06.23.10
Posted in News Commentary at 8:16 pm by steve
“What the hell did we do to deserve this?” - Tony Hayward CEO of BP after the Deepwater Horizon spill.
“Who cares, it’s done, end of story, will probably be fine” - unidentified BP employee in an e-mail before the Deepwater Horizon spill (Economist 19JUN2010 p65.) writing about the use of six centralizers rather than the 21 recommended by the drilling company.
On April 20th Deepwater Horizon burped, blew up, and started spewing oil at what is now estimated to be 60,000 barrels per day. In one hundred twenty days, that’s just short of 2 million barrels of oil. And at $100 / barrel, that amounts to about $200 million in lost product alone. Add to that the cleanup cost which could reach nearly $ 100 billion and the accident begins to look like a rather costly error.
For some brief period of time there was some question about whether this was simply a case of bad fortune. But within days of the accident it became clear that BP systematically cut corners over the whole life of the project. The quotation above suggests that BP employees knew that their work was shoddy; but hoped for the best.
A similar situation held for the piping. Virtually all major oil companies use double walled pipe, but BP chose to use cheaper single walled one, even though the decision violated their own standard
There were problems with the blowout preventer leaking hydraulic fluid and failing tests. Tests of the cement job were unsatisfactory.
It is common practice to circulate drilling mud before removing it in order to remove any gas that it has absorbed precisely to prevent blowouts. BP skipped this step. Similarly, there were serious questions about the quality of the cement job, due in part to the decision not to circulate and degas the drilling mud.
Arguments between the drilling company, Transocean and BP broke out on the rig days before the accident about how to remove the drilling mud. Transocean employees argued that BP’s method took unnecessary and potentially dangerous risks, to which BP’s Mr. Harrell said - referring to the faulty blowout protector - “I guess that’s what we have those pinchers for.” But on the day of the accident, the guy running to push the activation button didn’t get there in time. So we’ll never know whether it would have worked.
The stories about this accident demonstrate a theme. The theme is that BP considered being on time and under budget much more important than it considered safety. And that’s a culture of the company that goes back at least four years. It was in May of 2007 when John Browne resigned after the Prudhoe Bay oil spill and the Texas City refinery explosion that killed 15 employees. One explanation was a pattern of “willful and egregious” (Economist)breaches of safety procedures. Another explanation was that BP had systematically fired its most experienced and most technically savvy employees and had promoted its movers and shakers - the guys who did best at cutting corners. See also, the kind of guy’s who would write “… end of story, will probably be fine.”
Soon after Tony Hayward took the reigns from John Browne he decided to reorient the company. The goal was to improve shareholder value (at least in the short term). He eliminated the alternative energy operations, rendering the newly minted “Beyond Petroleum” slogan to mean nothing, literally. Nothing lay beyond petroleum for BP.
In May 2009, almost a year before the Gulf coast oil spill, Hayward gave a lecture at the Stanford Business school in which he outlined the many problems that he faced when he came to BP. A major issue, he noted, was that “We had too many people that [sic] were working to save the world. We had sort of lost track of the fact that our primary purpose in life is to create value for our shareholders…our primary purpose in life was not to save the world.”
BP’s “Beyond Petroleum” rebranding was, admittedly, the work of Hayward’s predecessor, Lord Browne, and Hayward was focused on developing the company’s core competencies. Then again, with only 6% of BP’s capital expenditure going into renewable energy sources, it’s not as if the company’s radical change ever extended much beyond its PR campaign.
See full article from DailyFinance: http://srph.it/9D107T
The question of how to treat alternative energy is an old one in oil companies: “Are we a primary energy company, or are we just an oil company?” Every oil company has people who believe passionately in one version or the other. One argument is that oil production and refining is a core competency, and that other forms of energy require other technologies and other forms of marketing and are, therefore, distractions. But if you are going to use the argument that you will focus on oil because that is your core competency, you really ought to be good at it.
If Tony Hayward came to Washington and said, “Sorry, we put our best people on alternative energy precisely because we want to end the dependency on oil,” then the appropriate response would be “Well you need to be better at doing oil, don’t you?” And that could be the end of the discussion. But if you have sacked all your best oil engineers because they cost too much, and if you have cut corners in every conceivable measure in the drilling operation - taking exceptions to industry standards and practices at every step, and if you have killed all the alternative energy programs, then it looks like the only concern you have is the bottom line - safety be damned. And after a huge accident such as Deepwater Horizon, it looks like you have been penny wise and dollar foolish.
It’s not behavior that helps the customer. It’s not behavior that helps the public. And ultimately, it’s not behavior that helps the shareholder. BP lost half it’s market capitalization as a result of the accident. And they suspended their dividends - which will make a lot of Brits, Her Majesty included, very upset.
But the failure to behave in a way consistent with generating long term value is not unique to the top levels of BP. It affects other companies.
People at the highest levels of any corporation at times need to abstract the operations of their companies in various ways in order to avoid getting bogged down in details. So operations of all sorts are viewed as black boxes. It’s both necessary and appropriate to do, sometimes.
But one of the great temptations is to view all operations as black boxes that work pretty much regardless of what you do to them, carefully ignoring all the details regarding what is required to make them work. The second half of the problem is to view the profits that operations produce as simply the difference between the cost of inputs and the revenue from sales. If you put these views together without any other information, the only logical step in maximizing profits is to increase sales and to cut costs.
One cuts costs fastest by cutting people. And one cuts the most expensive people first. Sometimes much can be gained by cutting corners in raw materials or processes. Or by cutting out safety redundancies in projects. But in this frame of thinking, because the operation is abstracted at the highest levels and is assumed to work regardless of conditions or constraints, then cutting costs on people or on materials, or on projects, or on quality assurance processes by definition cannot affect the outcome of operations. Operations keep on working, regardless. In this view of the unconditionally functional black box, there can be no straw that breaks the camel’s back.
What happened to BP resembles this in many ways. They kept cutting costs on pipe maintenance until oil leaked at Prudhoe Bay. They kept cutting operating costs at the Texas City refinery until it blew up. They kept cutting costs in drilling until they had produced the most costly oil leak in the history of the US. It demonstrates a serious problem in corporate culture, a problem that goes all the way to the top of the company.
Interestingly, what is happening at BP resembles what has recently been going on at Johnson and Johnson. In a Business Week interview, six or eight years ago soon after he became chairman of the board, Bill Weldon presaged his primary approach to managing the company. The days of 30% per year revenue growth were gone for good, he announced. So the company would have to cut costs.
Wave after wave of hiring freezes and job cuts followed. The first several cuts evidently produced no problems that were serious. But over the last year a significant portion of the products produced by J&J’s consumer pharmaceuticals company within J&J has been removed from the marketplace for quality defects. And the FDA is contemplating filing criminal charges against J&J employees. It’s a black eye for the most visible part of J&J’s business, and it will change for a decade or two how people judge J&J’s commitment to the quality of its products.
In all the details, BP’s Deepwater Horizon accident and J&J’s consumer products recalls are different. But in at least one way they are the same. They arose from a rather profound failure of one or more of the people at the top of the corporation to acknowledge the crucial importance of operations - a failure to acknowledge that cutting costs might start by cutting fat, but it eventually slices away muscle and bone and essential organs until, eventually, the body collapses or bleeds to death.
Treating operations as a black box that always functions, regardless of how it is treated, can produce serious problems. The further the CEO gets from operations, the more likely is the failure. Hubris, and the arts of networking and persuasion are crucial tools for CEOs. Many times CEOs succeed in getting their way because nearly all the constraints they face are political; it is, therefore, tempting for them to believe that the only political constraints exist. And to behave accordingly
But in the end, the real world does constrain our actions. It’s why we have standards and tests and procedures inside companies and in governmental agencies. It’s why companies and governmental agencies hire, train, and retain good people. It’s why CEO’s need to listen carefully and provide the resources for people to do their jobs properly. It’s why sprawling corporations have compliance and process excellence departments that report to the highest levels of the corporation, not to managers of individual business units. And it’s why CEO’s need to be quick to fire people who cut corners in order bolster profits.
Eventually, treating operations as a little black box that just keeps on cranking out profits - no matter what you do to it - will be the beginning of the end for your company.
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06.14.10
Posted in News Commentary, Politics at 4:15 pm by steve
Any science fiction or futurist writer worth his weight in muddy water would tell you that one of the more realistic plots for how civilization grinds to a a bloody end involves protracted resource wars between major players. There is a sense in which both of the first two World Wars can be viewed as resource wars. Japan sought access to cheap resources throughout Asia. Germany sought access to cheap resources throughout the mideast. And British fought to keep access to cheap resources in Africa, India, and the Far East. Ultimately, it is about who is to control resources that virtually every war is fought.
When Dubya invaded Iraq and the rest of the world declared that the whole thing was a charade, an elaborate grab for oil resources, most Americans were skeptical. But now that we see what has happened since, it seems like a most plausible explanation. The control of oil is, indeed, the most economically salient outcome of the invasion.
Iraq has the second largest proven reserves of oil in the whole world, surpassed only by the stated reserves of Saudi Arabia. And since Saudi Arabia keeps their stated reserves constant regardless how much oil they withdraw, nobody completely believes those statements. Which means that Iraq may hold more oil than any nation in the world. Regardless of rank, there are 112 billion barrels of proven reserves and almost twice that much in speculative reserves. At $100 per barrel, the value of the oil exceeds $10 trillion.
The US has spent in excess of $1 trillion on the war in Iraq. It has spent more than half a billion dollars on building the embassy alone. These acts suggest a seriousness of purpose. More telling are the permanent bases it intends to occupy indefinitely outside of populous areas, and the fact that they are located not far from the oil fields they are designed to protect. There can be no question that one [presumed] outcome of the invasion is the political stabilization of the area and improved access to the oil found there. Even the negotiations with Iraqis over the pricing of oil sought major pricing concessions that would have brought significant excess profits to the oil majors who operated there. So there simply can be no question about whether oil was a major motivating factor. The only question is whether it was the only motivating factor.
(I have never heard it argued before, but I think it is worth arguing that the US was willing to move out of South Vietnam at the point where it was decided that synthetic rubbers could do the job once done by natural latex rubbers and therefore Vietnam was no longer a source of an essential strategic resource. Without any rubber, the US’ major industry at the time - the auto industry - would fail. With rubber it would thrive.)
There never was any question about whether the war in Iraq was about terrorism. The Saddam regime was hostile to al Qaida and to radical Wahibbists in general. It was a regime interested in commerce with the west and with the Orient. And it was strongly motivated by sanctions.
Similarly, there never was much question about whether the war in Iraq was about weapons of mass destruction. Iraq had quite visibly dismantled its WMD programs. And there never was much evidence to the contrary. Furthermore, WMD is never the real reason one nation invades another. At least until the statehood of Israel it was assumed that a nation had the right to defend itself against aggressors with what armaments it could assemble.
What of the role of neocons? Neocons had grabbed the reigns of public opinion in the US and controlled most of the high-powered policy decision-making in Washington. Richly financed by the arms industry who sorely needed real action in order to justify continued lavish defense department expenditures exceeding half a trillion dollars per year, Neocons manufactured rationalizations for the war in Iraq. There can be some doubt, however, whether their arguments were purely mercenary or whether they were calculated to serve the interests of some other group.
They had, after all, advocated a US led occupation of Iraq and Iran some years before 2001, suggesting that war with Iraq and Iran had nothing to do with terrorism, in their minds. The level of preparedness for the invasions and for the bodies of law that followed the putative trigger to the invasion is remarkable, suggesting almost prescience on their part. Or perhaps when one prepares to invade nations to extract their resources, a considerable amount of the right kind of theater makes the job politically possible.
The fact that there exists something in excess of $10 trillion of proven oil reserves in Iraq, the fact that there might be two or three times that quantity there, the fact that political instability threatened access to those reserves, and the fact that an occupying force provides powerful incentive to create political stability within Iraq ought to be sufficient to suggest rather forcefully that the primary motivating force for the invasion was access to oil.
The invasion of Afghanistan has always made a little less sense. Afghanistan was the source of opium valued recently at more than $50 billion per year, and the Taliban had shut down the trade in the year prior to the invasion. After the invasion, the trade bourgeoned. So if one were to imagine, hypothetically, that the parties who benefitted most from this revenue stream also were officials instrumental in making the decision to invade Afghanistan, then the invasion would begin to make sense as a means of restoring the opium trade and the revenue that flowed from it. But it was easy to wonder if that was all. In comparison to the bountiful resources captured in Iraq, Afghanistan hardly seems worthwhile. At least until today.
A story in today’s New York Times sets Afghanistan’s mineral wealth in excess of $1 trillion, pronouncing its bounty huge in comparison even to the rich trade in opiates. Bear in mind that it will take twenty years at least to develop and extract its mineral wealth and $50 billion for 20 years is $1 trillion; therefore, if the mineral resources dwarf the opiate trade we are talking more of three or five or ten trillion dollars worth of resources.
This story begins to bring us closer to understanding the real reason for the invasion. The article suggests that this is new information. It also suggests that the information was known by the Soviets during their occupation of Afghanistan in the 1980’s but was unknown and ignored by the US until some time in the last coupla years. That’s a little hard to believe.
Perhaps it is true that before the survey spoken of in the article, the quantity and quality of Afghanistan’s mineral wealth was less certain; but there can be little question that it was completely unknown. Satellite reconnaissance could have scoured the rocky terrain of the country using special spectrographic techniques that would reveal the concentration of every valuable mineral known to man over almost every square foot of the nation. And this could have been done, probably, in the ‘nineties. So a very good estimate of the mineral wealth there could have been known to high level officials a decade ago, maybe two. The specialists who reported back recently could have merely been doing verification work, not exploration work.
So if we consider the total mineral wealth of Afghanistan and Iraq to be a minimum of $20 trillion and possibly as much as $30 trillion or more, and if we consider that the people who profit most from this mineral wealth will be using other people’s money to secure access to it, then the invasions of both countries would seem like a great deal for them.
The hypothetical question is: if there were to exist a great pot of money that was between $20 trillion and $30 trillion in size; and if that pot of money is known to only to a small group of military-industrialists, and if that group needed a good story to provide political cover to use military force to grab the loot, what do you suppose they might do?
If you stood a chance of getting $10 million for a pivotal part in selling half-truths and outright lies to the American public in support of a goal of access to $10 trillion worth of minerals, what would you do? What do you think your next door neighbor would do?
I mean, after all: those resources are unavailable until the region is politically stable. So the invasion physically improves the lives of all who benefit from the commercial successes of industry and trade as practiced in Europe, North America, and Asia. Doesn’t the end justify the means?
Of course it is impossible to prove just by examining events how people were individually motivated, but there can be no question that the wars in Afghanistan and Iraq gave western nations access to tens of trillions of dollars worth of strategic mineral resources that might have been unavailable otherwise. There can be little question that access to resources figured prominently in the decision to go to war. And that no war could be publicly justified on these terms, so there had to be another reason for public consumption.
The resource wars have begun.
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04.17.08
Posted in News Commentary at 3:16 am by steve
Hillary on the Stump
When Senator Clingon talks about what she really believes in, it can be a beautiful thing. Read her speech at the Newspapers Association of America (NAA) annual conference.
Burgeoning Paintball Terrorist Organization..
You probably remember the coupla guys who were arrested not long ago for plotting to invade Ft. Dix NJ, and the incriminating evidence - that they practiced in the woods with paintball guns. But do you remember this group? I’ll tell you, I’m starting to wonder whether we should’t just outlaw paintball.
Time to buy beachfront property in Orlando?
Not quite yet. But by the end of the century sea level will rise by as much as 1.5 meters. That’s the new concensus. It’s going to make life difficult in a great many areas that now exist near sea level.
Up in the Air - The Future of Fuel
Is it pure coincidence that on the same day we learn from the BBC that China has just taken the top spot in CO2 generation from the US and that the Dubya administration has decided to weigh in on the problem of global warming?
More on ‘Bitterness,’ ‘Downity,’ and America’s Favorite Game
See the fourth comment here.
See if it’s Still There..
Thousands of commentators blast ABC for their job hosting the Democratic “debate”
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04.16.08
Posted in News Commentary at 3:28 am by steve
As broccoli or arugula? Sadly, NO! “I don’t want the people I elect to government to down shots. I don’t want them to clear brush. I vote for them to run the goddamn government.” Me too.
Sadly, NO!“I have never in my life seen a such a large collection of catty, shallow and gossipy pieces of garbage. Instead of, say, talking about health care, gas prices, inflation, the Iraq war or the environment, these useless gasbags waste our time finding the most idiotic and petty anecdotes to spread around …” Am I the only one who is bitter, or what?
IT was at 666 Diggs plus one when I visited CBN . It’s interesting to hear what the actual subjects of the comment think about Obama’s ‘bitter’ comment.
Klaus from Canada weighs in with a good comment here
Background and Frame at Shakesville.
The CNN clip.
The brouhaha is beginning to reveal the omnipresent cracks in sanity that have plagued members of the neocon advocacy group, with guys like Rove and Kristol calling Obama a Marxist . Somebody is scared that Obama might win, and the screaming has started.
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04.02.08
Posted in News Commentary, Politics at 5:41 am by steve
There is an old saying variously attributed to Eleanor Roosevelt, Winston Churchill and Arabic mythology:
Third rate people talk about people.
Second rate people talk about events.
First rate people talk about ideas.
We wonder if the concept cannot be extended to the speech of political candidates. I think it also happens to be true of political reporters.
Third rate candidates talk about events.
Second rate candidates talk about issues.
First rate candidates talk about principles.
Think of Lincoln’s Gettysburg address. It was an address about an event, yet it made only a passing reference to the event. None of the battles or generals were mentioned, not even Gettysburg. Lincoln eschews talk about slavery as well. The speech is not about issues. Rather, Lincoln appeals to the noble principles upon which the nation was founded. He links the events and the issues to this set of noble principles. And the language he uses is terse, precise, memorable, compelling, ennobling. In remembering it we are made better. This is the stuff of good political discourse.
Aside from this example, there are several reasons to believe that speaking in terms of principles is desirable.
At one level we believe that intelligence is a desirable quality in a candidate. One important sign of intelligence is the ability to deal with abstractions. We note that issues tend to be abstractions about events. And principles tend to be abstractions about issues. Candidates who are capable only of talking about events, we have reason to believe, are probably not terribly bright. If a candidate only talks about issues it may be that they are incapable of fitting arguments about issues into a principled framework. Or it could mean that they don’t have a principled framework. The former is a sign of inadequate intelligence. The latter is a sign of a habit of expediency, laxity, sloppy thinking, or compromised principles.
The ability to speak articulately about principles and their relationships to issues and evvents is a clear sign of two forms of intelligence - the ability to make good distinctions and the ability to synthesize disparate facts into meaningful frameworks of knowledge.
The skill also confers a persuasive advantage. Politicians have who speak articulately in terms of principles frequently can get some broad agreement on a lofty principle long before they might be able to can get agreement on the policy details of an issue. And it is frequently true that when one gets agreement on principles, a good policy is easier to hammer out.
One of the great problems Hillary has had in her political carreer is that she has thought much more carefully about how to fix problems than she has about how to lead people toward a reasonable answer. She gets stuck in the details. She does not get early agreement on principles.
Her proposition for a single-payer health plan was among the most timely and important issues that faced Congress in 1992. Had it passed, it would have been seen decades later as Clinton’s most profound political contribution. Had it passed, a significatn number of the problems the US healthcare system now faces would be less severe. Her failure was not in getting the right plan. Her failure was in getting other people to buy into it.
Instead of going about Congress getting people to buy into a set of governing principles and getting thoughtful people with access to the press to advocate for those governing principles, she attempted to sell a fully formed plan. The surprise is not that she failed. The surprise is that she came so close to success using methods doomed to failure. While it was true that Hillary wowed Congress with her command of the facts and with the compelling logic of her arguments, opponents exploited fear and greed and turned the public against the plan.
But, I think, this need not have happened if Hillary had made the case for a set of principles. For instance, that the US should not rank after Cuba in infant mortality. It’s not even a first world ranking. Which politician is going to argue “No, no, America cannot afford to be as good as Cuba at protecting the health of the unborn and newlyborn?” This statistic, by the way is a metric of how access is severely limited for a substantial population of the poor. When they get very sick, they go to the emergency room where they are treated for five, ten or a hundred times what it would cost had they been given the right preventative care. The cost of treatment is higher and the outcomes are less favorable. So one might argue we need solutions that simultaneously achieve better outcomes, and ultimately cost less. Well, giving the right kind of free care to the indigent would absolutely achieve this end. For the fact that the indigent do not pay for emergency care does not mean that we do not.
I recently read a piece entitled “When Obama Channels Reagan.” It was actually about Obama invoking Reagan, but it got me thinking. Reagan was pretty good at talking about principles. He was good at getting agreement on those principles. Now it is my own opinion that a significant number of the principles that he sold were cheap, tawdry, and ignoble. Many were swindles and cheats, lies and deceptions, frauds and fictions. But that’s not the point. The point is his persuasive methods were effective. And it happened that I had just been thinking today that Obama does, in fact, share some of Reagan’s ability to talk about principles and to get us all to agree on them.
Obama is skilled at finding common ground and starting a discussion about change from that point. This is a powerfully effective technique. It is a technique that has some hope of swaying people who may not already agree with you. It is a technique in which Hillary displays not quite so much skill as Obama. Nor, I think, does Hillary show quite so much skill at it as McCain. For this reason, I think that Obama has a better chance in November against McCain. I will disagree with some of his policies; but I do believe that if he succeeds in advocating for a set of nobler principles to supplant the bankrupt ones of the Reagan legacy, the US and the world will be a better place for it.
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04.01.08
Posted in News Commentary, Politics at 2:54 am by steve
The “subprime mortgage” fiasco is being treated as if it is some kind of exotic financial disease heretofore unknown to man. There seems to be a lot of “how could we have known?” going around. But if one looks beneath the specifics and gets to the generalities, one quickly realizes the fiasco is of a type that can be traced far back in history The specifics are different but the generalities are the same. The problem is one of speculation.
Speculation is a problem associated with the perceived value of a thing depending at least to some degree on the expectation that the real price of a good will be higher later on. This speculative force draws its sustaining force from new people entering the marketplace, usually because a good is appreciating at a remarkable rate of increase. The joining phenomenon brings new players into the system, driving up prices. Then, when there are no more people entering the marketplace, the scheme collapses. Who is hurt most depends on the specifics of the game, but it is frequently the last to join the frenzy. To understand this game we must look at some historical examples
Of Tulipmania and Ponzi Schemes
An early example of this was the seventeenth century Dutch “Tulipmania.” People would purchase new tulip cultivars, hold them, then resell them a little later, and realize a significant increase in price. The breadth and depth of the craze was profound. Early on many people made a fortune. The mania spread and expectations grew wiith the extent of the infection. There were cases in which people mortgaged their homes to purchase a single tulip bulb in order to ride the speculative frenzy to new heights. But by that time the fever had almost run its course. Soon the market collapsed for lack of fresh fuel. If everyone has morgaged their house to buy a single tulip bulb, where does the money come from for the next wave of investors to purchase bulbs at an even higher level? Eventually such a scheme must collapse. Tulipmania is a classic, if somewhat exaggerated, example of a speculative bubble.
To get a handle on things we need to define some rarely used terms. The first is non-speculative price. Or normal price. This is the price that a widely traded good would fetch on an open market when the expectation of speculative gain is identically zero. A person buys the item not for what they expect it will fetch later, but for what it is right now. They buy it soley for the normal utility it provides.
Suppose one goes to a Wal-Mart to buy a pair of sneakers. One pays no premium on the sneakers. It’s because one does not expect that at some point in the forseable future those sneakers will fetch far more than one pays for them. This is what we mean by normal price. One can define a normal price for most goods that are widely traded. For one-of-a kind items such as an original Van Gogh painting it is not so easy to do. But for homes, for cars, for sneakers, for commodity goods, for most things that are purchased partly or mostly for their utility, one can always estimate a normal price. And when a price exceeds this level it is, by definition a speculative price.
Some kinds of speculative pricing is sometimes justified. A tulip bulb can be had on the open market for something like half a dollar. This is the normal price. A new introduction might be priced at two or three times this price. Here, a buyer might pay an extra amount to be the first in the neighborhood to grow a particular tulip. So if one is in the tulip business, one might purchase a handful of new tulip bulbs for many tens of thousands of dollars, paying for the exclusive propagation and distribution rights for a season or two.
The distributor might pay hundreds or thousands of dollars per bulb. We might define this increment as speculative price. But at least here the value of the speculative price is secured by a cartel agreement. The nature of the speculation is different. The speculative value depends on limiting distribution, not on creating an unsustainable psychological game of chance.
It is a very different kind of speculation from the sort at work during tulipmania. It limits the losers to the bulb company - if it fails to sell as many new bulbs as it expects to sell - and the bulb company’s customers who pay more than they otherwise would for new tulip varieties. But these losses are losses based on clearly defined risks. The people who lose know the parameters of the game going in. They enter the game understanding and accepting the risks.
The tulipmania game is categorically different. The nature of the speculation derives from the creation of buzz. It derives from the expectation of excess gain that exists only by virtue of someone else later on joining the game because it provides excess profits. This hope of gaining excess profits by controlling ownership of an appreciatiing asset we will call greed. Tulipmania existed because of greed. And it was sustained byan ever increasing body of new members who joined not because they were interested in growing tulips but because they were interested in making a quick profit.
The purest form of the game was invented in the early twentieth century by a New York whiz-kid named Ponzi. Ponzi advertised accounts that would pay15 percent interest per annum. This is quite a huge return on investment; but if money is very shrewdly invested it is not impossible to get these kinds of returns. Warren Buffet has done it. Early investors in Ponzi’s scheme, in fact, realized the advertised gains. They told their friends, neighbors. and business contacts. And many of them joined in, too. The game continued in this way for a while, but the population of joiners was finite and, as it turns out, Ponzi was a great marketer by a lousy investor.
He was not investing the funds at all. Rather, he was using the deposits of new investors to pay interest to existing investors. The “interest” was a wholesale distribution of funds from new entrants to older ones. If an account pays 15 percent interest in such a game, the game is sustainable only so long as the pool of new participants grows at more than 15 percent per year. Once that no longer holds, the obligations to investors quickly dwarf the assets available to fulfil them. And the institution comes crashing down. It is a mathematical fact that this conditon cannot be fulfilled; therefore the scheme must fail.
What was brilliant about Ponzi’s scheme was that it achieved what tulipmania did without there existing any underlying asset. Tulipmania participants, at least, could argue that “the value of an asset is what it will bear on the open market, so if I mortgage my house to buy a tulip bulb, that must be the value of the bulb.” Precisely the same reasoning was heard on Wall Street just before the dotcom crash. It illustrates the difference between normal price and speculative price and the dangers of confusing the two.
But in Ponzi’s scheme there was no underlying asset. People were trading on trust. And if they had understood how Ponzi was creating 15 percent returns, most of his investors would have looked elsewhere. Ponzi’s scheme, then, is a compelling argument for two qualities in investment instruments:
1) Transparency. Ideally, every financial transaction that might potentially affect value is represented on the publicly available books. A recent article about Citibank suggested that up to half its assets were off-balancesheet. No wonder it is selling itself cheap to offshore sovereign funds.
2) Comprehensibility. Ideally, every person who invests has a pretty firm grasp of what it is, fundamentally, that causes an investment to create wealth. This understanding allows an investor to assess risk. Financial instruments that require a PhD in mathematics to comprehend deserve to be used only by investors who can employ PhD mathematicians to protect their interests in real time.
In the Ponzi scheme the whole of the value of the investment is secured by subsequent joiners. This means that the last people to join must necessarily lose most or all of their investment.
Of Leverage and Levitation
This brings us up to the market crash that led to the Great Depression. In the “roaring twenties” new industries such as steel, and oil had passed through infancy and adolescence and were in early middle ages and t were turning out huge amounts of cash. Railroads were in their late middle ages. and were still turning out healthy profits. With the possible exception of automobiles, there were not so many new industries in which to invest - not on the same scale, anyway. Consequently, the price of equities was driven above the normal price. Meanwhile, speculators saw that share prices had been going up steadily for a long time, and they chose to exploit that fact.
Anytime an asset has appreciated steadily for a decade or more, there is a temptation to believe that the trend is permanent. And speculators did just this. But the real money was to be made by borrowing money to buy stocks. If one borrowed money at five percent and one realized ten percent in the stock market, it was like getting free money. Rich individuals did this. So did banks. It seemed like a sure bet. And it might have been, so long as the price of the equities was a normal price.
The result of this was that the price of assets slowly began to rise abovr the normal price. After some time they departed significantly from the normal price. A significant portion of the price of an equity became speculative. And because the continued rise in this speculative value relied on ever-increasing amounts of money entering the system, it was, by definition, not sustainable. On “Black Friday” in 1929 the market collapsed.
In normal circumstances, if a person buys an equity and the equity loses half its value, then the equity stake loses half its value. But these were not normal circumstances. Many speculators, individuals and banks had borrowed money to puchase equities, on the assumption that the price of equities could only go up.
If a person had borrowed an amount equal to their personal assets in land and other fungible assets to buy stocks; and if the stocks they bought fell by half, they could sell their stock holdings and half their other assets to make good on the loan. But, in fact, many investors were leveraged more than this. And some investments fell by more than half. As a result, many investors were wiped out. Many banks went bust. And their depositors lost their deposits. The capital markets dried up. And unemployment reached 25 percent. It was hard times.
The basic system can be described in many terms. It was a normal sort of speculative bubble driven by greed and hope of easy money. It was a speculative game that relied on an ever increasing number of players to sustain the excess return of early entrants. It was a case in which a significant portion of the price of an asset was speculative in nature - it was based on the expectation of future appreciation. And the effects of a downturn were amplified by leverage. The fact that borrowed assets were used as instruments to purchase a speculative asset meant that smaller downturns resulted in more devastating losses.
The tulipmania speculators lost only their own houses. They did not lose, as well, the houses of everyone on the block. But leverage which allowed an institution to make excess gains using other people’s money to buy speclative assets, also destabilized the system. It both led to a kind of speculative frenzy, and it assured that the end of the speculative frenzy would be ruinous not only to those who chose to play but also to people who did not even know they were participating.
My Stodgy Bank
The lessons of the Great Depression were not lost on legislators of the ninteen thirties and forties. They passed legislation that isolated banks from other kinds of financial institutions. From the point of view of depositors; they should be able to correctly presume when they deposit money in a checking or savings account that it will always be there to use when they need to usel it. The bank is presumed by depositors to be a safe place to put money. When this condition does not hold, it is a swindle to bank customers and it is a blot against the reputation of the banking industry.
Banking simply cannot survive without this high level of trust. If it is both to sustain this trust and warrant it, banking institutions must simply never lose people’s deposits through speculative misfeasance or malfeasance. They simply cannot be allowed to play unduly risky games with the money - whether they are smart enough to understand those risks or not. This was the thinking that underlay the legislation. And, until 1996, this kind of organizational principle made banking secure for bank investors and depositors.
Consider a simple case; the home mortgage lender of the mid-fifties. It was a neighborhood bank. It lent mortgage money to home owners who put twenty percent down on their homes. It lent from a pool of capital that came primarily from local savings. And so if Mr Smith defaulted on his mortgage, Mrs Jones and several of her neighbors may not be able to withdraw their savings to spend on cars or college for the children.
Actually; reserve requirements made it hard for this to actually happen; but the threat was always there. Banks lent wisely, for the most part, because it was in the best interest of the institution, because it was in the best interest of the community, and because it was in the best interest of the bank’s officers. They took their fiduciary responsibilities personally. They also lent wisely because there was a body of law that would prevent practices that would lead to the unstable conditions of the 1920s.
But things changed. Banks began trading mortgages. This was good because some places had an excess of capital; large cities for example. And commercial or industrial institutions sometimes generated huge sums of cash. And some areas, such as bedroom communities, had large demand for debt. All other things being equal, the business of selling mortgages helps efficiently allocate financial resources.
But already, all things are not quite so equal. Already the practice of selling a mortgage comes with a problem; if the originating institution - be it a bank or a service company - has no stake whatsoever in the quality of the debt instrument and the creditworthiness of the debtor, the game is set up to encourage companies that manufacture and sell morgage debt insturments without making sure these instruments actually have any minimal level of quality. Furthermore; institutional safeguards alone are not always so powerful as are safeguards that include a risk to reputation as well.
Still, economic theory predicts that in the long term market forces might weed out those institutions that are the worst offenders; but this takes time to discover. And it requires that one price mortage securities in accordance with this lower expetation of creditworthiness. In other words; when one changes the rules of writing mortgage securities in a way that increases risk; the securities need to be valued in accordance with this fact. Perhaps in some recent cases this has not been the case.
What actually happened over the last decade or so was that even if an institution that wrote a loan did have some financial stake, if it was a publicly held company that originated a loan, the company could flourish so long as it increased its monthly loan-writing volume. Fees for originating new loans would paper over losses from bad loans. for some time. Then, when the whole thing went south, the officers would bail out, keep their houses and big bonuses, and the shareholders and creditors would be left holding the bag.
Unlike the olden days when a bank loan officer was part of the community from which the equity originated, loans came from nameless pools of money. Now, nobody who benefitted from this legal sort of Ponzi scheme had to look a depositor in the eye and say “sorry Mrs Jones, I behaved like an idiot with your money. Your retirement is cancelled.”
The behavior of knowingly writing bad loans is destructive; and it is reasonable to have laws that punish people who are responsible for it. But things got much worse. Morgage securities were bundled into huge pools of securities. Then they were “sliced up.” This meant that certain kinds of risk - geographical, for instance, might be spread evenly through a large number of portfolios. This certainly did decrease the amount of risk in any given portfolio. And that is good. But the practice did not eliminate all kinds of risk. For instance, mortgage securities depended upon increasing home prices for borrowers to keep making payments. This meant that the creditworthiness of the whole pool depended upon consistently rising home prices. The risk associated with the failure of this condition was essentially the same, regardless of how things were sliced and diced.
If home prices stopped going up. And if people were borrowed to the max against their home equity, they would have financial incentive to walk away. Seeing this day coming, Congress revised bankrupcy laws in the early 2000’s to make this eventuality less attractive to homeowners. But this did not change the workings of the financial machine that derived its value from lending money it did not have. It did not fix the problem of leverage. It did not change the expectation of the average Joe that his own home would accumulate value almost like magid indefinitely.
The Value of a Home
It’s hard to say precisely when today’s real estate boom took off. There is a kind of continuity to it that can be traced all the way back to the end of WWII. The parents of todays boomer generation began building sprawling suburbs at the end of the war. And the building trend has continued apace ever since. People have become ever more productive, and the amount of resources they can dedicate to buying a house, in real terms, has increased. At the same time, inflation has changed the value of a dollar. All of these factors have conspired to drive up the nominal price of a home.
There have been ups and downs. Boomtimes occurred when real interest rates dropped. Bust times occurred when interest rates rose or when significant economic retrenchment occorred. But for the most part, homes kept pace with inflation or did a little better over the stretch from 1950 to 1996.
There was a point in time in the early 1970’s in which the inflation rate was nearly seven percent and the interest rate on a long-term loan was five percent. If one believed that the inflation rate was not going to become lower, then the only rational behavior was to borrow as much money as one could, and invest in real estate. All other things being equal, the house would appreciate at the inflation rate but the loan value would appreciate at a lower rate. It was like printing money. Paul Volker, whom President Carter brought in to chair the Federal Reserve thought it was a dangerous game. He jacked up interest rates to almost userous levels and inside of four years he had killed inflation dead.
That put an end to the most abusive kind of manipulations. But, nonetheless, homes have appreciated in nominal value almost monotonically since the early ninteen fiftees. If they have not proven good real investments; at least they have proven to be good hedges against inflation.
What this means is that if one looks at the trend in nominal home prices, houses appear to be a good investment. And if one wishes to really take advantage of the fact, there are good ways to do so. One way is to borrow money and buy investment properties. So long as the properties appreciate at a nominal rate that is higher than the rate of the note, one makes money. And it is easy money because the gains come from using other peoples money. A variation on the theme is to buy properties that are run-down, restore them, and “flip” them. These games are not without their risks. And the risks in the game have limited the amount to which they were played. It is probably true that most of the excess returns caused by such behavior was offset by risk. Nor is it possible to pin much of the current crisis on this sort of speculation.
But most home buyers understand nominal price better than they understand the real value. We need to illustrate. At seven percent inflation, a good will cost twice as much in ten years as it does now. Every good will. Even a house. So if one “invests” $100,000 in a home today and sells the home for $200,000 in ten years, the $200,000 (ignoring taxes) will buy precisely what the $100,000 did a decade earlier. It will buy the same house, the same number of recent model cars, the same number of dishwashers, the same number of barrels of crude oil and so on.
There is no real gain on the home, just a nominal one. What has changed in value is not the value of the house but the value of the currency. This idea is not well dealt with in the tax code. And it is not well understood by most home buyers. And for this reason it is easy for a home buyer to imagine that gains on a home amount to much more than they actuallly do.
To the extent that this is true, it means that homeowners will be inclined to commit too much to buying a home. That is, they will factor in the future price and the nominal gains into their buying decision, misinterpreting nominal gains for real ones. Part of the purchase price, then, becomes speculative in nature. And the speculative hope is attached to a fictional gain. So long as the portion of people who buys homes employs this this speculative thinking in buying a home, and so long as the number of people in the market is roughly constant, there is not much harm in the game. The system reaches equilibrium at an inflated price, perhaps, But not much bad stuff happens after that. Not until some condition comes along that challenges the assumption. At that point the speculative spell is broken and homes trade again near their normal price.
So long as people buy a home for what it is - a shelter that delivers a suite of comforts and amentities - not for what it might fetch when it is sold, the price of a home remains at a normal level. But when people buy a home primarily as “an investment” part of the price of the home is speculative. There are places in the nation where, arguably, most of the value in the price of a home is non-speculative. And there are places where a good portion might be speculative.
It’s not so difficult to get a handle on it. Find out what people are paying in rent per square foot in an area; and find out what they are paying per square foot for homes. If there is a rough equivalence; or if the differences can easily be explained entirely by objective desireability factors, then homes are priced at their nominal value. If, however, home owners are paying three or four times as much per square foot, there is good reason to believe that a majority of the price of the home is speculative in nature.
There was a point in recent history when this muiltiple was something like two or three for parts of coastal California. Perhaps the same was true in some parts of the east coast. It was not hard to tell that we were approaching the crest of the wave when one read in 2005 in the Economist that a clever fellow had worked out that in real terms the price homes had reached levels unprecedented for over a century; and one could see cartoons in the New Yorker depicting adolescents on the beach in front of an elaborate sand-castle saying “let’s flip it before the tide comes in.” Sensible people saw this one coming. So what about the experts?
The New Derivative
One recent article describes the financial underpinnings of the crisis. A bank makes money by lending. The more it lends, the more it makes. If that were all there were to it, there would not be much mess to clean up. But what happened in this case was that financial institutions used instruments that they falsely assumed to be secure to acquire new assets. Now in the old days, the days between the Great Depression and 1996 these instruments were primarily deposits. They were monies in checking and savings accounts. Banks could make loans on the basis of these accounts. The dollars were in the vault. Some portion they would hold in reserve in case lots of depositors withdrew money at the same time. And the Federal Reserve would lend money on favorable terms to cover day-to-day shortfalls so that banks could always meet their obligations to depositors.
But when banking deregulation came along, the kinds of financial instruments banks could use to collateralize new loans increased. It was no longer, cash. It was also other kinds of securities. Among these securities was mortgage-backed securities. These were securities whose value ultimately depended on the value of homes. What this meant was that banks could, in effect, lend money they did not have. Rather, they were lending money that they would have, assuming home prices kept going up and people kept on paying their mortgages. But it was money they did not have when home prices stopped going up and people defaulted on the mortgages. The problem for the banks was that once home prices started to fall and defaults exceeded expectations they had lent money they imagined they had but they actually didn’t have. That’s a violation of a fundamental rule of banking. And if a bank fails to bridge the gap, it collapses.
The reason financial institution behaved this way was because it was profitable, so long as the securities they used as collateral were sound. But ultimately it amounted to taking on debt obligations that were secured by the assumed inevitable rise in price of some asset. And when that assumption no longer held, the game was over. Just like Black Friday.
One might imagine that the game could go on forever but there were physical limitations. In order to realize excess profits on the scheme, they had to keep on expanding the pool of mortgage holders. And so long as they could do this by writing mortgages to creditworthy customers, the game would continue. Once this pool was exhausted there were two alternatives. One was to stop the game and settle on “normal returns.” The other was to lend to people who were known not to be creditworthy and keep pusihing the envelope. The motivation to do the latter was big because everyone saw a way to make a quick buck from pushing the game along. And everyone who knew the risks imagined that they could be passed along to other players.
What we have just described is a kind of game that sensible people will understand cannot be sustained indefinitely. It gains its power to enrich by enlisting new people in the gaime. And when it collapses it is generally the latest joiners who are hurt the most. What we describe is an old game in new clothes. It is a game that exploits a long term trend in the value of an asset. It is a game that derives a significant portion of its its percieved value from that long term upward trend in the value of an asset. It is a game that exploits speculative pricing. It is a game that ultimately depends on an ever-expanding pool of players. It is a game in which gains, then, ultimately depend on unsustainable conditions. And it is a game that hurts a lot of people when it collapses.
This game is pretty much like the Ponzi scheme. Two of the reasons it was not properly recognized as one are lack of transparency and lack of comprehensibility. Investors in companies engaged in the practice of securitizing loans with shaky mortgage investments often did not understand the risks. Sometimes it was because the people who wrote subprime loans purposefully lent to uncreditworthy customers. And people who were paid to know and care were paid more not to know and not to care.
To a significant degree, too, the problem was invisible because large institutitions carried risky assets off balance sheet. A recent article mentioned that half of Citibank’s assets were “off balance sheet.” And one can bet that the half that were so were the risky ones. So transparency certainly was a problem. Enron should have been enough to teach us the lesson; but evidently it did not.
There is some evidence that even many people in the business did not really understand the nature of many of the financial instruments they were dealing with.. Some of the instruments were highly complex derivatives whose movement was understood only by PhD mathematicians. To people who used them, the instruments were black boxes - just like Ponzi’s accounts.
This makes rational valuation impossible. It also makes a rational market impossible. It is one thing to allow markets to create fnancial instruments that are abstract and esoteric and to use these instruments at the margins for the purpose of arbitrage, with the goal of achieving an efficient market. But it is something else entirely to have people who are oblivious to how they work deal in them every day. It’s kind of like the difference between having a small nuclear arsenal that is very carefully controlled by trained people and handing out nuclear weapons to anybody who shows up at the corner of High Street anb Main. One can find good arguments for the former; but it’s not so easy to find good arguments for the latter.
Meltdown
Banking deregulation, then, produced a huge supply of new money. And it produced a huge supply of esoteric instruments. The money first went into homes, causing them to double in price since 1996. Some homeowners borrowed against the increase in value of their homes to buy consumer goods. This did not tend to drive up the cost of consumer goods in nominal terms; so it was not considered inflationary. It may be, however, that such goods would have fallen more in price were money not quite so loose.
More recently, the flood of money has driven up commodity prices. The spin on Wall Street is that it is demand in China and India that is responsible for spiraling oil, copper, and iron prices. Gold is speculative. Wheat is driven by the rise in corn. Corn is driven by ethanol. Ethanol is driven by oil. But the fundamental fact is that once all homes and raw materials have doubled in price; it is not long before other things will as well. A 30 percent drop in the dollar’s value against other currencies suggests something like the same kind of rise in the price of imported goods. Once every good one can buy has doubled in price; it is a safe bet that the currency is worth half as much. So it is not impossible that some significant portion of the rise in prices of all of these goods is simply an artifact of money produced by the same mechanism that caused the crisis. The world was awash in liquidity for a decade and now we pay the price. In other words, inflation.
If this is true then by the time the thing is over, the dollar will be worht half of what it was in 2005. Maybe less. In nominal dollars, we might hope our homes will be worth what they were in 2005, but in real terms they will be worth half that. Or less. The people who will be screwed will be the poor sods who held paper. It will be the people who held bonds of any sort. As it was in the 1920’s the people who were net savers, the people who placed their trust in financial institutions to vouchsafe their life’s savings will be screwed. Nobody else can afford to pay; not the federal government, not the financial institutions who profited from the scheme, not the people who borrowed the money, not the banks who used bad loans to securitize worse ones.
This, of course, assumes that the Fed is capable of keeping the whole system from coming unravelled. With each bailout and each rescue the picture looks worse and worse. The amount of leverage in the system appears to be pretty big. We know this because a few tens of billions of non-performing debt threatens to destabilize a system that has trillions of dollars in assets. Back before banking deregulations the level of assets held in reserve against adverse conditions was much bigger than this. And as any person with a bit of sense might have predicted, this increased leverage would flood the market with excess liquidity and it would threaten to destabilize the system. It’s a no-brainer.
One is forced to the conclusion that either the people who advocated for deregulation and those who voted for it were idiots. Or they were scoundrels. There’s a good chance that it was mostly idiots led by scoundrels. One more crusade.
Blame
No analysis of disaster is complete without an accounting of blame. So who owns responsibility for the mess? We offer some opinions for consideration.
1) The American electorate at large for voting into power a group of politicians who somehow never heard of the Great Depression or at least failed completely to comprehend the forces that caused it. Americans might argue that we did not know what these politicians might do. But this is nonsense. They ran and won elections on the premise that they would slash taxes and deregulate everything. Also they would put people in jail who objected to bad policy by burning flags. These candidates appealed first to greed and jingoism in their campaigns. They appealed to our meaner animal instincts, not to our better judgment. What should we expect? Politicians gave us what we voted for.
2) People in major financial institutions who should have known better than to leverage speculative instruments. Again, most of the people were just trying to make a buck. But the small portion of people who actually understood what was going on should have been voicing concern. There was none. It is so bad that we must wonder whether the whole system is run by idiots or whether it is run by and for scoundrels. For it is inconceiveable that a fair portion of the people who saw what was going could not have understood the non-sustainable nature of the game. Were players at the highest levels totally incompetent? Or did they intend for a crisis to occur?
3) People in financial services sector who originated loans without the adequate safeguards against bad debt. This group was the ground troops. They bore responsibility for the crisis in approximately the way draftees into the Wehrmacht owned responsibility for WWII. Maybe it could not have happened without them. But they were pretty much doing what was expected of them by the society they were a part of.. And that’s the way societies work, pretty much.
4) Irresponsible borrowers. Yes. It is true. Some borrowers got loans without either the means or the intention of paying them off. There exist cases in Ohio and Florida in which mortgagees have stopped paying loans but refused to vacate homes until the holder of the loan can produce the appropriate proof off ownership. And in some cases this has gone on for years. Simillarly, there are those who misjudge their ability to pay. And there are those whose financial position deteriorates due to loss of a job or health problems. And, it would seem that the portion of borrowers who fall into this category was artificially inflated by the recent practices of group 3) working to sell loans originated by group 2). based on a policy that can be traced back to group 1) One can argue to what extent bad debtors are abusers of trust and to what extent they are victims. There is a mix here. . We hope that laws and law enforcement make good distinctions here; but it looks like who has the best lawyers in this game wins.
Who will pay?
1) The American electorate. The taxpayer. Some portion of the crisis is being handled by handing money from the federal government to the banking system. Or at least by loan guarantees. Thus, the taxpayer is underwriting the failures of financiall institutions. There is a sense of justice here, because we elected the guys who deregulated the banks. We are getting what we asked for.
2) Head honchos in financial institutions whose primary assets were secured by the value of stock abd stock options they held in their failed instittuions Again, there is a sense of justice here. But one wonders whether some of them ought to spend some time in jail.
3) The people who touted deregulation at any cost rightly ought to lose their intellectual credentials. People who advocated for a kind of economic anarchy preached by the neocons and the radical libertarians of the eighties and ninnties ought to be laughed out of town. Really, the village idiot ought to be listened to more carefully. For, at least, we know that the village idiot hopes, at most , to end up getting a free meal out of any exchange we might have; while the radical libertarian hopes for a contract whose clever terms allow him permanent rights to your house and car and retirement assets.
4) Irresponsible borrowers. Again, there is some sense of justice here.
Whether the pain will be distributed roughly according to blame is doubtful. More probable is that the pain will be felt most by who has the least political and economic power.
Speculative Questions
In any Ponzi scheme, the early players do well and the later players do poorly. Tulipmania, the Roaring Twenties, and the Dotcom boom all relied on simple normal greed. Malfeasance was not involved. Or it was not the primary force motivating the game. The outcome was an almost inevitable result of the general shape of the investing environment and of attitudes at the time. It followed naturally from the rules of the game. The consequence of this is that it is reasonable for governments to set up rules that make these sorts of instabilities rare. It is reasonable that they set up rules that require that if one enters a speculative game, one both knows it is so, and one understands the nature of the risks. It was not true for bank depositors in the twenties. The Fed is working to assure it is, however, true today.
There is an important distinction between “saving” and “investing.” It’s a fundamental distinction. And it is all but impossible to understand why, given a long history of speculative booms and busts a legislature of well-informed and well-intentioned people put an end to it by dissolving the distinction between “bank” and “brokerage.” The most generous thing one might say is that they were duped. Or they were blinded by a loyalty to an ideal that they really did not understand. I mean, if Adam Smith were alive today and saw the kinds of abuses done in the name of his “invisible hand,” he would turn over in his grave!
The fact that we can explain the whole of the legislative snafu in terms of simple greed and slavish adherence to bad policy is suggestive of the idea that nothing nefarious is going on behind the scenes. But it does not remove all doubt. For example, we mentioned the bill making it more difficult for consumers to walk away from bad debts that was passed by Congress ca.. 2005. Who sponsored that bill saw this coming.
And at about the same time there was an article about the fact that the Chinese were beginning to buy mortgage securities instead of US Treasuries because of their perception that the federal debt was growing too big to be sustainable. In Wall Street language, the credit rating agency within the Chinese government that decides how to rate debt downgraded the credit rating of the US government.
Since the Chinese purchase perhaps a quarter of the US Treasuries; such a policy change risks putting a crimp in the Republicrat bad habit of spending more and taxing less. To attract the same amount of money, the US treasury would have to offer significantly higher rates of interest. And that would drive up the costs of borrowing. Since interest on the national debt is the largest line item behind entitlements and military spending, a big swing in the cost of borrowing could either force tax hikes or iresult in nsolvency.
A third alternative to the treatment of national debt is inflation. Weimar Germany did it; why should we not do it, too? As we noted earlier, if one has a high rate of inflation - one that exceeds interest rate, the advantage goes to the borrower.
One might argue that the whole speculative bubble in home prices was an attempt to create money and defile the currency. One might argue that banking deregulation was designed precisely to allow the kinds of abuses that occurred, knowing they would occur. By doing so, it would create a huge wash of currency and this, in turn, would drive inflation. If one set out to do this, one would have to have a ready-made piece-wise explanation why every single good and service became more expensive in order that nobody suspected the actual cause, too much money.
Inflation is a simple way to transfer money from creditors to debtors. It is a swindle that drives down the cost of borrowing. And if the Federal Government set out to do just this in 1996, it would have been difficult to invent a better scheme.
But in the end, a nation’s creditors wise up. They will not lend if they cannot expect to be fairly paid. If the US government gets a reputation for playing financial games that allow it to weasel out of its debt obligations, its credit standing will erode. And it will need to pay a lot more for loans in the future. That’s not some esoteric threat. It means some combination of higher taxes and less in the way of government protections.
There are other questions one might ask. If we grant that the inflationary cycle was created intentionally, we might also ask whether the credit crisis was engineered as well. In retrospect, it is impossible to imagine how it might have turned out differently.
But if it was engineered, to what end? Recall that the Southwest Savings and Loan scandal ended with billions of dollars missing, presumably in offshore accounts of some of the BCCI principals. The point is that there might be much money to be made from failed or failing banks, if one understands how to play the game; and if one has friends who are bankers and high government officials in places like Saudi Arabia. There were rumors that certain members of the Bush family did farily well in that BCCI debacle, being well connected with some of the principals. To what extent does the family hold interests in the sovereign funds that are “rescuing” the likes of Citibank? Here some transparency might help.
Conclusion
The machinery that manufactured this crisis was put in place in 1996 when the a body of legislation deregulating banks allowed for the kinds of practices that led to the problem. That it would happen was known to Congress in 2005 when it passed legislation making bankrupcy for individuals more difficult and costly. Exactly how the situation might affect the financial system might not have been known; but fact that creditworthiness among consumer borrowers was going to hell in a handbasket was well known.
We know that loose credit practices must have begun soon after deregulation since home prices began to escalate sharply at that point. We know that the cycle was propelled by greed among borrowers and lenders alike and that the financial machinery employed was leverage. Mortgage securities were used by banks to securitize new loans, knowing that this entailed ever bigger risks should housing prices ever fail to appreciate. We know that this kind of game was sustainable only so long as new players entered the game. We know that it had to break down soon after it ran out of new blood. And we know that the means used by financial institutions to carry out these practices involved hiding assets off balance sheet. There was a lack of transparency. These qualities, the fiasco shared with any Ponzi scheme.
In response to the crisis there might be a temptation to outlaw certain kinds of speculative games; but we believe a small number of controls might suffice. One is to require by law a kind of transparency in financial transactions that would properly reveal the risks. And to enforce that law.
Another is to change the requirement for collateral against which mortgages might be written by financial institutions. Mortgage-backed securities might be allowed as a small portion of the portfolio; but certainly once the quantity rises above a third, minor fluctuations in the housing market risk ruining the institution.
It is still a good idea to distinguish between institutions whose chief purpose is to vouchsafe savings from those whose purpose is to allow investors and speculators to invest and speculate. If such institutions offer other financial services that do not involve risking their own capital or that of their depositors, that’s not a problem. But there is a problem when an institution holds deposits for customers and, in a far-flung subsidiary, makes huge speculative bets on the currency market or the price of homes or the price of gold or oil or other commodities or securities. Such bets, ultimately, risk losing depositors’ money or destabilizing an entire banking system.
There is something to be said for that stodgy bank.
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03.18.08
Posted in News Commentary, Politics at 3:15 am by steve
We cannot forgive former governor Eliot Spitzer for wrecking his personal life; but we can forgive a president for wrecking his nation. Is there something wrong with this picture?
The question we need to ask is “Why is it that we can forgive one but not the other?” Why is it that when Dubya and the company he works for wreck a nation - when they wreck its free press, its military, its financial system, its system of justice, and its standing as a moral leader in the free world - we yawn and say “goodnight, Johnboy,” as if that’s precisely what is supposed to happen. No big deal, right?
We might argue that Dubya was too stupid to wreck the nation. If it is true, then it suggests that we prefer in our leaders a kind of sheer gross incompetence that, is capable of wrecking a nation to the kind of weakness that is capable of wrecking little more than a marriage. Or we prefer presidents too stupid to recognize when policy is in the public interests. Wrecked marriages are terrible; but when a politician’s marriage breaks up it does not mean another hundred thousand people out of work or another million people cast out of their homes for failure to pay the mortgage. Moral perfection is ideal in political leaders; but to paraphrase Bill Buckley, “as reality approaches the ideal, the costs become astronomical.” We may need to choose our flaws.
Just as poor moral character is a symbol suggestive of a person unfit to hold office, so too is the advocacy and promotion of the village idiot to run the free world. If Bush is an idiot; then the neocons need to be thrown out for good. Alternatively, if Bush is savvy and smart and if he is representing neocon policy, the neocons ought to be thrown out for good. In either case, neocon policy owns the failure.
We might argue that nobody could forsee the consequences of the policies. But this just seems silly. The problems caused by these policy problems have occurred many times before in history. The principles violated by these policies are at least as old as the Great Depression; some are as old as western civilization.
- The people who regulated banks after the Great Depression forsaw the consequences of a) an over leveraged financial system and b) the integration of banks with other financial service institutions. They made a body of laws that stood from the early 1930’s until 1996 when banking deregulation was passed by a Republican Congress and a conservative President. This one Dubya doesn’t own; but his neocon ventriloquist does.
- Foreign occupations have gone badly when the cultures in question were not like the US culture, and where the fundamental institutions that are required for success either do not already exist or are systematically dismantled. This, Vietnam should have taught Americans. Adventures in Latin America might have done the same thing. Or perhaps we could have learned something from Napoleon’s successful campaign in Russia or Hitler’s successful campaign in France.
- Preemtive strikes are morally questionable; any nation that engages in them loses the moral high ground. And this makes them inherently less trustworthy. That’s not a problem for a nation that neither has any trading partners nor needs any; but most of our raw materials are imported, and a large portion of our finished goods are as well. Trade is not axiomatic or automatic. Access to raw materials is not guaranteed. Preemptive strikes destabilize the world, turn nations against our own, and make commerce both more risky and more expensive.
- Arguably, $100 per bbl. oil is one of the consequences of destabilizing Iraq. And in light of the arguments above, it was forseeable. A cynic might argue that it was all so predictable that any fool would see that the purpose of the Iraq war was not just to secure oil but to drive the price up. Perhaps there is a moral problem with that?
- Then there is the Constitution. Dubya may be the only president in history to say “sure, I broke a law. I broke a lot of laws, so what?” The fact that he broke the FISA law and has not been prosecuted sets the precedent for a president who is above the law. This functionally means that the Constitution is not fully functional. The restraints that Congress properly ought to place on the Executive are not being enforced. And if it is the start of a trend, then Dubya’s administration will mark the point that tyranny became permanently established in the highest levels of the land.
The list could go on for pages. In all of these cases there is simply no question that something would break as a result of the policy. The questions were when and how badly. And who would pay. Neocons have arranged a cozy relationship with major parts of the press; and therefore, these policies were not critically examined in most major publications. The reason Joe on the street did not know of the risks was twofold. 1) He wasn’t very interested. 2) It was not in the interests of the neocons that he should know. Americans might plead ignorance.
In final analysis, the most likley reason we forgive Dubya for wrecking a nation while we cannot forgive Spitzer for wrecking his marriage is that we can clearly understand what Spitzer did. We understand what is morally wrong about Spitzer’s actions; but we do not understand the moral failings of the neocons’ policies.
We might reason that a person who is not of sound moral judgment and discipline is unfit to hold public office. This is fine reasoning as far as it goes; but there are a number of really big problems with applying it exclusively to Spitzer.
One is that the type of weakness Spitzer had is not so very uncommon among the people of power. As one government official put it during the Monica Lewinsky imbroglio, “If every Washington politician or bureaucrat who has slept with an aide were to be forced from office, it would be a great deal easier to find good parking spaces downtown.” When it comes to this particular sort of moral problem, the consequences it has on personal life may be material; but the affair is private and the effect on the public is symbolic, at best. In similar cases, the French try to just hold their noses and ignore minor personal failings.
Another problem in applying the moral argument only to Spitzer is that the argument presupposes that it is not some moral character flaw that motivates the bad policy of the neocon. Whether this is so depends, in part, on correctly distinguishing between Adam Smith’s idea that enlightened self interest, operating in a society of educated and ethically sound people - tends toward good results … in certain kinds of trading situations, and the blanket theological proposition upon which “neoconomics” is built that “greed is good.”
It may seem like a quibble; but a great deal of important stuff lies in the distinction. It is analogous to the difference between personal liberty in a well run western style democracy and personal liberty in an anarchic society such as post-invasion Iraq. In the former case laws and law enforcement sanction social behavior that is eggregiously destructive. In the latter case a total absence of governmental form and function was fundamentally anarchic - it allowed an unprecedented level of freedom. But the anarchy also caused violence that preyed on the weak or unfortunate.
Similarly, there are moral reasons not to invade nations whose natural resources one covets or for other arbitrary reasons.
And if one objects to moral arguments informing political discourse, all one need do is to set about trying to understand how cooperation, trade, and trust are what makes things work in a vast, interconnected, specialized society. Moral reasoning is concerned with preserving these qualities. Societies that fail to preserve trust and cooperation experience serious impediments to economic development. Or, if they are developed, they tend to fall into decline.
If one understands the moral arguments it is not difficult to see that the moral ground upon which most of the neocon’s economic and foreign policy agenda is built is not just swampland; it could barely support one of those little waterskeeters that skit across the surfaces of quiescent summer ponds. It’s little wonder that we frequently find our boots full of muck, and we sometimes feel in danger of drowning. Most of political policy since 1980 is built on this kind of moral reasoning. It is built to capitalize on short term trends by mortgaging and not maintaining assets of all sorts: capital, skill, goodwill, institutional, etc. It’s the perfect prescription for long-term societal failure.
The fact of Spitzer being out of office while Bush remains in office suggests that we are incapable of evaluating the moral implications of bad policy, even after it has borne bitter fruit. It is like seing adultery tear apart a million families and saying “So what? Why should people not do as they please, regardless of the consequences to the people involved?” That, after all, is the public policy purpose of laws prohibiting prostitution. In a public policy debate, that is the moral mandate for the law Spitzer broke.
If we persist in believing that the most productive way to operate a society is for Spitzer to be out of office and Bush to be in office, then there is neither much question about why our system of government is so broken nor is there much hope we might live to see it get any better. If we cannot understand arguments about huge policy issues, and if we are satisfied with that state of affairs, there simply is no hope that democracy might serve the public interest.
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11.29.07
Posted in News Commentary at 12:29 pm by steve
Nintety percent of an iceberg is below the surface of the water, hidden from view. And it’s that submerged part of the iceberg that sinks ships. We were reminded of this fact Tuesday when we heard an NPR report on the “bailout” of Citicorp by the Abu Dhabi Investment Group. The group invested over seven billion dollars. It got a guaranteed return of 11 percent. And it got the second largest equity stake in Citicorp.
At first this may seem unremarkable; but as the commentators suggested eleven percent is a higher return than junk bonds will bring, currently about 9.4 percent. So the risk must have been big. One would have to be quite desparate to borrow at that rate. But the fact that the investment firm got a huge chunk of equity in addition either makes this the sweetheart deal of the century or it means that Citibang was on the verge of complete collapse. In other words, one of two things must be true:
1) Citibank is in serious financial trouble. It was in imminent danger of collapse in the absence of these funds.
OR
2) The directors of Citibank have ceased to act in the interests of its shareholders and are acting instead in the interest of the holding company in question.
Both could be true. There are other, much less likely possibilities that come to mind. For instance, that Citibank nominated the transaction in dollars; and that it has solid reason to believe that the dollar will slide by much more than ten percent before the loan becomes due. This would be reason enough to take a loan at 11 percent. But it fails to explain why the huge equity transfer.
The first option is most likely. Citibank vaulted to its much vaunted position as one of America’s largest creditors by lending more aggressively than its competitors. One might expect, therefore, that it would necessarily be less picky about its debtors. And it might operate on thinner margins. These factors cause lenders to turn in better results in good times; but they can wreak havoc when the market turns downward.
The big question that is plaguing the market now is whether the credit market has bottomed out: whether we have seen all of the iceberg. Nobody knows. But if Citicorp is willing to sell huge chunks of its own equity on the cheap, imagine the positions of less muscular companies. It is likely that there are financial institutions in worse shape but who have either not figured it out or not figured out what to do about it.
And if the new psychology that the salad days of magically escalating home values are over finally changes the way homes are priced; and if this causes a lot of home buyers to walk away from their home loans, we may discover that the shakeout is not only not over - it has not begun.
On the coasts, four homes may be worth a million dollars . Four thousand homes would be worth a billion dollars; four million homes a trillion dollars. So forty million homes is ten trillion dollars. Half the value in these has been realized in the last ten years. It is not out of the question that home prices retreat by half. If that happened, five trillion dollars of value could evaporate overnight. And that loss of value would risk tempting twenty or thirty percent of mortgage holders into default. No part of our financial system is prepared for a catastrophe this size. And the federal government this time will be completely unable to help. Nobody will lend it a dime right now. So banks will be broke and the federal government will be broke. It could be cataclysmic. It could make the Great Depression look like a children’s birthday party.
One is tempted to think that item 2 is preferable; for it suggests not that the whole financial system is teetering on the edge of collapse but that the whole board of one of America’s biggest companies is completely corrupt. If it were an isolated incident of such corruption, then of course we would have nothing to worry about. But the society of corporate governance is a small one. Many directors sit on a large number of boards. Thus, if Citibank board members are willing to sell out their shareholders, it is suggestive of an atmosphere of corruption that may pervade the sphere of mega-corporate governance. That would be worrysome because it would mean that one could invest in any well run company and without a moment’s notice the board could sell it for pennies on the dollar to some foreign holding company. That company could be owned by the directors themselves. What a nifty deal that would be, to borrow money at an inflated rate from an opaque organization who rewards the directors with major equity stakes in their own financial company.
In the case of this deal, who actually provided the funds is a little unclear. Nobody knows who Abu Dhabi Investment Group represents. Presumably it is owned by the government of Abu Dhabi and/or certain of its high ministers or functionaries. It could, however, be fully or partly owned by members of the politically well connected Carlyle Group or other Bush cronies. In such a case we may be concerned not that the financial system is falling apart because of ineptitude and lack of foresight but because it suits the interests of the powerful insiders. If one is locked in a room with a lion and a lion tamer the most discouraging thing to realize is that the lion tamer is not there for your benefit but for the lion’s.
The great infusion of cash into Citicorp brought sighs of relief to the NYC financial community and bouyed the stockmarket on Tuesday. But if Citicorp made a smart move, one that is in the interests of all investors, either the dollar is in for a vicious pummeling or that company was on the brink of collapse. Either of these possibilities should have us all very concerned. Most of the dangers for Citicoro, its shareholders, and its competitors remain underwater where they will not be seen except when they threaten to sink other titanic companies.
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