A Question of Perspective

Last Friday, William Dudley, the president of the Federal Reserve Bank of New York delivered a long speech on “Lessons From the Crisis” in the Center of Economic Policy Studies Symposium at Princeton University. I don’t suppose you could get any more serious than that in terms of authority and setting, even though the speaker felt compelled to issue a disclaimer: “As always, my remarks reflect my own views and opinions and not necessarily those of the Federal Reserve System.” It is astounding how no one dares to speak freely, even when the subject is a non-political, technical one and the speaker is the president of the New York Fed.

My aim is not to offer a blow-by-blow critique of the speech. What I want to focus on, rather, is Dudley’s perspective, the way he sees things. I wrote about this seeing-things-through-the-eye-of-finance-capital in here and here. So the focus is not on Dudley. He is merely a Rumian part that adequately reflects the whole.

The technical description of markets and processes in the speech are generally accurate. But look at the circumlocution and the child-like narrative when the speaker explains the tri-party repo market.

In the case of the tri-party repo market, the stress on repo borrowers was exacerbated by the design of the underlying market infrastructure. In this market, investors provide cash each afternoon to dealers in the form of an overnight loan backed by securities collateral.

Each morning, under normal circumstances, the two clearing banks that operate tri-party repo systems permit dealers to return the cash to their investors and to retake possession of their securities portfolios by overdrawing their accounts at the clearing banks. During the day, the clearing banks finance the dealers’ securities inventories.

Usually, this arrangement works well. However, when a securities dealer becomes troubled or is perceived to be troubled, the tri-party repo market can become unstable. In particular, if there is a material risk that a dealer could default during the day, the clearing bank may not want to return the cash to the tri-party investors in the morning because the bank does not want to risk being stuck with a very large collateralized exposure that could run into the hundreds of billions of dollars. Overnight investors, in turn, don’t want to be stuck with the collateral. So to avoid such an outcome, they may decide not to invest in the first place. These self-protective reactions on the part of the clearing banks and the investors can cause the tri-party funding mechanism to rapidly unravel. This dynamic explains the speed with which Bear Stearns lost funding as tri-party repo investors pulled away quickly.

The result was a widespread loss of confidence throughout the money market and interbank funding market. Investors became unwilling to lend even to institutions that they perceived to be solvent because of worries that others might not share the same opinion. Rollover risk—the risk that an investor’s funds might not be repaid in a timely way—became extremely high.

These words are simultaneously convoluted and simplistic. When the speaker says that in the tri-party market “investors provide cash each afternoon to dealers in the form of an overnight loan backed by securities collateral”, it is as if a 5th-grader is explaining the market. And he has the order wrong. The drivers of the tri-party repo market are not investors who provide cash but the broker dealers who seek money to buy an asset that they themselves could not otherwise afford. If you miss this point, you will not understand the tri-party repo market.

Dudley’s language reflects his thought process, the ways he see things. But the language is not only a passive reflector. It also has a more active, pernicious side: It hinders thinking by creating the impression that something new was told and learned while in fact nothing of the sort happened. So the real cause remains unexplored. Look at this explanation of the crisis:

At its most fundamental level, this crisis was caused by the rapid growth of the so-called shadow banking system over the past few decades and its remarkable collapse over the past two years.

But why was there a remarkable growth of shadow banking? Why did it collapse? Mr. Dudley is giving as the explanation of the crisis the very things that he is called upon to explain.

With such muddled thinking, his “framework” to fix the problem naturally degenerates into a discussion of the “psychology” of lender and borrowers, as in this gem:

This second cause of liquidity runs—the risk of untimely repayment—is significant because it means that expectations about the behavior of others, or their “psychology”, can be important. This is a classic coordination problem. Even if a particular lender judges a firm to be solvent, it might decide not to lend to that firm for fear that others might not share the same assessment.

This is the nonsense that he must have heard from some CEO or one his minions as the cause of the crisis.

I wrote about the role of the tri-party repo market in fermenting the crisis here and here. Read them to see why I emphasize, and mean by, the perspective, the “angle of vision on reality”; it liberates the language and allows for imparting knowledge.

On the larger question of the cause of crisis, I have already pointed out that only two issues matter: the structure of the financial system which develops naturally and could be said to be imposed onto the system, and the fall in the value of the securities due to the transformation of values to prices. Most of this blog has been about the first issue. The question of transformation I will take up in Vols. 4 and 5 of Speculative Capital.

On “Industrial Policy”

What type of stories would I cover if I were a financial journalist?

A couple of weeks ago, The New York Times had an interview with William Clay Ford Jr., “perhaps the most seasoned auto executive in Detroit.” He has more than 30 years on the job at Ford Motor Company which was founded by his great grandfather. He is presently the executive chairman of the board. A Q&A and the follow-up went as follows:

Q: Is the financial support given by taxpayers to G.M. and Chrysler a positive development for the American economy?

A: The biggest concern that we had all through this was the collapse of the supply base. I believe that if G.M. and Chrysler had gone into free-fall bankruptcies, it could have devastated the entire industrial base of this country.

Q: Does the average American value the domestic auto industry?

A: They should. One cannot find a healthy economy anywhere in the world that does not have a strong industrial base, period. We seem to be the only country in the world that doesn't strongly value that. Everywhere else Ford does business in the world the government and people understand it, and do everything they can to enhance it. The notion that we can just simply become an information-age data provider as a nation is ludicrous.

The interview was published in a special section about cars and not in the business section.

If I were conducting the interview, I would note that Ford Jr. was lamenting the lack of an industrial policy, although he did not dare/care/want to mention that phrase. I would also note that he was lamenting the lack of an industrial policy the way one would lament the lack of, say, good beaches in the country.

I would gently push him on the subject, encouraging him to continue with his thoughts.

“Mr. Ford”, I would ask, “as a high ranking executive of Ford Motor Company and a powerful business executive, your views carry tremendous weight on the subject of manufacturing. You have the ear of every Fortune 500 executive and every policymaker in this country, including the president of the U.S. Since you maintain that without an industrial policy a nation is doomed, “period”, why is it that you have not pushed for the creation and adoption of just such a policy? More importantly, given the critical role of such policy, one would expect it to be the playbook of the business and the government activities. But it is not. Who and what stand in the way? Please take your time.”

I would then go to Larry Summers, the wunderkind working from the While House, and ask him the flip side of the question.

“Dr. Summers”, I’d ask. “The Wall Street Journal of February 13, 1998 carried an incredible news story on page A2 pertaining to your testimony in front of a congressional committee in the context of the Asian financial crisis that was then raging. Here is what you said:

There has been more progress in scaling back the industrial policy programs in these countries in the last several months than there has been in a decade or more of negotiations.

“In your testimony, you expressed satisfaction at the scaling back, or even the destruction of, the industrial policies in Asian countries. Is it now or has it ever been the policy of the U.S. to dismantle the industrial policies anywhere it finds them, including within the U.S.? If so, how and where is this policy set? If there is no coordinated opposition, why do you think that there has not been any such policy despite the conviction of manufacturing executives that it is absolutely needed?”

These are the questions I would ask if I were a financial journalist.

What We Learn From the Financial Journalists

This past Tuesday, The New York Times was plugging the new book by its “merger and acquisition correspondent”, Andrew Ross Sorkin, big time. The book is called, Too Big to Fail: The Inside Story of How Washington and Wall Street Fought to Save the Financial System – and Themselves. That long and yet empty title is what you get when you try to include all the “hot” issues of the day in a single phrase. But the gimmick apparently works, or it could have been the heavy promotion: the book sold out in New York’s Barnes & Nobles.

I have not read the book, but from the excerpt in the Times, I know what is inside. Here is a passage:

Increasingly desperate that morning – “I feel like I’m playing Whack-a-Mole,” he complained to his peers – Mr. Fuld decided to call his old friend John Mack, the chief executive at Morgan Stanley, the second-largest investment bank after Goldman Sachs. After dialing Morgan’s New York office, Mr. Fuld was transferred to Paris, where Mr. Mack was visiting clients in the firm’s ornate headquarters, a former hotel on the Rue de Monceau.

After some mutual disparagement of the markets, the rumors and the pressure on Fannie Mae and Freddie Mac, Mr. Fuld asked candidly: “Can’t we try to do something together?” It was a bold question and Mr. Mack had suspected it was the reason for the call. While he didn’t believe that he’d be interested in such a prospect, he was willing to hear Mr. Fuld out.

“We’ll come over to your offices,” Mr. Fuld, clearly anxious, said.

“No, no, that makes no sense. What if someone sees you coming into the building?” Mr. Mack asked. “We’re not going to do that. Come to my house, we’ll all meet at my house.”

On Saturday morning, Mr. Fuld pulled up to Mr. Mack’s mansion in Rye, N.Y. Despite the beautiful weather, he was tense. He could already imagine the headlines if it leaked.

The Morgan Stanley team had arrived and was socializing in the dining room, where Mr. Mack’s wife, Christy, had put out plates of food she had ordered from the local deli.

What we learn from the above is that:

• When Fuld called Mack, Mack was in Paris, in Morgan Stanley’s ornate headquarters, which was a former hotel on the Rue de Monceau.

• Mack and Fuld knew each other.

• Mack and Fuld did not like – or understand – what was happening in the markets.

• Mack had a sixth sense, certainly a strong intuition. When Fuld reached him in Morgan Stanley’s ornate office in Paris, he “suspected” that Fuld was calling him for something important.

• Fuld who had reached Mack in Paris to talk about his firm’s survival had not prepared a proposal or even an opening pitch. “Can’t we try to do something together?” is what he said, by way of proposing a merger involing about $2 trillion in assets.

• Fuld was a simpleton, suggesting to go to Mack’s office. A child would know not to do that. (Paulson met with the Goldman Sachs board in Russia – when he was the U.S. Treasury secretary.)

• Fuld was a quick learner. On Saturday morning, in front of Mack’s mansion, he was tense (although the weather was good) because he had learned that it was not good for him to be seen with Mack

• Mack’s wife, who goes by the name Christy, had ordered takeout food from a deli in Rye, New York which is where she and her husband, Mack, live in a mansion – Mack Mansion, presumably.

Perez Hilton, meet financial journalism.

It serves no purpose to comment on this trashy, gossipy writing masquerading as financial investigative journalism, except to point to the way it is intended to drum up the sale. The tidbits that permeate the narrative send the subliminal message that the author is close to the center of power and hence, privy to knowledge and inside information. That association is the source of his authority; he knows the cause of the crisis because he knows the players whose actions influenced it. That it is precisely the opposite, that businessmen and traders could shed absolutely no light on the cause of the crisis, that the more nonsensical tidbits you hear or read about the less you would know, is something that neither Andrew Ross Sorkin nor those who bought his book will easily believe – or understand. The milieu in which these events take place stands against such understanding.

I caught a glimpse of Ross Sorkin on Charlie Rose. The host and guest agreed that the main lesson of the crisis is “ultimately” about the human failure. You know about this the-fault-is-not-in-the-stars thing, akin to saying that an airplane crash was “ultimately” due to the gravity. The author is a young man. He talks fast and confidently, the way confidence men do. He has no qualms or doubts about what he knows; how could he, having heard the behind-the-scenes drama from the movers and shakers, knowing what a lawyer was wearing to a weekend meeting and which highway Fuld's driver took on the way to New York?

Not to be too harsh on him, but he, too, while also a victim, is at the same time a part of the fraud that is continuously perpetuated on the citizenry.

If the young lions of financial journalism are bad, the old timers are scarcely better. On Friday, Ron Chernow, the author of a confused history of J.P. Morgan, wrote an Op-Ed Page piece in the New York Times in which he compared the current financial crisis with the crash of 1929. Here are three sample statements, followed by my comments:

For many participants, a whiff of sin only enhanced the stock market's seduction. Small investors imagined that the large speculators who dominated the exchange could, if necessary, levitate the market and prevent unpleasant crack ups.

The modern markets, too, thrived on the whiff of scandal. All Madoff investors were told – and passed it to others – that the “New York people had a system.”

Margin loans equivalent to one-fifth the value of listed stock poised the market on a tall but shaky scaffolding.

In the current criss, while the margin on stocks was one-half, the firms as a whole had margins in excess of thirty to one, six times higher than what was allowed for the individual stock investors in the late 1920’s.

Unlike the 2009 crash, the 1929 debacle didn’t topple major banks or corporations. It simply wiped out a generation of speculators.

The crash of 1929 only toppled speculators and not banks because in 1929, banks were not involved in speculation. In 2007, they were.

Chernow has no central argument, he has no point. His writing is a hodgepodge of anecdotes and false parallels and analogies that ultimately leave the reader frustrated and exhausted.

What these men want to offer, but cannot, is a coherent narrative of a crisis that has devastated much of the world's economies in the past two years. I explained the crisis in some length in the Credit Woes series. Since Lehman’s case, for good reasons, is intricately linked with the crisis, let me once again use it to highlight the things we need to know. Only then we will be able to understand the crisis. This is not a “case study” approach, but an analysis of a part that contains some critical aspects of the whole.

Lehman had $1 capital, its own money. It then borrowed $32 and use all the money to buy securities worth $33. The securities were pledged as collateral for the loan, the way you would pledge your house for mortgage. Unlike your mortgage, though, Lehman’s borrowing was short term; it had to be refinanced, i.e., renegotiated, every day, or every week or every month.

In 2007, the securities prices dropped – crashed, really. (As an example of the severity of the crash, Merrill sold some of its securities for 22 cents on a dollar.) The securities that Lehman had purchased for $33 were now worth, say $20. The lenders did not accept holding $20 worth of collateral for loans totaling $32. As per terms of the loans, they demanded that Lehman pay the shortfall, the $12. Lehman had only $1. It could not pay $12.

Under these conditions, the die was cast. Short of a government bailout – the Fed or the Treasury giving Lehman the life-saving $12 – there was no way the firm could survive. Paulson and Geithner refused. The firm went under.

Three questions must now be answered, one specific to Lehman, the other two, general:

1. Why was Lehman allowed to fail?

To the extent possible, I answered this question here and here.

2. Why did Lehman follow a suicidal business model, borrowing 32 times its capital?

The answer is that it had no choice. Had it not pursued that specific business model, it would have been forced out of business or taken over many years prior to 2008. That was the case with all broker/dealers; Lehman was by no means an exception. So it is nonsensical to speak of management failure, as the decision to increase the leverage was conscious and deliberate.

Now, why is this so, i.e., why are financial institutions forced to behave in this way, is the subject of Vol. 4 and especially, Vol. 5, of Speculative Capital.

3. Why did prices drop?

The answer does not involve buyers going "on a strike" or the market being flooded with the securities or irrational exuberance. It has to do with the transformation of values to prices, something very objective. It is a fascinating subject that must be developed from the ground up and followed to its logical conclusion. That is the subject of Vols. 4 and 5 of Speculative Capital.

Stay tuned.

What We Learn From the Businessmen

If you did not recognize the style of Death of a Deal Man, you do not know John Das Passos. If you are an American, that is doubly unacceptable. His is the only name you can utter when an anti-American foreigner claims that your country has not produced a single writer or artist of international standing. Das Passos’s U.S.A. trilogy is a masterpiece of fiction in form and content. Once in this blog I asked the philosophical question: What do we need to know about something so we could say we know it? When it came to people, Das Passos knew the answer; he gave it to us with an impossible mix of brevity and completeness that approached poetry. Read the biographies in the U.S.A. and judge for yourself.

I thought of Das Passos when I was reading Wasserstein’s death notices. Even the man’s obituaries were hurried, as if rushing to complete an about-to-expire deal. Deal making alone drove the narrative, as in this gem in the Wall Street Journal (Oct 15, p. C3):

A former editor of the school newspaper at the University of Michigan, Mr. Wasserstein long has had an interest in media deals.

Do not blame the reporter for bad writing. The corollary is absurd because it captures the absurdity of a life whose focus on deals distorted all the relations. Eugene O’Neill perceptively captured this affliction in Hughie’s small-time gambler, Erie Smith. In the dinner party of a puritan hostess, with her children present, Erie recounts the story of one his wagers in a horse race, reasoning that the children would love “animal stories.”

The unintended humor is not confined to the dearly departed. In the same week, I also read the news of the retirement of James Simons, the founder of Renaissance hedge fund who made billions in trading. The Times said that “many on Wall Street” still believe that Mr. Simon has a “supernatural talent for making money.” Now that is a juxtaposition of spiritual and the material that only a Rumi could pull off. How life’s extremities give rise to poetry!

And there was John Mack, the outgoing CEO of Morgan Stanley, telling a TV interviewer on Friday that “our focus” must be on the job creation. This, from a man known as “Mack the Knife” for his relentless cutting of workers always and anywhere he went.

Now that a few market indexes are up and the immediate danger of a collapse seems to have passed, the men of finance are returning to the limelight, assuming Rodinesque poses and availing themselves to awe-struck financial reports for insights about “what went wrong”. They might even be right about the direction of the dollar or the yield of the 10-year Treasury by next year.

But that is not finance as discussed in this blog. We will learn nothing about finance from these men because what they see is always the appearance and never the substance. We will learn nothing from a mouse about the working of the cosmos, even though it could consistently find the cheese, as if by a supernatural talent.

If you are a student of real finance, you are in the right place. Stick around.

What We Learn From the Nobel Laureates

I had never heard of Oliver Williamson and Elinor Ostrom until they won the Nobel Memorial Prize in Economics this past week. So, what I know about their work is what I read in the papers. But that is sufficient; somewhere in this blog I wrote that everything you need to know is always right in front of your eyes!

Let us begin with Elinor Ostrom whose research, The New York Times tells us, led her to believe that something called the “tragedy of the commons” was inaccurate.

Ms. Ostrom concluded in her research that the “tragedy of the commons” was an inaccurate concept. Particularly in 17th- and 18th-century England and Scotland, the concept described villagers’ overgrazing of their herds on the village commons, thereby destroying it as a pasture. The solution often invoked was to convert the commons to private property, on the ground that self-interested owners would protect their pasture land.

Setting out to show that the tragedy of the commons is inaccurate is akin to setting out to show that Santa Claus does not exist. It is a curious starting point.

The idea of the “tragedy” came from a half-wit Texan by the name Garrett Hardin. His Wikipedia biography lists his “research” interests: overpopulation, immigration, race and intelligence – you get the idea. The Tragedy of the Commons is his magnum opus in which he argued that a shared social resource is doomed to exhaustion because the individual users will maximize their own interest at the expense of the long term social good. His conclusion: to avoid the ruin, the common property had to become private.

You see the angle. The Tragedy was published in 1968, just about the time when Milton Friedman was being pumped up to bamboozle the nation with his drivel.

So the good Indiana University professor wasted a good deal of time refuting something that did not merit a response. But what did she, herself, have to say on the subject?

Her most recent research has focused on relatively small forests in undeveloped countries. Groups of people share the right to harvest lumber from a particular forest, and so they have a stake in making sure the forest survives. “When local users of a forest have a long-term perspective, they are more likely to monitor each other’s use of land, developing rules for behavior,” Ms. Ostrom said in an interview.

Note the reference to “the relatively small forests in undeveloped countries” and earlier to the 17th- and 18th-century England and Scotland in the Tragedy.

The social system in a pre-Capitalist community is based on barter. In such a system, the members of the society use the common resource to satisfy their personal (including family) needs and not more. So, the common resource survives. Rules merely codify the individual uses that never exceed the capacity of the common resource.

With the rise of Capitalism, the society moves from barter to commodity trading. Now, the objective is no longer the satisfaction of the personal needs but the sale of the commodity for money – an open ended process that is limited only by the number of buyers. If the commodity happens to be fabric which is made from sheep wool, then to satisfy the demand for the expanding British fabric manufacturing, ever more sheep will have to be introduced to the pasture – far above and beyond its capacity. The result is first, overgrazing, and then the replacement of people by sheep. That is what caused the protracted Irish famines starting in 18th century. I thought this was known even to school children – but apparently not.

The Nobel laureate, who, by the way, is a social “scientist”, de-contextualizes the social system she is writing about, as if observing it in an imaginary Mister Rogers’ Neighborhood. That is why what she says comes across as simplistic, to the point of being childish. It is certainly irrelevant to our lives. Imagine we the people approaching Verizon or Chevron to ask for the management of our common resources, airwaves and oil!

For an adult’s take on the subject of the individual’s approach to a common resource within the given conditions, see Pontecorvo’s 1957 Wide Blue Road. You will learn more from this perceptive movie that all the works of all Nobel laureates in economics combined.

The work of Oliver Williamson, by contrast, is on a strictly contemporary phenomenon: the corporation. He discovered that, in the words of the same Times article, “large corporations exist because, under the right conditions, they are an efficient way to do business.” The Wall Street Journal (Oct 13, p. A19) explained his work in more detail:

Mr. Williamson showed that horizontal mergers of companies in the same industry – even those that increase market power and even those where the increase in market power leads to a higher price – can create efficiency. The reason is that if mergers reduce costs, the reduction in costs can create more gains for the economy than the losses to consumers from the higher price.

So Bruce Bid’Em Up Wasserstein was the agent of social efficiency. Also note Professor Williamson’s point of view in using the work “efficiency”. I earlier wrote about this view which is that of finance capital.

The most interesting part of the prize was the citation of the Award Committee that, perhaps innocently, but revealingly all the same, put the utterly incompatible works of Ostrom and Williamson next to each other to produce an anti-regulatory manifesto:

Rules that are imposed from the outside or unilaterally dictated by powerful insiders have less legitimacy and are more likely to be violated. Likewise, monitoring and enforcement work better when conducted by insiders than outsiders. These principles are in stark contrast to the common view that monitoring and sanctions are the responsibility of the state and should be conducted by public employees.

Bernie Maddoff could not agree more.

Wall Street and the “Real Economy”

A never-ending subject of thoughtful deliberation among economic and finance professors is the relation between the “Wall Street” and the “real economy” – whether the woes in the realm of finance spill over to the “real economy”.

You can see why the simple question remains an impossible puzzle. The very first step in answering it would be to define finance and explain what is meant by the real economy – without quotation marks. That, the university economics cannot do. Hence, the endless discussions and points and counterpoints.

In Vol. 4, I take up this question in detail. Before then, here is a news item from the New York Times to highlight the relation between finance and the real economy. The article is about the massing of lobbyist to influence the new law overhauling the financial industry.

But since virtually every imaginable company could be touched by the comprehensive legislation proposed by the Obama administration, the surprisingly broad array of lobbyist trooping to Capitol Hill also includes advocates for airlines, pawnbrokers, real estate developers, farmers, car dealers, retailers and energy and telephone companies. They want to make sure any new oversight of the financial system does not lead to tighter regulations of their businesses or make it more expensive for them to finance their operations or hedge their risks.

By far, the most direct link between finance and industry is through money markets, where hundreds of billions of dollars of the corporate working capital are parked to earn a few basis points. Any loss of this capital directly impacts the production and could even disrupt it, as we saw in the aftermath of the Lehman bankruptcy.

The Death of A Deal Man

Bruce ‘Bid’em-Up’ Wasserstein was born a deal maker. He was born in Brooklyn, went to the University of Michigan, studied business and law at Harvard, did a stint at Cambridge, became a Knox Fellow and authored a book, but his true love was deal making. He was called smart, driven, a chess player, a strategist, a tactician, but all he wanted to do was make deals. “In the deal world, there was Bruce, and then there was everyone else,” people said. He thrived in the deal making frenzy and he made deals always and everywhere so everywhere he went turned into the Deal World – the Hamptons, his Midtown office, home, planes, trains, automobiles. “Let’s make a deal,” he would say. And he made deals fast and furious, so fast and furious that once he overloaded First Boston’s phone system. His deals were many and varied: Philip Morri’s purchase of Kraft and General Foods; Ichan’s assault on AOL Time Warner; Kraft’s potential takeover of Cadbury; KKR’s takeover of RJR Nabisco; Texaco’s acquisition of Getty Oil; ABC’s sale to Capital Cities. Sometimes things did not work out. KKR’s takeover of Nabisco was a fiasco. Texaco’s acquisition of Getty led to a $10 billion court judgment. But through the thick and thin Bruce remained undeterred. He made deal making an art, made it a street fighter’s game, made it lucrative for himself and corporate raiders and greenmailers. He created the “Pac-Man defense” and “front-end loaded two-step tender”, built his own firm, sold his own firm, tried merchant banking, returned to deal making and accumulated immense wealth, but his true love remained deal making. On Wednesday, Bruce died. He left a wife, 3 ex-wives, 8 children, a tangled estate and an untold number of undone and as yet to be conceived deals behind.