Michael Lewis's 'The Big Short' (5 May 2010)

I borrowed The Big Short by Michael Lewis from a friend the other day and am rapidly reading my way through. I'm glad I waited until now to read it, because it makes for a smoother ride having already tried to digested the mechanics of Goldman Sachs's Abacus deal and the Magnetar trade. Some of it was familiar from my Portfolio days as well. The book masquerades as an aw-shucks account of some of the people who figured out that all the subprime lending made for a titanic house of cards and how they managed to get rich from their insight, but beyond that it's a pretty far-reaching critique of financial capitalism.

The way ideologues defend the inherent instability of the capitalist system ("creative destruction," etc.) is that competitive innovation may destroy individual firms but overall society reaps benefits from their espousing better ways of doing things. A firm that makes, say, steel cheaper buts the inefficient steelmakers out of business but lets society do more with steel.

But when capitalism is dominated by finance (and finance by 2007 was responsible for over 40% of all business profit in the U.S. by the mid-00s), competition and innovation become a matter of merely betting against fools rather than fixing the system that produced them. Financial innovation didn't allocate capital for the betterment of society; it allocated capital for the enrichment of Wall Street douches.

The people Lewis writes about don't seem especially douchy, and Lewis tends to try hard to make them sympathetic Cassandra figures who were on a quixotic quest to expose a financial system that had become systemically irrational. And they were merely acting on the basis of the prevailing ideology when they recognized that the whole financial system could meltdown but did nothing to prevent it and everything they could to profit from it -- their profiting from it, according to capitalist ideology, was supposed to be an expression of the system fixing itself. In reality, their wisdom that could have prevented financial calamity instead helped enable and intensify it. The glorification of markets presumes that everything of social worth and everything about human behavior is a matter of incentives, and anything worth doing will ultimately be incentivized. But there was no way to incentivize the prevention of financial disaster.

So Lewis's protagonists could have been heroes, might have mitigated a catastrophe, but instead fomented a profitable disaster because capitalism suggests that heroism is measured in profit and that profit can't be wrong. And many people probably still think that (what could be wrong with making money?), despite all the collateral damage to those who had nothing to do with subprime lending but ended up out of a job anyway, or the people who are still paying off an oversize mortgage on a house that got to be way, way, way overpriced thanks to the investment bankers' heedless rapaciousness inflating housing bubbles with insanely easy credit.

Market fundamentalists still probably think it's better to let a "self-regulating" system crash completely -- making a few winners and a society of losers -- then to have regulation (of derivatives, of rating agencies, etc.) designed to prevent such things from happening. That's the essence of Goldman's eagerness to hide behind the "sophistication" excuse that Thomas Frank points out in this WSJ op-ed. Nothing could be wrong with the gambling proclivities of sophisticated, consenting bankers, regardless of the collateral damage of their actions, which they seem simply to ignore as irrelevant. Lewis's book reveals that no matter how smart investors were, nothing they could do would prevent economic disaster. Frank's op-ed (a recapitulation of some of the arguments he made in One Market Under God) points out how the supposed sophistication of players in financial markets is used as an excuse to eschew regulation.

If the public is "smart," then who needs the nanny state? Meanwhile, as the familiar expression goes, those who support regulation "think you're stupid." So: Goldman Sachs builds up the "sophistication" of its counterparties because that, apparently, is what will get Goldman itself off the hook. And the boosters for the broader market build up the "sophistication" of small investors because that will get the market generally off the hook, by summoning up an "investor class" that will carry on Wall Street's war against the regulators.

(A variant on this is the idea that regulators are inevitably the people too stupid to hack it at the banks they are hired to regulate, so it all is a big waste of time.) Regulation, the banks allege, prohibits smart people from acting on their intelligence in the markets, thus wasting it. But what really happened in the past decade was that all the sophistication deployed in markets led only to making a bigger and bigger meltdown. The sophistication on various sides of trades doesn't balance out and produce optimal outcomes; it swirls and eddies and produces economic death spirals. Everyone tries to find the bigger fool, and everyone ends up getting made a fool of.

Paul Krugman argues here how regulation could have prevented what Lewis describes -- what Krugman calls "white-collar looting." And in this statement to a congressional subcommittee, Jamie Galbraith explains how the assumptions of market fundamentalism provided ideological cover for fraud.

Latter-day financial economics ... necessarily treats stocks, bonds, options, derivatives and so forth as securities whose properties can be accepted largely at face value, and quantified in terms of return and risk. That quantification permits the calculation of price, using standard formulae. But everything in the formulae depends on the instruments being as they are represented to be. For if they are not, then what formula could possibly apply?

Further discussion from James Kwak of the pros and cons of the financial regulation debate taking place now in Congress can be found here.

Magnetar (14 April 2010)

Magentar would be a decent name for a band (it refers to "the super-magnetic field created by the last moments of a dying star"), but it's the name of a Chicago area hedge fund that, according to this ProPublica article by Jesse Eisinger and Jake Bernstein, executed one of the more nefarious (and probably characteristic) trades of the housing bubble. (The story is also featured in this episode of This American Life.) It's complicated but well worth trying to understand. This is the general gist:

According to bankers and others involved, the Magnetar Trade worked this way: The hedge fund bought the riskiest portion of a kind of securities known as collateralized debt obligations -- CDOs. If housing prices kept rising, this would provide a solid return for many years. But that's not what hedge funds are after. They want outsized gains, the sooner the better, and Magnetar set itself up for a huge win: It placed bets that portions of its own deals would fail.

Along the way, it did something to enhance the chances of that happening, according to several people with direct knowledge of the deals. They say Magnetar pressed to include riskier assets in their CDOs that would make the investments more vulnerable to failure.

In short, investment banks needed equity investors to create new CDOs. Magnetar volunteered and then allegedly used its clout as investor to push the CDO managers into toxifying the securities in the structure so that it would fail. Magnetar wanted it to fail, despite owning the equity, because that loss would be made up many times over by the payout on the credit-default swaps (which essentially insure against default) that it had taken out on the crappified CDOs with earnings from the equity. As long as the CDOs paid out, Magnetar could buy the swaps. When the CDO failed, the swaps would give the big payday. It was magic, nearly miraculous -- kind of like magnets themselves. ("Fucking Magnetar, how do you work?")

Along with some useful elucidation, James Kwak explains the significance of this Magnetar business in a post aptly titled "The Cover Up":

The lessons of Magnetar are the basic lessons of the financial crisis. Unregulated financial markets do not necessarily provide efficient prices or the optimal allocation of capital. The winners are not necessarily those who provide the most benefit to their clients or to society, but those who figure out how to exploit the rules of the game to their advantage. The crisis happened because the banks wanted unregulated financial markets and went out and got them -- only it turned out they were not as smart as they thought they were and blew themselves up. It was not an innocent accident.

As Bernstein and Eisinger explain, "From what we've learned, there was nothing illegal in what Magnetar did; it was playing by the rules in place at the time." Obviously these "rules" are useless if they provide no safeguard against systematic abuses and unsustainable banking practices and apparently rampant rating-agency laxity. The whole point of having rules governing the financial sector, after all, is to allow it to function for the common good of the economy -- so that it can match savings with worthwhile investments like the apologists say it does. But instead we had legislation undoing Glass Steagall and forbidding regulation of derivatives, etc. -- establishing rules that made it seem as though the function of a financial system was to guarantee that bankers could make lots of money no matter what happened to the economy at large.

As for what to do about it now, Mike Konczal's useful paper (pdf) about the current state of financial reform is a start.

Bank rescues: the not so New Deal (27 March 2009)

Economist Willem Buiter, who also serves as a highly engaging and polemical blogger for FT, wants to know why more bankers and board members are not being perp-walked.

It is clear that the vast majority of the large border-crossing banks are continuing to exploit every accounting trick in the book to avoid recognising the marked-to-market losses on their dodgy assets. With most banks cursed with paper-thin equity cushions in relation to their assets, a more intense, let alone a quasi-forensic scrutiny of the balance sheet by a nosy expert paid for and acting on behalf of the government shareholder could easily precipitate a move from partial to full state ownership and thence into insolvency and an orderly restructuring or liquidation.
Too many bank insiders have exploited their monopoly of information and the control it bestows on them, to enrich themselves by robbing their shareholders blind. There has been a spectacular failure of corporate governance. Boards have foresaken their fiduciary duties. Surely, even the liability insurance taken out by board members ought not to shelter those who are guilty of, at best, such willful negligence and dereliction of duty? Where are the class actions suits by disgruntled shareholders? Where are the board members in handcuffs?
Now that there is no meat left on the shareholder drumstick, the rogue managers and employees are going after a piece of the really juicy bird - the ever-patient tax payer. I hope they choke on it.

These are good questions, and it would seem imperative that some punishment be doled out to some deserving scapegoats at some point, if only to defuse populist anger. The fact that all the malefactors in this crisis can't be punished shouldn't prevent authorities from singling out a few and laying the groundwork for the "few bad apples" argument -- i.e., it wasn't that the whole system was bad; there were just a few naughty bankers who abused our trust.

Paul Krugman, in his editorial today, will have none of that -- it sounds as though he wants, like Lionel Hutz, to put the system on trial. He describes securitization as a scheme to enrich financial intermediaries with no value added in terms of risk management or beneficial capital allocation:

Underlying the glamorous new world of finance was the process of securitization. Loans no longer stayed with the lender. Instead, they were sold on to others, who sliced, diced and puréed individual debts to synthesize new assets. Subprime mortgages, credit card debts, car loans — all went into the financial system’s juicer. Out the other end, supposedly, came sweet-tasting AAA investments. And financial wizards were lavishly rewarded for overseeing the process.
But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption.
Sooner or later, things were bound to go wrong, and eventually they did. Bear Stearns failed; Lehman failed; but most of all, securitization failed.

Economist Arnold Kling concurs, adding the codicil that securitization has always been a perversion of free-market principles. "My view is that securitization of mortgages would never have emerged in a free market. Instead, it came from our country's industrial policy supporting housing. Every major advance in mortgage securitization was a regulatory/accounting gimmick, encouraged or created in Washington." The insane promotion of homeowning for its own sake has caused no end of trouble. Perhaps, as this Boston Globe thinkpiece suggests, we're ready to move away from that ideology and stop subsidizing housing to the detriment of the rest of the economy.

Anyway, Krugman is wary of the few bad apples scenario, worrying that "the underlying vision" of the Obama administration "remains that of a financial system more or less the same as it was two years ago, albeit somewhat tamed by new rules." But that system, in his view, has proven a failure, and isn't worth saving. What will replace it though? Is he perhaps edging closer to Steven Waldman's idea of replacing credit administered by banks with a system of flat transfers for consumers, and investment trusts and locally targeted "narrow banks" for businesses. When mainstream discussion reaches that point, we'll know then that we are truly verging on a new New Deal.

Crisis opportunity (22 Jan 2009)

David Harvey's The Limits to Capital makes for especially interesting reading, given that he argues (extrapolating from Marx) that contradictions in "the circulation of capital" lead inevitably to economic crises that get expressed in the credit system (which had evolved, in his view, to solve lower-order crises of "overaccumulation" -- aka "savings gluts"). He looks at bubble phenomena from a Marxist viewpoint -- bubbles form when capitalist accumulation necessarily fails to achieve balance; the crises that occur when they pop are tentative, temporary solutions to the contradictions inherent in capitalism. When the capability to reinvest in capital formation is constricted for lack of viable opportunities --- when profit can't go back into making more capital -- fictitious capital is created via the credit system. That yields a speculative frenzy (since the relation between opportunity and underlying economic capapcity has been severed) that is unsustainable. So then, inevitably, there must be devaluation, to re-create opportunity in the ashes.

Perhaps that is where our economy is now. Indeed, Eliot Spitzer writes in his Slate column that we have yet to see enough creative destruction:

Although everybody claims to love the market, nobody really likes the rough-and-tumble of competition that produces the essential "creative destruction" of capitalism. At bottom, this abhorrence of competition and change are the common theme that binds together the near death of the American car industry, the collapse of the credit market, the implosion of the housing market, the SEC's disastrous negligence, the Madoff Ponzi scheme, and the other economic catastrophes of recent months.

He points to those tell-tale marks of capitalist decadence -- cronyism and rent-seeking -- and appears to be wishing for a real rain to wash the system clean. He concludes:

Both GM and the SEC need to see a change in market conditions as an opportunity—not a challenge to market share.... This is a unique opportunity for President Obama and the Congress to take two seemingly different entities and force them to play by the real rules of capitalism: compete and transform to produce better products.

It's the word force in that passage that strikes me as a bit ominous. That's probably because state repression of that sort plays a prominent role in Harvey's crisis theory. After differentiating between "periodic crashes" and "long-run problems that arise with the irreversible transformation of configurations in the circulation of capital, class formation, productive forces, institutions and so on," Harvey argues:

The latter, as Marx observed, are strongly affected by the increasing socialization of capital itself, first via the agency of the credit system and ultimately through socially necessary interventions on the part of the state. The character of periodic crashes is thereby also transformed. Instead of being the aggregate social effect of an essentially atomistic, individualized process, they become a social affair from the very outset. The state, via its policies, becomes responsible for creating what it hopes will be a 'controlled recession' that will have the long-run effect of putting accumulation back on track.
The options for the internal transformation of capitalism become increasingly limited, more and more confined to innovations within the state apparatus itself [think TARP, et. al.]. And once the limit of the state's capacity to manage the economy creatively is reached [think, the zero interest bound] the increasingly authoritarian use of state power -- over both capital and labor (though usually with far more devastating effects upon the latter) -- appears the only answer. Crises embrace the legal, institutional and political framework of capitalist society and their resolution increasingly depends upon the deployment of naked military and repressive power.

Not to get all paranoid, but this sort of argument puts Rahm Emanuel's intention to never let a crisis go to waste in a much more sinister light. Harvey reminds readers of Lenin's view of the matter, that imperialist nations can always resort to war to solve crises; nothing works better for devaluation than some wanton wholesale destruction. That may go a ways toward explaining Bush's inexplicable foreign policy. Obama has promised to end one war; let's hope the deteriorating economy doesn't force us into another.

The Madoff pyramid scheme (15 Dec 2008)

The sums involved in the fraud perpetrated by Bernie Madoff are so staggering, they're almost blasé. Madoff apparently ran a Ponzi scheme that racked up losses of $50 billion -- an incomprehensible amount of money outside the realm of government bailouts. This is not cash printed by way of state seigniorage; this is private money that at one time was possibly earned by someone. Confronted with that amount, my mind shuts down and absorbs it as though it was a figure named by Dr. Evil in mad scheme of world domination.

Madoff allegedly provided the illusion of steady returns for years mainly by managing to recruit new investors and distributing their funds to previous clients. When the market turned down, redemptions came in and the jig was up, the news was out, etc. What everyone wants to know now is why nobody noticed what he was doing before. As the NYT story notes, "Competing hedge fund managers have wondered privately for years how Mr. Madoff generated such high returns, in bull markets and bear, given the generally low-yielding investment strategies he described to his clients." His returns were too improbably regular, according to an analyst cited in the article. And in 2001, analysts were smelling something fishy about Madoff's funds and his "split-strike strategy". Naked Shorts links to this report that now makes for very interesting reading -- Madoff defends his investment approach against skeptics, who wondered "why no one has been able to duplicate similar returns using the strategy" and "why Madoff Securities is willing to earn commissions off the trades but not set up a separate asset management division to offer hedge funds directly to investors and keep all the incentive fees for itself" -- that is, why they outsourced the recruitment of new investors to other fund managers when they could have brought them in directly and earned more money. Of course, the answer is clear now -- those intermediaries were the advance guard for Madoff's pyramid scheme. The punch line is the report's last sentence:

Madoff, who believes that he deserves “some credibility as a trader for 40 years,” says: “The strategy is the strategy and the returns are the returns.” He suggests that those who believe there is something more to it and are seeking an answer beyond that are wasting their time.

But if some investing pros had been skeptical of Madoff for at least seven years, how did he keep his pyramid scheme afloat. Sadly, one can ask the same question about our entire subprime-loan-driven economy through the housing-bubble years. That makes the "cynical" take that Paul Kedrosky cites in this post especially piquant.

While many dopey investors in Madoff's funds thought he was actually running a "split strike option" strategy (and most of those people had no idea what that meant), most of the smart investors didn't. They just thought he was using the trading order flow from his securities firm to run a lucrative insider-trading operation, and they were happy to get a piece of it.

Kedrosky adds, "Imagine how pissed those wise-guy investors were when they found out that Madoff wasn't running the fraud that they thought he was. Instead, he was running a different fraud."

But it is possible to be even more cynical and figure that investors knew it was scam, but figured that as long as they got in and out early, relative to the rest of the herd. That trading strategy, if you believe Marx, is called capitalism.

Capital, which has such good reasons for denying the sufferings of the legions of workers that surround it, is in practice moved as much and as little by the sight of the coming degradation and final depopulation of the human race, as by the probable fall of the earth into the sun. In every stockjobbing swindle every one knows that some time or other the crash must come, but every one hopes that it may fall on the head of his neighbour, after he himself has caught the shower of gold and placed it in safety. Après moi le déluge! is the watchword of every capitalist and of every capitalist nation. Hence capital is reckless of the health or length of life of the labourer, unless under compulsion from society. To the outcry as to the physical and mental degradation, the premature death, the torture of over-work, it answers: Ought these to trouble us since they increase our profits? But looking at things as a whole, all this does not, indeed, depend on the good or ill will of the individual capitalist. Free competition brings out the inherent laws of capitalist production, in the shape of external coercive laws having power over every individual capitalist.

At some point, capitalism compels us, by its own integral logic, to adopt unsustainable approaches that can't be generalized to include everyone -- we all can't be at the top of the pyramid. Instead we become committed to a desperate effort to keep the machine moving, to bringing in more and more into the system so it won't collapse under its own weight, and the pile of grievances it generates through its merciless functioning. The more merciless the system becomes, the more merciless, we, its agents, have to become to perpetuate it. Subprime loans were made with no real faith that they will be repaid, but with some hope that new, even more desperate and exploitative techniques would be contrived to bring in a new influx of profit and prevent their insolvency from mattering. What has happened now is that for the time being, we have lost faith in the schemes, and we can't persuade ourselves to naively believe anymore, or alternatively, we have lost the will or ability to recruit new naifs.