Sunday, 30 May 2010

The Goldman Case – 2: CDOs

The Goldman case revolves around the CDOs. So, we must begin with these vehicles.

A CDO, or collateralized debt obligation, is a security, only more complex than traditional securities such as stocks and bonds. The complexity is not conceptual, as in, say, quantum mechanics, but procedural and functional. It can be measured by the words that are needed, as per requirement of the law, to describe the structure, pay off pattern and risks of the CDOs in the offering memoranda. These documents can run into hundreds of pages of legalese and still not cover all the material facts. The SEC’s charge against Goldman is precisely this “failure to disclose”, which constitutes fraud under the securities law.

A procedural/functional complexity can best be shown via an an example.

Take a bank which has lent the following amounts to 5 home buyers. The monthly payment for each loan is shown in brackets.

1: $200,000 [$1,150]
2: $240,000 [$1,250]
3: $250,000 [$1,300]
4: $300,000 [$1,700]
5: $260,000 [$1,600]

The total value of the mortgages is $1,250,000; their combined monthly payment, $7,000.

Mortgages are long-term loans, ranging from 10 to 30 years. So, the bank has locked $1,250,000 of its assets for at least a decade. Of course, in that period, it will receive interest and principal which is what banking is all about. But capital is locked and the bank’s ability to lend is reduced. If we assume the bank’s total lending assets to be $100 million and a typical mortgage around $250,000, then the bank can only make 95 loans – and no more. Afterwards, unless it could grow, it would have to seize lending.

We, as a group of investors, approach the bank and offer to buy the mortgages at their full value. The bank welcomes the idea because it would unlock its capital. With the $1,250,000 it gets from us, it could make 5 new loans and generate additional closing fees. In this way, the bank is out of the picture. We are now the owner of a pool of debt totaling $1,250,000 that brings in $7,000 a month.

Money is fungible, which is why we could speak of “one” loan of $1,250,000. We could also divide. For example, we could divide the pool into 10 equal parts of $125,000, with each bringing in $700 in monthly payments. In fact, that would be the math we had to follow if our investor group had 10 partners.

With the total mortgages ($1,250,000) and monthly payments ($7,000) remaining the same, the number of “pieces” the original pool is divided into determines the principal amount and the monthly payment of each piece. If the pool is divided into 100 pieces, each will be worth $12,500 with $70 expected monthly payment.

Such “slicing and dicing” is one of the technical conditions for securitization: selling private, illiquid assets and liabilities to investors. But securitization, precisely because it involves sales, requires the knowledge of market conditions, so that the product would appeal to potential buyers. The list of items to be considered in that regard is a legion. But two factors stand out above the rest.

One is the number of “slices”. Obviously, the more pieces a given pool is divided into, the smaller the principal amount and the monthly payment of each slice. If our pool is divided into 1000 pieces, each will be worth $1,250 with a monthly payment of $7. But, needless to say, if we divide the pool into 1000 pieces, we must sell 1000 pieces. For that, we would need a sales network, a critical factor to consider as few financial institutions have such networks in place. A large volume of products with low principal and monthly payments, further, is a retail product, while a product with a relatively large principal of $125,000 and only in 10 lots, is more geared towards the institutions or “sophisticated investors”. This technical phrase is pivotal to the Goldman case, so we will return to it. I only note here that the retail products, i.e., products that are offered to public, are governed by stricter disclosure requirements.

The other factor to be considered in securitization is the “risk appetite” of the CDO buyers: the yield they seek vs. the risk they are willing to accept. The fact remains that under the best of economic conditions, some borrowers would default. The reasons for default – a loss of job, disability or even death – do not concern us. But if that were to happen, if, for example, borrower 5 were to default, the pool would receive $1,600 less in monthly payments. That would reduce the pool’s annual return from 6.72% (7000 x 12/125,000) to 5.20% (5,400 x 12/125,000). That is a 23% decline, a tremendous loss in the fixed income world. Such potential volatility would keep away many investors. To appeal to them, we must reduce the uncertainty.

Finance professors speak of “risk averse” and “risk appetite” as if they were psychological and genetic attributes of investors. In reality, they are the investing parameters of mutual and pension funds which forbid them from buying any security not rated AAA. As these funds are the largest investors in the CDOs – because they sit on large piles of cash – their concerns must be taken into account.

The risk of our pool as a whole is given and cannot change; it is the risk of default of 1 or more of the 5 original borrowers. But the introduction of some “class system” solves our problem.

Let us “divide” the pool into three “tranches”. We'll call them the equity or first loss (FL) tranche, mezzanine (MZ) tranche and super senior (SS) tranche, and declare:
In the event of a default, the FL tranche, as its name implies, will have to absorb the loss. If more defaults follow, the FL tranche will continue absorbing losses until no more FL tranche is left, after which the MZ tranche will absorb the losses. The SS tranche, as the name implies (it refers to the order of being paid) will be the last piece to be affected by a default. The arrangement follows a “water fall” pattern where the $7,000 monthly income first satisfies the payment for SS, then “flows” to MZ and then, finally to FL.
The last part is the allocation of principal and yield to each tranche. Keeping in mind that the SS tranche is the most popular and that yield has to increase as the riskiness of the tranche increases, we allocate the original $1,250,000 principal and the $7,000 monthly payment in the following way among the tranches.

SS: $700,000 [$3,600]
MZ: $500,000 [$3,000]
FL: $50,000 [$400]

Based on this allocation, the yield for each tranche is as follows:

SS: 3,600 x 12 / 700,000 = 6.17%

MZ: 2,800 x 12 /500,000 = 7.2%

FL: $400 x 12/ 50,000 = 9.6%

The CDO structure is now complete. All we need at this point is to convince a rating agency – S&P’s or Moody’s – that the SS tranche that is “protected” against default by two loss absorbing layers FL and MZ, is as safe as the safest corporate bond or even the U.S. treasuries and therefore, should command AAA rating. With that, our lawyers put all these details into an offering memorandum and we begin contacting investors.

A while back, in discussing the “collapse of the whole intellectual edifice”, I mentioned Kurosowa’s Rashomon in which the director explores the relation between the narrative and Truth: what do we need to know about something so we could say we know it?

What do we now know about the CDOs?

First and foremost, it must be clear why CDOs are called “vehicle” or “structural products”. They are vehicles for transforming: i) the risk of loans from the bank to investors in capital markets; and ii) the risk profile of a given pool of securities from moderately risky to supposedly riskless and very risky – the latter would be SS and FL tranches. As for structured product, it is the very description of how we created the CDO; a CDO is nothing if not a structured product, a fact that is reflected in the limitless flexibility we have in its design.

I am not exaggerating about the limitless flexibility. Let us begin with the number of tranches. I suggested three. You could make it four. Or five. Or six. Or even seven, if you prefer.

Then there is the number of original loans in the pool. I had 5 because that was sufficient for illustration, but CDOs typically have over 100 securities in the pool. That large number is necessary to make the structure robust so that 3 or 4 defaults will not wipe out the entire pool. The ABACUS 2007-AC1 in the center of the Goldman case had 127 securities.

Then there is the matter of allocating the total pool between tranches. I had 56% of the total allocated to the SS tranche (700,000/1,250,000). You could make it 60% or 70%. Likewise with the MZ tranche. Finally, I allocated 4% to the FL tranche, which is just about standard. This tranche, also known as “toxic waste”, is the riskiest tranche and rarely finds any takers. So the originator of the CDO – Goldman, for example – is usually stuck with it. That must have been the reason why Goldman claimed that it had lost $75 million. The loss had to come from the toxic waste piece that the firm could not unload.

Now comes the most complicated part: the pricing and price behavior of the securities in each tranche. In our example, we have allocated $500,000 to the MZ tranche. Assume that we divide it into 1000 securities, each worth $500 and with $3 a month in payments. What would be the price of this security?

On one hand, the security is a simple bond. We price it using standard bond mathematics. We know if the interest rates increase, the bond price would decrease, and vice versa.

But this security is not a stand-alone bond. It is a mezzanine note from a CDO in which cash flows come from a pool of mortgages. If the default in the pool rises, it will first hit the toxic waste tranche, it is true, but by virtue of “eroding” this tranche, it will begin to threaten the MZ tranche. The MZ tranche, in other words, will be riskier. And since the yield of the bond is fixed at 7.2%, its price would drop, even if interest rates remain unchanged.

The same is true for the SS tranche whose price can show no sensitivity to the defaults in the FL tranche – until it does. This is the so-called “cliff effect” that everyone in the CDO market was aware of. Financial Times, March 21, ‘06, p. 25:
[An independent consultant] describes how a CDO tranche can absorb a number of credit events, such as defaults and downgrades, and retain its level of subordination – or the size of the cushion that protects it from losses – until it reaches a point at which one further piece of bad news can push it over the edge. “Several things can go wrong in a deal and it will still be triple-A,” she say. “But then you get one more event and boom!”
You see what I mean by procedural complexity. There is nothing about the CDOs that a 6th grader cannot understand or follow. But no one can account for all the parameters that influence the price of a CDO.
  • Are the original mortgages from California, New York, Florida or Chicago? Mortgages from these geographies have different default patterns.
  • Are the houses occupied by younger or older occupants? That would impact the default rates.
  • Who wrote the mortgages and when? (If Countrywide in 2006, you’d better run for the hills).
  • How is the national and regional economy doing? Can it maintain a steady employment rate?
You can write a PhD dissertation on the subject of CDO pricing. You can devote your life to studying the correlation of defaults across the CDO tranches. You would then become a quant, a rocket scientist or a financial engineer, but you would still know nothing about the CDOs either at the individual level so that you could make money from them or at the macro level so could understand what makes these vehicles “tick”.

Here is Exhibit A, a quant with impeccable academic credentials and work experience, writing to make us “understand” the risk of synthetic CDOs. I am not picking on him. I mention him precisely because his paper is well written and a cut above others. I urge you to read it. Yet, here is what the author wrote on page 2:
These “bank balance sheet” deals were motivated by either a desire to hedge credit risk, a desire to reduce regulatory capital, or both. Following these early deals, the same synthetic CDO technology has been used to create CDO tranches with risk-return profiles that investors find attractive. These later deals, driven by the needs of credit investors rather than banks, are termed “arbitrage” deals.
He goes on to opine:
The terminology has taken hold despite the absence of a true “arbitrage,” which can be loosely defined as a risk-free investment with a positive excess return.
What the author is looking at is the genesis of speculative capital: the transformation of hedging to arbitrage; I spend the entirety of Vol. 1 explaining it. But he does not see it because his professors at Stanford and MIT failed to teach him that words have meanings. So, he does not pause on the word arbitrage to ask himself, You, horse’s behind, what does this word exactly mean and why do you have to define one of the key terms of modern finance “loosely”?

Where is the arbitrage in a CDO? You would not see it in a million years by looking at a CDO structure.

Let us return to our example where “we”, a group of investors, approached the bank and offered to buy its mortgages. Why would we do this? What is in it for us?

Taking into account the expenses of creating a CDO – in millions of dollars that we have to pay to agents like Goldman Sachs – we could find easier and better uses for our $1,250,000. So what drives the market? The answer is arbitrage. From Vol. 3:
The point is that arbitrageur, by definition, has no money. That is why he could not put it in the mattress. Yet, to exploit the arbitrage opportunity, he has to create a portfolio that requires an outlay of cash. For that, the moneyless arbitrageur has to go to a lender. He must borrow money. One blushes at emphasizing this point. But the emphasis must be made...

In the example, you assumed that “we”, the group of investors, had $1,250,000. But we did not. Even if we did, the exercise would have been pointless because of its costs.

If the transaction was consummated, we must have borrowed the money. What is more, we’d borrow the money through a Special Investment Vehicle, with a large bank such as Citi as the guarantor, which allowed us to borrow at the commercial paper market at about 2%.

Now, the mystery is solved: borrowing at 2% and lending, i.e., buying the mortgages that yield 6, or 7 or 8%. That is arbitrage for you and God Bless America. See Part 8 of the Anatomy of a Crisis for more details.

But we are not done. The CDO in the center of the Goldman case is a synthetic CDO, where there are no real mortgages. A synthetic CDO “replicates” the behavior of real mortgages. For that, credit default swaps must be brought in.

Friday, 28 May 2010

Was the Top Kill "Chance of Success" a Made-for-TV Number?

I'm always curious about how people use and abuse the tools of probability and statistics. In structured finance, slices of CDOs failed at a rate completely inconsistent with their high-level ratings. Okay, that's bad. But even worse is that when strips of CDOs started being packaged in other CDOs, not only did the level of complexity rise in the new products (the "CDOs squared"), but sensitivity to initial misrating -- and the implied low probability of default -- exploded. (The explanation of why this is so is a bit technical, but is worth checking out at Marginal Revolution's The Dark Magic of Structured Finance.)

Now Top Kill has failed.

Failed to plug the spewing oil pipe a mile below the water's surface in the Gulf of Mexico.

Failed to stop the environmental carnage taking place in the ocean and along Louisiana's shores.

Top Kill came with its own simple, straightforward probability: a 60 to 70 percent chance of success. The number gave us comfort -- BP was doing the right thing, because it had better than even odds of stopping the oil belching into the seawater -- but not too much comfort, because, obviously, the flip side of that rate of success is a 30 to 40 percent chance of failure.

I thought for a while about BP's public stance on the likely effectiveness of Top Kill, and thought some more, and finally concluded: Whether BP planned it this way or not, they came up with the perfect public relations probability of success. If Top Kill's chance of success was exhaustively and scientifically studied then ascertained to be a number anywhere between 10 percent to 90 percent, and BP came to me, and I was a seasoned PR professional, my advice would be:

"Say publicly that Top Kill has a 60 to 70 percent chance of success."

Why? Well, imagine it actually has a 10 percent chance of success. And BP admits that. What's going to happen? The public, media, elected officials -- everyone will turn on BP and excoriate the oil giant for not coming up with a plan that has reasonable odds of working. Then when Top Kill fails, everyone will roll their eyes and say, "Of course it was going to fail. It was a lousy plan with only a 10 percent chance of success."

Now imagine the converse: there is actually a 90 percent chance that Top Kill will achieve its objective. And BP announces that. If the operation then succeeds, there will be a sigh of relief, but also a sort of collective shrug. What did you expect? After all, a 90 percent chance is the equivalent of an uncontested layup in the game of basketball. But if Top Kill failed, reaction would be furious: how could they screw up something with a 90 percent chance of working?

Now where's the sweet spot? It's a percentage that aligns with "cautiously optimistic." It's a percentage a little north of 50 percent -- but not too far north. It's a percentage that, if you fail, you can say, "Well, we knew from the beginning there was a large chance we weren't going to be able to do this," but if you succeed, you can say, "This was far from a sure thing, but we pulled it off, and congratulations to the great team at BP blah blah blah." That sweet spot, quantified: 60 to 70 percent.

Who knows what the actual chances of success were? I'm not an engineer, but once I learned a bit about Top Kill, it sounded fairly dubious. It sounded more like an operation with a 25 percent chance of working -- if that.

What if we wanted to find out what BP's top executives, in their heart of hearts, really thought were the odds of pulling off Top Kill?

Here's one way: the top 50 BP executives could've been forced to stake half of their wealth to a "futures" market on whether or not Top Kill would work. Sort of like betting on a prize fight. They would be allowed to trade in and out of odds that would fluctuate (much as is done for a heavyweight championship fight) depending on which position the money is favoring, and by how much ... and eventually, we'd get something resembling what BP really thought were its chances of plugging the leak. So, for instance, one guy would be betting half his wealth that Top Kill had a 65 percent chance of working (and would collect 35 percent if he won) and another executive at BP would be wagering it had a 35 percent chance of working (and would collect 65 percent if he won).

A little fanciful, and you may wonder -- well, who cares if BP lied to us (note: I have no idea if they did, but wouldn't be surprised) on the odds? Actually we should care because when the odds are 10 percent, not 60 to 70 percent, there's much more pressure to develop a "Plan B" -- and "Plan C" and "Plan D" as well. And I kind of wonder if the odds were at say 65 percent of Top Kill being a success -- and BP executives could take that position, but it would cost half of their wealth to play -- how many would've gamely said, "I'm in on that bet!" My guess: very, very few.

Sunday, 16 May 2010

Reading Between the Lines: Europeans Will Be Europeans No More

Last week, Greece became the byword for the European “fiscal crisis”. The mainstream press and media pulled out all the stops in hyping an impending doom if the severest austerity measure were not put in place – and soon. The Financial Times had little else in its opinion pages except warnings by its regular and guest columnists about the eurozone’s “race to the bottom”, Europe’s “lack of preparedness for austerity”, Britain’s “lack of preparedness for austerity” and the view in “Germany” – based on interviews with a few Germans – that the trillion dollar aid package was doomed because it did not address the fundamentals, which could only be corrected with more austerity.

The New York Times got into the act, too. It dispatched Tom Friedman to Greece for an interview with Papandreou. Friedman is an idiot, though of the useful kind. Because he never understands what the “shot” is, to show his importance, he reveals whatever he picks up in conversations. He paraphrased the prime minister that in return for the aid package “Greece’s entire economic and political system will have to change for Greeks to deliver their side of this bargain.”

Exactly. I could not have said it better myself. (Do you hear, Prof. Becker?)

FT’s Gideon Rachman is a fool of a different kind. He has business contacts and knows more of what is happening, but only as conveyed to him by business interests. But as the mouthpiece of capital, he uncomprehendingly – and inevitably – reveals more than he intended. Here is some of what he wrote last week, followed by my comments.
Most of the European Union is living beyond its means. Government deficits are out of control and public sector debt is rising. If European governments do not use their new breathing space to control spending, financial markets will get dangerously restless again.
Note the European Union. In Those Overspending Americans, we saw that American consumers were being scorned for spending more than they earn and thus, impeding the economic recovery. That cannot be said of the European consumers. They do not have personal debt the way Americans do precisely because the wages in Europe have kept up with productivity and inflation and the European governments have more generous social programs. Hence, Rachman’s attack on the European Union, by which he means the individual European governments.

Now, look at the threat: What would happen if European governments do not control spending? Will there be the bubonic plague? Will locusts come? Will the world end? No, only “financial markets will get dangerously restless again”.

What are financial markets? They are the province, the realm, of private capital. So, we see who – or rather, what – is pushing for the austerity. Governments, columnists, commentators, politicians are mere proxies. Rachman continues:
Unfortunately, European voters and politicians are simply unprepared for the age of austerity that lies ahead... Many have come to regard early retirement, free public healthcare and generious unemployment benefits, as fundamental rights. They stopped asking, a long time ago, how these things were paid for. It is this sense of entitlement that makes reform so very difficult.
One question, then, Mr. Rachman. If the citizens of the European Union must work till they die, cannot have free healthcare and will have to go hungry when unemployed, what does it mean to be a European? Were not these “entitlements” precisely the core lifestyles issues that the Union promised its citizens and on which the idea of the Union was sold to a skeptical public? Without these entitlements, how would you dangle the prospect of a “European life style” as the role model for the citizens of say, Afghanistan?

The man, though, asks one important question. How are these things paid for, he asks? He implies that these things cannot be paid for, because Europeans cannot afford them, so they have to cut the expenses. But he is being dishonest. There was a time – an extended time, really – when European governments did pay for all those entitlements, which is what made Europe, well, Europe. Come to think of it, even the U.S. companies apparently could afford to pay for such entitlement. In the 1950s, you got a job at GM, supported your family for 30 years, bought a car and a house and then retired with a pension to enjoy the rest of your life.

What happened? The answer, as I pointed out elsewhere, is that the rate of return of capital in the West declined. That is one thing you will not see mentioned in the coverage of the crisis. Necessarily then, the barrage, intended to soften up the rabble for the austerity, focuses on the diversions: overspending, immigrants and playing one group against the other. Rachman:
The growth in the size and power of the EU has fed a dangerous sense of complacency. For the countries of southern and central Europe – who joined later than the inner core – “Brussels” was sold as the ultimate insurance policy. Once they were inside the EU, it was felt that war, dictatorship and poverty were safely consigned to the past. Everybody could aspire to the relatively comfortable, stable lives of the French and Germans... There is already much bitter talk in Greece about the loss of national sovereignty, matched only by bitter talk in Germany about the cost of bailing out the feckless southern Europeans.
The ouzo drinking, grape-leaves eating Greeks thought that EU membership meant class; they were all going to be French and Germans! That is not the attitude of thuggish Rachman. Liberal Paul Krugman concurs:
So, is Greece the next Lehman? No. It isn’t either big enough or interconnected enough to cause global financial markets to freeze up the way they did in 2008.
(Parenthetically, note at the man’s mentality. I wrote about Paul Samuelson comparing the U.S. navy to an apple. Here is his disciple, the Nobel Prize winning columnist of the New York Times comparing a country with a sham operation and concluding that the sham operation – now defunct – was somehow “superior”. Like the under-aged prostitutes who remain in awe of their pimps no matter how much they criticize them, Krugman remains in awe of a place like Lehman – and Goldman and Citi – as the magical places of power run by tough guys such as these.)

Still, some might not have gotten the point. Rachman, a Larry Summers like fellow, spells it out for them:
The idea was that a Union that spanned 27 nations was large enough to protect a unique European social model from the uncertainties of globalisation. At the most fundamental level, the EU does indeed protect. But while Europeans no longer fear foreign armies, they are starting to fear foreign bondholders. Europe’s existence as a “lifestyle superpower” has depended on an ample supply of credit ... [They] are discovering that the “European project” provides no protection against the harshness of the outside world.
Uncertainties of globalisation. The harshness of the “outside world”. Curious admissions these, if you can read between the lines. The pieces are beginning to fall into place.

One question remains: why did Greece – and Spain and Portugal and even Italy – join the eurozone? What was in it for them, if their entire social and political system had to undergo a radical change without any protection against the harshness of the “outside world”?

The answer is that they did not join. They were dragged in against the will of their population. The idea was to bring in the cheap labor of poorer countries in southern Europe to boost the “productivity”. Then the newcomers began to entertain the fantasy that they had joined a country club as members. They were in fact brought in as workers and janitors. The financial crisis provided the opportunity to drive this point home, to disabuse them of their fantasies. What Clinton did to the poor in the “welfare reform”, the eurozone membership is doing to its southern members: their lives, as we know, will change. The target in the two cases is different but the underlying double whammy is the same: to stop paying the poor – there is no free lunch – and force them into the labor market to push down the labor costs to boost productivity. From today’s Financial Times, under the heading “Spain puts labour reform on agenda”:
In Frankfurt, Jean-Claude Trichet, president of the European Central Bank, said controls on public finance were essential to boosting eurozone countries’ economic prospects. “It is a complete fallacy to say that fiscal soundness dampens growth. It is exactly the contrary. It is the absence of fiscal credibility which dampens growth.”
There is no relation whatsoever between growth and spending. How much money you are earning or will earn in the future does not depend on what you spend. Yet, the president of the ECB links the two. Why? Because “fiscal soundness” he mentions is the code word for reducing labor costs by cutting their pay and pensions. That is what the fight is all about: to bring down the labor costs to at least temporarily boost the growth, i.e., increase the rate of return of capital, whose consistent decline in the past decade remains a matter of serious concern to the planners of the European Union.

Saturday, 15 May 2010

So Why Did the Stock Markets Do a Bungee Jump on May 6?

What I find interesting about this story (and if you think bungee jump is hyperbole, you haven't looked at the intraday Dow chart) is there's a decent analogy: Imagine that murder victims start turning up in some small, idyllic U.S. city. Throats slashed, bodies mangled. Residents grow fearful. They start locking their doors all the time, glancing over their shoulders, going out less. The pressure mounts for police to find the killer, to calm a jittery city.

Now imagine a hit-and-run of sorts in the financial markets. Stocks make a sudden, vertiginous plunge, only to rapidly recover. Billions of dollars of wealth evaporate, then reappear. But how did this happen? Who caused it? Who profited from it? Could they do it again, and what if the next time the markets don't bounce back? And so investors grow fearful. They wonder: Should I continue to put more funds into volatile stock markets? Can they be trusted?

And the search begins, among the financial forensic teams, to find a culprit for the turbulence on May 6.

Except -- here's where our serial killer analogy breaks down -- was it really a lone actor? We'd like to think that; it fits into a more comforting narrative, with justice to be meted out if we find wrongdoing, and if we don't, we at least know where to take measures to fortify the system. Could it be Mr. Fat Finger Trader? The clumsy oaf who pressed "b" for "billion" on his keyboard when he meant "m" for "million"? Or here's the latest suspect, according to
Shares of money manager Waddell & Reed Financial Inc. fell Friday as it was identified as the stock trader that sold off a large number of index futures contracts during last Thursday's market collapse ...

Waddell's sale of 75,000 e-mini futures contracts in a 20-minute span on May 6 drew the attention of regulators, Thomson Reuters reported.
These "minis" are tied to the S&P. A futures contract is a way to bet on which way you think a market, stock or commodity is going to move; narrowly defined it's an agreement to buy or sell something at a set price on a set day in the future.

Now that 75,000 number does seem impressive. Well, at first. tells us:
The current average daily implied volume for the E-mini is over $150 billion making it the most liquid trading derivative in the world.
What was the implied volume (I'm assuming "implied" refers to the contract's notional amount) for the 75,000-unit trade? Start with the notional value of an e-mini: $50 times the price of the S&P index. The high for the S&P that day was 2,407.8, so this trade was probably executed at somewhere south of that. Let's say the e-mini "dump" amounted to less than $9 billion of implied volume on May 6.

In other words, less than 6 percent of the typical daily volume came from this sale. Was this a big trade? Sure. Was it a little hard for the market to digest? Probably. Was it the real villain that we're seeking? I doubt it.

It's a media-ready story though. The storyline is simple. The government also surely realizes that finding a lone actor will make its job so much easier.

Unfortunately, a more sophisticated analysis of possibly the real culprit on May 6 has emerged, an analysis that is not so comforting. It suggests that our stock markets have a deep, systemic flaw. Paul Kedrosky at Infectious Greed nicely, and succinctly, laid out the argument in "The Run on the Shadow Liquidity System."

His view: good old-fashioned liquidity in the stock markets has been transformed in the age of supercomputers and high-frequency trading and algorithm-driven strategies:
... traditional providers of liquidity, market-makers and other participants, are not standing so ready to make the other side of the market. There are fewer traders prepared to make a market for the sake of market health. This is ... mostly because of what has happened with high-frequency trading, algorithms, and the like, which increasingly jump into the trading queue in front of and around orders, creating some liquidity, but also peeling pennies for themselves, frustrating market participants and heretofore liquidity providers...
The result:
... all of this changes market microstructure in insidiously destabilizing ways. For the first time we have large providers of this shadow liquidity, algorithms and high-frequency sorts, that individually account for large percentages of daily trading activity, and, at the same time, that can be turned off with a switch, or at an algorithmic whim.
Certainly we need to find what went wrong on May 6. We need to, to reassure the investing public that our stock markets are safe, fair, reliable -- places where you can feel comfortable putting a large chunk of your retirement nest egg. But, in the rush to judgment, we should be on guard against trying to largely pin the events on a lone actor, just to avoid a truth that is both complex and inconvenient.

Update: Actually, the fingerpointing at Waddell & Reed appears even more misguided than I thought ... you can blow up those calculations I made above; they were for a normal trading day. Turns out that during the 20-minute freefall on May 6, 842,514 e-mini contracts swapped hands (says Reuters). 75,000 is less than 9 percent of that number (and is probably only a few percent of the total for the day) ... again, it's sizable, but remove Waddell & Reed, and you still have a heavy, heavy volume.

Sunday, 9 May 2010

Weekend Musings: Why Bother With Mosquitoes?

James Cayne, the ex-CEO of Bear Stearns, and his lieutenants were called before the Financial Crisis Inquiry Commission I know not for what.

Even when everyone feigned surprise, it was a tired show. Surprise! Cayne did not curse. The Wall Street Journal:
At times, it seemed like the panel was caught off-guard by the matter-of-fact manner, beginning when Mr. Cayne kicked off his testimony by admitting that Bear's leverage was too high.

The New York Times:
He [Cayne] showed little emotion at the hearing, giving no hint of his reputation for outbursts during his nearly 15 years at the helm of the company before stepping down in January 2008.
What could an old whore do but repent from debauchery and a sacked sheriff from hectoring?
The goon turned walking gentleman offered this gem about the cause of the collapse of his firm. The firm’s collapse, he said, “was due to overwhelming market forces”.

Since the creation and continued operations of Bear Stearns was also the result of market forces, the ex-CEO volunteered that Bear died because it was alive. Try topping that as a “cause of death”.

Paul Friedman, a senior MD running the repo desk, said that “Bear decided in late 2006 to reduce its reliance on short-term unsecured funding, primarily commercial paper ... Despite those efforts, Bear couldn’t have obtained enough long-term financing or made other changes to save it from its eventual demise.”

Recall that the trigger of the crisis was the collapse of two Bear funds in June 2007. So in “late 2006” they already knew they had hit the iceberg, as anyone who knew Bear’s operations knew. The protestations of ignorance and being caught off guard were all lies.

Why would you invite mosquitoes to testify about the cause of malaria?

Wednesday, 5 May 2010

Epilogue: The Meaning of “System” in Systemic Risk

I was reading about tomorrow’s elections in England, when I thought of Tony Blair which reminded me of the two-part series, The Meaning of “System” in Systemic Risk. I had meant to end the series with an epilogue, but I forgot. So, if you were following it, my apologies for what surely seemed like an abrupt end.

Yet, as Rumi would say, we never really left the subject; all posts on this blog are about systemic risk. Such is the nature of the "relations" about which I have been philosophizing of late. When you get the main relation, the whole, right, the parts, in the forms of individual developments, will confirm, accentuate and strengthen it.

Yesterday, for example, I read that Chancellor Angela Merkel had quoted Swabian housewives to give a lesson to German and European “overspenders”: “One should simply have asked a Swabian housewife. She would have told us her worldly wisdom: in the long run, you can’t live beyond your means.”

I had written about this very topic the day before.

Also, yesterday, Bloomberg reported that the president of the European Central Bank was considering “tossing out” the bank’s rule book to better handle the Greek crisis:
European Central Bank President Jean-Claude Trichet, who capitulated on a January pledge not to relax lending rules for the sake of one country, may have to sacrifice more principles to prevent Greece from bringing down the euro.

Trichet yesterday diluted rules for the second time in a month to guarantee the ECB will keep taking Greek government bonds as collateral for loans. The central bank may have to extend that to other nations, renew a program of lending unlimited cash to banks for a year, and even start buying government debt if the 110 billion-euro ($146 billion) bailout plan for Greece fails to stem the euro’s slide, economists said. “Rather you break the rule book than the euro area,” said [a European economist].

This, too, is familiar to us. Recall that it was Bernanke who first tossed out the rule book, as I discussed here and here.

Returning now to election in England, you would do well to keep in your wholesome remembrance that the heated exchanges on immigration, EU membership and such are campaign tactics meant to highlight the differences among the candidates. These differences are real, to be sure, in the same way that the differences between a wolf, a fox and a coyote are real. But when it comes to farmers’ poultry and livestock, there is a remarkable, and altogether not surprising, convergence of opinion among the three.

The chicken coup and livestock in the British election are the NHS and the government services. Head, they will be sharply cut. Tail, they will be sharply cut. If the coin lands on its edge, they will be sharply cut.

So, what are the messages we have been getting from political leaders and their humble servants, the press?

  • People have to spend within their means.
  • Governments have to spend within their means.
  • The central banks have to toss out their rulebooks.
These issues are linked by one thread: the inability of capital to produce enough profits to regenerate itself. But profit is the driving engine of the existing social systems. It follows, then, that we are facing is the inability of the social system to preserve itself, i.e., the status quo. If profits were workers bees, I suppose you could call the phenomenon colony collapse disorder (CCD) , except that the cause of the disappearance of profits is no mystery to those willing to look.

The technical arguments for the austerity that you hear – that, for example, the population is living longer so there are less workers supporting a larger number of pensioners – have a modicum of truth in them. But they are the description of the effects, and not the cause. The underlying cause of the problem is the fall in the profit rate. That is why workers are laid off, in consequence becoming a double drain on resources: they do not contribute to tax revenues, and, furthermore, receive unemployment benefits.

The problem is actually quite serious. Imagine a 40 year old suburban woman comfortably married to a successful businessman. The husband dies, leaving behind some money, but not much. What are the woman's options, without any work experience or a trust fund to support her?

Realistically, there are two options. She could drastically, very drastically, cut back on her life style – goodbye SUV, good bye expensive handbags, gym and perhaps country club membership, clothes, jewelry – and become a teacher earning enough to put bread on the table. Or she could become a wealthy neighbor’s mistress. Given the mentality and social background of a suburban woman, there is really one choice. That is, there is no alternative.

Consider now, if you will, a political leader whose convictions about social issues – justice, equality, progress – are approximately at the level of the conviction of a suburban housewife about chastity. (Else he would not be a political leader.) Faced with the reality of falling revenues, he would have two alternatives: drastic cuts, or sacrificing convictions in the hope of re-starting revenues. That would be the story of Tony Blair who, as a Labourite, could not tolerate deep social cuts. That left him with no alternative but to embracing the only source of revenue which, for the social system he was elected to lead, was the “entrepreneurship”. All the compromises that followed, followed from there.

Blair, needless to say, is not alone. He is a politician of “our time”, in the sense that I have explained.

What complicates matter is that long term has finally caught up with us. It is now 20 years later and our suburban widow is no longer 40 but 60. Now there is really no alternative to draconian cuts. That is what we are seeing across the Western world.

The politics of the matter do not concern us here; of course politically conscious Greeks are more vocal than the social zombies in much of the Western Europe and the U.S.

What concerns us is the material basis of this phenomenon – the fall in the rate of profit – that is rooted in economics and finance. That is the subject of Vols. 4 and 5 of Speculative Capital. It will also be the subject of future posts on this blog.

Monday, 3 May 2010

Those Overspending Americans

Data released by the Commerce Department today showed that, once again, American consumers are spending more and saving less. As reported in The Financial Times, a JPMorgan analyst interpreted the numbers thus in a note to his clients:
Speculation that consumers are reforming, repenting and rebalancing now looks premature or overstated.
So, we are back to the narrative of irresponsible consumers bringing the U.S. economy to its knees by spending beyond their means. The fault, dear Brutus, is not in stars.

In several places on this blog, I have explained the material basis of this seemingly moral weakness. This time, I will let the vice president of the U.S. explain, as quoted in the same paper (April 21, p. 3)
Mr Biden, who is in charge of Barack Obama’s “middle class task force” said the last US economic cycle, which began in 2001 and ended in 2007, was the first in history that left median incomes where they were at the start.

Yet, over the same period, the growth in productivity, which had traditionally fed through into wage growth, hit record levels ... Economists say that the gap between productivity and wages has turned into a chasm since the last recession began in 2007. Real wage growth between the lat quarter of 2008 and the last quarter of 2009 was negative while productivity rose by 5 per cent.

That is the story in a nutshell. People are spending and not saving because they cannot save, because their income is not sufficient to cover their needs. End of story.

Or not. The truth is that the Morgan analyst is technically right by virtue of the definition of over-spending. If you earn $100 and spend $105, you are spending beyond your means, no matter what the explanation.

That narrow technical point is precisely what is being driven home. No one can spend beyond their means. One must cut down the spending or face bankruptcy and pauperism. Sure, cutting down the spending means less vacation, less meat, less discretionary income and therefore, an overall poorer work force, but so what? You have heard of regulatory arbitrage where the companies shop for the most forgiving regulator and tax arbitrage, when they shop for the most favorable tax treatment. Why not put in place a nice little labor arbitrage?

If you are good with Google, you can find a Bush administration official on the record saying that Americans must “tread water” until the Chinese work force materially catches up with them.

Saturday, 1 May 2010

The Goldman Case – 1: Introduction

You must know about the “freak shows” that were popular up until the middle of the last century. These macabre circuses traveled from place to place and exhibited their “freaks”: the elephant man, the snake woman, the scorpion girl and such.

The rabble went and paid to look at the freaks and count their blessings. Imagine being the parents of the “scorpion girl”!

Such naked exploitation of physical deformities is no longer acceptable. But the practice continues under a different guise. The freaks are now the child prodigies. The 5-year old Korean who plays Appassionata. The 4-year old Iranian who has memorized Qur’an –without knowing Arabic, no less! And the usually home-schooled, always awkward 8-year old who can correctly pronounce and spell onomatopoeia, hippocastanaceae and cwm.

These are mechanical performances, of course, like a bear dancing or a dog shaking hands. What these children know of music, religion and language is barely above what a space-traveling “astronaut” chimpanzee knows of Newtonian mechanics. The charade goes on because it promotes the idea of a haphazard and random life in which a lucky few are dealt a winning hand. You, too, could have been a contender, could have had class, if chance had not willed otherwise.

Art, religion and language are social systems that men create in order to survive. They help stabilize the social relations, stability being a prerequisite for reproduction. The more you are aware of these relations, the more “human” you are, the word used here in its social and not biological context. Humanity is precisely the awareness of others, both of people and relations. Exploring these relations is the subject of the humanities. (Exploring the relations in the natural world is the subject of science.)

The social relations, of course, do not have the permanence of natural laws and change with the development of human society. But they, too, are hidden from the view and must be discovered through a process, which is the search for Truth. Only through this process one gains the knowledge of physical and social worlds.

In the physical world, we verify the accuracy of our knowledge in practice. In the social world, the verification comes from the capacity of knowledge to systematically expand ; if such capacity is not present, the knowledge is false. But if knowledge corresponds to the essence of the phenomena, it must logically and perpetually move forward, with each stage containing and explaining whatever existed before. The process cannot contain unresolved contradictions.

Recognizing the Truth, thus, is the meaning and idea of human development. In the case of the writer, the composer, the painter, the philosopher – those, in short, whose vocation is exploring the social relations in search of the Truth – such development must reflect itself in progressive “maturity” of the producer and his works, resulting in ever deeper revelations about human relations.

That is another way of saying that in the investigation of social or natural relations, there are no accidents. But unlike in the natural world where our immediate sense of perception is limited by the properties of the material world – sounds beyond certain frequency we cannot hear, colors beyond certain frequency we cannot see – and must thus await the advancement of tools, the human relations are accessible to all. What is more, if their essence is understood, the understanding cannot but lead to the awareness of even more profound relations.

(Agamben has written about the “destruction of experience”, but he does not explore it from the one angle that can satisfactorily explain the destruction: the inability of the modern man to connect various aspects of his social contacts. That is what the destruction of experience means. Otherwise, experience, in the Kantian sense of the word, which is coming into contact with the outside world, cannot be destroyed. Agamben confuses – i.e., does not distinguish – the experience in the world of social and physical. So when, after a mystifying reference to the destruction of experience, he writes that “Hence, the disappearance of the maxim and the proverb, which were the guise in which experience stood as authority”, he is clearly talking about social experience. Maxims and proverbs work precisely by bringing in an example from the natural world to the social world to highlight social relations. I will return to this common confusion of contemporary Western philosophers in Vol. 5.)

That is why the spectacle a child playing a sonata by a master can only be a showcasing of instrumental skills. The content of the music, its message, can only be conveyed through the experience, a condition which precludes youth.

That is also why you would be hard pressed to name a contemporary writer, artist, philosopher, musician or director whose works have improved with time; I only know of John Berger and, to some extent, Beckett. The cultural personalities in the West are “adult prodigies”. They come to the public's attention with one “brilliant” performance or a “phenomenonal achievement” only to stagnate as the has-beens of the “cultural scene”.

Among the Western writers, Chekhov is the most outstanding example of consistent evolution. Thanks to the money men of commercial theater, many know him as the author of only Cherry Orchid, Three Sisters and Seagull. But his works are a legion. And they get better and more profound as the author ages.

Vladdimir Kataev has written one the most authoritative books on Chekhov accessible to layman. In fact, his “If Only We Could Know!” is so comprehensive that it is difficult to add anything original to it. Kataev explains that Chekhov’s writing is “about a discovery that destroys a previously held, superficial conception of life” and then adds elsewhere: “In Sakhalin [Island], Chekhov witnesses the terrifying extend of the evil prevailing in the world; but what he also realized was how carefully thought out and responsible any word of protest against that evil must be.”

That last comment brings us to the Goldman case.

I am not implying that Goldman is personified evil. On the contrary. The point is that comments that are not responsible and carefully thought-out would have absolutely no impact on the outcome, will achieve nothing and will go nowhere. That is the critical conclusion of a perceptive and mature social observer in his later years. It should not be taken lightly.

Goldman is a giant vampire squid wrapped around the face of humanity.

Goldman is doing God’s work.

Goldman good.

No, bad.

We need to take an objective look at the case. That is why we study finance: to take an objective look at matters of finance.