MARKET STUPIDITY: AN ACT OF GOD?

In Australia, James Bidgood, a first-time Member of Parliament (under investigation for selling pictures of a protester attempting to set fire to himself outside Parliament House), has made it official: the global financial crisis is an act of God.

Funny, but it seems to me that cheating and lying to each other in America's financial markets were acts of stupidity and greed. God may have had a good laugh at all of this, but I have to think that God - or whoever you look up to - is kind of having a good time watching us make fools of ourselves. Check this out ...

Back in Feb. of 1998 the Federal Registry of the United States told the world that the Federal Deposit Corporation (the FDIC) issued a set of new "guidelines" telling its member banks that private market players were cheating and gaming the system with incredibly complex financial instruments. The FDIC warned member banks to be on the look out.

Put another way, the federal government had an idea - and the private sector knew - that the US financial system was sitting on a profitable but explosive financial powder keg, at least ten years before the 2008 market meltdown began. Here's one of the stories I tell in my forthcoming book, The Myth of the Free Market: The Role of the State in a Capitalist Economy ...

One year before the Financial Services Modernization Act (1999) was passed into law, the FDIC issued a set of guidelines for member banks that managed transactions involving collateralized securities. Concerned that deposit-taking institutions had not exercised sufficient risk management, the FDIC distributed a “Statements of Policy”(SOP) document at the beginning of 1998, making it clear that collateralized security transactions were on its radar screen.

Although it set out to reacquaint institutions with basic due-diligence procedures, it also listed ways that private firms could defraud FDIC-backed institutions. The SOP guidelines said that private financial institutions weren’t always playing fair with FDIC-backed institutions, especially when it came to complex financial instruments.

Included among the embarrassingly basic rules of caution covered were “know your counterparty,” credit analysis, and credit-limit reviews. The guidelines were so simple that it was difficult to tell whether they were issued for seasoned FDIC-affiliated banking institutions or were really geared to the new finance guy at the local car dealership. Still, one thing stood out: in the wake of the 2008 market collapse, the 1998 SOP offered a crow’s nest view of what went wrong.

Pointing to the tactics of subsidiaries belonging to “financially stronger and better-known firms,” the SOP warns that larger corporations “may not be legally obligated to stand behind the transactions of related companies,” so the subsidiary may not be credit worthy. What is the FDIC’s advice? Don’t trust the other guy’s “character” or “integrity” until you get “the stronger firm’s” signature. That this needed to be said should have raised red flags back in 1998. Incredibly, the guidelines get even more basic.

We all know when we purchase a new car that we have to deal with the sales staff, and then with the finance and credit team, who also want to sell us stuff. There’s a reason why the owners of car dealerships keep these two positions separate. Apparently these auto dealer insights have not always been prevalent within the FDIC. Burned by too many conflict-of-interest transactions involving sales and finance pulling double duty, the FDIC found it necessary to remind banking institutions that credit evaluations for CDO-affiliated purchases, for example, should be done by “individuals who routinely make credit decisions” and not by those involved in sales. Incredibly, the SOP then advised institutions to be on the lookout for buyers who were already overextended.

Perhaps the greatest words of caution are saved for institutions that are inclined to believe that CDO instruments could be used as market collateral. The FDIC guidelines make it clear that because a bank has a CDO-affiliated instrument it doesn’t mean that it’s sitting on an asset for which the book value is equal to the market value. The 1998 guidelines suggest, for example, that, if a $100 million CDO transaction has occurred, “experience has shown” that the underlying product or contract “will not serve as protection” if the subsidiary fails or if the firm does not have control over the security.

While Christian fundamentalists, like James Bidgood in Australia, may believe that God gets his jollies from watching us suffer through market collapse, the reality is what's happening now is a product of greed and stupidity (which God, no doubt, gets a chuckle out of).

It's really that simple. We can fix this.

- Mark