Film Financing Scams: The Toronto Scam

I came across a recent scam that took me a little while to figure out and I thought I'd share because it's clever and targeting film production companies. It's similar to the Turin Group Scam in many ways, but different enough to be its own kind. I chose the Toronto Scam as a name solely because it is another "T" city, not because the participants are Canadian or come from Toronto - far from it.

Here are the characters:

A broker acts as the inside man; its his job to rope in the mark and to take as much time as is needed to get the mark primed. The broker may or may not be a witting participant in the scam itself, but the broker is at least promised compensation for his role. The outside man is in fact a company, a financing company, looking to get into a new field - film production, asset financing, etc. The outside man has had some experience that requires them to be a little guarded and secretive - a bad experience in the past, some potentially shady third world dealings, etc. The company will be a recently established, but not too new entity (e.g. 1 year old) whose ownership structure is opaque and probably foreign. The inside man, the mark and, if there is such a person, the mark's escrow money investor, form a joint venture for the division of the profits from the project. The inside man will require no creative or directional control, but will have some control over the disbursement of funds.


Here's the pitch:

The mark needs $10MM. The outside man can provide the full $10MM provided the mark can raise 30%. The 30% is held in an escrow account by the mark's own escrow agent. The escrowed funds will not be invaded for any reason whatsoever. As the outside man has had some problems in the past, in addition to this earnest money, the mark will also need to provide certain compliance information - no different than the information that is required by any business opening a bank account under the anti-money laundering provisions of the Patriot Act. Escrowed funds have to be held for 41 banking weeks, which amounts to a year.

Here's what I suspect happens:

The mark puts up the money in an escrow account and a JV is established between the parties. If it wasn't already agreed to, the inside man will come up with a reason as to why he has to tranche his payments. Then to the extent any funds from the inside man have been received, they will stop. The inside man, assuming he was in on the game will no longer be reachable.

Meanwhile, the outside man has opened up a bank account at a small unsophisticated bank in the JV's name. They perform some small transactions on the account and then get a line of credit for 1/2 of the escrowed amount, using the escrow as collateral. They may even make some interest payments while they soak up money from other marks. The mark has no knowledge that this account exists or that the inside man has tapped the line of credit. Then one day the outside man vanishes, taking all the money with him and leaving the marks and their escrow investors on the hook for the lines of credit established in the JV's names.

Here's why it works:

Of course there's the usual trappings of a real business - Delaware incorporation, people who have worked in the industry before as both inside and outside men, and some paperwork that might seem legit. They cite the right language of the Patriot Act and dress everything up in formality. But most importantly, is the amount of attention that they give to the escrow account and escrowed funds. They realize that it's anomalous, but it's part of their financing structure and it's how they have to prove earnest money. You spend all your time trying to figure out how they can get to the escrow account (at least I did). But you have to be looking at the JV structure to see where the scam is.

Of course, there's all the standard language - this is an "alternative" investment vehicle, and you have to be "open" to its "innovative" ways. The outside man is someone who wants to make great films. All transactions will be conducted between attorneys and with reputable financial institutions. (If this has to be said, it's probably not true.)

This scam seems to be making its way around the film production world right now, so I thought I'd put this out there. This is not based on a personal or client experience. But there was a offer of a similar nature made, which caused some wheel spinning and I thought I'd save anyone else some time and effort.

Dead Souls and Risky Assets

In Gogol's Dead Souls a man goes around the countryside buying up dead serfs. As there was only a census every ten years, these serfs would count as property on people's tax rolls causing their former masters years of tax obligations. Quite why this man was buying the dead souls remains a bit of a mystery - Gogol went mad and died before the completion of the work - but presumably he was going to use them for collateral or to advance his rank some how.

But a funny thing happens as he tries to buy the souls. He'd offer $500 for Mischa who passed away the prior year. But after he makes the offer, Mischa's very much alive master would say "$500 for Mischa! You have to be crazy. Mischa used to fix me the finest cup of tea, and never a drunk. Always on time and respectable. Mischa should be worth $10,000 at the least."

I suspect something similar is going to happen when these private companies try to buy the risky assets from the financial institutions currently holding them. The auction system put in place is meant to ameliorate this "Dead Souls" problem, but the selection of assets is going to present the same issue. For example, Citibank knows it has some real garbage loans and it dumps these on the market. Then it starts looking at other tranches of mortgage-backed securities and it'll do some guess work. "If we put this tranche on the market, how much do you think we'll get for it? Well, if there's profitability at that level, why would we sell?" Essentially, "Yes, but my Mischa is worth so much more."

I don't have a better answer and think that the auction system developed is a good way around the Dead Souls issue. But I still think that there's going to be systemic inaction and further ossification of credit lines because of an even greater inability to comfortably price debt.

Charles Ludlam's Axioms: Modern Truths to Live By

Last night I watched a rough of a client's doc about the No Wave film and the Transgressive Cinema movements. (Blank City - hopefully coming soon to a DVD near you.) The Transgressive Cinema movement had a manifesto, the whole idea of which felt both quaint and desirable to me. I thought that a set of principles to believe in that are easily comprehended and transmitted might not be such a bad thing. And yet, of course, such ease in comprehension permits little nuance. Then I was reminded of Charles Ludlam's Axioms for a Theater of Ridicule. They are:

1. You are a living mockery of your own ideals. If not, you have set your ideals too low.
2. The things one takes seriously are one's weaknesses.
3. Just as many people who claim belief in God disprove it with their ever act, so too there are those whose every deed, though they say there is no God, is an act of faith.
4. Evolution is a conscious process.
5. Bathos is that which is intended to be sorrowful but because of the extremity of its expression becomes comic. Pathos is that which is meant to be comic but because of the extremity of its expression becomes sorrowful. Some things which seem to be opposites are actually different degrees of the same thing.
6. The comic hero thrives on his vices. The tragic hero is destroyed by his virtue. Moral paradox is the crux of drama.
7. The theater is a humble materialist enterprise which seeks to produce riches of the imagination, not the other way around. The theater is an event not an object. Theater workers need not blush and conceal their desperate struggle to pay the landlords their rents. Theater without the stink of art.

I used to have these on my fridge, at the ready to humble me daily. These axioms are applicable to so much more than theater. There are manifestos and commandments, but few "truth statements" express the complexity of the human condition and the need to strive for success on our own terms like this. Of course, prohibitions on stealing, murder, and other such interdictions are just fine. But we can generally figure those out for ourselves and needn't be reminded of them on a daily basis. It was Charles Ludlam's axioms that I kept on my fridge for daily reinforcement. I think I'll do so again.

Facebook & TOS Issues for Networking Sites

Recently Facebook changed its terms of service ("TOS") in response to a concern of the company's attorneys about its old policy. The revised TOS were overreaching and overbroad to meet the legitimate concerns that Facebook had. After a justified outcry, Facebook recanted.

However, there is a legitimate concern at base here.

1. You post some information on your page, for example a haiku.
2. The copyright in the photo and haiku remain yours but you grant Facebook a license to use it on Facebook and in their marketing materials while you're a member of Facebook.
3. You cease to be a member.
4. License terminates.

But, what if you posted a haiku on your friend's page? When you cease to be a member and the license to Facebook terminates, do they have to pull down all your posts to others' sites as a default? You may very well want them to. You may not care.

Facebook wants to ensure that your posts on other pages remain up. (At least that's the excuse they gave, the actual policy was far more broad than that - I'm just giving them the benefit of the doubt.) And you may be cool with that. Alternatively, you may want all your posts down.

We have to look at how to address TOSs so that authors can keep control of their works after they leave a social networking site. But, if the author doesn't care, a networking site doesn't have to be denuded if people leave the site.

This has raised some interesting questions, and it will take some trial and error before we strike the right balance. As far as engaging to solve the problem, clearly Facebook put the wrong foot forward. Hopefully, we can find a more equitable solution going forward.

Objects Appear Very Far in the Rear View Mirror - Why We No Longer Need Fannie and Freddie

Firstly, I want to thank everyone for their comments and feedback. Many of you have pointed out other causal factors including: an indulgent or avaricious borrowing population and their lenders, short-term quarterly profit fixations of shareholders, credit rating agency negligence and accounting principles that are in need of a fix, amongst others. In the future I will try to address the accounting practices and how they affect the credit rating agencies who judge the value of the derivative or illiquid assets held by the financial institutions. However, someone asked a very good question that I think bears further examination. I was asked why I thought that a gradual winding down of Fannie and Freddie should be part of the solution.

Although there is clearly more than one cause to our current crisis, this question does go to the heart of the issue. In setting out my rationale, I will first start with a history of Fannie and Freddie, then move to a brief comparison of Fannie and Freddie to Ginnie, Fannie and Freddie's role in the growth of the mortgage-backed market and explain why I believe that their continued existence has an deflationary effect on the credit markets today by making credit artificially cheap - ironically, both what got us into this mess and why we need them to get us out.

I Never Thought I’d Say This…

It’s so difficult, just on a philosophical and gut level, for me to think back on the days of Reagan and Thatcher as a period of conservatism in the financial markets. I am shocked to be writing this. Ahh, the era of Glass-Steagall. The Glass-Steagall Act came out of the crash of 1928 and prevented investment banks (perceived to be riskier institutions) from owning depository banks (lower-risk institutions) in order to protect depositor's funds from being depleted in another meltdown. And there was a time, not too long ago, when investment bankers worked the long hours, took all the risks and either made it big or went broke. (Of course at the same time they made others very rich or pauperized more than a few of their clients.) Meanwhile, our commercial bankers at depository institutions wore suits several years out of fashion and could be found on the golf courses at 3pm on a weekday. They maybe had a bit of a better year if they attracted more deposits or took on a number of new mortgages or maintained a balance of cash flows between their fixed and floating rate debits and credits. They were risk averse and believed in a slower pace of growth.

In 1999 the US joined the rest of the financial world and let investment banks own deposit institutions, or what you think of as your typical bank. No other country in the world had such a distinction and new financial products were making the lines very blurry. The move to repeal Glass-Steagall crossed party lines and was passed with veto-proof support. (Not that Bill Clinton would have vetoed it anyway.) I remember watching the Senate vote on a tv in the lobby of the financial training institution where I worked. It passed 90 to 8. I still think that its repeal was a good idea. There were too many products crossing too many artificial lines; the regulators were stuck in jurisdictional morass, and given that nobody else had such a division, it seemed strangely artificial. One of the effects of Glass-Steagall’s repeal was to let investment banks participate in mortgage-backed security generation, which had previously been limited to depository institutions.

But, before we move on to the post-Glass-Steagall era, while we still think of deposit institutions like a Leave It To Beaver episode of politeness, risk aversion and a guy named Wally, let’s see what Fannie and Freddie looked like at the time. Fannie Mae was originally created to be a guarantor of government-issued mortgages. The US government has a need to be a guarantor of certain of our citizen’s mortgages. An example of mortgages that we might want the federal government to guarantee, might be the mortgages of the armed forces who from time to time may be called to service and not return or for returning veterans themselves. Fannie’s mission changed in the late 60s and this responsibility fell to the newly created Ginnie Mae, where it still rests today.

Fannie was to be a public-private hybrid, a “government sponsored entity” and, to keep it honest, we created Freddie Mac to compete with Fannie. Fannie and Freddie’s securities were no longer backed by the “full faith and credit” of the American government (as Ginnie's still are) but there was the general assumption that the government would bail them out if they became insolvent, which is what happened. As a government sponsored entity, Fannie and Freddie had to report to Congress and meet some Congressional demands, or possibly stand to lose their status. This status enabled Fannie and Freddie to save a fortune as the full risk of the instruments that they were creating wasn’t factored into the pricing of those instruments. And they are still partly private institutions with shares that trade openly with all the executive bonuses that attach thereto. They have a great interest in maintaining their ability to save billions by issuing discounted securities.

In a world of risk-averse, badly dressed, depository bankers, Fannie and Freddie helped to forward the policy goal of making home ownership easier for most Americans. Unlike today when deposit institutions create their own mortgage-backed securities, in the era of Glass-Steagall, this wasn’t happening to the degree that Congress wanted. To fill that need, Fannie and Freddie would come along, take the mortgages off the books of the deposit institutions, bundle them into mortgage-backed securities and sell them to the investment banks. This gave the deposit institutions free cash flow and helped to generate additional mortgage loans. Then the wall between deposit institutions and investment banks came down.

Most countries have a long history of the co-mingling of depository and investment banking cultures. Our modern history is less than 10 years old. And in that time we’ve managed to make a complete hash of it. Whatever endogenous risk-averse culture existed at large depository institutions was wiped away. Note though that credit institutions and independent or small regional banks have largely maintained this culture, some against a lot of pressure to do otherwise. Particularly at the large depository institutions, whether out of shareholder pressure, acquisition by an investment bank, pressure to increase share price to avoid a takeover, reveling in the fruits of new profits, or out of a sense of wonderment at the sheer novelty of it all, our stalwarts of bad dress and 3pm tee times began to dress better and work later.

Fannie and Freddie’s Search For Meaning

No other country in the world had a division like Glass-Steagall and no other country had government sponsored entities like Fannie and Freddie. In other countries, banks issue their own mortgage-backed securities and priced them based upon the risk-free rate and the perceived riskiness of the underlying assets in that bundle, also called a tranche. In a post-Glass Steagall world, depository institutions began to sell their highest creditworthy tranches directly. Fannie and Freddie, like any middle man, takes a cut of the action. By eliminating the middle man on the least risky securities, banks could sell directly and make more money. If they wanted to get their lower creditworthy loans off their books, banks could sell those to Fannie and Freddy.

Before Glass-Steagall was repealed there was never a year when more than $1 trillion dollars in mortgage-backed securities were issued by all issuers, private and government-sponsored entities. In 2003 we hit an all-time annual high with approximately $2.6 trillion issued, an increase of almost 300% in three years. This was a result of a number of factors coming together simultaneously: the cheap credit fostered by Greenspan’s monetary policies; changed risk tolerances in financial institutions; shareholder pressures; executive compensation packages that rewarded short-term profits; and the astronomical growth of the swap market where mortgage-backed securities are used as credit enhancers.

As I mentioned in my last post, where we hit a tipping point in this crisis, where we moved from a disaster to a complete fiasco, was in the use of leverage. Because mortgage-backed securities issued by Fannie and Freddie had the implicit backing of the US government they could carry credit ratings that didn’t accurately reflect their underlying risk. These riskier securities, which were mis-priced for their risk level, could be used to enhance the credit of other assets in a swap transaction. With a swap market of over $400 trillion, there was always a market for these credit enhancers, and Fannie and Freddie, desperate to remain relevant, were happy to provide them.

Facing increased competition in the higher creditworthy marketplace, and under intense pressure from Congress, Fannie and Freddie began to buy mortgages that were not just subprime, but were even riskier, they came without the usual documentation to verify borrowers incomes or savings. And these were turned around into mortgage-backed securities that still carried an A(ish)-class rating, on the low end of investment grade, but completely unrealistic given their risk properties. In 2007 alone, Fannie all by herself issued $79 billion of these securities. This is a classic moral hazard, where because of the perceived government backing, an instrument’s price lost all mooring from its risk and people perceiving high risk to be cheap engaged in even riskier activities.

Why I Think That Fannie and Freddie Need to Be Wound Down

Firstly, I think that with the repeal of Glass-Steagall, they’ve outlived their purpose. In hindsight, we should have wound them down when we repealed Glass-Steagall, but that’s ancient history now. Mortgage-backed securities can be created by private institutions themselves and priced appropriately. There is a healthy marketplace for them that leads to the appropriate pricing. We don’t need to insure these obligations.

I think that a strong case could be made for the continued existence of Ginnie Mae. We do want to promote, through cheap credit and artificially reduced risk, the home ownership of those who serve in the armed forces or returning veterans (along with a few other protected classes that fit into Ginnie's presently well-defined remit). I don’t think that our general service armed forces are paid enough for what they do. So as an additional compensation, making home ownership cheaper and easier seems fair to me. But if there ever comes a day where they’re compensated at a significantly higher rate, maybe Ginnie should go away too.

Ironically, right now we need Fannie and Freddie to buy distressed mortgage-backed securities back from the marketplace as no one trusts these assets anymore. They should perform their one last good deed, take the existing distressed mortgage-backed securities off the market, wait a while and then sell them back or eat the losses. But looking forward, there is enough that the government can do to incent home ownership through the tax code and other methods than to provide artificially high investment grade securities to investment banks on the cheap. I want my depository institution banker in tartan slacks, at his early afternoon tee time, with the leverage ratios, risk tolerance and culture of "only buy what you can afford" back. And we can't get there by having the government underwrite derivative instruments so that more people can live in bigger homes. Without the discount that Fannie and Freddie provide, some people who couldn't have mortgages in the first place wouldn't have their homes, true. And it also might force some people to buy smaller homes in more dense communities rather than McMansions in the exurbs. But these may turn out to be salutary effects, and I welcome a period where we see what happens in Fannie and Freddie's absence.

What the Hell Happened?

Without detracting from the strengths of either candidate for president (and expecting so little of our current leader), I’m mad as hell at the total failure of our political leadership to answer three fundamental questions:

1. What happened?
2. What’s going on now?
3. What’s to be done?

For those of you who know me by my entertainment career, I may seem a strange source for financial information. But, I was once the CEO of the Global Association of Risk Professionals, and so have a brief history of communicating complex financial transactions to a broader population. Sitting and stewing, I thought, “Hell, I might as well take a crack at it.” What follows is a plain-spoken, but detailed explanation, summed up with bullet points that I encourage anyone to forward to the overpaid speech writers for either campaign who are clearly asleep at their desks. It’s long – please don’t try this on a Blackberry – and I apologize if my attempt to explain this seems like foolish pride.

What Happened?

Rightly or wrongly, and the merits of it deserve to be debated, as American as apple pie and Mothers’ Day is home ownership. And it’s the government’s job to incentivize home ownership. This is done in a number of ways: most states provide home protection against tort or other legal liability – in New Jersey $200,000 of your home cannot be sought if there is a judgment against you, in Texas there is no limit (wonder why Ken Lay bought a $40MM home?); and of course, the big one, tax breaks for interest on mortgage payments. The mortgage interest deduction makes it easier for first time buyers to get their home as the payments in the earlier years will be offset by tax relief. While we claim that this fosters home ownership, what it’s done is foster home indebtedness as the incentive is on the interest portion of the mortgage and not the repayment of principal.

Unique amongst countries in the world, to facilitate this apple pie policy, we have Fannie and Freddie, well, and Ginnie, but we can ignore her as she’s serving the precise purpose for which she was established. Fannie and Freddie make home ownership easier by buying the mortgages from banks, guaranteeing some repayment conditions, packaging them in bundles that have similar risk properties, and then selling those bundles to institutions seeking those risk levels and expected returns. With the mortgage loans off their books and with money in their pockets, banks can make more mortgage loans. Until the bailout, Fannie and Freddy were not explicitly backed by the federal government (technically, they were government-sponsored enterprises), but everyone believed them to be and acted like they were. Their guarantees were thought to be solid and their debt was AAA rated. It was generally assumed that the Feds would come in if required, which is exactly what happened.

These bundles that I just described are mortgage-backed securities. In most countries, as well as in the United States, banks create these products themselves, without the need of a middle man. But Fannie and Freddie’s guarantees of repayment are much better than your average bank’s. Fannie and Freddie’s guarantees turned risky mortgage packages into investment grade obligations. In the US in 2007 there was almost $2 trillion issued in new mortgage-backed securities. Fannie and Freddie issued about two thirds of these securities. And sometimes, two thirds just isn’t enough.

Giant anomalies, neither private nor public, Fannie and Freddie couldn’t get no love. They did themselves some serious damage a few years ago when accounting scandals revealed some major problems in each. They turned on the charm and opened their wallets to their real masters – Congress. If combined, Fannie and Freddie would be the third largest spender on lobbying over the past ten years. And what happened? Congress berated them for not helping more lower income families to own their own homes. Topping the list of screamers were Barney Frank and Chuck Schumer. But who can argue against helping low income families to put a roof over their heads? It’s like cancelling Mothers’ Day. Meanwhile, Fannie and Freddie’s share of the higher credit worthy market was slipping. Oh, and there’s the fact that Fannie lost $2BN in 2007 and Freddie lost $3BN, due largely to their sub-prime practices. The first risk management failure was that of political risk management by both the execs at Fannie and Freddie and the politicians themselves.

If the taxation incentives, monetary policy (let’s not forget the low lending rates fostered by Greenspan), and political motivations created an unhealthy growth in the sub-prime market, derivative products ginned up the market. Now, don’t get me wrong, there were predatory lenders and borrowers and mortgage brokers providing patently false information that no bank ever verified. Some of this was illegal at the time and needs to be prosecuted. Most of it, negligent, legal, illegal or just stupid, is largely a moral hazard of the Fannie and Freddie system in the first place. But all of these problems together would not be enough to cause a crisis of these proportions. For this we needed leverage. And when you need leverage, look for a derivative product.

Here’s where everyone’s eyes glaze over and my real work begins. For everything I’m about to say, and most of what I’ve already said, there are nuances, digressions and complications. But, hell, some of the people who sell these products are not the sharpest tools in the shed. And if they can figure out these products' basic contours, you guys can too. So, here I go… An option on a stock, the right to buy the stock at a particular price within a set period of time, is a derivative product; it is not the stock itself, the option derives from the stock, put differently, the stock is the underlying asset from which the option derives. Derivative products are financial instruments that are anything but the underlying asset itself. Most often they provide leverage because, like the option, a smaller amount of money (the cost to purchase the option) can be used to participate in a much greater share of the underlying asset. However, there is greater volatility in this leverage and small changes in the value of the underlying asset will have greater effects on the value of the derivative.

One type of derivative product is a swap. Put simply, in a swap transaction two different types of risk are exchanged, but not their underlying assets. For example, a payment stream on a fixed rate loan is exchanged for a payment stream on a floating rate. The actual principal of the loans themselves is not exchanged. For example, as a financial institution, I have loaned somebody a fixed rate loan of 7% and I receive those payments; you loaned someone the same amount of money at prime plus 4%. For our various reasons, we enter into a contract between ourselves to exchange those cash flows, but not the underlying principal.

Unlike options which are classified as a security and regulated by the SEC, swaps are contracts and regulated by the self-regulatory industry association ISDA in London. Swaps are not regulated by anybody in the United States. Let me restate, swaps are not regulated at all in the United States. Worldwide these privately negotiated derivatives have a notional, i.e. underlying asset value, of well over $400 trillion. These numbers are huge. For a little perspective, the GDP of the United States in 2007 was about $14 trillion. It would take the entire output of the United States over 28 years to generate the amount of wealth in the underlying assets that are currently traded in the swap market.

US mortgage-backed securities, with their implicit US government guarantees, when combined with lower quality debt, can be used in swap transactions to increase one swap partner’s creditworthiness. They can also be used to reduce the amount of capital that an institution is required to hold because of their perceived low risk quality. So, global financial institutions use mortgage-backed securities in two ways, one derivative-related, and the other to shore up their capital on hand. Firstly, in swap transactions one party may bundle an A-rated debt instrument with the AAA-rated Fannie debt instrument and now have a package that looks like its AA-rated. Secondly, they hold mortgage-backed securities as regulatory capital – what financial institutions are required to hold in cash so that there’s money in the till if there’s a run on the bank. When these instruments turned out to not be as creditworthy as advertised, it blew a hole in the creditworthiness of many financial institutions; it reduced the amount of regulatory capital that they thought they had and caused some counterparties to default on their swap obligations.

Enter our next culprit – the credit default swap. This one will be easy to explain. It’s not really a swap at all. A credit default swap is an insurance contract. But due to the Commodities Futures Modernization Act of 2000 (one of the sponsors of which was McCain economic adviser Phil Gramm), so called credit default swaps could avoid the minefield of US insurance regulation and in fact, any regulation whatsoever. I’m not kidding. The law specifically banned the regulation of credit default swaps. OK, I confess to a little sympathy with the insurers here. Insurance regulation is messed up in this country. Insurance is regulated on a state-by-state basis, creating 50 different regulatory authorities. I want to digress here, but it wouldn’t help to explain the crisis. Let’s just say that insurance regulatory reform has to be a part of the solution. Of the over $400 trillion in swaps, approximately $62 trillion is the insured value of the credit default swaps.

A credit default swap is an insurance policy where the insurer takes a premium and guarantees that a counterparty won’t default on an obligation. Typically, what they’re insuring are payments on swaps. They insure that the counterparty to a swap transaction will continue to make its payments. As an insurer, those who demand the insurance will have conditions in place so that if the insurer’s credit rating slips, the insurer has to have at least enough money in the bank to make good on certain claims. As the insurer becomes less solvent, it needs to have more cash on hand. But it’s tough to have that kind of cash on hand when 30% goes out the door in the form of payroll each year. The average salary of an employee in AIG’s credit default department was $1 million. That includes mail room and secretaries. Average. Salary. Bonuses were on top of that. Greed wasn’t a culprit in the sense that it cheated a pensioner out of her retirement savings. Greed was a culprit because it robbed the kitty of the funds it needed for a the rainy day when the insurer has to make good on some defaults and because bonuses weren't tied to any risk measure, but just based on that year's profits alone for products whose profitability can be extremely variable over time.

Don’t think of default as never going to pay. Default just means missing some interest payments. But if the insurer has to start making payments, immediately the value of that policy sinks like a stone. The value of the insurer’s assets (the policy) drops, the insurer has to maintain more cash, yet with other defaults, the insurer has to make more payments, and the value of the insurer’s assets drops again … and you can see the vicious cycle at play. Not to mention, the kitty had been robbed by the financial geniuses who leveraged their institutions up to record levels. This is the story of AIG, where the former head of the credit derivative department earned $280 million over the past 8 years and he continues to earn $1 million a month while in retirement. Unfortunately, no kitty would have been sufficient for what befell AIG. The Fed came in and nationalized them with $84 billion, of which they’ve already spent $61 billion and the Fed just said that they would be willing to provide up to $38 billion more. No matter how rapacious the guys doing the transactions were, they weren’t skimming $122 billion off the books in bonuses. The problem of greed was compounded by the leverage of the instruments.

With all this leverage in the market: the credit default swaps, which are derivatives of the swaps, which are derivatives of any number of underlying assets, including mortgage-backed securities, which are derivatives of the mortgages themselves, the volatility can be insane as the value of the derivative products can go to zero much faster than that of the underlying assets themselves. The value of the credit default swap once an insured starts defaulting - zero. The value of a swap made up of defaulting mortgage-backed securities - anyone's guess, but zero is a safe one. You can see how use of leverage in a period of declining valuations can quickly reduce a firm's asset base.

So what does everyone want to do at a time like this – deleverage! Enter the credit crisis. It becomes a little easier to follow from this point forward because I have to rely less on financial instruments and products and come back to policy and the more understandable sheer panic. Suddenly everyone wants to sell what have come to be called their “toxic assets” but like the insurer, financial institutions have to have a minimum amount of cash in the bank – called a capital adequacy standard. The amount of cash on hand doesn’t have to be greenbacks, it can be in cash equivalents – like commercial paper issued by reputable companies like say, Lehman Brothers. If you thought it was hard to value your derivative products which are crashing to zero (although zero would probably be a good estimate) what value do you put on a 3 month piece of commercial paper from a huge multi-national firm that just yesterday seemed a picture of health. This isn’t a derivative product, this used to be treated like cash. What happens now if you have commercial paper from Hypo Real Estate Bank in Germany? Hypo is leveraged at 100 to 1 (although as the value of their assets falls, that ratio will be different again tomorrow) and just got a bailout from the German government. What’s their paper worth? Or General Motors, who just compelled to irrationally declare that they are not going to file for bankruptcy. But what if they keep some of their cash in a deposit institution that does declare bankruptcy and they don't have access to some of their cash in three months? Now panic sets in.

This is where I think that the comparisons to 1928 fall flat. This isn’t a crisis of a financial marketplace. It’s a bank panic, a crisis of liquidity in the credit markets and total confidence in the financial markets. This is clearly more like the bank Panic of 1837. And that flashback actually brings us up to the present. But before we get to “What’s Going On Now?” here are those promised bullet points:

What Happened?

• Government policies incent home indebtedness over home ownership
• Government institutions were compelled to take dubious sub-prime mortgages and guarantee them
• This created a moral hazard that mortgage providers used to generate more mortgages and then sell them to Fannie and Freddie
• The mortgage-backed securities were used to fulfill requirements for cash on hand in financial institutions, because they were almost as good as cash
• And they were also used to gin up the quality of financial instruments that rely on the use of leverage
• The global market in these instruments is $400 trillion. In 2007 the GDP of the US was $14 trillion.
• Not only does this leverage create greater volatility, many of these financial instruments trade in an entirely unregulated marketplace
• Wall Street paid bonuses that weren’t linked to the risk that they were taking on, but based solely upon the profitability of instruments that can be at times very profitable and at times very unprofitable. Some of these bonuses should have been saved for this rainy day
• As firms tried to sell the bad assets and reduce their holdings of the more volatile financial instruments that rely on leverage, there came a point when no one would buy
• Storied institutions with long standing favorable credit ratings began to fail
• Insecurity about who might be next poisoned the market and everybody stopped lending
• The engine that makes the world go around, credit, is coming to a halt
• Once the wheels of credit jam up, and banks can’t borrow and won’t lend, everyone began to feel the pain

What’s Going On Now?

It’s hard in the middle of a battle to assess what the field really looks like. But let me suggest that there are two elements to the crisis. One is market-based crisis of confidence and true erosion of capital and the other is various governments’ tactical approaches to dealing with the crisis. I have addressed the underlying issues in the crisis of confidence and erosion of capital in the What Happened section. Suffice to say, it is continuing and accelerating. The scope of the problem is too big for the financial institutions themselves to remedy. Fortunately, unlike in 1837, we have a central bank as a lender of last resort and a government willing to take tactical actions. (I separate tactical from policy because we haven’t even begun to address the policy requirements yet and any of the actions taken now are purely reactionary and entirely necessary.)

The $700 billion set aside for the bailout is going to be insufficient to the task. While it’s a good start, lending institutions clearly don’t think that it’s going to be sufficient. Credit markets are still seizing up. The indicator to look for in this market is the TED Spread which is a measure of banks’ willingness to lend to other banks. It is the difference between the interest on a 3 month US government bond and the rate at which banks lend to other banks. It has increased over 1,000% since the beginning of the year.

The only way to increase banks’ confidence in other banks and to start the wheels of credit turning again is to ensure lenders that the borrower is well capitalized and will repay the loan. It’s going to take months to clean up the balance sheets of these financial institutions with so many leveraged and defaulting assets on their books. But we don't have that kind of time and need to restore confidence in financial institution's abilities to weather this storm today. What everyone knows to be good money is government money. And that is why the Fed has stated that it will start buying stocks of banks. The likely way that this will work is that financial institutions will sell their own stock that they have in treasury (a reserve of stocks already issued but not available for sale). This will dilute existing shareholders, but it will provide the institution with immediate, much needed, capital.

These share purchases will make the government a shareholder in the bank, which is fraught with conflicts of interest and other problems (although except for shareholder rights, the shares will be non-voting), but it is the fastest way to restore confidence and provide a solid capital base from which the bank can both lend and against which it can borrow. Once the government becomes a significant shareholder, lenders can assume that the bank won’t go bankrupt as it has the backing of the government. (Note that in Paulson's speech announcing this, he did not guarantee the liabilities of these institutions - which I was surprised not to hear and could be a big problem in the plan.) That said, some governments may not be powerful enough. Iceland nationalized its largest bank and the share price remained unchanged at 18 cents, meaning that investors think that the government of Iceland about as likely to go bankrupt as its largest bank.

Dropping the Fed Funds Rate, which will affect the interest rate that people can borrow at is another approach. Governments across the world just did this the other day, dropping interest rates a half a percent.

Although I feel that it’s less effective than buying shares in financial institutions, buying the bad assets is another approach. This will at least help to clean up borrower’s balance sheets and make it less likely that they will fail. But I don’t feel that this approach carries the same effect of a restitution of confidence that buying shares outright does because financial institutions themselves don't feel that they know which of their assets are bad and which are not. Morgan Stanley's likely going to be downgraded. It's shares dropped more than 40% in one day. If Citi is holding $1BN in Morgan Stanley's commercial paper, which just three weeks ago was thought to be a cash equivalent asset, what is the value of that today? Financial institutions lack the confidence in their own ability to assess bad from good.

There also should be some kind of guarantee on commercial paper. This will help the other engines of the lending machine, the money market funds. The Treasury has already issued a temporary guarantee of money market funds, but they may need to guarantee the root issue as well - the commercial paper market.

And, hey, McCain does have a point, maybe some mortgages should be assumed directly by the government. It’s the least likely way to infuse any liquidity into the credit market. But it will make some people happy with Washington and it’s so damn apple pie that you can’t argue against it on the campaign trail. And, most importantly, it’ll make the Treasury Secretary’s other actions easier to do by placating a few constituents.

The catastrophic erosion of capital in the stock markets is a direct result of the credit crisis. But too much attention is paid to the value of the Dow Jones Industrial Average. We need to be focused, and I think that the regulators rightly are, on the credit crisis. Despite some high profile bailouts, there’s been little done so far, so it’s hard to point out winners and losers. But there is one unsung hero in this whole thing, Shelia Bair, chair of the FDIC. Amidst the bankruptcy of IndyMac, all the crisis and takeovers, 8% of Americans’ banking deposits moved from one institution to another. Except for some depositors in the bankrupt IndyMac, nobody who had their money transferred from one institution to another has lost a dime. The transitions have been smooth and seamless. WaMu depositors were welcomed to JP Morgan Chase the day after the acquisition and all their deposits were just as they had been. Somebody better treat Ms. Bair real well when she steps down.

The bullet points for What’s Going On Now:
• It’s a crisis of confidence and a credit crisis
• Washington and other governments are using all the tactics available to them to get the wheels of credit turning again
• Some of these tactics are: investment directly in banks, purchasing the bad assets from banks, refinancing and holding individual mortgages, lowering the interest rate
• The combination of these tactics will likely cost more than the $700 billion already allocated
• Shout out to Shelia Bair at FDIC (Bush may have picked Brownie – but for this crisis, thankfully he picked you!)

What Is To Be Done?

In the spirit of the nationalization of major financial institutions, I thought I’d entitle this segment after Lenin’s book.

Firstly, the current tactics that are being used by the Fed and the Treasury seem to me to have validity, they have the approval of Congress and there will be a calling to the carpet once the first $400 billion is spent. They should continue doing what they’re doing. But they will need more money and Congress should start looking to how it’s going to fund it.

Derivative Instrument Transaction Tax
For the next ten years (at least) there should be a tax on derivative instrument transactions. Taxpayers have just eaten a load of externalized costs associated with these transactions. We should make the securities industry internalize these costs by making them pay a tax on the transactions themselves – not just profits. Portions of this tax should be set aside for regulator training, FDIC, SIPC and a yet to be established money market insurance fund. There is at least a $400 trillion marketplace out there (that’s just the size of the swap market). We should get some of that back.

Home Ownership Incentives
I have misgivings about the whole nature of or rationalization for home ownership incentives. But arguing against them would be like trying to strip baseball of its national pastime title. So, let’s assume that we have to have some. I think that we should find a way to incent the “ownership” portion and not the “indebtedness” portion on a home owner’s primary residence. Reward the repayment of principal rather than the payment of interest. Admittedly, this doesn’t help first time buyers in the early years of their mortgage payments, which will be a problem in getting any traction for this kind of a change. But it’s got to be put on the table.

Shoot Fannie and Freddie – worry about Ginnie later
Once liquidity has been restored to the credit markets (in 5 – 6 months) we should begin what will be a long wind down process of Fannie and Freddie. They should slowly stop buying mortgages and slowly try to unload their inventory. Eventually, they’ll be stuck with the real duds and the American taxpayer will get a bill. But we have to cut out our guarantee of the middleman.

Unify the Regulatory Authority for All Financial Products
FIRE – Finance, Insurance and Real Estate – this should be the clarion call for regulatory reform. Insurance regulation should be nationalized. All financial products should be regulated by a federal authority. The era of self-regulation should end. A cry from the industry will go up that these products are so complicated that the feds won’t know what they’re regulating. Bullshit. Compensate adequately and you’ll find many people willing to do 9 – 5 work as opposed to the life of ulcers and early mornings they’d be giving up. Assess capital adequacy standards. Should they go down in times of crisis so that more funds can be available, or should they stay high so that the money’s there if people come calling? I don’t know, but capital adequacy has to be a part of the regulatory overhaul. Should leverage, like capital, also be regulated? Should there be maximum leverage requirements. Remember, Hypo in Germany is leveraged to the tune of 100 to 1. Long Term Capital Management was leveraged to the tune of 30 to 1. Something has clearly come unhinged in our permissible leverage ratios and this should be open to regulation in the future.

Shareholder Actions and Executive Compensation
Somehow there’s got to be a government motivated PR campaign to get compensation boards to tie executive salaries to a measure of risk called “risk adjusted return on capital” or RAROC, so that the risk of the profits are taken into account when determining compensation. If the execs have to eat RAROC in their comp plans, they’ll definitely force it down the ladder. This is a tough to implement because it requires shareholder action, but a broad information campaign may force the issue. It should definitely be implemented in any institution where the government has taken an ownership stake.

Government Guarantees
We’ve raised the FDIC insurable amount to $250,000, but are there other federal insurance programs that we should have in place? There’s SIPC, but it’s a joke. It’s run by the securities industry and seldom, if ever, pays on a claim. While we’re at it, the Feds should nationalize SIPC and look into providing some guarantees to individuals for money market funds and possibly commercial paper.

Mandate Specific Risk Management Practices Within Financial Institutions
Clearly there’s been a failure of risk management practices within financial institutions. We’re going to have to sift through the rubble to figure out where they failures lay and what could be done to strengthen them. But once we know, we should make these risk management practices part of the regulatory regime and enforce them.

I’m sure that there are many more ideas that will come from this crisis and these are just the few that I can think of. So again, for you lazy speechwriters, here are the bullet points:

• Tax complex financial transactions and use a portion of the proceeds to train regulators
• Reward home ownership, not indebtedness
• Wind down Fannie and Freddie
• Unify regulation across all financial and insurance products, end the self-regulatory regime and hire competent dedicated regulators who believe in free and transparent markets
• For all the companies that the government invests in make executive compensation tied to the risks that they take and encourage others to do the same
• Create an additional government insurance program for individuals who invest in money market funds
• Regulate risk management within financial institutions

Eventually, the government should divest itself of its holdings. The direct investment in financial institutions will likely be profitable over the span of a few years and there may even be some interest charges that the government will take. Some of the "toxic assets" will prove to be not so toxic after all and can be sold back to the very same financial institutions at a premium. Hopefully those gains will cover the losses incurred from assumed "toxic assets" that are truly worthless. The taxpayers will likely get their money back and we will be living in a different style of economy than we have been for the past thirtyish years.

If you’ve actually read all of this, thanks. It’s the world as I see it, and as these are huge issues with many contributing factors, I’m willing to be wrong on some of these issues. But, in the absence of any substance from above, I wanted to give it a shot. Hopefully it helps.

Cheers,

Adam

Copyright of Joint Works (in the 2nd Circuit)

As a general rule, the creator of a work is the party who first put a creative expression into a fixed or tangible medium. All copyright in the work is then held by this author.

Joint works are those owned by multiple authors. By its definition, multiple authors combine in the creation of the work or each author creates his/her work independently with the intention that it merge with the contributions of others as an inseparable or interdependent part of the whole. Under the 1976 Copyright Act, this definition of a joint work can be found at 17 U.S.C. Section 101.

The regulation of copyright is one of Congress' enumerated powers provided by Article 1 Section 8 Paragraph 8 of the Constitution. Any copyright action must be brought in federal court. Standards for what creates a joint work based on the definition given in the Copyright Act vary by federal circuit. In the Second Circuit, which covers the states of New York, Vermont and Connecticut, the most recent seminal case on the issue of the creation of a joint work is Childress v. Taylor.

Childress v. Taylor: Facts
Taylor, an actress, researched the life and times of the comedian Jackie "Moms" Mabley. With the opportunity of a limited production in a reputable summer stock theater and an extraordinarily tight timeframe (6 weeks), Taylor asked Childress to write a play using the information from her research and some of Taylor's own input. The play had a successful run but Taylor and Childress could not come to an agreement about the ownership of the work. After the run, Taylor presented Childress with a contract granting her co-ownership in the play. The relationship deteriorated and no contract was signed. Taylor then commissioned another playwright to write a new "Moms" Mabley play based upon Childress' original play and used review quotes and references to that summer stock play in the billing of the new version. Childress brought suit.

INTENT TO CREATE A JOINT WORK
Citing Committee reports surrounding the creation of the Copyright Act, Childress states:

"[A] work is "joint" if the authors collaborated with each other, or if each of the authors prepared his or her contribution with the knowledge and intention that it would be merged with the contributions of other authors as "inseparable or interdependent parts of a unitary whole." The touchstone here is the intention, at the time the writing is done, that the parts be absorbed or combined into an integrated unit.... House Report at 120; Senate Report at 103"

Drawing from this, the court found a stringent requirement for joint works, namely that the joint authors must have mutually intended to be co-authors at the time that the work was created.

WHAT TO LOOK TO FOR INTENT
The amount of the contribution is not enough. Even a significant contribution without a specific finding of mutual intent may not be enough. Some of the key indicia of ownership are:
Decision Making Authority: The ability to make creative decisions over what is included or excluded from the work. If final cut/approval over a work is retained by one party, the other will have a harder time proving join work statuts.
Billing or Credit: Though not decisive, billing or credit is very important in determining how the parties viewed themselves in relation to the work.
Written Agreements With Third Parties: If there are agreements with production companies or other third parties that list one party as the author of a work, this will be a strong indicia of authorship. This is especially true if the party signing the agreement did so without the consent of the other.
Additional Evidence: Any additional writings or facts that can contribute to a finding for or against the creation of a joint work.

INDEPENDENTLY COPYRIGHTABLE
Under Childress, in the Second Circuit, the contributions of all authors must be independently copyrightable. Meaning that, each author's individual contribution must possesses a modicum of originality and is in a fixed medium. The same tests that are applied in general for copyrightability would be applied to each individual contribution made. Thus, a contribution such as a piece of improv in a sketch comedy routine would likely not be enough to create a joint work as it would fail the copyrightability element.

If a joint work is established, the co-authors are co-owners of the copyright and have an equal and undivided ownership in the entire work. Each can do as they would like with the work, including license it to others on a non-exclusive basis, provided that the one party account to the other for the economic rights that they are due.