Saturday, June 18, 2011

Too Bad We Did Not Learn Our Lesson Back In 2008/2009....

We didn't figure out what causes contagion. Our stupid politicians didn't care what causes contagion; all they wanted to do was punish, was get even. We didn't understand or want to understand what happened between GS and AIG. We spent more time trying to punish the remaining institutions than figuring out what really went wrong with the ne'er-do-wells that collapsed. We had no idea what we were doing.

That's what I think about when I watch this Greek tragedy. Think about it. I am not saying we should not be hurt by a collapse in Greece. There should be pain concomitant to the amount of GDP of our country and theirs that might be lost. Same with Spain and Portugal. Our trade should suffer. There should be some repercussions from efforts in Europe to make it so the problems don't happen again, not that I can truly expect anything that clairvoyant from countries that seem to want a common currency without the fiscal responsibility of some of the partners in the currency.

But what should have happened is pretty simple: We should have figured out how to eliminate certain securities. We should have said that certain securities, notably credit default swaps, aren't in our national interest, as demonstrated by how much taxpayer money we had to shell out to those who wrote them. We should have said that some instruments that require very little margin but can truly cause pain to all of us, such as buying crummy mortgage bonds with almost no money, aren't in the national interest either.

We should have thought about national interest, not domestic equity. We looked at this problem from the point of view of which banks ran hedge funds -- I really blame Paul Volcker for that, because he truly didn't understand the way the world had changed in the last decade. We thought about which banks should be punished for stringing together suspect securities.

But we never looked at it from the point of view of margin and collateral. I always found this amazing, because The New York Times explained over and over again how these default swaps truly worked and the wrangling of collateral and how Goldman Sachs' legal right to a payoff from AIG was the proximate cause for the collapse of AIG.

Should EVERYTHING be traded? Should we even be able to insure financial products? We know that the banks and insurers who wrote this stuff didn't understand the ramifications at all or were so incentivized to write business that there were no standards.

But we didn't tackle it that way.

So our institutions wrote insurance on banks and government bonds and then didn't raise the collateral needed or sequester the capital needed if the contracts needed to pay off. Just like AIG.

I am sure some of that had to do with not willing to lose critical business to global entities that competed with them. The need to have "the full suite of services" has often been the excuse for why huge amount of risk with little reward -- or thought -- have occurred, and that's what happened with Greece and the other countries.

It isn't a matter of "we never learn." It is more a matter that the regulators didn't understand and that the hapless/stupid people in Congress really didn't get it at all. The incentive system to write this risky stuff is so great, the vig is so huge, that unless you ban it from being written entirely, it is going to keep happening. We didn't learn because we didn't attempt to understand. How much I wish that someone in Congress actually had been in sales at some point at any major bank. There would be no mystery to this at all. You sell the most irresponsible paper, because the gross credit or commission is the largest. Or you sell it because you need to keep the client from going to UBS or DB.

The endless belief, though, that once a product is created and sold it is therefore OK and can't be reviewed or pulled off the market is just catastrophic to our national interest, especially when we see the same thing at work now with Greece. Our banking system could have been immunized. The collateral system on physical assets, not financial assets, always worked. But financial assets? When it works, it's fine. When it doesn't, the system is in jeopardy and the national interest compromised.

I had thought that this problem MIGHT go away when the laissez-faire Republicans left the White House. But the Democrats didn't seem to think it was right to tamper with these toxic products either.

The lesson they may have taken from the New York Times series on Goldman and AIG is that Goldman is "bad" and deserves "sanctions." It is as if they thought Goldman acted criminally. Goldman was just following what it was allowed to do without being criminal.

Doesn't matter. Governmental punishment and retribution don't change the incentive structure and don't outlaw the product.

So we are stuck with our banks being hostage, and therefore our system being hostage. We are stuck with a true linkage that could be awful, and the usual suspects being involved. If they weren't, why don't they come out and say it?

Twenty-four years ago, we had shysters offering portfolio insurance against a decline in the market using stock futures. It didn't work. It also helped precipitate the devastating crash of 1987. After that, the clients forsook the product, and it went away.

But there is no incentive for the clients to forsake swaps, because the lesson of AIG is that if the insurer doesn't pay off, the government will. So why not take out the product? It's as cheap as term life, and all you have to do is take more of it than you have bonds or take it without the bonds. Either way, it is a good bet, because all that happens is that the Treasury pays off.

The alternative?


And as we have heard again and again, we must pull out all of the stops to make sure we don't have another Lehman. Alot of hedge funds are betting this way....

Which is exactly what this crisis is all about.

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