Sunday, 28 February 2010

Gary Gorton's Somewhat Flawed Take on Shadow Banking

When I saw this Feb. 20 .pdf on shadow banking, prepared for the U.S. Financial Crisis Inquiry Commission, I got kind of excited. Reading material for my one-hour stationary bike workout! And shadow banking no less, my latest pet obsession! Ah, Sunday morning nirvana for a finance wonk.

Then I started perusing the piece and, after turning over the bike pedals oh about 1,100 times (I try to spin at 90 rpm, and when I get involved in my reading, I'll hit the mid-90s), I grew a bit disenchanted.

Read it for yourself of course. If you want a better treatment of the material, Gorton is essentially cribbing off himself from an earlier paper -- "Slapped In the Face by the Invisible Hand" from May 9, 2009 -- which is a bit smarter, dares to be prescriptive and explores the subject in more depth. My nose de-wrinkled a little after reading "Slapped."

But please start with the crisis inquiry presentation because the writing is more accessible for people who aren't finance nerds. He does a few things that I really liked:

1. History: He presents some of the historical sweep of bank panics over the last couple of centuries.

2. Prime mover: He zeroes in on the real nexus where the financial system failed in our current crisis. In case you weren't aware, basically there was a bank run -- but it wasn't retail (i.e., little investors like you and me and Grandma Jones). It was wholesale, the big institutions that make up the "deposit" base of the shadow banking system.

3. Wild haircuts: he shows nicely how the "banking run" of 2008 took place, through the haircuts on repo'ed collateral that, by increasing from negligible levels, effectively "withdrew" money from the system. I know that line is a bit abstruse, so read his explanation on page 12.

But I think Gorton misses enough stuff that his paper ultimately disappoints. Here are four points he makes that left me shaking my head:
Holding loans on the balance sheets of banks is not profitable. This is a fundamental point. This is why the parallel or shadow banking system developed.
He's a bit intellectually sloppy here -- too busy to show his work or cite the evidence? If you read what he says about securitization (shadow banking's backbone and sine qua non) in his earlier "Slapped," you'll see that he is a bit more revealing, and subtle, there.
Why did securitization arise? We do not know for sure. One possibility, discussed further below, is that it was a response to bank capital requirements, which created a cost without a countervailing benefit. Banks, being private institutions, can exit the industry if it is not profitable. Another possibility is that the demand for collateral made securitization profitable, and this could not be accomplished on-balance sheet because deposit insurance was limited.
So there was a huge need for collateral (that $600 trillion worldwide derivatives market perches atop a mound of supposedly rock-solid collateral that, though relatively tiny by comparison, has grown enormously over the last two decades). And banks were chafing under capital rules.

Okay, I'll buy that. But that's a long way from a convincing argument that hold-the-loan-to-maturity banking is inherently unprofitable in the modern age. He rather disingenuously overlooks a big point: it's partly not profitable because of shadow banking which has (1) no capital requirements (2) no FDIC insurance to pay (3) no other regulatory burdens. So the shadow banks can operate more cheaply and pay more for funds, squeezing banks cleaving to a traditional model.

Point two where we don't quite see eye to eye:
In securitization, the bank is still at risk because the bank keeps the residual or equity portion of the securitized loans and earns fees for servicing these loans. Moreover, banks support their securitizations when there are problems. No one has produced evidence of any problems with securitizations generally ...
My reaction to this: ??????? No problems with securitization generally? That seems rather boldly dismissive. If banks support their securitizations when there are problems, why are they allowed to push the risk off balance sheet? That seems to be a legitimate issue. And the way that risk is imperfectly understood and shuffled down the line via securitizations -- a loan originator puts crap in the soon-to-be-securitized ground beef for the RMBS that's leaving his hands in a week and ultimately winds up in a hamburger patty served up to an investor in Singapore who can't make heads or tails of what he's buying and just relies on a AAA stamp bestowed by a team at Moody's that couldn't really understand what the hell they were rating either -- well, some would call that a legitimate issue too.

Another point where I think he's off base:
Why would dealer banks be growing their balance sheets if there was not some profitable reason for this? My answer is that the new depository business using repo was also growing ... Now, of course there is the alternative hypothesis, that the broker-dealer banks were just irresponsible risk-takers.
I'm not really going into this one -- this blog entry is getting too long already -- only to say this appears to be what they call a "false dichotomy" in debating circles. After all, dealer banks could have been pursuing irresponsible risk-taking that had a profitable reason behind it. That's pretty much self-evident if you read the entire section here.

Now, on to one last point, where he contends that AAA rated securities were marked too far down because of fire sales and cites, as proof, the fact that AA rated corporate bonds at certain times paid more than AAA corporate bonds. That's because so many AAA's were being dumped that the spread flipped, he says.

Okay, first, I'll confess I don't have the data set on that graphic he provides. But I'd sure like to explore it in more depth. Because, honestly, it makes no sense.

Quick bond primer: One piece of the yield attached to any bond represents credit risk. Credit risk is the chance that say IBM goes belly up and you're standing in line with other creditors, trying to get back money that you "lent" to IBM by buying its bond. If you assume more credit risk, you are compensated more. For example: if IBM bonds have a small chance of defaulting, but Wal-Mart bonds have a smaller chance, then IBM's bonds (of a given maturity) will be rated say AA and pay 6 percent and Wal-Mart will be rated say AAA and pay 5.4 percent.

Now bond buyers aren't stupid. Aunt Flo isn't a big player in this market; these are institutions and hedge funds and a lot of sophisticated money managers ... take a look at some bond-pricing formulas, study a little duration, and get back to me in the morning if you doubt what I'm saying.

The point I'm making is this: if these yields flipped, there's a good chance that the "fire sale" explanation is probably the weakest one to make. Because look: even if you're a fire sale buyer, scared as hell of what's going on in the financial markets, your IQ doesn't instantly fly out the window. Relatively speaking, you still prefer AAA over AA. If my fire sale price for AAA is 90 cents on the dollar, my fire sale price for AA isn't going to be 93 cents on the dollar. Because that's leaving free money on the table. That's your first lesson in Bonds 101. No one does that.

So how to explain what happened? Here are a couple of hypotheses that I think are probably more believable: (1) There was a lot of mis-rated AAA crap that really deserved to be graded A or below, and for some reason, the AA securities tended to be rated more accurately, or maybe they were mispriced somewhat too, but it took longer for the problems to be evident. (2) Something else -- maybe even fraudulent -- is going on here. Look at his chart and see how nonsensical it is -- in early March of last year, a good four months after the peak of the crisis, AA's were paying about 2.25 percentage points more than AAA's! By way of comparison, that's more than double the amount that AAA's ever exceeded AA's between January of 2007 and November of 2009.

So this is what Gorton asks us to believe: four months after the "panic button" phase of the financial crisis, there was a sudden move to massively offload AAA's at any price -- sellers were willing to get scorched on the asking price and buyers didn't recognize the value that they were getting compared to AA's and never pushed the spread back together. I mean, 2.25 percentage points?!?! That makes no sense to me.

I'm willing to bet there's something else going on there and I'm surprised that Gorton didn't sniff harder to try to find it.

So while I'm glad that Gorton's writing about shadow banking -- we all need to understand its role better -- he comes up a bit short by my yardstick.

Thursday, 25 February 2010

What's In a Name, You Ask. It Depends, I Say.

Bloomberg reported that Bernie Madoff’s daughter-in law, Stephanie, has filed a formal request to have her surname, and those of his two children, Audrey and Nicholas, legally changed to Morgan.

My compliments to Stephanie, not so much for the move itself but for the choice of the name. In preserving the family’s ties to finance, however indirectly, and keeping the children’s options open in the future, the name Morgan trumps Rockefeller or Carnegie any time.

But no matter how smart Stephanie is, she is the second best in the Madoff orbit as long as one Sonja Kohn is around. This latter woman even fooled me, and let me tell you, not as a boast, but as a tribute to her skills, that I am not easily fooled in matters of finance.

Yet, I was fooled, which is to say, completely, totally misled, upon reading that among Madoff’s “investors” were three Bank Medici funds.

Now, gentle reader, what would you have thought upon reading the same news?

If you knew anything about economics, finance, banking or European history, you would recognize the Medici name at once. It is synonymous with the rise of institutional banking

So, you would have thought exactly what I thought. Knowing that no institutional investors had a penny in Madoff funds – because everyone knew it was a sham operation – I said to myself that even the Medicis could not resist the temptation of high return in capital markets, however dubious the source of return.

That’s what you would have thought too and, if you read the story, you no doubt did.

It turns out the Medici Bank is the brain child of Ms. Kohn. In a nutshell, she returned from New York to Austria, and learned, to her delight, no doubt, that the Medici name was not protected. She registered it and started the “Medici Bank” which, after it had substantially grown, had a total of 16 employees. And, as to leave absolutely no doubts about her intentions, she commissioned a coat-of-arms for the new enterprise. That's how a Medici Bank with a coat of arms became a feeder to Madoff funds.

According to The New York Times, Sonja got money from Israel, Ukraine and the Russian “oligarchs”. In June 2008, she told The Voice of Russia “our history is a very conservative one”.

Our history.


You really have to read the whole article for yourself. One day, if the items on my do-list are reduced to a manageable number, I will return to Sonja Kohn and her world in detail. It is a fascinating story.

For now, here is a follow-up:
Prosecutors are looking into whether Mr. Madoff paid more than $40 million to Mrs. [Sonja] Kohn in exchange for turning three Bank Medici funds into feeder funds for his business … Mrs. Kohn received about … $11.5 million for research reports for which prosecutors were unable to find receipts … A spokeswoman for the former Bank Medici said Mrs. Kohn was “shocked” by the accusation that she received personal payments from Madoff and reject such assertions “vehemently”. Mrs. Kohn has not been charged with wrongdoing but Bank Medici surrendered its banking license in March.
She was shocked at the allegations. SHOCKED.

But it gets better.
Mrs. Kohn is now trying to rebuild her reputation in the Austrian banking industry. She renamed the bank 20.20 Medici, using the term with which optometrists describe perfect vision. Keeping the Medici name is a sign that Mrs. Kohn is not trying to “rid herself of what happened in the past,” [a lawyer for the bank] said. At the new venture, Mrs. Kohn plans to offer advisory and research services.
I do not know what has become of late of 20.20 Medici, but the name has stuck in the back of my mind. Perhaps because it sort of rhymes – in English, anyway. Perhaps the juxtaposition of a modern medical term with the name Medici is so stupid, so vulgar, so offensive – so Sonja Kohn – that it lodges itself in the subconscious, like the memory of a terrible accident.

Who knows, next time I need some objective, independent financial advice – say, about the value of some credit default swaps – I might give 20.20 Medici a ring.

P.S. (Mar 4, '10) - It was brought to my attention that the link to the Bloomberg story in the opening sentence is no longer valid; Bloomberg has taken out the story.

No matter. Here is a link to the aolnews. You want more, google "madoff name change morgan".

Wednesday, 24 February 2010

The Complexities of Interconnectedness

The social problems are difficult to solve because they are social. Each problem is related to a slew of others that, combined, comprise the social system in its entirety.

Take the topical issue of health care in the U.S. Why are there about 50 million people without health insurance?

The answer is cost. People have no health insurance because they cannot afford it.

Why is health insurance so expensive? Anthem Blue Cross in California just sent a rate increase notice of about 39 percent to its customers. Can anything be done about these spiraling costs?

Well, many factors contribute to the high cost of health care in the U.S., the bureaucracy and dead weight of the private health insurance companies being one. One other factor is obesity. According to the Center for Disease Control, obesity costs the U.S. health care system about $150 billion a year, enough to cover the premiums for all the uninsured. To control healthcare costs, the epidemic of obesity must be controlled.

Why are people fat?

The answer is that: 1) they do not exercise; and 2) they eat junk food.

Why don’t people exercise in the U.S.?

That is lengthy subject. There is the country’s “car culture” where everyone drives because distances are long and driving is often the only means of getting from here to there. Many people could not walk even if they wanted to because in many cities there are simply no sidewalks. Many others could not walk even if they wanted to because they have no time. They leave home early in the morning and by the time they get back home, they are exhausted. So they vegetate in front of the TV with some junk food.

Why do they eat junk food?

In four words: because it is cheap. People eat what they can find and afford. Good quality food is expensive and will drive up the cost of maintaining the labor force – wages and salaries, that it. So it is not the matter of the fast food and processed food industry – and industrial hog farming and poultry and fish farms, what have you – producing unhealthy or mercury-laden food. It is that they produce cheap food which, like Walmart producing cheap clothes and other cheap stuff, helps keep the wages low. Where did you think the legendary U.S. labor productivity come from?

That is why about 50 million Americans do not have health care insurance!

I mention this because today the SEC announced some restrictions on the short sale of stock. If a stock falls 10 percent from the previous day’s close, until the next day, the short sales could only be executed on an uptick. This was the Depression era rule in effect the SEC abolished it in 2007.

The rule is not particularly radical or complicated. But its impact will go beyond the equities market. When triggered, it would bring options trading on the stock to a halt. That is because all option valuation models work on the assumption of continuous trading of the underlying stock without any restrictions. Absent that condition, the neutral hedge cannot be formed, which means that the option cannot be valued. From Vol. 2:
Years later, in their search for a solution to the option valuation problem, Black, Scholes and Merton were forced to abandon the contrivances of economics and financial theories and adopt an approach that was grounded in real-life. That change of approach shows itself in the methodology of derivation of the Black-Scholes model, which is based on arbitrage: constantly, in fact, continuously, buying and selling.
Recall one of the most critical problems of the crisis that continues to date was determining the “fair value” of securities. Setting aside the arguments for and against short selling and focusing on options only, the SEC’s decision might or might not prevent the downward spiral of stock but it will surely introduces more price uncertainty to an active and technically unrelated segment of the market.

I am neither defending nor criticizing decision because it – it being the decision – matters little. I just note, in confirmation of what I have already written – here and here, for example – and what I will write about systemic risk, that the complexities of interconnectedness at the advanced stage of the reign of finance capital are real, daunting, and not susceptible to being cured with band aids.

Where the Courage to Reform is Lacking

The "hey we're missing the shadow banking market in all these reforms" meme is spreading. I like that, after my Jan. 24 post where I bemoaned the lack of attention to the 900-lb. gorilla in the room (or however much that mythical gorilla weighs). Marginal Revolution weighs in here. Mike Konczal at Rortybomb did his usual excellent calmly reasoned and thorough analysis here. And we got a superb Venn diagram by Raj Date (never thought you'd see one of them again after eighth grade -- guess again; check out page 3!) that reveals shadow banking to be the poop that's left unscooped in the proposed financial reforms.

So where is the courage to reform lacking?

Simply: we don't like pain (our politicians, our mirror images of the worst of ourselves, have all along taken the pain-avoidance steps in dealing with the financial crisis). Shadow banking is a means of leveraging up the financial system. Leverage provides the palliative of easy money (along with that extra risk). I'm betting Washington will leave the shadow banking/leverage mess untouched; who wants to prescribe two tablets of austerity for a hungover economy, even if it's good for overall future stability? We're a "now" people, impatient to have what we want, and cranky when we don't get it quickly.

Ah ...

Sunday, 21 February 2010

A Letter to Mr. Baxter

Dear Mr. Baxter,

I just read your testimony before the House committee investigating the financial crisis. You delivered a long, carefully prepared text to defend the Fed's bailout of AIG. As the executive VP and general counsel of the New York Fed, nothing less was expected from you.

Did I get your approach, your strategy, right?

Your strategy, I think, was to deliver a one-two punch wrapped around a coma-inducing narrative. One, you talked at length about the threat of a looming, apocalyptic crisis, which made the bailout necessary, almost a patriotic duty. Two, you said that it was all for the benefit of taxpayers. You used the word “taxpayer” 16 times, as in the Fed “protecting taxpayer interest”, or the Fed “securing both downside protection and upside participation for the U.S. taxpayer”.

Now, the Fed creating funds electronically from thin air and transmitting them here and there has nothing to do with taxpayers. But I am not writing to criticize you for using catch words that you thought would score a point with your audience. That would be missing the point, like criticizing a B-movie director for including too many sex and car chase scenes.

As for the length of the speech, may I say it was a benumbing case of too much transparecny and “putting everything on the table”, where you omitted what was necessary but included everything else, as in this gem:
The first 8-K was filed by AIG on December 2, 2008, after Maiden Lane III purchased the first group of CDOs. On December 18 and 22, 2008, Maiden Lane III purchased a second group of CDOs. Also, an agreement struck in November in conjunction with the original transaction, known as the Shortfall Agreement between Maiden Lane III and AIG FP, was amended as of December 18th. These events required the filing of a second 8-K on December 24, 2008.
Good performance. My compliments.

And, yet, sir, talking too much was an error. When you talk too much, even deliberately, you reveal things that you did not intend. If you want to de-emphasize something, or skip over it – if you want to hide something, in short – the less said the better. Ask any mobster or petty criminal who would tell you that unsaid favors you.

So what did you reveal?

On the question of the authority of the Federal Reserve to rescue AIG, nothing. You said not one word on the subject. And that was the revelation. I will return to that intriguing point in the next post because it goes to the heart of a matter that is dear to me. But before then, allow me to make a few comments on what you said about the Fed forcing AIG counterparts to accept less than par for their credit default swaps (CDSs). You said:
The Federal Reserve has been criticized by some for not using its regulatory power to force the counterparties to accept less money for the CDOs. The critics overlook a number of key factors.

First, there was little time, and substantial execution risk and attendant harm of not getting the deal done by the deadline of November 10th.

Second, the Federal Reserve had little or no bargaining power given the circumstances. This restructuring negotiation was taking place in November of 2008, less than two months after the decision to rescue AIG from insolvency and the infusion of tens of billions of dollars.

Finally, even if we had had bargaining power, the rating agencies, as discussed above, were closely examining AIG for signs that it would not be able to address its financial situation. If they saw the Federal Reserve take any action that seemed to suggest a lack of full support, in particular a bankruptcy threat, it might well have led to an immediate downgrade and the irreversible destruction of AIG, with the attendant consequences on the financial stability of our economy.

Some have said that, in the absence of other bargaining power, the Federal Reserve should have used its regulatory power ... to make regulated counterparties give up or compromise their contractual rights. We see that as an abuse of regulatory power.
Dear Tom,

In consideration of your first and second points – no time left for action and the Fed having no bargaining power – may I suggest that you refrain from playing poker in the future. When you voluntarily tip your hand, you will, of course have no bluffing/bargaining power.

The time to have forced a deal with AIG CDS counterparties was on the morning of September 15, when Lehman filed for bankruptcy. I will return to this point in a moment.

Regarding the final point, about the rating agencies closely examining AIG, come now, Tom. The purpose of the Fed’s intervention, as per your testimony, was to annul the CDS contracts. That is what the rating agencies were looking for. They would not have cared whether you paid 60 cents on a dollar to annul them, or full dollar, which you did. “Full support” does not, and did not, mean full payment.

Then, there is the question of authority. You brought up the issue the abuse of authority, which I found funny. I don’t mean ha ha funny but funny in the sense that you mentioned it in a hearing convened to examine the question of the Fed’s abuse of its authority to give $180 billion to AIG. But I know you did not realize it. (There was a ha ha funny part, though: a presentation by the boys in BlackRock where they told you that AIG counterparties would not acccept anything less than par. When I read about it, I actually laughed. Whose idea was that one, and what was the subject/title/agenda of the presentation?)

I will return to the question of authority in the next post. Let me now tell you when the Fed would have had tremendous bargaining power over all AIG counterparts without restoring to threat of abuse.

On Monday, September 15, 2008, Lehman filed for bankruptcy. That is when, according to you, hell broke loose. Le Monde said it was the day that Capitalism stopped functioning.

On that day, a meeting was held between Mr. Blankfein in his capacity as the CEO of Goldman Sachs and Mr. Timothy Geithner is his capacity as the president of the Federal Reserve Bank of New York.

  • Who proposed the meeting?
  • When was the meeting proposed – what day and what time?
  • When was the meeting held and for how long?
  • Was the meeting, to use that dreadful corporate word, “minuted” – is there a transcript of the meeting?
  • If not, why not?
  • Who else was at the meeting?
  • What was the agenda?
  • What topics, if any, were discussed in addition to the main agenda?
  • Did the AIG name come up in the meeting?
  • If so, in what context?
  • Did the issue of the AIG CDS come up?
  • What points were agreed upon at the end that were open in the beginning?
I remain.

Monday, 15 February 2010

Money, Capital and Art

The Appeal of the Walking Man generated heavy email feedback. If this were a commercial site, responding to the “customer demand”, it would have to be renamed Dialectics of Art. But it is not. More to the point, the dialectics of finance is the starting point of making sense of art, so we are on the right track.

This touches upon a point I made to a friend who wanted more about the role of money in influencing art. I said that the role of money is too easy to discern, and gave the example of one Eli Broad, a disagreeable boor who has become the arbiter of art in LA by virtue of having money to throw around.

But the role of capital in shaping art is more complex. I discuss the point at some length in Vol. 4 of Speculative Capital. In A Brief Commentary On a Picture I quoted a passage from the manuscript on the importance of the visual. Here is more, by way of proof that Vol. 4 is in the works.
The rise of the visual is a new cultural phenomenon; it has no precedence in either the Eastern or Western cultures, both of which persistently warned against trusting the eye as the instrument of reliable judgment. That appearances are deceiving or that treasure is buried in the ruins is a constant refrain in both cultures.

The Impressionist School in the West rose precisely from the recognition that appearances, as the observer saw them, do not correspond to the reality of the phenomena. The paintings of Cezanne, Degas, and Monet, among many others, reflect this ambiguity of the outside reality that comes into our ken.

Islam forbade painting of faces and discouraged painting in general, so the matter was expressed philosophically – and forcefully and categorically …

But in the land of salesmen, the demand of salesmen – expressing the anxiety of capital in circulation that must be converted from commodity form to money form – destroys long held social beliefs and creates new yardsticks of personal appraisal which gradually become social norms. Those most attuned to the business world carry these demands across culture the way insects pollinate flowers.

The salesman, nota bene, is not wrong. It is just that his concern and focus are different. Cezanne and Rumi were looking for the Truth. The salesman wants to sell. For his narrow but well defined purpose, judging from the appearances will do. Let others worry about the false reflection of reality in the human eye.

As sale assumes an ever more crucial role in the economy and the salesmen increase in number, the reliance on the visual becomes the standard practice and eventually, the social norm. The “visual arts” rises. Color, exaggeration and “flash” that define this art are all stock-in-trade of the salesman. They accentuate the visual and by virtue of being pronounced, create the impression of boldness, confidence and certainty. These, too, are in line with the modus operandi of the salesmen who must at all times show confidence in whatever it is that they are peddling.

In this way, doubt is removed from art. The ambiguity of Impressionist paintings gives way to the in-your-faceness of Warhol’s flashy illustrations. And the content becomes subjugated to the form: the question of what to paint, which is always the more difficult question of painting, is decided by the demands of the form. Hence, the purposefully commercial nature of the visual art’s subjects – a can of a soup, the face of a Hollywood sex symbol – which leaves no room for contemplation. Nay, it discourages contemplation. After all, what is there to contemplate about the packaging of a can of soup? A glance would be sufficient.

This development affects both art and its “consumers”. Consumers conditioned to make rapid judgments, gradually lose their habit – to say nothing of ability – to concentrate and ponder. Thus, the rise of the visual ironically leads to the debasing of the visible real life. This is the well known shrinkage in the “attention span”, whose extremity in the form of attention deficit syndrome is recognized for pathos that it is. Warhol’s perceptive comment about the “15 minutes of fame” captures this shrunken attention span that befalls on the observed, as well as the observer, at the age of the primacy of the visual.
I will return tomorrow with a discussion of a dry legal subject: the Fed’s bailout of AIG.

Sunday, 14 February 2010

Imaginary Dialogue with a Fed-Secrecy Defender

The make-believe dialogue that follows was inspired by this New York Times story that recaps the events leading up to, and the arguments surrounding, Bloomberg LP vs. Board of Governors of the Federal Reserve. That's Bloomberg's court battle to get the details on a bank bailout that has reached a staggering $2 trillion (according to the Times and, depending on how you count, may be actually a trillion or two higher). Much of the bailout has been cleverly orchestrated by the Fed behind the scenes, so Americans know little of who got what. Bloomberg wants to pierce the veil of secrecy to find out which banks received money, how much, in exchange for what collateral, under what terms.

And the Fed is stonewalling like crazy, fighting this tooth and nail through the court system.

So here's my imaginary dialogue with a Fed-secrecy defender (abbreviated below as "FD"). The parts in bold are taken right from the Times article; other secrecy arguments I have extrapolated on somewhat, in keeping with what I have read so far is the Fed's position.

Me: $2 trillion ... wow. That's a lot of Subway sandwiches. The mother of all bailouts. Seriously, what's the problem with revealing who got what through this hidden bailout?

FD: It's a terrible idea. Such disclosures could stigmatize financial institutions by suggesting they were desperately in need of government money and, therefore, weak.

Me: Hmm. That's an interesting line of defense. Let's make it more concrete. So you're saying disclosure of significant weakness is a bad idea. Sort of like if someone forced you to reveal you just took $3.4 billion of losses. That certainly might give the market the idea you were pretty weak and ripe for a boost from good ol' Uncle Sam.

FD: Right.

Me: Well, take a look at this. This is Citigroup admitting to investors in its 10Q regulatory filing from the second quarter of 2008 that it wrote down $3.4 billion of subprime mortgages. In fact, this entire filing seems to be full of stigmatizing disclosures of various types.

FD: That's different.

Me: Besides, such a "stigma" may be a good thing.

FD: How do you mean?

Me: We keep talking about "moral hazard" in this crisis, as in an actor tends to be more reckless when he knows somebody else will pick up the tab for his mistakes. So maybe a little "stigma" is a way to reduce moral hazard? Banks, realizing the stigma attached to being a recipient of a federal bailout program, will be more cautious and take on less risk next time.

FD: It's not that simple though. The banks, if perceived as weak, could be subject to 1930s-style bank runs.

Me: Oh really? So you'd say we're as vulnerable to bank runs now as we were in the 1930s. Ok, let's take a look. Most of these bank runs you're referring to were from 1929 to 1933. Do you want to guess what happened on Jan. 1, 1934?

FD: I'm not sure.

Me: Insurance of bank deposits took effect through the Temporary Federal Deposit Insurance Fund. Today most Americans know their bank deposits are FDIC-insured up to a generous limit ($250,000 currently). So bank runs are much less of an issue nowadays. And if you recall, all during this financial crisis, the government has thrown its weight behind the financial industry, further soothing anyone who panics easily. Remember the "Stress Tests" for the banks? Team Obama made it clear upfront that no one would be allowed to fail. So the idea of bank runs seems rather far-fetched.

FD: Listen, releasing this information would be a bad idea for other reasons too. Think of the future impact, if there were another crisis and the Fed had to rescue the financial system again! Even strong banks that were considering taking money might instead retreat in trepidation.

Me: Whoa, hold on a second. I'm a little confused. Why are we bailing out strong banks?

FD: Well, you have to be fair and account for the fact that, in the midst of such a crisis, a strong bank may need more capital than it originally set aside.

Me: Then shouldn't it turn to the capital markets?

FD: It may be too expensive to raise the needed funds in the capital markets. It's a credit crisis!

Me: I hate to sound heartless but maybe the "strong bank" just bites the bullet and raises the money the expensive way. Next time it prepares better for a rainy day huh? Or if it really can't raise the funds at all without being in danger of going under, I would question your premise that it's a "strong" bank. Maybe it's only a "strong" bank when the economy is roaring along. And if we rescue this "strong" bank, what signals are we sending to a more conservative bank that is smaller and less profitable only because it avoided taking the risks of the "strong" bank during the boom times?

FD: Nevertheless, I don't think you realize what damage would be caused, making public the specific, detailed information Bloomberg seeks. It would cause serious competitive harm.

Me: And I hate to sound like a broken record but -- one way a bank could avoid that "harm" is not to tap the government's aid programs. Plan better next time, take less risk, and you won't have to grab hold of the Fed lifeline -- and be exposed for doing so.

FD: That's easy to say, but the fact remains, we have to deal with the hand we're dealt.

Me: Okay, then, tell me what's this "serious competitive harm" exactly? Especially when most of the big banks are already drawing assistance from the panoply of Fed programs. How seriously is Citigroup harmed if we learn it's 85 percent on the government teat and Bank of America, its big competitor, is only 79 percent? Say we find out that JPMorgan has $200 million of collateral parked at Fed Loan Facility X. You think JPMorgan is suddenly going to go out of business as investors panic?

FD: You have a naive understanding of markets. We're not talking about just public perception. Savvy traders could quickly get their hands on such data in the future and use it to their advantage even as the government was trying to stabilize the markets.

Me: Okay. Let me ask you something. Have you ever wondered why a company's share price makes a few suspicious-looking spikes in the days running up to an announced merger in which it will be acquired at a premium?

FD: Obviously someone has gotten wind of the deal and is buying the shares to profit from that knowledge.

Me: Exactly. Markets are notoriously leaky. Savvy traders are already hearing things about Fed aid, and figuring out things, and acting on rumors, when it comes to the bets they're making on these banks. But what you have now is imperfect leakage: investors are punishing some banks that shouldn't be punished, others are being punished to an imperfect degree, and yet others are going scot-free when they should be punished.

FD: Well, still, disclosure has the potential to whipsaw the market at a very volatile and sensitive time.

Me: February of 2010? When Bernanke is saying the economy has recovered well enough that we ought to think more seriously about raising interest rates?

FD: No, I'm talking about the height of the crisis naturally.

Me: But the documents would be released now, and this isn't the height of the crisis. And, if the Fed fears timing is an issue going forward -- if it needs to be able to make decisions during times of stress without the immediate scrutiny of the market -- why not work out a time frame that allows a 60-day or 90-day period before disclosures?

FD: You have to admit that if this information were to come to light all at once, it would be terribly disruptive to the markets.

Me: I agree it could be. But why? Because the Fed has sat on so much information, in the dark, for so long -- almost a year and a half. If the Fed had a timetable for periodically releasing details of what it's doing, and with whom, the market would be better able to assimilate the revelations. So when do you advocate that the Fed come clean? Never, right?

FD: Well, you don't understand the Fed's culture. It has a longstanding policy against disclosure.

Me: So that makes it right? Do you support slavery?

FD: Of course not.

Me: Someone in the year 1850 could have argued that the U.S. Constitution had a longstanding "policy" of condoning slavery. The law of the land at the time said that escaped slaves had to be returned to their rightful owners.

FD: Obviously our Founding Fathers got that one wrong. But you don't understand that the Fed needs to be insulated from public opinion to do its job effectively.

Me: Actually I do and I think we need to be sensitive to that issue. But there are other issues too. Such as who watches the Fed? What if a malevolent personality were to be installed as Fed chairman, and the place became a sinkhole of graft and corruption. It seems ridiculous now, but it's certainly not beyond the pale. What body can effectively rein in the Fed? Shouldn't we be a little worried about an agency that engineers a covert $2 trillion bailout, the details of which we know very little about? It seems that the Fed, in return for the latitude that we give it to make decisions about monetary policy, should reward our trust with more transparency.

FD: Well, rant all you will -- you won't win this one. You'll see.

Me: You know something? That's finally something we agree on. I have little faith the Supreme Court will do the right thing. But "won't win" isn't the same as "shouldn't win."

Sunday, 7 February 2010

Weekend Musings: The Appeal of The Walking Man

The sale of Giacometti’s Walking Man I for a record $104 million was the main “art” news of the past week. The picture of the sculpture made the front page of the major papers, including the Wall Street Journal. Tout le monde was talking about it. So many that I did not know the art appreciation bug had bitten so many.

There was no word on the buyer. Rumors that he was a financier, probably a hedge fund manager, made sense. Only the financiers have that kind of money to throw around. I know of some hedge fund managers who buy masterpieces wholesale.

But lest we forget, for the “hegdies” the acquisition of art is strictly a matter of investing and capital appreciation. Working hand in glove with the gallery owners and auction houses, these merry men of finance accumulate art based on venture capital or takeover model. They either buy the works of relatively unknown artists and then promote them so the works would automatically appreciate – that would be like investing in a start up and taking it public – or do downright acquisition of established companies (artists) in the hope that the ensuing publicity will bring even higher bidders later.

Yet, the expensively acquired piece demands a commentary. What was about it that attracted the attention of a hedge fund manager or a takeover artist? Why this sculpture and not some other?

According to the Wall Street Journal, “the six-foot-tall bronze depicts a wiry man in mid-stride, his right foot jutting forward, his head erect and his arms hanging at his side.”

This description just about sums up the understanding of the art establishment of artworks. It is a description of an auctioneer, of a clerk taking an inventory, which, by the way, is how art is generally taught and interpreted in the West. It is not per se wrong, but irrelevant. It cannot help us understand the work or the secret of its appeal.

Walking Man is an abstract statue. The walker is skeletal, bereft of any particular characteristics. In that regard, he is the universal man. But the height could not be abstracted away. At 6 ft tall, it could not be that of a Chinese, or a Middle Eastern, or even a Latin man. In 1960, when it was created, only the Western man could be represented as being 6 ft tall.

What is about this Western man that attracts our attention?

Look at the pose of the Walking Man and compare it with the poster of a movie that came out the very same year, in 1960.

If you strip away Burt Lancaster’s gun, take away the rifle in his left hand, air brush the woman who is at his feet, strip him of his clothing and eliminate the vengeful expression on his face, you will get close to Giacometti’s Walking Man. In both cases, the upper body is bent forward, indicating a forward motion. And both stare at not what is under their feet but in the horizon.

We readily understand the poster’s message because conveying a succinct message is the function of posters. They do it by creating a context. So we know that Burt Lancaster is hell bent on shedding blood. It is probably revenge; surely the other guy must have started it. Pursuing that righteous fury, he will not heed the cries of the weak Audrey Hepburn trying to stop him. A man’s gotta do what a man’s gotta do. In this way, the poster defines the context of the picture.

Returning to construct the context of the Walking Man, we have several problems.

One is the matter of bent right leg. Lancaster’s forward leg is bent because he needs support, as he is dragging Audrey Hepburn.

The Walking Man’s forward leg is not bent, indicating that he is not carrying any load which he indeed does not. But then why bend forward? No one walks like that, certainly not a slender figure with long strides.

Then, there is the matter of hands and arms. When we walk, the left (right) arm and right (leg) leg move forward in unison. Such synchrony is dictated by gravity and the laws of dynamics. But the Walking Man's arms do not follow this rule. They are hanging beside him with a little forward lean. This posture is in contrivance of the laws of dynamics, which is why we feel the statue's pose is somehow not right.

Why would anyone assume such a posture in “mid stride”, as the Wall Street Journal describes the pose?

The answer is that no one would; maybe a robot, or an automaton, but our subject is a man.

The only way to explain the suspension of the laws of dynamics is to realize that the laws do not apply because there is no motion. The Walking Man is not walking at all. He has just stopped, almost suddenly, because he has seen something on the horizon. His look is without any expression, almost as if he were a cretin, but what is on the horizon is sufficiently worrisome to make even cretins pause in the mid stride and take note.

The name is not a tease. The sculpture we see is that of a walking man. Any other name would be incorrect. It is just that we are seeing a walking man at the instant of coming to a halt.

The Walking Man is Hank Paulson realizing that “the world is falling apart” and rushing to call his wife. He is Dick Fuld on the eve of Sunday, September 14, 2008, realzing that Lehman was doomed. He is Alan Swchartz, learning suddenly that cash hemorrhaging of Bear Stearns cannot be stopped. He is Alan Greenspan, realizing that everything he knew was wrong. And Sandy Weill, half-understanding that all was vanity and for naught.

The Walking Man is the cocksure man of finance. You will see him confidently talking in cocktail parties, with his mistress, as the special guest in MBA seminars, charity fund raisers and the Congressional hearings. He puts on a brave front day and night. But he knows that one day, something will appear on the horizon that will make him stop cold.

The Walking Man speaks to that uncertainty. That is its appeal to the hollow men of modern finance.

Saturday, 6 February 2010

5 Reasons Not to Expect the U.S. to Rein in Shadow Banking (or Pass Much Financial Reform)

When I was living in Hong Kong, I once saw a photo of the Chinese leadership that left a strong impression. China's political elite were having their annual conclave. The International Herald Tribune ran a photo of nine of the most powerful men in the country: all with hair dyed black, dark blue suits, red neckties -- except for one man wearing a blue one.

So, Sesame Street redux, one of these things was not like the others -- but the subtext was clear: not by a heck of a lot. Maybe he didn't get the "Red Necktie Memo." Or maybe he felt a little ornery that morning.

In the aftermath of the financial crisis, the U.S. government is the equivalent of the guy in the red necktie. He's different from those he regulates -- but not by much. That's a big reason the needle isn't likely to move much on financial regulation.

Just look at what was at the heart of the crisis: overly complex and leveraged products that sought to evade sensible (but inconvenient) accounting standards; that were blessed by ratings agencies with overt conflicts of interest; that were held at (a fiction of) arm's length through off-balance sheet vehicles (SIVs); and that supported a shadow banking system through such activities as repos and reverse repos.

Why would the government crack down on any of this since it's been captured, cognitively, by the financiers? In effect, the government is now doing all this stuff that caused our problems. Let's look:

1. overly complex and leveraged products: When Treasury Secretary Geithner was given the job of coming up with a proposal to rid the big banks of toxic debt, he created a complicated monstrosity that could've emerged from the Goldman Sachs war room (and for all we know, it did). Known as PPIP, the plan proposed pairing private money with public to buy distressed debt through auctions; private investors would use taxpayer funds to leverage up as high as six to one. Geithner suggested this after it was clear that too much leverage had helped spark the original disaster. All this led one to wonder: Did he sleep through the crisis? PPIP's most redeeming feature: it flopped.

2. sought to evade sensible (but inconvenient) accounting standards: Financial Accounting Standards Board shenanigans anyone? Under government pressure apparently, the standards board ditched mark-to-market accounting for certain bank assets in April last year, making it easier to pretend the shlock on your books was actually gold -- well, tarnished gold at the moment, but it would look better in a year or two, you could argue. So transparency wasn't a priority for Team Obama, it seems.

3. that were blessed by ratings agencies with overt conflicts of interest: The ratings agencies midwifed a lot of ugly babies that they pronounced beauty queens: crap securities that received AAA ratings. And what has Washington done to shake up the agencies, or reform the ratings system? As far as I can tell, approximately nothing. Why? Is it because the government may have an interest of its own in manipulated ratings, for the panoply of Fed lending facilities that require assets graded AAA? Geithner and Co. want to recapitalize the banking system on the sly -- without another ugly headline number like "$700 billion for TARP" -- and maybe the brain trust has decided to lay off the credit raters to ensure there's no avalanche of downgrades that, should it occur, would prevent shovelling that low-cost Fed money out the back door for suspect "AAA" collateral.

4. that were held at (a fiction of) arm's length through off-balance sheet vehicles (SIVs): This one's easy unfortunately. Fannie Mae and Freddie Mac are really the original off-balance sheet vehicles. It's no secret that Fannie Mae was moved off the government's balance sheet in the late 1960s because it was turning into a budget buster. Now it enjoys a funny quasi-public status: a "private" company that will get bailed out again and again (just like the SIVs of the big banks). Oh, and if you need another example, here's the government trying to spin a special-purpose vehicle off from TARP. Yup, they learned well from their Wall Street masters.

5. that supported a shadow banking system through such activities as repos and reverse repos: The Fed isn't so eager after all to shut down the repo market (in a repo, you sell a security to someone at a "haircut" price (that could be 10, 20, 30 percent off, depending on the security) with the promise to repurchase it shortly thereafter, say a day later). Turns out that the Fed plans to sop up extra liquidity through reverse repos of Treasuries. So since the reverse repo is a big part of its strategy, is it such a leap of the imagination to think that in the end the White House economic team will just advocate hands off most/all repos and reverse repos?

There you have it. The government has borrowed Wall Street's playbook. So why is anyone out there surprised we're not seeing reform?

Wednesday, 3 February 2010

The [Permissible] Boundaries of Bank Regulation

If you have been following current events, you are familiar with President Obama’s plan to “take on” banks. His plan, inspired by Paul Volker, calls for, among other things, the banning of proprietary trading by banks.

If you have been following this blog, you know that proprietary or prop trading is arbitrage trading – taking simultaneous long and short positions in two “equivalent” trades. That is the modus operandi of speculative capital which still, two years into a protracted crisis, dominates the markets.

The Theory of Speculative Capital posits that speculative capital would not, short of being forcefully subdued, accept any restraints or limitations on itself. From Vol. 1:
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.
So if my Theory of Speculative Capital is correct, then the President’s bank regulation plans, at least the part that deals with prop trading, should be dead on arrival, no matter what. From today’s New York Times:
The chairman of the Senate Banking Committee warned on Tuesday that the Obama administration’s new proposals to rein in Wall Street firms ran the risk of derailing months of delicate negotiations over overhauling financial regulations.“It’s not a movable feast,” the chairman, Christopher J. Dodd, told Paul A. Volcker, … who has become an influential outside adviser to President Obama, [adding] that the administration was “getting precariously close” to excessive ambition for the legislation.
There you have it.

Not to underestimate Congress’s ability to neuter any legislative proposal on cue no matter how ironclad the theory behind it, but the administration’s proposal, what President Obama called “Volker rule”, has a theoretical Achilles’ heel that makes it vulnerable to attack. The problem is the definition of prop trading. According to the Times, in answer to criticism that his rule was too vague, Volker said:
”Every banker I speak with knows very well what proprietary trading means and implies.” For example, he said, a pattern of exceptionally large gains and losses over time in a Wall Street firm’s trading book should “raise an examiner’s eyebrows.”
Sorry Mr. Volker, but large gains and losses or the intuitive recognition of bankers cannot be the basis of regulation; it must be made of sterner stuff.

Volker’s problem is theory. He cannot define prop trading because prop trading is arbitrage trading. And speculative and potentially ruinous arbitrage is, after the trade is made, indistinguishable from the “legitimate and conservative” hedging. That was my discovery in Vol. 1 that led to the Theory of Speculative Capital:
The most important point in the rise of arbitrage trading is that the practice develops logically from hedging and, on paper, is indistinguishable from it. What logically separates them is the purpose of each act which translates itself to the sequence of execution of trades. When done sequentially, the act is defensive hedging. When done simultaneously, it is aggressive arbitrage. Otherwise, the transformation of one to the other is seamless.
If you know Volker’s address, send him a copy of Vol. 1.

Monday, 1 February 2010

Hank Paulson On the Brink

A while back I criticized the book by a financial correspondent of the New York Times about the financial crisis as gossipy, trashy and not at all informative. Then, in today’s Wall Street Journal, I read an excerpt from Hank Paulson’s new book, On the Brink.

There is no doubt: on the evidence of his writing, the man is a cretin. In the half-page excerpt, he describes nonsensical and random details that would alarm a mad painter: leaving the Waldorf=Astoria Hotel early in the morning, speeding down a deserted Park Ave, getting to the Fed before 7am, riding the elevator to the 13th floor, wondering whether or not to take sleeping pills that were given to him in Washington D.C. (Being a Christian Scientist, he decides against it).

These details might or might not have been added for drama. But these are the things that he remembers precisely because he does not understand the crisis that is unfolding around him. He knows he is grossly out of his depth, so he does not dare/bother to pause, think, and contemplate. He merely moves – jumps really, like a headless chicken – from one scene of the crisis to the next. Naturally, then, after two days he is exhausted:
All weekend I’d been wearing my crisis armor, but now I felt my guard slipping.
And what does a former CEO of Goldman Sachs, now the Treasury secretary, do under these conditions?
I knew I had to call my wife, but I didn't want to do it from the landline in my office because other people were there.

”What if the system collapses?” I asked her. “Everybody is looking to me, and I don't have the answer. I am really scared.” I asked her to pray for me, and for the country, and to help me cope with this sudden onslaught of fear.
His wife, just back from the church, immediately quotes from the Second Book of Timothy, verse 1.7 which says that God “hath not given us the spirit of fear but ... of a sound mind”.

The objective conditions produced by this crisis enabled me to sharpen the Theory of Speculative Capital. The unintended humor produced by the various players in the crisis provided much needed comic relief after long hours of work. How many times, in the middle of the night, reading a seemingly serious piece on the crisis, have I burst out laughing!

Wearing one down and energizing him: that, too, I suppose, is a dialectical characteristic of the crisis.