Good Finance Gone Bad

As the Lehman anniversary approaches, defenders of the financial sector struggle into position – partly in response to your comments (also here).  They offer three main points:

  1. We need finance to make the economy work.
  2. Financial innovation delivers value, although it’s not perfect (but what is?)
  3. Don’t kill the goose that laid the golden egg.

Point #1 is correct, but this does not necessarily mean we need finance as currently organized.  The financial sector worked fine in the past, with regard to supporting innovation and sustaining growth.  Show me the evidence that changes in our financial structure over the past 30 years have helped anyone outside the financial sector.

On #2: Financial innovation has obviously benefited the people who run and operate large financial companies.  Has it helped anyone else, including their own sharedholders?  And if you can show broader social benefits (e.g., lower cost of capital, better ability to take nonfinancial risks that make sense, or anything else), do these outweigh the massive social/fiscal costs that are now apparent?

Which leads to point #3: what kind of egg did the finance goose lay?  Obviously we now need to go back and recalculate economic growth – if much of what was done by finance was issue loans that were not likely to be repaid (while not recognizing the probable losses). 

But the unfortunate side effects of finance lie much more in the future than in the past.  It’s not lowering recent growth by some fraction of a percentage point that should bother us, it’s the likely behavior of large-scale finance, now more powerful and with greater concentration of power.

Private sector capture of the state is bad enough, wherever it happens in the world.  But when the capturers have an unparalleled ability and willingness to “tax” the rest of us, we should really be afraid.

The business model of big finance is not to consolidate their position and live on comfortable annuities.  It’s to take as much as they can (“otherwise the competition will hire our best people”) while stuffing the risk (“which ordinary people don’t understand”) onto the taxpayer.  The technical details of this arrangement are loosely refered to as “financial innovation”.

Modern finance is more than quack medicine.  This is state capture, an old tradition for bankers – and in the modern American version their hands are in the deepest set of pockets ever.  Why would they ever let go?

By Simon Johnson

208 responses to “Good Finance Gone Bad

  1. “The Lone Ranger and Tonto
    Were riding down the Navajo Trail
    When a band of Indians found em
    Proceeded to surround em and
    The Lone Ranger turned kinda pale
    Tonto, our lives are in danger
    We got to get away if we can
    Tonto just looked at Lone Ranger
    What you mean, we, white man?”


    “Point #1 is correct, but this does not necessarily mean we need finance as currently organized.”

    Point #1 is correct if you choose to maintain capitalism. Probably the only people clinging to this antiquated system are those that are half or more psychotic and those that think we’ll be pulling out of this in a few months.

    What’s the endgame, damnit? I know you know. Send me an email, beam it straight to my screen. Enough’s enough — I’ve been on the edge of my seat for the past 3 years. Have we been taken out by “economic hit men”? If so, they’ll be sucking us dry for years to come, right? What’s the alternative? What is your policy recommendation?

  2. I was wondering why do we let investment banks hold positions in the markets anymore? If financial innovation means that everything can be securitized then why do we let the investment banks hold on to or back securities? If people are going to make a CDO vehicle (and in the process make all the feees) why cant we force them to also securitize the super-senior debt (or any other garantees) instead of hide it on their accounts virtually insured by the U.S. taxpayer? Why don’t we outlaw any originator from holding a position, they make fees. The second group would be hedge funds, institutional investors, and other market participants. Finally if you want a normal business loan we have plain vanilla banks who have to see through the terms of a loan that they grant. Any collusion between the actors can be investigated through insider trading rules. It may seem uneasy that whole security vehicles would be held up by the market, but isn’t this what innovation should be able to overcome anyway? This will not touch problems with executive incentives, but it seems like it would force people to be more upfront with information than the current institutional arrangement allows.

  3. You could argue that the system did deliver lower costs of capital. Who can argue the low mortgage interest rates. Those were borne by those assuming the actual risk of the loans – not the organized system.

  4. As interest rates were held low, prices went up so the result was that the debt acquired was substantially larger than if a person paid less for a property. A person usually buys based on what he can afford in monthly payment. Higher interest rates would have kept the housing balloon from forming, but since construction was pumping money into the economy, nobody wanted it to stop.. Now there is a glut that has to be absorbed and the unqualified buyers that should never have been in the market are worse off than before and the toxic loans are still on the books.

    We need to know who is holding the bad MBS that are hidden or the potential counterfeit ones and the CDS that were bets against them.. in multiples. If the ratings agencies never saw the tape for rating these MBS, it would be easy to sell counterfeit MBS with absolutely no assets behind them.

    I came across this. Strong stomach required.

  5. The Case for a Level Playing Field and the Golden Rule as Economic Axioms
    If we are to believe the postulates of basic string theory, we are all potentially connected to everything and each other (at least as my minimal understanding goes).
    Intuitively, maximum potential output for an economy should be all resources human and otherwise being utilized over time to the extent of their full latent possibilities. So reality would be some function of combined individual and collective implementation and utilization, that is, our own individual efficiency in relation to implementation of latent potential and collectively, our group´s, town´s, state´s, region´s, country´s, and ultimately, global implementation as an interactive system.
    Notwithstanding, we are always going to be pushing against limiting factors, as well as individual and collective attitudes and actions–both conscious and unintended–that may be contrary to maximizing this potential economic output, because at the very simplest level, we just do not have all of the answers.
    Thus if maximization of collective output depends on the degree of implementation and utilization of individual and collective latent possibilities, one can arrive at the fairly obvious conclusion that because we cannot know the best possible array or outcome top down, society should work from the bottom up, that is, to assure that the potential value of each individual and element can be maximized and implemented through efforts directed at supplying a level playing field for all. Conversely, a level playing field depends on responsibility for following or playing by fair rules being assumed at the individual level, that is, do unto other as you would have them do unto you, rather than do as I say, not as I do.
    Adam Smith, I am sure took this for granted when he spoke of the invisible hand and the nation´s founding fathers sought this when they referred to life, liberty, and the pursuit of happiness.

  6. David Goldstein

    >This is state capture, an old tradition for bankers – and in the modern American version their hands are in the deepest set of pockets ever. Why would they ever let go?

    First, I am on board with all of the above.

    However! :-)

    What I would like to know, after watching the last year of craziness in politics and the “private sector”, is who is going to wrest the reigns of finance from these “deepest of pockets” when we have a apathetic and well divided American public. Our elected officials? That remains very much to be seen.

  7. The biggest problem with financial regulatory reform is that there is no political will for it.

    The second biggest problem with financial regulatory reform is that there are very few people in this world who understand innovative products well enough to be specific about where things have gone wrong. It is difficult enough to explain the market for one specific product; to explain the financial system as a whole right now, you’d have to be Poincare.

    I think when people talk about financial innovation, they are really talking about the abuse of innovative products, not the products themselves. There are some financial products that are completely nonsensical. But many products are great products that would add tremendous value to the system if their use were limited to where it made sense.

    For example, I work a great deal with interest rate swaps. For people who understand them, swaps are an essential part of managing a fixed income portfolio. But the banks, realizing the potential for swaps to become fee machines, have also marketed swaps to unsophisticated investors. So, you ask, does the benefit the instrument provides outweigh the costs? This question assumes it is inevitable that innovative products will be abused.

    Abuse does not necessarily follow innovation. We can produce a regulatory system that directs the actual use of these products into their proper channels. Whether we will is another story.

    I think blaming innovation generally is the wrong way to go. Most innovations can be either good or bad. It is the behavior that is the problem and the culture that perpetuates the behavior.

    None of this bodes well for financial reform. To allow innovation to exist and combat its abuse, we are going to need highly sophisticated, independent regulators. Apart from the fact that the financial industry has tremendous resources at their disposal to devote to creating inefficient regulators, this task is complicated by the fact that the same players who engage in abusive transactions are also responsible for most of the productive financial activity in our country.

  8. There may not be a will for reform, but I don’t think there is a budget for this kind of bailout any more. So we can continue to push the boundaries of failure and go even more broke, or we can reform the system.

  9. When a business gets so complicated and obscure that it can be understood only by ‘Poincare’s’ it has gone too far. It no longer is a business, it is rent seeking based upon intellectual obscurantism. I have no problem with them gambling with their own money. I want them to pay, personally, for their mistakes. That’s capitalism at work. Right now they’re simply gaming the system. And they should be stopped.
    If people like you and I cannot understand what they are doing I don’t want them playing with my money.

  10. I do not think that complexity is a good reason to discard innovation. Swaps are complicated, but so is chemotherapy. We find a way to supervise complicated developments in other industries, and the same should be true for finance.

    The problem here is that we’ve let the industry develop for decades without any form of supervision, and the result has been chaos. We would need a Poincare to sort out the good and bad activities that have persisted so far. What net value these products have provided absent supervision is a purely academic question that does not reflect the value they could provide going forward if the system for providing oversight can be brought into the 21st century. For that to happen within the current framework requires tremendous political will.

  11. The medical analogy again? Isn’t that what Elizabeth Warren did last week? It’s wrong, just wrong. We can safely say that doctors who administer chemotherapy want to help people. Correct? The finance industry is meant to separate you from the fruits of your labors.

    Pardon me while I go bash my head into a wall.

    Get out of that world, Bond Girl. Go get a real job. Become a doctor, do something useful.

  12. Yeah, I’ve never met a doctor who cared about making money… Give me a break.

  13. Not arguing there aren’t mercenary doctors who put money above care. Of course there are. I’m even related to a few of them and know a few others, and they turn my stomach. But I think that even now most of them value providing care a little higher. In any case it’s an industry that’s built around helping people, not screwing people. We can say with confidence (excluding the ugly world of big pharma) that innovation in medicine is almost invariably good. We can hardly say this about financial innovation.

  14. @Billy,

    “We can say with confidence (excluding the ugly world of big pharma) that innovation in medicine is almost invariably good.”

    Yeah. I love how much attention they lavish on innovating a better erection. I’m sure that’s the highest and best you of the scientists’ time.

    There is nothing wrong with the profit motive. I think it is a great thing, in fact. But the focus on constant growth for public companies really has perverted everything. You can have a wonderfully profitable business, but unless you have a growth story, you won’t get credit for it in today’s equity markets, where shareholder value is measured solely by share price. We need to bypass the casino mentality.

  15. Your analogy is wrong because chemo is fairly well understood process. Why can’t the banks just focus on depositing money and lending it? Why should the banks be able to operate in the stock markets?

  16. Lavrenti Beria

    “Right now they’re simply gaming the system. And they should be stopped.”

    There you go, pacr, that’ll stop ’em, shoulding all over yourself and shaking your finger. And how would you propose bringing an end to this practice, son, through elections and a subsequently appointed instrumentality like the utterly terrifying Elizabeth Warren? Enlighten us, kindly.

  17. Bond Girl,

    I’d like to apologize if I seemed harsh sometimes in discussing regulation. But the Canadian experience, during this financial crisis, has been very different from the American.

    I’m asking myself how did Canada get it so right? Unlike other countries Canada was not consumed by practices that lead to the 2008 financial crisis. One answer is the Liberal government in power from 1993-2006. It banned foreign ownership of banks. Although in the late 90s there was a huge lobbying effort to allow Canadian banks to merge with American banks. The pro-merger argument, ironically, was Canadian banks needed to be bigger to be competitive and profitable. It was not until 2006, when the Conservatives formed a minority government, that Canada began to adopt American mortgage practices. Thankfully, this was too late in the game to cause too much damage.

    I read somewhere that the Canadian financial system is actually — less regulated — than its American counterpart. But our government is also less captured by corporate interests. So this must definitely be a factor. Richard Hoogesteger has also stated Canada has a functioning civil service.

    So it is not just regulation that speaks to the strength of a country’s financial system. But also, as others have pointed out here, the kind of government and ideology that leads a country.

  18. @Tippy Golden

    I can’t wait for global warming so I can move to Canada. ;)

  19. Tippy, just heresay, but I heard it from people who work in Canadian banks, but many of those quiet conservative canadian banks are said to be facilitating financial crime all over the globe. Maybe they can afford to not rip off their own. Plus it’s a much more homogenous society, so they enrich themselves no end, but make sure they don’t piss off the proles.

  20. Uncle Billy,
    are your “sources” implying that Canada has noiselessly become the Switzerland of the Americas? (which incidentally we get told all the time has the best health care and old age pension schemes imaginable)

  21. CBS from the West

    “But many products are great products that would add tremendous value to the system if their use were limited to where it made sense.”

    At the risk of digressing too far, and also of being a one-note Johnny, I’d like to point out that this is one of the fundamental problems with the health care system as well. I have often on this blog emphasized that about 1/3 of all health care services rendered in the US are useless. It is also true that most of that consists of services that, _applied to the right patients in the right situations_ are very useful and beneficial indeed! But the health care system seems to just proliferate treatments way beyond the confines within which they actually work.

    And as with finance, it will require people with extensive expertise to distinguish what is beneficial from what is not. And, also in health care those who deliver the useless care are, in general, also the purveyors of some of the best care.

    I’m not entirely sure what we can learn from the analogy in policy terms. But it suggests that part of the solution requires a major shift in the culture at large, away from unbridled expansionism and unending growth towards focusing on the creation of valuable output as the goal of human endeavors.

  22. CBS from the West, I’ve enjoyed your contributions to this blog. As most of us here agree, the problem in the financial and health sectors, in the United States, is political capture by rent-seeking interests. It is a very tough problem.

  23. I have this question – which is an honest question, without an underlying ax to grind:

    It’s certainly true that financial innovation have _some value_. But you yourself have argued elsewhere that financial innovators are simply smarter/faster/better than any regulators we could possibly hope to hire.

    The question then becomes whether we are capable of building a system that can not only sort the good from the bad, but continue to do so as new innovations are developed. Even a semi-privatized system ( ) would require a general structure that could conceivably be evaded by “bad” innovations, or even innovations that are good but being overused due to principal/agent problems.

    Even if a modern day Poincare materializes, and manages to acquire authority, can we institute a system that keeps the balance after that mythical figure loses power?

    If your answer to this is no, then SJ’s next challenge becomes material:

    On balance, do the innovations “outweigh the massive social/fiscal costs that are now apparent”?

    If we can’t tell the difference, and if on balance the innovations have been more harmful than beneficial, then the best thing to do is throw them all out – baby and bathwater together.

    But if we can tell the difference – how, exactly, do we build a system that can do so?

    I suspect, btw, that Team Obama’s response will be to try to preserve the baby and throw out the bathwater, so this is a very relevant question.

  24. The problem was never innovations, but outright fraud and departure from prudent standards (for example, Per has made the case many times that reserve ratios need to be lower and based on classic underwriting, not AAA ratings). The solution is therefore to stop fraud however it occurs, and write standards that enforce prudence. Simon’s suggestions about consumer protection would take care of the remaining cases of misuse.

    If you really wanted to stop the abuses, give everyone who broke the law 6 months in jail instead of carte blanche to keep doing it.


    That’s a fraudulent business practice. If it’s not illegal, it needs to be – with severe penalties for developing “innovative” loan docs that allow for such fraud – penalties that include jail sentences and heavy fines.

  26. Suppose health care had not been regulated at all for a long time – decades which included major worldview-changing developments – and it got to the point where even educated people had a difficult time distinguishing between legitimate, fraudulent, and somewhat unethical practices. Would you just say, forget about bypass surgeries, let’s go back to the leeches, it costs too much to sort this out? You can’t convince me that this is even a live option for finance right now. It is a strange situation, but the rent-seekers in the system are really just exploiting a Kuhnian crisis point; our main obstacle right now is description.

    Financial innovators are better, faster, etc. than government regulators, and I think for the most part, most people do not have a clue what government regulators’ learning curves on these instruments are. They are going to have to transition to a completely new regulatory responsiblity, and so far they can’t even get past their philosophies of regulation. (Should we try to get into the details of transactions, or just give market participants a broad set of principles to follow? … What does that even mean?)

    I think people wildly underestimate what this task requires, and yes, the cost. We need regulators that can do trade analysis, that can quanitify what a reasonable transaction is and what it is not. Trying to bring regulatory organizations up-to-date within their existing frameworks would undoubtedly be expensive. But there are people out there with this sophistication already, not just within the banks, but in consulting firms, etc. Finding a way to get them to participate in regulation would reduce the learning curve and the cost associated with it, and reduce the chances that our regulatory organizations just become an inexpensive vehicle for educating future bankers. It is also our best bet for creating a proactive regulator that can keep pace with new developments.

    I firmly believe that no progress will be made in holding the financial industry to real standards until market participants themselves start standing up and lending their credibility to the fight. Short of some sort of paradigm shift in regulation that allows them to participate, I’m not sure why they would risk it otherwise. Most Americans are not capable of viewing market participants’ contribution to this discussion intelligently, but cling to their generalizations and cariacatures like they might offer some sort of salvation from what this mess will become in the future.

    All of this is moot, however, until wrongdoing can actually be punished in some meaningful way. And that is a political problem.

  27. And if regulators actually did punish wrongdoing in a meaningful way, that would likely reduce the cost of regulation going forward.

  28. This did not happen over the course of decades. Let’s review some history:

    1990s: Greenspan advocates for derivatives. Summers repeals Glass-Stegal.
    2000: Criminals enter the Whitehouse from election fraud in Florida. Massive business scandals emerge.
    2001: WTC7 mysteriously collapses, along with all ongoing SEC invesigations. Criminals take over Wall Street.
    2001-2008: Era of fraudulent lending, securities fraud and insider trading. No one major goes to jail.
    2008: Collapse of economy. Government props it up temporarily by printing money.
    2009: Only major/minor player prosecuted so far is Madoff.

  29. I can tell you that swaps have been used in the muni market since the 80s at least. Securitization has also been around for quite a while.

    It is just that the use of these products increased substantially in the 1990s and thereafter.

  30. Sure, that was leading up to the enactment of the Commodity Futures Modernization Act, but that does not mean that the derivatives markets were a novel concept then. (And Greenspan’s reference, I’m sure, was with respect to London.)

    Usually something has been around for a while by the time legislation is drafted about it. Congress is hardly on top of innovation :)

    But you could add this to your timeline – May 2009: Obama taps Gary Gensler, one of the architects of the Commodity Futures Modernization Act and the left-wing version of Christopher Cox, as chairman of the Commodity Futures Trading Commission, which he wants to be the main regulatory player for derivatives oversight going forward. Adds a nice symmetry to events, you know?

  31. Sorry, was afk for a few days…

    I think your points are fair, but leave a very pessimistic view. I’m still struggling with the overall themes:

    1) Can we actually do “good regulation”? Can a government agency ever have that capacity, on an enduring time scale?

    2) If not, are financial innovations worth the costs?

    Regarding health care, there are a lot of people that argue that if we can’t discern whether a procedure is justified or not based on a test, then sometimes it’s better not to conduct the test. Thus, the American Cancer Society (aka, oncologists) currently does not recommend the PSA prostate cancer screen, while the Urologists do recommend it. So, medicine _is_ having these sorts of discussions. In finance, the issue is simply much larger in scale.

    3) In terms of a self-reinforcing system… what about the following (much of which borrows from your ideas):

    a) Increase capital ratios to make sure that derivatives creators have more of their own skin in the game.

    b) Write the laws to permit going after personal assets in a broader range of cases.

    c) Require X% of bonuses/commissions to go into escrow for 2 years prior to distribution.

    d) Open up financial regulation to class-action lawsuits. This gives incentives to a large range of private actors to engage in post-hoc regulation and recovery of assets, including personal assets.

  32. When I listen to claims about the benefits of financial innovation, I ask myself where’s the gain? Institutinally, you have legitimate pools of ‘managed’ money: mutual funds, pension funds, insurance companies. Then you have operating companies, non-profits, private fortunes, and penny ante individuals tuning in to Jim Cramer. Sure, all these ‘investors’ hope to manage risk, but every bet has two sides and all ‘innovation’ does is make the aggregate bets increase exponentially, while the money jumps from one asset class to another, and the ever increasing bets are supported by bank credit accommodated by the Fed money machine. There isn’t anything else that CAN happen, systemically, which makes it ridiculous that anybody didn’t understand that as the asset prices advanced the risk of collapse became bigger and bigger, and indeed collapse became inevitable, because sooner or later even lenders would realize their collateral was mispriced. Finance isn’t really a Ponzi scheme; its a game of musical chairs. The fact that it may have made increased credit available to consumers is only good so long as the consumers remain able to service the debt. Instead, they got the opportunity to pay $400k for a $100k house. Of course, since wage gains are a thing of the past, consumers certainly need credit. I would rather see the government providing household credit on reasonable terms, rather than building superfast trains from Disneyland to Las Vegas, but maybe that is just me.

  33. Is this suggested curative action untouchable?

    “The likely future is: more of the same, at least until we find a Jackson or a Roosevelt.”
    FOUND: Simon Johnson can do it — UNFOOL the people by getting these histories in their faces, ONGOINGLY:
    “Real Homes, Real Dow” at

    And, the foregoing two mispricings abetted the two ‘misbehavings’ here (second chart):
    “Real Dow & Real Homes & Personal Saving & Debt Burden” at

  34. David Goldstein

    >I think blaming innovation generally is the wrong way to go. Most innovations can be either good or bad. It is the behavior that is the problem and the culture that perpetuates the behavior.

    I guess I am not clear why you think innovation is good in finance, except for people who can act independent of the system, (aka, the truly rich folk of our world).

    My feeling is that all the financial “innovation” since the 401k is destined to fail us when we most need it.

    For instance. Wait till the financial “innovation” of 401k’s go crashing through the floor with a bunch of heavily indebted, geriatric old farts living on an insufficiently funded social security system.

    When will that crash occur? Well, it has started already – I have friends in their mid 60’s, trying to figure out what happened to their mutual fund “investements” that they had been so reassured would only grow for so many years. Many have delayed retiring, under the false assumption that the market will recover. In fact, it will only get worse as the biggest contributors to mutual funds stop contributing, (they have to at some point), and just want to coast on their “investements”. Ha. A house of cards.

    There will be no where near enough money being pumped into the hyper inflated stock market to sustain it, certainly not by baby booomer’s children where the ratio is something like one of them for two BB’s.

    As far as regulation goes, as soon as we institute it, (and I agree, there seem little political will, so make that a big “if”), there will a decades long war to dismantle it, (as took place up to and through the Reagan, Bush, Clinton, Bush years and even today), and with the short term nature of human memory, we will be back in this same boat again.

    BTW, I don’t want to sound too provincial, but my references are to the system as I understand it in the U.S. today.

  35. David Goldstein

    And I can spell “investment” even if my fingers do not cooperate!

    Once again, please let us edit our posts. :-)

  36. As an outsider to economics and all the theories that support that science, I remain astonished that highly educated, exceptionally well compensated people devised innovative tools and math models they used brilliantly to bring the global economy down.

    There was a great deal of intellectual endeavor that went into creating such a crash. Mortgage brokers decided to create an environment where loaning to people who could not afford the loan was an acceptable business practice. (Simply cannot wrap my head around this factor in the crash! “So you have no income to support this loan; we’ve created the NINJA loan for you!”)

    Investment bankers utilized innovative CDOs and CDSs to “minimize risk” and never asked themselves how packaging up so many bad loans would ever be a good deal when the loans came due. Apparently this was done because the homes themselves were to be acceptable collateral – never mind that housing prices were seeing a completely unsustainable rise in value – and a bubble was about to pop.

    Ratings agencies failed utterly to issue ratings based in the reality of what was being sold.

    And the regulatory environment, battered by 30 years of anti-regulatory propaganda, laid down and died in the last decade.

    What is even more astonishing is an investment banking community that seems to think that this way of doing business is acceptable. They are not outraged at all by the events that led to the crash (except perhaps those who worked at Lehman). Hard to be outraged when you’ve profited so nicely by questionable business practices.

    We have a financial system in which risk is rewarded, caution is penalized and the government is there with a no-strings bailout when the bankers fail.

    It is unacceptable to ask the American public to accept that a reliance on a math model or economic theory caused the crash. Grossly irresponsible human behavior is at the root of the crash.

    And as of today, the taxpayers are the ones held accountable. Not those whose irresponsible behavior led up to the crash. They’re actually making quite a tidy profit in today’s market – and setting aside “record” bonuses for themselves.

  37. Anne,

    You said:

    “Mortgage brokers decided to create an environment where loaning to people who could not afford the loan was an acceptable business practice. (Simply cannot wrap my head around this factor in the crash! “So you have no income to support this loan; we’ve created the NINJA loan for you!”)”

    The people making these loans were not fools, they were predators, and predators have different business practices. What mattered was getting the bad loans booked so they could then be used to spawn one or more rounds of derivatives, with fees being collected when the loan was originated and each time it was sold off. Since the bad loans were sold off immediately, the lender was never exposed to any risk by making a loan, and lending standards went out the window. They simply did not care if their marks could pay back the loans or not, there was a huge demand for subprime and Alt-A loans to be packaged into CDOs, and they were able to make a lot of money by feeding the beast.

  38. Yes – and who won this game? Predators.

    Innovation’s not the problem. Just like you cannot blame the existence of knives for murder, you cannot blame financial innovation for the utterly corrupt use of tools. But unlike the pharma biz, where pushing the boundaries will get you a large fine (as Pfizer saw this just last week), financial shenanigans instead get you the biggest bonus. There is no one holding any of those corrupt peddlers of junk accountable for practices that should be against the law.

  39. Agreed. But the pharma biz has to go through clinical trials that are closely monitored by the FDA before they can peddle their innovation. It would be nice to have similar regulatory oversight of the introduction and use of innovation, just so the regulations and accounting rules can keep up.

  40. ” I remain astonished that highly educated, exceptionally well compensated people devised innovative tools and math models they used brilliantly to bring the global economy down.”

    It’s not astonishing at all if you assume that this is what they intended to do, or at least those they work for intended to do.

  41. Who intended what? There are many versions of the story… here is one

  42. A while back I remember being troubled by seeing that Berkshire Hathaway was one of the largest shareholders of Moody’s. This prompted me to look into who controls the big three, Moody’s, Fitch, and S&P. The ratings were key, but exactly who are these people? At Moody’s currently, Berkshire is still number one of course. Fitch is owned by the French Fimilac. Who are these people? Fitch Group also owns Algorithmics, vendor of risk management software. Apparently this is quite the magical software. Is it used commonly in the industry? Only by people who work with Fitch? For some weird reason, their CEO, Steve Joynt, looks like William Janeway’s twin brother.

    (Maybe it’s just the moustache and glasses)

    S&P. This is more than just a little curious: “It is also worth mentioning that Standard & Poor’s apparently failed to predict the bankruptcy of all the largest Icelandic banks and a weaker position of the Icelandic Government in 2008, a country that had a very high rating until its economy suddenly collapsed.
    In April 2009 Standard & Poor’s called for “new faces” in the Irish Government, which was seen as interfering in the democratic process.In a subsequent statement they said they were “misunderstood””

    Here’s their CEO —

    Defense industry, George W. Bush’s Transition Advisory Committee on Trade…

    Was there any collusion between Wareen Buffett, Fimilac, and McGraw, or did they each have their own separate sphere of influence?

  43. Correction: Fimalac

    They just sold 20% of themselves to Hearst Communications.

    That’s an interesting connection. Fitch is a company that is involved in managing our perceptions of the quality of certain things. The Hearst corporation has always been about managing perceptions.

  44. Can’t forget Moody’s other big shareholder

    Shelby Senior was Ambassador to Switzerland (fancy that) and “was chairman and treasurer of the eponymous, conservative think-tank, the Shelby Cullom Davis Foundation, at the time of his death. He was also affiliated with the Heritage Foundation and The Sons and Daughters of the Mayflower”

  45. D. Christopher Leonard

    We have a financial system in which gain is privatized and loss is socialized. That is one of the core meanings of 30 years of ‘government is the problem’ rhetoric and ‘de-regulation’ the policy that begins with Goldwater and becomes institutionalized with the Reagen administration. “De-regulation” has worked out in principle to be permitting certain clusters of interests to shape state policy to their advantage whether by enfeebling government oversight, capturing the agency, or preventing oversight.

  46. So we are not talking or “de-regulation” but of “re-regulation”, right?

  47. This might be a stretch. But I’m wondering if there is an analogy between — counterfeit money — and what the financial industry did by packaging and repackaging several times over securitized debt. The casino analogy has substance. But what about compariing the financial debacle to 21st Century innovation in counterfeit money production?

  48. But I’m wondering if there is an analogy between — counterfeit money — and what the financial industry did by packaging and repackaging several times over securitized debt.

    Counterfeit money is money with AAA ratings imprinted by impostors who pass themselves out to be the official credit rating agencies. And so, at the end of the day the difference between real money and counterfeit might not be that much, since who is there to tell us that the false credit rating agencies have to be better than the real?

  49. I wonder how much of the innovation fixes a glitch in the market, and how much simply generates fees.

    I also wonder whether the investment bankers would have been so innovative if they had to fund their business from their own capital.

    To my knowledge none of these guys has gone into personal bankruptcy as a result of their innovative speculations.

    Perhaps we need to force them to play with their own money, not ours. then we’ll see just how ‘innovative’ they want to be.

  50. So, Simon: when are you and your colleagues in academia going to stop teaching the math and the theories that produce all this ‘innovation’.

    It is one thing to vent here, it is another to take action within the halls of MIT etc. Tell us what you’re doing to change the curriculum, that is a first step in taking back the economy!

    I remain skeptical of the chance for reform as long as our business, academic, and political elites still preach the free market theories that undergird this stuff. The ‘capture’ is not just of politics, it is of the entire intellectual structure of our economy.

    Perhaps Marx was right: rampant capitalism will destroy itself. I hope not.

  51. I think broad terms like “innovation” and “deregulation” can be misused. The devil is always in the details, not in the slogan. Allowing the investment banks to lessen their asset ratios to 30 or 40 to one was not innovation, it was sheer stupidity.

    Innovation can still be good for the economy. Changes to our complex financial regulatory system need to be thought through, and should not be a part of some populist political response. Lessons should have been learned from this debacle.
    Here are some of bad ideas we should not do again:

    1. Allow Government agencies like Fannie and Freddie, to loan trillions to millions of people who are unlikely able to repay their mortgage.
    2. Allow Banks to over leverage beyond historical ratios, whether it is through derivatives or latest fad financial innovation or not.
    3. Allow Securities firms to be banks. The banking industry should be separate from the securities industry.
    4. Allowing conflict of interest rules to be ignored, or disregarded, particularly in regard to parties with tremendous amounts of money to throw around.
    5. Allowing the Government to go so heavily in debt that it crowds out private borrowing, and/or severely devalues our currency.

    All of above lessons have not been learned. These things continue as before, and we still somehow think things will get better. They will not until reforms are made.

  52. “5. Allowing the Government to go so heavily in debt that it crowds out private borrowing, and/or severely devalues our currency. ”

    Please explain this point further because I am confused.

    You propose this as a lesson that should have been learned from this debacle, which suggests that you view this enumerated point as a cause of the debacle, which doesn’t make sense because the overextension of credit to the private sector is one of the primary cause of the trouble we’re in (you actually allude to this fact in your second point about leverage).

    Perhaps you’re arguing that the government’s response to this debacle was wrong, that the government debt incurred by all the bailouts is crowding out private borrowing and/or severely devaluing our currency. The “crowding out” argument doesn’t make sense to me. If we’re not seeing private borrowing, it’s because the banks aren’t lending it and/or the private sector already has enough debt and doesn’t want to take on more when the economy seems to be shrinking and the unemployment rate continues to rise. The currency has not been devalued (yet) by the Fed’s action because the money they’ve printed sits in the banks reserves and is not circulating.

    I’m with you as to points 2-4, though. Your first point is refuted quite nicely (and easily) by Barry Ritholtz in his book “Bailout Nation.”

  53. If a bank lends to a car company then the government requires it to have 8 percent of bank equity but if it lends to the government (the one who pays the regulators salaries) and so that the government can then lend to the car company then the bank is not required to have any equity at all. Who do you think the bank will lend to?

  54. Returning to #1, Fannie and Freddie did not lend money. They purchase mortgages on the seoncdary market.

    “These two government-sponsored enterprixes (GSEs) do not write individual loans; instead, they buy and sell mortgages in teh secondary market, providing a flow of liquidity to the nation’s lenders.” James R. Barth, “The Rise and Fall of the U.S. Mortgage and Credit Markets” (2009).

    Returning to #5, how does your hypothetical respond to my question? What if no bank would ever have loaned to the car company directly because its balance sheets were already in shock that it would not lend but directly to the government with the underlying guarantees. Isn’t that where GM and Chrysler were when the government stepped in? They couldn’t otherwise get financing because they were too close to insolvency? If that’s the case, where’s the crowding out? Would you have preferred that the government just gave the money away with no chance of repayment? I’m sure that would probably have been just as bad or not worse to some people.

  55. Paul “Allowing the investment banks to lessen their asset ratios to 30 or 40 to one was not innovation, it was sheer stupidity”

    Absolutely and in fact they allowed 62.5 to 1 whenever there was an AAA rating involved.

    But the real tragedy is that their real regulatory innovation was the introduction of a discriminatory treatment of risk which shocked the risk-allocation system of the market.

  56. Paul says never more “Allow Government agencies like Fannie and Freddie, to loan trillions to millions of people who are unlikely able to repay their mortgage”

    No, before the market, because of the huge demand for raw materials to use in the construction of AAA securities, could be so seduced into lowering the requirements for a mortgage loan, there was never any real danger of trillions given out in loans to people unlikely to repay them… as no one would have purchased these.

    There is though a need to stop the societal discrimination and extreme bias in favor of house-ownership, when compared to the rental market.

  57. “Which leads to point #3: what kind of egg did the finance goose lay?”

    A nuclear bomb in a white eggshell.

  58. Professor Johnson has properly eviscerated the defenders’ claims. Regarding Defense No. 3: uh, those things the defenders are calling golden eggs? They’re bubbles. Perhaps a visit to an optometrist should be in order.

    That the finance industry is vastly overstating their historic role in our general prosperity – disregarding the incredible chutzpah displayed in the wake of the economic disasters fueled directly by their recklessness – is the most ominous sign to me that this powerful sector sees itself as the driving force politically and economically going forward and that it has, at best, no intention at all to change the way it has been doing things. As Prof. Johnson notes, why would anyone in his or her right mind change when it has brought this degree of power and control?

    Paul, Anne and some of the others make good points regarding innovation and the fact that it is not all bad, but as the financial sector has acquired more power, it seems the innovations of more recent vintage have been nothing more than new games of chance designed by a casino to bring in new customers and more money. Any benefits to consumers and the public at large are likely short-lived at best and always secondary to the benefits to the house. (By the way, this is not a knock on casinos. It should be acknowledged that casinos are much better regulated and, as far as I know, are strong net funders of government instead of the other way around.)

    This sector, which once served as the WD-40 between various business and financial sectors, now calls the shots for all, even those who are supposed to govern this activity. Without the government strongly reasserting its regulatory powers and getting this sector back to its original purpose, there is no way this ends well. And it’s certainly not a free market in the meantime.

  59. Old Lady in Red

    James…. Pls delete my comment.

    I am sorry if I have posted something inappropriate
    in past.

    I will not post again.

    I’ve enjoyed the blog.


    ….Lady in Red

  60. If innovation is so great, let the innovators take the unknown risks they create. Strip the financial institutions of their limited liability status and make the shareholders, directors, managers and employees personally liable for anything that goes wrong. I suspect that when you put these people’s wealth at risk, they’ll sing a different tune about innovation.

    Alternatively, and less drastically, we could take all of the financial institutions that are public companies and force them to be private. I believe that the appetite for “innovation” is caused, in part, by shareholder demand for growth in share price. Private corporations can be managed in a way that provides just as much shareholder value with a lot less growth than demanded by the public markets.

  61. “Strip the financial institutions of their limited liability status…”

    Uh, that would pretty much work… But it would never happen.

    As to making such companies private, you would get public companies (with shareholders) that complain that these lucrative investment opportunities are being denied to individual investors, and so you’d get intermediaries that arbitrage that regulatory gap.

    Consider leveraged shorting, and the controversy around double short ETFs. Leveraged shorting is now available to the common investors – because they wanted it. Too bad for them.

  62. Have we got their attention yet?

    Wake me up when we’ve got the greedy, stupid banker’s attention.

    The ones that made stupid investments with other people’s money & are confiscating millions & billions of other people’s money for bonuses for themselves.

  63. Goldilocksisableachblond

    You say:
    “Which leads to point #3: what kind of egg did the finance goose lay? Obviously we now need to go back and recalculate economic growth – if much of what was done by finance was issue loans that were not likely to be repaid (while not recognizing the probable losses). ”

    “But the unfortunate side effects of finance lie much more in the future than in the past. It’s not lowering recent growth by some fraction of a percentage point that should bother us, it’s the likely behavior of large-scale finance, now more powerful and with greater concentration of power.”

    Recent growth attributable to excess debt was only some ” fraction of a percentage point” ? Are you kidding ?

    For decades economists have missed something so obvious and commonsensical — that x% growth with ever-increasing levels of debt is inferior to x% growth with stable levels of debt , which is inferior to x% growth with declining debt — that they are now frantically trying to rationalize their stupidity using the tried-and true techniques of navel-gazing.

    Yes , “obviously we need to go back and recalculate economic growth” , but for policy purposes one needs only to recognize that economic growth was MUCH , MUCH more robust during the first three post-WWII decades ( because it was accompanied by declining debt/GDP ) than in the three decades following those three ( getting it yet ? — because debt/GDP was rising then ).

    In effect , by reducing the debt/GDP levels during the postwar decades we were lending additional economic growth to the future. In recent decades we’ve been BORROWING it FROM the future.

    Then , one needs only to look at what we did in the interim to so muck things up . Supply-side , Reagonomics , call it what you will , it’s pretty obvious to me.

    Of course , I haven’t yet consulted ny navel , so I could be wrong about all this.

  64. “In recent decades we’ve been BORROWING it FROM the future.”

    Yep. While I think that’s always true when you extend credit, the way it’s been done for the last twenty five years or so has been unsustainable because they’ve been assuming a very rosie future that will never materialize. I call it “strip mining our future wealth,” although “clear cutting our future wealth” would capture the same idea.

  65. Great metaphor: “strip mining our future”

  66. The latest suggestion by Obama, that people have their income tax refunds put into savings bonds would be good for financing the national debt, but a lousy rate of return for a retirement investment. When they go back to having Series EE bonds that pay 6% (the rate the first Bank of The United States paid, I’m in.

  67. David Goldstein

    >but a lousy rate of return for a retirement investment.

    Interestingly, in a analysis done of people in lower income brackets and 401k mutual funds, the vast majority LOST money. We in the U.S. are being scammed.

    In addition, if anything is going to need something done to it to support the waves of old people about to retired in the U.S. we better shore up social security. Right now, 40% of retirees in the U.S.’s only source of money in retirement is social security. 50-60% require social security to to fill half their monthly needs.

    Forget the stock market, it is a house of cards.

  68. Simon said: “But the unfortunate side effects of finance lie much more in the future than in the past. It’s not lowering recent growth by some fraction of a percentage point that should bother us, it’s the likely behavior of large-scale finance, now more powerful and with greater concentration of power.”

    Working as a hands on building contractor of single family homes for the 30 years that have shaken finance, it is clear to me that I lived through 30 years of one federally supported Ponzi Scheme after another: Loss of county-wide commercial banking, the s&l debacle, the dot-come bubble, and the mortgage scheme to name the high points.
    A Ponzi scheme robs Peter to pay Paul. Ponzi schemes point to single-entry bookkeeping passing for double-entry. The culprit is gambling. Ponzi promised a 50% return in 45 days — double your money in three months! Like Madoff, Ponzi exchanges money on a promise. The bet has no artifact of cash-value, nor collateral posted to insure a capital-potential in exchange. Cash-value traded in exchange for capital-potential is the basis of a legitimate double-entry bookkeeping contract.
    A typical Ponzi scheme is Goldman Sachs being both a gambling casino and a FED sponsored national bank. Depositors can bet with citizen-guaranteed dollars in place of chips. When Las Vegas uses chips to control profit [loss] “The House” must also control the odds on winning, or its expenses would make it a losing proposition. When today’s FED backs “Casino-Bank” gambling, dollars play the role of the casino’s chips. What’s more, table winnings are deposited directly into the gambler’s casino-bank account. “Bank” playing the role “Casino” takes a fee for service, eliminating the need to track the odds on gains [losses]. Topping off this dream-scheme, the “Casino as bank” borrows cheap FED dollars to make bets at its own gaming tables.
    When casino-bankers have no reason to care whom wins or loses the game, The House jumps in to plays the game as well. Fee for service operations win even when The House bets against itself. The only loser is the U.S. citizenry that guarantees the dollars in place of chips that gambling creates to fill the bank accounts. Casino-bank gambling is lucrative; so lucrative “The Bank” hires the best and the brightest gamers to share house / gambler winnings as “bonuses.” Dollars created gambling are different from FED printed dollars that water down our currency. Creating casino-bank dollars is a counterfeiting operation: a Ponzi scheme to die for. The key to Paul’s success is that double-entry bookkeeping’s natural framework of rules leaves Peter, the citizenry, holding the bag when a gambling pyramid blows up, as it did with mortgage derivatives.
    Before bookkeeping went high tech both bookkeeper and auditor intuitively picked up Ponzi’s Scheme. Once business rules were coded into software — code that often fails to meet the historic double-entry standard — there is no easy way for Citizen Peter to audit what his intuition tells him is dead wrong. Blogger after blogger, and most contributing comments, sense that Ponzi plays a role in today’s casino-banks, but none among them reports single-entry bookkeeping passing for double-entry as the engine that drives today’s powerful and deadly, FED-backed Ponzi Scheme.
    Double-entry bookkeeping’s framework of rules cannot allow gambling gains [losses] to become income because “a bet” has no physical artifact in its marketplace trade. Bookkeeping’s first order of business is to measure an artifact’s value in trade against rights to capital ownership. The legitimate chip-driven casino is trading “sport and ambiance” in return for its fee for service. The gambler’s fee in their operation is paid in chips lost [or won] in return for the sport and the ambiance that the gambler enjoys while gambling.
    Gambling chips are the gambling house’s tokens as tally markers. The house sells chips to its customer, then wins back a share by setting gaming odds that favor the house. A legitimate gaming-house bookkeeper measures house profit [loss] as the cost of providing the games and the ambiance in return for the chips that favorable odds wins back from its customer. Goldman-Sachs, today, need not concern itself with the odds on winning its games, because their fee for services is built into each gambler’s bet. Its focus can be on derivative bets that will rob Peter to pay Paul for as long as the FED gig doesn’t blow up.
    Financial bloggers are typical banking and FED watchdogs. But these watchdogs never raise the bookkeeping issue. Their silence assumes that computers are keeping the bank’s books correctly. The blogosphere knows that something is being fudged, but none among them call attention to the switch between single and double-entry bookkeeping as today’s banking culprit. We have a classic case of doctor heal thy self.
    The double-entry bookkeeper’s mission is today as it has been for 670 years: to complete each contract, whose goods and services it tracks, in a way that makes all parties to each contract whole. Citizen Peter lost big time when mortgage derivatives blew up. Double-entry bookkeeping that distinguishes gambling from value-based investments has an urgent mission today to be recalled to service to protect Peter’s damaged capital structures from Paul’s next derivative-based wrecking ball.

  69. To those who talk of that concept, please point out at one recent financial innovation with public utility. Say in the last twenty years.

    That one innovation ought to be allowed. All others ought to be forbidden. And proposed new financial “innovation” ought to be legislated. After all new drugs are studied for years through a legislatively mandated process. Although medical drugs are invented to save lives.

    The malignant growth of the financial sector has sucked up most of the innovative capacity of the economy, not just by prostituting the very concept of “innovation”, but by sucking a lot of the available capital, and a lot of the human capital (the best and brightest are diverted from activities with public utility to activities more akin to old fashion piracy), besides capturing the political process, and elevating profit to the new golden calf to be adored in the guise of absolute morality.

    Patrice Ayme

  70. Excellent post – agree with it whole-heartedly.

  71. The “illegal immigrants” and “students”, speaking broadly, who did NOT default on their loans had access to opportunity in their lives through subprime loans. These were granted because they were liquid. They were liquid because of securitization of credit risk. The fact that the risk was miscalculated on subsequent derivatives because someone forgot to mention that statistics only give you a highly probably outcome and not the exact one doesn’t mean there wasn’t a benefit, overall. The evolution needs to be perfected, so less mistakes are made.
    Furthermore, there are several innovations made over the last 30 years on the fixed income side of derivatives that highly reduce costs of hedging for corporations and insurance companies, for example, without having provoked any harm for banks or the taxpayer. This allows the to allocate capital into other investments.
    Overall, I think it is a very big mistake to generalize the finance world structure and their risks or benefits, as it highly varies from asset class to asset class.
    As an economist, rigorous analysis should be a preferred method of approach rather than lazy populist generalisation.

  72. Excellent points Ana. However, finance isn’t the only group at fault, and so the analysis has to be more wide-ranging. For example, with student loans. Their availability drove up the price of education causing people who previously could have afforded higher education to have to take them out. Now, higher education has become as unaffordable as health care.

    Compare and contrast that with Europe where education is thought to be a right of the people who can benefit from it and who have shown themselves to be deserving of it and hence university is not only free, but poorer students receive outright grants to study. In the U.S., by contrast, university education has become dumbed down due to the fact that a university degree is required in many areas where it shouldn’t be.

    This is not the fault of finance of course, but one has to always look at the bigger picture.

  73. “This is not the fault of finance of course”
    Yakkis, it may not be the FAULT of finance but finance surely has a preference for increasing demands of loans – at least that’s what I have learnt in simple day to day negotiations with banks – they prefer customers with debts and why not, they are much better cash cows.

  74. To quote Nassim Taleb:

    “Modern finance(portfolio optimization, risk management, Black-Scholes, etc.) is a scam.”

    Respectfully submitted,
    Ed Beaugard

  75. There was a very good paper in the Minneapolis Federal Reserve’s publication “The Region”. Talks about the dangers of bailouts. Here is the link.

    I also saw a cartoon in Phi Delta Kappan magazine. A father is sitting in his big chair with the dog at his feet. A young boy in a baseball cap is holding up a report card to show his father with a big letter D showing. The kid says to his father “But in the business world, failure is rewarded with big bailouts.”

  76. What feels missing in this discussion (at least to me) is a serious examination of the social and political context this “problem” in the economy is taking place in.

  77. Here’s some context. Ignore if you mind going mildly off topic again.

    Do we all agree there’s a problem with our central bank(ing system)? Many believe we shouldn’t have one. The fringe believe that it’s a tool of control over more than just the economy. Who actually runs the Fed? The member banks, yes? Who are the largest member banks? Chase, Bofa, Citi, yes? Who control those banks? Hard to say, but the largest shareholders tend to be Barclays and State Street. Barclays is a conspiracy theorist’s dream. Check out their Chairman:

    Cambridge (there’s that pesky Cambridge again), Lazard, Harvard MBA.

    State street… monsterous. Custodian of over $10-$14 Trillion? Current CEO is Ronald Logue. Very slim profile on Wikipedia. Very few details elsewhere. Related to Ed Logue, arguably the most influential Bostonion of the 50’s and 70’s, who, with the blessings of bishops, built a huge chunk of Boston and New York.“ed+logue”+”nelson+rockefeller”&source=bl&ots=NFVERzCX0Q&sig=4c3-7wBKD0bj8FI8fYMLrKZPV14&hl=en&ei=qFajSv-1KY_-tQOkg-SMDw&sa=X&oi=book_result&ct=result&resnum=9#v=onepage&q=%22ed%20logue%22%20%22nelson%20rockefeller%22&f=false

    How are the Logues related? Father-Son? Uncle-Nephew?

    Skip a generation of CEO’s at State Street and you end up with Marshall Carter, Chairman of the New York Stock Exchange Group and Deputy Chairman of the parent company NYSE Euronext. Maybe Simon’s bumped into him? He apparently lectures at Sloan.

    For fans of cloak and sliderule, is this his dad?

    We’re debating innovation and pointing fingers, and these guys are laughin’. Oh how they’re laughin’.

  78. “Who actually runs the Fed? The member banks, yes?”

    Uncle Billy,
    tell me that this is not seriously so –
    I’ve tried to read up your Federal Bank construction on Wikipedia – too mind-boggling for an outsider – but it raises one question – how can an institution with such an opaque organization chart ever be held accountable for anything

    – after the rating agencies being paid by their customers you are now saying the Fed what I assumed to be the equivalent of our CentralBank is run by MEMBER banks – i.e. banks supervising or whatever themselves – all part of the big I scratch yours if you scratch mine crowd?

    and that in the country where every journalist feels obliged to disclose any entanglements he/she may have with a subject?

  79. Yes, they describe it as a quasi-public banking system

    “The Federal Reserve is regarded as a quasi-public banking system,[7], since it has aspects of both a government run system and private enterprise. According to the Federal Reserve, there are presently five different parts of the Federal Reserve System[8]:
    The presidentially appointed Board of Governors of the Federal Reserve System, a governmental agency in Washington, D.C., The Federal Open Market Committee (FOMC), which oversees Open Market Operations, the principal tool of national monetary policy,
    Twelve regional privately-owned Federal Reserve Banks located in major cities throughout the nation, which divide the nation into 12 districts, acting as fiscal agents for the U.S. Treasury, each with its own nine-member board of directors, Numerous other private U.S. member banks, which subscribe to required amounts of non-transferable stock in their regional Federal Reserve Banks, Various advisory councils”

    So, the Chairman and the Board of Governors are appointed for very long terms, but everything else is private including the 12 Federal Reserve Banks. An example of one of the appointments is Kevin Warsh, who basically went to law school, started working at an IBank, married into a billionaire’s family, and then was put in place as George Bush’s network’s personal liaison to Wall Street. If you reflect on the “conservative” nature of the people running State Street, for example, who seem to have a lot of say at the biggest member banks, and then consider that the Fed was a huge contributor to our new depression (just like they were in the old one) then you really have to wonder what the lunatics running this asylum are doing. They are *not* stupid people. They can game these events out on cocktail napkins.

    The fear originally when they founded the system was that it would be the personal plaything of JP Morgan, the Rockefellers, and their friends. It was a well founded fear.

  80. The problem, as I see it, is that, because of the capture problem, financiers became like gambling addicts who could keep their winnings and always lay off their losses, so that no matter how risky their bets, they always win. It is that way even more today than before the crisis. And that’s really scary. What golden egg, you mean the one being kept in lots of offshore banks by the goose that laid it.

    How sad that social morality has come to this.

  81. Please, all of you regular contributors to Baseline who can dig into such arcane details so well, let’s keep it simple.
    We have two”industries” that are supposedly serving the nation, business, and the public. Both are making huge amounts of money , want to make even more, and have no interest in “serving” or what’s good for the country, only their own interests matter.That’s just raw capitalism at work!
    Now we have a new administration with a President who campaigned mightily aqainst these entrenched interests and promised us transparency and “Change You Can Believe In”. But from his inauguration he has surrounded himself with key insider appointees from the financial sector and made at least one very private deal with the President of Big Pharma (Billy Tauzin)and seems to be giving up on the key “public option”for health insurance competition.
    In the President’s speech thus week we’ll find out which Obama shows up – the agent of change and the public good or the enabler of the established
    power interests . All the rest of our talk today is just chatter and blowing off steam. Let’s watch closely what”the man” does!Then we can talk seriously.

  82. There will be people throughout his presidency who will say, “let’s just wait until ____, and see what he does. Let’s give him one more chance.” 4 years worth of second, third, fourth, fifth,…. chances.

  83. David Goldstein

    >There will be people throughout his presidency who will say, “let’s just wait…

    Hoover, believing in some silly principles, waited on the wealthy and the captains of industry to step in after the 1929 market crash – they say by the time he left office, he was quite disillusioned.

    1932 came and Roosevelt were elected, as a result. The rest is history.

    I figure, at the very least, President Obama is well aware of this. If he is not, he will not be around for a second term.

  84. “second, third, fourth, fifth,…. chances.”

    that’s how community organizers – we call them Sozialarbeiter (social workers) – operate on all levels – that’s how the system kind of forces them to operate.
    As much as I am for public support for their projects the public support has the unpleasant side effect that when you get something done on your own you weaken or even loose your entitlement to subsidies.

    i.e. my unemployment benefits are based on my last salary – if I take up a new low paid job during the payment phase intending to work my way up in the new company and that job turns sour on me my new/renewed benefits will be based on the lower salary of in-between – it takes really adventurous persons who disregard stuff like that

  85. The most important change over the past 30 years wasn’t de-regulation, globalization, or even consolidation. The paradigm shift that caused this mess occurred when invesment banks cast aside the partnership model and floated their shares to become publicly traded entities. The firm that floated last, and the only one that arguably still has the partnership culture still in tact, has passed the test of the last few years with flying colors (inside information not withstanding).

    Trying to determine the merits between too-much innovation and too-little innovation misses the whole point. The problem isn’t immorality, selfishness, greed, etc. The problem lies in the incentives of the system. If a poor man steals a loaf of bread to feed his family, I cannot pass judgement until I’ve been poor and unable to feed my family. Similarly, any one of the “honest, hard working, salt of the earth” types who regularly berates bankers would, if re-born as a banker over the last 20 years, make the same decisions (mistakes) as our current crop. Human nature is such that we will act according to the incentives placed before us. Anyone lucky (or unlucky) enough to be in the financial sector over the last 20 years had such asymmetric incentives, that you would be surprised if they DIDN’T take the risks that they did. When the employees of the firm don’t own the firm, they are all long a massive call option on the bets they take.

    Unfortunately, regulators will never attract the aggressive, razor-sharp, super-charged personality types which go into banking. Therefore, they will always be behind the curve. (Even if the $ pay was equal, being on the banking side is much more fun than the regulation side). So instead of trying to figure out a way to create a super-regulator capable of preventing every possible bad innovation, why don’t we instead reinstate capitalism as it was meant to be: those taking risks should be the ones who bear the consequences of bets gone awry.

    1) Glass-Stegall should be reinstated
    2) Investment banks should be banned from becoming public companies
    3) Capital requirements on all financial entities should increase exponentially with balance sheet size (too big to fail tax).

    This way, we will have a system with many small, fiercely competitive investment banks/hedge funds who can innovate to their hearts desire. But if they F*** it up, the taxpayer isn’t on the hook (nor is the pensioner who’s portfolio had Lehman shares), and they will go out of business leaving the non-financial economy unscathed.

    Let’s not try to be smarter than we are. People will always be selfish. Bankers will always be faster than regulators. However, by reinstating TRUE capitalism, we can have a well functioning economy that doesn’t rely on the pipe-dream of super-regulators coming to save the day.

  86. I’m not willing to keep giving Obama”one more chance” I swallowed hard when he appointed Summers and Geithner as consummate insiders to oversee the
    the financial “industry” to which thet both owe so much. But the Big Pharma deal with Billy Tauzin was inexcusable when Obama had promosed transparency and that he’d even “conduct negotiations on C Span”. This is the week our President has his big chance – period!

  87. “Hope springs eternal in the human breast”

  88. Thank you Yakkis.

    On your point. I come from a small village in an almost developing country and because of my grades at secondary school (public and free) I was able to go to University in the UK, one of the best ones in Europe, paying about 1000 GBP per year on fees. I was able to access an overdraft from a UK bank to help me finance it, and I also got a side job.
    I was able to do a Summer internship at Goldman Sachs and eventually got a job as a trader in Fixed Income at another bank, moved to a hedge fund etc.
    So, ultimately I can say innovation in finance led me to success and I wouldn’t have made it without access to credit. I wouldn’t have been able to access credit if banks didn’t have a chance to pass on the risk.

    And with me there are thousands of other (international) students. Securitization of debt and credit risk promotes growth / opportunities to people that, because of the way society is structured, don’t just get given a chance to maximize their potential to become lecturers at MIT, bankers or even access an internet connection. But we have gone too far, unarguably.
    [I personally find it ridiculous the fees that are paid in the US (particularly for business schools!!) but that’s another point, related to US’s inability to find a balance between capitalism and socialism such as the one in Europe. But again, it is so because so it was the will of the people living there so far, and now if there is to be a change, it will be the American public to express its will. As it has always been.]

    I agree that the breakout in partnerships was perhaps an issue within banks, but only because it was allied to the incentives system. I had several bosses that put out trades of millions without having a clue or reasoning on what they were doing, laughing about being cowboys, as they had a free option. If it worked, they got a fat bonus, if not they would just lose their job and go elsewhere. So if you link everyone’s pay to the firm’s performance, this won’t happen (like at Goldman Sachs). It is just like the highly debated case for CEOs incentive to protect shareholders. This debate is widely extended outside the banking industry.

    My point is the following: when one opens up a business, you don’t expect it to go perfectly well at first. So I think what one needs is to understand WHAT went wrong and to stop that from happening. ADJUST. And, frankly, it is not THAT HARD as people think. Just take 4 weekends, buy a good options and credit derivatives book, and if you are all as educated as it seems, you will understand that what went wrong was the fact that people relied too much on statistics to predict future outcomes, discarding, as Krugman well pointed out, the whole side of behavioural finance.

    I understand that people are mad at bankers but, if you look at it, it was only the Credit department within the whole investment banking industry that created this whole mess. So you are talking about scrapping / consider useless the jobs of 90% of bankers who work everyday to oil up the system with liquidity, restructure companies’ debt, etc because of a 10% that were too smart, doing something complicated that nobody wanted to understand, so they were left alone to ride the bull.

    Stop generalizing or quoting people like Nassim Taleb without understanding what he really defends (which again is just a statistical perspective on derivatives). Sit down, go through Banks’ balance sheets, realize which things underperformed and caused this whole mess. Analize how to restructure or scrap those things alone. Don’t allow it to happen again!

    One last point on immorality. I don’t think it should be excused or discarded. The banking world is a dicomoty. You can either find the nicest of people that spend a huge deal of their time helping others because they have a lot of money and can afford to create opportunity. Then you have the total (*&%$£” who think they are so much smarter than everyone else and just want to get rich, go to Ibiza and St Tropez and bathe themselves on Crystal and drugs. They can be very intimidating and this should be addressed.
    The fact that there are (STILL!) people inside banking corridors going around talking about how their clients are idiots and don’t understand the risk of what they are doing, but it is not their fault that they are uncapable of understanding SHOULD BE ADDRESSED, should be discussed. Should not be allowed to happen! Banks should start promoting people within their organizations based on their values, managerial skills, and not just the money they make. That way you might mitigate a big part of the wrekcless greediness going on because a good trader will want to make money because he/she enjoys their job and knows how to read the market/invest, wants the best for the company and themselves (yes, there are a lot of these people out there believe it or not!!) and not because they are good at ripping off other people.

  89. …or we just close the casino.

  90. So that you can open yours?

  91. Per, if I had the brains, I might consider it, but I don’t, so happily it’s not an option.

  92. “Securitization of debt and credit risk promotes growth / opportunities to people that, because of the way society is structured, don’t just get given a chance to maximize their potential to become lecturers at MIT, bankers or even access an internet connection.”

    Isn’t this due to the fact that it is possible to offload the risk onto someone lacking any idea of the circumstances in which it is programmed to explode?

  93. Not that I’m paranoid… But when I read paragraphs like this in the Times, I wonder about how the incentives are going to play out over time:

    “””The bankers plan to buy “life settlements,” life insurance policies that ill and elderly people sell for cash — $400,000 for a $1 million policy, say, depending on the life expectancy of the insured person. Then they plan to “securitize” these policies, in Wall Street jargon, by packaging hundreds or thousands together into bonds. They will then resell those bonds to investors, like big pension funds, who will receive the payouts when people with the insurance die.

    The earlier the policyholder dies, the bigger the return — though if people live longer than expected, investors could get poor returns or even lose money.

    So, assume the financial sector, as a whole, places a large bet that life expectancy will decrease (as it did during Russia’s dieback). What are the larger implications?

  94. Do you even have to ask?

  95. On the other hand, maybe it would be fun to bet on whether specific people get sick or not too, and how much health care they will use if they do.

  96. And, once that gets going, wouldn’t it be fun to bet on whether certain “accidents” did not happen to certain people. You know, like your house burning down with you inside of it?

  97. Yakkis,
    some decades? back (in the 80s?) trading life insurances was tried/promoted in Germany – haven’t heard of any burning house incidents though –
    Once you pool the stuff the insured should be safe but beware of the individual buyer coming to your home, checking possibilities – grrr

  98. Life settlements?

    Oh yes! And I am sure there are already some innovative insurance policy originators putting together a big group of super-healthy with super long life-expectancies and selling themselves as obese non-exercising smokers with extreme short life expectancies, to make a killing in intermediation fees.

    And yes! I can already hear a lot of bona fide smokers negotiating their own deals… “If they give me such a bum treatment everywhere let me at least get some of it back capitalizing on my shorter life expectancies”

    And yes! I can almost hear some hedge-fund managers discussing how the real survival rate on some of the products is turning out much longer than what they predicted which negatively affects their produced return rate, which makes them look bad when compared to other hedge funds… and asking “are there any contractors out there to take care of this problem for us?”

    And yes I can almost hear investors writing their congressmen asking them to stop any increase in spending on health because they have a constitutional right to a good financial return on their investment and these actually require average life-length to go down.

    And yes I can see the Basel regulators debating whether they need health-rating agencies?

    And yes I can see the actuaries making a killing in professional fees … move over lawyers

  99. Per,
    before you get in on the spree check out the figures on the obese

    it seems there is a fairly wide range of obese who live longer than the conforming to current skinny standards cohorts

  100. Yes and one of the problems is that you can’t either really be sure that this year’s cull of obese will behave or die in the same way as last year’s… just the way all the mortgages to the subprime sector that had been functioning quite well over decades suddenly 2004-2007 morphed into monstrous loans when it was discovered that you could throw anything into the security sausage machine and it would still be able to come out as an AAA.

  101. 1) There must be a clear and defined frontier in the markets between a subprime loan or a microfinance loan.

    2) Subprime loans alone were not the reason for this crisis. It was mostly the mispriced correlation between these loans and normal loans that was embedded within credit derivatives, and hugely propelled by clueless rating agencies. Nobody seems to look up that most credit correlation in derivatives is based on asset returns due to lack of information on past credit events. And that no behavioural finance is taken into account in the banks requirements for hedging against CDS. The fact that billions of USD have been trading on the back of models with such constraints is still what amazes me until this day. Banks are to blame as much as the people who took have overleveraged themselves, to the people that just decided to behave as a herd and start to subscribe to credit derivative products without fully understanding what they were doing. Yes, surely there should have been more regulation but to the same proportion as there should have been less stupidity of people in relation to their investments.

    3) Everyone keeps on focusing on US, US, US. I feel like I need to remind that London has long surpassed NY as the financial capital of the world, and is therefore regulated by the FSA. That European bailouts have been huge too. Why is nobody speaking about what the FSA is doing regarding this? (Other than calling the banking industry socially useless for which I must add this article which has really amused me: )

    4) The products that have been described relating to life insurance policy have long been traded in the market. They are called “longevity” or “mortality” products. Imagine you pay a 10% premium per year on the payout you will get when you die. In order not to bear the risk of having to pay that payout alone, the insurance company will pass on the risk of your death but allocating a probability to the event through death risk model based on your age, address, etc. And sell it to a bank or a fund or whoever wants it. That way you receive more than the risk free interst rate on your investment but your risk, instead of the default on a bond, is the death of a person. You can argue against the calculation of this probability the same way as you can argue against why was it 10% in the first place (do you really do that when you do a life insurance plan??). And yes it’s a little strange but what we are dealing with is a financial risk for the insurance company that is represented by the death of a person and the fact a huge payout needs to be paid. So what? Banks won’t write down the names of the people in the pool of insurances that was securitized and make sure they eat healthy and live longer, or kill them either.

  102. Ana, are you saying these “longevity/mortality” products are premised on the assumption the life policy holder (who pays the 10% premium for the “life settlement”) will die in less than 10 years?

  103. So what? Banks won’t write down the names of the people in the pool of insurances that was securitized and make sure they eat healthy and live longer, or kill them either.

    Just out of curiousity, if I was a pension fund or insurance company, how much would it be worth to me to wreck the health care system, say by stopping reform with a few well-placed multimillion dollar political contributions?

  104. In other words, I can’t imagine them NOT making this calculation.
    1.) They are able to make it,
    2.) They make similar calculations about the effects of policy on their profitability all the time,
    3.) they have a much better understanding of how markets actually work, than to assume perfect elasticity of everything, and,
    4.) They routinely lobby for those policies that would increase their profitability.

  105. “how much would it be worth to me to wreck the health care system”

    probably a lot but almost impossible to engineer
    – you have probably hit on the – honourable – reason why they are so change-averse
    – once you introduce a major change in health care all their statistics on life expectancy may go out of wack and they have no data on which to establish new ones

  106. I am not an expert by any means but don’t think it is that linear. It involves things like interest rates expectations for the insurer, probability is also not uniform (say you just got out of a serious health problem so ur premium goes up for the first years after that, doesn’t mean if u pay 10%, are expected to die when u have paid back your whole potential payout). I dug up some info on this for you:

    It shows for how long this has been traded and what are the bleeps. I am not entirely sure someone at the FSA or SEC is now reading and analysing this carefuly but if so, please raise your hand!

  107. Ana, thanks for your reply.

    Per Kurowski (a frequent commentator here) blames Basel II for the financial crisis. As you may know, Basel II is a convocation of central bankers who apparently created a regulatory framework that allowed banks to leverage as high as 62:1 based on the “clueless” rating agencies.

    What is your opinion of Basel II and what can be done about it? The scary part is Basel II was (is?) on track for global implementaton.

  108. And has anyone wondered by the pricing and risk models withing investment banks are public to shareholders? Banks invest millions hiring PhD graduates to develop risk models because they aren’t public. There are huge discrepancies in model prices for certain derivative products. You know what happens? Bank X hires the modeler that worked for bank Y in order to replicate the model of Bank Y at Bank Z so that Bank Z knows how much the competitor is charging and then presenting the higher of both prices to the client – who is most of the times clueless why it’s 20bps more or less. Pricing models should be made public despite the fact that it will mean banks who invest in higher paid risk managers will see their investment dilute across the whole market.
    One of the places I worked at lost more than 200 million in two years because of problems in pricing of fixed income derivatives. I am pretty sure the shareholder nor the SEC or the FSA were aware because there are all sorts of confidentiality agreements around this.

  109. They aren’t made public because that is proprietary information that gives them a competitive advantage over the other banks. That is to say, the models are intellectual property – the same as a recipe, computer code, etc. Being an Intel shareholder, for example, would not make you entitled to knowing all the details of a to-be-released product. Same with the banks.

    I’ll agree that the rating agencies are pretty useless, but it is really only because they have been given a special status in the markets and in our regulatory framework that gives them little reason to improve.

    But people with little or no experience with credit analysis seem to think it is easier than it really is. You can’t value everything as if the perfect storm was going to happen tomorrow. Creditworthiness is always a moving target that involves a lot of different variables.

  110. I meant “why” they “aren’t” public.

  111. Seniors are particularly susceptible to flu. We have a flu pandemic that’s “predicted” to get much worse. If *you* were a scumbag, wouldn’t *you* bet on seniors dying early?

    I reported on this a couple of years ago at the CR blog after a sleazy commercial real estate broker told me he’d split the commission on every senior I sent him. With pensions in the loo, can’t imagine this is a very hard sell.

  112. Yakkis,
    You are right to assume that health care reforms will have impact on people longevity and therefore on the allocation of probability into these securities related to life insurance. But as soon as there is healthcare reform, this will all be priced in the models because they are based on statistics and future expectations.
    I.e. if you have free health care, you are less likely to die, therefore you will demand to pay a small life insurance premium. Or otherwise you won’t subscribe to a life insurance plan in the first place.

    I think on that note and more importantly US should focus on people’s eating habits, which I’d think affect longevity much more than health care at the moment (i.e. you have less probability of falling ill in the first place if you eat well and don’t overwork yourself).

  113. What about existing obligations of pension funds and current life insurance holders. Doesn’t the process of recalibrating the risk take time? Are you telling me as a pension or life insurer there is no money to be made by doing this?

  114. What is the difference from betting that seniors will die early or betting that a currency will be devalued after a devastating tsunami or war?

    You can’t argue with speculation and gambling, it’s been around for thousands of years.

    What you can argue for is a more transparent system where people know exactly what they are putting their money on and how probabilities are calculated and what are their constraints!

  115. Anna “What is the difference from betting that seniors will die early or betting that a currency will be devalued after a devastating tsunami or war?”

    It could be huge. Would you like the teachers of your children investing in a derivative that paid out on the basis of who many children did not make it to university?

  116. Ana, betting in a situation where everyone actually has the same information is sport and maybe even a tolerable business practice. We have a problem though — some people have more information than others, and some people create their own information. If there’s one thing we should have learned, it’s that the only people who consistently make money are the ones that own the casino.

  117. In fact, this is taught in every elementary course in discrete probabilities.

  118. “the only people who consistently make money are the ones that own the casino.”

    then the public should try to figure out in every system they get involved with where the Zero (Roulette) is located and if that particular Zero is an adequate service fee in the eye of the buyer.

    As real life “casinos” tend to be also full of Catch 22 hitches the task is almost impossible …

  119. Last year there was some discussions on whether the tax man was getting a fair deal when allowing some one-arm-bandits to operate in California.

    My reaction to it all was:

    “The gamblers, being the real victims of the one-arm bandit victims, and tax payers on top of that, should all stand up for their rights and request that these new licenses are awarded to those casinos that offer the highest odds and the highest pay out ratio.

    If we all like to think we live in times of more transparency, then being more transparent is a quite good place to start.”

  120. Well imagine I plan to invest 100,000 USD on my children’s education to make sure they make it to University. If I pay 2% a year of premium, I make sure that in the end, if they don’t, I will see my money back.
    If I deem that 2% is actually cheap considering the probability of them not making it, I will happily subscribe to that. And I don’t care if the other person wishes or not that my kids make it to Uni or not. I am hedged and I am happy about that because I won’t go backrupt due to my children’s incompetence, lazyness or willingness to pursue other things in life. Same way I don’t care if people that work for my insurer wish that I die or not. Same way I don’t care if I make it to retirement but I still subscribe to a private retirement plan.
    We aren’t discussing values, we are discussing how the ability to securitize risk brings value to society by allowing people to hedge themselves against unpredictable events and making investments more liquid, as long as abuses and frauds aren’t made.
    The perception of probability of an event being cheap or expensive depends on each one, as long as the way it was calculated is clear (and people understand volatility is stochastic), I don’t see anything wrong with this.

  121. Anna “I am hedged and I am happy about that because I won’t go bankrupt due to my children’s incompetence”

    So this is your worries about your children’s future? I am sure you cannot mean it. It sounds so very close to proposing going naked and buying 5.000.000 US$ coverage on your kids, helping them fail, so as to guarantee your own retirement fund.

  122. “as long as abuses and frauds aren’t made.”

    how are you going to prevent those if you allow a system to get so complex that it is fuller of hiding places than any medieval castle has ever provided?

  123. You get yourself some fraud and abuse rating agencies and then start praying no one will get to them.

  124. “If there’s one thing we should have learned, it’s that the only people who consistently make money are the ones that own the casino.”

    That is why I defend that pricing models, risk management models should be uniform and made public if these kind of investments are able to cause such systemic risk.

    You are not forced to invest in a bank stock if you aren’t comfortable with the level of transparency of its practices. But when the government bails banks out with your money, then it is a completely different ball game. Every taxpayer around the world should demand to know how banks conduct transactions and run their risk. And no person should ever put money into investments they don’t understand.

  125. Ana “That is why I defend that pricing models, risk management models should be uniform and made public if these kind of investments are able to cause such systemic risk.”

    Sometimes making the models public could make them even more susceptible to generate systemic risk.

    Did you not see how some lowly mortgage originators and savvy Wall Street operators managed to play the model when they found out the importance of the AAAs?

    The credit rating agencies have refused to make their models public because of the risk the interested would dress themselves up in accordance to the model.

  126. How about instead of pricing according to a model, we let the market decide what they’re worth?

    And while we’re at it, let’s get rid of mark-to-model accounting.

  127. Ana “allows insurers to charge smaller risk premiums because they won’t bear the whole cost themselves = frees up capital for the premium payer”

    If they are the experts why would they not have to bear the whole cost themselves?

    They want to offload some of the risk at a profit larger than what they would expect to obtain by keeping it all on their own books… which only means they know, or believe, that what they are selling off is a little less AAA than what the investors buying believes. And is not a loss a loss, independently who suffers it? That some have a better chance to withstand a loss does not make it a smaller loss.

    The last decade we have heard so much of the virtues of” spreading” out the risk so that they land where they can be most easily suffered. Utter nonsense, most of what was going on was the “hiding” of the risks

  128. Ana,
    as to level of transparency …

    how do you expect to do that?

    – Per has around August 26 very lucidly explained Basel II – I am still training myself to “internalize” the facts so that I can repeat them in my own words and as I have made my living as a paralegal I should be more apt on grasping the thing than most of us
    This cry for transparency is bogus – rules and regulations by their very nature defy all attempts at transparency even when they operate with all the best intentions
    (or why do you think for every sentence of law there are whole libraries about their ievery day consequences)

    – to understand any bundle of rules and regulations you have to immerse yourself so deep in them that it tends to end up as full-time job or all consuming hobby horse
    One just has to trust and hope that the person/institution who is trustworthy today is not rendered bogus by changing times tomorrow – if those guaranteeing trustworthyness have no financial or status enhancing interest in the matter there stamp of approval might be regarded as valid

  129. Amusing. That is why there isn’t an insurance against your kids not going to school and there is one against you dying. I was just taking on the metaphore to explain that you there is a borderline between values and financial securitization. As I posted, I think there is a number of symptomatic behaviours within the finance (and other) industries that promote greediness and fraud. That is because of what many people have mentioned already, there hasn’t been any serious legal action against those who have misled people into financial losses.

    I wouldn’t go short and help my kids fail, the same way I hope my family won’t kill me in return for the life insurance payout. But the insurers repackaging the risk of my death whilst giving other people an opportunity to get a higher return on their money if they believe I will not die (or die), based on the fact that statistically people with my characteristics didn’t (or did) is not immoral, on the contrary, allows insurers to charge smaller risk premiums because they won’t bear the whole cost themselves = frees up capital for the premium payer.

  130. Here comes Upton again: “It is difficult to get a man to understand something when his livelihood depends on his not understanding it.”

  131. uncle billy cunctator “here comes upton again: “it is difficult to get a man to understand something when his livelihood depends on his not understanding it.”

    Absolutely… and this is true whether the man works in private or in public service. Often in private you even have an alternative while sometimes in public service you have nowhere else to go.

  132. Per Kurowski, do you defend then that pricing models aren’t made public and any innovations that are made in predicting default risk and credit correlation stay within banks in order to allow them to arbitrage everyone else (inc. clients).

    On your point, I think credit ratings are totally useless, and credit ratings far too restrictive to reflect the differences in probability of credit default of firms and individuals and that is why people were able to arbitrage pricing models. Having AAA rating in the US or in Turkey should not be treated the same way (if not for more, because, for example, the US company is more likely to be bailed out (easy joke)). The CDS reflects this because it is tradeable therefore embeds more market information. If all CDS were liquid, they would distinguish companies to the the basis point, no need for credit rating agencies because the investors in CDSs have access to the same information as the credit agencies when they decide to buy or not buy a CDS.
    And if there were no credit agencies, probably no investor in the market would have given a “credit default risk” to pools of people whose financial situation they don’t know and these toxic assets wouldn’t have been introduced into the markets in the first place.

  133. If all CDS were liquid…

    That’s the problem right there.

  134. Ana “Per Kurowski, do you defend then that pricing models aren’t made public and any innovations that are made in predicting default risk and credit correlation stay within banks in order to allow them to arbitrage everyone else (inc. clients).”

    I am just mentioning a problem that is present whenever models are used. You must know very well how fast one learns to adapt to what is expected. A solution? I have never said its easy, but one better way could be, for instance in the case of the mortgages, that these have to stay and runoff 100% on the balance sheet of the originators, as it used to be; in other words 100% of the skin in game and no market intermediation profits to tempt.

    Ana “And if there were no credit agencies, probably no investor in the market would have given a “credit default risk” to pools of people whose financial situation they don’t know and these toxic assets wouldn’t have been introduced into the markets in the first place.”

    Agree but you need to start one step before. If the regulators had not, mainly through their capital requirements for banks, empowered the credit rating agencies so much, then even if the credit rating agencies that have been around for a long time had still existed…… then “probably no investor in the market would have given a “credit default risk” to pools of people whose financial situation they don’t know and these toxic assets wouldn’t have been introduced into the markets in the first place.”

  135. Yakkis,

    If it so elementary, why doesn’t a CEO of a company put all his savings into CDS of that company and then makes it to go bust, guaranteeing his retirement plan? Either because there is (already) regulation in place to prevent this or because people actually do not behave as greedily as you suggested to counteract my reasoning (although I still don’t get what is your point in this particular instance).

    “Then let the market decide.” The market will invariably decide what is the probability of an event based on a model because the human brain is incapable (to my knowledge) to consider and measure all variables at the same time.

    The way probabilities of events are calculated and what incorporates each derivative should be public knowledge for shareholders of banks that hold this risk, for the clients that buy these securities, to give everyone (and not just the banks that write these derivatives), including the regulators, a fair chance to analyse and keep up with financial innovation.

    Until this happens, values are changed within banks and hedge funds, incentive schemes reviewed, we will always lag behind and the taxpayer will even less control as to the size or predicability of economic busts (although it will have to pay for it).

    Blaming all financial innovation of the last 30 years and the whole financial structure of nowadays is just wrong.

    The Feb kept rates low for too long and ignore the rising credit growth impact on economic growth. I think they are even more responsible for this crisis than the greedy credit bankers.

  136. My only point is that when you run a casino, you create games where the house has to win (according to mathematical probabilities) more often than it loses. If you create games where this isn’t true, you go out of business.

  137. Also, I was under the impression that people who traded derivatives knew what they were doing, as in they are professionals with the correct qualifications. If they can’t price risk well (and who can really in situations of limited data where the risks are already poorly understood?), then maybe they shouldn’t be trading it. Just a thought.

  138. “They want to offload some of the risk at a profit larger than what they would expect to obtain by keeping it all on their own books… which only means they know, or believe, that what they are selling off is a little less AAA than what the investors buying believes.”

    They want to offload the risk because they can’t keep up with demand and they want to diversify their portfolios. And yes, they will do it at a profit because they need a return on their capital invested in gathering clients and paying their employees. The point I am making (and you’re still missing) is that NOBODY forces people to subscribe to this risk that insurers are trying to offload. Why are you blaming insurers and not the subscribrs? And why do you assume the insurers always win? As you know, probability doesn’t guarantee an outcome so it might be that, actually, the insurers are selling that risk for cheap!
    My point continues to be the same. If there is transparency regarding what each derivative entitles and how its price was calculated, then people would subscribe to derivatives only when they believed the risk that it entails is worth the return they get (as it happens with most cash based securities like tbills, corporate bonds, etc).

  139. Ana please tell us what additional transparency and which could have been checked up with reasonable costs could have stopped the investors from buying the securities backed by the subprime-mortgages awarded from 2004 on and rated AAA.

    Take away the AAAs and how many investors would have sat down and studied its price formation. The credit ratings, instead of illuminating, turned out obscuring.

  140. Yakkis, the people who trade derivatives usually know what they are doing, but they also know the limitations of their models. The clients don’t. That’s why better prepared banks didn’t suffer as much as unprepared banks, because they traded whilst being aware than things that weren’t priced in could go wrong.
    At the end of the day you are dealing with what is the probability of a future outcome occuring according to past data. People who invest in derivatives should be prepared outcomes around this, black swans, etc. But how can they be when don’t know what the models already take into account?
    With this, I shall retire.

  141. I understand what you’re saying, and I’m sure having access to the model would help them critique it. But does this solve the underlying problem, namely, that there is no good way to evaluate this risk in the first place?

    Also, I don’t see why there can’t be haggling based on model-computed risk. The client comes in with his model and says it’s only worth $X, and then it’s up to the seller to convince them it’s worth something else. I get the impression that these transactions are very poorly negotiated. It feels as if the clients agree to be suckers, since I supposed they are used to doing “due diligence” in every other aspect of their lives.

  142. Don’t worry, we’ll get our transparency Ana, just as we got regulators to make sure things stayed on the up and up, just as we have “Democracy.”

  143. To paraphrase Mark Twain on Cecil Rhodes: “Finance, I admire him, I frankly confess it; and when his time comes I shall buy a piece of the rope for a keepsake.”

  144. Uncle Billy,
    Mark Twain provides also essential reading on how you can get a system, any system, out of wack – just introduce one element regulations have not provided for because at the time of their writing it was an unthinkable – to date I have found no better analogy than the one described here – and as I believe vivid images help one to keep in contact with one’s sanity I quite often make myself think of this one

    to pool BAD loans and bet on the percentage which will not fail has certainly been an ingenious and probably new idea somewhere down the food chain …
    when Venetian merchants pooled money to run ships, they distributed risk while giving up on huge single profits but what might have induced them to pool money on a flotilla of leaking fishing boats I can’t imagine.

  145. Thank you for this extract. I had not read it and it is absolutely great. What a genius twain was!

    I am going to use it in Venezuela because every time an alternative to chavez lifts his head, immediately all the other aspiring alternatives to chavez trample him down

  146. Greenspan Speaks to Financial Institution Leverage and the Price YOU Pay:

    “..many of the benefits banks provide modern societies derive from their ..use of a relatively high degree of leverage . “..this same leverage ..greatly increase the possibility of bank failures. “…such failures
    could have large ripple effects that spread throughout great cost. ”

    “We should recognize that if we choose to have the advantages of a leveraged system of financial intermediaries , the burden of managing risk in the financial system will not lie with the financial sector alone.” …”Only a central bank, with its unlimited power to create money , can with a high probability thwart such a process before it becomes destructive. Hence, central banks..lenders of last resort. But implicit in the existence of such a role is that there will be some sort of allocation between the public and private sectors of the burden of risk of extreme outcomes.”

    So Greenspan says that society benefits from leverage, and therefore must share in losses.

    Presumably, this implies that the larger the financial sector, the greater the subsidies will be.

  147. fwm “Greenspan says that society benefits from leverage, and therefore must share in losses”

    Yes but it is also therefore the right of the society to have a word in deciding where those “leverages” should be invested, because just investing them in “risk-free” AAAs may not justify the sharing of in any loss.

    Question if you must share would you as a citizen prefer to share what could seem to be small losses in sustaining a housing boom or do you prefer to run the risk of having to share higher losses in activities that could better provide for sustainable and sort of decent jobs or to help fight climate change

    Some, most regulators included, are only trying to make a case for low-risk banks. Others, like me are thinking more in terms of high-purpose banks.

  148. I agree in principle with “high-purpose banking.” The problem is that banks are inherently undemocratic, so how can people have a say in what the “high-purpose” will be. For example, Bank of America got some billions in TARP money, and spent it not on increasing its reserves as the government wanted but on developing credit cards for Chinese people. While this was probably a wise use of the money, it seems the government really has no say at this point in what the purpose will be.

  149. Let me phrase it the following way. Just like some regulators think they have the right to impose the opinions of the credit rating agencies we should perhaps have the right to impose our “purpose-rating agencies”

  150. Per, I wish I could remember where I saw it, but at one point over the last year or two, one of the agencies actually used a “free speech” defense to justify their rating(s). I hope I remembered this correctly. Whatever it was exactly, was just…. no words.

  151. Yes the basic defense of the credit rating agencies is that under the First Amendment they have the right to hold opinions.

    The follow up question is then why do the regulators put in place some capital requirements on those opinions I mean as a substitute for all the capital requirements for banks that are freed because of favorable credit ratings?

  152. I am not sold on Greenspan’s basic concept- the benefits to society of leverage. That is a big assumption.

  153. Ana “I.e. if you have free health care, you are less likely to die”

    Some out there seem almost to argue the opposite ):

  154. I am European so I am definitely staying out of your health care wrestling ring.

    “But does this solve the underlying problem, namely, that there is no good way to evaluate this risk in the first place?

    Also, I don’t see why there can’t be haggling based on model-computed risk. The client comes in with his model and says it’s only worth $X, and then it’s up to the seller to convince them it’s worth something else. I get the impression that these transactions are very poorly negotiated.

    If the client’s model thought it was only worth X, he would buy it and arbitrage the bank, rather than warning it and vice versa. And you would be surprised how much banks make on this, rather than on actual fees for services they provide. There are proprietary trading desks in some regional banks in Europe that specialize in arbitraging big London banks (buy and selling the same option who’s been priced according to a different model). That is why banks invest millions on better faster risk management tools. So they can arbitrage each other. It’s ridiculous. They should invest in innovation like any other company (i.e. Apple), because innovation will lead to products that consumers want, which will generate fees.

    That’s why I think it should all be transparent.
    That is why Goldman Sachs did well in this whole crisis, they arbitrage the risk, offload the risk they don’t like instead of managing it, etc. Derivative transactions should be priced homogeneously just like future contracts are. Everyone should use the same model and work towards its innovation. Everyone should be aware of its pitfalls and increase capital reserves accordingly. Maybe I am just being a socialist but I think now is the only shot regulators will have to get in and break this culture.

    Greenspan tried to experiment with economics, to see what would happen with massive deregulation and overlegeraging. This is the result. He should just retire peacefully and make sure people don’t remember he was the main cause for all this in the first place.

    Soon the markets will get back to pre-recession levels and everyone will start behaving the same as before.

  155. Ana “I don’t see why there can’t be haggling based on model-computed risk. The client comes in with his model and says it’s only worth $X, and then it’s up to the seller to convince them it’s worth something else. I get the impression that these transactions are very poorly negotiated.”

    I agree 100% as with most in the rest of the post except for the part of “massive deregulation” because as I see it never ever have the regulators tried to regulate as much as when they got into the area of trying to discriminate among risks… something that (mostly) before the Basel regulations was left exclusively to the market. And then that in other areas they simply regulated lousily which of course neither has to do with massive deregulation.

  156. One problem with a lot of interest rate derivatives at least is that they simply cannot be structured in the same way, and that carries through to pricing. They are often tailored to debt instruments that can have a variety of structures, that can be amortizing and non-amortizing, that can have embedded options and priced forward, etc.

    You can have an exchange format for plain-vanilla derivatives, but everything else will end up with the same status as it always had…

    The arbitrage notion does not always apply. It depends on having available options.

  157. Pricing some derivatives and fixed income products would be almost impossible to standardize; this is why many of the quant firms are so valuable to their clients. They have to make assumptions about behavior and discount many different scenarios. This requires some pretty complex models.

    This isn’t just true for swaps and the more exotic stuff, either. You’ll find all kinds of academic debate on how to price an embedded option in a bond issue.

  158. “That is why Goldman Sachs did well in this whole crisis, they arbitrage the risk, offload the risk they don’t like instead of managing it”

    Is this the offloading to AIG, or the arbitrage associated with owninng the Treasury Secretary and the incoming President?

  159. History teaches us that men and nations behave wisely once they have exhausted all other alternatives.

  160. “History teaches us that men and nations behave wisely once they have exhausted all other alternatives”

    you and I must read different histories – history is full of self-destructing actions and the self-destructors afterwards may act meekly and docile – but to call that wise is crediting mankind with too much

  161. “History teaches us that men and nations behave wisely once they have exhausted all other alternatives.”

    No, “other alternatives” are not a finite resource but a renewable one. History would probably show us that once they have exhausted all other alternatives and finally could come to a wise conclusion, then come a new generation and starts it all over, from the very beginning. Also what’s the use of wisdom when it’s too late?

  162. The quote is:T

    “History teaches us that men and nations behave wisely ONLY WHEN they have exhausted all other alternatives.”

    In other words never, since there’a alway’s 1 more alternative

  163. “Maybe I am just being a socialist but I think now is the only shot regulators will have to get in and break this culture.”

    You have no idea just how captured the system is, do you? Or you’re pretending not to.

  164. This is one of the best debates I’ve read at this blog!

  165. Uncle Billy Cunctator
    I don’t believe in conspiracy theories but I agree with you that the system has been corrupted for a while. I have been working inside it for three years.

    Nonetheless, I am also young and I like to dream that things change for the better and we will have a financial Woodstock eventually. Hah.

  166. I am with Ana on this one. I do not believe in conspiratory theories either since that means assigning to much intelligence and capacity to some who do not possess it. (Which of course does not stop me from exploring the genesis of the AAA-bomb).

    Also and though I am not that young that does not stop me from dreaming either, though I am skeptical on getting anything productive out of a Financial Woodstock, you see the last one was mostly la la la!

  167. I’ve never really understood this argument against conspiracies. Couldn’t there be one brainy person and the rest idiots who agree to go along with him or her?

  168. One brainy person does not make a conspiracy. A conspiracy requires cadres of brainy persons, often with dubious instincts, to agree on a plan and keep silent about it, no matter how much the incentives for breaking that silence are. You see a conspirator has to place his trust in other conspirator’s hands… and that’s when it all starts crumbling.

  169. Per
    that’s exactly the reason why I keep harping on whether there is anybody “they” are grooming – somebody to get the public behind him or her, creating an avalanche and, if he/she is evil enough, outsmart the brainy ones as well, who in due course then can seem to have been totally innocent

  170. You can groom whoever you want but this does not mean that the groomed will turn out as you thought. The world abounds with frankensteins… there might be room for selling some derivatives to cover for this risk.

  171. The folk wisdom is that no one ever lost money underestimating the intelligence of the public. A workable corollary might be that a few have become incredibly wealthy because many have underestimated them

    The short version I used to spout is: “The big brains got together with the bad guys and broke the world.”

    [Insert Equation Here]

  172. “The big brains got together with the bad guys and broke the world.”
    the best short summary of the 3rd Reich I’ve read so far …
    (and amazing isn’t it that Heidegger and Carl Schmitt and others are still up there in the pantheon of the big brains while everybody is unanimous and rightfully so in being against the brown shirts)

  173. Silke: ““The big brains got together with the bad guys and broke the world.”
    the best short summary of the 3rd Reich I’ve read so far …”

    I would rather say: The big brains + regular folks following the herd.

    Imagine you’re a low rank worker at Auschwitz during WW2. Your job is to open a valve to let a mortal gas flow into a chamber. You don’t see what’s happening in that chamber. You have a wife and kids. All the people around you just obey orders. You would probably put yourself and your family at risk if you didn’t. But you do know you’re opening the valve for a gas to kill people.

    How bad are you? Maybe 90% of mankind would just follow the herd if put in that situation.

    If all people in that situation revolted and refused to do their job, the Holocaust could not have happened. At the same time all those people could reasonably deny responsibility.

  174. “I would rather say: The big brains + regular folks following the herd.”

    yes and no,
    I uphold that there are situations when it is perfectly understandable that somebody acts in an unpardonable way – still it remains an unpardonable way and the big mistake my generation (born in 1942) made is that we were so much into witch hunting our elders that we missed the chance to hear in detail how the slippery slopes work in real life. We just made them mum and that in a way is also unpardonable and my excuse is that to this day the callous way the few still alive talk about it makes it impossible for me to listen and to ask even today. It probably feels different if you grow up with them as teachers, instructors just everybody you have to act respectful towards as if it is learnt however diligently from afar. and btw other than most historians I do not think it was as easy to say no as they claim, after all amidst all the group pressure you couldn’t know that there were others having said no and gotten away without harm. (Schiller says in Don Carlos “Gewalt ist für den Schwachen stets ein Riese” Violence is to the weak one always a giant) But the other fact remains that the population got euthanasia stopped while “knowing nothing” about what was done to “minorities” – the one lesson we should draw from it though is when the mighty start to like nutty ideas of the big brains they mean it – for way too long those who could have changed things (Germans and foreigners alike) thought that that foaming shouting utterly ridiculous person Germany had made its chancellor was somebody that could be gotten rid off with ease.

    There were a lot of regular folks following the herd but in the beginning a lot of destitute and desperate and probably also rogue folk assembled under the Nazis’ banner and created quite a terror in assembly halls and in street fights. No matter how and why they first joined most of those who chose to stay in had a choice. The labour market was good again no reason to stay with the rabble if one was opposed to harrassing and beating up and killing people.

  175. one more try in a short version:
    I read Uncle Billy’s sentence as an apt description of the run-up period i.e. before 1933 and maybe some time after when appearances were still being upheld
    (apart from the Social Democrats all others voted in favour of the Ermächtigungsgesetz=empowerment law on March 23, 1933 knowing full well that they were giving thereby free reign to the bad guys)

  176. Ana, I considered myself a top-notch conspiracy theory debunker up until fairly recently. It is, however, getting harder and harder to debunk a lot of what was considered lunacy. 3 years ago, investors would have laughed their ass off if you had told them that two out of three floors of the lipstick building were window dressing and one was a boiler room. I have been to the penthouse of the lipstick building. From that vantage point people look very small and useful.

  177. Hmm… just took a look. The tenant I was visiting moved to the Seagram building and took a huge chunk of space previous to August of ’08.

    Tishman-Speyer sold the building in Summer of ’07, just before things started to get interesting. Prescient.

    So who occupies the penthouse of the Lipstick building now?

  178. Citizen & Taxpayer

    Ana, I’m glad you were able to finance your education. Above you say, “I wouldn’t have been able to access credit if banks didn’t have a chance to pass on the risk.” But of you couldn’t pay back your loan, who bears the consequences?

    It seems the meaning of “privatizing profits and socializing risks” describes the outcome of your situation when the financing institution (i.e. “bank”) needs to be “bailed out.” Educational roulette is a strange game to play no matter what “model” one uses!

  179. Citizen & Taxpayer,

    First, to insert the notion of probability. I would very likely pay back my loan because it was small, I was young (so I had more chances of getting a job eventually unless I didn’t work my whole life – not a bad thought!) and, in addition but on the side, I was in a very good university.

    To answer your question: When the bank securitizes my loan, the person who then purchases the risk is aware that I might default. The whole problem is that 1) this risk was underestimated 2) my loan was mixed with students that leveraged much more, therefore had more chances of defaulting 3) the probability of us defaulting at the same time (correlation) was mispriced 4) the person who purchased the risk from the bank didn’t quite understand how it was priced because the bank didn’t disclose its model 5) nobody supervised this deal which led to 6) Both the bank and the person who purchased part of the risk from the bank had money on the side to prepare for the fact I could default which led to 7) taxpayers money had to come in.

    So, if you improve 4) on 2) and 3), u make sure 5) is there and that 6) is enforced, then 7) is less likely to happen.

    This is only my humble simplification obviously :)

  180. What you have just described is a Rube Goldberg device.

  181. Ana, I’m not 100% sure but I would guess that behind your overdraft as a student there was a big fat government guarantee. It’s very common for governments in Europe to subsidize risky investments if they are expected to produce social value (and besides I seem to remember my wife who did her MsC in the UK telling me something about it). Direct grants as well as subsidies to student loans are common and young enterpreneurs can easily find an EU grant to start their business especially if they are expected to use innovative technologies. I doubt you could build a case for financial innovation on the premise that it allows bankers to offset risk and therefore to fund risky but socially beneficial investments such as lending money to students (I think that was one of your arguments). I can’t say I have a solid argument because I don’t have any numbers to back it, but I’m quite certain that students’ access to cheap credit is not dependent on the banks’ ability to micromanage the risk of their investments in order to squeeze more value out of them.

  182. I was sure I was oversimplifying what went wrong!

  183. “Pricing some derivatives and fixed income products would be almost impossible to standardize; this is why many of the quant firms are so valuable to their clients. They have to make assumptions about behavior and discount many different scenarios. This requires some pretty complex models.”

    Agreed that Fixed income derivatives are impossible to standardize, but the models and their assumptions aren’t (for each kind). I think there should be a public debate between banks, academics and regulators about pricing derivative risk. As well as about algorithmic trading (which regulators are light years behind on scrutinizing). Firms that use products and models outside of this scope should be heavily penalized. No new assumptions should be made without being scrutinized and regulated. Quants have been given their chance to innovate without regulation and this was the result. Just because governments came to the rescue doesn’t mean they can now snobbishly turn around and ignore the issues as if nothing happened.

    And even if there are 10000 derivatives across different asset classes, surely the time spent on them would be cheaper than the trillions spent so far because these things didn’t work. But of course it requires complex models. But surely if they were all public knowledge, the associated risks/assumptions underlying each product would be more evident. If a sales person / trader within a bank doesn’t FULLY understand the complexity of the risk, then the product shouldn’t be marketed. And if it does understand, so should the client and the regulator.

    Furthermore, as an options trader, I have witnessed arbitrage opportunities several times within first degree exotics in FX due to miscalculation of tail risk / skew within correlation crosses in EM and I have witnessed bank desks making millions (literally) on interest rate exotics and credit derivative deals because of model discrepancies because they made different assumptions. This is scary and it is real money we’re dealing with. Of course, and even more worringly, if those profits came to light when the beasts matured, I don’t know. But I know there is a huge deal of predator behaviour related to model arbitrage that goes on and shouldn’t go on, which shareholders and (definitely not) the taxpayer will ever hear about.
    I know of people that got fired inside investment banks for sending emails to colleagues saying things like “my client is such an idiot, just totally ripped him off”. THESE ARE FACTS.
    Of course, putting this to light would upset a lot of people, would mean a big drop in bonuses but I surely hope it does given how much harm everything has caused.

    The so-called complexity of things should be an excuse for them to remain confidential and obscure the incredible amounts of money banks make on the back of derivative deal fees because of those “different assumptions”. There is no free money.

  184. I can’t picture someone actually working at an investment bank (on an options desk, no less) who does not appreciate the idea of intellectual property. There isn’t even anything to debate there. What you are saying about unifying everyone under the same set of models and assumptions is nonsensical if you have actually tried to value these things. If traders are stealing from their clients, that is not a market issue.

    With respect to arbitrage, it is one thing to say something is mispriced. It is another thing to say that you can take advantage of the pricing error in that market, given your alternatives.

    Markets exist because people have different opinions about the value of things. Sometimes people have wildly different opinions about the value of things.

  185. “Markets exist because people have different opinions about the value of things. Sometimes people have wildly different opinions about the value of things.”

    YES! Just watch Antiques Roadshow for examples of this. There’s always someone who paid a pretty penny for a piece of junk. And because they didn’t do their due diligence – because they thought they knew so much more than they really did, they’re left holding a costly piece of junk.

    But imagine if the people dealing in antiques who failed to properly price objects weren’t the ignorant consumers, but the experts in the field – who used their expertise to create a false market for highly priced junk – and then when left with a store full of junk they could no longer sell, they turned to the US government to pay for it all. And when the government hands them a check, they continue their pursuit of junk, instead of reform their business practices.

    I still cannot understand how such financially literate people in so many areas of the financial sector (mortgage brokers, bankers, investment bankers), who were paid such extraordinary sums of money, allowed the accumulation of such mountains of junk on their balance sheets. The sheer volume of garbage they packaged up to sell remains astonishing.

  186. “financially literate people”

    on a strictly human basis I think I understand what a major contributing actors was:
    these people would have lost face or feared to lose it would they ever have admitted that they do not fully or even vaguely understand the models they operate with.
    At least in the corporate world I have lived in it is very very difficult to acquire knowledge of newly introduced basic skills once you have reached a certain level – whom are you going to ask? the mechanic who installs the computer who helps us clerks understand all kinds of trickinesses of details – what if the guy is going back to his workshop and tells how stupid you are and so on – you cannot go to a normal cheap evening class learning basics –
    no you have to keep up that you are in possession of superior knowledge and ability. If you do not whoever is ever going to believe you again that you are financially literate. Underlings do not make such fine discretions. We constantly alternate between sucking up and watching out for opportunities to cry “the emperor is naked” – unless the emperor is the rare person who can confess to what he/she doesn’t know from a position of strength and integrity he is bound to walk on brittle legs.

    still he shouldn’t sell himself for exorbitant money without bringing in exorbitant results – sustainable results …

  187. Yes but the truth is that you can do a lot of good mechanic work like changing tires without understanding or really having to understand how a car works.

    But there are others whose responsibility is precisely to understand how the car works but when these are so lazy they do not even read the major instruction manual, the Basel II regulations then of course everything breaks down. And I tell you 99% of the so called experts discussing these issues have evidently not taken their time to sit down and read that document, and this, at least from what I was reading from the sponsors of this blog a couple of weeks ago, includes them.

  188. “99% of the so called experts discussing these issues”

    what do you expect? in every patent workshop I have been, there were at the most between 10 and 15 percent who were really interested/fascinated in the subject and it didn’t matter one bit whether they were lawyers or paralegals – it was not a class thing

    – there are too many people in too many jobs which leave them cold and since being cool and detached and laid-back is the fashion of the day diligence which once might have make them perform is ridiculed. Get all fired up about something worthwhile and all you’ll hear will be ts, ts, ts – and in a way the cool ones are right, when they get fired only their finances are in shambles but their heart stays intact.

    – therefore actually reading stuff before one talks about it? “you gotta be kidding” – so and so has a brillant summary that’s all I need to know
    – consume your stuff pre-chewed and pre-digested is today’s way of doing it

  189. still cannot understand how such financially literate people in so many areas of the financial sector (mortgage brokers, bankers, investment bankers), who were paid such extraordinary sums of money, allowed the accumulation of such mountains of junk on their balance sheets.

    I have no trouble understanding how some lazy (in every sense of the word) people, who were overpaid, and had no loyalty to the people they owed a fiduciary duty to, would take the legal but unethical route of piling up AAA rated junk, long-term consequences be damned.

  190. “But of course it requires complex models.”

    before the complex models there has to be a very simple not at all complex set of do-s and don’t-s
    – a general agreement on what constitutes honourable behaviour and a consensus that dishonourable behaviour leads to exclusion

    to refer to the current crisis that if you sell knowledge for an exorbitant price you have deliver exorbitant value otherwise you are a fraud

  191. Intel doesn’t deal with people’s money and their lives. Their irresponsible behaviour will at most cause a little computer virus that can cost a few million and not drive the economy back a few years and cause massive unemployment around the world.

    Pharmacy companies also have intellectual property but, nonetheless, drugs are scrutinized before they come out. And the person who uses the drug should have the right to know IN DETAIL what’s it made of, how it can affect her and that some regulator will look it over and understand it. How’s that different from causing someone to lose their job, their home, their healthcare?

    Everyone who works within finance knows the is a number of things that are scandalous going on but the truth is politicians are walking hand in hand with bankers and nothing will change.

    Nobody here stated things were easy. What we are stating is that they are understandable and their assumptions should be made public so people who invest in a product understand why its value changes.

  192. To the extent that a financial company is dealing with people’s money and their lives – i.e., advisory services – people are given the details.

    That is different that when the company is making decisions with its own capital.

  193. “Their irresponsible behaviour will at most cause a little computer virus that can cost a few million ”

    what an optimistic view of what a little virus can accomplish …
    maybe that’s because computer programmers come from the technologically minded part of the public (the screw sits tight) – us from the record keeping part of the public got grey-haired with how hop-scotch the whole transfer to electronics was handled – bureaucratic procedures have traditionally had lots of redundancies – one of the purposes of going electronic has been to do away with those – it remains to be seen whether and how this will lead to a blow-up – blow-ups within paper shuffling offices took a long time to mature even in pre-electronic times …

  194. In a world where real estate attorneys were unable to fathom all the details of mortgage contracts, and where consumers have to rely on a wing and prayer that their medicines won’t kill them because the guy that owns the hospital where they’re running clinical trials gets an all expense paid trip to the Swiss Alps… it really doesn’t matter if the details are made public. The 10 page credit card contract is public. They are killing us with fine print. I think we need to better understand the broad strokes.

  195. …where real estate attorneys were unable to fathom all the details of mortgage contracts

    Actually, they were paid to turn a blind eye. The ones who didn’t saw their business dry up.

  196. Also, the players in this derivatives game are big. Presumably big enough to field their own quants and experts. It’s hard to feel too sorry for them.

  197. Uncle Billy
    I was once “typist in residence” when an American company bought a German one
    – there was huge difficulty in getting the formalities right as your system demanded that all contracts implicated in the sales contract became PART of the sales document
    – as a notary has to read everything aloud this would have meant sessions over days and days exhausting even a German notary’s ability to drone on – I do not remember how they fiddled their way around the divergence but I remember that your American way of doing it blew up the paper work out of all proportion by our standards – so maybe the endless credit card contracts are not so much bad intent by the bank but conforming to your general way of doing things

  198. I’ll bet! Did the americans keep talking about the “side letters”? We love those side letters.

  199. sorry, I do not remember having ever heard the term “side letters”
    but looked it up now – maybe they were the problem though, because a notary guarantees that there are no other parts to the contract than those read allowed.
    A German lawyer in his function as notary is a kind of civil servant and is in danger of loosing his job if he doesn’t conform by the rules – as the notary part is practically his old age insurance he is very careful of not endangering it by punishable fiddling

  200. At the risk of incurring the wrath of the Notary Assocation of America — it is indeed wondrous to remember how many frauds and crimes have been enabled with the imprimatur of the licensed notary.

  201. Uncle Billy,
    not to allow you undue American National Pride on frauds committed under due supervision

    we had a certified auditor/accountant, an if possible even more lofty person than a notary, sitting in Lebanon making Lebanese government stamps out of potatoes – yes the same way kids do in kindergarten

    – via the resulting documents investment offers were made for gas bottles for cooking stoves to be brougth to Lebanon financed probably predominantly by German doctors in order to save them taxes (because the income of doctors under socialised medicine is so poor they have to do something to evade the high income tax burden for top earners)

    the scam blew up when some clerk came up with the uncouth idea of checking the total number of gas bottles in Lebanon against the bottles the scam proposed to sell – guess which figure was higher!

  202. Ah Lebanon… I remember the good old days when I used to watch colonels getting busted carrying heroin across the border in their combat gear, and strings of almost new mercedes’ and bmw’s, freshly stolen from europe, lined up and ready for distribution after a handshake and a briefcase full of cash.

  203. that certainly was an admirable example of a truly and completely free market you witnessed there …

  204. I’m not in the financial league of most of the commenters here. It scares the hell out of me that such erudite, experienced etc. folks, to say nothing of all the other experts, don’t seem to have a parsimonious intervention to prevent the chaos of the past 24 months.
    Being unburdened by too much technical knowledge, it seems to me the root cause was/is the ability of the system as a whole to lay off risk until it all ended up being insured by AIG (mainly). No one apparently saw that no one was standing behind the insurer. which means the taxpayer was by default.
    So I ask isn’t there some parsimonious regulatory intervention that would interrupt that process? I suppose that is what various reserve requirements were supposed to do. obviously that boundary failed.

    my (I’m sure over simplified) solution is that every financial institution must pass a test: if it is too big to allow to fail, then it is too big to exist. Or, if it imploded, would it crash the entire system? If yes, change its financial structure in X months or begin dissolution of the institution into smaller, less dangerous pieces. Similar to antitrust process but based on systemic risk rather than restraint of competition.

  205. “No one apparently saw that no one was standing behind the insurer”

    They had no major reason to, AIG had an AAA rating.