Monday, April 26, 2010

E-Mails, Investment Banking, and the Rating Agencies

Thank goodness for emails! Now we know what was really going on at Goldman Sachs and Moody’s and Standard & Poor’s. How about Congress including in their bill on financial reform the requirement that all financial institutions and rating agencies and all other organizations having to do with finance (say the Federal Reserve and the Treasury and Fannie Mae and Freddie Mac…and Congress…and the White House) release all of their e-mails a week after they were written.

This would really provide the financial markets with transparency!

The thing that strikes me so much about the release of these e-mails over the past week or so is their humanity. These Wall Street villains talk like human beings, like you and me.

Gillian Tett, in my mind, has a terrific opinion piece in the Financial Times this morning titled “E-Mails throw light on murky world of credit” ( Her reflection on the e-mails is captured in the following sentence: “It is fascinating, almost touching, stuff.”

But, even more important she states that “Reading these e-mails with the benefit of hindsight, there is little suggestion that rating officials were engaged in any deliberate malfeasance. Many appear conscientious and hard-working.” These people are just human beings trying to do their job.

The same can be said of those people that wrote the e-mails at Goldman. This is captured in an article by Kate Kelly in the Wall Street Journal titled “Goldman’s Take-No-Prisoners Attitude” (
Kelly speaks of a world, which Tett describes as “so detached and rarefied”, in which betting applied to almost anything. The scene she presents in her article is one in which mortgage traders from Goldman Sachs “cast bets on a White Castle hamburger-eating contest” in December 2007. (Note that the problems in the subprime mortgage market were so severe at this time that the Federal Reserve announced the creation of a Term Auction Facility (TAF) on December 12, 2007 with the first auction being held on December 17, 2007.)

This behavior, Kelly reminisces, “resembled a scene out of ‘Liar’s Poker,’ a book (by Michael Lewis of the book ‘The Big Short’) depicting bawdy antics of (mortgage) bond traders at Salomon Brothers in the 1980s.” She argues that “It was a lower-stakes version of what went on ever day in the group: aggressive, take-no-prisoners trading.”

To Kelly, the world apparently didn’t change much between the 1980s and the 2000s!

Tett draws some conclusions from the picture present in the e-mails. She writes “by 2007 they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control. Their world was also a strange, geeky silo, into which few non-bankers ever peered.”

And, Tett goes on, “Indeed, this world was so detached and rarefied it is, perhaps, little wonder that S&P struggled to deal with the press, or that Goldman traders felt free to celebrate the mortgage market collapse.”

“Few expected external scrutiny or imagined their e-mails would ever be read.” They were just being human.

But, something was wrong! Something bigger than the traders or the raters had taken control and was driving the system.

And, this leads Tett to the first of two lessons she draws from the information in the e-mails: “what went wrong in finance was fundamentally structural, as an entire system spun out of control! It might seem tempting to lash out at a few colorful traders but that is a sideshow…”

She concludes: “what is needed is systemic reform that removes conflicts of interest.”

This is the only point on which I disagree with her. To me this whole “spinning out of control” was a result of the credit inflation that had been prevalent in the financial system for the past fifty years or so. The whole effort to inflate the American economy had resulted in the excessive creation of credit during this time period, the almost fanatical drive toward financial innovation (led by the federal government), and the assumption of more and more risk by the private sector in a search to sustain its returns.

The reference to the book “Liar’s Poker” is particularly relevant because the main story in that book is about the trading going on in mortgage-backed securities, something that did not exist until the early 1970s when the federal government created the instrument. Please note that the first mortgage-backed security was issued by the Government National Mortgage Association (Ginny Mae) in 1970. Before then mortgage-related issues were not traded on capital markets. By the time of the writing of “Liar’s Poker”, government-related mortgage-backed securities had become the largest component of capital markets.

As I have stated many times, the purchasing power of the United States dollar declined by roughly 85% between January 1961 and the present time. Although consumer price inflation was kept relatively low over the past decade or so, credit inflation permeated the asset markets as bubbles appeared in stocks and housing. House prices got so out of line with rental prices during this time that the collapse of the housing bubble became inevitable.

So, I agree with Tett in her statement that “what went wrong in finance was fundamentally structural, as an entire system spun out of control!”

But, human beings acted like human beings during this time. Again, to quote Tett: “they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control.”

And, as Chuck Prince, former CEO of Citigroup, called it: as long as the music is playing, people must keep on dancing. This doesn’t excuse them, but it puts, I think, the behavior in perspective. This was not the well-thought-out plot of evil people.

Lesson: inflation creates incentives that can get out of hand. If the government wants to conduct economic policies with an inflationary bias then they must deal with the consequences at a later time.

I do agree with Tett on her second lesson learned: “the whole murky credit business must be taken out of the shadows. So few people spotted that finance was spinning out of control because the financial system was so separated into silos that its practitioners lost any common sense.”

Tett “welcomes the publication of these emails” but warns us to “keep braced for the next installment.” She “suspects that US regulators and politicians have not finished publishing all those damning e-mails yet.” I look forward to these revelations, as well.