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.

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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.

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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.

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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.”

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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.

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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.