Friday, December 31, 2010

Remember Wall Street Reform?

Ever wonder what happened to the Dodd-Frank Wall Street Reform Bill? Remember when It became effective on July 21? The Democrats hailed it as landmark legislation that was really tough on the big banks and would prevent a repeat of an economic meltdown. The Republicans said it was anti- business and the meltdown was the governments fault anyway. The banks were against it as it would keep them from “providing their creative services to the public and employers.”

In short, all parties put out pure BS. The issues were apparently too complicated for the daily media to be helpful. So it has remained a mystery to most of the public.

Finally on Dec 28, 2010 Business Week has released an article that attempts to put in understandable format what has happened in the bill. It also discusses the politics and lobbying behind the results. A total of 9 journalists from New York and Washington are listed as contributing to the report. We have to be grateful to Business Week for this difficult but very useful task.

The phase “Wall Street Gets Pretty Much What It Wants” is included in the article headline and portends the sinking feeling citizens will feel as they read the article. The Wall Street victory is confirmed by looking at the record profits at the major banks only two years after their mismanagement led to the economic meltdown and to a comment by an ex-Citibank executive.

“We continue to listen to the same people whose errors in judgment were central to the problem,” said John Reed, 71, a former co-chief executive officer of Citigroup Inc., who estimated only 25 percent of needed changes have been enacted.

The article covers almost all the issues that congress talked about but sadly did little when it came time to write the laws. Like the boy that murdered his parents and then asked for mercy because he was an orphan the banks destroyed the economy with bad management and now fight any regulation on the grounds that it would hurt the recovery.

The biggest laugh of all (if it weren’t so pitiful) is that the banks seem to have convinced many congressmen that they are adding value to the economy with their “innovative” instruments.

Read the article and learn what happened to all that big talk after the lobbyists worked over congress. Remember too big to fail, the revolving door, bringing bonuses into line, banning certain derivatives, and walling off risky ventures from government guaranteed funds? The article discusses the politics and final inaction on all of these.

The only pro-citizen event was the establishment of the Consumer Protection Agency as designed by Elizabeth Warren. The banks fought that desperately but seem to have lost.(as of now). I remember a talk show where the banking representative, fresh from helping the industry set a world record for dumb management, said he was worried about her because she didn’t have enough bank management experience.

Please, surely we aren’t so dumb we will let them do it to us again.

The report is certainly discouraging and confirms that we need a complete rethink on the nature of the organizations that this nation uses to manage its financial infra-structure,

Once again, thank you Business Week.

Monday, December 27, 2010

Our Ideology Regardless of the Problem

Recent polls show that approval of congress has hit a new low of only 13%. I had hoped that this would cause the political party elites to show some humility and give us at least a few ideas on how they were going to correct the situation. Not so.

Last week a group of senators, congressmen, and citizens (about 1000) met in New York to launch an organization dedicated to reducing the party ideologue-based bickering and drive both parties to cooperatively focus on the nations’ problems. It is named "No Labels”. Although they apparently didn’t have time to spend on the low 13% ratings both the Republican and Democratic media attacked the No Labels concept, giving various reasons to reject it.

There were scores of negative posts from both the right and left, They went from insistence that the two party system was critical for debate, to noting that there already were 63 parties in the US, that working together was useless because our current leadership is incompetent, and that No Labels is just plain left wing.

The scariest of all were several writers who contended that No Labels was being set up to be a platform for Bloomberg to run for president. Thankfully No Labels says that they had taken no money from Bloomberg and that he spoke at the launching in New York because he was the mayor. Bloomberg himself has said that in no way would he run for president. Some evidence please.

It is pathetic when citizens feel they must form another party to try to force the two major parties to act reasonably. It is even worse that the self serving ideological media focuses its guns on them before they can even begin. Very typical of the way they are addressing problems. Fred Brown of the Denver Post sums this situation up very nicely.

Regardless of its final accomplishments No Labels is an encouraging example of American citizens starting to recognize and rebel against the bad decisions our leadership has put us through. If No Labels could cause a fracture in the “my ideology for everything” attitude that is smothering individual analytical thought it would be very valuable. The Tea Party, No Labels, and many other small organizations that are being formed are coming from different directions but pointing to the same objective. We all want a constitutional government that is focused on passing opportunity and freedom to the American people rather than power to itself.

That is what the Founding Fathers intended and is what we are honor bound to support.

Thursday, December 16, 2010

The More You Know the Worse it Gets…

While finance has never been my favorite area I became determined to gain a much better understanding of exactly what happened to cause the subprime waterfall of economic disaster that has fallen on our country.

Of the multitude of post meltdown books on the market I chose three: The Big Short by Michael Lewis, Gristopia by Matt Taibbi, and All the Devils are Here by Bethany Mclean and Joe Nocera. All authors have extensive experience as financial journalists during the 20 years of life in the subprime era. They tell their stories from different perspectives. The Big Short is from the viewpoint of a few low level hedge fund managers who discovered (to their surprise) glaring weaknesses in the execution of the sub primes business model. No one would listen to them but they initiated very successful hedge funds that played the subprime system short. Gristopia addresses in anger the outright foolishness behind the 20 years of government and private decisions that allowed the subprime business model to develop. He discusses the events, people and the bad decisions that allowed it to grow to the final catastrophic breakdown. All the Devils are Here presents a thoroughly documented historical approach of the last 20 years of bad management that lead to the meltdown. All three books cover the meltdown and the emergency effort by the government to save the financial sector.

This post only touches on a few of the items and at the thousand foot level. Read one of the books to get really incensed.

The subprime business developed during the Clinton administration, and was protected and grew under Bush. Then it fell completely apart. The naïve belief was that the industry would regulate itself. Greenspan was a powerful figure in furthering this philosophy.

The elements of the business plan are easy to understand. The goal was to drastically increase profits by tapping the revenue from the citizen’s multi trillion dollar housing market. This required transforming the normal low risk one lender to one borrower relationship into multi-mortgage securities which could be sold in the financial market with much greater profits. Thousand of mortgages were combined to create derivative securities, the most popular being called a collateralized debt obligation, or CDO. These were then sold on the open market at high yields.

A notable characteristic of the business model is the interconnected nature of the risks between the business units. A failure of due diligence or risk analysis in one business area could spread bankruptcy throughout the entire system. This is exactly what happened at the meltdown and explains the desperate and extremely expensive effort by the government to save the entire financial system.

Here are a few highlights of the role of the key participants and their contribution to the meltdown.

1.0 The mortgage originators that received revenue for finding the borrower

This is where the extraction of wealth from the American citizens began.

The demand for mortgages to bundle into securities was so great that several billion dollar plus public companies were created in this sector. To pay for the high fees the mortgage originators added closing costs that in some instances increased the mortgage cost by as much as 20%. Qualifications for a mortgage were lowered drastically to ensure a steady flow of applicants. Financial positions of borrowers were falsified and teaser rates with 2 year automatic resets to high rates were used to lure unsophisticated buyers into loans that they would never be able to repay.

Because the originators sold the mortgages to others they had little interest in their likelihood for later default. The mortgages they passed into the system were loaded with default potential.

2.0 The large banks and other institutions that assembled the thousands of mortgages into complex high yield securities.

These were the key drivers behind the business. They took the thousands of mortgages from the originators and chopped and structured them into levels of risk that determined the yields and levels of payback priority bundled into the securities. They were then sold to investors who received revenue from the mortgage payments. This was done to the tune of hundreds of billions of dollars. Because of the high yields the sub prime securities were very popular with investors and became the greatest source of profits for many of the banks

The banks did very little due diligence on mortgages being bundled into this essentially unregulated business. They packaged many bad loans into the securities. They placed pressure on the ratings companies for the necessary triple A rating for each security.

The amount of reserves held against failure of the loans of their own securities was left to the banks and proved to be ridiculously low.

3.0 The investors--consisting of institutions, retirement funds, insurance companies, hedge funds, and banks.

The investors received high yield revenue proportional to their ownership in the mortgage security. They also gained profits by trading their securities into the financial market. Obsessed by the high yields being offered they did little due diligence before investing billions of dollars-relying solely on the erroneous triple A ratings.

4.0 The rating companies

Default of a significant number of the mortgages in a CDO could drive its value to zero with complete loss to the investors. The probability of this happening was supposed to be indicated by the rating given by independent rating companies such as Moody’s A triple A rating means that the probability of default is small.

The rating companies did not accurately evaluate the risks of default of the mortgages making up the securities. Each security was complex with a very large number of embedded high risk mortgages. The rating companies could not adequately evaluate the securities and apparently yielded to the pressure to give undeserved triple A ratings. A few hedge funds did the necessary due diligence of the securities and discovered the rating companies error. They made large profits by short selling.

5.0 The companies that sold default insurance on the securities

Investors could buy insurance against the failure of the securities. These were called credit default swaps because they moved the credit risk from the investor to the insuring company. A leading company providing this insurance (AIG) took the insurance premiums but did not reserve capital to meet the amounts that became due on failure. This spread throughout the system and left many of the investors facing bankruptcy. The government eventually took over AIG and made the payments out of public funds.


When the mortgages in the securities began failing in very large numbers the whole system disintegrated. This left almost all of the investors with worthless (toxic) securities and mortgages on their books for which they had paid hundreds of billions. The failure of one business would cause failure in others as the securities became further devalued. None of the players had the reserves to meet their obligations and most were facing bankruptcy until the government and the Federal Reserve intervened with over a 3 trillion dollar injection of funds- announced so far. This does not include the toxic assets of Fannie Mae that are not yet publically announced.

The magnitude of the greed and sloppy business practices described by these three books certainly gives the lie to the fallacy that this industry is made up of the brightest of people who deserve the ridiculous bonuses paid.

There were many warnings of future problems by government regulatory agencies and other experts. Proposals of regulatory control were met by angry rejections of the concept from banks lobbyists, trade organizations and congress. This included threats of firings and loss of appropriations to government officials. While self regulation results were clearly becoming catastrophic the concept of self regulation was slow to die. In fact it still lives with many diehards.

The short term focus on immediate profits, sloppy business practices and the lack of executive foresight illustrates how poorly the financial sector is managed. There is really no concern for the American citizens who have paid a very high price for the incompetent practices. It also illustrates how ineffective the elected government is in protecting the citizen. The elected government and the financial sector mutually thrive on the basis of political power bought with our tax money.

Millions of Americans lives have been very badly affected because of the false values and incompetency of this sector. The sector has forgotten that its basic mission is to organize financial support for the productive enterprises of the country. They are now focused only on their own profits. This last gambit for their specific profits has caused terrible problems to the nation. Do we want to continue with them in their current position of power? This seems to be happening by default.

We need a complete review of the nation’s financial model with the goal of a new citizen oriented structure.