The Indictment

On June 18, 2008, the government filed an indictment in US District Court for the Eastern District of New York against Ralph Cioffi and Matthew Tannin, the two former hedge fund managers at Bear Stearns. This post is an attempt to put into English what the government is attempting to do.

The defendants are charged with violating:

1. 15 USC Sections 78j(b) and 78ff. The are the sections of the US Code that charge securities fraud.

2. 18 USC Section 371...Conspiracy to commit an offense

3. 18 USC Section 1343...Fraud by wire, radio or television

4. 18 USC Section 2...charging them as principals

5. 18 USC Section 981...forfeiture allegations

6. 18 USC Section 3551...If guilty, imprisonment

7. 21 USC Section 853(p)...if guilty, forfeiture of substitute property

8. 28 USC 2461(c)...the government's power to enforce forfeiture

They are the sections of the US Code that Cioffi and Tannin allegedly violated.

If you are paying attention by this point, you will have noticed that the "violations" of 2 through 8 enumerated above are all predicated upon a crime having been committed. In other words, 2 through 8 require a crime to have been committed in order for them to come into play. The only allegation of a crime is 1, an allegation of securities fraud.

In order for there to be securities fraud, a security must have been offered, purchased or sold at a price that is not market value. There is no ambiguity, no gray area, no innuendo. A security must have been offered, purchased or sold at a fraudulent price.

You can guess what the indictment is missing...that fraudulent price.

Instead, the indictment states that the total losses in the funds exceeded $1 billion. The indictment does not claim that the defendants took the money or that they profited by that amount.

If the government is successful in its prosecution, and considering the blood lust it is creating, it probably will be successful, these two men will spend the rest of their lives in prison. Plus, they and their families will be left destitute.

More later.

They did it

They actually did it. They indicted and arrested the two hedge fund managers for the Bear Stearns hedge funds, Ralph Cioffi and Matthew Tannin. For those of you interested, a copy of the indictment is available from The New York Times.

I just downloaded a copy and will be posting an analysis in the near future. However, based upon what I read so far, this is not going to be an easy case for the government. That is assuming the defendants will be allowed to defend themselves.

The only comment I will make now is this is a day that most investment advisers had been hoping would not come. What the government is saying by instituting this action is if you lose client funds you can be sent to prison even if you did not profit.

The effect is chilling.

Indict the Bastards!!

Can you imagine! Someone actually lost money in a hedge fund! And now the cry goes up to indict the money managers, have some sort of trial or better yet a plea bargain, then throw the bastards in jail.

I promised myself when I started this blog that I would not rant about the legal system. But yesterday's Wall Street Journal really got to me.

On the front page was an article about the two Bear Stearns hedge fund managers facing a possible indictment. Why? Because they had the audacity to "paint a rosy" picture of their funds. In case you missed the article, it is available from The Wall Street Journal.

Ralph Cioffi and Matthew Tannin were the managers of "two high-profile bond portfolios." According to the Journal, they could be indicted within the next week.

Having been there and faced the same problems, I have only one piece of advice. Fight this as much as you possibly can. Do not entertain a plea bargain nor be cooperative in any respect. These people are out for a trophy, and you are the target.

Accusations of painting a rosy picture of the fund are hollow at best. I guess they would have you paint a bleak picture of the outlook so the run on the bank could have started sooner with the same results.

Painting a rosy picture of an enterprise is not illegal, if you believe the picture. Unless it can be proven that you offered, purchased or sold a security at non-market prices or that your actions caused a security to be offered, purchased or sold at non-market prices, a fair and impartial judge must dismiss any indictment presented.

Good Luck.

Too little too late

Last week I was looking over the headlines at Market Watch for interesting articles about changes in municipal finance. What really looked out of place was a piece written by Alistar Barr titled  Regulators try to ease selling pressure on muni's.

The fact that this article ran on June 2, 2008 begs the question where has the National Association of Insurance Commissioners been for the last eight months!

On October 13, 2007, Penn State was trouncing Wisconsin 38 to 7. AMBAC's stock price had closed the prior day at 68.96, down from a high of 96. But anyone who was aware of the financial markets knew the monoline insurance companies were in serious trouble. You don't lose a third of your market capitalization without some sort of alarm going off.

The National Association of Insurance Commissioners did nothing.

Fast forward to January 1, 2008. AMBAC's stock price has now fallen to 26, having lost about 75% of its market value in less than a year. And Wisconsin was on the losing end in the game with Tennessee.

By now everyone knows there are major problems with municipal bond insurance companies. The market for municipal bonds is freezing. Liquidity is vanishing.

The National Association of Insurance Commissioners did nothing.

But here on June 2, 2008, we are to believe that the Association is going to save the day by assigning its own credit ratings through its Securities Valuation Office ("SVO").

Just think of how much more credible the action would have been had the Association made its announcement in October. Better yet, how about a decade ago.

I'm sure the market awaits the time when the SVO assigns a rating to a municipal issue higher than the rating given by Moody's or S&P. Maybe it's time for a little long range planning on the part of the Association.

Time to cry UNCLE!!

After almost 35 years of effort by the federal government, it may be time for the municipal bond market to cry uncle and give up the “benefit” of tax-exempt status on municipal bonds. Since 1974, the federal government has been placing a stronger and more vicious stranglehold on the muni market. It appears that the government’s long quest for the holy grail of no tax-exempt bond issues may be close at hand.

Recently, the United States Supreme Court held that the state of Kentucky could tax the interest paid by another state to a Kentucky resident. According to the Court, such taxation does not run afoul of the “Commerce Clause” of the U.S. Constitution. While this decision may be seen as a victory for Kentucky, it realistically should be viewed as a substantial setback for the proponents of maintaining the tax-exempt interest on municipal bonds.The Opinion is here.

Between the chipping away at the municipal market by the government through the operation of the arbitrage regulations and the self-destruct mode the muni market has been in for the last few years, it really is just a matter of time before all municipalities lose the right to sell tax-exempt bonds.

While this may be greeted with glee from some parties, Joe Mysak, Bloomberg, the halls of Congress and the SEC, we taxpayers will wind up shouldering most of the cost.

At this time, the spread between municipal and corporate rates is about 1%. In percentage terms, municipal rates are about 81% of AAA corporate rates. With approximately $200 billion in municipal debt being issued this year, the increase in borrowing costs will be about $2 billion annually.

But rather than trying to defend and keep the tax-exempt status, the municipal market would be well served to attempt to fashion a plan whereby they give up exempt status in return for other items.

For example, the elimination of the arbitrage regulations could be first on the list to be eliminated. It has been estimated that the costs of compliance with these regulations costs the tax-exempt market approximately $600 million a year.

Next, the federal government should be willing to eliminate its own tax-exempt status on the bonds it sells. Currently, municipalities cannot tax the interest on US government bonds; imposing an effective 5% rate on the interest paid on those bonds could generate almost a billion dollars per year. And that amount is only going up as the growth in federal borrowing exceeds the growth in municipal borrowing.

Lastly, eliminating the tax-exempt status of municipal bonds would open a huge new market of investors. Pension funds, IRA’s, Keogh’s, and other tax-exempt investors would all now be attracted to municipal bonds. The increase of efficiency and tradability in the market would assist municipalities in the issuance of their bonds.

Borrowing Costs

Recently, a lot of attention has been placed upon the borrowing costs of municipalities. Congressman Barney Frank has held hearings and has threatened the rating agencies, attempting to cajole them into rating municipal bonds on the same plane as corporate bonds.

At the same time, California State Treasurer Bill Lockyer has stated a campaign to have that state start its own insurance program to insure municipal bonds issued by California municipalities. His analysis suggests that municipal borrowing costs could be reduced if the state operated its own insurance program.

It is very easy to fall into the trap of more government oversight and government sponsored enterprises will benefit the taxpayer. But the facts make one question whether these efforts are really sound.

According to data published by the Federal Reserve, from 1977 until 1986, the yield of the Bond Buyer index averaged 76% of the yield of "AAA" Corporate bonds. The range was 64% to 92%.

After the tax reform act of 1986 reduced marginal tax rates, the average from 1987 until June of 1993 was 79% with a high of 90% and a low of 72%.

In June of 1993, the Internal Revenue Service issued its "Final" Arbitrage Regulations. Even that did not materially change the spreads. From June of 1993 until the end of 2003, municipal yields averaged 77% of "AAA" corporate with a maximum of 88% and a minimum of 70%.

Since 2003, the average spread has been 81% with a maximum of 91% and a minimum of 76%. It does seem that the level has risen but not markedly so.

Proposals to "fix" the municipal market have been around for decades. Fortunately, most of them have not been put in place. And I seriously question whether more government programs will materially affect the municipal borrower's cost of funds. The "AAA" corporate and the Bond Buyer yield spreads have been among the most stable and consistent over the last 40 years.

Be careful not to fix something that is not broken.

JP Morgan's Wells Notice

Recently JP Morgan has received a Wells notice from the Securities Exchange Commission. A Well's notice is official notification that regulatory action is being considered. But what's interesting about this is there is some question whether the SEC actually has jurisdiction for the action it is considering.

 

The SEC has the responsibility to insure the effective and honest operation of the securities markets. Their primary jurisdiction is contained in the US Code at Title 15 Sections 77q(a) and 78j(b) and Rule 10b-5. It is a well settle point of law that fraudulent activity under these sections must happen in the "offer, purchase or sale" of a security. The problem the SEC has is that the security owned by the municipalities was sold to them at market value pursuant to the government's own regulations.

 

It is possible for the Commission to claim that if Morgan violated the bidding procedure detailed in the arbitrage regulations (see the following post), that the market value of the derivative in question was misrepresented. But first, the SEC would have to show what the correct market value should have been and how Morgan's alleged misbehavior caused the market value to be misrepresented.

 

It appears that the jurisdiction for this case may not rest with the SEC. The crux of the government's argument is that Morgan may not have followed bidding procedure, not that the derivative was sold at other than market value. The IRS may have a claim against Morgan, because Morgan's actions may have cost the government some measure of arbitrage profit, but that is a claim not involving the SEC. What should not be forgotten is that the owner of the derivative, the municipality, probably acquired the derivative at fair market value.