Wednesday, 14 October 2009

Financial Regulation, Theoretical Poverty (2 of 2)

In a perceptive line in The Critique of Dialectical Reasoning, Jean Paul Sartre writes that “the future comes to man through things in so far as it previously came to things through man.”

The idea is not new, but Sartre expresses it more eloquently than others. What he is saying is that, in the course of his material activities, man creates tools and organizations whose very presence compels him to act in a certain way, thus shaping the course of the history. Sartre’s example is a machine. “Thus, the machine demands to be kept in working order and the practical relation of man to materiality becomes his response to the exigencies of the machine,” he writes. Man is the product of his product.

As with machines, so with the financial systems. They, too, demand to be kept in working order. But unlike machines which are built on well-understood principles and can be relied upon to work in a precise manner, the working of financial markets remains hidden from the view because they are created in response to the exigencies of finance capital. Finance capital cannot itself create markets. It employs the regulator, the trader, the professor and the banker as its proxies to the do job. These men are endowed with a free will, but, unbeknownst to themselves, they do the bidding of speculative capital, building the markets to its needs and specifications.

Speculative capital is capital engaged in arbitrage. In Part 1, we saw how it logically and seamlessly develops from trading and hedging. Vol. 1 in its entirety deals with this particular question.

Arbitrageable differences are never large enough to allow for a comparable return with other forms of capital; it would be a gross inefficiency in capital markets if they were. So, speculative capital boosts its return through leverage, i.e., borrowing. Wall Street Journal, Oct. 16, 1995:
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.
There is, however, little money to be made in Treasuries; the article makes it clear that the golden opportunity was arbitraged away some time ago. To make money through arbitrage in the bond market, one has to go down the credit ladder. But the lower-rated securities could not be pledged as collateral for borrowing. Could the Fed, perhaps, help? The WSJ, April 1996, describing what the Fed called “one of the most significant reductions in regulatory burdens on broker-dealers since 1934”:
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.
This is saying that many securities that were not eligible as collateral could now be pledged as collateral – for more borrowing. What follows is not merely predictable; it is inevitable. WSJ, Sept 22, 1997:
Everyone who has even thumbed casually through the books of securities firms recently agrees they are more highly leveraged than ever.
You see the loop-feedback mechanism at work. Every phase of the process, from the rise of speculative capital, to broker-dealers borrowing more than 30 times their equity, takes place rationally. Even the collapse is rational, as it is the necessary outcome of the operation of a self-destructive force.

What would you do if you were the Fed chairman or the Treasury secretary under these conditions? The “practical” answer is that, Lehman aside, pretty much what they have done in the past two years. There was, realistically speaking, no other option.

Speculative capital, you see, not only eliminates the arbitrage opportunities but the policy options as well. Men can boast of their free will. But what defines freedom is the availability of choices. As the choices narrow, the freedom is curtailed. A man without choice is a condemned man. Speculative capital limits the choices by creating conditions in which any action not in accordance with its interest looks naive, irrational or radical.

Such an environment is ripe for the rise of men most concerned about looking naive, irrational or radical. They are the functionaries and palan-doozan whose policy decisions at all times remain preordained. When they deviate from the prescribed course, not so much due to courage but incomprehension, the ensuing storm publicly chides and corrects them. Lehman bankruptcy was the Exhibit A in that regard.

Nothing illustrates this subjugation of man to the dynamics of speculative capital better than the option valuation theory. As I showed in Vol. 3, the entire option valuation literature is fundamentally incorrect and based on a misunderstanding. An option is not a right to buy or sell. It is right to default. This is the very “scientific-mathematical outlook” which Paul Krugman pompously called “the true glory of our civilization”.

Under these conditions, when the actions of the players are influenced by a hidden force, the regulation of the financial industry can proceed on only two paths. It must either be in conformity with the needs of speculative capital, such as creating a living will for the institutions to go out of business without complications, or skirt the issue altogether, which is just about everything else, including executive bonus and consumer protection. If any provision of the law currently being written contradicts this general outline, the matter will be worth a second look. But do not bet on it.

But is it possible to “do something”, Mr. Saber, anything at all, about the situation? After all, you criticized Godard for being nihilistic. Between not succumbing to speculative capital and destroying the system altogether, do you have any bright ideas?

To that hypothetical question, I had a modest answer a while back. I humbly suggested that shorting Treasuries be disallowed. This would be tantamount to turning a floodlight on a vampire. It will not kill the beast but temporarily paralyze it.

Given the reality around us – the amount of trading that is centered around Treasuries, for example, and the liquidity that such trading provides to the financial markets – the proposal is too radical and thus, naive.