Chapter 15 RISK

greg Schwarz headed risk analysis at the Irish Netherlands Bank. His world

turned around what should have been abstract questions of probability and

theoretical mathematics. The bank however, did not pay his princely

salary for abstract considerations; he was paid to develop sophisticated tools:

investment models and market trend prognosis.

Schwarz’s trained logical mind taught him that all questions related to economics

could be boiled down to mathematical formulas, which incidentally, in his mind,

and rightly so, were beyond the comprehension of simple bankers such as his

bosses, Kennedy in particular. As for politicians, few if any had the slightest

learning in such complex mathematical theory.

As Schwarz mingled with mathematicians at congresses in Tokyo, Boston or

Vienna, he realized a paradigm shift was taking place in economics, a revolution

comparable to the world of physics in 1910, when Alfred Einstein’s described

relativity and Max Planck launched quantum mechanics.

A whole new set of mathematical tools, not fully understood, even by quants and

analysts, were available. The science of predicting market movements was not

unlike trying to apply precision to weather forecasting, where an infinite number of

difficult to define variables came into play.

‘Look at it this way Pat,’ Schwarz tried to explain. ‘The kind of tools we have

today are seen by economists in the same way the Vatican saw Copernicus and

Galileo when they tried to demonstrate the world went around the sun, and not the

other way around.’

‘You really think we know that little?’ asked Kennedy, to whom the Vatican was

a respected source of knowledge, though he was somewhat confused as to the

involvement of Copernicus and Galileo who were perhaps Jesuits of some kind or

G

other.

‘Well it looks like it doesn’t it,’ replied Schwarz.

‘We’ll have to wait for future historians to decide that. As far as I’m concerned I

prefer my intuition to mathematical models!’

‘That’s the problem. Intuition and the lack of understanding the mechanics of the

system has put us in the shit we’re in today Pat. Our banking system was built on

trial and error and at this precise moment in time we’re seeing the result of one of

the biggest disasters in banking history.’

‘Created by economists, not mathematicians?’

‘No, politicians and incompetent management.’

‘Like me.’

‘You said it.’

There was an uneasy moment of silence.

‘So you’ve an answer to suggest?’

‘No.’

They burst out laughing, the tension vanished as they realized they were back to

square one.

Financial models had been debated by economists and mathematicians for

decades, who believed that equations were the answer to everything. The Austrian

school had a different approach, they believed the complexity of human choices

made the mathematical modelling of an evolving market almost impossible, hence

their laissez faire approach. To their way of thinking, the only means of

establishing a valid economic theory came from the observation of human action.

It was like a battle between science and theory, between Freud and Einstein.

For certain specialists the banking system was little different, in essence, to that

which existed at the time of the 18th century South Sea bubble, with bankers

scrambling to outdo each other in a mad rush for profits. Others compared it to a

game of Russian roulette, which ended when Lehman Brothers blew its brains out.

Whatever the analogy, never before in British history had there been such rush for

profits as banking became Aesop’s proverbial goose, capable of laying a limitless

number of golden eggs. Bankers, in the belief that asset prices would continue to

rise exponentially, and forever, killed the goose by leveraging themselves beyond

the realms of economic sanity.

What was worse, was Blair and his government had become mesmerized by the

success story of the City as it generated huge profits, attracting more and more

foreign investors, putting London at the centre of the international finance system,

thus creating a model for the world to follow.

The problem however was that few bankers, if any, really understood how the

model worked. All that mattered was that profits flowed in, vast profits. Banking

shares rocketed as did the price of City property. Once the bandwagon was rolling,

cheered on by Blair and Brown, every City banker, business organization and

investor, followed by every naïve, get rich quick home owner, and BTL

opportunist, dived into the scramble, and with their respective means started wildly

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leveraging, oblivious to the future and the enormous risks involved, both collective

and individual.

It was Bill Clinton who by repealing the Glass-Steagall Act, introduced by

Franklin D Roosevelt’s government in the 1930s in the wake of the Wall Street

crash, allowed commercial banks to undertake investment banking activities.

The Glass-Steagall Act was conceived to protect ordinary Americans from the

peril of losing their savings when bankers speculated on risk laden financial

markets. Thus Bill Clinton by his action was unwittingly responsible for provoking

the sub-prime mortgage crisis, which allowed commercial and retail banks, that is

to say high street banks, to engage in investment banking activities.

Many investment banks evolved from private partnerships, into public

companies, or became units of large commercial banks. This led to the formation

of too-big-to-fail financial giants, which driven by the growth and availability of

capital resources, speculated vast sums of investors’ money on highly risky

multifarious products.

It was no quirk of fate that one of the banks which gained most from this change

was the Citigroup, whose head was a major donor to the Clinton camp. Prior to

financial crash in 2008, Citigroup had become the world’s largest bank and

company in terms of total assets with over three hundred and fifty thousand

employees.

At the height of the crisis Citigroup was bailed-out by a cash injection of fifty

four billion dollars by the US taxpayer and three hundred billion in loan

guarantees, plus an astounding two trillion dollars in low cost loans.

During the Clinton administration, banks had been encouraged into offering

mortgages to sub-prime borrowers. This policy was based on the principal of

providing homes for low-income families and those of ethnic minorities, as

demonstrated by a 1994 decree designed to prevent banks from discriminating

against such groups. Consequently, Fannie Mae, the state-backed mortgage

financier, was encouraged to curb its policy of refusing to lend high risk borrowers

so as to bolster this policy.