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.

Fascinating.

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.

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.

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.

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.

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.