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Moral Hazard, part one

Blog entry posted by anciendaze, Jul 30, 2011.

I have previously suggested the problem with research on ME/CFS centers on a lack of funding for meaningful research with some chance of changing a dismal situation. I have also traced some current controversies to what I believe were scientific errors made decades ago, even before the label CFS had been invented. As a parallel example of the persistence of error and dysfunctional organization, I have pointed to the U.S. manned space program. Such disasters really do happen, and can become virtually impossible to correct from within an organization.

As I write, the world is gripped by the spectacle of the wealthiest nation on the planet teetering on the brink of default on its debts while politicians posture and tempt doom with dazzling displays of brinkmanship. For the past week we have been in a condition where the financial world might reasonably shift from reliance on T-bills to iBonds, as Apple is more liquid than the U.S. government. How did we get here?

The title I have chosen is Wall Street code for the problem of rewarding people who make bad bets, particularly with other peoples' money. What started, long ago, as "a cloud no bigger than a hand" on the horizon has now moved to center stage. This is a subject where a long memory can connect dots others would not know exist.

Once upon a time, there was a lawyer in the securities business named Ivan Boesky. He made a number of spectacular deals which ultimately landed him on the cover of Time magazine. He had made some $200,000,000 through bold moves which seemed almost uncanny. Unfortunately, they were easily explained by trading on insider information, which brought in the SEC and FBI. Wiretaps soon established his guilt beyond a reasonable doubt.

At this point Boesky cut a deal to keep doing business while the FBI collected evidence for use against other insiders. (Boesky ultimately served 3.5 years in prison, and paid $100,000,000 in fines.) This led to the arrest of Michael Milken, the "junk bond king" at Drexel Burnham Lambert. Milken was indicted on 98 counts of racketeering and securities fraud. After a plea bargain, he pled guilty to 6 counts, avoiding the worst. He served 22 months in prison, and paid hundreds of millions in fines and compensation. Drexel Burnham Lambert went bankrupt in 1990. In 2010 Milken was rated the 488th richest person in the world.

A second thread can be traced through the career of John Gutfreund, who led Salomon Brothers during the same period, and took the private firm public. One minor innovation in this period was the creation of a new kind of trade, the mortgage-backed security, which seemed like a great idea up until about 2008. At one time, Gutfreund was called "The King of Wall Street". Disaster at Salomon Brothers ended his reign. His reputation was destroyed, but he was never convicted of significant crimes, and served no time in jail.

If this is what happened to those conspicuously at the top of organizations with deceptive practices which crossed the line into criminal behavior, you have to ask what lessons were learned by those thousands who worked for them. Naturally, they picked up the pieces of their lives, and got on with their own careers.

The discredited Salomon Brothers was merged with the respectable brokerage house Smith Barney as Salomon Smith Barney. Guess which culture came out on top. You can find colorful descriptions of this history in the books "Liars' Poker" and "The Bonfire of the Vanities". This continued into Travelers, then Citigroup.

Besides the obvious advantages of gambling with someone else's money and golden parachutes, one major lesson from the period was the power of leverage. Multiple waves of mergers, leveraged buyouts and hostile takeovers put those who used this power in control of a major chunk of the U.S. economy. It should come as no surprise to anyone that exotic new financial instruments developed by a small group at J.P. Morgan, and scarcely understood by anyone outside that group, should combine with the culture I've described above to create a perfect storm of financial mismanagement. You can find good descriptions of this aspect in the books "Fools' Gold" and "The Big Short".

By the time this reached the corridors of power in 2007 and 2008, the institutions involved were "Too Big to Fail" (another relevant title). This last book gives more color to the story of how various important people tried to deal with the mess, very late in the game, but the quiet story apparent throughout is that those in charge did not know a great deal about what was happening. Had they known they could have made huge profits by accepting deals they rejected as inadequate. Later in the game, these would have been extravagantly better than the deals they were forced to accept.

The game of shooting craps with others' money, and passing on the risks, while collecting profits, has reached its ultimate limit. No higher authority exists to take over liabilities, absent an appeal to theology.

This is the environment in which we must find funding for medical research to help us and millions of others. The prospect is not encouraging.

Where did this process begin? A lot farther back than political commentators think. But, that is another story.
anciendaze

About the Author

As the name suggests, I am old and dazed. The avatar illustrates my rule of thumb: "Hang on! This ride isn't over."
  1. markmc20001
    sounds like it may be another good series.

    You may already know, but a common mis-conception pushed by the coorporate owned media is that the financial collapse was caused by reckless borrowing. This definitely had something to do with it. However, The root of the problem was leverage and bad loans because the banksters had no skin in the game.

    The bad loans were made because the banksters had the derivatives insured by AIG, rated by Moodies and S&P as triple A, and could sell the stuff around the world without keeping any of the junk on their books. I think many of the banksters had some idea what was going on, just wanted to play the game until it collapsed they were all making so much money.

    Now of course instead of letting the banksters taking a hair cut and failing like everybody else, they got bailed out at 100 cents of the dollar by the tax payers. Instead of collapsing and finding a new job at a start-up bank (like everybody else) the banksters got a taxpayer bailout and kept their exorbitnat pay packages that I feel would have fallen, if they were all allowed to start over without a taxpayer bailout.
  2. OverTheHills
    Anciendaze
    I am really enjoying your series of thought-provoking and informative blogs. The one about the space shuttle (and by implication medical research) was particularly excellent. Thankyou for making the effort to organise your thoughts and sharing with us.
    mwa
    OTH