Finance as the Discipline of Faith

Here is the economics columnist of The New York Times, Paul Krugman, on the cause of the recent financial crisis (Feb 15, '08):

Why has a crisis that began with loans to a limited group of home buyers ended up disrupting so much of the financial system? Because, ultimately, it’s more than a subprime crisis; indeed, it’s more than a housing crisis. It’s a crisis of faith.

There you have it: if only people had faith. The fault, dear Brutus, is not in our stars, but in ourselves.

A neo-liberal New York sophisticate is turned into a new born Christian – or is it Jew? – under the onslaught of events whose cause he does not recognize much less understand.

I will return with Part 3 of the "Credit Woes”.

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (2)

i) A nomadic capital with the need for rapid deployment under varying circumstances needs a new organizational shell to operate; the old mutual fund structure, where the type of activities must be specified in advance, would not do. Hence, the rise of hedge funds, where prospectus and offering memorandum give virtually unlimited discretion to the managers to engage speculative capital in spontaneous opportunities anywhere they arise.

Hedge funds are the organizational/legal form that speculative capital assumes in the market.

ii) Flexibility of its own structure is not sufficient for rapid execution; speculative capital needs accommodating market conditions as well. To that end, it adopts the derivative structure – long the narrowly used tool of farmers and commodity producers – to its own temp. Derivatives are the ideal vehicles for “linking” one market with the other.

Derivatives are the functional form that speculative capital assumes in the markets.

iii) Speculative capital does not have a command and control center. Whenever an arbitrage opportunity is detected, the mass of speculative capital, employed by thousands of hedge funds and proprietary desks, is directed to it. The rush of uncoordinated money overshoots the mathematical exactness of the relation, with the result that that the pendulum swings in the other direction.

Volatility is the result of attempts of speculative capital to profit from arbitrage.

iv) The “inefficiencies” that speculative capital exploits are small. (Consistently large spreads would imply a crude and inefficient economy that would exclude the rise of speculative capital.) The narrow spreads cannot sustain speculative capital. To boost its return, speculative capital needs to leverage itself. The smaller the spread, the larger the leverage.

Speculative capital has a tendency to employ increasingly greater leverage.

v) Speculative capital eliminates opportunities that give rise to it. This necessarily follows from its modus operandi. Simultaneous buying low and selling high increases the lower price and decreases the higher price, gradually narrowing the spread between the two and ultimately brining them into “equilibrium” and eliminating the arbitrage opportunity.

Speculative capital is self-destructive.

Self destructiveness is a logical tendency that manifests itself over the long run and in the context of the particular markets speculative capital is arbitraging. At the same time, speculative capital is antithetical and will not gently go into that good night. As the spreads erode, speculative capital will:

a) Compensate for the falling returns by increasing its size and leverage, thereby exacerbating the erosion of the spreads.

b) Search for new markets and products to arbitrage. In this way, speculative capital “links” the markets – first various markets within a country and then markets across the globe – by targeting products in them as the subject of arbitrage.

In consequence, ever newer markets are drawn to the orbit of speculative capital. The sole “use” of these emerging markets is their offering of arbitrage opportunities, hence their name: emerging markets

vi) The sovereigns have laws that might stand in the way of expansion of speculative capital. Those laws must give way to the exigencies of speculative capital. Ditto the local laws.

Speculative capital drives the march of deregulation, particularly in the financial industry.

vii) The linked markets – whether various markets such as commodities and equities within a country or different markets in different countries such as currencies – become the subject of the arbitrage action of speculative capital, with the result that their movement is synchronized.

Speculative capital increases the correlation between the markets it exploits – national and international.

To any one following the markets in the past 30 years, these are familiar developments. The explosion in number of hedge funds, the exponential growth in derivatives, the incessant drive for deregulation, synchronization of price movements across the markets, rise of emerging markets, increasing emphasis on shorter horizon – these are instances of different manifestation of speculative capital.

The current crisis is byproduct of speculative capital’s arbitraging of credit. The “credit” in question is the potential loss of the credit or loanable capital arising from the borrower’s default.

Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (1)

In the summer of 2007, financial markets in the US and UK suffered a heart attack.

The events leading to this seizure have been covered in detail from many perspectives but always within the same prescribed framework: the crisis as the culmination of a series of unfortunate events set in motion by (choose your emphasis) greedy traders, irresponsible lenders, foolish borrowers, sleeping-at-the-switch rating agencies and feeble regulators.

The focus on the human element makes for good storytelling and has an evangelically uplifting bent that is appealing: If only the bad guys were to be replaced with good guys – something definitely in the realm of possible – the wrongs will be set right. The fault, dear Brutus, is not in our stars, but in ourselves!

Such takes on the crisis are not inaccurate; they are irrelevant. The subject matter of finance is not people; it is capital in circulation. It is silly to point out that “ultimately” things happen in markets because people take actions; capital as a thing cannot trade or structure deals. People, however, do not act in a vacuum. They act on the basis of what they see and perceive in the market, which is another way of saying that their actions are shaped by the dynamics of capital – the form and pattern of its movement in the market. This movement takes place according to the objective laws that rise and operate independent of the actions of individual agents. To the extent that these individual actions also affect the markets, such effect is secondary. (Voltaire commented that incantations could indeed kill a flock of sheep if administered with a dose of arsenic.)

The complex interplay between the mass of capital and action of individuals demands a theory to be comprehended. Theory is a guide for action. It tells us what is happening, i.e., what is changing. It is impossible to understand the nature or direction of the change without knowing the characteristics of the force that is affecting it. The early 21st Century capital markets in the industrial countries have long since passed the point of being comprehended through observing the surface appearances. Finance is a science precisely because the outward appearances of phenomena in it do not readily point to their causes.

But without a theory and with the academics at sea, the simplistic description of the surface phenomena is what we got by way of explanation. Here is an example:

Question: Why did the asset-backed commercial paper market “freeze up” in the recent crisis?

Answer: Because the buyers went on strike!

That the so-called theory of modern finance has no explanatory power and concerns itself only with the interest of traders – derivatives valuation, hedging, portfolio diversification and the like – has always been known but politely ignored because it never seemed to matter. The crisis of the summer of ’07 showed the dangers of this rupture between theory and practice.

Recall the number of times corporate officers, central bankers, traders and analysts, in short those who should have known better, were “stunned” by the turn of events. Stunned to learn the size of losses (in their own institutions, no less), stunned to learn that even more losses were in the offing, stunned by how rapidly the crisis spread; stunned at how far it reached, about the lack of market response to official initiatives, and how just about everything seemed to go haywire.

Never, it seemed, had so many understood so little about so much.

But no one highlighted the appalling theoretical poverty surrounding this crisis as well as Chief Financial Officer of Citigroup. In explaining the multi-billion losses that Citi had suffered in its CDO positions, he was quoted thus: “We have a market-risk lens looking at those products, not the credit-risk lens …when it in fact was a credit event.”

Market lens instead of credit lens! The senior most financial officer of a two trillion plus dollar financial behemoth with a legion of analysts, accountants, quants and risk managers under his command fundamentally misunderstood the nature of his institution’s $100 billion exposure over an extended period of time.

And he is still wrong, caught up as he is in a false binary world of credit or market – now resolved to see zebras as black animals with white stripes after his equally arbitrary view of them as white animals with black stripes proved injurious to the bottom line.

Let us assist him.

What is taking place in the current crisis is the transformation of values to prices set in motion by speculative capital.

Descriptions impart little knowledge to readers and listeners and without background information, and the background information is precisely what is lacking in the current crisis. So we need to arrive at our description rather than merely give it. We need to elaborate its key terms, beginning with speculative capital.

• Speculative capital is capital engaged in arbitrage: buying low, selling high.

• Every sustainable economic activity is based on buying low and selling high; no one has ever invented another way of making money. If we buy low and sell high in bulk, for example, we are a wholesaler. If we buy low in bulk and sell high piecemeal, we are a retailer. How is the arbitrage different from wholesaling or retailing?

• Arbitrage is a category in finance. It develops logically from speculation – itself an offshoot of commerce – but stands in qualitatively different ground from both. Here is how:
  
  Speculation is naturally present as the antithesis of commerce. The source of its profit is likewise antithetical to the source of profit of commerce. The key to understanding the difference between the two lies in the difference between the individual random events and their mass characteristics.
  
  In running their businesses, the wholesaler and retailer will ignore short-term price fluctuations and trust their capital to the operation of statistical laws. They know from the experience and the history of their business that if in a given year what they sell takes longer than average time to sell or must be sold at below the target price, the next year (or the year after) it would take less than the average time and they could sell it above the target price. That follows from the definition of average. On average, the wholesaler and the retailer expect to realize the average profit of their business line.
  
  The speculator, by contrast, bets on the random events. Unlike the wholesaler and the retailer – or an industrialist or a banker – who count on a relatively long time horizons (established by the patterns of trade) as a way of insulating themselves against random fluctuations, the speculator enters the market precisely to take advantage of those fluctuations. That is what separates him from the rest of the pack.
  
  Precisely because he does not have the benefit of the smoothing affects of time after every purchase, the speculator faces the risk that what he has just bought will fall in price. Since holding a position, by definition, incurs risk, it follows that the longer holding periods incur larger risks. In this way, to the uncritical, yet practical, mind of the speculator, time appears as the source of the risk. He concludes that if the time between his purchase and sale is shortened, the risks of the transaction must proportionally diminish. In the extreme case, when the time between the two is zero, the risk would completely disappear.
  
  When the time between purchase and sale is reduced to zero, the two acts become simultaneous. A simultaneous “buy-low, sell-high” guarantees a risk free profit. What is more, it does not require an outlay of money, because the proceeds of the sales will cover the cost of purchase. That is arbitrage. The speculator – now arbitrageur – has discovered the alchemy of finance, its golden goose: making money without having and risking money.
  
  Capital engaged in arbitrage is speculative capital.

• Speculative capital is, by definition, “opportunistic.” It is constantly on the lookout for “inefficiencies” across markets to 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. The requirement to be opportunistic translates into the need to be mobile, to be nomadic and interested in short-term ventures. Such are the inherent attributes of speculative capital.

• Because these attributes define speculative capital, the manager of speculative capital must employ it in activities that are consistent with these attributes; he cannot invest in infra-structure projects in an emerging country. Thus, in the absence of any real option, the manager of speculative capital turns into its agent, someone who nominally “runs” the speculative capital but must in fact follow its “agenda.” Speculative capital becomes the grammatical subject of the sentence as if it were alive: speculative capital seeks arbitrage opportunities. Of course, it does so through its agent, the fund manager, but it is the speculative capital which determines the nature of its own employment and calls the strategic shots.
  
  (There is no better example of this subjugation of person to the dynamics of speculative capital than in the Black-Scholes option valuation model. There, the owner of the portfolio must not think. He exists as an automaton: to buy when the market is rising; to sell when the market is falling. Option valuation’s practical twin, portfolio insurance, does that in practice, hence its nom de guerre, program trading.)
  

From the foregoing, we can deduce some conclusions.

Two Views From the Top

Here is what Gary Crittenden, Chief Financial Officer of Citigroup, had to say about the losses Citi suffered in CDOs, courtesy New York Times:

We have a market-risk lens looking at those products, not the credit-risk lens looking at those products. When it in fact was a credit event.

The bank, we learn, was “caught off guard”.

Here is what John Thain, the CEO of Merrill Lynch, had to say about the losses Merrill suffered in CDOs, courtesy Financial Times:

There were a number of failures. First on the risk management front. This was really focused on the management of the risks of the trading desks because actually the credit risk management, particularly on the leveraged lending side, was very good but on the market side it wasn’t.

According to the Citi CFO, the problem was the lack of attention to credit risk.

According to the Merrill CEO, the problem was lack of attention to market risk.

Both men are talking about the multi-billion dollar losses their institutions suffered trading the same product, using the same strategy.

Both are officers responsible for setting things straight – first in their respective institutions and then in the international markets where they are among the key players.

After this easy setup, created by putting their words next to one another, flouting these men would be in bad taste – an intellectual equivalent of dwarf tossing.

More to the point, the subject of finance is not people. It is capital in circulation. I will return with a series of postings on the current crisis. These men need help.

Bankruptcy as Strategy and Tactic

In an article about the recent credit squeeze, Financial Times (February 5, p. 20) reminded us:

Several years ago, Hicks Muse and Kohlberg Kravis & Roberts each wrote cheques to acquire Regal Cinemas. They then loaded an additional $1.8bn in debt on to the company. The movie chain could not service all that debt and filed for bankruptcy protection.

Distressed debt funds paid 60 cents on the dollar for the debt, acquired control of Regal from the two private equity firms and eventually reaped windfall profits on the investment.

These few sentences make the modus operandi of buy-out firms clear as day light. Take control of a company and saddle it with a large debt that it cannot service. That is the tactic. The strategy? To drive the said firm into bankruptcy. The aim is "to reap windfall profits," for all concerned, including the lenders. All is calculated, methodical and systematic.

On this subject, the liberal columnist of the Times, Paul Krugman, has not one word to throw at a dog. Yet, he was all too willing to lecture Argentina in the 90's in the evils of default. He wrote:

Advanced countries – the status to which Argentina aspires – regard default on debt as a moral sin.

I criticized this empty sentimentality in the Enigma of Options:

The “moral aspects” of default about which columnists and scholars of law are in the habit of sounding off are the indignation of the owners of capital at the loss of their money.

It is not that feelings must be dismissed or belittled. One could sympathize with the European who consider the buy-out firms "locusts." But the subject of finance is not people. It is capital in circulation. To understand the developments in finance, we must adopt the level-headed detachment of finance capital, i.e., we must understand the dialectics of finance – in theory and in practice. Here is what I wrote in the Enigma on the subject of default.

Default is an incident in finance … As financial markets grow in size and sophistication, they take on the subject of default, peel its social shell and turn it into a tradable commodity … The next logical stage in this process is the commoditization of default, a development that is behind the creation and growth of the credit default swaps. At this stage, default is consciously embraced as a revenue source, so the pretence of morality is cast aside. Large banks that sell billions of dollars worth of credit default swaps do not consider default a moral failing on the part of the borrowers any more than insurance companies consider traffic accidents a character flaw in the part of the drivers. Such “failings,” on the contrary, are the very reason for the existence of the credit derivatives and insurance markets.

Buy-out firms play a particularly extreme and nasty version of the default game where, unlike the insurance and credit default swaps market, the event is intentionally engineered. But that, too, is in the realm of the expected. I will have more to say on this topic.

O Judgment!

That in the midst of the current market mayhem my first post on this blog is about a Supreme Court case could reveal a thing or two about me. So consider this a self introduction.

The case in point is the just decided STONERIDGE INVESTMENT v. SCIENTIFIC-ATLANTA. The editors in The New York Times and Financial Times gave it prominent coverage, so I reckon they understood its importance. But I have not seen any commentary and the case cries out for a commentary.

The facts are not in dispute. I quote from the ruling:

Charter, a cable operator, engaged in a variety of fraudulent practices so its quarterly reports would meet Wall Street expectations ... The fraud included misclassification of its customer base; delayed reporting of terminated customers; improper capitalization of costs that should have been shown as expenses; and manipulation of the company’s billing cutoff dates to inflate reported revenues.

In other words, you name it, they did it. As for details:

In late 2000, Charter executives realized that ...the company would miss projected operating cash flow numbers by $15 to $20 million. To help meet the shortfall, Charter decided to alter its existing arrangements with respondents, Scientific-Atlanta and Motorola. … Respondents supplied Charter with the digital cable converters … Charter arranged to overpay respondents $20 for each set top box it purchased until the end of the year, with the understanding that respondents would return the overpayment by purchasing advertising from Charter. Charter would then record the advertising purchases as revenue and capitalize its purchase of the set top boxes … The new … agreements [to formalize the scheme] were backdated to make it appear that they were negotiated a month before the advertising agreements. The backdating was important to convey the impression that the negotiations were unconnected, a point Arthur Andersen [Charter's accountant] considered necessary for separate treatment of the transactions. Charter recorded the advertising payments to inflate revenue and operating cash flow by approximately $17 million.

So that is what we have here: fraud, pure and simple.

Stoneridge, which was holding Charter's stock, suffered losses. Consequently, in addition to Charter, it sued Charter's suppliers Scientific-Atlanta and Motorola under Section 10(b) of Securities Exchange Act which makes it unlawful to employ "manipulative and deceptive devices in contravention of rules ... prescribed for the protection of investors."

The Court framed the case thus: whether Scientific-Atlanta and Motorola could be held liable for aiding and abetting the fraud under 10(b).

It found that they could not. Because:

[A]rrangement [i.e., the fraud]... took place in the marketplace for goods and services, not in the investment sphere ... The petitioner invokes...§10(b) and seeks to apply it beyond the securities markets—the realm of financing business—to purchase and supply contracts—the realm of ordinary business operations.

What the above reasoning means is this, that 10(b) under the Securities Exchange Act governs securities only. The fraud in the case took place outside the realm of securities and in the realm of the "ordinary business," as the justices called it. As such, 10(b) did not apply. They found for the defendant.

The most critical aspect of the ruling is that, by extension, it could also apply to Charter's accountant, Arthur Andersen, which, although not a party to the lawsuit, played a similar role as Scientific-Atlanta and Motorola. Imagine a post Enron, post WorldCom world in which independent auditors could escape accountability for aiding and abetting a fraud.

The ground from which such ruling springs is the confusion over the meaning of "security." The Securities Acts do not properly and authoritatively defines a security – because they could not. Defining a security requires and presupposes knowing the meaning of finance and its relation with the "real economy." In Vol. 2 of Speculative Capital, I wrote:

The Supreme Court has tackled the question of “What is a security?” at least nine times. In all cases, it reversed the ruling of the lower courts. Lower courts have been similarly inconsistent. Contrasting rulings by various courts have piled up on top of one another, providing an arsenal of supporting footnotes to widely divergent views. One unfortunate victim of this muddying of the legal waters has been the small investor, whose protection was the central purpose of the Securities Acts. [emphasis added]

The Court's ruling once again highlighted the relevance of the emphatic sentence above.

In justifying the ruling, the justices resorted to the Court's customary one-two punch. At the macro level they brought in the flag and patriotism:

The practical consequences of an expansion, which the Court has considered appropriate to examine in circumstances like these … provide a further reason to reject petitioner’s approach … contracting parties might find it necessary to protect against these threats, raising the costs of doing business … Overseas firms with no other exposure to our securities laws could be deterred from doing business here … This, in turn, may raise the cost of being a publicly traded company under our law and shift securities offerings away from domestic capital markets.

All this is drivel. It is a regurgitation of the "arguments" that some corporate executives and their friends in the stock market have been making in order to render toothless already mild provision of the Sarbanes-Oxley Act. To raise capital, companies go where capital is. If the dollar amount of IPOs in London and Shanghai surpasses the offerings in New York that is because more capital is available in UK and China. Laws mandating corporate governance and responsibility no more hinder securities offerings that traffic laws hinder driving.

The ruling was further justified at the micro level by the citation of benumbingly long list of incestuous cases. This tactic creates a phony sense of erudition that is meant to silence and discourage dissent. It also manages – and this is a particularly important point – to strike from the psyche any picture of the case as a whole and the overall meaning of the facts as they were presented.

(An egregious case of this missing the forest for the tree – shrub, really – is manifest in another securities law case, DUNN v CFTC. The central point of the case was whether options in foreign currency were "transactions in foreign currency." The justices consulted Black's Law Dictionary for the meaning of the word "in." After establishing that it meant "in regard to," "respecting," [and] "with respect to," they rendered their ponderous opinion – in error, naturally. The ruling put foreign currency options outside the reach of CFTC enforcement. Fraud in the FX options market immediately increased many-fold.)

We have seen this tactic in the discussions about the legality of torture: what level of pain, what kind of bruise and what type of organ failure constitutes torture.

Employed thus, the tactic evidences a rot. It violates and offends our sense of humanity; in one case, it offends our spontaneous conscious, in the other, our spontaneous sense of justice.