One of the things you learn in engineering is to be rigorous. If you build a bridge that falls down on a windy day, there’s going to be hell to pay. Financial markets are not like that; they are very noisy. It’s hard to tell who’s skillful and who’s just lucky. And a lot of analyses are done in extremely haphazard, primitive ways, but the investing public doesn’t know any better.

– Dan diBartolomeo, From the Feb 23, 2009 issue of Wired.

Dan diBartolomeo is the head of Northfield Information Services, a Boston financial analysis firm. He has a long history of analyzing investment strategies and complex securities. His comparison of financial markets to the rigors of engineering is noteworthy.

The “quants” of Wall Street, with their Ph.D.’s in advanced science and mathematics, have been painted in the press as geniuses who created financial products of such astounding complexity that mere mortals could not hope to comprehend them. I can’t help but wonder if they weren’t more akin to wizards and alchemists who used their formulas and models as a screen for the ultimate confidence game.

People who are smart look ahead to anticipate the implications of their actions. People who are smart create holistic systems rather than piecemeal schemes. People who are smart apply rigor and discipline to their ideas. It seems to me that the quants of Wall Street were more like pawns in a sea of opportunists than true geniuses.

Power tends to corrupt, and absolute power corrupts absolutely.
– Lord Acton

I was born in Canada and came to the US between my sophomore and junior year in high school. One of my first courses in my newly adopted country was high school civics. I learned with a newcomer’s sense of awe about the three branches of government and their important role in each checking the power of the other. It is highly attributed that this system of checks and balances is the genius of the America.

In the intervening years since those wide-eyed high school years I have been a casual observer of the reality that power and money are self preserving. The more you have of each the more you tighten the circle to protect and increase your lot. The fiasco on wall street is evidence of what happens when the self-reinforcing power/money loop runs exponentially out of control.

If there is any hope of reforming this mess, and I have no expectation that it will be reformed, it would seem that some sort of system of checks and balances will have to be devised. Increased (and effective) regulation might help with some of the “checks” that are needed. But are there “balances” that have yet to be devised? Does the final dissolution of trust by Bernard Madoff mean that investors will demand enough clarity and transparency to balance the unhealthy tendencies of money grubbing?

I have never been a strong advocate of regulation but it it seems to me that a more robust system of checks and balances is needed in our financial systems. The “checks” are somewhat obvious (i.e. regulation). The “balances” are yet to be determined.

• American productivity has risen almost 20% in the last decade (Source)
• Real median income over the same period has declined (Source)
• Executive compensation has risen astronomically (Source)
• Consumer debt has risen substantially (Source)
• Consumer spending comprises 70% of GDP

Rising productivity is what enables companies to increase employee’s pay. Increases in pay result in the overall rise in our standard of living. However, in the last decade, this relationship between productivity and rising employee pay seems to have been fractured.

Instead, the benefits from rising productivity over the last decade have been channeled primarily to executives. Their incomes and bonuses have continued to rise to unprecedented levels. Unfortunately, someone forgot to tell the masses that they were not included. Accustomed to general increases in standards of living and inspired by the rising wealth of the top earners, the majority of consumers mortgaged their homes and leveraged their credit cards to maintain an upward trend in standards of living. We borrowed to keep up with the Jones’s and maintain the illusion that we were making progress.

Enter the economic collapse of 2008.

Consumers have stopped spending. How could they do otherwise? Their credit cards are tapped and their mortgage options have evaporated. The pundits and the economists are pleading with consumers to resume spending but where is the disposal income supposed to come from?

It seems to me that the consumers are on strike. I can’t say that I blame them.

Here is what I have been able to figure out so far. Forget about the subprime mortgage crisis. A huge part of the problem is these credit default swaps – to the tune of $55 trillion dollars. These “insurance policies” were not only taken out by people who lent money to protect themselves against potential loss. Financial gamblers were also taking out credit default swaps on other people’s loans! This is raw gambling. Some analysts estimate that for every CDF taken out to by a lender to protect a loan, ten other CDFs were sold by and for third parties on the same loan.

I am growing weary of the daily refrain that what we have here is a failure of confidence. The bankers no longer trust one another and, consequently, are refusing to lend to one another or worthy customers. Nine months ago these cowboys were lending to anything that could breath, and then doubling down 10 to 1 on the loan. Now they don’t trust one another. I can’t say that I blame them.

Here is my simple solution to solve the crisis:

1. Declare all credit default swaps null and void. Nobody pays. Nobody is on the hook. The overlapping, hedged, web of CDFs is too complicated for anyone to “unwind.” Just wipe the slate.
2. Give all of the bankers and most of the traders a good smack and then send them to a ropes course – preferably somewhere in the vicinity of the Grand Canyon. I don’t think these guys ever really trusted one another. Now is a good time to learn.
3. Exercise the clause in the bailout plan that allows the federal government to take stock in the banks that need cash infusions. Then throw the bums out who have made this mess and start lending to the businesses that are desperate for “commercial paper” to keep their businesses running.

There, now that wasn’t so hard, was it?

First, a delightful  blog I discovered called The Big Picture by Barry L. Ritholtz. In a post titled The Underlying Basis of Finance and Credit, Mr Ritholtz observes:

Over the entire history of human finance, the underlying premise of all credit transactions — loans, mortgages, and all debt instrument — has been the borrower’s ability to repay.

Except for [the 5 year period from 2002 to 2007] the entire history of human finance was rather reasonable about the basis for making loans in general, and extending mortgage loans in particular.

For 99.9996% of the last 1.2 million years, loans were granted primarily on the condition of whether or not the lender believed that the borrower could repay. Between 2002 and 2007 this condition was dropped. Instead, loans were granted based on the lenders ability to sell the loan to someone else. Wow! I call that misaligned incentives.

Second, I am reading a delightful book called Traders, Guns and Money. In it Satyajit Daj offers an insider’s look at the complex world of financial derivates. Today I read the simple, self-evident line:

To make money, you need to make it from someone else.

For several years now I have been baffled by the absurd amounts of money being earned in the financial sector. How can it be that these analytical magicians could continue to generate such enormous profits? Where is this money coming from? Today I understand. With $700 billion taxpayer dollars (and some say up to a trillion could be required), the scoundrels of the financial sector were simply taking profits on future payments from the US taxpayers.

Finally, I was moved by Senator Bernie Sanders’ Four Point Plan in his article in the Huffington Post. I particulalry like his fourth point:

We need to protect ourselves from being at the mercy of giant companies that are “too big to fail,” that is, companies who are so large that their failure would cause systemic harm to the economy. We need to assess which companies fall into this category and insist they are broken up. Otherwise, the American taxpayer will continue to be on the financial hook for the risky behavior, the mismanagement, and even the illegal conduct of these companies’ executives.

I couldn’t agree more.