In yesterday’s New York Times, Joe Nocera incisively attacked the persistent falsehood that Fannie Mae and Freddie Mac were “ground zero” for the financial crisis. In “An Inconvenient Truth,” Nocera correctly observed that: “The reality is that Fannie and Freddie followed the private sector off the cliff instead of the other way around.”

In an analysis of the Financial Crisis Inquiry Commission Report, I challenged the blame-Fannie-and-Freddie for the crisis myth, here. As I wrote early in 2011:

Myth 4: The big government-sponsored companies (GSEs), Fannie Mae and Freddie Mac caused the Financial Crisis because the government pushed them to guarantee mortgage loans to poor homeowners as part of their public housing mission. Variations on this are that public housing mission drove bad underwriting by lenders who had to create risky mortgages to fulfill the demand of the GSEs who needed to buy them, as they were desperate to meet housing goals.

Reality 4:  Not exactly. Both the Report and the primary dissenting statement agree that on their own Fannie and Freddie did not cause the financial crisis. They focus blame largely on the so-called “private label” mortgage market. These are bank and non-bank,  brokers, lenders, and securitizers.  Fannie and Freddie did not originate loans; the “exotic” and dangerous loans were designed by and extended to borrowers through the private label channel. While the Report and the Thomas Dissent support the notion that Fannie and Freddie’s business model was flawed, they also agree that affordable housing goals did not either drive Fannie and Freddie to ruin or cause them create the overwhelming demand for predatory, high-risk, mortgages.

So, why is it that the distortions repeated by folks like Peter Wallison have traction with the public?

This phenomenon reminds me of an early scene in F. Scott Fitzgerald’s The Great Gatsby. At the start of the novel, upon reacquainting with her cousin Nick Carraway, Daisy Buchanan inquires whether the rumors of his engagement to a woman out West are true. Even Daisy’s husband Tom chimes in. Nick quickly denies any designs to be wed. However, Daisy brushes off his response and insists that she knows better: “We heard it from three people, so it must be true.”

The statement is funny on its face because Nick is the primary source. Surely, Daisy should recognize that he is more capable, than three gossips, of knowing whether he is or was engaged to be married.  Yet, what is also amusing is that beneath the surface, there is a kind of familiar truth to Daisy’s rejoinder. It resonates, echoing various biases to which many of us succumb. Through exposure to repetition, particularly by a seeming variety of sources, we accept a certain version of reality. Even when faced with credible contradictory evidence, we have a hard time shaking free of the various “truths” we have collected.

So what does this have to do with the financial crisis? The story of the crisis deals with very real people offering fictions, steeped in ideology.  Yet, there is a connection. There is much the falsehoods about the financial crisis, fed on ideology, politics and economic-self-interest have in common with Daisy’s triple-sourced “truth.”  The myths about the causes and responses to financial crisis are repeated by many people. Yet, notwithstanding clear evidence refuting them, even from a number of sources with better information, many of us continue to hold on to them.

Possibly my two favorite things are 80s music and Goldman Sachs-related grandiosity. So, a combo is a special treat. We have them together with the BBC-broadcasted-boastings of independent trader Alessio Rastani.  Rastani proudly proclaimed today,

“This is not a time right now for wishful thinking that governments are going to sort things out . .  The governments don’t rule the world, Goldman Sachs rules the world.”

You’ve got to give this guy credit. The bar was pretty high over at Goldman, what with Blankfein doing God’s work and Tourre deeming himself the “fabulous Fab.” The interview is jam-packed with other gems, and it will probably go viral soon, so it’s worth watching.  What about the 80′s music?  Tears for Fears, of course: Everybody Wants to Rule the World.

There is a lot to mourn and to fear in the brief interview with Rastani. The context alone is disturbing — the continued financial crisis that will soon be amplified with the problems in the Eurozone. Perhaps the most troubling is the flat out admission that:

“For most traders we don’t really care about having a fixed economy, having a fixed situation, our job is to make money from it.”

I guess this guy, as an outsider, did not get the memo that the firm was trying to live down the “great vampire squid wrapped around the face of humanity” reputation. Truly, this is the kind of thing that should be wiki-leaked, not shared in the bright lights of a global news network.

Update:  The trader is identified as independent, not a Goldman employee.

TURNING and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed,

(from William Butler Yeats’ The Second Coming (1919))

Sometime in the late 1980s bank executives discovered that their institutions should be “high performance companies.” It was no longer possible, after two decades of rampant disintermediation and the buffeting forces of deregulation, to generate quiet but respectable profitability by running highly efficient operations. Net interest margins had been stable enough to assure good profits to a protected business if one did not make bad loans. But banks had come face to face with fierce new, largely unregulated competitors and they discovered it was no longer business as usual.

Enter the management consultants. By the time I entered the financial industry in 1995 the exhortations from McKinsey & Company, perhaps the most influential of all for the industry, to stretch bankers’ goals and vision toward high performance had become a daily mantra among bank executives. We all read Jim Collins‘ Built to Last and Good to Great, inspiring works (though their lessons were not always heeded).

One of the axioms to be learned was that high performance banks should deliver an return on equity (ROE) of nothing less that 12 percent; indeed, the expectation (and for a while the norm) became 15-20%. And in a world in which net interest margin could not get us there, the only alternatives were more and more fee-income businesses and leverage. The former involved new ventures and business combinations–the beginning of the rise of the new American universal bank–and the latter entailed greater and greater risk with other people’s money. The math is unavoidable.

So while expenses had to be hacked out of the traditional bank in order to retain some success in an increasingly volatile and often yield-narrowing interest environment–read outsourcing, offshoring, layoffs and our mortgage foreclosure debacle. And new sources of revenue had to be discovered. The drive to increase fee income and increase leverage beyond official limits–read securitization and other off-balance sheet activities–led almost everyone in the financial industry down an inexorable path to systemic financial instability. The rest, as they say, is history. (There is of course a small problem with this history: it is coming around rather faster these days.)

Yet without profound industry, regulatory and market restructuring we have not readjusted our expectations. Indeed, all other things remaining the same, we probably cannot readjust them. It is likely that the executives of our gigantic financial institutions are still aiming at the same goals, that performance bonuses, though apparently sometimes inapplicable to CEOs, are still tied to the same results. Indeed, McKinsey & Company has just produced a report entitled In search of a sustainable model for global banking (for public access to the shorter version, see here). In its report the Company correctly notes the following:

In 2010, the US and European banking industries delivered Returns On Equity (ROE) of 7.0% and 7.9% respectively. Even when these returns are “normalized” by assuming loan losses equivalent to the 2000-07 average plus a “buffer”, the 2010 figures would only increase to 9.3% in the US and 9.2% in Europe. At this level, banks’ ROE is still some 1.5 percentage points below their cost of equity, which averaged globally 12% last year. Even before the industry has digested the additional capital requirements from Basel III, Systemically Important Financial Institutions (SIFI) surcharges and other national “finishes”, developed country banking is facing a significant “return gap”. . . .
Achieving ROE of 12% by 2015 will require US and European banks to increase their profits dramatically. This is asking a lot given that, over the past decade, fewer than one in ten US and European banks succeeded in improving both their cost to income ratio and their revenue margin.

McKinsey then gamely suggests a number of ways in which these institutions might try to achieve the goal of 12% ROE by 2015. The array of possibilities indicates that managements will be trying to do more of what they were doing in the runup to the crisis, not less. True, McKinsey does not encourage recklessness but it is hard to see how such might be avoided. A philosophical reflection suggests as much:

Banking is not the first industry to grapple with a profoundly changed operating environment. Telecommunications players, for example, experienced an upheaval in the late 1990s when regulators helped usher in new competitors and technologies by removing monopolies. In response, incumbent companies undertook far-reaching transformations, reducing cost and staff numbers by 30-50%, and improving productivity by a similar quantum.

And we see efforts to implement this advice playing out all around us as the large banks announce huge planned layoffs and new ventures.

Yet herein lies the dilemma: even if some financial companies do succeed in attaining heroic levels of performance, what about the ones that don’t? Martin Wolf, member of the Independent Banking Commission in the UK, which last week delivered the much publicized Vickers Report, put the problem succinctly to reporters:

If you live in a world in which the real rate of interest on safe government bonds, bonds that the world regards as safe, is about half a percent or less, you might wonder whether you can reasonably expect a reasonably safe return of 15 percent on equity in a bank . . . [Shareholder expectations] are just a little bit unrealistic.

In a turbulent and gloomy environment, here and even more so in Europe, the high performance play is a zero sum game that does not augur well. Who will keep us safe from those that lose?

Update

Last week it was reported that Lloyds Bank has a target ROE of 14.5%. This is consistent with the expectations described in this post. Today, Martin Wolf drives his point home in another succinct analysis of this expectation:

The conclusion is quite simple. If a bank says it needs a real return on equity of 15 per cent, to obtain funds from investors, it is telling you that it is running an enormously risky business. The question you need to ask yourself is this: can we afford to have financial institutions that are both so large and so essential and yet run such huge risks? I suggest the answer is: no. Make them safer. It really is not going to hurt.

I tell my class that a crisis can spring from the most unexpected sources. You never see the lightning that strikes you. Now we focus on some of the most obvious risks, such as a sovereign debt default. As Howard Schneider reported in the Washington Post yesterday, “European banks are facing a reckoning over hundreds of billions of dollars in loans extended to the continent’s cash-strapped governments with potential losses so large, if countries default, that some financial firms could be put out of business.”

Yet danger lurks in the form of many types of operational risk.

Normally when things unexpectedly go wrong in a single company, the system is able to contain the problem–see Long Term Capital Management. But this is not an obvious assumption in the case of large, complex financial institutions (LCFIs) or “universal banks.” They are so tightly coupled, or interconnected, that the failure of one can sometimes cause the failure of all–usually through a sudden and unmanageable liquidity crisis. Today is the three anniversary of the bankruptcy of Lehman, which provides just such an example (though Lehman did not fail because of an unexpected operational risk).

But it could have. The 233-year-old Barings Bank was brought down overnight by the trading activities of a 28-year-old trader, Nick Leeson, in 1995. The failure was contained by British regulators and ING, which bought the bank for the princely sum of £1, but Barings was minute compared to the LCFIs operating today. There have been many other prominent examples, one affecting Daiwa Bank in New York in 1995 ($1.1 billion), one in the late 1990s costing Sumitomo $2.6 billion, and one in France, where Jérôme Kerviel, described by the Wall Street Journal as the “ultimate rogue trader” and by the Financial Times as “the all time champ,” lost $7.2 billion at Societe Generale in 2008 (€4.9 billion) (Kim Krawiec posted a series on the whole Kerviel story on this blog; the last post is here). The list of other cases is not short.

Today we learn that UBS, Switzerland’s largest bank, and 20th largest in the world (at about $1.3 trillion in assets) has just suffered a similar experience at the hands of a rogue, 31-year-old trader in London.* Because of UBS’ size and unusually well capitalized condition, this problem will likely be contained (though its stock dropped dramatically on the news). It is worth noting, however, that UBS was fined £ 8 million less than two years ago for a prior episode of rogue trading. And just a few years earlier UBS had to pay Sumitomo $85 million for its part in the rogue trading episode already mentioned. This raises the question whether rogue trading is really controllable at all, and whether it is really only UBS that does not seem to manage operational risk very well.

The UBS incident is another reminder of just how fragile our system is, and why it is so important to insulate our taxpayer-backed banks from the high-risk-taking activities of trading and investment banking. As the Wall Street Journal, with deliberate irony, headlines its story today: “What Do You Call A ‘Rogue’ Trader Who Makes $2 Billion? A Managing Director“!

* Loss subsequently revised to $2.3 billion.

I am one of those who believes that we cannot possibly meet the challenges presented by the modern financial system, whether global or domestic (it’s almost all the same now), by using the traditional precepts of regulation. These precepts presuppose unrealistic methods of diktat, they involve static views of the agents that operate withing the financial ecology, and they take a artificially linear view of the activities of the marketplace. The financial ecology, as many have long recognized, is a complex adaptive system. To maintain its robustness, let alone understand it, requires a systemic comprehension and an acknowledgement that regulators, as much as the regulated, are interactive agents too. We have much to learn from complexity sciences as disparate as network science, immunology, game theory, to mention only some. Nicholas Taleb’s sweeping work on the randomness and The Black Swan is perhaps the most well known illustration of the power of complexity thinking in the turbulent and complex arena of financial risk management.

Now Daniel Carpenter, one of the most prominent writers on regulation and scholarship on the subject I greatly admire, has endorsed the application of complexity theory to the understanding and reform of regulation (hat tip, Ed Balleisen). In a new book review entitled Systemic Failure: How to think about financial regulation in an era of systemic risk, he discusses the shortcomings of traditional approaches to financial regulation and reviews the possibilities offered by a complexity approach. Writing in praise of the approach taken in a new book I have not yet seen (THE SUBPRIME VIRUS: RECKLESS CREDIT, REGULATORY FAILURE, AND NEXT STEPS, by Kathleen Engel and Patricia McCoy, O.U.P 2011), he notes that “[t]he critical and oft-neglected fact of the crisis rests in the deep connections between the worlds of consumer risk and systemic risk,” and that “[a] world of deep connectivity requires a different kind of regulation.”

This is a glimpse into what the language of regulatory reform will look like in the future.

This morning the British Independent Banking Commission (ICB) released its long-awaited Final Report. Given the clear direction signalled by the ICB in its Issues Paper: Call for Evidence released a year ago, the recommendations in the report had already been anticipated for months. The British Government has accepted the report, at least in principle. The Financial Times reports that the Chancellor, George Osborne, Business Secretary, Vince Cable, and the Prime Minster, David Cameron agreed last week that the report’s main recommendations should be enacted.

The Report contains three major sets of recommendations:

1. Retail banking operations should be “ring-fenced.” In other words, they should separated as legal entities from the larger corporate banking group of a “universal bank” (for example, one that provides wholesale and investment banking operations as well), and have their own boards of directors. The retail entity would be restricted to certain activities, and other financial organizations would be prohibited from engaging in these activities. There are numerous related restrictions which, in sum, vaguely resemble the kind of firewall created in 1933 by the US Glass-Steagall Act (now repealed).

2. Large banks should have higher “loss absorbency” capacity. This is defined through a series of requirements varying according to the size of the risk-weighted asset ratios of these organizations, their leverage ratios, and whether they are global systemically important financial institutions (so called “G-SIFIs).

3. Stricter enforcement of market efficiency and competition rules (the analogy to US antitrust laws), including greater transparency requirements. An interesting element of this recommendation is that the “product ranges” of banks should “include an easily comparable standardised product.” Here let us recall the continuing battle in the US over the Consumer Financial Protection Bureau and its powers.
The Report also welcomes the British government’s commitment to give the recently created Financial Conduct Authority a “new primary duty to promote competition.” A timely cross-Atlantic comparison is the enhanced investigation currently being conducted by the Fed of the proposed acquisition of ING Direct by Capital One–a deal that would have been hastily approved only a few years ago.

These are strong recommendations based to some extent, in my view (here and here), on the very sound principle of subsidiarization, which is designed to inject modularity into the structure of the behemoth universal banks. The recommendations are, however, a little weaker than banks had originally feared, and they would only need to be fully implemented by 2019 (timing designed to coordinate with the Basel III implementation schedule). As a result, the stocks of some British banks actually rose today, notwithstanding the fact that the recommendations will cost the industry approximately $9.5 Billion (£7 billion). A major part of this cost is the result of the higher cost of funding that investment and other non-retail banking will incur if they can no longer use the inexpensive contributions of retail depositors.

Of course the industry and its allies, including the Confederation of British Industry (CBI), are howling their opposition to the recommendations. The head of the CBI, John Cridland, was so moved that he delightfully called the anticipated ICB recommendations “barking mad.” So until the British Parliament actually enacts them into law we cannot be certain of their final form and strength.

But one should salute a sincere, thoughtful and robust effort on the part of the Commission to get at the source of one of our major sources of financial instability, namely the sprawling universal banks that, by virtue of their necessary Too-Big-To-Fail nature, hold all of us hostage to their fortunes.

Can we expect similar fortitude from our non-independent and grotesquely bureaucratic Financial Stability Oversight Council?

We ended part i, with some questions. The answers to these questions could fill volumes. Yet, a high-level response is in order.

First, can Dodd-Frank prevent another similar crisis? This is far from certain. The law depends too much on regulators to actually use the powers they have been granted. Past behavior suggests that they will not. And, even regulators who wish to act will have trouble completing the job of derisking and downscaling the banks to prevent collapse. Given the various advantages of being too bit to fail, we cannot expect the firms themselves to complete that task.

Second, what should we celebrate and where are the gaps? There is much to celebrate. Getting this first law enacted and to its first year, was a tremendous accomplishment.  As noted yesterday, we just need more to follow in its footsteps to make up for its weaknesses. And, some parts of the statute, such as the consumer financial protection bureau deserve particular praise. However, even while the consumer protection measures are worth celebrating, it is shameful that the law fails to do more for troubled homeowners.

Let me provide an explanation for this skeptical view.Here goes. Dodd-Frank provides a number of tools to prevent banks and other financial firms from engaging in excessive borrowing and betting that result in taxpayer-funded bailouts. Some of these tools appear more effective than others. Without a doubt, many need to be strengthened. And, shadow banks that still remain outside of regulatory scrutiny need to be brought into the light. Similarly, Dodd-Frank provides strong tools to better protect consumers, but industry-funded politicians are trying to weaken this part of the law.

So what are the meltdown prevention tools?  First, Dodd-Frank attempts to reduce leverage. Section 171, the “Collins Amendment,” establishes, for the first time, a cap on how much bank holding companies, thrift holding companies and nonbank financial firms (“nonbanks”) can borrow. However, the leverage cap is still too high. About $96 in borrowing for every $100 in total (non-risk-weighted) assets is allowed, and possibly as high as $97. Experts like Professor Anat Admati suggest a 15 to 20% equity cushion – or only $80 to $85 in borrowing should be permitted for every $100 in assets. Moreover, the limit does not apply to all. While banks are broadly covered, only a small number of nonbanks will be affected.Even though nonbanks include a variety of financial firms such as  hedge funds, industrial loan firms and insurance companies, and though these have been prone to messy insolvencies and bailouts, they are not all covered. In fact, so far, none are. Only those nonbanks designated by the new Financial Stability Oversight Council (“FSCOC”) as systemically important financial institution (“SIFIs”) will be subject to this restriction. So far, the FSOC has not revealed the criteria by which nonbanks will be designated as SIFIs.

In addition, Dodd-Frank provides extra tools to control the borrowing and other risky activities of large bank holding companies (those with more than $50 billion in total consolidated assets) and nonbank SIFIs.  Once again, only those nonbanks that get designated, and so far none have been. Under Section 165, the Federal Reserve is given the power to impose enhanced supervision and prudential standards on these companies.  These “more stringent prudential standards” are supposed to “prevent or mitigate risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected financial institutions.”

While leverage is still too high, liquidity is barely even touched. A key weakness of the statute is the failure to deal with short-term debt. For example, it is unfortunate hat Dodd-Frank failed to roll back the special treatment in bankruptcy that repurchase agreements backed by mortgage-related collateral were granted in 2005. Policy makers and academics supported this rollback, including Florida Senator Bill Nelson, who attempted to get this into Dodd-Frank, yet his amendment never received a floor vote. There is continued support for such a roll back, including by Professor Stephen Lubben, Professor David Skeel and President of the Kansas City Federal Reserve Bank, Thomas Hoenig. Though under an FDIC “orderly resolution” there is a 24 hour hold on the safe harbors, this is not sufficient, as resolution, is hopefully rare. Many financial firms are only eligible or may otherwise end up in a Chapter 11 bankruptcy. So, this still needs fixing.

Another way the law tries to avoid another meltdown is through “early remediation.” Under Section 166, the Fed is required to take preemptive action, up to and including selling off assets of, (or breaking up) the giant bank holding companies and nonbank SIFIs. The Fed is supposed to take such action if the company experiences “increasing financial distress, in order to minimize the probability that the company will become insolvent and the potential harm of such insolvency to the financial stability of the United States.”

Dodd-Frank also attempts to limit public subsidies of private speculation through Sections 619 – 621 (the “Volcker Rule”). The Volcker Rule limits the ability of banking entities that have access to FDIC deposit insurance or the Federal Reserve discount window to also engage in certain high risk, speculative practices. This part of Dodd-Frank precludes them (subject to exceptions identified below) from owning or sponsoring hedge funds and private equity funds. It also forbids them from trading for their own accounts. Importantly, it also includes a prudential backstop, allowing regulators blanket authority to prohibit a whole host of activities if they create a threat to the financial system.  This part of Dodd-Frank also prohibits firms from betting against their clients and other similar conflicts of interest.

There are notable gaps in Volcker, largely due to political expediency. In order to get 60 Senators on board and thus avoid a filibuster, it was necessary to provide a number of exemptions. One such exemption permits banks to operate or invest in hedge funds and private equity to start them up, so long as the amount of such investments does not exceed 3 percent of their Tier 1 capital. (Roughly, but not exactly, the amount left after subtracting the amount the bank owes from the value of its assets). Much of the details of this rule are unknown. Some complain that the line between permissible “market making” and impermissible “proprietary trading” will be difficult to draw. It is expected that the regulators will leave a lot of discretion to the internal compliance organizations at the covered banks to make those determinations.

And if prevention doesn’t work, Dodd-Frank sets out tools for intervention. Under Title II, the FDIC was given, subject to certain approvals, orderly liquidation authority. This encompasses the power to close down and sell off failing bank holding companies and nonbank SIFIs. Resolution authority is a third alternative – instead of the choice between a government-funded bailout (a la Bear Stearns) and a chaotic bankruptcy (such as Lehman).   Whether resolution authority will be used or will be equally chaotic is a question many have raised.  Some believe it will create even larger firms as they will buy up pieces of failed ones. And others express concern about whether this will work in a cross-boarder, complex financial firm.

Moreover, the funding for an FDIC resolution is first provided by the US Treasury. The taxpayers are fronting the funeral expenses. This means, if the sale of the failed firms assets are not enough to pay back Treasury, large financial firms may be asked to chip in after the fact, possibly when they are also weak. Of course, we remember that a bank-assessment to fill the orderly liquidation fund was strenuously opposed by Republicans in Congress who curiously called it a taxpayer-funded bailout.

So what to do? Prevention tools are not strong enough (and may not even be used by captured regulators) and intervention tools may be too discretionary and untested. Meanwhile, banks are still too big. The top five banks’ assets amount to 60 percent of GDP. In 1980, the top five held assets equal to only 16 percent of GDP.  Perhaps we need a revival of the Brown-Kaufman “Safe Banking Act” amendment, which would have reduced bank size by limiting the total borrowing (liabilities) of any bank to no more than 3 percent of GDP.  This would include amounts banks have on deposit from customers. And, it would have limited the non-deposit liabilities of any bank to no more than 2 percent of GDP. Or, better yet, perhaps we need a new Glass-Steagall, fully separating utility banking from securities operations, swaps trading and other high-risk, complex activities that are unrelated to deposit taking and credit extension.

On the consumer protection front, unmitigated praise is due for the creation and “standing up” of the Consumer Financial Protection Bureau. Though we hear repeated complaints about the weakness of Dodd-Frank, the CFPB is an example of a very strong and potentially very effective agency. That is why in the case of the CFPB, the financial services industry and sympathetic politicians in Congress are working hard to undermine it at every turn. This new agency has three major powers – rulemaking, supervision and enforcement. It will efficiently consolidate authority for numerous federal statutes related to consumer financial transactions. It also has “organic” rulemaking authority. This means it can prohibit a range of “unfair and deceptive acts or practices.”  The CFPB is intended to create a level playing field and uniformity. For example, nonbanks such as payday lenders, mortgage brokers and private student lenders will now be subject to rules, oversight and enforcement.

While this part of Dodd-Frank has tremendous natural strengths, it is in a very tough environment. This is why the CFPB does not have a director. This week, the President bypassed Professor Elizabeth Warren (who initially conceived of the agency and stood it up before the transfer date) and nominated Richard Cordray, the former Ohio Attorney General. While this decision disappointed progressives, it did not mollify conservatives. A group of 44 Republican Senators have not budged. They recently vowed to block the appointment of any director of the CFPB unless the agency’s power and funding are substantially diminished.

The demands fit the acronym, “B.A.D.”  Board. Appropriations. Diminished authority. They want a board and not a director to guide the agency. They want to subject the agency to the Congressional appropriations process. This would put the budget of the bureau in jeopardy based on Congressional whim. Even the expected $400 million budget is barely enough, given what industry lawyers estimate are 35,000 entities that might fall under its jurisdiction. Such lawyers have noted that the SEC has oversight over half as many firms with about three times that budget.  And, the 44 wants to diminish the agency’s ability to make rules by giving the new Financial Services Oversight Counsel (FSOC) greater veto power.

Meanwhile, without a director, it may be that the Bureau is restricted from making rules in certain areas. And, some contend that the CFPB cannot supervise or bring enforcement actions against payday lenders, mortgage brokers and other nonbanks until a director is appointed. Unless the Republicans bend, there will not be enough votes in the Senate to block a filibuster. Thus, many believe that President Obama may resort to a recess appointment in August to assure that Cordray is appointed.

While Dodd-Frank via the CFPB and other provisions may help future homeowners, it does not do enough for existing homeowners who are drowning in debt. An individual who owes more on his mortgage than his home is worth is still not able to use the bankruptcy process to reduce the principal outstanding to the home’s value.  Yet, a wealthier person with a vacation home can do so. And, a business with commercial real estate can as well. The bankruptcy code should have been amended long ago to fix this anomaly. The existence of the bankruptcy principal-reduction option would give all homeowners more bargaining power when they face foreclosure. Moreover helping consumers deleverage will be good for the economy and will discourage lenders in the future from using overvalued appraisals, risky mortgages, and poor underwriting standards, to extract too-big-to-pay commitments from borrowers.

In short, Dodd-Frank provides many tools for prevention and intervention. But it also has notable weaknesses. No surprise; the one-year-old law is not perfect. Yet, we should not throw the baby out with the birthday cake.  We can and must do more to help this law succeed and to enact future legislation to compensate for its limitations. But, we had better act fast. As Professor Tom Ferguson notes  ”the big banks are more dangerous and reckless than ever” and Admati warns that “the next crisis will happen sooner than later.”

People are talking. And, they are not being kind.  Word is, a year has passed, and Dodd-Frank is not living up to his potential.  This observation is painful, but true. Yet, we should not blame the birthday boy.  Here’s why. We expect him to be a doctor already, curing the bloated banking disease and immunizing consumers, yet he has not even taken his first steps. We have heaped upon this infant unreasonable expectations. Given his nature, the code itself, some goals are now and forever beyond his reach. Moreover, some folks intentionally are slowing the poor kid down and putting obstacles in his path. With such an environment, no law can do its best.

It is easy to point to places where Dodd-Frank falls short. Even at birth, gaps in the legislation were visible. At this young age, we can now also see gaps in how the numerous regulators are implementing the law. Yet instead of berating or abandoning this one-year-old, we should celebrate his strengths. And, we should find a way to fix the problems with strong implementing rules and additional legislation. In other words, add some siblings. It may take a family.

Previous reformers did more than lambast the limitations of a fledging statute. And, this approach paid off. For example, the New Deal era financial reforms kept us free from major panics and crashes for about fifty years. But this was not the result of a single statute. The Truth in Securities Act of 1933 was the first federal securities law. But it only covered initial offerings of securities. No problem. The following year, the Securities Exchange Act of 1934, was given life to focus on secondary market sales and the stock exchanges. Even Carter Glass had to push through two different banking laws, the Glass-Steagall Act of 1932 and The Glass-Steagall-Act of 1933, to ensure the FDIC was created and commercial banking was separated from securities operations. More securities law kin appeared in 1940 when the Investment Company Act and the Investment Advisers Act were added to address abuses in the investment trust industry and the provision of investment advice. These were concerns that arose before the Great Crash of 1929, but were not within the securities siblings’ DNA.

Back to the birthday boy. Dodd-Frank was supposed to be a doctor, created to provide bloated bank disease prevention and intervention. A challenging task.  We faced a kind of debt dependency disease. While we all indulged, depending upon home prices to rise forever, when the hot air started to leak out of the $8 trillion housing bubble, the suffering began. Wall Street received trillions of dollars in bailouts, low interest loans and other “liquidity” supports when home prices reversed, but Main Street was left to suffer. Financiers gained bonuses, kept jobs and grew wealthier. The middle class lost savings, lost jobs, lost homes or saw home values plummet, and with reduced tax revenues and budgetary pressures, lost public services.

How did this happen? Many giant banks (and other financial firms) had borrowed more than $97 for every $100 of assets they owned.  A 33 to 1 assets to equity leverage ratio. A decline of less than $3, or 3% percent in those assets spelled insolvency.  What’s worse, a good deal of the money they borrowed was due in the very short term, sometimes overnight. But the assets they owned were very hard to sell.  And, to make things even more shaky, it was not even clear that the mortgage-linked securities they loaded up on were worth the value they presented to shareholders, lender or regulators. The values of the mortgage-linked securities depended upon homeowners making their monthly mortgage payments in full and on time. And, the timely, full mortgage payments depended upon in part, the capacity of homeowners to pay, but more so, on the underlying home to increase in value.

This Ponzi scheme began to collapse after  home prices began to stabilize and fall, and homeowners began to default in larger numbers. Then in the summer of 2007, many mortgage-linked securities were downgraded. This combination of extreme leverage, overvalued, illiquid assets, and maturity mismatch would put any individual borrower at risk of insolvency. When the borrowers were giant, interconnected banks and nonbank financial firms, a domino effect of failures ensued.

What ability does Dodd-Frank have to prevent another similar crisis? What should we celebrate and where are the gaps?

Answers provided in part 2.

Sheila Bair’s five-year term as Chairman of the Federal Deposit Insurance Corporation (FDIC) ends today, Friday, July 8th. During her tenure, Bair racked up an impressive list of achievements. Notably, even with the recent wave of bank failures, Bair managed to use only the industry-supplied deposit insurance fund (DIF), and not taxpayer dollars to shut down and sell off hundreds of insolvent banks.

Reflected in her vigilance over the DIF was the broader view that financial institutions, their leaders and investors (and not the public) should bear the losses from their failures. This perspective appeared to inform her other policy choices.  Indeed, her final accomplishment was the FDIC board’s unanimous approval on Wednesday of a new rule to claw back banker pay. The rule permits the FDIC acting as liquidator, to demand the return of two years of pay from senior executives and directors who were substantially responsible for the bank’s collapse.

Also, Bair was a leading voice for establishing international limits on bank borrowing, with a total-assets-to-equity leverage ratio. Supplementing the easily-gamed risk-weighted measures, this simple leverage ratio could help block bank efforts to game the system with poorly designed or misused mathematical models. Bair fought successfully to expand the FDIC’s authority through the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. As a result, instead of choosing between a taxpayer-funded-bailout and a Lehman-style-chaotic bankruptcy, there is a third choice. The FDIC has the power to bring into receivership, liquidate and shutdown failing bank holding companies and certain other systemically important nonbank financial firms.  There are legitimate questions as to whether this “orderly resolution” authority will be used effectively, if at all. However, it’s existence encourages the ongoing debate over whether we still need to break up the banks in terms of lines of business to make them no longer too big or too interconnected to fail.

Perhaps the most admirable of her accomplishments was her ability to maintain clarity and dignity amid accusations that she was not a “team player.”  When that “team” scored points at the expense of the American people, in my view, her resistance deserves a badge of honor. The so-called team players who serve in public office do us no favors when they are “just following orders” of misguided leaders.

Bair was early to see the threat of predatory lending. From a previous position as Assistant Secretary of Financial Institutions at Treasury, before departing for a short term in academia, she tried in 2002 to end those practices and met substantial resistance.  Indeed, she would later testify before the Financial Crisis Inquiry Commission (“FCIC”) of the grave consequences of Alan Greenspan’s failure as Chairman of the Fed to use its authority under the Home Ownership and Equity Protection Act (HOEPA), to ban bad underwriting practices at both banks and “nonbank” institutions. According to the FCIC report:

“This was a missed opportunity, says FDIC Chairman Sheila Bair, who described the ‘one bullet’ that might have prevented the financial crisis: ‘I absolutely would have been over at the Fed writing rules, prescribing mortgage lending standards across the board for everybody, bank and nonbank, that you cannot make a mortgage unless you have documented income that the borrower can repay the loan.’” (emphasis added).

Also, Bair advocated strenuously for loan modifications to help prevent an avalanche of foreclosures.  Bair’s performance reminds us that people matter, not just the institutions which they inhabit.

In addition to being a public servant, Bair is also a former colleague from the University of Massachusetts, Amherst. While our paths overlapped, for about eighteen months, given that we were in different departments, I had only a few occasions to converse with her. However, I benefited greatly from her presence. Bair enriched our community with her interest in corporate governance and her contacts. While a faculty member, in 2005, Bair brought Senator Paul Sarbanes to visit and address a class of MBA students and also the wider University.  And, after she rose to be listed by Forbes magazine as the second most powerful woman in the world, Bair returned, including to speak about the financial crisis and also to deliver a commencement speech.  Not an academic by trade, Bair was welcomed by Isenberg School of Management, Dean Tom O’Brien. Though he refused to take credit for his foresight, O’Brien had a knack for attracting original thinkers and rising stars to our school and supporting their efforts. In addition to Bair, for example, he brought in Nassim Taleb who taught at UMass for a year, during which time he worked on his soon-to-be-acclaimed book, The Black Swan.

With Bair goes one of the three “New Sheriffs of Wall Street” featured on the cover of Time magazine May 13, 2010.  The cover photo mirrored one from a decade earlier. The now iconic and ironic February 15, 1999 Time cover portrayed the “Committee to Save the World.”  In that image, Alan Greenspan stood smiling assuredly front and center, flanked by a twinkle-eyed Robert Rubin and a seemingly annoyed Lawrence Summers. The subtitle of the article promised “The inside story of how the Three Marketeers have prevented a global economic meltdown – so far.”  Missing from that photo, quite unfortunately, was someone who could have actually help prevent a global economic meltdown – Brooksley Born, whom we have discussed, here. Born would resign from the CFTC a few months after the Time article.

On last year’s cover, SEC Chairman Mary Schapiro appeared in the center spot where Greenspan had posed. Professor Elizabeth Warren, then head of the Congressional Oversight Panel on the TARP and Sheila Bair took the places inhabited by Rubin and Summers. The subtitle identified the trio as “The Women Charged with Cleaning up the Mess.” Just as the Three Marketeers were not able to save the world, and indeed created quite a mess, the New Sheriffs, cannot on their own clean it all up.  And certainly not without the ongoing support of the Congress. Administration and other financial regulators.

After all, the build up and burst of the housing bubble was not a weekend-long frat party. Greenspan had more than twenty years to wreak havoc. In his own estimation, under oath last year, he volunteered that he was wrong thirty percent of the time.  Two decades of leadership with that ratio proved disastrous. And though Rubin and Summers were not each fixtures as Treasury Secretaries and other Administration roles for that long, they did manage to champion the most damaging acts of financial market deregulation in the past century. These included the gradual erosion and ultimate repeal in 1999 through Gramm-Leach-Bliley of the Glass-Steagall Act’s separation of commercial from investment banking. Also included was the passage in 2000 of the Commodity Futures Modernization Act, which fostered the explosion of credit default swaps. Both of those took place after the photo was snapped.

Sadly, one member of the sheriff-cleanup-crew is moving on. Yet, she leaves our country, the financial system, and my former University far better than she found them.

Secretive practices and institutions are common in contemporary finance. For those who’ve ceased the search for long-term value creation, temporary information advantage is key. Even commonplace practices can be reinterpreted as havens of hiddenness. My colleague Michael Simkovic’s article “Secret Liens and the Financial Crisis of 2008” exposes the role of derivatives and securitization as secretive borrowing strategies, designed to keep the naive or trusting from discovering the fragility of the institutions they loan funds to. His work has been presented to the World Bank Task Force on the Bankruptcy Treatment of Financial Contracts, and is relevant to both private and sovereign debt risks.

Simkovic argues that 80 years of erosion of classic commercial law doctrine ensured that “complex and opaque financial products received the highest priority in bankruptcy.” Products like swaps and over-the-counter derivatives were not adequately disclosed (either by banks in their consolidated financial statements or by their counterparties in publicly accessible transaction registries). By concealing those debts, these already overleveraged financial institutions were able to attract ever more credit and investment, at better rates than those who reported their overall financial health more accurately. (All other things being equal, it’s safer to lend to an entity that owes 10 billion rather than 100 billion dollars.) The genius of Simkovic’s article is to show how “fundamental causes of the financial crisis are relatively old and simple,” even as an alphabet soup of instrument acronyms (CDO, CDS, MBS, ad nauseam) and government programs (TARP, TALF, PPIP, et al.) makes our time seem unique.

As Simkovic explains:

Losses act as a spark; widespread leverage is the powder keg. Leverage can be “regulated” privately by creditors or regulated by government, but only if the extent of leverage is known [emphasis added]. Hidden leverage is a perennial problem because debtors rationally wish to borrow at the lowest price possible. Debtors can borrow at more attractive rates by hiding their existing debts and creating an exaggerated appearance of creditworthiness. [emphasis added]

Debtors who wish to hide their debts can exploit competition between potential creditors to gain active cooperation from some creditors. These cooperative creditors will work with debtors to hide loans either through simple non-disclosure or through complex structures. Debtors may compensate these cooperative creditors for their assistance with higher fees, a deeper business relationship with the creditors, or liens on the debtors’ property. The result of this subterfuge is lower financing costs for the debtor and lower profits—or steeper losses—for unsophisticated unsecured creditors.

Note that Simkovic’s work is more incrementalist than that of Stephen Lubben (another colleague of mine) or Mark Roe, who question the wisdom of safe harbors for derivatives in bankruptcy. Whatever you feel about that position—and however you feel about the relative advantages of regulation or market forces in deterring systemic risk—Simkovic’s work points to a fundamental problem that all sides in these debates must grapple with. Neither market forces nor regulators can deter systemic risk if there’s not fair warning that an interaction between secrecy and priority in bankruptcy can suddenly create disastrous runs on financial institutions. It’s one thing to create priorities (or supersecured creditors) that everyone knows about. It’s quite another to allow sophisticated debtors to promise the moon and stars to entities that have no idea what rival claimants are going to demand.

Pushing for Priority

For “financial innovators” in the years leading up to 2008, the game was straightforward: sophisticated lenders wanted to obtain first priority in bankruptcy (and/or the right to make collateral calls quickly), while borrowers wanted to hide how much they’d borrowed (and how encumbered their assets were). Like the fraudulent subprime broker who added a few zero’s to the end of his client’s W-2 form, leading bankers exaggerated the well-being of the desks and divisions they fronted for by obscuring certain obligations on their books.

How did they do it? Simkovic explains how the bankruptcy code now favors “securitized” over “secured” debt. The code forces secured creditors to try to keep their bankrupt debtor afloat during reorganization. For example, an “automatic stay[] prevents a secured creditor from seizing and liquidating the underlying collateral to recoup its investment.” A securitization can stave off such obligations by “distancing” certain obligations from bankruptcy. Simkovic explains these steps:

In an asset securitization, the debtor (or “Originator,” the term typically used in documentation) transfers financial assets such as credit card receivables or mortgage receivables to a special purpose entity, or SPE, typically a wholly-owned subsidiary of the debtor. The SPE (or another transferee) issues debt to investors. Investors pay the SPE which then pays the debtor.

For the securitization to isolate the underlying assets from the debtor’s bankruptcy, the transfer of assets from the debtor to the SPE must qualify as a “true sale.” Most securitizations do not economically resemble “true sales” because the debtor retains the risk of default or non-performance of the underlying assets. The debtor retains risk because the debtor owns the equity (or “first loss tranche”) in the SPE, and because the debtor may be required to repurchase assets from the SPE if losses reach a level exceeding . . . [a] pre-set trigger.

However, just as clever legislators let AIGFP characterize its disastrous CDS business as “protection-selling” (rather than insurance), Delaware’s Asset-Backed Securities Facilitation Act let securitizers safely call the SPE fancy footwork a “true sale” to avoid the responsibilities associated with secured debt. The debtor’s obligation to its SPE’s is kept “off balance sheet,” hidden from many creditors. Limited disclosure of asset securitizations (and their terms) means that “even professionals can underestimate the extent of debtors’ exposure to losses from securitized assets.”

Rating agencies have given very high ratings to securitized debt, reasoning that the originating “‘companies retain the subordinated interest in the transaction known as the equity tranche or ‘first-loss’ piece.’” But they ignored the underlying economic motivations behind the transaction: those who brokered the deals would walk away with huge fees regardless of how well it did overall. Aside from sacrificial wolf Fabrice Tourre, virtually everyone involved in the securitization machine has done fine financially. And as the WSJ noted in 2008, the SEC failed to require rating agencies to “disclose to the public all underlying information about any debt they are rating.”

Financial Innovation as Epiphenomen of Legislation: The Case of Credit Default Swaps and BAPCPA

Simkovic also highlights how another aspect of the CDO doomsday machine thrived on secrecy. Just as a firm could both stand behind a securitization (to assure buyers of the securitized assets) and not stand behind it (for accounting purposes, so it looked like it had less exposure than it actually did), so too could the buyers of securitized assets have their cake and eat it too. The securitized asset promised a steady income stream, and a transaction called a “credit default swap” allowed its beneficiary to offload the risk that the income would not materialize onto another entity, in exchange for steady payments of its own. So even when outside observers might bridle at the amount of leverage an entity took on to buy securitized assets (often from another entity that was heavily leveraged to create and support the same assets), the buyer could outwardly appear to be placing one bet with its publicly disclosed balance sheet, while secretly hedging its bets by buying a credit default swap from a well-capitalized firm that promised to pay in case the SPE and originator could not. Its purchase of the assets, a “vote of confidence” in public, might even be swamped by skepticism about the viability of the assets, if the CDS paid off far more than the expected value of the CDO it insured.

By September, 2008, AIG had sold $440 billion of CDS protection. It had no way of paying out anywhere near that amount, and had not reinsured itself, or offloaded some of the risk onto someone with deeper pockets. Where were the regulators? Stupefyingly uninformed, as the FCIC Report shows:

The Office of Thrift Supervision has acknowledged failures in its oversight of AIG. . . . [S]upervisors failed to recognize the extent of liquidity risk of the Financial Products subsidiary’s credit default swap portfolio. John Reich, a former OTS director, told the FCIC that as late as September 2008, he had “no clue—no idea—what [AIG’s] CDS liability was.” [emphasis added].

According to Mike Finn, the director for the OTS’s northeast region, the OTS’s authority to regulate holding companies was intended to ensure the safety and soundness of the FDIC-insured subsidiary of AIG and not to focus on the potential impact on AIG of an uninsured subsidiary like AIG Financial Products. Finn ignored the OTS’s responsibilities under the European Union’s Financial Conglomerates Directive (FCD)—responsibilities the OTS had actively sought. (350) [emphasis added]

Throughout late 2007 and 2008, the company’s accountant tried repeatedly to discover the true amount of risk involved in its transactions. As Simkovic shows, this was exceedingly difficult to do:

Credit default swaps, like most OTC derivatives, are an ideal vehicle for hidden leverage and secret liens because of their inherent complexity, limited disclosure, and superior treatment in bankruptcy. . . .Unlike exchange traded derivatives, which are standardized, simplified, and priced by the market through frequent trading, OTC derivatives are custom, bilaterally negotiated, relatively illiquid contracts and therefore difficult to price. The value of the derivative depends on three things: (i) the value of the underlying asset; (ii) the contractually negotiated formula that determines the counterparties’ obligations to each other based on that value; and (iii) the creditworthiness of the counterparty to the derivative, which determines the likelihood that the obligation will actually be paid. . . .

In the case of credit default swaps written on CDO tranches held by financial institutions: (i) the value of the underlying assets is difficult to determine because of the mathematically complex structuring that governs loss allocation among tranches and because of limited information about the credit quality of the underlying loans; (ii) the extent of counterparties’ obligations to each other is difficult to determine because of the subjective nature of determining when a “credit event” has occurred and the risk that disagreement will result in litigation; and (iii) the creditworthiness of counterparties is difficult to determine because they too have extensive and hard-to-measure exposures to derivatives such as credit default swaps.

Simkovic discusses how it may be impossible, even in principle, for large players to figure out the true extent of their exposure. CDS counterparties thought they were safe once they bought protection from AIG, and didn’t realize that AIG might go under. The banks didn’t accurately gauge the risk posed by AIG.

Willful Blindness

Simkovic’s position has been amply confirmed by other critics’ work. Consider, for instance, the cutting analysis from Eric Banks’s prescient The Failure of Wall Street (2004), which describes “financial controllers and auditors who don’t understand the nature of the business they are meant to be ‘independently monitoring,’” and trading desks which have little sense of “what kind of credit risks they are exposed to.” Combine these internal weaknesses with the regulatory arbitrage that allowed institutions to seek the most pliant “watchdogs,” and disaster was inevitable.

Of course, there were some forward-thinking participants in the financial markets who saw the risks, and ran away from them. As one report noted about Warren Buffett:

When Berkshire bought General Re in 1998, the reinsurance company had 23,000 derivative contracts. “I could have hired 15 of the smartest people, you know, math majors, Ph.D.’s. I could have given them carte blanche to devise any reporting system that would enable me to get my mind around what exposure that I had, and it wouldn’t have worked,” [Buffett] said to [a] government panel. “Can you imagine 23,000 contracts with 900 institutions all over the world with probably 200 of them names I can’t pronounce?” Berkshire decided to unwind the derivative deals, incurring some $400 million in losses.”

As one commentator observed, this type of complexity leads to a number of other problems:

Derivatives, because they are so hard to value, make it easier for traders and chief executives to inflate earnings. They exacerbate problems if a company, for unrelated reasons, suffers a credit downgrade that requires it to post collateral with counterparties – “a spiral that can lead to a corporate meltdown,” [Buffett] wrote. They create a “daisy chain” of risk as the troubles of one company infect another.

That “daisy chain” of risk echoes the diagnoses of Yale economist John Geanakoplos (whose work has indicated the instability caused by high leverage and “tight chains of financial interdependence”), Rick Bookstaber (who chronicles the instability inherent in “tightly coupled” systems), and Lawrence Baxter (who brings attention to recent network science on the “cascading failure” that is “common to many complex systems”). An interdependent system as complex as the OTC derivatives market can crumble at any moment. If key participants are too highly leveraged and one or more of them experience a shock, disaster is inevitable. The problem is not a “black swan;” it’s the black box dealmaking that make it impossible for markets or regulators to grasp how leveraged and fragile institutions really are.

Secrecy vs. Resilience

So how resilient should these systems be? That is a matter due much more political and regulatory attention than it is currently getting. Regardless of one’s views on leverage, one thing is clear: the types of opacity described in Simkovic’s article prevent us from getting any handle on the scope and severity of the problem. As he notes,

[E]ven basic information about OTC derivatives transactions can be extremely hard to come by. Market participants themselves are often unaware of the extent of their net exposures or the identity of counterparties to their transactions. Mandatory disclosures to third parties are even more limited, and the industry group, the International Swaps and Derivatives Association, has resisted voluntary disclosure.

Why the lack of clarity? There’s a fundamental contradiction in finance. Financial managers need to compete by keeping what they know secret so they can place big bets at “wrong” prices and make money when the prices eventually correct. At the same time, the policy justification for financial markets is that markets get the pricing right. As Simkovic has argued, “Allowing greater secrecy is essentially a decision to allow financiers greater private profits and to reduce the public benefit from quick ‘price discovery’ by markets.”

Accounting rules compound the difficulties, allowing certain deals to be quarantined from the rest of the bank’s financial status. For example, since a “simple fixed/ floating interest-rate swap contract . . . has zero value at the start,” it “is considered neither an asset nor a liability, but is an ‘off-balance-sheet’ item.” Lehman Brothers had $738bn in derivative contracts labeled as “off balance sheet arrangements” in its 2007 accounts, it’s now hard to accept uncritically its estimate of their ultimate “netted” value at the time. Carol Loomis did a post-mortem on the situation:

Lehman had a derivatives book of only $730 billion as it neared bankruptcy. Even so, when Lehman’s U.S. entities filed for Chapter 11 in September, this not-so-big figure translated into about 900,000 derivatives contracts. The great bulk of them have been “terminated” by derivatives counterparties which under industry protocols had the right to immediately “net” their accounts with Lehman in the event it declared bankruptcy. A handful – the last reported number was 18,000 – are still open.

Each of these contracts has a “fair value” – an amount that one side owes the other. Lehman, in fact, has a lot of open contracts that have been going its way. In a droll sign of how derivatives have come to be viewed as indispensable, Lehman has received permission from the court to buy them to hedge some of its open contracts, so that it can lock in the profits it has made since filing for bankruptcy.

Move now to the accounting problem. While sometimes the fair value of a derivative can be precisely determined, at other times it must be derived from murky markets and models that leave considerable room for interpretation. That gives the holders of derivatives a lot of bookkeeping discretion, which is troubling because changes in fair value flow through earnings — every day, every quarter, every year — and alter the carrying amounts of receivables and payables on the balance sheet.

The subjectivity involved in derivatives accounting also means that the counterparties in a contract may come up with very different values for it. Indeed, you will be forgiven if you immediately suspect that each party to a derivatives contract could simultaneously claim a gain on it — which should be a mathematical impossibility. In fact, we have a weird tale, gleaned from court documents, supporting that suspicion. It involves Lehman, Bank of America, and J.P. Morgan, and suggests how far some of those “terminated” contracts are from being truly settled.

That last point—that both parties could “simultaneously claim a gain” on what had to be zero-sum arrangements—is critical to understanding the risks posed by black box finance. It explains why deal complexity is often pursued for its own sake, and not for a genuine economic or investment purpose. Webs of debt become a smokescreen for what is really going on: institutions are rendered more and more vulnerable (both individually and collectively) so that privileged parties within them can reap enormous incomes from fees and bonuses. Formalities didn’t matter: as Stephen Lubben notes, “many credit default swaps were assigned to new protection buyers without the prior consent of the seller,” even though the ISDA Master Agreement governing such deals forbids this. Murky accounting kept Chuck Prince’s famous “music” playing ever longer, as a mountain of leverage and misallocated capital accumulated.

It Gets Worse: BAPCA’s Ugly Legacy

According to Simkovic, 2005 amendments to the Bankruptcy Code under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) have exacerbated the problem. This law assured that “derivatives counterparties effectively bear no risk of loss to the extent that the debtor posts collateral to cover its obligations.” Simkovic describes the rush of creditors to take advantage of its provisions, a stampede that made it “harder for those creditors to communicate with one another and monitor debtors’ leverage.” AIG was the poster child for overleveraged indebtedness, selling $440 billion in “protection” on CDOs. According to Lynn Turner, “In one year, the disclosures from the company had gone from not losing a dollar to over $26 billion in valuation losses and counter parties that to this day have not been disclosed demanding over $16 billion in collateral.” Since the Treasury Department believed that “the global economy was on the brink of collapse” when the the magnitude of the problem became clear, the government stepped in to bail out AIG (and, thus, its counterparties).

(Turner, former chief SEC accountant, describes how opaque AIG’s procedures were. The recent book Fatal Risk gives the “tick tock” details, chronicling the deepening unease of AIG’s auditors as the mark-to-fantasy approach of its subsidiary AIGFP became clear.)

From 2000-2008, AIG made $66 billion in profit, but in 2008, it had a $99.3 billion loss. The employees and execs who benefited in the boom years have kept nearly all their cashed out compensation. By January, 2011, according to the FCIC report, AIG had cost US taxpayers $152 billion (FCIC Report, 350). It’s an incredible sum for a process whose only social contribution, so far as I can see, was a marginal (and likely temporary) bump upwards in the rate of homeownership.

Simkovic describes financial sector creditors consumed by a desire for positional advantage, ignoring the slow erosion of the viability of the system as a whole. It’s an “I’ll be gone, you’ll be gone” culture, where accountability has largely vanished. If we really want to understand the recent investor rush to gold and commodities, it’s better to look beyond the central banks’ “printing money” and to think hard about why they’ve had to do so. Do you really want to park much money—be it in stocks, bonds, or some other instrument—at institutions staffed and run by people who bear virtually no pain in case of their collapse?

Picking Up Pennies in Front of a Bulldozer

Asymmetric compensation schemes are common in finance: managers enjoy substantial upside (perhaps even a life of leisure) if things go well; there is very limited downside if things go badly. Simkovic analyzes how opacity, corporate law, and bankruptcy code provisions help preserve this lack of accountability at the core of finance. The usual Wall Street metaphor for behavior like AIG’s is “picking up pennies in front of a bulldozer.” But the agency problems (and amounts involved) flesh out the metaphor: financial institutions are like wheezing couch potatoes, suddenly running to pick up suitcases of cash in front of a bulldozer of risk, and delivering most of the proceeds to high-flying managers lounging on settees by the side of the road. When the financial institution finally ends up getting a hand or arm caught under the bulldozer, it faces the horror of an impromptu amputation or annihilation. The managers will surely rue the untimely death or disability of their “runner,” but they’ll walk away with cash they’ve “earned,” and almost certainly find some other institutional form to renew the game another day. Even if some don’t, they may have made enough while the getting was good to fund an early retirement to the Caribbean.

At a recent event on the LSE report on the Future of Finance, panelists and audience members suggested that rent-seeking, as well as tax, accounting, legal, and agency distortions, are driving finance sector transactions more than the real economic substance of deals. Simkovic helps us understand the full extent of the problem. The bankruptcy code is becoming the tail that is wagging the dog of investment decisions. He argues that we need to “revive recordation,” as Hernando de Soto and other luminaries have urged. Perhaps real financial reform will ultimately depend on more radical approaches. But I see no way of significantly improving the situation without regulators taking seriously the problems Simkovic has described. In my next post on the issue, I will look at Michael Greenberger’s relatively optimistic take, and Arthur Wilmarth’s pessimistic view, on whether aspects of Dodd-Frank can address Simkovic’s concerns. Early developments have not been promising.