invariably argued that the securities in dispute were worth less than A.I.G. estimated — and in many cases, less than the prices at which other dealers valued the securities.

The pricing dispute, and Goldman’s bets that the housing market would decline, has left some questioning whether Goldman had other reasons for lowballing the value of the securities that A.I.G. had insured, said Bill Brown, a law professor at Duke University who is a former employee of both Goldman and A.I.G.

The dispute between the two companies, he said, “was the tip of the iceberg of this whole crisis.” “It’s not just who was right and who was wrong,” Mr. Brown said. “I also want to know their motivations. There could have been an incentive for Goldman to say, ‘A.I.G., you owe me more money.’ ”

Goldman is proud of its reputation for aggressively protecting itself and its shareholders from losses as it did in the dispute with A.I.G.

In March 2009, David A. Viniar, Goldman’s chief financial officer, discussed his firm’s dispute with A.I.G. in a conference call with reporters. “We believed that the value of these positions was lower than they believed,” he said.

Asked by a reporter whether his bank’s persistent payment demands had contributed to A.I.G.’s woes, Mr. Viniar said that Goldman had done nothing wrong and that the firm was merely seeking to enforce its insurance policy with A.I.G. “I don’t think there is any guilt whatsoever,” he concluded.

Lucas van Praag, a Goldman spokesman, reiterated that position. “We requested the collateral we were entitled to under the terms of our agreements,” he said in a written statement, “and the idea that A.I.G. collapsed because of our marks is ridiculous.”

Still, documents show there were unusual aspects to the deals with Goldman. The bank resisted, for example, letting third parties value the securities as its contracts with A.I.G. required. And Goldman based some payment demands on lower-rated bonds that A.I.G.’s insurance did not even cover.

A November 2008 analysis by BlackRock, a leading asset management firm, noted that Goldman’s valuations of the securities that A.I.G. insured were “consistently lower than third-party prices.”

To be sure, many now agree that A.I.G. was reckless during the mortgage mania. The firm, once the world’s largest insurer, had written far more insurance than it could have possibly paid if a national mortgage debacle occurred — as, in fact, it did.

Perhaps the most intriguing aspect of the relationship between Goldman and A.I.G. was that without the insurer to provide credit insurance, the investment bank could not have generated some of its enormous profits betting against the mortgage market. And when that market went south, A.I.G. became its biggest casualty — and Goldman became one of the biggest beneficiaries.

Longstanding Ties
For decades, A.I.G. and Goldman had a deep and mutually beneficial relationship, and at one point in the 1990s, they even considered merging. At around the same time, in 1998, A.I.G. entered a lucrative new business: insuring the least risky portions of corporate loans or other assets that were bundled into securities.

A.I.G.’s financial products unit, led by Joseph J. Cassano, was behind the expansion. To reduce its own risks in the transactions, the company structured deals so that it would not have to make early payments to clients when securities began to sour. That changed around 2003, however, when A.I.G. began insuring portions of subprime mortgage deals. A lawyer for Mr. Cassano said his client would not comment for this article. A.I.G. also declined to comment.

Alan Frost, a managing director in Mr. Cassano’s unit, negotiated scores of mortgage deals around Wall Street that included a complicated sequence of events for when an insurance payment on a distressed asset came due.

The terms, described by several A.I.G. trading partners, stated that A.I.G. would post payments under two or three circumstances: if mortgage bonds were downgraded, if they were deemed to have lost value, or if A.I.G.’s own credit rating was downgraded. If all of those things happened, A.I.G. would have to make even larger payments.

Mr. Frost referred questions to his lawyer, who declined to comment.

Traders loved Mr. Frost’s deals because they would pay out quickly if anything went wrong. Mr. Frost cut many of his deals with two Goldman traders, Jonathan Egol and Ram Sundaram, who had negative views of the housing market. They had made A.I.G. a central part of some of their trading strategies.

Mr. Egol structured a group of deals — known as Abacus — so that Goldman could benefit from a housing collapse. Many of them were actually packages of A.I.G. insurance written against mortgage bonds, indicating that Mr. Egol and Goldman believed that A.I.G. would have to make large payments if the housing market ran aground. About $5.5 billion of Mr. Egol’s deals still sat on A.I.G.’s books when the insurer was bailed out.

“Al probably did not know it, but he was working with the bears of Goldman,” a former Goldman salesman, who requested anonymity so he would not jeopardize his business relationships, said of Mr. Frost. “He was signing A.I.G. up to insure trades made by people with really very negative views” of the housing market.

Mr. Sundaram’s trades represented another large part of Goldman’s business with A.I.G. According to five former Goldman employees, Mr. Sundaram used financing from other banks like Société Générale and Calyon to purchase less risky mortgage securities from competitors like Merrill Lynch and then insure the assets with A.I.G. — helping fatten the mortgage pipeline that would prove so harmful to Wall Street, investors and taxpayers. In October 2008, just after A.I.G. collapsed, Goldman made Mr. Sundaram a partner.

Through Société Générale, Goldman was also able to buy more insurance on mortgage securities from A.I.G., according to a former A.I.G. executive with direct knowledge of the deals. A spokesman for Société Générale declined to comment.

It is unclear how much Goldman bought through the French bank, but A.I.G. documents show that Goldman was involved in pricing half of Société Générale’s $18.6 billion in trades with A.I.G. and that the insurer’s executives believed that Goldman pressed Société Générale to also demand payments.

Goldman’s Tough Terms
In addition to insuring Mr. Sundaram’s and Mr. Egol’s trades with A.I.G., Goldman also negotiated aggressively with A.I.G. — often requiring the insurer to make payments when the value of mortgage bonds fell by just 4 percent. Most other banks dealing with A.I.G. did not receive payments until losses exceeded 8 percent, the insurer’s records show.

Several former Goldman partners said it was not surprising that Goldman sought such tough terms, given the firm’s longstanding focus on risk management.

By July 2007, when Goldman demanded its first payment from A.I.G. — $1.8 billion — the investment bank had already taken trading positions that would pay out if the mortgage market weakened, according to seven former Goldman employees.

Still, Goldman’s initial call surprised A.I.G. officials, according to three A.I.G. employees with direct knowledge of the situation. The insurer put up $450 million on Aug. 10, 2007, to appease Goldman, but A.I.G. remained resistant in the following months and, according to internal messages, was convinced that Goldman was also pushing other trading partners to ask A.I.G. for payments.

On Nov. 1, 2007, for example, an e-mail message from Mr. Cassano, the head of A.I.G. Financial Products, to Elias Habayeb, an A.I.G. accounting executive, said that a payment demand from Société Générale had been “spurred by GS calling them.”

Mr. Habayeb, who testified before Congress last month that the payment demands were a major contributor to A.I.G.’s downfall, declined to be interviewed and referred questions to A.I.G. The insurer also declined to comment for this article. Mr. van Praag, the Goldman spokesman, said Goldman did not push other firms to demand payments from A.I.G.

Later that month, Mr. Cassano noted in another e-mail message that Goldman’s demands for payment were becoming problematic. “The overhang of the margin call from the perceived righteous Goldman Sachs has impacted everyone’s judgment,” he wrote to five employees in his division.

By the end of November 2007, Goldman was holding $2 billion in cash from A.I.G. when the insurer notified Goldman that it was disputing the firm’s calculations and seeking a return of $1.56 billion. Goldman refused, the documents show.

In many of these deals, Goldman was trading for other parties and taking a fee. As the mortgage market declined, Goldman paid some of these parties while waiting for A.I.G. to meet its demands, the Goldman spokesman said. But one reason those parties were owed money on the deals was that Goldman had marked down the securities.

Adding to the pressure on A.I.G., Mr. Viniar, Goldman’s chief financial officer, advised the insurer in the fall of 2007 that because the two companies shared the same auditor, PricewaterhouseCoopers, A.I.G. should accept Goldman’s valuations, according to a person with knowledge of the discussions. Goldman declined to comment on this exchange.

Pricewaterhouse had supported A.I.G.’s approach to valuing the securities throughout 2007, documents show. But at the end of 2007, the auditor began demanding that A.I.G. provide greater disclosure on the risks in the credit insurance it had written. Pricewaterhouse was expressing concern about the dispute.

The insurer disclosed in year-end regulatory filings that its auditor had found a “material weakness” in financial reporting related to valuations of the insurance, a troubling sign for investors.

A spokesman for Pricewaterhouse said the company would not comment on client matters.

Insiders at A.I.G. bridled at Goldman’s insistence that they accept the investment bank’s valuations. “Would we call bond issuers and ask them what the valuation of their bonds was and take that?” asked Robert Lewis, A.I.G.’s chief risk officer, in a message in January 2008. “What am I missing here, so I don’t waste everybody’s time?”

When A.I.G. asked Goldman to submit the dispute to a panel of independent firms, Goldman resisted, internal e-mail messages show. In a March 7, 2008, phone call, Mr. Cassano discussed surveying other dealers to gauge prices with Michael Sherwood, Goldman’s vice chairman. At that time, Goldman calculated that A.I.G. owed it $4.6 billion, on top of the $2 billion already paid. A.I.G. contended it only owed an additional $1.2 billion.

Mr. Sherwood said he did not want to ask other firms to value the securities because “it would be ‘embarrassing’ if we brought the market into our disagreement,” according to an e-mail message from Mr. Cassano that described the call.

The Goldman spokesman disputed this account, saying instead that Goldman was willing to consult third parties but could not agree with A.I.G. on the methodology.

Trouble Grows at A.I.G.
By the spring of 2008, A.I.G.’s dispute with Goldman was just one of its many woes. Mr. Cassano was pushed out in March and the company’s defenses against the growing demand for payments faltered. By the end of August 2008, A.I.G. had posted $19.7 billion in cash to its trading partners, including Goldman, according to financial filings.

Over that summer, A.I.G. had tried, unsuccessfully, to cancel its insurance contracts with the trading partners. But Goldman, according to interviews with former A.I.G. executives, would allow that only if it also got to keep the $7 billion it had already received from A.I.G. Goldman wanted to keep the initial insurance payouts and the securities in order to profit from any future rebound.

In addition to offering to cancel its own contracts, Goldman offered to buy all of the insurance A.I.G. had written for several other banks at severely distressed prices, according to three people briefed on the discussions.

Negotiating with Goldman to void the A.I.G. insurance was especially difficult, Federal Reserve Board documents show, because the firm did not own the underlying bonds. As a result, Goldman had little incentive to compromise.

On Aug. 18, 2008, Goldman’s equity research department published an in-depth report on A.I.G. The analysts advised the firm’s clients to avoid the stock because of a “downward spiral which is likely to ensue as more actual cash losses emanate” from the insurer’s financial products unit.

On the matter of whether A.I.G. could unwind its troublesome insurance on mortgage securities at a discount, the Goldman report noted that if a trading partner “is not in a position of weakness, why would it accept anything less than the full amount of protection for which it had paid?”

A.I.G. shares fell 6 percent the day the report was published. Three weeks later, the United States government agreed to pour billions of dollars in taxpayer money into the insurer to keep it from collapsing.

The government would soon settle the yearlong dispute between Goldman and A.I.G., with Goldman receiving full value for its bets. The federal bailout locked in the paper losses of those deals for A.I.G. The prices on many of those securities have since rebounded.

Alan Feuer contributed reporting.

April 24, 2010

Advantage: Ratings Game — How Debt Watchdogs May Have Been Compromised
Rating Agency Data Aided Wall Street in Deals

Raymond W. McDaniel Jr., chairman and chief executive of Moody’s, left, and Kathleen Corbet, former president of Standard & Poor’s, testified before the Senate’s Permanent Subcommittee on Investigations on Friday. Harry Hamburg/Associated Press

One of the mysteries of the financial crisis is how mortgage investments that turned out to be so bad earned credit ratings that made them look so good.

One answer is that Wall Street was given access to the formulas behind those magic ratings — and hired away some of the very people who had devised them.

In essence, banks started with the answers and worked backward, reverse-engineering top-flight ratings for investments that were, in some cases, riskier than ratings suggested, according to former agency employees.

The major credit rating agencies, Moody’s, Standard & Poor’s and Fitch, drew renewed criticism on Friday on Capitol Hill for failing to warn of the dangers posed by complex investments like the one that has drawn Goldman Sachs into a legal whirlwind.

But while the agencies have come under fire before, the extent to which they collaborated with Wall Street banks has drawn less notice.

The rating agencies made public computer models that were used to devise ratings to make the process less secretive. That way, banks and others issuing bonds — companies and states, for instance — wouldn’t be surprised by a weak rating that could make it harder to sell the bonds or that would require them to offer a higher interest rate.

But by routinely sharing their models, the agencies in effect gave bankers the tools to tinker with their complicated mortgage deals until the models produced the desired ratings.

“There’s a bit of a Catch-22 here, to be fair to the ratings agencies,” said Dan Rosen, a member of Fitch’s academic advisory board and the chief of R2 Financial Technologies in Toronto. “They have to explain how they do things, but that sometimes allowed people to game it.”

There were other ways that the models used to rate mortgage investments like the controversial Goldman deal, Abacus 2007-AC1, were flawed. Like many in the financial community, the agencies had assumed that home prices were unlikely to decline. They also assumed that complex investments linked to home loans drawn from around the nation were diversified, and thus safer.

Both of those assumptions were wrong, and investors the world over lost many billions of dollars. In that Abacus investment, for instance, 84 percent of the underlying bonds were downgraded within six months.

But for Goldman and other banks, a road map to the right ratings wasn’t enough. Analysts from the agencies were hired to help construct the deals.

In 2005, for instance, Goldman hired Shin Yukawa, a ratings expert at Fitch, who later worked with the bank’s mortgage unit to devise the Abacus investments.

Mr. Yukawa was prominent in the field. In February 2005, as Goldman was putting together some of the first of what would be 25 Abacus investments, he was on a panel moderated by Jonathan M. Egol, a Goldman worker, at a conference in Phoenix.

The next month, Mr. Yukawa joined Goldman, where Mr. Egol was masterminding the Abacus deals. Neither was named in the Securities and Exchange Commission’s lawsuit, nor have the rating agencies been accused of wrongdoing related to Abacus.

At Goldman, Mr. Yukawa helped create Abacus 2007-AC1, according to Goldman documents. The safest part of that earned an AAA rating. He worked on other Abacus deals.

Mr. Yukawa, who now works at PartnerRe Asset Management, a money management firm in Greenwich, Conn., did not return requests for comment.

Goldman has said it will fight the accusations from the S.E.C., which claims Goldman built the Abacus investment to fall apart so a hedge fund manager, John A. Paulson, could bet against it. And in response to this article, Goldman said it did not improperly influence the ratings process.

Chris Atkins, a spokesman for Standard & Poor’s, noted that the agency was not named in the S.E.C.’s complaint. “S.& P. has a long tradition of analytical excellence and integrity,” Mr. Atkins said. “We have also learned some important lessons from the recent crisis and have made a number of significant enhancements to increase the transparency, governance and quality of our ratings.”

David Weinfurter, a spokesman for Fitch, said via e-mail that rating agencies had once been criticized as opaque, and that Fitch responded by making its models public. He stressed that ratings were ultimately assigned by a committee, not the models.

Officials at Moody’s did not respond to requests for comment.

The role of the rating agencies in the crisis came under sharp scrutiny Friday from the Senate’s Permanent Subcommittee on Investigations. Members grilled representatives from Moody’s and Standard & Poor’s about how they rated risky securities. The changes to financial regulation being debated in Washington would put the agencies under increased supervision by the S.E.C.

Carl M. Levin, the Michigan Democrat who heads the Senate panel, said in a statement: “A conveyor belt of high-risk securities, backed by toxic mortgages, got AAA ratings that turned out not to be worth the paper they were printed on.”

As part of its inquiry, the panel made public 581 pages of e-mail messages and other documents suggesting that executives and analysts at rating agencies embraced new business from Wall Street, even though they recognized they couldn’t properly analyze all of the banks’ products.

The documents also showed that in late 2006, some workers at the agencies were growing worried that their assessments and the models were flawed. They were particularly concerned about models rating collateralized debt obligations like Abacus.

According to former employees, the agencies received information about loans from banks and then fed that data into their models. That opened the door for Wall Street to massage some ratings.

For example, a top concern of investors was that mortgage deals be underpinned by a variety of loans. Few wanted investments backed by loans from only one part of the country or handled by one mortgage servicer.

But some bankers would simply list a different servicer, even though the bonds were serviced by the same institution, and thus produce a better rating, former agency employees said. Others relabeled parts of collateralized debt obligations in two ways so they would not be recognized by the computer models as being the same, these people said.

Banks were also able to get more favorable ratings by adding a small amount of commercial real estate loans to a mix of home loans, thus making the entire pool appear safer.

Sometimes agency employees caught and corrected such entries. Checking them all was difficult, however. “If you dug into it, if you had the time, you would see errors that magically favored the banker,” said one former ratings executive, who like other former employees, asked not to be identified, given the controversy surrounding the industry. “If they had the time, they would fix it, but we were so overwhelmed.”

Comments - Goldman insider documents

May 19, 2010

Advantage: Information — Inside Insights Help Protect Banks' Interests, but Leave Clients Behind
Clients Worried About Goldman’s Dueling Goals

“Questions have been raised that go to the heart of this institution’s most fundamental value: how we treat our clients.”
Lloyd C. Blankfein, Goldman Sachs’s C.E.O., at the firm’s annual meeting in May
Lloyd Blankfein, Goldman’s leader, has been in Washington explaining the firm’s divergent roles. Chris Kleponis/Bloomberg News

As the housing crisis mounted in early 2007, Goldman Sachs was busy selling risky, mortgage-related securities issued by its longtime client, Washington Mutual, a major bank based in Seattle.

Although Goldman had decided months earlier that the mortgage market was headed for a fall, it continued to sell the WaMu securities to investors. While Goldman put its imprimatur on that offering, traders in the same Goldman unit were not so sanguine about WaMu’s prospects: they were betting that the value of WaMu’s stock and other securities would decline.

Goldman’s wager against its customer’s stock — a position known as a “short” — was large enough that it would have generated at least $10 million in profits if WaMu collapsed, according to documents recently released by Congress. And by mid-May, Goldman’s bet against other WaMu securities had made Goldman $2.5 million, the documents show.

WaMu eventually did collapse under the weight of souring mortgage loans; federal regulators seized it in September 2008, making it the biggest bank failure in American history.

Goldman’s bets against WaMu, wagers that took place even as it helped WaMu feed a housing frenzy that Goldman had already lost faith in, are examples of conflicting roles that trouble its critics and some former clients. While Goldman has legions of satisfied customers and maintains that it puts its clients first, it also sometimes appears to work against the interests of those same clients when opportunities to make trading profits off their financial troubles arise.

Goldman’s access to client information can also give its traders an advantage that many of the firm’s competitors lack. And because betting against a company’s shares or its debt can create an atmosphere of doubt about a company’s financial standing, Goldman because of its size and its position in the market can help make the success of some of its wagers faits accomplis.

Lucas van Praag, a Goldman spokesman, declined to say how much the firm earned on its bets against WaMu’s stock. He said his firm lost money on its bets against the other WaMu securities. In an e-mail reply to questions for this article, he said there was nothing improper about Goldman’s wagers against any of its clients. “Shorting stock or buying credit protection in order to manage exposures are typical tools to help a firm reduce its risk.”

WaMu is not the only Goldman client the firm bet against as the mortgage disaster gained steam. Documents released by the Senate Permanent Subcommittee on Investigations show that Goldman’s mortgage unit also wagered against Bear Stearns and Countrywide Financial, two longstanding clients of the firm. These documents are only related to the mortgage unit and it is unknown what other bets the rest of the firm made.

Goldman also bet against the American International Group, which insured Goldman’s mortgage bonds, and National City, a Cleveland bank the firm had advised on a sale of a big subprime mortgage lender to Merrill Lynch.

While no one has accused Goldman of anything illegal involving WaMu, National City, A.I.G. or the other clients it bet against, potential conflicts inherent in Wall Street’s business model are at the core of many of the investigations that state and federal authorities are conducting. Transactions entered into as the mortgage market fizzled may turn out to have been perfectly legal. Nevertheless, they have raised concerns among investors and analysts about the extent to which a variety of Wall Street firms put their own interests ahead of their clients’.

“Now it’s all about the score. Just make the score, do the deal. Move on to the next one. That’s the trader culture,” said Cornelius Hurley, director of the Morin Center for Banking and Financial Law at Boston University and former counsel to the Federal Reserve Board. “Their business model has completely blurred the difference between executing trades on behalf of customers versus executing trades for themselves. It’s a huge problem.”

Goldman has come under particularly intense scrutiny on such issues since the financial and economic downturn began gathering momentum in 2007, in part because it has done so well, in part because of the power it wields in Washington and on Wall Street, and in part because regulators have taken a keen interest in its dealings.

The Securities and Exchange Commission filed a civil fraud suit against the firm last month, contending that it misled clients who bought a mortgage security that the regulators said was intended to fail. Goldman has said it did nothing wrong and is fighting the case. Legislators in Washington are also considering financial reforms that limit potential conflicts of interest in the way that firms like Goldman trade and invest their own money.

Still, Goldman’s many hats — trader, adviser, underwriter, matchmaker of buyers and sellers, and salesperson — has left some clients feeling bruised or so wary that they have sometimes avoided doing business with the bank.

During the early stages of the mortgage crisis, Goldman seems to have unnerved WaMu’s former chief executive, Kerry K. Killinger, according to an e-mail message that Congressional investigators released.

In that message, Mr. Killinger noted that he had avoided retaining Goldman’s investment bankers in the fall of 2007 because he was concerned about how the firm would use knowledge it gleaned from that relationship. He pointed out that Goldman was “shorting mortgages big time” even while it had been advising Countrywide, a major mortgage lender.

“I don’t trust Goldy on this,” he wrote. “They are smart, but this is swimming with the sharks.”

One of Mr. Killinger’s lieutenants at Washington Mutual felt the same way. “We always need to worry a little about Goldman,” that person wrote in an e-mail message, “because we need them more than they need us and the firm is run by traders.”

Mr. Killinger does not appear to have known that Goldman was selling short his company’s shares. His lawyer did not respond to requests for comment. But because Bear Stearns, National City, Countrywide and WaMu all were hammered by the mortgage crisis, any bets Goldman made against each of those firm’s shares were likely to have been profitable.

Even though Goldman had frequently shorted the shares of other firms, it, along with another bank, Morgan Stanley, successfully lobbied the S.E.C. in 2008, at the height of the mortgage collapse, to forbid traders from shorting financial shares, sparing its own stock.

As Trading Arm Grows, a Clash of Purpose

When new hires begin working at Goldman, they are told to follow 14 principles that outline the firm’s best practices. “Our clients’ interests always come first” is principle No. 1. The 14th principle is: “Integrity and honesty are at the heart of our business.”

But some former insiders, who requested anonymity because of concerns about retribution from the firm, say Goldman has a 15th, unwritten principle that employees openly discuss.

It urges Goldman workers to embrace conflicts and argues that they are evidence of a healthy tension between the firm and its customers. If you are not embracing conflicts, the argument holds, you are not being aggressive enough in generating business.

Mr. van Praag said the firm was “unaware” of this 15th principle, adding that “any business in any industry, has potential conflicts and we all have an obligation to manage them effectively.”

But a former Goldman partner, who spoke on condition of anonymity, said that the company’s view of customers had changed in recent years. Under Lloyd C. Blankfein, Goldman’s chief executive, and a cadre of top lieutenants who have ramped up the firm’s trading operation, conflict avoidance had shifted to conflict management, this person said. Along the way, he said, the firm’s executives have come to see customers more as competitors they trade against than as clients.

In fact, Mr. Blankfein and Goldman are quick to remind critics that Wall Street deals with sophisticated investors, who they say can protect themselves. At the bank’s shareholder meeting earlier this month, Mr. Blankfein said, “We deal with the most demanding and, in some cases, cynical clients.”

Even Goldman’s mortgage department compliance training manual from 2007 acknowledges the challenges posed by the firm’s clients-come-first rule. Loyalty to customers “is not always straightforward” given the multiple financial hats Goldman wears in the market, the manual notes.

In addition, the manual explains how Goldman uses information harvested from clients who discuss the market, indicate interest in securities or leave orders consisting of “pretrade information.” The manual notes that Goldman also can deploy information it receives from a wide range of other sources, including data providers, other brokerage firms and securities exchanges.

“We continuously make markets and take risk based on a unique window on the market which is a mosaic constructed of all of the pieces of data received,” the manual said.

Mr. van Praag, the Goldman spokesman, said that the “manual recognizes that like many businesses, and certainly all our competitors, we serve multiple clients. In the process of serving multiple clients we receive information from multiple sources.”

“This policy and the excerpt cited from the training manual simply reflects the fact that we have a diverse client base and give our sales people and traders appropriate guidance,” he added.

Fostering a Market Then Abandoning It

Even now, two years after a dispute with Goldman, C. Talbot Heppenstall Jr. gets miffed talking about the firm.

As treasurer at the University of Pittsburgh Medical Center, a leading nonprofit health care institution, Mr. Heppenstall had once been pleased with Goldman’s work on the enterprise’s behalf.

Beginning in 2002, Goldman had advised officials at U.P.M.C. to raise funds by issuing auction-rate securities. Auction-rate securities are stock or debt instruments with interest rates that reset regularly (usually weekly) in auctions overseen by the brokerage firms that sell them. Municipalities, student loan companies, mutual funds, hospitals and museums all used the securities to raise operating funds.

Goldman had helped to develop the auction-rate market and advised many clients to issue them, getting an annual fee for sponsoring the auctions. Between 2002 and 2008, U.P.M.C. issued $400 million; Goldman underwrote $160 million, while Morgan Stanley and UBS sold the rest.

But in the fall of 2007, as the credit crisis deepened, investors began exiting the $330 billion market, causing interest rates on the securities to drift upward. By mid-January 2008, U.P.M.C. was concerned about the viability of the market and asked Goldman if the hospital should get out. Stay the course, Goldman advised U.P.M.C. in a letter, a copy of which Mr. Heppenstall read to a reporter.

On Feb. 12, less than a month after that letter, Goldman withdrew from the market — the first Wall Street firm to do so, according to a Federal Reserve report. Other firms quickly followed suit.

With the market in disarray, the interest rates that U.P.M.C. and other issuers had to pay investors skyrocketed. Rather than pay the rates, U.P.M.C. decided to redeem the securities.

Although Goldman had fled the market, it refused to allow a redemption to proceed, Mr. Heppenstall said, warning that its contract with the hospital barred U.P.M.C. from buying back the securities for at least another month.

U.P.M.C. had to continue paying lofty interest rates — as well as Goldman’s fees, even though the firm was no longer sponsoring the auctions, according to Mr. Heppenstall.

Goldman had been U.P.M.C.’s investment banker for about six years, Mr. Heppenstall noted in an interview, but this incident marked the end of that relationship. He said that the other Wall Street firms that had underwritten U.P.M.C.’s auction-rate securities, Morgan Stanley and UBS, had allowed it to redeem them. Goldman was the only firm that did not.

“This conflict was the last straw in our relationship with Goldman Sachs and we no longer do any business with them,” he said.

Mr. van Praag, the Goldman spokesman, declined in his e-mail message to respond in detail to U.P.M.C.’s complaints, other than to say that a contract is a contract and that governed how Goldman interacted with the hospital.

“The legal agreements that governed U.P.M.C.’s A.R.S. securities did not allow U.P.M.C. to bid for its own securities in the auctions,” he said.

Brokering State Debt and Advising Against It

Gary Schaer, a New Jersey assemblyman, complained to Goldman about its urging speculators to buy insurance on the state’s bonds, essentially betting against them. Goldman underwrote debt for the state. Robert Stolarik for The New York Times

A state assemblyman in New Jersey named Gary S. Schaer also has had unsettling encounters with Goldman.

Mr. Schaer, who heads the New Jersey Assembly’s Financial Institutions and Insurance Committee, said he became wary in 2008 when he learned that Goldman, one of the state’s main investment bankers, was encouraging speculators to bet against New Jersey’s debt in the derivatives market. (At the time, a former Goldman chief executive, Jon Corzine, was New Jersey’s governor).

Goldman had managed $4.2 billion in debt issuance for the state since 2004, receiving fees for arranging those deals.

A 59-page collection of trading ideas that Goldman put together in 2008, and which was reviewed by The New York Times, shows the firm recommending that customers buy insurance to protect themselves against a debt default by New Jersey. In addition to New Jersey, Goldman advocated placing bets against the debt of eight other states in the trading book. Goldman also underwrote debt for all but two of those states in 2008, according to Thomson Reuters.

Mr. Schaer complained to Mr. Blankfein in a letter in December 2008. A response came back from Kevin Willens, a managing director in Goldman’s public finance unit; he argued that Goldman maintained impermeable barriers between its unit that had helped New Jersey raise debt and another unit that was urging investors to bet against the state’s ability to repay that debt. Mr. Schaer replied that he doubted the barriers were impenetrable.

“New Jersey taxpayers cannot be expected to pay tens of millions of dollars in investment banking fees while another department of the very same firm — albeit one clearly and strategically walled off — actively or aggressively advocates the sale of the very same or similar bonds in the aftermath,” Mr. Schaer wrote.

Mr. Schaer said in an interview that he tried to get regulations passed to prevent banks from playing such dual roles in state finances, but has made little headway.

“I hope the federal government will undertake this problem, and it is a problem,” he said. “It’s unrealistic to think the wall — no matter how thick or how tall — will be effective.”

Goldman’s many financial roles have raised concerns well beyond the state level. Over the years, it has played the role of adviser and fund-raiser for a diverse range of countries, while occasionally drawing criticism for simultaneously betting against the ability of some countries, like Russia, to repay their debts.

As Client Positions Sour, Goldman Defends Own

Goldman’s powerful and nimble trading desk has become a reliable fountain of profits for the firm. But it has also instilled fear among some clients who say they believe, as Mr. Killinger and others at Washington Mutual did, that Goldman trades against the interests of some of its clients.

Trading desks make big bets using the firm’s and clients’ money. Goldman’s trading operation has grown so pivotal and influential that many analysts say the firm as a whole now operates more like a hedge fund than an investment bank — another benchmark of the firm’s internal evolution that can create new friction with clients.

For example, if Goldman makes a proprietary bet in a particular market, as it did in early 2007 when it amassed a huge wager against mortgages, what stops it from positioning itself against clients who operate in that market?

Bear Stearns, a now defunct investment bank, is a case in point.

With the housing crisis gathering steam in March 2007, Goldman created and sold to clients a $1 billion package of mortgage-related securities called Timberwolf. Within months, investors lost 80 percent of their money as Timberwolf plummeted.

Bear bought a $300 million slice of Timberwolf through some of its funds, and the investment was disastrous. The funds collapsed under the weight of Timberwolf and other errant investments, beginning a downward spiral for Bear itself that ended a year later with the firm forced into the arms of JPMorgan Chase to prevent a bankruptcy.

Goldman, however, benefited from the problems its securities helped to create, Congressional documents show. Around the same time that Bear was investing in Timberwolf, Goldman was placing a bet that Bear’s shares would fall. Goldman’s short position in Bear was large enough that it would have generated as much as $33 million in profits if Bear collapsed, according to the documents.

Mr. van Praag, a Goldman spokesman, declined in the e-mail message to say how much the firm earned on those bets or whether they were still on when Bear finally collapsed.

Goldman was busy with other clients as well during 2007, including Thornburg Mortgage, a high-end lender. Goldman was one of 22 financial companies that lent money to Thornburg; it was using about $200 million of a Goldman credit line backed by mortgage loans.

In August 2007, Goldman was the first firm to begin aggressively marking down the value of Thornburg assets used as collateral for the loan. Goldman said the assets were not valuable enough to repay the loan if Thornburg defaulted. Goldman demanded more cash to shore up the account.

According to five people briefed on the relationship who requested anonymity because they didn’t want to damage continuing business relationships, Goldman told Thornburg that the request was justified because the value of similar mortgages traded by other parties had been priced at lower levels. But Goldman, according to two people with knowledge of the situation, had not actually seen such trades.

Thornburg officials, however, pushed back on Goldman’s request, questioning the values the firm put on Thornburg’s portfolio. “When we tried to negotiate price, they argued that they were aware of transactions that were not broadly known on the Street,” said a former Thornburg employee briefed on the talks with Goldman. “That was their justification for why they were marking us down as aggressively as they were — that they were aware of things that others were not.”

Even as Goldman pressured Thornburg for cash, a Goldman banker pitched Thornburg to hire the firm to help it raise new funds. Thornburg turned elsewhere.

Thornburg wasn’t the only firm Goldman pressured this way. It made similar demands — using similar arguments — of A.I.G., the insurer that stood behind many of Goldman’s mortgage securities. Ultimately, Goldman’s demands drained the insurer of so much cash that a hobbled A.I.G. required a taxpayer bailout in September 2008. Meanwhile, Goldman had been buying protection against a possible debt default by A.I.G. at the same time that it was pressuring A.I.G. to pay it additional cash. Because Goldman’s own cash demands were weakening A.I.G., Goldman had a front-row seat to the distress the company was experiencing — giving Goldman added insight that buying default insurance on A.I.G. was probably a shrewd investment.

Although Goldman’s financial insight derived from proprietary dealings with A.I.G., and included facts that others in the market most likely didn’t have, Mr. van Praag, the Goldman spokesman, said that his firm was not capitalizing on nonpublic information.

Like A.I.G., Thornburg found that arguing with Goldman was fruitless, because the firm had favorable contracts with Thornburg governing disputes. So Thornburg accepted Goldman’s valuations, but then established credit lines with other banks.

Although Goldman lost a customer, its mortgage unit had gained a victory: the firm could cite the valuations that Thornburg accepted as proper pricing for mortgage securities when it got into similar disputes with other clients.

“If they could move our positions, they could then argue with A.I.G. or some of their other big positions that our marks were where the market was,” the former Thornburg employee said. “They could have this sort of client arbitrage going on.”

Mr. van Praag, the Goldman spokesman, said his firm’s dispute with Thornburg was about differing standards for valuing collateral, nothing more.

“We are a ‘mark to market’ institution and we mark our positions on a daily basis to reflect what we believe is the current value for a security if we decided to sell it,” he said. “Those marks are verified by our controllers department, which is independent from the securities division.”

Goldman said that the mortgage collapse and Thornburg’s financial problems vindicate the posture it took on how to value Thornburg’s collateral. “Subsequent events clearly indicated that our marks were accurate and realistic,” Mr. van Praag said.

Indeed, soon after Goldman demanded more funds from Thornburg, analysts began downgrading its shares on news of the collateral calls. Beaten down by the broader mortgage collapse, Thornburg filed for bankruptcy protection on May 1, 2009.

May 19, 2010

Goldman’s Responses on Relations With Clients

As The New York Times conducted reporting for an article examining how Goldman Sachs handles conflicts with its clients, the newspaper submitted a list of questions to Goldman on May 13-14, along with a follow-up on May 18. The inquiries dealt with Goldman’s philosophy and practices in serving its clients’ interests. Here are the questions and the responses received from Lucas van Praag, a Goldman spokesman.

1. The first of Goldman’s 14 business principles states that the firm and its employees must put clients first. Such a principle sounds to some like an expression of duty to Goldman’s clients and yet the firm’s executives in testimony before the Senate last month said they did not have a duty to customers. What is Goldman’s view on this?

Goldman’s Response: Of course Goldman Sachs has obligations to all of its clients. What is important to recognize is that our clients look to us to perform different roles in each of our businesses. The question put to some of our executives at last month’s Senate Subcommittee hearing was whether, as a market maker, we had a fiduciary duty to our clients. The answer to that question is no, market makers do not have a fiduciary duty to their clients.

Market makers are primarily engaged in the business of assisting clients in executing their desired transactions and are responsible for providing fair prices. This business is client-driven and serves an intermediary function, and in this role we are not giving our clients advice — a fact our clients understand.

2. In addition to the 14 principles, former employees contend that there is an additional, unwritten principle urging workers to embrace the conflicts of interest inherent in the firm’s business model and to consider such conflicts to be part of a healthy tension between client and firm. Could you comment on this?

Goldman’s Response: We’re not aware of this so-called “unwritten principle,” but every large financial institution, in fact virtually any business in any industry, has potential conflicts and we all have an obligation to manage them effectively.

3. On the topic of putting clients first, Goldman’s Mortgage Compliance Training Manual from 2007 notes that putting clients first is “not always straightforward” because the firm is a market maker for a wide variety of companies, and because the firm’s traders are in a position to gather and use information from a variety of sources— a mosaic constructed of all of the pieces of data received, is how the manual describes it. How does the firm, in practice, address this nuance? And what does Goldman mean by “not always straightforward”?

Goldman’s Response: We strive to provide all our sales and trading clients with excellent execution. This manual recognizes that like many businesses, and certainly all our competitors, we serve multiple clients. In the process of serving multiple clients we receive information from multiple sources. This policy and the excerpt cited from the training manual simply reflects the fact that we have a diverse client base and gives our sales people and traders appropriate guidance.

4. At the Congressional hearings in April, documents were produced showing that Goldman’s mortgage department put on short equity positions in securities of four big clients in the mortgage arena: Bear Stearns, National City, Washington Mutual, Countrywide Financial. Were these clients aware at the time that you were betting against their stocks? Because of Goldman’s dealings with these companies in the mortgage area, was Goldman using nonpublic information (the ‘mosaic’) about these companies’ weaknesses when the firm put on these negative trades? Does Goldman have internal guidelines about when the firm can and cannot take short positions in a client’s stock? How does shorting a client’s stock or buying puts on it comport with Goldman’s goal of putting clients’ interests ahead of the firm’s?

Goldman’s Response: One of the important functions we perform is to allow clients to increase or reduce various types of risk and we need to stand ready to allow them to accomplish that objective. Another very important obligation for any financial institution is to ensure its safety and soundness. To that end, it is essential that we appropriately manage our risks. It is only by doing this that we can continue to provide liquidity to a market place. Clients understand this. What is important is that we have the policies and procedures in place to ensure that we are conducting ourselves in an appropriate manner. Our goal is to always be best in class in this regard.

Shorting stock or buying credit protection in order to manage exposures are typical tools to help a firm reduce its risk. The intent is not to disadvantage anyone. In this regard, it is important to note that many institutions have long exposure to Goldman Sachs and it would be entirely consistent with prudent risk management practice if they bought credit protection or had a short position on our stock.

5. Our article will cite several examples of situations where it’s unclear whether Goldman is placing its clients’ interests ahead of its own and we’d appreciate receiving some very specific guidance from you to help us sort that out. One involves UPMC, the Pittsburgh health-care concern that was a Goldman client from 2002 until 2008. The firm advised UPMC to issue auction rate securities, which it did. After ARS spreads began to widen in late 2007, UPMC asked Goldman if it should exit the market. In mid-January 2008, Goldman advised it to stay in. Less than a month later, Goldman was the first dealer to withdraw support from the market and ARS froze up. UPMC tried to redeem the securities it had issued and submitted a redemption notice to the trustee. Goldman advised the trustee not to honor it, saying that the contract it had struck with UPMC required 30 days to pass before a redemption request could be honored. This forced UPMC to pay very elevated interest rates on its ARS for another 30-45 days and allowed Goldman to continue earning auction fees and to generate commissions selling the securities to its hedge fund clients. UPMC officials felt that Goldman put its interests first in this instance and fired the firm. What is Goldman’s view of these events?

Goldman’s Response: Goldman Sachs was not the first dealer to withdraw support for the auction rate securities market. The legal agreements that governed UPMC’s ARS securities did not allow UPMC to bid for its own securities in the auctions. The bond trustee has its own fiduciary responsibility to investors to interpret the provisions on redemptions.

6. Another case we cite involves Thornburg Mortgage, which had a line of credit with Goldman in the summer of 2007. That August, Goldman began aggressively marking down the collateral held on behalf of Thornburg and began calling for margin. Shortly after, a Goldman investment banker began pitching Thornburg on helping it raise capital. In making the margin call, Goldman cited transactions it had seen in the market as justification, but according to Goldman employees, the firm had not seen those trades. Instead, the Goldman employees said, the valuations used to call for margin from Thornburg were the result of Dan Sparks’s demands that his traders mark their books down significantly. After arguing over Goldman’s marks, Thornburg capitulated. But some of its employees believe Goldman may have had an interest in depressing prices on its marks to generate margin calls for the firm’s other counterparties. What is Goldman’s response to this contention of client arbitrage?

Goldman’s Response: We are a “mark to market” institution and we mark our positions on a daily basis to reflect what we believe is the current value for a security if we decided to sell it. Those marks are verified by our Controllers Department, which is independent from the Securities Division. We use consistent marks for multiple purposes across the firm, including for our own books and records. Subsequent events clearly indicated that our marks were accurate and realistic.

Not all institutions mark their positions to market and, as a result, it is quite possible that our marks differed from those of others.

7. We will also mention complaints made in late 2008 by Gary S. Schaer, a New Jersey assemblyman, about Goldman’s recommendation to buy protection on NJ bonds even as the firm has managed the state’s bond issues since 2002. We intend to quote from the letter Mr. Schaer received from Kevin Willens in your public finance unit but if you have any other comments on this interaction please let us know.

Goldman’s Response: As we said in the letter we sent to Mr. Schaer: “Keeping trading and investment banking origination functions strictly separated by a “Chinese Wall” is important both for regulatory reasons as well as to maintain trusted relationships with both investors and issuers.”

8. Does Goldman see any conflicts in the fact that it offers countries like Greece financial advice and help raising funds in the capital markets while also simultaneously engaging in trades that profit from financial woes in those same countries? Does Goldman have internal guidelines detailing when the firm can take negative trading positions on the debt of sovereign entities when Goldman is also advising those states?

Goldman’s Response: We have an obligation to our shareholders and, more broadly, to the financial system, to manage our business prudently. We, and other financial institutions, aggregate our risk exposure and hedging. This is considered prudent risk management. The fact that we may hedge our exposure is well known to our clients.

Implicit in the question is the suggestion that we have been “shorting” Greece. We have, in fact, had a generally net “long” bias in our exposure to Greece for a number of years, and that has also been the case recently.

9. Goldman has said that it bought CDS protection on AIG to protect itself if the insurer failed. Goldman purchased this protection when it had information about margin calls it was making on AIG and which AIG was resisting. Did Goldman tell the counterparties from whom it bought the CDS protection on AIG about the margin call information Goldman had on the insurer? Does Goldman feel that there were any conflicts involving its purchase of protection on AIG at the same time that it had nonpublic information about the insurer’s financial position?

Goldman’s Response: The premise of the question is wrong: we did not have material non-public information about AIG’s financial position. We had a series of disputes with AIG about the valuation of assets for which they were providing protection. That is quite different from having material non-public information about the financial condition of the company.

Also, if we had told another counterpart about our dispute with AIG, we would have been violating the confidentiality obligation we had to AIG.

10. What does Goldman think of Senator Levin’s legislation on client conflicts?

Goldman’s Response: We have no comment on this matter.

11. Would Goldman’s forthcoming business review committee likely find what occurred with UPMC, Thornburg or N.J. to fall below Goldman’s standards of serving clients first? Will the committee be reviewing the firm’s policies regarding shorting or betting against its clients, as it did with several players in the mortgage space?

Goldman’s Response: We believe that our practices were appropriate and consistent with our obligations to our clients. It would be premature to comment on the work to be conducted by our Business Standards Committee.

12. Also wanted to ask you about whether Goldman gained helpful info on Litton Loans in its role advising MGIC and Radian on sale of stake in C-Bass. The stake in C-Bass was never sold, but Goldman bought Litton. Was there a conflict in that situation?

Goldman’s Response: No. We participated in negotiations to purchase Litton as part of a competitive auction established by C-Bass and their advisor, and only did so after it was clear that the sale of the stakes held in C-Bass would not proceed. As part of the auction process, C-Bass and their advisors made available to bidders information relevant to a purchase of Litton.

13. Also, we forgot to ask re the negative bet on Bear Stearns shares in the Mtg NYC ABS Equities Portfolio: how much did GS make on that bet? And was GS still holding a negative position on Bear stock when it collapsed in March 2008?

Goldman’s Response: In the month of March 2008, our trading activity in Bear Stearns shares and options was very balanced. We had no directional positions, just normal two-way market making activity.

Regarding the mortgage desk trading portfolio, we had no positions in Bear Stearns at the beginning and end of March and there was no meaningful trading during the month.

14. [May 19] We would like to know how much Goldman’s mortgage unit made on the short bets it had on WaMu (puts and credit protection evidenced in documents from early 2007)and whether those or similar positions were still on Goldman’s books when WaMu failed.

Goldman’s Response: We closed out our puts months before WaMu filed for bankruptcy and we lost more money on WaMu’s bonds than we made on the credit protection we’d bought.

AIG bailout documents

June 30, 2010

Advantage: Friendly Regulators — Watching Out for the Banks
In U.S. Bailout of A.I.G., Forgiveness for Big Banks

A shareholder asked Robert Benmosche, A.I.G.’s chief, if there was a plan to recoup money from Goldman. Mark Wilson/Getty Images

At the end of the American International Group’s annual meeting last month, a shareholder approached the microphone with a question for Robert Benmosche, the insurer’s chief executive.

“I’d like to know, what does A.I.G. plan to do with Goldman Sachs?” he asked. “Are you going to get — recoup — some of our money that was given to them?”

Mr. Benmosche, steward of an insurer brought to its knees two years ago after making too many risky, outsize financial bets and paying billions of dollars in claims to Goldman and other banks, said he would continue evaluating his legal options. But, in reality, A.I.G. has precious few.

When the government began rescuing it from collapse in the fall of 2008 with what has become a $182 billion lifeline, A.I.G. was required to forfeit its right to sue several banks — including Goldman, Société Générale, Deutsche Bank and Merrill Lynch — over any irregularities with most of the mortgage securities it insured in the precrisis years.

But after the Securities and Exchange Commission’s civil fraud suit filed in April against Goldman for possibly misrepresenting a mortgage deal to investors, A.I.G. executives and shareholders are asking whether A.I.G. may have been misled by Goldman into insuring mortgage deals that the bank and others may have known were flawed.

This month, an Australian hedge fund sued Goldman on similar grounds. Goldman is contesting the suit and denies any wrongdoing. A spokesman for A.I.G. declined to comment about any plans to sue Goldman or any other banks with which it worked. A Goldman spokesman said that his firm believed that “all aspects of our relationship with A.I.G. were appropriate.”

A Legal Waiver
Unknown outside of a few Wall Street legal departments, the A.I.G. waiver was released last month by the House Committee on Oversight and Government Reform amid 250,000 pages of largely undisclosed documents. The documents, reviewed by The New York Times, provide the most comprehensive public record of how the Federal Reserve Bank of New York and the Treasury Department orchestrated one of the biggest corporate bailouts in history.

The documents also indicate that regulators ignored recommendations from their own advisers to force the banks to accept losses on their A.I.G. deals and instead paid the banks in full for the contracts. That decision, say critics of the A.I.G. bailout, has cost taxpayers billions of extra dollars in payments to the banks. It also contrasts with the hard line the White House took in 2009 when it forced Chrysler’s lenders to take losses when the government bailed out the auto giant.

As a Congressional commission convenes hearings Wednesday exploring the A.I.G. bailout and Goldman’s relationship with the insurer, analysts say that the documents suggest that regulators were overly punitive toward A.I.G. and overly forgiving of banks during the bailout — signified, they say, by the fact that the legal waiver undermined A.I.G. and its shareholders’ ability to recover damages.

“Even if it turns out that it would be a hard suit to win, just the gesture of requiring A.I.G. to scrap its ability to sue is outrageous,” said David Skeel, a law professor at the University of Pennsylvania. “The defense may be that the banking system was in trouble, and we couldn’t afford to destabilize it anymore, but that just strikes me as really going overboard.”

“This really suggests they had myopia and they were looking at it entirely through the perspective of the banks,” Mr. Skeel said.

Regulators at the New York Fed declined to comment on the legal waiver but disagreed with that viewpoint.

“This was not about the banks,” said Sarah J. Dahlgren, a senior vice president for the New York Fed who oversees A.I.G. “This was about stabilizing the system by preventing the disorderly collapse of A.I.G. and the potentially devastating consequences of that event for the U.S. and global economies.”

This month, the Congressional Oversight Panel, a body charged with reviewing the state of financial markets and the regulators that monitor them, published a 337-page report on the A.I.G. bailout. It concluded that the Federal Reserve Bank of New York did not give enough consideration to alternatives before sinking more and more taxpayer money into A.I.G. “It is hard to escape the conclusion that F.R.B.N.Y. was just ‘going through the motions,’ ” the report said.

About $46 billion of the taxpayer money in the A.I.G. bailout was used to pay to mortgage trading partners like Goldman and Société Générale, a French bank, to make good on their claims. The banks are not expected to return any of that money, leading the Congressional Research Service to say in March that much of the taxpayer money ultimately bailed out the banks, not A.I.G.

A Goldman spokesman said that he did not agree with that report’s assertion, noting that his firm considered itself to be insulated from possible losses on its A.I.G. deals.

Even with the financial reform legislation that Congress introduced last week, David A. Moss, a Harvard Business School professor, said he was concerned that the government had not developed a blueprint for stabilizing markets when huge companies like A.I.G. run aground and, for that reason, regulators’ actions during the financial crisis need continued scrutiny. “We have to vet these things now because otherwise, if we face a similar crisis again, federal officials are likely to follow precedents set this time around,” he said.

Under the new legislation, the Federal Deposit Insurance Corporation will have the power to untangle the financial affairs of troubled entities, but bailed-out companies will pay most of their trading partners 100 cents on the dollar for outstanding contracts. (In some cases, the government will be able to recoup some of those payments later on, which the Treasury Department says will protect taxpayers’ interest. )

Sheila C. Bair, the chairwoman of the F.D.I.C., has said that trading partners should be forced to accept discounts in the middle of a bailout.

Regardless of the financial parameters of bailouts, analysts also say that real financial reform should require regulators to demonstrate much more independence from the firms they monitor.

In that regard, the newly released Congressional documents show New York Fed officials deferring to bank executives at a time when the government was pumping hundreds of billions of taxpayer dollars into the financial system to rescue bankers from their own mistakes. While Wall Street deal-making is famously hard-nosed with participants fighting for every penny, during the A.I.G. bailout regulators negotiated with the banks in an almost conciliatory fashion.

On Nov. 6, 2008, for instance, after a New York Fed official spoke with Lloyd C. Blankfein, Goldman’s chief executive, about the Fed’s A.I.G. plans, the official noted in an e-mail message to Mr. Blankfein that he appreciated the Wall Street titan’s patience. “Thanks for understanding,” the regulator said.

From the moment the government agreed to lend A.I.G. $85 billion on Sept. 16, 2008, the New York Fed, led at the time by Timothy F. Geithner, and its outside advisers all acknowledged that a rescue had to achieve two goals: stop the bleeding at A.I.G. and protect the taxpayer money the government poured into the insurer.

One of the regulators’ most controversial decisions was awarding the banks that were A.I.G.’s trading partners 100 cents on the dollar to unwind debt insurance they had bought from the firm. Critics have questioned why the government did not try to wring more concessions from the banks, which would have saved taxpayers billions of dollars.

Mr. Geithner, who is now the Treasury secretary, has repeatedly said that as steward of the New York Fed, he had no choice but to pay A.I.G.’s trading partners in full.

But two entirely different solutions to A.I.G.’s problems were presented to Fed officials by three of its outside advisers, according to the documents. Under those plans, the banks would have had to accept what the advisers described as “deep concessions” of as much as about 10 percent on their contracts or they might have had to return about $30 billion that A.I.G. had paid them before the bailout.

Had either of these plans been implemented, A.I.G. may have been left in a far better financial position than it is today, with taxpayers at less risk and banks forced to swallow bigger losses.

A spokesman for Mr. Geithner, Andrew Williams, said it was easy to speculate about how the A.I.G. bailout might have been handled differently, but the government had limited tools.

“At that perilous moment, actions were chosen that would have the greatest likelihood of protecting American families and businesses from a catastrophic failure of another financial firm and an accelerating panic,” Mr. Williams said.

For its part, the Treasury appeared to be opposed to any options that did not involve making the banks whole on their A.I.G. contracts. At Treasury, a former Goldman executive, Dan H. Jester, was the agency’s point man on the A.I.G. bailout. Mr. Jester had worked at Goldman with Henry M. Paulson Jr., the Treasury secretary during the A.I.G. bailout. Mr. Paulson previously served as Goldman’s chief executive before joining the government.

A Close Association
Mr. Jester, according to several people with knowledge of his financial holdings, still owned Goldman stock while overseeing Treasury’s response to the A.I.G. crisis. According to the documents, Mr. Jester opposed bailout structures that required the banks to return cash to A.I.G. Nothing in the documents indicates that Mr. Jester advocated forcing Goldman and the other banks to accept a discount on the deals.

Although the value of Goldman’s shares could have been affected by the terms of the A.I.G. bailout, Mr. Jester was not required to publicly disclose his stock holdings because he was hired as an outside contractor, a job title at Treasury that allowed him to forgo disclosure rules applying to appointed officials. In late October 2008, he stopped overseeing A.I.G. after others were given that responsibility, according to Michele Davis, a spokeswoman for Mr. Jester.

Ms. Davis said that Mr. Jester fought hard to protect taxpayer money and followed an ethics plan to avoid conflict with all of his stock holdings. Ms. Davis is also a spokeswoman for Mr. Paulson, and said that he declined to comment for this article.

The alternative bailout plans that regulators considered came from three advisory firms that the New York Fed hired: Morgan Stanley, Black Rock, and Ernst & Young.

One plan envisioned the government guaranteeing A.I.G.’s obligations in various ways, in much the same way the F.D.I.C. backs personal savings accounts at banks facing runs by customers. On Oct. 15, Ms. Dahlgren wrote to Mr. Geithner that the Federal Reserve board in Washington had said the New York Fed should try to get Treasury to do a guarantee. “We think this is something we need to have in our back pockets,” she wrote.

Treasury had the authority to issue a guarantee but was unwilling to do so because that would use up bailout funds. Once the guarantee was off the table, Fed officials focused on possibly buying the distressed securities insured by A.I.G. From the start, the Fed and its advisers prepared for the banks to accept discounts. A BlackRock presentation outlined five reasons why the banks should agree to such concessions, all of which revolved around the many financial benefits they would receive. BlackRock and Morgan Stanley presented a number of options, including what BlackRock called a “deep concession” in which banks would return $6.4 billion A.I.G. paid them before the bailout.

The three banks with the most to lose under these options were Société Générale, Deutsche Bank and Goldman Sachs. Société Générale would have had to give up $322 million to $2.1 billion depending on which alternative was used; Deutsche Bank would have had to forgo $40 million to $1.1 billion, while Goldman would have had to give up $271 million to $892 million, according to the documents.

Société Générale and Deutsche Bank both declined to comment.

Ultimately, the New York Fed never forced the banks to make concessions. Thomas C. Baxter Jr., general counsel at the New York Fed, explained that a looming downgrade of A.I.G. by the credit rating agencies on Nov. 10 forced the regulator to move quickly to avoid a default, which would have unleashed “catastrophic systemic consequences for our economy.”

“We avoided that horrible result, got the job done in the time available, and the Fed will eventually get out of this rescue whole,” he said in an interview.

And yet two Fed governors in Washington were concerned that making the banks whole on the A.I.G. contracts would be “a gift,” according to the documents.

Gift or not, the banks got 100 cents on the dollar. And on Nov. 11, 2008, a New York Fed staff member recommended that documents for explaining the bailout to the public not mention bank concessions. The Fed should not reveal that it didn’t secure concessions “unless absolutely necessary,” the staff member advised. In the end, the Fed successfully kept most of the details about its negotiations with banks confidential for more than a year, despite opposition from the media and Congress.

During the A.I.G. bailout, New York Fed officials prepared a script for its employees to use in negotiations with the banks and it was anything but tough; it advised Fed negotiators to solicit suggestions from bankers about what financial and institutional support they wanted from the Fed. The script also reminded government negotiators that bank participation was “entirely voluntary.”

The New York Fed appointed Terrence J. Checki as its point man with the banks. In e-mail messages that November, he was deferential to bankers, including the e-mail message in which he thanked Mr. Blankfein for his patience.

Many Thank-Yous
After UBS, a Swiss bank, received details about the Fed’s 100-cents-on-the-dollar proposal, Mr. Checki thanked Robert Wolf, a UBS executive, for his patience as well. “Thank you for your responsiveness and cooperation,” he said in an e-mail message. “Hope the benign outcome helped offset any aggravation. Thank you again.”

The Congressional Oversight Panel, which interviewed A.I.G.’s trading partners about how tough the government was during the negotiations, concluded that many of the governments efforts were merely “desultory attempts.”

All of this was quite different from the tack the government took in the Chrysler bailout. In that matter, the government told banks they could take losses on their loans or simply own a bankrupt company; the banks took the losses.

During the A.I.G. bailout, the Fed seemed more focused on extracting concessions from A.I.G. than from the banks. Mr. Baxter, in an interview, conceded that the way that the New York Fed handled the negotiations meant that any resulting deal “took most of the upside potential away from A.I.G.”

The legal waiver barring A.I.G. from suing the banks was not in the original document that regulators circulated on Nov. 6, 2008 to dissolve the insurer’s contracts with the banks. A day later a waiver was added but the Congressional documents show no e-mail traffic explaining why that occurred or who was responsible for inserting it. The New York Fed declined to comment.

Policy experts say it is not unusual for parties to waive legal rights when public money is involved. Mr. Moss, the Harvard professor, said the government might have been concerned that the insurer would use taxpayer money to sue banks. “The question is: was this legitimate?” he asked. “The answer depends on the motivation. If the reason was to avoid a slew of lawsuits that could have further destabilized the financial system in the short term, this may have been reasonable.”

But two people with direct knowledge of the negotiations between A.I.G. and the banks, who requested anonymity because the talks were confidential, said the legal waiver was not a routine matter — and that federal regulators forced the insurer to accept it.

Even if the waiver was warranted, experts say it unfairly handcuffed A.I.G. and has undermined the financial interests of taxpayers. If, for example, the banks misled A.I.G. about the mortgage securities A.I.G. insured, taxpayer money could be recouped from the banks through lawsuits.

Unless A.I.G. can prove it signed the legal waiver under duress, it cannot sue to recover claims it paid on $62 billion of about $76 billion of mortgage securities that it insured. (A.I.G. retains the right to sue on about $14 billion of the mortgage securities that it insured.)

If A.I.G. had the right to sue, and if banks were found to have misrepresented the deals or used improper valuations on securities A.I.G. insured to extract heftier payouts from the firm, the insurer’s claims could yield tens of billions of dollars in damages because of its shareholders’ lost market value, according to Mr. Skeel.

A.I.G. still has the right to sue in connection with exotic securities it insured called “synthetic collateralized debt obligations,” which are known as C.D.O.’s. Such instruments do not contain actual bonds, which is why they were not accepted as collateral by the Fed.

A.I.G. had insured $14 billion of synthetic C.D.O.’s,, including seven Goldman deals known as Abacus. One of the Abacus deals is the subject of the S.E.C.’s suit against Goldman. A.I.G. did not insure that security, but A.I.G.’s deals with Goldman are similar to the one in the S.E.C. case.

Throughout the A.I.G. bailout, as Congressional leaders and the media pressed for greater disclosure, regulators fought fiercely for confidentiality.

Even after the New York Fed released a list of the banks made whole in the bailout, it continued to resist disclosing information about the actual bonds in the deals, including codes known as “cusips” that label securities. “We need to fight hard to keep the cusips confidential,” one New York Fed official wroteon March 12, 2009.

Regulators said they wanted confidentiality because they did not want investors trading against the government’s portfolio. Others dispute that, saying that Wall Street insiders already knew what bonds were in the portfolio. Only the public was left in the dark.

“The New York Fed recognizes the public’s interest in transparency and has over time made more information available about the A.I.G. transactions,” a Fed spokesman said about the matter.

It was not until a Congressional committee issued a subpoena in January that the New York Fed finally turned over more comprehensive records. The bulk remained private until May, when some committee staff members put them online, saying they lacked the resources to review them all.

October 18, 2010

Advantage: Financial — Getting Paid on the Upside, but Not Losing on the Downside
Banks Shared Clients’ Profits, but Not Losses

JPMorgan Chase & Company has a proposition for the mutual funds and pension funds that oversee many Americans’ savings: Heads, we win together. Tails, you lose — alone.

How Pension Funds Became Tangled in Securities Lending

Here is the deal: Funds lend some of their stocks and bonds to Wall Street, in return for cash that banks like JPMorgan then invest. If the trades do well, the bank takes a cut of the profits. If the trades do poorly, the funds absorb all of the losses.

The strategy is called securities lending, a practice that is thriving even though some investments linked to it were virtually wiped out during the financial panic of 2008. These trades were supposed to be safe enough to make a little extra money at little risk.

JPMorgan customers, including public or corporate pension funds of I.B.M., New York State and the American Federation of Television and Radio Artists, ended up owing JPMorgan more than $500 million to cover the losses. But JPMorgan protected itself on some of these investments and kept millions of dollars in profit, before the trades went awry.

How JPMorgan won while its customers lost provides a glimpse into the ways Wall Street banks can, and often do, gain advantages over their customers. Today’s giant banks not only create and sell investment products, but also bet on those products, and sometimes against them, putting the banks’ interests at odds with those of their customers. The banks and their lobbyists also help fashion financial rules and regulations. And banks’ traders know what their customers are buying and selling, giving them a valuable edge.

Some of JPMorgan’s customers say they are disappointed with the bank. “They took 40 percent of our profits, and even that was O.K.,” said Jerry D. Davis, the chairman of the municipal employee pension fund in New Orleans, which lost about $340,000, enough to wipe out years of profits that it had earned through securities lending. “But then we started losing money, and they didn’t lose along with us.”

Through a spokesman, JPMorgan’s chairman and chief executive, Jamie Dimon, declined a request for an interview. The spokesman, Joseph Evangelisti, said that JPMorgan had a long record of success in securities lending, and that the losses represented only a small fraction of the funds in the program.

Moreover, Mr. Evangelisti said, all of the investments had been permitted under guidelines negotiated with the bank’s clients. JPMorgan, he said, did not take undue risks.

“We have powerful incentives to take only prudent investment risks,” Mr. Evangelisti said. If customers lose money that they have entrusted with the bank, he said, that “can lead to a loss of clients and can affect the reputation of the business.”

The financial regulation bill that Congress just passed, after fierce lobbying by banks, is aimed at curtailing some of the practices that caused the financial crisis. But much of Wall Street has mostly gone back to business as usual. Nowhere are the potential conflicts more apparent than on the trading floors, where executives must balance their pursuit of profits and their duty to customers.

In addition to losing money for New Orleans workers and others, securities lending also played a central role in the near-collapse of the American International Group. Through securities lending, pensions and mutual funds borrow money to make trades, adding to the risks within the financial system.

Lawsuits are flying against JPMorgan and others, including Northern Trust. Clients say that they were not warned of the risks associated with this practice and that the banks breached their fiduciary duty. Wells Fargo lost such a suit over the summer and was ordered to pay four institutions a combined $30 million. The State Street Corporation, which took a $414 million charge in July to cover some of its customers’ losses, faces suits from other clients.

Representatives for these banks said the companies had acted appropriately and that they intended to fight the suits.

Despite such troubles, the securities lending business has rebounded after plummeting during the crisis. Today shares with a combined value of $2.3 trillion are out on loan, according to SunGard, which provides technology services to financial companies. In 2007, before the bubble burst, the total on loan was worth $2.5 trillion.

The quick revival of securities lending raises concerns about whether banks and their pension customers have learned any lessons. “What happened was the banks got greedy and they looked at the return they were getting on the collateral and said, ‘Why don’t we go further with this?’ ” said Steve Niss, the managing partner at the NFS Consulting Group, an executive search firm specializing in investment management. “But the clients got greedy right along with the banks.”

Quiet Growth
James Wilson entered the securities lending business in the 1990s, when it was still a backwater. The financial industry was then in the midst of a transformation that was threatening some of its traditional sources of earnings. Stock brokerage commissions were being squeezed, and profits from making loans were dwindling.

So at Chemical Bank, which was later absorbed into the JPMorgan empire, Mr. Wilson ratcheted up securities lending.

Though he was ambitious, former colleagues say Mr. Wilson had an unassuming way that won the confidence of clients. He was well-known at industry conferences, and he often stepped up to the microphone as a master of ceremonies.

Moreover, he saw the growth potential in securities lending and stayed in it longer than many of his peers and competitors, who moved on to more prestigious banking departments. Mr. Wilson, 55, retired after the 2008 losses. He declined to comment last month when reached by phone at his home in New Jersey.

The idea behind securities lending is simple: it allows big investors like pension funds to make extra money on their investments, without having to sell them. In a typical transaction, a pension fund or other institution lets a bank like JPMorgan lend some of its stocks or bonds to other investors, like hedge funds or banks. In return, those investors put up a cash security deposit, in case they are unable to return the securities. The pension funds and other institutions then authorize JPMorgan traders, like Mr. Wilson, to use that cash deposit to trade.

To pension fund managers, this is an attractive proposition. That is because eking out marginally higher returns on investments — even just another quarter or half of a percentage point a year — can make a difference over time.

At Chemical Bank and later at JPMorgan, Mr. Wilson pushed the trading linked to securities lending to new heights, according to former colleagues. He urged his customers — funds like the one for New Orleans workers — to let him put the cash into longer-term investments. The bigger risks led to bigger rewards, and more pensions signed on.

“If you can throw around a billion or two and make a million and then you take half of it, that’s not a bad day’s work,” said Evan Wolk, who worked with Mr. Wilson from 1993 until 2002 and now runs his own financial advisory firm in Florida.

Securities lending also fostered the rapid growth of hedge funds, which often borrow shares from pension funds to bet against those stocks. The practice also helped spur the creation of some of the arcane investments that eventually threatened the nation’s financial system.

Today, institutions around the world have about seven trillion shares worth a total of $20 trillion that they are offering to lend out. That is roughly twice the market value of every corporation included in the Standard & Poor’s 500-stock index. Only about a tenth of those shares are out on loan at any point in time, depending on which ones hedge funds and others want to borrow, according to SunGard.

Banks often pressure pension funds to participate in securities lending, pension consultants say. If funds refuse, banks raise so-called custodial fees, the charge for holding a fund’s securities.

“Whenever we say ‘no securities lending,’ then they say, ‘well, we need to talk about your custodial fees,’ ” said Jay Love, a pension consultant with Mercer.

Still, Mr. Love said, he advised clients against securities lending. Participating in such programs amounts to borrowing money to make trades in the financial markets, he said. Ultimately, the cash has to be returned. He said the stocks the pensions lend out can be viewed as a security deposit in exchange for cash used for other investments.

“It’s not a free lunch,” Mr. Love said.

The Temptation
No one would take Jerry Davis for a financial hotshot. A former commander in the Coast Guard, Mr. Davis, 67, worked until 2002 as the employee training officer for New Orleans. In 1986, he joined the board of the city’s pension fund. He has watched over the fund ever since. Along the way, he has also become something of a shareholder activist. He says he has led the pension fund in suing more than 30 companies or boards of directors that he believed failed in their duties to shareholders.

During the 1990s, Mr. Davis said he began bumping into Mr. Wilson at industry conferences, where JPMorgan’s bankers espoused the benefits of securities lending.

To Mr. Davis, the practice sounded like a low-risk proposition. So New Orleans began lending out some of the securities in its portfolio, turning modest profits. For instance, in 2007, the fund earned $70,000 by lending out its securities and letting JPMorgan reinvest the cash deposits. To earn even such small amounts of money, pensions have to lend out substantial amounts of securities — $20 million on average for New Orleans that year.

But there were several aspects of the program that always bothered Mr. Davis. Not long after the New Orleans pension became a JPMorgan customer in 2004, Mr. Davis asked Mr. Wilson why the bank could not provide him with industrywide return data for securities lending, Mr. Davis recalled.

JPMorgan representatives said industry rankings were too difficult to come by, Mr. Davis recalled. And regarding Mr. Davis’s other pet peeve, JPMorgan’s practice of taking a 40 percent cut of profits?

“They told me we were too small to do any better,” he said. That was in contrast to some giant pension funds, which share only 15 percent of investment gains with the bank.

JPMorgan declined to comment on its cut of profits and its discussions with Mr. Davis.

Still, Mr. Davis kept the New Orleans pension in the program. Securities lending helped the fund cover its operating costs, and unlike investing in, say, hedge funds, the fund officials did not consider securities lending to be risky.

It was, he said, “almost like free money.”

Dangerous Investments
When Matthew B. Sarson arrived on the securities lending floor at JPMorgan in 2004, as part of the bank’s merger with Bank One, Mr. Wilson and his team were hunting for new ways to expand their business.

Under Mr. Wilson, Mr. Sarson soon began managing a fund called CashCo, which pooled together the cash deposits that small pensions received for lending out their securities. One of those small pensions was the New Orleans fund.

Former colleagues described Mr. Sarson, 44, as a low-key Wall Street everyman. He invested his customers’ money according to guidelines to which the funds had agreed, according to former employees, and he adopted the don’t-blame-us attitude that pervaded the department. JPMorgan’s contract with the American Federation of Television and Radio Artists, for instance, stated that the customer bore the “sole risk” for the investments. It included a five-page appendix describing investments that were permitted. Among the requirements was that the investment carry a safe credit rating, of A or better.

That turned out to be a problem in 2008, as the financial crisis began to unfold.

Mr. Sarson bought a variety of investments that, while highly rated, turned out to be risky, including I.O.U.’s from Bear Stearns and Lehman Brothers, two Wall Street banks that foundered in the collapse.

As Bear Stearns hit trouble in March that year, the phones on the securities lending trading floor began ringing nonstop. Pensions and other clients were demanding to know why JPMorgan had left their cash in the plunging Bear Stearns investments, former JPMorgan employees said. JPMorgan’s response: the Bear investments were allowed under the clients’ guidelines.

The calls were particularly tense because JPMorgan had bought the stricken Bear Stearns on attractive terms. Some clients believed the bank should have known trouble was coming.

In the end, investors did not lose money on the Bear notes, but the tremors were a sign of trouble. Around that time, Mr. Sarson and other traders began to focus on another troubled trade: an investment vehicle known as Sigma.

JPMorgan had inside knowledge of Sigma, because the bank had helped finance it. But Sigma collapsed after JPMorgan pulled out to protect itself. “They sensed there were problems with these investments, but they didn’t tell the clients,” said one of the former employees. “They knew all along: we’ve got the out — the losses are yours.”

When Sigma collapsed, in September 2008, CashCo lost $99 million and other JPMorgan clients lost roughly $400 million more, according to JPMorgan client presentations. Sigma’s notes have recovered a little since then and are now worth 4 cents on the dollar.

CashCo also invested in Lehman Brothers securities. When Lehman collapsed, JPMorgan’s customers were on the hook. The value of those notes has plunged to 19.5 cents on the dollar.

Mr. Evangelisti, the JPMorgan spokesman, said the bank purchased Sigma and Lehman instruments “only after careful credit analysis.” The investments were widely held by major money market funds, other securities lending programs and other conservative investment vehicles, he said.

JPMorgan also had insights into Lehman’s health as one of Lehman’s business partners. A court-appointed examiner concluded this year that JPMorgan may have helped to push Lehman over the brink by demanding cash from the faltering bank. JPMorgan has said in a court filing that it actually helped Lehman stay alive by providing financing as others in the industry would not.

Bearing Losses Alone
When the bottom fell out, the officials in New Orleans were stunned. In January 2009, a representative from JPMorgan, Robert Bentz, visited to discuss the situation. “These are not easy meetings,” Mr. Bentz began, according to a tape recording from the meeting.

Mr. Bentz told the New Orleans officials that former workers from Citigroup created Sigma. “So it was like Bernie Madoff!” one city official exclaimed. Mr. Bentz replied: “I would like to think he was more of a crook, and these people were just smart.” But a deal was a deal, Mr. Bentz said, and he said JPMorgan did not plan to help the New Orleans workers cover their losses. Mr. Sarson, who managed the New Orleans money, has been promoted at JPMorgan. JPMorgan did not make Mr. Sarson available for an interview.

There are few signs of change in the industry. Some pensions have begun asking banks whether they will agree to share not only potential profits but also potential losses. The Missouri State Employees’ Retirement System, for instance, asked banks if they would promise to cover any such losses. All of the banks that replied declined to do so, according to Christine Rackers, a spokeswoman for that fund.

One of JPMorgan’s current clients, the pension for employees of the State of Texas, solicited information from banks this fall, including whether they would cover such investment losses, according to Mary Jane Wardlow, a spokeswoman for the fund.

In late September, JPMorgan bankers paid another visit to the New Orleans fund, which decided not to sue the bank but stood to benefit if two class actions were successful. The conversation shifted to the Lehman and Sigma losses, the lawsuits against JPMorgan and the pension officials’ belief that the bank had failed them. A JPMorgan banker mumbled apologies and rushed out.

Mr. Davis, the New Orleans official, said in an interview that the pension was considering looking for a new bank, even though leaving would mean his fund would have to immediately pay JPMorgan for its losses. He also said he was disappointed that regulators had not intervened on behalf of funds like his. He added, half-joking, that he wished his pension fund were a JPMorgan shareholder, rather than a JPMorgan customer.

“If I were a shareholder, I would say, ‘I love Jamie Dimon to death because he’s going to go out there and make money every way he can, no matter what happens to his customers,’ ” he said. “He’s making money off of me.”

BILAN    20 octobre 2010

La fin de l’ère dollar
Depuis 2000, la Fed a créé plus de dollars qu’en 224 ans d’existence des Etats-Unis.
Le dollar, c’est le plus grand schéma de Ponzi de l’histoire.
Par Myret Zaki

Depuis sa création, l’euro fait l’objet de toutes les nécrologies possibles et imaginables. Et tandis que tous les regards sont rivés de ce côté-ci de l’Atlantique, le problème le plus grave se situe à l’opposé.

Plus que l’euro, c’est le dollar qui pose aujourd’hui le plus grand danger pour la stabilité du système monétaire, économique et financier mondial. Mais le plus curieux, c’est que la monnaie de référence semble se trouver dans l’angle mort des analystes, qui parlaient même il y a peu de son statut de «valeur refuge». C’est compréhensible. Personne n’a intérêt à une crise du dollar, et cette peur explique les encouragements verbaux sans cesse renouvelés envers l’unité la plus importante du système financier. Mais le billet vert ne pourra s’éviter une crise majeure, celle de la dette phénoménale en dollars créée ces dix dernières années. Qui peut encore l’ignorer?

Depuis 2000, la Fed a imprimé, sur ordre du Trésor américain, plus de dollars que lors des 224 années d’existence des Etats-Unis. Le déficit budgétaire atteint 1500 milliards de dollars, soit 10% du PIB. La dette publique américaine a triplé depuis 1993, à 13 600 milliards, et atteindra 20 000 milliards en 2015, soit 102% du PIB. La dette publique et privée américaine dépasse quant à elle désormais 55 000 milliards de dollars, soit 360% du PIB. Toute la croissance de la dernière décennie a été achetée à crédit: de 2004 à 2007, la progression du PIB était basée, pour moitié, sur le boom de l’immobilier, lui-même reposant sur un surendettement catastrophique.

Cette gestion a fait de l’économie américaine une économie «Mickey Mouse», à laquelle il est impossible de croire car elle est techniquement en faillite. Si l’on soustrait aux 14 000 milliards de PIB les 55 000 milliards de dette, que reste-t-il? Une économie qui, pour produire 1 dollar de croissance, doit imprimer 4 dollars de dette, n’est tout simplement pas soutenable.

Cette analyse, que je soumets ici en résumé mais qui fera l’objet d’un livre à paraître en février prochain, soutient que la Fed a créé le plus grand schéma de Ponzi de l’histoire de l’humanité: celui de création infinie de papier dollar, qui se poursuit tant que le reste du monde accepte le billet vert et lui attribue une valeur. Cette politique est fort dangereuse car elle repose sur la seule perception des acheteurs de dollars. Et celle-ci peut changer, comme on le voit dans l’inconfort croissant de la Chine, détenteur des deux tiers de la dette en dollars, face à un système monétaire basé sur cette unique monnaie de référence. La Russie et le Brésil partagent cet inconfort, et ces deux puissances font partie de pays à excédents budgétaires, qui accumulent des réserves en or et dont le poids pèsera lourd dans la refonte inévitable du système monétaire.

Les «actionnaires» de america inc. sont mécontents Or les Etats-Unis ne sont pas préparés à cette situation. Ils n’ont pas prévu de devoir rembourser leur dette. La décennie de croissance achetée entièrement à crédit signifie que les taux d’intérêt de la Fed ne pourront peut-être jamais remonter. En effet, comment Ben Bernanke risquerait-il de percer la bulle de dette privée et financière gigantesque qui se maintient actuellement? La dernière fois que les taux sont remontés, sous son prédécesseur Alan Greenspan, passant de 1% en juin 2004 à 5,25% en juin 2006, cela a provoqué la plus grave crise financière de l’histoire non seulement des Etats-Unis, mais du monde. Or si les taux restent indéfiniment à zéro, après être restés négatifs durant 40% du temps depuis 2000, le pays va à sa perte. Les Etats-Unis n’auraient en théorie qu’une seule solution saine, mais c’est la pire: s’atteler à une très longue et douloureuse cure de désintoxication, c’est-à-dire de désendettement, qui durera des décennies.

Mais Washington ne veut pas soumettre sa population à un régime aussi sévère,  qui serait de toute façon trop long, et la fuite en avant prend la forme d’endettement supplémentaire, qui viendra s’ajouter au fardeau, déjà intolérable, des deux bulles précédentes. Dans ce contexte, le deuxième assouplissement quantitatif («QE II») de la Fed ne fera qu’aggraver le problème. Dès lors, Washington croit avoir trouvé la solution dans une dévaluation compétitive du dollar, afin de déprécier la dette et relancer, artificiellement là aussi, une demande anémique. Cette dévaluation, à l’origine de la guerre actuelle des monnaies, n’est autre que le symptôme des tensions au sujet du statut du billet vert. Sa dépréciation dilue la valeur des réserves en dollars des principaux actionnaires de America Inc. Et ces actionnaires ne sont pas contents. Ils  œuvrent déjà en faveur d’un système monétaire diversifié. L’ère dollar touche à sa fin.

Wall Street Journal    November 3, 2010

With "a leverage ratio of 69 to 1 ... the Fed's balance sheet could look very ugly, very fast"
High Rollers at the FED
The central bank becomes a Treasury profit center—for now

    The Federal Reserve's Open Market Committee seems poised today to make a historic decision to expand its balance sheet by as much as $1 trillion or more to boost inflation and reduce unemployment. We've said before that we think this is a monetary mistake, but the public and Congress should also be aware that it increasingly carries fiscal risks.
    In conducting monetary policy, the Fed has historically stuck to the purchase of short-term Treasury securities and other highly safe assets. That changed amid the financial panic, as the Fed grew its balance sheet to $2.1 trillion in 2009 from $900 million in 2007. That expansion was controversial but it was defensible on grounds that the central bank was fulfilling its duty as lender of last resort during a liquidity squeeze. Roughly $1 trillion of the new assets were in short-term credit facilities, including foreign central bank swaps.
    In 2008, the Fed began its dive into riskier assets by adding securities from Bear Stearns and AIG totaling about $70 billion, Fannie Mae and Freddie Mac debt of $45 billion and over $200 billion in Fan and Fred-guaranteed mortgage-backed securities. But those purchases remained a small part of the Fed's portfolio and were widely viewed as emergency measures amid a crisis. As it turned out, the Fed was only warming up.
    Today the Fed's balance sheet of more than $2.3 trillion has no term auction facilities, commercial paper funding facilities or liquidity swaps. In their place mortgage-backed securities have ballooned to $1.1 trillion, U.S. Treasurys to $821 billion and Fannie Mae and Freddie Mac debt to $154 billion.
    In the short-term, these investments have proven to be a revenue windfall for the U.S. government. In the first six months of 2010, the Fed says this portfolio produced net earnings of some $36.9 billion. Most of those earnings came from Treasurys, Fannie-Freddie debt and mortgage-backed securities (MBS). This compares to $16 billion in the first six months of 2009.
    The Congressional Budget Office reports that in fiscal 2010, which ended September 30, the Fed earned $76 billion, a 121% increase from a year earlier. To put that in perspective, $76 billion is more than a third of the $192 billion that the corporate income tax raised in fiscal 2010. The Fed has become one of the Treasury's biggest cash cows, helping to mask the real size of the budget deficit.
    As you may have read, however, there is no free lunch, and this revenue stream is the result of taking new risks. Before 2008, short-term government debt was the Fed's traditional instrument of monetary policy. Today the Fed's mortgage-backed portfolio has a maturity of more than 10 years, and nearly half of its portfolio of Treasurys is now greater than five years.
    This means greater interest rate risk, as outlined in a new paper in the American Institute of Economic Research, "The World's Most Profitable Corporation," by former Atlanta Fed President William Ford and Walker Todd, a former New York Fed lawyer specializing in monetary affairs. The authors estimate that if interest rates on 30-year fixed-rate MBS were to rise to 5% from 4%, "the Fed's current portfolio of such bonds ($1.079 trillion) would decline in value by about $162 billion—nearly three times the $57 billion of capital on the Fed Banks' consolidated balance sheet in mid-October 2010."
    The Fed's new risk profile also shows up in its capital to asset ratio. Messrs. Ford and Todd point out that the Fed's short-term portfolio has allowed it to carry only a 4% ratio of capital to assets compared to an 8% ratio at commercial banks. But since 2008, while the portfolio has become more risky, the capital ratio has dropped. The authors says that today the New York Fed's capital ratio is a measly 1.45%, which means a leverage ratio of 69 to 1 and the entire Fed system has a ratio of 2.46% or 47 to 1.
    More leverage together with extended maturities means that if there is a sharp rise in the yield of long-term bonds, perhaps due to rising inflation expectations, the Fed's balance sheet could look very ugly, very fast. Fed officials will rightly argue that they are able to hold these long-term assets to maturity without having to realize losses. But what if the Fed has to sell assets to drain liquidity from the economy faster than it might prefer, and thus take losses on its portfolio? The revenue gain for the government would become losses. Imagine how delighted that would make Congress, not to mention complicating the political task of Fed tightening.
    Everybody loves the Fed when it is easing money, as all but a few of us did during the credit boom and housing bubble of the mid-2000s. The trouble comes when the bill comes due. One task of the next Congress should be to better inform the public about the risks the U.S. central bank is taking, ostensibly on our behalf.

The Wall Street Journal    November 9, 2010

Ben Bernanke's Impossible Dream
The Fed's reckless notion that it can simultaneously raise inflation and lower interest rates
presumes bond buyers are fools. They aren't.

Federal Reserve Chairman Ben Bernanke may be an excellent economist, but he is not a very good bond salesman. Since his Aug. 27 speech at an annual Fed symposium in Jackson Hole, Wyo., he's been telling us that he thinks inflation is too low and long-term interest rates are too high. In a quixotic effort to "maximize employment," he's begun purchasing up to $600 billion worth of long-term Treasury obligations to push inflation up and bond yields down.

If it worked as planned, this would flatten the yield curve, meaning it would narrow the spread between short-term and long-term interest rates. Since banks make money by borrowing short and lending long, the effect would be to discourage bank lending. That seems an unpromising way to stimulate the economy. But the whole notion of simultaneously raising inflation and lowering bond yields presumes bond buyers are docile fools.

The University of Michigan survey of expected inflation has hovered around 2.7%-3.2% since the recovery began last July, aside from two low readings of 2.2% in September 2009 and September 2010. That measure of inflation expectations has been higher than it was in November 2002, when then-Fed Governor Bernanke first began fretting about "deflation." But inflation expectations are still not high enough to please the Fed chairman.

Alan Reynolds, a senior fellow with the Cato Institute, is the author of Income and Wealth (Greenwood Press 2006).

More by Alan ReynoldsDomestic and foreign investors have reacted to the Fed's plans by driving the dollar way down and commodity prices way up, which is consistent with higher expected inflation. So too is the gap between yields on regular Treasury bonds and the inflation-protected variety (TIPS), which has widened by more than 60 basis points since late August.

At Jackson Hole, Mr. Bernanke explained that "if inflation expectations were too low ... an increase in inflation expectations could become a benefit."

Well, he's certainly succeeded in raising inflationary expectations. But rising commodity prices and a debased dollar have proved harmful to many businesses because inflated costs mean deflated profit margins. The headlines on two recent news reports in this paper tell the tale: "Prices Squeeze Main Street: Some Retailers Are Trapped between Rising Commodity Costs and Low Inflation" (October 19) and "Dilemma over Pricing: From Cereal to Helicopters, Commodity Costs Exert Pressure" (October 21).

Producer prices rose at an annual rate of 5.5% in September and 4.8% in August. The broad price index for GDP rose at an annual rate of 2.3% in the third quarter, up from 1.9% in the second quarter and 1% in the first.

Mr. Bernanke is unconcerned, however, because he believes (contrary to our past experience with stagflation) that inflation is no danger thanks to economic slack (high unemployment). He reasons that if people can nonetheless be persuaded to expect higher inflation, regardless of the slack, that means interest rates will appear even lower in real terms. If that worked as planned, lower real interest rates would supposedly fix our hangover from the last Fed-financed borrowing binge by encouraging more borrowing.

This whole scheme raises nagging questions. Why would domestic investors accept a lower yield on bonds if they expect higher inflation? And why would foreign investors accept a lower yield on U.S. bonds if they expect exchange rate losses on dollar-denominated securities? Why wouldn't intelligent people shift their investments toward commodities or related stocks (such as mining and related machinery) and either shun, or sell short, long-term Treasurys? And if they did that, how could it possibly help the economy?

One heavily traded exchange-traded fund (ETF) provides a sensitive market forecast of how effective this quantitative easing is expected to be in reducing long-term interest rates. Trading under the ticker symbol TBT, this ProShares ETF goes ultra-short Treasury bonds with maturities of 20 years or more, making it a highly leveraged bet on the direction of long-term interest rates. If bond yields were expected to fall because of quantitative easing, then the price of TBT should fall sharply. But that is not what has been happening.

On the day Mr. Bernanke spoke in Jackson Hole, TBT closed at 31.95, up from 30.24 on Aug. 16. The Federal Open Market Committee minutes from September became public on October 12, revealing that the FOMC thought "Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment." TBT rose to 32.32 on the news, up from 31.64 the day before.

On October 15, Mr. Bernanke gave another speech, at the Boston Fed, saying, "Inflation is running at rates that are too low ... and the risk of deflation is higher than desirable." TBT rose again to 34.17, up from 33.34. On Nov. 3, when the scope of the Fed's long-term Treasury purchase plan was revealed, TBT jumped from 32.69 at 2:12 p.m. (EST), just before the news was released, to 34.99 by 3:34 p.m. (TBT closed Monday at 34.99.) If the Fed's plan really portends a sustainable reduction in long-term rates ahead, TBT should have moved in the opposite direction. When technocrats and markets disagree, it is rarely wise to bet against the markets.

There is ample evidence from commodity and foreign-exchange markets that world investors are indeed confident the Fed will raise inflation. However, the growing interest in shorting long-term Treasury bonds shows that the market does not believe higher inflation is consistent with lower long-term interest rates.

In other words, Mr. Bernanke and his FOMC allies are risking higher interest rates and inflated commodity costs in the pursuit of the contradictory objectives of higher inflation and lower bond yields, seemingly oblivious to all the evidence that they are pursuing an impossible dream.

Alan Reynolds, a senior fellow with the Cato Institute, is the author of Income and Wealth (Greenwood Press 2006).

BARRONS    JUNE 18, 2011

The Dollar at a Crossroad
The world knows America can pay its debts.
It doesn't know if America will.

It's perfectly reasonable to think that the Federal Reserve has a deliberate, if stealthy, policy of debasing the currency. Maybe the only serious question is how long the policy has been in effect.

The latest version of this conspiracy theory, which has many adherents in odd corners of the worldwide club called Wall Street, originates with the observation that the Fed is printing more dollars than the economy seems to need.

The Fed's new money buys Treasuries and other questionable securities on the open market, raising prices and pushing down interest rates. Some of the new money also pays for imports by exporting inflation.

Theoreticians of inflation say the Fed is doing this to make the national debt affordable. Knowing that the government must borrow excessively, the Fed accommodates the Treasury, monetizing the debt as it did during World War II—another moment in history when we could not afford high interest rates.

The theory of inflation-by-monetization is reasonable, but there are other possibilities. What passes for Occam's Razor in Washington contradicts it: "Never assume that events are being driven by a conspiracy when stupidity would explain them just as well."

Sad Eloquence
Last week, the Committee for a Responsible Federal Budget held its annual hand-wringing session. The bipartisan committee is composed of formerly important officials of good will and good sense, such as former chairmen of fiscal committees in the House and Senate, former directors of the Congressional Budget Office and the Office of Management and Budget. They have no power now but are liberated to speak the truths they have known for a long time.

The committee speaks for a policy that would clean up the tax code to raise revenue and clean up the spending side of the ledger to trim expenses. It speaks for a policy that recognizes the unsustainable growth of the big entitlement programs, that calls for all Americans to give up a little before they are forced to give up a lot.

The committee has been talking like that since 1981, which speaks with sad eloquence about the American addiction to an irresponsible federal budget. Unfortunately, there's no similar Committee for a Responsible Monetary Policy, which the U.S. has needed even more for even longer.

Curiously enough, the Committee for a Responsible Federal Budget invited the man responsible for monetary policy to discuss fiscal policy. Fed Chairman Ben Bernanke was the wrong man in the wrong place, but he obliged by giving fiscal advice anyway: Congress ought to extend the debt ceiling sooner rather than later, and Republicans should not insist on measures to reduce future deficits.

"Even a short suspension of payments on principal or interest on the Treasury's debt obligations could cause severe disruptions in financial markets and the payments system, induce ratings downgrades of U.S. government debt, [increase] fundamental doubts about the creditworthiness of the U.S., and damage the special role of the dollar and Treasury securities in global markets in the longer term," he said.

It's all more or less true, of course, at least as far as the Treasury can be trusted: It ran up against the ceiling for new debt last month and it says that it can't juggle its money past Aug. 2 without restoration of the power to borrow. Experience with political finance gives ample support for a suspicion that the deadline is artificial. Government lawyers pressed hard enough—or Goldman Sachs bankers paid well enough—likely will be able to conjure loopholes to permit more borrowing by another name.

The World Knows
Still, there is little doubt that some day will turn out to be the real Day of Reckoning, when the Treasury will have to stiff someone. If it fails to pay interest on some debt, that will be an event of default. If it instead fails to write government paychecks or fails to pay contractors' bills, that will be a shame.

The least frightening consequence, however, is the potential for a downgrade of Treasury debt by the major credit-rating "agencies." As the passive records of Standard & Poor's, Moody's and Fitch should demonstrate, they will never reveal anything that the world does not already know.

Indeed, the world already knows that the U.S. government has liabilities looming that are not included in the $14.2 trillion debt subject to the statutory limit. Bond traders are quite familiar with the government's implausible promises to the Baby Boom generation, to investors, depositors and homeowners, to the jobless, the homeless and the clueless and to anyone with pain that a politician can feel. What they don't know is when Americans will come to the end of their illusions.

Defaults of the Past
Contrary to well-nurtured popular belief, the U.S. has defaulted before without the dire consequences Bernanke outlined in his speech. In 1933, the government defaulted on its debt backed by gold by abrogating the gold clause in Treasury securities.

Wall Street, the record shows, was delighted. The Dow Jones Industrial Average was at about 53 the day before Franklin Delano Roosevelt was inaugurated. By July, it was over 100, and 1933 remains the second-best annual percentage gain ever recorded for the dear old Dow.

A remnant of the gold standard was in the system widely accepted after World War II, by which the dollar was accepted as good as gold by all other countries. Then, in 1971, Richard M. Nixon explicitly defaulted on this gold exchange standard, withdrawing the American promise to pay gold for dollars held by foreign governments.

Our creditors hardly blinked. The world moved on to floating rates for paper currencies and floating prices for gold as for other commodities, but the dollar remained the reserve currency, as if it were good as gold.

Can we be three times lucky?

However insincere the full faith and credit of the U.S. government is, it's based on the productive capacity of its people and the enormous value of their physical property and real estate. It's not about whether we can pay; it's about whether we will pay.

Credit is character, and the American character is being tested this summer.

Washington Post    August 22, 2011

Wall Street Aristocracy Got $1.2 Trillion in Secret Loans
By Bradley Keoun and Phil Kuntz

Aug. 22 (Bloomberg) -- Citigroup Inc. and Bank of America Corp. were the reigning champions of finance in 2006 as home prices peaked, leading the 10 biggest U.S. banks and brokerage firms to their best year ever with $104 billion of profits.

By 2008, the housing market’s collapse forced those companies to take more than six times as much, $669 billion, in emergency loans from the U.S. Federal Reserve. The loans dwarfed the $160 billion in public bailouts the top 10 got from the U.S. Treasury, yet until now the full amounts have remained secret.

Fed Chairman Ben S. Bernanke’s unprecedented effort to keep the economy from plunging into depression included lending banks and other companies as much as $1.2 trillion of public money, about the same amount U.S. homeowners currently owe on 6.5 million delinquent and foreclosed mortgages. The largest borrower, Morgan Stanley, got as much as $107.3 billion, while Citigroup took $99.5 billion and Bank of America $91.4 billion, according to a Bloomberg News compilation of data obtained through Freedom of Information Act requests, months of litigation and an act of Congress.

“These are all whopping numbers,” said Robert Litan, a former Justice Department official who in the 1990s served on a commission probing the causes of the savings and loan crisis. “You’re talking about the aristocracy of American finance going down the tubes without the federal money.”

It wasn’t just American finance. Almost half of the Fed’s top 30 borrowers, measured by peak balances, were European firms. They included Edinburgh-based Royal Bank of Scotland Plc, which took $84.5 billion. Germany’s Hypo Real Estate Holding AG borrowed $28.7 billion, an average of $21 million for each of its 1,366 employees.

The $1.2 trillion peak on Dec. 5, 2008 -- the combined outstanding balance under the seven programs tallied by Bloomberg -- was almost three times the size of the U.S. federal budget deficit that year and more than the total earnings of all federally insured banks in the U.S. for the decade through 2010, according to data compiled by Bloomberg.

The balance was more than 25 times the Fed’s pre-crisis lending peak of $46 billion on Sept. 12, 2001, the day after terrorists attacked the World Trade Center in New York and the Pentagon. Denominated in $1 bills, the $1.2 trillion would fill 539 Olympic-size swimming pools.

The Fed has said it had “no credit losses” from the emergency programs, and a report by Federal Reserve Bank of New York staffers in February said they netted $13 billion in interest and fee income from August 2007 through December 2009.

“We designed our broad-based emergency programs to both effectively stem the crisis and minimize the financial risks to the U.S. taxpayer,” said James Clouse, deputy director of the Fed’s division of monetary affairs in Washington. “Nearly all of our emergency-lending programs have been closed. We have incurred no losses and expect no losses.”

While the 18-month U.S. recession that ended in June 2009 after a 5.1 percent contraction in gross domestic product was nowhere near the four-year, 27 percent decline between August 1929 and March 1933, the economy remains stressed. Homeowners are more than 30 days past due on mortgage payments for 4.38 million properties in the U.S., and 2.16 million more properties are in foreclosure, representing a combined $1.27 trillion of unpaid principal, estimates Jacksonville, Florida-based Lender Processing Services Inc.

“Why in hell does the Federal Reserve seem to be able to find the way to help these entities that are gigantic?” U.S. Representative Walter B. Jones, a North Carolina Republican, said at a June 1 congressional hearing in Washington. “They get help when the average businessperson down in eastern North Carolina, and probably across America, they can’t even go to a bank they’ve been banking with for 15 or 20 years and get a loan.”

Fed officials had resisted releasing borrowers’ identities, saying it would stigmatize banks, damaging stock prices or leading to depositor runs. Last year’s Dodd-Frank Act mandated an initial round of such disclosures in December. A group of the biggest commercial banks last year asked the U.S. Supreme Court to keep some details secret. In March, the high court declined to hear that appeal, and the central bank made an unprecedented release of records.

Data gleaned from 29,346 pages of documents and from other Fed databases reflect seven programs from August 2007 through April 2010: the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, Commercial Paper Funding Facility, discount window, Primary Dealer Credit Facility, Term Auction Facility, Term Securities Lending Facility and single- tranche open market operations.

The data show for the first time how deeply the world’s largest banks depended on the U.S. central bank. Even as firms asserted in news releases or earnings calls that they had ample cash, they drew Fed funding in secret, avoiding the stigma of weakness.

Two weeks after the bankruptcy of Lehman Brothers Holdings Inc. in September 2008, Morgan Stanley countered concerns that it might be next to go by announcing it had “strong capital and liquidity positions.” Its Sept. 29, 2008, press release, touting a $9 billion investment from Tokyo-based Mitsubishi UFJ Financial Group Inc., said nothing about Fed loans.

That day, Morgan Stanley’s borrowing from the central bank peaked at $107.3 billion. The loans were the source of almost all of the firm’s available cash, based on lending data and documents released more than two years later by the Financial Crisis Inquiry Commission.

Mark Lake, a spokesman for New York-based Morgan Stanley, said the crisis caused the industry to “fundamentally re- evaluate” the way it manages its cash. While Lake said the bank had applied “the lessons we learned from that period,” he declined to specify what changes the bank had made.

For most loans, the Fed demanded collateral -- securities that could be seized if the money wasn’t repaid. As the crisis deepened, the Fed relaxed its standards for acceptable collateral, increasing its risk. Typically, the central bank accepts only bonds with the highest credit grades, such as U.S. Treasuries. By late 2008, it accepted “junk” bonds, those rated below investment grade, and stocks, which are first to get wiped out in a liquidation.

“What you’re looking at is a willingness to lend against just about anything,” said Robert Eisenbeis, a former research director at the Federal Reserve Bank of Atlanta and now chief monetary economist in Atlanta for Sarasota, Florida-based Cumberland Advisors Inc.

While the Fed’s last-resort lending programs generally charge above-market interest rates to deter routine borrowing, that practice sometimes flipped during the crisis. On Oct. 20, 2008, for example, the central bank agreed to make $113.3 billion of 28-day loans through its Term Auction Facility at a rate of 1.1 percent, according to a press release at the time.

The rate was less than a third of the 3.8 percent that banks were charging each other for one-month loans on that day.

New York-based JPMorgan Chase & Co. took $48 billion in February 2009 from TAF, a temporary alternative to the Fed’s 97- year-old discount window lending program. Chief Executive Officer Jamie Dimon said in a letter to shareholders last year that JPMorgan used TAF “at the request of the Federal Reserve to help motivate others to use the system.”

The data show that JPMorgan’s TAF borrowings peaked on Feb. 26, 2009, more than a year after TAF’s creation and the same day the program’s balance for all banks peaked at $493.2 billion.

“Our prior comment is accurate,” said Howard Opinsky, a spokesman for JPMorgan.

Goldman Sachs Group Inc., which in 2007 was the most profitable securities firm in Wall Street history, borrowed $69 billion from the Fed on Dec. 31, 2008. Michael Duvally, a spokesman for Goldman Sachs, declined to comment.

The size of bank borrowings “certainly shows the Fed bailout was in many ways much larger than TARP,” said Kenneth Rogoff, a former chief economist at the International Monetary Fund and now an economics professor at Harvard University.

TARP is the Treasury Department’s Troubled Asset Relief Program, a $700 billion bank-bailout fund that provided public capital injections to banks. Because most of the Treasury’s investments were made in the form of preferred stock, they were considered riskier than the Fed’s loans, a type of senior debt.

Citigroup, the most chronic Fed borrower among the largest U.S. banks, was in debt to the central bank on seven of every 10 days from August 2007 through April 2010. Its average daily balance was almost $20 billion.

Jon Diat, a Citigroup spokesman, said it used programs that “achieved the goal of instilling confidence in the markets.”

“Citibank basically was sustained by the Fed for a very long time,” said Richard Herring, a finance professor at the University of Pennsylvania in Philadelphia who has studied financial crises.

Whether banks needed the Fed’s money for survival or used it because it offered advantageous rates, the central bank’s lender-of-last-resort role amounts to a free insurance policy for banks in a disaster, Herring said.

Access to Fed backup support “leads you to subject yourself to greater risks,” Herring said. “If it’s not there, you’re not going to take the risks that would put you in trouble and require you to have access to that kind of funding.”

The New Yorker    August 15, 2011 .

How Bad Is It?
by John Cassidy

After the prime-time drama of showdowns on Capitol Hill, agita in the West Wing, and a doomsday deadline averted comes the local news, wherein bad things happen to real people. Friday’s payroll report for July showed that nearly fourteen million Americans are out of work, and more than six million of them have been jobless for more than six months. Those figures were slightly better than expected, but that just reflects how low expectations have sunk. Arriving a day after the Dow tumbled more than five hundred points—and just hours before Standard & Poor’s took the unprecedented step of downgrading the U.S. bond rating—the figures confirmed, if further confirmation was needed, that the country is facing an immediate economic crisis. But, even after the rating downgrade, it isn’t primarily a crisis of debt ceilings shattered, government spending gone wild, or any of the other hobgoblins that have dominated the discussion in the nation’s capital. It is, as President Obama acknowledged again last week, a crisis of jobs and prosperity.

For more than two years, the unemployment rate has been close to or above nine per cent. (That is the official rate; if the government counted people who have given up looking for work or who have been forced to work part time, the rate would be sixteen per cent.) And it’s not just the labor market that is frantically signalling distress. The gross domestic product, after growing modestly in 2009 and 2010, has hardly expanded at all this year. Consumer spending has stalled. In many places, house prices are still falling. On Wall Street, there is renewed talk of a double-dip recession.

A political system that responded rationally to the country’s problems would be concentrating on creating jobs. Washington is moving in the opposite direction: toward austerity and job cuts. In the past few months, the 2009 stimulus program has started to wind down, and the Federal Reserve has withdrawn its emergency-support operation, which pumped money into the financial system. Now comes the debt-ceiling agreement. The deal, which calls for more than two trillion dollars in spending cuts over the next decade, does less than nothing to promote economic growth or create jobs in the coming months, and next to nothing to solve the long-term fiscal challenges facing the country—hence S. & P.’s downgrade. In a statement, the ratings agency said, “The fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.” If the country is to be solvent ten or twenty years from now, there will need to be reasonable limits on entitlement spending and a substantial increase in federal tax revenues, which are currently languishing at fifteen per cent of G.D.P., the lowest level in sixty years. Yet neither entitlement reform nor revenue increases are dealt with in the agreement.

Still, the downgrade should not be allowed to distract attention from the unemployment crisis. What is needed, and what the system appears unable to deliver, is short-term action on jobs and credible long-term deficit reduction. About the best that can be said of the debt-ceiling agreement is that it doesn’t entail major spending cuts for this year or next. Of the nine hundred billion dollars in cuts already agreed upon, just twenty-five billion—less than one per cent of the federal budget—are slated for fiscal 2012. The cuts get steeper in later years. Where those cuts fall, and whether they are accompanied by significant revenue increases, will be determined by a “super committee” of congressional Democrats and Republicans, which is to report back in November with recommendations on how to find another trillion and a half dollars in deficit reduction. If the members cannot reach an agreement, or if Congress rejects its recommendations, a series of automatic cuts will go into effect in 2013.

In pushing the government to the brink of default, the House Republicans adopted outrageous tactics. Those tactics worked politically, but at great cost to the country. The debt downgrade was a direct result of the political paralysis in Washington. In retrospect, the White House erred last December in not demanding a raise in the debt ceiling as the price of extending the Bush tax cuts. Failing that, Obama should have refused to bargain with the House Republicans and threatened, if necessary, to raise the debt ceiling by administrative order, citing the Fourteenth Amendment.

But this was more than a failure of tactics: it was a failure of strategy. After last year’s midterm elections, when the Tea Party swept into Washington, the Administration moved toward fiscal conservatism, proposing four trillion dollars in deficit reduction over twelve years. This proposal depended on two assumptions: that Republicans would negotiate in good faith, considering tax increases as well as spending cuts; and that the economy was strong enough to sustain an expansion in the face of a shift to austerity policies.

Now that those assumptions have proved to be alarmingly false, the President, while not ignoring the imperative of long-term debt reduction, must return to the economics of growth. He has already put forward some proposals—extending the payroll-tax cut, passing new trade agreements, clearing away some of the red tape that businesses encounter—which would help, but not nearly enough. A substantive jobs bill is what’s called for, and the White House should send one to Congress as soon as possible after it returns from the summer recess.

What sort of policies might make a real dent in unemployment? Providing subsidies to businesses that hire new workers is one. Extending extra tax cuts to firms that build new factories and offices is another. More radical ideas include investing in infrastructure projects, importing a version of the job-sharing scheme that Germany has used, and launching a national community-service program. Most of these things would involve the federal government’s borrowing and spending more money, but that, of course, is what governments are supposed to do in an economic downturn.

On Wall Street, unlike in Washington, there is general agreement that the 2009 stimulus package was one of the main reasons that the economy expanded, however slowly, in the past couple of years. So suggestions that a new jobs package would spook the markets are without foundation. Even now, after the bond downgrade, the markets and credit-ratings agencies would probably embrace a carefully costed package that is limited in duration, because it makes economic sense. The quickest way to reduce the budget deficit is to get potential taxpayers back to work.

The real barrier to a meaningful jobs program is not the markets or the ratings agencies but the G.O.P. If the Republicans were to vote down a jobs bill, however, it would hurt not only the economy but also, potentially, their own prospects. Meanwhile, for a Democratic President, especially one who has disappointed many of his supporters, campaigning as someone who fought to create jobs, rather than as a copycat budget cutter, would seem a winning strategy.

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