Traders & Traitors: Time to Model Banks After Prisons

If you’ve ever toured a maximum security prison and had the opportunity to experience first-hand the secure quarters used to confine inmates, chances are you came away impressed with the same overriding sentiment that I did. Rather than beauty or transcendence or architectural elegance, it was obvious that the builders had predicated every design decision to support one single priority – security. They started with the fundamental underlying assumption that whatever furniture, substance, or material was present in the cell – no matter how benign – the inmate WOULD attempt to use it for evil. Every switch, screw, and spring, every mechanism and mattress, every faucet, pipe, pillow and headboard must be weighed and considered within the context of the criminal mind, the criminal mindset, and the criminal intent default and ask, “How could this be used for evil?” “How will this be used maliciously?” “How will this be used as a tool to escape, intimidate, or injure?” “How could this be used for the prisoner’s personal advantage?”

From Alcatraz to Al-Qaida

The great thing about STARTING with the premise of absolute evil is that you will never be startled when this outcome occurs. When you ASSUME the worst in people as a starting point, you are no longer vulnerable to being surprised or blindsided when this evil is realized. In fact, it is this same “preemptive evil” worldview that informs America’s foreign policy as it relates to our proactive stance in keeping nukes and the ingredients for creating weapons of mass destruction out of the hands of declared aggressors like Al-Qaida and Iran.

Stocks and Bonds

I find it ironic that just as stocks and bonds have been used for centuries to shackle and embarrass prisoners, these same words and instruments are now descriptors for various classes of investment – assets that have been battered and bruised over the past 2 years while dominating the media with increasingly sensational headlines. Our populist and political outrage came to a collective crescendo last week as the SEC “donned” their civil suit against Goldman Sachs - the archetype and embodiment of all things Wall Street – and the firm which Rolling Stone’s Matt Taibbi famously called, “A great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money." In his article, Taibbi notes, “If America is circling the drain, Goldman Sachs has found a way to be that drain — an extremely unfortunate loophole in the system of Western democratic capitalism, which never foresaw that in a society governed passively by free markets and free elections, organized greed always defeats disorganized democracy." While Goldman’s stature as the industry’s preeminent “market maker” positions them as a convenient and visible whipping boy for this crisis, targeting Goldman exclusively would tragically oversimplify the tentacles of our recent malaise, for nearly EVERYONE in this industry was in on the jail-break leading America (and the world) to the brink of financial disaster.

Wall Street On Debt Row

To keep this short, I have selected a single vignette emblematic of the current mindset of Wall Street today. According to the International Swaps and Derivatives Association, “The market for credit default swaps exploded from $632 Billion outstanding in the first half of 2001 to $62 Trillion in the second half of 2007.” That sentence is so striking you MUST read it twice. In the span of six years, this niche market went from $632 BILLION to $62 TRILLION. These CDS bilateral contract vehicles HAD been around since the early 1990’s, and HAD been used proportionately for nearly a decade, and then the SAME THING happened that ALWAYS happens – something designed for a good legitimate purpose was twisted and contorted for a use beyond what was intended. The fine folks at Wiki noted, “A holder of a bond may “buy protection” to hedge its risk of default. In this way, a CDS is similar to credit insurance, although CDS are not similar to or subject to regulations governing casualty or life insurance. Also, investors can buy and sell protection without owning any debt of the reference entity. Credit default swaps are not traded on an exchange and there is no required reporting of transactions to a government agency.” When Wall Street connected these dots and discovered a way to make money that was NOT subject to regulations governing casualty or life insurance and that was NOT required to be traded on an exchange and NOT required to be reported to a government agency, they STAMPEDED over each other to leverage, use, and ultimately ABUSE this instrument.

According to Lawrence McDonald, managing director of Pangea Capital Management, “I was on the trading floor at Lehman in 2007 when we started to talk about the ethics of these synthetic CDOs, and all they are, are wealth transfer vehicles -- essentially transferring wealth from the many to the few. They really don't serve a human purpose and Goldman CEO Lloyd Blankfein just admitted that there really isn't a point for a synthetic CDO.” Like prisoners systematically tapping a jail cell looking for a crack or hole in the wall, Wall Street had discovered a fissure in the foundation of our financial system YEARS before the sirens started going off. And the reason nobody was going to sound the alarm was because…

Even the “Guards” Were on the Take

In their April 30th article entitled “The Race to Kill the Ratings Agencies,” Fortune magazine reported that a federal court has just decided to allow a fraud case against Moody’s and Standard & Poor’s to move into the discovery phase. Ratings agencies like these were SUPPOSED to act like the guards in the prison, but the Senate’s Permanent Subcommittee last week laid out over 580 pages of investigation chronicling a culture of, “Ethical decay whereby it was company policy not to commit anything controversial to paper or email. The easiest way for the ratings agencies to boost market share was to lower credit standards, and in peak years Moody's and S&P rated more than 10,000 RMBS securities each, for which they charged anywhere from $50,000 to more than $1 million and their operating margins averaged 53%, far outpacing the margins enjoyed by Exxon (17%) and Microsoft (36%), during the same time. It was a trough far richer than the agencies ever imagined. So they gorged. By 2007, S&P derived 48% of its total revenues on this new business line.” According to the recent Senate testimony of Moody’s Eric Kolchinsky, "Despite the massive manifest errors in the ratings assigned to structured finance securities and the market implosion we were witnessing, it appeared to me that my manager was more concerned about losing a few points of market share than about violating the law.”

Prison Cells: The New Model for What Wall Street Sells

Here’s my solution. I propose that we use the same model for designing what Wall Street sells that we do for designing prison cells. I propose that we START with the premise - with the expectation - of absolute evil. The current Congressional hearings and financial reform proposals will ALL be a colossal waste of time unless we START with the premise of evil; unless we START by asking, “How will this new rule be abused? How can this regulation be skirted? How can the good intention of this bill or financial instrument be twisted and contorted for the benefit of a few and the detriment of many? Don’t legislate how an investment, risk, or insurance vehicle SHOULD be used, but rather start with the end game of how this WMD (Weapon of Monetary Destruction) COULD be used. If we ASSUME malice, then we won’t be surprised when that outcome is ultimately and inevitably realized.

Sachs and Violence

If this latest downturn has taught us anything, it has been to demonstrate - once and for all – that the quaint concepts of “integrity” and “good faith” and “taking the high road” are no longer fashionable. Not too long ago, things used to be black and white; right and wrong. Now it appears that grey is the new black, where it’s not a question of whether it’s ethical or unethical (it’s unethical) but whether they think they can get away with it in court, which is where it appears many firms are now headed. Sure, “transparency” is a great starting point, but no committee or Blue Ribbon Panel can ever be created to uncover or decipher the layers upon layers of purposeful deceit and corruption built into the culture of these institutions populating our current financial system. We need look no further than our penitentiaries to see how even full transparency can’t stop the problem. In prison, guards perform daily “bar exams” on the inmates and their cells, yet records continue to show a pattern of non-stop violence and abuse of even the most benign materials to unleash evil against others.

People WILL push the boundaries in the name of competition, in the name of greed, and in the name of winning – they always have. Baseball had its steroids, Vegas has its weighted dice and card counters. And how can we forget in 2009 when those weird polyurethane swim trunks were introduced “to aid speed and buoyancy.” Within weeks they were everywhere, and at the very next international swim meet 21 world records were broken. It’s not just the nature of Goldman, it’s the nature of Man. Remember the earlier quote, “Organized greed always defeats disorganized democracy.” However, if there’s one group that should hold to a higher standard about profits (and prophets) it would be Goldman, for wasn’t it the Old Testament’s Jeremiah that lamented, “The heart is deceitful above all things and desperately wicked.” Society’s only hope in bringing back the retail investor and reestablishing lasting confidence in our “laughing stock” market is to either change the heart of mankind itself or architect a system from the ground up that is more organized, more insightful, and more savvy than the “organized greed” that is forever seeking a loophole to exploit.