Economic Dreams - Economic Nightmares

'Presidential' Challenge: Confronting the Medical Industrial Complex

Recently I watched Frontline's Sick Around the World, and was once-again reminded how our various "industrial complexes" have gridlocked the US into at best mediocre economic performance relative to other economies around the world. At worst we Americans face a painful "day of reckoning".

Noteworthy is how Frontline's Sick Around the World helps us see that to fix the Medical Industrial Complex problem requires that we confront not only the American Medical Association's long-recognized power base and physicians (particularly "specialists") outrageous pay scales, but also the insurance industry, big medical consortiums, the pharmaceutical industry, and trail lawyers all feeding at the same trough. No small task. But a worthy, timely cause.

It will prove interesting to see how an incoming American president begins to confront the medical industrial complex, along with the petrochemical industrial complex, financial industrial complex, and military industrial complex. Wikipedia on Military Industrial Complex.

It will also prove interesting to see whether or not mainstream American media will ever begin to explore recent war profiteering and connections to American political power bases linked to Bush and Cheney. A military industrial complex that we have been forewarned against since the late 1950s. Here is Counterpunch, Bush Family War Profiteering, April 12, 2007. For more see Sourcewatch on this-round War Profiteering.

{Update, May 25}:

More on Bush Administration's War Profiteering, from Capital Gains and Games: The Bush Administration's Teapot Dome

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.

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?

Krugman: Fed Lacks Tools to Deal with Crisis

Paul Krugman says Nouriel Roubini was right: We are in the worst financial crisis since the Great Depression. AND, The Fed probably lacks the tools to deal with it. Then Krugman muses, "Who ya gonna call?", The White House? Greenspan? To Krugman:

Who ya gonna call? Paul Krugman, March 17:

Um, on second thought

Nouriel is right: this is the worst financial crisis since the Great Depression, and the Fed, with the best will in the world, probably lacks the tools to deal with it. Broader action is necessary.

But then comes the question: who ya gonna call?

The Gang That Couldn't think Straight still holds the White House; no good ideas will come from that quarter. Worse, Incurious George would probably veto any sensible plan from Congress, even if said plan could get past a filibuster.

Hey, here's an idea! Let's create a nonpartisan expert commission, headed by Alan Gr …. oh, wait. He's part of the problem. In fact, is there any way we can repossess his book royalties?

Seriously, it's very hard to see who can take charge.

Things fall apart, and the center doesn't exist.

PS. Most of what I dig up and find "most interesting to share", I now distribute via Google Reader on my Econ Dreams - Nightmares sidebar.

'Doom Foretold, and Prophets Ignored'

(via CapitalistImperialistPig, March 15)

Yet Another Chapter from the Chronicle of Doom Foretold, and Prophets Ignored:

No one could have foreseen . . ." is the familiar refrain of idiots who ignored warning signs apparent to many. Brad DeLong takes a look at the Panic of 2008, and those who could not see that train coming:

Paul Krugman comments on Dean Baker's ire:

The few, the proud, the ignored: Dean Baker is mad at Robert Rubin for suggesting that "few, if any" people saw the financial meltdown coming.

I'd say that there are two levels to this. First, a lot of people -- including Dean, me, Calculated Risk, and others -- saw that there was a huge housing bubble. It remains amazing that so many alleged experts failed to see the obvious.

Krugman and DeLong have a nice analysis, but I wonder if it's really to the point. The whole idea of a Ponzi scheme is not that nobody can see where it ends, it's that some are getting rich before it does.

We are in such a state because:

Quantitatively- and analytically-sophisticated Wall Street teams greatly overestimated their capability to assess and manage risk.
Institutions greatly overestimated the extent to which the QaASWSTs were assessing risk as opposed to simply writing out-of-the-money puts they could not value and claiming they had lots of alpha.
Investors greatly overestimated the extent to which institutions understood what their teams were doing.

Again, did they really fail to correctly assess risk, or did they just ride the cash train while it was going their direction?

Of course all are right: We are dealing with failed institutions, shortsighted formulaic analysis, and some unscrupulous, greedy bastards who would (and do) loot any system that allows for looting. Time to rethink many things: CEO compensation, Wall Street Bonuses, Regulation (including but not limited to disclosure, leverage), Truth in Advertising & Lending, Market-Government balance, and so on.

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).

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.

Banking Gone Bad: 'Privatizing gains and Socializing Losses'

Yves Smith at Naked Capitalism is one of the very best economic bloggers. She 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 leads to bad loans, which in turn leads to bad times. It’s happening right now, even though, remarkably, the last painful lesson came just seven years ago with the tech bust. Generational forgetting apparently happens much quicker in the markets than in the real world. Perhaps that is because in the markets there is an accelerant in the form of money – specifically bonuses – to be made in bubbles. Still, the question lingers: why don’t we ever learn?

The simple answer is that we don’t learn because we can’t. More specifically, a structured finance manager who hit the brakes because he realized that calamity lay ahead would have been fired for underperforming, or not being with the program … or he would find that his team had defected to other shops that were still happily running towards the cliff. Indeed, if the Ghost of Market's Future visited bank CEOs in 2005 and showed them what would happen in the fall of 2007, their first question would be, “Who else knows this?” …

Here’s a hot tip. Unless the present credit crisis actually brings down the global financial system (and we’re by no means out of the woods), this cycle will happen again. Yes, if we dodge this bullet, we’re likely to see the usual barn-door closing in the form of new regulations, etc., but as soon as things stabilize, bankers will abandon their pose as socialists demanding bailouts, and dust off their capes as buccaneer libertarians while decrying the suffocating regulations that impede “the normal working of the markets.” They’ll buy the votes in Congress to get what they want, and find a new asset class to gallop towards the next cliff (not really caring whether they go over because it’s not their money). This cycle can be broken, but to do so requires a profound shift in Americans' thinking about the role of government.

Here’s why.

The present mess grew mammoth in large part because banks were able to camouflage problems. Even as the credit bubble was in its early stages, a chorus of commentators began pointing out problems in subprime lending, looming resets in ARM mortgages, the scary leverage in CDOs, and the potential conflict of interest in the rating agencies. Despite this, banks and other financial institutions successfully hid or ignored these problems until this year. When some savvy investors began balking at buying the arcane and opaque instruments that financed the MBS market, the securitizers tried to fob them off on the Asians. When they too balked, the banks held the senior stuff themselves.

This is a little like financing a new wing on your house by pawning your children's organs and blood. It’s typical for securitizers to hold the most vulnerable equity tranches of the derivatives they package, but it is unusual for banks to keep tens of billions of dollars in the most senior AAA tranches. Why would they do this? Is it possible that they did it because the fees generated from securitizing fed near term profits and bonuses, while future write-downs would be somebody else’s problem?

Barry Ritholtz and other pundits have wondered what the markets would have looked like had the banks actually behaved responsibly and not booked tens of billions in profits that they are now writing down. Since the financials account for some 40% of S&P 500 earnings, it’s safe to say that markets wouldn’t have broken new records in the last couple of years without the performance enhancing effects of these phantom earnings. With vastly fewer structured products available to finance mortgage lending, it’s also safe to say that we wouldn’t have seen the housing bubble – or the housing bust.

When everybody has an incentive to cheat, the vaunted discipline of the marketplace goes AWOL (and “everybody” includes investors because they too have incentives to swing for the fences). Admittedly, in an absolute sense this is self-correcting without government intervention. For instance, if people lose confidence in prices and the guarantees of rating agencies, they will withhold their money (what they have left anyway) until trust is restored. Trouble is, the economy will likely grind to a halt while this is happening. So we have a choice: either we can grit our teeth and trust the market to sort this out, or we can grit our teeth and accept a greater government role in setting accounting standards and regulations – not because government knows better than markets, but because only regulation can force institutions to do things that they know that they should do, but lack the courage to do unless everyone else has to play by the same rules.

We’ll see what happens, but the pendulum shift towards a new appreciation of the role of government seems to be happening already. Chances are, it will overshoot, just as our infatuation with the godlike power of markets overshot during the past 20 years.

In the meantime, we can guess what asset class will fuel the next bubble should we not break this cycle. As one former [Goldman Sachs] securities packager put it, “Wall Street’s genius is taking simple, transparent and liquid tradable instruments and turning them into opaque and illiquid derivatives, while making money by overpricing the embedded options.” That’s not going to change, so take your best shot at guessing where the next bubble will pop up. There’s only one condition in this contest: The underlying assets will have to be big enough to support several trillion dollars in derivatives.

More from Linden:

The Ecology of Toxic Mortgages, Eugene Linden, Huffington Post, July 5: … I've been looking at the unfolding debacle in subprime lending, a slow motion, far-reaching toxic poisoning, whose reach and impacts have been obvious for at least eighteen months to anyone not involved in making money off the origination, sale, and securitization of these subprime loans.

Unfortunately for investors, that aforementioned conflicted group includes virtually everybody in finance, including the mortgage brokers, subprime lenders, Wall Street firms that securitize the loans into mortgage-backed securities, Wall Street firms that then resecuritize slices of these bonds into collateralized debt obligations, and the rating agencies that, for a price, enable all these securitizations and re-securitizations, by blessing these teetering structures with ratings that imply far less risk than is turning out to be the case. There has been a good deal written about the ecology of finance in recent years, but reading about theoretical parallels between the worlds of nature and finance pales in comparison to the thrill of watching a toxics crisis in finance unfold before your eyes almost exactly as it does in the environment. For all our vaunted foresight, it's interesting to see that when greed and self-interest come into play, collectively we're no smarter than fruit flies. …