Courtesy of Jaime Falcon.
This is an excellent interview. I suggest listening to it, or reading the transcript below.
On The Nature of Derivatives
Derivative just means “derived from.” It’s just referencing another obligation, like a bond or an equity, or you can even reference an option. You can have options on futures, as an example. So a derivative is just like handing out fifty photocopies of a model; you know it’s a derivative of something that actually exists.Let’s take an example. Goldman-Sachs used derivatives they used to help supply money to mortgage lenders by creating securitizations. And those securitizations were simply packaging up loans that were made by people like Countrywide. Countrywide of course was sued for fraud and settled for $8.3 billion with a number of different states for their predatory lending practices.So you take these bad loans, you package them up in securities, and if you can combine them with leverage, it will always look like you are making a lot of money. That’s classic control fraud, as William Black so eloquently keeps explaining to the market and as our financial media keeps ignoring. Now, how do you combine it with leverage? Well, derivatives are a very handy item if you want to lever something up. So as an example, the Wall Street Journal looked at a $38 million dollar sub-prime mortgage bond that Goldman created in June of 2006, and yet Goldman was able to leverage that up to cost around $280 million in losses to investors.Now how did they do that? They did that with the magic of derivatives.Because with a derivative, you can reference that toxic bond, that $38-million-dollar bond can be referenced, you can say If that bond goes up or down in value, the value of your securitization will change as that bond goes up or down in value. So you don’t actually put that bond in a new securitization; instead you use a derivative – a credit derivative, in this case – to reference that bond. And so with the credit derivative, you can basically create as many of those referenced entities as you want. Now, they stopped at around thirty debt pools; they could have done a hundred and thirty.Because with a credit derivative, all you’re doing is saying you are going to look to the value of that bond and we’re going to write a contract that your money is going to change when that bond goes up or down in value. That’s a derivative. You’re not actually putting the bond in; you’re just referencing that bond. You are basically betting on the outcome of something. And you don’t actually have to own its physical security. Now that’s a derivative. And that’s how derivatives were used to amplify losses and to magnify losses to make a bad situation much, much worse.
On Control Fraud
The root cause of it is control fraud – people in the financial system being able to do whatever they want and remain unchecked.. Where you have a group of individuals who are well rewarded for this kind of behavior and yet there is no punishment for this kind of behavior. As long as we keep that in place, you will just see more of the same. The way the Fed and regulators have chosen to deal with it is to pretend it’s not happening and just continue to print money. And, as I say, it acts as a neurotoxin in the financial system,
On Deriviative Risk in a Market Downturn
When you most need liquidity, it isn’t there. And that’s always true of leveraged products, by the way. You know, the thing that people overlook is – and this is why fraud is such a potent neurotoxin – when the market freezes, when you end in combination with that, when you have a liquidity event, then you see even good assets deteriorate in value quickly, as people need to sell them into a market that has no liquidity. So you get sucker punched a couple of different ways. So if you can’t stand low liquidity, again, you shouldn’t be playing with credit derivatives.Now, if you custom tailor your contract, it will be more difficult to offload that contract because people will have to take the time to read the contract, if they bother to read it at all. But that said, that’s not a reason not to re-write the language. With the ISDA standard documentation, the hype was, take our language, because if everyone accepts it, it will make it easier to trade these securities. And that was true, until credit events happen and then everyone pulls out their documents and says Oh my god, what did I sign?
On Gold and Countyparty Risk
Counterparty risk is the biggest risk.And if you’ve been reading the Financial Times, you see a lot of people who are dismissive of gold. Well, here’s an interesting thing: The Derivatives Exchanges accept gold in satisfaction of margin calls.We had credit derivatives traders who wanted to have contracts on credit derivatives on the United States that would settle in gold. Because if obviously the United States is in credit trouble, what would you want? You would want gold. You don’t want euros, you don’t want any other currency; you want gold. The thing about gold is that you don’t have counterparty risk. And if you look at the rebuttal for people who are saying that gold isn’t money, well, I’m sorry, but gold is being used as money already on derivatives exchanges around the globe. Now that wasn’t true five years ago. It’s true today. J.P. Morgan itself, around eighteen months ago or two years ago, said it will accept gold as collateral in satisfaction of margin calls. So they’ve de facto said gold is a currency.
Click the play button below to listen to Chris’ interview with Janet Tavakoli (54m:27s):
Transcript
Chris Martenson: Welcome to another Peak Prosperity podcast. I am your host, of course, Chris Martenson, and today, we are pleased to welcome Janet Tavakoli as our guest.
Janet is the President of Tavakoli Structured Finance, a Chicago-based firm providing consulting services to financial institutions and institutional investors. She’s also an expert on derivatives, a topic I’m most interested in discussing with her today. Janet is a former Adjunct Professor of Derivatives at the University of Chicago’s Graduate School of Business, as well as author of several related books, including the titles Credit Derivatives & Synthetic Structures [22] and Structured Finance and Collateralized Debt Obligations [23]. Perfect titles for what we’re going to talk about today.
Readers of the site are familiar with my belief that derivatives represent a truly potentially frightening financial time bomb. Global financial markets are literally awash in hundreds of trillions of dollars worth of derivatives, perhaps a quadrillion by some estimates. These are notional amounts. And I believe they are interconnected with such complexity that no one,no one really can understand or forecast how this overall market will behave in reaction to some potential systemic shock.
To be clear, I expect it’s more likely than not that one of these shocks will occur in the next two to four years and we’re going to have to live with the consequences. The global network of derivatives is enmeshed. It’s possible such a shock could create a cascading crisis that collapses faster than our current system safeguards can cope with.
But let’s ask the expert. Janet, thank you so much for joining us.
Janet Tavakoli: Hi, Chris. It’s great to be with you.
Chris Martenson: Well, I hope I haven’t scared you off with such a sobering introduction. But it reflects my idea that there’s just some confusion and maybe a fear of the unknown lurking in the derivatives markets.
Janet Tavakoli: Well, there is fear of the unknown. But let’s get to the root cause of the fear of the unknown. And that’s just not unique to derivatives, by the way; that’s true of bonds, equities, things that people are more familiar with. And the root cause of the problem remains the same, and that is unchecked fraud, widespread massive fraud in our financial system that has acted as a potent neurotoxin.
Now one example of this, that was tangentially derivatives-related, is the failure of MF Global, where we haven’t seen any indictments yet. And you’ve seen volumes collapse on the CME; they are down by around forty percent. And people that I’ve spoken with who trade derivatives are distressed and terrified by the lack of regulation and the blasé attitude by Congress – not necessarily blasé; I would say the enabling attitude by Congress and regulators that has allowed fraud to remain unchecked. And this is going to affect farmers being able to hedge the cost of growing food and producers being able to hedge the costs of their raw materials.
Chris Martenson: Well, I can’t wait to dive into this topic more fully. As bad as MF Global was, I was even more shocked – if possible – by the LIBOR scandal, and that was the manipulation of an interest rate which was and is tied to trillions in direct loans and hundreds of trillions in derivatives, so that was just remarkable. And the idea that the regulators should have known – probably did know – that this was occurring and chose to look the other way is really sobering for me.
Janet Tavakoli: Well, yes, but again, the same root cause of people in the financial system being able to do whatever they want and remain unchecked. And again, the root cause of it is control fraud. Where you have a group of individuals who are well rewarded for this kind of behavior and yet there is no punishment for this kind of behavior. As long as we keep that in place, you will just see more of the same. The way the Fed and regulators have chosen to deal with it is to pretend it’s not happening and just continue to print money. And, as I say, it acts as a neurotoxin in the financial system, so that thinking people see this, and you have a number of short sellers who point out the fallacy of being able to carry on this way, and they put their money where their mouth is.
Chris Martenson: Oh, fascinating; interesting that you mentioned neurotoxin, because I was, once upon a time, a neurotoxicologist.
Janet Tavakoli: Yes, I know that.
Chris Martenson: That’s so good of you to weave that in. Well done. So let’s start right at the beginning then. I want a few minutes here; give us an overview of what is a derivative. So what is a derivative contract? How would we explain this so that somebody who’s not familiar could then understand what they are?
Janet Tavakoli: Okay, I’d like to explain it, and then I’d like to show what happens in real life applications and why it helped bring the global financial system to its knees. Derivative just means “derived from.” It’s just referencing another obligation, like a bond or an equity, or you can even reference an option. You can have options on futures, as an example. So a derivative is just like handing out fifty photocopies of a model; you know it’s a derivative of something that actually exists.
Let’s take an example that might make it easier for your readers to understand. Goldman-Sachs used derivatives’ they helped supply money to mortgage lenders by creating securitizations. And those securitizations were simply packaging up loans that were made by people like Countrywide, as an example, Countrywide of course was sued for fraud and settled for $8.3 billion with a number of different states for their predatory lending practices.
So you take these bad loans, you package them up in securities, and if you can combine them with leverage, it will always look like you are making a lot of money. That’s classic control fraud, as William Black so eloquently keeps explaining to the market and as our financial media keeps ignoring. Now, how do you combine it with leverage? Well, derivatives are a very handy item if you want to lever something up. So as an example, the Wall Street Journal looked at a $38 million dollar sub-prime mortgage bond that Goldman created in June of 2006, and yet Goldman was able to leverage that up to cost around $280 million in losses to investors.
Chris Martenson: What?
Janet Tavakoli: Yes. Now how did they do that? They did that with the magic of derivatives. Because with a derivative, you can reference that toxic bond, that $38-million-dollar bond can be referenced, you can say If that bond goes up or down in value, the value of your securitization will change as that bond goes up or down in value. So you don’t actually put that bond in a new securitization; instead you use a derivative – a credit derivative, in this case – to reference that bond. And so with the credit derivative, you can basically create as many of those referenced entities as you want. Now, they stopped at around thirty debt pools; they could have done a hundred and thirty.
Because with a credit derivative, all you’re doing is saying you are going to look to the value of that bond and we’re going to write a contract that your money is going to change when that bond goes up or down in value. That’s a derivative. You’re not actually putting the bond in; you’re just referencing that bond. You are basically betting on the outcome of something. And you don’t actually have to own its physical security. Now that’s a derivative. And that’s how derivatives were used to amplify losses and to magnify losses to make a bad situation much, much worse.
Chris Martenson: So if I was holding a derivative in my hands, what would I be holding, physically?
Janet Tavakoli: You’d be holding a piece of paper.
Chris Martenson: So it’s a contract?
Janet Tavakoli: That’s right, and as I keep telling people, when banks trade with each other, they often get into disputes because these nice kids write the contracts with something that we call “asymmetry of information.” So that the smarter bank will put terms into the contract that can disadvantage the other guy even more. And you found that happening in the securitizations. So that the contracts would basically say that if this minor event happens, I can basically say, you’re entertaining a total loss, and you are going to lose your money.So that you were not only referencing a bad security, you were writing the contract in a bad way to disadvantage the person who would be on the hook for losses.
Chris Martenson: So this is a contract, then – to maybe make it tangible for the average listener – it’s a legal contract, maybe like a Purchase and Sale Agreement or something. There’s terms and conditions in there. We’ve identified some things. Like in the case of when Greece was clearly defaulting, there were a whole lot of credit default swaps outstanding, maybe $78 billion dollars’ worth at the notional level. And then those contracts would only get triggered because they had provisions in them for if an actual default event occurred and there was language, I guess, in this contract around that. And then there was an organizational body that was charged with determining whether a credit event had occurred or not, whether a default had occurred. Is that right?
Janet Tavakoli: Well, that was ISDA (the International Swaps and Derivatives Association), but ISDA basically took it upon themselves to try to interpret the language of the contracts. And these are over-the-counter contracts and are basically stalled in terms of their definition of default. And its people like me – I’ve written a whole book on creditors that say you don’t want to accept a contract that someone gives you. And you don’t have to accept the language of ISDA, which is basically an organization that was created by the banks to trade credit-default swaps. So they’re going to have the most influence over what ISDA says – and that’s happened time and again, by the way, and time and again through the years – there have been disputes about the interpretation of the language.
So I always say, you want to re-write that language to make it as clear as possible, and if you don’t like the terms and conditions, then re-write them. And if you aren’t in a strong enough position to make that happen, then don’t play. And of course, people widely ignore that advice. And why do they ignore it? Because of the temptation of leverage. People on the wrong side of the contract, time and again, hope and pray that leverage will work to their advantage and they’ll have the big pay day. And usually they are disappointed because the smarter guy wrote a contract that can disadvantage them when the chips are down.
Greece was a good example; in the end, the people who bought credit default protection on Greece did prevail because the situation in Greece deteriorated so badly. But ISDA did stall – they are very effective in stalling – and again, I tell people who are on the other side of that contract, well, you have to re-write the contract at the outset; it’s too late after you’ve done the contract to argue about the language.
Chris Martenson: So let’s imagine you and I wrote a contract together, it was a derivatives contract, you are Party A, I am Party B, and we traded it over the counter so it’s in that market. And how –
Janet Tavakoli: By the way, Chris, I guarantee you, you do not want to be on the other side of the contract with me.
Chris Martenson: I’m sure of that! So let’s pretend you and I wrote a contract together against another party. First of all, how complex is this piece of paper as you described it? Is it one page? Is it thirty pages?
Janet Tavakoli: It can be as many pages as you like. The important thing isn’t the number of pages. The important thing is that you make the language clear so that you are only on the hook or you are protecting the scenarios that you want to protect or the scenarios for which you want to be on the hook. And that’s the crucial element that people keep overlooking. Don’t look at the number of pages; read the actual language.
Chris Martenson: Yes, so let’s imagine we’ve written one of these things. But now I don’t want it anymore. Do we close it out with each other, or can I just pass this on to another party? Sell it to somebody else?
Janet Tavakoli: Well, it depends on what’s going on in the market. Because when you most need liquidity, it isn’t there. And that’s always true of leveraged products, by the way. You know, the thing that people overlook is – and this is why fraud is such a potent neurotoxin – when the market freezes, when you end in combination with that, when you have a liquidity event, then you see even good assets deteriorate in value quickly, as people need to sell them into a market that has no liquidity. So you get sucker punched a couple of different ways. So if you can’t stand low liquidity, again, you shouldn’t be playing with credit derivatives.
Now, if you custom tailor your contract, it will be more difficult to offload that contract because people will have to take the time to read the contract, if they bother to read it at all. But that said, that’s not a reason not to re-write the language. With the ISDA standard documentation, the hype was, take our language, because if everyone accepts it, it will make it easier to trade these securities. And that was true, until credit events happen and then everyone pulls out their documents and says Oh my god, what did I sign?
Chris Martenson: So in this case, we have derivatives, which actually can have a moderating influence. So if I actually bought – for whatever reasons, I’m a pension fund and I’m holding a whole lot of Greek debt, a couple of years ago, and I’m looking at it and I’m saying, you know what? I’d like to hedge this; I would like to protect myself. I might buy a credit default swap to cover my underlying position. That’s a covered derivative, I guess. But where you’re saying we have this incredible amount of leverage, I suppose almost by definition those have to be naked positions. Meaning it’s not possible for everybody to own the underlying $38 million contract in the Goldman example, right? So these are – basically, they are just speculations – it’s just bets at this point, right?
Janet Tavakoli: Well, it’s not possible for everyone to own the $38-million-dollar sub-prime mortgage bond or the tranche of the CDO (Collateralized debt obligation), which is a type of sub-prime mortgage bond. So therefore, they use credit derivatives to reference that bond. And that way you can amplify the effect of that given bond. Well if the given bond was poorly constructed or a piece of trash in the first place, then you’ve basically just allowed more people to accept the risk of a piece of trash. And that’s what the problem was with the global financial crisis.
Now when you look at what happened with AIG and AIG’s credit derivative, AIG got into trouble because it sold protection with some very bad terms by the way. As did MBIA and AMVAC, who are the former muni bond insurers; they amplified their risk by using credit derivatives, by not understanding the underlying risk, and not really – in some cases – understanding the implications of their contracts.
Chris Martenson: So as you’re describing it, this sounds fairly endemic to the system, is this sort of how it operates?
Janet Tavakoli: It’s how it doesn’t operate, isn’t it Chris?
Chris Martenson: Yes.
Janet Tavakoli: And time and again, if you read the profiles of the people who run these institutions, they are Hague geographies [sic] where these people are lauded.
Let’s take another example of problems with derivatives – J.P. Morgan, a recent example.
Chris Martenson: Right, the whale.
Janet Tavakoli: You have the President of the United State saying that he thinks that Jamie Dimon is a good bank manager. Well, that’s not true; he has a silo within J.P Morgan that he reported to him that blew up. I don’t see how you can say that Jamie Dimon is a good manager. This was his responsibility, and they are kind of saying, well, since the rest of the farm is profitable, it doesn’t matter that this particular silo blew up in a spectacular way due to negligence and basically ignoring every safety practice around grain dust. It’s just pretty ridiculous for the President of the United States to say that he’s a good bank manager. But they’re counting on the American people not being very bright or not being able to handle the truth.
Chris Martenson: Right.
Janet Tavakoli: Let me give you another example that most people can understand. You can have a great-looking bathroom with tiles that you imported from Italy and wonderful fixtures, but if you have cracks in your grout, you failed at the most basic level. And anyone who knows anything about it can tell you that there’s a huge problem, and that the person who’s telling you they installed a great bathroom is not a good installer, right? Well that’s Jamie Dimon; not a good installer. And it doesn’t matter what Jamie Dimon says, and it doesn’t matter what the President of the United States says; water doesn’t care what the President says, what Jamie Dimon says; it doesn’t care that you imported your tiles from Italy. It only cares that you have a crack in your grout, and it’s going to do what water does.
Chris Martenson: Yes.
Janet Tavakoli: And that’s exactly what happened with Jamie Dimon’s derivatives. He had leverage; he had a position that was way too big for that unit; they were making bets. This was all reported to him, but he wants to claim he didn’t understand the size of the position and what was happening. And there was not just one failure. It wasn’t just a crack in the grout; it was poor backing behind it. It was a whole bunch of other things that went wrong at J.P. Morgan that shows failure after management failure. The wrong risk manager, they had a series of risk managers, their earliest one wasn’t qualified, they didn’t have a CFO. You know I can go on.
It’s a pretty big list that the evidence shows that Jamie Dimon was not a good manager and should be held on the hook for Sarbanes-Oxley violations. So again, when people point their finger at derivatives, yes, the size of derivatives is a problem, but the reason it’s a problem is because of control fraud. And because of, you know, installers who show you their shiny imported tiles, and you are looking at it and saying yeah, but I see a huge humongous crack in your grout here, and anyone who knows what they’re doing sees these problems. So you have people like myself and Bill Black who are looking at this and saying, nice tile, but I don’t really care about that, because you’ve got a huge problem that’s quite obvious. And that’s what we’re looking at in the global financial system right now.
Chris Martenson: So this is fascinating to me, because when the sub-prime crisis was developing, I was writing about a housing bubble back in 2005 and 2006, and it was patently obvious with just any sort of metrics that we might want to use. The house-price-to-incomes, how many standard deviations around a normal price rise we were, how far above inflation we were; there was all kinds of evidence to say gosh, we’ve got a housing bubble here. And the Federal Reserve chose not to see it, and so many players chose not to see it. And now in the aftermath we find out that in fact, several inside players did see the cracks in this and were actively constructing bonds that were ready to blow up – Goldman being a prime example of that, with their work that they were doing in writing, and being the market-maker on both sides of bonds that were designed to fail on the collateralized debt obligations – not bonds but –
So here we are. You can look into this system, you and Bill Black and others can clearly look into the system and say this is constructed in a faulty manner, therefore there’s cracks in this. And these cracks – it’s in your mind then – as it was with the case of the housing market, is it just a question of when? Not if, but when at some point we’re going to have that water just flood through the cracks in this and create extraordinary difficulties?
Janet Tavakoli: Well, we’re seeing the difficulties already. That’s why you’ve got the Fed printing money like crazy and why the banks needed accounting changes within the banks. It’s not as if the problem went away. We just decided we’d try to cover it up, put some Scotch tape on where the grout – [laugh] It’s really pretty silly, what we’ve been doing. But these problems have been obvious for a long time, and here’s how perverse the system has been.
We have the fascination of our ambassador to Libya in the new – well, let’s talk about another ambassador. Roland Arnold was the ambassador to the Netherlands, and before he was the ambassador to the Netherlands, he was the founder of an institution, a high-risk lender called Ameriquest. Ameriquest was sued by, I believe, every state in the Union except perhaps one. And instead of Roland Arnold being held accountable for that, he said, Well, I was just the CEO, I really didn’t know it was going on underneath me. And incredibly, Congress approved his appointment to be the ambassador to the Netherlands under George W. Bush. So instead of being held accountable, it was as if this guy was rewarded. Even the Netherlands didn’t like it, their newspapers were alive with why is this guy being made ambassador to the Netherlands with his track record?
So this isn’t a new problem, and this isn’t just a problem that’s occurred under the past four years; this has been building up under the Clinton Administration, under George W. Bush’s administration, through Obama’s Administration. It’s a bi-partisan betrayal. And again, it all comes down to control fraud. If we didn’t have these toxic mortgages, we would have a much smaller problem.
You talk about a housing bubble, but what is the source of the housing bubble? It’s giving out loans to people who could not afford those loans, and often giving out loans on overvalued properties to people who couldn’t afford to pay back a loan on a property that was fairly valued. So you had a lot of that kind of thing going on, which causes the housing bubble. So when you look at the root causes – I can’t stress this strongly enough – widespread massive fraud has been the most potent neurotoxin that has taken down our financial system. And instead of getting people to face this head on, you’re getting massive denial from Congress. Who keep talking about the imported tiles from Italy and how shiny they are.
It’s like they are a bunch of blondes in Congress and in our regulatory system. But because the regulators have a swinging door with Wall Street and they know they’re going to be well rewarded, that probably won’t change, and it probably won’t change under Mitt Romney either. If you look at Mitt Romney’s track record, he hired a former regulator from the FDIC and he got a loan with terms that were very favorable to Bain; in fact, the loan terms were so favorable that they actually had a poison pellet hatched so that rather than pay back creditors, Bain could pay its management huge bonuses.
Chris Martenson: Right.
Janet Tavakoli: And of course, you know the FDIC gave Bain these favorable loan terms, and wouldn’t you know it, a key man from the FDIC was then hired by Bain, so he gets to participate in the bonus payday. And you see that sort of back-scratching between regulators and the people they are supposed to regulate all the time. So that pretty much means, for everyone in the financial system who’s an investor, you are on your own. If you aren’t part of the crony capitalist’s system, you are on your own.
Chris Martenson: And by “on your own,” what do you mean?
Janet Tavakoli: What I mean is, no one has your back.
Chris Martenson: Not the regulators?
Janet Tavakoli: No.
Chris Martenson: Not the –
Janet Tavakoli: The regulators serve the people that they are supposed to be regulating.
Chris Martenson: And not the prime brokerages? You are on your own.
Janet Tavakoli: Well, prime brokerages often are the people they are supposed to be regulating. If you look at the largest prime brokers, you know, CSSB, J. P. Morgan, Goldman, and so on, those are prime brokers. So I don’t know what you mean, not the prime brokers?
Chris Martenson: Those people don’t have your best interests at heart either – that’s what I mean.
Janet Tavakoli: Lord, no. [laugh] That’s like saying NF Global had your best interests at heart.
Chris Martenson: So when did all this start? At first – is it just because we have the Internet now and we can actually see these things happening in real time so we’re just observing something that’s always been there, or did this start to go off the rails?
Janet Tavakoli: No, I think people just haven’t been reading the – I think the financial media gets a bad rap sometimes. Obviously a lot of people in the financial media have been enablers, but I think that’s just because there’s been a plethora of financial media that’s exploded. But if you read the Wall Street Journal in the pre-Internet days, they did expose the Kidder Peabodys and the Drexalls and so on. And we’ve had books written about it in different areas. It’s all finance, of course, but it’s all related. You know, Barbarians at the Gate, Den of Thieves. We have had a good body of work in pre-Internet days. It’s just that we have a whole generation that grew up not having read that.
And so they think that the Internet is the source of truth – which, by the way, it isn’t. I’ve seen a lot of bad information and a lot of hysteria. And a lot of just wrong conclusions drawn on the Internet. And it doesn’t matter – again, as I say – it doesn’t matter what the Internet says, or what people who don’t know that they’re talking about on the Internet say, it doesn’t matter what the President says, and it doesn’t matter what Jamie Dimon says; if you’ve got a crack in your grout, water’s going to do what it does.
And if people are looking at the wrong problem or identifying the wrong problem, it doesn’t matter. So, I wouldn’t say that the Internet has been the be-all and end-all; I would say that people who are comparing some of the bad things in the print media today and can’t tell the difference then seem to dismiss all of print media. And there are some very good investigative reporters that are worth your time. And the other thing about the print media, they have the money and resources to go to the site, to physically go there to check things out and often to get the phone call returned, which people on the Internet do not have.
So it would be, I think, a bad thing if the financial media were not able to fund investigations. Because often a lot of the things that you see on the Internet are simply derived from what has been in the financial media. And they’re often piecing it together based on the investigative good work of print media reporters. So it’s a mixed bag. And if you don’t know what you’re doing, gullible people can read a lot of clap trap in both the print media and the Internet and come to the wrong conclusion. So I am a mixed fan of the Internet.
Chris Martenson: Well, you certainly have to learn to separate the wheat from the chaff, but there’s some incredibly good reporting out there on the Internet as well.
Janet Tavakoli: There is, and also I would say that there are also a lot of anonymous agendas; you have a lot of anonymous bloggers, and I’m not a big fan of that, by the way.
Chris Martenson: Yes.
Janet Tavakoli: I really think, why can’t you stand behind your work and let your name be known? And you see a lot of trolls who are anonymous on the Internet. So I’m not dismissive of the Internet; I actually use the internet to disseminate information. But I would say, be wary, especially of people who are putting information out anonymously.
Chris Martenson: Oh, absolutely.
Janet Tavakoli: And that’s not to detract from good anonymous bloggers; I understand that there are reasons why people may not want their identity to be known. But as some point, as useful as pen names can be, I do think you have to stand up and be counted, because this is a country of individuals who need to back up their work.
Chris Martenson: I totally agree.
Now I want to get back to derivatives, very quickly. So here we are. You say there’s this neurotoxin that’s in our system; there’s a lot of control fraud; this has been going on for a long time. And 2008 was our shot across the bow, I guess. That would have been a great time to look across the derivative universe and say Whoa! Maybe we’ve got a little too much leverage; maybe we’ve piled things up. Since then, I believe we’ve actually increased the notional amount of derivatives by a little over $100 trillion. So, message not learned, if indeed there was risk concentrated in derivatives.
Now derivatives as I understand them – it’s a zero sum game. You and I might be better on the future price of wheat or something like that, but your loss is my gain and vice versa. What is really the nature of the derivative risk that concerns you most here?
Janet Tavakoli: Counterparty risk.
Chris Martenson: Yes.
Janet Tavakoli: And that is the ability of the other side to pay when the crisis occurs. AIG is a stunning example of that. When push came to shove, AIG couldn’t pay. So U.S. taxpayers had to bail out Goldman Sachs and many others, people who had been involved in these trades in one way or another with Goldman – and I harp on Goldman because they were the key architect of those securitizations, which were the crooks of the September 2008 cash shortfall at AIG. That wasn’t AIG’s only problem, by the way; it just so happened that it was that problem that caused AIG’s problems to come to a head. So the U.S. taxpayer had to bail these people out because AIG wasn’t good for it when they needed to be.
And by the way, I had talked to Jamie Dimon in August of 2007 about AIG, looking at these CDO’s and at that exact problem. He was here in Chicago; I called his office and said I’d like to meet with Jamie; I have something important to say that he’s going to find useful or at least interesting. And he was dismissive of the AIG problem. Again, no cracks in his grout, right?
Chris Martenson: Yes.
Janet Tavakoli: No, he wasn’t a counter party, but the reason I went to J.P Morgan – Well, first of all, it was because Jamie knew who I was and would take the meeting. And J.P Morgan had the largest derivatives book in among all the U.S. banks. They had more than fifty-one percent market share at that time, according to the OCC (Office of the Comptroller of the Currency), meaning if you added up the derivative position of every other U.S. bank, J.P. Morgan had more than the sum total of every other U.S. bank. So given the counter party risk and the knock on effect of that, it would inevitably affect J.P. Morgan. And so that’s why of course, it would be of key interest to Jamie Dimon. And Jamie had a lot of influence.
And so I was going to him, basically, to use his influence about this matter. And he was dismissive of it – Oh, I know what a CDO is, I know all about this. I like AIG – and how did that end. So counterparty risk is the biggest risk. And if you’ve been reading the Financial Times, you see a lot of people who are dismissive of gold. Well, here’s an interesting thing: The Derivatives Exchanges accept gold in satisfaction of margin calls.
Chris Martenson: Hmm.
Janet Tavakoli: We had credit derivatives traders who wanted to have contracts on credit derivatives on the United States that would settle in gold. Because if obviously the United States is in credit trouble, what would you want? You would want gold. You don’t want euros, you don’t want any other currency; you want gold. The thing about gold is that you don’t have counterparty risk. And if you look at the rebuttal for people who are saying that gold isn’t money, well, I’m sorry, but gold is being used as money already on derivatives exchanges around the globe. Now that wasn’t true five years ago. It’s true today. J.P. Morgan itself, around eighteen months ago or two years ago, said it will accept gold as collateral in satisfaction of margin calls. So they’ve de facto said gold is a currency.
Chris Martenson: Has it been used as collateral, and more importantly, as payment, so far?
Janet Tavakoli: Well, these are over-the-counter transactions, so I haven’t seen it being used. But certainly it’s eligible to be used.
Chris Martenson: Right.
Janet Tavakoli: In satisfaction, so I can’t point you to specific examples and say you this bank has delivered gold in satisfaction of its margin call. But you could ask the LME or other entities and ask them if that’s been done, and if so, what percentage of contracts have seen that happen. Frankly, I’d rather give them paper currency.
Chris Martenson: I would, too. [laugh]
Janet Tavakoli: But the fact remains that gold doesn’t have any counterparty risk.
Chris Martenson: Yes. Excellent point.
Janet Tavakoli: And that’s why people are looking to have gold as a certain percentage of their portfolio –because it doesn’t have credit risk. That doesn’t mean it can’t go down in value; it can, but you won’t be left with absolutely nothing.
Chris Martenson: Now let’s talk about this counterparty risk, very quickly, because this to me is the key to this whole piece. We have a lot of financial –
Janet Tavakoli: Would you rather have Lehman as counter party, or would you rather have somebody give you gold in satisfaction of a margin call?
Chris Martenson: Oh, that’s an easy one. I’ll take the gold every day, as long as it’s fully allocated and not otherwise encumbered through other arrangements – make sure it hasn’t been hypothecated and re-hypothecated.
Janet Tavakoli: Yes, and you know, Lehman is a good example of counterparty risk in that it had a lot of leverage. Now that leverage wasn’t all tied to derivatives, by the way; a lot of it was tied to imprudent lending and assets that were the spawn of imprudent lending on its balance sheet. And of course, it levered up through repo transactions as well. And it just didn’t have the wherewithal to weather this storm. And you know, you found it wasn’t just liquid, it was close to insolvency despite what Dick Fuld says. If you read my book, Dear Mr. Buffett, the chapters on Bear Stearns and Lehman is exculpatory evidence for any short seller who shorted Bear Stearns and Lehman. Not all short sellers, unlike Jim Cramer’s –
Chris Martenson: Oh, right.
Janet Tavakoli: Not all short sellers give bad information to the media in order to bring down the company. Sometimes the short sellers are giving you accurate information, but the media doesn’t want to listen to it. They don’t want to see the cracks in the grout. And Bear Stearns and Lehman are good examples of that. When they needed to meet margin calls, they couldn’t.
Bear Stearns – if you listen to their CFO on CNBC as it was going under, he said we have $17 billion in liquidity – blah, blah, blah. But that was all money that it had on the deposit from hedge funds. So hedge funds withdrew their money. All they did was push a button, and boom! There went their $17 billion in liquidity. So again, it’s leveraged; it’s underlying assets, it’s not just derivatives. And it’s also massive control fraud, as well as people who just plain aren’t sticking to the basics of their business and getting the basics correct. And that’s why I would say Jamie Dimon is not a good manager. He failed at the most basic level.
Chris Martenson: Well, Janet, I’m interested in what happened, particularly – let’s take the case study of AIG. So they made all of these naked derivative contracts; they weren’t holding the underlines; they had a lot of leverage; it blows up. They should have been the ultimate in counterparty risk, and if I remember correctly – I might have the numbers slightly wrong – Goldman Sachs was a counter party for maybe thirteen billion. They were owned by AIG on these derivative contracts, and in my world, AIG unable to pay, that would have been Goldman’s loss, but they were made whole, is my recollection.
Janet Tavakoli: I don’t think you’re correct on your facts.
Chris Martenson: Didn’t AIG – didn’t Goldman receive a payout from the bailout?
Janet Tavakoli: Yes, they did and they received a massive payout. But here’s why I say you’re not correct on your facts, Chris. And I’ve written quite a bit about that, and I don’t have all the numbers to hand, but as I say, Goldman was a key architect of AIG’s distress at the time September 2008, when it was going under. Goldman had already extracted billions of dollars from AIG in collateral calls by September 2008. And in addition, after that, the Treasury paid Goldman one hundred cents on the dollar so that it got billions more.
But that’s just the beginning of the story. Because if you looked at the underlying securities, these were collateralized debt obligations. Many of them should be investigated. One of them, one of the Davis Square deals, is part of a lawsuit by, I think its Landesbank Baden-Württemberg. I may have Landesbank wrong, but it’s a German bank that has sued over Davis Square, I think its Davis Square VI, and they are suing Goldman for fraud. Well a different tranche of that same deal is one of the deals that was protected by AIG. And it doesn’t end there. Goldman worked with SocGen and Kelion to either co-create or create for them other toxic CDOs, and AIG protected them. So Goldman wasn’t just a beneficiary of its own deals; it was the side beneficiary, because SocGen and Kelion might have sued Goldman for those deals.
Chris Martenson: Hmm.
Janet Tavakoli: And they had gotten their deals protected with AIG. So it wasn’t just Goldman; it was Goldman and Goldman’s cronies who were bailed out in the AIG debacle. And none of it was investigated, and none of it has really been put in context in the mainstream media. And it didn’t end there. There were other contracts that AIG had some financings and securitizations for which SocGen and Goldman were also given payments. And so AIG had multiple business lines, and then when AIG unwound some of their contracts – this is after the crisis – their counterparties on unwinds of other derivatives, who were resolving some of the AIG’s problems in other areas, got windfall gains because there was basically no bid in competition when AIG was unwinding those deals. So if you look at the bad deal that the taxpayer got in the AIG debacle, it was a bad deal for taxpayers and it was a wonderful deal for all of AIG’s cronies. Because any competent liquidator would have clawed back from Goldman and SocGen and Kelion all of the money that AIG paid out to them before 2008, and it would have investigated them for fraud. And none of that happened.
Chris Martenson: And so this is a case where, I believe, civil fraud cases have already been settled, after trial and out of court and all kinds of things.
Janet Tavakoli Well, yes, that’s right. If you look at Merrill Lynch, if you look at Goldman, you’ve gotten settlements out of court. And one of the incentives for settling out of court is that the documents that came up in discovery will not be made public because it hasn’t gone to court. So these things are settled out of court, and then you don’t see the criminal prosecutions from our justice system because they’re not doing their job. They are looking the other way.
Chris Martenson: That’s been the puzzling part to me, because when we saw – like with the simple case where Bernie Madoff commits fraud and people who’d had money with him, who had taken it out up to four years prior to the fraud being discovered – there’s very reasonable chance that these people had no idea this was a Ponzi scheme. Apparently nobody did, not even the SEC. And the clawbacks happened from those client accounts years after the fact.
So it seems to me that there’s clear evidence and case of fraud here, but it’s not really been investigated in the full light of day because we settle out of court in the civil case and because, for mysterious reasons, there are no criminal prosecutions. The SEC (Securities Exchange Commission) and the Justice Department keep coming out and saying we couldn’t find any evidence of criminal wrongdoing here. In your mind, is there evidence of criminal wrongdoing here?
Janet Tavakoli: I’m sorry – where?
Chris Martenson: In the case of specific deals that have happened – say, in the AIG example? Do you think if you –
Janet Tavakoli: What I’m saying is that the entire mortgage securitization process from the beginning – residential mortgage-backed securities and the loans that went into them – have to be investigated. Now if you look at Carl Levin’s investigation, he came up with evidence from Clayton, who was a due diligence provider, which showed that the firms that were packaging securitizations ignored their reports and basically did not disclose to investors the gravity of the situation. Now that’s a classic situation for fraud that should have been investigated.
Chris Martenson: And it wasn’t, or hasn’t been.
Janet Tavakoli: No. Not to any meaningful degree. No.
Chris Martenson: Well, this picture you are painting is one where it sounds like anything goes. The rules, such as they are, will be ignored or suspended or not followed or investigated, should push come to shove. In your mind, if we have another derivatives accident, AIG style, will we again just have another bailout and – ?
Janet Tavakoli: You know, Chris, we’re not communicating here, because you keep harping on derivatives, and I keep saying that it’s not. Derivatives isn’t the root cause; it’s an exacerbating factor. It’s people who are basically already going down the wrong road or using derivatives to amplify the problem. And if you don’t get to the root cause of the problem, it won’t matter what you do with derivatives. You can have a bank that isn’t very leveraged fail, and it can fail because it’s giving out bad loans and it can’t get paid back. So if you don’t address the root cause of the problem, it won’t help you to go backwards. I mean, I think we should do both, obviously, and that is to unwind and contract the derivatives market by a great deal. But that alone will not solve our problem.
Chris Martenson: Well, if the whole market is shot through with fraud, and derivatives are an exacerbating factor, what I’m trying to get to here is the very difficult but simple question, which is how would somebody protect themselves in this particular environment, say a small investor, medium investor? I’m a company, I’m a CFO, I’m trying to manage my funds and keep them in a safe place; I’m a pension. How do you operate financially in a financial system that is shot through with fraud?
Janet Tavakoli: Well, now you’re asking me a completely different question. And I will give you the same answer that I give everybody, and it’s a general one. And that is to invest in companies that have low amounts of debt, a strong balance sheet, and good to cash position, and who are generating cash and who produce things that people want and need. And you try not to buy them when they are overpriced.
Now if you look at our current situation as an example, let’s take an example, the equities market. The last time we saw equities trading in high multiples like that, as far as I can recall, is around 1987 before the stock market crashed. It’s just – people have nowhere to run right now. On your safe – rather, so-called “safe” securities, you’re earning so little money that you can’t keep up with inflation. And that’s a distortion created by the Fed to try to plug the holes in the balance sheets of our banking system. They’re just printing money like crazy. So people have run to riskier assets and drive up the PE (price to earnings) multiples of even sound stocks, sound equities.
Is this sustainable? Well, I don’t know. Given that we’ve created such a distortion in the market, maybe we are in a new paradigm. It’s just that the last time that we saw PE multiples run up like this, it was in ’87. And people who stood on the sidelines looked and said Oh my god, the stock market’s going up and I’m missing out because I’m not buying stocks that I think are overvalued. And then within a couple of months, we had a huge correction, huge. And that would have been the time to buy in again, but of course people were too afraid to buy in at that time.
So are we going to have a huge correction here? I would say if you look at 1987, yes, but given the distortions, everyone is anxious and saying well, maybe things aren’t going to turn out the same way because we haven’t seen this kind of distortion before, or not the same kind. However, I’m just thinking of fundamentals, and I say stocks have never been a buy when you’ve had the PE ratios up at near twenty. And people are saying Well, I’m buying on forward earnings. But yet we’re seeing a contracting economy right now. So I don’t think those forward earnings are necessarily going to be there. And all that said, you still have to evaluate companies on an individual basis, not in general.
Chris Martenson: Isn’t it really a case of the Greenspan, now Bernanke, put market participants are saying if there’s another big accident, don’t worry – they’ll just pay for that over two and aren’t we really trading on that expectation as much as we forward earnings potentially?
Janet Tavakoli: Well, as I say, yes, because of the distortion that has been created. However, is that a good idea? No, I don’t think it is. Unless we’re going to say, you know, we fundamentally changed how we look at financial assets, I don’t think it is sustainable. I think, again, there’s a big crack in the grout. Although the tile’s nice and shiny. [laugh]
Chris Martenson: [laugh] I love the picture of this bathroom. I don’t like the grout right now.
Janet Tavakoli: I’ve been struggling to come up with things that the average person can understand. To show them how basically wrong it is, and how easy it is for people who understand what’s going on to recognize. And I think because people like the Fed have hidden behind the esoterica of financial jargon, it’s difficult for the average person to understand how easy it is for people like me to recognize that there’s a huge problem here and that people who are pointing out the shiny tile to you are lying to you.
Chris Martenson: And they get lots of air time, the shiny-tile people.
Janet Tavakoli: Yes, they do. They do. On CNBC, that’s all they talk about is the shiny tile.
Chris Martenson: Absolutely. Well, as you look forward over the next few years, what is the biggest risk that you see to our overall economic and financial health?
Janet Tavakoli: Widespread massive fraud in the financial system, I don’t know how many times I can repeat that – control fraud.
Chris Martenson: Is this reverse-Robin-Hood sort of behavior? I mean, this control fraud sounds like a great way to loot. And that money has to come from somewhere; control fraud’s no good unless the money is coming from somewhere.
Janet Tavakoli: Exactly, and it’s the fruits of control fraud which end up being a collapse – well, take a look at the silo that collapsed at J.P. Morgan; you see that happen time and again when you have that kind of problem. There are now seven people at J.P. Morgan who have lawyered up; this wasn’t a rogue trader.
Chris Martenson: Hmm, our favorite trader, the rogue trader, has fallen apart in this story.
Janet Tavakoli: Yes, exactly. Oh, it’s a rogue trader.
Chris Martenson: Oh, it’s the rogue trader. Well, this has been a fascinating conversation. I know we could continue and go on; I feel like we’ve gotten to the root of it, which is this idea of fraud and that this is really the core of the issue. And on top of that, we’ve layered all these other pieces and levered on top of that sort of rotten core. With obviously your important work and your excellent clear communications, how can people follow you besides getting the books that we’ve mentioned so far, including Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street [24], and how else can they follow you?
Janet Tavakoli: The New Robber Barons [25] is an eBook only, and it’s only available on Kindle, but it’s a compilation of some of my thoughts where I explain control fraud in a variety of different ways from the variety of different institutions. But anything that I put in the public domain is on my website and the primary outlet, in terms of the Web, is theHuntington Post. Obviously, I do private client work, but that’s not available to the general public.
And if I can leave you with another thought, I would just say that if you look at African countries that collapse or that are run by corrupt leadership, their economies are dismal and you see the corrupt leaders living like kings, driving Mercedes and so on. And it’s what I call the “corruption-to-production ratio.” When you aren’t producing very much, and you have a very corrupt system, you see an economy that is in shambles. Now the United States, you know we’re human beings – we’ve always had corruption in the United States, but we had checks and balances. And our production was so brilliant that the corruption basically didn’t matter that much because our corruption-to-production ratio was low.
Chris Martenson: Yes.
Janet Tavakoli: But in our lifetime, the corruption-to-production ratio has gotten out of whack. And so that’s why you’re seeing our economy basically being drained. And you are seeing fifty-one million people on food stamps right now, and you’re not seeing manufacturing coming back to create jobs for those people, which is our biggest problem. It’s one thing to have high unemployment; it’s another thing to have no manufacturing to create the jobs for those people. We have some manufacturing, yes, but we’ve sent a lot of our jobs abroad; more fools us. Because we don’t have those jobs that would allow those people who are on food stamps to get jobs at factories and make enough of a living to raise their families decently.
And you are seeing more of the middle class in service jobs who can’t get jobs back that pay them what they paid them before. So it’s an interesting experiment in the history of the United States to see our corruption-to-production ratio get so out of whack.
Chris Martenson: Maybe one distinction is, the original robber barons, at least they were robber-baroning around real things like oil and railroads and things like that. These new robber barons, what are they producing?
Janet Tavakoli: Shiny tiles. [laugh]
Chris Martenson: Pieces of paper; structured products. [laugh] Agreements, contracts; those sorts of things. It’s a whole new world. Well, this has been absolutely fascinating – thank you so much for your time, Janet.
Janet Tavakoli: Thank you, Chris. It was a pleasure talking with you.
Chris Martenson: And for people who are interested, the website is www.TavakoliStructuredFinance.com [26] – easy to find and follow Janet’s work there. So thanks again.
Janet Tavakoli: Thank you, Chris.
