derivatives

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Standard & Poor’s

It is good news that Standard & Poor’s is being sued by the government. S&P was complicit in the market rigging that led us to the bubble and the destruction of a boatload of wealth. It has escaped, thus far, any serious damage from its involvement in the creation of crisis and deserves to be taken down a peg or two. The amount of damages being sought is roughly equivalent to one year’s income of S&P’s parent company McGraw-Hill. That’s not enough to put the company out of business, but it is noticeable.

Anyone who is committed to a free market system will applaud the suit. Market rigging is about as serious a problem as can be imagined in a free market. It impedes the flow of information that is essential to proper price setting, distorts outcomes, and exposes those market players not involved in the scam to potentially massive losses. While I would never argue that any participant in the sale or purchase of complex derivatives is entirely innocent – they all claim to be sophisticated investors and/or advisors – clearly some folks were duped. The loss to pension funds was significant, which means that many an average retiree or average worker saving for retirement was exposed to possible loss.

Anyone, like me, who has a more jaundiced view of markets  and their ability to work without significant external propping up, will also applaud. Although in our case we will also ask why it took this long for the suit to be filed.

The question is, of course, whether S&P was complicit in rigging the market.

To me the answer is unequivocal: Yes.

But was it fraud?

The problem with the rating agencies is that they collect their fees and thus make their living by charging for the ratings they issue. This deprives them of any impartiality. It exposes them to the lure of bribery. It makes them an insider rather than an outsider offering objective opinions. No matter how hard they try to create artificial barriers and to protect their analysts from these problems the cold hard fact is that the rating agencies – S&P is not alone – are all part of the Wall Street ecosystem. They are thus feeders at the same trough as the investment banks, and rely on the deal flow the banks generate. Giving negative ratings would block that deal flow. It would reduce earnings and bonuses. So the bias is always to give positive reviews.

The only plausible defense that S&P can offer for its manifest errors is that it was simply deploying industry standard financial thinking when it gave out AAA ratings to what turned out to be junk investment products. In this it was not alone. The issue I have with this is that it implies that S&P has no higher standard or analytical ability than the average market player. This undermines its credibility as an expert. If S&P has no particular higher skill its opinions are not that useful. So why would we rely on its ratings? Furthermore, since we now know that the analytics underlying the entire mortgage derivative market were deeply and fatally flawed, to argue that S&P simply adhered to those analytics is tantamount to admitting duplicitous stupidity. In which case those ratings are even less useful. No one would pay top dollar to listen to the ramblings of a dunce.

And S&P was either a dunce or was trying to dupe innocent investors. Its business model was either built upon its own ignorance or upon preying on that of others.

I think the reality of the crisis was that the banks and their various co-parties were complete fools. They all jumped in willingly. They turned out to be latter day alchemists trying to turn lead into gold. Along the way they convinced themselves, in a spectacular example of group think, that they were brilliant and consequently deserving of enormous compensation. That they turned out to be petulant fools deserving of nothing hasn’t quite sunk in yet. S&P’s special corner of the Wall Street fools and idiots club was that it was the organization waving the magic wand over the lead and saying that it was gold. For this catastrophic stupidity it ought to be held accountable.

I am not sure that what S&P did was criminal. The fraud all took place inside the banks where distorted incentives and lax oversight encouraged, or at least turned a blind eye, to persistent lying. I tend to see S&P simply as a blind fool who was easily ensnared in the wider scam and made to feel significant by the flow of cash. Greed took over and S&P moved quickly from dupe to complicit duper. The problem being that it didn’t know what it was doing.

Remember that in the feeding frenzy of the bubble years all standards dropped to historic lows. Idiots were seen as geniuses. Pedestrian analysts were viewed as unparalleled seers. The self regard of the entire ecosystem shot through the roof. That it was all alchemy was yet to be revealed. The banks, the rating agencies, the lawyers, and the accountants all feeding at the trough never gave a second thought to intelligence, severe analysis, or public responsibility. They were all blinded by the cash. The massive volume of activity, the late night meetings, the urgency of getting the deal done, the adrenaline of the rapid pace and the lure of bonuses  all drove them totally mad. They were all irresponsible and utterly stupid. None should be trusted ever again. But they were not all criminal.

They were gigantically negligent. They were horribly destructive. They deserve all the opprobrium we can muster and hurl at them. This law suit is merely a start. Their culture still exists. The error could be repeated. They still represent a danger to us all. They need to be broken and discarded.

 

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Whither the Fed?

There has been quite a bit of discussion recently about the future both of the Federal Reserve Board with respect o its role as a regulator, and the future of Ben Bernanke its current chairman who term comes up for renewal in the not too distant future.

Let me wade into the discussion.

“It is possibly allowable to fail to see the tsunami building, but it is inexcusable to have allowed the risk prevention systems at the banks it regulated to atrophy to the degree they did. That’s akin to not checking whether the fire hoses work or whether the lifeboats float.”

First: Bernanke.

I must admit to a certain ambivalence here. Bernanke is a highly respected economist. He is an expert on the problems of the Depression, and the author of a well known text book. So his credentials are both good and mainstream. His actions to stave off economic disaster have been imaginative and forceful: the Fed has taken some extremely unconventional steps to flood the economy with liquidity even to the level that some are now worried about the inflationary consequences of that activity. As you know I think inflationary fears are way overblown presently – that’s something we can worry about in a couple of years – and, in any case, Bernanke’s recent testimony before Congress was full of all the right plans to suck that liquidity out before it does any long term damage.

It is the timing of the counter measures to the monetary expansion that we should be concerned about, and that’s where my ambivalence creeps in. That timing will require judgement – does Bernanke have it?

The problem I have with Bernanke is this: if he’s an expert, as he is, on matters such as the Depression, why did he not have a better handle on the crisis we are going through as it grew? Some of his statements and speeches from a few years back are too full of fawning praise for the likes of Milton Friedman and Robert Lucas whose monetary and general economic theories contributed so much to the disaster. I realize that due to the hegemony of neo-classical and monetarist thinking about macro economics that very few major economists saw what was coming – for which we should never forgive them – but he is the one who we rely on, the rest are merely commentators.

His handling of AIG and Merrill Lynch were heavy handed, but in the absence of solid background information I have no reason to fault him for being drastic on either. He was caught squarely in the ‘too-big-to-fail’ conundrum that none of us has yet to find a good solution to. Then again isn’t he supposed to be leading the search for such a solution?

My problem with replacing Bernanke ultimately boils down to two issues:

  • Who would replace him? There are very few names being floated that don’t suffer from the same issues that Bernanke has: notably their attachment to outmoded economics.
  • Independence. One of the Fed’s assets is its independence from politics. In its role as monetary policy arbiter the Fed needs to be seen as separate from political influence so that it can periodically pursue politically unpalatable policies. A major difficulty of the Fed during the Greenspan era was his very open advocacy of right of center politics. Ultimately this blinded him to the errors within neo-classical economics and especially its failure with respect to asset price bubbles. So: for Obama to change Bernanke right in the middle of the current crisis may be seen as a little too much politicking and a loss of independence.

For these two reasons Bernanke should stay … just.

That brings us to the second issue: that of the Fed itself, because errors made by Bernanke where supported by the work done elsewhere within the Fed. And there seem to have been plenty of errors.

Let’s look at some of the details:

When the crisis was building the Fed ignored the depth and breadth of the collapse in real estate. Bernanke kept telling us that the end was in sight, yet here we are three years into the down cycle and the bottom is only now tentatively on the horizon. Obviously there were major analytical problems in the Fed’s understanding of the real estate market. Which is odd since the Fed is a major regulator of the mortgage market. They of all folks should have a handle on real estate.

Next: the Fed and Bernanke seemed to have a very limited notion of the extent of the potential damage the implosion of real estate would or could do. In particular they had no notion, it now appears, of the volume of derivative type products dependent upon real estate that littered bank balance sheets. Not only this they had no idea of the tsunami like impact that the inter-connected nature of the derivative market would unleash: apparently they couldn’t, or didn’t, model the systemic nature of the derivative overlay on the banking system. And it isn’t as if derivatives are totally new. Nor has their growth been unobtrusive. That the Fed analytically overlooked the possible systemic risk being built up within one of the banking system’s fastest growing profit sources must be viewed as a major oversight and contributory factor to the crisis.

And this is a criticism of both the Fed and Bernanke: they were complacent within their economic theoretical constructs. So much so that they were blinded to more prosaic methods of control: any major systemic accumulation within a market such as derivatives should have drawn the attention of an auditor. So the Fed as controller/auditor failed because it was too invested in it economic role as central banker. I simply don’t care what all the experts – they call them ‘quants’ on Wall Street – were saying about the risk mitigation of derivatives, someone [at the Fed] with an old fashioned, and very dull auditing mentality, should have cast a skeptical eye over the market. Especially given its explosive growth and apparent profitability.

When a regulator uses precisely the same techniques as the regulated; when they both appear at the same conferences; when they both recruit from the same schools; and when they cross fertilize by exchanging personnel, the regulator becomes indistinguishable from the regulated. Group think and complacency build. Independence is lost. And no one is left taking a jaundiced view of likely outcomes.

This, I fear, is where the Fed has arrived: bereft of independent thought. Or at least bereft enough for it to fail just when it should have been raising the alarm.

Is this Bernanke’s fault?

Not especially.

The same argument can be made across the entire financial system. There is little diversity of theory and method in the places that matter: in the centers of risk management.

Further: those places where the alarm was raised were swamped by the rush for short term profit.

This raises another criticism of the Fed. The conflict between the incentive presented by short term profit, and its reinforcement by the aggressive bonus structures common on Wall Street, contradicted and disabled the proper functioning of the risk management processes of all our biggest banks. It destroyed a few, and ended up costing the taxpayers a fortune. Any competent auditor should have sensed this conflict and tested the controls in place to allow the voice of the risk managers to prevail if needed. The Fed fell flat on this issue too.

It is possibly allowable to fail to see the tsunami building, but it is inexcusable to have allowed the risk prevention systems at the banks it regulated to atrophy to the degree they did. That’s akin to not checking whether the fire hoses work or whether the lifeboats float.

I understand that checking control systems is boring work – heck I walked away from a career in auditing very quickly for that reason – but if it’s your job, you should do it well. Especially if the safety and soundness of the nation’s banking system relies upon your work.

All of this leads me to conclude that the Fed as an regulatory institution failed miserably. It gets a good grade for monetary policy and a failing grade for regulation.

This implies that the Fed is unfit to play a major role in the rejigged regulatory structure now being debated. Unfortunately the outcome looks to be very different: the Fed is making a strong play to remain the systemic risk overseer. This was exactly where it fell down. Frankly without radical changes in its staff and procedures I cannot see the Fed being credible in this role. Already it is failing to rein in the return of the conflict between bonus structures and risk management at places within its ambit of control – Goldman Sachs is the obvious name. That does not inspire a great deal of confidence.

So that’s it:

Bernanke can stay; but the Fed should be exclusively a central bank – as a regulator it failed and so it should exit gracefully from that line of work.

Personally I would advocate a single regulator overseeing the entire financial system and replacing the current fragmented approach we have now. Will that happen? I doubt it. Radical just doesn’t seem to be popular these days.

Addendum:

I just came across [via The Big Picture] a CBS story reporting that the Fed gets a low rating amongst all government agencies. maybe i wasn’t hard enough on them!

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Financial [Re]Regulation

It is a sad commentary on the state of the economy that I return after a few days of idle bliss only to discover that the main topic of discussion is precisely the same as it was last week. And the week before that. And … well the banks need fixing. Not a lot of surprise there I imagine for anyone who had inhabited planet earth during the last two years.

At least the exact topic has shifted. Sort of.

Now we are being treated to a wave of speculation about the shape and timing of the big new regulatory effort that will wind its way through the halls of Congress later this year. For instance the Financial Times speculates that reform of the regulatory system is being slowed down so as to allow other items on the administration’s agenda to have some space or focus while the details of the regulatory legislation is hammered out behind closed doors.

The centerpiece of the new system, whenever we see it, is likely to be an authority roaming over the whole of what is called ‘systemic risk’.

“Our failure to take dynamic and strong action to recapitalize the big banks is having all sorts of ‘knock-on’ effects.”

If there is one thing we learned through this crisis it is that the risk management activities of the financial industry are inept at managing risk. Truly inept. So poor are the banks at risk management that, in their zeal to hedge, offload, mitigate and otherwise purge themselves of it, they magnified, concentrated and loaded up on it to a disastrous degree. They simply fooled themselves. They moved risk off balance sheet as if that shed it entirely. They bought contracts to protect themselves against default only to find that their counter-parties could not honor the contracts and therefore represented a risk themselves. They hedged positions using models that only work in utopia. And their ‘innovation’ of risk management products produced a veritable menagerie of Frankenstein like contraptions that ran amok trampling the balance sheets of those unfortunate enough to have fallen prey to what we have to call the ‘risk-avoidance-but-is-really-risk-concentration’ disease that infected Wall Street and all who came into contact with it.

Swine flu has nothing on this one.

Somewhere Mrs Shelley is smiling at the inventiveness of the lunatics who dreamt all this stuff up.

It takes a particularly fertile imagination to conceive that some of these wonderfully innovative products represent any value to anyone other than the people peddling them. They certainly turned out not to manage risk.

My view is that the entire derivatives trade ended up being a massive con game, the whole purpose of which was to allow a few folks to generate vast wealth for themselves. The con artists lived in an incestuous fraternity skipping from one employer to another, oblivious to the goals and needs of their current employer, and supporting one another through the execution of thoroughly useless trades.

Why else would someone take out an insurance policy against the risk of default of the US Government? In the realm of senseless transactions that one shines most brightly.

Its purpose?

None.

None, that is, economically.

Its motive?

Bonus. Someone had to make a trade to meet a bonus target.

So I suppose that some risk was being mitigated: the risk of traders not hitting their bonus targets was assuredly eliminated. That and the monthly profit targets of the legions of lawyers, accountants and hangers-on necessary to transact these insanely arcane pieces trash.

Thus we need ‘systemic’ regulation.

The entire system can be brought down by the tortuous nonsense these folks created. So we need to protect ourselves against the consequences of their snake oil.

The old regulatory system focused on single banks. It had a vertical quality to it. The theory was to manage to banks, each in isolation, by controlling their activities one at a time. So regulatory efforts took the form of audits and examinations testing the risk management methods of the banks. This left unattended the linkages between banks. The labyrinthine entanglement created by the booming trade in derivatives went uncontrolled because it cut across the system. Its risk characteristics are every different when viewed horizontally between banks rather than vertically within a single bank. The collapse of AIG and the threat it became to other banks is an example of this.

So systemic is in.

But that means big changes to our current regulatory set up so political infighting will inevitably slow down enactment of anything meaningful. All our regulators stand to lose jurisdictional territory. Obviously someone will win, but in the meantime the knives are out.

Simultaneously with this systemic risk management effort is the other big component of re-regulation: the establishment of the authority to take over and wind down large banks.

One of the reasons the administration has failed to fix the capital problems of the big banks is that is has been hesitant to seize them and force them through a government run reorganization. It perceives it does not have the legal authority to dissolve a bank holding company in the way current law allows it to seize smaller banks. This perception was one major cause driving the Treasury Department to step around bank capital issues rather than tackle them head on. The new resolution authority will need to be funded in the way that the FDIC is and that raises political problems: small banks are objecting to having to contribute to a fund that has no impact on them. I assume this will be resolved quickly, but it demonstrates the tip-toeing necessary to get new regulation in place. At the same time the big banks, who will have to ante up to pay for the new authority, don’t want to contribute right now either: they need to retain every penny of their profits so they can earn their way back to health.

Which brings me back to my ongoing thesis with respect to the banks:

Our failure to take dynamic and strong action to recapitalize the big banks is having all sorts of ‘knock-on’ effects. In this case it is slowing to a crawl our ability to set up a new regulatory structure. We need the banks to earn their way free of the crisis. This will take time. There is no certainty they will succeed – the rising tide of credit card and commercial real estate defaults could swamp their efforts to retain profits. Meanwhile we remain exposed to the lunacy of the old structure.

It is tiresome to have to keep repeating this: we have not fixed our banks. The stress tests were a sham. The capital targets too low. The entire banking system remains undercapitalized even after all the frenzy of post stress test share and bond sales.

The best we can say is that the banks are now able to limp slowly. They no longer are crawling on all fours.

So the result of hundreds of billions of taxpayer dollars and many months of dodging and weaving by two administrations is that we have a ‘merely’ crippled system rather than a ‘near dead’ one.

Progress of sorts.

But not enough.

Plus ca change.

Addendum:

I neglected to refer to the administration’s announced efforts to impose regulation on derivatives. Remember that derivatives were specifically exempt from regulatory oversight or control during the Clinton administration: the thinking was that leaving the derivatives market unregulated would allow innovation to flourish. This innovation was thought to lead, inevitably, to market driven solutions to risk management.

This blind faith in market driven problem solving works well in the nirvana that is neo-classical economic theory. It tends to flop in the real world where the vanities and idiosyncrasies of less than rational people muddy the waters a bit.

So the effort to put boundaries around the derivatives market and to make it open to scrutiny is a welcome step forward.

I would have preferred that all derivatives be traded in the open. But as seems to be the case with much of what this administration does, caution has prevailed and we get only partly open trading. Too many of the administration’s experts are beholden to the market-is-best world view. So the fallacy lingers on near the center of policy making and manifests itself in the half steps taken instead of the whole steps that were available.

Sigh.