... all of the banks benefitted from what financial sector analyst Meredith Whitney called "back door financing." Whitney described what amounts to Fed-sanctioned front-running of the fixed income market by the banks. The Fed publicly telegraphed its intention to buy $750 billion mortgage backed securities from Fannie Mae and Freddie Mac and $300 billion in U.S. Treasury bonds. And that was AFTER it announced in late November of last year it would be wading in as a buyer for all agency bonds to support the U.S. mortgage market.What’s front-running? Simple: you get out in front of a customer’s order to line your own pockets. The illegal version goes like this: Shady Brokers ‘R Us gets an order from the Orphans Fund to buy 5 million shares of GE. First, Shady quietly slips in its own order and buys up, oh, let’s say 100,000 GE shares at $10 each. Then it executes that large Orphans Fund order; the heightened demand pushes the stock price up to $10.30. Shady now turns around and unloads its own shares at a price near $10.30, making out nicely.
Again, this is the illegal version. The legal version is what happened after the Fed announced publicly it would buy up agency bonds, mortgage-backed securities and U.S. Treasuries in the above amounts. If you were a private company that cared about getting the best price (unlike the Fed), and for some reason had to make those huge buys, you'd be very hush-hush and discreet about your purchases. Otherwise your competitors get there first and drive up the price and make you overpay.
Of course the U.S. government is the dumb money here. Or maybe not so dumb, as it appears the Fed actually wanted to overpay and make a gift to the banks.
Moving along, the really crazy stuff (if you haven’t seen this already) relates to Citigroup. Believe it or not, the bank essentially made a bet against itself and won $2.5 billion! This is sort of like if you said, "I'll bet $10 I'm the dumbest guy in this school" and your friend (who thinks you're stupid but not that stupid) says "You're on." And when the final class ranking comes out, you happen to anchor the #552 spot among 552 students and you say, "Ha ha. Told you I was pretty freakin' dumb. Now pay up." You might think this gives you an incentive to underachieve. Hmm.
I’m not quite sure of the precise details on how Citi's wager worked, but at the heart of it were the credit default swaps that are bought as insurance against bankruptcy:
... in plain English, Citi profited because it made a bet that the cost of insuring itself against a default would go up. The credit default swap market is the place where you can bet on the credit worthiness of a firm, or, essentially, the chance that a firm might default on its bonds. Citi appears to have reported a $2.5 billion trading gain in the fourth quarter precisely because the market thought the company stood a good chance of failing (hence the widening CDS spread).So it appears (as Denning notes), that if Citi was in even worse shape, on death’s door, it could have made even more on these derivatives. So think about that for a moment: $2.5 billion of Citi’s just-reported earnings were because the company went from “stinks” to “really stinks.” Remove this alone and Citi reports a $1 billion loss from the quarter.