Finding the Culprits of the Crisis

April 25, 2012 at 08:00 PM

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Janet Tavakoli calls it as she sees it — and what she often perceives isn't a pretty picture. But for any advisor, or other investment professional, to ignore this industry veteran's razor-sharp insights would be folly.

A gutsy critic of both Wall Street and the federal government, the Chicago-based consultant, specializing in derivatives and structured products, pulls no punches. Through her independent research into the global financial crisis, Tavakoli uncovered what she calls massive, widespread fraud committed by a network of mortgage originators, securitizers, and rating and regulatory agencies, among others.

Earlier, the founder of Tavakoli Structured Finance, 58, predicted the thrift industry blow-up and the demise of Enron. Then she foresaw that excessive leverage and structured products' misratings would lead to a global financial crisis.

In her just-published e-book, The New Robber Barons, Tavakoli charges that the relationship between failed mortgage lenders and investment banks that securitized and sold risky loans was "the largest Ponzi scheme in the history of our capital markets … a financial Pearl Harbor," where "investment bankers piloted many of the planes."

Now Tavakoli sees another huge financial crisis looming.

The University of Chicago MBA has traded, structured and sold derivatives at firms including Merrill Lynch, PaineWebber and Westdeutsche Landesbank; and she had earlier stints at Bear Stearns and Goldman Sachs. Research recently talked with her about red flags and preventive solutions.

You write that, in the past three years nothing has been fixed but that we must hold Wall Street responsible for the fraud that resulted in the financial crisis. What should be done?

We need to have investigations. But with the pushback and all the lobbying, what they've been counting on is that the statute of limitations for some of these frauds is expiring. So if you don't file complaints, you may not be able to.

Members of Congress are enabling the lack of punishment and covering up great misdeeds in our financial system — and they're doing it with no fear of consequences — i.e., being voted out of office, in which case they could find themselves the subject of investigation.

What do you mean: "covering up"?

Many people are covering up for cronies who have a lot of money sloshing around. We threw money into the financial system with no accountability and thus made the problem worse. Our system has been completely infiltrated and bought off. Things aren't changing because Big Money doesn't want it to change.

What other indications are there of a cover-up?

The MF Global dog-and-pony show. The attitude toward bundlers like Jon Corzine [the firm's ex-CEO], who is a big bundler for the Obama campaign, is that the guy can do no wrong. This was before he even testified. People who are raising big money for campaigns get off with no real investigation.

In the Sarbanes-Oxley age, for MF Global to say they were unaware of what they were doing beggars belief. And yet there has been no indictment.

Is President Obama part of the cover-up?

Yes, in that he's enabled it. He's left people in place who crashed the global financial system in the first place: [Treasury Secretary] Tim Geithner and [Federal Reserve chair] Ben Bernanke. Obama had told us: "You can't keep doing things the same way and expect different results." So he's been quite a hypocrite.

Who else is in the cover-up?

Mary Schapiro was appointed [by President Obama] to head the SEC. She was formerly head of FINRA, the antichrist of investor advocacy! Yet she was chosen SEC [chair] because the regulators are captive by and serve the people they're supposed to be regulating. They do not serve investors.

In a way, Obama has been the anti-regulator because he didn't put people in the regulatory agencies, the Fed or the Treasury who would investigate and fix things that are wrong in our global financial system.

If he's re-elected, then presumably, things will continue in this same way?

Yes.

What if a Republican is elected President?

Who else is not in the pocket of Big Money interests!

So, no matter who's President, these crimes — if you want to call them crimes — will be perpetuated?

Yes. And we do want to call them crimes! They are crimes.

What should Obama do now to help Americans?

He has a lot of resources at his disposal, one main one being moral suasion — he's got the pulpit. When there was a crisis, Reagan, Carter, Bush went on television and explained what needed to be done. We haven't seen that kind of leadership from President Obama. If anything, the American people have been told things to make them think [conditions] aren't really as bad as they are: inflation isn't as bad as you think because an iPad is cheaper now — nonsense like that.

So the public is being poorly informed?

Yes. Therefore, financial advisors need to be doing fundamental analysis of investments and not [only] be reading the Wall Street Journal or, God forbid, watching CNBC.

In other words, FAs should do their own research and figure things out for themselves.

Yes. Sadly, you're on your own. That's part of how we got into this mess: We lost the art of rolling up our sleeves and looking for opportunities.

On Internet TV, you stated that we're "absolutely vulnerable to a repeat [crisis] because the fraud went unpunished and we printed money like crazy to bail us out of the last one." That's scary.

But the fact is we've bailed people out and had no consequences for them. So it emboldened them to turn around and behave in the same way. Look at banks like JP Morgan: Shortly after the crisis, they thumbed their nose at the idea of trying to separate speculation from the rest of the bank. So if you don't have restraints on behavior, you'll see it repeated. And now we've made it worse. It's like handing a drunk driver who got into a crash the keys to a bigger, faster car together with a bottle of vodka.

In every area of finance where we bailed people out, you see the same wrongdoers volunteering to help fix the situation. That's pretty funny: They weren't trustworthy before, and they're not trustworthy now.

But what about the investigations that already have been held?

They're all for show, and people end up with a slap on the wrist for minor issues. Investigators should be looking instead at the interconnected fraud that infected the mortgage lending market. And there is still a lot today, especially fraud on borrowers. If you go to the root of the problem and choke off the money supply, you stop the fraud in its tracks.

But the banks say they lost money.

The fact that a bank lost money isn't an indication that they were a victim as opposed to being a perpetrator. A classic problem with control fraud is that the parasites destroy the host — in this case, the host being the bank and the parasites being the bank employees. If you were the victim of a control fraud by the people who worked in your own bank but meanwhile, you were collecting huge bonuses, you overlooked the control fraud within your own institution.

Why haven't the apparently guilty been punished?

We haven't seen the felony indictments that these people richly deserve because our regulators and investigators are captive — and Congress, more than ever, has been lobbied, courted and bought off by Wall Street. More than any time in the past, you've seen these big-money interests protected by Congress.

Is there an alternative to bailouts, such as those of the financial crisis?

Yes. Troubled financial entities should be restructured, old shareholders should be wiped out and we should return Glass-Steagall.

What should have been done in the case of, say, AIG?

Bankruptcy declared, and then [the government] says: "We'll back-stop your contracts for now, but we're going to investigate all those fraudulent credit derivative contracts and 'claw' money 'back' from your counterparties — like Goldman Sachs and Credit Suisse — if need be." So there's a controlled demolition. You're not just handing money out with no consequences.

And that is indeed what you maintain we did?

Yes. Today the Fed is saying taxpayers made money on the assets that it bought on those CDOs. That's a lie. Taxpayers are owed tens of billions of dollars that went out the door of AIG before the bankruptcy. So with sleight-of-hand and half-truths and innuendo, the Fed is lying to the American people. It's part of the cover-up.

"Unless we change direction," you write, "we'll have another crisis by 2015. Congress made all the wrong moves to guarantee it." Please elaborate.

Congress has been keeping interest rates very low, basically to subsidize the banking industry. We've never seen domination over Washington in the way we're seeing it now nor the Fed willing to keep interest rates low so long to subsidize the banks.

People aren't earning enough on investments of low risk to keep pace with inflation, which is being underreported because the [Consumer Price Index] doesn't include many things we use on a daily basis that are increasing in price. Inflation is the great destroyer of wealth. We're getting sleight-of-hand on the part of people who know better.

How would you characterize the overall state of the economy?

I see "strangulation." Even though we have some new household formations, the number of foreclosures and big inventory overhang show that the bad past practices have not yet been resolved. And even though there has been some improvement in the jobs figures, many people have not gotten back to the stable income level they had before the crisis.

What about new regulation? Will the Dodd-Frank Act accomplish anything?

No. It will accomplish as much as [the] Sarbanes-Oxley [Act] did, which appears to be nothing. The bank lobbying groups were all over Congress to water down regulation, and they succeeded. The game is to act as if even a weak regulation is a big deal to get through. And if Congress does manage to get it through, the banks effectively swoon. It's just theater. What should be done, as I said, is return [the] Glass-Steagall [Act]. But we are so far from that.

What does all this signal to financial advisors?

When MF Global can go in front of Congress and say, "We had controls in place, but I don't know where the [approximately $1 billion in customer money] went," nobody should be leaving extra cash in trading accounts with any of the major brokerage firms, such as Goldman Sachs or Merrill Lynch.

Really! That seems extreme.

After we've gone through a major financial crisis and everyone is claiming that nobody is to blame, advisors have to be more clever and say, "I'm not leaving money in any account in which I don't completely understand the finances of the entities where the money is." They have to safeguard assets. That is part of their responsibility today.

The financial crisis resulted largely from the use of credit derivatives. How?

We saw them hide risk and create a lot of leverage in the global financial system in securities and securitization, where one bad mortgage could be levered up to be in numerous different deals. That kind of malicious leverage had a big impact. A lot of fraudulent securitization provided funding for corrupt lending. Had we not done that, our housing crisis — and the situation we still have today — wouldn't have been nearly as bad. Derivatives helped supply the leverage to inflate the bubble.

Are they still dangerous?

Today we see a credit derivatives market that is poorly understood by regulators and even by many of the banks who are participating in the market. And there just doesn't seem to be a will to clean it up.

What should be done about sovereign credit default swaps?

When they were [first] sold, the hype was that they were useful hedging tools. The result is that they have been a game for speculators more than a hedge for hedgers. Speculators can go in and depress sovereign debt just when a sovereign needs to roll over debt — and of course the price of the credit default swap will shoot up. These games create temporary dislocations in the market. Given that we haven't driven speculators out of the market, it's a good idea to ban credit default swaps altogether.

What else can be done now to try to prevent another financial crisis?

In terms of money flow in the U.S., we have to write down debt and maybe have some sort of debt forgiveness. That's a radical thought, but some people will never be able to get out from under their debt in their lifetime. Going forward, we have to make responsible loans.

But you don't see Wall Street changing its behavior until there's punishment for the last crisis.

Right. In fact, those who pulled it off have a feeling of invulnerability. They've been richly rewarded for it. When your benchmark is money and you continue to be richly rewarded by the wrong behavior, you're not going to get the message.

What can financial advisors do to protect clients?

In the past few years, advisors have let themselves and their clients down badly by not paying attention to the bigger picture. Many companies have global businesses, so advisors should look at their overall picture. They need to look at currencies and what's happening in the global banking system because some money market funds invest in it. And they should pay attention to the safety of cash flows.

To sum up, your big-picture advice to FAs?

Unless there's a general awakening in the U.S., things may not change. Therefore, advisors might have to start with the assumption that things may not change and that they will get even worse. They need to look at that landscape and say, "How do I protect the wealth of my clients?"

So careful, smart investing is still the key?

One cannot control the craziness in Washington or distortions in the global economy, but one can invest to protect oneself from deflating assets and the inflationary effects of money printing on health care, food and energy — the "inconsequential" items excluded from the CPI that we all need to survive.

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