Friday, December 18, 2009

Paul Volcker On Financial Innovation

Earlier this week, the Wall Street Journal published a special section entitled "Fixing Global Finance." Apparently, the paper recently hosted a conference involving various senior executives of financial institutions, regulators, et. al.

Skimming through the section, I found nothing particularly interesting, other than Paul Volcker's remarks. Everyone else was either one of many unimpressive, unimaginative executives at a cookie-cutter made global financial institution, or hailed from a damaged one.

But Volcker was much different, as usual.

According to Alan Murray's written piece recounting Volcker's comments, he began,

"Well, you are not going to be very happy with my response. I heard an awful lot of particulars here that I agree with to some degree, but my overall impression is that you have not come anywhere near close enough to responding with necessary vigor or structural changes to the crisis that we have had.

I hear about these wonderful innovations in the financial markets, and they sure as hell need a lot of innovation. I can tell you of two—credit-default swaps and collateralized debt obligations—which took us right to the brink of disaster. Were they wonderful innovations that we want to create more of?

You want boards of directors to be informed about all of these innovative new products and to understand them, but I do not know what boards of directors you are talking about. I have been on boards of directors, and the chance that they are going to understand these products that you are dishing out, or that you are going to want to explain it to them, quite frankly, is nil.

I mean: Wake up, gentlemen. I can only say that your response is inadequate. I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy, just one shred of information. I am getting a bit wound up here."

Volcker waggishly announced that, in his opinion, the finest example of financial innovation in the past 20 years, more mechanical than financial, really, was the ATM.

But Volcker's correct. While extending the availability of consumer credit via cards and somewhat more flexible mortgages has been productive, the more esoteric financial engineering products have created more problems than they probably solved. And certainly not contributed to smooth, healthy economic growth.

To provide more conclusive evidence, Volcker reportedly then confided,

"A few years ago I happened to be at a conference of business people, not financial people, and I was making a presentation. The conference was being addressed by a very vigorous young investment banker from London who was explaining to all these older executives how their companies would be dust if they did not realize the joys of financial innovation and financial engineering, and that they had better get with it.

I was listening to this, and I found myself sitting next to one of the inventors of financial engineering. I didn't know him, but I knew who he was and that he had won a Nobel Prize, and I nudged him and asked what all the financial engineering does for the economy and what it does for productivity.

Much to my surprise, he leaned over and whispered in my ear that it does nothing—and this was from a leader in the world of financial engineering. I asked him what it did do, and he said that it moves around the rents in the financial system—and besides, it's a lot of intellectual fun."

The man to whom Volcker refers is almost certainly either Myron Scholes or Robert Merton, both of Long Term Capital Management infamy. It's a very telling tale, knowing this. The sort of comment which those who have always suspected financiers of being careless with the systemic impacts of their risk-related activities find confirming the worst of those suspicions.

Volcker continued,

" I am not sure that I said innovation in itself is a bad thing. I said that I have found very little evidence that vast amounts of innovation in financial markets in recent years have had a visible effect on the productivity of the economy. Maybe you can show me that I am wrong. All I know is that the economy was rising very nicely in the 1950s and 1960s without all of these innovations. Indeed, it was quite good in the 1980s without credit-default swaps and without securitization and without CDOs.

I do not know if something happened that suddenly made these innovations essential for growth. In fact, we had greater speed of growth and particularly did not put the whole economy at risk of collapse. That is the main concern that I think we all need to have.

If it is really true that the world economy was on the brink of a great depression that was greatly complicated by financial problems, then we have a rather basic problem that calls for our best thinking, and structural innovation if necessary. I do not want to stop you all from innovating, but do it within a structure that will not put the entire world economy at risk."

I like and agree with Volcker's point that productive, useful innovation is fine. But reckless innovation for the sheer sake of bolstering profit margins, which is actually the genesis of most of the more damaging so-called innovations, is not.

Consider, for example, if, instead of CDOs, financial service firms had created exchanges for trading whole mortgage loans. Instead of being forced to buy packages of loans of varying quality, an investor could diversify risk geographically, or otherwise, himself. Risks would be managed via collateral requirements for the exchange members, so the sort of daisy-chain defaults that so worry investors today would be non-existent.

Further, Volcker implies something I also believe, which is that credit derivatives add no value. Probably because he, too, realizes that they can't remove risk, only transfer it. At a cost.

Volcker then addressed what he feels would work,

"First, let us agree that we have a problem with moral hazard. I do not think that there is any perfect answer in dealing with it, but I would suggest that we can approach an answer by recognizing that elements of finance have always been risky and that's certainly true of the commercial-banking system.

I think we need the commercial banking system for more than automatic teller machines. Commercial banks are still at the heart of the system.

In a crisis, everybody runs back to the commercial banks. They, after all, run the payment system. We cannot have this global economy without commercial banks operating an efficient payment system globally as well as nationally. They provide a depository outlet for individuals and businesses, and they are still big credit providers for small and medium-size businesses, but they backstop most of the big borrowers as well. The commercial-paper market is totally dependent on the commercial banking market. They are an essential financial institution that has historically been protected. It has been protected on one side and regulated on the other side.

I think that it is extraneous to that function that they do hedge funds, equity funds and that they trade in commodities and securities, and a lot of other stuff, which is secondary in terms of direct responsibilities for lenders, borrowers, depositors and all the rest.

There is nothing wrong with any of those activities, but let you nonbank people do it and you can provide fluidity in markets and flexibility. If you fail, you're going to fail, and I am not going to help you, and your stockholders are going to be gone, and your creditors will be at risk, and that is the way that it should be.

How can I be so blithe about making that statement? We need a new institutional arrangement which I believe has a lot of support. We need a resolution facility. What can that resolution facility do? If one of you fails and has systemic risk, then it steps in, takes you over and either liquidates or merges you, but it does not save you. That ought to be a kind of iron cross."

This squares with my own, and my friend B's views. B predicted the evolution to these sorts of Glass-Steagal banks, as a few national banks morphed into today's Chase, Citi and BofA. He noted, as has Volcker, but over ten years ago, that such large deposit gatherers and lenders would need to be restricted from risking that capital in trading, underwriting or other investment banking activities.

The solution we need isn't more complex regulation, so much as a reasoned return to a past regulation, and better, permanent severing of the riskier finance activities from the federally-insured, mainstays of deposit-taking and basic consumer and commercial lending.

Thursday, December 17, 2009

Before The Fed: JP Morgan & The Panic of 1907- Risk & Government Intervention, Part 2

On Monday, I wrote this post, the first of the series focusing on poor financial sector risk management and government intervention.

Recently, I've been reading about JP Morgan's role as the orchestrator of a resolution of the Panic of 1907.

This website discusses some of the details of that Panic. The author, Fred Foldvary, teaches economics at the University of Santa Clara. Written in May of 2007, well before the first shot of the 2008 financial crisis, which was the failure of two Bear Stearns funds which invested in CDOs.

Salient passages from his piece on the Panic of 1907 include,

"One hundred years ago, there was a financial panic in the United States. There were runs on the banks as depositors rushed to take out their money before they ran out of currency. The stock market dropped to half its peak 1906 average.

The financial crisis began in New York City, home of most of the financial “trust” companies. The panic induced Congress to create the Federal Reserve System (the “Fed”) in 1913 to prevent any more such financial crises. But the Fed failed to prevent the even worse bank failures of the Great Depression.

The fundamental causes of the Panic of 1907 were the flawed monetary and fiscal systems of the United States. The federal government’s control of the money during and after the Civil War created a rigid money supply that did not respond to the demand for money. During that era, agriculture dominated the economy, and the inflexible money supply created a crunch and a spike up in interest rates whenever farmers and others need to borrow funds.

Federal taxes fell mostly on the sale of goods, with high tariffs and excise taxes on goods. The great expansion of state-subsidized infrastructure such as canals, railroads, and highways, along with other government services, pumped up land values, subsidizing land ownership. Economic booms were accompanied with land speculation as land values rose, and the speculation was financed with borrowed money. Real estate was a major asset of companies such as the railroads, whose shares rose in value as real estate prices escalated, and speculators also borrowed to buy the shares of stock. The stock market bubble rested on the real estate bubble, and then high interest rates and high real estate prices dried up investment, causing a recession and fall in stock market shares, resulting in bank failures as loans turned bad. Depositors would then panic and rush to take out their money.

The same story happened again and again, but after 18 years, new speculators had no experience with the previous panic, and older investors kept hoping to recover past losses and make a killing before the crash. The establishment of the Fed did create a more flexible money supply, as the Fed can expand the money without limit. Federal deposit insurance, starting in 1933, ended bank panics, but this only shifted the financial risks to the government and thus to taxpayers and bond owners. The fundamental policy of federal control of the money remained, and the fiscal system of taxing production while subsidizing land value also has remained.

The Panic of 1907 shook confidence in the U.S. financial system, but the people and the government officials learned the wrong lessons. The problem with the banking system was the federal control of the money supply, and the effective remedy would have been free market banking, where the banks and other private firms would issue private currency backed by gold. With competitive banking, the private bank notes and deposited funds would expand flexibly in accord with the demand for money and borrowing, while the redemption into gold would prevent inflation. That is how the Scottish free banking system worked previously. But instead, Congress moved towards greater federal control of money and banking, a policy which failed to prevent the Great Depression and which led to the continuous inflation since World War II and also to more recessions.

The effective policy to end panics and depressions is free banking and land-value tappation, the tapping of land value and rent for public revenue, which would prevent speculative excess. The institutional details are different today than one hundred years ago, but the fundamental structural causes of depression have not changed. The current real estate boom has peaked out, and with much of financial collateral based on real estate loans, the economy is headed towards the same end, a crash. This time, rather than a panic focused on financial institutions, federal policies have spread the risk to the entire economy, so the next crash will be much worse than the brief panic of 1907, and this time, a clique of bankers will not save us."

Foldvary points out that the creation of the Fed didn't remove any risk from the US financial system. It simply allowed the federal government to occasionally shift risk from the private sector to all taxpayers.

Again, we see how risk is conserved, never eliminated, when assets are simply sold or insured.

Further, I think it's noteworthy that Morgan's role as the ramrod among fellow financiers resulted in both contribution of capital by all parties, as well as the elimination of some banking houses. Foldvary doesn't provide details, but other sources you can Google on the subject do.

Here are the points I wish to make.

In the Panic of 1907, informed participants in the financial markets moved to clean up the mess. Being involved in the business, they had intimate knowledge of who should fail, what should be shored up, and how much money it would take. Their realization that further delay or failure to resolve the crisis might cause all of them more losses motivated them to resolution in the most efficient manner they could devise.

Somehow, without a Fed, printing more money, quantitative easing, or the federal government buying mortgages, the US and its economy managed to survive and prosper.

In 2008, just over one hundred years later, with a functioning Fed, the crisis that actually began in mid-2007 still isn't over. The Fed still has enormous amounts of private financial instruments on its balance sheet. It has printed billions of dollars, though for exactly what, has yet to be explained.

Rather than guide weak financial institutions to failure, the Fed and Treasury intervened to prop up failed banking managements and models. As a result, many inept management teams continue to populate the financial sector.

Additionally, despite 100 years of government oversight of the financial sector, the creation of the Fed, hundreds of rules and many regulatory agencies, the very same causes of financial panic which humans created in 1907 reappeared in 2007-08.

Does this not point out the futility of regulation which claims to reassure and insure the public against their own, innate behaviors? And didn't this regulation basically fail to avoid the same sort of crisis which occurred a century ago?

Rather than heavy-up regulatory oversight and further complicate operations of the financial sector, maybe it's time we admitted that natural human behaviors in a free society will lead to occasional panics. Central banks can't eliminate them. And the financial risks created on the way to panics can't be magically eliminated by a federal government or central bank, either.

Perhaps the best we can do is to magnify the penalties of excessive risk taking by making institutional failure the clear outcome. After setting margin requirements for loans and leverage, I think the best government can do is to oversee those simple safeguards, then get out of the way, and let those who imprudently take risks suffer the consequences.

That includes those who unwisely choose counterparties which fail, e.g., Goldman Sachs. Or banks which overpay for mortgage finance companies, e.g., Wachovia and BofA. Or mismanaged behemoths, e.g., Citigroup.

Our financial system survived prior panics in which the weak and inept were not saved. Why would it be any different today?

Santelli vs. Liesman On Inflation On CNBC

On Tuesday morning, CNBC's Chicago-based Rick Santelli administered yet another verbal spanking to the networks senior economic idiot, Steve Liesman.

The video of the exchange appears below. The verbal sparring begins at 4:20, with Santelli finally losing patience at 5:18.

Wednesday, December 16, 2009

Deficits Don't Matter- Unless They Do

I just saw former Fed Vice-Chair Larry Meyer on CNBC expounding on coming inflation. Or, rather, the lack of it.

Meyer uttered a dictum which I admit to believing. It was popular during the last eight years, during Bush's administration. The argumentative phrase is,

"Deficits don't matter."

Meyer conditioned it with the observation that there is no evidence that deficit levels are related to inflation rates.

As I noted, when it was uttered in the past decade, I concurred.

But I have begun to reflect more seriously recently on how models fail. Most economic and other behavioral models fail in times of extreme conditions and values.

My roots in quantitative work run to consumer choice modeling and statistical analysis of marketing data. Among a variety of quantitative models which were developed by the 1970s to explain or predict consumer choices between products were a class known technically as "disjunctive additive" models.

Rather than summing all terms to produce a score which was associated with some choice, these models contained thresholds which, when exceeded, caused different values to be returned.

These models weren't universally employed, in part due to the challenge of parameter estimation and, in part, due to the programming difficulties in software of the time.

But the salient point which I took away is the understanding that real human behavior is not linear over all values of relevant variables. At certain levels of environmental or model variables, behaviors change in non-linear fashion.

I'm now thinking that, throughout the past 80 years, Larry Meyer has been correct. The macro variables surrounding the US national debt and deficits- global conflict, existence of a powerful communist superpower, trading partners recovering from WWII devastation, lack of large pools of savings in other economic centers, a dynamically-growing, little-regulated US economy with sane social spending policies- were conducive to buyers of Treasuries calmly investing in said instruments.

However, it would seem that the US economy, monetary and social spending policies may now be causing the general assumptions and environments which existed in the past, which sustained Meyer's comment, to be violated. Regarding US deficits, the behavior of global investors with respect to US debt and dollars may even now be exceeding some threshold which will cause non-linear, changed behaviors with respect to their desire to hold US financial obligations, and the returns they will now demand for holding them.

Of course there is no direct, simple relationship between an annual US government budget deficit and the consumer price index, per se.

But, in extreme conditions, there probably will be. How?

Consider this transmission effect.

When total US spending grows to some very large level, necessitating either higher taxes, debt issuance, or, as I read yesterday in Von Mises' book, The Theory of Money and Credit, "the printing of notes," and there are no higher taxes, but increased debt issuance and printing of notes, then investors in Treasuries and holders of dollars will begin to observe the stealthy depreciation of their assets' values.

To Von Mises, this is inflation. It's the antecedent of Milton Friedman's historic statement,

"Inflation is always and everywhere a monetary phenomenon."

When investors in US Treasuries and/or dollars see more dollar obligations being created than value in dollars in the short term, they will demand higher rates, if they choose to hold Treasuries at all. They may even decline to bid on Treasuries at auctions and, then, when they do, demand higher rates to hold them.

Thus, government "crowding out" of private spending with government spending and/or borrowing, can create investor demands for higher rates on Treasuries, which will drive effective interest rates up for the US government.

As the effective value of dollars fall, with higher rates, prices of commodities and products bought with dollars, now having less value, will necessarily, in dollar terms, appear to rise.

That's inflation.

I think the current period is actually different than those prior periods underpinning the research on which Meyer relies for the validity of his observation.

Eighty years of nearly-constant explicit US government deficits, not counting the hidden unfunded social obligations of Social Security, Medicare, Medicaid and various state and local government employee pensions, seem to have delivered the US to a point at which deficits may now finally matter for inflation prospects.

GE CEO Jeff Immelt's 8 Year "On The Job Training"

Yesterday's Wall Street Journal reported on GE CEO Jeff Immelt's recent remarks on his management of the firm for the past 8+ years.

Here's one of Boss Immelt's gems,

"I should have done more to anticipate the radical changes that occurred."

For perspective, here's Forbes' view of Immelt's total compensation as GE CEO. For five years, which is only slightly more than half of his reign, it's over $72MM.

Now, Jeff hasn't said he'd return any of that compensation. Pay that, by Forbes' analysis, is roughly twice the median for comparable conglomerates.

The Journal piece provides some details,

"Those changes include big losses and asset write-downs at GE's giant finance unit, GE Capital, forcing Mr. Immelt to back-track on promises to shareholders. In February, GE reduced its dividend 68%, the first such cut since 1938. A month later, the company lost its coveted Triple-A credit rating, which it had maintained since 1967."

With those sorts of changes, you'd think Immelt would show some humility, beyond his comment, that he is "humbler and hungrier," and give some of his unjustified compensation back to his shareholders.

The article goes on to note,

"For his part, Mr. Immelt says he has changed his management style in response to the crisis and recession. Two Saturdays a month, he meets one on one with one of his 25 top executives. He is pushing more decisions-making to lower organizational levels. And the one-time applied-math major is now more comfortable with ambiguity."

Perhaps this is Immelt's way of sharing his owners' pain? You know, they have ambiguity with respect to how bad each year's performance at GE will be, and, now, Immelt has agreed to be similarly ambiguous about telling them how bad he thinks it will be.
As the nearby price chart of GE and the S&P500 Index clearly shows, from late 2001, Immelt has mismanaged GE's shareholder wealth such that the added wealth earned by holding GE equity since 1962 was totally erased by last year. By simply noting the slope of the lines for GE and the S&P from late 2001, when Immelt became GE's CEO, to now, it's clear Immelt has destroyed far more value for GE shareholders than the S&P sustained during the same period.

The Journal piece says Immelt has laid off 30,000 employees and trimmed expenses for the annual executive retreat.

But Jeff isn't giving back any money that he's looted from GE shareholders since September, 2001, when he replaced Jack Welch as CEO.

Tuesday, December 15, 2009

Jim Paulsen On CNBC This Morning

Wells Capital Management chief investment officer Jim Paulsen, PhD., was a guest host on CNBC this morning.

When asked about his take on the recession and recovery, Paulsen launched into a spectacularly sunny diatribe about how great the recovery has been. True, his math was a little vague.

For example, he noted the absolute difference between the -6.4% GDP growth in the worst recent quarter and the most recent +2.4% (these may be off by a few tenths of percents), proclaiming that a really great recovery.

Most economists with whom I'm familiar typically compare trough-peak measures to other peak-trough measures.

Not Paulsen.

No, he just marvels at how the trough is negative, the new recent value is positive, so, wow, things are great!

I wondered how he could be getting away with this, because the program's supposed foil for Paulsen was, in fact, another shill.

He's a 'chief equities strategist' at an investment bank. And he agreed with everything Paulsen said.

Then it hit me.....

These guys are on the program to talk their firms' books. You know, talk up viewer interest in equities which, as it happens, both guys' institutions hold. And, in the foil's case, also broker.

You can't say enough about how generous CNBC is to its guests.

Have an equity you hold and want to pump? Why, get on CNBC and be interviewed by Maria Bartiromo. Like Lee Cooperman did for Home Depot almost exactly three years ago.

So what we saw this morning was Paulsen's rather unusual depiction of a hearty, healthy, robust US economy which he confidently predicted would grow normally and fast, just like it has in "every other" recovery. No details. No mention of jobless recoveries which have been the norm since 1982.

Rather, Paulsen wanted to give the clear and strong impression that it's now full speed ahead for equities. Get in there behind Wells' book and make Paulsen proud....and a lot of money, too, by the way.

ATT Wireless, Network Management & Capacity, & the iPhone

Recently, I wrote this post regarding the general nature of ineffectual management at the old ATT and, for that matter, the bulk of its old-style telephony competitors, now the surviving Bell System companies Verizon and (new) ATT (old SBC).

One of the passages I wrote reflected my overall sense of the type of managerial skills and qualities bred by the old telephony companies,

"In all of this, however, there loomed large a business and financial fact. Old-style circuit-switched telephony depended upon regulatory tariffs. These were set, as with most utilities, like power companies, based upon assets.

In effect, those portions of your telephone service which were subject to regulation were priced to provide the telephone company a target rate of return on assets. That's why the old Western Electric built gold-plated, everlasting switchgear. That's why the telephone companies capitalized unbelievably large amounts of labor to install said switchgear as asset value.

In 1983, the average line management talent of ATT was basically involved in internal allocation fights, regulatory affairs management, and some small but ineffective amount of competitive activity. The truth was that what ATT and its units did was take a regulatory-provided pot of money and divide it up, using somewhat initially arbitrary, but thereafter consistent rules, among the various operating companies, Long Lines and Western Electric. From that pot of gold, funding for Bell Laboratories was also provided.

My point in relating this history is to provide some background for the world of then-middle and -senior ATT and operating company management. Folks like, well, Ed Whitacre. And some of my former colleagues who hung in at ATT and gradually moved up the ranks amidst the ongoing confusion as the newly-deregulated firm went through amazing changes."

Now comes word from ATT that they are seeking ways to incent iPhone customers to actually use their phones less for data and various other bandwidth-hogging applications.

This spoof, one of the "fake Steve Jobs" series, sent to me by a colleague, couldn't be more topical, nor accurate.

Of all the passages in the piece, perhaps these two best distills the point of "Jobs' " rant,

"So let’s talk traffic. We’ve got people who love this goddamn phone so much that they’re living on it. Yes, that’s crushing your network. Yes, 3% of your users are taking up 40% of your bandwidth. You see this as a bad thing. It’s not. It’s a good thing. It’s a blessing. It’s an indication that people love what we’re doing, which means you now have a reason to go out and double or triple or quadruple your damn network capacity. Jesus! I can’t believe I’m explaining this to you. You’re in the business of selling bandwidth. That pipe is what you sell. Right now what the market is telling you is that you can sell even more! Lots more! Good Lord. The world is changing, and you’re right in the sweet spot.

And now here we are. Right here in your own backyard, an American company creates a brilliant phone, and that company hands it to you, and gives you an exclusive deal to carry it — and all you guys can do is complain about how much people want to use it. You, Randall Stephenson, and your lazy stupid company — you are the problem. You are what’s wrong with this country."

But ATT can't really seem to shake that old regulatory mindset. Yes, they sell bandwidth. But it's not like they're going to actually raise capital to build a lot more cellular towers and figure out how to increase wireless network capacity.

No, they're happy with the old 'busy hour' mindset. The mindset that equates busy signals with a contentedly fully-used network. Why overbuild?

It is ludicrous to see a vendor mis-price a service, then, when stimulating demand, react by trying to cut usage, when the demand is habit-forming. If ATT were really intelligent, they'd address pricing with subsequent contracts, but, in the meantime, build out or lease capacity to satisfy demand and retain all those iPhone customers.

But I think that's like asking a leopard to change its spots. This is, after all, a unit of a telephone company.

Not some cutting-edge technology services firm.

No, it's only ATT.

Monday, December 14, 2009

On Conservation of Risk, Poor Risk Management & Government Intervention- Part 1

Over the weekend, I had an extensive discussion with my business partner on the topics of financial risk, Goldman Sachs, AIG, and the federal government and Federal Reserve's payment of AIG's credit derivatives obligations amidst its takeover of the insurer.

The reason for our renewed discussion was a Wall Street Journal piece over the weekend which cited several new sources that again called into question Goldman's management's assertions, which continue to this day, that it was adequately hedged and in possession of sufficient collateral, which would not have lost value, such that they were really indifferent to AIG's survival or bankruptcy.

The Journal's own staffers, the TARP's inspector general, and a private risk analyst from Chicago, retained by CBS to review and comment on an internal AIG memo, all have disputed Goldman's assertions.

The details contained in the Journal's weekend story, entitled "Goldman Fueled AIG Gambles," were somewhat shocking. At least, to me.

The investment bank, according to the Journal piece, was ultimately repaid for "trades with AIG covering a total of $22 billion in assets."

Elsewhere in the article, it is stated that Goldman intermediated $14B of CDO deals, to Merrill's $6B, and that AIG ultimately insured some $80B of CDOs with credit derivatives.

As my partner and I talked about Goldman's strong-arming of the Fed and Treasury to repay 100% of AIG's credit derivatives obligations, despite being effectively, but, thanks to government intervention, not technically bankrupt, he contended that one should credit Goldman for its cleverness and alacrity.

I disagreed, and continue to do so. Here's why.

First, Goldman's insistence on being repaid in full, rather than accept an AIG bankruptcy, and, indeed, argue for it, has fatally undermined the Constitutionally-enshrined, normal bankruptcy process. I believe the unintended consequences of this act will reverberate globally, to the ultimate detriment of faith in the US dollar and Treasury obligations.

Second, given that the preponderance of evidence points to Goldman now misrepresenting how vulnerable it was to bankruptcy from the losses it would have taken on its AIG transactions, it doesn't actually appear to be the same Goldman Sachs of, say, John Whitehead's reign as CEO.

In fact, the AIG debacle exposes Goldman for being just another financial services firm which mismanaged risk to a degree that should have caused its failure. A failure that is vital to terminating the control of assets by inept management.

True, Goldman Sachs weathered 2007 and part of 2008 by betting against the residential finance boom. But, in the end, it was undone by the simplest of risk management mistakes.

Goldman Sachs' management forgot that, until an actual financial loss, total risk in the financial system cannot be eliminated. It is conserved, and transferred via transactions such as credit derivatives.

But that does not eliminate it from the financial system. In fact, to the contrary, due to a hoary technical term known as "counterparty risk," a firm can sell its risk to another party, perhaps even at what seems to be an attractive price, only to find, later, it still owns the risk, when the counterparty fails.

Thus, when you examine the details of AIG's CDO credit derivatives book, you see that Goldman was in for about 25% of it.

Further, according to the Journal article, Goldman was securitizing mortgage pools that were no better in quality than others. They contained subprime mortgages, loans from Countrywide, known for pioneering low- and no-doc loans. In effect, Goldman's brand, in this case, carried no actual expectation of higher quality mortgages.

Nothing that Goldman did involving its underwriting of CDOs or trading credit derivatives on them with the intent of transferring the risk to AIG would seem to actually connote superior skills or value provided to its clients.

If anything, Goldman Sachs traded on its image by extracting value from everyone else in the deals in which it participated.

But it made one really big mistake. It's management overlooked the risk to its own firm of piling on too much risk with one other player, AIG. Goldman's risk managers apparently disregarded the likely outcome of one insurer, AIG, assuming far too much CDO valuation risk, for, as it turned out, prices which were much too low.

When all of that risk became concentrated in AIG, and then became realized with the bursting of the housing bubble, that risk went back to those firms which had attempted to sell it to AIG.

Unlike many other observers of last year's financial crisis, I have never believed that the government intervention embodied in the TARP and the Federal Reserve's liquidity creation was necessary to avert some sort of 'systemic meltdown,' or a 'plunge into a financial abyss.'

I continue to believe that Anna Kagan Schwartz was correct in her contentions in an interview with the Wall Street Journal last fall. She diagnosed the late 2008 financial crisis as one of institutional solvency, not liquidity.

As such, she opined, crippled, insolvent institutions should have been closed, with the excess financial capacity allowed to disappear. If the US financial system truly needed added capacity, there are plenty of private equity and hedge funds ready to move in and seize the opportunities thus presented.

The dirty little secret of US banking in the past two decades has not been a lack of capacity, but an overabundance. That's why so many exotic instruments were created. Because the basic equities and debt products became so marginally profitable.

Just when the US financial system had a chance to clean out poor financial risk management in a Schumpeterian wave of failures of credit providers, the government foolishly caved in to the affected, about-to-fail institutions and ran the monetary printing presses to bail them out.

How are the risk managers at Goldman Sachs and its ilk to learn from their mistakes if those gargantuan mistakes were simply erased?

Unfortunately, the damage has and will spread beyond just those institutions, as I'll discuss in the next post on this topic later this week.

to be continued.....