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.

A Correction

The second paragraph of the last post on the destruction of the Constitution, starting with “In places, content dominates...” was missing; since when I know not. Perhaps since Monday when I began writing the epilogue to the Goldman Case and somehow inadvertently deleted it. Or maybe it had been missing since the time of the posting. In any event, it is now corrected. My apologies for the omission which you no doubt noticed.

The Destruction of the U.S. Constitution: An Essay on the Commemoration of the 4th of July, 2010

The relation between form and content is a complex one. It lies at the core of man’s recognition of himself and his environment. It is the central question of all artistic activities, indeed all human communications: what to say and how to say it. It is a critical link in Hegel’s dialectics and the key to understanding Marx’s Capital.

In places, content dominates form, as in a rock, where the form is but the extension of the content, what the rock is. At times, the form dominates by virtue of the content’s absence, as in the Senate hearings surrounding the confirmation of Elena Kagan to the Supreme Court.

Pity the media which must hype up the event as a sign of the citizenry’s vibrant democracy in action. Hence the live coverage of the embarrassing exchanges on TV and over-the-top reporting in the press: CONSERVATIVES ATTACK KAGAN!!! MISSISSIPPI SENATOR ACCUSES KAGAN OF BEING A LEFT WING!!! CONFIRM KAGAN!!!

The citizenry, alas, refuses to bite. Call it apathy or passive resistance. But Joe Sixpack is just not going to care. And why should he, with the event being so removed from his daily concerns that it might as well be taking place in another planet?

So a calculating self promoter with little knowledge of the law and deep superficiality – she calls herself “famously excellent teacher” – is finally within her goal of becoming a Supreme Court judge. She would be “impartial”, she told the committee.

IMPARTIAL.

As if that word had any meaning in the context of interpreting the U.S. Constitution. As if she were going to be a referee in some ball game. Then again, misunderstanding their role seems to be a requirement for the Supreme Court judges.

I thought of all this because this past Wednesday, an NYU law professor by the name of Noah Feldman wrote a commentary in the New York Times in which he noted that after the confirmation of Kagan, the Supreme Court would have three Jews and six Catholics and no white, Anglo-Saxon Protestants, the so-called WASPs.

From this fact, he went on to conclude that the WASPs’ graceful, voluntary exit from the corridors of power, and especially the universities, had allowed other races and minorities to shine. Harvard is richer by the presence of Alan Dershowitz.

When Noah Feldman was not even 30, the Bush administration dispatched him to Iraq to write a constitution for the occupied country. He accepted the assignment with eagerness, never allowing a complete lack of familiarity with the country and its language, culture and history to stand in his way. On the strength of that “experience” he was made the commentator in matters of law, U.S. foreign policy, international relations, and please don’t mention Iraq.

An egregious fool like Feldman is programmed to get everything wrong; misreading things is probably in his DNA. But his statistics cannot be argued with. Three Jews and 6 Catholics and no WASPs on the Supreme Court. Does this make-up signify anything?

The answer is, Yes. It signifies the rise of speculative capital and its destruction of the “system” – including the legal system – about which I have repeatedly written on this blog and elsewhere.

For the proof of this assertion, we need to go no further than the front page of the same paper on the same day, which ran an article on the “evolution” of Chief Justice Roberts, how “The Roberts Court” had come of age.

The article began by quoting an ex-solicitor general that “more than in any other year since he became chief justice, this has truly become the Roberts court.” He was in the majority 92 percent of the time, more than any other justice.

Also quoted was one Tom Goldstein, a snapper up of trifles, who said that Chief Justice Roberts “cares about the position of the court in the American life. He is not pressing every ideological question but is willing to cross over.” Roberts, the readers were informed, “is not wedded to a single judicial methodology like the originalism and textualism that are the touchstones for Justices Scalia and Thomas.”

Let us see now.

Chief Justice Roberts dominates the Supreme Court and its decision-making process. He was in the majority an astonishing 92 percent of the time, which is another way of saying that in 92 percent of the time, the Supreme Court’s ruling followed his way of thinking.

There is nothing wrong per se with that. But the article goes further. It presents the Chief Justice as a man free from the constraints of a judicial philosophies and thus, a more flexible jurist. The message meant to register in the reader’s mind is this: Chief Justice Roberts who cares about the position of the court in American life is not wedded to a single judicial methodology and is willing to cross over ideological lines.

Yet, how does one interpret the U.S. Constitution without a judicial philosophy?

When you are asked to read and interpret a text, you must either focus on the words – what they actually mean to you as a reader – or go beyond the words to what you think the writer intended to say but for whatever reason did not, or could not, say.

The circumstances and context determine the approach. If you are reading an operating manual for a machinery, you should stick to the plain meaning of the words. If you are reading poetry, you must go beyond the words to find deeper meanings and truths, leading readers to such discoveries being the purpose and the very point of poetry.

The U.S. Constitution is but one document with a set language. In reading it, there is no equivalent of going back and forth between a technical manual and poetry. So, when you are asked to read and interpret it, you must decide on the approach. You have to go either with the plain meaning of the words or the intent of the Framers. What the actual case is all about does not matter; the entire point of taking a case to the Supreme Court is to determine which side’s arguments and facts are (more) in line with the Constitution. If you decide to decide the case on its own merits, you would probably have to tweak the interpretation of the Constitution to support your decision. That would be “judicial activistism”, a cardinal sin to conservatists who insisted on being faithful to the Constitution at all times.

Of course, reasonable men could disagree on what the Framers meant in each instance. So, there are various arguments and counter-arguments in interpreting the Constitution. But the point here is the consistency of the approach to the text and the role that such consistency plays in forming the judgment. The Times article highlighted that role:

Justices Scalia and Thomas, who voted together 92 percent of the time — the highest of any pair of justices — often take positions based on jurisprudential principles without regard to the outcome in a particular case. [According to a former solicitor general]: “It’s striking how often if the court gets to a pro-defendant result the majority includes Justice Scalia.”

Scalia is neither a thinker nor a legal scholar. He is more of a thug than a judge, what with his pugnacious and in-your-face way of expressing nonsensical ideas. At times almost child-like, he is a man who cites the performance of a fictional TV character to defend and justify torture. Yet, because he follows judicial principles, his rulings tend to favor the defendants. That is precisely the point and the philosophy of the law: to protect the accused (even though the accused in the Supreme Court cases are generally the defendant in the lower courts.) That was the purpose of Magna Carta, which formed the foundation of the Anglo-Saxon jurisprudence.

The judicial principles, then, are the tools of legal standardization. But they work in a different way from the “sentencing guidelines” that are usually written by a vengeful and bigoted legislature. The judicial principles are the result of collective, i.e., social, delibrations and, as such, transcend the individual tastes and preferences. They logically enforce judicial consistency by compelling judges to subjugate their personal views and tastes to more universal principles of humanity.

Chief Justice Roberts follows no principles:

Chief Justice Roberts and Justice Alito, by contrast, can appear more pragmatic.

What does it mean for the Chief Justice of the U.S. to be “pragmatic”? I commented on this adjective when it was being used to flatter Bernanke. I wrote:

The most outstanding characteristic of the “pragmatic man” is lack of conviction. He believes in no ideology, honors no conventions, adheres to no principles, follows no set rules, finds nothing per se wrong and rules out nothing categorically.

In the case of a central banker, though, it was at least possible to discern a meaning for pragmatism. It meant ignoring and breaking the rules to flood the system with money. Of course, the “system” was made up of large institutions which benefited from the policy. But we understood that.

What does the word mean when applied to the chief judge of the U.S. Supreme Court? What is the pragmatic way of reading and interpreting the Constitution?

The Times article had the the answer, only it was scattered throughout the article. I have put the pieces together for your ease of reading:

The centerpiece of the last term was, of course, the 5-to-4 decision in Citizens United, allowing unlimited corporate spending in elections. The ruling generated waves of criticism, including comments from President Obama … The outcry did not chasten the court. “I don’t think it made the least bit of difference to the five justices in the majority,” said Paul D. Clement, who also served as solicitor general in the second Bush administration

The Citizens United decision contained not a trace of minimalism, and it showed great solicitude to the interests of corporations. “They’re fearless,” said Lisa S. Blatt [a former solicitor general]: “This is a business court. Now it’s the era of the corporation and the interests of business.”

That trend, lawyers and legal scholars said, may well threaten recent legislation overhauling financial regulation and the health care system when challenges to them reach the court.

Let us take the points one at a time.

First, contrary to what the sycophant Bernstein said about Roberts “caring about the position of the court in the American life”, Chief Justice Roberts decides the cases the way he pleases, with the court following him 92 percent of the times. He doesn’t give a hoot to what “we, the people” think.

And he votes for the business interests, which is why he cannot follow any judicial principles. Such principles act as legal/philosophical straightjackets for the judges. A doctrinaire judge with a set agenda must, or necessity, ignore them. The results could at times be contradictory and embarrassing, but so what?

The court acted quickly – and, some critics said, rashly – in intervening in cases without full briefing and argument. In January, it halted the broadcast of the trial over the same-sex marriage in San Francisco partly on a rationale it seemed to disavow five months later. This month, it sent elections in Arizona into disarray by barring the use of a 12-year old campaign finance law.

It is this court that Elena Kagan will be joining.

What is her judicial philosophy, beside the famous impartiality?

One of the tidbits that came out in the hearing was that one of Kagan’s judicial heroes is the retired president of the Supreme Court of Israel.

Why would someone nominated to uphold the principles of the Anglo-Saxon jurisprudence have a hero in Talmudic law?

What would you say of a cardinal – or even a pope – whose spiritual hero was a mullah in Qum?

Wouldn’t that be strange? In fact, how could it possibly be?

The answer is that it could be because there is little left of the Anglo-Saxon jurisprudence, which is why there aren’t any Protestants in the Supreme Court.

Protestants created the system that governed much of the word throught the 20th century, and especially, after the WWII in the West. The “system” had many parts. There was the legal system, the economic and financial system, the individual government system and the cultural and artistic system. These aspects of social life naturally took local forms in individual countries. But it is impossible to look at any of these aspects in any country in the past century and not immediately see the handiwork of the WASPs.

WASPs were not magnanimous benefactors. Only the most ignorant fool would think of them that way. What they did they did for their own self-interests. The list of their failures and crimes is a legion, which is another way of saying that they were no different from other rulers. The system they created was was discriminatory and unfair and could be oppressive, but, as system, it was consistent. A vile usurer could invoke its rules to demand his pound of flesh.

When the system came under the attack by the rise of speculative capital, the WASPs who had the pride of ownerhsip, refused to take part in dismantling it. And they prevented other from dismantling it. Remember “the Arabists” in the State Department?

But the other side was more powerful and pushed the WASPs aside. In their place it put Catholics and Jews, Gonzaleses and Yoos. They were brought in to wreck the system – not directly and in plain sight, as that could not be done, but to hollow it from the inside like termites do.

That’s “meritocracy” for you.

And that’s the story behind the makeup of the Supreme Court.

But, Nasser, how does all this relate to speculative capital? So Elena Kagan is superficial. So Chief Justice Roberts is a doctrinaire. What is the relation of these people and their character with finance?

Marx famously remarked that people make their own history but not in circumstances of their own choosing. Everyone has to play the hand they are given.

But there is more to this observation. The circumstances into which people are born also play a role in shaping their character. Circumstances could make the man.

Weak men succumb to circumstances and are shaped by them. Heroes rise above the circumstances and shape the events.

In general, though, it is not easy to be a hero and men, who must earn a living, yield to the economic circumstances. In the age of the dominance of speculative capital, they take the characteristics of speculative capital as their own, which is how they become functionaries.

Speculative capital, you recall, is capital engaged in arbitrage. Arbitrage is generating short-term profits from the price difference between any two “targets”: buying one low, selling the other high. The larger the difference, the bigger the profit.

If there is no abitrageable price difference, speculative capital will create it. That is volatility. Speculative capital generates profit from volatility, which is why it “crosses the boundaries” and is not “wedded” to one particular strategy.

What speculative capital abhors is any mechanism, regulation, for example, that might stabilize the market and reduce the volatility. That would be interfering with the lifeline of speculative capital. From Vol. 1:

Such capital is, by definition, “opportunistic” . it is constantly on the lookout for “inefficiencies” across markets which it can exploit. The opportunities arise suddenly and at random points in time, so the capital that hopes to exploit them must always be available; it cannot afford to be locked into long-term commitments and investments. The requirement to be opportunistic translates into the need to be mobile, to be nomadic and interested in short-term ventures.

Short-term, profit maximizing speculative capital then creates men of the kind we have met in this blog as mountaineers, philosophers, intellectuals and businessmen. John Roberts is speculative capital in robes.

But speculative capital is self-destructive. It eliminates the opportunities that give rise to it. Which is how we know John Roberts is speculative capital in robes: judging with no judicial principles, no attention to the public opinion and no consideration of the lower courts rulings or the case law, doing, in short, his work inside the crumbling apparatus of the Anglo-Saxon jurisprudence in particular and the overall “system” in general.

The Goldman Case – 4: CDSs and Synthetic CDOs

The CDO at the center of Goldman case is a synthetic CDO.
According to the New York Times, a paper that has won many awards for educational reporting – that would be reporting that educates the public:

During the later stages of the boom, banks began offering so-called synthetic CDOs. Instead of combining bonds, these combine credit default swaps written against specific bonds or pools of bonds. Credit default swaps were developed as a kind of insurance on financial instruments, albeit in an unregulated form. Essentially, one party swaps the risk of holding debt with another by paying a fee to that swapholder in return for a promise that a certain amount of money would be paid in case of default.

According to Wikipedia:

In technical terms, the synthetic CDO is a form of collateralized debt obligation (CDO) in which the underlying credit exposures are taken on using a credit default swap rather than by having a vehicle buy assets such as bonds.

According to Investopedia, a synthetic CDS is:

A collateralized debt obligation that invests in credit default swaps. This investment can lead to large returns for holders of the CDO; however, the nature of credit default swaps may leave the holders liable for more than their initial investments, should there be significant changes in the credit default swaps.

These descriptions are not, per se, inaccurate. They are useless. You do not understand anything about CDOs from them because their language is clinical, the way a torturer would describe the details of torture without communicating anything about the horrors of the act. Clinical language is pernicious because it masquerades as the detached language of the “expert”, while decontextualizing the event it is supposed to describe. So we get empty words and the impression of knowledge being imparted, while nothing of the sort happens. Note how every definition above has a reference to credit default swaps without saying what they are or how they relate to the synthetic CDOs. Obscurum per obscuris.

Acquiring knowledge is an active process. It demands the conscious participation of the learner, which is another way of saying that knowledge has to be arrived at; it cannot be given. Let us return then to our investor group and see if, starting from where we left, we could arrive at comprehension of synthetic CDOs. Recall that we had “shot” the housing market by pressuring lenders and underwriters to indiscriminately create mortgages so we would bundle them into the CDOs and make a bundle in the process. The process wrecked the underwriting standards and pushed housing prices ever higher. With chickens about to come home to roost, the time has come to reverse gears. Now is the time to make money from the crashing housing market and defaulting mortgages. But, how?

Every trader knows the tools of the trade when things start going south: short selling and buying put options. Short selling is selling a security you do not own. The idea is to buy it back later, after it has fallen in price, for a profit. It is the time-honored buy low/sell high rule executed in the reverse order. While selling something you do not own is fraud in the standard commerce, in the securities market, it is de rigueur. The reason has to do with the peculiarities of the concept of security. From Vol. 2:

As a condition of opening an account in a brokerage firm, customers must sign a form granting the firm the right to lend the securities in their accounts to short sellers. When a security is “lent,” short sellers must compensate the original owners of the securities – the customers – in all respects such as dividends and splits save one: they do not and cannot grant the voting power to the customers because voting power is attached to shares and not the accounts. If the shares leave, so does the voting power. The condition for purchasing ownership in a corporation is agreeing to give up the legal rights of that ownership!

This fact may strike many as an absurd manipulation by the brokerage houses, but it is in fact a consequence of the very nature of a security. A security is evidence of ownership of notional capital. It confers on its owner not the right of ownership of the physical production apparatus but the right to appropriate a pro rata share of profits only. Since the short seller compensates the security’s owner for the profit portion, the owner has no more “rights” left.

But to be shorted, a security must be widely held, otherwise we cannot borrow it from another holder for the delivery. Individual mortgages are held by a single party. It would be impractical – indeed, impossible – to short them. How could we buy them back if the sole holder did not want to sell?

The other bear strategy, buying put options, is likewise not an option. There are no put options on mortgages, not the least because options pricing is based on a process that depends on short selling.

All this, however, is beside the point. It is missing the point, really, as these methods would not suit our purpose even if they were available.

Short selling and buying puts, you see, are capital market strategies in the sense that they are derived from, and exist, on the assumption of capital markets being a going concern. They assume uninterrupted trading. They are bearish strategies, of course, but they are the logical flip side of the bullish strategies which, combined, make up and define trading and capital markets.

We have an entirely different focus. We do not want a mere big win, a 10, 20, or 30 point gain from the price decline of some securities. Those are for boys -- and birds. We are men. Our aim is accordingly high. Why settle for mortgages declining when mortgages defaulting is in the cards? Since default is the extreme case of decline, our profits should be accordingly – and unprecedentedly – bigger. Our byword is implosion. We are shooting for a clean sweep that will come about in consequence of the collapse of mortgages.

Our strategy, then – and, by extension, the “products” designed to execute it – cannot be of capital markets. Implosion of securities negates securities trading.

Very little by way of contemplation is needed to realize that the only tool that fits the bill is a bet. We need a bet in which, if mortgages default, we would win big. But we need an intermediary, a financial powerhouse with contacts, which could find a counterpart to the bet and design and execute the plan. Would this intermediary let us pick the mortgages as well? After all, if we are betting big time, we need a fighting chance. It's only fair. Remember the $700,000 mortgage given to that Mexican strawberry picker who had made all of $14,000 in the prior year? How about something marginally better?

So, we take 5 “good” mortgages to the intermediary – Goldman, for example – and explain our plans. Here they are. We saw them in Part II:

1: $200,000 [$1,150]
2: $240,000 [$1,250]
3: $250,000 [$1,300]
4: $300,000 [$1,700]
5: $260,000 [$1,600]

The total value of the mortgages is $1,250,000; their combined monthly payment, $7,000.

The first step is creating a CDO in 3 tranches. Here is the CDO in three tranches: super senior (SS), mezzanine (MZ) and first loss (FL). The total principal and the monthly payment [in brackets] of each tranche is also given. We are familiar with this one as well from Part II:

SS: $700,000 [$3,600]
MZ: $500,000 [$3,000]
FL: $50,000 [$400]

Recall that the annual yield on the super senior (SS) tranche is 6.17%:

SS: 3,600 x 12 / 700,000 = 6.17%

With the raw material in hand, the intermediary calls upon its financial engineers, structure finance specialists, quants, wizards, rocket scientists and gurus to satisfy our demand, i.e., deliver to us a bet that would have the potential of a clean sweep. The focus, for the reason that will become clear in the sales pitch, is on the SS tranche only.

This is how the bet’s design process progresses:

What is the “other side” of the bet, the opposite of mortgages defaulting?

Well, it is mortgages not defaulting.

Good. How do we create the payoff? Who wins what if mortgages default – or don't?

Let us begin with the other side. What does the other side win if the mortgages in the SS tranche do not default?

The answer is, what the tranche pays, as long as there is no default. That is, $3,600 each month or $43,200 a year.

What would our client – here they are talking about us, the investor group – win, if SS mortgages default? Keep in mind that the client wants to win BIG.

What is the biggest number “pertaining” to the SS tranche? Yes, the absolute largest number “related” to the SS tranche, even if the question does not make sense.

The answer is the total principal of all mortgages in the tranche, equal to $700,000.

That is it then. The bet is set. Here is how it works.

One side gets $3,600 a month. The other side – we, the investor group – undertakes to pay it. Now, suppose mortgage No. 3, with the principal amount of $250,000 defaults. Nothing would happen in theory – and practice – because that does not affect the SS tranche. We would still have to pay $3,600 a month to our counterpart.

Then mortgage No. 4, with the principal amount of $300,000 defaults. Still, nothing happens to the SS tranche – in theory. We still would have to pay $3,600 a month to our counterpart.

Now, however, $550,000 worth of mortgages out of the total $1,250,000 have defaulted. The cushion that was protecting the $700,000 SS tranche is gone. One more default, and it will hit the SS tranche.

Suppose now mortgage No. 1 defaults. In that case: i) our monthly payment to the counterpart is reduced by $1,150, which is the monthly payment of mortgage No. 1; and ii) our counterpart has to pay us $200,000, which is the principal value of mortgage No. 1!

It gets better.

If mortgage No. 5 also defaults, the payment to our counterpart will be reduced by a further $1,600. Furthermore, the counterpart has to pay us an additional $260,000, which is the full principal of mortgage No. 5

Finally, if the last remaining piece, mortgage No. 2, also defaults, we would owe nothing in monthly payment to the other side. But the other side has to pay us $240,000, the mortgage’s principal amount.

If these scenarios were to happen, we would pay $3,600 a month for a few months, or a few years, until the mortgages began defaulting. In return, we would receive $700,000. That is the clean sweep, the big play. If you multiply the amounts in this example by about 1,500, they would approximately correspond to the transaction in the center of the Goldman case.

Note what happens to the mortgages when they are made the subject of a bet: they lose their characteristics as securities. To bet on their demise or survival, we no more need to own the legal title to them than a bettor in the race track needs to own the legal title to the horse he is betting on. This follows from the fact that our “strategy” is a mere bet and hence, outside the realm of finance. The sole role of the mortgages is now being a reference point – reference securities, they are called – for the determination of the winner and loser of the bet. In this way, our original, cash CDO becomes a synthetic CDO, where the mortgages as securities have been turned into mere virtual indices.

How is a synthetic CDO to be priced? If legal ownership existed, the question would be a simple matter of bond pricing. But there is no ownership, only the privilege to receive the monthly payment of mortgages, as if one owned them. So the question becomes, how much is that privilege worth?

The raison raison d'être of synthetic CDOs answers that question. The purpose of a synthetic CDO is generating a potential windfall for the seller, should the mortgages default. So, in return for receiving $3,600 a month, the buyer of a synthetic CDO tranche undertakes to pay to the seller the full principal amount of any bond in the tranche that defaults. This latter is a credit default swap: paying the full principal of a bond in case it defaults.

Synthetic CDOs, CDSs and their relations to one another are now clear. Return to the top and read the definitions. They will make sense.

All that is left is the small matter of selling this bet to the prospective buyers of the synthetic CDOs, say, ACA Management and IKB Deutsche Industriebank.

Here is the pitch:

Interest rates are at historically low levels. Five year Treasury rates are just over 4.17%, so if you invest $1 million, you will get $4,170 a year. How would you like to better that by 2 percentage points, to 6.17%, with the same credit quality?

Yes, really! Of course, in the fixed income area where the managers fight for two-hundredth of a percentage point, 2 percentage points does seem beyond the realm of possible, especially without sacrificing the credit quality and in fact improving it.

How do we do that? Well, we wouldn’t be a financial powerhouse if we couldn’t.(Smiles all around). But we offer this only to our best clients; not everyone can get into these deals, you know. Correct, exclusive deal, just like Madoff's.

But permit us to say that our deal is in fact better than it sounds. This will become clear if we get into the details.

How do you get $4,170 a year in Treasuries? You have to first invest $1 million. You will not earn interest unless you own the securities.

In the deal we are proposing, you invest nothing. Zilch. Zero. But receive $3,600 a month, as if you had invested $700,000 in these securities.

The catch? There is no catch. You pay for these securities, so to speak, by selling a credit default swap to the party that pays you the monthly $3,600.

What is a credit default swap? That's an excellent question. The best way to describe it is to say that it is an insurance policy. Basically, if the mortgage defaults, you have to pay the mortgage principal to the other party. As per the SEC requirements, we must warn you that this is risky. There is a potential that you will lose some money – or even a sum equal to the principal of mortgages – blah, blah, blah; you know how it works. As if life had no risk. As if there were any guarantees.

But, look! The securities are the super senior tranche of a synthetic CDO. The tranche is rated AAA by both Moody's and Standard & Poor's. The probability of default of a AAA-rared security, based on the historical default tables, is almost zero. They are like the U.S. Treasuries in terms of credit worthiness. Between us, though, they are probably safer, what with this runaway U.S. expenditure and the beating the dollar is taking in the international arena.

Why even safer than the Treasuries, you may ask? We are not exaggerating. Let us look at the facts. The mortgage default rates in the U.S. stand around 3%. The $700,000 SS tranche we are offering is part of $1,250,000 CDO. So, it is protected by a $550,000 cushion of mortgages, so to speak. That is, 44% of mortgages in the CDO must default before the SS tranche is affected. Now, do you believe that the historical mortgage default rates in the U.S. could suddenly jump to 44%? You decide.

Yes, we have the list of mortgages. You are welcome to perform your own due diligence. But we must warn you that it is not always easy to get background information about mortgages. Underwriters are not known for keeping the best of records. (Smiles all around.) Now, if you could sign here.

Game. Set. Match.

Everything said or written about the CDOs and CDSs comes from this pitch, which goes to show how the Wall Street controls the narrative of anything related to finance. That is why I started this series with a treatise of sorts on the importance of knowing and the need to penetrate the surface of the phenomena.

Note how a “synthetic CDO” is presented as a “you can have it all” product: getting the monthly payments without buying the securities that pay those payments. That is what is taught in the business schools and promoted in the financial press as one of the benefits of modern finance.

Note, also, how a CDS is presented as an insurance product. To the best of my knowledge, not a single person anywhere has challenged this spin. The most vocal critics of the CDSs start from the premise of a good idea of insurance gone bad by the misuse by bad people.

Bond insurance existed in the U.S. and many western countries for the longest of times. The businesses were known as monolines, mono because they only insured bonds. The business was low-margin but also extremely low risk. Ambac, MBIA and SCA were among the more well-known names that were sucked into the orbit of the CDSs and paid dearly for it.

A CDS is the “other side” of a bet that involves the default of a bond. It has absolutely nothing whatsoever to do with insurance. A CDS is designed to insure a bond in the same way that gallows is designed to support the weight of a man. The moment you speak of insurance, you are lost. You have understood nothing about them.

Look at this childish nonsense from Floyd Norris of the New York Times. I mention him because he is the most perceptive and competent among the financial reporters.

Credit default swaps are, in reality, insurance. The buyer of the insurance gets paid if the subject of swap cannot meet its obligation. The seller of the swap gets a continuing payment from the buyer until the insurance expires. Sort of like an insurance premium, you might say.

But the people who dreamed up credit-default swaps did not like insurance. It smacked of regulation and of reserves that insurance companies must set aside in case they were claims. So they called the new thing a swap.

In the antiregulatory atmosphere of the times, they got away with it. As Humpty would have understood, Wall Street was master. Because swaps were unregulated, calling insurance a swap meant those who traded in them could make whatever decision they wished.

A word is changed and the entire regulatory apparatus is fooled and, as a result, something bad is introduced to the financial system. Just like that.

The creation of CDSs as a bet is the logical extension of cash settlement that took the physical delivery of the underlying security out of financial transactions. From Vol. 2:

To make themselves more appealing to speculative capital, derivatives undergo changes which are intended to bring out and emphasize their betting aspects. One such change is cash settlement.

In cash settlement, the product on which the derivative is based does not change hands. Rather, the profit and loss of the trade is settled by exchange of money, calculated as the difference between the purchase and sale price. The commodity itself need not – actually, cannot – be delivered to satisfy the contract.

On the surface, this arrangement seems as a mere technicality, a change in rules for the sake of promoting “efficiency.” Otherwise, the P&L of the two sides remains unchanged … But the P&L is not the only thing that “matters” in trading derivatives … In cash settlement, the price of a commodity becomes a mere index that is used to determine the winner or loser of the transaction.

The implication of this change becomes apparent if we look at the flow of money. Previously, the seller delivered, and the buyer took delivery of, the underlying commodity [i.e,] always buyers paid, and sellers received, money. In cash settlement, not only the seller cannot deliver the commodity, he must also think of a possible payment obligation.

Cash settlement accommodates speculation.

The Goldman case is now clear, not based on the SEC allegations or the firm’s denial but “as God sees it”. The role of the firm, the role of us, the investor groups – that would be Paulson and his hedge fund – and the role of the buyers of the synthetic CDO – ACA and IKB, which lost a combined $1 billion – is understood.

We are in a position to judge.

I will return with the epilogue.

Of Labor and Women’s Rights in Europe

Today’s Financial Times published a joint commentary piece by the prime ministers of the UK and Sweden under the heading Reining in Europe’s deficit is just the first step. As you can infer from title, it was an economic manifesto put together “to ensure that Europe thrives and prospers”. It had “four clear steps”.

The first step was cutting back. “We have to accept that there are things we can no longer afford,” the authors said. Note the wording. First, a reference to things that we cannot afford, which everyone knows to be true. Then the “no longer”, slyly inserted; we are now talking about the things that “we” used to be able to afford but now, we have to accept, we cannot. Here, the two gentlemen of Europe are not talking about private jets. They are talking about retirees affording to live with some dignity. It is that, that “we” can no longer afford.

The second one was fixing the financial system.

Then came the third step:

The third step is creating the conditions for growth. Europe has huge advantages ... But we have deep structural problems. Productivity is shrinking. Our average growth rate is lower than the US, India and China ... So it is clear, we need deep-seated reform and we need it now. There is one area in particular where we both believe there is need for urgent change. It is shocking that in many parts of Europe women still do not have equal rights in the workplace. This is not just unfair; it makes no sense – because it deprives our economies of their full potential as workers and consumers. That is why in Brussels today we will be pushing this issue in discussion on Europe's next strategy for growth and employment.

What is this sudden, clearly out of place, reference to women’s rights in the middle of an economic manifesto?

Women in Europe are not particularly oppressed. I know of no country in Europe that discriminates against women in the workplace. And why this emphasis on women and their “full potential as workers” when tens of millions of European men are unemployed?

The answer is in the very text that gives rise to these questions. Note the concern for women’s right in the workplace is brought up in the “step” that talks about productivity. Productivity is output per labor; not labor in flesh and blood but labor as measured by wages. An enterprise producing 100 units of output with 3 laborers each earning $30 is more productive than one producing the same unit with one laborer earning $100.

Women and children have been historically used as tools for reducing the overall wages. They have less bargaining power and are more vulnerable to pressure, so they do the same work that men do, only with less wages. The result is downward pressure on all wages.

European children are protected by a variety of laws. And anyway, the manufacturing jobs, of the kind that employ children, have migrated to Asia and Latin America.

That leaves women.

One component of the “labor market overhaul” that is on the agenda of all the European governments is the reduction in wages. Women are the Trojan Horse that will be taken to the labor market to accomplish that goal. That is the source and extent of the prime ministers' interest in the women's rights. Read it. They clearly say it: By giving equal rights to women in the workplace, Europe will be able to compete with India and China!

But isn’t this plan too long-term and too complicated? Even if we assume that Cameron and Reinfeldt know of these complex relations, why would a couple of politicians care about implementing a plan which will come to fruition long after they have left the office?

The answer is that the plan is not theirs. It is given to them – and all the European prime ministers – as the policy issue to be implemented. No questions are permitted. That is why Socialists Papanderou and Zapatero, center right Sarkozy, Moderate Reinfeldt and Conservative Cameron all speak the same way. That is how you know everything is scripted at a supra-national level: politicians of different political orientations all say the same things. We are approaching the grand goal of divorcing policy decisions from politics.

As for the moral aspects of women’s rights, frankly I don't think they give a damn.

The Goldman Case – 3: Recapping CDOs

Recall that our purpose, when we got together as a group of investors, was making money. “A group of investors” has no other purpose.

I said the way to go was arbitrage.

Some of you were not clear on that point. You thought we were going to buy mortgages with the idea of selling them later – presumably for a profit. Where is arbitrage?, you asked, echoing the confusion of some of the country’s best quants.

“Friends”, I recall saying to you. “Let us set aside the not so small matter of being short in cash and focus on basic finance. A mortgage is a bond. Bond prices increase when interest rates decrease. Are we saying that we are buying the mortgages because we know interest rates will go down? If so, why bother with mortgages which have prepayment and relatively high default risks? Why not simply buy a bond – or a pool of bonds?

“No,” you responded. “We do not know which way the interest rates will go. And yes, we are short in cash. And now that you mention it, why indeed bother with mortgages? Why not just buy regular bonds?”

“Glad you asked,” I said. “Expecting to make money without initial investment and without knowing the future is a great expectation. Fortunately, in the age of speculative capital, the cause is not lost as the statement of our problem is the definition of arbitrage: making risk free profit without initial investment. But one has to know the game, and the game cannot be played with the Treasuries or corporate bonds. We need the relatively inefficient mortgage market. Even then, the plan is complicated and you must pay attention to understand it.”

“Tell us how”, you cried in unison, excited at the prospects of getting rich with no effort and no money down.

I explained the plan in easily digestible parts:

• We have to borrow money, but it must be at rates below the current mortgage market; it would be madness to pay 8% to get mortgages that pay 6%.

• Low rates are available in the commercial paper (CP) market, but only large corporations like Microsoft and IBM have access to that market.

• We cannot pass ourselves off as a large industrial corporation. Fortunately, we do not have to. What matters in the CP market is not the size per se but the credit rating. Since our ratings, as a group of investors, can never be AAA or its short-term equivalent, A1/P1, we shift the focus from ourselves to the product; we make the product to be AAA.

• Of course, in a million years, a pool of mortgages will not qualify for AAA rating; they're just too damn risky and triple-A means no default risk. So we will need to be innovative. We'll call it financial innovation! (Smiles all around). That is where the CDO structure comes in. You know the routine. Pool the mortgages and force a class system to the pool where the super senior tranche is protected against historical default rates.

• We take the CDO to the rating agencies and ask for AAA rating. They need revenues and will play ball. In fact, they will tell us what we need to do to get AAA rating. They might, for example, ask that we sign up a bank as a “liquidity provider”, or strengthen the loan covenants, but these are technicalities and you do not have to worry about them.

• Triple-A is the key to the CP market. We could now borrow at 2% to and buy mortgages that yield 6%. That's the golden goose of finance if there ever was one. We'd be the king of the world, the master of the universe.

Note the function of a CDO: it is an arbitrage vehicle – and nothing more. There is nothing more in finance as practiced by financiers and taught in schools.

Arbitrage is the anima mundi of modern finance, the single pillar on which the “whole intellectual edifice” of finance rests. It is at the core of everything that is taught at Chicago, Wharton, Stanford, Harvard and London business schools. It is the foundation of everything that the best of brightest of Europe and Asia vie to learn at INSEAD and Heyderabad.

Options, futures, swaps and all derivatives are priced from arbitrage. Relative value trading is based on arbitrage. Rise of the hedge funds, advent of prop trading, onset of globalization and the push for deregulation are all driven by arbitrage. Securitization? Due to arbitrage. Rise in markets volatility? Arbitrage. Synchronization of markets? That, too.

And yet, not a single one of the students and professors who study finance can define arbitrage, much less recognize the specific form of capital that is engaged in it.

In order to be company he must display a certain mental activity. But it need not be of a higher order. Indeed it might be argued the lower the better. Up to a point. The lower the order of mental activity the better the company. Up to a point.

The finance professor, the financial journalist, the think tank “scholar” and the PhD candidate constantly exalted and promoted the advantages of securitization and CDOs without realizing that these innovations were merely the prerequisites for the operation of speculative capital. To the extent that the innovations provide local collateral benefits, such benefits are accidental and incidental. What is more, they must always be in line with the immediate needs of speculative capital.

In our example, what happens after the first CDO? To continue the arbitrage, we would need more CDOs, i.e., more mortgages. Mortgages are provided by banks and mortgage bankers. So they are pressured to do more. At some point, the pool of the eligible people who could afford houses is drained. But that is no excuse to stop the arbitrage. We, the group of investors, cannot simply allow our golden goose to sit idle just because there are no eligible home buyers. Why, that would be hampering the American dream.

So the pressure doubles on banks and mortgage bankers to loosen the standards. They comply, because they, too, make money from issuing mortgages. At some point, that, too, ends. It is clear that no more life is left in the mortgage market. Nay, more than that: it is clear that a train wreck in the form of a housing collapse is coming towards us.

What do we do?

Après moi, le déluge, said Louis XV, the king of France. What a rogue peasant he was. We make money from the deluge. The Jew of kings had it right – Jews always have it right – that you buy when there is blood in the streets.

When there is no blood, we will see to it that there is. It’s business, you know. Nothing personal.

We, the group of investors, have shot the housing market in the US multiples of times. The blood will soon be running in the street. How can we make money from it?

The game plan is not immediately clear. What is clear is that we would need more financial innovation. We would need synthetic CDOs. We would need credit default swaps.

The Shape of Things to Come in Spain

Fundamental misunderstanding, when it comes from animals, is funny; we find the animals’ innocence in terms of “not getting it” endearing. Hence, the “animal jokes”. You’ve probably heard the old one about the horse turning to the jockey and saying: what are you hitting me for, there is no one behind us?!

Fundamental misunderstanding from people is not funny. It reeks of pathos, which is depressing.

It must have been over twenty years ago. I was waiting for a friend at the headquarters of then Citibank in New York. The bank had recently increased the minimum withdraw from its ATM machines from $20 to $40. A young woman came to withdraw what must obviously have been $20 and could not. She made a scene, complaining aloud to the bank staff, threatening that she would take her business elsewhere.

If she were a horse, the episode would have been funny. But as she was not, it was not: the spectacle of a young woman who thought she had money until she came head to head with the mass of finance capital.

I remembered all this because today’s New York Times ran an article about the austerity measures in Spain. It said in part:

Spaniards once thought their country was largely insulated from the debt crises in Ireland and Greece. Their mood has changed from giddy, when their homes tripled in value and they were protected by an elaborate safety net of public aid and family support, to grim.

The New York Times is a sleazy paper, a systemic falsifier of events, as coverage of the events of the past several days showed. And its reporters are as clueless as a horse.

You see, the focus, the aim, the central point of the crisis in Spain is precisely to smash the elaborate safety network of public aid. That is what the hoopla is all about. Without that destruction, Spaniards cannot be made to work for low wages, in the same way that without the destruction of the feudal system which made serfs homeless, they could not be made to toil in factories.

This will not happen tomorrow, or the next week, but will happen with the inevitability of night following day. The inevitability is there, in the internal logic of the very development that tripled home prices.

Thirty years from now, Spaniards will look back and will barely recognize their country. It will not be all bad. Some of them will be driving shinier cars and living in bigger houses. But they will also see homeless people in numbers that they do not presently see – or can imagine. The old trade-off stuff, you know. As for that famous family support? Well, that is partially a function of the elaborate social safety net. So it, too, will be gone. It will be every man for himself.

I am not preaching or haranguing or warning, merely stating an economic reality that Karl Marx used the wording of a “fish-blooded bourgeois doctrinaire” – “fish blooded” because what he “blurts out brutally” was accurate – to state succinctly:

In poor nations, the people are comfortable, in rich nations they are generally poor.