Our Financial System Is Intrinsically Fraudulent and Unstable

(November 7, 2011)


Our financial system is like a fast-mutating cancer that evades any control and is still perfecting its ability to game and loot.
Two frequent contributors provided fresh insights into why the current global financial system will implode: it is intrinsically fraudulent and acts as a financial cancer, evading the "immune system" of regulation and perfecting its ability to exploit and loot the last remaining pockets of low-risk capital.
We start with David P.'s excellent exploration of systemic fraud:

Your essay The Collapse of Our Corrupt, Predatory, Pathological Financial System Is Necessary and Positive was entirely correct about risk. But let me come at this from a different angle - namely fraud. Finance skims a percentage off the real economy. Some part of the skim is legitimate reward for capital allocation - a necessary part of a capitalist system and part of what makes it more efficient than a command economy. But some part of the skim is fraud.

Where are we now? Let's look at the sources of skim:

First there are the more legitimate skim sources - interest payments, management fees, IPO fees, M&A fees, trade commissions.
Then there are the less legitimate bank sources: penalty credit card interest rates, late fees, usage fees, over-the-limit fees, late payment fees, bounced check fees, low balance fees. And the capital markets sources - front-running, insider trading, account churning, manipulation of the news cycle, the captive analyst "ratings game", trading against your own client's order book, forex trades which are marked at the day high or low irrespective of when the trade took place, market manipulations at options expiration, stuffing your managed client accounts full of dubious IPOs and new issues that your organization is earning fees from originating.
Bucket shops and ponzi schemes take it even a step further - no actual financial activity takes place. Its simply robbery.

And now we add the new stuff: credit default swaps without margin, fraudulent loan origination, sliced & diced mortgages, mark to myth accounting, foreclosure halts to avoid realizing losses, extend & pretend, quote stuffing, HFT trading activity that boils down to denial of service attacks on exchange computers causing delays in pricing information, highly complex derivatives sold to unsuspecting but optimistic public servants, too big to fail status providing cheap backup in the event of trouble, and increased organizational size that facilitate cartel-like control over government and regulators.

But if that's not enough, there is the structure itself: they aren't doing this with saved capital, but rather with freshly printed and/or borrowed capital. Its all done with 12:1 leverage at a minimum. So only 8.3% of the gambling (optimistically anyway) is actual capital - saved surplus. And if Basel II says it's risk-free, well there's no need for reserves at all. It is just manufactured money, which effectively mean each bet is diluting the actual savings of real people. And if the bet goes bad, the Fed will ride to the rescue with low-cost money. But usually the bet goes well, because ordinarily the number of sources of fraud today is so HUGE, its practically impossible not to succeed.
Unless of course they get too greedy. Or the debt levels rise so high that large numbers of borrowers default. And guess where we are.

The financial system is supposed to allocate capital and take a modest skim as reward for helping society to be efficient. When they are doing this, they provide a net benefit to society because it's a win-win proposition. They are making society more efficient, and they thus earn their percentage.
However, and this is the key point: fraud provides no net benefit to society. Fraud extraction is a zero sum game. For every dollar extracted through fraud, someone in the productive society ends up losing - savings, salary, whatever. This is why fraud is bad.
(I say that leverage is zero sum because constructing money from thin air for a leveraged investment causes inflation and thus steals from savers.)

Currently, it is my opinion that the vast majority of today's highly profitable financial activity is fraud. They have gone way, way beyond their mandate of capital allocators. Because most of its activities are based on fraud, the finance industry is acting as a parasite, sucking the life blood from the rest of society. Its bad enough we have peak everything, a world population of 7 billion people, and globalization to deal with - but we also have to face these challenges while a leech is weakening us with every step we take!
As a result, when this bloated, fraud-based financial system dies, we'll have a awesome, positive chance to rip off the parasite and replace it with something more beneficial. Simply re-executing glass-steagall will do for a start. Bring back 9-3 boring banking, where banks retain the mortgage and live with the risk, and capital markets once again do their job of capital allocation -- but without the fraud so rampant today.

Same conclusion, different angle. Intrinsically, I believe that capitalism does actually allocate capital more efficiently than competitive systems. And yet, how the current system works is so wrong. And I figured out it was fraud. Fraud was the bad guy. Remove fraud, and things get a lot better.
But after re-reading your essay, fraud wasn't the whole answer either. Fraud might be the leech, but leverage is the system killer.

One other comment.
If you apply statistics incorrectly to market behavior, you get into trouble. It is possible to successfully hedge away risk if the failure of one investment is truly uncorrelated with another. Joe defaulting on his mortgage is a unique event, and won't affect Sam and the likelihood of him defaulting. Then you can apply statistics and things should work out fine. Of course, in a debt bubble or a recession, that's no longer true. The same factor that caused Joe to default will also affect the likelihood that Sam will default too. Unemployment, being underwater, herd behavior, "its better to rent" - it all correlates, completely destroying the underlying assumption. Real life trumps statistics.
This further supports your basic premise - in the real world, there are almost always hidden correlations that reveal themselves at the worst possible moment, typically at the point of maximum leverage. Thus for practical purposes, it is impossible to hedge away risk; as a result, leverage still kills.

We've seen this most recently in sovereign debt. Basel II lets banks lever to infinity on sovereign debt because it assumes sovereign debt has a zero default risk. Hmm...
So - remove fraud, remove leverage, admit risk will always exist, and the capital markets can go back to fulfill their traditional role in society of capital allocation, making us all more efficient.
But of course removing fraud and leverage removes all of the easy zero-sum profit opportunities; all that remains is the job of capital allocation. While its true that capital allocation materially contributes to society, it turns out it is also hard work. Who wants to do that when there's easy money to be made in fraud - with leverage! And that's why we have to have another crash so we can return finance to its proper - and necessary - role in society.

Contributor Michael M. explores the analogy that our financial system is in effect an aggressive cancer, and also explores the system's inherent instability:

I think the risk "hedging" can be split into two parts, first using/inventing "hedging" instruments who won't live up to their name in a major event (CDS anyone?), and second hiding risks in existing allegedly time-tested limited risk systems/instruments. You mostly covered the first part in your article.

Some more examples for the second variant, besides lowering the down payment on house mortgages, are: Gaming VaR models (so for a 1% VaR the risk in the 99 days remains the same, but the blowup in the 1-out-of-100 event becomes much much larger), or lowering of Fractional Reserve requirements, or Sweep accounts (deposits in checking accounts get sweeped into savings accounts, i.e. are put into money market funds where the risk is a [little] bit higher, but the owner of the capital [the depositor] doesn't receive higher premiums), or student loans becoming non-dischargeable.
"So what happens when one counterparty (issuer of a hedge) somewhere in the chain runs into trouble? The entire chain collapses."

Or the accounting rules are manipulated, so the entity next in line after the collapsed one is allowed to keep their risk valued at par on the books, even though their hedge just vanished (and they are not able to get replacement hedges at an acceptable price in the current market) and the ongoing collapse freezes in a state of suspended reality - but the trouble is not undone!
The system has not blown up yet because there are still some pockets of unimpaired, really low-risk capital available to game and loot.

In effect the financial system is still perfecting its ability to game and loot, just like a cancer which, due to non-self-restrained growth and fast mutation, continuously improves its ability to elude or withstand the immune system. Until the host cannot bear the strain anymore.

How could we ever get to this point?
Too much stability. Thereby lowering reserves and safety margins more and more, until one day (maybe even without a large increase in volatility first!) a swing exceeds the safety margin. Oops. Which is exactly what Nassim Taleb is saying, but almost no one fully understands him.
This leads to my quote, which I came up with myself:
Stability breeds stupidity.
But at the same time one must remain humble of being able to overview all relevant parts of the picture... it can go on for a LOT longer than oneself can come up with a functioning game plan for, no matter how far you stretch your imaginable reality.
Which makes me go back to my "(over-)complexity" meme. I nowadays also look at The Fourth Turning through my complexity goggles... and war is still the strongest simplifier - quicker and more rigorous even than a systemic collapse!

Thank you, David and Michael, for your incisive analyses. The system's stability is superficial, and we might yet see that facade stripped away in the remaining months of 2011.

courtesy Charles Hugh Smith

The Collapse of Our Corrupt, Predatory, Pathological Financial System Is Necessary and Positive

by Charles Hugh Smith

We are being throttled by the Big Lie: we're told that if the predatory financial system implodes, we'll all be ruined. The opposite is true: the only way to save our economy is to let the corrupt, pathological and flawed financial system implode.

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.

What does this promise of using leveraged capital to skim risk-free fortunes do to the "real economy" of production and investment in plant and technology? It guts it. The risk of industrial Capitalism is real and cannot be hedged away; high-risk investments may blow up or they may return high yields. It literally makes no sense to risk real capital in productive Capitalism when a zero-risk skimming operation can be developed that essentially needs near-zero capital.

Thus financial capital has come to completely dominate industrial or productive capital. The pernicious consequences of this dominance have poisoned the economy and culture on multiple levels.
In the political sphere, the aggregation of hundreds of billions of dollars in skimmed profits gave Wall Street and the banking sector unlimited budgets to buy political influence. This created a monstrously pathological feedback loop: the more political influence Wall Street bought, the higher their returns on financialization skimming.
Consider housing as an example. Housing was once a simple, barely profitable long-term investment for both the buyer, who had to place substantial capital at risk (20% down payment) and the holders of mortgages, who took a modest yield for 30 years in trade for low risk.

Wall Street and the banks financialized housing via political influence. opening up a vast new territory to be exploited via skimming. Since capital wasn't necessary in no-risk skimming, then down payments were dispensed with to increase the pool of debtors, as they are the foundation of all skimming operations.
the cost of servicing that debt was manipulated via "teaser rates" and "interest only" loans, further leveraging up American home buyers' modest income streams. Mortgages were bundled, tranched and hedged, and the mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) were sold to trusting investors aroudn the world.

It was a bonanza of unprecedented wealth creation from financial skimming. $1,000 down and a few hundred dollars a month for a "teaser rate" interest-only loan was leveraged into a global chain of "products" and counterparties that could be skimmed all along the chain.

That deepened the political corruption that fed the skimming operation, and introduced the "no risk" pathology into Mainstream America. Since real estate never went down in value, then buying a second, third or fourth home on leverage was simply rational; in a Federal Reserve-controlled world of near-zero yields on cash, it was irrational not to.

But there were two intrinsic flaws in the skimming operation: while the Wall Street players were hedged (or so they reckoned), the average Americans buying homes with near-infinite leverage were not hedged. That meant that when their razor-thin capital went to zero, they were insolvent. Once they defaulted, then the income stream feeding the chain of skimming went away and the chain collapsed.

Once one counterparty failed in the chain, the entire chain collapsed as well. As Mandelbroit explained, such disruptions were an intrinsic feature of the system; though the timing of a systemic disruption could not be predicted, the fact that disruptions would occur on a regular basis could be predicted.

Some players knew this, of course, but that led to another pathology: those investment players who avoided the "no risk" skimming casino could not generate the yields being "earned" by the leveraged skimmers with legitimate investing, and so their investors abandoned them for the fully rational reason that "no risk" yields were higher elsewhere.
This too created a feedback loop, where the capital available to be leveraged grew rapidly, while the pool of capital available for "patient" risky investments in actual productive assets declined. Capital available for productive investment thus became costly and scarce, while capital available for leveraged skimming became cheap and abundant.

The Federal Reserve bankrolled the skimming to the hilt. Indeed, the entire pathology of low-interest, unlimited leverage skimming was based on the Federal Reserve's manipulation and intervention. That remains true today.

What happens when the whole chain blows up and the foundation of debt is impaired? Since the whole system is based on the debt and the income streams devoted to servicing it, the entire edifice collapses when the debt is impaired--debtors default and the system clogs with bad debt, i.e. uncollectable debt.
In a transparent Capitalist system, the debt would be written down and all the insolvent borrowers, lenders and counterparties would be wiped out. But the political corruption that enabled modern finance to poison the American economy and culture has stopped that cleansing from occurring.

Such a systemic writedown of bad debt in a system with only razor-thin capital to support a mighty edifice of leverage and debt would wipe out Wall Street and the banks and reveal the skimming operation of modern finance as an impossible perpetual motion machine rigged to enrich a thin crust of citizenry at the expense of the rest. And since they skim enough money to buy political protection, Capitalism has been strangled and tossed in a shallow grave lest it disupt the skimming and the political corruption that keeps the machine running.
What we end up with is artificial valuations, endless propaganda and a zombie economy. When borrowers are left dangling in default and the assets left on the books at full value, you end up with zombie debtors, zombie lenders, a zombie government that only has one lever to pull to keep the whole corrupt pathology going--borrow and squander more money-- and ultimately a zombie economy, drifting and decaying in a fetid pool of lies, shadow banking, ceaseless official propaganda, jury-rigged "fixes," manipulated statistics, corruption, predation, exploitation and pathology.

That's the U.S. economy, and indeed, the economies of the E.U., China and Japan in a nutshell.
The only way to clear a zombie economy is to write off uncollectable debt and liquidate all the assets, loans and hedges. That would collapse our financial system, but since it is the cause of our political and economic dysfunction, that would be the highest possible good and extremely positive.
There is a great final irony in the scare-mongering threats of the skimmers and their political toadies. If the taxpayers don't bail out the skimmers, then we'll have martial law by the weekend, the smouldering fires of Europe will rekindle into open warfare, and so on.

The irony is the propping up of a deeply, intrinsically pathological and destructive financial system is not saving the economy, it's the reason the economy is imploding. The Big Lie technique of propaganda is to reverse the polarity of reality: we are told up is down until we believe it.

We are told that liquidating the overhang of bad debt, leverage and hedges would "destroy the world as we know it." The truth is that keeping the zombie system from expiring and covering up the corruption with propaganda is what's actually destroying the world as we know it.
Thus the collapse of the current financial system of central banks, pathological Wall Street and insolvent banks would be the greatest possible good and the greatest possible positive for the global economy and its participants.

courtesy Charles Hugh Smith from Of Two Minds