An Excerpt from Vol. 3 of Speculative Capital

The following is an excerpt from the last page of Vol. 3 of Speculative Capital: The Enigma of Options. The book came out in 2006. The lines were written in the late '05 or early '06.

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, its underwriter. It brings the credit to the trading arena and ensures its staying power 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. In this way, stock price comes to play a role in setting the price of credit. Traditional credit rating agencies are forced to take account of the development. They, too, shorten the time horizon of credit analysis.

A realization takes shape: if the stock price is an immediate measure of credit, perhaps credit and market price are more closely related than previously thought. This phenomenon plays out at the wholesale level as well, when corporations discover that they could sell their liabilities – and accounts receivable assets – in the market. So the tried and true concept of mortgage-backed securities (MBS) is extended to all forms of debt to create collateralized debt obligations (CDO), collateralized loan obligations (CLO) and, in case of accounts receivable, asset backed securities (ABS).

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. The march, driven by the profit-seeking, inherently self-destructive movement of speculative capital, creates financial entropy on its path, one manifestation of which is closing the longest running, most structural arbitrage opportunity of all: between the credit price and the market price. But the ensuing state of inert uniformity cannot be tolerated; speculative capital cannot sit by idly and will not go gently into that good night. It must disrupt the equilibrium to create profit opportunities anew. That brings about the systemic risk.

Keeping Our Eye On the Ball

Speaking of Harvard, in today’s New York Times William C. Apgar, a “senior scholar” at the impressively named Joint Center for Housing Studies at Harvard University said, “People are beginning to understand that home ownership can be a very risky venture”.

The context of this story is the rise in foreclosures and the decline of the homeownership in the US during the presidency of George Bush, whose one stated goal was the creation of an “ownership society”. Yet, Harvard’s senior scholar speaks of home ownership risk in the same vein that one would speak of the risk of say, deep water diving. The social context of the event, if noticed at all, is completely cast aside.

A day before, two Bear Stearns fund managers were indicted in relation with the collapse of their funds in June ‘07. The near simultaneous collapses triggered the systemic crisis we have been witnessing for over a year. The indictment was given wide coverage; ex Bear executives in handcuffs being led to the federal court. The message was that unscrupulous individuals who had gamed the system were now being called on the carpet.

In these two stories we have the perfect example of the binary system of explanation that I have been writing about: the failings of fallible humans, and/or the can't-do-anything-about-it nature of things. Nothing else is entertained. Nothing else is permitted. The philosophy of philosophers of our time or the indictment of failed fund managers all serve to reinforce this message.

I am familiar with the funds in question and how they imploded. Without defending the propriety of the actions of the managers or denying the commonness of petty crimes in finance, their collapse was the proverbial Exhibit A in the subjugation of men to the laws of finance. For those not sufficiently convinced, the $200 billion plus losses that some of the largest and most sophisticated global financial institutions have suffered in the past year – institutions that by virtue of their presence tend to game the system – offers yet a more compelling evidence.

This brings me to Speculative Capital. The central point of my theory is that the crises of various form and intensity that we have been seeing since the mid 1970s are not a one time – or two time or three time aberrations – but the necessary consequences of the growth of speculative capital. Speculative capital is self-destructive; it tends to eliminate the opportunities that give rise to it. Hence, only a conscious change in policy would avert the crippling systemic failure that is in the offing. But any such change in policy, while in the realm of the possible, borders on impossible. Recall from the Credit Woes series that broker/dealers, for example, need to operate with a 30-to-1 leverage, or their business model would not be viable. But a 30-to-1 leverage is inherently unstable, as Bear Stearns found out and Lehman is in the process of finding out. That brings us to the inner contradiction of the system: to function, the system has to be unstable.

All this is detailed in Vol. 4 of Speculative Capital, The Dialectics of Finance. I have returned to the manuscript with a sense of urgency. That is why the blog entries might at times be delayed. By way of compensation, I will occasionally post excerpts from the manuscript.

The Real Conflict of Interest (at Harvard)

In a front page article today, The New York Times reported that Dr. Joseph Biederman, a world-renowned Harvard child psychiatrist, had received at least $1.6 million from the drug companies in relation with consulting services that involved promoting their antipsychotic medicine. The article went on to say that Dr. Biederman’s work

helped to fuel a controversial 40-fold increase from 1994 to 2003 in the diagnosis of pediatric bipolar disorder, which is characterized by severe mood swings, and a rapid rise in the use of anti-psychotic medicine in children ... Some 500,000 children and teenagers were given at least one prescription for an antipsychotic in 2007, including 20,500 under 6 years of age.

The moral and social issues involved here – that a society chooses to tackle the problem of children’s behavior with the magic of pills, or the fact the news of this abuse has been out there for years – is not my concern; the subject of this blog is finance.

So let us talk about finance.

Do you recall, in the past ten or twenty times that you have come across Harvard’s name, what was it in relation to? It is a good guess that it was one of the following:

• the size of the university’s endowment fund; or


• the rate return of its endowment fund; or


• the change in the management of the fund; or


• the portfolio mix of the fund; or


• the investment strategy of the fund.

You get the idea; money is not an unconsidered trifle at Harvard. Just google “harvard + mohamed el-erian” – he managed the fund until last year – and see for yourself.

Consider now, if you will, the situation of a professor at Harvard. To advance his career, he must constantly produce and publish high quality research papers in prestigious journals. Publish-or-perish maxim rules at Harvard as in other universities.

The pressure to publish never ceases. It in fact increases with the tenure. That is because the driver of research is not the abstract love of knowledge but money, in the form of research grants. The more research grants you bring into your university, the faster you advance and the richer you become. Research grants, in turn, favor renowned schools and scholars. Hence, the incentive to become a world renowned expert in a prestigious school. It is a self-feeding, self-perpetuating loop.

The problem is that the only way a scholar could produce first rate, topical research is by aligning his research interests with the agenda of the world renowned publications that have advertising ties to the grant giving corporations. In the same way that fashion magazines create and dictate the fashion taste, companies create and dictate the research agenda. "Dictate” has a social connotation. It works through the internalization of values and manifests itself in the free choice of independent minded, even critical, scholars. To take the case of Dr. Biederman, it is inconceivable that he engineered a 40-fold rise in the use of anti-psychotic medicine in children against his beliefs. He must have believed that his work was contributing to the well-being of the children. If it also happened that it made money for him and the sponsoring corporation, it was icing on the cake.

Against this background, an “independent” scholar wanting to follow his own path – to do what he thinks is important – will be laughed out as a an out-of-touch fool, as the last old fashioned editor of the New England Journal of Medicine found out to his chagrin.

Conflicts of interest in medical science, biology and genetics tend to get closer scrutiny. But they pale in comparison with what takes place in economics and finance. Setting aside the petty corruption that is common, every single research paper and every general research topic in economics and finance is set in motion by the interests of traders, fund managers, bankers, investment bankers, broker/dealers and arbitrageurs. These interests also determine the framing of the problems, in consequence of which the direction of research and its results become preordained.

In Vol. 3 of Speculative Capital, I spent considerable time on this subject. Analyzing the steps that led Black, Scholes and Merton to their option valuation formula, I wrote :

They set out to solve the problem of option valuation. They were theorists, but the theory at their disposal was not up to the task. So they chose pragmatism. More accurately, pragmatism was forced upon them. They went to the market and adapted the solution of traders that had developed from the practice. That choice set the direction and limitation of the work, as everything they later brought into the model, no matter how theoretical, served the end of mimicking traders’ actions. But traders were wrong about options. They though an option was a right to buy or sell. It is in fact a right to default. In faithfully and uncritically replicating what traders did, Black, Scholes and Merton thus replicated their error.

That is the heavy price of the subjugation of thought to “practical” business considerations: the universe of solutions is reduced, with the right answer at times being altogether excluded from consideration. As just one, but very timely, example look at the bafflement in the face of what is taking place in the financial markets. Where are the esteemed professors of economics and finance, Nobel laureates, think tank “resident scholars”, investment gurus and corporate chieftains with their solutions? The best they have managed to do is to describe the events – and that incorrectly. Sartre’s pointed question in Critique of Dialectical Reason comes to mind: How could practical man think?

As for Harvard, it has not gone unpunished either. It is now home to Alan Dershowitz, a law professor specializing in civil liberties, no less, who advocates torturing detainees for quick confession. That is the pragmatism taken to its logical end – attending to the practical matter in hand, say extracting a confession, without any thought.

In the Inferno, the deformities in the bodies of the damned correspond to the kind of sin they have committed. Even Dante could not dream a more fitting punishment on Harvard.

The Crisis Continues

It is about 7:00 am here in New York. I am going to watch the shares of Lehman Brothers. And keep watching in coming days. Let us see how this thing will play out in light of the precarious condition of the broker/dealers that I described in Credit Woes series.

The Meaning of the "Bernanke Doctrine”

The New York Times informs us that there is a new doctrine in town. It is called the Bernanke Doctrine. The president of the New York Fed described it as “the overpowering use of monetary policies and lending to avert an economic collapse”.

On one level, what we have here is the ex post facto rationalization by Bernanke’s sycophant underlings of his actions in the past several months. But there is a subtext to the story.

Firefighters use an overpowering supply of water – as well as fire retardant and explosives, if need be – to fight fires, but they have no “doctrine” about the use of these measures because the need is self-evident and thus, sanctioned.

The Bernanke Doctrine, by contrast, involves policy actions that might violate the by-laws of the Federal Reserve Board. “Over a frantic weekend in mid-March, Ben S. Bernanke rewrote the rule book as chairman of the Federal Reserve,” we are informed.

The rule book of the Federal Reserve is a technical document. It does not lend itself to being “re-written” by one man – and that, in haste. But that is precisely what Bernanke did. That conduct is now being telegraphed as the standing modus operandi of the Federal Reserve: if the rules stand in the way of needful actions, they go. That is the gist of The Bernanke Doctrine, the “whatever it takes” of the cornered men bent on getting themselves out of a tight spot.

The Times gave a crisis-made-the-man spin to the story – how the mild-mannered academic rose to the occasion, etc. The paper quoted the president of the Dallas Federal Reserve who said about Bernanke: “He’s developed a serenity based on a growing understanding of the hardball ways the system actually works. You can see that it’s no longer an academic or theoretical exercise for him.”

That is the critical point of the article, the insinuation that the working of the “real world”, where men play hardball, is beyond the grasp of the theoretical bull that is the official finance and economics; Ben S. Bernanke finally grew up.

With regard to the medley of smatterings that is the official economics and finance, that assertion is certainly true. But is not true that the actions of Bernanke and his European counterparts at the ECB and the BOE are beyond the realm of comprehension and thus, must be conducted in an ad hoc and fly-by-the-seat-of-the-pants manner. Quite the contrary. As market grow more complicated, the need for a theory to explain what is happening, i.e., what is changing, becomes paramount; we have seen how little an ad hoc, gut-feeling approach, the monetary equivalent of a frightened soldier emptying round after round into the bushes hoping to hit a target, accomplishes.

If Bernanke is the contemplative economist that he is touted to be, he must know that the financial system at some point will outgrow his ability to influence the events. That, more than anything else, requires a theoretical understanding of the system, of the kind you will find in Speculative Capital and in entries in this blog. The Credit Woes series offered a glimpse of what a real theory could do.

Bernanke will of course learn no such thing. He could not. A defining characteristic of the systemic risk is its inevitability and the destruction that precedes it, be it of the U.S Constitution, Federal Reserve by-laws or the long held codes of conduct in the world of business.

How're They Doing?

Ed Koch, a cutting edge lowlife who was made the mayor of New York City in the late 70s – once collapsed in a restaurant from overeating – had a catchphrase. He used to ask, addressing no one in particular, How'm I doing? Not that he gave a damn about the answer, but it was good p.r., this show of going to the rabble for feedback.

How should we respond if the central banks, specifically, the European Central Bank, the Bank of England and the Federal Reserve, ask the same question? How are they doing in handling the ongoing liquidity/credit crisis?

The Financial Times of May 16, under the heading “ECB liquidity scheme fears” gave the answer in black and pink. The highlights are in red:

The European Central Bank yesterday voiced its “high concern” at growing evidence that banks are exploiting its efforts to unlock the frozen funding markets by using its liquidity scheme to offload more risky assets than it envisaged. Yves Mersch, a governing council member ... was speaking amid sign of some banks creating low-rated assets specifically so they can be traded for treasuries at the European Central Banks.

Central banks have become important in providing funding for difficult to sell mortgages on what is intended to be a short-term basis while securitisation markets remain frozen.

The Bank of England recently created a facility for UK banks to access funding for mortgages and the Financial Times has learned that almost £90bn ($175bn) worth of bonds are being created to be placed there – almost twice the £50bn initially expected when the scheme was launched only three weeks ago.

Meanwhile, Macquarie Leasing, a unit of the Australian bank, has done a securitisation of Australian motor loans, which will have a euro-denominated slice so that the investors who buy the deal can use it at the ECB. Investment bankers who work in securitisation say that their main business is structuring bonds that are eligible for ECB liquidity operations. Some analysts have concerns about whether the bonds being created will ever be saleable if markets recover… According to debt market sources, the banks planning to use the scheme are the UK’s eight largest lenders.

Let us see.

As part of its liquidity operations where it exchanges treasuries for junk, the BOE has taken in $175 billion worth of junk – twice the amount it was expecting only three weeks ago.

There is a critical point here that must be understood. When you give your high-yield junk (that you can neither finance nor sell) to a central bank and receive treasuries in return, the transaction is considered a security lending. What it means is that the ownership of securities does not change. You still own the junk and the central bank owns the treasury, so you receive the high coupon rate of junk and pay the low rate of treasuries. This is precisely the sort of arbitrage that triggered the current crisis, only now a central bank is the party to the transaction instead of the jittery and cautious CP investors.

What follows has the inevitability of night following day: Banks – including UK’s eight largest lenders – are specifically creating low rated assets (i.e., junk) so they can take them to the European Central Bank in return for treasuries. In fact, they have investment bankers whose “main business” is structuring bonds that are eligible for ECB liquidity operations.

And the news has spread to the far-flung corners of the “globalized” world. “Macquarie Leasing of Australia is adding a euro denominated slice to its auto loans so investors who buy the deal can swap it for treasuries”. From mortgages in the US to auto loans in Australia in ten months; it is a small world after all.

There is one more thing that must be understood. What do you suppose the banks do with the treasuries that they get from the central banks?

You guessed it. They pledge the treasuries, get cash and, if they are smart banker, buy high-yielding junk so they could take them to central banks for treasuries ... You get the idea.

There seems to be madness in the method. Certainly the central banks’ position that the program was intended to be a short-term exchange invites ridicule. They offer the banks and broker/dealers the risk-free opportunity to launder their junk and in the process earn about 3% spread and then expect them to say “enough” after an appropriate short time.

What we have, however, is neither naiveté nor madness. It is lack of options. With their backs against the wall, central banks had no choice but to do precisely what they have done for the past several months. Now all they can do is hope for the best.

The most outstanding characteristic of the systemic risk is its inevitability, a characteristic that is formed through the elimination of policy options.

US Financials and Fair Value Accounting

A few days ago, AIG reported first-quarter losses of $7.8 billion resulting from the sharp drop in the value of its mortgage securities and credit derivatives. If you were paying attention, you knew that something was in the offing. For some time now, the company’s CEO had been railing against the idea fair value accounting. As reported by Financial Times in March 14:

American International Group is urging regulators to change controversial accounting rules on asset valuation … Under AIG’s proposal, which has been presented to regulators and policymakers, companies and their auditors would estimate the maximum losses they were likely to incur and only recognise these in their profits … Martin Sullivan, AIG’s chief executive, told FT that “mark-to-market” rules forces companies to recognise losses even when they had no intention of selling assets at current prices.

First, note the word "controversial." That is FT's characterization. The paper's editors know where their sympathies must lie.

Why is fair value accounting controversial? It is a generally accepted accounting practice that purports to record and report securities at their fair market value. What could be foul about that?

In the fair value accounting, you have to mark the prices to market, i.e., take note of the changed price of a security and recognize the difference as either profit and loss, depending on your purchase price. Suppose you buy a security for $100. If the next day the price increases to $110, you'd have to report $10 profit; if the price drops to $90, $10 loss. That is how AIG was forced to report approximately $8 billion in losses. Hence, the unhappiness of the company’s CEO with the fair value accounting. His selfless proposal: to disregard the prices in the market and let the CEOs tell us what they think a security should be worth.

It is tempting to dismiss this as the nonsensical utterance of an embarrassed executive. But the idea is being seconded by others and might gain traction. If so, it would lead to less transparency and more misinformation.

There is more.

The concept of fair value accounting is improbably philosophical. It logically arises from the social nature of value and price and the transformation of one to another. It touches upon the question of the turnover of capital and the frequency and the speed of the circulation of its various components (within the same sphere of production) that gives rise, by turn, to money markets and capital markets.

The pressure to do away with it is the antithesis of the inner coherence of the financial system that has been maintained, however tenuously, since the collapse of the Bretton Woods regime of fixed exchange rates. It is made of the same cloth that makes Libor value questionable and pushes the authority of the Federal Reserve to its edge. It is, in short, the rise of yet another contradiction that is the hallmark of when things begin to fall apart and the center cannot hold.

These are the subject of Vols. 4 and 5 of Speculative Capital.