Margin Calling

 A common feature of both the 1929 Crash and the unnameable financial crisis of 2008 is a high volume of margin calls on highly  leveraged securities portfolios.  This time it's hedge funds that have done the excessively leveraged buying.  As the prices of the securities the hedge funds bought at a high margin plummet, the hedge funds need put up more cash collateral to their lenders to replace the lost collateral represented by the plunge in value of the security bought on margin.  This forces the excessively leveraged hedge fund to sell shares, driving prices down.  Forced sales to meet ever increasing margin calls creates a vicious cycle that leads to a market plunge.  This is what has been repeatedly happening in the markets  lately and was a key factor in the 1929 collapse.   An important provision of the Securities and Exchange Act of 1934 allows the Federal Reserve to set margin limits on the amount of leverage used to purchase securities.   The Federal Reserve does this through Regulation T.  But Hedge Funds exploit an exception in the Investor's Company Act of 1940 that allow investment entities comprised of sophisticated investors (investors holding more assets than most people have, no Mom & Pop investors need apply) to avoid margin regulations.  The exception was not meant to apply on the scale it is being exploited by Hedge Funds today.  No one foresaw the hedge fund explosion and how it would introduce the same systematic risk caused by over leveraged equity purchasing that proved so fatal in the fall of 1929.  Yet here we are again.  Despite the earnest arguments that hedge funds should be unfettered in order to take risks that are net beneficial for the economy, it makes no sense to allow them to engage in the same unregulated margin purchasing that destabilized the financial system in 1929 and now again in 2008.  The systematic risk from over leveraged security purchasing has nothing to do with the sophistication of the investor, rather it arises from the aggregate actions of a number of risk taking investors.  It is naive a la Greenspan to think that because someone is a  sophisticated investor they won't take on risk that when aggregated with that taken on by other sophisticated investors  proves disastrous.  This notion has been proven false now twice.  The loophole that hedge funds exploit to escape margin requirements needs to be closed.  This would be one small step to restoring sanity to our markets.       

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.