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.
John Quiggin 
@Alice
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).
Disclosures have been a big issue!
Kinda scary, don’t you think Alice?
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!
@SeanG
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.
@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…
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.
@Michael of Summer Hill
Twitter – The next fad Moshie….the next ,market hype…
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.
“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)?
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’.
@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.
@Michael of Summer Hill
Interesting.
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.
Tom Hickey, the FEBFA is solvent and time will tell whether Australia will follow suit.
@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).
[…] John Quiggin » The irrelevancy of the financial sector […]
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.
@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.”
Good one, Alice.
Most of these financial crisis are simply a variant of something that has gone before, only the names and faces change.
Update, Update, Update, Bank of America being sued for $1,784 billion, trillion. No bull.
@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.
Moshie
Its here SEC is taking out the lawsuit against the Bank of America
http://www.bloomberg.com/apps/news?pid=20601087&sid=apo3ELJ.CoxY
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.
@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!
Ernestine,
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!
SeanG, it was one big fraud just like rock-phishing.
SeanG @24, p2
The ‘chain of causation’ starts with your statement @3, p2
“CDOs are only useful if the underlying assets are not defaulting!”
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.
@SeanG
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.
No SeanG, when you have the ‘intent’ to deceive then that is fraud and criminally liable.
Ernestine,
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.
@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”.
Freelander,
You are stereotyping those who run banks.
Michael,
Most transactions were not fraudulent.
@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.
@SeanG
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.
@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! 🙂
Fran,
You may be able to imagine that, but that was not what happened.
.
Freelander,
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.
.
Ernestine,
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.
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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.
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.
@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.
Andy,
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?
http://www.washingtonpost.com/wp-dyn/content/article/2009/09/26/AR2009092602706.html
Alice,
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.
Andrew – I doubt anybody else on this blog will say it so I will. You are right.
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.
@TerjeP (say tay-a)
Of course you would Terje.
@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.
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.
Ernestine,
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.
@Andrew Reynolds
Either it is Ponzi or it is not. Yes, it is Ponzi-like or Ponziod if you prefer.