I'm Shocked, Shocked, To Find That Gambling Is Going On In Here

Like Claude Rains' Captain Renault in Casablanca, Alan Greenspan is all of a sudden shocked to find out gambling has been going on. Like Captain Renault, Greenspan knew it was going on all around him but thought nothing of it. And also like the Captain, Greenspan had an interest in ignoring the gambling because it rewarded him well. Greenspan was worshipped as a policy genius while the economy seemingly prospered from ever riskier behavior predicated on the belief that derivatives had ameliorated systemic market risk. Greenspan encouraged this risk by opposing regulation. The free market, he maintained, could regulate itself.

Greenspan believed a lending institution's self interest in protecting shareholder equity would prevent the institution from taking on risk that would damage that equity. But he implicitly made two theoretical assumptions that the markets have now proven wrong.

The first was assuming that the self interested behaviour of agents in the marketplace could never lead to a systemic financial collapse. Underlying this assumption was the belief that the agent's self interest in protecting shareholder equity would prevent bet the farm behavior that could lead to financial collapse. But the present crisis presents a prime example of marketplace agents self interested behavior leading to a financial collapse. And while the actions of individual marketplace agents in this case did not necessarily endanger business entities on their micro economic level, the sum of the self interested behavior has led us to our present financial collapse on the macroeconomic level. The sum is greater than the whole in this instance.

Most of the agents in the marketplace, acting out of self interest, bought insurance in the credit default swap market (CDS) on their risky bets and then went on to engage in even riskier behaviour because they thought their previous risky behavior was hedged. But because so many agents thought they were hedged against losses and then went on to engage in riskier behavior that didn't pan out, the trouble started. The failure of the agents' riskiest bets led to the collapse of the agents' previous hedging strategies, which resulted in a lot of market players going into a financial tailspin. What Greenspan didn't count on was self interested agents thinking they had hedged their bets when in reality they were engaging in willful blindness as to the risks they had incurred. Very few CDS market players inquired into the liabilities their insurers were carrying and what would happen if there were large scale defaults that required the insurers to pay out more than they had bargained for. And the insurers did not count on large scale defaults occurring. See AIG. Something similar happened in the securitized mortgage market. Thus the failure of marketplace agents riskiest bets led to a failure, or at least the perception of a possible failure (after all a lot of this crisis is a crisis of faith), and behavior that was previously believed to be hedged became suspect.

Greenspan's second and worse theoretical mistake was anthropomorphizing business entities through inapplicable metaphors. Inanimate objects do not have self interests, no matter how useful it may be to sometimes speak as if they do. And it is quite often convenient and harmless to talk as if inanimate objects like banks intentionally do things such as entering into contracts. But this is just a convenient short hand for discussing the behavior of the human agents who actually control the business entity in question, and it is a mistake to think that somehow the business entity has intentional psychological states that only belong to conscious animals. To say a bank's self interest will mitigate its risk taking is to attribute an intentional psychology to an inanimate object.

In terms of analyzing the self interest of agents in a marketplace a better place to start is with the agents who have the real psychological intentional states, the humans that run the entity. Once you start to look at the self interests of the intentional agents you can see how those self interests may cause them to make the entity take actions not in the entity's best interest. Stock options provide incentives to pump up stock prices and executive pay packages often include perverse incentives for the executive to act against the company's best interest. This is nothing new, but there seems to be a naive belief with many free marketers that business entities have intentional states such as self interest that exist independently of the human agents that run the entities, and this leads the free marketers to be shocked at behavior that is obvious to anyone who just takes a look around them.

God is Dead!

Isn't Alan Greenspan admitting that free markets need regulation to avoid collapse a little like the Pope admitting God is dead? I believe in free markets, but as I've said before equating freedom with anarchy is a mistake. And this is precisely the mistake that Milton Friedman and Alan Greenspan made. No rational person wants to live in a lawless society precisely because their freedoms become subject to the whims of the more powerful. It is the rule of law that is the basis of our freedom, not the lack of law. Some laws may be misguided, vindictive, or even irrational, but that is an argument for changing those laws and not for throwing out the entire legal system. Likewise, what has just happened in the markets is an argument for reforming the regulation of capitalism, not for abandoning capitalism for its empirically proven worse alternatives.

Milton Friedman We Hardly Knew You

Alan Greenspan just admitted that his central assumption regarding financial institutions, that they could take care of themselves without government regulation, was wrong. Pretty big mistake Alan. More on this later, I'm at work, but reading this admission from such a devout Friedman disciple made my jaw drop. Most economists strike me as naive in the sense that they generally don't have much real world experience that can temper their abstractions, and in this case we're paying a monumental price for the free market naivete of the Ayn Rand school.

Cry Havoc, and Release Henry Waxman!

Like a shark in the water I smell blood looking at the latest presidential polls.  The deal ain't sealed until the electorate speaks, but things look good for Obama right now.    I trust him to be restrained to our adversaries if he wins the election, but emotionally I need some payback after all the smack the other side has talked the last eight years.  I need some smackdown to demonstrate to the arrogant why arrogance is such a bad move in the first place:  You are either with us or against us.  Mission Accomplished.    John Ashcroft. John Roberts.  Samuel Alito.  Guantanamo Bay.  Iraq.  Torture. Faith Based Initiatives.  Valerie Palme.  Karl Rove.  Dick Cheney.  Donald Rumsfeld.  John Bolton.  Tom Delay.  Half a trillion dollar budget deficit.  Deregulation of Derivatives Leading to the Financial Crisis.  Decline in real wages.  Negotiating is for pussies war is for real.  The list goes on. How are you sleeping Karl Rove?  Probably in a fat bed paid for by your spoils.  Don't get too comfortable.      

Master of the Senate

Is it too much to ask that  our candidates have  read the Constitution?  You can't really display a greater ignorance of the Constitution than to state like Sarah Palin did that the Vice President is master of the Senate.  Clueless.  The Vice President is ceremonial president of the Senate and can only vote as a tiebreaker.  The Senate is not merely an appendage of the executive branch.  There is something disturbing about this basic failure to understand the separation of powers at the foundation of our republic.  Does she think Senator McCain answers to Dick Cheney?  Has no one yet explained to her the functions of the Vice President since July when she stated she didn't know what the Vice President did?  I thought she was a quick study?  Then why does she still not know the job description she's running for?  I think the Constitution should be amended to require all candidates for federal office to have read the Constitution in order to run.

Joe's Pipe Dreams

Joe the plumber is worried that Obama is going to tax his dreams.  Joe doesn't make the $250,000 plus a year where Obama's tax increase would kick in, and he doesn't own the plumbing business he's trying to buy that allegedly has a taxable net of $250k plus a year.  He doesn't even have a plumbers license nor is the plumbing business he aspires to buy licensed.  Yet he's worrying about a 3% tax increase on money he isn't making from a business he doesn't own.  If he's smart, he'll save the extra money he gets from Obama's tax break on his actual income now and use it towards a down payment on his dream business.    

Bring Me the Head of the Architect!

Karl Rove thinks Obama hasn't closed the deal yet.  Duh. No politician closes the deal with the American electorate until election night.  Obama knows this, and that's why he's on the offensive in traditionally Republican states.  Turd blossom needs to remind himself that there is a chance the Democrats won't control both the Executive and Congress after the election to allay his fears of what non-Republican obstructed investigations of his activities during the Bush years will reveal.  Mr. Rove needs to provide some answers about his role in the apparent political firing and hiring of United States District Attorneys in violation of federal law. Ditto for the Plame affair.  Indeed, the architect of the Bush years has much to answer for, and the thought of a Democratic landslide no doubt troubles his sleep.  Hence Wall Street Journal opinion page columns hoping for the best.

Or Maybe Not

Hard to tell what is going on in the credit default market. Some argue that there is no significant risk of things spinning out of control because the parties that insured Lehman's bonds were forced to pony up collateral as Lehman's bonds precipitously fell in price (CDS contracts have margin call clauses activated by price drops) and that this payment of collateral has already been written down on the parties balance sheets. Sounds plausible. Others are not so sure. But what scares me about those who say this is no big deal is that they are prefacing their statements with words like "probably" or phrases like "no one really knows." Which brings us back to the central fact that no ones knows WTF is going on in the markets right now. I doubt our wild ride is over.

The Next Wave

We are truly experiencing a post modern financial crisis. Uncertainty abounds. No one knows when the next wave is going to hit, or how big it's going to be. A front runner for churning out the next financial tsunami is the turbulence in the credit default swap market caused by the Lehman Brothers bankruptcy. Credit default swaps are a form of insurance sold to protect the buyer of a fixed income product from a default. In Lehman's case a buyer of Lehman's bonds could, as many apparently did, buy credit default swaps to insure against a Lehman default. By declaring bankruptcy Lehman has essentially defaulted on its bonds and the parties that insured those bonds now have to pay up. But no one knows how big a payment those parties have to make or whether they have the money.

This unknown liability on the part of the insuring parties could in turn set off a chain reaction of defaults by the parties if the combination of their credit default swap liabilities and their other liabilities exceed their assets and they are unable to get credit to meet their obligations because the credit markets are frozen. And if those defaulting counter parties' liabilities are in turn insured by credit default swaps, the next wave is going to get bigger. Lehman's default could lead to the default of parties that insured the Lehman debt, and the default of those parties could lead to the default of additional parties who insured the debts of the Lehman parties. This is one of the reasons the government is bailing out AIG: the concern that the failure of one party in the credit default swap market would lead to a wave of defaults .

It doesn't help that you don't have to own the underlying bond to buy a credit default swap for it. This fact results in the possibility that the liabilities of the Lehman credit default swap counter parties could be greater than the actual debt that Lehman issued if more than one party bought a credit default swap on the same bond.

What makes this whole thing post modern is that no one knows the extent of the Lehman credit default swap party liability because there is no central clearinghouse for credit default swaps that can provide this information. Essentially the credit default market as a whole behaved irrationally in that it acted as if the possibility of a large scale default was non-existent, and thus the necessary market mechanisms to cope with a large scale default never emerged. This was a direct result of a lack of regulation of the derivative markets.

McCain Über Alles!

Palin's historical ignorance leads her to rabble rouse.  This type of rabble rousing with calls for killing your political opponent have a long history of turning into violent bloodshed.  This is true in America as it is in the world.  But American political discourse should be above this.  I disagree with John McCain, but that doesn't make me want to kill him.  He's still my fellow citizen exercising his rights to democratic political action.  I'm just not going to vote for him.  Calling for the death of your political opponent is as uncivilized as it is dangerous.  Educated people know better.  Palin's advisors would do well to give her some history lessons.

As I was Saying: Hamilton v. Jefferson Redux Part II

Good op ed piece in today's Wall Street Journal regarding the Hamiltonian and Jeffersonian divide.

Risk Management Failure

The New York Times has a good article outlining the opposition to derivative regulation during the last couple of decades.  It's particularly damning to Alan Greenspan, and Robert Rubin, two avid proponents of not regulating derivatives.  For them and other free marketeers  derivatives had  dispersed risk among investors to a level that made the risk negligible.  Greenspan believed that derivatives were the ultimate hedge and used his stature to prevent derivative regulation on the grounds that doing so would damage the markets.  On the Oracle Greenspan's bidding, the Republican Congress legislatively blocked derivative regulation, and a lame duck President Clinton signed derivative deregulation into law.  High finance had solved the vexing problem of capitalism's cyclical credit crises.  

Events have revealed the extent of this hubris.  Irony has turned into tragedy.  The ultimate hedge spawned into viral risk spreading swiftly as the plague through the entwined parties and counterparties.  Now the best we can do is try to stanch the mortality rate while madly searching for a cure.  Take up the bodies.  

Hamilton v. Jefferson Redux

Pardon my disappearance, work has been hectic, to say nothing of the financial markets.  My 401(k) is down 30%.  Viva la bourgeoisie!  We will survive like cockroaches.

I digress.  My only comment for the moment is that the factions in this financial crisis have split  along the historical divide of the high finance Hamiltonians versus the Central Bank Hating Jeffersonians.  The Jeffersonians are rightfully angry at the Hamiltonians for delivering a gargantuan credit crisis.  Hamiltonian play in the field of derivatives exacerbated the  inevitable cyclical credit bust that is a given with capitalism.  The fact of this cyclical credit collapse is what justifies regulation with the aim of transparency and mitigation of leverage.  The margin requirements for the purchase of equities imposed by the securities laws of the 30's have done us well.  The current crisis is not an equity market crisis.  The traditional equity markets are certainly feeling the effects, but these effects are the result of collapses in the derivative markets, particularly securitized mortgages and mortgage backed collateral debt obligations (CDOs).  As Obama aptly said in the debate last night, we have 20th century securities laws for a 21st century market.  But I digress.

A Con Law Geek Moment

A quick note that the Senate is constitutionally stuck with the House's bailout bill and can only propose amendments to it.  Article I, section 7 of the Constitution requires that all revenue bills originate in the House and that the Senate can only propose or concur with amendments.  That's why the bailout bill in the Senate right now is an amendment to the House bail out bill, and also why the Senate could not have acted on this matter before the House.

Why Originalists are Annoying

The problem with asserting that originalism is the proper way to interpret the U.S. Constitution is that there is no evidence for this proposition in the Constitution.  There is no "original interpretation" clause in the U.S. Constitution.  Textualism does not support originalism, and a priori pronouncements as to correct interpretative methodologies are arbitrary.  Beyond the document itself, what originalist evidence is there for the originalist position?  Nothing jumps to mind.  Any dogmatic pronouncements about how the document should be interpreted are nothing more than speculation.  I can just as easily argue that "We the People" means "We the Living People" just as easily as someone can argue it means "We the Dead People" (which is essentially the originalist position).  There is no definitive method with which to interpret the Constitution, despite the cravings of those on both sides of the political spectrum for an absolute fixed point from which to anchor their ideological interpretations. Originalism is one useful tool with which to interpret the Constitution, but to maintain that it is the only dispositive one is dangerously simplistic given how much more complex our society and its institutions have grown since the framing of that venerable document.