Scary Movie 6? – The Banking Sequel

Corporate Social Irresponsibility
April 5, 2013
Metrosexual Me
April 23, 2013
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[Update:  April 19.   New NYTimes story, here.]

This almost reads as a parody of what we saw in 2007.  A parody because, certainly, we wouldn’t let it happen again.  This has to be a joke. Right? And it might even be funny – if it wasn’t true.

Here are a few excerpts from The New York Times website this morning [full text, here]:

“Banks have been shedding risky assets to show regulators that they are not as vulnerable as they were during the financial crisis. In some cases, however, the assets don’t actually move — the bank just shifts the risk to another institution….

“Citigroup, Credit Suisse and UBS have recently completed such trades. Rather than selling the assets, potentially at a loss, the banks transfer a slice of the risk associated with the assets, usually loans. The buyers are typically hedge funds, whose investors are often pensions that manage the life savings of schoolteachers and city workers.”

Sound familiar? Here’s the first truly scary part:

Known as capital relief trades or regulatory capital trades, “most of these trades are structured as credit default swaps, a derivative that resembles insurance. These kinds of swaps pushed the insurance giant American International Group to the brink of collapse in September 2008.”

And then here’s the kicker (I recommend you sit down for this). To paraphrase, in part:

One of the consultants advising a pension fund in New Mexico that invested in one of these trades said that his deal “has a little flavor of that” (meaning AIG-type swaps) but that this time, the investors did their homework (unlike AIG) and this time they have a better understanding of the risks. So, you see, it’s ok.

I say: RUN! Run for the hills! Anyone who will tell you that “this time, we really understand the risks” is either suffering from pathological hubris or simply didn’t read a newspaper in the past six years.

The fact is modeling the risks for many of these derivative products is about as accurate as most economists’ long-term predictions or today’s weather map for Christmas. There are too many variables. Too many possibilities in the future that are completely impossible until they become possible when they actually happen.

That fact is no secret. It was a completely impossible event – a nationwide blip in US housing defaults – that exploded exponentially through these derivative products, which rendered them impossible to value, that led to the recent crisis. (Remember that one?) AIG insurance did not help. It did not have enough money. Suddenly the banks were holding momentarily valueless paper. And that was enough…the financial industry went into cardiac arrest…and the crisis began.

And now the regulators, powerless they say, are watching and lamenting as it happens again. Why is it so impossibly hard to understand that if children cannot be controlled on a giant playground, you don’t just throw up your hands, you take away some toys and restrict what they’re doing?  I wouldn’t care if it’s just some investors losing money.  But these guys are tied up, inextricably, to our retail banks.

None of this is new. The danger has been evident for decades. People whose job it is to safeguard our money should not be the ones to tell us what it’s worth.

I first learned this lesson – and trust me, so did the regulators – more than 20 years ago. I was covering the insurance industry in Maryland (insurance is state-regulated in the US), and at that time, a huge insurance company named SunAmerica (ironically bought by AIG some 10 years later), moved its place of incorporation from Maryland to Nevada.

Regulators in Maryland were relieved. It seems SunAmerica had started investing some of its customers’ money in something new back then called derivatives, some of which were related to the founder’s other company, a giant homebuilder in the west. How these investments worked, what the underlying investments were, and how much they were worth was all unclear to this small state agency in charge of ensuring the company was financially stable. So when the company left, despite the state taxes it paid, everyone breathed a bit easier.

(And just so you see how old some of these games are, the reason the company picked Nevada was generally believed to be because the top insurance regulator there was elected. And regulatory oversight was loose. In Maryland, the top regulator was appointed. How much better to be somewhere you can actually – and legally – give money to the person at election time whose job it is to watch you.)

To the regulators’ credit, what they did understand about these investments was that virtually no one understood them.

For those of you unschooled in (or just bored by) the fine art of derivatives, let me explain briefly. There is nothing inherently new in the idea.  There is nothing inherently wrong or dangerous about them.  It’s just thanks to computers, and some highly paid “quants,” that disaster is now possible.

The fact is even an IOU is a simple derivative. It’s a piece of paper whose value is derived from something else. Now let’s see how, if you’re clever and paid to create games with no substance, this might work:

I sell my bicycle to my friend A for $100. He doesn’t have the money so he will pay me $10 a month for 11 months (to pay interest). But I want all my money now, so I sell that IOU to friend B for $101. I made a quick one dollar profit and my friend B is now due to receive a total of $109 over the next 11 months (deducting the one dollar he gave me). If A does not pay the money, then B loses out. But B will take the chance because he knows I trust A and that if I fooled him, he will never buy from me again.

I now have my $100 back. And so I do this again. I buy a new bike – I sell it to C – I then sell the IOU to D – and I make another one dollar.

I like this game. And now here’s where it gets good. I call one thousand friends and sell each of them a bike. I take all the IOUs and I put them in a box. Instead of selling them each for one dollar, I sell the whole box to a rich friend for $1,000.  I use $200 to buy insurance to protect my rich friend against possible losses if people don’t repay.  He now will collect lots of monthly payments and by the end of it all, he’s made a profit of $9,000 (remember, he paid me $1,000).  And I do this again, and again, and again.

My friend likes this game. He finds 1,000 people like me and he looks to buy 1,000 boxes. But for that he needs to borrow some money. It’s a lot of money so he needs lots of investors. Ok, he admits, some of these bike owners might not pay. So to some group of investors, he says, he’ll pay them back first. They won’t profit as much because there’s less risk. To another group, he says, he’ll pay them back second, or maybe third, and they’ll make a nicer profit but they have more risk. And just in case he’s wrong about being paid back, he’ll buy other insurance or trade some of his paper with somebody else’s paper in a way that will help insure all the payments. And he does this again, and again, and again.

And the investors like this. So they take their pieces of paper and they sell them, or pieces of them, to still other investors to raise still more money so they can invest in these more.

Now you tell me, what is that one last piece of paper really worth? And just what will happen when a million bicycle friends stop paying?

But who cares? Right? That box full of IOUs has suddenly transformed.

“The loans then look less worrisome — at least to the bank and its regulator,” The New York Times story explains. “As a result, the bank does not need to hold as much capital, potentially improving profitability.”

And how does it end? Like any terrifying movie, there’s always the promise of a sequel.

“These trades allow the banks to go to regulators and say the risk is gone,” said Anat R. Admati, a professor of finance at Stanford University, according to The Times. “But it’s not gone at all; it’s just been pushed into a murky corner of the market.”

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