The Financial System: More Dangerous than an Al Qaeda Attack?

“What we don’t know will hurt us, and quite possibly on a more devastating scale than any Qaeda attack”.

The quote is from a penetrating indictment of the state of the financial world, written by Frank Rich yesterday in The New York Times. The danger that Rich refers to as greater than Al Qaeda is our financial system. This Op Ed is as good a description of the viper we call finance as I have read.

While the average man on the street is likely to recognize the name Al Qaeda, many will probably shrug their shoulders at the mention of CDO or MBS. A mention of other financial derivatives based on the aforementioned unrecognized instruments will just deepen the glaze covering the eyes of Mr. Average American. By the time you get to CDS, the casino chips used to gamble on the solvency of companies that construct, own and trade these esoteric securities, Mr. AA has long since continued walking down the street.

Modern America has been built on a foundation of creativity. We are the home of Franklin, Fulton, Morse, Carnegie, Edison, Ford, Shockley, Gates and thousands more of the most creative geniuses in history. Yes, the rest of the world has also had creative genius but it seemed to be nurtured and came to flourish more in America than anywhere else. In the past 30 years, and especially in the last 20, creativity has exploded in financial engineering. Graduates in the fields of mathematics, science and engineering have found niches in the financial world where they have been able to design financial instruments that serve no more important purpose than to pile leverage on top of leverage, create huge profits for the creators and salesmen and transfer risk and losses to the masses. Some of America's creative genius has gone to the dark side.

Financial systems have been created where the profits are huge for a few and the risks are nearly unbounded for the many. This is clearly an ethical issue. But, beyond ethics, it is clearly an unsustainable condition in a democratic society. Yes, the democratic underpinnings of our Republic have been shaken by the capture of government by special interests. But this has happened before and others have risen to the occasion to change that. To mention a few names, try Jackson, Lincoln, both Roosevelts and Reagan.

Of course, those correcting the imbalances have never done it just right. Over reaction often accompanies correction and unintended consequences are usually attendant. I'm sure the reader will have plenty of examples for all five of the examples I cited. But I would argue that dealing with the unsustainable and then modifying the over reactions and unintended consequences is better than doing nothing. Doing nothing to correct the unsustainable leads only to collapse.

Frank Rich writes:

It’s against this backdrop that this week’s long-awaited initial public hearings of the Financial Crisis Inquiry Commission are so critical. This is the bipartisan panel that Congress mandated last spring to investigate the still murky story of what happened in the meltdown. Phil Angelides, the former California treasurer who is the inquiry’s chairman, told me in interviews late last year that he has been busy deploying a tough investigative staff and will not allow the proceedings to devolve into a typical blue-ribbon Beltway exercise in toothless bloviation.

He wants to examine the financial sector’s “greed, stupidity, hubris and outright corruption” — from traders on the ground to the board room. “It’s important that we deliver new information,” he said. “We can’t just rehash what we’ve known to date.” He understands that if he fails to make news or to tell the story in a way that is comprehensible and compelling enough to arouse Americans to demand action, Wall Street and Washington will both keep moving on, unchallenged and unchastened.

Angelides gets it. But he has a tough act to follow: Ferdinand Pecora, the legendary prosecutor who served as chief counsel to the Senate committee that investigated the 1929 crash as F.D.R. took office. Pecora was a master of detail and drama. He riveted America even without the aid of television. His investigation led to indictments, jail sentences and, ultimately, key New Deal reforms — the creation of the Securities and Exchange Commission and the Glass-Steagall Act, designed to prevent the formation of banks too big to fail.

As it happened, a major Pecora target was the chief executive of National City Bank, the institution that would grow up to be Citigroup. Among other transgressions, National City had repackaged bad Latin American debt as new securities that it then sold to easily suckered investors during the frenzied 1920s boom. Once disaster struck, the bank’s executives helped themselves to millions of dollars in interest-free loans. Yet their own employees had to keep ponying up salary deductions for decimated National City stock purchased at a heady precrash price.

Trade bad Latin American debt for bad mortgage debt, and you have a partial portrait of Citigroup at the height of the housing bubble. The reckless Citi executives of our day may not have given themselves interest-free loans, but they often walked away with the short-term, illusionary profits while their employees were left with shredded jobs and 401(k)’s. Among those Citi executives was Robert Rubin, who, as the Clinton Treasury secretary, helped repeal the last vestiges of Glass-Steagall after years of Wall Street assault. Somewhere Pecora is turning in his grave.

I am reminded of the old story about the leaky roof that never gets fixed. When it's raining, it's not safe to climb up and fix it. When it's not raining, it's not leaking.

Well, it's not raining on Wall Street right now so it is argued that there's no need to fix the financial system. However, it is raining (actually still pouring) on Main Street and the leaky roof is flooding millions of homes. If the need to fix the roof is not addressed, Main Street may yet be heard in Washington and the minions of Wall Street may be dispossessed.

A key to how this all plays out is the success or failure of the Financial Crisis Inquiry Commission referred to by Rich. Many of the Wall Street and Washington elite will be called to testify. The conclusion of the Rich column:

If they all skate away yet again by deflecting blame or mouthing pro forma mea culpas, it will be a sign that this inquiry, like so many other promises of reform since 9/15, is likely to leave Wall Street’s status quo largely intact. That’s the ticking-bomb scenario that truly imperils us all.

Note: Rich compares 9/15 to 9/11 as dates of pivotal changes in American history. Both represent attacks on the foundations of America. Virtually every American recognizes the significance of 9/11 (2001). Many Americans (readers of SA excepted) would fail to recognize 9/15 (2008), the day that Lehman Brothers went bankrupt. Both were historic attacks on America, one by Al Qaeda and the other by the financial system.

The reactions, of course, were entirely different. In 2001, we invaded Afghanistan to "destroy" Al Qaeda and, in 2008, we invaded Wall Street to "save" the financial system. As we enter 2010, both invasions have been, in my opinion, abject failures.

Disclosure: No positions.