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Summits and Sinkholes

We are either approaching a summit which will resolve the global financial crisis, or sliding into an economic sinkhole, depending on who is talking. Frankly, I've lost track of some of the financial legerdemain, and would not hazard a guess on which shell, if any, hides the pea.

My confusion is not entirely a personal problem. Even the most knowledgeable of financial experts have had lapses. A case in point is the 230 year-old fund MF Global Holdings, which recently filed for bankruptcy. It is now under investigation for mixing up customer funds with its own accounts, (a charge which has been made, but not by any means proved.) What can be said with some confidence is damning in a different way.

"A source familiar with the matter told Reuters that regulators are still not sure where the money is, and why they can't find it."

The man at the helm of this sinking ship was Jon Corzine, who has some claim on the title of the ultimate Wall Street insider. If you have followed the history of Goldman-Sachs for the last 20 years you will certainly know his name. If you remember the industry (non-government) rescue which kept Long-Term Capital Management from creating a crater which would swallow large parts of the investment banking industry you will also know that name. If you remember the wild ride during 2008 when it looked like the LTCM story was going to be replayed on an epic scale, you will also find the name familiar.

Jon Corzine is not some epitome of evil, he is part of a culture which has dominated finance even as it has lost its way in the dark woods of derivatives and credit default swaps. In many of those previous crises he played a role in fashioning a patchwork of measures to keep the whole financial industry from going down the tubes. When you are in such a crisis, there is little else possible. What he has not done is to avert crisis situations, or alter the practices which produce them.

As mentioned above, the Commodities Futures Trading Commission is now showing signs of life -- over 6 years too late. The Securities and Exchange Commission (SEC) is also becoming feisty, for example by questioning bond ratings agencies, again far too late. A penalty of some 285 million dollars against Citigroup for fraud has been accepted by Citigroup as part of the price of doing business -- without admitting wrongdoing. This is the fifth time the SEC has charged Citigroup with fraud in a decade.

In this case, it was hard to argue otherwise, since the company was flogging investments to customers at the same time it was selling those same investments short on its own account. A broader definition of fraud would cover cases in which the company was both buying and selling on its own account, but deliberately downplaying risk in investments it sold. This allowed billions in profits while the markets were moving up and inflating a bubble. For comparison, the company made 3.8 billion dollars last quarter, (though I am not claiming this was all due to fraud.)

We could have large debates about social responsibility and business ethics, but I am not going there at present. What I am saying is that in the very narrow definition of ethics provided by businesses with accounting, balance sheets and audits something is seriously wrong when you can't tell where the money is going, or what assets may be worth, if anything. An appeal to Generally Accepted Accounting Practices (GAAP) in defense of MF Global's behavior is not reassuring. I'm very much afraid deceptive practices may be GAAP.

This confusion extends to the finance of nations. Investors who might be willing to lend to a Greek borrower with a good business idea and some chance of getting a return on investment, (which is badly needed in that country,) can't be sure the money will not be used to meet current expenses without generating enough revenue to return the principle, let alone pay interest. The whole scheme of Collateralized Debt Obligations (CDO) has become suspect, and this is now a cornerstone of lending.

It is not at all clear that these and other financial instruments have been anything more than cutouts to separate those who generate loans and resell debts from risks associated with them. One commentator has even compared the mess at GF Global to the Ponzi scheme of Bernie Madoff.

If you can't easily distinguish a respectable investment from an outright scam with no investment whatsoever, absent inside sources, what does that say about the industry?


Interesting anciendaze though I must admit to a blind spot with my own finances. I did hear an interview with ?Neeson (a trader with Barings Bank and brought it down) admitting that the dealings were so complex he couldn't fully understand what was going on. Asked where were the Regulators he mentioned they couldn't keep up either. Hope I'm not misquoting but that was the gist in the interview. Seems they are not alone.
Unfortunately, obfuscation seems to be essential to making a profit in finance. In reconstructing the play-by-play action during the 2008 crisis several authors have made it abundantly clear those in charge often failed to understand either what their risk management department had done in the past, or what was taking place on the trading floor. The huge exposures at top investment banks came as a shock to many people within those firms.

To get a feel for what routine business in high finance has become, go back to my comment on a blog post which discusses "repo financing", a kind of perpetual motion money machine which is only possible for those who can borrow against an asset without taking a "haircut". Using whatever books you have available, and on-line resources, try to make sense of the way "repo financing" allows you to take both a long and short position, so you can make money when the spread narrows, regardless of the overall movement of the market, without tying up significant capital. If you are able to figure this out, you may have a new career opportunity.

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