Monday, 11 February 2008

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (1)

In the summer of 2007, financial markets in the US and UK suffered a heart attack.

The events leading to this seizure have been covered in detail from many perspectives but always within the same prescribed framework: the crisis as the culmination of a series of unfortunate events set in motion by (choose your emphasis) greedy traders, irresponsible lenders, foolish borrowers, sleeping-at-the-switch rating agencies and feeble regulators.

The focus on the human element makes for good storytelling and has an evangelically uplifting bent that is appealing: If only the bad guys were to be replaced with good guys – something definitely in the realm of possible – the wrongs will be set right. The fault, dear Brutus, is not in our stars, but in ourselves!

Such takes on the crisis are not inaccurate; they are irrelevant. The subject matter of finance is not people; it is capital in circulation. It is silly to point out that “ultimately” things happen in markets because people take actions; capital as a thing cannot trade or structure deals. People, however, do not act in a vacuum. They act on the basis of what they see and perceive in the market, which is another way of saying that their actions are shaped by the dynamics of capital – the form and pattern of its movement in the market. This movement takes place according to the objective laws that rise and operate independent of the actions of individual agents. To the extent that these individual actions also affect the markets, such effect is secondary. (Voltaire commented that incantations could indeed kill a flock of sheep if administered with a dose of arsenic.)

The complex interplay between the mass of capital and action of individuals demands a theory to be comprehended. Theory is a guide for action. It tells us what is happening, i.e., what is changing. It is impossible to understand the nature or direction of the change without knowing the characteristics of the force that is affecting it. The early 21st Century capital markets in the industrial countries have long since passed the point of being comprehended through observing the surface appearances. Finance is a science precisely because the outward appearances of phenomena in it do not readily point to their causes.

But without a theory and with the academics at sea, the simplistic description of the surface phenomena is what we got by way of explanation. Here is an example:

Question: Why did the asset-backed commercial paper market “freeze up” in the recent crisis?

Answer: Because the buyers went on strike!

That the so-called theory of modern finance has no explanatory power and concerns itself only with the interest of traders – derivatives valuation, hedging, portfolio diversification and the like – has always been known but politely ignored because it never seemed to matter. The crisis of the summer of ’07 showed the dangers of this rupture between theory and practice.

Recall the number of times corporate officers, central bankers, traders and analysts, in short those who should have known better, were “stunned” by the turn of events. Stunned to learn the size of losses (in their own institutions, no less), stunned to learn that even more losses were in the offing, stunned by how rapidly the crisis spread; stunned at how far it reached, about the lack of market response to official initiatives, and how just about everything seemed to go haywire.

Never, it seemed, had so many understood so little about so much.

But no one highlighted the appalling theoretical poverty surrounding this crisis as well as Chief Financial Officer of Citigroup. In explaining the multi-billion losses that Citi had suffered in its CDO positions, he was quoted thus: “We have a market-risk lens looking at those products, not the credit-risk lens …when it in fact was a credit event.”

Market lens instead of credit lens! The senior most financial officer of a two trillion plus dollar financial behemoth with a legion of analysts, accountants, quants and risk managers under his command fundamentally misunderstood the nature of his institution’s $100 billion exposure over an extended period of time.

And he is still wrong, caught up as he is in a false binary world of credit or market – now resolved to see zebras as black animals with white stripes after his equally arbitrary view of them as white animals with black stripes proved injurious to the bottom line.

Let us assist him.

What is taking place in the current crisis is the transformation of values to prices set in motion by speculative capital.

Descriptions impart little knowledge to readers and listeners and without background information, and the background information is precisely what is lacking in the current crisis. So we need to arrive at our description rather than merely give it. We need to elaborate its key terms, beginning with speculative capital.

  • Speculative capital is capital engaged in arbitrage: buying low, selling high.

  • Every sustainable economic activity is based on buying low and selling high; no one has ever invented another way of making money. If we buy low and sell high in bulk, for example, we are a wholesaler. If we buy low in bulk and sell high piecemeal, we are a retailer. How is the arbitrage different from wholesaling or retailing?

  • Arbitrage is a category in finance. It develops logically from speculation – itself an offshoot of commerce – but stands in qualitatively different ground from both. Here is how:

    Speculation is naturally present as the antithesis of commerce. The source of its profit is likewise antithetical to the source of profit of commerce. The key to understanding the difference between the two lies in the difference between the individual random events and their mass characteristics.

    In running their businesses, the wholesaler and retailer will ignore short-term price fluctuations and trust their capital to the operation of statistical laws. They know from the experience and the history of their business that if in a given year what they sell takes longer than average time to sell or must be sold at below the target price, the next year (or the year after) it would take less than the average time and they could sell it above the target price. That follows from the definition of average. On average, the wholesaler and the retailer expect to realize the average profit of their business line.

    The speculator, by contrast, bets on the random events. Unlike the wholesaler and the retailer – or an industrialist or a banker – who count on a relatively long time horizons (established by the patterns of trade) as a way of insulating themselves against random fluctuations, the speculator enters the market precisely to take advantage of those fluctuations. That is what separates him from the rest of the pack.

    Precisely because he does not have the benefit of the smoothing affects of time after every purchase, the speculator faces the risk that what he has just bought will fall in price. Since holding a position, by definition, incurs risk, it follows that the longer holding periods incur larger risks. In this way, to the uncritical, yet practical, mind of the speculator, time appears as the source of the risk. He concludes that if the time between his purchase and sale is shortened, the risks of the transaction must proportionally diminish. In the extreme case, when the time between the two is zero, the risk would completely disappear.

    When the time between purchase and sale is reduced to zero, the two acts become simultaneous. A simultaneous “buy-low, sell-high” guarantees a risk free profit. What is more, it does not require an outlay of money, because the proceeds of the sales will cover the cost of purchase. That is arbitrage. The speculator – now arbitrageur – has discovered the alchemy of finance, its golden goose: making money without having and risking money.

    Capital engaged in arbitrage is speculative capital.

  • Speculative capital is, by definition, “opportunistic.” It is constantly on the lookout for “inefficiencies” across markets to exploit. The opportunities arise suddenly and at random points in time, so the capital that hopes to exploit them must always be available; it cannot afford to be locked into long-term commitments. The requirement to be opportunistic translates into the need to be mobile, to be nomadic and interested in short-term ventures. Such are the inherent attributes of speculative capital.

  • Because these attributes define speculative capital, the manager of speculative capital must employ it in activities that are consistent with these attributes; he cannot invest in infra-structure projects in an emerging country. Thus, in the absence of any real option, the manager of speculative capital turns into its agent, someone who nominally “runs” the speculative capital but must in fact follow its “agenda.” Speculative capital becomes the grammatical subject of the sentence as if it were alive: speculative capital seeks arbitrage opportunities. Of course, it does so through its agent, the fund manager, but it is the speculative capital which determines the nature of its own employment and calls the strategic shots.

    (There is no better example of this subjugation of person to the dynamics of speculative capital than in the Black-Scholes option valuation model. There, the owner of the portfolio must not think. He exists as an automaton: to buy when the market is rising; to sell when the market is falling. Option valuation’s practical twin, portfolio insurance, does that in practice, hence its nom de guerre, program trading.)

From the foregoing, we can deduce some conclusions.