For over a decade, I have written about the lies we were and are being told about the Great Financial Crisis and predictable negative consequences of the actions taken based on those lies.  But I haven’t just written about the lies and the policy responses.  I have also written about who were the promoters of these lies.  Why?  Because until you understand what the truth is and who you can trust it is impossible to take the necessary actions to fix what is wrong with our economy, society and political system.

Boston University Professor Laurence Kotlikoff wrote an excellent paper addressing the issue of lies surrounding the Great Financial Crisis.  He calls it the “Big Con”.  In the paper, he debunks multiple false narratives about the financial crisis by showing they are unsupported by the facts or are descriptions of outcomes rather than causes of the crisis.

Standard explanations of the 2008 financial crisis and its associated Great Recession represent the big con. Like the movie The Big Short, they make bad actors, not intrinsic problems with the financial system and the economy, namely multiple equilibrium, facilitated by leverage and opacity, the culprits.

Bad/greedy/lazy/irresponsible actors, we’re told, engaged in all manner of financial malfeasance, risk taking, negligence, theft and greed. And what we’re told is true. There were plenty of bad actors – enough to fill up hundreds of books and movie scripts. But the story of these bad actors is not the real story of the Great Recession.

The story of the Great Financial Crisis is opacity.

Professor Kotlikoff recognizes it was an opacity driven crisis.  Citing the Financial Crisis Inquiry Commission he notes even it discovered opacity.

The crisis reached seismic proportions in September with the failure of Lehman Brothers and the impending collapse of the insurance giant American International Group (AIG). Panic fanned by a lack of transparency of the balance sheets of major financial institutions, coupled with a tangle of interconnections among institutions perceived to be “too big to fail,” caused the credit markets to seize up. Trading ground to a halt. The stock market plummeted. The economy plunged into a deep recession.

He discussed the role opacity played in the crisis.

Opacity is the midwife of financial panics. Bear Stearns was among the first to be picked off by those who stood to gain by a financial collapse because it was viewed as particularly opaque. According to Cohan (2010 ), no one on the street or, it seems, inside the bank, knew what its assets were really worth. What they did know is that its relatively high leverage and opacity made it vulnerable. …

The fact that Bear’s stock was valued at $60 per share one week before JP Morgan bought it for $2 per share (less a $29 billion sale of Bear’s troubled assets to the Fed valued at far less than $29 billion) tells us that no one knew anything about Bear’s assets, either before it died or when it died. Its valuation was, it seems, purely a matter of conjecture.

Opacity prevented the market from knowing Bear’s current exposure details.  Opacity further prevented the market from valuing many of the securities Bear was thought to be holding.

In the presence of opacity, when Wall Street’s valuation story for a security/bank is called into doubt, there is no logical stopping point in the decline of the security/bank’s value other than zero.   So it is not surprising Bear’s stock value drop from $60 per share to $2 per share in a week.

Bear’s collapse showed the market that there was potentially no there there in any of the banks. If Bear’s mysterious “rock solid” assets were worth a fortune yesterday, but nothing today, maybe the same was true of other bank’s assets. And as the next most “trustworthy” bank fell, because, again, it became clear that no one could really understand its assets either, the belief that yet more “trustworthy” bank’s assets were rock solid declined. The serial failure of the banks, thus, appears to accord with what opacity and faith-based asset valuations would deliver.

Professor Kotlikoff has described the mechanism for what I call the earthquake along the opacity fault line in the global financial system.

Naturally, he has a plan for eliminating opacity.

if opacity is a major problem, the answer is to have the government oversee disclosure. Why the government? First, private parties can’t, as we’ve seen, be trusted to provide truthful disclosure. Second, they can be mistrusted even if they are acting in a trustworthy manner. Third, information is a public good, making its disclosure a public good.

Since 1933, the government has been overseeing disclosure.  It is the SEC’s responsibility. The fact the SEC is no longer fit for this purpose is the result of Wall Street capturing the process by which the SEC sets disclosure requirements.

The Transparency Label Initiative was started so investors could take on the responsibility of requiring issuers to disclose all the information investors need so they can know what they own.

To his credit, Professor Kotlikoff also noticed the major shortcomings of the Dodd-Frank Act and why saying this Act reduces the chances for another financial crisis is a lie.

 

The Dodd Frank reform does very little to alter financial company leverage or limit the financial system’s opacity. … As for making financial companies transparent, it’s business as usual on Wall Street. The pass on opacity was implicitly endorsed by the FCIC report. That report runs 633 pages. The word opacity appears once. The word opaque appears seven times.

Please re-read these shortcomings and note how the choice to not address opacity was intentional!

The only way transparency is going to be restored in the financial system is if investors demand it.  And the way for investors to demand transparency is to concentrate their investments in securities that have been awarded a label indicating investors can know what they own.