Equity and Prop Desks

Below is a brief passage from what may become the third chapter of my proposed book as represented in the table of contents I provided on December 10, 2010.

This complements materials I've provided for the two previous chapters, and we will continue our march in a measured pace.

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3. Equity and Prop Desks

The distinction between equity and debt is critical to any serious discussion of modern finance. It is also, not coincidentally, critical to the understanding of corporate liquidations or reorganizations. We will begin there, and soon enough we’ll be discussing corporate governance, government regulation, and the mysteries of federalism.

Think of a newly bankrupt corporation as a see-saw with a much heavier weight on the left and a lighter weight on the right. The right end, then, is up in the air. The left end (the equity) sits on the ground. The fulcrum is in the middle.
In terms of the right to receive a payoff, the most senior debt has first dibs. This is the airiest part of the see-saw. After those debts are paid off, payments follow in a sequence defined by contract and law. In time, the liquidators of the estate come to the fulcrum – the point at which what remains to be distributed is the good will of the ongoing enterprise.

Let’s assume that there is some such value (if not, we’d be dealing with a liquidation rather than a reorganization). On this assumption, the holders of the “fulcrum security” will be reimbursed by the transformation of their securities into the equity of the reorganized company. The classes of security that are lower than the fulcrum security, including the holders of the old equity, will get nothing.

One quick way of expressing all of this is to say that the holders of the equity of a company are the ones who bear the “residual risk.” They are the ones most certain to lose out in the event of liquidation. Thus, their interests are aligned with the interests of the corporation as a continuing, sustainable, entity.

To use a serious maritime image rather than the frivolous playground imagery above, we might say this: it is because the captain would go down with the ship, in accord with maritime tradition, that the captain is the best one to entrust with the task of steering the ship safely. Passengers with secure access to a rowboat in the event of a mishap are less suitable for the task.

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A footnote in there may refer to “Chapter 11 Reorganization Cases and the Delaware Myth” by Harvey R. Miller (2002), an article that sought to rebut the widespread impression, the “myth” that “there is something fundamentally wrong, even reckless, with the reorganization process as it is practiced” in the federal bankruptcy court in bellwether Delaware.

A further theme of the chapter as it develops will be the critical role of speculation in uncovering the real value of assets. Specifically, the equity markets (and their speculators) reveal the value of an ongoing enterprise as its market cap. The difficulties caused by regulations that obscure that process, thus hiding the true value. Prices as data. Leonard Read’s pencil.

From there to the role of shorts, a return to the Enron scandal, what Skilling called a certain short. Hedge funds and the prop desks of banks.

From Florence to Houston

Below is an outline for the second chapter as represented in the table of contents for my projected book.

I've already done the same for the first chapter. We will focus here on the institution of lending money for a fixed rate of interest: this is "usury" or "riba" to its foes.

I. Renaissance Florence
A. Theology, Damnation, and Evasion
B. The Rise of the Medici

II. The North of Europe
A. Luther on usury
B. Calvin
C. Calvinism in the Lowlands
D. London and the Classical Economists

III. Colonies and States
A. Debt in the Colonies
B. Debt and the Founders
C. The Post-Classical Economics of Henry George

Here I will make in essence the points I sought to make in this blog on November 19, 2010.

D. Leverage, the Business Cycle, and Enron

The difficulties that arise when finance becomes too disconnected from the physical world, when an excess of liquidity gives rise to dreams of infinite leverage, are well illustrated in the rise and fall of the now infamous energy-trading firm, and it is a cautionary tale we should heed even this early in our study.

We have addressed thus far the fundamental ideas of speculation and leverage (i.e. debt). We need to introduce the final key idea from our subtitle, regulation: and we will do that in the next chapter.

The Old Stigma: Speculators as Parasites

I plan to fill in a bit here the first chapter as represented in the table of contents of my projected book. See yesterday's post for the context.

This chapter will flesh out the claim in the introduction that "a very old stigma of the speculator as an anti-social parasite has re-emerged."

I. Russia

A. Dostoyevsky's Raskolnikov and the death of a pawn broker
B. To the 20th century: who were the kulaks?
1. their speculations
2. their stigmatization
3. their deaths.

II. "But that was all so long ago!"

III. The CDS Market as our pawn brokers

A. What is a CDS market?
B. Consider a column Ben Stein wrote in The New York Times back when he was writing for them.
C. Or consider Goldman Sachs as "vampire squid" and the barrage of Congressional investigations.
D. Short course: why CDS' should not be scary.

IV. Transition.

If they are not in fact parasites, what function do they serve? That brings us into the next chapter.

My Book Proposal

Listen up publishers. Here's a book proposal.

I'd like you to bid on rights to my not-yet-complete manuscript, Gambling With Borrowed Chips: The Role of Leverage, Speculation, and Regulation in a Modern Economy.

I am willing to accept millions, though hundreds of millions would be nice.

When complete, this will be a scholarly ms of approximately 76,000 words, with approx. 30 figures in the text, and extensive endnotes for each chapter, an index, and a bibliography.

As I complete outlines of each chapter in subsequent posts, I'll use the chapter titles here as links, for convenient navigation.

Synopsis

Speculation performs at least three indirect but valuable roles that assist a broader society in the wise allocation of resources: it allows commercial parties to hedge their positions; it uncovers the real value of assets; and it creates accountability for corporate managers, who in the absence of active speculators are better positioned to entrench themselves.

Speculative activity can become excessive and abusive -- the best check upon this, though, is not through regulation, much less criminalization -- the best check is the systemic one of a hard money policy.

The events of recent years -- as they have been popularly misunderstod -- have delegitimized this valuable activity, and that has given rise to a lot of real and threatened policy consequences that have done or would do more harm than good. Or, to be more precise, a very old stigma of the speculator as an anti-social parasite has re-emerged.

Outline

Introduction

Part One: The Value of Speculation
Chapters
1. The old stigma: speculators as parasites
2. From Florence to Houston
3. Equity and Prop Desks
4. The Crisis of 2008
5. Commodities and Their Derivatives
6. Betting on Foreign Exchange
7. Accounting and Valuation
8. Corporations and Accountability.

Part Two: Important Abstractions
Chapters
9. Efficient Capital Markets, A Tidy Theory.
10. ECMH, The Much Sloppier Practice.
11. On Greed and Money.
12. A World Without a Monetary Superpower

Part Three: Some Policy Consequences
Chapters
13. Bankruptcies and Rescues.
14. Public and Private Pensions.
15. Home Ownership.
16. Energy.
17. Conclusion.

Contango: Another Year

Last year at around this time I wrote a fairly extensive blog entry about crude oil and contango.

As a refresher: Contango is the discount you can get on a non-perishable commodity by virtue of your willingness to accept delivery at once, or (stated inversely) the extra payment you make if you want the seller to hold it for you for some interim.

One would naturally expect this discount to be closely related to the costs of storage space. After all, if I buy crude today and tell you to deliver it six months from now, you have to keep it somewhere during the interval, and pay the maintenance on the storage facilities. If I take delivery now but I don't use it over the six months, then the cost of storage falls on me.

So: a year ago I simply measured the per-barrel price for March delivery (which was $46.47) against that for August delivery ($53.81) and extrapolated that into an annual rate. The five month delay in delivery cost the buyer $7.34 at that time, which extrapolated into an annual figure would have been $17.64, or about 38% of the price of the barrel.

Checking the figures a year later ... the price of a barrel is now $74.14 for March delivery, and $77.08 for August. That's a difference of $2.94 for storage. This annualizes to $7.06. That's roughly 9.5% of the price of the barrel.

Why has contango fallen so drastically over the course of the year? People were noticing the drop as early as May. But I can find very little blogospheric commentary that addresses the reason for the drop. Could storage space have gotten less expensive?

Let us go back to basics. Supply and demand. There could be more supply (available space) if the owners of storage facilities haven't been re-filling them as rapidly as they've been pumping the oil out toward the refineries and its trip toward retail use. Or perhaps the large contango of a year ago inspired entrepreneurs to invest in the creation of new storage facilities. Those facilities have since been coming on line, and that has driven the contango down, just as it should according to the textbooks.

Or it could be a demand issue. Anyone who wants to join in with some helping hypothesis ... I'm all ears.

Crude oil and contango

There are worlds of stuff I don't know, so bear with me. The price of a barrel of crude oil on the New York Mercantile Exchange at the end of trading Thursday was $43.26. It is heading back up from its lows in the 30s.

On Friday, a barrel for March delivery sold at the close for $46.47.

Could it be that the cold winter is pushing up demand? No. Markets look ahead. We're at the worst of the winter in the northern hemisphere, so you would have expected that meteorology would be fully discounted by now. Indeed, you might see the markets looking ahead to spring, which would indicate a lowering of demand for crude.

The market could be looking ahead in another sense, to the greater quantity of driving that generally comes with spring. But that would seem to be countervailed by the recession.

Or ... the market could be telling us that things are turning up. The optimistic reading of the price increase is that it results from speculative demand increase which in turn results from signs (seen by the speculators, if not by you and me) that the economy is about to turn around.

But let's not rush to that conclusion. Think first about contango, a word that appears to have nothing to do with Argentine dancing. [Yes, I had to get that one out of the way].

Contango, the word seems to be derived from "contingent," is the discount you can often get on a commodity by virtue of your willingness to accept delivery at once. Suppose I have a barrel of oil and I want to sell it. You want to buy ... but you want me to deliver it to your place of business six months from now. Why would you have to pay more?

Because the oil isn't doing me any good in the meantime! It is taking up space and there are maintenance costs associated with storage. So I make you pay for that. What you pay for my storage (or, looking at it the other way around, the discount you get for accepting the oil immediately) is your contango. This elemental reason for contango is called "cost of carry."

I've heard from no place worth mentioning that a good guess for costs-of-carry historically is about 14% a year. So if contango is greater or less than 14% there should be explanations other than "where the heck do I put the stuff."

The above barrel price, $46.47, is as I said for March delivery. That is as immediate a delivery as Nymex listings will get you. Going out further, a barrel for August 2009 delivery goes for $53.81.The present difference in price between March delivery and August delivery then is $7.34. That would work out to $17.64 annual. As a percentage of $46.47? About 38%. That's one mean contango.

I might like to suggest that this confirms our earlier suggestion: that the market is signalling a recovery soon. There is such high contango NOT because the costs of carry have gone up dramatically but because speculators would rather have crude oil six months from now than now. And they'd rather have in six months from now because they are getting signals that people are going to be driving more, the wheels of industry are going to be turning ... good times are back.

But then ... I'm still uncomfortable. After all, forgetting speculation, the simple cost-of-carry sort of contango might have increased to 38% annually. Why not? Maybe all the easy storage spaces are all used up, and it takes extra expense to bring new storage space on line (marginalism, anyone?) and THAT is leading to a sizeable discount for anyone who will take the stuff out of the marketers' hands quickly.

All this is making my head hurt. Enough!