Tag Archives: Financial crisis

Echoes of The ‘80s and The Collateral Damage of Fraud

Posted on March 17, 2010 by | 3 comments

By Sigrún Davíðsdóttir

Recently, I talked to the CEO of a very successful Icelandic company that has grown steadily over the decade it’s been operating. Every year, the CEO would go through the annual report, lean back and think with great satisfaction that his company was indeed showing a healthily steady growth. Then the banks and their satellite companies would come out with their annual accounts – and the CEO’s heart would sink, questioning what on earth was he was doing: compared to these companies his company’s growth was pitiful. Now, anno 2010, his company is still doing well and even hiring people. The three main Icelandic banks collapsed in October 2008 and most of the companies owned by those favoured by the banks are now bankrupt.*

This conversation came to mind as I read ‘Den of Thieves’ by WSJ journalist James B. Stewart, on the insider trading involving the arbitrageur king of the 1980s, Ivan Boesky and junk bond emperor Michael Milken. Their apparent success became a gold standard everyone else tried to achieve. But as it was based on questionable business practices and outright fraud this measure proved an unhealthy standard. Their success was also a measurement in remuneration, again not a healthy measure. The same happened in Iceland: the banks rapidly raised salaries after they had become entirely privatised in 2003. With hindsight, their success can now be doubted and their rising remuneration levels affected the whole business community.

In his book Stewart points out that the ‘arrival of the big-money ‘star’ system in the eighties had made national celebrities’ out of people like Milken, Boesky and others who were condemned for fraud and doomed old-fashioned investment bankers that earlier had dominated the financial world. There is no need to be unduly nostalgic about the old way of banking but one of the great but too little noticed harm of fraudsters like Milken ed al. is the unhealthy standards they created in terms of growth rates and remuneration.
We still do not know the extent of fraud within the Icelandic banking bubble. The Icelandic FME, comparable to the UK Financial Services Authorities, has already sent several extensive cases of alleged market manipulation to the Office of Special Prosecutor, set up to deal with possible cases of criminal activity connected to the collapse of the banks. The Special Prosecutor is both conducting his own investigations and working on specific cases that have been sent to him from i.a. the FME and the resolution committees of the collapsed banks.
Apart from the general damage of fraud by creating harmful standards it feels as if some of those who led the Icelandic banking bubble had reopened the tool kit of the prolific fraudsters that Stewart writes about. The difference is of course that Milken was working for his own benefit, often at the cost of the bank where he worked, whereas the Icelandic banks, in cahoots with major shareholders seemed to favour certain clients more than others and possibly worked against the interest of other shareholders.
In the Icelandic context, two of the counts to which Milken pleaded guilty are of particular interest. Milken pleaded guilty to selling stock without disclosing that included in the deal was the understanding that the purchaser would not lose money. The other count involves selling securities to a client and then buying those securities back at a real loss to the customer, but with an understanding that Milken would try to find a future profitable transaction to make up for any losses.

One of the peculiarities of Icelandic banking up until the collapse is that certain clients were sold stock with a kind of ‘no loss guarantee.’ This was particularly common among key staff at the banks: the staff would get a loan from the bank where they worked to buy shares in that same bank. In most cases these were bullet loans, the staff wasn’t expected to pay anything off the loans but had the shares at their disposal to reap the dividend. The benefit for the bank was that the shares would not be used for short-selling. This practice escalated in 2007 and 2008 as foreign banks made margin calls on some of their big Icelandic clients who had pledged Icelandic bank shares against foreign loans. In order to avoid dumping these shares into the market, causing further decline in the share price, the banks would ‘park’ them with their staff, lend against them, with the understanding that these arrangement wouldn’t harm the borrower.

A bank manager from one of the collapsed banks informed me recently that among the big favored clients there was an understanding that in deals where the client lost money the bank would then try to find a profitable transaction to make up the loss. There would be many ways of making this happen, i.a. buying assets at a price above market price. It’s difficult to ascertain if and when this happened but certain sales guarantees could be scrutinised.

The interesting thing is that Milken and others convicted at the end of the ‘80s were rogues in the financial markets who defrauded clients and the banks they worked for. The Icelandic example suggests that the banks’ management, together with their main shareholders, were operating like the rogue bankers of the ‘80s bubble. It is still early day, no big cases of fraud have so far been brought to court and when that happens it will take a while until the first cases are brought to closure. So far, the possibility of a certain echo of the ’80s’ financial fraudsters remains only an intriguing thought based on striking but so far unproven parallels.

* For more on various aspects of the collapse of the Icelandic banks and connections with international banking see Icelog, my blog at http://uti.is/

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What Do Our Nation’s Biggest Banks Owe Us Now?

Posted on March 16, 2010 by | 6 comments

By William K. Black

This week, ABC News World News with Diane Sawyer is airing a series about the struggling middle class. The show’s producers posed the following question to a few of the nation’s leading economic and financial analysts, including UMKC’s own William K. Black.

QUESTION: As the nation’s largest banks have regained their footing, what, if anything, can or should they do to help Americans still struggling as a result of the financial crisis and recession?  Are there specific solutions or actions the banks should take or HAVE they already done enough?  Do the banks have an “ethical obligation” to help those average American families still struggling?
ANSWER: First, banks have not recovered.  It is essential to remember that the banks used their political clout last year to induce Congress to extort the Financial Accounting Standards Board (FASB) to change the accounting rules such that banks no longer have to recognize losses on their bad assets unless and until they sell them.  Absent this massive accounting abuse, hiding over a trillion dollars in losses, banks would (overall) not be reporting these fictional “profits” and would not be permitted to award the exceptional executive bonuses that they have paid out.


Second, banks have, in reality (as opposed to their fictional accounting ala Lehman) been suffering large losses for at least five years.  They only appeared to be profitable in 2005-2007 because they provided only trivial loss reserves (slightly over 1%) while making nonprime loans that, on average, suffer roughly 50% losses.  Loss reserves fell for five straight years as bank risks exploded during those same five years.  Had they reserved properly for their losses the industry would have reported large losses no later than 2005. 
Third, banks have performed dismally when they were supposedly profitable.  They funded the nonprime and the commercial real estate (CRE) bubbles that not only cause trillions of dollars of losses and the Great Recession, but also misallocated assets (physical and human) during those bubbles.  Far too few societal resources went to productive investments that would increase productivity and employment.  Our nation has critical shortages of workers with expertise in physics, engineering, and mathematics — precisely the categories that we misallocated to finance instead of science and production.  In finance, they (net) destroyed wealth by creating “mark to myth” financial models that maximized executive bonuses by inflating asset values and understating risk. 

Fourth, when finance seems to be working well in the modern era it is working badly.  Finance is a “middleman.”  Its sole function is to allocate capital to the most useful and productive purposes in the real economy.  As with any middleman, the goal is to have the middleman be as small and take as little profit as possible.  Finance has not functioned that way.  It has gone from roughly 5% of total profits to roughly 40% of total profits.  That means that finance has, increasingly, become wildly inefficient.  It is a morbidly obese parasite (in economics terms) that drains capital from the productive sectors of the economy.   
Fifth, the things that finance is good at are harmful to our nation.  Finance is very good at exporting U.S. jobs to other nations.  Finance is very good at fostering immense speculation.  When banks “win” their speculative bets Americans suffer, e.g., when their speculation increases gas and food prices.  When they lose their bets the American people bail them out.  (The least they could do would be to support the proposed Volcker rules.  In reality, of course, they will gut them.)  For the overwhelmingly majority of Americans, increased speculation simply causes economic injury.  In very poor countries, however, “successful” speculation by hedge funds that runs up the price of basic food kills people.  Speculation has also become intensely political.  The right wing Greek parties engaged in accounting fraud to allow Greece to issue the Euro.  When a left wing Greek party defeated the right at the polls the banks and hedge funds decided to engage in a speculative frenzy designed to cripple the nation’s recovery from recession.  Finance is also superb at increasing inequality. 
Sixth, the rise of “systemically dangerous institutions” (SDIs) that the government will not allow to fail optimizes moral hazard (fraud and speculation) and means that future crises will be common and unusually severe. 
Seventh, while lending by smaller banks is flat, funding by SDIs fell by over $1/2 trillion.   
Eighth, banking theory is horribly flawed.  Financial markets are normally not “efficient”, markets do not inevitably “clear,” and banks fund “accounting control frauds” rather than providing effective “private market discipline.”  

To sum it up, whether I’m wearing my economics, law, regulatory, or white-collar criminologist hat the situation in banking demands prompt, fundamental reform so that banking will stop being so harmful.  Then we have to keep working to make it helpful. 

Banks cannot do many of the things that need to be done to fix our economy.  In the interest of limiting space, I’ll talk about only five economic priorities.  I think banks can be helpful in only a few of these priorities.  The most important thing we can do with financial institutions is reduce the damage they cause. 
1)  It is nuts that we think it is OK for 8 million Americans to lose their jobs (and far more lose their ability to work full time) and that we think that it makes sense to pay people not to work but is “socialism” to pay them to work during a Great Recession.  We need a government-funded jobs program. 

2) It is a disgrace that well over 20% of American children grow up in poverty.  It is a greater moral failing that ending this is not a national priority.  The banks have done a terrible job in this sphere.  They caused the greatest loss of working class wealth since the Great Depression and have made tens of thousands homeless.  This is overwhelmingly the product of what the FBI began warning of in 2004 — and “epidemic” of mortgage fraud.  The FBI states that 80% of the fraud is driven by finance industry insiders. 

3) It is insanity to the nth to run our state and local governments into massive cutbacks during a Great Recession when that undercuts the need for stimulus.  The obvious answer is a public policy with impeccable Republican origins — revenue sharing.  It passes all understanding that the Republicans and blue dog Democrats targeted revenue sharing for attack and reduced it to a pittance (relative to the scale of the crisis).  The best things the banks could do in this regard are to stop (a) all participation in “pay to play” corruption involving state & local bond issuances, and (b) stop all sales of unsuitable financial products to governments (and the public).  The opposite is happening:  Goldman fleeces its public sector clients, the SDIs sell toxic derivatives to small Scandinavian cities, the investment bankers are all over public pension funds desperate for higher yields (on their underfunded pension funds) selling them grotesquely unsuitable financial products (typically, the “dogs” they can’t unload on more sophisticated investors), and the inimitable Goldman Sachs helping Greek governments deceive the EU. 
4) Related to points two and three above, the most productive investment we can make is educating superbly the coming generations.  The best thing the banks can do is get out of student lending.  The governmental lending program for college students was administered in a much cheaper fashion.  The privatized lending program is an inefficient scandal that keeps on giving.
5) Banks could put the payday lenders out of business by outcompeting them.  That would be a real public service.
And, on a level of fantasy, banks as a group could tell FASB to restore honesty in accounting.  Individual banks could report their real losses and change their executive compensation systems to accord with the premises that purportedly underlie performance pay.  They could start making criminal referrals against the mortgage frauds (a mere 25 banks and S&Ls make over 80% of the total criminal referrals for mortgage fraud) — most banks refuse to file and help us jail the crooks.  They could stop adding to the glut in commercial real estate.  They could support the Kaptur bill to authorize the FBI to hire an additional 1000 agents so that we can investigate and jail elite financial felons.  They could support a prompt end to the existence of systemically dangerous institutions (SDIs) by supporting rules and regulatory policies to require them to shrink to the point that they no longer endanger the global economic system.  Pinch me if any of these dreams come true.  I’d like to be awake to experience and celebrate the miracle.

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Control Fraud and the Financial Crisis

Posted on March 2, 2010 by | 3 comments

Part I:

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Herr Henkel’s Hall of Shame

Posted on February 4, 2010 by | 1 comment

By William K. Black

Hans-Olaf Henkel was one of the primary German architects of the global financial crisis in his capacity as leader of the association that lobbied on behalf of Germany’s large businesses. He has written recently that a number of the CEOs running those businesses should be placed in a “Halle der Schande” (Hall of Shame). One hopes that he will find his continued association with them congenial when he his given the most prominent pedestal in that Hall.

Herr Henkel was the leading German business proponent of deregulation and the executive compensation systems that drove the global crisis. He brought a special passion to denouncing German tendencies toward social equality and the resulting cultural limitations on executive compensation. The government and equality were the twin evils and when the government sought to increase equality the combination was Henkel’s ultimate nightmare. It was certain, therefore, that he would blame the global crisis on government efforts to reduce discrimination against working class, particularly minority, Americans. It was equally certain that he would be enraged when Professor Galbraith refuted this claim. Herr Henkel replied:
Mr. Galbraith should familiarize himself Jimmy Carter’s “Housing and Community Development Act” where in Section VIII Banks were prohibited the practice of “red lining” which until then enabled them to distinguish “better living quarters” and “slums.”

It is not common to read nostalgia about the good old racist days when the government (the FHA) and businesses worked together to prevent loans from being made to blacks. Herr Henkel has an interesting concept of causality. His “logic” is that blacks, not the denial of home loans, caused “slums.” Banks, naturally, did not loan to blacks because blacks lived in slums. They drew “red lines” on maps around “slums” where they would not lend. Then came what Herr Henkel terms the “do-goodism” among politicians that banned the red lining of integrated and black neighborhoods (aka, “slums” in Henkel’s world view). The Fair Housing Act of 1968 (passed under President Johnson) outlawed redlining. Under Henkel’s “logic” it, after over a 30-year latency period, caused the global financial crisis. Black borrowers (“slum” dwellers all) destroyed the global economy. And Jews caused Germany to lose World War I by stabbing it in the back.

But it gets better. Herr Henkel claims that he is on a mission to fight a blood libel. He is enraged that opponents of the disastrous financial system smear (Verunglimpfen) that system on the basis of the wrongdoing of the CEOs leading our most elite banks. This makes his casual, fact-free, smear of blacks all the more appalling and hypocritical.

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Let the Mea Culpas Begin, Part 1

Posted on January 5, 2010 by | 3 comments

RUBIN AND BERNANKE APOLOGIZE (SORT OF) FOR PAST SINS
Alan Greenspan has already apologized for the damage he wrought, admitting the crisis reveals that his approach to economics is fundamentally flawed.
Apparently it is now time for mea culpas from the rest of the team most responsible for creating this mess: Rubin, Summers, and Bernanke. Rubin and Bernanke just provided theirs (here and here) —albeit somewhat half-heartedly, a bit more Tiger Woods than David Letterman.
Don’t hold your breath for an apology from Summers, who never owns up to his mistakes, ranging from his proposal to use developing nations as toxic waste dumps to his argument that females suffer from congenital handicaps that render them incapable of doing science (here and here).
Still, with three out of the four acknowledging errors, this could indicate a New Year’s trend. Next we can hope that the University of Chicago—the institution most responsible for producing the theories that guided our misguided policymakers—will apologize for its indiscretions. That could set an example for all mainstream economists who, as the Queen pointedly put it, failed to foresee the crisis.
The statements by Rubin and Bernanke are quite interesting—both for what they say and for what they leave out. Rubin claims to have learned that we “need to reform the financial system to better protect against systemic risk and devastating crises in the future.” Nice deduction, Sherlock! But he goes further, admitting he has long had misgivings about the shape of the financial system: “About four years ago, a well-known London investor said to me that the only undervalued asset in the world was risk. I had the same view, as did many others, and often said that markets, including credit, had gone to excess and that would probably be followed by a cyclical downturn—perhaps a sharp one—though the timing, as always, was unpredictable.” Really? Four years ago? Did he try to warn the Bush administration’s regulators? Or his protégé, Timmy Geithner at the NYFed who was busy (by his own admission) NOT regulating banks?
At that time did he feel any guilt, since he was among the most important deregulators who had created the conditions that would ensure undervaluation of risk? Did he push for re-regulation of the financial institution he was running into the ground?
To be fair, Rubin notes other problems with the “free market” approach he used to advocate, indeed, his complaints sound remarkably similar to the arguments long made by progressives (including heterodox economists). For example, the market should not be counted on to determine income distribution:

“Even before the recession hit, our current model had displayed major shortcomings that markets, by their nature, won’t address and that need to be met through public policy. For example, market-based economics, global integration, and the strong growth that has resulted have been accompanied by serious income-distribution problems around the world, though the circumstances differ among countries.”

He even engages in a bit of class warfare:

“For example, market-based economics, global integration, and the strong growth that has resulted have been accompanied by serious income-distribution problems around the world, though the circumstances differ among countries. In the United States, median real wages have lagged behind productivity growth for more than three decades (except for the second half of the 1990s), and income has become more heavily distributed toward the most affluent.”

Hold it a second. The redistribution of income toward the affluent occurred as Wall Street “fat cat bankers” grabbed an ever rising share of corporate profits—the source of the bonuses paid to Rubin and his cronies. In 2006 Rubin received $29.4 million from Citigroup. That was four years ago, when he was supposedly fretting that the whole financial bubble was heading toward collapse (see here).
How about some clawbacks? Compensation caps? Investigations for fraud and significant jail time for fat cat bankers? Ban Goldman Sachs alum from Washington? Unfortunately, Rubin is mum on these issues.
After acknowledging the real suffering generated by Wall Street’s excesses, Rubin concludes:

“…virtually no one involved in the financial system—whether institutions, investors, regulators, analysts, or commentators—recognized the breadth of forces at work or the possibility of a megacrisis, and this included the most experienced among us. More personally, I regret that I, too, didn’t see the potential for such extreme conditions despite my many years involved in financial matters and my concern for market excesses.”

The sentiment is touching, but the attempt to share the blame is factually incorrect. Many financial market participants and commentators saw this coming. Many warned of the consequences of allowing banksters to run wild—but they were mostly ignored or even ridiculed by Rubin and his buddies. There was a very strong will to believe that when the crash came, government would be able to quickly bail-out the financial institutions, as it had so many times before over the course of the postwar period. Of course, that will to believe was bolstered by a strong financial interest in engaging in those practices that would eventually lead to crisis. Perhaps Rubin’s claim that he had not foreseen such a deep crisis is correct, but many others did. He chose not to listen to them.
There are, however, two quite disturbing arguments raised by Rubin in his apology. First, he cites a fundamentally flawed study put out by the Commission on Growth and Development (a task force founded by the World Bank and a collection of “advisors” including Rubin) that purports to prove that market liberalization is a necessary condition for growth and development:

“In the six decades since the end of the Second World War, there has been a broad movement around the world toward a model of market-based economics, public investment, and global integration. With that move came enormous economic progress in industrial countries, including the recovery of war-torn Europe and Japan and, as time went on, in various developing countries.” Further, “The commission also found that no economy anywhere in the world had been successful with largely state-directed activities and high walls against global integration. The evidence, in other words, strongly suggests that a market-based model is still the best way forward.”

Surprisingly, the countries he cites as examples of the success of the Neoliberal market model are South Korea, Singapore, China, and India. While it is true that these nations have relaxed constraints on markets, none is a good candidate for demonstrating the wondrous advantages of market-based economics. Indeed, most analysts recognize that there is a highly successful alternative Asian model of development that opens markets only as development reaches a sufficient level to compete in international markets. Development then continues almost in spite of markets, guided by the very visible hand of government.
And China? Can Rubin actually believe that China’s success is due to reliance on free markets? True, the Chinese government uses international markets when it sees an advantage. And it squelches markets when that is advantageous. Its ability to avoid any of the damages of the “market fall-out” occasioned by the crisis is proof not that markets “work” but that a sovereign government does not have to allow markets to dictate economic outcomes. China grows at an 8% pace in spite of markets. Maybe to spite them—to show off the superiority of its government-led model. And unlike Obama, its premier has no fear of being called a socialist as its government ramps up spending and reigns-in errant entrepreneurs (occasionally sentencing particularly nefarious individuals to death—a practice Rubin might want to adopt here?). It avoids financial crises by avoiding financialization of the sort that Rubin pushed onto the US economy.
The other error is even more serious, as Rubin continues his role as cheerleader for deficit hawks. Clearly he learned nothing from his term as Clinton’s Treasury Secretary, when budget surpluses killed the economy and helped to bring on the NASDAQ-led equities crash. (Memo to Rubin: a decade later, stocks still have not recovered their values.) He still, mistakenly, believes that the Clinton boom was due to budget surpluses, failing to realize that the boom created the surpluses (as tax revenue exploded) and this fiscal drag sucked so much income and wealth out of the private sector that a crash was inevitable. He now wants to prevent recovery or at least kill one should it get underway:

“Putting another major stimulus on top of already huge deficits and rising debt-to-GDP ratios would have risks. And further expansion of the Federal Reserve Board’s balance sheet could create significant problems. Second, while the measures taken were absolutely necessary, unwinding the stimulus, restoring a sound fiscal regime, undoing the expansion of the Federal Reserve Board’s balance sheet, and reducing government’s involvement in the financial system will be very difficult, both substantively and politically.”

So what we have is a former head of the Treasury, and who still plays an outsized role in advising Obama administration policy-makers like Geithner, who does not understand how the Treasury works (or, for that matter, how the Fed works). It spends by crediting bank accounts; it taxes by debiting them; and any net spending by the Treasury (called deficit spending) adds to the nongovernment sector’s net income and wealth. There are no risks that would arise from additional stimulus; but there are huge risks of not doing enough. Rather than focusing on the budget deficit—which provides no information of importance to guide policy-makers—Rubin ought to be recommending policy that could create the 25 million or so jobs we will need to restore the nation’s health.
As to unwinding the Fed’s balance sheet, that will be done simply and following normal Fed operational procedures. That is the topic for the next blog, which will also examine Bernanke’s mea culpa.

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Prof. William K. Black on the Financial Crisis in the United States

Posted on November 10, 2009 by | 1 comment

Our own Prof. William K. Black delivered a presentation at the Corruption Forum 2009-University of Calgary.


See also the videos below.

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Selling Death: Wall Street’s Newest Bubble

Posted on September 7, 2009 by | 4 comments
When Wall Street’s commodities bubble crashed last year, I asked whether the next bubble might be in securitized body parts. Wall Street would search the world for transplantable organs, holding them in cold storage as collateral against securities sold to managed money such as pension funds. Of course, it was meant to be an apocryphal story about unregulated banksters gone wild. But as the NYT reports, Wall Street really is moving forward to market bets on death. The banksters would purchase life insurance policies, pool and tranch them, and sell securities that allow money managers to bet that the underlying “collateral” (human beings) will die an untimely death. You can’t make this stuff up.

This is just the latest Wall Street scheme to profit on death, of course. It has been marketing credit default swaps that allow one to bet on the death of firms, cities, and even nations. And the commodities futures speculation pushed by Goldman caused starvation and death around the globe when the prices of agricultural products exploded (along with the price of gasoline) between 2004 and 2008. But now Goldman will directly cash-in on death.

Here is how it works. Goldman will package a bunch of life insurance policies of individuals with an alphabet soup of diseases: AIDS, leukemia, lung cancer, heart disease, breast cancer, diabetes, and Alzheimer’s. The idea is to diversify across diseases to protect “investors” from the horror that a cure might be found for one or more afflictions–prolonging life and reducing profits. These policies are the collateral behind securities graded by those same ratings agencies that thought subprime mortgages should be as safe as US Treasuries. Investors purchase the securities, paying fees to Wall Street originators. The underlying collateralized humans receive a single pay-out. Securities holders pay the life insurance premiums until the “collateral” dies, at which point they receive the death benefits. Naturally, managed money hopes death comes sooner rather than later.

Moral hazards abound. There is a fundamental reason why you are not permitted to take out fire insurance on your neighbor’s house: you would have a strong interest in seeing that house burn. If you held a life insurance policy on him, you probably would not warn him about the loose lug nuts on his Volvo. Heck, if you lost your job and you were sufficiently ethically challenged, you might even loosen them yourself.

Imagine the hit to portfolios of securitized death if universal health care were to make it through Congress. Or the efforts by Wall Street to keep new miracle drugs off the market if they were capable of extending life of human collateral. Who knows, perhaps the bankster’s next investment product will be gansters in the business of guaranteeing lifespans do not exceed actuarially-based estimates.

If you think all of this is far-fetched, you have not been paying attention. From Charles Keating’s admonition to his sales staff that the weak, meek and ignorant elderly widows always make good targets, to recent internal emails boasting about giving high risk ratings to toxic securities, we know that Wall Street’s contempt for the rest of us knows no bounds. Those hedge funds holding CDS “insurance” fought to force the US auto industry into bankruptcy for the simple reason that they would make more from its death than from its resurrection. And the reason that most troubled mortgages cannot obtain relief is because the firms that service the mortgages gain more from foreclosure. It is not a big step for Wall Street and global money managers with big gambling stakes at risk to slow efforts to improve health. Indeed, it is easy to see some very nice and profitable synergies developing between Wall Street sellers of death and health insurers opposed to universal, single-payer health care. As AFL-CIO Secretary Treasurer Trumka recently remarked on NPR, we already have committees deciding when to cut-off care—the private health insurers decide when to deny coverage. It would not be in the interest of securities holders or health insurers to provide expensive care that would prolong the life of human collateral—a natural synergy that someone will notice.

It should be amply evident that Wall Street intends to recreate the conditions that existed in 2005. Virtually every element that created the real estate, commodities, and CDS bubbles will be replicated in the securitization of life insurance policies. If Wall Street succeeds in this scheme, it will probably bankrupt the life insurance companies (premiums are set on the assumption that many policyholders will cancel long before death—but once securitized, the premiums will be paid so that benefits can be collected). But it is likely that the bubble will be popped long before that happens, at which point Wall Street will look for the next opportunity. Securitized pharmaceuticals? Body parts?

Here’s the problem. There is still—even after massive losses in this crisis—far too much managed money chasing far too few returns. And there are far too many “rocket scientists” looking for the next newest and bestest financial product. Each new product brings a rush of funds that narrows returns; this then spurs rising leverage ratios using borrowed funds to make up for low spreads by increasing volume; this causes risk to rise far too high to be covered by the returns. Eventually, lenders and managed money try to get out, but de-levering creates a liquidity crisis as asset prices plunge. Resulting losses are socialized as government bails-out the banksters. Repeat as often as necessary.

Reform of the US financial sector is neither possible nor would it ever be sufficient. As any student of horror films knows, you cannot reform vampires or zombies. They must be killed (stakes through the hearts of Wall Street’s vampires, bullets to the heads of zombie banks). In other words, the financial system must be downsized.

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Financial Engineers and The Brave New World

Posted on August 4, 2009 by | Comments Off on Financial Engineers and The Brave New World
And some people say that no one saw this crisis coming. Bright people almost 10 years ago foresaw and understood the risks and consequences of private sector indebtedness and its relation to government surpluses.

by Warren Mosler and Eileen Debold

Just as the Corps of Engineers sustains the army’s fighting ability, our financial engineers have been sustaining the US post-Cold War economic expansion. Financial engineering has effectively supported an expansion that could have long ago succumbed to the ‘financial gravity’ economists call ‘fiscal drag.’ For even with lower US tax rates, the surge in economic growth has generated federal tax revenues in excess of federal spending. This has led to both record high budget surpluses and the record low consumer savings that is, for all practical purposes, the other side of the same coin. As the accounting identity states, a government surplus is necessarily equal to the non-government deficit. The domestic consumer is the largest component of ‘non-government’ trailed by domestic corporations, and non- resident (foreign) corporations, governments, and individuals.



It is our financial engineers who have empowered American consumers with innovative forms of credit, enabling them to sustain spending far in excess of income even as their net nominal wealth (savings) declines. Financial engineering has also empowered private-sector firms to increase their debt as they finance the increased investment and production. And, with technology increasing productivity as unemployment has fallen, prices have remained acceptably stable.

Financial engineering begins deep inside the major commercial and investment banks with ‘credit scoring.’ This is typically a sophisticated analytical process whereby a loan application is thoroughly analyzed and assigned a number representing its credit quality. The process has a high degree of precision, as evidenced by low delinquencies and defaults even as credit has expanded at a torrid pace. Asset securitization, the realm of another highly specialized corps of financial engineers, then allows non-traditional investors to be part of the demand for this lending-based product. Loans are pooled together, with the resulting cash flows sliced and diced to meet the specific needs of a multitude of different investors. Additionally, the financial engineers structure securities with a careful eye to the credit criteria of the major credit rating services most investors have come to rely on. The resulting structures range from lower yielding unleveraged AAA rated senior securities to high yielding, high risk, ‘leveraged leverage’ mezzanine securities of pools of mezzanine securities.

Private sector debt growth can only exceed income growth for a limited time, even if the debt growth is also driving asset prices higher. At some point the supply of credit wanes. But not for lack of available funds (since loans create deposits), but when even our elite cadre of financial engineers exhaust the supply of creditworthy borrowers who are willing to spend. When that happens asset prices go sideways, consumer spending and retail sales soften, jobless claims trend higher, leading indicators turn south, and car sales and housing slump. There is a scramble to sell assets and not spend income in a futile attempt to replace the nominal wealth being drained by the surplus. Consequently, as unemployment bottoms and begins to increase, personal and corporate income decelerate, and government revenues soon fall short of expenditures as the economy slips into recession. The financial engineers then shift their focus to the repackaging of defaulted receivables.

Both Presidential candidates have voiced their support for maintaining the surplus to pay down the debt, overlooking the iron link between declining savings and budget surpluses. For as long as the government continues to tax more than it spends, nominal $US savings (the combined holdings of residents and non-residents) will be drained, keeping us dependent on financial engineering to sustain spending and growth in the global economy.

Mr. Mosler is the chairman of A.V.M. L.P. and director of economic analysis, III Advisors Ltd. Ms. Debold is vice president, Global Risk Management Services, The Bank of New York.

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Another interesting piece, an interview of Professor L. Randall Wray, almost 9 years old saw the current crisis coming.

Q:Based on the current economic scenario, and taking into account the recent interest rates increases, how probable is the hypothesis of a “soft-landing” for the American economy?

LRW: It is highly improbable that an economic slowdown could stop at a “soft-landing”, given economic conditions that exist today. The U.S. expansion of the past half dozen years has been driven to an unprecedented extent by private sector borrowing. Indeed, the private sector has been spending more than its income in recent years, with its deficit reaching 5.5% of GDP in 1999. In order for the economy to continue to grow, this gap between income and spending must continue to grow. My colleague at the Jerome Levy Economics Institute, Wynne Godley, has projected that the private sector’s deficit would have to climb to well over 8% of GDP by 2005 in order to keep economic growth just above 2.5%. Even that is below the current rate of growth (about 4%). A smaller private sector deficit would mean even lower growth. There are two problems with this scenario. First, our private sector has never run deficits in the past as large as those experienced in this current expansion. In the past, private sector deficits reached a maximum of about 1% of GDP and then quickly reversed toward surplus as households and firms cut back spending to bring it below income. Not only are current deficits already five times higher than anything achieved in the past, they have already lasted two or three times longer than any previous deficits. Even more importantly, the private sector has had to borrow in order to finance its deficit spending, which increases its indebtedness. Private sector debt is already at a record level relative to disposable income. As interest rates rise, this increases what are known as debt service burdens—the percent of disposable income that must go to pay interest (and to repay principal) on debt. In combination with an economic slowdown, which reduces the growth of disposable income, many firms and households will find it impossible to meet their payment commitments. Defaults and bankruptcies are already on the rise, and things will only get worse. Thus, I believe there is a real danger that an economic slowdown could degenerate into a deep recession—or even worse.

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Wray also saw it coming (see here), as he put it:

How would Minsky explain the processes that brought us to this point, and what would he think about the prospects for continued Goldilocks growth?

First, I think he would argue that consumers became ready, willing, and able to borrow, probably to a relative degree not seen since the 1920s. Credit cards became much more available; lenders expanded credit to sub-prime borrowers; bad publicity about redlining provided the stick, and the Community Reinvestment Act provided the carrot to expand the supply of loans to lower income homeowners; deregulation of financial institutions enhanced competition. All of these things made it easier for consumers to borrow. Consumers were also more willing to borrow. As Minsky used to say, as memories of the Great Depression fade, people become more willing to commit future income flows to debt service. The last general debt deflation is beyond the experience of almost the whole population. Even the last recession was almost half a generation ago. And it isn’t hard to convince oneself that since we’ve really only had one recession in nearly a generation, downside risks are small. Add on top of that the stock market’s irrational exuberance and the wealth effect, and you can pretty easily explain consumer willingness to borrow.

I would add one more point, which is that until very recently, most Americans had not regained their real 1973 incomes. Even over the course of the Clinton expansion, real wage growth has been very low. Americans are not used to living through a quarter of a century without rising living standards. Of course, the first reaction was to increase the number of earners per family—but even that has allowed only a small increase of real income. Thus, I think it isn’t surprising that consumers ran out and borrowed as soon as they became reasonably confident that the expansion would last.

The result has been consistently high growth of consumer credit…The expansion might not stall out in the coming months, but continued expansion in the face of a trade deficit and budget surplus requires that the private sector’s deficit and thus debt load continue to rise without limit…What would Minsky recommend? So long as private sector spending continues at a robust pace, he would probably recommend that we do nothing today about the budget surplus. He would oppose any policies that would tie the hands of fiscal policy to maintenance of a surplus. Rather, he would push toward recognition that tax cuts and spending increases will be needed as soon as private sector spending falters. That means it is time to begin discussion of the types of tax cuts and spending programs that will be rushed through as the recession begins. For the longer run, he would recommend relaxation of the fiscal stance so that surpluses would be achieved only at high growth rates (in excess of the full employment rate of economic growth). For the shorter run, he would oppose monetary tightening, which would increase debt service ratios and push financial structures into speculative or Ponzi positions. He would support policies aimed at reducing “irrational exuberance” of financial markets; most importantly, increased margin requirements on stock markets would be far more effective and narrowly targeted than are general interest rate hikes that have been the sole instrument of Fed policy to this point. Most importantly, Minsky would try to shift the focus of policy formation away from the belief that monetary policy, alone, can be used to “fine-tune” the economy, and from the belief that fiscal policy should be geared toward running perpetual surpluses—in Minsky’s view, this would be high risk strategy without strong theoretical foundations.

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An Interview with Prof. L. Randall Wray

Posted on July 25, 2009 by | Comments Off on An Interview with Prof. L. Randall Wray
1- Historically, it seems the financial capital has a second wave from the 1970s. Peter Drucker referred the Pension Fund Revolution of the 1970s but it seems we have a convergence of trends, beginning with the closing of the gold window with Nixon and the progressive growing of a rent-seeking system gaining hegemony in the developed countries. Which fact or clustering of facts do you think are more symbolic of this shift?

Early last century, Hilferding identified a new stage of capitalism characterized by complex financial relations and domination of industry by finance. He argued the most characteristic features of finance capitalism is rising concentration which, on the one hand, eliminates ‘free competition’ through the formation of cartels and trusts, and on the other, brings bank and industrial capital into an ever more intertwined relationship. Veblen, Keynes, and, later, Minsky also recognized this new stage of capitalism: for Keynes, it represented the domination of speculation over enterprise while Veblen distinguished between industrial and pecuniary pursuits. Veblen, in particular, argued that modern crises can be attributed to the “sabotage of production” (or “conscientious withdrawal of efficiency”) by the “captains of industry”.

Much of this description of the finance capitalism stage can be applied to the current phase of capitalism—the money manager stage. Indeed, the intervening years, from the New Deal until the early 1970s, should be seen as an aberration. That phase of capitalism was unusually quiescent—the era of John Kenneth Galbraith’s “New Industrial State”, when the interests of managers were more consistent with the public interest. Unfortunately, the stability was interpreted to validate the orthodox belief that market processes are naturally stable—that results would be even better if constraints were relaxed. As New Deal institutions (broadly defined) were weakened, a new form of finance capitalism came to dominate the US and global economies. This is what Minsky called money manager capitalism—and what I am arguing is simply a return to finance capitalism. Finance capitalism is the normal version of modern capitalism. The Golden Age of capitalism was not normal.

2- Most of the analysts refer to a neo-liberalism approach dominant from the emergence of the monetarist school. But it seems – particularly since the end of the 1980s – that this second wave of the financial capital was driven by a “mix” of neo-keynesian and monetarist thoughts, an interesting new species in economic and financial though and ideology, whose “agent” of excellence was the Maestro Mr Greenspan. The acceleration of this second financial wave is “transversal” to Reagan and Clinton, to rightwing and left. Particularly at the end of Clinton Administration we saw the most important reversal of the legislative heritage from the 1930s. From a political-economic angle how we can deal with this “anomaly”?

In his new book, James K. Galbraith synthesizes Veblen’s notion of the predator with John Kenneth Galbraith’s new industrial state. The result is what the younger Galbraith terms the predator state. He argues the “industrial state”—related to Minsky’s notion of paternalistic capitalism– has been replaced by a predator state, whose purpose is to empower a high plutocracy that operates in its own interests. I link the Veblen/Galbraith notion of predators to the take-over of the state apparatus in the interest of money managers by neoconservatives (or what are called neoliberals outside the US). I wrote a piece on the neoconservatives, available as:
Public Policy Briefs August 2005 The Ownership Society Public Policy Brief No. 82, 2005, www.levy.org

Yes, I do agree that monetary policy was guided by a “new monetary consensus” that combined elements of monetarism, the old ISLM approach of “bastard” Keynesians, and the so-called New Keynesian approach. It supposedly put policy in the hands of the central bank and downplayed fiscal policy. I wrote about that in a brief available as:
Public Policy Briefs December 2004 The Fed and the New Monetary Consensus Public Policy Brief No. 80, 2004, www.levy.org

In reality, fiscal policy was still used, but in the interests of money managers. And now we know that the new monetary consensus policy never really worked. Monetary policy is in complete disarray.

3- Most of these “heroes” of the money manager capitalism, like Greenspan or Bernanke, thought that policies, particularly monetary manipulation and a growing rent-seeking system, can “moderate” the business or even the long cycles and that continuous growth was the perpetual horizon. This high qualified people has a weak memory from history?

Obviously, it was purely fantasy: the belief that the central bank can fine-tune the economy merely by controlling expectations of inflation. The central bank cannot control expecations, and it cannot control inflation. And, as everyone now recognizes, monetary policy has very little impact on the economy. That is why we have turned to fiscal policy. See my piece:
Public Policy Briefs March 2009 The Return of Big Government: Policy Advice for President Obama Public Policy Brief No. 99, 2009, www.levy.org

4- Which was the “Minsky moment” that triggered the present crisis? Which fact will you choose in 2007 to mark the bust of this crisis?

Hyman Minsky’s work has enjoyed unprecedented interest, with many calling this the “Minsky Moment” or “Minsky Crisis”. I am glad that Minsky is getting the recognition he deserves, but we should not view this as a “moment” that can be traced to recent developments. Rather, as Minsky had been arguing for nearly fifty years, what we have seen is a slow transformation of the financial system toward fragility. It is essential to recognize that we have had a long series of crises, and the trend has been toward more severe and more frequent crises: REITs in the early 1970s; LDC debt in the early 1980s; commercial real estate, junk bonds and the thrift crisis in the US (with banking crises in many other nations) in the 1980s; stock market crashes in 1987 and again in 2000 with the Dot-com bust; the Japanese meltdown from the early 1980s; LTCM, the Russian default and Asian debt crises in the late 1990s; and so on. Until the current crisis, each of these was resolved (some more painfully than others; one could argue that Japan never successfully resolved its crisis) with some combination of central bank or international institution (IMF, World Bank) intervention plus a fiscal rescue (often taking the form of US Treasury spending of last resort to prop up the US economy to maintain imports).

Minsky always insisted that there are two essential propositions of his “financial instability hypothesis”. The first is that there are two financing “regimes”—one that is consistent with stability and the other in which the economy is subject to instability. The second proposition is that “stability is destabilizing”, so that endogenous processes will tend to move a stable system toward fragility. While Minsky is best-known for his analysis of the crisis, he argued that the strongest force in a modern capitalist economy operates in the other direction—toward an unconstrained speculative boom. The current crisis is a natural outcome of these processes—an unsustainable explosion of real estate prices, mortgage debt and leveraged positions in collateralized securities in conjunction with a similarly unsustainable explosion of commodities prices. Unlike some popular explanations of the causes of the meltdown, Minsky would not blame “irrational exuberance” or “manias” or “bubbles”. Those who had been caught up in the boom behaved “rationally” at least according to the “model of the model” they had developed to guide their behavior.

Following Hyman Minsky, I blame money manager capitalism—the economic system characterized by highly leveraged funds seeking maximum returns in an environment that systematically under-prices risk. See my piece:
Public Policy Briefs April 2008 Financial Markets Meltdown Public Policy Brief No. 94, 2008, www.levy.org

With little regulation or supervision of financial institutions, money managers have concocted increasingly esoteric instruments that quickly spread around the world. Contrary to economic theory, markets generate perverse incentives for excess risk, punishing the timid. Those playing along are rewarded with high returns because highly leveraged funding drives up prices for the underlying assets—whether they are dot-com stocks, Las Vegas homes, or corn futures. Since each subsequent bust only wipes out a portion of the managed money, a new boom inevitably rises. However, this current crisis is probably so severe that it will not only destroy a considerable part of the managed money, but it has already thoroughly discredited the money managers. Right now, it seems unlikely that “business as usual” will return. Perhaps this will prove to be the end of this stage of capitalism—the money manager phase. Of course, it is too early to even speculate on the form capitalism will take.

5- Basle is obsolete?

Basle helped the money managers to create the conditions that led to collapse. I actually wrote in late 2005 that Basle II would generate financial fragility, and presented a paper in Brazil making that argument. It was published by the Levy Institute as:

Public Policy Briefs May 2006 Can Basel II Enhance Financial Stability? Public Policy Brief No. 84, 2006, www.levy.org

And it was also published in Portuguese in Brazil. Basle requirements operated on the belief that higher capital ratios would reduce risk; and further that greater market efficiency could be achieved by adjusting those ratios based on the riskiness of assets purchased. And, finally, it was believed that “markets” are best able to assess risk. In practice, larger institutions were allowed to asses the riskiness of their assets. We now know that failed completely—because all the incentive was for institutions to underestimate risks.

We must recognize, as Minsky did, that banking is a profit-seeking business that is based on very high leverage ratios. Further, banks serve an important public purpose and thus are rewarded with access to the lender of last resort and to government guarantees. What this means is that as soon as capital ratios decline toward some minimum (zero in the case of an institution subject only to market discipline, or some positive number set by government supervisors as the point at which they take-over the institution), management will “bet the bank” by seeking the maximum, risky, return permitted by supervisors. In any event, there is always an incentive to increase leverage ratios to improve return on equity. Given that banks can finance their positions in earning assets by issuing government-guaranteed liabilities, at a capital ratio of 5% for every $100 they gamble, only $5 is their own and $95 is the government’s. In the worst case, they lose $5 of their own money; but if their gamble wins, they keep all the profit. Imagine if you walked into a casino and the government gave you $95 to gamble with, for every $5 of your own—and you get to keep all the winnings. What would you do? Gamble! If subjected only to market forces, profit-seeking behavior would be subject to many, and frequently spectacular, bank failures. The odds are even more in their favor if government adopts a “too big to fail” strategy—although exactly how government chooses to rescue institutions will determine the value of that “put” to the bank’s owners.

Note that while the Basle agreements were supposed to increase capital requirements, the ratios were never high enough to make a real difference, and the insitutions were allowed to assess the riskiness of their assets for the purposes of calculating risk-adjusted capital ratios. If anything, the Basle agreements contributed to the financial fragility that resulted in the global collapse of the financial system. Effective capital requirement would have to be very much higher, and if they are risk-adjusted, the risk assessment must be done at arms-length by neutral parties. I think that if we are not going to closely regulate financial institutions, capital requirements need to be very high—maybe 100%. We used to have “double indemnity”: owners of banks were personally liable for twice as much as the bank lost. That, plus prison terms, would perhaps give the proper incentives.

6- Do you think we need a strict regulation of the financialisation of commodity markets (particularly oil) as Sarkozy, Gordon and the US regulator claimed, or this is a window for non-commercial investors that came to stay?

As implied above, any institution that has explicit or implicit government guarantees—either through deposit insurance or “too big to fail” policy absolutely must be closely regulated.

7- Do you think the sovereign wealth funds and the Asian banks from high liquidity countries (now the 3 top banks in capitalization are Chinese) will be dragged down by the crisis or they can lead a new financial capital wave?

No, I do not think they will lead a new financial wave over the next few years. There is little doubt that the Chinese economy will continue to become important and in the near future will displace the US economy as the largest in the world. It is certainly possible that its currency will eventually displace the dollar as the global reserve currency–but I think that is a long way off. I do not think it is even a role that the Chinese authorities would want right now. Finally, China uses markets where they work, but happily intervenes where markets do not fulfill the public purpose as defined by the government. Hence, I do not believe they would let their own domestic money managers “run wild” in the same way that the more market-oriented (neo-liberal) governments have done. After all, the Premier of China has no fear of being labeled a “socialist”–unlike President Obama!

Obviously, global financial losses are already huge, and will grow much larger over the coming years. Only the debt of sovereign nations is safe. Again, I hope, and expect, that we are seeing an end to this phase of finance capitalism. It will, of course, rise again—eventually. But with proper responses by governments around the world, we might be able to develop the conditions necessary for another “golden age”. Still, as Minsky said, stability is destabilizing so a golden age will allow finance capital to return. There is no “final solution” to the fundamental flaws of capitalism: an arbitrary and excessively unequal distribution of income and wealth, an inability to generate full employment, and a propensity toward financial instability.

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BIS Report Warns That Main Problems Have Not Been Solved

Posted on July 6, 2009 by | Comments Off on BIS Report Warns That Main Problems Have Not Been Solved

by Eric Tymoigne

The Bank for International Settlements (BIS) in its 79th Report makes several interesting points that are consistent with what has been argued on this blog. Echoing an argument made by William Black, the BIS notes that we must thoroughly analyze banks’ balance sheets in order to rebuild the financial system: “A major cause for concern is the limited progress in addressing the underlying problems in the financial sector . . . a precondition for a sustainable recovery is to force the banking system to take losses, dispose of non-performing assets, eliminate excess capacity and rebuid its capital base. These conditions are not being met. . . The banks must . . . adjust by becoming smaller, simpler and safer.”

The report also notes rightly that worries about “exit strategies” for current central banks’ policies are misplaced, because “even if central banks are not able to shrink their balance sheets, they can withdraw liquidity through repurchase operations or the issuance of central bank bills or by making it more attractive for banks to hold reserves.” As noted in previous posts by Scott Fullwiler and L. Randall Wray, there are straightforward means for a central bank to always meet its interest rate targets, and these strategies are not intrinsically inflationary.

The report also recognizes that “there must be a mechanism for holding securities issuers accountable for the quality of what they sell. This will mean that issuers bear increased responsibility for the risk assessment of their products.” The Report, however, does not go far enough in recognizing that some products should be banned even if used by “sophisticated” financial institutions. Not all financial innovations are a desirable sign of progress. This is especially so if they promote Ponzi finance, which should be a central criterion to judge the safety of a financial product and an institutional organization.

A final interesting point is the acknowledgement that price stability and economic growth are not guaranteed by fine-tuning policies, and that there is a need to manage financial stability. Indeed, the crisis has shown that price stability does not guarantee financial stability and that, contrary to what most economists believed until very recently (and some still believe), the fine-tuning of inflation by interest rates is of limited effectiveness. “The crisis has confirmed that the monetary and fiscal policy framework that delivered the Great Moderation cannot be relied upon to stabilize prices and real growth forever . . . policymakers must be given an explicit financial stability mandate and that they will need additional tools to carry it out.”

However, the way financial stability should be promoted is highly contentious. Most economists argue that the causes of financial instability are imperfections of markets (asymmetry of information, mispricing, etc.) or of individuals (lack of financial education, irrationality, etc.). Hyman Minsky provided a very different explanation of financial instability that did not rely on imperfections and bubbles but on the intrinsic mechanisms of market economies over a long period of economic growth. According to Minsky, over periods of long-term expansion, economic growth and the maintenance of competitiveness require the growing use of Ponzi finance. As a consequence, not only illegal and fraudulent activities, but also legal economic activities become financially fragile. He advocated policies that strongly discourage the use of Ponzi practices (e.g., tax incentives) and/or an outright elimination of legal and illegal Ponzi processes, no matter how necessary they may seem to be for the (short-term) improvement of standards of living and competitiveness. This, rather than improvements of risk-management techniques or improvements in the management of asset prices (detection and pricking of bubbles), would help to prevent financial instability. That would require a much more flexible regulatory system that includes all financial institutions and products, without any exception, and that constantly monitors innovations (i.e. new ways of using existing products or new products) to prevent the emergence of Ponzi processes.

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