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Saturday, November 29, 2008

Housing caused a Financial Problem, Greed and Stupidity made it a Crisis

There are derivatives and derivatives, most are clever instruments that are extremely efficient in generating leverage and spreading risk. It is in the way in which some of them were used that created the financial crisis.
Credit Default Swaps CDF’s:
Stupidity is issuing Credit Default Swaps insurance without setting aside any reserves.
Greed is accepting fees and payments for them without doing anything to legitimize their existence.
Stupidity is entirely relying on ratings and still not setting aside reserves to cover the risk of defaults.
Greed is allowing parties unrelated to a transaction to place side bets on defaults in order to receive fees and payments.
As a result of not setting aside reserves more CDF’s were issued than the issuers could possibly cover.
The taxpayers are now funding the liabilities of the issuers of these CDF’s (AIG and others) because the insurers were too greedy for fees and too stupid to set aside reserves when they should and could have.

Collateralized Debt Obligations CDO’s:
Stupidity is not balancing a portfolio by combining low risk/low interest CDO’s with high risk/high interest CDO’s.
Greed is having only high risk/high interest CDO’s to maximize returns without regard to the potential exposure of being wiped out.
As a result of this greed and stupidity the banks are holding worthless high risk/high interest CDO’s that have caused them to be greatly over leveraged and unable to lend.
The taxpayers are now funding the Banks that were overexposed to these worthless CDO’s because the banks were too greedy and too stupid to maintain a balanced portfolio of low risk/ low interest CDO’s.
So instead of behaving like rational prudent human beings, the management or guardians of our financial system were driven by greed and stupidity. Instead of treating one of the greatest inventions of our time, derivatives, responsibly and with care to expand credit and the economy, they instead turned them into a lethal weapon that changed a simple financial problem into a global nightmare.


What are Collateralized Debt Obligations, CDO’s ?

The instruments or Derivatives that were used to bundle mortgages issued by banks to homeowners are called Collateralized Debt Obligations (CDO’s).
These CDO’s were resold to other financial institutions to finance additional lending or issue more mortgages.
Each CDO was divided into roughly three slices or coupons. Coupon#1 was the safest guaranteed/low risk and thus carried a relatively low interest rate e.g. 5%, Coupon #2 was not entirely covered, held more risk but carried a higher interest rate e.g. 7% and the Coupon #3 was high risk and thus carried the highest 11% to 13% interest rate.
In case of any default or shortfall, holders of Coupon #1were the first to get paid and any surplus went first to coupon #2 and last to Coupon #3. Therefore, if any trouble or shortfall occurred the first coupon holders to get wiped out were those holding Coupon #3.
One of two things happened Coupons #1 and #2 were easily sold to prudent investors and the banks got stuck with coupon #3 or the banks were so greedy that they held on to coupon #3 because it had the greatest payout even though it carried the highest risk.

Integrity, Trust, Duty, Honor, not just words!

During Mr. Greenspan’s testimony before congress a couple of weeks ago he acknowledged that he had made one mistake.



He had assumed that the corporate “Elite” in charge of governance of our corporations, would behave with integrity and fulfill their duties with the honor deserving of the trust the rest of us, including himself, had invested in those who held the highest of corporate offices.

We can discuss the problem of using the word “assume” for ever but as we all know many people interpret it to mean “assume makes an ass of u and me” which is of course exactly what has happened.

However, the discussion here is whether Mr. Greenspan had good reasons to make the assumption about integrity when he did or not.

Around the 1980’s, the Foreign Corrupt Practices Act and its requirements for compliance forced corporations to clean up their “act” in terms of ethics and code of conduct.

Since then a new wave of other management techniques, mainly to cope with a myriad of social legislation (e.g. equal opportunity, diversity, sexual harassment, etc.) gave birth to the Vision, Mission, and Code of Conduct statements which turned up on a mostly voluntary basis in the more forward looking organizations.

It took until the post Enron/Worldcom era Sarbanes Oxly (SOX) legislation to make having these Vision, Mission and Ethics/Code of Conduct statements almost compulsory as evidence of the “tone at the top”

The problem with all these expressions of desired behavior was that they were just that, expressions of desired behavior. Agreed many companies trained their employees with lengthy and numerous training sessions, and management was encouraged to give these statements endless lip service, but with some minor exceptions nothing really changed especially not in the top echelon of the corporation. Top management rarely walked the talk.

Evidence the continued raping of the corporations and by default the shareholders with outrageous executive compensation, the blatant cheating by secretly backdating options, the petty thefts committed by executives on expense reports which ensured that hardly any private expense of the executive remained unpaid by claiming it as an entitlement or fringe benefit.

The reason why most people in high offices behave this way is because being in a high and powerful office is a new experience to them. Even though there are guidelines of how to behave with integrity and honor, it is not part of their DNA. There is no “noblesse oblige” mentality in their make up. They have worked hard to get to a position that they had no reasonable expectation to get to so they are “worth it”, they deserve everything they can get. It is difficult to deal with power responsibly if you have never been close to it or have never personally experienced it before.

Many fresh new executives have had no role model, no father who was in a high level position of power, whom they could have learned from at an early age, who they saw agonizing over difficult decisions he had to make which had major implications for a community, what it was like to be responsible for a large number of people, other than his immediate family’s, lively hood, how they had to be an example in their community and had to continue to earn their trust and confidence and so on.

Being taught by ones parents how to behave and conduct oneself in a position of power vis a vis ones servants thus learning how to treat them with respect, dignity and care is another example of learning at an early age that power demands duty and a sense of responsibility.

These are all things that shape an individual leader’s DNA. Admittedly it sounds like the preaching’s of an old era that is outdated and cannot work in a meritocracy. Therefore to assume that “noblesse oblige” is the M. O. in every high level executive is an unreasonable expectation. To expect that the ethics and self governance in the highest offices of the land are a substitute for sensible regulation and legislation is na├»ve and old fashioned to say the least. In this modern world omissions of a sense of duty and responsibility in some individuals can have global implications on the lives of millions of people.

Business is not just Business, it goes beyond the egotistical compensation and self help interests of the executives. Business is a serious undertaking; it carries with it responsibilities and duties to a broader community, it affects other peoples livelihoods and not only just those that work for the business, it affects whole communities, and as we have recently discovered, it affects the entire world.

It is time top management took the words seriously.