Monday, December 22, 2008

Anything Goes

Read this December 18 news flash from The American Banker:
A New York private equity firm has agreed to invest $250 million in Flagstar Bancorp, gaining 70% ownership of the thrift company. But the deal’s completion hinges on Flagstar receiving an additional $250 million from the Treasury Department’s Troubled Asset Relief Program.
I do not know the specifics of the transaction. But note the gist of the story. A private firm and the U.S. Treasury are both to invest $250 million in a bank, with the private firm getting 70% of the company.

That is why I called this entry Anything Goes. If you are a U.S. citizen, you can also read it as Your Tax Dollars at Work.

Saturday, December 20, 2008

Experts to the Rescue

Here is why I constantly emphasize the importance of theory:
A complete overhaul of banking regulation is needed in the wake of the global financial crisis, and one of the aims should be to insulate the real economy from the effects of future banking crises, according to some of the world’s top economists ... Robert Solow, who won the 1987 Nobel prize for economics, said: “I would like to see a regulatory system aimed at insulating the real economy from financial innovation in so far as that is possible”.
There you have it. Some of the world’s top economists, including at least one Nobel prize winner, think that the “real economy” can be insulated from banking and finance, and they are proposing to do just that in order to contain the financial crisis – “so far as that is possible,” of course.

One has to go back to the Middle Ages and the views of the priests about the solar system to find so great a chasm between the reality and its false reflection in human mind. But those priests at least did not attempt to correct the course of the heavenly bodies. The high priests of finance, on the other hand, are adamant in curing a crisis about which they know nothing. Between them and the pragmatic men of the Treasury and the Fed, whatever is left of the U.S. financial system is about to receive a new round of experimental shock treatments.

Tuesday, December 16, 2008

More on Merton and the “Collapse of the Whole Intellectual Edifice”

A couple of readers wrote to ask how I could blame one man for a such a large-scale financial collapse. Had I not said many times that the subject of finance is capital in circulation and not people? How could that assertion be reconciled with the claim that Merton single-handedly – whether consciously or not – brought about the downfall of the so-called Anglo-American financial system?

Merton’s idea about riskless portfolio earning riskless rate pertained to a definite point in the historical development of finance capital in which, thanks to its continuous growth and eventual dominance of financial markets, it claimed “recognition” on par with the full faith and credit of the U.S. government. Merton was simply the vessel for that expression. He was, you could say, chosen by fate. Like Oedipus, his deed was inflicted upon him rather than committed by him.

(In saying that finance capital claimed recognition on par with the full faith and credit of the U.S. government, I am not creating mysteries. I am talking about the functional form of equality that finance capital had won organizationally almost a century ago in the form of the establishment of the Federal Reserve. University professors perennially point to the appointment of the chairman of the Federal Reserve by the U.S. president as the proof of the “regulation” of the banking by the government. The opposite is true. The process is about elevation of private finance to the inner sanctum of the government. I will have more on this in Vol. 4.)

Monday, December 8, 2008

“The Collapse of the Whole Intellectual Edifice”

Things were moving at last, the Colonel said; as for himself he was putting every cent he could scrape up, beg or borrow, into options. He even suggested that Ward send him a little money to invest for him, now that he was in a position to risk a stake on the surety of a big turnover; risk wasn’t the word because the whole situation was sewed up in a bag; nothing to do but shake the tree and let the fruit fall into their mouths.
John Dos Passos in 42nd Parallel

You have no doubt noticed the theoretical bent of this blog. I refer to Rumi and T.S. Eliot, share my philosophical musings and write about the descent of man and the philosophers of our time. In the midst of a financial crisis, such seeming detachment from the events in the world of finance from a blog dedicated to finance could seem odd, the kind of stuff that gives Ivory Tower intellectualism a bad name.

But the underlying theory here is both serious and necessary. It is serious because its aim is to drag the reader into the sunlight and open his eyes. It is necessary because the full scope of this crisis can only be understood at a theoretical level; well-thought-of essays and considered opinion pieces would not do. That is another way of saying that the cause of the crisis cannot be given. It must be arrived at.

Nothing illustrates this urgency of theoretical understanding better than the travails of Hank Paulson. After his various plans failed to gain industry support and had to be abandoned or drastically altered, he has become the subject of universal scorn and ridicule, a financial Rumsfeld of sorts, ignorant of the matters of both strategy and tactic.

I am no defender of Paulson or his regulatory cohorts within the federal government. But he stands on a different plane than a bumbling fool like Rumsfeld. Everyone warned Rumsfeld against doing what he was about to do; the end result was so plainly evident. Paulson, on the other hand, received no such advice. The same Financial Times which now calls Paulson to task was the sycophantic promoter of anyone and anything related with the new financial “paradigm” – from Iceland’s “miracle” to Blythe Masters’ genius in inventing credit derivatives. Google them and see for yourself.

Under the circumstances, Paulson’s claim that he knows more than anyone comes across as a bombastic boast. But within the limits of his discourse, the man has a point. The extent of resources available to a U.S. Treasury secretary is too easily forgotten. Setting aside his long experience and extensive industry contacts, Paulson has access to all the public and non-public regulatory data of all the financial institutions in the U.S. as well as the collected wisdom of a legion of analysts, quants, consultants, and past and present officials. But is is not the quantity of knowledge that stands in his way. It is, rather, the quality, the kind of things he knows. If you have the wrong kind of knowledge, adding quantity will only take you further away from the solution.

Many of you must be familiar with Rashomon, Kurosawa’s seminal movie on the meaning of the knowledge. Four witnesses to a crime tell widely contradictory stories of what took place. No one is lying. They all agree on the evidence: a dead body, a dagger, a scarf. Yet they completely contradict one another. At the end, we learn that the narrator of the story, a juror in the trial who was expressing surprise at the contradictory stories, himself got the story wrong. The point of the movie is not so much that people have different points of view; it goes beyond that. Kurosawa, rather, is exploring the relation between the narrative and knowledge: what do we need to know about something so we could say we “know” it?

At heart, that is a question of the incompleteness of the knowledge, a philosophical subject that even pragmatic societies such as the U.S. have recognized in popular adages like “little knowledge is a dangerous thing”. The final word in this regard perhaps comes from Sa’di, Iran’s great 7th century poet/philosopher whose poetry about the brotherhood of man graces the general hall of the UN assembly. In a stanza too succinct and mastery to be translated here, he says that an Indian sword in the hand of a drunken slave – the Indian sword being the sharpest and most lethal, and a drunken slave being the epitome of ignorance and lack of self control – is better than knowledge falling into the hands of the unlearned.

His choice of the word unlearned makes us pause. An unlearned person could come to possession of material things by hard work or accident. But how could he come to possession of knowledge, which, by definition, needs pursuing? How could an unlearned person pursue knowledge, get it and yet, remain unlearned? What gives?

Sa’di, too, is warning about the dangers of “little knowledge”, but in masterfully shifting the focus to the possessor, he is telling us that it is not the insufficiency of the quantity of knowledge per se that is dangerous, but the possessor’s ignorance of the full impact of his knowledge. Such “impact”, you realize, could only be social. Thus, in a roundabout way, Sa’di injects social consideration to knowledge as its necessary component. Without this component, the possessor of knowledge is “unlearned”, no matter how complete his commands of the technical aspects of the knowledge.

The most common, perhaps because the most obvious, example of this genre of danger comes from the world of weaponry – which Sa’di also uses – with the gnome biology and cell engineering in recent years being added to the list. Endless articles have been written about the dangers of man’s technical skills dulling or overwhelming his social sensitivities.

No one has mentioned finance. But that is where we find one of the most fascinating cases of one man’s “little knowledge” – little precisely because the technical skill trumped everything else – creating a global financial catastrophe. The man is Robert Merton. The deed is option valuation.

Merton is not a household name. Even among those familiar with the Black-Scholes model, few know that he is the man behind the breakthrough that led to the creation of the model. That his name is missing from the Black-Scholes is one more irony among many ironies of option valuation that I detailed in Vols. 2 and 3 of Speculative Capital.

Here, I want to focus on the breakthrough.

The Black-Scholes has an imposing form. But that is due to the complexity of modeling the underlying stock price and has nothing to do with the option valuation. Focusing on the options, two critical insights led to the Black-Scholes.

One is that by combining a stock and its options we could create a riskless portfolio.

The other is that a riskless portfolio must earn the riskless rate of return.
The first insight came from the practical wisdom of option traders.

The second insight is due to Robert Merton.

Stay with me.

The options traders in the ‘60s had noticed that a properly weighted long-short portfolio of a stock and its call options maintained a constant value no matter what the stock price, as any decrease in the stock price was offset by a corresponding increase in the option price, and vice versa. I quoted one such observant trader in The Enigma of Options, who told the exciting story of his discovery (he uses warrant instead of options):
One evening as I studied my chart of the possible price relationships between the Molybdenum warrant and common stock, I realized that an investment could be made that seemed to ensure tremendous profits whether the common rose dramatically or became worthless. I would win whether the stock went up or down! It looked too good to be true.
What he is describing is this. He has noticed that the price of an at-the-money option changes $.50 for every $1 change in the stock price. Combining 1 share of stock and 2 short options would then create a riskless portfolio, a portfolio whose value remains constant. If, for example, the stock price decreases by $3, each of the short calls will increase by $1.50, for a total of $3, offsetting the loss in the stock price. If, conversely, the stock price increases by $2, each call will lose $1, for a combined loss of $2. Again, the value of the portfolio will remain unchanged.

This practical observation and the attention-grabbing notion of a ‘riskless portfolio’ that followed from it finally put the quest for option valuation on the right track. But one more relation was needed for the puzzle to be solved. Merton provided it by saying that a riskless portfolio must earn the riskless rate of return. It seemed an inspired observation, genius in its simplicity and self-evident logic. It solved the option valuation problem and created an intellectual foundation on which the volume of derivatives increased exponentially year after year.

“The most innocent words are the most pernicious; they’re the ones you have to watch for,” wrote Jean Genet in Our Lady of the Flowers.

Look closely at what Merton is saying. His reasoning seems to have the inevitability of syllogism, of “Men are mortal, John is man, John is mortal” type. Of course a riskless portfolio must earn the riskless rate of return.

But what is riskless rate? We have not yet defined it. From the Enigma:
For an old school economist, the existence of riskless rate would be an embarrassing paradox. It would palpably contradict the idea of risk that he had labored hard to make the centerpiece of Western economic thought as currently taught. If the return of capital were the result of exposure to risk, should not the riskless rate be always “returnless,” i.e., zero? Evidently not, as attested by the myriad of the US Treasuries with very positive yields. But there are few old school economists around and the young lions of finance are merrily ignorant of the fundaments so no embarrassment ensues.

In reality, when the government taps the credit markets to borrow, it must pay the prevailing rate that credit capital – the capital earmarked for lending – demands. Credit capital would naturally want to earn the highest rate. But interest rates in market are set by interaction of various technical and macroeconomic factors, including the creditworthiness of the borrower; the higher the creditworthiness (the lower the possibility of default) the lower the rate that credit capital would accept. As borrower without the risk of default, the US Treasury pays the lowest rate. This is the riskless rate. It is riskless because it is the rate that credit capital chargers the borrower without default risk.
So by saying that a riskless portfolio must earn the riskless rate of return, Merton equated one riskless, defined as the absence of change in value, with another, defined as the absence of default. In doing so, he substituted a concrete thing – the yield of the U.S. Treasuries – for a concept, akin to presenting the picture of a U.S. Treasury security as the definition of the riskless. What would happen if there were no Treasuries, and thus, no “riskless rate”? Option valuation was, after all, a conceptual problem and independent of any particular econo-political parameter. Yet, Merton had introduced precisely one such parameter as a catalyst for solving the problem.

His theoretical sleight of hand “solved” the problem but, precisely because of the way it did it, in ignorance of basic tenets of economics, it introduced the primordial contradiction of the economic system into the option valuation process and, from there, to the new paradigm of finance. The contradiction is there, plain for everyone to see, in the insights that led to the Black-Scholes.

Portfolio is riskless so its value must remain constant.

Portfolio is riskless so it must earn the riskless rate.

The two statements cannot co-exist; they cannot pertain to one and the same portfolio. If a portfolio is riskless because its value is constant, it cannot earn riskless rate, because (in consequence of earned interest) its value would then change.

But this contradiction was not of Merton’s making. He merely uncomprehendingly captured it. To what, then, does this contradiction correspond in real life and what are the consequences of leaving it unresolved in a model that became the foundation of the new financial paradigm?

Imagine a man who has kept $1 million cash in a vault for the past year and now demands to be paid the accrued interest on that sum with the 1-year Treasury rate in effect over the last year. His logic is Merton’s: the money is riskless and must therefore earn the riskless rate of the Treasuries.

Before Merton, we would have laughed at such simple-mindedness and given the man a lecture on fundamentals of finance of which he was so clearly ignorant. We would say:

“Dear friend, what you have in the vault is money, not capital. Money does not increase quantitatively by an iota no matter how long it is tucked away – in a vault or inside a mattress. To expand, it must become capital, possible only if it is thrown into either a production or circulation circuit. But the moment that quantum leap is made, the newly minted capital is subject to market dynamics, meaning that its value cannot stay constant. So you cannot have it both ways; either you keep your money in the vault knowing that it will stay constant (we will say nothing of inflation here) or turn it into capital in the hope of expanding it, but with the knowledge that a part or even all of it might be lost.”

Merton contravened this incontrovertible economic fundamental. His message was that you could have it all. (He was the first yuppie scholar.)

Had he been an economist, working with the industrial capital, the intervening steps in the conversion of money to capital – hiring workers, buying raw materials and machinery – would have alerted him to the limits of such conversion and the qualitative difference of money and capital. But in the realm of finance capital, it seemed that money could turn into capital and grow without limit through the alchemy of derivatives, thanks to the genius of “quants” and rocket scientists who had conceived them.

Merton’s reasoning opened the floodgates of securitization. Assume a stock trading at $100 and a man who had $100 cash in his wallet. This man could buy the stock, sell an at-the-money call option (on the stock) and use the proceeds to buy an at-the-money put. The price of call and put would be equal as per put-call parity. As a result of these transactions, $100 in money would be transformed into riskless capital ($100 worth of stock) – riskless because the long put and short call would keep the value of portfolio constant no matter what happened to the stock price.

And since risk was not the word, one could leverage the position by a factor of 10, or 20, or 30 – multiples that would seem like madness to the traditional credit officers but was the logical extension of the new paradigm that everyone said was like nothing anyone had seen before.

That Merton and his colleagues got options completely wrong is not the main point here. The point is the conditions for the transformation of money into finance capital whose laws and limits Merton’s insight egregiously violated and, in doing so, put the Western financial system into the collision course with them. It is those laws and limits that Paulson does not know. So he bluffs, frequently with the weaponry terminology – a bazooka, a gun, a nuclear option – and sometimes with the declaration of unlimited bailout that as of this writing stands over $7 trillion. He fancies that a gesture of his will create a supernatural disposition that will neutralize objective economic relations.

He is far from the only one in this ignorance. Many times on this blog you have seen the appalling insubstantiality of executives and officials of highest rank. Here is Greenspan, speaking in a recent Congressional panel:
“This modern risk-management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year.”
What the Maestro does not suspect is that the “modern risk-management paradigm” he so cherished was a colossal misunderstanding from the get-go. It kept on going because it was “making money for everyone”, as the saying goes. But there was never any there there and the collapse was preordained.

I will return with more on the subject. But now you see why the bent of this blog is theoretical. Here, theory is not a diversion, or recreation; a Senate seat to a Caroline Kennedy. It is not a parlor game.

Stay with me.

Thursday, December 4, 2008

I’m Still Around

My apologies for the longer-than-usual absence. Blame it on an event out of my control and a decision within my control. The event produced three fractured bones in my left arm. The decision pertained to a topic that proved difficult for a blog. I have discussed it in some length in the forthcoming Vol. 4 but had a hard time summarizing it for this space.

The pain in my arm is reduced to a tolerable level. The 3000-word entry is ready. After giving it a once over, I will post it tomorrow.

Thanks for understanding.

Tuesday, November 18, 2008

The Consequences of Efficiency (in practice)

Back in September I wrote about the flip side of “efficiency” in capital markets, singling out sec lending as a culprit.

Last month, A.I.G. asked for additional $38 billion in financing on top of the $85 billion it has already received, raising questions, according to the New York Times, “about how a company claiming to be solvent in September could have developed such a big hole by October.”

Here is a crucial part of the answer:
While about $7 billion of its quarterly losses … were connected with the insurance coverage ... a bigger share of the losses, about $18 billion, were incurred because the assets in A.I.G.’s investment portfolio had fallen in value. Of that total amount, losses of a little less than $12 billion were on investments made under A.I.G.’s securities lending program.
To understand what is taking place in the financial markets, on top of the theory, one must also know the nitty-gritty of the ways money is made. Only then theory could be deployed to connect the dots. Theorizing alone would not do.

Wednesday, November 12, 2008

Lehman On My Mind

Speaking of politics, those who track polls say that McCain’s fate was sealed on Friday, October 10. That is the day the Dow Jones opened 750 points down and McCain said that the U.S. economy was fundamentally sound. Almost immediately, his poll numbers which had been consistently close to Obama’s, sank and never recovered.

If so, blame the Lehman bankruptcy for at least contributing to McCain’s loss, with all the implications that follow. October 10, you recall, was the settlement date for the credit default swaps on Lehman. The dreadful opening of the markets in the U.S. was in anticipation of multi-billion dollar losses by Lehman CDS writers that was estimated to be in the order of $400 billion. It turned out that, thanks to netting, the ultimate payable amount was less than $6 billion. On that news, the Dow Jones recovered, but not McCain’s poll ratings.

The Lehman bankruptcy established a high water mark for the dislocated rates and prices and, in that regard, has become a de facto reference point for the crisis. All market rates and indices have a pre-Lehman and post-Lehman level, with the latter being drastically, at times almost unbelievably, different from the former. The Baltic Dry Index, for example, that measure the cost of shipping goods (as opposed to liquids such as oil and gas) dropped 76% in one month, from about 5,000 to 1150 post-Lehman.

I was away on the week of September 15, with little access to markets. Still, I wrote that Lehman bankruptcy would be an event to remember. I focused on the inability of the Fed to take action because it had reached the limit of its authority, something that Treasury secretary Paulson confirmed and emphasized in a recent interview. But there is more twist to the story. There always is

Why was Lehman allowed to fail? And under what general heading should we classify/archive the event?

I have a few thoughts on the subject. In coming weeks, I will share them with you.

Tuesday, November 4, 2008

Election Night Musings on Why We Fail to “Get It”

Vols. 1 and 2 of Speculative Capital were published by the Financial Times in 1999. Vol. 1 came out in March and was FT’s “Book of the Month”. It got a respectable review and relatively strong sales which increased over time.

Vol. 2 followed in June and, as far the options discovery was concerned, was an instant dud. No one reacted to it.

The silence surprised me. There were large and active equity, fixed income, commodities and FX markets with tens of thousands of users and traders. Option valuation was, and remains, a mandatory subject in all business school programs. Surely the proof that options were not what everyone had thought they were had to be newsworthy.

After a few months, the comments began to trickle in and they were uniformly critical. The 100-plus page proof, that an option is not a right to buy or sell but a right to default, somehow had failed to make its mark; even a few who praised it had not understood it. There was, furthermore, this weird reciprocity, as I did not understand what the critics were saying. “What do you mean by right to default?”, “Where is the default?”, “Who defaults in an option?”, the readers were asking, and I thought I had answered these questions clearly and unequivocally. So the disconnect was real. It certainly went beyond careless reading of the text.

It is said that authors are always complicit in misunderstandings of their work. With that in mind, I began the work on The Enigma of Options in late 2000. I resolved to answer all the questions from the “ground up” and explain the default aspect of options to everyone’s satisfaction. The “old” Vol. 3 which I had planned as the final volume of the Speculative Capital on systemic risk had to wait.

The Enigma of Options was published in 2004. In terms of sales, it did marginally better than its predecessor, but the baffling comments about the impossibility of options being a right to default still kept coming in. One reviewer for a hedge fund newsletter said the whole theory was wrong because it was as a Marxist interpretation of option valuation. You can read an abbreviated version of it here that was posted on the Amazon site for the Enigma.

One property of dialectics is intelligibility. The method must explain not only itself but the alternative views as well. The Enigma of Options follows the dialectical method. It shows how the standard option valuation is incorrect. It also shows why it is incorrect and how and why the model’s authors went astray.

I wondered why a plain-for-everyone-to-see mathematical argument appears as Marxist interpretation. Then noticed that I had given the answer in the Enigma, when I wrote that “the inability to take the next logical step – at times almost willful, as if one were afraid of consequences – demands an explanation”.

Our critic reads the Enigma and realizes that it is like nothing he has read or heard before – in style, argument and most important of all, in the progression of though from one point to the next. He looks around. He is surrounded by family members, friends, neighbors, strangers, enemies, none of whom talk or write in that particular way. The critic knows as surely as night follows day that he is an all American man, living in America and surrounded by the Americans (friends, family members, strangers, enemies). So if what he is reading is like nothing he has ever read or heard, it follows that the text must have come from some Other. What could the Other be? Islamic/terrorist is one possibility, but those folks do not write about options. The only other Other are Marxists, as our critic vaguely “knows” that Marx had something to do with economics – in the same vain that he knows Jesus was a good man. So he concludes accordingly.

That is the reason behind Palin and McCain’s reference to “real America” and “real Americans”. Prior to the publication of Speculative Capital, I, too, would have dismissed them as demagogues and hate mongers. But what they say is what they genuinely believe. They and their supporters listen to Obama and his supporters and immediately know that that is not how their families, friends and enemies talk. They know they are real, true, Americans. That makes anyone not speaking the same way not American – pardon the double negative, but you know what I mean. In all events, the feelings and beliefs are genuine.

But what about a character like Greenspan? How is it that he is “accepted” despite big words and a seemingly impenetrable argot?

The answer is that listeners know what he says is drivel. They like to hear big words from his mouth, a weakness that Mencken noticed more than seventy years ago. But they like them precisely because they know that the words are harmless.

The problem with the The Enigma of Options is that when our critic reads it, he can follow it. More, he understands it. And therein lies the question, the dilemma: how and whether to accept something logical even thought it negates our beliefs, our standing, our achievements? That dialectical question is the very essence of ethics and morality.

Thursday, October 30, 2008

The Group That Time Forgot

I had planned to write about Nobel Prize in economics and its latest recipient, Paul Krugman, but got distracted and the news got stale. Just a brief comment so I could scratch this one off of my to-do list.

The most telling part of the choice was the formal statement of the Royal Swedish Academy of Sciences explaining the choice. It said, in part:
Traditional trade theory assumes that countries are different and explains why some countries export agricultural products whereas others export industrial goods. The new theory clarifies why worldwide trade is in fact dominated by countries which not only have similar conditions, but also trade in similar products – for instance, a country such as Sweden that both exports and imports cars.
So, the ladies and gentlemen of the Prize Committee who must have been locked up incommunicado in the basement of Ricardo household since the 18th century think that everyone thinks that Japanese are supposed to export rice; Americans, car; Germans, beer and French, cheese. Naturally, Krugman who has “shown” that they all could and do export cars is an outstanding economic mind.


Tuesday, October 28, 2008

What Creates Volatility?

Gillian Tett of the Financial Times is one of the better financial journalists, perhaps the best. She was the first to make heads and tails of the structured investment vehicles before many who should have known better had any idea what an SIV was.

But reporters only report what they see and hear. And that, when it comes to the analysis of financial events, is not sufficient. The outward appearance of events has a driving force that remains hidden from the naked eye.

So there she was in her today’s column, writing about the return of unprecedented volatility which “has left many investors and bankers utterly dazed and confused”. Throughout the article, her focus remained entirely on people: “[The situation] remains a delicate war of investor psychology and computer models.”

The subject of finance is not people. It is capital in circulation. So, how do we explain the volatility if the people are taken out of the explanation?

By way of answer, here are a few quotes from Vol. 1 of Speculative Capital:
We use the term “speculative capital” to refer to capital employed in arbitrage. Such capital is not a single entity. Nor does it have a command and control center. A large number of private fund managers and institutions control various pools of speculative capital. They all have access to the same information. When a profit opportunity opens up or is created, they direct their capital towards the same target. If the British pound, for example, seems vulnerable, hundreds of funds would bet on its devaluation using swaps, forwards, options and futures.

The rush of fund managers to position themselves in a profitable arbitrage situation overshadows the mathematical exactness of the arbitrage, with the result that the target is overshot; the undervalued currency becomes relatively overvalued. So the process is repeated in reverse. As a result, we have the constant ebbs and flows of money directed from one market to another that seeks to arbitrage the spreads and, in doing so, restore “equilibrium” to the markets.

But if the equilibrium is restored, there can be no arbitrage opportunities and speculative capital must sit idle. Idleness brings no profits and speculative capital cannot self-destruct in this way. So it looks for new “inefficiencies” and in doing so, it disturbs the prevailing equilibrium and creates volatility. Volatility is the result of the attempts of speculative capital to restore equilibrium to markets.
That was the theoretical development. As for the evidence from the markets:
The spreading of volatility from one market to another–from foreign exchange to stock market–is the logical consequence of the operation of speculative capital. Speculative capital is born in the currency market. This market is large, liquid, and lends itself easily to arbitraging: buying the stronger currency and selling the weaker one. But no market is constantly turbulent. So speculative capital probes other markets and, finding arbitrage opportunities in them, invades them. In the US, the intrusion of speculative capital into the equities and fixed income markets is a fait accompli, with the result that the volatility in these markets has drastically increased. The New York Times reports on the increased volatility in mid-1997:
The [stock] market acts as if it is confronting storms blowing every which way. One day prices soar; the next day they sink just as fast. And then they lift off again…So far this year [1997], 31 percent of trading days have seen 1 percent moves based on closing figures. If that continues, this could be the most volatile year since 1987.
The Wall Street Journal picks up the same story early in 1998:
Last year [1997], there were 80 trading days during which the Dow rose or fell by more than 1%, up from 18 in 1995 and 43 in 1996. In January [of 1998] alone, 1% price swings were seen on eight trading days, or an average of two of every five trading days.
The trend continues. The same paper reported about the rise in volatility in the last trading month of 1998:
Stock price volatility is getting downright scary…”The sentiment swings in this market are making everybody’s head spin,” says [a technology stock trader]. “It is leading to exceptional volatility. Unprecedented volatility.” … James Stack of InvesTech Research … says that by his calculations, intraday volatility is at its highest level in 65 years.
Why has volatility increased? The Wall Street Journal tries to explain:
While there is a sharp division of opinion on what volatility means for the market’s direction, analysts largely agree on its causes. Topping the list: the quest for new investment ideas … Quick dashes in and out of individual stocks and sectors as fickle investors try out, then discard, new investment ideas has fueled volatility.
“Quick dashes in and out of individual stocks” are the signature activity of speculative capital. But the paper does not know that, so it attributes the problem to “fickle investors.” The tone of the article, furthermore, suggests that the surge in volatility is a passing phenomenon, an anomaly perhaps fueled by a bull market. The issue is further muddled by the frequent nonsensical comments such articles elicit from experts. In the same article, one fund manager dispenses wisdom about the cause of the volatility in the stock market: “Volatility is the price of admission [!] when you buy stocks offering good returns in this environment.”

In the absence of an understanding of why the volatility has increased, decision making becomes increasingly difficult and even seems arbitrary:
When stocks or sectors move in and out of favor in a matter of days, its becomes harder for professional money managers … to cling to their convictions that a stock is a good long-term investment … says … [an] equity strategist: “The fundamentals are very, very hard to understand and analyze, so the market becomes more emotional, and emotion translates into volatility at the micro level.”
The strategist quoted in this story is correct when he observes that an incomprehensible market makes the participants uneasy and emotional, and thus, ultimately, exacerbates the volatility. But the emotional behavior is not the cause of the volatility. Voltaire observed that incantations could indeed kill a flock of sheep if administered with a dose of arsenic. Money managers becoming emotional is the consequence of the operation of speculative capital which creates volatility that money managers do not understand.
These lines were written in 1996-98. A decade later, speculative capital is alive and well, with the credit market as the latest addition to its theater of operations.

The Blog’s Target Audience

A friend with marketing bent pointed out that despite infuriating gaps between postings, the readership of the blog was increasing. He asked who the target audience was.

The target audience is an advertising concept – like “teenager”, for example – devised to help sell products of one kind or another.

This blog has no target audience. Or, rather, everyone is its target audience. It is intended for everyone. If you must, think of it as an intellectual bell. Ask not for whom it tolls, for it tolls for thee.

Monday, October 27, 2008

Genuine Insights, Bold Recommendations, Expressed Resolutely

Speaking of T. S. Eliot, he disdains the intellectual vanity, of the kind his Mr. Appolinax exhibits: “There was something he said that I might have challenged.”

Now read this from a commentary by Larry Summers in today’s Financial Times:
In retrospect, the fact that 40 per cent of American corporate profits in 2006 went to the financial sector, and the closely related outcome – a doubling of the share of income going to the top 1 per cent of the population – should have been signs something was amiss.
That doubling of the share of income going to the top 1 per cent of the population could conceivably be a problem – something “amiss”, he says – this ex president of Harvard and ex Treasury secretary has realized only in retrospect.

He then offers his recommendations.
Therefore we need to reform tax incentives that encourage financial risk taking, regulate leverage and prevent government policies that give rise to a toxic combination of privatised gains and socialised losses. This offers the prospect of a prosperity that is more firmly grounded and more inclusive. More fundamentally, short and longer-term imperatives come together with respect to policies that seek to ensure that any future prosperity is inclusive.
On the same page, FT was promoting a special forum in which “several of the world’s most influential economists discuss Lawrence Summer’s regular monthly column.”

At times like this, I miss that nabob of nonsense, Oracle Alan.

Sunday, October 26, 2008

A Market “Walking, Loitering, Hurried”

What kind of a card game is being played if the lower card trumps the higher card?

Low poker, of course. That is an easy one.

What kind of a credit game is being played if subordinated debt trumps senior debt?
The auction that settled figures for the senior and subordinated bonds of Fannie Mae and Freddie Mac, the US government mortgage agencies, has led to widespread confusion and some participants losing out. In both cases the recovery rate for the senior debt – which in real-world defaults get first claim on all assets – came in lower than for the subordinated debt.
Now you are totally confounded and dumbfounded by this because you know that:
  1. With the US government guarantee, there is not supposed to be a “recovery rate” – how much a bond pays on a dollar. That should be par, or 100 cents on a dollar.

  2. The recovery rate for senior debt cannot be lower than the subordinated debt because by definition, senior debt gets paid ahead of subordinated debt.
Yet, there it is, the Financial Times article in black and pink reporting the results of the auction. The paper did not mention it but we will see later that (2) above is the consequence of (1).

In his book “T. S. Eliot”, Craig Raine quotes a line from Eliot – “I met one walking, loitering, hurried” – and explains that Eliot is telling us “gently that things aren’t exactly normal.” Eliot often creates paradoxes in the narrative to “dislocate the language into the meaning” – “savagely still”, for example, in reference to souls who are corroded by inaction.

Markets, too, create “paradoxes” that tell us things aren’t exactly normal. The Dialectical Reason recognizes such paradoxes as the “logical” result of what is taking place in the real world because it can see the complex interplay of the part and the whole. That is what Hegel meant when he said that what is real is logical.

Analytical Reason, by contrast, sees a paradox – characterized by incomprehensibility – precisely because it cannot see the course of the development of the phenomenon it is observing. Analytical Reason is static. Its frame of reference is an inventory, rather than an organization, of knowledge, because it cannot collect the experience of individual events into a synthetic whole. In consequence, when compelled to take action in the position of authority, its actions seems lacking in the “systemic” depth. They seem “disjointed”, “Whack-A-Mole approach”, “moving goals”, and always “one step behind”. The Analytical Reason itself finally throw up its hand in despair.

The events we are witnessing in the financial markets are driven by speculative capital – capital engaged in arbitrage. I discussed the characteristics of this force and the laws of its motion in the preceding volumes of Speculative Capital. In the next several entries, in response to a friend who wants to know the “real reasons of the turmoil”, I will look at the events in the financial markets in light of the Theory of Speculative Capital. You will then see that paradoxes will disappear. The fog will clear. That has been the intent of this blog all along; recall the 10-part Credit Woes series. But that format was too restrictive, too scholastic. I need “space” to develop!

In Masnavi, Rumi begins a story and in the midst of it branches into another story and then yet another story within the second and so on; you would not know digression until you have read Masnavi! Finally he “catches” himself, saying that it is time to return to the original story. He then corrects himself, saying that when did he ever leave the original story? That is Rumi’s way of saying – showing, rather – that everything in the universe is connected, coming together towards the “Totalized Spirit” – the Absolute Spirit in Hegel.

So, if the subsequent entries in the blog do not appear sequential, bear with me. There is a method in the disorder. In them, you will also see a glimpse of what is to come in Vols. 4 and 5 of Speculative Capital.

Monday, October 6, 2008

Who Could Have Seen This Coming?

In a front page article this past Friday, The New York Times suggested that an obscure decision by the Securities and Exchange Commission in ’04 to loosen the debt limits of the broker/dealers had set the stage for the meltdown in financial markets.

The story had lots of tidbits in the tradition of the best tabloids: a bright spring afternoon, a basement meeting, a pensive commissioner and a Cassandra in the form of a software developer – a clueless geek with extra time on his hands, really – who wrote to warn the commissioners that they were about to make a grave mistake.

Whether the piece was a hatchet job on Christopher Cox, the SEC chairman – it probably was – is not important. (The article opened by quoting Cox talking about the broker/dealers – “we have a good deal of comfort about the capital cushions at these firms at the moment” – and went on to ask, How could Mr. Cox have been so wrong? The answer is that Cox was wrong, but when it came to ignorance about what was about to happen, he had nothing on a long list of policy makers, academics and financial executives with more direct roles in the coming crisis. Bear’s CEO did not know what hit him, even after his firm had gone under.)

I bring up this article to once again highlight the perils of theoretical poverty. In the absence of a firm understanding of what is taking place in the financial markets, we are liable to mistake the manifestation of the events for their cause. The mistake leads to wrong conclusions and wrong remedies. The Times article and the Treasury's $700 billion bailout plans are the proverbial “Exhibit A” in each case.

The Theory of Speculative Capital is the only theory that explains what is happening in the financial markets, i.e., what is changing. It identifies the driver of the change (speculative capital), the consequences of its operation (in legal, social and financial areas) and points to its direction (self destruction). It is only then that we could begin devising solutions.

So, what could the Theory of Speculative Capital do in relation with the current crisis?

Below, I am quoting select passages from Vol. 1 of Speculative Capital. Note the references to money markets and shadow banking. Most important of all, note the role of the Federal Reserve in creating the high-leveraged broker/dealer industry by allowing previously ineligible securities to be pledged as collateral for borrowing. That was full 8 years before the SEC rule changes.
Systemic risk is the risk of a chain reaction of bankruptcies which then disrupt the process of circulation of capital.

In a pamphlet published by the Federal Reserve Bank of New York, Gerald Corrigan, then president of the bank, wrote:
The hard fact of the matter is that linkages created by the large-dollar payments systems are such that a serious credit problem at any of the large users of the system has the potential to disrupt the system as a whole.
Corrigan was specifically writing about a “gridlock” problem in CHIPS, the interbank clearing system in New York. That is what he meant by the “large-dollar payments systems.” He was concerned that the default of a major bank with a myriad of large payments could cause a chain reaction of defaults in CHIPS. The term systemic risk he is said to have coined referred to the risk arising from such cross-defaults: the risk of disruption in the clearing system.

That is a narrow understanding of systemic risk. It is on the same footing as regarding finance as the study of cash flows; it reduces diverse aspects of the subject into a quantitative flash point. The problem so narrowly delineated is easily solved. But for that very reason, the cause of the problem escapes scrutiny, only to surface more menacingly at a higher level.

It is impossible to understand systemic risk without knowing speculative capital and understanding the financial, regulatory, legal and political aspects of its operation.

The “system” in systemic risk is the process of circulation of capital and the markets which form the circuitry of the process – the course of its movement. Alternatively, we can say that the system is a web of markets linked together by the thread of speculative capital. Thus, the “system” has two components: process and markets.

A system defined by such terms as circuitry and flow lends itself to superficial analogies. Often, electrical circuits are used to depict it. Occasionally, one hears of traffic systems and “gridlock.” Writing in the Wall Street Journal, George Soros gave it a human touch and compared it to the body’s blood circulation system–with the US, naturally, being the heart.

But the system of concern to us is a social one; it has little in common with physical or biological systems. The “market” component of the system varies greatly in size, from a stock exchange in a country to the country’s national currency. The strength of the market’s linkage to the system is shaped by its size, regulatory structure, the political environment in which it functions and the country’s proximity to existing centers of international trade and finance. There are numerous secondary factors as well, which, sometimes reinforcing and sometimes offsetting one another, further contribute to shaping the characteristics of the system.


The CHIPS manager who proudly announces the establishment of credit lines to cover the failure of two largest net debits must ask himself this question: under what conditions two largest net debits in CHIPS – say, J. P. Morgan and Chase – would fail? What would cause such failures? That is the question that we answer in examining systemic risk.

Systemic risk comes into existence as a result of formation of basis risk in leveraged positions.

Webster’s definition of leverage as “increasing means of accomplishing some purpose” in finance refers to increasing the rate of return of capital through the use of credit capital. Such increase, when credit capital interacts with industrial or commercial capital, is always modest because the amount of credit capital available to a factory owner or a wholesaler is limited by their equity. That is why some factory owners and wholesaler could avoid debt “as a matter of principle.” One could say that these businessmen have the mentality of pre-capitalist peasants; they have not grasped the advantages of borrowed capital. But more to the point, they could afford to have that mentality because the contribution of credit capital to their bottom line is modest.

No manager of speculative capital, on the other hand, can afford to avoid leverage. With regards to speculative capital, credit capital is more than a booster of return. It is a vital component of support, an engine of sorts, without which speculative capital cannot operate. This new role develops logically and naturally, and in consequence of the real-life conditions under which speculative capital generates profits.

In real life, the arbitrageable spreads yield returns which are considerably below the average rate of return of capital. It would be an unimaginably gross inefficiency of the markets if it were otherwise. The very operation of speculative capital further tends to diminish its rate of return. The small-time speculator – a pit trader in a futures exchange, for example – compensates for the narrowness of the spreads by trading constantly and incessantly.

The mass of speculative capital cannot act in that way. It is impossible to turn over the multi-billion dollar portfolio of a hedge fund many times a day or even a week. So speculative capital searches for venues that will allow it to increase its return without increasing its size. One such venue is through enlisting the aid of credit capital. Acting as a lever, credit capital raises the return to levels which speculative capital in itself cannot produce. The mathematics of leverage is widely known in the market. According the The Wall Street Journal:
Before [February 1994], speculators had been borrowing at a short-term rate of like 3% and buying five-year Treasury notes yielding around 5%, a gaping spread of two percentage points that enabled some to double their money in a year. The math was tantalizing. Using leverage, an investor with $1 million could borrow enough to acquire $50 million in five-year Treasury notes. And the spread of two percentage points could generate about $1 million in profits on the $1 million investment, as long as rates remained stable or declined.
To a bank loan officer who lends on the traditional criteria, that leverage is incomprehensible, almost madness. No business could generate sufficient profits to service debt 50 times the owner’s equity. But arbitrage is no ordinary business. In fact, it is not even a business. It is a refined version of the banks’ own practice of borrowing low and lending high, so the banks readily recognize it. The strategy is “refined,” because now the profits are guaranteed to be riskless “no matter what happens to interest rates.”

That is why and how speculative capital comes to depend on credit capital for survival. The expansion of credit capital becomes a condition for its own expansion. Credit capital, too, assumes a support function unlike any it had before. It becomes imperative for it to “be there” when called upon and to follow speculative capital into new arbitrage ventures such as leveraged finance, leveraged buyouts and junk bonds. These markets are the manifestation of the incestuous relation between credit and speculative capital: they revolve around credit capital but, without speculative capital in the lead, they could not have been developed. In the speculative frenzy of the 1920s, for example, the role of credit capital did not go beyond the traditional boosting of returns through margins because the independent form of speculative capital did not exist. Just how closely the junk bond market is associated with speculation is shown by the following:
“High-yield bonds should outperform during the next six weeks, but in the next six months, I’d concentrate on higher-quality bonds because I’m still worried about corporate earnings next year,” says Joseph Balestrino of Federated Investors.
Prior to the advent of speculative capital, bonds of all kinds were purchased and held for years, even decades. Balestrino’s horizon, when speaking of junk bonds, is six weeks.

The most important aspect of the relation between credit and speculative capital is the quantitative one. Because speculative capital constantly expands, credit capital, too, must expand.

Where does the credit capital for sustaining such colossal expansion come from? The ambiguity and apparent subjectivity of the word “credit” at times make it seem that it is created out of thin air. The practice of banks in creating credit money further reinforces that illusion.

In reality, “credit” is credit capital. Its creation, expansion and movement have their own laws and are governed by a complex set of rules. Their detailed analysis is beyond the scope of this book. Here, we are only concerned with the source of the expansion of credit capital and the consequences of that expansion. The source of expansion is the easy credit policy of the Federal Reserve. “Easy credit” involves more than reducing interest rates. It also includes technical rule changes which provide fresh sources of credit. In April 1996, for example, the Wall Street Journal reported:
“The Federal Reserve moved to ease scores of regulations affecting margin requirements, calling it “one of the most significant reductions in regulatory burdens on broker-dealers since 1934.”
Apparently unconvinced of the significance of the Fed’s announcement, the Journal relegated the story to page 18. It said, in part:
The final rules … will eliminate restrictions on a broker-dealer’s ability to arrange for an extension of credit by another lender; let dealers lend on any convertible bond if the underlying stock is suitable for margin; increase the loan value of money-market mutual funds from a 50% margin requirement to a ‘good faith’ standard … and allow dealers to lend on any investment-grade debt security … the Fed will allow the lending of foreign securities to foreign persons for any purposes against any legal collateral … It will also expand the criteria for determining which securities qualify for securities credit, a change that will sharply increase the number of foreign stocks that are margin-eligible.
The changes described in the article were too technical to be individually analyzed here. (That is probably why the news received very little attention.) The important point is the purpose of the rule changes: to open the floodgates of credit capital. The Fed was correct about the significance of the decision.

As one example, note that the new rules allowed the money market mutual funds “to be treated like their underlying securities for margin purposes.” The US Treasury bills in such funds could be purchased with a 90 percent margin. A mutual fund with $1 million in investment can buy up to $10 million in Treasury bills. When the mutual fund itself is treated like its underlying security, its shares can in return be pledged as margin for buying securities ten times their value. The result is a leverage ratio approaching 100 to 1.

Rule changes by the Federal Reserve do not take place on a whim. In fact, they never take place without a strong impetus: in this case, the pressure of speculative capital whose expansion called for ever larger amounts of credit capital. In the familiar scenario of speculative capital forcefully breaking down the regulatory walls, the Fed had to give room and reduce the “regulatory burdens.” An unrelated New York Times article, published a few weeks after the rule changes were announced, told of the source of the pressure:
Everyone who has even thumbed casually through the books of securities firms recently agrees they are more highly leveraged than ever … It is [the] matched-book portion of firms’ balance sheets, where assets and liabilities are paired … that has soared in recent years … [two] consultants…have suggested that the bloating of the industry’s asset-liability structure reflects an unprecedented and somewhat involuntary commitment to “yield arbitrage,” or the practice of taking advantage of small differences in interest rates … Securities firm executives insist and analysts generally agree that this business generates little market risk, just a dollop of credit risk and perhaps more operations related risk than anything else.
The two consultants quoted in the article noticed the role of yield curve arbitrage in increasing the leverage of the securities firms. Their observation that the firms’ commitment to this strategy is “somewhat involuntary” is especially perceptive. Of course, speculative capital engages in great many arbitrage opportunities; yield curve arbitrage is only the most readily recognizable one.

The increase in leverage surpasses anything seen in the bond market: “The demand for financing, and for leveraged purchases of bonds, has reached a ridiculous level.” But the Federal Reserve is forced to loosen the rules even further:
The Federal Reserve Board proposed new capital guidelines … that would provide the biggest break to banks that sell triple-A rated asset-backed securities. Currently, banks … are assessed an 8% capital charge on the security’s full value. Under the proposed guidelines, the 8% charge would be … [reduced to] an effective [rate of] 1.6% … a Fed financial analyst who helped write the proposed rules [said]: “This rule will fit in nicely with the way the market is moving.”
The analyst is right on the mark. In fact, he is more right than he could suspect. In saying that the rule changes “fit in nicely with the way the market is moving,” he has in mind the general deregulatory trend and the need of banks for constantly increasing amounts of credit capital. But there is one other, more fundamental, movement in part of the market which is not readily discernible. That movement is the gradual advancing of the markets toward a sudden disruption.

These lines were written in 1997-99. Speculative Capital offered the only critical examination of the events taking place in the financial markets at that time. Otherwise, no one in the academia, regulatory and credit rating agencies, and certainly no one on Wall Street, questioned the leveraged-based business model that speculative capital was imposing on the markets.

Read again, “Securities firm executives insist ... little market risk ... just a dollop of credit risk” and think of the cast of characters: Fuld, Komansky, Prince, Weill, Greenberg, Schwartz, Paulson, Corzine, Purcell. Nothing exposes the poor players who strutted their little hour upon the stage of Global Finance more mercilessly than a global crisis.

But this is not the end. It is not even the beginning of the end. In Vols. 4 and 5 of Speculative Capital, I will take on the subject of systemic risk in all its dimensions, not only economic and financial, but social and cultural as well.

Thursday, October 2, 2008

A Report From the Money Markets

In several places, I have written about the crisis in the money markets.

Today’s Financial Times had an article on this subject under the heading “Triple blow spurs central banks”. As usual, there was no mention of the cause of the “blows”, only reporting of the facts. I thought two paragraphs in particular might be of interest to the readers of this blog. [Italics added for emphasis].

The first paragraph was about the result of an auction:
Yesterday morning in Europe the ECB offered $30bn of overnight money and found banks scrambling for the cash, willing to bid vastly over the 2 per cent policy rate of the Federal Reserve. The money was ultimately lent at a rate of 11 per cent.
To the best of my knowledge, this rate differential is unprecedented in any dealing of the Western banks with a Western central bank.

The second paragraph is about freeze in the “wholesale” money markets which I described in the previous entry:
The lack of any business in wholesale money markets was demonstrated by the enormous use of the European Central Bank’s standing lending and borrowing facilities. Some European banks parked €44bn overnight at the ECB on its penalty 3.25 per cent rate on Monday night while others borrowed €15.4bn at its 5.25 per cent penalty rate.

They did not deal with each other, as they would normally.
The end-of-quarter funding requirements no doubt exacerbated the money famine. But even accounting for the technical distortions, what we are witnessing is a deep crisis in the financial system whose real causes remain hidden from the view of virtually all experts and policymakers.

Monday, September 29, 2008

The Unraveling of the Money Markets: The Flip Side of Efficiency

To the uncritical mind of finance professors who see the markets with the eye of a P.R. agent, the changes that have taken place in the past thirty years in the financial markets were a series of inspired events brought about by visionary bankers, insightful academics and bold traders. The result, naturally, was “sophisticated” and “efficient” markets which benefited all.

In reality, finance is a dialectical discipline. Its development follows the logic of internal evolution of finance capital which turns the phenomena to their opposites – commerce to speculation, hedging to arbitrage, equilibrium to volatility, just to name a few. The most benign phenomena then reveal a hidden side that is in contrast to their docility. Such is the case with the “efficient” markets.

By efficient markets, the academics mean a market where, thanks to arbitrage, the borrowing costs are low and capital is allocated in the optimum way. In practice, this means markets in which capital never stands idle. It is employed at all times, earning however small a return. In a time of crisis, this constant engagement turns into entanglement. To free the capital then, it is necessary to unwind; mere selling would not do. Search for “unwind financial markets” in Google for various instances of unwinding.

In money markets, two areas oil the efficiency engine. One is the tri-party repo market which I described in Credit Woes. The other is the even larger securities lending market – called “sec lending” by everyone in the industry – whose size is well above the tri-party’s $4 trillion daily transactions.

The sec lending market is driven by short selling, or shorting, which is selling something you do not have. Outside the financial markets, the practice amounts to fraud; if you sell a house, or a car, or a farm you do not have, you would probably go to jail. In the financial markets, the practice is legal and very common. With the ownership requirement eliminated, the buy-sell sequence could be reversed; instead of buying first and selling later, you could sell first and buy later. So if we think that, IBM, for example, might fall, we call our broker and short 1000 IBM shares. We hope to buy them back later when the price falls.

For every seller, there is a buyer. Someone must have bought the 1000 shares we just sold. But we did not posses the shares. How are we going to deliver the shares to the buyer? That brings us to sec lending.

Take a large investor – a mutual fund, for example – that owns tens of billions of dollars worth of securities. In the modern financial markets, there is no physical certificate. All securities, rather, are held in street name, for the fund, by a custodian bank.

In the efficient capital markets, with the constant struggle by funds to improve their performance by even 1/100th of a percent, these securities are a potential source of addition income to the funds which own them. So as part of an active arbitrage strategy, the custodian bank approaches the fund and makes the following pitch:

We are holding large securities positions for you that currently sit idle. Through our sec lending program, we could lend all or part of them to short sellers. You need not worry about risk. Among various precautions, we indemnify the lent securities, so that should you suffer any loss, we would make you whole.

As collateral for the lent securities – you will even have the option of telling us whom not to lend to – we would receive cash collateral from the borrower (short seller). We would invest the cash and share the proceeds in some equitable manner, say 80-20, where you get 80% and we get 20% .
After the securities owner (the fund) agrees, the custodian bank inform short sellers that it is open for business.

Assuming the same 1000 IBM shares is trading at $120 per share, the following then takes place:

1. The custodian bank “delivers” 1000 shares, worth $120,000, from the fund’s account to the short seller, or the borrower (of stock)

2. The borrower posts cash collateral to the bank equal to $122,400, which is 102% of the value of the borrowed stock.

(Upon termination of the short sale, the securities are returned to the fund. The bank returns short seller’s $122,400, plus accrued interest calculated at the Fed Funds rate.)

3. The bank invests $122,400. If the spread between what the bank earns for this investment and the Fed Funds rate is 10 basis points, the interest income would be $122.50, which is split in a pre-agreed manner between the bank and the fund.

This is the most critical step. Since the interest income is the difference between what the bank can earn and the Fed Funds rate, there is a strong incentive for the bank to invest aggressively. In the mean time, short sellers do not sit on their positions for long, so the investment has to be short term, which is the realm of money markets.

There are two ways to increase – to enhance, in the language of marketing brochures – the return on a money market fund: to go down the credit ladder, or to extend the term. The first option exposes the fund to the risk of loss due to a downgrade. The second, in addition to a credit downgrade, locks up money for a period ranging from one week to just under one year.

Imagine now that the borrower of shares is Lehman Brothers. The owner of the shares – a mutual fund, in our example – becomes concerned about the health of the firm and instructs the bank not to deal with Lehman. The lent shares must now be recalled and $122,400 with the accrued interest returned to Lehman. If the bank has locked the money in a money market fund that has an as-yet-in-the-future maturity, it has to liquidate the position. If the money market fund is aggressive and has invested in junk mortgage securities that have dropped in price, the hit to the principal is even more pronounced. The custodian bank must then make up the shortfall, an act that requires an immediate infusion of cash. It is in this way that short term markets come under pressure, which is why the Treasury immediately responded by guaranteeing the principal in money market funds; large custodian banks with trillions of dollars in custodial accounts, not to mention many “boutique” firms, are actively engaged in sec lending. The efficiency of markets brought about by the sec lending business is one of the primary sources of disorder in money markets that is reflected in unprecedented Fed Funds/Libor/OIS spreads.

That is also why the stock price of custodian banks took a beating on September 18, a process that continues to date. Check State Street, for example, whose violent price swings on that day showed that traders were aware of the role of the “custody banks” and the vulnerability that follows from their business model.

All in all, the individual stock price changes, like today’s 700 plus point drop in the Dow Jones, are mere consequences. That index could rebound tomorrow – or the day after. The unraveling of the money markets, on the other hand, is here to stay – well beyond tomorrow and the day after.

Tuesday, September 23, 2008

A Question for Secretary Paulson

I chose the wrong week to go on vacation and must now catch up with the unread papers of an eventful week.

The demise of broker-dealers was news only in the manner it played out. But the business model was doomed. I wrote on this blog that for broker-dealers “to function, the system has to be unstable”.

The wording was slightly imprecise. I meant that to function, the system needed to be balanced on a razor’s edge. And for over a decade it was. But the ongoing turmoil in money markets disrupted the shaky balance beyond any hope of restoration.

AIG, too, was an easy bet. You could see something was rotten in the state of the company from the vehemence that it attacked standard accounting principles.

What I did not know was the extent of AIG’s involvement in the troubled money market funds. Then, under the cover of arranging an $85 billion bail-out of AIG, the Treasury announced that it would also rescue money market funds regardless of their affiliation. This happened on Thursday, after several funds “broke the buck”, meaning that their investors would lose some portion of their principal.

The news came out on Friday and after a few comments about how unprecedented it was, disappeared. Count on the mainstream media to ignore important news.

Let us see now. The U.S. Treasury is handing out money to money market funds to ensure that these funds, many of them with absolutely no affiliation with banks, broker-dealers or other financial institution, would preserve their $1 net asset value. Why? Note that this is taking place in the midst of a blood bath that forced Merrill Lynch to sell some assets for as little as 22 cents on a dollar. Why would it matter then if a money market fund's NAV dropped by a penny, to 99 cents? And why would that concern the U.S. Treasury?

The answer is that money markets are the critical link between industrial and finance capital, or, as your economics professor would say, between the financial markets and the “real economy” – the “real economy” always in quotation marks because he cannot define the term but expects you to understand it, very much like pornography.

The relation between the industrial and finance capital is a chapter in Vol. 5 of Speculative Capital. Here, I will have to be brief.

Assume your business purchases a machine for $12,000. The machine has an average life of 5 years, after which you have to replace it due to either wear and tear or obsolescence.

It is an elementary principle of accounting and finance that, ignoring the price change due to innovation, you have to set aside $2,400 every year for 5 years to create a reserve fund for the replacement of the machine. It is this money – $2,400 the first year, $4,800 the second year, and so on – that is placed in money markets and never in capital markets, the latter having a completely different function.

Money markets provide an extra income to funds while funds are waiting to be employed. But that income is absolutely secondary to preserving the original sum. This sum, when called upon, must be available for turning into fixed assets. If it falls short, it could not purchase the assets and the process of industrial production would suffer. It might even come to a halt. That is how money market is “related” to the real economy.

One of the funds in trouble was the famed Reserve Fund. Here is its “inventor” in an August '07 interview with the Financial Times. The man must have seen what was coming.
Bruce Bent, the inventor of the money market fund, has criticised the “flagrant abuse” of the concept – which he introduced in 1970 – that has come to light in recent weeks.

Mr Bent, who established the world’s first money market fund, the Reserve Fund, says the original idea behind the fund is being ignored. His displeasure stems from a sense that many money market funds have exposure to sectors or securities they should not be in, claiming his original concept was not designed to give investors any headline risk and should give them immediate liquidity and safety above all else.

“The money market fund was created to provide effective cash management, to guarantee at least a dollar in and a dollar back and beyond that, a reasonable rate of return,” Mr Bent says.
Like all fund managers, old Bruce is a practical man and cannot exactly or convincingly explain the nature of the “flagrant abuse” he is complaining about; when it comes to matters of theory, the “sense” will take you only so far. But he is right on the mark in describing the characteristics of money market funds. All traders know that, which is why on Thursday, the rates on the 3-month T-bills dropped to 3 basis points, which is to say, zero. I even heard that the market ran out of the T-bills. Thus, through rates and prices, the only way they know how, traders defined money markets for us: a place where the safety of principal trumps the interest income at all costs.

What about the Treasury secretary? Does he know the relation between the money markets and the real economy?

I must say, Yes. His hurried response to the shortfall in the money market funds is not sufficient proof. You could argue that it was the practical reaction of officials deluged by panicked calls from bankers and fund managers; the back office of any clearing institution on that Thursday must have been a scene to behold.

So I have other evidence, thanks to Larry Summers whose picture made The New York Times the other day as a potential Treasury secretary in the Obama administration. I remember him speaking in his capacity as the Deputy Treasury Secretary (to Bob Rubin) of the “benefits” of the Southeast Asian financial crisis. The time was February 13, 1998. The Wall Street Journal reported it on page A2 under the heading “U.S. Presses Japan to Stimulate Economy”:
’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,’ Mr. Summer said.
So Larry Summers knows that a financial crisis can setback industrial output and boasts of having achieved just that in Southeast Asia. He no doubt passed this knowledge to the Treasury staff as part of the “knowledge transfer” initiative that any responsible technocrat would undertake.

That brings us to the question. If the Treasury secretary and his underlings knew of the relation between money funds and the “real economy”, why did he not interfere to prevent the perversion of money markets that I described in the Credit Woes series? The perversion was a long time in the making and took place in the plain view of everyone in the market.

For that matter, where was Larry Summers, as Deputy Treasury Secretary, as Harvard President, as an eminent Financial Times columnist, to raise the issue? After all, it was under his watch and that of his mentor, Consigliere Rubin, that the money markets began metamorphosing into trading places.

These are rhetorical questions; I gave the answer in Vol. 1 of Speculative Capital, in discussing the dynamics of speculative capital and the way it operates through human subjects. But they are still questions to ponder in the midst of this crisis where grave-looking men in dark suits who try to end it find themselves grossly out of their depth.

(The last entry on Lehman bankruptcy had several errors, typos and an incomplete sentence. Blame them on the slow and spotty Internet connection I was using at the time. All are corrected, with apologies.)

Wednesday, September 17, 2008

Lehman’s Bankruptcy: An Event to Remember

The most outstanding characteristic of the “pragmatic man” is lack of conviction. He believes in no ideology, honors no conventions, adheres to no principles, follows no set rules, finds nothing per se wrong and rules out nothing categorically.

This is neither criticism nor moral posturing. It is an elaboration of what logically follows from the word “pragmatist”, what it implies. A pragmatist is ruled by the exigencies of the moment. He is a compromiser, a deal maker, a justifier, a fixer.

Central bankers are a pragmatic lot.

The news of Lehman and Merrill reached me at sea, in Alaska’s Inside Passage, to be exact. Without the phone reception and the spotty and outrageously expensive access to the Internet in the glaciated valley, I do not know the details, but the details do not matter. There is only one central question. Why was Lehman allowed to fail after long words about the systemic implication of the failure of much smaller Bear Stearns– and, if you want to go further back, Long Term Capital?

The Fed’s decision to let Lehman go under will be explained by the usual hangers on in the media as a courageous call and a necessary message to the officers of private enterprises that they must face the consequences of their actions. This will be celebrated as the triumph of free market and the application of tough love that everyone agrees corporate America desperately needs.

But central bankers are a pragmatic bunch and the Federal Reserve is no exception. It is inconceivable that the Fed would force a major broker dealer whose CEO sat on the board of directors of the Federal Reserve into bankruptcy for the sake of making an ideological point. The Lehman failure is a defeat, a setback. The Fed would have done everything within its power to save the firm. That it did not, because it could not, is the central story behind Lehman’s failure. In the Lehman crisis, the Federal Reserve reached the limits of its omnipotence. It was rendered impotent because it did not have the financial wherewithal to intervene.

In several entries on this blog, I have pointed out how the Fed’s Term Auction Facility, like the Bank of England’s Special Liquidity Scheme, was being abused by banks and broker dealers, Lehman included.

These “facilities” were created as a temporary solution to the seizure in money markets. The institutions holding impaired mortgage-related securities could pledge them with the central bank and receive Treasuries in return.

The idea was a “pragmatic” one. The activities of broker-dealers, for example, fell outside the Federal Reserve jurisdiction, but the facility was extended to them any way. It was believed by men who know nothing of the fundamentals of finance capital and explain everything in terms of human behavior that the scheme would somehow jump start the markets.

It did not turn out that way. The financial institutions immediately began swapping their existing junk securities for Treasuries. As the junk ran out, they sought and created junk specifically for the purpose of swapping it with Treasuries. Junk trading was back, except that now the central banks – the Fed in the U.S., and the BoE and ECB in Europe – were on the receiving end.

As the central bankers tried to clamp down on the practice, the markets fell.

The Bank of England’s money-market “reforms” that is in the works is intended, gingerly and with extreme caution, to finally get the Bank out of junk trading business. Hence, the comments of the Mervin King, its governor that the bank “will not and cannot solve the shortage of funding to finance bank lending”.

It was against this backdrop that Lehman’s funding needs turned into a crisis. Every day, the bank had to finance some $600 billion securities in the tri-party market. The Federal Reserve, having destroyed its assets through its Facility, could no longer take on such crushing load. It had to stand aside and let Lehman go down.

I will have more on this topic when I return.

Tuesday, September 9, 2008

Secretary Paulson Jumps the Gun – and Fires His Bazooka

Treasury’s takeover of Fannie Mae and Freddie Mac over the weekend meant that Secretary Paulson’s bazooka strategy had failed – but only because he chose to fire without having to do so. Otherwise, following his own words that “government support needs to be either explicit or nonexistent,” he could have extended an explicit government guarantee to Fannie and Freddie and achieve the same results he got with the takeover with much less suspense and fanfare. But the point, of course, was not to save Freddie and Fannie, but to bury them.

The extensive coverage of the event that followed added nothing of substance to the subject. That was par for the course for the media, as the readers of this blog know from the Destruction of Fannie Mae and Freddie Mac. A few tidbits, though, I found interesting.

One was Secretary Paulson’s using a secure video link from a bunker to brief the president. I understand the show-off, the ego trip: look Ma, I am talking to the president from a bunker. But there could not have been anything confidential about the plan that required secure communications. The Treasury’s plan was a rehash of the “prescription” – castration, really – that The Wall Street Journal presented on its July 10 editorial. I quoted it in the Destruction series. So, a few lines on any message board, with a link perhaps to the Journal article, would have sufficed.

As if to confirm this point, the New York Times reported that Mr. Paulson had also briefed Warren Buffet. No explanation was offered for this private briefing of a private investor by the U.S. Treasury secretary – doubly inappropriate because it took place in the context of an issue that involved, as per Secretary Paulson himself, a “conflict between public and private purposes”.

The Sage of Omaha then had this to say:
Secretary Paulson has made exactly the right decision for the country. He is minimizing the problem of moral hazard and maximizing the benefits for the housing market and for the smooth functioning of financial markets.
And you thought drivel – pure, unadulterated, absolute drivel – was the purview of politicians only.

I also learned that Fannie Mae CEO, Daniel Mudd had pleaded with Paulson to spare his institution. He pointed to his success in raising capital and emphasized that Fannie was in much better shape than Freddie Mac. He must have been certain that Fannie Mae could survive on its own, else he would not have dared to press the point in an atmosphere of the crisis. But his reasoning went nowhere. Paulson told him that “Freddie was nearing a crisis and that, in the eyes of the markets, the companies were joined at the hip”.

And why was Freddie Mac nearing a crisis?

It needed capital. When the CEO, Richard Syron went to New York to seek investors, The New York Times reported, “potential investors told Mr. Syron there was too much uncertainty around the Treasury’s intentions; if investors acted now, and Freddie was later seized by regulators, they would lose everything they had invested.”

So the reason Freddie Mac could not get capital was the uncertainty about the actions of Treasury. And that – Freddie’s inability to raise capital because investors were unsure about the Treasury's actions – was the reason that Fannie Mae also had to go.

None of this is will surprise the readers of this blog who read the Destruction series. Unbeknown to the CEOs, the fate of Fannie Mae and Freddie Mac was sealed long before the first weekend in September 08. That is why the Treasury’s rescue plan now “bans [Fannie/Freddie] from lobbying the government, putting an end to their ability to use their political machine on Capitol Hill.”

This is the equivalent of creating a “no fly zone”, proof that opponents are in the driver's seat and the sign that they are planning to have their way with you.

A matter of a small indignity remained. The New York Times said:
The seizure of Fannie and Freddie is all the more surprising because, as recently as late March, Washington viewed the companies as saviors of the housing market and the economy, rather than as risks to them. Instead of requiring Fannie and Freddie to scale back, regulators gave then a green light to buy and guarantee more and bigger mortgages.

On March 19, James B. Lockhart, their chief regulator, dismissed swirling rumors about their financial health. “The actions we’re taking today,” Mr. Lockhart declared, referring to a decision to ease restrictions on how much capital they were required to hold, “make the idea of a bailout nonsense in my mind. The companies are safe and sound, and they will continue to be safe and sound.
This remembrance of the events past is hard on Paulson and Lockhart. It makes them look like fools who misread the situation even after the collapse of Bear Stearns.

Such characterization would be fine with both men, certainly with Lockhart. That is because the real story is even more damning.

The plan, you recall from the Destruction series, was to take out the agencies. The job had to be done in a “clean” and controlled manner; it would be foolish to do otherwise. But in the midst of the plot, the unpredictable intervened: the credit market froze. After the collapse of Bear Stearns in March, panic set in. In desperation, the attention turned to two healthy institutions that, up to that point, had been incessantly maligned. Suddenly, the tune changed, hence Lockhart's passionate declaration that “the companies are safe and sound, and they will continue to be safe and sound”. The second half of the statement is a wishful thinking, almost like a promise you know you could not keep. Anyway, by then it was too late.

I will have more to say on this subject in Vol. 5 of Speculative Capital.

Monday, September 8, 2008

The Critical Role of Interest Rate Swaps in Financial Markets and the Real Economy

Sometime in the fall of 1990, during a lunch conversation with colleagues in what was then Credit Lyonnais, I brought up the idea of writing a book on swaps. The head of HR who had some knowledge of the publishing industry thought I was setting myself up for disappointment. Publishers would not accept a book proposal without an introducing agent, and no agent would take a writer as a client who was not already a published author. Like first jobs and the experience requirement, it was one of those well-known catch-22s, he said.

The same evening – it was on a Thursday – I wrote a 4-page proposal and sent it to Dow Jones Irwin. On Monday they called and offered a contract.

Valuation, Trading and Processing Interest Rate Swaps came out in 1993 under the imprint of Business One Irwin – even then the publishing industry was in turmoil – and, according to the statistics of the legendary McGraw Hill bookstore in New York anyway, became an “industry bestseller”; industry meant technical books in finance. I received a princely sum of $7,500 and many compliments. One mildly critical comment stood above the rest. An academic reviewer wrote: “The chapter on operations is interesting in that it addresses issues not discussed elsewhere but I doubt many people would be interested in how it works”.

I had almost forgotten the book until a friend recently suggested adding it to the list of the books on the blog as a part of the blog’s (very) gradual overhaul.

Interest Rate Swaps has been out of print for a long time. But interest rate swaps are going strong as ever. In fact, though I did not know it then, the spectacular growth of the swap market in the 80s was the driver and the resultant of the rise of speculative capital.

An interest rate swap is simple in concept. Two sides agree to the exchange of interest payments based on a notional amount. (“Notional” because it does not change hands and merely serves as the reference for the calculation of interest amount.) One party pays fixed rate; the other, variable. The variable index is generally the London Interbank Offered Rate, or Libor (pronounced like MY DOOR.) It typically resets every quarter.

Operational issues aside, there is little to add to this description. But nothing exists out of context. Taken into capital markets for which it was designed, the swap structure proved quite revolutionary. It made possible arbitraging corporate credit and interbank lending markets.

The clue to this critical function is in the Libor index, which pertains to the rate banks charge one another. Interest rate swaps enable corporations to borrow cheaper in the variable rate Eurobond market and swap it to a fixed rate.

The quantitative impact of this funding mechanism was phenomenal. Twenty years ago, 80% of the corporate borrowing was through bank financing and 20% through bond market. Today, the ratio is reversed; it is 80% through capital markets and only 20% through bank financing.

Far more important, however, was the qualitative transformation of the markets. You see, if you could use swaps to arbitrage the cheaper inter-bank lending market and the long-term capital market rates, why stop at corporation? Why not bring in municipalities to the game as well, to take advantage of the “efficiencies” of the modern financial markets and collecting no so insignificant fees and bonuses in the process?

That is precisely what transpired. Hence, the rise of auction-rate securities (ARS) and the option tender bonds (OTBs). Under the relentless pressure of speculative capital which aims to shorten the trade horizons, the Libor reset was also reduced to its irreducible overnight frequency. In this way, the overnight swap index (OSI) was born.

Note here that OSI and the Fed Funds rate serve the same exact purpose. They are the rates that banks can borrow overnight from each other (OSI) and the Fed (Fed Funds). Hence, it stands to reason that the difference between them should only be a few basis points (accounting for the higher credit quality of the Fed). That was indeed how it was until summer '07. Since then, the persistently large spread between OSI and FF, over 60 basis points, has provided one of the most compelling signs of continued malaise in the markets.

If you sleep with dogs, you wake up with fleas. If the corporate and municipal bond market are linked to the interbank lending market through swaps, then they are bound to suffer the consequences of any dislocation in the financial markets. Somehow the top central bankers and top economist and top fund managers in Jackson Hole did not seem to grasp this obvious link between the financial markets and what they call – always in quotation marks – the “real economy”.

In Vol. 5 of Speculative Capital, I will show the exact manner in which crises in the financial sector impact the industrial production and service activities. In the mean time, read the following news stories that provide useful background material on auction-rate securities, option tender bonds and the role of interest rate swaps.

The last one is the most entertaining. It deals with the question of the “reliability” of Libor because the index did not behave the way college textbooks and the learned professors had said it should. There were serious and protracted discussion about reforming or replacing the Libor until the discussion slowly faded away, one hopes from embarrassment. There never was a more egregiously foolish shooting of the messenger.

Sense of crisis growing over interbank deals (FT, September 5, '07)

In particular, the cost of borrowing funds in the three-month markets – as illustrated by measures such as sterling Libor or Euribor – is continuing to rise, suggesting a frantic scramble for liquidity among financial groups. This trend is deeply unnerving for policymakers and investors alike, not least because it is occurring even though the European Central Bank and the US Federal Reserve have taken repeated steps in recent weeks to calm down the money markets. Or as UniCredit analysts say: “The interbank lending business has broken down completely … it is a global phenomena and not restricted to just the euro and dollar markets.”

Strategies reborn and lessons learnt – hopefully (FT, October 8, '07)

The TOB programme is a trust that borrows short-term money to buy US municipal bonds. The people setting it up ... buy long-dated US munis with money borrowed at Libor. After paying for a hedge against a rise in Libor, they might net 30 to 50 basis points, but they can leverage that trust up perhaps 12 to 14 times ... The managers have the option of liquidating the trust in case things go against them in some way, or if they decide they want to wind up the business. What they had not counted on was, of course, what happened. In the summer crunch, Libor blew out as banks became suspicious of each other. At the same time, like all non-sovereign bonds, US munis came under suspicion.

Global funding pressures intensify (FT, April 15, '08)

Strains across money markets intensified yesterday and are approaching levels last seen in mid-December ... This was illustrated by higher swaps rates, which compare the difference between overnight lending rates set by central banks and three-month Libor, the rate at which banks lend to each other. In the UK, this spread known as the overnight index swaps (OIS) rate, rose above 100 basis points yesterday and in the US increased to 80.6bp. … These are highly elevated levels and compare with swap rates of around 15bp before the credit crunch emerged last year.

Slowly does it, as calls grow for Libor shake-up (FT, April 22, '08)

The British Bankers’ Association has opened the door to “evolutionary change” in how it calculates London Interbank Offered Rate – Libor – in response to growing criticism about the accuracy of the global benchmark for borrowing costs … The rate has traditionally been considered a key barometer of financial stress and swings in Libor can have big economic implications since many loan and derivatives contracts are based on it ... However, bankers fear the index has become distorted in recent months, particularly in dollar markets, because it is calculated according to bank’s perceived funding costs rather than actual trades.

The emphasis on Libor, OTB and ARS in these stories tends to obscure the central role of interest rate swaps. But that role is ever-present; it is central to the stories. No student of finance can afford to be in the dark about these critical tools of arbitrage. Good finance teachers will see to that.