If you are new to this blog, you are invited to read first “The Largest Heist in History” which was accepted as evidence and published by the British Parliament, House of Commons, Treasury Committee.

"It is typically characterised by strong, compelling, logic. I loosely use the term 'pyramid selling' to describe the activities of the City but you explain in crystal clear terms why this is so." commented Dr Vincent Cable MP to the author.

This blog demonstrates that:

- the financial system was turned into a pyramid scheme in a technical, legal sense (not just proverbial);

- the current crisis was easily predictable (without any benefit of hindsight) by any competent financier, i.e. with rudimentary knowledge of mathematics, hence avoidable.

It is up to readers to draw their own conclusions. Whether this crisis is a result of a conspiracy to defraud taxpayers, or a massive negligence, or it is just a misfortune, or maybe a Swedish count, Axel Oxenstierna, was right when he said to his son in the 17th century: "Do you not know, my son, with how little wisdom the world is governed?".

Sunday, 25 October 2009

Will the UK go bust after the elections?

Sir Howard Davis made some very refreshing comments at recent HSBC clients gathering in London. It is clear that the public do not understand the scale of the crisis which was caused by a collapse of the giant pyramid scheme. The demands of those who are still at work, from postal workers to university professors, make it clear that the current crisis appears as something unreal. And, ironically, it is.

The government have no idea of the size of liquidity hole they are trying to plug. It may still be some hundreds of billions, if not trillions, of pounds. On top of that they keep on spending money to sustain artificially the lifestyle the UK cannot afford any longer (if it ever afforded at all). This puts the country in even more debt. As the government does not want to lose the next elections (or to lose them by the least possible margin), they keep the public in delusion of affluence like someone who got unemployed and is draining his credit cards to their limits.

The Conservatives, seeing the public mood and appetite for continued high lifestyle, are too afraid of telling the harsh truth: that the UK is already in a very deep debt hole and tightening of the belt has to start now. They do not want to be accused of scaremongering by the Labour, which may well result in scuppering their elections chances of near-certain (at the moment) victory.

It is this rather unholy alliance of interests of both sides of political spectrum: the Labour's and the Conservatives' that contributes not only to irresponsible but economically irrational behaviour. We try to live financially as nothing has happened. After the publication of the recent economic figures, the time till the next elections increasingly looks like the last dance on the Titanic. The reality check will come after the elections. Doesn't matter who wins: there is a pretty good risk that the UK will be bust by then.

We seem to believe that what happened to Albania in 1996 – 1997, Argentina in 1999 – 2002 and is happening in Zimbabwe now will never happen to us. That all these can happen to others. Well, it may already have started happening…

Monday, 12 October 2009

The Economist exonerate the bankers

(The author of this blog has to declare his personal interest in this article as a person who was brought up on The Economist and is still a very keen reader. Therefore this article might be too benevolent to The Economist than it possibly should have been.)

On 8 October 2009 The Economist wrote in a Leader "It wasn’t me" that banks bosses "were mostly useless, not venal." This may actually be correct, to some degree, but it does not justify the key premise as somehow this crisis was a giant global cock up caused by "useless" bankers.

Cautious conclusions, based on other fraud investigations, indicate that a bunch of quite (not that) clever financiers changed the banking system practice from "fractional reserve banking" (i.e. lending with loan to deposit ratio below 100%) to, what the author of this blog called, "depleting reserves banking" (i.e. lending with loan to deposit ratio above 100%, which technically and legally is a pyramid scheme).

"Depleting reserves banking" rather than accumulating cash reserves at every deposit – loan cycle, depletes them. To cover this up a lot of instruments and methodology were invented (so-called "financial innovations") giving an illusion that whilst banks' reserves were rid of cash they somehow still had the reserves to cover for cash liabilities. This has nothing to do with whether cash is a paper or electronic record, but who is the guarantor of liability. Cash is guaranteed by a state. This is the key to understand this crisis: whilst capital reserves appeared to have been sufficient at the start of this crisis they collapsed in value as there was no sufficient cash on the market and only a state intervention prevented the financial system from a melt down.

"Depleting reserves banking" practice needed an army of incompetent "professionals" to run it. Incompetent to such a degree that they did not understand that this was a crude pyramid scheme that was bound to collapse. Hence a huge bunch of history, anthropology, other social sciences and, importantly, lawyers were employed as banks executives to execute heist designed that way. Typically these people's career in banking was very often based on hang-ups. A huge majority of them were very poor in math in school and banking environment gave them a sense of massive self-importance and belief. They became "masters of the universe" whilst many of their friends who were so much better at it in school were left behind in pretty poorly paid and mundane engineering jobs. This was very important to the heist organisers. It created a mindless and incompetent army of financiers, like child soldiers in Africa. It also built a massive lobbying army protecting heist organisers from criminal consequences. It is rather impossible to lock up thousands of influential thieves, most of whom did not even understand they were stealing. A lot of them still believe they were "creating value". Psychologically it is like prosecuting child soldiers in Africa. However this time we deal with the adults who should have known not to do jobs they were not suited for. Like a butcher should know that he cannot operate on humans: even taking appendix out which is a surgically trivial operation.

The Economist should not rush to any conclusion. Exonerating the bankers does not look like a balanced and objective judgement. Their leader writer does not have to agree with the analysis above. However in old Economist tradition it should advocate a thorough forensic examination of the causes and mechanics of this crisis which is too big for half a page broad brush editorial judgment.

Wednesday, 7 October 2009

UK government officially confirmed it does not have a clue about the size of the liquidity hole

On 28 March 2009, the author of this blog wrote to the British Chancellor of the Exchequer (top Minister for Finance and State Treasury in the UK), Alistair Darling, asking a question:

"What is the size of the liquidity hole in the banking system that the government is currently trying to plug?"

On 1 October 2009 HM Treasury official, Paulette Wright, responded with a lengthy letter listing measures that the UK government has undertaken to ensure the financial system stability, including Assets Protection Scheme (APS). However with respect to the crux of the question the response stated:

"It is not possible to set out estimated costs for certain at this point: part of the point of this scheme is to insure assets the market cannot value at the moment, and due diligence on these contracts is continuing. The Treasury will report any losses through the normal budgeting and accounting process."

Garages and garden sheds up and down the country are full of "assets the market cannot value". They are called 'junk'. Clearly the financial industry have gone bonkers: they hold reserves for cash liabilities not in cash (as if a refinery were holding oil reserves in, say, coal), they call pyramid scheme operations: "value creation" and they call a resulting unsaleable junk: "assets". Where is the limit to this absurdity?

The UK government admitted that it does not have a clue about the size o the liquidity hole it is trying to plug and signed a blank cheque underwriting any future costs of further bailouts.

The signs are that the liquidity crisis is far from over. The financial pyramid that was created by the financial industry and caused this crisis in the first place collapsed only partially. By buying and underwriting massive volume of bogus assets, the government is trying to support the remains that may be far larger than the losses that have already been suffered. It is spending hundreds of billions of taxpayers' money to buy junk, throwing good money after bad. Notwithstanding continued government spending spree on junk, it looks increasingly likely that these remains may collapse causing another liquidity crisis wave, far larger than ones that we have experienced thus far.

Even if these pyramid remains do not collapse, the costs of supporting them are incredibly high, in a long run far higher than taking one off hit of a complete collapse, which may prove inevitable anyway. The scheme whereby taxpayers are paying banks for junk has the financial structure of extortion racket run by loan sharks: their victims keep on paying as much as they can forever.

Apology from the bankers

The causes and mechanics of the current crisis require a proper legal investigation. The perpetrators of a pyramid that caused the current crisis must languish in jail (like some Albanian gangsters or Mr Madoff) and their wealth (including stashed offshore) must be confiscated. Governments (including the UK and US) must make their position clear in this respect. Incidentally HSBC appears to have been acting prudently all along with healthy Loan to Deposit ratio of 90% and seems to have been affected by other banks’ actions. Such investigation may be in HSBC own interest. But are they prepared to stand up to the rest of the industry?

Tuesday, 6 October 2009

How to make money? (revisited)

It appears that it is in Goldman Sachs interest that CIT files for Chapter 11.

Without making or implying any judgment or even suggestions on Goldman’s investment strategy and tactics with respect of CIT, readers are invited to revisit articles: "How to make money?" and "The government must get a grip on large private investors".

FSA: coming back to their senses

(...or facing the abyss?)

It has taken months, if not years, for the Financial Services Authority, FSA, to understand the glaring obvious: that banks have liabilities in cash therefore they must have also good reserves in cash for that purpose. As explained in the article "Economic world remains confused", refineries need crude oil to maintain operations, hence they keep reserves in crude oil. Not, for example, in hard coal with a hope that they will be able to sell it and buy oil in case of its shortage.

It is astounding that it has taken the FSA such a long time to understand the obvious. One would ponder whether this is a testimony to substandard level of professionalism or, possibly, a rather too close (read: corrupt) relationship with the financial industry.

The financial industry is not too happy. They criticised the FSA that their action was "posing a risk to economic recovery and hindering London’s position as an international financial centre".

It is possible that the financial industry is run by such incompetent individuals that they cannot understand the glaring obvious. But it is also possible that the existing liquidity hole is so great, and the bankers are aware of that, that trying to plug it with additional liquidity will bring the system to a halt. Even the government does not have an idea about its size. Therefore the bankers' criticism may be correct not for the reasons that they appear to suggest or are publicly disclosed. The effect of the giant global pyramid scheme created by the financial industry may still prove lethal.

Saturday, 3 October 2009

Experts at odds (John Kay vs Charles Goodhart)

In his analysis, "Narrow banking: the reform of banking regulations", John Kay wrote, in the context of near-collapse of the financial system last year:

"The issue of robustness is central. No systems, however well designed, can eliminate mistakes and failures. While good systems seek to reduce the likelihood of mistakes and failures, a central feature of all well designed engineering – and biological – systems is that they are robust to the failures that will inevitably occur.

Robust systems are structured so that failures can be contained within a single component, or so that error correction mechanisms come into play. In other interconnected utilities, such as water or electricity, substantial resource – both technical ingenuity and capital expenditure – is devoted to ensuring that such failsafe measure exist, which is why major disruptions are rare. Financial services are different. But they should not – and need not – be different.

Robust engineering systems are designed with modularity – so that one component can fail, and be replaced, with little damage to the whole. They have independent back up systems. They are loosely coupled, so that small disruptions are easily absorbed. All financial institutions apply these principles to their technology, but similar measures are not in place – or widely thought relevant – to substantive operations of these institutions, or for the financial system as the whole."

This is very refreshing but pretty much obvious to any scientist like mathematician, physicist, chemist, computer programmer or engineer. This is the crux of any logical or engineering design. For any first year student of engineering this is blindingly obvious concept.

However in the beginning of this year, Charles Goodhart argued that:

Wishing good luck to historians, political scientists, social anthropologists and so on if indeed few more of them are hired by the banks, and they are in charge of designing modular complex failsafe systems. Is it not astonishing that they are not employed in a similar capacity in an automotive industry, shipbuilding or by airline manufacturers? It would be surprising if many of them understood what John Kay is writing about.

Friday, 2 October 2009

Economic world remains confused

(On capital reserves requirements and other regulations)

The recently published report by John Kay, "Narrow banking: the reform of banking regulations" shows that the financial and economic world is confused about banks’ capital reserves requirements. Let us start with an example.

In world of energy resources there is a parallel requirement in terms of holding adequate reserves of various energy sources. Typically, subject to energy industry structure, a country needs to hold sufficient reserves of crude oil and hard coal. Both sources of energy can be seen as "liquid" between each other. In the world of science the equivalence is in energy units. However in the world of trading the equivalence is in prices. Therefore a country could hold crude oil reserves in coal: in case of shortage of crude oil, a country would sell its coal reserves and buy required amount of crude oil. This would be especially attractive for countries that have massive coal resources and limited crude oil resources.

Despite such appealing "innovative" structure of holding energy sources reserves, no country practices this approach. In fact it would be considered as foolish. When a shortage of crude oil comes, the value of coal is very likely to decrease dramatically to the original equivalence assessment and the energy producers, like refineries, are very unlikely to accept delivery of coal instead of crude oil.

If banks have cash liabilities (and a lot of them are precisely these), the reserves must be in cash and in currencies in which these liabilities exist (Zimdollars would not be good reserves for Norwegian Kroners liabilities, would they?). There is a room for a margin of "reserves" being held in other forms, but these are NOT reserves but investments that attract a certain liquidity risk of not being convertible into the original liability.

John Kay observed in his analysis:

"During the crisis, several banks continued to report compliant capital ratios although the pricing of their equity and subordinated debt indicated that the market believed that they were insolvent."

The business world understands that you cannot keep copper reserves in iron ore, crude oil reserves in coal, or timber reserves in polymers. Similarly, the financial world had also understood for centuries, until a couple of decades ago, that liquidity reserves had to be kept in cash. Fractional reserve banking, with loan to deposit ratio below 100%, in reality below 90%, has been a great risk management achievement: putting more money into economy whilst still keeping adequate cash reserves to cover ongoing liquidity needs.

As pointed out in the "The largest heist in history" and other articles on this blog, in the last couple of decades this system has been turned upside down. Fractional reserve banking was replaced by depleting reserves banking i.e. lending with loan to deposit ratio above 100%, depleting cash reserves by pushing them onto the market (into deposit – loan cycles). This system was possible as financial papers and instruments other than cash were allowed to serve as capital reserves intended to assure banks liquidity. A complete and obvious lunacy: it was like if, in a different industry, timber was an accepted reserve for a polymer stock (or the other way round). It is possible, but only to a very limited degree. The nonsense of such reasoning still seems not to be appreciated in the world of finance, despite the fact that any, even a small investor, knows that the value (i.e. cash value) of financial papers and instruments can go up as well as down. This is despite the fact that until a couple of decades ago, bankers had understood this for centuries.

The liquidity crunch happened a year ago (and still continues) precisely because the banks did not have sufficient cash reserves. The capital reserves were to a massive extent bogus created as a result of a global massive pyramid scheme. (The article "Exercise/example – how does it work?" shows how once well-priced capital becomes bogus in the presence of depleting reserves banking.) It is almost certain that it was a scam premeditated to steal cash for banks' reserves and taxpayers (through bail-outs and subsidies). Of course a lot of bankers were just silly (i.e. criminally negligent), but quite a few of them were crooks who designed, operated (and still operate) this system.

John Kay is not correct in asserting that regulatory requirements proved inadequate (let alone massively inadequate). Laws and regulations of any civilised country prohibit creation and running pyramid schemes such as the one that caused the current crisis. And this is precisely what bankers (with the blessing of regulators and some politicians) were doing. Therefore it is somewhat vacuous to think about knew regulatory framework. Prosecution of all pyramid purveyors that caused this crisis should be an urgent priority.

In this context it is very refreshing to read John Kay's observation: "Financial services activities are particularly attractive to sophisticated criminals. Preventive and punitive activity against fraud is essential". You can say it again, Professor Kay.