Saturday, March 15, 2008

Comintern Capitalism, Moral Hazards, & Bear Stearns

Three days after Wall Street partied hearty over its latest 200 billion dollar bail-out, the swains at Bear Stearns blurted out that they're, ummm, dead. Death not being allowed, in course they will require expensive resuscitation from JP Morgan Chase and the Federal Reserve Bank. (So, the 200 large flashed on Tuesday wasn't enough?) Never the most forthcoming of creatures except (in my personal observation) on matters of obscenity, B-S execs blindsided their investors with insolvency, the already-sunken share price losing half its value in an hour.

Since banks are required to hold only pitiful, essentially meaningless slivers of their deposits in reserve, their actual health is highly correlated with perceptions of their health, and vice-versa. Although Bear Stearns bankers will come to work next week, who will they find to do business with them? And who other than the Usual Suspects will now claim the housing crisis hasn't bled out into a banking crisis? Bear Stearns quickly hired old-line firm Lazard Freres to study "strategic alternatives," such as getting cut up like a diseased ox and parceled out to whatever lucky firms get to take on the carrion in return for Federal Reserve promissory notes. The inflation resulting from this and other massive credit transfusions will take only 6 months to hit the grocery stores, where the surly beast has already gathered speed and looks on the mark of running wild.

People ask me to explain various Wall Street thingies, and my reply should usually be, "Well if I understood, wouldn't I still be working there?" In truth it's almost twenty years since I last donned the black exchange jacket. During that gap, financial "derivatives" (in old lingua fracas, "bets") have grown rather prettified, and the underpinning values of some securities pulled by hidden gears and distant block-and-tackle rigs are leveraged 100:1 or even more. Charmingly, right along with the rest of us little people, neither big sellers nor big buyers understand them.

Lack of understanding is why French and German banks and public funds got screwed when Goldman Sachs sagaciously unloaded its termite-eaten, triple-A rated mortgage-backed securities. The guys with the funny accents were nodding and saying, "Wow, what a great yield on our investment for so little risk. We can stockpile these babies, rest easy, and watch the money roll in. Because Moody's (the bond rating service) and Goldman Sachs (most successful Wall St. investment bank for last 20 years) say we can! And what could be safer than real estate?" Now little invest-a-lambs like the state retirement fund for Nordrhein-Westfalen are fleeced, whereas Bergen (a city in Norway) can't maintain its roads because of mortgage write-offs. Big pros like Banque Paribas, a huge consumer of mortgage-backed securities, was forced to fictionalize a "rogue trader" as being solely responsible for about $20 billion in losses. (Smooth move, Goldmanites.)

Derivatives and their markets may be unregulated and opaque, but on a fundamental level, understanding high finance is a snap. Macro or micro, Wall Street runs on promises. When a broker walked up to my stock exchange booth and wanted to do a 100,000 share block trade, we would eventually settle on a price, and he or she would hastily scrawl the order down on a little slip of paper, in pencil, handing it to me and fully expecting my employers to honor it. After all, I made a promise, although millions of dollars were to be transferred on nothing more secure than eye contact and chicken scratch.

Every investment also hinges on a simple question: if you're screwed, what recourse do you have? In the above example, if I made a bad mistake like selling the stock too cheap, or it otherwise hurt my firm's position, I could choose to DK it (DK="Don't Know"), denying the transaction's validity. Usually such disputes are compromised via back office horse-trading. Interestingly, despite all the added high-tech training wheels and record-keeping intended to eliminate the DK rate, it is as resistant to eradication as the common cold, remaining just above 1% of transacted value. That was the rate when Wall Street brokers were still dropping their orders out of windows to the curb below. (The American Stock Exchange's nickname is still "The Curb.") The thing is, that broker would know I broke a promise, and thus I would imperil both my firm's and my own, especially my own, reputation. Reputation is currency. If the broker worked at an important firm and had recourse, I could get fired as a small part of compensation.

At the very least a correspondingly large debit would be withdrawn from my boss's Favor Bank to cover my malfeasance, favors which came precious hard. While the temptation to break promises would at times be extreme, the consequences for doing so were hard to predict, and often severe. So there you have it. Operationally, conceptually, really, that's how "Wall Street" works. The whole thing starts off as volumes of verbal commitments, they're transformed into bets by bevies of bookies, then entered electronically into a nexus of contracts with a million nodes. Finance is a nexus of contracts, and trades are the peroracyon of promises.

At the moment, promises are being broken wholesale, all over the Street. Not just to last-in-line nobodies, neither. Some investors in sexy $2-mill minimum hedge funds can't get their money out while they're staring down the abyss of hyperinflation. If you have money, you've gotta hate that. Of course in a fair world Bear Stearns would be allowed to die, and all the investors who believed the spiels, coming from one of the most obnoxious, sleazy firms to ever swim the Moral Hazards, would be shit out of luck. But they won't be, and neither will the executives and investors of the next bank failures; rather, their poor judgment and fixity of greed will be rewarded with federal Get-Out-Of-Poverty Free cards. The corporate bail-out creates its own moral hazard, because if a game is rigged, the players soon forget how to play it well.

The Fed will issue statements of stalwart support this weekend, probably as I write this sentence, and likely they'll cut the interest rate an unprecedented full percentage point this coming week. Taking some of the pain required to keep the financial system from spiraling out of control, understandable as that would be after decades of headlong credit expansion, is unthinkable. One must remember, these are the very same down-is-up economists from supply-side Munchkin-Land who turned borrowing into a virtue, saving into a vice. Just like the totalitarian communists continually bailed out failing factories and collective farms, our totalitarians are going to bail
bail out every bloated, overindulgent, discredited bank under their protection.

So why can't Bear Stearns just effing die? Hmm. Maybe I should ask another question. What good are free markets when you've painstakingly built a command economy? Rather than let Wall Street take it on the chin, it is preferable to break the currency, then gaze in the distance and whistle innocently. Hoping no one will notice.
(Hyperinflation. It can happen here.) These dubious bozos are going to make the S&L crisis look like a round of miniature golf, but that's ok. The important thing, that very American thing, is that we can all get rich. Though it be the extent of a logical conclusion which becomes ridiculous, countless handsome charts have proven that the best way to get rich is to invest in the stock market. Perceptions of its health trump all other concerns.


Anonymous said...

Well, 1 in 100 U.S. residents are millionaires, after all. Things can't be that bad.


Brother Tim said...

Excellent post, Marc, thanks. Well-summarized. On a related note, did you catch Greg Palast's Bernanke/Spitzer backstory?

Jon said...

I look at it this way: why don't most Americans take their entire life savings down to their local Indian casino, and put all of it down on black on the roulette wheel? Wouldn't that solve their retirement savings problems? Of course, the answer is that it's too risky; half the people would end up with nothing.

Unless, of course, the government stepped in to the losers and said "oh, poor baby, it came up red? Here's your money back. Better luck next time!" Then everyone would gamble. And it would work out fine, except that the government would need to borrow all that money from China, and if there were, say, a crisis in Tibet, American leaders would not stand up for democracy and human rights, but would stick their fingers in their ears and hum loudly. Junkies do not talk back to their dealers.

MarcLord said...


"Junkies do not talk back to their dealers."

Sure they do! And they say, "Please, please, please, for the love of god puh-leez!"

MarcLord said...

bro tim--

ha-ha, pretty darned long summary, now that I see it. Thanks for the linkie, I'm not aware of the Spitzer/Bernie backstory, but figgered one musta existed for him to get outed. Not like the FBI doesn't hear a whole lotta rich folk calling up for $5,000 per hour pros...

MarcLord said...

Dear LW--

yes, and in an odd coincidence, 1 in 100 Americans are in jail.