Saturday, September 25, 2010

The Timeline Topic by Topic -- with a Greek Chorus 23

The chronological timeline from yesterday's blog shows us:

The development of derivatives:

Black, Merton and Scholor adopting a physics formula, the opening of the Chicago Board Options Exchange, the October 19, 1987 stock market crash (whiwas the result of the New York stock exchange opening at different times and being out of synch with the Chicago options market), the establishment of the Plunge Protection Team, the collapsesesese of Metallgesllschaft Refining, the Orange County bankruptcy, the Bankers Trust loss of $200 million, the Barings Bank bankruptcy, the development of an unreviewable comlanguageageuate (APL), a political fight over whether to reign in derivatives or not between the CFTC, Alan Greenspan and Robert Rubin which the CFTC lost in spite of the bankruptcies noted aboconceptcreleaseeaseeave by the CFTC which is ignored, the disbanding of Salomen Brothers arbitrage unfailure faioure o Long Term Capital Management (established by the Nobel winning economists who developed the1973 formula noted as the first item above), the Bank of America acquisition of Merrill Lynch due to derivatives and Merrill's responsibilities as a counter-party), the filbankruptcykruoptcy by Lehman Brothers, the collapsestock marketckmarket in late September 2008, and the seizure of Washington Mutual and its records by the Office of Thrift Supervision, all of which led to TARP I, which itself failed to pass the House of Representatives the first time around until it was laded with pork. The “notational value” of derivatives, the amount of the betting contracts totaled up, as of 2010, is between one quadrillion dollars (that's a thousand trillion) and $1.6 quadrillion dollars, which is to say, about 20 times the GDP of the entire world. That's how much money is in the pot in the middle of the table being gambled every business day.

The end of the accounting profession as the auditor of fair financial statements:

In 1972 the accounting profession stopped setting its own rules and allowed bankers and academics into the rule making process in a failed effort to avoid control by politicians during Nixon's price control scheme. In the 1990s, the accounting profession's association (AICPA) dabbled successfully in lobbying, making it much more susceptible to political pressures [not on the timeline]. In September of 2008, the SEC ordered the accounting profession not to implement a rule (FASB 157) that would have treated derivatives conservatively and thus have protected investors. This indicates that the auditing profession is moribund and the SEC works to prop up banks rather than its chartered purpose to protect investors.

The increase of market volatility by rapid trading of large blocks of equities held for a very short term:

James Simons stated renaissance Technologies in 1982, launching the spectacularly successful Medallion Fund in 1988. The Renaissance Institutional Equities Fund for institutional investors was launched in 2005. By 2006 60% of London Stock Exchange trades were by high frequency traders. By 2009, 73% of USA equity trades were by high frequency traders. On May 6 of 2010 a “flash crash” occurred for which a CFTC and SEC preliminary report has just been issued.

The fatal mistakes of politicians on behalf of the finance industry insured a crash in 2008:

A Plunge Protection Team was set up to rig stock prices and avoid another crash after October of 1987; Russia defaulted on its loans in 1998 (leading directly to the failure of Long Term Capital Management, which was disassembled by fiat by the Federal Reserve under Alan Greenspan). In late 1999, the Gramm-Leach-Bliley Act combined commercial banks, investment banks and insurance companies without SEC oversight of investment banks. Late in 2000, the Commodities Futures Modernization Act was passed (authored by Senator Phil Gramm (R-TX), a PhD economist. It essentially allows banks to act as money-making underwriters of bets (“derivatives”) to clients in lieu of taking out insurance. The derivatives supply insurance without reserves and without legal supervision such as the state insurance bureaus, themselves disallowed to interfere with derivatives as part of this legislation. In 2004, the SEC proposes voluntary market regulation of derivatives in which the holding companies follow their own computer models. In Marcy of 2008 Bear Stearns is acquired by JOP Morgan Chase with guarantees from the Federal Reserve. On September 7 Fannie Mae and Freddie Mac are laced in conservatorship by the Federal Housing Finance Agency,. On September 16, A.I.G. (the largest insurance company in the USA and a Dow 30 Industrials component) goes broke and is loaned $85 billion by the Fed,. On September 26, the SEC chairman shuts down the 2004 voluntary compliance program since all the brokerages in the program are bankrupt or absorbed or converted to commercial banks. On October 9, the FED loans AIG another $37.8 billion. On November 10 the US Treasury purchases $490 billion in newly issued AIG preferred stock. In 2010, an intentionally ineffective bill on financial stability is passed by congress and signed by the president.


We have a quadrillion dollars worth of bets sloshing around, most being traded privately with minimum regulation. Government regulation is ineffective, the lessons of the depression have been repealed, and the effected entities exposed to derivatives do not have to include the dangers on their financial statements. Along with dollar and treasury instability (which would allow many of these derivatives contracts to be called immediately), we have entered an era of anomalously enormous risk. Nations are going broke (Hungary, Iceland, Greece, potentially Portugal, Spain, Ireland and Italy).

Did Greek Mythology Provide a Useful Warning?

Tykhe, the goddess of fortune, carries a ball. This is a sphere which can roll in any direction. Her companion, Nemesis, punishes those who are arrogant or insolent, the often fatal characteristic of hubris (such as the 1973 fake conquering of risk by a physics formula for heat transfer in liquids, supposedly complex enough to sensibly express the valuation of options (which themselves are derivatives).

The preposterous claim to have conquered risk should have been met with fear, alarm and suspicion by economists and certified public accountants. The derivatives-based crash of 1987 and bankruptcies of the early 1990s should have stopped any legislation seeking to encourage the growth of derivatives. The result was the crash of 2008 and high uncertainty ever since. Nemesis wants to be fair but has been forced, by humans with their expectations of exceeding what is fair, to be vengeful.

Losers: the citizens of the bankrupt nations and the taxpayers of the USA.

Who is to blame: economists, the executives of the CPA profession stupid enough to think they could win at lobbying, and, especially, a small amateurish, unprofessional “business specialty” called “risk management.”

Also to blame: Deans of universities who have failed consistently to recognize the need for a broad education. A university graduate with time spent at a chemistry lab bench and time spent reading Shakespeare and time discussing the Greek tragedies (this used to be called a “broad” or “liberal” education but is now dissed as a background based on “dead white European males”) is much more likely to spot the cracks before a dam like the derivatives crisis bursts.

Oh. We're not done. There was also in this saga an overwhelming failure in ideology, exemplified by Alan Greenspan. That is the subject of the next blog entry, which deals with cognitive bias married to ideology.

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