Home > Economics - General, Metablogging > The irrelevance of the financial sector

The irrelevance of the financial sector

September 25th, 2009

Here’s my piece from the Fin on Thursday

The global financial crisis that began early in 2008 has put many of the seemingly unstoppable processes of globalization into reverse. The volume of international trade has fallen sharply, and that of international financial transactions even more so. The banks and financial markets that seemed to define the global economy have retreated into the arms of national governments.

There is one striking exception to this pattern of retrenchment. According to the TeleGeography Global Internet Geography Research Service, international Internet traffic has grown at an annual rate of 74 percent in 2009, well above the 55 percent growth measured in 2008.

In part this is a matter of momentum. The huge growth in capacity that was already committed before the crisis ensured that growth could continue. Although new investment in fibre optic capacity has slowed as a result of the crisis, the system has proved capable of absorbing massively greater traffic.

But there are more fundamental forces at work here. Although the Internet and its main manifestation, the World Wide Web depend on physical communications networks and commercial service providers, they are not, in the end, about cables and modems.

The Web is a set of protocols and social institutions for the expression and exchange of ideas of all kinds, whether expressed as text, audiovisual material or software. Ideas are public goods. They can be shared without losing value, and they cannot easily be restricted. The Web is a prime example of a global good, one which benefits people everywhere in the world and depends for its value on contributions made all over the world.

The fact that the spectacular expansion of Internet activity has continued, and even accelerated through the financial crisis shows that the global exchange of information does not depend, in any important way, on the global financial sector. Most Internet innovations have been developed on a non-profit basis, and even for-profit companies like Google maintain strong independence from the short term demands of financial markets.

On the other hand, the productivity of the real economy, and therefore the financial sector depends hugely on innovations that have arisen from the growth of the Internet. The first-generation innovations of the Web in the 1990s universally adopted by business and governments. Now they are shifting to ‘Web 2.0’ technologies, including wikis, blogs and web-centric applications.

There has, then, been a huge shift in the location of innovation. Many of the innovations that have driven productivity growth over the past two decades depend on public goods mostly produced outside the market and government sectors.

When we compare the huge social and monetary cost of the global financial crisis with the huge and continuing benefits of the global exchange of information, almost all of it given away free of charge, a striking paradox emerges. With a handful of exceptions the innovators who gave us the Internet received little or nothing in the way of financial reward.

Leading figures like Tim Berners-Lee, the initiator of the World Wide Web have become famous, but not, at least by the standards of the global financial sector, wealthy as result. And the thousands of contributors whose efforts turned these innovative ideas into reality have received little more than a warm glow of satisfaction.

Meanwhile, the innovators who gave us such boons as the CDO-squared, the option-ARM mortgage and the stapled security have walked away, collectively, with billions in salaries, bonuses and share options, leaving the rest of us to clean up the mess they created when the whole edifice of collapsed so spectacularly a year ago. ??Even during the dotcom boom, when financial markets were eager to finance Internet-based innovation, their efforts were spectacularly misdirected. Billions were hurled at ludicrous ventures like the on-line sale of pet food. Meanwhile, the innovations that were to produce the Web 2.0 wave, such as the first blogs and wikis, were being developed without any significant input of credit or venture capital.

This contrast raises questions about the way we organise our economic system , the way we regulate financial markets, and the incomes derived from those markets. If monetary returns are weakly, or even negatively, correlated with the value of social production, there’s no reason to expect financial markets to do a good job in allocating resources to supporting innovation.

?As a result, it seems unlikely, that the massive incomes generated in the financial sector to reward financial innovation are beneficial to anyone except, of course, the recipients.

Categories: Economics - General, Metablogging Tags:
  1. SeanG
    September 25th, 2009 at 21:56 | #1

    “The global financial crisis that began early in 2008 has put many of the seemingly unstoppable processes of globalization into reverse.”

    Wrong. The credit crunch started in July 2007 when SocGen had to shut down two of their hedge funds. The money markets dried up as evidenced by the bailouts of Northern Rock, Fannie and Freddie and numerous other financial institutions. The first series of liquidity measures came in August and September of 2007 and then the first fiscal stimuli was applied from the beginning of 2008 onwards.

    “There has, then, been a huge shift in the location of innovation. Many of the innovations that have driven productivity growth over the past two decades depend on public goods mostly produced outside the market and government sectors.”

    What a load of twaddle. Do you think that banks utilise wikis? What is your view of financial innovation such as internet banking, using mobile phone technology to now act as a debit/credit card or to provide a resource for online share trading? Massive innovation has come from the financial sector. Have you ever been on a trading floor? Have you ever seen the sheer brainpower that goes into some of the technology used there which can then be applied elsewhere in both the economy and society? Productivity-boosting appliances such as… excel or word or any number of online applications have been developed by companies which make money from it. Yes, absolutely nothing to do with the marketplace.

    “If monetary returns are weakly, or even negatively, correlated with the value of social production, there’s no reason to expect financial markets to do a good job in allocating resources to supporting innovation.”

    If you are so brilliant at finding these inefficiencies; why don’t you put together a fund, make millions in the process and then prove that you are right?

    I am sick to death of finance-bashing rhetoric from people with only a cursory knowledge of what has actually happens out there.

  2. jquiggin
    September 25th, 2009 at 22:03 | #2

    The fact that you have to start with a silly dating quibble is indicative of the weakness of your case. As for the rest, way to miss the point!

    The article is not about minor process innovations in retail finance, but about the innovation elsewhere in the economy the finance sector is supposed to drive. But, if it were about retail finance, I’d ask you how long it takes to get a US cheque credited to an Australian account (Hint: the answer is in weeks, not days). And this at a time when an individual with modest tech skills like myself can manage something far more complex like this blog.

  3. SeanG
    September 25th, 2009 at 22:10 | #3


    The beginning is important because it is like starting any debate about WW2 ignoring the first stage. If you ignore 2007-2008 you ignore massive fiscal stimuli that did nothing to lift the US out of recession. You also ignore the huge government bailouts. And you ignore that during this time, we have an “inflation genie” problem. It links in with a lot of public policy issues and ignoring the Credit Crunch to focus on a hyper-crunch post-Lehman brothers restricts the field of vision about the causes, and responses to the crisis.

    You talk about paying the US. There is a reason why – the US government is horrific when it comes to moving money between accounts. It has something to do with terrorist financing and because of it, it means that moving money between the US and anywhere else in the world is like pulling teeth.

    The above paragraph is not meant to be an anti-gov’t diatribe BUT the US takes a huge interest in money being moved between accounts. I can explain it later on but it deserves a separate post.

    Sorry about losing my temper with the first post.

  4. SeanG
    September 25th, 2009 at 22:17 | #4

    One other thing…

    When it comes to technological development, you will see over the next couple of years the developments in computer technology made in hedge funds being applied to a much wider context. A lot of quants and computer programmers have been laid off and they are now moving into the tech sector so I am very excited about that.

  5. Rationalist
    September 25th, 2009 at 22:21 | #5

    Perhaps the befuddlement of the financial sector will see a rationalisation and refocus with investment into more concrete concepts. Things like technological research, bricks and mortar development, energy systems, bulk transportation. Not much can go wrong there.

  6. SeanG
    September 25th, 2009 at 22:41 | #6

    The movement has already begun. Firms are downsizing their trading floors and are now moving towards corporate finance which provide longer payoffs.

  7. Freelander
    September 25th, 2009 at 23:32 | #7

    Quite agree with the article. Good stuff as usual. Not all innovation is desirable at you note. Also, it is exceedingly rarely that it is the CEO or other senior executives who do the innovating anyway, so the frequently heard claims that these overpaid parasites need to continue to be overpaid so the innovation continues is debatable. In financial markets, given the structure of the markets and excess volatility, the activities of commercial banks and others may not be efficiency promoting anyway. They may simply be earning their profits by, in effect, taxing investment flows. If the activity of those making profits by buying and selling in markets does not improve allocative efficiency, then to the extent that their trading activities extract profits, their activities could be interpreted to be a tax on those markets without any compensating benefit. As for ‘price discovery’ the questions are, is the price discovery quick enough to provide allocative benefits and does it discover the price or rather, just introduce more noise and excess volatility.

  8. Michael of Summer Hill
    September 25th, 2009 at 23:40 | #8

    SeanG, you seem to forget that there are other service providers venturing into the traditional areas of banking and investment services ie social banking.

  9. September 26th, 2009 at 00:34 | #9

    and you seem to be forgetting the reasons they have not been doing it for decades – but then you want still more of that reason – regulation.

  10. SeanG
    September 26th, 2009 at 00:45 | #10


    Social banking – what is that? Giving money away to people who cannot afford it?

  11. September 26th, 2009 at 03:44 | #11

    It becomes increasingly obvious that neither the political nor the financial fraternity are fit for authority.
    Whither now?


  12. El Poppin
    September 26th, 2009 at 07:44 | #12

    I don’t get the point of the article. Having worked in telecommunications R&D for the over a decade, I can certainly say that a lot of the innovations have been paid by the private sector and consumers. Indeed the internet turns 40 this year and whilst it is true that the “big bang” concepts have been done by people that have not earned a conmesurate reward, this has always been the case: Alexander Graham Bell did not invent the telephone but he certainly got the money, RCA did not invent the TV but the poor sucker who did died in poverty.

    Now as to what is the real cause of the increase of productivity in the economy, I would argue that the decrease in the cost of computing power and data storage has been the real driver. The internet and its related applications depend on these two factors. I have access to the drop in cost of broadband over copper (xDSL) and within two years the cost dropped from about $US75 to about $US15 per port (largely to the entry of China).

    So what drives innovation? Well we don’t know. There is incremental innovation which is really a process based thing and then there is the “where did that come from” innovation. The former is what drives all established businesses – I give Apple as the only example of both, they were not the first to create a computer but were the best at it when they started, when they started drifting they brought in a guy from pepsi who tried to make more of the same in a better way, and it was not until Jobs came back and established the iPod product line as a second innovation (although once again not the first to do so but with the better business model).

    The idea that anyone can predict what innovation will succeed is bollocks – this applies as much to the government as to the private sector. Sometimes little things that seem unimportant at the time acquire enormous significance (PCI bus anyone).

    as an aside governments created both the OSI model for communications (never really came into existance as a single product) and TCP/IP which did. If you had to bet on which one would win it would have been OSI since that had more money, more people and wider support. Instead, today its ideas live on as a structure to understand communications but TCP/IP won because it was built with a small team that had a real product and a deadline.

    Finally, financial sector innovation – well certainly the innovations introduced over the last decade or so have been proven to be dangerous, misguided and malignant. I am still undecided whether this was fraud on a massive scale (willingly or unwillingly).

    Once I read a quote which from recollection had a judge asking an armed robber as to why he held up banks, to which the reply was because that is where the money was. So the finance sector attracts thieves, full stop.

    Martin Wolf in the Financial Times explores the reason for the behaviour in a series of articles and his argument that this happened because the incentives and rewards are badly flawed has merit (at least to this untrained person). The real worry is Larry Summer who is on the record as saying he does not want to kill off innovation. However he has not explained why innovation in Finance is important, secondly he has not explained whether historically finance was not innovative or how innovative it should be (is there really such a demand for new products say compared to IT applications) and has has not considered why strict regulatory regime would reduce innovation. A comparative case would ne medicine, lots of heavy regulation (in some cases not heavy enough) but still innovation continues and we don’t have squillions of people dying or becoming crippled. Sadly larry Summers will dictate what kind of regulation we get.

  13. Michael of Summer Hill
    September 26th, 2009 at 08:10 | #13

    SeanG, there are a lot of people struggling in this world trying to make ends meet and some rely on ‘social banks’ to get a small loan and better themselves. If they had the opportunity I’m sure many would opt to get a CISA or better.

  14. Michael of Summer Hill
    September 26th, 2009 at 08:11 | #14

    Andrew Reynolds, wrong.

  15. SeanG
    September 26th, 2009 at 08:44 | #15

    Financial sector innovation has been caused by the increasing use of sophisticated technology and was thought to have been extremely beneficial. Like original nuclear reactors – the outcomes can be toxic. This crisis will make the financial markets even more innovative because they learnt that for all the PhDs they can amass, the models and predictive behaviour they thought would occur, did not.

    Creative destruction will take place and what will come out on the other side is something far more resiliant.

  16. Michael of Summer Hill
    September 26th, 2009 at 08:52 | #16

    SeanG, who is ‘they’?

  17. SeanG
    September 26th, 2009 at 09:04 | #17

    The financial sector.

    People are saying things are Business As Usual. Only those in journalism have used that. No one that I know of in the financial sector have expressed that things are like they were.

    The financial sector has been through a traumatic change. It is changing.

  18. TerjeP (say tay-a)
    September 26th, 2009 at 09:07 | #18

    If finance is irrelevant then why does the government need so much of the damn stuff (borrowed and or stolen). Why can’t we be governed by good will and the warm inner glow that comes from personal contribution. Of course I’d argue that we can be, at least to a much larger extent to which we currently are. If government was smaller we would have more Internet style civil society solving problems and making advances. And of course we would also still have the private sector.

    Would real businesses be so dependent on external finance if we taxed them less?

  19. SeanG
    September 26th, 2009 at 09:10 | #19

    Funny thing – the government is borrowing from the exact same people who channelled their money to homes and businesses creating a bubble.

    Now we have a bubble in government debt!

  20. Michael of Summer Hill
    September 26th, 2009 at 09:11 | #20

    SeanG, juornalists were not responsible for the calamity. Try again.

  21. Michael of Summer Hill
    September 26th, 2009 at 09:16 | #21

    TerjeP (say tay-a), welcome to reality & the democratic socialist forum.

  22. SeanG
    September 26th, 2009 at 09:17 | #22

    I never said they were.

    Re-read my comments and if you don’t understand then I will explain using smaller words.

  23. Michael of Summer Hill
    September 26th, 2009 at 09:22 | #23

    SeanG, I am a bit thick and slow these days and you should really explain who are ‘they’?

  24. Jill Rush
    September 26th, 2009 at 10:14 | #24

    Sean G – there is a model of social banking which is called seed funding where small amounts of money are loaned to people (often women) unable to access funds from traditional sources because of a lack of collateral. The programs are usually funded on very small sums initially and rely on money being repaid to pass loans to the next applicants. This model fits in well with Prof Q’s proposition that people who are motivated for reasons other than money will produce social change in a way that the mainstream economic and financial systems cannot and will not as it is based on aggregation of wealth to individuals.

  25. September 26th, 2009 at 10:25 | #25

    Well argued. I can see exactly why I was wrong. Your exposition was both in depth and tightly argued.
    I can see, from your argument, why regulation has in fact helped the smaller institutions and disadvantaged the bigger banks and how more regulation will, in fact, provide us with a vibrant and diverse financial sector, well able to withstand the shocks that exposure to the world provides on a regular basis.

  26. TerjeP (say tay-a)
    September 26th, 2009 at 10:29 | #26

    Jill Rush – fellow blogger and libertarian John Humphreys has started something similar to this type of fund for educating students in Cambodia. It is non-profit. It is worth a look. They are in need of further seed capital so they can expand the student intake, so if you have any given them your consideration.

    There main page is on WordPress:-


    For pictures of sponsored students and universities see the page on Facebook:-


    Sponsored students are required to contribute 10% of their income post graduation back into the fund for a period of 5 to 10 years.

  27. September 26th, 2009 at 10:36 | #27

    And the reason why that model will struggle in Australia is simple – the people that provide it (all client facing staff) would need to be PS 146 (that is from the FSRA) qualified, the institutions that provide it will need to be APRA certified (a process that takes at least 18 months and costs a fortune) if they want to take any deposits. Presuming they are an incorporated body (difficult otherwise) they will need to go through ASIC (could be quick) to incorporate and then get an AFSL (Australian Financial Services License – a long and expensive process for a small company), ensure that they have appropriate lawyers and auditors on retainers (expensive) and have sufficiently qualified senior staff to satisfy all of the regulators – and these are not cheap.
    The ATO will also need to be dealt with (particularly if they want to claim charitable status) as will several other agencies. That is just the Federal government dealt with. The State government then regulates several other activities that they may want to do to pursue that type of business.
    That’s why big business simply loves more regulation. It stops pesky little small businesses from even competing.

  28. iain
    September 26th, 2009 at 10:59 | #28

    In a related vein, Daniel Pink has done some good work highlighting how contingent motivation (particularly financial) is not related to social good.

    He had a very good ted talk on this a while back.


  29. TerjeP (say tay-a)
    September 26th, 2009 at 11:00 | #29

    Andrew – we can’t have just anybody helping other people. That would be dangereous.

  30. Fozzy
    September 26th, 2009 at 11:26 | #30

    As an IT person with no formal economics training, I find this an innovative fascinating argument which I wholeheartedly agree with. I hope this idea helps overturn the current “conventional wisdom”. Thanks John!

  31. TerjeP (say tay-a)
    September 26th, 2009 at 12:47 | #31

    Iain – thanks for the TED talk. It was great. I have featured it here:-


    However it doesn’t make the case for more regulation or more intervention in markets. In fact the point about autonomy couples nicely with the notion that governments should stop micro managing what we do and how we relate to eachother.

  32. Michael of Summer Hill
    September 26th, 2009 at 13:40 | #32

    Andrew Reynolds & TerjeP (say tay-a) & SeanG, maybe you should read up on micro-credit and how many now depend on social banking. Furthermore, in respect to innovative banking accross Africa mobile payments are transforming the continent, in Japan, mobile internet banking is changing their world, in Spain, social finance is top of the agenda and last year BBVA launched the first Web 2.0 banking application Tu Cuentas (You Count) and now Caja Navarra (CAN) has launched the first bank-led social lending system. The above few innovative examples is what JQ is trying to allude you three stooges to. Gotta go.

  33. Alice
    September 26th, 2009 at 13:46 | #33

    Sean G
    You asked Moshie “Social banking – what is that? Giving money away to people who cannot afford it?”

    I cant help myself Sean…Id say giving money away to people who cannot afford it seemed to be the mainstay of the contents of the pandoras boxes of CDOs which fuelled the US housing bubble. Is that what you call private sector social banking Sean? CDOs – the “hot potato” game. Last bank left holding them explodes.

  34. Alice
    September 26th, 2009 at 13:56 | #34

    @Jill Rush
    Ive seen docos on this Jill. Its a great idea. Very small loans for small business ideas that the large global banks turn their noses up at (no collateral, or women in developing nations etc). Thats another massive problem of the global financial institutions. They arent operating on the ground willing to issue these micro loans where they are needed, typically in developing nations, yet they BS on about globalisation and free markets and de-regulation for themselves. They would prefer to fund some large global company to dump waste in the developing nation.

  35. TerjeP (say tay-a)
    September 26th, 2009 at 14:35 | #35

    Andrew Reynolds & TerjeP (say tay-a) & SeanG, maybe you should read up on micro-credit and how many now depend on social banking.

    I haven’t criticised micro-credit. I think it is a great idea. See comment #26 above.

  36. SeanG
    September 26th, 2009 at 16:13 | #36

    @Jill Rush


    If we are talking about microcredit then I am not about to criticise that. But this is on an entirely different scale. Giving someone a very small loan compared to a mortgage. This is the difference.

  37. SeanG
    September 26th, 2009 at 16:15 | #37


    CDOs didn’t fuel the housing bubble. Huge spare cash from China coming into the US, artificially low interest rates, subprime mortgage underwrting from Freddie and Fannie call contributed to the growth of credit BEFORE a CDO has ever been written.

  38. Ernestine Gross
    September 26th, 2009 at 16:39 | #38

    SeanG, since you say you are an expert on and possibly an insider of the finance industry, would you like to explain
    a) how the CDO experts understood Merton’s paper on risky debt portfolios
    b) why CDOs were invented if Freddie and Fannie underwrote any amount of subprime mortgages

  39. SeanG
    September 26th, 2009 at 17:43 | #39

    a) If we are talking about composing a CDO then it is far less complex than the portfolio problem. Firstly, you have the front office guys who are pushing for “the deal”. This is about getting the CDO compiled and to sell off individual tranches. “The deal” is primarily based around what the market can take in terms of risk premium for the individual tranches and they go around to the funds managers etc parading a CDO. This is a glorified technical position.

    Getting onto Merton. I assume what you state “risky debt portfolios” we are talking about the interest rates paper from the 70s or are you talking about a different paper? I must admit, I have never heard anyone mention “now Merton said this”.

    Putting together tranches is different from pricing those tranches.

    I think you are potentially mixing up the buy and sell sides here. If you are on the sell side, you are trying to pump this out into the market and the pricing is determined by the current state of the credit markets and by the rating given by the credit ratings agencies. The buy side, e.g. right now, has enormous power to get a high risk premium because the law of supply and demand are in effect. Are you talking about how the securitisation team originally pricing the tranches?


    CDOs were invented so that different risk appetites can purchase tranches, or so if you purchase and entire CDO you can off-set good and bad debts.

    Why were they invented if Freddie and Fannie underwrote debt? Because if you are a European bank you will still want to slice up your debt. Plus, if you bought debt from a financial company that was underwritten by Fannie and Freddie, when you onsell that debt there is a high change that it will not be reviewed by the buy-side who will slice that debt again and on sell it.

    Slicing is important because it tries to find uncorrelated debt to put together. In theory this makes the securitised debt more attractive.

  40. SeanG
    September 26th, 2009 at 17:49 | #40


    I do not know your background, but maybe you can enlighten us about how warehousing is used by mortgage providers with securitisation?

  41. Ernestine Gross
    September 26th, 2009 at 19:32 | #41


    Thank you for describing the practical side of creating and selling CDOs and the beliefs held by the practioners.

    Given your description, the practioners failed to check whether the conditions for ‘slicing risky debt’ are fulfilled.

    Specifically, practitioners who, as you say believe: “Slicing is important because it tries to find uncorrelated debt to put together” – because “In theory this makes the securitised debt more attractive” are misguided. Uncorrelated debt is not a sufficient condition. This is where R. Merton (and subsequent authors’) work on continuous time trading comes in. The development of this literature is in R. C. Merton (1990) Continuous Time Finance”, Oxford, Basil Blackwell.

    My academic background is in general equilibrium theory (post 1950s). This body of literature is concerned about finding conditions under which ‘a market’ exists, its properties, including welfare and stability.

    PS: Who knows, maybe you may never wish to work in the finance industry again if you study the theory seriously. Unfortunately, the negative externalities of people learning by doing are too big to be acceptable by the rest of society. I would not hesitate to agree with a substantial wealth tax on the practioners of financial innovation – I’d see it as an insurance policy against future damage.

    Re your #40: I am sure you are in a better position than I to tell us about the pratical side of it.

  42. Ernestine Gross
    September 26th, 2009 at 19:52 | #42

    A further question, SeanG,

    Why is it that, in contrast to the UK and (and most if not all of the EU) and Australia the USA legal framework lacks a sharp distinction between debt and equity? That is, if debt is risky at the time of issue then it should be called equity. The CDO fiasco is but a version of the junk bond problem of not long ago.

  43. SeanG
    September 26th, 2009 at 19:59 | #43


    Uncorrelated debt is the combination of mortgages, university debt etc because when you get a deal proposal you have a list of the different components of that. If you are a funds manager and you see these, your credit risk people will say that mortgage debt is different to, for instance, university loans and that California debt is different to Illinois debt. It is a way, or so people thought, of having a lower risk product.

    I’ll read up on Merton’s work. Admittedly, my academic background is not as in-depth as yours but I do have time to read some work (for instance, Prof Qs) but others as well.

    It is true that people in finance earn on average more than people elsewhere. However, it is only a small percentage that earn massive amounts of money and the way the remuneration packages are structured does not work in favour of risk management. If you are in an investment bank and you are front office, your remuneration package will have a bonus element which is based off earnings (risk adjusted return on capital). The risk management team will have their remuneration package based on their relationship with you. If you are unhappy with them, then they will receive a smaller bonus and because they earn less than front office staff, this makes things worse for them.

    In the UK and US, bonus packages are larger than in Australia. However, salaries vary and very often there is no automatic salary increases which force people to become more reliant on a bonus.

    This is why I have troubles with pay caps or wealth taxes. They are trying to slap down a specfic segment of people in specific areas of finance whereas if the regulators were more forceful in getting the risk departments better remuneration packages in banks, then the risk departments would have no hesitation in being far more aggressive in containing risky activities.

    I know this is slightly off-topic but I felt that this is a far more realistic approach.

  44. SeanG
    September 26th, 2009 at 20:07 | #44


    I do not think that there is a sharp difference between debt and equity in UK and Australia compared to the US. But if you are investing in instruments, your clients want a specific return on their investment. You are desperate to get it, so you are more willing to leverage up in the hope that a small return on assets can lead to a larger return on capital.

    Junk bonds are far easier to understand than CDOs are because they are related, usually, to a single company.

    If you are a financial firm, you want to be able to sell your debt. So you are going to issue one CDO with one overall credit rating but sell individual tranches with their own ratings to individual investors. The lowest rated tranche is the equity tranche and this is kept by the institution who issued to debt to show that when losses occur, they’ll take the first hit.

    On the warehousing topic – this is an issue which is the agent-principal question comes into it and I will put a single post about it.

  45. SeanG
    September 26th, 2009 at 20:18 | #45

    Warehousing is a financial innovation that can allow for greater competition in the mortgage market.

    It has also helped create an asset bubble, is incredibly short-sighted and represents the primary problems with the financial industry today.

    Whenever a bank lends money to mortgage holders and then securitises their debt, they create a special purpose vehicle (SPV) or investment vehicle (SIV). These are paper companies and the revenue flows from the mortgage payments pass through this SPV to investors who pay a lump sum for it. This is essentially a securitised asset. However, it is predicated on the bank having money in the first place.

    I will try to explain warehousing using an analogy.

    Imagine Professor Q gets bored at uni and decides to enter into finance.

    He wants big profits, he wants good return on capital, BUT he has no real money himself. What to do?

    Professor Quiggin establishes Quiggin Mortgages Ltd, headquartered at Brisbane. He then establishes Mars Alpha, an SPV based in the Bahamas or Jersey or some sort of tax haven for $100. Professor Quiggin, along with an investment banking buddy then go to all these pension funds across Australia or the world. Their pitch is simple: “if you devote $100m to this venture, then I can guarantee you a return of between 5-7% p.a. over a thirty year period”.

    ProfQ explains that as the money comes in via the investors, it goes through the Mars Alpha to Quiggin Mortgages and will be lent out to people for mortgage rates between 6-11% depending on credit ratings done by an external agency. When mortgage interest payments come through, they are then sent off from Quiggin Mortgages to Mars Alpha and to the investors.

    Some of the investors want the safest tranche, others want less safe but higher returning tranches.

    ProfessorQ is happy. All he has is a website, mortgage brokers finding him prospective clients and doing most of the paperwork, and $100m to invest. This is warehousing.

    But wait, it gets better.

    Some of the pension funds/investors in the AAA rated part of Quiggin Mortgage loan book are worried. They want certainty. So Professor Quiggin shops around and finds an investment or commercial bank. Professor Quiggin says that these people want an insurance policy over their AAA rated part. The commercial bank says “we’ll do it, we want a fixed fee and if we have to reimburse them we want a guaranteed repayment plus interest”. Professor Quiggin does the mental calculation and realises that even with this, he still makes 0.5% margin for AAA-rated mortgages.

    The deal is signed. A law firm sends out the legal documents. It is done.

    Let us end the analogy there. This is a typical type of transaction. This is warehousing, a liquidity facility deal and securitisation wrapped up in one.

  46. SeanG
    September 26th, 2009 at 20:23 | #46

    I have got a graphic that I would like to put on this website but I do not know how to do it. Maybe someone can help me? It is a breakdown of mortgage lending in the UK over a decade. The above transaction was so popular that it was one of the main causes for the property bubble that the Brits have experienced.

    This is why I think it is short-sighted: you are lending out billions through conduits to people who are already over-leveraged, doing nothing productive, not achieving anything.

    At least on a trading floor they are engaging in risk management for clients or trying to get returns for other clients. That is an investment or hedging operation.

    In other areas, it is to ensure that a client can go to a branch and have all the possible products and options available for them.

    This is innovative, it works, it makes money… but doesn’t this just sound like innovation for it’s own sake?

  47. Alice
    September 26th, 2009 at 20:34 | #47

    Oh for goodness sake Sean “CDOs didnt fuel the housing bubble…”
    Of course they did. Since the day they were invented the madarins of Wall street realised they culd bundle these thingsn in a box and get them triple A rated by the shonks in the ratings agencies and ON FLOG them for a hefty commission…they wouldnt have cared if there was cow manure in the box and all they would have been interested in was inb getting as many suckers in the box as possible…come on on Sean – this is the real thing.
    You get commissions for packaging and flogging things for which you bear no risk, and there were plenty hungry to buy them (triple A rated…ha ha…how could they lose…?? Housing just goes up forever right …ooops wrong). Now Sean – you have heard the stories have you not??? Salesmen paid attractive commissions to go out there and convert prime borrowers to subprime rates??
    What did those borrowers know (really, really know) that in the fine print was a reset date…maybe three years away and then three years after that…where the initial very cheap borrowing rate suddenly turnsn into 12% and then 15% on the rest dates….?

    And you are telling me CDOs didnt fuel the housing bubble in the US??

    Utter rubbish Sean. Of course they did…backed by an army of aggressive commmission agents and a general public used to credit getting ever cheaper and not used to fine print (ultra fine print).

    Yeah sure the Chinese lent to the US – so did every other country who held US as a reserve currency – so what? IT took the mandarins on wall street to bamboozle the borrowers and lenders with CDOs and cosy relationships with ratings agencies.

    Game, set and match. A giant ponzi scheme.

  48. SeanG
    September 26th, 2009 at 20:42 | #48

    Fair point. CDOs helped sellers find buyers in the wholesale market and when the loans went sour they had issues in finding out which loans were poor and which loans were good.

    However, the growth in CDOs did not drive additional borrowing. People were willing to borrow money to purchase houses and there are a lot of agents making a lot of money. If you want to call it “greed” then everyone, including the people who borrowed to buy a house, was in on it.

  49. Alice
    September 26th, 2009 at 20:51 | #49

    And after this lucid example Sean….using Prof Quiggin as the “warehouser” – are you telling me the bubble wasnt the fault of CDOs? OK then – I concede defeat….it wasnt just CDOs…it was the entirety and complexity of everyone in the Casino wanting their take and getting it by conning investors..

    No wonder I dont like the damn sharemarket…I was always taught “if investors dont have confidence in the integrity of the sharemarket that is a warning bell…there must be controls to safeguard against loss of investor confidence…etc etc bla bla…

    I havent put a cent in the damn thing and I never will voluntarily because I see few controls these days and its become so corrupt and full of sheisters, spin and media hype its not only unpalatable – its entirely unbelievable …but I am forced to donate inputs by super regulations (why the hell should they have my money when I dont trust anything about the stockmarkets…its a gamblers paradise where the big firms always win (and if they dont they get bailed out). Why cant I pay off a mortgage with my super???? Huh??? Why I am being NOT told what ethereal assets are bought and sold in my name – and Im am not being told at all.. The losers here are decent taxpaying employees..and they about to lose again soon.

    Its just a lose lose all round.

  50. Michael of Summer Hill
    September 26th, 2009 at 20:58 | #50

    Alice, I have posted an examnple of how the free market fraudsters work. On 16 January 2009, Merrill Lynch paid $550 million to settle a collateralized debt obligation (CDO) lawsuit brought by the Ohio State Teachers Retirement System, among others for artificially inflating share prices of CDOs and other assets backed by subprime mortgages by issuing false and misleading statements about CDOs. Incomplete disclosures and unsuitable recommendations by investment advisers led many institutional investors, pension plans, and individuals to invest large portions of their accounts into these securities. These investors trusted those representatives with their investments only to watch their account values plummet when the subprime housing market started to unravel. Now, these accounts are worth a fraction of their original value. Bloody crooks.

  51. Alice
    September 26th, 2009 at 20:59 | #51

    In fact Ill go so far as to say that by the time many people in our generation retire…there wont be much left from that mandatory super. The government makes money on it, the commissions in the finance industry dictate they makie money on it..but the poor sheep who earned it is going to wonder where the hell it went at retirement.

    If I didnt have to be in it I wouldnt. It sucks. My money and I have no control and I could make more out of it than I have earned in super fund returns which anre nicely constructed to be just a bit above bank interest on average – oh but then there will be fees to move it and so on ad nauseum. It gives me a royal pain that they have it (my money).

  52. SeanG
    September 26th, 2009 at 21:00 | #52

    Disclosures have been a big issue!

    Kinda scary, don’t you think Alice?

  53. SeanG
    September 26th, 2009 at 21:15 | #53

    Financial innovation can be extremely beneficial but it can blow up. As I said before, kind of like the first nuclear reactors – a great leap forward but one that has a lot of risks.

    In the future, CDOs will be used but it will be within a different environment entirely. CDOs are only useful if the underlying assets are not defaulting!

  54. Alice
    September 26th, 2009 at 21:16 | #54

    Its not just disclosures Sean….they make rules about disclosures and they disclose so much unnecessary information its really hard to find the relevant disclosures….it becomes a large thesis that after two pages of reading you think …”Christ!! I cant bear reading any more”. Disclosures that manage to obscure a multitude of sins.

    It just adds to one thing for me. I dont trust the entire edifice. I can make more money without going anywhere near it…I have a preference for land and bricks because to me its real and it doesnt matter if it goes down you can still use it.

    The stockmarket is quite enough to scare the hell out of me. I dont even trust the share prices of companies. I think most are rabidly overvalued.

  55. Alice
    September 26th, 2009 at 21:26 | #55

    @Ernestine Gross
    As usual Eernstine comes up with something that blows my mind…I never thought about it..but this comment strikes a chord

    “I would not hesitate to agree with a substantial wealth tax on the practioners of financial innovation – I’d see it as an insurance policy against future damage.”

    That substantial wealth tacx would be in place were it not for governments making money from super Ernestine. But dont worry…it might just come to pass when they have no way of paying their own deficits back. Expect to see taxes rise every where else (but on the wealthy, where they urgently need rise) first though. That wont help either…and ultimately, after all other avenues are exhausted…

  56. Michael of Summer Hill
    September 26th, 2009 at 22:20 | #56

    Update, Update Update, Bloomberg Twitter Inc., the social-networking site used by everyone from Oprah Winfrey to British royalty, received venture financing that values the company at about $1 billion. Twitter received $100 million from two anonymous individuals in return for a 10 percent stake.

  57. Alice
    September 26th, 2009 at 22:40 | #57

    @Michael of Summer Hill
    Twitter – The next fad Moshie….the next ,market hype…

  58. Tom Hickey
    September 27th, 2009 at 09:13 | #58

    It is revealing to consider the Internet and financial system in terms of positive and negative externality. Defining “externality” as the spillover of a transaction beyond the parties to the transaction, the development of the Internet and financial “innovation” produced almost diametrically opposed results in terms of value, considered qualitatively as well as quantitatively. The Internet is building prosperity in the broad sense of creating value qualitatively, primarily through education and networking, as well as quantitatively through business, while the result of financial “innovation” is in the process of plunging the world economy into global depression quantitatively, the qualitative effects of which are unimaginable for untold numbers, even in developed countries like the US. Something is wrong with this picture.

  59. Ernestine Gross
    September 27th, 2009 at 12:05 | #59

    “CDOs are only useful if the underlying assets are not defaulting” (SeanG @3, page 2)

    SeanG, you got it.

    Now, lets think about it.

    If the underlying securities (eg mortgages to finance the acquisition of real assets, eg buying real estate) are not defaulting then we don’t need rating agencies (another problem solved) and there is no need for ‘slicing’, hence no income for ‘slicing experts’ (saving) and no bonus for what you call ‘pushers’ (another problem solved) and…there is no need for the term CDO because every mortgage is a ‘colateralised’ (secured by a real asset) plain vanilla debt security at the time of issue.

    We can also get rid of the term ‘securitisation’ because we already know that a mortagage is a type of security. But I am using the terminology of theoretical models of economies with a sequences of physical (as understood by scientists not by the ASX) markets (goods and some types of services, and real assets, using the terminology of accounting and micro-economics) and financial markets (where two elementary types of securities are issued, bought, and traded; debt and equity).

    By contrast, in the unreal world of contemporary banking, ‘securitisation’ means ‘selling securities backed by the assets on banks’ balance sheets. Think about what this means. The banks’ assets consist of securities, issued by other people (the borrowers) and bought by the bank. Creating securities on top of the original securities means one is building a pyramid. It is ‘pyramid selling’. It is a ponzi scheme. It is ‘Windhandel’ – to misuse the term used in Holland to refer to the stock exchange (equity) around the time when this institution was introduced.

    A version of what certain banks indulged in during the recent past is found in corporate non-bank structures, where a string of corporate entities (each one of them with a set of relatively high income earning managers) are built upon a possibly tiny operating company. Your excellent description of ‘warehousing’ is the financial sector version thereof.

    All this is part of the unreal world of the corporatised version of capitalism. The unit of analysis is no longer ‘the individual’ (as it is in the theoretical models of market economies) but an artificial entity – an accounting entity with artificial legal rights. Funny that this unreal world is marketed to the public, via a so-called communications strategy, as the real world.

    Now, you tell me, SeanG, how much would you be prepared to pay for the services of the contemporary Windhandel?

    I venture to say that the beginning of the Financial Crises is the time when Banks and other Financial enterprises were allowed to use the Balance Sheet as their financial recording devise – in the late 15 or early 16th century. Balance Sheets allow Windhandel transactions to be denominated in the same currency unit as transactions in goods and physical assets. I understand the fishermen and women in Iceland have worked this one out by now.

    JQ uses the term ‘unproductive’ for what I call the Windhandel of high finance.

    Now, you tell me, SeanG, how much those in the Windhandel business who ‘made money’ (to buy real assets) should pay to those who lost (the tax payers)?

  60. Michael of Summer Hill
    September 27th, 2009 at 12:15 | #60

    Tom Hickey, read up on FEBEA’s charter and you will see that there is an alternative to the traditional banks for the emphasis is not on ‘rent seeking’.

  61. Freelander
    September 27th, 2009 at 12:46 | #61

    @Ernestine Gross

    And the problem is not just the CDOs, it is the CDSs (Credit Default Swaps) that allowed tranches to be turned into AAA+ bonds. The problem was, because the risk of default was systemic, the CDSs were worthless when they were needed most, because the institutions that issued them wouldn’t have been able to pay when lots of defaults were happening at once. (And significant defaulting ought to have been predictable when there was wholesale lending to people who couldn’t repay.) The ‘masters of the universe’ used CDSs rather than normal insurance because the insurance industry is regulated (in the US) and they couldn’t have gotten away with it. They wouldn’t have been able to purchase the insurance. The CDSs also allowed myopic credit rating agencies to give AAA+ ratings to tranches which then allowed them to be on sold to myopic fund managers managing superannuation and other funds around the world. It is not as though there weren’t people who foresaw that it wasn’t sustainable. However, everyone was making great money, most of which they have managed to keep, so no one really cared.

  62. Tom Hickey
    September 27th, 2009 at 13:00 | #62

    @Michael of Summer Hill


    FEBEA members promise to respect the following charter:

    Our aim does not amount to seeking profit alone
    To have political and economic independence
    To finance economic initiatives which strive towards the following goals: job creation, sustainable development, ethical and cultural diversity, international solidarity and fair trade


    Good heavens, it sounds positively “un-American.” What would Goldman Sachs say? :)

    Presently, the big banks in the US consider themselves the lynchpin of the US economy, and the Fed and Treasury agree, and apparently Congress and the president do, too. In effect, policy is run for them at their demand and command — “or else.”

    The problem is really with the Big Four. They control the financial system in the US.

  63. Michael of Summer Hill
    September 27th, 2009 at 13:03 | #63

    Tom Hickey, the FEBFA is solvent and time will tell whether Australia will follow suit.

  64. Alice
    September 27th, 2009 at 13:31 | #64

    @Ernestine Gross
    says “Creating securities on top of the original securities means one is building a pyramid. It is ‘pyramid selling’. It is a ponzi scheme. It is ‘Windhandel’”

    Exactly Ernestine. The poor original lender or super contributor does not even know what is being created by banks behind the scenes on the next level up of the pyramid (with their original money). Thats why I object to mandatory super. I have NO control except at the base level of the pyramid (where your money doesnt stay grounded) and swapping funds does not give me any degree of further control. Its a lucky dip, where the chooser may as well be blindfolded (blindsided?) and the products are well wrapped, superficially appealing, but ultimately dangerously manipulated and riskier than you ever wanted or agreed to (and then there is the excessive leaks).

  65. Ernestine Gross
    September 27th, 2009 at 14:47 | #65

    Yes, I know Freelander @11. The financial history preceding the 1929 crash contains earlier versions of essentially the same scheme. We need a new record keeping system for monetary economies. One which is general enough to allow the tracing of all physical and financial securities transactions, denominated in currency units.

    Alice @14, could we set superannuation aside for a more suitable thread? But your point is taken.

  66. Alice
    September 27th, 2009 at 15:38 | #66

    @Ernestine Gross
    1929 crash.. earlier version of same scheme …same animal. We could put super in a separate post but it has been acting as the guaranteed pyramid base drip feed for these ponzi schemes (a form of industry protection really). The same thing happened after the goldrush in response to the injection of liquidity (what to do with all that extra liquidity in the the domain of the financial sector??…except to go forth and and multiply thyselves and it innovatively).
    McKay in 1841 “extraordinary popular delusions and the madness of crowds’ Book documented in three parts 1) national delusions 2) peculiar follies 3) philosophocal delusions. This ponzi scheme is more a mix of 2 and 3 but mostly 3.
    The best quote;
    “”Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”

  67. Ernestine Gross
    September 27th, 2009 at 15:41 | #67

    Good one, Alice.

  68. Freelander
    September 27th, 2009 at 16:13 | #68

    Most of these financial crisis are simply a variant of something that has gone before, only the names and faces change.

  69. Michael of Summer Hill
    September 27th, 2009 at 16:19 | #69

    Update, Update, Update, Bank of America being sued for $1,784 billion, trillion. No bull.

  70. Alice
    September 27th, 2009 at 17:28 | #70

    @Michael of Summer Hill
    Whaaaat Moshie? U serious? Who is suing? What worries me is US T Bond obligations. I must admit I am full of gloom about US capabilities and cant help wondering whether – if they cant hold up their obligations or their dollar value (same thing and after all that they printed…I worry) will all those countries who have been holding $US as reserve currency give in to a rushed exodus (or am I being too pessimistic?).
    Here we are discussing what regulations may be needed? Is it too late? Something like this (the lawsuit you speak of Moshie) could spook the markets.

  71. Alice
    September 27th, 2009 at 18:10 | #71

    Its here SEC is taking out the lawsuit against the Bank of America


  72. Michael of Summer Hill
    September 27th, 2009 at 18:45 | #72

    No bull Alice, Dalton Chiscolm has a history of using the legal system to make a name for himself and previously sued his landlord for $892 million billion.

  73. Alice
    September 27th, 2009 at 18:53 | #73

    @Michael of Summer Hill
    Moshie – this is a nonsense story and the lawsuit wont even take off let alone fly.

    This lawsuit is not by the SEC but by an individual./..

    Its an outer space lawsuit by a loony Moshie – it aint going to fly!

  74. SeanG
    September 27th, 2009 at 19:06 | #74


    An interesting post, bit long but there is something you said:

    “If the underlying securities (eg mortgages to finance the acquisition of real assets, eg buying real estate) are not defaulting then we don’t need rating agencies (another problem solved) and there is no need for ’slicing’, hence no income for ‘slicing experts’ (saving) and no bonus for what you call ‘pushers’ (another problem solved) and…there is no need for the term CDO because every mortgage is a ‘colateralised’ (secured by a real asset) plain vanilla debt security at the time of issue.”

    Personally, I do not understand the chain of causation.

    Firstly, there is no guarantee that mortgage holders will not default on their mortgage.

    Secondly, credit rating agenices are used because they were perceived as being independent. Everyone now knows that the agencies were pretty useless. It was a good way to sell the package to buyers.

    The slicing and dicing aspect is the agent problem because too many people were getting too much money. Using that ProfQ example, we have the mortgage holders getting cash, mortgage brokers getting a commission, ProfQ getting a massive lump sum payment and thin margin, you have the investors getting a stream of revenue each and every year, you have the commercial bank getting money for providing that insurance over the AAA-rated tranche, you have the lawyers getting money across each stage, you then have the accountants getting the money across each stage!

  75. Michael of Summer Hill
    September 27th, 2009 at 19:18 | #75

    SeanG, it was one big fraud just like rock-phishing.

  76. Ernestine Gross
    September 27th, 2009 at 19:24 | #76

    SeanG @24, p2

    The ‘chain of causation’ starts with your statement @3, p2

    “CDOs are only useful if the underlying assets are not defaulting!”

  77. SeanG
    September 27th, 2009 at 19:31 | #77

    Sorry, now I got it!

    Michael, it is not fraud but taken to the extreme it became a monster. If we had less overall leverage in the economy and society, then securitisation is a good tool.

  78. Freelander
    September 27th, 2009 at 19:32 | #78


    Credit rating agencies are used because they are the least worst of a bad choice, which is why they are still being used now that everyone knows how shonky they are.

    The story is that those running banks don’t care because all the money, except what they manage to ladle into their own pockets is other peoples money. That is the money is equity or borrowings from some other mug, you or me through super funds or direct investing. What they ladle in commissions etc. just used to be other peoples money.

  79. Michael of Summer Hill
    September 27th, 2009 at 19:41 | #79

    No SeanG, when you have the ‘intent’ to deceive then that is fraud and criminally liable.

  80. September 27th, 2009 at 20:14 | #80

    In this case you are straight out wrong – evidently you do not understand what a Ponzi scheme is to have made that comment.
    A Ponzi scheme is a very old method of fraud – of which Charles Ponzi started one (his was not the first).
    The way a Ponzi works is simple – “investors” put money in to the scheme and there is no investment made by the scheme. Anyone seeking to withdraw money from the scheme is paid out of investor’s funds.
    CDOs were not like that. If you put your money into CDOs the funds were used to buy assets – and ones that would hopefully produce enough returns to cover interest payments.
    The difference is clear – Ponzis do not invest in anything at all. CDOs invested in mortgage finance. Ergo – these are not Ponzis.
    You may think them another form of fraud, but “Ponzi” has an exact meaning – and one that does not fit with a CDO.

  81. Fran Barlow
    September 27th, 2009 at 20:28 | #81

    @Andrew Reynolds

    The objection is fair enough Andrew, though one can easily imagine using Ponzi-style finance to purchase actual asset derivatives in order to drive an asset-price bubble etc …

    Not strictly a Ponzi-scheme, but maybe “Ponzoid”.

  82. SeanG
    September 27th, 2009 at 20:30 | #82


    You are stereotyping those who run banks.


    Most transactions were not fraudulent.

  83. Freelander
    September 27th, 2009 at 20:32 | #83

    @Andrew Reynolds

    The interest rate holidays (low or no interest for the first couple of years givven to the sub-prime borrowers) did make the scheme Ponzi-like, because for part of the initial time those who brought tranches would have been effectively being paid partly with their own money (or at least money borrowed from someone else). Just more complicated, but still Ponzi-like, and it all fell over when the sub-prime borrowers came back to reality after their ‘holiday’.

    Just one big fraud.

  84. Freelander
    September 27th, 2009 at 20:34 | #84


    True, I am. But you don’t get to be in charge of the Mafia without having engaged in a little bit of crime. I think the sterotype fits.

  85. Ikonoclast
    September 27th, 2009 at 23:29 | #85

    @Ernestine Gross

    Ernestine and I have our disagrements on some issues eg the term “neoclassical economics”. However, I agree 1,000% with Ernestine’s comments on CDOs etc. This is an excellent analysis, succinctly expressed, a perfect no-nonsense summary. Brilliant! :)

  86. September 28th, 2009 at 01:02 | #86

    You may be able to imagine that, but that was not what happened.
    The low interest at commencement style deal was not included in the majority of the home loans securitised in this way. Not even “Ponzi-like” then.
    The whole basis of your argument is simply flawed. Selling one security based on another is not creating a pyramid – it is creating some derivatives.
    I avoided the “pyramid” bit earlier as the Ponzi one was even easier to deal with, but some here (Ikonoclast for one) seem to be desperate to agree with you on this. I would suggest you look up (on wikipedia should do – it is a simple enough question) what a pyramid scheme is (and a Ponzi) before you weigh in again using such terms.
    The instruments (CDOs) were selling the rights to a future income stream and the forecasts of the value of that stream proved very wrong in many cases. That does not render it fraud unless the parties to it knew it would go bad. Unless you can show they did know this then you really have no case.

  87. Michael of Summer Hill
    September 28th, 2009 at 06:48 | #87

    No SeanG, thousands of investors in the USA have been caught up in $330 billion investment scandal in which banks allegedly misled consumers about the level of risk involved in what they called auction-rate securities 30-year bond packages sold in chunks as short-term investments. Bloody crooks.

  88. Michael of Summer Hill
    September 28th, 2009 at 07:13 | #88

    SeanG, maybe fraud is trivial to you but under Title 18, U.S. Code, Section 1344 reads as follows: the BANK FRAUD DEFINITION & PUNISHMENT:

    Whoever knowingly executes, or attempts to execute, a scheme or artifice—
    1) to defraud a financial institution; or
    2) to obtain any of the moneys, funds, credits, assets, securities, or other property owned by, or under the custody of or control of, a financial institution, by means of false or fraudulent pretenses, representations, or promises; shall be fined not more than $1,000,000 or imprisoned for more than 30 years, or both.

  89. Alice
    September 28th, 2009 at 08:15 | #89

    @Andrew Reynolds
    Andy -CDO unregulated derivatives turned ponzoid. Whats the difference with ponzi except a level of exceptionally and knowingly poor and high risk investments marketed as low risk by ratings agencies over no investments at all in your definition of ponzi scheme? Andy its hair splitting and I think most here would agree with Ernestine’s summation on CD/Os.

    Andy the parties KNEW they would go bad (making it fraud), thats why large Wall St firms were the originators solely at the wholesale level and had vested interests in packing as many CDO boxes with whatever they could put in them and moving them out as fast as possible (rubbish loans). Once passed on the dirt went around the globe. You know that.

  90. Alice
    September 28th, 2009 at 09:45 | #90


    You may want to take a look at this if you dont think there was anything ponzi about subprime loans sales and packaging… US Congress is considering sacking the US federal reserve. Does that mean Bernanke would get the bullet?


  91. September 28th, 2009 at 11:59 | #91

    Firstly – what is “ponzoid”? Either it is a Ponzi scheme or it is not. Remember, a Ponzi scheme is where people put money in and the originators of the scheme have no investments out of which to pay the (promised in advance) return. In the case of CDOs banks sold the instruments that gave an entitlement to whatever cash flows eventuated from associated home lending. How, in any way, is that “ponzoid”? It is not hairsplitting: it is (on your part) a total failure to understand what a Ponzi scheme is. Most here may agree with Ernestine, but that does not make it any less wrong than it is.
    Another correction – the CDOs were not unregulated. They were issued (without exception IIRC) by (some of the most heavily) regulated institutions on the planet. Perhaps it meets your fantasies to imagine that these banks were “unregulated” but fantasising about it does not make it so. The US regulators are an alphabet soup of over 57 different regulators (to which Obama wants to add more), most of them with almost unlimited powers to shut a business down and order almost any sorts of changes. How you get this to being “unregulated” is simply beyond belief.
    If the parties knew (or were so negligent that it constitutes wilful misconduct) they were not going to be able to pay out then, I would agree, it is fraud and the people can, and should, be tried and convicted in a court of law for their conduct. You will not get any arguments on that from me. I would even go further and say that if their conduct was even a little more than slightly negligent that I would think that no-one should employ them in the industry any time soon and their clients should have a cause of action against the banks that mis-sold the products.
    That, however, does not make the selling of products by heavily regulated institutions any more of a Ponzi scheme than it was before it.

  92. TerjeP (say tay-a)
    September 28th, 2009 at 12:35 | #92

    Andrew – I doubt anybody else on this blog will say it so I will. You are right.

  93. Alice
    September 28th, 2009 at 12:48 | #93

    ANDY – you are hairsplitting. The subprime loans that were in those boxes Andy, were in about 14% of cases issued by the banks own “non bankn affiliates”. Go read the linkn Andy. Sure “banks” may have had some regulation NOT ADEQUATELY ENFORCED by the fed who carried on with a “hands off policy” under Greenspan and Bernanke ( US FED in bed with Goldmans and AIG and Citigroup no doubt – especially when a senior Harvard Law Professor is now saying that financial oligarchies have essentially taken over control).

    So Andy – you are telling me there was adequate regulation over subprime loans then? Because they were what exploded in the CDOs.

    Andy – Your denial is trailblazing in the extreme.
    When the US large banks felt they had too much regulation they just bought or established their own non banks and flogged and bundled through those affiliates. Not only that the marketing and punitive interest rates were racist if you actually read that link Andy.

    Ponzoid was a term invented here in the last twenty four hours to distinguish the TOTAL hair split between a Ponzi scheme and what happened with subprime loans and CDOs in the US leading into the GFC.

    If it looks like a ponzi, waddles like a ponzi, but invested in other highly damn questionale assets Andy (after working with close associates to package them as clean and safe) – then the term “a ponzoid operation” fits.

    The trouble is…Wall st Scions have been ponzoid, negligent and fraudulent for years Andy – it just got much more so.

  94. Alice
    September 28th, 2009 at 12:50 | #94

    @TerjeP (say tay-a)
    Of course you would Terje.

  95. Alice
    September 28th, 2009 at 12:58 | #95

    @Andrew Reynolds
    Andy…anywya – you just shot yourself in the foot. Last week you were arguing the big firms like regulation because it stops the little firms growing. Well if they loved it so much why did they lobby so long and hard to have Glass lifted? Why did they need to open, buy or form their own non bank affiliates who did the dirty work of promoting these crappy loans to people (funded by big daddies on Wall st), who were less regulated, if the big financial firms loved regulation so much.
    Your argument doesnt stack up and its sounds like you will indulge in any excuse at all for more de-regulation a la ALS.

  96. Ernestine Gross
    September 28th, 2009 at 13:28 | #96

    Andrew Reynolds,

    I am not impressed.

    First. You introduce a qualifier in response to Freelander’s by writing: “The low interest at commencement style deal was not included in the majority of the home loans securitised in this way.” The qualifier is “not the majority”. (Freelander provided some detail in support of what I wrote). But you fail to acknowledge my qualifier @9, p 2, namely, “certain banks”. (Freelander did not remove my qualifier.). I call this an attempt to slant the argument (without wishing to assert intention). But this is only an apropos. The important question is: Was the mass of “certain banks” big enough to topple the financial system?

    Second. I tried to be careful in the usage of terminology by providing at least a short hand reference to the contextual source (eg theoretical model of an economy ….; micro-economics, accounting) or I explained my usage of a term (eg pyramid) by means of describing the process. Nowhere in the literature I have indicated or in my explanation of my usage of terminology does the term “fraud” come in. (I know University degrees in Accounting include one or several law subjects – eg Business Law, Contract Law, Corporations Law . But these subjects are about the institutional environment and not about Financial Accounting per se.)

    This raises the question in which context are you using the term fraud?:
    Are you using the term ‘fraud’ in a legal sense, and if so, under which jurisdiction.? Further, I suggest we shall have to wait and see how the legislative and legal systems in various countries respond to the financial innovations which are the subject of the thread.

    If you are using the term ‘fraud’ in a non-legal sense (eg people using the term fraud to mean an action or behaviour is considered wrong on ethical or moral grounds), then, what is your point?

    Third, you write: “The instruments (CDOs) were selling the rights to a future income stream and the forecasts of the value of that stream proved very wrong in many cases.” What nonsense. The ‘instrument’ is not selling anything. It is the issuer of the ‘instrument’ which is selling something. And the general term of the ‘instrument’, a sheet of paper or electronic data entry which contains the contractual terms, is called ‘a security’.

    I am particularly disappointed that you come with this vague talk, given that I sent you a copy of a paper by Andreas Furche and myself, titled “Model of Money Tokens:
    A Uniform Description of Monetary Objects and their Circulation”, asking for your comments from the perspective of a practitioner knowledgeable in banking. I have yet to receive a response. Perhaps you apply the model by writing down all the transactions to see who was getting which ‘income stream’ from what activity.

  97. September 28th, 2009 at 14:34 | #97

    To deal with the second one first – operating pyramid or Ponzi schemes (as correctly defined) are regarded as financial fraud across all developed financial markets. Thus an allegation of operating one of those types of scheme is to make an allegation of criminally fraudulent activity in any relevant jurisdiction.
    On to the first. I would agree that the question is, as you put it “Was the mass of “certain banks” big enough to topple the financial system?”
    The numbers of resets (the jargon term for these) was, while a substantial dollar figure, a low proportion of the content of CDOs issued and an even lower proportion is the amount (in dollar terms) sold to people who could not afford them after the reset. The reset issue is, therefore, not the problem here.
    The real core of this problem is the drop in home prices and increasing unemployment (“real” economy problems) after 2006 and the simple fact that US consumer home loans are (by regulation) non-recourse, so the incentives of the owner to walk away from the home when in financial difficulties or the loan is in a negative equity position is greatly increased, magnifying the subsequent downturn in prices. The extent, and snowballing nature, of this downturn was not allowed for in the models used to price these instruments and so the models were wrong. It was not Ponzi-like, a pyramid scheme or anything like this but (in the great majority of cases) it was simply an error in the models used. This is not illegal behaviour (or even unethical) unless it was known that the models were in error at the time the instruments were issued. The issue is simple – forecasts of the possible future trends in the prices of housing and in employment levels proved to be wrong. How that comes to be fraud I cannot see.
    On your third point – you are right, my wording was sloppy. The underlying argument, though, is sound. I should have said something like “the purchase of the instrument gives a contractual right to receive a certain portion of the future cashflows of the related income stream from the underlying assets”. I believe, though, the intent and meaning of my original statement is correct.
    I do know how these deals are strutured and how the cash flows work as, years ago, I assisted in evaluating some of these types of deals. I should add here that the ones I was involved in have not gone bad, but from that experience I can see how they could have.

  98. Freelander
    September 28th, 2009 at 14:37 | #98

    @Andrew Reynolds

    Either it is Ponzi or it is not. Yes, it is Ponzi-like or Ponziod if you prefer.

  99. September 28th, 2009 at 14:45 | #99

    Glass was an excption to the general rule – and a frequently ignored and useless one in any case.
    Having the odd exception to a rule does not invalidate the rule.

  100. Alice
    September 28th, 2009 at 15:45 | #100

    @Andrew Reynolds
    Well now at least one Fed Governor (Atlanta??) has dissented and said the unemployment number promoted by the Fed is nonsense at 9% and it is really 16% in the US. What else are they hiding?

    Andy – you say

    “It was not Ponzi-like, a pyramid scheme or anything like this but (in the great majority of cases) it was simply an error in the models used.”

    An error in computer maths models used…have people become so reliant on pre programmed mathematical models, they are incapable of thinking.

    A mistake in a mathematical model caused the GFC??

    I dont think so Andy. I would bet there are truckloads of faulty mathematical computer models out there fooling their two bit mechanic handlers in Treasuries.

    Dont think, just follow the Tstats and all will be well.

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