Monday, June 27, 2005


Additional flaws in MDL reporting: Liability and exposure

This is the second of a two-part post to address what we see as some significant recent flaws in the reporting on MDL - signficant in the sense that they serve to downplay how risky, stupid and irresponsible those around the MDL debacle were.

This one will be shorter than part one.

BWC's exposure to MDL losses:
We had a good laugh when we saw this reported comment:
Barry Slotnick, the attorney for MDL Chairman Mark D. Lay, said the direction of the economy was to blame for the losses, not his client.

“This is an example of trying to get the public excited,” said Mr. Slotnick, who is defending MDL against a lawsuit filed by the state. “Had interest rates gone up as expected, Ohio would be a very rich state and would have acclaimed Mark’s brilliance.”
That's like saying the roulette wheel is entirely to blame for losing a thousand bucks because the ball landed on red instead of black.

Uh, Barry . . . no fidiciary authorized Mark Lay to create his short-selling pyramid.

And, as one acquaintence of ours said, "even if I had won enough gambling to buy a new car, my wife would have divorced me for taking the chance."

C'mon. Is Lay's best defense really going to be that, "heck, he might have won that bet"?

Lay's and Terry Gasper's transgressions (aside from Gasper being an investment hack who got his job at BWC under murky circumstances having mainly to do with his political connections)
are that they engaged in unauthorized and highly-risky short selling amplified by their strategy to manipulate investment durations.

After laughing at Slotnick, we also laughed when we read this:
Financial speculation with state funds hit $5.6 billion last year in an investment strategy far exceeding a company's contract with Ohio's fund for injured workers, according to a report released Friday.

The state says it was never at risk for losing that much money because of the contract. . . [BWC] spokesman Jeremy Jackson said Friday. Jackson said a clause in the bureau's contract with MDL prohibited it from being held liable for more than the sum of its investment.
Give us an f'ing break. That's damn easy for BWC to assert now, but if the amount of the loss had exceeded the initial investment, we have no doubt that the state of Ohio - one way or another - would have been liable.

Let's parse the statement, "The state says it was never at risk for losing that much money because of the contract".

We'll start with the "never at risk" part. How likely MDL could have at least a billion dollars (as compared to hundreds of millions)? The answer is that it would have been relatively easy although most likely improbable. That's a far cry, however, from never.

Again, anytime someone engages in short selling of securities, the exposure to losses is unlimited. As we have noted before, there is more safety in shorting bond-related securities because the prices tend to move in smaller increments than equities. Nonetheless, all it would have taken for MDL to lose a billion or two is a major "shock" to the financial world such as another 9/11 event or an earthquake or international currency scandal. These would trigger huge jumps in the bond markets. Smaller events can also have the same effect.

So we can't talk about the idea of billions of dollars of losses in terms of whether it can or can't happen. We can only talk about it in terms of what the probabilities are that it can or can't happen.

Our point is that such a loss could happen, and it is those kinds of probabilities that good portfolio managers are supposed to spend a lot of time thinking about it. Anyone that claims that a billion dollar loss by MDL could never have happened has no idea what he or she is talking about.

The second part to parse is the clause, "because of the contract." We are willing to grant the the contract may have initially indemnified BWC from certain losses, but the fact is that a loss in the range of a billion or more dollars would have tested the contract protections in the furnace of real-world finances, politics and courts - and we believe that the contract would have been reduced to ashes.

There is just no conceivable way that BWC or the State of Ohio would have been able to walk away from some bank, investment house or other financial entity that is demanding that someone pay the $1 billion (or whatever) that they are owed. Mark Lay's pockets aren't that deep. He may have been insured, but it's doubtful that he had coverage for short-selling.

Inevitably, the State of Ohio would have been forced to eat all or part of the entire loss.

The bottom line is this: There, indeed, was the potential for the MDL to spiral out of control to the extent that billions of dollars had been lost, and BWC/State of Ohio would have had to make good on the loss. They might have been able to settle for pennies on the dollar, but, they would have to had to make good one way or another.


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