Sunday, 27 June 2010

The Goldman Case – 4: CDSs and Synthetic CDOs

The CDO at the center of Goldman case is a synthetic CDO.
According to the New York Times, a paper that has won many awards for educational reporting – that would be reporting that educates the public:
During the later stages of the boom, banks began offering so-called synthetic CDOs. Instead of combining bonds, these combine credit default swaps written against specific bonds or pools of bonds. Credit default swaps were developed as a kind of insurance on financial instruments, albeit in an unregulated form. Essentially, one party swaps the risk of holding debt with another by paying a fee to that swapholder in return for a promise that a certain amount of money would be paid in case of default.
According to Wikipedia:
In technical terms, the synthetic CDO is a form of collateralized debt obligation (CDO) in which the underlying credit exposures are taken on using a credit default swap rather than by having a vehicle buy assets such as bonds.

According to Investopedia, a synthetic CDS is:
A collateralized debt obligation that invests in credit default swaps. This investment can lead to large returns for holders of the CDO; however, the nature of credit default swaps may leave the holders liable for more than their initial investments, should there be significant changes in the credit default swaps.
These descriptions are not, per se, inaccurate. They are useless. You do not understand anything about CDOs from them because their language is clinical, the way a torturer would describe the details of torture without communicating anything about the horrors of the act. Clinical language is pernicious because it masquerades as the detached language of the “expert”, while decontextualizing the event it is supposed to describe. So we get empty words and the impression of knowledge being imparted, while nothing of the sort happens. Note how every definition above has a reference to credit default swaps without saying what they are or how they relate to the synthetic CDOs. Obscurum per obscuris.

Acquiring knowledge is an active process. It demands the conscious participation of the learner, which is another way of saying that knowledge has to be arrived at; it cannot be given. Let us return then to our investor group and see if, starting from where we left, we could arrive at comprehension of synthetic CDOs. Recall that we had “shot” the housing market by pressuring lenders and underwriters to indiscriminately create mortgages so we would bundle them into the CDOs and make a bundle in the process. The process wrecked the underwriting standards and pushed housing prices ever higher. With chickens about to come home to roost, the time has come to reverse gears. Now is the time to make money from the crashing housing market and defaulting mortgages. But, how?

Every trader knows the tools of the trade when things start going south: short selling and buying put options. Short selling is selling a security you do not own. The idea is to buy it back later, after it has fallen in price, for a profit. It is the time-honored buy low/sell high rule executed in the reverse order. While selling something you do not own is fraud in the standard commerce, in the securities market, it is de rigueur. The reason has to do with the peculiarities of the concept of security. From Vol. 2:
As a condition of opening an account in a brokerage firm, customers must sign a form granting the firm the right to lend the securities in their accounts to short sellers. When a security is “lent,” short sellers must compensate the original owners of the securities – the customers – in all respects such as dividends and splits save one: they do not and cannot grant the voting power to the customers because voting power is attached to shares and not the accounts. If the shares leave, so does the voting power. The condition for purchasing ownership in a corporation is agreeing to give up the legal rights of that ownership!

This fact may strike many as an absurd manipulation by the brokerage houses, but it is in fact a consequence of the very nature of a security. A security is evidence of ownership of notional capital. It confers on its owner not the right of ownership of the physical production apparatus but the right to appropriate a pro rata share of profits only. Since the short seller compensates the security’s owner for the profit portion, the owner has no more “rights” left.
But to be shorted, a security must be widely held, otherwise we cannot borrow it from another holder for the delivery. Individual mortgages are held by a single party. It would be impractical – indeed, impossible – to short them. How could we buy them back if the sole holder did not want to sell?

The other bear strategy, buying put options, is likewise not an option. There are no put options on mortgages, not the least because options pricing is based on a process that depends on short selling.

All this, however, is beside the point. It is missing the point, really, as these methods would not suit our purpose even if they were available.

Short selling and buying puts, you see, are capital market strategies in the sense that they are derived from, and exist, on the assumption of capital markets being a going concern. They assume uninterrupted trading. They are bearish strategies, of course, but they are the logical flip side of the bullish strategies which, combined, make up and define trading and capital markets.

We have an entirely different focus. We do not want a mere big win, a 10, 20, or 30 point gain from the price decline of some securities. Those are for boys -- and birds. We are men. Our aim is accordingly high. Why settle for mortgages declining when mortgages defaulting is in the cards? Since default is the extreme case of decline, our profits should be accordingly – and unprecedentedly – bigger. Our byword is implosion. We are shooting for a clean sweep that will come about in consequence of the collapse of mortgages.

Our strategy, then – and, by extension, the “products” designed to execute it – cannot be of capital markets. Implosion of securities negates securities trading.

Very little by way of contemplation is needed to realize that the only tool that fits the bill is a bet. We need a bet in which, if mortgages default, we would win big. But we need an intermediary, a financial powerhouse with contacts, which could find a counterpart to the bet and design and execute the plan. Would this intermediary let us pick the mortgages as well? After all, if we are betting big time, we need a fighting chance. It's only fair. Remember the $700,000 mortgage given to that Mexican strawberry picker who had made all of $14,000 in the prior year? How about something marginally better?

So, we take 5 “good” mortgages to the intermediary – Goldman, for example – and explain our plans. Here they are. We saw them in Part II:

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.

The first step is creating a CDO in 3 tranches. Here is the CDO in three tranches: super senior (SS), mezzanine (MZ) and first loss (FL). The total principal and the monthly payment [in brackets] of each tranche is also given. We are familiar with this one as well from Part II:

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

Recall that the annual yield on the super senior (SS) tranche is 6.17%:

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

With the raw material in hand, the intermediary calls upon its financial engineers, structure finance specialists, quants, wizards, rocket scientists and gurus to satisfy our demand, i.e., deliver to us a bet that would have the potential of a clean sweep. The focus, for the reason that will become clear in the sales pitch, is on the SS tranche only.

This is how the bet’s design process progresses:

What is the “other side” of the bet, the opposite of mortgages defaulting?

Well, it is mortgages not defaulting.

Good. How do we create the payoff? Who wins what if mortgages default – or don't?

Let us begin with the other side. What does the other side win if the mortgages in the SS tranche do not default?

The answer is, what the tranche pays, as long as there is no default. That is, $3,600 each month or $43,200 a year.

What would our client – here they are talking about us, the investor group – win, if SS mortgages default? Keep in mind that the client wants to win BIG.

What is the biggest number “pertaining” to the SS tranche? Yes, the absolute largest number “related” to the SS tranche, even if the question does not make sense.

The answer is the total principal of all mortgages in the tranche, equal to $700,000.

That is it then. The bet is set. Here is how it works.

One side gets $3,600 a month. The other side – we, the investor group – undertakes to pay it. Now, suppose mortgage No. 3, with the principal amount of $250,000 defaults. Nothing would happen in theory – and practice – because that does not affect the SS tranche. We would still have to pay $3,600 a month to our counterpart.

Then mortgage No. 4, with the principal amount of $300,000 defaults. Still, nothing happens to the SS tranche – in theory. We still would have to pay $3,600 a month to our counterpart.

Now, however, $550,000 worth of mortgages out of the total $1,250,000 have defaulted. The cushion that was protecting the $700,000 SS tranche is gone. One more default, and it will hit the SS tranche.

Suppose now mortgage No. 1 defaults. In that case: i) our monthly payment to the counterpart is reduced by $1,150, which is the monthly payment of mortgage No. 1; and ii) our counterpart has to pay us $200,000, which is the principal value of mortgage No. 1!

It gets better.

If mortgage No. 5 also defaults, the payment to our counterpart will be reduced by a further $1,600. Furthermore, the counterpart has to pay us an additional $260,000, which is the full principal of mortgage No. 5

Finally, if the last remaining piece, mortgage No. 2, also defaults, we would owe nothing in monthly payment to the other side. But the other side has to pay us $240,000, the mortgage’s principal amount.

If these scenarios were to happen, we would pay $3,600 a month for a few months, or a few years, until the mortgages began defaulting. In return, we would receive $700,000. That is the clean sweep, the big play. If you multiply the amounts in this example by about 1,500, they would approximately correspond to the transaction in the center of the Goldman case.

Note what happens to the mortgages when they are made the subject of a bet: they lose their characteristics as securities. To bet on their demise or survival, we no more need to own the legal title to them than a bettor in the race track needs to own the legal title to the horse he is betting on. This follows from the fact that our “strategy” is a mere bet and hence, outside the realm of finance. The sole role of the mortgages is now being a reference point – reference securities, they are called – for the determination of the winner and loser of the bet. In this way, our original, cash CDO becomes a synthetic CDO, where the mortgages as securities have been turned into mere virtual indices.

How is a synthetic CDO to be priced? If legal ownership existed, the question would be a simple matter of bond pricing. But there is no ownership, only the privilege to receive the monthly payment of mortgages, as if one owned them. So the question becomes, how much is that privilege worth?

The raison raison d'être of synthetic CDOs answers that question. The purpose of a synthetic CDO is generating a potential windfall for the seller, should the mortgages default. So, in return for receiving $3,600 a month, the buyer of a synthetic CDO tranche undertakes to pay to the seller the full principal amount of any bond in the tranche that defaults. This latter is a credit default swap: paying the full principal of a bond in case it defaults.

Synthetic CDOs, CDSs and their relations to one another are now clear. Return to the top and read the definitions. They will make sense.

All that is left is the small matter of selling this bet to the prospective buyers of the synthetic CDOs, say, ACA Management and IKB Deutsche Industriebank.

Here is the pitch:

Interest rates are at historically low levels. Five year Treasury rates are just over 4.17%, so if you invest $1 million, you will get $4,170 a year. How would you like to better that by 2 percentage points, to 6.17%, with the same credit quality?

Yes, really! Of course, in the fixed income area where the managers fight for two-hundredth of a percentage point,
2 percentage points does seem beyond the realm of possible, especially without sacrificing the credit quality and in fact improving it.

How do we do that? Well, we wouldn’t be a financial powerhouse if we couldn’t.(Smiles all around). But we offer this only to our best clients; not everyone can get into these deals, you know. Correct, exclusive deal, just like Madoff's.

But permit us to say that our deal is in fact better than it sounds. This will become clear if we get into the details.

How do you get $4,170 a year in Treasuries? You have to first invest $1 million. You will not earn interest unless you own the securities.

In the deal we are proposing, you invest nothing. Zilch. Zero. But receive $3,600 a month,
as if you had invested $700,000 in these securities.

The catch? There is no catch. You pay for these securities, so to speak, by selling a credit default swap to the party that pays you the monthly $3,600.

What is a credit default swap? That's an excellent question. The best way to describe it is to say that it is an insurance policy. Basically, if the mortgage defaults, you have to pay the mortgage principal to the other party. As per the SEC requirements, we must warn you that this is risky. There is a potential that you will lose some money – or even a sum equal to the principal of mortgages – blah, blah, blah; you know how it works. As if life had no risk. As if there were any guarantees.

But, look! The securities are the super senior tranche of a synthetic CDO. The tranche is rated AAA by both Moody's and Standard & Poor's. The probability of default of a AAA-rared security, based on the historical default tables, is almost zero. They are like the U.S. Treasuries in terms of credit worthiness. Between us, though, they are probably safer, what with this runaway U.S. expenditure and the beating the dollar is taking in the international arena.

Why even safer than the Treasuries, you may ask? We are not exaggerating. Let us look at the facts. The mortgage default rates in the U.S. stand around 3%. The $700,000 SS tranche we are offering is part of $1,250,000 CDO. So, it is protected by a $550,000 cushion of mortgages, so to speak. That is, 44% of mortgages in the CDO must default before the SS tranche is affected. Now, do you believe that the historical mortgage default rates in the U.S. could suddenly jump to 44%? You decide.

Yes, we have the list of mortgages. You are welcome to perform your own due diligence. But we must warn you that it is not always easy to get background information about mortgages. Underwriters are not known for keeping the best of records. (Smiles all around.) Now, if you could sign here.
Game. Set. Match.

Everything said or written about the CDOs and CDSs comes from this pitch, which goes to show how the Wall Street controls the narrative of anything related to finance. That is why I started this series with a treatise of sorts on the importance of knowing and the need to penetrate the surface of the phenomena.

Note how a “synthetic CDO” is presented as a “you can have it all” product: getting the monthly payments without buying the securities that pay those payments. That is what is taught in the business schools and promoted in the financial press as one of the benefits of modern finance.

Note, also, how a CDS is presented as an insurance product. To the best of my knowledge, not a single person anywhere has challenged this spin. The most vocal critics of the CDSs start from the premise of a good idea of insurance gone bad by the misuse by bad people.

Bond insurance existed in the U.S. and many western countries for the longest of times. The businesses were known as monolines, mono because they only insured bonds. The business was low-margin but also extremely low risk. Ambac, MBIA and SCA were among the more well-known names that were sucked into the orbit of the CDSs and paid dearly for it.

A CDS is the “other side” of a bet that involves the default of a bond. It has absolutely nothing whatsoever to do with insurance. A CDS is designed to insure a bond in the same way that gallows is designed to support the weight of a man. The moment you speak of insurance, you are lost. You have understood nothing about them.

Look at this childish nonsense from Floyd Norris of the New York Times. I mention him because he is the most perceptive and competent among the financial reporters.
Credit default swaps are, in reality, insurance. The buyer of the insurance gets paid if the subject of swap cannot meet its obligation. The seller of the swap gets a continuing payment from the buyer until the insurance expires. Sort of like an insurance premium, you might say.

But the people who dreamed up credit-default swaps did not like insurance. It smacked of regulation and of reserves that insurance companies must set aside in case they were claims. So they called the new thing a swap.

In the antiregulatory atmosphere of the times, they got away with it. As Humpty would have understood, Wall Street was master. Because swaps were unregulated, calling insurance a swap meant those who traded in them could make whatever decision they wished.
A word is changed and the entire regulatory apparatus is fooled and, as a result, something bad is introduced to the financial system. Just like that.

The creation of CDSs as a bet is the logical extension of cash settlement that took the physical delivery of the underlying security out of financial transactions. From Vol. 2:

To make themselves more appealing to speculative capital, derivatives undergo changes which are intended to bring out and emphasize their betting aspects. One such change is cash settlement.

In cash settlement, the product on which the derivative is based does not change hands. Rather, the profit and loss of the trade is settled by exchange of money, calculated as the difference between the purchase and sale price. The commodity itself need not – actually, cannot – be delivered to satisfy the contract.

On the surface, this arrangement seems as a mere technicality, a change in rules for the sake of promoting “efficiency.” Otherwise, the P&L of the two sides remains unchanged … But the P&L is not the only thing that “matters” in trading derivatives … In cash settlement, the price of a commodity becomes a mere index that is used to determine the winner or loser of the transaction.

The implication of this change becomes apparent if we look at the flow of money. Previously, the seller delivered, and the buyer took delivery of, the underlying commodity [i.e,] always buyers paid, and sellers received, money. In cash settlement, not only the seller cannot deliver the commodity, he must also think of a possible payment obligation.

Cash settlement accommodates speculation.
The Goldman case is now clear, not based on the SEC allegations or the firm’s denial but “as God sees it”. The role of the firm, the role of us, the investor groups – that would be Paulson and his hedge fund – and the role of the buyers of the synthetic CDO – ACA and IKB, which lost a combined $1 billion – is understood.

We are in a position to judge.

I will return with the epilogue.

Thursday, 17 June 2010

Of Labor and Women’s Rights in Europe

Today’s Financial Times published a joint commentary piece by the prime ministers of the UK and Sweden under the heading Reining in Europe’s deficit is just the first step. As you can infer from title, it was an economic manifesto put together “to ensure that Europe thrives and prospers”. It had “four clear steps”.

The first step was cutting back. “We have to accept that there are things we can no longer afford,” the authors said. Note the wording. First, a reference to things that we cannot afford, which everyone knows to be true. Then the “no longer”, slyly inserted; we are now talking about the things that “we” used to be able to afford but now, we have to accept, we cannot. Here, the two gentlemen of Europe are not talking about private jets. They are talking about retirees affording to live with some dignity. It is that, that “we” can no longer afford.

The second one was fixing the financial system.

Then came the third step:
The third step is creating the conditions for growth. Europe has huge advantages ... But we have deep structural problems. Productivity is shrinking. Our average growth rate is lower than the US, India and China ... So it is clear, we need deep-seated reform and we need it now. There is one area in particular where we both believe there is need for urgent change. It is shocking that in many parts of Europe women still do not have equal rights in the workplace. This is not just unfair; it makes no sense – because it deprives our economies of their full potential as workers and consumers. That is why in Brussels today we will be pushing this issue in discussion on Europe's next strategy for growth and employment.
What is this sudden, clearly out of place, reference to women’s rights in the middle of an economic manifesto?

Women in Europe are not particularly oppressed. I know of no country in Europe that discriminates against women in the workplace. And why this emphasis on women and their “full potential as workers” when tens of millions of European men are unemployed?

The answer is in the very text that gives rise to these questions. Note the concern for women’s right in the workplace is brought up in the “step” that talks about productivity. Productivity is output per labor; not labor in flesh and blood but labor as measured by wages. An enterprise producing 100 units of output with 3 laborers each earning $30 is more productive than one producing the same unit with one laborer earning $100.

Women and children have been historically used as tools for reducing the overall wages. They have less bargaining power and are more vulnerable to pressure, so they do the same work that men do, only with less wages. The result is downward pressure on all wages.

European children are protected by a variety of laws. And anyway, the manufacturing jobs, of the kind that employ children, have migrated to Asia and Latin America.

That leaves women.

One component of the “labor market overhaul” that is on the agenda of all the European governments is the reduction in wages. Women are the Trojan Horse that will be taken to the labor market to accomplish that goal. That is the source and extent of the prime ministers' interest in the women's rights. Read it. They clearly say it: By giving equal rights to women in the workplace, Europe will be able to compete with India and China!

But isn’t this plan too long-term and too complicated? Even if we assume that Cameron and Reinfeldt know of these complex relations, why would a couple of politicians care about implementing a plan which will come to fruition long after they have left the office?

The answer is that the plan is not theirs. It is given to them – and all the European prime ministers – as the policy issue to be implemented. No questions are permitted. That is why Socialists Papanderou and Zapatero, center right Sarkozy, Moderate Reinfeldt and Conservative Cameron all speak the same way. That is how you know everything is scripted at a supra-national level: politicians of different political orientations all say the same things. We are approaching the grand goal of divorcing policy decisions from politics.

As for the moral aspects of women’s rights, frankly I don't think they give a damn.

Monday, 14 June 2010

So How Should We Respond to Regulatory Failure?

Mark Thoma poses the question on his blog. Specifically, he notes:
I keep reading arguments that start with the fact that regulators have been imperfect in the past and use it to argue that we should eliminate (or substantially reduce) the amount of regulation that is imposed. However, just because regulators missed things in the past like Bernie Madoff, the financial meltdown, and the risks that BP was taking does not imply that regulation ought to be reduced or eliminated.
Agreed. And the conservatives beating the anti-regulation drum are getting tiresome. Let's do a 30-second review of regulatory failure and the financial crisis.

There were structural reasons for the failure:

1. We have a confusing hodgepodge of regulators (OTS, OFHEO, FDIC, SEC, OCC, Fed, etc.). Is it any surprise that regulatory issues fall through the cracks between their respective walled fiefdoms? Or that their regulatees go "regulator shopping," trying to find a sympathetic ear, with such a plethora of choices? Our Balkanized regulatory system is defeating us. What if the Food and Drug Administration, an acclaimed regulator, were broken up into the Vegetable Administration, the Fruit Administration, the Meat Administration etc. Is there anyone who thinks that would be more effective?

2. What needed to be regulated wasn't regulated. The huge shadow banking system wasn't on anyone's watch list. That needs to change by, say, yesterday. By rights the Fed is the best equipped to oversee shadow banking. But the Fed, we're learning, is an academic-minded, banker-sympathetic institution that enjoys gazing at its theoretical navel. These guys have no appetite for bare-knuckles regulation. So we'll have to figure out another way to do it, unless we can graft a pair of cojones onto this gelding.

There were cultural causes of failure:

1. Regulators didn't believe in their mission. Christopher Cox. SEC. Need I say more? And that's just one example. Under Bush, too many foxes were assigned to head The Association for the Safety of Chickens.

2. Regulators who didn't believe in their mission were, not surprisingly, uninformed about the latest innovations/questionable activities going on. Why spend your afternoon learning about credit default swaps/CDOs/some other complicated thing when your boss doesn't really care anyway and some really racy porno on the office computer is only a few mouse clicks away?

The single most important part of the solution, besides fixing the above:

Disable or at least severely crimp Wall Street's loophole-diving, rule-evading capability. Wall Street will always be a step ahead of the regulators in "innovating" cool new products that avoid tax payments and arbitrage capital regulations. We can shrug and meekly accept regulatory impotence. Or we can have a deeper conversation and realize it's time we started thinking outside of the box.

What about saying to the lords of high finance: any new product, whether intended for institutional or retail consumption, is illegal unless it has been approved by a new "Financial Products Safety Commission." Sure, Wall Street would howl. And such a requirement would quash some innovation. But, as we've seen, in this Brave New World of high finance, a lot of innovation is ultimately destabilizing and incredibly complex to no good purpose.

Or what about getting radical on accounting? Currently we let Goldman, Morgan Stanley et al do the limbo in a thousand creative ways to avoid capital constraints and make themselves appear more robust than they are. What if we told them the game has changed? That they are liable for criminal/civil penalties for using any accounting treatment that later is found not to accord with the spirit of existing regulations, as judged by say a "reasonable corporate accountant" or some such? Will this be chilling and cause more conservative accounting? Sure. But isn't that what we need after the free-for-all of the last decade?

It's fun to dream, though I'm not optimistic that any of my ideas will be adopted. We need big thinkers, big thoughts, ambitious men (and women!) to pull off meaningful change. And that's not what we have right now in Washington.

Thursday, 10 June 2010

The Goldman Case – 3: Recapping CDOs

Recall that our purpose, when we got together as a group of investors, was making money. “A group of investors” has no other purpose.

I said the way to go was arbitrage.

Some of you were not clear on that point. You thought we were going to buy mortgages with the idea of selling them later – presumably for a profit. Where is arbitrage?, you asked, echoing the confusion of some of the country’s best quants.

“Friends”, I recall saying to you. “Let us set aside the not so small matter of being short in cash and focus on basic finance. A mortgage is a bond. Bond prices increase when interest rates decrease. Are we saying that we are buying the mortgages because we know interest rates will go down? If so, why bother with mortgages which have prepayment and relatively high default risks? Why not simply buy a bond – or a pool of bonds?

“No,” you responded. “We do not know which way the interest rates will go. And yes, we are short in cash. And now that you mention it, why indeed bother with mortgages? Why not just buy regular bonds?”

“Glad you asked,” I said. “Expecting to make money without initial investment and without knowing the future is a great expectation. Fortunately, in the age of speculative capital, the cause is not lost as the statement of our problem is the definition of arbitrage: making risk free profit without initial investment. But one has to know the game, and the game cannot be played with the Treasuries or corporate bonds. We need the relatively inefficient mortgage market. Even then, the plan is complicated and you must pay attention to understand it.”

“Tell us how”, you cried in unison, excited at the prospects of getting rich with no effort and no money down.

I explained the plan in easily digestible parts:

  • We have to borrow money, but it must be at rates below the current mortgage market; it would be madness to pay 8% to get mortgages that pay 6%.
  • Low rates are available in the commercial paper (CP) market, but only large corporations like Microsoft and IBM have access to that market.
  • We cannot pass ourselves off as a large industrial corporation. Fortunately, we do not have to. What matters in the CP market is not the size per se but the credit rating. Since our ratings, as a group of investors, can never be AAA or its short-term equivalent, A1/P1, we shift the focus from ourselves to the product; we make the product to be AAA.
  • Of course, in a million years, a pool of mortgages will not qualify for AAA rating; they're just too damn risky and triple-A means no default risk. So we will need to be innovative. We'll call it financial innovation! (Smiles all around). That is where the CDO structure comes in. You know the routine. Pool the mortgages and force a class system to the pool where the super senior tranche is protected against historical default rates.
  • We take the CDO to the rating agencies and ask for AAA rating. They need revenues and will play ball. In fact, they will tell us what we need to do to get AAA rating. They might, for example, ask that we sign up a bank as a “liquidity provider”, or strengthen the loan covenants, but these are technicalities and you do not have to worry about them.
  • Triple-A is the key to the CP market. We could now borrow at 2% to and buy mortgages that yield 6%. That's the golden goose of finance if there ever was one. We'd be the king of the world, the master of the universe.
Note the function of a CDO: it is an arbitrage vehicle – and nothing more. There is nothing more in finance as practiced by financiers and taught in schools.

Arbitrage is the anima mundi of modern finance, the single pillar on which the “whole intellectual edifice” of finance rests. It is at the core of everything that is taught at Chicago, Wharton, Stanford, Harvard and London business schools. It is the foundation of everything that the best of brightest of Europe and Asia vie to learn at INSEAD and Heyderabad.

Options, futures, swaps and all derivatives are priced from arbitrage. Relative value trading is based on arbitrage. Rise of the hedge funds, advent of prop trading, onset of globalization and the push for deregulation are all driven by arbitrage. Securitization? Due to arbitrage. Rise in markets volatility? Arbitrage. Synchronization of markets? That, too.

And yet, not a single one of the students and professors who study finance can define arbitrage, much less recognize the specific form of capital that is engaged in it.

In order to be company he must display a certain mental activity. But it need not be of a higher order. Indeed it might be argued the lower the better. Up to a point. The lower the order of mental activity the better the company. Up to a point.

The finance professor, the financial journalist, the think tank “scholar” and the PhD candidate constantly exalted and promoted the advantages of securitization and CDOs without realizing that these innovations were merely the prerequisites for the operation of speculative capital. To the extent that the innovations provide local collateral benefits, such benefits are accidental and incidental. What is more, they must always be in line with the immediate needs of speculative capital.

In our example, what happens after the first CDO? To continue the arbitrage, we would need more CDOs, i.e., more mortgages. Mortgages are provided by banks and mortgage bankers. So they are pressured to do more. At some point, the pool of the eligible people who could afford houses is drained. But that is no excuse to stop the arbitrage. We, the group of investors, cannot simply allow our golden goose to sit idle just because there are no eligible home buyers. Why, that would be hampering the American dream.

So the pressure doubles on banks and mortgage bankers to loosen the standards. They comply, because they, too, make money from issuing mortgages. At some point, that, too, ends. It is clear that no more life is left in the mortgage market. Nay, more than that: it is clear that a train wreck in the form of a housing collapse is coming towards us.

What do we do?

Après moi, le déluge, said Louis XV, the king of France. What a rogue peasant he was. We make money from the deluge. The Jew of kings had it right – Jews always have it right – that you buy when there is blood in the streets.

When there is no blood, we will see to it that there is. It’s business, you know. Nothing personal.

We, the group of investors, have shot the housing market in the US multiples of times. The blood will soon be running in the street. How can we make money from it?

The game plan is not immediately clear. What is clear is that we would need more financial innovation. We would need synthetic CDOs. We would need credit default swaps.

Wednesday, 2 June 2010

The Shape of Things to Come in Spain

Fundamental misunderstanding, when it comes from animals, is funny; we find the animals’ innocence in terms of “not getting it” endearing. Hence, the “animal jokes”. You’ve probably heard the old one about the horse turning to the jockey and saying: what are you hitting me for, there is no one behind us?!

Fundamental misunderstanding from people is not funny. It reeks of pathos, which is depressing.

It must have been over twenty years ago. I was waiting for a friend at the headquarters of then Citibank in New York. The bank had recently increased the minimum withdraw from its ATM machines from $20 to $40. A young woman came to withdraw what must obviously have been $20 and could not. She made a scene, complaining aloud to the bank staff, threatening that she would take her business elsewhere.

If she were a horse, the episode would have been funny. But as she was not, it was not: the spectacle of a young woman who thought she had money until she came head to head with the mass of finance capital.

I remembered all this because today’s New York Times ran an article about the austerity measures in Spain. It said in part:
Spaniards once thought their country was largely insulated from the debt crises in Ireland and Greece. Their mood has changed from giddy, when their homes tripled in value and they were protected by an elaborate safety net of public aid and family support, to grim.

The New York Times is a sleazy paper, a systemic falsifier of events, as coverage of the events of the past several days showed. And its reporters are as clueless as a horse.

You see, the focus, the aim, the central point of the crisis in Spain is precisely to smash the elaborate safety network of public aid. That is what the hoopla is all about. Without that destruction, Spaniards cannot be made to work for low wages, in the same way that without the destruction of the feudal system which made serfs homeless, they could not be made to toil in factories.

This will not happen tomorrow, or the next week, but will happen with the inevitability of night following day. The inevitability is there, in the internal logic of the very development that tripled home prices.

Thirty years from now, Spaniards will look back and will barely recognize their country. It will not be all bad. Some of them will be driving shinier cars and living in bigger houses. But they will also see homeless people in numbers that they do not presently see – or can imagine. The old trade-off stuff, you know. As for that famous family support? Well, that is partially a function of the elaborate social safety net. So it, too, will be gone. It will be every man for himself.

I am not preaching or haranguing or warning, merely stating an economic reality that Karl Marx used the wording of a “fish-blooded bourgeois doctrinaire” – “fish blooded” because what he “blurts out brutally” was accurate – to state succinctly:
In poor nations, the people are comfortable, in rich nations they are generally poor.