By Barry Elias

April 23, 2011

In  a recent presentation to the University of Pennsylvania’s Wharton School of Business, Dow Chemical CEO, Andrew Liveris, was astonished to learn that 70% seek careers in finance.

This type of thinking precipitated the systemic failure of our economy.

I will return to the prescient presentation delivered by Mr. Liveris later in this piece.

Following a two year study, the U.S. Senate Permanent Subcommittee on Investigations Recently issued a 635-page bipartisan report that describes the causes of the financial crisis.

The Chairman of this committee, Senator Carl Levin, D-Michigan,  stated the following:  “Using emails, memos and other internal documents, this report tells the inside story of an economic assault that cost millions of Americans their jobs and homes, while wiping out investors, good businesses, and markets.  High risk lending, regulatory failures, inflated credit ratings, and Wall Street firms engaging in massive conflicts of interest, contaminated the U.S. financial system with toxic mortgages and undermined public trust in U.S. markets. Using Their own words in documents subpoenaed by the Subcommittee, the report disclosures how financial firms deliberately took advantage of their clients and investors, how credit rating agencies assigned AAA ratings to high risk securities, and how regulators sat on their hands instead of reining in the unsafe and unsound practices all around them. Rampant conflicts of interest arethe threads that run through every chapter of this sordid story.”

The report cites four key aspects of the crisis: (1) high risk mortgage lending by thrift institutions, (2) unjustified credit ratings by Moody’s and Standard and Poor’s, (3) creation and sales of ill-conceived financial products by investment banks, primarily Goldman Sachs, and (4)ineffective government oversight and regulation by the Office of Thrift Supervision (OTC).

At the core: these institutions knowingly participated in financial malfeasance that sowed a macroeconomic earthquake.

In 2003, Washington Mutual Bank (WaMu) embarked on a high-risk mortgage lendingprogram.  Within three years, its lowrisk loan originations dropped to 25% from 64%, while its high risk loansincreased to 55% from 19%.  At the time,the bank’s senior executives said the housing market “signifies a bubble” andthe risks “will come back to haunt us.”

In2006 and 2007, 90% of all AAA ratings for mortgage backed securities weredowngraded to junk status following sever default rates occurring in themarket.  In 2006, more than 40% of thehigh risk subprime and Alt-A loans defaulted. In fact, that same year, Long Beach Securities was able to boast aperfect record:  all 75 AAA-rated LongBeach securities it created were eventually classified as junk.

Investmentbank fees to construct , underwrite, and market mortgage-backed securitiesranged from $1 million to $8 million, while that for collateralized debtobligations was between $5 million and $10 million.  A handsome return for a destructive product.

Referringto Gemstone 7, the $1.1 billion Deutsche Bank CDO, its top CDO trader describedit as “crap” and “pigs,” while rushing to sell it “before the market falls offa cliff.”

GoldmanSachs marketed four CDO’s to its clients: Hudson, Anderson, Timberwolf, and Abacus.  Disclosure of material information regardingthese securities was incomplete at best and intentionally misrepresented atworst.  In fact, while claiming itsinterests were aligned with Hudson investors, Goldman held 100% of the shortside for this CDO.  Goldman selected theassets in the CDO, but claimed that function was performed by an independentthird party.

Today,25% of all mortgages are underwater, whereby the debt exceeds the market priceof the underlying property.  Moreover, millionsof foreclosures are anticipated in the near future.

Unfortunately,financial regulators were incognito as these events unfolded.

SheilaBair, Chairman of the Federal Deposit Insurance Corporation (FDIC), addressedthese regulatory challenges in a speech two days after the release of theSenate report.

In atelling assessment, Ms. Bair claimed that while many foresaw an unsustainableincrease in real estate prices, less understood the danger of insufficient debtservice ability, even less appreciated how risk was obscured in financiallyengineered vehicles, and almost no one anticipated a lack of short term liquidityto offset negative cash flows.

Sheconcluded the engineered financial products and vehicles fell outsideprudential supervision.  As a result, thehigh transaction risk was transferred from shareholders and creditors to thesociety at large.

Ms.Bair remains confident that the recent Dodd-Frank legislation will prevent its recurrence.

Thelegislation authorizes the creation of the Financial Stability OversightCommittee (FSOC), comprised of the Treasury, Federal Reserve Bank, FDIC, andother regulatory bodies, and the Consumer Financial Protection Bureau (CFPB).

TheFSOC is charged with measuring financial systemic risk and implementing riskmitigating measures.  Criteria for thisassessment include:   leverage,off-balance-sheet exposures, concentration, and interconnectedness.  The CFPB will, for the first time, apply thesame federal consumer protection to non-bank financial companies that itapplies to banks.

The legislation requires loanoriginators to own at least 5% of most loan originations, as risk retention, todeter high risk lending practices.

The international Basel Committeehas issued the Basel III proclamation to define international liquiditystandards.  These include the Liquidity Coverage Ratio and the Net Stable Funding Ratio toaddress the short and long term liquid capital requirements, respectively.  Moreover, these requirements are higher, notlower, for Systemically Important Financial Institutions (SIFI) as compared withsmaller institutions.

Assessingwhere we are today, the New York Times reports, “Sales of new single-familyhomes in February were down more than 80 percent from the 2005 peak, farexceeding the 28 percent drop in existing home sales. New single-family salesare now lower than at any point since the data was first collected in 1963,when the nation had 120 million fewer residents.”

Thisis not encouraging news.

I return to Wharton, Mr.Liveris, and our financial future.

Theviews presented by Mr. Liveris are well aligned with my perspective and recentwritings.  His prescription: focus lesson finance and more on value creation. Creation of value creates demand, and this demand creates prosperity: avirtuous cycle.

Headvocates a return to manufacturing: advanced manufacturing.

Advancedmanufacturing involves engineering to develop nanotechnology, robotics, andsemiconductors (not clothing and steel). The economic multiplier associated with manufacturing is double that ofservices (1.4 versus 0.7).

Over the past several decades the US became haughty, believing it can simply innovate and allocate capital so the world can manufacture.  The empirical evidence suggests otherwise.

Singapore,China, and India are educating their population more effectively and efficiently than us.  Their students are occupying a greater percentage of our selective universities.  They return to their home country where they innovate, manufacture, and allocate capital.

Thegovernments of these countries have adopted a pro-business climate (e.g., taxand energy policies) that creates value added synergies.

Incontrast, the U.S. government has created policies that enabled market forcesto disable the financial and macroeconomic infrastructure.

TheU.S. seems blind to this reality.

Areturn to manufacturing is the only way out.

Incidentally,the starting salary for a chemical engineer: $120,000.

Thereason: strong demand, short supply.

Barry Elias Biography

Barry Elias is a recognized economist and journalist.

Mr. Elias, a member of the Newsmax Financial Brain Trust, provides weekly commentary to Newsmax Media’s Moneynews.com.

He served as a consultant to many high profile financial institutions, including Oppenheimer Capital, Merrill Lynch, JPMorgan Chase, Bank of New York, and Mellon Bank.

His work has been cited and acknowledged in several recent best-sellers co-authored by Dick Morris, former political adviser to President Bill Clinton.

Mr. Elias graduated Phi Beta Kappa with a degree in economics from the State University of New York at Binghamton.  Following university, he attended medical school at Upstate Medical Center in Syracuse New York.

He currently resides in Manhattan, where he appreciates the diverse cultural offerings.

Mr. Elias may be contacted at the following email address: This e-mail address is being protected from spambots. You need JavaScript enabled to view it This e-mail address is being protected from spambots. You need JavaScript enabled to view it .