The following is an excellent excerpt from the book “ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism” by Yves Smith from Chapter 6 “How Deregulation Led to Predation” on page 151 and I quote: “In 1997, Brooksley Born, the head of the CFTC, undeterred by her lunch with [Alan] Greenspan, started looking into regulating derivatives and invited comments on particular types, including credit default swaps (CDS), a new, rapidly growing product. In fact, CDS are not derivatives in the traditional sense, since their price is not based on, or “derived” from, something else.
CDS are unregulated insurance agreements. One party, the “protection buyer,” contracts with the insurer, called in finance-in-speak the “protection seller,” to guarantee against the risk of default of a specified amount of exposure (say $100 million dollars) for a certain time period (three and five years are most common) for a particular company (say British Petroleum) or an index.
Even though calling CDS derivatives was debatable, that stance meant they were unregulated. And when Born threatened to change that treatment, the backlash was swift and hard. On multiple occasions, Greenspan, Treasury Secretary Rubin, Deputy Secretary Summers, and SEC chairman Levitt pressed her to back down. When she persisted, Greenspan, Rubin, and Levitt end-ran her in June 1998, going to Congress to bar her from acting until “more senior regulators” came up with a fix. The fall 1998 implosion of the hedge fund Long Term Capital Management, widely seen as barely averted systemic crisis, vindicated her concerns. Here a firm composed of the very best and brightest, Nobel Prize winners and the very best traders and quants, had been unable to handle the risks of the new complex OTC markets. Yet, incredibly, Congress gave the CFTC a stunning rebuke, blocking the commissions’ regulatory authority for six months. Born resigned shortly thereafter.
Taking no chances, in November 1999, the “senior regulators” urged Congress to wrest all regulatory authority for derivatives from the CFTC. Arthur Levitt shepherded the Commodity Futures Modernization Act through Congress in 2000. It exempted OTC derivatives from regulation and went to some length to highlight that energy derivatives were included. Mark Brickell, the lobbyist representing the International Swaps and Derivatives Association, drafted important sections of the bill.
We have seen how regulators and courts were either unable or unwilling to impede predatory behavior. What about ratings agencies?
Unfortunately, just as in the Banamex case, investors frequently placed mistaken faith in rating-agency grades of complex instruments. Dubious ratings played a central role in the peso crisis and our latter-day mess. Grades come from “nationally recognized statistical rating organizations,” a designation conferred by the SEC. While the ratings agencies have a hundred-year history, their importance increased greatly in the 1970s as ratings were officially made a consideration for a host of investors. For instance, many institutions are prohibited from owning much of anything in the way of below-investment-grade securities, meaning those that scored lower than BBB or Bbb. Some bond funds commit to keeping their average ratings above a certain level. Bank capital regulations also use ratings, with higher-rated paper needing less capital held against it. Even the Fed used ratings to determine how much of a haircut to take to paper pledged as collateral for loans, for example at its discount window and its recently created facilities.
Amazingly, despite their central role, ratings agencies cannot be sued for erroneous scores. Courts have upheld the rating agencies’ argument that their marks are merely opinions of the credit strength of an issuer and thus subject to First Amendment protection.
The ratings agencies have come under well-deserved fire for their lapses and complicity with issuers in peddling complex paper. Even though investors depend on the agencies’ scores, the ratings are in fact paid for by the issuer, and structured securities pay better than simpler paper. The complexity of the deals meant the agencies may not have fully understood the transactions, particularly since staff who developed expertise would depart for better-paying jobs at investment banks or fund managers. And the fact that the organizations seeking the ratings were prospective employers of the individuals involved made pushback even less likely.
But at a higher level, the ratings had already been compromised. The very fact that ratings are enshrined in regulations means that a particular rating is presumed to be equivalent across products. An AA should mean the same level of risk whether the bond issuer was a corporation, a municipality, a sovereign state, or a structured vehicle (the ratings agencies have tried to claim otherwise as they have come under attack, but a reading of their past pronouncements shows otherwise).
In fact, structured products like those using residential mortgages had important inherent differences from corporate bonds that made them riskier and therefore made their ratings misleading. For structured credits, the risks are biased to the downside. Moreover, highly structured paper like tranches in collateralized debt obligations is subject to catastrophic falls in cash flows when certain levels of default are reached, which lead to dramatic downgrades. In the world of corporate bonds, a ratings decline of more than a couple of grades is a rare event absent massive fraud. Yet in the credit bust, rating downgrades of twelve, and even as much as eighteen grades, were fairly common on subprime-related paper. It became a joke that a fund manager could go to lunch owning AAA-rated paper and come back and find it lowered to CCC, which is not merely junk, but speculative.
While rating agencies have received a great deal of well-deserved criticism for acting as enablers of the crisis, dubious treatment of off-balance-sheet vehicles also played a role. We will discuss those accounting issues in chapter 7.
Many factors impede misbehavior coming to light and being punished. If victims are professionals who have a fiduciary duty to their clients, exposing their incompetence would open themselves up to claims. So some wronged parties can have more to lose from revealing their errors of judgment than to gain in restitution, which invariably discourages legal activity. Moreover, as we have seen certain legislation and court decisions have raised the bar for private redress.
Finally, even in cases where regulators can do something, enforcement has become a rare event, limited to high-profile cases like the $65 billion Bernie Madoff Ponzi scheme (and even then only after the horse had left the barn and was in the next county).
It took not the SEC but New York State attorney general Elliot Spitzer to ferret out widespread fraud in the dot-com era, namely, brokerage firms touting stocks they knew to be junk, eventually extracting a $1.5 billion settlement from twelve firms. Similarly in 2008, it was states not the SEC, who took the first action of the auction rate securities scandal, when retail investors were told these instruments were safe and liquid, only to find they could not access their funds when dealers quit supporting the market.
The “free markets” advocates have created a hall of mirrors. Milton Friedman believed that the courts were an important mechanism, if not the key mechanism, for preserving property rights and keeping markets fair. Yet the Department of Justice and the SEC effectively stopped going after complex cases, sticking to easy-to-prove cases with high media potential. State attorneys general have upon occasion moved to fill the gap, but they are not ideally situated to pursue high finance. That leaves private suits of the sort Friedman would endorse as the sole policing mechanism. Yet powerful interests and the very ideology Friedman backed succeeded in gutting this channel.
Now the only defense a hapless investor might have is looking for “reputable” firms. But if standards have decayed across the board due to the lack of legal and regulatory costs of bad behavior, why should any firm care much about its reputation?
What we can observe is therefore a very small fraction of underlying activity. But even with our current, fragmentary knowledge, it is clear that predatory tendencies of the intermediaries only grew and helped precipitate the crisis.
We will focus on the credit crisis and skip over well-covered abuses such as the Wall Street equity analysts pushing dot-com stocks they knew to be dreadful, Enron, and the 2002 accounting scandals.
Let’s review some elements that were critical both in the Mexican banking crisis of 1994 and now:
Use of derivatives to evade regulations, leading banks to be undercapitalized. In Mexico, the banks used derivatives to increase their economic exposures which was tantamount to increasing the size of their balance sheet, when they were at the limits of what their equity levels would permit and should not have expanded any further. This contributes directly to systemic instability. Thinly capitalized banks are more prone to failure.
One very large example; AIG wrote over $300 billion of credit default swaps for European banks. Its financial statement for 2007 said they had written the CDS, “for the purpose of providing them with regulatory capital relief rather than risk mitigation in exchange for a minimum guarantee fee.”
AIG’s role in providing what turned out to be fictive capital to European banks was a major reason the United States rode in to rescue the giant insurer. As of June 2009, the total size of the bailout was $180 billion.
Investors taking on risks they did not understand and would never have knowingly accepted. This has been endemic, as insufficiently skilled investors too often relied on glib salesmen’s descriptions and ratings. For instance, Lehman and other major banks sold collateralized debt obligations (CDOs) to retail customers. Readers may recall that CDOs are highly structured paper, often a resecruitization (tranches of other structured deals often went into CDOs, which themselves were tranched into risk classes). They were designed so that the highest quality layers fetched AAA ratings. We discuss CDOs in more detail in chapter 9.
It was clear most buyers relied on the rating. The deals were very complex, containing pieces from many other deals, each of which needed to be assessed to come up with the likely cash flows were the raw material for the deal, and then used to determine how those flows were distributed among the tranches. It could take a skilled person using specialized software a full weekend to evaluate a single deal. Yet the buyers included town councils and fire brigade boards in Australia (one reported losing 80% of its investment) and Narvik, a Norwegian village 140 miles north of the Arctic Circle.
The German Landesbanken, famous for their haplessness, took an estimated 300-500 billion euros worth of now-troubled U.S. assets, between purchases and guarantees to U.S. bank off-balance-sheet vehicles such as conduits (bank-like vehicles that funded consumer receivables, such as auto loans, credit card receivables, and student loans) and their more exotic cousins, structured investment vehicles, or SIVs.
And it wasn’t just subprime or structured credits that produced large losses. Jefferson County, Alabama, entered into a series of complex interest-rate swaps to lower the cost of a $3.2 billion financing for its sewer authority. If the municipality declares bankruptcy, it will have the dubious honor of being the largest of its type, beating 1990s derivatives victim Orange County. In Italy, 600 local bodies ranging from Milan to Polino (home to 290 people) entered into over 1,000 derivatives contracts on 35.5 billion euros of debt. Unrealized losses at the end of 2008 were 1.93 billion euros. Giorgio Questa, a former investment banker, now finance professor, stated the obvious: “It makes no sense for local governments to dabble in derivatives. At best they get ripped off.”
Related to the point above, but distinct, is investors as bagholders, meaning a dumping ground for intermediaries’ risks. Recall that in the later stages of the Mexico mess, Morgan Stanley wasn’t simply arranging trades to collect fees on those deals. It also teed up some swaps specifically to shift onto customers a risk that it wanted out of, namely, that of Mexico suspending convertibility of the peso.
Another class of cases was synthetic CDOs, which were used by investment banks and hedge funds to lay off the risk of credit default swaps. Recall that a credit default swap is effectively an insurance policy: the protection writer receives payments, based on the riskiness of the guarantee, then has to pay out if the entity it has insured defaults or goes bankrupt.
While AIG took this risk, most financial intermediaries did not. They would hedge it by entering into an offsetting contract, getting someone else to insure their insurance. While their guarantor often turned out to be AIG the giant insurance company stopped writing many types of credit default swaps in 2006. Banks and traders needed new parties to eat their risks. A popular way was to bundle them into complex products and dump them on to clueless investors.
A regular CDO takes real assets, like mortgages, corporate loans, or pieces of other securitized deals, such as mortgage securitizations or securitizations of loans used to fund corporate buyouts. But in these cases, the underlying assets are loans of various sorts, which pay interest and principal. In a synthetic CDO, the cash flows come from the “premium” payments on various credit default swaps. This means investors in these CDOs will have to make payments if the defaults on the CDS guarantees exceed certain trigger levels. The bottom, equity layer takes the first losses. Then when it is exhausted, the next layer, the “mezz” or BBB layers, must make payments if defaults rise higher.
A common type of synthetic CDO held credit default swaps written on, or “referencing,” corporate debt. These CDOs allowed large investment banks to offset the risk of credit default swap “guarantees” they wrote in the course of their regular business. Think of it as a form of reinsurance. Variants of this product were sold far and wide, including to Belgian banks, bush towns in Australia, retail investors in Singapore, and U.S. municipalities. These investors were unknowingly guaranteeing an aggregate trillions of dollars in U.S. debt. Estimates on how much they will have to pay out range from the tens to hundreds of billions of dollars.
Often buyers were treated as stuffees. Highly complicated paper was being sold to people clearly incapable of evaluating it.
An example: a synthetic CDO blew up on five Wisconsin school districts, causing losses of $150 million. It was bad enough that they were told by the broker that the investments were extremely safe, that the CDS were on high quality corporations, and the default trigger was almost certain never to be reached: “there would have to be 15 Enrons before you would be impacted”; “On the investment side, we’re sticking to AA/AA.” The schools repeatedly asked whether the CDOs were exposed to subprime debt and were told no. And had they understood the deal, there was not much additional return for taking on the extra exposure. The districts had $35 million to invest. Had they put this money into Treasuries, they would have made $1.5 million a year, while this deal, if everything worked out, would yield them $1.8 million a year. Oh, but we forget, a key difference was that this transaction also netted the brokerage firm $1.2 million in fees.
In fact, the CDO contained credit default swaps that were written on risky credits, including home equity loans, subprime mortgages, and credit card receivables. Even worse, the districts, based on the broker’s advice, borrowed $165 million on top of the $35 million that was their own money. When they took losses of $150 million on the $200 million they had invested, that meant they lost all of their own money and were faced with the prospect of paying $115 million to the lender.
Derivatives expert Satyajit Das sums up the pattern here:
“Dealers began seeking new ways to improve profitability and started marketing structured products directly to retail customers, the widows and orphans of legend. . . . Structured product marketers set out into the suburbs and strip malls. The logic was compelling–you had less sophisticated clients, the margins would be richer. In short, you could rip them off blind.”
The investment banks were finally hoist on their own petard. Investment banks operate tactically, taking advantage of often-fleeting opportunities. Former Columbia business school professor Amar Bhide called it “hustle as strategy.” Morgan Stanley, when it embarked on its Mexican adventures, assumed it could operate as a pure middleman, simple arranging trades and taking big fees. It didn’t envision that it would wind up getting in so deep that it would be exposed to the inevitable peso meltdown.
Yet short-term thinking has become endemic in the public company, “other-people’s -money” model. For instance, Christopher Ricciardi, who headed Merrill Lynch’s collateralized debt obligations group from 2003 to early 2006, built a business that produced an estimated $400 million in underwriting profits in 2005. But Ricciardi had become leery of the increased riskiness of the product and waning investor appetite. He had merely budgeted no growth for his highly profitable unit for 2006, and then, allegedly because he did not get a hoped-for promotion, left for a boutique firm. However, Ricciardi, who had been a pioneer in the late 1990s wave of CDO issuance, had managed the neat trick back then of leaving his employer right before the market fell apart.
Merrill, determined to show it was still a contender in this high-profit business, pushed ahead aggressively even as the market was clearly cooling. Ricciardi’s successor charged ahead, issuing $44 billion, a more than three-fold increase from the 2005 level. But as Ricciardi had foreseen, investor interest was flagging. Merrill wound up with more and more unsold paper on its balance sheet.
J.P. Morgan estimated that Merrill and other major CDO vendors like Citigroup, UBS, and Deutsche Bank wound up keeping roughly two-thirds of the top-rated tranches of the 2006 and 2007 deals, which accounted for the bulk of the value of a transaction, typically 65% to 80%. To be conservative, two-thirds times 70% is roughly 45%, a simply massive retention. It would have been unheard of in the days of partnerships for an investment bank to hang on to an unsold underwriting (it would be seen as a horrid mistake, not to be repeated).
But the new world of other people’s money produced a cavalier attitude toward risk. As we will discuss in chapter 7, accounting foibles meant traders could bring future earnings from these holdings back to the present and have their bonus payout based on years of future, unearned profits. The incentives were terrible and the banks paid out rich compensation on positions that in the end delivered enormous losses.
For instance, Merrill, which had held onto CDOs and other subprime paper, bet on the positions recovering in value. But when they continued to deteriorate, Merrill was forced to unload them. It sold one block of $30.6 billion of CDO paper for $6.7 billion, an eye-popping near-80% loss.
But even that summary overstates the sales price. The buyer, a hedge fund called Lone Star, paid only 5.5 cents on the dollar in cash; the rest of the payment was financed via a loan from Merrill. That loan was secured by the paper, which means if the value of the CDOs sold fell further, Lone Star could simply refuse to repay the loan and return the CDOs to Merrill. Thus Merrill would still take any further losses above the 5.5% payment that Lone Star had already made. Market participants say it is a virtual certainty that the CDOs are worthless, meaning Merrill will suffer a 94.5% loss.
The Securities Industry and Financial Markets Association pegged global CDO issuance for cash flow and hybrid CDOs, at $411 billion in 2006 and $340 billion in 2007. Of that total the type that has blown up most spectacularly, so-called ABS CDOs (for asset-backed securities) constituted 50% to 60%. Recall the J.P. Morgan estimate, that the industry retained 50% of the value of those deals. Experts say that that even the “super senior” or the very top tranches of one type, mezzanine CDOs, which has riskier assets, are worthless. The somewhat less risky AAA tranches of “high grade” CDOs are worth 15 to 20 cents of the dollar as of this writing. Let’s charitably assume an average across all types of 15 cents on the dollar. That means the banks aggregate have sustained $160 billion to $190 billion of losses on this product alone.
It may seem incredible that the cunning of the big financial firms has redounded so severely against them. But neoclassical economics offers a ready explanation. Recall that in the theory, the locus of all economic behavior lies in the decisions of self-interested individuals, and larger groups like corporations are an afterthought.
In an aggressive profit-seeking setting, is it then any surprise that employees of the major financial firms turned their predatory instincts against their own companies? If the staff had found a way to line their own pockets at the expense of investors, then why would they stop to line their own pockets at the expense of investors, then why would they stop even if maximizing their bottom line damaged the enterprise? After all, to Jeremy Bentham, groups were mere “fictitious bodies” and should not constrain a man’s pursuit of pleasure. We’ll see what happened when this reasoning was taken to its logical conclusion in the next chapter.”
(THE FOLLOWING IS ON THE INSIDE JACKET COVER AND I QUOTE:
“This is a riveting historical sweep of how the widespread implementation of unsupported and misguided economic theories paved the way for this disaster. In this book Yves Smith reveals:
- why the measures taken by the Obama Administration are mere palliatives and are unlikely to pave the way for a solid recovery.
- how economists have come to play a profoundly anti-democratic role in public policy.
- how the employees of major financial firms looted their companies, enriching themselves and leaving the mess to taxpayers.
- how arcane trading strategies directly increased the severity of the housing bubble and caused the subprime collapse to detonate into a general economic crisis.
This is the first book to put the financial crisis in its proper context, as not merely a subprime mortgage meltdown, but the inevitable culmination of a process building over decades yet endorsed by mainstream economists and enabled by their flawed precepts.”
THESE ARE MY COMMENTS AND I QUOTE: A LOT OF THESE BIG INVESTMENT BANKS CONSIDER THEMSELVES RISK TAKERS SO MUCH TO THE POINT, THEY CAUSED THE 2008 FINANCIAL CRASH WHICH THE TAXPAYERS HAD TO BAIL THEM OUT OR EITHER LET THEM CRASH DUE TO THE FACT OF LACK OF REAL REGULATIONS, WHICH WALL STREET AND THE BIG INVESTMENT BANKS DIDN’T THINK WAS NECESSARY. THE UNREGULATED HEDGE FUNDS AND DERIVATIVE MARKET HAS PROVEN TO BE VERY, VERY HIGH RISK. THAT’S WHY YOU MUST SEE THE DVD MOVIE “TOO BIG TO FAIL” WHICH YOU CAN GET THROUGH YOUR LOCAL LIBRARY AND YOU’LL COME TO THE CONCLUSION THAT REGULATIONS ARE NECESSARY JUST LIKE PRESIDENT FRANKLIN ROOSEVELT FOUND OUT AND ENFORCED.
LaVern Isely, Progressive Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran