naked capitalism

By Mark Ames, the author of Going Postal: Rage, Murder and Rebellion from Reagan’s Workplaces to Clinton’s Columbine. Cross posted from The eXiled.

Last week it finally started to dawn on the slow-as-Stegosaurs media: Why is Ron Paul going so soft on frontrunner Mitt Romney, his natural ideological opposite? Dr. Paul has been flaying every other candidate, particularly when that candidate threatens Romney’s front-runner status—why is Ron Paul so protective over internationalist/neocon Rockefeller Republican, Mitt Romney? Does this point to some sort of alliance between the two? And if so, doesn’t that raise further disturbing questions about the supposed rock-solid-principles guiding Ron Paul’s campaign?

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By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

In the old Soviet Union, Pravda, the official news agency, set the standard for “truth” in reporting. Discriminating readers needed to be adroit in sifting the words to discern the facts that lay beneath. Readers of The Economist’s “Special Report on Financial Innovation” (published on 23 February 2012) would do well to equip themselves with similar skills in disambiguation.

Faith Based …

The Economist sees financial innovation as positive; regarding it in the same sense as charity and goodwill to one’s fellow creatures. The reader is told that: “Finance has a very good record of solving big problems, from enabling people to realise the value of future income through products like mortgages to protecting borrowers from the risk of interest-rate fluctuations.” The definition of the “big problems” of our time is obviously subjective.

The Report lacks doubt: “The evidence of this special report suggests that the market does a brilliant job of nurturing and refining instruments that people want.” A closer review of the evidence suggests that the authors of the Report have followed Adlai Stevenson, the Democratic candidate for president in the 1952 and 1956 elections: “Here is the conclusion on which I base my facts.”

The approach is puzzling as the Report repeatedly admits the difficult of actually measuring the benefits of financial innovation: “… quantifying the benefits of innovation is almost impossible” and “To sift through the arguments on both sides is to confront a basic problem with any financial innovation: the difficulty of measuring its benefits.”

The Economist quotes a 2011 NBER paper by Josh Lerner and Peter Tufano which argues the impossibility of quantifying the impact of a financial innovation because finance involves many (often unintended) externalities. Instead the paper proposes a “thought experiment”, imagining what the world would look like without a particular innovation. The Report undertakes this thought experiment, without the requisite imagination and with a pre-disposition to the self evident benefits of finance.

In David Hare’s play The Power of Yes, Adair Turner, head of the English FSA, is asked whether the fact that nobody understood what was going on was an issue. Turner responds that no, it wasn’t a problem as, for people like Alan Greenspan, it was just a matter of faith. The Economist follows their mentor’s modus operandi.

Finance is as Finance Does….

Arguably, the function of finance is to match borrowers and savers, provide safe and secure payment mechanisms and also provide efficient tools for risk management. But the Report lacks a discernible working thesis as to what finance should do and how specific financial instruments, new and old, either do or do not further these objectives. Finance’s primacy is held by The Economist as another self evident truth.

Despite a self conscious mention of innovations in “microfinance products aimed at the very poor, social impact bonds, and all manner of whizzy payment technologies”, the focus is on “wholesale products and techniques”. This is because “they are less obviously useful than retail innovations and because they were more heavily implicated in the financial crisis”. The Report outlines the case for securitisation, credit default swaps (as an example of derivatives), exchange traded funds (“ETFs”) and high frequency trading (“HTF”).

The thesis is that all financial innovations are prima facie good and useful. Occasionally people push them too far and things go wrong. It is Alan Greenspan’s “irrational exuberance”. Excesses are the work of out-of-control “rogue traders”. The sub-text is that the products and system are fundamentally sound. Occasionally unavoidable accidents are always an acceptable cost of progress – collateral damage for greater good.

In 2008, defending deregulated markets, Greenspan stated: “You can have huge amounts of regulation and I will guarantee nothing will go wrong, but nothing will go right either.” This is the central premise of The Economist’s analysis.

Transference…

Techniques of risk transfer – securitisation (collateralised debt obligations (“CDOs”) and credit default swaps (“CDS”) – are good: “… even now it is hard to find fault with the concept [of the CDO], as opposed to the practical application, of many of the most demonised products.”

The defence of securitisation is: “[a CDO] is really just a capital structure in miniature”. In addition, “securitisation—which worked well for decades—allows banks to free up capital, enabling them to extend more credit, and helps diversification of portfolios as banks shed concentrations of risks and investors buy exposures that suit them”. Europe’s ill-fated and discredited adoption of CDO technology for its bailout fund (the European Financial Stability Fund) is the proof of concept, at least for The Economist.

While securitisation is not without benefits, the extension of the technique, for example, into re-securitisations (CDO2) created problems – as the Report readily accepts. However, the Report does not fully understand the true role and effects of securitisation.

While a CDO might be like a bank (a capital structure in miniature), it is unregulated. Securitisation for the last 15-20 years entailed shifting assets from banks to structure which reduced the amount of capital required, arbitraging regulatory capital requirements.

If a bank already held a loan funded with deposits, then in aggregate by selling the loan to the same depositors does not increase the supply of credit. The increase in credit is a function of the several things: (1) shifting risk into the shadow banking system; (2) alchemy (tranching) to create highly rated securities (AAA or AA) which acts as collateral to allow further re-leveraging; and (3) the ability to re-hypothecate the collateral over and over again, such as in re-securitisation.

The process increased leverage (crudely the capital against risk in reduced), model risk, liquidity risk, complexity and linkages via counterparty risk. It also moves risk from somewhere where it is highly visible to where it is less visible. In cutting and dicing risk, it encourages mis-pricing. It also creates difficulties in resolving problems – a delinquent loan is difficult to restructure when it no longer exists in its original form and different slices of the cash flows are held by different investors.

The case for securitisation also misses that banks sell off risk and then re-acquire it either directly through linkages with the shadow banking system or indirectly by financing investors secured against the securitised bonds created. Instead of actually assisting diversification, the entire process concentrates risk while simultaneously lowering the amount of capital and liquidity reserves held against the loans.

Recent research and enquiries have presented considerable evidence that CDOs were a direct contributing factor for the toxic phase of the asset bubble in US housing, commercial real estate and private equity market. But if The Economist is aware of these problems, then they are not covered in any detail.

The only problem with CDOs apparently was that “they were stuffed full of subprime loans but treated by banks, ratings agencies and investors as though they were gold-plated”. Given that sub-prime mortgages were only a part of the much larger CDO market, the wider fall in value of securitised debt and the losses must have been a collective hallucination.

Giving Credit…

After the expected Oxbridge cross Channel sneer at “choking Europeans”, the Report concludes that CDS contracts are “sound”. Sovereign CDS contracts perform “a useful signalling function”.

The only problem apparently is that banks sometimes sell protection on their own governments increasing their exposures to the sovereign. Given large banks dependence on the sovereign for their own existence, the absurdity of a bank insuring the nation’s risk collateralised by government debt is ignored.

CDS, if it is used as a pure hedge, can be useful. Over time, the market, led by dealers keen to make credit a tradeable commodity, has evolved differently. The major drivers of the market are the ability to short credit and take leveraged positions on bonds. In addition, the fact that CDS contracts are not limited by the availability of underlying bonds or credit assets (at the peak the CDS market was around 4/5 times the available underlying assets) has encouraged the growth of the market.

Standardisation of the contract to facilitate trading has created significant “basis risks” for hedgers. The recent restructuring of Greek debt, designed to specifically, avoid triggering CDS contracts, highlights the problems. A number of episodes over the last 4 years have highlighted documentary issues – trigger events and loss payouts – which cast serious doubts as to the utility of the contract.

Curiously, The Economist cites that fact that “conservative” India has recently given permission for CDS contracts to commence trading as proof of the utility of the product. The Report neglects to mention that approval was highly conditional, being designed to ensure that the only contracts traded were pure hedges of underlying positions.

In the film Casablanca, Rick (Humphrey Bogart) tells Captain Renault (Claude Rains) that he came to the city “for the waters” because of his health. Informed that they are in the desert, Rick ironically rejoinders that he was “misinformed”. The Economist as well as investors and banks, including those who purchased Greek sovereign CDS to protect themselves against the risk of default, may have been similarly misinformed.

ETF….

Exchange Traded Funds (“ETF”) are a hoary old chestnut, a listed and tradeable version of an index fund; hardly a revolutionary “innovation”. As the Supplement notes the absolute size of the ETF market is also relatively modest compared with estimated global assets under the control of fund managers.

Vanguard founder John Bogle might take justifiable issue with the statement that ETFs “allow retail investors access to diversified portfolios of assets that had previously been the sole preserve of institutional investors”. Mr. Bogle founded the Vanguard 500 Index Fund as the first index mutual fund available to the general public in 1975, more than a decade before ETFs.

Argument and analysis is replaced by over energetic prose – “finance’s infectious creativity”; “vibrancy looks like a victory for the investor over the fund manager”; “It is in the nature of finance that experimentation never stops.”

ETFs are “good”, reducing transaction costs and increasing efficiency. The Report notes criticism of ETFs – counterparty risk to delaers where funds use derivatives to replicate exposure to the underlying assets. Closer reading of the IMF report on ETFs suggest deeper concerns that do not merit mention – the market impact of simultaneous trend following trading by ETFs and “innovations”, such as leveraged and other versions.

There is no discussion of a key underlying issue – the idea of diversification. The Economist argues that “the dotcom bust had underscored the importance of diversification”.

Diversification to reduce risk is not without problems. As equity indexes are weighted typically by market capitalisation, as an individual share price rises it becomes a larger part of the index and therefore the ETF. During manic market phases, such as the dot com and now the AGF (Apple Google Facebook) boom, ETF investors may inadvertently find them heavily exposed to such stocks.

In asset classes such as debt, the idea of indexation is more problematic. As the indexes are weighted by the amount of bonds on issue, as an issuer borrows more it becomes a larger part of the ETF, irrespective of its ability to make repayments. As Worldcom and more recently European sovereign debt shows, the results are not pretty.

While successfully managing the portfolios of an insurance company and the King’s College endowment, Keynes insisted that diversification was flawed: “To suppose that safety…consists in having a small gamble in a large number of different [stocks] where I have no information…as compared with a substantial stake in a company where one’s information is adequate, strikes me as a travesty of investment”. Mark Twain’s Pudd’nhead Wilson would have agreed: “Put all your eggs in one basket, and watch that basket.”

HFT….

The Economist sides with the high frequency trading (“HFT”) practitioners who are “frustrated by what they perceive as an unfair onslaught”. The Report resorts to tried and tested rhetoric – HFT is difficult to define; there is not enough data. But these factors present no barrier to the conclusion reached that “high-frequency traders provide liquidity and ‘knit’ together our increasingly fragmented marketplace, resulting in tighter spreads that benefit all investors” (citing testimony delivered to the Securities and Exchange Commission in 2010 by George Sauter of Vanguard, a big fund manager).

Liquidity and lower transaction costs only benefits an investor when they trade. High liquidity and tight bid-offer spreads are only available, as all practitioners know, when it is not needed, becoming the first casualties of market downturns and volatility. Market-making needs adequate compensation for the risk assumed. Forcing return below sustainable levels encourages dealers to boost revenue from proprietary trading (often using the information gained from client activity) and trading structured products, creating different risks.

The Report ignores the real problems of HFT – the problems of potential market manipulation, insider trading, front running client flows and increased market volatility often at critical times. The Economist cannot imagine a world without HFT which is “an “outcrop” of the market structure”.

High trading volumes are regarded as normal and desirable. In the zero sum game of trading, the presence of super fast computers copulating with other super fast machines provides uncertain benefits in financial intermediation.

Average investment periods for shares have shortened from around 7 years to 7 months since 1940. HFT now accounts for over 60% of equity trading, with an average holding period of around 11 seconds. High levels of trading may create excessive “noise” preventing prices from reflecting true value, ultimately leading to a loss of confidence in certain markets discouraging investment. HFT may damage the process of long term capital accumulation and allocation.

Collateral Damage …

The Report believes that collateral is problematic “the whirring of financiers’ minds … spells trouble” but confusingly sees it is as also breeding innovation. The discussion may remind the reader of an observation of Groucho Marx: “A child of five would understand this. Send someone to fetch a child of five”.

The use of collateral contributed significantly to the financial crisis. Secured lending, collateralised by securities, including high quality bonds especially created through securitisation, contributed to the increase in debt. It allowed a shift of focus from repayment ability based on income and cash flow to the value of the asset securing the borrowing. As debt fuelled a virtuous cycle of price appreciation it allowed the level of debt to increase rapidly.

The process relies on a steady and unending rise of debt and prices – a Ponzi scheme, in effect. It also relies on the ability to trade and the liquidity of markets. Unfortunately, the virtuous cycle turns vicious when the supply of debt ceases and prices fall.

The system creates exposure to short term price fluctuations as the amount of collateral required varies. It effectively amplifies the broader financial problems of funding short and lending long.

Collateral also facilitates access to derivative markets for less credit worthy counterparties.

The problems of Bear Stearns’ hedge funds, AIG and Lehman all can be traced, in different degrees, to the system of collateral. Unfortunately, those unlikely to be able to meet demands for payment are unlikely to be able to meet collateral calls – a fact which financial institutions and their regulators failed to understand.

At a broader level, collateral underlies the entire shadow banking system, which proved so problematic during the crisis.

Left Unsaid…

Mistakes of commission are compounded with errors of omissions.

The Report notes that risk transfer may encourage excessive risk taking and lending. It identifies that the illusion of stability may cause instability, an idea first put forward by economist Hyman Minsky (who does not gain a mention).

The systemic side effects of financial innovation are barely recognised. Financial innovation played a crucial role in allowing the increase in debt levels and leverage. It created complex linkages between financial participants increasing systemic risk and informational failures.

The appropriate size of some markets, such as for over-the-counter derivative, is not considered. The Economist points to interest-rate swaps “which are used to bet on and hedge against future changes in interest rates, as an example of a huge, well-functioning and useful innovation of the modern financial era”.

Interest rate derivatives (including interest rate swaps) are about 70% of total derivative outstanding on $600 trillion, which equates to over $400 trillion roughly 6 or 7 times global GDP and a significant multiple of all financial assets in existence. Daily currency turnover is between 30 and 50 times trade flows.

Derivative volumes are inconsistent with pure risk transfer. The necessity for or utility of such high trading volumes does not figure in the discussion.

A quaint economic concept – cost benefit analysis -. weighs the benefits of any actions against the costs. Unable to identify the benefits accurately by their own admission, the Report decides to ignore costs arguing: “Even bad ideas are not a problem when they first arise. If only a few people get burned by a duff product, the wider world need not care”.

Given the high cost of failure of financial innovations as evidenced by the significant and ongoing costs of global financial crisis, the case for financial innovation, at least of many of the products cited, may fail on cost-benefit grounds. Defenders of financial innovation have a high burden of proof to overcome.

Super Smarts…

The Economist fails to understand the real motivations of financial innovation. They believe that: “Products … mutate constantly, in part because patenting is not common”. Citing Franklin Allen of the Wharton School at the University of Pennsylvania and Glenn Yago of the Milken Institute, wholesale financial innovation, they argue, is the creation of new capital structures that align the interests of lots of different parties.

In practice, the major alignment of interests relates to getting a deal done to enable the bankers to receive substantial bonuses based on mark-to-market values of the product. The profit frequently does not fully recognise the long term consequences or risks to either the client or the financial institution.

Confusing bankers with saintly figures in line for beatification, the Report approvingly cites Goldman Sach’s Martin Chavez who explains that innovation is in response to the “clients call”… We can’t tell them ‘no thanks’.” This, undoubtedly, is “doing God’s work”, which the head of the firm once stated was its primary mission.

It is difficult to reconcile this position with statements by another Goldman Sachs’ employee Fabrice Tourre, who sold the Abacus deals to unwitting “widows and orphans”. Among tender emails to his girlfriend Serres, the self-styled “Fabulous Fab” observed in January 2007: “More and more leverage in the system. The whole building is about to collapse anytime now?.?.?.? Only potential survivor, the fabulous Fab[rice Tourre] standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!”

Tourre stated that Abacus was “pure intellectual masturbation”, “a ‘thing’ which has no
purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price”. But Tourre was not assailed by self-doubt: “Anyway, not feeling too guilty about this, the real purpose of my job is to make capital markets more efficient and ultimately provide the U.S. consumer with more efficient ways to leverage and finance himself, so there is a humble, noble, and ethical reason for my job :) amazing how good I am in convincing myself!!!”

Stéphane Mattatia, Société Générale’s global head of equity flow engineering and advisory, told The Economist of a hedge based on the Euro falling and gold rising for a client worried about French CDSs. Of course, SG managed to lose Euro 5.9 billion through its inability to hedge its own risk on positions taken by rogue trader Jerome Kerviel. If the client was concerned about positions in French CDS, wouldn’t it have been just easier to close out its existing position rather than enter into a complex, potentially expensive and illiquid instrument?

There is no acknowledgement that much of what is called financial innovation is economic rent extraction, exploiting lack of transparency as well as information and knowledge asymmetries. There is no discussion of the destructive bonus culture which encourages certain behaviours in financial institutions. Thomas Philippon and Ariel Reshef have estimated that around 30-50% of the extra pay bankers received compared to similar professionals is attributable to economic rents.

In a January 2009 speech, Lord Adair Turner, chairman of UK’s Financial Services Authority, observed that: “Much of the structuring and trading activity involved in the complex version of securitized credit was not required to deliver credit intermediation efficiently, but achieved an economic rent extraction made possible by the opacity of margins and the asymmetry of information and knowledge between…users of financial services and producers…financial innovation which delivers no fundamental economic benefit, can for a time flourish and earn for the individuals and institutions which innovated very large returns.”

The unpalatable reality that few, self interested industry participants and their cheerleaders are prepared to admit is that much of what passes for financial innovation is specifically designed to conceal risk, obfuscate investors and reduce transparency. The process is entirely deliberate. Efficiency and transparency is not consistent with the high profit margins on Wall Street and the City. Financial products need to be opaque and priced inefficiently to produce excessive profits. The Report does not canvas this issue.

Fixing It ….

The Report makes prescriptions for strengthening financial innovation – protection of investors, more capital, improved operational procedures and stronger regulators. The solutions are familiar dictums which have been tried before with limited success. As former New York Federal Reserve President Gerald Corrigan told policy-makers and financiers on 16 May, 2007: “Anyone who thinks they understand this stuff is living in lala land.”

The problem of protecting investors arises because of the difficult in “judging the sophistication of a client”. Not only retail investors, it seems, need protection. The Report approvingly quotes a regulator: “A German Landesbank should be treated like a child”.

The risk management problems of “sophisticated” firms (Citibank, UBS, Lehman, Bear Stearns, Merrill Lynch and Long Term Capital Management (whose numbers included Myron Scholes and Robert Merton as well a large number of highly trained financiers)) suggest that most of the industry have not reached pimply adolescence let alone sage maturity. Given a tendency to self harm, most industry participants need protection from each other and themselves. Regulatory initiatives may need to encompass preventive detention for all parties.

In the last 20 years, capital held by banks and brokers against loss fell, increasing leverage. The definition of capital was expanded to include hybrid capital, debt ranking below deposits and senior borrowings. Cheaper than normal equity, hybrids avoided dilution of existing shareholders. Increases in debt and leverage reflected “improved financial flexibility…the results of massive improvements in technology and infrastructure”, according to regulators. Banks’ liquidity reserves, designed to cover withdrawal of deposits, were reduced, freeing up money for lending.

The risks were ignored. Alan Greenspan argued: “The lack of a spare tire is of no concern if you do not get a flat.”

The prescription for higher capital and liquidity reserves has been tried before. Each capital regime promises more stringent control, but is ruthlessly arbitraged. This time around a fragile global economy means the willingness to compromise the integrity of the financial system for greater credit fuelled growth will be difficult to avoid.

In his review of the global banking crisis, Lord Adair Turner noted that: “An underlying assumption of financial regulation in the U.S., the UK and across the world has been that financial innovation is by definition beneficial, since market discipline will winnow out any
unnecessary or value destructive innovations. As a result, regulators have not considered it their role to judge the value of different financial products, and they have in general avoided direct products regulation, certainly in wholesale markets with sophisticated investors.”

Regulators may always lag markets and financial institutions in knowledge, experience and pay. Regulatory capture ensures over time the loss of oversight and control. History suggests that the next time will not be different.

Realpolitik…

Given its reputation, the weaknesses of The Economist’s Special Report are disappointing.

Information on the issues is all in the public domain. There are a plethora of reports, such as Financial Crisis Inquiry Commission Report, the Turner Report etc, which explore financial innovation and the financial crisis. There is also, I understand, a relatively new innovative Internet-based tool – the “search engine” – with could have been used by The Economist to check and research such facts.

In recent stories and reports, The Economist has presented an increasingly strident defence of bankers and their ‘City’ as well as resistance to regulation of the financial system.

Professor Simon Johnson has pointed repeatedly to one cause of the financial crisis – the political economy of the financial system and the lobbying power of financial institutions. If the press becomes part of this political economy, consciously or subliminally, then the problems are exacerbated. Advertising and sponsorship revenues as well as control over access to information and key decision makers, deemed news worthy, are essential commercial links which make newspapers and media susceptible to being influenced.

Zdener Urbanek, the dissident Czech novelist, observed that assumptions about what was written are dangerous: “In dictatorships…. We believe nothing of what we read in the
newspapers and nothing of what we watch on television, because we know it’s propaganda and lies. Unlike you in the West. We’ve learned to look behind the propaganda and to read between
the lines and, unlike you, we know that the real truth is always subversive.”

There is an important and necessary debate about financial innovation but it is not to be found in The Economist’s Special Report on the subject.

By Cathy O’Neil, a data scientist who lives in New York City and writes at mathbabe.org

A bit more than a week ago I went to a panel discussion at the Met about the global financial crisis. The panel consisted of Paul Krugman, Edmund Phelps, Jeffrey Sachs, and George Soros. They were each given 15 minutes to talk about what they thought about the Eurocrisis, especially Greece, the U.S., and whatever else they felt like.

It was well worth the $25 admission fee, but maybe not for the reason I would have thought when I went. I ended up deciding something I’ve suspected before. Namely, economists don’t understand the financial system, and moreover they don’t get that they don’t get it. Let me explain my reasoning.

The panelists all were pretty left-leaning guys, and each of them talked about how the U.S. government should stimulate the economy in one way or another. Krugman kept saying that hey, this isn’t too hard, we’ve seen financial crises before, and this is no different: we should immediately pass a massive stimulus package, that’s the one and only thing that we should be discussing. Sachs was very consistently saying we should do something else: namely, start planning long-term for the future. He focused on the percent of tax dollars going into infrastructure and basic education and research. Phelps also wanted stimulus, but he consistently referred to his own economic models in how exactly it should work. I didn’t completely follow his train of thought.

Soros was the most interesting of the four, in my opinion. He started by saying that we should all acknowledge that, as nice as it would be to think we can model the economy and feel control over the situation, this is a pipe dream and we should get used to not really knowing what will happen when we do one thing versus another. He suggested that we should instead work together to develop a theory, or perhaps even an philosophy, that assumes uncertainty itself. He ended by saying that, even with the three colleagues on the panel with him, who are essentially all united in thinking we need to be proactive, his ideas are essentially being ignored.

The rest of the evening essentially consisted of everyone ignoring Soros and arguing about how Keynesian they all were and how exactly different kinds of stimulus would work and which way they should use 2% of GDP to jumpstart the world’s economy. So basically exactly what Soros said would happen.

It got me more and more riled up. Here are these expert economists, two of whom have Nobel Prizes and the third who runs the Earth Institute at Columbia and is considered a huge swinging dick in his own right, and they don’t seem to acknowledge how much power they actually have over the situation (specifically, not much). For that matter, they clearly don’t know the nitty gritty of the financial system. To listen to them, all you need to do is spread a thick paste of money on the system and it would revive whole cloth. Soros is the exception, probably for the reason that he actually traded and made money inside the system.

At the end I asked a question, since they allowed a few questions, and as you know I’m not shy. I asked how we are going to make the system simple enough to actually make it possible to regulate it. Krugman basically said that Dodd-Frank is going to do it. My conclusion from that is that Krugman must really have only an outline in his head of how this stuff works- the devil, as we know, is really in the detail, and I’m too acquainted with the Volcker Rule’s list of exemptions to have a lot of hope on this score. To be fair, Phelps mentioned Amar Bhide’s book A Call for Judgment, which I’m reading and seems pretty good and at least addresses this exact issue head-on.

Overall, the evening brought me back to the credit crisis, and working at D.E. Shaw, when Larry Summers was consistently quoted at the firm as saying that the “magical liquidity fairy” needed to come and “spread some magical liquidity dust” in the markets to make everything better. No, I’m not kidding.

What I felt then and what I still feel is that these super influential economists are so high on their clean, simple economic models of the world (about the only variables of which are GDP, stimulus, and tax rates) that they focus on the model to the exclusion of the secondary issues. Sometimes you get important results this way: simplifying models can be really useful. But sometimes it’s really truly misleading to do so, and I believe this is one of those cases.

I’m left thinking that they (the economists) are so entranced with their simplified world view that still don’t understand what actually fucked up the world in 2007 and 2008, namely the CDO market’s implosion. Message to Krugman: this is not exactly like other financial crises, because it’s partly caused by complexity, and nobody seems to have the balls to fix it. The problem is that the financial system has been allowed to get so complicated and so rigged in favor of the people with information, that normal people, including homeowners, credit card users, politicians, and regulators have been left in the dark, and many of the little guys are still stuck in ludicrous contracts left over from the outrageous securitizations that took place in the CDO market.

What is especially enraging is how these same economists are still the experts that people turn to to help figure out how to get out of this mess, when they don’t actually understand the mess itself. Why else would a large audience be willing to pay $25 a piece to hear them talk about this? Why else would Obama be considering Larry Summers to lead the World Bank?

As an aside: please, Mr. President, do not let Summers lead the World Bank. He does not understand the system well enough to lead it. And he is too arrogant to admit what he doesn’t know. I can introduce you to a bunch of people that may be less imposing but are more informed, more ethical, and wiser. Give me a call any time and we can chat and form a short list of candidates.

By the way, I’m not saying we shouldn’t have a major stimulus, or that we shouldn’t do longer term planning and invest more in infrastructure. I think we should do both. But I also think those efforts will be futile unless we enforce a basic system that is simple enough to be regulated. Otherwise we will be reliving this entire ordeal in another 15 years.

I wonder at what age people born on February 29 decide that having a real birthday only one year in four is no biggie.

New evidence suggests Stone Age hunters from Europe discovered America Independent (hat tip Lambert)

Google offers 1 million dollars to Chrome hackers Nation (hat tip reader furzy mouse)

Safety Alerts Cite Cholesterol Drugs’ Side Effects New York Times. I recall, not that long ago, doctors declaring statins to be so safe that they wanted to add them to the water supply!

Bill Gates’ support of GM crops is wrong approach for Africa Seattle Times (hat tip reader furzy mouse)

Gloom, doom — and Lester Brown’s ‘Plan B’ Japan Times

A brief history of the time Stephen Hawking went to a sex club: University says physicist visited California swingers’ club with friends Daily Mail. This from a hedgie reader who will go unnamed.

Corseted Minds: Does Fear of Irrelevance Send Conservative Men Fleeing to the Victorian Age? Lynn Parramore, Alternet

Wikileaks Reveals Privately Run CIA’s Dirty Secrets (Update 2) Gizmodo (hat tip reader May S)

Rachel Marsden: New WikiLeaks stash: a frightening view of government intelligence Chicago Tribune

Wikileaks emails indicate Stratfor discovered Israel already destroyed Iran’s nuclear facilities Raw Story (hat tip reader Amit). As we indicated, Haaretz reported on this yesterday.

Exploding the myth of the Iranian Bomb Spiked (hat tip reader May S)

U.S. Cuts Iran Cash Pipeline Wall Street Journal. With as much offshore banking as there is and people like Marc Rich very much around, I suspect the headlines exaggerate the achievement.

We won’t give US advance warning of Iran strike, says Israel Independent (hat tip Lambert)

Hi, I’m from the IMF. I’m here to help. MacroBusiness

ECB’s Second Three-Year Loan May Be Last Bloomberg

Europe banks hungry for second helpings Financial Times

Phone-hacking will be the single largest corporate corruption case for 250 years because ‘cover up’ went up ‘to the very highest levels, says MP Daily Mail (hat tip reader May S).

Manchester, Liverpool and Birmingham becoming ‘no-go areas’ because of drugs gangs… just like Mexico and Brazil says the UNITED NATIONS Daily Mail (hat tip reader May S)

Virginia Says No to Lawless Imprisonment David Swanson

Ayn Rand Worshippers Should Face Facts: Blue States Are the Providers, Red State Are the Parasites Alternet (hat tip reader furzy mouse)

Democracy Alliance Pulls Support for Organizations that Don’t Play Ball Dave Dayen, Firedoglake (hat tip reader Carol B). More veal pen in action.

Why I do not like small cap stocks much at the moment John Hempton

Lawmakers To The Rescue? Legislation Filed To Fix “Ibanez” Foreclosure Title Defects Massachusetts Law Blog. Reader Deontos does not like the look of this.

Fannie Mae, Freddie Mac, and the MBS sleeper defense Alison Frankel (hat tip reader Deontos). Bye bye FHFA putback suits?

So, how can bankers live with themselves? Guardian (hat tip reader John L)

Antidote du jour:

It’s bad enough that we are being subjected to relentless propaganda about how housing is just about to turn the corner and the state-Federal mortgage settlement is such a great deal for homeowners. In fact, as we’ve stressed, and bond investors such as Pimco have reiterated, the deal is above all a back door bailout of the banks. Bloomberg weighed in yesterday:

Bank of America Corp., Wells Fargo & Co. and three other banks that settled a nationwide probe of foreclosure practices this month will get a bonus from the deal: protection for $308 billion of home-equity loans they hold…

It’s “a gift to the banks, at investors’ expense,” said Goodman, a member of the Fixed Income Analysts Society’s Hall of Fame. “A proportionate write-down of the first and second represents a reversal of normal lien priority.”

But to add insult to injury, the chump public will be given bread and circuses enforcement theater to distract it from the fact that the banks are getting a sweetheart deal.

The show is already on the road. The Financial Times tells us that Wells Fargo and Goldman have reported that they have received so-called Wells notices, which is an advanced warning that the SEC staff plans to file civil charges. SEC is pursing firms that it believes misrepresented the quality of loans that were bundled and sold as mortgage backed securities.

This all sounds great, right? Wrong. Take a look at your calendar.

The toxic phase of subprime issuance started in the late summer-early fall of 2005 and screeched to a halt in June 2007. But the statute of limitations for securities liability is five years. So the ONLY deals the SEC can pursue now are the last gasp transactions of March- June 2007, and on those, the clock is ticking. Those were particularly dreadful and no doubt would provide some colorful anecdotes, but who are we kidding? The SEC has sat on its hands until an election year need to Look Tough will lead to a filing of a few random lawsuits to rough up the usual suspects. But the reality is that the horses have left the barn and are now in the next county.

Contrast this with the flailing about on MF Global. From the New York Times, emphasis ours:

Federal authorities are struggling to find evidence to support a criminal case stemming from the collapse of MF Global, even after a federal grand jury in Chicago has issued subpoenas.

Investigators, unable to find a smoking gun amid thousands of e-mails and documents, increasingly suspect that chaos and poor risk control systems prompted the disappearance of more than $1 billion in customer money, according to several people involved in the case.

Have none of these people heard of Sarbanes Oxley? This sort of failure falls right in its crosshairs. As we wrote a year ago:

Contrary to prevailing propaganda, there is a fairly straightforward case that could be launched against the CEOs and CFOs of pretty much every US bank with major trading operations. I’ll call them “dealer banks” or “Wall Street firms” to distinguish them from very big but largely traditional commercial banks like US Bank.

Since Sarbanes Oxley became law in 2002, Sections 302, 404, and 906 of that act have required these executives to establish and maintain adequate systems of internal control within their companies. In addition, they must regularly test such controls to see that they are adequate and report their findings to shareholders (through SEC reports on Form 10-Q and 10-K) and their independent accountants. “Knowingly” making false section 906 certifications is subject to fines of up to $1 million and imprisonment of up to ten years; “willful” violators face fines of up to $5 million and jail time of up to 20 years.

The responsible officers must certify that, among other things, they:

(A) are responsible for establishing and maintaining internal controls;
(B) have designed such internal controls to ensure that material information relating to the issuer and its consolidated subsidiaries is made known to such officers by others within those entities, particularly during the period in which the periodic reports are being prepared;
(C) have evaluated the effectiveness of the issuer’s internal controls as of a date within 90 days prior to the report; and
(D) have presented in the report their conclusions about the effectiveness of their internal controls based on their evaluation as of that date;

These officers must also have disclosed to the issuer’s auditors and the audit committee of the board of directors (or persons fulfilling the equivalent function):

(A) all significant deficiencies in the design or operation of internal controls which could adversely affect the issuer’s ability to record, process, summarize, and report financial
data and have identified for the issuer’s auditors any material weaknesses in internal controls; and
(B) any fraud, whether or not material, that involves management or other employees who have a significant role in the issuer’s internal controls

The premise of this requirement was to give assurance to investors as to (i) the integrity of the company’s financial reports and (ii) there were no big risks that the company was taking that it had not disclosed to investors.

This section puts those signing the certifications, which is at a minimum the CEO and the CFO, on the hook for both the adequacy of internal controls around financial reporting (to be precise) and the accuracy of reporting to public investors about them. Internal controls for a bank with major trading operations would include financial reporting and risk management.

It’s almost certain that you can’t have an adequate system of internal controls if you all of a sudden drop multi-billion dollar loss bombs on investors out of nowhere. Banks are not supposed to gamble with depositors’ and investors’ money like an out-of-luck punter at a racetrack. It’s pretty clear many of the banks who went to the wall or had to be bailed out because they were too big to fail, and I’ll toss AIG in here as well, had no idea they were betting the farm every day with the risks they were taking.

The nice thing about Sarbox is a lower risk civil filing can lead directly to a criminal case on the same issues. And based solely on news reports, there seem to be at least two general routes that could be pursued with MF Global. The first is the abject risk management failure that got them in the mess in the first place, the infamous “repo to maturity” trade on short-term Italian government debt. The fact that this was Corzine’s trade, and that he levered it up, and had no apparent understanding that it would be subject to a collateral posting requirement if the price of the debt move against him by more than 5% is managerial incompetence. Either MF Global’s risk management systems were deficient (which means his Sarbox certifications were false) or he overrode them, making them deficient (the fact that he got rid of one manager who insisted on briefing the board about the trade and reduced the independence of his successor supports that idea).

Second is the customer funds that went poof. This has never never never happened to a broker dealer or commodities broker ex fraud. Even in Refco’s embezzlement, accounts were transferred to new firms without a hitch. The media has repeatedly discussed how the staff was not sure of what was happening in the panic to save the firm. I’m sorry, but other firms have faced liquidity crises and the resulting high trading volumes as customers closed out trades and accounts without “accidentally” pilfering customer funds (start with Bear, which went down in a mere ten days). A trading firm needs to be robust enough to handle market turmoil and panicked trading and unexpected calls for collateral, both from a balance sheet and systems standpoint; that should be obvious after September-Octover 2008.

If no one can make an argument for prosecution on deficient controls using Sarbox in a case this egregious, that’s because no one is trying very hard. And that is no surprise.

As we’ve discussed the “where’s the note?” problem of mortgage securitizations, some readers who are old enough to have sold a home more than once have said that while they’d gotten a cancelled mortgage note back on their first sale, on a more recent one, they hadn’t. They were concerned, and as this post will show, they are right to be.

By way of background, the popular press has done the public a disservice by talking about “mortgages”. A “mortgage” consists of two instruments: a promissory note, which is a IOU, and a lien against the property, which is referred to as a mortgage (in non-judicial foreclosure states, they are typically called a deed of trust and confer somewhat different rights, but we’ll put that aside for purposes of this discussion).

What appears to be happening on all too often in Florida is that when borrowers signed warranty deeds in lieu of foreclosure when they can no longer keep these homes, they often get only a satisfaction of mortgage, not a cancelled note. This is not what is supposed to happen. When a borrower deeds his property to the bank, the objective of the exercise is to cancel the debt. If the note has not been extinguished, it is referred to as a “zombie note”. As the Fort Myers News-Press reported last year:

Carol Kaplan, a spokeswoman for the Washington-based American Bankers Association, said leaving the note off the satisfaction of mortgage is “not a practice we’ve ever heard of.”

Turns out that’s a bit disingenuous. The article quoted Jack Williams, resident scholar at the American Bankruptcy Institute and a bankruptcy professor at Georgia State University:

“We saw something very similar to this in the debacle in the ’80s, people buying notes from the government and suing,” Williams said. “I won’t rule out that could happen again. They sold the note to collection agencies and law firms and places like that.”

In the real estate meltdown of the ’80s, he said, it was the Resolution Trust Corp., set up by the federal government to liquidate mortgage loans and other real estate assets held by failed savings and loan associations.

“Let me tell you, people made millions of dollars suing homeowners back in the day,” Williams said.

Some of the debt was in the form of deficiency notes: court judgments saying a certain amount was owed even after the property was sold at public auction.

But in other cases, Williams said, it was the note, straight up.

Even though the lawyers who’ve taken note of this practice are in Florida, the ground zero fo the foreclosure crisis, it is important to stress that anything that is happening in one state on a meaningful basis in securitized mortgages is very likely to be happening elsewhere. The securitizations were set up to be widely dispersed geographically and the servicers have set up their procedures to be as standardized as possible even with the differences in real estate law across states. If borrowers aren’t getting notes back in Florida, it’s quite probable that that is occurring in other states.

Xiomara Cruz, a Coral Springs attorney who has taken an interest in this topic, sent a warning to fellow lawyers:

I have seen in dozens if not hundreds of foreclosure suits allegedly “settled” for properties in Florida, MOST only include language satisfying the mortgage BUT DO NOT INCLUDE SPECIFIC CANCELLATION/SATISFACTION of the promissory Note. So that in essence your client just got a Release of Mortgage and nothing else.

I hate these tactics being used against consumers, the recording system and the judiciary. It is wrong. Regular people are being conned. Judges are being conned. Even many lawyers are being conned. The words “mortgage loan” and “mortgage” are being used by Fannie, Freddie, all Servicers, Banks as if they were interchangeable with ‘debt’ and ‘NOTE’ when the foreclosure mills walk into court or settle for their ‘clients’. Yet, when you ask the mills or the banks, servicers, Fannie, Freddie to put their money where their mouth is, all of a sudden its “we only made an agreement to settle the foreclosure suit, we dismissed with prejudice, we filed a satisfaction of mortgage, we can’t back to sue you” That is serious BOLOGNA and I don’t mean the capital city of Emilia-Romagna!

The very inherent INTENT of every borrower entering into a settlement is to cancel the debt, otherwise what good is to settle to give back the collateral willingly? Filing the satisfaction of mortgage only helps the banks, servicers, and Fannie/Freddie obtain clear title so they can sell it and make more money after already getting fat with interest for years, servicing fees, selling ‘beneficial rights’ to receive monthly payments, but not selling the actual underlying note. This situation gets horribly worse because if the note is left outstanding, it can be used upon by anyone else who obtains that note in the flow of commerce. A suit on the note is left open.

And she reports in a later message to me that servicers and even judges don’t take well to being pushed on this issue:

When this happened to my client, he immediately raised the flag requesting specific performance in the underlying foreclosure suit. However, the bank voluntarily dismissed the foreclosure action with prejudice while the motion for specific performance was pending hearing (which had already been set) and the judge ceded to the bank’s voluntary dismissal. He then hired me specifically after a year of calling everyone from members of congress to the OCC to the AG to obtain the cancelled note back because no one would give it him back to him marked cancelled. The bank and Fannie stated through their attorneys, over and over in every instance before our suit, that they never promised him anything else but a dismissal of the foreclosure suit and a satisfaction of mortgage, and he got a dismissal with prejudice. Long story short, its still there, the circuit judge dismissed all counts of the unfair consumer practices, unfair debt collection practices, with prejudice and although he really wanted to couldn’t dismiss with prejudice the breach of contract, specific performance counts but dismissed them without prejudice and with leave to amend “because he didn’t like some of the WHEREFORE clauses”.

This story borders of Kafkaesque. Yet Cruz is not being unreasonable. 25 years ago, an attorney who did not demand the cancelled note in satisfaction of a mortgage would have been considered grossly negligent. And the risk is not theoretical. Professor Williams described how people were defrauded in the wake of the S&L crisis when notes that should have been cancelled got into the wrong hands. April Charney had just seen a case on a 2008 foreclosure where the ex parte order returned the original note to the plaintiff/servicer. The hapless borrower is now being sued by the private mortgage insurer. PMI was typically used to insure the LTV over 80% on high LTV loans. In in the subprime market, lenders bought mortgage insurance on loans and paid the premiums themselves (via the trust) rather than have the premiums paid by the borrower, as is the more traditional structure.

Tom Adams suggested that this issue probably arose when the insurer would have had no direct relationship with the borrower but would have been at risk to the loan defaulting. But regardless, this is an ugly business, and serves as a reminder to homeowners: if your friendly servicer asks you to deviate from a long-established practice, your assumption should be that it is for a very good reason, and that reason is for their benefit, not yours.

By Philip Pilkington, a journalist and writer living in Dublin, Ireland

Vote or die muth#%#^*#, muth#%#^*# vote or die,
Rock the vote or else I’m gonna stick a knife through your eye,
Democracy is founded on one simple rule,
Get out there and vote or I will muth#%#^*# kill you.

– P. Diddy ‘Vote or Die’

The Irish Taoiseach Enda Kenny has announced that a referendum will be called so that the Irish people can vote on the new and oh-so-suicidal fiscal compact. If it is voted for Ireland will be subject to years of harsh austerity. Nothing new there. But, perhaps worst of all, if the vote goes through this austerity will crush the Irish economy into ruin wearing the mask of democratic consent.

Last week we reported murmurings coming from within the opposition party calling for a referendum. The senior opposition party adviser that I spoke to indicated that he might try to push for a referendum, calling the fiscal compact “madness”. Fair enough, we’re all agreed there. But this was probably a political manoeuvre plain and simple.

The opposition thought that they could have a few swipes at the government by questioning the democratic legitimacy of their decisions. But apparently the government have called their bluff and agreed to hold a referendum.

My reading is that the government are perfectly confident that they can push the vote through. The Irish people are against austerity, but they have a vague inclination that ‘There Is No Alternative’. The government are confident that they can play on this fear in order to push the public into voting the way they want them to.

The previous government did something similar with the Lisbon Treaty. The Irish people had originally voted it down much to the annoyance of the Eurocrats, so the Irish government repackaged it and made people vote again. They then launched a massive campaign scaring people into thinking that if they didn’t vote ‘Yes’ to the treaty they would see mass unemployment in the country. The campaign was called ‘Yes to Lisbon, Yes to Jobs’.

In Ireland at the time people joked around that we had voted ‘wrong’ last time and that we must now vote ‘right’ this time. Many people who had voted ‘No’ to the original treaty either did what they were told because they believed the government’s blatant lies about the link between the Lisbon Treaty and Irish employment or they simply stayed at home on voting day. Most people I know who voted ‘No’ the first time around were too cynical to vote a second time, resenting the fact that they were being treated like children by their government.

The PR campaign that was launched during the Lisbon campaign was carried by most major media outlets, most businesses and most political parties. Put simply, almost the entire Irish elite got behind it. The voices pointing out the hypocrisy of having the Irish people vote twice on the same issue were drowned out in a flood of misleading soundbites and ideological op-eds that poured forth from almost every outlet.

With the coming referendum on the fiscal compact the government and the media will ramp up the rhetoric to an even higher pitch. We already see business groups and major political parties coming out in support of the fiscal compact.

What’s more, the government won’t have to lie this time around. They will be able to quite honestly say that if the Irish people don’t vote the compact through our funding will be cut off. This will be far more effective than he nonsense they tried last time linking Irish employment to the Lisbon Treaty – and remember, even that worked when it was shoved down peoples’ throats at the time.

Put simply: this isn’t a real vote because no one in their right mind would vote for their own suicide. If the Irish people do dare to vote against the fiscal compact they will be told to vote again and battered with ever more serious threats (no doubt backed by European leaders who will come up with all sorts of awful things they will do to us if we don’t accept the terms). The democratic legitimacy gained by the vote will then be used in the coming years to justify the slow and painful death that our economy will be subject to.

After this referendum the Irish people will be seen to have made a real decision and will be said to have no reason to complain. This reminds me of an old point of logic.

A mugger approaches a man in a dark alley points a gun at him and says “Your money or your life”. Of course, the mugger is being dishonest because if the man refuses to fork over the cash the mugger will shoot him and take the money anyway. So, he really has no choice – if he doesn’t give over the money he will lose both his money AND his life.

Ireland will soon be put in a similar position. We will be given the false choice to either vote for immediate economic destruction or gradual economic destruction. No prizes for guessing what we’ll choose. And afterwards commentators and politicians will insist that we have no right to complain; after all, we handed over the money voluntarily… right?

To Get at Treats, This Dingo Uses Tools Discover (hat tip reader Robert M)

Japan Weighed Evacuating Tokyo in Nuclear Crisis New York Times. Holy shit.

Engine room fire leaves cruise ship adrift off Seychelles Yahoo (hat tip Lambert)

Google Search Engine Software goes ‘Chemistry’ Nature (hat tip reader furzy mouse)

Dogs’ feet give Japan scientists paws for thought Reuters (hat tip Lambert)

Co­lo­ni­al­ism in Africa helped launch the HIV epidemic a century ago Washington Post (hat tip Lambert)

Gordon Gekko tells Wall St greed is not good Financial Times. A little late, no?

Five Key Developments Including Vote on Greek Deal 2.0 Credit Writedowns

Police cover-up of phone hacking revealed to Leveson inquiry Guardian (hat tip Buzz Potamkin)

Can China avoid the middle-income trap? MacroBusiness

Threatened Goldman Japan Workers Unionize Japan Times (hat tip DAH)

Israel, Kurdish fighters destroyed Iran nuclear facility, email released by WikiLeaks claims Haaretz (hat tip Lambert). So we can all make nice now, right?

Taiwan bubble set to burst MacroBusiness

Buffett: Banks Victimized by Excesses of Ousted Homeowners Bloomberg. Buffett makes clear he is either completely shameless or does not understand the difference between a servicer and an investor. Well, given that he also says, “The banking industry is back on its feet,” when that is due solely to the munificence of the great unwashed public, I think we know which is at work.

AIJ Tokyo Asset Management: Billions In Customer Funds Are Missing Jesse. From last week but still noteworthy.

Upper classes ‘more likely to lie and cheat’ Telegraph (hat tip reader Swedish Lex). Another reason to promote a more equal distribution of income. It keeps people honest.

Early customers find Boots closed Mid Sussex Times (hat tip Richard Smith). Aaaw, how cute!

The SEC Mulls An Investigation Calls Grow For John Boehner To Resign Politics USA (hat tip reader furzy mouse)

Walker Won’t Contest Signatures in Wisconsin, Recall Virtually Assured Dave Dayen, Firedoglake

There Was No Bowles-Simpson Commission Report Dean Baker (hat tip Lambert via Atrios)

MASSiVE insider SeCReT dealing scheme with STRATFOR and G Sachs, maybe [Updated] FT Alphaville. The Stratfor response is silly.

Dividing Dimon? Analyst Offers Case for a JPMorgan Split New York Times

Banks Win Reprieve on Home Equity Loans in Settlement: Mortgages Bloomberg (hat tip reader Brian). You read it here on Feb. 6.

Pity the Poor Judges Cynthia Kouril, Firedoglake (hat tip reader Carol B)

BONY-Countrywide Settlement Removal Reversed by 2d Circuit Adam Levitin, Credit Slips (hat tip reader Deontos)

For the Costliest Homes, Foreclosure Comes Slowly Wall Street Journal. And here we keep being told it’s the borrowers’ fault that foreclosures take so long.

Federal judge weighs whether to let regulators rein in oil speculators McClatchy (hat tip reader Paul T)

Bending the Tax Code, and Lifting A.I.G.’s Profit Andrew Ross Sorkin, New York Times

YoBucko talks money for 20-somethings McClatchy (hat tip Lambert)

Eviction of Occupy London Begins: Livestream Firedoglake :-(

Antidote du jour:

There has been so much news on the mortgage beat the last few weeks that I managed to neglect one of my missions, which is my personal Ben Stein watch on Adam Davidson, who operates as the Lord Haw Haw for the 1% in his column in the Sunday New York Times Magazine.

His latest piece, “Why Are Harvard Graduates in the Mailroom?” is more accurately titled “In Praise of Exploitation.” When you strip his argument down, it amounts to: “A lot of people choose to be exploited, and voluntarily take jobs where they are paid less than they deserve because they hope to be big winners.” As in really big winners. Davidson repeatedly compares the payoffs to various activities (working the the mail room at William Morris, being a low level drug dealers, acting, working in a law firm or investment bank) to a lottery.

The lottery analogy, which Davidson uses through the entire piece, is wonderfully, nails-on-the-chalkboard screechingly at odds with his claim: “That’s the spirit of meritocratic capitalism!” Lotteries involve random, blind draws of “lots”. Modern lotteries, the kind that plug holes in government deficits, are such astonishingly low odds affairs that they are described as “a tax on people who are bad at math.” So Davidson appears to be telling us that success in modern capitalism is painfully unlikely and pretty much random.

And there are ample proofs that meritocracy is a fantasy. A devastating 1992 paper by Patrick D. Larkey and Jonathan P. Caulkin, “All Above Average and Other Unintended Consequences of Performance Appraisal Systems,” declared that 100 years of dealing with performance review systems proved they were inherently unable to produce objective results. Among the reasons: the complexities of the boss-subordinate relationship, the fact that virtually all performance appraisals are subjective (even ones of salesmen should allow for who has better or worse territories), and that it is pretty much impossible to devise sensible ways to compare staff caliber across departments. When I was a young person on Wall Street, getting comp right was management’s most important job, and at Goldman, they spent the better part of six weeks of the year on it.

Or consider the example portrayed in Michael Lewis’ book Moneyball. The baseball industry has always measured players’ skill and achievements by a handful of well-known statistics. To make the most of a limited budget, Oakland A’s general manager Billy Beane relied on statistical analysis to sign low-salaried players that appeared to be dramatically undervalued. The result: The team, with one of baseball’s lowest payrolls, has placed first or second in its division for eight seasons running.

Remember: baseball is a business where the recruiting is unusually transparent, the basic rules have remained unchanged for decades, competitive encounters are in full view, and the incentives for success are high. This would seem to be the perfect environment for developing good rules for hiring and promotion, yet the entire industry was largely wrong.‘

And that’s before we get to the role of good old fashioned bias. A 1997 Nature paper by Christine Wenneras and Agnes Wold, “Nepotism and Gender Bias in Peer-Review,” determined that women seeking research grants need to be 2.5 times more productive than men to receive the same competence score. Similarly, Tom Ferguson has combed though the data sets underlying a recent study claiming that the executive ranks of large firmswere meritocratic, and the underrepresentation of “out groups was due to their lack of skills. Ferguson found that the distribution suggested otherwise: ethnic groups are in fact over-concentrated in a few pockets, when they should be scattered evenly if merit selection dominated.

And another part of the fantasy that Davidson and other status quo apologists exploit successfully is the desperate need to believe the system is fair. As Stanford neuroscience professor Ben Barres (who knows more than a bit about discrimination, having formerly been Barbara) noted, citing research:

When it comes to bias, it seems that the desire to believe in a meritocracy is so powerful that until a person has experienced sufficient career-harming bias themselves they simply do not believe it exists.

Another intelligence-insulting aspect of this article is how Davidson force fits all sorts of different jobs into the same simple-minded generalization. One of the reasons some career paths have extreme power law payoffs is lots of people are willing to do the work for no or little pay because it is creative and intrinsically enjoyable (at least for some people). Writing and the visual and performing arts fall into this category. By contrast, as Frank Partnoy’s book FIASCO made clear, highly paid derivative salesmen hated the work and all said they’d do anything else, including haul garbage, if they could make anything resembling the money they were earning.

Not that we should fell sorry for the aspiring partners or equivalents in accounting, consulting, investment banking, or the law that Davidson weirdly equates with drug dealers or mail room boys looking to leap into a professional role. Those jobs are all well paid to very well paid. The hours are typically exploitative, but the young’uns are also learning a trade, as well as how to manage clients, not just doing scut work. And unlike the mail runners who never get their break, the downside for people in banks or professional firms who don’t make it to the very top are usually very handsome. Indeed, a not trivial number opt out into better careers than if they had stayed with their firm and had made it to the top.

So Davidson misleads in suggesting that a normal organizational pyramid, or the more Darwinian “up or out” version of law, accounting, and consulting firms, is a “lottery” when the upside and downside payoffs of those career paths are very attractive, as contrasted with the typical payoffs of trying to be a professional performing artist (for instance, a woman I know who majored in dance and had gotten hired as a ballerina had to turn to stripping to pay off her school debts).

But there is one way in which Davidson’s lottery metaphor is apt. A 2008 study found that poor people spent a whopping 9% of their incomes on the lottery. I’ve read various theories as to why, most of them of the moralizing “aren’t they dumb/irresponsible” subtext. But as someone who once in a great while buys a lottery ticket (only when it is a rational bet after taxes, and that occurs very rarely when the pots are super huge, and even then, with the predictable lack of success), the explanation that seems most plausible is that the wager allows them to engage in some pleasant fantasizing, just as shelter and vacation magazines do for the more affluent (you can argue that this fantasizing comes at a high cost, but people who are poor need their pleasures too, and there are worse choices than lottery tickets).

So unintentionally, Davidson’s lottery metaphor is apt for those who aren’t on the fast track: exploiting people’s tendency to dream to get them to accept economic propositions that are hopelessly stacked against them. And his insistently cheerful tone tells us we should recognize that this is all for the best in this best of all possible worlds.

__________________

I must report that Davidson did e-mail me after one of my salvos at him, but I chose not read his message. If he would like to take issue with one of my posts, he is free to do so in my comments section. I do correct posts pronto if I have made a mistake or misconstrued an argument or data. Felix Salmon argues, and I concur, that one of the values of the blogosphere is that participants can engage in conversations in public, and it forces everyone to sharpen their discourse.

By Matt Stoller, the former Senior Policy Advisor to Rep. Alan Grayson and a fellow at the Roosevelt Institute. You can reach him at stoller (at) gmail.com or follow him on Twitter at @matthewstoller.

I went through the Federal Reserve’s Quarterly Release on Household Debt and Credit released today, and there were two notable trends.  One is that the amount of consumer debt is declining, but that delinquency rates are stabilizing above what they were before the crisis.  And the second is in this graph, which is that the number of people subject to third party collections has doubled since 2000, from a little less than 7% to a little over 14% of consumers.  Ten years ago, one in fourteen American consumers were pursued by debt collectors.  Today it’s one in seven.

The experience of debt collection can be chilling, as this 2007 ABC News report suggests.

Consumers around the country have taped threatening phone calls from collectors who have called in the middle of the night, used abusive language and have threatened to have people fired from work or thrown in jail.  All of these tactics are illegal under federal law.

One of the characteristics of the new social contract ushered in by both George W. Bush and Barack Obama is the increasing power of creditors to govern outright, from tax farming by banks to the use of credit checks to access employment opportunities.

There are now thousands of people legally jailed because they aren’t paying their bills, ie. debtor’s prisons have returned.  Occasionally elites let it slip that this is not an accident, but is their goal – former Comptroller General David Walker has wistfully pined for debtor’s prisons overtly (on CNBC, no less).

This may be somewhat mediated by government action, as the CFPB is beginning to make noise around debt collection and credit ratings, and Illinois Attorney General Lisa Madigan is working to stop debt-related arrest warrants.  But only somewhat, only where the government can protect you and only when there is the political will to do so.  Increasingly, creditors are coming to set up the institutional structures for financial surveillance, state-sponsored enforcement of their claims through tightened bankruptcy laws and the selective use of jail, and the denial of economic opportunity based on one’s interaction with the financial system.

This is part of the new social contract.  The sheer percentage of consumers with third party collections in pursuit is striking.  Additionally, the uptrend through both Bush boom and Obama bust years of the percentage of people being tracked down by third party collection agencies suggests we live in a different country than we did just ten years ago.

Again, ten years ago, one in fourteen Americans were pursued by debt collectors.  Today it’s one in seven.  I suspect this number will keep going up.  And though debt collection is a highly competitive field, it’s also a growth industry.

By Philip Pilkington, a journalist and writer living in Dublin, Ireland

I prefer the company of peasants because they have not been educated sufficiently to reason incorrectly.

– Michel de Montaigne

The so-called ‘games’ depicted in game theory include some particularly disingenuous and evasive intellectual constructions. In times past people devised rationalisations in the most fantastic of ways, summoning up imaginary demons, angels, witches and warlocks to contextualise their psychological and existential difficulties. Today, some turn instead to mathematical games.

Long ago our ancestors constructed mythological systems wherein the world was a place inhabited by mystical and animistic forces. Those who summoned these forces generally lived in close proximity, giving immediate presence to magic and intrigue. Religious systems came later. These were more abstract and impersonal; the leader-figure no longer lived nearby and miracles became increasingly rare and valued.

After some time the more “civilised” and organised societies began to create more rational theologies. By fusing the key structural aspects of the religions with certain metaphysical principles, great systems were constructed that vied with one another for authority.

It was all imagination of course. All of these systems were just ways that men made sense of the world around them. These great mythic, religious and theological systems were just rationalisations used to organise and lend authority to otherwise arbitrary social institutions. The most important and probably most primal among these institutions was marriage, which we will have ample occasion to return to in what follows.

The Age of Enlightenment came next and with it the more fantastic products of the human imagination were dissolved into the bland homogeneity of Reason. The Enlightenment philosophers described social relations primarily in terms of equality – an obvious value judgment on their part. The world was not an equal or a harmonious place, but the Enlightenment philosophers pretended as if it were and concocted their ideological systems accordingly. To look back on the crass oversimplifications these men came up with – many of which continue to haunt us today – is an exercise in both entertainment and caution.

Those that did raise issues of conflict and change – like Hegel and Marx – quickly veneered over them with vast metaphysical and teleological systems that assured us all that society was moving from point X to point Y. The imbalances, they both thought, would be levelled by History – an unstoppable moving force that would reduce all to complete equality and homogeneity.

Today the great leveller is ‘The Market’. And neoclassical economics is the great metaphysical system that supports it. The Market, we are assured, is moving to a state of harmony and equilibrium – an equality in the sense that everybody will be content, of course (they will have their ‘utility maximised’).

What characterised the later metaphysical systems however – modern economics included – was that they banished the relations they were trying to describe to the margin, only to take them up by applying to them pre-constructed systems of reasoning. While marriage – which we take again because it is, as the anthropologists well know, the primal social institution – is absolutely central to social organisation it is completely ignored in the latter day systems. Whereas it occupied a central role in the older systems, it is only dealt with by the later systems by applying pre-established principles (marriage is a utility-maximisation operation; marriage will be unnecessary under Communism etc.).

But every now and then these more primal social relationships bubble up in the new doctrines. And when they do the effort to force fit them into the new construct is far from convincing.

Sexual Politics

Back to game theory. Why do we claim that it is so evasive? Because it nakedly displays the nature of the material it deals with and then denies that it is indeed this material that it is dealing with. Game theory sets up ‘games’ between certain personalities and then claims that the players have no personalities.

The ‘Battle of the Sexes’ game is perhaps the most outlandish example of this. The game, as we will see, is blatantly a psychological construction set up to assuage the theorist that he has a perfectly rational means with which to understand his/her interpersonal relationships. The theorist sets up a game that deals with a difficult interpersonal marital issue and then tries to solve it with various mathematical formulas. When this psychological dimension is pointed out to the game theorist they vigorously deny it, claiming that it is only a ‘pure’ mathematical game and says nothing about his or her conception of their own interpersonal relationships; this even though they have explicitly labelled this game ‘the battle of the sexes’ and allowed the participants’ relationship to be that of an intimate couple.

Here’s how the game works. We have a man and a woman. We assume that they are in a long-term relationship, most likely married. The man wants to go to a football game and the woman wants to go to the opera. They both want to go somewhere together, so they will not simply go their separate ways to their desired event.

Game theorists see two so-called equilibrium points. One is that the couple go to the football game; the other is that they go to the opera. The game theorists then tie themselves in knots trying to figure out probabilities and equitable solutions. They torture themselves when they find that in order for equilibrium to be obtained one ‘player’ has to lose. They introduce bizarre tropes to equalise this, one being a ‘randomising element’ – in other words the couple agree to flip a coin to see which event they will attend.

What a pile of garbage!

Let’s say I’m writing a script or a story wherein such a circumstance arises. Do I break out my game theory book and do some calculations in order to decide how to move the plot forward? Of course not. Instinctively – based largely on empirical experience and common sense – I would argue that there are only two probable outcomes to this so-called ‘game’:

(1) The person assuming the masculine role submits and the couple attend the opera.

(2) The person assuming the masculine role remains recalcitrant, the ‘game’ breaks down and the couple go home.

Yes, there is a certain amount of stereotyping undertaken here. Yes, some people negotiate their relationships differently. And the answer in real life probably depends in particular how extreme one partner’s aversion is to the other’s choice.

But when dealing with this sort of material we’re always dealing with stereotypes and ‘averages.’ Anyway, they can be modified later if we wish. For now, let us just try to tease out some of the underlying structure.

The ‘game’ will not stop there. Two new ‘scenes’ arise organically from both these outcomes:

(1) After the opera the couple return home and have an, erm, romantic evening.

(2) The couple have a temporary falling out. The person assuming the masculine role then make amends and possibly gives the person in the feminine role a gift.

Again, these do not follow from each other in some quasi-mathematical or pre-determined manner, but they form a coherent narrative. They are realistic and convincing representations of the so-called ‘game’.

Before moving on to the implicit rules structuring this so-called ‘game’ let us note a few things:

(1) As we will see, the ‘game’ is not based on a relationship of strict equality. We cannot interchange the two ‘players’ with one another without changing the outcome (for a given ‘player’). Their position vis-à-vis one another determines the potential outcomes of the ‘game’. Their positions are thus not static, but relational.

(2) The relational positions of the two players are implicitly structured by ‘external’ rules that must be taken into account before establishing how the ‘game’ will be ‘played’.

(3) The ‘game’ does not have to result in so-called ‘equilibrium’. It can easily break down. We can assume that an infinite and unknowable amount of variables ‘plug in’ to the ‘game’ in order to determine the outcome. Everything from the mood of the two ‘players’ to the nature of the events that they may attend must be taken into account. These elements are 100% unknowable prior to being empirically established and even then they are probably impossible to pin down.

Let us now move onto the implicit rules structuring the so-called ‘game’. Again, we will have to engage in some pretty heavy stereotyping here but such is the nature of the material. Different ‘games’ could easily be constructed taking into account different personal or cultural ‘rules’. Our exposition is merely to try to provide a deeper understanding of what really determines the outcome of such ‘games’ and why game theory is a pointless and absurd device for even trying to approach this sort of thing.

Rules of the Game

So, let’s say that our little narrative appears convincing. Yes, it is almost crassly stereotypical and would not apply to every couple under the sun, but let’s accept it as a ‘model case’ of sorts. What are the structuring principles that lead to the outcome of our so-called game?

When boiled right down this is implicitly an issue of debt. The key rule structuring the ‘game’ is that the player assuming the masculine role is always already in debt to the player assuming the feminine role. There is no need for us here to try to understand why this is the case, we will merely hint that it probably has to do with certain marital/sexual institutions and norms in Western culture (again, and we must stress this: these are not universal).

This ‘indebtedness’ is the key element that leads to the possible outcomes of the game. Either the player in the masculine position plays ‘by the rules’ or the game breaks down. This means that the ‘game’ starts out from a position of inequality rather than equality. Indeed, the implicit argument here is that any ‘game’ that is set up will always start out from a position of inequality and the very idea of a ‘game’ that begins from a position of equality is a mere fantasy. It is the dimension of debt – a burden of debt, as it were – that enforces this inequality at a structural or institutional level.

The ‘game’ thus has no ‘equilibrium’ position. Instead it should be seen as a relationship of force based upon given rules. The rules allow the game to potentially have a sociable but not immediately equitable outcome. Without the rules the ‘game’ would merely break down into bickering. Of course, if force is pursued outside the rules by the player in the masculine position the game will fall apart anyway. So, while the rules give the game a path through which it can be resolved in a fairly sociably acceptable way they do not pre-determine the outcome of the game.

Does this make the game a zero-sum game plain and simple? Does this mean that the player in the masculine position always ‘loses’? No. Recall that we have already alluded to what other outcomes the game would likely have in the medium-run. By reaching a socially equitable compromise – albeit one that they are not particularly pleased with – the player in the masculine position will likely get a ‘payoff’ eventually. It is also likely that said player is quite consciously aware of this.

Because the outcomes of the game run throughout time and are the basis of a relationship that cannot be said to be constantly ‘in balance’, it should not be thought of in terms of equilibrium. There is no static equilibrium. There are simply relations of force structured within social rules or norms. Again, this is not to imply that this is an institutional structure that is completely unstable. Instead it should be seen as an institutional structure that, being constantly out of balance, requires that the participant constantly negotiate various forces that threaten to destabilise the entire structure.

Of course, when you strip away all the fancy language the point being made is rather simple: relationships – all human relationships – never tend toward some sort of fantasy ‘equilibrium’ position. Rather, they are inherently mired in power-imbalances and compromise formations or rules that allow these imbalances to be navigated. Most of the time the compromise formations (or: rules) hold; but sometimes when the power-imbalances become too pronounced and the entire structure of the relationship breaks down.

Arrested at a very primitive level of psychological development game theory cannot even begin to approach this. Indeed, one would be better trying to derive lessons about the real world from a consultation with a fortune-teller or a shaman – they tend to be more subtle psychologists.

Game theorists will, of course, tell me that I have cheated and misrepresented them. “We only play ‘pure’ games,” they will protest. “These are not supposed to be applied to real people with real psychologies in real institutional settings.” If the reader cares to look over the series of ‘games’ that the theorists set up – replete as they are with characters ranging from star-struck lovers to nefarious crooks – and finds the game theorists’ defence to be a credible one then they can happily discount my argument.

For my part, I don’t believe this defence for a second. It is quite obvious what the game theorists seek to do, constructing their little islands of Reason amidst the great sea of indeterminacy and change in which we all exist. Perhaps, indeed, we all need something to hold on to amidst such chaos and tumult. But surely we can do a little better than this crude child’s play that the game theorists have concocted.

By Michael Hudson, a research professor of Economics at University of Missouri, Kansas City and a research associate at the Levy Economics Institute of Bard College

I have just returned from Rimini, Italy, where I experienced one of the most amazing spectacles of my academic life. Four of us associated with the University of Missouri at Kansas City (UMKC) were invited to lecture for three days on Modern Monetary Theory (MMT) and explain why Europe is in such monetary trouble today – and to show that there is an alternative, that the enforced austerity for the 99% and vast wealth grab by the 1% is not a force of nature.

Stephanie Kelton (incoming UMKC Economics Dept. chair and editor of its economic blog, New Economic Perspectives), criminologist and law professor Bill Black, investment banker Marshall Auerback and me (along with a French economist, Alain Parquez) stepped into the basketball auditorium on Friday night. We walked down, and down, and further down the central aisle, past a packed audience reported as over 2,100. It was like entering the Oscars as People called out our first names. Some told us they had read all of our economics blogs. Stephanie joked that now she knew how The Beatles felt. There was prolonged applause – all for an intellectual rather than a physical sporting event.

With one difference, of course: Our adversaries were not there. There was much press, but the prevailing Euro-technocrats (the bank lobbyists who determine European economic policy) hoped that the less discussion of possible alternatives to austerity, the easier it would be to force their brutal financial grab through.

All the audience members had contributed to raise the funds to fly us over from the United States (and from France for Alain), and treat us to Federico Fellini’s Grand Hotel on the Rimini beach. The conference was organized by reporter Paolo Barnard, who had studied MMT with Randall Wray and realized that there was plenty of demand in Italian mass culture for a discussion of what actually was determining the living conditions of Europe – and the emerging financial elite that hopes to use this crisis as an opportunity to become the new financial lords carving out fiefdoms by privatizing the public domain being sold off by governments that have no central bank to finance their deficits, and are tragically beholden to bondholders and to Eurocrats drawn from the neoliberal camp.

Paolo and his enormous support staff of translators and interns provided an opportunity to hear an approach to monetary and tax theory and policy that until recently was almost unheard of in the United States. Just one week earlier the Washington Post published a review of MMT, followed by a long discussion in the Financial Times. But the theory remains grounded primarily at the UMKC’s economics department and the Levy Institute at Bard College, with which most of us are associated.

The basic thrust of our argument is that just as commercial banks create credit electronically on their computer keyboards (creating a bank account credit for borrowers in exchange for their signing an IOU at interest), governments can create money. There is no need to borrow from banks, as computer keyboards provide nearly free credit creation to finance spending.

The difference, of course, is that governments spend money (at least in principle) to promote long-term growth and employment, to invest in public infrastructure, research and development, provide health care and other basic economic functions. Banks have a more short-term time frame. They lend credit against collateral in place. Some 80% of bank loans are mortgages against real estate. Other loans are made to finance leveraged buyouts and corporate takeovers. But most new fixed capital investment by corporations is financed out of retained earnings.

Unfortunately, the flow of earnings is now being diverted increasingly to the financial sector – not only to pay interest and penalties to banks, but for stock buybacks intended to support stock prices and hence the value of stock options that managers of today’s financialized companies give themselves. As for the stock market – which textbook diagrams still depict as raising money for new capital investment – it has been turned into a vehicle to buy out companies on credit (e.g., with high interest junk bonds) and replace equity with debt. Inasmuch as interest payments are tax-deductible, as if they were a necessary cost of doing business, corporate income-tax payments lowered. And what the tax collector relinquishes is available to be paid out to the bankers and bondholders who get rich by loading the economy down with debt.

Welcome to the post-industrial economy, financialized style. Industrial capitalism has passed into a series of stages of finance capitalism, from the Bubble Economy to the Negative Equity stage, foreclosure time, debt deflation, austerity – and what looks like debt peonage in Europe, above all for the PIIGS: Portugal, Ireland, Italy, Greece and Spain. (The Baltic countries of Latvia, Estonia and Lithuania already have been plunged so deeply into debt that their populations are emigrating to find work and flee debt-burdened real estate. The same has plagued Iceland since its bank rip-offs collapsed in 2008.)

Why aren’t economists describing this phenomenon? The answer is a combination of political ideology and analytic blinders. As soon as the Rimini conference ended on Sunday evening, for instance, Paul Krugman’s Monday, February 27 New York Times column, “What Ails Europe?” blamed the euro’s problems simply on the inability of countries to devalue their currencies. He rightly criticized the Republican party line that blames European welfare spending for the Eurozone’s problems, and also criticizing putting the blame on budget deficits.

But he left out of account the straitjacket of the European Central Bank (ECB) unable to monetize the deficits, as a result of junk economics written into the EU constitution.

If the peripheral nations still had their own currencies, they could and would use devaluation to quickly restore competitiveness. But they don’t, which means that they are in for a long period of mass unemployment and slow, grinding deflation. Their debt crises are mainly a byproduct of this sad prospect, because depressed economies lead to budget deficits and deflation magnifies the burden of debt.

Depreciation would lower the price of labor while raising the price of imports. The burden of debts denominated in foreign currencies would increase in keeping with the devaluation, thereby creating problems unless the government passed a law re-denominating all debts in domestic currency. This would satisfy the Prime Directive of international financing: always denominated debts in your own currency, as the United States does.

In 1933, Franklin Roosevelt nullified the Gold Clause in U.S. loan contracts, enabling banks and other creditors to be paid in the equivalent gold value. But in his usual neoclassical fashion, Mr. Krugman ignores the debt issue:

The afflicted nations, in particular, have nothing but bad choices: either they suffer the pains of deflation or they take the drastic step of leaving the euro, which won’t be politically feasible until or unless all else fails (a point Greece seems to be approaching). Germany could help by reversing its own austerity policies and accepting higher inflation, but it won’t.

But leaving the euro is not sufficient to avert austerity, foreclosure and debt deflation if the nation that withdraws retains the neoliberal policy that plagues the euro. Suppose the post-euro economy has a central bank that still refuses to finance public budget deficits, forcing the government to borrow from commercial banks and bondholders? Suppose the government believes that it should balance the budget rather than provide the economy with spending power to increase its growth?

Suppose the government slashes public welfare spending, or bails out banks for their losses, or takes losing bank gambles onto the public balance sheet, as Ireland has done? Or for that matter, what if the governments do not write down real estate mortgages and other debts to the debtors’ ability to pay, as Iceland has failed to do? The result will still be debt deflation, forfeiture of property, unemployment – and a rising tide of emigration as the domestic economy and employment opportunities shrink.

So what then is the key? It is to have a central bank that does what central banks were founded to do: monetize government budget deficits so as to spend money into the economy, in a way best intended to promote economic growth and full employment.

This was the MMT message that the five of us were invited to explain to the audience in Rimini. Some attendees came up and explained that they had come all the way from Spain, others from France and cities across Italy. And although we did many press, radio and TV interviews, we were told that the major media were directed to ignore us as not politically correct.

Such is the censorial spirit of neoliberal monetary austerity. Its motto is TINA: There Is No Alternative, and it wants to keep matters this way. As long as it can suppress discussion of how many better alternatives there are, the hope is that the public will remain acquiescent as their living standards shrink and wealth is sucked up to the top of the economic pyramid to the 1%.

The audience requested above all more theory from Stephanie Kelton, who gave the clearest lecture on economics I had ever heard – a Euclidean presentation of MMT logic. For a visual of the magnitude, see http://www.youtube.com/watch?v=XP60tpwu5cs. At the end, we felt like concert performers.

The size of the audience filling the sports stadium to hear our economic explanation of how a real central bank should operate to avoid austerity and promote rather than discourage employment showed that the government’s attempt to brainwash the population was not working. It was not working any better than Harvard’s Economics 101 class, from which students walked out in protest against the unrealistic parallel universe thinking whose only appeal is to Aspergers Syndrome sufferers who are selected as useful idiots to train to draw pictures of the economy that exclude analysis of the debt overhead, rentier free lunches and financial parasitism.

This is a real shame. Bloomberg reports that Bank of American and Bank of New York have prevailed in their effort to have the $8.5 billion Bank of America mortgage settlement returned to state court in New York.

The use of a Article 77 proceeding for the settlement (a rarely-used New York state procedure) looked really sus, and the initial Walnut Place filing was very persuasive, and Judge William Pauley’s ruling approving the removal to Federal court was blistering (as in he was appalled by the conflicted role played by Bank of New York).

I attended the hearing on the appeal and I suppose should not have been surprised at the absence of anyone from New York attorney general Eric Schneiderman’s office. Even though he filed an objection to the settlement, the use of a Section 77 procedure (which has a strong presumption that the trustee is acting in good faith, which is clearly bogus in this case) places a very high bar for the settlement to be overturned. Had Schneiderman weighed in on the side of Walnut Place, the odds are high the ruling would have gone the other way.

And that is further compounded by the fact that the New York judge to which this case has been assigned, Barbara Kapnick, is widely depicted as at best bank friendly and at worst clueless. So this is a big win for Bank of America, since it looks like any scope of investigation will be severely limited and the deal will sail through. As we wrote before, this settlement is a screaming bargain relative to the liability that BofA faces on these deals.

By Chris Cook, former compliance and market supervision director of the International Petroleum Exchange. Cross posted from Asia Times

The end game is about to begin. On the one hand you have the noise and rhetoric. Greedy speculators gouging gasoline prices; mad mullahs preparing to wipe Israel off the map; bunker buster bombs and fleets being positioned; huge demand for oil from the BRIC countries; China’s insatiable thirst for oil; the oil price will head for $200 a barrel and will never again fall below $130 …

On the other hand you have the reality.

Oil Markets

The oil markets are completely manipulated and orchestrated, and the conductors of the orchestra have the benefit of having already held a rehearsal in 2008.

History never repeats itself, but it does rhyme. This time around it is not demand from the United States that is collapsing, but European Union and United Kingdom demand, as oil prices in euros and pounds sterling have never been higher. In the meantime, the US is awash in oil as domestic production quietly increases, flushed out by the high prices.

As I have outlined in previous articles, the culprit for the high oil prices between 2009 and 2012 – with the exception of the speculative “spike” between March 2011 and June 2011 driven by Fukushima and Libyan price shocks – has been passive investment by risk-averse investors, which enabled producers to support oil prices at high levels.

Much of this passive money underpinning the market and enabling producers to monetize inventory pulled out of the market in September 2011, and another wave pulled out in December 2011.

What is now happening is the end game: an orchestrated wave of noise that is drawing in speculative money. This is enabling the producers who are actually in the know to hedge by selling production forward during what they confidently expect will be a temporary – and pre-planned – managed fall in the oil price.

The Game Plan

The smartest kids on the block knows that gasoline prices much over US$4 per gallon will be both deflationary and lethal to President Barack Obama’s re-election chances. So that won’t happen other than briefly.

I am by no means the only commentator who has pointed out the complete counter-productivity of these oil sanctions. The smart kids are well aware that oil sanctions are completely useless, and simply enable China to fill its strategic reserves at a discount to the market price at the expense of Greece and Italy in particular.

But the US has been quite happy to let the EU – as useful idiots – take the economic hit. The high oil prices caused by all this noise and nonsense are actually a net benefit to Iran – which rattles its sabre loudly as elections approach.

The effect of a managed decline in oil prices to, and probably over-correcting well through, $60 a barrel – which is coming fairly soon – will be extremely beneficial to the US in two ways.

Firstly, it will be catastrophic in particular for Iran, Russia and Venezuela – not exactly on the White House party list – whose hugely oil-dependent revenues will collapse. The ensuing economic mayhem will open these countries up to regime change and to rescue plans which Wall Street will be dusting off.

Secondly, the US population will be laughing all the way to the gas station as gasoline prices fall – at least temporarily – below $2.50 a gallon and release purchasing power into the economy, thereby doing the president’s re-election chances no harm at all.

What will then happen is that members of the Organization for Petroleum Exporting Countries will panic and genuinely reduce their production. The Saudis/Gulf Cooperation Council will again orchestrate the inflation of the oil price – as they did in 2009 – comfortable in the knowledge that they have been able to hedge against this temporary fall in prices at the expense of the speculators currently pouring in to the market.

That’s the game plan as I see it of the smartest kids on the block. What could ever go wrong?

A Buyers’ Strike

Quite clearly, consumer nations, like everyone else, are in the dark in relation to what has been going on in the oil market and have swallowed the populist “greedy speculator” meme. They are simply unaware of the nature and cosmic scale of the oil market manipulation that has been taking place, and as a result have been happily overpaying for oil for years.

What happens if they simply refuse to pay these prices?

Possibly a “buyers’ strike” by China would be enough to crater the market. We’ve already seen the effect of that on Iran, which has clearly agreed new terms with China after the latter held back purchases earlier this year.

Or possibly speculative short selling of crude oil by hedge funds funded by Chinese investment? I pointed out at a rather spooky conference on “economic terrorism” a few years ago in Lausanne – which examined ways in which terrorists might make economic rather than physical attacks – that the only difference between an economic terrorist and a hedge fund is motive.

System Fragility

The markets in oil have never been so fragile and susceptible to shocks. Private inventories of oil are low. The investment banks interpret this – as they interpret everything – as a sign of physical demand and therefore as bullish for the oil price … oh, and by the way, here are some oil funds they have to sell you.

The reason inventories are low is that private intermediary buyers will only store oil if they can both finance it and lock in a higher forward sale price. Bank financing is scarce and getting scarcer, while forward prices are below current prices; the result is that inventories are low.

The systemic shortage of finance capital means that neither physical oil traders nor the remaining proprietary traders of banks can afford to take into storage much of the approaching flood of oil onto the market.

Also, derivative market risk has become concentrated – since intermediaries are no longer capitalized to take it – in centralized clearing houses, which have for commercial reasons become fragmented silos.

In my view, the steep decline which is planned could easily get out of hand in a not dissimilar way to the tin market in 1985 when the price collapsed – literally overnight – from $8,000 per tonne to $4,000 per tonne.

We will then see whether the clearing houses are “too big to fail” – and ask why, if so, such utilities are run for private profit?

When, Not If

In my analysis, absent a massive, and sustained, shortfall in oil supplies – which I cannot see occurring, since all involved have every interest in ensuring it does not occur – the oil price will, as I have already forecast, fall dramatically by the end of this year’s second quarter at the latest. It’s not a matter of if, but when it will happen.

Finally, as an interesting aside, I have credible reports that Marc Rich – who got on well with both the Shah of Iran and Imam Khomeini, and who sold oil from Iran to Israel for 20 years between 1973 and 1993 – has recently been seen again in Tehran. I doubt that this is for the night life, or because he prefers Tehran air to Swiss: but as a trusted third party there would be few better placed to act as a go-between.

Let’s hope so. Once the stultifying political uncertainties of elections in Iran and Russia are over, things could get interesting.

By Matt Stoller, the former Senior Policy Advisor to Rep. Alan Grayson and a fellow at the Roosevelt Institute. You can reach him at stoller (at) gmail.com or follow him on Twitter at @matthewstoller. Cross posted from New Deal 2.0.

Sometimes finance executives let slip the way they really feel: that they hold the world in the palm of their hands.

It’s not often that the people in charge admit what is really going on: a global game for political dominance. I just saw an interview with Wall Street superlawyer Rodgin (“Rodge”) Cohen of Sullivan & Cromwell, the secret force behind (among other things) the expanded emergency lending power of the Federal Reserve through section 13(3). You know, that’s the law allowing the Fed to lend unlimited sums based on whatever it wants to lend, a section amended in 1991 at Cohen’s behest. He was involved in “more than 17 deals” during the crisis in 2008, including the bankruptcy of Lehman Brothers, the $85 billion AIG bailout deal, and the takeover of Fannie Mae by the federal government. He is, as Bill Black said, the fixer of Wall Street. Here’s his quote, at minute 3:39 of this Bloomberg interview:

Hopefully we will not see the major financial institutions in this country disappear because if we do we will also see a loss of ability to influence events not only financially but also politically throughout the world.

That’s pretty clear. It reminds me of this quote from an anonymous military officer while he was touring JP Morgan’s trading floor (emphasis added):

JPMorgan Chase yesterday hosted about 30 active duty military officers (across all branches and agencies) from the Marine Corps War College in Quantico, Va. The officers met with senior executives, toured the trading floor and participated in a trading simulation. They discussed recruitment, operations management, strategic communications and the economy. Aside from employees thanking them for their service as they passed by, they also received a standing ovation on the trading floor. Said one officer after a senior JPM exec thanked him for his service: “We promise to keep you safe if you keep this country strong.”

There are always conspiracy theories out there about a global linkage between large financial institutions and American empire. They don’t, however, usually come from the people running the place.