Wednesday, April 30, 2008

On the Significance of Bob Rubin Being a Citi Consigliere

I read somewhere that about 70% of non-sport content in the US papers is PR generated. The New York Times interview with the former US Treasury secretary Robert Rubin that I mentioned below is the proverbial "Exhibit A" in that regard. Laudatory adjectives abound: “elder statesman”, “Yoda” (the wise ass from the Star Wars), “corporate and political wise man,” “consigliere” and, in conjunction with Alan Greenspan, “Olympian duo”.

Olympian duo.

Rubin and Greenspan.


The only way to top that would be to include Larry Summers in the mix and call the trio “The Committee to Save the World.” And the only way to top that would be to add Curly and Moe to Larry and call the bunch “The Committee to Restore Dignified Conduct”. And do that in earnest.

I am not being facetious.

Take “consigliere”; we learned from the article that “people” in Citi went to Rubin to “get a dose of wisdom.”

As popularized and defined by the Godfather movies, the function of a consigliere in a crime family is giving advice. The function grows from the realization that violence is not an end in itself but a means towards an end. (You recognize Von Clausewitz’s observation that war is a continuation of politics by other means.) The end is making money through a business; a violence prone business, perhaps, such as prostitution, but business nevertheless. The consigliere maintains the business orientation of the enterprise by constantly reminding the thugs that thuggery must be subjugated to the exigencies of making money. Force, after all, as Karl Marx pointed out, is an economic factor. Only the pathologically depraved will have an apparatus for the application of force without any economic benefit to result.

A multi-trillion dollar financial behemoth is supposed to have its orientation in place – and firmly. The high ranking Citi executives in charge of multi-billion dollar business lines are expected to be intimately familiar with the ins and outs of their operations at both strategic and tactical level. Without operational responsibility, in fact, it is impossible to develop a strategic vision. The existence of a consigliere in Citigroup is affront to its senior executives.

“Lighten up,” I hear you saying. “It is not that consigliere was Rubin's job title. The term is used affectionately. And don’t lose sight of the big picture. At the end of the day, the point was to give a $15 million a year sinecure to one of ‘our crowd’. (How do you suppose Glass-Steagall was repealed?) With Rubin’s insistence on not having any operational responsibility – polite way of saying that he didn’t want to do any work – consigliere seemed an easy, handy title. So, really, lighten up. There is such a thing as over interpretation, you know.”

I know.

What sort of advice would Rubin give? His actions as a Treasury secretary to correct a perceived imbalance in dollar-yen relation offer a clue. Again, from the newspaper of the record (Sept 22, 1996):

Mr. Rubin’s first, tentative efforts to bolster the dollar … failed; the intervention was washed away by investors who knew that the governments did not have the resources to outbid them. So he and his deputy … retreated … Then, when the dollar had fallen off the front pages and the market’s attention was elsewhere, they ambushed the currency speculators, ordering the Treasury to buy dollars. The idea was to sow so much uncertainty about the Treasury’s tactics that no big speculators or hedge funds would risk being caught with a huge position in yen.
In Vol. 1 of Speculative Capital, I pointed out the irony of the US Treasury secretary fixing the exchange rate of the dollar against the yen by sowing uncertainty about their exchange rate!Recall from Part 1 of the “Credit Woes” series that:

The manager of speculative capital turns into its agent, someone who nominally “runs” the speculative capital but must in fact follow its “agenda”.[Emphasis added.]
As a life-long currency arbitrageur, Rubin is the personification of speculative capital. Like Oedipus, his deeds are inflicted upon him rather than committed by him.

By assigning the role of consigliere to him, Citi sealed its fate. Prince’s much ridiculed statement that Citi had to keep dancing as long as music continued was Rubin’s, in spirit if not in exact words. What followed in terms of losses in the ABCP-CDO arbitrage chain was preordained.

Monday, April 28, 2008

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – Epilogue

I had planned to write an epilogue to the “credit woes” series. Then I read the New York Times’ long interview with Robert Rubin this past Sunday in which he was quoted as saying: “I don’t know of anyone who foresaw a perfect storm.”

I suppose this statement is correct in the sense that Bob Rubin does not know me. So as the epilogue and for the record, here is the final page of Vol. 3 of Speculative Capital, The Enigma of Options. The book was published in 2006. The text was written in 2005. As they say, you can check it out.

The role of speculative capital in the creation of the credit derivatives market cannot be overemphasized. Speculative capital is the conceptual rainmaker of this market. It is its underwriter. It brings the credit to the trading arena and ensures its staying ability there by “grooming” it in accordance with the needs of the market. The most outstanding handicap of credit in the new environment is the long time horizon. The traditional credit analysis is “through the cycle,” extending 5 to 7 years in the future to allow for the evaluation of an entity during a business cycle.

Speculative capital would have none of it. Having brought credit into its orbit, it trims its horizon to mere months. Credit, thus shortened and thrown into the market, seeks the confirmation of its price in the most short-term, readily available and actively traded instrument: stock. …

The rise of credit derivatives is the latest qualitative change in the evolution of finance capital that brings together its market and credit “dimensions.” We are currently witnessing the early stages of this development. But armed with the theory of speculative capital we could see what is happening, i.e., what is changing. We could also discern the cause, pattern and characteristics of the change. So while for others credit derivatives are the risk-diversifying, need-fulfilling products of an innovative Wall Street, for us they are the footprint of speculative capital on its march towards systemic crisis.
Let me emphasize: It is impossible to understand the events taking shape around us without the benefit of the Theory of Speculative Capital.

Sunday, April 27, 2008

A Philosopher of Our Time

Nassim Taleb is the man of the hour, sought after by the press, on demand as a speaker in financial seminars.

The sudden fame comes from the success of his most recent book, The Black Swan. Like Taleb’s previous book, Fooled by Randomness, The Black Swan is about the unpredictability of the unknown. For the longest time, everyone thought that swans were white. Then, some folks in Australia came upon a couple of black swans. The popular belief was wrong. One never knows.

Taleb is a self-proclaimed “philosopher of chaos.” No, not a statistician; mass characteristics of random phenomena does not interest him. That was the concern of a more optimistic era when philosophers and mathematicians were looking for, and therefore discovered, order in chaos.

Taleb is interested in chaos, period. And cataclysmic chaos in that, say a thermonuclear accident or an economic collapse; mere mishaps won’t do. (He never tells us why sighting a few black swans entails a calamity .)

That alone would make Taleb a philosopher of our time. But his thrust into the limelight has more compelling, albeit less visible, reasons. Both form and content play a role.

The central point of The Black Swan is that experience provides facts, not necessity. That is a settled issue in the Western philosophical thought. But to make the case, as Hume and Kant do, for example, you have to resort to sine qua non of philosophical discourse, which is abstract thinking. (In Critique of Pure Reason, Kant begins with the limitation of experience and goes on to show that the highest Truth must be void of any experimental content.)

Taleb could not do that. He is the philosopher of an image-dominated culture with no tolerance or capacity for abstract thought. So he makes his case via tidbits and grandmotherly anecdotes. In doing so, he sets himself up for inconsistency, incoherence and ultimately, defeat.

I explain.

Hearing the title of the book and its premise in a dinner party, my daughter commented that Black Swan was a pretentious name; the more familiar black sheep could have conveyed the same idea. A good observation from a 15 year old, everyone thought.

Later, leafing through the book, it occurred to me that while Taleb could be a pretentious writer, something deeper made him forget about the black sheep.

The connotation of black sheep is social. In the idea of black sheep, folklore recognizes the commonness of social aberrations. (Natural aberrations do not even merit a comment, as they are fully expected.) As Beckett put it as only Beckett could: “There is a little of everything, apparently, in nature, and freaks are common.”

Taleb’s “black swan” is universal. It applies to the social, as well as the natural, phenomena. That is another way of saying that Taleb makes no distinction between nature and society, between matter and thought. How could he, relying on anecdotes to develop a theory?

By missing the distinction between social and natural, Taleb signs on to the idea that the laws of economics and finance mirror the laws of nature, the implication being that the socio-economic system is as stable as the universe. Under these conditions, rare events are rare events whether they occur in nature or in society. So the discovery of Viagra is a Black Swan (a “good” Black Swan, as he calls it.) The collapse of the asset-backed commercial paper market is also a Black Swan. The message of The Black Swan is thus that Black Swans are a fact of life and must be accpeted as such. It is this message that appeals to the embarrassed officers of banks, funds and brokerage houses. Who could have foreseen the collapse of subprime mortgages and the ensuing mayhem? If they did not have a back-handed defender like Taleb they had to invent him.

Behind his railings against the “establishment,” Taleb is a court philosopher, which is why he has become the man of the hour.

Monday, April 14, 2008

Anatomy of a Crisis: The “Credit Woes” of the Summer of ‘07 – (10)

I said overnight the technicalities grow in importance. In fact, the important technicalities are always present. The next day, they merely come to the surface.

At 8:30am the next day, the term of the loan ends. The investor is due its $10 million (with the accrued interest). When it is paid, the collateral would be released. This is called unwinding. But where would the $10 million from? We only have $250,000. That is the given of the situation.

Our clearing bank comes to the rescue. As part of its function as the tri-party repo agent, it sends the investor the $10 million and takes the possession of the security as collateral. This is a temporary arrangement. The bank is making a “daylight” loan to us – paying for the security on our behalf – until a new investor is found (before 4:00pm.) When the new investor sends $10 million to the bank, the bank takes the money and transfers the possession of the security as collateral to the investor. Another overnight cycle thus begins.

Here comes the most critical aspect of the “structure of the US financial and capital markets”. If our clearing bank refuses to unwind the collateral, meaning that it refuses to send $10 million to the investor, it is the end of the line for us. Absolutely! And nothing – short of a flagrant intervention by the Federal Reserve – would save us.

To see this point, let us return to the fateful morning hour and consider a critical factor that we have so far left unconsidered: a change in the price of the security. Let us assume that the price of our security falls overnight to $9.5 million.

If that were to happen, our clearing bank that must send $10 million to the investor would be left with collateral worth $9.5 million. That would expose it to a potential $500,000 loss. Clearing banks manage trillions of dollars of collateral every day. They cannot afford such unanticipated exposure. And because, by virtue of having both money and collateral, they have the upper hand, they are quick to protect their interests.

To that end, our clearing bank sends us an ultimatum in the form of a “margin call”: Send $500,000 cash immediately or we would liquidate (sell) the collateral. Since we do not have $500,000, the bank sells the securities for $9.5 million and sends the money to the investor. The investor that lent us $10 million has now lost $500,000. That is the risk of every lending, including overnight lending. But that does not mean that the investor will let go of $500,000. It immediately files a suit to recover the damages. Woe to us with $250,000 equity and $500,000 in debt.

What follows is easy to see but it does not concern us. What needs emphasizing is that long before the matter reaches such critical point even a hint that we cannot meet the margin call will spell our doom. That follows from our business model. We never had money to pay for our purchase. From the get-go, we relied on the kindness of the strangers – a clearing bank here, a mutual fund or an insurance company there – to give us vital financial support. Anytime that support is withdrawn, we would not last an hour, certainly not a day.

That is why broker-dealers are so vulnerable to “rumors” and “reputational risk” – and why The Bank of England has officially declared a war on “rumour mongering”).

Reputations risk has nothing to do with “ungentlemanly”, downright vile or borderline unethical conduct; such “subjective” matters hardly matter in finance as long as you can deliver. The term, rather, unbeknownst to many of its users, refers to the perception in the market about a broker-dealer’s ability to meet the margin calls.

As broker-dealers grow, they expand into other branches of finance such as underwriting, private equity, venture capital and mezzanine financing; it is a logical strategy to diversify one’s revenue sources. The expansion and diversification makes them less dependent on their broker-dealer operation so they gradually become “investment banks” – “I-banks”, if you want to be more uppity. Such is the case with Merrill Lynch, Morgan Stanley, Goldman Sachs and Lehman Brothers. But we should not for a second let names obscure the fundamental nature of the business of these firms, with all the vulnerabilities that follow.

Bear Stearns did not go out of the business overnight because its underwriting fees vanished or its venture investments went sour. It went out of business, rather, because it became clear on the night of Sunday, March 16, that come Monday morning, no one would extend credit to the firm to carry its 200 odd billion dollar position. That was the end of the line for the firm.

In our example, we were bought $10 million bonds with $250,000 down payment. Our leverage was 40 to 1. Here is the leverage of the Big Five as of 12/31/07:
Merrill Lynch: 27.8 to 1

Morgan Stanley: 32.6 to 1

Goldman Sachs: 26.2 to 1

Lehman Brothers: 30.7 to 1

Bear Stearns: 32.8 to 1
That is why the comment of the Bear’s newly appointed CEO that “we are collective victims of violence” was so incredulous and betrayed a profound ignorance of how his firm worked. Both the man and the firm were doomed.

I will return with the epilogue.

Present at the Destruction: Further Evidence From the Marketplace

A few days back I wrote about the collapse of the insurance business model in the US. I pointed out that the traditional business model is breaking down under the strain of newly developed forces.

Today’s New York Times had a front page article on the multifold increase in the co-payment for expensive prescription drugs. I am quoting selected passages from it as bullet points. The meaning and context is not altered.
Heath insurance companies are rapidly adopting a new pricing system for very expensive drugs, asking patients to pay hundreds and even thousands of dollars for prescriptions for medications that may save their lives or slow the progress of serious diseases...

Insurers say the new system keep everyone’ premiums down... But the result is that patient may have to spend more for a drug than they pay for their mortgages, more, in some cases, than their monthly income…

The system, often caller Tier 4 … is the fastest growing segment in private insurance ... Five years ago it was virtually nonexistent … Now 10 percent of them have Tier 4 drug categories…When people who need Tier 4 drugs pay more for them, other subscribers in the plan pay less for their coverage…

[Says] a health economist: “It is very unfortunate social policy. The more the sick person pays, the less the healthy person pays.” Traditionally, the idea of insurance was to spread the costs of paying for the sick. “This is an erosion of the traditional concept of insurance,” [a policy analyst] said. “Those beneficiaries who bear the burden of illness are also bearing the burden of cost.”

Sunday, April 13, 2008

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (9)

The “structure of capital and financial markets” is a standard course in every business school. It has a set agenda, designed around descriptions and definitions such as: what is a stock exchange, how corporations raise money and the difference between money markets and capital markets. (The students, like their teachers, rarely appreciate the last point, which is why later in the position of power in financial institutions they think nothing of funding capital market instruments with a money market product such as commercial paper. I mentioned this earlier and will return to it again in some detail because the point needs emphasizing.)

These technical descriptions are at some level important. But they are irrelevant to us. 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. For that, we need to know the role of broker-dealers and their clearing banks.

Broker-dealers are large retailers of financial products. When you call your broker to purchase a security, say 1000 shares of IBM or $50,000 face value of a 2-year bond, your order is filled from the broker-dealer’s inventory. That is how these retailers make money, by buying and holding inventories and then selling them at a slightly higher price to you. In that regard, they are no different from any large retailer, say a supermarket or a car dealership, only in their case the truck is now a bond; a can of soup, a stock.

Like all retailers, broker-dealers must finance their inventory. Depending on its size, a broker-dealer would hold from tens of millions to hundreds of billions of dollars of securities in inventory. It would simply be impossible to pay to for those securities in full, much less run an economically viable business.

There are thousands of BDs in the US. The largest five – now four – are household names. They are: Merrill Lynch, Goldman Sachs, Morgan Stanley, Lehman Brothers and the late Bear Stearns.

This “description” of the broker-dealers is accurate and factual in every sense. But it, too, suffers from a flaw in that it is not “pointed” enough. It is benign – neutered, if you will. It is a description put together by a clueless finance professor or an ignorant CEO of a large sinking broker-dealer. That is because it takes the focus away from the critical aspect of the business of broker-dealers and, by virtue of that fact, is misleading. To really understand the broker-dealer business, we need to go inside the business. The best way of doing so is to start one. All we need is a telephone and a clearing bank and we are in business. (I am exaggerating only slightly. In addition to an easily obtained license, we would also need some nominal “start up” money, which could be as little as $250,000)

Broker-dealers make money by buying and selling securities. So we immediately get to the business. The rules permit us to buy $10 million worth of US Treasuries with our current equity of $250,000. That is what we instruct our clearing bank to do. The trade is immediately filled. It will settle T+1, i.e., the next day.

We must now turn our attention to the large elephant in the room that we managed to ignore in our initial excitement: we just purchased $10 million worth of securities for which we have no money. We need to come up with the money before the next day settlement.

Our clearing bank will be more than willing to lend us money and take the securities as collateral. It suggests to us, however, that we could more cheaply borrow from an investor. These “investors”, in the parlance of the Wall Street, are large mutual funds, pension funds and insurance companies. They hold daily excess cash for redemptions. They also receive a constant flow of money from new subscribers. Instead of leaving the cash idle, they like to invest it overnight; every bit helps. So they are more than glad to take our securities as collateral and lend us $10 million. The arrangement is no different than buying a house where the purchase is financed by pledging the house as the collateral. Only when the collateral is a security instead of a house, the transaction is called repo. And when a clearing bank manages the transfer of money and collateral, in fact acting as the third party between us and the investor, the transaction is called tri-party repo.

Repo financing is mostly overnight. This means that the loan starts at about 4:30pm on the day of transaction and ends the next day at 8:30am, when the Fed securities wire opens.

Why do we and the investor both insist on an overnight loan? For the investors, they might need the cash the next day. Also, in the overnight lending, the credit exposure to us is minimal; something going wrong with our finances between 4:30 pm and 8:30am of the next day (when the markets are closed) is less likely. (All these references are to the US market. But the principle applies everywhere, as we will see.)

As for us, for the transaction to make economic sense, the interest we are paying for the financing must be less than the interest we are getting from the bond. In a positively-sloped yield curve environment which generally – but by no means always – reigns, the shorter the term of the loan the lower the interest rate. So the overnight borrowing is the cheapest.

That is why tri-party repos are typically overnight. The term of deals might extend longer, up to one month, but not much longer.

Having thus secured the financing, we go home to have a good night's sleep.

Overnight, the technicalities grow in importance.

I will shortly return with the 10th and final part of the series.

Saturday, April 5, 2008

Present at the Destruction

If you live in the US, you are familiar with the Geico lizard. Thanks to saturation advertising on TV, Internet and in the print media, there is no escaping the talking reptile that pushes Geico car insurance with an Australian accent.

The hook is lower premium–music to ears of the mortgage-ridden US drivers in the age of high gasoline prices. But how could Geico charge less, spend millions on advertising and still make money? What gives?

Credit the company’s business model, most unorthodox for an insurance company but of the kind that these times simultaneously demand and create.

Geico refuses to pay the claims. Of course, it cannot do so openly and directly. So it opts for the next practicable solution: it discounts the claims with a vengeance. The damage to your car is $1000? Geico offers $150. If you refuse the offer and sue, the company fights through repeated appeals until the time and expenses of litigation wears you off. This is done openly. So the contingency-fee lawyers are also put on notice that taking on Geico would be prohibitively expensive. At the end, the discouraged drivers give in. Geico wins.

At the level of a damaged car, the harm of this strategy remains local. When taken into more universal area, say health insurance, damages reach far and wide. The New York Times, April 1, 2008:

The Social Security system is choking on paperwork and spending millions of dollars a year screening dubious applications for disability benefits … Insurance companies are the source of the problem… The insurers are forcing many people who file disability claims with them to also apply to Social Security – even people who clearly do not qualify for the government program…

Forcing people who are injured to apply for Social Security before paying their claims appears to bolster insurers’ profits in several ways. If claimants refuse to apply, the insurers can simply stop paying their benefits…

More typically … people apply for Social Security when an insurer tells them to. That allows the insurer to reduce its claim reserves, money that is kept in conservative investment for benefit payments. And in the insurance industry, smaller reserves mean bigger profits. …

Finally, disability insurers tell many of their claimants to appeal Social Security’s rejections again and again, until some are finally accepted. Then the insurers can take those people off their rolls, shifting the cost to the government.
What we are witnessing here is the breakdown of the “business ethics” – not of the kind taught in the business schools, as only fools believe in that nonsense – but the set of rules that, like morality, is developed to preserve the system by putting it on the right. For the insurance “industry” to be viable in the long run, its payouts must approximately correspond to actual losses.

The erosion and violation of this code is not due to some newly discovered need for sharp business practices. (The subject of finance is not people.) It is, rather, due to the impossibility of conducting business-as-usual within the confines of the old code – the evidence of the structural turn of the conditions for the worse.

So the old codes give way, whether through legislatively sanctioned “reforms” or the downright deceitful and misleading practices – an impossibly small fine print here, a less than full disclosure there.

This trend is visible at the government level as well – the US government weakening and destroying the international institutions put in place by the US government for the purpose of preserving the supremacy of the US government because they stand in the way of the immediate objectives of the US government.

Or take the Federal Reserve, forced to repeatedly trample on its own rules to avert systemic shocks. Under such conditions, naturally, out goes the “doctrine” of moral hazard that has kept many court philosophers and economists gainfully employed. The New York Times, Mar 17, 2008:
In Washington, the Treasury secretary … signaled strong support for the Fed’s role in supplying a lifeline to Bear Stearns during crisis negotiation, saying his priority was to stabilize the financial system and to worry less right now about the problem of avoiding a “moral hazard” by bailing out errant institutions. “We’re very aware of moral hazard,” Mr. Paulson said in a television interview … “But our primary concerns right now – my primary concern – is the stability of our financial system, the orderliness of the markets. And that’s where our focus is.”
In a crisis, there is no room for pretense.

So, it is in this way, one conceptual destruction at a time, that an economic system, like the political system representing it, approaches the point of exhaustion.

Speculative capital is not the only element of the system that is self-destructive.