THE DARK SIDE of American Capitalism; Centuries of Scandals and Corruption
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Corruption and scandals have always been part of the American story, although little mentioned in the history books except for the few gigantic financial fiascos too big to ignore. Every economic crisis seems a shock, but each decade records dozens of major failures, partly from incompetence and bad luck, but many from the fallout of frauds and other types of massive corruption. The good news is current scandals pale in comparison to the incredible corruption of 19th century American business and politics—granted, the multi-trillion dollar price tag of the current debacle catches one’s attention. The bad news is opportunism and corruption still function effectively after decades of increasingly complex business regulation and substantial monitoring. Too often, government worsens the problem, sometimes because of extreme regulations (or deregulation) or taxes, partly by directly helping the bad guys. The motivations of individual and institutional greed seem basically unchanging, although incentive structures change. If more violations now exist, it is probably because there are more laws to break, an increasingly complex environment, and more regulators to investigate.
Different cultures can explain the problems of different periods. Land speculation, counterfeiting, and bank fraud characterized much of the first half of the 19th century; railroad missteps and fraud the second half. Power bankers created multiple monopolies by the start of the 20th century. The mass-market speculation of the late 1920s allowed stocks bought mainly on margin and open rigging of stock prices. Stock pyramiding based on debt and inadequate equity dominated utilities and railroads. During the go-go years of the 1950s-60s, conglomerates, electronics and aerospace were the hot stocks, with irrational stock prices. Earnings manipulation centered on the flexibility of merger accounting, which allowed amazing valuations, gains and write-offs. Conglomerates posted big accounting earnings numbers when economic reality indicated disaster. During the 1980s hostile takeovers and leveraged buyouts dominated. Manipulation focused on merger accounting, aided by available credit from junk bond king Michael Milken. Increasing the sleaze was the insider trading scandals of Milken, Ivan Boesky and others, plus the savings and loans collapse, a newly-deregulated industry. Derivative debacles continue from the 1980s; only the levels of risk and losses increased. Different cultures, same result: speculative bubbles followed by crashes. Coming full circle are the similarities of currency and real estate speculation during and after the Revolutionary War and the current sub-prime loan/financial collapse. Former geniuses turned out to be incompetent, crooks or both. New regulations might be effective, until the next generation of scam artists comes up with new tactics for evasion, aided by lax enforcement and calls for new deregulation.
About the Topic
The fundamental topic is Janus-faced American capitalism, entrepreneurial spirit and innovation versus short-term greed and extensive corruption, with a touch of incompetence and government involvement. It cannot be explained solely by economics, public policy, psychology; these and more are driving the major players as well as motivating the hoi polloi—from euphoria to fear, identified by Keynes as “animal spirits.” The roles of government are complex and important as well as usually poorly understood. Major players can exploit the political system for good or ill
The primary objective of the book is to provide insight into the development of financial and corporate America, emphasizing the moderating effects of the dark side. Railroad promoters and speculators may have been crooks and overbuilding led to periodic depressions, but the nation developed a superb rail infrastructure. The tech bubble had similar results: chaos and scandals with the bust, but superior new technologies. Most of the backyard inventors went bust, but those remaining developed billion dollar industries.
The role of government suffered from fits and starts with increased regulations, then deregulations, not to mention continued corruption at all levels. Political corruption became particularly rampant toward the end of the 19th century, with Tammany’s Boss Tweed the poster boy for political machines. The roles of politics and regulation, money and banking, corporations and commerce all evolved, ultimately beneficial although often painful along the way.
Top Ten Villains in the Subprime Loan Crisis
Of course we didn't dodge the mortgage mess. We lost money, then made more than we lost because of shorts.
|Alan (I Am Not to Blame) Greenspan & the Federal Reserve||Through most of his long tenure as Federal Reserve Chairman, Alan Greenspan was labeled one of the best chairmen ever. His reputation began to crack when the tech bubble burst, the end of the go-go era of stock price and economic growth, exacerbated by the Fed’s cheap money policy. Greenspan’s monetary policy proved too accommodating for “irrational exuberance.” His reputation crumbled with a combination of really cheap money in the 21th century which fueled the housing bubble and his refusal to regulate the mortgage market. Greenspan’s replacement, Ben Bernanke did not depart from Greenspan’s easy money, non-regulation policy until the bubble burst; the Fed finally passed regulations in mid-2008.|
|Richard (Delusional Dick) Fuld & Lehman Brothers||Investment banks, with Lehman the only one unfortunate enough to go belly up, were central to structured finance to deceptively package super-risky loans as high-quality bonds. The quant wizards of wall street developed the vehicles to turn toxic assets to credit gems, or at least give that appearance. Lehman and the rest developed an insatiable appetite for risky loans, fueling increasing amounts of questionable, sometimes fraudulent loans when the evidence of real problems was growing. What’s really amazing is they drank their own kool-aid. They kept huge portfolios of toxic assets on their books as investments (at least some because they could not sell them), while simultaneously increasing leverage to extraordinary levels. Lehman had huge positions in lower tranches of subprime mortgage CDOs and wrote credit default swaps. Lehman declared bankruptcy in September 2008. CEO Fuld was one of several Lehman execs to receive New York grand jury subpoenas for securities fraud late in 2008.|
|Angelo (Mad Mortgage) Mozilo & Countrywide||Countrywide Financial was the largest mortgage company before its collapse and originated 25% of all US mortgages in 2006, including huge amounts of subprime loans, often using deceptive or predatory practices. Since they sold off the loans quickly, they paid little attention to proper due diligence and documentation—which had been standard practices for decades. The get-the-most-bucks-quick strategy meant signing up as many mortgagees as possible, whether qualified or not, with minimum documentation. CEO Mozilo was known for his “Friends of Angelo” VIP program for favorable mortgages to powerful politicians. Bank of America acquired Countrywide in 2008. Attorneys general in several states sued Countrywide and others for unfair lending practices. The SEC filed fraud charges against Countrywide and Mozilo in 2009.|
|Bond Rating Agencies: Moody’s, Standard & Poor’s: You Can’t Blow Up the Financial World Without Us||It’s the bond ratings that make structured finance-created bonds (aka: mortgage-backed securities, collateralized debt obligations, etc.) work. (Note that only a handful of corporations have Moody’s Aaa ratings, and fewer than half the rated companies get investment-grade ratings.) The MBS investors buy the ratings rather than the underlying loan portfolio, which they cannot observe. This became a big revenue sources for Moody’s and the other rating agencies (and a real conflict of interests because there are few firms issuing these bonds). The top tranches of the structured bonds got Aaa ratings, while the lowest usually got Baa—still investment grade. Even before the bursting home bubble, these Baa bonds were defaulting at a relatively high rate. After the bust, default rates exploded. For some reason, Moody’s models envisioned housing prices only going up—the models were not changed until 2007. Investors lost big, but Moody’s & S&P were still pocketing the revenues. Because of the high ratings and regulations encouraging investment grade bonds for many investor classes, the bonds were sold around the world in vast quantities.|
|Fannie Mae & Freddie Mac, Twin Towers of Terror||A bad housing debacle happened during the Great Depression of the 1930s. The Federal National Mortgage Association (Fannie Mae) was established in 1938 to provide liquidity for the mortgage market. Fannie was chartered as Government Sponsored Enterprises (GSEs) in 1968, turning it into public companies with something of a public policy mission. The Federal Home Loan Mortgage Corporation (Freddie Mac) was created in 1970 as a competitor to Fannie. Fannie and Freddie are the biggest buyers of home mortgages and hold or guaranty about half of all US mortgages; they were encouraged by Congress to buy subprime mortgages, including those with little equity and minimal documentation. This was a high risk strategy, apparently with little concern for what would happen is the housing market collapsed. Unfortunately, the GSE execs had the same incentives for oversize pay packages as the heads of any giant corporations and rewarded themselves abundantly. Various accounting scandals became part of the compensation story in the 21th century. The two GSEs collapsed and placed in conservatorship by the Federal Housing Finance Agency in September, 2008.|
|Housing & Urban Development, other federal agencies: The Bad Guys Need Us||Congress and the various administrations (especially Bush and to a lesser extent Clinton—but administrations beginning at least with Ford have some level of responsibility) get into the picture in a variety of ways, mainly bad in this analysis. Congress encouraged sub-prime loans to allow more people into their own homes, especially with revisions to the Community Reinvestment Act changes of 1995. They also supported Fannie Mae and Freddie Mac when they were over-leveraged and various aggressive earnings practices were discovered. Basically, federally elected officials ignored, in some cases made worse, considerable problems that became more and more obvious. Add federal regulators: Various regulations exist on the books that could have mitigated the damage, perhaps have stopped the scandal cold. For a variety of reason, these were not enforced. In 2004 the SEC removed the rule requiring investment banks to limit leverage to 15 times capital (leverage proceeded to double, dramatically increasing risk).|
|Bond Insurance & AIG: Super Goofs||How does an investor protect his- or herself from possible bond default? Bond insurance. What could be safer than high-yield subprime mortgage bonds backed by credit default swaps (CDS)? AIG sold CDSs by the billions without much if any consideration of the risks involved. ABX, an index of subprime mortgages, became available in 2006 and from 100 to 60 early in 2007, then collapsed to the 20s. No one considered the ramifications of a $60 trillion credit default swap market, especially when U.S. mortgages totaled at most $12 trillion. The feds bailed out AIG to the tune of hundreds of billions, seemingly the most clueless of the perps.|
|Home Buyers—From Suckers to Perps||Most subprime borrowers should never have taken out mortgages. Some were duped by predatory practices; some viewed home equity as a convenient ATM machine; some were speculating, expecting to be bailed out by continually rising housing prices; some were crooks.|
|Structured Finance Quants, Creators of the Modern Financial Dark Side||These new credit investment vehicles evolved from their beginnings in the 1970s to a multi-trillion dollar world market in the 21st century. The bonds are backed by tranches (slices) of risky assets based on relative default potential. The schemes are based on technical math models, incomprehensible to mere mortals. These were hailed as a great innovation, providing market liquidity for a multitude of lending classes and a technique to enhance both yields to investors and substantial profits to originators. Accounting magic even allowed them to disappear from the bank’s balance sheet. Unfortunately, the real risks were not properly evaluated by the quants or anyone else. It turns out transforming crappy loans into high-tech bonds result in really risky high-tech bonds.|
|Lloyd (“I’m Doing God’s Work”) Blankfein & Goldman Sachs||Goldman often gets kudos in the press as the one investment bank on top of the subprime crisis, actually making money out of the panic. [Michael Lewis (2010) makes the case Goldman was late to make their “short sub-prime” move, but beat out the other banks—making them less incompetent.] As the leading investment bank saving itself at the expense of other banks and customers, Goldman gets high marks as the most unethical. Thanks to Treasury’s supporting AIG (with former CEO Paulson at its head), Goldman got paid 100 cents on the dollar for their credit default swaps. An SEC lawsuit accusing Goldman of fraud related to CDOs finally came in 2010. This gang lead the industry and likely could have pulled the plug and “saved” the financial world, but chose to let it collapse for their own benefit. [Michael Lewis quote (2010, p. 78): “Why didn’t someone, anyone, inside Goldman Sachs stand up and say, “This is obscene.” Lewis (p. 105) also noted that Goldman shared the spotlight with Lehman Brothers as packaging America’s worst home loans.]|
|Contenders||Hundreds of other players played prime or supporting roles in the scandal, from banks executives and specific employees, to government officials, regulators, and many others. Others receiving top-10 votes include Bear Stearns CEO Jimmy Cayne, Stan O’Neal and Merrill Lynch, Chuck Prince and John Thain at Citigroup, Ken Lewis and Bank of America, the SEC, and a whole host of politicians pushing various deregulation bills (with former Senator Phil Gramm leading this category).|
|Supporting players||Supporting players by the thousands exist, primarily the lower level employees required to make illicit activity work, from mortgage originators to bond traders and sales people and analysts at every step in the process. Then there are auditors, attorneys, and countless regulators. Various hedge funds round out the list.|
|Media||Where were the business journalists? As with politicians, they hyperventilated after the fact, but only a few of them sounded the alarm. Granted, there were not a lot of experts (economists for example) predicting doom—but not zero. Robert Shiller, for one, demonstrated national housing prices roughly doubling, which had never happened before. Hardly a ripple of panic came of it before the market started the collapse in 2007.|
|John Gutfreund, Investment Banks Going Public||Michael Lewis blamed former Salomon Brothers CEO Gutfreund for all investment bank problems because he took Salomon public. The remaining investment banks followed (actually Merrill Lynch went public earlier). Investment banks were traditionally partnerships, meaning their own money was on the line; high risk and bad decisions would mean financial ruin for all the present and past partners. With a corporation, the executives (formerly partners) take in big compensation, while the stockholders take all the risks. More risk means greater profits and more compensation. When the high-risk schemes blow up, the execs move on (perhaps with golden parachutes), the stockholders lose big. Guess what: leverage and risk skyrocketed; executive compensation went way up—until collapse happened (except for a few big losers, compensation stayed high). Lewis was only surprised that it took twenty years before investment banks blew up the financial world.|
The Ten Big Problems
|Capital Requirements||Banks needs leverage caps. The big investment banks proved incapable of limited themselves and increased leverage to 30 to 1 and more when allowed, virtually guarantying bankruptcy or bailout.|
|Banks Trading on Their Own Accounts||Investment banks invest for their own accounts, seemingly a violation of distributing capital efficiently. It’s one thing to hold securities as underwriters with an intent to sell as soon as possible, it’s quite another to trade against their own customers. Banks have inside information and all the tools for illicit actions—including cover ups; of course, they make money. The banks no doubt claim market efficiency, but there seems no obvious good side for the economy as a whole.|
|Mark-to-Market||Fair value versus historical cost has been a centuries’ long debate and still not settled. Accounting standards shifted toward fair value for financial assets over the last couple of decades, a seemingly good idea with disastrous results. Banks love to book gains, but the big losses can lead to failure.|
|Executive Compensation||Follow the money. Incentives drive actions—period. When CEOs and others make the big bucks from short-term earnings performance and stock price, expect little if any focus on long-term results. (Michael Lewis quote, 2010, p. 256: “Greed on Wall Street was a given—almost an obligation. The problem was the system of incentives that channeled the greed.”)|
|Derivative Regulation||Derivatives are gigantic markets. Without transparent market trading and regulation, expect high-priced derivatives with hidden risks not explained to investors and likely not understood by the organizations originating them. Derivatives led to financial blowups every five or so years over the last quarter century.|
|Consumer Protections||It is difficult to provide any protection for naïve investors and related consumers (like house buyers). Sellers have too many incentives to mislead buyers to make sales. If bigger commissions are available for outright lies and fraud, expect outright lies and fraud. There have been no lack of consumer protection legislation and agencies and some success.|
|Regulator Effectiveness||Ultimately, it is up to the regulators to protect the various parties and the public. This requires diligence, appropriate goals, and an adequate budget. Despite plenty of regulators this century, two major financial scandals occurred. How to guaranty regulator success is anyone’s guess.|
|Viable Markets||Active markets usually trade standardized products, are regulated, and provide relevant up-to-the-minute information. Over- the-counter derivatives, without a market or regulation guaranties future financial debacles.|
|Transparency||Complete disclosure is the goal needed for fair transactions. Lack of transparency (called asymmetric information in economic circles) leads to bad results for the one without the information—aka, the sucker. “The subprime mortgage market has a special talent for obscuring what needed to be clarified” (Lewis, 2010, p. 127).|
|Boring Banks||Bank operations should be boring. The old post-World War II 3-6-3 principle (pay 3% on deposits, collect 6% on loans, on the golf course by 3), worked pretty well. The go-go period advancing since the 1980s boosted profits, compensation, liabilities and huge risks for the financial sector—with the “privatize profit, socialize losses” syndrome, provided few obvious benefits for the rest of the economy. Banks claim deregulation spurs innovation, a claim that scares the hell out of me.|
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