The Ten Trillion Dollar Black Swan

It is nearly unanimous. The reason for the current financial mess isn't over-leveraging, or criminally negligent management and Directors, or even an excess supply of millions of homes. It is that darn mark-to-market rule. Just ask Warren Buffet, Donald Trump and other financial geniuses. Even the journalists are on board...Steve Forbes, Ben Stein, Lou Dobbs, and (gasp) Bill O'Reilly. I haven't heard Cavuto on the subject. He is usually the sharpest, most level-headed one of all, so I'm hoping he's not on the same train. Politicians galore...no big surprise...anything to find an easy scapegoat.

My usual reaction to that kind of herd mentality is that if they all agree, they must be wrong. Yes, I'm that much of a cynic. But then I see that even Newt agrees. Wow. Maybe this time they are right. And then I start thinking. It is unlikely that a huge mess like this has a single cause. But imagine that we follow their advice.  Instead of marking to market, let the firms carry bad paper at face value. Wait just a minute (I hear you cry)! That paper really isn't so bad. Just because the collateral doesn't cover the loan amount doesn't mean the loan will go bad. Well, maybe you're right. I know how you can prove it. Just buy the stuff at a 10% discount to face value. That should be a good cushion. Put your money where you mouth is or shut up!

But no, none of the blabbermouth billionaires (if they really are billionaires) wants to buy it, but they know that somebody will step up to the plate. Just ask P.T. Barnum or W.C. Fields. What they want to do is to mark it at face value; claim that the firms have adequate capital; then find some suckers to loan them still more money using that toilet paper as collateral. How big a loan should I put you down for Warren? Donald? Steve? O'Reilly? Newt?

But wait just another darn minute (I hear you scream)!  Why not just have the government loan the money, or better yet give it them as equity capital. Golly gee, I sure wish I had thought of that. But luckily, I didn't have to be that smart. Hank Paulson convinced a majority of Congress that it was a good idea. A trillion dollars with virtually no research and no debate. It passed faster than a bill to name a post office after a corrupt politician.

With all due respect to Senator McCain, the money would be better spent on studying the DNA of every animal species in North America. Paternity or criminal? Who cares?  We will save approximately $999,900,000,000. For all you public school graduates, that is 999 billion, 900 million, leaving us with all but $100 million for the taxpayer, and a generous stipend for the scientists, who, after all, are performing a rather  tedious task.

As a poor taxpayer, I am at least entitled some entertainment for my money.  Fire
all the top executives and sue them for every penny they have on the grounds that they totally abandoned even a fig leaf of fiduciary responsibility to their share holders and bond holders. I bet we can get some lawyers to do that pro bono! But no, instead we have to vomit every time one of those self-serving empty suits who run the banking industry appears on TV telling us that we are too dumb to understand the intricacies of modern finance. Then he shakes his head solemnly, while proclaiming to us how unlucky they were.

It is unfair to blame every bank CEO. Just to name one, (I know there are others) Wells Fargo Bank share holders were sent a note of apology because earnings were off by 7% from the previous year because of bad mortgage loans. Gee whiz! They took what was believed to be a prudent risk and it didn't work out. So the shareholders took a tiny hit, not in value, but in potential increased value. That is true capitalism. But small risk equates to small bonuses. How could you have expected  the heads of Bear Stearns, Lehman Brothers, AIG, Morgan Stanley, Goldman Sachs, etc. to disappoint their employees with mere 6 or 7 figure bonuses?

And oh yeah. The aforementioned CEO of Wells Fargo was summoned to Washington by the Treasury Department's secret police and water-boarded for 48 hours until he agreed to accept $25 billion or so, in order to save his badly managed competitors any embarrassment.

Am I being too harsh? After all we are repeatedly assured (as if we were the morons) that it was a perfect storm. No, worse than that. A black swan!  Sure, hindsight is 20/20, but who could have anticipated it?  Let's see. You leverage your firm 30 or 40 to 1. That means (public school graduates) that you have a billion dollars of your own money. Then you use your "strong" balance sheet (no silly marking to market) to borrow another $39 billion. You loan out $35 billion of it and pay the other $4 billion to yourself or other co-conspirators. Your risk managers fire off e-mails telling you that if housing prices decline by as little as 5% to 10%, the entire firm is lost. What a bunch of academic worry-warts! Everyone knows that housing prices can never go down. Maybe one intrepid risk analyst (who earns less that 1% of your well deserved compensation) has the temerity to remind you that the latest reports show an excess supply of more than 2 million homes nationwide as compared to people who need a home to live in. After firing her, you console yourself with some caviar and truffles washed down with a $10,000 bottle of wine.

There was a time when the greed factor cited above was balanced by its equally famous sibling, the fear factor. Before 1970, investment banks and other NYSE members had to be individuals or general partnerships. When they converted to publicly traded corporations the risk was transferred to the shareholders but the rewards still went disproportionately to the senior managers. Why is that important? When that e-mail warning of the risk hit the CEO's computer, he could ignore it, knowing that he had accumulated tens or even hundreds of million dollars in prior years. At worst, he could retire comfortably. Had he been the managing partner, the firm's creditors could go after every penny he had to his name. Say goodbye to Mister Greed and hello to Mister Fear!

What about all those arcane "derivatives" that only 3 people in the whole wide world truly understand? Sorry again. That's just one more self-serving lie. Anyone with the mathematical sophistication of a good freshman calculus student can understand them. That lets out every single member of Congress (to the best of my knowledge). Why do you think they never tell you the actual terms of these instruments? They don't dare to tell you. You just might be a freshman!

This rant would be incomplete without a nice metaphor to take home. It was not a black swan that caused this crisis. It was a whole flying wedge of white swans flying over Wall Street marking the market in their own charming way.
It is nearly unanimous. The reason for the current financial mess isn't over-leveraging, or criminally negligent management and Directors, or even an excess supply of millions of homes. It is that darn mark-to-market rule. Just ask Warren Buffet, Donald Trump and other financial geniuses. Even the journalists are on board...Steve Forbes, Ben Stein, Lou Dobbs, and (gasp) Bill O'Reilly. I haven't heard Cavuto on the subject. He is usually the sharpest, most level-headed one of all, so I'm hoping he's not on the same train. Politicians galore...no big surprise...anything to find an easy scapegoat.

My usual reaction to that kind of herd mentality is that if they all agree, they must be wrong. Yes, I'm that much of a cynic. But then I see that even Newt agrees. Wow. Maybe this time they are right. And then I start thinking. It is unlikely that a huge mess like this has a single cause. But imagine that we follow their advice.  Instead of marking to market, let the firms carry bad paper at face value. Wait just a minute (I hear you cry)! That paper really isn't so bad. Just because the collateral doesn't cover the loan amount doesn't mean the loan will go bad. Well, maybe you're right. I know how you can prove it. Just buy the stuff at a 10% discount to face value. That should be a good cushion. Put your money where you mouth is or shut up!

But no, none of the blabbermouth billionaires (if they really are billionaires) wants to buy it, but they know that somebody will step up to the plate. Just ask P.T. Barnum or W.C. Fields. What they want to do is to mark it at face value; claim that the firms have adequate capital; then find some suckers to loan them still more money using that toilet paper as collateral. How big a loan should I put you down for Warren? Donald? Steve? O'Reilly? Newt?

But wait just another darn minute (I hear you scream)!  Why not just have the government loan the money, or better yet give it them as equity capital. Golly gee, I sure wish I had thought of that. But luckily, I didn't have to be that smart. Hank Paulson convinced a majority of Congress that it was a good idea. A trillion dollars with virtually no research and no debate. It passed faster than a bill to name a post office after a corrupt politician.

With all due respect to Senator McCain, the money would be better spent on studying the DNA of every animal species in North America. Paternity or criminal? Who cares?  We will save approximately $999,900,000,000. For all you public school graduates, that is 999 billion, 900 million, leaving us with all but $100 million for the taxpayer, and a generous stipend for the scientists, who, after all, are performing a rather  tedious task.

As a poor taxpayer, I am at least entitled some entertainment for my money.  Fire
all the top executives and sue them for every penny they have on the grounds that they totally abandoned even a fig leaf of fiduciary responsibility to their share holders and bond holders. I bet we can get some lawyers to do that pro bono! But no, instead we have to vomit every time one of those self-serving empty suits who run the banking industry appears on TV telling us that we are too dumb to understand the intricacies of modern finance. Then he shakes his head solemnly, while proclaiming to us how unlucky they were.

It is unfair to blame every bank CEO. Just to name one, (I know there are others) Wells Fargo Bank share holders were sent a note of apology because earnings were off by 7% from the previous year because of bad mortgage loans. Gee whiz! They took what was believed to be a prudent risk and it didn't work out. So the shareholders took a tiny hit, not in value, but in potential increased value. That is true capitalism. But small risk equates to small bonuses. How could you have expected  the heads of Bear Stearns, Lehman Brothers, AIG, Morgan Stanley, Goldman Sachs, etc. to disappoint their employees with mere 6 or 7 figure bonuses?

And oh yeah. The aforementioned CEO of Wells Fargo was summoned to Washington by the Treasury Department's secret police and water-boarded for 48 hours until he agreed to accept $25 billion or so, in order to save his badly managed competitors any embarrassment.

Am I being too harsh? After all we are repeatedly assured (as if we were the morons) that it was a perfect storm. No, worse than that. A black swan!  Sure, hindsight is 20/20, but who could have anticipated it?  Let's see. You leverage your firm 30 or 40 to 1. That means (public school graduates) that you have a billion dollars of your own money. Then you use your "strong" balance sheet (no silly marking to market) to borrow another $39 billion. You loan out $35 billion of it and pay the other $4 billion to yourself or other co-conspirators. Your risk managers fire off e-mails telling you that if housing prices decline by as little as 5% to 10%, the entire firm is lost. What a bunch of academic worry-warts! Everyone knows that housing prices can never go down. Maybe one intrepid risk analyst (who earns less that 1% of your well deserved compensation) has the temerity to remind you that the latest reports show an excess supply of more than 2 million homes nationwide as compared to people who need a home to live in. After firing her, you console yourself with some caviar and truffles washed down with a $10,000 bottle of wine.

There was a time when the greed factor cited above was balanced by its equally famous sibling, the fear factor. Before 1970, investment banks and other NYSE members had to be individuals or general partnerships. When they converted to publicly traded corporations the risk was transferred to the shareholders but the rewards still went disproportionately to the senior managers. Why is that important? When that e-mail warning of the risk hit the CEO's computer, he could ignore it, knowing that he had accumulated tens or even hundreds of million dollars in prior years. At worst, he could retire comfortably. Had he been the managing partner, the firm's creditors could go after every penny he had to his name. Say goodbye to Mister Greed and hello to Mister Fear!

What about all those arcane "derivatives" that only 3 people in the whole wide world truly understand? Sorry again. That's just one more self-serving lie. Anyone with the mathematical sophistication of a good freshman calculus student can understand them. That lets out every single member of Congress (to the best of my knowledge). Why do you think they never tell you the actual terms of these instruments? They don't dare to tell you. You just might be a freshman!

This rant would be incomplete without a nice metaphor to take home. It was not a black swan that caused this crisis. It was a whole flying wedge of white swans flying over Wall Street marking the market in their own charming way.