naked capitalism

Goldman seems to be making a renewed effort at PR in the wake of the letter by derivatives staffer Greg Smith accusing the firm of caring only about profits and treating customers as stuffees (“muppets” was revealed to be the new term of art). That observation probably came as no surprise to anyone save Goldman staffers, most of whom probably thought they had conned their clients into believing otherwise, and a few like Smith who believed the party line.

The Goldman CEO, Lloyd Blankfein, had an interview today with a very friendly outlet, Bloomberg News. The chat served to remind viewers of how inward looking and self referential the financial services industry has become.

We need to deal with the obvious misrepresentations before getting to the unintended revelations:

…..we’ll have to do a better job, getting out there and telling people how important this industry is, what it does when we advise companies on their growth plans and finance their growth plans and manage their assets for them and how important this is for the economy, the markets and obviously society at large.

Yves here. First, since your industry succeeded in holding up governments around the world and continues to do so (witness the backdoor bailout of German and French banks at the expense of ordinary citizens in the rolling Eurocrisis), you can spare us the false modesty. Second, you don’t advise companies on “growth plans”, you advise them on transactions. Third, you and your cohorts have done a crappy job at anything other than looting. Andrew Haldane of the Bank of England did a quick and dirty estimate of the cost of the last crisis, and his low figure was one times global GDP. If you try to make the big banks like Goldman repay the costs of the damage they didn’t, they can’t even begin to. If you try amortizing that low estimate of the losses over 20 years, the big banks can’t even afford the first year levy. It exceeds their market capitalization. So firms like Goldman don’t create value, they destroy it in a massive, profligate manner.

But Blankfein tries to pass off the idea that Goldman is misunderstood, as opposed to all together too well understood:

I think the average American probably had no contact and had never heard of Goldman Sachs before three years ago. Shame on us in a way for not anticipating how important that would be. We’re an institutional business with no consumers. It turns out, another name for consumers are citizens and taxpayers. They became important for reasons that are obvious. They always should have been important, but it wasn’t part of our audience as we thought about it. Now we will have to develop those muscles a little better than we have. Shame on us.

Translation: We should have been buying more retail advertising, like JP Morgan does, so all those financial section editors would have to think twice before dumping on us.

Later in the interview. in response to whether Goldman would have survived if it didn’t have access to the Fed’s discount window:

We did not have access to the Fed window as the bank leading up to the crisis because frankly we run ourselves very conservatively. One of the reasons why we came out of that crisis, that moment so well is because we went into so strong. Today, we carry over $170 billion of liquidity. We are very highly capitalized among the highest tier in our industry. We don’t borrow from the discount window.

This is such tripe. Goldman became a bank holding company in the crisis, remember? That was so the Fed could intervene if needed. Having access to the discount window plus all sorts of backdoor and direct bailouts, like the TARP, the Primary Dealer Credit Facility, guaranteeing money market funds, rescuing AIG, kept Goldman afloat. As derivatives trader and now venture capitalist Roger Ehrenberg wrote in 2009:

Goldman is a great firm with a stellar culture, and in most circumstances it’s risk management and funding practices have been second to none. Except when the crisis hit. It stood with the rest of Wall Street as a firm with longer-dated, less liquid assets funded with extremely short-dated liabilities….In exchange for giving the firm life (TARP, FDIC guarantees, synthetic bail-out via AIG, etc.), the US Treasury (and the US taxpayer by extension) got some warrants on $10 billion of TARP capital injected into the firm…

There is not a Wall Street derivatives trader on the planet that would have done the US Government deal on an arms-length basis. Nothing remotely close. Goldman’s equity could have done a digital, dis-continuous move towards zero if it couldn’t finance its balance sheet overnight. Remember Bear Stearns? Lehman Brothers? These things happened. Goldman, though clearly a stronger institution, was facing a crisis of confidence that pervaded the market. Lenders weren’t discriminating back in November 2008. If you didn’t have term credit, you certainly weren’t getting any new lines or getting any rolls, either. So what is the cost of an option to insure a $1 trillion balance sheet and hundreds of billions in off-balance sheet liabilities teetering on the brink? Let’s just say that it is a tad north of $1.1 billion in [option] premium. And the $10 billion TARP figure? It’s a joke. Take into account the AIG payments, the FDIC guarantees and the value of the markets knowing that the US Government won’t let you go down under any circumstances. $1.1 billion in option premium? How about 20x that, perhaps more. But no, this is not the way it went down….

Where we are left today, dear taxpayer, is a lot poorer. Unless you are a major shareholder and/or bonusable employee of Goldman Sachs. Brains, ingenuity and value creation should be rewarded in all fields, Wall Street included. But when value created is the direct result of the risks borne by others for your benefit, the sharing of benefits needs to be re-allocated. This has not and apparently will not be done, and we, dear taxpayer, are the worse for it.

Now let’s get to the juicy bit. While Blankfein tries to maintain that Goldman can manage its conflicts of interests, he paints the firm as so inherent conflict-ridden as to make the case that clients can’t be well served dealing with a firm that can’t have an undivided loyalty to you. That is tantamount to an admission that big corporate and institutional clients would be better served if there were more players, better yet, firms that were more specialized.

Let’s start with his basic premise:

I think no one who is going to be effective in this business can avoid conflicts of interest coming up. You can do that if you only represent one client in every industry, in which case you won’t really be able to be that effective, knowledgeable, or influential. You won’t be able to get anything done.

Ahem, that’s an investment banking side argument, and it isn’t remotely true. As debunked above, investment banks are not strategic advisors. And even then, he’s also wrong on his premise that “you wouldn’t be effective or knowledgeable” if you represent only one client in an industry. That has long been Bain’s business model, and Bain has long been one of the top three consulting firms.

The reason that banks have industry specialization on the banking side is a bad reason: CEO and CFOs feel more comfortable with a banker who knows the gossip and the deals in their industry. But guess what? That patter is irrelevant to getting deals done. A generalist banker (say at a boutique like Rothschild) can work up the industry comparisons in very short order. And the knowledge of how to price securities offering is held on the sales and trading side of the firm, not among the glad-handed investment bankers.

We have this bit:

If you advise a client today, you have to lend to that client. If you lend to that client, they have to pay back. Now you have a stake in the outcome of their business decisions. You give them advice, but since you are a lender to them, like every bank has to be today, you have conflicts of interest. They always have to be managed.

Again, for a Goldman, that takes place in the context of M&A, and the lending role is exaggerated. Takeover loans are put into collateralized loan obligations and are sold to investors. The lead banks retain a small slice (for credibility reasons, unlike mortgage backed securities, investors like to see the lead banks have some skin in the game) but most is sold off. And a bank like Goldman would likely hedge at least some of the credit risk with credit default swaps.

With prime brokerage clients, the conflicts are even more rife. Goldman lends to many of its hedge fund clients (that’s where the real juice is), yet hedgies are acutely aware that their broker can and will trade against them, and so go to great lengths to disguise their positions and intentions by trading through multiple firms. Consider how this conflict worked against dealers in the case of Long Term Capital Management: the firm was massively leveraged, and when traders realized it was hugely on the wrong side of certain trades, they began exploiting its distress, which only made matters worse for the firm and ultimately for the dealers, who had to bail out LTCM so it could be wound down in an orderly manner. But preying on smaller hedge funds that got it wrong has never bothered the big banks, and many feel they were treated badly in the crisis when their prime brokers squeezed them by raising haircuts far beyond what seemed to be warranted even given the terrible market conditions.

The problem, of course, is that clients see the roles differently that Goldman does. This is Blankfein’s account:

For example, in the market making business, we give prices to our client and a client decides whether to trade or not. We hope as a result of that exchange, we will make money and not lose money. If over time we lose money, we will be out of business. We have other businesses or we are an adviser and other businesses where we are a pure fiduciary. One of the things we set up to do when we wrote our business standards report is go out and carefully delineate for our audience what our roles and responsibilities are in each segment of our business. As an adviser, we work for the best interests of our clients. As a fiduciary, our clients to come first. As a market maker, we have to protect Goldman Sachs.

But remember the Greg Smith letter. As a salesman, he saw his role as advisory (and there is a tension in being a salesman of any sort for a bigger firm: the salesman is often more protective of his clients than the house is, since loyal clients might very well follow him if he leaves the firm). Yet it was very clear from Blankfein’s testimony before Congress in 2010 that he saw Goldman’s role in CDOs like Timberwolf as that of a market-maker (caveat emptor!) when some clients thought Goldman was acting in at least an advisory capacity. To pretend that firms like Goldman don’t prey on that gullability is naive.

So the newer, friendlier Lloyd Blankfein isn’t that much more persuasive than the old version, save maybe to those who hold similar views. But until Blankfein and his ilk are subject to meaningful pressure, all he need to do is make occasional contrite gestures, like this Bloomberg chat, as he carries on as before.

John Whitehead is being proven right.

The former Goldman co-chairman took the unheard of step of excoriating Lloyd Blankfein for Goldman’s “shocking” pay levels of 2006. As anyone who has been following Wall Street knows, compensation levels were even higher in 2007, 2009, 2010 and last year. Per an interview with Bloomberg:

“I’m appalled at the salaries,” the retired co-chairman of the securities industry’s most profitable firm said in an interview this week. At Goldman, which paid Chairman and Chief Executive Officer Lloyd Blankfein $54 million last year, compensation levels are “shocking,” Whitehead said. “They’re the leaders in this outrageous increase.”

Whitehead went even further, recommending the unthinkable, that Goldman cut pay:

Whitehead, who left the firm in 1984 and now chairs its charitable foundation, said Goldman should be courageous enough to curb bonuses, even if the effort to return a sense of restraint to Wall Street costs it some valued employees. No securities firm can match the pay available in a good year at the top hedge funds.

“I would take the chance of losing a lot of them and let them see what happens when the hedge fund bubble, as I see it, ends,” Whitehead, 85, said….

The Galtian traders who carry on as if they are solely responsible for their profits are being shown to be more dependent on the franchise, in particular, the concentrated information flows from dealing with lots of customers and counterparties, than they had persuaded themselves and management. Bloomberg today tells us that the prop traders who have decamped from Goldman, convinced that they’d be able to rack up stellar returns, are floundering. It isn’t just that they aren’t racking up huge wins; they are losing money and falling short of hitting the average for their trading strategy. As the report notes:

Ex-Goldman Sachs (GS) Group Inc. traders led by Pierre-Henri Flamand and Morgan Sze raised more than $4.5 billion for their own hedge funds..

So far, none of them has made money for clients.

The two are among at least six traders who have left Goldman Sachs’s biggest proprietary-trading group in the past two years, which the New York-based bank shuttered in response to new U.S. regulations. All, including Daniele Benatoff and Ariel Roskis, trailed this year’s stock market rally after losing money in 2011, investors said…

Flamand, 41, who was the global chief of Goldman Sachs’s principal strategies group before he quit two years ago to start Edoma Capital Partners LLP in London, has lost about 2.4 percent through February since his $1.8 billion hedge fund started in November 2010, according to investors.

Edoma is an event-driven fund, which invests in companies undergoing events such as mergers, spinoffs and bankruptcies. Such funds returned an average 3.9 percent in the same 16-month period…

Sze, 46, who ran Goldman Sachs’s principal strategies team in Asia before briefly replacing Flamand as global head, left the bank in 2010 to start Azentus Capital Management Ltd. in Hong Kong, hiring 13 former Goldman Sachs traders. His event- driven fund lost about 4.8 percent through February since its April 2011 inception, said a person with knowledge of its returns.

Event-driven funds declined 2.4 percent in the same period…

We’ve long been skeptical of the idea that big firm traders are worth their outsized pay packages. Of course, it nevertheless make sense for management to play along, since higher pay levels for traders justify robust pay for everyone senior to them in the hierarchy (yes, a top trader will often be paid more than the top brass, but it’s an anchoring issue. And pay in banks at the senior levels has become more hierarchical than it was in the 1980s and 1990s).

Long standing readers may recall the 2009 row over the pay level of Andrew Hall, the head of a Citigroup oil trading unit. He had made $100 million in 2008 on a long-standing pay arrangement that gave him a pay deal for his team that was just below 30% of profits, a level unheard of since Mike Milken at Drexel (and we all know how well that turned out). Kenneth Feinberg, Obama’s pay czar, refused to back down, leading to the predictable hue and cry as to how terrible it would be to break Hall’s contract (we pointed out that there were likely ways to do just that, that big producers like Hall were often guilty of expense abuses that would allow for termination for cause).

Consistent with the notion that Hall needed Citi more than he’d pretended earlier, he started negotiating with the bank (if he really was such a hot item, one would think he’d be able to decamp and raise money). As we pointed out at the time:

A LOT of Hall’s performance was due to cheap funding from Citi, and probably massive leverage too, conditions he could not replicate anywhere else. A risky, highly geared operation should pay an interest rate appropriate to the hazards it is taking, not the borrowing costs of its parent (this basic premise is widespread in financial firms, embodied in approaches like RAROC (Risk Adjusted Return on Capital), the Basel I and II rules, and Economic Value Added models.

And the denouement, from ECONNED:

Phibro, along with its richly paid chief, Andrew Hall, is leaving Citigroup for Occidental Petroleum. The price Oxy paid for Phibro was only the current value of its trading positions–liquidation value and not a brass razoo more. There was NO premium for the earning potential of Hall and his supposed money machine. It’s not hard to see why. Hall’s returns were heavily dependent on high leverage, cheap funding, and market intelligence from other trading desks, all huge subsidies from Citigroup. In turn, these concentrated capital and information flows do not come about naturally, but are the product of industry-favoring policies.

His example illustrates that the widely proclaimed view that highly profitable traders are worth their exorbitant pay is often a fiction. The fact that no other buyers, not a financial firm, commodities trader, or consortium, stepped forward when Citi was looking for a graceful exit shows that the business was worth very little on a stand-alone basis.

Instead of seeing the Hall episode as further evidence that industry pay practices are extractive, the media focused instead on “government interference” or how Citi would be harmed by losing the revenues from taxpayer-supported commodities speculation.

The problem, of course is that given how much traders and investors who appear to generate outsized returns (query at what risk and with what information advantages) are celebrated in their circles almost as much as sports stars. Their allure is fading bit by bit, but it will be quite a while before the ascendancy of traders is reversed.

There is a great post by Bethany McLean at Reuters debunking a major “what caused the crisis” urban legend. Many, including Joe Stiglitz and Alan Blinder, have claimed that an SEC 2004 rule change regarding the leverage of securities firm holding companies allowed the leverage of major investment banks to skyrocket, helping to trigger the crisis. McLean’s article demolishes this idea.

McLean also asks why the myth still lives, and I can tell you why. Opinions are set. I had wanted to take this idea on in ECONNED, since all you had to do was look at investment bank leverage over time, and you could see it had been as high in 1997 and 1998 as it was immediately before the crisis. Even after sending both BIS charts and a separate analysis one of my book helpers put together, I still got resistance from some of my draft readers. I realized I’d have to spill a lot of ink to cut through the prejudice on an argument that wasn’t essential to the thesis. So I avoided the topic entirely and discussed what I found to be the drivers.

McLean provides an in-depth account, although some NC readers might have preferred she get to the meat rather than anchor her story in a narrative on how the idea first gained a following and the efforts to correct the record. The big issue is the SEC never regulated the leverage at the holding company level (remember, the failure of Drexel was a holding company insolvency). Its authority extends only to the broker-dealer subsidiaries. As McLean notes:

There was never any explicit leverage limit at the holding company level before or after the rule change. Even at the broker-dealer subsidiaries, a 12:1 limit [cited by some former SEC staffers] didn’t exist. Smaller broker-dealers had an early warning at the 12:1 ratio, and an actual limit of 15:1 — but even these ratios didn’t exist in the way the economists seemed to interpret them, because they were calculated in a way that excluded big chunks of debt. In any event, since 1975, the broker-dealer subsidiaries of the big five investment banks had been using a different method, which had nothing to do with 12:1 or 15:1, to calculate their leverage limit. That method was unchanged in 2004. (Interestingly enough, the holding companies for the big investment banks might actually have made it under the 15:1 limit if you calculate the ratios by excluding the debt that the SEC does.)

McLean also describes that the 2004 rule change did allow for changes in the calculation of net capital at the broker-dealer level, but other provisions of the rule change undermined the way they would have taken advantage of it, namely, by sending dividends to the holding company. Oh, and Goldman and Merrill started using the rule only in 2005, and Bear, Lehman, and Morgan Stanley began in 2006. McLean again:

Overall, the SEC says that capital, as measured before most of the expected impact of the rule change, stayed stable or even increased after 2004. Several people at the broker-dealers at the time also tell me that the new rule was totally inconsequential in how they managed their capital levels…For example, in both 2006 and 2007, Bear Stearns had seven times the amount of capital that the SEC required, or more than $3 billion in excess net capital. This might suggest that the amount of capital the broker-dealers kept was boosted by factors other than the SEC’s requirements, like business needs, or rating agency and customer demands.

So why have perceptions remained so stubborn? A big one seems to be the human desire to have tidy explanations of complex phenomena. Leverage is much easier to understand as a culprit, and it is true that all the major financial firms were running with much too little in the way of risk buffers relative to the risks they were taking. One the culprit was that securities firms, and big banks that were running major securities and derivatives businesses, kept holding more and more of their exposures in illiquid, hard to value instruments, yet were financing them with repo, which is relatively short term funding. Historically, securities dealers held only assets that traded actively or had prices that were established readily and reliably with reference them (corporate bonds were the classic example).

Dealers are structurally long financial assets. Particular firms might be able to hedge single positions or even (in the case of Goldman) a large book, but the big players are too large to be anything other than net long the major markets they trade. As the Fed and other central banks engineered a long-term fall in interest rates from 1983 onward, banks and securities dealers benefitted from a gradual rising tide. That plus the Greenspan put (the Fed rushing in to limit the downside of a market decline) emboldened dealers to take more risk. But at least as far as US securities firms were concerned, it took place much more via an increasing mismatch between the illiquidity of many of their assets versus their heavy reliance on short-term funding rather than nominal leverage. The change in the composition of their exposures should have led the authorities to require them to carry more capital, but in the era of “markets know best” that sort of intervention would have been seen as overreaching and a proof that the regulator was a Luddite. The Greenspan-Rubin-Summers pillorying of Brooksley Born over her effort to regulate credit default swaps no doubt had a chilling effect on any other regulators who might have challenged the destructive orthodoxy they put in place. As McLean concludes her piece, quoting Andrew Lo: “If we haven’t captured the killer, then the real killer is still out there somewhere.”

Ed Wyatt of the New York Times has released an important story tonight on how the SEC goes easy on big banks by giving them exemptions to laws meant to stop securities fraud. This report stands in stark contrast to a Reuters story which repeats the favorite Administration mantra: it’s really hard to prosecute financial-related cases. It sure is when you don’t chose to use the powers you have.

The gist of the Times piece is that the SEC gives the biggest banks like JP Morgan and Goldman waivers so that they can continue to have ready access to the financial markets without a lot of hassle. The overview:

An analysis by The New York Times of S.E.C. investigations over the last decade found nearly 350 instances where the agency has given big Wall Street institutions and other financial companies a pass on those or other sanctions. Those instances also include waivers permitting firms to underwrite certain stock and bond sales and manage mutual fund portfolios.

JPMorganChase, for example, has settled six fraud cases in the last 13 years, including one with a $228 million settlement last summer, but it has obtained at least 22 waivers, in part by arguing that it has “a strong record of compliance with securities laws.” Bank of America and Merrill Lynch, which merged in 2009, have settled 15 fraud cases and received at least 39 waivers.

Only about a dozen companies — Dell, General Electric and United Rentals among them — have felt the full force of the law after issuing misleading information about their businesses. Citigroup was the only major Wall Street bank among them. In 11 years, it settled six fraud cases and received 25 waivers before it lost most of its privileges in 2010.

What the article does not make quite clear is the SEC rationale for this double standard. I’d hazard that it’s that big financial players are often in the market raising funds, and restricting their access is, well, just a bit too mean since they are money junkies. Just look how hard it was for Citi when it fell out of the SEC’s most favored nations status and lost its ability to use so-called “shelf registrations” to sell stock and bonds:

And the companies continue to use rules that let them instantly raise money publicly, without waiting weeks for government approvals. Without the waivers, the companies could not move as quickly as rivals that had not settled fraud charges to sell stocks or bonds when market conditions were most favorable.

OMG, if you break the law, you might be put at a competitive disadvantage! Can’t have that, now can we? Specifically:

Citigroup is one of the rare Wall Street giants that has lost significant privileges recently…

Because those accusations involved Citigroup’s statements about its own financial well-being, the company lost for three years the ability to insulate itself from lawsuits over mistaken predictions about its business. It also lost, for the same three years, the exemption for “well-known seasoned issuers,” which allowed it to quickly raise capital in the securities markets. As a result, Citigroup has had to file thousands of pages of new documents with the S.E.C. and wait weeks for the agency’s approvals to make itself eligible to sell stocks, bonds and other securities to the public.

Now you might think that the SEC is drawing the line at misrepresenting your own financial health. But that doesn’t even seem to be the standard. Remember when Bank of America failed to tell investors in its merger proxy of the size bonus payouts to Merrill staffers? The SEC didn’t rough it up the way it did Citi. Citi, as an official sick man of the crisis, seemed to get the regulatory version of halo effect treatment.

Similarly, JP Morgan, the bank that among other things, bankrupted Jefferson County, gets off easy:

JPMorganChase is among the big Wall Street firms that have been granted multiple waivers with nearly every settlement of S.E.C. fraud charges. Last July, it agreed to pay $228 million to settle civil and criminal charges that it cheated cities and towns by rigging bids with other Wall Street firms to invest the money raised by several municipalities for capital projects.

JPMorgan received three waivers related to that case for privileges that it otherwise would have lost. But the S.E.C. said the company’s fraudulent actions didn’t involve misleading investors about JPMorgan’s business.

“That distinction doesn’t do it for me,” said Richard W. Painter, a corporate law professor at the University of Minnesota and the co-author of a casebook on securities litigation and enforcement. “If a company has trouble telling the truth to investors in one batch of securities it is underwriting, I would not have confidence that it would tell the truth to investors about its own securities.”

Despite six securities fraud settlements in 13 years, JPMorgan rarely if ever lost any special privileges. It has been awarded at least 22 waivers since 2003, with most of its S.E.C. settlements generating two or more. In seeking the reprieves, lawyers for JPMorgan stated in letters to the S.E.C. that it should grant a waiver because the company has “a strong record of compliance with the securities laws.” The company declined to comment for this article.

It is hard to overstate the importance of this story. As we have said, one of basic rules of regulating is to make sure the regulated know you are not cowed by them. When I was a young person working on Wall Street, investment banks were afraid of the SEC. By contrast, this article reveals, as many have suspected, that regulators have plenty of tools to bring banks to heel. They choose not to use them.

The SEC does have a defense of sorts, which is (as we have recounted) that Congress has cut off funding when it merely tried to be tough in defending retail investors from abuses under Arthur Levitt in the 1990s. The passivity of the SEC is a symptom of elite corruption. A reform-minded President could choose to cross swords with Congress and defend the agency against harassment for tough minded enforcement. But that would be in a parallel universe where the banks were not in charge.

Although I endeavor to treat high dudgeon as an art form, it is difficult to find words adequate to convey the level of ridicule and opprobrium that Adam Davidson’s latest New York Times piece, “What Does Wall Street Do for You?” deserves. I had the vast misfortune to come across it late last week, and have gotten an unusually large volume of incredulous reader e-mails about it. Ms. G’s e-mail headline “NYT – Not a Parody” was typical:

This one is so bad, even for NYT, I’m wondering if the paper wasn’t secretly sold to Murdoch, Bloomberg & the Fed Reserve sometime in the past few days.

The problem with the piece isn’t that it’s propaganda. The majority of what you read in the mainstream media these days is propaganda. It’s that it’s shameless, blundering, obviously false propaganda. Eddie Bernays must be spinning in his grave.

Things have now gotten so bad that we now need official propaganda ratings, maybe on a crowd sourced or an Intrade model. I never thought the day would come when I would hold up Andrew Ross Sorkin or Baghdad Bob Ezra Klein as models, but what they write has a tangential connection to reality and sounds plausible if you are not terribly well informed. By contrast, Davidson is all bumptious presumption, evidently hoping that if he sallies forth with enough vigor and enthusiasm, he will overcome any resistance.

You really need to read this train-wreck of a piece to understand how vomititiously bad it is. It argues we’d be living in mud huts were it not for Wall Street, which he defines as “The country’s largest investment banks, commercial banks and a few big insurance companies.” In other words, we don’t appreciate all the good the too big too fail firms are doing for all of us. Yet there is not a shred of evidence, not an iota of proof offered for any of Davidson’s assertions. And the overall thrust of his argument and many of its particulars are embarrassingly wrong (well, I am probably being charitable in assuming Davidson is capable of being embarrassed).

Davidson asserts that the big financial firms:

play the crucial role of intermediation — matching borrowers with lenders. Most of the time, the industry does this extremely well (though in the case of matching homeowners’ debt to the global financial system, too enthusiastically).

Lordie, lending money goes back to the Bronze Age. We don’t need massive financial firms to do that. And they don’t do it particularly well. FICO based credit lending has proven to be a poor proxy for creditworthiness. The banks blew themselves up, not out of “overenthusiasm,” but as we described in ECONNED, adoption of fatally flawed ways of measuring risk and management structures which make the senior managers both hostage to and in cahoots with “producers” led to widespread looting. This isn’t a benign and efficient financial system; it’s a rampant predator. And it does not do a particularly good job of allocating capital. Aside from the fact that the expansion of the financial sector is correlated with slower growth and more frequent financial crises, investors have also become more short term oriented. As Andrew Haldane of the Bank of England described, required investment returns show a marked short term bias, which leads to underfunding of projects with back-end weighted payoffs, such as infrastructure and new technologies.

And Davidson not only misleads, he says things that are completely false:

Most know that Ben Bernanke, Henry Paulson and Tim Geithner (like central bankers and treasury officials everywhere) were following the hallowed advice that Walter Bagehot, onetime editor of The Economist, set down in 1873: during a crisis, a country must do everything possible to preserve its banks.

This is what Bagehot actually said:

The cardinal maxim is, that any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.

As much as I’d enjoy thrashing the piece further, Amar Bhide, who is uniquely to do so, has graciously offered to help. Bhide is the author of a landmark book on entrepreneurship, The Origin and Evolution of New Businesses, and his most recent book is
A Call for Judgment: Sensible Finance for a Dynamic Economy. We were both members of the financial institutions group at McKinsey. Bhide became a proprietary trader before joining Harvard in its finance faculty, then switched to focusing on entreprenuership. He now teaches at Fletcher.

From Bhide:

The author invites readers to imagine what life would be like without Wall Street. How awful: the poor would remain poor, there would be no middle class etc etc.

The reality is that all the good things that a financial system is supposed to do were in place more than half a century ago. There would certainly have been no mass market for automobiles and radios and vacuum cleaners without consumer finance. But that was invented in the 1920s.

The issue is of balance. We need a financial system that extends credit to those are likely to repay, not to reckless borrowers. A good diet must have protein but an all protein diet is dangerous.

What we have had in the last 30-40 years is excess piled upon excess.

I can very easily imagine life with finance as it used to be say in the 1960s, without a credit producing machine that enables reckless borrowing, without instruments that are supposed to reduce risks that have in fact gutted the real economy, and too big to fail banks like JP Morgan with more than 75 trillion dollars of derivatives on their books.

The piece reminds me of Blankfein claim in a London Times interview that Goldman “does God’s work” which he later said was a joke; but it did not amuse in at a time when unemployment was crossing 10 percent. In the same interview, Blankfein asserted that Goldman Sachs served a ”social purpose” by “help[ing] companies to grow by helping them to raise capital. Companies that grow create wealth. This, in turn, allows people to have jobs that create more growth and more wealth. It’s a virtuous cycle.”

Blankfein’s claim, which was presumably not intentionally jocular, is hard to take seriously as an explanation for the tripling of the Goldman’s revenues from $13 billion in 1999 to $46 billion in 2007, and of employee compensation from $6 billion to over $20 billion. Equity underwriting – issuing stock for real companies – accounted for about 3 percent of Goldman’s 2007 revenues, and debt underwriting (which includes mortgage and other asset backed securities, not just corporate debt) accounted for another 4 percent on revenues.

Meanwhile, trading and principal investments amounted to 68 percent of revenues, and asset management and securities services (which also have little to do with raising money for real companies) 16 percent.

It is also difficult to imagine that trading and principal investment revenues were more than five times as great in 2007 as they had been in 1999 because Goldman’s traders had become five times better. Rather, Goldman multiplied its trading profits by multiplying its risk taking and leverage, borrowing vast sums from banks and shadow banks.

Davidson’s last two pieces for the Sunday New York Times magazine exemplifies the “do whatever you can get away with” attitude that now seems pervasive in big finance. But it is an open question why the Grey Lady is giving this sort of work such prominent placement.

This post first appeared on July 8, 2009

John Kay comes perilously close to nailing a key issue in his current Financial Times comment, “Our banks are beyond the control of mere mortal” in that he very clearly articulates the problem very well but then draws the wrong conclusion:

At Oxford university, I often hear people say there is nothing wrong with the system: the problem is the vice-chancellor/master/bursar/ university officials. And, in a sense, they are right. If the vice-chancellor had the wisdom of Socrates, the political skills of Machiavelli and the leadership qualities of Winston Churchill, not to mention the patience of Job, he or she would be very likely to be able to fulfil the conflicting demands of the post. But such paragons are few and far between. In the meantime we must try to find structures that can be operated by ordinary mortals.

In the same way, the claim that the fault with the banking system lies not with the structure of banks but with the boards and executives that claimed to run them is both correct and absurd…if the failures are both as widespread and as persistent as it appears, the problem is in the job specification rather than with the incumbent. If you employ an alchemist who fails to turn base metal into gold, the alchemist is certainly a fool and a fraud but the greater fool is the patron.

The bank executives pilloried by the UK’s Treasury select committee of MPs were all exceptional people. The vilified Sir Fred Goodwin was an effective manager who had slashed through the National Westminster bureaucracy and revived a failing institution – a task that had defeated many able men before him. His chairman, Sir Tom McKillop, offered experience and ability that met every possible specification for such a role in a big international corporation. As chairman of HBOS, Lord Stevenson was Britain’s supreme networker. This skill is a particularly valuable attribute in an environment where the essence of banking is to extract very large sums of taxpayers’ money while giving as little as possible in return. His chief executive, Andy Hornby, was criticised for being a retailer. But Halifax, half of HBOS, needed retail expertise. The only thing it needed to know about complex securitised products was that there was no good reason to buy them.

Like Sir Fred, Sir Tom, Lord Stevenson and Mr Hornby, most of the people who sat on the boards of failed banks were individuals whose services other companies would have been delighted to attract…

The hapless four were criticised for their lack of banking expertise but it is, in fact, not clear what modern banking expertise is. The world of modern banking requires all the skills of these gentlemen, plus some others, and no one can expect to have all these attributes.

It has been said of Jamie Dimon (who does not have a banking qualification) that his dominance exists because at every meeting all the participants know that he could do each of their jobs better than they could. But the business world cannot operate at all if it can operate only with individuals of the calibre of Mr Dimon. Better, as so often, to follow an aphorism of Warren Buffett’s: invest only in businesses that an idiot can run, because sooner or later an idiot will.

Our banks were not run by idiots. They were run by able men who were out of their depth. If their aspirations were beyond their capacity it is because they were probably beyond anyone’s capacity. We could continue the search for Superman or Superwoman. But we would be wiser to look for a simpler world, more resilient to human error and the inevitable misjudgments. Great and enduringly successful organisations are not stages on which geniuses can strut. They are structures that make the most of the ordinary talents of ordinary people.

The problem is Kay is applying traditional managements structures to investment banking, Even though these entities may have substantial retail arms and bank charters, the area that poses the management challenge is the capital markets businesses. And he makes a dangerous, erroneous assumptions: that mere mortals, meaning generalists, can run these businesses. That is bogus.

What makes capital markets businesses different from any other form of enterprise I can think of is the amount of discretion given of necessity to non-managerial employees, meaning traders, salesmen, investment bankers, analysts. In pretty much any other large scale business, decisions that have a meaningful bottom line impact (pricing, new sales campaign, investment decision) are deliberate affairs, ultimately decided at a reasonably senior level. The discretion that customer-facing staff have in pretty much any business in limited. At what level does someone have the authority to negotiate a contract? And even then, how many degrees of freedom do they have?

By contrast, think how many decisions traders and salesmen in capital market firms make in a day, and their potential bottom line impact (though experiment: how much damage could a truly vindictive trader do in a day or a week, if he decided to blow up his employer?) Investment bankers work over longer time frames, and like many normal businesses, have a lot of things routinized so as to make them more efficient, but it also limits their latitude (standard forms for many types of client agreements, standard pitch book formats, etc). However, unlike “normal” businesses, a frequent activity in investment banking is creating new products, often in a very ad-hoc way, with teams with relevant skills thrown together to try to push something through. The politics are often sharp-elbowed, but people are too pragmatic to let turf issues interfere with getting a new deal launched).

The approach for managing these businesses in the days of partnerships, when the owners were personally liable for losses, was to have small units with partners running them who knew the business and could oversee it properly. Effectively you had four layers: associate/analyst (the college kids, the analysts, did pretty much the same stuff the associates did, who usually had MBAs, except the MBAs got to go to client meetings more often), VPs, and partners, but some of the more senior partners were department heads in units that also had partners (who’d manage either people on their desks, if traders of salesmen, or if in investment banking, had accounts and various VPs and associate types working on each client). But those department heads had also grown up in the business, and were still active in it. Heads of significant departments in turn would be on an executive committee, a part-time role.

The problem with this model is it starts to come under strain when the partner group gets too large. And OTC markets have strong network effects, so having bigger market share confers a competitive advantage. And now there are high minimum scale requirements for being in the business. You need to be in all major times zones with a pretty broad product array. all kinds of back office support, all kinds of IT for risk management, communications, position management…

So the scale of operation required to be competitive is too large for it to be managed by player-coaches who had deep expertise, and like the Dimon example, were more expert than the people working for them. But the normal corporate/commercial banking management structure, with more managerial layers, and the top brass having broader spans of control, was devised in earlier stages of industrial organization, when you had factories or service business with a great deal of routinization of worker and middle manager tasks. Traditional commercial banks are on the same factory format. They handle large volumes of very simple, standard transactions with a high degree of control and oversight. That’s a big reason why it took commercial banks over 15 years to make meaningful headway against investment banks. Although regulations were an issue, the bigger barrier was the radical difference between the two management cultures. There was no regulatory barrier to commercial banks offering mergers & acquisitions, for instance, but they were lousy at that for a very long time.

So Kay is effectively asking for a traditional commercial banking model, businesses “that make the most of the ordinary talents of ordinary people”. There are businesses like that in banking, but they are mainly in retail banking and corporate lending. If you want that world, you need a far more radical change in the industry than anyone is contemplating now. You’d need to go to the world that Taleb advocates, From a list of his ten suggestions:

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.

5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.

6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.

If we can’t shut down credit default swaps, which the more I dig, the more I see they had a very direct role in the meltdown CDS on subrprime mortgages started in 2004, and there is a longer form gloss as to how that played a major role, if not the key role, in the superheated demand for “product” particularly subprime, in the manic phase of the credit bubble), we will never get to a world like the one Kay wants to see, or at least not until we hopelessly break the one we have now.

I normally steer away from political posts, but this two part interview with Dennis Kucinich on Keith Olbermann’s Countdown focuses on economic issues. The interviewer was throwing softballs, but the critique of Obama was blunt. Is a primary challenge in the offing?

Hat tip reader furzy mouse. Part 1:

Part 2:

Lordie, I can’t believe someone who professes to understand markets has written, at length, that caution, no, “excess of overcaution,” was a major contributor to the criss. Or has Felix Salmon been spending too much time with lobbyists from ISDA and SIFMA?

I hate seeming rude, but Felix has a habit of tearing into Gretchen Morgenson for errors much less significant than the one he made in a post today. He wrote, apropos this chart, which comes from FT Alphaville:

The big-picture thing to remember when looking at this chart is something which I’ve said many times before — that it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution, with an attendant surge in demand for triple-A-rated bonds. On a micro level, triple-A securities are safer than any other securities. But on a macro level, they’re much more dangerous, precisely because they’re considered risk-free. They breed complacency and regulatory arbitrage, and they are a key ingredient in the cause of all big crises, which is leverage….

Then look at the green line. Triple-A debt wasn’t a huge part of the bond market back in the early 90s, but for the past decade it has invariably accounted for somewhere between 50% and 60% of total global fixed income issuance. That’s possibly the most horrifying bit of all: it simply defies credulity for anybody to be asked to believe that more than half the bonds issued in any given year are essentially free of any credit risk.

Now anyone who had read the Financial Times in 2006-early 2007 or was in the credit markets then would know that this statement, “it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution” is demonstrably counterfactual. All you had to do was look at the spreads for risky assets. There was a simply astonishing compression between the yields of perceived-to-be-risk-free assets, such as Treasuries and their toxic counterfeits, the AAA rated tranches of CDOs and CLOs, and risky assets, like the lower-rated tranches of the same bonds, as well as junk bonds. If there was “overcaution” you would have seen a wide spread between AAA bonds and lesser-rated bonds.

But to Felix’s point, demand for AAA paper was robust. But that was not the result of caution; two big drivers of demand (particularly for “manufactured” AAA paper, the kind created by structured credit legerdemain, was as repo to serve as collateral for OTC derivatives positions, and for bonus gaming. In the 1980s, the ONLY acceptable collateral for repo was Treasuries; that started expanding as time went on to other AAA rated assets (and even lower rated assets, but the haircuts were significant). We described both in ECONNED. First on the explosion of OTC derivatives stoked demand for AAA instruments:

Brokers and traders often need to post collateral for derivatives as a way of assuring performance on derivatives contracts…

Due to the strength of this demand, as early as 2001, there was evidence of a shortage of collateral. The Bank for International Settlements warned that the scarcity was likely to result in “appreciable substitution into collateral having relatively higher issuer and liquidity risk.”

That is code for “dealers will probably start accepting lower-quality collateral for repos.” And they did, with that collateral including complex securitized products that banks were obligingly creating.

As time went on, repos grew much faster than the economy overall. While there are no official figures on the size of the market, repos by primary dealers, the banks and securities firms that can bid for Treasury securities at auctions, rose from roughly $1.8 trillion in 1996 to $7 trillion in 2008. Experts estimate that adding in repos by other financial firms would increase the total to $10 trillion, although that somewhat exaggerates the amount of credit extended through this mechanism, since repos and reverse repos may be double counted. The assets of the traditional regulated deposit-taking U.S. banks are also roughly $10 trillion, and there is also double counting in that total (financial firms lend to each other).

In other words, this largely unregulated credit market was becoming nearly as important a funding source as traditional banking.21 By 2004, it had become the largest market in the world, surpassing the bond, equity, and foreign exchange markets.

Now I must confess I have not tried to update the BIS chart. But I have a sneaking suspicion that while derivatives outstandings took a hit in the crisis, between a rise in risk aversion and a concerted effort in credit default swaps land to reduce the notional amount outstanding by netting out offsetting positions, that the old pattern of derivatives outstanding growing more rapidly than the economy has resumed. And now that no one is terribly interested in using AAA rated CDOs as collateral for repo, Treasuries are probably even more important as repo collateral than they were before the meltdown.

A second, significant demand for AAA rated paper was structured credit product creators uncharacteristically eating their own cooking because it enabled them to game their firms’ bonus systems. If you hedged an AAA instrument with a credit default swap from a high rated counterparty, Basel II allowed firms to treat it as having no capital requirement (and there was considerable latitude in the rules as to how much or little hedging was necessary to achieve this happy outcome). US banks in theory had analogous capital weightings, but their higher funding costs for this sort of activity and less permissive treatment of the hedges meant they didn’t do this sort of trade in anywhere near the same volume (save at Merrill, which engaged in accounting chicanery).

The net effect of these so-called negative basis trades were to allow the trading desks to credit FUTURE income (often years into the future), namely, the yield on the instrument less the funging and hedge costs, discounted to the present and was credited to the desk’s P&L. Nothin’ like getting paid on income never to be earned.

Now how significant was this activity? Again, from ECONNED:

J.P. Morgan estimated that Merrill and other major CDO vendors like Citigroup, UBS, and Deutsche Bank wound up keeping roughly two-thirds of the top-rated tranches of the 2006 and 2007 deals, which accounted for the bulk of the value of a transaction, typically 65% to 80%.

Read that again. 2/3 of the AAA CDO tranches were retained by the issuers. These were most assuredly NOT “overcautious”. Has s Felix forgotten some of the pre-crisis dismissals of caution, like US investment banks hoovering up subprime originators and servicers in late 2006 and early 2007? Or how about former Citigroup CEO Chuck Prince’s famously ill-timed expression of optimism in a Financial Times, right before the crisis began in earnest (early July 2007):

Chuck Prince on Monday dismissed fears that the music was about to stop for the cheap credit-fuelled buy-out boom, saying Citigroup was “still dancing”.

The Citigroup chief executive told the Financial Times that the party would end at some point but there was so much liquidity it would not be disrupted by the turmoil in the US subprime mortgage market.

It’s alarming that someone like Felix, who not merely lived through the crisis but also chronicled it in some detail, seems so keen to engage in revisionist history.

A recent post by Ezra Klein, “What ‘Inside Job’ got wrong,” manages the impressive feat of being spectacularly off base, rhetorically dishonest, and embarrassingly revealing of the lack of a moral compass all at once.

Since being off base is a major part of Klein’s brand, I suppose one should not be surprised; those who’ve had the good fortune to have limited contact with his output can read Jon Walker’s “Ezra Klein: Insurance Exchanges Don’t Work and Must be Expanded Dramatically,” or Physicians for a National Health Care Program’s “Does Ezra Klein really think ‘managed care didn’t kill anyone’?” for two of many examples.

I’m going to shred this piece in some detail, first, because it will be entertaining, and second, I hope that it will encourage readers to take a cold, bloodyminded look at the excuses made for malfeasance in our elites.

Let’s start at the top:

I finally watched “Inside Job” this weekend. It was an excellent documentary for people who don’t want to understand the financial crisis but want to believe they would’ve seen it coming. Watching it, you’d think that the only people who missed the meltdown were corrupt fools, and the way to spot the next one is to have fewer corrupt fools. But that’s not true. Worse, it’s dangerously untrue. In telling the wrong story about how the financial crisis happened, it misinforms about how to keep it from happening again.

The only objection Klein raises to Inside Job is that it punctures the favorite defense of economists, regulators, and their mouthpieces in the media “whocoulddanode?” Klein rejects the notion that corruption played a role; there no effort to rebut the evidence proffered in Inside Job and numerous other accounts (including on this blog and in ECONNED). He simply sidesteps the issue of corruption via straw-manning: “corrupt fools”.

The most corrupt were decidedly not fools, they knew better and still took the destructive, profitable course. One can say a lot of bad things about Larry Summers, but no one would call him a fool, and given his track record (Inside Job sidesteps Summers giving his pal Andrei Shleifer a free pass over allegations of self-dealing in Russia that Harvard had to pay at least $31 million to settle), the “corrupt” label fits all too well. Similarly, it is no accident that the hedge fund Magnetar, which successfully bet against lethal CDOs that it created, was named a type of star that emits copious amounts of toxic radiation. Bear Stearns, hardly known for having an elevated sense of morality, still refused to create CDOs for John Paulson in 2005 because it was obvious to them that the deals would be designed to fail. But pretty much everyone else on the Street was happy to peddle the finance equivalent of sewage to their clients. And that’s hardly a new tradition; the Frank Partnoy book FIASCO describes how he and his colleagues took great pride in the early 1990s ripping off the faces of customers and blowing them up (their lingo, not mine)

And courtesy Richard Smith, let’s look at some of Klein’s rhetorical sleights of hand:

Watching it, you’d think that the only people who missed the meltdown were corrupt fools (straw man), and the way to spot (no, avert, not “spot”; you are getting ahead of yourself, the next few paras are about spotting) the next one is to have fewer corrupt fools. But that’s not true (isn’t it? would a lower corrupt fool quota help, or not?). Worse, it’s dangerously untrue (how: what’s untrue? what’s dangerous?). In telling the wrong story about how the financial crisis happened (unsubstantiated assertion), it misinforms about how to keep it from happening again (unsubstantiated assertion).

From this unpromising start, the post goes completely off the rails. Yes, Klein makes weak attempts to fulfill some of the charges made, but as we will see, they range from not-terribly-convincing to outright absurd.

But first, we need to perform an osculectomy, which former investment banker and New York Observer columnist Michael Thomas has outed as a surgical procedure only done on a very hush-hush basis in New York, Los Angeles, and Washington, DC. It becomes necessary when Party A has kissed the ass of Party B with such intensity that a vacuum bond is formed that is so strong that it can only be broken by surgical intervention. In this case, Klein needs to be forceably detached from the posterior of Michael Lewis.

Klein holds up Michael Lewis’ book The Big Short as the ne plus ultra on the financial crisis. That’s mighty peculiar, since Lewis wrote about the subprime shorts, a subset of players involved in the US mortgage mess (which itself was the detonator rather than the totality of the financial crisis), and even then only some carefully selected players (his most notable omission is John Paulson). And it isn’t even the best account of this investment strategy; the more comprehensive and instructive book there is Greg Zuckerman’s The Greatest Trade Ever, which was published five months before The Big Short . As we wrote in March 2010:

Lewis’ tale is neat, plausible to a mass market audience fed a steady diet of subprime markets stupidity and greed, and incomplete in critical ways that render his account fundamentally misleading. It’s almost too bad the book’s so readable, because a lot of people will mistake readability for accuracy, and it’s a pity that Lewis, being a brand name author, has been given a free pass by big-name media like 60 Minutes (old people) and The Daily Show (young people) to sell to an audience of tens of millions a version of the financial crisis that just won’t stand up – not if we’re really trying to get to the heart of the matter, rather than simply wishing to be entertained by breezy well-told stories that provide a bit of easy-to-digest instruction without challenging conventional wisdom.

The balance of the post provides ample support for those charges.

Klein’s touting of Lewis is in keeping with his posture towards the crisis: he wants to stay on the well trodden path of accepted narratives. And that serves the perps just fine. Complexity, opacity and leverage were the generators of this disaster; the more the financial services industry can do to deter investigation into them, the better.

The piece gets even more bizarre:

In 2007, Lewis wrote a piece mocking the worrywarts trying to sound the alarm at Davos. “Davos,” he wrote, “is where people with no talent for risk-taking gather to imagine what actual risk-takers might do.”

It’s ironic that Lewis, who later wrote a book lionizing outsiders who bet against the herd mentality when they were later proven right, took the low risk course in early 2007 and ridiculed nay sayers. If you read the short Bloomberg piece, Lewis was the loud and proud mouthpiece of conventional superficial nonsense circa January 2007: he had bought the Great Moderation and the idea that the world had actually reduced risk significantly by slicing, dicing, and trading it. Before you say it’s easy for me to say that, in post four days before the Lewis piece, “The Beginning of the End?“, we wrote:

We’ve commented from time to time on loose credit conditions (see our “Rising Tide of Liquidity“, plus Part 2 and Part 3 on the same topic) and indifference to risk (“Where Has the (Perception of) Risk Gone?“).

The tide may be turning. Today, the New York Times had a lengthy, well researched article, “Tremors at the Door,” on the reversal of fortune in the subprime mortgage market. Defaults by borrowers have risen to a level where the lenders themselves are increasingly in jeopardy:

Yet Klein tries to invert the interpretation of this embarrassingly bad Lewis piece:

He knows financial markets, knows the people in financial markets, and knows the products in financial markets. But he missed it. Completely. And no explanation of the financial crisis that doesn’t have room for Lewis to miss it is sufficient.

What kind of meshugas is this? Because Klein’s favorite financial writer missed the onset of the crisis, we are to give all the analysts, economists, regulators, and bankers a free pass? And he can say this with a straight face after the Financial Crisis Inquiry Commission documented in far more detail than Inside Job that there were plenty of warning signs?

Let’s get down to real basics: can Klein simply not tell the difference between Lewis, a bond salesman 25 years ago, and author/journalist since then, and a genuine in-touch expert on some aspect or other of modern finance?

Or do we assume Klein does know the difference, which makes Klein’s remark a decidedly, not to say, insanely journalist-centric view of the crisis. I shall not speculate about why a journalist who doesn’t know anything about finance might be tempted to conclude that the crisis was actually all about journalism. Still, it’s impressive (though not necessarily in a good way) to see someone actually publish that conclusion, quite unselfconsciously; if that’s what he meant to say.

And this is where Klein’s choice (whether deliberate or out of learned blindness) is particularly convenient ; it’s the device he uses to dodge the central issue of corruption. As Tom Adams noted via e-mail:

I am fairly amazed that someone purporting to be writing about how “inside Job” is dangerously wrong can spend the entire rest of the article discussing Michael Lewis.

In so doing, Klein ignores the most obvious reason that he is effectively confirming his own summary about “Inside Job” – that it suggests anyone who didn’t see it coming was corrupt.

Obviously – the answer is that Lewis has been corrupted as well. It’s not the hard corruption of CDO salesmen saying the CDO manager was independent when he was fig leaf that allowed the bank to dump its toxic exposures, or of mortgage brokers telling their customers they were getting a 30 year fixed rate mortgage and instead giving them documents for an options ARM at closing, but it is a form of corruption nevertheless. He is a member of the NYC media elite, a group enraptured by its own wonderfulness. For Lewis and his peers, the crisis aws an excellent marketing device and they exploited it for their own purposes. Lewis was not interested in explaining (or anticipating) the financial crisis. He was interested in selling books. With his books, he is also deeply in love with his own narrative devices – outsider takes on the establishment, acts unconventionally, wins.

He was not looking to explain why everyone got it wrong nor did he bother to take on two of the biggest forces in the market – Paulson and Magnetar – because they didn’t fit his narrative. And the narrative was what mattered because Lewis has honed his storytelling approaches and has a large audience eager for more stories that present the same arc. That is what the was selling, not the “truth”.

Then Klein tries the dodge because no one saw the particular way the crisis played out, no one can be held responsible for not seeing it:

A lot of observers understood we had a housing bubble — Dean Baker, for instance, had been sounding the alarm for years — but few of the housing skeptics saw everything going on behind the bubble: That the subprime mortgages had been packaged into bonds, that the bonds had been sliced into tranches, that the formulas being used to price and rate the tranches got the variable expressing correlation wrong, that an extraordinary number of banks had purchased an extraordinary amount of insurance against getting that correlation wrong from AIG, that AIG had also priced the correlation wrong and would be unable to pay its debts in the event of a meltdown, that a meltdown would freeze the mostly unregulated shadow market that major financial institutions and players used to fund themselves, that the modern financial system was so fragile that an uptick in delinquent subprime mortgages could effectively crash the global economy.

Klein needs to get out more. See the fallacy in his reasoning? Note he demand that someone have foretold the specific path the crisis went down for them to get credit for having called it. And as an aside, par for his knowledge of the crisis, Klein’s discussion of AIG is badly confused. He mistakes the damage that the collapse of AIG would have caused via its status as being the world’s biggest insurer (which would have been horrific) with the losses that resulted from AIG having written credit default swaps on subprime-related CDOs that it could not honor (you can debate how much that ultimately cost, but the New York Fed forked over roughly $30 billion, which is a large but not financial-system-wrecking number).

Why is Klein’s requirement that someone have been able to project the course of the crisis unreasonable? Even if you can specify PERFECTLY the rules that govern how a system works, in a system subject to not all that many forces, it quickly becomes impossible to make an accurate forecast. This issue was identified in 1899 by mathematician Henri Poincaré, who won a prize for demonstrating that a long-unsolved puzzle from physics, that of determining the movements of three or more celestial objects (meaning their gravitational forces could affect each other), was for all practical purposes unsolvable. You needed to specify their initial conditions (mass, location, velocity) to such an extraordinary degree of precision that even a miniscule error leads the
actual path of the object to diverge from the predicted path. Those deviations increase as time passes, so that the actual path may lose all resemblance to the predicted path.

Think of how much more complicated our financial system is than the movements of three celestial bodies. We can’t specify how actors operate with highly accurate mathematical formulas. We have a lot more than three actors. Therefore any attempts to predict what will happen are likely to be subject to the same problem that Poincaré stumbled upon: even if you can describe the forces at work accurately, you cannot make useful predictions, at least not over anything other than very short time frames.

But you could nevertheless very clearly see in late 2006 and 2007 that Things Were Going to End Badly merely by reading the Financial Times. You could tell we were in the midst of a global credit mania. There was regular discussion of the “wall of liquidity”. Credit spreads for every type of lending were at unprecedented, astonishingly low levels by any historical standards. It was not hard to anticipate with so much profligate lending going on in every sector of the market that there would be tremendous losses down the road.

If you want to see what a financial services expert who was not a credit markets insider could infer before the crisis, I suggest you read the paper released in April 2007 by an equity analyst, Henry Maxey of the UK investment management boutique Ruffer. It’s a remarkable piece of work.

Cracking the Credit Market Code

We then get to more dictation from the Ministry of Truth via Klein:

What’s remarkable about the financial crisis isn’t just how many people got it wrong, but how many people who got it wrong had an incentive to get it right. Journalists. Hedge funds. Independent investors. Academics. Regulators. Even traders, many of whom had most of their money tied up in their soon-to-be-worthless firms. “Inside Job” is perhaps strongest in detailing the conflicts of interest that various people had when it came to the financial sector, but the reason those ties were “conflicts” was that they also had substantial reasons — fame, fortune, acclaim, job security, etc. — to get it right.

Huh? He can write this with a straight face? He has the incentives 100% wrong.

Asset bubbles are very popular. They look like increased wealth to the community. That’s why regulators are reluctant to intervene. If they do, they make people look less prosperous immediately, and they can’t prove the counterfactual, if they had left things alone, the damage would have been worse. Recall the orthodoxy then was you couldn’t recognize a bubble in progress, better to clean up afterwords. And that’s before you get to the corruption that Klein is so keen not to discuss: regulatory revolving doors, annual bonus cycles which promote the institutionalized “devil take the hindmost” attitude, known in finance as “IBG-YBG” for “I’ll be gone, you’ll be gone”.

Did Klein miss the rise of access journalism? Clearly so. Even then, the Economist, the oracle of leading edge conventional wisdom, pointed out the existence of a global housing bubble in June 2005, in a can’t-miss-it cover story with lots of supporting analysis. The subtitle: “The worldwide rise in house prices is the biggest bubble in history. Prepare for the economic pain when it pops.”

The salient characteristic of this bubble was the so-called wall of liquidity. There were plenty of nervous longs as of early 2007, but they figured they could get out when things got bad. That turned out to be incorrect, and predictably so, because liquidity collapses in bear markets.

But with hedge funds and other money managers subject to monthly reporting, and punished if they show lower performance than their peer group, their incentives are to follow the herd. Contra Lewis and popular wisdom, every mortgage industry conference had worried panels about subprime from 2005 onward. I’ve spoken to industry participants who said they knew they were rationalizing continuing to participate in the market because the institutional pressures were to do so. Other people looked to be making money, so exiting the market would lead to pushback from shareholders. And this behavior isn’t new either. As Keynes said, “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him”

And then we get to Klein giving everyone (most importantly the elites!) a free pass:

And ultimately, that’s what makes the financial crisis so scary. The complexity of the system far exceeded the capacity of the participants, experts and watchdogs. Even after the crisis happened, it was devilishly hard to understand what was going on. Some people managed to connect the right dots, in the right ways and at the right times, but not so many, and not through such reproducible methods, that it’s clear how we can make their success the norm.

This is worse than useless, since Klein incorrectly throws up his hands and effectively says no one can understand what happened and therefore there’s no answer. One of the reasons the crisis has been so “difficult to understand” is that the government and banking elites have been taking extraordinary efforts to obscure the truth. The AIG bailout, the GSE bailouts, the alphabet soup of Fed facilities, the con game of the “stress tests”, the refusal to release information, the ridiculous government programs to “restart” the market, the efforts to deny the mortgage crisis, HAMP, the ongoing efforts to prop up the banks even though the are insolvent, they are all massive efforts at obscuring what really happened and what is still going on. This is not a coincidence; it is a deliberate effort orchestrated by the banks, the Fed, and the Treasury.

And plenty of people have sound proposals for what ought to be done. The best formal work in this area, if Klein would bother doing even the most basic digging, comes from the Bank of England. The answer, in short form, is prohibition: banning certain activities and products, breaking up the banks and implementing other measures to reduce the interconnectedness of the system and contain risk taking.

Before you say we can’t do that, the banks will decamp to the Caymans or innovate around it, let me tell you the dirty secret the finance industry does not want you to know: the ECB or the Fed and possibly even the Bank of England could impose what amounted to a global regulatory regime on the biggest banks any time they wanted to (and that could include hard restriction on lending to parties outside the regulatory cordon sanitarie).

First, any big bank needs to be backstopped by a pretty solid central bank. They all know that even if they harrumph otherwise, no big bank is going to take much counterparty risk with a not-credibly-backstopped big player; they’d see their funding costs rise and the positions they could take reduced, which would quickly reduce profits and those sacrosanct bonuses). Second, all bank payment systems in a particular currency ultimately need to be settled via central bank payment system for that currency (for instance, the US’s Fedwire is the critical dollar payment system) and there is no way for the banks to innovate around that. And the big dealer banks need direct access to Fedwire; going through a correspondent is not viable from a cost and operational standpoint. If you are a serious capital markets player, your need to trade dollar and euro instruments. The need to use to central bank controlled facilities in the dollar and euro means the Fed and ECB could dictate terms if they chose to.

So this gets us back to the issue that Klein wants us to ignore: corruption and capture. The problem is not that there are no solutions. There are steps that we could take now to make modern finance much less risky, but that involves imposing pain on bankers. And that has not happened because, as Simon Johnson pointed out in May 2009, is that the US has suffered a “quiet coup” and is now in the thrall of financial oligarchs. The obstacle isn’t scariness or complexity, it’s the lack of political will.

It’s easy to understand why Klein writes this sort of piece. What is hard to fathom is why anyone, other than his patrons, continues to give what he has to say much credence.

It has taken forever for the SEC to probe the workings the biggest sponsor of toxic CDOs and of course the agency is going after only one highly publicized doggy deal. Nevertheless, the SEC has finally decided to look at the less than arm’s length relationship between the hedge fund Magnetar, whose Constellation program played a central role in blowing up the subprime bubble, and its collateral manager, which in this case a Merrill affiliated firm called NIR. As we will discuss, collateral managers were critical because they effectively served as liability shields for the other participants.

Note that Magnetar does not appear to be the target; the Financial Times reports that the SEC is examining how the deal’s underwriter Merrill sold the deal and how it worked with NIR.

The very same CDO that is the focus of the SEC probe, Norma, was also the first to be noticed outside the comparatively small community involved in creating and buying these deals, in a Wall Street Journal story by Serena Ng and Carrick Mollencamp in late 2007. By the standards of CDOs, Magnetar’s were somewhat exotic, in that they were heavily synthetic. Most (but not all) of the assets were credit default swaps; about 20% of the deal’s asset were bonds, primarily BBB tranches of subprime bonds or the lower rated tranches (AA to BBB) of other “mezz” (for mezzanine, meaning made largely of lower rated bond tranches) CDOs.

Ng and Mollencamp did a second story about Magnetar, which discussed how it had launched a series of CDOs (by their tally, $30 billion) and had set the deals up to fail. We did a fuller treatment of Magnetar in our book ECONNED and broke the story of how the fund played a central role in pumping up demand for the very worst subprime mortgages in the toxic phase of the bubble

Magnetar constructed a strategy that was a trader’s wet dream, enabling it to show a thin profit even as it amassed ever larger short bets (the cost of maintaining the position was a vexing problem for all the other shorts, from John Paulson on down) and profit impressively when the market finally imploded. Both market participant estimates and repeated, conservative analyses indicate that Magnetar’s CDO program drove the demand for between 35% and 60% of toxic subprime bond demand. And this trade was lauded and copied by proprietary trading desks in 2006.

As a source who worked in the structured credit area of a firm that did Magnetar trades explained in ECONNED:

At their peak, Magnetar was *THE* driver of RMBS [residential mortgage backed security] CDO issuance. The size of their “Constellation” program was the most amazing thing I’ve seen in my entire career. . . .

Magnetar’s idea was that CDOs were destined for long term failure—that the leverage on leverage based on cr*p assets made the BBB tranches long-term zeros. And, they realized that while most other hedge funds were content shorting the BBB tranches from subprime RMBS, shorting BBB tranches from RMBS CDOs was a much more slam dunk of a trade. The commentary is right . . . without someone willing to fund the equity of a CDO there was no way to get one done. So, Magnetar made the logical leap . . . they’d fund the equity necessary to create the structures and then short a multiple of the bonds their equity money had allowed to be created.

The gravy was that the equity was typically good for one or two VERY HEFTY cashflow distributions—i.e., these structures went terrifically bad, but it usually took a little while from a timing perspective for that to happen. So, their carry cost of the shorts was offset by the one or two equity payments. After that, their upfront costs were covered and they would own the 100 point options for free.

Magnetar made A TON of money . . . I’d expect every bit as much as Paulson

The important part of this arrangement was that the equity funder put up 4-5% of the deal in a cash or hybrid CDO. Because this was the scarce part of the equation, and the riskiest exposure, this investor was the sponsor of the deal and gained control over its parameters. At a minimum, the equity investor had veto rights over the bond exposures chosen, and reports from various Magnetar deals indicate that in some cases it presented lists of bonds to go into the deal and/or set criteria (as in the bonds be particularly “spready” which also meant drecky). Since Magnetar was using its equity stake to make sure it would be able to establish a short position that was a multiple of its equity position, making it net short, its interest lay in using its influence to make sure the CDO had particularly bad exposures.

One of the keys to this arrangement was the role of collateral managers (also called “CDO managers”), which were often not independent even if billed as such (for instance, the Levin report includes Goldman pitch books for its really doggy CDOs have pitchbooks that stress the quality of the CDO manager, when internal e-mails show the firm favoring CDO managers who were expected to be compliant). Many were small free standing firms (the industry joke was “a couple of guys with a Bloomberg terminal”) who depended on investment bank warehouse lines (lines of credit) to stay in business. We’ve written often about the questionable role of the CDO manager, first in ECONNED, and repeatedly on the site. From ECONNED:

If credit defaults swaps were regulated, this would be insurance fraud on a massive scale….

Anyone involved in these transactions probably understood the implicit logic, even if no one acknowledged it. But there is a remarkable absence of anyone who could be pinned with liability. Magnetar officially had no legal relationship to these deals. The investment bank packager/structurer was off the hook as long as he made reasonable disclosure (and remember, the standards are much lower here than for instruments that fall in the SEC’s purview). The only party on whom liability could be pinned is the CDO manager, who does have a fiduciary responsibility to all investors, not just the sponsor. But the fact that the party who in theory had the most to lose, Magnetar, approved their investments, would seem to exculpate the CDO manager.

From a 2010 post by Tom Adams, “SEC/CDO Litigation: Why Aren’t the Collateral Managers Being Sued Too?“:

One issue that continues to puzzle us, in looking at the sudden furor about seemingly duplicitous dealings by investment banks in the real estate related CDO business, is that the focus thus far has been primarily on the investment banks that packaged and sold these toxic investments….

On the other hand, in the great majority of CDOs, the collateral manager was presented as an independent party whose role was to make sure that the CDO performed well…..Thus the CDO manager can also be argued to have defrauded investors to the extent it acted as a rubber stamp for the wishes of the sponsor, and/or simply served as a marketing device for the investment bank packaging and arranging the deal…

It is also hard to imagine that the collateral managers didn’t understand the intentions of CDO sponsors like Magnetar and Paulson who were using CDOs as a way to establish a short position more cheaply than they might have otherwise. If you look at our list of Magnetar deals, sorted by collateral manager, four firms, Harding Advisory, GBC Partners, Putnam Advisory, and NIBC Credit Management, worked on multiple transactions. How plausible is it that they had no idea of the sponsor’s true aims?

The Ng/Mollencamp story (in 2007, mind you) suggests that the CDO manager for Norma was simply a shield for Magnetar’s true intent:

In 2006, [former penny stock operator Corey] Ribotsky [who headed the Merrill affiliated CDO manager NIR] says Merrill came to NIR with a new proposition: One of the investment bank’s clients, a hedge fund, wanted to invest in the riskiest piece of a certain type of CDO. Merrill worked out a general structure for the vehicle. It asked NIR to manage it.

“It was already set up when it was presented to us,” Ribotsky says. “They interviewed a bunch of managers and selected our team.”

So with the outlines of a case set forth in the Wall Street Journal over three years ago and the role of CDO managers getting considerable attention here and in other venues, most notably Michael Lewis’ The Big Short, the Financial Times tells us the SEC has finally roused itself:

The Securities and Exchange Commission is investigating Merrill Lynch’s sale of a complex mortgage-related security it created for Magnetar, an Illinois hedge fund, and the collateral manager involved in the deal, according to people familiar with the matter.

The investigation is one of several SEC probes into banks that helped underwrite billions of dollars of collateralised debt obligations, securities comprised of mortgages or derivatives linked to them.

It also marks a broadening of the SEC’s investigation into the role of collateral managers, institutions that help select the assets included in CDOs.

NIR Capital Management, a Roslyn, New York firm run by Corey Ribotsky, served as manager for the security under scrutiny, a $1.5bn CDO known as Norma. Neither Mr Ribotsky nor his attorney returned calls seeking comment.

Regulators are looking at whether collateral managers, which are supposed to serve CDO investors’ interests, fulfilled their obligations…

Regulators are also looking into whether Merrill mispriced assets in the CDO, these people say. Bank of America, which acquired Merrill Lynch, declined to comment. The bank previously said it lost $900m on the Norma CDO.

Merrill got stuck with a lot of CDO inventory when the music stopped. Louise Story in the New York Times described how Merrill engaged in dubious accounting to hide how large its holdings were.

And even better….the SEC case piggybacks on a private action:

In 2009 Dutch bank Rabobank, which invested in Norma through a loan, sued Merrill in a New York state court, alleging the bank overvalued some assets by marking them at face value even though their market value had already deteriorated by 15 per cent…

According to Rabobank’s lawsuit, Merrill allegedly created Norma as a “tailor-made way to bet against the mortgage-backed securities market”. The suit said: “Merrill Lynch hand-picked a beholden collateral manager that was willing to ignore its fiduciary duties to Norma’s investors by selecting Norma’s collateral pool at Merrill Lynch’s behest rather than on the basis of the rigorous independent analysis.”

This is an indication of how asleep at the wheel the SEC has been. Normally, you expect regulators to launch investigations and develop cases and then have private claimants build on the groundwork they have laid, not the reverse.

Tom Adams and I have tried multiple times to get the attention of the SEC, with no success. Tom is an attorney and an industry expert, and there are virtually none who are willing to jeopardize their union card by helping develop litigation strategies and/or serve as an expert witness. We finally did get to someone in the SEC Compliance division but we were told Compliance and Enforcement don’t play well together, and the Compliance officer got nowhere with Enforcement.

It is one thing if the SEC had met with us and decided we would not add much to their team, but the lack of interest when there were very few people who had a seat at the table in the CDO business to begin with seems very short sighted. But as this post suggests, the SEC’s approach here seems to be to go after only the lowest-hanging fruit, and in a product area as complex as CDOs, that will yield very few targets.

The Goldman defense against the Levin report is so late and so pathetic that it looks increasingly evident that the bank is simply hoping to cause confusion and muddy the waters rather than mount a frontal, fact-based rebuttal. Mind you, sniping and innuendo can prove reasonably effective if done persistently and loudly enough. The book Agnotology describes how Big Tobacco managed to sow doubt over decades of the link between smoking and lung cancer well after the medical evidence had gone from suggestive to compelling.

The first Goldman salvo was an Andrew Ross Sorkin piece on Monday which we deemed as unpersuasive. While it did point to an error in the Senate report, it failed to make a real dent the report’s findings, and most important, the notion that Goldman staffers, in particular Lloyd Blankfein, were pretty loose with the truth.

The most contested statement is the Blankfein denial that the firm had a “massive short” position; as Matt Taibbi points out today, the only way out on that one is to get into Clintonesque parsings of the word “massive”. Given the overwhelming evidence that Goldman intended to get out of its mortgage risk in late 2006 and its staff DID get the firm short in February 2007, then reversed that position in March to correctly catch a short term bounce (the market recovered from March to May, when it went into its free fall). And in the March-May period, it was still getting as much crap product out the door and lying to clients about its position in the deals, claiming its incentives were aligned when its effective short position in the deals meant the reverse, that it would profit if they tanked, which they did.

But focusing on the “massive short” issue is misdirection pure and simple. Levin sent the entire report over to prosecutors. He didn’t tell them what legal theories to pursue. There are clearly others a prosecutor could pursue, such as misrepresentations Goldman made in selling CDOs like Hudson and Timberwolf, or other questionable statements made by Blankfein and others in Senate testimony (for instance, as we wrote earlier this week, the Blankfein argument that Goldman was merely a market maker is patently untrue, but probably not worth pursuing in isolation).

What is interesting is the Goldman defense reveals how much damage Taibbi has done to the firm. Notice that it is not primarily rebutting the Levin findings; it’s trying to dent its credibility by pointing out errors, but it is not addressing the report’s framing. Instead, it is dealing with Taibbi’s distillation of the report in his article “The People vs. Goldman Sachs,” and specifically, the argument that Taibbi made, that the simplest case was to get the Goldman execs on perjury:

Though many legal experts agree there is a powerful argument that the Levin report supports a criminal charge of fraud, this stuff can keep the lawyers tied up for years. So let’s move on to something much simpler. In the spring of 2010, about a year into his investigation, Sen. Levin hauled all of the principals from these rotten Goldman deals to Washington, made them put their hands on the Bible and take oaths just like normal people, and demanded that they explain themselves. The legal definition of financial fraud may be murky and complex, but everybody knows you can’t lie to Congress.

“Article 18 of the United States Code, Section 1001,” says Loyola University law professor Michael Kaufman. “There are statutes that prohibit perjury and obstruction of justice, but this is the federal statute that explicitly prohibits lying to Congress.”

The law is simple: You’re guilty if you “knowingly and willfully” make a “materially false, fictitious or fraudulent statement or representation.” The punishment is up to five years in federal prison

By contrast, Levin said to the Financial Times in May:

The senator said Goldman’s payment of $550m to settle fraud allegations from the Securities and Exchange Commission in connection with the marketing of one structured debt product did not preclude other allegations. He said Goldman executives misled his committee but suggested they might have stopped short of lies with “wiggle words”.

“They obviously spent a lot of time parsing words,” he said, adding he was “not going to judge whether they committed perjury”

Let me state this again: the Goldman defenders are attributing Taibbi’s legal theory to Levin when Levin left that up to the prosecutors. Slick, no?

Now let’s deal with the latest Goldman-prompted rebuttals. One was e-mailed by Goldman alumni relations, which hardly ever sends anything other than infrequently touting select research pieces:

The Jenkins piece, once you edit out the invective and ad hominem attacks, has remarkably little in the way of substance. It’s a classic example of the old saw, “If the law is on your side, pound on the law; if the facts are on your side, pound on the facts; if neither is on your side, pound on the table.”

He calls Levin a whole bunch of names, falsely claims that he is “now backtracking” on perjury accusations Levin never made (when the report was released, he used the word “misled” and has stuck with that formulation) and accuses him of opportunism (on what grounds, exactly? Attacking a famous representative of a powerful donor group like bankers is hardly a pro-survival strategy for a Congressman these days). And he straw mans big time, depicting the report as a witch hunt on Blankfein. Huh? That remark just makes it blindingly obvious that Jenkins didn’t read the report.

He also reveals that he understands nothing about trading or the role of CDOs and credit default swaps in the crisis As we’ve said repeatedly, short sellers via CDS bear no resemblance to short sellers in other markets, and go through the math in long form in Chapter 9 of ECONNED as to how the subprime shorts played a direct role in stoking the subprime bubble and turning what would otherwise have been a contained subprime crisis into a global financial criss. If Jenkins would like to avoid so visibly putting his foot in mouth and chewing in public, he might educate himself rather than take Goldman PR as gospel.

And it also, contrary to multiple source of evidence in the Levin report, tries to depict the firm as dumb and lucky, when it was clear it made a strategic decision to dump as much mortgage risk as possible in late 2006, chose to get net short in February 2007, and then successfully caught a short-term bottom and went long.

Jenkins also bizarrely claims that the failure of Goldman to ride a short position to the market bottom represents some sort of exoneration of Goldman. That’s so barmy I don’t know where to begin. No trader expects to catch peaks and troughs; the pros I know say if you get 50% of a market move, you’ve done very well. And if you read Michael Lewis’ The Big Short, the people who really understood this trade, namely Steve Eisman and the hippie hedgies of Cornwall Capital recognized that if it worked out, it could well represent the end of the financial system, which proved to be a valid concern. The Cornwall folks were very worried about counterparty risk and closed out their trades early.

There is an equally bizarre rebuttal-by-innuendo at the Goldman PR annex over at the New York Times’ Dealbook. In fairness, it reports on the issuance of a Goldman-favoring one-page note by bank stock tout Dick Bove, who seems to have appointed himself a one-man vigilante effort to impede prosecution of his meal tickets (he accused New York attorney general Eric Schneiderman, who seems to be systematically investigating mortgage fraud, of being on a “witch hunt” and “out to make a name for himself”. Since it was the banks that leaked work of Schneiderman’s probes, it’s backwards and uninformed for Bove to accuse Schneiderman of grandstanding).

The problem is there is nothing of substance in the piece, save that Goldman had a little chat with Bove and he is now a true believer:

But now, having gone through the report with Goldman and looked at the supporting documents, he doesn’t believe the allegations that have been levied against the firm. He said he is “perplexed” why Goldman didn’t come forward earlier with their objections to the report.

So we are supposed to trust Goldman via Bove. If the evidence is so persuasive, why is Goldman keeping it so close to the vest? Attorney and structured credit expert Tom Adams said via e-mail:

Apparently unembarrassed by Matt Taibbi’s stinging attack on Dealbook’s shilling for their financial partner, Goldman Sachs, Dealbook continues to due the bidding of their master again today. This time, they interview Dick Bove, of Rochdale Securities, regarding his just published surprising “about face” on Goldman. The report cleverly takes the passive voice, saying that “evidence is now mounting” that a terrible wrong has been done to Goldman because they really didn’t have a net short position, as cited by Senator Levin’s report.

Where is this evidence? Who is it mounting with? In his interview with Goldman, Bove reveals that Goldman themselves walked Bove through their “evidence,’ just as they did for Andrew Ross Sorkin earlier this week, prompting him to echo the new Goldman line that the Senate report was wrong. In his one page note, Bove does not trouble readers with any of the details of the evidence – thus providing no ammunition for potential critics to challenge his conclusion. But Goldman’s hand holding was sufficient to allow Bove to conclude that the Senate committee “misread” the numbers.

Normally, one might expect someone making such an argument – accusing a Senate Committee of lying, basically – to provide some support for such a bold conclusion. Not Bove, though. Perhaps, however, Mr. Bove wasn’t really able to accurately read or understand what Goldman put in front of him. In his interview with Dealbook, he goes even further than what Sorkin argued (that Goldman’s net short position was smaller than what the Senate report claimed because of supposed “offsetting” long positions in mortgage loans elsewhere in their portfolio), and Bove concludes that he doesn’t believe the Senate’s allegations at all and he has “completely changed my attitude about whether they did something wrong”. Instead, he believes Goldman is being unfairly scapegoated.

Taibbi noted when critiquing Sorkin’s article, the more important theme for Goldman’s PR effort appears to be an attempt to undermine the motion that Goldman CEO Lloyd Blankfein lied to the Senate under oath when Blankfein denied that Goldman was “massively short”. Bove dutifully trots out an attempt to defend Blankfein, as well. Comically, Bove compares Blankfein to Andrew Mellon who was subjected to a tax investigation by the Roosevelt administration but ultimately exonerated. This apparently proves to Bove, that rich powerful bankers are commonly the targets of unfair investigations and “scapegoating” and that this is grave miscarriage of justice.

Even an ardent bank defender such as Bove is not persuaded completely. He concedes that Goldman may have done things that “were not correct”, but that the Levin report did not uncover them. Not exactly a firm vote of confidence, in reality, and quite a bit less of a newsworthy story than the Dealbook headline (“Richard Bove Does an About Face on Goldman”) trumpets.

Why has Goldman taken this unconvincing approach to defending itself through the use of bank friendly analysts or reporters? What do they hope to gain from this? Why haven’t they released real numbers and analysis to back up their supposed claims, as reports suggested they might do? This manipulative approach to selectively revealing contradictory evidence, without the courage of a true public defense, seems to a poor solution to their problems. It exposes both the shilly quality of their defenders and a lack of confidence in their counter-attack.

Indeed, there would be some comparatively simple ways to shut up critics and the failure of Goldman to use them raises red flags about their rebuttals. For instance, my understanding is Goldman calculates value at risk (VAR) down to the level of fairly small units within the firm. VAR has its defects, but for this purpose, it would not be a bad first order approximation for contending they were not net short in a meaningful way in the relevant instruments.

The failure of Goldman to provide any metrics over the time frame analyzed in the Levin report, when it clearly depicts strategic decisions of a number of individuals, both at senior levels and on the relevant desks, and then in advance, when trades were being executed, and after the fact, presents an evidentiary hurdle that the firm must surmount. Nothing it has provided even remotely meets that standard.

And it needs to put the arguments and backup before people who can judge it, not reporters or equity analysts. They may be generally intelligent but don’t know the risk characteristics of the various instruments that Goldman would use in establishing and reversing positions in the mortgage market and thus can easily be misled. Goldman’s soliciting votes of approval from people utterly unable to judge the evidence is a sign of weakness, not strength.

.

On the one hand, this is just a subpoena of Goldman from the Manhattan DA’s office, but on the other, after all the crisis investigations, we finally have a prosecutor somewhere deciding to take some abuses during the crisis seriously enough to see if they add up to a legal case. (Yes, the SEC did file a suit against Goldman on one synthetic CDO, one transaction out of 25 in its Abacus program, which Goldman settled for $550 million, but this was litigation on one deal, not on broader patterns of misconduct).

And it came not out of the splashy but designed not to accomplish much FCIC, but the quieter and more tenacious Senate’s Permanent Subcommittee on Investigations. I hardly ever do media briefings, but I was on the blogger call for both reports, and the contrast was night and day. The FCIC briefing was softball PR, with Phil Angelides and Brooksley Born (who by definition had not done the work and therefore were not big on detail) leading the call. The Senate call was led by staffers who demonstrated impressive command of the products and industry economics and transmitted information at a very high bit rate.

Not surprisingly, the information request comes from a local prosecutor. The DoJ continues to be missing in action.

In one sense, these suits are about whether the officials believe markets should be kept safe for investors. That was the premise of the securities legislation of 1933 and 1934; CDOs technically are not securities (mortgage bonds, by contrast, are) and are thus are subject to a lower level of investor protection. Goldman and its ilk effectively rely on the “consenting adults” idea: per them, no one can claim any harm or foul; everyone should know investment banks are on every side of a trade and will probably screw you.

But the process of issuing CDOs was almost guaranteed to prevent adequate due diligence. The deals would be marketed based on general parameters about 60 days before the targeted closing. Some deals were “managed” meaning they were “trust me” paper where investors relied on the independence and experience of the firms hired to be CDO managers. We’ve since learned that in many cases these firms were NOT independent; indeed, the material presented in the first round of the Levin hearings showed that Goldman was looking for compliant managers, meaning ones that would not ask too many questions about the dreck Goldman wanted to put in these CDOs. For the “static” deals, the list of what was in the CDO would typically be presented the day before closing, which was not enough in advance to allow for a serious evaluation.

Put it another way, if you had consensual sex with someone who had HIV and didn’t tell you about it, how would you react? It may not be illegal under the law but it sure ought to be criminal. And some jurisdictions have found it to be criminal even with no specific laws against it on the books.

Bloomberg broke the story and the New York Times provided a summary:

Goldman Sachs has received a subpoena from the office of the Manhattan district attorney, which is investigating the investment bank’s role in the financial crisis, according to people with knowledge of the matter.

The inquiry stems from a 650-page Senate report from the Permanent Subcommittee on Investigations that indicated Goldman had misled clients and Congress about its practices related to mortgage-linked securities.

This Bloomberg video provides additional detail as to the issues highlighted in the report that look to be relevant to prosecutors:

Switzerland has taken the sensible move of recognizing that it cannot credibly backstop banks whose assets are more than eight times the country’s GDP. It is in the process of imposing much tougher capital requirements, expected to be nearly 20% of risk-weighted assets, well above the Basel III level of 7%.

UBS apparently plans to partition the bank in a Glass-Steagall lite split, leaving the traditional banking operations in Switzerland and putting the investment bank in a separate legal entity outside Switzerland. This resembles the approach advocated in the preliminary draft of the UK’s Independent Banking Commission report, of having retail banking and commercial banking separately capitalized.

The problem is that the devil lies in the details. Regulators need to be scrupulous that there is no lending or guarantees between the two units, or even cross promotion which may create liability. Recall that auction rate securities, a capital markets product, were sold as an alternative to money market funds. Regulators would need to bar this type of cross marketing if they were serious about separating the entities from a risk assumption standpoint. And if they really were THAT separate, why are they under the same roof? Managerially, it’s hard to manage such disparate businesses, particularly if you end the offsetting benefit of cheaper funding (well, there is one reason they will probably keep the companies combined: executive level pay in banking is very highly correlated with the size of the balance sheet).

The Wall Street Journal questions whether this finesse will work:

Under UBS’s planned overhaul, the investment bank would be transformed into its own legal entity, according to the people familiar with the matter. Swiss regulators hope that the change would mean that if the investment bank encountered problems, the parent company, which also includes a large wealth management arm, would no longer be liable for the losses. Right now, the bank’s units abroad have less capital than they otherwise would need because UBS has agreed to serve as a financial backstop, promising to bail them out if they ran into trouble, these people said.

However, it is unclear whether creating a legally and financially independent investment-banking vehicle will truly insulate the UBS parent company—or the Swiss government—in the event of another disastrous crisis. Local regulators could still demand that the Swiss government step in to cover any future losses at the investment bank….They haven’t decided where to locate the investment-banking entity or how to structure it.

Yves here. I recall well when Swiss Bank Corporation (the company that was dominant in the SBC-UBS merger despite the survival of the UBS name) decided to transform itself into a major capital markets player by investing in and later acquiring a client of mine, the cutting edge derivatives firm O’Connor & Associates. O’Connor had decided it needed access to a much bigger balance sheet in order to remain competitive. The European universal banks have tremendous funding cost advantages; US players in the 1990s would often contend that they needed to have a similar degree of integration to hold their ground. So query whether this arrangement will be economically viable continued cross subsidies between the two entities that vitiate the structural separation.

And of course, let us look at the intent. Whether or not the UBS scheme works, the objective is to move the risk of the investment banking operations to somewhere outside Switzerland. All the US investment banks needed to be rescued in the crisis (spare me the “Goldman was sound” palaver. And pretty much no one save a few loyal defenders of the Administration believes that the Dodd Frank Title II resolution authority will work for a meaningful capital markets firm. If you had told most financial professionals in 2006 that a crippled investment bank would be rescued by the government, they would have told you you were nuts. We now know better. So why should the US (or the UK) voluntarily take on risky operations that they may have to backstop? (One could cynically say this is a moot issue, given that the Fed lent money generously to foreign banks in the crisis).

The WSJ article voices some similar doubts:

Part of that calculus appears to hinge on where the investment bank would enjoy the greatest latitude to operate, although Swiss regulators want the unit headquartered in a country where the investment bank has major operations…

Under its current setup, the Swiss parent company has agreed to serve as a financial backstop for the world-wide operations of UBS’s investment bank if they encounter problems. As a result of those guarantees, local regulators in various countries permit the units to operate with thinner capital cushions than they would otherwise need to maintain.

Better insulating UBS’s investment bank from other operations could make it difficult, or at least costlier, for its bankers to use the company’s vast balance sheet to win deals, according to people familiar with the matter. Currently, the investment bank is able to use the heft of the balance sheet of the entire firm to borrow against to participate in deals. That financing capability would be reduced if the investment bank was isolated from the rest of the company and its balance sheet was smaller.

The UBS CEO complained that the Swiss rules will increase their cost of doing business. That is a feature, not a bug. Effective insurance is not free.

Taibbi discusses the lack of financial reform and failure to prosecute Wall Street on RT America (hat tip reader May S):

It’s telling in extended blogosphere debates when one side starts resorting to cherry picking, distortions, ad hominem attacks, and projection as its main lines of attack. In his last offering on the FDIC’s paper which uses Lehman to show how it would use its new Dodd Frank resolution authority, Economics of Contempt proves only one thing: that he’s not interested in open or fair-minded discussion (see here to see what that might look like) and that he wants to put a stop to it.

So, mindful of the possibility that I might simply be feeding a modestly upmarket troll, it seems that all I can do now is illustrate how he has misrepresented my arguments; for instance, by absurdly suggesting that I missed the fact that the FDIC would be on site, in its Lehman counterfactual, when I raised a completely different issue, that their presence would become too large and too intrusive to keep secret (EoC seems blissfully unaware of the fact the word was all over the markets when the FDIC went in to kick the tires of Citi’s portfolio of loans to see-through buildings in the early 1990s).

Or I can point out that that he distorts the reason that Barclays did not buy and almost certainly never would have bought Lehman in toto ex a very large subsidy or unsecured creditor cramdown. The bank and the FSA were agreed that they’d do a deal only if it made economic sense, and the FSA was certain to be conservative on that front in the wake of the RBS-ABN-Amro fiasco. This wasn’t a matter, as EoC asserts, echoing Administration PR, of failure to communicate, nor of FSA’s stubborn insistence on UK shareholder procedures. Barclays was not about to buy a pig in the poke and the liquidity backstop in combination with the mechanics of the shareholder approval process, would allow the deal to be retraded if need be. That’s a very sensible precaution (especially for a non-US bank). Similar issues arose for BofA, which bought the believed to-be-much-sounder Merrill. When more horrors came to light, BofA threatened to exit its acquisition to secure more subsidies.

And what, pray, is EoC’s evidence that the FSA report which sets out these matters is “dubious”? It’s certainly inconvenient for EoC; in fact, it wrecks his argument: is that what he means by “dubious”? It may indeed be that the FSA’s director, Sants is a liar, and content to publish a lie (that’s something EoC’s “dubious” definitely implies); and it may be that Barclays’ then-CEO Varley simply goes along with the lie. But without the evidence for such a large claim, EoC’s affirmation is just bluster.

Another example of his method of operation: in a previous post, EoC wrote,

Criticism #2: Egregious underestimation of Lehman losses

This is a non-sequitur, and not even a good one. For one thing, Yves confuses creditor claims with creditor losses, so her so-called “gap” analysis is fundamentally flawed.

Except, it isn’t: the $300Bn of claims is a reasonably good number, and comes straight from the bankrupt estate. Against that, there are about $60Bn of assets after the derivatives counterparties got first dibs. We wrote about it here: the original claims totalled north of $1.1 trillion, and all the double claiming, negotiation and estimating has already been taken into account to reach that $300Bn figure. EoC omits that fundamental point, adding “That’s Bankruptcy 101“, to complete the slur. But he never bothers to show why he knows better than the Lehman bankruptcy overseers Alvarez & Marsal, to the tune of hundreds of billions of dollars. That reticence is either because it’s a commercial secret, or because it’s just tripe (hint: it’s tripe).

And of course, EoC also simply ignores other issues we raised, any one of which also renders the Lehman counterfactual inoperative: politics (that the Administration would find it hard to pull the trigger, and would never have done so in March 2008); the fantasy of Fuld agreeing to put Lehman on the block (he’d have to be fired, which implies a process more like that of putting Fannie and Freddie into conservatorship, which again rules out a leisurely marketing process) and the unheard of process of shopping a distressed company widely to candidates who are not only direct competitors but also significant counterparties/creditors (just imagine what would happen to Lehman’s repo haircuts if this were done without Lehman already being a ward of the state, which is what the FDIC paper sets forth). Or how about FDIC’s due diligence assumption, when that effort would simply uncover the true magnitude of the hole in Lehman’s balance sheet and the mess of Lehman’s derivatives books?

But there isn’t any point in unpacking this in further detail, because EoC’s last two posts have shown him to be relying, in lieu of substantive arguments, on the worst sort of credentialism: that as a putative insider, his jibes, in lieu of real refutation, should be treated as definitive. EoC continues to huff and puff that Dodd Frank Article II will work….basically because he and the FDIC say so. We are to take it from him: appeals to foreign regulators would trump the actions of foreign creditors. He might familiarize himself of the nasty consequences under UK law of being a director of a company found to be “trading insolvent”.

In the absence of sound logic or facts, any one can appeal to status and credentials. But when it comes to international bank resolution, one is always on sounder footing appealing to the factual existence of actual players and authorities who, however inconveniently, exist ‘abroad’. These authorities don’t agree with EoC and the FDIC at all. Inconvenient? Yes. But there it is.

For one, the Bank of International Settlements, which has access to perfectly good securities and bank regulatory experts, worldwide, begs to differ. In its Report and Recommendations of the Cross-border Bank Resolution Group the BIS said that even if cross border resolution regimes were better coordinated, (which, of course, Dodd Frank does not achieve), it “recognizes the strong likelihood of ring fencing in a crisis” due to the failure to implement cross-border burden sharing and the national nature of legal and bankruptcy regimes. It thus recommends a framework that “helps ensure that home and host countries as well as financial institutions focus on needed resiliency within national borders.” In other words, it accepts a national process as inevitable and recommends dealing with that reality.

And note also: FDIC asserts, in their Lehman counterfactual (and, they assume, in Title II resolutions generally), that the local regulator would have cooperated. Yet the FSA, in its Turner Review, has fallen in line with the BIS ring-fencing notion. The FSA is moving towards requiring local entities be better capitalized and is placing little faith in yet to be realized greater international coordination. Both documents pre-date the finalization of Dodd-Frank, which, in its obliviousness to the international dimension, simply confirms the prior BIS/FSA line.

Similarly, the Institute for International Finance, a blue chip group from the industry (meaning it has every reason to depict Article II as workable, since the alternative is structural remedies, aka breaking up banks, and/or much higher capital levels for national entities, would have a disruptive impact on their operations) has been on the same page as the BIS and has seen nothing in Dodd-Frank to change its mind: see pages 31-2 of their latest on this subject:

Title II remains problematic in the limited attention that it pays to cross-border issues…

…cooperation and coordination is, under Dodd-Frank, dependent upon the goodwill of the different parties and perceived common interest in the circumstances…

Much, accordingly, remains to be done to render the Dodd-Frank approach appropriate for application in the context of cross-border fnancial groups.

If EoC can persuade the BIS Cross-border Bank Resolution Group and the Institute for International Finance that he knows better than they do, he might be worth listening to. Until then, if they’re channelling anyone, it’s ‘Naked Capitalism”, not “Economics of Contempt”