Shedding Some Light on the Department of Justice's CDS 'Markit' Investigation

For those who are intimidated by the complexity of the esoteric $59 trillion credit default swaps market (CDS), let me explain in raw layman’s terms the likely nature and significance of the Department of Justice’s antitrust inquiry into Markit, a company owned by more than a dozen Wall powerhouses including Goldman Sachs (GS) and JP Morgan (JPM): The DOJ wants to know whether Markit’s owners manipulated the company’s pricing data and index formulation to enrich themselves and screw their customers.

If the Obama Administration has the conviction and political temerity to investigate and prosecute the wrongdoing the DOJ suspects, it could forever change the “heads I win, tales you lose,” way the big Wall Street firms do business and could result in billions of dollars in fines and restitution, not to mention possible jail sentences.

Although no one has yet been accused of any wrongdoing, having cut my teeth at the Federal Trade Commission litigating antitrust cases (including the one that attacked “Big Oil’s” price-fixing scheme), I can say with considerable authority that the DOJ hasn’t opened this investigation merely on a hunch. The potential for wrongdoing is enormous because Markit determines the critical month-end pricing that major financial institutions use to “mark” their CDS securities; Markit also compiles critical indexes and the company’s Wall Street owners could benefit greatly if they have input on how these indexes are compiled and weighed.

Even those with unlimited charity in their hearts should find it difficult to give the big Wall Street firms the benefit of the doubt. There are countless examples of these firms putting their interests ahead of their customers. In 1996, NASDAQ market makers settled an antitrust case for more than $1 billion because they were artificially widening the spread on stock trades so they could pocket additional commissions. Wall Street’s manipulation of the IPO market during the dot.com boom provides yet another example. And let’s not forget Wall Street’s rigging of the auction rate securities market.

It’s one thing to launch an investigation, having the political will to see it through is another. Wall Street’s influence in Washington is immeasurable and there is some disturbing evidence that Congress and the Fed serve at the pleasure of Goldman Sachs and not the other way around. The financial consequences Markit’s owners could suffer is immense if wrongdoing can be found and proven.

Wall Street firms have long regarded regulators as mere gnats that can easily be swatted away. If the DOJ aggressively investigates and pursues this investigation and holds the big Wall Street firms criminally and financially accountable for any wrongdoing, President Obama will have indeed made good on his pledge to achieve “Change We Can Believe In.”

Comments

[Moon Kil Woong:]

Sadly the results of these investigations are alwayssettled for some amount of money which is less than the skim and without anyone acknowledging guild. In fact, often times, it doesn't even result in a change in law or business practices to prevent future abuses. Within a few months all parties are back to their usual behavior abet a little more cautious about getting caught. After all, giving up 25% on your ill gotten gains is still a good enough incentive to avoid getting caught red handed again.

Jul 17 05:30 AM

[morph366:]

"If the DOJ aggressively investigates and pursues this investigation and holds the big Wall Street firms criminally and financially accountable for any wrongdoing, President Obama will have indeed made good on his pledge to achieve “Change We Can Believe In.”

I'm not holding my breath on this.

Jul 17 05:38 AM

[socrateazz:]

As with any regulations. The regulations make certain actions wrongdoing. Wrongdoing is in the eyes of the person affected. every action can be concidered wrongdoing by some people. If a regulation affects me negatively then it is wrongdoing to control. Is taxing to gain revenue wrongdoing? Is threatening the loss of the most needed government needs while supporting fluff by politicians wrongdoing? Is supporting groups which act illegally for manipulative reasons by politicians wrongdoing? The financial system does have people who act wrongly and somme control is needed. But you expect people who manipulate propaganda and want to continue to manipulate beliefs to actually come up with truely fair solutions! I do not expect it! Good luck with your so called improved regulations. Have you not seen what government writes as regulations? could they be written more clearly and concisely? Are they? Why? The less clear any bill is the more it can be manipulated or reinterpreted to suit those wanting change. Or used to cover up reality. Fix problems by creating different problems for others. Is that not the result of most regulations? can you name one regulation brought forth recently that was all help to all people? does not exist!

Jul 17 07:32 AM

[John Lounsbury:]

Let me give my simple minded view of how the CDS scheme went astray. It is a great oversimplification, but let's consider two firms: A and B. The firm A sees a chance to make some easy money by selling a credit guarantee to B. After all, B is a AAA super bank with great profitablilty. So A agrees to sell a guarantee of $100 billion of B's debt issuance for five years for a 5% premium. In A's mind, B can never suffer defaults more than 2 or 3% based on historical records, so this is $2 -$3 billion free money.

Now B sees that it no longer has any exposure for default on $100 billion so it goes right out and places another $100 billion in loans and debt based securities to maintain its max leverage position. By paying $5 billion to A for "insurance", B has enabled another $25 billion (or more) of income over the next five years. The market for placing high quality debt has been degraded by all the debt issued previously, so the new debt is issued to lower quality borrowers.

With the system now stretched, defaults start to increase. The defaults depress economic activity, which triggers more defaults. The historical limit assumed by A is exceeded and soon A has no more assets to back the CDS guarantees. That leaves B with double the leverage they assumed existed after buying the CDS protection. All this happens in a market that exceeds the historical pattern maxima for defaults. And the valuation of the still performing assets must be written down to reflect continuing growth of defaults. Once the dam is broken, A & B are swept under by balance sheets that show massively negative net worth. They are insolvent and the negative net worth is falling further in cascades as defaults continue to accumulate.

Now, the accounting community comes to the "rescue". They say that accounting rules can be changed so that future defaults can be assumed non-existent. Recognize the value that assets would have if debt performance continued at the levels of the past quarter. That improves the balance sheets because the financial institutions can always assume things will never get worse than what they have been. This doesn't improve anything unless the economy improves and defaults actual melt away. Otherwise, the day of reckoning is simply postponed.

Was any of this illegal? Maybe something illegal will be found, but, in my opinion, it was the absense of law that allowed this to happen.

Jul 17 03:13 PM

[Swashbuckler:]

IMO----The DOJ would never be allowed to pursue the investigation of the big Wall Street firms. The investigation would be killed before it went public. There would be talk behind the scenes, such as "the investigation may jeopardize the integrity of the markets, which must be maintained at all costs...." or other similar bullsh#t rationalization in order to keep the status-quo intact. Oh, there would likely be a payoff or two behind the scenes to make the problem disappear, but disappear it would.

Jul 17 03:44 PM

[MutantCapit...:]

The malfeasance of Markit owners extends well beyond the Sherman Act deep into netherworlds of financial engineering and market manipulation.
In 2006 Markit rolled out the ABX.HE Index, a vehicle for subprime CDS that went far beyond commonly accepted risk management
with participants at times utilizing 100x leverage.
www.forbes.com/2007/08...
It is no surprise that Markit's ABX.HE index was the creation of Wall Street traders, employed by Markit's owners, major Wall Street investment banks.
www.bloomberg.com/apps...
What may come as a surprise to some is the extent of complicity between Markit owners and subsidiary mortgage servicing units which these investment banks rushed to acquire in recent years. It is epidemic mortgage servicing fraud that not only fed Markit's ABX CDS frenzy, mortgage servicing fraud and insider knowledge of it rigged these bets. To give an idea of how widespread mortgage servicing fraud is, the following 2 FTC settlements involved only 2
well known mortgage servicers and yet the combined victim classes exceeded 367,000 victims.
www.ftc.gov/os/caselis...
FTC v. Fairbanks/SelectPortfo...
www.ftc.gov/os/caselis...
FTC v. EMC/Bear Stearns
There were no fire walls between trading desks and subsidiary servicers who fabricated bogus defaults, "credit events" that subprime shorters could cash in CDS bets on. Just as mortgage REITs comprising ABX series were selected every 6 months in informal meetings with a Goldman Sachs' managing director, they were also targeted for mortgage servicing fraud.
DOJ needs to look at REITs that fed Markit's ABX beast, tracing them back to servicers' loan files where they will see servicer manufactured defaults, then find out who, higher up in this food chain gave servicers their orders and who placed all the CDS bets rigged with this insider knowledge. (Well, I think we know who did that.)
There is no doubt Markit has become a cartel tightly controlled by its Wall St. owners but it goes so much deeper. DOJ needs to investigate criminality behind thes bets on Markit indices.

Jul 17 11:39 PM

[Mike Dillon:]

First, I'm one of those 281,100 FTC-certified victims of Fairbanks/SPS that Mutant Capitalism cited above. USA/Curry v. Fairbanks happened in 2004 ($55M in exchange for admitting no wrongdoing...$40M divided by 280,000 is what?) and Mortgage Servicing Fraud has been around far longer than that. Quite possibly right back to early 90's when Dime Savings Bank imploded - if not sooner. FTC v. EMC/Bear happened in 2008. 86,000 victims split $28M if I remember correctly. Apparently, USA/Curry wasn't the "deterrent" that it was heralded to be by the FTC, HUD and other regulatory agencies.

Until the phrase "without admitting wrongdoing" is stricken from legal dictionaries, neither any of what DOJ may find nor the civil repercussions will have any meaning. Until criminal charges are brought, civil "penalties" will be viewed as nothing more than the cost of doing business - especially as long as the perpetrators (perpetraitors?) can tap into D&O and/or E&O insurance policies to cover any financial settlements.

We're beginning to see obvious signs of potentially intentional malfeasance in the industry via a recent case in NY involving Deutsche and MERS (surprise, surprise). So is it REALLY that much of a stretch to think that the rest of the gang was/is in on it?

foreclosuredefensenati...
"Significant in the ruling was the court’s observation and question as to why, 142 days after the borrower was claimed to be in default, that MERS would assign a “toxic” loan to Deutsche Bank. The court also required a satisfactory explanation, by sworn Affidavit, from an officer of the securitized trust as to why, in the middle of “our national subprime mortgage financial crisis”, Deutsche Bank would purchase from MERS, as alleged “nominee”, a nonperforming loan. The court further inquired as to whether Deutsche Bank violated a corporate fiduciary duty to the note holders of the securitized mortgage loan trust with the purchase of a loan that had defaulted 142 days prior to its assignment from MERS to the trust.

It appears that Deutsche Bank may have done so to take advantage of one or more “credit enhancements” inside of the securitized mortgage loan trust which pay benefits upon declaration of default. These credit enhancements are extremely complicated and multi-layered, and are required by law in connection with the issuance and sale of the mortgage-backed securities “backed” by the trust.

The assignment of the mortgage and note to the securitized trust, which were already in default well in advance of the assignment, would permit Deutsche Bank to both realize a profit through payment of credit enhancement benefits (which effect a pay down of the claimed “default”) while simultaneously permitting Deutsche Bank to institute a foreclosure, resulting in a “double dip” for Deutsche Bank. This is, of course, illegal, but unless competent counsel raises the issue, it goes unnoticed and Deutsche Bank, like so many other foreclosing parties, winds up stealing the borrowers’ property and getting paid for doing it. "

Jul 18 02:08 AM