Convicted fraudster Bernie Madoff.  Photo: Woopidoo Biographies

When the Madoff scheme first came to light, followed by other, smaller fraud schemes, a new meme started appearing in the mainstream press regarding the economic meltdown.  Roy Clancy displays this meme very well in his editorial in today's Calgary Sun, Swindle with a Smile.  The main thrust of his column, that Canada has become a haven for fraud schemes like this because of our lax regulations and even laxer enforcement (white-collar fraud convicts are eligible for parole after serving only 1/6th of theis sentences), is a solid argument.  I've personally never understood why white-collar fraud is treated any differently than knocking over a convenience store or a bank.

However, in making his point, Clancy throws out the following line, without corroboration or evidence.  "Then again, financial markets collapsed because sophisticated money managers bought into ventures with the same characteristics."  There is no doubt that part of the economic landscape of the past few years has been money managers investing in questionable Ponzi schemes like Madoff, or Earl Jones in Canada.  To say that was the cause of the financial collapse is very much overstating the case however.

This meme, it seems to me, is an attempt to deflect attention from the real causes of the meltdown.  This wasn't a meltdown caused by a few rogue criminals in the financial world ... this is a meltdown caused by that very system itself.  There's little doubt that people like Madoff flourished in the lax environment of the past few years, but they were merely taking advantage of a system that was already in place.

There are two key factors in this meltdown that, to a layperson at least, seem unforgivably stupid.  The first factor involves the selling of debt.  One of the most fundamental corrective mechanisms of the lending market, at least from the perspective of a layperson, is the assumption of risk.  When someone considers giving out a loan, a KEY part of the system that encourages them to ensure it's a good loan, is that they are assuming the risk of default.  They are left holding the bag in the case of a bad loan, and that encourages due diligence and the writing of only solvent loans for the most part.

But a key part of the recent economic landscape has been the ability to sell debts after the fact, thus transferring risk from the entity granting the loan.  Under normal circumstances, this still isn't a huge problem ... the purchasing entity has a chance to do due diligence on the debt being purchased, and can ensure themselves of it's solvency before buying.  But in the past few years, a remarkable thing has happened.  Financial services companies have been creating opaque packages of debt which they sold to people who then had no ability to do any due diligence on the individual contents of the packages.

Given such a process, it's easy, for a layman at least, to see how abuse can occur, and shaky loans get into the mix.  In institutions writing the original loans, the need for due diligence on the borrowers is greatly reduced, because lenders know they can pass the risk on to someone else down the road, in a situation where that buyer can't see whether this particular loan is good or bad.  If that same firm is offering performance bonuses for the value of loans written, the broker suddenly has incentive to write as many loans as possible, and make them as large as possible, without really caring about the solvency of the loan.  It's the perfect environment to create and feed a housing bubble.

It's worth noting that a complicit player in all this were the ratings agencies.  The packages created out of the mortgages, good and bad, were rated AAA in most cases, as the safest of possible investments.  While it's clear in hindsight that those ratings were bogus, it also begs the question (one that seems rarely asked at the moment) of how those ratings were arrived at.  How could ratings agencies accurately assess those debt packages when even they were unable to examine the individual components making up the packages?

The second key factor over the past few years involves capitalization of financial institutions in the US.  In the past, entities like banks have been required to keep a 6-1 ratio of obligations to assets in order to be considered solvent.  In other words, a bank needed to have access in assets to at least 1/6th of it's total debt obligations.  Those regulations were quietly relaxed over the past decade, allowing many entities to operate on ratios as low as 35-1.  Again, to the layperson, it's pretty easy to see why only having 1/35th as much cash as you need to satisfy your obligations isn't a sustainable situation.

When you combine these two factors at the same time, it created a perfect storm of bad economics.  With the natural barriers to lending thrown out, more and more loans were written on shakier and shakier grounds.  At the same time, the same institutions that were writing all the new mortgages were allowed to operate without any real ability to make good on the obligations they were agreeing to.  In essence, they were giving loans to people who couldn't pay them back, out of assets that didn't ever exist in any real sense.  How could a meltdown NOT happen eventually in an environment like that?

Sure, people like Bernie Madoff took advantage of that situation, and created vast schemes with no real assets backing him up.  But honestly, how is that different from ANY of the companies writing bad mortgages at capitalization levels of 35-1?  Madoff, and other criminals like him, are merely a symptom of the systemic problems that were created in the financial industry over the past decade.

As astonishing as this is, Madoff is small potatoes, and people like Earl Jones in Canada are barely on the radar.  Madoff, the biggest frauster of the bunch by far, is accused of losing as much as $50 billion in investor funds ... the collapse of the economic sector involves TRILLIONS of dollars in toxic debt in mainstream financial institutions.  It seems clear, to the layman at least, which is the more likely cause of a massive, global meltdown.

And at the end of the day, that's what seems most astonishing to the layman here.  There is very little discussion of the true causes of our recent problems, very little analysis of the structural issues that caused the collapse.  There is very little in-depth discussion of the role of ratings agencies in pumping up investments that they couldn't examine in detail.  There is very little discussion of the role of assumption of risk and due diligence in maintaining the integrity of the lending system.  There is very little discussion of the practice of allowing entities to lend out 35 times as much as they could reasonably expect to cover.  (It should be noted that Andrew Leonard, from Salon's How the World Works, has done a great job of asking many of the same questions I ask here)

Those things seem very basic and fundamental to the layperson, in my opinion.  It's not rocket science to work out that removing the assumption of risk might be a bad idea for lending institutions.  It's hardly rocket science to question the idea of 35 times as much debt as assets.  And yet, there is still a meme that what caused a multi-trillion dollar, worldwide economic meltdown was paltry billions of Madoff and his ilk.  Why isn't there an intense discussion about the policy that actually caused the mess we are in?