As we’ve explained before, a lot of money that flowed into building a housing bubble came from derivative securities.

These derivatives included several layers, or ‘tranches.’  The topmost tranche was rated very safe, AAA.  As you went down the tranches the ratings fell until you got to the smallest and riskiest tranche, the ‘equity’ tranche which normally amounted to about 5% of the derivative’s value.   The problem for investment banks who constructed and then sold these derivatives–normally valued at $100 million in total–was that pesky equity tranche.  It was hard to sell because of its risk.  But if it wasn’t sold to someone, the entire derivative fell through.

So along comes Magnetar, a hedge fund.  They basically bought the equity slices and thus made the derivative securities possible for sale.  Why would they do this?  Because they shorted the derivatives they made possible.  In fact they were often allowed to pick the underlying securities that went into the derivative, thus making it more likely the whole caboodle would collapse if housing prices fell.  And the Magnetar guys were smart.  They could see that this was a bubble and it was headed for a crash.  In fact, a lot of Wall Street saw it coming and did the same thing.  Magnetar wasn’t alone, it was just among the largest.

What about the investment bank?  It was making hefty commissions all along the way and Magnetar’s equity purchases increased those commissions.  But didn’t the investment bank have a whiff that this stuff was toxic, or ‘nuclear’ as was a common descriptor?  Of course they did.  Like Magnetar they were shorting their own product even as they were selling it to supposedly sophisticated clients.  The investment bank’s problem wasn’t that they didn’t realize the crash was coming, what they didn’t realize was they would get caught with hundreds of millions, even billions of dollars, worth of unsold nuclear derivatives.  When the turn came, the investment banks found out the market for this security toxic waste was very thin.  That’s known as an ‘illiquid’ market.

So Magnetar made billions of dollars shorting that which they made possible.  And the investment banks, en masse, became insolvent almost overnight, in the end to be bailed out by taxpayers.     Socialism for the rich.

And that dear reader is how you loot an economy.

Beezer here.  In any sane world this is considered fraud and subject to criminal prosecution.  So now we’re supposed to believe further de-regulation is going to help?

First, let’s get something very clearly understood:  More than three years after the Great Recession, all of our major banks, as well as the major banks in Europe, remain insolvent.  From Yves Smith’s brilliant book, Econned, How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism.

“Andrew Haldane, the Executive Director for Financial Stability at the Bank of England, concluded that it was impossible for the financial services industry to pay for the damage it wrought in the global debacle.  The lowest plausible estimate of the total costs that he could come up with, amortized over 20 years, still resulted in a first year’s bill that exceeded the total market capitalization of the biggest banks.”

It took 40 years to unwind a regulatory structure that was the envy of the world.  That regulatory discipline allowed America to become the world’s greatest manufacturer.  Common sense regulations,  forged in the heat of the Great Depression and responsible for a long period of economic growth widely shared by the majority of citizens, were systematically dismantled.

As the dismantling progressed the nation’s financial industry grew in size and profitability.  Once only 8% of the economy, it soared to 25%.   In terms of total corporate profits, finance grabbed more than 40% of profits.  At the core of this expansion were a new class of financial ‘innovations’ called derivatives.  Layered over traditional financial instruments like bonds, stocks, insurance contracts, commodity futures and related options, these derivatives exponentially increased the amount of money going into finance and, for all intents and purposes, dramatically under-priced risk.  Derivatives had the nefarious effect of funding debt that was hugely under-priced, causing trillions of dollars in ‘bets’ to be made on all aspects of finance.

It wasn’t just in housing mortgages either.  This surge in under-priced debt went everywhere:  Student loans, car loans, merger and acquisition funding, sovereign debt, insurance contracts–everywhere–you name the financial function and this explosion of liquidity drove down interest rates to the point where those rates couldn’t come close to covering repayment problems or other risks.

The only solution is structural change that reduces the size and interconnectedness of the major actors.  Given the fact that these ‘major actors’ provide the primary funding for political campaigns, including millions of dollars in political advertising aimed at influencing the public’s understanding and perception of events, efforts to make structural changes face huge political hurdles.

• Shrink the use of derivatives, most specifically so-called credit default swaps (CDS).  These instruments are pure bets on insurance contracts.  They avoid the ‘insurable interest’ rule of insurance (you can’t pay for insurance on your neighbor’s house, for one obvious example, because you have an incentive to burn it down!) and have no legitimate economic purpose other than being a fee generating machine for the financial services industry.   These derivatives still exist and are still exempt from regulation, believe it or not.  They are so pervasive inside bank balance sheets, an outright ban is probably not wise.  Regulating them, however, will end the cowboy type of behaviour common with their use.  Regulating them will increase their cost, in other words, and limit their use.  This will also restore more accurate risk assessment.
• Limit guarantees to critically important banking and capital market activities by installing a modified version of the Great Depression era, Glass Steagall legislation.  Commercial banks would be limited to making traditional loans and using plain vanilla hedges.  They could also engage in pure fee businesses such as those of being custodians or trustees.  Any use of CDS derivatives would be limited to regulated CDS insurance subsidiaries.  Investment banks would become more strictly regulated although their traditional functions would remain unchanged: Underwriting and distributing equities and bonds and market making; CDS activity limited to regulated insurance subsidiaries; mergers and acquisitions; asset management providing the asset manager does not rely in any way on funding from the investment bank.  Proprietary trading and the trading and sale of over the counter (OTC) derivatives would be prohibited, however.  Lending to hedge funds, save against specific positions on conservative terms, would be barred, as would warehouse facilities and bridge loans.
• Tighten other regulations to close gaps and extend liability to responsible parties.  These regulations should not be rules-based, but principles-based, a.k.a. ‘if it walks like a duck and quacks like a duck, it’s probably a duck.’  A low tolerance policy towards ‘innovation’ designed to evade standards would be more effective than any attempts to craft airtight regulations.
• Restore secondary liability.  In 1994 the US Supreme Court disallowed suits against advisors like accountants and lawyers aiding and abetting frauds.  In criminal law the guy who drives the getaway vehicle is an accessory, why isn’t an accounting firm who prepared misleading financial statements an accessory to fraud?
• Increase the budgets of regulators.  More auditors are needed who can sniff out that something is not right.  The claim that everyone who knows the inner workings will be in the private sector and won’t want to be a regulator is specious.  There are many examples of experienced private market actors who decide to become regulators.  Sometimes for, God forbid, altruistic reasons!   The enforcement team would need to attract only a few of these experienced individuals to make a great difference.
• ‘Free market’ mania, quoted from Econned:  “Powerful business interests, largely captive regulators and officials, and a lapdog media took up this amorphous, malleable idea and made it a Trojan horse for a three-decades long campaign to tear down the rules that constrained the finance sector.  The result has been a massive transfer of wealth, with its centerpiece the greatest theft from the public purse in history.  This campaign has been far too consistent and calculated to brand it with the traditional label, ‘spin.’  This manipulation of public perception can only be called propaganda.  Only  when we, the public, are able to call the underlying realities by their proper names–extortion, capture, looting, propaganda–can we begin to root them out.”

Beezer here.  Econned is the best book I’ve read so far, and I’ve read many, that explains in terms the average person can understand just how we got into this mess–and explain how we might be able to extricate ourselves without burning the whole house down.  In our opinion the last bullet is obviously the most important.  The public has to be better informed in order to understand that what we have now is decidedly not capitalism and the markets we have now are decidedly not ‘free.’   The first job is to take on the propaganda machine.  It’s giving the public a Potemkin Village version of reality.  What we need is reality.

Three years plus after the financial meltdown there is still little public understanding about its underlying causes.   If you want to learn in some detail the real dynamics involved you should read Yves Smith’s book Econned and former New York Times journalist Jeff Madrick’s Age of Greed.

Both books chronicle the same swirl of change that began more than 40 years ago.    In Econned, which offers more detail about the inner workings of these dynamics,  Smith goes back even further in order to explain the evolution (or devolution) in economic thought which she is convinced enabled and magnified the unintended ill effects of changes in finance.  She makes a very good case.

In any case a summation.  The Great Depression laws; FDIC insurance, stricter SEC regulation, the Glass Steagall separation of investment and commercial banking being the most notable worked pretty well.    For almost 80 years there was no run on a bank.  Recessions were relatively mild and short lived.  America grew smartly and there was almost always more than sufficient capital and liquidity to support that growth.

But as America grew, and as international growth began to accelerate, demand for financial services grew as well and this growth put pressure on the structure of American banking, particularly investment banking.   Investment banks historically were private companies where the principals had their own money at stake.   Income came from acting as middlemen in any merger or acquisition, underwriting new stock or bond issues to raise investment capital for corporate clients, or proprietary trading of financial instruments with the firm’s money.  Much of this business was fairly routine and often  awarded based on who you knew rather than what you knew.   Proprietary trading and merger and acquisition were the two most lucrative areas.

The pressure came basically because America’s largest corporations expanded dramatically around the world, opening offices and operations literally in every country.  Their banks needed to follow them, offering services everywhere their clients went.   This tremendously expanded the need for capital by investment banks.  In rapid fashion this explosion in the need for capital outstripped the private, principal owned model of investment banking.   So they all went public and became shareholder owned in order to raise the additional capital.  Goldman Sachs was the last holdout and went public in 1999.   The new capital was good, except that it was ‘other peoples’ money’ now.  That cut the risk tether imposed under the private model where the firm’s money was at stake.

The next dynamic was the one which ended up tearing down the Glass Steagall firewall between investment banking and commercial banking.  That occurred primarily due to commercial banks wanting entry into the higher margin businesses of merger and acquisition and proprietary trading.   Under Glass Steagall commercial banking was a utility.  Regulations virtually guaranteed a bank moderate profits, but those same regulations kept commercial banks out of the riskier investment bank businesses where FDIC insured deposits could end up being lost.   Investment bankers were also eager to gain access to the immense capital Glass Steagall guaranteed for the commercial side.

A third dynamic was involved.  This was the one of financial ‘innovation.’   Derivative securities in particular offered large profits.  But they are complicated and risky.

Taken together these changes produced a nightmare for management.   Decision making often got pushed down below managerial level, particularly in the derivative areas, because each required specific skills and expertise.   Because these areas were often among the most lucrative ones, traders could and often did, take out-sized bets without manager approval.  Unlike most other large businesses, profit opportunities come and go swiftly in investment banking, particularly in the numerous and often unique derivative markets.    This is not something for the faint of heart and it opened up many avenues for abuse, not least one where trader specialists could manipulate the profit margins and the timing of trades in order to boost their bonuses.  Many times these profit boosting trades were booked at inflated prices which would be paid for by customers.   And with a little bookkeeping manipulation profits could be ‘shown’ when a trade was entered into–before anyone including the trader knew whether the trade was even profitable.

Given the inability of banks to manage risk within their own ranks, it should come as no surprise that government regulators had no clue.  And even when they did make a complaint to their administrators, regulators were often told to look the other way–called ‘forbearance.’  This was not only because of the cold hard political cash forthcoming to campaigns from banks rewarding regulatory ‘forbearance,’ but also because the dominant economic/political views were that government regulation was unnecessary.   Unfettered private markets and industry would naturally smoke out the cheaters better than a government bureaucrat could.  That was the theory, anyway.

As Yogi Berra pointed out, sometimes theory and practice are different.  Unlike the experience when Great Depression regulations were in full force, this new business model has produced a long series of blowups spanning more than 40 years, each more severe than the prior.   The 2007-08 financial meltdown was the first systemic banking collapse since the one that threw America into the Great Depression in the 1930s.   It was the first ‘bank run’ since the Great Depression.

Additionally, without the Great Depression rules in force, taxpayers ended up bailing out financiers.   For the first time since the imposition of FDIC insurance, there was a devastating run on the entire banking system.  And that run ended up, for all practical purposes, forcing taxpayers to insure all types of deposits and investments–hundreds of billions of which were not even in American banks.  It was a Great Depression lesson forgotten by this generation at unimaginable cost.

The big banks are bigger now than when the 2007-08 collapse happened.  The murky, complicated derivatives are still primarily traded Over the Counter (OTC) outside of regulatory view.  Most importantly, Congress and the administration still depend upon bank campaign cash for their survival, so efforts to re-regulate finance, to restrain risk taking, are weak to non-existent.

Beezer here.  Will the next blowup be another one created by financial risk and irresponsibility?  Who knows.  There doesn’t appear to be the political will to restrain bank speculation.  Even after the last meltdown.  Apparently it takes something even worse for the public majority to do something to protect themselves.

David Cay Johnston, a Pulitzer Prize winner who now writes at Reuters, highlights the less than zero sum game our bond and equity markets have become–casinos in other words–and argues we should consider losses in those markets as gambling debts that are not enforceable in US courts.  If we did that, these markets would not be profitable as casinos and would return to doing what they are supposed to do, provide real price discovery for assets and provide investment capital for productive activities.

The basic idea isn’t even original to Johnston, who in a recent article cites the work of Professor Lynn Stout, of the University of California, Los Angeles (UCLA).

Professor Lynn Stout, a deeply principled Republican capitalist who teaches corporate law at the University of California, Los Angeles, raised this issue at a conference where we both spoke about the 2008 Wall Street meltdown.

“Derivatives are gambling,” she said, referring to credit default swaps, at the University of Missouri-Kansas City law school conference on the financial crisis. “They are a zero-sum game in which one side loses the bet and one side wins,” Stout said.

Actually they are worse than that, since the hefty fees Wall Street pockets for arranging the bets result in a less-than-zero-sum game.

As Wall Street fights meaningful financial regulations, and draft regulations remind us how complex and unfathomable regulations can be, this is a good time to remember the basic principles that served society so well until Chicago School theorists, and casino corporations, together with commodities and currency traders convinced us we were too modern to need them.

UNENFORCEABLE GAMBLING DEBTS

Stout recounted the history of unenforceable gambling debts back to the Romans. She cited an 1884 Supreme Court case on what were then called “difference contracts” to show that derivatives have a long history of being treated by the law as unproductive at best and often damaging to society, just as we saw in 2008.

“I have not found a successful economy that did not have legal restrictions on bets,” she said.

She said that in addition to being nonproductive, such bets add risk to the system, invite bad conduct because bets can be rigged and foster asset bubbles, which are inevitably followed by crashes like the one from which we still have yet to recover.

As the author of a book on the gambling industry’s rise, “Temples of Chance,” and as a lecturer at Syracuse University on the regulatory law of the ancient world, I recognized Stout’s points were spot on. But her warnings are being drowned out by radical anti-regulatory rhetoric, the army of Capitol Hill lobbyists working for derivatives sellers and the politicians to whom they donate.

Stout noted that speculators these days like to call themselves by other names — for instance, hedge fund managers. But hedging suggests engagement in a business such as oil or grain and buying or selling contracts backed by assets you have or will use.

PURE SPECULATION

Most of the bets on Wall Street were pure speculation. Against $15 trillion of mortgage bonds, Stout said, Wall Street marketed credit default swaps in 2008 with a notional value of $67 trillion. Worldwide, traded swaps at their peak equaled $670 trillion or $100,000 for each person on the planet, vastly more than all the wealth in the world. Those numbers make it a mathematical certainty that the swaps were mostly speculation, not hedging.

Stout likened some derivatives to a market in fire insurance in which you buy coverage not for your own home, but for those of strangers. Such insurance would create an incentive to commit arson for profit. Yet we allow speculative derivatives that melted the housing market.

Stout’s approach would not stop derivatives that are backed by hard assets, such as a mortgage whose interest rate is derived from an index like the London Interbank Offered Rate or Libor and thus varies over time.

But credit default swaps that are just bets on which one party wins and which one loses would vanish if we restored the ancient, time-tested and therefore profoundly conservative rule that government will not enforce the collection of gambling debts.

Making gambling debts unenforceable produced its own problems. For one, it created work for people like the late Harry Coloduros, who sat in my kitchen 25 years ago, bouncing my little Molly on his knee as I made coffee, and told me about gamblers he beat up to make them pay up.

I cannot imagine Goldman Sachs hiring the likes of Harry to collect on bets when the losing party fails to pay up. So, unless taxpayers cover the bets, as they were forced to at 100 cents on the dollar in the AIG wagers, Goldman would likely get out of speculative bets and stick to actual hedging.

And that shows the immense value of restoring the sound policy of making losing bettors suffer their losses without any help from government.

Beezer here.  As a former Merrill Lynch stockbroker, we’ve become very skeptical and critical of the current equity and bond markets, domestic and international.  Much of what we now see in these markets is simple gambling.  Reporters at popular ‘financial news’ cable channels like CNBC seldom even bother to refer to market activities as ‘investments’ and more commonly use the proper nomenclature for gambling–’bet.’   This is what naturally evolves in markets that are unregulated.  They become casinos where all the participants are ‘betting’ on whether an asset price will move up or down in the very short term (in a the case of high volume trading, which is nothing more than jumping the que or getting first in line always, short term can be seconds), and there is next to no concern about the asset’s underlying fundamentals.   One result of this transformation of competitive, price discovery markets into casinos is low volume during most sessions.  That’s because the so-called ‘retail’ investor no longer invests.  They may not be professionals, but they do know the markets are now just casinos and no place to put their hard earned savings.

For a number of reasons, we haven’t visited the conclusions of a commission charged with explaining what happened to the United States economy.  The conclusions can be read here.

After pointing out the rapid growth of the financial sector as a portion of GDP, financial profits as a percentage of all corporate profits went from 15% in 1980 to 27% in 2006 and from 1978 to 2007 debt rose from $3 trillion to $36 trillion, the commission concluded the following.

• The Crisis was Avoidable.
• Widespread failures in financial regulation and supervision proved devastating to the stability of nation’s financial markets.
• Dramatic failures of corporate governance and risk management at systemically important financial institutions were a key cause of this crisis.
• A combination of excessive borrowing,  risky investments, and lack of transparency put the financial system on a collision course with crisis.
• The government was ill prepared for the crisis, and its inconsistent response added to the uncertainty and panic in the financial markets.
• There was a systemic breakdown in accountability and ethics.
• Collapsing mortgage lending standards and the mortgage securitization pipeline lit and spread the flame of contagion and crisis.
• Over-the-counter derivatives contributed significantly to this crisis.
• The failure of credit rating agencies were essential cogs in the wheel of financial destruction.

Conspicuously absent from these conclusions is the role played by the GSEs, Fannie and Freddie.  The commission explained why.

‘We conclude these two entities contributed to the crisis, but were not a primary cause.  Importantly, GSE mortgage securities essentially maintained their value throughout the crisis and did not contribute to the significant firm losses that were central to the financial crisis. 

The GSEs participated in the expansion of subprime and other risky mortgages, but they followed rather than led Wall Street and other lenders in the rush for fool’s gold.  They purchased the highest rated non-GSE backed mortgages and their participation in this market added helium to the housing balloon, but their purchases never represented a majority of the market.”

Beezer here.  These are the conclusions only.  The linked document also runs a narrative summarizing each conclusion, but the link doesn’t contain  underlying data detail.  And there were dissenters on the commission.

Professor James Galbraith, of the University of Texas, is a powerful speaker and writer/critic of recent economic thought.  Here is a devastating critique of what the financial sector actually did to the American taxpayer, made in a written statement to the Senate Judiciary Committee.