Every day CNBC features talking heads who drone on with the same platitude that there is fear in the market regarding the lack of transparency in the banks. "Lack of transparency" is really a euphemism for "bankrupt." Whether it is Citicorp, AIG, Fannie Mae, or your pension funds, all these large financial institutions own or guarantee trillions of dollars worth of collateralized debt obligations (CDOs) that contain subprime mortgages and other worthless collateral which people now realize are total scams. The most outrageous part of this drama is that the government will allow these investment bankers who dreamed up this financial engineering in the first place to receive millions of dollars each in the form of yearend bonuses for underwriting all this worthless paper. This latest boom and bust of not only subprime mortgages, but of all types of credit ranging from out-of-control consumer credit card issuance to rampant private equity acquisitions have created the largest transfer of wealth from the poor to the rich in modern history. None of the experts on television will ever admit to it because if the average American actually understood what has happened, social upheaval would probably ensue.
Mark to model (as opposed to mark to market) is the method these large financial institutions value CDOs. They claim to use this method because the market for these securities has evaporated. To put it bluntly, valuing these things using "mark to market" is legalized stealing. If no one wants to buy a worthless piece of paper, it should be valued at ZERO-- not ten million or a hundred million or whatever arbitrary number they're currently using--because any other number is by definition inflated. The conflict of interest lies in the fact that the traders whose bonuses and jobs depend on making profits from trading these securities are the same people who price these securities. If they mark them to zero, not only will they not receive a bonus, they'll most likely be out of a job so they have every incentive to lie about the value of these securities. Auditors can't keep them honest because auditors just ensure that banks follow a checklist of procedures. Auditors have no way of verifying whether prices are inflated when each bank uses proprietary computer models to value these securities. But according to a friend of mine who is the head of risk management at a large British investment bank, these auditors don't even know how to ask the right questions.
It is entirely possible that all of the U.S. banks are currently bankrupt. Just because Citicorp generates billions of dollars every day in revenue doesn't mean that it has any equity left. Between 2005 and 2007, over a quadrillion dollars of CDOs were underwritten. A one percent writedown would amount to at least a trillion dollars worth of losses. Most CDO analysts at the large investment banks have already publicly stated that they expect at least several hundred billion in writedowns, although to date, less than a hundred billion has been announced.
My guess is that neither the Treasury nor the Fed has any idea what to do about this credit mess. Treasury Secretary Paulson has no risk management experience. He was a relationship banker, meaning he was just a plain old sales guy, who politically maneuvered his way to the top job at Goldman. Insiders say that he accepted the Treasury post knowing that he was soon to be ousted. At the Federal Reserve, nobody on the board of governors, including Bernanke, has any experience with these types of markets either. When I met with Gerald Corrigan, former New York Fed President and current Vice Chairman at Goldman Sachs in October 2006, I asked him why his Counterparty Risk report only addressed how to deal with operational risk and not credit risk. He confessed that risk managing CDOs was well over his head and added that no central banker had any idea what to do if things went wrong. So much for leadership at the top.
Where do we go from here? I wish there would be an equitable solution possible, but I'm getting cynical in my old age. Realistically, I bet all the bankers will get to keep the hundreds of millions they all made selling and trading these securities while the rest of America face foreclosures and bankruptcies since politicians in Congress and elsewhere depend too heavily on Wall Street to get elected and to stay in power. I doubt Congress will never do the right thing and pass legislation that will demand more transparency in banks. They will never pass legislation for more regulation of financial services now that this industry is more than twenty percent of our economy. Most likely, the final chapter to this credit mess will end with taxpayers footing the bill should the government need to step in and bail out one or more of these large financial institutions. Meanwhile, the rich Wall Streeters will dream up the next innovative way to fleece the world again.