The financial system, as we know it, is dead

Politicians, economists, bankers and mainstream media financial pundits fail to acknowledge the obvious: the financial system as we have known it for a hundred years or so is dead. Literally.

Until 2008 in the financial system a central bank was at its heart in every country (or a currency region like eurozone). It was regulating the money creation process by creating a lending base upon which commercial banks created credit. In a nutshell if economy had been getting overheated, i.e. there was an oversupply of money, sometimes called a "cheap credit", and inflation increased above what was regarded as an acceptable target (usually pretty low, in single percentage figures), the central bank would have raised the interest rate making borrowing more expensive. On the other side if inflation was too low, or growth too stagnant, the central bank would have lowered the interest rate thereby lowering the costs of borrowing. The interest rate had to be above an inflation rate as otherwise lending would not have made commercial sense. This is an obvious wisdom. What is somewhat less obvious is why it was so? Why if a central bank had raised or slashed interest rate, until the outbreak of the current financial crisis, all commercial banks would have had to follow? By no means this was regulated by any directives or government pressure. These were open market operations that worked until September 2008.

A central bank has a sole prerogative of printing money (whether as banknotes or through electronic credit, but this is the same). When a central bank set its interest rate it meant that it was prepared to lend to the financial markets at that rate. It would have also borrowed from the commercial markets below that rate. This was done using financial instruments bought and sold on the financial markets and priced by the financial markets. I.e. the price was real as other commercial institutions were selling and buying the same instruments at the same price. It is called open markets operations. A central bank was buying the financial instruments if they were giving more yield than its interest rate and selling them otherwise. This was producing the balance of money supply with inflation and growth as the commercial banks were lending at the rate that followed very closely the central bank’s own rate. For any commercial bank the central bank was, in practice, unlimited source of credit supply at the cost of its rate. The difference between a commercial interest rate and a central bank’s interest rate represented operating costs of a commercial bank and a customer risk (i.e. were insurance against bad loans).The existence of a number of commercial banks created competition market so their interest rates followed very closely central bank’s rate. The government did not have to tell the banks to lend money. After all it was their core business. Instead a central bank was raising or lowering its interest rate, did open market operations and the financial markets did the rest. All recessions as we knew them until 2008 were in fact market readjustments, balancing acts, between inflation, growth and money supply.

This does not work anymore. The central banks’ interest rates in the countries that suffered from the financial meltdown of 2008 (US, UK, Eurozone) are at the rock bottom. Below the inflation rates. The commercial banks are scarcely offering credit, well above the central banks’ interest rates. In fact they do not want to offer it at all and the governments are pathetically calling for the banks to start lending. (Well, they would if they could. It is their core business after all.) What’s happened? Why, as before and for a hundred years, central banks cannot intervene through open markets operations and let the financial markets sort that out?

The current financial crisis was caused by the financial institutions, with help from the regulators and the governments, setting up the giant global pyramid scheme by lending with loan to deposit ratio greater than 100%. The banks’ cash reserves were depleted and the money multiplier reached stratospheric levels. In fact no one knows it if risks of contingent and possible liabilities parked in OTC contracts and the shadow banking system are taken into account: the lowest estimates are around 50. Therefore a huge number of financial instruments on the financial markets do not represent much commercial value but the scale and depth of the pyramid scheme. Commercial buyers do not want to buy them. These instruments are worthless. Hence central banks cannot buy them either for newly printed money. Almost any additional liquidity is produced through quantitative easing. This is a centrally controlled process of spending newly printed (or electronically transferred) money on financial instruments for which there are no commercial buyers. This is in sharp contrast to how it used to be: the process of money supply was controlled by central banks and dynamically executed by the financial markets.

This crisis shows that financial system, with all its mechanisms like mark-to-market, worked till 2008. But it was simply killed when it was turned into a giant pyramid scheme. Little surprise there. The current governments’ actions of pouring taxpayers money (through quantitative easing, financial stimuli and spending cuts) are nothing more than pathetic attempts to revive rotting and smelly corpse of the pyramid scheme. Instead this pyramid must be liquidated and the system must be started afresh. There will be losers of course. The current political and financial establishments are trying to push the costs on the taxpayers. Taxpayers sometimes protest that they do not want to pay for the damage caused by the political and financial establishment (who still reward themselves very handsomely for the mess that they caused). It is still not clear who, in practice, will win this argument as the problem simply appears to be too big to be quietly absorbed by the taxpayers in an ordinary course of politics (taxes, spending cuts and government and businesses propaganda). Or, as the signs are, we might end up in an even bigger mess.

Does Bob Diamond (new CEO of Barclays) understand banking?

The first answer that comes to mind is emphatic: yes. His position proves that. Hence it is worthwhile to reflect on his opinions in the recent Telegraph. As it was reported: "Bob Diamond, the new chief executive of Barclays Bank, has turned on critics of "casino banking" saying that the use of the term "has no basis in reality. [...] [Investment banks] aren't casino businesses. These are real, client-driven businesses. We are providing services to corporate clients, to fund managers, to retail clients through branch banking and high net-worth banking."

Over a year ago the author of this blog observed in his article "Investment banking perverse casino model": "[...] the modern investment banking business is operated like a casino whose owner lends tokens to punters at a very high interest rate. However the punters’ loans and interest become only payable to a casino owner out of their winnings.

No sane casino owner would have ever accepted such a self defeating business model. Yet the banks are such casinos. Banks’ stakeholders (shareholders and depositors) are such casino owners. And bankers are the punters."

Casinos are also "client-driven businesses" providing services. Albanian pyramids as well as a Madoff's pyramid were also such businesses. In fact similarly to Albanian pyramids' and a Madoff pyramid's clients many direct (and indirect, like the whole economy) clients of investment banks went bust. As shown in the "The largest heist in history" the entire financial system was turned into a giant global pyramid.

The crux of the matter is that casinos and pyramids do not create any tangible value but are mechanisms of wealth redistribution heavily biased (i.e. giving the disproportionally large proceeds) to those who control them. That is why gambling, which additionally due to its addictive character is considered by many as vice, although legally accepted in many countries is generally heavily regulated. Financial pyramids, which proved lethal to economies on very many occasions throughout history, are banned altogether in the civilised parts of the world.

An unbelievably professionally shallow character of Bob Diamond's comments (e.g. "[Investment banks] aren't casino businesses. These are real, client-driven businesses.") seems to suggest that he does not really understand the fundamentals of banking (in particular the mechanism of money multiplication). And as a PR exercise these comments were insulting to any half-intelligent taxpayer who has to pay, by higher taxes and cuts in public spending, through his (or her) nose for the costs of the crisis caused by the banks' engineered crude financial pyramid. However it is reasonable to assume that Mr Diamond is representative (or rather above the average) of top financial executives. No wonder then we are in such a massive financial and economic mess now, listening to unreasonable and actually irrational excuses type-"it is global, no one could have predicted that". However, thanks to no more competent politicians, thus far the financial establishment is successful preserving the perverted nature of the financial industry.

James K. Galbraith: "Fraud at the root of the financial crisis"

James K Galbraith, along with Bill Black and a few others, have been making similar arguments to the author of this blog for a long time. Hopefully the work on this blog contributes to the technical and legal arguments that prove that the current financial crisis is a result of fraud (whose mechanism is a classic pyramid scheme). The title given by this blog author.

Statement by James K. Galbraith, Lloyd M. Bentsen, jr. Chair in Government/BusinessRelations, Lyndon B. Johnson School of Public Affairs, The University of Texas at Austin, before the Subcommittee on Crime, Senate Judiciary Committee, May 4, 2010.

"Chairman Specter, Ranking Member Graham, Members of the Subcommittee, as a former member of the congressional staff it is a pleasure to submit this statement for your record.

I write to you from a disgraced profession. Economic theory, as widely taught since the 1980s, failed miserably to understand the forces behind the financial crisis. Concepts including “rational expectations,” “market discipline,” and the “efficient markets hypothesis” led economists to argue that speculation would stabilize prices, that sellers would act to protect their reputations, that caveat emptor could be relied on, and that widespread fraud therefore could not occur. Not all economists believed this – but most did.

Thus the study of financial fraud received little attention. Practically no research institute sexist; collaboration between economists and criminologists is rare; in the leading departments there are few specialists and very few students. Economists have soft-pedaled the role of fraudin every crisis they examined, including the Savings & Loan debacle, the Russian transition, the Asian meltdown and the dot.com bubble. They continue to do so now. At a conferencesponsored by the Levy Economics Institute in New York on April 17, the closest a formerUnder Secretary of the Treasury, Peter Fisher, got to this question was to use the word “naughtiness.” This was on the day that the SEC charged Goldman Sachs with fraud.

There are exceptions. A famous 1993 article entitled “Looting: Bankruptcy for Profit,” by George Akerlof and Paul Romer, drew exceptionally on the experience of regulators who understood fraud. The criminologist-economist William K. Black of the University of Missouri-Kansas City is our leading systematic analyst of the relationship between financialcrime and financial crisis. Black points out that accounting fraud is a sure thing when you can control the institution engaging in it: “the best way to rob a bank is to own one.” The experience of the Savings and Loan crisis was of businesses taken over for the explicit purpose of stripping them, of bleeding them dry. This was established in court: there were over one thousand felony convictions in the wake of that debacle. Other useful chronicles of modern financial fraud include James Stewart’s Den of Thieves on the Boesky-Milken era and Kurt Eichenwald’s Conspiracy of Fools, on the Enron scandal. Yet a large gap between this historyand formal analysis remains.

Formal analysis tells us that control frauds follow certain patterns. They grow rapidly, reporting high profitability, certified by top accounting firms. They pay exceedingly well. At the sametime, they radically lower standards, building new businesses in markets previously considered too risky for honest business. In the financial sector, this takes the form of relaxed – no, gutted – underwriting, combined with the capacity to pass the bad penny to the greater fool. In California in the 1980s, Charles Keating realized that an S&L charter was a “license to steal.” In the 2000s, sub-prime mortgage origination was much the same thing. Given a license to steal, thieves get busy. And because their performance seems so good, they quickly come to dominate their markets; the bad players driving out the good.

The complexity of the mortgage finance sector before the crisis highlights another characteristic marker of fraud. In the system that developed, the original mortgage documentslay buried – where they remain – in the records of the loan originators, many of them since defunct or taken over. Those records, if examined, would reveal the extent of missingdocumentation, of abusive practices, and of fraud. So far, we have only very limited evidenceon this, notably a 2007 Fitch Ratings study of a very small sample of highly-rated RMBS, which found “fraud, abuse or missing documentation in virtually every file.” An efforts a year ago byRepresentative Doggett to persuade Secretary Geithner to examine and report thoroughly onthe extent of fraud in the underlying mortgage records received an epic run-around.

When sub-prime mortgages were bundled and securitized, the ratings agencies failed to examine the underlying loan quality. Instead they substituted statistical models, in order to generate ratings that would make the resulting RMBS acceptable to investors. When one assumes that prices will always rise, it follows that a loan secured by the asset can always be refinanced; therefore the actual condition of the borrower does not matter. That projection is,of course, only as good as the underlying assumption, but in this perversely-designed marketplace those who paid for ratings had no reason to care about the quality of assumptions. Meanwhile, mortgage originators now had a formula for extending loans to the worst borrowers they could find, secure that in this reverse Lake Wobegon no child would be deemed below average even though they all were. Credit quality collapsed because the system was designed forit to collapse.

A third element in the toxic brew was a simulacrum of “insurance,” provided by the market incredit default swaps. These are doomsday instruments in a precise sense: they generate cash-flow for the issuer until the credit event occurs. If the event is large enough, the issuer thenfails, at which point the government faces blackmail: it must either step in or the system willcollapse. CDS spread the consequences of a housing-price downturn through the entire financial sector, across the globe. They also provided the means to short the market in residential mortgage-backed securities, so that the largest players could turn tail and bet against the instruments they had previously been selling, just before the house of cards crashed.

Latter-day financial economics is blind to all of this. It necessarily treats stocks, bonds, options, derivatives and so forth as securities whose properties can be accepted largely at face value, and quantified in terms of return and risk. That quantification permits the calculation of price, using standard formulae. But everything in the formulae depends on the instruments being as they are represented to be. For if they are not, then what formula could possibly apply?

An older strand of institutional economics understood that a security is a contract in law. It canonly be as good as the legal system that stands behind it. Some fraud is inevitable, but in afunctioning system it must be rare. It must be considered – and rightly – a minor problem. Iffraud – or even the perception of fraud – comes to dominate the system, then there is no foundation for a market in the securities. They become trash. And more deeply, so do the institutions responsible for creating, rating and selling them. Including, so long as it fails torespond with appropriate force, the legal system itself.

Control frauds always fail in the end. But the failure of the firm does not mean the fraud fails: the perpetrators often walk away rich. At some point, this requires subverting, suborning ordefeating the law. This is where crime and politics intersect. At its heart, therefore, thefinancial crisis was a breakdown in the rule of lawin America.

Ask yourselves: is it possible for mortgage originators, ratings agencies, underwriters, insurers and supervising agencies NOT to have known that the system of housing finance had becomeinfested with fraud? Every statistical indicator of fraudulent practice – growth and profitability– suggests otherwise. Every examination of the record so far suggests otherwise. The verylanguage in use: “liars’ loans,” “ninja loans,” “neutron loans,” and “toxic waste,” tells you that people knew. I have also heard the expression, “IBG, YBG;” the meaning of that bit of code was:“I’ll be gone, you’ll be gone.”

If doubt remains, investigation into the internal communications of the firms and agencies inquestion can clear it up. Emails are revealing. The government already possesses critical documentary trails -- those of AIG, Fannie Mae and Freddie Mac, the Treasury Department andthe Federal Reserve. Those documents should be investigated, in full, by competent authorityand also released, as appropriate, to the public. For instance, did AIG knowingly issue CDS against instruments that Goldman had designed on behalf of Mr. John Paulson to fail? If so,why? Or again: Did Fannie Mae and Freddie Mac appreciate the poor quality of the RMBS theywere acquiring? Did they do so under pressure from Mr. Henry Paulson? If so, did SecretaryPaulson know? And if he did, why did he act as he did? In a recent paper, Thomas Ferguson and Robert Johnson argue that the “Paulson Put” was intended to delay an inevitable crisis past theelection. Does the internal record support this view?

Let us suppose that the investigation that you are about to begin confirms the existence of pervasive fraud, involving millions of mortgages, thousands of appraisers, underwriters, analysts, and the executives of the companies in which they worked, as well as public officials who assisted by turning a Nelson’s Eye. What is the appropriate response?

Some appear to believe that “confidence in the banks” can be rebuilt by a new round of goodeconomic news, by rising stock prices, by the reassurances of high officials – and by notlooking too closely at the underlying evidence of fraud, abuse, deception and deceit. As youpursue your investigations, you will undermine, and I believe you may destroy, that illusion.

But you have to act. The true alternative is a failure extending over time from the economic tothe political system. Just as too few predicted the financial crisis, it may be that too few are today speaking frankly about where a failure to deal with the aftermath may lead.

In this situation, let me suggest, the country faces an existential threat. Either the legal systemmust do its work. Or the market system cannot be restored. There must be a thorough, transparent, effective, radical cleaning of the financial sector and also of those public officials who failed the public trust. The financiers must be made to feel, in their bones, the power ofthe law. And the public, which lives by the law, must see very clearly and unambiguously that this is the case. Thank you."