Fradulent, or Just Wrong

This writer does not normally comment on legal issues, but this one is just too interesting, and raises too many questions, to leave alone.

On Monday, in the Central District of California, the US Justice Department (together with 16 states that have joined the action) filed a civil lawsuit against Standard & Poor's (a rating agency, owned by McGraw-Hill), alleging that, from September 2004 through October 2007, S&P "knowingly and with the intent to defraud, devised, participated in and executed a scheme to defraud investors" in certain securities. Prior to the filing, settlement talks between S&P and the Justice Department had broken down, principally because the government had insisted that S&P admit wrongdoing, pleading guilty to at least one count of fraud.

The securities were collateralized debt obligations, known as C.D.O's, complicated instruments composed of bundled mortgage-backed securities, which in turn were made up of individual home loans (hence the term "derivative" commonly used to describe such instruments). The filing, seeking $5 billion in penalties (about 5 times S&P's 2011 profit) to cover the losses to investors (particularly institutions like state pension funds and federally-insured financial firms) was done in the California district that was home to the now defunct Western Federal Corporate Credit Union. It collapsed (along with many others throughout the United States) during the financial crisis in 2008, as a result of losses on mortgage-backed securities rated by S&P.

S&P says it will vigorously defend itself against "these unwarranted claims". Its lead lawyer, Floyd Abrams, is best known as an expert in defending First Amendment (freedom of religion and speech) rights. But he is apparently intending to launch a much simpler approach in court (if the case ever reaches that point), saying on CNBC this morning that, put bluntly, "the ratings that were issued were believed by the people who issued them. And that's what the government has got to disprove". That S&P's opinions turned out to be wrong (even spectacularly, though hardly uniquely, so) is not fraud. The issue is did S&P say one thing, but believe another? Did S&P intend to mislead, for the sake of protecting its clients and its profitability?

Despite now possessing reams of internal S&P emails, and interviewing more than 150 people at S&P, the Justice Department would seem to have an uphill battle in proving fraud. Proving fraud is always tough. Watch for the suit to drag on for months or years, and become political, particularly as Republicans accuse the Obama administration, through its Justice Department, of re-fueling the Wall Street versus Main Street debate.

What Now?

This morning, French President Hollande, along with his Ministers of Defense, Foreign Affairs and Development, and Malian President Dioncounda Traoré, strolled through the streets of Timbuktu in Mali. They received a hero's welcome, following the routing by French and Malian army ground forces, and by French airstrikes, of radical Islamists who had controlled the city for months. This was the culmination of the French intervention in Mali (a French colony through much of the 19th century until its independence in 1960), begun just last month at a point when an assortment of al-Qaeda-led rebels had gained control of most of the northern and central cities of Mali, and looked poised to seize the country's capital, Bamako.

Such a rapid and efficient sweep by the French in Mali is reminiscent of another swift and decisive assault, that on Baghdad by American-led coalition forces that began on March 20, and ended 20 days later, on April 9, 2003. Of course, the fall of Baghdad was not the end, but just the very beginning, of a conflict that would last for years, with American military personnel not being finally withdrawn from Iraq until December 2011.

This is the risk now in Mali - of a quagmire - and the French know it. The Islamist jihadists are gone from (or absorbed into) the cities, but may be preparing for a prolonged counterinsurgency, surviving and attacking as guerrillas from desert hide-outs. The French are promising to stay until Mali is stabilized - "It's going to take a few more weeks", President Hollande said today in Timbuktu, noting that "our African friends will be able to do the work that was ours until now". But the Malian army is badly-trained and ill-disciplined (there are reports of Malian soldiers committing revenge killings against the Tuareg minority in the north), and even with assistance from the EU, and from various African countries' forces being sent from the 15-member Economic Community of West African States, it will be challenged to effectively fight rebels in the desert. 

Wary of earlier Western experiences in Vietnam, Iraq, and Afghanistan, it is not surprising that President Hollande is already speaking of an exit strategy for France's 3,500 ground troops in Mali. Watch for a decision by the UN to send in a peace-keeping force - much-needed, when the French forces leave, because putting Mali back together again, politically and economically, may take somewhat longer than "a few more weeks".  

Equities and Growth

At first glance, there seems to be a disconnect.

As this writer noted two weeks ago, US equity markets have been rallying, to multi-year highs. This month alone is the best January for the S&P 500 index in some 24 years (up 5% from the end of 2012, and 14.5% from a year ago). For the first time in five years, funds are just beginning to flow out of the safety of US Treasury bonds (with prices dropping, and, hence, yields rising) into equities. As the S&P 500 goes this month, so goes the rest of the year (so says the January Barometer, a consistent indicator). And, further, it's not just the US financial markets that have exhibited recent strength - so have Chinese, Japanese, and even European markets.

But yesterday's first estimate of fourth quarter US GDP suggests a stalling economy, with overall output actually declining by 0.1% at an annual rate (the consensus prediction was for an expansion of 1.1%). In this weak economic environment, are financial markets irrationally exuberant?

The simple answer is no. Investors are looking beneath the headline GDP number, focusing instead on the components of the aggregate. The principal contributor to the fractional drop in GDP, other than a big swing in business inventories, was government spending, which fell at a 6.6% rate, as defense outlays dropped 22.2%, reflecting concerns over the pending fiscal cliff of scheduled tax hikes and, particularly, large budget cuts to defense. In contrast, private consumption (which accounts for two-thirds of the economy), business fixed investment, and residential construction all grew at an accelerating rate from the previous quarter. The continued strength in business investment is especially significant, given that such investment is widely recognized as being closely correlated to both employment and, more importantly, labor productivity (that is, the amount of output obtained per unit of input). With this relative buoyancy in the private sector, US corporate earnings currently being released for the fourth quarter, as well as outlooks for the coming year, are mostly beating expectations. And ultimately, it's earnings and their multiples - which have room to expand - that drive stock prices.

This is not to deny ongoing concerns. These can be described in two words - policy risks - emanating from Washington. Thus, the sequester ( large, and blunt, government expenditure cuts) now scheduled for March 1 could, if implemented, produce several further quarters of anemic GDP growth, or contraction. And then there are the postponed, but impending, debt-ceiling and federal budget negotiations, either or both of which could lead to another credit downgrade of American debt. Financial markets would not react well should this occur.

Riots Resume

At the beginning of this month, this writer suggested that President Morsi of Egypt pay less attention to transforming the country into an Islamist society, and focus instead on economic matters, as a better way of preventing his government being swept away by further popular uprisings in the street. He didn't listen.

Egyptians have resumed rioting, in Cairo, and in other cities like Port Said, Ismailia, Suez and Alexandria, despite tear gas and curfews, and despite the ubiquitous presence of the military that is once again empowered, as it was under Hosni Mubarak, to arrest civilians. Between 50 and 60 people are believed to have been killed over the past five days, in protests that began peacefully last Friday to mark the two-year anniversary of the revolution. At the core of the protests is outrage regarding the relentless, and clearly miscalculated, push by President Morsi's Muslim-Brotherhood-backed, 7-month-old government to impose strict Islam-dominated rule on a populace that is now significantly (though by no means entirely) politically secular.

What's different in this round of rioting is a sense that Morsi's government is no longer trusted or accountable, and thus losing control as an atmosphere of near-anarchy emerges. On Sunday night, Morsi declared a state of emergency in certain cities, promising even harsher responses to further unrest, then called on representatives from eleven political parties - Islamists, liberals and leftists - to attend reconciliation talks at the presidential palace. Only the Islamists showed up.   

With these uprisings, the much-needed, and much-delayed, $4.8 billion loan from the International Monetary Fund is once again subject to re-negotiation, and more delay. Without it, President Morsi cannot stop and reverse the Egyptian economy's downward spiral, despite short-term financial assistance from some Middle East governments. But this may soon be a moot point, as it is entirely possible to envisage the collapse of Morsi's government well before the IMF loan is finally made available. 

Muslims Fighting Terrorists

The Algerian army battled terrorists this week. Today, in a final storming of a natural gas complex in the Algerian Sahara, the secularist army regained control of the complex seized last Wednesday by Islamist hostage-takers, of several nationalities. Casualties are apparently heavy. Western governments have expressed surprise and frustration (but, privately, relief as well) that the Algerian response has been so rapid and heavy-handed. An audio recording released by the Algerian security forces indicates that the terrorists' goal was to force negotiations for a swap of 100 prisoners long held by the Algerian government. The government opted for force instead.

Algeria's insistence on not negotiating with terrorists should be of no surprise to anyone. Over ten years ending in 2002, the Algerian government, and more particularly the Algerian military, talked then fought with Islamists in a complex, blood-stained civil war about which the rest of the world, including France, adopted a policy of mostly benign neglect and buck-passing. It is estimated that upward to 200,000 Algerians died, in a war where deliberate massacres were not uncommon, but their reasons opaque, in that who was killing whom, and why, was often unclear. At the time, Algerian generals, who had seized power during the 1992 elections when Islamist parties appeared poised to form the next government, were divided between "dialoguistes", who favored talking to the Islamists, and "eradicateurs", who believed there was no such thing as a "moderate Islamist", and wanted to eliminate them. The debate raged for years. More Algerians, including civilians who were specifically targeted, died each year, and it was not until an amnesty issued in 1999 to guerrilla fighters by a newly-elected President, Abdelaziz Bouteflika, that violence subsided, with full victory for the government some two years later.  

A decade later, Mr. Bouteflika remains the Algerian President. Still recovering from the legacy of the civil war, he clearly sided this week with the "eradicateurs", deciding on a response of overwhelming force in dealing with the Islamist terrorists in the Sahara. He won this battle. But, although not yet affected by the Arab Spring, it seems nonetheless difficult to imagine how Mr Bouteflika and his military-backed government can ultimately escape the kind of pressures that two years ago swept away similar power structures in Tunisia, Egypt and Libya. As in these neighboring Arab countries, the Islamists, in the form of Muslim- Brotherhood-backed political parties, are well-organized, and may yet emerge in Algeria as the new power elite. Last Spring, following elections, even Mr Bouteflika seemed to acknowledge the possibility, when he said that "my generation has had its time".