Thursday, 29 October 2009

Selected Readings for a Thursday Morning

1. Under Attack, Credit Raters Turn to the First Amendment

First, a disclaimer on my recommendation for this Huffington Post investigation: a version of this story has been done before; it's not exactly anything new. To wit: Moody's and friends like to scurry behind the First Amendment when outraged investors seek recompense for losses after believing their inflated ratings.

I know the argument the credit raters are trying to make, but it always has offended me somewhat. You think of the great figures of American history who have invoked the First Amendment, and how it has been this core, unassailable principle that makes our democracy so powerful. And then Moody's ... well, subverts it to this end. I suppose my reaction is akin to the reaction you'd expect from a Fox commentator who discovered footage of a beatnik casually wiping his butt with the American flag.

For now the lesson we must learn is to treat the credit-rating agencies as untrustworthy, unfortunately, as they consider their ratings to be basically on par with an opinion column in a NAMBLA newsletter. It's all just free speech, right? But remember what motivates their "free speech." They can in effect "sell" good ratings, as they are paid by the company that issues the product they're rating.

Even if prostitution is deemed legal (as it is in some places), a whore is a whore is a whore. To some degree, credit-rating agencies will continue to be whores (or have pronounced whore-like tendencies, at the least) as long as they are paid by the people whose products they're judging. So investors, caveat emptor.

2. Naming Systemically Dangerous Firms

This guest post by David Moss at The Baseline Scenario left me clutching my head and moaning. Apparently the systemic risk legislation for the financial industry that's beginning to wend its way through Congress would identify "Too Big to Fail" institutions and then NOT make their names public. The stated reason: identifying them would encourage "moral hazard."

No. No. No. No. No. (Draw picture of me here, repeatedly banging my head against a brick wall.)

Sometimes I wonder what kind of chowderheads we have drafting laws in this country (actually, I should know by now: they're not the men and women we elected; they're the lobbyists that paid for their campaigns). Assuming that we decide to allow "Too Big to Fail" institutions to exist (believe me, there are many Americans who question the wisdom of this), why the hell should we keep their identities in the closet? Remember, one big pillar on which regulatory reform needs to be built:

Transparency.

One more time:

TRANSPARENCY.

The truth is, there will be enough leaking of this "Too Big to Fail" list that plenty of people will know who's on it. The market will make adjustments; you'll get your damn moral hazard anyway. What you may not get is the open and vigorous debate that we need about the TBTF's that appear on the list. Any bank that merits a Too Big to Fail should be regulated within an inch of its life, like a common utility. And it should be watched really, really closely, because when it blows up, it can blow a gaping hole in the side of the good ship the U.S. Economy.

And for all of us to be super-vigilant about these Too Big to Fails, we all need to know who they are.

"Too Big to Fail" shouldn't be some neat little merit badge you get at a moonlit ceremony in the heart of the dark woods. It needs to be a stamp, hopefully more akin to a scarlet letter, that gets planted on your forehead in full view of the public (which has to pay for your Too Big to Fail-ness, if you do screw up, so believe me, there's plenty of justice here).

Wednesday, 28 October 2009

Nobody Rides for Free? Think again, Jackson Browne

Lately I've been thinking about the "free rider" problem in economics, partly because free riders are so easy to find once you start looking for them. It's an unbelievably easy Easter egg hunt.

The free rider of course is someone who partakes of a benefit but doesn't help pay the associated cost. If you live in a village of 1,000 people, and there's one dirt road in, absent a local government structure someone might try to collect funds to have the road paved. If 999 people contribute $1,000, but you don't deem the project worthy and decline to pay anything, then you "free ride" on that nice smooth road when it's finally covered with a shiny black layer of pavement.

This winter, I may be a swine flu free rider. How? I'm leaning against getting a protective shot. Part of my reasoning is: Because of the general feeling of panic, and the constant media drumbeat about the dangers of swine flu, millions will get vaccinated. They will help form a protective buffer around me, damping the spread of the flu. Thus, I benefit from the precautions they take.

You can also appreciate this on a mathematical level. Possible infection rates for swine flu have been predicted to be around 30 percent (which strikes me as very high -- but as a free rider, that's okay, because it just means that this figure will scare more people into getting vaccinations, and so give me an even better free ride). But the more people who get the vaccine, the lower that infection rate will be. Now, if 299,999,999 people out of a population of 300 million get a swine flu shot (or nasal injection), and I'm the only one who doesn't, then my chances of getting the virus are practically zero. Because, obviously, where am I going to get it from? An airborne petri dish?

If you feel annoyed at me for free riding, don't be. Everyone's free riding somewhere. Just look around.

Take Afghanistan. It's a justifiable war, I think, unlike Iraq. Yet it still looks like a hopeless quagmire. The legitimacy of the Afghan government has been hollowed out by incompetence and corruption. I would find a way to get troops out of there, fast. This conflict will only end badly. General McChrystal is right: he does need more troops, but even then he may only be able to fight the enemy to a standstill.

But back to the free rider part: There are apparently plenty of other nations that want the U.S. to stay in Afghanistan, to try to sort out this opium-growing and strife-torn mess of a country that is an all-too-convenient hatching ground for future terrorists. The whole world reaps the benefits of fewer Al Qaeda cells operating within Afghanistan's mountainous borders. But other countries are reluctant to commit their troops or their funds to support our combat operation. They would rather sit back and free ride. And so the U.S., still thinking it's the superpower with the mostest, takes this burden on its shoulders.

One more free rider example to complete the set of three today:

I'm about to move to New York City. I was doing comparisons to see how a given salary stacks up in different metro areas. Zounds! New York is frightfully expensive (as if I really needed to be told that, but once you see the numbers in black and white, it is pretty sobering).

I'll be forking over a big chunk of my paycheck to the federal government for taxes. In fact, New Yorkers most certainly contribute a big slice of the federal taxes collected in this country. The irony is that the people who complain the most bitterly about taxes and big government live in the conservative red states, in the heart of America, where salaries are lower. So they get to gripe while free-riding, to some degree, off the liberals.

Example (go here for the cost-of-living calculator): $100,000 in Manhattan salary would buy the same as $40,384 in wages in that reddest of red capitals (and believe me, I know, having lived there once), Oklahoma City. So here's the picture: Oklahoma residents are fuming about government being too large, taxes too high, and meanwhile the typical worker in the state capital probably pays a good deal less to support our troops abroad than the liberal president of the Sierra Club in New York City.

(For those who say it all balances out, because New Yorkers get proportionately higher salaries, two things: (1) If you're making $40,384 in Oklahoma City, good luck transplanting to Manhattan and getting $100,000 just because, you know, you deserve more because of the cost-of-living differential. (2) Our income tax scale is progressive, so $100,000 puts you in a much steeper tax bracket than $40,384.)

Nobody rides for free, Jackson? Au contraire ...

Tuesday, 27 October 2009

What We Learn From the Financial Journalists

This past Tuesday, The New York Times was plugging the new book by its “merger and acquisition correspondent”, Andrew Ross Sorkin, big time. The book is called, Too Big to Fail: The Inside Story of How Washington and Wall Street Fought to Save the Financial System – and Themselves. That long and yet empty title is what you get when you try to include all the “hot” issues of the day in a single phrase. But the gimmick apparently works, or it could have been the heavy promotion: the book sold out in New York’s Barnes & Nobles.

I have not read the book, but from the excerpt in the Times, I know what is inside. Here is a passage:
Increasingly desperate that morning – “I feel like I’m playing Whack-a-Mole,” he complained to his peers – Mr. Fuld decided to call his old friend John Mack, the chief executive at Morgan Stanley, the second-largest investment bank after Goldman Sachs. After dialing Morgan’s New York office, Mr. Fuld was transferred to Paris, where Mr. Mack was visiting clients in the firm’s ornate headquarters, a former hotel on the Rue de Monceau.

After some mutual disparagement of the markets, the rumors and the pressure on Fannie Mae and Freddie Mac, Mr. Fuld asked candidly: “Can’t we try to do something together?” It was a bold question and Mr. Mack had suspected it was the reason for the call. While he didn’t believe that he’d be interested in such a prospect, he was willing to hear Mr. Fuld out.

“We’ll come over to your offices,” Mr. Fuld, clearly anxious, said.

“No, no, that makes no sense. What if someone sees you coming into the building?” Mr. Mack asked. “We’re not going to do that. Come to my house, we’ll all meet at my house.”

On Saturday morning, Mr. Fuld pulled up to Mr. Mack’s mansion in Rye, N.Y. Despite the beautiful weather, he was tense. He could already imagine the headlines if it leaked.

The Morgan Stanley team had arrived and was socializing in the dining room, where Mr. Mack’s wife, Christy, had put out plates of food she had ordered from the local deli.
What we learn from the above is that:
  • When Fuld called Mack, Mack was in Paris, in Morgan Stanley’s ornate headquarters, which was a former hotel on the Rue de Monceau.
  • Mack and Fuld knew each other.
  • Mack and Fuld did not like – or understand – what was happening in the markets.
  • Mack had a sixth sense, certainly a strong intuition. When Fuld reached him in Morgan Stanley’s ornate office in Paris, he “suspected” that Fuld was calling him for something important.
  • Fuld who had reached Mack in Paris to talk about his firm’s survival had not prepared a proposal or even an opening pitch. “Can’t we try to do something together?” is what he said, by way of proposing a merger involing about $2 trillion in assets.
  • Fuld was a simpleton, suggesting to go to Mack’s office. A child would know not to do that. (Paulson met with the Goldman Sachs board in Russia – when he was the U.S. Treasury secretary.)
  • Fuld was a quick learner. On Saturday morning, in front of Mack’s mansion, he was tense (although the weather was good) because he had learned that it was not good for him to be seen with Mack
  • Mack’s wife, who goes by the name Christy, had ordered takeout food from a deli in Rye, New York which is where she and her husband, Mack, live in a mansion – Mack Mansion, presumably.
Perez Hilton, meet financial journalism.

It serves no purpose to comment on this trashy, gossipy writing masquerading as financial investigative journalism, except to point to the way it is intended to drum up the sale. The tidbits that permeate the narrative send the subliminal message that the author is close to the center of power and hence, privy to knowledge and inside information. That association is the source of his authority; he knows the cause of the crisis because he knows the players whose actions influenced it. That it is precisely the opposite, that businessmen and traders could shed absolutely no light on the cause of the crisis, that the more nonsensical tidbits you hear or read about the less you would know, is something that neither Andrew Ross Sorkin nor those who bought his book will easily believe – or understand. The milieu in which these events take place stands against such understanding.

I caught a glimpse of Ross Sorkin on Charlie Rose. The host and guest agreed that the main lesson of the crisis is “ultimately” about the human failure. You know about this the-fault-is-not-in-the-stars thing, akin to saying that an airplane crash was “ultimately” due to the gravity. The author is a young man. He talks fast and confidently, the way confidence men do. He has no qualms or doubts about what he knows; how could he, having heard the behind-the-scenes drama from the movers and shakers, knowing what a lawyer was wearing to a weekend meeting and which highway Fuld's driver took on the way to New York?

Not to be too harsh on him, but he, too, while also a victim, is at the same time a part of the fraud that is continuously perpetuated on the citizenry.

If the young lions of financial journalism are bad, the old timers are scarcely better. On Friday, Ron Chernow, the author of a confused history of J.P. Morgan, wrote an Op-Ed Page piece in the New York Times in which he compared the current financial crisis with the crash of 1929. Here are three sample statements, followed by my comments:
For many participants, a whiff of sin only enhanced the stock market's seduction. Small investors imagined that the large speculators who dominated the exchange could, if necessary, levitate the market and prevent unpleasant crack ups.
The modern markets, too, thrived on the whiff of scandal. All Madoff investors were told – and passed it to others – that the “New York people had a system.”
Margin loans equivalent to one-fifth the value of listed stock poised the market on a tall but shaky scaffolding.
In the current criss, while the margin on stocks was one-half, the firms as a whole had margins in excess of thirty to one, six times higher than what was allowed for the individual stock investors in the late 1920’s.
Unlike the 2009 crash, the 1929 debacle didn’t topple major banks or corporations. It simply wiped out a generation of speculators.
The crash of 1929 only toppled speculators and not banks because in 1929, banks were not involved in speculation. In 2007, they were.

Chernow has no central argument, he has no point. His writing is a hodgepodge of anecdotes and false parallels and analogies that ultimately leave the reader frustrated and exhausted.

What these men want to offer, but cannot, is a coherent narrative of a crisis that has devastated much of the world's economies in the past two years. I explained the crisis in some length in the Credit Woes series. Since Lehman’s case, for good reasons, is intricately linked with the crisis, let me once again use it to highlight the things we need to know. Only then we will be able to understand the crisis. This is not a “case study” approach, but an analysis of a part that contains some critical aspects of the whole.

Lehman had $1 capital, its own money. It then borrowed $32 and use all the money to buy securities worth $33. The securities were pledged as collateral for the loan, the way you would pledge your house for mortgage. Unlike your mortgage, though, Lehman’s borrowing was short term; it had to be refinanced, i.e., renegotiated, every day, or every week or every month.

In 2007, the securities prices dropped – crashed, really. (As an example of the severity of the crash, Merrill sold some of its securities for 22 cents on a dollar.) The securities that Lehman had purchased for $33 were now worth, say $20. The lenders did not accept holding $20 worth of collateral for loans totaling $32. As per terms of the loans, they demanded that Lehman pay the shortfall, the $12. Lehman had only $1. It could not pay $12.

Under these conditions, the die was cast. Short of a government bailout – the Fed or the Treasury giving Lehman the life-saving $12 – there was no way the firm could survive. Paulson and Geithner refused. The firm went under.

Three questions must now be answered, one specific to Lehman, the other two, general:

1. Why was Lehman allowed to fail?

To the extent possible, I answered this question here and here.

2. Why did Lehman follow a suicidal business model, borrowing 32 times its capital?

The answer is that it had no choice. Had it not pursued that specific business model, it would have been forced out of business or taken over many years prior to 2008. That was the case with all broker/dealers; Lehman was by no means an exception. So it is nonsensical to speak of management failure, as the decision to increase the leverage was conscious and deliberate.

Now, why is this so, i.e., why are financial institutions forced to behave in this way, is the subject of Vol. 4 and especially, Vol. 5, of Speculative Capital.

3. Why did prices drop?

The answer does not involve buyers going "on a strike" or the market being flooded with the securities or irrational exuberance. It has to do with the transformation of values to prices, something very objective. It is a fascinating subject that must be developed from the ground up and followed to its logical conclusion. That is the subject of Vols. 4 and 5 of Speculative Capital.

Stay tuned.

The Inanity of the Home Buyer Tax Credit Laid Bare

For anyone who missed it, Nemo at self-evident had a good post on why the tax credit for newbie home buyers is a really dumb idea (The First-time Home Buyer Tax Credit is Idiotic; he doesn't mince a lot of words). He had a follow-up here to explain it all in (brace yourself) the economic parlance of supply and demand curves.

I'll just cherry-pick a few reasons why the tax credit is stupid:
1. It forestalls the setttling out of home prices at their natural bottom, which is what we desperately need before the U.S. housing market can begin a sustained recovery.
2. It encourages first-time homebuyers to leverage up too much to buy a home (and what's more, they won't be buying at the natural bottom -- see point #1 -- so they stand a greater chance of winding up underwater on their mortgage).
3. Once you start shifting around the supply and demand curves, you find that the tax credit, if anything, induces developers to boost the supply of homes in the market. But the housing market, if anything, is suffering from a glut of units right now.

So why do we have an idiotic tax credit gumming things up? To throw a crutch under the housing market to help the banks and beleaguered homeowners, even though we could do more with the money by just writing everyone a bunch of checks and save all the paperwork and economic distortion? Yeah, that's part of it.

The other part is what Washington has become: a giant pork pull. Politicians know that their policies don't need to make any economic sense as long as they're shoveling enough free money out the door to keep enough Joe Averages in the constituency happy enough to re-elect them.

Health Care Reform? I'm Busy Counting My Gold, You Dark-skinned Whippersnapper!

The title says it all:
U.S. Health Care Reform Mainly Opposed by Rich Old White Men

Sunday, 25 October 2009

That Time of Year: WSJ Op-Ed Defends Insider Trading

I say "that time of year" because periodically (okay, maybe not every year, but as sure as the swallows land at Capistrano), the WSJ runs an op-ed piece that defends the practice of insider trading.

This year's version is written by Donald J. Boudreaux and, owing to its sort of porky length, I am betting that it appears only online and not in the print Journal. Boudreaux makes enough sense that, if you want to see the real fright gallery for this Halloween-timed piece, check out the comments section afterwards. You'll find a lot of people -- they smell like traders to me; they have that sort of smart knowingness about the markets on a very micro level -- cheering him on. Clearly Boudreaux managed to quickly assemble his own amen corner.

So what is wrong with insider trading? Boudreaux offers many reasons why it's actually a good thing. But does his exuberant defense capture the whole picture?

First, what is insider trading? It's pretty much what it sounds like: insiders buying and selling stocks of publicly traded companies based on knowledge that they have that others don't. Obvious example: You know, as a director on the board of Cisco, that the company will be bought out by the Chinese at a 30 percent premium. The formal announcement will come in two weeks. So in the meantime you buy every share you can lay your hands on. When Cisco pops say $15 a share, you cash in.

That's illegal. In Boudreaux's world, it wouldn't be (though, as he proposes, Cisco would be left to define its own narrow or broad version of "insider trading" -- for example, it could mandate that no insiders can trade on information related to takeovers/mergers. The company then would be free to sue any violators itself; federal regulators wouldn't get involved).

Let's look at what Boudreaux is saying, bit by bit. First, he points out that regulating insider trading is a messy, imperfect business to begin with. The application of the enforcement rules is unavoidably biased. Here he makes an interesting (and valid) point:
These prohibitions are meant to prevent all insiders with non-public information from profiting from the use of such information before it becomes public. It follows that unbiased application of these prohibitions should target not only traders whose inside information prompts them to actively buy or sell assets, but also traders whose inside information prompts them not to make asset purchases or sales that they would have made were it not for their inside information.
Okay, here's what he's saying, in easier-to-parse English: Insider trading catches only sins of commission, not sins of omission. It catches people who are buying and selling (they leave a paper trail, alas), but not those who would have bought and sold, if not for their privileged information.

So picture Fred, who's working for King Kazoo. He's a mid-level manager who happens to glimpse a copy of King Kazoo's sales for August, on the desk of his boss. At lunch, Fred was planning to place an order to sell 5,000 shares of King Kazoo. But he sees kazoo sales rocketed higher in August. The stock is going to soar. Fred thinks to himself, "Ah, maybe better not call my broker after all." And when the stock subsequently jumps 20 percent, Fred is sitting pretty.

That's not insider trading. Fred never made a trade. But it is insider knowledge that leads to a profitable advantage. And it's undetectable. We can't hook up Thought Monitors to everyone who works at, or deals with, a public company to see what they would have done had they not seen Document X or heard Y.

It's a problem for sure. But I think it's a problem of a different order of magnitude that we might just have to swallow hard and live with. It's a different order of magnitude because out-of-the-blue or less-motivated decisions to buy or sell stock (as with Fred above) are going to be smaller than motivated decisions to buy or sell based on a clear advantage. Okay, that's confusing, so here's what I mean more plainly: Fred was going to sell 5,000 shares and decides not to, seeing the great August sales figures. Now if insider trading were allowed and Fred was thus encouraged to profit off any information he had, he'd certainly be motivated to go out and buy a bunch of shares. But I think he would try to buy a much larger chunk of shares -- maybe 50,000 -- knowing he can make a bucketload of money.

So here's the contrast: the action he doesn't take is more likely based on a weak-motivation decision (he's going to sell the shares to generate a little cash, he has a vague feeling the stock will drop, he had a bad burrito last night and just doesn't feel like owning as much stock). But the action he does take -- buying or selling -- is based on a strong-motivation decision (he's almost certain the shares are heading higher). And when he acts on strong motivation, many more shares are likely to be involved.

The upshot is that I don't think the "sins of omission" are excusable, just that they tend to be less bad, so it's not worth getting too overexercised on that point.

Moving on: the core of Boudreaux's argument would warm the cockles of the heart of any efficient market theorist. Remember, that theory holds that the price of any stock, in an efficient manner, adjusts to reflect all relevant, available information. So, in this ideal world, the price of Kazoo stock is exactly what it should be.

But, of course, this overlooks something (actually a big something, in that it doesn't account for bubbles, momentum movements and the myriad irrationalities of human nature, but we'll let that part go for now). Kazoo stock can't be perfectly priced (even disregarding the irrational stuff), because the market doesn't have all the relevant information. Insiders do possess much of this information. And so, by allowing them to add their "information" to the market's understanding of the stock, this gives us a better approximation of its true value. And this is good, Boudreaux points out, for many reasons:
Suppose that unscrupulous management drives Acme Inc. to the verge of bankruptcy. Being unscrupulous, Acme's managers succeed for a time in hiding its perilous financial condition from the public. During this lying time, Acme's share price will be too high. Investors will buy Acme shares at prices that conceal the company's imminent doom. Creditors will extend financing to Acme on terms that do not compensate those creditors for the true risks that they are unknowingly undertaking. Perhaps some of Acme's employees will turn down good job offers at other firms in order to remain at what they are misled to believe is a financially solid Acme Inc.
In economist speak, capital (human and otherwise), is being misallocated in this scenario. Acme may receive too much credit, on too generous terms, because its stock price shows a healthy company that does not indeed exist. Talented managers at Acme -- who could be launching profitable startups or using their expertise to propel other firms to greatness -- are instead pouring their valuable time into a black hole of a company that's about to declare bankruptcy.

The argument appears compelling. Where does it break down? I think it's on the shareholder side, with the help of a feedback loop. Because while I think Boudreaux is on the cusp of a valid point with his "economic inefficiency argument," I think he misses badly on the share-price analysis, and this flaw then turns around and undercuts his efficiency point.

So let's look at this more closely, using the Acme example that Boudreaux himself has provided. Imagine Acme is a paragon of insider trading -- by this I mean that everybody has free rein to trade on whatever insider information they can obtain. A Boudreaux-ian would say, "Great, the stock price is really accurate and very efficient. The markets must love that!"

But do they? What are the two bedrock principles most often cited when discussing ideal markets? Free and fair. Certainly the Boudreaux world qualifies on number one. But it falls far short on number two. So what are the implications?

Let's go back to what a fluidly functioning market is all about. There are buyers. There are sellers. Shares change hands, and a moment later the stock ticks higher or lower. For that transaction, at that instant in time, there is a winner. And there is a loser. I personally think this is a more useful paradigm for understanding stock trades, especially shorter term, than that of "mispricing."

So let's imagine there are two investors in Boudreaux's world, Joe Insider and Ted Outsider. Acme is at $30 a share. Joe Insider sees evidence of the company's shakiness. Ted is unfortunately oblivious. Joe starts to sell. Ted sees a buying opportunity and scoops up cheap shares of Acme. Meanwhile Acme falls all the way to $10 a share.

Now, you can argue that a certain amount of mispricing was eliminated during this process. Acme now trades at a "truer" price. But let's examine what happened in the market. Ted realizes he's been had. He took the wrong side of the trade; Joe took the right side because he knew what was really going on.

Okay, Acme now trades at $10. That's good because the price is now more accurate, right? So now Ted should feel more comfortable about buying up more Acme shares because it's settled at this fair $10 price. So he snatches up Acme at $10 each. At the same time, Joe sees inside evidence that the price is going to drop even further. He dumps his holdings, does some short-selling, and makes a profit when the stock hits $3. Ted, meanwhile, takes a bath again.

Now Ted is irked. He's still got some shares, which slowly climb back to $10. At this price, he figures, "That's it. I'm out of this turkey." But at the same time, on the inside Joe sees that Acme is on the verge of acquiring a patent that will turn the company around. And so Joe grabs a whole bunch of shares, Ted divests his, and Acme has a super run up to $20 a share.

What does it mean when you have a situation like this? Ted, who is an active trader and contributing to making the market more liquid, is probably going to steer away from companies with heavy levels of insider trading. Why? This one doesn't take a rocket scientist folks: for every trade, there's a winner and a loser, and going up against insiders on his trades more often than not, Ted's going to turn out to be the loser.

Acme's stock then becomes more illiquid. Not good.

Boudreaux does claim that firms such as Acme will enjoy a lower cost of capital because their stock prices reflect a truer value of the company. But is that really so? Could their cost of capital actually be higher?

How so? On the equity side, the broader investment community will be more reluctant to put money in a company where insiders have the advantage in stock trades, by virtue of the information only they possess. More and more investors may take a pass in trading these shares, as it becomes clear that in any trade, you are increasingly likely to be across from an insider who has an edge. The stock price will naturally fall when a smaller pool of investment dollars is chasing a given set of shares. And so the company may, paradoxically, appear to be weaker than it actually is.

This is the feedback loop part.

What else will happen at Acme, if it becomes a haven for insider trading? Well, other unpleasant possibilities: there could be information hoarding, because information is clearly money, and if you have it and others don't, then that money is all yours to make. Also, insiders at Acme might form links to big money hedge funds, selling them information (which would appear to be legal in this brave new world -- if you can profit on insider information, why can't you then take partners or sell that information for others to profit on), as these large funds would be able to leverage the insiders' information more effectively.

Is this really the world we want? Insider trading occurs unfortunately all too frequently right now. It is hard to police; that's undeniably true. But once you take the "fair" out of "fair" market, what do you have left?

Thursday, 22 October 2009

Are the American People Really the American Sheeple?

Have we turned into a nation of sheep? Are we really so tractable and fleece-able as an outsider might think, considering the rather feeble response of the average American to the outrages of the financial crisis?

Everyone basically agrees on where we are now, one year after last fall's implosion. The Too Big to Fail banks are even bigger than before (and thus even more immune to failure). Wall Street bonuses and pay are rocketing higher again, even as 500 desperate people (including a master's degree holder and a seasoned business analyst) compete for a single lousy admin spot at a trucking school that barely pays $27,000 a year. The financial industry is battling the small elements of reform tooth and nail; God knows what resistance we'll get when we try to introduce big, meaningful reform.

What prompts my musing is this story in the Huffington Post showing the large, yawning gap -- chasm really, if you will -- that has opened up between Wall Street bonuses and the average American's yearly paycheck. Once again, to be clear: this isn't a straight-up comparison of salaries; this is a comparison of dessert (bonus) to meat and potatoes (living wage). And, to continue with the metaphor, Wall Street is not just getting a much better main course than the rest of us, their dessert alone makes our meat and potatoes look like scraps of rat tails and moldy French fries.

The gap has been widening for years. And yet -- even now, after the Wall Street's whole edifice of debt and derivatives just about toppled a year ago -- we seem to be uttering a collective "baaaaaaa" and going about our grass-grazing with nary an eyeblink. What explains such quiescence? That's what really puzzles me. Here are some of the theories, though I'm not saying I completely agree with all of them. Pick the one you like.

1. Americans are just too fat and content to be bothered: we are the expected products of an affluent society that offers up lots of cheap, high-fat food, easy-to-digest entertainment -- and not enough to chew on when it comes to intellectual stimulation. Despite the high unemployment, even now we find enough ways to get by. As long as we can scrape up the funds to pay the cable bill, don't go looking for a revolution. We get mad, then we realize that The Amazing Raze is on in ten minutes, and pretty soon we've forgotton why we were so pissed in the first place.

2. Americans are, on the whole, just not that smart, and the financial mess requires the ability to understand very complex topics. Ask an American to locate Afghanistan on a world globe, and chances are decent his finger will land somewhere east of Tibet or south of Sumatra. And even the smarter among us are much challenged to understand this complicated financial engineering that creates "credit default swaps" and "synthetic CDOs," and how everything interrelates.

3. Americans tend to have a simple worldview and are easily led astray by clever charlatans who twist our fundamental ideological beliefs. What American would oppose the noble principle of freedom? So then why would anyone oppose free markets? Isn't that the bedrock of our capitalist system? If something goes wrong, it can't be the fault of free markets; the meddling hand of government regulators must be involved. This theme has emerged on the right (and to be fair, there is an element of truth, because regulation has distorted markets). And so then the clever demagogue sells the great themes of America -- freedom! innovation! the self-made man! -- back to the wage slaves who might be jealous of Wall Street. And, cowed, they slink back into the herd of sheeple.

4. Maybe we really aren't sheeple; we just haven't reached a critical mass of fury yet. A cynicism about the big bank bailouts and the White House's kid glove treatment of Wall Street is deepening across the land, hollowing out the legitimacy of our public institutions. There actually is a lot of anger, even among those who complain nothing can be done. These people aren't marching in the streets yet, but they're getting closer to. And if politicians continue to be tone deaf to the masses, the sheeple will cast off their woolly-headed subservience and make their voices heard, in a big way.

Tuesday, 20 October 2009

What We Learn From the Businessmen

If you did not recognize the style of Death of a Deal Man, you do not know John Das Passos. If you are an American, that is doubly unacceptable. His is the only name you can utter when an anti-American foreigner claims that your country has not produced a single writer or artist of international standing. Das Passos’s U.S.A. trilogy is a masterpiece of fiction in form and content. Once in this blog I asked the philosophical question: What do we need to know about something so we could say we know it? When it came to people, Das Passos knew the answer; he gave it to us with an impossible mix of brevity and completeness that approached poetry. Read the biographies in the U.S.A. and judge for yourself.

I thought of Das Passos when I was reading Wasserstein’s death notices. Even the man’s obituaries were hurried, as if rushing to complete an about-to-expire deal. Deal making alone drove the narrative, as in this gem in the Wall Street Journal (Oct 15, p. C3):
A former editor of the school newspaper at the University of Michigan, Mr. Wasserstein long has had an interest in media deals.
Do not blame the reporter for bad writing. The corollary is absurd because it captures the absurdity of a life whose focus on deals distorted all the relations. Eugene O’Neill perceptively captured this affliction in Hughie’s small-time gambler, Erie Smith. In the dinner party of a puritan hostess, with her children present, Erie recounts the story of one his wagers in a horse race, reasoning that the children would love “animal stories.”

The unintended humor is not confined to the dearly departed. In the same week, I also read the news of the retirement of James Simons, the founder of Renaissance hedge fund who made billions in trading. The Times said that “many on Wall Street” still believe that Mr. Simon has a “supernatural talent for making money.” Now that is a juxtaposition of spiritual and the material that only a Rumi could pull off. How life’s extremities give rise to poetry!

And there was John Mack, the outgoing CEO of Morgan Stanley, telling a TV interviewer on Friday that “our focus” must be on the job creation. This, from a man known as “Mack the Knife” for his relentless cutting of workers always and anywhere he went.

Now that a few market indexes are up and the immediate danger of a collapse seems to have passed, the men of finance are returning to the limelight, assuming Rodinesque poses and availing themselves to awe-struck financial reports for insights about “what went wrong”. They might even be right about the direction of the dollar or the yield of the 10-year Treasury by next year.

But that is not finance as discussed in this blog. We will learn nothing about finance from these men because what they see is always the appearance and never the substance. We will learn nothing from a mouse about the working of the cosmos, even though it could consistently find the cheese, as if by a supernatural talent.

If you are a student of real finance, you are in the right place. Stick around.

Is Naked Shorting Really as Benign as Mom and Apple Pie?

I found myself pondering this after reading Matt Taibbi's latest screed called Wall Street's Naked Swindle. Taibbi comes down hard on the practice, but then I wandered over to Clusterstock where John Carney says, in so many words, "Wrong, wrong, wrong, Taibbi -- naked shorting isn't a villain."

There are several comments I was going to make on Taibbi's piece, but I'll keep this entry manageable by looking only at naked short-selling of shares. For those already shaking their heads -- the phrase does sound indecent, on the very face of it -- this refers to a variation on the practice of short selling.

Short-selling stock is what you do when you think the price is going to drop. Let's say IBM is at $30 a share. You borrow 100 shares, sell them, wait until IBM falls to $10, then buy 100 shares on the market to replace those that you borrowed. Sweet payday: $30 x 100 - $10 x 100 = $2,000 in your pocket, ignoring transaction and borrowing costs.

Naked short selling is all of the above except -- you don't borrow the shares in the first place for whatever reason. Say trading in the stock is relatively illiquid and the shares are simply hard to find. Or you just can't be bothered. Or ... (there could be a nefarious reason, as we'll soon see).

Now, if you tried to sell a car you didn't own -- and that you hadn't even bothered to contractually borrow from someone else -- the outcome would be rather predictable. Some guy in a blue uniform would show up on your doorstep and put a pair of hard-metal bracelets around your wrists and take you for a little ride to the county courthouse. But let's let that go for the moment. Because, after all, just the act of buying a stock is a pretty complex transaction, once you get behind the scenes, as Carney does in his glibly titled Everything You Always Wanted to Know About Naked Shorting but Were Afraid to Ask. (On another day, when the winds of time are favorably at my back, I'd like to deconstruct his little 23-part lesson, as I think he loses the forest for the trees in his explanation in a way that sheds light on why we're in such a financial mess.)

So, for the moment, let's ignore the felonious-seeming nature of naked shorting (and the racy naughtiness suggested by its very name). Let's get right down to mathematical brass tacks and see what there might be to worry about.

Okay, this is an extreme case I'll paint below, but it's an extension of the principles, and sometimes when you extend the principles, you can get a sense of what's right or wrong to begin with. Let's imagine a world where naked shorting is embraced with the same vigor that say a naked Jessica Alba would be (Naked Shorts Gone Very Wild?).

In this world Fusty's Freezers is an oh-so-small public company. It has 100 shares that trade at $100 each. That gives it a "market capitalization" of $10,000.

In this world the naked shorts decide that tiny Fusty's is ripe for some manipulation. Now, if they had to sell shares short the regular way, they'd have to borrow them. So, for instance, if they sold short 100 shares, they'd have to borrow those 100 first. Supply wise, nothing would change in trading of Fusty's Freezers stock. Even though there are new owners of the 100 shares, the existing owners (who have lent their stock to the short sellers), can't go ahead and lend their stock again or sell it. It's already spoken for, tied up, frozen. (Theoretically anyway.)

Now suppose the naked shorts decide to sell shares they don't own ... and that they haven't borrowed either. A LOT of shares. Let's take an extreme case and say that they sell another 900 shares of Fusty's Freezers into the market.

What would you expect with 1,000 shares of a $10,000 market cap company in circulation? Easy: the price would fall to $10 (actually it wouldn't be quite $10, but that's a complicated tangent that we don't need to chase here). So in other words, the act of naked shorting would drive the stock's price down about 90 percent. (One other note: I'm disregarding momentum effects too, which arguably would drive the price down even more.)

Wow. Even though this is an extreme example, I think a skeptical reader's sniffers should activate. Hmm, something doesn't smell right here. And a couple of interesting questions pop up: (1) Those short sellers made a lot of money. Was it deserved? They made it simply because of the math of what occurred and the laws of supply and demand; there was no underlying weakness in the company that would prompt the share price drop, in my example. (2) Now the SEC, in this rather longish document (just do a search at the top of the page on "counterfeit" and you'll find the relevant section), says naked shorting doesn't actually produce "counterfeit" shares (as Taibbi mistakenly says). But that raises a second question: So could an acquirer swoop in now and grab a $10,000 company (remember Fusty's Freezers is still worth $10,000) for $1,000, as its 100 shares now sell for $10 each?

So imagine Joe Naked Short working in tandem with Vulture Vic. Joe Naked drives down the share price, then Vulture Vic swoops in and snatches up the company for a song. Cool! ... unless you're one of the poor shareholders who got screwed. Remember, no value is being added anywhere here. What Joe Naked and Vulture Vic make, some other shmuck loses.

Now this is an extreme example, granted. Carney does protest that "the overwhelming amount of naked shorting takes place when companies announce abnormally positive results and contrarian traders scramble to fight the tape." In other words, the naked shorters are just really smart, motivated short sellers who can't get their fingers on the shares they need, at that very second, and every second counts.

Okay, maybe true (I haven't researched it). Still, if naked shorting has the potential for massive manipulation, and even if it's done for that purpose only 1 percent of the time, that could be the life or death of a particular small company. So the rare outlier events here could be pretty darn big.

Anyone care to defend naked shorting? I admit to not knowing a whole lot about it. But from what I've seen, I'm pretty skeptical. Instead of trying to preserve naked shorting, I think we'd be better off trying to shore up the legitimate and quite valuable practice of regular short selling. Why not just spend our energy on trying to make ordinary shorting work better so that it's more responsive to a rapidly changing market?

Sunday, 18 October 2009

What We Learn From the Nobel Laureates

I had never heard of Oliver Williamson and Elinor Ostrom until they won the Nobel Memorial Prize in Economics this past week. So, what I know about their work is what I read in the papers. But that is sufficient; somewhere in this blog I wrote that everything you need to know is always right in front of your eyes!

Let us begin with Elinor Ostrom whose research, The New York Times tells us, led her to believe that something called the “tragedy of the commons” was inaccurate.
Ms. Ostrom concluded in her research that the “tragedy of the commons” was an inaccurate concept. Particularly in 17th- and 18th-century England and Scotland, the concept described villagers’ overgrazing of their herds on the village commons, thereby destroying it as a pasture. The solution often invoked was to convert the commons to private property, on the ground that self-interested owners would protect their pasture land.
Setting out to show that the tragedy of the commons is inaccurate is akin to setting out to show that Santa Claus does not exist. It is a curious starting point.

The idea of the “tragedy” came from a half-wit Texan by the name Garrett Hardin. His Wikipedia biography lists his “research” interests: overpopulation, immigration, race and intelligence – you get the idea. The Tragedy of the Commons is his magnum opus in which he argued that a shared social resource is doomed to exhaustion because the individual users will maximize their own interest at the expense of the long term social good. His conclusion: to avoid the ruin, the common property had to become private.

You see the angle. The Tragedy was published in 1968, just about the time when Milton Friedman was being pumped up to bamboozle the nation with his drivel.

So the good Indiana University professor wasted a good deal of time refuting something that did not merit a response. But what did she, herself, have to say on the subject?
Her most recent research has focused on relatively small forests in undeveloped countries. Groups of people share the right to harvest lumber from a particular forest, and so they have a stake in making sure the forest survives. “When local users of a forest have a long-term perspective, they are more likely to monitor each other’s use of land, developing rules for behavior,” Ms. Ostrom said in an interview.
Note the reference to “the relatively small forests in undeveloped countries” and earlier to the 17th- and 18th-century England and Scotland in the Tragedy.

The social system in a pre-Capitalist community is based on barter. In such a system, the members of the society use the common resource to satisfy their personal (including family) needs and not more. So, the common resource survives. Rules merely codify the individual uses that never exceed the capacity of the common resource.

With the rise of Capitalism, the society moves from barter to commodity trading. Now, the objective is no longer the satisfaction of the personal needs but the sale of the commodity for money – an open ended process that is limited only by the number of buyers. If the commodity happens to be fabric which is made from sheep wool, then to satisfy the demand for the expanding British fabric manufacturing, ever more sheep will have to be introduced to the pasture – far above and beyond its capacity. The result is first, overgrazing, and then the replacement of people by sheep. That is what caused the protracted Irish famines starting in 18th century. I thought this was known even to school children – but apparently not.

The Nobel laureate, who, by the way, is a social “scientist”, de-contextualizes the social system she is writing about, as if observing it in an imaginary Mister Rogers’ Neighborhood. That is why what she says comes across as simplistic, to the point of being childish. It is certainly irrelevant to our lives. Imagine we the people approaching Verizon or Chevron to ask for the management of our common resources, airwaves and oil!

For an adult’s take on the subject of the individual’s approach to a common resource within the given conditions, see Pontecorvo’s 1957 Wide Blue Road. You will learn more from this perceptive movie that all the works of all Nobel laureates in economics combined.

The work of Oliver Williamson, by contrast, is on a strictly contemporary phenomenon: the corporation. He discovered that, in the words of the same Times article, “large corporations exist because, under the right conditions, they are an efficient way to do business.” The Wall Street Journal (Oct 13, p. A19) explained his work in more detail:
Mr. Williamson showed that horizontal mergers of companies in the same industry – even those that increase market power and even those where the increase in market power leads to a higher price – can create efficiency. The reason is that if mergers reduce costs, the reduction in costs can create more gains for the economy than the losses to consumers from the higher price.
So Bruce Bid’Em Up Wasserstein was the agent of social efficiency. Also note Professor Williamson’s point of view in using the work “efficiency”. I earlier wrote about this view which is that of finance capital.

The most interesting part of the prize was the citation of the Award Committee that, perhaps innocently, but revealingly all the same, put the utterly incompatible works of Ostrom and Williamson next to each other to produce an anti-regulatory manifesto:
Rules that are imposed from the outside or unilaterally dictated by powerful insiders have less legitimacy and are more likely to be violated. Likewise, monitoring and enforcement work better when conducted by insiders than outsiders. These principles are in stark contrast to the common view that monitoring and sanctions are the responsibility of the state and should be conducted by public employees.
Bernie Maddoff could not agree more.

Saturday, 17 October 2009

New York Times, Better Late Than Never Department

Yves Smith at naked capitalism savages the NYT for, well, stating the obvious with their story Bailout Helps Fuel a New Era of Wall Street Wealth.

She's right. To most sentient observers of the financial industry, that Wall Street was getting a big earnings shot of adrenalin through the bailout was evident after first-quarter earnings were reported. Back then though, as I recall, the media was still mesmerized by "green shoots" pixie dust. They were speculating about how the banks were turning themselves around.

But what we do we have today, two quarters later? A moribund economy (a close to 10 percent jobless rate with foreclosures creeping higher and the other shoe yet to drop on commercial real estate). This isn't the sort of economy you'd expect two quarters after the banking industry started turning itself around. But it is exactly what you'd expect after a massive government intervention to prop up the biggest players in the financial system (there's a good reason the Federal Reserve is prepared to fight Bloomberg News' open record request all the way to the Supreme Court, if necessary). The intervention goosed the Too Big to Fail (Wall Street) sector of the economy, while at the same time arguably juicing the stock market as well. But it was a small, directed intervention that strangely rewarded the culprits behind the financial mess while doing little for the larger economy.

All this has brought us to a weird place, namely the province of the "jobless recovery." This increasingly strikes me as an amusing oxymoron, like "jumbo shrimp." What the hell is a "jobless recovery"? Seriously. Oh, I know technically what it is. I know what you wonk types will say, about GDP expanding even as the unemployment picture stays bleak. But how can you call that creature a "recovery"? It boggles the mind. Consumer spending is what -- two-thirds or so of economic activity? And people can't spend at a normal pace without jobs.

So what the hell is a jobless recovery when the jobless rate is almost double digits? Personally, I think if the unemployment rate is north of 8 percent, we should just automatically call it a recession.

I've always been of the opinion that inflation is more of a bookkeeping problem. It's inconvenient, it does exact a cost (don't get me wrong), and it's downright hazardous to your economic health when it reaches Zimbabwean levels.

But unemployment is a tragedy. Above a certain level, it's senseless. And so I wonder whether we should even be allowed to talk of "recovery" if it's in the face of such high and unacceptable levels of unemployment.

We need the wealth to spread farther than a group of financial institutions huddled on a stub of street on the bottom tip of the island of Manhattan.

Thursday, 15 October 2009

Wall Street and the “Real Economy”

A never-ending subject of thoughtful deliberation among economic and finance professors is the relation between the “Wall Street” and the “real economy” – whether the woes in the realm of finance spill over to the “real economy”.

You can see why the simple question remains an impossible puzzle. The very first step in answering it would be to define finance and explain what is meant by the real economy – without quotation marks. That, the university economics cannot do. Hence, the endless discussions and points and counterpoints.

In Vol. 4, I take up this question in detail. Before then, here is a news item from the New York Times to highlight the relation between finance and the real economy. The article is about the massing of lobbyist to influence the new law overhauling the financial industry.
But since virtually every imaginable company could be touched by the comprehensive legislation proposed by the Obama administration, the surprisingly broad array of lobbyist trooping to Capitol Hill also includes advocates for airlines, pawnbrokers, real estate developers, farmers, car dealers, retailers and energy and telephone companies. They want to make sure any new oversight of the financial system does not lead to tighter regulations of their businesses or make it more expensive for them to finance their operations or hedge their risks.
By far, the most direct link between finance and industry is through money markets, where hundreds of billions of dollars of the corporate working capital are parked to earn a few basis points. Any loss of this capital directly impacts the production and could even disrupt it, as we saw in the aftermath of the Lehman bankruptcy.

The Death of A Deal Man

Bruce ‘Bid’em-Up’ Wasserstein was born a deal maker. He was born in Brooklyn, went to the University of Michigan, studied business and law at Harvard, did a stint at Cambridge, became a Knox Fellow and authored a book, but his true love was deal making. He was called smart, driven, a chess player, a strategist, a tactician, but all he wanted to do was make deals. “In the deal world, there was Bruce, and then there was everyone else,” people said. He thrived in the deal making frenzy and he made deals always and everywhere so everywhere he went turned into the Deal World – the Hamptons, his Midtown office, home, planes, trains, automobiles. “Let’s make a deal,” he would say. And he made deals fast and furious, so fast and furious that once he overloaded First Boston’s phone system. His deals were many and varied: Philip Morri’s purchase of Kraft and General Foods; Ichan’s assault on AOL Time Warner; Kraft’s potential takeover of Cadbury; KKR’s takeover of RJR Nabisco; Texaco’s acquisition of Getty Oil; ABC’s sale to Capital Cities. Sometimes things did not work out. KKR’s takeover of Nabisco was a fiasco. Texaco’s acquisition of Getty led to a $10 billion court judgment. But through the thick and thin Bruce remained undeterred. He made deal making an art, made it a street fighter’s game, made it lucrative for himself and corporate raiders and greenmailers. He created the “Pac-Man defense” and “front-end loaded two-step tender”, built his own firm, sold his own firm, tried merchant banking, returned to deal making and accumulated immense wealth, but his true love remained deal making. On Wednesday, Bruce died. He left a wife, 3 ex-wives, 8 children, a tangled estate and an untold number of undone and as yet to be conceived deals behind.

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.

Sunday, 11 October 2009

Why "Bailout Nation" is Like Water Torture

Early on in this financial crisis (that has now "ameliorated" to become more or less just a protracted mess), the U.S. as a nation stood at a juncture. There were two roads that lay before us: A difficult one that would lead to more short-term pain, but better prospects for a swifter, and more fair, economic recovery. And an easier one that would minimize the immediate pain but that would prolong the necessary adjustments and fail to fix the inherent abuses that led to the crisis in the first place.

Of course we chose the second path. The U.S. has shown itself good at prescribing tough remedies to small weak countries in financial distress that need our help. Yes, metaphorically speaking, they should have their teeth filled without the benefit of Novacaine. But for ourselves, we want only the best in sedation dentistry.

The second path I think we should all agree to name "Bailout Nation," with the obligatory tip of the hat to Barry Ritholtz, who penned a book by that title. Because Bailout Nation, viewed largely, is a philosophy -- that's what we need to understand. There is "Take Your Medicine Nation" -- that would be an adherence to a more primitive (though arguably more just, compared with what we got) form of capitalism. But "Bailout Nation" describes a far different country: socialism for the financially powerful and entrenched.

The "Bailout Nation" approach has some foreseeable, and unpleasant, consequences. To wit: you can either clean up your banking system by punishing bondholders and zeroing out shareholders and encouraging a new wave of banks to take their place -- banks that presumably will act in a more prudent manner in the candy shop of risk. Or you can prop up the old and corrupt institutions and give them enough financial blood transfusions that their gray pallor finally clears, and they start to look healthy again.

By doing the latter -- propping up the old and corrupt -- the trouble is that you're very quietly and insidiously punishing the rest of the economy. That is because, as financial commentators are often noticing now, banks that have to earn their way back to good health also like to sit on their piles of gold, a bit more nervously and conservatively, and charge borrowers a higher rate of interest overall.

We have all seen the stories by now of the large banks putting a borderline usurious squeeze on credit card holders. The irony is being pointed out by financial reporters: these banks are borrowing at near zero percent, only to turn around and hit their subjects with 25, 30 percent interest rates. These wounded banks engaged in this practice aren't doing anything unexpected: they want to widen the "spread" (the difference between what they borrow at and what they lend at) to get healthier. The trouble is, they need this fat spread because they are in such a deep hole and we refuse to let them die (part of the "Bailout Nation" philosophy -- tenet number six, if you will -- is that "certain institutions will be deemed too big to fail and will be protected by the state").

The other problem I mentioned is that the banks simply won't lend out as much if they're ill. And this too we're seeing, as in this new MarketWatch article:
Banks Cutting Back on Loans to Businesses

And the money paragraph:
But if the decline [in lending] is mainly due to weak banks unable or unwilling to lend, then a turnaround in credit creation may have to wait until banks' balance sheets are repaired, a process that could be delayed by further expected defaults in consumer loans, mortgages and commercial real-estate loans.
So the large sick banks that we refuse to let perish will exert this subtle tax on economic growth, for the next umpteen quarters, punishing us for saving them. (Note: I realize that, in this climate, any bank would be more nervous about lending, but the sicker your balance sheet, the more tentative you're going to be -- and we've pretty much guaranteed that the sickest of the sick will be nursed along.)

There you have life in "Bailout Nation." We should get used to it. Instead of taking our pain all at once, we prefer to drag it out, so that the misery goes on and on. Like water torture, if you will.

Thursday, 8 October 2009

Financial Regulation, Theoretical Poverty (1 of 2)

One of the issues being debated these days is the regulation of over-the-counter derivatives, the privately negotiated, customized contracts that exist in a legal world parallel to their standardized, exchange-traded cousins. The Financial Times was surprised that even the European industrial companies had come out against the regulation:
Some of Europe’s industrial companies have warned they could shift their financial hedging away from Europe if proposed reforms of the vase over-the-counter (OTC) derivatives markets go ahead as proposed by the European Commission ... The comments show that opposition to a key part of US and European proposals for reform of the financial system is gathering from an unexpected quarter: industrial companies.
The paper gave the reason for the opposition without, naturally, understanding the centrality of the issue to the current crisis:
Many companies use OTC derivatives, such as interest rate and currency swaps, to hedge routine business risks like fuel purchase and future pension liabilities.
This need of industrial companies for hedging is the genesis of the speculative capital, the latest and most versatile form of finance capital, that is born from the marvelously dialectical transformation of defensive hedging to predatory arbitrage. I was first to explain this metamorphosis in Vol. 1:
The most important point in the rise of arbitrage trading is that the practice develops logically from hedging and, on paper, is indistinguishable from it.

The purpose of hedging is preserving the owners’ equity. The hedger begins with an existing asset (liability) and seeks to find a liability (asset) which will offset its adverse price changes. The purpose of arbitrage, by contrast, is profit. The arbitrageur has neither an asset nor a liability. To that end, he looks for any two positions which will enable him to “lock in” a spread. The two acts are mathematically indistinguishable. What logically separates them is the purpose of each act which translates itself to the sequence of execution of trades. When done sequentially, the act is defensive hedging. When done simultaneously, it is aggressive arbitrage. Otherwise, the transformation of one to the other is seamless.
The sole subject of finance is studying the laws of movement of finance capital and its various forms such as speculative capital. The role of individuals, to the extent that it exists, is incidental.

The centrality of finance capital in studying finance is acknowledged – if only unconsciously and unknowingly – by the mouthpieces of the orthodox economics. They, who never tired of sounding off on the primacy of the individual and his supposed “free will” as an “economic agent”, these days talk of “jobless recovery”. Google the phrase and see how through sheer usage it has become an accepted term of discourse.

Writing in his column about the expanding army of the unemployed, Bob Herbert of The New York Times condemned this point of view without understanding its roots.
The Beltway crowd and the Einsteins of high finance who never saw this economic collapse coming are now telling us with their usual breezy arrogance that the Great Recession is probably over. Their focus, of course, is on data.
In the phrase “jobless recovery”, the news pertaining to the people is grim; there are no jobs to be had. Yet it contains “recovery”. So, what is it that is being recovered? The answer is: the agreeable rate of return of capital. The “data” measures the pulse and performance of capital, which the university professors study and comment about without ever understanding the larger issue surrounding it.

The outward appearance of the phenomena in economic life is deceiving. In fact, the appearances tend to show the opposite of what is actually taking place. Hence, the authority of the great thinkers of the classical economics who showed us the way.

The story-telling school of economics and finance that is in currency now concerns itself with the most immediately visible. Naturally, it gets everything wrong. Here is a full time professor of economics and finance at Yale explaining a crisis that has paralyzed much of the world for the past two years:
“The fundamental problem, as Franklin Delano Roosevelt said in 1933, is fear”, [Robert] Shiller, a Yale University Professor said. The great depression was deepened by a “sense of lost confidence and animal spirits that was a self-fulfilling prophesy. The worry is that we will have the same kind of issue rising again,” he said.
Even academics are beginning to see the superficiality of their theories; the long-present elephant in the room can no longer be ignored. The policymakers always knew it, which is why they practiced “pragmatism”. But in markets dominated by finance capital, pragmatism – doing the “proper” thing given the circumstances – is nothing but yielding to the diktat of finance capital. That is the part that neither the policymaker nor their critics who accuse them of “taking the side of their banker friends” understand. Like the focus on the data that Herbert criticizes, the problem goes much deeper.

I will return shortly with the second and final part of this piece.