What is to be done?

There are reports this morning of a done deal on Capitol Hill. The degree of concord may again be over-stated.

Nonetheless, the wisest discussion I've yet found of how policy makers might overcome the Wall Street crisis, how they might in the process "save capitalism from the capitalists," is that set out here on the faculty page of a professor at the graduate school of business, University of Chicago.

Dr. Zingales sees the issue as one of an expedited bankruptcy proceeding. In bankruptcy, what happens is that equity is wiped out, and debt is traded for equity. This means that those who had control of the enterprise formerly take the first wave of loss, and those who had lent them money move into the position of greatest risk, and of greatest control moving forward, vis-a-vis that enterprise.

We can not wait for bankruptcy proceedings to move forward in the case of the investment banks of Wall Street. There simply isn't enough time. But that doesn't mean that the principle should be scrapped.

There is no need to put taxpayers on the hook at all. The stockholders of the investment houses at issue must logically take the loss, and the bondholders must step up to the plate, in a way that maintains continuity for the counter-parties of those institutions.

Janet Tavakoli, an influential consultant, the principal of Tavakoli Structured Finance, is echoing Dr. Zingales' message, as she does here for example.

I'm happy to be counted in their number.

[Note: By use of the term "echo" I didn't mean to make a judgement about chronological priority. Ms Tavakoli reminds me that she advocated related views more than a year ago, as here. All who advocate a debt-for-equity swap as a crucial part of the proper government response to this situation are taking the truly capitalistic side, whatever the chronology of it. Call it 'echoing' one another without chronological presumption.]

Deregulation as a Scapegoat

No debate analysis here. I don't do tactical campaign stuff.

I do want to take a look at the notion, though, broached by Obama, that "deregulation" is the cause of the present Wall Street crisis. I think that a mistaken diagnosis, and reform instituted on such a premise will likewise be mistaken.

The current Wall Street crisis appears to have taught many of our nation’s politicians that every important piece of financial deregulation in the last thirty years has been an error. In this scramble to ‘learn from our mistakes,’ each of several measures – each blameless, and each indeed a forward step for the U.S. and world markets – has come under fire.

I refer for example to: the securitization of mortgages; the abolition of the walls that for decades kept commercial banking apart from investment banking, and that kept both sorts of banks isolated from insurance companies; the exemption of over-the-counter derivatives from a regulatory system designed for standardized exchange-listed products; the abolition of the uptick rule. Of those changes only one, the the abandonment of the uptick rule, can be blamed upon -- or credited to -- this administration. These are all the new “usual suspects,” rounded up when something has gone wrong in “Casablanca.”

In order to think straight about such matters, we might begin by abandoning the label “subprime crisis." Yes, subprime mortgages are inherently risky. That's what the word "subprime" means, after all: more risky than prime. The current troubles may early on have taken the form of a subprime problem, but if it had been only or chiefly that they would have long since have settled down.

What we have is the aftermath of a credit bubble. That bubble burst, which is what bubbles do. The bursting in turn caused an equity bubble to do likewise, because the equities are so leveraged. That, in turn, is inspiring moronic socialistic moves by alleged free marketers.

One key lesson is never learned, however often this sort of drama plays out: that what causes a bubble to burst is precisely the fact that it has been blown. The seeds of the bust are always planted by the boom. Only in October weren’t some of the administration’s admirers complaining that it wasn’t receiving enough credit for the record-high stock market index figures of that time? The Bushies should get exactly as much credit as they are willing to shoulder blame: because the Dow 14,000 of October is one facet and the Dow 11,000 of the following September is another facet of the same fact, the fact of boom-bust psychology.

Question: what is it that markets are good at?

Answer: aggregating information. Any price (whether the price of a barrel of crude oil, a newly manufactured pencil, or a share of equity in a corporation) expresses information. It either does so accurately (and keeps the whole productive system humming) or it does so inaccurately (and throws sand into its gears).
Leonard Read’s famous 60-year-old fable about the price of a pencil makes this point marvelously well.

Let’s observe, while we are so close to the point, that the Securities and Exchange Commission’s decision to impose an emergency ban on short selling was idiotic. Capital markets are obviously less efficient without shorting than they are with it, simply because shorts bring information to the table.

At any rate, every one of the deregulatory moves listed above was a good idea, one that smoothed the flow of information into prices, and so assisted the optimal alignment of incentives throughout the economy.

The risks inherent in subprime mortgages, and in the instruments built from them, are in principle familiar and manageable. Why have they not been managed? Because there are a lot of new restraints on the free flow of information that impeded that risk management task. None of these restraints by itself would have been disastrous, but they’ve had a cumulative effect. Consider the condition of an artery near the heart of an over-eater. It is hard to say which donut is fatal. But in sum, they are. They create the arterial gunk that will block the flow of vital blood/oxygen/information to tissue that needs it.

Gordon Crovitz had a fascinating op-ed piece on this subject in Monday’s [Sept. 22]Wall Street Journal, under the headline, "Information Haves and Have-Nots."

The money quote. "There are now about half as many Wall Street analysts as in 2000. Former New York Attorney General Eliot Spitzer eviscerated the profession with $1.4 billion in settlements and a new mandate for how the industry would be structured, which made the analysts uneconomical....The now-former senior executives at Bear Stearns, Lehman and Merrill must wish they had been able to retain all those star banking analysts."

Another Spitzer legacy that has contributed to our present troubles was his Ahab-like pursuit of Hank Greenberg, effectively kicking him out of the executive suites of the insurance company Greenberg did so much to build -- AIG.
Other issues that contributed to the crisis: a ramping up of insider-trading prosecutions (including a perp walk for Ralph Cioffi and Matthew Tannin in June). The people who are deterred from trading by insider trading prosecutions are being who are … the best informed. The whole idea of criminalizing such trades strikes at the heart of the real function of markets.

Further, there is room for concern that the federal bankruptcy courts have become part of the problem. This March, Judge Posner, of the 7th circuit court of appeals, suggested that bankruptcy trustees need to be reined in, writing: “While the management of a going concern has many other duties besides bringing lawsuits, the trustee of a defunct business has little to do besides filing claims that if resisted he may decide to sue to enforce.”

In particular, trustees have become quite aggressive of late in pressing claims for fraudulent conveyance. The result is that counter-parties to any institution that may even be close to bankruptcy, which may even be rumored to be close to bankruptcy, have gotten very jittery. Why set one’s self up to be the defendant in a lawsuit brought by the next aggressive trustee?

It is a legal climate that encourages “runs on the bank,” and that is what we have gotten.

So the right lessons to draw emphatically aren’t lessons about how deregulation has “gone too far.” Nor are they lessons about the GSEs, or about the greedy golden-parachute-endowed CEOs.

No. The right lessons to draw are that the information arteries in the U.S. market system have become clogged, and after the immediate crisis has passed, the U.S. will have to take up a new metaphorical diet to keep that from happening again.
In the meantime, though: what is to be done? How can the immediate situation best be addressed?

I'll have something to say under that heading tomorrow.

The Scandalously Wimpy New York Times

All the news that might not give offense.

Here's a correction The New York Times ran yesterday:

A front-page headline on Wednesday with an article about Warren E. Buffett's plan to invest $5 billion in the Wall Street investment banking firm Goldman Sachs described that company as "ailing." While its stock has been battered and it has agreed to tighter government regulation and wants to raise more capital from investors, "embattled" would have been a more accurate headline description of Goldman's state than "ailing."

What kind of letter did a Goldman lawyer have to write to get that "correction"?

Anyone who thinks that "ailing" is an unfair term to apply to Goldman Sachs just isn't paying any friggin' attention!

It seems clear to me that TNYT wants to occupy the niche of utter gutlessness.

They should, as my older brother likes to say, "man up," at least to the minimal extent of calling an ailing bank ... an ailing bank! without apologizing for it. This is so classically "wimpy" one expects the editors to head out to a cheeseburger joint, offering to pay Tuesday for a cheeseburger today.

Pedantic note. "Embattled" is an odd word. Nowadays it is often used as the author of that wimpy correction seems to mean to use it, to mean "battered by battles."

But there was a time when it meant -- and it sometimes still means -- "prepared for battle".

Remember the poem Ralph Waldo Emerson wrote about the minutemen at Concord in April 1775?

By the rude bridge that arched the flood,
Their flag to April's breeze unfurled,
Here once the embattled farmers stood
And fired the shot heard round the world.

He is describing the farmer/soldiers just as the battle was to start. So "embattled" doesn't mean battered. It means "ready to take what battering may come in the impending battle."

The shot heard round the world refers to the FIRST shot of that battle, logically. And they were already "embattled." So the term has the meaning of "in readiness."

As always, when I make these semantic points, I do so to serve a substantive point. The Times is complciit in hiding the fact that the bankers of Wall Street today aren't "embattled" in the right sense, the Emersonian sense. They aren't ready to do battle like proper entrepreneurs with a risky world.

A wimpy press of this sort is proper for a monarchy, not for the descendants of the farmer who fired that shot at Concord in defiance of a monarch.

That's a scandal.

"The mountains are high"

There's an old Cantonese saying: The mountains are high and the Emperor is far away.

It means what the late American politician Tip O'Neill also meant when he said, with less imagery but greater concision, "All politics is local."

I encountered this proverb in a novel recommended to me by a friend, Fragrant Harbour (2002) by John Lanchester. It comes into play there because one of the characters, Matthew Ho, runs an air conditioner manufacturing business, headquartered in Hong Kong but with certain crucial investments in Canton, the province of mainland China surrounding that special administrative region.

Matthew's investments run into trouble, of a sort that's make-or-break for his business as a whole. He tries to threaten a provincial official with the prospect of goig over his head to Beijing, only to be told: "The mountains are high and the Emperor is far away." We do our own thing around here, buddy.

Read about Lanchester's novel here or just admire the front cover above.

To test whether the proverb was perhaps the product of Mr. Lanchester's imagination, I did manage to drop it into a conversation I had with a businessman while I was in Hong Kong recently. He recognized it, and seemed pleased that I knew of it.

The idea that the southeast of China does things differently, that the mountains are high, etc., long predates the arrival of the Brits in the region. It may date to a Mongol invasion of China in the 13th century. As the Mongols conquered the north, the remnants of the Song dynasty retreated into what Canton. Though the Mongols eventually ended resistance there, too in one of the largest naval battles of history, and the Cantonese had to recognize Kublai Khan as their emperor, they may have begun soon thereafter to take solace in the idea expressed in the proverb.

He's up there in his "stately pleasure dome," and we're here shaking down air conditioner makers.

Tony Blair at Yale

The former prime minister of Great Britain, Tony Blair, is now a Roman Catholic.

That's old news? Well, maybe. But here's something a bit newer: he's also now a lecturer on religion at Yale University.

It's a part time gig. He'll deliver five lectures a year for three years, in return for a nominal fee and a donation to his foundation.

In his honor, then, here's a quotation from The Varieties of Religious Experience, on the appeal of the Church of Rome.

"To intellectual Catholics many of the antiquated beliefs and practices to which the Church gives countenance are, if taken literally, as childish as they are to Protestants. But they are childish in the pleasing sense of 'child-like,' -- innocent and amiable, and worthy to be smiled on in consideration of the undeveloped condition of the dear people's intellects. To the Protestant, on the contrary, they are childish in the sense of being idiotic falsehoods. He must stamp out their delivate and lovable redundancy, leaving the Catholic to shudder at his literalness."

Why Read the Classics?

This is a wonderful passage from the book BEGIN HERE, by Jacques Barzun.

But why, after all, learn to read differently by tackling the classics? The answer is simple: in order to live in a wider world. Wider than what? Wider than the one that comes through the routine of our material lives and through the paper and the factual magazines—Psychology Today, House and Garden, Sports Illustrated; wider also than friends’ and neighbors’ plans and gossip; wider especially than one’s business or profession. For nothing is more narrowing than one’s own shop, and it grows ever more so as one bends the mind and energies to succeed. This is particularly true today, when each profession has become a cluster of specialties continually subdividing. A lawyer is not a jurist, he is a tax lawyer, or a dab at trusts and estates. The work itself is a struggle with a mass of jargon, conventions, and numbers that have no meaning outside the specialty. The whole modern world moves among systems and abstractions superimposed on reality, a vast make-believe, though its results are real enough in one’s life if one does not know and follow these ever-shifting rules of the game.

Insanity

The relevant regulators in the US and the UK have both now indulged themselves in the ultimate in knee-jerk reactions.

They've banned short selling in a wide range of stocks. Just to be clear: they haven't banned "naked" short selling, or "abusive" short selling, or closed any loopholes on the existing regulations that govern the practive.

They've banned short selling. Full stop. This is the logical equivalent of prohibiting pessimism.

Here's the SEC's press release.

And here's the counterpart from the other side of the Pond.

I have long believed that the history of the United States breaks down into a series of distinct equilibria. Leaving the colonial and revolutionary eras out of account, there have been three republics.

The first began in 1787 and lasted a little more than 70 years, then collapsed into a period of turmoil and civil war.

The second began in 1868, with the enactment of sweeping new amendments that made in effect for a new Constitution. This second republic lasted about 60 years. It, too, collapsed dramatically.

The third republic was up and running as of 1937, when Roosevelt's court-packing plan induced the Justices to acknowledge sweeping new interpretations for the Constitution. It is this third republic that is now crashing in upon us, and the ban on short selling is a sign of that.

You WILL BE CHEERFUL about stock prices. Washington (and London) command it!

The next logical step is a ban on any trade whatsoever at a price lower than the preceding trade on that asset. Unless, maybe, the asset in question is made out of hydrocarbons, in which case that might be reversed.

A hypothetical television commercial comes to mind.

"Crazy country. We'll sell you appliances. We'll make up prices. We'll order ourselves about like we're in a Three Stooges short. Crazy country. Our rules are ... INSAAAAANE!"

Antietam

Yesterday, September 17, was the 146th anniversary of the bloodiest single day in the history of the United States.

For on September 17, 1862, Union and Confederate forces met just to the east of Sharpsburg, Maryland, along a creek known as Antietam.

What might have happened had Lee forced McClellan to retreat from that ground on that day? Assume for example that the union retreat had been managed in good order, and that the Army of the Potomac kept itself thereafter between Lee and the district of Columbia. Assume then that although Lee won the battle, his hypothetical win was itself short of a "knockout."

Still, a victory for Lee's army that day might have been of enormous importance in persuading the UK and France to enter to war on the side of the rebs. It might have been, thus, through diplomatic indirection, a knock-out after all.

Here's a link to a map of the clash.

Back to real time

The next you'll hear from me on this blog will be this Thursday, the 18th.

And that will be an entry written Thursday. This is the last of the pre-scheduled doohickeys.

Since yesterday's entry compared subway maps with medieval art, we might as well continue that throught today.

Here's a well-written passage from the pen of Henry Adams, speaking of Gothic art and architecture in general, although with Chartres in mind especially.

"No two men think alike about it, and no woman agrees with either man. The Church itself never agreed about it, and the architects agree even less than the priests. To most minds it casts too many shadows; it wraps itself in mystery; and when people speak of mystery, they commonly mean fear. To others, the Gothic seems hoary with age and decrepitude, and its shadows mean death."

For himself, and for his receptive reads, Adams says a little further on, "our amusement is to play with it, and to catch the meaning in its smile; and whatever Chartres may be now, when young it was a smile."

If all is going well

My travels are now far advanced.

In recognition of that fact, I thought that for this day I'd post a subway map, and a link to another.

The above map is for the subways of Seoul, Korea.

The link here will take you to a similar map for Hong Kong.
I love the stylization of such maps. They remind me of medieval art, before naturalism or even before perspective.

A subway map is like the Bayeau Tapestry a bit of which is here. for your own comparative purposes!

Spector's Retrial scheduled for October

I haven't been following the legal proceedings with regard to the once-renowned record producer Phil Spector and the death of Lana Clarkson.

I did follow the trial last year, and the more retentive of you may recall that I wrote some posts on it here. The upshot was that the jurors couldn't reach a verdict, and the judge dismissed them last September.

Here's a link to what the BBC had to say about it at the time.

The latest, though, is that after a lot of manuveuring it appears the re-trial will commence in October.

The re-trial is never as much trashy fun as the original.

Delphi liquidation

In early August, General Motors agreed to yet another infusion of capital into bankrupt auto parts manufacturer Delphi. Specifically, it said that it would increase the size of an expected loan from $650 million to the $950 million now seen as the minimum in liquidity for any newly viable Delphi.

The background to all this, aptly described in a recent book on America's pension crises by Roger Lowenstein, takes us at least as far into the hinterlands of memory as 1950.

That was the year of a crucial settlement between GM and the United Auto Workers union under Walter Reuther. GM felt flush at that time. It had earned record profits in 1949 and had just declared a stockholder dividend of $190 million. Only labor unrest could disturb its serenity, and it decided to buy off the union by picking up half of the tab for the members' hospital and medical insurance, and offering a pension of $125 a month—the equivalent of $1,040 a month in 2008 dollars.

Fortune hailed this as "the Treaty of Detroit." In his 1963 memoir, Alfred Sloan, who was GM's chairman at the time of this "treaty," patted himself on the back over introducing "an element of reason, and of predictability" into GM's labor relations.

But it was easy to fudge the issue of adequate funding for those promises. This became easier in subsequent contract talks, when the issue wasn't creating a pension system but embellishing the benefits offered in the existing system.

Forward now quickly to 1999. It was in that year that GM spun Delphi off into (nominal) independence. It was also the year that an analyst at Goldman Sachs analyzed the significance that pension numbers had come to hold for the parent. The analyst, Gary Lapidus, concluded that 90% of GM's value was committed to its retirees.

"For various reasons," Mr. Lowenstein wrote, "Delphi was even less prepared the handle the legacy burden than General Motors. Its pension plan, $1.7 billion in the red at the time of the spin-off, had been falling deeper in the hole ever since. Delphi was a strange creation—a newborn conceived with the hardened arteries of an old man."

The spinoff and the continuing mutual dependence of Delphi and GM meant that the same losses, required by pension and health benefit obligations, that otherwise would have accumulated within a single corporate entity were now split between two. Mr. Lowenstein cited estimates that Delphi has been producing spark plugs for $2.05 each. The same plugs can be purchased in China for $1.05. By contract, GM buys them from Delphi for $1.70. Each party to the supply contract is suffering a loss. GM is paying 65 cents more than it otherwise would, and its supplier is losing 35 for the privilege of making the sale.

GM's management seems increasingly to be coming around to the conclusion that the federal government should take health care costs off its hands through a nationalized insurance system. In a 10Q quarterly report filed with the Securities and Exchange Commission in May 2006, the company said that it "will support public policies at the federal and state level that will enable all Americans to have health insurance."

All this provides background for a story that appeared in the Wall Street Journal on August 29. Despite even the latest agreement by GM to up its ante, there may bot be any feasible re-organization plan for Delphi on the horizon. It might be necessary for the court to liquidate Delphi, and in the process to return its physical assets, the plants, to the parent company.

The pension obligations already vested would presumably go back to GM's balance sheet as well. As Batman said (back when "Batman" was a corny television show, not an increasingly dark movie franchise): "Sometimes you just can't get rid of a bomb."

For the law students out there

A new semester has begun, and perhaps there are some amongst my readers who are currently in law school (as I was more than a quarter century ago). Amongst you in turn there may be one or two starting the second year, which means you're taking an Evidence course.

All those hearsay exceptions can get awful confusing. Gotta love YouTube.

Frederick Douglass

Here's a neat quotation from Frederick Douglass, assessing Abraham Lincoln's role in the end of slavery in the US.

Thanks to my friend Henry Cohen, in whose review of a recent book on Lincoln I discovered this.

"Viewed from genuine abolition grounds, Mr. Lincoln seemed tardy, cold, dull, and indifferent; but measuring him by the sentiment of his country, a sentiment he was bound as a statesman to consult, he was swift, zealous, radical, and determined."

A timeline for the fall of Barings Bank

Feel free to correct me. It's a story with some moss on it, having passed from "journalism" to "recent history," but it intrigues me.

Feb. 25, 1967, Nick Leeson is born. His first home was in Orbital Crescent, North Watford, to the northwest of London, off M1.

1985-1989. During this period, Japan's "bond warrants" market accounted for most of the earnings of Barings Securities. Japanese companies had discovered they could get a substantial discount on the interest cost of bonds if they offered a sweetener, a "warrant" -- a long-duration stock option -- with the bond proper. Due to the relative lack of transparency the market for these warrants was inefficient and allowed an informed trader to make a steady income. This income fueled the ambitons and expansion of Barings in the far East.

1986. Trading began at SIMEX (Singapore International Monetary Exchange) on futures contracts written on Japan's Nikkei 225 index.

1987. Ian Martin becomes the finance director of Barings Securities. Martin will create the Business Development Group (BDG), a corporate trouble-shooting outfit.

1988. Nikkei futures contracts begin to trade on the Osaka stock exchange. Over the following years, there will be small discrepancies between their value in Osaka and the value of the same contracts in Singapore on the SIMEX, creating opportunties for arbitrage.

July 1989. Leeson joins the settlements department (the back office) of Barings. In London.

1990. Leeson, now part of Martin's BDG, is sent to Jakarta, Indonesia, because their back-office has become a tangle of never-completed settlements.

Sept. - Oct. 1991. Leeson, now credited with a success in Jakarta, is given another assignment back in London. Investigating an apparent fraud in derivatives dealing. This, too, enhances his standing in the firm.

Feb. 1992. Leeson applies for a City of London trading license. Some questions arise relative to a judgment against him in a county court, and the application never goes through.

March 1992 Leeson marries Lisa Sims, also a Barings employee. they honeymoon in Venice.

April 1992, Nick Leeson is posted to Singapore, to run the back office of the SIMEX operation there.

July 1992, a software technician establishes account 88888 for Barings at Simex, an "error account." Leeson soon excludes it from all reporting lines.

Late 1992, Leeson takes an exam and becomes entitled to take trade on the SIMEX floor. This means he was hereafter both making and settling trades -- a fateful set-up.

March 1993, Barings senior management is restructured. Longtime head Christopher Heath is out. Peter Norris is in as CEO.

October 1994, Mary Walz, head of Equity Derivatives, starts asking questions about Leeson and the improbable size of the profits he's reporting. This is also the month in which Leeson bares his buttocks in public, is arrested, then bailed out by Barings brass. The incident is hushed up.

December 1994, Walz was right. The profits were fictitious. In reality, by the end of the year his losses exceeded 208 million pounds.

January 16, 1995. Leeson, who has decided that he needs a big score to get out of the hole, places a huge "short" bet on volatility, in both Singapore and Japan. In other words, he bet that there'd be no immediate sudden shift in the value of Nukkei stocks.

January 17, 1995, an eathquake strikes Japan, 7.2 on the Richter scale, with devastating consequences for people, property ... and exchange-traded stock prices. Leeson's accounts head into a final downward spiral.

February 23, 1995. Nick disappears. It was his habit to work on the trading floor until 2:30 PM, then to attend to the office work. This day, he walked off the trading floor at the usual time, talked shop over drinks with colleagues (to whom he seemed his usual self) for an hour, then met up with Lisa and left Singapore.

Barings execs in both Japan and London had become increasingly insistent he "clear up" some problems they saw at last in the numbers, and this was his answer.

Feb. 25-26, the weekend of Leeson's 28th birthday. Barings officials break into a locked desk drawer and discover the remnants of some rather sloppy cut-and-paste jobs Leeson had used to fake crucial documents.

The rest is end game.

Not in real time

This and the next few posts have been prepared in advance.

I'm traveling and won't be spending a lot, if any, time on the net. So this and the next seven posts on this blog were actually composed days ago. It's neat how blogger lets me pre-schedule the day and time of posting.

Allow me today [?] to recommend to you a recent work of military/social history,

LENINGRAD: State of Siege, by Michael Jones.

Mr. Jones is a fellow of the World Historical Society, and this is his fourth book. Each of his four books has focused on a particular battle, two of them medieval (Bosworth and Agincourt). He is also the author of STALINGRAD: How the Red Army Triumphed.

He's made quite a jump, then, from writing about 15th century battles at the western end of Europe to writing about 20th century battles in its east.

I haven't read the other three but his latest is a rippin' good yarn.