I Guess It Really Ain't Over 'Till It's Over

Anything I wanted was a phone call away. Free cars. The keys to a dozen hideout flats all over the city. I bet twenty, thirty grand over a weekend and then I'd either blow the winnings in a week or go to the sharks to pay back the bookies.
Didn't matter. It didn't mean anything. When I was broke, I'd go out and rob some more. We ran everything. We paid off cops. We paid off lawyers. We paid off judges. Everybody had their hands out. Everything was for the taking. And now it's all over.
And that's the hardest part. Today everything is different; there's no action... have to wait around like everyone else. Can't even get decent food - right after I got here, I ordered some spaghetti with marinara sauce, and I got egg noodles and ketchup. I'm an average nobody... get to live the rest of my life like a schnook.
-- Henry Hill, Goodfellas

Just a little more than 17 months ago, I convinced myself that Wall Street bankers had finally screwed up the racket they had going and were destined, like Ray Liotta's character in Goodfellas*, to live out the rest of their lives like "schnooks." Bank stocks plummeted. Credit markets froze. And Michael Lewis -- who wrote the seminal take on industry -- even declared that Wall Street had finally reached "The End."

* Speaking of the mafia, a Jimmy Breslin quote --with a slight modification by me--seems particularly apt for this occasion. It appears to me that Wall Street bankers, just like gangsters, have  "yet to find anything that's too small to steal."

Ah, how naive we were...

As if you needed any further proof that wasn't going to happen, here it is: Lloyd Blankfein--The $100 million Man.

It's tough to decide what angers me most about this middle-finger to taxpayers, the millions of Americans still out of work and those being forced out of their homes. Perhaps it's that Goldman--despite its protests otherwise--has benefited from government assistance in many ways other than the TARP money it claims it didn't need, from the government guarantees of its debt to its conversion to a bank-holding company to when it got billions of dollars through a back-door bailout of AIG. Or, it could be that Wall Street cares extraordinarily little about fixing the pay practices encouraging behavior that hurts shareholders, clients, and taxpayers. But maybe it's just that these assholes actually think they deserve it.

Whatever the case, it's pretty clear we're a far cry from where we were just a little while ago. I remain unconvinced that even the current plan to regulate the financial industry will do much to eliminate the worst practices on Wall Street or make the economy safer. And if it looks that way now, just imagine what it will look like in 17 months...

Who is To Blame?

Although it’s fun to vilify bankers, the truth is that there are many people whose interactions helped contribute to the financial crisis. People want to treat finance like physics, but it’s much more like biology. As Richard Bookstaber points out in his excellent A Demon of Our Own Design, the financial system is similar to a complex ecosystem—a minor event in one part of the world can eventually move through the system and lead to a major blow-up in another.

Unfortunately, many of the people within the system have incentives that are not aligned with the economy’s greater good. In a vacuum, many of these actors may believe there is nothing wrong with acting in their own self-interest. But when these actions are combined, the result can be disastrous.

These actors include:

Investment Banks: Salesmen have an incentive to sell products to clients (even if inappropriate for that client), traders have incentives to take risks, investment bankers have incentives to create bigger and bigger deals, etc. Not spending too much time on it because you’ve heard this all before.

Institutional Investors: Often, they are judged by relative, rather than absolute, performance. Even if a fund manager believes buying a CDO, for instance, is a bad idea in the long-term, he might need to buy them now or risk being outperformed by competitors (which would lead to funds flowing out of his funds and into the better performing ones). And even if the CDOs eventually do blow up, he can simply point to these other funds to show he shouldn’t be blamed—“no one else saw it coming, either”. As long as he does no worse than his competitors, he’s not in bad shape. This “Keeping Up With The Joneses” mentality can increase demand for products (whether CDOs or tech IPOs) from investment banks, whether or not the investments are sound.

Monoline Insurers and AIG: They were paid for taking on risk—not surprisingly, they took on a lot of it. They’re willingness to insure many of the structured finance products allowed many of the deals to be workable (on paper, at least) for the banks. No doubt this helped drive the issuance of these products.

Rating Agencies: They are paid by the issuers of the securities, so they have an incentive to give better ratings (even if they claim they aren’t influenced by it). You’ve heard of the we’d- rate-these-if-they-were-structured-by-cows fiasco. But they also have an incentive not to look too foolish. Once they began actually downgrading the structured finance instruments and the insurers, it led to a downward spiral across the financial system.

Mortgage Originators: They were paid for making mortgages and, thanks to securitization, did not need to worry about the risks. Not surprisingly, they sold as many mortgages as they could, some resorting to boiler-room tactics including misrepresentation and fraud. They clearly did not have the best interests of the client in mind.

Regulatory Agencies: Some of them are funded by the people they regulate, so they have incentives to race-to-the-bottom when it comes to regulations. They also might have incentives to govern by rules rather than standards—easier to administrate, but also creating a demand regulatory arbitrage (triple-A requirements led to demand for the insurers). A cynic might also suggest that the regulators themselves have incentives not to question the people the regulate too much for fear of losing future employment opportunities when they move to the private sector.

Politicians: Obviously, “increasing homeownership” is a pretty good platform for both parties. Unfortunately, it leads to the creation of policies that allow many of these other actors to do bad things.


Homeowners: If they weren’t willing to trust financial professionals and take out mortgages, the investment banks couldn’t have created quite as many products (although, of course, many of the more complicated products were synthetic and, therefore, did not require actual mortgages).

A simple list that can go on and on.

The bigger point of this is that reforming the financial system requires more than just taking on banks on a few issues--it will require an extraordinary overhaul.

Theory vs. Reality?

A letter to the editor in the WSJ the other day caught my eye, because it highlighted a divergence between theory and how at least one investor perceives reality.

According to standard theory, shareholders actually want managers to take risks. In fact, corporations are in many ways designed to discourage managers from being too risk-averse. As Jonathan Macey said in a WSJ op-ed "the public shareholders of these companies tend to be highly diversified against the risk of failure at any particular financial institution, so they have a strong personal interest in seeing the bankers who manage their leveraged investments swing for the fences." 

One letter writer did not agree:

Jonathan Macey lays the blame for the fury about bank bonuses on the government's too-big-to-fail approach, stating that shareholders actually want the banks to take risks in the hopes of outsized returns ("Obama and the 'Fat Cat Bankers'," op-ed, Jan. 13).
Perhaps some amorphous institutional shareholders seek that, but the individual shareholder surely does not. We have not seen the fruits of these new profits the banks are earning. The bankers are still getting millions of dollars and stock (diluting our holdings), while we have seen our stock values fall by two-thirds or more and our dividends cut by as much as 80% or 90%. I also don't buy the argument that talent will leave. There is plenty of talent out there, and frankly, there aren't that many places to go these days.
Former Citigroup CEO John Reed is not mistaken that the bankers "don't get it." The government doesn't get it either, but don't fault the shareholder. We are not "enjoying the rewards" of this risk-taking, nor do we endorse it. Try being a small shareholder and getting heard by bank management or the board of directors.
Sure, we could sell our stock to express our displeasure, but at greatly reduced prices because of the bankers' actions. Banks should be giving something back to shareholders and reducing bonuses proportionately to do so, before rewarding more risk taking by their staffs.
Annie Eagan
Chicago

I thought the letter highlights two interesting issues:

First, the theoretical view clearly doesn't reflect the desire of some individual shareholders, especially when it relates to institutions such as banks. Certainly, many people invest in mutual funds (which should give them some diversification) but  I imagine many of the individual shareholders in the largest banks (such as Citigroup) and other "blue-chips" such as General Electric invested large portions of their holdings in these companies because they considered them "safe and steady" investments (maybe that's dumb, but it's not that point). They wish these companies took fewer risks, not more.

Second, there is clearly a conflict of interests between the institutional shareholders (who might hold some power) and the individual shareholders (who probably don't have any). Granted, the institutional shareholders are in a sense just proxies for the individuals with stakes in their funds, but I assume managers' priorities are not in harmony with those of the underlying shareholders because of various other incentives and motivations in play. Even if the individual are diversified (through owning a mutual fund, for instance), would these individual investors prefer that the institutional shareholders push the managers to be more risk averse?

"Lure people into that calm and then just totally fuck 'em"

Over this winter break, I spent a good deal of time reading finance-related books that were written prior to the current crisis. Although many people that bear responsibility for the crisis have attempted to exonerate themselves with the argument that “No one saw it coming,” it appears to me that many people warned about the dangers of derivatives well in advance. As many of you know, I’m not exactly enamored with the practices on Wall Street. So it came as even a surprise to me that I’d finish reading these books even more outraged.

I have always been somewhat skeptical about the value of derivatives. Looking at credit-default swaps*, for example, it’s quite easy to see how they can have many negative side effects. Many people look to the CDS markets as a sign of a company’s health; a less scrupulous trader might realize this gives them an opportunity sell a stock short and then manipulate the more thinly-traded CDS market to stoke unfounded fears about a company. CDS contracts also pay 100 cents on the dollar; this gives a CDS-buying creditor holding bonds nearing default an incentive to push a company into bankruptcy to recover its full investment, rather than working out a restructuring agreement with the company and other creditors that would benefit them all. Finally, CDS allow traders to wildly speculate on a market in dollar quantities many multiples of the available underlying assets; we all saw how that whole insuring CDO thing worked out for AIG.

* CDS essentially allow a trader to buy an insurance policy that will pay in the event another company defaults. However, unlike a home or car insurance policy, you don’t need to own the underlying asset (in this case a bond) in order to purchase the insurance.

After reading these books, I came away troubled not just because of the potentially nefarious uses of structured finance products, but because we've known about these issues for many years. As the quote in the headline of this blog post indicates (from Frank Portnoy’s FIASCO), investment banks can use the complex nature of these instruments to deceive naïve investors (see Orange County's bankruptcy and Proctor & Gamble's $100 million+ derivatives loss) and run-up their own profits. Or they can collude with fund managers to trick government regulators and investors about the true nature of their strategies — many derivative securities are created to allow fund managers to sidestep regulations that ban them from trading foreign currencies or making leveraged bets. And in one of the more egregious abuses of derivatives, investment banks have also used these products to help companies cover-up hundreds of millions of dollars of losses, turning bad investments into something that looked like a big gain for current management, but that would surprise shareholders with enormous losses later.

I really don’t understand why we allow so many things like this to go on in the financial sector without much questioning. There are certainly benefits we enjoy from the use of derivatives (especially the simple futures and forwards that allow for hedging) — but shouldn’t we also consider their costs? Again, I turn to the toaster analogy. If 86% of a certain type of toaster blew up, there’d certainly be some push for further regulation. But 86% of CDOs backed by mortgages (originated in 2007) have defaulted, and we’re still waiting for something to be done.

I Thought It Was the Dadgum Librls That Didn't Understand Business

In today’s Wall Street Journal, columnist Holman Jenkins predictably defends investment banks such as Goldman Sachs from criticism of their despicable behavior leading up to the current economic crisis. Following the reasoning of other free-market ideologues that have backed the banks, Jenkins makes his claim using two points: First, that the investment banks sold their products to “professionals” that should have known better, and second, that investment banks always take positions counter to their clients' interests. These arguments demonstrate either ignorance about the investment banking business, or a willingness to mislead readers on how it really works.

Jenkins wrote:

“Goldman chief Lloyd Blankfein was understandably wide-eyed with wonder at last week's hearing of the Financial Crisis Inquiry Commission. He pointed out that the people on the other side of every Goldman housing-related trade were, for Jiminy Cricket's sake, professional investors.”

Many of the investment banks' defenders have used the “professional investors” argument, but it stands up neither to general nor specific critiques.

Generally speaking and contrary to popular belief, caveat emptor is not a well-established legal principle (thanks contracts class!). Professionals in other fields have many avenues of recourse when they are sold a defective product—just because you’re an expert doesn’t mean you’ve disclaimed all warranties (if this wasn’t true, we wouldn’t need lawyers). Certainly, if a supplier sold GM a faulty $1 part used in a Chevrolet, we wouldn’t want to shield the supplier from liability simply because there are automotive “professionals” that also work at GM. It eludes me as to why you’re liable if a $15 toaster blows up, but not if a $1 billion collateralized debt obligations of asset-back securities does. (These arguments also fail to take into account that Goldman is certainly much more sophisticated than many of the clients it sells to. Clients such as public pension funds in the middle of Wisconsin relied on these financial professionals to give them sound advice—not send them to the poorhouse.)

More specifically, the behavior as it relates to these complex financial products goes beyond investors making a bad deal — there is evidence of fraud and misrepresentation when it comes to creation of these products. Many of the bond insurers (who similar to AIG insured these CDOs) have gone back to find documentation for mortgages stuffed in CDOs is missing or falsified. It’s one thing to fault an investor for buying a product based on the assumption that housing prices will always go up. It’s quite another to assume that they should have been aware the purchaser of a home made only $50,000 per year instead of $100,000, despite an investment bank and its lawyers telling them the mortgage application said otherwise. It seems to me that the shady mortgage origination practices, rating agency bribery, and corrupt sales techniques practiced by investment banks has gone overlooked (or has been forgotten) in this discussion.

Jenkins’ second argument is no better:

“He might have added that Goldman bets against its clients every time it buys something they want to sell or sells something they want to buy. He might have suggested that any client who doesn't understand Goldman is looking after its own interests (just as Goldman expects the same of its client) is an idiot and has no business being in business.”

This line of defenses misses two key points about the issue at hand.

First, it doesn’t fairly represent what investment banks do when they make markets for their customers. When they buy a security from a client, they’re not making a bet on the future price path—they’re simply selling liquidity to the customer. In return for the service of buying at almost any time the client wants out of a product, the investment bank “charges” the customer by buying the security for slightly less than it’s really worth. It makes it money not by holding onto the bond and praying its price will go up, but rather by quickly flipping it to another client willing to pay full price.* This has nothing to do with taking a position opposite either client.

*The idea of a bid-ask spread is familiar to anyone that collected baseball cards as a kid and read Beckett's.

But even if we take the market-makers argument at face value, it really has nothing to do with the practice FCIC chairman Phil Angelides was referencing when he compared the investment banks to salesman who sold cars with faulty brakes while taking out insurance on the driver — the origination of complex structured finance product. In this case, the banks are not taking a position against the clients — they’re just selling them a product they created. Issuing a CDO of ABS is no different than taking a company public—except with more complex models and a lot more profit for the bank. Using investment bank’s market-making business is an attempt to excuse bank's behavior by shifting the argument to a completely different service the banks provide.

It’s unfortunate the much of the furor over investment banks have focused on their outrageous bonuses. Although most investment bankers are certainly overpaid and overconfident, it distracts the public, the media and even me (at times) from digging into the real questions about their business practices. I remain unconvinced that anything will be done to taking real steps to clean up this corrupt industry.

UPDATE: Principle not principal. Thanks to commentor Nemo on the Baseline Scenario for pointing that out.