Thursday, 29 January 2009

Let Jeremy Stein Sort It All Out

Terrific news: Harvard economist Jeremy Stein is joining Obama’s team of savants who are trying to form a plan for dealing with the financial mess. I like this guy a lot. Check out this from the WSJ Real Time Economics site (the bolding is mine):

He advocated aggressive government audits of banks, aimed at separating solvent ones from insolvent ones. Once that was done, insolvent banks would be forced into closure or sale while solvent ones would be pushed to raise more private capital. In addition to dealing with the bad bank problem, putting the plan in place would remove much of the uncertainty in financial markets that the government’s ad hoc approach to banks thus far has helped instill.

Great stuff. The nationalization debate has heated up lately, with some justification as it becomes clear to everyone that many U.S. banks are insolvent. But how do you take over swaths of a banking system gracefully, effectively, without setting off a mass panic? I'm coming to the conclusion that it's a mistake to lead the discussion with the nationalization idea -- it freaks out Republicans too much and also introduces too many thorny "how do we do this and what are the effects?” questions.

A better approach: begin with aggressive government audits of the banks, as Stein proposes. Aggressive means a tough accounting of those distressed assets on their books. In the first round start out with the largest 20, 50, 100 U.S. banks -- however many you can audit in a relatively short time frame, say two to four weeks. (This exercise should be easier right now since the banks have just done their end-of-year audits.)

After round one, you have a very critical commodity that the Paulson-led Treasury never possessed or seemed much interested in: good hard information about who’s fine, who’s in some trouble, and who’s in really deep doo doo. Now you don't have to indiscriminately sling around bailout dollars; you can make calculated decisions on who is strongest and should be propped up. The insolvent ones, if they can't raise capital, should be unwound in an orderly fashion. Or, if they're too big to fail, they get nationalized as a last resort.

Two reasons why this is a good approach: one, it's not a perfect way to eliminate the moral hazard problem, but it's a vast improvement over Paulson's scattering of funds without regard to viability. Think of it as like grading along a curve. The banks that made the worst bets, or the most insolvent, will go bust. That's as it should be. Others who are solvent or who are close to solvency will be rescued.

Two, as Stein astutely points out, this process restores a degree of certainty to financial markets in an area where it matters hugely: which of the players in the financial industry are on solid financial footing. Not resolving this issue arguably contributes the most to the freezing of credit. After a series of hard-nosed audits, banks essentially will become marked as either survivors or losers, with an impartial auditor’s stamp of approval (or disapproval).

Hiring Jeremy Stein was an excellent idea. Now Obama should listen to him. Carefully.

Wednesday, 28 January 2009

A Writer of Our Time

John Updike died at the age of 76. The newspapers were full of laudatory obituaries. He was described as “kaleidoscopically gifted”, “intuitive” and “lyrical”. Mostly though, he was remembered as a “chronicler of the American middle class,” a writer who wrote about the Average Joe.

Chekhov, too, wrote about the average man, about the art students, civil servants, workers.

Chekhov’s “average man” stands for mankind. By tackling the concrete problem of individuals, Chekhov addressed larger issues facing men everywhere. That is what Sarte called littĂ©rature engagĂ©e or committed literature. Vladimir Kataev describes some of it characteristics in his competent Chekhov critique, If Only We Could Know!
The point at which other writers would think they had completed their task – by making the hero break or intend to break with the social milieu, or by registering their protest against vulgarity and their support for humanity, culture, dignity and personal independence – is the very point at which the real problem and investigation begins for Chekhov.

Truth in Chekhov is above all a synonym for complexity. And most often the Chekhov hero does not know the whole truth.

For Chekhov, an essential component of truth in all its completeness is always beauty.

A further requirement of the “real truth” is that it should be universally significant.

Finally, truth for Chekhov is inseparable from fairness.
Chekhov is a Western writer because his ideas and discoveries are in line with the artistic/philosophical discoveries of the Western artists and philosophers. In his Philosophy of Ethics, for example, Kant shows that the defining characteristics of ethics must be its universality. What is ethical on your part cannot be unethical on the part of your enemy.

For Updike, writing about the average American in the suburbs meant, as the Financial Times correctly stated, writing about “sex, marriage, divorce, materialism”. Salman Rushdie equally accurately said that Updike wrote about “wife swapping in the suburbs”.

Updike’s average man has no social significance; the author could not discern the social issues the way he “discerned” the smell of a barn in a New England village. This provincialism was in full display whenever he took on what the New York Times called the “exotic” subjects. The “Coup”, “Brazil” and “Terrorist” were downright embarrassing.

Updike, too, was part of the milieu in which the current financial crisis is unfolding.

Mr. Geithner Issues a Directive

The most telling news of the day was Treasury secretary Geithner’s promise to curb the banks’ lobbying for bailout money. “Geithner Limits Lobbying for Bailout Money”, The New York Times informed its readers.

Recall that in October then Treasury secretary Paulson forced the CEOs of the banks to accept the bailout money. The Times reported:
The chief executives of the nine largest banks in the United States trooped into a gilded conference room at the Treasury Department at 3 p.m. Monday. To their astonishment, they were each handed a one-page document that said they agreed to sell shares to the government, then Treasury Secretary Henry M. Paulson Jr. said they must sign it before they left.
That was then.

Now the banks are lobbying for the money. Ordinarily, you would think that the bailout money would go to banks in need of capital; emergency help goes to those who need it. Ordinarily, the Treasury should easily determine which banks need the money. That should leave no room for influence peddling. But these are no ordinary times.

That in a mere 90 days the money earmarked for saving the U.S. financial system has turned into potential loot and the Treasury has to issue directives to protect it speaks volumes about the milieu in which the financial crisis is unfolding.

Monday, 26 January 2009

The Subject Matter of Finance

Among the mainstream press, FT’s Lex column offers one of the more consistently thoughtful business observations. This past Friday’s column noted that after the firing of “Mr. Fix-It” from BofA and the hiring of Parsons as the Citi chairman – both considered good news for very different reasons – the stock of both companies dropped. From this evidence, the paper concluded:
The truth is that coming and (popular) goings of bank executives are a side-show. The financial crisis is not discriminating on the basis of management quality. The economic forces unleashed by financial crisis are so powerful that leaders have to a great extent been reduced to mere spectators.
In this backhanded way, and thanks to an unprecedented crisis, the FT finally recognized what the readers of this blog have always known, that the subject matter of finance is not people. It is capital in circulation.

There is more.

Financial crises that befall a financial system do not come from without. They are created from within the system, from its internal developments. Far from being aberrations, these crises are the natural stages – different moments, to use a term from mechanics – of a system whose functioning requires and produces a state of unstable equilibrium.

The process is not mechanical and depends on the actions of “market participants”. The executive officers of financial institutions, in particular, play a critical role in it by virtue of the exercise of their powers that influence the events. They acquire, divest, hire, fire en masse, grant favors and dictate the legislation. In the current crisis, they have been in the hyperactive mode, working feverishly to influence the events to their liking.

Yet, to the observant Lex writer they seem as spectators. What gives?

The answer is that the human actions are the very cause and source of the crisis. Who, but these very same executives and their counterparts in investment funds and trading rooms, brought about the current crisis? The most critical point, however – the point that separates the Theory of Speculative Capital from the simple narratives of the crisis – is that people do not act in vacuum. Within the modern financial market, in particular, they act under conditions created by speculative capital and in line with its dynamics. In doing so, they become the agents of speculative capital, a force that guides their actions but remains hidden from them.

Speculative capital is self destructive; it tends to eliminate the opportunities that give rise to it. This tendency manifests itself in many and varied ways, from the simplest, most obvious pruning of “excess spreads” between two European government bonds to the most spectacularly indirect. Lehman bankruptcy was an example of the latter.

The agents of the speculative capital follow the same self-destructive course, which is why their actions ultimately become self-defeating. Under such conditions, it does not matter which executive is in charge, a fact that the “market” eventually recognizes and reflects in a company’s stock price. But this happens not because managers are passive spectators. It happens because they are active agents. This process goes on at all times but it is more transparent at times of crisis.

The interaction of humans and markets is ultimately the interaction of the thinking and being. That is what this blog explores via its commentaries. A systematic exposition of the subject must await the publication of Dialectics of Finance.

Tuesday, 20 January 2009

Why Was Lehman Allowed to Fail?

The question of why Lehman was allowed to fail had preoccupied me ever since the news reached me while on vacation.

That Lehman’s was the largest bankruptcy ever – with about $630 billion in assets – did not tell the full story. Lehman was a major prime broker and one of the largest players in the commercial paper market. Its notes were widely held by institutions of all stripes and there was a large and active credit default swap market linked to the company’s name. Additionally, the firm’s broker-dealer arm financed well over $100 billion a day in the tri-party market. These activities directly linked the firm to all the major banks, broker-dealers, pension funds, hedge funds, mutual funds and money market funds, to say nothing of thousand of small and medium size firms and municipalities. A place such as Lehman could not gently go into that good night even if it wanted to.

And it did not. On the news of Lehman’s bankruptcy on Monday, September 15, the short-term repo, interbank lending and CP markets froze. By mid-October, the crisis had spread to all parts of the credit markets in the U.S., the Western “liberal democracies” and many emerging markets. One could argue that a substantial portion of $9 trillion in commitments that the Fed and the Treasury have pledged to “calm” the markets in the past three months is the cost of the Lehman failure.

The decision to let Lehman go under is now universally recognized as an epic blunder. In an uncharacteristically harsh editorial, The New York Times called for grilling Geithner in his upcoming confirmation hearings for his role in Lehman’s bankruptcy. The editorial pointed to the shifting explanations of the Treasury and the Fed as evidence that the true story had yet to be told. Indeed, save for Paulson’s shifting explanations – first, “we had no business saving Lehman”, and then, as things got hairy, “we had no authority to save Lehman” – no explanation is given for the fateful decision. Presumably, only Paulson, Bernanke and Geithner know the answer – and they are not talking.

Or do they?

In Othello, Shakespeare reaches to the intellectual dominance of the man in man-beast relation to give us the visually compelling metaphor “being led by the nose”, making someone do something that he would otherwise not do.

The Moor is of a free and open nature,
That thinks men honest that but seem to be so,
And will as tenderly be led by the nose
As asses are.
I, too, was led by a faulty conviction to saying and writing things that I would otherwise not say and write. Here is what I wrote upon hearing the news:

It is inconceivable that the Fed would force a major broker dealer ... into bankruptcy for the sake of making an ideological point. The Lehman failure is a defeat, a setback. The Fed would have done everything within its power to save the firm. That it did not, because it could not, is the central story behind Lehman’s failure. In the Lehman crisis, the Federal Reserve reached the limits of its omnipotence. It was rendered impotent because it did not have the financial wherewithal to intervene.
The passage is on the mark on its fundamental premise: that Lehman’s bankruptcy would become an event to remember and that it was a defeat for the Fed. But look at the unbridled faith in authority: “It is inconceivable that the Fed would force a major broker dealer into bankruptcy for the sake of making an ideological point.” The day I wrote this must have been my salad day, when I was green in judgment.

Or take the comment about the Fed’s lack of “wherewith”. It, too, was technically accurate. But if it only were true that the Fed would be restrained by legal constraints!

One learns. With what has come to light in the past couple of months, I can now surmise why Lehman was pushed over the cliff. As always, characters and incidental events matter, but they play out against a backdrop set by finance capital and the dynamics of its latest, most developed form, speculative capital.

Most immediately, Lehman was allowed to fail because no one in the position to save it understood the consequences of the failure as they unfolded. The haphazard response of both, the Treasury and the Fed, to the unfolding events – one observer characterized it as a ”Whack-A-Mole” approach – provided ample proof of that. I also wrote a long piece here , explaining why despite having detailed knowledge of technicalities, the officials did not understand the situation.

The incidentals played a role as well. Lehman’s broker-dealer arm was organized as a separate legal entity, an obvious “strategic” decision that, whatever original purpose or merits it might have had, ultimately contributed to the undoing of the firm. As a separate entity, the BD could be kept out of the bankruptcy proceeding, as indeed it was. The consideration of that scenario must have added to the bravado of the decision makers at the Fed and the Treasury, leading them to believe that with the critical BD out of the way, they could handle the post-bankruptcy situation. (On the very same day September 15, the Fed guaranteed about $90 billion of trades for the LBI New York trades, Lehman’s broker-dealer subsidiary.)

But why the bravado? Even if Paulson, Bernanke and Geithner did not understand the consequences of Lehman’s failure, why the cavalier attitude ?
This summer, as he fought for the survival of Lehman Brothers, Richard S. Fuld Jr., its chief executive, made a final plea to regulators to turn his investment bank into a bank holding company, which would allow it to receive constant access to federal funding. Timothy F. Geithner, the president of the Federal Reserve Bank of New York, told him no, according to a former Lehman executive … One week later, Goldman and Morgan Stanley were designated bank holding companies.

This claim that Fuld also repeated under oath in front of a Congressional panel was never denied. The question then arises: Why the intransigence, this uncompromising stand, under clearly risky circumstances from an institution with born-in bias to err on the side of caution?

The answer has to do with the machismo that, as a byproduct of the rise of speculative capital, has infested the financial culture in the West and particularly in the U.S.

At the root of this machismo stands the need to be “unpredictable”. The financiers of bygone eras who thought of themselves as gentlemen bankers would have taken offense at such characterizations. But with the rise of short-term trading driven by speculative capital, unpredictability, like being foul-mouthed, became a virtue. The latter meant to project an image of toughness in a business that was considered cut-throat. The former was fashioned after the conduct of gamblers; it was a virtue in the sense that the rivals could not "read" one's hand and, by extension, the next move. Both were the logical results of a system that promoted every-man-for-himself profit maximization.

I pointed to this mindset in Vol. 1 of Speculative Capital in discussing Robert Rubin’s conduct as a Treasury secretary. I looked at a case where he “ambushed” the currency markets to drive up the dollar against the yen and wrote: “So the Treasury secretary of the United States fixes the exchange rate of the dollar against the yen by sowing uncertainty about their exchange rate!”

It is perhaps worth commenting that one of the birth places of this traders' culture was Lehman. Ken Auletta’s Greed and Glory on Wall Street is a readable chronicle of the takeover of the control of Lehman Brothers by “traders” who pushed aside the "gentlemanly" investment bankers in 1984. The palace coup was led by the head of trading, Lew Glucksman. Auletta describes him:
Glucksman usually worked in a glass-walled office ... where his people could see him, feel his presence ... hear him bellow profanities ... watch his round face redden with rage, see him burst the buttons on his shirt or heave something in frustration, watch him suddenly hug or kiss employees to express appreciation ... He sometimes rewarded or terminated employees whimsically ... Employees fondly remember how would pause and laughingly instruct them how to use words like gelt or shmuck ... His legendary temper was carefully cultivated.
The “bad boy/tough guy” conduct, with the unpredictability that went with it, soon became the currency of the trading room and, from there, turned into an attribute of leadership. All office boys with executive ambitions wanted to be unpredictable and able to surprise.

In light of everyone’s expecting Lehman to be saved, letting it go down must have been seen as the ultimate sign of unpredictably, a tough executive decision under trying circumstances that pointed to leadership qualities.

Still, the decision of such magnitude could not have been made without consultation with the industry. The Times article quoted earlier said as much and then went further:

Mr. Geithner, 47, played a pivotal role in the decision to let Lehman die and to bail out A.I.G. A 20-year public servant, he has never worked in the financial sector. Some analysts say that has left him reliant on Wall Street chiefs to guide his thinking and that Goldman alumni have figured prominently in his ascent.
I have no knowledge that “Goldman alumni” were behind Geithner’s decision to play hardball with Lehman. But what is certain is that they did not intercede on Lehman’s behalf either. Neither did other broker-dealers. Had the “industry” rallied behind Lehman, it could have swayed the Fed’s decision; following a meeting between Geithner and Blankfein, the Fed rushed to bailout A.I.G., a Goldman client.

That brings us to the final piece of the puzzle: why other institutions, especially trading institutions, did not lobby the Fed on Lehman’s behalf given the strong bonds within the industry? While the competition amongst the financial firms for trading and business was always fierce and real, every competitor at the same time was a potential counterparty to a trade. That consideration created a common interest that rose above the local rivalries. This common interest was, and still is, reflected in many professional organizations that lobby and speak on behalf of the “financial industry”. In the case of Lehman, that common interest failed to save the day because it no longer existed.

Blame it all on speculative capital.

Speculative capital, capital engaged in arbitrage, is self-destructive; it eliminates opportunities that give rise to it. As the bid/asked spreads narrow due arbitrage, speculative capital increases its size to partially compensate for the falling profit. But the increase in size puts even greater pressure on the spreads, to a point that it is not possible to make any profit, especially when the leverage ratios are substantially reduced. In the face of a dwindling profit pie, the surest way of protecting one’s share is reducing the number of participants in the market. That simple fact is behind the seemingly high minded recent self-regulatory proposals that were recently announced with fanfare:
Complex securities businesses that once fuelled explosive profit growth on Wall Street and in the City of London would be dramatically limited in scope and size under proposals revealed yesterday by leading banks in response to the credit crisis.

The blueprint would restrict complex financial products to only the most sophisticated investors, tighten oversight of large swathes of the derivatives markets and require banks to spend more on technology and risk management.

The plan – backed by banks including JPMorgan Chase, Merrill Lynch, Citigroup, HSBC, Lehman Brothers and Morgan Stanley – will be presented to US and global regulators considering various ideas for increasing oversight of the credit markets ...

Perhaps the most unexpected proposals by the banks involve new criteria for the “sophisticated investors” allowed to buy complex financial products. Under the plans, even pension funds and other institutional investors would no longer be automatically allowed to buy bonds backed by assets such as subprime mortgages.
It was the natural expansion of speculative capital in search of arbitrage opportunities that created conditions that led to the demise of many financial institutions, including Lehman. Lehman’s case stands out. Other financial institutions could have prevented it but chose to stay on the sidelines because they calculated that Lehman’s demise was their gain. This was a consideration that had never before entered the calculus of the Wall Street – certainly not in relation with a firm of Lehman’s size and stature.

But Lehman was an integral part of the “the Wall Street”. In letting Lehman fail, the Wall Street also took an ax to itself. In a few places, I have written about the self-destructive tendency of speculative capital that manifests itself by the self-destructive action of the financial agents. Lehman’s failure was the most compelling example of that tendency to date.

The subject of the dialectics of finance is studying these self-destructive tendencies which arise naturally, i.e., logically, from the internal developments of the systems.

Monday, 19 January 2009

Bush: Blissfully out of Touch Until the Very End

“The actions taken by my administration in response to the financial crisis have laid the groundwork for a return to economic growth and job creation, and they are beginning to show some early results,” President George W. Bush said in a letter to Congress that accompanied the annual Economic Report of the President.

Back in the 1980s cartoonist Garry Trudeau did a series of strips about the inside of Ronald Reagan’s brain. It was a spooky jungle of fused and drooping synapses, a no man's land of muddled thought. Sometimes I wonder what the George Bush brain would look like. A vast and empty desert of feel-good banality?


His administration is forecasting the U.S. economy to snap out of its slump in the second half of 2009. This prediction is most likely self-serving or cynical or both. Obviously, to preserve what he can of his tattered legacy, Bush would like us to believe we are poised for recovery. Then he can claim that his presidency took the body blow from the financial crisis, but he made the painful decisions that put this country on the right track.

Of course that’s -- not to mince words -- crap. Paulson and his minions have done little more than transfuse blood into an army of zombie banks. The zombies will be back for more blood after Bush is gone. The U.S. taxpayer will be asked to bare a vein once more.

What if Bush had spoken the truth in his quote? It might sound like this:

“The actions by my administration in response to the financial crisis were taken only after much foot dragging and were half-hearted; I realize what we did looks like corporate welfare of the worst kind, but that is only because we ideologically oppose government intervention in free markets even when those markets have hugely failed, in part because of a climate of regulatory indifference that I encouraged,” President George W. Bush said in a letter to Congress that accompanied the annual Economic Report of the President. “We decided a couple of months ago to tread water and not do anything radical to solve this crisis, preferring to leave an intractable mess for the incoming Democratic president so that when economic growth and job creation don't materialize, Obama and his advisers can be blamed."

Friday, 16 January 2009

Wake up Washington!!!

This is a short entry as I sit and stew in frustration. Bank of America just got $20 billion more in federal funds and guarantees of support on $118 billion of assets. These bailouts will go on and on and on and on until Washington understands a very basic fact about this financial crisis:

The major banks in the U.S. are insolvent.

One more time: insolvent.

That's spelled I-N-S-O-L-V-E-N-T.

Nationalize them. Or let them perish. Just stop, please stop, dumping money into these bottomless pits.