Posts filed under “Really, really bad calls”
I don’t understand why, but I keep seeing portfolios strewn with Ultra-Short inverse funds. These are the ETFs that bet 2X and even 3X that major indices will go down. 20, 30 even 40% of some accounts are laden with these.
Eventually, the downside bet will be a moneymaker. Eventually. But if you make that Macro call even a few Qs early with a leveraged bet, the negative consequences could be severe. As I have frequently suggested, waiting for a technical signal prior to shorting is a much better approach than guessing.
Note that I have no problem with the concept or the use of these – but you must understand the risks and issues of using these very short term instruments. There is lots of slippage relative to the indices they seek to short, meaning lots of tracking error. But that is the technical reason for why these should be used sparingly, or as a hedge, and only for days and weeks — not years.
The more basic question is the foolishness of shorting strong indices running straight up — without any technical or timing signal, it is suicidal to guess when this all comes to an end.
It is one thing to miss opportunity sitting in Treasuries or cash; it is something else entirely to fight the tape, let the trend run you over, and argue with the market.
Unless you have a red “S” on your chest and wear a cape, do not step in front of a speeding locomotives . . .
James Glassman must be a helluva salesman. How else can you explain how the co-author of Dow 36,000 was able to convince a publisher to allow him to demonstrate his lack of acumen on a related subject? After penning what became the classic exemplar of Dot Com excesses — a spectacularly wrong tome about equity…Read More
Category: Really, really bad calls
Fascinating discussion by SImon Johnson at Economix: The key finding is that chief executives were “30 times more likely to be involved in a sell trade compared with an open-market buy trade” of their own bank’s stock and “the dollar value of sales of stock by bank C.E.O.’s of their own bank’s stock is about…Read More
Relentlessly shameless bank shill William Isaac gets up off his knees just long enough to pen an absurd FT piece: Banks should be allowed to pay out dividends. It is such a bizarre statement that we are left truly wondering what color the sky is on his planet. Isaac seems to be just making it…Read More
I’ve been doing the slow burn on a very foolish article in Tuesday’s NYT Dealbook, about European Short Selling rules. The author is somewhat clueless about shorting. He writes: “Companies have long complained that short-selling can lead to stock manipulation. In the financial crisis, managers at Bear Stearns and Lehman Brothers accused large investors of…Read More
Bill Black is an Associate Professor of Economics and Law at the University of Missouri-Kansas City. He is also a white-collar criminologist, a former senior financial regulator, a serial whistleblower, and the author of The Best Way to Rob a Bank is to Own One.
Peter Wallison dissented from the Commission’s finding that deregulation played a material role in the crisis. Here are the key excerpts.
Deregulation or lax regulation. Explanations that rely on lack of regulation or deregulation as a cause of the financial crisis are also deficient. First, no significant deregulation of financial institutions occurred in the last 30 years [p. 445].
Moreover, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) substantially increased the regulation of banks and savings and loan institutions (S&Ls) after the S&L debacle in the late 1980s and early 1990s, and it is noteworthy that FDICIA—the most stringent bank regulation since the adoption of deposit insurance—failed to prevent the financial crisis [p. 446].
The shadow banking business. The large investment banks—Bear, Lehman, Merrill, Goldman Sachs and Morgan Stanley—all encountered difficulty in the financial crisis, and the Commission majority’s report lays much of the blame for this at the door of the Securities and Exchange Commission (SEC) for failing adequately to supervise them. It is true that the SEC’s supervisory process was weak, but many banks and S&Ls—stringently regulated under FDICIA—also failed. This casts doubt on the claim that if investment banks had been regulated like commercial banks—or had been able to offer insured deposits like commercial banks—they would not have encountered financial difficulties [p. 446].
The Commission report and the dissents do not distinguish between the three “des” – deregulation, desupervision, and de facto decriminalization. Deregulation occurs when one reduces, removes, or blocks rules or laws or authorizes entities to engage in new, unregulated activities. Desupervision occurs when the rules remain in place but they are not enforced or are enforced more ineffectively. De facto decriminalization means that enforcement of the criminal laws becomes uncommon in the relevant industries. These three regulatory concepts are often interrelated. The three “des” can produce intensely criminogenic environments that produce epidemics of accounting control fraud. In finance, the central task of financial regulators is to serve as the regulatory “cops on the beat.” When firms gain a competitive advantage by committing fraud, “private market discipline” becomes perverse and creates a “Gresham’s” dynamic that can cause unethical firms and officials to drive their honest competitors out of the marketplace. The combination of the three “des” was so criminogenic that it generated an unprecedented level of accounting control fraud, which in turn produced unprecedented levels of “echo” fraud epidemics. The combination drove the crisis in the U.S. and several other nations.
Wallison discusses only one example of deregulation – the repeal of the Glass-Steagall Act. I show that his claim that “no significant deregulation of financial institutions occurred in the last 30 years” is false.
I do not discuss here in detail the enormous S&L deregulation and desupervision that occurred at the federal and state level that occurred in 1982-83 and made possible the second phase of the S&L debacle – then the worst financial scandal in U.S. history. The first phase of the debacle was caused by interest rate risk. It, ultimately, cost the taxpayers roughly $25 billion to resolve. The second phase of the debacle was driven by the epidemic of accounting control fraud by S&Ls. Deregulation and desupervision in 1981-1983 created the criminogenic environment that allowed that epidemic of fraud. I have written about it extensively in my staff reports to the National Commission on Financial Institution Reform, Recovery and Enforcement and my book: The Best Way to Rob a Bank is to Own One. Akerlof & Romer (1993) used the second phase of the debacle as an exemplar of the title of their article – “Looting: the Economic Underworld of Bankruptcy for Profit.” The criminologists Calavita, Pontell, and Tillman discuss the fraud epidemic in their book – Big Money Crime. Airbrushing the deregulation and desupervision that permitted the second phase of the S&L debacle out of history is necessary to Wallison’s central task – defending his disastrous lobbying for decades for financial deregulation. We will see that the S&L deregulation and desupervision are not alone in disappearing from Wallison’s rewrite of history.
I will also not discuss in detail the enormous desupervision that occurred at the SEC that permitted the Enron-era frauds. The budget and staffing of the SEC were kept relatively flat while its workload grew enormously. The percentage of fillings it reviewed declined to five percent. Congressional Republicans consistently sought to cut the SEC’s budget and staffing levels in the 1990s. Criminologists refer to the result as a “systems capacity” problem. (see here and here)
As SEC enforcement director Robert Khuzami emphasizes, the SEC must serve as the regulatory “cops on the beat.” The staff and budgetary limits rendered the SEC incapable of performing its primary statutory mission.
In sum, Wallison’s history excludes the deregulation and desupervision that permitted the two massive financial crises that preceded the current crisis. We will see that Wallison also ignores the major acts of deregulation, desupervison and de facto decriminalization that made possible the current crisis.
This column addresses the role of deregulation in allowing the current crisis. I break the discussion in to three subsets: deregulation by legislation, deregulation by rule changes, and an odd hybrid – the SEC’s Consolidated Supervised Entities (CSE) program.
Deregulation by Legislation
Gramm-Leach-Bliley (1989) repeals the Glass-Steagall Act and Reduces CRA Examination
The repeal of Glass-Steagall demonstrates the complexity of what deregulation can mean. The banking regulatory agencies were extremely hostile to the Glass-Steagall Act. They eviscerated the Act by adopting rules and interpretations that created so many exceptions to Act’s separation of “banking and commerce” that the separation was rendered ineffective. The federal regulators also did not enforce the remaining provisions of the Act vigorously even before it was repealed in 1999. The combination of deregulation and desupervision by the banking regulators so gutted the Act that its formal repeal by the Gramm-Leach-Bliley Act in 1999 had little practical effect.
Wallison refers to a modest regulatory strengthening of the CRA rules in 1995, but he does not inform the reader that the GLB Act reduced the frequency of examinations of smaller and rural banks under the Community Reinvestment Act (CRA) and sought to discourage alleged extortion by housing activist organizations (e.g., ACORN) by requiring the disclosure of any agreements they made with banks not to challenge mergers. Senators Dodd and Schumer led the group of Democrats that successfully pushed these anti-CRA provisions on a reluctant White House because the Democrats were so eager to repeal Glass-Steagall. (see here)
Wallison does not disclose this deregulatory aspect of the GLB Act because it falsified his claim that the CRA caused the crisis.
If there is doubt that these lessons are important, consider the ongoing efforts to amend the Community Reinvestment Act of 1977 (CRA). Late in the last session of the 111th Congress, a group of Democratic congress members introduced HR 6334. This bill, which was lauded by House Financial Services Committee Chairman Barney Frank as his “top priority” in the lame duck session of that Congress, would have extended the CRA to all “U.S. nonbank financial companies,” and thus would apply, to even more of the national economy, the same government social policy mandates responsible for the mortgage meltdown and the financial crisis [p. 443].
There are many crippling flaws in Wallison’s claim that the CRA was “responsible for the … crisis.” Here, I note only the fact that the timing and direction of regulatory changes falsify his claim that the CRA was responsible for the crisis. The obvious problem is that the CRA had been in effect since 1977 – so one must assume a fictional latency effect of 15 years, a period that included two recessions, before the CRA suddenly became toxic. The recessions should have exposed any toxic aspects of the CRA long before the current crisis. The less obvious problem is that the CRA was weakened, not strengthened, after 1999. This refutes Wallison’s assertion that the CRA was “responsible for the … crisis.” As I will explain, the statutory weakening of the CRA in 1999 was compounded by other forms of deregulation and desupervision during the run-up to the crisis in 2001-2007.
I prepared the chart below by searching the FFIEC data base for CRA rating by date of the CRA examination.(see FFIEC website here)
The chart confirms a number of points that anyone who has ever been a financial regulator after the passage of the CRA in1977 knows. CRA ratings have long been like Lake Woebegon’s children: they’re virtually all above average. Fewer than ten banks get rated as a serious problem – and even they get treated with kid gloves. Examine the data for 1999 and 2000. The examiners discover seven serious CRA problems in 1999 – slightly above one-tenth of one percent of the banks examined. That CRA rating “substantial noncompliance” triggered a requirement for annual CRA reexaminations of the non-magnificent seven and should have led to immediate enforcement actions. Clinton was President and had appointed each of the regulatory leaders. By 2000 the regulators appointed by Clinton (who Wallison seeks repeatedly to cast as the villains) acted so aggressively against the seven that the 2000 exams revealed that there were still seven awful banks. It’s not like banks were failing frequently in this period and requiring the regulators’ attention to be paid solely to “safety and soundness.” The claim that banks lived in fear of the CRA and that the CRA drove their lending decisions is pure fiction. Banks routinely got satisfactory or outstanding ratings by making good loans. Banks had to try hard to get poor ratings and even the tiny minority that did so rarely faced any meaningful sanction.
The data in the chart also show that the statutory deregulation, reducing CRA examination frequency, was significant. The number of annual CRA examinations in the 2000s was typically well under one-half of the number of CRA examinations in 1995. Wallison is deliberately disingenuous in stopping his discussion of CRA changes in 1995. Both statutory and regulatory deregulation of the CRA occurred after that date. (My next column will also discuss the desupervision of CRA compliance that occurred during the 2000s.) The CRA, and its enforcement, became weaker as the mortgage fraud epidemic surged. That (further) falsifies Wallison’s claims that the CRA was “responsible for the … crisis.”
Statutory changes that allowed the creation of “private label” MBS
The SEC, Department of the Treasury, and OFHEO (which regulated Fannie and Freddie) created a joint task force, which issued: A Staff Report of the Task Force on Mortgage-Backed Securities Disclosure in January 2003.
In Friday’s reading, I mentioned Michael Lewis’s piece in Vanity Fair: When Irish Eyes Are Crying. It is your must read of the weekend. The problems in Ireland makes the woes in Greece look merely like a bounced check. And Ireland’s eejit politicians, FOLLOWING THE ADVICE OF MERRILL LYNCH, turned the entire population of the…Read More
Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He is a white-collar criminologist who has spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.
The big news in U.S. regulation last week was the release of the Financial Crisis Inquiry Commission reports. (There’s a major article in the New York Times about Kabul Bank that supports warnings made in my earlier column on that scandal.) The Commission report and the two dissents discuss some of the most important topics in financial regulation, so I will devote a series of columns to the reports, beginning with the dissent of the nation’s leading anti-regulator – Peter Wallison. Wallison’s passion, for forty years, has been financial deregulation and desupervision. The Republican Congressional leadership appointed him to the Commission to serve as apologist-in-chief for the deregulation and desupervison that made the crisis possible.
We’ll explore Wallison’s dissent in greater detail in future columns, but this overview column addresses his three primary arguments: Fannie and Freddie are the Great Satans, they caused the crisis because of demands politicians put on it to purchase the subprime loans that caused the crisis, and all of this was compounded by the Fed’s easy money policies.
This column discusses Wallison’s views on the first two subjects while the crisis was developing. Wallison is well-known for his long-standing criticisms of Fannie and Freddie, but most people do not know the nature of those criticisms. Wallison praised subprime mortgage loan and complained that Fannie and Freddie purchased too few subprime loans. Wallison (correctly) explained that Fannie and Freddie’s CEOs acted to maximize their wealth – not to fulfill any public purpose involving affordable housing. He also explained that they used accounting abuses to make themselves wealthy. He predicted that low capital costs would increase economic growth. Wallison’s prior views contradict his current claims. Aspects of Wallison’s prior views were correct. They support the conclusion that Fannie and Freddie were accounting control frauds.
Wallison’s Ode to Low Interest Rates
Testimony before the Subcommittee on Securities of the Senate Committee on Banking, Housing and Urban Affairs
By Peter J. Wallison | Senate Committee on Banking, Housing, and Urban Affairs
(July 19, 2000)
If capital costs are low, more capital will be available for companies that need it, capital will be allocated more efficiently, we will have faster and broader-based economic growth, and the welfare of all Americans will be enhanced.
(Parenthetically, Wallison’s July 19, 2000 Senate testimony disputed the claim that there was a high tech bubble – even as the bubble was collapsing.)
Wallison’s Ode to Subprime Lending
Wallison and his AEI colleague Charles Calomiris co-chaired AEI’s project on financial market deregulation . They were also members of the Shadow Financial Regulatory Committee (a self-selected group of deregulatory scholars and practitioners associated with AEI).
Statement of the Shadow Financial Regulatory Committee on Predatory Lending
December 3, 2001. Statement No. 173
The Federal Reserve is in the process of drafting detailed regulations dealing with alleged problems of so-called “predatory lending” in the subprime mortgage market, and the Congress is considering actions to curb various alleged abuses in this type of lending.
Because much of what is classified as predatory lending involves loans to low-income, minority, and higher-risk borrowers, a central principle that should guide legislation and regulation in this area is the desirability of preserving access to subprime mortgage credit for such borrowers, who are most at risk of losing access to this market in the wake of misguided and punitive regulations. The democratization of consumer finance that has occurred over the past decade has created new opportunities for low-income consumers. This is now threatened by chilling effects that inappropriate regulations and laws might have on the supply of subprime credit to these consumers.
Subprime credit to low-income consumers necessarily entails higher interest rates.
As recent evidence of increasing loan defaults demonstrates, this line of business is risky, and institutions will only be willing to provide such credit if interest rates are sufficiently high relative to risks and other costs of servicing consumers. One of the risks that must be borne by intermediaries is regulatory risk. Laws or regulations that place lenders at greater risk of legal liability for having entered into a loan agreement (for example, state and municipal statutes that penalize refinancings that could be deemed contrary to the interests of the borrower) generally will reduce the supply of beneficial lending as well as predatory lending. Illegal lending, however, would not be reduced; indeed, it would be encouraged.
Wallison Criticized Fannie & Freddie for Making too Few Loans to the Less Wealthy
Wallison’s critique of Fannie and Freddie emphasized their failure to make more subprime loans and loans to minorities.
H.R. 3703 and its Effects on Government Sponsored Enterprises
By Peter J. Wallison | House Subcommittee on Capital Markets
(September 06, 2000)
The GSE form–at least as it is embodied in Fannie Mae and Freddie Mac–contains an inherent contradiction. It is a shareholder-owned company, with the fiduciary obligation to maximize profits, and a government-chartered and empowered agency with a public mission. It should be obvious that it cannot achieve both objectives. If it maximizes profits, it will fail to perform its government mission to its full potential. If it performs its government mission fully, it will fail to maximize profits.
[T]he incentives of their managements [are] to increase their own compensation.
This has direct consequences in the real world. Since 1992, Fannie and Freddie have had an obligation to assist in financing affordable and low income housing. Obviously, doing so would be costly, and would thus reduce their profitability. Studies now show that their performance in financing low income housing—especially in minority areas—is far worse than that of ordinary banks. In other words, despite the fact that Fannie and Freddie receive subsidies to perform a government mission—in this case support of low income housing—their need for and incentives to retain a high level of profitability is an obstacle to their performance.
The Public Trust of a GSE
By Peter J. Wallison | 2002 Federal Home Loan Bank Directors Conference
(November 14, 2002)
Other GSEs–and here I am thinking specifically of Fannie Mae and Freddie Mac–while they hold a government charter, are much closer to the business corporation model. They have actual shareholders, are listed on a securities exchange, and in terms of the way they present themselves to the financial markets are profit-maximizing entities. Although five of their directors are appointed by the president, I am told that these directors are advised by counsel for Fannie and Freddie that their duty of loyalty runs to the corporation and its shareholders and not to any stakeholder or any government mission.
[T]he subsidy realized by Fannie and Freddie is the worst kind of corporate welfare–a transfer of wealth from the taxpayers to both the generally well off (Fannie and Freddie’s investors) and the genuinely wealthy (Fannie and Freddie’s managements).
We understand from the rules of corporate governance that the directors of corporations like Fannie Mae and Freddie Mac are expected to serve the interests of the corporation and the shareholders by seeing to the maximization of profits. The fact that they have a government mission is irrelevant–as is, we are told, the fact that some of them are appointed by the president. So, in a quite literal sense the directors of Fannie and Freddie face a conflict between the government mission of their corporations and their duty to maximize profits for shareholders. Any claim that they are discharging a public trust is an illusion. To the degree that they do anything less than maximizing profits it is to maintain their valuable franchise by reducing their political risk, not because they are voluntarily fulfilling some public trust. It can’t be otherwise; they are legally bound to a duty only to the corporation and its shareholders.
This is very clearly seen in Fannie and Freddie’s activities in affordable and minority housing. Study after study has shown that they are doing less for those who are underserved in the housing market than banks and thrifts. Not only do they buy fewer mortgages than are originated in minority communities, the ones they buy tend to be seasoned and thus less risky. Despite Fannie’s claims about trillion dollar commitments, they are meeting their affordable and minority housing obligations by slipping through loopholes in the loosely written and enforced HUD regulations in this area.
In other words, two companies that are immensely profitable and claim to have a government mission, are doing as little as they can get away with for those who most need assistance–while swamping the airwaves with advertising that they are putting people in homes. This should be no surprise, since their incentives push them in this direction. As shareholder-owned companies, they are maximizing their profits–as they must–while doing just enough to avoid the criticism that might result in the loss of the government support that enables them to earn these profits.
Wallison dismisses the concept that Fannie and Freddie’s senior managers (the “genuinely wealthy”) even consider the public interest – their “government mission is irrelevant” to their decision-making. He explains that Fannie and Freddie’s leaders act like fully private CEOs.
Fannie Mae and Freddie Mac
By Peter J. Wallison | House Subcommittee on Commerce, Trade and Consumer Protection
(July 22, 2003)
Fannie and Freddie suggest that they provide special assistance to minority families hoping to become homeowners. And if they did this disproportionately–that is, helped minorities or low income borrowers more than they helped middle class borrowers–that would be a powerful argument for preserving their current status.
But they do not do this. Instead, according to a study by Jonathan Brown of Essential Information, a Nader-related group, Fannie and Freddie buy proportionately fewer conventional conforming loans that banks make in minority areas than they buy in middle class white areas. Other studies have shown that the automated underwriting systems that Fannie and Freddie use to select the mortgages they will buy approve fewer minority homebuyers than similar automated underwriting systems used by mortgage insurers.
The sad fact is that Fannie and Freddie–two government sponsored enterprises that have a government housing-related mission–do less for minority housing than ordinary commercial banks. Studies have repeatedly shown that banks and other loan originators make more loans to minority borrowers than Fannie and Freddie will buy. That in itself should be a scandal, together with the fact that both companies seek through their soft-focus advertising to create the impression that they are actually using their government benefits for the disadvantaged in our society.
Wallison’s verbal assault on Fannie and Freddie was vigorous. He viewed their failure to make more loans to minorities to be a “sad fact” and a “scandal.”
I will begin the explanation in this column of why Wallison’s lack of understanding of accounting fraud leads him to err in his view that Fannie and Freddie’s senior managers were acting to fulfill their fiduciary duties to the shareholders. (It’s an odd error for a man whose normal premise is wealth maximization. As with “public choice” theory, the neoclassical prediction should be that the CEO will act to maximize his wealth – not the shareholders’ wealth. Term it “CEO choice theory.”) Wallison does not understand that Fannie and Freddie’s controlling officers would come to see that purchasing large amounts of “liar’s” and subprime loans was an ideal strategy for short-term wealth maximization. Nonprime mortgage loans made it easy for Fannie and Freddie’s senior officers to supply the first two ingredients in the four-part recipe by which lenders (and purchasers of loans) that are accounting control frauds maximize short-term accounting income.
Discuss. UPDATING: In the deep, dark recesses of my mind, I knew this chart was the result of accounting changes. But I more or less spaced when I was going through charts at FRED and decided this was discussion-worthy even though I really did know better. I apologize to all for the brain fart; I’ll…Read More