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

Some truth about "Climate Change": Monckton

Uploaded by sdamatt2 on Oct 27, 2011

Al Gore Debates Lord Monckton

Uploaded on youtube by ClimateScam

While The Euro & Dollar Die; Brother Nathanael Explains

courtesy Brother Nathanael Foundation

Gilad Atzmon: Armageddon Ahead

Gilad Atzmon

It does not take a genius to gather that the Israeli aggression towards Iran would endanger every living species on this planet. Devastatingly enough, our Western governments  do nothing to stop the Jewish State. That should not take us by surprise: our politicians are largely funded and vetted by Israeli lobbies that openly support attack on Iran.

Here in Britain Defence Secretary Liam Fox had to resign two weeks ago when it became clear that he was ‘breaching ministerial laws’. The British press went out of its way to reduce the issue of his resignation into just another ‘gay-ish mini scandal’. But we actually have strong reason to believe that Fox was working intensively for Israel. He was enthusiastically advocating Israeli interests such as an attack on Iran.  Together with his ‘best friend’ Adam Werritty,   he was also funded by the Israeli lobby. We  know also that Fox and his ‘flat mate’ Werritty were in direct contact with  Mossad, and were even warned by MI6 about it.

But Fox was not alone: with 80% of our leading party’s MP’s being Conservative Friends Of Israel’s (CFI) members, we have good reason to believe that treachery is now institutional amongst UK elected politicians.

As we brace ourselves while learning from the Israeli press about the IAF’s final preparations ahead for an attack on Iran’s nuclear plants, I would like to share with you a short passage from The Wandering Who.

In the following extract, I explore the exact genocidal scenario that Israeli pilots are now  training to accomplish, in these very days. As much as it is clear that our treacherous elected puppets will fail to restrain Israel, it is equally and tragically obvious that Israel lacks the means to restrain its own madness.

“…I will try to elucidate this idea through a simple and hypothetical yet horrifying war scenario. We, for instance, can envisage a horrific situation in which an Israeli so-called ‘pre-emptive’ attack on Iran escalates into a disastrous nuclear war, in which tens of millions of people perish. I guess that amongst the survivors of such a nightmare scenario, some may be bold enough to argue that ‘Hitler might had been right after all.’
The above is obviously a fictional scenario, and by no means a wishful one, yet such a vision of a ‘possible’ horrific development should restrain Israeli or Zionist aggression towards Iran. As we know, Israeli officials threaten to flatten Iran rather too often. In practice, pre-TSD[1] Israelis make this devastating scenario into a possible reality.
Seemingly, Israelis and Zionist politicians fail to see their own actions in the light of history.  They fail to look at their actions in terms of their consequences. From an ethical perspective, the above  ‘imaginary’ scenario is there to prevent Israel from attacking Iran. Yet, as we all know, Israel and its lobbies are desperate to dismantle the so-called ‘Iranian threat’. My explanation is simple. The Jewish state and the Jewish discourse in general are completely foreign to the notion of temporality. Israel is blinded to the consequences of its actions, it only thinks of its actions in terms of short-term pragmatism. Instead of temporality, Israel thinks in terms of an extended present.” (The Wandering Who pg. 179)

The Jewish State and its lobbies are the greatest threat to world peace.  If we want to save ourselves, there is no other way of doing so than looking closely into Jewish, Israeli and Zionist culture, identity and ideology. There is no other way of doing so than scrutinising Israel’s unique and relentless attitude towards lobbying.
The issues we are dealing with here are not solely political  they are actually deeply philosophical, psychological and sociological — and it is also about life and death.

from The Ugly Truth

71% of Germans want a referendum

Germany itself is now demanding a referendum. According to Welt, 71% of Germans want a referendum, and want to to vote directly on important decisions for Europe and the Euro. Only 27% oppose the motion. And the same poll has found that 63% of Germans think Greece should be kicked out of the Euro, with just 32% believing the country can still be saved.
(...)
Chancellor Merkel and President Sarkozy, in response to the idea of a Greek referendum on the bail-out package, raised the possibility of a country leaving the euro – so far a taboo in European political circles. This is the second time in less than four months that European leaders could have  opened a Pandora’s Box: on July 21, the decision to involve the private sector in the Greek bailout signaled that euro area government debt is no longer risk-free and thus sparked massive contagion into Spanish and Italian debt markets. This past week, by raising the possibility that a country might (be forced to) leave the euro, core European governments may have set in motion a sequence of events which could potentially lead to runs on sovereigns and banks in peripheral countries that make everything we have seen so far in this crisis look benign.

the whole thing at Zero Hedge

Wikileaks Exposes German Preparations For "A Eurozone Chapter 11"

The following cable from US ambassador to Germany Philip Murphy ("Ambassador Murphy spent 23 years at Goldman Sachs and held a variety of senior positions, including in Frankfurt, New York and Hong Kong, before becoming a Senior Director of the firm in 2003, a position he held until his retirement in 2006") "CONFIDENTIAL: 10BERLIN181" tells us all we need to know about what has been really happening behind the smooth, calm and collected German facade vis-a-vis not only Greece, but all of Europe, and what the next steps are: "A EUROZONE CHAPTER 11: DB Chief Economist Thomas Mayer told Ambassador Murphy he was pessimistic Greece would take the difficult steps needed to put its house in order.  A worst case scenario, says Mayer, could be that Germany pulls out of the Eurozone altogether in 20 years time.  In 1990, Germany's Constitutional Court ruled that the country could withdraw from the Euro if: 1) the currency union became an "inflationary zone," or 2) the German taxpayer became the Eurozone's "de facto bailout provider."  Mayer proposes a "Chapter 11 for Eurozone countries," which would place troubled members under economic supervision until they put their house in order.  Unfortunately, there is no serious discussion of this underway, he lamented." This was In February 2010. The discussion has since commenced.

Full cable, created on February 12, 2010, presented with no comments, and just the occasional highlight, as all of what Germany is really saying has already been said by us as well.
C O N F I D E N T I A L SECTION 01 OF 03 BERLIN 000181 

read the whole thing at ZERO HEDGE