Wired: The Formula That Killed Wall Street

Probably the best article that I've read so far explaining how Wall Street got into the mess that it did:

A year ago, it was hardly unthinkable that a math wizard like David X. Li might someday earn a Nobel Prize. After all, financial economists—even Wall Street quants—have received the Nobel in economics before, and Li's work on measuring risk has had more impact, more quickly, than previous Nobel Prize-winning contributions to the field. Today, though, as dazed bankers, politicians, regulators, and investors survey the wreckage of the biggest financial meltdown since the Great Depression, Li is probably thankful he still has a job in finance at all. Not that his achievement should be dismissed. He took a notoriously tough nut—determining correlation, or how seemingly disparate events are related—and cracked it wide open with a simple and elegant mathematical formula, one that would become ubiquitous in finance worldwide.

For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

Then the model fell apart. Cracks started appearing early on, when financial markets began behaving in ways that users of Li's formula hadn't expected. The cracks became full-fledged canyons in 2008—when ruptures in the financial system's foundation swallowed up trillions of dollars and put the survival of the global banking system in serious peril.

I finally got what tranching is from this article, and the explanation of how Li's formula was used by the financial world to blind themselves to risk is stellar.

And the article isn't hard on Li at all. It's not like he's John Yoo, out there perverting the Constitution so Bush could play Jack Bauer. Even he warned against the shortcomings of his formula.

Something keeps bothering me about all of this.

The CDS and CDO markets grew together, feeding on each other. At the end of 2001, there was $920 billion in credit default swaps outstanding. By the end of 2007, that number had skyrocketed to more than $62 trillion. The CDO market, which stood at $275 billion in 2000, grew to $4.7 trillion by 2006.

Should this fact in and of itself be a red flag to people? How can two associated markets grow 6740% and 1710% respectively in five or six years and somebody not say, "Whoa, whoa, whoa," especially when the one growing 6740% is basically unregulated? Are there no adults that could see that and think, "What are those crazy kids doing over there?"

I'm thinking that, although the article didn't say it, Li's formula amounted to a dangerous procyclical effect in the markets. Procyclicality is bad news. It turbocharges the effects of the market. An example in the physical world: let's say the market is a roller coaster. The market goes up and down in the normal course of events, just like the roller coaster. Some markets are kiddie rides, and some are whacked-out scream machines. But you know the risks when you get on them.

Well, supposing that instead of seats on the little trains, the owners of the roller coaster attached contraptions that dangled bungee cords on either side of the little trains? Now every time you go up, you really go up, and when you go down, you're plummeting. That's procyclicality in action.

And now suppose some stupid teenagers with their pot and acid decide to leap from bungee cord to bungee cord, from roller coaster to roller coaster, maintaining that high as long as possible? "Whee! Whee! I'm never coming down! Whee!"

That essentially was our marketplace over the past few years, thanks to the jumbo-sizing of the credit default swap market. And then the the markets went down, and some people hit the pavement in rather ugly messes, and everyone else got the notion that being on a roller coaster dangling from bungee cords isn't such a hot thing to do, they threw the brakes.

And now the roller coasters are stopped, little trains are stuck in every place imaginable, and Geithner and Bernanke are climbing up, disentangling all of these people, getting them back down to the ground...

...and then refunding them the price of admission.

After all, we don't want to stifle innovative recreation park ride creation, now, do we?

Barney Frank Defends Against Idiotic Attacks

As only Barney Frank can.

According to the Republicans' misty memories of the period before 2007, I allegedly singlehandedly blocked their determined efforts to regulate Fannie Mae and Freddie Mac, and my supposed intransigence literally caused the worldwide financial crisis.

Fortunately, we have tools to aid memory -- pencil and paper, word processing, transcripts, newspapers, and the Congressional record. And as described in the most reputable published sources, in 2005 I in fact worked together with my Republican colleague Michael Oxley, then Chairman of the Financial Services Committee, to write a bill to increase regulation of Fannie Mae and Freddie Mac. We passed the bill out of committee with an overwhelming majority -- every Democrat voted in favor of the legislation. However, on the House floor the Republican leadership added a poison pill amendment, which would have prevented non-profit institutions with religious affiliations from receiving funds. I voted against the legislation in protest, though I continued to work with Mr. Oxley to encourage the Senate to pass a good bill. But these efforts were defeated because President Bush blocked further consideration of the legislation. In the words of Mr. Oxley, no flaming liberal, the Bush administration gave his efforts 'the one-finger salute.'

Lots more there, all with Frank's trademark humor. Good on you, Congressman!

Japanese Internment Camp Apologist Degrades Holocaust Warning

Michelle Malkin made her mark defending America's use of internment camps for Japanese-Americans during World War II. She's gone on to screech and villify the left at every opportunity, even appearing to be the heir apparent on "The O'Reilly Factor" until even Bill had to kick her hatred and drama to the curb.

She's still got one of the top-viewed blogs on the Internet, though, and she's leading the charge against the Democrats over the AIG news. She's been instrumental in blaming Chris Dodd entirely for something he did at the behest of the Treasury Department, and then portrayed Dodd as spineless for knuckling under when it was only his relenting that ensured the Obama Adminstration did have a process to try and get that money back.

However, today she's finally found her vicious stride. Today the House Democratic plan for taxing the bonus recipients to get the money back comes under her fire, and her headline is a shocker:

First They Came For The AIG Bonuses

This is of course the bastardization of a famous quote from Martin Niemöller about the hideous inaction of the German people in the face of the Nazi threat.

In Germany, they came first for the Communists, And I didn’t speak up because I wasn’t a Communist;

And then they came for the trade unionists, And I didn’t speak up because I wasn’t a trade unionist;

And then they came for the Jews, And I didn’t speak up because I wasn’t a Jew;

And then . . . they came for me . . . And by that time there was no one left to speak up.

Malkin's appropriation of this poem cheapens it, and all in service of protecting people who got cash even while their company tanked the world economy.

Get your bloody hands off Niemöller's poem, Ms. Malkin. Someone who's spent her life drowning out the people who dare speak up has enough sins to atone for.

The Dodd Mess

Comes Chris Dodd to Hardball to explain how the February 11 language was put into the bill:



So, number one, Chris Dodd knew the language was going in during the House-Senate conference. His staff wrote it in.

Number two, it was at the insistence of Treasury who would otherwise have had the entire section taken out.

Number three, it was a senior administration official telling The New York Times on deep background that Dodd put the language in, while leaving out the Treasury's part in the matter. For what it's worth, Greenwald thinks it was Rahm.

Very depressing stuff to look through here. One of the few bright spots in this:



Still looks more and sounds more like a president than Bush ever did.

Greenwald on Dodd Smear: Obama's Fingerprints

Glen Greenwald has pulled together the best presentation of this yet, and it's clear that the language exempting bonuses before February 11, 2009 in the stimulus legislation was put in at the behest of the Obama administration.

And the smear against Dodd is also coming from the White House:

Yet now, the Obama administration is feeding reporters the accusation that it was Dodd who was responsible for the exemptions that protected already-vested bonuses. The Times article from Saturday that started the Dodd scandal thus contains this outrageously misleading claim:

The administration official said the Treasury Department did its own legal analysis and concluded that those contracts could not be broken. The official noted that even a provision recently pushed through Congress by Senator Christopher J. Dodd, a Connecticut Democrat, had an exemption for such bonus agreements already in place.

And yet another New York Times article from today ("Fingers Are Pointed Across Washington Over Bonuses") -- this one by David Herszenhorn -- contains this White-House-mimicking, misleading passage:

But Mr. Reid mostly ducked a question about whether Democrats had missed an opportunity to prevent the bonuses because of a clause in the economic stimulus bill, part of an amendment by Senator Christopher J. Dodd, Democrat of Connecticut, that imposed limits on executive compensation and bonuses but made an exception for pre-existing employment contracts.

That was the exact provision that Geithner and Summers demanded and that Dodd opposed. And even after Dodd finally gave in to Treasury's demands, he continued to support an amendment from Ron Wyden and Olympia Snowe to impose fines on bailout-receiving companies which paid executive bonuses (which was stripped from the bill at the last minute). But now that Treasury officials are desperate to heap the blame on others for what they did, they're running to gullible, mindless journalists and feeding them the storyline that it was Dodd who was responsible for these provisions. And today, during his White House Press Conference, Robert Gibbs advanced this dishonest attack by repeatedly describing the offending provisions as the "the Dodd compensation requirements."

How in Hades did these "administration officials" think they could get away with it? This is going to be the first real mess that the Obama White House has gotten themselves into, full fledged. Stupid politics, stupid internicene war, stupid all around.

Fox News Smears Chris Dodd -- Did NOT Grandfather AIG Bonuses

There has been a lot of fury expended over the past few days about the bonuses AIG executives in the derelict Financial Products division received, and rightfully so. However, Fox Business has published what it considers a scandalous story. According to them, Chris Dodd inserted language into the stimulus package bill that protected these bonuses.

While the Senate was constructing the $787 billion stimulus last month, Dodd added an executive-compensation restriction to the bill. That amendment provides an “exception for contractually obligated bonuses agreed on before Feb. 11, 2009” -- which exempts the very AIG bonuses Dodd and others are now seeking to tax.

Of course, this is going all over the conservative blogosphere.

Yet funnily enough, the actual text of Dodd's amendment concerning executive compensation doesn't have this February 11th exception in the text. In other words, the Fox Business smear merchants didn't bother to do any basic research. They knew Dodd had submitted this section through amendment, and there the language is now, so Dodd must have put it in there, right?

Well, no. Actually Dodd's amendment was to another amendment to the main bill, Amendment 98. Amendment 98 was a substitute amendment, so called because it wipes out the language of the bill or amendment it is "amending" and substitutes its own. Dodd's amendment to #98 did pass, but the original amendment was withdrawn later on.

The final bill passed by the Senate on February 10 was the text of another substitute amendment (#570) submitted by Republican senator Susan Collins of Maine. It did have the language of Dodd's Amendment 354, but the grandfather clause currently giving Dodd-haters the vapors is still not in there.

That language was not inserted until the House-Senate conference to reconcile differences between the bills. This was the next day, February 11, 2009, and funnily enough, that was the date used to grandfather these bonuses in. And since Dodd was not one of the conferees working out these details, it remains to be seen just how he was supposed to have inserted this language.

The actual conferees were, from the House: Obey, Rangel, Waxman, Lewis (CA), and Camp -- and from the Senate: Inouye, Baucus, Reid, Cochran, Grassley. Of these, four are Republicans -- Grassley, Cochran, Lewis, and Camp.

There is no indication whatsoever that Chris Dodd had anything to do with this clause. Consider this right wing lie debunked.

AIG Names Names

The gig is up and Congress' questions are answered. AIG has released names and numbers for who got what from them directly and from Maiden Lane II and III.

Maiden Lane II was dealing with unwinding loans made on good assets to buy up toxic assets.

The top beneficiaries of payments tied to the unwinding of the securities lending portfolio were Barclays (BCS) of the U.K., with $7 billion, Deutsche Bank, with $6.4 billion, BNP Paribas of France, with $4.9 billion, Goldman with $4.8 billion and Bank of America (BAC, Fortune 500) with $4.5 billion.

Maiden Lane III was buying bad toxic assets from institutions that had purchased credit default swaps from AIG on those toxic assets:

...the top recipients of payments under the CDO purchase program, with SocGen getting $6.9 billion, Goldman $5.6 billion, Merrill $3.1 billion and Deutsche Bank $2.8 billion.

And finally, those same institutions who sold their toxic CDOs to Maiden Lane III were made whole through payouts from AIG that also terminated the CDSs:

The top recipients of CDS-related collateral were France's Societe Generale, with $4.1 billion, Germany's Deutsche Bank (DB), with $2.6 billion, and Goldman Sachs and Merrill Lynch of the United States, with $2.5 billion and $1.8 billion.

I wonder what the Wall Street Journal was looking at, though. They said the biggest two recipients were Goldman and Deutsche Bank, but by far the biggest recipient of taxpayer cash from AIG was Societe Generale, with $11 billion coming through Maiden Lane III and AIG directly.