False Gods Fleece the Faithful (2010) (ed.2)

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A B R O K E N E C O N O M Y - C A N T R U S T B E R E S T O R E D ?

DAVID COLLETT with ZENDA COLLETT



AT THE BEGINNING OF THE 21st CENTURY we again face another

severe economic crisis which threatens to cause suffering akin to that of the

Great Depression. How is this possible when we have reached such dizzying

heights in our ability to generate abundance? Will our seemingly limitless

progress be the cause of our demise?You will enjoy the simplicity with which False Gods Fleece the Faithful

discusses the dominant causes of the current economic crisis and how we

failed to learn from the lessons of the past. This book tells you how and why

you have been deceived by many in positions of trust; why unemployment is

likely to increase in the coming years; why the values of your home, savings

and other investments are likely to decrease, all while your living expenses

continue to increase; and inallywhymanywill be exposed to continuinghardship despite the abundance surrounding them.

Thisbookwillnotonlyempoweryoutoparticipatewithconidenceinfuture

debates about the causes of the current crisis, but it will also tell you why the

solution is in your hands. Most importantly, this book will equip you to resist the

invisibleforceswhichthreatentodestroyallofus–greed,selishnessandman’s

apparent inability to share abundance.

ANCHORAGE INVESTMENTS

anchorage-investments.com

DAVID COLLETT is a Chartered Accountant

with more than 25 years experience in the eld of

forensic investigation. He has acted as an expert on

many subjects such as business, investment and share

valuations; fair presentation in nancial statements

and prospectuses; lax credit standards, credit risks and

professional liability. Over the past decade he closely

followed the nancial markets. Through a series of

presentations made to the nance and investment

communities, he forecasted the collapse of nancial

markets and the 2008 stock market crash.

This book pro vides an excellent insight into the curr ent

econom ic crisis. In typically thorou gh fashion, David applies

his considerable forensic skills, to focus on the overwh elming

evidence available prior to the crisis, which w as so patently

ignore d by a self serving bu siness and p olitical leadership.”

- B R Y A N H O P K I N S -

Was the co-author of a leading and a uthoritative book on Generally Accepted Accounting

Practices. He is a former Chief Investment Ofcer of Old Mutual and ABSA Asset Management,

which controlled assets worth in excess of $50 billion. He currently sits on the board of various

listed companies.



CONTENTS

Ak .................................................................................................... 13

F........................................................................................................................... 15

PART ONE: DÉJÀ VU - AN OVERVIEW OF THE MODERN WORLD

ECONOMY .......................................................................................................................... 19

I ............................................................................................................... 21

C 1: T G D................................................................. 23

Innovation and Productivity .................................................................................. 23

Income and Wealth Inequality ............................................................................. 23

Credit Expansion ........................................................................................................... 24

Deregulation and Monopolies .............................................................................. 26

Real Estate and Mortgage Credit Growth ...................................................... 26

The Share-Market Bubble of 1929..................................................................... 27

Economic Contraction and Consequences.................................................... 29

A Timeline of the Great Depression .................................................................. 30

Important Changes Brought About by President Roosevelt

and World War II ........................................................................................................... 32

The Pecora Investigation: The Shame of the Super Rich ..................... 33

The Plotters Who Nearly Changed History ................................................. 37



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C 2: T J C ............................................................................... 41

Innovation and Productivity .................................................................................. 41Income and Wealth Inequality ............................................................................. 41

A Strong Japanese Currency ................................................................................. 43

Credit Expansion—1980s ....................................................................................... 43

Growth in the Real Estate and Stock Markets ............................................ 44

The Aftermath of the Japan Crisis ...................................................................... 45

C 3: T C C........................................................................ 49

General Overview of the Current Status of the World Economy .... 49

Innovation and Productivity .................................................................................. 50

Growing Income and Wealth Inequalities..................................................... 51

Credit Expansion ........................................................................................................... 62

The Dot-com Bubble ................................................................................................... 64

The Residential Real Estate Bubble ................................................................. 66

Old versus New Banking Systems ...................................................................... 66

New Innovations........................................................................................................ 67

Flawed Risk Models .................................................................................................. 68

Spectacular Rise in House Prices........................................................................ 69

Collapse of Real Estate ............................................................................................ 72

Fed Rate Cuts and Mortgage Rates..................................................................... 72

Housing Bubble Questions...................................................................................... 73

Pyramid Scheme........................................................................................................ 73

Important Bubble Factors in Maintaining the Pyramid Scheme .......... 74

Faith in the Abilities of the Financial Institutions and

Their Creations........................................................................................................................... 74

Why Did the Risk Models Fail?............................................................................. 75

Lax Underwriting Standards ................................................................................ 76

Rating Agencies ......................................................................................................... 77

Banks Join the Party by Leveraging ................................................................. 78



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The CDS Factor ............................................................................................................... 79

The Stock Market Crash ............................................................................................ 80

Response from the Authorities ............................................................................ 81

C 4: D C Mj C ..................................... 83

Lessons from History ................................................................................................. 83

How Growing Wealth Inequality can Cause an Imbalance in

the Economy..................................................................................................................... 86

Model A : Example of a Closed Economy in the 1950s

and 1960s .......................................................................................................................... 86

Model B : Example of a Closed Economy in the 2000s ......................... 89

Dominant Causes .......................................................................................................... 98

Changes in Taxation ................................................................................................. 100

A Synopsis of the Effect of Growing Wealth Inequalities on the

Current Crisis................................................................................................................ 103

Is There a Solution to the Current Crisis? .................................................. 104

PART TWO: THE ENEMY WITHIN ..................................................................... 105

C 5: M Mk B ........................................................ 107

Madoff’s Ponzi Scheme .......................................................................................... 108

Post-mortem ................................................................................................................. 112

Pervasiveness of the Culture of Make Believe ......................................... 113

C 6: T R F F G .................. 115

Rise of the Financial Gods .................................................................................... 116

The Splendor of the Gods’ Financial Innovations ................................. 117

ProitingfromtheHousingBubble............................................................... 123

Collapse of the Financial Industry .................................................................. 125



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Achievement versus Compensation............................................................... 127

Countrywide Financial Corporation: Angelo Mozilo .............................. 127

Lehman Brothers: Richard Fuld....................................................................... 129

Merrill Lynch: Stanley O’Neal ............................................................................ 131

UBS: Marcel Ospel .................................................................................................. 133

Royal Bank of Scotland (RBS): Sir Fred Goodwin..................................... 134

Legacy of the Fallen Gods ..................................................................................... 135

Bonuses Criticized..................................................................................................... 136

Financial Gods Fight Back ................................................................................... 136

Doing God’s Work ...................................................................................................... 138

The Best and the Brightest .................................................................................. 143

Failure of Risk Management ............................................................................... 144

Some Perspective on the Fallen Gods ........................................................... 148

C 7: C T ......................................... 151

Bucky’s Giants.............................................................................................................. 151

FederalReserveBankoftheUnitedStatesDeies

Transparency ................................................................................................................ 153

The Financial Gods’ Hold on Power.............................................................. 156

Transparency and Complexity in Financial Reporting ...................... 160

Fair Value Accounting ............................................................................................. 163

Mark-To-Myth—A Real-Life Example .......................................................... 166

Mark-to-Market ........................................................................................................... 176

Defense Against the Gods of Complexity and Opaqueness ............. 183

C 8: T S C ..................................................... 185

Plato’s Republic: The Myth of the Cave........................................................ 185

The Veil of Credibility.............................................................................................. 187

The Credible and the Incredible....................................................................... 190

Presumption of Credibility................................................................................. 190



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The Credible Elite................................................................................................... 193

The Contrarians ...................................................................................................... 196

Credibility, Experts, and the Power of Groupthink .............................. 198

PART THREE: IN PURSUIT OF A SOLUTION.................................................. 203

C 9: C, S, R ............ 205

Cause for Great Concern........................................................................................ 205

Can the Current Crisis Be Resolved? .............................................................. 209

Government and Central Bank Intervention .............................................. 209

The Contrarian View............................................................................................. 211

The Authors’ View.................................................................................................. 212

What If We Fail? .......................................................................................................... 219

A Creed for the Enlightened................................................................................ 220

S ............................................................................................................................. 222



FOREWORD

Forsomeofus,ightingforinancialsurvivalisnearlyasstressfulas

facing death. In our pursuit of making ends meet, many of us develop

tunnel vision. Our focus narrows to such an extent that we exert all of

our energy on the next paycheck, the next job, or the next deal. When

things get tight, we become fearful and sometimes compromise our

values in the hope that we might postpone our perceived demise.From time to time, our hopes are buoyed by news of government

stimulus packages, stock market rallies, and optimism for an

economic recovery. In our daily struggle we cling to the promise of a

better tomorrow. We trust that those who rule over the economy are

doing a good job and that they have our best interests at heart.

Our trust, however, might be misplaced. In the world of capitalism

and free markets, the mantra is self interest—the survival of theittest.Fewofthosewhoholdswayoverthefruitsoftheeconomy

have our interests at heart. In fact, anyone in the upper echelons of

business empires who shows too much empathy towards his or her

fellow citizens is often worked out of the system.

Nevertheless, the majority of Western society has embraced

capitalism and free markets. In the twentieth century, this ideology

has triumphed over all others. With the demise of the Soviet Union

and with China’s implementation of its own brand of free markets,

the victory of capitalism seems complete. We even accept the

drawbacks of capitalism because we have faith that the rules of the

game are being applied fairly. We believe that we all compete on a

levelplayingieldunderthewatchfuleyeofdemocracy,inwhich



| 16

everyone gets the same opportunities to rise to the top. As long as

wearesuficientlydisciplined,hardworking,anddedicated,wetoo

can rise to the top. We trust the guardians of the system and believetheir promises to protect us. We are continually assured that those

at the top deserve to be there because they have worked harder and

therefore have achieved more.

Butistheplayingieldreallylevel?Doeseachoneofushavea

fair chance to progress through hard work alone? Is our faith in the

so-calledrainmakersandguardiansofthesystemjustiied?

For the moment, let’s compare capitalism to a rose garden. Likea rose garden it is tough, resilient, and has its seasons. Roses send

up vigorous new shoots from their base every year. With time,

however,thesenewshootsgrowold,producefewerlowers,and

become easy targets for pests and diseases. The bushes become

congested by inward-growing branches that prevent the sun from

reaching vital parts of the plant. This happens when the roses are

not pruned regularly. However, all is not lost—pruning the oldest branches and cutting back the younger ones makes room for new

stems. In short, removal of formerly productive branches stimulates

vibrant new growth.

Capitalism is similar to a rose garden in many respects. When

capitalism is not pruned by regulatory oversight, restructuring,

or even liquidation, it becomes like rose bushes that grow out of

control. The disease of excessive greed soon infects it. When that happens, it does not take long before cronyism takes root; a problem

thatisdificulttoeradicateonceithasbecomeestablished.

Democracy is the gardener that is supposed to prune capitalism

to ensure vigorous new growth; growth that is beneicial to all

participants. When democracy is not doing its job, the garden

of capitalism can quickly become tangled, overgrown, and

unproductive before inally becoming barren. More speciically,the gardeners are represented by our elected oficials, who are

supposed to act according to our wishes. But in real life, these

gardeners often ignore our wishes, preferring political and business

opinions to public opinion.



| 17

To make sense of our economic landscape, we must walk through

it with an inquisitive and open mind. This is a daunting task. The

sheer volume of the interconnected branches of the economy isoverwhelming. Information is often tainted by the favored ideology

or the popular economic philosophy of the day. The mechanics of

the economy is often presented as being more complex than it really

is. This is by design in some cases: such obfuscation is meant to

discourage us from taking part in the debate, which not only affects

our own future, but that of our families, our children, and our fellow

man. It leaves us at the mercy of those who supposedly grasp it alland act as if they have ascended to the level of gods. These false

gods assume that they have the ability and right to dispense the

fruitsoftheeconomyastheydeemit.Ifwedon’tstanduptothem,

our share will become smaller and smaller until nothing is left.

But capitalism is not only about economics; it is more often about

power, greed, and manipulation. Unless we have the knowledge and

tools to guide us through the smoke and mirrors we often encounter,we will remain at the mercy of those who think that they are the

masters of our universe. This book will take you on a short journey

through previous crises, analyze the current crisis, and demonstrate

the extent to which we are unable to learn from the past.

Neither the Great Depression of the 1930s nor the current

crisis can be described as periods of famine or of shortages of

goods and services. Rather the opposite is true. They were bothperiods of initial abundance, where supply exceeded demand. The

1930s were, despite the abundance, a period of human suffering

and destitution for many. The toll of the current crisis has yet to

be tallied. As technology and productivity continually improve, the

very abundance they have produced might destroy the economic

fabric of society as we know it. This presents us with the greatest

challenge of all time—to ensure that this progress and abundanceare a blessing to all and not only to a privileged few. Our survival

might depend on inding the solution. This is what this book is

about—exposing how inequality and greed conspire to destroy the

progress of which we are capable, and what we can do to change it.



| 1.éà:60

Table3.fonceagainconirmstheextenttowhich theamount

of debt taken on by the bottom 80% increased between 1983 and

2004. The bottom 80% have become substantially more dependent

Figure 3.4

Percentage Ownership of Each Category of Assets

Source: The State of Working America

90.7% 90.8%

65.4%

84.7%

9.3% 9.2%

34.6%

15.3%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Common Stock Non-EquityFinancial Assets

Housing Equity Total Net Worth

Bottom 80%

Top 20%

Table 3.f

Increase in the Amount of Debt of the Average Household

Percentile of allhouseholds

1962($’000)

1983($’000)

% Increase1962 to

1983

2004($’000)

% Increase1983 to

2004

Bottom 80% 24 24.5 2 59.2 142

Top 20% 43.5 87.7 102 158.63 81

Source: State of Working America



mDOMINANT CAUSES OF

MAJOR CRISES

L H

All three crises described in the previous chapters were preceded

by many similar economic factors and trends. Determining thedominant cause or causes of the above crises is important, not

onlytounderstandwhytheyhappenedbutalsotoindthemost

appropriate solutions. There is still no consensus regarding the

dominant causes of either the Great Depression or the Japanese

crisis. There is even less agreement as to what solutions were

the most effective. To credit World War II with ending the Great

Depression obscures the economic factors that contributedto the relatively prosperous period—more than two decades—

that followed.

Why did the United States succeed in overcoming the Great

Depression while Japan is still struggling to escape its 1990 crisis?

One obvious answer, but one that offers little information by itself, is

World War II. A more comprehensive answer is found by examining

the economic factors that dominated before and after each crisis. Inthe case of World War II, certain factors were in play that were not

present in the Japan crisis.

The similarity of economic factors and trends that preceded each

of the three crises is discussed in previous chapters. In response to



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the 1990 crisis, Japan followed a recipe used by the United States

and other industrial countries in an attempt to resolve the Great

Depression.Japan’sdeicitspendingbegantoballooninthe1990s,but although the United States raised taxes during the 1930s and

1940s, Japan lowered taxes from 1990 onwards.

The lesson of the Great Depression and World War II was

thatmassive deicit spendingbygovernments can play a role in

economic recovery. In response, the GDP of the United States and

ofmostothercountriesincreasedsigniicantlyandunemployment

dropped. But it is also clear from the relatively poor resultsachievedbyJapaninthe1990sthatsuchhugedeicitspendingby

itself is not a sure resolution to a major crisis. The extent to which

Japan’staxationstrategymighthaveinluenceditsrecoverywillbe

discussed later in this chapter.

Two things the World War II era did achieve for the United

States, in addition to GDP growth and lower unemployment,

was signiicant improvement in wealth inequalities. As incomeinequalities continued to improve throughout the 1950s and

1960s, real GDP growth was at a record high, despite relatively

high tax rates.

Although Japan still has a comparatively low rate of unemployment,

unemployment has more than doubled since the 1980s and has not

yet returned to its previously low levels. Japan’s income inequality

improved continuously after World War II but has worsenedsubstantially since 1980 and shows no signs of reversing. From

the early 1990s Japan experienced one of the worst periods of

economic growth since World War II.

The United States experienced a substantial deterioration

in income inequalities since the 1980s, and in 2009 the unequal

income distribution reached pre-depression levels, with the top

1% of income earners taking 25% of all income (see discussion inChapter 3). From a historical perspective, it seems as if there is a

strong correlation between deteriorating income inequalities and

major crises, and conversely that there might also be a link between

improvement in income inequalities and subsequent recoveries. It



j | 85

therefore makes sense to consider the potential effect that growing

income inequalities might have on economies over time.

There can be little doubt that factors like credit bubbles, asset bubbles, irrational exuberance, banking crises, stock market

bubbles, and their subsequent collapses are closely linked to

major crises. This begs two important questions: does each factor

originate independently and does any one factor or combination of

factors inevitably lead to a crisis? As it seems that growing wealth

inequalities—especially income inequality—preceded most of

the above factors, we will look at the potential effect of wealthinequalities on economic contraction as well as the roles of credit,

asset, and stock market bubbles in causing major crises.

The interaction between capital, labor, inance, savings,

productivity, taxation, investment, production, government and

private consumption, and economic growth is complex and very few

people, if any, have a complete understanding of the mechanics of

all these interactive processes. In order to provide some insight asto why growing wealth inequalities are likely to create economic

imbalances, which then lead to major crises and economic

contraction, a simpliiedmodelwillbe illustrated.Themodelwill

mainly focus on income from labor and investment; production;

and personal consumption. The model therefore does not attempt

to provide for all of the above interactive processes. This model

compares the trends of the 1950s and 1960s with trends observed inthe2000s.Duetothefactthattherearenotsuficientdataavailable

to ensure absolute accuracy in all respects, some assumptions are

made. In this way, the growing imbalances caused by growing wealth

inequalities and the role they play in the expansion and contraction

of an economy can be illustrated more easily.

Throughout this book, wealth inequalities and changes therein

are explained by comparing two groups: the bottom 80% and top20% of income earners. There is no particular reason why one

could not split the groups differently, such as into the bottom 90%

and the top 10%, or even the bottom 99% and the top 1%. The 80

and 20% groups are used because historic data are more readily



| 1.éà:86

available and are commonly used to demonstrate the effects of

growing wealth inequalities on economies.

H G W Iq C C I E

In Models A and B below, it is assumed that there is a closed economy

with a limited number of players. In addition, total household

income ($100) is assumed to be equal to the value of all products

and services produced by the economy and consumed by the twogroups (the top 20% and the bottom 80%). In the real economy,

savings, the government, private investment, imports and exports,

taxation,andvariousotherfactorsalsoplayasigniicantrole.For

the sake of simplicity, however, these models will only address those

role players and economic factors that are considered necessary to

illustrate the impact of growing wealth inequalities.

ModelArelectsasituationwhereincomedistributionissimilar

to what was observed in the 1950s and 1960s. The bottom 80%

of households earned around 56% of total disposable income

and the assumption is made that they contributed 57% to total

consumption. Model B refers to the period from 2001 to 2004,

where the 80% group earned around 52% of total income but

contributed 62% to total consumption.

Model A

Example of a Closed Economy in the 1950s and 1960s

In Models A and B, the 80% group contributes mainly labor to

the Production Module, where goods and services are produced

for sale to the Personal Consumption Module. For this input, the

Production Module compensates them in the form of wages and

salaries. The top 20% also contributes labor to the ProductionModule,butitsmaincontributioniscapital(inance,sharecapital,

etc.). For its contribution, the top 20% is compensated in the form

ofsalaries,interest,dividends,tradingproits,andotherformsof

remuneration associated with its capital investments.



j | 87

H O U S E H O L D

I N

C O M E M O D U L E

B o t t o m

8 0 %

5 6

%

$ 5 6

T o p 2 0 %

4 4

%

$ 4 4

T o t a l

1 0 0

%

$ 1 0 0

P

E R S O N A L C O N S U M P T I O N M

O D U L E

B o t t o m

8 0 %

5 7 %

$ 5 7

T

o p 2 0 %

4 3 %

$ 4 3

T o t a l

1 0 0 %

$ 1 0 0

P R O D U C T I O N M

O D U L E

( G O

O D S

A N D

S E R V I C E S )

C o m p e n s a t i o n

S a l e s

C a p i t a l

$ x

G o o d s & S e r v i c e s w o r t h

$ 1 0 0

L a b o u r

$ y

T o t a l

$ 1 0 0

$ 1 0 0

M O S T L Y W A G E S

& S A L A R I E S

G O O D S & S E R V I C E S

$ 5 6 + $ 1 = $ 5 7

( B O R R O W E D F R O M T O P 2 0 % )

S A L A R I E

S , I N

T E R E S T

&

D I V I D E N D S

$ 4 4 - $ 1 = $ 4 3

( L E N T T O B O T T O M 8 0 % )

M o d e l A



| 1.éà:88

The total compensation paid to the Household Income Module

in Model A comes to $100, of which the 80% group receives $56

and the 20% group gets $44. The 20% group receives a higherportion of total income if measured by individual household

formainlytworeasons.Theirstreasonisthatitownsmostof

the capital; more than 90% of all common stock and non-equity

inancial assets (see Figure 3.4). The second reason is that

members of this group are compensated more for their labor

input due to their higher perceived value in producing goods and

services. The Household Income Module then decides how toutilize this income. The 80% group spends its full income of $56,

plus $1 it borrowed, on the goods and services produced by the

Production Module. The 20% group spends $44 ($45 – $1) of its

income on the above goods and services and saves $1, which in

turn gets lent to the 80% group.

By looking at Model A, there seems to be no alarming imbalance

that threatens the above closed economy. The 80% group couldhave conceivably serviced the cost (interest and capital) of the $1

itborrowedandthe20%groupbeneitedbyvirtueoftheinterest

received. More importantly, there was a market for all of the goods

and services produced by the Production Module, which in turn

ledtohigherproitsviadividendsandinterest.Thesystemalso

beneited laborviawages andsalaries, because the Production

Module would employ all workers required to satisfy demand. Inreality, the 1950s and 1960s might even have had a more balanced

economy than the one provided in the model. America as a nation

had a relatively high savings rate and the economy, as measured

by the GDP, grew more robust in these two decades than it did in

the last two decades. Also, the growth in wealth (income and net

worth) was more evenly spread between the above two groups.

The situation has changed substantially in Model B. It isassumed that the closed economy doubled in growth to $200.

It is further assumed that the Production Module increased

the value of goods and services due to greater innovation and

improved productivity.



j | 89

Model B

Example of a Closed Economy in the 2000s

The total compensation paid to the Household Income Module in

Model B comes to $200, of which the 80% group receives $104, or

52%, and the 20% group gets $96, or 48%. The 20% group receives

a higher portion of total income as measured by household, for

reasons described in Model A. The Household Income Module then

decides how to utilize this income. The 80% group spends its full

income of $104, plus $20 it borrowed, on the goods and services

produced by the Production Module. The 20% group spends $76

($96 – $20) on the above goods and services and saves $20, which

in turn gets lent to the 80% group.

The imbalance in the closed economy of Model B is obvious. The

80% group’s share of total income has diminished substantially, and

it borrowed a substantial amount ($20) from the 20% group, which

enabled it to contribute 62% ($124) to the Personal Consumption

Module (see Tables 3.g and 3.h). The 80% group thereforemaintained a higher standard of living than that allowed by its

income from salaries and wages alone. On the other hand, the 20%

groupbeneitedsigniicantlyfromthisarrangement.Itreceiveda

relatively greater share of total income as measured by household.

Its net worth was increased by way of savings and the rising value of

its investments (e.g., value of listed shares also increased). This was

mainlyachievedbyindingamarketforallofthegoodsandservicesproduced by the Production Module, which led to higher earnings.

Without substantial lending by the 20% group and borrowing by

the 80% group, there was no market for 10% ($20/$200) of the

goods and services produced by the Production Module. If they

could not sell the 10% of goods and services, it would result in

overcapacity and less sales for the Production Module. That would

have translated into economic contraction and less compensationto the Household Module.

The imbalance comes about because the production of goods

and services cannot be absorbed by the consumers (both the bottom



| 1.éà:90

80% and top 20%) without the top 20% affording ever-increasing

debt to the bottom 80%. As the 80% group’s debt increases every

year by the above $20, it becomes less likely that it will be able toservice it. These imbalances, however, would not have come about

if the 80% group still received 56% or more of total income and

consumed an equal percentage of goods and services. However, if

productivity increases and more goods and services are produced

by roughly the same resources—mainly labor and capital—and

the beneits of productivity are not shared equally between the

respective wealth groups, supply will overwhelm demand. Thisgrowing gap between supply and demand can only be bridged by

growing credit, lower taxes, and negative savings.i

The imbalance reaches the breaking point when the 80% group

is unable to service its ever-increasing debt (see Table 3.h) and the

value of the collateral (mainly housing), on which the 20% group

relies, begins to collapse (see Figure 3.6). It is important to note

that in the real economy the gap between consumption and incomeforthe80%groupisnotsolelyilledbycreditalone,butalsoby

the use of savings. For the purposes of this example, the potential

contributionofnegativesavingsbylowerincomegroupstoillthe

gap between demand and supply is not considered.

This collapse in the value of collateral is inevitable in a bubble

economy because credit fuels the rise in value, which in turn fuels

a further rise in credit (as collateral values increase) to the point where it becomes unserviceable. This inability of the 80% group

to service its debts obviously has the potential to destroy the net

worth and income of both groups. The 80% group’s net worth

is destroyed by the decreasing values of its members’ homes,

while the value of their debt (mortgages and other forms of debt)

remains the same. In addition, as production is cut back and job

losses increase, the Production Module aims to cut costs in anattempt to remain proitable, and to compensate the owners of

capital (share capital, bonds, debt, etc.). This further undermines

the 80% group’s ability to negotiate a higher price for its labor,

i When an individual, such as a retiree, uses his or her private savings for consumption.



j | 91

H O U S E H O L D

I N

C O M E M O D U L E

B o t t o m

8 0 %

5 2

%

$ 1 0 4

T o p 2 0 %

4 8

%

$ 9 6

T o t a l

1 0 0 %

$ 2 0 0

P

E R S O N A L C O N S U M P T I O N M

O D U L E

B o t t o m

8 0 %

6 2 %

$ 1 2 4

T o p 2 0 %

3 8 %

$ 7 6

T o t a l

1 0 0 %

$ 2 0 0

P R O D

U C T I O N M

O D U L E

( G O O D

S

A N D

S E R V I C E S )

C o m p e n s a t i o n

S a l e s

C a p i t a l

$ x

G o o d s & S e r v i c e s w o r t h

$ 2 0 0

L a b o u r

$ y

T o t a l

$ 2 0

0

$ 2 0 0

M O S T L Y W A G E

S & S A L A R I E S

$ 1 0 4 + $ 2 0 = $ 1 2 4 ( B O R R O W E D F R O M T O P 2 0 % )

S A L A R I E S , I N

T E R E S T

& D I V I D E N D S

$ 9 6 - $ 2 0 = $ 7

6 ( L E N T T O B O T T O M 8 0 % )

G O O D S & S E R V I C E S

M o d e l B



| 1.éà:92

and hence leads to even less income with which to buy goods

and services.

The net worth and income of the 20% group are also threatenedby the following disturbances.

1. Thevalueofitsstockinvestmentsmightdropsigniicantlyin

value due to an expected decrease in future earnings,

2. The value of its debt investment deteriorates because of

increasing defaults by the 80% group and a drop in value of

the collateral for that debt, and3. There is a decrease in income from bonuses, commis-sions,

andothercompensationpreviouslyjustiiedbyhighearnings.

The 20% group is further threatened by a lack of liquidity and by

insolvency because it or the vehicles (banks, insurers, etc.) in which

it is invested are highly leveraged in order to maximize proits.

Because neither party wants to buy the other’s assets above themarket value and because the sale of investments at market value

could make the seller insolvent, trading stops and the velocityii of

money in the economy slows. This happened to the United States

and most of the other developed countries in 2008.

If the Fed, other central banks, and governments did not step

in to save the 20% group and its investment vehicles, then the net

worth and income of all income groups could have suffered hugelosses. By supplying more than ample liquidity, at virtually no

cost, to this group’s various investment vehicles (mainly banks)

against their illiquid investments as security, the investment

vehicles started to trade among themselves, the Fed, and the US

Treasury. This trading increased the value of various investment

assets (especially shares and corporate bonds) in 2009, thereby

improving the net worth of the wealthiest owners of capital.Despite receiving this extensive assistance from the Fed, credit

lines to most of the 80% group have been cut and the cost of

inanceincreasedinmanycases.Thereasonsareobvious:why

ii The number of times the total money supply in circulation is turned over or circulatedthrough the system in a given period.



j | 93

lendtopeoplewhocannotservicesuchdebt,whohaveinsuficient

collateral, orwhose inancialpositionwillprobably deteriorate

further due to increasing job losses? Neither was it sensible toinvest in further capacity as supply already exceeded demand.

Hence, trading with each other and the government was the

best option.

Further Analysis of the Above Models

In digesting the above, the following questions might arise.

Why doesn’t the 20% group spend more of its income on

consumption to make up for the loss of spending by the 80% group?

Wealthy households’ needs have a limit. It is similar to the law of

diminishing returns.iii For example, say a household has bought

four cars for each inhabitant. It is unlikely that there is a need

tobuyaifthorsixthcar.Irrespectiveofhisorherwealth,fewpeople want to buy 100 cars simply because they can afford to

do so. The same goes for food, clothing, electronic equipment, and

soforth.Oncetheneedsofafamilyhavebeensatisied,itwilltend

to save the balance of its income.

In the beginning phases of economic contraction, the wealthier

households might choose to increase their spending for a while

because of bargain prices. Alternatively, they might choose tocutbackontheirownconsumptionbecauseasigniicantpartof

their spending might be discretionary (e.g. buying a boat) and a

sudden decrease in the value of their assets might make them more

cautious. On the other hand, most of those in the 80% group have

little discretionary spending and are more likely to have many

unsatisiedneedsthattheywouldsatisfyiftheycould.Thusthe80%

group would increase spending and consumption substantially if it

had access to additional income or credit.

The unsatisied needs of the 80% groupmake it an obvious

target for the owners of capital during economic expansion,

iii The law of diminishing returns states that for every unit that one consumes the addedbeneitorsatisfactionthatonederivesfromitdiminishes.



| 1.éà:94

especially when credit becomes cheap. Cheap credit is often a

function of interest rate policies, as determined by the central

banks (e.g., the Fed). Cheap credit often causes the value of assets,such as residential real estate, to rise. As house prices rise, it

gives the owners of capital and savings the opportunity to supply

the 80% group with more credit since they can more readily risk

lending their capital against the rising value of collateral assets

(mainly housing). As credit becomes more affordable and more

available, spending and consumption increase. This in turn leads to

an expanding economy and often to higher asset prices.

Why does it lend more to the 80% group than can be serviced?

In times of growing wealth inequality, those who have the most

unsatisiedneeds(e.g.,the80%group)haveincreasinglylessand

less income to spend on consumption relative to the total goods

and services produced by the economy. The wealthier group (e.g.,

the 20% group) has more and more to save for investment. In short,

the owners of capital can produce more goods than the consumer

can afford or wants to consume. When central banks then lower

interestrates,theownersofcapitalwilloftenindinnovativeways

to give more credit to the 80% group, which is willing to spend

more on consumption if it were able. By supplying more and more

credit to the lower-income groups, larger markets for goods and

services are created, thereby enhancing income growth and the net

worth of the wealthiest groups.

Why does the production of goods and services escalate so rapidly

while the relative compensation provided to the 80% group

decrease substantially?

There are many reasons for this, but only those considered most

relevant will be discussed below.

Astheeficiencyorproductivityoflaborincreases,moreunits

of goods and services can be produced with the same amount of

labor. The wealthiest group, which is generally in control of the

Production Module referred to above, is often not willing to increase



j | 95

the compensation for labor in a manner commensurate with the

increaseinproductivity.Thismeansthatmostofthebeneitslow

to the 20% group, which has limited needs, while the 80% group isnow unable to consume the extra goods and services.

Although not part of the closed economy referred to above, the

outsourcing of labor-intensive processes to countries that have

much lower wages leaves those who have done the job previously

with less negotiating power to maintain or to increase their income.

Outsourcing, on the other hand, increases proits and thereby

the income and net worth of the wealthiest, who owns most of the capital (share capital and non-equity inancial assets). This

process obviously leads to further growth in wealth inequality and

increases the gap between what owners of capital can produce and

what demand can consume. An argument can be made that such

outsourcing spreads wealth more globally, and to some extent this

is true. But it worsens the problem globally because ever-lower

wages are paid to produce the same goods and services, whichincreases the gap between supply and demand. This gap can only

beilledwithcredit,whichinevitablyleadstoanewcreditbubble.

A further factor is improvement in technology that diminishes the

value of labor. Mechanization, robotics, and information technology

are continuously competing with, and are in fact winning the war

against, human labor. But the eventual winners are once again the

wealthiest group; those who own the capital required to acquirethe necessary tools of mechanization, robotics, and information.

Although highly specialized labor, with the technical know how,

mightbeneitfromthisdevelopment,thevastmajorityofworkers

do not. The only way to combat this phenomenon is to re-train

and to re-educate displaced laborers to ensure their value to the

production process.

Last but not least is the abuse of power. The richest and most wealthy (mostly those in the top 1% income or net worth bracket)

exerciseincreasinginluenceovergovernments,regulatorypowers,

public information, and various other facets of life that insure that

this group maintains the upper hand in competing for the fruits



| 1.éà:96

of the economy. This gives them a huge advantage over labor and

small to medium businesses, which can often only compete on the

fringes. This issue is probably one of the largest obstacles for along-term sustainable economic recovery. This issue will be dealt

with in more detail in the following chapters.

Is the 20% group homogeneous as far as income earnings and net

worth are concerned, or should one distinguish between groups

within this 20% group in order to identify which sub-group has the

biggest impact on wealth inequality?

Whenanalyzing the top20%group,one indsa largedifference

in wealth measured either by income or net worth between the

80 to 90% group, the next 9% group, and the top 1% group. The

average net worth for the above three groups in the United States is

displayed in Table 4.a.

When comparing the net worth of the 80 to 90% group with the

average net worth of the 60 to 80% group, iv the average net worth

of the wealthier group exceeds that of the 60 to 80% group by a

factor of 2.37. The net worth of the next 9% group exceeds that

of the 80 to 90% group by a factor of 3.1, and the top 1% group

exceeds that of the next 9% group by a factor of 8.3.

The 20% group earned 48%1 of total income in 2004. The top

1% group’s share of total income is 17% by itself.2 This situation

iv The 20% group between the bottom 60% and the top 20%.

Table 4.a

Average Net Worth of Wealth Groups

Wealth Group Average Net Worth (2004)

i. 60 to 80% group $243,000

ii. 80 to 90% group $576,000

iii. next 9% group $1,776,000

iv. top 1% group $14,791,000

Source: State of Working America



j | 97

worsened after 2004, and by 2009 the top 1% group earned 25%

of total income.3

The above illustrates the extent of wealth inequality, even withinthe 20% group. One could certainly argue that the 80 to 90% group

is closer to the 60 to 80% group than it is to the next 9% group. It’s

also clear that the top 1% group is from another planet altogether.

A further analysis of the top 1% group would probably show even

larger wealth inequalities between the rich and the super rich.

One should also bear in mind that there is also wealth inequality

within the 80% group. In fact, the average wealth of the bottom20% is negative, in other words the liabilities of some members

from this group exceed their assets.4 Also, the 60 to 80% group’s

average annual income exceeds the average income for the bottom

20% by 2.86 times.5

However, despite the above differences within the two main

groups, comparisons between the 80% group and the 20% group

aresuficienttodemonstratetheextenttowhichwealthinequalityhas increased, and to what extent it could cause imbalances in an

economy.

Why doesn’t the price of goods and services drop to a level where

the economy finds a new equilibrium between supply and demand?

Some prices do drop when imbalances caused by wealth inequality

lead to economic contraction, but a drop in prices cannot close the

gap between supply and demand unless the prices of goods and

services drop to a greater degree than do the wages and salaries

paid to the 80% group. In such a scenario, the top 20% group gets

a lesser share of the income cake. Such a measured drop in prices

to rectify the imbalances caused by wealth inequalities is unlikely

to occur in an economy that is under the control of the wealthier

classes. The wealthier classes would prefer to cut production. Asshown previously in Chapter 1, industrial production fell by 45%

between 1929 and 1932.

During a crisis with severe economic contraction, prices of

assetsofallclassestendtodropirst,followedbygoodsthatare



| 1.éà:98

the subject of discretionary spending or that fall under the luxury

goodscategory.Ifpricedelationsetsin,lowerpricescouldspread

to all goods and services. There are many reasons why pricedelation does not become the norm in economic contractions.

First, governments normally react with all available monetary and

iscalmeasurestostoppricedelation.Themeasurestakenbythe

US government to prevent a major price decline in agricultural

products during the Great Depression is one example, while the

Fed’seffortstolowerinterestratesandtoloodthemarketswith

liquidity in the current crisis is another. Furthermore, as shown inChapters 1 to 3, the aforementioned three crises were preceded

by growing monopolization and concentration of economic power.

When a major crisis occurs, the concentration of economic power

normally intensiies when competitors are either taken over or

liquidated. During such times, those business with the most access

to liquidity and capital—big businesses—have the best chance to

survive. An unintended, but nevertheless real, monopoly formsdue to the loss of smaller competitors. These monopolistic empires

exercise great control over prices that would otherwise have

dropped to a level that would bring an equilibrium between supply

and demand. Such monopolies decrease the production of goods

andservicestoprotectproitsandlowertheirinputcosts(suchas

wages and salaries) to an even greater extent.

D C

Growing wealth inequalities were most likely one of the dominant

causes, if not the dominant cause, of the current and previous crises.

Credit, housing, and stock market bubbles and their subsequent

collapses were also major factors. If one asks what caused the

abovebubblesandsubsequentcollapses,it’sdificulttoignorethe

imbalances caused by growing wealth inequalities.

As the growing imbalance between supply and demand fuels

credit growth to consumers,which in turn increasesproitsand

the net worth of the top wealth groups, not all surpluses or

savings are reinvested in the production of goods and services.



j | 99

Nor does this always translate into credit to the lower income

groups. Some of these surpluses or savings are earmarked for

speculativeinvestmentsinstocksandotherinancialassetsthatare mainly traded between members of the top wealth groups.

This speculation, buoyed by increasing consumer spending,

often leads to irrational exuberance among the wealthier groups

that causes them to borrow from each other (mostly indirectly

through some form of investment vehicle). This borrowing is done

in order to leverage speculative investments, causing a bubble in

thevalueofmostinancialassets,suchasstocksandmortgagesecurities (see Chapter 6 for a more detailed discussion). As the

bottom 80% group starts to default on its debt and starts reducing

itsconsumption(lessdemand),lessmoneyiltersthroughtothe

wealthier groups’ speculative assets, causing a drop in value. When

these values drop beneath their debt values (amount borrowed

for investment), the wealthier group and its investment vehicles

areintrouble.Duetothegroup’sconsiderableinluenceandthesystemicriskthatitsinancialhardtimesholdfortheeconomy,

governmentsandcentralbanksfocusmostoftheirinancialaid

to this group. The rationale is that such assistance will trickle

down to the lower wealth groups. Preventing systemic risk has

merit, but the rest of the above argument lacks substance. This

measure at best only delays the inevitable unless the dominant

causes are addressed. A sustained recovery can only come afterthe imbalances (supply versus demand, debt versus income)

caused by growing wealth inequalities are addressed. One way to

approach this issue is to focus on improving the value of human

capital in order to ensure a better distribution of income. Another

way is to institute measures to limit runaway credit bubbles.

Long-term sustainable recovery in the United States, and probably

most other industrialized countries, is unlikely unless this issue isacknowledged and addressed.



| 1.éà:100

C T

Raisingtaxesisnotagoodideainanyeconomyasitmightstilegrowth, but there might be times where it cannot be avoided. It is

probablyanecessaryingredientinresolvingsigniicantinequalities

in wealth distribution. Higher taxes on the wealthier classes not

only give the government more room to restructure the economy

(e.g., by retraining of workers), but they also serve to assist in

repairing the imbalance in the economy. Taxation could serve as a

vehicle to redistribute wealth to the neediest consumer in order tobring a better balance between supply and demand. World War II

brought about higher public spending and higher taxes, especially

onthewealthiestclasses—afeatthatwouldbedificulttoachieve

in peacetime economies.

The top income tax bracket for US residents was lowered from

73% in 1921 to 25% in 1925.6 Many economists and tax analysts like

tosaythattheloweringoftaxesisalwaysbeneicialtotheeconomy.

To prove their point, they refer to the tax cuts of the 1920s and 1980s,

which they then correlate with larger tax collections and stronger

economic growth.7 In contrast, they will often refer to the 1930s,

when president Hoover and especially president Roosevelt pushed

marginal tax rates much higher, to above 70%. These higher taxes are

thencorrelatedwiththelargedeicits,higherunemployment,and

poor economic growth of the 1930s. But is this a fair and balanced

view of historical facts?

First, the prosperity and exceptionally good economic growth

of the late 1940s through the 1960s coincide with a period of high

tax rates. This fact contradicts any argument or theory to the effect

that high economic growth and prosperity can only exist in an

environment of low taxation.

Second, the 1929 stock market crash occurred in an environment

of very low tax rates that had prevailed since 1925. The economic

contraction that followed continued to worsen for nearly three

years while taxes remained at the 1925 level, and tax rates were

not increased until June 1932. By the end of 1932, the GNP had



j | 101

already fallen by more than 30%, stocks had lost 80% of their

value since 1929, and unemployment rose to above 23%.8

Third, despite the tax increases of 1932 the free fall in GNPand unemployment slowed in 1933 and the US economy did make

a recovery from 1934 to 1937, when jobless rates dropped from

25% to under 15% and both the GNP and the stock market

gradually improved.

Last but not least, the 2008 credit crisis was preceded by nearly two

decades of decreases in taxation in many of the major industrialized

countries. The United States lowered its top income tax rates from73% in 1980 to 35% in 2006, and gave further tax rebates in 2008.

Due to further concessions for high-income earners, the effective

tax rate for the top 400 American income earners was below 20%

in 2008. Japan also dropped its top tax rates from 75% in 1980 to

65% in 1990, and then to 50% by 2000. Reducing the tax burden

neither prevented the crises nor solved them.

There can be little doubt that the lowering of taxes in the1920s stimulated the economy by increasing demand, but at the

same time it probably also contributed to the overheating of the

economy. When the stock markets crashed in 1929 and the value

of most collateral assets (e.g., housing) dropped, credit contracted

and the boom was over. The economy simply could not be reignited

by further tax cuts or by issuing more credit. The stagnation in the

1930s came about because supply exceeded demand. The economycould then only depend on demand as determined by the normalv

income of consumers, which was decreasing due to the growth

in unemployment.

The economic contraction of the 1930s, which followed the

stock market crash of 1929, was not caused by higher taxes.

Although higher taxes from 1932 probably stiled consumer

demand and economic growth to some extent in the short term, theseeds of destruction that caused the deep economic contraction of

the 1930s were sown during the 1920s. The growing inequalities

in wealth, especially in terms of income distribution, caused an

v Income from mainly wages and salaries, but excluding credit.



| 1.éà:102

imbalance between supply and demand. This imbalance was

temporarily countered by making more and more credit available

to the consumer and by the lowering of taxes, both of which wouldhave increased disposable income and demand. However, neither

of these measures could neutralize the growing imbalance on a

permanent basis, and probably contributed to the stock market

bubble of the time. As capital provided by the wealthier classes

produced more goods and services than could be consumed by the

middle classes, the wealthy put their capital to more speculative

uses, such as the stock market. This probably played a major rolein the stock market bubble and the inevitable subsequent collapse.

Whatcanwelearnfromthis?Althoughsigniicanttaxreductions

preceded major crises, as shown by the Great Depression, the Japan

crisis, and the current crisis, this does not necessarily prove any

direct causal link between lower taxation and the ensuing crises.

What the above does show, however, is that higher taxes do not

necessarily cause economic harm, nor do lower taxes ensurecontinued economic prosperity.

There might, however, be an indirect link between the lowering

of taxes and subsequent major crises. Lower taxes might over

time contribute to wealth inequalities and would probably serve

to mask (by increasing disposable income) the growing economic

imbalances that build up in periods that precede major crises.

The 1930s, and especially World War II, served as a consolidationperiod wherein the economic imbalance, caused by growing wealth

inequalities of the 1920s, was adjusted to some extent. Whether higher

taxes,higherbudgetdeicits,orWorldWarIIhadanysuchintent

is debatable. Irrespective of intent, what we do know is that these

factors lead to an improvement in wealth distribution (especially in

terms of income distribution) and nearly full employment, and that

it probably laid the foundation for the prosperous decades of the1950s and 1960s.

As wealth inequalities increased substantially beginning in

1980, the tax cuts since the early 1980s would have temporarily

stimulated consumer demand. But it probably also had the effect of



j | 103

temporarily masking the growing imbalance between supply and

demand. This imbalance was caused mainly by wealth inequalities,

which started to worsen signiicantly in the 1980s and whichcontinue today. When taxes are cut during a period of expanding

credit and lower interest rates, the combination can push demand

to very high levels that are unsustainable in the long run. Capital

investment is stimulated, which in turn leads to an increasing supply

of goods and services. However, when taxes cannot be lowered

any further and credit cannot be expanded, consumer demand is

limited to normal consumer income. This inevitably leads to a dropin demand, causing the economy to contract.

A S E G Iq C C

The growing inequality in income distribution referred to in

Chapter 3, and that began in the early 1980s and increased in

pace after 2000, caused a growing imbalance between supply and

demand. The bottom 80% group’s ability to consume a major part

(61.4% of total personal consumption; Table 3.g) of products and

services produced by the economy was stretched well beyond the

group’s share of income (earned 52.4% of disposable income). This

imbalance was alleviated by the extension of credit to consumers,

which increased annually. The amount of credit that can be given

to consumers, however, is limited to what an individual or group

can service from its income. From not later than 2000 onward, the

80% group took on more debt than what was serviceable from its

income. This was made possible by initially lower interest rates,

inancial innovations, and laxunderwriting standards supported

by a perception that the value of collateral, namely housing, would

continue to rise. As long as the value of housing collateral continued

torise,theinancialinstitutionskeptthecreditspigotsopen.When

consumers started to default on debt payments and house prices

started to drop at an increasing rate from 2007, credit to this group

was quickly frozen. In addition, the 80% group suffered severely

from job losses that negatively impacted its ability to service its



| 1.éà:104

debts and to spend. When the main engine for consumption stalled,

the writing was on the wall. As demand dropped, production was

curtailed, resulting in economic contraction. The banking crises andtheotherbubblesreferredtoabovealsocontributedsigniicantly

to the current crises. Much was done to solve the latter but as long

as the 80% group remains in the emergency room, any recovery in

the economy will probably be limited and unsustainable.

I T S C C?

Possiblesolutionswillbediscussedintheinalchapterofthisbook.

Before we proceed to the solutions, it is important to understand

why the economy is not really free and fair and why society is so

misguided and receptive to manipulation and deceit. We will also

look at the role played by the bankers, their innovative credit-

related products, their extraordinary compensation packages, and

theinluencetheyandbigbusinessexerciseovertheeconomyand

society. These and many other factors might restrict us from coming

up with genuine, long-lasting solutions. In Part Two (Chapters 5

to 8) we will investigate these issues.



| 143

T B B

David Halberstam made the phrase “the best and brightest” famousin his 1972 book of that name.53

What was it about the men, their attitudes, the country, its

institutions and above all the era which had allowed this tragedy

to take place? They were after all “the best and the brightest,”

so why did it happen? . . . They had, for all their brilliance and

hubris and sense of themselves, been unwilling to look and learnfrom the past.54

Halberstam asked these questions regarding US policy in Vietnam,

buthisquestionisequally relevant today regardingthe inancial

crisis. If the talented bankers were the best and the brightest, why

did they fail so miserably to foresee or to prevent the crisis?

On what merits do they base their claim as the best and the

brightest? They may have high IQ scores and graduated cum laude

from the best universities, but so have many scientists, surgeons,

and programmers who work for a relatively small fraction of a bank

executive’s pay. They might argue that they have to take huge risks

in high-pressure situations, but more so do surgeons (median salary

of $300,000),55ireighters(mediansalaryof$40,000),56 and senior

militaryighterpilots(around$140,000).Theonlyargumentthey

actuallyhaveistheamountofproitstheyclaimtogeneratefortheir

irms.Thequestionis,however,aretheyreallythatmuchbetterat

what they do than other talented traders who trade on their own

account, or do they simply excel due to the advantages bestowed

onthemby the big inancial institutions?They areprobablynot

that good without all the advantages that come with working for a

largeandinluentialirm.Iftheycouldtradeata98%winrateby

themselves, they probably would be doing so.

Their record speaks volumes regarding their actual abilities

to manage money. Many of the top executives destroyed more

value than they created between 2002 and 2008. In the process,

they acted at best foolishly, behaved irresponsibly, and in some



| 2.144

instances conducted business illegally. They lacked foresight and

panicked when a crisis hit their markets. They and their allies

threatened, squirmed, threw tantrums, and eventually had to relyon the taxpayer to save them. They forced changes in accounting

rules and exchanged their rotten apples for cash at central banks.

As soon as they got back on their feet, they kicked the taxpayer out

of their business, keeping only their guarantees and nearly interest-

free loans from the Fed. Then they put their arms consolingly

around the taxpayer, explaining how happy they should be when

the bankers make fortunes—after all, the bankers are doing God’swork. These men can hardly claim to be the “best and the brightest.”

F Rk M

Anotherimportantfactorintheinancialcrisiswasthefailureof

riskmanagement,notonlyintheinancialsectorbutinmanyother

industries. Although there is general acknowledgement that a lack

of discipline in risk management contributed the credit crisis, few

arepreparedtobespeciicabouttherealcausesofitsfailure.

Relyingoncleverinancialandmathematicalmodelsaloneoffered

little protection. Without understanding human behavior, such as

greed and the seeking of status, using the veil of false credibility, or

employing deception by way of complexity, risk management is at

the mercy of manipulating executives and trusted agencies.

Much reliance was placed on rating agencies, the credibility

oftheirmsthatissuedthemandtheprotectionboughtinterms

of CDSs. Many of the securitized mortgage products and other

structured inancial products (e.g., CDOs) were insured by the

issuers of CDSs. In her book, Fool’s Gold , Gillian Tett vii describes the

pressure exerted by major banks on the rating agencies.

Investors generally relied on ratings agencies to guide them

through this strange new land, which seemed a rational easy

solution to contending with the complexity. . . . Better still, they

vii Gillian Tett is a multi-award winning journalist who writes about global markets forthe Financial Times, and has a Ph.D. in social anthropology from Cambridge University.



| 2.166

legitimacy and credibility. They need them in order to justify their

huge bonuses and toobtain new capital. If inancial institutions

are allowed to publish both versions—historical and fair valueaccounting—the markets, investors, and shareholders will judge

them by their fair value anyway. The campaign against fair value

accounting will continue for some time, in order to give banks the

freedomtovalueassetsastheydeemitandstillappearcredible.

Let’s assume for the moment it is sometime between 1996

and2006:themarketsseemtoknownoupperlimit,proitsare

soaring as measured by fair value accounting rules, share valuesare increasing, and large bonuses are paid to bankers. Would

anyone expect these same role players to criticize fair value

accounting? Very few, if any, of the role players did. Fair value

helped banks, especially those involved with investment banking,

to show huge proits during the good times. Many inancial

companies worldwide used their countries’ versions of fair

valueaccountingtomaximizereportedproits,justifyingbonuspayments and touting their share prices in the meantime. They

used the latest market prices when it suited them and mark-to-

mythviii models when market values were not considered suitable

for valuing their investments.

Mk-T-M—A R-L E

Let’s look at a real-life example of the type of reporting sometimes

employed.42 For the sake of simplicity, only the details necessary or

relevant to illustrate the mark-to-myth issue will be used. During

the late 1990s, a South African investment bank, Corpcapital

Ltd., acquired an investment in an internet start-up gambling

company Netainment (later called Cytech), which was based in the

Netherland Antilles and later in Belize.

The South African accounting rules allowed entities to value

certain assets at fair value (market value) and to include such

gains in their earnings reports. As market prices for the relevant

assets were not available, Corpcapital used a hybrid discount

viii Avaluethatcannotbejustiiedintermsofprevailingrealities.



x | 167

cash-low model. The basics of such a valuation are that the

company must determine its future cash low and the rate at

whichitwilldiscountthatfuturecashlowbacktothepresenttime. This formula forms the basis of most valuations when mark-

to-market is not possible. The formula attempts to determine the

market value by recognizing all relevant market factors that apply

to similar assets.

Although Corpcapital’s model was more complex than the one

presented below, it was based on the same principles. The most

basicformulaforcashlowmodelsisthefollowing:

Valueofinvestment=Futurecashlow/Discountrate,or

V = F/D (author’s own abbreviations).

Now let’s assume that the actual current cash low is $100 per

annum and a fair discount rate is 10% after considering all of

the relevant market factors. Let’s further assume that there is noobjectiveevidencethatfuturecashlowwillchangefromthe$100

per annum. Based on the above equation,

V = $100/10%

V = $1000.

Assume next that the investment entity hopes to raise future cashlowto$200.Realizingthatsuchafuturecashlowishighlyunlikely

to be achieved; they attempt to justify it by raising the discount rate

from 10 to 12%, an increase of 20%. They then calculate the value

in year one as

V = $200/12%

V = $1666.67.

Butlet’ssupposethatcashlowinfact slips to $80 in year two and

to $60 in year three. The value of the investment should then be

calculated as not more than the following:



| 2.168

V(end year 2) = F/D = $80/10% = $800

V(end year 3) = F/D = $60/10% = $600.

The investor, however, persists in his belief that he can improve

cashlowto$180inyearfour.Theinvestorthereforevaluesthe

investment as follows as at end of year three:

V = $180/12%

V = $1500.

One can then determine the extent of overvaluation by comparing

the following:

V(end year 2) = $1666.67 – $800.00 = $866.67

V(end year 3) = $1500.00 – $600.00 = $900.00.

If one assumes that the investor bought the investment for $1000,hewouldpostaproitof$500($1500–$1000)insteadofaloss

of $400 ($1000 – $600) at end of year three. Imagine now that the

investoracknowledgesthathiscashlowforecastFistooaggressive

but that because he upped the discount rate D by 20% from 10%

to 12%, one should still consider the valuation as correct. One does

not need to be a rocket scientist to know this is delusional thinking

andthattheestimatedproitsgeneratedinthismanner(mark-to-myth)cannotbejustiied.

But add complexity to the above, as was done in this case,

and you can probably convince most people, and even the watch

dogs of society, into accepting such higher valuations as fair and

reasonable. This is what seemingly happened in Corpcapital’s

valuation ofNetainment. FromFigure 7.1, see how future proit

growth F and revenues (red and green lines) of Netainment wereprojected higher for valuation purposes, contrary to the downward

trendofactualproitsandrevenue(orangeandbluelines).



x | 169

Figure 7.1

Netainment (Cytech) September 2001 Valuation Forecast

Revenue and Proit vs Actual Revenue and Proit

$ 0

$

5 0 0 , 0

0 0

$ 1 , 0

0 0 , 0

0 0

$ 1 , 5

0 0 , 0

0 0

$ 2 , 0

0 0 , 0

0 0

$ 2 , 5

0 0 , 0

0 0

$ 3 , 0

0 0 , 0

0 0

$ 3 , 5

0 0 , 0

0 0

$ 4 , 0

0 0 , 0

0 0

$ 4 , 5

0 0 , 0

0 0

$ 5 , 0

0 0 , 0

0 0

T r e n d l i n e S e p t e m b e r 2 0 0 1 F o r e c a s t - R e v e n u e

S e p t e m b e r 2 0 0 1 F o r e c a s t - R e v e n u e

T r e n d l i n e S e p t e m b e r 2 0 0 1 F o r e c a s t - P r o f i t

S e p t e m b e r 2 0 0 1 F o r e c a s t - P r o f i t

A c t u a l P r o f i t

C o r p c a p i t a l F i n a n c i a l S t a t e m e n t s ( * ) A c t u a l P r o f i t

A c t u a l R e v e n u e

False Gods Fleece the Faithful (2010) (ed.2)

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