If You Can Take It

There's been a number of good articles come out that I haven't had time to blog about (along with the fact I had a good post going when my computer bluescreened).

Let's start with an article titled, The Two Documents Everyone Should Read to Understand the Crisis,

As a white-collar criminologist and former financial regulator much of my research studies what causes financial markets to become profoundly dysfunctional. The FBI has been warning of an "epidemic" of mortgage fraud since September 2004. It also reports that lenders initiated 80% of these frauds.¹ When the person that controls a seemingly legitimate business or government agency uses it as a "weapon" to defraud we categorize it as a "control fraud" ("The Organization as 'Weapon' in White Collar Crime." Wheeler & Rothman 1982; The Best Way to Rob a Bank is to Own One. Black 2005). Financial control frauds' "weapon of choice" is accounting. Control frauds cause greater financial losses than all other forms of property crime -- combined. Control fraud epidemics can arise when financial deregulation and desupervision and perverse compensation systems create a "criminogenic environment" (Big Money Crime. Calavita, Pontell & Tillman 1997.)

The FBI correctly identified the epidemic of mortgage control fraud at such an early point that the financial crisis could have been averted had the Bush administration acted with even minimal competence. To understand the crisis we have to focus on how the mortgage fraud epidemic produced widespread accounting fraud. [emphasis mine - OG]

I get really suspicious when people keep copping to "incompetence." It can hide much more nefarious motives.

These two documents are enough to begin to understand:

• the FBI accurately described mortgage fraud as "epidemic"
• nonprime lenders are overwhelmingly responsible for the epidemic
• the fraud was so endemic that it would have been easy to spot if anyone looked
• the lenders, the banks that created nonprime derivatives, the rating agencies, and the buyers all operated on a "don't ask; don't tell" policy
• willful blindness was essential to originate, sell, pool and resell the loans
• willful blindness was the pretext for not posting loss reserves
• both forms of blindness made high (fictional) profits certain when the bubble was expanding rapidly and massive (real) losses certain when it collapsed
• the worse the nonprime loan quality the higher the fees and interest rates, and the faster the growth in nonprime lending and pooling the greater the immediate fictional profits and (eventual) real losses
• the greater the destruction of wealth, the greater the (fictional) profits, bonuses, and stock appreciation
• many of the big banks are deeply insolvent due to severe credit losses
• those big banks and Treasury don't know how insolvent they are because they didn't even have the loan files
• a "stress test" can't remedy the banks' problem -- they do not have the loan files

Wired has an article about this Chinese economist David X. Li,

For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.

David X. Li, it's safe to say, won't be getting that Nobel anytime soon. One result of the collapse has been the end of financial economics as something to be celebrated rather than feared. And Li's Gaussian copula formula will go down in history as instrumental in causing the unfathomable losses that brought the world financial system to its knees.

Isn't that special...

The damage was foreseeable and, in fact, foreseen. In 1998, before Li had even invented his copula function, Paul Wilmott wrote that "the correlations between financial quantities are notoriously unstable." Wilmott, a quantitative-finance consultant and lecturer, argued that no theory should be built on such unpredictable parameters. And he wasn't alone. During the boom years, everybody could reel off reasons why the Gaussian copula function wasn't perfect. Li's approach made no allowance for unpredictability: It assumed that correlation was a constant rather than something mercurial. Investment banks would regularly phone Stanford's Duffie and ask him to come in and talk to them about exactly what Li's copula was. Every time, he would warn them that it was not suitable for use in risk management or valuation.

In hindsight, ignoring those warnings looks foolhardy. But at the time, it was easy. Banks dismissed them, partly because the managers empowered to apply the brakes didn't understand the arguments between various arms of the quant universe. Besides, they were making too much money to stop.

And isn't that what it's all about?

"Li can't be blamed," says Gilkes of CreditSights. After all, he just invented the model. Instead, we should blame the bankers who misinterpreted it. And even then, the real danger was created not because any given trader adopted it but because every trader did. In financial markets, everybody doing the same thing is the classic recipe for a bubble and inevitable bust.

Yeah, they deserve all that money because they're such frakkin' geniuses.

Li has been notably absent from the current debate over the causes of the crash. In fact, he is no longer even in the US. Last year, he moved to Beijing to head up the risk-management department of China International Capital Corporation. In a recent conversation, he seemed reluctant to discuss his paper and said he couldn't talk without permission from the PR department. In response to a subsequent request, CICC's press office sent an email saying that Li was no longer doing the kind of work he did in his previous job and, therefore, would not be speaking to the media.

It's probably nothing.

I was commenting on The Quiet Coup, when my computer bluescreened,

The crash has laid bare many unpleasant truths about the United States. One of the most alarming, says a former chief economist of the International Monetary Fund, is that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time.

It's worth the read.

Sleep Well.

/eom

Michigan Reality Check.

I talked to my brother in Michigan today. He’s lived in Grand Rapids for thirty five years or so. Here’s the reality of the state that bases the auto industry. As I’ve said before, Michigan was a good place to grow up. The economy was humming and it was hoppin’ and poppin’. My brother told me that Muskegan, a city on Lake Michigan a little southwest of Grand Rapids, has an unemployment rate at twenty-two to twenty-five percent, and that up where my mother lives it’s near fifty. These are depression levels already and the auto industry hasn’t totally collapsed yet.

But if it’s up to a cabal of southern senators the American auto industry will collapse. These most vocal senators against making loans to the auto industry, who are ubiquitous in the media, every one of them has a foreign car plant in their state. Even in my own state of Georgia, where both of my Republican senators were filibustering against the auto companies, KIA is moving in. They even gave the governor a KIA to drive. It is obvious these senators are acting as agents for foreign corporations in an economic war against the remaining three American automakers. If the American companies go under, it is these foreign companies which stand to gain. These senators are economic traitors to the United States of America and to the American working people.

I called both of my senators 800 numbers Friday and chewed out the person on the other end of the line. I couldn’t believe the line of garbage they were trying to hand me. Then I saw this memo that was circulated among Republicans. This whole thing is about busting the UAW. It’s a union busting exercise. They want to take down the union. This confirms that the line they were giving me over the phone was utter garbage – a pack of lies. Not only do they not represent my interests as a working person, they have so little respect that they will literally bullshit me over the phone.

Every one of the states got these companies to build a plant in their respective states by giving all kinds of concessions, tax breaks, and most of all, assurance of help in keeping the unions out. They say Alabama shelled out what amounted to two hundred thousand dollars per job to get the Mercedes plant. On top of that, the state bought twenty five hundred of the first vehicles to roll off the line – the whole state fleet. That’s Shelby’s state. The loan would amount to five thousand dollars per job.

Never forget that it is so-called conservative, supply side, low tax, Republican, Reaganomic economics that has brought us to the brink of depression – and as I wrote in the opening paragraph, a very real depression already in Michigan. What is this type of economics? It is an economic system whereby wealth is transferred from the poor to the already wealthy. It is a system where the top one-tenth of one percent get as much as the entire bottom half, and it’s not enough!

Oh yeah, my brother told me that his wife, president of the Michigan Diabetic Association who has even testified before Congress, lost her job of some twenty years at the hospital in a cost cutting move. It's starting to get ugly out there.

This is good: 7 Myths About Detroit Automakers

/