Streetwise Professor

July 14, 2012

Blame it on Ben?

Filed under: Derivatives,Economics,Financial crisis,Financial Crisis II,Regulation — The Professor @ 7:55 pm

The futures industry is reeling over the latest theft of segregated customer funds, this time by Peregrine Futures’ Russell Wasendorf.  Wasendorf admitted to stealing seg funds in a note left at his side when he attempted suicide after it looked like his scheme was unraveling.  He has been indicted for fraud committed over the 2010-2012 period.  Over $200 million is missing, and his company is undergoing Chapter 7 liquidation.

Following hard on the heels of the MF Global disaster, the Peregrine revelations are raising further fears about what had once been considered sacrosanct: that customer funds are inviolate.  Even the CME Group, which has historically been a stalwart defender of the traditional segregation model in which FCMs are the custodians of customer money, has suggested that changes may be necessary:

Without question, the current system in which customer funds are held at the firm level must be reevaluated.

CME Group recognizes that the demand for its services is reduced to the extent that suppliers of complementary services-such as brokerage-are deemed untrustworthy.

I consider it virtually inevitable that this will be the last nail in the traditional segregation model.  This will lead to a dramatic change in the organization of the FCM industry.  Though (as I discuss a below) that industry was already under tremendous strain.  Peregrine and MF Global are symptoms of that strain.

Other big news this week was JP Morgan’s reporting of a $4.4 billion dollar Q2 2012 loss, and a $459 million restatement of its Q1 results-along with an admission that the “integrity” of the marks in the CIO books.

Do Peregrine, MF Global, and JP Morgan’s travails have anything in common, except for bringing further discredit onto the finance and banking industry?  I think they do.  I think they are all consequences of near-zero interest rates.

The traditional FCM revenue model relied on interest income from customer funds invested by the FCM.  Very low interest rates make that model unviable.  That is a major reason why Corzine felt it imperative to transform MF Global-and to take on more risk.  I conjecture that similar pressures led Wasendorf to commit fraud.  (Though his admission that he had been doing so for 20 years cuts against that interpretation.  A hypothesis: Wasendorf had been engaging in this activity on a smaller scale for years, but escalated it sharply as the financial pressures on Peregrine grew in the low interest rate environment.)

The Morgan story is different, but the extraordinary monetary policies that have driven interest rates to extremely low levels are at the center of the story.  Morgan had about $360-$500 billion in deposits that it needed to invest, but traditional investments such as Treasuries offered such low yields that the bank went hunting for yield, and invested in more risky securities and derivatives to get it.  Yield chasing in Fed-created low interest rate environments has contributed to previous big losses, such as Orange County’s in 1994.

Bernanke and the Fed initially pursued a low interest rate policy in an attempt to prevent another depression, and have continued it in attempt to spur growth.  These are the justifications for these policies, and they are defensible ones.  But these policies cause collateral damage.  Financial blowups-from MF Global to Peregrine to the Whale-are plausibly just that.

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  1. as long as it’s not a tax. the fear is the regulatory agencies will flex their muscles, use Dodd-Frank as an excuse and blow the whole thing for everyone. No matter what statutes or rules were written, Wasendorf and Corzine were hell bent to steal.

    Comment by Jeff — July 15, 2012 @ 12:10 am

  2. Yup, Jeff. Like I said in the post earlier this week: regulation is an activity for which failure is the primary justification for more of it.

    The ProfessorComment by The Professor — July 15, 2012 @ 6:52 am

  3. […] Best can really be traced back to Ben Bernanke, appointed by Bush, so it’s really his […]

    Pingback by Breakfast Links | Points and Figures — July 15, 2012 @ 7:18 am

  4. What concerns me more than the effects of the low interest rate environment on the futures industry is the effects of the low interest rate environment on the economy as a whole. Pension funds with high actuarial rates of return built into payouts are getting creamed. While payouts continue based on 8% equity returns and 5% fixed income returns, portfolio earnings are not keeping up with assumptions. Endowments are in a similar situation. Add in the group of people aged 45-60 who have seen net worth decline in the past 5 years and we have a scenario where stressed investors are going to be chasing high yield schemes. The effects of artificially low interest rates on the economy are starting to show. Its just a matter of time until those effects become widespread.

    Comment by Charles — July 15, 2012 @ 8:30 am

  5. I agree Charles. There will be huge collateral damage. For each of the reasons you mentioned and probably more. You cannot distort such a fundamental price for so long without doing serious harm. The post was intended merely to point out how this plays a role in some of the big scandal stories, a role that is almost always overlooked.

    The ProfessorComment by The Professor — July 15, 2012 @ 9:35 am

  6. Just as you said, Charles. The linked post refers to corporate defined benefit plans. Just think of the implications of low, low, low rates for all those government employee plans.

    The ProfessorComment by The Professor — July 15, 2012 @ 10:03 am

  7. Not to go all behavioral on you, Prof., but see also Boddy, Clive R., “The Corporate Psychopaths Theory of the Global Financial Crisis,” Journal of Business Ethics (2011) 102:255–259. You’ve got to get past the moralizing, but the theory cannot be dismissed. More than a few studies are surfacing from the neuroscience literature indicating the per capita incidence of psychopathology on Wall Street is multiples that of the rest of society.

    There’s another interesting thought making the rounds in the zeitgeist that is somewhat related; to wit, the failure of the elites in our key institutions including government, education, media and finance. This is being spurred by Christopher Hayes’s new book, “Twilight of the Elites,” most recently reviewed by David Brooks in the NYT a couple of days ago ( ). Brooks disagrees with Hayes’s argument that elites, once they’ve ascended to positions of power based on their individual merit, become corrupt and rig the system in their favor to deny opportunity to those coming up behind them. Brooks contends that the elites are just harder working and willing to make greater sacrifices to benefit their children, which shows up in providing tutoring them for schools and test prep, and a more enriched life at home. Naturally, they will — and do — succeed, given such advantages.

    There’s a common theme in these streams of thought: The elites — be they psychopaths, just plain corrupt (after advancing thru the meritocracy), or hard-working souls who willingly sacrifice for their kids — all believe they sit atop the income distribution for good reason. By dint of hard work and natural endowment, their ascent is completely justified and easily explained.

    I think we need to take a step back and figure out where we are and how we got there. I do not disagree with your thesis that the Fed’s “unconventional” policies induced massive distortions in credit and resource allocation, affecting human behavior at many levels. But at the end of the day, we are dealing with humans, and we are witnessing something that’s got a lot of thoughtful people wondering what went wrong. At the personal level.

    I do not think everyone is addressing these unintended consequences of monetary policy by becoming totally reckless. Some folks are figuring things out, while others remain paralyzed by inaction — everything they were taught or thought they knew no longer holds. And the folks they relied on in the past to explain things, offer advice, and help in allocating capital are no longer providing reassurances they know what’s going on.

    Part of this is due to what Hayes correctly identifies as the upper-income strata’s mastering of the process of gaining access to and fully comprehending the credentialing process in our important institutions, beginning with education. You see this in school admission, testing, graduation rates, etc. Tutoring can take average kids who’re willing (or compelled) to work hard and give them the test scores of someone apparently gifted (or at least smart). You also see similar behavior in work: people with the prep such an upbringing provides, who, nonetheless, fall on either side of average intelligence, figure out how the system they’re in works and then optimize their performance within the system’s reward matrix — by means fair or foul — to max their comp.

    This is meritocracy run amok, but not for the reasons he attaches to the phenomenon. Hayes — and Brooks, for that matter — conflates mastery of the credentialing process for success achieved thru ability or giftedness. As does society at large. So, for example, gaining entry to an elite institution of higher learning is conflated with intelligence, rather than what it actually is in most instances (i.e., appearing intelligent via mastery of the test-taking process). Getting good grades is conflated with intelligence. Getting in to a good firm and being successful is conflated with being intelligent and possessing mastery of whatever the firm sets itself to doing. You get the idea.

    Nature always has stratified in multiple dimensions, intelligence and task-mastery being two of them. There is a distribution of ability and giftedness in all of these dimensions. True giftedness in anything — thinking, speaking, writing, playing music, organizing a process, creating a business by meeting a need … — is rare (it is the far right side of the distribution of any dimension). It is unaware of its historical significance while it is creating — cf, Alan Turing or Fischer Black, two of the smartest people to have lived during the 20th century. The former gave us the technology, the latter a way of thinking; when Black’s way of thinking was harnessed to a Turing’s learning machines the world changed. Similar things can be said of biology, electronics, literature … great minds got way out in front and we all eventually caught up with them. How? There always is, and always will be, a group to the left of that far-right tail that can see what’s going on an can follow in its wake. It can convey to others in that group what going on, and together those folks can make sense out of what’s being done by those in the far-right tail of the distribution; it may take them decades to do so (cf, again, Turing), but they eventually get there. Likewise, there’s a grouping to the left of that vanguard cohort that follows in its wake; but it’s understanding and comprehension of what’s being done in the group ahead of them becomes increasingly foggy the further to the left they get. And so on, and so on, … . Still, down to a pretty dense part of the distribution, most folks can learn how to mimic these gifted souls, and that’s what they set about learning.

    Most of the folks occupying positions of importance in business, academia and other critical institutions (e.g., government) have mastered the wake-following process and mimicry. You’ve got a huge cohort that does not recognize it favors others who also have mastered this process: They are incapable of distinguishing ability and the semblance of ability. To state the obvious, what you’re seeing now is the triumph of those who have successfully navigated the meritocratic process; however, now that they’ve reached their desired endpoint, they are incapable of performing at the level required of the position they occupy. This is true in our politics and in our critically important institutions. (See for a very germane exposition of this vis-a-vis finance from Henry Hu, the Allan Shivers Chair in the Law of Banking and Finance at University of Texas, and the former head of Risk Fin at the SEC.)

    These world-historical collapses of our institutions are the natural consequence of this process. This is a tragedy. And it has happened before (cf the 1930s). I’m beginning to think the institutional failures may be nature’s way of hitting the global “reset” key and forcing a shake-out that’s more aligned with actual ability and a capacity to think beyond one’s own personal enrichment. That’s a tall order, but I think we’ll live to see it come to pass.

    I also would posit, along the line of thought developed by E.O. Wilson in “Consilience,” and J. Stiglitz in “The Price of Inequality” that nature will force a return to noblesse oblige because it is required for societies’ continuance. Without it, societies vanish, and, critically for America, markets cannot function. The wealthy cannot prosper by plundering their societies. That, in a nutshell, is nature’s way of getting what it wants — the stuff that works endures, the stuff that doesn’t fades away.

    Comment by markets.aurelius — July 15, 2012 @ 12:18 pm

  8. If I had to pick one profession to be in during the next 20 years, it would be devising and executing financial frauds. Thankfully, I have another profession (and ethics) but the environment is horribly ripe for fraudsters to devise novel schemes (real estate, lock in for 10 years and wait for prices to mean revert would be one I can think of) to give those suffering from the drop in real assets and effects of low interest rates a chance to catch up.

    Demand is there, those affected are more likely savers who have suffered under performance than spenders, so assets are available. Regulators have no interest whatsoever in reforming, so we can expect enforcement will be as non-existent moving forward as it has been over the last 20 years. The pool of individuals and organizations needing to figure out how to stretch their assets is enormous and the list of attractive investments is small. Unless regulators and law enforcement get their acts together and prepare for an upcoming wave of schemes promising above normal returns with long time horizons, starting in about 5 years a wave of ponzi schemes are going to start to come to light. The Feds need to tell investors to expect these schemes, give people resources to report suspected schemes, train investigators warning signs of schemes and start enforcing existing regulations.

    Comment by Charles — July 15, 2012 @ 1:00 pm

  9. @markets-Based on personal observation it seems at least in some corporations the process has been different. If you look at the popular management theories promulgated by elite academics you find that war was declared on the individual many years ago. “Star Performers” are fingered as the root of poor performance in business and compliant conformist teams are the path to business Valhalla. Now many many CEO’s were not a dreaded start performer and have little successful experience but were able to sit conspicuously compliant throughout their bureaucratic careers. Rather than not recognizing talent I think they actually loathe and are paranoid of talent.

    I absolutely agree that the lack of detachment from self interest has been the largest contributor to what has happened but doesn’t even that suggest the possibility of contempt for real ability once the system has become sufficiently saturated with these demonstrably NOT star performers.

    The Gaussian curve is one of the big targets of the progressive’s assault on US culture but that curve is still there and will always be there. It is at a deeper and ultimately inescapable level of reality. I can’t speak to the financial industry nor most corporations on the basis of personal experience but I would never ever advise anyone sufficiently on the right side of the curve to ever work for any of the large corporations that I know of first hand and as they are currently constituted. You will by definition be an enemy of good management practices. In the long run the only alternatives to ethics and talent are very dark and unstable places.

    Comment by pahoben — July 15, 2012 @ 7:18 pm

  10. -As to the rise of the unexceptionable in organizations- this is hardly new. Gilbert & Sullivan made their living mocking high placed lickspittles and fools. I believe it was Dean Swift who wrote that one can recognize a genius by this sign – when a confederacy of dunces rises against him.

    Comment by sotos — July 18, 2012 @ 4:39 pm

  11. […] zero interest rates are wreaking havoc among FCMs. I recall reading something about that.  Heck, I remember writing something about that about a week […]

    Pingback by Streetwise Professor » Sounds Familiar — July 21, 2012 @ 6:30 am

  12. […] zero interest rates are wreaking havoc among FCMs. I recall reading something about that. Heck, I remember writing something about that about a week […]

    Pingback by Stocks and Sectors » Blog Archive » Near Zero Interest Rates, FCMs And The Inevitability Of Shakeouts — July 22, 2012 @ 7:34 am

  13. […] zero interest rates are wreaking havoc among FCMs. I recall reading something about that. Heck, I remember writing something about that about a week […]

    Pingback by Near Zero Interest Rates, FCMs And The Inevitability Of Shakeouts — July 22, 2012 @ 8:27 am

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