Saturday, 30 January 2010

Why Structured Finance?

It's a provocative meta-question that has preoccupied me a lot lately. My question is meant to be a loaded one, as in, "What is the value of structured finance?"

To start out, Wikipedia does a serviceable job of getting us going, definition-wise:
Structured finance is a broad term used to describe a sector of finance that was created to help transfer risk using complex legal and corporate entities. This risk transfer as applied to securitization of various financial assets (e.g. mortgages, credit card receivables, auto loans, etc.) has helped to open up new sources of financing to consumers. However, it arguably contributed to the degradation in underwriting standards for these financial assets, which helped give rise to both the credit bubble of the mid-2000s and the credit crash and financial crisis of 2007-2009.
Okay, let's start by looking at securitization: specifically, securitization of mortgages. That's a hot topic. We'll pay a visit to a site I found called Derivative Dribble, written by Charles Davi. He's the self-described resident derivatives wonk at the Atlantic Business Web site. He aims for lucidity when he writes -- kinda like me actually. Here's how he begins his explanation (the bold is mine):
We will explain how securitization works by first exploring the most basic motivation for isolating assets: access to cheaper financing. Assume B is a local bank that focuses primarily on taking deposits and earning money through very low risk investments of those deposits. Further, assume that B is a stable and solvent bank, but that it lacks the credit quality of some of the larger national banks and as such it has a higher cost of financing. This higher cost of financing means that it can’t lend at the same low rates as national banks. B’s local community is one in which home values are high and stable, and as a result the rate of default on mortgages is extremely low. As such, B would like to be able to compete in the local mortgage market, but is struggling to do so because its rates are higher than the national banks. What B would really like to do is borrow money for the limited purpose of issuing mortgages in its local community. That is, B wants to separate its credit quality from the credit quality of the mortgages it issues in its community. Securitization is the process that facilitates this isolation.
So what do we have in Bank B? A stable, solvent bank that makes low-risk investments. Hmm. I know what you're thinking -- if only we had a few more of those around! So if you cleave to one view of finance -- that your friendly neighborhood bank should be making low-risk investments and not doing anything too dangerous -- then you're probably ready to give up on securitization already. But let's keep going.

Bank B wants to grab some market share in its community, where home prices are high and stable. (Ah, did you catch that? High and stable ... so we're postulating a community rather like Lake Wobegon, where all the women are strong, all the men are good-looking, all the kids are above average -- and all the home prices are high and stable. So you may wonder -- what happens when Bank B tries this same strategy, but home prices are low and volatile, or only appear high and stable but are actually poised for a crash?)

Moving on: "B wants to separate its credit quality from the credit quality of the mortgages it issues in its community." B wants to enjoy the same solid credit profile of a large national bank and save a few basis points on the cost of its funds. Sounds like a win-win, right? Consumer gets a cheaper loan, B gets access to cheaper financing, so what's not to like?

Well, why does B have lower credit quality and access only to more expensive financing? Sure, it could be simply due to B's smaller size. But what if it isn't, not completely? What if one reason B's credit quality lags is that, even though it appears to be a stable institution, its loan agents aren't the sharpest saws in the shed. Not by much -- I mean not enough to get it into trouble really -- but should it really be allowed to simply pass its credit risk, even if small, down the chain?

Or here's another thought: Let's even say Bank B is perfectly responsible, but once it gets into this securitization business all of a sudden something happens. Its incentive structure changes. It's skimming a fee off these loans and not holding them anymore, so who's to worry about the borrower defaulting? All of a sudden Bank B basically starts flinging beef into the securitization machine to be turned into tranche patties of mortgage securities.

Now here's the next step Davi outlines:
We know that so long as B owns the mortgages, B’s creditors will still consider B’s credit as an institution when lending to it, even if that lending is for the limited purpose of issuing local mortgages. The solution to that problem is simple: B sells the mortgages off shortly after issuing them. But to whom? Well, common sense tells us that investors are not going to be too excited about buying mortgages piecemeal. So, B will wait until it has issued a pool of mortgages large enough to attract the attention of investors. Then, it will set up a special purpose vehicle (SPV) where that SPV’s special purpose is to buy the mortgages from B.
So B is out of the picture now. Phew. Or is it? Look over news stories from the past two years and count up all the banks that tractor beam-ed in their structured investment vehicles after these entities began to flounder financially. And who invented the SIV back in 1988? A bank that right now isn't exactly a shining beacon of financial stability and good sense: Citigroup.

Time to skip right to his conclusion:
Thus, the rate paid on the notes issued by the SPV will be determined by examining the credit quality of the mortgages themselves, with no reference to B. Since the rate on the notes is determined only by the quality of the mortgages, the rate on any individual mortgage will be determined by the quality of that mortgage.
Now let's think hard about this. These mortgages are being sold on to investors. All the securities will have to be rated by a big-name rating agency, say S&P. Now how many S&P analysts do you think live in our imaginary Lake Wobegon? No, they're in their New York City bunker. They're not going to know anything about the local steel mill rumored to be in danger of closing, about the series in the newspaper suggesting a toxic underground plume of chemicals may be spreading near the neighborhood of homes whose mortgages they're rating, about the fact half these places are in a neighborhood starting to go to seed. Instead they'll just look at the area's default rates, sales prices, then crunch numbers in some model.

Of course the best people to judge what's going to happen to these mortgages probably sit right in the headquarters of Bank B. They're doing banking for the community's needs. The bankers drive through these neighborhoods all the time. They see fresh construction projects on the east side, they see acts of vandalism on the north side, they know which business are doing well, and where, and have some sense of the community's future.

Okay, that went much longer than I expected! Enough for today. But I've got many more thoughts (and much more material) for future installments of this look at structured finance.

Monday, 25 January 2010

The Driver of Social Change – (Epilogue)

Why did I choose an obscure dispute over the regulation of derivatives to expound on the macro themes of social change and public alienation?

The reason is that the dispute goes to the heart of the matter. It is the heart of the matter – the definition of finance, the dialectics inherent in a dispute (that is pregnant with new developments), the abstract nature of the argument (that goes over the collective head of the hoi polloi) and the uncompromising position of the parties (who know what the stakes are) – are all there.

Let us begin with the definition, which is a highlighting of relations. The definition sets the direction of the investigation by establishing the investigator's point of view, his angle of vision to reality. If it is set right, things will fall into place.

Here is a finance professor writing to the editor of the Financial Times to volunteer his unsolicited 2 cents about the crisis :

First, “finance” must not be considered as one homogeneous discipline. The traditional finance (asset management, corporate and international finance) did not create the crisis, but the mathematical finance/economics that invented the structured products certainly played a part because they feed the financial markets’ appetite for generating excess profits based on non-existing assets.
Finance not a homogeneous discipline!

Finance concerned with asset management and corporate finance. (Thanks, Paul Samuelson!)

Mathematical finance “inventing” structured products!

With this appalling insubstantiality as the starting point, our professor could not go far – or at all.

Finance is the discipline of studying finance capital. Finance capital is capital in circulation that is evolved to the point of subjugating the industrial capital, the capital in the realm of production.

Capital in circulation – historically its two dominant forms were merchants’ capital and bank capital – is necessary for the realization of the value of products; a product must be sold for the profit in it to be realized, hence the critical role of say, merchants’ capital, that delivers the products from the producer to consumers. In that regard, while it logically plays a subordinate role to the industrial capital, its existence is nevertheless necessary, because without the conversion of commodities into money, the production cycle would cease.

From this historical position of being a “humble servant” of the industrial capital, capital in circulation evolves to the point of dominating the tempo of the entire production process, including that of industrial capital.

In the previous volumes of Speculative Capital, I touched upon the nature of this transformation. In the upcoming Vols. 4 and 5, I will delve into the subject in further detail. But two words that I just used need elaborating.

One is “subjugate”. What does the word mean when applied to the relation of two forms of capital?

For the answer, consider the car market in the West, especially in the U.S. Whilst previously cars were purchased, they are now leased, typically with 3-5 year terms. The change was brought about, driven and dictated by the funding exigencies of the finance capital that resides, among other places, in the financial subsidiaries of auto manufacturers.

The design engineers, the marketing executives, the raw material producers and the parts suppliers are then forced to react to the fact that the average life of the car on the road is reduced to the terms of the lease. That is the dominance of production by finance capital.

Or take a case from the aviation. Two recent events, the test flight of Airbus A380 and Boeing 787 made the news. While the A380 is a totally new plane with new concepts, the 787 is a rehash of the existing lines. Still, the plane was more than 2 years behind in the delivery schedule and experienced considerable design difficulties. Why did Boeing engineers who invented the mass production of the commercial aircraft have such a hard time with the latest model? From The Financial Times of February 27, 2004:
Boeing has left it too late to catch up with Airbus in modernizing its commercial aircraft range because shareholder “short-termism” would not allow the scale of investment needed, the head of BAE Systems claimed yesterday … The failure to renew its product range resulted in Boeing being overtaken by Airbus in terms of deliveries for the first time in 2003 … Sir Richard Evans, the outgoing chairman of BAE … estimated Boeing would need to spend between $40bn and $50bn over the next 10 to 15 years to “match” Airbus’s product range.
Note that the culprit is not financing, in the sense of the availability of capital, but the speed of the turnover of finance capital that has a tendency to increase, leading to the “short-termism” of the executives.

The other word is “evolve”, as in “capital in circulation evolves to the point of dominating the tempo of the entire production process”. The word has a historical connotation. It includes expansion and growth – both, quantitatively in size, and qualitatively in form.

For the size, it will suffice to quote from the finance professors who regularly cite that the size of “finance" as a percentage of the GDP has doubled from about 4% in the mid 1970s to about 8%. In terms of form, there is of course the rise of speculative capital, the latest and most aggressive form of finance capital which reaps profit from volatility. From Vol. 2:
Derivatives are the functional form that speculative capital assumes in the market. This form is fundamentally a bet. But like the bodies of the damned in the Inferno whose deformity corresponds to the sort of sin they have committed, the particular composition of each derivative corresponds to the sort of arbitrage opportunity that speculative capital intends to exploit. Arbitrage opportunities are many and varied; hence the confusing array of derivatives.
It was the expansion of speculative capital, being pushed by one side and resisted by the other, that took the form of the fight over the regulation of derivatives.

The U.S. side demanded constant marking-to-market, a practice that presupposes trading. That is the realm of finance capital.

The “end users”, all industrial companies representing industrial capital, wanted to prevent finance capital from getting a foothold within their accounting system, and eventually, their production cycle.

For the time being, the two sides being approximately equal in political power, the matter ended in a draw. The two sides agreed to disagree. But we have not heard the last of this dispute.

What I discovered theoretically about speculative capital, speculative capital and its agent know instinctively. From the New York Times of April 27, '08, describing a meeting in which then Treasury secretary Rubin got uncharacteristically angry in a meeting in which he was trying to block the regulation of derivatives.

But on at least one occasion, Mr. Rubin lined up with Mr. Summers and Mr. Greenspan to block a 1998 proposal by the Commodity Futures Trading Commission that would have effectively moved many derivatives out of the shadows and made them subject to regulation ... At an April 21, 1998, meeting with Brooksley Born, the chairwoman of the commodities commission, Mr. Rubin made no secret of his feelings about her proposal. “It was controlled anger. He was very tough,” Mr. Greenberger [then director of trading and markets at the CFTC] recalls. “I was at several meetings with him, and I’ve never seen him like that before or after”.
From the Nice Jewish Boy to a bully in a few seconds! One more word from Brooksley Born and Bob Rubin would have pulled a knife on her!

Why this uncharacteristic anger? Why the Treasury secretary of the U.S. who, by all accounts is a mild mannered, almost shy, individual, gets all worked up over something like the regulation of derivatives?

The answer is that he is not the Treasury secretary in the institutional sense of the word, with all the duties and obligations of the office that go with it, but an ex-Goldman FX arb trader occupying the office. He gets angry because he instinctively knows that the proposed regulation would get in the way of arbs making money.

Look at this unbelievable passage, unbelievable because what a single individual is allowed to do under the auspices of the U.S. government, from a laudatory article in the New York Times that I quoted in Vol. 1:
Then, when the dollar had fallen off the front pages and the market’s attention was elsewhere, they [Rubin and Summers] ambushed the currency speculators, ordering the Treasury to buy dollars. The idea was to sow so much uncertainty about the Treasury’s tactics that no big speculators or hedge funds would risk being caught with a huge position in yen.
I commented there:
So the Treasury Secretary of the United States fixes the exchange rate of the dollar against the yen by sowing uncertainty about their exchange rate!
A palan dooz is allowed to run the U.S. Treasury Department like a hedge fund – and then go further still:
His [Rubin’s] first move was to impose an ironclad rule that he would be the only one in the Administration even to talk about the dollar, the loquacious president included … Mr. Rubin had a free hand in fighting the dollar war; the President almost never got involved.
The president of the U.S. is forbidden by his Treasury secretary from talking about the U.S. currency.

We now see the larger issue behind the regulation of the derivatives. To facilitate its movement, finance capital changes the laws to its favor. If the laws, including those of the sovereign nations, stand in its way, they have to go. Hence, the “globalization”, a term that is void of national and political connotation precisely because speculative capital deems them irrelevant.

Because the laws enabling, empowering and propelling speculative capital are enacted at a macro, almost abstract level, they appear as a “given”, like the laws of nature, with the result that they remain outside the political discussions and agenda; think of the Fed’s “independence”. In this way, policy making become removed from the hands of policy makers. Policy is removed from politics.

Under these conditions, the difference between one politician and the next becomes the color of their skin, and not the content of their policy – or even character.

Such changes are far from natural. In fact, they are the elements of the most extreme and disruptive form of social engineering. But because the dynamics of the process is hidden from the people, they feel powerless to bring about any change. They become passive, alienated, superstitious and angry.

All the while, Prof. Becker, who dislikes social engineering very much, will have nary a word on these subjects.

Sunday, 24 January 2010

What's to Become of Shadow Banking?

I listened to Obama's new, tougher stance on the banks (limit their size, eliminate proprietary trading) with a bit of skepticism. One, I don't quite trust him the way I did, say, three days after his election, when I thought that maybe -- just maybe -- the soaring rhetoric would be matched by an iron will and an incorruptible character. I'm no longer convinced he's on the side of the average American, though he displays a masterful populist oratory at times. Is he just a political elite who swaps in and out of roles, like a skillful actor?

In this case though, there's a bigger reason for my skepticism.

Obama is missing a huge part of the problem. To be blunt, what happens to shadow banking? It has revived in impressively scary fashion since seizing up completely in the aftermath of the Lehman bankruptcy. This is a world of repos (repurchase agreements), asset-backed securities, "haircuts" and off-balance sheet vehicles. This is a world that Washington needs to understand much, much better. The Fed (and other regulators) really need to think out a few things -- what implications does shadow banking activity have for effective money supply, for financial system leverage, for systemic fragility, for the efficacy of regulatory agencies. What does it mean to have a large, and thriving, shadow banking system that has no oversight and no liquidity backstop?

What good is it to remove proprietary trading from commercial banks, if we end up shoving volatile market activities into a dark corner, where they threaten again someday to haul down the entire financial system? What firewalls are we building between the regular banking system and the shadow one? What size do we want the shadow banking system to be? What role do we want it to have? What kinds of companies do we want operating in this "darkness"? What do we want them doing? Not want them doing?

I'm surprised that this subject isn't being more intensely debated. This is a biggie, folks.

Support Your Local Bank!

Sometime in December, I had a stunningly obvious epiphany: If Obama wasn't going to do anything about the banking behemoths, and Congress wasn't either because our representatives were in thrall to the lobbyists paid for by the special interests funding Congressional campaigns, I -- and millions of fellow Americans -- could act. We could vote our anger with our deposits.

And so when I recently relocated to New York, I found a nice cozy little neighborhood bank to put my money in. This bank pays a decent rate of interest on my savings. On Saturdays there's no line at the teller's window. The loan officer/manager/Kleenex box changer is usually sitting at his desk near the lobby, gazing idly out the window, ready to serve you. The place has a relaxed, down-home feel.

I figured: These are guys who played it safe, and conservative, and didn't throw buckets of money into risky securities before the financial crisis. Shouldn't they be rewarded? Shouldn't we -- the American people (forget about the corrupt power structure) -- feed the good banks, the community lenders and the credit unions, and try to starve the Citigroups and Bank of Americas that screwed up so egregiously?

I'm happy that my epiphany wasn't a sole flash of insight in the darkness. After I resolved to place my money in a community bank, I saw on the Huffington Post site that Arianna was urging others to do the same. I don't know how much of an impact this campaign will have, but at last I feel as if I'm doing something good, and not just complaining.

Up and Running Again, Finally

New York is a major international city? Really? Out here in Forest Hills (that's Queens, New York City, for those who haven't been sucked into the metropolis), it took me five weeks to get Internet access. Time Warner wanted everything but a tissue sample from me to prove my identity, apparently because the last tenant in this apartment absconded with some of their equipment (I imagine it was the little modem that's now blinking at me that's about the size of three stacked slices of bread -- yup, that's gotta be really valuable). Okay, frustrated rant over. Back to the blog.

Sunday, 17 January 2010

The Driver of Social Change (2 of 2)

This past year I spent a grim November in Zurich. Grim were the politics; Zurich is a beautiful city and I have dear friends there.

The talk of the town was the national referendum to ban the construction of minarets in Switzerland. The anti-minaret poster which itself became the subject of controversy was everywhere. It showed a woman in burka next to a cluster of minarets that looked like missiles, all juxtaposed over a Swiss flag. The message was that backwards Islam will destroy Switzerland.

On November 29, the measure passed with 57% of votes.

In the past couple of years, we have seen the variations of this theme played across Europe, most recently in France, where wearing burka was banned in school. The President of the Republic himself took a very public stand against this “symbol of oppression”.

But I couldn't help noticing the changing narrative in Switzerland. Whilst previously the talk had been around the Muslim hordes invading the idyllic European landscape, the anti-minaret campaign focused on the “power” of Islam; hence the modern “missiles”. The general secretary of the Swiss People’s Party which had sponsored the anti-minaret measure said that its passage was “a vote against minarets as symbols of Islamic power”.

The claim seems absurd. Any passer-by could readily see that Muslims have no political influence or say in Switzerland – or anywhere in Western Europe. A Tissin butcher’s social and political influence will trump theirs any time. To which Muslim power then was the general secretary of SVP referring?

***

The same November, another dispute reached its climax. This one could not have been more removed from the minaret controversy in terms of public awareness, sentiment and reaction. Few people in Switzerland and Europe heard about it. Even if they had, a question about the issue would have drawn a blank stare, because it involved the regulation of derivatives.

The U.S., with the support of the U.K., wanted to move the trading of the over-the-counter derivatives to the exchanges. The claim was that such a move would reduce the counterparty risk and add to the transparency.

The Europeans, headed by France and Germany, opposed the move. They claimed that exchange trading would add to the costs by subjecting the trades to margin calls. The Financial Times reported the split:
Europe’s largest companies have accused the US of being “adamantly unwilling” to relax proposed reforms of the over-the-counter derivatives markets ... The comments made by the European Association of Corporate Treasurers (EACT), raise the possibility that Europe and US may go their own ways in implementing reforms of the OTC derivatives market ... The administration of Barack Obama in the US and the European Commission argue this is needed to reduce so-called counterparty risk in the financial system since clearing houses ensure that transactions are completed even if one party to a trade defaults.

Companies counter that they would be unfairly penalised if such reforms became law because the laws would oblige them to set aside extra cash – margin – to guarantee those trades ... Richard Raeburn, chairman of the EACT, whose members include Volkswagen, Siemens and Rolls Royce, said his body would not hesitate to “look to the European Commission and Parliament to be prepared to take a more considered and pragmatic approach” than that of the US. Mr Raeburn said that if this resulted in “divergence from the US, so be it”.
First, take note of the parties to the dispute. On one side is the “Obama administration”, i.e., the U.S. government; on the other, Volkswagen, Siemens and Rolls Royce, backed by EACT and then, the European Commission and European Parliament. But lest you think this is a U.S. vs Europe issue – no issue ever is strictly Europe vs. U.S. – here is a subsequent paragraph from the same article:
In the US, the issue of company exemptions from OTC derivatives reform is likely to be raised today at a hearing of the Senate’s agriculture committee.

The Coalition for Derivatives End-Users, a recently formed lobby group representing 180 US companies including Apple, Intel, Caterpillar and 3M recently wrote to House speaker Nancy Pelosi urging lawmakers to “preserve the ability of companies to manage their individual risk exposures by ensuring access to reasonably priced and customised over-the-counter derivatives”.
So, in addition to Volkswagen, Siemens and Rolls Royce in Europe, Apple, Intel, Caterpillar and 3M in the U.S. are also against the “reform”; they are against the derivatives being traded in the exchanges.

These are all industrial companies. If you read their letter to members of Congress, you will not find Goldman Sachs, Morgan Stanley, Citigroup or Bank of America among the petitioners. This latter group is represented by the “Obama administration”. What we have here is a quarrel between the industrial and finance capital, each side jockeying to place itself in the most advantageous position within the system. And no one is budging; inconsistent accounting treatment of the derivatives in the U.S. and Europe? “So be it”.

In the U.S., finance capital reigns. The industrial capital can only appeal to Congress. Finance capital owns it. So the “financial reform” legislation will force trading of OTC derivatives in whole or in part into the exchanges.

In Europe, the European Commission is also under the spell of finance capital. The industrial companies know that; hence their threat to take the matter to European Parliament, which they control and has the power to strip the European Commissioners of their authority.

Where could the European industrial companies go if there was no EU? The answer is, nowhere; without the EU mechanism they would have had no place to go to protect their interests.

By following the obscure and technical matter of the regulation of the derivatives, we thus arrive at the reason for the creation of the European Union, its raison d’etre.

EU is created for the explicit purpose of advancing the interests of the “European” capital, as a counterweight to the “Anglo-Saxon” capital in the U.S. and U.K. “Existence of a functioning market economy and the capacity to cope with competitive pressure and market forces within the Union” is the main criterion of membership.

Within the Union, the industrial and finance capital occupy relatively equal positions of power. They have a peaceful coexistence of sorts but tension surfaces every now and then when the interests of one side are too clearly threatened. (Hence the ambivalence of finance capital-dominated U.K. to the Union, despite the geographic proximity and cultural links.)

The remoteness of the derivatives dispute is symptomatic of the “macro”, almost abstract, level in which the various treaties, directives, rules, laws and regulations of the Union are implemented. These measures affect every area of life in the Union, including agriculture, competition, economic and monetary affairs, education, environment, external trade, public health, institutional affairs, research and taxation. Yet, the population remains woefully ignorant about them. What is more, they have had no say or choice in their implementation. The Constitution of the Union which codified these far reaching changes – it is referred to as the “Lisbon Treaty” to make it sound dull and uninteresting – was imposed from the top.

In countries where it could be adopted through the political machinery, the governments quietly obliged. In countries where a direct vote by the population was required, a “Yes” vote was called for. When the vote turned out to be “No”, it was promptly ignored. “We cannot say that the treaty is dead” said the European Commission President after the French “No” vote, although, in theory, the treaty had to be dead because a unanimous approval was a condition for its passage.

The same thing happened in Holland and, later, in Ireland, when the “No” vote was dismissed as the mindless act of uncouth peasants who did not know what was good for them. Capital will simply not take a “No” for an answer when the course of its future development is at stake.
When the French and the Dutch voted against the constitutional treaty in May and June 2005, the document reappeared as a “mini-treaty”, longer than the original, and was ratified by governments without recourse to a referendum. Many countries have reneged on promises they made to their electorates about a referendum.
The Irish had to vote again until they got it right. As Margaret Thatcher put it, “there is no alternative”.

The European citizenry cannot articulate these developments, but they perceive the contempt that they signify. They look for an alternative, a total Other, and some of them find Islam.

Switzerland is not a part of the EU, but fits this description to a tee. So in the most unlikely places in Zurich, you see businessmen in the tight fitting dark European suite with a kaffieh wrapped around his neck and suddenly you understand the reference to the power of Islam and concerns about it. The concerns are neither due to minarets nor the Turkish emigrants manning fast food stands, but the Swiss, repelled by the system that despite protestations to the contrary, have begun to suspect, no longer reflects their concerns.

I will return with the epilogue.

Wednesday, 6 January 2010

The Role of Businessmen In Shaping Events

On Sunday, The New York Times had a long article on Sandy Weill. It was the vintage Times P.R. piece, including hyped style to give the story a Homeric or Shakespearean dimension. The man who rose from a humble childhood to build Citi to a powerhouse had it all, got humiliated, now is sad, hurt, lonely, unwanted; “There is no creature loves me” stuff. He is still “baronially wealthy” (of course); he wants to be remembered for his charity work.

Sandy Weill is an easy mark for mockery. But we should resist the temptation, first, because his vulnerability makes mocking him improper, almost obscene, like an intellectual equivalent of dwarf tossing. More importantly, jesting distracts us from the larger question of the role of businessmen in shaping the events which his story can help us explore. The issue is defined in the contrasting views expressed in the article:
Though he [Weill] was once viewed as a brilliant deal-maker, some critics now cast him as the architect of a shoddily constructed, unmanageable financial supermarket … “The dream, the mirage has always been the global supermarket, but the reality is that it was a shopping mall,” says [a critic]…

Mr. Weill vigorously defends his record, rebutting critics who say that Citi was an unstable creation. [A friend] who worked with Mr. Weill on his autobiography, said that Citi’s problem wasn’t that it was unmanageable, but that it lacked enough good managers… “Had he picked a different successor things could have turned out very differently,” [he said].
Is the friend right? Was it a matter of one mistake – choosing a wrong successor – which brought Citi to its knees? Or was the fall pre-ordained, the seeds of the failure planted by what had come before?

The premise that with a better person at the helm, things could have turned out differently is intuitively appealing because it is within the realm of possibilities. We could have won last month's lottery if we had chosen the winning numbers, you know.

But the analogy is false. The lottery example is from the inanimate world where relations are fixed and therefore, have no context; they are memoryless, in the jargon of mathematicians, meaning that what happened in the past has no bearing on the future.

The fate of Citi after Weill is in the realm of finance, which is the realm of social (because value is a social concept). In this realm, all actions have their roots in the past. Nothing exists out of context, including the character of personalities.

What was the context, the milieu, in which Sandy Weill chose his successor?

The article had all the clues for the looking:
“This is my final annual meeting as chairman,” says Sandy Weill, standing near the window of his office, peering at a grainy photograph of him and his wife on stage at Carnegie Hall more than three years ago. They are smiling broadly, and behind them is a packed house of cheering Citigroup shareholders. A huge banner dangling from the balcony reads “Thank You Sandy.” On that day, April 18, 2006, Citi’s share price was $48.48.
Like the witches in the opening scene of Macbeth, the stock price in the opening paragraph of the story sets the stage for what is to come. But unlike the witches, the stock price in the Sandy Weill story does not go away. It hovers over and drives the narrative.
Mr. Weill firmly contends that what he built at Citigroup created huge value for employees and shareholders.
Even after retirement:
Mr. Weill continued to track it [stock price] closely. “He was watching every movement of the stock; he was reading everything,” recalls Mike Masin, a longtime friend and a former chief operating officer of Citigroup. “We have had conversations about the fact that he has to make Citi less a part of his life.”
Mr. Masin does not know his longtime friend well enough. It was not Citi with which Sandy Weill was obsessed. It was money. The bank and its stock were mere proxies towards which the obsession was channeled. This, Sandy Weill tells us himself, though, without realizing:
He [Weill] has raised $950 million for Weill Cornell’s $1.3 billion fund-raising campaign and recently put together a $110 million bond offering for Carnegie Hall. “It was like being back in business again,” he says. “I get the same kind of kick by getting somebody to make a major charitable contribution. It’s the same kind of adrenaline rush.”
Functionally, fund raising on behalf of charities and running a financial conglomerate are two entirely different things. But they have one commonality, namely, money. It is money which gives Sandy Weill a “kick”, “an adrenaline rush”, just “like being back in the business again”. For Freud, money was “laughing gas”. For Sandy Weill, it is crack. The man is the embodiment, the personification, of the “rational man” of economic textbooks who always “prefers more to less”. When the subject of the desire is a commodity, as in the old economic textbooks, there is a limit to the desire. Hence, the “decreasing marginal utility” concept: the second Rolls Royce would be slightly less satisfactory than the first one. And there is a limit to the number of hamburgers one could eat. (Again, economics textbooks example).

In finance, the subject is money. Money has no decreasing marginal utility. The second dollar is as valuable as the first, perhaps more. So the pursuit of money does not – cannot – stop. In the narrative of Weill's life story, money has the same role that sex has in “120 Days of Sodom”.

But how do you constantly get more money? How could you make the stock price constantly go up – deliver “value to the shareholder”? A medium size financial company's normal return would not do the trick. The only way to go is through acquisition.

Enter Sandy Weill as a “brilliant deal maker”. The P.R. angle aside, the Times description is accurate. The man created a financial behemoth with 200,000 workers and almost $2 trillion in assets. That required buying, appending, acquiring with a religious zeal. Such deals are complicated, time-consuming, exhausting. Imagine the amount time of money spent on lobbying for the repeal of a major piece of legislation such as Glass-Steagall, which made the merger of Travelers and Citibank possible.
On another wall [in Weill’s office] hangs a hunk of wood — at least 4 feet wide — etched with his portrait and the words “The Shatterer of Glass-Steagall.” The memento is a reference to the repeal in 1999 of Depression-era legislation; the repeal overturned core financial regulations, allowed for the creation of Citi and helped feed the Wall Street boom.
Weill had to be good at what he did. He could easily be the best deal-maker alive – second best, if you counted the dead.

How does a man like Weill choose a successor?

The successor had to continue the legacy, he had to keep the flame alive. That was the requirement which trumped all other considerations. The successor could not let the shareholders, Weill himself the most prominent among them, down.
He no longer had any official position at Citigroup, having retired as chief executive in 2003 and as chairman in 2006. But he was still hugely invested in the company. He owned more than 16 million shares in 2006.
Look. Sandy has just retired. The stock closed at $48.48. There are these structured finance instruments – lawyers call them special purpose vehicles -- through which you could borrow at under 3% and lend through the CDOs to mortgage holders at 6%. It is an incredibly profitable business, guaranteed to boost the stock price. What do you say to that Mr. New CEO?

No successor to Weill could ignore or oppose that pitch, not with the constant pressure to boost the stock price. The choice had to be a Chuck Prince.

And so it was. Prince’s much ridiculed comments about the CDO market that, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing” was the accurate description of his mission statement. Citi stock went from $48.48 to $55 and change before the crash came.

What about a good “manager”, a good “executive”, of the kind who could manage the disparate business lines that Weill had accumulated under the Citi umbrella? That was impossible. Weill could not know such person. He would not know a good manager if one kicked him in the teeth. A good manager would not get past Weill's first secretary. He would not get pass Weill’s doorman.

That is because such “manager” would be a relic of the past, an organizational man from the 50's. The idealized manager, of the kind wished for in the Times article belongs a more serene time, when the business tempo was “calm” because it was set by the predictable turnover of the industrial capital. So the GM’s five disparate car divisions – Pontiac, Buick, Cadillac, Chevrolet, Oldsmobile – plus its military wings and other divisions – far more diverse than anything Sandy Weill could put together – could be successfully managed.

At the age of speculative capital, which generates profit not from production but from price volatility, there can be no managers in the old mold. They have to be replaced by the deal-makers of Weill’s stripes. Witness how fast John Reed was gotten rid of. I am not sure what his managerial credentials were, but as an M.I.T. trained engineer, he was not a deal maker. And that was sufficient for his undoing:
In November, Mr. Weill’s former co-C.E.O. at Citi, John Reed, told Bloomberg News that he was sorry for his role in helping to end Glass-Steagall. When asked about Mr. Reed’s apology, Mr. Weill says: “I don’t agree at all.” Such differences, he says, were “part of our problem.”
Sandy Weill no doubt wonders what this fool Reed could be thinking, regretting the repeal of a law that stood in the way of making more money.

Could Sandy Weill have picked another person, a more “competent” manager?

The answer is No, he could not have. He could have, only under conditions that Rumi, as usual having the last word, said an impossible would be possible:

If it were to be possible for the life to go on without you, then the world had to be upside down.

For Sandy Weill to have picked a different successor, the deregulation must not have happened, Glass-Steagall must have remained intact, Citi must have not have become a behemoth, the CDO market must not have been created which means, ultimately, that Sandy Weill himself must not have existed.

So, you see, Mr. Weill, everything was, in a sense, pre-ordained. For the cause of what you see around yourself, may I suggest consulting a mirror?

But that in no way means that I blame you for what happened. I know that like Oedipus, your deeds were inflicted upon you rather than committed by you. And unlike Oedipus, you managed to put away a nice little something from which you could enrich New York’s cultural institutions. That’s the stuff philanthropies are made of!

Is that the fate of all men, then, ultimately being crushed by events, hoping at best to be remembered by their charitable givings, like a society lady?

The answer is, no. Historical personalities fare better because they know the direction of the movement of history and align themselves with it. At times, they even move ahead of the events. The awareness and the will to act on it distinguish the historical figures from the businessmen.

The subject of this blog is precisely the march of history as it manifests itself in the realm of finance.

Sunday, 3 January 2010

The Driver of Social Change (1 of 2)

In developing the characteristics of speculative capital, I wrote in Vol. 1:
Speculative capital is, by definition, opportunistic. It is constantly on the lookout for “inefficiencies” across markets which it can arbitrage. The opportunities arise suddenly, so the capital that hopes to exploit them must always be available; it cannot afford to be locked into long-term commitments. The requirement to be opportunistic translates into the need to be mobile, to be nomadic and interested in short-term ventures. Such are the inherent attributes of speculative capital.
Then added:
Because these attributes define speculative capital, the manager of speculative capital must employ it in activities that are consistent with these attributes. This rigidly defined role turns him from being a manager of speculative capital into its agent, someone who nominally “runs” the speculative capital but must in fact follow its “agenda.” Speculative capital becomes the grammatical subject of the sentence as if it were alive.
In addition to traders who act on its behalf, capital also has agents who speak on its behalf. These agents are a curious mix of dissembling advocates and ventriloquist dummies. Their advocacy is unconditional but indirect, as if to throw off the scent. Yet, they are unaware of the role and influence of their ever-present “client” and speak of their “free will” in earnest. That is how they are dissembling advocates and ventriloquist dummies; knaves and fools in equal parts.

Observe, if you will, Prof. Gary Becker of University of Chicago. He is commenting on the U.S. economy in The Wall Street Journal of Dec. 21:
Productivity has gone very well actually throughout the decade, even during recession. That’s an excellent sign for the economy, if that can continue … The thing that concerns me is whether we are getting too much regulation and social engineering in the next few years. I would be concerned about that as a possible factor that is putting brakes on the growth of the economy.
Now, return and read these comments again, this time substituting “capital” for “I”, “me” and “economy”.

The substitution clarifies the professor's comments and eliminates the seeming contradiction implied by “even during recession”. This is how it appears to me, with my thoughts automatically appending themselves to the text in brackets:
The productivity [that is, workers producing more with the same or lower wages and salaries,] has gone very well actually throughout the decade. [It is not surprising that this has taken place] even during recession. [In fact, it is precisely during a recession that workers can be made to produce more with less.] That’s an excellent sign for [the further accumulation of] capital, if that can continue. The thing that concerns capital is whether we [i.e., the sum total of capitals] are getting too much regulation and social engineering in the next few years. Capital would be concerned about that as a possible factor that is putting brakes on the growth of the capital.
There is no reference to people, either explicitly or implicitly; productivity and recession are mentioned in the same vein one might describe good air quality or bad weather – or the sighting of a black swan. And Prof. Becker is the winner of the 1992 Nobel Prize in economics “for having extended the domain of microeconomics analysis to a wide range of human behavior and interaction”.

I am not writing to criticize the good professor's language. His is the standard language of economics and finance professors everywhere. What I want to focus on here is social engineering. Prof. Becker does not like social engineering because it puts “brakes on the growth of the economy”. By the same token, he does not like regulation because it is the agent of social engineering. His ideal society, we can surmise, is one where the “economy” grows “naturally”, without any regulatory burden or interference.

Prof. Becker is correct in associating regulation with social engineering. Social engineering is consciously influencing and altering the course of the development of the society. It is the attempt by men to direct the social and economic forces towards a definite end. To the extent that regulation is aligned with that goal, it can be the agent of social engineering.

But Prof. Becker is fundamentally wrong in believing that the absence of regulation is synonymous with the “natural” economy or society. There is no such thing as natural economy, no matter how primitive the society. And there is no such thing as the absence of the regulation, only that law and regulation favoring the dominant force in the society are enacted at such tectonic scale and fine level of technicality that they are all but invisible to the general populace – and economics professors. What is the deregulation on whose behalf Prof. Becker and his colleagues have been the most tireless cheerleaders for the past 35 years if not the most brazen attempt in social engineering undertaken on behalf of speculative capital?

I devoted a full chapter in Vol. 1 to the way speculative capital – the latest and most advanced form of capital in circulation – affects the law and regulation. I wrote:
Speculative capital abhors regulation. Regulations interfere with the cross-market arbitrage that is its lifeline. If speculative capital cannot freely operate, it cannot generate profits and must cease to exist. The opposition of speculative capital to regulation is thus not a matter of some technical or tactical disagreement but a question of life and death.

The attack of speculative capital on regulation is not indiscriminate. Speculative capital singles out only those regulations which directly or indirectly hinder its free flow across the markets. Meanwhile, it supports and pushes for the passage of sweeping laws that favor its expansion. In so opposing the regulation and supporting the law, speculative capital distinguishes between the two in ways few philosophers of law could.
And the beat goes on. Listen to Bill Gross, the chief investment officer of PIMCO, the largest fixed income fund in the world. He is talking to the New York Times about the impact of near zero interest rates which has forced the traditional savers, always risk-averse, to financing a “second bailout of financial institutions”:
“What the average citizen doesn’t explicitly understand is that a significant part of the government’s plan to repair the financial system and the economy is to pay savers nothing and allow damaged financial institutions to earn a nice, guaranteed spread,” said William H. Gross, co-chief investment officer of the Pacific Investment Management Company, or Pimco. “It’s capitalism, I guess, but it’s not to be applauded.”
The good man is exactly wrong – or expediently pretends not to know – in saying that “it’s capitalism”. It is precisely not capitalism, in the sense of the market forces determining the prices and the rates. If it were, the interest rates would skyrocket in the face of massive debt financing, as they did in the case of the auction-rate securities.

The near-zero interest rate, rather, is the result of sustained interference in the markets by the Federal Reserve in accordance with a deliberate policy set by the Federal Reserve. Prof. Becker does not see that as social engineering, but regardless of his sensitivity to what takes place around him, the effects are there. Look at this reverse mortgage “product” from the same Times article:
Eileen Lurie, 75, is taking out a reverse mortgage to help offset the decline in returns on her investments tied to interest rates ... Such mortgages allow people who are 62 and older to convert equity in their homes into cash tax-free and without any impact on social security or Medicare payments. The loans are repaid after death.
The name itself is interesting. Mortgage and reverse mortgage. Just like repo and reverse repo.

But there is a difference. Repo and reverse repo are transactions in capital markets. Both refer to temporary financing. In repo, you borrow money and post security as collateral. At the end of the term, typically overnight or a week, you pay back what you borrowed (with interest) and receive your collateral. Reverse repo is the reverse. You lend money and get security as collateral.

In reverse mortgage, there is no reversing in the sense of having a second transaction. You receive monthly payments on your house. When you die, the lender gets your house.

Note the reference to tax and Medicare. In the U.S., income is taxable (except for the Maddoff “investors”). Also, in the U.S., income beyond a certain level would disqualify an individual from receiving Medicare, the government run health insurance. Someone has gone through the trouble of introducing legislation to specifically exclude the reverse mortgage payments from the calculation of income. One could always claim that the deed benefits senior citizens. But the law has also made reverse-mortgages enticing to cash strapped senior citizens. It has made the product “salable”. If I were a betting man, I would bet that lobbying for the measure did not come from isolated senior citizens.

A reverse mortgage transforms capital to money. A house is capital by virtue of its capacity to generate rent. That is why its price increases over time. The money received as part of the value of the house and spent on say, food and medicine, is wealth (capital) converted to money. So whilst previously a working man could dream the American dream of owning a house and perhaps leaving it to his children, now he must hand it over in return for sustenance. That is a curious twist on New Hampshire’s state motto, Live free or die. It is now live and die free – of worldly possessions.

That is social engineering par excellence.

It is social engineering in excelcis.

But Prof. Becker would have nary a word on it because a social condition that enables predators to get the better of the old and the vulnerable is a part of the natural order of things for him.

Still, these are small matters. I will return with a discussion of the European Union, the counter move to deregulation; one of the most brazen social engineering projects in history being countered by one of the most colossal social engineering projects in history.

And Prof. Becker has had nary of word on them.