Wednesday, June 25, 2008

An Excerpt from Vol. 3 of Speculative Capital

The following is an excerpt from the last page of Vol. 3 of Speculative Capital: The Enigma of Options. The book came out in 2006. The lines were written in the late '05 or early '06.
The role of speculative capital in the creation of the credit derivatives market cannot be overemphasized. Speculative capital is the conceptual rainmaker of this market, its underwriter. It brings the credit to the trading arena and ensures its staying power there by “grooming” it in accordance with the needs of the market.

The most outstanding handicap of credit in the new environment is the long time horizon. The traditional credit analysis is “through the cycle,” extending 5 to 7 years in the future to allow for the evaluation of an entity during a business cycle. Speculative capital would have none of it.

Having brought credit into its orbit, it trims its horizon to mere months. Credit, thus shortened and thrown into the market, seeks the confirmation of its price in the most short-term, readily available and actively traded instrument: stock. In this way, stock price comes to play a role in setting the price of credit. Traditional credit rating agencies are forced to take account of the development. They, too, shorten the time horizon of credit analysis.

A realization takes shape: if the stock price is an immediate measure of credit, perhaps credit and market price are more closely related than previously thought. This phenomenon plays out at the wholesale level as well, when corporations discover that they could sell their liabilities – and accounts receivable assets – in the market. So the tried and true concept of mortgage-backed securities (MBS) is extended to all forms of debt to create collateralized debt obligations (CDO), collateralized loan obligations (CLO) and, in case of accounts receivable, asset backed securities (ABS).

The rise of credit derivatives is the latest qualitative change in the evolution of finance capital that brings together its market and credit “dimensions.” We are currently witnessing the early stages of this development. But armed with the theory of speculative capital we could see what is happening, i.e., what is changing. We could also discern the cause, pattern and characteristics of the change. So while for others credit derivatives are the risk-diversifying, need-fulfilling products of an innovative Wall Street, for us they are the footprint of speculative capital on its march towards systemic crisis. The march, driven by the profit-seeking, inherently self-destructive movement of speculative capital, creates financial entropy on its path, one manifestation of which is closing the longest running, most structural arbitrage opportunity of all: between the credit price and the market price. But the ensuing state of inert uniformity cannot be tolerated; speculative capital cannot sit by idly and will not go gently into that good night. It must disrupt the equilibrium to create profit opportunities anew. That brings about the systemic risk.

Sunday, June 22, 2008

Keeping Our Eye On the Ball

Speaking of Harvard, in today’s New York Times William C. Apgar, a “senior scholar” at the impressively named Joint Center for Housing Studies at Harvard University said, “People are beginning to understand that home ownership can be a very risky venture”.

The context of this story is the rise in foreclosures and the decline of the homeownership in the US during the presidency of George Bush, whose one stated goal was the creation of an “ownership society”. Yet, Harvard’s senior scholar speaks of home ownership risk in the same vein that one would speak of the risk of say, deep water diving. The social context of the event, if noticed at all, is completely cast aside.

A day before, two Bear Stearns fund managers were indicted in relation with the collapse of their funds in June ‘07. The near simultaneous collapses triggered the systemic crisis we have been witnessing for over a year. The indictment was given wide coverage; ex Bear executives in handcuffs being led to the federal court. The message was that unscrupulous individuals who had gamed the system were now being called on the carpet.

In these two stories we have the perfect example of the binary system of explanation that I have been writing about: the failings of fallible humans, and/or the can't-do-anything-about-it nature of things. Nothing else is entertained. Nothing else is permitted. The philosophy of philosophers of our time or the indictment of failed fund managers all serve to reinforce this message.

I am familiar with the funds in question and how they imploded. Without defending the propriety of the actions of the managers or denying the commonness of petty crimes in finance, their collapse was the proverbial Exhibit A in the subjugation of men to the laws of finance. For those not sufficiently convinced, the $200 billion plus losses that some of the largest and most sophisticated global financial institutions have suffered in the past year – institutions that by virtue of their presence tend to game the system – offers yet a more compelling evidence.

This brings me to Speculative Capital. The central point of my theory is that the crises of various form and intensity that we have been seeing since the mid 1970s are not a one time – or two time or three time aberrations – but the necessary consequences of the growth of speculative capital. Speculative capital is self-destructive; it tends to eliminate the opportunities that give rise to it. Hence, only a conscious change in policy would avert the crippling systemic failure that is in the offing. But any such change in policy, while in the realm of the possible, borders on impossible. Recall from the Credit Woes series that broker/dealers, for example, need to operate with a 30-to-1 leverage, or their business model would not be viable. But a 30-to-1 leverage is inherently unstable, as Bear Stearns found out and Lehman is in the process of finding out. That brings us to the inner contradiction of the system: to function, the system has to be unstable.

All this is detailed in Vol. 4 of Speculative Capital, The Dialectics of Finance. I have returned to the manuscript with a sense of urgency. That is why the blog entries might at times be delayed. By way of compensation, I will occasionally post excerpts from the manuscript.

Saturday, June 7, 2008

The Real Conflict of Interest (at Harvard)

In a front page article today, The New York Times reported that Dr. Joseph Biederman, a world-renowned Harvard child psychiatrist, had received at least $1.6 million from the drug companies in relation with consulting services that involved promoting their antipsychotic medicine. The article went on to say that Dr. Biederman’s work
helped to fuel a controversial 40-fold increase from 1994 to 2003 in the diagnosis of pediatric bipolar disorder, which is characterized by severe mood swings, and a rapid rise in the use of anti-psychotic medicine in children ... Some 500,000 children and teenagers were given at least one prescription for an antipsychotic in 2007, including 20,500 under 6 years of age.

The moral and social issues involved here – that a society chooses to tackle the problem of children’s behavior with the magic of pills, or the fact the news of this abuse has been out there for years – is not my concern; the subject of this blog is finance.

So let us talk about finance.

Do you recall, in the past ten or twenty times that you have come across Harvard’s name, what was it in relation to? It is a good guess that it was one of the following:

  • the size of the university’s endowment fund; or

  • the rate return of its endowment fund; or

  • the change in the management of the fund; or

  • the portfolio mix of the fund; or

  • the investment strategy of the fund.

You get the idea; money is not an unconsidered trifle at Harvard. Just google “harvard + mohamed el-erian” – he managed the fund until last year – and see for yourself.

Consider now, if you will, the situation of a professor at Harvard. To advance his career, he must constantly produce and publish high quality research papers in prestigious journals. Publish-or-perish maxim rules at Harvard as in other universities.

The pressure to publish never ceases. It in fact increases with the tenure. That is because the driver of research is not the abstract love of knowledge but money, in the form of research grants. The more research grants you bring into your university, the faster you advance and the richer you become. Research grants, in turn, favor renowned schools and scholars. Hence, the incentive to become a world renowned expert in a prestigious school. It is a self-feeding, self-perpetuating loop.

The problem is that the only way a scholar could produce first rate, topical research is by aligning his research interests with the agenda of the world renowned publications that have advertising ties to the grant giving corporations. In the same way that fashion magazines create and dictate the fashion taste, companies create and dictate the research agenda. "Dictate” has a social connotation. It works through the internalization of values and manifests itself in the free choice of independent minded, even critical, scholars. To take the case of Dr. Biederman, it is inconceivable that he engineered a 40-fold rise in the use of anti-psychotic medicine in children against his beliefs. He must have believed that his work was contributing to the well-being of the children. If it also happened that it made money for him and the sponsoring corporation, it was icing on the cake.

Against this background, an “independent” scholar wanting to follow his own path – to do what he thinks is important – will be laughed out as a an out-of-touch fool, as the last old fashioned editor of the New England Journal of Medicine found out to his chagrin.

Conflicts of interest in medical science, biology and genetics tend to get closer scrutiny. But they pale in comparison with what takes place in economics and finance. Setting aside the petty corruption that is common, every single research paper and every general research topic in economics and finance is set in motion by the interests of traders, fund managers, bankers, investment bankers, broker/dealers and arbitrageurs. These interests also determine the framing of the problems, in consequence of which the direction of research and its results become preordained.

In Vol. 3 of Speculative Capital, I spent considerable time on this subject. Analyzing the steps that led Black, Scholes and Merton to their option valuation formula, I wrote :

They set out to solve the problem of option valuation. They were theorists, but the theory at their disposal was not up to the task. So they chose pragmatism. More accurately, pragmatism was forced upon them. They went to the market and adapted the solution of traders that had developed from the practice. That choice set the direction and limitation of the work, as everything they later brought into the model, no matter how theoretical, served the end of mimicking traders’ actions. But traders were wrong about options. They though an option was a right to buy or sell. It is in fact a right to default. In faithfully and uncritically replicating what traders did, Black, Scholes and Merton thus replicated their error.
That is the heavy price of the subjugation of thought to “practical” business considerations: the universe of solutions is reduced, with the right answer at times being altogether excluded from consideration. As just one, but very timely, example look at the bafflement in the face of what is taking place in the financial markets. Where are the esteemed professors of economics and finance, Nobel laureates, think tank “resident scholars”, investment gurus and corporate chieftains with their solutions? The best they have managed to do is to describe the events – and that incorrectly. Sartre’s pointed question in Critique of Dialectical Reason comes to mind: How could practical man think?

As for Harvard, it has not gone unpunished either. It is now home to Alan Dershowitz, a law professor specializing in civil liberties, no less, who advocates torturing detainees for quick confession. That is the pragmatism taken to its logical end – attending to the practical matter in hand, say extracting a confession, without any thought.

In the Inferno, the deformities in the bodies of the damned correspond to the kind of sin they have committed. Even Dante could not dream a more fitting punishment on Harvard.

Wednesday, June 4, 2008

The Crisis Continues

It is about 7:00 am here in New York. I am going to watch the shares of Lehman Brothers. And keep watching in coming days. Let us see how this thing will play out in light of the precarious condition of the broker/dealers that I described in Credit Woes series.