17-04-2009, 02:58 AM
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Zombie banks
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They look like banks, they walk like banks and they quack like banks, but they're really the undead. Shells filled with toxic assets. Killing these living dead is probably political suicide because of the collateral damage, but it's the way to go say leading economists. Reporter Stan Correy.
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Stan Correy: This is Background Briefing on ABC Radio National.
I'm Stan Correy.
While the G-20 protesters were rioting and marching and chanting and waving placards with catchy phrases like 'Capitalism stole my virginity', or 'When I say banker, you say wanker'. And our favourite, 'Make love not leverage'.
Not far away, perhaps in an apartment down a side street from the defaced and shattered Royal Bank of Scotland, picture the swank offices of a little-known American hedge fund. Financial entrepreneurs Hank and Dagny are finding that leverage is the biggest aphrodisiac they know.
Dagny: Scream your secret passions, Hank Rearden!
Hank: Derivatives!
Dagny: Yes!
Hank: Credit-default swaps!
Dagny: Oh yes! Yes!
Hank: Collateralised debt obligation!
Dagny: Yes! Yes!! YES!
Stan Correy: We'll hear more later from Hank and Dagny as they stimulate their passion for debt and the millions some people can make out of it.
These packages of debt were sold on like pass-the-parcel, making fortunes as they went, but ended up causing a world economic crisis. Both the disease caused by these toxic assets and the cure are painful.
In America, there are over 250 banks that are considered at risk of failure. Some of the biggest banks are already zombies, that is, they are living, but dead. Here's a recent report from the NBC network.
Man: From horror movies, financial regulators have a name for them, zombie banks. Deeply troubled banks that are barely alive but not dead yet, and too big to let die or kill, without triggering financial chaos; the swarm of zombie banks is only growing scarier.
By far the biggest zombie bank is Citibank, even after getting $45-billion from the government and having hundreds of billions in losses guarantees, it's still in deep trouble.
Stan Correy: Australian banks aren't infected with the zombie virus, but the global plague has immense reverberations here too. If prosperity is to be resurrected, the zombie banks have to die.
Few economists follow the economics of the living dead but those that do, get their inspiration from the classic Hollywood zombie Movie, Night of the Living Dead. In this scene, a reporter is asking if these un-dead are dangerous.
Reporter: Chief, if I was surrounded by six or eight of these things, would I stand a chance with them?
Chief: Well there's no problem. If you had a gun, shoot 'em in the head. That's a sure way to kill them. If you don't, get yourself a club or a torch. Beat 'em or burn 'em, they go up pretty easy.
Reporter: Are they slow-moving, Chief?
Chief: Yes, they're dead, they're all messed up.
Stan Correy: They're dead and messed up, but they are still causing havoc as their toxic assets trickle down to all the companies they deal with, their shareholders and their staff.
The IMF has just estimated that this toxic debt, sitting on the balance sheets of banks and insurance companies could rise to $US4-trillion by the end of next year.
The economics of the living dead isn't just about working out how zombie banks get billions in bail-out treats. It's about how the banks got infected with the zombie virus in the first place. The term 'zombie banks', was invented by Professor Ed Kane, from Boston College.
Ed Kane: I was just puzzled as to how to get across, how important it was not to keep pumping money into these institutions; how to get across that they had incentives that were really harmful to society. And I came up with this because of my misspent youth in reading comic books and going to horror movies.
Stan Correy: And the zombie I suppose, the living dead, was the best term to describe what you thought was happening?
Ed Kane: My hope was that by explaining it in such a folksy way, or accessible way, that authorities would never do this again, although my theory of government behaviour is that they would do it every time.
Stan Correy: And they have done it again. But Ed Kane says that's not the way to do it.
Ed Kane: The first thing is you have to take them over. You kill the stockholders completely. You change the control and put it under government control.
Stan Correy: Ed Kane says that keeping these banks on a drip feed for government money and small transfusions is a terrible mistake. You have to kill them, no matter what the consequences of that. And he's very critical of the Geithner plan, the way that US Treasury Secretary Tim Geithner wants to deal with things.
Ed Kane: The plan that focuses on the assets is just giving more subsidies to zombies, and in fact even gives zombies a chance to pretend that they're acting in a socially beneficial way when they're buy these newly securitised assets.
Stan Correy: In one article say 'The dirty little secret is that the zombies don't want to surrender their toxic assets'.
Ed Kane: They want more, that's right. They want more such assets because this is one of the beautiful things about the zombie metaphor. It goes back even to a song by Harry Belafonte you may have heard years ago called The Zombie Jamboree, and the chorus is, 'They don't give a dam, they done dead already'.
ZOMBIE SONG
Back to back, belly to belly
I don't give a dam, I done dead already
Oho! back to back, belly to belly
At the Zombie Jamboree.
Stan Correy: The zombie banks are 'done dead already', so finish them off, is the message. Way back in the 1980s, there was the Savings and Loan scandal, and in the 1990s, the Japanese had a plague of zombie banks. Former bank regulator, Bill Black, watched it all happen and is not pleased about what is happening now.
Bill Black: After the savings and loan crisis, US Treasury Secretaries of both parties, for 15 years, went over to Japan every year and said, You know, the policy you have of covering up the bank losses is a terrible policy; it means that you don't recover. It's why you're having this lost decade, you ought to do what we did that was successful in resolving the savings and loan crisis, which is recognise the losses, be honest about them, put them into receivership. Wipe out what we call the risk capital, in other words the shareholders and the subordinated debt holders, who make a contractual agreement that said if the place is insolvent, we get nothing. And of course that saves the taxpayers a lot of money, but it also creates the right incentives.
Stan Correy: Now that's an important point you made. The US didn't listen to their own advice in terms of how to kill a zombie bank, that is, you actually kill it, you can't keep it alive?
Bill Black: Right. Instead of following our past record of success, we've adopted the Japanese system, that we told them, and we saw was an abject failure. It's mind-numbing.
CALYPSO SONG - THE UNDEAD
It was a Zombie Jamboree
Took place in a New York cemetery
It was a Zombie Jamboree
Took place in a New York cemetery.
Stan Correy: At the same time as there were sharks being reported on the coastline of Australia, the financiers were worried about attacks from the regulators. There's a constant battle going on between financial institutions like banks and the government regulators, each trying to be one step ahead of the other. But it's mostly the financial institutions who are way ahead of the regulators.
This is called 'regulatory arbitrage'.
Sitting at Cronulla Beach in Sydney, looking out to sea on an autumn day, is a good place to discuss such things. Justin O'Brien.
Justin O'Brien: One of the ways in which finance operates is through regulatory game-playing by designing a product, implementing a product, before a competitor does and before a regulator closes a loophole. So in many ways part of the process, part of the process of innovation, is very much pushing the envelope as to what is actually permissible. This is particularly the case in jurisdictions like the United States, where if something is not explicitly rendered illegal, it is legal. And many of the things that happened in this current crisis are effectively legal. This was a legally inspired, legally engineered crisis.
Stan Correy: The rules that led to the crisis had to do with the management of risk, and for many years, mathematical models have been used to do that. But mathematical risk models can be wrong. ANU Professor Justin O'Brien.
Justin O'Brien: If you have a situation where everybody is using the same risk management tools, and risk was mispriced, the level of risk in the system was mispriced; I think Joseph Stiglitz put it very well in testimony to Congress last year, in which he described the regulatory system as a system based on innovation over security, and I think we're all paying the price of that.
Stan Correy: Professor Justin O'Brien.
One of the amazing things of the past 18 months of financial crisis is the constant surprises. Surprises about what a bank did not reveal about bonuses or use of bail-out funds. And also what did the regulators know? And how will we, the investing citizens, ever know? This is a critical issue for US regulatory expert, Jerry Caprio.
Jerry Caprio: If we've got to hold supervisors accountable for ensuring the safety of financial systems, then in effect we have to know a lot more about what did they know about what was going on, and when did they learn it? So although there are a lot of meetings which talk about supervisory accountability, in fact they don't really mean it, because if they meant it, they would have to divulge a lot more information than is the case.
Stan Correy: Banks are often criticised for not being transparent enough in the information they reveal to investors. But what about the banks' supervisors, the regulators?
Jerry Caprio: I think we need to really debate what is the case for supervisors holding any information confidential. I understand and they will quickly say, well divulging information might cause a crisis but in fact when information is divulged early on, it's less dangerous than when it's allowed to accumulate over long periods of time and the losses typically get greater.
Stan Correy: Professor Jerry Caprio, on the phone from Williams College in the United States.
Early this year at a conference in Germany, there was a special panel on how financial risk was managed before and after the financial crisis. There's link to the full recording of the panel on Background Briefing's website.
One of the speakers was Nobel Prize winner, Daniel Kahneman, talking here about watching the former head of the Federal Reserve in America giving testimony.
Daniel Kahneman: For me one of the interesting moments in this crisis has been what I call Greenspan's Confession, and many people I think here are aware of it, that it is actually quite striking when you see a man his age and after his life experience, saying 'My theory of the world was wrong; my framework was wrong'. And he articulated the framework. He said that he had expected firms, financial firms in particular, to be in the best possible position to protect their interests and protect their long term survival, and he had not expected them to engage in what turned out to be essentially suicidal policies.
Stan Correy: Daniel Kahneman. Greenspan, as a believer in the free market, had thought that everyone would behave in their own self interest, and it was in the self interest of the financiers to run good banks and institutions. It didn't work out that way.
Here now is Greenspan, himself appearing before the committee.
Alan Greenspan: Well remember that what an ideology is, is a conceptual framework with the way people deal with reality. Everyone has one. You have to, to exist you need an ideology. The question is whether it is accurate or not. And what I'm saying to you is Yes, I found a flaw, I don't know how significant or permanent it is, but I've been very distressed by that fact.
Mr Waxman: You found a flaw in the reality?
Alan Greenspan: A flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak.
Mr Waxman: In other words, you found that your view of the world, your ideology was not right, it was not working?
Alan Greenspan: Precisely. That's precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.
Stan Correy: Alan Greenspan in his younger days was a follow of the libertarian capitalist philosopher, Ayn Rand. Rand's novels, The Fountainhead and Atlas Shrugged are celebrations of risk-taking and unrestrained free markets. The government is always the enemy in her novels, and anti-capitalist protesters would be called moochers, bludgers who feed off the wealth of her risk-taking entrepreneurs.
While her former disciples like Greenspan may have found a flaw in her philosophy, the libertarian capitalists are nevertheless dusting off their copies of Atlas Shrugged. Here's part of a recent Colbert Report on the US network, The Comedy Channel.
Colbert: Folks, in these times of uncertainty, many of the power elite are turning to the wisdom of a visionary.
TV Report 1: One book that is just phenomenal because it makes the author look like a prophet, is Ayn Rand's book, Atlas Shrugged.
TV Report 2: The Ayn Rand stuff, I love the idea, it's romantic.
TV Report 3: You've got to let the Ayn Rand characters rise up and rebuild the nation.
Colbert: Author, philosopher and female comb-over pioneer Ayn Rand. Now Rand wrote about an out-of-control government siphoning the profits of the rich in her 1957 novel 'Atlas Shrugged'. And according to The Economist, sales of the book have risen sharply since Obama's election, surging every time he announces another spending plan. That's right, things have gotten so desperate Americans are actually reading. In the novel, all of the country's great Titans of industry begin to disappear, but there's a twist. It turns out that these business leaders were just disgusted that their earnings were going to the needy, or as Rand calls them, 'the moochers who claim your product by tears'. Just another example of the little guy trying to keep the man down. So what happens is all the successful people go on a strike ...
Stan Correy: On Background Briefing's website, there's a link to Colbert's full report on how the capitalists went on strike, until the government left them alone.
Late last year, before the copies of Atlas Shrugged started marching off the bookshelves, American satirist, Jeremiah Tucker, updated the novel Atlas Shrugged especially for the global financial crisis.
We have had it acted out. Dagny Taggart is a 30-something business entrepreneur. Hank Rearden, one of her many lovers, is now running a hedge fund. Both of them are rather upset at the creeping socialism that's arrived in Washington because of the financial crisis.
Hank: Damn it, Dagny! I need the government to get out of the way and let me do my job!
Reader: She sat across the desk from him. She appeared casual, but confident; a slim body with rounded shoulders like an exquisitely engineered truss. How he hated his debased need for her, he who loathed self-sacrifice but would give up everything he valued to get in her pants.
Did she know?
Dagny: I heard the thugs in Washington were trying to take your Rearden Metal at the point of a gun. Don't let them, Hank. With your advanced alloy and my high-tech railroad, we'll revitalise our country's failing infrastructure and make big, virtuous profits.
Hank: No, no, no. I got out of that sucker's game. I now run my own hedge fund firm, Rearden Capital Management.
Dagny: What?
Reader: He stood and adjusted his suit jacket so that his body didn't betray his shameful weakness. He walked toward her and sat informally on the edge of her desk.
Hank: Why make a product when you can make dollars? Right this second, I'm earning millions in interest off money I don't even have.
Reader: He gestured to his floor-to-ceiling windows, a symbol of his productive ability and goodness.
Hank: There's a whole world out there of Byzantine financial products just waiting to be invented, Dagny. Let the leeches run my factories into the ground! I hope they do! I've taken out more insurance on a single Rearden Steel bond than the entire company is even worth! When my old company finally tanks, I'll make a cool $877-million.
Reader: Their eyes locked, with an intensity she was only beginning to understand.
Dagny: Yes, Hank, claim me. If we're to win the battle against the leeches, we must get it on, right now. Don't let them torture us for our happiness, or our billions.
Reader: He tore his eyes away.
Hank: I can't. Sex is base and vile!
Dagny: No, it's an expression of our highest values and our admiration for each other's mind.
Hank: Your mind gives me the biggest boner, Dagny Taggart.
Reader: He fell upon her like a savage, wielding his mouth like a machete, and in the pleasure she took from him, her body became an extension of her quarterly earnings report, proof of her worthiness as a lover. His hard-on was sanction enough./
Dagny: Scream your secret passions, Hank Rearden!
Hank: Derivatives!
Dagny: Yes!
Hank: Credit default swaps!
Dagny: Oh yes! Yes!!
Hank: Collateralised debt obligation!
Dagny: Yes! Yes!! YES!
Stan Correy: Dagny and Hank want to make love and leverage at the same time. Debt is good, as long as you can turn it into toxic packages that can be sold and resold on the global market, while you make profits. It doesn't matter who ends up with the empty package.
To one former derivatives trader this obsession has led to a bout of forgetfulness about the meaning of financial risk.
Now Professor of Law at the University of San Diego, Frank Partnoy.
Frank Partnoy: One of the things that I find so interesting about financial markets is that unlike history or science, we don't seem to build knowledge incrementally. We don't seem to remember anything. I think finance in some ways is more like sex than science. It's this thing that everyone has to experience on their own, you can't really be told about it, you have to go through a collapse like this. And no-one seems to remember anything about financial history. Do people even remember Enron in any detail? They certainly don't remember scandals from the '70s, and no-one remembers the '20s.
Stan Correy: One influential book about economics actually had its inspiration from the black swans of Western Australia. Nassim Taleb, a Professor of Risk Engineering used them as an example of how all risk must take into account the unknown. Everyone thought all swans were white, until it was discovered there were black swans in Australia.
Now we turn to something called the VAR. That V.A.R. stands for value at risk, and it's a dangerous little time bomb widely used in risk management.
Speaking in February at a conference in Munich, angry at the use of VAR is Professor Nassim Taleb.
Nassim Taleb: I was waging a war against value at risk, something called value at risk that doesn't work, to me it's charlatanism, pure charlatanism, it doesn't work. It doesn't work and people say, well, we know it doesn't work, but it doesn't cause any harm. What do you mean it doesn't cause any harm? Nonsense! There is harm in giving an idiot, never give a fool sterile information because he cannot ignore it.
Stan Correy: According to Nassim Taleb, banks were misled by the numbers produced by the risk models into thinking that rare events could never affect their profits.
Nassim Taleb: Turn the TV on and you hear about the financial crisis. In my opinion it came from the underestimation by banks of the risks of rare events; so like a pilot who doesn't know there are storms, and that came from financial models. Visibly the plane is going to crash, right? If the pilot doesn't know about storms, because there are storms out there.
Now the economics profession was made aware of storms by a lot of thinkers, from Pareto, Mandelbrot, a lot of people, throughout history. These people don't publish in normal journals. Why? It's not that the financial profession doesn't know, or the financial economics profession that there are rare events, it's that these are so hard to model they prefer to ignore them. Exactly like someone, you know, the drunk person looking for his keys under the light, and you ask him, 'Did you lose your keys here?' And he says, 'No, no, no, I lost them over there, but I'm looking here because there is light.' That's pretty much what they're doing.
Stan Correy: And Nassim Taleb's anger at the abuse of financial risk models isn't only directed at the banks but at the financial regulators.
Nassim Taleb: So the system is too fragile, and was fragilised further by Bernanke and Greenspan, by their policies of making banks gigantic bureaucratic firms, and there's one thing I'd like to mention: don't think that regulators are particularly intelligent. Regulators help banks take the risks, so what we should be doing is not encourage this, because we have a facing complexity, we should have simplicity with the financial instruments to counter this complexity.
Stan Correy: The International Actuarial Association is very interested. They, after all, represent the group of mathematical wizards who can in theory, keep an eye on all this complexity. One of their representatives on the issue of financial risk is Australian Tony Coleman, and Background Briefing went to talk to him at his office in Martin Place in Sydney. VAR, or value at risk, has been overused, says Tony Coleman, and the Association have it in their sights.
Tony Coleman: The value at risk is essentially the amount of money that you would expect to lose if you had a 1 in 100 type event. The model will tell you if you have that event, that this is the amount that you could expect to lose. Now a whole series of issues suddenly appear around that. The first one is are the assumptions underlying the model indeed valid and correct and is it a reasonable representation of what actually happens in the market?
Stan Correy: And if they aren't a 'reasonable representation' of reality, the value at risk numbers aren't very useful to anyone.
Tony Coleman: It doesn't tell you at all about what happens if you happen to be unlucky enough to have a 1 in 150, 1 in 200, 1 in 500 event, because obviously you will lose a hell of a lot more. So suddenly people who built a whole risk model and advised their boards, and many of them did, using VAR measures or value at risk measures, tended to seriously understate their true levels of risk, even if the models were right, and of course for reasons we've already talked about, often the models were not right.
Stan Correy: Tony Coleman.
Now if you do a search for information about value at risk, or VAR, and its relevance or its non-relevance, you're likely to come up with pretty complex stuff. You may actually need a degree in pure mathematics to understand what it's about.
The value at risk model was developed by the US bank, JP Morgan about 25 years ago, and legend has it that at the time its CEO, Dennis Weatherstoane, wanted on his desk every day at a quarter past four, a piece of paper with a number on it that would tell him how much the bank could lose in the next 24 hours. He was given a VAR number.
There's a book that tells this story, and it goes on to say that ironically now, 25 years later, J.P. Morgan is one of the few banks that has not relied on VAR for its assessment of financial risk. The author is Financial Times journalist, Gillian Tett, and here is a reading from her book.
Reader: At JPMorgan Chase, however, managers were highly cynical about the worth of VAR, even though (or perhaps because) the bank itself had helped to create the concept a decade earlier. VAR measures were taken, but typically, used alongside other techniques for analysing risk.
Stan Correy: Others agreed that financial institutions needed other techniques as well. Here is Professor of Accounting and Finance at the University of Nottingham, Margaret Woods.
Margaret Woods: What you can tend to do, it's a bit like driving a car, you know, if a car is built with lots of extra safety features, then you tend to think you can drive faster. And I wonder if what happened within the banking sector is that they have a measure, they report that measure, and so long as we're measuring things and keeping an eye on that number, then you can carry on taking risks, and we'll be all right.
Stan Correy: Using the value at risk model as a measure of financial risk was mathematically dodgy. The financial numbers used for example, the value of mortgages, were themselves based on faulty credit ratings. So it was garbage in and garbage out.
Margaret Woods: What's been going on is the banks have used a lot of the time, historical numbers as the basis for working out their values at risk. So they're looking at what's happened to prices in the past and how much they've moved, and therefore the likelihood of prices collapsing in the future. And that drives the value at risk number. But there's no guarantee that history is going to carry on repeating itself. And when the problems in the sub prime market started to emerge, and the value of a lot of the instruments that banks held started to collapse, then of course, all those past forecasts of what would happen to prices, went out of the window.
Stan Correy: Transparency is one of the key words in reform of the financial markets, but with risk reporting the way it is, the future is murky. Margaret Woods.
Margaret Woods: It might be that transparency is being translated into printing more pages and the thicker the annual report the better. But that's not necessarily true, because quantity and quality don't necessarily equate with one another. There was an interesting debate on our morning news program in the UK, and a commentator observed that if you look at a set of bank accounts, it's actually sometimes easier to find out whether they're using double flushing toilets than to find out whether they're actually taking risks that might cause meltdown in the financial system. And I think that actually is a nice summary of the state of play.
Stan Correy: This is Background Briefing on ABC Radio National. I'm Stan Correy.
The G-20 is now over, but it's still not quite clear what they all agreed to do about all this.
Reader: World leaders declare war on risk.
Stan Correy: Variations on the word 'risk' are repeated frequently in the G-20 communiqué.
Reader: Strengthened regulation and supervision must promote propriety, integrity and transparency; it must guard against risk across the financial system; it must dampen rather than amplify the financial and economic cycle; it must reduce reliance on inappropriately risky sources of financing; and discourage excessive risk-taking.
Stan Correy: But what exactly will be disclosed? For years, international financial supervisors instructed banks to measure their risk, using financial models like VAR.
Here now is Frank Partnoy.
Frank Partnoy: All the major financial institutions have to disclose a lot more about the nature of their risks, they have to disclose more than just, 'Oh, we have half a trillion dollars of notional value of credit default swaps', that's not meaningful disclosure; that doesn't give anyone information. I think if we want back in time and AIG and the major financial institutions had disclosed not just information about their models, but information about the actual contracts that they had entered into, that we would not be in a crisis now, because smart analysts and people who watch these companies, would have seen the dangers.
Stan Correy: Use the power of the internet, says Frank Partnoy, to introduce radical transparency.
Frank Partnoy: Just imagine this thought experiment: imagine that we go back in time and AIG and Citigroup and all the major financial institutions have actually disclosed all of their contracts, all the data. Right? We have a big internet out there, it would require some bandwidth, but not that much. Imagine that they had disclosed all their contracts, these trillions of dollars worth of contracts, well over the course of a year or two you would have had a lot of savvy journalists and analysts who would have spotted some of the dangers. They would have said, 'Look at the potential downside associated with this transaction'. There would be smart people who would apply financial models to the transactions that were disclosed. None of that was possible; instead what we did was we let the banks and insurance companies decide, using their own models what would be disclosed.
Stan Correy: And in reality, not much got disclosed. Well, not much that was any use in predicting whether a bank was going to lose a massive amount of money.
Financial risk experts told Background Briefing that most people who produce these numbers or know how they are produced, have very little faith in them. One pointed out, since value at risk uses the past to predict the future, if tomorrow is nothing like the past, then the numbers are totally misleading.
Britney Spears sings Toxic.
With a taste of your lips
I'm on a ride
You're toxic I'm slipping under
With a taste of a poison paradise
I'm addicted to you.
Don't you know that you're toxic
And I love what you do
Don't you know that you're toxic ...
So how are our two capitalist lovers, Hank and Dagny dealing with the toxic assets? The assets that have shattered the careers of their friends in investment banking. In this scene of the satire recently written, based on the book, Atlas Shrugged Hank and Dagny are searching through the wreckage of a bank, a victim of the financial meltdown.
Reader: As they stepped through the c rumbling cubicles, a trampled legal pad with a complex column of computations captured Dagny's attention. She fell to her hands and knees and raced through the pages and pages of complex math, written in a steady hand. Her fingers bled from the paper cuts, and she did not care.
Hank: What is it, Dagny?
Dagny: Read this.
Hank: Good God!
Dagny: Yes. It's an experimental formula for a financial strategy that could convert static securities into kinetic profits that would increase at an almost exponential rate.
Reader: Hank studied the numbers.
Hank: The amount of debt you would need to make this work would be at least 30 to 1, but a daring, rational man who lives by his mind would be willing to take that risk!
Dagny: Yes, and it's so complex the government could never regulate it.
Hank: It's perfect. There's only one problem: half the pages are missing. Could you reconstruct it, Dagny?
Reader: Her answer escaped her lips like air from a punctured galvanised-steel duct.
Dagny: No.
Hank: I didn't think so, but why leave such an achievement to rot here? It's the greatest thing I've ever laid eyes on, made by a monumental genius, the sort of mind that's only born once in a century ... Dagny, why are you fondling your breasts?
Stan Correy: But what Dagny and Hank had really found was the formula to create a disease that would transform banks into zombies.
Song:
I was working at my bank late one night
When before my eyes this financial sight,
My bank from its slab began to rise,
And suddenly to my surprise
It is a bank
It is a Zombie Bank
Such a terrible stank
It is a bank
Once our profits have sank
It is a bank
We did the Zombie Bank
From my laboratory in the nation's east,
Come Zombies hungry for some bail-out treats.
Just a little more flesh will keep them alive.
They've got much bigger worries than our rules survive.
It is a bank ...
Stan Correy: Back in Washington D.C., earlier this year, Federal Reserve Chairman Ben Bernanke is squirming and in denial under questioning, about the economics of the living dead.
Senator Graham: Is AIG a zombie institution?
Ben Bernanke: AIG is in a very difficult place; it's lost a lot of money, and it was a good company, a strong insurance company that was ambushed by the financial products division and other bad financial debts.
Senator Graham: If AIG is not a zombie institution, who would be?
Ben Bernanke: I don't know of any large zombie institutions in the US financial system, and our idea with AIG is in fact to allow it to stabilise and to become profitable enough to repay the obligations it has to the United States.
ZOMBIE MOVIE
MUSIC
Singer: They're coming to get you Barbara.
Man: They're coming for you, look, there comes one of them now.
MUSIC
Stan Correy: Many eminent economists think there's only one proper action to take. Get whatever you need to kill a zombie and use it.
Having watched this sort of thing for nearly 20 years, the Professor of International Economy at the University of California in San Diego, Takeo Hoshi says drastic and quick action must be taken, otherwise you end up with a slow and economically painful death, like in Japan in the 1990s. The Japanese banks were kept alive for years even though they were full of toxic assets, like bad or non-performing loans.
Takeo Hoshi.
Takeo Hoshi: So what happened in Japan, which is very much like what's been happening in the US, was that Japanese government tried many things like buying up toxic assets, or tried to recapitalise the banks. Some of those had limited success of calming down the financial system, but none of them worked until 2002 when the Japanese government finally got serious about forcing the banks to get rid of those non-performing loans and expose the zombie banks.
Stan Correy: Takeo Hoshi says killing zombie banks is difficult politically. It's reasonable simple to nationalise them and bury them, but the problem is the collateral damage. A lot of innocent bystanders will get hurt - the employees, the shareholders and the companies that have dealings with those zombie banks.
Takeo Hoshi: Shutting down the zombie banks or a zombie firm is very costly in terms of employment; there are lots of jobs to be lost and also shareholders lose from the failure of the banks, and firms as well. So that is not politically attractive and that creates a problem for politicians.
Stan Correy: So in a sense, you're saying that once you get into this zone of zombie economics, it's very difficult to break the cycle, unless you really go for mass annihilation I suppose?
Takeo Hoshi: Right. It's very difficult to get out and it takes a real political will to stop the process and kill the zombies and start the new recovery.
Stan Correy: Takeo Hoshi.
The big question is whether world leaders, America in particular, can take the political gamble of causing unemployment and misery all around in order to finally kill off these toxic institutions. In the past they've often not taken that political step. Economist Ed Kane.
Ed Kane: It's unconscionable to me that the government would run these gambles with taxpayers' money. I have come to this position and it's a very harsh position, that some of our best servants in government are policemen, firemen, soldiers; these people risk their lives for relatively modest compensation, and these top financial regulators won't risk their careers in the sense of getting criticism from the industry for over-regulating in times when of course over-regulation is in fact a misnomer, it's disinformation.
Stan Correy: What Ed Kane is saying is that there will be no 'over regulation'. Those who scream about that, saying it will kill free enterprise, are self-interested and want 'no regulation'. Good regulation is very important. The incentive system, for example, has been widely abused, says Bill Black.
Bill Black: When you have executive compensation systems that are perverse, that are based on short-term accounting games and when you have extremely short tenure in senior positions, you get something that we refer to in economics as a Gresham's dynamic. This is after a British economist. Gresham's law says that bad money drives good money out of circulation. In this case, bad practices drive good practices out of circulation. In the United States, the average chief financial officer or CFO, lasts slightly less than three years. And how long is he going to last if he does not put his institution heavily into sub prime lending when that is booking record earnings.
Stan Correy: Former US bank regulator, Bill Black. This short term way of handling risk management and the pressure to quickly make big profits for shareholders, no matter how, has been a disaster. From the International Actuarial Association, Tony Coleman.
Tony Coleman: A risk manager may well go in a certain given situation, and simply say, 'No, that's too much risk; you're not allowed to do that deal', to a line manager within the organisation, a trader if you like, or someone in charge of a trading desk, or higher up. Depending on how the management culture of that organisation works, one or two things will happen. The risk manager's view will either prevail, in which case the deal is not done. Alternatively, the management trader person might well manage to lobby his chief executive or whoever, and say, 'That risk model is full of a whole lot of assumptions, here's the ifs and buts. I don't believe it, I don't accept it and therefore I won't go and do this deal.' And the chief executive might say, 'Oh well, there's going to be x-million profits; if you do the deal, I'll let you do the deal.'. So effectively the risk view gets over-ridden.
Stan Correy: There might be a more traditional way of curbing excessive risk-taking. From the London School of Economics, Jon Danielson.
John Danielson: In the old days, lots of financial institutions used to be these 'partnerships', this meant that if your bank went bust all the partners, they lost their houses, they lost everything along with it because their fortune was tied up in it. So a sensible proposal would be to say, 'If everything goes well you get the reward; if everything goes badly, your personal fortune is directly tied in to the fortune of the bank, you will lose your house, you will not be able to work in this industry again. That will make you behave lots more conservatively.'
Stan Correy: In the coming debates about executive compensation, or bankers' bonuses, Danielson says you'll hear a lot about the phrase 'risk adjusted'., Essentially that means that the bankers' bonus will be measured using a risk model. But as we saw with value at risk, or VAR, risk adjusted compensation can also be manipulated and we may end up with a worse system than before.
This kind of thinking about risk management came about, says Danielson, because a powerful myth took hold in the world of finance. The idea that financial regulators assume that risk can be accurately measured, that financial engineers like civil engineers, can design safe products with sophisticated maths.
Take risks, yes, but the public shouldn't have to pay for the mistakes.
Frank Partnoy.
Frank Partnoy: Some people are arguing you should have done that in a more efficient way through nationalisation. Some people think the banks should have been allowed to go into bankruptcy. All that is spilt milk now. I think what the Administration is trying to do is to move forward and focus on the future. So we've got to put this behind us, we've got to clean them out, and people will be critical of this program, but I think what has to happen and what people hopefully will not lose sight of, and it sounds like the President clearly understands this, is that the playing fields of the future has to change. And we can't clean this mess up only to see that a year or two from now, Wall Street is again inventing fantastic derivative instruments designed to take advantage of dsysfunctionalities in the ratings process, and they will do that; that will happen again, it won't take long. In a year or two, this will all get started again and we will see the same type of instruments and the same kinds of complexities and then we'll have another crisis and it might not take that long. We might go back to 100 years ago when we were experiencing banking crises every few years. The only way to avoid that is to put a new set of smart regulations in place and to get rid of the old regulatory apparatus.
Stan Correy: Back at the satire of Atlas Shrugged, Dagny is now with another of her lovers, John Galt, the ultimate super capitalist.
Galt and Dagny are in a very smart apartment, looking out at where all the very rich people have gathered to hide from the government that wants to take their money. Dagny has an important-looking document in her hand.
Dagny: The financial strategy, the financial strategy I found, it was you who made it?
Galt: Yes.
Reader: John Galt's face betrayed no signs of pain or fear or guilt, and his body had the clean, tensile strength of a foundry casting, with skin the colour of a polished full-port brass valve. In the centre of this secret mountain valley with the titans of Wall Street had retreated for an extended junket, was a 3-foot tall dollar sign of pure gold, atop a granite column. It was tacky, yes, but it was also their emblem, a symbol of their triumph.
Dagny: But why did you leave it behind?
Galt: Because once I committed the plan to memory I no longer needed it.
Dagny: I don't understand.
Galt: The capital gains tax, Dagny, we loathe it.
Reader: He pointed to the houses of men she knew, and the names sounded like the richest stock market in the world, a roll call of honour.
Galt: Her money represents our spirit's value. When the government takes our profits, it is literally robbing us of our souls. I will not apologise for my wealth to a nation of looters. We who live by the mind could have been engineers, scientists, doctors, extreme-sports enthusiasts, but there is no more purer pursuit than the pursuit of money. A is A. Money begets more money, and ...
Reader: Galt went on like this for what seemed to Dagny like hours, until, finally, something he said piqued her interest.
Galt: ... And that's why I created the financial plan you found. It's true, it works. But it is not sustainable. It will ruin this country's financial system, and then we'll see how those who despise us prosper, when their lenders and investors refuse to invest or lend.
Reader: He laughed joylessly.
Galt: It's funny, isn't it? I must destroy the very thing I love in order to save it.
Dagny: Just to avoid paying taxes?
Galt: I do not compromise my beliefs, and I will kill anyone who asks me to!
Reader: A silence fell between them, and it was awkward. Finally, Dagny asked:
Dagny: So, just out of curiosity, how much are your worth?
Reader: He shrugged.
Galt: What is infinity?
Dagny: She let out a rich, powerful moan, like the sound of a passing diesel train in the night.
Stan Correy: Background Briefing's Co-ordinating producer is Linda McGinnis. Research by Anna Whitfeld. Technical producer, Mark Don. Actors, Paula Arundell, Justin Monjo and Tyler Coppin. Narrator, Mark Hortsman. Thanks also to Jeremiah Tucker for his satirical update of Atlas Shrugged.
There'll be links to that and other material, including an animated version of the Zombie Bank song on Background Briefing's website.
The Executive Producer is Kirsten Garrett. I'm Stan Correy and this is ABC Radio National.
Zombie banks
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They look like banks, they walk like banks and they quack like banks, but they're really the undead. Shells filled with toxic assets. Killing these living dead is probably political suicide because of the collateral damage, but it's the way to go say leading economists. Reporter Stan Correy.
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Stan Correy: This is Background Briefing on ABC Radio National.
I'm Stan Correy.
While the G-20 protesters were rioting and marching and chanting and waving placards with catchy phrases like 'Capitalism stole my virginity', or 'When I say banker, you say wanker'. And our favourite, 'Make love not leverage'.
Not far away, perhaps in an apartment down a side street from the defaced and shattered Royal Bank of Scotland, picture the swank offices of a little-known American hedge fund. Financial entrepreneurs Hank and Dagny are finding that leverage is the biggest aphrodisiac they know.
Dagny: Scream your secret passions, Hank Rearden!
Hank: Derivatives!
Dagny: Yes!
Hank: Credit-default swaps!
Dagny: Oh yes! Yes!
Hank: Collateralised debt obligation!
Dagny: Yes! Yes!! YES!
Stan Correy: We'll hear more later from Hank and Dagny as they stimulate their passion for debt and the millions some people can make out of it.
These packages of debt were sold on like pass-the-parcel, making fortunes as they went, but ended up causing a world economic crisis. Both the disease caused by these toxic assets and the cure are painful.
In America, there are over 250 banks that are considered at risk of failure. Some of the biggest banks are already zombies, that is, they are living, but dead. Here's a recent report from the NBC network.
Man: From horror movies, financial regulators have a name for them, zombie banks. Deeply troubled banks that are barely alive but not dead yet, and too big to let die or kill, without triggering financial chaos; the swarm of zombie banks is only growing scarier.
By far the biggest zombie bank is Citibank, even after getting $45-billion from the government and having hundreds of billions in losses guarantees, it's still in deep trouble.
Stan Correy: Australian banks aren't infected with the zombie virus, but the global plague has immense reverberations here too. If prosperity is to be resurrected, the zombie banks have to die.
Few economists follow the economics of the living dead but those that do, get their inspiration from the classic Hollywood zombie Movie, Night of the Living Dead. In this scene, a reporter is asking if these un-dead are dangerous.
Reporter: Chief, if I was surrounded by six or eight of these things, would I stand a chance with them?
Chief: Well there's no problem. If you had a gun, shoot 'em in the head. That's a sure way to kill them. If you don't, get yourself a club or a torch. Beat 'em or burn 'em, they go up pretty easy.
Reporter: Are they slow-moving, Chief?
Chief: Yes, they're dead, they're all messed up.
Stan Correy: They're dead and messed up, but they are still causing havoc as their toxic assets trickle down to all the companies they deal with, their shareholders and their staff.
The IMF has just estimated that this toxic debt, sitting on the balance sheets of banks and insurance companies could rise to $US4-trillion by the end of next year.
The economics of the living dead isn't just about working out how zombie banks get billions in bail-out treats. It's about how the banks got infected with the zombie virus in the first place. The term 'zombie banks', was invented by Professor Ed Kane, from Boston College.
Ed Kane: I was just puzzled as to how to get across, how important it was not to keep pumping money into these institutions; how to get across that they had incentives that were really harmful to society. And I came up with this because of my misspent youth in reading comic books and going to horror movies.
Stan Correy: And the zombie I suppose, the living dead, was the best term to describe what you thought was happening?
Ed Kane: My hope was that by explaining it in such a folksy way, or accessible way, that authorities would never do this again, although my theory of government behaviour is that they would do it every time.
Stan Correy: And they have done it again. But Ed Kane says that's not the way to do it.
Ed Kane: The first thing is you have to take them over. You kill the stockholders completely. You change the control and put it under government control.
Stan Correy: Ed Kane says that keeping these banks on a drip feed for government money and small transfusions is a terrible mistake. You have to kill them, no matter what the consequences of that. And he's very critical of the Geithner plan, the way that US Treasury Secretary Tim Geithner wants to deal with things.
Ed Kane: The plan that focuses on the assets is just giving more subsidies to zombies, and in fact even gives zombies a chance to pretend that they're acting in a socially beneficial way when they're buy these newly securitised assets.
Stan Correy: In one article say 'The dirty little secret is that the zombies don't want to surrender their toxic assets'.
Ed Kane: They want more, that's right. They want more such assets because this is one of the beautiful things about the zombie metaphor. It goes back even to a song by Harry Belafonte you may have heard years ago called The Zombie Jamboree, and the chorus is, 'They don't give a dam, they done dead already'.
ZOMBIE SONG
Back to back, belly to belly
I don't give a dam, I done dead already
Oho! back to back, belly to belly
At the Zombie Jamboree.
Stan Correy: The zombie banks are 'done dead already', so finish them off, is the message. Way back in the 1980s, there was the Savings and Loan scandal, and in the 1990s, the Japanese had a plague of zombie banks. Former bank regulator, Bill Black, watched it all happen and is not pleased about what is happening now.
Bill Black: After the savings and loan crisis, US Treasury Secretaries of both parties, for 15 years, went over to Japan every year and said, You know, the policy you have of covering up the bank losses is a terrible policy; it means that you don't recover. It's why you're having this lost decade, you ought to do what we did that was successful in resolving the savings and loan crisis, which is recognise the losses, be honest about them, put them into receivership. Wipe out what we call the risk capital, in other words the shareholders and the subordinated debt holders, who make a contractual agreement that said if the place is insolvent, we get nothing. And of course that saves the taxpayers a lot of money, but it also creates the right incentives.
Stan Correy: Now that's an important point you made. The US didn't listen to their own advice in terms of how to kill a zombie bank, that is, you actually kill it, you can't keep it alive?
Bill Black: Right. Instead of following our past record of success, we've adopted the Japanese system, that we told them, and we saw was an abject failure. It's mind-numbing.
CALYPSO SONG - THE UNDEAD
It was a Zombie Jamboree
Took place in a New York cemetery
It was a Zombie Jamboree
Took place in a New York cemetery.
Stan Correy: At the same time as there were sharks being reported on the coastline of Australia, the financiers were worried about attacks from the regulators. There's a constant battle going on between financial institutions like banks and the government regulators, each trying to be one step ahead of the other. But it's mostly the financial institutions who are way ahead of the regulators.
This is called 'regulatory arbitrage'.
Sitting at Cronulla Beach in Sydney, looking out to sea on an autumn day, is a good place to discuss such things. Justin O'Brien.
Justin O'Brien: One of the ways in which finance operates is through regulatory game-playing by designing a product, implementing a product, before a competitor does and before a regulator closes a loophole. So in many ways part of the process, part of the process of innovation, is very much pushing the envelope as to what is actually permissible. This is particularly the case in jurisdictions like the United States, where if something is not explicitly rendered illegal, it is legal. And many of the things that happened in this current crisis are effectively legal. This was a legally inspired, legally engineered crisis.
Stan Correy: The rules that led to the crisis had to do with the management of risk, and for many years, mathematical models have been used to do that. But mathematical risk models can be wrong. ANU Professor Justin O'Brien.
Justin O'Brien: If you have a situation where everybody is using the same risk management tools, and risk was mispriced, the level of risk in the system was mispriced; I think Joseph Stiglitz put it very well in testimony to Congress last year, in which he described the regulatory system as a system based on innovation over security, and I think we're all paying the price of that.
Stan Correy: Professor Justin O'Brien.
One of the amazing things of the past 18 months of financial crisis is the constant surprises. Surprises about what a bank did not reveal about bonuses or use of bail-out funds. And also what did the regulators know? And how will we, the investing citizens, ever know? This is a critical issue for US regulatory expert, Jerry Caprio.
Jerry Caprio: If we've got to hold supervisors accountable for ensuring the safety of financial systems, then in effect we have to know a lot more about what did they know about what was going on, and when did they learn it? So although there are a lot of meetings which talk about supervisory accountability, in fact they don't really mean it, because if they meant it, they would have to divulge a lot more information than is the case.
Stan Correy: Banks are often criticised for not being transparent enough in the information they reveal to investors. But what about the banks' supervisors, the regulators?
Jerry Caprio: I think we need to really debate what is the case for supervisors holding any information confidential. I understand and they will quickly say, well divulging information might cause a crisis but in fact when information is divulged early on, it's less dangerous than when it's allowed to accumulate over long periods of time and the losses typically get greater.
Stan Correy: Professor Jerry Caprio, on the phone from Williams College in the United States.
Early this year at a conference in Germany, there was a special panel on how financial risk was managed before and after the financial crisis. There's link to the full recording of the panel on Background Briefing's website.
One of the speakers was Nobel Prize winner, Daniel Kahneman, talking here about watching the former head of the Federal Reserve in America giving testimony.
Daniel Kahneman: For me one of the interesting moments in this crisis has been what I call Greenspan's Confession, and many people I think here are aware of it, that it is actually quite striking when you see a man his age and after his life experience, saying 'My theory of the world was wrong; my framework was wrong'. And he articulated the framework. He said that he had expected firms, financial firms in particular, to be in the best possible position to protect their interests and protect their long term survival, and he had not expected them to engage in what turned out to be essentially suicidal policies.
Stan Correy: Daniel Kahneman. Greenspan, as a believer in the free market, had thought that everyone would behave in their own self interest, and it was in the self interest of the financiers to run good banks and institutions. It didn't work out that way.
Here now is Greenspan, himself appearing before the committee.
Alan Greenspan: Well remember that what an ideology is, is a conceptual framework with the way people deal with reality. Everyone has one. You have to, to exist you need an ideology. The question is whether it is accurate or not. And what I'm saying to you is Yes, I found a flaw, I don't know how significant or permanent it is, but I've been very distressed by that fact.
Mr Waxman: You found a flaw in the reality?
Alan Greenspan: A flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak.
Mr Waxman: In other words, you found that your view of the world, your ideology was not right, it was not working?
Alan Greenspan: Precisely. That's precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.
Stan Correy: Alan Greenspan in his younger days was a follow of the libertarian capitalist philosopher, Ayn Rand. Rand's novels, The Fountainhead and Atlas Shrugged are celebrations of risk-taking and unrestrained free markets. The government is always the enemy in her novels, and anti-capitalist protesters would be called moochers, bludgers who feed off the wealth of her risk-taking entrepreneurs.
While her former disciples like Greenspan may have found a flaw in her philosophy, the libertarian capitalists are nevertheless dusting off their copies of Atlas Shrugged. Here's part of a recent Colbert Report on the US network, The Comedy Channel.
Colbert: Folks, in these times of uncertainty, many of the power elite are turning to the wisdom of a visionary.
TV Report 1: One book that is just phenomenal because it makes the author look like a prophet, is Ayn Rand's book, Atlas Shrugged.
TV Report 2: The Ayn Rand stuff, I love the idea, it's romantic.
TV Report 3: You've got to let the Ayn Rand characters rise up and rebuild the nation.
Colbert: Author, philosopher and female comb-over pioneer Ayn Rand. Now Rand wrote about an out-of-control government siphoning the profits of the rich in her 1957 novel 'Atlas Shrugged'. And according to The Economist, sales of the book have risen sharply since Obama's election, surging every time he announces another spending plan. That's right, things have gotten so desperate Americans are actually reading. In the novel, all of the country's great Titans of industry begin to disappear, but there's a twist. It turns out that these business leaders were just disgusted that their earnings were going to the needy, or as Rand calls them, 'the moochers who claim your product by tears'. Just another example of the little guy trying to keep the man down. So what happens is all the successful people go on a strike ...
Stan Correy: On Background Briefing's website, there's a link to Colbert's full report on how the capitalists went on strike, until the government left them alone.
Late last year, before the copies of Atlas Shrugged started marching off the bookshelves, American satirist, Jeremiah Tucker, updated the novel Atlas Shrugged especially for the global financial crisis.
We have had it acted out. Dagny Taggart is a 30-something business entrepreneur. Hank Rearden, one of her many lovers, is now running a hedge fund. Both of them are rather upset at the creeping socialism that's arrived in Washington because of the financial crisis.
Hank: Damn it, Dagny! I need the government to get out of the way and let me do my job!
Reader: She sat across the desk from him. She appeared casual, but confident; a slim body with rounded shoulders like an exquisitely engineered truss. How he hated his debased need for her, he who loathed self-sacrifice but would give up everything he valued to get in her pants.
Did she know?
Dagny: I heard the thugs in Washington were trying to take your Rearden Metal at the point of a gun. Don't let them, Hank. With your advanced alloy and my high-tech railroad, we'll revitalise our country's failing infrastructure and make big, virtuous profits.
Hank: No, no, no. I got out of that sucker's game. I now run my own hedge fund firm, Rearden Capital Management.
Dagny: What?
Reader: He stood and adjusted his suit jacket so that his body didn't betray his shameful weakness. He walked toward her and sat informally on the edge of her desk.
Hank: Why make a product when you can make dollars? Right this second, I'm earning millions in interest off money I don't even have.
Reader: He gestured to his floor-to-ceiling windows, a symbol of his productive ability and goodness.
Hank: There's a whole world out there of Byzantine financial products just waiting to be invented, Dagny. Let the leeches run my factories into the ground! I hope they do! I've taken out more insurance on a single Rearden Steel bond than the entire company is even worth! When my old company finally tanks, I'll make a cool $877-million.
Reader: Their eyes locked, with an intensity she was only beginning to understand.
Dagny: Yes, Hank, claim me. If we're to win the battle against the leeches, we must get it on, right now. Don't let them torture us for our happiness, or our billions.
Reader: He tore his eyes away.
Hank: I can't. Sex is base and vile!
Dagny: No, it's an expression of our highest values and our admiration for each other's mind.
Hank: Your mind gives me the biggest boner, Dagny Taggart.
Reader: He fell upon her like a savage, wielding his mouth like a machete, and in the pleasure she took from him, her body became an extension of her quarterly earnings report, proof of her worthiness as a lover. His hard-on was sanction enough./
Dagny: Scream your secret passions, Hank Rearden!
Hank: Derivatives!
Dagny: Yes!
Hank: Credit default swaps!
Dagny: Oh yes! Yes!!
Hank: Collateralised debt obligation!
Dagny: Yes! Yes!! YES!
Stan Correy: Dagny and Hank want to make love and leverage at the same time. Debt is good, as long as you can turn it into toxic packages that can be sold and resold on the global market, while you make profits. It doesn't matter who ends up with the empty package.
To one former derivatives trader this obsession has led to a bout of forgetfulness about the meaning of financial risk.
Now Professor of Law at the University of San Diego, Frank Partnoy.
Frank Partnoy: One of the things that I find so interesting about financial markets is that unlike history or science, we don't seem to build knowledge incrementally. We don't seem to remember anything. I think finance in some ways is more like sex than science. It's this thing that everyone has to experience on their own, you can't really be told about it, you have to go through a collapse like this. And no-one seems to remember anything about financial history. Do people even remember Enron in any detail? They certainly don't remember scandals from the '70s, and no-one remembers the '20s.
Stan Correy: One influential book about economics actually had its inspiration from the black swans of Western Australia. Nassim Taleb, a Professor of Risk Engineering used them as an example of how all risk must take into account the unknown. Everyone thought all swans were white, until it was discovered there were black swans in Australia.
Now we turn to something called the VAR. That V.A.R. stands for value at risk, and it's a dangerous little time bomb widely used in risk management.
Speaking in February at a conference in Munich, angry at the use of VAR is Professor Nassim Taleb.
Nassim Taleb: I was waging a war against value at risk, something called value at risk that doesn't work, to me it's charlatanism, pure charlatanism, it doesn't work. It doesn't work and people say, well, we know it doesn't work, but it doesn't cause any harm. What do you mean it doesn't cause any harm? Nonsense! There is harm in giving an idiot, never give a fool sterile information because he cannot ignore it.
Stan Correy: According to Nassim Taleb, banks were misled by the numbers produced by the risk models into thinking that rare events could never affect their profits.
Nassim Taleb: Turn the TV on and you hear about the financial crisis. In my opinion it came from the underestimation by banks of the risks of rare events; so like a pilot who doesn't know there are storms, and that came from financial models. Visibly the plane is going to crash, right? If the pilot doesn't know about storms, because there are storms out there.
Now the economics profession was made aware of storms by a lot of thinkers, from Pareto, Mandelbrot, a lot of people, throughout history. These people don't publish in normal journals. Why? It's not that the financial profession doesn't know, or the financial economics profession that there are rare events, it's that these are so hard to model they prefer to ignore them. Exactly like someone, you know, the drunk person looking for his keys under the light, and you ask him, 'Did you lose your keys here?' And he says, 'No, no, no, I lost them over there, but I'm looking here because there is light.' That's pretty much what they're doing.
Stan Correy: And Nassim Taleb's anger at the abuse of financial risk models isn't only directed at the banks but at the financial regulators.
Nassim Taleb: So the system is too fragile, and was fragilised further by Bernanke and Greenspan, by their policies of making banks gigantic bureaucratic firms, and there's one thing I'd like to mention: don't think that regulators are particularly intelligent. Regulators help banks take the risks, so what we should be doing is not encourage this, because we have a facing complexity, we should have simplicity with the financial instruments to counter this complexity.
Stan Correy: The International Actuarial Association is very interested. They, after all, represent the group of mathematical wizards who can in theory, keep an eye on all this complexity. One of their representatives on the issue of financial risk is Australian Tony Coleman, and Background Briefing went to talk to him at his office in Martin Place in Sydney. VAR, or value at risk, has been overused, says Tony Coleman, and the Association have it in their sights.
Tony Coleman: The value at risk is essentially the amount of money that you would expect to lose if you had a 1 in 100 type event. The model will tell you if you have that event, that this is the amount that you could expect to lose. Now a whole series of issues suddenly appear around that. The first one is are the assumptions underlying the model indeed valid and correct and is it a reasonable representation of what actually happens in the market?
Stan Correy: And if they aren't a 'reasonable representation' of reality, the value at risk numbers aren't very useful to anyone.
Tony Coleman: It doesn't tell you at all about what happens if you happen to be unlucky enough to have a 1 in 150, 1 in 200, 1 in 500 event, because obviously you will lose a hell of a lot more. So suddenly people who built a whole risk model and advised their boards, and many of them did, using VAR measures or value at risk measures, tended to seriously understate their true levels of risk, even if the models were right, and of course for reasons we've already talked about, often the models were not right.
Stan Correy: Tony Coleman.
Now if you do a search for information about value at risk, or VAR, and its relevance or its non-relevance, you're likely to come up with pretty complex stuff. You may actually need a degree in pure mathematics to understand what it's about.
The value at risk model was developed by the US bank, JP Morgan about 25 years ago, and legend has it that at the time its CEO, Dennis Weatherstoane, wanted on his desk every day at a quarter past four, a piece of paper with a number on it that would tell him how much the bank could lose in the next 24 hours. He was given a VAR number.
There's a book that tells this story, and it goes on to say that ironically now, 25 years later, J.P. Morgan is one of the few banks that has not relied on VAR for its assessment of financial risk. The author is Financial Times journalist, Gillian Tett, and here is a reading from her book.
Reader: At JPMorgan Chase, however, managers were highly cynical about the worth of VAR, even though (or perhaps because) the bank itself had helped to create the concept a decade earlier. VAR measures were taken, but typically, used alongside other techniques for analysing risk.
Stan Correy: Others agreed that financial institutions needed other techniques as well. Here is Professor of Accounting and Finance at the University of Nottingham, Margaret Woods.
Margaret Woods: What you can tend to do, it's a bit like driving a car, you know, if a car is built with lots of extra safety features, then you tend to think you can drive faster. And I wonder if what happened within the banking sector is that they have a measure, they report that measure, and so long as we're measuring things and keeping an eye on that number, then you can carry on taking risks, and we'll be all right.
Stan Correy: Using the value at risk model as a measure of financial risk was mathematically dodgy. The financial numbers used for example, the value of mortgages, were themselves based on faulty credit ratings. So it was garbage in and garbage out.
Margaret Woods: What's been going on is the banks have used a lot of the time, historical numbers as the basis for working out their values at risk. So they're looking at what's happened to prices in the past and how much they've moved, and therefore the likelihood of prices collapsing in the future. And that drives the value at risk number. But there's no guarantee that history is going to carry on repeating itself. And when the problems in the sub prime market started to emerge, and the value of a lot of the instruments that banks held started to collapse, then of course, all those past forecasts of what would happen to prices, went out of the window.
Stan Correy: Transparency is one of the key words in reform of the financial markets, but with risk reporting the way it is, the future is murky. Margaret Woods.
Margaret Woods: It might be that transparency is being translated into printing more pages and the thicker the annual report the better. But that's not necessarily true, because quantity and quality don't necessarily equate with one another. There was an interesting debate on our morning news program in the UK, and a commentator observed that if you look at a set of bank accounts, it's actually sometimes easier to find out whether they're using double flushing toilets than to find out whether they're actually taking risks that might cause meltdown in the financial system. And I think that actually is a nice summary of the state of play.
Stan Correy: This is Background Briefing on ABC Radio National. I'm Stan Correy.
The G-20 is now over, but it's still not quite clear what they all agreed to do about all this.
Reader: World leaders declare war on risk.
Stan Correy: Variations on the word 'risk' are repeated frequently in the G-20 communiqué.
Reader: Strengthened regulation and supervision must promote propriety, integrity and transparency; it must guard against risk across the financial system; it must dampen rather than amplify the financial and economic cycle; it must reduce reliance on inappropriately risky sources of financing; and discourage excessive risk-taking.
Stan Correy: But what exactly will be disclosed? For years, international financial supervisors instructed banks to measure their risk, using financial models like VAR.
Here now is Frank Partnoy.
Frank Partnoy: All the major financial institutions have to disclose a lot more about the nature of their risks, they have to disclose more than just, 'Oh, we have half a trillion dollars of notional value of credit default swaps', that's not meaningful disclosure; that doesn't give anyone information. I think if we want back in time and AIG and the major financial institutions had disclosed not just information about their models, but information about the actual contracts that they had entered into, that we would not be in a crisis now, because smart analysts and people who watch these companies, would have seen the dangers.
Stan Correy: Use the power of the internet, says Frank Partnoy, to introduce radical transparency.
Frank Partnoy: Just imagine this thought experiment: imagine that we go back in time and AIG and Citigroup and all the major financial institutions have actually disclosed all of their contracts, all the data. Right? We have a big internet out there, it would require some bandwidth, but not that much. Imagine that they had disclosed all their contracts, these trillions of dollars worth of contracts, well over the course of a year or two you would have had a lot of savvy journalists and analysts who would have spotted some of the dangers. They would have said, 'Look at the potential downside associated with this transaction'. There would be smart people who would apply financial models to the transactions that were disclosed. None of that was possible; instead what we did was we let the banks and insurance companies decide, using their own models what would be disclosed.
Stan Correy: And in reality, not much got disclosed. Well, not much that was any use in predicting whether a bank was going to lose a massive amount of money.
Financial risk experts told Background Briefing that most people who produce these numbers or know how they are produced, have very little faith in them. One pointed out, since value at risk uses the past to predict the future, if tomorrow is nothing like the past, then the numbers are totally misleading.
Britney Spears sings Toxic.
With a taste of your lips
I'm on a ride
You're toxic I'm slipping under
With a taste of a poison paradise
I'm addicted to you.
Don't you know that you're toxic
And I love what you do
Don't you know that you're toxic ...
So how are our two capitalist lovers, Hank and Dagny dealing with the toxic assets? The assets that have shattered the careers of their friends in investment banking. In this scene of the satire recently written, based on the book, Atlas Shrugged Hank and Dagny are searching through the wreckage of a bank, a victim of the financial meltdown.
Reader: As they stepped through the c rumbling cubicles, a trampled legal pad with a complex column of computations captured Dagny's attention. She fell to her hands and knees and raced through the pages and pages of complex math, written in a steady hand. Her fingers bled from the paper cuts, and she did not care.
Hank: What is it, Dagny?
Dagny: Read this.
Hank: Good God!
Dagny: Yes. It's an experimental formula for a financial strategy that could convert static securities into kinetic profits that would increase at an almost exponential rate.
Reader: Hank studied the numbers.
Hank: The amount of debt you would need to make this work would be at least 30 to 1, but a daring, rational man who lives by his mind would be willing to take that risk!
Dagny: Yes, and it's so complex the government could never regulate it.
Hank: It's perfect. There's only one problem: half the pages are missing. Could you reconstruct it, Dagny?
Reader: Her answer escaped her lips like air from a punctured galvanised-steel duct.
Dagny: No.
Hank: I didn't think so, but why leave such an achievement to rot here? It's the greatest thing I've ever laid eyes on, made by a monumental genius, the sort of mind that's only born once in a century ... Dagny, why are you fondling your breasts?
Stan Correy: But what Dagny and Hank had really found was the formula to create a disease that would transform banks into zombies.
Song:
I was working at my bank late one night
When before my eyes this financial sight,
My bank from its slab began to rise,
And suddenly to my surprise
It is a bank
It is a Zombie Bank
Such a terrible stank
It is a bank
Once our profits have sank
It is a bank
We did the Zombie Bank
From my laboratory in the nation's east,
Come Zombies hungry for some bail-out treats.
Just a little more flesh will keep them alive.
They've got much bigger worries than our rules survive.
It is a bank ...
Stan Correy: Back in Washington D.C., earlier this year, Federal Reserve Chairman Ben Bernanke is squirming and in denial under questioning, about the economics of the living dead.
Senator Graham: Is AIG a zombie institution?
Ben Bernanke: AIG is in a very difficult place; it's lost a lot of money, and it was a good company, a strong insurance company that was ambushed by the financial products division and other bad financial debts.
Senator Graham: If AIG is not a zombie institution, who would be?
Ben Bernanke: I don't know of any large zombie institutions in the US financial system, and our idea with AIG is in fact to allow it to stabilise and to become profitable enough to repay the obligations it has to the United States.
ZOMBIE MOVIE
MUSIC
Singer: They're coming to get you Barbara.
Man: They're coming for you, look, there comes one of them now.
MUSIC
Stan Correy: Many eminent economists think there's only one proper action to take. Get whatever you need to kill a zombie and use it.
Having watched this sort of thing for nearly 20 years, the Professor of International Economy at the University of California in San Diego, Takeo Hoshi says drastic and quick action must be taken, otherwise you end up with a slow and economically painful death, like in Japan in the 1990s. The Japanese banks were kept alive for years even though they were full of toxic assets, like bad or non-performing loans.
Takeo Hoshi.
Takeo Hoshi: So what happened in Japan, which is very much like what's been happening in the US, was that Japanese government tried many things like buying up toxic assets, or tried to recapitalise the banks. Some of those had limited success of calming down the financial system, but none of them worked until 2002 when the Japanese government finally got serious about forcing the banks to get rid of those non-performing loans and expose the zombie banks.
Stan Correy: Takeo Hoshi says killing zombie banks is difficult politically. It's reasonable simple to nationalise them and bury them, but the problem is the collateral damage. A lot of innocent bystanders will get hurt - the employees, the shareholders and the companies that have dealings with those zombie banks.
Takeo Hoshi: Shutting down the zombie banks or a zombie firm is very costly in terms of employment; there are lots of jobs to be lost and also shareholders lose from the failure of the banks, and firms as well. So that is not politically attractive and that creates a problem for politicians.
Stan Correy: So in a sense, you're saying that once you get into this zone of zombie economics, it's very difficult to break the cycle, unless you really go for mass annihilation I suppose?
Takeo Hoshi: Right. It's very difficult to get out and it takes a real political will to stop the process and kill the zombies and start the new recovery.
Stan Correy: Takeo Hoshi.
The big question is whether world leaders, America in particular, can take the political gamble of causing unemployment and misery all around in order to finally kill off these toxic institutions. In the past they've often not taken that political step. Economist Ed Kane.
Ed Kane: It's unconscionable to me that the government would run these gambles with taxpayers' money. I have come to this position and it's a very harsh position, that some of our best servants in government are policemen, firemen, soldiers; these people risk their lives for relatively modest compensation, and these top financial regulators won't risk their careers in the sense of getting criticism from the industry for over-regulating in times when of course over-regulation is in fact a misnomer, it's disinformation.
Stan Correy: What Ed Kane is saying is that there will be no 'over regulation'. Those who scream about that, saying it will kill free enterprise, are self-interested and want 'no regulation'. Good regulation is very important. The incentive system, for example, has been widely abused, says Bill Black.
Bill Black: When you have executive compensation systems that are perverse, that are based on short-term accounting games and when you have extremely short tenure in senior positions, you get something that we refer to in economics as a Gresham's dynamic. This is after a British economist. Gresham's law says that bad money drives good money out of circulation. In this case, bad practices drive good practices out of circulation. In the United States, the average chief financial officer or CFO, lasts slightly less than three years. And how long is he going to last if he does not put his institution heavily into sub prime lending when that is booking record earnings.
Stan Correy: Former US bank regulator, Bill Black. This short term way of handling risk management and the pressure to quickly make big profits for shareholders, no matter how, has been a disaster. From the International Actuarial Association, Tony Coleman.
Tony Coleman: A risk manager may well go in a certain given situation, and simply say, 'No, that's too much risk; you're not allowed to do that deal', to a line manager within the organisation, a trader if you like, or someone in charge of a trading desk, or higher up. Depending on how the management culture of that organisation works, one or two things will happen. The risk manager's view will either prevail, in which case the deal is not done. Alternatively, the management trader person might well manage to lobby his chief executive or whoever, and say, 'That risk model is full of a whole lot of assumptions, here's the ifs and buts. I don't believe it, I don't accept it and therefore I won't go and do this deal.' And the chief executive might say, 'Oh well, there's going to be x-million profits; if you do the deal, I'll let you do the deal.'. So effectively the risk view gets over-ridden.
Stan Correy: There might be a more traditional way of curbing excessive risk-taking. From the London School of Economics, Jon Danielson.
John Danielson: In the old days, lots of financial institutions used to be these 'partnerships', this meant that if your bank went bust all the partners, they lost their houses, they lost everything along with it because their fortune was tied up in it. So a sensible proposal would be to say, 'If everything goes well you get the reward; if everything goes badly, your personal fortune is directly tied in to the fortune of the bank, you will lose your house, you will not be able to work in this industry again. That will make you behave lots more conservatively.'
Stan Correy: In the coming debates about executive compensation, or bankers' bonuses, Danielson says you'll hear a lot about the phrase 'risk adjusted'., Essentially that means that the bankers' bonus will be measured using a risk model. But as we saw with value at risk, or VAR, risk adjusted compensation can also be manipulated and we may end up with a worse system than before.
This kind of thinking about risk management came about, says Danielson, because a powerful myth took hold in the world of finance. The idea that financial regulators assume that risk can be accurately measured, that financial engineers like civil engineers, can design safe products with sophisticated maths.
Take risks, yes, but the public shouldn't have to pay for the mistakes.
Frank Partnoy.
Frank Partnoy: Some people are arguing you should have done that in a more efficient way through nationalisation. Some people think the banks should have been allowed to go into bankruptcy. All that is spilt milk now. I think what the Administration is trying to do is to move forward and focus on the future. So we've got to put this behind us, we've got to clean them out, and people will be critical of this program, but I think what has to happen and what people hopefully will not lose sight of, and it sounds like the President clearly understands this, is that the playing fields of the future has to change. And we can't clean this mess up only to see that a year or two from now, Wall Street is again inventing fantastic derivative instruments designed to take advantage of dsysfunctionalities in the ratings process, and they will do that; that will happen again, it won't take long. In a year or two, this will all get started again and we will see the same type of instruments and the same kinds of complexities and then we'll have another crisis and it might not take that long. We might go back to 100 years ago when we were experiencing banking crises every few years. The only way to avoid that is to put a new set of smart regulations in place and to get rid of the old regulatory apparatus.
Stan Correy: Back at the satire of Atlas Shrugged, Dagny is now with another of her lovers, John Galt, the ultimate super capitalist.
Galt and Dagny are in a very smart apartment, looking out at where all the very rich people have gathered to hide from the government that wants to take their money. Dagny has an important-looking document in her hand.
Dagny: The financial strategy, the financial strategy I found, it was you who made it?
Galt: Yes.
Reader: John Galt's face betrayed no signs of pain or fear or guilt, and his body had the clean, tensile strength of a foundry casting, with skin the colour of a polished full-port brass valve. In the centre of this secret mountain valley with the titans of Wall Street had retreated for an extended junket, was a 3-foot tall dollar sign of pure gold, atop a granite column. It was tacky, yes, but it was also their emblem, a symbol of their triumph.
Dagny: But why did you leave it behind?
Galt: Because once I committed the plan to memory I no longer needed it.
Dagny: I don't understand.
Galt: The capital gains tax, Dagny, we loathe it.
Reader: He pointed to the houses of men she knew, and the names sounded like the richest stock market in the world, a roll call of honour.
Galt: Her money represents our spirit's value. When the government takes our profits, it is literally robbing us of our souls. I will not apologise for my wealth to a nation of looters. We who live by the mind could have been engineers, scientists, doctors, extreme-sports enthusiasts, but there is no more purer pursuit than the pursuit of money. A is A. Money begets more money, and ...
Reader: Galt went on like this for what seemed to Dagny like hours, until, finally, something he said piqued her interest.
Galt: ... And that's why I created the financial plan you found. It's true, it works. But it is not sustainable. It will ruin this country's financial system, and then we'll see how those who despise us prosper, when their lenders and investors refuse to invest or lend.
Reader: He laughed joylessly.
Galt: It's funny, isn't it? I must destroy the very thing I love in order to save it.
Dagny: Just to avoid paying taxes?
Galt: I do not compromise my beliefs, and I will kill anyone who asks me to!
Reader: A silence fell between them, and it was awkward. Finally, Dagny asked:
Dagny: So, just out of curiosity, how much are your worth?
Reader: He shrugged.
Galt: What is infinity?
Dagny: She let out a rich, powerful moan, like the sound of a passing diesel train in the night.
Stan Correy: Background Briefing's Co-ordinating producer is Linda McGinnis. Research by Anna Whitfeld. Technical producer, Mark Don. Actors, Paula Arundell, Justin Monjo and Tyler Coppin. Narrator, Mark Hortsman. Thanks also to Jeremiah Tucker for his satirical update of Atlas Shrugged.
There'll be links to that and other material, including an animated version of the Zombie Bank song on Background Briefing's website.
The Executive Producer is Kirsten Garrett. I'm Stan Correy and this is ABC Radio National.
"The philosophers have only interpreted the world, in various ways. The point, however, is to change it." Karl Marx
"He would, wouldn't he?" Mandy Rice-Davies. When asked in court whether she knew that Lord Astor had denied having sex with her.
“I think it would be a good idea” Ghandi, when asked about Western Civilisation.
"He would, wouldn't he?" Mandy Rice-Davies. When asked in court whether she knew that Lord Astor had denied having sex with her.
“I think it would be a good idea” Ghandi, when asked about Western Civilisation.