Guest Post: Financial Cancer: Our Financial System Is Intrinsically Fraudulent and Unstable

Tyler Durden's picture

Submitted by Charles Hugh Smith from Of Two Minds

Financial Cancer: Our Financial System Is Intrinsically Fraudulent and Unstable

Our financial system is like a fast-mutating cancer that evades any control and is still perfecting its ability to game and loot.

Two frequent contributors provided fresh insights into why the current global financial system will implode: it is intrinsically fraudulent and acts as a financial cancer, evading the "immune system" of regulation and perfecting its ability to exploit and loot the last remaining pockets of low-risk capital.

We start with David P.'s excellent exploration of systemic fraud:

Your essay The Collapse of Our Corrupt, Predatory, Pathological Financial System Is Necessary and Positive was entirely correct about risk. But let me come at this from a different angle - namely fraud.


Finance skims a percentage off the real economy. Some part of the skim is legitimate reward for capital allocation - a necessary part of a capitalist system and part of what makes it more efficient than a command economy. But some part of the skim is fraud.


Where are we now? Let's look at the sources of skim:


First there are the more legitimate skim sources - interest payments, management fees, IPO fees, M&A fees, trade commissions.


Then there are the less legitimate bank sources: penalty credit card interest rates, late fees, usage fees, over-the-limit fees, late payment fees, bounced check fees, low balance fees. And the capital markets sources - front-running, insider trading, account churning, manipulation of the news cycle, the captive analyst "ratings game", trading against your own client's order book, forex trades which are marked at the day high or low irrespective of when the trade took place, market manipulations at options expiration, stuffing your managed client accounts full of dubious IPOs and new issues that your organization is earning fees from originating.


Bucket shops and ponzi schemes take it even a step further - no actual financial activity takes place. Its simply robbery.


And now we add the new stuff: credit default swaps without margin, fraudulent loan origination, sliced & diced mortgages, mark to myth accounting, foreclosure halts to avoid realizing losses, extend & pretend, quote stuffing, HFT trading activity that boils down to denial of service attacks on exchange computers causing delays in pricing information, highly complex derivatives sold to unsuspecting but optimistic public servants, too big to fail status providing cheap backup in the event of trouble, and increased organizational size that facilitate cartel-like control over government and regulators.


But if that's not enough, there is the structure itself: they aren't doing this with saved capital, but rather with freshly printed and/or borrowed capital. Its all done with 12:1 leverage at a minimum. So only 8.3% of the gambling (optimistically anyway) is actual capital - saved surplus. And if Basel II says it's risk-free, well there's no need for reserves at all. It is just manufactured money, which effectively mean each bet is diluting the actual savings of real people. And if the bet goes bad, the Fed will ride to the rescue with low-cost money. But usually the bet goes well, because ordinarily the number of sources of fraud today is so HUGE, its practically impossible not to succeed.


Unless of course they get too greedy. Or the debt levels rise so high that large numbers of borrowers default. And guess where we are.


The financial system is supposed to allocate capital and take a modest skim as reward for helping society to be efficient. When they are doing this, they provide a net benefit to society because it's a win-win proposition. They are making society more efficient, and they thus earn their percentage.


However, and this is the key point: fraud provides no net benefit to society. Fraud extraction is a zero sum game. For every dollar extracted through fraud, someone in the productive society ends up losing - savings, salary, whatever. This is why fraud is bad.


(I say that leverage is zero sum because constructing money from thin air for a leveraged investment causes inflation and thus steals from savers.)


Currently, it is my opinion that the vast majority of today's highly profitable financial activity is fraud. They have gone way, way beyond their mandate of capital allocators. Because most of its activities are based on fraud, the finance industry is acting as a parasite, sucking the life blood from the rest of society. Its bad enough we have peak everything, a world population of 7 billion people, and globalization to deal with - but we also have to face these challenges while a leech is weakening us with every step we take!


As a result, when this bloated, fraud-based financial system dies, we'll have a awesome, positive chance to rip off the parasite and replace it with something more beneficial. Simply re-executing glass-steagall will do for a start. Bring back 9-3 boring banking, where banks retain the mortgage and live with the risk, and capital markets once again do their job of capital allocation -- but without the fraud so rampant today.


Same conclusion, different angle. Intrinsically, I believe that capitalism does actually allocate capital more efficiently than competitive systems. And yet, how the current system works is so wrong. And I figured out it was fraud. Fraud was the bad guy. Remove fraud, and things get a lot better.


But after re-reading your essay, fraud wasn't the whole answer either. Fraud might be the leech, but leverage is the system killer.


One other comment.


If you apply statistics incorrectly to market behavior, you get into trouble. It is possible to successfully hedge away risk if the failure of one investment is truly uncorrelated with another. Joe defaulting on his mortgage is a unique event, and won't affect Sam and the likelihood of him defaulting. Then you can apply statistics and things should work out fine. Of course, in a debt bubble or a recession, that's no longer true. The same factor that caused Joe to default will also affect the likelihood that Sam will default too. Unemployment, being underwater, herd behavior, "its better to rent" - it all correlates, completely destroying the underlying assumption. Real life trumps statistics.


This further supports your basic premise - in the real world, there are almost always hidden correlations that reveal themselves at the worst possible moment, typically at the point of maximum leverage. Thus for practical purposes, it is impossible to hedge away risk; as a result, leverage still kills.


We've seen this most recently in sovereign debt. Basel II lets banks lever to infinity on sovereign debt because it assumes sovereign debt has a zero default risk. Hmm...


So - remove fraud, remove leverage, admit risk will always exist, and the capital markets can go back to fulfill their traditional role in society of capital allocation, making us all more efficient.


But of course removing fraud and leverage removes all of the easy zero-sum profit opportunities; all that remains is the job of capital allocation. While its true that capital allocation materially contributes to society, it turns out it is also hard work. Who wants to do that when there's easy money to be made in fraud - with leverage! And that's why we have to have another crash so we can return finance to its proper - and necessary - role in society.

Contributor Michael M. explores the analogy that our financial system is in effect an aggressive cancer, and also explores the system's inherent instability:

I think the risk "hedging" can be split into two parts, first using/inventing "hedging" instruments who won't live up to their name in a major event (CDS anyone?), and second hiding risks in existing allegedly time-tested limited risk systems/instruments.

You mostly covered the first part in your article.


Some more examples for the second variant, besides lowering the down payment on house mortgages, are: Gaming VaR models (so for a 1% VaR the risk in the 99 days remains the same, but the blowup in the 1-out-of-100 event becomes much much larger), or lowering of Fractional Reserve requirements, or Sweep accounts (deposits in checking accounts get sweeped into savings accounts, i.e. are put into money market funds where the risk is a [little] bit higher, but the owner of the capital [the depositor] doesn't receive higher premiums), or student loans becoming non-dischargeable.


"So what happens when one counterparty (issuer of a hedge) somewhere in the chain runs into trouble? The entire chain collapses."


Or the accounting rules are manipulated, so the entity next in line after the collapsed one is allowed to keep their risk valued at par on the books, even though their hedge just vanished (and they are not able to get replacement hedges at an acceptable price in the current market) and the ongoing collapse freezes in a state of suspended reality - but the trouble is not undone!


The system has not blown up yet because there are still some pockets of unimpaired, really low-risk capital available to game and loot.


In effect the financial system is still perfecting its ability to game and loot, just like a cancer which, due to non-self-restrained growth and fast mutation, continuously improves its ability to elude or withstand the immune system. Until the host cannot bear the strain anymore.


How could we ever get to this point?


Too much stability. Thereby lowering reserves and safety margins more and more, until one day (maybe even without a large increase in volatility first!) a swing exceeds the safety margin. Oops. Which is exactly what Nassim Taleb is saying, but almost no one fully understands him.


This leads to my quote, which I came up with myself:


Stability breeds stupidity.


But at the same time one must remain humble of being able to overview all relevant parts of the picture... it can go on for a LOT longer than oneself can come up with a functioning game plan for, no matter how far you stretch your imaginable reality.


Which makes me go back to my "(over-)complexity" meme. I nowadays also look at The Fourth Turning through my complexity goggles... and war is still the strongest simplifier - quicker and more rigorous even than a systemic collapse!

Thank you, David and Michael, for your incisive analyses. The system's stability is superficial, and we might yet see that facade stripped away in the remaining months of 2011.

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Odin's picture

I- International

M- Mathematical

F- Fraud

Manthong's picture

Well, NOW it is..

Ghordius's picture

Well, where is the CDS market here?

I'd say under operation of a gambling environment with other people's money and credit.

All in all I'd say this is one of the best Smiths I've read so far. And he now understands Taleb's point!

Mountainview's picture

What about the CDS market in the case of Greece? Is the voluntary haircut of 50% a sufficent event for Greece CDS? If not, forget about CDS!

gojam's picture

It's the biggest fundamental of all the fundamentals and it can't be said enough.

Charles Hugh Smith surveys the forest while too many others are staring at the trees.

The entire system is fucked!


Ethics Gradient's picture

It's alright, the EFSF has just managed to raise €3bn. We're saved! Yay!

Odin's picture

E- Everybody

F- Funds

S- Someone-else's

F- Fuck-up


Grinder74's picture

Ooh, ooh, do one for the SEC.  It's Monday and my brain's not working.

Odin's picture

S- Shadow

E- Enterprise

C- Compensation


....k that one's a little harder

DaveyJones's picture

S sex. E every. C computer.

El Viejo's picture

Big bonuses for taking risk.

DormRoom's picture

I like the way you think, Mister.


skimming in a credit ladden capitalist system also has a multiplier effect....


assume skim rate @ .2

(.2) + (.2)(.2) + (.2)(.2)(.2) + .... So in the long run the real economy is choked off from capital/resources.


Multiplier effects are the feedback loops in the system, and its negation 1-(multiplier rate) series has a built in reflexive property

gojam's picture

Are you a genius or is that just bullshit way over my head ?

It looks right to my eye, so on the off chance you are a genius I'll give you +1

narapoiddyslexia's picture

If my memory serves [and it usually doesn't] that series converges to 25%, or

x + x^2 + x^3... for absolute value of x <1, or 

[ 1/[1-x] ] -1 = .25

Which sounds about right. The bankers are stealing about 25% of the income and in exchange they see that we have pliable leadership.

Do you deserve more? Your congresscritter doesn't think so. So shut up and enjoy it. 

11b40's picture

.25 off the top sounds about right. 

After all, 30 years ago, the "financial" componet of our economy was less than 15%.  We had lots of jobs and actually manufactured lots of things.

Now, the financial contribution to GDP is over 40%.  No wonder we are where we are, fiscally speaking.

Kickaha's picture

Yes, and somebody ought to recalculate GDP ex-financials to arrive at the true rate of decline in actual US GDP during those 30 years.  Maybe then the numbers will match up with everybody's daily observations regarding the sorry state of the real economy here, and why there has only been one depression, and that using GDP or the S&P to argue for any sort of recovery is total BS.

HD's picture

It's very, very simple. If you don't have moral hazard you don't have efficient, stable markets. The massive CDS market, bailouts and the fed have all but destroyed real free market capitalism.

Losses must be taken before we can start again.

jayman21's picture

HD - I like telling the NYC OWS folks the same thing.

Downward mobility is just as important as upward mobility.  We lost the downward part when someone on Wallstreet fucks up.  They are allowed to continue to make the same mistakes over and over.  This is not capitalism.  OWS is protesting against a kleptocracy and they are realizing this.  They loved that word as do I.  Well, love/hate.

agent default's picture

Of course you have a fraudulent system!  When the a central bank can print money out of thin air, lend it to some bank at close to 0% and the bank lends that money to the market at something like 5% (pick a number here), it is a gross distortion of the market, it is manipulation, and it is a ponzi through and through.  And as usual with all market manipulations, the snap back is always vicious.  The larger the distortion and the longer it is maintained, the more vicious.  To the point of totally wrecking the manipulator.  Sound familiar to the situation we are in?

JustObserving's picture

All frauds are intrinsically unstable

Ruffcut's picture

I met with my congresscritter this morning for a meet and greet. I flat out ask him about fraud, freddy and freaky, boy what A bullshit storm. The others were grey hairs worried about social security and medicare.

What a mother fucking deflective fuck. I made him sweat and rattled.

He sure liked using the phrase "free markets".

As far as help coming from the district of dipshits? forget it.

You are on your own, BITCHEZZ.....

11b40's picture

Good for you!  Election season is coming & I hope far more of us turn out for these local meetings.  They will be held in every district over the coming months.  Draw up your list of questions that will force discussion of real economic isues, and be prepared to chalenge and not accept bullshit answers.

Ask them if they are in favor of bringing back Glass-Stegal.  Ask if they believe we can solve problems of debt with more debt.  Ask if they approve of this low-interest program from the FED, which is robbing millions of savers the interest they are entitled to and destroying the ablity of pension plans to meet future obligations.  Ask them if they beieve corporations are people...& if they do, ask them if they can vote.

The list can go on & on, but you get my drift. I, too have been to a number of meetings with local Congressional representatives, and Ruffcut is right....most people attending are older and more concerned with general issues like Social Security and Medicare, or they are supporters of the speaker.  It is good and healthy to shake them up and make them stutter.

Ruffcut's picture

I brought up glass steagle and he thought it was goldman steal and went into frank dodd.

A state senator was behind me and said all the fucky freaky MBS was bwarneys fault, and he was in the mortgage thft business. Yes fre held a gun to the heads of countrywide, wamu and chase to underwrite no doc reverse amort and teaser rate loans. I told him that and he ducked behind me, out of the room. I did not see him again.

Fuck, Im still pissed off.

BlueStreet's picture

Chuck Ponzi would be immensely proud that his life's work has been carried on in such a grand fashion.  

fuu's picture

Gold bitches!

Vergeltung's picture

never understand the down dings for these comments. isn't it the trademark ZH phrase?


jomama's picture

aren't the down dings trademark ZH?



MissCellany's picture

It is, but he didn't spell it bitchez.

(No, I didn't junk him.)

RockyRacoon's picture

The junks are from those who don't have any gold.   At the current ratio of +/- (5/2) I'd say that's about the ZH average population who hold/don't hold gold.   Jealousy!

SilverRhino's picture

Until bankers / investment houses and crooked regulators start doing perp walks and/or getting hit with lynch mobs the financial system will not correct.  

Too many examples exist of outright theft and corruption for unethical men in the markets to fear justice.  So it will continue until systemic collapse.

XitSam's picture

I fear the systemic collapse will be engineered so that unethical men go unscathed and the replacement system allows for just as much, if not more, fraud.

tired1's picture

when did you become such an optomist?

11b40's picture

Right after he got his 'opto' degree.

FlyPaper's picture

Absolutely.  And not just fraud, XITSam.  They want to go way past that into some form of pretend-democratic society where-you-have-no-freedom because you are regulated to death; and they will confiscate your wealth without due process should you break the regs.   

Seasmoke's picture

if those who gambled and lost were not made to pay, it made the rest of us (well some of us) realize they we could make our own bailouts for ourselves and justify .....moral hazard is a bitch, but i would like to thank them for waking me up that i do not have to follow the rules that kept me really was 2008 the end or really the beginning

HD's picture

If by "make our own bailouts" I assume you mean you stopped paying your Visa bill.  And to that all I can say is - I'm jealous, wish I had thought of it.

ClassicalLib17's picture

My Visa card is issued from my credit union,  and I would not think of defaulting on an organization that has served me fairly for the last 39 years.  Should I get a different card from a bank so I can max it out on  GOLD, BITCHEZ?

El Viejo's picture

Like Minsky said, Too much money in the markets and they become unstable.

Blame 401ks and Under-taxed rich.

Ignore the history of LTCM and go broke. 

There once was a time when retirement plans were diverse. (Corp pensions and CSRS govt employees retirement plans) Then some brilliant person came up with the idea that everyone should manage their own retirement plans and all the Darwinian lovers of money said yeah. Until their time came and they cried foul or put their faith in gold.

Imagine where we would be now had Bush succeeded in making Soc Security Taco Bell ... I mean 401k now.

Shizzmoney's picture

Das on Financial Sector: "Like Big Tobacco, the Financial Sector "forgets" to factor in the one big variable: Externalities"

Dick Darlington's picture

And this is where societys end up as a result of the systematic and prolonged fraud where small portion of the population gets almost everything.

Vergeltung's picture

that was a great read. tons of good stuff in there. first guy really describes it well.....

El Oregonian's picture
Greek Prime Minister Papandreou, London School of Economics Alumni George Soros, London School of Economics Alumni... HMMM... I'm sure this is completely unrelated with the financial collapse of Greece.. More interesting tidbits... Chelsea Clinton, graduate of... You guessed it... London School of Economics. But wait... So was Monica Lewinsky... How weird is that???

Come on you investigative journalists out there, lets get on it...



earleflorida's picture

they're called "Honey [trap] Pot's",...

Mayer Amschel Rothschild's picture

Tally sticks, bitches!

lynnybee's picture

so many articles, so many vague generalities, so many frauds yet no names named. when will there be a real expose naming the culprits (culprits ? I mean CRIMINALS ! ) The word is fraud & outright looting of the U.S. TREASURY & systematic looting of the American taxpayer to support the military industrial complex & Wall St. & the City of London & don't even get me started on 9/11 & the twin towers & what really went down that day ... do your own research; i did mine & it's gut-wrenchingly sick, makes you want to vomit & get a pitchfork or worse & go after these sick son-of-a-bitches. I hope they all rot in hell.

11b40's picture

But the real crime, Lynnybee, is that so much of it is legal.

RiskAverseAlertBlog's picture

Not mentioned is the fact that, what is intrinsically fraudulent and unstable, indeed, is intended, and this to hasten the pipe dream of neo-fascists the world over whose given name today is "governance."

Mark123's picture

The maginot line worked really well, until it didn't.  Then France collapsed like a house of cards.


maginot line = US treasury market