Tuesday, December 9, 2008

Melamine on Wall Street

There are some odd parallels between America's financial crisis and the tainted milk scandal in China. In each case greed, combined with a lack of proper governance, caused the crisis. In each case there were laws, bank oversight and credit evaluation standards, or food purity regulations, that should have prevented the crises.

A Chinese milk farmer who was arrested for adding melamine said he knew the chemical is not human food, and his family doesn't drink his adulterated milk. However he had no idea of the actual consequences, and never thought about it. For him, adding melamine was another investment risk necessary for doing business. The vaguer knowledge of the consequences, the fewer qualms he felt. But the ignorance did not prevent him from being arrested. To him the whole concept of his actions causing kidney failure in infants was as baffling as, say, a mortgage backed derivative.

One would think Harvard educated Robert Rubin, Treasury Secretary for Clinton administration and economic advisor for Obama's Transition, would know a lot more than an uneducated Chinese farmer. Yet it was this Robert Rubin who saw no red flags as he led Citigroup to make bold bets, who pushed for a more aggressive approach toward risk-taking that eventually resulted in Citi's demise.

I can see how those traders on the financial front lines selling mortgage backed derivatives and inflating credit ratings probably did not understand exactly what they were doing. They may have known something was wrong. They may also have shied away from their own creations when building their personal portfolios. But they did not see the consequences. They were just taking necessary risks to further business goals.

But for an economic expert like Robert Rubin? Either he, like the farmer, was blinded by greed, or the financial system he believes in has something inherently wrong. Or both.

The financial crisis has upset Americans for many of the same reasons the tainted milk upset the Chinese. The difference is, while what the Chinese milk farmer did was illegal, what the traders and companies in the US did is legal, and a lack of understanding actually prevents the guilty from being arrested.

What the poor Chinese farmer did was to make one gallon of milk look like two gallons and still pass the nutrition test. Buying melamine was cheaper than producing real milk. He had discovered his way to wealth through leverage. Had he lived in the US, he needn't bother with melamine, because he could get a lot bigger leverage LEGALLY.

Leverage, of course, is fabulously effective way to make amazing amounts of money. Homes could be bought with no money down, stocks bought with the slimmest of margins, and derivatives could be created without constraints from their underlying basis. Who would have thought it was leading to the credit collapse and market meltdown?

True, without the leverage a lot less "wealth" might have been generated. House prices would never have gone as high. The stock market would not have seen the gains it had. But what do the high-leverage derivatives do, really? Do the fortunes thus created actually create goods and services? Do they stimulate healthy productivity growth, or simply feed the greed and increase market volatility? Do we get more milk, or just milk that tastes different and make us sick?

The tainted derivatives are the melamine on the market. Yet Americans aren't shying away from them. Instead they are treated as an advantage of the financial system. As a Chinese saying goes, "The biting dog does not bark." The unseen poisons of derivatives are more damaging than melamine.

Worse yet, now the concept of derivatives is likely to be imported into China's financial market. Some insiders are hoping China will begin to trade derivatives next year. That is, China's financial system is poised to follow in America's steps.

I remember in 2000, before the tech bubble burst, one day at a Chinese neighbor's party I heard the host explaining the concept of derivative trading to a man visiting from China. The visitor, who had never heard such a concept before, was in awe and became visibly excited, arms dancing and eyes shining, in the hope one day China would also be trading such "advanced" novelties. Well, his dream may soon be realized. When that happens, Chinese people will not be so lucky to escape the damage the way Americans skipped melamine tainted Chinese milk. I just hope the stewardship of China's financial system falls to someone wiser than Robert Rubin and such a calamity can be avoided. It's not too late to stop introducing derivatives trading into China's financial market.

One final note: apparently, milk tainted with melamine is causing a new problem in China. There is too much of it; the cost of disposing is too high; dumping it into rivers increases toxicity. Now a food safety official in Canton has found a solution: burning the bad milk to make nice bricks.

With tainted derivatives, however, there will be no such clever way to "turn a bad thing into good." The only thing they will be burning is money. Tax payers' money.

(image from ChinaDaily.com)


Anonymous said...

Very interesting analogy!

However, I'm not so sure that leveraging and derivatives themselves should be blamed, but rather their slack regulation. Cheap credit and speculation is one thing, but wasn't the real cause of the loss of confidence the fact that the ratings agencies gave good ratings to instruments that contained low-quality debt? It seems like somewhere along the line, they put their reputation and credibility up for sale. That was a huge blow.

A real estate bubble is one thing, but having it lead to something like the current mess is quite another.

Perhaps someone more qualified could explain.

Xujun Eberlein said...

There certainly are more issues than leveraging and derivatives alone, however I find those trading instruments a very troubling concept. As I asked in my post, what useful purpose do they serve other than increasing traders' greed and market volatility? They do make a small number of traders rich, at the price of higher market volatility. Yet more and more derivatives are created every year, with endless creative ideas.

I have searched around but no one provides thorough and satisfactory explanation for the current mess. Perhaps those in the know don't want to touch on anything that is fundamentally wrong with the system, but more likely they don't understand it either.

Anonymous said...

I find this post a bid odd.

How is cheating a buyer by adulterating the food supply equivalent with 'getting leverage'? Is it not simply another form of the 'cheat the customer' mentality that lies at the root of rather too many Chinese business plans?

For the farmer, getting leverage legitimately might involve mortgaging some asset to obtain money to buy more cows. Getting leverage illegitimately might involve having a friend in the bank lend money against a non-existent or worthless asset.

In contrast, poisoning your neighbor's baby by selling its parents additive laced milk has nothing to do with 'leverage'; it is just an example of criminal greed.

Xujun Eberlein said...

The farmer in the cited case did not know the exact consequence of adding melamine, but of course that doesn't mean he did not commit a crime. This certainly can be analogized to some people on Wall Street who used leverage to a toxic extent and resulted in harming all of us. Both are the results of human greed.

Xujun Eberlein said...

Hmmm, there was an arrest yesterday - the WSJ reported: "Bernard L. Madoff, a former chairman of the Nasdaq Stock Market and a force in Wall Street trading for nearly 50 years, was arrested by federal agents Thursday,..." see http://online.wsj.com/article/SB122903010173099377.html

Anonymous said...

I stumbled upon your blog while searching something on banking. There is one major flaw with this comparison; leveraging mortgages IS regulated, and it is that regulation that lead to this moral hazard. for instance, if you had a speed limit in a school zone of 55 mph, you would likely drive 55. If the sign said "caution, school zone" you are likely to drive much slower. In a nutshell, that is what happened with the US lending system. Today I spoke with the guy who has issued more ARM loans than anyone else in the eastern US. He is now recommending all his clients to go 30 year fixed; this is due to markets, not regulation. ARMs were encouraged by the congress in '02 to encourage more home ownership for lower income people... tada!

As far as melamine, this is beyond a farmer trying to make a buck. The chemistry is not so simple, and this type of fraud is an industry within an industry in China. The farmers clearly know they are committing a crime.


Anonymous said...

I agree that the 'analogy' is pathetic.

Xujun Eberlein said...

A recommended reading for you all: http://cnreviews.com/kai_pan/nyt_reminds_us_westerners_not_much_better_than_chinese_20090105.html .

perspectivehere said...

Xujun, a similar analogy was made in the comments to this Huffington blogpost:


Following this thinking, a slightly more apt comparison than set out in your post is:
1. subprime borrowers = poor dairy farmers
2. mortgage brokers and banks = raw milk dealers and middlemen
3. rating agencies = milk inspectors
4. subprime mortgage securities issuers = milk companies (like Sanlu)
5. subprime securities institutional investors (fund managers, insurance companies) = companies using tainted milk as raw material for candy, cookies, milk powder
6. retail investors = retail consumers

The Caijing article mentioned in the comment elaborates on the breakdowns in quality due to privatization of the milk supply system, and the incentives to adulterate. It was the milk dealers who collected the milk from hundreds of small farmers and resold it to the milk companies that had the greatest incentives to adulterate the milk, not the individual milk farmer. (Although certainly there were some individual milk farmers involved in the adulteration as well, just as there were some subprime borrowers who actively participated in fraudulent borrowing schemes).

In the subprime cases, it was the mortgage brokers and banks who encouraged borrowers to take out mortgages that were at high risk of not getting paid; because the brokers and banks could onsell these subprime mortgages to the securities issuers for repackaging as subprime securities for a fee, there was no incentive for policing the quality of the mortgages being onsold.

The ratings agencies which gave triple aaa ratings to subprime securities were using models which were not capable of ascertaining the real quality of the securities. Similarly, the milk inspectors used tests which could not catch the adulteration. In some cases, the rating agencies and the milk inspectors were incentivized by conflicts of interest not to find problems.

This is why privatization must be accompanied by well-thought out and enforced regulation or the public interest can suffer.

Blind calls for privatization can result in weak planning and faulty assumptions in this regard. Sometimes state ownership and control of prices and market players can be a better means of assuring the public interest than a poorly regulated privatize system. This is about good supply chain design, good regulation and good management. A "democracy" and "free market" is not necessarily the best way to achieve these ends unless it is well thought out and executed (and trial-and-error experimentation definitely helps).

By the same token, there is nothing wrong with derivatives per se, but the regulatory system must be appropriate for the risks inherent in the way these products are used or abused. As is becoming apparent, the Greenspan assumption that the market will always take care of itself has been found wanting. The U.S. made bad choices by assuming that freedom for market participants was the best way to go, while some sensible minds who thought otherwise were ignored: http://www.stanfordalumni.org/news/magazine/2009/marapr/features/born.html