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.

Saturday, 4 October 2008

Gazing into the Crystal Ball

Congress, in an appalling failure of imagination, approved Treasury Secretary Paulson's wrongheaded plan to bail out financial firms that acquired too many risky assets. He got his $700 billion check (in installments) to start snapping up distressed bonds and other investments that have taken a tumble in the U.S. housing meltdown. Ironically, members of Congress who voted for the unpopular legislation will probably glumly console themselves that they made a tough but necessary stand. Come on. It requires little courage to play the role of the outraged lapdog. Not one of 535 legislators deemed it worthy to craft an alternative, despite all the better ideas put forth by economists on the right and left.

But what's past is past, so let's look forward. Here are my predictions for the post-bailout bill future.

1. This bill, despite all the hoopla, won't even be the big rescue effort. We’ll see a more aggressive, all-encompassing solution that will probably involve seizing banks. Once this moment arrives, look for a few commentaries on the themes of “Where the hell did that $700 billion go?” and “Why didn't we just do this in the first place?”

2. Now there will be a financial version of the Oklahoma land run, as companies from Singapore to Switzerland, carrying a Baskin-Robbins assortment of toxic financial waste created in America, race forward to dump it with the U.S. government. Look for brigades of lobbyists and politicians to step in and try to direct the spoils, since everyone knows that $700 billion won't be nearly enough to buy up all the crap out there.

3. Success has many fathers; failure is an orphan. When this rescue plan flops, look for at least one of its high-profile backers to disown it publicly (Paulson? Pelosi? Dodd?) This person will complain bitterly about not being told some vital bit of information, or about how the original good idea got perverted in the execution because of all those damned incompetent Washington bureaucrats/Democrats/Republicans.

4. There'll be a House cleaning when voters go to the polls in November.

Friday, 3 October 2008

The Bailout: The One Thing I Don’t Get

It’s early Friday morning. In hours, the House will vote on what would be a historic $700 billion bailout of Wall Street. The bill will likely pass, though it’s essentially the same as the version the House shot down on Monday. (The Senate sprinkled on some pork and tinkered with FDIC limits on deposit insurance.)

What’s puzzling is that, facing the financial crisis of a lifetime, Congress can’t manage to draft even one alternative to the lousy Hank Paulson plan at the heart of this legislation. They could’ve been working on something since Monday. They could’ve consulted the legion of economists who have burst forth brandishing better proposals. In fact, I have yet to read a worse idea than what the Treasury Secretary wants to do: Buy a slew of bad assets with taxpayer money while failing to directly recapitalize struggling banks. This seems exactly the prescription for a long, drawn-out endgame of this mess with the likelihood we’ll start chucking good money after bad.

There is a vibrant marketplace of ideas in a democracy; it is one of our greatest strengths. We have the right to debate and disagree: with each other, with our government. And during this crisis, the response in the financial blogosphere has been smart, electric, incisive. Many, many good ideas are circulating. But no one in Congress sees fit to offer even one rival bill to the deeply flawed Paulson plan.

I don’t get it.

Thursday, 2 October 2008

Your Bailout Bill, Presented by the Other White Meat

The Senate overwhelmingly passed a version of the bailout bill that, instead of taking the bull by the horns, seized the pig by the ears. Amid what may be the greatest financial crisis of their lifetimes, Senators rolled up their sleeves ... and began stuffing the legislation with pork. Most egregious example seen so far: a tax exemption for certain kinds of wooden arrows designed for children.

Now, if the House can browbeat a few members into switching their “nay” votes, the $700 billion rescue of Wall Street will be complete. That something needed to be done quickly was becoming frighteningly apparent. The New York Times did a nice job of laying out, in plain language, how the financial system could come undone.

It's a shame though that legislators crafted such a poor bill. They could've driven a hard bargain. They could've said to Wall Street firms, “Hey, we’ll buy your bad assets, even pump in capital, but we want to own a chunk of your company in return, no exceptions.” That would've scared away hundreds of opportunists from seeking bailout funds. Instead look for chaos as this plan unfolds and firms both domestic and foreign make a grab for that big, fat $700 billion mound of money.

Wednesday, 1 October 2008

A Report From the Money Markets

In several places, I have written about the crisis in the money markets.

Today’s Financial Times had an article on this subject under the heading “Triple blow spurs central banks”. As usual, there was no mention of the cause of the “blows”, only reporting of the facts. I thought two paragraphs in particular might be of interest to the readers of this blog. [Italics added for emphasis].

The first paragraph was about the result of an auction:
Yesterday morning in Europe the ECB offered $30bn of overnight money and found banks scrambling for the cash, willing to bid vastly over the 2 per cent policy rate of the Federal Reserve. The money was ultimately lent at a rate of 11 per cent.
To the best of my knowledge, this rate differential is unprecedented in any dealing of the Western banks with a Western central bank.

The second paragraph is about freeze in the “wholesale” money markets which I described in the previous entry:
The lack of any business in wholesale money markets was demonstrated by the enormous use of the European Central Bank’s standing lending and borrowing facilities. Some European banks parked €44bn overnight at the ECB on its penalty 3.25 per cent rate on Monday night while others borrowed €15.4bn at its 5.25 per cent penalty rate.

They did not deal with each other, as they would normally.
The end-of-quarter funding requirements no doubt exacerbated the money famine. But even accounting for the technical distortions, what we are witnessing is a deep crisis in the financial system whose real causes remain hidden from the view of virtually all experts and policymakers.