Wall Street Greed and Delusion

Derivatives (complex financial instruments) are time bombs and “financial weapons of mass destruction” that could harm not only their buyers and sellers, but the whole economic system.

“Derivatives generate reported earnings that are often wildly overstated and based on estimates whose inaccuracy may not be exposed for many years.”

Warren Buffet (2003)

After seeing Michael Lewis on both 60 Minutes and The Charlie Rose Show last week, I had to read The Big Short: Inside the Doomsday Machine, the just released book by Lewis about the subprime mortgage disaster. Lewis is a fabulous story teller, and I cannot recommend this book enough.

He tells how the subprime mortgage market was created, who benefited, who lost, the cons, the dupes and the dopes and “how some of Wall Street’s finest minds managed to destroy $1.75 trillion of wealth in the subprime mortgage markets” and created the worst financial crisis since the Great Depression.

Essentially billions of dollars were lent to people who had very little chance of ever paying it back. And Wall Street firms earned billions of dollars creating, packaging and betting on complex financial instruments whose raw material was the risky mortgage loans they created. And that was just the beginning.

Tremendous leverage (using borrowed money to magnify possible returns) increased the risk of destroying entire firms.

Lewis follows a few very colorful individuals who gradually figured out just how corrupt the entire risky mortgage system was. These investors made billions by betting against the subprime market by selling short.

Note that “selling short” is an entirely legal transaction, but generally considered a high risk one that involves betting against something, i.e. a stock, bond, or currency, for example, which isn’t “actually” owned by the investor. Selling short requires astuteness, foresight, excellent timing and staying power. Being “right” too soon can be both nerve wracking and very costly, because until the market agrees with your assessment, you are at risk of losing a great deal of money. (Disclosure: I do not sell short.)

In reading Lewis’s gripping story, I alternated between nodding my head in recognition of the self-serving greed that categorized Wall Street to shaking my head in disbelief that Wall Street bankers could have been so deluded that they ended up believing their own lies, I mean “models.” As I read, I found myself laughing out loud more times than I can count – truly, Lewis has a way with words.

To give you some background info, in the “old” days, a bank lent money to a home buyer and they held the mortgage. The bank was very serious about getting repaid, so before they agreed to fund the loan, they did some rather basic things like verify the borrowers’ creditworthiness, check their employment and salary history and retain an appraiser to assess the value of the property being bought. A good credit history, a stable job and a property value that would support the loan were enough incentive for banks, back in the “old” days, to grant a loan request.

But when banks started selling the mortgage to a Wall Street firm who repackaged the loan and then sold the package to investors, the incentives became very different. It was like the Wild West before the Marshall came to town to establish law and order.

The acronym IBGYBG came into being. The brokers who made more money than they ever imagined said, “I’ll be gone, you’ll be gone” so let’s not worry about the suckers who will probably lose their homes or the gullible institutions that bought the crappy investments in the purposely opaque financial instruments. And it was easy to rationalize the sleazy behavior, because, after all, it was possible that this will all work out, if home prices keep rising. That was a big IF.

It was really a mammoth legal Ponzi scheme, or as Lewis called it a “mass delusion.”

The individual characters’ stories are fascinating, but I will not try to summarize them. Instead, here are some observations that emphasize the need for fundamental financial regulation of Wall Street firms.

1. No one goes to Wall Street investment banks to make the world a better place. “Greed on Wall Street is assumed – almost an obligation. The problem was the system of incentives that channeled the greed.”
2. People see what they have an incentive to see. Wall Street employees, managers and CEOs had an incentive (i.e. huge bonuses – surely, you’ve heard about them) not to see the truth.
3. When Wall Street firms were partnerships and the principals had their own money at risk, they had a sane long-term approach to their business operations. When these same firms became publicly traded corporations, risk was transferred to the shareholders. But, of course, huge bonuses were paid to successful traders based on one year’s results. In the short term, traders had every incentive to take large risks. “Heads I win, tails someone else loses, perhaps some time in the future.”
4. The fixed income (bonds) world dwarfs the equity (stocks) world in size. The stock market is transparent and heavily policed. On the other hand, “bond salesmen could say and do anything without worrying that they would be caught. Bond technicians could dream up ever more complicated securities without worrying too much about government regulation – one reason why so many derivatives had been derived, one way or another, from bonds.”
5. The world of mortgage-backed securities (pooled investments backed by mortgages) and derivatives (financial instruments created by Wall Street) were intentionally difficult to understand, so no one even bothered to try. The book describes the nature of asset-backed securities, tranches, collateralized debt obligations, credit default swaps, etc. You, dear reader, can safely skip those portions if you want to. The horse is already out of the barn.
6. It’s difficult to appreciate the amount of backstabbing, mistrust and cynicism that is endemic at Wall Street firms. “Wall Street doesn’t care what it sells.” Investment banks exploited their institutional customers (pension funds, mutual funds, banks). The same firm that is advising them on what to invest in (the sell side) also has an in-house operation that is trading for its own account. Why is this blatant conflict of interest allowed?
7. While there may have been some criminal behavior, in the end, group think, mass delusion and incompetence were more important factors. Wall Street firms did not understand the money-making machine they had created or the risks they had taken.
8. When lenders ran out of customers who would qualify for a normal mortgage, they dreamt up new ways to lend to people who could not afford to pay the old fashioned way. Hence the introduction of “interest-only negative-amortizing adjustable-rate subprime mortgages.” Translation: you don’t have to pay any principal or any interest on your new mortgage; we’ll just keep adding that to the amount you owe.
9. Amazingly enough, Wall Street firms convinced bond ratings agencies (Moody’s, S&P) to give such garbage a Triple A rating. That credit rating agencies are “educated” by and paid by the issuers of the bonds is quite a conflict of interest! And it still exists.
10. Lewis asserts that today “nobody believes that Wall Street knows what it is doing.” He understands why Goldman Sachs and Morgan Stanley, for example, want a say in how they are regulated. He wonders why anyone would listen to them.

Conclusion

The greed and miscalculation of Wall Street firms caused the near collapse of the world economy. Governments around the world felt forced to commit trillions of dollars to resuscitate the banks.

Regulation of firms and people which have fundamentally the wrong incentives will not be easy. Regulatory reform of institutions that are too well connected to fail will not be easy. Change is never easy. But it is absolutely essential or we will all be at risk of a repeat performance of the last financial crisis. Without reform, the investment banking system can crash again, taking with it jobs, savings and U.S. tax payer dollars.

Consumer Protection: Funny & Serious

 

“This isn’t liberal or conservative.” – Elizabeth Warren.

Why would six former presidents (two of whom are deceased) take the trouble to visit President Obama? And who arranged this “Presidential Reunion”? For the answer, visit Funny or Die, the popular comedy Web site.

Of course, consumer protection is really no laughing matter, especially if you or someone you know is paying 18% interest on credit cards or has seen their mortgage payments balloon to unpayable (i.e. forecloseable) amounts.

For a detailed, intelligent 20 minute discussion of the issue, click on the Charlie Rose interview with Elizabeth Warren, the Chair of the Congressional Oversight Panel.

Here is a summary of some of her points.

According to Professor Warren, of the Harvard Law School, no federal agency is looking out for the consumer when it comes to such matters as credit cards, mortgages, check overdraft fees, and car loans. She has been pushing for the formation of a new consumer agency for much of the last year, and it is currently the subject of Congressional negotiations.

Professor Warren believes that the current regulatory framework is “inefficient, and either ignored and ineffective, or captured by the large financial institutions. A fractured, bloated, overly fat — I just don’t know what else to say — regulatory system is what we’ve got now. It works very well for the large financial institutions because it means no effective regulation.”

Regarding the proposed Consumer Protection Agency, she says “You’ve got to have an agency that’s ultimately independent, whether it’s located within the Fed, within Treasury, the Department of Agriculture, or whether it sits in its own separate place. The key is whether or not it is functionally independent — does it write its own rules, does it enforce those rules, and does it have access to a budget that’s independent of the folks who want to smother it.”

“This is an agency that just makes sense. It’s about readable credit cards, it’s about readable mortgages, it’s about prices that are transparent. This isn’t liberal or conservative. The American Enterprise Institute, very well respected, very conservative, has put model two-page mortgage agreements, two page check overdraft agreements on its Web site. … A consumer agency makes sense to get the market working again. So this isn’t a division of ideology. This is about bank lobbyists. This is about people who are paid professionally to stop this agency, their words, “to kill this agency” so they can protect the revenues for the Wall Street banks.”

By the way, Professor Warren also has some very interesting observations on how the government mishandled the financial crisis and what to do about the “too big to fail” financial institutions. So do watch the entire video, if you have the time.

And for a not-so-serious article on the same subject you can learn how the Presidential Reunion video was made possible by reading the New York Times story.

While not directly involved in the making of the video, Ms. Warren did comment on the video’s premise. “Why wouldn’t our past presidents agree on shrinking government by transforming a bunch of bloated, ineffective and unaccountable consumer-protection bureaucracies into a smaller, streamlined, and effective agency? And why wouldn’t they all support two-page credit card agreements?”

Conclusion

Pardon me for getting political (an arena I try very hard to stay out of), but one indication of whether Congress can pass any meaningful reform on anything is whether it can withstand intense lobbying against consumer finance protection. Today Senator Christopher Dodd of Connecticut is scheduled to release his proposed legislation. We will see if his solution, which covers many more things than just consumer protection, will be acceptable to enough Senators and eventually to the American people.

If this issue is important to you, let your voice be heard. You have the ability to pass this post on to friends; simply click on the title of a post, then “Share This” to forward.

President Obama’s Economic Agenda

Sunday’s New York Times article, After the Great Recession, gives us rare insight into President Obama’s thinking and thought processes concerning a host of issues and “why he was taking on so many economic issues so early in his administration.”

The interview, conducted by David Leonhardt, covers several economic issues including the role of financial institutions, the need for new financial regulation, making education relevant, how to improve global competitiveness, how to achieve greater gender and employment equality, and the need and difficulty of achieving health care reform.

Whew!  Just writing that sentence makes me gasp.

While After the Great Recession is a very long (two cups of coffee) article, I believe it is well worth reading, in its entirety. Whether or not you supported Barack Obama in the presidential election last November, I think it’s important to understand where he plans to take the country.

If you don’t have time to read the entire article, here are some relevant quotes.

I. The Future of Finance

Leonhardt: I wonder if you would be willing to describe a little bit of your learning curve about finance, and what you envision finance being in tomorrow’s economy: Does it need to be smaller? Will it inevitably be smaller?

THE PRESIDENT:  …What I think will change, what I think was an aberration, was a situation where corporate profits in the financial sector were such a heavy part of our overall profitability over the last decade. That I think will change. And so part of that has to do with the effects of regulation that will inhibit some of the massive leveraging and the massive risk-taking that had become so common.

Now, in some ways, I think it’s important to understand that some of that wealth was illusory in the first place.

… Wall Street will remain a big, important part of our economy, just as it was in the ’70s and the ’80s. It just won’t be half of our economy. And that means that more talent, more resources will be going to other sectors of the economy. And I actually think that’s healthy. We don’t want every single college grad with mathematical aptitude to become a derivatives trader. We want some of them to go into engineering, and we want some of them to be going into computer design.

And so I think what you’ll see is some shift, but I don’t think that we will lose the enormous advantages that come from transparency, openness, the reliability of our markets. If anything, a more vigorous regulatory regime, I think, will help restore confidence, and you’re still going to see a lot of global capital wanting to park itself in the United States.

Leonhardt:  There was this great debate among F.D.R.’s advisers about whether you had to split up companies — not just banks — you had to split up companies in order to regulate them effectively, or whether it was possible to have big, huge, sprawling, powerful companies — even not just possible, but better — and then have strong regulators. And it seems to me there’s an analogy of that debate now. Which is, do you think it is O.K. to have these “supermarkets” regulated by strong regulators actually trying to regulate, or do we need some very different modern version of Glass-Steagall.

THE PRESIDENT: You know, I’ve looked at the evidence so far that indicates that other countries that have not seen some of the problems in their financial markets that we have nevertheless don’t separate between investment banks and commercial banks, for example. They have a “supermarket” model that they’ve got strong regulation of.

But when it comes to something like investment banking versus commercial banking, the experience in a country like Canada would indicate that good, strong regulation that focuses less on the legal form of the institution and more on the functions that they’re carrying out is probably the right approach to take.

II. The Ticket to the Middle Class

Leonhardt:  I’m curious what you think today’s ticket to the middle class is. Do you want everybody aspiring to a four-year-college degree? Is a two-year or vocational degree enough? Or is simply attending college, whether or not you graduate, sufficient to reach the middle class?

THE PRESIDENT:  We set out a goal in my speech to the joint session that said everybody should have at least one year of post-high-school training. And I think it would be too rigid to say everybody needs a four-year-college degree. I think everybody needs enough post-high-school training that they are competent in fields that require technical expertise, because it’s very hard to imagine getting a job that pays a living wage without that — or it’s very hard at least to envision a steady job in the absence of that.

And so to the extent that we can upgrade not only our high schools but also our community colleges to provide a sound technical basis for being able to perform complicated tasks in a 21st-century economy, then I think that not only is that good for the individuals, but that’s going to be critical for the economy as a whole.

But, again, I think the big challenge that we’ve got on education is making sure that … you are actually learning the kinds of skills that make you competitive and productive in a modern, technological economy.

That’s why I don’t just want to see more college graduates; I also want to specifically see more math and science graduates, I specifically want to see more folks in engineering.

But the broader point is that if you look at who our long-term competition will be in the global economy — China, India, the E.U., Brazil, Korea — the countries that are producing the best-educated work force, whose education system emphasizes the sciences and mathematics, who can translate those technology backgrounds or those science backgrounds into technological applications, they are going to have a significant advantage in the economy. And I think that we’ve got to have enough of that in order to maintain our economic strength.

III. The New Gender Gap

Leonhardt: There is still sexism, there’s still a pay gap, clearly, but the pay of men has stagnated, and the pay of women has gone up.

I think there are a lot of men out there today, working at G.M. and Chrysler and other places, who feel the same kind of dejection that your grandfather did. What do you think the future of work looks like for men?

THE PRESIDENT: I think it’s an interesting question, because as I said, you know, you go in to factories all across the Midwest and you talk to the men who work there — they’ve got extraordinary skill and extraordinary pride in what they make. And I think that for them, the loss of manufacturing is a loss of a way of life and not just a loss of income.

I think a healthy economy is going to have a broad mix of jobs, and there has to be a place for somebody with terrific mechanical aptitude who can perform highly skilled tasks with his hands, whether it’s in construction or manufacturing. And I don’t think that those jobs should vanish. I do think that they will constitute a smaller percentage of the overall economy.

I mean, nursing, teaching are all areas where we need more men. I’ve always said if we can get more men in the classroom, particularly in inner cities where a lot of young people don’t have fathers, that could be of enormous benefit.

IV. Where the Economists are Coming From

Leonhardt:  When you and I spoke during the campaign, you made it clear that you had thought a lot about the economic debates within the Clinton administration. And you said that you wanted to have a Robert Rubin type and a Robert Reich type having a vigorous debate in front of you. And clearly you have a spectrum of Democrats within your economic-policy team.

THE PRESIDENT:  … I’ve been constantly searching for is a ruthless pragmatism when it comes to economic policy.

Somebody who has enormous influence over my thinking is Paul Volcker, who is robust enough that, having presided over the Carter and Reagan years, he’s still sharp as a tack and able to give me huge advice and to provide some counterbalance.

When I first started having a round table of economic advisers, and Bob Reich was part of that, and he was sitting across the table from Bob Rubin and others, what you discovered was that some of the rifts that had existed back in the Clinton years had really narrowed drastically.

If anything, the only thing I notice, I think, that I do think is something of a carry-over from Bob Rubin — I see it in Larry, I see it in Tim — is a great appreciation of complexity.

… I think that one of the things that we all agree to is that the touchstone for economic policy is, does it allow the average American to find good employment and see their incomes rise; that we can’t just look at things in the aggregate, we do want to grow the pie, but we want to make sure that prosperity is spread across the spectrum of regions and occupations and genders and races; and that economic policy should focus on growing the pie, but it also has to make sure that everybody has got opportunity in that system.

I also think that there’s very little disagreement that there are lessons to be learned from this crisis in terms of the importance of regulation in the financial markets. And I think that this notion that there is somehow resistance to that — to those lessons within my economic team — just isn’t borne out by the discussions that I have every day.

… As we’re making economic policy, I think there is a certain humility about the consequences of the actions we take, intended and unintended, that may make some outside observers impatient. I mean, you’ll recall Geithner was just getting hammered for months. But he, I think, is very secure in saying we need to get these things right, and if we act too abruptly, we can end up doing more harm than good. Those are qualities that I think have been useful.

V. Postreform Health Care

Leonhardt:  You have suggested that health care is now the No. 1 legislative priority. It seems to me this is only a small generalization — to say that the way the medical system works now is, people go to the doctor; the doctor tells them what treatments they need; they get those treatments, regardless of cost or, frankly, regardless of whether they’re effective. I wonder if you could talk to people about how going to the doctor will be different in the future; how they will experience medical care differently on the other side of health care reform.

THE PRESIDENT:  First of all, I do think consumers have gotten more active in their own treatments in a way that’s very useful. And I think that should continue to be encouraged, to the extent that we can provide consumers with more information about their own well-being — that, I think, can be helpful.

I have always said, though, that we should not overstate the degree to which consumers rather than doctors are going to be driving treatment, because, I just speak from my own experience, I’m a pretty-well-educated layperson when it comes to medical care; I know how to ask good questions of my doctor. But ultimately, he’s the guy with the medical degree. So, if he tells me, You know what, you’ve got such-and-such and you need to take such-and-such, I don’t go around arguing with him or go online to see if I can find a better opinion than his.

And so, in that sense, there’s always going to be an asymmetry of information between patient and provider. And part of what I think government can do effectively is to be an honest broker in assessing and evaluating treatment options. And certainly that’s true when it comes to Medicare and Medicaid, where the taxpayers are footing the bill and we have an obligation to get those costs under control.

So when Peter Orszag and I talk about the importance of using comparative-effectiveness studies as a way of reining in costs, that’s not an attempt to micromanage the doctor-patient relationship. It is an attempt to say to patients, you know what, we’ve looked at some objective studies out here, people who know about this stuff, concluding that the blue pill, which costs half as much as the red pill, is just as effective, and you might want to go ahead and get the blue one. And if a provider is pushing the red one on you, then you should at least ask some important questions.

Now, there are distortions in the system, everything from the drug salesmen and junkets to how reimbursements occur. Some of those things government has control over; some of those things are just more embedded in our medical culture. But the doctors I know — both ones who treat me as well as friends of mine — I think take their job very seriously and are thinking in terms of what’s best for the patient. They operate within particular incentive structures, like anybody else, and particular habits, like anybody else.

And so if it turns out that doctors in Florida are spending 25 percent more on treating their patients as doctors in Minnesota, and the doctors in Minnesota are getting outcomes that are just as good — then us going down to Florida and pointing out that this is how folks in Minnesota are doing it and they seem to be getting pretty good outcomes, and are there particular reasons why you’re doing what you’re doing? — I think that conversation will ultimately yield some significant savings and some significant benefits.

Now, I actually think that the tougher issue around medical care — it’s a related one — is what you do around things like end-of-life care —

So that’s where I think you just get into some very difficult moral issues. But that’s also a huge driver of cost, right?

I mean, the chronically ill and those toward the end of their lives are accounting for potentially 80 percent of the total health care bill out here.

Leonhardt:  So how do you — how do we deal with it?

THE PRESIDENT:  Well, I think that there is going to have to be a conversation that is guided by doctors, scientists, ethicists. And then there is going to have to be a very difficult democratic conversation that takes place. It is very difficult to imagine the country making those decisions just through the normal political channels. And that’s part of why you have to have some independent group that can give you guidance. It’s not determinative, but I think has to be able to give you some guidance. And that’s part of what I suspect you’ll see emerging out of the various health care conversations that are taking place on the Hill right now.

VI. Out of the Rough?

Leonhardt:  Do you think this recession is a big-enough event to make us as a country willing to make some of the sorts of hard choices that we need to make on health care, on taxes in the long term — which will not cover the cost of government — on energy? Traditionally those choices get made in times of depression or war, and I’m not sure whether this rises to that level.

THE PRESIDENT:  Well, part of it will depend on leadership. So I’ve got to make some good arguments out there. And that’s what I’ve been trying to do since I came in, is to say now is the time for us to make some tough, big decisions.

The critics have said, you’re doing too much, you can’t do all this at once, Congress can’t digest everything. I just reject that. There’s nothing inherent in our political process that should prevent us from making these difficult decisions now, as opposed to 10 years from now or 20 years from now.

It is true that as tough an economic time as it is right now, we haven’t had 42 months of 20, 30 percent unemployment. And so the degree of desperation and the shock to the system may not be as great. And that means that there’s going to be more resistance to any of these steps: reforming the financial system or reforming our health care system or doing something about energy. On each of these things — you know, things aren’t so bad in the eyes of a lot of Americans that they say, “We’re willing to completely try something new.”

But part of my job I think is to bridge that gap between the status quo and what we know we have to do for our future.

Leonhardt:  Are you worried that the economic cycle will make that much harder? I mean, Roosevelt took office four years after the stock market crashed. You took office four months after Lehman Brothers collapsed. At some point people may start saying, Hey, why aren’t things getting better?

THE PRESIDENT:  It’s something that we think about. I knew even before the election that this was going to be a very difficult journey and that the economy had gone through a sufficient shock and that it wasn’t going to recover right away.

What I’m very confident about is that given the difficult options before us, we are making good, thoughtful decisions. I have enormous confidence that we are weighing all our options and we are making the best choices. That doesn’t mean that every choice is going to be right, is going to work exactly the way we want it to. But I wake up in the morning and go to bed at night feeling that the direction we are trying to move the economy toward is the right one and that the decisions we make are sound.

Conclusion

In watching political commentary on PBS TV, for example Charlie Rose’s interview with David Brooks, I have heard time and time again how confident President Obama is, how comfortable he is with debate within his administration, and how he is a supreme pragmatist. These are all good things.

The phrases that jumped out on me in the interview were: “ruthless pragmatism,” “a great appreciation of complexity,” and “a certain humility about the consequences of the actions we take, intended and unintended.”

Good. Boldness and supreme confidence seasoned with a dash of humility and a modicum of caution sounds like a good recipe to me.

That said, he certainly has more issues to deal with than any other president ever had. And this interview was only about economic issues, totaling omitting foreign affairs – “little” things like two wars, Iranian nuclear aspirations, the potential collapse of Pakistan’s government, etc., etc., etc.

Good luck, Mr. President.

Photo by Nadav Kander for The New York Times.

Greed and Stupidity

Last week, I had lunch with an old friend who told me that he was very upset because he had lost so much money on his investments. He said that he was of two minds about the people who caused his pain. On the one hand, he wanted to forgive them, but on the other hand, he wanted to get even. Both, perfectly natural feelings. Of course, the problem with the revenge approach is the he did not know exactly whom to blame. Like many people, he really didn’t understand how we got into this economic mess in the first place.

Well, as previous posts have discussed, it’s a complicated tale in that there are a lot of culprits and more than enough blame to go around, including lax government regulation, unscrupulous mortgage brokers and mortgage lenders, overoptimistic rating agencies and everyone who thought real estate prices could only go up. But focusing on the banking system tells a large part of the story.

Recently, David Brooks wrote a column, Greed and Stupidity, which references some very good articles and contrasts the two theories of why and how bankers screwed up. Here are some relevant quotes regarding the two explanations – greed and stupidity.

What happened to the global economy? We seemed to be chugging along, enjoying moderate business cycles and unprecedented global growth. All of a sudden, all hell broke loose.

There are many theories about what happened, but two general narratives seem to be gaining prominence, which we will call the greed narrative and the stupidity narrative. The two overlap, but they lead to different ways of thinking about where we go from here.

The best single encapsulation of the greed narrative is an essay called “The Quiet Coup,” by Simon Johnson in The Atlantic.

Johnson begins with a trend. Between 1973 and 1985, the U.S. financial sector accounted for about 16 percent of domestic corporate profits. In the 1990s, it ranged from 21 percent to 30 percent. This decade, it soared to 41 percent.

In other words, Wall Street got huge. As it got huge, its prestige grew. Its compensation packages grew. Its political power grew as well. Wall Street and Washington merged as a flow of investment bankers went down to the White House and the Treasury Department.

The result was a string of legislation designed to further enhance the freedom and power of finance. Regulations separating commercial and investment banking were repealed. There were major increases in the amount of leverage allowed to investment banks.

The second and, to me, more persuasive theory revolves around ignorance and uncertainty. The primary problem is not the greed of a giant oligarchy. It’s that overconfident bankers didn’t know what they were doing.

Many writers have described elements of this intellectual hubris. Amar Bhidé has described the fallacy of diversification. Bankers thought that if they bundled slices of many assets into giant packages then they didn’t have to perform due diligence on each one.

Benoit Mandelbrot and Nassim Taleb have explained why extreme events are much more likely to disrupt financial markets than most bankers understood.

To me, the most interesting factor is the way instant communications lead to unconscious conformity. …Global communications seem to have led people in the financial subculture to adopt homogenous viewpoints. They made the same one-way bets at the same time.

Jerry Z. Muller wrote an indispensable version of the stupidity narrative in an essay called “Our Epistemological Depression” in The American magazine. … Banks got too big to manage. Instruments got too complex to understand. Too many people were good at math but ignorant of history.

The Remedies

The greed narrative leads to the conclusion that government should aggressively restructure the financial sector. The stupidity narrative is suspicious of that sort of radicalism. We’d just be trading the hubris of Wall Street for the hubris of Washington. The stupidity narrative suggests we should preserve the essential market structures, but make them more transparent, straightforward and comprehensible. Instead of rushing off to nationalize the banks, we should nurture and recapitalize what’s left of functioning markets.

Both schools agree on one thing, however. Both believe that banks are too big. Both narratives suggest we should return to the day when banks were focused institutions — when savings banks, insurance companies, brokerages and investment banks lived separate lives.

We can agree on that reform. Still, one has to choose a guiding theory. To my mind, we didn’t get into this crisis because inbred oligarchs grabbed power. We got into it because arrogant traders around the world were playing a high-stakes game they didn’t understand.

Conclusion

I agree with Brooks’ belief that the main cause of our economic meltdown was stupidity – not understanding the real risks in using “outsized” leverage to buy risky assets. On the other hand, investment bank managers were receiving “outsized” bonuses based on short-term results, and the long term risks and ramifications was someone else’s problem.

Who says we have to choose between greed and stupidity?

CNBC Financial Advice

The Daily Show With Jon Stewart	Mon – Thurs 11p / 10c
CNBC Financial Advice
www.thedailyshow.com
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Last week Jon Stewart of the Daily Show ridiculed the usefulness of financial predictions made on some CNBC shows.  Stewart exposed the theatrics and general silliness of many CNBC commentaries, not to mention the shameful sucking up to CEOs.

Remember that the Daily Show is on Comedy Central, so have a good laugh. This is not meant to be fair and balanced.

Yes, CNBC has had some very good interviews with the likes of investor Warren Buffet, author John Bogle and PIMCO executive and author Mohamed El-Erian. But remember that many CNBC shows are essentially infotainment; they are meant to keep you watching so that CNBC can sell ads.

By the way, keep watching the show to see a humorous but also enlightening interview with New York Times columnist Joe Nocera.

Financial Crisis for Beginners

I recently had dinner with my cousin who said, “I don’t understand how the economy was fine for so many years and now it isn’t fine. How did this happen? I don’t understand.”

Well, this is much too complicated a subject to discuss over just dinner, but I would imagine that many people feel the same way and are asking the same question as my cousin. “Why?”

Besides this blog, which has quite a few posts on this topic, I recommend checking out The Baseline Scenario, a web site whose tagline is “What happened to the global economy and what we can do about it.”
The founder of The Baseline Scenario is Simon Johnson, 46, currently a professor at the Massachusetts Institute of Technology’s Sloan School of Management. Previously, he was chief economist of the International Monetary Fund. Peter Boone and James Kwak also contribute to the site’s articles and posts.

Johnson is interviewed and quoted frequently, both in the mainstream media and on the internet. He has published many, many opinion pieces and articles on the global economic situation and possible solutions. He also writes for the New Republic and has been interviewed on NPR radio and the Charlie Rose program. Whew! It’s exhausting just following him around on the Internet!

In my opinion, The Baseline Scenario web site is so much more than just a simple blog. Rather, it’s a free online lesson on macro, monetary, and global economics.

The section, Financial Crisis for Beginners, quite effectively lessens the confusion. It covers pretty much everything, from old-fashioned bank runs to new-fangled credit default swaps. There are also very informative and helpful articles such as The Federal Reserve for Beginners and Interest Rates for Beginners. You’ll also find links to a thought-provoking article and radio interview, National Debt For Beginners.

Worth noting is the Japan’s Lost Decade article. While many economists, analysts and financial writers compare our current economic situation to the Great Depression, The Baseline Scenario suggests that “in many ways, a more relevant comparison may be the Japanese ‘lost decade’ of the 1990s, when the collapse of a bubble in real estate and stock prices led to over a decade of deflation and slow growth.”

It’s quite amazing that a single web site, and one ubiquitous observer, can have such an impact on the national debate. I highly recommend that you follow the articles and posts at The Baseline Scenario.

P.S. This is my 100th post. For some reason, this is supposed to be significant.

Stabilize House Prices, Part 6

Over the past several months, economists have been coming up with one proposal after another in an attempt to stabilize falling home prices. This blog has reviewed several of them starting here.

It is clear that, despite the various proposals, the previous administration did very little to alleviate the problem. It’s also clear that it is now a matter of some urgency for the new Obama administration.

The February 19th New York Times article, $275 Billion Plan Seeks to Address Housing Crisis leads with this, “President Obama announced a plan on Wednesday to help as many as nine million American homeowners refinance their mortgages or avert foreclosure, saying that it would shore up housing prices, stabilize neighborhoods and slow a downward spiral released his proposal…” and summarizes it as follows:

The plan has three components. The first would help homeowners who are still current on their payments, but who are paying high interest rates and cannot refinance because they do not have enough equity in their homes, a problem afflicting growing numbers of people as housing values tumble.

A second component would assist about four million people who are at risk of losing their homes. It would provide incentives to lenders who alter the terms of loans to make them affordable for the troubled borrowers. A third component would try to increase the credit available for mortgages in general by giving $200 billion of additional financial backing to Fannie Mae and Freddie Mac.

Beyond luring lenders with government money, the plan also calls on Congress to give bankruptcy judges the power to change the terms of mortgages and reduce the monthly payments.

Questions of fairness and efficacy were immediately raised. While some have criticized the plan as not doing enough, Edward L. Glaeser, a Harvard University economist, believes that one virtue is that it does not try to solve every problem.

For his assessment of the advantages and shortcomings of the Obama initiative, read Housing Plan: The Virtues of Moderation which was published online.

Conclusion

In my opinion, most of the issues facing the Obama administration (and therefore all U.S. citizens) are more complicated than it first appears. Given the depth and breadth of our financial problems, we need reasoned arguments and a nuanced assessment of any new plan. We do not need knee-jerk responses, either pro or con.

Whatever the proposal on the table, there is always room for improvement, and certainly, more initiatives will be needed. We desperately need constructive criticism and cooperation. Professor Glaeser’s analysis delivers a useful starting point.

How to Repair a Broken Financial World

The previous post, The End of the Financial World as We Know It, wrote about short-term incentives operating at investment firms, credit rating agencies, the Securities and Exchange Commission and the U.S. Treasury Department.

In How to Repair a Broken Financial World, Michael Lewis and David Einhorn lay out their policy prescriptions.

There are other things the Treasury might do when a major financial firm assumed to be “too big to fail” comes knocking, asking for free money. Here’s one: Let it fail.

Not as chaotically as Lehman Brothers was allowed to fail. If a failing firm is deemed “too big” for that honor, then it should be explicitly nationalized, both to limit its effect on other firms and to protect the guts of the system. Its shareholders should be wiped out, and its management replaced. Its valuable parts should be sold off as functioning businesses to the highest bidders — perhaps to some bank that was not swept up in the credit bubble. The rest should be liquidated, in calm markets. Do this and, for everyone except the firms that invented the mess, the pain will likely subside.

This is more plausible than it may sound. Sweden, of all places, did it successfully in 1992. And remember, the Federal Reserve and the Treasury have already accepted, on behalf of the taxpayer, just about all of the downside risk of owning the bigger financial firms.

If we are going to spend trillions of dollars of taxpayer money, it makes more sense to focus less on the failed institutions at the top of the financial system and more on the individuals at the bottom. Instead of buying dodgy assets and guaranteeing deals that should never have been made in the first place, we should use our money to A) repair the social safety net, now badly rent in ways that cause perfectly rational people to be terrified; and B) transform the bailout of the banks into a rescue of homeowners.

There are also a handful of other perfectly obvious changes in the financial system to be made, to prevent some version of what has happened from happening all over again. A short list:

Stop making big regulatory decisions with long-term consequences based on their short-term effect on stock prices. Stock prices go up and down: let them. An absurd number of the official crises have been negotiated and resolved over weekends so that they may be presented as a fait accompli “before the Asian markets open.” The hasty crisis-to-crisis policy decision-making lacks coherence for the obvious reason that it is more or less driven by a desire to please the stock market. The Treasury, the Federal Reserve and the S.E.C. all seem to view propping up stock prices as a critical part of their mission — indeed, the Federal Reserve sometimes seems more concerned than the average Wall Street trader with the market’s day-to-day movements. If the policies are sound, the stock market will eventually learn to take care of itself.

End the official status of the rating agencies. Given their performance it’s hard to believe credit rating agencies are still around. There’s no question that the world is worse off for the existence of companies like Moody’s and Standard & Poor’s. There should be a rule against issuers paying for ratings. Either investors should pay for them privately or, if public ratings are deemed essential, they should be publicly provided.

Regulate credit-default swaps. There are now tens of trillions of dollars in these contracts between big financial firms. An awful lot of the bad stuff that has happened to our financial system has happened because it was never explained in plain, simple language. Financial innovators were able to create new products and markets without anyone thinking too much about their broader financial consequences — and without regulators knowing very much about them at all. It doesn’t matter how transparent financial markets are if no one can understand what’s inside them. Until very recently, companies haven’t had to provide even cursory disclosure of credit-default swaps in their financial statements.

Credit-default swaps may not be Exhibit No. 1 in the case against financial complexity, but they are useful evidence. Whatever credit defaults are in theory, in practice they have become mainly side bets on whether some company, or some subprime mortgage-backed bond, some municipality, or even the United States government will go bust. In the extreme case, subprime mortgage bonds were created so that smart investors, using credit-default swaps, could bet against them. Call it insurance if you like, but it’s not the insurance most people know. It’s more like buying fire insurance on your neighbor’s house, possibly for many times the value of that house — from a company that probably doesn’t have any real ability to pay you if someone sets fire to the whole neighborhood. The most critical role for regulation is to make sure that the sellers of risk have the capital to support their bets.

Impose new capital requirements on banks. … A better idea would be to require banks to hold less capital in bad times and more capital in good times. Now that we have seen how too-big-to-fail financial institutions behave, it is clear that relieving them of stringent requirements is not the way to go.

Another good solution to the too-big-to-fail problem is to break up any institution that becomes too big to fail.

Close the revolving door between the S.E.C. and Wall Street. At every turn we keep coming back to an enormous barrier to reform: Wall Street’s political influence. Its influence over the S.E.C. is further compromised by its ability to enrich the people who work for it. Realistically, there is only so much that can be done to fix the problem, but one measure is obvious: forbid regulators, for some meaningful amount of time after they have left the S.E.C., from accepting high-paying jobs with Wall Street firms.

But keep the door open the other way. If the S.E.C. is to restore its credibility as an investor protection agency, it should have some experienced, respected investors (which is not the same thing as investment bankers) as commissioners. President-elect Barack Obama should nominate at least one with a notable career investing capital, and another with experience uncovering corporate misconduct. As it happens, the most critical job, chief of enforcement, now has a perfect candidate, a civic-minded former investor with firsthand experience of the S.E.C.’s ineptitude: Harry Markopolos.

The funny thing is, there’s nothing all that radical about most of these changes. A disinterested person would probably wonder why many of them had not been made long ago. A committee of people whose financial interests are somehow bound up with Wall Street is a different matter.

Conclusion

The articles by Michael Lewis and David Einhorn are well written, providing extremely useful context. And they make very sensible recommendations. However, the “Financial Crisis” goes well beyond the United States. Any negative effects felt within the U.S. economy quickly spread far and wide. As we know now, the sub-prime problem in the U.S. negatively impacted the economies of many countries, even bankrupting the economy of Iceland.

Therefore any comprehensive solution needs to encompass all of the intertwined global economies. We cannot solve our economic problems on a nation by nation basis. A global approach to monitoring (and regulating) the financial sector is essential in order to avoid another “Financial Crisis.”

The End of the Financial World as We Know It

“The Madoff scandal echoes a deeper absence inside our financial system, which has been undermined not merely by bad behavior but by the lack of checks and balances to discourage it. Greed doesn’t cut it as a satisfying explanation for the current financial crisis. … The fixable problem isn’t the greed of the few but the misaligned interests of the many.” – Michael Lewis and David Einhorn.

To arrive at the solution to any question, you first need to understand the extent, nature and causes of the problem. This is especially true with respect to the continuing and escalating “Financial Crisis” (now, unfortunately, worthy of capital letters and quotations), primarily because we just don’t have a playbook to refer to. Worse still, the “Financial Crisis” has morphed into a full-blown economic recession.

Previous posts have emphasized different aspects of the economic meltdown. Here’s another perspective. In two related articles published in the New York Times, Michael Lewis and David Einhorn have written in-depth about both the causes of our current problem and their recommended solutions.

The End of the Financial World as We Know It uses the Madoff scandal as a starting point to illustrate the perverse incentives operating at investment firms, credit rating agencies, the Securities and Exchange Commission and the U.S. Treasury Department.

Wall Street Firms

…leaders of public corporations, especially financial corporations, are as good as required to lead for the short term.

Our financial catastrophe, like Bernard Madoff’s pyramid scheme, required all sorts of important, plugged-in people to sacrifice our collective long-term interests for short-term gain. The pressure to do this in today’s financial markets is immense.

Credit Ratings Agencies

Everyone now knows that Moody’s and Standard & Poor’s botched their analyses of bonds backed by home mortgages. But their most costly mistake — one that deserves a lot more attention than it has received — lies in their area of putative expertise: measuring corporate risk.

These oligopolies, which are actually sanctioned by the S.E.C., didn’t merely do their jobs badly. They didn’t simply miss a few calls here and there. In pursuit of their own short-term earnings, they did exactly the opposite of what they were meant to do: rather than expose financial risk they systematically disguised it.

The Securities and Exchange Commission

… the S.E.C. itself is plagued by similarly wacky incentives. Indeed, one of the great social benefits of the Madoff scandal may be to finally reveal the S.E.C. for what it has become.

Created to protect investors from financial predators, the commission has somehow evolved into a mechanism for protecting financial predators with political clout from investors. (The task it has performed most diligently during this crisis has been to question, intimidate and impose rules on short-sellers — the only market players who have a financial incentive to expose fraud and abuse.)

The instinct to avoid short-term political heat is part of the problem; anything the S.E.C. does to roil the markets, or reduce the share price of any given company, also roils the careers of the people who run the S.E.C. Thus it seldom penalizes serious corporate and management malfeasance — out of some misguided notion that to do so would cause stock prices to fall, shareholders to suffer and confidence to be undermined. Preserving confidence, even when that confidence is false, has been near the top of the S.E.C.’s agenda.

It’s not hard to see why the S.E.C. behaves as it does. If you work for the enforcement division of the S.E.C. you probably know in the back of your mind, and in the front too, that if you maintain good relations with Wall Street you might soon be paid huge sums of money to be employed by it.

The U.S. Treasury

Say what you will about our government’s approach to the financial crisis, you cannot accuse it of wasting its energy being consistent or trying to win over the masses. In the past year there have been at least seven different bailouts, and six different strategies. And none of them seem to have pleased anyone except a handful of financiers.

… Treasury Secretary Henry M. Paulson Jr. persuaded Congress that he needed $700 billion to buy distressed assets from banks — telling the senators and representatives that if they didn’t give him the money the stock market would collapse. Once handed the money, he abandoned his promised strategy, and instead of buying assets at market prices, began to overpay for preferred stocks in the banks themselves. Which is to say that he essentially began giving away billions of dollars to Citigroup, Morgan Stanley, Goldman Sachs and a few others unnaturally selected for survival. The stock market fell anyway.

It’s hard to know what Mr. Paulson was thinking as he never really had to explain himself, at least not in public. But the general idea appears to be that if you give the banks capital they will in turn use it to make loans in order to stimulate the economy. Never mind that if you want banks to make smart, prudent loans, you probably shouldn’t give money to bankers who sunk themselves by making a lot of stupid, imprudent ones. If you want banks to re-lend the money, you need to provide them not with preferred stock, which is essentially a loan, but with tangible common equity — so that they might write off their losses, resolve their troubled assets and then begin to make new loans, something they won’t be able to do until they’re confident in their own balance sheets. But as it happened, the banks took the taxpayer money and just sat on it.

To be continued.

Professor Explains Financial Crisis, Part 2

The last post highlighted an article by Alan S. Blinder, professor of Economics and Public Affairs at Princeton University, which briefly summarized the causes of the Financial Crisis.

What Really Lies Behind the Financial Crisis? summarizes a 90-minute talk by Jeremy Siegel, a professor of Finance at the Wharton School. The two professors both blame government policy mistakes. However, Siegel adds Fed Reserve Chairman Alan Greenspan to the list of people who could have made better choices. Professor Siegel also focuses on the role of financial institutions in causing the crisis.

What was the true cause of the worst financial crisis the world has seen since the Great Depression? Was it excessive greed on Wall Street? Was it mark-to-market accounting? The answer is none of the above, says Jeremy Siegel, a professor of finance at Wharton. While these factors contributed to the crisis, they do not represent its most significant cause.

Financial firms bought, held and insured large quantities of risky, mortgage-related assets on borrowed money.

Many troubled banks and insurers continued to prosper in almost every other aspect of their businesses right up to the 2008 meltdown. The exception was the billions of dollars in mortgage-backed securities that they bought and held on to or insured even after U.S. home prices went into a free-fall more than two years ago. American International Group (AIG), the insurer that received an $85 billion federal rescue package last September, is a prime example. Some 95% of its business units were profitable when the company collapsed. “AIG has 125,000 employees,” Siegel noted. “Basically, 80 of them tanked the firm. It was the New Products Division, which had an office in London and a small branch office in Connecticut. They came up with the idea of insuring mortgage-backed assets, and nobody at the top decided it wasn’t a good idea. So they bet the house — and the company went under.”

Lapse over Lehman

According to Siegel, federal officials — particularly outgoing Treasury Secretary Henry Paulson ­– mishandled initial efforts to intervene in the crisis. For example, Paulson was concerned about the political backlash that might be unleashed by bailing out Lehman Brothers. He allowed the firm to collapse last September but underestimated the impact of Lehman’s demise on financial markets. Despite a $700 billion bailout, banks are still unwilling to extend credit.

While angry investors and taxpayers are anxiously looking to assign blame for the current state of the economy, it’s important to know not only which factors led to the meltdown, but which ones did not. He said that government programs encouraging home-buying by low- and middle-income families and short-selling of financial stocks — which was halted for a time last fall — have little to do with the crisis on Wall Street.

Instead, Siegel pointed to two interlocking issues: One is a massive failure, not only by traders, but by CEOs of financial firms, their risk management specialists and the major rating agencies to recognize that an unprecedented housing-price bubble began building after 2000. Their faulty reasoning was that the inability of homeowners to pay their mortgages — and the consequent foreclosures — would not pose a threat to their mortgage-backed securities. They believed that as long as home prices kept rising, the underlying value of the real estate would provide a hedge against the risk of such defaults. They failed to realize that this reasoning was based on the assumption that home prices would go in just one direction — up. In fact, these assets became enormously risky once the housing bubble burst and home prices began their inevitable decline.

Siegel also argued that ultimately, the buck stops with corporate CEOs who didn’t ask hard enough questions about the risks posed by mortgage-backed assets. He said he and others have wondered why firms like Lehman Brothers, Bear Stearns and Morgan Stanley — which survived the much more severe Great Depression of the 1930s — collapsed during 2008. One reason, he suggested, might be that, back then, these firms were organized as partnerships. In such an organizational structure, the partners would have to risk their own capital. When the partnerships were reorganized as widely held public companies, however, they no longer had such constraints. “Back when it was a partnership, you had your life invested in that company,” said Siegel, noting that banks also began making higher-return but higher-risk investments in recent years as public ownership increased.

Greenspan’s Role

One other key player that Siegel criticized for not heading off the collapse of the mortgage-backed securities is former Federal Reserve chairman Alan Greenspan, who oversaw the government’s central bank until 2006. Greenspan was so influential while he oversaw the Fed that he could have easily blown the whistle on the over-accumulation of mortgage-backed assets by the U.S.-based financial giants. He, however, failed to discover that firms were taking such large, risky individual stakes without protecting themselves against a housing market collapse. “[Greenspan was] the greatest central banker in history — he had access to every piece of data,” Siegel said. “He could have looked at the balance sheets of Morgan Stanley or Citigroup and said, ‘Oh my God — they didn’t neutralize their risk.’”

Another reason why federal officials and economists failed to detect the perilous economic risks of the 2000s, Siegel said, is the so-called “Great Moderation.” This term refers to the fact that since the 1980s, the volatility of the business cycle has declined, thanks to more aggressive fiscal policy and the rise of a service-based economy, among other factors. Siegel noted that a similar flattening of the economic cycles had occurred during the 1920s after the 1913 establishment of the Federal Reserve Bank, a factor that caused stock investors to ignore risks, which eventually led to the stock market crash of 1929 and the Great Depression.

“People asked, ‘Are we ever going to have a big recession again?’” Siegel said of today’s policy makers. “Everybody thought we were in a new stage and risk premiums didn’t need to be so high.” But those risks hit home last year. While it would have been difficult for federal regulators to save Lehman Brothers — which had invested billions of dollars in assets related to subprime mortgages — even if they had acted six months sooner, the fall of the 158-year-old financial house had a disastrous impact on the wider financial market. Lehman Brothers was connected to 950,000 or so transactions. As a result, bankers became gun-shy about making any type of loan, even to companies with a flawless credit history.

Trouble with TARP

For that reason, Siegel said, the initial phase of the Bush administration’s Troubled Asset Relief Program (TARP) was seriously flawed. Paulson’s Treasury Department decided to buy equity stakes in troubled banks, assuming they would make more loans with more capital on hand. The amount of capital, though, has little to do with the reluctance of banks to make loans, even as the rate on federal funds is slashed to near zero. John Maynard Keynes, the British economist, called this situation a “liquidity trap,” Siegel noted. “The big failure of TARP was that it misunderstood why banks weren’t lending. Officials thought it was because they didn’t have enough capital. In reality, they were worried about the solvency of all the borrowing that was out there.” Siegel suggested that the government rescue plan could be improved with guarantees that recipients demonstrate they are using the federal dollars to extend credit.

According to Siegel, monetary policy has failed to stimulate the U.S. economy. The U.S. faces a situation similar to what happened in Japan during the 1990s when interest rates of zero could not revive the country’s moribund financial markets. The only viable solution now open to American policy makers is Keynesian fiscal policy, a stimulus program that lowers taxes or increases government spending or both. Indeed, this is exactly the type of program — costing at least $825 billion — that the Obama administration and Senate Democrats are considering. Siegel said that policymakers should not worry about the impact on deficits; it is large, he added, but not dangerously so.

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