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Sunday, October 24, 2010


This organization (Financial Crisis Inquiry Commission) is bringing its scheduled activities to a close. I have been reading a lot of the testimony, and I thought others might be interested. This page gives you the index to the hearings, and you can click on each hearing and read the testimony. All the hearings are worth reading. The stuff below is from day 1 of the Subprime Securitization stuff.

My personal favorite is Patricia Lindsay's testimony on her work with New Century:
The Definition of a good loan changed from, “One that pays” to “One that can be sold”. The loans were no longer held by portfolio lenders, but sold to investors, most of whom placed them into securities.
And who could possibly have imagined that this could be a problem?
I was compensated with salary plus bonus based on company performance with part of that being discretionary based on personal performance. The compensation was significant for the top producing salespeople, some of whom were making several million dollars a year. Many of the sales managers and account executives lacked any real estate or mortgage experience. They were missing the depth of experience necessary to make an informed lending decision. These same sales mangers had the ability to make exceptions to guidelines on loans, which would result in loans closing with these exceptions, at times over the objections of seasoned appraisers, underwriters or risk personnel.
At the end of the day, we had a system that went into a downward spiral because of layering risk rather than offsetting the risk because there was such a huge demand for the products. Our loans were sold before we even made them, which put more pressure on the production groups to get loans closed. Wall Street packaged and sold the Residential Mortgage Backed Securities to unsophisticated bond buyers/ investors. By unsophisticated, I mean they did not understand the true risk of the underlying loan product. The process was so convoluted it was nearly impossible to get a fraud loan pulled out of the entanglement to repurchase it. I actually had a Wall Street investment banker chastise me for trying to buy a fraud loan back.
The most damning is probably Murray Barnes' discussion of "stress tests" at Citi:
During my tenure, Market Risk assessed potential exposures in a variety of ways, including through the use of stress tests, which employed assumptions using historical data to stress for potential loss.
These marks reflected the widely held belief—both within the Company and throughout the market—that the super-senior positions bore almost no risk of loss. As the unprecedented market events unfolded in 2007, and new issuance of CDOs froze, the business developed a model to price its super-senior positions based, in part, on an intrinsic cash-flow methodology of the CDO’s underlying RMBS collateral.
Indeed, given the widely held view that the super-senior positions posed only an extremely remote risk of loss prior to the unprecedented events of 2007, it is still difficult to imagine how the severity of the decline in house prices – and its effect on the CDO market – could have been predicted, let alone modeled.
This is wild stuff. If you stress test based on no-loss assumptions, you will not come up with risk predictions. That much is true. But if you look at cash-flow assumptions to model, you'll come up with a very different picture.

Read the above first, and then go on to Bowen's testimony about RE lending at Citi.

These loans were nothing like mortgage loans issued before, yet the "Risk" assessment was performed using assumptions gleaned from properly underwritten loans. Amazing.

The same methodology is now being used by those who claim the Social Security and Medicare Trust Funds are assets. Some people never learn, although it is a tragedy when a person whose profession is to assess risk cannot even perceive his error in hindsight.

If you read through this stuff, you will slowly gather the picture that almost without exception, the idiocy of explanation and an inability to perceive error is positively correlated with higher positions in the, shall we say, "prestige ladder".

And if you don't believe that, end with Greenspan's testimony, which should live in everyone's memory as an epic example of Fed-Gone-Bad. There is so much complete nonsense in this one pdf that someone should write a book rebutting it line by line. If you read Greenspan's testimony and don't see the glaring falsehoods, then read Bitner's testimony. Notice that while both begin in the 1980s, one is discussing pertinent events and one is blowing smoke.

In a microcosm, this is what has gone wrong in our society. The further up you are, the less you know and the less responsibility you will take for your actions.

Update: Please also see today's post by Shrinkwrapped on the topic of disconnected elites. I love a man who resorts to the US Census to get numbers. However even if you do not, his basic argument is valid and may well go a long way toward explaining the oddity that I have been contemplating while reading through the FCIC hearings. My thesis is that the current Ivy culture is one that teaches irresponsibility.

The topic of learned irresponsibility was proposed by Deresiewicz in his American Scholar article. The article is entitled "The Disadvantages of An Elite Education":
As two dozen years at Yale and Columbia have shown me, elite colleges relentlessly encourage their students to flatter themselves for being there, and for what being there can do for them.
The second disadvantage, implicit in what I’ve been saying, is that an elite education inculcates a false sense of self-worth.
He then goes on to discuss the training in responsibility:
An elite education not only ushers you into the upper classes; it trains you for the life you will lead once you get there. I didn’t understand this until I began comparing my experience, and even more, my students’ experience, with the experience of a friend of mine who went to Cleveland State. There are due dates and attendance requirements at places like Yale, but no one takes them very seriously. Extensions are available for the asking; threats to deduct credit for missed classes are rarely, if ever, carried out. In other words, students at places like Yale get an endless string of second chances. Not so at places like Cleveland State. My friend once got a D in a class in which she’d been running an A because she was coming off a waitressing shift and had to hand in her term paper an hour late.

That may be an extreme example, but it is unthinkable at an elite school.
In short, the way students are treated in college trains them for the social position they will occupy once they get out. At schools like Cleveland State, they’re being trained for positions somewhere in the middle of the class system, in the depths of one bureaucracy or another. They’re being conditioned for lives with few second chances, no extensions, little support, narrow opportunity—lives of subordination, supervision, and control, lives of deadlines, not guidelines. At places like Yale, of course, it’s the reverse. The elite like to think of themselves as belonging to a meritocracy, but that’s true only up to a point. Getting through the gate is very difficult, but once you’re in, there’s almost nothing you can do to get kicked out. Not the most abject academic failure, not the most heinous act of plagiarism, not even threatening a fellow student with bodily harm—I’ve heard of all three—will get you expelled.
What the professor is describing is a system that trains people to be irresponsible and expect not to be held accountable.

So much fraud wrapped in the veneer of respectability.
Time = Money
Knowledge = Power
Power = Work/Time
so Knowledge = Work/Money
or Money = Work/Knowledge.

So the less you know, the more you make.

Until that extremely screwed-up idea of how to run a country is thoroughly repudiated, the mess is going to get worse.

To be fair, I am intimately familiar with that sinking feeling in the stomach that comes with having screwed up in a way which is going to adversely affect a large number of people. It's a hard thing to own up to it, and an easy thing to dismiss that feeling with a nice game of "extend and pretend". I can sympathize with these people somewhat.

What's dismaying is that the system is rigged to reward the game and punish those who come clean. Only chumps do the right thing.
Our loans were sold before we even made them,

I sure would like to know specifically who the buyers were to see if my taxes are covering their losses.
THANK YOU for posting this! I love your blog!!

Common Cents
Charles - most pension funds buy MBS.

So in terms of public sector retirements, I'd say that you are facing a hefty tax liability.
MoM, I know that intuitively but I would like to know them specifically. Although I suspect the answer is "all of them".

My sister runs a continuing education program at Harvard Med. She has a psych degree from Harvard, her Ph. D. is from a non-ivy institution. She worked for a physician in high school, got an associates degree from the local JC, then went to nursing school. She got the Harvard education because she took a job with her emplyer's son at Harvard. So she worked full-time while working toward her undergrad degree which she said is almost unheard of there. (She was 32 when she graduated.) She immediately left Harvard upon graduation and worked for a law firm and then an architecture firm before taking part-time work while raising a daughter (up until age 6). Some of the part-time work was at Harvard and after she got her Ph. D. she took her current full-time job.

That is all background for showing that she has not led an isolated life amongst the Harvard culture. And her stories echo those of Deresiewicz - her customers are physicians taking continuing education courses and she is disgusted by the laziness and sense of entitlement most of them bring. These courses meet about 8 times, more than one absence is supposed to be an automatic failure - and the excuses she hears (and threats) rival those of an alcoholic. Each student in such a situation goes over her head and gets a pass from the dean. Her argument - if these people claim to be so busy, how did they find time to have a three hour impromptu meeting with the dean but couldn't arrange their schedules to take a class they signed up for months in advance.

The same pass is bestowed to ALL Harvard employees. She has had employees with attendance records below 50% in a month (non-medical) she cannot fire, her superiors simply will not be bothered with such trivial matters even though they are the only ones who can approve such measures.

What happens to the few "good" employees there? At some point, they get so disgusted they take positions at MIT where job performance actually means something.
Charles - well, what they are really selling is the name, and I suppose the coursework is totally unimportant. As long as they write the checks....

The problem with this sort of thing are Challenger incidents. When credentials are more important than competence, money always overbids competence, and the culture changes.

Clearly, that's where we are. I think we will have to escape it before we see much in the way of change.
what they are really selling is the name, and I suppose the coursework is totally unimportant. As long as they write the checks....

Well there are 2 types of continuing education she is responsible for. One is seminars, which she agrees are more informal and are more for networking and passing on information. The coursework types are something else entirely and are a degreed program - the instructors are physicians and some of them find it unethical that passes are given for a phsyician that hasn't actually proven to have acquired the skills.

Of course you're correct in that the dean isn't making any distinction as long as the checks clear; indeed, the doctors enrolling in the courses and not doing the work are only seeking to up their credentials in order to up their pay. The entitled credentialing the entitled, so to speak.
40 years ago, Peter Drucker (himself an Austrian who spent much time elsewhere in Europe) contrasted the American and European systems of higher education...asserting that one of America's great strengths was that you did NOT have to attend one of a small number of "elite" institutions in order to have a stellar career.
Higher education teaches corporate lifestyle, fosters administrative managerial thinking as the basis for modern life which is not isolated to Ivy League schools. The emphasis on corporate thinking as the basis for problem solving has created a society dedicated to top down elitist culture that craves material wealth and power at the expenses of the general good of society.
I just finished "TO BIG TO FAIL" by Andrew Ross Sorkin. It's an exhaustive, day by day recap of what went down both on Wall Street, at the Treasury, and the Fed.

if Sorkin got his facts right (always a question in a tome like this) the CEOs, CFOs of CITI, BAC, Bear, Lehman, Chase, etc., etc. did not understand (and probably did not want to understand) the complexities of the mortgage backed securities. The primary factor was that they were making money - lotsa money! A few on Wall Street tried to warn about the risks, and the over-leveraging. They were ignored because the money was speaking much louder than any concept of fiduciary responsibility.

When things began to fall apart the CEOs, (Fuld, Dimon, Lewis, Blanfein, Pandit, etal,) Paulson at Treasury, and Bernanke (and Geithner) at the Fed were all blind sided. At first they thought it was easily containable. Gradually the facts came out and the enormity of the situation became clear.

Assuming Sorkin's facts are correct, we were facing a lock up and then melt down of the system. No one was sure how to proceed.

The big mistake was saving Bear Stearns and Merrill then letting Lehman go belly up. That provided a picture of government picking winners and losers, which destroyed the confidence in all because no one could guess who the government would save and who they would leave for dead. That really panicked the system and started the flight from risk.

TARP stenched the bleeding, but was so questionable in itself that almost immediately Paulson, Bernanke and Geithner began damage control. They tried to devise a program for a public private partnership to buy up illiquid assets (MBSs, CDOs, and CDSs) from the financial institutions. This was not well received and went nowhere. They were saved by the FASB cancelling mark to market requirements for the illiquid MBSs, CDOs, and CDSs.

Since then, there has been a reliquification of the financials along with some work offs of losses. However, as we all now know, the paperwork trail for many of the securitized mortgages is not easy to untangle. We are probably only half way through unraveling the mortgage mess and getting the housing market back on some kind of even footing. The eventuakl losses at the banks will be huge, but with low interest rates and an accomodative Fed, the banks are working their way out of the hole.

In the meantime, it's my opinion that the financial reform bill passed by Obama, Reid, & Pelosi is mostly an exercise in trying to increase taxes/fees on banks while not addressing the real issues.

The financial crisis was all too much the result of very smart people not paying proper attention to all aspects of their companies. The mortgage securitization business was in the boring fixed income division of most of these companies. The CEOs were much more vigilant over their stock and commodities trading divisions. Of course the Ratings Agencies providing AAA ratings affected everyone's normal due diligence. All very human, all very easy to understand........in hindsight.

The truth is, another big crisis will happen somewhere down the road. It will again, "Catch everyone by surprise!"
JimmyJ.."The CEOs were much more vigilant over their stock and commodities trading divisions"...I've noticed that a very common organization structure looks like the following:

-VP of stuff CEO finds interesting
-VP of stuff CEO finds interesting
-VP of stuff CEO finds interesting
-SrVP of stuff CEO finds boring
---VP of boring stuff
---VP of boring stuff
---VP of boring stuff
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