The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

I was reading this piece from Michael Hiltzik of the L.A. Times, and I was struck by something intriguing.

The debate over the deficit is quite revealing about the speaker: What they choose to omit is every bit as important as what they emphasize.

Consider these two short paragraphs:

“As Henry Aaron of the Brookings Institution observes, the current government deficit is the result of an enormous tax cut mostly for the wealthy, of paying for two wars by credit card, of the Great Recession, and of spending to address that recession . . .

Medicare’s ills are entwined with our national system of healthcare — how it’s used and how it’s distributed. You’re not going to make a dent in the problem unless you change the underlying system.”

No single factor is responsible for the deficit — quite a few different ones helped to cause it.

When I was out promoting BN, I constantly ran into this issue. It seemed that everyone tried to use the financial crisis and market collapse as proof of their pet issue. It wasn’t a combination of things, it was _______ [Insert Pet Peeve].  If you believed these folks, the crisis was caused by Acorn, or the CRA, or Fannie Mae, the poor, regulations, Unions, going off the Gold Standard, minorities, high taxes, deficits, and of course, the Federal Reserve. The Democrats blamed the Republicans, and the Republicans blamed the Democrats.

I never could tell if it was naked opportunism or merely selective perception.

The takeaway is this that whenever you hear some pundit pontificating on some event, think about their ‘blame emphasis’. Their omissions are quite revealing about their bias.

>

Previously:
The Crisis Was Caused by [Insert Pet Peeve Here] (January 26th, 2011)

Source:
A moral alternative for curing Medicare’s ills
Michael Hiltzik
LATimes, June 5, 2011   
http://www.latimes.com/health/la-fi-hiltzik-20110605,0,1312792.column

John Sherffius has this terrific depiction of the next leg down in housing. (Sherffius contributed cartoons and did the cover of Bailout Nation):
>

Source: John Sherffius

The “Datapoint of the Day” comes from the NYT column we referenced yesterday: The mind-boggling drop in Justice Department criminal referrals over the past decade.

I find this specific factoid astounding:

“Data 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.”

This is more “Nonfeasance” — that is what I accused the Greenspan Fed of doing in Bailout Nation. It is also what the Office of the Comptroller of the Currency did and what the Office of Thrift Supervision engaged in.

They did not do a bad job int he discharge of their duties. THEY REFUSED TO DO THEIR JOBS AT ALL. They simply refused to discharge their legal obligations, because the people in charge did not believe, philosophically, in regulations.

This is yet another crime we should be prosecuting people for. It is no different than safety regulators who failed to inspect carnival rides and 100s of children died. The bank regulators who refused to discharge their duties for ideological reasons should be prosecuted. That means investigating John Duggan and John M. Reich for nonfeasance. How are they any different from people who took payoffs from carnies and allowed children to die on unsafe rides?

Consider how bad it was under these to radical deregulators: We’ve mentioned this stat previously, but its worth repeating: Referrals for criminal prosecution plummeted under the Bush administration fell by 95%. While I have been frustrated by the poor policy and personnel choices Obama has made — and continues to make — the Bush administration was uniquely incompetent when it came to filling regulatory positions with anti-regulators. (Think Harvey “Shred-’em-before-the-subpoena-arrives” Pitt as SEC chair).

Its no surprise that these criminally negligent appointees did not do their jobs. These so-called regulators were far too cozy with the regulated. Friends, pals, drinking buddies. And so, they failed their charges, and left the taxpayer at the mercy of thieves.

• Why was John M. Reich, a former banker and Senate staff member appointed in 2005 by President George W. Bush, uninterested in prosecuting Countrywide or Angelo R. Mozilo, its chief executive? Reich said that “he was a good friend of Mozilo’s.”

• Why were FCIC investigators (during Obama’s Presidency) told “Countrywide was off limits?”

If you want to understand why the public remains so angry about the bailouts, these facts are merely frosting on the cake. The bailouts work to prevent the government from fulfilling its duties as prosecutors. Once they get in bed with banks, they refuse to do anything to “harm” that investment.

And the public gets angrier and angrier.

This morning’s must read MSM piece is over at NYRB: The Wall Street Leviathan. Jeff Madrick simultaneously reviews:

• Financial Crisis Inquiry Commission Final Report

• Inside Job

• Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance

• Reforming US Financial Markets: Reflections Before and Beyond Dodd-Frank

This should give you the flavor of the article:

“Dodd-Frank Act has largely pushed responsibility for writing and implementing the new rules onto existing regulators, including the Federal Reserve, the Securities and Exchange Commission, the Commodities Futures Trading Commission, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency. This will likely prove a damaging flaw. These regulators are by and large the same agencies that tolerated the excessively risky behavior in the first place. Even if they write effective rules they will face pressure from Wall Street lobbyists and mostly Republican legislators to soften restrictions and eliminate some of the critical ones. If the restrictions remain intact, which is likely in view of the Democratic majority in the Senate, the question remains whether the regulators will enforce them vigorously once the economy recovers and the crisis fades in memory. Several agencies have already missed the deadlines to write new rules. Some are worried that the Consumer Financial Protection Bureau will be neutralized by Congress. Wall Street spent $2.7 billion on lobbying between 1999 and 2008 and is lobbying vigorously again…”

That is a damning indictment of a government controlled by Wall Street.

My only quibble:  Madrick writes “the Financial Crisis Inquiry Commission (FCIC) is the most comprehensive indictment of the American financial failure that has yet been made.” Numerous prior works have been both comprehensive and devastating (The Big Short, The End of Wall Street, Bailout Nation). And these authors did not have an $8 million dollar budget or a huge staff.

But that’s only a quibble, and the FCIC report is a giant 576 pages of tiny print (662 pages in PDF form).

It is a beast of an article, well worth your time to read . . .

>
Source:
The Wall Street Leviathan
Jeff Madrick
New York Review of Books, APRIL 28, 2011
http://www.nybooks.com/articles/archives/2011/apr/28/wall-street-leviathan/?pagination=false

John Sherffius, who did the cover (and the awesome cartoons) for Bailout Nation, takes his own satirical swipe at GE:

>

via John Sherfius

In their starched white shirts . . .

PIIGs: 5 Year CDS

chart via Bianco Research

The Finance sector is back to record revenue, and of course, record bonuses and pay. I was surprised to see how much greater the Commercial Bank revenue and comp was versus Wall Street totals. When you think about it, they have many more assets, transactions and commercial activity than Wall Street does, so it makes sense.

One of the things I think people misunderstand about Wall Street pay: In finance, people are paid commission or fees or both (there are some salaried employees as well, but they are not the big bonuses getters). If you are a sales trader, for instance, you are paid based on the total volume of activity. If you did well for your clients, you may catch a bonus from them, which shows up as extra commission, year end. Some folks who are fee based are paid based on Assets Under Management (AUM), while others receive performance pay (or both).

This isn’t popular to say, but its true: There is nothing wrong with most of the compensation that is paid to Wall Street. It was the insanely misaligned compensation — getting paid huge bucks to sell things people knew were likely to blow up — that helped create the crisis. Remember, Wall Street and the Banks employ millions of people; it was much less than 1% of these people who blew the economic world up.

At AIG, the Financial Products division that brought down the firm (the intenral derivatives hedge fund that generated 32% of AIG’s profits)  were less than 400 people out of a firm that once employed 116,000 people.

Its ironic that of all people, I am defending Street pay, given how vociferously I criticized Wall Street in Bailout Nation. But there is a huge between merit pay for work done and misaligned compensation.

And given that these firms were not allowed to die when they became insolvent, the outsized proportion of revenue they garner is still in effect. But for the bailouts, the definacialization of America would have proceeded. It was halted by trillions of taxpayer and Federal Reserve largesse.

Here is the WSJ:

“When it comes to paychecks, Wall Street’s law of gravity is back in full force: What goes down must come back up.

In 2010, total compensation and benefits at publicly traded Wall Street banks and securities firms hit a record of $135 billion, according to an analysis by The Wall Street Journal. The total is up 5.7% from $128 billion in combined compensation and benefits by the same companies in 2009.

The increase was fueled by a revenue rebound as the financial crisis recedes in the rearview mirror. At 25 large financial firms that have reported full-year results, revenue rose to $417 billion, another all-time high, even though last year’s 1% increase was just a fraction of the industry’s revenue jolt from 2008 to 2009 as trading and investment banking sprang back to life.”

There are some additional elements at work:

-deferred compensation made up as much as half of total pay, up from about a third peviously

-increased base salaries, rather than Smash & Grab bonuses. (to “encourage employees to focus on longer-term”)

-Employees who boosted the bottom line got much of the gains in pay — the “star system” is very much in effect.

>

>

click for interactive version

>

Source:
On Street, Pay Vaults to Record Altitude
AARON LUCCHETTI And STEPHEN GROCER
WSJ, FEBRUARY 2, 2011   
http://online.wsj.com/article/SB10001424052748704124504576118421859347048.html

“The F.C.I.C. is the first to take a close look at the missteps at Citigroup, which virtually every book about the financial crisis has overlooked. It is a devastating portrait of negligence at the top — including the once sainted Robert Rubin.”

-Joe Nocera, NYT, Inquiry Is Missing Bottom Line

>

Say it ain’t so, Joe!

How did you miss this? Bailout Nation, Chapter 18 is titled “Too Big to Succeed.” It is about the history of Citigroup, its numerous missteps leading up to the crisis, the role of Robert Rubin and Larry Summers in the repeal of Glass-Steagall, and Citi’s role in the collapse. (Bank of America makes a guest appearance in the last third of the chapter).

It is, to say the least, rather critical.

The Glass-Steagall repeal may not have been the cause of the crisis, but it sure as hell made the damage far worse. It allowed banks to own businesses they otherwise could not, and to manufacture and buy junk paper in quantities far greater than would otherwise have been possible.

When Glass-Steagall was in effect, Wall Street collapses were kept on Wall Street and for the most part, away from Main Street.

Do you remember the devastating credit crisis and recession caused by the 1987 crash? No, because it never happened. As Bailout Nation makes clear, Glass-Steagall was a major factor why.

Anyway, Chapter 18 is posted in our Bookshelf. And in light of the FCIC report, the rest of the book should be next in your queue.

>
Previously:
Bailout Nation Updated Reviews

Source:
Inquiry Is Missing Bottom Line
JOE NOCERA
NYT, January 28, 2011
http://www.nytimes.com/2011/01/29/business/29nocera.html

Bailout Nation, Chapter 18

The Year of the Bailout, Part II: Too Big to Succeed?

By William K. Black

When Reputation becomes Ineffective or even Perverse

Control fraud also makes reputation perverse. Theoclassical economists predict that reputation trumps everything, even auditors’ conflicts of interest. This prediction has repeatedly been falsified by reality. The asserted reputational trump ignores crippling errors. Several theoclassical assumptions about reputation and fraud are implicit and interrelated. Implicit assumptions pose the greatest risk of error because the people making the assumption never had to defend the unstated assumptions. Reputation and fraud turn out to have an important, and complex, relationship. One cannot understand reputation without understanding fraud techniques. Common theoclassical assumptions, most of them implicit, about fraud and reputation include:

• An individual has a consistent set of behaviors that drive his reputation
• The public’s perception of an individual’s reputation is accurate
• Members of the public have a consistent perception of an individual’s reputation at any given time
• A good reputation can only be achieved through consistent good deeds
• Fraud is discovered because of its very nature
• Fraud is discovered because of “private market discipline”
• The people who lead frauds are discovered
• The people who lead frauds are sanctioned so that fraud does not “pay”
• All other market participants that might deal with the entity will learn promptly that it has engaged in fraud
• Other market participants will not aid or permit fraud by another party
• Other market participants will not deal with an entity with a reputation for acting fraudulently even if the entity has not (yet) defrauded those market participants
• The people who lead frauds suffer disabling damage to their reputation that makes it impossible for them to commit future frauds even if they are not sanctioned
• Elite financial firms and independent experts will not commit, aid, or permit frauds because of their interest in their reputations
• Elite financial firms and independent experts would lose their valuable reputations if they committed, aided, or permitted frauds
• The least likely persons to commit frauds in elite institutions are their senior leaders
• When CEOs set a “tone at the top” that tone emphasizes integrity and reputation

White-collar criminologists have found that each of these assumptions is unreliable. Economists rarely study fraud or read the criminology literature, yet they often have powerful ideological “priors” about fraud. Easterbrook & Fischel (1991), the deans of applying law and economics to the study of corporate law, exemplify each of these characteristics. They assert that “a rule against fraud is not an essential or … an important ingredient of securities markets.” That assertion is remarkable for its certainty, lack of exceptions, and certitude. It would be wonderful if the assertion were true. Fraud, one of history’s great scourges, would (like polio) be eradicated. Financial markets would be efficient. Bubbles would be much rarer and far less severe. Unfortunately, the assertion is also unsupported and unsupportable. Fischel was an expert for three notorious control frauds during the S&L debacle, where he employed the theories he and Easterbrook would soon write about in their 1991 treatise containing their remarkable assertion.

Individuals, entities, society, and market participants are all far more complex than theoclassical economists assume. It is normal that the same person is perceived differently by every person with a perception, and those differences can be polar. “Fraud” is one of the most variegated of activities. One common characteristic, however, is that fraudsters do not rely on fooling everyone. Many successful frauds, such as the Nigerian “419 frauds”, are obvious to nearly everyone, but “nearly” universal detection of the 419 frauds is not sufficient to prevent them from being profitable. Fraud detection is rarely universal because people vary in their susceptibility and because detection by one person typically fails to spread to most people.

When most people, including economists, think of “fraud” they generalize from what they know from personal life. Nigerian 419 scams, most things advertised on cable television after 10:00 p.m., and con jobs shown on television dramas are what the general public thinks of when they consider “fraud.” The nature of these frauds typically leads the victim to discover (albeit too late) that he has been defrauded. Victims of 419 frauds send “fees” or make “deposits” and do not get the $40 million in funds that the late oil minister allegedly stole from the Nigerian government. The “debt counseling” service charges its victims fees, falsely claims that one need no longer pay one’s creditors and leaves its victims even more insolvent.

These frauds, if they succeed, almost certainly will be discovered by the victim. (There are important exceptions – many fraudsters prey on victims suffering from the earlier stages of Alzheimer’s, those who are functionally illiterate in English, or are incapable of understanding financial matters. Fraudsters profit from their selective reputation with their peers as criminals by selling their mailing lists of vulnerable victims to other fraudsters.) The fraudsters who run the 419 and debt counseling scams know that most of their victims will become aware that they were defrauded. The fraudsters also know that they can continue to defraud others even though the victims learn that they were defrauded and even if the government closes their business. Entry is exceptionally easy for each of these common frauds. If the government shuts down a debt counseling scam it can create a new name and be in operation again within a week. If the fraudulent CEO were banned from the industry he would recruit someone to serve as his “straw” and be back in operation within a week.

Victims of some common, unsophisticated frauds typically do not discover that they have been defrauded. The classic example is the scam drug that promises to enlarge the penis. The victim buys the drug. He is desperate for the drug to work. It is easy for the victim to believe that the drug is working. The alternative is to feel inadequate, hopeless, and made a fool of by a con. This fraud illustrates a key point; an “unsophisticated” fraud can be highly successful because it rests on an insightful understanding of human nature and vulnerabilities.

Accounting control frauds closely approximate the perfect crime. To be a nearly perfect crime a control fraud must reduce the risks of regulatory and prosecutorial sanctions. They are normally not identified as frauds. Even when they are identified as frauds they are normally not sanctioned. Instead of destroying the CEO’s reputation, accounting control fraud normally creates the CEO’s undeserved reputation as a “genius.” This is a subject deserving of extended treatment in future columns, so I will only summarize the key points here in the context of mortgage lending.

• Everyone is reluctant to view a seemingly legitimate lender as a criminal enterprise
• The fraudulent CEO increases this reluctance by mimicking many corporate mechanisms
• No overt conspiracy is required – the CEO creates the perverse incentives and uses his ability to hire, promote, compensate, discipline, and fire to ensure that the recipe will be implemented at the firm and by its loan brokers and that the independent experts will bless the fraudulent valuations and loss reserves
• The CEO can quickly convert large amounts of firm assets to his personal benefit –sufficient to make him wealthy – through seemingly normal corporate compensation mechanisms driven by the record (fictional) income generated in the short-term by employing the recipe
• If there is a bubble, particularly one hyper-inflated by an epidemic of accounting control fraud, then the lender’s bad loans can be refinanced and the record income created by the recipe can be continued beyond the short-term
• The firm fails eventually, but a CEO can always offer a non-fraudulent explanation for a bank failure. This is particularly true when an epidemic of accounting control fraud hyper-inflates a bubble and triggers a severe recession.

Control frauds exploit “agency” problems in order to turn reputation perverse. The Big Four audit firms do have a substantial financial interest in their reputations. The Big Four audit firms are able to charge far more for their audits than can second tier firms. Unfortunately, the more valuable the audit firm’s reputation the more value the audit partner can extract by “selling” that reputation by blessing an accounting control fraud’s financial statements. White-collar criminologists have found that the theoclassical assumptions about top tier audit firms are false.

Read the rest of this entry »