Alchemists of Loss

How Modern Finance and Government Intervention Crashed the Finance System

by Kevin Dowd and Martin Hutchinson , Published by Wiley 2010.

This book is a page turner. It is a must for anybody who has an interest in what has gone wrong with our financial system and thus the economy, and what can be done to fix the problems created.

It is an unparalleled tour de force of the last 300 years of modern finance with special focus on the last 30 years and microscopic focus on the last 30 months. In years to come this will be a book that our children and our grandchildren refer to when studying “The Great Crash” of the last years of the last decade. Sensible lesson are learnt from the Japanese 20 year recession rather than the 30’s. The various stimulus packages and failed deficit spending should be there in your face for anyone with above room temperature IQ to learn what not to do, but hey ho — every generation, like monkeys, we seem to have to re learn everything in economics all over again. The short sharp shock of the Savings and Loan crisis of the early 80’s could well show us a way forward on the 00’s.

The alchemists in the title are 7 Nobel Prize winners, investment bankers, the political class, other economists, and regulators.  They exploit the frailty of the human condition — our impulse to believe that “this time, things are different.”

Dowd and Hutchinson show beyond all reasonable doubt how the financial centre of the economy has become one massive rent extraction machine where gains are privatised and the losses are socialised — paid by the likes of you and I, the hapless taxpayer. The bailouts are unquestionably the biggest examples of this. No other industry on the whole planet would get this treatment. Smaller examples of rent seeking are the successes of the industry in achieving light touch regulation and non-domiciled tax status for over 100,000 UK financial service workers. Indeed, unbeknown to most, the UK is one of the biggest tax havens in the world.

The authors also conclude, like I do, that excessive bails outs funded by deficit spending leads to government debt crises, which is “solved” by either monetisation of the debt (inflation), or straight forward sovereign debt default.

We must remember that in 2008, one quarter losses of the financial system cost us taxpayers, one quarter of a century of profits! Read that again.  It is so staggering a figure that anyone who even believes these Alchemists should be allowed even near their own money, let alone ours, occupies a different planet to me.

My in-depth review follows. I am inviting the authors to critique it. There is much good debate to be had. I start with their conclusions that will give you a flavour of the book and you may well stop at that. If you want to delve deeper, I explore some of the issues more. However, this is no substitute buying the book. I hope the compelling policy recommendations will be taken up and the book itself will be a major historical book that will last the test of time, and be read by generations to come.

How to Exit this Mess

  • No more bailouts just bankruptcy and a realignment of capital to those who are more prudent.
  • Make debt for equity swaps if need be with over leveraged banks.  Ironically, this is the policy the banks themselves are forcing on companies that they deem to be too highly leveraged. What is good for the goose is good for the gander.
  • Abolish deposit insurance.
  • Remove failed management in the banks and in the regulators.
  • Abolish the regulators and put the individual back in change of his/her risks.
  • Move to historical cost accounting and not mark to market.
  • Move back to partnership banks with open-ended liability. Like doctors who have an open-ended liability to you in the advice they give and medicine they administer, they are professional experts and you are not. They have a fiduciary duty to you. So too should the bankers go back to having this fiduciary duty to you.
  • If mathematical models are to be used at all in risk management, they suggest the “Expected Shortfall” or the “Probable Maximum Loss” model. I personally have reservations about any mathematical models as I favour sound entrepreneurial judgment.  If you do not have this, you should not be playing, thinking you are investing, with savers’ money.
  • My view on Maths in banking is that Bayesian or non Bayesian, Cauchy not Gaussian, fuzzy logic or good old fashioned Aristotelian logic is all by the by — if you don’t have a talent for matching the needs of savers and borrowers, you should not do banking. No mathematical system will aid you in this.  This alternative model outlined by Dowd and Hutchinson is new as far as I am aware, and needs to be debated. It is certainly better than our Alchemists of Loss failure model. Personally, I favour entrepreneurial judgement by bankers with open-ended liability.
  • Scenario planning should become a major factor in banks’ internal risk assessments. I agree, predictions are binary and assumption-laden.  Scenario planning, especially if it is ongoing, is like musical chairs — you always have an eye on a seat should the music suddenly stop!
  • Rating agencies should be compelled to remove conflicts of interest by not being paid to assess a security by the issuer of the security!
  • CDS instruments should only be allowed to be sold to you if you have an “insurable interest” in the underlying asset. See more in the article about this very interesting proposal.
  • Use the language of investment and not speculation. If you use the latter, you are a gambler, if you use the former, you are a banker.
  • Let judgement rule over the mathematical models. Do not diversify for the for the sake of the model.
  • If you do not understand it, do not buy it.
  • The recommendation they make to set up Zombie banks, I take it to read as simple saving and lending, plain vanilla banks like Jimmy Stewart / George Bailey in “It’s a Wonderful Life” would have run, as opposed to the Zombiefied state owned banks that we see today that are very challenging to deal (as anyone in business will testify).
  • Root money back into a commodity standard such as gold.  This would require no central bank support (i.e. the central bank could be abolished).
  • If a central bank does exist, go for the hard money Volcker-style monetary control or hard currency control like the early Bundesbank.
  • They suggest a tax on assets to make the very large banks shrink. Personally I would suggest that if that is the way they want to go, they can just lawfully enact legislation to break them up. If free competition in banking with no central bank and no legal privilege is allowed, then the Behemoth banks would wither on the vine anyway.
  • Concerning the ad valorem tax, should we keep the existing banking system, it will only push up the prices for the products sold. I do not know how this will achieve their desired objective of limiting excessive trading.
  • Equalisation of taxes on dividends and interest as a foil against excessive leverage sounds a plausible reform should we stay with the existing banking system.
  • Abolition of the non dom tax breaks which allow 100,000 people in the City of London to work in the biggest tax haven in the world and pretend that most of their income comes from elsewhere should be abolished.
  • Establish a monetary constitution via legislation like the 1994 New Zealand Fiscal Responsibility Act sounds like a very good move to prevent the governments from going back to their old ways of monetising debt.
  • Abolish the IMF and the World Bank, as these just perpetuate the international bureaucrat class that feathers its own nest and gives bad advice for recipient countries they lend to.
  • Stop crony capitalism where bankers become politicians with ease, then go back to banking again. Make a mandatory time separation required should anyone want to move between the two, as has become fashionable during this period.
  • Abolish any estate duties / inheritance tax so families can once again be the primary owners of banks and long term shareholders encouraged, often on an intergenerational level which is lacking today. Wealth confiscation by these taxes has created the big unaccountable beasts we have today. Let us go back to shareholder capitalism and not institutional crony capitalism.
  • Above all bin Modern Financial Theory – it has utterly failed us.

For me I say amen to pretty much all of the above.

Modern Financial Theory

The authors see the current mess we are in as a blend of two very wrong belief systems. The first is what is called Modern Financial Theory and its offspring of the Efficient Market Hypothesis, Capital Asset Pricing Model, Black-Scholes equation for option valuation, Modern Financial Risk Management. The intellectual edifice of the above was spawned by 7 Nobel winners, the lead Alchemists of Loss. I find these distinguished mathematicians to be great builders of elegant mathematical models, but they are abstract and do little to help us study and understand the human condition.

A good start point for Modern Financial Theory is the 1958 seminal Modigliani-Miller Theorem. Believe it or not, this Theorem states the following: the value of a company is invariant to its capital structure; or simply put, the capital structure, the balance between debt and equity, is irrelevant!

Gloriously the theorem assumes;

  1. No taxes,
  2. No difference between the rates at which corporations can borrow,
  3. Zero transaction costs,
  4. The complete absence of agency costs

This gave academic credence to equity light, heavily laden, debt leveraged companies. With assumptions like the above, it is hard to imagine what relevance this has in the real world that we live in. It has always alarmed me that such mathematical economics with its unrealistic, otherworldly assumptions should be taken seriously as tools with which to govern our lives.

Modern Portfolio Theory came along around this time as well.  You have a steady income if you diversify your risks.  Ideally you want to have an investment portfolio with negatively correlated companies so if one is tanking seasonally, there is another over performing etc. The volatilities are labelled as a sigma and the higher the sigma the more volatility. A portfolio manager should not worry about individual sigmas but about the sigma of the whole portfolio.  I would add a further point: if a portfolio manager is so dull that he can’t look for companies with at least some of the following traits, then perhaps he is in the wrong business:

  1. Strong balance sheet with good equity and retained profits for a rainy day,
  2. Ongoing investment,
  3. Inspiring entrepreneurial leadership,
  4. Good executive management,
  5. Sensational, functional product,
  6. High or strong barriers to entry

Modern Portfolio Theory

In enters Harry Markowitz, another Alchemist of Loss, he claimed to be able to fix this problem of capital allocation in an investment portfolio by using statistical methods. Assume a Gaussian distribution of return from all investments — i.e. a Bell Curve and know the sigma and plot the correlations between them — and there you have it: capital allocation choices are no longer subjective, but objective and quantifiable. Now you could just take your pick of your preferred tradeoff between risk and reward.

Furthermore, you could now mathematically determine if a new share was added, its riskiness (beta) or its potential for reward (alpha). So the search was on for low beta and high alpha. My points one to six mentioned above never seem to get a mention.

The Gaussian curve (think Bell Curve) clusters most sigmas in the bell of the curve with the lip tailing off to the most improbable sigma events.  To give you a flavour, 5 sigma loss is a 14,000 year event. A 23 sigma event is measured in many millions of years. In 1987 we had one when the stock market crashed, and we had one again in 2008. The authors quite rightly question the sanity of anyone who can believe in this nonsense:

So when Goldman Sachs Chief Financial Officer David Viniar famously admitted to being puzzled by a sequence of “25-standard deviation moves” in August 2007, it might have occurred to him and others that Wall Street’s risk management methods even at the best-run institutions where hopelessly inadequate.

Efficient Market Hypothesis

This was the claim that market prices were efficient, i.e. they fully reflected all available price data . This fitted in nicely with the homo oeconomicus of the Neoclassical School: that perfect all-seeing, all-knowing, rationally acting man.

The Blend with Keynes

The Keynesian system of state intervention and deficit spending, via gigantic monetary pumping is the other trend line that has rollercoasted us into a brick wall. Even though they all accept that credit is the creator of the boom and the bust, they see more credit as its cure. I call these economic practitioners witch doctors and mystics; the politeness of Dowd and Hutchinson does not allow them to use this language, but I am sure they agree with my sentiment.

The Emergency of Crony & Managerial Capitalism

With the advent of Modern Financial Theory, we have seen the explosive growth in institutional ownership of shares and the demise of the private share owner. There has also been a shift in the investment horizon from the long term to the short term. In the 1950’s institutional ownership was some 15% of shares in the USA.  Death duties and other measures such as a pro inflationary policy had extracted wealth from the long terms savers and by the 1980’s , over 50% of shares were held by institutions, where it remains today.  The family owners who controlled their shares have been usurped by the middle manager, a salaried man commonly incentivised by a short term bonus and not the underlying shareholder gains.

Modern Financial Theory also has suggested that the management are perfectly aligned with their shareholders if they are given options to effectively make them mini owners, the reality is most hold options for the shortest time period and sell for gain as soon as they can. If there is no gain, they lobby their senior manager to have their sunken options re-valued again so they can have another go until they hit the cash-in jack pot.

CEO salaries from the 1980’s in the USA have grown from 42 x average worker earnings to 520 times. The Theory would work if shareholder value had risen accordingly. Sadly, this annual growth of over 8.5% in CEO salary corresponded with a 2.9% annual growth in profits. Management somehow managed to get rewarded when shares went up, but never had to return their bonuses when the share value went down. The dice now seem to be loaded in favour of the manager rather than the owner.

Management while in control can push down dividends (now yielding 1% on average in the USA), load up debt, and thus push the share price but not the net value of the company up, forcing more events to run through the extraordinary line and not the income statement.  Practices like this are more prevalent now than ever.

The authors conclude that our system of capitalism is little better than the corrupt crony capitalism of the new Russia, where only a handful of people gouge the majority.

One statistic that shocked me is that fees to financial management account for $620bn in the USA or a full 4.5%of their GDP. Once you take into account the need to pay these fees before you even earn a dime, it is little wonder that it is hard to get a return while the “croupier” is always winning!

Hedge funds regularly charge “2 and 20” i.e. 2% management fee each year and 20% of the upside. They never give 20% of the downside back when the shareholders suffer loss, it is almost a one way bet for the fund manager.


Outstanding trades are 10 times larger than global GDP at $512 trillion. With global GDP at $50 trillion, they estimate that only $2 trillion is actually used for some genuine hedge purpose.  The liquidity that we actually need to facilitate transactions is only a fraction of the hedge value, so why the need for all of these trades? To me they are just bets, mere gambling. The authors do not spell this out, but I suspect they would agree. They label these trades as just plain rent seeking, another way for Wall St et al to extract more and more wealth from the system.

If it is gambling, I say let them gamble, but like a gambling contract, give it no enforceability in law. Make them do it in casino companies and not banks that should have a fiduciary duty to its stakeholders!

The Ticking Time Bomb Securitization

If you can package up your mortgage book and sell the income stream to some third party for a profit on the income stream, even though you have not had to wait for the full 30 years of the mortgage income to come through to you, you can a) hold less capital in place to cover defaults on these loans and b) book all the income into the income statement in one year. This means big bonuses being paid on profits that have not even materialised! I personally would love to book 30 years hypothetical profits of my business into one year and take and mother of all bonuses. Also, being a simple seller of fish and meat, this opportunity does not offer itself up. Being a banker however and way-hey, you are in the money big time! No wonder there has been a rush to securitize assets in banks like this. With the backing of Modern Financial Theory giving you the academic basis to stretch your capital as far as possible, and leverage, leverage, leverage, in the knowledge that high numbered sigma events are a 1 in 10 thousand or million year events, you are off to the races with sure fire certainty that this is the right thing to do.

Needless to say, you can see the moral hazard in being able to sell mortgages in the knowledge that you will never have to see them through to the end of their life. Unless you are really unlucky and have some very early month defaults, you will never see a default as it is not your problem.

The rating agencies that are complicit in this process are paid by the bank that is selling the security – no conflict of interest here then!

The Community Reinvestment Act 1977

This act was a push to force lending to minorities and poorer families, well intentioned I do not doubt, but the sad fact was, for the sake of box ticking with regulators and with the sure fire knowledge that you could lend to sub optimal borrows and remove it from your balance sheet AND book profits for the whole duration of the loan to your current year P&L via securitisation, and the time bomb of subprime was set. The only wonder is how long it took to explode!

The Unbalanced Economy

At the start of the 80’s in both the UK and the USA, the finance industry was around 5% of GDP, now it is close to 30%. The authors point out that whilst the croupier can feed on us for a while, what indeed are we going to feed ourselves on in the future? The authors are correct to point out the dire straits that both economies (USA/UK) are in and rightly question what the long term survival of both is going to be predicated on.

Credit Default Swaps

These were created in the 1997 and from nothing reached $62 trillion by 2007. They allow the owners of the swap to manage their risk exposure to a particular credit default (“going bust”) event. Consider this as an insurance policy against an underlying asset going bust on you. You could now own a bond in a company and hedge your bets by taking out a CDS and now bet that the company could fail. This was a perverse incentive when the CDS became more valuable that the bond itself. The authors liken this to a spectator shouting “jump, jump” when some poor desperate soul is contemplating suicide. You did not even have to have any relation with the company insured against as we saw with Lehman as CDS positions were compelling the quick death of this company.

Life Assurance Act 1774

The authors make a very important point. The above act introduced the concept of “insurable interest.” Before this a life policy could be taken out by anybody over anybody. There was presumably a high incidence of death for no apparent reason and the concept that you must have an insurable interest to have the policy came into existence. A move to establish the insurable interest equivalent for the CDS is certainly a way forward worth investigating.

The reality is, with Modern Financial Theory and its faulty mathematics predicting very remote possibilities of loss, the selling of CDS to support securitisation, that biggest of all money spinners was easy money for all in the finance sector. The horn of plenty continued to gush forth money for all involved in these operations. AIG was one of the biggest counterparties. They loved the fee income and with Modern Financial Theory saw the risks to be negligible.

Mark to Market Accounting

The move from “historical cost” or “lowest realizable value” is lamented by the authors as the finance sector has moved to “mark to market”. This allowed the ever rising valuations in the balance sheet, from which income that was not earned could be extracted in the form of bonuses. Naturally if the valuation went the other way, nobody was ever asked to put their bonuses back.

Deposit Insurance

Because banks lend more than they have in the vaults (i.e. they maintain a fractional reserve, unlike every other kind of commercial entity, which needs to keep its creditors whole), the USA introduced deposit insurance in the early 30’s to assuage the rational fear that people have of a bank run. The Alchemists, Diamond and Dybvig show in their abstract model of 1983 that if you include this policy in your banking systems, you stabilise the system so it can on lend as much as it likes. There is no surprise to anyone that more risk is thus taken and capital driven to its lowest possible number so all capital is working efficiently!

Investor Protection

Dowd and Hutchinson show how this moves the onus of protection from the individual to a whole array of government bodies that end up not protecting you. Never has there been a bigger system wide banking failure with tens of thousands of regulators.  In my industry with have fish quotas and controls set on scientific measures undertaken by the EU. No one believes their data on sustainability so new organisations in the private sector have been created to fill this gap giving sustainability information such as the MSC and the British Soil Association. If we all have a stake in our industry we manage to provide for the long term. Shift the responsibility to a third party to look after us (or be forced to be looked after via the government) and it is no surprise that the whole house of cards has toppled down.

The Regulators

The story of the incompetence of the FSA and the SEC is told, and it would be funny if it were not such a telling bit of real financial history with us as the victim.


Bankruptcies have been made easier to undertake, and to recover from. We should go back to the old bankruptcy laws.

Basel  I, II & III

If you wish know in detail how the Alchemists’ VaR (Value at Risk) modelling has made this juicy bit of regulation positively dangerous then I believe Dowd and Hutchinson make a compelling case indeed.  The banks working under their partnership model with open ended liability would not have historically countenanced such mathematical abstractness to justify massive risk taking.

Some History

All historic recessions are shown to have been caused by either just one of these five causes or a combination of them:

  1. Rampant speculation,
  2. Government involvement,
  3. Misguided monetary policy,
  4. Misguided regulation or legislation,
  5. New financial technology

All five were present in the 2007/08 Crash!

Values Lost

Partnership and open ended liability was the way forward for most of the great names in banking historically. Limited liability was something that you had to apply to parliament for. The knowledge that you could lose your entire wealth as a bank partner historically kept you from undertaking risky acts. You were prudent, your reputation was everything. This ethical and commercial stance was no hinderance on the creation of wealth in society as Modern Financial Theory will tell you; indeed we must remember that the whole industrial revolution was built on very solid financial foundations. The authors give ample evidence for this.

Although Dowd and Hutchinson do not explicitly mention it, the language of banking was of the fiduciary and now it is that of gambling.

The authors mention that the during the period of partnership-led banking there was also the establishment of such organisations as the Accepting Houses Committee in 1914, which you would not be allowed to join if not of a certain reputation, and you would not be allowed to have your trade bills “accepted” by the Bank of England.

The Financial Services Act 1986 swept all of this away. I remember being very supportive of this liberalisation as a child, but in hindsight it was ill thought out legislation.  My personal view is that instead of a banking system based on bankers holding fractions of deposits in reserves against liability claims, we need 100% reserve free banking to produce a robust system. No amount of good practice can ensure the system stays solid when it is inherently illiquid by any normal commercial accounting standard. The authors suggest that a fractional reserve free banking system similar to the Scottish system in the early 1800’s would be the model to follow with all of the reputational and partnership ethic strengthening up the system.  This however is a small quibble about their reform program and not with what they have to say about what has got us into this mess.

Buy the book, it is a sensational read.


Dowd and Hutchinson on Economics

They hold the view espoused by Friedman and Schwartz that the problem with the 1930’s was that the Fed did not keep the money supply at the levels seen in the build up to the 1929 crash. They hold a conventional monetarist position. They do not discuss or entertain the possibility that the massive uplift in money supply from 1913 – 1929 may well have been the direct cause of the asset inflation, i.e. excess credit created the boom that led to the bust.

By advocating that during this bust stage we should not do what other monetarist inspired economists have done (such as Bernanke, who flooded the market with liquidity), they take what I would call a hard monetarist view and suggest a route of keeping money supply growing only at the rate that productivity and the needs of trade demand. They do not discuss the Austrian Theory of the Business Cycle, which I think is the most useful theory for explaining the boom and bust. This is puzzling.

The official launch for Alchemists of Loss will take place on Wednesday 30 June 2010.  Contact the IEA if you are interested in attending.

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