Friday, July 25, 2008

Increased Risk Of Regulatory Scrutiny Of Private Bankers

Senators Baucus (D-Montana) and Grassley (R-Iowa) of the Senate Finance Committee (SFC) are seeking to place their names next to Senator Sarbanes (D-Maryland) and Representative Oxley (R-Ohio). These SFC leaders are planning new laws against offshore tax evasion.

Now offshore tax evasion is not “News” as IRS had complained about this back in 2002. According to Global Policy Forum, IRS estimated in 2002 that anywhere from 1 to 2 million Americans were evading taxes. This is a problem as old as the beginning of time as it is in human nature to abhor having to pay a levy/tax to a central body. (For you theologians, check out Able and Cain story, referencing the grain offering by Cain.)

The reason why the latest government action on tax evasion is a Private Bank risk issue is that most people identified with tax evasion are the wealthy. It is not surprising then any new regulations and law would focus on the bankers working with wealthy clients.

Even without the new regulation / law the regulators have plenty to go after bankers. With the introduction of the PATRIOT Act in 2001, Bank Secrecy Act of 1970 (BSA) and the Money Laundering Control Act of 1986 (MLCA) were strengthened. The Title III of the PATRIOT Act provides the Government with additional reach into the international arena to find and persecute money laundering. While the original intent of the PATRIOT Act was to prevent terrorism, the act can be used for any acts of money laundering, be it to fund terrorism, narcotics, or to simply avoid paying taxes.

While money laundering has been a major concern for broker-dealers, hedge funds, and investment banks, the same cannot be said for Private Banks. For centuries, the Swiss Bankers – the ones who pioneered the modern day Private Banking concept – have had the reputation of complete secrecy. This allowed the wealthy to use the Swiss Banks to hide their assets from prying eyes. Naturally, this included any enquiry from the taxman.

While most people using the Private Banking services are honest folks, there are some who try to “push the envelope” with the aid of the Private Bankers. One such Private Bank that has been flagged twice in the recent past for aiding clients in this field is UBS. In 2007, a UBS Private Banker was one of 19 arrested in Brazil for money laundering.
Then, again in 2008, two top UBS Private Bankers were indicted for aiding in tax evasion.

Given that many Private Banks have been structuring deals for their wealthy clients that could be deemed to be money laundering or tax evading, the scrutiny and pressure are mounting against the Private Bankers. Even the Private Bankers themselves know this. According to the Times article, one Private Banker in London is quoted saying "My God, we're doomed."

Perhaps. It will be interesting in the next few months as the international effort into curtailing tax evasion and money laundering intensifies. This will be especially true for Chinese nationals as China is very tough on any crime that it focuses on to prosecute. . I agree with Professor Reuven Avi-Yonah’s comment that "The whole world of private banking is full of this stuff.” Maybe Senators Baucus (D-Montana) and Grassley (R-Iowa) may be relevant in the current dragnet, or maybe not. At least, if the Senators are successful, they can put a colorful moniker for their law.

SOX is just a bad moniker. I recommend that Senators Baucus and Grassley label their effort BAG-A-CHEATE, which stands for BAucus-Grassley Amendment to Congress Headed Efforts At Tax Evaders. This would be just as colorful a moniker as CAN-SPAM and just as difficult to remember what it actually stands for. Senators, you are free to use my suggested moniker, if you wish.

Oh, for those who are curious, here is the link to CAN-SPAM. Yes, it is an actual law.

Ed Kim
Practical Risk Manager

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Tuesday, July 22, 2008

A Quick “Q&A” styled Risk Assessment Of Select Current Events

Q: What will happen to the gasoline prices once a hurricane hits anywhere near the oil refineries?
A: It will go up. Even if the hurricane misses the oil refineries, any close call will result in a decrease production of oil distillates. This is a normal precautionary measure taken by the refiners as they move employees out of danger and reduce the pressure within the pipes. If the hurricane hits the refineries directly, do expect to see a repeat of another immediate $0.30 to $0.40 per gallon spike. In case of a near miss, a rise of $0.05 to $0.10 could occur.

Q: Will the new President put his emphasis first on the economy or the war?
A: As it was in 1992, when a the incoming President had to focus attention on the economy (remember the slogan: “It’s the Economy, Stupid”?), the newly elected President will, once again, have to clean up after a Bush and focus most of his attention on reviving the economy.

Side note: Isn’t it interesting to note that after the Presidency of both George Bushs, we are left with a stagnant economy, large deficit ($290 billion in 1992 and $268 billion as at July 11), and having to pay to rebuild the armed forces after a Gulf War (1992 estimate, here). Like father like son.

Q: Will Ford or GM survive to see 2010?
A: Their respective cash burn rate is alarming. According to BusinessWeek, “GM burned through $6 billion in cash from the end of October [2007] to the end of March [2008].” This is a burn rate of approximately $1 billion per month. With about $24 billion as of March 2008, GM may be able to just squeak into 2010 with just enough pocket change. However, along the way, look for GM to jettison various units and cut payroll continually. This is analogous to the occupants of a falling hot air balloon trying to lighten the ballasts to stay afloat.

As for Ford, analysts think that they are in a better shape. According to JPMorgan analyst, “…Ford's 2008 cash, marketable securities and loaned securities will decline by $10.9 billion year over year to $23.7 billion." By the end of 2010, this is expected "to decline to $9.5 billion by the end of 2010." However, given their overweight and dependence on trucks and SUVs, Ford may be a bigger disappointment.

Q: Will Citigroup stay as a financial supermarket or be broken apart and realize its value?
A: The 10-year Sandy Weill’s experiment of trying to run a vertically integrated financial supermarket has been proven to be a failure. The market realizes this. I hope Pandit realizes this as well. Its parts are indeed more valuable than the whole. Having been a part of the Citi culture, I can attest to the difficulty management faces in trying to make all of its pieces fit together. The future of Citi lies with separating itself into four separate businesses: SmithBarney Asset Management, which can easily fit with Merrill Lynch or Charles Schwab; Consumer Banking and Cards (the true retail bank unit); Citi should revive the Salomon name and make it a stand-along Investment Bank unit; and the Global Wealth Management unit, which holds the core of the private bank businesses. However, I am only thinking out loud, just like the Union (American Federation of State, County and Municipal Employees Union, that is).

Q: Will the Federal Reserve fight to tame inflation or will it fight for growth?
A: They should try to fight to tame inflation. The operative word here is “try” as they have a long way to go if they really want to lower the price shock to the American consumer. Unfortunately, the “sticker shock” is only beginning. Companies have been holding back raising their prices for a while and they can’t hold it back any further. As more and more companies begin passing the higher costs of raw materials, expect to see the core CPI numbers to shoot up.

What will the Fed do? They will try to something that would be a good imitation of the Keystone Cops.

Q: Will the real estate market recover?
A: Yes.

Q: Will the new bankruptcy law help to keep people from filing for BK chapter 7?
A: No. The new bankruptcy law is not so new and, while it is not friendly to consumers, it has not prevented people from filing for bankruptcy. In fact, according to the U.S. Courts’ bankruptcy filing statistics, BK filing increased 29.7% for the 12-month period ended March 2008 from 12-month period ended March 2007. While the total number of filings of 901,927 as of March 2008 is below the high water mark of 1.6 million filing set in 2004, the trend is very disturbing. (Click here for a historic trend of BK filings from 1986 to 2003.)

Ed Kim
Practical Risk Manager

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Monday, July 21, 2008

Risk Of Emergency SEC Emergency Rule Backfiring

There will be a temporary moratorium on naked short sale of select financial stocks, starting Monday, July 22. SEC enacted this moratorium to prevent flagrant speculations that, in the view of the SEC, were causing the financial stocks to be abnormally low.

Perhaps the SEC’s assumption is correct. However, the very action of forbearing natural capitalistic actions by employing such artificial stopgap measures will only cause a larger ripple in the market. The removal of the uptick rule for short selling perhaps was the undoing for the stock market. However, by implementing a desperate block on free and open trading, the SEC and the financial industry are inviting future litigations and reputational harm.

The basis of the stock market is the free and open trading of shares and options, based on a set of rules agreed upon by the stock exchange and the governing laws of the states. To change a major trading rule by carving out a list of no naked shorting when there is nothing in the market to indicate that there is a “run” or a panic, is openly admitting that there is something fundamentally wrong with the current pricing of the financial industry stocks to which the general public is not privy.

The Market will speculate on what the banks are hiding from public disclosure. These speculations will build and, when the naked short sale ban is lifted, look for new record lows for the financial stocks. The recent rise in financial stock prices is, in my view, a “fat” cat bounce, which is analogous to the dead cat variety. However, in this case, the bounce will allow those investors to cash out of their underwater position, before the total value of their portfolio is wiped out with subsequent valuation erosion.

The banks are not out of the credit mess. The picture is pretty bleak when one factors in the credit card landscape. More Americans are carrying higher balances on their credit cards as other sources of borrowing dries up for them. Having the credit cards still plying borrowers with zero interest until 2009 isn’t helping the matter.

Banks are still busily giving out credit cards. It will be only a matter of time, and soon at that, when they will start showing major losses and write-offs on ABS secured with credit card receivables. This will be on top of the write-offs of losses on vehicle leases. I am guessing that the 3Q 2008 will be just as bleak as the first half for the financial stocks.

So much for the temporary stop on naked short sales and SEC's vain attempt of manipulating the market. This action will only lead to more aggressive actions my those investors whose trading strategy have been hampered momentarily by the SEC.

Ed Kim
Practical Risk Manager

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