Fragments

Kafka’s “The Top” is a story about a philosopher who spends his spare time around children so he can grab their tops in spin. To catch a top still spinning makes him happy for a moment in his belief “that the understanding of any detail, that of a spinning top for instance, was sufficient for the understanding of all things.” Disgust follows delight almost at once and he throws down the top, walks away. Yet hope of understanding continues to fill him each time top-spinning preparations begin among the children: “as soon as the top began to spin and he was running breathlessly after it, the hope would turn to certainty but when he held the silly piece of wood in his hand he felt nauseated.”

The story is about the delight we take in metaphor. A meaning spins, remaining upright on an axis of normalcy aligned with the conventions of connotation and denotation, and yet: to spin is not normal, and to dissemble normal uprightness by means of this fantastic motion is impertinent. What is the relation of impertinence to the hope of understanding? To delight?

… I [do not] believe this philosopher really runs after understanding. Rather, he has become a philosopher (that is, one whose profession is to delight in understanding) in order to furnish himself with pretexts for running after tops.

— Anne Carson, Eros the Bittersweet: An Essay ¹

Out of curiosity, I did a count of the unpublished posts in my Blogger.com workspace this evening. Not counting this one, there are 70 fragmentary posts, in various stages of completion, stacked up in my virtual lumber room. Some of these are nearly finished and ready to go, but I have held them back because I reworked them and published them in different form. Some are in limbo because I started writing and lost the plot, or found myself tangled in thickets of unresolved or contradictory thought. Some argue for positions I have subsequently renounced or discovered, after many tedious hours at the keyboard, that I disagree with. Some are utter crap.

Most of my unfinished posts are more fragmentary than this, though: a paragraph or two of argumentation, a thought-provoking quote I am saving to illustrate a topic to be addressed later, an amusing picture just waiting for the proper light of day. Some are simply titles. I have lots of great blog post titles in here, in addition to those jotted down on the curling post-it notes scattered about my office. I’m good at picking titles. It’s one of my true talents. (Too bad they don’t give out MacArthur Foundation grants for title picking. I’d be on a tropical island somewhere right now, leafing through Bartlett’s Familiar Quotations and sucking down a mojito.)

* * *

I started writing one of these selfsame unfinished posts yesterday evening, in response to some small kerfuffle kicked up in the blogosphere over the Wall Street blog listicle this very site had been included in just the other day. I intended to give a magisterial exposition of my view and philosophy of the blogosphere, and the proper form and function of each and every blog and blog author in it. But then, halfway through, I was pulled up short and hard by two sudden realizations: one, I was nearly out of single malt scotch (without which my characteristic eloquence is as sere and barren as the Mojave Desert), and two, who the fuck cares?

There may be some small number of you among my Dear and Long-suffering Readers who might actually be interested in my views on this subject, but I bet you could be counted on one hand. Do you really want to know that I think not only is the blogosphere big enough and varied enough to contain all sorts of material—serious, whimsical, scathing, satirical, professional, amateurish, foolish, inane—but also that the vast quantities of unadulterated crap which demonstrably exist do not weaken or demean the good and serious stuff, but rather exalt it by comparison? You might, but I seriously doubt it. I mean really: Who. The fuck. Cares.

Not me.

Which neatly illustrates one major reason why, at the end of the day, I write this blog. Sitting down to keyboard with cigar and libation in hand does wonders to clarify not only my own thoughts on any particular subject, but also whether it rises to the level of something I might find interesting from another pen. If not, back to the woodpile it goes, where I can scavenge it for useful material later or consign it to the fireplace for fuel. The false starts, dead ends, and inchoate beginnings embodied in my unpublished oeuvre represent the very essence of active thought. Too bad I’ll never let you see them in all their messy glory. If you did, you just might begin to believe that I don’t really know what I’m talking about.²

Now, if you’ll excuse me, I must get back to chasing those tops. I’ll get back to you if I catch an interesting one.

¹ Princeton: Princeton University Press, 1986, pp. xi–xii.
² Don’t start getting all superior on me, though. This is exactly how your own brain works most of the time, too: you figure out what you “know” and what you believe by consciously thinking about it. Put that in your epistemological pipe and smoke it.

© 2010 The Epicurean Dealmaker. All rights reserved.

Beware of Dog

Your Humble Correspondent from the Ninth Circle of Hell—otherwise known as Wall Street—is quite chuffed to have received the Good Housekeeping seal of approval from David Weidner at The Wall Street Journal today. Mr. Weidner kindly saw fit to include my tiny, obscure little hobbyist soapbox in a list of “Ten Wall Street Blogs You Need To Bookmark Now,” along with such blogging legends as Barry Ritholtz, Yves Smith, and some scurrilous yellow journalists I have never heard of.

At first, I was excessively pleased to discover TED ranked #5 on the list, ahead of such wacko … er, pageview magnets as Zero Hedge, but then I realized it was in alphabetical order. Whatever renown this blog may or may not have achieved, it certainly cannot be laid at the feet of numerical popularity. I expect almost every other blogger on Mr. Weidner’s list gets more visitors and page hits in an hour than this site has seen in its entire three-plus years of existence.

Oh well, TED continues to rank #1 in the only measure that really matters: the Most Widely Respected Finance Blog that No-one Ever Reads.

* * *

During the mercifully brief period in which thousands of unwashed masses unsuspecting victims flood to these pages for the first (and probably last) time, however, I suppose I should extend some sort of grudging welcome and a brief introductory tour. This being the internet, and Mr. Weidner not being the first respected public figure to have maliciously directed his hapless readers to this site out of some sort of twisted spite, I happily have a canned introduction ready to hand. It is listed to your left (no, your other left) under the link entitled

“Introduction”

Read it, study it, and be ready for a pop quiz next Wednesday. Or else.

* * *

In closing, I would like to make three observations.

First, this is not the first time that Your Dedicated Bloggist’s labors have been recognized by the Great and Good among the punditry. The most notable such accolade has to be TED’s inclusion in Felix Salmon’s map of the “Econoblogosphere,” which he compiled when he was blogging at Portfolio.com a couple of years ago. Notwithstanding the creative destruction endemic to the internet and the consequent disappearance of several of the blogs Felix mentioned, this list remains a surprisingly good and current entry point for blog-centric discussion of the broader economic sphere. It remains a valuable resource for those among you who might hanker for a broader view of the real economy outside the rank echo chamber which is Wall Street. I encourage you to explore it.

Second, while these encomia from the fourth estate really do tickle Your Underappreciated Curmudgeon’s fancy, I must admit I receive the greatest psychic pleasure from the screams, insults, and oaths directed at me from the various personalities I eviscerate for your amusement in these pages. There is nothing I like better than to receive a blistering email or a typo-laden restraining order from one of the Great and Good who has fallen under my lens. Among all the plaudits I have received for my work, there are none I cherish more than having Steve Schwarzman, Lloyd Blankfein, or some gormless economist shriek in frustration

“Who the fuck is this asshole?!”

It warms the cockles of my icy heart.

Finally and lastly, I did note with alarm that Mr. Weidner failed to do an adequate job dampening speculation about Your Resolutely Secretive Scrivener’s true identity when he illustrated his online piece with a bit of playful video banter. This identity, for those of you who do not know, is a secret so vile, so sinister, and so unfucking-likely-to-ever-be-revealed-in-this-century-or-the-next that Mr. Weidner and his fellow journalists might as well try to discover the true identity of the person who wrote Hamlet. In other words, it ain’t gonna fuckin’ happen. (And yes, I did write Hamlet.)

I already have ace investigative Twitterer Heidi N. Moore on my ass, digging through my garbage for revealing clues, Mr. Weidner. I don’t need you or any more of your MSM colleagues helping her out. Just drop it.

Besides, what do you think I paid you that $10,000 “advisory fee” for in the first place?

© 2010 The Epicurean Dealmaker. All rights reserved.

The Mouth of Sauron

At its head there rode a tall and evil shape, mounted upon a black horse, if horse it was; for it was huge and hideous, and its face was a frightful mask, more like a skull than a living head, and in the sockets of its eyes and in its nostrils there burned a flame. The rider was robed all in black, and black was his lofty helm; yet this was no Ringwraith but a living man. The Lieutenant of the Tower of Barad-dûr he was, and his name is remembered in no tale; for he himself had forgotten it, and he said: 'I am the Mouth of Sauron.'

...

'Is there any one in this rout with authority to treat with me?' he asked. 'Or indeed with wit to understand me? Not thou at least!' he mocked, turning to Aragorn with scorn. 'It needs more to make a king than a piece of elvish glass, or a rabble such as this. Why, any brigand of the hills can show as good a following!'

Aragorn said naught in answer, but he took the other's eye and held it, and for a moment they strove thus; but soon, though Aragorn did not stir nor move hand to weapon, the other quailed and gave back as if menaced with a blow. 'I am a herald and ambassador, and may not be assailed!' he cried.

'Where such laws hold,' said Gandalf, 'it is also the custom for ambassadors to use less insolence.'

— J.R.R. Tolkien, The Return of the King

Max Abelson has an interesting piece in print at The New York Observer, profiling Goldman Sachs spokesman Lucas van Praag. In it, Mr. Abelson ponders aloud—and gets several anonymous competitors, PR flacks, and ink-stained wretches from the fourth estate to ponder aloud with him, strictly not for attribution—why it is that Mr. van Praag seems to be making such a hash of his job.

For hash it definitely is, as Your Dedicated Correspondent has observed in the past and Mr. Abelson so ably demonstrates. As mouthpiece for the simultaneously most successful and most hated financial institution in the world today, Mr. van Praag has done a bang-up job buffing the most-hated aspect of Goldman Sachs' image to a blindingly brilliant shine. His superiors and colleagues have certainly given him ample material of an embarrassing, questionable, and even damning nature to deal with and spin to the outside world. But van Praag's "majestic Victorian taunts" (in Mr. Abelson's apt coinage) have only served to alienate potential allies and enablers in the press and project a supercilious institutional arrogance which only serves to confirm the unflattering portrayals offered up by the firm's detractors.

Part of the problem is a matter of style. Mr. van Praag seems to take obvious pleasure in the parries, ripostes, and counter-ripostes he makes to attacks upon his employer. He delivers them with a studied and almost ornate verbal style that conveys the message that not only are you wrong, but also he is smarter and better-educated than you. In my experience, this modus operandi tends to play better in Mr. van Praag's native Britain, where the art of sharp, witty, spirited debate is still seriously practiced by public figures and enjoyed by most spectators.

But here in the United States, schizophrenic home to both the largest number of elite universities in the world and the broadest-based strain of anti-intellectualism known to Western democracy, the aggressive debating style of lobbing witty insults at your opponent only plays well on reruns of Monty Python. If you doubt me, just look at the inarticulate clods we elect to public office. Most of these morons cannot even deliver a coherent speech, much less bandy about gerunds and subjunctive clauses in the midst of a heated argument. Most Americans would probably try to impeach them if they did. This is just not a country where you can use words like "egregious," "febrile," and "chimera" in public without running the risk of being lynched for general asshattery.

Why do you think this blog is pseudonymous?

* * *

But mismatched style, surely, cannot account for all of the problem. Nor can it be that Goldman is unique in having committed acts which caused—or can be seen to have caused—much of our present financial woe. Credible evidence exists that all of the major investment and commercial banks extant helped collect and pour the effluent from a thousand sewers upon the unwitting heads of taxpayers, governments, and investors everywhere. But, as Mr. Abelson relates, JP Morgan's Jamie Dimon and Morgan Stanley's John Mack currently have public images only slightly less saintly than that of Florence Nightingale. Nor is Goldman noticeably incompetent, unlike its universal bank peers Bank of America and Citigroup. A pragmatic and striving lot, Americans love competence, but BofA and Citi are only regarded with contemptuous pity, whereas star performer Goldman is about as welcome in the public sphere as a dose of the clap.

Goldman has other natural advantages. It is immensely rich, and Americans admire rich things. Great wealth is commonly associated with virtue in this culture, if only because everyone wants to be rich. (Or so the advertising industry tells us.) Also, unlike many of its competitors, Goldman is a venerable American success story, headquartered in America. There are many foreign banks and investment banks like Deutsche Bank and Société Générale—which sucked as many billions from the public teat during the gang rape of AIG as Goldman did—which are just as big a target as the Squid. Americans love to bash Europeans (especially the French—hello?!), but it is Marcus Goldman's little commercial paper cart which has remained in the gunsights. Why so?

Well, one theory is that Lucas van Praag is just incompetent. Goldman Sachs may be as pure as the driven snow, and does not merit the slings and arrows sent its way by jealous journalists and pandering politicians. Or, perhaps less unbelievable, Goldman is no better but no worse than any of the other large financial institutions which helped drive the global economy into a ditch. It's just that van Praag is no good at getting the message out.

But this is not credible. His continued tenure as spokesman for the firm would require other senior management to be asleep at the wheel, powerless to influence the message van Praag's department conveys to the public, and/or excessively timid and fastidious about encouraging him to retire to a small private island. None of these are consistent with the image and behavior of ruthless, switched-on Masters of the Universe.

Another theory is that Mr. van Praag is actually fighting a clever and resourceful rearguard action. By slapping upstart journalists down hard and turning the messenger rather than the message into the story—normally a big no-no in public relations—he is distracting attention from other, potentially more damaging stories and revelations. He is consciously and intentionally sacrificing his reputation and political capital with the press for the good of the firm. This theory would be consistent with the type of selfless, jump-on-the-grenade culture Goldman prides itself on and demands from its employees. It would also be consistent with the conspiracy theories of the pitchfork-toting tinfoil hat crowd that Goldman Sachs is the Devil's own bank. In any event, I am afraid there will be no way to tell whether this theory is true until and unless someone unearths more bombshells.

* * *

My preferred theory is different.

I think van Praag is completely on-message. I think he is conveying exactly what Lloyd Blankfein and the other executive managers of Goldman Sachs want him to convey: that Goldman Sachs has done nothing wrong, that we deserve our fearsome reputation and our outsized compensation, and, if you don't like it, you can all go fuck yourselves.

This is a trader's mentality. A trader never apologizes. A trader never admits he made a mistake. A trader never says he's sorry. To do so, in his mind, would be to admit weakness. Another trader could use such an admission against him in the next trade. By the same token, a trader never sits back and takes it. If someone attacks him, he attacks back, preferably in greater strength, to discourage similar attacks from his opponent or others in the future. Perceived weakness is blood in the water in trading, and it attracts other sharks.

At the same time, a trader understands that all other traders behave in the same fashion, and he should not take sharp elbows or direct attacks personally. After all, most trading is conducted among a relatively small number of firms, among a relatively small number of traders, all of whom know or know of each other. At the end of the day, you've gotta shrug off your wounds and bruises from the battles of today and get ready to trade with the same bunch of assholes tomorrow. No harm, no foul. No hard feelings.

Goldman Sachs is run by traders. Lloyd Blankfein is a trader. Gary Cohn is a trader. Lucas van Praag's career at Goldman has coincided with the rise of traders into positions of power during the Great Moderation and credit boom. van Praag made partner in 2006, not too long after Henry Paulson, the last of the Goldman investment banking old guard—corporate finance client guys—left the CEO slot for Treasury. Traders already held most of the executive power by then anyway. Lucas van Praag has been running public relations at Goldman Sachs just like he would have for a giant institutional hedge fund. Because that's what it has been.

I suspect the disconnect in many people's minds—including mine, I must admit, on occasion—comes from the fact that Goldman perfected the image so many years ago of being a selfless, anonymous, client-first organization dedicated solely to their clients' success. Parts of it still operate that way, but the power and most of the money are made elsewhere. And it is made for Goldman alone.

* * *

Intentional or not, however, Goldman's current PR strategy is truly dangerous. It does not take into account that Goldman is simply too big, too interconnected, and, yes, too successful to behave like an arrogant Big Swinging Dick toward everybody. Most of its institutional trading counterparties probably don't give a shit. They probably think Goldman is just a big, powerful bunch of assholes, but they have to trade with it because it is the market axe. Besides, most of them probably figure they would behave in exactly the same way if they were in Goldman's shoes. Corporate clients have mixed feelings about the firm. A lot more of them than in the past truly distrust Goldman's size, power, and proprietary intentions, but a huge number still like having the 800-pound gorilla in their corner. Goldman's clients are not its biggest PR problem.

The rest of the world is. It has to figure out a better way of dealing with politicians, the press, and the general public than its current like-it-or-lump-it strategy. I fear the traders running the place do not understand that, while they are the biggest and baddest players in the global financial markets, who have to apologize or explain themselves to no-one, they don't control the game. Politicians and regulators do. (And they answer, at least indirectly, to the general public.) These are the people they have to appease. Or at least not piss off. These are the people who pay attention to Goldman's public communications strategy.

The Japanese have a saying: the nail that sticks up gets hammered down. Right now, Goldman Sachs is the biggest fucking nail on the board. And Lucas van Praag is the miniature douchebag standing on top of the nail yelling, "Nyah, nyah! Go ahead, hit me! I dare ya!"

Okay.


More Goldman goodness:
The Fish Stinks from the Head (June 30, 2009)
The Dirt Bag Chronicles (January 22, 2009)
Overheard at 85 Broad Street (June 18, 2008)

© 2010 The Epicurean Dealmaker. All rights reserved.

On Bullshit

I try to stay positive, Dear Readers, I really do.

I try to believe that any glimmer of illumination I can occasionally shed on the structure, function, and operation of global financial markets has a positive effect on the net stock of knowledge about my business out there in the world. Not only with you, my direct and regular audience, but also hopefully with unconnected and more distant intelligences like regulators, executives, and legislators who might collectively have the will and ability to change conditions for the better. Or at least not fuck them up so regularly.

But then I stumble on unmitigated codswallop like this, from industry lobbying group The Financial Services Forum, in response to President Obama's announcement today of new proposed regulations governing the banking sector:

The problem of ’too-big-to-fail’ isn’t that some institutions are large, it’s that there is currently no statutory authority to wind down a financial conglomerate in the way that the FDIC is currently authorized to unwind banks. More effective supervision, coupled with the authority to seize and wind down large firms, is the appropriate remedy ‘to too-big-to-fail’.

Large institutions provide significant value to customers – in the sheer size of credits they can deliver, in the array of products and services they can provide, and by their geographic reach – that smaller institutions simply cannot provide. This unique economic value is particularly important to large, globally active clients and contributes directly to economic growth and job creation. Large institutions are also far more diversified in their business mix as compared to smaller institutions, which tend to be engaged in fewer businesses and regions and, therefore, are exposed to greater concentration risk. In this regard, larger institutions are more stable than smaller institutions. Rather than being a source of risk, size can mitigate risk.

No, no, no. A thousand times no.

* * *

Well, okay, I do agree that some regulatory agency needs both statutory authority and the institutional capability (and cojones) to liquidate large financial conglomerates the next time one or more of them trip over their own dicks, which I guarantee will happen sooner than any of us expect. It would also be a pleasant surprise if someone in authority actually decided to supervise these mongrel idiots, instead of going on golf outings with them every six weeks and approving their regulatory fitness reports over cocktails.

But the assertion that large, multi-line financial conglomerates provide customers with services no smaller institutions can deliver is pure poppycock. The mid-1990s concept of globe-striding financial supermarkets has been completely discredited, most notably by their sad-sack poster child, Citigroup. Wholesale institutional clients make a point of using more than one investment or commercial bank for virtually all their financial transactions, no matter what they are. In fact, the bigger the deal, the more banks the customer usually uses. This is because banking clients want to 1) spread transaction financing and execution risk across multiple service providers and 2) make sure none of these oligopolist bastards has an exclusive right to grab the client by the short and curlies. Just look at securities underwriting data, for chrissakes: as the number of independent investment banks has shrunk (and their product lines, geographic reach, and balance sheets have swollen) over the past 20 years, the average number of book running underwriters per transaction has risen. This is not the result one should expect if one believes customers prefer to use giant universal banks as one-stop shops.

And the last argument—that larger size and greater diversity lead to lower risk concentration and greater systemic stability—is flatly untrue. In fact, the truth is quite the opposite, as these prescient words of wisdom from August 2007 demonstrate (emphasis added):

Now, to be fair, ... hedge funds did not invent the use of leverage in investment management, and they are not the only market participants who use it. Nevertheless, I think few would argue that hedge funds, in aggregate, deploy a great deal of leverage, ... in pursuit of higher returns. Much of this is direct leverage, in the form of margin loans borrowed from their prime brokers, the investment banks. But another substantial chunk consists of embedded leverage, which takes the form of structural leverage embedded in tradeable securities and derivatives. Often, hedge funds use margin loans to purchase and hold structurally levered derivatives, thereby compounding leverage upon leverage. This, as I am sure you will agree, can be a combustible mix.

Complicating the picture is another transformation in the market from previous practice, concerning the distribution of risk. Risk—fundamentally in the form of risky securities and derivatives—is widely believed to have become far more broadly distributed among investors, hedge fund and otherwise, than it used to be. A common example is the new paradigm for corporate loans. Where before commercial banks originated and held such obligations on their balance sheets for the duration of the loan, now commercial and investment banks originate, package, and distribute the lion's share of such loans to a broad universe of investors, thereby diffusing these risks throughout the system.

Some market pundits argue that this development (and analogous developments in other securities markets) has not only made the financial markets more efficient—by directing specific risks to those investors with particular appetites for them—but also safer, since the consequence of any one particular security or issuer blowing up should be more broadly and diffusely distributed across the universe of investors. Should Chrysler go belly up, the argument goes, a great many investors will feel a fair amount of pain, but no one investor or lending institution should blow up with it. Furthermore, the proliferation of hedge funds with different investment strategies means that there are plenty more investors out there to take the other side of losing trades. Shocks to the system should get dampened pretty quickly. Intuitively, these concepts make a lot of sense.

But if this is true, why does the recent meltdown in the subprime mortgage market seem to be spilling over into other, apparently unrelated securities markets, like those for corporate and high yield debt? Do investors really believe that subprime mortgage defaults in Florida and Las Vegas are going to affect Cerberus Capital's ability to repay the loans it wants to use to buy out Chrysler? Why has the blow up of Bear Stearns' subprime hedge funds put the kibosh on KKR's ability to issue debt to buy British pharmacy operator Alliance Boots? Whence this fabled "contagion" whereof everyone speaks? Wherefore the "flight to quality?"

Well, consider this. A fund with a highly levered balance sheet, and its investment fingers in many pies, is hit with losses in one of its sub-portfolios. Due to the nasty two-edged bite of leverage, its equity drops significantly, and the only way it can restore its risk profile is to raise more equity or liquidate some of its investments. Given the poor market conditions in the affected sub-portfolio, it is often more prudent to liquidate securities in other sub-portfolios. But this, as you can imagine, puts downward price pressure on securities in those previously unrelated markets. Presto, contagion. This is the "common holder" problem which some believe is the primary culprit.

Consider further. What if a substantial portion of our hedge fund's holdings consisted of loans to other investors—hedge funds, perhaps—whose own portfolios were experiencing losses? Well, then, "liquidating" those positions and reducing its risk exposure would look an awful lot like calling the loans, or reducing their outstanding balances. Finally, add this to the mix. What if our fund had another side to its business, which generated revenues from the origination, market-making, and placement of securities, which revenues were negatively affected by turmoil in some or all of the markets where it also had investments? Well, that would be a triple whammy, and our little hedge fund would look an awful lot like a prime broker investment bank.

Market-making investment banks are usually net long in many securities markets at any one time, so they are directly affected by declining liquidity and declining prices. Prime broker investment banks are also by definition long credit exposure to hedge funds and other levered investors, and when the portfolio values of those investors come under pressure, the risk and value of those margin loans goes up and down, respectively, forcing the prime brokers to deliver margin calls. (Unlike most hedge funds, clearing banks and securities firms are subject to intense regulatory oversight on their own creditworthiness, so they do not normally have the luxury of sweeping problems under the carpet, as some might suggest.) And finally, investment banks earn substantial fees from activities like M&A, securities underwriting, and securities placement, which all come under pressure in times of market turmoil.

Investment and commercial banks remain the primary transmitters of contagion in times of market stress, because they remain the central nodes through which the lifeblood of credit flows, and because they are exposed so strongly to both direct and indirect effects of market swoons. They remain the lenders of last resort—at least in the short term—as the gently swaying spans of tens of billions of dollars of hung equity and debt bridges can attest. And they are the quickest and fiercest enforcers of the risk reduction and delevering responses to market disruptions, because their own highly levered balance sheets keep them regularly poised on the edge of the abyss themselves.

* * *

So you can see, Dear Reader, what was already pretty obvious to me, mere months into what would turn out to be the greatest financial panic in generations: large, integrated investment and commercial banks concentrate contagion and risk in the marketplace. Sadly, even I was too naïve to realize our crack corps of financial regulators were missing in action, and the executive managements of these financial institutions were off smoking crack in the boardroom instead of minding the store.

But the point of my previous tirade stands: large, integrated, multi-line commercial and investment banks with fingers in almost every financial pie around the globe do not reduce systemic risk in the slightest. Instead, they comprise both the source and the pathway of contagion for systemic risk and potential breakdown.

Too big to fail banks are not the solution to our problems: they are the source of them. And no amount of PR bullshit will ever change this irrefutable fact.

Put that in your pipe and smoke it, Mr. Volcker.

© 2010 The Epicurean Dealmaker. All rights reserved.

Conventional Wisdom

The third-rate mind is only happy when it is thinking with the majority. The second-rate mind is only happy when it is thinking with the minority. The first-rate mind is only happy when it is thinking.

— A.A. Milne

A quotation is a handy thing to have about, saving one the trouble of thinking for oneself.

— A.A. Milne

Serendipity, O Dearly Beloved, can be a marvelous thing.

I was reminded of this this morning when I checked my super-secret email drop box and discovered a link to a recent post by Justin Fox over at The Curious Capitalist. In it, he poses the query: "Financial capitalism, what is it good for?" This is a good question.

The conventional answer, of course, is that Wall Street and financial markets' principal function in an economy is to intermediate capital flows; that is, to direct capital from those who have it—savers and investors—to those who would employ it in productive enterprise. Unfortunately, as Justin and the correspondent who triggered his ruminations point out, there seems to be a preponderance of evidence indicating that this in fact is not Wall Street's primary function; or, indeed, that if it is, financial markets have strayed disturbingly far from the true path.

I like what Mr. Fox and his interlocutor have to say, so I will beg your forbearance while I quote the article at length:

A reader (well, this Pulitzer-winning genius newspaper columnist of a reader), e-mails after reading my book:

From the very beginning of financial capitalism, the goal seems to have been to beat the market, which is to say, anticipate and profit the upside and downside of the market—not the industry or business of the stock traded. Basically, to make money on nothing, returning no value to the world. I always thought the goal of the stock market was to capitalize growing businesses so they could return value to the world. ...

Why didn't any of these smart guys, Fisher et al., realize that in developing various kinds of mathematical models to conceptualize the "market," they were succumbing to what seems to me a fundamentally anti-capitalistic temptation? To just be money traders and NOT makers of value. And when I look at high-speed, supercomputer-assisted trading that goes on today, squeezing out profit in the nanoseconds fluctuations in stock prices, I'm appalled. I also think big, mature companies—without reasonable expectation of growth—should get out of the market, because shareholders' spiraling expectations of profit almost inevitably hollow out value in the core company, and cause companies to make products cheaper, move labor off shore, etc.

Interestingly, that last paragraph sounds a bit like Michael Jensen's famous 1989 Harvard Business Review article 'The Eclipse of the Public Corporation.' ... Jensen argued that being publicly traded was a poor fit for big, mature companies. More controversially, he argued that leveraged buyouts—what we now call private equity—provided the perfect solution to this problem.

But that's not really the main point my reader was trying to get at. It's that a big share of financial market activity doesn't seem to generate any real value for the rest of the economy. Everybody agrees that raising money for new ventures is important for the economy, but such fund-raising constitutes only a tiny portion of Wall Street activity. The rest can only be justified as (1) providing liquidity, so the economy's actual creators of value are able to cash in on their efforts and (2) allocating capital efficiently, by correctly setting the prices of financial assets.

Financial markets clearly aren't very good at (2), at least not on a short- to medium-term basis. Case in point: the fact that worthless "old GM" currently has a market cap of $500 million. I doubt anybody else (government, for example) would be any better at it. But I don't buy that today's financial markets are much more efficient (in the capital-allocation sense) than the vastly smaller markets of 40 years ago—which leaves only liquidity provision as justification for the giant size of our financial sector and the giant paychecks pulled down by some of those who labor in it.

These are interesting points, and they are worthy of further thought. Let me take you on a brief detour, and we will return to them later in the post.

* * *

Now for the serendipity part.

Repeat visitors to this site will remember I recently published a post in response to an article by Paul Krugman bemoaning the apparent ignorance or disingenuousness of investment bank CEOs about the sources of our recent financial travails. In it, I explained that—notwithstanding the irrefutable fact that these gentlemen (and most investment bankers) rank quite high in conventional measures of intelligence and achievement—they do not concern themselves with foundational issues such as these. In fact, senior investment bank executives are almost universally and intentionally ignorant of such matters. Instead, they focus their limited time and considerable energy and intellect on wrestling with competitors and colleagues over the swollen heaps of money which fall out of their firms' participation in the global financial markets. This, when you think about it, is not entirely unpredictable.

I also explained that the fast pace and high pressure of the business tend to attract individuals who do not attach great importance to deep, theoretical, or introspective thought. Rather, quickness of intellect, nice interpersonal judgment, and a certain calculating capacity akin to the ability of practiced chess players to think several moves ahead are the most valuable and prized attributes in my industry. What I did not explain was the natural corollary to these observations; namely, that due to their vocational preoccupations and intellectual predispositions, investment bankers tend to be extremely adept and quick at sussing out and acting on what is commonly known as the conventional wisdom.

This should not be surprising, either. After all, investment bankers spend all their waking hours figuring out and relaying to clients what "the market thinks" about deals, securities, and prices. Investment banks are gatekeepers to the markets, whether underwriting securities, trading financial instruments, or structuring and executing mergers and acquisitions. And what is the market itself but a gigantic, multi-tentacled, complexly interlinked engine for the real-time calculation of conventional wisdom? Figuring out, anticipating, and shaping conventional wisdom is what investment bankers do. It is the ocean in which we swim.

In any event, I decided to publish a follow-on post expounding this very argument, as part of my ongoing public penance for participating in the organized institutional rape of Main Street. I intended to illustrate it with a recent piece by Graham Bowley at The New York Times on the challenges facing the new CEO at Morgan Stanley. For my purposes, this article possessed the singular virtue of illustrating not only the peculiar (and different) forms of intellectual firepower which John Mack and now James Gorman bring to the task of managing that venerable investment bank, but also how one can ascribe much of that institution's recent success, failure, and near death to its on-again, off-again romance with the conventional wisdom of how to run a global investment bank. (For the record, they were massively criticized a few years ago for not following the herd and increasing risky proprietary trading activities early in the credit bubble and massively criticized—and nearly bankrupted—recently for barreling whole hog into those same activities right before the bubble burst. Sometimes you just can't win.)

Naturally, I began to search for a pertinent quote to headline my treatise, as is my usual practice. I recalled an appropriate aperçu by John Maynard Keynes:

Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

I directed myself to its source, Chapter 12, "The State of Long-Term Expectation" in that economist's magnum opus, The General Theory of Employment, Interest and Money, in order to verify its exact phrasing and provenance. What I found there instead, to my surprise, was one of the most perceptive dissertations I have read on the nature, benefits, and drawbacks of financial markets themselves. In particular, Keynes fields a perceptive and devastating critique not only of the ineluctable hold of conventional wisdom on financial markets, but also of the natural tendency of markets to devolve into an unhealthy preference for liquidity over long-term investment.¹

Writing nearly three quarters of a century ago, it turns out that John Maynard Keynes has just the answer to Justin Fox's questions.

* * *

For the purposes of our discussion, I think it is fair to interpret Keynes as ascribing the key characteristics of financial markets to two main underlying causes: our fundamental ignorance of the future and the separation of ownership of productive enterprise from its management. While the latter, as realized in the form of financial markets, theoretically broadens the base of investment capital available to businesses in search of it, it also paradoxically increases investors' aggregate ignorance of the true value and prospects of the enterprises in which they invest, since they no longer enjoy the insight of the people who manage such enterprises day to day. In combination with our natural tendency to project current conditions uncritically into the future—which Keynes decries as unrealistic but acknowledges to be the only sensible course open to us—this leaves financial markets overly sensitive to short-term fluctuations in sentiment and opinion.

Thus markets, he argues, evolve inevitably into echo-chambers: self-referential fora for determining and anticipating conventional wisdom. His argument is worth quoting at length:

It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it “for keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.

...

This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional; — it can be played by professionals amongst themselves. Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. ...

Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

* * *

It is clear that Keynes was not an uncritical fan of financial markets. It is also apparent he did not trust market prices to be clear and reliable measures of long-term value of underlying investments. So what does this have to say about the second proper function which Mr. Fox assigns to markets in general, "allocating capital efficiently, by correctly setting the prices of financial assets," and his example of "worthless 'old GM' [having] a market cap of $500 million"?

Well, I have no interest in arguing that the long-term fundamental value of Motors Liquidation Company is measurably greater than zero. I imagine few rational investors would. However, you do not need to see any long-term value in old GM to make a case that its equity could be "worth" $0.64 per share, as it traded today. All a rational speculator would need to assume is that sometime in the next 30 days MTLQQ could trade 1) at a price above $0.80 per share, as it did earlier this month, and 2) on sufficient volume that he could sell his entire position at that price. Successfully done, such a Hail Mary pass could generate a nominal return on investment of 25% or more in less than 30 days, which is a hell of a risk-adjusted return in my book. Such a speculative investment depends only on short-term sentiment—including the necessary existence of numbnuts willing to buy the stock at eighty cents—and market liquidity. MTLQQ is simply a far-out-of-the-money option, and all a prospective buyer of it really bets on is random Brownian motion and the ability to monetize it.²

So, in fact, market liquidity itself can indeed create or abet silly price signals in the market, which in turn can distort the proper allocation of real capital in the real economy. Sometimes, as in the dot com boom, these silly signals can persist for very long periods of time. But, as Keynes himself might have said, just because trees have never grown to the sky in the past doesn't mean it's not rational for us to assume a growing tree will continue to grow. In the short term, at least.

I will venture to say that Keynes would not have been a popular investment adviser.

* * *

Neither was he uncritical of market liquidity:

Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelop our future. The actual, private object of the most skilled investment to-day is “to beat the gun”, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.

But Keynes did acknowledge that liquidity broadens access to capital from investors who might otherwise demur from supplying it:

[The] liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment. For the fact that each individual investor flatters himself that his commitment is “liquid” (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk. If individual purchases of investments were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma. So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing actual capital assets cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and knows very little about them), except by organising markets wherein these assets can be easily realised for money.

So, really, Mr. Fox is incorrect when he asserts the first function of financial markets should be "providing liquidity, so the economy's actual creators of value are able to cash in on their efforts." Actual creators of value, in the form of entrepreneurs and business owners, can get liquidity any day of the week, in the form of a check for all or part of the business they own. They do not need public markets for that. All they need is a buyer with enough cash and a good lawyer.

Instead, the true purpose and value of liquidity in financial markets is to reduce investors' uncertainty. It does this first through the regular publication of price data, which serves as a relatively reliable (but: see above) proxy for the true current value of their investments. Second, it reduces investors' uncertainty as to their ability to exit from their investment when they so choose. Together, these two effects turn what might be a long-term bond or permanent equity capital into what looks like a series of rolling, short-term investments with reasonably good pricing certainty. Ceteris paribus, a rational investor should require a lower expected return on such an asset. (Tell me, by contrast, that I cannot sell Apple Inc. stock before 2015, and I will be willing to pay a lot less than current market price for it and will expect a commensurately higher return. I do not think I am unusual in this regard.)

Therefore, at least in theory, market liquidity should reduce the cost of capital for businesses which require it. There is good evidence supporting this from the opposite example of private equity, which ties up substantial chunks of equity capital in entire businesses which it closely oversees for many years. Required returns in the private equity market have always been well in excess of those prevailing in the public equity markets. Call it, if you will, a premium for lack of liquidity. That this liquidity effect on cost of capital dominates the countervailing fact that private equity typically has far more intimate knowledge of the business prospects and actual potential value of its investments than the typical public shareholder can be seen in this positive differential. If it were not so, we should expect to see required returns from illiquid, intermediate investments in private companies to be the same or lower than those required in the less-informed public market.³

* * *

So, financial market liquidity broadens the availability and and likely lowers the cost of investment capital, at the price of increased volatility, unproductive speculation, and increased noise in the public signals about productive enterprise value. Whether you find this a worthwhile trade-off probably depends on your own position and interests in the markets. But Mr. Keynes says more.

He claims that the very difficulty inherent in true long-term investment behavior—like that practiced by Warren Buffett in our time—and the greater ease and potentially even greater (short-term?) profitability of speculative investing will combine, over time, with increased market liquidity—which, in fact, facilitates speculation to a far greater extent than long-term investing—to shift more and more of the market's activity toward pure speculation.

Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. Moreover, life is not long enough; — human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money — a further reason for the higher return from the pastime to a given stock of intelligence and resources. Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks.[4] For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

And, in fact, that is what we have seen over the past thirty years: markets have ballooned into giant souks where speculative activity dwarfs pure investment. Keynes wrote primarily about equity markets, but the financialization of markets has spread like kudzu across the entire landscape. Mortgages, corporate loans, physical assets, commodities, and credit assets in general have become liquified and atomized and repackaged and securitized in a billion different ways, aided and abetted by the Lego-like building block technology of derivatives and armies of eager investment bankers. All markets have become liquid, but at what price?

Arguably a leading reason why the mortgage and credit markets imploded in 2007 and 2008 is because newfound liquidity enabled the separation of ownership from management of the underlying assets. (Sound familiar?) Lenders (investors) no longer had to own or even manage (service) the loans they originated. Banks no longer had to underwrite and screen mortgages or corporate loans as if they planned to hold them to maturity, as they once did: they bundled them up and sold them off instead. A passel of morons in Mayfair wrote billions of dollars worth of naked puts on CDOs they didn't understand because the markets and their counterparties made it look like free money. Hedge funds who took a negative view on a company could purchase credit default swaps in amounts which dwarfed not only the company's entire outstanding debt but also its entire enterprise value. Everybody outsourced credit analysis and credit judgment to the ratings agencies, which were more than happy to take a fee for telling everybody what they wanted to hear. Aggregate market liquidity went up, and aggregate investor knowledge went down. Everyone became a market maker. (That, at the margin, is what a speculator is.)

Naturally investment banks swelled like a tick on a dog in this environment. Increased liquidity begat increased volume, which begat more investment bankers earning more money for moving value from one pocket of the global economy to another. (Productivity in terms of volume of deals per banker always lags overall market growth.) It didn't matter to them where the money was going, or if it was doing anything truly productive on the way. That wasn't their job to worry about. They just had to make sure the moolah got from column A to column B intact and on time.

And, of course, take their cut off the top.

* * *

But here's the thing about liquidity, as we have quoted Mr. Keynes before:

[Each] individual investor flatters himself that his commitment is “liquid” (though this cannot be true for all investors collectively)

and

there is no such thing as liquidity of investment for the community as a whole.

No matter how much liquidity a market boasts, it will never be enough when everybody wants to get out at once. Mr. Fox is correct to say opacity and poor organization accelerated the freeze-up of derivatives and debt securitization markets and exacerbated their collapse. But transparency and better documentation would not have prevented it.

In his piece, Keynes ventures the opinion that regulators should impose external transaction taxes, or mandatory holding periods, to counteract the pernicious effects of creeping liquidity and speculation on financial markets. Whether these are appropriate ideas or not I will leave for other minds and another day to discuss. What I will say is the prescription for regulation of both investment banks and financial markets is clear: you cannot rely on the participants to regulate themselves. We are too busy counting the paper and inflating the bubble to care. The answer must come from outside the bubble, where the real economy and society lives.

But please, whatever you do, don't take too long. We are depending on you for answers.

"I don't see much sense in that," said Rabbit.
"No," said Pooh humbly, "there isn't. But there was going to be when I began it. It's just that something happened to it along the way."

¹ For those of you already familiar with Mr. Keynes' magnum opus, I apologize for my novice's excitement. While I was familiar in outline with the basic contents of his argument, I must admit I had previously included the GTEIM on my list of Extremely Important Books Which I Really Must Get Around to Reading One Day. I never said I was perfect. (Did I?)
² IMPORTANT DISCLAIMER: For God's sake, please understand that this simplistic example is an illustration, not an actual investment recommendation. Don't even think about taking anything on this site as investment advice. I am deadly fucking serious. Christ.
³ I am ignoring, of course, the positive return differential to private equity which should arise from the extra financial risk of debt assumed in leveraged investments. I am not aware of studies which quantify such an effect, but they may exist. Nevertheless, my intuition that a term structure of required returns on equity exists for most investors—if only implicitly—still stands.

© 2010 The Epicurean Dealmaker. All rights reserved.