Monday, 25 February 2008

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (2)

i) A nomadic capital with the need for rapid deployment under varying circumstances needs a new organizational shell to operate; the old mutual fund structure, where the type of activities must be specified in advance, would not do. Hence, the rise of hedge funds, where prospectus and offering memorandum give virtually unlimited discretion to the managers to engage speculative capital in spontaneous opportunities anywhere they arise.

Hedge funds are the organizational/legal form that speculative capital assumes in the market.

ii) Flexibility of its own structure is not sufficient for rapid execution; speculative capital needs accommodating market conditions as well. To that end, it adopts the derivative structure – long the narrowly used tool of farmers and commodity producers – to its own temp. Derivatives are the ideal vehicles for “linking” one market with the other.

Derivatives are the functional form that speculative capital assumes in the markets.

iii) Speculative capital does not have a command and control center. Whenever an arbitrage opportunity is detected, the mass of speculative capital, employed by thousands of hedge funds and proprietary desks, is directed to it. The rush of uncoordinated money overshoots the mathematical exactness of the relation, with the result that that the pendulum swings in the other direction.

Volatility is the result of attempts of speculative capital to profit from arbitrage.

iv) The “inefficiencies” that speculative capital exploits are small. (Consistently large spreads would imply a crude and inefficient economy that would exclude the rise of speculative capital.) The narrow spreads cannot sustain speculative capital. To boost its return, speculative capital needs to leverage itself. The smaller the spread, the larger the leverage.

Speculative capital has a tendency to employ increasingly greater leverage.

v) Speculative capital eliminates opportunities that give rise to it. This necessarily follows from its modus operandi. Simultaneous buying low and selling high increases the lower price and decreases the higher price, gradually narrowing the spread between the two and ultimately brining them into “equilibrium” and eliminating the arbitrage opportunity.

Speculative capital is self-destructive.

Self destructiveness is a logical tendency that manifests itself over the long run and in the context of the particular markets speculative capital is arbitraging. At the same time, speculative capital is antithetical and will not gently go into that good night. As the spreads erode, speculative capital will:

a) Compensate for the falling returns by increasing its size and leverage, thereby exacerbating the erosion of the spreads.

b) Search for new markets and products to arbitrage. In this way, speculative capital “links” the markets – first various markets within a country and then markets across the globe – by targeting products in them as the subject of arbitrage.

In consequence, ever newer markets are drawn to the orbit of speculative capital. The sole “use” of these emerging markets is their offering of arbitrage opportunities, hence their name: emerging markets

vi) The sovereigns have laws that might stand in the way of expansion of speculative capital. Those laws must give way to the exigencies of speculative capital. Ditto the local laws.

Speculative capital drives the march of deregulation, particularly in the financial industry.

vii) The linked markets – whether various markets such as commodities and equities within a country or different markets in different countries such as currencies – become the subject of the arbitrage action of speculative capital, with the result that their movement is synchronized.

Speculative capital increases the correlation between the markets it exploits – national and international.

To any one following the markets in the past 30 years, these are familiar developments. The explosion in number of hedge funds, the exponential growth in derivatives, the incessant drive for deregulation, synchronization of price movements across the markets, rise of emerging markets, increasing emphasis on shorter horizon – these are instances of different manifestation of speculative capital.

The current crisis is byproduct of speculative capital’s arbitraging of credit. The “credit” in question is the potential loss of the credit or loanable capital arising from the borrower’s default.