Category: Financial Institutions

Deceptive by Design: Derivatives as Secret Liens

Secretive practices and institutions are common in contemporary finance. For those who’ve ceased the search for long-term value creation, temporary information advantage is key. Even commonplace practices can be reinterpreted as havens of hiddenness. My colleague Michael Simkovic’s article “Secret Liens and the Financial Crisis of 2008” exposes the role of derivatives and securitization as secretive borrowing strategies, designed to keep the naive or trusting from discovering the fragility of the institutions they loan funds to. His work has been presented to the World Bank Task Force on the Bankruptcy Treatment of Financial Contracts, and is relevant to both private and sovereign debt risks.

Simkovic argues that 80 years of erosion of classic commercial law doctrine ensured that “complex and opaque financial products received the highest priority in bankruptcy.” Products like swaps and over-the-counter derivatives were not adequately disclosed (either by banks in their consolidated financial statements or by their counterparties in publicly accessible transaction registries). By concealing those debts, these already overleveraged financial institutions were able to attract ever more credit and investment, at better rates than those who reported their overall financial health more accurately. (All other things being equal, it’s safer to lend to an entity that owes 10 billion rather than 100 billion dollars.) The genius of Simkovic’s article is to show how “fundamental causes of the financial crisis are relatively old and simple,” even as an alphabet soup of instrument acronyms (CDO, CDS, MBS, ad nauseam) and government programs (TARP, TALF, PPIP, et al.) makes our time seem unique.
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Review of Daniel Altman’s Outrageous Fortunes

Daniel Altman’s book Outrageous Fortunes is consistently smart, engaging, and counterintuitive. Ambitious in scope, it discusses several important forces shaping the global economy over the next few decades.

Very long-term thinking has two characteristic pitfalls. As the Village’s deficit obsession shows, sometimes panic over a distant threat can derail attention to much more pressing ones. There’s also little accountability for long-term prognosticators. A lot can happen between now and 2030, and as Philip Tetlock has shown, media and academic elites rarely lose visibility or credibility in the wake of even grotesquely wrong predictions. The futuristic novel can be a much safer place to conjure up ensuing decades.

But unlike speculative fiction, or the slightly less speculative macro-predictive fare of a “Megatrends” or “Bold New World,” Altman’s book is grounded in a deep engagement with current economic dilemmas. His analysis works on two levels. First, for a self-interested investor, it’s good to be aware of the long-run influences on productivity and power that Altman outlines. For example, his discussion of the new colonialism demonstrates both the short-term profits and long-term risks that arise when countries like China and Saudi Arabia start buying rights to agricultural land and other resources in poorer places. He also challenges conventional wisdom on disintermediation, making a compelling case that certain middlemen and arbitrageurs can only gain from market integration.

Outrageous Fortunes also succeeds as a work for wonks, taking its place in the often noble genre dubbed by David Brin the self-preventing prophecy. As Altman puts it, “a frequent goal of prediction is to alter the future – to warn of impending danger so that it can be avoided.” The book describes many impending dangers, including increasing inequality driven by global warming, accelerating brain drains, and an enormous financial black market that is developing outside of traditional financial centers. Altman’s description of that black market is particularly acute, and worth discussing in some detail.
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Zombie Banks and the Need for a Public Option in Finance

I recently heard Thomas Ferguson discuss his work in political economy with Chris Hayes. He mentioned this paper, which does a pretty remarkable job summarizing what’s happened in finance since the bailout:

[Banks have successfully lobbied] for free or low cost money: the euphemism is the need to “get a new balance sheet into the game.” . . . Along with bank creditors, which in the U.S. include giant bond funds like Pimco and BlackRock, bankers also form a phalanx against making bank creditors share any costs of bailouts by converting debt into equity – which, of course, is exactly what states concerned about their taxpayers should do.

Financiers also hate the idea – important for reasons of moral hazard – of losing their jobs, or limits on their salaries and bonuses[, or clawbacks]. Not surprisingly, wolves are artful specialists in crying wolf: Moves by states to make banks pay the costs of cleaning up are greeted by what we like to call the “immaculate deception”: that such steps amount to “socialism” and will choke off recovery and drive “talent” out of the banks.

Where bad banks or other schemes for warehousing assets are set up, the price at which those assets are eventually resold often generates another mare’s nest of problems. And finally, there is the issue, widely overlooked in the literature, of how impaired banks treat customers. In the current U.S. case and, we suspect, many others, “zombie” banks gouge clients by raising fees and other charges. More generally, in a financial equivalent of the Night of the Living Dead, they try to raise margins everywhere they can. All too often, they can almost everywhere, thanks to the waves of consolidation that financial crises bring in their wake.

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Roger Lowenstein, Meet Bill Black

In an essay in Bloomberg Businessweek, financial journalist Roger Lowenstein compares those calling for more criminal investigation of Wall Street to 9/11 truthers and conspiracy theorists. He also distinguishes the current crisis from the S&L debacle by claiming that “The bankers convicted in the savings and loan scandal who dealt sweetheart loans to friends were fraudulent. These people had their hands, willfully, in the till—and knew it.”

You would think that anyone making that argument would want to engage with the work of William K. Black, who has repeatedly compared the finance practices of 2003-2008 to those which led to the S&L crisis. But no, Lowenstein appears too detached to confront Black’s ideas, which have been published in articles and finance sites, and repeatedly debated in televised programs. Praised for his prior work by Paul Volcker, George A. Akerlof, and many other luminaries, Black is off Lowenstein’s radar.

Lowenstein also fails to address the structural foundations of the recent lack of prosecutions; namely, the lack of referrals from financial regulators to law enforcers:

[D]ata supplied by the Justice Department and compiled by a group at Syracuse University show that over the last decade, regulators have referred substantially fewer cases to criminal investigators than previously. The university’s Transactional Records Access Clearinghouse indicates that in 1995, bank regulators referred 1,837 cases to the Justice Department. In 2006, that number had fallen to 75. In the four subsequent years, a period encompassing the worst of the crisis, an average of only 72 a year have been referred for criminal prosecution.

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From Truth to Trust

In my last post, I praised Hernando de Soto’s proposal to improve business recordkeeping, or “economic facts.” Commenter A.J. Sutter responded that de Soto’s “notion of ‘economic facts’ itself represents a fallacious reification. Those ‘facts’ are constructed by social actors.” Sutter emphasizes the inevitably subjective, contingent aspects of accounting practices. He concludes that “rolling back some [accounting] innovations might be a good idea,” but “the recovery of some sort of ‘objectivity’ is not likely to be the result.”

He is in good company; consider, for instance, this dismissal of de Soto’s ideas from Annelise Riles’s profound and original book Collateral Knowledge: Legal Reasoning in the Global Financial Markets:

Contrary to De Soto’s simplistic claim that the very existence of registered property rights produces clarity and certainty about the delineation of powers and obligations (and hence that the only necessary reform of the financial markets is the creation of an adequate registration system for property in derivatives), most of property law is in fact about the enormous ambiguities that surround what powers and obligations flow from titled property ownership. If I own a piece of land, does that mean I have a right to build a factory on it that billows smoke onto neighboring property? If I own a shopping mall, does that mean I have the right to exclude protesters from demonstrating there? . . . As Duncan Kennedy and Frank Michelman pointed out . . . [in 1980], formal property law increases certainty for some that reduces it for others; it increases certainty about some expectations but decreases certainty about others. The real issue is whose certainty do you want to maximize, and about what. (164-65)

Both Sutter and Riles are right to criticize anyone who thinks the only, or even the major, “necessary reform of the financial markets is the creation of an adequate registration system for property in derivatives.” It is naive to think that, if only we had more information, the crisis could have been avoided. To take but one of many possible examples: even if the analysts at the rating agencies had done far more due diligence on the quality of the loans behind the residential mortgage-backed securities that were sliced and bundled into collateralized debt obligations, they still could have come up with some rationale for a AAA rating. Many understood what was going on, but “danced while the music was playing.” To the willfully blind, the naive, or the dense, virtually any arrangement can seem opaque.
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Invisible Hand or Hidden Fist?

In his press conference last week, Ben Bernanke concluded on an upbeat note. He had high hopes for a US recovery, since he believed that the Great Financial Crisis (GFC) of 2008 hadn’t taken from the US any of its basic productive capacity.

Whatever the merits of that view, the GFC did highlight debilitating trends in US finance infrastructure that have been intensifying for years. In this week’s Businessweek, Hernando de Soto (with Karen Weise) highlights one of the most important: the opacity of key markets and relationships. With scant exaggeration, de Soto warns that the US is on its way to levels of uncertainty more common in developing and communist countries:

During the second half of the 19th century, the world’s biggest economies endured a series of brutal recessions. At the time, most forms of reliable economic knowledge were organized within feudal, patrimonial, and tribal relationships. . . . The result was a huge rift between the old, fragmented social order and the needs of a rising, globalizing market economy.

To prevent the breakdown of industrial and commercial progress, hundreds of creative reformers concluded that the world needed a shared set of facts. . . . The result was the invention of the first massive “public memory systems” to record and classify—in rule-bound, certified, and publicly accessible registries, titles, balance sheets, and statements of account—all the relevant knowledge available, whether intangible (stocks, commercial paper, [etc]), or tangible (land, buildings, boats, machines, etc.). Knowing who owned and owed, and fixing that information in public records, made it possible for investors to infer value, take risks, and track results. The final product was a revolutionary form of knowledge: “economic facts.”

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“Politics is the shadow cast on society by big business”

In the run-up to passage of financial reform, internal tensions among Democrats were frequently on display. (The GOP political landscape appears much simpler: whatever can be labelled as “anti-regulation” gets approval from both the leadership and the Tea Party freshmen.) Now the grand guignol over interchange fees has exposed growing faultlines among Senate Democrats. The future of the party lies either with Chuck “Wall Street” Schumer, or Dick “Austerity” Durbin. Their struggle illuminates a great deal about the modern legislative process.

Ryan Grim and Zach Carter lay out the contours of the battle:

Delivery surcharge. Paper charge. Equipment charge. There’s an additional fee for using cards from banks outside his contract, but [retailer Charlie] Chung says he has no way of knowing until he’s gotten his bill how much of that pricier plastic has been swiped. The fees Chung pays are a tiny fraction of Wall Street’s swipe fee windfall; banks take in a combined $48 billion a year from these “interchange” fees on debit and credit cards, according to analysts at The Nilson Report. That money comes out of the pockets of consumers as well as merchants, as stores pass on whatever costs they can to their customers.

Last year’s financial reform bill ordered the Federal Reserve to crack down on debit card swipe fees, a $16 billion pool of money from which $8 billion flows to just 10 banks. As a concession to Wall Street, credit card fees were left unscathed. But the clock never ticks down to zero in Washington: one year’s law is the next year’s repeal target.

Mike Konczal and Adam Levitin have exhaustively analyzed the interchange battles; suffice it to say, it’s hard to read their work (and compare fees internationally) without getting the sense that banks are getting a massive windfall here. Usually that kind of extractive industry can use its profits to buy endless favors in DC. But the extremely high rates started irking retailers, who had enough leverage to push for legislation that required the Fed to reduce the swipe fees. Now Chuck Schumer (and his surrogate, Jon Tester) want to delay that reduction; Illinois Senator Dick Durbin, who sponsored it, is fighting back. According to Carter & Grim, “118 ex-government officials and aides are currently registered to lobby on behalf of banks in the fee fight,” and retailers “have signed up at least 124 revolving-door lobbyists.”

In phrasing a bit less poetic than the Dewey quote I titled this post with, a “frustrated moderate Democratic senator” described the battle as emblematic of the broader tone in Washington:
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Congratulations to ProPublica on its Pulitzer

Though executive branch officials have disappointed many with their investigations of the financial crisis, some journalists have done an outstanding job. Over the past year, I’ve frequently linked to stories from The Wall Street Money Machine, an exceptional series by reporters at ProPublica. Today, the Pulitzer Committee recognized their efforts, giving the first award in its storied history to a series that never appeared in print:

ProPublica reporters Jesse Eisinger and Jake Bernstein have been awarded a Pulitzer Prize for National Reporting for their stories on how some Wall Street bankers, seeking to enrich themselves at the expense of their clients and sometimes even their own firms, at first delayed but then worsened the financial crisis.

The Eisinger and Bernstein series was essential because it helped challenge the idea that all “banks” or “hedge funds” are stable, self-preserving entities that would guard against bad behavior to preserve their reputations. Anyone familiar with the work of Karen Ho or Satyajit Das would take a darker and more realistic view: that is often in the interest of individuals in the industry to be part of shadowy and unstable ensembles of desks and divisions whose main goal is slipping by whatever bonus-maximizing scheme won’t set off alarms among risk managers and regulators. In a piece called “The Subsidy,” Eisinger and Bernstein explained how payments of a few million in “bonuses” to employees running one division of Merrill Lynch helped those running another division “offload” billions of dollars in toxic assets to their own firm:
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From “Qui Pro Domina Justitia Sequitur” to “Elite Frauds Go Free”

Should they change the motto at the Department of Justice? John Ashcroft modestly covered a statue of lady justice during his tenure as AG. But a series of reports suggests that, at least when it comes to financial heavyweights, Domina Justitia has left the building.

Consider first Morgenson & Story’s article, “In Financial Crisis, No Prosecutions of Top Figures:”

As the crisis was starting to deepen in the spring of 2008, the Federal Bureau of Investigation scaled back a plan to assign more field agents to investigate mortgage fraud. That summer, the Justice Department also rejected calls to create a task force devoted to mortgage-related investigations, leaving these complex cases understaffed and poorly funded, and only much later established a more general financial crimes task force.

To be sure, the DOJ has talked a good game here, unleashing Operation Broken Trust to catch the small fry. But even in December of last year, Andrew Ross Sorkin was ringing alarm bells:

To hear Eric H. Holder Jr. tell it, the Justice Department is aggressively cracking down on financial fraud. . . . But after you get past the pandering sound bites, a question comes to mind: is anyone in the corner offices of Wall Street’s biggest firms or corporate America’s biggest companies paying any attention to Mr. Holder’s “strong message”? Of course not. (I actually called some chief executives after Mr. Holder’s news conference, and not one had heard of Operation Broken Trust.)

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