Richard Gabel

Coworking, Office Space and Meeting Rooms / Strategic and Business Planning Consultant
Issaquah, Washington

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The Diminution of Risk or How We Learned to Stop Worrying and Love Debt

When the risk return relationship ceases to exist, greed runs amok in the capitalistic system. Greed drives the capitalist system. I do not mean that in the pejorative sense, but as the natural human behavior to want more.

Written Oct 05, 2009, read 1287 times since then.

Having suffered through more than a half-dozen economic traumas in my professional career, I had grown complacent and philosophical about economic cycles. That of course ended as we entered the latest recession and as one of the self employed I found myself more than inconvenienced, but one of the traumatized. Instead of focusing solely on the managing through the consequences of economic distress, I found myself in economic distress. I hadn't realized we had collectively built an economic doomsday machine and then set it off.

I still follow my advice to clients and keep pursuing new lines of business and creating opportunities for greater growth through the cycle. I have no doubt that as we enter recovery, my business will be far more profitable and larger. The returns will not translate into a higher standard of living, but only the ability to recover personal wealth for some years to come.

I am left with trying to understand what happened and to discern the fundamentals of the financial crisis. My conclusion is basic; financial stability is predicated on a fundamental relationship between risk and return and that relationship was nullified through misperception created by advanced risk transfer instruments. The creation of highly complex financial instruments designed to transfer risk have altered the perceived relationship between risk and return. Credit risk transfer through credit default swaps, collateralized debt obligations and a variety of other derivative products have blurred the risk return relationship. The fact of the matter is that while these instruments have transferred and dispersed risk, they cannot eliminate it.

What has happened is that the failure rate of individual obligations has overwhelmed the viability of the financial instruments designed to mitigate the risk. The larger problem is that personal, corporate and government behavior was influenced by the perceived lack of risk eliminating sound decision making that was traditionally tempered by the risk return relationship.

Public policy makers unfettered by traditional measures of risk made policy and influenced regulatory agencies in ways contrary to established norms to satisfy their desires to provide opportunities to individuals that were beyond their means and to allow corporate sponsors to grow beyond rational expectations. Corporations and individuals made similar irrational decisions intoxicated by the perceived lack of risk. The combined effect culminated in an overload of risk in the neatly packaged securities, insurance contracts and safety nets.

When the risk return relationship ceases to exist, greed runs amok in the capitalistic system. Greed drives the capitalist system. I do not mean that in the pejorative sense, but as the natural human behavior to want more and therefore, what is the foundation of the work ethic that has made capitalism the only viable model for modern economies.

Greed, as I define it, is kept in check by an understanding of the consequences of over-indulgence and if not that, limits placed on individuals, corporations and governments by their stakeholders. Greed and irrationality creates economic bubbles and ultimately the system collapses. The solution cannot be the banning of sophisticated financial instruments; that is impossible to control in any rational manner. Full disclosure of the use of the instruments and their inherent risks will create an environment of their prudent use and rational decision making that may prevent the unsophisticated from becoming victims of their own ignorance and greed. The melt down cannot be blamed on any one group of individuals; it was the collective failure of society to recognize the consequences of their own actions or maybe fluoridation.

His corporate career was focused on restructuring failing businesses. Gabel worked with management to develop a viable strategic plan. Most often, he would then assume control and implement the plan. He now prefers to help small businesses grow.

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Posted by Beck Davlatov, Bloomingdale, Illinois | Oct 05, 2009

I have read somewhere on the internet that the "Federal Reserve" might have something to do with this boom/bust business cycles. Is that true?
Posted by Richard Gabel, Issaquah, Washington | Oct 06, 2009

There were no innocents in this debacle. Some say Greenspan was solely responsible, Greenspan blames the growth of China as an economic superpower, some blame the Clinton adminstration for opening up credit standards on Fannie Mae backed home loans, others blame Congress for encouraging and allowing both the Clinton and Bush administrations to relax regulations, still others blame the banks, rating agencies and insurance companies and so on ad nausium.

It's too complicated for me to get my arms around other than at the 50,000 foot level. We're all responsible, some more than others. There aren't too many of us that didn't get sucked into thinking that our home were really worth what Zillow told us at the peak. In the end, we collectively forgot about the risk of exagerated asset values. Someone that hasn't been through a cycle as an adult can be excused. I certainly should have known better.

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Posted by Beck Davlatov, Bloomingdale, Illinois | Oct 06, 2009

I just finished reading a book that talks a lot about Greenspan and the Federal Reserve. The book is called: "End the Fed" by Congressman Ron Paul. Have you read it? If you have, what do you think about it?
Posted by Richard Gabel, Issaquah, Washington | Oct 06, 2009

Sorry Beck, I haven't read it. Let's see if anyone else has that reads this article.

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Posted by Brian Willoughby, Bellevue, Washington | Oct 08, 2009

I think you're absolutely right, Richard. The only thing I would add is that you're looking merely at the most recent and most severe of the symptoms of our disease. Before all of these complex financial instruments (that nobody understands) came into the picture, there were already problems that we were unwilling to take care of.

One important symptom of the disease is the FDIC insurance on banks. This is one way that risk is artificially extended from individuals and groups to the entire country. It surely is comforting to think that the government is there to help you out if you choose to place your money in a bank which happens to lose your money, but the fact is that there are consequences no matter how we might try to wish them away. When banks do not need to fear that they will lose deposits or customers, then they do not take responsibility to the same degree as they should. When the FDIC does cover insured deposits, we all pay the price in deflated currency and inflated prices.

The FDIC is just one aspect of banking that is a problem. True "regular" deposits are not available, and what is called a "deposit" by all U.S. banks is actually fraud. That's a tough one to explain, but it's actually quite simple when you look into it. The consequences are what we're afraid to face up to.

Another symptom is the altruistic desire to help out the unfortunate. When the government encourages banks to help people obtain a home loan that they would not otherwise qualify for, most of us feel like it's a good thing to help someone buy a home. But the unfortunate truth is that lowering interest rates artificially in this way and lowering standards for loans all add up to inflated housing values and shifts the risk from individuals and banks to the public at large. While it might seem like a good thing to make it easier to get a home, what this really means is that it makes it easier to get a home that is too expensive - and when that happens, there is too little pressure keeping home prices in check, so the housing price bubble rises and rises until it bursts. As we've learned the hard way, when the real estate bubble breaks, it affects everyone, not just those individuals who obtained loans. Even the stock market sectors that are unrelated to real estate suffered, because manipulation of interest rates distorts currency. This problem is true of all loans, including business loans - not just home loans (although home loans did show the most volatile changes).

The biggest symptom is that our government and legal system force us to use a fiat currency which only has value because the government says it has value. In the rush to satisfy every voting constituent, manipulations of currency by printing more, borrowing more, and arbitrarily setting interest rates by a centralized authority all add up to a dangerous disconnect between risk and return.

It may seem like complex financial instruments have earned the full blame for our economic woes, but that's too easy. There are a great many problems, many of which seem convenient or even necessary because we have grown accustomed to them, and the truth is that we really need to reform currency and take control away from the government. We also need to look at banking and rethink the tradeoff between convenience and responsibility.

Finally, I notice that you mentioned capitalism, greed, and the risk return relationship. I'd like to point out that you can leave capitalism out of it and the same would be true. Human beings are self-interested (i.e. greedy, to an extent), and problems with the risk return relationship will always lead to disaster. It's popular to blame capitalism, and I'm not implying that you are, but I think it is helpful to describe the situation without blurring distinctions.
Posted by Karen Floyd, Seattle, Washington | Oct 08, 2009

Thank you for your article Richard. My expertise is not in the financial world as yours so clearly is based on your description of our current economic predicament. My expertise resides in the behavior of individuals both conscious and unconscious. When I look at the 'big picture' it is easy for me to see that the current lack of security was a consequence of a society that is fear based and reactive. Less than conscious actions perhaps deliberately so, if that is possible, allowed individuals to remain unaccountable leading to an inflated sense of success and prosperity. I could feel the flimsiness of perceived value especially in the late 80's and early 90's in .com and other start-up companies that promised quick and lasting profits. When fear and lack are the motivating factors then judgement is clouded and behaviors like greed prevail. Fear of lack motivated grabbing the brass ring every time it flashed before our eyes. I strongly believe that this current recession provided us with an opportunity to re-evaluate and re-imagine a scenario that is vastly different from the paradigm in which we have been operating. It is also my belief that until we begin to need less because we trust more this trend of greed will not be corrected. Trust in ourselves that we are ok and not headed for disaster unless we can take while the taking is good. This is a tall order to accomplish. When people wake up and become aware that acting out of fear/greed will end in disaster and not abundance then we will begin to think, plan and behave responsibly and enjoy the wealth that is already available.

Karen Floyd
Posted by Beck Davlatov, Bloomingdale, Illinois | Oct 08, 2009

Is anybody going to talk about the Federal Reserve? I saw Brian mentioned "fiat currency" but never said why it is fiat and who is in control.

I read in the "End the Fed" book by Congressman Ron Paul that it is the Federal Reserve (a private bank cartel) that prints these paper or fiat money.

He also mentioned that in it's almost 100 years of existence it has never been audited and operated in a complete secrecy (printing the fiat money that we are forced to use?)

In this book he also talks about devaluation of the dollar by 96% since the creation of the Federal Reserve in 1913.

I wonder if anybody read this book and can help me understand if this is true or a fiction and a fantasy?

I hope he is wrong, please help me clarify this. Thanks!
Posted by Brian Willoughby, Bellevue, Washington | Oct 08, 2009

Beck,

Ron Paul speaks the truth. There is no dispute about the facts. It is not fiction or fantasy, but nobody talks about it because it's not deemed "newsworthy" by the entertainment media. I'm sure that Google can confirm everything that you've read in "End the Fed."

For a graphical depiction of how the U.S. dollar changed, both before and after the creation of the Federal Reserve, see:

http://mises.org/images/SeanMaloneRiseFallDollarMedium.jpg

For more history on the originals of the Fed, read the following:

http://mises.org/journals/qjae/pdf/qjae2_3_1.pdf

excerpted from:

http://mises.org/books/historyofmoney.pdf
Posted by Mike Mitte, Lynnwood, Washington | Oct 08, 2009

Total BS! Your statement – “it was the collective failure of society to recognize the consequences of their own actions or maybe fluoridation”, is total BS! It was not a collective failure. Most people didn’t contribute to the meltdown.

The simple truth is the following; banks and mortgage companies made 100% loans to people they knew could not pay them back.

The banks called these “liar loans” and NINA loans (No income no assets). The banks made huge fees knowing they would sell the loans to others. They sold the bad loans to quasi-government agencies (Fannie Mae), taxpayer backed institutions knowing the taxpayer would be on the hook.

The loans they couldn’t sell to the taxpayer they sold to Wall Street. Wall Street then turned the “bad fraudulent loans” into securities and sold them to pension plans and others.

These acts are by definition fraud and they (the banks, Wall Street, the FED, SDIC, SEC, Fannie Mae, etc) knew it was fraud. So why didn’t those in power to stop this do their jobs? The FED (Greenspan, Bernanke), SEC (Donaldson, Cox), FDIC, Fannie Mae, and the Treasury (Paulson) were in the hands of people who didn’t enforce the law because they don’t believe the rich should have to obey the law.

Personal greed was the underlying element, but the failure to enforce the law was the major cause. The regulators knew what was going on and looked the other way. The massive fraud was perpetrated by a few institutions (banks, mortgage companies and Wall Street) and then the politicians bought and paid for by those who perpetrated the fraud bailed out the crooks with $2 trillion dollars in taxpayer money.

To say the person who was raped is a part of the problem is total BS! This is the kind of BS thinking that got us into this depression we are now suffering through.

There is a reason we have speed limits and laws regulating our banks and investment companies – to protect society. When we don’t enforce the laws people are hurt and in this case tens of millions of Americans were hurt.

They are not what caused the problem. To say they are is total BS!
Posted by Beck Davlatov, Bloomingdale, Illinois | Oct 08, 2009

Congressman Ron Paul wants to audit the Federal Reserve (a private bank cartel) that has never been audited and operated in a complete secrecy since it's creation in 1913.

Do you think the Federal Reserve should be audited?

Why does a cartel of private banks can just print money and not back it up by anything and then also force everyone else to use that paper as an exchange commodity?

This stuff is crazy if you really read it and understand. It is actually simple to understand, it's just the size and the scope of this activity and the affect of it on the lives of everyday Americans makes it difficuilt to believe.

It seems that since 1913 there was no free market in the US. If a private cartel of banks can set and control interest rates instead of the capital formed from people's savings, it is not a free market.

Brian, thank you for the links. Congressman Ron Paul has those illustrations in his book "End the Fed" also, and he mentioned the Austrian economics as fundamentals for the free market economy.

Madoff is a microscopic pest compared to the Federal Reserve.

No wonder the book "End the Fed" is currently one of the bestsellers on the Amazon:

http://www.amazon.com/End-Fed-Ron-Paul/dp/0446549193

It was an eye opener for me and I am still trying to digest the information and comprehend what's what.

Thanks for your help Brian, and have a nice week!
Posted by Richard Gabel, Issaquah, Washington | Oct 08, 2009

This conversation seems to have taken on a life of its own so I'll throw in a couple of comments on the interesting points raised so far.

Brian, you make an excellent point on FDIC insurance. We just take it for granted. If it wasn't there we would all be a lot for thoughtful about what banks we do business with.

I'm not for going back to the gold standard and I do think that most currencies work well in the free market. The value of any currency reflects the strength of the economy, interest rates, the world political situation and a host of other factors relative to other countries. Where currencies are valued at what the government says they're worth like China, there's trouble brewing. I'm sure withing the next 10 or 15 years we'll be facing another financial crisis brought on by the revaluation of the Yuan.

Karen, every time we have a recession we scream that the world is coming to an end and if we get through it we'll never let something like that happen again. Unfortunately, we return to prior behaviors as fast as we can. That's been my view of it.

Mike, it's all a matter of perspective. You're right, my use of the word "collectively" does sound like everyone was involved and that's not true. Enough were involved that to say it's all the Fed's fault or the evil banks is a stretch. If the banks were all so on top this why did so many of them keep mortgage backed securities in their inventory and not dump them instantly on some poor unsuspecting investor?

Enough people in your industry benefitted from all of this. Not you of course, but builders, real estate agents, mortgage brokers etc. were all on the gravy train of easy money. Not too many people were asking questions. Most of us are old enough to have lived through real estate bubbles before. Too many people were living for the day and didn't think twice about over extending themselves or expanding their home equity line.

Sure, there are plenty of horror stories about poor unsuspecting people being told not to worry, just sign on the bottom line. I guess it all depends on perspective. I tend towards putting a lot of weight on personal responsibility.

You seem to give elected officials a pass on this. You mention them being bought and paid for, but the didn't make your hit parade of guilty parties. Here's an excerpt from a prior article of mine.

In the third quarter of 1999 Fannie Mae announced a pilot program to ease credit requirements on mortgages it would acquire from banks and other lenders. The objective was to encourage banks to extend mortgages to individuals that would not otherwise qualify for conventional mortgages. The pilot program was hoped to go nationwide by spring of 2000.

In a September 30, 1999 article in the New York Times, Fannie Mae Eases Credit to Aid Mortgage Financing by Steven Holmes, the action was described to be as a result of "pressure from the Clinton Administration to expand mortgage loans among low and moderate income people" and "pressure from stock holders to maintain its phenomenal growth in profits." In a particularly prophetic way, the article states:

"In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's."

Thanks to all of you that have commented.

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