Frankenstein Finance: Supercomputers Play Craps with Mortgages!

No kidding – what is at the heart of the credit industry meltdown is so bizarre that Kurt Vonnegut might have channeled the story:  literally a game of computerized craps.

While the US homeowner is being impugned and scapegoated for the credit meltdown in the MSM, the comely mask was torn off a monster, exposing insider trading at the heart of the fiasco.  While the MSM pillories the US mortgage holders, finance media blogsphere erupts into a field day satirizing “Frankenstein Finance” and computers gone berserk

Time to shred the costumery and parlance adorning hedge funds.  This is too easy to understand.  This credit crash evokes 2001: A Space Odyssey and the treacly voice of Hal, one seemingly omniscient computer. 

Hal, you there?  Hal, can you help us make sense of this mess?

[note:  “LSD economics for poets…” is coming.  I need to put this up first as a sort of reference page – cross-posted at DKos to little notice]

“Dave?  Dave?  What are you DOoooing, Daaaaave??”

August 9 – The Wall Street Journal (Henny Sender and Kate Kelly): “Computers don’t always work. That was the lesson so far this month for many so-called quant hedge funds, whose trading is dictated by complex computer programs

“Dave, calm down…  You’re Getting Emotional, Dave…”

Quant funds – ‘quant’ stands for quantitative — generally operate by building computer models of market behavior and then allowing the computer programs to dictate trading
‘Our risk models failed to pick up the fact that we were due for a correction,’ says Keith Campbell, founder of Campbell & Co. ‘We were highly diversified. It was the perfect negative storm.'” source

In fairness not all hedge funds used the “quant” system.  But evidently the Frankenstein species is endemic now to hedge fund trade.

Yes, Computers Playing Craps

A fellow Kossack verifies that the name of the derivatives game (think of a dealer at a game table) is craps  in his response to my comment:

I used to be a “Derivatives” trader. I think that Craps is a better comparison for derivatives than Poker. All the side bets in Craps is what it is all about. That is exactly what derivatives are all about. Side Bets.
A friend of mine said I should go and play craps and that would speed up my trading in options. (Realize I was making hundreds of trades a day for a large discount brokerage at a large call center.) I went that weekend and learned to play craps and realized that derivatives and craps are basically the same game…

Again for fairness sake, please read the full comment, which explains that derivatives can  be a good thing (in the hands of humans).  Farmers for one would be lost without that trade. 

But recently a lot of supercomputers ripped the hull out of their collective boat, venturing up the proverbial creek sans paddle.  They weren’t programmed for stormy weather.

“Dave, stop.  Please.  Dave, I Can Help You…”

Oooopsie Daisy, a little insider trading comes to the light of day…

… inventors of these funds tried to put together what he labels an “Ivy League Ponzi scheme” that attempted to pair put-and-call options with borrowed money
“…when hedge funds multiply, they essentially bet against one another and require one another to validate their bets,” he says. It was doomed to failure, he says.  source

Borrowed money… mark that phrase.

But if They’re Rich Why Not Use Their Own Money?
And just how much borrowed money is in hedge funds?

Take a deep breath; sit down, consider what Al Martin has to say in his analysis of the New York Federal Reserve Bank’s public statement about hedge funds:

the $17-trillion hedge fund industry [figure includes actual assets plus “market positions” at the time of writing, now decreased – Stonemason], 93% of which is debt financed, or in other words, based principally on borrowed money (…)the principal driver of the global economic collapse scenario is and will be the hedge fund industry.
As the Fed points out, referring to the total “assets” of the hedge fund industry is a misnomer. It should be really called the total “debt” of the hedge fund industry, since 93% of their assets are debt, even though they carry it as “assets” on the books.
aggregate hedge fund debt is now approximately twice the average daily ‘free money supply’ of the entire planet. Free money supply (…) “free” meaning “net,” i.e. the unencumbered money supply of the planet.

In other words, they borrow money (at cheap interest rates) to lend the same money out (at very expensive interest rates) to mortgage holders of dubious credit and other debtors who “deserve” to have to pay high interest rates.

Hedge funds are exclusive because of the “risk” they take.  They seek money-lending situations where borrowers, through personal misfortune (such as being born in a third world country where “emerging market” debt is the hot up-and-coming “product”), are faced with extortionary levels of interest.  They briefly collect all the interest on these massive “packages” of debt then quickly toss the debts back on the game table.  Hedge funds’ dealer Mr. Derivatives then doles these debts to the next hedge fund at the table, and so on.

They buy and sell huge groups of mortgages… fast.

Speed of turnover is a part of avoiding “risk.”  The same debt might be “repackaged” and bought/sold several times a year – or a month – by various hedge funds (and, by the way, takes on a new identity as “collateral” in the global assets bubble each time).

Or think of a hedge fund (technically a private offshore investment bank) as a mower that comes along to mow “fields” of interest and then move on.  No responsible relationship with the parties who are paying all that principle and interest.

Did your mortgage rate change several times last year?  That would likely be because ownership of your mortgage was tossed like a hot potato from hedge fund to hedge fund.  You can thank computers for making those decisions. 

“Trust Me, Dave, Trust Me…”

This computerized craps game?  Insured

…Banks used to hedge their loan books with derivatives. Now they sell that insurance to hedge funds and other market players. The fallacy of banks selling insurance… is akin to “… buying insurance on the Titanic from someone on the

The insured status of our computerized craps game tempts what is known in the trade as “moral hazard,” when traders lack caution towards other people’s money for knowing that insurance safeguards their hubris.

The majority of “value” in the “securities” created by the hedge funds is the value of derivatives attached to these deals.  Remember:  a derivative is an advance selling option.  It is just like a crapshoot, with its side bets.  Someone’s going to win, you just don’t know who.  The banks have now insured the derivatives – literally an insured bet on a crapshoot.

“Dave!  Dave?  Let Me Explain, Dave…”

A chimerical force has been rampaging through global markets in recent months, wreaking widespread havoc. Cobbled together from myriad agreements, assumptions, and transactions by academics, financiers, and marketers, this labyrinthine creation was once seen as an unmitigated success of new age financial alchemy.

But now, with changing economic and financial conditions exposing the derivatives-securitization monster to the harsh light of day, the nightmare of Frankenstein finance is coming home to roost.  link

By the way, when the credit system crashed, it made a huge mess of finance markets everywhere. 

Think of dumping various foods into a blender, turning it on the highest speed, then taking the lid off as the blender is in action, liberally splattering every surface with the goo.  This is analogous to “risk spreading” within the money-lending realm (finance).  Everybody’s retirement has been splattered with this mixture of bad debts. 

“Dave, calm down… We Can Work This Out…”

Yes, a bunch of young ivory tower league money boys had quite a Ponzi scheme which got tipped over when their computers were unable to do thinking for them.  See how big their hubris grew:

So how did this hedge fund fiasco get started? You’ve got 12 to 14 TRILLION dollars out there which started out life as about $400 billion. Now nobody knows who owes what to whom. And there’s no market for those $12 trillion in securities.

…nobody actually knows who owes what to whom. This is the most complex and convoluted mess that has ever been created by man. source

What the craps game did was to “dice, slice, chop” etc. all the “risk” and bleed it into securities, equities, every kind of product on wall street.  Securities are baskets of previous debt groups “shuffled” in with yet other debt, repackaged, re-hypothecated, whatever it took to auger up the value, in order to use it at an elevated value again for collateral…

It’s like the flu for the finance realm.

Here is a picture of “baskets” of mortgages “changing identity” through the derivatives trade (also known as “structured finance”):

For years, industry insiders and so-called experts have proclaimed the virtues of slicing, dicing, and repackaging risk. (…) They suggested any sort of exposure could be disbursed and dissipated to the point where it essentially disappeared. Some even claimed that the crises of the past would no longer exist.

Yet amid the hype and assurances, few supporters spoke of the dark side of wanton and widespread risk-shifting. They didn’t seem – or want – to acknowledge that by combining complicated risks in unfamiliar and unnatural ways, the end result could be an uncontrollable monstrosity-one that eventually turned on its masters.

Nor did they heed the notion that by scattering risk into every nook and cranny of the global financial system, the vast web of overlapping linkages virtually guaranteed that serious problems in one sector, market, or country would trigger far-reaching shockwaves. Much like, for instance, the allegedly “contained” meltdown in the subprime sector has

Yes we’re talking about your retirement portfolio here, no matter what:  everybody got hit with the mess, and no doubt it reduced all values.

“Dave?  Dave, Let’s Talk, We Can Work This Out…”

In fact this is the elephant in the great living room of finance which no one wants to mention.  And there is good reason why…  what people in finance and government fear most is a “bank run” – that people will rush to get their money out of the all-sacred finance sector.  This is why the scapegoat of the US homeowner is necessary for their cover at this time.

“Dave, Come Back, Where are you Going?  Dave?

Of course now that the rich have moved on… expatriating the US at a record rate of around 30,000/month, most of the bag-holders of this crash are going to be the little guy… the pensioner… (see comments on link):

The whining from Wall Street is growing louder. Those brilliant high-flying hedge fund managers are now facing the prospect of financial ruin. It seems that they are holding hundreds of billions of dollars of mortgage debt, some of which is worthless, and much of which is worth considerably less than it was a few weeks ago. Since the hedge funds are heavily leveraged (they borrowed heavily to buy assets), many of them could be wiped out.

Given the gravity of the situation, the hedge fund crew is doing what all good capitalists do when things go badly: run to the government.

Specifically, they want the Federal Reserve Board to bail them out with lower interest rates. They hope that this will buy them the time needed to dump their mortgages on less well-informed investors.
One final point: the hedge fund crew may try to take the homeowners hostage, arguing that the only way to keep millions of low and moderate income homeowners from being thrown out on street is to bailout the hedge funds. This is not true. Congress can just pass legislation that allows homeowners who default to remain in their house as renters, as long as they pay the fair market rent (as determined by an independent appraisal) for their home.

We must be careful not to confuse the plight of distressed homeowners with the plight of the hedge fund crew. As we all know, you can never give in to hostage takers, especially if they run hedge funds.

And how rich did the rich become due to hedge funds?

Solstice has only about 80 members. Platinum membership costs them $875,000 to join and then a $42,000 annual fee. In return they get access to 10 homes from London to California and a private yacht in the Caribbean, all fully staffed with cooks, cleaners and ‘lifestyle managers’ ready to satisfy any whim from helicopter-skiing to audiences with local celebrities. As the firm’s marketing manager, Cain knows what Solstice’s clientele want. ‘We are trying to feed and manage this insatiable appetite for luxury,’ Cain said with pride.
The reason behind the sudden wealth boom is, according to some experts, the convergence of a new technology – the internet and other computing advances – with fluid and speculative markets. It was the same in the late 19th century when the original Gilded Age of conspicuous wealth and deep poverty was spawned by railways and the industrial age. At the same time government has helped by doling out corporate tax breaks. In the Fifties the proportion of federal income from company taxes was 33 per cent, by 2003 it was just 7.4 percent. Some 82 of America’s largest companies paid no tax at all in at least one of the first three years of the administration of President George W Bush.
But who are the new rich? Some of the names are familiar, Microsoft tycoon Bill Gates and savvy stock investor Warren Buffett. But most are unknown, often springing from the secretive world of financial hedge funds.

Names, names…  From a now-defunct (scrubbed?) CNN article:

WASHINGTON (AFP) – What do three former US Treasury secretaries, one time secretary of state Madeleine Albright, a former US ambassador to the United Nations and ex Spanish prime minister Jose Maria Aznar have in common? They have all been recruited by powerful hedge funds or private equity firms since departing government…

The secrecy surrounding such investment firms and media headlines about the vast riches generated by SAC Capital Advisors, the Blackstone Group and the Carlyle Group among others have only added to their mystique.

Industry alarm about a US regulatory clampdown, however, has risen amid calls from some congressional lawmakers for better transparency despite assertions by the US Treasury that the sector’s self-policing is adequate.

Executives and insiders say, however, that a feared regulatory assault only partly explains the race to hire well-connected officials…. Unlike public corporations, hedge funds and private equity firms are lightly regulated in the United States and as such operate largely out of the public eye.

Naming names… the last three Treasury secretaries; John Snow/chairman of Cerberus Capital Management, Dan Quayle; DE Shaw & Co. hired Clinton-era Treasury chief Lawrence Summers, Paul O’Neill advises Blackstone who also hired former Canadian prime minister Brian Mulroney; London-based Centaurus Capital hedge fund hired former US ambassador to the United Nations Richard Holbrooke, who is a vice chairman of Perseus; Former US President George Bush and ex-British prime minister John Major both worked for the Carlyle Group.

Looks like there’s a turnstile on the back door of Congress…

“Noooooooo… Daaaaave….. Noooooooooo….  Stopppppp, Puuut thaaaaaaaaaat doooowwwwnnnnn, Daa  aa  aaa….”


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  1. The following is for those readers who are more familiar with compounded loan scams:

    In the new game, Das points out, banks “originate” loans, “warehouse” them on their balance sheet for a brief time, then “distribute” them to investors
    The more loans that were sold, the more they could use as collateral for more loans, so credit standards were lowered to get more paper out the door — a task that was accelerated in recent years via fly-by-night brokers now accused of predatory lending practices.

    Buyers of these credit risks in CDO form were insurance companies, pension funds and hedge-fund managers from Bonn to Beijing. Because money was readily available at low interest rates in Japan and the United States, these managers leveraged up their bets by buying the CDOs with borrowed funds.
    So if you follow the bouncing ball, borrowed money bought borrowed money. And then because they had the blessing of credit-ratings agencies relying on mathematical models suggesting that they would rarely default, these CDOs were in turn used as collateral to do more borrowing.
    As assets bought with borrowed money rose in value, players could borrow more money against them, and it thus seemed logical to borrow even more to increase returns. Bankers figured out how to strip money out of existing assets to do so, much as a homeowner might strip equity from his house to buy another house.

    These triple-borrowed assets were then in turn increasingly used as collateral for commercial paper — the short-term borrowings of banks and corporations — which was purchased by supposedly low-risk money market funds.
    When you add it all up, according to Das’ research, a single dollar of “real” capital supports $20 to $30 of loans. This spiral of borrowing on an increasingly thin base of real assets, writ large and in nearly infinite variety, ultimately created a world in which derivatives outstanding earlier this year stood at $485 trillion — or eight times total global gross domestic product of $60 trillion.

    Without a central governmental authority keeping tabs on these cross-border flows and ensuring a standard of record-keeping and quality, investors increasingly didn’t know what they were buying or what any given security was really worth.


  2. I’m reading!

    I have always had an instinctual understanding of what they are doing. But seeing the gears turn is very educational.

    It is of course the same (designed and perpetrated) feeling of helplessness that pervades politics that allows this to happen.

    For complex systems we rely on the government, when the government is a scam…what else can we expect?

    • 3card on September 25, 2007 at 1:53 am

    We seem to have crossed that bridge some time ago.  In the late seventies and early eighties all state and federal usury laws were done away with. At the time there was high inflation and the legitimate goal was to restore credit and liquidity… BUT rather than adjust the definition of usury and peg it to a base inflation rate, the concept was just eliminated and dispensed with.  Just one example – there was a story on NOW this week about a Mexican investment bank that was making micro-credit loans to poor people at an effective rate of 100%, all the while claiming what humanitarians they were. 

    What the average person would call loansharking and fraud is now business as usual by the largest and “most respected” banking and financial institutions – not to mention the more obscure hedge and equity funds. Financing ponzi schemes seems to have become common, and legal.

    It almost sounds like what you are describing is passing nine sacks of shit and one bag of cash from hand to hand and waiting to see who ends up holding what when the music stops.  Piss poor odds unless you’re the one paying the orchestra.

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