Tuesday, October 19, 2010

Sensational ... but true

Photograph by Terry McCombs
My writings in this space are usually somewhat academic and what I think is an objective view point, whenever I stray from highly academic topics. A recent article from the Rolling Stone magazine, though, caught my eye. The writer talks about the systematic way in which Wall Street banks touting their financial engineering expertise have expanded their influence into small governments in America. The banks have peddled products that have invariably resulted in huge amount of financial distress for these agencies. See link here.

The phenomenon of bankers behaving badly with small governments or for that matter even with larger ones (state pension funds) is nothing new. The 1994 bankrupting of Orange County by Robert Citron (Citron? for Orange Country?), the county treasurer, is a well-known story. See a really good article about this failure here. Another notable example from the same period is Proctor & Gamble's dalliance with derivatives that resulted in a lot of grief for themselves as well as for Banker's Trust, their investment banking advisers. The human psyche seems particularly frail and susceptible to smooth talking operators, talking interesting numbers and displaying other forms of spreadsheet gadgetry, and promising the moon in return for money. In addition to the banks' rapacity, the people at the customer end - that sought to invest in little understood financial instruments, where the risk of the counterparty is bounded but your own downside is infinite - are as much to blame. Not for the lack of financial savvy, but for getting into a situation where such financial gimmickry needed to be resorted to in the first place.

The primary problem here is the particular weakness of small government bodies to be reckless about spending during good times. In an attempt to do something big and important for their constituents (ascribing the best motives), governmental bodies take on big projects when the economic cycle is positive and tax revenues are abundant. They take on big loans which need servicing even when things go bad - when tax revenues decline or interest rates rise or whatever. And then these agencies find themselves strapped for money and start to resort to financial gimmickry. And fall into the arms of the Wall Street firms.

Reminds me of the famous Roald Dahl story about the old man who has a priceless painting tattooed on his back. And who goes away with a smooth talking stranger who promises to keep him happy for the rest of his life, only if the old man displayed his painting to the stranger's guests at his hotel. Needless to say, but in a few weeks, the painting appears sans the old man in a famous art gallery.

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