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.