Total Return Swaps Fraud

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

The NY Times
By RIVA D. ATLAS

January 9, 2004

The New York State attorney general and the Securities and Exchange
Commission are investigating whether some large banks financed improper
mutual fund trades by hedge funds.

The financings being investigated, which involved total return swaps,
are reminiscent of the sort of transactions done by bankers on behalf of
the Enron Corporation
<http://www.nytimes.com/redirect/marketwatch/redirect.ctx?MW=http://custom.marketwatch.com/custom/nyt-com/html-companyprofile.asp&symb=ENRNQ>
to conceal debt and artificially inflate earnings, regulators said. In
both situations, the banks appear to have been "knowingly aiding and
abetting a securities violation," said Stephen M. Cutler, director of
enforcement at the S.E.C.

David D. Brown IV, head of the Investment Protection Bureau under the
New York attorney general, Eliot Spitzer, and the point person on its
mutual fund investigation, said, "This is the next big focus of our
investigation."

Among the banks whose transactions are being studied are Bank of America
<http://www.nytimes.com/redirect/marketwatch/redirect.ctx?MW=http://custom.marketwatch.com/custom/nyt-com/html-companyprofile.asp&symb=BAC>
and the Canadian Imperial Bank of Commerce
<http://www.nytimes.com/redirect/marketwatch/redirect.ctx?MW=http://custom.marketwatch.com/custom/nyt-com/html-companyprofile.asp&symb=BCM>,
people briefed on the investigation said.

C.I.B.C. reached an $80 million settlement with the commission last
month for its role in setting up vehicles that allowed Enron to hide
debt and inflate its profits by more than $1 billion and its operating
cash flows by almost $2 billion.

Neither Mr. Brown nor Mr. Cutler would comment on any specific subjects
of their investigation.

A spokesman for the Canadian bank said it would "not comment on
speculation." A spokesman for Bank of America said that the bank
announced in October that it would no longer do business with hedge
funds involved with improper mutual fund trading and that it continued
to cooperate with regulators. He declined to comment on the regulators'
latest area of interest.

Regulators are examining whether derivatives trades allowed hedge funds
that were engaged in improper fund trading to expand greatly the size of
their bets, Mr. Brown said.

In some instances, the banks set up accounts that were one-third backed
by hedge funds engaged in the improper trading, with the remaining
two-thirds backed by the banks themselves, Mr. Brown said. In return,
the hedge funds agreed to pay a specific interest rate on the bank's
capital.

The hedge funds were essentially betting that they would earn a greater
return on their mutual fund trades than the rate that they had promised
the banks. This trading is known as a total return swap and allowed the
hedge funds to produce greater profits on smaller investments.

The hedge funds routed mutual fund trades by these accounts through
brokerage firms or other third parties. Many trades were processed after
the market closed but at an earlier price, a process known as late-day
trading, Mr. Brown said. This form of trading is illegal, regulators
have said, because traders could take advantage of information available
after the close.

For at least one of the banks being investigated, "this was a major
business," Mr. Brown said. There is evidence that the banks, through
their own due diligence, knew that the hedge funds were engaged in
illegal trading, he added.

C.I.B.C.'s name surfaced in a suit filed in November by the commonwealth
of Massachusetts against former brokers and managers of Prudential
Securities who regulators say made many improper fund trades. Prudential
had trading arrangements with two hedge funds, Head Start and Chronos
Asset Management, referred to it by C.I.B.C., the suit said. The bank
provided financing for Chronos, the suit said.

Derivatives trades by Bank of America tied to improper fund trading were
described in the settlement reached in September between Mr. Spitzer and
Canary Capital Partners, a hedge fund managed by Edward J. Stern. The
trades described in that complaint relate to another form of derivatives
trading, which involved selling a portfolio of securities mimicking the
holdings of the mutual fund, which would protect the hedge fund against
a loss if the fund's value declined.

But Bank of America may also have arranged total return swaps, according
to a person briefed on the bank's activities.

Many banks provided some form of derivatives financing for hedge funds
engaged in frequent trading of mutual funds, said Frank Partnoy,
professor of law at the University of San Diego who was a derivatives
salesman in the mid-1990's. "Every derivatives desk had good order flow"
from these sorts of trades.

I wrote in Asia Times: im May 2002:

Total return swaps (TRS) can make short-term dollar loans (liabilities)
appear as portfolio investments. Also, the requirement to
meet margin or collateral calls on derivatives may generate sudden,
large foreign exchange flows that would not be indicated by the amount
of foreign debt and securities in a nation's balance of payments
accounts. As a result, the balance of payments accounts no longer serve
as well to assess country risk.

In the event of a devaluation or a sharp downturn in securities prices,
derivatives such as foreign exchange forwards and swaps and TRS
functioned to quicken the pace and deepen the impact of the crisis.

Derivatives transactions with emerging market financial institutions
generally involve strict collateral or margin requirements. Asian firms
swapping the TRS on a local security against LIBOR were posting US
dollars or Treasury securities as collateral; the rate of
collateralization was estimated at around 20 percent of the national
principal of the swap.


If the market value of the swap position were to decline, then the East
Asian firm would have to add to its collateral in order to bring it up
the required maintenance level. Thus a sharp fall in the price of the
underlying security, such as would occur at the beginning of a
devaluation or broader financial crisis, would require the Asian firm to
immediately add dollar assets to their collateral in proportion to the
loss in the present value of their swap position. This would trigger an
immediate outflow of foreign currency reserves as local currency and
other assets were exchanged into dollars in order to meet their
collateral requirements. This would not only quicken the pace of the
crisis, it would also deepen the impact of the crisis by putting further
downward pressure on the exchange rate and asset prices thus increasing
the losses to the financial sector.

The BIS "Lamfalussy Report" defined systemic risk as "the risk that the
illiquidity or failure of one institution, and its resulting inability
to meet its obligations when due, will lead to the illiquidity or
failure of other institutions". Similarly, contagion is the term
established in the wake of the Asian financial crisis of 1997 to
describe the tendency of a financial crisis in one country to adversely
affect the financial markets in other, and sometimes seemingly
unrelated, economies. It is the notion of systemic risk taken to the
level of national and international markets.

The presence of a large volume of derivatives transactions in an
economy creates the possibility of a rapid expansion of counterparty
credit  risk during periods of economic stress. These credit risks might
then become actual delinquent counterparty debts and obligations during
an economic crisis. The implication is that even if derivatives are used
to reduce exposure to market risk, they might still lead to an increase
in credit risk.  For example, a bank lending through variable rate loans
might decide to reduce its exposure to short-term interest rate
variability, thus the volatility of its income, by entering into an
interest rate swap as the variable rate receiver. If short-term rates
were to rise, then the fair market value of the bank's swap position
would rise, and thus would increase the bank's gross counterparty credit
exposure above that already associated with the loans which were being
hedged.

In so far that derivatives increase counterparty credit exposure
throughout the economy, they increase the impact of one entity becoming
unable to fulfill its obligations. And to the extent that derivatives
are not used to reduce firms' exposure in the market, then the greater
leverage brought to speculative investments increases the likelihood of
such a failure. In this way, derivatives contribute to the level of
systemic risk in the financial system.

The presence of derivatives can also increase the global financial
system's exposure to contagion by the international nature of markets.
Many derivatives involve cross-bred counterparts and thus losses of
market value, and credit rating in one country will affect counterparts
in other countries. The second channel of contagion comes from the
practice of financial institutions responding to a downturn in one
market by  selling in another. This demand for collateral assets can be
sudden and sizable when there are large swings in financial markets, and
thus this source of contagion can be especially fast and strong.

The process of policy formation was much more straightforward in the
wake of the 1980s' debt crisis. The borrowers were mostly governments,
and the private lenders were the large money center banks. This meant a
single representative borrower for each debtor country was therefore
represented by a single borrower, and the key lenders could  be gathered
into a single room. Together with the relevant multilateral
institutions, all the parties could negotiate a plan to restructure
debt payments.

The policy making process became much more complicated in the 1990s.
There were many different private and public debtors and issuers of
securities. There were many investors and many different types of
claims on parties in the affected developing countries. Capital flows in
the form of stocks, bonds and structured notes meant that there were
hundreds of major investors and millions of lesser investors. These
claims were all the more complicated because of derivative contracts.
Derivatives added to both the number of potential counterparts and
raised problems as to who held the first claim on outstanding debts and
other obligations.

http://www.atimes.com/global-econ/DE23Dj01.html


Warren Buffet in the Berkshire Hathaway 2002 Annual Report:

Indeed, in 1998, the leveraged and derivatives-heavy activities of a
single hedge fund, Long-Term Capital Management, caused the Federal
Reserve anxieties so severe that it hastily orchestrated a rescue
effort. In later congressional testimony, Fed officials acknowledged
that, had they not intervened, the outstanding trades of LTCM--a firm
unknown to the general public and employing only a few hundred
people--could well have posed a serious threat to the stability of
American markets. In other words, the Fed acted because its leaders were
fearful of what might have happened to other financial institutions had
the LTCM domino toppled. And this affair, though
it paralyzed many parts of the fixed-income market for weeks, was far
from a worst-case scenario.

One of the derivatives instruments that LTCM used was total-return
swaps, contracts that facilitate 100% leverage in various markets,
including stocks. For example, Party A to a contract, usually a bank,
puts up all of the money for the purchase of a stock, while Party B,
without putting up any capital, agrees that at a future date it will
receive any gain or pay any loss that the bank realizes.

Total-return swaps of this type make a joke of margin requirements.
Beyond that, other types of derivatives severely curtail the ability of
regulators to curb leverage and generally get their arms around the risk
profiles of banks, insurers, and other financial institutions.
Similarly, even experienced investors and analysts encounter major
problems in analyzing the financial condition of firms that are heavily
involved with derivatives contracts. When Charlie and I finish reading
the long footnotes detailing the derivatives activities of major banks,
the only thing we understand is that we don't understand how much risk
the institution is running.

The derivatives genie is now well out of the bottle, and these
instruments will almost certainly multiply in variety and number until
some event makes their toxicity clear. Knowledge of how dangerous they
are has already permeated the electricity and gas businesses, in which
the eruption of major troubles caused the use of derivatives to diminish
dramatically. Elsewhere, however, the derivatives business continues to
expand unchecked.
Central banks and governments have so far found no effective way to
control, or even monitor, the risks posed by these contracts.

Charlie [Munger, Buffett's partner in managing Berkshire Hathaway]and I
believe Berkshire should be a fortress of financial
strength--for the sake of our owners, creditors, policyholders, and
employees. We try to be alert to any sort of mega-catastrophe risk, and
that posture may make us unduly apprehensive about the burgeoning
quantities of long-term derivatives contracts and the massive amount of
uncollateralized receivables that are growing alongside. In our view,
however, derivatives are financial weapons of mass destruction, carrying
dangers that, while now latent, are potentially lethal.