Draw Breath

Bethany McLean in her landmark article on Enron in 2001:

“Enron is a big black box,” gripes another analyst. Without having access to each and every one of Enron’s contracts and its minute-by-minute activities, there isn’t any way to independently answer critical questions about the company. For instance, many Wall Streeters believe that the current volatility in gas and power markets is boosting Enron’s profits, but there is no way to know for sure. “The ability to develop a somewhat predictable model of this business for the future is mostly an exercise in futility,” wrote Bear Stearns analyst Robert Winters in a recent report. To some observers, Enron resembles a Wall Street firm. Indeed, people commonly refer to the company as “the Goldman Sachs of energy trading.”

Now, Bethany McLean on Goldman Sachs in 2009:

Despite the public financial statements Goldman files every quarter, no outsider can tell how the firm really makes its money. You cannot see into “the black box” of the trading empire. Blankfein says that only about 10 percent of Goldman’s profits come from purely proprietary trades, but there is no way any outsider can confirm that independently.

McLean didn’t know that the black box obscured illegality (if it did) when she wrote about Enron in 2001 and, just as with McLean, I’m not at all, not even in a blogishly snide/oblique way, suggesting that Goldman is engaged in illegal activities. That wasn’t McLean’s point in 2001 (since at that stage no outsiders were aware of the extent of Enron’s problems) and it isn’t her point now. The problem is that financial institutions have come to a point where profits accrue from necessarily – and probably willfully – complicated vehicles. These vehicles, at least during the boom, were designed in part to avoid regulatory oversight.

So here’s the key political battle surrounding moves towards any new ‘macro-prudential’ regulatory regime: how to do global capitalism but in a manner that’s legible to regulators? In other words, the moves towards global regulation will involve regulators demanding that financial knowledge be constructed on their terms, not those of bankers. It doesn’t matter that the black box model involved bankers replacing knowledge with swagger: they will argue that obscurity and complexity are vehicles for efficiency and competitive advantage. In a rational world you’d think that investors would be inclined to perform proper oversight and argue against this outlook but they have historically been very poor at doing this kind of thing. They prefer to reap profits from trading shares and securities when they banks etc do well and litigate when they do badly. So the argument should lean towards ending black boxes. Any bets on regulators winning the argument?

I’m skipping through this paper (h/t Baseline Scenario) this evening (in between finishing more appropriately weekendish books) and am very much enjoying it. Check out the two charts on page 24 if you want to get an insight into what’s gone wrong with global capitalism in the last three decades. Anyway, I love this quote from the intro:

As in the Middle Ages, perceived risks from lending to the state are larger than to some corporations. The price of default insurance is higher for some G7 governments than for McDonalds or the Campbell Soup Company. Yet there is one key difference between the situation today and that in the Middle Ages. Then, the biggest risk to the banks was from the sovereign. Today, perhaps the biggest risk to the sovereign comes from the banks.

I suppose that this article in the Belfast Tele is getting in first where a lot of the week’s papers are going to follow. A good day for the FTSE and good results for the banks might mean the end of the banking crisis.

Not at all.

In the UK this is the end of the credit crunch wave of the banking crisis. The next wave, I’d guess at year’s end, will come when all those newly unemployed people run out of money and default on enormous credit card (also here), mortgage and sundry other debts. In other words, the financial banking crisis may be coming to a close, but the retail banking crisis is yet to kick in.

I’ve spent the last few months combining my time between reading critical theorists on finance and reading financial theorists on finance, both of which I find strangely entertaining and interesting. I have an empty empty life.

Anyway, reading Andrew Leyshon and Nigel Thrift’s ‘The Capitalisation of Almost Everything’ (published in Theory Culture & Society in 2007, but a pdf draft is here) I came across this very interesting point. Leyshon and Thrift are interested in countering arguments that financialised capitalism is pure speculation. Rather, it is connected to predictions about more or less definite income streams (from mortgages, rents, PFI contracts etc), all of which can be bundled up and sold on as what used to be thought of as low-risk bonds.

Part of the article is devoted to Northern Rock and its switch from building society to aggressive mortgage retailer. As with everyone else in the mortgage game in recent years, Northern Rocks’ business model was based on the debt-as-revenue model involving borrowing in the wholesale banking market in order to sell mortgages that could be repackaged and sold on as bonds. Anyway, this is where sponsorship of Newcastle United came in:

The change in the business model of the bank, from marketing for depositors to fund its mortgages, to marketing for investors to buy its securities, was symbolized by Northern Rock’s sponsorship of the English Premier League football club, Newcastle United, which advertises the bank’s logo on the chest of the team’s strip. This sponsorship was designed not to link the organization to the area in which both it and the football team are based, but rather to raise the profile of the bank’s brand in Asia – where Premier League football is keenly followed – because the financial markets of that region are where it sold a large proportion of its securitized mortgage bonds, which are based on the monthly repayments of UK home-owners.

My guess is that this is the start of the next wave in Ireland’s recession. While our woes are partly down to American sub-prime and the new style of global crisis, we also have the classic bust to come. Make no mistake: the demise of construction firms hurts banks.

Cross-posted from the Irish Left Review, perhaps to be read in the light of this not entirely surprising news from P. O’Neill on Irish Election.

"If you owe us £1,000, it’s your problem; if you owe us £1 million, it’s our problem" was how Justice Moriarty described the AIB’s attitude towards lending when he was chairing the tribunal investigating Charlie Haughey’s adventures with AIB.

How right he was. While we read the good news about the American government’s using vast amounts of Chinese money to rescue the global capitalist system from total collapse, we shouldn’t think that takes us all out of the path of disaster.

The Irish are bound to go the same way in 2009 that Spain is going at the moment. Like us, the Spanish have been enjoying an enormous property boom for the last few years. And, as in Ireland, it has just come stuttering to a halt, prompting a massive rescue from the Spanish government as the sector struggles "with high debt, plunging prices and an overhang of unsold houses and flats."

This is where Ireland is headed, but we’re probably going to experience something much worse.

As I pointed out in a comment thread in April 2007 on Slugger (itself following a post from here), construction constituted 23% of the Irish economy at the height of the boom. That was twice the EU average (which was 12%). So property going belly-up is very bad news indeed for us. While we talked up the role of investment and industry in the Celtic Tiger, we forgot that a whole lot of what looked like wealth was actually us sticking increasing amounts of our money into private debt. And if we have £1000 problems, it’s also given the banks £1m-style concerns (for a serious of discussions, see UCD’s Morgan Kelly). 30% of their loans are to property developers who now find that they can’t sell houses.

Ireland’s property development business model has proven very dangerous for the banks. They’ve been caught short in two directions. First, they lent to the developer who was essentially selling off the plans (or as good as), in the certainty of a quick return. Second, they’ve been busily lending increasing amounts to mortgage payers in the knowledge that they could repackage the risks from those high-stakes several-multiples-of-income 100% mortgages and sell it on the credit default swaps (CDS) markets. But these have all gone down the hole. Banks can’t lend on wholesale markets so they can’t borrow to feed the mortgage frenzy. And they can’t offset their risky bets. AND the property developers have no customers so can’t repay their loans. AND the risky mortgage-payers are going to default.

On property developers, with the country strewn with half-finished developments, the banks have a series of unpalatable choices. They can shut indebted developers down and repossess more or less worthless (for now) unfinished properties. Or they can continue to send good money after bad to developers who have no revenue. Neither option is good for the banks but they seem to be letting the small boys go to the wall and are propping the big boys up. The question is: how long can that keep going?

On mortgage debt, the real hike in Irish unemployment is yet to hit. And also, we haven’t yet seen the shakedown from all those people who borrowed to the max when interest rates are low – unless their mortgages are fixed they’re at risk of losing their homes (even if they don’t lose their jobs). In other words, the banks are looking at inheriting a whole load of property that they can’t sell as their debtors go bust.

This was all predicated on a global trend towards treating debt as if it was money. The Irish problem is that we’ve just done it more than most both domestically through the property market and globally through hosting businesses in the IFSC. So our trouble is a hybrid of what we’re seeing from London and what’s going on in Spain. We’re in the worst of both worlds.

No wonder everyone is on the blower to Leinster House. The governmental failures have all happened already and the only option left is a huge dig out. That will be no easy thing, especially as Irish company and income tax revenues plummet in 2009. But it will be the best possible solution in the current circumstances.

Then read this.

If ever people need an incentive to upgrade to firefox (3?) or to Internet Explorer 7, it's the British Banking Code. As LSN news points out (behind LexisNexis's paywall), section 12.11 of the code (here, pdf) tells you, regarding online banking. that "If you act without reasonable care, and this causes losses, you may be responsible for them. (This may apply, for example, if you do not follow section 12.5 or 12.9 or you do not keep to your account’s terms and conditions.)" Amongst other things, section 12.9 says "Keep your PC secure. Use up-to-date anti-virus and spyware software and a personal firewall" and "Treat e-mails you receive from senders claiming to be from your bank or building society with caution."

Apparently this policy has been in the code for a while, although it was updated in April just gone. While no bank seems to have invoked the clauses, you can pretty much bet that they will at some stage. Which will be bad news for the elderly and the ignorant when they discover that, having been pushed out of branches to save the banks money, they are also responsible for the security of the banks' alternative offerings.

While I of course recommend ditching dodgy Windows for altogether better operating systems, and while I find it perplexing that I still get hits from people using IE6 and IE5, I do think we ought to be sympathetic with people who simply don't know how the software on their machines works and who don't read the latest missives on internet security. If fraud does become sufficiently problematic as to make banks consider invoking the responsibility clause, there's an easy solution: publicly acknowledge that the internet, Windows-style, is not an appropriate venue for financial transactions and take steps to encourage people back into branches. In other words: the banks should just swallow whatever is the cheaper alternative.

The San Francisco Chronicle has a depressing piece on the proposed solution to the sub-prime crisis. It makes a gloomy companion piece to this article from the FT in August, outlining the various frauds (criminal and not) surrounding this shoddy saga.

Unlike the Enron debacle, if this one shakes out into a full-blown crisis (as it well might), there'll be no getting away from systematic failures of surveillance, governance and the like. Or to mix a couple of metaphors, when there are more bad apples than good, you start thinking that something's wrong with the basket (hat tip to Meditations71 for passing on the SF Chronicle article).

I'm making my way through a few books at the moment and have just finished Neil Collins's The Great Irish Bank Robbery, on Allied Irish Banks and the DIRT tax. The book is one of those marvellous journalistic pieces: an easy rolicking read covering the events and (primarily) personalities behind a scandal without bothering the reader with much in the way of analysis. Given this, I don't think I'm with Shane Ross in calling the book a 'humdinger.' Still, the book does reveal the complete breakdown of governance in Allied Irish Banks throughout the late 1980s and 1990s as ambition overtook the willingness to address scandal after scandal after scandal.

While many journalists can do analysis (Andrew Marr's History of Modern Britain, is one example), Collins is more concerned with the good story. Nothing wrong with that. In fact, given the hints of analysis he does include, it's probably a good thing that Collins doesn't burden the reader with more. He doesn't seem to make up his mind whether large-scale tax evasion in Ireland was down to a 'culture of greed' or already-punitive tax rates plus instability caused by various factors including the fact that "socialists in the Labour Party were intent on a wealth tax." Perhaps he thinks it was both. I'm not sure that we find out. Either way, Irish culture is not uniquely greedy¹ and neither did people with real power need the assistance of those who barely had a say to destroy the economy.

The real questions that ought to be asked are not 'why did so many people seek to evade tax?' and 'why did the banks collude with them?' The real problem was more systematic: why was a system established that allowed tax evasion to occur on such a large scale? I suspect that the Irish version of what Michael Moran describes as 'club government' came into play, with a senior oligarchy stretching across government, business and the civil service, all colluding in creating a tax collection system that could not work. Business people did not want profits reduced, politicians didn't want trouble from these clients and from client-constituents and civil servants (the least culpible to my mind) didn't speak out.

In the end, the PAYE sector paid high taxes while, as it transpires, a vast number of people illegally paid no taxes at all. The most depressing thing is that the cabal that colluded in this, at best through their inaction, are still running the show, even if the infrastructure of state underwent some minimal modernisation (such as the establishment of the IAASA as suggested by the post-DIRT Review Group on Auditing).

Despite its strange, if thankfully infrequent, quasi-analysis and despite its reading like a 250 page Indo analysis article (at least you won't have your head turned by many polysyllabic words), Collins's book is still worth the effort. It's a bit of a shock to see how corporate governance can break down so fundamentally, especially when actions are facilitated by a clientalist state. It's also depressing to realise that the DIRT scandal was the first of many. The specific problem was fixed but we all know that few if any of the fundamental problems Collins hints at have been taken seriously by Ireland's ruling classes.

1 For instance, why did so many Americans engage in large-scale fraud in the run-up to the sub-prime crisis? It was not because they were culturally disposed. Rather, it was because collusion from the banks combined with weak anti-fraud enforcement mechanisms meant that they could (back).