Friday, May 11, 2012

Lest We Forget: Why We Had A Financial Crisis

These numbers do not include Wall Street whose most recent boom/bust cycle vaporized $4.2 trillion dollars in residential estate value.  Then there's your 401K...


The Washington PostMay 11, 2012
Ezra Klein's Wonkbook

Of the big banks, JPMorgan Chase arguably came through the crisis best. And its CEO, Jamie Dimon, has been using the credibility built up during that period to fight the Volcker rule. “Paul Volcker by his own admission has said he doesn’t understand capital markets,” Dimon told Fox Business earlier this year. “He has proven that to me.”

And then, last night, JPMorgan Chase announced it had lost $2 billion on some very big, very dumb hedges. For proponents of stricter financial regulation, Dimon's giant loss is a huge gift. The final version of the Volcker rule is scheduled to be released in the coming months. Dimon swears that these trades would have been compliant with the previous drafts of the Volcker rule. That will give regulators a strong incentive to make sure future trades like these aren't.

Dimon, for his part, doesn't see the relevance. “Just because we’re stupid doesn’t mean everybody else was,” he said on a Thursday conference call. “There were huge moves in the marketplace but we made these positions more complex and they were badly monitored.” (Alan here... "Just because we're stupid doesn't mean everybody else was." In the midst of betting frenzy, don't bet the farm on limited stupidity. In contemporary American capitalism, stupidity - at least from the vantage of The Common Good - is limitless...)

But the point of the Volcker rule -- and of financial regulation more generally -- isn't to punish banks for being evil. It's to protect the rest of us from banks being stupid. And if the most prudent of the big banks can't keep itself from being this stupid this soon after the financial crisis, then it's pretty clear we're going to need very strong rules to keep them from being stupid in the years to come, when the lessons of the financial crisis have faded more completely.

As Reuters' Felix Salmon writes, "JP Morgan more or less invented risk management. If they can’t do it, no bank can. And no sensible regulator can ever trust the banks to self-regulate."

Top story1) A massive bet gone wrong cost JP Morgan Chase at least $2 billion. "A massive trading bet boomeranged on J.P. Morgan Chase & Co., leaving the bank with at least $2 billion in trading losses and its chief executive, James Dimon, with a rare black eye following a long run as what some called the 'King of Wall Street.' The losses stemmed from wagers gone wrong in the bank's Chief Investment Office, which manages risk for the New York company. The Wall Street Journal reported early last month that large positions taken in that office by a trader nicknamed 'the London whale' had roiled a sector of the debt markets. The bank, betting on a continued economic recovery with a complex web of trades tied to the values of corporate bonds, was hit hard when prices moved against it starting last month, causing losses in many of its derivatives positions. The losses occurred while J.P. Morgan tried to scale back that trade." Dan Fitzpatrick, Gregory Zuckerman, and Liz Rappaport in The Wall Street Journal.

The loss is putting the spotlight on the Volcker Rule. "JPMorgan Chase’s $2 billion trading loss, which was disclosed on Thursday, could give supporters of tighter industry regulation a huge new piece of ammunition as they fight a last-ditch battle with the banks over new federal rules that may redefine how banks do business...The centerpiece of the new regulations, the so-called Volcker Rule, forbids banks from making bets with their own money, and a final version is expected to be issued by federal officials in the coming months. With the financial crisis fading from view, banks have successfully pushed for some exceptions that critics say will allow them to simply make proprietary trades under a different name, in this case for the purposes of hedging and market-making. The missteps by JPMorgan could highlight that murky line between proprietary trading and hedging. The bank unit responsible for losses takes positions to hedge activities in other parts of the bank." Nelson Schwartz in The New York Times.


The "new nature" of investment banking is hidden in plain sight.

Wall Street is a predator and the overwhelming probability is that you are being fleeced.

Few human traits are as widespread as homo sapiens' tendency to  "overlook the obvious," a trait fostered by our inclination to "be penny wise and pound foolish." 

What, exactly, are we overlooking?

Wall Street no longer invests in actual production -- at least not as its primary function.

Instead, Wall Street places bets on "numbers." 

In mathematical - and gambling - parlance, Wall Street "runs numbers."

Derivatives, credit default swaps and other forms of hedging are "confections" cut whole cloth from "numbers" masquerading as productive business activity. 
Money, Power and Wall Street (PBS Frontline): 

If derivatives and credit default swaps were proposed in the 1950s, "The Greatest Generation" would have identified this financial excrement as the equivalent of Las Vegas slot machines.

It bears repetition:

Wall Street is not, primarily, about production of goods and services, it is about numbers; numbers that create a vortex of apparent "business activity" but whose primary purpose is to engender centripetal force that sucks money from gullible investors who reside outside "The Vortex." 

In turn, Wall Street "market makers" -- inhabiting the "still center" of the storm they've deliberately created -- pocket the gullible money ventured by any outsider foolish enough to enter the vortex.

Maybe not at first... 

But sooner or later the gullible outsiders get blown away.

Wall Street thrives on creating "the boom" that eventually goes bust.

The Scam is all pyrotechnics - a few pretty lights in the boundlessness of night.

As the resident croupier of American economics, Wall Street pitches lightning-fast gambling profits gleaned by placing complicated mathematical bets whose odds are skewed toward "the house." 

At least in the beginning...

Then, as bets get bigger -- and the "debt to pay-out ratio" ever more lopsided in the direction of debt -- all betting is geared toward handing "the bag" to one terminal sucker (or group of suckers) before the boom -- composed of ever more meaningless numbers -- busts.

In the 2008-2009 bust, The American Taxpayer was designated as "terminal sucker."

Willa Cather said “ There are only two or three human stories, and they go on repeating themselves as fiercely as if they had never happened before. ”

One of these stories is the deliberate creation of bogus boom, followed by devastating bust.

Boom. Bust.

Boom. Bust.

Which is to say: Wall Street sequesters wealth (The Boom) while citizens surrender wealth (The Bust).


"A New Dark Age?" by Noam Chomsky



Lest We Forget: Why We Had A Financial Crisis

When a true genius appears in the world you may know him by this infallible sign, that the dunces are all in confederacy against him.
Jonathan Swift
It is clear to anyone who has studied the financial crisis of 2008 that the private sector’s drive for short-term profit was behind it. More than 84 percent of the sub-prime mortgages in 2006 were issued by private lending. These private firms made nearly 83 percent of the subprime loans to low- and moderate-income borrowers that year. Out of the top 25 subprime lenders in 2006, only one was subject to the usual mortgage laws and regulations. The nonbank underwriters made more than 12 million subprime mortgages with a value of nearly $2 trillion. The lenders who made these were exempt from federal regulations.
How then could the Mayor of New YorkMichael Bloomberg say the following at a business breakfast in mid-town Manhattan on November 1, 2011?
It was not the banks that created the mortgage crisis. It was, plain and simple, Congress who forced everybody to go and give mortgages to people who were on the cusp. Now, I’m not saying I’m sure that was terrible policy, because a lot of those people who got homes still have them and they wouldn’t have gotten them without that. But they were the ones who pushed Fannie and Freddie to make a bunch of loans that were imprudent, if you will. They were the ones that pushed the banks to loan to everybody. And now we want to go vilify the banks because it’s one target, it’s easy to blame them and Congress certainly isn’t going to blame themselves.” (Alan here... This rationale is like a Mexican drug cartel kingpin saying his "clients made him do it.")
Barry Ritholtz in the Washington Post calls the notion that the US Congress was behind the financial crisis of 2008 “the Big Lie”. As we have seen in other contexts, if a lie is big enough, people begin to believe it.
Even this morning, November 22, 2011, a seemingly smart guy like Joe Kernan was saying on CNBC’s Squawkbox, “When the losses at Fannie and Freddie reach $200 billion… how can the ‘deniers’ say that Fannie and Freddie were enablers for a lot of the housing crisis. When it gets up to that levels, how can they say that they were only into sub-prime late, and they were only in it a little bit?”
The reason that people can say that is because it is true. The $200 billion was a mere drop in the ocean of derivatives which in 2007 amounted to three times the size of the entire global economy.
When the country’s leaders start promulgating obvious nonsense as the truth, and the Big Lie starts to go viral, then we know that we are laying the groundwork for yet another, even-bigger financial crisis.

The story of the 2008 financial crisis

So let’s recap the basic facts: why did we have a financial crisis in 2008? Barry Ritholtz fills us in on the history with an excellent series of articles in theWashington Post:
  • In 1998, banks got the green light to gamble: The Glass-Steagall legislation, which separated regular banks and investment banks was repealed in 1998. This allowed banks, whose deposits were guaranteed by the FDIC, i.e. the government, to engage in highly risky business.
  • Low interest rates fueled an apparent boom: Following the dot-com bust in 2000, the Federal Reserve dropped rates to 1 percent and kept them there for an extended period. This caused a spiral in anything priced in dollars (i.e., oil, gold) or credit (i.e., housing) or liquidity driven (i.e., stocks).
  • Asset managers sought new ways to make money:  Low rates meant asset managers could no longer get decent yields from municipal bonds or Treasurys. Instead, they turned to high-yield mortgage-backed securities.
  • The credit rating agencies gave their blessing: The credit ratings agencies — Moody’s, S&P and Fitch had placed an AAA rating on these junk securities, claiming they were as safe as U.S. Treasurys.
  • Fund managers didn’t do their homework: Fund managers relied on the ratings of the credit rating agencies and failed to do adequate due diligence before buying them and did not understand these instruments or the risk involved.
  • Derivatives were unregulated: Derivatives had become a uniquely unregulated financial instrument. They are exempt from all oversight, counter-party disclosure, exchange listing requirements, state insurance supervision and, most important, reserve requirements. This allowed AIG to write $3 trillion in derivatives while reserving precisely zero dollars against future claims.
  • The SEC loosened capital requirements: In 2004, the Securities and Exchange Commission changed the leverage rules for just five Wall Street banks. This exemption replaced the 1977 net capitalization rule’s 12-to-1 leverage limit. This allowed unlimited leverage for Goldman Sachs [GS], Morgan Stanley, Merrill Lynch (now part of Bank of America [BAC]), Lehman Brothers (now defunct) and Bear Stearns (now part of JPMorganChase–[JPM]). These banks ramped leverage to 20-, 30-, even 40-to-1. Extreme leverage left little room for error.  By 2008, only two of the five banks had survived, and those two did so with the help of the bailout.
  • The federal government overrode anti-predatory state laws. In 2004, the Office of the Comptroller of the Currency federally preempted state laws regulating mortgage credit and national banks, including anti-predatory lending laws on their books (along with lower defaults and foreclosure rates). Following this change, national lenders sold increasingly risky loan products in those states. Shortly after, their default and foreclosure rates increased markedly.
  • Compensation schemes encouraged gambling: Wall Street’s compensation system was—and still is—based on short-term performance, all upside and no downside. This creates incentives to take excessive risks. The bonuses are extraordinarily large and they continue–$135 billion in 2010 for the 25 largest institutions and that is after the meltdown.
  • Wall Street became “creative”: The demand for higher-yielding paper led Wall Street to begin bundling mortgages. The highest yielding were subprime mortgages. This market was dominated by non-bank originators exempt from most regulations.
  • Private sector lenders fed the demand: These mortgage originators’ lend-to-sell-to-securitizers model had them holding mortgages for a very short period. This allowed them to relax underwriting standards, abdicating traditional lending metrics such as income, credit rating, debt-service history and loan-to-value.
  • Financial gadgets milked the market: “Innovative” mortgage products were developed to reach more subprime borrowers. These include 2/28 adjustable-rate mortgages, interest-only loans, piggy-bank mortgages (simultaneous underlying mortgage and home-equity lines) and the notorious negative amortization loans (borrower’s indebtedness goes up each month). These mortgages defaulted in vastly disproportionate numbers to traditional 30-year fixed mortgages.
  • Commercial banks jumped in: To keep up with these newfangled originators, traditional banks jumped into the game. Employees were compensated on the basis loan volume, not quality.
  • Derivatives exploded uncontrollably: CDOs provided the first “infinite market”; at height of crash, derivatives accounted for 3 times global economy.
  • The boom and bust went global. Proponents of the Big Lie ignore the worldwide nature of the housing boom and bust. A McKinsey Global Institutereport noted “from 2000 through 2007, a remarkable run-up in global home prices occurred.”
  • Fannie and Freddie jumped in the game late to protect their profits: Nonbank mortgage underwriting exploded from 2001 to 2007, along with the private label securitization market, which eclipsed Fannie and Freddie during the boom. The vast majority of subprime mortgages — the loans at the heart of the global crisis — were underwritten by unregulated private firms. These were lenders who sold the bulk of their mortgages to Wall Street, not to Fannie or Freddie. Indeed, these firms had no deposits, so they were not under the jurisdiction of the Federal Deposit Insurance Corp or the Office of Thrift Supervision.
  • Fannie Mae and Freddie Mac market share declined. The relative market share of Fannie Mae and Freddie Mac dropped from a high of 57 percent of all new mortgage originations in 2003, down to 37 percent as the bubble was developing in 2005-06. More than 84 percent of the subprime mortgages in 2006 were issued by private lending institutions. The government-sponsored enterprises were concerned with the loss of market share to these private lenders — Fannie and Freddie were chasing profits, not trying to meet low-income lending goals.
  • It was primarily private lenders who relaxed standards: Private lenders not subject to congressional regulations collapsed lending standards. the GSEs. Conforming mortgages had rules that were less profitable than the newfangled loans. Private securitizers — competitors of Fannie and Freddie — grew from 10 percent of the market in 2002 to nearly 40 percent in 2006. As a percentage of all mortgage-backed securities, private securitization grew from 23 percent in 2003 to 56 percent in 2006.

The driving force behind the crisis was the private sector

Looking at these events it is absurd to suggest, as Bloomberg did, that “Congress forced everybody to go and give mortgages to people who were on the cusp.”
Many actors obviously played a role in this story. Some of the actors were in the public sector and some of them were in the private sector. But the public sector agencies were acting at behest of the private sector. It’s not as though Congress woke up one morning and thought to itself, “Let’s abolish the Glass-Steagall Act!” Or the SEC spontaneously happened to have the bright idea of relaxing capital requirements on the investment banks. Or the Office of the Comptroller of the Currency of its own accord abruptly had the idea of preempting state laws protecting borrowers. These agencies of government were being strenuously lobbied to do the very things that would benefit the financial sector and their managers and traders. And behind it all, was the drive for short-term profits.

Why didn’t anyone say anything?

As one surveys the events in this sorry tale, it is tempting to consider it like a Shakespearean tragedy, and wonder: what if things had happened differently? What would have occurred if someone in the central bank or the supervisory agencies had blown the whistle on the emerging disaster?
The answer is clear: nothing. Nothing would have been different. This is not a speculation. We know it because an interesting new book describes what didhappen to the people who did speak out and try to blow the whistle on what was going on. They were ignored or sidelined in the rush for the money.
The book is Masters of Nothing: How the Crash Will Happen Again Unless We Understand Human Nature by Matthew Hancock and Nadhim Zahawi (published in 2011 in the UK by Biteback Publishing and available on pre-order in the US).
In 2004, the book explains, the deputy governor of the Bank of England (the UK central bank), Sir Andrew Large, gave a powerful and eloquent warning about the coming crash at the London School of Economics. The speech was published on the bank’s website but it received no notice. There were no seminars called. No research was commissioned. No newspaper referred to the speech. Sir Andrew continued to make similar speeches and argue for another two years that the system was unsustainable. His speeches infuriated the then Chancellor, Gordon Brown, because they warned of the dangers of excessive borrowing. In January 2006, Sir Andrew gave up: he quietly retired before his term was up.
In 2005, the chief economist of the International Monetary Fund, Raghuram Rajan, made a speech at Jackson Hole Wyoming in front of the world’s most important bankers and financiers, including Alan Greenspan and Larry Summers. He argued that technical change, institutional moves and deregulation had made the financial system unstable. Incentives to make short-term profits were encouraging the taking of risks, which if they materialized would have catastrophic consequences. The speech did not go down well. Among the first to speak was Larry Summers who said the speech was “largely misguided”.
In 2006, Nouriel Roubini issued a similar warning at an IMF gathering of financiers in New York. The audience reaction? Dismissive. Roubini was “non-rigorous” in his arguments. The central bankers “knew what they were doing.”
The drive for short-term profit crushed all opposition in its path, until the inevitable meltdown in 2008.

Why didn’t anyone listen?

On his blog, Barry Ritholtz puts the truth-deniers into three groups:
1) Those suffering from Cognitive Dissonance — the intellectual crisis that occurs when a failed belief system or philosophy is confronted with proof of its implausibility.
2) The Innumerates, the people who truly disrespect a legitimate process of looking at the data and making intelligent assessments. They are mathematical illiterates who embarrassingly revel in their own ignorance.
3) The Political Manipulators, who cynically know what they peddle is nonsense, but nonetheless push the stuff because it is effective. These folks are more committed to their ideology and bonuses than the good of the nation.
He is too polite to mention:
4) The Paid Hacks, who are being paid to hold a certain view. As Upton Sinclair has noted, “It is difficult to get a man to understand something, when his salary depends upon his not understanding it.”
Barry Ritholtz  concludes: “The denying of reality has been an issue, from Galileo to Columbus to modern times. Reality always triumphs eventually, but there are very real costs to it occurring later versus sooner .”

The social utility of the financial sector

Behind all this is the reality that the massive expansion of the financial sector is not contributing to growing the real economic pie. As Gerald Epstein, an economist at the University of Massachusetts has said: “These types of things don’t add to the pie. They redistribute it—often from taxpayers to banks and other financial institutions.” Yet in the expansion of the GDP, the expansion of the financial sector counts as increase in output. As Tom Friedman writes in the New York Times:
Wall Street, which was originally designed to finance “creative destruction” (the creation of new industries and products to replace old ones), fell into the habit in the last decade of financing too much “destructive creation” (inventing leveraged financial products with no more societal value than betting on whether Lindy’s sold more cheesecake than strudel). When those products blew up, they almost took the whole economy with them.

Do we want another financial crisis?

The current period of artificially low interest rates mirrors eerily the period ten years ago when Alan Greenspan held down interest rates at very low levels for an extended period of time. It was this that set off the creative juices of the financial sector to find “creative” new ways of getting higher returns. Why should we not expect the financial sector to be dreaming up the successor to  sub-prime mortgages and credit-default swaps? What is to stop them? The regulations of the Dodd-Frank are still being written. Efforts to undermine the Volcker Rule are well advanced. Even its original author, Paul Volcker, says it has become unworkable. And now front men like Bloomberg are busily rewriting history to enable the bonuses to continue.
The question is very simple. Do we want to deny reality and go down the same path as we went down in 2008, pursuing short-term profits until we encounter yet another, even-worse financial disaster? Or are we prepared to face up to reality and undergo the phase change involved in refocusing the private sector in general, and the financial sector in particular, on providing genuine value to the economy ahead of short-term profit?
Steve Denning’s most recent book is: The Leader’s Guide to Radical Management (Jossey-Bass, 2010).
Follow Steve Denning on Twitter @stevedenning

Berkshire Hathaway: Wall Street 'Rats in a Granary'

Charlie Munger, Vice Chairman of theBerkshire Hathaway Corporation [BRK A, BRK B], had an interesting interview last Friday with with Becky Quick on CNBC’s Squawkbox.
Munger, a Republican, contrasted the productive investments of Berkshire Hathaway with activities of Wall Street which are either socially useless or positively harmful.

What went wrong in the Great Recession?

Munger talked first about why the Great Recession happened:
“People are always quoting Mark Twain. History doesn’t repeat itself but it rhymes. A lot is the same. The panic that came as a predecessor of the Great Recession had common themes that are always the same. The crazy greed. The crazy leverage. The crazy delusions. We were very lucky that the outcome wasn’t worse. If there was a just God, we deserved worse than we got.
“We knew it was coming and we used to say when people asked us about the crazy consumer credit and so on, we said, “It’s going to happen, but we can’t tell you when.”
“The big mistake was allowing the boom to run so crazy and letting so much evil and folly to run so rampant. Greenspan, to his credit, has recognized that he was wrong. He is the only one who has done that. Everyone else has managed to look at this enormous denouement and leave the previous ideas intact.”

Wall Street traders: like rats in a granary

Has the problem been fixed?
“Wall Street now is better than it was but the majority of what was wrong has not been fixed. I agree with Michael Lewis that the Volcker Rule needs to have a lot more teeth. Take the rapid trading by the computer geniuses with their algorithms: those people have all the social utility of a bunch of rats admitted to a granary. I never would have allowed the rats to get in the granary.
“I don’t want the brilliant young men of America dawdling away their lives in someone else’s granary. It’s not my idea of the right way to run the Republic. If you let me write the laws it wouldn’t happen. I wouldn’t allow the system to be that way at all. I wouldn’t allow people to make money out of short term trading. I might have Tobin taxes. If we changed the incentives, a lot of this regrettable behavior would go away.
“There would be less gambling and productive investment and more long term thinking and less of short-term trading frenzy. I would not allow people to run hedge funds and work their pay as long-term capital gains. We do a lot of things that are literally insane. Once you allow this wrong culture to be entrenched and be remunerative, you create political power that protects activities that are regrettable. What good is it doing civilization to have people “clipping” money through computer algorithms that work a lot like legalized front-running of orders? Why has the situation gone on as long as it has? Both parties are getting a lot of donations from these people.

Civilized people don’t invest in gold

The discussion turned to gold as a hedge:
“Gold is a great thing to sew into your garments if you are a Jewish family in Vienna in 1939. Civilized people don’t buy gold. They invest in productive businesses. Berkshire’s businesses by and large are doing useful work. They are not just outsmarting the computer system in the trading markets.”

Growth versus cost containment

What catalysts will cause CEOs to shift focus from cost containment to growth?
“Everyone always wants to do growth. It’s when that avenue looks difficult that people go to cost containment. A friend with a moving business used to have 330 employees with perks. Now he has about 240 most of whom are independent contractors. He did that because he had to in the Great Recession. He didn’t shift to cost containment as some kind of involved strategy. Life was forcing it upon him. A lot of that has happened in business. Everyone would prefer to build new plants based on anticipated demand and growth. Cost containment is stuff they do as a second choice. Berkshire has always tried to act like we are having a recession when we aren’t. So the cost containment is already there. Some of our businesses are good at that. Others are less good.
“The jobs aren’t coming back. One of the great problems in the economy is that everyone has done what my friend in the moving business has done. It’s perfectly logical. It’s the way capitalism works. Firms can to some extent act as a shock absorber before they translate the impact into the pay checks of employees. But they also have to change their cost structure to adjust to the competitive reality. People had no alternative.
“It’s amazing what happened to American manufacturing. I have a brother in law who made stools in a little factory in Omaha. When the Chinese got good at making stools, it was impossible for that business to continue. It wasn’t evil. That kind of creative destruction happens in capitalism with free trade. It’s very painful for the people who get hit by it.
“It’s painful for Kodak when technology changes. There’s no villain. It’s just the natural outcome of capitalism. It’s awful for Rochester and it’s awful for a lot of people. But it’s probably good for the greater system of the world.”

The tragedy is not inevitable

I agree with much of what Munger said. Where I don’t agree is the idea that the destruction of firms like Kodak is inevitable. Its demise was eminently avoidable if the management had focused, not of maximizing shareholder value, which results in futile efforts to protect existing profits, but rather on meeting needs that customers actually had. It’s a shift from an inside-out mindset to the outside-in focus of radical management.
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