Relevant and even prescient commentary on news, politics and the economy.

“The messenger wore a skirt,” says Marna Tucker, “Could Alan Greenspan take that?”*

by run75411

Re-posted from New Agenda April 2009, Bill reminds us of some of the history leading up to today:

Editor’s note: We are pleased to present this guest post by Bill H, who’s known around the internet as run75441, and who can usually be found writing in his area of expertise: finance.

Recently, Stanford Magazine did a nice article on one of the University’s former law review presidents who graduated at the top of the 1964 class. The first female to hold either distinction of graduating first in her class and also as president of the school’s Law Review. “Prophet and Loss.” April 2009.

“Well, you probably will always believe there should be laws against fraud, and I don’t think there is any need for a law against fraud,” Alan Greenspan

“I thought it was counterproductive. If you want to move forward . . . you engage with parties in a constructive way,” Rubin told the Washington Post.

“My recollection was . . . this was done in a more strident way” … “characterized as being abrasive.” Arthur Levitt

It would seem these three, coupled with Larry Summers’s push back in Congress on the regulation of derivatives, had the problem and not Brooksley Born. Since then, all three men have suggested there should have been more regulation of the derivatives market that Greenspan has called its recent collapse a “once in-a-century credit tsunami.” Called a modern day Cassandra by Stanford Magazine, one could only wonder where we would be today if the economic and financial wizards had heeded her words.

Short histories on CDO/CDS . . . Collateral Debt Obligations (CDO) were invented by Drexel Burnham Lambert (Milken) as a way to package asset based securities. The CDO was tranched into similar asset backed securities of the same rating allowing investors to concentrate on the rating rather than the issuer of the bond. Ten years later, JP Morgan invented Credit Default Swaps (CDS) was used as a mechanism to bet on a 3rd party default. In 2000, CDS were made legal with the passage of the Commodity Futures Modernization Act and any regulation of them was stymied with this bills passage. Later on, an investment firm decided to team CDS and CDO together, transferring the risk from the CDO to the issuer of the CDS, and creating a synthetic CDO.

It was 1994, that Bankers Trust lost ~$800 million from various derivative investments. The chief losers were P&G and Gibson Greetings. Bankers Trust was formed by a consortium of banks, shedding the loan image for conducting trades. Bankers Trust was successfully sued by P&G for its losses by claiming racketeering and fraud. Bankers Trust also became known for its remarks about Gibson Greetings not knowing what Bankers Trust was doing. In 1998, Bankers Trust pled guilty to institutional fraud due to the failure of certain members of senior management to escheat abandoned property to the State of New York and other states. Again in 1998, LCTM was struck by a downturn in the market when Russia defaulted on government bonds, a security LCTM was holding. To make a significant profit on small differences in value, the hedge fund took high-leveraged positions. At the start of 1998, the fund had assets of about $5 billion and had borrowed about $125 billion. When investors panicked and sold Japanese and European bonds and bought US treasuries, the spreads between LCTM holdings increased, resulting in a loss of ~$1.8 billion by August 1998. LCTM was saved by an orchestrated Fed bailout utilizing private investors.

It was in 1998 and Brooksley Born testified to Congress about the dangers of the unregulated derivatives market referencing the LCTM losses as a recent example. It was also then that deputy Treasurer Larry Summers testified to Congress that Born’s desire to regulate is “casting a shadow of regulatory uncertainty over an otherwise thriving market.” Larry’s testimony set the stage for Congress to rein in the power of the Brooksley Born’s CFTC and the passage of Phil Gramm’s Financial Service Modernization Act of 1999 prohibiting the regulation of the derivatives market (In 2005, the revised bankruptcy laws would place derivatives outside of the laws also making it the first to receive compensation). W$ and banks had clear unregulated sailing in the sea of laissez faire in 2000 with a closing of the door for debtors in 2005. It was little better than a roach motel, you could check in but you can not check out.

Again in 1999 and in the Senate that opposition arose to the passage of the Financial Services in the form of Senator Dorgan of North Dakota. An excerpt from the Senator’s speech that day before the bill was passed:

“I, obviously, am in a minority here. We have people who dressed in their best suits and they just think this is the greatest piece of legislation that has ever been given to Congress. We have choruses of folks standing outside this Chamber who spent their lifetimes working to get this done, to say: Would you just forget all that nonsense back in the 1930s about bank failures and Glass-Steagall and the requirement to separate risk from banking enterprises; just forget all that. Time has moved on. Let’s understand that. Change with the time. 

We have folks outside who have worked on this very hard and who very much want this to happen. We have a lot of folks in here who are very compliant to say: Absolutely, let me be the lead singer. And here we are. We have this bill, which I will bet, in 5, 10, 15 years from now, we will be back thinking of this bill like we thought of the bill passed in the late 1970s and early 1980s, in which this Congress unhitched the savings and loans so some sleepy little Texas institution could gather brokered deposits from all around America and, like a giant rocket, become a huge enterprise. And guess what. With all the speculation in the S&Ls and brokered deposits and all the things that went with it that this Congress allowed, what did it cost the American taxpayer to bail out that bunch of failures? What did it cost? Hundreds of billions of dollars. I will bet one day somebody is going to look back at this and they are going to say: How on Earth could we have thought it made sense to allow the banking industry to concentrate, through merger and acquisition, to become bigger and bigger and bigger; far more firms in the category of too big to fail?

Senator Dorgan’s Speech, November 4, 1999 on “Gramm-Leach-Bliley Act” also known as the Financial Services Modernization Act

Larry Summers has been present throughout much of this change, supporting it, denigrating the opposition, and now claiming his experience at D. E Shaw gives him an insider’ knowledge as to how the derivatives market works. While President of Harvard University; Larry received a letter (May 12, 2002) from Iris Mack, a new employee of the Harvard Management Company managing Harvard’s endowment funds. A Doctorate in Mathematics from Harvard and a former employee of Enron who dealt in derivative trades, she expressed concerns about the trades (swaps and other complex financial instruments) being made by the funds and the lack of understanding of the trades by the traders. On July 1, Iris was called into the office of Jack Meyer, the chief manager of Harvard Management. On July 2, Iris was fired for making what Harvard Management termed as: “baseless allegations against HMC to individuals outside of HMC.” “Ex-Employee Says She Warned Harvard of Risky Moves” Boston Globe, April 3, 2009. While Harvard Management Company claims above normal returns on its endowment funds, it has spent much of last year selling off private equity and investments to raise cash.

The attitude expressed by our head of the Economic Council is one of “trust me now” as I have all of the experience necessary to fix the current economic and financial problems even though he has helped to initiate today’s issues by denigrating Brooksley Born’s request for regulatory power to Congress, even though he ignored the advice of Iris Mack at Harvard University, even though he consulted to D.E. Shaw, a hedge fund, and making ~$5.2 million while being the financial engineer’s engineer, and even though he has been repeatedly wrong in his direction and advice to Congress and Industry. In the name of deregulation and global efficiency, Larry was its cheer leader while signing off on a letter encouraging the dumping of toxic wastes in Asia at the World Bank. He helped to shepherd China into the WTO claiming:

“’The agreement with China is a one-way street,’ Summers said. ‘China opens its markets to an unprecedented degree, while in return the United States simply maintains its current market access policies,’ he said. ‘It is difficult’, Summers added, ‘to discern any disadvantage to the United States in passing this legislation.’”

— Robert Waldman, Economist, Angry Bear blog.

Personality, ego, and a blind belief in the ability of the market place to dictate the proper path and the correction has gotten in front of common sense. Maybe it is time to sideline Summers and his protégé Geithner in favor of Born, Mack, and Dorgan. Each has shown more foresight into how today’s problems and issues were created and how to resolve them.

“I certainly am not pleased with the results,” she adds. “I think the market grew so enormously, with so little oversight and regulation, that it made the financial crisis much deeper and more pervasive than it otherwise would have been.”   

Brooksley Born, Stanford Magazine, April 2009

*“The messenger wore a skirt,” says Marna Tucker, a Washington lawyer and a longtime friend of Born. “Could Alan Greenspan take that?”

Tags: , , , , Comments (8) | |

The Meaning of "Monty Python and the Meaning of Life"

Robert Waldmann

Barry Ritholtz argues that the problem with mortgages was underwriting standards and not securitization. He appeals to the very great authority of Monty Python. Click the link.

Ritholtz seems not to be familiar with this new idea in economic theory called “Nash equilibrium”. Over -rated yes. Totally irrelevant not so much. One can not assume that underwriting standards are exogenous. If there had been no MBS, no firm would have underwritten those mortgages. It was exactly because it was possible to blend them, and then sell them to people who didn’t spin the mortgage tapes before buying, that the mortgages existed in the first place.

Let me work with his analogy. First, while I have great respect for the Monty Python team, few people have been killed by canned Salmon. Even blended into mousse, it kills fairly quickly and can be tracked back to the canner. The way bacteria work is that if you mix some contaminated stuff with other stuff you have trouble for sure. It doesn’t work that things seem fine until people notice.

At a way lower cultural level than Ritholtz I appeal to road runner cartoons. Wile E. Coyote runs along in mid air until he notices. Then he falls. As noted by everyone, this is the way financial markets really work. The non Monty Python quality humor is based on the fact that gravity doesn’t really work that way. Neither do bacteria. Analogies between rotten mortgages and rotten Salmon fail for this reason.

Notably, the ingredients in the Salmon mousse are few enough that the dead diners immediately know what went wrong when death points at the mousse. That’s not the way MBS work let alone CDOs of MBSs or CDOS of tranches of CDOS.

A better analogy would be making hamburger. Bits from hundreds of steers end up in the same package at the supermarket. If one bit has E. coli on it, you can get sick. If they tried to sell you that bit, you wouldn’t buy it because it would stink. However, mixed in with hundreds of uncontaminated bits of beef, it doesn’t stink.

Is there a hamburger problem? Yes there is. One is much more likely to get food poisoning from hamburger than from unprocessed meat. Is the solution special regulation of hamburger? It sure is.

Tags: , , , , , , Comments (23) | |

Why didn’t CDO purchasers just pool for themselves ?

Robert Waldmann

One brief question about structured finance and a possible answer. Why did investors need financial operators to make pools for them ? Now it is easier to make sense of financial intermediaries which pool than of those which pool and tranche. The obvious explanation is that an investor investing a small amount of money can’t buy a diversified portfolio without paying absurd amounts in odd lot fees.

However, this doesn’t seem to fit the CDO market. Correct me in comments if I’m wrong, but I thought the final investors were entities with a good bit of money to invest — pension funds, endowments, insurance companies etc. Importantly one can achieve almost as good a risk return portfolio buying only assets in a randomly chosen subset of say 10% of all assets. The variance of a portfolio is a sum of say the market variance plus … plus idiosyncratic variance on single assets. So a term which can’t be diversified away plus stuff plus terms which are proportional to the inverse of the number of assets in the portfolio.

I have an idea. People investing other people’s money in fixed income instruments do not like to pool, because it is too easy ex post to find a better portfolio of fixed income instruments. Some will default. The principal is likely to note one bond that defaulted and ask the manager why he bought that bond not the similar one which didn’t default.

Letting someone else pool means you get an asset which pays a fairly high fairly safe return and those ugly but unimportant specific underlying assets which defaulted are hiden from the principal’s eyes.

Tags: , , , Comments Off on Why didn’t CDO purchasers just pool for themselves ? | |