By Shah Gilani
Contributing Editor
Money Morning

Two years ago, an associate of mine lost $100,000 because he didn’t listen to me. A year ago, I saved a manufacturing company from the same scam. And just last week I saved a friend of mine $300,000.

For several years now, a far-fetched but seemingly plausible investment opportunity has been wreaking havoc across the globe. In the United States alone, an estimated $10 billion has been lost in this particular gambit. The scheme is typically hidden behind such legitimate-sounding names as “Prime Bank Trading Programs,” “High-Yield Investment Programs,” or “Roll Programs.”

These are not legitimate investment opportunities. The reality is, they are outright scams. And my role as a professional investor has provided me with an up-close-and-personal vantage point from which to observe some of these con games.

Everything I am relating in this story is true. This story – along with real names, contact information and associated documents – has been forwarded to the Federal Bureau of Investigation and the U.S. Securities and Exchange Commission in an effort to catch these brazen conmen and to save unsuspecting investors from further losses.

While there are variations of this scam, once you read this article you should be able to see the set-up and con game from a thousand miles away.

And that’s as close as you ever want to get to any of this.

Raymond’s story

When the real estate market collapsed, my friend “Raymond” had several million dollars invested in the development of a couple of tracts of land in Florida. With the bank threatening foreclosure, he turned to a mortgage broker he knew. The broker, in turn, put Raymond in contact with someone she had not met. But, as the broker subsequently told me, this contact – a man we’ll call “Moss” – had been approved by her company as a source of funds for borrowers that the mortgage company wasn’t able to accommodate.

Raymond called “Moss” to discuss his predicament. Moss identified himself as an Atlanta attorney and offered to put Raymond into an “investment opportunity” that would generate huge gains. But it was only available to a select few big-time investors, Moss said.

The “No Collateral” Come-On

The first oddity about this “investment opportunity” is that it doesn’t require any collateral. Even though Raymond had a multi-million dollar piece of land that was serving as collateral for the bank loan he needed to pay off, Moss wasn’t interested in the property. What made his deal so enticing to Raymond was that Moss was offering to make Raymond twice what he owed on the bank loan – without requiring him to put up any collateral.

A variation on the “no-collateral-required” theme was evident when I steered the manufacturing company away from this same scam. In that variation, conmen offer to raise money for a worthy cause, such as a humanitarian program, or for the construction of a facility that would provide employment for a certain number of people.

But the organizers of these scams never request that part, or all, of the project being “financed” be put up as collateral. They make it sound like all they need to know is what the money is being used for. If it “fits” into one of their “programs,” you don’t need to put up any collateral.

That’s your first red flag: They don’t want collateral, only cash.

“Secret Trading Platforms”

Secret trading platforms are where giant banks and the super rich make tons of money.

In explaining the “investment opportunity” to Raymond, Moss said that it’s really pretty simple. Apparently, there are “trading platforms” out in the market, where “traders” trade “debentures,” which are described as “bonds” or “MTNs” (medium-term notes) that are issued by the big “prime” banks around the world.

Other banks and rich investors trade these instruments. You haven’t heard about these “platforms” because they’re secret, and that’s why the rich get richer and banks make so much money.

There are different programs that get traded on these platforms. But your contact will tell you that he can get you into one of these programs, so that you’ll soon be earning the same returns as the super rich.

But wait. You haven’t yet heard the best part: It’s risk-free!

I was so excited for Raymond that I decided to call Moss and hear the pitch for myself.

A Personal Pitch

What the traders do, Moss explained to me, is match buyers and sellers. The traders are the only ones who can do this. They find a seller – maybe a bank or a rich person – who wants to sell their debentures, their MTNs, or some other high-yield investments. Or maybe the seller is executing a “roll program,” where an investor or institution rolls over an investment, and must then find a buyer to take the other side of the “trade.”

But since all the trader is doing is matching buyers and sellers, there is no risk. It’s really profitable because the “spread” – the difference between what the buyer pays and what the seller sells for – are far apart. The trader keeps the difference and would share that with Raymond. How profitable are these trading platforms, I asked?

Very, very profitable, came the reply.

Said Moss: “You’ve heard of the Rockefellers – haven’t you?”

If it Sounds Too Good To be True …

We’ve all heard the old investing adage: “If it sounds too good to be true, it probably is.”

Well Moss was essentially promising Raymond a 100% return on his money – every month.

And to get started down this golden pathway, all Raymond had to do was put $300,000 into an escrow account.

On its face, that seemed to promise safety. For the funds to be released, both Raymond and Moss had to sign. So Raymond didn’t have to worry, because if he never signed a release, Moss could never get the money.

In the meantime, the escrow account would be “blocked,” so that it would be guaranteed to stay there for a year. Moss would let his “traders” use the money in the escrow account as “show money.” The traders could claim that they were “attached” to the account, meaning they could then borrow up to 10 times that amount to trade prime debentures on their platforms.

With 10-1 leverage, the traders would find “one of the smaller programs” to trade (according to the pitch, there apparently are only two or three small programs … all the other programs are for the rich guys who trade in really big blocks). And since it’s all risk-free, Raymond was told that he could expect to make back his initial investment – about $300,000 – every month.

And he might even be able to make more if the traders could find more of these pesky “small” programs to trade, Moss told Raymond.

On a Scammer’s “Do Not Call” List

I asked Moss what would happen if there weren’t any of the small programs available for Raymond to trade.

His answer was priceless.

Moss said he would have suggested this earlier, but said he’d rather see Raymond make $300,000 a month and pay off his loan than to get involved with the alternative investment. The “alternative” was for Raymond to use his $300,000 to actually “buy” a “leased instrument.”

Under this scenario, Raymond would be buying into a leased instrument that would make him part owner of a giant pool of rich investor money. And because most of the trades are big block trades, he could then participate in the big trades and make enough money in one trade to pay off the bank and make a lot more, and it would probably take about a week.

I’d heard enough. It was now my turn to ask “Moss” some questions.

Needless to say, his answers were so unbelievable, impossible, or just plain ignorant that I found myself switching between wanting to laugh and wanting to explode in anger – and struggling to control both urges.

The bottom line: He apparently didn’t like the questions I asked, and he now won’t take any more calls from me or from Raymond.

Spotting a Scammer’s “Tell”

Here’s what you need to know to avoid becoming a victim of this gambit.

First, there’s no such thing as “buying” a “leased instrument.” In fact, if you just consider it for a moment, it doesn’t even make logical sense.

Second, there’s no such thing as putting money into an escrow account so someone else can leverage it to trade against. Here’s the hint: If the trader loses money, how are they supposed to get at the “blocked” money to settle up?

Third, there’s no such thing as “risk-free” trading – period.

There’s no such thing as special programs where you can get high returns on investments because you’re going to use the money you make to build a factory to employ people or to fulfill some other philanthropic void.

There’s no such thing as a secret trading platform where prime bank debentures or any other instrument is secretly traded by global banks or the super rich.

There’s no such thing as unlicensed traders trading in some “European” or cyberspace market where they are not registered. And to imply that they are governed by the International Monetary Fund (IMF), the World Bank, or some other international body such as the International Chamber of Commerce (ICC) is just plain stupid.

Don’t be stupid.

And don’t be greedy.

There’s no such thing as making 100% per a month, or a week.

They were going to get Raymond’s money by forging his signature on the escrow agreement, by talking him into writing a check for some non-existent leased instrument, or through any one of several other pathways they could lead him down – before parting him from his money.

Don’t just take my word for it. Do an Internet search on “bank debentures trading scam” (to see the results of that search, please click here). As you’ll see, there are literally pages upon pages of information on these ugly and expensive scams. A lot of sophisticated people have been drawn in and duped. These scammers are pretty sophisticated themselves.

Epilogue: It turns out that “Moss” was once a member of the Florida bar, but is not licensed to practice law in Georgia. I followed up on his e-mail contact information, which included an address at an Atlanta law firm. I contacted the firm and found that he actually had been hired there to do some research work, but then was fired for lack of performance. The partners of the firm were obviously not happy to hear that their good name was being employed as part of a scam. But they were obviously grateful that I alerted them to the problem.

[Editor's Note: As today's investigative story demonstrates, successful investors have to know when to act, and when to hold back.
But they also have to know where to look.

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News and Related Story Links:

• Investopedia:
  Debentures.
• The Investment Machine:
  Roll Program.
• Investopedia:
  Medium-Term Notes.
• Quatloos.com:
  Bank Debenture Trading Scam.

By Shah Gilani
Contributing Writer
Money Morning

Is the government creating another subprime-mortgage bubble?

The first time around, the three-headed federal serpent – the Bush administration, the Treasury Department and the U.S. Federal Reserve – used Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) to “legitimize” trillions of dollars worth of toxic financial waste known as subprime mortgages.

The result was the worst financial crisis since the Great Depression – a mess that was global in nature.

And we’re now headed for a repeat performance.

Some of the players may have changed since the first subprime-mortgage crisis, but the game apparently remains the same. With banks currently unwilling to lend, the new federal triumvirate of the Obama administration, the Treasury and the Fed are trying to inflate the moribund U.S. housing market. This time around, however, the FHA is the weapon of choice.

Obama & Co. are making an all-or-nothing bet that the U.S. economy will recover and bail out the housing market before the final bill for this ill-advised gambit comes due.

When this bubble bursts – and it will – U.S. taxpayers will be on the hook for more than $1 trillion in government-guaranteed debt.

Ginnie Mae: Fannie and Freddie’s Once-Quiet Cousin

As a direct result of the real-estate meltdown, U.S. banks have become reluctant lenders. And they’ve raised their loan standards considerably. Federal officials knew they had to keep the mortgage spigot open, especially to suspect borrowers, so they turned to their new “secret weapon” – the FHA.

The FHA has been cranking out new government-insured subprime loans, which it packages into government guaranteed securities for sale to banks. This frightening reflation of the subprime bubble is being engineered for two key reasons:

• To put a floor under falling house prices.
• And to let banks swap toxic Fannie and Freddie securities for new toxic debt that is 100% guaranteed by U.S. taxpayers.

The almost inevitable insolvency of the FHA could rapidly undermine the fragile recovery of the U.S. economy. And it could plunge stock prices and bank viability to new lows.

Why the FHA?

That’s simple. In an era of increasingly stringent lending standards, the FHA’s standards are laughably lax.

Created by the National Housing Act of 1934, the FHA insures private mortgage lenders against borrower default on residential real estate loans. But its current allure is that it opens the door to prospective homebuyers who almost certainly wouldn’t qualify for a conventional home mortgage. These are buyers with no credit history, a history of credit problems, or not enough cash to cover the down payment and closing costs.

The FHA has quadrupled its insurance guarantees on mortgages in just the last three years, with the bulk of that growth coming in the past two years. Currently, the FHA insures $560 billion of mortgages.

Loans that are FHA-insured are pooled and packaged into mortgage-backed securities (MBS) by the Government National Mortgage Association, more commonly known as Ginnie Mae. Ginnie Mae insures the actual MBS pools composed of FHA loans. Ginnie Mae securities are the only mortgage-backed securities backed by the full faith and credit of the U.S. government.

Two weeks ago, Ginnie Mae proudly announced that it had issued a monthly record $43 billion in FHA mortgage-backed securities, and through the end of July held guaranteed securities with a value of $680 billion. It is on track to exceed $1 trillion worth of guaranteed securities by the end of calendar year 2010.

Ginnie Mae is a cousin of its better-known siblings Fannie Mae and Freddie Mac. Those two mortgage giants are technically insolvent, and were forced into government conservatorship at the height of the financial crisis – ostensibly due to concerns that foreign central banks in China, Japan, Europe, the Middle East and Russia might stop buying our bonds. As “government-sponsored enterprises,” or GSEs, Fannie and Freddie were only supposed to have the “implicit” backing of the U.S. government. But recent events have shown these to be fully backed by taxpayers.

The implosion of Fannie and Freddie severely threatened the mortgage market. It essentially shut down the two giant repositories that bought the loans banks and mortgage originators didn’t want to hold as assets on their own balance sheets.

The FHA and its mortgage-backed securities “factory” – Ginnie Mae – have taken up where Fannie and Freddie left off, and are now the dumping ground for toxic mortgages. Using the FHA is the core strategy in the administration’s misguided effort to prop up mortgage origination and modifications, real estate prices and insolvent banks.

Warning Signals?

Administration officials might want to take heed of some eerie parallels between the current situation and the one involving Fannie and Freddie. They could serve as an early warning system.

First and foremost, the FHA has already started to acknowledge systemic fraud in its business. In the earlier subprime crisis, similar circumstances led to the revelation of massive fraud in the issuance, packaging, ratings and sale of subprime toxic mortgage-backed securities.

On Aug. 4, the FHA suspended Taylor, Bean & Whitaker Mortgage Corp., one of its largest approved independent mortgage originators, from making anymore FHA-backed loans. The suspension came one day after federal investigators raided Taylor Bean’s Ocala, Fla., headquarters.

Since 2007, the value of FHA-backed loan originations underwritten by Taylor, Bean had soared 117%. By contrast, the origination of conventional loans by the firm dropped 34% over the same period. Taylor, Bean subsequently filed for bankruptcy.

Earlier this summer, the U.S. Department of Housing and Urban Development (HUD), which oversees the FHA, raised concerns about FHA practices. On June 18, HUD released an internal inspector general’s report that revealed that the FHA’s default rate exceeded 7% and that more than 13% of its insured loans were delinquent by more than 30 days.

In a “Review and Outlook” piece, The Wall Street Journal reported that the FHA’s reserve fund dropped from 6.4% in 2007 to about 3% today, putting it dangerously close to its mandated 2% minimum. That translates to a “33-to-one leverage ratio, which is into Bear Stearns territory,” the newspaper report stated, referring to the now-failed investment bank that had been a central player in the original subprime mortgage crisis.

Bear Stearns is now owned by JPMorgan Chase & Co. (NYSE: JPM).

The HUD inspector general’s report stated that the agency’s growth makes it “vulnerable to exploitation by fraud schemes” and that it may need “Congressional appropriation intervention.”

In a recent article – “FHA Disputes Whispers of Capital Reserve Problems” – on the Mortgage News Daily Web site, HUD Secretary Shaun Donovan said in June that “there’s a better than even chance that we will stay above the two percent reserve threshold. That suggests, not just for the 2010 business, but overall for the portfolio, that we’ll more than likely to stay out of a broader need for any taxpayer funding.”

It may be more than a little disheartening to know that in a very uncertain economic environment, precisely due to fraud in mortgage lending and increasing borrower defaults, that our government is stretching a 50/50 wager on the backs of taxpayers.

That’s only part I of the FHA dilemma story.

Part II is even more frightening.

A Look Ahead

Banks are dumping Fannie and Freddie-backed securities onto the Fed’s balance sheet and replacing them on their own balance sheets with FHA-insured loans packaged into government-insured securities issued by Ginnie Mae. Banks aren’t reducing their net assets, they are aggressively swapping acknowledged toxic securities that no-one wants for a new variety that no one will want in the future. Why?

It’s not just that Ginnie Maes are fully backed by the U.S. taxpayers and Fannie and Freddie’s securities are only implicitly backed. All of them will be covered by taxpayers.

The devil is in the details.

Because Fannie and Freddie securities are only implicitly guaranteed, banks that hold these securities as assets on their balance sheets must “haircut,” or set aside reserves, based on a 20% risk-weighting assigned to the value of those holdings.

Because Ginnie Maes are explicitly 100% guaranteed, they are considered “risk free,” and on par with U.S. Treasury bonds, notes and bills. There is no reserve requirement, or haircut, on Ginnie Mae securities.

By replacing their asset mix and holding Ginnie Maes, banks don’t have to set aside reserves. They can use the money they otherwise would have to set aside to actually leverage-up their balance sheets. And guess what they’re buying?

More Ginnie Maes, naturally.

The effect of the asset swap – basically one toxic pool for a replacement that’s not much better – creates the illusion that banks have healthier balance sheets and that they are meeting their reserve requirements. It’s such a good deal for the banks and actively promoted by the Fed and Treasury, that banks are using Troubled Assets Relief Program (TARP) money to buy Ginnie Maes.

But it’s all a façade.

Capital ratios are being manipulated and insolvent banks are being propped up.

The danger of relying on the FHA to prop up the shaky housing market by facilitating mortgage origination, modifications and refinancing to less-than-stellar borrowers will only result in more subprime loans being stockpiled on the Federal Reserve balance sheet.

Eventually, defaults will overwhelm the FHA. And the hoped-for floor in residential real estate pricing will be pulled out from under us all. The next down-round in real-estate values will expose bank balance sheets for what they really are: Over-leveraged and over-stuffed with junk. Already on the ropes, banks will lose capital and will have to tighten the credit screws on consumer borrowers even more.

We may be headed for another bruising round of real-estate and MBS-related depreciation. Even a mild financial-markets setback could put the economy and the stock market onto the canvas for a 10-count. Further pummelling of shaky consumer confidence accompanied by a couple of major bank failures could easily send the U.S. market down for the financial-system equivalent of a TKO.

Taxpayers, always the lowly cornermen holding the spit buckets, are already in place with the safety nets. We will catch the FHA loans because we insure private lenders against subprime borrowers with no skin in the game. We then will have to catch the buyers of Ginnie Maes, because we guarantee those MBS securities. And we will be forced to catch the falling banks, because we already insure depositors through the Federal Deposit Insurance Corp. (FDIC).

Perhaps our ultimate fate is that of the permanently punchdrunk veteran boxer, who rues his decision to stay in the game, realizing that he fought “one bout too many.” If that’s the case, that “one bout too many” could be Subprime Crisis II, arranged by the very market referees whose job it was to protect us from such beatings.

News and Related Story Links:

• Money Morning Investigative Report on the Bank Bailouts (Part I):
  Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout.
• Wikipedia:
  Subprime Mortgage Crisis.
• Associated Content:
  National Housing Act of 1934.
• SEC.gov:
  Mortgage-Backed Securities.
• About.com:
  What is a Ginnie Mae Security?
• InvestorWords.com:
  What is Full Faith and Credit?
• InternationalForecaster.com:
  Great Doubts for the Benefit of the Stimulus Package.
• Wikipedia:
  U.S. Department of Housing and Urban Development.
• Investopedia:
  Government-Sponsored Enterprise.
• The Wall Street Journal:
  Taylor Bean Suspended From Making FHA Loans.
• The Orlando Sentinel:
  Ocala-based Taylor, Bean & Whitaker Mortgage files for Chapter 11.
• Wikipedia:
  Bear Stearns Cos.
• Mortgage Daily News:
  FHA Disputes Whispers of Capital Reserve Problems.
• Money Morning News Analysis:
  Inside Wall Street: That Ticking Sound You Hear Out in the Mortgage Market is the FHA.

When it comes to the U.S. credit crisis, we’ve all heard the numbers. The stock market decline wiped out $7 trillion in shareholder wealth. It forced the federal government to commit to $11.6 trillion in bailout programs and stimulus spending. And it’s led to the longest U.S. downturn since the Great Depression.

Everyone also knows that some of the key culprits behind this financial mess were the credit-rating firms like Standard & Poor’s and Moody’s Investors Service, which assigned top-tier “AAA” ratings to investments that were actually backed by subprime mortgages and other toxic debt.

Whether it was collusion or incompetence almost didn’t matter: The firms claimed that the credit ratings they issued were constitutionally protected free speech. With this First Amendment shield, S&P, Moody’s and others said they were protected from lawsuits or other liabilities.

But that’s about to change.

A federal court judge in New York last week stripped the ratings firms of that defense, a decision that could expose the companies to billions of dollars worth of liabilities from investors who were burned by the faulty ratings.

Let’s legal case involved three specific firms – two firms that rated collateralized debt securities, and an investment bank that sold the debt. Those three companies were:

• Standard & Poor’s, which is owned by The McGraw-Hill Cos. Inc. (NYSE: MHP).
• The Moody’s Investor’s Service unit of Moody’s Corp. (NYSE: MCO), which is 19% owned by Warren Buffett’s Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B).
• And Morgan Stanley (NYSE: MS).

This particular case had been brought against Moody’s and S&P by Abu Dhabi Commercial Bank PJSC and Washington State’s King County. The case involved losses suffered from an investment in a structured investment vehicle (SIV) called Cheyne Finance. Although the debt securities Cheyne issued were backed in part by subprime mortgages, they received ratings as high as “AAA.”

In return for the high rating, the companies received higher-than-normal fees.

The $5.86 billion Cheyne Finance SIV went bankrupt in August 2007. The plaintiffs claimed fraud. The suit is seeking class-action status on behalf of investors who were burned when Cheyne was forced to dump securities it had issued between October 2004 and October 2007.

Since lawyers for the plaintiffs say the ruling could be applied to any deal involving SIVs, it could have a substantive impact. Before the financial crisis caused the value of these asset pools to plummet, experts estimate there were $350 billion to $400 billion worth of SIVs in existence.

“There certainly will be other cases filed – that’s the future impact of this decision,” San Diego attorney Patrick Daniels told The Wall Street Journal.

Moody’s and S&P had sought a dismissal, citing their First Amendment protections. But U.S. District Court Judge Shira Scheindlin ruled on Sept. 2 that securities ratings that were distributed to a small group of investors don’t warrant the same First Amendment protections that are afforded to the widely circulated ratings of corporate bonds.

Judge Scheindlin acknowledged that ratings constituting “matters of public concern” are typically protected from liability. That’s especially true when the ratings are distributed to the general public. But it wasn’t the case here.

“Where a ratings agency has disseminated their ratings to a select group of investors rather than to the public at large, the ratings agency is not afforded the same protection,” Judge Scheindlin ruled.

The ruling will likely be appealed. And it could end up in front of the U.S. Supreme Court.

The case spotlights the biggest problem with the business of rating securities: The ratings firms are paid by the issuers to rate them.

When you get right down to it, ratings firms are in business not to rate but to make money for themselves by rating issuers and their securities. The surprise isn’t that the obvious lack of objectivity fostered abuses in the credit-rating process – it’s that the problem took so long to come to a head. The complexity of mortgage-backed securities (MBS), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs) only exacerbated the investor risk.

The decision received widespread media attention. But it’s only half the story.

And the media missed the other half.

In an ironic twist that transforms the credit-rating firms into legal sacrificial lambs, the U.S. Securities and Exchange Commission (SEC) has in recent weeks acknowledged its own failure to protect the public from the same ratings firms that the federal agency mandates that investors rely upon.

This admission – combined with the legal assault on the constitutional protections ratings firms are used to hiding behind – could threaten the ratings firms’ very existence. It not only will further fuel investor ire, it could also provide litigants with additional needed legal ammunition. The ratings involve tens of billions – if not hundreds of billions – of dollars of failed securities.

A series of internal reviews by the SEC – one reaching back to last year – has highlighted some of the abuses.

About a year ago – in July 2008, to be exact – the SEC concluded a 10-month examination of the ratings industry that uncovered “poor disclosure practices and procedures guiding the analysis of mortgage-related debt and insufficient attention paid to managing conflicts of interest.”

According to the report, there was an obvious degree of knowledge and complicity in playing the ratings game.

E-mail exchanges between analysts at “unnamed” ratings firms back this up. In one, an analyst said the firm’s ratings model didn’t capture “half” of the deal’s risk, but said that the security “could be structured by cows and we would rate it.” In a Dec. 15, 2006 missive, a manager wrote that the ratings industry was creating “[an] even bigger monster – the CDO market.”

Confided the manager: “Let’s hope we are all wealthy and retired by the time this house of cards falters.”

In July of this year, in testimony to Congress, SEC Chairwoman Mary Shapiro said she supported proposals to impose liability standards that would make it easier for investors to sue credit ratings firms. That’s a bit ironic given that the SEC is charged with supervising the ratings firms.

According to the internal investigation conducted by the Office of Inspector General, the SEC failed to exercise its duties as the nation’s watchdog of the same credit ratings firms that many large investors are forced to trust.

By law, certain investors must rely on the ratings of a handful of companies, known as  “Nationally Recognized Statistical Rating Organizations,” or NRSROs. In many cases, the NRSROs determine what are “eligible” or “appropriate” investments. And it’s the SEC that determines who is, or who can be, an NRSRO.

For instance, most state insurance regulators say that insurance companies can only invest in assets that carry one of the top four credit ratings. And it’s the NRSROs that certify those ratings.

Similarly, money-market funds can only invest in the highest NRSRO-rated securities.

Countless institutions – public and private, domestic and international – rely on rules that determine what assets are acceptable investments. And that acceptability is determined by financial due diligence and the resulting credit ratings – as determined by SEC-certified rating agencies.

It’s not clear that any of this is really protecting investors, according to a Feb. 15, 2008 “Review & Outlook” piece in The Journal. Drexel University Finance Prof. Joseph Mason took a look at CDOs that were “Baa” (an investment grade rating) by Moody’s. His finding: They were 10 times more likely to default than equivalently rated corporate bonds.

In that same article, an S&P spokesperson was asked if they actually examined the mortgage debt that made up the investment pools that make up a CDO.

The spokesperson’s answer was not confidence-inspiring: “We are not auditors; we are not accounting firms.”

News and Related Story Links:

• Money Morning Market Commentary:
  Fraud and Greed of Trusted Rating Agencies Helped Spread the Credit Crisis.
• The Wall Street Journal:
  Judge Limits Credit Firms’ 1st-Amendment Defense.
• The Wall Street Journal:
  
  Moody’s Stays in the Eye of the Storm.
• Wikinvest:
  
  Mortgage-Backed Securities.
• Investopedia:
  
  Collateralized Mortgage Obligations.
• USA Today:
  Ruling: Credit-rating agencies can’t use free-speech defense.
• Money Morning News:
  Career Regulator Mary Schapiro – a “Strong Investor Advocate” – is Reportedly Obama’s Choice for SEC Chief.
• Wikinvest:
  Structured Investment Vehicle.
• Wikipedia:
  First Amendment.

A new Federal Deposit Insurance Corp.  (FDIC) plan to offload busted banks to vulture investors strikes an uneven balance between private equity players and public taxpayers and may inadvertently sow the seeds for another round of bank failures.

The FDIC currently insures bank depositors up to $250,000 – up from $100,000 prior to the financial crisis. So far this year, 81 banks have failed, costing the FDIC an estimated $21.5 billion.

And the situation is almost certainly going to get worse.

A Growing List of Troubled Banks

The FDIC reported yesterday (Thursday) that the number of distressed banks rose to the highest level in 15 years during the second quarter, thanks to an economic malaise that’s saddling banks with a growing level of bad loans.

The number of troubled banks rose to 416 at the end of June from 305 at the end of March. The FDIC hasn’t had that many banks on its “problem list” since June 1994, when there were 434, the agency said. Assets at these troubled institutions totaled $299.8 billion – the worst level since the end of 1993, according to the FDIC.

The FDIC’s insurance fund, as of March 31, was down to its last $13.5 billion. Bank failures in the second quarter cost the insurance fund an estimated $9.1 billion. These hits were mostly offset by an emergency special assessment of $6.2 billion and an additional $2.6 billion raised as part of the regular quarterly assessment on FDIC-insured banks.

The FDIC just took another hit due to the recent failure of Colonial Bank, which cost the fund an estimated $2.8 billion, and the failure last week of Guaranty Bank, which cost an estimated $3 billion. FDIC Chairman Sheila C. Bair is determined to not have an insolvent FDIC turn to the U.S. Treasury Department to draw on a $500 billion line of credit set up for just this purpose, although that move is clearly inevitable.

In a fatalistic twist of irony, however, the FDIC’s demand for another special assessment in the fourth quarter and another expected special assessment in the first quarter of 2010 may tip several more banks into failure.

Although there seems to be a desperate need for private equity capital to come running to the rescue, the reality unfortunately isn’t that simple.

A Disappointing Decision

As most all consumers and investors know, the FDIC only covers insured deposits. However, the ongoing cost of a busted bank becomes higher for the FDIC if the agency cannot merge that failed institution with a healthy player, or can’t sell it outright. When The FDIC can’t find a willing partner or buyer, the agency must instead manage the “unwinding” of every failed bank’s stockpile of illiquid and toxic assets. With so many more banks in trouble and so many fewer banks willing to acquire additional suspect assets, private equity firms have offered to step up and buy failed banks these professional investors believe can be turned around.

On July 9, the FDIC published and sought comments on its “Proposed Statement of Policy on Qualifications for Failed Bank Acquisitions.” The controversial proposed policy statement suggested tough terms and conditions under which the federal agency would be willing to sell failed banks to non-traditional buyers – specifically, private equity firms.

A total of 61 comments were filed during the 30-day comment period – most of them from private-equity firms, their lawyers, financial-services trade associations and lobbyists. There were also comments from academics, four U.S. senators and six individuals. The FDIC also received 3,190 form-letter comments in support of the controversial proposal.

The FDIC issued its final decision on the matter on Wednesday. The new version was much weaker, once again underscoring the federal government’s proclivity for weakening banking regulations – a willingness we’ve repeatedly warned will have dire consequences for the U.S. financial system, as well as for the broader economy.

These alterations are setting the stage for an escalation in bank failures. The real losers will once again be the U.S. taxpayers, who will end up footing the bill for the FDIC’s failure to take a tough stand.
                                                                                               
How much weaker were the new regulations, when compared with the earlier proposals? In one instance, instead of the initially proposed requirement that new investors maintain a 15% Tier 1 common equity capital ratio – three times what traditional bank holding companies are required to maintain – the new entry hurdle is only a 10% ratio.

Private equity firms will be spared the requirement of other bank holding companies and will not be called upon as a “source of strength,” should their investment in a bank need shoring up.

Bank holding companies have to make their resources available if their banking operation requires support. But private equity companies don’t want to expose their vast pools of capital to any one investment. Just as Cerberus Capital Management LP refused to put any more money into its failed Chrysler LLC investment – leaving taxpayers to bail it out – firms are loathe to be put into a position to support a bank holding with anything more than what was deemed as a suitable capital investment at the outset.

The FDIC granted other compromises granted in favor of private equity buyers. For instance, the agency spared them from having to cross-guarantee their portfolio-bank investments – unless they owned at least 80% of two or more banks.

Getting “Real” About Private Equity

Private equity interests certainly didn’t get everything they wanted. For one thing, the final policy statement prohibits “insider” and “affiliated” loan transactions and strips firms of using a controversial “silo” structure to obfuscate ownership and control positions.

The final policy statement reads like the painful enunciation of a split decision in a controversial heavyweight title fight. The valiant efforts Bair, the FDIC chairman, to keep the howling wolves of private equity at the door and out of the banking henhouse were ultimately undermined by the rapidly dwindling coffers of the Deposit Insurance Fund, which brought the FDIC to its knees. The compromises in the final policy statement grant the private-equity crowd a lot of what it was lobbying for while only momentarily sparing the FDIC the embarrassment of being knocked out.

But make no mistake. That day of reckoning is on its way. And not even the entrepreneurially gifted private-equity set will be able to keep that from happening.

Let’s be clear: We’re not saying that the private-equity sector is made up of angels (angel investors, yes, but outright angels, no way). Indeed, as we’ve demonstrated in past columns, the private-equity set is actually a group of uber-capitalists who are hell-bent on turning their gargantuan ambitions into extraordinary wealth – and who aren’t above shopping for regulators or hardballing Congress to get what they want.

Private-equity players demanded – and got – the FDIC to agree to share whatever losses they might incur, whereby the government (meaning taxpayers) must bear the brunt of the losses incurred when risky loan pools are acquired.

In all fairness to private equity firms, acquiring banks also have loss-sharing agreements with the FDIC. But they are regulated entities and private equity firms are not. Nor will private equity firms willingly become regulated in order to buy banks.

And there are actually some advantages in having private equity investors acquire failed banks – including a host of issues that critics describe as “self-serving,” grousing that the private-equity benefits come only at a cost to taxpayers.

Given the new set of rules, private equity firms can swoop in and pick up failed banks by banding together and dividing the equity commitment and investment liability assumed upon purchase. If there is no recourse against other private equity firm assets or even any cross-guarantees against other acquired banks, unless they are 80% owned, the consortiums cannot be called upon and certainly not relied upon to be a “source of strength” for their depository, taxpayer-backed portfolio banks.

Regardless of any rules on self-dealing, as sure as “bank” is a four letter word, private equity firms will find a legal way to lend from their taxpayer-backed banks to leverage their other portfolio companies and extract their usual exorbitant fees. If they don’t lend to their own portfolio companies, they will surely lend to other private equity firms’ portfolio companies in a modified version of the “club deals” that bind them together. These firms have a mutual interest in generating deal fees and in controlling their lucrative franchises.

A Glimpse of What’s to Come

The problem with banks is that they became too leveraged. When they couldn’t amass assets on their books, against which they had to set aside “reserves,” they established “off-balance-sheet” vehicles to acquire leveraged pools of assets. They were leveraged inside and out.

But now the originators of the leveraged-buyout business model want to control taxpayer-backed banks, to apply another round of leverage to already crippled banks in order to squeeze out all the profits possible. Although this comes at a cost to duped and already drained taxpayers, regulators, legislators and the American public would be foolish to expect anything else from the private equity crowd. If the FDIC thinks it has a problem now, wait until the next implosion of leveraged banks happens.

In a comment letter to the FDIC on the original policy proposal, the Private Equity Council, an industry advocacy group, without recognizing the irony of its comment, suggested that mandating higher capital ratios for private equity buyers of failed banks would actually increase the risk at those banks because their owners would essentially have to employ more leverage to generate sufficient returns to meet the higher capital standards – while still generating returns high enough to satisfy the investors in their private-equity funds.

If that’s not an advance look at the next round of financial-sector problems we could be facing, we are deluding ourselves.

Private equity should be allowed to buy banks, but should also be held to a higher standard. They have a proven record of success at leveraging companies when they have access to cheap funding, and they also have a record of spectacular failures that resulted from their leverage. The last thing that American banks need – especially right now – is a hyper-aggressive management that leverages them to the hilt in order to generate “acceptable” rates of return for a select group of private investors.

Unfortunately, we’ve once again placed ourselves in a position where the viable solutions to the problems that were created will end up causing an entirely new set of problems – problems that always seem to provide a benefit to the old crony network while leaving the battered U.S. taxpayer as the ultimate victim.

We have no one to blame but ourselves.

More town hall meetings and more vocal opposition to being duped and used by Wall Street would be a good place to start.

[Editor’s Note: For more insights into the quandary facing the Federal Deposit Insurance Corp., check out this related story that appears in today’s issue of Money Morning. The story, accessible at no charge, can be accessed by clicking here.

A new offer from Money Morning seeks to eradicate some of the economic uncertainty that's emanating from the ongoing climb in U.S. unemployment, and actually represents a two-part bargain for investors. The reason: It offers the new best-selling investment book penned by acclaimed financial commentator Peter D. Schiff and a subscription to The Money Map Report newsletter, a sister publication to Money Morning. Schiff's new book - "The Little Book of Bull Moves in Bear Markets" - shows investors how to profit no matter which way the market moves, while our monthly newsletter, The Money Map Report, provides ongoing analysis of the global financial markets and some of the best profit plays you'll find anywhere. To find out how to get both, check out our newest offer.]

News and Related Story Links:

• Money Morning Commentary:
  
  By Dismantling Banking Rules, U.S. Government Has Guaranteed Future Financial Travails.
• Money Morning Commentary:
  By “Shopping” for Regulators, Private Equity Firms Have Discovered How to Buy Banks – Leaving Taxpayers With All the Risk.
• FDIC.gov:
  Official Web Site.
• FDIC.gov:
  Deposit Insurance Fund.
• CNNMoney.com:
  
  BB&T buys Colonial bank; 4 other banks fail.
• San Francisco Business Times:
  
  BBVA Compass buys failed Guaranty Bank.
• Yahoo Answers:
  What are Toxic Assets?
• Wikipedia:
  Tier 1 Capital.
• Federal Reserve National Information Center:
  
  Bank Holding Companies.
• BusinessDictionary.com:
  
  Insider Loan.

In just a few short years, exchange-traded funds have become the hottest item on the stock-market menu, with U.S. ETFs alone now holding more than $600 billion of investors’ money.

While that’s dwarfed by the $9.3 trillion managed by non-ETF mutual funds, exchange-traded funds have an allure that conventional funds seem to lack: In 2008, when the global financial crisis caused markets to nose-dive, investors still poured $176 billion into ETFs. Although the pace of investments have slowed this year, investors have still stashed $35 billion in new cash into ETFs – even as they yanked $49 billion out of conventional mutual funds, according to a recent report by Strategic Insight.

This popularity is understandable: ETFs trade like stocks, but can be used to target torrid markets such as China, or white-hot investing trends such as gold or commodities.

But ETFs have a dark side, too – involving risks that most investors probably weren’t aware of, but that government regulators are now investigating. Investors need to understand those risks, and make their future ETF-related investment choices accordingly.
The government inquiry could bring a lot of those risks to light.

CFTC Hearing: In the Spotlight, On the Hot Seat

In a hearing on Wednesday – in what amounted to a rare regulatory assault on speculators – the U.S. Commodity and Futures Trading Commission (CFTC) heard testimony from people who produce, manufacture and hedge commodities and commodities-based products. Among the targets of interest were several of the gigantic exchange-traded funds that allow investors to place bets on certain specific commodities, as well as on diversified, commodity-based indexes.

The CFTC oversees regulated futures exchanges and has been examining how those exchanges could dampen energy-price volatility, possibly by limiting the number of “futures contracts” that hedge funds, investment banks and other speculators can control. Wednesday’s hearing was the third the CFTC has held.

Commission Chairman Gary Gensler reiterated his view that the CFTC should “seriously consider” speculative position limits for energy futures trading. The agency plans to publish any rule proposals this fall.

But executives with the ETFs that invest heavily in energy commodities on Wednesday told the CFTC that that the funds were not the cause of the wild price gyrations experienced by crude oil and natural gas.

John Hyland, chief investment officer (CIO) for U.S. Commodity Funds LLC – an industry player with $3.9 billion in assets under management as of March 31 – was one of the big ETF players on the hot seat. Hyland is the CIO of both the United States Oil Fund LP (NYSE: USO) and the United States Natural Gas Fund LP (NYSE: UNG) – two ETFs that are among the largest such products in the world.

The executive said that ETFs provide market liquidity by helping buyers and sellers find each other.

“We believe that the significant increases in energy prices last summer were wholly unrelated to the activities of our commodity-tracking funds using the commodity futures market to hedge the exposure to investors that results from their obligation to track the price movement of a commodity,” Hyland said. “In fact, rather than acting as a source of risk, the funds provide investors with a transparent, highly regulated, unleveraged vehicle through which to hedge their pre-existing price risk in commodities.”

The U.S. Oil Fund peaked last February at just over $4 billion, and is now down to $2.4 billion. Oil’s sister fund, U.S. Natural Gas, stands at an even-larger $4.5 billion, and is pending approval from the U.S. Securities and Exchange Commission (SEC) to issue even more shares. The size of the funds points to increasing investor interest in energy-based ETF products – and possibly to the potential for increased volatility in the underlying price of both oil and natural gas.

As of last July, investors who bet on commodities – including the energy complex of instruments – had more than $300 billion directly invested just in index funds designed to track the value of commodity futures, reports the Paris-based International Energy Agency (IEA).
The question at the forefront of the CFTC hearings is whether all this interest is properly placed.

Last year, after oil zoomed upward to establish an all-time-record high in excess of $145 a barrel, a CFTC report attributed the near-vertical price escalation and accompanying volatility on supply-and-demand factors.

Walter Lukken, former U.S. President George W. Bush’s acting-CFTC chairman at that time, later testified to the House Committee on Agriculture that the CFTC “did not find direct evidence that speculation was driving up prices.”

According to The Wall Street Journal, CFTC Commissioner Bart Chilton dissented from the 2008 report, calling the data “deeply flawed,” as well as limited and unreliable.

“We didn’t have all the information we should have and we gave it to Congress anyway, and we spun it,” Chilton is reported to have said at the time.

Enforcement Turf War

U.S. President Barack Obama’s appointment of Gensler as new CFTC chairman began a turnaround at the agency. Addressing speculation in commodities from the CFTC’s perspective intersects with – and perhaps even conflicts with – the power and authority of the SEC squarely in the front yard of ETFs.

ETFs are governed by the SEC and generally come under the rules and regulations of the Investment Company Act of 1940. But, when it comes to commodity-based ETFs, the underlying instrument, or index being tracked, is considered the front yard of the CFTC.

When it comes to commodity-based ETFs, the CFTC and SEC have to work together, something that hasn’t happened in the past.

The problem with so many investors, or speculators, betting on oil and gas – be it directly, or through indexed benchmarks – is that in order for ETF funds to actually track a commodity or index, the funds’ operators must generally trade in the underlying futures markets to take positions that ETF investors are trying to emulate.

The problem with this entire exercise is that if there are finite amounts of a commodity being pursued by increasing amounts of speculative capital, what will happen to prices, and how will the ebb-and-flow of capital influence price volatility?

Sign up below… and we’ll send you a new investment report for free: “Credit Crisis Report.”

Investors vs. the Speculators

At the peak of 2008’s commodity grab-fest, the total notional market value of all U.S. commodity futures and options contracts was less than $1 trillion. According to Barron’s, “that’s less than the market value of just five oil companies, and far less than the trillions in speculative funds that could be invested in commodities.”

As interest in commodity investing and hedging and portfolio diversification increases, the lines between speculation and investing may become indistinguishable.

Placing position limits on institutions and traders transacting in the futures markets could go a long way to dampen excessive speculation, no matter how that’s ultimately defined.

But, it won’t solve the problem; in fact, it could increase volatility and boost systemic risk. The reason: ETFs can use complex financial instruments known as derivatives. These can include swaps (swap dealers are exempt from position limits), as well as highly customized exotic instruments – fashioned as private contracts – to mimic any commodity, commodity index, stock or stock index the ETF operator wants to track.

Investors Beware

For investors, the very proliferation of ETFs that makes them attractive to investors – because the explosion of choices makes it easy to play the trend of the day – also makes them highly risky. Not that there is anything wrong with ETFs. They are great – conceptually speaking. But so were mortgage-backed securities before they were sliced and diced into products with nuclear cores that melted down.

It’s one thing for an ETF to track a benchmark or any duly created “index” by actually holding the underlying stocks that make up that index (which isn’t always practical and often isn’t economical). But it’s quite another for the underlying instruments to consist of  derivative contracts.

The problem is with the derivatives. Someone actually takes the other side of these contracts and is expected to make good on them if they are called upon to make delivery on some underlying credit, real asset or cash. But, as we saw with Lehman Brothers Holdings Inc. (OTC: LEHMQ) and American International Group Inc. (NYSE: AIG), even the biggest counterparties with whom contracts are written may not be able to fulfill their paper commitments.

Then there’s the multiplier effect – a “daisy chain” of risk. When a “synthetic” obligation is created, it exposes the contracted party to risk. To mitigate that “paper” – but very real – risk, another derivative is often created to offset the initial contract risk, and then sold to another counterparty.

Wall Street loves ETF products because they have created another separate profit center for the insiders to rape and pillage. The cover is often explained as a healthy arbitrage that keeps the EFT universe of instruments trading near their net asset values. While that’s true, it’s a built in goldmine for the Street, which when it becomes tilted away from them will cost the markets and our faith in them to once again crumble.

It works like this: So-called “authorized participants,” or AP (read that to mean chosen relationships or Wall Street insiders), actually buy or create the underlying tracking portfolios, usually in 50,000-share packets known as “creation units.” The ETF sponsor engages in an “in-kind” swap, accepting the units from the AP in return for an equivalent amount of ETF shares. Finally, the AP, through their relationship outlets, sells the ETF shares to buyers, who bid for them on the exchanges.

The opposite can also happen. In a so-called “redemption,” only APs can buy back ETF shares and swap them for the creation units that are the actual underlying instruments.

When the shares of an ETF trade, for any number of reasons, at a discount or premium to their net asset value, or NAV, the APs rush in to “arbitrage” the difference. Buying or selling shares, and swapping them out on the other side to the ETF sponsors, theoretically drives the ETF price closer to NAV. There are billions of dollars to be made – chiefly by insiders, or those connected to insiders – in this exercise, which is why it’s become a business in and of itself. The more ETFs there are, the more locked-in arbitrage opportunities there are for the insiders. It’s brilliant. The problem, not just because I didn’t think of it, is that is skews trading-volume figures, creating a false sense of liquidity – and with that a false sense of safety.

Credit Suisse Group AG (NYSE ADR: CS) now estimates that ETFs account for a quarter of U.S. equity volume.

But now that you understand how this works, here are three obvious – and somewhat scary – questions to ask:

• How much then of the volume we presume to be available on a daily basis in our markets actually consists of ETF-related arbitrage-transaction volume, meaning it isn’t actually providing greater liquidity?
• And does that mean that our financial markets are actually in much worse shape than we realize?
• And, lastly, are the ETFs that retail investors employ to be safer than individual stocks in reality much-riskier instruments?

The questions will be answered – and the reality revealed – when a significant hitch occurs in the stock market’s trading mechanisms, an eventuality you can count upon seeing.

Back to the Future?

The New York Stock Exchange (NYSE: NYX) is already building a 400,000-square-foot fast-trade-hub on the site of an old rock quarry in New Jersey, where it will house the high-frequency-trading computers that are required in order to trade in microseconds (millionths of a second). And the reason – you guessed it – is to give traders a leg up on the arbitrage-type opportunities that the quickly expanding ETF universe continues to create. Regulators, specifically at the SEC, are worried that the glitches that such a rapid-fire-trading marketplace can create will generate systemic risk way beyond anything they can conceive of, let alone calculate.

On a more mundane level, leveraged ETFs and inverse ETFs have finally been fingered as the day-trading vehicles they really are – meaning that they’re inappropriate for the masses who bought them to “hedge” or increase their bets on a controlled basis. They don’t work as they were promoted.

Already, Edward D. Jones & Co. LP, Morgan Stanley Smith Barney (NYSE: MS), and The Charles Schwab Corp. (Nasdaq: SCHW) are steering customers away from these products. The Financial Industry Regulatory Authority (FINRA) has issued warnings and guidance for broker-dealers on determining suitability of these products for clients. And UBS AG (NYSE: UBS) has suspended the sale of leveraged, inverse and inverse-leveraged ETFs.

What may begin as an assault on speculators may very well end up being an assault on speculative instruments. If the end result of that exercise is that ETFs end up being scrutinized from every angle in order to assess their efficacy and the risk they pose to both investors and to the overall markets, we’ll all end up being the better for it.

Right now it’s probably a big revelation that ETFs – a growing favorite of the retail investor – is actually the latest wolf in sheep’s clothing bred by Wall Street.

Also surprising is that speculation isn’t the real problem here.

The problem is that – even after one of the worst financial crises we’ve seen since the Great Depression – Wall Street is still infecting the economy with suspect – and even toxic – instruments that make insiders rich while exposing the rest of the world to their infectious greed.

Let’s hope that the CFTC gets the ball rolling with the currently scheduled hearing, that the SEC follows up with an investigation of its own, and that Congress then steps in to keep this from happening all over again.

[Editor’s Note: As detailed look at popular exchange-traded funds underscores, the global financial crisis made the investing game much more tricky than ever before. has changed the rules of the investing game forever.

But don’t let that reality scare you way. The flip side is that the global economic recovery will create an estimated $300 trillion worth of global-investing-profit opportunities. To profit, you just need to know where to look.’

And for that, you need a guide. In a free Money Morning Webinar, Investment Director Keith Fitz-Gerald will detail the “$300 trillion global recovery” that will create some of the most profitable investment opportunities that we’ll see in our lifetime. Fitz-Gerald will outline this opportunity, as well as some specific companies global investors might want to consider. To find out more about this free Webinar, please click here.]

Also, two related stories that appear elsewhere in today’s issue of Money Morning further detail the controversies involving exchange-traded funds (ETFs). In one story, investors detail the profit potential they believe that ETFs continue to offer individual investors. To access that story directly, please click here. The second story details the results of a hearing from earlier this week, as well as the regulatory challenges that remain.]

News and Related Story Links:

• Money Morning Credit Crisis Investigative Series:
  The Inside Story of the Collapse of AIG.
• Commodity Futures Trading Commission:
  Official Web Site.
• ETFDailyNews:

  U.S. Commodity Funds LLC To Defend ETFs Wednesday Morning.

• Investopedia:

  total notional market value.

• Wikipedia:
  Arbitrage.
• Investopedia:

  Authorized Participants.

• Investopedia:
  Net Asset Value.
• The Wall Street Journal:
  NYSE’s Fast-Trade Hub Rises Up in New Jersey.
• Investopedia:

  Inverse ETFs.

• ETFDatabase:
  UBS Bans Leveraged, Inverse ETFs.
• Reuters:
  Funds to CFTC: Don’t blame us for energy price swings.
• The Wall Street Journal:
  Traders Blamed for Oil Spike

At its most basic level, the U.S. Federal Reserve’s so-called “exit strategy” is designed to let government bailout and liquidity programs unwind on their own, as markets return to a state of “normalcy.”

But what investors don’t realize is that without an exit strategy that includes plans for unwinding insolvent mortgage giants Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) – now more accurately defined as government-sponsored hedge funds – recent market gains will be limited and will likely reverse. If those setbacks cause the nascent U.S. housing market rebound to stall, it could even lead to a decade-long downturn.

And Fed Chairman Ben Bernanke’s exit strategy ignores Fannie and Freddie.

The Government-Sponsored (800 Pound) Gorilla

When the U.S. government – succumbing partly to pressure from foreign bondholders – last September forced Fannie and Freddie into government conservatorship, it essentially nationalized what amounted to the world’s two largest hedge funds.

Essentially, in the government-brokered deal, taxpayers bought senior preferred stock (with a 10% annual dividend yield) from Fannie and Freddie, which each received $1 billion in capital. Both firms were also granted a backstop guarantee worth $200 billion. In March, amid escalating fears that these arrangements wouldn’t provide enough support, an additional $200 billion of taxpayer muscle was added to the support pyramid.

Why are we supporting run-amok government-sponsored hedge funds?

Describing Freddie Mac – and especially Fannie Mae – as “aggressively competitive” is a lot like calling the Grand Canyon “a ditch.” Both firms use their special status as “government-sponsored enterprises” (GSEs) to borrow trillions of dollars in the public markets – at spreads just a couple of basis points above U.S. Treasury debt.

This GSE status induced investors throughout the world – including virtually every major government- to load up on Fannie and Freddie debt, since that nurtured the belief these institutions were backed by the full faith and credit of the United States. As it turned out, any doubt about the status of GSE backing was put to rest. The September 2008 Congressional Research Service (CRS) Report for Congress – titled “Fannie Mae and Freddie Mac in Conservatorship” – plainly states that “the U.S. Treasury has put in place a set of financing agreements to insure that GSEs continue to meet their obligation to holders of bonds that they have issued or guaranteed. This means that the U.S. taxpayer now stands behind about $5 trillion of GSE debt.”

By borrowing cheaply and stymieing any threatening regulation by means of dispensing payoffs from its $350 million Fannie Mae Foundation – as well as from a 10-year, $170-million lobbying effort – Fannie and Freddie eventually managed to leverage themselves at a ratio of 60-to-one. Both firms successfully glad-handed powerful legislators into granting them clearance to keep expanding their balance sheets: Eventually, the two firms accumulated more than $6 trillion in mortgage balance sheet assets between them. The explosion of debt and leveraged assets was even more troubling because it came against a backdrop of lower and lower capital, the result of an ongoing relaxation of capital requirements, the specific result of targeted campaign donations

From Mortgage Facilitator to Financial Market Predator

Fannie and Freddie – with the GSE status acting as a U.S. government imprimatur – had easy access to cheap capital, and a massive leveraging capacity that would be the envy of even the most aggressive private-sector hedge funds. Does any one remember Long-Term Capital Management?

Together these two factors enabled Fannie and Freddie to buy back massive amounts of their own securitized pools of mortgage loans and – in a brazen money grab – to purchase huge amounts of private-label, bank-pooled securities that didn’t have their own mortgage-borrower guarantees. The game was about juicing up net-interest income by using cheaply borrowed money to buy high-yielding “junk” mortgages.

Originally, the term “hedge fund” applied to managers of alternative assets who once actually “hedged” their portfolios. Not only did Fannie and Freddie fail to hedge their rising risk exposure to any meaningful degree, they were insanely non-diversified, because they held only one class of assets: Mortgage-backed securities.

Despite such ill-advised strategies, the executive echelon at Fannie and Freddie paid themselves like private-sector hedge-fund honchos. In the middle part of this decade, Fannie Mae was involved in an $11 billion accounting scandal in which shareholders were allegedly deceived and regulators stonewalled. The company “managed” (manipulated) its quarterly earnings to smooth out returns and impress stockholders enough to induce them to drive its stock price higher and higher – a gambit designed to trigger big bonus payments for top executives.

Once a Vice, Now a Habit

In last week’s “Semiannual Monetary Policy Report to the Congress“ and in his July 21 Wall Street Journal Op-Ed piece, Bernanke, the U.S. central bank chairman, laid out plans to wind down government credit extension programs and combat any potential inflationary pressures. What was not addressed was how – or even if – the two government-owned and operated de-facto hedge funds, with combined assets of more than $6 trillion, would be unwound, or whether they would remain in place as they are in order to be used as back-door fiscal and monetary policy tools.

In what amounts to more than just a bailout on an unprecedented and under-reported scale, the takeover of both Fannie and Freddie provides the Fed and the U.S. Treasury Department a super sponge to both guarantee new mortgages and absorb all the unwanted mortgage-backed securities that banks and non-bank originators package and need to offload.

Because they lack sufficient capital – or lack the appetite to hold any new mortgage paper on their balance sheets – banks need this government-sponsored outlet for the mortgages they want to unload. The Fed and the Treasury Department are using their taxpayer-supported hedge funds to grease the rusted wheels of the mortgage money machine to gain traction where there is none.

The Housing Market is the Key to an Economic Rebound

Without a rebound in the U.S. housing market, most economists agree that the overall U.S. economy has almost no chance for a resurgence of its own. In fact, barring a turnaround in housing, the best we can hope for is to have the U.S. economy just limp along for years. And the reality is that without a resurgent housing market, the outlook for the general economy is actually much, much worse.

The prospect for a housing recovery is predicated on an end to the ongoing slide in real estate prices, followed by sufficient availability of low-interest credit – as well as a buying public that’s willing to use that credit to buy new homes if the cycle isn’t likely to repeat itself.

In an uncertain real-estate environment Fannie’s and Freddie’s wholesale purchasing of new mortgage pools is the only hope the U.S. government has of stimulating and accelerating the velocity of mortgage money. These hedge funds are now indispensable fiscal and monetary policy levers.

Beware of the “Bear Trap”

Propping up teetering banks may serve to shore up near-term public confidence in the financial system. But it also destroys the same system by dislocating any meaningful capital-allocation strategy by extending the life of sick institutions that suck up scarce resources. What’s happening at Fannie and Freddie is no different – except that it’s happening on an exponentially more debilitating scale.

As the buyer of last resort, the U.S. government is letting its two hedge funds continue to borrow and leverage themselves to backstop the nation’s mortgage-origination market. The Treasury Department also is buying up any mortgage-backed securities that Fannie and Freddie don’t add to their own balance sheets.

Taxpayers are being duped into believing that the mortgage market is recovering and that money will be flowing when they decide it is time to buy homes again.

But there’s a big problem here: At some economic “inflection point” – a point that will come together very quickly if interest rates unexpectedly spike – losses at the “twin terrors” of Fannie and Freddie could spike into the stratosphere, as well, meaning the financial reality that we’re detailing here will necessitate another bailout, but on a scale we’ve yet to envision.

In the first quarter alone, Fannie lost $23.2 billion – its seventh-consecutive quarterly loss – and it drew another $19 billion from its government piggybank. The firm has a negative-net-worth of $18.9 billion.

Fannie Mae isn’t just insolvent, it’s dead – though its functions are being maintained by a federal-government life-support system.

Freddie Mac had a $9.9 billion loss for the quarter and drew $6.1 billion from the U.S. Treasury. Freddie’s 10% dividend to the government on the $51.7 billion it has drawn to date is costing it $5.2 billion a year – an amount that exceeds what it earned in nine of the last 10 years.

Investors should be afraid. While the “bear trap” hasn’t been sprung yet – it’s clearly been set. Recently trotted out earnings that only look good because they exceed analysts’ doomsday estimates are not going to override the reality that mortgage financing won’t be easy or cheap when buyers return en masse. Unless our government weans itself off its own tainted tonic – and makes a concerted effort to create a financially viable private-sector mortgage-origination and investment outlet – the U.S. stock market will remain weak for decades.

Two Moves the U.S. Government Needs to Make Now

Unlike the unworkable plan that Bernanke outlined last week, there is an “exit strategy:” that will work. Government leaders need to understand that bigger is not always better, especially in light of the concentration of risk and taxpayer exposure that’s been created by these government-sponsored hedge funds. This exit strategy consists of two key initiatives:

• Get Competitive Again: Break up all the big banks and create a greater number of highly localized, community-centric banks. Let community and regional bankers securitize pools of mortgages using transparent “conforming” disciplines, and force originators and lenders to keep skin in the game. Create national ratings standards and let originators pool strictly defined, varying-quality loans into properly labeled packages, and let investors determine their risk tolerances without being blindsided. Large loans can easily be syndicated across multiple banking institutions and large risk-taking, non-deposit-taking institutions – such as real hedge funds and private-equity companies that will constitute the new “equity merchant banks” – can do a better job of high-stakes lending.

• Bring Down the Curtain on Fannie and Freddie: It’s time to break up Fannie Mae and Freddie Mac. The government has proposed reducing their portfolios by about 10% per year, but that’s not happening. In an end-around maneuver, while Fannie and Freddie are being propped up and still growing, the government is buying mortgages through the Federal Reserve. Either way, taxpayers end up holding massive pools of mortgages that no one else wants. Doing away with the socialization of homeownership financing will put the market back in control of appropriating risk.

The bottom line is this: The only “exit strategy” we really need is to position ourselves to diversify risk and promote stable rewards by taking apart what history has proven to be too-big-to-control.

Shutting down sick banks and unwinding government schemes to mask illiquidity will be painful and would certainly stress the financial markets again. But those are short-term pains that will lead to meaningful long-term change. On our current path, we may be keeping things copasetic in the near-term – but in the long run we remain on a potential collision course with some painful periods that will be deep and drawn out.

• The old adage tells us that “those who forget the past are doomed to repeat it.” After the tragic financial travails of the past year or so, the last thing the U.S. economy needs is to spring a bear trap that results in a 10-year financial malaise. Let’s learn from the mistakes  of the most-recent past and make the changes needed to avoid this pending dour outcome.

[Editor's Note: For additional insights on Fannie Mae and Freddie Mac, please click here to check out this additional story, which appears elsewhere in today's issue of Money Morning.

A new offer from Money Morning seeks to eradicate some of the economic uncertainty that's emanating from the ongoing climb in U.S. unemployment, and actually represents a two-part bargain for investors. The reason: It offers the new best-selling investment book penned by acclaimed financial commentator Peter D. Schiff and a subscription to The Money Map Report newsletter, a sister publication to Money Morning. Schiff's new book - "The Little Book of Bull Moves in Bear Markets" - shows investors how to profit no matter which way the market moves, while our monthly newsletter, The Money Map Report, provides ongoing analysis of the global financial markets and some of the best profit plays you'll find anywhere. To find out how to get both, check out our newest offer.]

News and Related Story Links:

• Money Morning Investigation of the Banking Bailouts:
  Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout.
• National Park Service:
  Grand Canyon.
• Wikipedia:
  Government-Sponsored Enterprise (GSE).
• Answers.com:
  Full Faith and Credit.
• Congressional Research Service (CRS) Report:
  “Fannie Mae and Freddie Mac in Conservatorship.”
• The Washington Post:
  Fannie Mae Shuts Down Foundation.
• The Street Authority:
  Junk Bond Debt.
• Wikinvest:
  Mortgage-backed Securities.
• The Free Republic (2006):
  Fannie Mae Manipulated Accounting (Trading Halted).
• USA Today:
  Fannie Mae whistle-blower feels vindicated by SEC decision.
• Money Morning News Analysis:
  Economic Outlook Improves, But Unemployment and a Possible Jobless Recovery Remain Wild Cards, Bernanke Warns.
• Money Morning Special Investment Report:
  Four Ways to Profit if Bernanke’s ‘Exit Strategy’ Backfires.
• Money Morning Mid-Year Forecast:
  Bank Stock Outlook: Will First-Half Gains Give Way to Second-Half Pain?
• Wikipedia:
  Long-Term Capital Management?
• Money Morning Market Commentary:
  Equity Merchant Banks: The Financial Sector’s Profit Powerhouse of the Future.

Fannie Mae (NYSE: FNM), originally designated as a “government-sponsored enterprise” (GSE), was born in 1938 as a child of U.S. President Franklin Delano Roosevelt’s Great-Depression-fighting “New Deal,” and was designed to stimulate mortgage lending.

Fast-forward 30 years. In 1968, Fannie Mae shares were sold to the public to help finance the Vietnam War.

Freddie Mac (NYSE: FRE), also a GSE, was created by Congress in 1970 to compete with the growing – but monopolistic – Fannie Mae.

Both firms were successful, profitable and made steady money by charging a fee to guarantee mortgage-originators against homeowner defaults. Their combined guarantees totaled almost $3.7 trillion at the end of 2008.

They also developed high standards for loans that they themselves would buy and then package into mortgage-backed securities (MBS). They sold these pools of “conforming” loans to institutional investors and made even bigger profits as the MBS business exploded.

It all changed in the 1990s for Fannie and Freddie. Intensely competitive banks and investment banks aggressively rounded up their own pools of mortgage loans to package and sell to eager investors. Non-bank originators – the largest and most aggressive of which was Countrywide Financial Corp. (NYSE: BAC) – were eager to supply the growing demand for mortgages to be pooled and sold to investors

The resulting “velocity” of mortgage money meant that competition for good borrowers became tremendous as easy and cheap money flooded the economy. To keep mortgage origination pipelines full, standards began to fall. New products were created to entice new borrowers. Subprime, Alt-A, Pick-A-Pay, adjustable rate mortgages (ARMS), and a host of other offerings brought in lower quality borrowers who eagerly bet the farm their homes and their futures on the rising real estate bubble’s ascent to investment and speculative heaven.

 In the end, however, real estate was merely the latest financial bubble, which burst like all of its predecessors.

[Editor's Note: For additional insights on how Fannie Mae and Freddie Mac will short-circuit Fed Chairman Ben S. Bernanke's so-called "exit strategy," please click here to check out an additional story, which appears elsewhere in today's issue of Money Morning.

A new offer from Money Morning seeks to eradicate some of the economic uncertainty that's emanating from the ongoing climb in U.S. unemployment, and actually represents a two-part bargain for investors. The reason: It offers the new best-selling investment book penned by acclaimed financial commentator Peter D. Schiff and a subscription to The Money Map Report newsletter, a sister publication to Money Morning. Schiff's new book - "The Little Book of Bull Moves in Bear Markets" - shows investors how to profit no matter which way the market moves, while our monthly newsletter, The Money Map Report, provides ongoing analysis of the global financial markets and some of the best profit plays you'll find anywhere. To find out how to get both, check out our newest offer.]

News and Related Story Links:

• Money Morning Investigation of the Banking Bailouts:
  Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout.
• Wikipedia:
  Government-Sponsored Enterprise (GSE).
• Wikipedia:
  New Deal.
• WhiteHouse.gov:
  Franklin Delano Roosevelt.
• Wikinvest:
  Mortgage-backed Securities.

If Goldman Sachs Group Inc.’s (NYSE: GS) blowout second-quarter earnings demonstrated one thing, it’s that the new “equity-merchant-banking model” – the replacement for the Wall Street investment bank of pre-financial-crisis days gone by – is where financial-sector investors will make their money for years to come.

And there are two clear frontrunners that investors will want to watch – Goldman, and a second equity-merchant-banking firm that every financial-sector investor should take the time to know intimately.

Before we analyze both firms, however, it’s important to understand just why this transformation from investment bank to equity-merchant bank is taking place.

In the fall of 2008, succumbing to the raging inferno of the financial crisis, Goldman Sachs Group and Morgan Stanley (NYSE: MS) – the two survivors of what was once a cabal of insanely powerful and profitable investment banks – fell swiftly.

Goldman and Morgan, who had laughed off the failure of rival Bear Stearns Cos. and cheered the bankruptcy of even-more-powerful competitor Lehman Brothers Holdings Inc. (OTC: LEHMQ), weren’t so smug when remaining rival Merrill Lynch & Co. Inc. ran into the arms of Bank of America Corp. (NYSE: BAC). Fearing their own spontaneous combustion, the last two remaining full-service investment banks underwent an emergency U.S. Federal Reserve makeover, and emerged as bank holding companies. The objective: to be able to access the federal government’s capital and liquidity safety nets.

As risk-taking investment banks imploded, the overly aggressive use of leverage in an easy-credit environment left the private-equity sector reeling from a devastating one-two punch that some feared threatened the very future of that business: Not only are the private equity firms bruised and battered, many of their leveraged buyout target companies have been pummeled into bankruptcy.

While investment banks and private-equity shops were down for the count, they weren’t actually knocked out. Given this beating, however, it’s clear the two institutions will have to standardize their fighting styles, meaning that one day soon you won’t be able to tell investment banks and private-equity players apart.

But that won’t matter. Once transformed, this new type of institution will constitute the new “equity-merchant-banking class,” and may be the strongest green shoots to emerge from the financial firestorm they both helped ignite.

Some firms, like Goldman Sachs, will not miss a beat. In fact, Goldman is already building on its reputation as one of the greatest-money-making machines the world has ever known. For proof, just look at Goldman’s latest earnings, which are nothing short of spectacular.

Goldman’s Profit Picture

Goldman Sachs earned $3.44 billion for its fiscal second quarter, an all-time record for the company and a result that actually exceeded what it made all last year. Revenue from stock underwriting and from trading hit record levels, too, less than a year after Goldman accepted $10 billion in U.S. bank-bailout money.

Financial risk was clearly amped up and spreads on all the financial instruments Goldman trades and makes markets in were wide enough to drive a truck through, which means there was plenty of “low-hanging fruit” for the company’s traders to benefit from.

As a bit of a back-handed slap at the taxpayers that had lent the company the $10 billion when it needed it – and that gave it another $12 billion from the American International Group Inc. (NYSE: AIG) – Goldman set aside 33% more cash for compensation for its suddenly no-longer-struggling employees.

Land of the Giants?

Though the temple of Goldman Sachs fears no evil, for it finds so many of its former priests in the highest of positions across the fertile valley of American government. The bank spreads its message and money through its proselytizing army of lobbying angels, and there are heretics in the land who have not drunk the “Goldman Kool-Aid” and who are agitating for a reformation.

An upcoming congressional debate on financial regulation will be very telling, since it should allow us to see just how much influence Goldman has on the U.S. legislative process. Any discussion about how to deal with financial firms deemed ‘too big to fail” that doesn’t highlight Goldman serves as evidence of that final hardening of the mix of money and politics that cements our future.

Even if Goldman sidesteps the big question, other issues are percolating, including:

• Is Goldman’s compensation model the poster child for moral hazard, as it rewards a take-no-prisoners risk-taking approach to trading every instrument under the sun – and those in the shadows, too?
• Does Goldman enjoy too many “insider” perks, such as unrestricted position trading of energy and other commodity futures, and forward contracts and swaps – even though it is not a producer of any of the commodities it claims to need to hedge?
• Will it finally come to light that Goldman’s recently stolen “proprietary” trading software actually soaks up market liquidity and increases volatility for the rest of the investing public, while Goldman reaps vast rewards?
• Will Goldman be allowed to become a clearinghouse agent in the multi-trillion-dollar underworld of credit-default-swap trading, and be allowed to keep an eye on all its counter party trades?
• Will Goldman’s moneymaking and money-distributing machine be able to continue to grease its success in controlling American government?

Time to Call the Trustbusters?

With Congress diving into the swirling crosscurrents propelling both sides of the debate on all matters of financial regulation, anything can happen. For instance, there have been calls for a return to the good old days of Glass-Steagall, when commercial banks and investment banks were legally kept separate. One of those calls was made by Paul A. Volcker, the inflation-fighting hero and former Fed chairman who is now the chairman of U.S. President Barack Obama’s Economic Recovery Advisory Board.

And while the powers that profit from the status quo – including most of our legislators and politicians – may let their best ride on the bigger-is-better theory, if there is a push to separate commercial banks from their investment-banking counterparts, investors would do well to follow the spin-offs: It will be the investment banks that will once again have greater leverage latitude to rake in profits, while deposit-taking institutions will be heavily guarded from once again causing an explosion whose fallout debilitates both the Federal Deposit Insurance Corp. (FDIC) and the U.S. taxpayers.

The Looming Profit Picture

JPMorgan Chase & Co. (NYSE: JPM) reports its earnings today (Thursday), while Bank of America Corp. (NYSE: BAC) reports tomorrow (Friday). A close look at the two banks’ mixed revenue picture may show a rebound – if not underlying strength – in JPMorgan’s investment-banking and capital-markets business lines, and in BofA’s Merrill Lynch component. Morgan Stanley will be next up, and close scrutiny of its earnings will shed more light on how the old investment-banking model is faring in this post-credit-crunch environment.

The other equity merchant banks – the giant leveraged buyout (LBO) shops that, in the last market dust-up, got good public relations advice and began calling themselves private equity firms – are aggressively plotting their own next set of moves. They are having their troubles, but the largest and most powerful firms will end up seated at the pinnacle of the new financial-services-market pyramid right next to Goldman Sachs.

Investors might do well to watch the stock of one specific LBO shop as it morphs into a full-blooded equity merchant bank.

That player is The Blackstone Group LP (NYSE: BX).

A Player For Investors to Watch

In 1985, with a mere $400,000 in capital, former Lehman Brothers, Kuhn, Loeb Inc. Chairman and Chief Executive Officer Peter G. Peterson – along with Steven A. Schwarzman, Lehman’s former head of global mergers and acquisitions business – formed Blackstone. This duo of investment-banking heavyweights understood that in order to build a so-called “legacy” firm with real marketplace staying power they would have to populate the company with pedigreed descendants of other venerable banking, trading and political dynasties. And that’s just what the two Blackstone founders did.

Today, Blackstone Group is best known as one of the largest private equity shops in the world. What’s less well known is that Blackstone is much more than just your run-of-the-mill private-equity, LBO shop.

Blackstone is the prototype of the new equity-merchant bank.

Blackstone has four very lucrative business segments that are operated separately from a profit-and-loss standpoint, but still serve as an interconnected web of relationships, transactions, spheres of influence and future-profit-generating potential. The four segments consist of:

• The Corporate Private Equity Segment, in which Blackstone uses pooled money gathered from pension, insurance, endowment and sovereign wealth funds, as well as other institutional sources. This unit had first-quarter revenue of $68.4 million, a major turnabout from negative revenue of $193.6 million for the fourth quarter of 2008.
• The Real Estate Segment, which invests directly and indirectly in U.S., European and so-called “special-situation” real-estate transactions through a series of funds. The troubled real estate business had negative revenue of $211.9 million for the first quarter of 2009, compared with negative revenue of $477.8 million for the fourth quarter of 2008, and positive revenue of $47.9 million for the first quarter of 2008.
• The Marketable Alternative Asset Management Segment, also known as MAAM, which utilizes proprietary hedge funds, funds of funds, closed-end mutual funds, mezzanine debt financing, and senior and subordinated debt investment vehicles. MAAM had revenue of $99.5 million in the first quarter, following negative revenue of $55.7 million for the final quarter of last year.
• The Financial Advisory Services Segment, which consists of three distinct – but overlapping – businesses: Private Placement Advisory, Restructuring and Reorganization Advisory, and Corporate and Mergers and Acquisitions. This unit has demonstrated some substantial potential of late. Revenue was $92 million for the first quarter, up 29% from the first quarter of 2008, but down 13% from the fourth quarter of last year. Net-fee-related earnings from operations were $24.7 million for the first quarter of 2009, an increase of $22.1 million from the first quarter of last year and an advance of $3.9 million from last year’s final quarter.

It won’t be all roses and champagne for Blackstone in the near future, as even Hamilton E. “Tony” James, Blackstone’s president and chief operating officer recently lamented, “the underlying economy continues to decline and the timing of a turnaround is still uncertain.”

While it’s entirely possible that neither the financial markets nor Blackstone may seen their fortunes soar anytime soon, when the recovery finally does take hold, and capital is flowing more freely again, Blackstone could lead the market in a steep upward ascent.

Near-Term Challenges Abound

In the meantime, however, Blackstone and its private-equity brethren – indeed, the entire private-equity sector – could be facing a host of challenges that essentially amount to another potential reformation movement.

The McKinsey Global Institute and data provider Preqin recently reported that private equity assets under management totaled $1.2 trillion last year, up from $900 billion in 2007.

But there’s bad news. In 2009, fundraising is down an estimated 78% to a projected annualized total of only $89 billion, the McKinsey and Preqin report states. Nearly 43% of assets under management, or some $535 billion, has not been committed to deals. The good news about all that “dry powder” is that it can be put to work to buy distressed and already-discounted assets at their cheapest point. But the bad news is that without easy credit and the ability to leverage debt, all that capital will have a hard time generating the types of returns that private-equity investors signed up for.

 Institutions that commit capital to private equity funds typically allocate a set proportion of their total capital pool to the leveraged-buyout alternative asset category. As their own investment portfolios have shrunk due to the financial collapse, their allocation to private equity now exceeds their intended allocation limits.

In an exquisite irony, however, private equity firms are now beginning to mark down their portfolio companies so deeply that the value of the holdings of their institutional investors is once again below their allocation limits to private equity. That means it’s going to be hard for investors to beg off when private equity firms come calling on their institutional investors to ask for additional capital infusions.

But this irony is creating a backlash from some institutional investors that may ultimately change the way investors commit capital to private equity.

Another issue facing Blackstone is a push by the Obama administration to end the practice of “carried interest,” which allows general partners to not have to “mark-to-market” and have their unrealized profits taxed as ordinary income, but lets them carry their profits until portfolio holdings are sold so that they can then be taxed at the 15% capital gains rate. Even so, as we’ve seen with the reformist attempts aimed at Goldman Sachs, many of the attempts to crimp Blackstone and its big private equity brethren will be pushed back by the powerful machinery of these mega-wealthy financial juggernauts.

With all the potential new regulatory propositions, tougher capital requirements and compensation restrictions hanging over commercial banks, equity-merchant banks like Goldman and Blackstone will have more room to move, more institutional participation through their separate fund vehicles and far greater growth potential in such areas as:

• Mergers-and-acquisitions dealmaking.
• Corporate reorganization businesses.
• Investments in distressed assets.
• Fee-based investment-banking services.
• Capital markets trading.
• Leveraged buyouts.
• Direct investments in public companies.
• And private placements.

If they are not sliced and diced as a result of the upcoming congressional regulatory battles, both of these equity merchant giants will be investor favorites for years to come.

[Editor's Note: In a market as uncertain as the one investors face now, it helps to have a guide. And the ideal guide is The Money Map Report, the monthly investment newsletter that's a sister publication to Money Morning. In fact, a new offer from Money Morning is a two-way win for investors: Noted commentator Peter D. Schiff's new book - "The Little Book of Bull Moves in Bear Markets" - shows investors how to profit no matter which way the market moves, while our monthly newsletter, The Money Map Report, provides ongoing analysis of the global financial markets and some of the best profit plays you'll find anywhere - including such markets as Taiwan and China. To find out how to get both, check out our latest offer. ]

News and Related Story Links:

• Money Morning News Analysis:
  Goldman Sachs Reports Record Earnings, but Financial Sector Far From Out of the Woods.
• Bloomberg News:
  Goldman Sachs Posts Record Profit, Beating Estimates.
• Wikipedia:
  Too Big To Fail.
• Money Morning Market Commentary:
  Here’s Why It’s Time to Ban Credit Default Swaps.
• Wikipedia:
  Economic Recovery Advisory Board.
• Money Morning Market Analysis:
  How Deregulation Eviscerated the Banking Sector Safety Net and Spawned the U.S. Financial Crisis.
• Wikipedia:
  Paul A. Volcker.
• Wikipedia:
  Private Equity Firms.
• Wikipedia:
  Leveraged Buyout.
• PrivateEquityOnline:
  Blackstone Fund VI raises $8 billion.
• Answers.com:
  Carried Interest.
• Money Morning News Analysis (Part I of II):
  Will the Dark Cloud of Commercial Real Estate Blot Out the U.S. Recovery?
• Money Morning News Analysis:
  By Relaxing “Mark-to-Market” Rules, Has the U.S. Switched Off its Financial Crisis Early Warning System?

Just when you thought the U.S. banking system had regained its footing, the reality is that a carefully woven federal-government PR campaign may actually be masking the next phase of the worst financial crisis since the Great Depression.

Indeed, it’s what’s just out of sight that has some analysts and economists scared to death.

To rebuild public confidence in America’s ailing banks the government has greased the system’s liquidity wheels, directly injected capital, backstopped and guaranteed loan facilities, lowered banks’ cost of funds, changed accounting rules to make balance sheets look better, bestowed passing grades on high profile stress tests and then allowed the propped-up (but still not healthy) banks to pay back government loans.

Analysts and economists question whether this race to instill confidence will outpace rising unemployment and lagging economic data, or will trigger the next phase of the global financial crisis if shaky banks end up snapping borrower lifelines.

The big confidence game began with a single “relief” program. Now, many of the titanic banking system’s torpedoed institutions are remaining afloat only because of some rescue programs developed by the U.S. Federal Reserve and U.S. Treasury Department. Deemed absolutely necessary to prevent total financial collapse at the time of their hasty implementation, the legacy of these programs will be their indiscriminate reinforcement of weak links in the banking system and the acceptance of moral hazard.

The Trouble With TARP

The granddaddy of all these rescue plans – the Troubled Asset Relief Program, or TARP – is a $700 billion program that was originally designed on fewer than four pages, and that was sold to Congress as a plan to buy toxic assets from sick banks.

That never happened.

Once passed, TARP immediately morphed into a direct-capital-infusion system for banks, allowing them to meet regulatory capital requirements and stay afloat. A wide variety of other relief programs followed. There were programs to backstop the commercial paper market, money market mutual funds, and issuers and purchasers of various asset-backed securities. There was a mortgage-relief initiative. And now there is even a re-constituted public-private partnership plan – worth between $1 trillion and $2 trillion – that is supposed to buy toxic assets from the same banks that still hold them.

With all the government backstopping going on directly and indirectly behind the scenes, what remains to be seen is whether the banks can succeed without the federal government cheerleading the public into believing that these institutions are actually standing on their own feet – when, in reality, many are still on their knees.

Without these plans, many banks would certainly be on their last legs.

Underlying all the relief programs, the U.S. Federal Reserve has done everything in its power to keep interest rates low – especially the benchmark Federal Funds Rate, the rate at which banks borrow from each other on an overnight basis.

One of the positive signs being pointed to lately by government public relations spinners is the positive net interest income being earned by banks. What they don’t point out is that it’s only as positive as it is because the government is artificially keeping banks’ “cost of funds” low through a 0.00% Fed Funds Rate policy, and by continuing to grease every lever of liquidity to keep funding cheap. What’s eventually likely to be overwhelming will be the impact on net interest income when artificially cheap funding dries up, interest rates rise and commercial-paper and money-market spigots are not gushing funds like they did before the global financial crisis took hold.

The combination of capital injections, relief programs and low interest rates was designed to work together to facilitate liquidity in the vast interwoven system of institutions and markets that makes business and finance possible. Banks are the singular linch-pin in the system, without whose proper functioning the entire system would seize up.

And yet, in spite of all that was being done to keep the banking system afloat, it was still sinking.

Rock-Paper-Scissors

Not unlike the children’s game rock-paper-scissors, the Fed’s scissors that were used to cut out impediments to liquidity were smashed by the falling Rock of Gibraltar – namely the continuing erosion of trust in crumbling banks, to the point that only by papering over losses at banks could the game be won. 

With a strong push from lobbyists, legislators threatened to make legal changes to accepted accounting standards. With a nod of approval from the highest government powers attempting to triage ailing banks, legal changes weren’t necessary. Instead, two amendments to U.S. Generally Accepted Accounting Principles (GAAP) were hastily approved by the Financial Accounting Standards Board (FASB):

• The first of the two amendments gave guidance to assist preparers on how to determine whether a market is not active and a transaction is not distressed, which provides allowances for sidestepping mark-to-market rules and essentially allows internal modeling of asset values.
• The second amendment provides a neat trick that facilitates changes in the recognition and presentation of other-than-temporary impairments on debt instruments. In short, if you don’t want to declare losses in full view of the public, stick them in a walled-off section of your financials where you can pretend that they are going to be held to maturity and paid back in full. Scissors beats paper in the children’s game, and in the case of banks the scissors of any sharp accountant will eventually shred the paper façade that’s masking huge losses.

Not content to try and get the public to merely notice things might be getting better, the federal government PR machine decided that bank stress tests would provide definitive proof that progress was being made. The result of the much-ballyhooed stress tests was, indeed, effective. The announcement – more like a pronouncement – proclaimed the system sound, saw a strengthening of institutions in general and only pointed to a few laggards.

But in a recent Bloomberg Markets article entitled, “Stress Management,” Janet Tavakoli, president of Structured Finance Inc., told writer Yalman Onaran that “the Federal Reserve, which designed the stress tests, used a 21% to 28% loss rate for subprime mortgages as a worst-case assumption. Already, almost 40% of such loans are 30 days or more overdue.”

Tavakoli predicts defaults actually might reach 55%.

Positive Earnings or Positive Spin?

The release of the stress-test results coincided with some strong first quarter financials from banks. The markets rallied amid fertilized talk of “green shoots” and the actual arrival of spring. Now that’s really good PR. Too bad, like a lot of PR, it was managed to look that way.

Using the accountant’s scissors embedded in Onaran’s Bloomberg Markets article, Citigroup Inc. (NYSE: C) picked up 25% of its 2009 first quarter net income from a debt securities accounting rule change. It subsequently increased its loan-loss provisions more slowly – even as more loans were souring. Without the accounting changes Citi, would probably have posted a net loss of $2.5 billion for the quarter, concluded Martin Weiss, founder of the Jupiter, Fla.-based Weiss Research. Inc.

Weiss also found that “the new standards let Wells Fargo (NYSE: WFC) boost its capital $2.8 billion by reassessing the value of some $40 billion of bonds, and augmented net income by $334 million because of the effect of the rule on the value of debts held to maturity.”

In June, in a McKinsey Quarterly piece, writersLowell Bryan and Toos Daruvala are even more outspoken about the problems that accounting rules are masking, stating, “It might seem odd that accounting methodologies can make such a big difference. At the end of the day, what counts is the net present value of the cash flow from each asset, but those are unknowable until after a debt is repaid. Fair-value accounting, based on mark-to-market principles, immediately discounts assets when the expectation of a default arises and ability to trade the asset declines. Fair value therefore makes the holder of the asset look worse, sooner. Hold-to-maturity accounting works in reverse and makes the holder look better for a long time.”

Looking Good is All That Matters

Why would 10 banks on the edge of the financial abyss only a few months ago want to pay back $68 billion in government bailout money when they have:

• No idea what the future holds for them?
• Or if they’ll need to make a return visit to the taxpayer-filled rescue trough?

And why would the government, after all its bluster, let them pay the money back, especially in the face of a firestorm about extraordinarily excessive executive compensation at those same institutions?

Because it’s all about looking good.

It’s part of the PR spin to make banks look healthier than they are. And it just might spin out of control.

You can put lipstick on a pig, but you can’t make a silk purse out of a sow’s ear. Instead of admitting the depth of systemic risk we’re facing from teetering banks and making the hard decision to shut some of them down or break them up once and for all, the federal government would rather pretty up the picture to try and convince us to open our purses again and more-quickly recharge our consumer-driven economy.

The danger in this government PR campaign to make banks look healthy is that if another meaningful economic bump rattles consumer confidence in a banking system the government says is safe, the resulting fear of a separate reality might engender a run on banks that would make the Great Depression look like a walk in the park.

News and Related Story Links:

• Money Morning Special Investment Report:
  Money Morning’s Bank Stress Test Says These Three Banks Are the Strongest.
• About.com:
  Confidence Game.
• About.com:
  Moral Hazard.
• Wikipedia:
  Troubled Assets Relief Program.
• Money Morning News Analysis:
  Motivations Abound for Federal Reserve’s Delayed Release of Bank Stress Test Results.
• Wikipedia:
  Toxic Assets.
• U.S. Federal Reserve:
  Federal Funds Rate.
• WiseGeek.com:
  Cost of Funds.
• Wikipedia:
  Rock-Paper-Scissors.
• Wikipedia:
  Generally Accepted Accounting Principles.
• Wikipedia:
  Financial Accounting Standards Board.
• Financial Accounting Standards Board:
  Determining Fair Value of a Distressed Security.
• Financial Accounting Standards Board:
  Other-Than-Temporary Financial Impairments.
• Money Morning News Analysis:
  By Relaxing “Mark-to-Market” Rules, Has the U.S. Switched Off its Financial Crisis Early Warning System?

With its regulatory overhaul of the U.S. financial system, the Obama administration has granted the federal government new powers to take over systemically important businesses, but has done so in a way that may well mask a potentially dangerous drift toward American state capitalism.

The administration’s 88-page “white paper,” released last Wednesday (June 17), goes a long way in identifying most of the weak links in the regulatory chain that was supposed to protect America from a financial freefall. But, as always, the devil is in the details.

In 85 of those 88 pages, extensive fixes are put forth in an attempt to create additional financial institution transparency, to bolster consumer protections and to enhance supervisory oversight. But, in fewer than four of those pages, without any detail, the white paper calls for a  “regime” to “provide for the ability to stabilize a failing institution by providing loans, purchasing assets from the firm, guaranteeing the liabilities of the firm, or making equity investments in the firm.”

The blind spot in the need to create such a “regime” if it isn’t intentional – is the missed assumption that all of the reforms supposed to constitute “A New Foundation” will still not be enough to arrest the failure of systemically important firms. The black spot on the administration and legislators’ records may ultimately be their complicity in not breaking up so-called “too-big-to-fail” institutions, Instead, the current and past administrations and elected officials coddled these firms and allowed them to continue to grow in both size and influence, to the point that they became large enough and important enough – as well as frail enough – to end up as assets in an American-style, taxpayer-funded sovereign wealth fund.

A Threat to the Economy’s Free-Market Foundation

Democratic capitalism – the foundation of our economic system – has two inherent characteristics that, if left unimpeded by government interference, result in almost-certain economic success. The first is the ideal of free markets and the other is the notion, popularized by Austrian economist Joseph Schumpeter, of creative destruction. Building from the foundation is a straightforward process: Free markets will themselves engender creative destruction, maximizing the ability of innovative entrepreneurs to destroy the hegemony of existing companies by creating and delivering new and better products and services to a free-to-choose public. Government coddling or the takeover of failing institutions destroys both of these foundational principles.

Keeping our eyes on the prize necessitates not impeding free markets or the process of creative destruction. And while prudent regulation is absolutely necessary to check and arrest the ever-present bad seeds from choking our field of dreams, allowing the pendulum to swing too far in the direction of government control subjects the democratic capitalist model to attack by socialist influences. And that assault is already underway.

In the face of financial devastation in America and throughout the world, government intervention has been a welcome intrusion meant to lessen the pain of lost savings, foreclosed homes, violated security, broken dreams and the horrendous fear that many of us will never rise out of the hole created by the implosion of trusted systems we rely upon for our way of life.

The danger now is that welcoming the seeming suave of government intervention may embolden some misguided politicians and the vested-interest big-government/big-money crowd to permanently corrupt our once free markets. Government intervention has the potential of destroying the creative processes by undermining entrepreneurs and small businesses to protect an emerging and quickly growing portfolio of government-controlled assets.

If it’s not intentional, why does the administration’s regulatory reform package lead us directly down this path?  By leaving in place discredited supervisory bodies and the failed regime of ineffective regulatory officers and soldiers, does the assured future failure of protected and coddled firms signal a policy paradigm shift towards more government intervention, control and ownership of giant, systemically important firms? Are we headed towards a more socialist economic model?

I brought these concerns to Bill Singer of BrokeAnd Broker.com, a partner at powerhouse law firm Stark & Stark, a veteran regulatory lawyer, staunch advocate for the rights of smaller broker-dealer firms, registered persons and defrauded investors, and a regular commentator on television and Forbes.com panelist.

“Look, I’d love to rail against creeping socialism and state capitalism, and you may well be right – that may be the sad legacy,” Singer said. “While it would be expedient to say that I don’t like it (and, frankly, I truly don’t), I like the concept that someone, somewhere has a cord to pull in the event of an emergency – the problem is whether there is anything at the end of that line when it’s pulled, or whether it merely sets off a series of contingency steps that will only reach some final stage long after the harm is done.”

When Too-Big-To-Fail Becomes Too-Big-To-Succeed

Whether it is an intentional shift towards a more socialist economic model, or the drift from the fallout of well-intended government assistance to save jobs, firms or industries, there’s an easier, more familiar and well-proven path that should be cleared and undertaken. Start by looking backwards. If too-big-to-fail firms constitute systemic threats, don’t allow firms to get too big. It really is that simple. There is no need and no place for socialist tendencies in this country if we already know that free markets create a level playing field for all willing participants and then take steps to make sure that they are not crowed out by vested interests that are backed and protected by the government.

Regulatory reforms must ensure that free markets remain free. Part of what’s necessary is to reform the tendencies of firms to overdo the concept of economies of scale. Bigger isn’t always better if it crowds out the processes of creative destruction, the drain in the tub that can overflow and undermine the floor and foundation of democratic capitalism.

It was big banks, big super-regional banks, big investment banks and big mortgage originators that deposited us into the economic sinkhole in which we’re presently mired. Community banks and small loan originators didn’t conceive of the weapons of mass destruction, but they were forced to compete with the big brothers of business by engaging in many of the same practices and investments as a way to remain competitive or be destroyed by the sprawl of bigger, bolder, and badder brethren. Why not disallow firms to get so big they swallow or destroy all competition?

To those that argue that larger and better-capitalized foreign firms will command the high ground, I say nonsense. If we want to compete with outsized international firms, we already have a mechanism to do that. For example, banks already syndicate large loans. By having even more banks participate in syndicated loans, it spreads the credit risk across a wider array of institutions. And maybe if our automotive industry hadn’t been allowed to get so large and cumbersome, we’d have more auto firms offering more innovative products and supporting a more robust industry of manufacturers, dealers and suppliers.

There’s a Way, But is There the Will?

Of course, without being overly protectionist, prudent legislation and regulation could easily control the sprawl of overly ambitious monster foreign interests. As politicians look at the power and potential of sovereign wealth funds, there may well be an inclination to compete with them by facilitating America’s own version of such a fund. Without enunciated exit plans from the asset control and ownership now enjoyed by the U.S. government, we’re going to move in that direction. A U.S. sovereign wealth fund can carry another name – state capitalism.

By keeping the old guard on duty and only giving them new binoculars, we may well see the next set of failures on the horizon – but will be powerless to stop them. Whether intended or unintended, the result will be the destruction of free markets and entrepreneurship.

We would do well to express our outrage at the prospects of such an outcome long before the debate goes behind closed doors and we end up with an oligopoly run by a cadre of self-serving officers.

Or, as best put by Singer, the veteran regulatory attorney: “Unless we are prepared to clean house – to purge ourselves of the majority of politicians now in power and to substantively overhaul the boards of directors of most public companies into meaningful, hands-on overseers, then we’re just deluding ourselves,” he said. “This isn’t merely a battle to re-start American capitalism; it is a battle for the heart and soul of our way of life.  While it would be popular to suggest that we still have a fighting chance, I think we also need to wonder whether we have the political will to implement the wholesale changes that are necessary.”

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News and Related Story Links:

• Money Morning News Analysis:
  Obama’s Financial System Overhaul Would Give the Fed Broad Powers Over Wall Street.
• Money Morning News Analysis:
  Wall Street vs. Main Street: The Regulatory Battle Begins Tomorrow.
• Wikipedia:
  U.S. Too Big to Fail Policy.
• Money Morning Economic Forecasting Series (2008):
  Outlook 2008: Three Ways to Profit From Sovereign Wealth Funds – the “Next Wall Street”.
• BusinessDictionary.com:
  Free Markets.
• Wikipedia:
  Joseph Schumpeter.
• UCSB.edu:
  Joseph Schumpter/Creative Destruction.
• Wikipedia:
  Socialist Economic Model.
• RRBDLAW.com:
  Bill Singer Bio.
• Economist.com:
  Economies of Scale.