Tuesday, September 08, 2009

The Fraud Of Financial Engineering & Financial Innovation - A Future Of Doom Is Set Without Substantial Financial Reform

"The only thing that interferes with my learning is my education." -- Albert Einstein

I think we can generally glean the truth behind that statement. Learning is about the search for truth and knowledge. An education often involves biased perspectives, beliefs and prejudice. Education is what stands between transformation of our economy & our financial system and truth.

This is a follow up the Steve Pearlstein post of a few weeks ago. Where Pearlstein wondered out loud in a Washington Post article how fast computer trading really needed to be. Couldn't we just back off the gas pedal a little bit he asked. I want to use that perspective to reframe the truth. Possibly words Pearlstein was seeking but couldn't quite verbalize because the financial monster before him was too complex to completely digest. That is, the system of financial engineering needs to be abolished all together. We need to return to investing. Not only in financial markets but in the real economy. You remember the real economy? The real economy is the only reason financial markets exist. Were a capitalist of the late 1800s to come back from his or her grave today, they would look at the American economy and wonder what the hell these elitist boobs in Washington and Wall Street had created. Surely not capitalism. Surely not an entrepreneurial economy. Surely not American-style worker capitalism. Although the Robber Barons would be happy that government has deregulated nearly every part of the economy possible. Thus benefiting big business - the longest work hours in the developed world, pensions being robbed and shut down, wages for most in a multi-decade death spiral, health care being stripped from Americans at an alarming rate. The fraud has become so ingrained and the "education" so pervasive that no one has really stepped back to ask the most pertinent question - Why the hell does this financial Frankenstein even exist in the first place? The answer is very simple. It exists to steal. There is no other reason. Putting patches and more regulations on a fraudulent system accomplishes what? More lipstick on the pig so the elitists can continue their theft of this nation. Stealing from the middle class. From the vast majority of Americans who aren't dealt into the game of wealth transfer. There can be no other mathematical outcome. Haven't you ever wondered why the income statistics are even more disparate than they were in 1929? It's the greatest wealth transfer in the history of the United States.

Give me an oil options condor with an oil futures long position coupled with a 130-30 equity market exposure and a hedged put covered call, mortgage-backed securitized, cap and trade derivative position with a double shot of espresso and a beer chaser. To make matters even more insane we now have Wall Street, flush with cash, running around pulling bear raids on every stock with a substantial short position. We surely know this is so because high short interest stocks have returned nearly 4x the overall market in the last few months. Bear raids, bull raids, jams on large options positions, futures traders ramming shorts, stock raiders driving shorts out of completely bankrupt companies and god knows what else.

And as I highlighted in a comment the day after, on a Monday of a few weeks ago, Freddie Mac and Fannie Mae were up about 40% in a single day. That move in those two companies represented about a third of all New York Stock Exchange volume - probably an event that has never been seen in the two hundred year history of the New York Stock Exchange. Even in the early days when there were a handful of shares trading. That is, two insolvent companies representing such an enormous percentage of volume. Add in the volume of a few insolvent banks and you have the vast majority of New York Stock Exchange volume for that Monday's session. Some have been speculating this is the government propping up stocks. That makes no sense. This market action is pure financial speculation. And it is a very, very dangerous dynamic if volume does not pick up. In other words, it will lead to future liquidity shocks. Liquidity shocks we uniquely called before this crisis hit and that we have said are going to happen again unless...........we see true market reform.

So here's a simple question. How the hell does any of this financial engineering help or even reflect the economy? Or maybe better put is how does any of the Frankenstein finance structure on Wall Street benefit main street or wealth creation in the economy? It doesn't. The bad news for the bulls is eventually the two shall marry again. In other words, the economy and financial markets will eventually meet in the market place and resolve themselves to a same outcome. Yes government-provided financial market liquidity has given the appearance of stabilizing fundamentals but it is not a recipe for economic recovery. That liquidity too shall pass. Just as massive liquidity in 2006 and 2007 eventually passed. The employment work week increases a few tenths of a percentage point after $12 trillion in stimulus money we don't have? Well, hell, let's throw another $300 trillion dollars of debt into the market and maybe we can employment up to some reasonable number.

What we are witnessing is the Federal Reserve temporarily restarting the credit engine to pile even more debt onto a broken economy. Something that has already been happening for nearly twenty years. And as we highlighted in a recent post, business is now almost universally bullish about an economic recovery - nearly 90% surveyed. And as a result of the Federal Reserve restarting the credit cycle, we not only see record debt issuance by public sources but also by companies around the globe. Companies in Europe and the U.S. have piled on record debt in 2009 thanks the the Federal Reserve and other central banks. Little to none of this debt is for the intent of creating capital in the economy. It is not going into new plant and equipment. To employee training. To enter new markets. To create future wealth. It is simply being issued to survive. Hope to fight another day. Debt based on hope. That's a real winner. This is no different than shifting money between credit cards while out of work. Hoping to find a new job. But, then we have already written this exact remark quite some time ago. In other words, the policies and actions of the government are making matters worse. And the private sector is dysfunctionally enabled to similar destructive actions only because government policy is encouraging it. Government has become the enabler to the drug addict. The drug is more debt. And more economic fallacies embraced by ruling elites.

"Policy does not allow a choice between depression and no depression, but between depression now and a worse depression later: inflation pushed far enough would undoubtedly turn depression into the sham prosperity so familiar from European postwar experience, and would, in the end, lead to a collapse worse than the one it was called in to remedy." -- Joseph Schumpeter, one of the greatest economists to ever grace the profession

If you believe the government has pulled off a hat trick and the economy is recovering, you believe the move in financial markes is divining the future. If you truly understand Wall Street's Frankenstein finance, you realize financial markets are simply embracing the same failed schemes we saw before the market collapse. The same failed schemes that had no reflection on the underlying economy. The same failed schemes that failed miserably when fundamentals started encroaching on financial markets. The same failed schemes that will fail again. Absolutely none of the U.S.'s economic problems are being resolved constructively. And already government has lost any momentum to embrace transformational change. Back to the stooges of the political unions carping back and forth while Rome burns. Once again our political stooges are deluded by appearances. By the fraud they helped create and now perpetuate.

I highlighted YRC Worldwide some weeks ago - the largest trucking company in the U.S. It was basically trading down 99%. Their business has imploded. Literally revenue is down 50% and the company is in a fight for its very existence. News continues to be negative with concerns about even more lost revenue. Such a catastrophe would likely push YRC into bankruptcy. Shortly after that post the stock doubled in a period of a week. Most assuredly some hedge fund or traders at a major Wall Street firm used government-provided liquidity to hunt down shorts. In other words, the government has rewarded Wall Street for punishing anyone who may have done their homework and were short YRC. This type of action in YRC, Freddie, Fannie and other extremely speculative stocks is often a late stage rally dynamic. Especially since Frankenstein finance has gained a lock on financial markets. In any event, this action sure helps the out of economy now doesn't it?

So, let's look at another chart. Wynn Resorts. Wynn reported a 91% drop in profit. The stock then almost doubled in two weeks on completely terrible fundamentals. Please don't tell me it is based on future expectations either. That is even more ridiculous. It is more financial fraud. Most likely someone with free Federal Reserve money jamming negative positions in the stock or its options. Raiding. And what benefit does this type of activity have on the American economy? Financial engineering has no relevance to fundamentals, except for one - liquidity.

If anyone buys into this all-knowing stock market forecasting sunny skies ahead, you need to wake up. It isn't forecasting anything more than it was forecasting before the market collapsed in 2007 and 2008. Financial markets were at record highs while the underlying economy had been deflating since the mid nineties - something we wrote years ago. Why should markets reflect reality? The dynamics are still the same courtesy of a government unwilling to address reform in a rigorous and expedient fashion. Instead this is a return to theft and gambling with society's money and the subsequent destruction of society's wealth. This very fact is what I was alluding to in my remarks about Stephen Pearlstein's comments a handful of days ago. What Pearlstein intuitively understood about high frequency trading but couldn't quite verbalize is that the problem isn't high frequency trading. The problem isn't credit default swaps. The problem isn't securitized debt. The problem isn't program trading. The problem isn't banks trading oil derivatives. The problem is financial engineering in its grand entirety is literally larceny. It doesn't add to society's wealth one iota. It serves no productive purpose for society's capital. It is strictly a compendium of wealth-shifting strategies. Strategies that only work because Wall Street paid politicians so they uniquely could set the rules to the game and determine its outcome. It is the greatest of fraudulent acts against our country's citizens. Ever.

Financial engineering and its wealth-shifting dynamics creates an even greater risk when society's capital stock is not increasing as is the case at this very moment. Factoring in this dynamic, financial engineering creates an environment very similar to playing poker with either a set-limit pot or a shrinking pot. A game where more and more players are unable to stay in the game due to greater and greater losses. Unless the pot is replenished and more players are willing or able to join the game, Wall Street is actually trading its way to its own demise. Something we have already written of. Counterparty risk in financial markets is increasing dramatically as I type this. All at a time when major financial firms have re-entered the risk trade in a big way. Many people think Wall Street has won and will return to the status quo because of the money they are minting today. Paul Wilmott, one of the world's best known financial engineers, remarked of this some months ago. We wrote that Wilmott was completely wrong and this fact clearly indicated Wilmott did not understand the unsustainable dynamics of Frankenstein finance he helped create. Indeed Wall Street has won nothing. They are literally creating their own destruction without realizing it.

As we have written, Wall Street CEOs don't have any idea what their businesses are actually doing. And they are getting paid hundreds of millions of dollars to do it. Whatever "it" actually is. Case in point is that we have already seen the concentration of winnings to the top handful of firms in total derivatives. But with that also goes the concentration of risk. Now we have equity market liquidity similarly being dominated by those same firms. And, again with it the concentration of risk. What we are basically seeing is all firms are playing a similar or the same poker hand with a smaller and smaller pot. That means the game is going to get a lot more interesting. Karma has a funny way of revealing itself but I believe the financial markets are again nearing a very dangerous place without ever increasing government-provided liqudity. Liquidity needed to continue the remain in the game.

Financial engineering taught at every major MBA program in the U.S. and in Europe and practiced by every major financial firm in the U.S. and Europe is nothing more than legalized fraud. Fraud whose very foundation is to steal money from others (financial counterparties) that has the effect of creating unsustainable bubble earnings at banks. Earnings made off of the back of society through every sort of usury imaginable. The banking sector's profits are nothing more than a tax on society's productive capital. ATM fees, money management fees, derivatives trading, credit card fees, commodities investing, and on and on and on. Usurious fees for everything imaginable. All of this contributes to artificial earnings that allow financial executives to steal even more from society through hefty compensation and bonus packages. Packages that are rationalized because these firms are making huge, unsustainable profits that are actually destroying productive capital in the American economy. Profits stolen from the American people.

I doubt many people truly understood the economic consequences of the Frankenstein before us. I believe politicians were effectively being politicians - taking part in a system which encourages them to fiddle and fidget with laws and regulations so they can raise money from their corporate donors to get re-elected. In other words, most politicians are simply being greedy politicians benefiting from Corporate Personhood without an understanding of their utter stupidity and complicity in this mad house. Banksters on the other hand, they had an agenda. They knew exactly what they were doing. They were paying politicians to rig the game. They got exactly what they wanted - fraud.

Government officials need to fix the problems in our financial system and our economy instead of listening to financial lobbyists and the learned idiots running Wall Street. Every day government doesn't act contributes to greater destruction of our economy. The alternative is to be guaranteed future crises as financial engineering drains even more liquidity out of markets and the economy.

Wall Street's game is up. There is no recovery. There is no magic of financial genius. There is no brilliance of bankers minting profits. There is no genius in our Ivy League MBA programs. There is no recovery in financial earnings. There is no solvency in the banking system. There is no wonderful spirit of the American people pulling us out of this crisis.

There is only fraud and its impending doom. And it shall come to pass without serious and lasting reform. It's time to start learning from our mistakes. Mistakes contributed to by our ruling elite's "education". Or we shall be doomed to repeat them.

"The only thing that interferes with my learning is my education." -- Albert Einstein

Einstein's quote is quite appropriate to describe an intellectually deficient elitist class which continues to embrace failed ideologies (education) across a wide spectrum of issues. The greatest being a failed economic model. What is most amazing about this dynamic is that elitists are embracing ideologies which are leading to the destruction of their own prosperity. But then this dynamic has been in play throughout history countless times.

Comparatively, we have a society which generally understands these deficiencies all too well. If not by specific understanding, by a realization that government no longer works for the betterment of society. Which is why the babbling idiots in our government, our banks and our business institutions have such a low approval rating. Who's fooling whom? As Einstein would tell us, we watch and learn as truth and knowledge trumps the best education money can buy. Or maybe that is the best fraud money can buy.
posted by TimingLogic at 10:43 AM