Posts Tagged ‘Derivatives’
Greece is merely prelude; the global chain of risk recognition lies just ahead.
The essence of financialization is also the heart of our economy: the counterfeiting of risk-free assets.
Think about what is totally dependent on the counterfeiting of risk-free assets:
1. The mortgage market and thus the housing market
2. The derivatives market and thus the entire hedging-risk mechanism of the global financial market
3. The sovereign debt market, i.e. government bonds that support deficit spending on a massive scale
Think about what happens in each of those markets when the real risk is recognized.
Consider housing. The housing bubble was predicated on the fabrication/ counterfeiting of risk-free assets and debt based on the phantom collateral of those assets.
For example: a no-down payment, no-document “liar loan” mortgage is issued to an unqualified buyer for a house with an inflated appraisal–i.e. phantom collateral. The buyer’s level of risk is masked, as is the collateral’s inflated value.
Given that the buyer cannot actually afford the house without a heavily gamed mortgage (interest only, etc.), the mortgage is toxic, i.e. doomed to default from its origination.
The lender takes this high-risk mortgage and bundles it in with higher quality mortgages and then sells them as a AAA-rated, essentially no-risk mortgage-backed security (MBS).
This risk-free asset is entirely counterfeit.
The same can be said of all the derivatives based on credit default swaps and other financial instruments with phantom collateral and masked levels of risk.
Everyone claims their government bonds are risk-free until they’re suddenly not. Greek bonds were risk-free until they were suddenly not, and Japanese government bonds are risk-free until they are not. The same can be said of U.S. Treasuries: they are risk-free until the risk that is being suppressed by the Federal Reserve suddenly breaks free of manipulation/suppression.
The same can be said of the stock market. The “Bernanke Put” has supposedly rendered the stock market nearly risk-free, as the Fed will always act to prevent any serious decline.
Enron and Lehman Brothers stock were essentially risk-free, for example–until they weren’t.
Counterfeiting risk-free assets inflates increasingly fragile bubbles of trust, phantom collateral and risk. When the counterfeit risk-free assets are recognized as intrinsically risky, the entire house of cards collapses: stocks, real estate, government bonds and the deficit spending those bonds supported.
Greece is merely prelude; the global chain of risk recognition lies just ahead.
Charles Hugh Smith – Of Two Minds
Did you watch the presidential debate on Wednesday night? It is absolutely amazing how they can have an hour and a half debate about the economy and say so little. It seemed like both candidates were falling all over each other wanting to talk about how much they value education, but will more education really solve our problems? After all, 53 percent of all Americans with a bachelor’s degree under the age of 25 were either unemployed or underemployed in 2011. So perhaps they should just both agree that education is a good thing and start talking about how to create more jobs for all of us. If you want to grade the debate from a technical standpoint, clearly Romney was the winner of the debate. Romney was full of energy and was generally sharp with his answers. Obama looked like he had just popped a couple of antidepressants and was ready for nap time. As a result, this might have been the worst blowout in the history of presidential debates. A CNN/ORC International poll that was taken right after the debate found that 67 percent of all Americans that had watched the debate thought that Romney was the winner. Never before had any presidential candidate crossed the 60 percent mark in the history of their post-debate polling. So Romney definitely had a big night. But the reality is that both candidates were telling the American people what they want to hear. If either Obama or Romney told the truth about what we are facing they would lose votes, and in a race this tight both of them really want to avoid doing that. Obama and Romney both desperately want to win this election, and the words that are coming out of their mouths have been carefully crafted to appeal to the “undecided voters” in the swing states. If you actually believe that they can deliver on everything that they are promising, then you must not have been paying much attention to U.S. politics over the past several decades.
Perhaps the biggest failure on Wednesday night was debate moderator Jim Lehrer of PBS. His questions were about as far from “hard hitting” as you could get.
The hour and a half debate was almost entirely about the economy, and yet almost all of the critical economic issues were ignored.
Yes, Obama and Romney have slight differences when it comes to tax rates and regulations, but those small differences are not going to do much to change the direction of this country one way or another.
Meanwhile, there were some really huge issues about the economy that were not addressed at all last night….
1 – In an hour and a half debate about the economy, the Federal Reserve was not mentioned a single time.
2 – In an hour and a half debate about the economy, Ben Bernanke was not mentioned a single time.
3 – In an hour and a half debate about the economy, quantitative easing was not mentioned a single time.
4 – In an hour and a half debate about the economy, the term “derivatives” was not used a single time. Considering the fact that derivatives could bring down our financial system at any moment, this is an issue that should be talked about.
5 – In an hour and a half debate about the economy, there was no mention of the millions of jobs that have been shipped out of the country. Considering the fact that both Obama and Romney have played a role in this, it is probably a topic they both want to avoid. Overall, the United States has lost more than 56,000 manufacturing facilities since 2001.
6 – In an hour and a half debate about the economy, neither candidate mentioned that the velocity of money has plunged to a post-World War II low.
7 – In an hour and a half debate about the economy, the fact that the rest of the world is beginning to reject the U.S. dollar as a reserve currency was not mentioned a single time, but this has enormous implications for our economy in the years ahead.
8 – The fact that the Social Security system is headed for massive trouble was only briefly touched on during the debate. At the moment, there are approximately 56 million Americans that are collecting Social Security benefits. By 2035, that number is projected to grow to an astounding 91 million. Overall, the Social Security system is facing a 134 trillion dollar shortfall over the next 75 years. When are our politicians going to honestly address this massive problem?
9 – In an hour and a half debate about the economy, the nightmarish drought the country is experiencing right now was not mentioned a single time.
10 – In an hour and a half debate about the economy, the financial meltdown in Europe was basically totally ignored. But considering the fact that Europe has a larger economy and a much larger banking system than we do, perhaps someone should have asked Obama and Romney what they plan to do when the financial system of Europe implodes.
11 – In an hour and a half debate about the economy, the student loan debt bubble was only briefly mentioned.
12 – In an hour and a half debate about the economy, there was not a single word about the fact that the gap between the wealthy and the poor is now larger than it has been at any point since the Great Depression.
13 – In an hour and a half debate about the economy, there was no mention of TARP (which they both supported at the time). Would they both bail out the big banks if another financial crisis erupted?
14 – In an hour and a half debate about the economy, there was no mention of the economic stimulus packages (which they both supported at the time). Would they both want more “economic stimulus” if we entered another recession?
15 – In an hour and a half debate about the economy, neither candidate talked about the fact that most of the jobs our economy is producing now are low income jobs. In fact, since the end of the last recession, 58 percent of the jobs that have been created are low paying jobs.
16 – In an hour and a half debate about the economy, neither candidate mentioned that more than 100 million Americans are enrolled in at least one welfare program run by the federal government or that more than half of all Americans are now at least partially financially dependent on the government. I can’t blame Romney for avoiding this point though – he probably wanted to avoid the phrase “47 percent” at all costs.
Is this really the best that America can do?
Tens of millions of Americans tuned in hoping to become more informed about the candidates, and instead what they got was an hour and a half of tap dancing as Obama and Romney constantly tossed out buzzwords such as “education”, “energy independent” and “middle class”.
I honestly don’t know how you can possibly have a debate about the economy without talking about the Federal Reserve, quantitative easing, the trade deficit, Europe or the decline of the U.S. dollar.
But it just happened right in front of our eyes.
I don’t think that I can ever remember another presidential debate that lacked substance as much as this one did.
So what did you all think about the debate? Please feel free to post a comment with your thoughts below….
A deficiency in our democracy was revealed following the crisis, when people who were incapable of the analysis necessary to foresee the crisis were put in charge of guiding us through it. That, in itself, is evidence that our system is broken; any properly working – and sustainable – system removes the dead-weight as it is discovered. This applies equally to a productive business, a well-functioning ecosystem, and to an uncompromised political system.
Michael J. Burry is one of the few who saw the crisis coming in all its glory and bet heavily on that unmistakable eventuality. Bernanke and Geithner and Greenspan and Summers and Rubin did not see it coming. Yet, who has been in charge of guiding us out of this predictable and self-inflicted crisis? Greenspan’s prodigies: Bernanke, Geithner, Summers, Rubin and many other profoundly compromised parties.
Michael J. Burry, in the video below, delivers the keynote address at the 2012 UCLA Department of Economics Commencement. In it, he describes the process he undertook in determining that the credit bubble would pop, the housing sector would crash, and that the financial world’s blindness to the obvious would, if properly harnessed, vault him into the 1%. All of it was 100% foreseeable. There was no “black swan”. Yet, our most esteemed economic leaders were blind to it.
In 2010, Burry wrote an op-ed in the New York Times (text following video) entitled, I Saw the Crisis Coming. Why Didn’t the Fed? No member of government ever reached out to Burry to discuss the issue – to see if there was any way to bring his focused wisdom and uncompromised analysis to a government that was tragically deficient. Instead, within 2 weeks of the publication of the op-ed, all 6 of his defunct funds were audited. Soon thereafter, the FBI initiated an investigation into his activities.
Greenspan’s prodigies are beyond compromised. That the IRS and the FBI were sent to create havoc for Burry is a form of abuse of process. Our democracy is failing us. Checks and balances have been subverted by money, people in leadership positions protecting their failed legacies, and absolute impunity for the power elite who are successfully marginalizing the truth-tellers. As Burry notes, they are rewriting history.
I Saw the Crisis Coming. Why Didn’t the Fed?
“Pink slime” just had its fifteen minutes of fame. BPI, the producer of pink slime, calls it “Lean Finely Textured Beef.” BPI’s slogan is “expect a higher standard.” Pink slime starts with fatty tissues that are inherently more likely to be repositories of salmonella and e coliinfections. The tissues are shredded and rendered and most of the fat drained off. The pink slime, however, is still more likely to be infected after this processing and that makes it dangerous and can make it smell spoiled. BPI’s “innovation” was to gas the pink slime in Mr. Clean (ammonia) to try to kill bacteria and reduce the stink. The resultant pink slime is then frozen into bricks and shipped in bulk.
Pink slime was originally limited to dog food, but it has secretly been fed to Americans for a decade. Major hamburger chains, grocery stores, and school lunch programs added it to make up 15% of our burgers. The government didn’t require disclosure of pink slime or ammonia. Tests have established that pink slime remains more likely to harbor dangerous bacteria and that the only way to reduce that problem is to add so much Mr. Clean that the pink slime stinks and tastes awful. Because BPI could not sell the product if it continued to stink and taste awful they reduced the amount of Mr. Clean they used in processing and the risk of the pink slime harboring dangerous bacteria rose.
The New York Times revealed the pink slime scandal in a story that ran on December 31, 2009. Unfortunately, it buried the lead. The story broke the news that Gerald Zirnstein, a government microbiologist, had dubbed the product “pink slime” in 2002, but it did so around the 25th paragraph and the story did not generate a demand for reform.
A few weeks ago, Kit Foshee, a former BPI employee fired for blowing the whistle on pink slime, helped make the secret adulteration of hamburgers with pink slime a scandal. Once the public focused on pink slime they decided that they did indeed “expect a higher standard” for their burgers and BPI lost so much business that it closed three of its four plants producing pink slime.
The infected, odiferous, and bad tasting pink slime (aka, the “higher standard”) secretly added to our burgers for over a decade would be embarrassing to any system that pretends to the label “free enterprise,” but it has special resonance amongst economists. Adam Smith’s most famous saying, which captures his central vision of markets, is a seemingly paradoxical tale about butchers. He wrote that we could rely on the butcher providing us with wholesome meat not because of his altruism, but because of his far more reliable devotion to self-interest. Our butcher may not care about us, but he cares about whether he gets our business. This causes him to act reliably as if he cared for our well-being. He knows that if he sells us unfit meat we will cease buying meat from him and his business will fail. Pink slime is inconceivable in Adam Smith’s ode to the self-interested butcher.
Relying on corporate butchers’ self-interest (greed) has been proven to be unreliable by the pink slime deception. Greedy corporate butchers taught that they should not really care about the customer’s well-being realized that they could maximize their self-interest by selling us pink slime as long as they could do so secretly.
Modern finance theory extended Smith’s paradoxical tale about the butcher to the financial world. Theorists assured us that financial markets were, absent regulation, reliably “efficient” because they were “self-correcting.” Any pricing error created a profit opportunity for trades and those trades removed the pricing error. “Accounting control fraud” is impossible because it would create a consistent pricing bias by overstating the value of the securities issued by the frauds. The markets exclude fraud so effectively that “a rule against fraud is not an essential or … an important ingredient of securities markets” (Easterbrook & Fischel 1991).
“Private market discipline” adds to the impossibility of accounting control fraud. Creditors suffer severe losses and fail if they make imprudent loans. They have an incentive to develop the experience, expertise, and systems to ensure that they underwrite superbly prior to making large, risky loans. A lender’s central expertise should be underwriting and an investment bank’s central expertise should be “due diligence.” The biggest banks and investment banks, which pay starting compensation of well over $100,000 should have incomparable skills in conducting, respectively, underwriting and due diligence.
It is, therefore, inconceivable under modern financial and economic theory that the financial crisis we continue to suffer from could occur. As with the perversion of Adam Smith’s reliable butcher into a corporate butcher specializing in aiding the secret adulteration of our burgers with pink slime, however, the CEOs of our leading financial firms have adulterated our financial system with green slime (the color of our money.) Pink slime was limited to 15% of our burgers and it generally does not makes purchasers sick. Green slime became one-third of the mortgages made in 2006 and close to 100% of our collateralized debt obligations (CDOs). Green slime typically caused severe financial losses. The financial CEOs did not add Mr. Clean to their green slime to reduce its endemic infestation by pathogens. They did, however, tell us to “expect a higher standard.” Indeed, they ensured that the rating agencies would rate the green slime “AAA” and the outside auditors would give clean financial opinions to financial statements claiming that green slime was “prime” and free of adulteration. The meat butchers and the financial butchers called their slimed products “prime” – prime meat and prime loans.
Green slime drove the current crisis, just as it did the Enron era frauds and the second phase of the S&L debacle. Studies of “liar’s” loans have shown their fraud incidence to be 90% — they are virtually all fraudulent. The Orwellian term that BPI used to disguise the nature of pink slime was “Lean Finely Textured Beef.” The Orwellian term the industry favored to disguise the nature of green slime was “Alt-A.” “A” signifies that the mortgage is of the lowest credit risk – it is “prime.” “Alt” is short for “alternative” and, falsely, implies that the loans were underwritten by an alternative process. Failing to underwrite, e.g., by verifying the borrower’s income, is not an “alternative” means of underwriting. Honest mortgage lenders do not make liar’s loans (the term that the lenders used in private to describe their green slime) because they create severe “adverse selection” and encourage endemic fraud. Both results mean that the expected value of making such loans is negative. In plain English, that means that the lender will suffer catastrophic losses and fail.
Liar’s loans became the most common form of non-prime mortgage loans. Many commentators make the fundamental mistake of assuming that liar’s loans and subprime loans are mutually exclusive. “Subprime” refers to borrowers known to have serious credit defects. “Liar’s loans” refers to the lender’s failure to verify essential information such as the borrower’s income. Mortgage lenders created the most toxic form of green slime by making liar’s loans to subprime borrowers. By 2006, roughly one-half of the loans called “subprime” by the lenders were also liar’s loans. That means that by 2006 roughly one-third of all mortgage loans made that year were liar’s loans. Liar’s loans grew massively between 2003 and 2006. The growth rate appears in that period appears to be over 500%. Liar’s loans hyper-inflated the housing bubble.
The rapid growth in liar’s loans continued after the mortgage industry’s own anti-fraud experts and federal and state regulators warned that loans were endemically fraudulent – green slime. Lenders and their agents were responsible for putting the lies in liar’s loans by creating perverse compensation systems and encouraging liar’s loans despite the fact that they knew such policies were the perfect growth medium for green slime. (Criminologists call environments that create the perverse incentives for crime “criminogenic” – a direct steal from microbiology’s concept of a “pathogenic” environment.)
Liar’s loans constitute the ideal “natural experiment” that allows us to test why lenders made millions of liar’s loans and why the largest commercial and investment banks purchased the green slime to create the even slimier CDOs. No government official, law, or rule required any mortgage lender to make liar’s loans or any entity (and that includes Fannie and Freddie) to purchase liar’s loans or CDOs. To the contrary, federal regulators – even under the Bush administration – warned against making liar’s loans and Fannie and Freddie did not get credit toward their “affordable housing” goals for making liar’s loans. Lenders made, and the largest investment banks and Fannie and Freddie purchased, vastly more liar’s loans after being warned that such loans were overwhelmingly fraudulent and likely to cause enormous losses.
Why did lenders make, and investment banks purchase, over a trillion dollars in liar’s loans and sell roughly a trillion dollars in CDOs in which the “underlying” was overwhelmingly liar’s loans? Contrary to many commentators’ claims, it was the norm for sales of green slime to be made “with recourse” so lenders typically had enormous “skin in the game” even if they sold their liar’s loans to the secondary market. Indeed, the sales of liar’s loans inherently required that the fraudulent lenders engage in further frauds when they made false “reps and warranties” as to the quality of the green slime they were selling. Making, selling (with recourse), and purchasing liar’s loans and CDOs was certain to produce massive losses.
All of modern finance theory predicted that green slime would immediately be driven out of the marketplace. Instead, green slime spread rapidly for many years and became dominant in some massive financial sectors (CDOs), common in one of the world’s largest financial spheres (U.S. residential housing), and the norm at most of the world’s most prestigious commercial and investment banks. Three of America’s five largest investment banks were destroyed by their embrace of green slime. Green slime grew so rapidly that it caused financial bubbles in several nations to hyper-inflate.
Modern finance theory was falsified by research findings in criminology two decades before modern finance theory was created. Control frauds cause greater financial losses than all other forms of property crime – combined. The “weapon of choice” for financial control frauds is accounting. The optimal “recipe” for a lender or purchaser of loans engaged in accounting control fraud calls for the creation of vast amounts of green slime. The recipe has four ingredients.
- Grow extremely rapidly by
- Making or purchasing crappy loans or derivatives (green slime) at a premium yield while
- Employing extreme leverage and
- Providing only trivial allowances for the inevitable eventual losses
The title of George Akerlof and Paul Romer’s classic 1993 article explaining why green slime can become epidemic explains why it is rational for CEOs to cause “their” firms to make and purchase green slime (“Looting: the Economic Underworld of Bankruptcy for Profit”). Akerlof & Romer emphasized that the fraud recipe produces a “sure thing.” Indeed, it produces three sure things. It guarantees that the firm that follows the recipe will report enormous (albeit fictional) income in the near term. (If many firms in the same industry follow the same recipe and use the same ingredients they will hyper-inflate financial bubbles. This can greatly extend the life of the fraud because losses on the bad loans will be hidden by refinancing. The saying in the trade is that “a rolling loan gathers no loss.”) Modern executive compensation, which the CEO typically determines, guarantees that the record reported income will promptly make the CEO wealthy. The fraud recipe also guarantees that the firms will suffer massive losses, particularly if the frauds hyper-inflate a financial bubble. As Akerlof and Romer’s title makes clear, the firm fails (“bankruptcy”), but the CEO looting the firm walks away with a huge “profit.”
It should, of course, be impossible for lenders making liar’s loans to sell such endemically fraudulent loans to the world’s (allegedly) most sophisticated sources of private market discipline. In fact, roughly 90% of the endemically fraudulent liar’s loans were sold to the world’s most prestigious commercial and investment banks and, eventually, Fannie and Freddie. Those commercial and investment banks pooled the green slime mortgage loans to create the ultimate in cynicism and fraud – the greater green slime known as CDOs. The underlying instruments for CDOs were commonly liar’s loans. The “AAA” tranche of the typical CDO represented 80% of the overall CDO. Think of what that means. The investment banks took loans they knew to be endemically fraudulent – the slimiest of green slime available – and called the vast bulk of the slime “AAA” – the credit rating that is supposed to be granted only to the investments posing the absolutely lowest degree of credit risk. Calling green slime “AAA” is the ultimate in financial chutzpah.
The key function of regulators in food or finance is to prevent the spread of pink and green slime. If cheaters gain a competitive advantage over honest firms it creates a “Gresham’s” dynamic – bad ethics drives good ethics out of the markets. Market forces become perverse. The Federal Home Loan Bank of San Francisco understood this in 1990-1991 when we used normal supervisory powers to put an end to the making of liar’s loans, which were becoming common among Southern California savings and loan. We were veterans of the regulatory struggle to identify, close, and prosecute the accounting control frauds that drove the second phase of the S&L debacle so we recognized that liar’s loans were certain to be open invitations to fraud and disastrous. Unfortunately, the fraudulent lenders that made liar’s loans moved overwhelmingly to ensure that they were not subject to federal regulation, e.g., by becoming mortgage banks.
Congress responded to this regulatory black hole by passing the Home Ownership and Equity Protection Act of 1994 (HOEPA). HOEPA gave the Federal Reserve the exclusive authority to ban any unsafe mortgage lending practice by any lender, even those not normally subject to federal banking regulation. Sheila Bair, originally a senior Treasury official appointed by President Bush, worked with Federal Reserve Board Governor Gramlich to urge the Fed to ban liar’s loans. Liberal consumer groups, including ACORN, and state regulators asked the Fed to use its HOEPA authority to crack down on liar’s loans.
Fed Chairman Alan Greenspan and his successor Ben Bernanke, however, were devout believers in the dogma that held that securities markets automatically excluded fraud. They refused to ban liar’s loans. (Bernanke, under intense Congressional pressure, finally adopted a rule on July 14, 2008, under HOEPA banning liar’s loans. Even then, he delayed the effective date of the rule until 2009.) Greenspan and Bernanke were so gripped by anti-regulatory dogma that they refused to even send examiners into bank holding company affiliates making liar’s loans to get the facts.
The Fed had at all relevant times during the crisis complete statutory authority under HOEPA to ban green slime. Its leaders’ refusal to do so was what allowed fraudulent loans to become endemic and drive the crisis. The nation and much of the globe continue to pay a terrible price for Greenspan and Bernanke’s anti-regulatory dogma, which ascribed miraculous abilities to markets to eliminate green slime – abilities that had no basis in reality. The markets did the opposite, massively expanding the origination and sale of green slime. Adam Smith’s reliable butcher had become a mass purveyor of green slime. The financial markets’ embrace of green slime was so complete that they collapsed and could only be rescued by extraordinary governmental aid. Green slime is the great killer of jobs and the mass destroyer of wealth, particularly working class wealth. The recent passage of the fraud-friendly JOBS Act will produce increased green slime. The Bush and Obama administrations’ failure to hold the elite CEOs who led the massive control frauds that spread the green slime accountable for their crimes is as pusillanimous and reprehensible as it is dangerous. In the financial sphere, our top priority should be ensuring that we end the frauds that produce the green slime that causes our recurrent, intensifying financial crises.
William K. Black for Financial Sense