11/29/11
''View from Across the Pond''- By Joe McGrath
Which Product is Defective? The Chevy Volt or the CDO?
After General Motors announced yesterday that it would provide loaner vehicles to owners of the Chevy Volt due to potential owner concerns over the safety of the gas-electric vehicle, it had me thinking once again about concept of product defects, and the markedly different way we view consumer products and financial products. Just as when Toyota was being victimized last year by the US Congress and the press for runaway vehicles due to alleged sticky gas pedals, I continue to wonder where the specific outrage is over toxic and deadly financial products. It can be easily argued that some of these products have destroyed far more lives in America than any consumer or industrial product, yet they are still being designed, manufactured, and sold every day. The massive bureaucracy of Dodd-Frank, while seemingly well intentioned, does not appear to even come close to curbing the hazard inherent in many of these products. Meanwhile they are too complex for your average OWS (Occupy Wall Street) protester to articulate how they need to be fixed toward rebalancing the ‘’99/1’’.
I have worked in consumer and industrial product companies nearly my entire professional career, recently as Vice President of Supply Chain for SunPower Corporation. In every single one of the four product and product development companies that I have worked for over the last 20 years, the safety and reliability of the end product was always paramount. Of course delivering shareholder value is always a must, but it was never considered that one must be compromised to deliver the other. In fact, quite the opposite. Concepts like Six Sigma, FMEA (Failure Modes and Effects Analysis), and Lean etc are standard lexicon in your average American consumer product company. If you produce fewer defects and waste, both consumer and shareholder benefit. Oh, and by the way, the employee also benefits with the pride and integrity inherent in efficiently producing a high quality, safe and reliable product.
The Collateralized Debt Obligation (CDO), which during the mortgage debacle that caused our economy to explode in 2008, was a product used to take the riskiest (lowest-rated) tranches (with typically the highest content of the riskiest type of subprime loans like ‘’no-docs’’ and ‘’ARMs’’, and negative amortization loans, etc) of Mortgage Backed Securities (MBS) and re-package them into a high-yielding and ‘’low-risk’’ securities. Because they were ‘’diversified’’ across multiple MBSs, the statistical argument went, the Rating Agencies accorded them a AA, or AAA rating. As the rating agencies were not keen to bite the hand that fed them and maintain market share and grow revenues, they willingly complied and failed to even look under the hood to evaluate the poor quality of the underlying loans. From the consumer product perspective, this seems akin to GM taking a used junker, painting it a bright new color, spraying new car smell on it, and selling it as a brand new car?! Oh, and with the added benefit of GM not having to warrant the product, nor be liable for its performance.
Why is there such a distinct difference in how these two industries and their consumer view the producer’s role in backing a safe and reliable end product? Does our society hold hardware companies more liable than financial companies because of our ability to comprehend a product we interact with on a daily basis? A car is tangible. We understand when it works and when it doesn’t. If my iPhone doesn’t work I will know immediately. Recently RIM was excoriated for being down for 2 days and punished severely by Blackberry customers and shareholders. RIM responded aggressively to address the situation. I am supremely confident that the robustness of the RIMs systems are being hardened as we speak. This did not even require regulation. There simply was no moral hazard. If RIM can’t deliver a safe and reliable product or service, the future of the entire company is at stake. Why is this? Is it because the hardware brand is stamped all over the product, and reputation and brand equity cannot be sacrificed without severe implications? Is it because of the legal concept of a product warranty, where a company must stand behind its product for a period of many years in some cases ? Is it the concept of product liability? These basic closed-loop accountabilities do not seem to exist for many modern financial products – creating severe moral hazard. These products are often sold and re-sold along with the liability for them severed from the producer or originator. In the solar industry the product is warranted for 25 years. That is not a typo – for 25 years there is an assurance on every solar panel that it must output at least 80% of its power rating for that period. And the original manufacturer must bear the burden of the warranty even if the product is sold thru distributors, re-sellers, or installers. Irony of all ironies is that it is the financial institutions that require the 25-year warranty period for security of their returns over a long payback period. And if the product causes a fire or personal injury, there are agencies like CPSC (Consumer Product Safety Commission) that regulate the ability to sell that product. These agencies hold the company accountable for fixing the issues, even requiring restitution if necessary to the parties involved.
The CDO was created and sold as a high-yielding, low risk product. Its beauty is its complexity. The argument is that it can only be sold to the savvy institutional investors so buyer beware should suffice. The problem is that the savvy institutional investor is not always that savvy, and heavily depends on a credible and ethical system with strong ratings standards and the appropriate checks and balances. The other problem is that the institutional investor is not only playing with his or her money. That money is often the retirement accounts and pensions of your average American. As far as I know, while dangerous, the CDO is still being manufactured and sold. And there are even worse products like ‘’CDO Squared’’, ‘’CDO Cubed’’ and even ‘’Synthetic’’ CDOs. Synthetic CDOs are not even real assets. They only reference real assets, and are basically a wager – you just need two parties to take each side of the bet. And you thought gambling was only legal in Las Vegas and on Indian Reservations? The Synthetic CDO can be replicated many times using the same reference, causing it to catastrophically amplify risk. In order to sleep at night, Wall Street hypothetically protects its exposure by insuring these instruments with Credit Default Swaps (yet another dangerous product), while at the same time arguing for low capitalization for every financial entity involved, so that when the toxic and feeble product fails, it cannot possibly be backed, and either investor or taxpayer (or both) take the brunt of it. Government bailouts then of course reinforce bad behaviour by further removing moral hazard. I have now read three books on the events leading to 2008, and it still boggles my mind. (At one point I questioned even the value of the Mortgage Backed Security. I have come around to seeing the value of the MBS in providing liquidity in the lending market. Its value would seem to offset its risk, and I believe its risk can be tamed with prudent controls).
There are apparently 2300 pages in Dodd-Frank. I have of course not read it. I doubt many have. It seems the Federal Government and Wall Street are both interested in creating financial and regulatory complexities that confuse the average American. It should not be that complex. The US Constitution is six pages long. If you completely decouple lender and borrower, while at the same time maintain an environment of moral hazard by removing closed-loop accountability for the quality, safety, and reliability of any product or service, the system will be continue to be ripe for corruption and manipulation. Dodd Frank does not address the products themselves which, as designed, are inherently unsafe. These products, particularly the CDO require far too much of the system to work ethically and responsibly to be safe and reliable. And they are too complex for the market to understand them, let alone regulate them. And while the press seems to have abandoned its role in educating and informing the public, it is no wonder that OWS protestors cannot yet coalesce on a specific set of reforms or ideologies. They just know that something is woefully wrong. And, by the way, for those who argue that all the OWS protestors want is redistribution of wealth from rich to poor, consider this - redistribution of wealth, from poor to rich, is precisely what occurred prior to the meltdown of the US economy in 2008, and many of the toxic financial products were critical instruments to make this happen. Fees and high interest rates from mortgages were piped from your average American through your local mortgage broker, through your multinational bank, thru Wall Street and even crossed the Atlantic all the way to AIGs Financial Products division. Every one of those entities took a very nice little cut along the way. Fannie and Freddie were feeding off the gravy train as well, somehow losing complete site of their charter. The lower income and even the average American ended up over-leveraged and in debt, the wealth, well, redistributed. Liberating massive credit to make homes affordable to all, of course, had the perverse effect of raising home prices and making homes less affordable while indebting and bankrupting many Americans. (I am not, by the way, saying these borrowers do not share any culpability).
So why should we continue to allow for a derivative of a derivative to be created. These CDOS are defective products whose purpose is to confuse the investor by effectively spray-painting junk status securities, and in the case of CDOs on mortgage backed securities, in particular, further severe the connection between lender and borrower. If there is any one conclusion of the recent book All The Devils Are Here, by David Seabrook, it is that severing the relationship between lender and borrower is intrinsically dangerous. Much as it would be if we severed the relationship between manufacturer and consumer. Dodd Frank brings some transparency to the buying and selling of these derivatives but does not address the legitimacy of the product itself, nor the basic danger of decoupling.
These products are far more dangerous than the Lithium Ion battery pack in a Chevy Volt, and have a much higher likelihood to injure the average American. Thank you General Motors for acting responsibly. Wall Street? Congress? Mr. Obama?
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