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.
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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.