It is unfortunate that in a generally sound article (The Financial Crisis, April-May) Joyce Clark continues to propagate canards and long-since discredited bases for the current financial implosion. This detracts from an otherwise commendable piece (especially as her position on mark-to-market accounting is very spot-on). However, she veers off course on page 6 where she writes that it all started: "with a community organizer in Chicago and many others like him, who thought that the poor, the black, the non-citizens ... were somehow entitled to own houses anyway". This is total baloney. First, there was no "community organizer in Chicago" who started anything and if she is making a hyberbolic reference to drag Barack Obama into the mix she is so far off base as to be nearly on Charon, the satellite of Pluto.
What community organizers may have done is to bring general attention to some in the Clinton Administration on the plight of working lower and lower middle class people who were having a hard time affording a home. Not surprising, considering that the median price for a home in the U.S. went from ~ $48,000 in 1970 to nearly $169,000 in 1995.
This set the stage for legislation now known as the Community Reinvestment Act (CRA). From the time awareness of this act dawned on the American Right, all their yapping heads from Neil Cavuto of FOX, to Rush Limbaugh and even WaPo columnist George Will (the intellectual "elite" of the Right) have non-stop insisted that the financial crisis manifested because banks were “forced to lend” to the poor, minorities. This is the ugliest and basest codswallop.
Here are the facts:
1)The CRA only applied to banks that got federal insurance, which excluded 75% of those that made the sub-prime loans.
2)No clause, provision or code existed anywhere in the Act which required a bank to make a sub-prime loan to any borrower. Indeed, at 180 degrees from this – the Act called on banks in needy communities to make loans "consistent with the safe and sound operation of the lending institution".
3)Contrary to other Limbaugh-esque blovation, a number of studies have shown that the CRA recipients paid their bills on time and ultimately became successful homeowners. Thus, the claim by the Rights' blowhards that the CRA unleashed millions of deadbeats who caused the system to melt down is pure, unadorned bollocks.
Even IF it were true that ALL the CRA loans were bad, and all were packaged apart from all other mortgage loans (in CDOs or collateralized debt obligations) they still would not have created or incepted the financial wreckage (mainly in the investment banks, but also many commercial banks we behold. The sad fact of the matter is that the "home loans to the poor did it" is just a nasty excuse to avoid blaming the real villains on Wall Street.
Even in one of the capitalist prime media organs, FORTUNE (October, 2008, p. 135) the authors of the piece "The $55 TRILLION QUESTION" had the sense and intelligence to know where the blame for the mess adhered, to do with $55 trillion in credit default swaps.
The reference therein is to OBSCURE credit derivatives created by Wall Street's "quants" - most of whom had forsaken bright careers in science or mathematics to invent these devious financial instruments for investment banks. Joe Schmoe on Main Street certainly didn't invent them!
As the piece observed:
"You can guess how Wall Street's cowboys responded to the opportunity to make deals that:
1)can be struck in a minute,
2)require little or no cash upfront and
3)can cover anything."
Now, let's back up and ascertain what about these derivatives (credit default swaps or henceforth CDS) was so infernally toxic.
Those who possess the quantitative skills or background, and have a high threshold of tolerance for financial esoterica, can find the answers in depth in the WIRED (March) article "A Formula for Disaster".
The equation is none other than the "Gaussian Copula" formula and its destructive form (as applicable to the bond and securities) markets was first devised by David X. Li while working at JP Morgan Chase and articulated in his (2000) paper: "On Default Correlation: A Copula Function Approach" (For those unaware, a "copula" is a statistical device employed to couple the behavior of two or more variables).
Since Li's publication of his seminal paper, the CDO universe has come to be almost exclusively ruled by one or other copula-based correlation model. (And if I may remind readers, correlation is NOT to be confused with causality! An axiom that if learned properly might have spared us much grief!)
The beauty of Li's model is that anything in the financial universe could be quantified. Run and x and y or u and v variables together, no matter what, and get a correlation coefficient. (In some copula models at some investment banks, all one had to do is punch in the desired variables - say to orchestrate a particular CDS and package million together into SIVs or "structured investment vehicles".
What transpired now is that any rating agency for bonds, such as Moody's or AIG, no longer had to puzzle over the underlying securities. To model the risk of a given tranche you just nabbed the magic correlation number and you were good to go. The number then informed the rating agency how safe or risky the tranche was. Because of that, anything at all could be bundled together, and novel credit derivatives were most popular because they represented bets that could be made on anything. Once a party and counterparty existed, the bet could be made. Once it was quantified via the copula, an insurance agency could be found to insure the "bet".
Enter AIG which took on these bets big time, to the extent it transmogrified from an insurance company to a literal hedge fund. CDS bet after bet piled up, but since money was being made left, right and center no one fretted over the day when all the markers might have to be paid back. The insurers, most of them didn't worry. As the WIRED article noted:
"As a result just about anything could be bundled and turned into a triple A bond: corporate bonds, bank loans, mortgage backed securities, whatever you liked. The consequent pools were known as collateralized debt obligations or CDOs.
"You could tranche that pool and create a triple A security even if none of the components were themselves triple A. You could even take lower rated tranches of other CDOs, put them into a pool, and tranche them - an instrument known as "CDO-squared" which at that point was far removed from any actual underlying bond or loan or mortgage that no one had a clue what it included.
The last is the most critical aspect to process and understand. Because the copula allowed tranched "squaring" of securities (and no doubt "cubing" was also feasible, e.g. by incorporating another tranche level) the significance of the bond instrument - as well as its true bond rating - became totally divorced from reality. THIS is what has brought our finance system to its knees, and why Tim Geithner's toxic asset cleanup plan is crucial to its overall, long term survival.
These instruments are now spread across the banking system and they are precisely what's stymied the flow of credit (since no single bank knows how much any other bank's equity has been diminished). This is also precisely why the LIBOR that Ms. Clark references is out of whack. It cannot get back to a normative range until bank credit is flowing again, and that means the CDS infiltration has been effectively reduced to nil.
It is always, of course, much easier to insinuate or invoke facile answers. Why not? They are more readily understandable and - especially if one blames "the poor-black-noncitizen" (read in what you want) people - then you also get a collage of defined human faces to fulminate over as well. This set-up is vastly to be preferred over an abstract, difficult and obscure financial instrument - supported by an even more abstruse formula - not to mention the technicalities of the underlying financial manipulations (e.g. "tranching".) themselves.
Obviously the human mind clings to embracing simplified, basic causes as opposed to more abstract ones. But the problem with that approach is first, we will never ever get to the underlying truth - and then be more likely to repeat the same errors again, and second, we only end up demonizing a whole cohort of fellow citizens who were as much victims as everyone else.
Hopefully, Joyce groks that before she writes again on this subject.
Editor: P.A. Stahl makes some interesting points about Li's flawed formula, but in his desire to deny the core role of politically driven government manipulations of the economy in creating the current crisis, he mistakes means for motive, and process for purpose. He dismisses the well-documented "simplistic" real cause and attempts to use the camouflage of complexity to claim that the free market is at fault. The typical reason for complexity is to conceal corruption, and no where is that more true than in economics. Li's formula didn't create the sub-prime mortgage crises, it just facilitated the later stage deceptive offloading of these toxic assets onto unsuspecting victims - aided and abetted by government in one form or another.
Li's formula wasn't the reason for the intentionally deceptive practice of concealing bad securities amongst good ones and then falsely labeling the true nature of the bundle. Li's formula wasn't the reason government regulated banks made sub-prime loans to unqualified buyers and then connived with government to deceptively sell those bad loans under false pretenses to third parties.
Li's formula only helped the unsuspecting buyers to believe they could accurately calculate the risk involved - a calculation that couldn't possibly be accurate because the buyers were being intentionally deceived about the real contents of what they were buying. Government was a willing participant in that deception, and the primary cause of the large scale corruption of the economy that resulted.
To quote Thomas DiLorenzo, professor of economics at Loyola College in Maryland and senior faculty member of the Mises Institute:
"The purpose of government is for those who run it to plunder those who do not. Throughout history, governments have used violence, intimidation, coercion, and mass murder to enforce this system. But governments' first line of "defense" is always a blizzard of lies about its own alleged benevolence, altruism, heroism, and greatness, along with equally big lies about the "evils" of the civil society, especially the free market.
"The current economic crisis, which was instigated by the government's central bank and its boom-and-bust monetary policies, among other interventions, has once again been blamed on 'too little regulation' and too much freedom.
"Will Americans ever catch on to this biggest of all of government's Big Lies?"
Not if P.A. Stahl can keep them distracted by contrived complexity so that they don't see the "simplistic" base corruption at its core.
Professor DiLorenzo goes on to point out:
"Most recently, the current economic crisis is said to be caused by the 'excesses' of economic freedom and 'too little regulation' of the economy, especially financial markets. This is said by the president and numerous other politicians, with straight faces, despite the facts that there are a dozen executive-branch cabinet departments, over 100 federal agencies, more than 85,000 pages in the Federal Register, and dozens of state and local government agencies that regulate, regiment, tax, and control every aspect of every business in America, and have been doing so for decades.
"Laissez-faire run amok in financial markets is said to be a cause of the current crisis. But the Fed alone - a secret government organization that is accountable to no one and which has never been audited - performs hundreds of regulatory functions, in addition to recklessly manipulating the money supply. And it is just one of numerous financial regulatory agencies (the SEC, Comptroller of the Currency, Office of Thrift Supervision, FDIC, and numerous state regulators also exist). In a Fed publication entitled 'The Federal Reserve System: Purposes and Functions,' it is explained that 'The Federal Reserve has supervisory and regulatory authority over a wide range of financial institutions and activities.' That's the understatement of the century. Among the Fed's functions are the regulation of:
Bank holding companies
Foreign branches of member banks
Edge and agreement corporations
US state-licensed branches, agencies, and representative offices of foreign banks
Nonbanking activities of foreign banks
National banks (with the Comptroller of the Currency)
Savings banks (with the Office of Thrift Supervision)
Nonbank subsidiaries of bank holding companies
Thrift holding companies
Accounting policies of banks
Business 'continuity' in case of an economic emergency
Securities dealings of banks
Information technology used by banks
Foreign investments of banks
Foreign lending by banks
Bank mergers and acquisitions
Who may own a bank
Capital 'adequacy standards'
Extensions of credit for the purchase of securities
Mortgage disclosure information
Community Reinvestment Act subprime lending requirements
All international banking operations
Privacy of consumer financial information
Payments on demand deposits
"Fair credit" reporting
Transactions between member banks and their affiliates
Truth in lending
Truth in savings
"That's a pretty comprehensive list, the result of 96 years of bureaucratic empire building by Fed bureaucrats. It gives the lie to the notion that there has been 'too little regulation' of financial markets. Anyone who makes such an argument is either ignorant of the truth or is lying."