TSF has been in business more than 10 years focused on massive risks and windfall opportunities presented by grave flaws in structured finance. Here’s a glimpse into this week in history, where we are today, and what it means for the future. Let’s zero in on July 16, 2010.

“Dire Consequences” from a Collapse in Confidence

Despite massive bailouts by U.S. taxpayers, there have been no meaningful investigations into the widespread criminal activity at U.S. banks and investment banks. Investigators were starved for expertise and for a budget. Regulators looked the other way.

It appears Washington, regulators, and banks manufactured a narrative to shelter the guilty. The public was told the world teetered on the brink collapse with unimaginably dire consequences. We were told the lesser of two evils would be to let a lot of people get away without consequences than to risk a collapse in confidence.

Today President Obama’s camp seems to believe it is better to let a lot of criminals get away with it than spend political capital needed for health care, LGBT rights, Supreme Court nominees and “ending” wars. So how is that working out for the nation?

The U.S. is mired in stagflation and unemployment remains high, especially for full-time jobs. Investors are tempted to seek unrewarding risks in the hunt for higher returns, since “risk-free” interest rates are suppressed. China’s GDP growth rate has declined even by its own fuzzy metrics, and the Euro-zone can’t seem to get its GDP growth above 1%.

It appears the only “dire consequences” we avoided were Wall Street’s massive pay cuts, wholesale purges at the top of TBTF financial institutions, and criminal indictments for senior TBTF bank officers.

Two Years After Goldman’s $550 million SEC Settlement

On July 16, 2010, I wrote a commentary on the Huffington Post observing that IKB’s CEO was charged in Europe, but U.S. bank CEOs are skating. Goldman Sachs settled fraud allegations with the SEC for $550 million. The case involved the packaging and selling of a CDO called Abacus. Goldman Sachs admitted to no wrongdoing.

IKB’s Convicted CEO

IKB was an investor in the Abacus CDO that Goldman underwrote. IKB’s losses mounted to $150 million, and it recovered that amount out of the SEC’s settlement with Goldman. A German court found Stefan Ortseifen, IKB’s CEO at the time of the CDO investment, guilty of market manipulation by a German court.

On July 20, 2007, as credit markets started to fall off a cliff, IKB issued a press release claiming its exposure to subprime was limited and all was well for it to make forecasted profits.

It was very far from the truth. IKB was drowning in losses. German taxpayers eventually bailed it out with more than €10 billion (around $12.7 billion) in government-backed loans.

The SEC apparently hasn’t investigated the merit of prosecutions for the CDOs that Goldman underwrote and on which AIG sold protection, including other Abacus CDOs. Goldman not only underwrote or co-underwrote some of the CDOs, it bought protection on other misrated CDOs. It was the key architect of AIG’s distress due to credit derivatives AIG wrote against flawed CDOs.

Joseph Cassano, the AIG Financial Products officer who resigned in February 2008, got away with few questions about the due diligence he apparently failed to perform on the CDOs against which he sold credit default protection. He reportedly earned total compensation of $315 million from 1987 to 2008, much of it earned during the period in which he put AIG at the most risk.

In August 2007, I publicly challenged AIG’s accounting statements in the Wall Street Journal due to the risks in his unit. Yet he wasn’t held accountable.

The Word is Fraud

Privately I wrote clients:

I believe AIG’s assertions are incorrect.  For example, it has a $19.2 billion ‘super senior’ exposure to CDO-squared (BBB tranches).  It would have a large immediate mark-to-market loss and a reasonable probability of future actual material losses.  The portfolio consists of BBB tranches of CDOs that have an average of 29% subprime in the original CDO portfolios (from which the BBB’s were tranched).  Even though the ‘super senior’ originally had a 36% cushion, it could be eaten through and more.  Although the cushion loss is debatable; it is not zero.  A substantial percentage of the former ‘super senior’ would no longer be deemed ‘super senior.’  Granted AIG claims little exposure to 2006/7 subprime vintages, but even 2005 has problems not to mention Alt-A and prime mortgage loans with poor underwriting standards originated in 2005.  Since January, BBB tranches of multisector deals have widened more than 500 bps and are currently around 900 bps at current dealer average levels [last week I saw one for LIBOR + 1200 and some trade wider for 2006/7 vintages].

Martin Sullivan is planning to take over (from J.C Flowers) Wurttembergische und Badische Versicherungs AG (Wuba) and its major subsidiary Deutsche Versicherungs- und Ruckversicherungs AG (DARAG), and his employees just put a huge embarrassing whoopee cushion under his CEO chair.

But wait! Maybe AIG is right, and I am simply financially unfashionable.  If everyone agrees, we can start a new trend for troubled CDO mortgage backed product.  If you think that defaults will not touch your tranches (or at least will not touch them for a while), then just stop trading – we are nearly there already – and refuse to recognize a decline in value.  If anyone challenges the marks, simply trade some amongst those in-the-know to prop up those marks (European banks did this with “super senior” tranches of CDOs backed by ‘investment grade’ corporates when Enron, Kmart, Worldcom, and more started defaulting).  But that would be…what is the word I am looking for?

Felony Indictments

AIG is pursuing its own remedies, but since taxpayers bailed out AIG, it is also a matter of public interest.

In this post-Sarbanes-Oxley world, U.S. CEOs and CFOs should also be held accountable for misleading statements and SEC filings in the run up to the financial crisis. Sarbanes-Oxley was meant to hold CEOs and CFOs accountable for accounting fraud and public misstatements about the health of their financial institutions. Yet, there haven’t been felony indictments for accounting fraud and securities fraud.

As of now, investors are on their own when it comes to assessing the risks and rewards of structured financial products, and the systemic risks they pose. Today the global financial system is even more opaque than before the financial crisis.

We changed U.S. accounting rules in April 2009 to cover-up the messy balance sheets at our largest TBTF banks. Accounting obfuscation helps disguise leverage.

See finance articles by Janet Tavakoli for more on Goldman Sachs and other financial crisis issues.