The “Miracle” Still Goes On For Someone…

This guest post is by Ivo Pezzuto, Professor at the Swiss Management Center University (SMCU) in Zurich, Switzerland, and an experienced observer of the global financial services industry.

I share the analysis of most economists and observers that the following are among the main causes of the current global financial crisis:

  • the U.S. Federal Reserve’s low interest rate policy at the beginning of the last decade, the resulting credit euphoria of both lenders and borrowers;
  • the more ”relaxed” credit initiation and control policies and procedures of lenders;
  • the “exotic” innovative features of some mortgage lending products;
  • the overwhelmingly optimistic view of future house prices which prevailed in the market that has led to both the housing and the mortgage lending bubbles;
  • the widespread use of badly controlled (OTC trading) innovative financial engineering tools (i.e., derivatives, securitizations, CDS, CDO, MBS, RMBS, CLO, etc.).
  • Imbalances, exchange rates and interest rates differences between the US and other emerging economies and the resulting speculative trading and arbitrages.

As I reported on October 7th, 2008 in my SMCU working paper (ISSN 1662-761X), however, from a more thorough and in–depth analysis of how the U.S. subprime mortgage loans crisis has originated and evolved, it seems to me that this dramatic financial and economic event might not have been generated only by the above mentioned items.

My assumption is that many bankers probably knew quite well what was really happening to their subprime mortgages portfolios and why. These explanations are reported in my SMCU working paper which can be downloaded free-of-charge from this link, or reading my chapter (chapter 16) in the forthcoming book of Robert W. Kolb, Professor of Finance/Frank W. Considine Chair of Applied Ethics at the School of Business – Loyola University Chicago. 

These days, unfortunately, we are still reading of the persistence of unethical or at least “questionable” behaviours of some key players in the financial industry. Some of these organizations are rewarding their executives with higher salaries and bonuses, while 10% of the American workforce is unemployed thanks to “miraculous lending and financial engineering” practices.

I am not against in principle granting employees and executives generous bonuses if they are well deserved. I just hope that after such a dramatic crisis, there will be more rigorous attention to reward only those who have actually worked to improved general economic conditions and not only their personal wealth through financial speculation.

Furthermore, it seems as if some organizations are still relying on the “too-big-to-fail” philosophy and on the government’s protection to continue to grow aggressively their highly volatile derivatives and investment banking portfolios, or using the TARP funds (provided by the US taxpayers) and the Federal Reserve’s aggressive “monetary easing” policy (Fed Funds close to zero % or “money for free”) to increase their present and future salaries/bonuses through more profitable speculative operations.

The massive protections, recapitalizations, nationalizations, and financial and liquidity support banks received were orchestrated by governments and central banks to avoid systemic risks (long recession and potential depression) and the highly probable implosion of giant banks and other key financial institutions in the US and other markets.  Now it is very sad to see that some of these funds have been misused by some bankers to continue to speculate in highly profitable and risky financial engineering operations instead of devoting their time, money, effort, and soul in helping troubled companies to avoid bankruptcy, the overall economy to grow, to reduce unemployment, to invest in R&D and innovation projects, to finance sustainability and green economy projects, and to restore trust and hope in the mind of troubled mortgage loans borrowers.

It is also sad seeing some bankers aggressively rejecting any introduction of additional and necessary regulation of the financial sector since they think that the bad times are over now. Regarding this last issue, I would like to stress the an important point. We all know that banking and financial markets are globalized today, thus the G20 countries have to be very careful not to introduce in the coming months or years significant discrepancies in their countries’ regulations of the financial sector – otherwise there will new opportunities for arbitrages and speculations taking advantage of the different national policies and rules.

Overall, I think we still have a long way to go…. …… but fortunately, I feel that President Obama is moving in the right direction.

By Ivo Pezzuto

14 responses to “The “Miracle” Still Goes On For Someone…

  1. You were going so well, and then:

    I feel that President Obama is moving in the right direction.

    How about rewriting this conclusion to (a) use “think” instead of “feel”; (b) explain what proposal you are talking about; and (c) explain how it connects to anything else you wrote?

    Grade: C+, pending rewrite.

  2. I liked your “Newspeak” post Nemo. I think you and I are on different sides politically, but you make some good points and I like your posts on Bonds and interest rates. I think I’ve made it clear I strongly dislike “Bond Girl” but it probably improves your site for most people with more rapid posts.

    I may link that “Newspeak” post on my blog later today, pretty good. Hope you have a good MLK Day.

  3. True confessions from Jamie Dimon (JPMorgan Chase), as reported in the New York Times article by Joe Nocera dated 10.24.08 (albeit late, but just in time again, as Wall Street delivers on yet another year of excessive bonuses):

    http://www.nytimes.com/2008/10/25/business/25nocera.html?_r=1&scp=1&sq=be%20a%20little%20bit%20more%20active%20on%20the%20acqusition%20side&st=cse

    “In point of fact, the dirty little secret of the banking industry is that it has no intention of using the money to make new loans….(He didn’t mean to, of course, but I obtained the call-in number and listened to a recording.) …..“Twenty-five billion dollars is obviously going to help the folks who are struggling more than Chase,” he began. “What we do think it will help us do is perhaps be a little bit more active on the acquisition side or opportunistic side for some banks who are still struggling. And I would not assume that we are done on the acquisition side just because of the Washington Mutual and Bear Stearns mergers. I think there are going to be some great opportunities for us to grow in this environment, and I think we have an opportunity to use that $25 billion in that way and obviously depending on whether recession turns into depression or what happens in the future, you know, we have that as a backstop.”

    Strangely enough, I thought the deer-in-the-headlights Bush would stick by his free market principals if it had not been for the desperate Goldman Sachs portfolio graduate, Henry Paulson.

  4. I’m with Nemo. You had me the entire way and then lost me at the very last sentence. First, the Obama administration is pursuing many objectives in many particular ways. To what specific prescriptions of the administration are you referring? Which ones are good in your view and which ones are either bad or need tweaking?

    The simplest solution I envision is to allow banks and their Boards to set their compensation scheme any way that they choose with the exception that any pay tied to “performance” be tied to periods of 5 years or more. Being paid well for creating long-term value is one thing, but short-term incentives encourage short-term behaviors. The risk of clawbacks must be real, as well.

    Two other solutions I like are: 1) requiring originators to retain a “significant” (others can argue over the meaning of that word) portion of the risk of the loans that they originate; and, 2)institutions must have good reason to fear failure. Failure must be an option. We can put in all the rules and safeguards about how to dismantle failed firms but they simply must be allower to fail.

  5. markets.aurelius

    Huh?!?

    One would think you’re living a world in which capitalism and the rule of law had been completely overturned. We live in a time of miraculous recovery and largesse.

    While it may be true, as Lloyd and Jamie told the FCIC in sworn testimonry last week, that the banks, former investment banks, and their regulators had no idea of the risks they were creating and trading among each other in the time leading up to the “events” of 2007-08, clearly that is not the case now.

    Now we have fully restored financial institutions doing God’s work: They’ve done yoeman service in restoring their balance sheets, to say nothing of a shattered global economy.

    Thankfully, the apocalypse was averted, largely thru the efforts of these dedicated men and women in finance acting, as they’ll gently remind you, largely on their own to not only restore global markets, but to set the stage for renewed growth and prosperity for all. They are indeed the true servants of the public weal.

    One is proud, as a taxpayer and citizen, to have done one’s small part in restoring our financial institutions. And, let’s be fair, one is frankly more than a bit awe-struck at the brilliance of the effort and alacrity of the response among the banks and former investment banks in righting the markets and global economy. Thankfully, the oh-so-dire turn of events only a year or so ago now safely behind us. The only thing that didn’t survive — the investment banking model — has been re-imagined and deployed in ways never considered. How wonderous. One hopes — nay, prays — these institutions will find ever-more creative ways to deploy capital and create new instruments and new trading markets for the distribution of new risks we’ve yet to consider.

    The largess we are about to witness being distributed to the people who were able to so completely correct what could have been massively destructive behaviour and risk taking is so well deserved. One can only hope 2010 brings equal good fortune. And that our children will hold these lessons forever in their hearts. Lord knows they will be paying for them.

  6. I would like to point out what was going on in Michigan that I haven’t heard very much about as a leadup to the crisis. Since the early 90s when interest rates began to fall, families that I know were refinancing their mortgages and rolling auto loans, credit card loans, etc. into their mortgage. As either rates fell, or the value of the home increased, the families would run the credit cards, buy another vehicle and refinance all that again. All the while, they would either lose a job and get another making a less or they would not receive increases in compensation. As long as they could keep refinancing, their consumption patterns did not change. With the crash in the housing market (due to what? people losing their jobs and not being able to make payments on McDonald’s wages), and the credit freeze, this perpetual refinancing of debt ground to a halt.

  7. Tee hee, amen markets.aurelius…I think. Only thought I’d add this little bit I read the other day regarding imbalances in the world: Goldman Sachs, Morgan Stanley and JPMorgan Chase combined have set aside $47 billion for bonuses; Haiti’s annual gross domestic product in nominal terms – $7 billion. http://theendisalwaysnear.blogspot.com/2010/01/pact-with-which-devil.html

  8. Is this April Fool’s day?

  9. The issue of bankster bonus largesse can be resolved to the benefit of the country at large by forcing the banksters to receive bonus in the currency of the toxic assets on their balance sheet which ironically they sold to the market before the Big Meltdown.

  10. I wholeheartedly agree, certainly to the extent that Obama has offered a reappointment to Bernanke (a Greenspan years protoge) and continues the employment of Geithner and Summers, who are supporters of the Wall Street status quo, and who has never mentioned listening to the recent wisdom of other significant voices (including Volcker and Greenspan himself) who have couseled and different, far more restrictive course for the bloated (non Glass-Steagall regulated) financial behemoths. We are foundering at the offering of any really significant hard-nosed reform, but soft soaping the entire deal. But then, that’s just one man’s opinion.

  11. Was the inflation in house values revealed in the Fed’s inflation numbers?

  12. You write, “Now it is very sad to see that some of these funds have been misused by some bankers to continue to speculate in highly profitable and risky financial engineering operations instead of devoting their time, money, effort, and soul in helping troubled companies to avoid bankruptcy, the overall economy to grow, to reduce unemployment, to invest in R&D and innovation projects, to finance sustainability and green economy projects, and to restore trust and hope in the mind of troubled mortgage loans borrowers.”

    Um, why is this very sad, or, more importantly, surprising? Wall Street isn’t responsible for doing all of those things, in order, that is the role of:

    “Helping troubled companies to avoid bankruptcy”: Management, Board of Directors, shareholders, creditors, other stakeholders. If you mean banks as creditors, then their only obligation is to their own shareholders/creditors, so a bank’s incentive is not necessarily to help the troubled company.

    “the overall economy to grow, to reduce unemployment:” uh, what? This is not the role of banks. Their role is to act as financial intermediary (or principal).

    “to invest in R&D and innovation projects, to finance sustainability and green economy projects:” Uh, what? How is this a bank’s responsibility?

    “and to restore trust and hope in the mind of troubled mortgage loans borrowers:” Ok, fair enough, but this is not the role solely of banks. The issue is far more complicated than I have time to spell-out, but I don’t necessarily disagree with this one, per se.

    All-in-all the Government – with its populist pandering and finger-pointing – has ascribed responsibility to the financial services sector that contradict its role in the economy. Do you want banks to increase lending to consumers and businesses or do you want them to strengthen their balance sheets? Its an either/or thing, you cannot have your cake & eat it, too.

  13. Anal-yst is right. He saves his most important point for last. That is, “Do you want banks to increase lending to consumers and businesses or do you want them to strengthen their balance sheets? Its an either/or thing.” We can quible about what each individual bank should do to strengthen itself, thereby making the entire system more stable, but should that decision be left to one central planner or to each bank, with its management, its Board, its and stakeholders?

  14. Best post of the lot….