Economic Dreams - Economic Nightmares

Gillian Tett: 'Derivative Thinking'

It struck me this week that maybe I ought to get rid of all other "finance" sources and just read/watch London's Financial Times. I won't, but might find the move efficient. For example, I spent time watching FT "View from the Market" video interviews with Nouriel Roubini, Henry Kaufman, George Soros, and Peter Bernstein. Today I ran across this very good Gillian Tett historical perspective on Financial Derivatives, looking at both the bright and dark sides of "animal spirits", Shupeterian "creative destruction", innovation, regulation and more. To Tett:

Derivative Thinking, Gillian Tett, Financial Times, May 30, 2008: … If you believe in the concept of what Joseph Schumpeter called "creative destruction" — the idea that innovation is best served by letting market forces decide which ideas fail and which ones flourish — then the finance industry is entering a crucial phase. In the past eight months, it has experienced a brutal shake-out that has pushed some hallowed institutions, such as Northern Rock and Bear Stearns, over the edge. This, in turn, has prompted some politicians to call for an overhaul of how finance is practised — an overhaul that would, perhaps, impose greater control.

Yet some in the banking industry argue that restricting innovation is the wrong thing to do. … If you believe the bankers, the best response to the current crisis is more innovation, not less.

The issue of innovation in the financial world touches on questions that run far beyond banking alone. It even reaches the problem of whether the state should try to control the animal spirit of entrepreneurs. [The story] really starts a couple of decades ago when some bright young bankers on Wall Street hit upon the idea of derivatives. As the name suggests, derivatives are essentially instruments whose value derives from something else. If you buy an equity derivative, you are not buying shares in a company but instead a contract linked to the level of a share price. Sometimes, this type of contract can be used to help investors protect themselves from risk. If you are a pension fund manager worried about share prices falling, you might, in exchange for a small fee, buy equity market derivatives that allow you to sell shares at an above- market price if the market starts to tumble. In that sense, derivatives act rather like insurance.

However, investors also use derivatives to speculate. If a hedge fund manager thinks the stock market is going to fall, then he might buy equity derivatives contracts that pay out when share prices are low - meaning that they will benefit. And since these contracts can be created electronically, in an instant and in vast size, trading derivatives is often more efficient than buying and selling actual shares.

The first derivatives were created in the 1980s and known as interest-rate swaps or foreign-exchange swaps, since they enabled investors to place bets on movements in interest rates or currencies. Then, in the late 1980s, the business proliferated and became far more complex. There is a bitter irony that stalks the modern investment banking world: while many financial institutions exude vast power, they are highly vulnerable because it is so hard to patent their ideas. Thus, whenever a new product is invented, it tends to be copied quickly. That means that although new instruments — such as interest-rate swaps — typically start out as high-margin, bespoke products, they soon become low-margin, ubiquitous products. The only way that a bank can beat its competitors — other than having more capital or financial muscle — is to be much more creative.

However, in the early 1990s, there was another factor that made the derivatives world boom: interest rates were extremely low. That meant that the level of returns investors could achieve by holding, for example, a government bond were also low. Consequently, bankers hunted for other ways to help investors achieve good returns — such as using derivatives. "The thing to realise about the early 1990s was that you had a falling interest rate environment for several years following the recession of late '89/'90," recalls T.J. Lim, a Malaysian-born banker who was part of the original group of JPMorgan bankers who developed interest-rate swaps in the mid-1980s, and who went on to become one of the most senior bankers in the derivatives and debt world. "Everyone was looking for yield — it was a period when bankers could do almost anything you could dream of and people would buy it. For example, we had structures [with names] such as Libor squared, Inverse Floater, Power options, Convexity forwards, etc. That drove a lot of innovation."

However, in an uncanny echo of what has happened over the past year, the boom of the early 1990s ended badly. In 1994, the interest rate climate suddenly changed, unleashing wild market turbulence and causing many of the derivatives contracts to produce huge losses — or "blow up", as traders call it. For a while everyone hated derivatives — "it became a dirty word," says Lim. "I was very outspoken then in saying that there is nothing wrong with the product — it's just that the excesses got out of control. But it was a very humbling period. It brought down a number of traders and senior people. There was a lot of soul searching."

As the turmoil mounted, calls emerged for derivatives to be more tightly controlled. But the International Swaps and Derivatives Association fought back furiously, arguing that a regulatory clampdown would not only run counter to the spirit of capital markets, but also crush creativity. Their aggressive lobbying campaign was effective: by the mid-1990s, regulatory pressure had died away, and the derivatives market was free to innovate — albeit under the close eye of lawyers. "We set out to design a business guided by market discipline because we believed that it should be an even better guide to good behaviour than regulatory proscription," explains Brickell, a principal architect of ISDA's public policy framework, which helped avert a regulatory clampdown back in the 1990s.

The financial community responded to this new lease of life with a vengeance — but not quite in the way that some had expected. In the years after the 1994 turbulence in the derivatives markets, activity in the swaps world slowly recovered. However, the business had lost much of its earlier glamour, not simply due to the huge losses on derivatives, but also because of a more mundane problem: the innovation cycle. Swaps had started life as a high-margin business, but by the early 1990s they had been copied so widely that they had turned into a mass-market product. Almost as soon as the derivatives scandals had died down, bankers started the hunt for the next big thing.

… In the mid-1990s … about 80 … bankers who worked in [JP Morgan's] derivatives business were summoned to a plush hotel in Boca Raton, Florida, for a brainstorming session. The man who ran that team was a British banker called Peter Hancock. Hancock had taken over the derivatives team in the late 1980s, and seen the business become commoditised. For a few days, the young JPMorgan bankers brainstormed ways of overcoming this. Eventually, the group alighted on a potentially fertile new frontier for derivatives: credit. Until that point, banks that made large loans didn't have a way of protecting themselves against the chance of a borrower defaulting. Similarly, investors who held bonds did not have any mechanism to insure against an issuer refusing to pay out. What would happen, the JPMorgan bankers asked, if somebody created a contract that mimicked that credit risk, and then sold that risk to another investor, for a fee?

The group in Boca Raton were certainly not the only ones playing around with these ideas: rival teams at institutions such as Bankers Trust and Credit Suisse were thinking along the same lines. But JPMorgan offered an unusually fertile laboratory for experimentation. One reason was that Hancock had gathered a close-knit team of young, highly creative bankers who were open to sharing ideas. Another was that JPMorgan had a vast pool of loans on its books, thus giving Hancock's team plenty of raw material with which to conduct experiments.

Most important of all, JPMorgan's top management had a compelling reason to innovate. At the time, the bank had so many loans on its books that it was finding it expensive to keep doing business: it needed large "rainy day" reserves to protect against the chance of the loans turning sour. Hancock's team believed that if they found a way to sell this "default risk" to somebody else by repackaging the loans into derivatives, then they could persuade the regulators that they did not need to post such big reserves. "They say necessity is the mother of invention," recalls Andrew Feldstein, a former lawyer who worked with Hancock. "In this case, JPMorgan had a good reason to look at how it handled credit."

In the late 1990s, men such as Feldstein were trying to develop financial techniques that would turn loans into derivatives they could sell on. They started off doing this on an ad-hoc basis but soon discovered that if they created bundles of derivatives contracts linked to loans, then it was easier to sell these instruments to investors — in the same way that it is easier for banks to sell an investor a stake in a mutual fund than shares in an individual company.

Later generations of bankers would refer to these derivatives bundles by the unwieldy name "synthetic collateral debt obligations". But JPMorgan christened its brainchild Broad Index Secured Trust Offering — or Bistro. Within a few months, it was feeding a wide range of assets into this financial machine, ranging from corporate debt to student loans, and generating fat profits. "The business we were doing grew exponentially," recalls Terri Duhon, a young banker from Louisiana who was part of the Bistro team. "We went out and 'Bistro-ed' everything we could."

But then the vagaries of the innovation cycle kicked in. Soon, the ideas behind Bistro started to leak out. Similar products proliferated across the financial world, with equally odd names: ABN Amro, for example, created structures called "Heineken" and "Amstel". But, as the copycat process grew more intense, margins started to fall again — spurring the bankers to hunt for even more exotic and creative ways to generate returns. Some banks started to put riskier assets into the mix.

As the new century dawned, the teams that had traditionally handled "subprime mortgage" finance — or loans extended to borrowers with a poor credit history — started talking to the derivatives groups. "One of the crucial points happened in late 1997 — around then credit derivatives structurers started to meet with securitisation structurers," recalls [Robert] Reoch, who by this time was working at the Bank of America. "The bingo moment was in the coffee queue of our Chicago office when the two groups met by chance and realised they needed to talk to each other."

Out of this collision of ideas, a new game was born: bankers began to use subprime loans to create these bundles of loan default risk, now called collateralised debt obligations (CDOs) on an explosively large scale.

Ironically, perhaps, JPMorgan itself never rushed too far down this new path. Indeed, this decade JPMorgan has been notably wary of turning subprime mortgage loans into synthetic CDOs. "We couldn't see how other banks made that business work," says Bill Winters, formerly a member of Hancock's team, but now co-chief executive officer of the investment bank. "[This] was a good stance to take, in retrospect."

Other banks had fewer qualms. When the credit turmoil finally erupted last summer, investment banks such as Merrill Lynch and UBS discovered that they were holdings tens of billions of dollars of CDOs, many of which have subsequently led to losses even more devastating than in the derivatives blow-up of 1994.

"It is all about the herd instinct. People do stupid things in search of yield when interest rates are so low without proper risk-reward considerations," says T.J. Lim, who has been warning for at least three years that the boom in CDOs was heading for disaster — largely because he has always believed there were powerful parallels between this latest leg of the innovation cycle and what happened in the early 1990s.

The bankers who stoked the derivatives market boom are, unsurprisingly, at pains to distance themselves from the current credit turmoil. "This crisis has nothing to do with innovation. It is about excesses in banking," says Bill Winters, another former member of the pioneering JPMorgan team and now the co- chief executive of its investment bank. "Every four to five years there is a new excess in banking — you had the Asian crisis, then the internet bubble. The problem this time is extraordinary excess in the housing market." Or, as Hancock says, "a lot of the problems in structured finance have not been due to too much innovation, but a failure to innovate sufficiently... People have just taken the original Bistro idea, say, added zeros and done it over and over again without really thinking about the limits of diversification as a risk management tool. There is a big difference between using this structure for corporate loans, as we did at JPMorgan, and subprime mortgages."

Meanwhile, the ISDA is now fighting to ensure that regulators do not try again to clamp down on the industry. "This credit crunch gives good evidence that market discipline has guided the derivatives business better than regulation has steered housing finance," Brickell told a recent conference in Vienna.

Paul Calello, head of the investment bank at Credit Suisse, told the same conference that the derivatives industry needed to engage more fully with regulators. Winters thinks that it is time for banks to think about creating a centralised system for processing credit derivatives trades to make the market more transparent and reliable. "We need to have that debate," he says.

Hancock, the credit derivatives pioneer, thinks that more innovation is needed in terms of how bankers pay themselves — to prevent them from taking crazy risks in pursuit of fat bonuses. Meanwhile, Reoch recently co-wrote a reform paper for the European Parliament calling for changes in the incentives that drive the financial world. He also thinks it could be time to standardise complex instruments, making it easier for investors to understand them. "There is scope to create a standard CDO product," he says.

It is an open bet whether any of these ideas for reform will fly. After all, when products become simpler and more transparent, the margins typically fall. Bankers, in other words, have a strong motive to retain complexity and opacity — which is why the innovation cycle keeps turning. "I think in the next year or two, finance may become simpler," says one senior banker. "But after that we will probably just go back to the old ways again."

As the debate rumbles on, some bankers are already getting creative. These days Lim works in Mayfair as a consultant in the booming business of helping to restructure CDOs for investment groups suffering losses. Duhon works in another Mayfair consultancy, training lawyers and others to understand how credit derivatives work. Other former members of the JPMorgan team, such as Andrew Feldstein, are running hedge funds.

Meanwhile, JPMorgan itself recently bought Bear Stearns, the Wall Street brokerage felled by the credit turmoil, for a knockdown price. With Bear Stearns, it acquired a vast pile of complex financial instruments it is now trying to restructure. JPMorgan has also recently acquired a huge portfolio of so-called equity-release mortgage loans from Northern Rock and is using these to create a flurry of innovative new derivatives contracts, involving issues such as "longevity" (or placing bets on how long mortgage-borrowers might live).

"The speed at which the market has found opportunities [after this crisis] is impressive," says Winters. "I suppose you could call that innovation." Or, at least, creativity in search of another fat profit.

Gillian Tett is capital markets editor of the FT.

Will we see effective regulation that doesn't unduly stifle needed innovation and proliferation of better derivative instruments? Or will the banking industry in succeed in once-again stifling all regulatory reform in order to retain their "complexity and opacity"? We'll see!

Tett also provides a handy list of working definitions for key terms. Back to Tett:

Soros: Financial Crisis Stems from Super Bubble

Like me, George Soros is no believer in "equilibrium economics". Rather he believes that sometimes we will see an equilibrium, but that it will be short-lived. Like Hyman Minsky, Soros argues that stability will itself sow the seeds of the next instability. Soros says we are in a unique place with our current crisis, experiencing both inflation and a recession at the same time. Hear/read more from Soros on today's NPR Morning Edition, Financial Crisis Stems from Super Bubble:

… Soros blames what he calls a "super-bubble" that started about 25 years ago. That's when a less-is-more philosophy became popular with economic regulators. That allowed Wall Street to invest increasing amounts of money in credit.

"The idea was that regulators always make mistakes, state interference in the markets just messes things up," Soros says. "And that was a false idea .... Regulators are human and bound to make mistakes, but markets are also human and they are also bound to make mistakes. Instead of markets always being right, they're actually always groping at trying to find out what the facts are. But they never get it right." …

Soros says there's a "super-bubble" in the economy that's bigger than just the recent housing crises, and he blames exotic financial instruments for helping cause it.

"The markets have introduced financial instruments with fancy names — CDOs and CLOs and all these strange instruments that are traded in very large volumes. And they were all constructed on the belief deviations are random.

Soros also has a new book out. Here is a snip from the introducion:

A New Paradigm for Financial Markets, Introduction, George Soros: We are in the midst of the worst financial crisis since the 1930s. In some ways it resembles other crises that have occurred in the last twenty-five years, but there is a profound difference: the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process; the current crisis is the culmination of a super-boom that has lasted for more than twenty-five years.

To understand what is going on we need a new paradigm. The currently prevailing paradigm, namely that financial markets tend towards equilibrium, is both false and misleading; our current troubles can be largely attributed to the fact that the international financial system has been developed on the basis of that paradigm.

The new paradigm I am proposing is not confined to the financial markets. It deals with the relationship between thinking and reality, and it claims that misconceptions and misinterpretations play a major role in shaping the course of history. …

Let me explain briefly how the theory of reflexivity applies to the [current] crisis. Contrary to classical economic theory, which assumes perfect knowledge, neither market participants nor the monetary and fiscal authorities can base their decisions purely on knowledge. Their misjudgments and misconceptions affect market prices, and, more importantly, market prices affect the so-called fundamentals that they are supposed to reflect. Market prices do not deviate from a theoretical equilibrium in a random manner, as the current paradigm holds. Participants' and regulators' views never correspond to the actual state of affairs; that is to say, markets never reach the equilibrium postulated by economic theory. There is a two-way reflexive connection between perception and reality which can give rise to initially self-reinforcing but eventually self-defeating boom-bust processes, or bubbles. Every bubble consists of a trend and a misconception that interact in a reflexive manner. There has been a bubble in the U.S. housing market, but the current crisis is not merely the bursting of the housing bubble. It is bigger than the periodic financial crises we have experienced in our lifetime. All those crises are part of what I call a super-bubble—a long-term reflexive process which has evolved over the last twenty-five years or so. It consists of a prevailing trend, credit expansion, and a prevailing misconception, market fundamentalism (aka laissez-faire in the nineteenth century), which holds that markets should be given free rein. The previous crises served as successful tests which reinforced the prevailing trend and the prevailing misconception. The current crisis constitutes the turning point when both the trend and the misconception have become unsustainable. …

NPR Does Subprime

If you want a very good lay person's edition of the Credit Bubble mess, listen to NPR's Global Pool of Money Got Too Hungry (audio, 13 min., All Things Considered, May 9): "Adam Davidson and This American Life's Alex Blumberg jointly report on how rising defaults on subprime mortgages in the U.S. have became a global financial crisis. This American Life host Ira Glass talks with Michele Noris".

NPR demystifies SEVs, CDOs, MBSs, "Liar Loans," and more. The narrative concludes: "… Nobody really questioned things. And why should they? Everybody was making money — right up to the day the bottom fell out."

An hour-long version — The Giant Pool of Money — airs this weekend on This American Life.

Short take on MuCulley at the Hyman Minsky Conference

I've been meaning to post up a cut-down version Paul McCulley's recent assessment of our current plight: "Reverse Minsky Moment" interview with Kathryn M. Welling, but haven't yet. So yesterday I was glad to see Floyd Norris do a spot on McCulley's talk at the Hyman Minsky Conference for the NY times, titled Ponzi Squared:

… Minsky argued there were three levels of investment as the cycle progresses. First comes hedging, in which investments are made to reduce risk. Then comes the speculative phase, and finally the Ponzi phase, in which the investment can be justified only by the assumption that prices will keep rising, not by the expected income.

Paul McCulley of Pimco, the big bond manager, gave an interesting speech in which he said the recent subprime mortgage fiasco proceeded to a fourth level — one that he called "Ponzi-squared" — before it collapsed.

At the end, he said, the marginal subprime loan was:

No money down
No documentation of income
Initial below-market teaser interest rate
Negative amortization

That is not a loan, he said. Instead, it amounted to giving the home buyer a call option to buy the house at the current market price, coupled with a put option to sell the house back at that price.

If house prices kept rising, the "buyer" could make the small interest payments to keep the option open, and eventually sell the house. That happened for a time, and led to the conclusion by rating agencies that such borrowers were good risks.

But when prices went down, the "buyer" would suffer no loss if he exercised the put and gave the house to the lender. That is just what happened.

As Paul Simon wrote in 1975, said Mr. McCulley, the strategy became:

Drop off the key, Lee,
And set yourself free.

Here is the written version of McCulley's April 17 talk at the Minsky Conference. Oddly, the "Drop off the Key" remarks are not included, although they are in the longer, Welling-McCulley rendition above. Some tidbits:

… [I]n what I call a "Reverse Minsky Journey" … Ponzi Units evaporate. Then many Speculative Units morph into Ponzi Units and are shot. Surviving Speculative Units are only those with explicit liquidity support from banks, who have explicit liquidity support from the Federal Reserve. Hedge Units, of course, remain standing tall, fundamentally sound, though cheaper in price, providing an excellent long-term buying opportunity.

This has been precisely the process in place since almost a year ago, and particularly since last August, when the shadow banking system — defined as any levered lender who does not have access to (1) deposit insurance and/or (2) the Fed’s discount window — experienced a modern-day run, with asset-backed commercial paper holders refusing to roll over their paper. It has not been fun. It has not been pretty. And it is not over.

Along the way, policy makers have slowly recognized the Minsky Moment followed by the unfolding Reverse Minsky Journey. But I want to emphasize "slowly," as policy makers, collectively, still suffer from more than a thermos full of denial. Part of the reason is human nature: to acknowledge a Reverse Minsky Journey, it is first necessary to acknowledge a preceding Forward Minsky Journey — a bubble in asset and debt prices — as the marginal unit of debt creation morphed from Hedge to Speculative to Ponzi.

That is difficult for policy makers to do, especially ones who claim an inability to recognize bubbles while they are forming and, therefore, don’t believe that prophylactic action against them is appropriate. Nobody likes to admit they were blind, dumb, or asleep at the switch. Or all three. …

That's not to say that Minsky had confidence that regulators could stay out in front of short-term profit-driven innovation in financial arrangements. Indeed, he believed precisely the opposite:

"In a world of businessmen and financial intermediaries who aggressively seek profit, innovators will always outpace regulators; the authorities cannot prevent changes in the structure of portfolios from occurring. What they can do is keep the asset-equity ratio of banks within bounds by setting equity-absorption ratios for various types of assets. If the authorities constrain banks and are aware of the activities of fringe banks and other financial institutions, they are in a better position to attenuate the disruptive expansionary tendencies of our economy."

Minsky wrote those words in 1986! Twenty-two years later, we can only bemoan that his sensible counsel was ignored. …

Minsky's insight that financial capitalism is inherently and endogenously given to bubbles and busts is not just right, but spectacularly right. And when the financial regulators are not only asleep but actively cheerleading financial innovation outside their direct purview, a disaster is in the making, as the last year has taught us. We have much to learn and relearn from the great man as we collectively restore prudential common sense to bank regulation — both for conventional banks and shadow banks.

Butier Responds to Greenspan's Latest Attempt to Rewrite History

{Updated, April 9}
At maverecon Willem Butier counters Alan Greenspan's latest claim the he and the US Fed not be held responsible, in large part, for our current mess. Butier's eight policy "tragedies":

1. The Greenspan Fed (August 1987 - January 2006) did indeed contribute, through excessively lax monetary policy, to the US housing boom that has now turned to bust.
2. The Greenspan-Bernanke put is real. It is an example of an inappropriate monetary policy response to a stock market decline.
3. The Greenspan Fed focused erroneously on core inflation, rather than using all available brain cells to predict underlying headline inflation in the medium term.
4. The Greenspan Fed failed to appreciate the downside of the rapid securitisation during the first half of this decade and acted exclusively as a cheerleader for its undoubted virtues.
5. The Greenspan Fed displayed a naive faith in the self-regulating and self-policing properties of financial markets and private financial institutions.
6. The Greenspan Fed, by enabling the rescue of Long Term Capital Management in 1998, acted as a moral hazard incubator.
7. The failure of the Greenspan Fed to press, before or after LTCM, for a special insolvency resolution regime with prompt corrective action features for all highly leveraged private financial institutions that were likely to be deemed too big and too systemically important to fail, demonstrates either bad judgement or regulatory capture.
8. During his years as Chairman of the Federal Reserve Board, Mr. Greenspan's statements reflected a partial (in every sense of the world) understanding of how free competitive markets based on private ownership work. This partial understanding guided his actions as monetary policy maker and financial regulator. Mr Greenspan's theories have been comprehensively refuted by the financial crises of 1997/98 and 2007/08.

Butier elaborates on each. We will bring forward only one, dealing with possibilities for moral hazard. But before we do, I just found Martin Wolf's counter-balancing position, Ft.com, April 8, still praising Greenspan, while fearing that over-zealous regulatory reform spaned by a Greenspan "blame game" will kill the "good" that free-er (my word, Wolf uses "free) market mechanisms bring. Whereas Butier lists eight "tragedies" of Fed policy/practice, Wolf highlights two: (1) regulators should have been "tougher", in subprime and elsewhere, and (2) monetary policy should have been tigher, not looser — to lean against prevailing winds of excess instead of leaning with them.

David Beckworth, via Macro and Other Musings, adds insight into why Butier's critique is on target:

… [T]he Federal Reserve is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are pegged to dollar. Thus, it's monetary policy is exported across the globe. This means that the ECB, even though the Euro officially floats, has to be mindful of U.S. monetary policy lest its currency becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. The Fed's loosening, therefore, of monetary policy in the early-to-mid 2000s triggered a global liquidity glut that set the stage the subsequent housing boom-bust cycle. This is not to say the 'saving glut' and financial innovation had no role, but rather that loose monetary policy was a key factor behind the boom. …

Back To Butier:

The Greenspan Fed: a tragedy of errors, Willem Butier, maverecon:Financial Times, April 8: Mr Greenspan's apologia pro vita sua in the Financial Times of Monday, April 7 2008 fails to convince. …

Death Dance: Bear Stearns and Carlyle Capital Linked

I try not to lift others' posts in their entirety. But this time I'm going to make an exception, and just highlight points readers here may find especially important. Loretta Napoleoni wrote this piece too well to chop it up, and the tale told is too important to miss. It's a tale of greed, corruption in highest places and ultimately the beginning of the end this time around, hopefully, for those who have been looting our financial systems. To Napoleoni:

Bear Stearns and Carlyle Debacles Are a "Modern-Day Greek Tragedy", Loretta Napoleoni, Huffington Post, March 17 The collapse of Carlyle Capital and the temporary rescue of Bear Stearns may go down in history as the key events signaling the end of the 'roaring nineties' (which lasted into the 21st century), nearly two decades of easy money, cheap credit and soaring global debt. Exceptional events -- such as the Fed for the first time in 50 years throwing a monetary lifeline to a bank on the verge of bankruptcy -- constitute the choreography of the closing scenes of this financial catastrophe which so much resembles a modern-day Greek tragedy.

The victims, a hedge fund and a bank, systematically ignored the bad omens because they felt omnipotent. Only a few months ago, while the British government struggled to save Northern Rock, the London-based European chairman of Bear Stearns dismissed any future troubles linked to the sub-prime meltdown. The rescuers, the Federal Reserve and J.P. Morgan, are determined to perform against all odds, but unless a Deus ex Machina, which for the Greeks was an impossible, supernatural event, takes place, their efforts will be in vain. Even the chorus, i.e. the market, follows a well known script: in one moment howling for the unlucky fate of the actors, and in the next scheming against them.

For the ancient Greeks the roots of all tragedies lie in men's uncontrollable passions: love, hate, power and greed. Carlyle Capital's and Bear Stearns' destinies confirm this belief. Bear and Carlyle are deeply intertwined because they both jumped on the easy credit bandwagon to make money. In other words, greed motivated them. Both had reputations of being highly aggressive and competitive-ruthless, many in Wall Street would add. But these characteristics are common in globalized finance where the old fashioned rules of the game are ignored or simply forgotten. What brought down Carlyle Capital and crippled Bear Stearns was not their business behavior but the sub-prime house of cards they contributed to building. Their fall was an event that was bound to happen but that none of them was willing to consider. And in the best Greek tragedies, those who fall are given the chance to avoid disaster.

The script for this modern tragedy is a masterpiece of the power of illusion in the hands of those who believe to be gods, Tom Wolfe's 'Masters of the Universe.' Carlyle Capital was indeed half human and half superhuman. An offspring of the Carlyle Group, the "club of the powerful", whose members include former prime ministers such as John Major, presidents of the United States, Bush senior, and the Arab super rich, among whom are the bin Laden family, the fund used its amazing connections at the highest political and financial levels to gather cheap credit. Giants of global finance, Citigroup, Deutsche Bank, Bear Stearns, Lehman Brothers and UBS, got into financial scrums to become Carlyle Capital's lenders at phenomenal and ridiculous conditions: for each dollar in assets held by the fund, they lent $31 more. Carlyle Capital's leverage, the ability to raise money in the world market, was simply unique. When it went down it had $22 billion outstanding debt against assets of about half a billion.

Almost $2 billion came from Bear Stearns, a major player in the mortgage-backed securities s secondary market linked to the booming housing market. Over the years, Carlyle Capital had built a portfolio exclusively of such stocks. On paper it was a match made in heaven -- or better, in the Olympus of global finance. Advised by the members of the 'club of the powerful', the fund had bought triple-A mortgage-backed securities, implicitly guaranteed by the US treasury, issued by Fannie Mae and Freddie Mac, two of the most reputable institutions in the metamorphosis of the US housing debt into a global asset. Within the sub-prime secondary market, these stocks were among the most secure. And this is the unexpected twist of this tragedy: that the first ones to fall are those who had invested in 'secure' mortgages.

The game lasted as long as the housing market boomed. Carlyle Capital borrowed money from Bear Stearns money to buy mortgage-backed securities and used their increasing value to keep borrowing more and more. It was a win-win game. Each time the interest rate went down, borrowing became cheaper and housing demand went up while property prices rose. On paper(remember we are talking about a house of cards here) both partners were making money because one held and the other funded purchases of homes that were rising in value. For a decade the deflationary policy of the Federal Reserve fueled this mechanism. Hundreds of thousands of similar partnerships took place, creating a global web where every financial institution is linked to every other. Then one day the wheel of fortune turned, Americans could not meet their mortgage payments any longer. As prices of properties began to slide, paper assets of companies like Carlyle Capital and investment banks like Bear Stearns vanished. Inside the web of easy credit, people panicked and began calling on their loans. Carlyle Capital fell victim to its own lenders' demands for cash and Bear Stearns, one of Carlyle's lenders, may well share the same destiny for the same reason.

The last scene of this modern financial tragedy will be played out this week. Tickets are already on sale in the major financial centres, from Wall Street to the City of London. Book soon because we are expecting a full house!

Loretta Napoleoni is the author of the bestselling book Terry Inc.: Tracing the Money Behind Global Terrorism. She is an internationally recognized expert on money laundering and terror financing. Her current book is Rogue Economics: Capitalism's New Reality.

HT: Naked Capitalism

{Update:} On Carlyle Capital via The Ground Floor from Urban Land Institute:

Don't Feel Sorry For Carlyle

We're not being hard-hearted or gleeful about someone else's troubles. You know the expression: you live by the sword, you die by the sword. As reported in the European edition of the Wall Street Journal, March 14: "…Carlyle Capital would exploit the differences between the interest earned on its investment in mortgage securities and the costs of financing those investments. The secret to making money was borrowing massive sums. Carlyle Capital managed only $670 million in client money, but used borrowings to boost its portfolio of bonds to $21.7 billion, meaning it was 32 times leveraged." If some numbers we did on the back of an envelope are correct, if Carlyle's directional play had worked -- if the yield on its investments had followed the downward yield curve of U.S. Treasury securities -- to the tune of 0.50%, Carlyle would have made about three times its investment. Similarly, if interest rates went the wrong way, or if the prices of its securities portfolio did not follow and align with the yields on Treasuries, Carlyle would suffer huge losses. It appears that Carlyle became mired in the same trap as Long-Term Capital Management did in 1998 when the flight to quality turned into a flight to both quality and liquidity. Carlyle got caught by one of those "Black Swan" events -- totally unexpected and therefore totally devastating. They made a strategic bet, backed with it huge leverage, and suffered the unexpected consequences. In a letter to investors Carlyle Capital management noted: Carlyle Capital "believed this [its strategy] to be a creative and thoughtful approach and one that was time tested in the markets for these types of assets."

My question: Why was ANYONE loaning money to Carlyle recently?

'Financial Model' Abuse Linked to Market Meltdowns

William Shadwick was responsible for establishing the Fields Institute for Research in Mathematical Sciences before entering the finance industry in 1998. He is the founder of Omega Analysis, a quantitative research firm in London. Yesterday, at All About Alpha, Shadwick issued a dire warning to quants and investors who are increasingly falling victim to 'quant jocks'. Read it! Here's a snip:

Shadwick to Quants: "Financial models should come with health warnings!": … In general, the rise of quantitative tools in finance has been highly beneficial but the widespread use of models has been a decidedly mixed blessing. In science, the constant development of theories expressed as mathematical models to be tested, rejected, confirmed or refined through observation and experiment is the main source of progress in our understanding of the physical world. This process is also crucial for engineering and technology where it is the key to predicting future events and controlling them to our advantage.

It was inevitable that this paradigm would eventually be adopted in economics and finance too. In the half century since Markowitz put portfolio construction on a quantitative footing there has been a steady growth in the use of increasingly sophisticated and complex models and statistical techniques in investment management.

The nature of the financial markets is such that this growth in models has not been accompanied by the sort of testing that the field science demands. Finance academics simply cannot perform experiments like those upon which the sciences rely, and they are also severely constrained in the type of observations they can make. Data and information about what goes on in reality (as opposed to theory) is, and is likely to remain, in very short supply in comparison to the sciences.

The end users of the models in finance are not intent on understanding how markets may be explained. That is the goal of academic research. Instead, they want to employ theory and models to produce profits. Like physical engineering, which has had its share of collapsing bridges, financial engineering has therefore led to many accidents.

For example, the current mess in the credit markets would not have been possible without the extensive and inappropriate rise of "sophisticated" models. The results of mis-priced risk have now been cascading through the financial system for several months and show no sign of abating..…

There are more dangerous assumptions than returns being independent and identically distributed. One might also assume that they were normally distributed. Probably everyone has heard the "black swans" argument about the importance of extreme events in markets and Mandelbrot and Taleb's attacks on the reliance on normal distributions in finance theory.

I think they have greatly overestimated the number of academics who haven't yet noticed that market returns aren't normal. However there is no doubt that the persistence of press and industry descriptions of large market losses in terms of standard deviations (and ascribing an extremely low probability to such an event in consequence) indicates a widespread hidden assumption of normality. …

In great part, these dangers are a consequence of another hidden model, namely the use of standard deviation of returns as a proxy for risk. The realization that this model of risk is especially dangerous when applied to hedge funds has led both academics and finance practitioners to make use of skewness and kurtosis in an attempt at more "sophisticated" modeling of risk.

Skewness is intended to model asymmetry - the mismatch of upside and downside risk. Kurtosis is intended to model the likelihood of extreme events or "fat tails". Of course, certain assumptions must be satisfied for these models to perform as intended. Dangers introduced by relying on these metrics are compounded by the great sensitivity of skewness and kurtosis to (even moderate) outliers. These are not statistics meant for small samples.…

Models are everywhere in quantitative finance but it is almost impossible to find any attendant statements regarding the assumptions upon which they are based. Their purveyors should issue "health warnings" that tell the user that hidden assumptions are present and that failing to check that the assumptions are valid may be dangerous to investment health.

It is essential that we recognize the difference between finance and science. In science, increasingly sophisticated mathematical techniques always produce better results over time. But this need not be the case in finance. Nevertheless finance can and should aspire to the status of an engineering discipline.

While you are unlikely to find health warnings on financial models any time soon, there are a few simple principles which can reduce the danger they present:

• It is far more important to look to simplicity (and common sense) than it is to look to increasing complexity as a means to better control investment outcome.
• A model whose robustness is unknown or unknowable should never be employed.
• Sophisticated tools should only be used if it is possible to verify that all required assumptions are satisfied (at least to a good approximation). When this condition can be met, a simple application of a sophisticated technique is preferable to a complicated one.

Keeping these in mind will reduce the risk that financial models may pose to your investment health!

{UPDATE:}Steve Hsu, Information Processing, March 1, gives us reason to be suspicious of Taleb's take on 'Black Swans' and/or Taleb's approach to investing:

Taleb or not Taleb? : Nassim Taleb, love him or hate him, has appeared quite a few times on this blog. Personally I find him quite amusing. I like his irreverence for "expert" opinion (especially that of economists) and his skepticism toward finance theory (in particular, towards Black Scholes and assumptions about perfect hedging and normally distributed risks). His earlier book Fooled By Randomness is largely devoted to making the simple point (amazingly, not appreciated by many otherwise very smart people) that it is quite difficult to tell whether success is due to ability or plain luck. In Wall Street terms, when is there enough data to be confident about someone's alpha?

I recently found this interesting essay by Eric Falkenstein, which is quite critical of Taleb and his book The Black Swan. Many of Falkenstein's points are well taken, although one should evaluate his arguments carefully -- his background (worked on VAR, an economics PhD) might predispose him to dislike Taleb. He criticises Taleb's hero Mandelbrot and the use of fractal ideas in finance, but these criticisms point to the fact that the ideas do not lead to easily implementable models, not that they are wrong as a fundamental description of the underlying phenomena. See, e.g., here and here for more discussion. Eventually, he cuts to the chase and notes that Taleb's earlier hedge fund was probably a loser, and that if he had had any success as a trader he wouldn't be out there hawking books and giving lectures on the rubber chicken circuit :-)

Taleb's trading strategy, based on the idea that others in the market are insufficiently aware of fat tailed distributions, was to buy out of the money puts in hopes of a profiting from a catastrophe. Under this strategy his fund constantly lost small amounts of money in hopes of making a big killing. Sadly for Taleb, he never hit the jackpot, although (see the Fooled By Randomness comment above) that doesn't necessarily undermine the validity of the strategy. More damaging, however, is the fact that insurance companies are basically on the other side of Taleb's trade all the time, and they seem capable of generating steady profits for long periods of time. My guess is that any trader who sold a put to Taleb's fund would pad out the price so much that even if their probability distribution were off at the tails, they would still exact a premium over the real value of the option. The deeper out of the money you go, the more careful and suspicious your counterparty is likely to be. …

Help! I need more insight into this. Are both Shadwick and Hsu right, as I suspect? Or is there reason to be suspicious of one slant v. the other?

{UPDATE 2:} Add bad legal writing to the mix of unbridled greed, wanton abuses of power, and blind faith coupled to bad models and bad decision-making:

Credit crisis lurches from bad numbers to bad writing, by Arturo Cifuentes, Financial Times, March 10 : … [W]e have gone from bad models to bad writing. From a failure of numbers to a failure of words. Which brings us to another issue: maybe the “quants” who ran the models and interpreted the results were incompetent. But what about the structured finance lawyers who drafted these legal documents? Did they read them? More relevant perhaps, did they understand what they wrote?

Marc Faber Takes Fed to Task

Worth Watching: 15 Minutes with Marc Faber

Click for Video

Bloomberg News Video, March 5
Hat Tip: The Big Picture

Early this year I began to pay less attention to bearish views than for the past several years. Marc Faber is, of course, the king of the bears—but not the only bear I've drawn inspiration from. Most likely the fact that I'm now discounting hyper-bear rhetoric is a signal that investors should run for cover. Still, the US dollar plumbs new depths each day, and US exports surge providing some hope that we can indeed work our way out of our mess. Yes, US consumers are, on average, "in over their heads." And there are signs of US recession at every turn. And yes, the world is not highly decoupled from the US. Still, there are reasons to at least be hopeful. Just as there are reasons to believe that financial derivatives time bombs may still detonate.

Faber begins with a declaration that the US is already in a recession. Then follows with "gloom and doom", i.e. world markets being positioned for a bust, following 76 months of boom.

Faber follows up with a shot across the bow of the US Fed, and blames both Greenspan and Bernanke for the mess we are now in. So have I, in earlier musings. But Faber goes further and suggests that Bernanke will destroy the US dollar. I disagree. I believe that Bernanke and other major league central bankers are just trying to keep the world's currency markets solvent. Bernanke's next steps will be telling — or not — since if we are in a liquidity trap the Fed is pretty much impotent in any case.

Faber then goes on to talk about markets. Faber believes that Gold may go higher. But he really likes sugar. I'm not into commodity trading — or trading generally — so I'll leave that for what it may be. Besides, I missed this Gold rush early on, and will likely leave it alone now.

Faber also thinks Google, Apple, and RIM [Research in Motion LTD, (Nasdaq: GS:RIMM)] will all see at least a 50% reduction from their recent highs. Maybe. If so I might even take a bite of Google, as I did long ago with Apple (minor personal disclosure). {Update: Here is Fortune, Mar 7, on Apple v. RIM's Blackberry going forward.}

Faber also notes, importantly, that the US S&P 500 is not pricey in terms of Euros, indeed the S&P 500 is down 50% from its peak in 2000. Question is, What next for international currencies?

Faber believes that dollar devaluation will likely continue and we will see the imbalances work out there rather than in "asset declines in nominal terms measured in US dollars." China and India stock markets, by contrast may correct 30% to 40%. Finally, US Long Term Bonds, are, in Faber's opinion a "disaster waiting to happen", as are Long Term Treasuries.

Finally, Faber also says he hopes to see a major bank in the US fail, if only to see some discipline rebuilt into the US financial system. I want to see such discipline too, and suspect it will not be forthcoming short of more pain felt in the banking community that brought us to the brink of the abyss.

On Sheep and Greedy, Corrupt Shepherds

As I've watched the Securitization Mess unfold since last August, and opined about its inevitability prior, I have been awestruck by the silence from those who ought to have spoken loudly about the systemic corruption at work. I have been disgusted by the wanton greed from those who were knowingly profiteering from what inevitably would hurt those drawn into the deception. I have been dumbfounded by the blind faith of true believers in so-called "new economy" thinking, whether pundits, politicians, or CEOs. In all it brings to mind a couple of my favorite quotes:

Those who give no thought to that which is distant will find sorrow near at hand. Confucius (paraphrased)

People don't learn from the mistakes of others. They seldom learn from their own mistakes. Never underestimate the power of human stupidity. Robert Heinlein (paraphrased)

As to why we don't learn from mistakes, we need not look further than what cognitive psychologists and decision theorists have been yarding together for years under headers like Self-deception Biases, Heuristic Simplification (information processing errors), Emotion/Affect Disorders, and Social Interaction Disorders.

As to the systemic nature of this Securitization Mess, I'll leave you with Doug Noland's recent words:

Confirmations, Doug Noland, Credit Bubble Bulletin, Feb. 22: … [T]he unfolding Credit Crisis has made a major leap toward the heart of the Credit system. I have no way of knowing to what degree widening spreads are being dictated by "technical" hedging-related trading dynamics, as opposed to fundamental issues with respect to the faltering U.S. economy; rapidly deteriorating corporate balance sheets; a highly susceptible leveraged speculating community; the vulnerable GSEs; a distressingly illiquid Credit market; and heightened systemic risk more generally. To be sure, a strong case can be made that the current backdrop is quite detrimental to a highly leveraged and speculative Credit system. The markets rallied late this afternoon — and perhaps they will rally further next week — on talk of a bailout for troubled Ambac. Unfortunately, there has been ample Confirmation that the Evolving Credit Crisis has quickly spiraled way beyond the "monolines."

Related: Flock Mentality, from Alea

P.S. I'm now pulling together recent "finds" from others on the sidebar of my blog. Or you can find them here, via Google Reader "Shared Items" (along with a feed).

Doug Noland: 'Breakdown of Wall Street Alchemy'

In his latest Credit Bubble Bulletin, Doug Noland concludes that "GSEs are poised as the next shoes to drop — the next Dominoes in an Escalating Contagion. … Simplifying highly complex circumstances, the various risk models that empowered the greatest leveraging of risk in the history of finance no longer function as expected — or as required to maintain highly leveraged exposures to a multitude of escalating risks. And it was all just only a matter of time. The overriding flaw was to ignore that a runaway Bubble in market-based finance ensured that various market and Credit risks all coalesced into One Massive, Unmanageable, Highly Correlated, Unhedgable, Undiversifiable Association of Interrelated Systemic Risks. "

Although Noland's assessments continue to be bleak, I find them to be more 'on the mark' week-on-week than any other source I go to. Maybe I'm just hearing what I confirms my preconceived biases. Or maybe not? More from Noland (emphasis added):

The Breakdown of Wall Street Alchemy, Doug Noland, Feb 15: This week provided further confirmation of ongoing momentous Credit market developments. … Like the asset-backed commercial paper market that was popular with structured investment vehicles until last summer, auction-rate securities, a form of rolling short-term funding for long-term municipal commitments, have become fashionable in recent years."

"Auction-rate securities" has joined the beleaguered ranks of "subprime," "asset-backed commercial paper," "SIVs," and the "monolines" — financial structures that flourished during the prolonged Credit Bubble but no longer pass market muster in today's Post-Bubble Risk Revulsion Backdrop. This week's "unwinding" of the "auction-rate" market and the blowing out of Credit spreads should be seen as an escalation of the ongoing unwind of "Contemporary finance" and its many avenues of Risk Intermediation.

On numerous fronts, the markets and economy confront a Highly Problematic Breakdown in "Wall Street Alchemy" — the disintegration of key processes that had for some time transformed ever-increasing quantities of risky loans into perceived safe and liquid debt instruments that enjoyed insatiable demand in the marketplace. In the case of the “auction-rate securities,” it was a clever restyling of long-term and generally illiquid municipal debt (as well as student loans and other borrowings) into perceived liquid securities that could be easily sold at regularly recurring auctions (every one to a few weeks). With scores of flush corporate treasury departments and wealthy clients (managing huge Credit Bubble-induced cash-flows) keen to earn extra (after-tax) yield on "cash equivalents," the Wall Street firms had been diligent in ensuring (making markets for clients, when necessary) a highly liquid and enticing marketplace. Now, with the onset of Risk Revulsion and Acute Financial Sector Balance Sheet Pressures, investors are running for cover and Wall Street firms are shunning the use of their own capital to support this and other markets. Market liquidity has evaporated, confidence has been shattered, and we are witnessing yet another "run" on a previously popular risk market/asset class. The music has stopped for another game of musical chairs.

This week saw heightened systemic stress stampede toward the epicenter of the U.S. Credit system. It certainly didn't help that insurance behemoth AIG Group reported an almost $5bn writedown of its Credit default swap portfolio or that international securities dealer behemoth UBS reported massive losses on its U.S. Credit positions. Confidence was further shaken by huge losses reported by mortgage insurers, as well the twists and turns of the "monoline" bust turned apparent bailout. In the markets, various indices of investment grade Credits widened sharply to record levels. The key "dollar swap" (interest-rate derivative hedging) market saw spreads widen sharply. Agency spreads also widened significantly. Benchmark Fannie Mae MBS spreads widened a remarkable 20 bps against 10-year Treasuries, while agency debt spreads widened a noteworthy 12.5 basis points to 69.5 bps (high since November). The Breakdown of Wall Street Alchemy is now pushing the Credit Market Dislocation uncomfortably close to the core of our monetary system.

I'll return to financial aspects of this crisis, but I definitely feel the economic ramifications of the unfolding Credit Crisis are receiving short shrift in the media. This week saw parts of the municipal debt market grind to a virtual halt and the corporate debt market take another significant blow. Investment grade debt issuance has now slowed markedly after beginning the year at near record pace. At this point, the junk, CDO, ABS, "private-label" MBS, muni, and even investment grade debt markets are all somewhere between impaired, dislocated and completely dysfunctional. There is no mystery behind the recent string of abysmal economic reports.

The preliminary reading on February University of Michigan Consumer Confidence dropped 8.8 points to the lowest level since the 1992 recession. The Economic Conditions index sank and the Economic Outlook index plunged, while one-year Inflation Expectations rose from 3.4% to 3.7%. The Economic Outlook has sunk a remarkable 22 points since July. Falling national home prices are clearly wearing on confidence. This week, Dataquick reported that home sales throughout much of California have collapsed to more than 20-year lows, while home price declines accelerate. This is a huge unfolding issue/debacle for the MBS, agency, mortgage insurance, CDO, and Credit derivatives markets, not to mention the U.S. banking system and real economy. Countrywide Financial reported delinquencies on its $1.5 TN mortgage servicing portfolio had jumped to 7.47%, up from the year ago 4.32%. The New York "Empire" Manufacturing index sank to the lowest levels since April 2003.

The economy is now faltering badly and there is every reason to expect the downturn to gather pace — negative real interest rates compliments of the Fed and stimulus package compliments of the federal government notwithstanding. While fourth quarter data is not yet available, one can look to the first nine months of 2007 to gain important perspective. Despite the dislocation in the subprime mortgage market, Non-Financial Debt Growth accelerated from Q2's 7.2% to Q3's 8.9% (from the Fed’s Z.1 report). And while Household Debt Growth had slowed to a 6.9% pace, Business Borrowings accelerated to a blistering 11.9% annualized rate in the third quarter. This was the strongest corporate debt growth since the tech/telecom boom in the late nineties. Importantly, total (financial and non-financial) Corporate Debt expanded at an 11.1% rate during the first three quarters of 2007, followed by 9.3% growth in State & Local government borrowings. And while residential mortgage debt was slowing meaningfully, Commercial Mortgage Debt was expanding at an almost 13% rate.

Total (financial and non-financial) Credit expanded a seasonally-adjusted and annualized record $5.0 TN during the third quarter — as nominal GDP expanded at a 6% pace. While many trumpeted the "resiliency" of the U.S. economy in the face of mortgage and housing woes — more adept analysis would have focused on the massive Credit creation that had come to be required to sustain the Bubble Economy. Importantly, the faltering subprime market initially instigated only greater excesses throughout commercial real estate, municipal finance, M&A finance, and corporate lending more generally. The Credit Bubble was sustained at the great cost of heightened instability and weakened structures — especially throughout leveraged lending, state & local finance, and investment-grade corporate borrowings. Keep in mind that through the third quarter CDO issuance was actually running ahead of 2006's record pace. Until the fourth quarter, record Credit growth continued to fuel the finance-driven economy. This is all now coming home to roost.

Today, with bursting bubbles in corporate and municipal finance joining the mortgage bust, the U.S. Bubble economy has quickly fallen desperately short of sufficient Credit and liquidity. And the greater the Credit market dislocation and broad-based tightness of Credit, the bleaker become economic prospects and the more intense the Revulsion to Wall Street's Credit instruments. The days of free-flowing cheap finance for home buyers, state and local governments, LBO firms, commercial real estate speculators, college students, risky auto buyers, and high-risk Credit card holders are over — and they will not be returning for some time to come.

When I have previously underestimated the "resiliency" of the U.S. Credit Bubble and economy, it was in each instance a failure to appreciate the capability of Wall Street finance to expand to ever greater degrees of Bubble excess. Today, with "contemporary finance" mired in a historic collapse, I am confident that the Credit system is today only in a position to surprise on the downside. It is this framework that shapes my view of a rapidly escalating Credit crisis feeding an arduous economic adjustment period.

And while it could undoubtedly prod a highly speculative stock market, there is no resolution to the "monoline" dilemma that would meaningfully influence the trajectory of the unfolding Credit and economic bust. As we've been saying for awhile now, confidence in Wall Street finance has been irreparably shattered. Trust has been broken in "AAA" ratings, "mark-to-model," CDO structures, myriad risk models, Credit insurance, counter-party risk, and various instruments and vehicles for intermediating risk in the markets. Moreover, old fashioned lending will not come close to sufficing the demands of a highly imbalanced Bubble economy, especially with bankers nervous and retrenching. Again, we're witnessing nothing less than the Breakdown of Wall Street Alchemy — one that took a turn for the worst this week.

In a disconcerting development, recent market developments seem to confirm that the leveraged speculating community and the GSEs are poised as the next shoes to drop — the next Dominoes in an Escalating Contagion. Along with the "monolines" and mortgage insurers, the "Credit default swap market" and GSE mortgage Risk Intermediation were at the epicenter of the most egregious Systemic Risk Distortions and Accumulations. They are now quickly moving to the forefront of Current Acute Fragilities. Simplifying highly complex circumstances, the various risk models that empowered the greatest leveraging of risk in the history of finance no longer function as expected — or as required to maintain highly leveraged exposures to a multitude of escalating risks. And it was all just only a matter of time. The overriding flaw was to ignore that a runaway Bubble in market-based finance ensured that various market and Credit risks all coalesced into One Massive, Unmanageable, Highly Correlated, Unhedgable, Undiversifiable Association of Interrelated Systemic Risks.

Las Vegas Asset Securitization 'Job Fair'

Richard Benson (Via Prudent Bear) condenses the securitization mess in a few paragraphs built around a Las Vegas extravaganza conference. Soundbite: How can the Central Bankers, Wall Street bigwigs, rating agencies, appraisers, bond insurers, and investment bankers sleep at night when they know they stooped so low to make a profit. Each time they provided the liquidity to wrap, rate, sell and finance a mortgage, or security, they took advantage of innocent people. Sure, every borrower should read and understand the fine print and be held accountable when they execute a legal document, but the magnitude of the predatory lending practices during this bubble reached proportions never seen before in history. Many borrowers are now literally struggling to survive and eat, and will soon be facing foreclosure.

The Happy American Dream has been taken away and replaced by a nightmare. … When yesterday's liquidity looks in the mirror, it's insolvency that is staring back! As this credit tragedy unfolds, I noticed last week while attending the Asset Securitization Forum in Las Vegas … there were over 6,500 Wall Street preppies there and over 1,500 had resumes and were looking for jobs. More:

Liquidity Looked in the Mirror but Insolvency Stared Back, Richard Benson, Prudent Bear, Feb. 8: … When we were first introduced to credit back in the late 1960's, bankers learned about the 3 C's of credit: Collateral, Character, and Cash Flow. There was no such thing as a NINA (No Income, No Assets) loan. Indeed, back then it was virtually unheard of to lend money to an unqualified borrower. It wasn't until I arrived on Wall Street some 15 to 20 years later and was involved in the securitization industry (particularly the sub-prime industry) that I realized hundreds of institutions, employing thousands of employees, were willingly making millions of loans to borrowers with, yep, you guessed it, No collateral, No income, No character! Some of these were white shoe institutions with blue-chip stocks. (The article in the Wall Street Journal today, "The Rise of Mortgage Walkers", says it all). Of course mortgage borrowers are walking away and feeling no shame as they fling the front door keys to the wind! I have been writing about this and speaking about it at conferences for years, and wondered why nobody listened.

As a result of many years of predatory lending, the United States is facing an insolvency problem that is unprecedented. Leverage must be reduced to restore faith in the solvency of institutions before anyone will trust them again with their hard-earned cash. Lending has begun to go back on balance sheet but it’s already too late to save the ailing SIV’s and if the monoline insurers fail, say goodbye to the asset-backed CP market.

Why is America looking so insolvent? Well, for one reason, the easy money policies of the past have resulted in at least three trillion of really dodgy loans issued for mortgages, automobiles, home equity lines of credit (HELOC), and credit cards. …

Over the next few years, the character of many millions of Americans will be tested as they are forced to make very tough decisions on how they will live and spend money. Will they do the honorable thing and pay down their credit card or mortgage from Countrywide (after reading that the head of Countrywide left the firm with a gazillion bucks), or will they buy groceries for the kids? This morning Wal-Mart announced their sales figures and, surprise, their store-offered gift cards are now being used to buy groceries and necessities, rather than iPods and DVD’s. At the same time, credit cards are being maxed out for the same reason!

How can the Central Bankers, Wall Street bigwigs, rating agencies, appraisers, bond insurers, and investment bankers sleep at night when they know they stooped so low to make a profit. Each time they provided the liquidity to wrap, rate, sell and finance a mortgage, or security, they took advantage of innocent people. Sure, every borrower should read and understand the fine print and be held accountable when they execute a legal document, but the magnitude of the predatory lending practices during this bubble reached proportions never seen before in history. Many borrowers are now literally struggling to survive and eat, and will soon be facing foreclosure. The Happy American Dream has been taken away and replaced by a nightmare. So;

When yesterday's liquidity looks in the mirror, it's insolvency that is staring back!

As this credit tragedy unfolds, I noticed last week while attending the Asset Securitization Forum in Las Vegas (which I fondly refer to as "lost wages"), there were over 6,500 Wall Street preppies there and over 1,500 had resumes and were looking for jobs. It looked to me like the entire conference was in a state of total denial. In my 25 years of attending these securitization finance conferences, this one felt more like a job fair than an industry conference. When I needed to adjust my watch to the correct time, I realized you never know what time it is in a casino because there are no clocks. Time doesn’t matter there so it’s never too late to gamble. Indeed, the players at the credit casino should have left the gaming table last year!

Not all of the attendees at the ASF Conference were bleak, though, and many were smiling, or perhaps smirking. The smart smirking ones were crossing the street to the Debt Buyers Association Conference and were looking to pick up trashed assets for pennies on the dollar. A number of people were also employed at firms that perform due diligence, but they cut deals with the State Attorney General to stay out of jail in return for immunity and fingering some big-name Wall Street houses. These Wall Street firms forgot to disclose that the large number of loans issued to borrowers with no verifiable income, was off the charts. As a result, new law firms are sprouting up like weeds as they gear up for investor class-action lawsuits. Misfortune creates opportunity. …

Financial Crisis: '20 Years in the Making'

Doug Noland tells us — preaching to the choir, since no one else will listen — that the stage for the mess now unfolding was built on a foundation laid over 20+ years by US Federal Reserve policy, cheerled by Wall Street finance. Noland says, "The unfolding financial and economic crisis has been more than 20 years in the making. It's a creation of flawed monetary management; egregious lending, leveraging and speculating excess; unprecedented economic distortions and imbalances on a global basis. And I find it rather ironic that Wall Street is so fervidly lambasting the Fed. For twenty years now the Fed has basically done everything that Wall Street requested and more." Here's more:

More than 20 Years in the Making, Doug Noland, Credit Bubble Bulletin, Jan. 25: … When the junk bonds, LBOs, S&Ls, and scores of commercial banks all came crashing down beginning in late-1989 to 1990, the Greenspan Fed initiated an historic easing cycle that saw Fed funds cut from 9.0% in November 1989 all the way to 3.0% by September 1992. In order to recapitalize the banking system, free up system Credit growth, and fight economic headwinds, the Greenspan Federal Reserve was more than content to garner outsized financial profits to the fledgling leveraged speculator community and a Wall Street keen to seize power from the frail banking system. Wall Street investment bankers, all facets of the securitization industry, the derivatives market, the hedge funds and the GSEs never looked back — not for a second.

In the guise of "free markets," the Greenspan Fed sold their soul to unfettered and unregulated Wall Street-based Credit creation. What proceeded was the perpetration of a 20-year myth: that an historic confluence of incredible technological advances, a productivity revolution, and momentous financial innovation had fundamentally altered the course of economic and financial history. The ideology emerged (and became emboldened by each passing year of positive GDP growth and rising asset prices) that free market forces and enlightened policymaking raised the economy’s speed limit and increased its resiliency; conquered inflation; and fundamentally altered and revolutionized financial risk management/intermediation. It was one heck of a compelling — alluring — seductive story.

But, as they say, "there's always a catch". In order for New Age Finance to work, the Fed had to make a seemingly simple — yet outrageously dangerous — promise of "liquid and continuous" markets. Only with uninterrupted liquidity could much of securities-based contemporary risk intermediation come close to functioning as advertised. Those taking risky positions in various securitizations (especially when highly leveraged) needed confidence that they would always have the opportunity to offload risk (liquidate positions and/or easily hedge exposure). Those writing derivative "insurance" — accommodating the markets' expanding appetite for hedging — required liquid markets whereby they could short securities to hedge their risk, as necessary. There were numerous debacles that should have alerted policymakers to some of New Age Finance's inherent flaws (1994's bond rout, Orange Co., Mexico, SE Asia, Russia, Argentina, LTCM, the tech bust, and Enron to name a few). Yet the bottom line was that the combination of the Fed's flexibility to aggressively cut rates on demand; ballooning GSE balance sheets on demand; ballooning foreign official dollar reserve holdings on demand; and insatiable demand for the dollar as the world's reserve currency all worked in powerful concert to sustain (until recently) the U.S. Credit Bubble — through thick and thin.

Despite his (inflationist) academic leanings and some regrettable ("Helicopter Ben") speeches as Fed governor, I do believe Dr. Bernanke aspired to adapt Fed policymaking. His preference was for a more "rules based" policy approach of setting rates through some flexible "inflation targeting" regime, while ending Greenspan’s penchant for kowtowing to the markets. Today, it all seems hopelessly naïve. Inflation is running above 4%, while the FOMC is compelled to quickly slash the funds rate to 3%. And never — I repeat, never — have the financial markets been more convinced that the Federal Reserve fixates on stock prices while is permissive when it comes to inflationary pressures. Today, the contrast to the ECB and other global central banks could not be starker. The Fed has climbed way out on a limb, and it is difficult at this point to see how they regain credibility as inflation fighters or supporters of the value of our currency. It is not only trust in Wall Street-backed finance that is being shattered.

The greatest flaw in the Greenspan/Bernanke monetary policy doctrine was a dangerously misguided understanding of the risks inherent to their "risk management" approach. Repeatedly, monetary policymaking was dictated by the Fed's focus on what it considered the possibility of adverse consequences from relatively low probability ("tail") developments in the Credit system and real economy. In other words, if the markets (certainly inclusive of "New Age" structured finance) were at risk of faltering, it was believed that aggressive accommodation was required. The avoidance of potentially severe real economic risks through "activist" monetary easing was accepted outright as a patently more attractive proposition compared to the (generally perceived minimal) inflationary risks that might arise from policy ease. As it was in the late 1920s, such an accommodative ("coin in the fuse box") policy approach is disastrous in Bubble environments.

The Fed's complete misconception of the true nature of contemporary "inflation" risk was a historic blunder in monetary doctrine and analysis. To be sure, the consequences of accommodating the markets were anything but confined to consumer prices. Instead, the primary — and greatly unappreciated — risks were part and parcel to the perpetuation of dangerous Credit Bubble Dynamics and myriad attendant excesses. Importantly, the Fed failed to recognize that obliging Wall Street finance ensured ever greater Bubble-related distortions and fragilities — deeper structural impairment to both the financial system and real economy. In the end, the Fed's focus on mitigating "tail" risk guaranteed a much more certain and problematic "tail" — a rather fat one at that.

Fundamentally, the Greenspan/Bernanke "doctrine" totally misconstrued the various risks inherent in their strategy of disregarding Bubbles as they expanded — choosing instead the aggressive implementation of post-Bubble "mopping up" measures as necessary. They were almost as oblivious to the nature of escalating Bubble risk as they were to present-day complexities incident to implementing "mop up" reflationary policies. "Mopping up" the technology Bubble created a greatly more precarious Mortgage Finance Bubble. Aggressively "mopping up" after the mortgage/housing carnage in an age of a debased and vulnerable dollar, $90 oil, $900 gold, surging commodities and food costs, massive unwieldy pools of speculative global finance, myriad global Bubbles, and a runaway Chinese boom is fraught with extraordinary risk. Furthermore, the Fed's previously most potent reflationary mechanism — Wall Street-backed finance — is today largely inoperable. …

It is also as ironic as it was predictable that Alan Greenspan — Ayn Rand "disciple" and free-market ideologue — championed monetary policies and a financial apparatus that will ensure the greatest government intrusion into our Nation’s financial and economic affairs since the New Deal. Articles berating contemporary Capitalism are becoming commonplace. I fear that the most important lesson from this experience may fail to resonate: that to promote sustainable free-market Capitalism for the real economy demands considerable general resolve to protect the soundness and stability of the underlying Credit system. …

Trouble in Hedge Fund Land?

Via Financial Reality, Hedge Shearing?, Jan25: According to Marketwatch, markets are nervous today in part because of rumors of hedge funds in trouble. How can there not be? Most of the big banks and brokerage houses are in trouble to a greater or lesser degree, and the hedge funds are in many of the same trades, and typically use much more leverage than the big corporations. It is unlikely that all the hedge funds have better traders and knowledge than the big boys who have been handed their heads on a platter. …

Jim Cramer's Rant: 'Fiction in Financials'

Normally I'm not one to recommend financial madman Jim Cramer's rants. But I'll make an exception today for: Cramer Rages on Banks: 'Where's the SEC?!'. The video feed (embedded in the CNBC post) is well-worth a few minutes of your time, even to endure a short ad at the beginning. The CNBC post begins, "Why isn't the Securities and Exchange Commission getting more involved in the whole banking sector writedown situation? Especially since the numbers are likely to get worse, not better? That's what Jim Cramer, CNBC's resident stock guru, wants to know." Then continues:

… "It's all fiction!" [Cramer] declared during a forceful exchange ….

"How can we have these levels of fiction in financials after Sarbanes-Oxley? How do people get away with this? How do they live with themselves?"

Cramer made his comments while reviewing results from Merrill. But his real consternation surrounded the insurers who cover banking investments. Some of those insurers haven't come clean about their liabilities, Cramer speculated. Eventually they will, and then the "fiction" will disappear, he said.

The banking sector and its related industries are all too chummy, Cramer accused. That led the numbers related to mortgage investments -- investments that are currently souring -- to break from reality.

"I think the financial guys all belong to the same club and they got to protect each other," he said.

Worse, those executives behind the current credit crunch are unlikely to get any punishment for their mistakes and disingenuousness about their numbers, Cramer opined.

"I'm fed up with it. The American people should be fed up with it. And the SEC should be fed up with it," Cramer said.

"This is what the SEC is supposed to protect us from," he added. …

P.S. Cramer takes aim too at so-called "mortgage insurers".

Hat Tip: Paul Kedrosky, Infectious Greed.

Catching up on Financial 'Interesting Times'

Let's begin with Paul Krugman's Dec 14 Authors@Google Series video on how we got into our current financial mess and some "mysteries" on how we might get out of it this side (or the other side) of a 'hard landing.' In this very good hour with Krugman, he covers the previous Long Term Capital Management induced mess, the Nasdaq "tech bubble", the housing bubble, the Fed, "financial innovation", and more. Good insights for we who don't spend 24/7 dealing with matters financial:

Krugman believes that the housing mess is with us for about the next six years, guessing, based on early '90s S. California housing bust, with an average 30% price drop (in "real" dollars) from "bubbleicious" peaks. In a blog post today, Unknown Housing Territory, Dec 19, Krugman gives us more:

… The bubbles in the most bubbleicious areas were bigger than anything we've ever seen — and there's every reason to think that the required fall in prices in those areas will be much bigger than anything we've seen since the Great Depression. …

In the video, Krugman admits being surprised by the enormous impacts of the housing and related credit crunch have on the "financial system". He highlights how the Fed has been 'behind the curve' on dealing with this latest crisis, naïvely believing that the same medicine that 'solved' the LTCM mess years ago would suffice here. Since that medicine didn't work this time, Krugman gives us glimpses of the newer approaches central bankers are trying to put into play.

One Highlight: Glassman's law, as a correlary to Stein's law (also from Bubble Denial, Dec 10 on Krugman's blog):

… [B]ack in 2005, when I started writing about the housing bubble — it didn't take much to see that something was way out of whack.

So how come the housing crisis has come as such a surprise to so many people?
Part of it was the usual bubble psychology. Economists like to cite Stein's Law: "If something cannot go on forever, it will stop." I think it needs to be paired with another law — let's call it Glassman's Law — along the lines of "If something unsustainable goes on for a while, there will be people claiming it can go on forever."

According to Krugman, everybody looks to the 1998 'fix' for the Long Term Capital Management debacle as a model for this episode. Problem is, that strategy doesn't seem to be working this time. The 'fix' as applied last August, seemed to work for awhile, but 'trouble' is now welling up again. So the Fed and other Central Bankers are now trying hard to funnel short- to medium-term liquidity into the system.

Krugman is hoping this latest, belated effort from central bankers will work, although he suggests there are no 'quick fixes' to this mess — adding that we still don't even know the size and extent of the mess. "Steve Cechetti is hopeful but has his doubts", says James Hamilton in his Monetary Policy Using the Asset Side of the Fed's Balance Sheet, Dec 16. Whatever you read from these extended hyperlinks, don't miss Cechetti's The Art of Crisis Management: Auctions and Swaps, Dec 16.

Noruiel Roubini is even less sure that even this latest easing will help , although he has been advising central bank "easing" for some time. See Roubini: First, Central Banks Are Getting Desperate in Dealing with the Liquidity Crunch …, Dec 18, and second, Why Monetary Policy Easing is Warranted Even in the Current Insolvency Crisis, Dec 15

Finally, Michael Shedlock (as an interesting member of the Libertarian Right) is apoplectic, not only at what he considers continuing mis-steps by the Fed, but also since Roubini, whom he admires as a forecaster, doesn't buy Shedlock's particular brand of 'free market fundamentalism': asking for the Fed to be abolished and for a return to the gold standard and private banking. See Shedlock's Missing the Boat on Monetary Easing, Dec 18.

Quite a bunch of interesting stuff out and about! Mostly I just sit back and read from the really good commentators I track on my sidebar (and my Google Reader). I don't pretend to be in the same league as they are on matters of finance and geopolitics. But I do like to try to sort out some of it, second hand. Ocasionally I even help others in their own sorting, and that makes this little hobby of mine worthwhile.

Happy Holidays to those who are celebrating such during this season.

Banking Gone Bad: 'Privatizing gains and Socializing Losses'

Yves Smith at Naked Capitalism is one of the very best economic bloggers. He keeps the rest of us up to date on a daily basis. Today, I'm impressed with this particular find/commentary (snipped, in part):

Why banking is an accident waiting to happen", Nov28: Martin Wolf, the well respected lead economics editor of the Financial Times, turns to a favorite topic: why banks regularly get themselves in trouble. His answer: it's "a risk-loving industry guaranteed as a public utility." Privatizing gains and socializing losses, particularly if the employees share in that arrangement, is a formula for reckless behavior.

Wolf takes note of the persistent high profitability of the banking industry, in return on equity terms, and attributes it to formal and informal public guarantees (they allow banks to borrow more cheaply than otherwise) and undercapitalization relative to the risks assumed. But there is another way to look at bankings' relative profitability. Remember, ultimately, the banking industry provides services to the productive economy and individuals and extracts fees for those services. Its high profits represent a wealth transfer from the productive sector to what ought to be a support function.

Wolf briefly reviews some possible remedies …

Banks are wards of the state. The sooner the powers that be recognize that and treat them accordingly, the better off the rest of us will be.

From the Financial Times:

Why does banking generate such turmoil, with the crisis over securitised lending the latest example? Why is the industry so profitable? Why are the people it employs so well paid? The answer to these three questions is the same: banking takes high risks. But the public sector subsidises this risk-taking. It does so because banks provide a utility. What the banks give in return, however, is gung-ho speculation. …

Governments are not totally stupid. They guarantee banks because the latter provide a social utility: a safe haven for money, and a payment system. But governments also realise that they are providing incentives for banks to economise on capital and take on risk. So governments impose capital-adequacy ratios, rules on risk management and (if they are sensible) liquidity requirements, as well. Unfortunately, these institutions are not only complex, but are staffed by single-minded and talented people. They go round regulations, just as water flows round an obstruction.

The result of this ingenuity includes “special purpose vehicles”, hedge funds and even, in some respects, private equity funds. These are all, in varying ways, off-balance-sheet banks: ways to exploit the exceptionally profitable opportunities (and corresponding risks) created by high leverage and maturity transformation. Securitisation, to take a salient example, is a clever way to shift what would once have been bank loans on to the books of these quasi-banks, with the consequences we all now see. …

So what we have is a risk-loving industry guaranteed as a public utility. One result has been insufficient capital. That permits splendid returns in good times. But the capital may well prove inadequate in bad ones. The loss of capital could well lead to a tightening of credit in the years ahead.

If so, the structure and regulation of banking might have to be reconsidered, again. One possibility would be higher capital requirements. This would lower peak returns and so reduce the chances of subsequent negative returns. Mr Smithers and Prof Wood suggest a 40 per cent increase in capital for the UK. Other possibilities are measures to make regulation easier: narrow banking is an old favourite, although hard to make work. Henry Kaufman, a highly experienced observer of credit markets, suggests intense scrutiny of banks deemed “too big to fail”.

What seems increasingly clear is that the combination of generous government guarantees with rampant profit-making in inadequately capitalised institutions is an accident waiting to happen – again and again and again. Either the banking industry should be treated as a utility, with regulated returns, or it should be viewed as a profit-seeking industry that operates in accordance with the laws of the market, including, if necessary, mass bankruptcies. Since we cannot accept the latter, I suspect we will be forced to move towards the former. Little can be done now. But when the recovery begins, we must impose higher capital requirements.

More Money than Mystery in the Mortgage Mess: Money to be Made, Sheep to be Fleeced

At lunch today an attorney friend of mine asked me how it was that financial professionals were sucked into this latest mess. That is, Why were financial people playing games with highly leveraged sliced, diced, and securitized debt instruments, derivatives and other stuff that I can barely pronounce, let alone begin to understand? Games which they should have known looked way too much like the the games Charles Ponzi was famous for. {Update 11/21: For more on the contemporary "games" See today's DeLong/Ehrenberg post on "sheep fleecing", and read the follow-up comments.}

Eugene Linden covered the territory well in our last post, but Paul Krugman was mulling it over too:

Mystery of the Mortgage Mess, Paul Krugman, Nov. 15: There's a very good Economic Letter
from the Dallas Fed about the housing crisis, which explains a lot about how the mess happened. In short: lenders began making lots of dubious loans in large part because they were able to slice and dice the loans and sell them off to investors who didn’t know what they were buying. My only fault with the letter is that it doesn’t emphasize the extent to which borrowers were also suckered in.

But here's what I don't quite understand: how could people have been convinced that all this made sense? …

More from one of Krugman's readers:

This essay ignores one of the primary enablers in this debacle – the rating agencies. These private companies rated subprime mortgages using assumptions that are inaccurate. In addition to getting it wrong, the rating agencies have very definite conflicts of interest rating these, as documented by Frank Partnoy. (His paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract=900257). They are paid by the parties looking to sell the ultimate securities who profit if the ratings are higher. Also related to this is the fact that bank capital requirements are related to the ratings on off-balance sheet entities that finance a lot of this so it also impacts the health of the financial system. Floyd Norris has a piece on this at his blog today.

Wall Street banks and the rating agencies were profiting nicely from all of this, and they kept the wheels turning for as long as they could. They should have, and maybe even did, know better. This is where the research should be because this is where the incentive to make bad loans came from in the first place. Instead, congress has placed the blame at the feet of mortgage bankers who were providing Wall Street with exactly what it wanted – more food for the machine.
— Posted by Polecolaw

{Update Nov 21: See too, The Abysmal Track Records of Moody's, Fitch and S&P, Barry Ritholtz, The Big Picture.Nov 21 }

Krugman gets the last words: "I guess hype really does spring eternal."

Credit Crunch: Why We Don't Learn from Our Mistakes

I've been watching, and not saying much as many of the predictions echoed here seem to be unfolding. Two big questions remain: Just how big is this mess? And, Can we learn from our mistakes? On the first we are just now beginning to see what many believe to be the tip of a very large iceberg of impending losses (Banks/Brokerages, GSEs). On the second, Eugene Linden says no, we can't learn from our mistakes. He helps us better understand why:

Could This Credit Crunch Have Been Avoided? Eugene Linden, Minyanville News & Views, Nov 15: One recurring rhythm of economies is that when times are good, banks relax lending standards, which lea