Heady Polarities

Balance is a funny thing. It doesn't sound very interesting. Yes, the most prudent choice is probably somewhere in the middle; wisdom may engender caution, but chances are it won't get your blood pumping much faster. But fifty feet of open air between you and the ground, on the side of sheer cliff, will do the trick. You can't convince your adrenaline gland of the relative safety offered by a harness and rope. That's a lot of air. So you talk yourself down: focus on moving up; channel the hormones pumping through your flesh on digging your toe into that tiny, tiny foothold. For the first fifty feet, that worked fine. Now, you're at your limit. The reach is far, the foothold is only about a foot and a half below your hand, and all of this is on top of 3 foot overhang that leaves pretty much nothing too the imagination: over there, is death. The biochemicals kick up a notch. The logic your chemistry never bought is sounding a lot less, well, logical. What if the guy on the other end of the rope fucks up? What if the rock breaks? You remember that fear is just your genes way of keeping you alive. This is fucking crazy. That is balance, and it is not boring. It is not a middle-ground you reach by unweighting the scales, it is a storm in a teacup; kilotons against kilotons, and who knows how little will send the whole thing tumbling. You can press on, focus on moving your hands and shove down the fear, but you might just meet the end your bones are warning you of. Not quite such a dull type of balance.

Sweatshops, Underdevelopment, and Progress

Growing up, the word sweatshop had vivid imagery: cramped, hot, grueling, and exploitative. Eventually, I contextualized that situation within the history of colonialism and capitalism. Sweatshops seemed a sort of neo-slavery: when the rich could no longer directly enslave the less fortunate, they turned to business, offering pittance wages and developing a system of cheap foreign labor that stocks the shelves of Macy's and Wal-mart and drives corporate profit. But eventually another question presented itself: why do people work in sweatshops? The answer is complex. They do not, literally, have to - they can quit (in fact, the threat of severance is often used to ensure acceptance of harsh conditions and low pay). Yet they have little alternative. Some are born in cities with no other prospects, others migrate from the countryside and hope to send money back to their families. Sweatshops are the first rung on the social ladder, the story goes. So can we work to eradicate them, eviscerating the one meager opportunity of the poor? Companies argue that higher standards of wages or conditions will effectively do just that - restrain business conditions and force firms to shut down their operations. For me, the answer lies beyond the cities in the countryside where people historically dwelt.

Why leave their ancestral home? Underdevelopment is a widely used term, connotative of hunger and disease. Yet I will not believe that the pre-industrial world was brutish and ugly, identical with the one poor third-worlders now flee for sweatshops. One anthropologist suggested altering our conception of underdevelopment from that of a noun to a verb: it is a process that has created the state of misery we observe today. This is a powerful distinction. It essentially supports the thesis that sweatshops are a new form of the same old colonial exploitation: we came in, destroyed their land, stole their treasure, and left with no alternatives, they were forced onto plantations (and later into factories). There is one omission in that explanation, however: time. We cannot turn back the clock on underdevelopment by reeling in the forces of industry and restoring the third world to its pristine, natural state. Take the example of cash cropping. Rather than growing food and eating it, goods are grown and sold at market. Cash cropping is desirable because tobacco or sugar is worth more than maize - thus, you can buy more food than you would have grown. With cheaper food available and labor in high demand, population grows - and grows, beyond the point that was naturally sustainable. In the process, nutrition plummets, disease spreads, and vast tracts of land are converted to monocultures. Suddenly the bottom falls out of the sugar market, and workers are forced to leave and seek work elsewhere.

This is a simplistic story of underdevelopment, but it is nevertheless emblematic. Poor peoples are only "under" the standards of the industrialized world - they lack the machinery and infrastructure to subsist independently within the industrialized system. Returning to the state of affairs prior to colonization would require massive reversals: soil would need to regain nutrients, mining cyanide cleansed from aquifers, diseases eradicated, forests re-grown, dams unbuilt, but most importantly and repugnantly people would have to die in huge numbers. This is not possible, and for the latter reason, wholly undesirable. But if de-underdevelopment is out of the cards, is development the only other option? If underdevelopment is a lack of adaptation to the changes set in place by industrial colonization, then development would be successful adaptation: tractors, freeways, shopping malls, skyscrapers; in short, USA the Sequel. I find this idea disturbing. I believe strongly that the third world deserves to be restored to a humane condition, and would not impede that goal out of ideological aversion to my own homeland. The only hope, then, is to create a new world. This is undeniably ambitious. Quite justifiable, many in the third world are busy enough trying to combat malaria and improve economic opportunity; they have no time or resources to pursue experimental and potentially fruitless paths to "a brighter future". Yet I only pray they will. That is, until I can help them.

Great Minds

"Capitalism is a system in which the central institutions of society are, in principle, under autocratic control. Thus, a corporation or an industry is, if we were to think of it in political terms, fascist, that is, it has tight control at the top and strict obedience has to be established at every level... Just as I'm opposed to political fascism, I am opposed to economic fascism. I think that until the major institutions of society are under the popular control of participants and communities, it's pointless to talk about democracy".

Noam Chomsky

"The tyranny of a prince in an oligarchy is not so dangerous to the public welfare as the apathy of a citizen in a democracy".

Montesquieu

I can't approach the eloquence of Montesquieu or Chomsky, but there is a connection between these two thoughts that I don't think speaks for itself.

There is in America today an unprecedented amount of economic freedom. I can buy shares in a corporation, claiming a bit of their profits. But more importantly, I can start my own corporation - with incredible ease. All I need do is apply for a business loan. (There are definitely complexities and difficulties involved in that, and I have little knowledge of them, but I would be absolutely shocked if they were not fewer and less severe than those of my forebears.) If our liberal, progressive ideas are so great, put them in to action! And I do not mean to say that our ideas are not great - I mean that we should put them into action. The corporate system is deeply flawed, what is unique about today's situation is that we have the opportunity to participate in it. And thus the connection: in as much as commerce has been democratized, along with politics, the onus lies on the citizen. If we find the status quo repulsive, how can we blame its authors when we hold in our hands the pen and in our guts the ink?

Brevity will, I hope, leave the artistry of those two scholars somewhat intact. The issue is complex - corporations hold power, government may play for the status quo, the profit rule itself raises serious considerations. But consider those two thoughts, and the space between them.

Efficient Markets - the Lehman Example

A letter in today's Financial Times gave a good example of why the efficient market hypothesis is a load of crap:

Lehman Brothers senior secured debt is trading at 15% of face value, while at the same time Lehman equity is going for 15 cents a share.

What does that mean? Senior secured debt-holders get paid back completely before stockholders see a cent. So if Lehman's stock is worth anything, its senior debt should be worth 100% of face value. The two prices are in complete disagreement.

Lehman is an extreme example, but it raises an important point: the dynamics of any particular market can have as much effect on price as the "available information". If demand is low and supply is high, prices will drop. At the same time, if prices are bordering on free, the prospect of making a quick buck will push someone to gamble. This is only one way that markets can be made inefficient, but you only have too look as far back as the bankrupting of Lehman in the first place for another one.

LTCM and the Financial Crisis of 2008

Nearing the end of When Genius Failed, it is striking to me how similar the situation Long Term found itself in resembles the crisis which Wall Street was bailed out of in late 2008. Both could not find buyers for the assets they needed to sell, just as both found their capital stores diminishing rapidly. In 1998, Long Term found itself losing money on almost all of its trades. The marks that they valued their assets were dwindling, fast, and any attempt to sell only lowered those marks further. In 2008, banks started building up losses on their securities, mortgage-backed ones most dramatically. Long Term believed whole-heartedly that once markets moved past their panicked aversion to the types of assets the firm was losing on, prices would return to more typical levels and their losses would be recouped in part or whole. The problem they faced was that those losses were accumulating so quickly and widely that their capital was vanishing, pushing them rapidly towards insolvency. Wall Street experienced an identical problem: as assets declined in value, they booked huge losses regardless of whether they sold. Hence the capital infusions of the bailout.

To be continued.

Equality and Financial Knowledge

Most Americans outside of the financial industry have very little understanding of how banking, investing, trading, and the various other components of finance work. That banks take deposits and give loans most people grasp, but throw in leverage, interbank loans, portfolios, proprietary trading, or many other activities that are deeply threaded in with deposit taking and the layman is lost. The same is true of investment; buy stocks and if the price goes up, you made money. Buying stock in a company that manages a portfolio of government bonds? Once again, I think most people's grasp beyond the cultural fundamentals is thin.

Now, you could easily say I'm patronizing Joe the plumber. I have very little knowledge of organic chemistry, which no doubt contains as much as nuance and probably more than finance; why should Joe bother divining the likes of arbitrage or ABS tranches? My answer is the very thing I sat down to explore: the idea that understanding how money works, or can work, would greatly alter both how people use it and how money works in the first place. I mean first off there's the fact that by not investing even a tiny slice of his income, Joe is passing up life-changing profit - profit that is constantly garnered by the in-the-know, that is, the rich. Now, the trick lies in the reality that there isn't some magical asset that everyone just needs to realize they should buy. Their are tons of such assets - funds, equities, indexes, CDs.

So now that I've gotten that far in writing that, I see two flaws in my reasoning that I'd have to overcome to keep pushing the point.

1. People can't buy most financial assets (as far as I know). If they thought corporate bonds or Brazilian government debt were good buys, they don't have direct access to them. They either don't have the bulk to buy those things in the huge chunks they exist in (hey, I think I just figured out why they say investment banks "make markets"), or the things aren't traded in publicly accessible exchanges.

2. You have to beat inflation. If people aren't going for big returns (which was going to be my next point - people should play it safe, but start playing when they're still young), they risk getting run over by inflation.

So my initial excitement over the power of financial democracy via knowledge is a bit diminished... but I'll have to think on those two problems.

To summarize the original idea: if people know how financial markets worked, they could engage in them and exploit them the same way the wealthy and the financiers themselves do. Supporting that idea: the industry fights tooth-and-nail for tiny, marginal leads over competitors; if you're not concerned with beating the guy next to you, just making a modest return, you can spend much less time and be much less expert - thus managing your portfolio without quitting your day job.

Long Term Capital Management

A response to:

When Genius Failed: The Rise and Fall of Long Term Capital Management by Roger Lowenstein.

Reading the book in the summer of 2009, the book seems as pertinent as ever. It deals extensively with financial theories that had a role in the crises in mortgage and credit markets, and eventually the broader economy. The parallel continues, as the Fed decided to intervene then as it has now. As a case study, LTCM offers a window into the worlds of arbitrage, academia, and financial markets generally.

There seem to be a few key points to LTCM's strategy and composition:

First, it made heady use of software models. Two partners in particular played huge parts in the development of quantitative finance: Myron Scholes and Robert Merton. Scholes was one half of the Black-Scholes formula, Merton developed that formula even further and also contributed to the Efficient Market school of thought.

Second, it relied on massive capital. Their strategy was to make massive bets with very small pay-offs, "sucking up dimes" as the firm put it. That relied on a huge investor base ($1.25 billion at its inception) and even more colossal amounts of borrowing. In 1995 the firm pulled in a 56% return before fees (43% after). By that time, their capital had grown to $3.6 billion. Their assets under management, meaning capital plus borrowed cash? $102 billion, 28:1 leverage. If they had invested at 1:1 leverage, their return would have been approximately 2.45% (in fact, that doesn't take account of derivatives transactions, which were held off balance sheet - if derivatives were included, the return might have been as low as 1%). Sucking up dimes indeed. Relying on that degree of leverage begs the question of whether the LTCM was really all that good at investing, or if they just had a lot of cash to throw around. So long as you can wait out losses, thanks to a huge amount of capital you can draw on and use to avoid forced sales, you can weather out storms that knock out smaller players. Keynes had a poignant insight on that idea: "markets can remain irrational longer than you can remain solvent." Lowenstein points to an early lesson learned by the LTCM's founder, John Meriwhether, when he was a trader at Salomon Brothers. A bond trader had made what he believed to be a good bet that the spread between bond futures and the actual bonds would narrow, so he bought futures and shorted bonds. But the spread only widened further, until eventually the trader had taken on so much loss he was being forced to sell. Salomon, and Meriwhether, looked at the trade and decided it was in fact a good bet. The little guy simply didn't have the capital to wait it out. So they bought him out, and sure enough, a little while later the spread narrowed and Salmon made a killing. The lesson? Have enough capital to wait out the storm. And eventually, in running LTCM, that's exactly what Meriwhether did - took in massive investment and then massively leveraged it, to the point where he was controlling a hundred billion dollars.