We're In An Asset Bubble With Good Chances Of Popping: Structured Finance Consultant Janet Tavakoli

by: Harlan Levy


Artificially low interest rates push investors into stocks in a precarious bubble.

No large banks engaged in derivatives have a good grasp of their risk.

Post-financial crisis changes are cosmetic, financial system not safer.

Wall Street has bought Washington. Why bank managers in scandals are ever punished.

Captured, compliant zombies won’t challenge gross misrepresentations of economic facts.

Janet Tavakoli is president of risk consulting firm Tavakoli Structured Finance and author of "Decisions: Life and Death on Wall Street." She spent more than 20 years in senior investment banking positions.

Harlan Levy: It's a few weeks after the eighth anniversary of the 2008 financial crisis. What, if anything, has changed?

Janet Tavakoli: The point of "Decisions" was to talk about why the system can't change unless we change the way that money flows between Wall Street and Washington. Any change that we've seen has just been cosmetic and incremental. That did nothing to merely insure that the financial system is safer than it was when it collapsed.

All we've done in the meantime is put a Band-aid over this problem and provide undeserved subsidies to banks with enough strings attached to cover up the problem.

So, rather than reform the financial system, they decided to loot taxpayer money and paper over the problem, literally, with paper money.

H.L.: What's the possibility that we'll soon face a similar crisis?

J.T.: By papering over the problem, we see asset prices going up. But we're in an asset bubble, and part of the reason we're in the bubble is because in order to paper over this problem, we've ballooned our national debt. It's not the only reason, but it's part of the reason.

Also, the ability of Congress to spend money without check, with no standard or benchmark against our currency, the way we had when we had the gold standard. Then we could see how we were doing against a firm benchmark. But that's gone, so this created the ability to write blank checks, and that's what we've done.

In order to keep doing that the Federal Reserve is artificially keeping rates low, because our interest-rate burden is becoming higher and higher, much less our ability to pay off the principal.

One thing that surprises me when I talk about debt to the average American, they think somehow that our national debt is something like a mortgage, where you make a payment, and you pay down principal and interest, eventually paying it off. They don't realize that actually we're not making payments on our principal. We're just borrowing more money to pay off what we already owe in interest. You'd think that's pretty basic. They have this idea that we're amortizing our debt.

But we're not amortizing bonds. Our debt has grown so much that we're driven to the point that it's difficult. We have these commitments that we keep rolling over, which requires the good faith of foreign powers, because we have so much debt that we are no longer merely buying it internally. We have off-shored our debt to people who may not like us very much. If they all decided to sell their debt all at once, interest rates would skyrocket. That hasn't happened, fortunately, because we've been a flight to safety.

In order to keep spending, the Fed has had to keep interest rates low, so interest rates have been artificially suppressed. That means that people looking to get any kind of return on their investments have been pushed into riskier behavior. So you see money flowing into stocks that have P/E multiples that are much higher than historically.

So any kind of dividend stock is getting bought up. That has put our pension funds in a very precarious position, because they can't defease their assets in a way where they can actually count on that money being there. They've had to allocate more money into risky buckets in order to earn any kind of income.

This has happened all across the board, individuals, pension funds, and so on. So now we're looking at an asset bubble in the stock market. It's a nice thing to be in the middle of a bubble, and you hope it will expand even more. But the reality is that if the bubble comes down to size, there will be a lot of destruction, because it's paper wealth.

H.L.: What are the chances of the bubble popping?

J.T.: There certainly is a good chance that this will happen. You look around the globe, Europe has never really recapitalized its banks. What is it going to do?

We keep saying our banking system is safe, that we have no risk. Well, our counterparties are at risk. And when your counterparties are at risk, then you're at risk, too.

The narrative since the financial crisis, first of all, if you look at the media during the financial crisis, the words "systemic risk" were taboo. You didn't want to say it was systemic. You wanted to say it was isolated to Bear Stearns, it was isolated to AIG, and you kept hearing that. There was complete denial that there was systemic risk.

Today it's the same thing, complete denial, that our fortunes aren't in any way dependent on what's going on in Europe, or that a shakeup at Deutsche Bank or Banco Santander, or other banks in Europe could have implications for us, because they're intertwined businesses.

It's the same thing with derivatives transactions, which have ballooned. They keep saying that credit derivatives have gone down in size, and yes, they have, but it's still many multiples of where they'd be if there weren't a lot of speculation in the credit derivatives market.

So instead of solving our problems, politicians cynically have created a narrative that we have solved our problems, when we haven't. Their idea of achievement is creating a narrative that is strong enough that the American public swallows it. So, instead of solving problems, people have been rewarded for being presentable, glib, slick liars. That's what people are being rewarded for today.

H.L.: Are there good chances there will be a bursting of the bubble soon?

J.T.: No one can predict market timing, and I'm not going to play that game.

H.L.: What do you mean by a "race to the bottom"?

J.T.: I wrote "Decisions" to talk about why this keeps occurring and what sort of personalities are attracted to the race to the bottom and the toll it takes upon them and the pressure they put on the people around them to conform to things that they know they shouldn't be doing.

It's really about the money. It's very tempting. You're well-rewarded. Within your own firm you're very powerful. The media enables it by writing hagiographies of these men. "If they're bridge players, that must mean they must be great at markets." Or "If you're a good chess player that must mean you're a genius and great at markets."

If you didn't know the individuals, you would think they were more handsome than Adonis, stronger than Atlas, smarter than Einstein, richer than Croesus. That's the kind of think you see in the financial media all the time. I even had one Wall Street Journal editor tell me when Jamie Dimon was going through some difficulties, "Oh, but I like Jamie Dimon." He was just bubbling over about Jamie. If you have that sort of narrative on your side, you start to believe it yourself. People lose their grounding pretty quickly.

One of my former bosses, Edson Mitchell of Deutsche Bank (NYSE:DB), brought his mistress in London to their London Christmas party and everyone else was bringing their spouses. His wife was in Maine, and she was waiting to fly to Maine for their family Christmas. He never made it, because the plane crashed, and he died. The idea that you so lost your moorings that you walk into a Christmas party at work while you're a very senior person on the board and think that everyone is going to think that's OK. Because it's you who is doing it.

That really backfired after his death, because power brokers were struggling within the bank to try to get an edge, and part of trying to get an edge was to discredit their predecessor who was deceased. That was a very powerful hook to raise the question of morality, to bring his mistress to the Christmas party.

He was one of the people responsible for growing the derivative operation at Deutsche. When he died in 2000, everyone thought that was a huge derivative operation that was growing very rapidly. But it was nothing compared to the growth in credit derivatives that we saw in the intervening years. Then credit derivatives were maybe a trillion in market volume. At the time of the 2008 financial crisis, it had grown to $64 trillion.

That attracted even more people into the business and a lot of people who were cutting corners and doing things they shouldn't have been doing, which enabled widespread massive fraud in the business. It grew so fast, and money was being made out of thin air. It was like letting your teenage friends drive your parents' Ferrari for a dollar a ride. You collect a lot of cash, but when they wreck the Ferrari, it's a disaster. That's in effect what was happening.

They were renting out the bank's balance sheet, taking on enormous risk for way too little money. The classic example of that was AIG (NYSE:AIG). Bear Stearns was another example. So was Lehman Brothers. They were renting out the balance sheet at the institution they worked for, and it looked like they were taking in a lot of money, but it was not nearly enough to cover the risks they took on with the balance sheet. It was all about pricing risk properly. When you don't have an incentive to price risk properly you won't. In fact, your incentive is to price risk incorrectly, because then you can do more business, and the only entity you're putting at risk is the entity for which you work. And when you know you're not going to be criminally prosecuted for it then it makes economic sense to do it, not moral or ethical sense.

H.L.: How's the derivative market now?

J.T.: It's opaque. The idea that we were going to have transparency in derivatives quickly evaporated after Congress completely gave up any leverage it had over the financial industry in exchange for campaign contributions.

Today we have enormous derivative risk in options that are sold in the interest rate market and jump options, which are opaque, in the equity market, and we've got credit risk, a lot of risk that banks are having difficulty getting their arms around.

As for Deutsche Bank, they didn't even have their paperwork in order. They didn't have the ability to capture their trades properly. In one instance, they were recording the trades incorrectly for interest rate swaps. They were recording buys as sells. And then financial crisis happened.

As for the state of risk in the banking system, It's "net valid" at banks. You have a variety of different models, some of which are internally inconsistent with other models that are pricing similar things in terms of the methodology. And when they try to run scenario analyses on them, the scenario analyses are not very good. They're just scrambling up incompatible models in Monte Carlo simulations, and they're not getting a good idea where the risks to a bank really lie and whether certain risks are biased against them.

This is a surprising statement that should terrify people: For all of our large banks that are engaged in derivatives, none has a good grasp of its risk.

After the financial crisis, we were told that the banks had a handle on risk. Yet in 2012, the "London Whale" happened at J.P. Morgan (NYSE:JPM). It was the poster child for bad practices and risk management. There wasn't one red flag. There were dozens of red flags in just that one year that was reported directly to Jamie Dimon.

The point is that our large banks haven't been doing the work they needed to do to get their hands around risk.

Banco Santander (NYSE:SAN) is another example recently cited in New York for having insufficient systems in place to give a report on risk that they had in the New York office when they said they were going to hire people and go on a project to get their hands around the risk.

But this, again, was seven years after the financial crisis. How can it be that our captured are so lax that they are not compelling banks to both scale down and get their hands around the risk that they have underneath them? But there's no incentive for top managers to do that, because they won't be put in jail for not doing that. They were supposed to personally affirm that they understood the risks of their institutions and that their financial statements were accurate when they signed them. But even though it's been proven time and time again that their financial statements were not accurate, and they did not have a handle on the risk, there's been no consequences or penalties on a personal level of any of these bank managers who've been involved in scandal after scandal after the financial crisis.

H.L.: Again, why?

J.T.: Washington is bought by Wall Street, and Wall Street gives jobs to the extended family of people who work in Washington. That's really below the radar, because you didn't see that question very much. They end up getting these people appointments on boards after they leave Congress. People in the regulatory system get jobs in banks. They get campaign contributions to continue their careers in Congress. It's a complete buy-off of people in Congress.

H.L.: So do you think that small investors should sell all their stocks and put the money in a mattress?

J.T.: It depends. Again, if you're looking at the market as a whole, what does well in good and bad times are companies that actually have assets, not those that have phantom assets with a prayer and a hope, companies that produce something that people want and need that have reasonable P/E ratios.

H.L.: How do you see the asset bubble working?

J.T.: The problem that investors have had is that we've created what is called the "Great Distortion." Normally what people do in a situation like this is to put widows and orphans into bonds. But you can't earn any income on that money because of the distortions we've created in the market. This is the distortion that the government has created, and that's why the bubble has persisted as long as it has, because retirees, pension funds, others who rely on their investment income can't live off the money that bonds provide, so they're forced into the stock market, which makes people feel simultaneously wealthier and nervous.

The prices have gone up, but the minute the bid disappears, the prices will drop like a stone, and people know that. You have this great degree of inclement insecurity. When people feel that way they don't spend as much. You see that reflected in the low growth we've had in the economy. So, regarding this "Great Distortion," I would argue that the narrative that we have currently that we have to keep interest rates low serves Wall Street. It doesn't serve savers. Savers have been punished as a result of the financial crisis. They've been punished in order to reward bankers.

H.L.: What's your take on the Federal Reserve?

J.T.: I had a conversation with a former head of one of the Federal Reserve offices, and we were talking about printing money and buying assets with no benchmarks and how they justify it, and he said, "We're in uncharted territory. No one knows what comes next. No one knows what they're doing."

So the Fed is willing to do that to enable bankers to prosper. Somehow people think the Fed is part of a branch of government, and it isn't, really. They're pretty much independent actors, and that's why [former Texas U.S. Representative] Ron Paul keeps saying, "End the Fed." What he really means is "Get those guys under control," because right now, it can print money pretty much willy-nilly, and Congress dances to their tune.

But the Fed hasn't come up with a rationale as to why this is going to be good for the country. They claim that this is good for growth, when it really isn't. If you look at the jobless rate, it's not a pretty picture. We have more than 46 million people on food stamps. In cities like Chicago and other major urban centers where there are large minority populations you see 60 percent of the men, strong, able-bodied men who would like to find decent-paying jobs have no jobs. We're spouting numbers without talking about the serious, critical problems in our country and trying to pretend they don't exist.

For example, Jamie Dimon, the chairman and CEO of J.P. Morgan Chase, on Sept. 12 spoke to The Economic Club of New York, and he said that the U.S. economy is actually doing OK, that it's been chugging along at 2 percent GDP growth.

How did he get to 2 percent, because in the fourth quarter of 2015, it was 1.4 percent. In the first quarter, it was 0.8 percent; and in the second quarter, it's 1.4 percent. That's not 2 percent. We've had three quarters in a row less than 2 percent. More than that, even if it were 2 percent, that's less than half the growth we need in order to create the jobs we need and in order to create the kind of growth we need to get out of this hellacious debt problem we've got.

So there's a whole fantasy world that bankers live in, that as long as we have a persuasive, wonderful narrative in front of all of our friends, and we dress well, and we look well while we're saying it, and we're persuasive pleasant liars, then everything will be OK, because it's OK in our world, then it will allow this to continue unquestioned. And nobody at The Economic Club challenged that. You see a whole bunch of captured, compliant zombies who won't even challenge gross misrepresentations of the facts. In fact, you'll be lionized if you go up there and say it pleasantly, and it's a narrative that everyone wants to hear, because their bonuses will thrive on that narrative.

H.L.: What's your prediction for the economy and GDP?

J.T.: We're going to chug along at a sub-optimal performance, and it will continue to be great for the bankers and sub-optimal for everyone else. We're going to languish in a crumbling infrastructure with 46 million people having no jobs and getting their plastic cards for food stamps, and we'll have continual societal tension as people realize that they're barely making it. This is a great problem in the U.S., because it's become the invisible depression.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.