Bernanke Discovers a Weak Link in the System

The Financial Times reported that the chairman of the Federal Reserve Board is now concerned about the “use of tri-party repo and the systemic risks in this crucial, but little understood area of finance.”

“Recent experience demonstrates the need for additional measures to enhance the resilience of these markets, particularly as large borrowers have experienced acute stress,” said Mr Bernanke this week.

The tri-party repo market is indeed crucial but “little understood”? Perhaps only by the Fed. Witness the chairman’s comment about “experience demonstrates.”

This is no place for a discussion of categorical imperative, but I must insist that if you know anything about the tri-party repo market, you would not need experience to tell you what is likely to follow, in the same way that if someone is throwing knives at his friend, you would not need experience to know that eventually the friend is going to get hurt.

I wrote in detail about the tri-party repo market and its systemic implications almost a year ago. I wrote:

In the context of the discussion of a crisis centered around liquidity and credit risk, the most critical thing we must know about the structure of markets is the function of the tri-party repo market.

Your can read the full entries here and here.

If you happen to know Bernanke’s email send him a link as well. With Larry Summers eyeing his job, the chairman needs all the help he can get.

A Coded Admission

Over coffee this Sunday afternoon (somehow this line reminded me of Aznavour’s “café-crème” line in La boheme) I read the reminisces of 5 former Bear Stearns executives in the New York Times. The paper had decided to visit them a year after the firm’s demise.

It was a wasted 10 minutes. Like a prime-time Hallmark sponsored TV special, it only confirmed my prejudices. Not one of the 5 – and except for one saleswoman they were all senior people – had any clue as to what had taken place. All focused on themselves and their hardship. Not one of them had a word about the larger issues that the Bear Stearns collapse signified. That included the firm’s ex vice-chairman who begged the readers to remember Bear Stearns for its – of all things – charitable givings.

I only hope that when future generations think about Bear Stearns, if they do at all, they will remember its philanthropy.

This “if they do at all” is incriminating. It speaks of a self-doubt that no one reaching vice-chairmanship of a place like Bear Stearns could possibly afford to possess; the swagger of these guys was something to behold. The expression, rather, is from T. S. Eliot:

Those who have crossed
With direct eyes, to death’s other Kingdom
Remember us – if at all – not as lost
Violent souls, but only
As the hollow men
The stuffed men.

Maybe I am over-interpreting, but I think in reaching to T.S. Eliot whom he must have remembered from college years, the ex vice-chairman of Bear was admitting to himself and to those who could decode him that he had been a hollow man all along.

A Haunting Picture

The Financial Times reported that cargo ships are being used as the storage place for new cars because: i) cars are piling up due to lack of demand; and ii) ships are idle due to lack of cargo. Two machines, expressly made for transporting commodities, are forced into a state of idleness – compound idleness, really, one inside the other.

This is beyond allegorical.

Motion is the form of the existence of the matter. It is also the form of the existence of capital; capital could only be understood as a thing in motion. A cargo ship is capital but only by virtue, and in consequence, of its capacity to move. A new car is also capital to the company that produced it. But for the profit to be realized, it must be sold. Unsold cars in idle cargo ships is capital laid to waste through and through. In a Capitalist system that functions on the basis of employment of capital, that is the picture of death on a grand scale, which is why a picture of idles ship is haunting. It is the out-of-ordinariness of a “walking, loitering, hurried” market in the age of destruction.

Palan-doozan who know nothing about these matters pressure the banks to lend. Banks do not need pressure to lend. They are in business for that very purpose. But there is no place for the capital to go, thanks to the destruction of its employment opportunities by speculative capital. Speculative capital moves in and withdraws rapidly, which means that it also destroys rapidly. Hence the suddenness of the current collapse and the unprecedented pace of the job losses.

The Education of a Reporter

To study the properties of sub-atomic particles, physicists use particle accelerators to smash the atoms at high speed. The ensuring destruction creates extreme conditions in which the particles reveal new properties.

The economic/financial destruction brought about by the speculative capital has likewise opened up opportunities to learn economics and finance, if only one is willing to look.

A while back, I wrote that the Financial Times’ Gillian Tett is among the keener observors of the global financial collapse. Recently, writing about the upcoming G20 summit in London where the main agenda is expected to center around containing the crisis, she commented on the difficulties of regulating the markets:

The past decade of frenetic financial innovation and globalisation has created a western banking system where numerous entities are entwined in some unpredictable and near-indefinable ways. Just think of the chain reactions unleashed by Lehman Brothers’ collapse.

Thus, the $64 trillion question now is whether the risks created by this “interconnectivity” can be effectively controlled – without simply banning all entrepreneurial activity or innovation from finance? It is a fiendishly difficult circle to square.

The driver of the “frantic financial innovation and globalization” is of course speculative capital. The “interconnectivity” Tett is referring to is the linkage of markets brought about by the arbitrage activities of speculative capital. Tett knows none of these but she has noticed the tension between regulation and the way markets operate. The financial system cannot be regulated without banning “entrepreneurial” activity and “innovation”, which she vaguely suspects and implies, is something bad.

Let us help this perceptive reporter with the problem, beginning with a clear statement of the case.

1. Capital must expand, not because expansion is “good” but because “expansion of capital is the condition for its preservation.”

2. Expansion of speculative capital takes place through arbitrage. Arbitrage opportunities rise randomly and must be exploited rapidly. Speculative capital is thus nomadic and mobile.

3. Speculative capital is self destructive; it eliminates opportunities that give rise to it.

4. To rein in the self-destructive tendency of speculative capital, its movement must be reined in. That means blocking the expansion of speculative capital and destroying the mechanism of its self-preservation.

So what is to be done? Let speculative capital destroy the markets or suffocate it through regulation? That is Gillian Tett’s $64 trillion question. She calls the problem fiendishly difficult because she realizes there are not good options.

We could eliminate speculative capital. Speculative capital dominates the financial markets in the sense that it imparts the mode and the consequences of its operations to markets, making them appear as markets’ own characteristics. Hence, the increase in volatility, decline in spreads, and the bias towards short-trading horizons that have become the feature of markets across the globe.

Quantitatively, however, speculative capital is a relatively small portion of the mass of finance capital in circulation. It is within the realm of possible to curtail and even eliminate it altogether. That could be done through prohibiting hedge funds, proprietary trading desks of banks, day trading, derivatives, cross-border and cross-market arbitrage – in short, all vehicle through which speculative capital operates.

But as I showed in Vol. 1, the rise of speculative capital is logical and not accidental. The rise in volatility and linkage of markets and products, for example, increase liquidity. The fall in spreads makes financial transactions cheaper. In consequence, the markets become “efficient”, i.e. relatively less costly, to traders and investors. Within the prism of cost-benefit analysis, this efficiency is an incontestable fact. It was constant emphasis on this point – and the chicanery of framing all the issues in the cost-benefit framework – that made hollow men such as Milton Friedman seem to “have a point”.

Returning to our subject, the choices are now more sharply defined. To prevent speculative capital from destroying markets, we can choose to eliminate it. But that would entail returning to the crude days of bygone eras and more costly financial markets. With the profit margins under constant pressure, that is hardly an option.

We have just run into a conceptual wall. The problem, as presented, is insoluble. Both alternatives lead to the same dead end.

The solution lies in the realization that the seeming no-way-out is the result of the development of a contradiction that existed within speculative capital and finance capital since their inception. It is part of their DNA, existing in the latent form and pushed into the surface as a result of the severe financial crisis.

“The limit of capital is capital itself,” Marx wrote. Until recently, few could comprehend this supremely theoretical statement. The statement is cryptic because it contains information that cannot be squeezed into a sentence. It could only be understood if it is arrived at; it cannot be given.

Gillian Tett not only comprehends it but discovers it. For that, we have the current crisis to thank. Not that she ever was a dilettante, but she could not have noticed the contradiction a year ago. That is how educators get educated.

Next, when she realizes that the crisis is not an aberration but a logical consequence of what came before, she will be well on her way to making a bonfire of finance and economic textbooks, the way a fellow blogger of hers recently suggested. That would place her on the course to solve the next and final piece of the mystery, which is the source of the original contradiction.

Palan-doozan at the Helm

In Farsi, palan–with two long ‘a’s, like the French pronunciation of Sagan – is the saddle for donkeys. Saddle for horses is zeen. Zeen is a noble product, made of leather by skilled craftsmen. Palan is made of cloth and, being exclusively for donkeys, does not require much skill. In fact, you don’t really make palan. You sew it, stitch it from rough cloth. That is the job of a palan-dooz (plural: palan-doozan), someone who stitches palan. It is the lowest of the specialized jobs, just one notch above the unskilled laborer.

In Divan-e Shams, Rumi asks the rhetorical question: What does a palan-dooz do wherever he goes? Why, he stitches palan; that is all he knows.

Geithner is now at the Treasury. The New York Times described his plan for rescuing a banking and financial system that is brought to its knees by the over-supply of junk securities purchased with 95% financing at low interest rates:

The Treasury Department and the Federal Reserve plan to spend as much as $1 trillion to provide low-cost loans and guarantees to hedge funds and private equity firms that buy securities backed by consumer and business loans.

Under the program, the Fed will lend to investors who acquire new securities backed by auto loans, credit card balances, student loans and small-business loans at rates ranging from roughly 1.5 percent to 3 percent.

Depending on the type of security they are borrowing against, investors will be able to borrow 84 percent to 95 percent of the face value of the bonds. Investors would not be liable for any losses beyond [their] equity.

So the game that brought down the house is slated go on, only that now the U.S. government will provide the borrowed funds, thanks to its printing press. (Keep in mind that the $1 trillion mentioned is only for starters.) What that would do the position of the dollar as the reserve currency and, from there, to the U.S. power and international standing, will be slow in coming but it will come with the inevitability of night coming after the day.

Recently, Prime Minster Erdogn of Turkey told his critics who were pushing for what he considered a rash decision: “Dear friends, we are not running a grocery store here; we are running the Turkish Republic.”

That distinction is lost on Bob Rubin and his disciples. In his days, he ran the Treasury like a hedge fund. His disciples, including the “brilliant” Larry Summers, think of it as a private equity fund. That sets the direction and limitation of any solution they devise.

The most outstanding feature of the systemic risk brought about by speculative capital – what constitutes risk – is that it narrows the range of the activities within the system at the same time that it excludes the consideration of solutions from the “outside”. A vague realization of this destructive tendency is behind looking for the solutions “outside the box”. More than any revelation, though, the corporate catechism is the confirmation of the limitations within which the system must operate – until it no longer can.

Indices Gone Wild

Here is a news story from the Feb 12 Financial Times about the West Texas Intermediate no longer being a reliable measure of oil prices:

The global market’s most important pricing benchmark, the West Texas Intermediate crude contract, was criticised yesterday for “sending mixed and misleading price signals, not only to the market but to economic forecasters, government officials and policymakers”.

The International Energy Agency warned that “deterioration in the fragile WTI pricing mechanism would only serve to reinforce the view that the crude has become an irrevocably broken benchmark”. The damning verdict on the WTI contract, which is traded on the New York Mercantile Exchange, by the energy watchdog of the developed world reflects concern among analysts, traders and investors in commodity indices.

Mike Witter, global head of oil research at Société Générale, said: “Brent is more representative of the global market right now and the disconnect between WTI and Brent is an issue.”

Here is a news story in the same paper from October of last year about Libor not being a reliable measure of interbank lending:

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 …

However, bankers fear the index has become distorted in recent months, particularly in dollar markets, because it is calculated according to the bank’s perceived funding costs rather than actual trades. As a result, some bankers are calling for greater use of indices derived from actual market trades.

You see the similarities, including the wording that puts the blame for misbehaving and misleading the public on the index.

Indices, by definition, reflect the markets; only the markets they are reflecting now are the markets of crisis. One of the characteristics of a speculative capital induced crisis is the destruction of arbitrage relations, so that it is not possible to hedge the positions. That impossibility appears as a “disconnect”, by which traders mean that they could not make risk-free profit from differences that finance theorist had insisted had to be arbitrageable.

In the case of Libor, we saw what the disconnect entailed. Libor stood more than 200 basis points over the Fed Funds for months. In theory, a bank could borrow at the Fed Funds rate of 50 basis points and lend it in the interbank market at 2.50% for an easy profit of 2%. But no bank could do it because: i) their credit lines at the Fed were maxed out and they had no acceptable collateral; ii) whatever sums they could borrow were immediately needed; and iii) they did not trust the counterparty bank to stay solvent.

We shall see in coming weeks what the disconnect in the oil market entails.

All this, too, is a part of the destruction about which I wrote earlier, here and here.

A Change in the Order

Since early January, I have been working on Vols. 4 and 5 of Speculative Capital, putting hundreds of pages of disjointed writings into a recognizable manuscript form. This is the most time-consuming part of writing a book for me, where the broad outline of the book, the title and order of the chapters, takes shape. The process involves incorporating hundreds of “notes to myself”, references to books and newspaper articles and random thoughts jotted down over the years into a coherent ensemble with well-defined chapters. The last part is especially challenging because many thoughts, at times expressed in tens of consecutive pages, could be placed under different headings with equal justification. It requires long, concentrated hours to determine the chapter headings and the text that should come under it.(It is said of Andrew Lloyd Webber’s music that the scores in all his musicals are interchangeable. I would take no offense at similar charge pertaining to the text in Speculative Capital and would in fact welcome it as a sign of the coherence of the theory; the entire Speculative Capital series is logically but one book.) Dialectics precludes arbitrariness. Each chapter of Speculative Capital must logically lead to the next. It is the progression of these “means” in the dialectical method that is precisely the end. (It was the enforcing of this logical progression a decade ago in a book supposed to be on derivatives that led to the Theory of Speculative Capital.)

I bring up this background because in streamlining the manuscript of Vols. 4 and 5 I realized that their order was wrong. Systemic Risk, planned as the final Vol. 5, must come before Dialectics of Finance, currently slated to be Vol. 4. Therefore, the next book in the Speculative Capital series will be Systemic Risk. It will be followed by the 5th and final Vol., Dialectics of Finance.

Before settling on the decision, I had to convince myself that it was not influenced by the “opportunism” of rushing a book on systemic risk to market in the midst of a systemic crisis, however unconscious and subliminal that influence might be. This was especially pertinent because Systemic Risk could be completed and published sooner than Dialectics of Finance. But I think that my decision was independent of these considerations.

Systemic collapse is an historical event created from the self-destructive movements of speculative capital, the latest and most developed form of finance capital. The development of finance capital is the subject of Dialectics of Finance, which subject “contains” the systemic risk.

The Theory of Speculative Capital helps us see and understand the mechanical aspects of the current crisis. In the 10-part Credit Woes series and several other entries in this blog I have broadly described the various dimensions of the collapse. Vol. 4 will provide further details.

But what explains the price fall – collapse is really the word – across all markets? Why did the prices collapse?

Those with monopoly on high quality thoughts who monopolize the Op-Ed pages and the TV air time inform us that the reason is Bubble. Bubble explains everything. The economy has bubbles as the water has, they tell us. And economic Bubble has popped. That is the answer.

In reality, the price collapse we are witnessing is due to the transformation of values to prices. You do not hear about this topic because it is difficult!

Say, you pay $200k for land, spend $200k on the material and pay $200k for workers to build you a house. The value of the house is $600k. The offer you get, in line with the market price, is $420. The “whereabouts” of the $180k loss is the subject of this transformation, which takes us to realm of value – the exchange value, to be exact. The value is a social concept. Like other social concepts such as honor or morality, it has no meaning to man on a desert island. To understand value, then, we have to go beyond the technical description of the financial events and study the social relations as well. That is precisely the realm of Dialectics of Finance, where the movement of finance capital is investigated in the entirety of its social interconnections. The works of writers of our time, the philosophers of our time and the justices of our time are thus relevant to our investigation.

When I began the Speculative Capital series more than a decade ago, the collapse of the financial markets seemed its logical end, the terminal point for the self-destructive movements of speculative capital. What else could there be after the system-wide collapse of the financial institutions?

But that view is mechanical because it sets an arbitrary ending point for the investigation. A systemic collapse, of however unprecedented scope and intensity, does not spell the end of finance capital. It merely begins a new phase for it. Speculative capital is self destructive, but it is also self reinvigorating and self reconstructing. (Such is the nature of dialectical attributes!) After each crisis, it rises again in a new form to declare: En ma fin est mon commencement. No serious student of finance could ignore these developments.

Truth, the cognition of which is the business of philosophy, became in the hands of Hegel no longer an aggregate of finished dogmatic statements which, once discovered, had merely to be learned by heart. Truth lay now in the process of cognition itself, in the long historical development of science, which mounts from lower to even higher levels of knowledge without ever reaching, by discovering so-called absolute Truth, a point at which it can proceed no further, and where it would have nothing more to do but to fold its hands and admire the absolute Truth to which it had attained.

I would not be finished after the delivery of Systemic Risk. I have barely begun to write.