The fundamental dishonesty of our financial system

I've recently come across a few articles that sum up the fundamental dishonesty, corruption and - frankly - criminal nature of our financial system. If, after reading them, you still believe that we can get out of our present economic mess without wholesale reforms . . . you clearly haven't been paying attention.

First, a guest article at Zero Hedge reminds us that 'You Cannot Build a Financial System on Rumors and Lies'.

This is not a monetary Crisis; it is a Crisis of values and morals. It is a Crisis caused by the notion that you can lie about virtually everything pertaining to a business deal (the quality of the assets, who owns them, whether they’re even legitimate, etc) and get away with it.

To review how we go into this mess, Wall Street and other industries lobbied Congress to loosen regulations. However, the secondary nature of those lobbying efforts was it trained Congress to see Wall Street as the hand that feeds, thereby making it unlikely for Congress to prosecute or pursue any criminal activity on the part of the bankers.

Take away consequence and rules and you have anarchy. And that’s virtually what we had in the Financial System leading up to the Crisis. Looking back on some of the more glaring situations (AIG, Goldman Sachs, etc) it’s simply amazing the whole mess didn’t blow up sooner.

The Federal Reserve and regulators then blew a one in 100 years opportunity to reform the system. We’re now finding out that instead of doing anything positive, Bernanke literally gave away TRILLIONS of Dollars to the banks.

In simple terms, the Fed engaged in the exact same business practices that blew up the mortgage lenders: giving money away without inquiring as to the borrowers real financial position or needs.

By doing this, the Fed spread the lies (and toxic debts) onto the public’s balance sheet, thereby compromising the Republic’s creditworthiness.

. . .

The whole system is now built on lies. The lie that banks are solvent. The lie that the Federal Reserve actually cares about regulating the financial system. The lie that crimes will be punished. The lie that Congress will reform Wall Street. The lie that we’ll get “change” at the ballot box.

. . .

You cannot build a financial system on lies. It simply doesn’t work. All it does is breed distrust and resentment. And as any businessperson can tell you, without trust business cannot work.

There's more at the link.

Next, Charles Hugh Smith points out that 'The Collapse of Our Corrupt, Predatory, Pathological Financial System Is Necessary and Positive'.

I was recently challenged by a contributor to write something positive, and so I decided to write about the single most positive outcome of the current financial crisis in Europe: the complete collapse of the corrupt, predatory, pathological global banking sector and its dealers, the central banks. Exploring why this is so reveals the insurmountable internal conflicts in our current financial system, and also illuminates the systemic political propaganda which is deployed daily to prop up a parasitic, corrupting, pathologically destructive financial system.

Our first stop is modern finance itself. Modern financial "products" and "instruments" are often highly complex and abstract, but the entire edifice can be distilled down to this: the system is based on the assumption that all risk can be hedged, and the difference between the initial position's yield/gain (i..e. placement of capital at risk for a gain) and the cost of hedging the risk of the wager to zero can be skimmed from the system risk-free.

That is the entire system in a nutshell, and we can immediately see the advantages of this system over traditional Capitalism, where risk can be hedged but never to zero, and the return is correlated to the risk taken on.

In modern finance, high-risk "investments" (wagers) with high returns can be taken on without worry because any and all risk can be hedged to zero, even in super high-risk wagers.

And since even high-risk positions can be seamlessly hedged to zero, then there is no reason not to borrow money to increase the size of your wagers: since you can't lose, then why not? Wagering in risk-free skimming with borrowed or leveraged money is simply rational.

Put these together and we see how a system based on risk-free skimming eventually leverages itself to the point that the slightest disruption can bring down the entire over-leveraged, over-extended system.

Why is this so? Every hedge has a counterparty who is supposed to pay off if the initial wager blows up. A system based on risk-free hedging is ultimately a self-organizing system which maximizes return by increasing bet sizes, leveraging/borrowing to near infinity and hedging every hedge as well as every wager.

This creates long chains of hedges and counterparties. Here's an example based on an asset we all understand, a house. Let's say someone buys a house for $1,000 down, something that was common in the housing bubble. That $1,000 is leveraged up to buy a $200,000 house via a $200,000 mortgage.

The "owner" of the house then buys a hedge to protect himself from the house losing value, so the risk is reduced to zero: if the value rises, the owner reaps the gain and if it declines, then he collects the payoff of the hedge from the counterparty, for example, a Wall Street investment firm.

The counterparty calculated the risk of real estate declining and then priced the hedge accordingly. There is some small risk that the loss will exceed the cost of the hedge, so the issuer of that hedge bundles similar bets and then buys a hedge or "insurance" from another player, who makes the same calculations of risk and return.

Meanwhile, the mortgage has been tranched (sliced into principal and interest and into various pools of risk) and bundled with other "low-risk" mortgages and sold to investors, who also buy a hedge against any loss in the tranch, for example, a credit default swap (CDS) which pays out if a borrower defaults. Those hedges are sold or "insured" with another hedges.

All of this debt and all of these hedges are based on a mere $1,000 of actual capital. The players who originated each hedge are similarly leveraged, because since risk can be lowered to zero, who needs capital?

So what happens when one counterparty (issuer of a hedge) somewhere in the chain runs into trouble? The entire chain collapses. With razor-thin capital to cover any losses, then each link in the chain dissolves into insolvency if their counterparty fails to pay off.

This is how we get hundreds of trillions of dollars in "notational" derivatives: every hedged is hedged with another "instrument," "products" are bundled and insured, and so on. The system is based on the principle that risk can be reduced to zero, and so there is no need for capital.

Unfortunately, that premise is demonstrably false. Benoit Mandelbrot dismantled the notion that risk can be reduced to zero in his prescient masterpiece, The (Mis)behavior of Markets. The founder of fractal geometry showed that markets are fractal in nature, and are thus intrinsically prone to unpredictable disruptions. Simply put, risk cannot be massaged away.

Thus the fundamental premise of all modern finance is flat-out wrong, and this explains why systemic risk, rather than being eliminated, actually rises with every ratchet up in debt, leverage and counterparty hedging.

The entire global financial system is thus based on the equivalent of a perpetual motion machine: money can be borrowed or leveraged into existence in essentially unlimited quantities, and then deployed in risk-free skimming operations to harvest unlimited wealth.

There's much more at the link. It's essential reading, in my opinion, as is Mr. Smith's follow-up article two days later, 'Financial Cancer: Our Financial System Is Intrinsically Fraudulent and Unstable'. Both articles are very highly recommended.

The third article made headlines today, and illustrates precisely why the previously referenced articles above are exactly correct - our financial system is demonstrably corrupt, dishonest and rigged against all but the 'insiders' who control it. Bloomberg reports that Treasury Secretary Henry Paulson gave advance, inside information about US government intentions to hedge fund managers who would be directly affected by those intentions, allowing them the opportunity to not only prevent massive losses, but actually make fortunes, by using that information to their advantage. The information was not public knowledge at the time, and would not become so until enough time had passed for those advance recipients of it to make full use of it. Some commentators quoted in the article pointed out the injustice of this.

William Black, associate professor of economics and law at the University of Missouri-Kansas City, can’t understand why Paulson felt impelled to share the Treasury Department’s plan with the fund managers.

“You just never ever do that as a government regulator -- transmit nonpublic market information to market participants,” says Black, who’s a former general counsel at the Federal Home Loan Bank of San Francisco. “There were no legitimate reasons for those disclosures.”

Janet Tavakoli, founder of Chicago-based financial consulting firm Tavakoli Structured Finance Inc., says the meeting fits a pattern.

“What is this but crony capitalism?” she asks. “Most people have had their fill of it.”

There's more at the link.

So there you have it. Most participants in the market were 'frozen out' of this information, which was disseminated to a privileged few, allowing them (at least potentially) the opportunity to use it to their advantage while the rest of us lost money. It may possibly have been legal (because of the way our laws have been framed by special interests), but was it honest? Upright? Moral? Ethical? Like hell it was! The inimitable Karl Denninger goes so far as to call it theft, pure and simple, and asks, "Where are the handcuffs?"

I suspect the correspondents quoted above are correct. Our financial system appears to be fundamentally dishonest as presently structured. Perhaps the current economic crisis might provide us with opportunities for a house-cleaning . . . and of our political system as well!





Peter