Sunday, September 26, 2010

Another worse GFC is coming

Without a Nobel Prize in Economics, or even a degree in it, how can I make this assertion:
There will be another GFC, and it will be worse than 2007, and make it confidently?

Because we didn't see the last one coming nor did the controls to prevent such disasters, work.

The 2007 GFC was initiated by the inevitable, predictable collapse of the US "sub-prime" mortgage market. ["sub-prime" is disingenuous double-speak for 'very risky' or 'junk'. People buying houses with this money couldn't afford to pay it back, the lenders knew it and still loaned them money and resold the debt as quickly as they could, collecting a tidy profit along the way.]

We saw this before at the end of the 1980's with the rise and collapse of "Junk Bonds".

Why weren't "sub-prime" mortgages a problem, or even a market, before 2000?
Because of the economic slow-down when the "Dot Boom" turned to the "Dot Bust", the US reacted to prevent a recession.

The US Federal Reserve, with the backing of the US Government and Central Banks around the world, dropped interest rates to near zero on US Government Bonds, the benchmark "risk-free" investment. That created the conditions for the next "market bubble".

There are two points in there that need to be unpacked from that:
  • "Zero" interest rates are not numerically "0.0", they take inflation into account.
    If inflation is at 3% and you're getting 3% interest, your wealth increases by NIL over the course of a year. You can buy exactly the same number of burgers or cars at the start and end of the year.
  • Economic Theory for judging the proper return from investments is based on the Risk/Reward principle.  Higher Risk translates into higher Reward (or interest rates).
    But compared to what? The equations that describe the valuation of financial "instruments" assume a baseline or benchmark: the "risk-free" rate that everything else is compared to.
    Which is the Government Bond rate. If the Government can't pay interest when due or redeem its bonds, you have bigger problems.
How did a reasonable and well-proven response to an economic slow-down convert into a massive "Market Bubble"? The usual suspects of "Fear and Greed", the same drivers of the 1980's Junk Bond bubble and all before it.

With "safe" investments offering no returns, investors looked for other avenues to get good returns: this was the environment which created a bubble in just 10 years.

There were/are a number of special conditions in the USA that created this particular scheme. Be clear: the same investors and the same money would've chased any of the other myriad schemes possible.

The peculiarities of the markets in the USA:
  • Mortgagees can walk away from their debt with impunity. Banks, not borrowers, bear the risk of default (the norm in the rest of the world).
  • Mortgage Debt wasn't held by banks, but resold to one of two "Government Sponsored Enterprises" (Freddie Mac and Fannie Mae) at a small discount, allowing the banks to relend the same money over-and-over again.
  • The two Federal Mortgage consolidators resold their debt into the larger US and global markets.
There were two inventions that allowed the explosion of this "commercial paper" to be sold by the Investment Banks:
  • CDO's, "Collaterized Debt Obligations". Individual mortgages were bundled together (aggregated) and sold together as a single lot.
  • CDS's, "Credit Default Swaps". These are a form of commercial insurance. They were used to convert the highly risky CDO's into "AAA" (risk-free) debt.
  • Investment Banks are not regulated like normal "Deposit Taking Institutions": Retail Banks.
    They can sell what they like because they deal with "Sophisticated Investors" who fully understand the risks they are taking and the deals they are entering into.
Which brings in another critical player: the Investment (or Credit) Rating Agencies.
Standard and Poor and Moody's are two of the largest global players.

Credit Rating Agencies are thought to be impartial and expert assessors that investors can rely upon.
As events transpired, all those "AAA" rated high-yield bonds were both too good to be true and entirely wrongly assessed.
And that the notional risk implied by the high returns were massively understated.

How could a catastrophic mistake on a massive scale and as-wrong-as-it-gets be made?
This was a systemic fault - it applied everywhere to all the Rating Agencies.

As in Why could that happen at all, and Why did it not get noticed by oversight bodies?

The simple answer is that the Ratings Agencies didn't understand the real risks: they were incompetent in their work (or more politely, unaware of the full implications), were deluded or duped, knew and didn't properly inform investors, or were complicit or negligent.

The central conflict is the Rating Agencies are paid by the Seller, not Buyer. They could only make money by assessing instruments as "very low risk", very wrongly as it turns out, and they did.

One of the contributing factors in all this, globally as well, is that individuals responsible for each part of this process bear no consequences for losses, but do gain from all sales and often share in the profits.

This asymmetry, there is no personal downside for actors in Finance and Investment, is a monumental systemic flaw that will only lead to more problems.

If you think this isn't so or doesn't matter, ask this question:
 Did any of the people who personally benefited from the bubble have to pay back their profits or make any reparations?

In most other areas of Commercial Law, fraudulent or suspect transactions can be "unwound" or reversed. At least for the last 7 years.
  • Would the impact of the GFC have been nearly as bad if 7 years of faulty transactions have been reversed? [No]
  • Could Governments and Financial Regulators around the world have done that? [Yes]
  • Would recovery have been complete? [Not nearly]
  • Would more people have been personally affected? [probably]
  • Would those involved in Finance/Investment now be more cautious? [Yes]
One of the major weapons now against selling drugs is the seizure of assets and "proceeds of crime".
Losing your improperly acquired wealth is a far more potent penalty than even jail-time.

But obviously Governments don't hold this view for "white collar" crime, preferring to spread the pain to the innocent and less wealthy.

So what's my thesis?
  • None of the responsible professions foresaw the 2007 GFC, nor acted to warn Governments, Investors or the Public.
  • Not Accountants, Economists, Auditors, Valuers, Investment Advisors, ....
  • The existing Regulatory Framework was wholly inadequate.
  • The oversight bodies and control mechanisms failed completely - they didn't warn of the building problem and failed to prevent the collapse.
  • The Guilty kept their ill-gotten gains, the rest of us paid through failed banks and Government bailouts - and will pay for decades to come.
  • Those responsible for outright fraud and deception have not been brought to book.
    Those who's inaction, negligence, incompetence or indolence created the economic maelstrom have been allowed to escape unnoticed and without consequence.
  • Systemic problems of inherent conflict of interest and lack of personal consequences remain unchanged.
As a global community,
we don't know precisely what elements, apart from greed, led to the GFC,
nor what changed to trigger it.

Without knowing the causes, we are helpless to prevent more recurrences.
There have to be more financial meltdowns simply because we don't know why the 2007 GFC happened.

In the Military, generals are always fighting the last war.
In Government and Economics, they are always fighting the last crisis.

From the New York Review of Books:
Partly this was because the most serious economic crises are centered in the banking and financial system, the basic source of credit, and none of those that occurred during this period involved the banking system in a major way.
The list of crises that were contained is long and impressive,
including the stock market crash of 1987,
the junk bond collapse of 1989–1990,
the Asian crisis of 1997,
the Russian default in 1998,
the failure of Long Term Capital Management—a large and hugely leveraged hedge fund—later that year, and
the collapse of technology stocks in 2000–2001.
 Quick and effective responses to these and other dangers by Greenspan’s Fed appear to have induced banks and investors to rely unduly on its ability to stave off collapses that threaten the system, and to ignore the serious malfunctioning of the financial markets.
These same successes may have led Greenspan himself to believe that he actually was, in the words of the Financial Times, the “guardian angel of the financial markets.”
The general pattern of those years was similar to earlier extended periods of growth and great optimism.

Saturday, June 12, 2010

Andy Muirhead, Collectors and Presumed Guilty whilst Facing Charges

Last night I was I was deeply saddened and shocked to hear that a favourite TV program of mine has been taken off-air. Andy and Collectors have been a beacon for me in the rather bleak existence that's been my life for the last few years.

The ABC has released a statement that the TV program, Collectors, has been taken off-air until further notice. It says Andy won't present radio or TV programs until the legal proceedings are concluded - but not quite that: "pending the outcome", which is what?

It's unclear to me, if the decision to step aside was Andy's or the ABC's, alone or jointly. The reasons must be multiple and complex.

This process will take much longer than 6 months to conclude and will damage all involved.

I worked with someone, Mark Lambert, who was charged by the AFP for similar offences in 1996.
His security clearance was "temporarily revoked", which meant, as a contractor, he lost his job - immediately.
When the matter was "resolved", he wasn't reinstated nor eligible for compensation.

This is the only write-up of the two year affair I could find, from June 1998.
Roger Clarke mentioned the start of the case, twice, in 1996.

Mark lost his job, savings, his four kids and marriage and almost his life after a suicide attempt.
He'd moved to Canberra from Adelaide to start a new career in I.T.
That obviously ended badly for him. I've no idea what happened to him after this ordeal.

The case ended with Lambert pleading guilty to a "technical breach" and receiving a 3-year good behaviour bond. The reasoning in choosing a plea was probably the usual pragmatic one: Lambert didn't have the money to fight the case, and would've (correctly) received this advice "these things are never certain".

The light sentence was due to an uncontested fact:
  • Lambert approached the AFP  with details of a child-porn ring in Sydney he'd uncovered.
Interestingly, no mention was made about the AFP or NSW Police pursuing those Lambert had identified.

I'm not going to second-guess the legal process or the police investigation. Here are some troubling facts:
  • Lamberts' actions are inconsistent with a guilty persons.
  • He sought advice from a friend and took them along when making his statement as an independent witness. Again, not consistent with guilt (two stories are harder to control than one).
  • The courts finally held his only crime was material on disk. Lambert had intended to move the offensive material to backups, but only copied it. Incompetence or mistake, yes, but inconsistent with guilt. If you were trying to hide all traces, you'd be much more through.
  •  Around the same time in the USA, Randal Schwartz, a noted computer expert, was convicted of 3 counts of "cracking" passwords at Intel. Schwartz had uncovered lax security practices and been trying to report them. Another well-intentioned geek nailed to the wall for seeking to help his employer.
 Justice, Equity and the Presumption of Guilt.

The Mark Lambert and Randal Schwartz cases are different to Andy Muirheads', no question.
There are many lessons around those cases that can be learnt.

The light, non-custodial sentences of both Lambert and Schwartz demonstrate that when the Courts did get to decide the matters, they weren't that impressed with the prosecutions' case but there'd been "technical" breaches that couldn't be swept aside.

Both Lambert and Schwartz lost years of their lives and suffered badly - mentally, emotionally and financially. They now have criminal convictions, which has consequences for the rest of their lives.

In the Andy Muirhead case, would he have been taken off-air for other crimes?

Like tax evasion or a false declaration on a bank loan or stealing some clothes - all well reported celebrity crimes.
Drink driving, drug-use, driving-related damage/injury and even domestic violence are so passé with celebrities, they only get passing mention in the media.

While Muirhead has been charged, he is formally "Innocent until proven guilty" - a principle enshrined not only in the British legal system, but around the world dating back thousands of year.

Yet, commercially and publicly, he is being treated as if he were guilty. This is not equitable, just nor legally accepted.
Like Lambert and Schwartz, he will, not just potentially, suffer damages even if vindicated, with redress or compensation possible.
We know this because it's already started. The bell cannot be "unrung".

Can Muirhead demand a writ of habeas corpus from those currently causing harm to his reputation and livlihood? Why have his reputation and interests been injured on the suspicion of an act?

Wikipedia on habeas corpus:
The writ of habeas corpus protects persons from harming themselves, or from being harmed by the judicial system.
My argument here is quite simple:
Publicising a suspicion of crime (charges laid) and suspending employment are ruinous to a public figure.  There is an effective Presumption of Guilt in both these acts, which violates fundamental Common Law principles and the UN Human Rights declaration.

"Justice Delayed is Justice Denied". 

It took years for Lambert and Schwartz to get their day in court. In the meantime, they suffered material and mental punishment as if they'd been guilty and handed stiff sentences. Those presumptive punishments and penalties were many times over harsher and more punitive than those eventually properly decided and handed down by the courts. But there is no redress or recompense available to those so victimised.

This is de facto sentencing and punishment by the community. Neither pretty, Equitable or Just.

The Legal system has a duty to uphold the Law and provide Justice.
Part of which is just sentencing and punishment, which, I argue, should endeavour to include two important points:
  • resolve the matters expediently (months not year), or suppress publication of charges until ready for trial, and
  • if not able to provide relief/redress for pre-trial damage/injuries, then to explicitly include those considerations in sentencing. Up to an including not recording a criminal conviction, with all its consequences.
Andy Muirhead is a bright star, this episode will not help him nor the community he serves.
What could he achieve if treated well?

This is not first time, nor will it be the last, that some "creative" has deeply offended public morals.

Oscar Wilde was hounded out of Britain and ruined for what is now commonplace in Sydney and L.A.
Was the loss of a such a genius truly warranted?
How much did we lose as a culture by the premature termination of his career?

We, as a community and culture, are sitting at a cross-roads.
It can be "Business as Usual" and this guy gets treated very badly, or we can find a sensitive, compassionate way to enforce our moral code without destroying Our Best and Brightest?

What's it to be?
Sacrifice Andy on the altar of Sensationalism, or
attempt to preserve and develop our exceptional talent, whatever their weaknesses?