Ethel the Blog

John Lanchester - whose A Debt to Pleasure more than lived up to its title for me - has supplied what I’ll call the read of the month in his LRB piece It’s Finished.  It’s a Brit-centric and deliciously vicious bit about how the financiers have propelled a couple of Aegean stablesworths of shit at the fan.  A fan which is, of course, not pointed at the financiers.  The whole thing is bloody well worth a couple of reads.  I’ll steal the last bits from which I’ve pinched the title.

…

About twenty years ago I bumped into Alan Hollinghurst at a party at the Poetry Society. He greeted me with the words, ‘Hello. I’m going to tremendous, Basil Fawltyish lengths to avoid being introduced to Sir Stephen Spender,’ whose collected poems he had just given an unglowing review. ‘Tremendous, Basil Fawltyish lengths’: that phrase stuck with me. It comes to mind when I look at Anglo-Saxon attempts to address the crises in their respective financial sectors. The UK and US plans are different, as I’ve said, but at their heart they both show the governments going to tremendous, Basil Fawltyish lengths in order to avoid taking the troubled banks into public ownership. Our governments are prepared to pay for them, but not to take them over.

There are four reasons for the reluctance to take over the banks, of which the first isn’t a real reason but a piece of political bullshit.

1. Because the government would be bad at it. This is the only reason governments are willing to give in public, and it fails the most elementary test of all: only a professional politician can say it with a straight face. Bad at running the banks, compared to the bankers who broke capitalism? Please. But this is the closest they can get to admitting the first real reason, which is:

2. Because if the banks were taken over, then every decision they take would come at a potential political cost to the government. Your state-owned mortgage lender is threatening to repossess your house, after you fell behind on the payments? Blame the government. Your firm is laying off half its workforce because the bank won’t roll over its loan? Blame the government. This, of course, is in addition to all the other economic things for which people are already blaming the government. People are grumbling now, but to nothing like the extent they would if the banks were directly owned by the state. Politicians simply aren’t willing to take on the responsibility for the banks’ actions.

3. They also don’t want to admit the extent to which we are all now liable for the losses made by the banks. Guess what, though: it’s too late. The 30 per cent collapse in the value of sterling over the last months is something which is only just beginning to be noticed by the public at large; but it is unlikely to go away as quickly as it arrived. The reason sterling has crashed is simple: the markets are pricing in the fact that we the taxpayer are on the hook for the losses made by our banks. The markets assume that we can’t or won’t default on our government debts – that would mean we simply can’t afford to pay back the amount we’re currently borrowing. They’re probably right about that. But Alistair Darling’s desperately grim Budget made it clear just how deep in the mire we are. As for how bad it is, and how quickly it’s gone bad, well: in March last year, at the time of the Budget, the projected deficit for 2009-10 was £38 billion. By 24 November, the projected deficit was £118 billion. In the Budget on 22 April, Darling admitted that the real figure is going to be £175 billion. The total projected borrowing for the next four years is £606 billion. National debt will hit 79 per cent of GDP – the highest peacetime figure ever. The economy is going to have its worst year since 1945. The debt is going to cost in the range of £35 to £47 billion a year to service. That’s just the debt alone; we’re going to be spending more on debt than we are on the entire transport budget. Perhaps New Labour might consider changing its motto from ‘Education, education, education’ to ‘Debt, debt, debt’.

That means tax rises, a near total freeze on government spending, swingeing public-sector job cuts, companies laying off every worker they can to save costs, and a dramatic upward spike in unemployment. The one easy thing the government will be able to do to help itself is to make inflation go up – that helps, because it decreases the real cost of the debt. An inflation rate of 5 per cent means that the debt goes down in cost by 5 per cent every year, magically and just by itself. From the point of view of a heavily indebted government, that’s good news; for other parts of the economy, for borrowers and for anyone holding sterling, it’s less good. To compound this already desperate picture, we also have huge levels of personal debt, directly arising from our credit bubble. The average British household owes 160 per cent of its annual income. That makes us, individually and collectively, a lot like the cartoon character who’s run off the end of a cliff and hasn’t realised it yet. None of this is secret, and investors looking at the prospects for sterling are making up their minds and bailing out. The investor-pundit Jim Rogers, colleague of George Soros, is advising anyone who will listen to ‘sell any sterling you might have. It’s finished. I hate to say it, but I would not put any money in the UK.’ This isn’t nice or polite, but it puts into the public domain what a lot of international money men are saying in private. More to the point, it’s a policy on which they have already acted. This is the reason an auction of government debt held in March failed. The debt was for 40-year bonds paying out at a rate of 4.25 per cent, and the reason it failed to sell everything on offer – the last time that happened was in 2002 – is that the markets thought inflation likely to rise, making the bonds a bad bet.

And the reason for that is that we in Britain are, to use a technical economic term, screwed. Economies across the whole world are struggling. Because nobody is spending money, even relatively blameless countries such as Germany, with low levels of debt and workforces who actually make things, are having a difficult time. Germany’s economy is predicted to contract by 5.4 per cent this year. A banker explained it like this: ‘When your country’s economy depends on people buying a car every three years, and they decide that they’ll only buy a car every five years, you’re fucked. Off a cliff.’ So the German economy is fucked off a cliff. But it will recover, when people start buying cars again, and when it does, at least their underlying levels of debt are manageable. Something similar goes for Spain, where the ending of the property boom has caused a spike in unemployment to 17.4 per cent, almost doubling in a year, or Ireland, which has contracted by a truly horrendous 8 per cent and where people have gone from owning private helicopters to losing their homes in six months flat. All of these countries are in deep trouble. But there are four things you don’t want to have, going into the current crisis. 1. You don’t want to have had a boom based on a property bubble. 2. You don’t want to have a consumer credit bubble. 3. You don’t want to have an economy based on financial services. 4. You don’t want your government to have just gone on a massive spending spree. We have all four of those things that you don’t want.

It is possible that we are on course for the worst-case scenario. That would involve all our big, TBTF banks turning out to be insolvent, with the result that their balance sheets go onto the public debt. If that were to happen, Britain itself could become insolvent. Countries do go broke. A famous-to-economists example was Newfoundland, which in 1934 effectively went into administration and opted for direct rule from Britain because it was broke – becoming in the process one of the only colonies anywhere in the world ever to have voluntarily given up independence. A modern-day equivalent is having to go to the IMF and ask for money. It happened in 1976 and could happen again. The trigger would be a general view in the markets that the government’s tax receipts weren’t sufficient to meet its debt payments. That would cause a ‘buyer’s strike’ in the bond market: nobody would want to buy UK government bonds, so the government could no longer keep going back to the markets for cash to pay its liabilities. That would leave the government facing an immediate need for cash with no means of raising it – and it’s that which would send us prostrate to the IMF. Sterling would be more or less worthless. Travel would be next to impossible, imports would be unaffordable, interest rates would zoom up and stay up, there would be cuts in all aspects of public sector spending, especially employment. It would be brutal. Nobody thinks this scenario is likely, but quite a few people are willing to admit that it is possible. In 1976, Britain went broke running an annual deficit – the gap between tax revenues and government spending – of 6 per cent of GDP. Next year that figure is going to hit 12.4 per cent. A bad omen.

Even if we fall short of the IMF option in favour of a run-of-the-mill severe recession, the consequences for Britain are going to be horrific. Roads and schools and hospitals will go unbuilt and unrepaired, medical treatments will go unbought, nurses and policemen and council workers will be laid off. Six hundred thousand jobs have been created in local government in the last few years. Most of them will have to go. And then the really gigantic argument will have to be had, over the public service pensions which are paid for out of current tax receipts. I don’t know anyone who has studied this problem who thinks the government will be able to afford them. Can you imagine the fights that are going to happen? The political polarisation between public and private sector employees, the savagery of the cuts, the bitterness of the arguments, the furious sense of righteousness on both sides? It’ll be Thatcher all over again, and the current period of managerial non-politics will seem as distant as the Butskellite consensus did in the 1980s.

All of this leads us to the fourth and deepest reason why the government won’t nationalise the banks. The deepest reason is:

4. Because it would be so embarrassing. Some of the embarrassment is superficial: on the not-remembering-somebody’s-name-at-a-social-occasion level. The Anglo-Saxon economies have had decades of boom mixed with what now seem, in retrospect, smallish periods of downturn. During that they/we have shamelessly lectured the rest of the world on how they should be running their economies. We’ve gloated at the French fear of debt, laughed at the Germans’ 19th-century emphasis on manufacturing, told the Japanese that they can’t expect to get over their ‘lost decade’ until they kill their zombie banks, and so on. It’s embarrassing to be in a worse condition than all of them.

There is, however, a deeper embarrassment, one which verges on a form of psychological or ideological crisis. To nationalise major financial institutions would mean that the Anglo-Saxon model of capitalism had failed. The level of state intervention in the US and UK at this moment is comparable to that of wartime. We have in effect had to declare war to get us out of the hole created by our economic system. There is no model or precedent for this, and no way to argue that it’s all right really, because under such-and-such a model of capitalism . . . there is no such model. It just isn’t supposed to work like this, and there is no road-map for what’s happened.

It’s for this reason that the thing the governments least want to do – take over the banks – is something that needs to happen, not just for economic reasons, but for ethical ones too. There needs to be a general acceptance that the current model has failed. The brakes-off, deregulate or die, privatise or stagnate, lunch is for wimps, greed is good, what’s good for the financial sector is good for the economy model; the sack the bottom 10 per cent, bonus-driven, if you can’t measure it, it isn’t real model; the model that spread from the City to government and from there through the whole culture, in which the idea of value has gradually faded to be replaced by the idea of price. Thatcher began, and Labour continued, the switch towards an economy which was reliant on financial services at the expense of other areas of society. What was equally damaging for Britain was the hegemony of economic, or quasi-economic, thinking. The economic metaphor came to be applied to every aspect of modern life, especially the areas where it simply didn’t belong. In fields such as education, equality of opportunity, health, employees’ rights, the social contract and culture, the first conversation to happen should be about values; then you have the conversation about costs. In Britain in the last 20 to 30 years that has all been the wrong way round. There was a reverse takeover, in which City values came to dominate the whole of British life.

It’s becoming traditional at this point to argue that perhaps the financial crisis will be good for us, because it will cause people to rediscover other sources of value. I suspect this is wishful thinking, or thinking about something which is quite a long way away, because it doesn’t consider just how angry people are going to get when they realise the extent of the costs we are going to carry for the next few decades. I think we will end up nationalising at least some of our big banks because the electorate will be too angry to do anything that looks in the smallest degree like letting them get away with it. Banks can’t change their behaviour, so we have to do it for them, and the only way to do it is to take them over. We can’t afford any more TBTF.

I get the strong impression, talking to people, that the penny hasn’t fully dropped. As the ultra-bleak condition of our finances becomes more and more apparent people are going to ask increasingly angry questions about how we got into this predicament. The drop in sterling, for instance, means that prices for all sorts of goods will go up just as oil and gas prices have spiked downwards. Combined with job losses – a million people are forecast to lose their jobs this year, taking unemployment back to Thatcherite levels – and tax rises, and inflation, and the increasing realisation that the cost of the financial crisis is going to be paid not over a few years but over a generation, we have a perfect formula for a deep and growing anger. Expectations have risen a lot, over the last three decades; that’s going to have a big impact on how furious people feel about the hard years ahead. The level of future public spending cuts implied in Darling’s recent budget – which included the laughably optimistic idea that the economy will grow by 1.25 per cent next year – is greater than the level of cuts implemented by Thatcher. Remember, that’s the optimistic version. If we’re lucky, it won’t be any worse than Thatcherism.

Naked Capitalism discusses a Martin Wolf editorial in which he doesn’t exactly mince words when describing a cure for our current plague of financier flu.

The UK has a strategic nightmare: it has a strong comparative advantage in the world’s most irresponsible industry. So now, in the wake of the biggest financial crisis since the 1930s, the UK must ask itself a painful question: how should the country manage the cuckoo sitting in its nest?

The question is inescapable. London is one of the world’s two most important centres of global finance. Its regulators have, as a result, an influence on the world economy out of proportion to the country’s size. In the years leading up to the crisis, that influence was surely malign: the “light touch” approach led the way in a regulatory race to the bottom.

The fiscal costs of this crisis will be comparable to those of a big war….Loss of jobs and incomes will also scar the lives of hundreds of millions of people around the world.

All this occurred, in part, because institutions replete with highly qualified and highly rewarded people were unable or unwilling to manage risk responsibly….This is a time for self-examination.

A recent report on the future of UK international financial services…fails to provide such self-examination…the report’s remit was “to examine the competitiveness of financial services globally and to develop a framework on which to base policy and initiatives to keep UK financial services competitive”.

If you ask the wrong question, you will get the wrong answer. The right question is, instead, this: what framework is needed to ensure that the operation of the financial sector is compatible with the long-run health of the UK and world economies?

Quite simply, the sector imposes massive negative externalities (or costs) on bystanders. Thus, the recommendation “that the financial sector be allowed to recalibrate its activities according to the sentiments and demands of the market” is wrong. A market works well if, and only if, decision-makers confront the consequences of their decisions. This is not – and probably cannot be – the case in finance: certainly, people now sit on fortunes earned in activities that have led to unprecedented rescues and the worst recession since the 1930s. Given this, the industry has become too big. If implicit and explicit guarantees and externalities, including volatility, were fully charged, the sector would surely shrink.

So how should one manage a sector that produces such “bads”? The answer is: in the same way as any polluting activity. One taxes it. At this point, the authors of the report will surely ask: “How can you suggest taxing a sector so vital to the UK economy?” The answer is: easily. Financial services generate only 8 per cent of gross domestic product. They are more important for taxation and the balance of payments. But this tax revenue turns out to be perilously volatile. True, in 2007, the last year before the crisis, the UK ran a trade surplus of £37bn in financial services, partially offsetting an £89bn deficit in goods. But smaller net earnings from financial services would have generated a lower real exchange rate and more earnings elsewhere. Given the costs imposed by the financial sector, a more diversified economy would have been healthier. Such sacrilegious ideas are, of course, not to be found in the Bischoff report.

How then should the UK approach policy towards the sector? I would suggest the following guiding ideas.

First, the UK needs to make global regulation work. It should discourage regulatory arbitrage even if it expects to gain in the short run.

Second, it must, in particular, help ensure that owners and managers of financial institutions internalise most of the costs of their actions.

Third, it must reject egregious special pleading from the industry. The sector argues that moving derivatives trading on to exchangesmight damage innovation. So what? Maximising innovation is a crazy objective. As in pharmaceuticals, a trade-off exists between innovation and safety. If institutions threaten to take trading activities offshore, banking licences should be revoked.

Fourth, while trying to create a stable and favourable environment for business activities, the UK should try to diversify the economy away from finance, not reinforce its overly strong comparative advantage within it.

Fifth, UK authorities need to ensure that the risks run by institutions they guarantee fall within the financial and regulatory capacity of the British state. They should not let the country be exposed to the risks created by inadequately supported and under-regulated foreign institutions. At the very least, they should not undermine other governments’ efforts to regulate their own institutions.

The “old normal” was simply unsustainable. The “new normal” must be very different. It is far from clear that the industry and government recognise this grim truth.

A few comments are also yoinkworthy.

This is right on. Negative externalities are a core refutation of the “free market” lie, since in a true free market 100% of costs would be paid and harms compensated by the willing patricipants in a transaction. (That’s why I refer to myself only half-ironically as one of the only true free marketeers, since I would use whatever level of government action was necessary to purge the false market of externalities, to free us of them.)

I especially like the cuckoo metaphor. Parasitic feudal entities indeed do nothing but take up space and resources and generate cost and complexity. The FIRE sector does not add real value but only a froth of hype, pseudo-growth, and debt.

Any alleged economy built on false growth and exponential debt is built on sand. It seems the only possibilities from here on are to take adult responsibility and transform ours to a steady state economy, as described by Hermann Daly and others, or to continue to experience the violence of ever more chaotic boom-bust convulsions.

All TPTB can think of is to seek to reflate bubbles. That’s the British government’s only idea, just as it is the Obama admin’s only idea. That’s why their only policy is to try to restore the “market” as dictated by the feudal FIRE pseudo-industry.

and

You can also accomplish it by clamping down hard on fiduciaries (ie, prohibiting them from dealing with offshore players), and most important, denying those who go offshore to access to funds transfers (in the US, Fedwire and CHIPS). They would have to go through other parties. If you are a big intermeidary (bank, broker dealer) that is a very unattractive position to be in, Mere Japanese corporates in the 1980s needed their banks to have access to Fedwire and CHIPS (I worked with a bank that looked into giving up its banking license to do a US deal and concluded the cost was unacceptable). You also bar anyone inside the cordon from lending to parties outside it.

Trust me, it could be done if anyone had the will. At the very worst, you’d have wealthy individuals (maybe) able to invest offshore. You don’t need to achieve an absolute prohibition to have won this battle, merely to make it so difficult as to make the size of it not very consequential.

and

I agree that it could be done, but your suggestion is essentially an end to free flows of capital in and out of the regime.

For instance, Goldman Sachs become regulated by the new regime, and are (still) in the US. Can they lend money to a bank in China? Can they invest in Chinese stocks? Can they act as a broker for Chinese stocks to US clients?

On the other side, can a Chinese business buy stocks in the US if China has a different tax regime? Can a Chinese bond fund buy US treasuries (that’d cause a few headaches)?

How would Citi live in this world? Would it need to sell it’s overseas enterprises? Could it even be an American bank anymore?

To really make it work, there would be a massive wrenching of money flows, money moving in and out, fire sale prices, cries of protectionism (which having lived in Asia for a while, doesn’t really seem that bad), and probably general chaos. Politically, it’d be too difficult and while Geithners in charge, and the FED consolidates is powers (by superceding the SEC) there’s little hope.

You guys need a revolution. It’s the only hope.

Personally I think there should be loads of little banks, with very little leverage (i.e. 1:5 , with some maximum limit on the 1 e.g. $1b (or whatever) ). This would massively spread the risk about, with more Birth / Deaths of small banks.

The irony is in the US and the UK the opposite seems preferable to the authorities.

This here talk of revolution is most intriguing.  First we need a really good t-shirt design.

From Uponnothing in the comments section at Craig Murray’s blog:

This is the trouble with party politics, sometimes people are forced to defend the indefensible simply because if they don’t their structured worlds fall down around them.

I find it strange that we have a formalised slanging match and call it a functioning democracy.

The comments section itself is quite a match.  By the way, should that be “slagging” rather than “slanging”, or am I just falling behind in keeping up with the latest slang from the isles?  I’ve been a fan of British invective since first reading Sam Johnson’s riposte to the chap on the bridge who was slagging him as he boated down the Thames.

As for the “structured worlds” thing, I’ve spent much mental time and effort reducing the formal structures important to my weltanschauung to dogs, beer, books and bebop.

Why the hell a bilious rant by a failed former vice-president is being treated seriously and equivalently to a major speech by a sitting president by even NPR is beyond me.  On second thought, given the crapfest that is the media, it really isn’t.

At Prudent Bear, Martin Hutchinson does us the favor of embedding some insightful analysis in some most enjoyable invective.  It’s the first bit I’ve encountered wherein the confusion between randomness and nonlinearity is shown to be one of the key problems leading our current financial difficulties.  A nonlinear system is nonrandom and predictable, but the predictions are only as good as the exactness of one’s initial conditions.  Even a little imprecision in the initial conditions can lead to quick divergence from the actual solution since the errors propagate exponentially.  I recall reading something around 10 years ago about how Doyne Farmer and other members of the Santa Cruz Nonlinear Systems “Mafia” from the 1980s were attempting to use their knowledge of nonlinear systems to profit in the stock market.  The writer made it quite clear that nobody was willing to divulge much of anything, especially whether or not their efforts were actually bearing fruit.  I haven’t encountered any follow-ups on the matter, though.

Over the last 30 years, the capital markets have been restructured through the tenets of modern finance in its various forms, which together have gained six Nobel Prizes (Modigliani, Sharpe, Markowitz, Miller, Merton, Scholes) and might have generated a couple more (Fama and Black.) This has been enormously profitable for the financial services sector, which has doubled its share of U.S. economic output. As we are only now coming to see, it has proved pretty well disastrous for the global economy as a whole.

The most fundamental error of the modern financial edifice was its assumption of randomness in market movements, without a true understanding of the conditions necessary for randomness to hold. The laws of probability and the idea of randomness were generated by the 17th century French mathematician Blaise Pascal, who used them to help in winning card games, roulette and other activities in which tiny physical variations cause a discrete change in results. Since tiny physical variations are themselves unpredictable, their results are truly random.

This true randomness almost never holds for economic activities. Some of them are governed by complex underlying equations, impossible for mediocre mathematicians to solve, which produce pseudo-random “chaotic” behavior, in which prices or other variables appear to move randomly but are in reality mostly determinate. The interaction between economic variables is partly random (itself partly caused by inadequacies in our ability to measure economic quantities quickly) and partly determined by these kinds of complex non-linearities.

Other economic variables are also not random, and may not be governed by discoverable laws; they are simply unknown. Next year’s Gross Domestic Product, for example, is theoretically determinable from factors we could already know (plus a few random elements). But it is mostly not random; we simply do not know what it will be.

Pretending that deterministic (but chaotic) quantities or unknown quantities are random is a huge category error. If such quantities are not random, they will not obey the laws of randomness. In particular calculations that depend on the properties of randomness, such as Monte Carlo simulation, the Value at Risk methodology or the Black-Scholes options model will be quite simply wrong, often very badly wrong.

For non-random quantities, one of the most important properties of truly random quantities, the tendency of their distributions’ “tails” to disappear at around three standard deviations from the mean, will not hold. In probability, the chance of four events happening is the product of their four probabilities; in fuzzy logic, the alternative analytical system for the unknown, the “belief” of four events is the minimum of their beliefs. If each event has a probability/belief of 1 in 10, it’s the difference between 1 in 10,000 (random) and 1 in 10 (unknown).

Nassim Taleb in his best seller criticized Wall Street for being “Fooled by Randomess.” He had it precisely wrong; in reality, Wall Street and the economists and “mathematicians” (mostly not very good ones, or good ones who figured out there was a problem but stayed around for the money) have been fooled by assuming randomness where it does not exist.

That assumption makes the equations easier to solve; random quantities tend to be linear, exponential or normal, the three types of equations economists know how to deal with. Chaotic quantities generally obey power-series equations, or even nastier ones, while unknown quantities by definition don’t obey any equations at all.

Financial quantities, mostly a mixture of the chaotic and the unknown, are thus frightfully hard to model; one has some sympathy. Even Benoit Mandelbrot, a truly superior mathematician who invented fractal geometry, made devastating criticisms of others’ models in his 2004 “The misbehavior of markets,” but was unable to come up with a better alternative.

The invention of PCs, together with the intellectual “advances” of modern financial theory, from around 1980 caused an explosion of mathematical modeling on Wall Street. Models were used to price options, to value complex packages of securitized debt, to manage investments and above all, to manage risk, even being incorporated into the “Basel II” bank capital requirements.

In the “Value at Risk” risk management system, for example, the model calculates the maximum possible loss in 99% of periods covered. Even if the model worked, that would be a foolish way to manage risk for an entire bank when the periods are as short as a day or a month; 100 trading days is only five months and even 100 months is only eight years. While the 200 year life expectancies of the old merchant banks may have been excessively conservative, eight years is surely rather too short a life expectancy for banks if the market is to function soundly.

The VAR assumption, that even in the other 1% of periods the model wouldn’t be too far wrong, is completely and dangerously false. When David Vinear, chief financial officer of Goldman Sachs, said in August 2007, “We were seeing things that were 25-standard-deviation events, several days in a row,” he was condemning his risk management out of his own mouth. In a truly random system, 25-standard-deviation events would not just be rare, they would be literally impossible, of infinitesimal probability during the entire history of the universe.

Not only are price movements not random, the market is not “efficient.” It is subject to bubbles and periods of depression – indeed one of the most profitable strategies during the latter, employed by the late Sir John Templeton and others, is to buy small out-of-the-way stocks at random, since analysts stop covering the lesser names when business is bad, and their prices drift down arbitrarily far. (Conversely, that’s why many of the best investment managers, mostly invested in small stocks, did so badly in 2008, down 70% or 80% when the market overall was down only 40%; the market was de-arbitraging as the financial system fell apart.) As innumerable behavioral finance professors have demonstrated, expectations are not rational.

The Capital Asset Pricing Model also doesn’t work, as many have found to their cost. On the corporate side, it combined with the tax-deductibility of debt interest and short-term oriented compensation systems to leave banks and corporations excessively leveraged. Lehman Brothers shareholders have lost more through bankruptcy than they previously gained through leverage; business failure is in itself an extremely expensive process. Of course, bailouts here, there and everywhere have mitigated the costs of owning, say, AIG or Citigroup shares, but on the other hand, being a debt-holder in Chrysler or General Motors has proved unexpectedly expensive, as the Obama administration has reallocated resources to its union friends. In the last six months, the resource allocation process has become almost entirely political, and will remain so until the U.S. government runs out of money, which fortunately shouldn’t take too long.

On the investment side, the CAPM has led to the development of innumerable phony asset classes, whose returns were supposed to be uncorrelated to the stock market, but which were mostly notable for the hugely greater fees they provided to their sponsors. Hedge funds depend on excessive leverage and the continuance of misguided financial engineering; private equity funds depend on the existence of a thriving public market for takeout; and emerging markets funds depend on the health and liquidity of the world economy. None of them diversify risk more than marginally and all of them add huge new layers of cost. The Yale Model of investment management does not work – except for the lavishly rewarded investment managers who developed it.

Securitization appeared to be a mechanism that allowed banks to remove assets from their balance sheets, while providing relatively low-risk, liquid assets for investors. It also didn’t work. First, banks were left with most of the residual risk, so allowing them to remove the assets from their balance sheets merely encouraged excessive leverage. Second, the ratings agencies assumed randomness of outcome in, say, pools of subprime mortgage assets, an assumption that proved to be laughably wrong. When mortgage underwriting standards deteriorated, they deteriorated everywhere, so all pools ended up with their share of almost-worthless “liar loans.” Even when underwriting standards were maintained, real estate mortgage losses were not probabilistically independent, since a nationwide housing-price decline caused an ever-increasing cascade of losses, far beyond past experience. Housing and credit card loans are not probabilistically independent, because the business cycle isn’t random; in a down cycle they all go wrong at once.

The largest nirvana for mathematically-generated profits was the derivatives markets. Here the “vanilla” markets were relatively sound, with risks manageable and finite. They were, however, almost infinitely arbitrageable, so became a trading desk heaven, with far too much volume for the contracts’ real uses, endless speculative games played, and infinitesimal margins. Most important, they produced an explosion of counterparty risks so that even the dodgiest bank or broker active in the markets could not be allowed to go bust. That problem can largely be solved by President Obama’s proposed legislation forcing standard derivatives to trade over recognized exchanges, eliminating most of the counterparty risk and concentrating the rest in one place.

In order to increase profits, traders devised more and more complex derivatives types, the management of which required dangerously false assumptions about randomness. These more complex contracts up-fronted most of their profit, leading to bonus bonanzas, while leaving their risks ticking like a time-bomb through their entire duration of several years – so we may not yet have seen all the loss explosions this business will produce.

Finally, there were credit default swaps (CDS). As derivatives, these were poorly designed, because their settlement rested on a primitive auction procedure that is itself gamed by the major dealers, who use it to extract rent from the U.S. government and any companies unfortunate enough to near bankruptcy. As we have recently seen in two cases, Abitibi-Price and General Growth Properties, CDS deviate even further than most derivatives from the theoretical efficient-market modern finance ideal in that they allow debt-holders to “game” the default process itself.

In essence, CDS holders, who if they are also bondholders can vote in the bankruptcy process, act like spectators at a suicide, yelling, “Jump! Jump!'’ and pushing companies into default in order to reap bonanza profits from their CDS. This is particularly attractive if the CDS were issued by AIG and so effectively guaranteed by taxpayers.

CDS also act as highly efficient vehicles for short selling; their cost is so low in relation to their potential profit and their volume so large that they can provide huge incentives to unscrupulous speculators to drive viable companies over the edge – this was part of the problem at Lehman Brothers, for example.

In summary, the dangers of CDS are so out of proportion to their modest advantages as risk management tools that it seems wisest for the authorities to ban them altogether, not something I would normally recommend.

We gave poor Jeff Skilling of Enron 24 years in jail for inventing a new trading platform that turned out to be unsound. As we peer out from the wreckage that modern finance has left, one can’t help thinking that there are a number of Nobelists who more deserve such Draconian punishment.

By the way, this makes the second time the word “draconian” has appeared hereabouts today.

Somebody’s a bit confused over at Financial  Armageddon.  A heartfelt tale about how a good friend’s Chrysler dealership is one of the victims of the Chryster downsizing turns quickly into a rant about how the evil gummint “is destroying capitalism in a methodical fashion”.  How?  Apparently when the evil gummint stepped in to pump billions of dollars into this fail[ing/ed] capitalist endeavor, it was doing it only so the eviler car czar/fuhrer could grab ultimate control of said failed capitalist endeavor and, while twisting his moustache and emitting rudely sinister noises, point the finger of doom at the good friend’s “family operated” - if you use the word “family” in your argument, then the other automatically assumes a Stalin-esqe demeanor - dealership.  The basic upshot is that the bailout specifically is turning the USofA into the newest banana republic by suddenly creating a rogue, out-of-control gummint.

The rant goes on about how the commie-nazis are destroying the purity of the capitalist American dream.  For some reason, I’m reminded of the final hockey game scene in “Slapshot” where the game starts with everybody on both teams beating the living shit out of each other out on the ice.  Everybody except one, who nods to the organist and dances around the rink while slowly removing all of his uniform to the tune of the “Stripper’s March.”  After a while, the combatants slowly and dumbfoundedly take notice.  One of them, with one hand holding his human punching bag by the collar and the other stalled halfway through delivering another punch, says in a shocked and hurt tone of voice, “He’s making a mockery of the game!”

A couple of folks in the comments section are thinking a bit more clearly.

The global financial services industry has been turning small (by United States standards) nations into “banana republics” for decades. This was part of what we were told was official government policy, part of bringing democracy to “backward” states.The banana in “banana republic” was, after all, put there by United Fruit and other transnational corporations, as first exposed by Major General Smedley Butler and outlined in his book “War Is A Racket” published in 1935.What really puts the U.S. in the same banana boat is the close ties between the financial services industry and the federal government. As the finaciers have garnered more favors from the government that they finance, keeping profits but shifting debt on to the public, the U.S. is being driven into the receivership of the IMF.This is a core condition that defines a “banana republic” and we are virtually there already. An honest accounting is all that is required, not that we will likely get one.

and

Well, it’s a shame about his dealership - I know a ruined Chrysler dealer myself, and it’s painful to see. But the same approach, taken with the banks, might be exactly what’s needed. No, really. The banking oligarchy is more private than public at this point, and one of the few ways government regulators can assert control is with soft credit and concomitant extortion. Look at Russia: Putin can control his plutocrats only by framing them and locking them up, or by assassinating them in a pinch. Too bad for the rule of law, but they never had it there anyway. Same here. We’ve been a lawless, oligarchical banana republic for years. We need to accept that fact and ask, How do we stop the corruption now? When a country’s this far gone, autocratic dirigisme may the only way. It might not work, but the private sector’s turned malignant, the invisible hand is fisting you.

All I’ll add is that if you spend too much time arguing and fighting about whether it’s the invisible hand that’s fisting you or the iron boot that’s doing the forever thing on you, you might not notice just which hand is lacing up just which boot.

Via Solari, we find the following from Senator James Webb:

“We have 5 percent of the world’s population and 25 percent of the people in prison. Either we’re the most evil people on earth, or we’re doing something wrong . . . I saw more drug use at Georgetown University Law Center when I was a student there than I’ve seen anywhere else in my life. And some of those people are judges.”

There’s also the economic cost of sating the baser urges of the neo-puritan punishment fetishists, for whom all behavior not in accordance with their stated principles - rather than, of course, their actual behavior - must be at the very least proscribed and preferably punished.

The mass imprisonment philosophy that has packed prisons and sent corrections costs through the roof around the country has hit especially hard in California, which has the largest prison population, the highest recidivism rate and a prison budget raging out of control.

According to a new federally backed study conducted at the University of California, Irvine, the state’s corrections costs have grown by about 50 percent in less than a decade and now account for about 10 percent of state spending — nearly the same amount as higher education. The costs could rise substantially given that a federal lawsuit may require the state to spend $8 billion to bring the prison system’s woefully inadequate medical services up to constitutional standards.

The solution for California is to shrink its vastly overcrowded prison system. To do so, it would need to move away from mandatory sentencing laws that have proved to be disastrous across the country — locking up more people than protecting public safety requires.In addition, the state also has perhaps the most counterproductive and ill-conceived parole system in the United States. More people are sent to prison in California by parole officers than by the courts. In addition, about 66 percent of California’s parolees land back in prison after three years, compared with about 40 percent nationally. Four in 10 are sent back for technical violations like missed appointments or failed drug tests….

The Holy War on Drugs has been every bit as effective as the Holy War on Terrorism.

Intermittently useful NPR ran a piece this AM about a strategy that’s proven effective in significantly decreasing the cultivation of the coca plant in one region of Colombia.  Rather than going for the viagra-like effect of rushing in with this year’s billion dollars worth of U.S. military funding and killing everything that moves, the military did indeed rush in, but exercised some discretion by only chasing away the obvious soldiers of the cocaine cartel.  At this point, people without guns came into the area to build roads and schools such that the peasant farmers might develop options for economic survival that don’t involve growing coca plants.  It’s nice to see that with all the money, verbiage and lives wasted in the Holy War on Drugs in the last 30 years, an idea was not only conceived but implemented that didn’t involve killing dirt-poor people in other countries to excuse sociopathic asshole cokeheads (Wall Street, fraternities, etc.) in the USofA from having to deal with the consequences of the draconian drug laws they supported.

Unfortunately, I suspect that this strategy will suffer the dodo-like fate of Nixon’s extremely effective methadone clinic strategy back in the early 1970s.  The usual suspect list of quasi-literate paleo-politicians will jump on the “git tuff” bandwagon to guarantee the votes of their similarly enlightened constituents and go back to the old, familiar strategies that serve as better conversational grist for their intense policy sessions with their soon-to-be fifth wives.

The Institutional Risk Analyst writes about the beginnings of Credit Default Swaps (CDS), how the financiers turned them into monsters, and how the the regulations being designed to supposedly reign them in will have the predictable effectiveness of a mosquito fart in a hurricane.

Despite bringing the world economy to its knees and costing taxpayers hundreds of billions of dollars in bailouts for events such as Bear Stearns, Lehman Brothers and American International Group (NYSE:AIG), the Masters of the Universe who run the largest Wall Street firms of have learned not a thing when it comes to credit default swaps (”CDS”) and other types of high-risk financial engineering. Indeed, not only are the largest derivative dealers fighting efforts to reform the CDS and other derivative instruments that caused the AIG fiasco, but regulators like the Federal Reserve Board and US Treasury are working with the banks to ensure that a small group of dealers increase their monopoly over the business of over-the-counter (”OTC”) derivatives.

Why such a desperate battle for the OTC derivatives markets? For the world’s largest banks, the OTC derivatives markets are the last remaining source of supra-normal profits - and also perhaps the single largest source of systemic risk in the global financial markets. Without OTC derivatives, Bear Stearns, Lehman Brothers and AIG would never have failed, but without the excessive rents earned by JPMorgan Chase (NYSE:JPM) and the remaining legacy OTC dealers, the largest banks cannot survive. No matter how good an operator JPM CEO Jamie Dimon may be, his bank is DOA without its near-monopoly in OTC derivatives — yet that same business may eventually destroy JPM. The key thing for the public and the Congress to understand is that the “profits” earned from these unregulated derivatives markets are illusory and do not cover the true risk of OTC derivatives. Put another way, on a systemic basis, risk-adjusted profits from OTC derivatives are not positive over time. As with the current crisis, the net loss from the periodic collapse of what is best described as gaming activity gets off-loaded onto the taxpayer, thus OTC derivatives must be seen as any other speculative activity, namely a net loss to the economy and society. But unlike taking a punt on a pony at the racetrack, bank dealings in OTC derivatives vastly increase systemic risk, make all banks unstable and threatens the viability of the real economy.

…

The immediate objective of JPM and the dealer community is to counter attempts to truly regulate and, most important, make standardized commodities of OTC derivatives, even as the dealers clothe the new regime proposed by Tim Geithner for clearing and trading OTC contracts in the language of reform, transparency and efficiency. Terms like innovation, productivity and competitiveness are again heard in the halls of Congress after a several months hiatus, this in connection with arguments that OTC derivatives help to manage, rather than create, risk.

But the fact is that for JPM, Citigroup (NYSE:C), Goldman Sachs (NYSE:GS) and other dealers, the OTC derivatives markets are the last remaining source of supra-normal profits - and also perhaps the single largest source of systemic risk in the global financial markets. Without OTC derivatives, Bear Stearns, Lehman Brothers and American International Group (NYS:AIG) would never have failed, but without the excessive rents earned by JPM and the remaining legacy OTC dealers, they cannot survive either.

…

A clearinghouse would eliminate the need for counterparties to post collateral and a lucrative source of revenue for the dealer firms. So they bought the Clearing Corporation, an inactive company that had been the clearinghouse for the Chicago Board of Trade. If they had to clear their trades, the dealer firms reasoned, at least they would find a way to profit by controlling the new clearing firm. Such is the logic of the GSE mindset.

Meanwhile, other viable candidates for OTC derivatives clearing were eager to get into the business, such as the Chicago Mercantile Exchange and the New York Stock Exchange. Both had over 200 years experience in clearing trades and were well suited to serve as the impartial central counterparty to the banks and their customers. If the NYSE and CME were to trade derivatives, the big banks knew they would not be able to control their fees or capture the profits from clearing. Therefore, they sold The Clearing Corp. to the Intercontinental Exchange, or ICE, a recent start-up in the OTC derivatives business which had been funded with money originally provided by, you guessed it, the banks. In the deal with ICE, the banks receive half the profit of all trades cleared through the company. And the large OTC dealer banks made sure, through their connections with officials at the Fed and Treasury, that ICE was the winner chosen over the NYSE and CME offerings. That’s right, we hear that Tim Geithner personally intervened to make sure that ICE won over the NYSE and CME clearing units.

…

Karl Denninger provides a graphic of some stock trading action yesterday and comments vigorously on the underlying dynamics.  Basically, some already filthy rich financiers turned yet more insider information into yet more cash at the expense of those without a dozen vacation homes.  If such smoking guns as this continue to be ignored by the financier’s employees in the gummint, the gunsmoke just might become a lot more literal.

…

From this chart it is clear that “someone” (or a handful of someones) knew of this offering before the market closed.

The volume that started showing up at 2:00 PM - to the downside - was VERY significant and the selling picked up bigtime going into the bell.

This sort of information leak and trading on it before it is disclosed is illegal.

What’s even worse is that an hour after this news “broke” Bank of America still hasn’t issued a press release on the matter.

We saw this sort of “favored garbage” all the time in the 90s.  As a consequence Regulation FD, for “fair disclosure”, was passed.  It mandates that you cannot issue information that is material to your stock price to only a few select people - you have to give it to everyone at the same time, and the most common way you do this is to request a halt on your stock from the NYSE, issue the press release, then have the NYSE lift the halt.

This way nobody can get either long or short in front of your announcement and nobody gets to profit unfairly (or get screwed unfairly) as a consequence of whatever it is you need to announce.

Banks are not immune from this regulation.

People need to start going to prison for this BS.  There are real investors who are harmed by this intentional and outrageous gaming in the markets, sometimes very significantly.  This issue is at a 20% discount to the trading price earlier today and the dilution will hit EPS forever.

Oh, and it gets better.  What happened yesterday?

LONDON (MarketWatch) — Bank of America was upgraded to buy from neutral and added to the conviction buy list at Goldman Sachs, which says the stock overhang should start to abate and that the bank may earn 25 cents a share during the second quarter, well above consensus estimates of a penny a share. “Our optimism is based on another solid mortgage and capital markets quarter, given observable activity levels since March,” the broker said.

The stock overhang should start to abate?

I want to know who ran the book for this secondary and further, I want to know if Goldman was one of the firms selling into this.

What I do know, because I have a real-time squawk feed with commentary, is that Goldman was very quietly selling S&P futures in the back of the pit this afternoon.

The SEC needs to start issuing subpoenas NOW.  This has gone on now for more than two years, dating back to the 2007 “surprise” discount rate cut, the “short ban” on financials and more.  It is abundantly clear from a simple examination of the price and volume immediately in front of these announcements that someone is being given the information before the rest of the market gets it and they are trading on it, and that is against the law.

Period.

I have said that you can’t buy or own any financial-related stock at present as an investor.  This sort of BS is why - you will be traded against by people with inside information who will take every opportunity to destroy your investment while profiting from your loss, and they will do so using information that is not available to you, the average person, until well after their trade against your position has been put on - whether those acts are legal or not.

WHERE ARE THE DAMN COPS?

On the other hand, the proles are probably too busy watching the season finales of their favorite reality shows to give a flying rat’s ass.

One of the categories I created in my recent Google Book Search frenzy is populism.  It contains various directly and less directly related texts by those in the 1800s and early 1900s who were less than enthralled about financiers, wars, imperialism, plutocrats, etc., and who for a while at least had legitimate standing in the national political arena, or at least in some regional political arenas.  Such dissent was fairly quickly and brutally forestalled during the First Great War via the suppression (jailing, killing, etc.) of those who dared disagree with any of the components of the national mythology deemed necessary by the plutocracy. There’s some fascinating stuff contained within the 80+ books (so far) I’ve shoved into that category.  My interest in the topic was piqued by a series of posts over at John Emerson’s Trollblog over the last several months in which John and several commentators are having a go at both the historical aspects of populism and the possibility of such a movement getting off the ground these days.  I’ll just offer that in dipping into several of these books, I’ve read many a paragraph from 100+ years ago that could have been appropriately published in the last year with little or no changes to reflect a century of supposed change.