2009 - Year of the Banker

OK, first rant coming up. My version of recent financial history.

The world economy is in a terrible state because of bankers. That bald statement really is the truth and the buggers still don't get it. OK, I should also include derivatives underwriters and traders, fund managers, market analysts and credit rating agencies...and the rest. Maybe gullible and, possibly, stupid, house buyers too. Of course, we should never forget to blame estate agents (for everything, as we always do). But it's the bankers who started it. It's the bankers who should have known and were paid a huge amount to know.

What happened? It started at the end of the 90s, with China making lots of currency, especially dollars, and the main place they put it is back in the US economy. Result, lots and lots of cash - liquidity. In short, bankers got their hands on an ocean full of cheap money they'd done nothing to earn. What did they do?  These clever bankers spread the dough around like a lottery winner on cocaine. Once they ran out of even the dodgiest of credit card holders, the shakiest of businesses and the most over-blown of equities to invest in they decided to ride the property bubble and blow it up even more. They ended up throwing billions, no, trillions at mortgages for people who would never be able to pay back the loans, the so called NINJA customers (no income, no job, no assets). They got "creative" by offering suicidal repayment structures with fancy names but which all meant that, give it a couple of years and the repayments would be way beyond the borrowers' financial capabilities.

So at this point it got worse, much worse, because the even cleverer derivatives chaps (almost all solid alpha males on testosterone overdose) then decided to spread the risk - yes, they knew that these "sub prime" (bullshit for wildly dangerous) mortgages were risky - by using more of that famous creativity. These wonderful people did the obvious to the poisonous loans, they securitized them: they found ways of selling on the risks of the loans without making it too obvious what they were doing. This is the financial and almost infinitely more profitable version of respraying a dangerous old car and upping the price tag. They created collateralized mortgage obligations ("CMOs"), mortgage-backed securities ("MBS") and asset backed securities ("ABS"). The sleight of hand is in the risk ratings system. They did deals with the credit ratings agencies by slicing up the risks involved into tiers and spreading them on with nice comfortable ratings letters AAA, AA, BB+ etc. Of course, by then nobody understood - or, more probably, nobody wanted to know - the real cumulative risk on the underlying assets: they were just pieces of (virtual) paper with a reassuringly quantifiable ratings score, not home loans that nobody could repay.

By now all these trillions of dollars in time-bombed, unstable debt instruments had been sold on and re-sold and repackaged thousands of times. The Bankers got even more devious in their need to satisy their greed and open up more credit lines for more of this toxic stuff by moving most of it off their balance sheets into nasty but huge and dangerous "Special Investment Vehicles (SIVs). They could then raise more MBS's etc and sell on bonds and shares in the SIVs without overburdening the balance sheets.  By the time the clever bankers started to deal in derivates on these derivative off-balance sheet instruments (we are now at least five levels of repackaging away from the original sub-prime mortgages), they forgot or chose to forget that they were simply buying back the criminally dodgy loans they and their mates had issued in the first place. In the meantime, all those brilliant derivatives issuers and intermediaries had taken their slices of profit too (in cash, though little was generated) and the recycled loans were not only explosively risky but - the black comedy touch - they were now even more expensive in order to pay for all those slices! But they looked good, all nicely wrapped in pompous and comfortingly arcane acronyms like SIVs, CMOs, MBSs and ABSs. It was not accidental that only a handlful of people understod what these instruments really were.

In parallel, all this business was itself being funded. A lot of the derivatives activity was being funded by further hedging instruments, more financing deals and lots and lots more credit risk spread around with no cash flow measures to back it up.

What happens next is so tragically predictable (in hindsight of course!). The poor suckers (some of them pretty dodgy too but then the bankers never wanted to check how dodgy their customers were) who had taken out the loans couldn't pay once those charming introductory repayment holidays and reduced interest sweeteners ran out. That is, once the home loan repayments actually reflected the true cost of financing the home purchase, the shit hit the fan. Repayments failed and houses were repossessed. Not just thousands but hundreds of thousands.

The property marked crashed. The loans and the fancy instruments grown off them (CMOs and all) became worthless. The bankers financing the sale and purchase of the derivatives found that their customers couldn't in turn pay their loans. The cash - which had never really existed in the first place - disappeared in smoke and the banks started running out of liquidity. The banks lending money to banks stopped trusting that they would get repaid so they turned off the tap and more banks failed. Real businesses making tangible goods and real services found they couldn't get even the simplest operational credit. Consumers, so dependent on huge extensions of credit, stopped buying cars and refrigerators. Industry came to a halt. So, for a little while, did China. So, in a massive detonation, did the banks.

In stepped governments to sort out the whole god-damned mess. Unlike the 30s, this time, by and large, governments got it right: supplying emergency liquidity to keep banks functioning and also fuelling spending with demand side injections to keep industry going. Dear old Keynes became popular again (he'd always been misread anyway, by both sides of the economic divide).

Why am I and so many others so angry at the bankers and all the other financial whizz-kids? Because of their despicable hubris, unlimited arrogance and their systematic theft of our money.These are nasty accusations, I know.

The most basic lesson of finance is that there's no such things as a free lunch. To get a high return you have to take a high risk, to get low risk you have to expect low returns. That is a deep, fundamental law of the financial market. There are no exceptions. Risk and return are always and inescapably positively correlated, even if dislocated temporally. But then the brainiest analysts seemed to forget that axiom and, more importantly, forgot that the toughie in the real world is accurately ascribing a numerical risk to a real asset and its performance over time.  An example of the hubris was my Financial Markets Prof at business school. He is/was a whiz kid fund manager from New York and loved to remind us how clever he and his friends were. Irritating smugness apart, he was, to be fair, an excellent teacher and it was, indeed fascinating. Lots of formulae, lots of equations, lots of enticing maths. Using all this stuff. risk and return (spiced up with volatility) could be packaged into nice clear cut answers: this exact risk needs exactly this return. Exciting intellectual concepts. As a one time mathematician, I loved it. It was comforting, being opened a window into this clever, clever world where all the complexities of the free market could be understood, if you were smart enough, by applying the right equations, by running the best simulations. The Prof was always very clear about just how clever you needed to be. Masters of the Universe (MOUs) had to be dead smart. He once said that only one member of my class - the only one to have a doctorate (even though it was in political economics) - could possibly join this elite. He wasn't interested in the real world of real assets, real company performance, just intellectual fire-power.

Well, Prof, you were dangerously and arrogantly wrong.  In creating all these beautiful risk models you indeed forgot the nee to understand the real risk underlying all the numbers - the quality of a business's management, the stability of someone's job, the real need for a new product, the sustainable value of property - and substituted that unpredictable reality with the false security of statistics and ratings and formulae and equations. Trouble is, you and your comrades made the stupidest error - the statistical assumptions to derive risk values were very crude and ignored the distorted curves and outliers of the real world of imperfect markets. More crudely: shit in means shit out, however shiny the fan.

The little discussed scandal of the ratings agencies made it all so much worse. Fitch's, Moody's, Standard & Poors's  (etc.) risk assessments on countries, business equities, debt obligations and other investments are mostly paid for by the investment banks who need to sell the very instruments being assessed. The agencies therefore had every reason not to tell the dirty truth about the worthlessness of the wonderful new sub-prime derivatives. But of course, Prof, your intellect was what it was all about and why you were so highly paid. The fact that so many of you checked-in common sense, business acumen and, to be honest, integrity at the door on your way in, is what you are all scrambling to hide; it's what is drowned in the testosterone flood.

Then we have the ultimate scandal, where mere mortals like me feel disgust, where we seek the blood of these financial hyenas. This sleight of hand - the swapping of care, integrity and common sense for mathematical nonsense - is paid for not handsomely but outrageously. There are three, malevolent factors here:

1. Only in financial markets and drug dealing do you get paid in the very commodity you deal with. Because bankers et al deal in trillions of (virtual) dollars, euros, pounds, whatever, so they think that a few little percentage points for themselves is reasonable. But it is not. Oil exploration managers don't get paid in oil, even though they are regularly dealing in finds worth billions. Car company executives don't get a percentage of the production, though they are also responsible for turnover in the billions. But bankers and dealers and equity analysts and the rest are different, they take a cut of the product. Why? Because they can. The real scam is that we pay for all this because bankers don't create wealth themselves, they only manage the money of those who do. Our and our businesses' interest rates, bank charges and myriad financial fees end up in their pockets. It is us little people who pay the MOUs.
   
2. The bonuses - again a cut of the product - are paid on the upside and, unlike for real business owners, there is no downside. The upside target is invariably short term. So, when the market is on the up, almost always due to the activities of consumers and industry not those of bankers, all the bonuses are plucked ripe from the heavy laden market tree. When the market goes down, well, a few Bears pick off further winnings by the risky chance of betting short but most stand and watch and simply get lower bonuses (never zero) for a month or two. The parameters are short term, linked to P&L, not to the balance sheet, and rarely look at individual performance over a long period. Economic/financial sustainability of the deals does not come into consideration.
   
3. The people who approve this disgraceful level and structure of remuneration are members of the same club - bank (etc) shareholders are mostly bankers and fund managers. Spot the conflicting interest.

Can anyone tell me why a 22 year old derivatives dealer, whose only skill is that of the poker player (and probably not as good as the best of those) should earn maybe ten or even a hundred times more than an experienced company MD employing 1000 people and making good honest products for consumers and a decent return for his shareholders? You think I exaggerate about the kind of people involved.

James Cayne was appointed CEO of of one of the most prestigious temples of MOU-dom, Bear Stearns, mainly because he was a great bridge player and a successful salesman (originally photocopiers and scrap iron). No qualifications, no experience of running a business but great at calculating short term risk. Wow, no wonder he made hundreds of millions from other people's money and came out with most of it when the company went down the tubes and lost investors billions. Yet it was the brilliant acumen of all those clever bakers that put him at the helm.

I know. Not all bankers are like this. For all the hundreds of MOU investment bankers, fund managers and equity analysts there are thousands of thoroughly decent folk in retail and commercial banking (or even in investment banking). Indeed, there's the rub. The fat cat investment banking types screwed up and the innocent retail/commercial bankers paid the bill. Actually it's worse. To avoid the unthinkable run on retail banks, to protect ordinary consumer and business deposits, we tax-payers ended up bailing out the MOUs who had caused the disaster. Too right they should separate off investment banking and let them fail when they screw up, without taking the rest of us down with them.

We need free markets, we need financial markets, we need derivatives. We really do need clever and creative bankers and their chums but the market needs rules and most of those need to make sure risk is truly assessed, truly managed and truly apportioned, so that bankers do what they are supposed to and manager our money responsibly as well as profitably. Most importantly, if they to continue to get the sureally high returns they think they deserve, then by their own creed, the personal risk to them should be equally high.The present high return, low risk system of remuneration is profoundly dishonest. Anyone can skim the foam of the bull wave and paddle round the flotsam of the bear trough.

The sad thing is that memories are short. In the US, the UK and elsewhere the focus of anger has already moved from these culprits to those who saved us from total meltdown, the much maligned politicians. They may have unwillingly landed us with a huge long term bill to pay but their ethics are pure as angel feathers compared with most MOUs. Without quick and courageous action from Gordon Brown, Barack Obama and even George W, the bankers could well have destroyed Western civilization. Crucially, politicians get thrown out if they screw up and sometimes even if they don't. The Bankers, even those bailed out with our and our children's taxes, are back on bonus and smugness. Big time.

Oh, by the way, if you think all this is just sour grapes or the ignorance of an outsider, see what the former CEO of Barclays, Martin Taylor, has to say about his profession in his opinion article Innumerate bankers were ripe for a reckoning in the FT on 15 December 2009 (thanks to fellow Linked-In users for this one). While this puny blog attacks the wanton irresponsibility of the number crunchers, he focuses more on the innumerates (more strictly speaking, the accounting illiterates) in banking for confusing profit with cash. Interestingly, he reminds us that the mega bonuses are not some necessary, systemic, motivator for the financial whizz kids but a very recent creation of the noughties greed bubble. Rock on.