naked capitalism

As readers may know, a recent post, “Frontline’s Astonishing Whitewash of the Crisis,”discussed the first half of the Frontline series, “Money, Power & Wall Street.” Producers Mike Wiser and Martin Smith sent a letter taking issue with this review, and I made an exception to my usual practice and posted their missive.

The major dispute is over whether their series lets the financial services industry off too lightly. The producers contend they attempted to provide “an accurate and informative telling of the crisis,” that they were indeed tough on financial firms, and that I “misunderstood” their program. The bulk of the letter then consists of extracts from the program meant to address specific criticisms.

I’ll deal with their particular claims in due course. But most important, their letter fails to engage the basic issue raised in the initial post: that of the overall message conveyed by this segment. Their assertion is that I misunderstood, when it it the obligation of Frontline to make sure its message is clear. And as we’ll also see, I am far from alone in “misunderstanding” their show.

Any form of storytelling, be it print or televised journalism, fiction, even scholarly work, involves choices as to what material present, how to guide the reader/viewer through the information, and what points to emphasize. Emphasis can take place in numerous ways, including by presenting information early (first impressions stick and are hard to dislodge), repetition, amount of time spent. One major choice is whether to provide a range of points of view and let viewer decide, or supplying a clear perspective. The use of a narrator (and this series had a narrator) signals that the producers intended to provide a perspective.

What happens if you fail to give non-expert viewers sufficient guidance through a complex fact set? The audience not only gets little in the way of illumination, but it also reionforces the idea that the situation is complicated and hard to grasp. That message is bank friendly. We’ve stressed repeatedly that complexity, opacity, and leverage serve the interests of financiers to the detriment of society at large. Treating this evolution as something that just happened is far too kind to the authorities and big banks. It represents a fundamental shift from the financial services industry providing mainly valuable services to becoming increasingly extractive. As we said in our original post:

So thus far, we have some populist decorating of a profoundly pro-Establishment account. Yes, the system got really out of control, but whocoulddanode? It just got SOOO complicated no one could understand it, not even those super well paid top Wall Street executives. There isn’t a single mention of ideas like looting, bogus accounting (remember the fictitious Lehman balance sheet, or Merrill’s CDO-hiding Pyxis, or the $40 billion of Citi CDOs that appeared out of nowhere?) or abuses in other areas (like swaps sold to municipalities all over the world, or rapacious privatizations, the auction rate securities blow up, or chain of title abuses). Nah, it’s just a bunch of fundamentally good ideas taken too far. And they really expect you to believe that.

In fairness, Part 2 does cover the swaps sold to municipalities in some detail, but even then, as we’ll discuss in a later post, this discussion also falls short.

But the most charitable conclusion you can reach is, in the words of a colleague who has taught at the Columbia School of Journalism for over ten years, is that this is “mediocre journalism,” that the producers didn’t recognize that the story they thought they were conveying was different than the one they actually presented.

Various viewers of the program also found that the overall message was favorable to Wall Street. I’m told there were many critical tweets on the first and second program. This assessment came via e-mail:

I happened to watch the two hours in one sitting yesterday as a film and I came away sharing most of Yves’ observations. The overall criticism that it was more a People Magazine expose (well done at that level with its bevy of interviews of key players!) that was heavy on characters and narrative and light on illumination is valid. While the narrative did have some great general quotes like the ‘infectious greed” described by Frank Partnoy, “the greed of Wall Street broke Main Street” by Roy Barnes and Reich’s “Wall Street got away with bank robbery” they were used more as attack lines on the “bad people” on Wall Street rather than the system.

Of course, the proof is simple: What conclusions is the viewer of the first two hours led to? Forget the throwaway lines here and there used for cover. I see three simple ones that were artfully laid out. Obama is smart and capable. The Republicans are stupid and incompetent. The bailout was flawed but necessary.

In other words the Frontline programs provided some great quotes, especially those of Alan Greenspan mumbling his bizarre bible that people in white shirts can be trusted to be more moral and aware than the 99%. The show did not deal with the inherent racist and classist attitude of our plutocrats that the 1% are less criminally inclined than the 99% and do not need the policing that the rabble do when, in fact, they need more because of the perverse economic “incentives” they face.)

And this e-mail reacted to the producers’ letter:

I find the response by Frontline is in denial regarding your criticism of the general tenor and overall effect, which really is what you were saying. In fact, the more I read of their apologia, the more annoyed I get. It’s a long set of excuses, with a few finger-pointings at you for writing overly fast.

Frontline response refused to acknowledge that it WAS bank friendly. It criticize you for pointing out that JP Morgan Chase was trying to solve its OWN problem.

You’re right. The Frontline show GENERALIZED the description, as if economists were trying to solve risk IN GENERAL, not shift their OWN risk somehow onto their own counterparties.

Your points are specific. Without concretizing what is happening, viewers are left with a lack of focus (“solving problems”) as to Cui bono?

Regarding the other “warnings” the Frontline show cites, these are like warning labels on a pack of cigarettes or liquor bottle (“Don’t drink to excess. Be responsible.”) They tend to get lost in the overall spirit of the show.

The Born comment simply got lost. Here was a real boxing match. They somehow glossed it over in a way that ONLY the people who actually had followed the story would know what was being said. It’s like a literal translation of Sumerian cuneiform — so brief that only someone who knows the context can understand what the tablet is all about.

What really is at issue is the importance of how to FRAME a point to highlight and explain it. They SAY that they explained that securitizing junk mortgages was what caused the problem. But this just wasn’t done effectively and straight-forwardly. Again, only the insiders who have been following things will get the message. It’s as astutely buried as cigarette companies bury the cancerous effects of their products. What Frontline did was “UNFRAME” the issue, to coin a verb, where this would really be confrontational with Wall Street. In a more popular word, it was simply wimpy.

I.e., “SOME of these mortgages MAY BE subprime.” “I wanna buy A LITTLE BIT of CDO” C’mon! They reduce it all to technocratic stuff — a problem to be solved, not a plan for a rip-off!

It’s like God drove a steamroller over the earth, flattening out the mountains, so that nothing stands out. Or like a composer of a symphony that had everything mezzoforte, no high points, no focal points. It was … blah.

You’re absolutely right. There didn’t HAVE to be a choice between bailout or “meltdown.” So the bondholders would have lost — the money they doubled as a proportion of US income and wealth 30 years ago. So what?

The Angelides quote implied that Obama DID have to “save the economy.” Not that it was NEEDLESS, as you say.

Bottom line: I’m “baffled” that Mr. Wiser is “baffled” at your comment. Perhaps Frontline needs someone who is NOT baffled!

Let’s now deal with their responses, many of which do not engage the issues raised, but instead seek to cast doubt about the accuracy of the post.

First is their objection to the idea that they “cribbed” from Gillian Tett’s account of the development of the credit default swaps market, Fool’s Gold. In fact, the series starts with the same narrative that Tett used, that of JP Morgan staffers first coming up with the idea of CDS at a corporate retreat, and even has the same hijinks. While people who read Fool’s Gold would see the inclusion of Tett in that part of the documentary as a way of acknowledging her influence, that does not obviate the fealty of Frontline to Tett’s storytelling. While “cribbed” may be deemed to be unduly strong, some readers saw this comment as “the lady doth protest too much.”

The much more important issue with starting with the genesis of credit default swaps is it launches the program on a pro-Wall Street footing (yes, there is the meant-to-rivet-your-attention, “we had a meltdown” juxtaposed with Occupy Wall Street protestors, but that is quickly undercut by various statements by apparent experts as to how complicated this all is, so the criticism is almost immediately diffused).

The producers chose to start with the genesis of the corporate credit default swaps market, which is a bizarre place to begin. Corporate credit default swaps had nothing to do with the crisis. The narrator describes their creation as “innocent” (!). CDS are depicted as an “innovation” repeatedly, with all of its positive overtones (and recall that no less than Paul Volcker begs to differ). They are also presented simply as a way to transfer risk, and that is presented as salutary, as opposed to a way to solve a big problem for JP Morgan and other banks (as the readers above noted, lack of agency is all too common in this broadcast).

The only reason to go that early might be to depict the missed opportunity to regulate them and prevent the creation of a standardized template for CDS on asset-backed securities, which as we described long form in ECONNED, is responsible for the toxic phase of subprime origination (third quarter 2005 to summer 2007). They try to have it both ways in their letter, saying they covered that ground in another Frontline documentary. Sorry, that doesn’t pass muster. A presentation needs to be self contained. And even with hard core Frontline viewers, this also demands that they recall content from an earlier program, when in our information-overloaded society, that is a lot to expect of those who do not follow the finance beat.

The letter continues to argue that the program did cover the notion that corporate credit default swaps were devised to transfer risk, which benefited banks. But this softpedals the motivation, which was set forth in our post: that JP Morgan was carrying more corporate credit risk than it was comfortable with (my recollection is that Fool’s Gold discussed specifically that JPM’s growth would be constrained). And recall in the viewer quotes above, that they also found that the issue of “cui bono” from the creation of CDS was skipped over. (I also have to note that one of the people they quoted in this section is Mark Brickell, identified in the program as a former JP Morgan employee. Most viewers would assume that that means he would give an unbiased take. In fact, Brickell is an uber financial services and even shows up twice in Frank Partnoy’s Infectious Greed as a bad guy of sorts).

Next, they shift to arguing that their discussion of CDS did cover the idea that they were tantamount to unregulated insurance. But merely citing text where CDS are referred to by various interviewees as insurance is inadequate for a generalist audience.

Contractually, a financial product cannot be both a “derivative” (price or payoff defined in terms of a readily priced underlying instrument) and “insurance” (payoff when an event of loss takes place). The JP Morgan misbranding of CDS as derivatives has been remarkably effective.

If you look at the transcript, the CDS are referred to a full 22 times as “derivatives” and there are three additional mentions of general concerns about derivatives that in context before you even hear the word “insurance”. These include seven separate comments by the narrator, some of which use the word “derivative” multiple times with reference to CDS, starting with this one:

NARRATOR: Credit default swaps, a kind of derivative that insures a loan against default.

This was a very new concept. Traditionally, derivatives were a way to bet on the future value of something. For hundreds of years, farmers have traded derivatives to protect themselves against fluctuating crop prices. It is this type of derivative that has been traded on the Commodities Exchange in Chicago, along with the futures of fuels, currencies and precious metals.

In Boca Raton, the JP Morgan team realized that they could use credit derivatives to trade their loan risks.

So get this: the narrator, the proxy for the producers, defines credit default swaps as a derivative, and presents them as being part of a proud history of derivatives. And how does the booming narrator first use the word “insurance” in the CDS discussion?

NARRATOR: Others wanted them to be regulated like insurance.

In other words, this is presented as a minority view, well after “CDS = derivatives” is well cemented in the viewer’s mind, and not adequately explained. Even before getting to the way CDS are described in the documentary, given the common lumping of CDS with true derivatives, it would take a clear statement that CDS are tantamount to insurance, likely with some factual support, to overcome the sloppy use of terms.

In context, the narrator comment presents “CDS are insurance” as a minority position. Yet the implications of it being economically equivalent to insurance are fundamental to understanding why the product blew all the major guarantors up. Insurers receive money up front. They may not take enough money (they underestimate the risk and price it too low) and/or they don’t husband it well (among other things, they pay too much in bonuses and dividends, leaving too little for policyholders). If that happens on a big enough scale, they go bust when the payments come due (or alternatively, engage in all sorts of fraud to escape payment on legitimate claims). Satyajit Das, who was interviewed for this program, and others have stressed that if you required protection-writers to post enough margin to allow for jump to default risk, CDS would be uneconomical. Pretty much no one would buy it. Underpriced insurance produces over time losses to insurers, and insurers who write enough are pretty certain to hit the wall, eventually. And that is pretty much what happened.

So we have the show coming out firmly behind industry PR, yet denying it when challenged.

The next new charge they turn to is our remark:

Similarly, the account hews to conventional lines in making Goldman out to be the poster villain in the CDO market, yet merely in passing, has Deutsche Bank CEO Joseph Ackermann admitting to being one of the banks that stuffed Landesbanken like IKB full of toxic debt. Crisis junkies know that Deutsche Bank trader Greg Lippmann was the most aggressive middleman in helping subprime shorts like John Paulson create and sell CDOs designed to fail (and they had their own program, Start, which was a synthetic CDO series just like Goldman’s better known Abacus trades).

They argue that they thought this oversight was OK because Goldman made “millions” while Deutsche lost “billions.”

That isn’t true. Goldman lost $1.2 billion on mortgage securities. It appears to have made boatloads of money on a net short position 2007, but the subprime short traders at Goldman were eating more than half the firm’s total risk exposure, and Blankfein and senior management told them to cover their short. They appear to have traded the February 2008 swoon and March rally in subprime well, but they went into the worst of the crisis net long and took losses that more than offset their earlier short gains (admittedly, they were behaving badly in 2008 in scrambling to offload risk, but they had lots of company in that exercise).

The producers next turn to this charge:

The segment provides anecdotes of the crazed subprime lending, but fails to explain how mortgage backed securities and CDOs were linked to lending (or most important, that CDOs came to drive demand for RMBS, which in turn drove demand to the worst loans).

They next quote a former Georgia governor stating that mortgage loans were securitized tranche and a “feeding frenzy” resulted. That is not an explanation.

The next bit they quote was one I had pointedly avoided addressing because it so embarrassingly wrong and hate criticizing Chris Whalen, who is very sound when it comes to traditional banking:

Chris Whalen (Tangent Capital Partners): Let’s say I have a pool of mortgages– I have a thousand mortgages from California and I want to package these up. But I decide, “Well some of these mortgages may be subprime and I wanna buy a little bit of credit default insurance.
Martin Smith: And by doing that, you improve the profile—
Chris Whalen: In theory, yes.
Martin Smith: –of your CDO—
Chris Whalen: That’s right.
Martin Smith: So you can sell it better.
Chris Whalen: And I can go get a rating for it, too. I could go to Moody’s and say, “Look. I have laid off 2% of the risk on this portfolio. Shouldn’t I get a better rating than if I just sold the pool as it was?”
Martin Smith: So you take a lot of crap—
Chris Whalen: That’s right.
Martin Smith:–a lot of mortgages that are—
Chris Whalen: Hi– hideous crap.
Martin Smith: But you insure it and the credit agency says, “Hey. That’s a good idea.”
Chris Whalen: Yes. Yes.

I’m sure Chris knows the difference between a mortgage-backed security and a CDO, but listening to this, you’d have no idea they were two different beasts. And he is completely wrong about CDS being used within any CDOs (and only an extremely limited basis in RMBS in the late 1990s) to lay off risk and get a better rating (there are such things as synthetic and hybrid CDOs, where all or most of the assets are credit default swaps, but that bears no resemblance to what Chris is discussing).

There’s no excuse for including this garbled bit of an interview. I know Frontline spoke at length to at least one serious CDO expert who could have prevented misinformation like this being conveyed.

They also quote Gillian Tett saying that “many investors” took more risk (RMBS risk? CDO risk?) because they thought they had laid most of it off with CDS. I beg to differ. “Investors” ex hedge funds rarely use CDS. The reason is that it typically requires the creation of a unit that can post collateral and that in turn requires regulatory approvals for most fiduciaries.

And the use of the term “investors” obscures which player were the biggest holders of CDOs and users of CDS to reduce the risk: the banks themselves. We described in ECONNED The “investors” that did that in a serious way weren’t what viewers would consider to be investors. It was Eurobanks who (remarkably) retained or in some cases even bought AAA tranches of CDOs, then hedged the risk with CDS, which their firms treated as “freeing up capital” which was tantamount to discounting all the future profit of the trade (interest from the CDO less hedge and funding cost) and booking it in the current period. This was system gaming on a massive scale, and was one of the big culprits in the crisis (US firms like Merrill and Cit wound up in similar positions through different mechanisms).

So let me repeat: the program never makes clear the relationship between RMBS and CDOs, and it fails to explain that CDOs kept the subprime party going well beyond its sell by date, and were directly responsible for driving demand to the very worst mortgages.

The discussion of the second hour contains a remarkable display of cognitive blindness. We pointed out, as did many readers, that the program set up the false dichotomy of “bailout versus disaster”. In any complex situation, there are always alternatives besides taking a specific course of action and doing nothing. There was robust debate before the crisis of various options for dealing with insolvent banks, including the approaches used by Nordic countries in the early 1990s and forced haircuts of bondholders (Nouriel Roubini was early to argue for this remedy).

Yet remarkably, in trying to defend that the show did not convey that message, Mike Wiser repeats a quote from Phil Angelides, which was particularly prominent by closing April 24 program (emphasis mine):

The real question is, how did it come to be that this nation found itself with two stark, painful choices, one of which was to wade in and commit trillions of dollars to save the financial system, where we still end up losing millions of jobs, millions of people lose their homes, trillions of dollars of wealth is wiped away, and the other choice is to face the risk of total collapse.

I’m gobsmacked that Wiser can’t see that the section he quotes supports my point perfectly. He provides more material from Angelides, Born, and Stiglitz which all talk about how regulators had become lax well before the crisis. And he also boldfaces this bit:

NARRATOR: For three decades, Washington had steadily moved to a hands-off attitude towards Wall Street. And with little oversight, inside these black boxes, Wall Street had created a host of complicated but lucrative financial products.

This is completely besides the “bailout or disaster” message. This accepts and reinforces the meme that by 2008, the authorities’ hands were tied, they had no choice other than rescue the now-terribly-important financiers they had allowed to run wild.

This is nonsense. I’ve said, for instance, that I’m not convinced that Bear was insolvent, as opposed to illiquid (remember how Jamie Dimon kept crowing what a great deal he had gotten, until he seemed to realize that if he kept saying that, any future rescues might not have such generous subsidies?). Bear was initially offered a 28 day loan by the Fed, which, with no explanation ever given, was turned into an overnight loan, enough to carry the beleaguered firm into the weekend. Why no 28 day loan? That would have given the Fed and Treasury a ton more time to look at Bear’s books and make a much better assessment of the impact of a firm failure on the markets, particularly CDS counterparties, and make other provisions for dealing with any fallout if the run on Bear was warranted.

And as we mentioned in our original post, the “we lacked authority” is also bollocks. Regulators have powerful tools. Frontline reported Paulson told Wells Fargo that it would be declared capital insolvent if it didn’t play ball. They could have threatened the investment banks with halting or curtailing their direct access to Fedwire (in simple terms, the Federal Reserve operated payment system used to settle net interbank balances at the end of day and for large payments during the day). The authorities didn’t just lack will. They had been part of the problem and were unable to recognize how disastrous their policies had been until the evidence was undeniable.

I recognize the Frontline producers strove to adopt a polite tone in their letter and they may take umbrage at this reply. But the stakes are too high to allow for courtesy to dilute a message they seem unwilling to hear. This disagreement isn’t a matter of mere aesthetic or reportorial choices. Most people in this country are not very well informed about the financial services industry. As you can tell from the comments on the Frontline website, many take this series to be gospel truth. For Frontline to let the banking industry off easy does the public and the cause of reform a great disservice.

Regular NC readers have seen us repeatedly invoke the work of Andrew Haldane, the executive director of stability of the Bank of England. His thoughtful and original work on the risks and costs of our financial system have provided serious ammunition for reform advocates.

At the recent INET conference in Berlin, Haldane recapped some of his recent observations under the rubric of an arms race, in which efforts of individual players to improve their own position wind up leaving everyone worse off.

I have one quibble with his presentation. Haldane depicts the increase in returns to global banks post 1990 as due to leverage. That isn’t entirely true. The early 1990s saw the rise of the over-the-counter derivatives business, and big banks had an advantage over securities firms, since it took a big balance sheet and a decent position in the related cash market to be successful. The rise of derivatives gave the behemoth banks a new business they could enter on the ground floor. And while derivatives are leveraged, the real attraction to banks was the opacity, in that dealers could load a lot of margin into the various risk attributes without the customers being able to see what a bad deal they were getting. The exceptional profitability of OTC derivatives provide a big boost to bank bottom lines, and attributing all the increase to leverage misses an important shift in the mix of business at these players.

By Michael Olenick, creator of FindtheFraud, a crowd sourced foreclosure document review system (still in alpha). You can follow him on Twitter at @michael_olenick or read his blog, Seeing Through Data

While researching a HUD database for clues on Thomas Lawler, the frequently-cited foreclosure and heavy-metal loving “housing economist” often cited by the business media, and a favorite of Calculated Risk, I came across background information that raises more questions than it answers.

In the spirit of CR’s former housing writer, Doris “Tanta” Dungey, who did not seem to hesitate to present puzzling information and ask her readers what they thought it meant, I thought I’d do the same. Tanta passed away of cancer at the age of 47 in late 2008 and it’s a shame CR has discontinued the practice.

Starting in 1998 Thomas Lawler held the job of SVP Portfolio Management, SVP Financial Strategy, and SVP of Risk Strategy at Fannie Mae until he unceremoniously left in January, 2006, following an $8 billion financial fraud that occurred under his watch. Lawler, along with the rest of Fannie’s executive team, cooked the books spectacularly. That was back in the early 2000s, when a billion dollars was still real money.

Lawler’s Project Libra

It’d be impossible to summarize Lawler’s ethical mosh-pit better than OFHEO, Fannie’s former regulator which morphed into the FHFA, already did so I’ll just cut-and-paste from their 2006 “Report of the Special Examination of Fannie Mae” (emphasis mine):

According to Thomas Lawler, Senior Vice President for Portfolio Management, when Fannie Mae entered the income-shifting REMIC transactions, the Enterprise was concerned that the steep decline in interest rates in 2001 would cause higher near-term and lower long-term recognition of income under GAAP. Mr. Lawler explained that in the context of developing strategies to address that concern, Peter Niculescu, Senior Vice President for Portfolio Strategy, may have suggested the income-shifting REMIC idea. He was not aware of anyone senior to Mr. Niculescu playing a role in initiating the transactions.

Andrew McCormick, Senior Vice President for Portfolio Management (then reporting to Mr. Lawler), indicated he believed Goldman Sachs (Mr. Niculescu’s former employer and the underwriter of the transactions) was the source of the idea.209 In fact Goldman Sachs described the proposed transaction in a November 19, 2001, presentation to Fannie Mae. David Rosenblum, a Goldman Sachs managing director, attached PowerPoint slides for the presentation to a December 3, 2001, e-mail to Mr. Niculescu. Mr. Rosenblum referred to the project as ‘Project Libra.’

Mr. Lawler acknowledged that a motive for creating the REMICs was to effect ‘a change in the expected [pattern of] recognition [of income].’ He also emphasized that without the income-shifting REMICs he did not believe the GAAP earnings that the company would have realized would have accurately reflected the underlying economics. Although he referred to economics, Mr. Lawler was actually talking about the GAAP accounting mismatch Goldman Sachs cited. In an e-mail to a colleague, Jeff Juliane, who, as a member of the Office of the Controller had operational responsibilities for accounting for premiums and discounts on the tranches Fannie Mae retained, ‘these (REMICs) were structured to transfer income from 2002 to out-years.’

Is it just me or, in much the same way every fairy tale starts with “Once upon a time,” every government report on a major scam seems to include the line “Goldman Sachs described the proposed transaction.”

Back to the point, the report makes it clear that Thomas Lawler’s Fannie Mae didn’t play well with Patrick Lawler’s (no relation) OFHEO. At one point when OFHEO provided Congress with Fannie executive compensation Fannie “suggest[ed] that members of Congress might face criminal sanctions if they made the information public,” according to the OFHEO report.

A few months before that scathing report was released Thomas Lawler unsurprisingly left Fannie Mae, moving to a rural farm and into semi-retirement. But Thomas Lawler’s version of “retirement” was to join the Board of Directors of one of John Paulson’s hedge funds as Paulson was famously buying CDS short positions.

Unsurprisingly once Lawler jumped to Paulson he quickly became bearish on real-estate prices. “Poison Said It All in 1990 in a Song Reportedly Inspired by a Mortgage Lender After Housing Crashed that Year, and Low/No Doc (“Liar”) Loan Defaults Skyrocketed,” Lawler wrote in his presentation, going on to spell out the lyrics. That presentation ends with a cute graphic of “Franklin, the Fair Housing Fox,” a likely reference to Lawler’s former boss Fannie Mae CEO Franklin Raines.

Somehow between the heavy-metal lyrics and kitschy graphic I can’t find a disclosure anywhere that Lawler’s new boss was massively shorting the housing market. An oversight, I’m sure, as Lawler was focused on remaking himself from an executive at the center of a massive scam to a “housing economist” in the public image.

Soon after it became clear that the payout to Paulson looked inevitable Lawler switched his position again, arguing the now well-known Big Lie that increased foreclosures also increases home prices. As early as June 13, 2008, while Bear Stearns was barely dead and Lehman Brothers still barely alive, the Wall Street Journal quotes Lawler opining about the economic benefits of “bargain hunters scooping up foreclosed homes from banks,” no matter that these same “bargain hunters,” likely ended up massively upside-down soon after.

Lawler also went after the jugular of real economists who disagreed with him, most notably Yale University economist Robert Shiller, co-inventor of the famous Case-Shiller home price index, which Lawler called “bogus,” in an April 24, 2009 WSJ article announcing that Thomas Lawler has created his own index: “Mr. Lawler has created an adjusted version of the Shiller chart, backing up [Thomas Lawler's] view that house prices already are nearing a bottom in much of the country.” Shiller responded in the article that Lawler was making “wild allegations.”

I suppose “wild allegations” is a toned down version of what most people would have said, which would be something along the lines of “WTF – Lawler’s a known housing fraudster who cooked the books in an $8 billion scam: why are you listening to him?” though academics rarely talk like that, unfortunately.

Needless to say, Lawler’s 2008 housing bottom didn’t quite work out that way, nor did his view that Shiller’s index was incorrect, but most pundits pass over those small issues the same way that prosecutors passed over indictments in the Fannie accounting fiasco.

The Surprise In the Desert

Back to that primary research based on the HUD data during and after the time that Lawler was managing Fannie’s portfolio, financials, and risk. It turns out that Fannie had an appetite for financing homes in some ZIP codes at rates wildly higher than others. I compiled about 26 million loan-level records that Fannie and Freddie acquired between 2004-2007. Fannie and Freddie don’t lend directly — they buy loans from banks — so this data-set would be from the time Lawler was at the height of influence setting policy there.

Fannie and Freddie’s loans use MSA rather than ZIP codes but I cross-referenced them to ZIP codes using tables provided by the Census Bureau. MSA codes sometimes span a small number of ZIP codes, so when there were multiple ZIP code possibilities I’d choose the ZIP code with the highest proportion of residential properties. This could result in slight overconcentration, though the error rate doesn’t matter given the extremes I found in the data.

Certain communities were much more likely to receive loans from the GSE’s than others. Surprise, AZ, in ZIP code 85374, is #1 with 24,788 loans, a 14.7 standard-deviations above the other 20,821 ZIP codes which have a mean loan volume of 532 loans each. The Census Bureau reports Surprise, AZ grew 281% from 2000 to 2010, to the current population of 117,517. As Yves would say, Quelle Surprise, though this time literally.
There are 52,586 housing units in Surprise so it’s safe to say the town is akin to some sort of modern Hoover Dam project, a large scale building project, in the middle of nowhere, built with government money. Except the spending occurred during an economic boom, and is now curtailed thanks to a corresponding economic bust. Actually, the government didn’t really mean to spend the money — during that time Fannie and Freddie were private — so it was GSE executives, especially Lawler, who decided to build a town in the middle of nowhere.

One statistic that comes through clearly is Lawler’s preference for fast foreclosures. All top ten ZIP codes by loan volume are in non-judicial foreclosure states: five in CA, two in AZ, and one each in NV, NC, and TX. We have to drill down to the seventeenth position until we find a judicial ZIP code.

It isn’t clear how Fannie and Freddie decided to hyper-concentrate their loans in a few distinct areas since majority of ZIP codes received less than 1,000 loans. Almost all the high volume ZIP codes are exurban construction boom-towns: environmentally irresponsible far-flung bedroom communities that externalize the cost of construction to everybody except the builders who disappear even faster than the demand for shiny new properties to flip.
Other stats also pop out. For example, the average age of the primary borrower in this large sample is 44 1/2, so they’ll pay off their 30-year mortgages when they’re a spry 74.5 years-old. That obviously doesn’t bother Fannie and Freddie who wrote at least 9,821 loans to people 90 years and older. Fifteen loans went to people one hundred years and older. I understand that age discrimination is illegal but given all the other exemptions Fannie and Freddie received — which includes virtually everything — you’d think they’d lobby for the ability to question the ability of centenarians to repay their 30-year loans.

Many people question the role Fannie and Freddie played in the subprime meltdown. Gretchen Morgenson and Josh Rosner convincingly argue in their book on the subject, Reckless Endangerment, that the GSE’s created an anything-goes culture which private lenders picked up to compete. This data supports that theory: Fannie and Freddie led the way while private money followed.

It’s not clear why CR and so many mainstream media outlets blindly quote Fannie Mae’s former economist, allowing him to “move on” from some spectacularly poor decisions that led to painful costs borne by everybody else. We continue watching the bailout money quietly flow and I wonder when “personal responsibility” for one’s prior decisions became an exclusive obligation only for those neither wealthy nor well connected.

As Winston Churchill pointed out, history is written by the victors. The big end of finance, having won decisively in the global financial crisis, is in the process of rewriting history to suit its liking. The cover story in the current Atlantic by Roger Lowenstein on Ben Bernanke, titled simply, “The Hero,” is a classic example of this type of revisionist history.

I don’t know what has happened to Lowenstein. His book on the collapse of hedge fund Long Term Capital Management, When Genius Failed, is a terrific piece of reporting. People I know who were on the inside of the LTCM rescue negotiations give his account high marks. But he has increasingly fallen into the role of scrivener for powerful interests, when his previous standards of writing and his knowledge of the finance beat says he must, on some level, know what he is doing.

The Fed couldn’t have gotten better PR if it had paid for it. Lowenstein’s account has just enough muted criticism of Bernanke (he was slow to see the severity of the crisis, his critics on the left may have a point in saying he hasn’t been aggressive enough in trying to reflate the economy) to mask its hagiography.

And this sort of spin-meistering is effective. Not only did people at the Atlantic economy conference, which coincided with the release of the piece, take up the “Bernanke did a great job in the crisis” mantra (they seemed to appreciate a piece that reinforced inside-the-Beltway conventional wisdom) but the cover, with a beatific picture of Bernanke and “THE HERO” blazed across his chest, will be seen by lots of people walking by newsstands and have an impact well beyond those who read the piece. As further proof of its faux-objectivity, the title inside the magazine is “The Villain,” to highlight the way (as Lowenstein positions the piece) Bernanke is being unfairly pilloried.

I’ll turn to the major arguments shortly, but one of the things that was particularly annoying was the way it repeatedly gilded a rotting cabbage. These are devices that most readers would miss, by virtue of not reading carefully enough to recognize their construction, or not knowing the terrain well enough to discern how Lowenstein skews his account. Here are a few of numerous examples:

Lowenstein offers a key parenthetical, in discussing quantitative easing:

…we have no way of knowing whether the economy’s improvement would have been less robust, and how much so, without Bernanke’s efforts

This is a twofer: it paints a tepid, technical recovery as “robust” and gives Bernanke meaningful credit for it.

Lowenstein mentions the nervous collapse of Montagu Norman, the governor of the Bank of England during the Great Depression, as proof of how tough it is to be a central banker during a crisis. Um, Montagu had a long history of mental instability and had had a breakdown in 1912. His psychological fragility is described at length in Liaquat Ahamed’s book Lords of Finance.

Lowenstein depicts Bernanke as an apt student of economic history, when his account shows the Fed chair is either intellectually dishonest or has issues with reading comprehension:

As we began to discuss his policies, the Fed chief urged me to pick up a copy of Lombard Street, a seminal book on central banking written by Walter Bagehot, the 19th-century British essayist. “It’s beautiful,” Bernanke said of the book—obviously appreciating that Bagehot had urged central bankers to take vigorous action to forestall panics.

Huh? Most people who know anything of Bagehot can recite his famous Bagehot rule: Lend freely, against good collateral, at penalty rates. You can cherry pick Bagehot to emphasize the “lend freely” bit, and one can argue that a central bank has the power to make any collateral into “good seeming” collateral by dint of throwing enough money at it. But the message of this paragraph is that Bernanke is a faithful student of well-established principles of central banking. In fact, Bernanke has thrown central ingredients of the formula out the window: the rescue is to be only of solvent but illiquid institutions, and then it has to be sufficiently painful as to deter them from coming back any time soon.

Lowenstein takes dictation in reporting one vignette from Bloomberg’s long-running fight over Fed transparency. Keep in mind that the piece depicts Bernanke as engaged in a sincere effort to make the Fed more open, when the Fed has fought Bloomberg’s FOIAs tooth and nail and even when compelled to cooperate by court rulings, has often engaged in redactions that appear unjustifiable. This is only footprint of this long-running row in the article:

Soon after my visit, he [Bernanke] released a letter he had written to Senate leaders refuting, point by point, a spate of articles that had characterized a Fed lending program as “secret” (the names of the borrowers were secret, but not the existence of the program or its size), and that had reported the total of Fed loans and bailouts as $7.7 trillion, a wild exaggeration.

Whoa! This is what actually went down, as we reported at the time:

It’s telling that the Fed was dumb enough to try upping the ante in its ongoing fight with Bloomberg News over the central bank’s refusal to disclose many critical details about its emergency lending programs during the crisis. Any poker player will tell you you don’t raise with a weak hand when the other side is pretty certain to call your bluff…

Bernanke sent a letter that is pissy by the standards of Fed discourse…

First, it tries the sneaky device of complaining about all the bad press it is getting, and alludes in passing to the latest Bloomberg report (“one last week”). So are we dealing with the general or the specific? The attachment to the letter, which makes a series of specific claims of where the coverage allegedly was off beam, was rebutted with great speed and vigor by Bloomberg. So trying to have it both ways (attacking Bloomberg but trying to depict it as part of general critic wrongheadedness) backfired.

But what is even more striking is the tone and substance of the letter: overreaching words like “egregious,” the patently false claims that there is nothing new in the latest (and by implication, earlier) Bloomberg stories, that the disclosure issues are settled. If there was no new information given to Bloomberg, then why did the Fed fight so hard to prevent the release of information? The Fed has never been cooperative. Even with the Congressional Oversight Panel, the so called Sanders report coming out of Audit the Fed (and remember, the Fed succeeded in lobbying to narrow the scope of Audit the Fed), a new GAO report, the latest Bloomberg FOIA still pried loose more information. The Fed is clearly not interested in transparency, but keeps trying to claims that everything that anyone would want to know is public, and there really is nothing here to discuss any more.

There’s a lot more here on how misleading the Fed letter was; we suggest you read the post in full.

Right on the heels of this no-name swipe at Bloomberg, Lowenstein starts the next paragraph with: “Bernanke is bothered by attacks that seem to be little more than smears…” which in context, suggests that a pitched battle with a preeminent financial media organization about transparency and accountability is a smear. Nicely played.

Ironically, the Fed chief appears to have revealed what his true aims were in increasing Fed disclosure (which despite his claims otherwise, came in response to demands from Congress, the media, and critics):

According to Greg Mankiw, formerly President George W. Bush’s top economist and now an adviser to Mitt Romney, Bernanke earnestly believes in the democratic process; he thinks disclosure will lead to a more responsible electorate.

“A more responsible electorate”? “Responsible” in the sense of accepting the need for austerity? (The Fed has come out firmly in favor of budget cuts, in particular of social programs). “Responsible” in the sense of accepting the central bank’s propaganda recognizing the wisdom of the Fed’s policy choices?

The use of “responsible” telegraphs that Bernanke sees the electorate as irresponsible, which puts lie to his pretenses of being responsive to democratically determined outcomes. Bernanke is interested in listening to voters only after they have been re-educated by the Fed.

Now let’s get to the thrust of the argument, that Bernanke did a great job in the crisis and its aftermath, and that critics, save maybe Paul Krugman, are ignorant populists (Krugman is presumably an educated populist). This thesis conveniently sidesteps the fact that Bernanke is at best a doctor who unnecessarily amputated both legs of the economy and is now being applauded for attaching badly fitting prosthetics to the stumps. And there are numerous experts who have criticized the Bernanke Fed, ranging from Steven Roach, Chris Whalen, former central banker Willem Buiter, as well as former Fed staffers and financial markets professionals of the non-goldbug variety.

Another central banker, Andrew Haldane of the Bank of England, has done some rough estimates of the cost of the crisis to the global economy, and the low end of his range is one times global GDP. That is such a large number that if you were to try to make the biggest banks to pay for it over 20 years, the first year charge would exceed their market value. Haldane has pointed out in other articles that big bank shareholders and executives who have equity linked pay are in the position of option-holders: they have capped downside (the authorities will ride in to the rescue) and unlimited upside. And the more volatile the performance of the underlying instrument (bank stocks) the more an option is worth. Bankers not only have powerful incentives to take risks, even worse, they are in a position to generate systemic risk, and that’s the best course of action for them. Yet last week, after another round of stress test theater, the Fed gave all but a few banks permission to pay out dividends and buy back stock rather than bolster their equity bases, even as the mortgage settlement is based on the premise that the banks are still too fragile to pay for the damage they’ve done.

Lowenstein argues, in keeping with other Bernanke defenders, that the crisis was Greenspan’s doing rather than Bernanke’s. It isn’t that cut and dried. Bernanke, as a notable monetary scholar, gave intellectual legitimacy to Greenspan’s unprecedentedly long period of low interest rates in the dot-bomb era that many argue stoked the credit bubble. Bernanke’s famous 2002 speech on deflation, which Lowenstein refers to, was a defense of Greenspan’s overreaction to the stock market bust. The unwinding of that bubble, unlike our current one, did not represent a threat to the financial system, since the speculation was not fueled by borrowing.

Bernanke was vocal proponent of the “no bubble to see here” view when he took the helm of the Fed, and argued the runup in household debt was benign, since consumer balance sheets were in good shape. But that of course was based on unsustainable home prices.

There is much that Lowenstein ignores in his piece, and that’s because it is necessary to paint such a flattering picture of Bernanke. First is the Fed’s record during the crisis. Lowenstein depicts it as a success, when you can conclude that only by dint of applying a very liberal grade scale. The only missteps he mentions are the “75 is the new 25,” the central bank’s panicked rate cuts when it realized the crisis was more severe than it thought, and the AIG bailout.

But that only scratches the surface. I’m not certain that Bear Stearns should have died. The Fed was originally going to give it a 28 day loan which some believed would allow Bear to find more capital or persuade the markets it was being unfairly stigmatized. And the Fed also created an unprecedented facility to lend to primary dealers. Had Bear gotten the loan it was originally promised, it would also have gotten access to the new program, which might have enabled it to survive. No explanation has ever been given of why the Fed changed its mind and reneged on its a 28 day loan promise, extending instead an overnight loan to carry it through to a weekend subsidized sale to JP Morgan.

But if you assume the Fed was right, Lehman was simply a bigger version of Bear, and Merrill and UBS were also known to be at risk. And most observers assumed the reason Bear was bailed out what its credit default swaps exposures, which had the potential to turn a Bear failure into a bigger mess. Yet, as we recounted at some length at time, Bernanke, Paulson and Geithner went into Mission Accomplished mode after the Bear rescue. Instead of seeing the Bear implosion as a wake up call, and mounting a full bore effort to diagnose the health of the major players, or get a grip on CDS exposures, the Fed and SEC notched up supervision only a smidge. The Fed sent a grand total of two people to Lehman, for instance. By contrast, the FDIC had to send 160 bank examiners to get a handle on a single (admittedly large) loan portfolio when Citi was on the ropes in the early 1990s.

And Lehman was a self-inflicted wound. Bernanke, Paulson, and Geithner had only one plan, and that was a private sector rescue. They didn’t even look at what the alternative might entail; they hadn’t even talked to Harvey Miller, the dean of the bankruptcy bar who had been retained by Lehman. They were utterly flat footed when the negotiations failed. Miller has stressed that the lack of any prep (including the use of a thin form bankruptcy filing) made outcomes much worse than they needed to be.

In an interview, Bernanke cut short Lowenstein on AIG, and there’s good reason why. Its original bailout was the only one I approved of; it did adhere to the Bagehot rule by applying a high rate of interest and securing the loan with all of AIG’s assets. But one also has to note that the very fact that the Fed figured out a way to make massive emergency loans to AIG undermines its “we had no legal authority” defense of the Lehman debacle. (The other excuse has been that Lehman didn’t have enough good collateral, but time has proven that to be true with AIG, plus Bloomberg-forced disclosures revealed that some of the other emergence lending, such as that to Morgan Stanley, also had dubious backing).

But the authorities not only lent AIG more money, they kept improving the terms, and allowed its intransigent new CEO Robert Benmosche to defy the original plan, which was to dismember AIG, which would have been a very effective way pour discourager les autres. That in turn resulted from the Fed’s failure to require the board to resign as one of the conditions of the rescue.

And this is all before we get to the Fed’s two-facedness about contracts. It insists contracts have to be observed strictly when they favor bankers, such as the credit default swaps contracts AIG had written, or pay agreements with bank executives and major producers that would have been worthless ex taxpayer support and Fed intervention. But it has no problem with banks running roughshod over agreements with homeowners and investors. As recounted here and elsewhere, the mortgage settlement incorporates, among other things, that wrongful foreclosures at a rate of up to 1% (which equates to 33,000 homes since 2008) is acceptable servicing and the Fed and other regulators will give it a free pass. Similarly, the Fed has joined in a effort to reverse the long-established creditor hierarchy, allowing banks to modify first liens owned by investors (and count this use of other peoples’ money towards the settlement of their own misdeeds) without wiping out second mortgages they own, as would be required contractually.

The second major theme of the piece is that Bernanke is a fine economist and ideally suited to steer the central bank now. To the extent that Bernanke is held in high regard, it says more about the state of orthodox economics than it does about his expertise. Anna Schwartz, who with Milton Friedman authored the influential Monetary History of the United States, upbraided Bernanke for his handling of the crisis, stressing that he failed to recognize that it was a solvency crisis, not a liquidity crisis (needless to say, that issue is absent in Lowenstein’s account).

Bernanke is also a firm believer in the discredited “loanable funds” view, that if you make put money on sale by making interest rates low and credit readily available, businesses will take advantage of it and borrow and invest. But that’s just silly. The cost of money is a secondary consideration in investing. The primary one is: will there be enough buyers for your output and will they pay what you need to charge to make the project work? And we can see that in the result of the Fed’s operations. As Richard Koo points out in his latest research report, the Fed has increased bank reserves by over 320% since Lehman, yet the money supply has increased only 25%.

The worst is that the Lowenstein article is long enough and consistently wrong-headed enough that there is much more I could add to this shredding, but in the interest of not taxing reader patience, I’ll stop here. I’m afraid we are due for a steady diet of this sort of thing. And even though we can’t stop it, we can let the people putting out this sort of disinformation and our colleagues know that we aren’t fooled.

By Richard Smith, who is easily distracted.

I promised in my last meander, about international scammers and media screwups, that my next post was going to be set in Australia. But I found this little gem, while looking for something else, and so the exotic locations this time are Colombia and Vancouver (the big Canadian Vancouver, not the little Vancouver in Washington, US, which, as it happens, might also get a look-in in a future post in this rambling series).

But this one is still about scammers and media screwups, so we are still on track, sort of. Here’s BBC World Business giving Rahim Jivraj an opportunity to puff his pump-and-dump Colombian mining company, Mercer Gold.

That was February 16th 2011. What a pity it is that the researchers at BBC World Business hadn’t found out how to use Google by then. If they had, they might have found this (10th Sept 2010), from the blogger Otto Rock, at the blog IKN, about Mercer Gold:

The stock is open for promotion and will try to jump on the Colombia gold bandwagon, but the management team put together has an air of improvisation about it (new recruit James Stonehouse ran the local ops of the trainwreck known as Ascendant Copper/Copper Mesa, kicked out of Ecuador due to bad practices) and inquiries made by this author regarding the property have been met with comments such as “skinny veins…..ok for smalltime producing….will probably be good for a flashy NR headline….not a real mine”. So once the $2m is spent and the pumped-up headlines are shot, MRGP is 100% certain to be adding paper in return for extra cash before too long.

There’s a rejoinder from the company’s geologist Keith Laskowski here (12th Sept 2010), but it doesn’t seem to put off our man at IKN, who publishes this (20th Sept 2010):

… we ran this post that included director and geologist Keith Laskowski’s differing opinion on points raised by this humble author’s position.

All fair enough and we admired (and still admire) Laskowski’s wherewithall in replying, pushing back on the IKN post and also agreeing to allow his mail to be put in the public sphere. Here at IKN nerve centre we have no problem about that and no problem at all over the potential of the Guayabales deposit as explained by its director, but once again we’re forced to raise a red flag on the stock as today it’s getting its name screamed at the naive by bullshit boilerhouse pennystock pump houses in some sort of paid-for in-cahoots concerted promo push.

That gets Otto a legal threat, the very next day, from the soon-to-be televised Rahim Jivraj. At which Otto scoffs:

Now for obvious reasons I’m not going to directly paste up here his private mail to this author without permission, but what we can do without problems is offer my full reply to him, which went like this:

So how come you popped up on those scumbags’ radar? Just unlucky, I guess.

Rahim, I was not born yesterday. You know the one about “if it walks like a duck?”. You’re the duck. So if you want to jump straight from point A to point ‘legal action’, well I suggest you better just get on and do it. Your lazy threats are of no import to me and it’ll be interesting to find out just how much of it is pure talk.

He then wrote back quickly and I can report he backtracked somewhat, saying that his his threat of legal action wasn’t a threat at all (note to readers; it was and he’s a lying scumball).

And Otto follows up with an explanation of how these pump and dumps work; (23rd September 2010),

Otto notes a couple of days later that the legal threat has not been followed by any action (25th September 2010).

Next Otto kindly identifies the man behind the scam, Brent Pierce, (9th October 2010), and notes that killer bad sign, the resignation of the Chief Geologist, (4th November 2010). The new capital raisings foreshadowed in Otto’s posting here (30th December 2010) further substantiate Otto’s claim that there’s a pump and dump underway.

Mercer Gold issue one last bit of tortured PR (4th January), glossed by Otto as follows:

DENVER, Jan. 4, 2011 /PRNewswire/ — Mercer Gold Corporation (“Mercer Gold” or the “Company”) (OTCQB: MRGP; AN4 -Frankfurt) has received a whole heap of crappy gold and silver values from Hole MGDH-02 from the Guayabales Gold Project in the Marmato District in Caldas Department, Colombia but is determined to slap a kilo of lipstick on this pig and try to pass off the pisspoor results as something positive and encouraging.

To that end, we publish the mediocre grades but immediately launch into a whole bunch of geological babble to try and pull the wool over the eyes of those stupid enough to have believed us in the first place and who have already bought into our spiel. We understand the power of suggestion and affirmation because that’s exactly how this type of scam manages to survive more than a few weeks.

The company is also pleased to report that we managed to re-negotiate optioning terms with the local owners of our property. This is because we didn’t spend enough money on the property in 2010 due to the fact that we have no cash to spend. We’re now obliged to spend $5.75m in 2011 which means that either we’re going to dilute your asses to kingdom come or that we’re going to lapse on the terms of the deal at the end of 2011 and lose the whole shebang.

Next (we are now back at Feb 16th 2011) Mercer Gold co-opt the numbskulls at BBC World Business Scam, who haven’t noticed any of Otto’s very penetrating and accurate commentary. Which means they haven’t done much in the way of background checking their Colombian mining expert, Rahim Jivraj, and Mercer Gold; not even a couple of Google searches.

Just 6 weeks later, (29th March 2011) Mercer Gold dumps.

The typical junior mining scam such as Mercer Gold (MRGP.ob) that’s pumped by paid newsletter tripe suddenly swandives and dumps out on no apparent newsflow. This is because the scum behind it, in this case previously convicted securities fraudster Gordon Brent Pierce, decide to pull the plug and get out with whatever’s left over. Meanwhile the poor bagholder innocent are left wondering WTF is going on.

If anyone can find any trace of BBC Business World following up on the dump part of the story, I’d be happy to post it.

By contrast, there are no worries about Otto following up: he records further shenanigans here (he was right about the man behind the scam) and here.

Overall  I reckon we can notch up a score to the blogger and a black mark to the BBC.

Maybe one day I’ll have something more to say about Colombian mining. It is full of, ahem, color. Or colour.

Let’s see if we make it to Australia in my next. In the mean time, BBC World Business join FT Advisors FT Advisers FTAdviser, Reuters, the BBC, The Sun, The Oxford Mail and BBC Radio Oxford in NC’s trophy cabinet of scammers’ stenographers.

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

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

Faith Based …

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

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

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

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

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

Finance is as Finance Does….

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

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

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

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

Transference…

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

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

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

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

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

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

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

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

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

Giving Credit…

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

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

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

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

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

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

ETF….

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

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

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

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

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

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

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

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

HFT….

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

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

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

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

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

Collateral Damage …

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

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

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

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

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

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

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

Left Unsaid…

Mistakes of commission are compounded with errors of omissions.

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

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

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

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

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

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

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

Super Smarts…

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

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

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

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

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

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

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

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

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

Fixing It ….

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

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

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

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

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

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

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

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

Realpolitik…

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

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

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

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

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

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

I have to confess I have yet to do more than sample this video, but I intend to watch it in full as soon as I have a breather. This is a video of a panel discussion at NYU Law School earlier this month at which former prosecutors Neil Barofsky and Eliot Spitzer took on party-line-defending Lanny Breuer of the Department of Justice, and to a lesser degree, Mary Jo White, former US attorney who now works on the defense side. Various reports on the discussion indicate that sparks flew at several junctures, so I am confident the NC audience will find it engaging as well as informative.

By Michael Olenick, creator of FindtheFraud, a crowd sourced foreclosure document review system (still in alpha). You can follow him on Twitter at @michael_olenick or read his blog, Seeing Through Data

“A lie told often enough becomes the truth.”
– Vladimir Lenin, adopted and reused by Joseph Goebbels

Every doctor knows the fastest way to stabilize a patient is to kill them, because there is nothing more stable than death. While that solution may be fast and inexpensive it’s also sub-optimal. Yet pundits repeatedly posit the fastest way to end the housing crisis is through mass foreclosures. In a strict sense they’re right, that will achieve stability, though so will other policies calibrated to cause less micro and macroeconomic damage .. and a lot less human suffering.

Honest economists explain their reasoning, which is that there is a need to find a market bottom. They argue that in a healthy market sellers should not compete with REO properties and buyers need not worry an oncoming glut of foreclosures will drive down the value of their house. These economists, who remain in the minority, usually preface this is a lousy solution albeit the only one they can think of.

More common are bankers and economists who paint a rosy picture at the notion of throwing millions of families to the street, and millions of homes to the market.

“Once distressed inventory comes down and all of a sudden there’s not enough homes, you’re going to have a real bounce,” said JP Morgan Chase CEO Jamie Dimon in a recent interview.

Dimon surely knows the 2010 Census reports 131.8 million residential housing units for 312.9 million people, including about 17 million empties, so I’m not sure where his housing shortage comes from.

Dimon’s bank is sitting on a powder-keg of $87.6 billion of mostly worthless second mortgages at the end of Q3, 2011, according to the FDIC, so I can see why he’s playing cheerleader for a housing renaissance. But treating people like chumps, by encouraging them to buy in this broken market, crosses the line from puerile to patronizing.

If Dimon’s bank is genuinely bullish on housing then let them show it by dramatically ratcheting up their non-GSE lending. It will be interesting to see how JPM investors react to what I’m sure will be Dimon’s forthcoming announcement that JP Morgan Chase plans to lower credit-standards, increase private mortgage lending, and retain the loans on their own balance sheet.

Every argument housing cheerleaders advance is easily debunked.

Dimon argues household formation is increasing. I argue that’s irrelevant because the new couples do not qualify for home loans. Bloomberg reports that student-loan debt is approaching a crippling $1 trillion, preventing young people from qualifying for mortgages.

Bloomberg’s story focuses on a pharmacist with $110,000 in student-loan debt and a steady job that pays $125,000 a year, but who doesn’t qualify for a mortgage. It isn’t only employed professionals: the Bloomberg article goes on to note the Federal Reserve reports the number of 29-34 year old’s who qualified for a first mortgage declined from 17 percent ten years ago to 9 percent in 2009-2010. That is, young people are forming rented households.

This meme, that it’s a great time to buy a house, is relentless.

In a Bloomberg story along the same lines, Potomac Gap Shows Court Foreclosures Delay Housing Recovery, former Fannie Mae chief economist Thomas Lawler compares Maryland and Virginia house prices to argue expedited foreclosures increase home prices.

Asking Fannie’s former chief economist his thoughts on housing is akin to asking Francesco Schettino, Captain of the domed Italian cruise ship, his thoughts on maritime safety. Let’s ignore that though and focus on Lawler’s conclusion, which the data doesn’t support.

Lawler argues that Virginia and Maryland have virtually identical characteristics, yet that house prices in VA rose .8 percent last year while MD prices fell 3.6 percent. Lawler attributes this to the fact that MD is a judicial foreclosure state — where foreclosures require court approval that move through the system slower — whereas VA is a non-judicial state, where banks can simply auction a house after a default.

I have a simpler answer: house prices in MD ran up considerably higher than those in VA during the bubble so prices in both states are now adjusting towards the mean.

Specifically, according to the FHFA’s Housing Price Index (HPI) data Maryland house prices rose 17.7% higher from Q1, 2000 to Q3, 2007, when prices in both state’s peaked. Prices in MD are still 10.8% higher than those in VA, even though, by Lawler’s reasoning, they should be the same.

If anything, the data suggests judicial foreclosure is dampening home price declines in MD, by slowing foreclosures and the drag they place on home prices.

Less foreclosure inventory in judicial foreclosure states, thanks to slower foreclosure processing, reduces supply and stabilized home prices is a simpler explanation, though it’s seldom explored. I’ll refer to it as the Linda Green House Price Stabilization theory.

Obviously, people cannot continue to live in houses they are not paying for forever. But crafting public policy to figure out how to work with these people, which has the least impact on both the economy and the families involved, requires an honest and forthright dialog that just isn’t happening.

My own home state of FL is an economic disaster zone thanks largely to foreclosures and other housing related dysfunction. I often find myself spending the evening discussing housing finance.

It is not uncommon for those current, or with paid-off houses, to launch into a harangue about their irresponsible neighbors and demand that they’re thrown to the street immediately. But when I ask these people to quantify how much they’re willing to pay to punish their neighbor the answer is always zero.

I explain there are two options. One option involves modifying their neighbors mortgage, arguably giving their neighbor a windfall but limiting their own home price decline to no more than 10-percent. The other option involves throwing their neighbor to the street, decreasing the person’s home value by more than 10-percent. Nobody has ever opted to throw their neighbor out if it will personally cost them anything.

Dimon argues “indiscriminate blame of both (economic) classes denigrates our society, destroys confidence .. and damages us.” I agree, though argue the relentless “break the borrowers bones,” theme, combined with less than honest discourse about economic reality, is more destructive than frustration-fueled barbs launched towards those like him who pocketed a $21 million paycheck last year while relying heavily on corporate welfare.

Depending on one’s understanding the 50-state Attorney General settlement is worth somewhere between about $5 and $40 billion. Let’s use the higher number: we still have about a half trillion gap to put a long-term floor on the housing market. It’s time for an honest, open, fact-based national dialog about how to make that happen.

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

Yesterday I caught a lecture at Columbia given by statistics professor David Madigan, who explained to us the story of Vioxx and Merck. It’s fascinating and I was lucky to get permission to retell it here.

Disclosure

Madigan has been a paid consultant to work on litigation against Merck. He doesn’t consider Merck to be an evil company by any means, and says it does lots of good by producing medicines for people. According to him, the following Vioxx story is “a line of work where they went astray”.

Yet Madigan’s own data strongly suggests that Merck was well aware of the fatalities resulting from Vioxx, a blockbuster drug that earned them $2.4b in 2003, the year before it “voluntarily” pulled it from the market in September 2004. What you will read below shows that the company set up standard data protection and analysis plans which they later either revoked or didn’t follow through with, they gave the FDA misleading statistics to trick them into thinking the drug was safe, and set up a biased filter on an Alzheimer’s patient study to make the results look better. They hoodwinked the FDA and the New England Journal of Medicine and took advantage of the public trust which ultimately caused the deaths of thousands of people.

The data for this talk came from published papers, internal Merck documents that he saw through the litigation process, FDA documents, and SAS files with primary data coming from Merck’s clinical trials. So not all of the numbers I will state below can be corroborated, unfortunately, due to the fact that this data is not all publicly available. This is particularly outrageous considering the repercussions that this data represents to the public.

Background

The process for getting a drug approved is lengthy, requires three phases of clinical trials before getting FDA approval, and often takes well over a decade. Before the FDA approved Vioxx, less than 20,000 people tried the drug, versus 20,000,000 people after it was approved. Therefore it’s natural that rare side effects are harder to see beforehand. Also, it should be kept in mind that for the sake of clinical trials, they choose only people who are healthy outside of the one disease which is under treatment by the drug, and moreover they only take that one drug, in carefully monitored doses. Compare this to after the drug is on the market, where people could be unhealthy in various ways and could be taking other drugs or too much of this drug.

Vioxx was supposed to be a new “NSAID” drug without the bad side effects. NSAID drugs are pain killers like Aleve and ibuprofen and aspirin, but those had the unfortunate side effects of gastro-intestinal problems (but those are only among a subset of long term users, such as people who take painkillers daily to treat chronic pain, such as people with advanced arthritis). The goal was to find a pain-killer without the GI side effects. The underlying scientific goal was to find a COX-2 inhibitor without the COX-1 inhibition, since scientists had realized in 1991 that COX-2 suppression corresponded to pain relief whereas COX-1 suppression corresponded to GI problems.

Vioxx Introduced and Withdrawn From the Market

The timeline for Vioxx’s introduction to the market was accelerated: they started work in 1991 and got approval in 1999. They pulled Vioxx from the market in 2004 in the “best interest of the patient”. It turned out that it caused heart attacks and strokes. The stock price of Merck plummeted and $30 billion of its market cap was lost. There was also an avalanche of lawsuits, one of the largest resulting in a $5 billion settlement which was essentially a victory for Merck, considering they made a profit of $10 billion on the drug while it was being sold.

The story Merck will tell you is that they “voluntarily withdrew” the drug on September 30, 2004. In a placebo-controlled study of colon polyps in 2004, it was revealed that over a time period of 1200 days, 4% of the Vioxx users suffered a “cardiac, vascular, or thoracic event” (CVT event), which basically means something like a heart attack or stroke, whereas only 2% of the placebo group suffered such an event. In a group of about 2400 people, this was statistically significant, and Merck had no choice but to pull their drug from the market.

It should be noted that, on the one hand Merck should be applauded for checking for CVT events on a colon polyps study, but on the other hand that in 1997, at the International Consensus Meeting on COX-2 Inhibition, a group of leading scientists issued a warning in their Executive Summary that it was “… important to monitor cardiac side effects with selective COX-2 inhibitors”. Moreover, in an internal Merck email as early as 1996, it was stated there was a “… substantial chance that CVT will be observed.” In other words, Merck knew to look out for such things. Importantly, however, there was no subsequent insert in the medicine’s packaging that warned of possible CVT side-effects.

What the CEO of Merck Said

What did Merck say to the world at that point in 2004? You can look for yourself at the four and half hour Congressional hearing (seen on C-SPAN) which took place on November 18, 2004. Starting at 3:27:10, the then-CEO of Merck, Raymond Gilmartin, testifies that Merck “puts patients first” and “acted quickly” when there was reason to believe that Vioxx was causing CVT events. Gilmartin also went on the Charlie Rose show and repeated these claims, even go so far as stating that the 2004 study was the first time they had a study which showed evidence of such side effects.

How quickly did they really act though? Were there warning signs before September 30, 2004?

Arthritis Studies

Let’s go back to the time in 1999 when Vioxx was FDA approved. In spite of the fact that it was approved for a rather narrow use, mainly for arthritis sufferers who needed chronic pain management and were having GI problems on other meds (keeping in mind that Vioxx was way more expensive than ibuprofen or aspirin, so why would you use it unless you needed to), Merck nevertheless launched an ad campaign with Dorothy Hamill and spent $160m (compare that with Budweiser which spent $146m or Pepsi which spent $125m in the same time period).

As I mentioned, Vioxx was approved faster than usual. At the time of its approval, the completed clinical studies had only been 6- or 12-week studies; no longer term studies had been completed. However, there was one underway at the time of approval, namely a study which compared Aleve with Vioxx for people suffering from osteoarthritis and rheumatoid arthritis.

What did the arthritis studies show? These results, which were available in late 2003, showed that the CVT events were more than twice as likely with Vioxx as with Aleve (CVT event rates of 32/1304 = 0.0245 with Vioxx, 6/692 = 0.0086 with Aleve, with a p-value of 0.01). As we see this is a direct refutation of the fact that CEO Gilmartin stated that they didn’t have evidence until 2004 and acted quickly when they did.

In fact they had evidence even before this, if they bothered to put it together (in fact they stated a plan to do such statistical analyses but it’s not clear if they did them- or in any case there’s so far no evidence that they actually did these promised analyses).

In a previous study (“Table 13″), available in February of 2002, the could have seen that, comparing Vioxx to placebo, we saw a CVT event rate of 27/1087 = 0.0248 with Vioxx versus 5/633 = 0.0079 with placebo, with a p-value of 0.01. So, three times as likely.

In fact, there was an even earlier study (“1999 plan”), results of which were available in July of 2000, where the Vioxx CVT event rate was 10/427 = 0.0234 versus a placebo event rate of 1/252 = 0.0040, with a p-value of 0.05 (so more than 5 times as likely). This p-value can be taken to be the definition of statistically significant. So actually they knew to be very worried as early as 2000, but maybe they… forgot to do the analysis?

The FDA and Pooled Data

Where was the FDA in all of this?

They showed the FDA some of these numbers. But they did something really tricky. Namely, they kept the “osteoarthritis study” results separate from the “rheumatoid arthritis study” results. Each alone were not quite statistically significant, but together were amply statistically significant. Moreover, they introduced a third category of study, namely the “Alzheimer’s study” results, which looked pretty insignificant (more on that below though). When you pooled all three of these study types together, the overall significance was just barely not there.

It should be mentioned that there was no apparent reason to separate the different arthritic studies, and there is evidence that they did pool such study data in other places as a standard method. That they didn’t pool those studies for the sake of their FDA report is incredibly suspicious. That the FDA didn’t pick up on this is probably due to the fact that they are overworked lawyers, and too trusting on top of that. That’s unfortunately not the only mistake the FDA made (more below).

Alzheimer’s Study

So the Alzheimer’s study kind of “saved the day” here. But let’s look into this more. First, note that the average age of the 3,000 patients in the Alzheimer’s study was 75, it was a 48-month study, and that the total number of deaths for those on Vioxx was 41 versus 24 on placebo. So actually on the face of it it sounds pretty bad for Vioxx.

There were a few contributing reasons why the numbers got so mild by the time the study’s result was pooled with the two arthritis studies. First, when really old people die, there isn’t always an autopsy. Second, although there was supposed to be a DSMB as part of the study, and one was part of the original proposal submitted to the FDA, this was dropped surreptitiously in a later FDA update. This meant there was no third party keeping an eye on the data, which is not standard operating procedure for a massive drug study and was a major mistake, possibly the biggest one, by the FDA.

Third, and perhaps most importantly, Merck researchers created an added “filter” to the reported CVT events, which meant they needed the doctors who reported the CVT event to send their info to the Merck-paid people (“investigators”), who looked over the documents to decide whether it was a bonafide CVT event or not. The default was to assume it wasn’t, even though standard operating procedure would have the default assuming that there was such an event. In all, this filter removed about half the initially reported CVT events, and about twice as often the Vioxx patients had their CVT event status revoked as for the placebo patients. Note that the “investigator” in charge of checking the documents from the reporting doctors is paid $10,000 per patient. So presumably they wanted to continue to work for Merck in the future.

The effect of this “filter” was that, instead of it seeming 1.5 times as likely to have a CVT event if you were taking Voixx, it seemed like it was only 1.03 as likely, with a high p-score.

If you remove the ridiculous filter from the Alzheimer’s study, then you see that as of November 2000 there was statistically significant evidence that Vioxx caused CVT events in Alzheimer patients.

By the way, one extra note. Many of the 41 deaths in the Vioxx group were dismissed as “bizarre” and therefore unrelated to Vioxx. Namely, car accidents, falling of ladders, accidentally eating bromide pills. But at this point there’s evidence that Vioxx actually accelerates Alzheimer’s disease itself, which could explain those so-called bizarre deaths. This is not to say that Merck knew that, but rather that one should not immediately dismiss the concept of statistically significant just because it doesn’t make intuitive sense.

VIGOR and the New England Journal of Medicine

One last chapter in this sad story. There was a large-scale study, called the VIGOR study, with 8,000 patients. It was published in the New England Journal of Medicine on November 23, 2000. See also this NPR timeline for details. They didn’t show the graphs which would have emphasized this point, but they admitted, in a deceptively round-about way, that Vioxx has 4 times the number of CVT events than Aleve. They hinted that this is either because Aleve is protective against CVT events or that Vioxx is bad for it, but left it open.

But Bayer, which owns Aleve, issued a press release saying something like, “if Aleve is protective for CVT events then it’s news to us.” Bayer, it should be noted, has every reason to want people to think that Aleve is protective against CVT events. This problem, and the dubious reasoning explaining it away, was completely missed by the peer review system; if it had been spotted, Vioxx would have been forced off the market then and there. Instead, Merck purchased 900,000 preprints of this article from the NE Journal of Medicine, which is more than the number of practicing doctors in the U.S.. In other words, the Journal was used as a PR vehicle for Merck.

The paper emphasized that Aleve has twice the rate of ulcers and bleeding, at 4%, whereas Vioxx had a rate of only 2% among chronic users. When you compare that to the elevated rate of heart attack and death (0.4% to 1.2%) of Vioxx over Aleve, though, the reduced ulcer rate doesn’t seem all that impressive.

A bit more color on this paper. It was written internally by Merck, after which non-Merck authors were found. One of them is Loren Laine. Loren helped Merck develop a sound-byte interview which was 30 seconds long and was sent to the news media and run like a press interview, even though it actually happened in Merck’s New Jersey office (with a backdrop to look like a library) with a Merck employee posing as a neutral interviewer. Some smart lawyer got the outtakes of this video made available as part of the litigation against Merck. Check out this youtube video, where Laine and the fake interviewer scheme about spin and Laine admits they were being “cagey” about the renal failure issues that were poorly addressed in the article.

The Damage Done

Also on the Congress testimony I mentioned above is Dr. David Graham, who speaks passionately from minute 41:11 to minute 53:37 about Vioxx and how it is a symptom of a broken regulatory system. Please take 10 minutes to listen if you can.

He claims a conservative estimate is that 100,000 people have had heart attacks as a result of using Vioxx, leading to between 30,000 and 40,000 deaths (again conservatively estimated). He points out that this 100,000 is 5% of Iowa, and in terms people may understand better, this is like 4 aircraft falling out of the sky every week for 5 years.

According to this blog, the noticeable downwards blip in overall death count nationwide in 2004 is probably due to the fact that Vioxx was taken off the market that year.

Conclusion

Let’s face it, nobody comes out looking good in this story. The peer review system failed, the FDA failed, Merck scientists failed, and the CEO of Merck misled Congress and the people who had lost their husbands and wives to this damaging drug. The truth is, we’ve come to expect this kind of behavior from traders and bankers, but here we’re talking about issues of death and quality of life on a massive scale, and we have people playing games with statistics, with academic journals, and with the regulators.

Just as the financial system has to be changed to serve the needs of the people before the needs of the bankers, the drug trial system has to be changed to lower the incentives for cheating (and massive death tolls) just for a quick buck. As I mentioned before, it’s still not clear that they would have made less money, even including the penalties, if they had come clean in 2000. They made a bet that the fines they’d need to eventually pay would be smaller than the profits they’d make in the meantime. That sounds familiar to anyone who has been following the fallout from the credit crisis.

One thing that should be changed immediately: the clinical trials for drugs should not be run or reported on by the drug companies themselves. There has to be a third party which is in charge of testing the drugs and has the power to take the drugs off the market immediately if adverse effects (like CVT events) are found. Hopefully they will be given more power than risk firms are currently given in finance (which is none)- in other words, it needs to be more than reporting, it needs to be an active regulatory power, with smart people who understand statistics and do their own state-of-the-art analyses – although as we’ve seen above even just Stats 101 would sometimes do the trick.

By Daniel Alpert, the founding Managing Partner of Westwood Capital. Cross posted from EconoMonitor

While we may be hours away from a partial (and certainly a stopgap) agreement in the talks among the Greek government, the troika and private sector creditors, it is doubtful that a deal will emerge in a fully constructed fashion that will survive its application in the real economy.

It is likely that the only common view amongst participants in the various talks is a desire to try to avoid a disorderly default. Beyond that there is a severe disconnect fostered by parallel realities that seem unable to intersect. Accordingly, a deal that can hold up both in the streets of Greece and in the markets is both illusive and unlikely. Here’s why I think so.

Recently I have had opportunities to meet with and question senior members of the economics establishment within the German government and the broader German intelligentsia. Our meetings were held under Chatham House rules so I can’t name names, but – after several meetings with policy delegations from Germany over the past 60 days – I am prepared to sum up what appears to be the pretty-universally-held German policy position as follows (my apologies if the below evidences some degree of frustration – but these encounters leave me quite chagrined):

• Yes, since 2004 we have been in surplus and have benefited tremendously from debt fueled over-consumption in the periphery.

• Yes, we provided the loans (together with our core partners) to irresponsible borrowers who lacked the fiscal fortitude to protect our money. Shame on us, but we still want our money back (Greece is the only exception we believe we will have to make – and even then, only the private sector will suffer losses).

• Yes, we were a little irresponsible in the early days of monetary union, when the periphery was enjoying the benefits of competitive wages and the global situation was not as unbalanced. But we quickly recognized the error of our ways, remembered that we are Germans and took steps to cut our deficit.

• What you don’t understand is that after we entered surplus and could have shrunk our debt-to-GDP ratio using growth alone, we flogged ourselves with policy aimed at limiting consumption, increasing savings and avoiding a renewed encounter with the dreaded One Hundred Trillion (gr. Billionen) Reichsmark Note inflation we fear every day of our lives (Note: I sometimes jot down how long it takes in conversations with German policy folks before Weimar inflation enters the conversation, along with the aforementioned note). We didn’t have to do this but we did it because we are…well, you know. And during the Great Recession we didn’t just lay off all our workers like you did – we are civilized, we shared jobs (kurzarbeit).

 

 

 

 

 

 

 

 

• And by the way, before you tell us how to handle our periphery, you must remember that you in the U.S. were incredibly irresponsible too and destroyed the entire world economy and now you are obsessed with deflation and are printing money like mad which will, of course, inevitably result in [the dreaded One Hundred Trillion Reichsmark Note inflation we fear every day of our lives].

• Yes, yes, we studied Brüning and the deflation of the early 30′s that you say really brought about the National Socialism that nearly destroyed us and resulted in global horror, but we nevertheless attribute the trouble to the Weimar inflation.

• Don’t blame us for being incredibly productive and economically abstemious, we can’t help it if we make the best cars and everyone wants to buy them. And it is not our fault that the countries of the periphery are unproductive anachronisms that make nothing anyone wants to buy at the prices they want to sell their goods for. OK, we should have noticed the latter before we lent them all the money (and probably should have looked more closely at their books) – but it was the euphoria of European unification that made us do it, we’re only human.

• No full fiscal union, no Eurobonds….don’t even think about it.

• It’s one thing for Bavarians to share their wealth and income with northern and eastern Germany, but you must be kidding if you think we can get our electorate to support sending their money to support slothful southerners.

• We will never permit the ECB to monetize the sovereign debts of its member countries the way you have done in the U.S., the U.K. and Japan. Not only isn’t that the deal we made with each other but it will tank the Euro and result in [the dreaded One Hundred Trillion Reichsmark Note inflation we fear every day of our lives].

• There will be no exiting of any country from the Euro System. The System was only designed as part of a continuum leading to the full unification of greater Germ…uh…Europe.

• But we are not yet in a position to support transfer of national authorities, we Germans are not prepared to surrender national sovereignty (but we really did think that the suggestion for installing an Oberführer to supervise Greece was a nifty idea and aren’t sure why it got people so upset). [Fine, no one really used the word Oberführer]

• Finally, we believe in the written word – in law and in treaty. We can make more promises to each other and – unlike the last two times – we can this time honor them. Why do you doubt that?

All of this ends with a full-throated advocacy of the concept that has become known as “expansionary austerity” which forms the bedrock of German and other core nations’ policies towards the massively over-indebted periphery: Countries that have been irresponsible borrowers need only to demonstrate their fiscal discipline and prudence, reduce their indebtedness and reform their inefficiencies and over-regulation and investment and growth will resume because markets will once again have confidence in the economies of those countries. Yes, there it is…the return of the same confidence fairy that supply-siders hold out as the magic pixie dust that allows economies to fly once more without regard to the adequacy of demand or the competitiveness of a given nation relative to others.

In other words Tinkerbell Economics.

[Tinkerbell] was saying that she thought she could get well again if children believed in fairies….’Do you believe?’ Peter cried.

— The Adventures of Peter Pan, J.M. Barrie

There are many quite practical reasons why “Austerianism” will not work, and countless others have written on the subject at length. For the purposes of this essay I will briefly list three:

1. The continuing presence of several of the GIPSI’s within the Euro System effectively blocks two of the three transmission mechanisms that would otherwise enable those countries to re-balance trade. They can neither devalue their currencies nor, given their membership in the EU, can they restrict trade and take action (which would be highly unlikely anyway) to internalize production.

2. The world in general is fighting over insufficient demand relative to a global glut in the supply of labor, productive capacity and capital. Within the Eurozone, the countries of the core have been the principal beneficiaries of whatever internal and external demand exists. Yes, this results from their superior productivity and manufacturing talents, but – relative to global demand – is substantially enhanced by the weakness of the Euro relative to the value of former or reconstituted core currencies. Even if the German view were to suddenly change relative to ECB monetization, the devaluation would be universal (throughout the zone) and would not re-balance trade amongst the 17 member countries.

3. The core-recommended re-balancing transmission mechanism – internal devaluation (falling wages and prices – to the level of depression if the pixie dust doesn’t work its magic) – is functionally impossible. It is the economic equivalent of ancient bloodletting. Not only does it it result in killing off even more internal demand, but it necessitates a level of austerity that cannot possibly be tolerated by citizens of countries that still enjoy sovereign borders and popularly elected governments, merely to repay foreign creditors. They will simply refuse, at the ballot box or through other means. To believe otherwise is very much akin to believing in fairies.

A colleague of mine, present at one of the above mentioned meetings, likened the German response, to Eurozone realities, to Act II of Richard Wagner’s ring series opera, Seigfried. As Fafner the dragon is awoken from his slumber and warned by the conniving Alberich that the hero Siegfried is on his way to kill Fafner, the fearless dragon dismisses Alberich’s warning and returns to sleep.

The world cannot afford the luxury of sleeping on this. What is at stake here is more than the issue of recovering monies lent to Greece. A very substantial amount of European capital is at stake and plans to recover it by placing the populations of the GIPSI’s under indentured servitude to their creditors are the stuff of fairies and pixie dust.

It is past time to tighten the belt at both ends, recognize the money that has been lost throughout the periphery, recapitalize core institutions and bite the bullet on the secession of the defaulting nations. Sorry Tinkerbell!

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

A shorter version of this article in German will run in the Frankfurter Algemeine Zeitung on January 28. 2012

The inherently symbiotic relationship between banks and governments recently has been reversed. In medieval times, wealthy bankers lent to kings and princes as their major customers. But now it is the banks that are needy, relying on governments for funding – capped by the post-2008 bailouts to save them from going bankrupt from their bad private-sector loans and gambles.

Yet the banks now browbeat governments – not by having ready cash but by threatening to go bust and drag the economy down with them if they are not given control of public tax policy, spending and planning. The process has gone furthest in the United States. Joseph Stiglitz characterizes the Obama administration’s vast transfer of money and pubic debt to the banks as a “privatizing of gains and the socializing of losses. It is a ‘partnership’ in which one partner robs the other.” Prof. Bill Black describes banks as becoming criminogenic and innovating “control fraud.” High finance has corrupted regulatory agencies, falsified account-keeping by “mark to model” trickery, and financed the campaigns of its supporters to disable public oversight. The effect is to leave banks in control of how the economy’s allocates its credit and resources.

If there is any silver lining to today’s debt crisis, it is that the present situation and trends cannot continue. So this is not only an opportunity to restructure banking; we have little choice. The urgent issue is who will control the economy: governments, or the financial sector and monopolies with which it has made an alliance.

Fortunately, it is not necessary to re-invent the wheel. Already a century ago the outlines of a productive industrial banking system were well understood. But recent bank lobbying has been remarkably successful in distracting attention away from classical analyses of how to shape the financial and tax system to best promote economic growth – by public checks on bank privileges.

How Banks Broke The Social Compact, Promoting Their Own Special Interests

People used to know what banks did. Bankers took deposits and lent them out, paying short-term depositors less than they charged for risky or less liquid loans. The risk was borne by bankers, not depositors or the government. But today, bank loans are made increasingly to speculators in recklessly large amounts for quick in-and-out trading. Financial crashes have become deeper and affect a wider swath of the population as debt pyramiding has soared and credit quality plunged into the toxic category of “liars’ loans.”

The first step toward today’s mutual interdependence between high finance and government was for central banks to act as lenders of last resort to mitigate the liquidity crises that periodically resulted from the banks’ privilege of credit creation. In due course governments also provided public deposit insurance, recognizing the need to mobilize and recycle savings into capital investment as the Industrial Revolution gained momentum. In exchange for this support, they regulated banks as public utilities.

Over time, banks have sought to disable this regulatory oversight, even to the point of decriminalizing fraud. Sponsoring an ideological attack on government, they accuse public bureaucracies of “distorting” free markets (by which they mean markets free for predatory behavior). The financial sector is now making its move to concentrate planning in its own hands.

The problem is that the financial time frame is notoriously short-term and often self-destructive. And inasmuch as the banking system’s product is debt, its business plan tends to be extractive and predatory, leaving economies high-cost. This is why checks and balances are needed, along with regulatory oversight to ensure fair dealing. Dismantling public attempts to steer banking to promote economic growth (rather than merely to make bankers rich) has permitted banks to turn into something nobody anticipated. Their major customers are other financial institutions, insurance and real estate – the FIRE sector, not industrial firms. Debt leveraging by real estate and monopolies, arbitrage speculators, hedge funds and corporate raiders inflates asset prices on credit. The effect of creating “balance sheet wealth” in this way is to load down the “real” production-and-consumption economy with debt and related rentier charges, adding more to the cost of living and doing business than rising productivity reduces production costs.

Since 2008, public bailouts have taken bad loans off the banks’ balance sheet at enormous taxpayer expense – some $13 trillion in the United States, and proportionally higher in Ireland and other economies now being subjected to austerity to pay for “free market” deregulation. Bankers are holding economies hostage, threatening a monetary crash if they do not get more bailouts and nearly free central bank credit, and more mortgage and other loan guarantees for their casino-like game. The resulting “too big to fail” policy means making governments too weak to fight back.

The process that began with central bank support thus has turned into broad government guarantees against bank insolvency. The largest banks have made so many reckless loans that they have become wards of the state. Yet they have become powerful enough to capture lawmakers to act as their facilitators. The popular media and even academic economic theorists have been mobilized to pose as experts in an attempt to convince the public that financial policy is best left to technocrats – of the banks’ own choosing, as if there is no alternative policy but for governments to subsidize a financial free lunch and crown bankers as society’s rulers.

The Bubble Economy and its austerity aftermath could not have occurred without the banking sector’s success in weakening public regulation, capturing national treasuries and even disabling law enforcement. Must governments surrender to this power grab? If not, who should bear the losses run up by a financial system that has become dysfunctional? If taxpayers have to pay, their economy will become high-cost and uncompetitive – and a financial oligarchy will rule.

The Present Debt Quandary

The endgame in times past was to write down bad debts. That meant losses for banks and investors. But today’s debt overhead is being kept in place – shifting bad loans off bank balance sheets to become public debts owed by taxpayers to save banks and their creditors from loss. Governments have given banks newly minted bonds or central bank credit in exchange for junk mortgages and bad gambles – without re-structuring the financial system to create a more stable, less debt-ridden economy. The pretense is that these bailouts will enable banks to lend enough to revive the economy by enough to pay its debts.

Seeing the handwriting on the wall, bankers are taking as much bailout money as they can get, and running, using the money to buy as much tangible property and ownership rights as they can while their lobbyists keep the public subsidy faucet running.

The pretense is that debt-strapped economies can resume business-as-usual growth by borrowing their way out of debt. But a quarter of U.S. real estate already is in negative equity – worth less than the mortgages attached to it – and the property market is still shrinking, so banks are not lending except with public Federal Housing Administration guarantees to cover whatever losses they may suffer. In any event, it already is mathematically impossible to carry today’s debt overhead without imposing austerity, debt deflation and depression.

This is not how banking was supposed to evolve. If governments are to underwrite bank loans, they may as well be doing the lending in the first place – and receiving the gains. Indeed, since 2008 the over-indebted economy’s crash led governments to become the major shareholders of the largest and most troubled banks – Citibank in the United States, Anglo-Irish Bank in Ireland, and Britain’s Royal Bank of Scotland. Yet rather than taking this opportunity to run these banks as public utilities and lower their charges for credit-card services – or most important of all, to stop their lending to speculators and gamblers – governments left these banks operating as part of the “casino capitalism” that has become their business plan.

There is no natural reason for matters to be like this. Relations between banks and government used to be the reverse. In 1307, France’s Philip IV (“The Fair”) set the tone by seizing the Knights Templars’ wealth, arresting them and putting many to death – not on financial charges, but on the accusation of devil-worshipping and satanic sexual practices. In 1344 the Peruzzi bank went broke, followed by the Bardi by making unsecured loans to Edward III of England and other monarchs who died or defaulted. Many subsequent banks had to suffer losses on loans gone bad to real estate or financial speculators.

By contrast, now the U.S., British, Irish and Latvian governments have taken bad bank loans onto their national balance sheets, imposing a heavy burden on taxpayers – while letting bankers cash out with immense wealth. These “cash for trash” swaps have turned the mortgage crisis and general debt collapse into a fiscal problem. Shifting the new public bailout debts onto the non-financial economy threaten to increase the cost of living and doing business. This is the result of the economy’s failure to distinguish productive from unproductive loans and debts. It helps explain why nations now are facing financial austerity and debt peonage instead of the leisure economy promised so eagerly by technological optimists a century ago.

So we are brought back to the question of what the proper role of banks should be. This issue was discussed exhaustively prior to World War I. It is even more urgent today.

How Classical Economists Hoped to Modernize Banks as Agents of Industrial Capitalism

Britain was the home of the Industrial Revolution, but there was little long-term lending to finance investment in factories or other means of production. British and Dutch merchant banking was to extend short-term credit on the basis of collateral such as real property or sales contracts for merchandise shipped (“receivables”). Buoyed by this trade financing, merchant bankers were successful enough to maintain long-established short-term funding practices. This meant that James Watt and other innovators were obliged to raise investment money from their families and friends rather than from banks.

It was the French and Germans who moved banking into the industrial stage to help their nations catch up. In France, the Saint-Simonians described the need to create an industrial credit system aimed at funding means of production. In effect, the Saint-Simonians proposed to restructure banks along lines akin to a mutual fund. A start was made with the Crédit Mobilier, founded by the Péreire Brothers in 1852. Their aim was to shift the banking and financial system away from debt financing at interest toward equity lending, taking returns in the form of dividends that would rise or decline in keeping with the debtor’s business fortunes. By giving businesses leeway to cut back dividends when sales and profits decline, profit-sharing agreements avoid the problem that interest must be paid willy-nilly. If an interest payment is missed, the debtor may be forced into bankruptcy and creditors can foreclose. It was to avoid this favoritism for creditors regardless of the debtor’s ability to pay that prompted Mohammed to ban interest under Islamic law.

Attracting reformers ranging from socialists to investment bankers, the Saint-Simonians won government backing for their policies under France’s Third Empire. Their approach inspired Marx as well as industrialists in Germany and protectionists in the United States and England. The common denominator of this broad spectrum was recognition that an efficient banking system was needed to finance the industry on which a strong national state and military power depended.

Germany Develops an Industrial Banking System

It was above all in Germany that long-term financing found its expression in the Reichsbank and other large industrial banks as part of the “holy trinity” of banking, industry and government planning under Bismarck’s “state socialism.” German banks made a virtue of necessity. British banks “derived the greater part of their funds from the depositors,” and steered these savings and business deposits into mercantile trade financing. This forced domestic firms to finance most new investment out of their own earnings. By contrast, Germany’s “lack of capital … forced industry to turn to the banks for assistance,” noted the financial historian George Edwards. “A considerable proportion of the funds of the German banks came not from the deposits of customers but from the capital subscribed by the proprietors themselves. As a result, German banks “stressed investment operations and were formed not so much for receiving deposits and granting loans but rather for supplying the investment requirements of industry.”

When the Great War broke out in 1914, Germany’s rapid victories were widely viewed as reflecting the superior efficiency of its financial system. To some observers the war appeared as a struggle between rival forms of financial organization. At issue was not only who would rule Europe, but whether the continent would have laissez faire or a more state-socialist economy.

In 1915, shortly after fighting broke out, the Christian Socialist priest-politician Friedrich Naumann published Mitteleuropa, describing how Germany recognized more than any other nation that industrial technology needed long term financing and government support. His book inspired Prof. H. S. Foxwell in England to draw on his arguments in two remarkable essays published in the Economic Journal in September and December 1917: “The Nature of the Industrial Struggle,” and “The Financing of Industry and Trade.” He endorsed Naumann’s contention that “the old individualistic capitalism, of what he calls the English type, is giving way to the new, more impersonal, group form; to the disciplined scientific capitalism he claims as German.”

This was necessarily a group undertaking, with the emerging tripartite integration of industry, banking and government, with finance being “undoubtedly the main cause of the success of modern German enterprise,” Foxwell concluded (p. 514). German bank staffs included industrial experts who were forging industrial policy into a science. And in America, Thorstein Veblen’s The Engineers and the Price System (1921) voiced the new industrial philosophy calling for bankers and government planners to become engineers in shaping credit markets.

Foxwell warned that British steel, automotive, capital equipment and other heavy industry was becoming obsolete largely because its bankers failed to perceive the need to promote equity investment and extend long term credit. They based their loan decisions not on the new production and revenue their lending might create, but simply on what collateral they could liquidate in the event of default: inventories of unsold goods, real estate, and money due on bills for goods sold and awaiting payment from customers. And rather than investing in the shares of the companies that their loans supposedly were building up, they paid out most of their earnings as dividends – and urged companies to do the same. This short time horizon forced business to remain liquid rather than having leeway to pursue long term strategy.

German banks, by contrast, paid out dividends (and expected such dividends from their clients) at only half the rate of British banks, choosing to retain earnings as capital reserves and invest them largely in the stocks of their industrial clients. Viewing these companies as allies rather than merely as customers from whom to make as large a profit as quickly as possible, German bank officials sat on their boards, and helped expand their business by extending loans to foreign governments on condition that their clients be named the chief suppliers in major public investments. Germany viewed the laws of history as favoring national planning to organize the financing of heavy industry, and gave its bankers a voice in formulating international diplomacy, making them “the principal instrument in the extension of her foreign trade and political power.”

A similar contrast existed in the stock market. British brokers were no more up to the task of financing manufacturing in its early stages than were its banks. The nation had taken an early lead by forming Crown corporations such as the East India Company, the Bank of England and even the South Sea Company. Despite the collapse of the South Sea Bubble in 1720, the run-up of share prices from 1715 to 1720 in these joint-stock monopolies established London’s stock market as a popular investment vehicle, for Dutch and other foreigners as well as for British investors. But the market was dominated by railroads, canals and large public utilities. Industrial firms were not major issuers of stock.

In any case, after earning their commissions on one issue, British stockbrokers were notorious for moving on to the next without much concern for what happened to the investors who had bought the earlier securities. “As soon as he has contrived to get his issue quoted at a premium and his underwriters have unloaded at a profit,” complained Foxwell, “his enterprise ceases. ‘To him,’ as the Times says, ‘a successful flotation is of more importance than a sound venture.’”

Much the same was true in the United States. Its merchant heroes were individualistic traders and political insiders often operating on the edge of the law to gain their fortunes by stock-market manipulation, railroad politicking for land giveaways, and insurance companies, mining and natural resource extraction. America’s wealth-seeking spirit found its epitome in Thomas Edison’s hit-or-miss method of invention, coupled with a high degree of litigiousness to obtain patent and monopoly rights.

In sum, neither British nor American banking or stock markets planned for the future. Their time frame was short, and they preferred rent-extracting projects to industrial innovation. Most banks favored large real estate borrowers, railroads and public utilities whose income streams easily could be forecast. Only after manufacturing companies grew fairly large did they obtain significant bank and stock market credit.

What is remarkable is that this is the tradition of banking and high finance that has emerged victorious throughout the world. The explanation is primarily the military victory of the United States, Britain and their Allies in the Great War and a generation later, in World War II.

The Regression Toward Burdensome Unproductive Debts After World War I

The development of industrial credit led economists to distinguish between productive and unproductive lending. A productive loan provides borrowers with resources to trade or invest at a profit sufficient to pay back the loan and its interest charge. An unproductive loan must be paid out of income earned elsewhere. Governments must pay war loans out of tax revenues. Consumers must pay loans out of income they earn at a job – or by selling assets. These debt payments divert revenue away from being spent on consumption and investment, so the economy shrinks. This traditionally has led to crises that wipe out debts, above all those that are unproductive.

In the aftermath of World War I the economies of Europe’s victorious and defeated nations alike were dominated by postwar arms and reparations debts. These inter-governmental debts were to pay for weapons (by the Allies when the United States unexpectedly demanded that they pay for the arms they had bought before America’s entry into the war), and for the destruction of property (by the Central Powers), not new means of production. Yet to the extent that they were inter-governmental, these debts were more intractable than debts to private bankers and bondholders. Despite the fact that governments in principle are sovereign and hence can annul debts owed to private creditors, the defeated Central Powers governments were in no position to do this.

And among the Allies, Britain led the capitulation to U.S. arms billing, captive to the creditor ideology that “a debt is a debt” and must be paid regardless of what this entails in practice or even whether the debt in fact can be paid. Confronted with America’s demand for payment, the Allies turned to Germany to make them whole. After taking its liquid assets and major natural resources, they insisted that it squeeze out payments by taxing its economy. No attempt was made to calculate just how Germany was to do this – or most important, how it was to convert this domestic revenue (the “budgetary problem”) into hard currency or gold. Despite the fact that banking had focused on international credit and currency transfers since the 12th century, there was a broad denial of what John Maynard Keynes identified as a foreign exchange transfer problem.

Never before had there been an obligation of such enormous magnitude. Nevertheless, all of Germany’s political parties and government agencies sought to devise ways to tax the economy to raise the sums being demanded. Taxes, however, are levied in a nation’s own currency. The only way to pay the Allies was for the Reichsbank to take this fiscal revenue and throw it onto the foreign exchange markets to obtain the sterling and other hard currency to pay. Britain, France and the other recipients then paid this money on their Inter-Ally debts to the United States.

Adam Smith pointed out that no government ever had paid down its public debt. But creditors always have been reluctant to acknowledge that debtors are unable to pay. Ever since David Ricardo’s lobbying for their perspective in Britain’s Bullion debates, creditors have found it their self-interest to promote a doctrinaire blind spot, insisting that debts of any magnitude could be paid. They resist acknowledging a distinction between raising funds domestically (by running a budget surplus) and obtaining the foreign exchange to pay foreign-currency debt. Furthermore, despite the evident fact that austerity cutbacks on consumption and investment can only be extractive, creditor-oriented economists refused to recognize that debts cannot be paid by shrinking the economy. Or that foreign debts and other international payments cannot be paid in domestic currency without lowering the exchange rate.

The more domestic currency Germany sought to convert, the further its exchange rate was driven down against the dollar and other gold-based currencies. This obliged Germans to pay much more for imports. The collapse of the exchange rate was the source of hyperinflation, not an increase in domestic money creation as today’s creditor-sponsored monetarist economists insist. In vain Keynes pointed to the specific structure of Germany’s balance of payments and asked creditors to specify just how many German exports they were willing to take, and to explain how domestic currency could be converted into foreign exchange without collapsing the exchange rate and causing price inflation.

Tragically, Ricardian tunnel vision won Allied government backing. Bertil Ohlin and Jacques Rueff claimed that economies receiving German payments would recycle their inflows to Germany and other debt-paying countries by buying their imports. If income adjustments did not keep exchange rates and prices stable, then Germany’s falling exchange rate would make its exports sufficiently more attractive to enable it to earn the revenue to pay.

This is the logic that the International Monetary Fund followed half a century later in insisting that Third World countries remit foreign earnings and even permit flight capital as well as pay their foreign debts. It is the neoliberal stance now demanding austerity for Greece, Ireland, Italy and other Eurozone economies.

Bank lobbyists claim that the European Central Bank will risk spurring domestic wage and price inflation of it does what central banks were founded to do: finance budget deficits. Europe’s financial institutions are given a monopoly right to perform this electronic task – and to receive interest for what a real central bank could create on its own computer keyboard.

But why it is less inflationary for commercial banks to finance budget deficits than for central banks to do this? The bank lending that has inflated a global financial bubble since the 1980s has left as its legacy a debt overhead that can no more be supported today than Germany was able to carry its reparations debt in the 1920s. Would government credit have so recklessly inflated asset prices?

How Debt Creation Has Fueled Asset-Price Inflation Since The 1980s

Banking in recent decades has not followed the productive lines that early economic futurists expected. As noted above, instead of financing tangible investment to expand production and innovation, most loans are made against collateral, with interest to be paid out of what borrowers can make elsewhere. Despite being unproductive in the classical sense, it was remunerative for debtors from 1980 until 2008 – not by investing the loan proceeds to expand economic activity, but by riding the wave of asset-price inflation. Mortgage credit enabled borrowers to bid up property prices, drawing speculators and new customers into the market in the expectation that prices would continue to rise. But hothouse credit infusions meant additional debt service, which ended up shrinking the market for goods and services.

Under normal conditions the effect would have been for rents to decline, with property prices following suit, leading to mortgage defaults. But banks postponed the collapse into negative equity by lowering their lending standards, providing enough new credit to keep on inflating prices. This averted a collapse of their speculative mortgage and stock market lending. It was inflationary – but it was inflating asset prices, not commodity prices or wages. Two decades of asset price inflation enabled speculators, homeowners and commercial investors to borrow the interest falling due and still make a capital gain.

This hope for a price gain made winning bidders willing to pay lenders all the current income – making banks the ultimate and major rentier income recipients. The process of inflating asset prices by easing credit terms and lowering the interest rate was self-feeding. But it also was self-terminating, because raising the multiple by which a given real estate rent or business income can be “capitalized” into bank loans increased the economy’s debt overhead.

Securities markets became part of this problem. Rising stock and bond prices made pension funds pay more to purchase a retirement income – so “pension fund capitalism” was coming undone. So was the industrial economy itself. Instead of raising new equity financing for companies, the stock market became a vehicle for corporate buyouts. Raiders borrowed to buy out stockholders, loading down companies with debt. The most successful looters left them bankrupt shells. And when creditors turned their economic gains from this process into political power to shift the tax burden onto wage earners and industry, this raised the cost of living and doing business – by more than technology was able to lower prices.

The EU Rejects Central Bank Money Creation, Leaving Deficit Financing to the Banks

Article 123 of the Lisbon Treaty forbids the ECB or other central banks to lend to government. But central banks were created specifically – to finance government deficits. The EU has rolled back history to the way things were three hundred years ago, before the Bank of England was created. Reserving the task of credit creation for commercial banks, it leaves governments without a central bank to finance the public spending needed to avert depression and widespread financial collapse.

So the plan has backfired. When “hard money” policy makers limited central bank power, they assumed that public debts would be risk-free. Obliging budget deficits to be financed by private creditors seemed to offer a bonanza: being able to collect interest for creating electronic credit that governments can create themselves. But now, European governments need credit to balance their budget or face default. So banks now want a central bank to create the money to bail them out for the bad loans they have made.

For starters, the ECB’s €489 billion in three-year loans at 1% interest gives banks a free lunch arbitrage opportunity (the “carry trade”) to buy Greek and Spanish bonds yielding a higher rate. The policy of buying government bonds in the open market – after banks first have bought them at a lower issue price – gives the banks a quick and easy trading gain.

How are these giveaways less inflationary than for central banks to directly finance budget deficits and roll over government debts? Is the aim of giving banks easy gains simply to provide them with resources to resume the Bubble Economy lending that led to today’s debt overhead in the first place?

Conclusion

Governments can create new credit electronically on their own computer keyboards as easily as commercial banks can. And unlike banks, their spending is expected to serve a broad social purpose, to be determined democratically. When commercial banks gain policy control over governments and central banks, they tend to support their own remunerative policy of creating asset-inflationary credit – leaving the clean-up costs to be solved by a post-bubble austerity. This makes the debt overhead even harder to pay – indeed, impossible.

So we are brought back to the policy issue of how public money creation to finance budget deficits differs from issuing government bonds for banks to buy. Is not the latter option a convoluted way to finance such deficits – at a needless interest charge? When governments monetize their budget deficits, they do not have to pay bondholders.

I have heard bankers argue that governments need an honest broker to decide whether a loan or public spending policy is responsible. To date their advice has not promoted productive credit. Yet they now are attempting to compensate for the financial crisis by telling debtor governments to sell off property in their public domain. This “solution” relies on the myth that privatization is more efficient and will lower the cost of basic infrastructure services. Yet it involves paying interest to the buyers of rent-extraction rights, higher executive salaries, stock options and other financial fees.

Most cost savings are achieved by shifting to non-unionized labor, and typically end up being paid to the privatizers, their bankers and bondholders, not passed on to the public. And bankers back price deregulation, enabling privatizers to raise access charges. This makes the economy higher cost and hence less competitive – just the opposite of what is promised.

Banking has moved so far away from funding industrial growth and economic development that it now benefits primarily at the economy’s expense in a predator and extractive way, not by making productive loans. This is now the great problem confronting our time. Banks now lend mainly to other financial institutions, hedge funds, corporate raiders, insurance companies and real estate, and engage in their own speculation in foreign currency, interest-rate arbitrage, and computer-driven trading programs. Industrial firms bypass the banking system by financing new capital investment out of their own retained earnings, and meet their liquidity needs by issuing their own commercial paper directly. Yet to keep the bank casino winning, global bankers now want governments not only to bail them out but to enable them to renew their failed business plan – and to keep the present debts in place so that creditors will not have to take a loss.

This wish means that society should lose, and even suffer depression. We are dealing here not only with greed, but with outright antisocial behavior and hostility.

Europe thus has reached a critical point in having to decide whose interest to put first: that of banks, or the “real” economy. History provides a wealth of examples illustrating the dangers of capitulating to bankers, and also for how to restructure banking along more productive lines. The underlying questions are clear enough:
* Have banks outlived their historical role, or can they be restructured to finance productive capital investment rather than simply inflate asset prices?
* Would a public option provide less costly and better directed credit?
* Why not promote economic recovery by writing down debts to reflect the ability to pay, rather than relinquishing more wealth to an increasingly aggressive creditor class?
Solving the Eurozone’s financial problem can be made much easier by the tax reforms that classical economists advocated to complement their financial reforms. To free consumers and employers from taxation, they proposed to levy the burden on the “unearned increment” of land and natural resource rent, monopoly rent and financial privilege. The guiding principle was that property rights in the earth, monopolies and other ownership privileges have no direct cost of production, and hence can be taxed without reducing their supply or raising their price, which is set in the market. Removing the tax deductibility for interest is the other key reform that is needed.
A rent tax holds down housing prices and those of basic infrastructure services, whose untaxed revenue tends to be capitalized into bank loans and paid out in the form of interest charges. Additionally, land and natural resource rents – along with interest – are the easiest to tax, because they are highly visible and their value is easy to assess.
Pressure to narrow existing budget deficits offers a timely opportunity to rationalize the tax systems of Greece and other PIIGS countries in which the wealthy avoid paying their fair share of taxes. The political problem blocking this classical fiscal policy is that it “interferes” with the rent-extracting free lunches that banks seek to lend against. So they act as lobbyists for untaxing real estate and monopolies (and themselves as well). Despite the financial sector’s desire to see governments remain sufficiently solvent to pay bondholders, it has subsidized an enormous public relations apparatus and academic junk economics to oppose the tax policies that can close the fiscal gap in the fairest way.

It is too early to forecast whether banks or governments will emerge victorious from today’s crisis. As economies polarize between debtors and creditors, planning is shifting out of public hands into those of bankers. The easiest way for them to keep this power is to block a true central bank or strong public sector from interfering with their monopoly of credit creation. The counter is for central banks and governments to act as they were intended to, by providing a public option for credit creation.

One of my buddies who must go unnamed because he is involved in the Lehman bankruptcy told me many months ago that the unwinding was going to cost over $2 billion. A new story at Bloomberg suggests that his prediction is on track. The costs of various advisors to the Lehman estate in now in excess of $1.6 billion, and it ain’t over.

But perhaps more important, my mole, who has oodles of experience on big messy international bankruptcies, was incensed at the way various advisors, in particularly Alvarez & Marsal, which is running what is left of Lehman and is the major domo, and the lead law firm, Weil Gotschal, were feeding at the trough. Bloomberg also tells us that the fees paid to A&M are now over $500 million. This of course is the sort of thing that is inherently difficult to discern from the outside, since there aren’t that many people with the experience base and the vantage to discern that. And the people who do see it are either direct beneficiaries (as in they are working for Lehman) or are representing clients who are trying to improve their recovery. The advisors to creditors are in many respects part of a criminogenic environment, since the fees and costs incurred by the Lehman advisors legitimate their charges. And if someone was high-minded enough to object, waging a quixotic war over self-serving practices is not likely to help their client or their career.

Now some of the expense of the BK is due to people who have something to hide trying to reduce liability. We’ve pointed several times to one factoid supplied by A&M, that Lehman’s
“disorderly bankruptcy” cost as much as $75 billion (we’ve had fun since 2008 trying to explain the size of the Lehman black hole, and the figures offered don’t even begin to add up). But why did A&M even bother making this report and going on a PR push? As we noted in 2009:

We now have the interesting question, :”If the board was told as much as $75 billion was due to the chaos, pray tell where did the other $55 billion go?” And the assertion that Chapter 11 would have produced a vastly better outcome is questionable. As we pointed out then:

Here is where readers are encouraged to correct me if I have something wrong or a bit askew. I was under the very strong impression that securities firms do not decay in an orderly fashion, but instead collapse rapidly once certain triggers are breached, making it well-nigh impossible to contain the unwind. In fact, you’d need pretty substantial changes in both bankruptcy law and the way that trading counterparties deal with each other to have the sort of managed process that the A&M reports argues should have taken place.

….

So if the logic above is correct, the A&M report looks like a costly ass-covering exercise to protect the board from lawsuits. And the Journal did the board a favor by giving it reasonably prominent placement.

Oh, by the way, our last sizing of the Lehman black hole put it at $140 to $245 billion (total losses of $216 to $319 billion less giving full credit for A&M’s as much as $75 billion attributable to the disorderly unwind. If you take out $50 billion for Repo 105, you still have $90 billion to $195 billion of losses that have not been adequately explained. But Bryan Marsal has maintained that Lehman had a liquidity, not a solvency problem! That’s certainly the line the board that hired him would want him to take.

And we have footprints of more Alvarez & Marsal featherbedding. For instance, in an older post, we took issue with A&M trying to act as a global bankruptcy administrator, which is quite a reach given that bankruptcies are always national affairs. But this seemed to be a no lose proposition from a fee perspective: either administrators hired in other jurisdictions would play ball, giving A&M more work by pretending to babysit them, or they’d fight, and the scrapping would still produce more billed time.

Or how about this?

In the video, Marsal mentions that his firm hired some 400 ex Lehman staffers to help unwind the trades, and threw out a $500,000 salary and a $500,000 bonus if recovery targets were met as a representative figure.

The world happens to be awash in unemployed structured credit types these days, I would bet at least 300 of those 400 jobs could have been filled at much lower cost. But Alvarez & Marsal has no incentive to do that. Paying more makes it easier to hire people, and also makes their fees look more reasonable. And say “derivatives” and a BK judge will buy in, even if the skills required may not be all that high level. In the LTCM bankruptcy, Myron Scholes worked for a mere $250,000 a year, which in today’s dollars is about $330,000. Am I to believe in that there is good reason to pay more than the equivalent of $500,000 all in for a successful job in winding down a company that you helped destroy? Well, sadly yes, pay escalated with perilous little justification, since most of the money supposedly made turned out to be smoke and mirrors, and those high water marks are still holding.

What is distressing isn’t that this sort of looting is happening, it’s that pretty much no one is bothered that it is happening, and that for every Lehman, there are hundreds of smaller scams disguised as Serious Professionalism underway. The airy assumption among the elites that they are entitled to their cut, no matter what, seems to be beyond question these days. The executive classes in the old days were kept somewhat in line by the need to maintain appearances and stay within certain bounds in order to preserve their authority. But now the top operates in a self-referential realm, where the contempt of the lower orders does not penetrate. They’ve made their fate independent of most of the rest of us, until some calamity, say a pandemic, or an infrastructure failure (think of what would happen if the US got no chips for 18 months) or a loss of control of the police makes them realize that the costs they imposed on broader society will come to haunt them.

A speech by New York Fed president William Dudley is a bit of a surprise, in that it acknowledges the severity of the deepening mortgage crisis and sets forth some specific policy proposals. I still find these recommendations frustrating, in that they are insufficient given the severity of the problem and also fail to come to grips with widespread servicer abuses (not just servicer driven foreclosures, but also what amounts to theft from investors, via schemes such as double charging fees to borrowers and investors, inflating principal balances, reporting REO as sold months later than the transaction closed, and getting kickbacks on third party charges). But they are more serious than other ideas from senior financial officials. Specifically, the Dudley advocates principal relief via a program of “earned principal reduction” which would allow for put options for all severely underwater borrowers who stay current on their mortgages for three years. But as we will discuss, this proposal is less meaningful than it sounds.

It looks at if the NY Fed is trying to provide intellectual leadership in the debate around the housing mess, which given the level of denial and kick the can down the road strategies being offered as alternatives, means this effort stands out in part by virtue of the shoddy alternatives. And this posture put it squarely at odds with the Board of Governors, whose paper published earlier this week pooh-poohs principal writedowns and specifically opposes giving broad scale principal reductions to homeowners with negative equity. One has to wonder whether the Board of Governors paper was released prior to the Dudley speech with the specific aim of undermining it. Similarly, the NY Fed is also in opposition to the GSE’s resistance to offering principal mods, as evidenced by the leak from the mortgage settlement talks, in which the GSEs refused participate in the banks’ scheme to use mods on securitized loans (which would include GSE loans) as a way to reach the settlement target for principal mods.

One of the reasons this speech is nevertheless encouraging is that it acknowledges that regulatory/housing policy and macro-economic activity are linked:

Monetary policy and housing policy are much more complements than substitutes.

As I hope I have convinced you today, while the Fed has will do all it can to achieve our dual mandate of maximum sustainable employment in the context of price stability, we have to recognize that there is more to economic policy than just monetary policy. Low interest rates help housing, but cannot resolve the problems in that sector that are pressing on wider economic activity. With additional housing policy interventions, we could achieve a better set of economic outcomes than with just monetary policy alone.

Although the Board of Governors paper earlier this week implicitly admitted that monetary policy could not solve housing market problems, Dudley’s more forthright statement makes a case for more intervention.

Here is the principal relief trial balloon in the Dudley speech:

One option developed by my staff is for Fannie Mae and Freddie Mac to give underwater borrowers on loans that they have guaranteed the right to pay off the loan at below par in the future under certain circumstances, including that the borrowers have continued to make timely payments. For instance, the borrower could be given an open-ended option to pay off the loan at an LTV of 125 percent, and the right to pay off the loan at an LTV of 95 percent after three years of timely payments.

The borrower would be protected from further declines in home prices, but in return would give up a portion of any upside from future capital gains on the home via a shared appreciation agreement. Note that under this arrangement some of the reduction in the loan amount would be paid by the borrower as the outstanding balance was amortized by continued monthly payments….

Based on recent data on borrower behavior, my staff calculates that the taxpayer (through the effect on Fannie Mae and Freddie Mac) would be better off with earned principal reduction under a base case of roughly flat house prices and persistent weakness in the jobs market. Under a scenario of modest house price increases, the combination of fewer defaults and shared appreciation also produces a net benefit.

This result occurs before taking into account the positive externalities of nudging house prices onto a stronger path, which would reduce the magnitude of losses on loans that do default. On an expected value basis, such a program appears still more compelling, since Fannie Mae and Freddie Mac are currently exposed to the downside risk of further declines in home prices.

While it isn’t hard to imagine that any approach is better than “do nothing,” I wish I could see the assumptions being used in the model. One troubling bit is the apparent failure to consider that housing prices could deteriorate further, particularly since shadow inventory appears to be larger than most commentators recognize.

More important, it isn’t clear how many people will really be helped. Borrowers won’t get any concrete benefit unless they sell the house. And if they have a home equity line of credit in addition to the first mortgage, they may still be under water, and the second lienholder may block a sale as brokers report they do now. So this plan may increase liquidity, but only for some borrowers, and would also provide a new fee source for Wall Street firms (you can bet they will securitize the shared appreciation rights). This scheme appears to be mainly a carrot to give underwater borrowers more incentive to stay current, in other words, to prevent strategic defaults. Given that we think the “strategic default” meme has been considerably overhyped, we are puzzled at Dudley giving so much attention to this aspect of the mortgage mess.

But the probable small tangible impact of this program may in fact be quite deliberate, a cheap gimmie to borrowers who were prudent but are upside down by virtue of buying near the peak in the markets than went into the biggest tailspins. Devising a low cost program that provides a benefit to homeowners who have remained current may be seen as a necessary sop to forestall objections to programs that provide more substantial relief to borrowers where deeper loan mods would be a win/win to both the homeowner and the investor/guarantor.

But the additional forms of relief that Dudley advocated would certainly be helpful, but again were narrow. One was a bridge loan program for the unemployed, which he estimated would cost $15 billion a year. Note that Dudley suggested that lenders be required to write down mortgages to allow for the bridge loan to be secured to avoid it serving as a bail out to the lender. That is nice in concept, but probably makes the program a non-starter . Logically, any seconds should be written down first (frankly, most should be written off, but that is another story), and it is hard to see banks going along with that, plus you have no ready mechanism for cramming down mortgages in private label securitizations.

Dudley also advocated a more borrower friendly Freddie and Fannie program (as in a more generous revision of HARP) and more aggressive moves to convert foreclosed properties owned by the GSEs, banks (as principals and on behalf of securitized trusts) moved into rentals, including having Fannie and Freddie lend to prospective landlords and accelerating depreciation schedules for residential rental property.

These are all good ideas, but they have a rearranging-the-deck-chairs-on-the-Titanic feel to them. They don’t come to grips with the central problem, that many people are in the process of losing their homes or will lose them if their finances come under further stress, and given how steep loss severities are (and they are only getting worse), a lot of them could be salvaged with deep principal mods. And the Fed fails to acknowledge the existence of a second large problem, the extent of servicer fraud, not just foreclosure-related abuses, but servicer driven foreclosures and out and out theft from investors (inflated and double charged fees, kickbacks from third party providers, overstated principal balances, delayed reporting of sales out of REO).

The Venezuelans have a saying I am fond of: “They have changed their minds, but they have not changed their hearts.” The good news is that the officialdom is beginning to come to recognize how bad the mortgage mess is. The bad news is that they don’t have the stomach for the sort of aggressive measures needed to remedy it.

To some readers, the answer to the headline may seem obvious: Yes, American management is clearly worse than it was, say, thirty or fifty years ago, because short-termism is endemic among public companies, and short-termism leads to all sorts of bad outcomes, like underinvestment and accounting gaming.

But that analysis is simplistic. Short-termism simply shows that management has adopted good for them, bad for pretty much everyone else (save maybe their bankster allies) goals and are pursuing them aggressively.

A comment by John Kay of the Financial Times has the effect of raising much more fundamental questions about the caliber of top managers. Forgive me by starting with a personal anecdote. When I was at McKinsey in the early 1980s, one of my clients was then then Citibank. The partner on the account asked me to get the organization charts of the major investment banks (commercial banks in those days were desperate to become investment banks and not very good at most of the investment banking businesses they could participate in, like M&A and private placements).

I knew Citi’s problem was not its organizational structure but its culture, so I dutifully followed orders, got the org charts, and then wrote a presentation that contrasted how investment banks operated versus commercial banks on five major issues. It became a best seller at Citi.

More than 20 years later, when I saw the partner who was still at McKinsey, he remarked, “You remember that document you wrote on investment banking culture? They are still using some of the slides at Citi.” He thought that was a good thing.

I thought it was a bad thing. It meant Citi had still not learned the lesson of the presentation.

Now to Kay. His article keys off a new book, Good Strategy/Bad Strategy, by Richard Rumelt at the Anderson School at UCLA. What I found disconcerting was this passage, which effectively says that despite the greatly increased presence of MBAs in the corporate world, business practice has not improved and has maybe even regressed:

The message of Prof Rumelt’s book is that strategy is really just careful thinking about business problems. Checklists – Swot (strengths, weaknesses/limitations, opportunities, threats), five forces or seven Ss – are popular because they are a starting point for people who are unaccustomed to structured thought. Good strategy begins with diagnosis. And diagnosis is analysis, not a description of symptoms. You don’t go to your doctor to be told you have a sore throat. You go to be told you have an infection and that an antibiotic will fix it. The doctor tries to discover “what is really going on here?” and the measure of his competence is his ability to do that.

If that also sounds obvious, it isn’t what business people typically do. In the business world – as sometimes in the surgery – the reputation of the CEO or value of the consultant is measured not by the accuracy of the diagnosis but by the confidence with which the prescription is dispensed. Many business gurus resemble George Bernard Shaw’s doctor, Sir Colenso Ridgeon, who treated every ailment with an exhortation to “stimulate the phagocytes”. Their PowerPoint presentations reiterate the patient’s complaint and prescribe their universal template.

Now I am big on stating the obvious, that the MBA is an overrated degree. But one of the things that that degree does provide is some commonsensical frameworks and tools. And naive me, I had assumed that the big reason that the big consulting firms like McKinsey were doing less good old fashioned strategy work was that the prevalence of MBAs meant that big companies were now doing more of the analytical work related to strategy in-house.

But Kay’s observations suggest instead that the effect of more “professionalized” management, perversely, is a greater need to be on the cutting edge of conventional wisdom in order to stand out, which makes them even more susceptible to hucksterism.

An alternate interpretation is that the short-termism has promoted faddishness, since any con that is good enough to enlist top managers can also be sold to the great unwashed investing public, and will pop a stock for a while (or even longer: look at how much the market liked “reengineering” and “outsourcing” and “offshoring”). Or maybe prolonged use of PowerPoint makes people stupid.

By Jake Romero, an economics student at Portland State University. You can reach him at jvc613 (at) gmail.com

Economics has always been something of a battleground, but in November a group of about seventy Harvard students opened a new front in the ongoing hostilities: its introductory pedagogy. In solidarity with the Occupy movement, the students staged a walkout of their principles course to protest what they called its “inherent bias.”

In his rebuttal in the New York Times, Greg Mankiw countered that his teaching is careful to avoid policy conclusions and that its subject matter falls squarely within the current mainstream of the discipline. Narrowly correct, he nonetheless profoundly missed the broader points that his students, to be fair, seemed unable to articulate fully.

Firstly, one needn’t make explicit policy prescriptions to reproduce, in generation after generation of students, the fetishization of “free markets” that has been eroding civil society worldwide. If not quite a wink and a nod, then an omission here and oversimplification there will do just fine. That’s precisely the tack Mankiw takes in his introductory textbook, Principles of Economics. His approach is surely only in the name of student accessibility, but we all have good intentions, don’t we?

Secondly, it is precisely the mainstream of economics that is complicit in the ongoing economic upheaval and ensuing social unrest we’re witnessing worldwide. Mankiw is correct in pointing out that his textbook is hardly unique, but, to tweak the aphorism, one man’s modus tollens is another’s modus ponens. That Mankiw’s style of teaching basic economics is common is less exculpatory of this style than it is damning of his discipline for almost universally adopting it. If Mankiw wants to quote Paul Samuelson, he should also heed his lament shortly before his passing: “Alas, many textbooks have strayed too far toward over-complacent libertarianism.”

The great irony and tragedy of “intro econ” is that it is at its introductory level that economic theory is both most broadly consumed and most malignantly simplistic. In a recent study, economists at the University of Washington found there to be an “indoctrination effect” for non-majors who take an economics course: on average, they behave more selfishly and hold less regard for others after taking such a course.

Generations of the world’s business people and public policy makers have been nursed on such courses. To gain some insight into why our economies and institutions are crumbling beneath us, then, imagine an engineer equipped with a rudimentary understanding of physics that omits gravity, and a certain above-average disregard for human life not his own. Now imagine him building all the major bridges in the world.

From personal experience, I can attest that a good principles course, taught by someone with a sense of responsibility for her students, can be a mind-expanding experience. Taught by someone else, it can be a profoundly narrowing one. Surely Professor Mankiw would have no trouble agreeing that not all teachers of introductory economics are of his caliber. But, on the one hand, if even someone of his stature can mislead some (most?) students, imagine what’s going on out in the provinces. On the other, the children of the elite have an outsized influence on our culture and institutions. Perhaps some arrive to Ec 10 precociously predisposed to “over-complacent libertarianism,” but, given their likely future influence, isn’t that all the more reason to challenge their biases?

The typical introductory economics course, taught carelessly, corrupts even as it enlightens. With a rhetorical sloppiness that turns mathematical idealization into socially destructive ideology, it compels the naive reader to think like a “rational actor,” without offering any caveat about how doing so undermines community, stifles creativity, enervates leadership, and licenses greed.

Like Occupiers more generally, the students of “Occupy Economics” may not have been able to make the best case for their action, but they were smart enough to recognize a good intuition when they sensed it. By providing an occasion for reflection, they’ve succeeded in reminding us that the manner in which economics is taught can make it easier or harder to abuse economic theory in ways that perpetuate the greed and underwrite the shamelessness of the one percent.

We’re now reaping the bitter harvest of generations of this kind of corruption—gross inequality, debased values, a corroded civil society. It now falls on a new generation to resist, combat, and ultimately root out such insidiously pervasive abuses of the language and logic of the market.

As illustration, let’s spend some time in the interstices between economic theory and economic reality to point out a few things to keep in mind if you’re an economics student who wishes to retain his conscience, or just someone who values intellectual responsibility:

Ten Principles of Responsible Economics

1) In theory, rational people think at the margin. In reality, these people are a fiction that exist only in mathematical models

You are not a “rational” actor—not in the economic sense of the term. The newcomer to economics, well-intentioned as she is, surely wants to be rational in the everyday sense. Having learned from her textbook that, without qualification, to be rational is to be a self-interested utility-maximizer, she learns to emulate such behavior. So begins the process of learning to deprecate non-market values—which are “irrational,” after all—and rely exclusively on self-interest to justify and understand action. This naive economism’s implicit justification for selfishness is that acting in one’s self-interest at the margin is “only rational.” Inside the fictional world of an economic model, this is tautologically true. Outside of it, we still call that sociopathic greed.

2) In theory, there is no difference between self-interest and greed. In reality, economists aren’t typically trained in moral philosophy

Spend enough time studying economics, and you might eventually feel greed become empty of meaning. You’ve learned that acting in your own self-interest is not only rational but virtuous—it creates better outcomes for everyone—and surmised that greed is perhaps merely an expression of envy or an atavism from a benighted age of religious taboo. You would be wrong. In the real world, greed exists. As a crude approximation: acting in your own self-interest just means “not shooting yourself in the foot.” You can think of greed as shooting the other guy in the foot so you can get away with his wallet.

3) In theory, voluntary trade can make everyone better off. In reality, it’s often not so voluntary, makes some people better off while making others worse off, and empowers the beneficiaries to make sure they get to keep their gains

“Free market” reforms generally improve aggregate outcomes while increasing inequality, so that poverty increases even as overall wealth does. Basic economic analysis treats distribution as a secondary concern—it assumes that once the market maximizes benefits in the aggregate, the political system can ensure that they’ll be redistributed in an equitable way. But as we’ve been learning all too well, with greater wealth comes greater control over the political system.

4) In theory, markets are usually a good way to organize economic activity. In reality, “markets in everything” has a way of sliding into “everything into markets”

There’s a difference between thinking about a real-world interaction as if it were a market—market analysis—and transforming that real interaction into an actual market—marketization. The latter is a natural seduction once you’ve gained some facility with the former, and some people seem to reflexively think organizing any activity as an actual market would be an improvement over the status quo. We can think of these people as blowtorch-wielding pyromaniac children playing in a barn, but they are not, of course, actually blowtorch-wielding pyromaniac children playing in a barn.

5) In theory, market models assume that the existing distribution of wealth is just. In reality, poor people exist

Hiding in plain sight in many marketization proposals is something of a dirty little secret: When you apply an idealized market model to the messiness of reality, some people, those without enough purchasing power to enter the market in the first place, will have to go without in the name of efficiency. Famine, thirst, and lack of access to education can be effective market solutions.

6) In theory, people respond to incentives. In reality, different people respond differently to different incentives, and not always the way you hoped for

“Pay for performance” is sold as “more money for better results” but typically results in “gaming the metrics to get that cash money now.” The people who respond best to monetary incentives are the people who value money the most, not necessarily the people who value education or innovation or whatever you’d like them to value the most. Such incentive schemes also tend to result in sacrificing long-term or substantive success in favor of superficial short-term gain.

7) In theory, governments can sometimes improve market outcomes. In reality, sometimes sometimes means often

Real markets are always imperfect and intrinsically tend toward monopoly, a market failure. Introductory textbooks make note of such market failures, but typically only in a way that makes them seem like outliers. They are in fact the norm.

8) In theory, there’s a distinction between “positive” and “normative” economics. In reality, the positive is at once fictional and normative in effect

Ostensibly, “positive” economics refers to the description of economic reality—the “is” questions–while normative economics deals with policy prescriptions—the “ought” questions. But in the context of neoclassical economics, the only reality we have access to is a set of rather crude idealizations—in a sense, we study the reality of a fiction—and since studying positive economics clearly has an effect on people’s behavioral patterns, it is de facto normative.

9) In theory, models are just aids to reasoning—the map is not the territory. In reality, it’s just so easy to reify

Many lesser economists have a habit of justifying the strong modeling assumptions of economics by claiming they’re “generally true” or excusing them with a wave of the hand and a “well, there are always exceptions, right?” This is a telltale marker of someone who takes his models too literally. Properly understood, the toy models of economics are tools for organizing thought, testing intuition, and generating sets of hypotheses to be tested against data—not objective descriptions of reality.

10) In theory, economics is a science. In reality, economics is a science the way Ayn Rand is a literary luminary

To casually label economics a science is at best aspirational, at worst manipulative, at a minimum misleading. At the introductory level, the issue at stake is less one of methodology than of how deferential the layperson or novice should be to the authority of expert or policy entrepreneur appeal to economic theory. Skepticism is always a virtue. When evaluating claims based on simple economic models, it’s self-defense.