Thursday, 25 December 2008

The Real Reasons Why Hank Paulson Screwed Up

For Hank Paulson's detractors (and there are many), the U.S. Treasury Secretary's main mistakes in dealing with the 2009 financial crisis often boil down to: 1. Letting Lehman Brothers go bankrupt. 2. Relying on an ad hoc approach: one day the $700 billion bailout is about buying bad assets, the next it's about recapitalizing struggling banks (remember the quote from a Washington lawmaker accusing him of flying a $700 billion plane by the seat of his pants).

But is this really where the former Goldman Sachs chairman blundered?

First, Lehman Brothers: Did its collapse really play such a large role in ushering in the nuclear winter in credit markets? It's not that hard to imagine that, absent a Lehman going belly up, a different bankruptcy or dire event would have brought us to the same juncture. Remember too that Lehman was revealed to be in worse shape than anyone imagined: its bonds wound up fetching a paltry nine cents on the dollar. Its implosion spooked markets partly because investors saw how much rot had spread through asset books of financial companies.

Of course a countervailing argument is that letting a Lehman perish isn't smart because of the outsized effect on money flows. Fear and caution become ascendant to an irrational degree; overnight lending rates between banks skyrocket as everyone wonders where the next Lehman Brothers may be hiding. The system is too fragile to allow such a big company to fail.

But imagine the Treasury made a mighty 11th hour effort; there was no bankruptcy; Lehman was saved. Then what would we have today? For one, an even more entrenched corporate bailout culture. Loans would flow a bit more smoothly for a while, while the underlying weaknesses remained the same. The financial system would still be highly susceptible to small shocks.

Now what about the second Paulson criticism: Does he deserve to be pilloried for being too quick to change direction? This seems misplaced. Steadfastness may be a virtue for a 50-year marriage; its value is much less clear for a complex, fast-changing crisis that has global ramifications. Should we favor hardheadedness and inflexibility over what may be a smarter, pragmatic approach that happens to look a bit messy?

So how did Paulson screw up? The best answer to that question comes from contrasting the American and British responses to the crisis. Paulson failed to:

1. Aggressively recapitalize and resolve uncertainty around struggling banks. The Treasury Secretary and Fed should be coordinating efforts to audit banks to determine who's really insolvent and who simply needs more capital to weather hard times. The insolvent companies need to be merged with healthier rivals or unwound. This would go a long way toward restoring confidence in the industry. This requires the political will to grab the bull by the horns; Bush's free-market ideologues have been reluctant to do so.

2. Strike hard bargains in return for bailout funds. Britain did this more effectively. The U.S. government should offer money on conditions close to what the private sector would demand: preferred stock, board seats, maybe a top-level reshuffle (throw out a president or two -- or three or four). When Barclays saw what the British government wanted in exchange for assistance, it promptly began looking elsewhere for capital. The benefits to knuckling down are many, including: 1. Lessening moral hazard risk. 2. Creating more opportunities for taxpayers to benefit from providing the rescue funds. 3. Necessitating fewer bailouts, meaning less government involvement and less money being paid out by an overburdened Treasury. 4. Encouraging private capital to move off the sidelines to recapitalize banks (private capital no longer has to compete with a government that offers sweetheart deals). That then helps establish a floor price for bank valuations -- and that, of course, is a necessary prelude to any long-term recovery.

Forget Lehman. Forget the ad hoc policy. These are the real failures Hank Paulson should answer for.

Monday, 22 December 2008

Anything Goes

Read this December 18 news flash from The American Banker:
A New York private equity firm has agreed to invest $250 million in Flagstar Bancorp, gaining 70% ownership of the thrift company. But the deal’s completion hinges on Flagstar receiving an additional $250 million from the Treasury Department’s Troubled Asset Relief Program.
I do not know the specifics of the transaction. But note the gist of the story. A private firm and the U.S. Treasury are both to invest $250 million in a bank, with the private firm getting 70% of the company.

That is why I called this entry Anything Goes. If you are a U.S. citizen, you can also read it as Your Tax Dollars at Work.

Saturday, 20 December 2008

Experts to the Rescue

Here is why I constantly emphasize the importance of theory:
A complete overhaul of banking regulation is needed in the wake of the global financial crisis, and one of the aims should be to insulate the real economy from the effects of future banking crises, according to some of the world’s top economists ... Robert Solow, who won the 1987 Nobel prize for economics, said: “I would like to see a regulatory system aimed at insulating the real economy from financial innovation in so far as that is possible”.
There you have it. Some of the world’s top economists, including at least one Nobel prize winner, think that the “real economy” can be insulated from banking and finance, and they are proposing to do just that in order to contain the financial crisis – “so far as that is possible,” of course.

One has to go back to the Middle Ages and the views of the priests about the solar system to find so great a chasm between the reality and its false reflection in human mind. But those priests at least did not attempt to correct the course of the heavenly bodies. The high priests of finance, on the other hand, are adamant in curing a crisis about which they know nothing. Between them and the pragmatic men of the Treasury and the Fed, whatever is left of the U.S. financial system is about to receive a new round of experimental shock treatments.

Tuesday, 16 December 2008

More on Merton and the “Collapse of the Whole Intellectual Edifice”

A couple of readers wrote to ask how I could blame one man for a such a large-scale financial collapse. Had I not said many times that the subject of finance is capital in circulation and not people? How could that assertion be reconciled with the claim that Merton single-handedly – whether consciously or not – brought about the downfall of the so-called Anglo-American financial system?

Merton’s idea about riskless portfolio earning riskless rate pertained to a definite point in the historical development of finance capital in which, thanks to its continuous growth and eventual dominance of financial markets, it claimed “recognition” on par with the full faith and credit of the U.S. government. Merton was simply the vessel for that expression. He was, you could say, chosen by fate. Like Oedipus, his deed was inflicted upon him rather than committed by him.

(In saying that finance capital claimed recognition on par with the full faith and credit of the U.S. government, I am not creating mysteries. I am talking about the functional form of equality that finance capital had won organizationally almost a century ago in the form of the establishment of the Federal Reserve. University professors perennially point to the appointment of the chairman of the Federal Reserve by the U.S. president as the proof of the “regulation” of the banking by the government. The opposite is true. The process is about elevation of private finance to the inner sanctum of the government. I will have more on this in Vol. 4.)

Monday, 8 December 2008

“The Collapse of the Whole Intellectual Edifice”

Things were moving at last, the Colonel said; as for himself he was putting every cent he could scrape up, beg or borrow, into options. He even suggested that Ward send him a little money to invest for him, now that he was in a position to risk a stake on the surety of a big turnover; risk wasn’t the word because the whole situation was sewed up in a bag; nothing to do but shake the tree and let the fruit fall into their mouths.
John Dos Passos in 42nd Parallel

You have no doubt noticed the theoretical bent of this blog. I refer to Rumi and T.S. Eliot, share my philosophical musings and write about the descent of man and the philosophers of our time. In the midst of a financial crisis, such seeming detachment from the events in the world of finance from a blog dedicated to finance could seem odd, the kind of stuff that gives Ivory Tower intellectualism a bad name.

But the underlying theory here is both serious and necessary. It is serious because its aim is to drag the reader into the sunlight and open his eyes. It is necessary because the full scope of this crisis can only be understood at a theoretical level; well-thought-of essays and considered opinion pieces would not do. That is another way of saying that the cause of the crisis cannot be given. It must be arrived at.

Nothing illustrates this urgency of theoretical understanding better than the travails of Hank Paulson. After his various plans failed to gain industry support and had to be abandoned or drastically altered, he has become the subject of universal scorn and ridicule, a financial Rumsfeld of sorts, ignorant of the matters of both strategy and tactic.

I am no defender of Paulson or his regulatory cohorts within the federal government. But he stands on a different plane than a bumbling fool like Rumsfeld. Everyone warned Rumsfeld against doing what he was about to do; the end result was so plainly evident. Paulson, on the other hand, received no such advice. The same Financial Times which now calls Paulson to task was the sycophantic promoter of anyone and anything related with the new financial “paradigm” – from Iceland’s “miracle” to Blythe Masters’ genius in inventing credit derivatives. Google them and see for yourself.

Under the circumstances, Paulson’s claim that he knows more than anyone comes across as a bombastic boast. But within the limits of his discourse, the man has a point. The extent of resources available to a U.S. Treasury secretary is too easily forgotten. Setting aside his long experience and extensive industry contacts, Paulson has access to all the public and non-public regulatory data of all the financial institutions in the U.S. as well as the collected wisdom of a legion of analysts, quants, consultants, and past and present officials. But is is not the quantity of knowledge that stands in his way. It is, rather, the quality, the kind of things he knows. If you have the wrong kind of knowledge, adding quantity will only take you further away from the solution.

Many of you must be familiar with Rashomon, Kurosawa’s seminal movie on the meaning of the knowledge. Four witnesses to a crime tell widely contradictory stories of what took place. No one is lying. They all agree on the evidence: a dead body, a dagger, a scarf. Yet they completely contradict one another. At the end, we learn that the narrator of the story, a juror in the trial who was expressing surprise at the contradictory stories, himself got the story wrong. The point of the movie is not so much that people have different points of view; it goes beyond that. Kurosawa, rather, is exploring the relation between the narrative and knowledge: what do we need to know about something so we could say we “know” it?

At heart, that is a question of the incompleteness of the knowledge, a philosophical subject that even pragmatic societies such as the U.S. have recognized in popular adages like “little knowledge is a dangerous thing”. The final word in this regard perhaps comes from Sa’di, Iran’s great 7th century poet/philosopher whose poetry about the brotherhood of man graces the general hall of the UN assembly. In a stanza too succinct and mastery to be translated here, he says that an Indian sword in the hand of a drunken slave – the Indian sword being the sharpest and most lethal, and a drunken slave being the epitome of ignorance and lack of self control – is better than knowledge falling into the hands of the unlearned.

His choice of the word unlearned makes us pause. An unlearned person could come to possession of material things by hard work or accident. But how could he come to possession of knowledge, which, by definition, needs pursuing? How could an unlearned person pursue knowledge, get it and yet, remain unlearned? What gives?

Sa’di, too, is warning about the dangers of “little knowledge”, but in masterfully shifting the focus to the possessor, he is telling us that it is not the insufficiency of the quantity of knowledge per se that is dangerous, but the possessor’s ignorance of the full impact of his knowledge. Such “impact”, you realize, could only be social. Thus, in a roundabout way, Sa’di injects social consideration to knowledge as its necessary component. Without this component, the possessor of knowledge is “unlearned”, no matter how complete his commands of the technical aspects of the knowledge.

The most common, perhaps because the most obvious, example of this genre of danger comes from the world of weaponry – which Sa’di also uses – with the gnome biology and cell engineering in recent years being added to the list. Endless articles have been written about the dangers of man’s technical skills dulling or overwhelming his social sensitivities.

No one has mentioned finance. But that is where we find one of the most fascinating cases of one man’s “little knowledge” – little precisely because the technical skill trumped everything else – creating a global financial catastrophe. The man is Robert Merton. The deed is option valuation.

Merton is not a household name. Even among those familiar with the Black-Scholes model, few know that he is the man behind the breakthrough that led to the creation of the model. That his name is missing from the Black-Scholes is one more irony among many ironies of option valuation that I detailed in Vols. 2 and 3 of Speculative Capital.

Here, I want to focus on the breakthrough.

The Black-Scholes has an imposing form. But that is due to the complexity of modeling the underlying stock price and has nothing to do with the option valuation. Focusing on the options, two critical insights led to the Black-Scholes.

One is that by combining a stock and its options we could create a riskless portfolio.

The other is that a riskless portfolio must earn the riskless rate of return.
The first insight came from the practical wisdom of option traders.

The second insight is due to Robert Merton.

Stay with me.

The options traders in the ‘60s had noticed that a properly weighted long-short portfolio of a stock and its call options maintained a constant value no matter what the stock price, as any decrease in the stock price was offset by a corresponding increase in the option price, and vice versa. I quoted one such observant trader in The Enigma of Options, who told the exciting story of his discovery (he uses warrant instead of options):
One evening as I studied my chart of the possible price relationships between the Molybdenum warrant and common stock, I realized that an investment could be made that seemed to ensure tremendous profits whether the common rose dramatically or became worthless. I would win whether the stock went up or down! It looked too good to be true.
What he is describing is this. He has noticed that the price of an at-the-money option changes $.50 for every $1 change in the stock price. Combining 1 share of stock and 2 short options would then create a riskless portfolio, a portfolio whose value remains constant. If, for example, the stock price decreases by $3, each of the short calls will increase by $1.50, for a total of $3, offsetting the loss in the stock price. If, conversely, the stock price increases by $2, each call will lose $1, for a combined loss of $2. Again, the value of the portfolio will remain unchanged.

This practical observation and the attention-grabbing notion of a ‘riskless portfolio’ that followed from it finally put the quest for option valuation on the right track. But one more relation was needed for the puzzle to be solved. Merton provided it by saying that a riskless portfolio must earn the riskless rate of return. It seemed an inspired observation, genius in its simplicity and self-evident logic. It solved the option valuation problem and created an intellectual foundation on which the volume of derivatives increased exponentially year after year.

“The most innocent words are the most pernicious; they’re the ones you have to watch for,” wrote Jean Genet in Our Lady of the Flowers.

Look closely at what Merton is saying. His reasoning seems to have the inevitability of syllogism, of “Men are mortal, John is man, John is mortal” type. Of course a riskless portfolio must earn the riskless rate of return.

But what is riskless rate? We have not yet defined it. From the Enigma:
For an old school economist, the existence of riskless rate would be an embarrassing paradox. It would palpably contradict the idea of risk that he had labored hard to make the centerpiece of Western economic thought as currently taught. If the return of capital were the result of exposure to risk, should not the riskless rate be always “returnless,” i.e., zero? Evidently not, as attested by the myriad of the US Treasuries with very positive yields. But there are few old school economists around and the young lions of finance are merrily ignorant of the fundaments so no embarrassment ensues.

In reality, when the government taps the credit markets to borrow, it must pay the prevailing rate that credit capital – the capital earmarked for lending – demands. Credit capital would naturally want to earn the highest rate. But interest rates in market are set by interaction of various technical and macroeconomic factors, including the creditworthiness of the borrower; the higher the creditworthiness (the lower the possibility of default) the lower the rate that credit capital would accept. As borrower without the risk of default, the US Treasury pays the lowest rate. This is the riskless rate. It is riskless because it is the rate that credit capital chargers the borrower without default risk.
So by saying that a riskless portfolio must earn the riskless rate of return, Merton equated one riskless, defined as the absence of change in value, with another, defined as the absence of default. In doing so, he substituted a concrete thing – the yield of the U.S. Treasuries – for a concept, akin to presenting the picture of a U.S. Treasury security as the definition of the riskless. What would happen if there were no Treasuries, and thus, no “riskless rate”? Option valuation was, after all, a conceptual problem and independent of any particular econo-political parameter. Yet, Merton had introduced precisely one such parameter as a catalyst for solving the problem.

His theoretical sleight of hand “solved” the problem but, precisely because of the way it did it, in ignorance of basic tenets of economics, it introduced the primordial contradiction of the economic system into the option valuation process and, from there, to the new paradigm of finance. The contradiction is there, plain for everyone to see, in the insights that led to the Black-Scholes.

Portfolio is riskless so its value must remain constant.

Portfolio is riskless so it must earn the riskless rate.

The two statements cannot co-exist; they cannot pertain to one and the same portfolio. If a portfolio is riskless because its value is constant, it cannot earn riskless rate, because (in consequence of earned interest) its value would then change.

But this contradiction was not of Merton’s making. He merely uncomprehendingly captured it. To what, then, does this contradiction correspond in real life and what are the consequences of leaving it unresolved in a model that became the foundation of the new financial paradigm?

Imagine a man who has kept $1 million cash in a vault for the past year and now demands to be paid the accrued interest on that sum with the 1-year Treasury rate in effect over the last year. His logic is Merton’s: the money is riskless and must therefore earn the riskless rate of the Treasuries.

Before Merton, we would have laughed at such simple-mindedness and given the man a lecture on fundamentals of finance of which he was so clearly ignorant. We would say:

“Dear friend, what you have in the vault is money, not capital. Money does not increase quantitatively by an iota no matter how long it is tucked away – in a vault or inside a mattress. To expand, it must become capital, possible only if it is thrown into either a production or circulation circuit. But the moment that quantum leap is made, the newly minted capital is subject to market dynamics, meaning that its value cannot stay constant. So you cannot have it both ways; either you keep your money in the vault knowing that it will stay constant (we will say nothing of inflation here) or turn it into capital in the hope of expanding it, but with the knowledge that a part or even all of it might be lost.”

Merton contravened this incontrovertible economic fundamental. His message was that you could have it all. (He was the first yuppie scholar.)

Had he been an economist, working with the industrial capital, the intervening steps in the conversion of money to capital – hiring workers, buying raw materials and machinery – would have alerted him to the limits of such conversion and the qualitative difference of money and capital. But in the realm of finance capital, it seemed that money could turn into capital and grow without limit through the alchemy of derivatives, thanks to the genius of “quants” and rocket scientists who had conceived them.

Merton’s reasoning opened the floodgates of securitization. Assume a stock trading at $100 and a man who had $100 cash in his wallet. This man could buy the stock, sell an at-the-money call option (on the stock) and use the proceeds to buy an at-the-money put. The price of call and put would be equal as per put-call parity. As a result of these transactions, $100 in money would be transformed into riskless capital ($100 worth of stock) – riskless because the long put and short call would keep the value of portfolio constant no matter what happened to the stock price.

And since risk was not the word, one could leverage the position by a factor of 10, or 20, or 30 – multiples that would seem like madness to the traditional credit officers but was the logical extension of the new paradigm that everyone said was like nothing anyone had seen before.

That Merton and his colleagues got options completely wrong is not the main point here. The point is the conditions for the transformation of money into finance capital whose laws and limits Merton’s insight egregiously violated and, in doing so, put the Western financial system into the collision course with them. It is those laws and limits that Paulson does not know. So he bluffs, frequently with the weaponry terminology – a bazooka, a gun, a nuclear option – and sometimes with the declaration of unlimited bailout that as of this writing stands over $7 trillion. He fancies that a gesture of his will create a supernatural disposition that will neutralize objective economic relations.

He is far from the only one in this ignorance. Many times on this blog you have seen the appalling insubstantiality of executives and officials of highest rank. Here is Greenspan, speaking in a recent Congressional panel:
“This modern risk-management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year.”
What the Maestro does not suspect is that the “modern risk-management paradigm” he so cherished was a colossal misunderstanding from the get-go. It kept on going because it was “making money for everyone”, as the saying goes. But there was never any there there and the collapse was preordained.

I will return with more on the subject. But now you see why the bent of this blog is theoretical. Here, theory is not a diversion, or recreation; a Senate seat to a Caroline Kennedy. It is not a parlor game.

Stay with me.

Thursday, 4 December 2008

I’m Still Around

My apologies for the longer-than-usual absence. Blame it on an event out of my control and a decision within my control. The event produced three fractured bones in my left arm. The decision pertained to a topic that proved difficult for a blog. I have discussed it in some length in the forthcoming Vol. 4 but had a hard time summarizing it for this space.

The pain in my arm is reduced to a tolerable level. The 3000-word entry is ready. After giving it a once over, I will post it tomorrow.

Thanks for understanding.

Monday, 24 November 2008

The View Through the Bushian Looking Glass

GM got a stern dressing down when it showed up in Washington with Detroit's other suffering automakers, hat in hand, seeking a bailout. Would you rescue an outfit with these characteristics:

The company is on shaky financial footing, perhaps insolvent. It is guilty of overpaying workers (blue-collar employees got generous union contracts that provided unsustainable benefits). Its core business suffered from stunningly bad decisions (not developing enough good high-mileage or green vehicles, for example, leaving the company with unpopular products it has trouble selling).

The verdict: Let it perish! But what about the following supplicant:

The company is on shaky financial footing, perhaps insolvent. It is guilty of overpaying workers (white-collar executives got outrageous bonuses and salaries that didn't reflect the long-term viability of the operations they oversaw). Its core business suffered from stunningly bad decisions (taking on too much leverage and acquiring risky, complex securities, leaving the company with unpopular products it has trouble selling).

The verdict: Save it at any cost!

Of course this second example is Citigroup. The financial giant not only received a bailout, but the terms were astonishingly generous. First Citigroup gets a $20 billion loan. Then the federal government agrees to backstop its losses on $306 billion of potentially crappy mortgage-backed securities. That's billion with a “b.” Worst-case scenario, taxpayers would be on the hook for roughly $250 billion on the backstop provision alone. That's more than ten times how much the embattled Big Three automakers sought to borrow, only to be rebuffed.

To be clear: GM shouldn't get a rescue package, not without a tough shakedown. But what about Citigroup? I know it's large. I know letting it fail would be akin to letting die the guy in the science-fiction film whose body is teeming with highly virulent viruses that, if he expires, will explode into the air and perhaps wipe out civilization.

But can’t the Bush team knuckle down and drive a hard bargain with at least one of these financial companies, especially since they’re bargaining from a position of weakness? It’s really baffling.

Monday, 17 November 2008

The Consequences of Efficiency (in practice)

Back in September I wrote about the flip side of “efficiency” in capital markets, singling out sec lending as a culprit.

Last month, A.I.G. asked for additional $38 billion in financing on top of the $85 billion it has already received, raising questions, according to the New York Times, “about how a company claiming to be solvent in September could have developed such a big hole by October.”

Here is a crucial part of the answer:
While about $7 billion of its quarterly losses … were connected with the insurance coverage ... a bigger share of the losses, about $18 billion, were incurred because the assets in A.I.G.’s investment portfolio had fallen in value. Of that total amount, losses of a little less than $12 billion were on investments made under A.I.G.’s securities lending program.
To understand what is taking place in the financial markets, on top of the theory, one must also know the nitty-gritty of the ways money is made. Only then theory could be deployed to connect the dots. Theorizing alone would not do.

Saturday, 15 November 2008

Give Me a Lever Long Enough and I'll Buy the World

When the definitive history of this financial crisis is written, the role of leverage should get a hard look. In the ailing credit markets, leverage turned what should have been chest pains into a full-blown heart attack. The “seize up" metaphor became especially apt.

Those following the storyline closely will know that leverage at Wall Street investment banks soared from levels of 12-1 to 30-1 in about four years. But what does that mean? To the average guy on Main Street, leverage is a rather abstract, foreign concept. However it's critical to grasp the destabilizing power of leverage to understand the mess we're in.

The standard definition of leverage compares money borrowed to equity. So if you take out a $3 million loan and your only equity is a $300,000 house, you’re leveraged at 10-1. But there's another way to look at this idea that illustrates the vulnerability created.

Let's say you buy a stock option (that financial engineers have dreamed up) that behaves this way: it costs $3.33 and captures the return on a $100 share of stock. That's leverage at 30-1. The upside is wonderfully lucrative. If that stock gains a bit more than 3 percent, you double your investment. Beautiful, you may be thinking. The only problem is that when it drops the same amount, you find yourself wiped out. So leverage magnifies risk.

Dizzying amounts of leverage contributed to the demise of Long Term Capital Management in 1998. When it began to implode, the firm had $4.9 billion of capital supporting a towering, Seussian edifice of $1.25 trillion of positions not reflected on its balance sheet. LTCM effectively had no cushion to fall back on when setbacks in the market began eating up its capital.

When LTCM began crumbling, the Federal Reserve had to intervene to ensure an orderly dismantling of the company. LTCM had become too big to let it simply collapse. Sound familiar? One takeaway lesson should have been that financial regulators need to closely monitor levels of leverage in the system. But somehow we lost sight of that.

Tuesday, 11 November 2008

Lehman On My Mind

Speaking of politics, those who track polls say that McCain’s fate was sealed on Friday, October 10. That is the day the Dow Jones opened 750 points down and McCain said that the U.S. economy was fundamentally sound. Almost immediately, his poll numbers which had been consistently close to Obama’s, sank and never recovered.

If so, blame the Lehman bankruptcy for at least contributing to McCain’s loss, with all the implications that follow. October 10, you recall, was the settlement date for the credit default swaps on Lehman. The dreadful opening of the markets in the U.S. was in anticipation of multi-billion dollar losses by Lehman CDS writers that was estimated to be in the order of $400 billion. It turned out that, thanks to netting, the ultimate payable amount was less than $6 billion. On that news, the Dow Jones recovered, but not McCain’s poll ratings.

The Lehman bankruptcy established a high water mark for the dislocated rates and prices and, in that regard, has become a de facto reference point for the crisis. All market rates and indices have a pre-Lehman and post-Lehman level, with the latter being drastically, at times almost unbelievably, different from the former. The Baltic Dry Index, for example, that measure the cost of shipping goods (as opposed to liquids such as oil and gas) dropped 76% in one month, from about 5,000 to 1150 post-Lehman.

I was away on the week of September 15, with little access to markets. Still, I wrote that Lehman bankruptcy would be an event to remember. I focused on the inability of the Fed to take action because it had reached the limit of its authority, something that Treasury secretary Paulson confirmed and emphasized in a recent interview. But there is more twist to the story. There always is

Why was Lehman allowed to fail? And under what general heading should we classify/archive the event?

I have a few thoughts on the subject. In coming weeks, I will share them with you.

Thursday, 6 November 2008

Wall Street’s Deafening Silence

Throughout the long dark days of this financial crisis, one thing that has struck me is the silence of Wall Street’s public relations machines. I keep waiting for one bank, any bank, to give us their best-spin version of what went wrong, or why they aren’t as bad as all those others – or to say something. Surely they must see how vilified they have become. Shareholder activist Nell Minow even quipped that the Street is one bonus away from having the villagers descend with torches.

But when “60 Minutes” did its exposé on the financial crisis early on, none of the major Wall Street banks would comment, apparently in any form. None of them even sent what I call the “coward’s note” – that carefully crafted defense/statement that is read on air at the end of the broadcast segment. Later, when the bank CEOs went to Washington to sign off on billion-dollar bailouts, they left the meeting with Treasury Secretary Paulson and fled to their limousines. They adroitly dodged the press corps waiting outside. None of them did so much as issue a short statement of thanks or say that the money would help them extend more loans to unfreeze the credit markets.

How to explain this total silence? Partly it may stem from a “duck and cover your ass” mentality: anyone who raises his head to defend himself at this unsettled time may just draw more incoming fire. Also the more you say, the more ammunition you supply prosecutors and lawyers busy cobbling together investigations and lawsuits related to the financial meltdown. But the biggest reason may be simply that Wall Street’s largest banks realize how badly they screwed up.

When you think you’re an innocent man, you want to shout your message to the world. When you think you’re innocent to some degree, you seek ways to disseminate your version of events. When you think you’re guilty as hell, you shut up and pray for an earthquake or something that will bump news of your misdeeds off the front page.

Tuesday, 4 November 2008

Election Night Musings on Why We Fail to “Get It”

Vols. 1 and 2 of Speculative Capital were published by the Financial Times in 1999. Vol. 1 came out in March and was FT’s “Book of the Month”. It got a respectable review and relatively strong sales which increased over time.

Vol. 2 followed in June and, as far the options discovery was concerned, was an instant dud. No one reacted to it.

The silence surprised me. There were large and active equity, fixed income, commodities and FX markets with tens of thousands of users and traders. Option valuation was, and remains, a mandatory subject in all business school programs. Surely the proof that options were not what everyone had thought they were had to be newsworthy.

After a few months, the comments began to trickle in and they were uniformly critical. The 100-plus page proof, that an option is not a right to buy or sell but a right to default, somehow had failed to make its mark; even a few who praised it had not understood it. There was, furthermore, this weird reciprocity, as I did not understand what the critics were saying. “What do you mean by right to default?”, “Where is the default?”, “Who defaults in an option?”, the readers were asking, and I thought I had answered these questions clearly and unequivocally. So the disconnect was real. It certainly went beyond careless reading of the text.

It is said that authors are always complicit in misunderstandings of their work. With that in mind, I began the work on The Enigma of Options in late 2000. I resolved to answer all the questions from the “ground up” and explain the default aspect of options to everyone’s satisfaction. The “old” Vol. 3 which I had planned as the final volume of the Speculative Capital on systemic risk had to wait.

The Enigma of Options was published in 2004. In terms of sales, it did marginally better than its predecessor, but the baffling comments about the impossibility of options being a right to default still kept coming in. One reviewer for a hedge fund newsletter said the whole theory was wrong because it was as a Marxist interpretation of option valuation. You can read an abbreviated version of it here that was posted on the Amazon site for the Enigma.

One property of dialectics is intelligibility. The method must explain not only itself but the alternative views as well. The Enigma of Options follows the dialectical method. It shows how the standard option valuation is incorrect. It also shows why it is incorrect and how and why the model’s authors went astray.

I wondered why a plain-for-everyone-to-see mathematical argument appears as Marxist interpretation. Then noticed that I had given the answer in the Enigma, when I wrote that “the inability to take the next logical step – at times almost willful, as if one were afraid of consequences – demands an explanation”.

Our critic reads the Enigma and realizes that it is like nothing he has read or heard before – in style, argument and most important of all, in the progression of though from one point to the next. He looks around. He is surrounded by family members, friends, neighbors, strangers, enemies, none of whom talk or write in that particular way. The critic knows as surely as night follows day that he is an all American man, living in America and surrounded by the Americans (friends, family members, strangers, enemies). So if what he is reading is like nothing he has ever read or heard, it follows that the text must have come from some Other. What could the Other be? Islamic/terrorist is one possibility, but those folks do not write about options. The only other Other are Marxists, as our critic vaguely “knows” that Marx had something to do with economics – in the same vain that he knows Jesus was a good man. So he concludes accordingly.

That is the reason behind Palin and McCain’s reference to “real America” and “real Americans”. Prior to the publication of Speculative Capital, I, too, would have dismissed them as demagogues and hate mongers. But what they say is what they genuinely believe. They and their supporters listen to Obama and his supporters and immediately know that that is not how their families, friends and enemies talk. They know they are real, true, Americans. That makes anyone not speaking the same way not American – pardon the double negative, but you know what I mean. In all events, the feelings and beliefs are genuine.

But what about a character like Greenspan? How is it that he is “accepted” despite big words and a seemingly impenetrable argot?

The answer is that listeners know what he says is drivel. They like to hear big words from his mouth, a weakness that Mencken noticed more than seventy years ago. But they like them precisely because they know that the words are harmless.

The problem with the The Enigma of Options is that when our critic reads it, he can follow it. More, he understands it. And therein lies the question, the dilemma: how and whether to accept something logical even thought it negates our beliefs, our standing, our achievements? That dialectical question is the very essence of ethics and morality.

Thursday, 30 October 2008

The Group That Time Forgot

I had planned to write about Nobel Prize in economics and its latest recipient, Paul Krugman, but got distracted and the news got stale. Just a brief comment so I could scratch this one off of my to-do list.

The most telling part of the choice was the formal statement of the Royal Swedish Academy of Sciences explaining the choice. It said, in part:
Traditional trade theory assumes that countries are different and explains why some countries export agricultural products whereas others export industrial goods. The new theory clarifies why worldwide trade is in fact dominated by countries which not only have similar conditions, but also trade in similar products – for instance, a country such as Sweden that both exports and imports cars.
So, the ladies and gentlemen of the Prize Committee who must have been locked up incommunicado in the basement of Ricardo household since the 18th century think that everyone thinks that Japanese are supposed to export rice; Americans, car; Germans, beer and French, cheese. Naturally, Krugman who has “shown” that they all could and do export cars is an outstanding economic mind.


Why Homeowner Mortgage Relief Ain't Going to be Easy

Like many others, I was rather shocked last month on hearing about the need for a $700 billion bailout of Wall Street. The early storyline was that financial firms were saddled with too many securities backed by distressed U.S. home mortgages and, in a climate of fear and panic, they couldn't sell them at fair value. So that meant the government would have to step forward and act as a buyer.

Setting aside the fact that this narrative was disingenuous at best, dishonest at worst (the assets are most likely cheap because -- surprise -- they're simply not worth that much), I found the approach bass ackwards. It seemed more efficient to work from the ground up. Namely, if the securities were hard to value because of uncertainty over the mortgages they held, why not provide a structure for homeowners and lenders to rework troubled mortgages? In this “trickle up” approach, the securities would gradually become more stable and thus easier to trade. It seemed like a pretty good idea.

I soon discovered a huge, gaping flaw: your 2005 mortgage probably isn't held by your friendly neighborhood bank. Rather, it was sold off by the mortgage originator (maybe your bank, maybe a mortgage company) and the payment stream was repackaged as part of a security. In fact, your mortgage payments may even have been sliced into pieces and spread across 10 or even 50 different securities.

Now here's where the headache begins. Once you begin modifying mortgages on a large scale, you create all sorts of havoc. An investor who bought a mortgage-backed security under one set of rules and understandings, now is operating under a different one. Some investors will win, others will lose -- and this being America, the losers will likely litigate. That's why the managers of the pools of loans, the so-called “master servicers,” probably won't renegotiate them. It's a real mess that can only be circumvented by some kind of federal law, and even then at a potentially dangerous precedent of rewriting contracts.

This New York Times op-ed piece captures the predicament about as well and lucidly as any I have read so far and proposes a solution. But don't be fooled: any solution is going to be very tricky to execute.

Tuesday, 28 October 2008

What Creates Volatility?

Gillian Tett of the Financial Times is one of the better financial journalists, perhaps the best. She was the first to make heads and tails of the structured investment vehicles before many who should have known better had any idea what an SIV was.

But reporters only report what they see and hear. And that, when it comes to the analysis of financial events, is not sufficient. The outward appearance of events has a driving force that remains hidden from the naked eye.

So there she was in her today’s column, writing about the return of unprecedented volatility which “has left many investors and bankers utterly dazed and confused”. Throughout the article, her focus remained entirely on people: “[The situation] remains a delicate war of investor psychology and computer models.”

The subject of finance is not people. It is capital in circulation. So, how do we explain the volatility if the people are taken out of the explanation?

By way of answer, here are a few quotes from Vol. 1 of Speculative Capital:
We use the term “speculative capital” to refer to capital employed in arbitrage. Such capital is not a single entity. Nor does it have a command and control center. A large number of private fund managers and institutions control various pools of speculative capital. They all have access to the same information. When a profit opportunity opens up or is created, they direct their capital towards the same target. If the British pound, for example, seems vulnerable, hundreds of funds would bet on its devaluation using swaps, forwards, options and futures.

The rush of fund managers to position themselves in a profitable arbitrage situation overshadows the mathematical exactness of the arbitrage, with the result that the target is overshot; the undervalued currency becomes relatively overvalued. So the process is repeated in reverse. As a result, we have the constant ebbs and flows of money directed from one market to another that seeks to arbitrage the spreads and, in doing so, restore “equilibrium” to the markets.

But if the equilibrium is restored, there can be no arbitrage opportunities and speculative capital must sit idle. Idleness brings no profits and speculative capital cannot self-destruct in this way. So it looks for new “inefficiencies” and in doing so, it disturbs the prevailing equilibrium and creates volatility. Volatility is the result of the attempts of speculative capital to restore equilibrium to markets.
That was the theoretical development. As for the evidence from the markets:
The spreading of volatility from one market to another–from foreign exchange to stock market–is the logical consequence of the operation of speculative capital. Speculative capital is born in the currency market. This market is large, liquid, and lends itself easily to arbitraging: buying the stronger currency and selling the weaker one. But no market is constantly turbulent. So speculative capital probes other markets and, finding arbitrage opportunities in them, invades them. In the US, the intrusion of speculative capital into the equities and fixed income markets is a fait accompli, with the result that the volatility in these markets has drastically increased. The New York Times reports on the increased volatility in mid-1997:
The [stock] market acts as if it is confronting storms blowing every which way. One day prices soar; the next day they sink just as fast. And then they lift off again…So far this year [1997], 31 percent of trading days have seen 1 percent moves based on closing figures. If that continues, this could be the most volatile year since 1987.
The Wall Street Journal picks up the same story early in 1998:
Last year [1997], there were 80 trading days during which the Dow rose or fell by more than 1%, up from 18 in 1995 and 43 in 1996. In January [of 1998] alone, 1% price swings were seen on eight trading days, or an average of two of every five trading days.
The trend continues. The same paper reported about the rise in volatility in the last trading month of 1998:
Stock price volatility is getting downright scary…”The sentiment swings in this market are making everybody’s head spin,” says [a technology stock trader]. “It is leading to exceptional volatility. Unprecedented volatility.” … James Stack of InvesTech Research … says that by his calculations, intraday volatility is at its highest level in 65 years.
Why has volatility increased? The Wall Street Journal tries to explain:
While there is a sharp division of opinion on what volatility means for the market’s direction, analysts largely agree on its causes. Topping the list: the quest for new investment ideas … Quick dashes in and out of individual stocks and sectors as fickle investors try out, then discard, new investment ideas has fueled volatility.
“Quick dashes in and out of individual stocks” are the signature activity of speculative capital. But the paper does not know that, so it attributes the problem to “fickle investors.” The tone of the article, furthermore, suggests that the surge in volatility is a passing phenomenon, an anomaly perhaps fueled by a bull market. The issue is further muddled by the frequent nonsensical comments such articles elicit from experts. In the same article, one fund manager dispenses wisdom about the cause of the volatility in the stock market: “Volatility is the price of admission [!] when you buy stocks offering good returns in this environment.”

In the absence of an understanding of why the volatility has increased, decision making becomes increasingly difficult and even seems arbitrary:
When stocks or sectors move in and out of favor in a matter of days, its becomes harder for professional money managers … to cling to their convictions that a stock is a good long-term investment … says … [an] equity strategist: “The fundamentals are very, very hard to understand and analyze, so the market becomes more emotional, and emotion translates into volatility at the micro level.”
The strategist quoted in this story is correct when he observes that an incomprehensible market makes the participants uneasy and emotional, and thus, ultimately, exacerbates the volatility. But the emotional behavior is not the cause of the volatility. Voltaire observed that incantations could indeed kill a flock of sheep if administered with a dose of arsenic. Money managers becoming emotional is the consequence of the operation of speculative capital which creates volatility that money managers do not understand.
These lines were written in 1996-98. A decade later, speculative capital is alive and well, with the credit market as the latest addition to its theater of operations.

The Blog’s Target Audience

A friend with marketing bent pointed out that despite infuriating gaps between postings, the readership of the blog was increasing. He asked who the target audience was.

The target audience is an advertising concept – like “teenager”, for example – devised to help sell products of one kind or another.

This blog has no target audience. Or, rather, everyone is its target audience. It is intended for everyone. If you must, think of it as an intellectual bell. Ask not for whom it tolls, for it tolls for thee.

Monday, 27 October 2008

Genuine Insights, Bold Recommendations, Expressed Resolutely

Speaking of T. S. Eliot, he disdains the intellectual vanity, of the kind his Mr. Appolinax exhibits: “There was something he said that I might have challenged.”

Now read this from a commentary by Larry Summers in today’s Financial Times:
In retrospect, the fact that 40 per cent of American corporate profits in 2006 went to the financial sector, and the closely related outcome – a doubling of the share of income going to the top 1 per cent of the population – should have been signs something was amiss.
That doubling of the share of income going to the top 1 per cent of the population could conceivably be a problem – something “amiss”, he says – this ex president of Harvard and ex Treasury secretary has realized only in retrospect.

He then offers his recommendations.
Therefore we need to reform tax incentives that encourage financial risk taking, regulate leverage and prevent government policies that give rise to a toxic combination of privatised gains and socialised losses. This offers the prospect of a prosperity that is more firmly grounded and more inclusive. More fundamentally, short and longer-term imperatives come together with respect to policies that seek to ensure that any future prosperity is inclusive.
On the same page, FT was promoting a special forum in which “several of the world’s most influential economists discuss Lawrence Summer’s regular monthly column.”

At times like this, I miss that nabob of nonsense, Oracle Alan.

Sunday, 26 October 2008

The Danger of Clinging to Myths of Security

In my fairly voracious reading on the current financial mess, I've yet to see anyone tackle in thematic fashion the idea of “myths of security.” I think this is a highly relevant subject (a tad philosophical, but not too much heavy lifting I promise), as it helps explain why an asset bubble can become grossly inflated. Security is, after all, the comforting touchstone to reality we seek when we’re faced with counterintuitive evidence, such as home prices surging 20 percent a year.

So what myths of security allowed the housing market to soar so high? By myths of security, I refer to a false sense of safety or comfort. These myths create what might be called a “security premium” in prices of assets, such as homes. In other words, investors are willing to shell out more money for assets perceived as safe and reliable.

A quick detour: Why is this last sentence true in general? 1. The pool of investors, and thus the overall demand, grows larger for safe investments. Example: pension funds were enticed to buy mortgage-backed securities because of the glowing credit ratings on the products. 2. Investors want compensation to assume risk. If you offer to sell an IOU for $1,000, payable in one year, you may get $995 if you're a moral, upstanding citizen with a good job. But if you're Sam Shady, an out-of-work transient, that IOU may fetch only $800, $700 or even less.

(There is an interesting corollary of all this that I'll skip over here, but it goes like this: if you appear to wave a magic wand and create a secure investment with a return of say 8% when other similar-yielding investments are much riskier, you start to suck money away from those others. This can further pump a bubble. In fact, the myths of security play into a vicious feedback loop: money is diverted to investments that, at a given yield, are seen as “safer”; these assets then spiral higher, drawing in more money.)

Here are four chief “myths of security” in the housing and financial mess:

Housing prices never fall.
This myth was fairly widespread. I remember hearing it from a good friend in late 2005, while living in South Florida. At the time, home prices inexorably climbed every month; flippers and speculators were running rampant, snatching up unbuilt condos and queuing up overnight to be first in line for sales in new developments. The reasons for the myth are easy to understand: houses are real, tangible, critical assets. Everyone needs shelter. But even the most indispensable assets can become significantly overvalued.

The Federal Reserve under Greenspan would intervene to prop up falling prices of major assets, such as homes.
This myth is key because it was on Greenspan's watch that home prices had such a huge run-up. That rise in value benefited from a phenomenon known as “the Greenspan put.” “Put” in this context is a high-finance term. It refers to a product that protects an investor from losing money on an asset. Believers in the Greenspan put thought that, should home prices start to fall, the Fed chairman would step in and pump money into the markets to support prices.

Good ratings from respected agencies such as S&P and Moody's made mortgage-backed securities safe to buy.
The market for bonds backed by shaky U.S. home loans could never have grown so huge had they not received such high safety ratings from S&P and Moody's and Fitch. Now we find that the raters were mostly trying to win customers and boost revenue. They weren't that careful or rigorous in their evaluations. The cynic’s view is that their ratings became the best that money could buy, so to speak.

Even if you weren't confident of the ratings on mortgage-backed securities, you could buy insurance on the investments to hedge against a drop in value.
Insurance-like products called credit default swaps were supposed to provide this extra layer of protection. The trouble is, the credit default swap market became huge and is opaque and unregulated. It's not clear how many “insurers” actually have enough money to make good on future losses on mortgage-backed securities. Many of the insurers were hedge funds, an industry on the ropes amid the current market turmoil.

What happens when you inflate a bubble on four big “myths of security”? Once these myths are exposed, the bubble deflates quickly and violently, it would seem from what we are now seeing.

A Market “Walking, Loitering, Hurried”

What kind of a card game is being played if the lower card trumps the higher card?

Low poker, of course. That is an easy one.

What kind of a credit game is being played if subordinated debt trumps senior debt?
The auction that settled figures for the senior and subordinated bonds of Fannie Mae and Freddie Mac, the US government mortgage agencies, has led to widespread confusion and some participants losing out. In both cases the recovery rate for the senior debt – which in real-world defaults get first claim on all assets – came in lower than for the subordinated debt.
Now you are totally confounded and dumbfounded by this because you know that:
  1. With the US government guarantee, there is not supposed to be a “recovery rate” – how much a bond pays on a dollar. That should be par, or 100 cents on a dollar.

  2. The recovery rate for senior debt cannot be lower than the subordinated debt because by definition, senior debt gets paid ahead of subordinated debt.
Yet, there it is, the Financial Times article in black and pink reporting the results of the auction. The paper did not mention it but we will see later that (2) above is the consequence of (1).

In his book “T. S. Eliot”, Craig Raine quotes a line from Eliot – “I met one walking, loitering, hurried” – and explains that Eliot is telling us “gently that things aren’t exactly normal.” Eliot often creates paradoxes in the narrative to “dislocate the language into the meaning” – “savagely still”, for example, in reference to souls who are corroded by inaction.

Markets, too, create “paradoxes” that tell us things aren’t exactly normal. The Dialectical Reason recognizes such paradoxes as the “logical” result of what is taking place in the real world because it can see the complex interplay of the part and the whole. That is what Hegel meant when he said that what is real is logical.

Analytical Reason, by contrast, sees a paradox – characterized by incomprehensibility – precisely because it cannot see the course of the development of the phenomenon it is observing. Analytical Reason is static. Its frame of reference is an inventory, rather than an organization, of knowledge, because it cannot collect the experience of individual events into a synthetic whole. In consequence, when compelled to take action in the position of authority, its actions seems lacking in the “systemic” depth. They seem “disjointed”, “Whack-A-Mole approach”, “moving goals”, and always “one step behind”. The Analytical Reason itself finally throw up its hand in despair.

The events we are witnessing in the financial markets are driven by speculative capital – capital engaged in arbitrage. I discussed the characteristics of this force and the laws of its motion in the preceding volumes of Speculative Capital. In the next several entries, in response to a friend who wants to know the “real reasons of the turmoil”, I will look at the events in the financial markets in light of the Theory of Speculative Capital. You will then see that paradoxes will disappear. The fog will clear. That has been the intent of this blog all along; recall the 10-part Credit Woes series. But that format was too restrictive, too scholastic. I need “space” to develop!

In Masnavi, Rumi begins a story and in the midst of it branches into another story and then yet another story within the second and so on; you would not know digression until you have read Masnavi! Finally he “catches” himself, saying that it is time to return to the original story. He then corrects himself, saying that when did he ever leave the original story? That is Rumi’s way of saying – showing, rather – that everything in the universe is connected, coming together towards the “Totalized Spirit” – the Absolute Spirit in Hegel.

So, if the subsequent entries in the blog do not appear sequential, bear with me. There is a method in the disorder. In them, you will also see a glimpse of what is to come in Vols. 4 and 5 of Speculative Capital.

Thursday, 23 October 2008

Shakespeare and the Credit Rating Agencies

The current crisis in the financial markets is being portrayed as, above all, a failure of trust. Banks are seeking unreasonably high rates to lend to each other because they don't know who is hiding skeletons in the closet and may be teetering on the brink of insolvency. But if you really want to understand the concept of trust squandered, you would do well to look at the plight of the credit rating agencies.

These companies slapped attractive ratings on dubious mortgage-backed securities. Investors then snapped up the securities, reassured by the seals of approval bestowed by Moody's and S&P. Of course the ratings agencies had a conflict of interest so huge it was surprising that Washington regulators never had a Homer Simpson “d’oh” moment: Whichever bank created a security also paid for it to be rated. It's like a poor student who can buy good grades, except with more disastrous consequences, as we are now seeing.

How bad did it get? In an informal instant message exchange in April of last year, one S&P official expressed skepticism to another about a mortgage-backed security, saying the model being used for the rating “does not capture half the risk.” Then she made the snarky remark: “It could be structured by cows and we would rate it.”

Credit rating agencies are edging toward irrelevancy because they compromised their ideals and let their names be sullied in pursuit of short-term profits. Their very business model relies on their reputation and integrity of their work. When investors lose faith in their ability to evaluate products and entities, their role in the financial system becomes entirely superfluous.

They would be wise to remember Shakespeare who once wrote wisely, “He who steals my purse steals trash/but he that filches from me my good name robs me of that which not enriches him and makes me poor indeed.”

Tuesday, 14 October 2008

Hank Paulson: He Isn't One of Us

The John McCain line about Barack Obama could easily apply to the U.S. Treasury Secretary. Paulson, as you may recall, submitted an awful $700 billion bailout plan that was fortunately improved through the legislative process. But Paulson had to be dragged kicking and screaming into doing the right thing (agreeing to take ownership stakes in firms that take bailout money, so as not to leave taxpayers too much on the hook). He apparently preferred to just blow $700 billion on a mountain of bad assets and cross his fingers that they'll be worth something in five years.

Hank Paulson is now paid by the U.S. taxpayer, but he still hears most clearly the siren call of Wall Street, where he once headed Goldman Sachs and argued against regulations that could have helped avoid this current mess. Considering his conflicted heart, we would do well to monitor the Treasury closely during bank rescue operations. Paulson still wants to play Santa Claus; he has already said that the government will take only nonvoting preferred stock in banks it helps. That's like investing millions in a struggling company and then being told to keep your mouth shut about how they run things.

For the story, just read Felix Salmon’s astute and timely blog post here at

Monday, 13 October 2008

Fannie and Freddie: Not the Boogeymen

Check out this article from the Washington bureau of McClatchy Newspapers about why Fannie and Freddie shouldn't be the fall guys for the global financial crisis. The structure and logical flow are a bit choppy in places, but the central contention is dead on. It was good to see the authors argue the point forcefully, which newspaper reporters are often too timid or self-conscious to do. Anyway, the excerpt below shows how Fannie and Freddie were laggards in subprime lending, not leaders.

Between 2004 and 2006, when subprime lending was exploding, Fannie and Freddie went from holding a high of 48 percent of the subprime loans that were sold into the secondary market to holding about 24 percent, according to data from Inside Mortgage Finance, a specialty publication. One reason is that Fannie and Freddie were subject to tougher standards than many of the unregulated players in the private sector who weakened lending standards, most of whom have gone bankrupt or are now in deep trouble.

During those same explosive three years, private investment banks — not Fannie and Freddie — dominated the mortgage loans that were packaged and sold into the secondary mortgage market. In 2005 and 2006, the private sector securitized almost two thirds of all U.S. mortgages, supplanting Fannie and Freddie, according to a number of specialty publications that track this data.

And Now a Word from our Sponsor

Now for some good news about the market for credit default swaps (those insurance-like products that guarantee the value of corporate bonds and mortgage-backed securities). These details are by way of a clearinghouse for trades that goes by the name Depository Trust and Clearing Corporation (DTCC).

* Pleasant surprise #1: DTCC, which claims to handle the "vast majority" of trades on credit default swaps, says it has registered $34.8 trillion of such contracts. That would make the credit default swap market about half of earlier estimates of $60 trillion, thus reducing its "neutron bomb" capacity for widespread destruction.

* Pleasant surprise #2: Less than 1% of its credit default swaps are for mortgage-backed securities. So, presumably, even if these securities (whose value rests on the fortunes of the cratering U.S. home market) take a tumble, that won't trigger huge CDS claims.

* Pleasant surprise #3: The net payout in the Lehman bankruptcy, from the sellers of credit default insurance to the buyers, will be about $6 billion, not $365 billion or some other ghastly-high figure. This is because, apparently, the players in this market are well hedged. In other words, if A owes B $30 billion, he's mostly covered because C owes him $29 billion.

The DTCC corrected all these misperceptions in an October 11 press release in which it decried "inaccurate speculation." What's going on here, I think, are several things. DTCC is trying to (1) quiet investor fears about swaps, (2) show that the products aren't part of some crazy Wild West marketplace being run off Uncle Jed's back porch, and (3) position itself for the coming onslaught of Washington regulation.

This disclosure is useful, though it helps underscore why there's so much concern about credit default swaps in the first place. The market has been operating in too many dark, unregulated corners. The fact that the net payout from the Lehman bankruptcy could have been misestimated by a factor of 60 shows how little is known about how these swaps work and who has how many of them.

Saturday, 11 October 2008

Halloween Costume Idea: Go as a Credit Default Swap

We are now entering a new roller coaster phase of the financial crisis. The G7 meeting this weekend produced little more than the illusion of a hint of group resolve. The communiqué that was issued contains fine-sounding principles but no plan of action. Markets will likely respond no more than if they had been slapped with a wet noodle.

The real news this week will be quietly going on behind the scenes: a scramble for cash to meet credit default swap obligations after the Lehman Brothers bankruptcy. That's a mouthful, and since I created this blog for curious people who aren't from the world of finance, I'll go slow here.

First, when you go bankrupt, your owners are wiped out. In Lehman's case, this means the stockholders. The bondholders, being creditors, are in a better position. They get to divvy what's left of the carcass, if you will. For every dollar they lent to Lehman, they may get 70 cents, 50 cents or even 10. Turns out, unfortunately, it's pretty close to 10 cents, as determined Friday.

So are the bondholders almost completely wiped out? Well, not so fast. If they owned credit default swaps, a sort of insurance on their bonds, they get to recover the remaining 90 percent. (Cue the rousing cheer sound effect.) So far, this sounds like a very savvy bit of Wall Street financial engineering, these credit default swaps, eh?

The problem, as with any insurance, is your insurer must have enough money to pay out the claim or the whole scheme falls apart. Large Wall Street banks and hedge funds have been happily writing credit default swaps and raking in the fat premiums for the last eight years. They don't have to show that they have sufficient funds to make good on the swaps because this market is COMPLETELY UNREGULATED. I could theoretically write one of these contracts from my bedroom, in my pajamas, with $26 in my savings account. And the CDS market has exploded in size to about $60 trillion. (That's the cost of about 100 Iraq wars).

Here's another wrinkle: you can buy these pseudo-insurance policies without even owning the underlying bond. In other words, it would be like taking out a fire insurance policy on Fred's house across town. You don't own the house, but you can collect when it burns down. That wrinkle matters hugely because it inflates the size of the CDS market. Lehman, I believe, had about $128 billion of bonds and an estimated $400 billion worth of credit default swap coverage on those bonds. This is where a CDS stops looking like insurance and more like a roulette wheel bet. Insurers write swaps for buyers who just want to take a flyer on whether or not Lehman will go belly up.

Now, to the heart of the matter: why this week could be especially turbulent in the markets. The insurers for the Lehman credit default swaps will have to start coughing up about $365 billion -- that's right, billion with a “b.” Now remember, the CDS market is totally unregulated, so no one is entirely clear who all these insurers are, or how much they’re on the hook for, or whether they'll be able to come up with the funds.

Two possible outcomes: 1. If some of the CDS insurers are cash-strapped hedge funds, they may have to sell off truckloads of stock to meet their obligations, driving down the Dow and S&P for yet another week. 2. If some of the CDS insurers are banks, the steep payouts could potentially bankrupt them. The second possibility is scarier, as it ushers in a death-spiral scenario: they go bankrupt, which triggers payouts on the credit default swaps on their own debt, which causes more bankruptcies, etc. etc.

This week and the next could be a major stress test for the credit default swap market. And then the whole thing starts anew with Washington Mutual's bankruptcy settlement at the end of this month. Better take some Dramamine.

Tuesday, 7 October 2008

Pin the Blame on the Donkey?

The search for a scapegoat in the U.S. financial crisis will reach new heights if markets around the world continue to gasp and flounder. Banks are still terrified to lend to each other. Who can you really trust in a high-stakes shell game where mounds of bad assets are hidden somewhere, but where exactly?

One narrative of the financial crisis would lay the blame at the feet of Fannie Mae and Freddie Mac. The two mortgage giants, conservatives contend with increasing vigor, were pushed hard by Congress (especially by Democrats) to lend more to low-income families who had poor credit. What brought this mess upon us, so goes this interpretation of events, were meddling politicians, not failures of regulation or the free market.

It’s a nice story, especially for those who tend to see bleeding-heart liberals behind every tree (or hugging every tree). But it’s like trying to put a size 6 foot inside a size 12 shoe – not a good fit. Sure, Fannie and Freddy screwed up. They did buy home loans made to risky borrowers. And their very structure seriously needs reform. Congress created a monster: private companies with public responsibilities. So they can take risk like a private firm, while knowing the government will be there to bail them out if they get in trouble. Uh oh.

Still, this crisis needed rocket fuel to take off. To be this severe, it needed something beyond a bunch of plain vanilla subprime loans going belly up. And that’s where Wall Street comes in. Firms on the Street dabbled in a lot of sophisticated financial engineering. They sliced and diced lousy mortgages like a financial Ron Popeil, creating a bewildering assortment of securities and derivatives. They pushed their levels of leverage from 12 to 1 to 30 to 1. In short, they made wild bets with massive amounts of borrowed money.

Wall Street embraced unheard-of levels of risk, and that’s the main story, though there were lesser culprits. It’s a complicated narrative that requires an understanding of an alphabet soup of products and entities: ABS, CLOs, CDOs, SIVs. Listeners also have to wrap their minds around the concept of credit default swaps to appreciate how the teetering tower got so tall. But I suspect in the weeks to come, Congressional hearings will give us all a crash course in the story of 21st century risk taking, Wall Street style – and how it brought us to this awful juncture.

Sunday, 5 October 2008

Who Could Have Seen This Coming?

In a front page article this past Friday, The New York Times suggested that an obscure decision by the Securities and Exchange Commission in ’04 to loosen the debt limits of the broker/dealers had set the stage for the meltdown in financial markets.

The story had lots of tidbits in the tradition of the best tabloids: a bright spring afternoon, a basement meeting, a pensive commissioner and a Cassandra in the form of a software developer – a clueless geek with extra time on his hands, really – who wrote to warn the commissioners that they were about to make a grave mistake.

Whether the piece was a hatchet job on Christopher Cox, the SEC chairman – it probably was – is not important. (The article opened by quoting Cox talking about the broker/dealers – “we have a good deal of comfort about the capital cushions at these firms at the moment” – and went on to ask, How could Mr. Cox have been so wrong? The answer is that Cox was wrong, but when it came to ignorance about what was about to happen, he had nothing on a long list of policy makers, academics and financial executives with more direct roles in the coming crisis. Bear’s CEO did not know what hit him, even after his firm had gone under.)

I bring up this article to once again highlight the perils of theoretical poverty. In the absence of a firm understanding of what is taking place in the financial markets, we are liable to mistake the manifestation of the events for their cause. The mistake leads to wrong conclusions and wrong remedies. The Times article and the Treasury's $700 billion bailout plans are the proverbial “Exhibit A” in each case.

The Theory of Speculative Capital is the only theory that explains what is happening in the financial markets, i.e., what is changing. It identifies the driver of the change (speculative capital), the consequences of its operation (in legal, social and financial areas) and points to its direction (self destruction). It is only then that we could begin devising solutions.

So, what could the Theory of Speculative Capital do in relation with the current crisis?

Below, I am quoting select passages from Vol. 1 of Speculative Capital. Note the references to money markets and shadow banking. Most important of all, note the role of the Federal Reserve in creating the high-leveraged broker/dealer industry by allowing previously ineligible securities to be pledged as collateral for borrowing. That was full 8 years before the SEC rule changes.
Systemic risk is the risk of a chain reaction of bankruptcies which then disrupt the process of circulation of capital.

In a pamphlet published by the Federal Reserve Bank of New York, Gerald Corrigan, then president of the bank, wrote:
The hard fact of the matter is that linkages created by the large-dollar payments systems are such that a serious credit problem at any of the large users of the system has the potential to disrupt the system as a whole.
Corrigan was specifically writing about a “gridlock” problem in CHIPS, the interbank clearing system in New York. That is what he meant by the “large-dollar payments systems.” He was concerned that the default of a major bank with a myriad of large payments could cause a chain reaction of defaults in CHIPS. The term systemic risk he is said to have coined referred to the risk arising from such cross-defaults: the risk of disruption in the clearing system.

That is a narrow understanding of systemic risk. It is on the same footing as regarding finance as the study of cash flows; it reduces diverse aspects of the subject into a quantitative flash point. The problem so narrowly delineated is easily solved. But for that very reason, the cause of the problem escapes scrutiny, only to surface more menacingly at a higher level.

It is impossible to understand systemic risk without knowing speculative capital and understanding the financial, regulatory, legal and political aspects of its operation.

The “system” in systemic risk is the process of circulation of capital and the markets which form the circuitry of the process – the course of its movement. Alternatively, we can say that the system is a web of markets linked together by the thread of speculative capital. Thus, the “system” has two components: process and markets.

A system defined by such terms as circuitry and flow lends itself to superficial analogies. Often, electrical circuits are used to depict it. Occasionally, one hears of traffic systems and “gridlock.” Writing in the Wall Street Journal, George Soros gave it a human touch and compared it to the body’s blood circulation system–with the US, naturally, being the heart.

But the system of concern to us is a social one; it has little in common with physical or biological systems. The “market” component of the system varies greatly in size, from a stock exchange in a country to the country’s national currency. The strength of the market’s linkage to the system is shaped by its size, regulatory structure, the political environment in which it functions and the country’s proximity to existing centers of international trade and finance. There are numerous secondary factors as well, which, sometimes reinforcing and sometimes offsetting one another, further contribute to shaping the characteristics of the system.


The CHIPS manager who proudly announces the establishment of credit lines to cover the failure of two largest net debits must ask himself this question: under what conditions two largest net debits in CHIPS – say, J. P. Morgan and Chase – would fail? What would cause such failures? That is the question that we answer in examining systemic risk.

Systemic risk comes into existence as a result of formation of basis risk in leveraged positions.

Webster’s definition of leverage as “increasing means of accomplishing some purpose” in finance refers to increasing the rate of return of capital through the use of credit capital. Such increase, when credit capital interacts with industrial or commercial capital, is always modest because the amount of credit capital available to a factory owner or a wholesaler is limited by their equity. That is why some factory owners and wholesaler could avoid debt “as a matter of principle.” One could say that these businessmen have the mentality of pre-capitalist peasants; they have not grasped the advantages of borrowed capital. But more to the point, they could afford to have that mentality because the contribution of credit capital to their bottom line is modest.

No manager of speculative capital, on the other hand, can afford to avoid leverage. With regards to speculative capital, credit capital is more than a booster of return. It is a vital component of support, an engine of sorts, without which speculative capital cannot operate. This new role develops logically and naturally, and in consequence of the real-life conditions under which speculative capital generates profits.

In real life, the arbitrageable spreads yield returns which are considerably below the average rate of return of capital. It would be an unimaginably gross inefficiency of the markets if it were otherwise. The very operation of speculative capital further tends to diminish its rate of return. The small-time speculator – a pit trader in a futures exchange, for example – compensates for the narrowness of the spreads by trading constantly and incessantly.

The mass of speculative capital cannot act in that way. It is impossible to turn over the multi-billion dollar portfolio of a hedge fund many times a day or even a week. So speculative capital searches for venues that will allow it to increase its return without increasing its size. One such venue is through enlisting the aid of credit capital. Acting as a lever, credit capital raises the return to levels which speculative capital in itself cannot produce. The mathematics of leverage is widely known in the market. According the The Wall Street Journal:
Before [February 1994], speculators had been borrowing at a short-term rate of like 3% and buying five-year Treasury notes yielding around 5%, a gaping spread of two percentage points that enabled some to double their money in a year. The math was tantalizing. Using leverage, an investor with $1 million could borrow enough to acquire $50 million in five-year Treasury notes. And the spread of two percentage points could generate about $1 million in profits on the $1 million investment, as long as rates remained stable or declined.
To a bank loan officer who lends on the traditional criteria, that leverage is incomprehensible, almost madness. No business could generate sufficient profits to service debt 50 times the owner’s equity. But arbitrage is no ordinary business. In fact, it is not even a business. It is a refined version of the banks’ own practice of borrowing low and lending high, so the banks readily recognize it. The strategy is “refined,” because now the profits are guaranteed to be riskless “no matter what happens to interest rates.”

That is why and how speculative capital comes to depend on credit capital for survival. The expansion of credit capital becomes a condition for its own expansion. Credit capital, too, assumes a support function unlike any it had before. It becomes imperative for it to “be there” when called upon and to follow speculative capital into new arbitrage ventures such as leveraged finance, leveraged buyouts and junk bonds. These markets are the manifestation of the incestuous relation between credit and speculative capital: they revolve around credit capital but, without speculative capital in the lead, they could not have been developed. In the speculative frenzy of the 1920s, for example, the role of credit capital did not go beyond the traditional boosting of returns through margins because the independent form of speculative capital did not exist. Just how closely the junk bond market is associated with speculation is shown by the following:
“High-yield bonds should outperform during the next six weeks, but in the next six months, I’d concentrate on higher-quality bonds because I’m still worried about corporate earnings next year,” says Joseph Balestrino of Federated Investors.
Prior to the advent of speculative capital, bonds of all kinds were purchased and held for years, even decades. Balestrino’s horizon, when speaking of junk bonds, is six weeks.

The most important aspect of the relation between credit and speculative capital is the quantitative one. Because speculative capital constantly expands, credit capital, too, must expand.

Where does the credit capital for sustaining such colossal expansion come from? The ambiguity and apparent subjectivity of the word “credit” at times make it seem that it is created out of thin air. The practice of banks in creating credit money further reinforces that illusion.

In reality, “credit” is credit capital. Its creation, expansion and movement have their own laws and are governed by a complex set of rules. Their detailed analysis is beyond the scope of this book. Here, we are only concerned with the source of the expansion of credit capital and the consequences of that expansion. The source of expansion is the easy credit policy of the Federal Reserve. “Easy credit” involves more than reducing interest rates. It also includes technical rule changes which provide fresh sources of credit. In April 1996, for example, the Wall Street Journal reported:
“The Federal Reserve moved to ease scores of regulations affecting margin requirements, calling it “one of the most significant reductions in regulatory burdens on broker-dealers since 1934.”
Apparently unconvinced of the significance of the Fed’s announcement, the Journal relegated the story to page 18. It said, in part:
The final rules … will eliminate restrictions on a broker-dealer’s ability to arrange for an extension of credit by another lender; let dealers lend on any convertible bond if the underlying stock is suitable for margin; increase the loan value of money-market mutual funds from a 50% margin requirement to a ‘good faith’ standard … and allow dealers to lend on any investment-grade debt security … the Fed will allow the lending of foreign securities to foreign persons for any purposes against any legal collateral … It will also expand the criteria for determining which securities qualify for securities credit, a change that will sharply increase the number of foreign stocks that are margin-eligible.
The changes described in the article were too technical to be individually analyzed here. (That is probably why the news received very little attention.) The important point is the purpose of the rule changes: to open the floodgates of credit capital. The Fed was correct about the significance of the decision.

As one example, note that the new rules allowed the money market mutual funds “to be treated like their underlying securities for margin purposes.” The US Treasury bills in such funds could be purchased with a 90 percent margin. A mutual fund with $1 million in investment can buy up to $10 million in Treasury bills. When the mutual fund itself is treated like its underlying security, its shares can in return be pledged as margin for buying securities ten times their value. The result is a leverage ratio approaching 100 to 1.

Rule changes by the Federal Reserve do not take place on a whim. In fact, they never take place without a strong impetus: in this case, the pressure of speculative capital whose expansion called for ever larger amounts of credit capital. In the familiar scenario of speculative capital forcefully breaking down the regulatory walls, the Fed had to give room and reduce the “regulatory burdens.” An unrelated New York Times article, published a few weeks after the rule changes were announced, told of the source of the pressure:
Everyone who has even thumbed casually through the books of securities firms recently agrees they are more highly leveraged than ever … It is [the] matched-book portion of firms’ balance sheets, where assets and liabilities are paired … that has soared in recent years … [two] consultants…have suggested that the bloating of the industry’s asset-liability structure reflects an unprecedented and somewhat involuntary commitment to “yield arbitrage,” or the practice of taking advantage of small differences in interest rates … Securities firm executives insist and analysts generally agree that this business generates little market risk, just a dollop of credit risk and perhaps more operations related risk than anything else.
The two consultants quoted in the article noticed the role of yield curve arbitrage in increasing the leverage of the securities firms. Their observation that the firms’ commitment to this strategy is “somewhat involuntary” is especially perceptive. Of course, speculative capital engages in great many arbitrage opportunities; yield curve arbitrage is only the most readily recognizable one.

The increase in leverage surpasses anything seen in the bond market: “The demand for financing, and for leveraged purchases of bonds, has reached a ridiculous level.” But the Federal Reserve is forced to loosen the rules even further:
The Federal Reserve Board proposed new capital guidelines … that would provide the biggest break to banks that sell triple-A rated asset-backed securities. Currently, banks … are assessed an 8% capital charge on the security’s full value. Under the proposed guidelines, the 8% charge would be … [reduced to] an effective [rate of] 1.6% … a Fed financial analyst who helped write the proposed rules [said]: “This rule will fit in nicely with the way the market is moving.”
The analyst is right on the mark. In fact, he is more right than he could suspect. In saying that the rule changes “fit in nicely with the way the market is moving,” he has in mind the general deregulatory trend and the need of banks for constantly increasing amounts of credit capital. But there is one other, more fundamental, movement in part of the market which is not readily discernible. That movement is the gradual advancing of the markets toward a sudden disruption.

These lines were written in 1997-99. Speculative Capital offered the only critical examination of the events taking place in the financial markets at that time. Otherwise, no one in the academia, regulatory and credit rating agencies, and certainly no one on Wall Street, questioned the leveraged-based business model that speculative capital was imposing on the markets.

Read again, “Securities firm executives insist ... little market risk ... just a dollop of credit risk” and think of the cast of characters: Fuld, Komansky, Prince, Weill, Greenberg, Schwartz, Paulson, Corzine, Purcell. Nothing exposes the poor players who strutted their little hour upon the stage of Global Finance more mercilessly than a global crisis.

But this is not the end. It is not even the beginning of the end. In Vols. 4 and 5 of Speculative Capital, I will take on the subject of systemic risk in all its dimensions, not only economic and financial, but social and cultural as well.

On the Lighter Side

From the “how NOT to do Wall Street PR” department
The photo above accompanied CNN’s Friday story about the House passing the financial rescue bill. I know the intent was to show Wall Street's jubilation. But what we got was this well-fed trader who appears to be laughing at, not with, the U.S. taxpayer (especially since the market took a dive Friday).

How to make your own financial crisis. Step one: get a snow blower. Step two: fill it with money. Step three: turn it on.

“I wouldn't have loaned me the money. And nobody I know would have loaned me the money.”
-- Clarence Nathan, as quoted in the New York Times. Nathan had no job and no assets, but received a $450,000 mortgage.

My favorite 15-word analysis of the Paulson plan, which Congress passed, to buy hundreds of billions of dollars of toxic financial assets:

Throw a trillion dollars down a rathole with no debate and no alternatives considered.
-- poster Jeffrey Knoll, in the comments section of Econbrowser.