Updated: Jan 23, 2021
New York | Across the financial world, readers of The Institutional Risk Analyst know very well, there seems to be a growing incidence of fraud and chicanery, this as the rate of interest paid on securities falls. The “bezzle,” what John Kenneth Galbraith described as the “inventory of undiscovered embezzlement,” is contracting along with the cash flow from financial assets.
The European Central Bank is threatening to place limits on leveraged loans even as interest rates in Europe sink further negative. Do you think anyone at the Fed or ECB understands the connection between low interest rates and financial fraud? More than merely shifting risk preferences, low or negative interest rates create a seller's market for bad securities and, worse, nothing at all.
The shrinkage in available plunder causes those living on the edge of propriety to develop ever more devious and complex games. Technology enables this wastage as do the pressing needs of the criminal world. And the ability of policy makers and regulators to keep pace with the new scammers is similar to the situation facing online security vendors. The perpetrators are just a little faster and certainly better motivated.
Bitcoin: Money for Nothin'
Our favorite game in recent years has been bitcoin, the first and only “independent” crypto token that also is a technologically enabled fraud. People exchange legal tender dollars or other currencies for, well, the equivalent of a bus token or lottery ticket. The value of bitcoin is based entirely upon the existence of a greater fool who will give you a thing of value in the future in exchange for this token. But not all bitcoin is bought for value, as we discuss below.
Proponents of bitcoin point out that the exchange of tokens is independent of a biased political issuer like the Federal Reserve System or Bank of Japan. Yet the fact that other tokens issued by various entities around the world, particularly the shadowy Tether, can be used to buy bitcoin renders the market susceptible to manipulation. Tether is under investigation by the New York State attorney general’s office.
In a must read post on Crypto Anonymous (H/T Dick Hardy), the enormous scale of the role of Tether in bitcoin price movements was described (“The Bit Short: Inside Crypto’s Doomsday Machine”). As the author stated:
“The upshot: over two-thirds of all Bitcoin — $10 billion worth of it — that was bought in the previous 24 hours, was being purchased with Tethers. What’s more, this pattern wasn’t unique to Bitcoin. I saw the same thing for all the other popular cryptocurrencies. It seemed I’d been wrong to dismiss Tether. Tether wasn’t just in the crypto markets — Tether was the crypto markets.”
The graphic above illustrates several groups of fraud victims, but the group to the right of the bitcoin market seem to be the most leveraged. At the very least, Tether seems to be the single largest source of liquidity flowing into bitcoin and other currencies. But what is Tether?
Many of the users of bitcoin may believe that their market is protected from manipulation because of the use of blockchain and algorithms, yet this post suggests that both bitcoin and the other, downstream cryptos are being manipulated via Tether. And offshore, the author suggests, leverage as high as 100:1 is available on some crypto markets and with zero KYC. This makes Tether and other "issuer" cryptos perfect vehicles for money laundering.
This apparent manipulation of bitcoin by Tether is significant, in our view, because US regulators have differentiated between “independent” markets such as bitcoin and other cryptos such as Tether, which to us look like issuers of securities, securities that are being issued and trade in apparent violation of US law.
The technological differences of bitcoin vs other crypto tokens seem to lack any meaningful distinction in light of the role of Tether, de facto, in setting bitcoin prices. Tether reportedly accounts for some 70% of flows into crypto. This suggests perhaps that the SEC and FINRA ought to have another look at the entire bitcoin/crypto ecosystem. Maybe our pals in the financial media who have become advocates for bitcoin ought to look again as well.
Q: Is the Tether/bitcoin/crypto chain the biggest fraud in recent human history? Maybe. But hold that thought.
Recapitalizing the GSEs
There are, of course, many types of games. Some are concealed by technological complexity as with bitcoin and Tether, but others are hidden in plain sight, under the warm blanket of public policy and legal arguments that are unfamiliar to professional managers and analysts much less individual retail investors.
Consider the case of Fannie Mae and Freddie Mac, two companies that were once thought to be private but in fact never left government control. An “incomplete sale” imputes fraud conclusively, according to the US Supreme Court almost a century ago. The shareholders of the GSEs are the victims of an ancient fraud committed half a century ago by members of Congress during President Lyndon Johnson's Administration.
But more recently, the long-suffering shareholders of the GSEs were victims of a new deception, this perpetrated by Wall Street funds and investment houses. These well-informed professionals floated the twin theory that 1) the US Treasury would magically forgive the more than $200 billion taxpayers have invested in the GSEs and 2) that Treasury Secretary Steven Mnuchin would then release Fannie and Freddie from government control.
Neither of these statements were ever really true, but a number of individuals and firms made repeated written and verbal declarations that the GSEs would be returned to shareholder control. These false statements to investors were reported extensively in the financial media, but were rarely challenged by journalists or regulators.
Federal Housing Finance Agency Director Mark Calabria participated in this grotesque act of manipulation of retail investors. In fact, neither Secretary Mnuchin nor Director Calabria ever had the authority to forgive this $230 billion in money owed to the taxpayer. As with General Motors (NYSE:GM), Citigroup (NYSE:C) and American International Group (NYSE:AIG), the Treasury must be repaid for moneys advanced to any private entity.
Veteran Washington analyst Isaac Boltansky at CompassPoint put the situation in concise perspective for his clients last week:
“At the highest level, the agreement allows GSE capital retention up to the regulatory minimum capital, including buffers, outlined in the recently released GSE capital rule. Under that rule, as of 2Q20 the GSEs in aggregate would have been required to hold $283B in adjusted total capital. In return for allowing GSE capital retention, the liquidation preference of the Treasury Department’s senior preferred will increase on a dollar-for-dollar basis until the minimum capital requirements are met. As a matter of context, the liquidation preference of the UST's aggregate senior preferred position already stands at $228.7B.”
In the latest agreement with the Treasury, the GSEs will be allowed to retain more than $200 billion in capital, but the existing private shareholders are diluted further as the Treasury’s preferred equity stake grows towards a nominal half a trillion dollars. Of course, the GSEs will never be worth more than about $200 billion, so the new transfers to the GSEs engineered by Mnuchin and Calabria represent a future loss to the Treasury.
The change in the capital retention of the GSEs is an act of fraud on the taxpayer. The Treasury is no longer paid for the credit support provided to the GSEs. The fact of more capital retained by the GSEs will not affect the “AAA” credit standing, which is entirely a function of government ownership. As funds are transferred to the GSEs, the government gets more preferred shares -- but no additional value for the taxpayer.
“Treasury officials said Thursday they were unwilling to significantly restructure the government’s senior stakes in the firms, now valued at roughly $230 billion, saying the issue should be subject to further study,” reports Andrew Ackerman of The Wall Street Journal. “That move effectively means it will be up to a Biden-led Treasury Department to tackle the question. Reducing the stakes was a longtime goal of private shareholders that would put the companies on a path to exit government control eventually.”
Not only was the promise of wiping out the GSE debt to US taxpayers never a real possibility, the idea of “releasing” Fannie Mae and Freddie Mac to private ownership was likewise never practical or possible. In the post-Basle III and Dodd-Frank world, without direct credit support from the US Treasury, the GSEs would be downgraded by the major credit rating agencies and quickly collapse. Without a “AAA” credit rating, the GSEs have no reason to exist.
Of course, the retail investors in GSE common and preferred shares have no more understanding of federal finance than do policy wonks and professional investors. But the question we have is why has the SEC taken no notice of the erroneous puffery regarding GSE stocks? Retail investors who purchased GSE common and preferred shares reliant upon the numerous false statements made regarding repayment to the Treasury and/or release from conservatorship may have a cause of action – and perhaps a better legal case going after the Wall Street actors than suing the federal government.
The moral of the story is that as easy ways to invest prudently dry up, investors are forced to look ever harder for acceptable returns – and may be more vulnerable to frauds like crypto currencies and promoters of penny stocks like the GSEs.
As investors load up on more and more low-cost leverage on less and less real assets, it seems appropriate to ask how this will all end. Perhaps the situation was summed up best by our friend Jim Rickards in “The New Great Depression,” his timely book about the post-COVID world. “The veneer of civilization is paper-thin, and the paper is now torn,” he writes.