Sunday, 19 December 2010

High Frequency Trading and Flash Crash – 3: How the Die Was Cast

Nathan Rothschild, head of the family’s London branch, had an agent in the Battle of Waterloo. Upon seeing that the tide of the war was turning against Napoleon, the agent rode to nearby Brussels and hired a sailor for the unheard sum of 2000 francs to take him across a stormy Channel to England and his boss. With valuable intelligence at hand, Nathan rushed to the London Stock Exchange and feigned selling. The crowd followed, on the belief that Wellington had lost. After the share prices had collapsed during the selling frenzy, Nathan Rothschild began buying, making millions.

Whether this is a true story or a legend is not the point here. The point is ethics.

No, I am not talking about Nathan Rothschild. Good for him, I say. If the goyims were slaughtering one another over money, why shouldn’t a Jew make few a pounds from the mayhem?

The question of ethics pertains to the Rothschild agent. What would you say if he had used a mule instead of a horse, or had waited for a “scheduled” ferry and calmer seas?

Why, such willful delaying tactics would amount to sabotaging his mission. That would be treason, a crime punishable by death at wartime.

Imagine now, if you will, that the Rothschilds had an equally sharp rival family. We call them Rosenzweig.

The Rosenzweigs, too, considered war a man-send opportunity for making handsome profits, but they could not place an agent in Waterloo. What they did, instead, was place a jockey with a fast Arabian horse at the ferry stop on the English side. They instructed their jockey to take a peek at the open message that the Rothschild agent was carrying and rush to the Rosenzweigs with that information ahead of Rothschild’s man.

The scenario is a bit contrived (for a really contrived scenario you have to read Friedman’s “government helicopter” dropping money on the rabble), but you see where I am going with it. Would the ethical dimension of the story change if the Rothschild agent had used a steamboat instead of a sailboat, or if the Rosenzweig man had used a car instead of horse, or one of them had used a cell phone to pass the message along or traveled with the speed of electrons?

These progressively faster means of “getting there” take us in principle from Waterloo to high-frequency trading (HFT).

In principle, but not exactly. That is because in HFT, the dialectical law that the accumulation of quantitative changes results in a qualitative change kicks in and creates a situation with its own peculiarities; there is a long way from the one off stunt of an ear-to-the-ground businessman to the way HFT works in modern, decentralized exchanges. But I started from a technical angle to show that “getting there first” – because there is money to be made from speed – is the driver of both scenarios and the sole purpose of the game. The “fairness” issue – as in the HFT not being “fair” to “others” – is a fig leaf to cover the self interest of those critics of the HFT whose interests the practice threatens. Long before the rise of HFT, brokerage firms touted their fast execution capabilities – like how news organizations tout their speed in covering “breaking news” – as a competitive advantage and selling point. It was only a matter of time before competition and technology would push the speed to its physical limit. That time having arrived, we could now focus on the financial aspects of HFT.

The practical man of finance who started the stock exchanges on both sides of the Atlantic knew that bringing buyers and sellers together, the way it is done in a flea market or a bazaar, would not in itself be sufficient for creating a viable exchange. That was only the first step, a necessary but not sufficient condition.

Why and how a stock exchange is different from a flea market or a bazaar is a relatively advanced topic in economics and finance theory. The space limitations of a blog preclude me from delving into it in detail. But I cannot give the subject a short shrift because its understanding is a condition for understanding HFT. Consider what follows a compromise.

A stock (share in the UK) is a security. A security is the evidence of ownership of notional capital.

Imagine an aspiring entrepreneur who approaches 10 people and raises $100,000 from each for a venture to produce widgets. He gives a receipt to each contributor.

After the completion of the fund raising, the entrepreneur has $1,000,000 in cash. The balance sheet of his corporation (which he has set up to produce widgets) would show $1,000,000 cash under Assets and 1,000,000 under Owners Equity. Separately, each one of the 10 people have a receipt indicating that they have given the entrepreneur $100,000.

Afterwards, the entrepreneur goes to work. He rents a space ($100,000), installs tools and machinery ($500,000), buys the raw materials ($200,000) and hires workers ($100,000). He keeps $100,000 cash for operations.

After these activities, the value of his company’s assets remains unchained at $1,000,000. But the composition of assets is different. Cash is used to buy the components of the production apparatus that will create the widgets. We could say that it is converted into those components. The conversion turns:
  • The original $1,000,000 from money into capital.
  • The people who gave money into investors.
  • The receipts in investors’ hand into securities.
From here the definition of a security as the evidence of ownership of notional capital follows. Capital is notional or imaginary because it is already spent. If one of the investors has a change of heart at this point and wants his money back, he would be out of luck. The entrepreneur would remind him that his $100,000 is already spent – converted into the elements of production. What is more, it is impossible to determine which 10% of the total enterprise belongs to a particular investor. All $100,000s were combined to create a synthetic, organic whole.($100,000 cash is as much a necessary part of operations as wages and the raw material). That, of course, was the plan all along: to spend the money in a precise, purposeful manner which would make it capable of producing profit. It is to this profit that the holder of the security is entitled on a pro rata basis.

System-wide, though, the situation of the investor who wants his cash back is not hopeless. The economic system that creates stocks also creates stock exchanges precisely for that reason: for investors to sell their securities to other investors. The mechanism merely replaces the title of the ownership of the capital but otherwise leaves it undisturbed in the production process.

That is how the stock exchanges are different from a flea market or bazaar. In the latter places, the participants are consumers and producers and what is exchanged is a commodity – worked matter, generally.

In a stock exchange, the participants are capitalists. They are not buying and selling commodities but converting one form of capital into another.

The change of forms of capital signifies movement, which is the defining characteristic of capital – in the same way that breathing is the defining characteristic of live creatures. Yet, it remains unknown to professors and bankers. That is one reason for their profound and often embarrassing ignorance of events taking place around them.

Note, for example, what happens after the widgets are produced. The composition of the company’s balance sheet changes again, reflecting another change of form of the capital. Under Assets, raw material is reduced and the tools are depreciated. But there is now a new item: widget inventory. The widgets are produced and ready to be shipped.

To keep his factory working, our entrepreneur must begin a new cycle of production. He has to buy raw material, pay the rent, pay the workers and also pay the investors. But no one wants to be paid in widgets. They all want money, which means that he must sell the widgets. That is, he must convert his capital from commodity form into money form.

It is no exaggeration to say that, unless you are reading this in a remote village, everything you see around yourself is shaped by that process. A full chapter in Vol. 4 deals specifically with that topic. As a pitch for the book, but also as further background, let me quote a few paragraphs:
During production, the entrepreneur was in full command because he had paid for, and therefore, owned, everything within in the production process. Now, the sale must be affected by buyers – outsiders over whom he has no control.

It would be saying too much to say that like the Blanche DuBois character, our entrepreneur depends on the kindness of strangers to sell his widgets. No hawker of goods ever sat completely passive. Throughout the millennia, the craftsmen in the East and West have used various venues, with varying degrees of subtlety and aggressiveness, to attract buyers. The techniques in all forms revolved around a two prong strategy that is intuitively obvious to a seller: being noticed by the potential buyers and then actually “closing the sale” against the energetic pitch of competitors. The idea of bazaar that exists in one form or other in all early communities, is the practical realization of the strategy to bring all the buyers into one place, to affect what in the modern retail business is called “foot traffic.”

An entrepreneur of the 21st Century, where Capitalism reigns supreme in much of the world, must go beyond these passive measures. He has to actively seek buyers and then entice them to buy his product as opposed to the products of his competitors who claim to offer superior or cheaper alternatives.

Every entrepreneur begins the venture by asking probing questions about the sales prospects of the product he is planning to produce: Will it sell? Who would be the buyers? How long will they continue to buy? What price would they be willing to pay? Who are the competitors?

These are the intuitive and obvious questions. But the complexity of the modern markets demands more than an intuitive approach. It demands a systematic and methodical analysis of the markets, with the goal of turning the subjective, intuitive lesson of selling into a “science” with principles. Hence, the advent of marketing which, alongside finance, is the core subject of all the business schools.


Advertising is the ‘art’ of ‘effecting sales’. Note that there is no reference here to the product. Advertising is the means affecting the sales of any product. In the eyes of a salesman, houses, nuclear waste, electronic gadgets and plots of cemeteries are all products to be sold. Only the sales pitch varies, depending on the product and circumstances. In this way, in advertising, the fundamental, which is the product, becomes an incidental, to be addressed through the manipulation of the form, which is the way the product is promoted. The fundamental is the conversion into money of whatever that is being sold.


On the surface, “affecting sale” pertains to the product, but its target is in fact the buyer. It is the buyer who must be persuaded to part with his money in exchange for the product. What we have in “affecting sales”, therefore, is influencing the behavior of potential buyers – making them buy a product which they would not have otherwise bought. When the focus thus shifts to the buyer and the ways of influencing his behavior, it matters little whether the product serves a real need. If the advertising can create the need and persuade the customer to act on it, the goal of the exchanging product for money is accomplished.
Returning to our entrepreneur, if he cannot sell the widgets, the cycle of capital’s circulation, involving re-ordering raw material, extending the lease, keeping the workers, and distributing profits to investors, would be interrupted. That would translate to a crisis, a phenomenon whose analysis is beyond our subject. I merely note that while commodity-to-money form of capital’s transformation is the most intuitive and immediately accessible, the other forms and the ease of their transformation into one another are no less important in preserving capital’s cycle.

The practical businessmen who started the exchanges did not know these theoretical fine points but they did not have to, in the same way that a six year-old who rides bicycle need not know about the preservation of angular momentum that keeps the bicycle on two wheels.

The businessmen realized that a stock is a title and claim to future steam of incomes. Future profits being inherently uncertain, an element of speculation is always present in stock prices. At times, that aspect of stock trading could get out of hand and disrupt the “equilibrium” of the supply-demand. Under such conditions, the relation of the stock prices and the underlying physical reality of capital could be severed, as it happened in 1907’s Bankers’ Panic.

Then, J.P. Morgan prevented a collapse by ordering wholesale buying of stocks. But the crisis showed the need for a formal mechanism to stabilize the market. Markets were outgrowing the capacity of one individual or firm to control them. That experience led to the establishment of the Federal Reserve in 1913, an institution whose central mission was to act as the “lender of the last resort”.

The Fed was about lending and borrowing money. The stock exchanges needed a buyer and seller of last resort. So it came that the “specialist system” was established in the New York Stock Exchange. Each specialist was assigned a group of stocks in which he had to “make market”: bid for the shares of those who wanted to sell, and offer the shares to those who wanted to buy. Buyers and sellers could not trade with one another the way they did in a flea market. They had to go through the specialists.

Later when the Nasdaq market started, the same function was duplicated there, only in Nasdaq, the title was “market maker” and they were typically the arms of the Wall St. firms such as Goldman, Lehman and Merrill Lynch.

You can see the centrality of the specialist position and how lucrative and privileged it was. Profits were virtually guaranteed. An IBM specialist, for example, would buy the stock from A for $40.125 and sell it to B at anywhere from $40.25 to $40.625. A change in the stock had generally no impact on specialists’ profits. He could maintain the same “spread” between bid and offered prices if that stock rose to $43 or fell to $38. Assuming a daily volume of 200,000 shares, that translated to about $100,000 a day.

Sure, occasionally stocks went south and sell pressure forced the specialists and market makers to dip into their own capital and buy stocks where no other buyer was present. But these instances were few and far in between.

Far more important, the specialists could see the overall buy and sell orders for a particular stock and position themselves accordingly; they could buy for their own account if they saw a strong buy order or sell if there was a sell bias in the market. That is “front running” which has always been illegal. Occasionally a few small time brokers were charged with the practice, but it was virtually impossible to prove or enforce it in the case of specialists and market makers.

Then came the Crash of ‘87. On that fateful October day, as the unprecedented sell pressure mounted and the buyers disappeared, specialist and market makers refused to accept orders. In fact, they refused to answer the phones. And then, they walked out. They had little choice. Their capital was close to exhaustion, with no end to selling in sight. At 3pm on October 19, 1987, no one dared to buy because there was no telling how much further the stock prices could drop. The normal functioning of the market had broken down.

There is a large number of books, reports and studies on the cause of the crash of ‘87. Not a single one of them got the story right. You could not get the story right without knowing speculative capital. Quite a few mentioned “program trading” as the cause of the crash without realizing that “program trading” and its cousin, “portfolio insurance” are the particular manifestations of speculative capital. The rest offered drivel. Here is what Michael Steinhardt, a hedge fund manager who had become the all-purpose commentator on the markets, said: “The stock market is supposed to be an indicator of things to come, a discounting mechanism that is telling you of what the world is to be. All that context was shattered. In 1987, the stock-market crash was telling you nothing.”

Was he wrong! Oh, boy, was he wrong! Never was the stock market so prophetic. But how could a moneyman realize that the stock market was signaling the collapse of the stock exchange system – its destruction under the onslaught of speculative capital? That is what specialists and market makers leaving their posts signified.

A Roundup: The FCIC Republicans and an Intellectually Fraudulent Take on the Financial Crisis

Alas, I'm late to this story, but it was so mind-boggling I had to weigh in with something. The four Republicans on the Financial Crisis Inquiry Commission went rogue and issued their own (slim, fact-lite) report on their findings about what caused the crisis ... beating the publication date for the actual report. Sadly their analysis of the crime scene looks something like this, for the comprehension impaired:


Most disturbing was the report (on Huffington Post -- nice job, guys) that the four Republicans voted to ban the following phrases from the official FCIC report: "Wall Street," "shadow banking," "interconnection" and "deregulation." Which is sort of like writing the history of apartheid in South Africa and not being allowed to use the words "race," "white," "black" and "prejudice."

Anyway, my best contribution at this point isn't opining but stepping back and rounding up the financial blogosphere reaction. So much good has been said that it deserves aggregation and linking (please click through and read each!) without any further commentary from me. So here you go:

Yves Smith, naked capitalism:

How can you talk coherently about the crisis and NOT talk about the shadow banking system, which grew to be at least as large as the official banking system and was the primary object of the various government rescue operations? It’s like trying to talk about AIDS and pretend there is no such thing as intercourse. Similarly, excessive interconnectedness, or as Richard Bookstaber vividly called it, “tight coupling” was another critical driver. AND HOW CAN YOU NOT TALK ABOUT DEREGULATION?!? What is there left to talk about once that is excised? Sunspots?

Barry Ritholtz, The Big Picture:

They released a silly analysis that could have been written by wingnut think tanks like the AEI or others BEFORE the crisis even occurred (and indeed, there are many examples of this findable via the wayback machines of the intertubes). ... The Gang-o-four absolves Wall Street and the banks, blames the government — for everything — and ignores the data that conclusively demonstrate otherwise.

Joe Nocera, New York Times:

To fix a problem ... it helps to know what the problem is. The F.C.I.C., with all those witnesses and documents, could have really helped here. But the paper released by the commission’s Republicans this week reads as if they couldn’t be bothered. It simply reiterates longstanding Republican dogma that could have been written without a $6 million investigation.

Mike Konczal, Rortybomb:

I have to hand it to them. They decided to take one for the team and release this report that implies markets can never fail, only governments. No sources, no numbers, no new info, not even 10 pages, but they put it out there so reporters have the option to go “well, on the other hand the Republicans said this.” That’s how seriously the conservative movement takes ideological warfare.

Paul Krugman, New York Times:

We should have realized that the modern Republican Party is utterly dedicated to the Reaganite slogan that government is always the problem, never the solution. And, therefore, we should have realized that party loyalists, confronted with facts that don’t fit the slogan, would adjust the facts.

Alain Sherter, BNet:

The document is a wholly expurgated version of events that omits key facts while twisting others to fit certain ideological preconceptions.

Nick Baumann, Mother Jones:

In this story, Wall Street, shadow banking, and deregulation had nothing to do with the meltdown. Republicans have been pushing this fairy tale for years.

Dave Ribar, Applied Rationality:

A report on the financial crisis that omits the words, "Wall Street," "fraud," "underwriting," "collusion," and "derivatives" and that overlooks Wall Street's view of most clients as "suckers" isn't worth the paper it's written on.

Ezra Klein, Washington Post:

I'm puzzled by the decision the panel's Republicans made to break away, declare certain words off-limits and release a nine-page report that reads like a long op-ed from a generic Republican politician.

Cardiff Garcia, (on the Republican vote to ban "deregulation" etc. from the FCIC report)

Depending on your point of view, this is either sad, funny, weird, pathetic, or just idiotic.

Wednesday, 15 December 2010

Revolving Whores, Dec. 15 Edition

That didn't take long!

After launching my "Revolving Whores" feature a few days ago, I've already got a second installment as Wall Street greases the palm of another public official, according to Bloomberg:
Theo Lubke, who headed the Federal Reserve Bank of New York’s efforts to reform the private derivatives market, joined Goldman Sachs Group Inc. to help Wall Street’s most profitable firm navigate the looming overhaul of financial regulations.
Ka-ching! Mr. Lubke, your bathtub full of caviar awaits ...

Sunday, 12 December 2010

High Frequency Trading and Flash Crash – 2: A Philosophical Prelude to Part 3

I sat down this morning to write the second and final part of HFT. I knew how the piece was going to end. It would end on a note of uncertainty and low-grade despair, that “nothing to be done” condition familiar to Beckett readers.

But the dialectics of finance is precisely about going beyond the passive acceptance of events just because they are, to influence and shape them. The inconsistency between the seemingly resigned ending and the active world view that drives the dialectics of finance called for an elaboration.

To purposefully shape events, we must know their dynamics and understand why and how they occur. A financial crisis, for example, has its roots in finance. Saying that the lenders’ stupidity or the borrowers’ greed caused it is saying nothing. After such “explanations”, the erudite explainers shake their head at human folly and go their way, leaving the subject exactly where they had found it. To understand the events, we must take them as they develop “on the ground”. Hegel’s assertion that what is real is rational shows us the way to proceed.

To Hegel, the real is what has happened; historical if it involves humans, natural, otherwise.

Rational involves reason and reason involves necessity.

Hegel is saying that what has happened: i)had to happen; and ii)[for that very reason] it can be logically explained.

The critical point in all this is that the “had to” part refers to the internal dynamics of the phenomenon and is defined within its confines and boundaries. There is “nothing to be done” only with the available (including permissible) means within the situation, because those means are either the results or the conditions of the situation in the first place. A cancer-ridden body cannot in itself fight cancer because it is the source of the cancer. The help must come from the outside in the form of dietary change, surgery or chemical intervention.

Far from being a passive justification of the status quo, “what is real is rational” is a call for knowledgeable action – “praxis” in Sartre’s terminology – when the “rational” proves undesirable.

Let me elaborate on this abstract point through an example from the ongoing mortgage/foreclosure mess.

Take a bank – Bank of America (BoA) would be a good example – with a large mortgage portfolio. As part of a CDO securitization, the bank sells 1000 of those mortgages to a Wall St. firm, say, Morgan Stanley. I described the process in the Goldman Case.

Borrowing money to buy a home is a process that must satisfy a variety of legal requirements, which is why the buyers must sign a thick batch of documents on the closing day. One of those documents is the “mortgage” which authorizes the bank to auction off the property and take its money in case of the borrower's default. Another document is the promissory note, which is the evidence and proof that the home buyer has borrowed money from the bank. Yet another document is the title insurance that guarantees that the home is the property of the seller and is now being transferred to the buyer and there is no dispute in that regard. With the rest, we are not concerned here.

Now, attention! Did the bank – the BoA in our example – transfer the notes to Morgan Stanley as part of the securitization process?

This is not a trick question. It does not involve gray areas, competing narratives, conflicting viewpoints and personal interpretations. Like the question of pregnancy, it is the quintessence of a binary question with a only ‘yes’ or ‘no’ answer.

If yes, if the bank did transfer the notes to the trustee and the CDO originator, then it does not have the notes, which means that it cannot foreclose on home buyers who are in default. The first step in seeking judicial relief from a court in relation with a claim is proving the claim. No proof of indebtedness, no case. Period.

If the bank did not transfer the notes to the CDO originator, then the originator – Morgan Stanley, in our example – never owned the mortgages. In that case, the securitization would not have been legal, with almost mind-numbing implications. For example, the originator would have the right to put the mortgages back to BoA. With the mortgages anywhere from 30 to 70 percent underwater, that would wipe out BoA many times over.

It is tempting to ask, Which one is it, then? But that is a sophomoric question concerned with winning a point. Hegel teaches us to look at the facts on the ground for understanding . From the National Mortgage News under the title B of A Disowns Its Own Lawyer's Argument in Fumbled Mortgage Case:
To quell doubts about its mortgage unit's handling of documents, Bank of America Corp. is distancing itself from … itself.

B of A now says that a senior litigation manager .. was out of her depth when she testified in a New Jersey courtroom about the unit's document practices ... In a series of unforced admissions, the B of A manager ... and ... the company's outside attorney described how Countrywide had failed to adhere to the most rudimentary of securitization procedures, such as transferring the original promissory note to the trusts that had purchased the loans, as required under the pooling and servicing agreement.

Both ... said it was standard practice for Countrywide to hold onto the original mortgage notes ... despite securitization contracts that require the notes be physically transferred to sponsors, trustees or custodians.
There! So the original mortgage notes were not transferred to the CDO trustee. But the CDO trustee had sold those notes to public and private funds. Who owns the promissory notes and, more to the point, how the title insurance company handles the title insurance?

From the Financial Times of November 29, under the heading US courts battle with backlog as foreclosures rise:
Florida’s legislature assigned $9.6m earlier this year to set up special foreclosure courts, labeled “rocket dockets”, with the aim of paying retired judges to clear 62 per cent of the backlog by next July.
The article reported that in a 3-month period between July 1, when the money was allocated and September 30, 65,000 cases were “cleared”. It added:
It is a truism that justice delayed is justice denied, but some say that high-speed courts are themselves risky and have an inherent bias towards the banks. “The system is designed to tilt towards the plaintiffs; the easiest, fastest, cleanest way to do this is to just grant summary final judgment and award the properties to them,” says Chip Parker, a lawyer who defended homeowners in Jacksonville.

Lawyers such as Mr Parker allege that these courts show leniency towards the sloppy bookkeeping of the banks, but crack down on homeowners who are ill-prepared.
What “sloppy bookkeeping” are the lawyers talking about? We just saw that the promissory notes were not transferred to the CDO trustees, so the banks could technically foreclose because they were holding the notes.

But often banks cannot locate the notes despite their claims to the contrary. That is the robo signing that you have been reading about.

Mr. Parker the lawyer told FT: “Countrywide was not the exception. Countrywide was the rule. Everyone did it that way, showing that securitization was never done properly.”

He then added: “After this, the judges in foreclosure cases are going to have to start ignoring massive systemic violations of law in order to grant foreclosures … Do we save the financial markets and sacrifice the rule of law? You can’t save both, you’ve got the sacrifice one for the other.”

The rule of law or the financial markets: only one can be saved. One has to choose.

Now you see the source of my interest in the breakdown of law. Starting from the very first post, O Judgment!, I have frequently written on the subject. See here, here, and here, for example.

The breakdown we are witnessing is pervasive and systematic. The Florida bankruptcy courts are merely following a trend set by the Supreme Court and the Federal Reserve.

Law is a mechanism set up to prevent social conflicts and antagonisms from being settled by force – or turning violent. As every thug knows, violence might be a necessary tool in the early stages of establishing a business, but it later becomes unnecessary and even detrimental to the business.

When the established legal system in a society is violated from the top, it is a sign that the dominant institutions of the society cannot continue business as usual under the relations that they themselves had drafted. These institutions force for even more favorable conditions which, through one off court decisions, ad hoc rulings and laws tilted towards the defendants translates in practice to lawlessness.

All these developments are rational. They all develop logically from the inner workings of the system. And they all gradually move the system towards instability and collapse.

HFT is one such development.

Saturday, 11 December 2010

Too Big to Fail, the Book, and Inside Job, the Movie

I just finished reading/watching both of these (okay, I know I'm way late on "Too Big to Fail;" it's been a busy year). Some quick takeaways:

"Too Big to Fail" -- here's what particularly struck me in this fascinating fly-on-the-wall account (in fact, I've never read a more "fly on the wall" book than this one) of the events immediately leading up to the financial crisis in the fall of 2008:

* Christopher Cox, former SEC head: Inept. Clueless. Ineffectual. Stupid. It's truly mind-boggling just how bad this guy was.

* Speed dating, capitalism style: It was amazing how many mergers people were trying to engineer behind the scenes at the fever pitch of the crisis. Goldman buying Wachovia? Bank of America buying Lehman? And the Jewish mothers arranging the hookups were usually Hank Paulson and Tim Geithner (some banking executives even started calling Geithner eHarmony).

* The U.S. could have saved Lehman. Sure, you can parse all the differences between the Bear Stearns situation and Lehman's mess and make a lot of rationalizations for why the two were different -- but once Sorkin shows you how creative and frantic and ad hoc things were behind the scenes, you realize that grounds could have been concocted to save Lehman. The government just decided to draw a line in the sand and see what happened.

"Inside Job":

* If you've read a lot about the financial crisis, much of this film will be like "Sing Along with Mitch." You know the words, the characters, the plot, the outrage that's on slow simmer ...

* "Inside Job" is still a great film because, for my money, it makes its argument about what happened with the most coherence and the least distracting shrillness/gimmickry (plus, where else are you going to hear that old Ace Frehley classic "New York Groove" dusted off?)

* The film's original contribution is the spearing of the academic economists. Watching Glenn Hubbard's facade of reasonableness degenerate to hostility is revealing, as Ferguson pressures him about his connections to the financial industry. Even more unnerving though is watching Marty Feldstein, who seems amusedly detached and really doesn't appear to give a shit about all the havoc that ensued from flawed theories about economics and deregulation.

Revolving Whores

The debut of my new acerbic feature, "Revolving Whores: An Attempt to Shame the Shameless and Expose How Broken Our Damn Government Is." (I'm channeling my inner Denninger today, with some spicy zero hedge-type attitude on the side.)

Today's featured personality: Peter Orszag. (I meant to blog about this earlier in the week, but now Mike K. has alertly jumped on the story; he has some good observations about Orszag's latest career zig).

Reuters lead:
Citigroup Inc. named U.S. President Barack Obama's former budget director as a senior global banking adviser on Thursday, strengthening its ties to high-profile former officials the same week the bailed-out bank finished shrugging off U.S. government ownership.
So a bank that was, not long ago, the largest in the world in assets, the quintessence of "Too Big to Fail," has now paid a (presumably) big contract to free agent Peter Orszag, who will help Citi hit a few dingers out of the park using his special knowledge of all recent things White House.

America, cleanse thyself.

Monday, 29 November 2010

The Ultimate Retail Business Model in the U.S.

Today’s American Banker had an article titled What YouTube Teaches Banks About Customer Experience.

I do not know what YouTube teaches banks about customer experience. But I know what the iPhone and iPad have taught swindlers – hence the connection between the business and crime.

Apple’s business model is to provide cheap apps to a large number of users; about 250,000 apps to over 10 million users. You pay a few dollars for an app that often performs magnificently. Everyone is happy. You, because you got a good application at a next to nothing price, the vendor, who sold tens and maybe hundreds of thousands of apps, and Apple, which gets a cut from all this. The trick is the low price and large volume – the ultimate retail model.

Imagine now that you are a big company with a large number of customers and you go rouge: you begin to charge them a few dollars each month for no reason. Would anyone complain or notice? And if they did, would anyone have time to spend 45 minutes on the phone with “Mary” in Bangladesh to clear a $2 charge?

Exactly. (And if someone complains, refund their goddam few dollars.) So you get to make tens of millions of dollars a month swindling customers and hoping not to get caught.

How does this model work in practice? Click on the following links for the answer. You don’t have to read the articles. Just glance at the heading or the lead paragraph.

Click 1

Click 2

Click 3

Click 4

These are mere samples. Spend a few minutes goolging “class action lawsuit and telecom” and you will be surprised at the pervasiveness of the fraud.

Now comes the punchline: click here to see why your government has 3 branches and why the Supreme Court exists.

Sunday, 21 November 2010

L'Arrogance: The High-Finance Scent That Never Goes Out of Fashion

By now, unless you've been under one of those proverbial rocks, you've heard about the massive, pending insider-trading charges, a story apparently broken by the Wall Street Journal:
Federal authorities, capping a three-year investigation, are preparing insider-trading charges that could ensnare consultants, investment bankers, hedge-fund and mutual-fund traders and analysts across the nation, according to people familiar with the matter.

The criminal and civil probes, which authorities say could eclipse the impact on the financial industry of any previous such investigation, are examining whether multiple insider-trading rings reaped illegal profits totaling tens of millions of dollars, the people say. Some charges could be brought before year-end, they say.
Admittedly, I'm a guy sometimes entranced by small detail, so I found this bit of the article most curious, an e-mail sent by a John Kinnucan, a principal (or analyst) at a firm called Broadband Research LLC (and former portfolio manager at Crabbe Huson Special Fund, so his high-finance bona fides are legit):
Today two fresh faced eager beavers from the FBI showed up unannounced (obviously) on my doorstep thoroughly convinced that my clients have been trading on copious inside information," the email said. "(They obviously have been recording my cell phone conversations for quite some time, with what motivation I have no idea.) We obviously beg to differ, so have therefore declined the young gentleman's gracious offer to wear a wire and therefore ensnare you in their devious web.
My first reaction was: Wow. You could build a whole psychology class around the tone of this e-mail. If you were enterprising, you could even bottle it into a scent to be sold to financiers.

"Obviously," the first thing you notice is how effortlessly the writer captures a breezy arrogance. There's a strong grace note of condescension, as if a visit from a couple of FBI agents is to be treated with the same disdain as the appearance on one's doorstep of a pair of vacuum cleaner salesmen. A sniggering-up-the-sleeve quality ("ah yes, these bumbling little investigator types!"). Self-importance. High-brow sarcasm. Haughty disdain for the rule of law. Megalomania.

Where have we seen this before?

Oh yeah. Throughout the whole damn financial crisis.

Banks ungrateful for being bailed out (remember it made headlines when a few bailed-out CEOs actually managed to say "Thank you, America," in testimony a good year after the meltdown). Banks riding the Bernanke liquidity wave to enormous profits and, with little sense of irony, declaring themselves master surfers and paying out lavish bonuses for their "skill." Indignant workers at AIG Financial Products who couldn't believe anyone would try to reduce their fat bonuses even though their division cratered the damn company. Lord Blankfein telling us that Goldman Sachs is doing "God's work."

Plus ca change, plus c'est la meme chose.

Thursday, 18 November 2010

An Essay On the Emergence of India

During his recent trip to India, President Obama said that India “it not simply emerging. Indian has emerged”.

I concur in principle. But I am not the president of the United States and my assertions will not be accepted as proof. So, I am writing a short essay to explain my concurrence.

In the simple sentence India has emerged, we have no problem with India. The reference is clear and universally understood. But the “has emerged” part is vague because it is obviously metaphorical; as a large country, India was never hidden or submerged. I must then explain: i) what does emerge mean in the context or, to put it differently, in what sense can a large country “emerge”; and ii) what is the evidence that India in practice has accomplished the task, or fulfilled the requirements, of emerging.

Recall that capital takes social relations as it finds them and then, over time, turns them into capitalistic, i.e., transaction based, relations. The transformation is alternatively heralded as “improvement”, “reform”, “modernization”, “progress” and “development” – all words with positive connotations because the yardsticks of judgment are shaped by, and thus favor, capital-based relations.

Take modern. The word is nothing but a reflection and measure of the extent of the intrusion of capital into social relations, a point that Chaplin noticed and relayed in Modern Times. The more the intrusion, the more modern a society is said to be.

To make this point clearer, look at Cavallini’s 1290 painting, The Last Judgment.

Now compare it with Holbein’s 1533 painting, The Ambassadors.

The span between the two works is a mere 240 years. Cavallini’s work, furthermore, belongs to the Renaissance period which immediately preceded modernity. Yet, a sea change has taken place between the two. The Last Judgment looks “old” to us, with an unmistakable undertone of otherworldliness.

The Ambassadors, by contrast, is contemporary and modern. The two men confidently gazing at us could be models posing for a fashion journal in New York City.

The difference, as I previously remarked, is in the transformation of European society from the feudal to capitalist system. The Ambassadors are surrounded by a collection of valuable, traded commodities with the means of navigation symbolizing overseas trade. To capture all that, Holbein is forced to use the oil medium in the same way that modern advertisers use color picture: to accentuate the colors and fineness of the men’s wealth, including their wardrobe. Their pose and gaze is the pose and gaze of successful men of affairs, something that we see everyday in the business section of newspapers. That is why The Ambassadors looks modern to us.

Emergence has the same genealogy. The more capital-based relations intrude into the social fabric of a country, the more “emerged” it becomes. When even the far away villages are conquered in this way, the country can be said to have fully emerged.

Before taking up the case India, though, let us read this short passage from Vol. 3:
This confusing of moral, legal and financial is a common error among those looking at the appearances only. Here is the economic columnist of the New York Times [Paul Krugman] injecting morality into the subject of default: “Advanced countries – the status to which Argentina aspires – regard default on debt as a moral sin.”

In truth, “advanced countries” hold no such view. In the U.S., corporations use bankruptcy for a variety of strategic and tactical reasons – most commonly when they plan to renege on their pension liabilities. More fundamentally, in the Anglo Saxon jurisprudence, there is no inherently immoral or forbidden concept, of the kind one finds in religion. The foundation of this jurisprudence is the commercial consideration of the early stages of capitalism in England.

The “moral aspects” of default about which columnists and scholars of law are in the habit of sounding off are the indignation of the owners of capital at the prospect of losing their money. Because their views and interests set the social and cultural agenda, this view is gradually codified through casuistry and given a moral and ethical cover – and sold to the public as such.

Default is an incident in finance. Starting from the primitive societies in which “recalcitrant debtors … could be put to death and even hewn in pieces by their creditors or sold as slave beyond the Tiber” we arrive at Shylock at the dawn of capitalism who demands a pound of flesh in lieu of his money. His demand, nota bene, is legal, written into an enforceable contract. More humanitarian imprisoning of delinquent borrowers then follows, a “remedy” still in practice in many societies. As commerce develops, usury is recognized as impediment to business and outlawed. But the usurer continues to exist in the margins of the society, supplying the “weak credit” with funds and using various loopholes of the law to enforce payment.

As financial markets grow in size and sophistication, they take on the subject of default – itself a subset of credit risk – peel its social shell and turn it into a tradable commodity. The process begins with the most receptive and “logical” markets such as corporate bonds, where the relative value of credit and the possibility of default are an integral part of pricing; “cost of default” has long been a staple of this market: “Mr. Goldman [a fixed income strategist] says that a corporate bond’s interest rate spread over the government bond curve is the cost of issuer’s option to default.” Shaming, like jailing and maiming, is still used as a way of reducing defaults.

When I was writing these lines in 2005, microfinancing – lending a few hundred dollars to poor peasants to turn them into successful entrepreneurs – had captured the imagination of social reformers as the practical side of Mother Teresa’s dispensing of love to the poor. Its promoter, Muhammad Yunus, received the Nobel Peace Prize in 2006.

I was struck by the shamelessness and the absurdity of the idea. In the Inferno, the sinners’ physical deformities correspond to the kind of sin they have committed. I imagined that had there been a paradise with the same logic of reward, Mother Teresa and Muhammad Yunus would be present there, one with a large bleeding heart, the other with an oversized penis, both overlooking the wretchedness of the earth.

Five years later, the verdict is in, as reported in today’s New York Times:
Initially the work of nonprofit groups, the tiny loans to the poor known as microcredit once seemed a promising path out of poverty for millions. In recent years, foundations, venture capitalists and the World Bank have used India as a petri dish for similar for-profit “social enterprises” that seek to make money while filling a social need. Like-minded industries have sprung up in Africa, Latin America and other parts of Asia.

But microfinance in pursuit of profits has led some microcredit companies around the world to extend loans to poor villagers at exorbitant interest rates and without enough regard for their ability to repay. Some companies have more than doubled their revenues annually.

Now some Indian officials fear that microfinance could become India’s version of the United States’ subprime mortgage debacle, in which the seemingly noble idea of extending home ownership to low-income households threatened to collapse the global banking system because of a reckless, grow-at-any-cost strategy. Responding to public anger over abuses in the microcredit industry — and growing reports of suicides among people unable to pay mounting debts — legislators in the state of Andhra Pradesh last month passed a stringent new law restricting how the companies can lend and collect money.

Government officials in the state say they had little choice but to act, and point to women like Durgamma Dappu, a widowed laborer from this impoverished village who took a loan from a private microfinance company because she wanted to build a house.

She had never had a bank account or earned a regular salary but was given a $200 loan anyway, which she struggled to repay. So she took another from a different company, then another, until she was nearly $2,000 in debt. In September she fled her village, leaving her family little choice but to forfeit her tiny plot of land, and her dreams.

“These institutions are using quite coercive methods to collect,” said V. Vasant Kumar, the state’s minister for rural development. “They aren’t looking at sustainability or ensuring the money is going to income-generating activities. They are just making money.”

Reddy Subrahmanyam, a senior official who helped write the Andhra Pradesh legislation, accuses microfinance companies of making “hyperprofits off the poor,” and said the industry had become no better than the widely despised village loan sharks it was intended to replace.

“The money lender lives in the community,” he said. “At least you can burn down his house. With these companies, it is loot and scoot.”
The last point is crucial. There was always a village usurer. But however hateful he was, he lived in the community and was a part of it. It was inconceivable for him to force a widower to flee the village. He would gain nothing from it.

With the bankers and venture capitalists as usurers – they charge 30% per annum – the indebted widower must flee. There are grand designs for her village.

Has India emerged, then? I must say that it has, in principle. But we have not heard the last of this story yet.

Tuesday, 9 November 2010

A Footnote to the Post Below

Using footnotes in blogs is awkward. It forces the reader to switch back and forth between the main text and footnote, an extra step that disrupts reading. Hypertext suffers from the same drawback.

In a printed page, the matter is easier, but only if the footnote is at the bottom of the page. With a quick movement of the eyes then, the reader can read the footnote and continue with the main text.

In my books I use footnotes in two ways: to provide the source for a material I quote and to buttress the argument I make in the main body of the text. In the post below, I pointed out that when capital cannot generate profits, it will have no reason to borrow money, even if the money is offered at no cost. Under that condition the focus shifts to cutbacks, including dismantling the plant and equipment.

If I were writing that in a book, I would have footnoted it with the following Financial Times story. Under the heading US banks see demand for business loans drop, the paper reported today:
Bank loan officers say that demand for loans from small US companies fell in the past three months, casting doubt on how much the Federal Reserve can stimulate the economy ...every bank reporting a decline in small business loan demand said that its customers had caught back on their investment in plant or equipment.

There was a decline in loan demand from larger companies as well, with 25 per cent of loan officers saying it had fallen compared with 18 per cent who said that it rose.
Does Bernanke know this? That is the subject of the concluding part of the Time Preference/QE series.

Sunday, 7 November 2010

Time Preference, Kim Kardashian, Quantitative Easing, Good Black Swan – 1 of 2

The depth, sophistication and musicality of Persian poetry is unmatched in any other language. Many of the great Iranian poets were believed in their time to have divine inspirations, so perfect is the fusion of form and content in their poems. And then there was the legendary spontaneity. A popular form of entertainment in the court or bazaar alike was throwing 4 impossibly unrelated words at a poet — toe, cow, ocean and Christ, for example — which he then used fil-bedaheh in a 4-line stanza to express an overlooked truth about life. Fil-bedaheh means on the spot, without thinking and contemplation. Such power I think had its roots in the poets’ philosophical and religious world view. If you believed that all things came from God, then all had commonalities, i.e., all were related. It was only the matter of perception of seeing the common link and the skill of putting them into a coherent whole.

The title of this post comes from that tradition, except that there is nothing fil-bedaheh about it. In fact, I made up the title after I had finished the piece, which is not quite the same thing! I, too, am a man of our time, writing in New York of 2010 where, like Ace Greenberg, everyone is looking for a little unfair advantage.


There is, in the standard economics theory taught to all freshmen, the notion of “time preference”. According to this conjecture, “people” — that would be all people: men, women and children everywhere — prefer “now” to “then”; they’d rather have $100 now than one year later. So if they wait one year to get the money, they would demand more, say $105, for their sacrifice. That is why interest rate exists! The difference between $100 now and $105 in one year is the 5% annual interest rate.


On Wednesay, the Federal Reserve announced phase II of its quantitative easing program (QE2), in which it will buy $600 billion of long-term U.S. government bonds over the next eight months. The idea behind QE2 is to “drive down interest rates and encourage more borrowing and growth”.


Gotcha, Ben Shalom Bernanke! Remember your Washington Post article, published just after the announcement of QE2 to soften the critics?
Easier financial conditions [by you pushing the rates lower via QE2] will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment.
Never mind that housing shows no sign of life. What is the story about lower corporate bond rate encouraging investment? You are saying that QE2 will spur growth because it will make money available to businesses now.

But if the rates are lowered, the time preference will be destroyed. That’s what you taught in your Princeton economics course. With zero or very low interest rates, there is no incentive to act now, because the difference between then and now is zero or very little. In that case, why would corporations choose to invest now instead of say, one year from now, huh? What do you have to say to that?


I believe in the narrowest interpretation of time preference: that in our mid to late 50s we tend to be more mature than third-graders. I know that it is not a general or inexorable law.


Between being hanged today and next year, people would choose next year. That is also true of having a colonoscopy, getting an eviction notice, losing one’s job and life's other unpleasantries. Why, the word procrastination would not exist if people always preferred “now” to “then”. But it does, thus pointing to the hidden hedonistic supposition behind time preference: it exists only in relation with acquiring and consuming pleasurable things. The mindset that conjures up time preference, in other words, is that of a Kim Kardashian or a Paris Hilton. The economists representing that mindset take the idea and dress it up in high language and mathematical notations for respectability. Paul Samuelson, whose name pops up whenever a vacuous idea comes up, was one of the most vulgar, and therefore the most outstanding, representatives of that lot. Look at the title of his paper and then read the drivel in the abstract to see what I mean.

Beyond empty-headed women and mountebanks, what gives rise to the illusion of time preference and helps sustain and institutionalize it is the commodity fetishism of a consumer society. That is why this moon-is-made-of-green-cheese nonsense that a first-grader could refute survives. No less than the “anti-establishment” author of the Black Swan divides black swans to good and bad groups. He calls Viagra a good black swan!

Here is a link to Wikipedia on time preference. Do not limit yourself to that site. Google “time preference” and take a look at some of the results — this one, for example, written by 3 inquiring minds from the nation’s premier institutions of higher learning — to get an idea about the level of scholarship and critical thinking in 21st century America.


There is no such thing as time preference in economics. Interest rates do not arise because humans prefer now to then. If that were the case, we would have billions of interest rates, corresponding to the subjective perception of every person on the planet. Quite the opposite: it is precisely because interest rate exists that time has “value”.

Interest is a deduction from profit. It is the share that finance capital claims from the profit of industrial capital. From Vol. 3:
When the rate of return of industrial and commercial capital falls, credit capital must likewise lower its rate. Otherwise, it would have to sit idle, having found no takers. Interest rates could indeed fall to zero and remain there for a long time if commercial or industrial capital cannot generate a profit. Under such conditions, they would have no reason to borrow, as borrowing would only aggravate the loss. In that regard, the Federal Reserve in the U.S. that raises and lowers interest rates to “cool down” or “stimulate” the “economy” merely reacts to market condition rather than shapes it.
These lines were written more than 5 years ago. What are the conditions now?


The industrial capital in the West has migrated to the East and South in search of lower labor costs and higher profits. (Capital has migrated, not its owners.)

Alas, the investment opportunities in the East and South cannot accommodate all the mass of ready-to-be-employed capital. So, a portion of capital in the West is left behind, sitting idle with no place to go.

That cannot go on. It cannot be allowed.


One way of generating employment opportunities for the idle capital is lowering labor costs in the West. If you are reading this in the Western hemisphere, everything you read in your local newspaper about economics and “politics” revolves around this issue. Cameron, Sarkozy, Papandreou, Zapatero, Cowen, Dombrovskis, even Merkel have no higher priorities. I have written about this issue. See, for example, here and here.

This idleness has a physical manifestation as well, but its most telling sign is the large pile of cash that corporations have amassed on their balance sheet.

Economics-professor-turned-the-Fed-chairman does not understand this process; at best he understands it superficially. He is trying to revive the activities of industrial capital by lowering the rates, fancying that with rates at zero or close to zero, the prospect of even low profit rate like 2% will induce corporations to borrow and invest. But the process is not reversible. Corporations cannot be induced to making investment – no matter how low the interest rates – if their investments would not generate income. That is why they have large spare, i.e., unused, capacity. Bernanke absent-mindedly admits that much when he writes that “low and falling inflation indicate that the economy has considerable spare capacity”. When corporations do not use the money they already have – because they cannot – what would they do with more money?


Corporations sitting on a large pile of cash which they cannot invest buy other corporations to benefit from “synergy”. That is the polite word for layoffs – hardly the stuff of economic recovery.


If QE2 will not influence investment decisions and economic recovery, what will it do?

Sunday, 24 October 2010

High Frequency Trading and Flash Crash – 1: The Ones Who Saw It Coming

The ignorant, pompous academics who created “Continuous-time Finance” — ignorant because they were pompous, pompous because they were ignorant — considered it the crown jewel of their intellectual achievements. Happy were those years of success in the limelight, with this one nominating that one for the Nobel Prize who then turned around and nominated this one for the same. Nobels all around, was the happy cry. Nobels to the Crowd!

To understand Continuous-time Finance (CTF), we have to understand Newtonian mechanics and its language, differential calculus.

Newtonian mechanics revolve around key terms like instantaneous speed and constant acceleration. These are not intuitive concepts. The only way of really grasping them is through mathematics, specifically, calculus. In fact, this branch of mathematics was invented by Newton (and independently, by Leibniz) for that very purpose.

Newton was working to solve the puzzle of the working of celestial bodies that begins with the old question: Why does an apple fall from a tree to the ground but the moon does not? The answer is that the moon is constantly falling but is kept in orbit by the centrifugal force of its rotation around the earth. To get to that answer, one has to know the dynamics of falling bodies: how far they fall and how fast. That is the definition of speed.

We calculate the speed of a moving object by dividing the distance it has traveled by the time it takes to travel. The distance between NY and LA is 3,000 miles. If a plane travels it in 5 hours, the speed of the plane is 600 miles/hour.

What about the speed of a golf ball dropped from the top of the Empire State Building? The building is 1,800 ft tall and it takes 10 seconds for the ball to hit the sidewalk.

In this case, we cannot directly divide the distance by time. What worked for the speed of the plane won’t work here because we assumed the speed of the plane was constant, a logical assumption for our purposes. But the speed of the falling golf ball is not. It’s zero at the top of the building, just before the fall. It is quite high — something we need to calculate — when the ball hits the sidewalk. Between these two points, the speed constantly increases. Since space and time are continuous, it is a perfectly valid question to ask: what would the speed of the ball be in, say, 3.21 seconds after the fall, or after it has fallen 329.73 feet? That is instantaneous speed, the speed at that instant. That is where differential calculus comes in. It is a tool for calculating the instantaneous change in the value of a variable (speed or distance fallen, in our example), as a result of instantaneous change in another variable (time).

CTF is the adaptation of this system to finance. It is finance in a “world” in which prices change continuously and instantaneously, just like the distance traveled by a falling golf ball, only that prices are bi-directional. They go up and down.

The first use of calculus in finance dates back to the beginning of the 20th century. In 1900, French mathematician Louis Bachelier published a differential equation describing stock price movement. It is a perceptive and intelligent model. In Vol. 3 I showed how its use decades later significantly contributed to the success of the Black Scholes option valuation formula.

Of course, the stock price changes in the Paris Bourse of the early 20th century were far from instantaneous. But Bachelier reasoned that the sum of instantaneous changes could approximate the price change over longer intervals; that, after all, is what the other half of calculus – integral calculus – is all about. At any rate, the stock prices seemed to set the irreducible minimum level of activity to which one could apply calculus without looking absurd or ridiculous. Sure, one could use calculus to “calculate” the change in the price of a pizza pie “as a result of” change in its size. But that would be a fool’s errand, a pointless and absurd exercise that only an idiot would undertake. So the matter rested there for nearly 50 years.

It must be a cosmic law of fools that if a fool’s errand exists, a fool is bound to show up, if not sooner then later. The fool came in the form of Paul Samuelson. The future “Titan” had set out to make a name for himself and had decided on mathematics as the desired means. If a Frenchman could apply differential calculus to stock prices, the American was going to outdo him and apply it to all prices – a pound of sugar, a house, an airplane engine, a dozen eggs, a cup of coffee, a diamond ring, a bulldozer. He was coming whether prices were ready or not.

A publicity picture that the New York Times used in his obituary last year shows Samuelson against a blackboard with some bogus equations. Here is the picture.

In this picture, the blackboard is used the way a Caribbean Island might be used in the photo-shoot of a swim-suit model: to accentuate the main attraction’s endowments – physical in one case, intellectual in the other. Let us look at it closely.

In the center, there is price-vs-quantity (P-Q) graph, the crudest and most superficial idea in economics, the if-price-goes-up-demand-drops stuff that only a Sarah Palin might buy. That is what Samuelson is teaching. But he has jazzed up that nonsense with the standard notation of calculus. P and Q have become P(t) and Q(t), meaning that they are “functions of time”, i.e., they change with time.

In the upper right hand corner, at about “one o’clock”, P is expressed by a partial derivative equation. The first term is L, which must stand for labor. The second term is t, which is time. The equation is saying that price — any price — changes with “labor” and time. “Labor” is presumably the “price of labor” or wages.

I need to digress here to say a few words on the role and function of math and why we use it.

Take this simple problem. A father is 48 years old; his son, 18. How many years from now will the father’s age be 3 times the son’s?

If all you know of math is arithmetic, you will struggle with this problem; you have to use a relatively complex chain of reasoning to solve it.

Thanks to Islamic mathematicians, however, we have algebra, the science of manipulating the unknowns. Let the unknown “number of years from now” be X. X years from now, father will be (48 + X) years old; his son, (18 + X). For what value of X then (48 + X) is 3 times (15 + X)? Solving (48 + X) = 3 (18 + X), we get X = -3. Negative X means that the event happened 3 years ago, when the father was 45 and the son 15.

Note how math corrected us. We stated the problem in the future tense: “how many years from now will ...”. Math ignored that phrasing and gave us the right answer by pointing to the past.

That is the function and raison d`etre of mathematics: a tool to employ when intuition, imagination or contemplation could not solve the problem, or solve it only with great difficulty. In the example of the falling golf ball, if you do not know how to differentiate a function, you could not possibly know that the speed of a golf ball 3.21 seconds after the fall would be 102.72ft/second.

Return to the blackboard now and look at P(t)and Q(t): Price and quantity are functions of time, meaning that they change with time. What purpose does this addition of “change with time” serve? Time is a condition of experience. There is absolutely nothing in the world, without exception, which is not a “function of” time. We bothered with learning algebra and writing the equation (48 + X) = 3 (18 + X) because it helped us solve a problem. But writing P(t) instead of P merely looks more complex without in any way helping us learn more about how prices change.

Every single expression on the blackboard behind Samuelson is an indictment of the writer, a prime facie evidence of chicanery. Only a complex character – 1/3 pompous ass, 1/3 ignorant fool, 1/3 perspicuous cheat – would put this tritest of facts into mathematical language – and pose in front of it.

(In calculus, the “function of” association is used not for stating the obvious but for signaling the variable with regards to which a function is to be differentiated or integrated. The distance X that a golf ball falls is X = 16t(squared). To find the speed of the ball at an instant, we must differentiate the function with respect to t. So, we say that X is a function of time, t: X = f(t). The differentiation, by the way, yields V(t) = 32t. The speed of the ball 3.21 seconds later would be V(3.21) = 32 x 3.21 = 102.72ft/second.)

Not everyone fell for Samuelson, though. Harvard refused to hire him. The newspaper of the record mentioned the incident in the obituary but used a red herring to spin it:
Harvard made no attempt to keep him, even though he had by then developed an international following. Mr. Solow said of the Harvard economics department at the time: “You could be disqualified for a job if you were either smart or Jewish or Keynesian. So what chance did this smart, Jewish, Keynesian have?”
We could see that Mr. Solow is being disingenuous. Harvard not keeping Samuelson had nothing to do with his smartness or Jewishness or Keynesianism. Only that the pre-Dershowitz, pre-Summers, pre-Kagan Harvard of yesteryears at times saw through the fools and passed on the opportunity to retain them. Those were the days that the nation’s oldest university could have gone either way.

There was of course a reason for Samuelson’s embrace of mathematics, which I pointed out in Vol. 1:
The years leading up to World War II and immediately following it, brought unprecedented advances in technical and theoretical knowledge that culminated in the building of the atomic bomb. Mathematics was instrumental in that success. A skillful mathematician, it was believed, could solve all problems that lent themselves to mathematical formulation.

Pursuing mathematical finance was advantageous in other ways too. It provided a respite from the contentious ideological disputes in economics between the Left and Right that in the era of McCarthyism were beginning to assume an ever sharper, and potentially career-ruining, tone. Research in mathematical finance had no downside risk. It was socially safe, it provided a perfectly respectable line of research and, with luck, it could lead to new discoveries and from there, to fame and fortune.
Even the purest of mathematical thoughts are not completely void of ideological content, so there was a subtext to the use of mathematics, a hidden message of sorts. If Western economics could be described by the mathematics of Newtonian mechanics, it “followed” that economic system of the West was as solid and permanent as the world itself. And it would last that long. That theoretical lagniappe played no small part in facilitating the funding and propagation of Samuelson’s economics.

Ultimately, though, what the man said was drivel. It corresponded to nothing in real life, so it was forgotten. Then came the collapse of the Bretton Woods system in the early 70s and the rise of speculative capital which gave a new lease on life to the application of mathematics in finance.

Speculative capital is capital engaged in arbitrage: simultaneously buying and selling two equivalent positions. That amounts to – and requires – the instantaneous buying and selling of the positions. From Vol. 1:
After any purchase, the speculator faces the risk that what he has just bought will fall in price. That can only happen with the passage of time. It is through time that the price of widgets drops, and it is through time that the speculator fails to find a buyer. Time is the medium through which the risk–and everything else–materializes. To the uncritical, yet practical, mind of the speculator, time appears as the source of the risk. He concludes that if the time between his purchase and sale is shortened, the risks of the transaction must proportionally diminish. In the extreme case, when the time between the two is zero, the risk would completely disappear. In that case, he could earn a risk-free profit. That is because no purchase is made unless a sale is already in hand. When the time between purchase and sale is reduced to zero, the two acts become simultaneous. A simultaneous “buy-low, sell-high” results in a risk free profit. That is arbitrage. The speculator has found the Holy Grail of finance: making money without risking money.
Speculative capital rapidly expanded to dominate the trading pattern of financial markets. The expansion required people skilled in mathematics to detect the arbitrage opportunities. These people were found in the math and physics departments. The newcomers applied themselves and their skills to their new field and soon produced a voluminous body of work in finance that seemed coherent, even revolutionary and groundbreaking. The Black-Scholes option valuation formula is perhaps the most outstanding example of their accomplishments.

That is how continuous-time finance came to be, with the practitioners of the discipline becoming known as “quants” or “rocket scientists” by virtue of their mastery of mathematics.

But they knew nothing of economics or finance. In Bernestein’s early 90s bestseller, Capital Ideas, tellingly sub-titled The Improbable Origins of Modern Wall Street, there is a telling passage about them:
The gap in understanding between insiders and outsiders in Wall Street has developed because today’s financial markets are the result of a recent but obscure revolution that took root in the groves of ivy rather than in the canyons of lower Manhattan. Its heroes were a tiny contingent of scholars, most at the very beginning of their careers, who had no direct interest in the stock market and whose analysis of the economics of finance began at high levels of abstraction.
“No direct interest in the stock market” means no background in economics and finance. And the “high levels of abstraction” that Bernstein observed likewise had to do with forcing mathematics on finance without regard to, or awareness of, its social aspects. We saw in Vol. 3, for example, how Black, Scholes and Merton priced the options and yet got the options fundamentally wrong.

The consequence of this ignorance, as always, was in prediction of the future. If you know the relation between mass, force and acceleration, you could predict with precision the behavior of a satellite millions of miles from the earth. You could surmise the existence of a planet even if you could not see it.

Economic relations are never that exact, but fundamentals still apply. If you know that profit rate tends to fall, you would not be surprised by the persistent unemployment in the West or the events taking place in Europe; you would not ask, How is it that as the people’s health improve, they have to work longer and harder for less wages and a smaller safety net?

Or, if you know that arbitrage is by definition self-destructive, you would expect a crash in financial markets – if not sooner, then later.

But the pioneers of modern finance knew nothing of these principles. They noted the increase in trading and observed that it led to lowering spreads. But they interpreted it as the march of capital markets towards “efficiency”, which to them meant low trading costs. And since the markets were only rising, it stood to reason that everyone would soon be trading.

The new world of CTF thus envisioned was a bona fide Norman Rockwell tableau in which everyone constantly and incessantly traded: businessmen in New York during their commute, Valley girls in LA on their way to parties, salt-of-the-earth farmers in the Midwest, the rednecks in the South, retirees in Florida, blacks in Watts and smartly dressed preppies in Greenwich – they all traded all the time. Jews, too. Yes, most definitely Jews, too.

The real life turn of events proved a tad more Gothic.

Tuesday, 12 October 2010

The Foreclosure Mess: 7 Reasons Why It's Much Worse Than You Think

We're in a big, big mess with home foreclosures in the U.S. (foreclosuregate, if you will). I'm not sure many people understand the awful magnitude of this train wreck. So here is my look at seven reasons why it's much worse than you think. Below I partly synthesize much of the fine analysis being done elsewhere (Mike Konczal has been absolutely superb on this issue, as has Yves Smith).

Quick background: In 1996, a private company was formed called Mortgage Electronic Registration Systems, or MERS for short. Why should you care? Chances are better than 50-50 that, if you own a home, MERS officially recorded the mortgage -- probably unknown to you. MERS is headed by R.K. Arnold, a former U.S. Army Ranger with a law degree from Oklahoma City University, ranked #104 in the nation this year by the Association of American Law Schools.

Now you may be worried that Arnold, a guy who apparently doesn't exactly have a stellar legal pedigree, is the CEO of this giant institution that registers millions of mortgages from Big Sur to Beacon Hill. Don't be. Because MERS doesn't have any real employees. It's kind of a shell. MERS Treasurer William C. Hultman revealed as much during a deposition in Bank of New York v. Ukpe:
Q I thought, sir, there’s a company that was
formed January 1, 1999 [sic], Mortgage Electronic Registration
Systems, Inc. Does it have paid employees?
A No, it does not.

Q Does it have employees?
A No.

Q Does MERS have any employees?
A Did they ever have any? I couldn’t hear you.

Q Does MERS have any employees currently?
A No.

Q In the last five years has MERS had any
A No.
Why the heck would you form a company, then not hire anyone? Well, what's the purpose of your company? If you're making widgets, you need widget inspectors, widget engineers, widget fabricators etc. But MERS was created for mortgage banks to dodge paying local recording fees (and doing the associated paperwork, one assumes) when mortgages were re-assigned. So let's say Wall Street wants to bundle a bunch of mortgages into a security, which then is cut up into teeny pieces to go into another security, which is diced once more to go into another security ... thanks to MERS, you can do all this with a minimum of hassles/expense.

Cool beans, until it all starts to come apart at the seams, and you realize that the companies making the original loans were extending credit to people who could barely fog a mirror in the midst of a huge housing bubble and you've got to foreclose and where's all that paperwork you're going to need dammit?

So, without further ado, here are seven reasons we're in the middle of a really epic mess right now:

1. MERS may be a fraudulent company at its very core.

This becomes obvious in the answer to a simple question: How does a company with no employees foreclose on millions of homes across the U.S.? Easy. Apparently it "simply farms out the MERS Inc. identity to employees of mortgage servicers, originators, debt collectors, and foreclosure law firms." MERS even sells its corporate seal for $25 on its Web page. This corporate structure "is so unorthodox as to arguably be considered fraudulent," says Christopher Peterson, a law professor at the University of Utah.

Exacerbating this problem: no state legislature or appellate court ever gave its stamp of approval to MERS in the first place, so it has no acknowledged legitimacy.

2. Widespread fraud may be taking place to cover up the lapses of MERS.

Mike at Rortybomb does a great job explaining how your mortgage consists of two parts, a promissory note (you promise to repay the lender X dollars, and under what conditions, and with what penalties for missing payments) and a mortgage, known in some states as a deed of trust. Mike reduces all this nicely: "The note is the IOU, it’s the borrower’s promise to pay. The mortgage, or the lien, is just the enforcement right to take the property if the note goes unpaid." Common sense dictates that both parts are necessary to move to foreclose. You can't apply the enforcement without knowing the terms of the note and how much remains unpaid.

But as Yves Smith alarmingly details at naked capitalism, the banks apparently got impatient with the messiness of paper notes in an electronic age. Again, without anyone's approval to do this (no courts signed off, no legislatures gave authority), it looks like they converted physical notes on a massive scale to electronic documents -- safer, cheaper, easier to store etc. ... and destroyed or misplaced a lot of those original notes.

The trouble is when the homeowner being foreclosed on demands that the note be produced. The ensuing document scramble has led to fraudulently created replacements. It's hard to say on what scale this is occurring, but Yves included a chilling quote that she says came from the CEO of a big subprime lender, who defended the practice of transfers lacking paper notes, then had a nervous moment of doubt: “Well, if you’re right [that it's a problem], we’re f**ked. We never transferred the paper. No one in the industry transferred the paper.”

3. This mess is greatly complicated by long, complex chains of securitization.

Mike at Rortybomb provides a good diagram. Start with Joe Homeowner, whose mortgage is originated by say Easy Mortgages 'R Us. Easy Mortgages 'R Us passes the note to the next link in the chain, a sponsor for the security being created (say it's Bank of America, which will scoop up a thousand mortgages, including Joe Homeowner's, and turn them into a product called a residential mortgage-backed security). Then there's a depositor that stands between Bank of America and the trust itself for the mortgage-backed security.

Phew. That's plenty complex. But Mike gave readers only the short form. The residential mortgage-backed security can itself be bundled with other similar securities into a creature called a collateralized debt obligation, or CDO (that should sound familiar from Congressional hearings). And then the CDO can be sliced up and bundled with other strips of CDOs into something known as a CDO squared. Now do it one more time and you get a CDO cubed.

Now remember that old saying: a chain is only as strong as its weakest link. Now here are the many links we've just created for Joe Homeowner's mortgage:

Joe Homeowner --> Mortage Originator --> Sponsor --> Depositor --> Trust for RMBS --> CDO --> CDO squared --> CDO cubed. Moreover, I've probably left out a few entities on the CDO level; I'm sure they use similar intermediary units as the RMBS to create their securities.

Exacerbating this problem: The chains were created too quickly, during what turned out to be unstable times (a bad real estate bubble being inflated). So they're not even relatively robust chains.

4. Ladies and gentlemen, I present: Lawsuit-palooza.

Mike delves into this. Foreclosuregate is a full employment act for lawyers. You could have lawsuits anywhere up and down that chain of document transfer. Investors in the mortgage-backed securities will sue servicers. Homeowners will sue on being foreclosed on, demanding to see the note (with the number of suits increasing exponentially as there are more victories, creating a crushing backlog of cases in our legal system). Investors in the securities will jostle for position and battle with each other, the junior debtholders aligned against the senior. The RMBS trust will go after the sponsor for dumping mortgages on it that lacked the proper paperwork.

5. This will be resistant to fixes, for one, because the mortgage-servicer system for the securities is badly set up, with all the wrong incentives.

Mike nails this one too. The smart way to fix these problems would involve lenders working with homeowners to pare down the loan principal for deeply underwater homes. This approach has been shown consistently to work out better for all parties than foreclosing. At the same time, the lender could take the opportunity to remedy the defective paperwork.

But the mortgage servicer, the one who controls what happens with the mortgages that are now embedded in a security (or maybe multiple securities -- remember those CDOs squared?), doesn't have an incentive to do this. His incentives are narrowly structured: he gets fees, on a certain schedule, for foreclosing. He doesn't get paid for the time-consuming process of working out a solution that would ultimately benefit the investor in the security and the homeowner as well.

In fact, as Mike notes, securitizations must be passive entities to win a bunch of tax breaks. As such, they can't do much hunting down of notes or anything else, it seems, without risking losing their tax-exempt status. A really miserable setup, which is going to be an obstacle to resolving this mess.

6. This will also be resistant to fixes because it's going to be hard to wave a magic wand on the federal level and make the problems disappear.

This situation is playing out locally, not federally -- county by county, state by state. And as the political heat builds on the big, bad banks -- much of America already hates them for their oversized bonuses, for their lack of repentance after driving the economy into the ditch, for the bailouts that saved their asses while leaving double-digit unemployment in its wake -- it's going to be hard for Congress, operating under the klieg lights, to ram through the kind of legislation that could straighten things out. Congress is already perceived as being snugly in the pockets of Wall Street. One thing is for certain: NOTHING will happen before the election. This is a live third rail right now.

7. MERS owns more than 60 percent of U.S. mortgages.

I haven't seen anyone sort through the implications of this, but I've seen in the comment sections of blogs, some people sniffing about, sensing the implications. Namely: I make regular mortgage payments, I have great credit, but what if I ask to see my note? What if they can't produce it? Does that then make me foreclosure proof? This will add an interesting element to valuing more than 60% of the mortgages in this country. How much will Joe Investor pay for the right to payments from a mortgage that may be "foreclosure proof"?

So there you have it. Seven reasons why we really need to be paying attention to the mortgage mess. It's hard to overstate how serious it is.

Verdicts on TARP: What I Wish I'd Said

When the authority of TARP recently expired, a predictable flurry of opinions made cases for and against the largest bank bailout Western civilization has ever known. I could weigh in too, but I found someone who expressed my sentiments so well, I'd just like to quote her for a few short paragraphs.

Alice Schroeder was writing in Businessweek about Charlie Munger, Warren Buffett's right-hand man, who rather scornfully told an audience of Michigan college students that we "shouldn't be bitching about a little bailout" of the banks. Munger also said, in a curious application of the second-person pronoun (is he secretly from another civilization? or planet?), that the bailouts were "required to save your civilization." (The phrasing carries the whiff of the moral harangue from the elder who knows best; one imagines gramps pulling his cracked leather belt from his trouser loops and announcing to the youngster about to get a good strappin', "I'm doing this for your own good.")

And this is Schroeder's very intelligent response (my bold):
... the problem is the false dichotomy it presents. The choice wasn't between the bailout or no bailout. It was between the bailout we financed, which didn't resemble capitalism in any known form, and a bailout more intelligently executed.

No one made us bail out shareholders along with the banks' bondholders. We didn't have to preserve institutions that are still too big to fail in any meaningful sense of the term. We could have propped them up temporarily, then recapitalized them as smaller, more manageable entities, with former equity holders assuming the cost of the risk they assumed.

We missed the chance to reduce systemic risk by comprehensively rewriting regulation for the financial-services industry. Instead of withdrawing government guarantees, we increased them. So there are plenty of reasons to complain about the bailouts.

Monday, 11 October 2010

The Laborers of the World! Behold the Three Nobel Prize Winning Labor Economists: Larry, Curly and Moe

In an ideal world, I would not have bothered with this year’s three Nobel Prize winners in economics; they would not have merited a mention. But this is not an ideal world.

According to the New York Times, three men won the Nobel Prize in economics for their work on “markets where buyers and sellers have difficulty finding each other, and in particular on the difficulties of fitting people to the right jobs.”

So, in a nutshell, the contribution of prize winning scholars to economics is applying the business model of dating services to the labor market.

As for the specific applications of their research:
Some of the applications of the research include understanding why unemployment rises during recessions, why similar workers get different wages, why wages do not fall much during recessions even though that might make additional hiring more attractive to employers, and how so many people can be unemployed even when there are a large number of job openings available.
Three mature, presumably fully developed adults trained as economists want to know why unemployment rises in times of recession.

Without having the slightest familiarity with their plans, let me then predict their future research topics: why some work in factories, others in department stores and still the third group in banks? Why some workers commute long hours and some don’t? Why do workers look different? Why are some workers men, others women?

But let’s not laugh, even though the characters are clownish, as behind their seemingly idiotic research stands a serious and sinister purpose. Why else would their research be funded?

Note, for starters, “why wages do not fall much during recessions even though that might make additional hiring more attractive to employers”. You do know where this line is going, right? In case you don’t, the Times spells it out for you:
Their work has suggested, for example, that unemployment benefits can have the unintended consequence of prolonging joblessness by making it less costly to be without work.
Unemployment benefits prolong joblessness. That’s one conclusion for you.

There is more. According to Robert Shimer of the University of Chicago:
“Most of these models suggest that even in a depressed economy, more generous unemployment benefits tend to raise the unemployment rate.”
And according to Prof. Lawrence Katz of Harvard:
“If you make it harder to hire and fire, then you end up with what’s called a sclerotic labor market, with less movement between jobs and more long-term unemployment.”
So, now we “know” that: i) the unemployment benefits increase unemployment; and ii) unemployment is the result of labor market regulation.

The logical policy directive, then, if you are a politician who really cares about the unemployed? Why, cut the unemployment benefits and make sure that workers are not protected by regulation.

Let me end with a question of protocol.

Aren’t three Nobel Prize winning academics entitled to a respectful treatment of their work, without being called stooges? Can’t disagreement with them, no matter how strong, be polite?

The answer is, No. It would have been Yes, if the agenda of their research had been their own, set by them. But it is not. The purpose of their research is to ennoble the ideas of businessmen beneath the veneer of science. And not ordinary, everyday businessmen, but the most self-serving, vicious, narrow minded and ignorant of the lot.

In Opinions That Men Hold, I quoted Mortimer Zuckerman from a Wall Street Journal opinion piece. Here is a longer paragraph of what he wrote:

If there is one great policy failure of this recession, it’s that we have not used the crisis to introduce structural reforms. For example, we have a gross mismatch of available skills and demonstrable needs. Businesses struggle to find the skills and talents that are needed to compete in this new world. Millions drawing the dole to sit around should be in training for the jobs of the future that require higher educational skills.
There is a gross mismatch of available skills and demonstrable needs.

People drawing dole to sit around and do nothing.

If there is one great policy failure of this recession, it’s that we have not used the crisis to introduce structural reforms”, i.e. cut the unemployment benefits and do away with labor regulation.

Sound familiar?

Enough said.