November 27, 2010

What caused the financial crisis. (Laying bare the end of banking.)

Another month, another mini-crisis. Many banks remain in trouble, many countries too, adding weight to the claim that we're not through yet. Say hello, double dip, or depression. Whatever the economists end up calling it, it will be with us for a few years yet.

For what it's worth, I'd suggest this will be a 10 year story. Today's news is about Ireland, yesterday we were in Greece, tomorrow it will be another fun travel destination, where our money will buy more, as long as it's not us.

Each of those countries are looking at scenarios that will be a decade minimum to work through, to pay off their debt.

What does that make a citizen think?

Whatever you think about your national profits for the next decade being expropriated for the sins of your fathers, it seems to make sense to take more than ordinary care, and to sort it out properly this time. This one isn't the localised moral hazard of the S&L crash, it isn't the Asian Financial story of dominos too cozy, it isn't the Russian panic, nor LTCM.

Those were regular, this one's exceptional. This is more like the Japanese experience, on an OECD scale, or the Great Depression. Both things which were at their root central banking crises.

So what's the cause? It does all seem to be a bit bemusing as theory after damnable theory goes wafting by, and still we don't see the end of the crisis. Theories I've seen and dismissed as mere symptoms:

There is one and only one underlying cause for this crisis. It's the thing that answers everything, and the thing that nobody wants to talk about. It's the massive shift in structural nature of the business that took 30 years to develop, and suddenly everyone's caught by surprise.

It's banking, or more precisely, it's

the end of banking, as we know it

(Which is why I wrote a long post on what banking is.) Banking is no longer essential to society because there is now another method to achieve what banking achieves. That is, we now have two methods to distribute society's savings on the stage of the economy: from small-left to big-right, as it were. Both methods work, but the new method has advantages that will make it dominate over time.

The new method is called:


It's new, because it was invented in the USA in 1970 (hence the Z). While it is pretty simple to describe, it is (arguably) complex to see:

  1. take say 1000 vertical loans to people such as housing mortgages,
  2. aggregate them up into a huge single fund (essentially, a company that handles the cash flow from the loans)
  3. then slices the fund up horizontally into say 5000 shares
  4. sell the shares!
  5. new shareholders are paid the a tiny slice of each mortgage, until term.

I'll leave it as an exercise for the reader to compare how that relates to banking, and just skip to the essence of the shift from the definition of banking: term. The bank can "originate" these loans to the 1000 customers, aggregate them into a fund, slice the fund into shares, and sell the shares.

Here's the clanger: At this point, the bank has sold off the loans to other investors, which means the bank has sold off the risk.

After this point, the bank is no longer in the risk business! What's more, it can do this in 100 days and under. Which means it is no longer in the term business either.

Which means, the bank and those loans are no longer at risk of the economy. Nor a run. In fact, the bank need no longer be in the risk business at all, because it can sell off all its risk. To a market. As the ever-popular Prof Ferguson puts it:

These changes swept away the last vestiges of the business model depicted in It's a Wonderful Life. Once there had been meaningful social ties between mortgage lenders and borrowers. James Stewart's character knew both the depositors and the debtors. By contrast, in a securitized market the interest you paid on your mortgage ultimately went to someone who had no idea you existed. The full implications of this transition for ordinary homeowners would become apparent only 25 years later.

Which means, anyone doing business in securitization is not doing banking.

Now go back to the structure of the banking industry. I showed that the structure, and the regulation, was predicated on the risk inherent in the term structure of banking loans.

As banks are no longer taking on that risk, the structure is no longer required. That is, central banking is no longer useful to the economics of banking, and regulation based on public policy interests and lender of last resort issues is therefore unfounded.

Which further means the regulation is probably (almost certainly) wrong, the incentives are mismatched, the risk analysis is unnecessary, ... on and on it goes. Add in a dash of technology like the Internet, cryptography, and disintermediation (think Zopa or microfinance) and the mix is heady, and unstoppable.

Banks are not doing banking any more, so trying to make them act like they were doing banking is not helpful, it is harmful. In economics terms, there is a fundamental shift:

from banking to markets

But the world is still treating banks as if they do banking. From Basel-3 on down:

But on one point Pandit [Vikram Pandit, CEO of Citigroup] cannot be challenged. Since the promulgation of Hammurabi's Code, in ancient Babylon, no advanced society has survived without banks and bankers. Banks enable people to borrow money, and, today, by operating electronic-transfer systems, they allow commerce to take place without notes and coins changing hands. They also play a critical role in channelling savings into productive investments.

When the banking system behaves the way it is supposed to - as Pandit says Citi is now behaving - it is akin to a power utility, distributing money (power) to where it is needed and keeping an account of how it is used. Just like power utilities, the big banks have a commanding position in the market, which they can use for the benefit of their customers and the economy at large.

So the regulators are making mistakes, a steady series of them. Says TheFinanser's Chris Skinner in evident disgust at the BIS's numberitis:

Hmmm ... HBOS had a higher Tier I Capital Ratio than Lloyds TSB in 2008; Alliance & Leicester and Bradford & Bingley were well above the BIS requirements; RBS is particularly well capitalised; and Northern Rock appeared to have no issue in 2007, as mentioned.

And yet, these are all the failed banks of Britain!

This Tier I Capital Ratio measure ain't that good is it?

The rules of the financial world have changed, the structures have not.

In particular, banks are off-the-hook for term failures, but they still make money as if they were on-the-hook. Hence, as banks and other participants discovered that securitization was a licence to print money (because the risk had been sold off to others in the funds markets) what happened?

Everyone dived madly into subprime. Everyone made money! Appetite for risk went sky high, because ... the risk was sold off to the market, and all that was left was the fees! Hence, we had a bubble of risk off-selling in many forms which ultimately led to the global financial crisis.

(You're probably wondering why the banks got so stuck when they had sold off their risk. It may be because <drumroll> they also bought securitized assets from the same markets that they'd sold into! </tara> Outstanding shift from Banking to Speculators, further exercise left for reader, look to the definition of banking again!)

Nobody in the world of banks dares admit it, because the money is too good. But it can't last, and some are wise to the game. Prof. Ferguson pointed to a speech by Mervyn King:

Mervyn King, governor of the Bank of England, called on Tuesday night for banks to be split into separate utility companies and risky ventures, saying it was "a delusion" to think tougher regulation would prevent future financial crises.

Mr King's call for a break-up of banks to prevent them becoming "too important to fail" puts him sharply at odds with the direction of domestic and international banking reform.

What's the new world, where banks are no longer needed to do banking? Well, smaller, more purpose-limited ventures is one good start. "Utilities" is a good word. Expect to see more of this sort of proposal.

But, don't expect to see anyone agree that it's the end of banking, as that is still too politically untenable.

  1. What banking is. (Essential for predicting the end of finance as we know it.)

  2. What caused the financial crisis. (Laying bare the end of banking.)

  3. A small amount of Evidence. (In which, the end of banking and the rise of markets is suggested.)

  4. Mervyn King calls us to the Old Lady's deathbed?

  5. (Introducing the death of the partner and the central bank as turbocharger as 2 new causes)

Posted by iang at November 27, 2010 09:50 PM | TrackBack

> > Which means, the bank and those loans are no longer at risk of the
> > economy. Nor a run. In fact, the bank need no longer be in the risk
> > business at all, because it can sell off all its risk. To a market.

Why not call a spade a spade? What you are describing is bookmaking. This is usually a boringly lucrative business; the banks are in crisis because they're not very good at it, neglecting to cover both sides of each bet and instead trying themselves to play the illusory games they created for the punters.

The bookie analogy seems more apt than that of a utility (although the distinction is sometimes blurred, cf. Enron).

Regulation perhaps goes against your political grain, but I think it's too simplistic to argue that since banks are no longer doing traditional banking, regulating them is pointless. A case can be made that society benefits from regulation of both bookies and utilities.


P.S. A (probably overly) charitable explanation for banks' ineptitude as bookies is that by holding some of the "safest" securities they considered themselves to be engaged not in speculation but rather in banking, i.e., bearing term risk.

Posted by: Ray at November 27, 2010 08:11 AM

big part of securitization coming to dominate finance was that the sellers could buy triple-A ratings (when both the sellers and the rating agencies knew they weren't worth triple-A); it had been used during the S&L crisis to obfuscate the underlying values ... but w/o anywhere near the success that comes with being able to buy triple-A.

there were enormous fees and commissions related to dealing in the securitization transactions ... providing sufficient individual greed motivation to overcome any concern regarding what the transactions might have on the institution, economy, and/or country. The NY comptroller had report that wall street bonuses spiked over 400% during the bubble (lots of subsequent activity to prevent bonuses from returning to pre-bubble levels) and other reports that financial services industry tripled during the bubble (as percent of GDP & providing no positive benefit to society). The report about total of $27T in such transactions during the bubble, easily accounting for the bonus & industry size spike (only part of the total siphoned out of the infrastructure doing the bubble).

Sarbanes-Oxley actually included something about having SEC look at rating agencies ... but didn't actually result in anything. In fact, it appeared like SEC was doing little or nothing during the period; as evidence in the Madoff hearings by the person that tried for decade to get SEC to do something about Madoff. Possibly because GAO also didn't think that SEC was doing anything, even after SOX ... it started doing reports about audits of financial filings of public companies showing increase in fraudulent filings and/or audit errors (even after SOX). A question then is 1) SOX had no effect on fraudulent filings, 2) SOX motivated the increase in fraudulent filings, 3) if it wasn't for SOX, all financial filings would have been fraudulent.

Don't look at it as the institutional motivation for doing or not doing anything. There was enormous, wide-spreed, unbridled, personal greed that totally overwhelmed everything else (even assuming any concern for institution, economy and/or country).

Posted by: Lynn Wheeler at November 27, 2010 03:42 PM

Jeremy Rifkin wrote on

Two spectacular failures, separated by only 18 months, marked the end of the modern era. In July 2008, the price of oil on world markets peaked at $147/ barrel, inflation soared, the price of everything from food to gasoline skyrocketed, and the global economic engine shut off. Growing demand in the developed nations, as well as in China, India, and other emerging economies, for diminishing fossil fuels precipitated the crisis. Purchasing power plummeted and the global economy collapsed. That was the earthquake that tore asunder the industrial age built on and propelled by fossil fuels. The failure of the financial markets two months later was merely the aftershock. The fossil fuel energies that make up the industrial way of life are sunsetting and the industrial infrastructure is now on life support. [...]

The problem runs deeper than the issue of finding new ways to regulate the market or imposing legally binding global green house gas emission reduction targets. The real crisis lies in the set of assumptions about human nature that governs the behavior of world leaders--assumptions that were spawned during the Enlightenment more than 200 years ago at the dawn of the modern market economy and the emergence of the nation state era.

Posted by: Jeremy Rifkin wrote (from Todd) at November 27, 2010 06:13 PM

It's quite a stunning statement, "that securitization is the root cause." I'd like to see a detailed explanation one by one showing how it was behind all the other things you list.

Posted by: Hasan at November 27, 2010 07:07 PM

supposedly commodities market were for traders that had substantial interest in the commodity ... to keep out speculators that would result in large irrational price fluctuations ... but after a series of confidential/secret letters allowing major speculators to play ... the market started to have huge fluctuations.

Griftopia: Bubble Machines, Vampire Squids, and the Long Con That Is Breaking America

Comeback America: Turning the Country Around and Restoring Fiscal Responsibility

Posted by: Lynn Wheeler at November 27, 2010 07:11 PM

one of the explanations was that executives could boost their compensation significantly with the erroneous filings and even if they were later restated ... the extra compensation *WAS NOT* reclaimed

'Financial Statement Restatements: Trends, Market Impacts, Regulatory Responses, and Remaining Challenges'

from above:

While the average number of companies listed on NYSE, Nasdaq, and Amex decreased 20 percent from 9,275 in 1997 to 7,446 in 2002, the number of listed companies restating their financials increased from 83 in 1997 to a projected 220 in 2002 (a 165 percent increase) (table 1). Based on these projections, the proportion of listed companies restating on a yearly basis is expected to more than triple from 0.89 percent in 1997 to almost 3 percent by the end of 2002. In total, the number of restating companies is expected to represent about 10 percent of the average number of listed companies from 1997 to 2002.

... snip ...

along with

Financial Statement Restatement Database

and more recent update (2006)

Financial Restatements: Update of Public Company Trends, Market Impacts, and Regulatory Enforcement Activities


Financial Restatement Database
and update

from above:

The database consists of two files: (1) a file that lists 1,390 restatement announcements that we identified as having been made because of financial reporting fraud and/or accounting errors between July 1, 2002, and September 30, 2005, and (2) a file that lists 396 restatement announcements that we identified as having been made because of financial reporting fraud and/or accounting errors between October 1, 2005, and June 30, 2006.

... snip ...

Posted by: Lynn Wheeler at November 27, 2010 08:40 PM

Hence the Volcker rule which would separate the casino function (investment banking) from utility function.

John Kay makes the case here

Posted by: Gunnar at November 27, 2010 11:40 PM

Well, the basis of keeping records has fallen down. There are millions of inaccurate transactions recorded and the managers have played around with the numbers so much to insure their bonus that over the course of twenty years nothing is for certain.

I have seen too many credit payment plans for all sorts of assets miss-recorded and improperly-serviced in banks to believe that any level of accuracy can be assured. The whole system is based on people sending in payments monthly and when that falls short, utter collapse is the outcome.

Every year people in my role say to each other there will have to be a large reconciliation and every year for 15 years there isn't. Things are written off and forgotten and the managers receive their bonus. The new business coming in paves the way over the old unreconciled debacle and no lesson is learned. This pretend-and-extend method works well in government except when the banks start to come up short after years of fluffy scenarios, the assets i.e. loans are rendered worthless in an economic downturn.

As it turns out payments are never really different than the assets, in that loans held as assets rely upon payments which are applied to the loan, making it a viable asset. The payments are the pieces that if not made or made inaccurately sum quickly into failed assets and failed banks.

The securitization debacle was easily covered up via the banks that aggregated the loans where the lenders to the trust when there was a short fall in collections and they made a good profit. The systematic short falls in securitized assets collections are bridged via the same institution that sold the loan into the securitized pool to begin with.

Posted by: jim nesfield at November 27, 2010 11:40 PM

a great deal of the loans were by unregulated loan originators that would have had very little money to lend w/o being able to pay the rating agencies for triple-A ratings for everything they packaged. Since they could immediately sell off everything they wrote regardless of quality as triple-A, they no longer had to care about loan quality or borrowers qualification (only thing limiting their income was how fast they could make loans, and how big they could make them).

Speculators found the no-documentation, no-down, 1% interest only payments extremely attractive ... possibly 2000% ROI in parts of the country with 20-30% real-estate inflation (with the speculation further fueling the inflation). The enormous speculation and inflation help create the appearance that demand was significantly larger than actually existed. This resulted in all sorts of infrastructure investment for demand that didn't exist. When the bubble bursts the effects spread thru-out the economy.

There have been a number of reports regarding the events leading up to the repeal of Glass-Steagall (including the account in Griftopia mentioned upthread) which eliminated the separation of investment banking and regulated depository institutions. The investment banking operations then participated in the securitization frenzy ... heavily involving those financial institutions in the bubble.

Early last year, I was asked to take a copy of Pecora hearing (which had been scanned the previous fall at the Boston public library), html it, heavily cross-index, and also provide some number of references between what happened then corresponding to what happened this time (apparently in anticipation that the new congress had appetite to do something about it). After putting quite a bit of effort into the project, i got a call saying it wouldn't be needed after all. There is direct relationship between the 20s "brokers loan's" that were at basis of the '29 crash and the securitized funded loans that were behind this bubble ($27T in triple-A rated toxic CDOs)

Posted by: Lynn Wheeler at November 28, 2010 12:35 AM

item from member of Boyd "mafia" (early days of OODA-loop):

Wall Street Does NOT Produce Value


What Good Is Wall Street? Much of what investment bankers do is socially worthless.

There is a industry publication that gives detail industry operations ... couple hundred pages, possibly 50-60 lines per page ... the avg for the major regional banks compared to the major ("too big to fail") national banks. For whatever reason, just as the bubble was starting, the regional bank operation avgs. were slightly better than the national banks avg (implying that the national banks should have been allowed to get smaller, rather than getting larger).

Posted by: Lynn Wheeler at November 28, 2010 10:05 PM

extract from griftopia

earlier article by the author

earlier book by author "What Good Is Wall Street"

How Markets Fail

Posted by: Lynn Wheeler at November 29, 2010 10:54 PM

There's Turmoil in the Municipal Bond Market as Cities Struggle; Does this mean municipal bonds are no longer the "safe" investment they once were?

The municipal bond market had collapsed two years ago when investors realized that rating agencies had been selling triple-A ratings for ($27T?) toxic CDOs and there was huge ambiguity whether any ratings could be trusted. Buffett stepped in at that time to rescue municipal bond market by providing insurance.

The real-estate speculation (because of enormous amount of funds available from securitization which also eliminated any concern regarding loan quality and/or borrower's qualification) problem is with the demand appearing much larger than it actually was, resulted in a lot of additional developments. The increase in developments also resulted in all kinds of borrowing for new infrastructure; commercial loans for stripmalls; muni-bonds for roads, water&sewer systems, etc. The municipalities were assuming that the bonds could be covered by big increase in real-estate collections ... which didn't materialize when the bubble burst.

Posted by: Lynn Wheeler at November 30, 2010 02:40 PM

so besides all the properties that have been abandoned and the cities&towns aren't getting taxes (lots of situations where they were expecting revenue to cover new bonds floated for new infrastructure) .... there are large parts of the country where real-estate appraisals have dropped by 30% or more. Wide-spread drop in appraisals of 30% results in corresponding shortfall in real-estate tax collections (until they get around to increasing the tax rate) affecting ability to cover pre-existing obligations (salaries, other bonds, services, etc).

Posted by: Lynn Wheeler at November 30, 2010 07:46 PM


Classic systemic collapse ... of course if we'd known that beforehand, we would never have relied so much on it !

Issues like this can't really be solved by putting more liquidity into the market, because people will take the liquidity and put it somewhere else. Once confidence in a previously trusted market fails, that's it, it's over for a decade. And any posturing by the federal government won't be easily trusted.

So there will be a big issue in assessing how much the hit to municipals results in bankrupcies & failures. Which then moves on to also hit the rest of the economy. If some significant proportion of municipals are facing bankrupcy, at some point this constrains any recovery and causes a depression.

All conventional, after the fact wisdom, of course. With systemic crises, the direction that the falling dominoes take isn't easily predictable.

Posted by: Iang at November 30, 2010 08:04 PM

In the late 90s we were asked to look at all the ways that securitized instruments could be perverted ... since they were on the rise again, after having been used to obfuscate underlying loans during the S&L crisis. However, this century all we could do was watch ... since nothing was being done about it.

then there is the item about the "Man Who Beat The Shorts" when he raised the issues that securitizing loans and selling
them off met that the loan originators no longer had to care about loan quality and/or borrowers' qualification

As previously mentioned the bubble/crash in the 20s was in the stock market directly attributable to "Brokers' Loans" ... this time the bubble/crash was in the real-estate market directly attributable to loan originators being able to securitize and sell off all loans (being able to pay for the triple-A ratings helped immensely). In many ways, speculators were able to treat the real-estate market similar to the unregulated stock market of the 20s

Unregulated loan originators had unlimited amount of money from being able get get triple-A ratings on all their toxic CDOs (regardless of underlying value/quality). Repeal of Glass-Steagall met that unregulated investment banking arms of regulated depository institutions could buy up trillions in toxic CDOs and carry them off-balance (while putting the regulated depository institutions at risk of collapse).

The disastrous effects of the individual pieces had been understood since the 30s; this time with lots of individuals playing in self-interest ... apparently believing their individual graft&corruption wouldn't be that significant ... however, the combination resulted in nearly a perfect storm (aka systemic).

If any one of the pieces weren't there ... it could have significantly mitigated the aggregate effects ... for instance, if Glass-Steagall hadn't been repealed, it would have cut-back on the money for buying the toxic CDOs (limiting the total amount that would have been sold, and therefor decreasing the number of such loans that would have been made).

At the end of 2008, it was estimated that the four largest too-big-to-fail financial institutions were carrying $5.2T (toxic CDOs) off-balance ... courtesy of their unregulated investment banking arms. Early on, one of those institutions had unloaded something like $60B at 22 cents on the dollar. If the four had been forced to deal with the $5.2T at that price, they would have had to been forced to liquidate and dissolved (lots of claims about large amount of obfuscation going on because they are insolvent)

Posted by: Lynn Wheeler at November 30, 2010 09:55 PM

Bernanke warns on long-term joblessness

one metaphor is that there were a lot of regulations keeping the individual pockets of greed and corruption separated and damped-down. This century the regulations were repealed, ignored and/or not enforced, resulting in the individuals pockets of greed and corruption to combine into a firestorm

another methaphor was that all the control rods in the economic reactor were removed and it goes critical with major meltdown. it may take the (economic) environment years to recover from the resulting toxic radioactive mess.

The crash of 2008: A mathematician's view

from above:

Markets need regulation to stay stable. We have had thirty years of financial deregulation. Now we are seeing chickens coming home to roost. This is the key argument of Professor Nick Bingham, a mathematician at Imperial College London, in an article published today in Significance, the magazine of the Royal Statistical Society.

... snip ..

Posted by: Lynn Wheeler at December 1, 2010 12:52 AM

needed to help cover in $5.2T in off-balance toxic CDOs

Federal Reserve's 'astounding' report: We loaned banks trillions; The Federal Reserve offers details on the loans it gave to banks and others at the height of the financial crisis. One program alone doled out nearly $9 trillion.

Posted by: Lynn Wheeler at December 1, 2010 09:13 PM

Several times in the past two years ... I've pointed out that with Fed lending trillions at near zero percent ... then it is relatively straight-forward to earn hundreds of billions by relending with spread of four percent of more (.04 of $10T is $400B profit) ... and if it was used to buy Treasuries ... why didn't FED just give the US treasury free money.

Also, rhetoric on floor of congress was that primary purpose of GLBA was: if you were already a bank, then you got to remain a bank and if you weren't already a bank you didn't get to be a bank (this is in addition to repeal of Glass-Steagall and "opt-out" PII sharing). FED gave out bank charters to some number of investment banks (so they could get free money) ... which would appear to be counter to GLBA.

Posted by: Lynn Wheeler at December 2, 2010 11:01 AM

aka massive shell game, take free fed money ... buy treasuries ... the interest on the US treasury easily pay back TARP with interest. auto quotas were to reduce competition, significantly increase profit to be used to totally remake themselves. when that didn't happen and money was spent "business as usual" ... there was call for 100% unearned profit tax

Posted by: Lynn Wheeler at December 2, 2010 12:48 PM

If you have not seen them may I suggest a visit to...

and watch the first talk that is there...

The video is available as a download and is best viewed at 1:1 size (it is a large frame size) using "VLC Media Player".

This is an open source media player and freely downloadable

I would suggest watching at least the first 15 minutes of the Hudson talk as well (2nd video down).

These may provide some useful insight.

Posted by: Observer at December 5, 2010 11:21 AM

....Start with the folly of the financiers. The years before the crisis saw a flood of irresponsible mortgage lending in America. Loans were doled out to “subprime” borrowers with poor credit histories who struggled to repay them. These risky mortgages were passed on to financial engineers at the big banks, who turned them into supposedly low-risk securities by putting large numbers of them together in pools. Pooling works when the risks of each loan are uncorrelated. The big banks argued that the property markets in different American cities would rise and fall independently of one another. But this proved wrong. Starting in 2006, America suffered a nationwide house-price slump.

The pooled mortgages were used to back securities known as collateralised debt obligations (CDOs), which were sliced into tranches by degree of exposure to default. Investors bought the safer tranches because they trusted the triple-A credit ratings assigned by agencies such as Moody’s and Standard & Poor’s. This was another mistake. The agencies were paid by, and so beholden to, the banks that created the CDOs. They were far too generous in their assessments of them. ....

Posted by: Economist on Causes (iang) at September 15, 2013 07:15 AM
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