The Big Investment Lie

Good questions

With the opening today of the federal government's official Financial Crisis Inquiry Commission, at which the CEOs of the four biggest banks — Goldman Sachs, Morgan Stanley, JPMorgan Chase, and Bank of America — will be the first star witnesses, the sport of asking people what questions should be posed to them has intensified.

The New York Times assembled a distinguished group of contributors, who pose an excellent list of questions.

The single best question, surprisingly, comes from David Stockman, Ronald Reagan's then-wunderkind Director of the Office of Management and Budget from 1981-1985, who was "taken to the woodshed" by the President after being quoted in an Atlantic article as saying, "None of us really understands what's going on with all these numbers," among other seemingly incredibly naive things. Stockman's question is:

"Without the Troubled Asset Relief Program, Wall Street banks would not have survived the shock to the financial system that occurred in September 2008. Nor would they have subsequently accrued large profits and bonus pools in 2009. Shouldn’t a substantial share of those bonus pools be sequestered on bank balance sheets for several years to increase the banks’ capital levels and shield taxpayers against another bailout?"

The rudest questions — because terse and right to the point — come from Simon Johnson of MIT:

1. Describe in detail the three worst investments your bank made in 2007 and 2008 — that is, those transactions on which you lost the most money. How much did the bank lose in each case?

2. What was the total compensation of each manager or executive supervising those three transactions — including yourself — in 2007 and 2008?

3. Are those executives still with your bank? What investments do they supervise today? How much will they be paid for 2009, including their bonuses?

But the best, lengthier elaboration of those terse questions comes from consultant Yves Smith. Read it all here.

The Voice of Wisdom

The Wall Street Journal published a special Future of Finance report in which Paul Volcker refreshingly weighed in.

Volcker was the titan who, as Fed Chairman, single-handedly stopped galloping US inflation in the early 1980s, after a risible campaign in the '70s called Whip Inflation Now—or WIN (complete with lapel pins)—failed completely.

Now Volcker at 82 is an elder statesman with true wisdom who can say what he wants and speaks the plain truth.

It is well worth reading his entire contribution to the Journal's report. The coverage of Volcker begins with the question, "Does financial innovation contribute to economic growth?" Volcker responded that the ATM was the only financial innovation he could think of that has improved society.

Other key excerpts:

A few years ago I happened to be at a conference of business people... The conference was being addressed by a very vigorous young investment banker from London who was explaining to all these older executives how their companies would be dust if they did not realize the joys of financial innovation and financial engineering, and that they had better get with it.

I was listening to this, and I found myself sitting next to one of the inventors of financial engineering. I didn't know him, but I knew who he was and that he had won a Nobel Prize, and I nudged him and asked what all the financial engineering does for the economy and what it does for productivity.

Much to my surprise, he leaned over and whispered in my ear that it does nothing—and this was from a leader in the world of financial engineering. I asked him what it did do, and he said that it moves around the rents in the financial system—and besides, it's a lot of intellectual fun.

Now, I have no doubts that it moves around the rents in the financial system, but not only this, as it seems to have vastly increased them...

I was just talking to a high-tech company about the immense attraction to go into finance when both Britain and the United States are suffering from a basic inability to produce things competitively, to keep up with the new economy. Is this a result of financial innovation that we should be really worried about?...

I do not know if something happened that suddenly made these innovations essential for growth... we had greater speed of growth [in the 1950s and '60s] and... did not put the whole economy at risk of collapse.

Help for Goldman

An article in today's Wall Street Journal says that Goldman Sachs played a major role in helping AIG to "insure" the scores of billions of dollars of mortgage assets—like CDOs—that AIG covered with credit default swaps (CDSs).

We put "insure" in quotes because AIG didn't have the assets to back up the insurance, so there really was no insurance.

Nevertheless those that bought the insurance—Goldman foremost among them—got paid in full, as if AIG did have the assets to back it up. They were paid by the Federal government.

Some think Goldman shouldn't have received full payment, on the principle of caveat emptor—let the buyer beware.

That's not the way Goldman sees it. According to the article, "A Goldman spokesman says that up until AIG was rescued by the government, the insurer 'was viewed as one of the most sophisticated financial counterparties in the world. It wasn't until the government intervened in September 2008 that the full extent of AIG's problems became apparent.'"

In other words, how could Goldman have known AIG would default? Oh, come on! — a little due diligence please?

But Goldman received another advantage. According to the WSJ article, "The trades [of CDSs] ... gave Goldman a unique window into AIG's exposure to losses on securities linked to mortgages."

Funny, Goldman is known to have made money for its own account by selling securities with exposure to falling housing prices, while at the same time facilitating purchases—for a fee—of those same instruments by clients. Nothing like a window on the trading world is there? That's what puts Goldman in its leading position to make so much money.

But as they—or their spokesman—sees it, AIG "was viewed as one of the most sophisticated financial counterparties in the world." What the spokesman means is: viewed by those not in the know—but undoubtedly not by Goldman itself.

Bent only on amassing a fortune

Theodore Roosevelt, Republican, 26th President of the United States, 1901-1909, said it sharpest and truest:

There is not in the world a more ignoble character than the mere money-getting American, insensitive to every duty, regardless of principle, bent only on amassing a fortune.

Somehow people in the financial world -- who are exactly those ignoble characters, as anyone who observes them up close can see -- have convinced themselves (and to a great degree the rest of us as well) that by being bent only on amassing a fortune, they are somehow performing every other conceivable duty as well.

This is the ultimate perversion of the doctrine of self-interest. It takes only common sense to realize it is not true.

Gillian Tett, in the final reflection of the Epilogue of her book "Fool's Gold", identifies this insensitivity to duty and principle -- a "silo" mentality -- as the problem of the financial industry that needs to be fixed:

The finance world's lack of interest in wider social matters cuts to the very heart of what has gone wrong.

...A "silo" mentality has come to rule inside banks, leaving different departments competing for resources, with shockingly little wider vision or oversight... Most pernicious of all, financiers have come to regard banking as a silo in its own right, detached from the rest of society. They have become like the inhabitants of Plato's cave, who could see shadows of outside reality flickering on the walls but rarely encountered that reality themselves. The chain that linked a synthetic CDO of ABS, say, with a "real" person was so convoluted, it was almost impossible for anybody to fit it into a single cognitive map...

...And locked in their little silos, almost nobody could see how the pieces fitted together as a whole or how overbloated finance had become.

...In the last two decades, as finance spun so out of control, it stopped being a servant of the economy but became its master. That must be reversed.

Friedrich Hayek on socialized medicine

Margaret Thatcher, Britain's Iron Lady of privatization, ascended to lead the Conservative Party and become Prime Minister in the late 1970s when Britain's economy was mired in problems caused by a semi-socialistic system.

Thatcher was a great admirer of the political economist Friedrich von Hayek. This anecdote provides an example:

[A]t a Conservative Party  policy meeting in the late 1970's, "Another colleague had also prepared a paper arguing that the middle way was the pragmatic path for the Conservative party to take .. Before he had finished speaking ... the new Party Leader [Margaret Thatcher] reached into her briefcase and took out a book.  It was Friedrich von Hayek's The Constitution of Liberty.  Interrupting [the speaker], she held the book up for all of us to see.  'This', she said sternly, 'is what we believe', and banged Hayek down on the table.  (John Ranelagh, Thatcher's People:  An Insider's Account of the Politics, the Power, and the Personalities.  London:  HarperCollins, 1991.)

The great Hayek himself, supreme skeptic of government, had this to say about socialized medicine:

Nor is there any reason why the state should not assist the individuals in providing for those common hazards of life against which, because of their uncertainty, few individuals can make adequate provision. Where, as in the case of sickness and accident, neither the desire to avoid such calamities nor the efforts to overcome their consequences are as a rule weakened by the provision of assistance, where, in short, we deal with genuinely insurable risks, the case for the state's helping to organize a comprehensive system of social insurance is very strong.... there is no incompatibility in principle between the state providing greater security in this way and the preservation of individual freedom. (Friedrich von Hayek, The Road to Serfdom, page 125.)

It is worth noting that in all her reforms, Thatcher never tried to dismantle Britain's system of socialized medicine.

Why we need to teach the efficient market model

The efficient market hypothesis (EMH) has many problems, not least of which is that it is not clear what it says.

One of its most common formulations is that "the market price reflects all available information". How does it reflect it? The hypothesis does not tell us.

It is sometimes understood to mean that the market price of a security is the best estimator of its true value.

What, then, is the true value? How can it be defined? Is it the present value of the future earnings that will actually occur, which we would know if only we had a crystal ball?

No, it cannot be that; it can only be the present value of the best current estimate of unknown future earnings, not the earnings that will actually come to pass. But how is one to know what is the best current estimate of future earnings?

The efficient market hypothesis has come under attack because it seems that in bubbles the market consensus -- because of groupthink, trends, fads, bandwagon effects, and market participants racing each other not to be the last greater fool -- can be drastically wrong on occasion.

But the EMH's most important lesson has not been absorbed.

Even if the EMH is not universally correct, it is correct often enough, and nearly enough, to be instructive. And the lesson it teaches, which is correct almost all of the time, has not been absorbed by the vast majority of investors.

That lesson, to put it in simple and familiar terms, is past investment results are not predictive of future results.

Most investors do not understand or believe this, because they don't understand or believe that the efficient market hypothesis is almost always true within an unimportant margin of error. They think that, as in other fields that produce data, you can use those data to determine trends, and rely on those trends to continue into the future.

Not so in the investment field. If people understood the efficient market hypothesis better they would understand why.

Academicians in finance respond to perverse incentives too

At last someone has written a whole article pointing out that academicians in the finance and economic fields are conflicted because they respond to financial incentives in their fields. "After all," says author Devesh Kapur, "many of the intellectual underpinnings of the causes of the current crisis – be it financial innovations, capital account convertibility, deregulation or stock options – come from the best and brightest in US academia."

Devesh says that a "troubling reason behind the failure of academics in the current crisis is the nature of their financial incentives and the resulting conflicts of interest – not dissimilar to what so many in Wall Street faced." He adds:

"One factor, in particular, needs highlighting: the hidden financial conflicts of interest that a growing number of academics face. Many academics, particularly those from institutions that enjoy high prestige and reputation, now have serious business interests and an array of financial ties to the very institutions that their studies address. These interests range from lucrative speaking fees, advisory roles at financial institutions, managerial roles and stakes in private equity and hedge funds to corporate non-executive directorships."

These incentives have caused the academic field of finance to become a travesty, responding like Pavlov's dog to incentives to add fuel to -- or at least not to totally debunk -- any fad that adds lucratively to the coffers of financial institutions.

Those who forget Heisenberg will be doomed to reinvent him

The bursting of two asset bubbles in the 2000s -- the tech-stock bubble and the housing bubble -- has shined a light on a long-accepted theory in academia, the Efficient Market Hypothesis, or EMH. This hypothesis is generally credited to the Chicago school of thought, residing in the University of Chicago's department of economics.

Now many people are saying the EMH was terribly wrong, and perhaps even seriously damaging to the economy. The debate is reviewed in an excellent article by Joe Nocera in today's New York Times.

Clear failings have resulted from pushing efficient market concepts too far. For example, Milton Friedman, a Nobelist Chicago-school stalwart, believed that the U.S. FDA (Food and Drug Administration) was not needed to protect the public because rational food and drug corporations would never endanger their market values by taking the risk of selling contaminated food and unsafe drugs. Such theory-bound extremism has now been exposed for what it was.

But as Justin Fox, quoted in Nocera's article, makes clear, the EMH is useful and mostly right. Perhaps it is like Newtonian physics, which works in almost all cases except extreme ones -- for example when you're approaching the speed of light. For that, you need a new theory that encompasses the old: Einstein's theory of relativity.

What will the new theory be? So far it hasn't really gelled. There is much talk about behavioral economics and behavioral finance, but those are mainly sets of experimental results and observations and do not rise to the level of theory.

I believe the answer lies in a maxim I will now coin: Those who forget Heisenberg will be doomed to reinvent him. What do I mean? I mean that the observer is as much a part of the experiment as the observed facts, from which the observer pretends to be removed. (Heisenberg was the physicist who created the Uncertainty Principle, which says you can't accurately observe the position and velocity of a particle at the same time.)

In securities markets, the pretense is that its participants observe the facts of the companies in which they buy and sell securities, making accurate estimates of their values based on those facts. What this ignores is that the participants are also observing each other. They try to guess what others think they are thinking, playing a kind of poker game with them -- who can get out of the game while the value is high before it crashes, who can get in while a bubble is being created then get out in time, who can bluff until others sell out. Should they be doing this? -- after all, it amounts to the demeaned practice of "speculation" -- but that is irrelevant, they will do it. And what they do doesn't only distort the market values of securities, it creates them -- thereby also creating fundamental facts about the underlying companies.

The person who has, at this point, come closest to articulating this new theory is George Soros, whose "theory of reflexivity" is receiving renewed attention. But much more work will be required before a body of thought that really rises to the level of theory is created. Stay tuned.

Watch out ... the bankers may be back to business as usual

A column by Nobel Prize winning economist Paul Krugman in The New York Times, on the occasion of a story that bankers' compensation levels may be recovering to their shocking 2007 levels, is worth quoting at length:

[T]here’s no longer any reason to believe that the wizards of Wall Street actually contribute anything positive to society, let alone enough to justify those humongous paychecks.

Remember that the gilded Wall Street of 2007 was a fairly new phenomenon. From the 1930s until around 1980 banking was a staid, rather boring business that paid no better, on average, than other industries, yet kept the economy’s wheels turning.

So why did some bankers suddenly begin making vast fortunes? It was, we were told, a reward for their creativity — for financial innovation. At this point, however, it’s hard to think of any major recent financial innovations that actually aided society, as opposed to being new, improved ways to blow bubbles, evade regulations and implement de facto Ponzi schemes.

...Rightly or wrongly, the bankers seem to believe that a return to business as usual is just around the corner.

We can only hope that our leaders prove them wrong, and carry through with real reform. In 2008, overpaid bankers taking big risks with other people’s money brought the world economy to its knees. The last thing we need is to give them a chance to do it all over again.

Break the financial oligarchy

An article in the Atlantic by former International Monetary Fund Chief Economist, and now MIT professor Simon Johnson has been getting a great deal of press lately -- deservedly.

Johnson views the financial crisis through the lens of an IMF Chief Economist, who has seen crises that the IMF had to deal with in developing countries and their causes, and who sees eerie parallels with the current industrial world crisis.

In the developing country crises, a power elite -- an oligarchy -- encompassing both government, and the captains of industry who are its private-sector allies, overreached and took too many risks.

In the United States, that oligarchy consists of the captains of the financial industry -- many of whom shuttle between government and Wall Street. Johnson says, "the American financial industry gained political power by amassing a kind of cultural capital—a belief system...it benefited from the fact that Washington insiders already believed that large financial institutions and free-flowing capital markets were crucial to America’s position in the world."

He then says,

By now, the princes of the financial world have of course been stripped naked as leaders and strategists—at least in the eyes of most Americans. But as the months have rolled by, financial elites have continued to assume that their position as the economy’s favored children is safe, despite the wreckage they have caused.

And unfortunately, they are largely getting away with this assumption. But Johnson argues, "recovery will fail unless we break the financial oligarchy that is blocking essential reform."