Bernie Madoff reportedly spends his time
in prison, where he has been assigned for the next
150 years, in fear of an imminent violent or
sexual assault on his person. [1] That may seem
like just desserts to many people who invested
their savings with the man. Even so, news of his
suffering doesn't bring a sense of justice to
anyone - especially not given the thousands of
investment bankers, mortgage lenders, rating
agency officials and central bank employees who
violated laws, threw ethics to the wind and
basically forgot about their real responsibilities
all through.
At the current rate of
progress shown by the various enquiries and
reports by independent commissions of Western
governments, I half suspect that Madoff will be
"released" from jail posthumously
before any indictments of
bankers, rating agency chiefs, central bank
supervisors and other assorted minor criminals are
forthcoming, even 150 years from now, from the
Republic of America (by then a wholly owned
subsidiary of the People's Republic of China) or
the European Union (formally occupied by the
Republic of India).
An example of how all
these good folk continue to evade even the very
thought of prison though has been answered over
the past few weeks: not only were the people
charged with adult supervision proved stupid at
the time, it appears that they are still pretty
dumb. As evidence of the continued dumbness that
permeates policymakers and their attendant
helpers, we have three exhibits released over the
course of the past three weeks. All three
contenders are weighty reports (quite literally
clocking up 1,061 pages between them) but without
a smidgeon of useful narrative or policy
prescription between them.
In the spirit
of saving the planet and/or at least saving
readers from the bother of perusing 1,000 pages of
drivel, I have attempted a summary of sorts in
this article.
Exhibit 1: The
Levin-Colburn Report from the US Senate - coming
in at truly "supersize me" total of 650 pages.
[2] Exhibit 2: The International
Monetary Fund's Global Financial Stability Report
- a "summary" report that clocks up an impressive
197 pages. [3] Exhibit 3: The
UK's Vickers Report from the "Independent
Commission on Banking" - at a healthy 214 pages.
[4]
That senate
report "Why, a child of five could
understand this. Fetch me a child of five." -
Groucho Marx.
Taking the wonderfully
concise Levin-Colburn senate report into
consideration first, we notice the impressive
stuff in the opening statement:
This Report is the product of a
two-year, bipartisan investigation by the US
Senate Permanent Subcommittee on Investigations
into the origins of the 2008 financial crisis.
The goals of this investigation were to
construct a public record of the facts in order
to deepen the understanding of what happened;
identify some of the root causes of the crisis;
and provide a factual foundation for the ongoing
effort to fortify the country against the
recurrence of a similar crisis in the
future.
I can just about hear
Americans groan: "Two years of bipartisan
investigations and all we have is this telephone
directory to show for it", whilst your author is
more concerned with the cost of this
investigation, and as a gentle, middle-age sort of
thing to worry about, the sheer expenditure on
coffee and cookies over the course of this
investigation. But I digress.
It outlines
four areas of focus, then provides a stunningly
long description of each area somehow achieved
without any attention to causal factors. As things
stand in the report, the quick summary of the four
parts are:
1. High Risk Lending: Case
Study of Washington Mutual Bank (summary: they
converted from a bank to a casino and hoped no one
would notice). 2. Regulatory Failures: Case
Study of the Office of Thrift Supervision
(summary: they didn't what to look for). 3.
Inflated Credit Ratings: Case Study of Moody's and
Standard &Poor's (summary: the two credit
rating companies forgot basic math and statistics
101). 4. Investment Bank Abuses: Case Study of
Goldman Sachs and Deutsche Bank (summary: they
knew what they were doing, even if it was pure
evil).
There are a number of errors in the
analyses, driven by what I suspect to be very
basic understanding of the world of banking. That
isn't, however, the worst part of this report:
rather it is what follows as recommendations.
Take for example the first one on the
issue of high-risk lending: the committee
prescribes that "Federal regulators should use
their regulatory authority to ensure that all
mortgages deemed to be 'qualified residential
mortgages' have a low risk of delinquency
or default" and secondly that "Federal regulators
should issue a strong risk retention
requirement under Section 941 by requiring the
retention of not less than a 5% credit risk in
each, or a representative sample of, an asset
backed securitization's tranches, and by barring a
hedging offset for a reasonable but limited period
of time."
Really - it is that simple. Of
course, there is the little detail of how anyone
is supposed to find out when making a loan or
retaining it on their balance sheet that there
would be a delinquency or a default in the distant
(or even near) future. If the bankers who didn't
know enough about the credit risk of the borrower
couldn't spot the impending crisis (say five years
away), somehow federal regulators are expected to
do so. This would involve the awfully trivial task
of knowing the future to an impressively precise
fashion - something that I haven't personally
witnessed either bankers or regulators to possess.
Then again there is an alternative explanation.
[5]
Then there is the boneheaded second
recommendation about risk retention, namely that
banks have to keep 5% of the credit risk on their
balance sheet without hedging.
So let's
say a California bank that makes high-risk loans
and earns a spread over its borrowings of say 1%
then sells off 95% of its portfolio through Wall
Street to the new breed of willing suckers (sorry,
I meant Asian central banks) and then posts 40%
loan losses on the portfolio over five years.
Under this scenario - borrowed from a real world
example during the financial crisis, by the way -
the bank would make 0.6% (as in 1% margin every
year less one fifth of 40% delinquency on the 5%
held in its own books) every year on the portfolio
even as the poor suckers (sorry, Asian central
banks) that bought the stuff would lose their
shirts.
Then the second part of the
prescription namely "no hedging" - this is worse.
Suppose a relatively good bank decides to retain
80% of its portfolio but sees an adverse economic
climate - it couldn't hedge under the rules. Fair
enough, you might say - but that leaves out the
vast majority of the 8,430 (as of 2008) commercial
banks operating under the umbrella of the Federal
Deposit Insurance Corporation in the United
States, which are mainly local community banks
that didn't participate in any of the
securitization related madness but still witnessed
loan losses as a result of the crisis.
I
am not even going into the recommendations about
regulatory failures except to say that the best
regulation for a financial system is a constant
monitoring of good collateral by a competent
discounting authority. In any event, a number of
my other articles touch on the subject of
regulatory failures and how to fix them.
The senate committee moves into full
comedy mode when recommending ways of dealing with
inflated credit ratings. The first one is an
absolute hoot: "Rank credit rating agencies by
accuracy". How are you going to do that, senator:
by the number of ratings or by the quantum? In
other words, what if, say, Moody's gets a vast
majority of its credit ratings correct (say 25,000
out of 30,000 ratings) but investors still lose
money (which they would on the 5,000 credits that
are downgraded later). Alternatively, say S&P
could get the dollar value of its credit ratings
correct - ie $5 trillion out of $6 trillion is
correctly rated. That still leaves investors
nursing losses on the $1 trillion that isn't. In
any event, how does ranking help? Have the three
major rating agencies - Fitch being the third -
demonstrated sizable dispersion in the overall
quality of their work? Not that I have noticed:
which means that rank no1 versus no3 is the kind
of difference that folks on the "Biggest
Watermelon in Kansas" crave.
In the case
of recommendations to curb investment banking
abuses, I laughed when reading the last section
with the gem: "Regulators conducting the banking
activities study under Section 620 should consider
the role of federally insured banks in designing,
marketing, and investing in structured finance
products with risks that cannot be reliably
measured and naked credit default swaps or
synthetic financial instruments."
As any
writer will tell you, the last bit about credit
default swaps and synthetic financial instruments
(largely, the same dang thing) has been inserted
into the rest of the paragraph on structured
finance (Asset-backed securities) almost as an
afterthought into this part of the document so
that the senators could show competence and
understanding if not exactly a strong command of
English.
Overall, the senate report is a
wonderful example of how normally intelligent
people can be easily fooled by jargon and reams of
documents when they don't have a sufficiently
robust understanding of how operating systems
interact. By distracting the committee with gory
details, the macro-crimes that underpinned and
indeed caused the financial crisis are completely
glossed over. In turn, this renders all talk about
fixing the problems rather comical.
The
IMF report "From the moment I picked
your book up until I laid it down, I was convulsed
with laughter. Someday I intend reading it." -
Groucho Marx.
If the US Senate report is a
prime exhibit for the yawning gap between
practitioners and authorities in the financial
system, the IMF report is representative of a
completely different flaw. It is a report that is
excellent in many ways but the first rate analysis
is let down by prescriptive flaws in the
recommendations. There is a useful section at the
tail end of the report:
The main task facing policymakers in
advanced countries is to shift the balance of
policies away from reliance on macroeconomic and
liquidity support toward more structural
policies - less "leaning" and more "cleaning" of
the financial system. Policymakers in advanced
economies need to reduce leverage and restore
market discipline, while avoiding financial or
economic disruption during the transition.
Private sector participation in future
resolutions is necessary to restore market
discipline. However, the transition is best
sequenced by addressing legacy problems revealed
in the run-up to or in the aftermath of the
crisis.
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