"Regardless, if banks are "concentrating wealth" they must be doing something right since after all, the ultimate purpose of a business is to make money. If they do so through illegal means (fraud, deception, etc.), we already have a legal system in place to deal with that."

You're not grasping the situation or what actions have been taken in this example, and with the crisis and bailouts in the US. These are banks setting the rates at which governments borrow money, and the rates at which banks receive money to lend. Manipulation of those rates is illegal, unethical, and highly profitable. It's been abused on a monumental scale, so much so that it has begun to appear "normal" to the people participating in it. But, despite being the norm, it's fraud on a massive scale, and it destroys wealth and robs taxpayers.

I'm not at all arguing that more government/bank interaction is the solution. But, as long as banks have access to all the levers in our economy, and the ability to borrow money at rates they control and lend it out to governments at market rates (a free money funnel for taxpayer dollars), there needs to be regulation of those banks. If you can convince our government to remove that intimate connection between creating money (not wealth; we're taking about the currency that represents debts) and lending money and the rates at which banks borrow money being introduced into the economy (i.e. end or dramatically rethink the Federal Reserve in the US, and figure out a way to resolve the fraud in LIBOR in the UK, and whatever equivalent there is for the Euro), I'll sign right on for your cause. Independent currencies, like Bitcoin, are something I have high hopes for, but the Bitcoin economy is measured in millions...it'll be decades before we have an alternative economy and an ability to opt out of the horribly broken state currency markets and into a free market currency.

In the short term, laws need to be upheld, in London, in the US, in the world markets. People who have committed fraud worth billions or trillions of dollars need to go to jail. Just because someone is rich, well-educated, and doing what everybody else in their industry is doing, doesn't mean they should get a pass.

http://en.wikipedia.org/wiki/Liberty_Dollar

But, I'm highly suspicious of any system that allows the people who loan money to governments to also be the people determining the rates at which they borrow money (usually indirectly, as there is a very high bandwidth revolving door between the Fed and the big banks in the US, but some of the biggest banks actually had people working directly for the Fed while working for the bank, which is an SEC violation; likewise, the banks themselves are determining LIBOR, which determines the rates at which they get and loan money to governments). This is obviously inviting the fox into the hen house and expecting them to help keep the hens warm at night. Turns out that foxes, when invited into hen houses, tend to eat the hens. There's also been bid-rigging on a massive scale in the US, including JP Morgan Chase and Bank of America in their bids for municipal accounts, which studies indicate has cost taxpayers billions.

At one point I might have argued, on principle, that regulation was the cause of all of life's problems, and that market solutions should be sought. I still lean very far libertarian (or market anarchist), but I'm not convinced our society is quite enlightened enough to get there yet--and when politicians do use libertarian rhetoric it's usually a corporatist agenda masquerading as freedom. In the meantime, the bleeding has to be stopped. We can't keep pumping trillions of dollars out of the middle class all over the world and into the hands of a select few billionaire bankers and expect anything good to happen. Freedom for a few to rob the masses is not libertarian.

You do realise that the 'IB' in LIBOR stands for 'inter-bank'? The LIBOR rate has no bearing on the cost of a sovereign government's cost of funds - e.g. in US, treasury bills. The spread between them can be quite volatile (http://en.wikipedia.org/wiki/TED_spread). In short - governments don't lend or borrow at LIBOR - that's the point of having LIBOR in the first place.

Isn't that obvious? Capture of the political and regulatory process. As Senator Durbin said of Congress, banks "frankly own the place". Tech does not.

Whatever capture finance has achieved of Congress is possible largely because nobody truly understands what's happening in hardcore finance.

The very best reporters covering e.g. the credit default swap debacle still have only a surface level understanding of how and why swaps are traded and what their relevance is to the whole market.

So you have a situation in which there's two strong ambient forces --- regulate vs. deregulate --- and no comprehension, and so it's very easy to push e.g. pro-business economic- libertarian-leaning into their default position of "let's keep our hands off this stuff".

Yes, that's a product of undue influence by lobbyists and the financial industry, but it works mostly because of ignorance.

There's close to a consensus among the sources I read (Simon Johnson, Nouriel Roubini, Martin Wolf, William K. Black and other apparently credible experts, as well as the usual muckrakers) that political influence is the reason why, for example, the too-big-to-fail banks are bigger than ever despite the systemic risk. Ron Suskind's book even claims that Obama ordered Geithner to wind down Citi and Geithner just ignored him.

It's not as if there weren't major players advocating for such radical ideas as "bondholders should take losses when an institution fails" (http://www.nytimes.com/2011/07/10/magazine/sheila-bairs-exit...). They just lost politically. No?

Like most people who actually pay some attention to what happened in finance, I trace much of the problem back to deregulation and poor enforcement.

The parties who successfully rolled back regulation made a grave mistake, and should bear the consequences of their terrible judgement.

Similarly, the people who today suggest that regulation isn't the answer, but rather that we should simply let failed banks fails, those people are making today's grave mistake. The people who argued that systemic vulnerability would prevent any failed bank from actually failing were, as I see it, obviously correct. As it turns out, we can't even let a single auto company crash, let alone a nationwide megabank.

Having said all that:

It does us no good to pretend that the other side of this debate isn't a "side", but rather a bought- and- paid- for theater role occupied by those lucky enough to receive lobbying dollars.

The reality is that it's an animating principle of roughly half the American political establishment that regulation is bad, and that its unintended consequences will tend to harm the economy more than crashes will. A pretty large subset of those people also believe that however painful a megabank failure is, it's survivable, and one or two of them will suffice to teach CEOs not to allow their companies to gamble to the brink of failure.

It's no surprise that this half of the establishment receives truckloads of money from financiers; their principles align with the lobbyist's interests. But attributing those principles to the lobbying contributions is an instance of the post-hoc fallacy, unless you genuinely think that finance subcommittee legislators, Republicans, and pro-business "new Democrats" really don't believe in deregulation.

I can separate the bad principle from the "influence" here, is all I'm saying, and having done so have started to conclude that maybe the influence is a red herring in this case.

Lobbying "influence" is bad for all sorts of other reasons! Most importantly: because it consumes gigantic amounts of time, time that could be spent grooming a staff that could have some hope of understanding the issues they're dealing with.

It's a bit tangential but Dan Ariely had a brilliant post the other day about how, in conflict-of-interest situations, disclosure not only isn't a solution but actually makes the problem worse. Outsiders have little idea how to interpret what's being disclosed, and insiders feel that they've fulfilled their entire duty by disclosing and proceed to do as they please.

No.

The proximate purpose of a business is to make money. It's a means to the end: the ultimate purpose of businesses are to improve human well being.

* The purpose of a business, i.e. what organisations like Google want to do; and

* The purpose of businesses, i.e. why organisations like Google are permitted/encouraged to exist.

The purpose of a publicly traded business is to make money and thus profit for it's shareholders. Everything else becomes secondary.

There is a huge difference in responsibility between the two.

So it's not that money (as used to mean currency) is a defining characteristic of for-profit business, it's that value is. If a for-profit business existed to "maximize shareholder value in terms of cows", they would try to maximize shareholder NPV as measured in cows. The reason that for-profit companies exist is because the economics-theoretic ideal point for production in an economy (the point that benefits all consumers the most) is at supply-demand equilibrium, which is where profits are maximized for an individual company. The fact that there are non-profit companies is simply indicative of market inefficiency--in a "perfect" market, all companies would be for-profit. That doesn't mean that nonprofits shouldn't exist right now; in fact, it means that they have to.

So let's change "money" to "value" to be more specific. And then yes, value is indeed a defining characteristic of business, no matter how you measure it: currency accumulated via industry, children vaccinated, or political points spread. That's because humans tend to take action to maximize what they value most, humanitarian or self-serving, and business is the systematic application of human action.

Thus it's not at all clear here that financial innovation is a net win, and, further, any comparison with innovation in the tech world is fatuous.

It's like telling someone who bought a car that's had its mileage manipulated that they shouldn't have bought the car. Well duh !

Libertarian free-market types love talking about the power of incentives. However, the incentives in the banking industry do not line up with the creation of an efficient market. This much by now should be painfully obvious.

Albeit, this is only my probably wildly inaccurate and hastily sketched opinion.

And yet.

[Edit: imagine two bookies, both of them placing odds on different horses. how, exactly, are you going to figure out which bookie to bet with in order to get the fairest odds?]

In other words, arbitrage would only work if the bookies showed odds for the equivalent horses. But in this scenario they don't. (also see my most recently posted comment)

So banks are a quasi public institution, and there is tension between their public and private roles. Arguments that banking should just be a totally regulated public "utility" are not uncommon.

On a practical level, it seems obvious to me that the To Big To Fail banks have a major mismatch between the risk/reward trade off. The incentives to take risks when you're managing a company that you know will be bailed out is just too huge to ignore.

In short it's a complicated matter, with tough constraints.

For one, yes banks do concentrate wealth a lot more than Facebook and google. HFT/prop desks/Cdo desks and the firms PE and IB arms are extremely well paid. They concentrate wealth very effectively.

They are doing something wrong, and from the emails which have come out its clear that the extent of it is literally unbelievable. As in the wrongdoing is so obvious, that people can't believe it's happening and move on.

I cant offer you too many links, because I don't keep a list of all the evidence the banks churn out, but the recent libor trader emails are a great start. You can follow that up by reading about the magnetar trade, or abacus - where Goldman Sachs sold their customers a CDO all the while shorting it because they knew it sucked. Edit: After that the emails where they forged ownership documents of mortgages would be illuminating.

The mechanisms are failing us, and the financial industry is extremely good at dancing on the edge of the words, but completely outside of the spirit of regulation.

Further regulation has been reduced, most notably glass steagal in 1999. We are actually seeing the crisis because of a proliferation of financial institutions and instruments caused directly by deregulation. Which is exactly what you are asking for. (edit: this also brings us to the edge of what we can discuss in general terms - you could mean deregulating so that we get a 100 bank of America's)

At the same time the regulators have been understaffed and weakened, so malicious actions are easier to get away with.

On top of all this, there is a chasm of understanding between a lay person and the rituals of wall street.

It was news to me that if the sec says its going to take a bank to court, it means the banks usually will settle.

The sec has few resources, so they choose cases where they know they can make an impact and not waste effort/respirces. when they do tell someone they are in their cross hairs, it's enough for people to realize "ok, we better dial it down". If they say they will take you to court, it translates as "the sec knows they have evidence against you, likely sufficient to get a judgement"

To this most banks immediately plea bargain so that they pay a fine, take measures to correct it, and importantly - don't have to publicly admit to wrongdoing.

Banks work very hard to make sure they don't have to say they broke the law.

Only Goldman recently was arrogant enough to fight the sec and they lost. It was one of th largest fines in the sec's history, and yet it was a drop in the ocean for GS.

This matters because wall street is treated and reported in the main stream press using normal language. The reality of what's going on if translated better is hair raising.

As people are commenting "anyone with a Bloomberg terminal in 2006, knew that libor was being manipulated"

Edit: honestly once you talk to a few traders or just keep up to date with finance news it starts becoming revolting. Many things are open secrets but are artfully reasoned away each day.

Also, banks is a huge term for what they do.

All of these transactions are explicitly caveat emptor. My grandma couldn't go out and buy a piece of ABACUS 2007-ACA; sales are restricted to "qualified investors".

Of course we all know that's basically meaningless, at least the assumption that "qualified investors" always understand what they're doing. I know from experience that "qualified investors" in this kind of deal mostly don't do any serious due diligence. [On Abacus, it was practically impossible anyway. There were O(1,000,000) loans underlying the deal and there is no way you'd have been able to get the loan details for even a significant fraction.]

But I wonder whether we're expecting more from GS/MS/etc. than we expect from our local car dealer, and whether the remedy should be any different. That is, everyone is told to be suspicious of used car dealers, so you poke around, kick the tires, look for leaks, get a mechanic to look it over, read the repair records, etc. before you buy. If it still turns out to be a lemon, and you discover the dealer told you something explicitly false about the car, you have a legal remedy; otherwise (IANAL) I don't think you do. But you have a social/market remedy, i.e. don't buy from that dealer again and tell your friends not to buy from that dealer again. Likewise, if you find a dealer who always tells it straight and prices it fair, you go back to that dealer the next time and tell your friends about him.

Why isn't that the right remedy for these CDO deals as well? Sure, if GS said something provably false about the deal, there's a fraud case. But if (as I suspect is more accurate) they just sold it for what it was (namely an extraordinarly complex and impossible-to-price derivative financial instrument, offering an attractively high risk-weighted rate of return), and the buyers didn't bother (or have the computational resources, as almost none of them did) to do their own pricing analysis, is that the fault of GS? If you buy a CDO and lose your shirt, well, don't buy CDOs again and maybe don't buy from GS if you didn't like how they sold it.

But at some point, does a product like this become such a toxic POS that it is obvious it shouldn't be in the market? We don't let people create and market, for instance, a phone that happens to explode on contact with air. We don't allow cars that, say, don't have brakes. Should there be some regulatory structure in place that looks at new offerings like this and a least provides an opinion to the validity of the product? Now, naturally, this would be very difficult - both because the SEC and CFTC both suffer from lack of funding, not being staffed by appropriate experts and being (depending on how you view it) captured. But it just strikes me that these things should never have been allowed on the market in the first place - especially given, as you rightly point out, that most buyers are not going to have the ability to actually perform the appropriate level of due-diligence.

And while you're right that grandma can't go out and buy Abacus, her pension fund could, and therefore it does effect her.

I do love the idea of comparing GS to a local car dealer - but I can't remember another business I've ever seen that is so willing to throw their own customers/clients under the bus to make a buck. So I'd actually put them below the local car dealer. :)

There are few things that you can't sell with proper warning labels. And even these toxic packages of bad loans had some value. They didn't pay out anywhere near expectations but they paid out something.

An art product isn't going to sell or be sold as widely as a commodity or even a CDO.

And even under the auspices of art people won't let you sell toxic waste.

And Some of those toxic products made 0 money. You may have had some interest roll in from a tranche, but if it lost its value even before it reached market (some CDOs lost value between inception/assembly and final release on the market.)

The money that rolls in is irrelevant, since the net effect is wealth destruction.

Edit: wait, how is wealth destroyed? I don't see how selling bad bonds would inherently destroy wealth, such as if they cost a fair price of pennies, nor do I understand how overcharging would destroy wealth as opposed to taking wealth. Am I missing something?

Also when a bond fails, wealth is destroyed - a bond is a promise of payment, upon which other things are built. If it defaults wealth is destroyed. Which is why having working rating agencies for bonds was and is a big deal.

I ageee and am not saying selling bad bonds Is inherently wealth destructive.

Anyway- I understand you are describing a way these things could be sold, is all.

When a counterparty calls GS up for a quote on the JPY/USD cross, they don't care one iota what GS's internal positioning is, or where GS thinks the JPY/USD will be in 3mths time, or any other number of things. These are sophisticated counterparties (as you pointed out) who

1) know that GS doesn't owe them a fiduciary duty, and 2) don't expect it to.

It seems like theres a whole population of people out there who think that GS is playing some sort of trusted financial advisor role in OTC derivative trades, when in fact it's in a bidding war between 4 other banks to get you the lowest rate.

That's the case in Abacus as well, AFAICT. If you don't want to trade thinly traded opaque credit derivatives, don't trade them. No-one is forcing you to. But if you don't understand your risks, you trade, and your position moves against you, don't blame your counterparty. Blame yourself.

Also, and correct me If I am wrong - you've moved to discussing a quote from GS for a product (JPY/USD cross to be specific), and not CDOs in particular.

This is in order to point out that:

GS has no fiduciary duties to the buyer

This point is reiterated in your last line as well - no one is to blame if you made a bad trade, other than yourself.

So in essence, you are arguing caveat emptor - correct?

There's no significant distinction (IMO) between a trade on a 3m butterfly on the JPY/USD vs. a the 3%-7% tranche of Abacus - both are derivative transactions with well-defined risk/rewards, and you do your own research and come to your own conclusions on the value of the product. Sure, one is more liquid, more transparent, etc. but that's a factor to be taken into account when buying, not a reason for complaining when MTM moves against you.

But the distinctions are also important. With a CDO, you have the ability to stuff it with bad debt, which is what banks did.

When bankers are intentionally creating debt instruments which are going to explode, then it's different from just calling a bank to get their quote.

And at that juncture we can also ask, if a situation where mortgage payout =x, but banks are aiming for 30x by betting that the owner defaults - aren't the incentives off?

Also, when the bank is shorting the instrument and doesn't disclose it... Well generally that at the very least sounds like something most people here would want to disrupt, because it's well, not what regular people consider to be fair business.

The standard cabeat emptor defense also stands because we believe in the qualified investor aspect of the equation. And right now, not most investors are qualified for it. As svdad said - most investors aren't doing their diligence, and couldn't do it even if they tried. So perhaps that needs to be fixed, or we need a stronger regulator to gate entry.

(And reaching a situation where our regulators are not powered enough to grok the derivative, is just something we want the system to move away from over time.)

Edit: above is opinion, I'm open to listening, I do have a pretty firm idea, but work actively to dislodge it. Standard boiler plate. As I said before, I'm not the most eloquent.

At this point I've spent a lot(!) of time trying to express my thoughts, but it keeps over expanding once I start discussing or thinking about social proof and the Salesman analogy -

Let me see if I can create a framework, or at least tease a few distinct strands apart.

1) Qualified Investors: I tend to agree, it seems not many investors know whats going on in the things/CDOs they expose themselves to. Its a word which carries a legacy meaning that I think needs to be updated, or at least "Qualified Investor" should stop meaning "Patsy".

2) The Car Salesman analogy. If it is describing an ideal of where we should reach, then I think we agree - yes buyers should have genuine ability to decipher the complexity/accurately asses the security. They should have genuine choice between them and other banks. They should not suffer information asymmetries.

This means that we have, at the very least, working rating agencies, strong regulators to enforce rules and break up abuse, among many other prereqs.

3) Social proof - I am not satisfied with my arguments/ability to put it across but here is a rough draft -

Social proof should be working but its not. There are probably a constellation of reasons for this likely - Lack of choice/competitors in major banks, network and reputation effects enjoyed by the big banks, talent asymmetry, information asymmetry, regulatory capture/weakening.

Social proof, for that people have to have a choice between trustworthy and less trust worthy banks. If all banks are tarnished, then the choice is irrelevant. You end up choosing between different levels of competence and equal levels of avarice. All the car salesman are out to get you, maybe go for a scooter.

There are honestly far too many ways to approach this analogy/point and I would love to get away from it.

4) Finally in your last para you are essentially saying "Caveat emptor".

Come now.

Caveat emptor right now ends up ignoring wall street attitudes, obvious and even proven(! "can you imagine the idiots got caught") malfeasance, industry acceptance of morally agnostic standards, constant and now expected abuse of information/talent/power asymmetries.

I think you will also agree that the letter of the law is seen often as an obstacle course that people have to find the shortest path through. Heck the sheer artistry and creativity in the financial instruments being created is impressive. How many times have you come across a structure and said - wow, nice way to get out of that restriction.

I liken wall streeters to hackers - they like finding imaginative ways they can make their bets. They just don't see it in a moral sense. Its about optimum paths and optimum outcomes. If you plan wrong, you suffer. Your punitive lessons are your losses. The strong survive.

Ok I need a break, I really am hesitant to put this out there, because I can see a few angles of attack, which are arising from an overlap between different portions of finance and because I've generalized/glossed over details in some places. This was done in the interest of not getting too focused/bogged down. Probably needs to be addressed though.

That's a completely ridiculous statement. The barriers to entry in banking are coming up with huge amounts of capital. Silicon Valley is the complete opposite. You can build Facebooks and Googles with very little capital up front.

In SV, many relatively small investments are spread over lots of startups, with the expectation that something like ~90% will fail, ~9% will just break even, 0.99% will do well, and 0.01% will become the next Microsoft, Google, or Facebook.

The small number of successes more than compensate for the huge number of failures, and the failures are not systemic and pose no risk to the greater economy. There is no apparent way for systemic risk or systemic fraud to undermine the system and put the entire global economy at risk.

The banking system on the other hand is the definition of systemic risk. Every company in every industry depends on it, for short-term cash needs to long-term investment loans. If the banking system fails for some unrelated reason (say, too much bad mortgage debt used as collateral for too much prop-trading leverage, the financial crisis in a nutshell), then every company in every other industry is at risk of failure as well.

Look at the history of banking and you see the same bubble-crisis-collapse played out over and over, to varying degrees of severity. From 1800 to 1929 there's a banking crisis literally almost every 10 years, with a few 15-20yr gaps. Read up on the history of banking crises [1] [2] and you can see it's endemic to the system.

But that is clearly not the case with the startup ecosystem, because the risk model is the inverse of the banking system risk model.

If those two mechanisms are failing us, as some people claim, I'd be genuinely curious to know why it fails specifically for banks while it works wonders in other industries such as tech.

The banking system of late is really creating and concentrating debt, not wealth. They create assets like mortgage-backed instruments of various sorts, get them AAA-rated, then use them as ostensibly high-quality collateral on which to borrow even more.

But when the cash flows on that collateral began to collapse in 2007/2008, it became apparent it wasn't AAA after all, and that it could not support so much leverage, and suddenly the entire system was at risk of insolvency and needed a government bailout, massive central bank support, and economic stimulus to prevent total collapse and all the collateral damage to other industries that entailed.

Conversely, Silicon Valley concentrates equity and cash-flow-generating businesses, rather than debt, and high failure rates are expected and built into the financing model. Risk is limited to the risk-takers, and not the broader economy or government.

1. http://en.wikipedia.org/wiki/Banking_crisis

2. http://www.economics.harvard.edu/files/faculty/51_This_Time_...

What, other than scale, is different when you look at the collapse of a single company? Think of the havoc that would be caused if Amazon or Google disappeared.

That is clearly not the case for the banking system.