When all this financial crisis stuff first started hitting the headlines I did a post pointing out that, contrary to what you might be reading elsewhere, banks were not actually failing, and things were nowhere near as bad as they were in the Great Depression. That’s because most Western democracies have something like the FDIC that insures the bank deposits of small customers like you and me, and generally sees to an orderly takeover of banks that get into trouble. So while a number of US and British banks have ended up being sold, no one has actually lost their money.
Until now.
The problem, as I mentioned briefly yesterday, is Iceland. The banks there are failing, and there doesn’t appear to be much in the way of a safety net. Why? Mainly because the government of Iceland just doesn’t have enough money to prop up a collection of international banks. This is terrible news for the Icelandic people, but it isn’t much fun for people elsewhere either.
A substantial number of British citizens had money in Icelandic banks. Gordon Brown has promised that individual citizens will be protected, and assets of Icelandic banks in the UK have been seized to help make good that promise. But it turns out that many British governmental bodies banked with Icelandic companies too. My own local council in Somerset has, according to the BBC this lunchtime, some $50m at risk. Transport for London, which runs all of the capital’s public transit, has around $80m at risk. Some of this money may be recoverable, but just how much is not certain.
Note that this was not the result of wild speculation by local councils. It was actually the result of prudent diversification. To make sure that they were not at risk from financial disaster, British councils put their money in a variety of different banks in different countries. So they haven’t lost everything, but even so some may have lost millions.
And here’s where the crisis comes home to roost. Because if that money can’t be recovered it will mean less money for schools, less money for public transit, less money for care for the elderly and so on. There will, I’m afraid, be more of this in the weeks to come. I’m watching California’s already debt-ridden finances with some nervousness. As I said a while back, we are all in this together.
Interestingly, one of the ways Government entities are being screwed in America, is that they were told to diversify into Stocks and bonds and mortgage funny money. After all it was all Well Rated! Sold to them by respected Wall Street companies (now bankrupt!).
Millions of Tax Dollars lost. Money for schools, highways, public transit, hospitals gone. Just when those kinds of projects could help us out of economic hard times, they won’t be happening, because the money was stolen.
But the Wall Street crooks will get $700 billion to rescue their asses.
Mind you, we are told that we can’t spend the money on Government projects as that would increase the deficit. WTF?
Lisa:
The reason local government invested in Wall Street is because it got a better return. It is the same with pension plans. We put our money in them because it grew faster than it did in an ordinary savings account, or under the bed. Whether we liked it or not, that’s the world we lived in, and in many ways were dependent on. It will be interesting to see how society develops in the wake of this, but if we go back so saying we’ll put our money where we get the best return then we’ll end up doing exactly the same things again.
So long as we don’t go back to saying we’ll put our money where we get the best return on the assumption that there’s no such thing as risk.
(What’s that? Why do those investments pay higher returns if there’s no such thing as risk? I can’t hear you, I have my fingers in my years…)
Its not just about risk methinks, but also about mis-classification, because my sense was that the way many of these investment instruments were created was something like taking lots of bits of Grade D meat and mashing them together and adding some special sauce and calling it Grade A . . .
Risk is clearly an issue. Understanding risk is a rather bigger one.
Being an investment banker is a bit like being a professional gambler. You take a lot of risks, but you make money on it a) because you can quantify those risks, b) because you have enough money to keep playing through a losing streak, and c) because you are smarter than the other guys. You hope.
Now part of the trouble with gamblers is that they tend to think too big. You can play poker in a safe casino environment where even if you have a bad night it won’t cost you too much, or you can play poker in a no-limit, high-stakes game where you could win millions, or lose your house. Suppose you were planning to marry a poker player and live off his earnings: would you go for the guy who always plays safe games, or the no-limit, high-stakes guy?
The trouble is that with financial investments you can’t always tell which is which. As David said, the places that give the best returns are generally those with the biggest risk. But not always. In theory we have all sorts of services such as credit rating agencies to tell us where the safe places to invest our money are. In practice those agencies got things badly wrong, either because they didn’t understand what the companies they were rating were up to, or because they naively assumed that certain companies were “too big to fail”.
And finally there are the companies themselves. Do they know how much risk they are taking? Possibly not. They all have mathematical models that are supposed to tell them how stable their finances are, but those models could be wrong, or the company bosses could choose to feed them overly optimistic assumptions, because they don’t like hearing bad news.
The key here is transparency. If we want to have a flourishing investment climate, it must be possible for investors to understand they risks they are taking, and choose to take the level of risk that is comfortable for them.
Speaking as an erstwhile employee of a quasi-public agency, I can assure you that we lost none of our taxpayers’ money because our investment guidelines were too stringent to allow us to do so. When I look at this debacle, I see a systematic corruption that began with Greenspan, in his position as God-touched oracle, persuading the Senate, against the many Cassandras, that derivatives required no regulation. Indeed, that Capitalism was innately self-regulatory. Well, it was a lie. And they killed, many times over, the boy that cried that the Emperor was naked.
G:
I haven’t followed Greenspan’s career very closely, so I can’t talk in detail about his positions. But I do know that when I was teaching people about risk management I had a quote from Greenspan that I used. He was clearly aware of the issues.
I’ve just been reading this speech of his from 1999. One of the argument he makes is that the sort of regulation of financial markets that people were asking for would not do any good because it would be less effective than what the banks were already doing themselves. There are issues here. Unless a regulator is intimately involved in a business, it can’t really know how much risk that business faces. Quite often politicians suggest forms of regulation that do more harm than good, and that’s the case in many industries, not just finance.
But Greenspan was aware that banks were not doing their job well. In that speech he talks about how existing risk models break down during periods of financial crisis. I quote:
He’s actually talking about the Asian financial crisis of the late 1990s here, but what he says is equally true of what we are facing now. I know people ignored me when I lectured them about the need for stress testing. I suspect they ignored Greenspan too. Should they have been forced to do it? Probably. Could we have enforced such regulations effectively? Probably not.
So yeah, we did need regulation, and we will need it in the future, but we have to think very carefully about the sort of regulation we want, otherwise it won’t do any good at all.
Actually, your quotes are the originals of the quotes in the Times article I embedded. But as an accountant, I was there when others raised these issues repeatedly (in the country and aware, not in the room) and when Greenspan and his coterie forced down, through sheer force of influence, the frequently stated, clearly stated, reasons for regulation. GAAP have not been able to deal with derivatives accounting for the same reason: Political quashing of intensely needed legislation. The fact that Alan Greenspan was an early member of Ayn Rand’s circle clearly shows where his views on governmental intervention or regulation lay. Perhaps if anyone had bothered to read Rand, they might have noticed that her view of Capitalism was just as far whacked out as Lenin’s view of Communism.
Sorry- I see it didn’t embed. http://www.nytimes.com/2008/10/09/business/economy/09greenspan.html?em
G:
Well, clearly you were there and I wasn’t, so I bow to your superior experience. I’ve certainly seen that sort of silliness go on elsewhere. And you don’t really need to read Ayn Rand to start worrying – all you have to do is listen to her supporters.
But there’s still an issue as to where we go from here. The Socialists are all very happy and complacent because in their view if the Government is in charge of all of the banks then the banks will never do anything bad. But I don’t actually see that having one big government bank will make the people in charge of it any more risk averse than the people in charge of small, private banks. More to the point, it won’t have a government to regulate it, and it won’t have a government to bail it out if it gets into difficulty.