Outside the movies in Amite City, Louisiana
Ilargi: It took just a few months after the Berlin Wall came down for Russian organized crime to settle in as the most powerful force in the country. The reason they could was very simple: with the downfall of the communist party, they were the only existing group left that was indeed organized. Of course Yeltsin's disaster doctrine politics helped them along to a huge extent. While the population was decimated by rapidly declining medical care food shortages and overall misery, the major mob bosses, the capi now known under the far too flattering moniker of "oligarchs", were allowed to rob the nation blind, almost literally, of all its exportable resources. It doesn't take much imagination or exaggeration to figure out that the present occupants of the Kremlin owe their positions to what is perhaps Russia's main export industry these days, the mob and its henchmen.
In Italy, the history is a clear as it is well-known, and yet so opaque behind its veil of secret oaths. Still, at the same time it's also a public secret that the mafia is alive and kicking. It has been for centuries, and it's not going to disappear because of a few decades of affluence. The opposite is probably true. Looking at the connections between Romano Prodi, Silvio Berlusconi, the Banco Ambrosiano and a thousand other individuals and institutions, the Italian mafia appears to have a stronger control than ever, be less visible than ever, and ideally positioned to take advantage of en economic turn for the worse. It's all about organization, loyalty, trust, fear and violence.
In Britain, reports about accumulating garbage in the streets talk about the increasing presence of rats and mice, certainly a fitting metaphor for the preceding stories, which, all of them, deserve far more attention from the public at large. When our societies decline and become impoverished, something that is by now obviously inevitable, and on a much larger scale than 99% of the population understands, whoever is well organized has a shot at the title. And the title will ultimately go to the organization most willing and equipped to play on fear.
In North America, the link between business, politics and organized crime is probably more embedded than elsewhere, with Italy as a possible exception. For many foreigners, it's hard to believe what they see happening before their eyes. In democracies there are always problems and discussions, but the flagrant disregard for what either is, or should be, the law, as witnessed in America is exceptional. It's dangerous as well, to have the ruling class, in full public view, place itself above the laws that it insists still apply to everyone else. It's doubtful that there are many Americans, let alone foreigners, left who have the idea and the faith that the US judicial system works effectively to protect them from crime and that has the ability to ensure their possessions are safe.
The bankruptcy proceedings of General Motors and Chrysler, both of which seem imminent, will have devastating effects on the pensions of people throughout all industries in the nation, even though that may not be show immediately. Of course this shouldn't be that much of a surprise in a society in which many millions already scrape out a (non-)living with no pension whatsoever flipping each other's burgers or greeting each other at the doorsteps of Wal-Mart branches. Still, there will be a point when people finally will wake up long enough from their diabetic slumbers to understand that what they lose in pension funds is lost only because the choice is consciously being made to transfer it to the accounts of bankrupt institutions controlled by the very people who do the transferring.
We're starting to insult ourselves pretending we're in just a financial crisis. One look at the reasons why we're here tells us we're in much deeper waters.
Bear Stearns, AIG Dumped $74 Billion in Subprime, CDOs on Fed
The Federal Reserve took on more than $74 billion in subprime mortgages, depreciating commercial leases and other assets after Bear Stearns Cos. and American International Group Inc. collapsed. In its biggest disclosure of the securities accepted to stabilize capital markets, the Fed said yesterday it had unrealized losses of $9.6 billion on the assets as of Dec. 31. The bonds, swaps and notes were taken in from Bear Stearns, once the fifth-biggest Wall Street firm by capitalization, and AIG, which had been the world’s largest insurer.
The losses on securities backed by assets such as home loans in Florida and California signal that U.S. taxpayers may be forced to reimburse the central bank through the Troubled Asset Relief Program, according to Christopher Whalen, managing director of Torrance, California-based Institutional Risk Analytics. "The numbers basically confirm that Treasury is going to have to take some TARP money and reimburse the Fed," said Whalen, whose financial-services research company analyzes banks for investors. "It is essentially up to the Treasury to get the Fed out of this." The central bank lent $2 trillion to financial institutions and hasn’t disclosed information about most of the collateral backing those loans.
The Fed report follows requests from lawmakers to identify the collateral and a lawsuit by Bloomberg News. Fed Chairman Ben S. Bernanke pledged to expand disclosure, assigning Vice Chairman Donald Kohn to lead the effort. The central bank has refused to name the borrowers, the amounts of loans or the assets banks put up as collateral under most of its programs, arguing that doing so might set off a run by depositors and unsettle shareholders. That would be less of a concern for New York-based AIG, now 80 percent owned by the federal government, and Bear Stearns, taken over by New York- based JPMorgan Chase & Co. a year ago. Bloomberg, the New York-based company majority-owned by New York Mayor Michael Bloomberg, sued Nov. 7 under the Freedom of Information Act on behalf of its Bloomberg News unit. The public is an "involuntary investor" in the nation’s banks, according to an April 15 court filing by Bloomberg.
In the report, the Fed detailed its assets in three limited liability corporations, all called Maiden Lane, after a street in Lower Manhattan that runs past the New York Fed. The $9.6 billion in losses are unrealized because they represent the difference between the fair value of the security under accounting rules and the amount outstanding. The losses become real if the principal isn’t returned. Maiden Lane I is a $25.7 billion portfolio of Bear Stearns securities related to commercial and residential mortgages. JPMorgan refused to buy them when it acquired Bear Stearns to avert the firm’s bankruptcy. The Fed’s losses included writing down the value of commercial-mortgage holdings by 28 percent to $5.6 billion and residential loans by 38 percent to $937 million as of Dec. 31, the central bank said. Properties in California and Florida accounted for 45 percent of outstanding principal of the residential mortgages.
Maiden Lane II contains almost $11 billion of outstanding subprime mortgage-backed securities from the AIG transaction that the Fed said lost $180 million so far. The fund also contains $6.2 billion of Alt/A adjustable-rate mortgage-backed securities that the report said has $936 million of unrealized losses. The Fed values $11.4 billion of assets in Maiden Lane II with mathematical modeling, the same methods used by banks and AIG itself. About 19 percent of the mortgage-backed securities are rated speculative grade, or BB+ at Standard & Poor’s, according to the Fed. About 40 percent are given the top rating of AAA. Maiden Lane III has lost $2.6 billion after being created Oct. 31 to buy collateralized debt obligations from AIG counterparties, according to the Fed. CDOs in this unit include three parts of a high-grade asset-backed security known as TRIAX 2006-2A, totaling about $3.2 billion.
Maiden Lane III also has two parts of a commercial mortgage-backed CDO called MAX 2007-1 A-1 with a face value totaling $7.5 billion. The fair value of those two is less than half that much, or $3.3 billion, according to the central bank. A third of the amount outstanding in the Maiden Lane III CDOs are speculative grade, or deemed by ratings companies as having a greater chance of default. Another 27 percent are rated AA+ to AA-, the second-highest tier of S&P’s scale, the Fed said in its report. All but $155 million of the $26.8 billion in CDOs are classified as Level 3 assets, or those valued with mathematical models instead of market prices.
AIG’s Liddy to Testify in Congress on Additional Funding Needed
American International Group Inc. Chief Executive Officer Edward Liddy has been asked to testify on May 6 before a House of Representatives committee about whether the insurer will need more government aid. Representative Edolphus Towns, chairman of the Committee on Oversight and Government Reform, sent Liddy a letter dated April 22 asking him to appear before the panel and also to discuss "what went wrong" at the New York-based insurer. Lawmakers are frustrated that AIG has needed four government bailouts after losses on contracts protecting banks that invested in bonds backed by subprime mortgages. Liddy, 63, was also asked to be prepared to discuss the "major problems" still facing the company and whether insurance operations are financially sound.
Liddy’s first appearance before Congress as CEO of AIG in March was dominated by discussion of $165 million in retention bonuses paid to employees of the Financial Products unit, which was most responsible for the company’s losses. He asked employees getting awards exceeding $100,000 to return half of the payments. "Mistakes were made at AIG on a scale few could have imagined possible," Liddy said at the March 18 hearing before a House Financial Services subcommittee. "The most critical of those was the creation of a credit-default swap portfolio" that led to a liquidity crisis at AIG. His predecessors at AIG, Martin Sullivan and Robert Willumstad, testified before the Oversight Committee in October, blaming AIG’s downfall on an accounting rule that forced the firm to book unrealized losses.
Maurice "Hank" Greenberg, who led AIG for almost four decades until 2005, appeared before the committee this month. He blamed his successors for allowing the Financial Products unit to take excessive risks. AIG has said that Greenberg was responsible for creating the business. Liddy stepped down from the board of Goldman Sachs Group Inc. last September to become AIG’s chief executive. Henry Paulson, then-Treasury Secretary and a former Goldman Sachs CEO, had asked Liddy to run AIG during the government rescue. AIG’s rescue, valued at $182.5 billion, includes an investment of as much as $70 billion in preferred stock and warrants, $52.5 billion to buy assets owned or backed by the insurer, and a $60 billion credit line. AIG had borrowed about $46 billion on that line as of April 2.
New Worries for Next Tier of Banks
Absent fresh details on how the nation’s 19 largest banks fared in a new government test of their health, analysts are turning the spotlight on a handful of major regional banks that they reckon may be the next weak links in the financial industry. On Friday, the Federal Reserve reported that the banks whose books it had analyzed recently had enough capital to offset a raft of new losses, reinforcing the belief that the government would support the largest banks even if their financial health eroded, and buoying the stock market. But the agency warned that banks would need a new cushion of financing on top of the current minimum levels as a buffer against higher losses if the economy worsened. That guideline, analysts say, could force at least a handful of banks, including several regional lenders, to sell large amounts of common stock to the government or private investors.
While Citigroup and Bank of America remain troubled, regional banks subject to the government’s tests — including Regions Financial of Alabama, SunTrust Banks of Georgia and KeyCorp and Fifth Third of Ohio — are girding for huge losses. They are among the hardest hit by the housing bust, and are saddled with a pile of commercial real estate and corporate loans expected to sour further this year. Regions Financial, for example, added just $35 million to its reserves for future loan losses in the first quarter, an amount analysts say may not be enough to cover a surge in its nonperforming loans. Regulators met top executives from the 19 banks behind closed doors at the Federal Reserve Bank of New York on Friday, and at some of the 12 other regional Fed Bank offices, to review the preliminary results of the tests and inform bankers how much additional capital they must raise.
The information will not be publicly released until May 4, although the banks have the next several days to dispute any of the findings of the tests. On Friday, Morgan Stanley came forward with its own analysis of which banks might need to raise capital, the latest in a series of private estimates being tallied to allow gambling investors to position themselves to profit from fluctuations in the stock prices of the banks. The report identified SunTrust, KeyCorp and Regions Financial — all major regional banks — as those that the government would probably determine needed billions in additional capital. Bank of America and Wells Fargo fall into a "gray zone," the report said. Earlier this week, Keefe, Bruyette & Woods, a boutique investment bank, said all of the 19 banks might need a total of $1 trillion of fresh capital.
David H. Ellison, the chief investment officer of FBR Equity Funds, a mutual fund that invests in financial stocks, said all the uncertainty around the stress test results might provide opportunities for big gains. He has viewed at least a half dozen of such makeshift stress tests produced by research firms. "You make most of your money in financial stocks from going from ugly to O.K., not from good to great," he said. "Right now, we are ugly." Even before official stress test results are released, the gap between the strongest and weakest banks has been widening. Among those best positioned to withstand a sharp downtown without needing capital, analysts say, are the major investment and custodial banks, including Goldman Sachs, Morgan Stanley, the State Street Corporation and Bank of New York Mellon. A handful of well-run commercial banks, like JPMorgan Chase and U.S. Bancorp, are unlikely to need additional money.
Besides the regional lenders, a few big banks are also staring down trouble. Citigroup, which has been bruised by the credit crisis, has already announced plans to strengthen itself by converting a portion of the government’s $45 billion preferred stock investment into common shares. Some analysts say that GMAC, the privately held finance arm of General Motors, and Bank of America may need to consider taking similar action. Federal officials said that some banks might need to raise additional capital. Others might need to change the form of their existing capital by converting preferred shares into common stock, which is better at absorbing losses. Both measures could dilute existing shareholders or give the government a greater stake.
The prospects of the remaining lenders are even more unclear. Their fate rests wherever federal banking regulators draw the line on how much capital is enough to provide a cushion. Big credit card lenders, like American Express and Capital One, have huge numbers of customers defaulting on their bills, but they typically set aside more money to cover losses than traditional banks. The BB&T Corporation of North Carolina, PNC Financial and Wells Fargo all showcased their ability to generate earnings in the first quarter, but face a coming wave of heavy losses. MetLife Bank, which is part of the insurance giant, is also a wild card.
Even so, investors found some relief in the vague 21-page report on stress tests put out Friday afternoon by the Fed. In fact, after starting the day down on nervousness that the report would reveal more trouble at the banks, financial stocks rose sharply when the report suggested the 19 banks were well capitalized. Mr. Ellison said the Fed’s report seemed to suggest that the stress test results would not be worse than Wall Street expected. "Three months ago, all the banks were going to be nationalized and you might just give up and go home," he said. "We are now getting a reality check on how bad it is: sure, it’s bad, but it’s not the end of the world."
Waiting For Banks' Stress Test Results Is 'Water Torture'
Investors and bankers are still waiting for closure from the Federal Reserve about stress tests for banks. Friday's 19-page white paper describing the methodology of stress testing doesn't tell investors how the 19 big banks subject to the test fared. Regulators do intend, eventually, to make some of that information public. Bankers, who were told on Friday by regulators where their institutions stand on the test, are concerned about what information will find its way to the public, and how. "It's water torture," and its going to continue, said John Douglas, the chair of the banking and financial institutions group at law firm Paul, Hastings, Janofsky & Walker LLP, and a former general counsel of the Federal Deposit Insurance Corp.
The Fed intended to strengthen the banking system by determining which of the nation's 19 largest banks, which have assets of more than $100 billion, would need more capital to make it through the financial crisis and the recession. On Friday, the Fed disclosed generally how it conducted its test. Still, while the methodology and benchmarks used for the bank stress tests is now known, what isn't known is how these will play out among individual banks, since each will be treated individually. "This could lead to a lot of confusion" and unsettled financial markets, said Anthony Sabino, professor of Law and Business at St. John's University.
After the Fed said it would stress-test banks, a slew of analysts created their own scenarios and methods to apply to banks and, they hoped, get some idea what the Fed would find. The new details on the methodology could be "dangerous," as the market doesn't know which banks need more capital or not, said Sabino. The Fed white paper will be dissected in the next few weeks, and new misconceptions may arise about which banks need government assistance, he said. Unclear also is what information, if any, investors will get from the test about whether banks are allowed to pay back money they received from the Troubled Asset Relief Program, or how well capitalized they would be if they paid it back. As one observer put it: Leaks about the test results could be worth their weight in gold - or send people to prison.
Regulators have said they do intend to make some information about the result of the stress tests public, but neither market participants nor bankers themselves know specifics about the disclosure. The details regulators collected are confidential information about the banks' own assumptions about loan losses and capital needs. Banks never disclose such information, if only because they don't want their competitors to know. If such information leaked, or even false information become a matter of market speculation, bankers might be forced to disclose or correct the information.
It's not clear how the Securities and Exchange Commission, which is the regulator concerned with disclosure to shareholders, would react to bankers' disclosure, or lack thereof, about stress-test results. The damage from imprecise information, even from efforts to rank the banks by perceived capital strength, could be considerable. "What would you do if you were a customer of the bank that ranks 19? You would take your money out," Douglas said. So from the bankers' perspective, the market might have to settle for less information than investors wish. But the uncertainty about the process of disclosure is keeping at least some bankers up at night, regardless of the actual outcome of the test.
The process itself took banks through the wringer. The methodology was rigorous but left room for dialogue, at times intense, between bankers and their regulators. "I am pleased with the process and the methodology," because it used a similar methodology on all banks but left room for bank's individual circumstances, Douglas said. "I just disagree with the public nature of it." It was neither the checkup from the family doctor, nor the standardized exam an insurance company would use on an applicant for a life insurance company - rather a bit of both. The Fed's disclosure on Friday revealed that the fear of some observers that the test would be too much of a cookie-cutter approach was unfounded. The Fed used one set of metrics, but left room for the individual bank's practice. Bankers have the right to try to rebut the regulators' judgment, as they have in every regulatory exam.
U.S. Presses Some Banks to Act After Stress Tests
Federal officials are pushing several of the country's largest banks to bolster capital reserves, people familiar with the matter said, as regulators try to repair bank balance sheets and the public image of the U.S. banking sector. The identities of the banks, among the 19 institutions that were subjected to federal "stress tests," couldn't be learned. Analysts believe they likely include regional banks with large exposures to commercial real estate in the Midwest and Southeast. Three people familiar with the matter said at least three banks are in this position.
Government officials believe most banks in need can improve their capital footing without taking money from the government bailout fund. This would be done by raising funds from private investors or converting the government's existing investments in banks into a new type of equity that would better cover banks in case of future losses. In the latter scenario, the U.S. could end up owning large chunks of banks, raising the specter of something akin to nationalization. Federal officials have said any such move would be temporary. Some banks could end up requiring a cash infusion from the Treasury.
In February, the Obama administration said 19 bank holding companies with more than $100 billion of assets would have to undergo a stress test. The move was designed to calm fears about the solvency of the banking system. The exams, conducted by more than 150 federal regulators, analyzed potential losses from residential mortgages to complex securities products. Regulators want banks in the future to be able to maintain an additional "buffer" of capital above the minimum standards, a Federal Reserve official told reporters Friday. The official wouldn't identify the specific buffer.
The Fed released the methodology for the tests Friday, although didn't provide many of the specifics that bank investors and analysts had been seeking. In embarking on the tests, government officials are walking a tightrope. The move could have the opposite its intended effect and raise public fears that banks ordered to raise more capital are on the verge of collapse. The Fed specifically said Friday that needing to boost capital should not be viewed as "a measure of the current solvency or viability of the firm." Banks will have several days to challenge the findings before the government makes results public the week of May 4. In a briefing, White House spokesman Robert Gibbs said it was his "understanding" that the banks themselves would release specific results.
Under the tests, all 19 banks are all believed to be "well capitalized" by current standards. The tests, however, pushed banks to determine what their conditions would look like if the economy worsened precipitously. Fed officials met Friday with top management at the country's biggest banks, from Citigroup Inc. in New York to Wells Fargo & Co. in San Francisco, to go over the results. Fed officials and some of the banks wrapped up in less than 60 minutes; others dragged on for several hours, according to people familiar with the matter. Participants were told to keep mum on what was discussed.
The government confirmed the following list of the 19 banks undergoing stress tests:
J.P. Morgan Chase & Co.
Bank of America Corp.
Wells Fargo & Co.
Goldman Sachs Group
PNC Financial Services Group
Bank of NY Mellon Corp.
SunTrust Banks Inc.
State Street Corp.
Capital One Financial Corp.
Regions Financial Corp.
American Express Co.
Fifth Third Bancorp
U.S. Stress-Test Accounting May Raise Capital Levels
Financial regulators may force many of the largest U.S. banks to raise new capital or conserve extra cash after accounting for assets held off their balance sheets. The Federal Reserve yesterday released the methods used in stress tests on the 19 largest U.S. banks, which incorporated an accounting proposal that would bring about $900 billion onto lenders’ books. The accounting change suggests most of the 19 will need to take some action to buttress their capital, analysts said. Stronger banks may keep dividend payments low or apply retained earnings, with others selling new shares to make up the amounts, they said. "We think that most banks are going to have to raise capital through some or all of those means," said Dino Kos, a former markets director at the Federal Reserve Bank of New York who is now a managing director at Portales Partners LLC, a New York research firm. "All of them will need to conserve capital through retained earnings."
Karen Petrou, managing partner of Washington-based research firm Federal Financial Analytics, said banks may need as much as $70 billion in new capital just to cover the added burden of the accounting changes. Banks were given preliminary results from the stress tests yesterday, with final results due for publication May 4. The 19 firms include Citigroup Inc., Bank of America Corp., Goldman Sachs Group Inc., GMAC LLC, MetLife Inc. and regional lenders including Fifth Third Bancorp and Regions Financial Corp. Financial stocks advanced yesterday even as the report stopped short of indicating how much new money regulators will demand to be raised. The report said "most" banks have capital "well in excess" of regulatory requirements, without specifying how the stress tests would impact those levels.
The Standard & Poor’s 500 index rose 1.7 percent to 866.23, and the S&P 500 Financials Index, which includes 80 banks, insurers, brokers and credit-card firms, gained 2.5 percent. The financials index is down 62 percent since the start of 2008. The report is part of a federal effort to restore public confidence in banks, some of which have seen their capital "substantially reduced" by the recession and financial crisis. The assessments calculated the capital buffer the 19 biggest banks will need to keep making loans even if the economic downturn worsens this year and next. They also put a focus on common stock as a key component of capital. White House Chief of Staff Rahm Emanuel said the tests will reveal "gradation," with some being "very, very healthy" and others needing assistance. Emanuel made the comments in an interview on Bloomberg Television’s Political Capital With Al Hunt.
The Fed’s report said that a bank’s capital buffer assessment is "not a measure of the current solvency or viability of the firm." Regulators have been concerned that the release of the test results may roil the shares of banks with the largest capital needs, people familiar with the matter have said in the past week. While the report said that banks’ own assessments were "not necessarily consistent" with the estimates of the regulators, a Fed official added that the firms shouldn’t be surprised at the figures. The official spoke to reporters on a conference call on condition of anonymity. In calculating the capital buffers, regulators accounted for off-balance sheet securities that banks will be incorporating in 2010 as a result of proposed accounting rules changes. Banks may bring on about $900 billion to their balance sheets as a result of the change by the Financial Accounting Standards Board. Supervisors boosted the risk-weighted assets in their assessments by $700 billion, the Fed said.
"The regulators have decided to err on the very cautious side, assuming FASB finalizes the rule and throws $700 billion of risk-adjusted assets into the capital calculation," said Petrou of Federal Financial Analytics. That change, she said, "makes the test considerably more stringent." "We conclude that it will be very, very difficult for any big bank to get out" of the government’s capital assistance program, she added. JPMorgan Chase & Co., Bank of America, Citigroup and Wells Fargo & Co. are among the major banks with off-balance-sheet assets, analysts said. The 19 banks in the test hold two-thirds of the assets and more than one-half of the loans in the U.S. banking system, the study said. Regulators used a consistent metric for all the firms to measure how much of an additional capital buffer is needed over standard regulatory ratios of capital to risk-weighted assets, officials said, declining to identify what the measure was. The Fed officials said supervisors will work with banks to maintain the buffer over time, indicating that firms with high- risk portfolios will face a larger challenge to maintain it.
Regulators used the market shocks of the second half of 2008, when Lehman Brothers Holdings Inc. declared bankruptcy, as the model for testing banks with trading portfolios of $100 billion or more. Supervisors will weigh how much capital each company holds, its ability to retain earnings over the next few years, future access to private capital and the extent any asset writedowns. Taxpayer aid for a troubled bank will come from the Treasury’s $700 billion Troubled Asset Relief Program for banks that need a stronger buffer. The Treasury is also open to converting its current preferred shares into common equity, a step that would boost capital levels and reduce banks’ dividend payments.
Recession, Far From Over, Already Setting Records
The current recession has become the second-worst in the last half-century and is close to surpassing the severe 1973-75 downturn, according to the Index of Coincident Indicators, based on government data and compiled each month by the Conference Board, a private organization. Unlike the more widely followed Index of Leading Indicators, which is supposed to help forecast changes in the economy, the coincident index is aimed at simply recording how the economy is doing now.
The accompanying chart shows how far that index has declined from prerecession peaks during each downturn since 1960. The figure for March, released this week, showed a decline of 5.6 percent from the high set in November 2007, the month before the recession began, according to the National Bureau of Economic Research. The decline in the 1970s recession was 6 percent, a figure that is likely to be eclipsed within a few months. The index is based on four elements, covering different aspects of economic activity. The strongest performance in this cycle is in the area of personal income, excluding transfer payments, like Social Security and unemployment benefits, and adjusted for inflation. The sharpest fall so far in the current recession was a decline of 2.4 percent through February, and the indicator rose a little in March.
If that proves to be the worst reading for this recession, it will be a smaller decline than in the downturns of 1990 to 1991, or in the brief 1980 recession, and less than half the decline in the 1973-75 recession. That performance may be misleading, however. Personal income includes the cost of benefits, so rising health care expenses for employees count in that number. The decline would be larger if it were based strictly on wage and salary receipts. The two areas in which this is already the worst recession since 1960 are employment and industrial production. The number of jobs in the country has fallen by 3.9 percent, exceeding the 3.2 percent decline in the 1981-82 recession. Economists generally expect those numbers to get worse before they stabilize.
The 15.4 percent fall in industrial production, while worse than in previous recessions, is better than in some countries. The worldwide recession has slashed both production and international trade, and the impact is being felt most in export-driven economies in Asia. The fourth category used in the coincident indicators is manufacturing and trade sales, a broad picture of total transactions in the economy. Adjusted for inflation, that has fallen 10.8 percent since the peak, a bit more than the decline in 1981-82 but not yet close to the 14.8 percent decline in the 1970s recession.
This recession is also bidding to be the longest in recent history. If it ends in May — which seems unlikely — it will have lasted 16 months, tying it with the 1973-75 and 1981-82 downturns as the longest since World War II. The Index of Coincident Indicators did not exist in the 1930s. But there is no doubt that the declines in the Great Depression would have been far greater than anything experienced since. It also lasted much longer. As measured by the National Bureau, there were actually two recessions during the period we now remember as the Great Depression — 1929 to 1933 and 1937 to 1938 — separated by a recovery that did not come close to restoring the economy to its pre-Depression size. That first downturn lasted 43 months, nearly three times as long as this recession has lasted until now.
GM employee stock fund dumps all company shares
The manager of General Motors' employee stock fund has sold off all remaining shares of the troubled auto maker, which is closing plants and slashing costs in a bid to avoid bankruptcy. General Motors revealed in a regulatory filing late Friday that its employee stock-purchase plan has unloaded all shares of the company in favor of short-term and money market investments. The plan's financial manager, State Street Bank and Trust Co., said it began selling off shares of the Detroit automaker in late March "due to the economic climate and the circumstances surrounding GM's business." GM disclosed the development in a filing with the Securities and Exchange Commission.
State Street said the General Motors Savings Plan now consists entirely of short-term, cash-based investments. By the end of May, the GM Common Stock Fund will be eliminated as an option for company employees, the investment manager said. The selloff underscores the grim outlook for GM, which plans to shut down more than a dozen plants over the summer to conserve cash, slash costs and align production levels with demand. The company is racing against the federal government's June 1 deadline to squeeze larger concessions from bondholders and the United Auto Workers union. The cost-cutting efforts are expected to lead to thousands more layoffs and temporary factory closures.
Plight of Carmakers Could Upset All Pension Plans
Decisions that the government will make soon on the future of General Motors and Chrysler could accelerate the decline of traditional pension plans, which have sheltered generations of workers from an impoverished old age. Pension experts predict that a government takeover of the two giant plans would spur other auto companies and all types of manufacturers to abandon such benefits for competitive reasons. For hundreds of thousands of retired auto workers, a federal pension takeover would mean sharply reduced benefits. For the federal agency that insures pensions, it would mean a logistical nightmare in the short term — and most likely a slow demise eventually as fewer and fewer small plans remain in the system and pay premiums.
So far, the prospect of a grueling grind through bankruptcy court has been a major deterrent to companies that might want to rid themselves of pension obligations. But retirement and labor specialists are watching closely to see whether the administration’s auto task force will give either of the auto companies an easier way to shed their huge pension funds, blazing a simplified trail for others to follow. With or without a bankruptcy filing, the government is quietly making the preparations that would be needed to take over Chrysler’s pension plan, with its 255,000 participants, according to government officials. Even if Chrysler manages to strike a deal to sell many of its assets to Fiat, perhaps in conjunction with a bankruptcy filing, experts doubt Fiat will agree to take on its pension plan without extraordinary assistance. One possibility being considered is a cash infusion of $1 billion from Daimler, which previously owned Chrysler and had agreed to backstop a pension failure for several years.
The future of General Motors’ pension plan is also unclear. G.M. has until June 1 to come up with an acceptable business plan. If it declares bankruptcy, it still may try to keep its pension plan afloat. G.M.’s plan for hourly workers, which covers 485,000 people, was in reasonably good shape until last fall’s market turmoil, and would not require cash contributions until 2013. If one or both of these plans collapse, the federal agency that insures pension benefits, the Pension Benefit Guaranty Corporation, will lose a big source of the premium revenue it collects from companies with pension funds. But more important, the demise of the bellwether auto plans might set a template for other companies seeking to cut costs and stay competitive.
“If one of these companies solves its pension problem by shunting it off to the federal government, then for competitive reasons the others have to do the same thing,” said Zvi Bodie, a professor of finance at the Boston University School of Management and longtime observer of the government’s pension insurance system. “That is the death spiral.” nThough the automakers’ plans each have a gap between what they have on hand and what they owe their retirees over the years, if they failed, most of that shortfall would be made up by workers in the form of smaller benefits — not by the companies or the government. The government estimated that Chrysler’s plan was $9.3 billion short as of last November — but said it would be responsible for only about $2 billion of that. Most of the shortfall would be sliced from workers’ benefits. At G.M., the estimated shortfall was $20 billion as of last November, but the government would assume $4 billion of obligations and G.M.’s workers would lose the rest.
When Daimler sold a majority stake in Chrysler in 2007 to a private equity firm, Cerberus, it promised to pay $1 billion into the government’s pension insurance program if the pension plan failed within five years. The Treasury could try to persuade Daimler to put some of that money into the plan to avoid a failure. For years, traditional pensions — those that shield workers from market risk — have been in a slow decline, with troubled sectors like aviation and steel shedding their plans in bankruptcy court as new types of individually managed benefits like 401(k) plans have taken hold. But big sectors, particularly manufacturing and financial services, have clung to the old plans. The Pension Rights Center, a consumer group in Washington, estimates that 18 million Americans are still building up such benefits every year, and millions more retirees are receiving guaranteed payments from their former employers. “Those that are fortunate enough to have those plans are sleeping soundly,” said Karen Ferguson, director of the center.
The loss of the auto pensions would be devastating partly because Detroit sustains many other businesses and partly because of their history. It was the United Automobile Workers union, more than any other force, that pushed Congress to enact laws forcing companies to put money behind their pension promises and creating the federal guarantor. The failure of a major auto workers plan would be a blow to the whole system. Not only would Ford have reason to opt out of the expense of maintaining a pension plan, but so would Toyota and Honda, which also have pension plans at their American plants, said Teresa Ghilarducci, a professor of economics at the New School for Social Research and former member of the P.B.G.C.’s advisory board. Professor Ghilarducci said she believed the Obama White House had selected people for its auto task force who understood these stakes, and would strive to find some middle ground.
The pension insurance agency, currently operating with an $11 billion deficit, has long viewed the automakers’ plans with anxiety, though its officials declined to discuss the situation. G.M.’s plan alone is bigger than the guarantor. The agency has roughly $67 billion in assets to cover the benefits of nearly 4,000 failed pension plans; G.M. has $84 billion in trust just to cover promises to its own workers. In a failure of that size, the agency’s immediate challenge would be logistical, not financial. Its insurance covers a simple benefit, not the much richer pensions negotiated over the years by the U.A.W. It would have to process applications from thousands and thousands of workers, most of whom would get the bad news that they were going to get less than promised.
The government’s maximum benefit is $54,000, but coverage falls off rapidly for workers who are younger when their plan fails. For a 62-year-old the maximum is $42,660, and for a 55-year-old, it is only $24,300. Calculating which workers would bear how much of the losses would be fiendishly complex. The government’s rules favor older participants and contain tripwires and arbitrary cutoffs that can leave similar workers with sharply different benefits. None of this can be sorted out in advance, because the calculations also depend on the amount of money in a pension fund on the day it terminates — something the pension benefits corporation does not yet know.
Some pension specialists, aware of these difficulties, are hoping the Obama administration’s auto task force will spare at least the G.M. pension fund. Not only would that let laid off workers keep receiving full benefits, but it could also break the death spiral among other plans. For traditional pension plans, “maybe this is their last stand,” said Jeffrey B. Cohen, a partner with the law firm Ivins, Phillips & Barker in Washington who was chief counsel for the Pension Benefit Guaranty Corporation from 2005 to 2007. If the automakers’ plans fail, he added, “the biggest domino will have fallen for the P.B.G.C.”
Recovery Without Rebalancing
The Economist has a long hard look at the glimmers of green shoots of hope we've all been discussing, and comes away a bit skeptical. The problem is this: government policy will probably put an end to the decline in output, but from where do we get new demand?As the inventory adjustment ends and the stimuli kick in, America's slump is sure to ease. Cushioned by the government, the economy may even begin to grow again before too long. But it is hard to see the ingredients for a recovery that is robust enough to stop unemployment rising. Weakness abroad will crimp exports. America's banks are propped up with public capital, but their balance-sheets are clogged with toxic assets.
Consumer spending and firms' investment will be dragged lower by the need to pay back debt and restore savings. This will be a long slog. Private-sector leverage, which rose by 70% of GDP between 2000 and 2008, has barely begun to unwind. At 4%, the household savings rate has jumped sharply from its low of near zero, but it is still far below its post-war average of 7%. Higher unemployment and rising bankruptcies could easily cause a vicious new downward lurch...
For the time being, the brightest light glows in China, where a huge inventory adjustment has exaggerated the impact of falling foreign demand, and where the government has the cash and determination to prop up domestic spending. China's stimulus is already bearing fruit. Loans are soaring and infrastructure investment is growing smartly. The IMF's latest forecast, that China's economy will grow by 6.5% this year, may prove conservative. Yet even China has its difficulties. Perhaps three-quarters of the growth will come from government demand, particularly infrastructure spending.
American consumers are tapped out, and China has huge reserves at its disposal. The hopeful conclusion everyone has attempted to reach is that China will begin consuming more and America producing more -- that the engine of recovery would be a rebalancing of global trade patterns. As Brad Setser writes, however, IMF forecasts indicate that this is unlikely. Quite the opposite, in fact. Global imbalances may soon boil down almost entirely to one very straightforward imbalance -- China's surplus will be America's deficit. And the financial implications are pretty clear. Setser notes that China's $2.3 trillion in claims on the world would double in the next four years, based on its projected surplus.
What does this mean, exactly? Well, one thing it could mean is that IMF projections are off, but let's assume for the moment that that's not the case. In that case, it means you have in China a country convinced that an undervalued RMB and export-led growth are important to its development, even if that means continued accumulation of claims beyond a level with which it already seems somewhat uncomfortable. But that also implies an America growing enough to support continued imports from China, which in turn implies economic growth and a somewhat functioning banking system.
But if The Economist's outlook is in the right ballpark, that outcome is in doubt. America may need to spend hundreds of billions of dollars or more on a banking rescue, and it may need to top up its stimulus plan, also to the tune of hundreds of billions of dollars. Those steps would prove to be tricky, politically, but they'd also probably make policymakers nervous. Somewhere out there is an American debt level that will precipitate a sudden stop in dollar demand and some very unpleasant macroeconomic choices.
The logical outcome staring out at me is the negotiation, in some form, of a new international financial framework between America and China. Forget decoupling, the two nations are more inextricably linked than ever (and not just in macroeconomic terms). A deeper level of communication and understanding between the two powers is an inevitability anyway, and it makes sense to begin the conversation with the financial crisis.
What would it involve? Presumably a commitment by China to keep buying American debt, so that America can clean up its banks and do its next round of stimulus. Similarly, there would be an American commitment to meet certain Chinese macroeconomic demands (the most important of which would be not to default, and not to inflate). Beyond that, the sky is the limit. Is this a reasonable expectation? A very rapid turnaround in American growth in the second half of the year would make it less likely, as might domestic politics in either country. But it wouldn't surprise me.
Emanuel Says Obama Has '100% Confidence' in Fed Chief Bernanke
President Barack Obama fully backs Federal Reserve Chairman Ben S. Bernanke, who has come under scrutiny for his role helping engineer Bank of America Corp.’s purchase of Merrill Lynch & Co., a top White House aide said. "The president has 100 percent confidence" in the U.S. Fed chief, White House Chief of Staff Rahm Emanuel said in an interview on Bloomberg Television’s "Political Capital with Al Hunt," airing this weekend. Bank of America Chief Executive Officer Kenneth D. Lewis told investigators for New York Attorney General Andrew Cuomo that he was under pressure from Federal Reserve and Treasury officials to close the merger, even though Lewis was concerned about Merrill’s deteriorating finances. Lewis said regulators were worried that the deal’s collapse would cause systemic risk and leaned on the bank not to reveal the situation to shareholders. Bernanke said April 23 through a spokeswoman that no Fed officials had advised Lewis on any disclosures.
Emanuel also said the so-called stress tests on the 19 biggest U.S. banks will reveal a "gradation," with some being judged "very, very healthy" and others needing assistance. The public will be given details of the test results early next month, as the administration seeks to dispel the "fear and confusion" that has driven bank stocks down, he said. "There will be full transparency there," Emanuel said. Emanuel, 49, a former congressman from Illinois, rejected criticism by some investors that the reviews are based on overly optimistic assumptions, saying they reflect "pretty strenuous economic conditions." "The stress test was developed as a way to have a demarcation that put that fear and confusion aside," Emanuel said. "That will be the test of the stress test: whether it actually removes the fear and gives you a sense of clarity."
On the nation’s struggling automakers, Emanuel said the Obama administration is working in an "aggressive" way to get an agreement between Chrysler LLC, Italian automaker Fiat SpA and stakeholders to avoid a bankruptcy filing next week. The talks may come down to the April 30 deadline, he said. Senator Debbie Stabenow, a Michigan Democrat, said in an interview earlier this week that the U.S. Treasury Department is pushing Chrysler to prepare a bankruptcy filing as a matter of "due diligence." Auburn Hills, Michigan-based Chrysler has until the end of the month to seal an alliance with Fiat, get its banks to agree to cut the company’s debt and reach agreements with the United Auto Workers and Canadian Auto Workers unions on labor-cost reductions, or face a likely bankruptcy.
On the issue of how the administration will deal with those responsible for interrogating suspected terrorists, Emanuel said Obama doesn’t want memos written by Bush administration lawyers authorizing the CIA’s use of aggressive techniques to become a "a proxy to litigate the past and everything that went into the past around the war, around torture, Abu Ghraib, Guantanamo." Emanuel said he wouldn’t put "his thumb on the scale" in determining whether the lawyers, or senior Bush administration officials like former Vice President Dick Cheney, should be prosecuted. "Here at the White House, we don’t make the decisions to prosecute or not," he said "That’s not to be addressed by us," he said. "That should be addressed by the Department of Justice."
He dismissed criticism by Karl Rove, once the top political adviser to former President George W. Bush, that Obama was politicizing the issue when he authorized the release of the memos. "He’s allowed his opinion," Emanuel said of Rove, calling it "ironic," because "the entire attempt here by the president is to do exactly the opposite." On Pakistan, where Taliban troops are just miles away from the nation’s capital, Emanuel said the administration’s message to the Pakistanis is the same in private as it is in public. The government of President Asif Ali Zardari has to be "willing to effectively engage and deal with the security of their country" so the Taliban doesn’t pose as much of a threat. Emanuel said that in Obama’s first 100 days in office the president has logged some "dramatic" legislative accomplishments and succeeded in rehabilitating the U.S. image overseas. He also said the public mood in America had improved. "Consumer sentiment is up," he said. "Some elements of that have to do with how the economy is, but also how they’re feeling about the economy."
Brazil, China and Russia Consider IMF's First Bond Offering
The International Monetary Fund is finalizing plans for its first bond offering and lining up Russia, China and Brazil as potential purchasers, said officials gathered for an IMF meeting. Brazil, China, Russia and India -- the so-called BRIC countries -- met Friday, in part, to hash out a common position on terms they want to see in such a bond, said Brazilian Finance Minister Guido Mantega. Brazil plans to buy the bonds, he said, to contribute to the quadrupling of IMF resources to $1 trillion. A new bond "is an important instrument" to help the IMF "meet the capital needs of emerging countries," said Mr. Mantega, who would not estimate how much Brazil planned to buy. .
Russian Finance Minister Alexei Kudrin said Moscow would be a purchaser as well, although he also didn't name an amount. "We'd like to buy IMF bonds," he said after a speech at the Peterson Institute for International Economics. "We're interested." China is expected to buy $40 billion of the bonds, British Prime Minister Gordon Brown said at the Group of 20 summit of industrialized and developing countries early this month. It isn't clear whether India would buy, too. The IMF has been working on a bond offering since at least January as a way to increase the amount of money it has to lend struggling nations. Japan has made the IMF a $100 billion loan. Brazil and others prefer a bond because they consider it more flexible than making a loan and easier to reverse. "We want ways to get the money back if conditions change," Mr. Mantega said.
The bond would be sold to central banks, not to individual investors. Even so, some IMF critics at development institutions worry that IMF bonds could become competition for developing-nation sovereign debt and increase the interest rates those nations would need to pay. BRIC countries want to make sure the bonds are tradable on the secondary market. Mr. Mantega said the IMF and the BRIC countries are discussing terms for the bonds, whether they could be counted as part of a nation's reserves, and the interest rate the IMF would pay, among other issues. The yield "can't be very much different from U.S. Treasury bonds," he said. "Maybe just a little more." Negotiations could wrap up by next week, he said.
The IMF didn't comment on its plans to issue a bond. At the London G-20 summit, IMF Managing Director Dominique Strauss-Kahn said the IMF has the authority to issue bonds. "China has said that it could be interesting to use ... this vehicle [rather] than another one," he said at the time. The bond would probably be denominated in an IMF quasi-currency called special drawing rights. Russian and Chinese officials have suggested that SDRs could eventually replace the dollar as a global reserve currency; having an SDR bond could bring them a step closer to that goal. Separately, Mr. Mantega said he believed Brazil will avoid a recession this year, with gross domestic product growing 2%, followed by 4.5% growth next year. His estimates are far more optimistic than the IMF's, which this week forecast that Brazil's economy would contract by 1.3% this year and grow 2.2% in 2010.
Geithner Sounds Darker Tone Than G-7
Treasury Secretary Timothy Geithner said the world's economies are beginning to stabilize but cautioned that it is "too early" to say risks have receded and that more action needs to be taken to counteract the worst financial crisis in generations. "Financial conditions in some markets have shown modest improvement," Mr. Geithner said, adding that it would be "wrong to conclude that we are close to emerging from the darkness that descended on the global economy early last fall." The secretary struck a more somber tone than a statement released by the Group of Seven finance ministers who gathered in Washington before weekend-long meetings at the International Monetary Fund.
In their statement, the finance ministers said "the pace of decline in our economies has slowed and some signs of stabilization are emerging. Economic activity should begin to recover later this year amid a continued weak outlook, and downside risks persist." The finance chiefs pledged to continue efforts to shore up financial institutions across the globe, including providing "liquidity support," injecting capital into banks and taking "all necessary actions to ensure the soundness of systemically important institutions." The group also promised to "deliver the scale of sustained fiscal effort necessary to restore growth."
Mr. Geithner said the ability of other countries to shore up their economies is critical to the U.S. recovery. "Recovery in the U.S. depends significantly ... on recovery in those large and previously rapidly growing markets," he said. Some economists worry about growth in Europe. The meeting took place the same day the U.S. released the methodology behind stress tests it is conducting on the nation's 19 largest banks. The tests are part of the U.S. response to the financial crisis. Mr. Geithner said he "did not discuss the preliminary results" of the stress tests with his counterparts but said they all agreed to make sure there's "enough capital in the financial system." Mr. Geithner has pledged to make enough capital available so banks can resume making loans.
Shareholders Be Damned!
How the Washington gang brought Ken Lewis to heel and forced Bank of America to go through with its acquisition of loss-ridden Merrill Lynch. If everything's coming up roses, why are corporate insiders selling? It was just like one of those noir flicks crafted from a Raymond Chandler novel. Imagine the opening scene. The time is last December. It's a cold night with the wind howling. The camera zooms in on a dimly lit room in the center of which sits a bespectacled banker sweating bullets, his body limp in a ratty chair, surrounded by a bunch of nasty-looking hombres wearing double-breasted suits, sinister fedoras and stone expressions.
One of the gang, obviously a capo, leans menacingly toward the banker and snarls, "Do what we tell you to do or you've had it!" The banker knows he's in the tightest spot he has ever been in his 62 otherwise wonderful years on this blessed earth. (Worse by far than the time he had to collar that killer disguised as a little old lady threatening to blow the bank up with a stick of dynamite "she" had sequestered in "her" bloomers.) If he agrees to do what they want, he risks losing his good name and with it the irreplaceable precious fruits of a lifetime of earnest labor. If he doesn't...
The toughs grow impatient. Shaking with fear, the banker rises from the chair to face his remorseless tormentors. From the hidden depths of his being he somehow summons up the courage to declare in a suddenly strong and unwavering voice: "I'll take it up with my board." OK, so this audacious show of verbal defiance may not quite reach the level of "Give me liberty or give me death." But we live in a less eloquent age than did Patrick Henry and, remember, our hero is a banker, not a fiery patriot. And it takes a very brave man to tell his board anything more substantive than what's on the menu for lunch.
Moreover, this was no celluloid chiller. It was the real thing. The banker, as you may have guessed, is Ken Lewis, CEO of Bank of America . And the bad guys harassing him are Hank Paulson, then Treasury secretary, and Ben Bernanke, head of the Federal Reserve, aided and abetted by shadowy henchmen. The script for this stranger-than-fiction melodrama was provided by that rabid (and fiercely ambitious) bulldog New York state attorney general, Andrew Cuomo. Mr. Cuomo, back in February, had been grilling Mr. Lewis on what his keen canine eye detected as another indignity -- the awarding of $3.6 billion to employees of Merrill Lynch, the giant brokerage firm acquired by BofA on Jan. 1 of this year.
What had Mr. Cuomo frothing at the mouth was that the $3.6 billion was shelled out even though Merrill suffered losses upwards of $15 billion in 2008's fourth quarter alone. We must point out how fortuitous it was that losses had not reached, say, $30 billion, since by the peculiar calculus being used to reward red-ink, that would have boosted Merrill's bonus tab to $7.2 billion. And enraging the chronically enraged Mr. Cuomo all the more was that the bonuses were distributed even while the losses manifested themselves but were not disclosed, least of all to the bank's shareholders. According to Mr. Cuomo's dour narrative, the product of four hours of interrogation of Mr. Lewis, the merger with Merrill was proposed in September after two days of due diligence (sounds more like due negligence to us).
It gained approval of shareholders of both companies on Dec. 5. Barely a week later comes the revelation: Merrill's losses were spiraling ever higher, causing an increasingly frantic Mr. Lewis to weigh calling the marriage off. He reckoned he could legally do so thanks to MAC (material adverse event), recognizing that $7 billion more in losses than had been projected when the merger was agreed to was a very big MAC, indeed. He diffidently informed the powers-that-were of his plan to nix the nuptials and was summarily summoned to powwow with them in Washington that very evening. And it was there that Messrs. Bernanke and Paulson put the screws to him to not break the deal lest he trigger a systemic calamity.
On Dec. 21, Mr. Lewis, still of a mind to ditch the merger, communicated his determination to Mr. Paulson, who bluntly warned that he would give the boot to Mr. Lewis and his board unless the acquisition went through. To that bald threat, Mr. Lewis' retort was a resounding purr: "That makes it simple. Let's de-escalate." And de-escalate he did. The merger became a done deal right on schedule. To help salve any hurt feelings, Bank of America got $118 billon in loan guarantees from rich Uncle Sam to absorb any potential losses from Merrill.
We don't mean to beat up on Mr. Lewis. We haven't the faintest doubt his refusal to stand tall was not prompted by fear of being fired. Heavens to Betsy, no. Rather, it likely sprang from too much heart: a deep-seated solicitude for his shareholders and a touching desire to shield them from the awful truth about the Merrill acquisition. Sure, they're the putative owners of the company, but best not to upset them over something they'd inevitably learn about in due course when those losses started to eat up the bank's bottom line. As to Mr. Paulson and Mr. Bernanke, we're sure they, too, are decent souls and value truth, except when it's inconvenient. Despite vows of transparency and all that blah, they were more than complicit in a rather shabby cover-up; they conceived it, pursued it and made certain through means fair and foul it was carried out.
Why, then, should anyone worry about the results of the bank stress tests slated to be released early next month and have inspired so much anticipatory dread on Wall Street? As one wise cynic asks, given its demonstrated devotion to the banks and the financial markets, do you really think that the Washington gang is going to throw anybody of significance under the bus? Since we ended the last item with a question (two, to be precise), we feel, just in the interest of interconnectivity, we should begin this one with a question: How come, if the stock market is telling us everything is coming up roses -- the Dow has shot up 23% since March 9, the S&P 500 28% and dear old Nasdaq 34% -- corporate insiders are selling like there's no tomorrow?
Much as anything, we suspect, what has given legs to this rather improbable but undeniably impressive rally is the rally itself. Let us assure you that we haven't gone mystical (we've enough sins to atone for without adding still another). Let's put it this way: As a stimulus for equities, come rain or come shine, just about nothing beats higher prices. They entice risk-shy investors, including or especially (hard to decide) those who have been mauled by the bear market, to edge off the sidelines and get their feet wet. Higher stock prices (as Ken Lewis might say) escalate expectations and earnings estimates of analysts, most of whom are, in any case, reflexively bullish.
They give the yak-yaks on Tout TV something to crow over and excite their innocent viewers. In other words, they serve to inject a dose of euphoria into the investment atmosphere, particularly after a long and morose stretch of gloomy markets, like last year's. Of course, rising equity prices also inspire less chimerical reasons for the quickened interest in the stock market. They are widely taken by institutions, individuals and kibitzers as a welcome harbinger of economic recovery, and there's been a lot of that lately. Our own feeling, as you may have gleaned, is that such hopes are heavily laced with wishful thinking.
Leading us to the question with which we began these musings: If those now infamous shoots of recovery are popping up all over, why would insiders be so aggressively dumping stocks? Yet, they indisputably are. According to a study prepared for Bloomberg by Washington Service, a research outfit, directors, officers and the like have sold $353 million worth of stock in this fading month, or 8.3 times the total bought. As a matter of fact, according to the firm, insider purchases of $42.5 million are on track to make April the skimpiest month for such buying since July 1992. The pace of selling in the first three weeks of this month, incidentally, was the swiftest since the market peaked and the bear came out of hibernation with a vengeance in October '07.
We're quite aware that insiders are not infallible. But they are, after all, in the front lines of commerce and industry and so presumably have a better fix on the economy and the prospects for recovery than analysts and economists, whether of macro or micro persuasion. And just as they wouldn't be laying off people in such extraordinary numbers if they thought their business was about to rebound soon, they'd be loath to liquidate their holdings in such an emphatic way if they espied a turnaround in the offing. It all boils down to this: Nobody ever sold a stock because they thought it would go up. And as a group, corporate insiders obviously are scarcely enthusiastic about the prospects for a genuine bull market.
We Need Public Directors on TARP Bank Boards
by Robert Reich
I don't know whether Bank of America shareholders will oust Ken Lewis from his chairmanship next week. I don't know if Treasury Secretary Timothy Geithner will eventually do it, either. What really worries me is I don't know who would actually be responsible for doing the deed, or by what criteria. When it comes to keeping top corporate executives in line we usually entrust the job to shareholders -- or, as a practical matter, institutional investors that represent shareholders' interests. When it comes to keeping top public servants in line we generally trust voters -- or, as a practical matter, the elected officials who represent them. But when, as now, the public has committed large amounts of its money to particular companies in the private sector, we're in a quandary.
The $45 billion we've sent to the Bank of America should give the public some say over whether Mr. Lewis remains in his job because he is now accountable to us as well as to his shareholders. But to which group should he be more accountable? And: Is Mr. Lewis's main job still to make money for his shareholders, or does he now have a higher public responsibility to lend more money to Main Street? Was that public responsibility also paramount last fall when Federal Reserve Chief Ben Bernanke and Treasury Secretary Hank Paulson told Mr. Lewis to proceed with the Merrill-Lynch merger -- and when, according to Mr. Lewis's sworn testimony, he believed they didn't want him to disclose Merrill-Lynch's financial losses?
It's not even clear who represents us as members of the public. Next month, AIG holds its annual shareholders meeting. Are you attending? Maybe you should. The $170 billion we've committed to AIG so far amounts to nearly 80% of its shares. Some private shareholders are pushing for a vote to oust an AIG board member and to further restrict executive pay. But these dissident shareholders represent only a slice of the 20% of AIG's private owners. AIG has three public trustees, each of whom is being paid $100,000 a year. Should they vote with the dissidents? There's no way to know, because the public trustees have no charter or mission statement to guide them, and they don't seem to report to anyone, either.
The question of public representation keeps growing. Now that our loans to Citigroup have been turned into common stock, you and I and other members of the public are poised to become Citigroup's biggest shareholder, holding about 36% of its voting shares. But who represents us, and how should they vote? The Obama administration apparently wants to do more of these debt-for-equity swaps. They're a means to get more capital to the banks without returning to Congress to ask for more money -- which Congress would be very reluctant to provide. But the swaps also expose the public to more risk. At least loans have to be repaid. Share prices, as we've seen, sometimes go down. Yet without a means for representing the public's interest in the governance system of these banks, we can only rely on the Treasury secretary to keep a watchful eye over the ongoing decisions of every bank. That's unrealistic.
Even if our public interests were being represented, it's not clear exactly what they are beyond getting repaid or possibly making a bit of a profit. Presumably taxpayer dollars are being committed because of some larger public purpose. Yet companies are designed to make profits, not to fulfill public responsibilities. Suppose the government, representing the public, instructs the Wall Street banks it now controls to lend more money to Main Street. But top bank executives believe they can better raise share prices by using the money for new investments, bigger dividends, or to lure and retain "talent?" The executives have a duty to do what the government tells them to do, but they have an even larger fiduciary responsibility to their shareholders to raise share prices.
Suppose the government instructs AIG to clean up its balance sheet, but AIG's executives think they can make more money by inventing new off-balance-sheet derivatives? The executives' primary job is to make money for their shareholders. The fact that the public now owns 80% of AIG doesn't change that. Suppose we tell General Motors Corp. -- now partly ours -- to shift its fleet to more fuel-efficient cars. Yet its executives know that as long as gas prices are low, Americans remain infatuated with highly profitable SUVs and pickup trucks? GM executives would have a perfect right, if not a duty, to disregard what we as citizens tell them to do in favor of what shareholders want them to do.
Democratic capitalism entails two systems by which people with significant power are held accountable. One is capitalism, by which companies and their executives are accountable to the market. The other is democracy, by which public agencies and their leaders are accountable to voters. Americans may disagree about how much we want of one or the other, but most people understand we need both systems of accountability. When we confuse the two, we run the danger that people with great power may escape accountability altogether.
That's the problem right now. Bank of America's Ken Lewis is fully accountable to no one. AIG's public trustees have no charter or public mission to guide them. GM is trying to satisfy the Treasury and its shareholders simultaneously, and is doing neither very well. Even as the public takes larger ownership stakes in big Wall Street banks, the public has no systematic means of expressing its growing interest, whatever it is. Perhaps government had no business meddling in the private sector to begin with. AIG, the big banks and the auto companies should have been forced to work out their problems with their creditors, or else be put into temporary receivership until their profitable units or nonperforming loans could be sold off. Perhaps any company that's judged too big to fail is too big, period. Antitrust laws should have been used to break these giants up before they got so big.
These arguments may be relevant to the recent past and possibly to the future, but they're beside the point right now. The immediate challenge is to sort out public from private responsibilities and to create clearer lines of accountability. At the least, when government takes an ownership stake in a company, the pubic should be represented on that companies' board of directors in direct proportion to the size of its stake. Those public directors should be appointed by the president. In exercising their oversight function, they should seek guidance from the president and his top economic officials. And their votes on critical issues before the board -- such as whether to fire Ken Lewis -- should be made public.
Fiat Is a Winner in Chrysler Debt Talks
Chrysler LLC's lenders continued to soften their stance toward a debt-restructuring plan with the Treasury, concessions that lenders say are proving most beneficial to a player not even in the room: Italian auto maker Fiat SpA. The lenders said Friday that they would trim their $6.9 billion in secured debt to $3.75 billion, down from a $4.5 billion offer made Tuesday. The creditors dropped their request for $1 billion of preferred stock in Chrysler and a separate request that Fiat put $1 billion of cash into Chrysler as part of an alliance between the car makers, people familiar with the matter said.
The lenders stayed firm in their request to keep 40% of the equity in a restructured Chrysler, said a person familiar with the matter. That leaves the lenders and the government still far apart on the main terms: The government wants the lenders to keep just $1.5 billion of the debt and 5% of the equity of a revamped company. The government has set an April 30 deadline to determine the auto maker's fate. Debt holders have expressed agitation about Fiat, itself weakened by the global recession. As designed, the Turin company would get 20% of the auto maker without putting a dollar of its own capital at risk. Fiat's main commitment to Chrysler would be to provide some technology and to share the guts, or "platforms," of certain models.
The U.S. government has already agreed to forgive the $4 billion it lent Chrysler and to inject another $6 billion into the auto maker to finance its possible bankruptcy and operations. Most important to Chrysler's health, the government has negotiated a deal with the United Auto Workers union that should reduce the company's pension and health-care costs, lifting a burden off the company. For the lenders, the fear is that Fiat doesn't have enough at stake in the negotiations, given it will likely assume day-to-day control of the company without putting up its own money.
Several lenders said their concern is Fiat will overcharge Chrysler for new technologies or parts, effectively stripping money out of Chrysler over time via technology-transfer agreements. It could also make in-kind equity contributions over time to build up its equity stake if it does decide Chrysler has a future. This is why lenders' proposals to the government have demanded senior management appointees, governance provisions and technology transfers that are acceptable to them. The lenders also are pushing for a board seat and rights to oversee how Fiat governs the company. The financial stakes are greater for the lenders, the U.S. government and the UAW. Each could lose billions of dollars if Chrysler can't eventually pay its bills or its equity stake turns out to be worth little.
"Fiat is getting a good deal," said Aaron Bragman, an analyst at IHS Global Insight. "The ownership equity stake is coming with no money. They are getting access to North America, dealers and manufacturing. The only thing they are putting in is tooling. There is very little risk for them." Mr. Bragman said Fiat has the strongest negotiating position because "they are needed. They are coming at this from a position of strength." Mr. Bragman said it is unclear how long $6 billion will keep Chrysler afloat, but its purpose is to tide the company over until private financing becomes available again. He said $6 billion won't last the company even 18 months. Still, Fiat Chief Executive Sergio Marchionne risks retooling a company with an empty product pipeline and a bloated dealership network.
Rats Feed Off U.K. Recession as Trash Mounts, Buildings Empty
For British rats, the worst of times has turned out to be the best of times. The vermin more associated with the Dickensian era than modern Britain are thriving, with shuttered shops and half-built housing sites to live in, rotting piles of uncollected garbage for dinner and fewer exterminators sent out to kill them. "Sometimes I drive into the car park and there are at least 20 of them in the bins," said Paul Hood, 46, a north London resident. "You see them running away in the headlights. During the day, they just sit in the bushes sunbathing." As the biggest economic bust in 60 years fostered a boom for rodents, municipalities were called an estimated 700,000 times to deal with infestations in the last 12 months, compared with 650,000 the previous year, said Peter Crowden, chairman of National Pest Technicians Association Ltd.
The rat population has swollen by 13 percent this year to more than 50 million, one for every person living in England, according to an industry consensus cited by Crowden. Rats and mice are capable of spreading more than 35 diseases, including a fever inducing nausea and muscle aches passed to humans either via a bite or the rodent’s urine. "The government needs to look at this," Crowden said. "Budgets are being cut. If they don’t do something, it’s going to be a serious public-health risk." The economy is expected to shrink 3.5 percent this year, Chancellor of the Exchequer Alistair Darling told parliament in his budget speech this week. The housing market slump has starved local authorities of property development and planning fees that they used to fund services like waste removal.
Weekly collections at 12.5 million British homes fell 7.1 percent in the last three months of 2008 from a year earlier, according to government data compiler WasteDataFlow. Those providing services on a biweekly basis increased 32 percent. "They jump out of the bins," said Jason Goodright, 36, a neighbor of Hood at Larch Close in north London. "People are frightened and just throw rubbish from a distance onto the ground, making the situation worse." U.K. councils, which have a total income of 106 billion pounds ($157 billion), face a deficit of up to 7 billion pounds this year because of the decline in building work, according to property consultants EC Harris LLP. A London-based spokesman for the Local Government Association, or LGA, which represents English and Welsh municipalities, declined to comment.
The recession is also leading to more empty stores and unfinished homes across Britain as businesses collapse. More than four out of five councils are currently reporting an increase in empty properties, according to the LGA. A record 15 percent of British stores will be vacant by the end of 2009 as 1,600 retailers go out of business, according to the world’s biggest credit-checking company, Experian Plc. "Wherever there are empty properties, there’s a problem," said Kevin Higgins, a spokesman for the trade group British Pest Control Association. "It’s not just rodents, it’s cockroaches as well. It’ll have a big effect as time goes on." And it’s not just affecting vacated buildings. Gurinder Sahni, director of Master Traders Ltd., which exports ethnic food to mainland Europe from London, said he’s lost about 500 pounds worth of goods, including almonds, fruit juice and even palm oil to rats during the past year. "They come in at night and just eat everything," said Sahni. "There’s no favorite. They’ll eat anything."
IEnquiries from homeowners are rising at Rentokil Initial Plc, the world’s biggest rat-catcher, said Savvas Othon, who’s in charge of developing the company’s new pest-control techniques in the U.K. Rentokil’s products include pasta-based and chocolate-scented rat baits as well as traps set off when a rodent breaks an infrared beam. As the downturn bites, consumers and businesses are looking for ways to cut exterminator costs, including trying home-grown solutions, not always successfully. "We’re coming across people putting down improvised traps and over-the-counter products and finding they’re not getting success," said Jim England, head of London-based Protex Pest Control Ltd. "Inevitably, they end up having to get us in. It costs them more in the end." Hood in north London relies on his two smooth-coat Jack Russell terriers to get the job done. "They catch one every other day," he said. "They kill more than the pest controller," he said.
The most common complaint to councils involves the brown, or Norwegian, rat, according to the National Pest Technicians Association, which is based in Kinoulton, England. The brown rat can breed throughout the year, with a female producing up to five litters during that period of as many as a dozen babies. Damage to infrastructure caused by rats, which can harm buildings by burrowing underneath their foundations, costs the U.K. economy as much as 209 million pounds a year, according to the Chartered Institute of Environment Health. "If we aren’t careful, the recession will play into the hands of both rats and mice," Crowden said.
Italy's Mafia Thrives In Global Financial Meltdown
While businesses around the world are hunkering down for survival, the Italian mob is living a golden moment. Italy's various organized crime syndicates _ often lumped together colloquially as Mafia Inc. _ are gobbling up gas stations, muscling in on supermarket franchises, making loans to cash-starved businesses, taking over trattorias and acquiring buildings in swank neighborhoods in Rome and Milan, investigators say. These mobsters have lots of what is in short supply for many businesses these days _ liquidity _ as well as centuries-honed expertise in preying on the vulnerable, whose ranks are swelling in the current financial crisis. It all means the mob is free to sink cash into two areas that lie at the heart of the global meltdown: real estate and credit markets.
The crime syndicates are flush with billions of euros from extortion rackets, drug trafficking and booming sales in fake designer clothing made in China expressly for the Italian mob _ an increasingly lucrative trade as hard-hit consumers search for bargains, prosecutors and police said in recent interviews. For the mob bosses, the global economic meltdown "is only an advantage," said anti-mafia prosecutor Franco Roberti, in his office in Naples, the chaotic port city that is home to the Camorra, one of the Italy's major crime syndicates. Italy has scored some spectacular successes in its decades-long fight against the Mafia, capturing top bosses, persuading turncoats to testify, and encouraging ordinary citizens to resist shakedowns. But the mob keeps growing _ and its drive in recent years to grab chunks of legitimate business is paying off big time in the financial crisis. In Rome, in the high-rent neighborhoods around the Spanish Steps, Piazza Navona and Trevi Fountain, mobsters are snapping up real estate, anti-Mafia prosecutor Giancarlo Capaldo said in a courthouse interview.
In probes of what Capaldo described as "indications" that mobsters have taken over hotels, restaurants and cafes in Rome, police seized assets of some of these businesses, although the establishments remain open. "These places are well run because they want to make money," Capaldo said. He declined to identify the establishments because the probe is still being conducted, saying only that "you'll find some of them in tourist guide books." Capaldo's office also confiscated auto dealerships in Rome from suspected Camorristi or their allies. "The Camorra makes the money here in the south, but it invests it in legal activities up north," customs and tax police Gen. Giovanni Mainolfi said in his Naples office. If the mobsters built posh places in the largely undeveloped south "they would stand out, but do it in Milan ... and they blend right in," Mainolfi said.
In an operation code-named "Easy Money," police this year seized a hotel in the exclusive Tuscan sea resort of Punta Ala, as well as a supermarket, two Ferraris, a gas station in the wealthy northern Reggio Emilia region and other properties, altogether totaling euro30 million (about $40 million). All were believed to be owned by the Camorra, flush with drug profits. The revenues raked in by Italy's crime syndicates would be more than respectable for many a stock market-listed company these days _ although, of course, the mobsters hardly issue annual reports. The Rome-based Eurispes think tank has estimated that in 2008, "Mafia Inc." earned euro130 billion (then $167 billion), or about 8 percent of Italy's GDP, from its criminal activities, nearly half of that from drug trafficking. Eurispes, which analyzes social, economic and criminal trends, said loansharking brought in an estimated euro12.6 billion ($17 billion) of that income. It calculated that some 180,000 merchants and other businessmen got their loans, directly or indirectly, through organized crime in Italy.
With much of the world financial crunch making its impact in Italy in the first months of this year, it's too early to tell how much more profit organized crime might make. Government probes have found that as they launder illicit revenues, mob bosses are increasingly moving their money out of the underdeveloped south where the syndicates are rooted and into affluent central and northern Italy. In March, Italy's intelligence services warned in a report that rising unemployment and the credit crunch could help crime syndicates tighten their tentacles around vast swaths of the nation's business sector, including supermarkets, real estate and tourism. A main engine of the mob's recent strength _ the age-old practice of loan-sharking _ is thriving as banks hoard cash, allowing the Mafia to elbow in on legitimate businesses. The mobsters are poised to "acquire control of businesses in difficulty, especially through their consolidated practice of loan-sharking," as well as to "snap up assets put on the market by enterprises experiencing liquidity crises," the intelligence report said.
The dire predictions seem borne out by businessmen's complaints. SOS Impresa, an Italian business lobby dedicated to fighting organized crime, estimated in a report late last year that in the Camorra has "multiplied by 10, 100, perhaps 1,000 times, its penetration of the economic and social fabric, stepping up its business presence in our country, in Europe and the world." In Rome, Camorra men or those in their employ have been spotted hanging out at pawnbrokers' auctions to learn which businesses might be in financial straits, said Carabinieri Lt. Col. Roberto Casagrande. Those businesses would then be approached _ and offered a loan they could scarcely refuse. The Camorra offers shaky businesses attractive interest rates, calculating that the businesses will end up part of its economic empire if the owner falls behind on payments, Roberti said. The mobsters sometimes leave the original owner as a figurehead to thwart suspicion, police said.
The 'ndrangheta crime syndicate _ based in Calabria, the "toe" of Italy's boot _ is also brazenly taking over struggling businesses and snapping up prime northern Italian property at a bargain during the real estate slowdown, investigators say. Genoa Mayor Marta Vincinzi told a rally against organized crime in Naples late this spring that Mafia bosses, particularly from the 'ndrangheta, were "gobbling up entire neighborhoods" and pressuring merchants to pay "protection money" in the gritty, northwestern port city. Investigators believe that flourishing ties with Colombian cocaine cartels have helped the 'ndrangheta to surpass Sicily's Cosa Nostra in international drug dealing. Cosa Nostra has taken blows in recent years. Longtime fugitive bosses have been captured and a rebellion by island businessmen against paying "protection money" is starting to take root. But the anti-extortion revolt is not widespread enough to significantly reduce the Sicilian Mafia's coffers, the intelligence services' report noted.
Particularly tempting to the mob is Italy's recent explosion of supermarkets, a boon to consumers long frustrated by the often limited hours and selection offered by mom-and-pop stores. In Sicily last year, authorities seized euro$700 million (then worth $900 million) in assets, including supermarket outlets, from a businessman who was known as the island's "king of supermarkets" and was suspected of letting Cosa Nostra use his businesses to launder money. Prosecutors in Palermo said the owner's name turned up on handwritten notes scribbled by Bernardo Provenzano, the longtime fugitive "boss of all bosses" who was captured in 2006. The intelligence services report predicts that mobsters would step up production of counterfeit name-brand goods given consumers' apparently increased appetite for fake designer items. The Eurispes think tank estimated this growing business earned the mob euro6.3 billion ($8.5 billion) last year.
Naples anti-organized crime prosecutor Roberti said the Camorra has pumped up what once was a kind of cottage industry, with crime clan bosses knitting closer ties with mobsters in China, where fake designer clothing, shoes and accessories are now churned out in factories for the mob. Trafficking in fake designer goods _ which investigators suspect the Camorra is also peddling in the United States, France, Britain and Germany _ is now becoming more profitable for the Neapolitan syndicate that dealing in cocaine and hashish, said Mainolfi, the customs and tax police general. He has calculated that for every euro it costs to manufacture the counterfeit designer goods, the Camorra earns 10 euros, while for every euro spent to run drug trafficking, it earns six or seven euros. The fakes, sold in street stalls and clothing shops in the Naples and Rome areas, arrive by the tons in Naples' sprawling, chaotic port, where custom officials manage to check only some 5 percent of the shipping containers being unloaded, Mainolfi said.
How We Got in Over Our Heads
A political economist argues our high levels of consumer debt derive more from political decisions than from economic conditions.President Obama met on April 23 with representatives of the credit card industry to encourage them to curtail what some have called abusive lending practices. Lawrence Summers, his chief economic advisor, recently accused the firms of encouraging Americans to become "addicted" to their products. That metaphor is half-right, in that the companies can be viewed as both addicts and suppliers. That's the conclusion of a pointed critique Miller-McCune originally posted last October.
Political economist Johnna Montgomerie called the issuing of credit cards and other forms of consumer debt a "pyramid scheme" in which banks and other lenders made money by issuing more and more cards to people who went further and further in debt. Consumers whose wages had stagnated indeed became addicted to this source of credit, but so did the companies which relied on those revenue streams. The report, which remains a remarkably clear explanation of why the economic system came close to collapsing, is reposted below.
Suicidal bankers jumping from their office windows is an indelible, if largely apocryphal, image of the Great Depression. Johnna Montgomerie jokes that if any group of professionals is considering making the plunge this time around, it should be the economists. She’s kidding, of course, but she argues few practitioners of the "dismal science" foresaw the current financial meltdown, and fewer seem to truly understand it. "It’s often portrayed as a crisis in the financial services sector," she noted, "and there’s a lot of discussion of how much spillover it will have in the ‘real economy.’ My take is the ‘real economy’ is the cause of the crisis." A native of Canada now living in England, Montgomerie is a political economist and a research fellow at the University of Manchester’s Centre for Research on Socio-Cultural Change. She has just published a timely paper titled "Financialization and Consumption: An Alternative Account of Rising Consumer Debt Levels in Anglo-America."
As we’ve been reminded periodically over the past two decades and insistently over the past two weeks, American (and, for that matter, British) households have long been spending more than they take in. A 2004 Washington Post piece warned of the "alarming surge" in consumer debt — which had just topped $2 trillion — and quoted one expert as saying "our standard of living has to go down." Four years later, that bleak prospect seems increasingly likely. But did things have to play out this way? Not at all, according to Montgomerie, who argues the debt problem resulted from a mixture of stagnant wage growth, the increased availability of credit and a culture built on consumerism. She notes the decisions to tamp down wages and create new ways of borrowing money were political ones, made by leaders going back to Ronald Reagan. This mess, in other words, was a long time coming.
Consumer debt is only one small facet of the current financial crisis; as Montgomerie notes, it is dwarfed by mortgage debt. But she argues that looking at what has been happening in that market — credit cards, car loans and the like — gives us a much better idea of how far we have gotten off course over the past three decades. "Consumer credit is a small-scale version of what is happening with mortgages, in terms of how credit is created and recycled," she said. "The current crisis was instigated in the mortgage market; that was the flame that lit the fuse. But by looking at consumer credit, we see a microcosm of the financial processes involved. It allows us to see there are much bigger problems in the economy that relate to the household sector." To understand what she’s talking about, we need to start with a definition of "asset-backed securities," which were invented in the 1970s and came into widespread use in the 1980s.
"To a lender, when you have an outstanding debt, your interest payments are their revenue," she noted. "The credit that they have is their capital — like a machine (in a factory). How they use their capital, their ‘machine,’ is to lend it. The revenue they get back is the interest payments. "If you’re a manufacturer and you have a stable order of T-shirts from Sears every six months, you can go to the bank and say, ‘This is my order book. I have a three-year contract, where I deliver this many T-shirts every six months, and this is the revenue I get.’ The bank will then lend you money based on that future revenue stream." Similarly, banks approached other, larger financial institutions and showed they had reliable "revenue streams" in the form of interest payments on credit cards, auto loans and the like. They then sold these "assets" to the larger organizations, which bundled them and sold them to still larger ones — with fees being collected each step of the way. The odd loan that went sour didn’t matter since it was submerged in a pool of good loans.
"Yes, it is a pyramid scheme," Montgomerie said. "Loads of people made money — insurance companies, investment banks. In describing this new practice, they talked a lot about ‘risk dispersement,’ but it wasn’t really being used to disperse risk. They were making money off of fees." As long as individuals kept taking out additional loans or credit cards, the banks could keep accumulating new "assets" in the form of projected interest payments. It all worked beautifully … for a while. "What becomes problematic is: How do you keep this recycling going?" Montgomerie said. "The only thing you are selling is a reliable stream of interest payments — ‘reliable’ being the key word. What you need to do is find people you are sure to get interest payments from. "It’s a delicate game. From their (the lenders’) perspective, paying off all your debts is bad. But you (the lenders) need them (individual borrowers) to not default. So you need to offer them all kinds of different products — adjustable rates, introductory rates and so on.
"This is why if somebody is hugely in debt and is struggling to get by, they get offers for new lines of credit in the mail. If you have a huge amount of debt, you are considered a reliable stream of interest payments (since you are unlikely to get into good enough financial shape where you can pay off what you owe). It’s called ‘behavioral scoring.’ They’re monitoring your accounts all the time." To summarize: In a rational system, if you were in a huge amount of debt, you would be considered a bad risk and wouldn’t have access to still more credit. In our system, the opposite was true. This situation was not sustainable — although our greatest financial minds seemed to think it was.
"Alan Greenspan (longtime chairman of the Federal Reserve) was pressured over and over again to form some type of oversight of what was going on, but he would not do it," Montgomerie said. "It was his political belief that regulation would hinder the market. He believed these finance people would never be too foolish." At the same time that banks, mortgage brokers and lightly regulated non-bank lenders were offering loans to nearly anyone with a pulse and selling bundles of these loans to investors eager for the higher interest such loans generated, incomes were stagnating. The New York Times noted that after adjusting for inflation, the average American family’s income actually decreased from $61,000 in 2000 to $60,500 in 2007. Montgomerie argues the trend dates back to the 1980s, when President Reagan and Paul Volcker, Greenspan’s predecessor at the Federal Reserve, decided it was imperative to crack down on inflation (which was a major economic problem in the 1970s). "The idea was inflation needed to be busted as a way of maintaining economic stability," she said. "But when they said ‘inflation has to be low,’ that meant ‘wage inflation has to be low.’"
Thus began a major shift in government policy in both the U.S. and the U.K., de-emphasizing the goal of full employment in favor of price stability. Regulations were changed to allow companies more flexibility in employment practices. Many chose to outsource, move operations overseas or employ contract workers, part-timers and others not covered by health insurance and other benefit programs. "The long-term effect of that has been a decline in real wages," Montgomerie said. "Productivity has been rising in the U.S., but wages have not. We ended up with low inflation but diminished purchasing power. Prices continued to increase for certain things, such as medical bills, even as wages stayed stagnant. This was a political choice, but it has been obscured by all this economic language." Montgomerie argues it is this combination of factors that has proved so toxic, creating the current debt explosion. With wages stagnating and certain unavoidable costs (such as health care) increasing, people were looking for new sources of revenue to maintain their standard of living; these new sources of credit gave them the means to do just that. They were, in effect, an efficient way to postpone the pain.
"This has been going on since 1989," she said. "The Clinton administration, like Tony Blair’s government in the U.K., had its heart in the right place, but it was unwilling to address the issue that needed to be addressed, which was: How do you maintain a standard of living based on everybody getting regular wage increases while controlling inflation? They couldn’t square that circle. Cheap credit provided a way of smoothing over that conflict." Of course, we could have bitten the bullet, thrown away those tempting credit-card offers and cut back on our purchasing. There are early signs that may be happening at last: On Wednesday, the Federal Reserve reported that consumer borrowing fell in August at an annual rate of 3.7 percent — the first time total borrowing had fallen since January 1988.
Nevertheless, Montgomerie believes the urge to hit the mall remains lodged deep in our national psyche. "Any concept of prosperity and material well-being is bound up in consumerism," she said. "You don’t un-ring that bell." Unless, of course, there really is a new Great Depression. "That’s a very real possibility — so real it frightens me," she said. "But there is a growing awareness that this is not a temporary problem, and major changes are needed." And what big changes would she recommend? "Proposals for a new regulatory framework need to start happening now. It needs to be an open framework for regulating the entire financial-services industry as a series of interrelated markets."
In a larger sense, "The real pinch that is going to happen both in the finance industry and the business community is they’re going to have to let wages rise," she said. "They’re going to have to do it for the good of the American economy. The household sector cannot take any more pressure. More defaults will only lead to more instability. "The government cannot really do anything to make that happen, but it can set that tone. If (a new president and Congress) said, ‘This is an idea we support,’ that would be a really radical change. It would say maximizing profits is not sacrosanct. It is not in the Bill of Rights! The corporation is not a person — it’s a legal entity. Legal entities don’t need to be protected above people."
A Cyber-Attack On An American City
Just after midnight on Thursday, April 9, unidentified attackers climbed down four manholes serving the Northern California city of Morgan Hill and cut eight fiber cables in what appears to have been an organized attack on the electronic infrastructure of an American city. Its implications, though startling, have gone almost un-reported. That attack demonstrated a severe fault in American infrastructure: its centralization. The city of Morgan Hill and parts of three counties lost 911 service, cellular mobile telephone communications, land-line telephone, DSL internet and private networks, central station fire and burglar alarms, ATMs, credit card terminals, and monitoring of critical utilities. In addition, resources that should not have failed, like the local hospital's internal computer network, proved to be dependent on external resources, leaving the hospital with a "paper system" for the day.
Commerce was disrupted in a 100-mile swath around the community, from San Jose to Gilroy and Monterey. Cash was king for the day as ATMs and credit card systems were down, and many found they didn't have sufficient cash on hand. Services employees dependent on communication were sent home. The many businesses providing just-in-time operations to agriculture could not communicate. In technical terms, the area was partitioned from the surrounding internet. What was the attackers goal? Nothing has been revealed. Robbery? With wires cut, silent alarms were useless. Manipulation of the stock market? Companies, brokerages, and investors in the very wealthy community were cut off. Mayhem, murder, terrorism? But nothing like that seems to have happened. Some theorize unhappy communications workers, given the apparent knowledge of the community's infrastructure necessary for this attack. Or did the attackers simply want to teach us a lesson?
Although they are silent on the topic, I hope those responsible for emergency services, be they in business or government, are learning the lessons of Morgan Hill. The first lesson is what stayed up: stand-alone radio systems and not much else. Cell phones failed. Cellular towers can not, in general, connect phone calls on their own, even if both phones are near the same tower. They communicate with a central switching computer to operate, and when that system doesn't respond, they're useless. But police and fire authorities still had internal communications via two-way radio. Realizing that they'd need more two-way radio, authorities dispatched police to wake up the emergency coordinator of the regional ham radio club, and escort him to the community hospital with his equipment. Area hams dispatched ambulances and doctors, arranged for essential supplies, and relayed emergency communications out of the area to those with working telephones.
That the hospital's local network failed is evidence of over-dependence on centralized services. The development of the internet's communications protocols was sponsored by the U.S. Department of Defense, and they were designed to survive large failures. But it still takes local engineering skill to implement robust networking services. Most companies stop when something works, not considering whether or how it will work in an emergency. Institutional networks, even those of emergency services providers, are rarely tested for operation while disconnected from the outside world. Many such networks depend on outside services to match host names to network addresses, and thus stop operating the moment they are disconnected from the internet. Even when the internal network stays up, email is often hosted on some outside service, and thus becomes unavailable. Programs that depend on an internet connection for license verification will fail, and this feature is often found in server software. Commercial VoIP telephone systems will stay up for internal use if properly engineered to be independent of outside resources, but consumer VoIP equipment will fail.
This should lead managers of critical services to reconsider their dependence on software-as-a-service rather than local servers. Having your email live at Google means you don't have to manage it, but you can count on it being unavailable if your facility loses its internet connection. The same is true for any web service. And that's not acceptable if you work at a hospital or other emergency services provider, and really shouldn't be accepted at any company that expects to provide services during an infrastructure failure. Email from others in your office should continue to operate.
What to do? Local infrastructure is the key. The services that you depend on, all critical web applications and email, should be based at your site. They need to be able to operate without access to databases elsewhere, and to resynchronize with the rest of your operation when the network comes back up. This takes professional IT engineering to implement, and will cost more to manage, but won't leave you sitting on your hands in an emergency. Communications will be a problem during any emergency. Two-way radios have, to a great extent, been replaced by cellular "walkie-talkie" services that can not be relied upon to work during an infrastructure failure. Real two-way radios, stand-alone pager systems, and radio repeaters that enable regional communications are still available to the governments and businesses that endure the expense of planning, acquiring, maintaining, and testing them. Corporate disaster planners should look into such facilities. Municipalities, regardless of their size, should not consider abandoning such resources in favor of the less-robust cellular services.
Satellite telephones can be expected to keep operating, although they too depend on a land infrastructure. They are expensive, and they frequently fail in emergency situations simply because their users, administrative officials rather than technical staff, fail to keep them charged and have no back-up power resource once they are discharged. A big plus for Morgan Hill was that emergency services had an well-practiced partnership with the local hams. Since you can never budget for all of the communications technicians you'll need in an emergency, using these volunteers is a must for any civil authority. They come with their own equipment, they run their own emergency drills and thus are ready to serve, and they are tinkerers able to improvise the communications system needed to meet a particular emergency.
Which brings us to the issue of testing. No disaster system can be expected to work without regular testing, not only of the physical infrastructure provided for an emergency but of the people who are expected to use it, in its disaster mode. But such testing takes much time and work, and tends to trigger any lurking infrastructure problems, creating outages of its own. It's much better to work such things out as a result of testing than to meet them during a real disaster. We should also consider whether it might be necessary to harden some of the local infrastructure of our communities. The old Bell System used to arrange cables in a ring around a city, so that a cut in any one location could be routed around. It's not clear how much modern telephone companies have continued that practice. It might not have helped in Morgan Hill, as the attackers apparently even disabled an unused cable that could have been used to recover from the broken connections.
Surprisingly, manholes don't usually have locks. They rely on the weight of the cover and general revulsion to keep people out. They are more likely to provide alarms for flooding than intrusion. Utility poles are similarly accessible. Much of our infrastructure isn't protected by anything so tough as a manhole cover. Underground cables are easily accessible in surface posts and "tombstones", boxes often located in residential neighborhoods. These can be wrecked with a screwdriver. Most buried cable cuts are caused by operating a back-hoe without first using one of the "call before digging" services to mark out the location of all of the buried utilities. What's done accidentally can also be done deliberately, and the same services that help diggers avoid utilities might point them out to an attacker.
The most surprising news from Morgan Hill is that they survived reasonably unscathed. That they did so is a result of emergency planning in place for California's four seasons: fire, floods, earthquakes, and riots. Most communities don't practice disaster plans as intensively. Will there be another Morgan Hill? Definitely. And the next time it might happen to a denser community that won't be so astonishingly able to sustain the trouble using its two-way radios and hams. The next time, it might be connected with some other event, be it crime or terrorism. Company and government officers take notice: the only way you'll fare well is if you start planning now.
Of couples and copulas
Johnny Cash and June Carter met backstage at the Grand Ole Opry. It was a little like a country song: he was married, she recently divorced, and an affair ensued; both singers had young children, and Cash would have three more with his first wife before she left him in 1966, citing his drinking and carousing. Two years later, he proposed to Carter on stage and, despite having turned him down numerous times before, she accepted. They’d each found a life match. It ended like a country song, too. In 2003, Carter died in Nashville of complications from heart surgery, and Cash followed her to the grave four months later. The heart complication for him, it seemed, was that it was broken: "It hurts so bad," he told the audience at the last concert he would give. The pain, he said, tuning his guitar, close to tears, was "the big one. It’s the biggest."
Cash was speaking for many a bereaved partner – and well before Johnny ever met June, scientists had noticed that cases of spouses dying in rapid succession were not at all unusual. By the 1980s, medical researchers had started writing about "stress cardiomyopathy", or "apical ballooning syndrome", the ungainly name for the peculiar condition whereby an individual’s brain, following an intense emotional trauma, would inexplicably release chemicals into the bloodstream that weakened the heart – in some cases, causing it quite literally to break. The medical community was interested because it offered a chance, potentially, to intervene and prolong life. Another industry was interested in the phenomenon, too – but less to stop it and more to understand it. These were the actuaries working in life assurance. Actuarial science is the study of the statistics surrounding life and death – and the statistics surrounding the broken heart phenomenon were striking. Pages and pages of death records showed the same marked trend: that in human couples, the death of one partner significantly increases the chances of the death of the other.
Dying of a broken heart – in the most general sense, not necessarily from stress cardiomyopathy – was not a rare occurrence, but something of a statistical probability. So much so that life assurers, in order to conduct their business, needed to incorporate it into their models. In a March 2008 study, Jaap Spreeuw and Xu Wang of the Cass Business School observed that in the year following a loved one’s death, women were more than twice as likely to die than normal, and men more than six times as likely. "This implies … that joint life annuities [in which payments continue at the same price until both partners die] are underpriced while last survivor annuities [in which payments increase after one partner dies] are overpriced," concluded the authors. Even before the definitive Cass study, however, actuaries had begun to incorporate the broken heart trend into their mathematical models calculating the chances of clients dying. How could such an ephemeral relationship be reliably captured? The actuaries, of course, relied on probability.
While they could not hope to devise a model that predicted the likelihood of death from a broken heart for a specific couple, they could use statistical science to devise a fairly accurate picture across a group of people. They borrowed from physics and devised a formula based on something called a Markov chain: a way of expressing a series of statistical events whose outcomes are dependent upon one another. In physics, Markov chain processes underlie our most basic understanding of the world around us, from the way liquid turns to gas to the way a drop of vivid ink might slowly diffuse through a glass of water. If you treated people like atoms, the actuaries reasoned, you could apply the same maths.
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In the autumn of 1987, the man who would become the world’s most influential actuary landed in Canada on a flight from China. Neither Xiang Lin Li nor the handful of fellow junior academics with whom he was travelling – all from the University of Nankai – had ever been abroad before, yet they had come at the behest of the Chinese and Canadian governments to do something most unusual: study capitalism. The small band of mathematicians and statisticians would be taking business degrees at Quebec’s Laval University. For Li, going to Canada was just the latest in a series of unlikely opportunities that had shaped his life up to then. Decades earlier, his family had suffered at the blunt end of Mao’s cultural revolution: his father, a mid-ranking police official, was precisely the kind of lowly bureaucrat that the red guard mob was intent on re-educating, and the family was uprooted to a small village in southern China. In the countryside, the chances of young Xiang Lin going to school – let alone university – were slim. But he was talented and driven, and made it not only into school, but on to ?Nankai, one of the country’s most prestigious institutions. Li studied economics, and had just passed his master’s examinations when the Canadians came calling. Determined to be among those sent to Quebec, he learnt French in four months – as much at home studying the language, it seemed, as he was crunching numbers.
Li’s drive did not abate abroad. Four years after arriving in Canada, he’d earned his MBA; by this stage, he had no intention of returning home. In the few years he had been away, China’s mini-glasnost period had withered. Hu Yaobang, general secretary of the Communist party and a pro-democratic reformist, had been ousted, and Chinese leader Deng Xiaoping was now wary of the liberalism genie that had been let out of the bottle. In 1989, the world had looked on as students were mowed down in Tiananmen Square. Universities such as Nankai were not exactly the safest places for ambitious young students – especially not ones returning from MBA courses in the west. As if to make clear the break, Xiang Lin changed his name and became David Li. After graduation from Laval, he enrolled at a new university, Waterloo, near Toronto. He would now be studying actuarial science. And this wasn’t the only change: the move from genteel, francophone Montreal to the more worldly and business-oriented Toronto was profound – and deliberate. According to Jie Dai, a fellow immigrant from China and a classmate at Laval, "I clearly remember [Li] mention that if you are an actuarial guy, you can earn a lot of money."
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The big money in the 1990s, of course, was not to be found at Waterloo but in Silicon Valley, on Wall Street and in the City of London. The first of these might have been an obvious destination for a talented mathematician, but the latter two were also becoming magnets for the likes of Li. In 1984, Robert Rubin, who a decade later would become US treasury secretary, made a bold decision for his employer at the time, the investment bank Goldman Sachs. Rubin decided to hire Fischer Black, an economist and academic at the Massachusetts Institute of Technology’s Sloan School of Management. Prior to 1983, a few academics had toyed with economics and markets, but as intellectual curiosities; Black was the first of his kind – a serious academic, with publications under his belt and a tenured position to boot – to make the move to Wall Street, putting theory into practice and risking the scorn of his ivory tower colleagues.
Rubin’s bet earned Goldman many multiples of Black’s salary. At the bank, the professor pioneered the use of mathematics in pursuit of money. He was one half of the duo that came up with the Black-Scholes formula, which revolutionised Wall Street by promising to determine a rational price for market risks – a principle that would become the founding doctrine of a new field, quantitative finance. Quantitative finance’s practitioners were trying to outwit the markets, using maths to eliminate risk by first using maths to calculate it. And the numbers of those practitioners grew quickly. With the collapse of the Soviet Union, the end of the arms race and, in 1993, the cancellation by the US congress of the superconducting super collider – intended to be the world’s greatest physics experiment – particle physicists, experts in quantum mechanics and computing engineers were twiddling their thumbs. For the younger generation of newly qualified grads and PhDs, applying their expertise to finance was the obvious alternative to fighting it out for the dwindling number of jobs strictly in their fields.
Emanuel Derman – a particle physicist – was such a convert. He joined Goldman in 1985, working under Black before eventually taking over from his mentor, and recalls members of the "quant" influx being referred to as "POWs" – physicists on Wall Street. Equally accurate was the acronym used by Andrew Lo, another Wall Street quant and now a lecturer at MIT. What Wall Street was really after, said Lo in a recent lecture, was not PhDs, but PSDs: people who were "poor, smart and with a deep desire to get rich". At Waterloo, Li fitted that description to a T. He was studying for his PhD in actuarial science, but no one expected him to go on to a career in academia. Instead, in 1997, after earning his doctorate, he took a job at one of Canada’s largest banks, Canadian Imperial Bank of Commerce (CIBC).
For graduates such as Li, joining the rough and tumble world of business could be something of a shock, even when armed with MBAs. At best, the mathematicians were semi-disparagingly referred to as quants; if they were lucky, trader colleagues might slap them on the back and call them, half in flattery, "rocket scientists". Emanuel Derman recalls a time at Goldman Sachs when he and another quant colleague were standing on the trading floor, on either side of a central aisle, and a senior trader passed between them. The trader "winced, clutching his head with both hands as though in excruciating pain, and exclaimed, ‘Aaarrggh-hhh! The force field! It’s too intense! Let me out of the way!’" And yet by the time Li got to New York, in 1998, the quants had taken over the asylum. In the summer of that year, Long Term Capital Management, a hedge fund run by the finest minds in quantitative finance, required a massive bailout from the federal government. But far from serving as a warning that mathematical models could get investors into serious trouble, LTCM exploded the notion of quantitative finance as a geeky, back-office support task. The fund’s might before its fall – and the fact that its failure might have left a trillion-dollar hole in the financial system – discounted the notion that traders’ instinct and experience counted more than numerical intelligence.
The quants weren’t exactly out on the trading floor, however. The best of them still spent their days writing papers, crunching numbers, applying their academic expertise to the world of business. Li had come to New York to work for a consultancy called the RiskMetrics Group, which had been spun out of JP Morgan, but he was still thinking about life, death and love. In 2000, he published a paper in the prestigious Journal of Fixed Income that gained some serious attention. In it, Li performed a most elegant trick. Borrowing from his work in actuarial science and insurance and his knowledge of the broken-heart syndrome, he attempted to solve one of Wall Street quants’ most intractable problems: default correlation. Markets do not function in laboratory-like isolation. They are linked, correlated. It isn’t enough for any quant to try and know the probability of each individual company in his bank’s portfolio going bust; he has to know how the bankruptcy of one company – or several – might increase (or decrease) the likelihood that other companies will default. Suppose, for example, that a bank loans money to two outfits – a dairy farm and a dairy. The farm, according to ratings agencies, has a 10 per cent chance of going bust and the dairy a 5 per cent chance. But if the farm does go under, the chances that the dairy will follow will rise above 5 per cent – quickly and steeply – if the farm was its main milk supplier.
And it gets more complicated from there. How correlated are the default probabilities on bonds issued by our Irish dairy farm and those issued by a software company in Malaysia? Not at all, you might think: the businesses not only provide totally different products and services, they’re also geographically remote from each other. Suppose, though, that both companies have been lent money by the same troubled bank that is now calling in its loans. In fact, this is exactly what sank LTCM. How correlated are Russian government bonds and those in Mexico? Not at all, according to LTCM’s model, which, it should be noted, crunched data going back a hundred years. And yet it turned out for the hedge fund that both markets were dominated by the same few investors. The 1998 financial crisis in Russia, when Boris Yeltsin’s government defaulted on its bonds, caused panic selling in Mexico as investors rushed to de-risk their portfolios. Li realised that his insight was groundbreaking. Speaking to The Wall Street Journal seven years later, he said: "Suddenly I thought that the problem I was trying to solve [as an actuary] was exactly the problem these guys were trying to solve. Default [on a loan] is like the death of a company." And if he could apply the broken hearts maths to broken companies, he’d have a way of mathematically modelling the effect that one company’s default would have on the chance of default for others.
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When mathematicians and physicists want to describe the chances of events occurring, they often rely on a curve called a copula. The Latin root is a noun meaning a "link or tie", and indeed, copulas connect variables in such a way that their interdependence can be plotted. Throughout his PhD at Waterloo, and at CIBC, Li had been interested in how he could use copulas to develop existing actuarial models of the ?broken heart syndrome. The problem with relying on Markov chains was that they painted a far too mechanical, physical – atomic, even – picture of the human lifespan. Li reasoned that with a copula that showed a probable distribution of outcomes, a more accurate, encompassing picture of the broken heart or, for that matter, the broken company, could be devised.
He decided to use a very standard type of curve – the Gaussian copula, which is better known as a bell curve, or normal distribution – to map and determine the correlation on any given portfolio of assets. In the same way that actuaries could tell their employers the chances of Johnny Cash dying soon after June Carter without knowing anything about Cash other than the fact of his recent widowhood, so quants could tell their employers the effect one company defaulting might have on another doing the same – without knowing anything about the companies themselves. From this point on, it really could be, would be, a number-crunching game.
By 2003, Li’s paper had made his name on Wall Street. By now he was director and global head of derivatives research at Citigroup, and on a bright Tuesday morning in November, he arrived at the annual Quant Congress to bask in the glory with a presentation about his work. In front of a room of hundreds of fellow quants ("not a million miles from some kind of science fiction convention", one person who was there recalls) he ran through his model – the Gaussian copula function for default. The presentation was a riot of equations, mathematical lemmas, arching curves and matrices of numbers. The questions afterwards were deferential, technical. Li, it seemed, had found the final piece of a risk-management jigsaw that banks had been slowly piecing together since quants arrived on Wall Street.
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By 2001, correlation was a big deal. A new fervour was gripping Wall Street – one almost as revolutionary as that which had struck when the Black-Scholes model brought about the explosion in stock options and derivatives in the early 1980s. This was structured finance, the culmination of two decades of quants on Wall Street. The basic idea was simple: that banks no longer had to hold on to risks. Instead they could value them, using complex maths and modelling, then package and trade them like any other, ordinary security. Mortgages were the prime example. Rather than make a mortgage loan and gradually collect interest over its lifespan, banks began to bundle the loans together and sell them into specially created off-balance-sheet shell companies. These companies in turn issued bonds to raise cash. And by using the modelling and maths being cranked out by quants, banks were able to tailor the structure of mortgage portfolios to ensure that bonds of varying risks could be issued to investors. The problem, however, was correlation. The one thing any off-balance-sheet securitisation could not properly capture was the interrelatedness of all the ?hundreds of thousands of different mortgage loans they owned. As a consequence, structured finance had remained a niche and highly bespoke practice throughout the 1990s.
On August 10 2004, however, the rating agency Moody’s incorporated Li’s Gaussian copula default function formula into its rating methodology for collateralised debt obligations, the structured finance instruments that subsequently proved the nemesis of so many banks. Previously, Moody’s had insisted that CDOs meet a diversity score – that is, that each should contain different types of assets, such as commercial mortgages, student loans and credit card debts, as well as the popular subprime debt. This was standard investing good practice, where the best way to guard against risk is to avoid putting all your eggs in one basket. But Li’s formula meant Moody’s now had a model that enabled it to gauge the interrelatedness of risks – and that traditional good practice could be thrown out of the window, since risk could be measured with mathematical certainty.
No need to spread your eggs across baskets if you knew the exact odds of your one basket being dropped. A week after Moody’s, the world’s other large rating agency, Standard & Poor’s, changed its methodology, too. CDOs built solely out of subprime mortgage debt became the rage. And using the magic of the Gaussian copula correlation model, and some clever off-balance-sheet architecture, high-risk mortgages were re-packaged into triple-A-rated investor gold. The CDO market exploded. In 2000, the total number of CDOs issued were worth somewhere in the tens of billions of dollars. By 2007, two trillion dollars of CDO bonds had been issued. And with so many investors looking to put their money in debt, that debt became incredibly cheap, fuelling a massive boom in house prices and turbo-charging the world’s economies.
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The unwinding started, as we all now know, in the US subprime housing market. Defaults started to increase in late 2006. The banks weren’t worried at first. Their models assumed that the pinprick default points all over the US were not correlated. But the defaults kept coming. By early 2007, it was clear that the US subprime market had a problem and by that summer, homeowners all over the US were defaulting on their mortgages. The cheap debt made available by the finance revolution was so cheap, in fact, that the loans should never have been made. And the correlation model was still mapping the housing market as it had been in 1990s, not the grossly inflated monster it had become. The development of the model had, ironically, changed the nature of the reality it was modelling. The losses the banks began to take against their holdings of CDOs were staggering. And as the institutions grew fearful about one another’s solvency, they stopped lending to each other. Global liquidity dried up. The rot spread from asset class to asset class, and the banks’ pain spread to the real economy. Suddenly, everything was highly correlated.
How had Li’s formula failed to anticipate this? The problem was that it assumed events tended to cluster heavily around an average – a "normal" state. In actuarial science, Li’s formula could adequately capture binary outcomes such as life or death, but in the messy world of mortgages and economics, it faltered. The range of possible outcomes here was more complicated, and indeed, random, than those facing an insurance company’s clients. Markets – particularly the mortgage market – were far more prone to extreme correlation scenarios than were insurers. Death from a broken heart, for all its poetic associations, is far easier to predict than the more prosaic, but ultimately unknowable, interrelatedness of markets.
Why did no one notice the formula’s Achilles heel? Some did. Nassim Nicholas Taleb, author of the bestselling The Black Swan – a book about the importance of considering outliers when looking at copulas – was a voluble critic of quantitative finance and Li’s formula. "The thing never worked," he says. "Anything that relies on correlation is charlatanism." In 2007, David Li left Wall Street and moved back to China. He could not be contacted for this story. But two years earlier, before the financial system blew up, he did warn: "Very few people understand the essence of the model." Harry Panjer, a professor of statistics and actuarial science who was Li’s mentor at Waterloo, strikes a balance between Taleb’s accusations and the stance of Li. Earlier this year, Panjer told The Toronto Star newspaper: "We have a saying in statistics, ‘All ?models are wrong, but some are useful.’" And David Li’s model was, for a period, profoundly useful.