The Financial Times recently used the phrase “casino capitalism” in an article which is part of a series on the “future of capitalism.” This particular piece examined the Asian approach to capitalism. The dean of Singapore’s Lee Kuan School of Public Policy is quoted as saying Asians have added the following lessons to the capitalist mix – “…borrow in moderation, save in earnest, take care of the real economy, invest in productivity, focus on education.”

The “casino” phrase is relevant to American capitalism I think because of credit default swaps (CDS). I have been trying to think of a an analogy to describe swap agreements, and the closest I can get is to discuss the game of blackjack. If a dealer turns up an ace as the face card, you will be offered insurance against the dealer having a twenty-one at the price of up to one-half of your original bet. If the dealer has a blackjack, you lose your original bet (unless you also have a blackjack), and the net effect is that you break even (assuming you bet the full one-half bet for insurance). If the dealer does not have a blackjack, you lose the insurance and still have to play the original hand. In this sense, placing an insurance bet in blackjack is like entering into a hedging transaction.

But what if instead of buying insurance from the dealer you buy it from one of the other players at the table. And then what if the other player buys insurance from yet another player (a “counterparty”) to offset the possibility of having to pay you if the dealer has a blackjack. This is staring to look like a CDS.

Consider an investor that has lent money to a corporation. The investor may turn to Bank A and buy protection against a default on the part of the corporation by entering into a CDS. Bank A may then decide that it wants to “hedge” its exposure to your CDS by entering into another CDS with Bank B. And so it goes. Ultimately, there is only one “real” asset – the loan the investor has made to the corporation. But several parties have placed many bets on whether the loan gets repaid.

A hedging transaction is rather like buying a little insurance, and a CDS is a type of hedge. Suppose I invest $100 and stand to get $200 back if all goes well. Depending on my risk tolerance, I may let it ride, or I may buy “insurance” for $50 (a “hedge”). If the investment tanks, I get my $100 back from the insurance but am out the $50 for the cost of the insurance. I have limited my possible downside. Of course I’ve also reduced my possible profit as well.

Hedging began as a way of reducing price risk on agricultural products. The farmer who plants a crop now, would like to lock in a price that will be paid when the crops are taken to market. This is done by entering into a “futures contract.” These contracts are traded on the Chicago Mercantile Exchange which is described on their website as “…the world’s largest and most diverse derivatives exchange and clearinghouse.”

“Hedge funds” are actually limited investment partnserships which are exempt from registering with the Secutities and Exchange Commission and are part of what is called the “shadow banking” system. As an industry, hedge funds have grown from $35 billion in 1992, to $1.5 trillion in 2007. What that means is that investors have been moving a lot of money out of a regulated financial system into an unregluated system. We shall explore the shadows in a subsequent blog…

In today’s editorial, the Financial Times states that the bill passed in the House of Representatives this week regarding taxation of AIG bonuses is a “bad law.” Concerning the rage over the bonuses, the FT notes that “understandable or otherwise, the response smacks more of banana republic than good government.” The paper also states that “…these bonuses were paid not as a reward for past performance, which would indeed be absurd, but to retain people deemed necessary to the unwinding of its mistakes.”

First off, how do you reconcile the FT’s statement that the bonuses were paid to “retain” staff when a report in this week’s Economist (Cranking up the Outrage-O-Meter ) states that “…$57m of its ‘retention’ payments were earmarked for staff it [AIG] planned to lay off”?

Secondly, note the use of the phrase “its mistakes.” If we recognize that “it” is AIG, doesn’t the sentence say “…these bonuses were paid to keep the people who screwed up so they could have a go at putting things right.” How absurd is that?

Congress really needs to see the outrage over AIG bonus payments as symbolic. “Main Street” finally has something it can understand that doesn’t involve a swap, sweep or swindle. Although Main Street must be careful that it doesn’t lose sight of the trillion dollars or so that are being spread around far too liberally for the sake of $165m in bonuses. This would be like seeing the trees but missing the forest. And like Macbeth, when Great Birnam wood marches to high Dunsinane hill, that would not be a good thing.

“Why man, they did make love to this employment.” So says Hamlet to Horatio as he describes how he foiled the king’s plot to assassinate him, instead sending Rosencranz and Guildenstern to their deaths (Hamlet, V, ii, ln 55). It seems like the U.S. government is on the verge of nationalizing the two largest banks in the world. But who is being saved and who “goes to it?”

In the early 1990s, Sweden successfully nationalized two banks, wiping out shareholder positions, but at the same time guaranteeing investors who extended loans to Swedish banks. According to the head of the Swedish National Debt Office, Bo Lundgren, this allowed banks to continue to do business while giving the government several years to sort them out and re-privatize them. Mr. Lundgren will be in Washington this week to advise Congress. Let’s hope they listen.

According to The Local – Sweden’s News in English, “…Washington’s rescue package appears to favour stock holders without much prospect of the tax payer-spent money ever being reimbursed. ‘What’s happening in the United States now entails a big risk that stock holders will win. If the banks survive, the stock holders’ holdings will still be there but the tax payers will have to foot the bill,’” Lungren is quoted as saying.

The U.S. approach seems not unlike the kind of Ponzi scheme that would have Bernie Madoff smiling quietly to himself. Money is taken from the taxpayers to payoff the shareholders. Or perhaps it is like the former UBS banker who testified to helping a client smuggle money out of the U.S. by stuffing diamonds into a tube of toothpaste?

Or even like today’s report that our government continues to bail out AIG so that it can pay lavish bonuses. The Sacramento Bee quotes Obama’s top economic adviser as saying “the easy thing would be to just say … off with their [AIG] heads, violate the contracts. But you have to think about the consequences of breaking contracts for the overall system of law, for the overall financial system.” This shows a remarkable lack of imagination on the part of the Obama administration. The easier thing to do is to not provide AIG with additional taxpayer funds. It would be hard for those economic terrorists at AIG to collect their bonuses wouldn’t it?

My advice to Obama is simple – yes you can!

Terrorism

On the matter of “economic terrorism,” the Oxford English Dictionary defines a terrorist as “a person who uses and favors violent and intimidating methods of coercing a government or community,” and also as “a person who tries to awaken or spread a feeling of fear or alarm.”

Plato’s Republic was mentioned in a prior blog. One of Plato’s positions was that morality is beneficial to its possessor. Using metaphor and allegory, Plato constructs an imaginary community for the purpose of understanding individual psychology. In this sense, he did not really believe that “the Republic” was actually attainable. According to author Robin Waterfield, “Plato…saw democracies enact sensible laws, but he knew the system was capable of terrible abuse.”

If you’ve seen It’s a Wonderful Life, you know about “building and loans,” the precursors to savings and loans, or what are also called “thrifts.” In order to help the thrifts out with a liquidity crisis, not unlike what is happening now, President Hoover established the Federal Home Loan Bank Board (FHLBB) in 1932 for the purpose of lending money to thrifts so that they could lend money to people like you and I.

Savings and loans did a fairly respectable business and saw their assets rise from $10bn in 1945 to $600bn in 1979. According to Paul Clikeman in Called to Account – Fourteen Financial Frauds that Shaped the American Accounting Profession (which is the source of information for this blog), “…savings and loan executives thrived by following the simple ‘3/6/3 rule’ – take in deposits at 3 percent interest, make loans at 6 percent interest, and be on the golf course by 3:00 every afternoon.” The loans were secured by real estate and borrowers needed a reasonable down payment or a federally insured loan. Not much in the way of risk.

Although, those in the business of making loans can be exposed to something known as “interest rate risk.” You probably know that if you put $10,000 in a bank, the money doesn’t actually sit in the vault night and day humming a Cole Porter tune and waiting for you to visit. The bank lends most of it to others at a higher interest rate than it pays you, pocketing the difference. This is fine so long as what the bank pays you is less than what it can get on its loans. Someone in the government apparently figured that bankers couldn’t follow the basic math and passed the Interest Rate Control Act in 1966 which limited the rates that banks and thrifts could pay depositors.

I mentioned above that there wasn’t much in the way of risk connected with savings and loans. But what happens when the markets start paying depositors 10%? If, as a banker, I don’t come close to the prevailing rate, people will take their money elsewhere to get a better return. And here’s where it starts to get difficult. All my loans are for 30 years fixed at 6%, but I now have to pay 10% to the people whose money I’ve lent. It sounds like I’m going to come up 4% short on my green fees. This is “interest rate risk.” It is compounded (pardon the pun) by the fact that I have “borrowed short and invested long.” That is, I’ve borrowed from my depositors for perhaps one or two years (in a certificate of deposit) and lent it out for 30 years.

You’re probably thinking Rick’s been reading too much of the tax code lately – banks don’t pay 10% on savings accounts! Well, they couldn’t because of the Interest Rate Control Act. But in 1980, treasury bills were paying 15.6%, and people could invest in treasuries through something called a money market fund. So, when their certificates of deposit termed out, vast amounts were pulled out of S&Ls by depositors and moved into money markets (never mind that money market accounts were never really insured until recently when a new phrase enter the vernacular – “break the buck”).

Regulatory Cascade

In 1980, President Carter signed the Depository Institutions Deregulation and Monetary Control Act which allowed S&Ls to increase the rates paid on depository accounts. So far so good. At least S&Ls could stem the tide of cash flowing into money markets. But what about that “borrowing short and investing long” problem? The solution was found in something called the adjustable rate mortgage (ARM). In 1982, President Reagan cut the shackles on the S&L industry in the form of the Depository Institutions Act and allowed S&Ls to issue ARMs which alleviated interest rate risk. But like all good legislation, more is better. S&Ls could now issue unsecured loans and invest in something called “junk bonds” (think Michael Milken).

Interest rates were rising in the late 1970s, and it would be some time before accounting standards moved away from the historical cost principle and adopted “Mark-to-Market.” Remember all those loans made at 6% under the “3/6/3” rule mentioned above? Well, if I can now get 12% on a loan, my 6% loan isn’t worth as much any more. It has decreased in value. Thanks to the historical cost principle, however, S&Ls were not required to report losses on these loans – causing the value of the assets on their balance sheets to be overstated.

Compounding matters yet again, in 1982, the FHLBB allowed S&Ls to use what are called Regulatory Accounting Principles (RAP) rather than Generally Accepted Accounting Principles (GAAP). According to Clikeman, “RAP inflated savings and loans’ assets and hid the severity of the industry’s problems…Using RAP, only 73 savings and loans were insolvent in 1984.” Using GAAP, however, 449 S&Ls were insolvent.

The worry among economists in the current crisis is that by not allowing large banks to fail and instead tinkering with regulatory and reporting requirements, the U.S. will duplicate the mistakes made by Japan with its banks in the 1990s which resulted in a decade of no growth. Rather than studying the Great Depression, the government should probably be studying the S&L crisis instead.

Remember the saying – a rising tide floats all boats. It’s only when the tide goes out that you see who’s been swimming naked.

This Latin phrase was brought to mind today as I read a piece in the Financial Times about Sir Allen Stanford and his alleged $8bn fraud scheme involving certificates of deposit in Antigua. The phrase is loosely translated as “who will guard the guards?” and is from a Roman poet by the name of Decimus Junius Juvenalis (c. 50 – c. 130). Plato used it for one of his dialogues in the Republic which addresses the problem of determining the ideal state.  The phrase is profoundly relevant to our financial crisis thanks to the Securities and Exchange Commission (SEC). I told you they would be a frequent guest in these blogs, and they have yet to disappoint.

Following a routine examination, the SEC began a more formal probe of Stanford Financial Group and Stanford International Bank in October 2006. However, according to the Financial Times, the “SEC ‘stood down’ on its investigation at the request of another federal agency in the spring of 2008.” The SEC has declined to provide the name of the federal agency. As Congress begins weaving a new regulatory framework, it is essential that “unnamed” federal agencies be brought to light and held to account.

Remember Sir Walter Scott’s quote… “oh what a tangled web we weave when first we practice to deceive.”

George Soros bet the farm in 1992. Using more than the entire capital of his Quantum Fund, a hedge-fund named in honor of Werner Heisenberg’s “uncertainty principle” (physics will re-appear in this blog), Soros wagered $10bn that the British pound would be devalued. He was right. According to Niall Ferguson, “Soros reasoned that the rising costs of German reunification would drive up interest rates and hence the Deutschmark.” Aside from netting Soros a tidy sum, his bet forced the pound to be devalued and knocked Britain out of the European Rate Mechanism causing interest rates to decline, and shortly thereafter, took Britain out of recession.

Soros is also famous for his concept of “reflexivity” where perceptions shape reality. Essentially, market participants (you and I) operate with a bias. This bias can influence events and “…create the impression that markets anticipate future developments accurately…” However, the “Efficient Market Hypothesis” (somewhat of a misnomer) notes that markets are unpredictable. This is because at any point in time stock prices “…reflect all information relevant to their value, so that their prices change only on the receipt of new information which by its nature is random…this so-called random walk theory is incompatible with the notion of stock market bubbles, since during bubbles investors react to changes in share prices rather than new information…” (see page 330, of Devil Take the Hindmost, A History of Financial Speculation by Edward Chancellor).

Commenting on reflexivity, The Economist states that “once people come to believe that house prices never fall, they will buy too much property – and house prices will fall. When they believe that shares always do well in the long run, they will buy too many shares…,” and we know what follows that.

But why do so many “high caliber” (see previous “Revolutionary Road” blog) financiers and bankers make disastrous goofs from time to time? They forget to ask the “Silly Question” (see prior blog) and rely too much on complex, often flawed, mathematical formulas which can only be understood if you happen to know some physics, differential equations and calculus.

Before we proceed, let’s steep back a bit…

Economic historians trace the origin of modern stock exchanges to1602, the year in which the Dutch East India Company was formed. Voyages to the east were lengthy and hazardous, and the invention of the “joint-stock company” was a means of pooling resources and in a sense, spreading the risk – thereby minimizing the risk any one investor would be exposed to. A stock represents ownership of a company. My risk in the venture is limited to the amount of money I have invested.

According to Niall Ferguson, “ownership of the Company was thus divided into multiple partijen or actien, literally actions (as in ‘a piece of the action’).” This was followed by the creation of a secondary market (the Amsterdam Bourse) in which these “shares” could be bought or sold – the first stock market. Although the Romans engaged in financial transactions in the Forum where money could be exchanged, lent and invested.

In Going Dutch, How England Plundered Holland’s Glory, Lisa Jardine notes that the Amsterdam Bourse (stock exchange) “…was a place to charter ships, to insure their cargos, to obtain credit, to make payments, to rent warehouse space and to hire labourers for loading and unloading vessels…The Bourse was also where information of all kinds, from all around the globe, was exchanged and discussed, and turned into knowledge of prices, markets and trading opportunities.”

It is at this point that assessing risk is still rather simple. If I know that only one voyage out of ten succeeds, I have a 90% chance of losing my investment. But what happens as what I invest in becomes further removed from any actual underlying asset or business venture? What is the underlying asset behind a “liquidity put” or a “LIBOR-cubed swap?” From what assets do these financial instruments derive their value?

Like the game of craps where I can place many types of bets on what is essentially one throw of the dice, stock markets began to invent different ways of investing in one venture to appeal to people’s appetites for speculation. This was accomplished through the creation of the derivative, which was born out of speculation. Edward Chancellor observes that “…the Exchange became a crucible for speculative activities. Futures contract – agreements to deliver or take delivery of a commodity at a fixed price some date in the future – were common.” A futures contract is an example of a derivative. Something that “derives” its value from some underlying asset, such as a stock certificate, a commodity such as corn or even real estate.

But how should the price of a derivative be determined? Skipping the next 370 years, in 1973 Fischer Black and Myron Scholes worked out how to use share prices to calculate the value of derivatives in what is now known as Black-Scholes. Their calculations use partial differential equations and Brownian motion (like the theory of entanglement, physics pops up again) and can be seen here.  According to The Economist (In Plato’s Cave, January 24, 2009), ” it is as if you had a formula for working out the price of a fruit salad from the prices of the apples and oranges that went into it…Confidence in pricing gave buyers and sellers the courage to pile into derivatives.”

Myron Scholes went on to work with Robert Merton at Long Term Capital Management (LTCM) in the hopes of turning Black-Scholes into a cash register. In 1998, one year after Scholes and Merton received the Nobel Prize in economics for their work in the development of the derivatives market, Russia defaulted on its debt and the markets bolted for safety, wrecking LTCM. The Federal Reserve Bank arranged a $3.6bn bailout and investors saw their holdings plummet from $4.9bn to $0.4bn. According to Chancellor, Alan Greenspan told Congress only a few weeks before the bailout that hedge funds were “strongly regulated by those who lend the money.”

And here is the flaw in the model – LTCM’s models calculated that the loss it suffered was so unlikely it should never happen. “But that was because the models were working with just five years’ worth of data. If the models had gone back even eleven years, they would have captured the1987 stock market crash. If they had gone back eighty years they would have captured the last great Russian default, after the 1917 Revolution” notes Niall Ferguson.

So this is where we find ourselves. From The Economist again, “…the idea behind modeling got garbled when pools of mortgages were bundled up into collateralised-debt obligations (CDOs)…a typical CDO might receive income from several hundred sources…” making it “…impossible to model in anything but the most rudimentary way…neither could the models take account of falling mortgage-underwriting standards.”

Edward Chancellor, writing in 1999, observes that “financial risks that were formerly well understood have become arcane…new derivatives serve no other purpose than to facilitate speculation – in particular, enabling fund managers to circumvent prudential restrictions on their investments…the former head of the New York Federal Reserve Bank…warned that ‘the increasing complexity of the financial markets could override the ability of the most sophisticated efforts to monitor and manage risk’…the Federal Reserve, however, saw things differently and headed off moves to regulate the over-the-counter derivatives market.”

George Soros addressed “…the desirability of regulation to the House Committee on Banking in April 1994, but the Republicans’ capture of Congress later in the year – assisted by generous campaign contributions from other hedge fund managers – killed off any further moves to regulate hedge funds. Alan Greenspan of the Federal Reserve also lobbied against hedge fund regulation on the grounds that it would only send the hedge funds offshore (where most were already registered in order to avoid the scrutiny of financial regulators).”

 Thinking Around the Bend (Rather Than Outside the Box)  To followup on the physics theme, Soros’ notion of reflexivity is somewhat related to Schrödinger’s cat, a thought experiment involving quantum mechanics and Heisenberg’s “uncertainty principle.” The uncertainty principle basically states that you can never accurately know both a sub-atomic particle’s speed and position (“pairs of conjugate variables”) at the same instant in time. The more accurately you know the position of a particle, the less accurately you can know its momentum. This has something to do with the wave nature of particles, but I didn’t pass my university quantum mechanics class and can’t help you out…Getting back to the cat, to try and explain some of quantum mechanics’ absurd implications, Schrödinger imagined a cat in a box that was both alive and dead at the same time until you opened the box and observed which state the cat was in (by the way, I love cats – we have two of them). The cat has no reality unless it is observed. This prompted Einstein’s famous quote “God does not play dice.” But investors do, and it is not through observations but through their perceptions that investors affect market outcomes – which is reflexivity.

Bankers receiving taxpayer money are complaining that they can’t make do on meager salaries of $500,000 per year. How will they be able to retain talented staff? An article in today’s Sacramento Bee notes that “dozens of California Senate employees have their pay padded by a combined total of several hundred thousand dollars a year through a little-known method not disclosed publicly as salaries.” Although not quite up to banking standards, a spokesperson is quoted as saying “these discretionary funds are used to retain high-caliber staff, who can earn significantly more in the private sector.” 

Well, they’ve all done such a fine job, haven’t they. I mean, the highly paid “talented” bankers and our “high-caliber” legislative staff have been the best that money can buy. Isn’t it time that this fallacy is debunked? What about paying a fair salary to someone who desires to do a good job in and of itself, regardless of pay? There are people in the world who are talented and take pride in the quality of their work. I don’t put in less effort on the job merely because I am paid less than someone else. What would that say about my self esteem if I did? That I can only feel good about myself if I am paid lots of money?

The country needs a good revolution every two-hundred years or so. It is time to test the myth that you can’t get “high-caliber” staff without paying obscene salaries (we’ll test the myth of “too big to fail” in a subsequent blog). Perhaps it is time for another revolution…