AND THE ENTIRE MACHINE WAS DESIGNED TO DISGUISE THE RISK:

What do we want from Wall Street? (Spengler , 11/08/11, Asia Times)

In some ways, the 2008 financial collapse was Enron writ large. The ratings agencies - Moody's, Standard and Poor's, and Fitch - agreed that it was inconceivable that more than a third of a pool of subprime mortgages could default. If the banks got one group of investors to accept the first 35% of losses on the pool, the ratings agencies would label the rest of the pool default-proof, and give it a triple-A rating.

The banks then went to the Federal Reserve and asked permission to increase leverage on what the ratings agencies called ultra-safe securities. Normally banks can hold about $12 of loans or securities for every $1 of their own money, but the Fed allowed them to own $70 of the phony subprime triple-A's for every $1 of shareholders' capital. Some of those bonds are now trading at 33 cents on the dollar.

That's one reason the banks had massive losses, but not the only one. Banks (and insurance companies) were writing huge amounts of guarantees on phony triple-A-rated debt, generating up-front fee income in return for turning the banks' balance sheet into a toxic waste dump.

By the time that Lehman Brothers went under in September 2008, there is no way that its chairman, Dick Fuld, could have calculated the volume of losses for which his bank was on the hook. Every derivatives and structuring desk was taking in all the fees and back-loading all the risk it could, telling the risk managers as little as possible. [...]

The root of the problem, I believe, lies in the measurement of risk. The incentive to cheat always will be there as long as bankers can represent a sow's ear as a silk purse. Both managers as well as the public need to measure risk, such that they understand the way that investments or innovations add to or reduce risk.

Some popular finance writers insist that risks are inherently impossible to measure, because conventional risk models based on the normal distribution of returns don't assign enough weight to the likelihood of extreme outcomes. In fact, the point of risk models is to estimate the likelihood of an extreme outcome, and the banks have reasonably good models of borrower defaults which do just that.

Posted by oj at November 8, 2011 6:14 AM
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