14:   The Multi-frauds of Risk Management have Begun Unravelling

William Krehm

Much of this issue of ER is devoted to the frauds of risk-management that in several areas of the economy have begun coming apart. One of these is the Canadian federal budget process that has been based on the belief that in government, hiding assets – a criminal matter in the private sector – is an aid to virtue. At the end of the year, some of these can then be trotted out as proof of the finance minister’s "fiscal responsibility."

Private corporations have used unregulated derivatives – trades in an abstract feature of a security which is unregulated and can be kept off the books – to create the illusion of more demand for the security itself. These derivatives may deal in interest earned, or the exchange value of the currency in which the underlying security is denominated, in calls or call options or swaps in trades of these abstractions ("swaptions" is only a simpler sample of what is becoming the best rewarded high technology of our period).

Another such – the hedge funds that originally were the happy hunting ground of billionaires – are now being used by more modest investors who have cashed in their profits during the aging boom market. They have also become a favorite haunt of overextended banks that by their own admission are unloading much of their bad debt on unwary modestly wealthy folk who don’t know what to do with their winnings. Bankers are coming clean on such matters, since their consciences have been sensitized by the revelations of New York state prosecutor Eliot Spitzer. His subpoenas have achieved costly settlements by some of the greatest names of insurance for using derivatives "to aid their own results with the complex techniques that they pioneered and marketed over the past 20 years. Insurance has moved beyond its core business of insuring against fires and earthquakes" to the damage by artificial overheating and tremors of their own making.

As a result, our leading Canadian bankers have moved in closed rank from opponents of regulating derivatives to supporters of the idea. Canada’s banks have reached humiliating settlements running into several hundred millions of dollars for having participated in the off-balance sheet partnerships of Enron.1

The change of heart of our bankers on the subject of derivative regulation has not come inexpensively for the Canadian taxpayer.

The Risks of Risk Management

We should make clear that we are not against risk management as such. Like personal virtue it is much to be commended but devilishly difficult to achieve. Partial success towards the goal can certainly be reached by such policies as deficit budgeting by government so that during a recession a heightened degree of government spending for necessary capital purposes will help keep employment and economic activity higher. However, the risk management encouraged by hedge funds and other large financial corporations has precisely the opposite effect. It adds wind and bluster to the financial bubbles and increases the violence of the busts.

The Wall Street Journal (15/02, "Spitzer, SEC subpoena AIG over complex deal accounting" by Theo Francis) wrote:

"American International Group Inc., fresh off settlements with the US Justice Department and the Securities and Exchange Commission for its role in allegedly helping their earnings with complicated financial products for its own possibly illegitimate purposes.

"The New York insurance giant yesterday disclosed new subpoenas from New York Attorney-General Eliot Spitzer’s office and the SEC. They seek information related to certain types of insurance arrangements ‘and AIG’s accounting for such transactions,’ the company said.

"AIG added that it received the inquiries just after it reported its fourth-quarter earnings last Wednesday and seemingly closed the book on two regulatory inquiries that have lingered over it for months.

"The new subpoenas show regulators’ mounting interest in a line of insurance products that was obscure just 16 months ago. But since regulators were caught off guard by the billions of dollars of loans that have targeted financial services firms that allegedly aid corporations in financial machinations, Enron filed for bankruptcy court protection in December 2001.

"Specifically, the subpoenas relate ‘to investigations of non-traditional insurance products and certain assumed reinsurance transactions and AIG’s accounting for such transactions,’ AIG said.

"Many non-traditional insurance products blend insurance with financing. Regulators believe the products can allow users to inappropriately shift losses from the buyer’s balance sheet, aiding the bottom line in the short run while misleading shareholders and regulators.

"Last fall, AIG settled allegations that it had helped PNC Financial Services Group Inc., a Pittsburgh banking company, improperly shift liabilities off its books, and that it helped Brightpoint Inc., a Plainfield, Ind. cell phone distributor, cover up losses using a bogus insurance policy. AIG agreed to pay $128 million in penalties and other costs but neither admitted nor denied wrongdoing.

"Separately, Mr. Spitzer’s office has named the company as a participant in a bid-rigging scheme with other major insurers and insurance broker Marsh & McLennan Cos.; two former AIG employees have pleaded guilty in that scheme, but AIG said last Wednesday that it had found no indication of wrongdoing outside the single unit in which those individuals worked.

"Some of the complex ‘alternative risk’ transactions that regulators are looking into across the industry allow insurers to compensate for reserve shortfalls in the short run by seemingly transferring risk for these reserves from one insurer to another.

"AIG has long been one of Wall St.’s favourite insurance stocks, known for its steady earnings growth in an industry where results typically are banged around by everything from hurricanes to adverse developments in asbestos litigation."

The classic insurance worries may be put in the shadows by the risks of being too successful in the new jungle of derivatives technology.

William Krehm

1. In his The Last Science of Money – the Mythology of Money – The Story of Power Stephen Zarlenga succinctly explains the fraud: In 1688 Joseph de la Vega, a Jewish stockbroker in Amsterdam, wrote a book called Confusione de Fonfusiones which gave a detailed roadmap of how manipulators could launch a bear campaign (to lower prices), outlining 12 stratagems for the purpose. One had to do with "ducatoons" – the equivalent in abstract value to one tenth of the value of a Dutch East India Company (DEIC) share. "The ducatoons were a monthly phenomenon with the old ducatoons redeemed and a new series each month. They attracted smaller investors and speculators. Readers familiar with modern stock index futures will immediately see the ducatoon was similar to a stock index future, except that it was based only on one company, and for one month at a time, whereas stock indexes are based on an index of many companies, and future expirations are more extended. [Like trading in stock indexes today] such trading is structurally defective because it allows the price of an item [the ducatoon, or index future] to be artificially determined by the supply and demand of an entirely separate item. Hence selling it does not artificially create a future demand, as would the shorting of a share of stock, while the sale of just a ‘derivative’ of the stock fails to do. The resulting manipulation and cheating is made possible by the fact that the dependent contract is settled for cash rather than by the delivery of the underlying item."

-- from Economic Reform, April 2005