The Question Concerning Finance: Party Like It’s 1929? Or Prepare Like It’s 1957?
posted by Frank Pasquale
Another day, another story of Wall Street’s failure to allocate capital responsibly. Today’s installment appears on ProPublica, and describes how “Wall Street bankers perpetrated one of the greatest episodes of self-dealing in financial history:”
Faced with increasing difficulty in selling the mortgage-backed securities that had been among their most lucrative products, the banks hit on a solution that preserved their quarterly earnings and huge bonuses: They created fake demand.
A ProPublica analysis shows for the first time the extent to which banks — primarily Merrill Lynch, but also Citigroup, UBS and others — bought their own products and cranked up an assembly line that otherwise should have flagged. The products they were buying and selling were at the heart of the 2008 meltdown — collections of mortgage bonds known as collateralized debt obligations, or CDOs.
As the housing boom began to slow in mid-2006, investors became skittish about the riskier parts of those investments. So the banks created — and ultimately provided most of the money for — new CDOs. Those new CDOs bought the hard-to-sell pieces of the original CDOs. The result was a daisy chain that solved one problem but created another: Each new CDO had its own risky pieces. Banks created yet other CDOs to buy those. . . .Because of Wall Street’s machinations, more mortgages had been granted to ever-shakier borrowers.
The article explains the details of the deals, whose byzantine structures should be numbingly familiar to anyone who’s read ProPublica’s earlier work on Magnetar, or chapter 9 of Yves Smith’s book Econned. Smith calculated that, “if you look at the non-synthetic component, every dollar in mezz ABS CDO equity that funded cash bonds created $533 in subprime demand” (Econned, 261). (If mezz ABS CDO means nothing to you, I highly recommend Smith’s blog, or John Lanchester’s I.O.U., the most stylishly written of the “crisis” books.)
Behind all the reticulated swaps of risk and reward, in article after article, the crash of 2008 is boiling down to a familiar story: endless leverage designed to support ever more fee-generating deals. It didn’t take genius to come up with these schemes; as Thorvaldur Gylfason writes, our bankers were about as creative as Mel Brooks. (Or, as Clive Dilnot puts it, “The Producers were more inventive, the stock-exchange games of the 1920s were more complex.”) Consider John Kenneth Galbraith’s chapter “In Goldman Sachs We Trust” in The Great Crash of 1929, which includes this excerpt on investment trusts:
In 1929 the discovery of the wonders of the geometric series struck Wall Street with a force comparable to the invention of the wheel. There was a rush to sponsor investment trusts which would sponsor investment trusts, which would, in turn, sponsor investment trusts. The miracle of leverage, moreover, made this a relatively costless operation to the ultimate man behind all of the trusts.
ProPublica’s Jake Bernstein and Jesse Eisinger describe a daisy chain of CDOs whose “incestuous trading . . . made the CDOs more intertwined and thus fragile.” They make it clear that “banks were lending money to CDO managers so they could buy the banks’ dodgy assets.” In the end, who cared what entity was ultimately responsible for assessing real asset values, as long as the fees and bonuses got paid. “A CDO called Octonion bought some of Adams Square Funding II,” then “Adams Square II bought a piece of Octonion;” like Enron’s imaginatively named off-balance-sheet-entities, the CDO shuffles permitted investment activity to become ever more unmoored from the real economy it is supposed to support. Indeed, as one longtime finance reporter puts it, “the ratings agencies . . . [whose] triple-A rating could compensate for the complexity of the products emerging from the CDO-creation pipeline. . . proved even more flawed in their ability to serve as some kind of guardian of the health of the financial system than the accountants who had blithely overlooked years of financial misstatements by the likes of Enron and WorldCom” (Suzanne McGee, Chasing Goldman Sachs, 285).
What’s next for finance? A number of legal scholars have penetratingly written about intertwined failures of technical and legal compliance systems in the financial system; I particularly recommend the work of Kenneth Bamberger and Erik Gerding. They have outlined commendable changes for the current regulatory framework.
Nevertheless, I worry that Wall Street dealmaking has become so rococo that something more than new regulation is needed. As Suzanne McGee suggests in Chasing Goldman Sachs, “pursuing the maximum level of profits and return on equity, without heed to systemic risk or the interests of all the stakeholders in the money grid,” is a recipe for future stagnation and crisis (306). Moreover, as Mahmoud A. El-Gamal and Amy Myers Jaffe write in Oil, Dollars, Debt, and Crisis, “energy policy, the regulation of financial markets and institutions, and international relations as they pertain to Middle East geopolitics are so closely intertwined that it makes little sense to contemplate any of the three without contemplating the other two simultaneously” (191). The fundamental question for critics of Wall Street now is: where should the capital misinvested in the MBS/CDO/CDS hall of mirrors have been allocated? Without a clear idea of the substantive answer to that question, all that we can reliably expect in the future is that capital will be allocated to whatever instruments lead to the highest fees for finance intermediaries. These fees bear no necessary relation to the long-term infrastructural and investment needs of society as a whole.
Smith has noted that Amar Bhide’s recent “indictment of modern finance” in the Harvard Business Review is “unlikely to get the traction it deserves because no new paradigm is waiting in the wings.” I think that there are such paradigms available, but their implementation would require either patient and public-regarding investors (who might do much more to promote green projects) or ambitious government actors (who could push the industrial policy already pursued by DOE, HHS, and DOD into new sectors of the economy, perhaps in part by making socially responsible investments more attractive than the mine-run of stocks and bonds). All are in short supply now. But the ever-increasing Chinese and European investment in green energy should be a Sputnik moment for America—that 1957 catalyst for collective action that spurred the nation to commit resources to enterprises likely to bear real and equitably distributed returns in the future.
August 27, 2010 at 9:19 pm
Posted in: Corporate Finance, Corporate Law, Corruption, Current Events, Economic Analysis of Law, Philosophy of Social Science, Politics, Technology
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Responses (7)
A.J. Sutter - August 27, 2010 at 11:57 pm
I’m puzzled by the premise of this piece, that capital was “misallocated” and “should” have been allocated elsewhere. Whose capital are we talking about? And what standards — and whose — are we talking about? Maybe a clue comes from your last paragraph, about “enterprises likely to bear real and equitably distributed returns in the future.” So it sounds like you’re not talking about the standards of investors, whose capital is at issue, but the standards of some sort of social justice angel.
When has this ever been the case in reality? Why should financiers care about this? Were the government actors who responded to Sputnik focused on social responsibility (sounds suspiciously like socialism, don’t you think?), or by Cold War military worries? Rhetorical question.
And as has been mentioned before on this blog, recall that the value of shares traded on equity exchanges alone is a several-times multiple of US GDP, the appreciation in all major share indices is a several-times multiple of GDP growth, and 49% of capital gains go to the richest 0.1% of US taxpayers. So even if the funds had been invested in equities — which arguably are more “real” than derivatives — the equitable distribution wouldn’t necessarily follow. To the extent there was more “equitable” distribution in the 1950s and 1960s, in the sense that rising per capita GDP was accompanied by rising median income (unlike today), this was related in large part to the power of labor unions, and the Cold War fears that labor union unrest could lead to a tilt toward Redness. (See, e.g., H.W. Arndt’s The Rise and Fall of Economic Growth (1978).) But labor unions are unlikely to come back.
So history suggests that what we really need is a new Cold War. But against whom? The push for mobility of capital has made our industrialists and VCs too tied to investments in China, the most obvious potential enemy. The Muslim world is another potential target, but, even ignoring the interconnections you cite, a Cold War with them might only stimulate exploitation of American oil, not a green tech revolution. The most efficient — and most likely — thing might be a surge in our cold (hot?) war on Gaia. Her counterassault might be what galvanizes peoples’ attention. Assuming we can get them to acknowledge there’s a war on at all.
Frank Pasquale - August 28, 2010 at 11:34 am
AJ, I think you’re making the case that it’s unrealistic to hope for socially responsible investing. But if “49% of capital gains go to the richest 0.1% of US taxpayers,” it sounds to me like there are many people out there with some “freedom of maneuver” who could choose lower returns in order to promote more sustainable companies. Of course, this hope may be as naive as David Callahan’s hypostatization of new tech and finance elites:
http://www.washingtonpost.com/wp-dyn/content/article/2010/08/06/AR2010080602659.html
But I still think that someone with with millions of dollars in the bank may be attracted to, say, Stonyfield Farms Yogurt, or Interface Carpeting (described here: http://www.treehugger.com/files/2008/04/interface-carpet-cleans-up.php)
rather than the more profitable “vice companies” described here:
http://www.middletownpress.com/articles/2010/08/24/business/doc4c732f5c49a1d717896087.txt
I sense from the rest of your comment a materialist theory of social change. The “great compression” of wages from 1947 to 1974 was due to union power and fear of communists; educational investment after Sputnik was merely epiphenomenal of a larger struggle for military superiority. I see the point, but I think Weber’s caution here is important:
“Not ideas, but material and ideal [ideological] interests, directly govern men’s conduct. Yet very frequently the world images that have been created by ideas, like a switchman, have determined the tracks along which action has been pushed by the dynamic of interest.”
To return to the first point: the desire of a Gates or a Buffett for fame has, fortunately, been channeled to egalitarian philanthropy. It could have just as easily have gone into “Singularity University” (described here:
http://www.nytimes.com/2010/06/13/business/13sing.html). An explanation of so much history as a manifestation of self-interest and conflict can end up reinforcing the very attitudes it claims merely to recognize.
Ken Rhodes - August 28, 2010 at 6:28 pm
Two brief comments, plus a soapbox rant:
1. I think maybe the best written of the crisis books is Michael Lewis’ “The Big Short.”
2. After the Crash, the Pecora hearings exposed the absurd machinations of Wall Street, and Congress responded with Glass-Steagall, the Securities Act, and additional enabling legislation. For a half century, the U.S. limped along with commercial banking being the boring world of taking in people’s deposits and lending them out to [mostly] credit-worthy borrowers. Bankers were not usually highly paid, but they were usually highly respected and trusted.
Then we got the idea we had to “remove the shackles” from our poor disadvantaged bankers. Glass-Steagall was gutted, then rescinded, and the SEC became the home of what we think of the worst of Civil Service — bureaucrats pushing paper for a comfortable salary without actually doing anything. We sowed the wind, and sure enough, we reaped the whirlwind.
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There are a hundred million Americans who have seen their retirement accounts eviscerated by forces they neither control nor understand. Try explaining to Mr. and Mrs. Smith that “investment,” which used to be a non-zero-sum game of creating value, has become “speculation,” which is a zero-sum-game in which the insiders fleece the rest of us without creating any goods or services.
“Capital allocation?” Bull! It was the same old boiler-room scam practiced in the Twenties, but this time with more sophisticated computer programs and more opaque concealment of the machinations.
You write “I worry that Wall Street dealmaking has become so rococo that something more than new regulation is needed.” Well of course it is! They got it right 75 years ago. What we have to do is dig up the transcripts of the Pecora hearings and the text of the laws they engendered, then pass the same legislation all over again. Get the commercial banks out of the real estate brokerage business, out of the stock brokerage business, out of the insurance business, and out of the equities speculation business.
A.J. Sutter - August 29, 2010 at 1:23 am
Frank, I’d like to believe in some social justice angel. And I understand the role of utopias in inspiring practical action. But the notion that social justice and profit maximization go hand-in-hand is too utopian. Much “socially responsible investment” attempts to maintain that the two are consistent. Your angel also assumes an invest-and-hold strategy. But if those enlightened shareholders sell their shares, the successors might not have the same vision. So cooperatives, and stock corporations that are closely-held, might be more reliable vehicles than publicly-traded companies.
I’m also skeptical about the beneficence of private companies who lease things to us for use in our everyday lives while they retain ownership — leasing from a community organization seems like a better way to go.
I’d rather see the labor movement make a comeback and play the kind of role it does in Germany than to rely on the kindness of billionaires. And maybe the billionaires would allow a bit more democratic involvement in the distribution of their largesse? It especially worries me that so many of the new elites made their money in technology (though not so different, maybe, from the ones who made their money in oil): their Promethean illusions may yet screw up the planet far worse than currently.
Nate Oman - August 29, 2010 at 3:50 pm
One point: There is nothing inherently suspect about turning loans that you originate into MBS and then purchasing them. It has the effect of turing a highly illiquid asset on your balance sheet into a highly liquid asset. There are obvious advantages to holding liquid assets, particularly for institutions that have very liquid liabilities like demand deposits or short term debt. There are situations in which this might lead to abuse, but to dismiss the basic transaction as suspect self dealing strikes me as rather simplistic.
Frank - August 29, 2010 at 6:46 pm
Ken, I see your points, and I was heartened to see the McCain/Cantwell effort to revive some aspects of Glass-Steagall. But I worry that developments in “dark pools,” hedge funds, and other aspects of the shadow banking system may render that style of regulation obsolete.
AJ, I see all these points; I guess I am just very disheartened about the prospects of labor organization.
Nate, I think your point reinforces my desire to see more emphasis on developing substantive incentives for certain forms of investment. If classic finance theory (or corporate self-interest) promotes the sort of daisy chains of CDOs described in the article, I think that’s more of an indictment of the theory/self-interest, rather than a defense of the transactions involved.
To put in a few more words for substantive finance regulation: my proposals are just aimed at making certain forms of investment more favorable than others, via the kind of tinkering with tax and other rules that are already vast swathes of our economy. I admit, that sort of tinkering has gone wrong in many ways already…”upside-down subsidies” to homeowners, the regulatory promotion of SUVs, etc., are just two examples. But it appears to me that people that care about sustainability (and other social goals) need to get involved, or else the finance sector will just get more unmoored from clear needs in the real economy.
Ken Rhodes - August 29, 2010 at 9:56 pm
” If classic finance theory (or corporate self-interest) promotes the sort of daisy chains of CDOs described in the article, I think that’s more of an indictment of the theory/self-interest, rather than a defense of the transactions involved.”
Frank, an endless daisy chain of CDOs does not significantly change the amount of debt or the amount of risk; it merely moves it from one player to another. It was the Credit Default Swaps (CDSs) — the “insurance” policies issued by insurers who had no idea how to measure the risk, nor how much premium to charge for it, nor how much reserve to carry against it — that brought down the house of cards.
Insurance, in the old fashioned sense, is best done by pooling a lot of uncorrelated risks so that when the law of large numbers takes over, the payout from reserves is somewhat less than the revenue from sales of policies, so the random losses are indemnified and the insurer makes a nice little profit.
In the market of CDSs, though, what the issuers failed to recognize was that the risks were highly correlated, because the same forces (mark-to-market inaccuracies, adjustable interest rates, overheated real estate market pricing, all driving upside-down conditions) were exerting the same influences on all the underlying instruments in the pools. So when the marginal loans began to fail, the failures were quick and widespread. The insurers had acted essentially as though their premium collections were simply their reward for being smarter than the rest of the world. Suddenly it turned out that they had no idea what they were doing.
And this is why I made the plea earlier for the return to Glass-Steagall separation of the commercial banks from the brokers and the insurers. The way the market used to work, I really wouldn’t care a whole lot if the “wealth managers” at Lehman Brothers went down the drain, taking their wealthy clients with them. Commercial/retail banking would go on its boring way, and the country would survive quite nicely.
Now, however, we have even the small local banks involved in real estate brokerage and stock brokerage. Towne Bank is a ten year old local bank in my home area of Southeastern Virginia. I go to their website and from their home page I see tabs for personal, business, and corporate banking. That’s great; that’s what a local bank should be doing. I also see tabs for investments, insurance, and real estate. Hmmm … do you suppose that when they have to evaluate the risk in a proposed mortgage loan, or the terms to offer, they might be influenced by the fact that one of their real estate agents is making the sale?
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