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The hearings of the Financial Crisis Inquiry Commission were held this past week, attempting to find who is to blame for the financial crisis.
It was particularly interesting on Thursday when the commission questioned former Citigroup CEO Charles Prince and former Citigroup Chairman Robert Rubin, who was also the Treasury secretary in the Clinton administration.
Both men, according to NPR, blamed everyone but themselves, although at least Prince apologized, while Rubin refused to do so.
There's one particular statement, by commission member Byron Georgiou, that I want to focus on.
Very long-time readers of this web site are well aware that this subject has been highly emotional for me. Over the years, I've lost many hours of sleep because I could see what was coming. I made mocking and contemptuous remarks about politicians, journalists, investors and analysts. I frequently referred to the utter insanity going on in Washington and on Wall Street. And a couple of times I pointed out how, when I get in the morning, I have to ask myself whether I'm crazy or the rest of the world is crazy.
Well the statement by Byron Georgiou confirms that I was right -- that I was sane and the rest of the world was crazy. He didn't use the word "crazy," of course. He used the words "medieval alchemy" to refer to what was going on, and the word "hallucinatory" to characterize the result.
In fact, the evidence brought forth by Georgiou is actually a "smoking gun" that provides, circumstantially, that widespread fraud was committed by bankers. No one in the mainstream media has commented on Georgiou's statement or his evidence, which shows how oblivious those people are, since obviously Georgiou sees it as evidence of criminal activity.
You can see presentation for yourself on a CSPAN video, at approximately the 1:38 point. Here's my transcription:
Recall that collateralized debt obligations (CDOs) are the structured securities that were created by "slicing and dicing" subprime residential mortgage back securities (RMBSs), which were in turn created from subprime mortgages. When the mortgages started failing, then a chain reaction occurred, and the RMBSs failed, which caused the CDOs to fail.
One is that Citi wrote off more then $30 billion of the $43 billion that you had on the books, which was roughly a third of the capital that you had at the time, and second, because I think it's emblematic of something that went seriously wrong in our system that everybody believed was impossible.
I mean yesterday we had a panel of your underlings, if you will, who were very serious, high-ranking people in the bank, who sat there -- four of them -- Messieurs Harris, Dominquez, Bushnell and Barnes. and they all made a lot of money, in one instance almost $100 million in the course of the three years before all the troubles hit at Citi. And notwithstanding that, and not withstanding their respective responsibilities for originating these CDOs, supervising the risk associated with them, and all the other aspects of their responsibilities, all of them essentially said that this was inconceivable, unknowable, couldn't have happened, everybody thought it didn't happen, every other institution who was dealing with them had the same view, and so we were hit with this calamity which nobody could have anticipated."
He's summarizing the standard excuses given by people in the financial services industry -- that they were experts, making millions of dollars, but they were too dumb to figure out that their models were wrong.
This excuse works in 2002, in 2003, in 2004, and maybe even in 2005. But the real estate bubble started bursting in 2006, and these super-brilliant financial engineers must have known that it would mean that their models were failing.
And the most damning evidence of all is that when the real estate bubble was bursting in 2006 and 2007, and the financial engineers should have been warning investors of the danger, just the opposite happened. They sped up the creation and sale of the CDOs, in order to make as much money in commissions as possible before the game was up.
This is circumstantial evidence but, in my opinion, it's evidence that criminal fraud was being perpetrated on a large scale by financial institutions. These financial engineers and their managers should be in jail.
As Chuck Prince famously said in July, 2007, "As long as the music is playing, you’ve got to get up and dance. We’re still dancing."
Returning to Georgiou's statement. He makes his remarks about "medieval alchemy" and hallucinations, and then produces some fascinating figures:
And this is something that I think really deserves exploration, because if you look at the fundamentals, it belies logic. That's not to say that there weren't a lot of people who believed it.
But, I just want to focus your attention on it yet one more time, if I can.
These RMBS securitizations that occurred resulted -- and this is out of a Goldman Sachs post hoc analysis, basically -- resulted that 75% of the tranches were AAA, 10% AA, 8% A, 5% BBB, and 2% equity in the underlying RMBS.
So the BBB tranches were at the bottom 7% of the tranches in the underlying securities. Now they take all the BBB tranches out of all these underlying RMBS, and slice and dice them, and what you get in the collateralized debt obligation is 60% of something that's characterized to AAA super senior tranches, 20% AAA, 6% AA 5% A, and only 2% BBB, 2% BB, and 5% equities.
So suddenly you've taken what was the bottom 7% of the underlying security, and made more than 90% of it above A rated. And it strikes me that the fact that everybody believed this, [including] regulators, Mr. Prince, as you mentioned in your testimony, nobody questioned this, is highly troubling, because at the end of the day, this was the most significant single matter that impacted your books, and it certainly impacted the books of a whole lot of other financial institutions."
I haven't seen these figures before, but they're absolutely fascinating, and they provide a "smoking gun."
I'm going to state this in simple terms. What these financial engineers did was to take a collection of B rated securities, apply their slicing and dicing process, and convert them into 90% A rated securities, and the rest B rated. That's not mathematically possible.
Three years ago, I wrote and posted "A primer on financial engineering and structured finance." That article describes the mathematics of the "slicing and dicing" process.
If you work through the math, then the bottom line is this: If you start with a bunch of B rated securities, and you slice and dice them to create some A rated securities, then, roughly speaking, there must be an equal amount of C rated securities. The average rating of the securities that come out of the slicing and dicing process must be equal to the average rating of the securities that went in.
That's why Georgiou used the phrase "medieval alchemy." Alchemists in the middle ages believed that it was possible to use chemical means to "transmute" one substance into another, and their research focused on trying to do that. The biggest goal of them all was to find an elixer that would transmute lead into gold.
Well, the financial geniuses at Citibank and other banks finally achieved the medieval dream of transmutation. By using deceptive mathematics, they transmuted B rated securities into A rated securities, and that's impossible.
The financial engineers excuse themselves from this deception by pleading ignorance, but I don't believe that for a minute. These people have PhDs in finance, mathematics, and related subjects, and it is literally impossible that they did not know what they were doing.
And here's one more thing to throw into the mix: Two years ago, I quoted Warren Buffett as saying that he'd tried to evaluate a CDO offering, and he found that you'd have to read and understand 750,000 pages of documentation to do the evaluation. (See "Regulators attempt to formulate new laws to prevent the subprime crisis.")
Once again, I don't see this as some sort of accident, or an act of carelessness. There's no doubt in my mind that the structuring and resulting documentation was done to obscure what was really going on, to prevent anyone from doing an evaluation. These financial engineers knew that converting B rated securities to A rated securities was mathematically impossible, so they purposely (in my opinion) did it in as obscure and complex a way as possible, so that supposedly sophisticated investors could be defrauded.
There's one more thing that Warren Buffett said, with respect to the 750,000 pages of documentation that had to be evaluated: "And the mind can't comprehend that. What people did comprehend was that the fees were terrific in selling them to the people."
And that's the point. These financial engineers had nothing to lose. They were making were making "terrific" fees by creating fraudulent structured securities and selling them to investors, and made them as obscure as possible to prevent anyone from figuring out what they were doing.
Here's the rest of Georgiou's statement:
And basically these models -- somebody was modeling this, and somebody believed in a modeling that resulted in these analyses. That is, the underwriting people at your shops, the credit rating agencies, the regulators, to the extent that they evaluated this.
But we now know that everybody was horribly wrong, to the tune of over a third of your capital."
And here's where I part company a little from Georgiou. Yes, maybe some people believed in these models, but there's no way that the brilliant financial engineers believed in the models that they were creating, because the results were mathematically impossible. They were committing fraud, and they knew it.
And so I've now discussed three different types of circumstantial evidence that there was massive, purposeful fraud going on at Citi and other investment banks:
As I've been saying for years, a lot of these bankers are going to end up going to jail. I said that because that's what happened in the 1930s, although it took several years for the process to reach a conclusion. The process is now repeating in 2010.
As we noted above, Prince and Rubin denied having any responsibility for the fraudulent activities.
They're right about one thing: They could not possibly have known the details of how the fraudulent CDOs were put together. Only the brilliant Gen-X financial engineers who created them understood them.
But that doesn't let Prince and Rubin off the hook. They knew that the real estate bubble was bursting, and they knew that you can't use alchemy to create A rated securities out of B rated securities. They earned multi-million dollar salaries, and so should have know those things and a lot more, and they should have stopped the fraudulent activities from continuing.
This brings me back to what I've been writing about for years, about how the financial crisis could not have worked if it had been perpetrated by JUST the Gen-Xers or JUST the Boomers. The nihilistic Gen-Xers were needed to create the fraudulent securities, and to sell them to investors. The incompetent Boomers (and Silents) were required because they were in charge, and they had to permit the fraudulent activies to occur. The one thing that people in both generations had in common was their willingness to commit fraud to screw investors in order to earn multi-million dollar fees and commissions. It's really sickening.
It's worth repeating something I've said before: it wasn't just Citi and other large banks that committed fraud.
The question that I keep focusing on on this web site is this: How is it possible that so many crimes were committed by so many people in so many different companies, and everyone looked the other way? How is that even possible?
How could so many people -- in every organization, at every level -- have committed some kind of fraud for their own personal gain, or at least condoned such fraud. People in my parents' generation would not have done this.
The housing bubble was caused by massive fraud throughout the entire financial and real estate industries, from top to bottom, whether it was homeowners lying on their applications, construction firms colluding with appraisers and brokers to get kickbacks by over-valuing homes, lenders who resold mortgages without checking any of the claims, lenders who adopted predatory lending practices, granting loans to people with no hope of making payments, investment banks that securitized loans based on the assumption that real estate prices would rise forever, ratings firms and monoline insurers that took fat fees to lie about these potentially worthless securities.
The only possible explanation for such ubiquitous debauchery is generational. There's no other way that it could have reached every corner of every financial and real estate organization except in the contemptuous attitudes of nihilistic Generation-Xers, perpetrating fraud right under the noses of their stupid Boomer bosses, who condone the crimes because they also gain. This lethal combination of Gen-X nihilism and greed, combined with Boomer stupidity and greed is what got us where we are.
The important thing to understand about all this is that nothing has changed. The level of insanity is just the same in Washington and on Wall Street. The same people are in charge, with the same greedy, nihilistic personalities.
I'm always still astounded by this issue of million dollar bonuses. A year ago, the bankers were talking openly about being entitled to these bonuses, apparently because they believe they were smarter than the rest of us in being able to create fraudulent securities.
Today, you don't hear bankers talking openly about being entitled to bonuses any more. But you never hear them saying that they don't deserve the bonuses, either. Instead, they seem to have entered a kind of "public relations" mode where they expect to get the bonuses, but not brag about them to everyone. These are people who defrauded investors out of trillions of dollars, but they still don't understand why they don't deserve million dollar bonuses.
Michael Panzer posted an interesting graphic on the Financial Armegeddon blog. He wanted to show that investors are taking as much risk today as they were in May 2007, at the peak of the credit bubble.
One way of measuring this is to compute the ratio of high-risk high-yield bonds to low-risk corporate bonds. The result is the graph on the right. What this graph shows, according to Panzer, is that "risk-taking is back with a vengeance."
This is still circumstantial evidence, of course, but it was confirmed on Friday by the WSJ. According to the article, "Major banks have masked their risk levels in the past five quarters by temporarily lowering their debt just before reporting it to the public, according to data from the Federal Reserve Bank of New York."
There's craziness at all levels. A couple of days ago, I linked to a CTV story about how the average home price in Vancouver in March was over a million dollars. And yet the real estate broker quoted in the story sees no danger.
Dear Reader, the insanity has not changed. It's still true that the stock market has been historically overpriced by substantial amounts since 1995, and by the Law of Mean Reversion, will have to fall sharply and stay down there for a comparable length of time (15 years). This is a mathematical certainty. (See "How to compute the 'real value' of the stock market.")
(Comments: For reader comments, questions and discussion, see the Financial Topics thread of the Generational Dynamics forum. Read the entire thread for discussions on how to protect your money.)