The truth behind the financial crisis of 2007.

Read the whole article, “Dear Uncle Sucker” by Barry Ritholz at http://www.cnbc.com/id/40255045/

During the week of 25 October 2010 the Euro was trading at CHF 1.36 up from a month previously when the Euro hit a bottom of CHF 1.28 in the waves following the crisis of Greece’s bailout.

Since April 2010 the Swiss National Bank has intervened massively to try to stem the rise of the Swiss Franc and has succeeded in pushing it up roughly 7% from its low last month against the Euro.

In mid-August, the Swiss Central Bank reported losses of nearly CHF 20 billion from frenzied purchases of Euros in an attempt to stem the Euro’s fall against the Swiss Franc.

Switzerland currently has the majority of its reserves in Euros, which is troubling Swiss leaders and reducing the maneuvering ability of the Central Bank.

The Swiss Cantral Bank is trying vainly to brake the rise of its currency out of fears of a negative impact on its ability to export.

But experience has shown that central banks do not ultimately succeed in countering the tide of informed global forex trading. Thus did George Soros make over $1 billion betting on the fall of Sterling when the UK government was intervening massively to prop it up. At that time, twenty years ago, the volume of forex trading was a fraction of the $ 4 trillion that is traded daily.

Because of the serious over-indebtedness of Euro countries, analysts and traders are expecting a further plunge of the Euro against the Swiss Franc in December expected to settle at a rate of CHF 1.20 – 1.21 to the Euro.

The disintegration in American financial markets and the ensuing contagion to global financial markets is largely a result of lack of proper oversight and regulation, the same sort of mistakes that led to the great depression 80 years ago.

It is the tragic affliction of humanity that our collective memory spans perhaps twenty years and we are therefore condemned to continue making the same mistakes over and over again, in kaleidoscopic variation and increasing severity.

Thus did the recent republican administrations in the US beginning with Reagan in the 80’s and Thatcher’s administration in the UK unwind, undo or repeal regulations and controls on financial markets dating from the 30’s. In fact, with the advent of complex financial instruments such as derivatives and credit default swaps, regulation should have become more stringent rather than loose.

The crisis is thus imputable entirely to incompetence and stupidity – the foolish ideological belief that markets are self-correcting. The plummeting declines in the housing market can be expected to continue making waves for at least another year.

Most of the world’s biggest banks, including Citigroup and UBS have recorded hundreds of billions in asset write-downs and credit losses since the beginning of 2007, including reserves set aside for bad loans.

Authorities did not take responsibility for controlling asset bubbles and rather promoted them with cheap money. Markets such as credit-default swaps have been totally unregulated, which is a major cause of the troubles.

Credit-default swaps are contracts designed to protect investors against default and used to speculate on credit quality. The market for derivatives also grew enormously in the run-up to the crisis, as did the coverage of notional risk via credit default swaps, according to the BIS, which was formed in 1930 to monitor financial markets and regulate banks.

Total losses for banks, hedge funds, pension funds, insurance companies, and sovereign wealth funds is so far in excess of $1 trillion, the IMF said in a recent report.

And we have not yet seen the full effect of the recession into which we have slid. The aforementioned losses only relate to the decline in the value of the various financial instruments which are held by the banks and other institutions. IMF’s estimates don’t reflect possible decline in the quality of the loans that they hold. These are the eventual losses that are yet to be seen.

Uncertainty about the ability of investors and traders to meet contract obligations has created mistrust in the markets that will not clear up until a regulated delivery mechanism is put in place and there is oversight of the market.

The crisis is therefore likely to last much longer than authorities predict.

Banks routinely deal with customers who wish to offload large blocks of shares without suffering the significant losses which can result from affecting the market price with large volume transactions.

The bank has several options for executing the trade on behalf of the client: They can sell all the shares uniformly from 8-4pm throughout the day, or they can apply algorithms that match the volume of trades executed for that share, such that the sale follows the surges and lows in trading, thus masking that the supply of shares is increasing in the market.

The first option is not an advisable one, because the market will notice that shares are being sold even during hours that are usually quiet for this stock.

The second choice of algorithmic trading –applying a specific algorithm to a program trade to minimize transaction costs– achieves the best market price because the transaction has minimal market impact.

The process of algorithmic (program) trading involves pre-trade modeling (estimation of trading costs, risk analysis and calculation of optimal horizon), portfolio optimization (risk analysis, optimization and fair value pricing), and post-trade analysis (performance and benchmarking).
A program trading platform requires that quantitative models and a technology infrastructure for the execution of the trades.

Over time the term program trading has evolved to refer to any transaction that involves multiple securities at once and with a significant order size. Program trading is also known as basket trading or portfolio trading, and can be applied to any asset classes. There is a high degree of automation and the term is inspired by the nature of this kind of trading, which is usually performed by computers.

An example of a program trading algorithm would be two comparable securities, mis-priced, but expected to converge to the same price target because of a fundamental similarity.

In such an example, the program would instruct the trader buy the relatively undervalued security and sell short the relatively overvalued security. Slicing a large trade into smaller pieces is the basis of program techniques known as “slicers”. These are used to slice up a large block order and thus make minimum market impact. There are a few ways to slice up a large order:

1) A uniform slicer: sell some percentage of the stock throughout the trading day (8am – 4pm). Not particularly wise, as noted above.

2) Ideally, the bank will shadow the volume profile traded daily so that the sale of the shares is done with minimum impact.

A few metrics are used to measure the effectiveness of slicer, including Volume Weighted Average Price (VWAP), Time Weighted Average Price (TWAP), Arrival Price (AP).
VWAP measures whether a fair price was delivered to the client. Many clients insist banks meet at least the daily VWAP. In VWAP trading, an attempt is made to trade a fixed number of shares at a price that tracks the VWAP. The computational simplicity of this benchmark makes it popular with traders.

To understand daily share volume movement, one has to forecast the volume. One way is studying historic intra-day volume patterns. Simple implementations use an average VWAP over the last three months to predict the VWAP over the day for some stock. More complicated algorithms will try to increase performance through timing executions and estimation of market direction.

The time-weighted average price (TWAP) is an algorithm for trades that have to be completed at a certain point and also for trades in illiquid stocks. This method permits traders to slice up a trade over time — a time slicer as opposed to a volume slicer. VWAP will trade less stock when the market volume dips, and TWAP will trade the same amount over the same time slot throughout the day. This is reassuring for traders confronted with illiquid assets unable to predict the volume distribution.

The order arrival price is the price of a stock when the order was made and is used a pre-trade benchmark to measure execution quality. The difference between the order arrival price and the execution price can be used to determine the implementation shortfall. For orders submitted prior to the market opening, the previous day’s closing price is used as a proxy.

A substantial part of the trillions of dollars of global assets changing hands every day, is traded automatically, triggered by computer algorithms, a process known as �program trading.�

Program trading, which evolved rapidly during the 80�s with the advances in both computer technology and mathematical finance, evaluates market discrepancies and arbitrage opportunities and initiates trades automatically based upon computer analyses. Program Trading involves the simultaneous trading of a portfolio of stocks (in contrast to buying/selling one stock at a time). The NYSE defines program trading as any trade involving fifteen or more stocks with an aggregate value over $1 million.

Program trading grew out of several advances in mathematical finance, which in turn took advantage of the computing revolution. Important papers in mathematical finance proved that diversified portfolios consistently performed the best, and diversity in terms of correlated risks became quantified.

Program trading has been associated with several trading strategies, such as duration averaging, portfolio insurance, and index arbitrage. Duration averaging and portfolio insurance are both used to decide how much of an investor’s funds to invest in stocks versus other instruments such as bonds. Duration averaging is based on the venerable idea of buying low and selling high. Fund managers shift assets into stock portfolios when prices are low, and shift assets out of the stock portfolio when prices are high. This strategy can lead to losses if prices fall our of expected ranges and miss opportunities for profit if prices rise too much. Duration averaging reduces price volatility because duration averagers buy when prices fall and sell when prices rise, reducing the size of the move in either direction.
Portfolio insurance insures a minimum value for a portfolio in a falling market while still allowing participation in a rising market. This is done through use of derivative instruments such as, for example, �put” options on the S&P 500.
In dynamic hedging strategies, fund managers sell as prices fall and buy as prices rise, increasing market volatility because both create extra selling pressure when prices fall and extra buying pressure when prices rise.

Index arbitrage between the stock market and the futures and options markets is an important form of program trading. Financial products sold in the futures and options markets are mathematically related to the underlying products from which they are derived. When the price of one falls relative to its mathematically related others, index arbitragers can buy the cheaper product, sell the other one, and secure gains.

Fair Value, Sell Active, Sell Threshold, Buy Threshold, and Buy Active — these terms indicate when index arbitrage program trading activity could occur and can produce sudden, sharp market movements. Foreknowledge of the likelihood of an adverse program trade can help investors determine the wisdom of initiating long or short positions in stocks, index futures, Exchange Traded Funds (ETFs), and options.

Buy programs occur when the futures market is over-valued relative to the stock market and consists of the index futures being sold and the stocks in the index being bought. Sell programs, the opposite case, occur when the futures market is under-valued relative to the stock market and consists of the index futures being bought and the stocks in the index being sold. Over-valued and under-valued conditions arise because trading in the futures and equities markets occurs independently. The key to determining these over or under-valued conditions is the arithmetic difference between the futures and the spot index, known as the premium.

The five terms of fair value, sell active, sell threshold, buy threshold, and buy active refer to specific values of the arithmetic difference of an index futures contract price minus its spot price. If for example the S&P 500 futures contract price is 1000 and the S&P 500 spot index is 990, the difference is 10, and whether this difference has bearish or bullish implications depends on whether it falls in the range of sell programs, no programs, or buy programs.

This difference between the futures contract price and the spot index is called various names of premium, spread, and basis; the nomenclature adopted here will be premium (prem), in accordance with the CNBC ticker. Other data feeds use the symbol of $PREM.X, $PREM, or SP-PREM for the S&P 500 premium and ND-PREM for the NASDAQ 100 premium.
A sell program is the simultaneous short sell of all or most of the stocks in the index and the purchase of the index futures contract. The stocks comprising the index should therefore decline and, correspondingly, the index futures should rise, producing the effect of a stock market decline and futures market rise. Two significant values in the sell program range are the sell active and the sell threshold values.
A buy program is the simultaneous purchase of all or most of the stocks in the index and the sale of the index futures contract. The stocks comprising the index should therefore rise and, correspondingly, the index futures should decline, producing the effect of a stock market rise and futures market decline. Two significant values in the buy program range are the buy threshold and the buy active values.

Walking Accounts

One popular ruse used by criminals is to open an account in a given jurisdiction with standing instructions for incoming funds to be immediately transferred to another location. This was popular during a certain epoch with Panamanian banks. In this scenario, the fronting bank is instructed that in case of any inquiries, officials at the bank to which funds are forwarded must be informed. Of course the second bank has standing instructions to transfer the funds elsewhere in the case of such notice.

Law enforcement refers to these arrangements as “walking accounts”, and the software in use by most banks automatically flags for scrutiny this sort of activity. Banks which permit these kinds of accounts complicate severely law enforcement efforts aimed at seizing dirty money.

Banks located in loosely regulated jurisdictions have fee structures tailored to profit from this kind of account. Deposits come in, and the money immediately moves back out. This kind of account can also act as a warning mechanism when inquiries by law enforcement occur, allowing countermeasures to protect the money.

Opening your own Bank

A more sophisticated layering tool is to open your own bank. Money trails are more difficult to follow if the launderer owns his own bank, particularly in one of the jurisdictions of loose regulation. Obviously, one has much better control of a bank’s procedures and compliance and record keeping if one owns the bank. It doesn’t cost that much to open your own bank. It can be done for less than $50,000 and in some jurisdictions less than half that will do. If things get hot, the launderer closes the bank and destroys any records.

Using Intermediaries

Money launderers usually use lawyers all along the way because that way you are protected by attorney-client confidentiality. Offshore centers are nearly always used, their brokers and agents generating customers, acting as account intermediaries, and providing key insulation.

Laundering is a serious profession and requires a thorough knowledge of accounting and fiduciary practices, banking regulations in different jurisdictions, and law enforcement practices. Professional launderers obviously therefore include accountants, lawyers and private bankers.

Among the panoply of services offered by numerous offshore financial institutions are the generation of false invoices, bills of lading, end-user certificates and other forms of documentation.

A variety of AML software currently in use in 2007, is equipped with mechanisms to flag a wide variety of suspicious activity for further scrutiny.

Launderers usually move their activities to jurisdictions where there are weak anti-money-laundering measures in place. Favorite spots are the financial services havens and offshore centers.

What are referred to as “offshore banks” can be located anywhere in the world and refer to banks that accept deposits only from non-residents. The general public often thinks of the Caribbean when hearing the term “offshore” but there are numerous offshore banks around the world.

As of 2007, offshore banking centers harbored over $5 trillion in assets – $1 trillion in bank deposits and $4 trillion in the form of stock, bonds, real estate and commodities.

The largest offshore centers are, in order, London, New York, Tokyo and Hong Kong, and the Cayman Islands. The Cayman Islands has roughly 600 licensed banks, with deposits of over $500 billion.

During the last two decades, many countries with few prospects and limited natural resources have succeeded in the growing their economies and developing their financial strength by becoming tax havens and offshore banking centers.

These countries offer low tax rates that are attractive to investors, company owners and ordinary citizens anxious to reduce their tax burdens. Used by many legitimate business, they are also highly sought after by the world�s tax evaders, since these havens also offer structures –which are only for non-residents and only for use offshore– designed to defeat the tax laws of other countries.

Bank Secrecy

As a general rule, tax havens offer strict financial secrecy, which critics say shield foreign investors from investigations and prosecutions from their home countries, but defenders note protect privacy in an international context of decreasing respect and protection of private information. Interestingly, the countries which complain the most about other countries banking secrecy laws are precisely the jurisdictions which the highest rates of identity theft.

Money-laundering does not need an environment of bank secrecy and perpetrators usually actively avoid it precisely because of the increased scrutiny which operations from these jurisdictions arouses.

Corporations and Shell Companies

Money launderers of typical sophistication will set up a bank account in a financial haven as a corporation. Individuals with a numbered account are largely a thing of the past although they still do exist. The �legitimacy� of the corporation�s activity will then be created through the establishment of some kind of history of actual activity.

It should be recalled that many of the world�s top multinational companies use these same havens, advised by the top accounting and consulting firms, to legally channel their profit centers to low tax jurisdictions.

Many of these special tax havens have the legal requirement that the registrant company may no do business locally. Other jurisdictions do not require corporate books or records, which can be useful for concealing the origin and destination of goods in international commerce, and is at least highly useful for reducing accountancy and fiduciary fees.

Often such companies are capitalized with bearer shares, which does not record a company owner: the person who physically possesses the share certificates owns the company.

The term “money laundering” purportedly originates in Mafia use of ownership of laundromats in the United States to mask the provenance of receipts of large quantities of cash from extortion, prostitution, gambling and bootleg liquor. Laundromats were actually the first businesses used as fronts and the legitimate earnings of these businesses were salted with the revenues from criminal activities.

Laundromats were chosen by these gangsters because they were cash businesses.

Al Capone was a pioneer in the use of Laundromats and was ultimately convicted not for his homicides but for inability to thoroughly launder his proceeds. The final step of moneylaundering is usually taxation, where the money enters the financial systems, and is taxed. Capone was convicted of tax evasion.

Money laundering is so-called because criminal proceeds — “dirty money” — are put through a cycle of transactions, or washed, so that they emerge as legal, “clean” money.

The conviction of Capone was a signpost of the infancy of moneylaundering and the lack of sophistication in its techniques. Meyer Lansky, called “the Mob’s Accountant, — was troubled by the conviction of Capone for something as obvious as tax evasion, and he resolved that the same fate would not happen to him.

He gave the problem of money laundering and hiding money its first ponderous consideration. Lansky discovered the benefits of numbered Swiss Bank Accounts. Lansky started the first true laundering techniques, creating the “loan-back” concept, where hitherto illegal money would be disguised by “loans” provided by compliant foreign banks, which could subsequently be declared to be “revenue” if necessary, with a tax-deduction obtained into the bargain!

Had he lived in a later epoch, Lansky might have been a superb, highly paid Arthur Andersen consultant.

The term “money laundering” is relatively recent, first sighted in press reporting of the Watergate scandal in 1973. The expression first appeared in a judicial context in 1982 in the case US v $4,255,625.39 (1982) 551 F Supp.314. The term has since been widely accepted and is in popular usage throughout the world.

Money laundering only attracted interest in the 1980s, surfacing within the context of drug trafficking. It was out of an increasing awareness of the huge profits generated from this criminal activity and a concern at the massive drug abuse problem in western society that governments began to act against the drug dealers by developing legislation that would allow them to attack the illicit gains, and relieve them of the necessity of proving particular criminal activity, such as drug dealing. Governments were also frightened that the huge profits taken in by criminal organizations could permit them to contaminate and corrupt the structures of the state at all levels, which of course history proved to be correct with the creation of narco-states.

Money laundering is nearly always an international activity. The amount of energy and expense that will be invested into covering and obscuring a money trail will depend on criminal’s assessment of how serious and effective the police probes are likely to be in that jurisdiction.

Below are a variety of online resources for banking applications, systems providers and financial technology solutions for banking:

–Retail Banking � The Future of Retail Banking � ACI White Paper (PDF), Retail Payments Innovation & The Banking Industry � Federal Reserve Bank of Chicago (PDF)
–Mortgages � List of mortgage backed securities technology products from Applied Financials, Mortgage Technology web site
–Payment Cards � New Faces in Payment Cards � from Bank Systems & Technology, CRM through Branded Payment Cards � Tech News World, Bobs Guide Listing of Payment Cards Technology Providers
–Retail Banking Solutions � The Heterogeneous Technology of Retail Banking � A White Paper � FTP download (PDF)
–ATM Technology � ATM Hardware Manufacturers list
–Check (Cheque) Processing � Check Processing

Technology Solution Info from EDS
–Customer Accounts Management � Microsoft Vision for Banking � Full Service Customer View, Making Retail Banking More Personal � MS Press Release
–Document Storage, Archival & Retrieval
–Wholesale/Commercial Banking � Wholesale Banking Casts Technology Towards the Top Line � Bank Tech, Celent Wholesale Banking Reports Listingtreating topics of : Cash Management, Credit Administration, Global, Custody, Repo and Securities Lending, Syndicated / Project Loans, Trade Finance

Commercial Banking Solutions
–Banking Treasury Management � Misys website has a paper on Banking Systems Treasury Management Capabilities on a Pay-as-you-use Basis. Topics: Treasury Analytics, Central Banking,
Deal Capture, Dealing Room, Debt Management, Front and Middle Office, Other Treasury Systems, STP,
Financial Markets Solutions.

Financial Information Systems are increasingly a target for Identity Thieves. Identity theft — a major scourge in the United States for more than a decade – is gradually spreading around the world.

Intrusions into banking and financial systems are now an accepted, if frightening, fact of life for major financial institutions, as well smaller ones with lesser means to deploy for security. The US Government Accountability Office recently issued a report (July 2007) claiming that while the large amount of information lost or stolen is disturbing, it’s difficult to prove that these breaches lead to identity theft.

The major reasons that identity theft is so much more prevalent in the United States than elsewhere are the weak regulations protecting treatment of private information combined with the prevalence of its collection. Personal financial information is collected everywhere – the US Government even bestows Authority to Collect financial information on motor vehicles offices for the reneal of drivers licenses. It’s no surprise that more than one in ten Americans has been a victim of identity theft in the past few years.

The GAO issued a report examining two dozen of the largest data breaches from January 2000 through June 2005, as well as five breaches that involved federal agencies. The concluded that ‘ the extent to which data breaches resulted in identity theft is not well known.’ The US Government’s sophistry is reminiscent of the four decades which elapsed between proven correlations of cancer frequencies and smoking and the final, incontrovertible, refutable-not-even-by-a-cretin evidence which had to be brought to bear before the establishment, with its evident stake in cigarette sales and the cigarette company stock prices, finally agreed that, well, yes, smoking was after all carcinogenic.

So at this time, for the US Government, largely –if indirectly– responsible for the widespread identity theft within its borders, “it’s difficult to figure out how” an “individual’s personal information fell into the wrong hands.”

Concurrently, the FBI’s Cyber Division reported it was currently working on more than 1,300 pending cases of network intrusions in which data breaches resulted from unauthorized electronic access to computer systems, such as hackings. The Secret Service in 2006 alone opened 327 cases involving network intrusions or data breaches, specifically in which financial information was lost or stolen

Improvements in overall security have been achieved in most industry sectors, but the financial services industry has seen an increase in the average number of IT vulnerabilities, according to London-based NTA Monitor’s 2007 Annual Security Report. The study analyzed vulnerability tests conducted on a variety of U.K. companies, including financial services firms. Among the interesting remarks: “Flaws that our testing discovered could permit hackers to gain entry to corporate networks,… which could wreak corporate havoc. ” (Cont. >> next page)