From “Financial Economics, Deregulation and OTC Derivatives: Interview with Yves Smith of Cfdtrade,” , February 22, 2010
“Wall Street once ran from a graveyard to a river. It now runs from an ocean to an ocean, and beyond. It has become, in Dr. Charles A. Beard’s measured words, a new Appian Way of the world. As the Street has changed, the men who rule it have changed, too. Giants of a new breed are in control today, as different from the Vanderbilts and Harrimans and Morgans of the past as the Street is different from the railroad right of way and the bankers’ byway it was formerly.”
Mystery Men of Wall Street, Earl Sparling, Blue Ribbon Books, NY (1930)
In this issue of The Institutional Risk Analyst, we feature a conversation with Yves Smith, the nom de plume of the creator of Cfdtrade and one of the most savvy and respected members of the blogosphere. In professional life Yves is known as Susan Webber and is the founder of Aurora Advisors in New York. She is a graduate of Harvard College and a Baker Scholar and Loeb Fellow graduate of Harvard Business School.
The IRA: Thanks you for taking the time to speak with us today. First tell us about your upcoming book.
Smith: The book is ECONNED: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism and is out next week. It is one of the first books to explain the origins and mechanisms of the financial crisis. It takes a historical sweep, going back to the 1940s and 1950s, which was when the economic discipline made a deliberate effort to become more “scientific” which to them meant more mathematical. This methodological choice favored neoclassical economics and promoted the rise of financial economics whose fundamental flaws were incorrectly dismissed as inconsequential. These faulty ideas nevertheless became the basis of public policy, and led to deregulation in financial services, which in turn produced predation and looting. ECONNED exposes some particularly destructive trading strategies that played a key role in making the crisis much worse than it otherwise would have been, yet have been overlooked by regulators and the press.
The IRA: The economists wanted to mimic the great minds in the world of physics. They figured if the mathematicians could use quantum theory to solve problems of big physics, then why not use the same scientific method to address economic issues. The problem, of course, is that economics involves human behavior, so you cannot use mathematics to describe it. In the February 25, 2010 issue of The New York Review of Books, Freeman Dyson, Professor of Physics Emeritus at the Institute for Advanced Study in Princeton, wrote a wonderful profile of Paul Dirac, who along with Albert Einstein was the father of modern quantum theory. Dirac did not have Einstein’s talent for publicity and self-promotion, so few people know of his crucial contribution. Dyson described Dirac’s views about the use of mathematics outside of the rational, verifiable world of science in areas such a philosophy. Economics falls into the same social science bucket as philosophy. Dyson writes: “Dirac took no part in these debates and considered them to be meaningless. He said, as Galileo said three hundred years earlier, that mathematics is the language of that nature speaks. When expressed in mathematical equations, the laws of quantum mechanics are clear and unambiguous. Confusion arises from misguided attempts to translate the laws from mathematics to human language.” One wonders what Dirac would say today about modern economics.
Smith: Exactly. One of the problems with financial economics is that in order to make the mathematics tractable, economists assume rationality and consistency in human behavior. It is telling that economics is the only social science that makes these assumptions. Every other social science assumes human irrationality and inconsistency. A second problem is that economists prefer a proof-like stylization of their argument, and that further constrains how economists can model real-world behavior. Ironically, mathematicians look down on the way that economists use mathematics.
The IRA: Well they should. In the hard sciences this type of malfeasance and poor methodology choices get you bounced out of the profession, but in economics it is rewarded.
Smith: Yes. So when the economist tries to present his argument in a proof-like style, that methodological choice forces him to assume stability. We all know that is a suspect assumption.
The IRA: So whether we are talking about financial economics or the use of statistical models to predict corporate default or prepayments on mortgage backed securities, the basic assumptions are all wrong and thus the final product is useless. This is, by the way, why we chose to embrace a quarterly survey approach for our bank stress ratings that uses fundamental factors and not statistics. Only by testing each quarter using consistent criteria can you capture the changes in the entire banking industry and individual bank business models.
Smith: Right. That illustrates one of the difficulties of the approaches the discipline prefers, that it makes it hard to integrate qualitative information. “Hard” data that can be quantified easily is preferred, which produces drunk under the street light behavior, of framing empirical analysis around where economists can get clean data, rather than around what questions really are important to be answered, and then figuring out how to get insight with the information, both hard and soft, that is available.
The IRA: Correct, thus we have the spectacle of efficient market theory reliant upon equity market prices to predict default. This brings us to the luncheon discussion we had with Nouriel Roubini last week and our favorite topic, namely credit default swaps (CDS). We have always seen CDS and OTC derivatives in legal terms as an outgrowth of the market for currencies and interest rates. When OTC swaps were just about currencies and interest rates or even energy, there really was no problem because these contracts are priced against visible, liquid cash markets. But when the banks went into credit products, in our view at least, they went a bridge too far because there is no cash basis for the derivative. Instead the banks use models that were developed by financial economists in partnership with the large banks. Indeed, if you think of CDS as the creation of an ersatz, speculative market such as trading carbon credits, it fits very nicely with your description of the speculative nature of financial economics. What is your view of the evolution of CDS?
Smith: People use the term “swap” for CDS, but things like credit contracts or carbon trading markets are at best prediction markets. The whole use of the term swap is a misnomer. There is a great fondness for prediction markets, but they can and do perform badly. It really comes down to whether the people making the bets are making informed judgments. I’m sure you’ve heard your clients complain like mine that the marginal price of these instruments are being made by a 24 year old who knows nothing about the underlying relationships. The CDS market is almost entirely divorced from old fashioned credit analysis and, indeed, the participants basically say that if CDS says X, why do I need to do credit analysis?
The IRA: Precisely. We see numerous examples in the academic literature where economists take CDS prices as biblical text and rely on these contracts to support research. The profession is effectively eating its own tail, but they don’t seem to appreciate such distinctions. If you look at the Bloomberg or any of the other commercially available models to calculate probability of default, the reality is that the users are simply pricing off volatility, not any thoughtful measure of default risk. At lunch last week you started to talk about Phibro-Salomon and the competitive issues which drove the evolution of CDS at the largest banks. Care to expand?
Smith: There was a very interesting bit of industry evolution which led to the creation of the swaps market. People forget history. Back in the 1960s, over 70% of securities industry revenue was from commissions on equities. Firms held very small inventories. Institutional investors held longer dated Treasury and corporate debt to manage the fixed liabilities in their portfolio. Because pension funds and life insurers matched assets against exposures, bonds did not trade very much in the secondary market. The interest rate environment was stable and people were fairly confident in their ability to forecast. In the newly volatile interest rate environment of the 1970s, you suddenly saw a shift to bond trading. This was also the period of deregulation of stock brokerage commissions, so you saw the safe businesses squeezed. These changes in the business environment drove an increase in trading of instruments and this forced dealers to increase their inventory to accommodate trading and began to put pressure on the old line partnerships. It meant they needed bigger balance sheets, hence more equity, when revenues were falling and risks were rising.
The IRA: Correct. We saw that working at Bear, Stearns in the 1980s. They could not handle the huge leverage structure that rested on top of their capital position. Indeed, if you look at the banks that we cover today in the IRA Advisory Service, names such as Goldman Sachs (GS) and Deutsche Bank (DB) are heavily reliant on trading revenue. In the case of DB, the bank’s primary business line is now cash and derivatives trading out of their London operation. So did deregulation cause the financial crisis of 2007? This sounds like yet another case in point where efficiency is not necessarily a good thing. When we deregulated Wall Street, did we force the banks to become more speculative?
Smith: I don’t think that anybody thought through the implications. Deregulation was seen as benign. All of the measures that the SEC took to wring more easy profits out of the industry were justified in the name of helping the little guy, the small investor. We went from trading stocks on eighths to decimalization. But while deregulation was justified as being pro-consumer, the results do not bear this out. Look at the unintended consequences. The average holding period for stocks has dropped dramatically. It used to be something like 22 months, now it is well below a year. “Investors” can no longer be considered to be investors anymore.
The IRA: No, they are speculators. This is the Jim Cramer, CNBC school of day trading as “investing.” And this also goes to your point about the speculative nature of financial economics.
Smith: Exactly. Along with the changes in the markets and the behavior of individual investors, you had growing pressure on banks to generate profits and expand their balance sheets. Salomon Brothers responded by selling out to Phibro, a publicly traded commodities dealer, to gain access to cheaper capital in 1981. As the inflation-stoked commodities boom became a bust almost immediately after the deal closed, the old Salomon partners engineered a bit of a coup and came out on top. This was during the explosive period of growth in the mortgage-backed securities market, a very profitable business which Salomon pioneered. Salomon made more money in the mid 1980s than all of the other major firms combined. This freaked-out their competitors. Salomon was aggressively building out its platform internationally and this infrastructure expansion also put a lot of pressure on other firms. The economics of the traditional partnerships with higher cost of capital could not accommodate these demands. By 1986, all the full-line investment banks were public firms, with the lone exception was Goldman Sachs because they took an investment from Sumitomo Bank.
The IRA: And of course you worked for both firms during this period.
Smith: Yes. The second wave of pressure on investment banks came with the rapid growth of the OTC derivatives in the early 1990s. That business favored commercial banks with bigger balance sheets and this gave the commercial banks the chance to get in on the ground floor. The commercial banks had been pecking away at getting into the old-style investment banking business during the 1980s and had not made much progress. OTC derivatives was a market where the commercial banks had an advantage. They could get into the business using quants trained in the world of financial economics, a lot of them acquired via acquisitions of teams or established firms. So, again, the investment banks were forced to bulk up even further and acquire more capital.
The IRA: This suggests one of our favorite topics, which is that efficiency is not always good. The founders of the United States rejected efficiency arguments and instead used mechanisms such as checks and balances to deliberately make our political system inefficient, but the financial economists took the nonsense of efficient market theory to its most extreme.
Smith: Correct. The policies that came out of the Great Depression, which policy makers thought about carefully, were successful until the environment changed radically. We had forty years of stability on Wall Street under the rules established in the 1930s. Commercial banks were kept stupid and comfortably profitable, but that approach depended on there being little volatility. The old rule of 3-6-3, gather deposits a 3%, lend a 6% and the bank officer leaves as 3:00 in the afternoon was the model and it worked well.
The IRA: That is the description of a community bank today. They have a couple of funding choices and can perhaps go the Federal Home Loan Banks, but that’s about it. But all banks are about to get to know the old boogie man of interest rate risk when the Fed ends its asset purchases next months. Our friend and mentor Martin Mayer likens the evolution of the OTC markets as a pre-1930s bucket shop model, a completely speculative model. Do you agree with that characterization?
Smith: That isn’t too far off the mark. The new behemoth capital markets players really saw the role of traditional investment and commercial bankers eroded, so the new culture is a trading culture. The concerns on the investment banking side had acted as somewhat of a check on behavior. Branding and reputation matters to bankers, so you can’t be seen to be ripping off your clients. Now with the trading side ascendant at most firms, the attitude is that anything goes and all fair in love and war. This has resulted in a predatory posture by most firms toward their clients. If trading is all that matters and you are not concerned about traders and the sales desk killing the goose that laid the golden egg in terms of buy side clients, then you end up with situations like the one destroyed Bankers Trust. Proctor & Gamble sued them in a dispute over P&G’s losses, and got access to taped conversations by BT’s staff. The comments about clients became public and they contained incredibly damaging material, remarks like “We lure them into the dark and fuck them.” That attitude has become common today. The only difference is that people in the industry today haven’t been caught talking about it the way the Bankers Trust did.
The IRA: There was a little bit of reporting on this in the New York Times recently, talking about the difference between a sales person and an investment adviser. The former has no duty of care to the institutional client while the latter has an affirmative duty to follow rules on suitability and know-your-customer. Do you think that the SEC should revisit this issue and consider imposing a duty of care on all employees of banks and dealers?
Smith: Yes, because then you would have grounds for private lawsuits.
The IRA: Correct. Such a regime would also imply an end to FINRA arbitration to hide the bad acts so that investors could sue dealer firms for fraud and negligence when the duty of care was not performed. People often forget that there are many former employees of dealers who now work in the hedge fund community, including some very prominent names and owners of funds, who cannot be registered with FINRA because of previous transgressions.
The IRA: What do we do to fix this problem? Other than imposing suitability and a duty of care by the employees of dealers, what else would you do to lessen the speculative character of the financial markets?
Smith: I would subject everything to SEC disclosure standards. One of my pet peeves is significant omissions in disclosure. For example, one of the things that the FDIC is pushing in its proposed changes for securitization rules is that the parties very clearly disclose their intent. Under the current rules, you cannot determine who intended to do what in a given transaction. Whoops! The underwriter of a securitization is using the vehicle to go short? Most investors would give a deal a lot more scrutiny if they knew that to be the case. Goldman’s Abacus and Deutsche Bank’s Start programs were each a series of synthetic CDOs that the firms used to put on real estate shorts. Most people think those deals did not pass the smell test; indeed, Bear Stearns refused to work with John Paulson when he wanted to create synthetic CDOs for the same purpose, to go short. But that sort of arrangement is kosher under the current rules. That’s the sort of thing the FDIC wants to change. They would require the Paulsons, Goldmans and Deutsches to explain their true aims.
The IRA: Would you require that holders of CDS be compelled to deliver the underlying asset in order to receive payments on their default insurance? This would essentially take us back to the pre-Delphi world.
Smith: That would make a huge difference. I do not understand a world in which you can change the rules on existing contracts, as the industry did to preserve the CDS market when Delphi declared bankruptcy, on the one hand, but then rail about the sanctity of contracts on the other. All CDS prior to Delphi required that you present the bond to the protection seller, who would then pay you the face amount that he had guaranteed. Suddenly ISDA discovers in Delphi, the first real test of the CDS market, that the notional value of the contracts on Delphi greatly exceeds the face amount of outstanding bonds. Rather than risk the credibility of a product that was a big profit engine for its members, it modified the rules on the fly to allow for cash settlement. And that has allowed for a lot of destructive behavior, particularly the role that shorting subprime played in the crisis. It allowed the amount of subprime exposure to become much greater than that of the actual subprime market, greatly increasing the amount of damage done to financial institutions and costs to taxpayers.
The IRA: Well, this is the dirty secret about Paul Volcker and Gerry Corrigan. As regulators each of these men stood by and watched all of these developments in the banking industry and did nothing. Indeed, each of them encouraged these evil evolutions in order to boost the short-term profitability of the large banks but never understood or cared that on a risk-adjusted basis these returns were in fact negative.
Smith: One thing that has been disappointing is that here we are, approaching three years since the start of the crisis, and there have been no investigations of fraud on Wall Street. Lehman was clearly a fraud. Hank Paulson effectively says that in his new book, that Lehman had greatly overvalued its assets in its SEC filings. Some argue that we should not pursue fraud claims with respect to Lehman because that would complicate the bankruptcy. That is not a good enough reason because who knows where a thorough investigation would lead. The other part that I find disappointing is that people keep talking about banks, but don’t differentiate between ones those with dealer operations and those without. None of the reform proposals on the table now, including the Volcker rule, deal with this distinction. Trading and market-making operations pose very different sets of risks, both to the institution itself and to the financial system than traditional banking, and therefore need to be addressed differently.
The IRA. We could not agree more. Thanks Yves and good luck on the book.