Sunday, August 1, 2010

Epilogue –The Goldman Case: The Insanity of the Rational

If the securities laws in the U.S. were consistent, there would be no Goldman case. A consistent body of the securities laws would be based on a scientific understanding of finance and the legal and the economic definition of a “security” would match. Since neither a CDO nor a CDS is a security, matters related to them would fall outside the jurisdiction of the SEC.

But the law is muddled. The Securities Acts (of 1933 and 1934) and their various amendments do not define a security (because they could not). Rather, they confer the status of security on select products and contracts by declaration, by designating them as such. A note is a security because the statute says so. So is a stock, for the same reason. How about a “product” such as a synthetic CDO that is not named in the statute? That is referred to case law, to be decided in light of the various definitions and tests for a security that courts have established over the years.

But judges could shed no more light on the meaning and the definition of a security than economists could. In fact, they have made the darkness opaque by their case-based improvisations which have led to contradictory rulings. The Supreme Court itself took up the question of what is a security at least 10 times in the past 65 years. In what must be a record, each time it reversed. That is, in every case, it rejected the interpretation of the court of appeals which was naturally based on the last interpretation of the Supreme Court itself.

I showed in Vol. 2 that to define security, we must begin with capital and its various forms. A security is the evidence of ownership of notional (fictitious) capital. There could be no security without capital outlay, which is why CDOs and CDSs are not securities. They are bets and fall under contract law, not securities law.

In reality, the securities law, with all its contradictions and inconsistencies, exists and applies. Goldman could not question the jurisdiction of the SEC, because its offering memorandum said that the CDOs were notes, and the note, as per statute is a security.

In the mean time, the SEC charges, pertaining to Paulson’s role in selecting the securities, whether that role was clearly disclosed and whether IKB and ACA were sophisticated investors, fell into the uncertain areas of law and perception. Neither the SEC nor Goldman could risk a trial that could go either way, and had to settle, which they did. That was the end of the case legally.

But there point to be made it, philosophically and socially.

Philosophically, the case gives an excellent opportunity to understand the meaning of Hegel's famous declaration that history is rational.

In this statement, Hegel is not rationalizing or justifying the unjust and criminal acts of the past. What he means, rather, become clear if we understand the meaning of “rational” in Hegelian usage. What he means by the word is something whose history of development can be logically explained – logical in the sense of how “one thing led to another”. The securities law is inconsistent and irrational in the common usage of the words because the statutes and various rulings and interpretations contradict one another. But these shortcomings are rational in the Hegelian usage of the word because their history – how the existing and therefore, “real”, tangled mess came to be – can be satisfactorily explained, as I did in Vol. 2. I will return to this point later.

Let us now look at the case socially.

In what is undoubtedly the most profound statement in Western philosophy – it is the irreducible minimum of the core Western thought, including Karl Marx’s conception of value, and more pointed than “man is the product of his product” – Jean Paul Sartre writes that the future comes to man through things in so far as it previously came to things through man. Man creates things which then compel him to act in a certain way. A machine demands to be used.

The tripartite relation – man, thing, future – is the formula of social change. It applies with equal force to conceptual creations, which is the form the “thing” takes in the realm of finance. Given the man and the thing, the relation affords us a look into the future, not deterministically or pictorially, but logically.

We are familiar with man’s use of the mortgage CDOs and the resulting economic/financial crisis that hit many countries across the globe. But that is not the full story and the impact goes further – and deeper. The mortgage CDO market, you see, has gone bust, but the CDO model, the CDO idea, is around and demands to be used. Our man will gladly—in fact, insistently—comply.

A few words about the “man” are in order here.

Sartre’s man is the abstract man. He stands for history. That is why we understand his motive for creating things.

A CDO, by contrast, is a specific product. To understand our man’s insistence – even his compulsion – for continuing to use this destructive tool beyond the realm of finance, we need to know more specifics about him.

Delving into the man’s personality is not inconsistent with my oft repeated emphatic remark that the subject of finance is not men but capital in circulation. The aspects of man’s personality that are of interest to us are precisely the ones that are shaped by speculative capital; they are none other than the way of operation of speculative capital that it instills in men.

In several places I have explained this subjugation of man to speculative capital whose most noteworthy aspect is narrowing the man’s range of activities. From Vol. 1:

Because speculative capital dominates the financial life of the society, it elevates the men who have internalized its modus operandi to the position of power. These men with limited freedom of action then become palan doozan at the helm.

So, no, it is not inconsistent with the dialectical approach to finance to want to get closer to men in flesh and blood who do speculative capital’s bidding. In fact, it is necessary for understanding their motivations and manner of thinking. And the best way to learn about them is to go to their natural habitat. That would be inside the Wall Street Journal, which had a recent article about the ways of Goldman mortgage traders. It was an enlightening piece:
Young traders in Goldman’s mortgage unit were told to take a cue from Tom Brady, the New England Patriots quarterback regarded as methodical and cool under pressure ... For a group filled with Red Sox and Patriots fans—and led by a Texas A&M University graduate who traveled back to his alma mater for football games—the analogy struck a chord.
Manliness, then, was the order of the day—tough, macho men, “cool under pressure”, qualities that the trading room apparently needed. Note the Journal’s allusion to the Patriots and the Red Sox, both New England teams, implying that many traders were Harvard or MIT graduates. These were not only tough men but smart men, men with qualities, which they showed. From the same article:
Goldman Sachs Group Inc.’s mortgage traders ... made markets in more than just bonds during the real-estate bubble.

They also cast bets on a White Castle hamburger-eating contest.

In December 2007, after the firm distributed multimillion-dollar bonus checks in part thanks to bets on a mortgage meltdown, about 10 Goldman mortgage traders, surrounded by dozens of cheering colleagues, wolfed down the burgers, according to attendees. Bystanders wagered cash on how many burgers the traders could eat.
One of the “in” things in Versailles in the dying days of the monarchy was for the men to engage in sex with several women in front of the king and his courtiers. The men with the most endurance were recognized.

Modern day macho traders have neither the means nor the uninhibited playfulness of the Versailles paramours. So, they go down one rung, to what every advertiser knows to be a convenient substitute for sex: food. They stuff themselves with junk food.

But I suspect that like all modern men, they got the “correspondence” of sex and food all wrong. Rumi was probably closer to the truth. In one of the few occasions that he departs from the decorum, he compares overeating – the throat that will “take in anything” – to the vagina of a female donkey.

Who is the real man, then? “Man is one who finds fault with himself”, wrote Sa’di. Note the depth of this observation, with the implication of “watching oneself to correct for errors” that John Berger considers to be the hallmark and meaning of genius.

Returning to the mortgage traders, did they stay cool under the pressure, as inspired to do so by their sport heroes? The same article, again:
Joshua Birnbaum, a Goldman trader from Oakland, Calif., played a major role in the short, or bearish, bet that led to nearly $4 billion in gross profits for Goldman, these people say. In February, Mr. Birnbaum, then in his mid-30s, briefly lost his cool and slammed down a phone receiver, these people say, when a more senior bond trader insisted on unwinding some of his trades to cut risk.
The “February” is February 2007, when the credit indices had already fallen sharply from their high and there were rumors of trouble in two Bear Stearns funds. These were the mortgage funds whose failure several months later was the harbinger of the coming financial collapse. Our man is nonchalant, and throws a tantrum when told to play it safe. According to the article, he took it easy in the summer, vacationing in the Hamptons, learning French. At the end of the summer, having thoroughly relaxed, he was ready for a big play:
Months later, Mr. Birnbaum argued to the firm’s top brass that Goldman should buy as much as $10 billion in subprime assets, according to an email, even though a plunge in risky home loans was roiling credit markets.

There is “an extraordinary opportunity for those with dry powder,” he wrote in a late August email to Goldman Co-Presidents Gary Cohn and Jon Winkelried, among others.
In late August 2007, the crisis in the credit markets was in full swing; the markets had gone down steadily since the beginning of the year and the phone slamming incident. Within two months, the CEO of Citigroup would be forced out after the bank posted $11 billion in mortgage related losses. By then, no one who followed the markets or read the papers had any doubts that the worst was yet to come. From the Financial Times, August 1, 2007:
The ratings implied by the credit default swaps for Bear Stearns, Goldman Sachs, Merrill Lynch and Morgan Stanley, for example, have fallen to “junk” status this month – although in reality they all carry investment grade ratings … The disparity reflect[s] investors’ awareness that many institutions have significantly larger embedded losses and risk exposures that they have acknowledge.
The hot shot trader interprets all this to mean that the time has come for “bottom fishing”. He pushes for a $10 billion investment in subprime junk, a recommendation that, if accepted, given the leverage ratios of broker dealers then, would have wiped out the firm. On the plus side, he had a discriminating taste:
A healthy eater with a daily workout regimen, he wouldn’t touch the food at a McDonald’s despite being famished after a long flight that July, recalled Kyle Bass, a friend and hedge-fund manager, in an interview at the time. Mr. Birnbaum also avoided participating in the burger-eating contests.
You have the picture now. Imagine a Harvard or MIT MBA who has been consistently wrong over an extended period of time about the most devastating financial crisis in the past 100 years and yet, will slam the receiver on you if you second guess his trading idea. A repeat offender, in other words, a perfect antithetical specimen to Sa’di’s idea of a man.

No match in heaven was ever more harmonious or binding than the one between this man and a CDO.

A CDO is a segregation vehicle. It turns a pool, i.e., an average, of mortgage bonds into a caste system: this is super senior, this is the mezzanine or the middle, and this is the bottom of the barrel, the toxic waste to be written off.

In that regard, a CDO is similar to linear programming, only linear programming is a mathematical method with strict rules and produces numerically incontestable results: there is only one “best” way – the optimum way, it is called – of flying 20 airplanes between 15 cities so that the profit will be maximum, or costs, minimum.

By contrast, everything about a CDO is arbitrary. The number of bonds, the type of bonds, their maturity, ratings, number of tranches – they are all in the discretion of the manager. To describe and convey these layers of arbitrariness so that they are understood and agreed upon by all the parties, long legal documents must accompany any offering of the CDOs.

That is the relation, then, between man and the thing he creates. The thing has the imprint of the man, the way he sees the word: mostly rabble, some in the middle, and the few with discriminating taste at the top who would starve rather than “touch the airplane food”. They are th VIPs or super seniors. A perverted, albeit pointed, example of the identity of knowing and being!

That this man is the instrument and personification of speculative capital goes without saying. Speculative capital is capital engaged in arbitrage. It profits from the differences, the “spread” between the high and low. When no such difference exists, it moves to create one. A pool of mortgages is not arbitrageable, so speculative capital, in the personas of hot shot traders, financial engineers, structured finance specialist and alike divides it into the “super senior” and “toxic waste” tranches. Arbitrage could then proceed.

Because arbitrage is self destructive – it eliminates the opportunities that give rise to it – speculative capital is self-destructive. But that statement must be properly understood. Speculative capital does not destroy itself. If it were so, there would be no speculative capital. Rather, it destroys the conditions that give rise to a particular form of arbitrage. Because these conditions are, by definition, social, speculative capital destroys social relations and institutions supporting them. Think of homeowners, mortgage lenders, banks, mortgage investors and even rating agencies who were undone by arbitraging of the CP and mortgage markets.

But after each collapse, destroyer rises out of the ruins to move to the next “play”; en ma fin est mon commencemet is its leitmotif. And the next play could be anywhere. Speculative capital is nomadic and not bound to anyone market, location, currency or concept.

This limitlessness of speculative capital's “theater of operations” is a critical point because the destruction that follows its visitation and the collateral damage it leaves behind can now affect every part of the social system and not the financial markets alone. In fact, the latest such play is currently unfolding in the realm education under the guise of the fight over the “charter schools”.

The idea of charter schools is a simple one: the government pays you to take your child to the school of your choice, including private schools.

The idea started a couple of decades ago when the Hassidic Jews in a small village in New York pestered the state to fund their religious schools. The state, through its highest court, repeatedly refused, correctly pointing to the separation of the church and state that is the First Amendment of the U.S. Constitution. The Jews pestered more and then pestered even further until improbably they got their way. Or, perhaps, not so improbably, if you read the last post in this blog.

This is not a place to expound on the Doctrine of the Separation of Church and State in the U.S. Constitution that was championed by no other than Thomas Jefferson; Google the subject or read a simple explanation here and you will get the gist of the matter. Suffice it to say that the plain language of the text and the forceful manner in which it is stated categorically rules out the U.S. government support for any religious institution. Any reading to the contrary would be a repeal and not an interpretation of the First Amendment. Imagine the government of the Islamic Republic of Iran supporting and funding a whiskey distillation plant.

Yet, under the relentless assault, the Supreme Court – the entire the system, really – caved in. The public funding of the religious schools received a green light and soon became a fait accompli. Here is the result, in the front page of the New York Times:
“Eretz Yisrael sheli yaffa v’gam porachat!” – My land of Israel is beautiful and blossoming! … Aalim and Aalima are not Jewish … But at the Hebrew Language Academy, they fit right in ... The school’s organizers say it has been so successful that they plan to help create dozen like it ...

Charter schools are publicly financed but privately run, and in some cases attract substantial private support. At Hebrew Language Academy ... some backing comes from Michael H. Steinhardt, a retired hedge fund manager who has given away more than $200 million and is a supporter of Israel and Jewish causes.

Some civil libertarians have criticized the school, saying that it is too difficult to navigate the church-state divide, particularly around Israel, a country with explicit ties to religion. “Israelis themselves have a hard time around the question of whether Israel is a Jewish state or a democracy,” said Charles C. Haynes, a senior scholar at First Amendment Center in Washington. “Why would we want to involve a public school here in that question?”

Mr. Steinhardt’s daughter, Sara Berman, the chairwoman of the school’s board, said that learning about Hebrew and Israeli culture was no different from learning about Bastille Day and baguettes in French class. “This is a dual-language school, contextualized by a rich culture,” Ms. Berman said. “To say that you can’t learn about what it is like to go to a shuk in Jerusalem because it’s too complicated or tied to religion or politics, that’s just not the case.”
According to the Times, there are two teachers in each class, one of them always a Hebrew teacher. The food is kosher and students are taught “Eretz Yisrael sheli yaffa v’gam porachat!” Just like baguettes. And the expansion plans are under way, courtesy of the U.S. taxpayers.

Speculative capital exploits the arbitrage relations on the basis of conditions that it first finds them. Baguettes and kosher food are the same to it. In the Hebrew Academy model of public-money-for-private-education it recognizes an opportunity and moves to expand and exploit it; the presence of an inveterate speculator like Steinhardt is never coincidental or benign. But a full exploitation of this particular opportunity requires the destruction of the existing public school system. And so it is resolved. It is Fannie/Freddie's destruction redux under the banner of improving education through “charter schools”.

It is beyond the subject of this post to show every aspect of this front assault on the U.S. public education system. A few highlights will suffice. Read the following stories and keep in mind that, as I pointed out in Vol. 1, “hedge funds are the functional form that speculative capital assumes in the markets.”

The New York Times reporting “How charter schools became the ‘hot cause’ for New York’s hedge fund managers”:

Mr. Pertry, 38. and Mr. Greenblat, 52, may spend their days poring over spreadsheets and overseeing trades, but their obsession – one shared with many other hedge funders – is creating charter schools, the tax-funded, independently run schools that they see as an entrepreneurial answer to the nation’s education woes. Charters have attracted benefactors from many fields. But it is impossible to ignore that in New York, hedge funds are at the movement’s epicenter.

“These guys get it,” said Eva Maskowitz, a former New York City Council member, whom Mr. Petry and Mr. Greenblatt hired in 2006 to run the Success Charter Network, for which they provide the financial muscle, including compensation for Ms. Moskowitz of $371,000 her first year. “They aren’t afraid of competition or upsetting the system. They thrive on that.”
I bet they are not. I bet they do. I could not have said it better myself.

But what form does this obsession take in practice? How, in other words, do the financiers intend to “upset” the system? Under the heading “Charter School’s Unlikely New Cheerleaders: Financiers”, the same paper gives the answer: with a “laserlike focus in the political realm”.
When Attorney General Andrew Cuomo wanted to meet certain members of the hedge fund crowd, seeking donors for his all-but-certain run for governor, what he heard was this: Talk to Joe.

That would be Joe Williams, executive director of political action committee that advances what has become a favorite cause of many of the wealthy founders of New York hedge funds: charter schools.

Wall Street has always put its money where its interests and beliefs lie. But it is far less common that so many financial heavyweights would adopt a social cause like charter schools and advance it with a laserlike focus in the political realm.

Hedge funds executives are thus emerging as perhaps the first significant political counterweight to the powerful teachers union, which strongly opposed expanding charter schools in their current form.

But the money managers are drawn to the businesslike way in which many charter schools are run; their focus on results, primarily measured by test scores; and not least, their union-free work environments, which give administrators flexibility to require longer days and a longer academic year.
The clueless reporters think that hedge fund managers have embraced the charter schools as a “social cause”. Yet, almost despite themselves, they manage to covey the role of speculative capital in pressuring and shaping the political/legal system, about which I wrote in detail in Vol. 1.

The pressure goes beyond the states. It is applied with particular intensity and focus on the federal level because the wholesale dismantling of the country's education system requires the active participation of the federal government. Under the Bush administration, the code word for the “project” was No Child Left Behind. Under the Obama administration, it is a called Race to the Top. Here is how it works. The article in question pertains to Colorado, but as you will see, applies to virtually all states:
Democrats backed by the state’s largest teachers’ union nicknamed legislation overhauling Colorado’s tenure and evaluation rules the “teacher scapegoat” bill, and several lawmakers wept in public sessions during their monthlong battle to stop it. But other democrats joined with Republicans to pass Colorado’s law, the most comprehensive of a dozen similar bills passed around the nation this year, in part to increase states’ chances in a $4 billion federal grant competition. Louisiana, Oklahoma and New York also approved bills modifying their tenure and evaluation rules in the last week just in time to meet Tuesday’s application deadline for Round 2 of the competition, known as Race to the Top.

This flood of legislation, along with new rules in many states allowing for more charter schools, pioneering union contracts in several cities and a state-led effort to rewrite the nation’s academic standards, have made this spring a watershed period ... With states across the nation facing huge budget shortfalls, governors, legislators, mayors and educators in about three dozen states have been working to win Race to the Top money by bringing their school policies in line with President Obama’s education agenda.
Read the last paragraph again and summarize it: cash-strapped states are passing a “flood of legislation” to get their hands on the federal dollars whose conditions are dismantling their local education system.

In this regime, the government pays the students to go to the private, i.e., “charter”, school of their choice. Through various incentives, including tying the teacher's salary and job security to the reading score of the students, the hope is that the reading skills of the students improve. That, in any event, is the pitch. The test score is the equivalent of profit here, the only thing that matters. That is not surprising because the charter schools are run by the hedge fund managers.

The students who can leave are the lucky ones. They are the “super senior” tranche.

But the charter schools, by definition, cannot take all the public school students. Many will be left behind. Those are the toxic waste.

That is how the CDO model is applied to the education arena.

In a few places in this blog, I criticized others for confusing social and natural phenomena. Yet, as you have no doubt noticed, I occasionally use the natural expression of “with the inevitability of night following day” in reference to social relations.

Now, you see why and when. Take a public school of some size. Give money to those who could leave for smaller, better-equipped charter schools. What do you suppose will happen to those left behind – the students, who, for whatever reason, but mostly for financial reasons, cannot afford to move?

The answer is that with the inevitability of night following day, they are dead. May be not physically and immediately, but socially and gradually. They are the forsaken, the abandoned, the left behind. And they know that. There is no fooling oneself there.

The name of the program under various administrations? No Child Left Behind. The Race to the Top. There you have it.

But are these people sincere? Do they really believe in the merits and virtues of the privatization of education or are they mocking us?

The answer is that they are mocking us. For proof, we have to momentarily return to the Goldman case. (When did we really leave it?)

You no doubt recall that in addition to Goldman Sachs, a 28-year old trader in the firm by the name Fabrice Tourre was also charged with fraud. (I found it surprising that he was not included in the final settlement and was left to fend for himself.)

As part of the investigation, the SEC had subpoenaed his emails, some which found their way to the papers. One message was particularly revealing. In the beginning, referring to himself in third person as the last man standing, he wrote:
Seul survivant potentiel, the fabulous Fab ... standing in the middle of all these complex, highly levered exotic trades he created without necessarily understanding all the implications of these monstruosities !!! Anyway, not feeling too guilty about this, the real purpose of my job is to make capital markets more efficient and ultimately provide the US consumer will more efficient ways to leverage and finance himself, so there is a humble, noble and ethical reason for my job ;) amazing how good I am in convincing myself !!!
So he knows! Of course, being a trader, he cannot help taking credit for the ways of justifying his acts. What he writes about the efficiency of capital markets is not his justification but what is formally taught at every MBA program and every economic course in every major university in most of the world. And the man knows it is all bunk.

What a rogue and peasant slave I must have been to criticize official economics and finance, thinking that I was divulging something new. Yet, there he is, a pipsqueak of an engineer half my age who, in a few lines, does the subject more justice than I ever could.

Of course, if he knows that, then his more sophisticated, phone slamming colleague knows that. And if he knows that, then his boss, and his boss’s boss knows that. They all know it.

And yet, they do it. More to the point, they are allowed to do it.

And all is rational, all the actions capable of being fully and satisfactorily explained. The hedge fund manager who sets out to replace the existing education system with a privately run patch of schools because he will make money from it; the politician who toes the line because he gets campaign contributions from him; the parent who wants nothing but the best for his child; the educator who agrees test scores are the sole measure of educational success; the legislator who adapts federal standards to get his hands on federal money – the actions of all these actors in this theater of the absurd is rational.

Therein lies the madness.

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