Think back to 2006-early 2008 and recall how the financial mess that unfolded later in '08 came to be. We beheld Alan Greenspan having held interest rates to next to nil levels for years (providing cheap money for speculators to fuel a huge asset bubble) while peddling the disastrous instruments known as ARMS (adjustable rate mortgages) which along with the subprime mortgages nearly destroyed this country's financial system.
By the Fall of 2008, the word finally began to emerge of the little horrors hidden in banking ledgers, hitherto unknown to the sleeping public. Chris Wolf, hedge fund operator, quoted in FORTUNE, October 7, wrote:
"This has become essentially the dark matter of the financial universe..."
comparing it to the dark matter discovered in astrophysics. Meanwhile, Morgan Stanley derivatives salesman (Frank Partnoy) quoted in FORTUNE (ibid.) wrote:
""The big problem is there are so many public companies- banks and corporations, and no one really knows how much exposure they have to CDS (credit default swap) contracts"
A short time later, The Financial Times, in a major headline ('Index Points to Record Default Threat', p. 13, Dec. 2) continued to warn of the unfolding crisis in CDS or "credit default swaps". By now the politicos were finally aboard, racing to try to get a bank bailout ready, just in case. Massive bank failures were not an option, but the error was in letting banks escape with minimal accountability.
Within a week of the FT article, alarm bells should have been ringing like Japanese Tsunami warning sirens as the Mrkit iTraxx Crossover index rose over 1000 basis points for the first time since its creation and meanwhile, in the U.S., the main credit default swaps indicator (for 125 companies) rose to 271 basis points. Some of the world's leading investment grade companies now looked to be in danger of default according to CDS prices.
Meanwhile, investment banks - including regular commercial banks that had been acting as such- were holding nearly $55 trillion in worthless paper bonds. Caught sleeping, the credit rating agencies like AIG and Moody's, now realized that these "side bet" engineered bonds were barely worth one-hundredth of their claimed worth. The banks, acting with next to nothing capital ratio (the ratio of actual holdings in cash reserves, to their obligations) had bought these things (called credit default swaps) like crack cocaine.
Now, nearly two years after a potentially calamitous financial collapse, what do we find? Well, one of the key progenitors is aggressively defending attempts to regulate the tactics, including the leverage strategies, which incepted it! In an article written in yesterday's Financial Times ('How Dodd-Frank Fails to Meet the Test of Our Times') Alan Greenspan claims the putative regulators are just too dumb to oversee complex istruments. According to this wizened gnome:
"The problem is that regulators can never get more than a glimpse at the workings of the simplest financial system"
He then adds a few paragraphs later:
"In the most regulated financial markets, the overwhelming set of intersections is never visible"
The gist of his dubious argument therefore appears to be that it's just too hard to regulate today's global economy. Greenspan failed, or rather, to use his own words, was "caught flat-footed" by the crisis, and therefore so will all future regulators. Though Greenspan has always been known for being a man of few words (mostly too dense to parse), this analysis and predictable interlocution will go down in history as one of the greatest examples of purposefully idiotic misdirection of all time.
Contrary to Greenspan's BS, I would submit that the problem here is not the simple-mindedness and inablity of the regulators, but rather inadequate budgetary support for the necessary numbers to accomplish oversight to the standards needed. In addition, as we detect from Greenspan's comment on "the overwhelming set of intersections", the financial instruments being used today are simply overly complex. This brings up the issue of: WHY are they so complex?
WHY is it necessary then, to create instruments using David X. Li’s Gaussian copula formula? This formula, for the benefit of financial novices, provided the effective operational basis for the concatenation and intertwining of relatively innocuous securities (with high bond ratings) with 'toxic waste' in the form of the sub-prime mortgage securities via credit derivatives. (Again, for those who don’t know, derivatives were invented by physicists who had migrated to finance and based their creation on the concept of the mathematical derivative, e.g. dy/dx, such that a minute fractional incremental variation in one variable (dy) generates a corresponding change in another (dx).)
Li's formula provided the facile enabling mechanism and basis to accomplish millions of financial "intersections" with little oversight because the obscure mathematics was generally not well understood by the investment banks (like Lehman’s) that offered the spuriously blended instruments. For that reason, not one in a thousand financial regulators would have been au fait with it either. (Hell, most advanced mathematicians aren't familiar with it!) Thus, Greenspan's argument here is disingenuous!
Li's formula, as well as current 12-dimensional vector state space gimmicks (to apply to a new breed of derivatives) are EXACTLY THE PROBLEM! Their sole intent is to obfuscate, confuse and bamboozle with bullshit so avid buyers (including banks) to whom these things are peddled, will stupidly just scarf them up if they believe a profit can be made!
The solution goes even beyond what the Dodd-Frank law demands (which is basically to enhance capital ratios, i.e. lower the leveraging capacity of banks. It is to simplify all financial instruments across the board to make them fully transparent to all potential buyers. That may mean putting ten thousand former physicists and mathematicians out of work, but it's preferable to allowing them to continue inventing obscure devices in their etheral realms that will make the next financial catastrophe ten thousand times worse. My point? Physicists ought to find better things to do with their time and energy than to abet and enable speculators!
To that end, I'd also ultimately recommend banning all these complex derivatives, or placing them under the exclusive scrutiny of regulators with the mathematical abilities and qualifications of the physicists ("quants") who had invented them in the first place! Thus, with ample pay, they could ensure the total protection and oversight needed. Until these post-quant regulators are in the mix, no further sales of obscure instruments are permitted.
Following that, I'd also advocate re-instating the Glass-Steagall regulation from 1935, which repeal (in 1999) had opened the way for commercial banks to act like invesment banks. That law, which previously separated the investment banks from deposit taking banks, is needed now more than ever to keep commercial banks doing what they were designed for: taking deposits! Canada never went down the CDS gambler path and they didn't experience the meltdown we did.
What to do in the meantime? Clearly, former Fed Chairman Paul Volcker had the answers with his 'Volcker rule'! Described in The Financial Times (Feb 15, 2009, 'Goldman Faces Stark Choice on Volcker Rule'), the banks would either have to make do with no "proprietary trading" (such as in the risky derivatives market) or they cease to be afforded the protection of the government, including the Federal Reserve - which entails giving up federal deposit insurance protection, as well as any Federal Reserve bail outs for misguided moves. As Volcker put it, quoted in the FT piece:
"Don't expect the support you would get from being a bank within the club of insured deposits, and access to the Federal Reserve and all the loving attention you get as a banking organization"
In the meantime, until the rule is imposed:
1- All CDS pricing and volume need to be made public
2- All OTC (over-the-counter) derivatives need to be centrally cleared. This will lead to proper margin payments to all parties.
Elements of these are already in Dodd-Frank, and hence there exists some protection to avert a massive credit meltdown on the scale that preceded the 2008 financial crisis. Thus, no one knew the price of any given credit default swap, and counter party risk (for those holding them) went to astronomical proportions, leading to hundreds of banks holding worthless paper, causing them to essentially cease all lending transactions.
What we can't do now is allow turkeys like Greenspan (or more recently Jamie Dimon, of J.P. Morgan Chase, complaining in today's FT about Dodd-Frank's higher capital ratio demands) to lead us all down the primrose path again. Even if the bankers refuse to protect themselves from a potential torches and pitchfork -wielding public (if another collapse ensues) we have to step in and do it for them, for the interest and welfare of the commonweal.
As for Greenspan's cynically invoking Adam Smith, e.g.
"Today's competitive markets, whether we seek to recognize it or not, are driven by an international version of Adam Smith's 'invisible hand' that is irredeemably opaque"
Should also remember the following words of Smith from his Inquiry into the Wealth of Nations:
"What improves the circumstances of the greater part can never be regarded as an inconvenience to the whole"
Maybe both Greenspan and Dimon need to go back to school, a la Rodney Dangerfield.
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