Financial Derivatives: Coming from Foolishness, Fallacies, or Fraud?

Derivatives are a hot topic today. There are various groups assembling to defend the purpose and value of derivatives in the financial markets, others who decry their abusive and destructive nature, those who want to regulate them, some who want to constrain where and to what they can apply, and certainly other interests that have their own particular bent on derivatives. And of course there are the Congressional hearings on the Financial markets collapse and on the Financial Reform effort to address regulatory needs, if any, that the government should establish.

Derivatives are not a new financial concept they have existed in different forms for centuries if not millennia. The derivatives that were created in conjunction with the housing mortgage bubble and other financial bubbles that have contributed to the devastating financial markets’ near collapse were perhaps more ‘complex’ instruments but they were based on the same financial principles that derivatives have always been created upon. And if regardless of what Congress decides to do in terms of regulating, restricting, or intervening on with respect to derivatives; they will not change the need for nor the availability of some financial instrument that will function to the same purpose as derivatives. So the question is will Congress recognize what the real issue is that they need to address?

Where derivatives foolish investments? No, some derivatives did very well for those who invested in them. In fact, they made literal fortunes. Of course others got wiped out. So they were not foolish investments unless you had misjudged the situation that they related to, or you invested in them without any understanding of what the risk was versus the reward potential that they offered. There does appear to be a foolishness factor with some of the investors in the derivatives like the collateralized debt obligations. Even big, smart, sophisticated, and “best and brightest” financial institutions got sucked into buying derivatives that they did not understand or have any means of properly evaluating. And on the other side of the equation, there were those putting together derivative packages that they may have not understood.

But foolishness alone is not the story. Did anyone make plain and simple mistakes or base their actions on false assumptions? Yes. There were fallacies aplenty. People used information given to them about derivatives without any attempt to verify it, to assess it, or to apply the information that the derivative was formulated on to how it affected or influenced the value or risk of their other investments. The derivatives were being treated by many individuals/entities as if they were independent of other financial consequences in the market. So fallacy played its own contributory role in the melt-down.

Now for the last factor: Fraud. Was fraud involved in the derivatives? Yes it was, but don’t assume that it was strictly and exclusively only the banks and financial institutions. Fraud was probably present in every layer and part of the process that created not only the derivative instruments, but that was involved in the underlying investments that seeded the housing mortgage bubble. And fraud was an essential component in the marketing of the derivatives and in the underlying investments. Both instruments were not marketed in the same context, to the same customers and with the same disclosure information.

The issue that Congress, the financial industry, the investment community and the public need to focus on and demand be addressed by way of business, government and societal reform is the very principle that capitalism is based upon: an open market place where everyone has access to the same information and has the same opportunity to compete. This is where the derivatives market went woefully wrong. Deals were made behind closed doors, information was kept for some groups and provided to others, and false and misleading information was used to mislead some investors for the benefit of others.

If Congress is to succeed in protecting the country, the pubic and the free democratic system that they are sworn to serve then Congress is going to have to see beyond the special interests, beyond the public outrage, and beyond the political opportunity and perceive the valid principles of American capitalism.

Goldman Sachs the Public

The Gulf Oil rig accident is not only an ecological disaster but it catastrophic proportions will regrettably pollute the public attention paid to the Goldman Sachs investigation just as the oil slicks will contaminate the environment. Conspiracy theorists might even be expected to infer some connection between the accident and Goldman Sachs. The supposition of course being that Goldman Sachs arranged for the oil platform disaster explicitly to draw media and public attention away from headlines and stories about their culpability in the financial crisis.

But let’s get back to a more grounded reality. Goldman Sachs claims that they did nothing wrong, at least nothing more wrong than what was being done by their peers and their lesser comrades in the financial community. They may admittedly have been foolish to engage in trading in complex synthetic collateralized debt obligations (CDO) without truly understanding the real risks involved for their clients and themselves; but hey, everyone was doing it.

Now there may be some truth in this assertion, but is Goldman Sachs actually willing to also public admit that they are no more and actually less knowledgeable, informed and capable than other leaders in the financial market place? Is their stellar reputation really just smoke and mirrors? Perhaps their ability to make money is due to the cultivated and privileged influences that they have established with Governmental policy makers, elected officials and our illustrious and copious bureaucratic agencies. The familiar ‘revolving door’ between industry and Government seems well oiled and in robust motion.

So some questions for Goldman Sachs:

• How is it possible that Goldman Sachs was able to hedge your positions on CDOs without understanding both the nature of the risk, and more importantly the associated relative values of the CDOs to the leveraged default obligations based upon their failure?

• Did Goldman Sachs merely set up a hedge fund instrument that they knew would pay off handsomely because they knew that the mortgage-based instruments were unsound or valueless?

• Didn’t Goldman Sachs lose some money on the CDO because they had no choice except to hold some CDOs in their own positions; otherwise it would be patently obvious that they had determined that these instruments had become or always were worthless?

• What amount of capital was at risk with the hedged default obligations relative to the CDOs; and how was the return value on that determined? And, if that potential rate of return was as attractive as it appears it was, shouldn’t Goldman Sachs have been aggressively marketing those instruments to the same clients to whom they were marketing the mortgage-backed CDO?

• How much money did Goldman Sachs’ executives lose on personally owned CDO investments, versus how much did executives make on their hedged counterparts?

These are the kinds of questions that Congress, the media and the public should be insisting get answered? Before we worry about whether they are guilty of some planned malfeasance, the American people and their representatives should be demanding that a comprehensive explanation of what was involved in creating these investments and permitting them to become so ‘toxic’ without any apparent alerts being attended to by the industry (particularly Goldman Sachs itself), the Government and its oversight agencies, and the media experts who provide the public with their in-depths analysis and understanding of the marketplace.

I am sure we can all sit back and await the Congressional and the SEC’s efforts to get to the bottom of this cesspool; but I fear that what will float to the top are results that we get from the same politicians and special interests that we always get.

Bagging Bank Bonuses – Another Miss

The Obama administration and many politicians are looking to score big with the public by going after the ‘fat cat’ bankers. With the recent announcements that exceedingly large bonuses were in the offing for major financial companies there was a seismic-scale reaction among the new media, the public, and therefore of necessity the politicians. Everyone in their own appropriate way predictably went postal.

Now I can understand how this little factoid would prove to be a highly effective irritant given the current economic problems and difficulties that have affected everyone, not just domestically but internationally. It doesn’t require any special insight or intuitive feel for the emotional and subjective reactions that have and are playing out in public and private. And I have to admit that I also thought that the bonuses were inappropriate and that the banking and financial institutions executives and probably many of the employees receiving such bonuses should be held to account for the “wrongness” of these bonus amounts/levels. But I think that my reasons for believing that the bonuses are unjustified are different than the vast majority, if not everyone else.

I also think that the remedies that are being pursued are either mis-guided and/or ill-conceived.

So as to why the bonuses are wrong, let’s see where I deviate from the norm.

Everyone* holds that the financial institutions and banks were the primary actors responsible for the financial crisis due to their unconstrained willingness to take risks that they did not understand or probably in some cases did not care that they understood. I agree that these players were essential parties in the disaster, and that they exercised exceedingly poor judgment given their fiduciary responsibilities. They were not alone however. Politicians, policy-makers, government bureaucrats, and let’s face it the public in general were all contributors to the fiasco in any number of ways. Some are more guilty than others, but it would be irresponsible to make just the ‘bankers’ the scape-goats for this mess. I don’t want to let them off the responsibility-hook, but I think there are others to consider for their own appropriate remedial repercussions.

Now since the disaster and the bail-out that saved their (and our) collective asses, the economy has struggled and started to recover. And these companies have also experienced improvements in their status, which is the very thing that set the stage for their action to award the big bonuses. In fact, given that the companies that took TARP money when they were in trouble, these institutions deliberately and aggressively sought to re-pay the bail-out funds. And they did this with full intention of getting out from under any Government over-sight or influence in their operations. Now free of such constraints, they decided that their successful rebound from the precipice is sufficient justification to warrant awarding very good (perhaps obscene) bonus amounts. And that’s where everyone says, hey it’s not fair. We bailed you out, and got nothing or worse; and now you’re getting rewarded for you part in the crisis.

I don’t see it that way. They aren’t being rewarded for their part in some of the stupidest investment decisions that they could possibly have made. And it is not true that we did not get anything out of the bail-out. We did save ourselves from the greater disaster that could have come from hiding our heads in the sand and doing nothing.

What the bankers and their ilk are being rewarded for is the inevitable. The economy had to recover to the current point eventually (or else it had to crash), and in this case it recovered in part because the excessive fear of a collapse had abated. Investments were returning and the economy was and is improving. Did this recovery really happen because of the banks? Did the financial institutions and their management really do anything that ‘caused’ the recovery to the point that we have now? Or did our bail-out produce the stability? And did not the return of our businesses and industry to a positive growth outlook create an economic value that required the banks to attain “profits” from the positions that they had caused their businesses to have sunk to from their own mismanagement?

So my problem with the bankers is that they are rewarding themselves for returning to profitability that they were not directly responsible for, and perhaps not even contributory to. So if the bankers are just benefiting from our risk, for our actions, and from our work; I think the bonuses are misplaced.

And the efforts to tax the banks to get our funds back is not unreasonable; but the approach will be used by the banks to make this a cost that we pick up and pay for. And they will still pay large bonuses whether they do a good job or a bad one. And it’s not just the banks that are stealing money from your pockets in this manner. The executives of most large corporations are using the same approaches to rewarding themselves huge bonuses. Rewards for achievements that “only they could have delivered” and that is why we have to give them these fortunes; otherwise we can not “keep these special individuals working at the company” without these large payments. If they would leave to be paid more elsewhere, well let them go. If enough of them leave, the price for their high-caliber talent will either crash like the economy did, or we will find that there are a lot of even more talented people who will do even better then them.

Notes:

* I concede there is always some none-zero subset of people who will be an exception, but in this case it is certainly a uniquely small subset.

How Dare They Let Me Be Stupid!

This apparently is the attitude of many consumers. There was a news article in my newspaper today (yes, I still get a paper) that indicated the shocking surprise that a man and woman had when they noticed a gas station’s price sign. The sign simply showed a much reduced price for a gallon of gas for cash versus the price for the same gallon purchased with a credit card. The couple seemed to think that this was not right and the station owner was somehow cheating them, as they decided to not purchase their gas at the station.

Now I don’t think that all consumers are represented by these two individuals; but I am equally sure that the couple does represent a large rather than trivial percentage of consumers. What were they shocked about? And more importantly, what did this startling revelation imply that they understood; or more to the point, what did it demonstrate that they had not understood about credit cards and costs to consumers?

The couple perhaps had never thought about the true and total costs of using a credit card. We can assume that they understood that when they charged something that they would pay interest on any unpaid balance that remained on their card after the billing date. This is a pretty basic and essential concept of credit cards. And while there are some folks that don’t grasp this concept, I have to believe that that group is less than one in ten people. Now if this is all that you understood about credit cards then seeing a difference between cash for gas versus credit for gas should probably tick you off.

But obviously there must be more to the true costs of credit cards then that, or I would not be discussing this. What the couple was not considering or aware of was that there are other costs when using credit cards not only for themselves, but also for the merchants who accept them and for everyone related to abuses attributable to the cards. The couple is likely to have a credit card issuer that charges them an annual account fee and there may be various charges for other events and situations related to their account, charges and payments. These extra charges all add to the true cost of using their credit card; but doesn’t explain why the gas station owner would presume to charge more for a credit purchase than a cash one.

What the couple is not factoring in is that the credit card companies do is to charge the merchants, who accept their cards for purchases, a percentage of the price that is being charged. Additionally the merchant has to have equipment for accepting the card, and today that means a system that allows them to have the credit card validated in real-time to help protect the consumer, the credit card company and themselves against fraud. This protection also adds a cost to the merchants operation, since there is a cost for the verification system/operation. Now you might argue that the validation cost is really a savings, since it prevents abuse. And you would be right, it does do that. However, it really only reduces the amount of abuse that the merchant is exposed to from the absolutely ridiculous to something more economical and “affordable”. There is still a cost of fraud to the merchant and you, and it comes in two phases. First the merchant is likely to be charged some amount of the fraud that is associated with their own operation; and then the merchants (and you and I) all have to absorb the cost of fraud from throughout the entire credit card issuer’s system. For every dollar of fraud that occurs on an issuer’s cards, the issuer makes that cost part of their operating expense and distributes that dollar into the costs that they charge in interest, in fees you pay directly, and in merchant fees that you pay indirectly. All this cost is why a credit card is more expensive to use than cash is. And it’s more expensive for everyone, and thus the reason that the gas station owner would offer you a better deal on cash.
For those of you to young to remember, when credit cards were yet to have become the necessity that they are today, it was not uncommon for merchants to offer a cash discount on the price to be able to keep more profits from their sales. Then more and more consumers became addicted to the plastic and merchants found out that they sold more stuff on plastic because people spent more than they could afford. So instead of encouraging you to go cash, the merchants helped trap our economy in the credit death spiral. And it has gotten so bad, that we may see more merchants experimenting with cast discounts to see if they can make more money this way.

But don’t blame the merchants. It’s the consumers that did this to the consumers. The couple is outraged because they have always been charging themselves more for everything; and they just hate that the gas station has the nerve to rub it in their faces.

Let’s Have Another Round of Oversized Bloated Banking Bonuses

The public has generally been outraged over the Government’s bailout of the financial industry. The public’s major issues revolve around the CEOs and other executives of those companies not only keeping their jobs, but also receiving large bonuses after their stellar performance in bringing on the crisis. On top of this is the insult added to that injury, of the Government not providing bailouts for other businesses and industrial areas that were as dramatically impacted by the near financial collapse. Financial companies were assigned surgeons to help repair their life-threatening problems, while the rest of the economy was ask to handle their injuries with some band aids.

Now that the economy is beginning to show viable signs of a sustainable come-back, the executives of the financial companies are rewarding themselves with more super-sized bonuses. And we will hear from them the ever popular refrain about how these bonuses are essential to keeping these highly valued individuals who would go somewhere else if they weren’t paid these huge sums.

The Government’s solution to this is mostly non-existent because they are not allowed to directly interfere with the operation of a public-sector company. At least the Government does not intervene when it involves companies that provide large political contributions and funds very effective and well connected lobbyist groups. For those financial companies that are still holding Government TARP funds the Government has restricted pay and bonus amounts; but I am sure that this will be duly corrected when these companies pay back the bailout funds.

In an effort to ameliorate public discontent, the Government is proposing lots of solution to the problem the public sees. One of the easiest solutions that also offers the most emotionally satisfying reaction is to tax such bonuses. Of course, if we all step back and think about this for a moment we can see the fundamental flaw in this plan. Just as we all Government funds come from taxes, and all taxes come from the public; all bonuses come from the public’s purse also. So when we take some of their bonuses away, we are still the ones who paid the original price. This tax bonuses approach has been adopted by the European Union, so this simultaneous discovery of how to help protect the public and our economies from financial institutions’ abuse and greed will unquestionably work out.

Other Government proposals are to require the bonuses to be in the form of stock awards that have to be held for five years before they can be redeemed. This is really going to protect us, because as everyone knows this financial crisis was the result of things that were done in less than a five year period. And we won’t have to worry about these guys fiddling with the numbers or devising processes that will let them game the system (which they define) all over again. I don’t want to make you feel stupid or anything; but you only have to be of average intelligence and possibly are reasonably proficient with Algebra-level mathematics.

Our real problem is that the Government is still only able to understand and react to economic and societal risks with the same tools and concepts that they have been using for and from the last century. And given the empirical data from the 1900’s we can clearly see how successful these means and methods have been at averting these problems. In fact, since we are going to tackle these problems in the same way as before, they must not have really happened.

And why are we depending on the Government to have the brains and know-how to ensure that we can protect ourselves? Isn’t this another case of the same tool that just failed being the tool that is being recommended to solve the problem this time around? The politicians always talk about it being time for change; and I don’t just mean the present administration. Both parties and every administration says that they are going to change how we do things and make it work this time. It’s not that I don’t believe that they think they are going to fix things; it’s that I don’t think they understand how to comprehend the problems they are trying to solve. A prerequisite to solve a problem is to know the space in which a solution (if you believe that there is one) can be found.

What evidence do we have that politicians have demonstrated even a random chance at getting things right? I would contend that in some non-Las Vegas manner they cannot even win half the time when the odds are fifty-fifty.

What Congress Hasn’t Gotten Yet: It’s The Economy Stupid!

The results are in. The electorate has spoken. And apparently the public is unhappy about the economy. How anyone could have discerned that before this election, I cannot imagine. Thank God the Republicans are going to save us and return the economy to a robust and dynamic state. Because we know that Republicans would never be fiscally irresponsible, they would never spend money that we don’t have, or allow the financial industry to engage in risky and irresponsible investment and monetary policies, and they would never allow international trade policies and agreements to threaten the long term interests of the country.

Wait! I forget; didn’t the Republicans actually do all these things? These stalwarts of conservative philosophy and America First posturing, aren’t they as or even more responsible for the atrocious financial situation that we find ourselves in then the Democrats? Who else could have funding a war on “off-the-books” budgeting? Or, who could have deregulated banking and blindly assumed that the banks and financial institutions would be focused on the national interests before their own? And has anyone done a better job in supporting the ever growing trade deficit with the rest of the world, and devaluing the dollar against other currencies?

I don’t mean to say that the Democrats haven’t demonstrated the same levels of incompetency in their skills and expertise. They have been the prime movers on any number of Governmental programs that have managed to completely hose up Government budgets, taxes, regulation, trade, and all the other elements of our national economy.

All that aside; we can all look forward to the Republicans arriving as the saviors of the economy. And because Republicans are the defenders of citizens who seek individual freedoms, small government, the efficiency of the free market system, and a strong defense; we can expect them to step up and force America to face the hard facts. The Republicans will bring a strict monetary accountability upon not only the Government, but upon corporations and upon the populace. The new leadership (it must be a new leadership, because the old leadership couldn’t do it) will expect Americans to live within their means, and will require companies to be prudent with and tie bonuses to long-term delivered performance and not short-term promised future value.

The way that we know that Republicans are up to this task is that they have never demonstrated any indication of being aware of such responsibilities, and they are only interested in protecting campaign funding sources to keep them in office. In other words, they are just like the Democrats. Promise with is easy, and what people want but don’t want to have to pay for. Blame anyone else for the problems, and accept none of the responsibility. Yes, be a politician.

So whichever party you are expecting to return America to its strong economically dominate position in the world order, what do you expect them to do? Do you expect them to strengthen the dollar, to stop borrowing money from the rest of the world (reverse the trade deficit), and prevent corporate and business leaders from funneling the value of companies into their own pockets? Do you think they are going to make executive be accountable for and paid according to their mis-management, high risk bets that are unprofitable, and for self-interest directed fiduciary irresponsibility?

Do you really think either party even knows how to do this?