BobbyG's Blog

All I ever wanted to do was play guitar for a living


Las Vegas, Nevada, USA
February 09
All I ever wanted to do was play guitar for a living.
Quantitative analyst and writer, mostly. Primus inter pares Santa Fe fan, bookworm, statistician, SAS programmer, teacher, perpetual student, musician, songwriter, photographer, 2 guard (Mr. No-Hops, a.k.a. "old school"), skier, loyal husband, father, grandfather, friend. DISCLAIMER (06/25/09): has chosen to force unsolicited advertising directly into our blog posts, without consent or warning. We have no say in the matter -- with respect to either ad content or placement, -- nor do we make any money from them. I in no way endorse what they pitch on my pages. You may be able to use AdBlock Plus to block such things.


FEBRUARY 25, 2009 3:41PM

Investigate Wall Street?

Rate: 3 Flag

Dr. Julian Zelizer of Princeton just wrote an OpEd on calling for congressional hearings into the current financial meltdown. I subsequently sent him this email:


Hi -

Just read your piece at

I've been corresponding lately with William K. Black (the "Control Fraud" guy, now at UMKC), and he's graciously sent me a lot of stuff to read. I'm just a citizen of no note.

My take on a lot of this -- some of which I wrote about in my "Tranche Warfare" post on my blog -- is that this meltdown is overwhelmingly the result of unprecedented deliberate white collar fraud, not simply risk assessment naivete and concomitant consumer overreaching. Dr. Black's stuff only bolsters this feeling. My next blog post, "The Dukes of Moral Hazard," will delve into this concern in some detail.

You write "Congress needs to learn more, not only about the kind of criminal activity for which Bernard Madoff is being charged, but also the legal practices -- such as risky home loans -- that created dangerous bubbles and put families at risk."

I could not agree more. Although, these eye-glazing "blame the CRA" or "it's all the fault of Mark-to-Market" canards are already beyond tiresome.

One concern I have -- that I will air on my blog -- is that national officialdom looks to be trying to tip-toe past the mass insolvency graveyard, i.e. trying to keep the public in the dark as to the extent of actual insolvency in the banking/shadow banking systems (correctly and honestly measured), for fear of unleashing widespread downward-spiral panic given the anxieties to which you allude.

I just finished reading Foster & Magdoff's "The Great Financial Crisis: Causes and Consequences." Confirms much of what I already thought, but the larger historical "de-coupled financialization of the economy" context was nice. Some things are true even when asserted by unapologetic "socialists" who dare invoke the name of "Marx."

Yeah. We've been living in a Potemkin economy for quite some time now. A lot (perhaps most?) of what we continue to politely call "troubled/toxic assets" are in fact essentially worthless, unenforceable paper obligations totally divorced from anything resembling a recoupable tangible asset.

Gonna be an interesting year. Dangerously so.

Best regards,

Bobby Gladd



Dr. Black, author of the book depicted above, wrote this (below), in some comments to a congressional aide:

From: Black, William

Sent: Thu 2/19/2009 5:12 PM

Subject: Why you need to sample loan files to evaluate fraud/credit risk of nonprime loans and paper (and CDS counterparty risk) 

You asked me to explain why it was critical to sample loan files to evaluate fraud/credit risk of nonprime loans and paper and its value.

The old joke in banking about loans is that it's far more important to secure the return of capital than a return on capital. An example helps. If you make a $1 million loan at 10% interest rate that quickly defaults and never repays you don't simply lose the interest you expected to earn (roughly $100,000), but also the amount of the principal that is never repaid (hypothetically, and realistically for a fraudulent mortgage, 50%, $50,000). You can see that one bad default swamps the income from a whole lot of good loans. Historically, prime mortgage loans had default rates around 1% and loss rates well below that (because the loans are collateralized by the borrower's home). Mortgage lending is highly competitive, so the profit margins on prime loans are low. Prime lenders, therefore, have to keep defaults and losses extremely low if they are to earn a profit. Default risk is the primary risk that mortgage lenders face, and mortgage fraud poses the most virulent risk of default and exceptionally large losses...


 OK, let me run with that. Some simple arithmetic readily reveals that, if you loan out a million dollars at 10% and the loan goes completely bad, you are out $1.1 million and will have to make 11 more such loans that perform perfectly just get to get back even -- a zero % ROI from a total of $12 million placed at risk. A total of 20 such loans, then, -- 19 performing perfectly after your initial loss -- gets you only to a 4% aggregate ROI. If your going-in "ROI Hurdle" was 10%, you can now never get there -- absent raising your subsequent interest rates (as CitiGroup recently, insultingly did to one of my credit cards, notwithstanding my 800-range FICO and small debt balances).

Now, while some loans indeed have eventually (<100%)  recoverable tangible asset collateral (though I would perhaps take issue with Bill Black's expectation example of "50%" during a time of mass foreclosures), you can put all of these data in a spreadsheet and vary the loss frequency ("incident loss rate") and net amount scenarios  (the latter "dollar loss rate" comprising the far more salient concern) and quickly see the highly adverse effect of even a relatively small number of defaults. Particularly given that so much of lending in recent times has itself been done using recursively borrowed money (multiple layers of "leverage"). Leverage cuts sharply both ways, as we are now seeing to our dismay. Again, see "Tranche Warfare" (in particular, scroll down to my take on "The OPIUM Economy").


 We really at this point have no idea as to the extent of utterly insolvent "zombie banks" and kindred institutions out there. And, I  have to wonder about the extent of federal political appetite for fully and publicly investigating it.


I worked for a number of years in subprime credit card risk management. We did "stress-tested" ROI analyses for everything. Our CEO had set a "stress-tested 10% ROI hurdle" policy for every marketing and internal ops initiative (basically to assess the "opportunity cost" of the money). We had to use his Excel Sheet-From-Hell "profit model" (he'd formerly been our CFO), which looked out monthly for five years. If you couldn't project -- worst-case -- surmounting the "hurdle" within a specified period (typically a year or less) your project simply wouldn't get funded, period (which led to all manner of bullshit data gaming -- mostly by Marketing --, but that's another story).

Beyond that, even for approved projects and products, execs would be sweatin' basis-point bullets when monthly "actuals" came in that diverged ever so slightly from the "projecteds," such was the anxious awareness of the ever-present random-walk adverse volatility potential (I always found the 5-year look-ahead thing amusingly lipstick-on-a-pig stupid anyway).


 Geithner's post hoc "stress-testing," done openly and forthrightly, might reveal a level of actual insolvency that the government would prefer we not know about.

UPDATE: Also, Dr. Black makes a wonderfully salient point regarding the Quixotic nature of "stress testing" absent analytical access to original loan data:


 "...a professional credit rater has told his superiors that he needs to examine the mortgage loan files to evaluate the risk of a complex financial derivative whose risk and market value depend on the credit quality of the nonprime mortgages "underlying" the derivative. A senior manager sends a blistering reply with this forceful punctuation:

Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don't have it and can't provide it. [W]e MUST produce a credit estimate. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so.

Fraud is the principal credit risk of nonprime mortgage lending. It is impossible to detect fraud without reviewing a sample of the loan files. Paper loan files are bulky, so they are photographed and the images are stored on computer tapes. Unfortunately, "most investors" (the large commercial and investment banks that purchased nonprime loans and pooled them to create financial derivatives) did not review the loan files before purchasing nonprime loans and did not even require the lender to provide loan tapes.

The rating agencies never reviewed samples of loan files before giving AAA ratings to nonprime mortgage financial derivatives. The "AAA" rating is supposed to indicate that there is virtually no credit risk -- the risk is equivalent to U.S. government bonds, which finance refers to as "risk-free." We know that the rating agencies attained their lucrative profits because they gave AAA ratings to nonprime financial derivatives exposed to staggering default risk. A graph of their profits in this erarises like a stairway to heaven [PDF]. We also know that turning a blind eye to the mortgage fraud epidemic was the only way the rating agencies could hope to attain those profits. If they had reviewed even small samples of nonprime loans they would have had only two choices: (1) rating them as toxic waste, which would have made it impossible to sell the nonprime financial derivatives or (2) documenting that they were committing, and aiding and abetting, accounting control fraud..."


Precisely. "Risk" is an empirical matter. If you cannot sample and correctly analyze at least a minimally acceptable sample "n" you cannot draw any cogent conclusions.

Let the investigations begin, indeed. But, I won't hold my breath.


 "The Dukes of Moral Hazard" is now underway. Probably gonna be another long one.


February 24, 2009 (LPAC)--A senior regulator for the Resolution Trust Corp. during the 1980s savings-and-loan crisis demanded a "new Pecora investigation" and prompt bankruptcy receivership for U.S. banks, in a column on Feb. 23.

William K. Black, now a University of Missouri-Kansas City economics professor, forcefully laid down two principles for action in the column, entitled "Why Is Geithner Continuing Paulson's Policy of Violating the Law?" First, the S&L debacle of the 1980s established a financial regulatory system based on legal requirement of "prompt corrective action" by regulators to put insolvent banks into receivership quickly, before their drawn-out failure would explode the demands on the funds of the FDIC. U.S.-based banks, Black says, are collectively insolvent by a margin of at least $2 trillion, possibly much more. "Paulson's and Geithner's flouting of the law" will cost at least hundreds of billions in Federal credit, he says.

Black's second strong demand is for "a modern Pecora investigation.... If we were dealing with a crisis of airplane crashes and someone opposed studying the causes of the failures, we would (correctly) label him a lunatic.... It appears that only intense public pressure will suffice to overcome Congressional and Administration resistance to a Pecora investigation."


NOTE: I apologize for the embedded ad below, now forced on us on June 25th without advance warning by Not my doing, and not within my power to delete. 

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You taught me a lot here. I have to come back and review a couple more times, but this is an extraordinary explanation of the country's financial Black Hole. Thank you.
Yes, Sally, I feel the same way...appreciative, but also disturbed. Thanks, BobbyG...I think!
[and now for our musica obscura section of the program]


I like black and white
Dream in black in white
You like black and white
Run runaway

See chameleon
Lying there in the sun
All things to everyone
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If you're in the swing
Mud in everything
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Don't beat around the bush
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