New Hope for Financial Economics: Interview with Bill Janeway

“NOTHING the Government does will work until they get rid of these nightmares. Letting credit default swaps (“CDS”) redefine insolvency as failure to post collateral means systemically critical counterparties such as Lehman Brothers or Bear are certain to fail once they wobble and, even worse, that there will be NOTHING LEFT for traditional creditors (including commercial paper) when they do. This has seized up the money markets, which no longer function without government assistance. This means the Government picks winners and losers, encourages investors NOT to underwrite and incents those “chosen” to sit on the money they can raise and keep credit velocity at zero. As long as CDS exist in bilateral form there is structural uncertainty in what it means to have a balance sheet. For everybody. CDS should be DOA.”
–A reader of The IRA

“Political economy is not a science, it’s a clinical art, like medicine.”
Eliot Janeway


As this issue of The IRA goes to press, we hear that the Obama camp is considering our friend and former Fed Chairman Paul Volcker as Treasury Secretary. The idea is to have Volcker lead the toxic waste cleanup for a year, so it is suggested, to be followed by New York Fed chief Tim Geithner.

Our advice to Chairman Volcker is to turn down this dubious honor. Paul Volcker has enormous credibility and judgment, but he does not have enough experience with and understanding of these financial markets to be effective, at least in our view.

We have only two things to say about Tim Geithner, who we do not know: AIG (NYSE:AIG) and Lehman Brothers. Throw in the Bear, Stearns/Maiden Lane fiasco for good measure. All of these “rescues” are a disaster for the taxpayer, for the financial markets and also for the Federal Reserve System as an organization. Geithner, in our view, deserves retirement, not promotion. His link to Larry Summers is not a plus for us either.

When people ask us who we’d like to see in positions of financial responsibility such as Treasury Secretary in the Obama Administration, we have three simple tests:

First, the ideal candidates should not have been involved in formulating the financial rescues and bailouts of the past 18 months. The horrifying results of AIG, etc., seem to make that an absolute requirement. When the next Attorney General starts to review the decisions made by the previous administration during the rescues of AIG and Bear, Stearns, the various decision makers may be called to account before Congress and other competent tribunals.

Second, ideal candidates may never have worked for Goldman Sachs (NYSE:GS). Let’s face it, the banksters from GS are aggressive, but they are hardly the best and the brightest in the world of finance — our view. Time for some new faces and new perspectives on how to solve the crisis, perspectives from outside the conflicted precincts of Wall Street and particularly GS.

And third, the ideal candidates should not be economists or at least among that tendency of economist who believe that markets are efficient and complete, that people are rational and that supporting concepts like OTC derivatives and fair value accounting are good and practical public policies. FYI, read the front-page profile of Senator Phil Gramm in the New York Times today, “Deregulator Looks Back, Unswayed,” by Eric Lipton and Stephen Labaton.

By the way, last week Bloomberg News published a very important article talking about the role played by Larry Summers, Alan Greenspan et al. in blocking greater disclosure from and regulation of the OTC derivatives markets. The key voice for greater oversight of OTC derivatives was Brooksley Born, then chairwoman of the CFTC and now a retired partner at Arnold & Porter law firm. The behavior of Summers and Greenspan over a decade ago in personally attacking and smearing Born when she dared to suggest that OTC derivatives might pose a systemic threat to the global economy enabled the explosive growth of the OTC derivatives markets. The link to the November 13, 2008, Bloomberg News story by Matthew Leising and Roger Runningen is below:

Today there are over $50 trillion in outstanding credit default derivatives contracts, for example, contracts which must be funded by the global financial system as default rates rise and credit recovery rates fall. As we have written previously (“In the Fog of Volatility, The Notiional Becomes Payable, October 27, 2008”) funding these CDS contracts as they move into the money may become an oppressive drain of liquidity from financial institutions and the global economy.

Meanwhile, last week Treasury Secretary Hank Paulson, finally admitted that his asset purchase idea was DOA. Although Paulson had sold the Congress on the bailout proposal based on purchases of assets, he has finally come around to the view we and others have been espousing for months, namely that capital injections into solvent banks is the first, best use for the bailout funds. But it may not be the only use for the bailout funds provided by the Congress.

As we shall be discussing in our comments at the Risk Management Association this Thursday in New York, we may actually need an asset purchase program after all, but not as originally envisioned by the Congress or the Bush Administration. Instead of a vague, voluntary program to allow banks to tender assets to the Treasury, we believe that the Congress must eventually legislate a mandatory exchange program to remove all of the extant CDS and complex structured assets from the global financial system. So serious and enduring are the negative effects of financial cancers such as CDS and complex structured assets, in our view, that the only way to save the patient – that is, the global economy and financial system – is mandatory surgery.

To continue our search for understanding as to the antecedents of today’s financial mess, we turn to one of the smartest private equity investors on Wall Street, William H. Janeway. Bill is a Managing Director and Senior Advisor of Warburg Pincus, and now a lecturer at Cambridge University, where he received his doctorate in economics as a Marshall Scholar. The youngest son of Elliot and Elizabeth Janeway, Bill’s friendship and advice are highly valued by his clients and associates. We asked him to put the current financial crisis in context based upon his nearly two decades as a professional money manager, banker and economist. We spoke to Bill in his office in New York several weeks ago as the financial markets were tumbling.

The IRA: So Bill, you picked an interesting week to be back in New York. We actually started posting equity volatility numbers on our web site just for kicks. They are mostly in triple digits. How did we get into this mess?

Janeway: It took two generations of the best and the brightest who were mathematically quick and decided to address themselves to the issues of capital markets. They made it possible to create the greatest mountain of leverage that the world has ever seen. In my own way, I do track it back to the construction of the architecture of modern finance theory, all the way back to Harry Markowitz writing a thesis at the University of Chicago which Milton Friedman didn’t think was economics. He was later convinced to allow Markowitz to get his doctorate at the University of Chicago in 1950. Then we go on through the evolution of modern finance and the work that led to the Nobel prizes, Miller, Modigliani, Scholes and Merton. The core of this grand project was to reconstruct financial economics as a branch of physics. If we could treat the agents, the atoms of the markets, people buying and selling, as if they were molecules, we could apply the same differential equations to finance that describe the behavior of molecules. What that entails is to take as the raw material, time series data, prices and returns, and look at them as the observables generated by processes which are stationary. By this I mean that the distribution of observables, the distribution of prices, is stable over time. So you can look at the statistical attributes like volatility and correlation amongst them, above all liquidity, as stable and mathematically describable. So consequently, you could construct ways to hedge any position by means of a “replicating portfolio” whose statistics would offset the securities you started with. There is a really important book written by a professor at the University of Edinburgh named Donald MacKenzie. He is a sociologist of economics and he went into the field, onto the floor in Chicago and the trading rooms, to do his research. He interviewed everybody and wrote a great book called An Engine Not a Camera. It is an analytical history of the evolution of modern finance theory. Where the title comes from is that modern finance theory was not a camera to capture how the markets worked, but rather an engine to transform them.

The IRA: When you factor in the influence of politics in areas such as housing policy or financial regulation, it is easy to appreciate the engine metaphor.

Janeway: The book comes to an end at the end of ’06 and the start of ’07, the peak moment. It is really useful both as a framework and a narrative for understanding how this came to be. How it came to be, for example, that financial institutions largely owned by their employees could leverage themselves 35:1 and then go bust, destroying the jobs and destroying the wealth of the very same people! It is very easy unfortunately, as both Republican candidates said, to blame this mess on the greed and corruption of Wall Street, it is very easy to look at this crisis as another lesson in agent-principal conflict…

The IRA: We discussed that very issue with Alex Pollock at AEI some time ago (“Conflicted Agents and Platonic Guardians: Interview with Alex Pollock’, May 13, 2008”).

Janeway: Yes, but here the agents were principals! I think something else was going on. It was my son, who worked for Bear, Stearns in the equity department in 2007, who pointed out to me that Bear, Stearns and Lehman Brothers had the highest proportion of employee stock ownership on Wall Street. Many people believed, by no means only the folks at Bear and Lehman, that the emergence of Basel II and the transfer to the banks themselves of responsibility for determining the amount of required regulatory capital based upon internal ratings actually reduced risk and allowed higher leverage. The move by the SEC in 2004 to give regulatory discretion to the dealers regarding leverage was the same thing again.

The IRA: And both regimes falsely assume that banks and dealers can actually construct a viable ratings methodology, even relying heavily on vendors and ratings firms. There are still some people at the BIS and the other central banks who believe that Basel II is viable and effective, but none of the risk practitioners with whom we work has anything but contempt for the whole framework. It reminds us of other utopian initiatives such as fair value accounting or affordable housing, everyone sells the vision but misses the pesky details that make it real! And the same religious fervor behind the application of physics to finance was behind the Basel II framework and complex structured assets.

Janeway: That’s my point. It was a kind of religious movement, a willed suspension of disbelief. If we say that the assumptions necessary to produce the mathematical models hold in the real world, namely that markets are efficient and complete, that agents are rational, that agents have access to all of the available data, and that they all share the same model for transforming that data into actionable information, and finally that this entire model is true, then at the end of the day, leverage should be infinite. Market efficiency should rise to the point where there isn’t any spread left to be captured. The fact that a half a percent unhedged swing in your balance sheet can render you insolvent, well it doesn’t fit with this entire constructed intellectual universe that goes back 50 years.

The IRA: But doesn’t this certainty about the ability of science and mathematics to reveal truth go back to WWII and the Whiz Kids of McNamara’s Pentagon? Then we see the emergence of physics as the real leader of 20th Century scientific research. Finally, in the latter decades of the century physics is applied to finance.

Janeway: Yes, but here is the problem. Real scientists tend to be much more skeptical about their data and their models, and thus tend to be critical empiricists. We can blame the crisis on failed physicists; they had all of the math but none of the instincts of good scientists that would enable them to be good physicists.

The IRA: And none of the discipline. So you combine the commission-driven sales culture of Wall Street with quack science and you end up with structured finance and OTC derivatives.

Janeway: Curiously Fisher Black, who would die before receiving the Nobel Prize, was extremely skeptical about the practical application of these models.

The IRA: We’ve heard similar lamentations from Bob Merton, though perhaps we need to invite him to an interview with The IRA.

Janeway: We’ll, wait a minute, Merton did produce those little flashcards for the traders on the floor of the Chicago exchanges, so let’s be a little careful about that when we are talking about real world applications!

The IRA: Touché!

Janeway: On the one hand, what you have driving all of this an intellectual movement that was enormously appealing and that for a variety of reasons fit within a larger frame of what was happening within economics. Paul Samuelson wrote his original work on the foundations of economic analysis in 1939, which took the principles of economics and translated them into math. This allowed researchers to run data against the math, to go from writing words to
describe economics to writing equations, and to use math to empirically test the

The IRA: The day that economics died, in our view.

Janeway: Samuelson laid down a fundamental philosophical principle, namely that we have to apply to economics what is known as the ergodic principle from the natural sciences, which is the notion that the underlying processes are stationary, the results, the observables they generate arrive stochastically, seemingly randomly, but the distribution is stable over time. Without that principle, we cannot do “positive economics.” Now, interestingly, Milton Friedman, the other philosophical father of financial economics, came together with Samuelson on this principle applied to the “real world.” Friedman, in his essay on positive economics, says basically that we all know that the assumptions we are making are not true. This is not how people really are, perfectly rational, etc., etc. But Friedman proposed the “as if” principle, namely that we should do our work “as if” they were, as if people were rational.

The IRA: What is the old saying, people become fearful in
crowds but wake up to reality one at a time. We had a conversation with Timothy
Dickinson some time ago (“The Tyranny of Reason: Interview with Timothy Dickinson’, July 30, 2008”) in which he argued that the economists expropriated the apparent rationality of societies over the long term and said that therefore short-term behavior must also be rational, informed, deliberate, etc. He also questioned whether the façade of rational direction of large enterprises and states is not a political illusion maintained to give people comfort that somebody somewhere is actually well-enough informed to make reasonable decisions.

Janeway: Well, we need to be a little careful when we talk about the long sweep of history. We did have, on the one hand, 1917. We did have 1933. In terms of just the history of capitalism, there are a number of events which call into question whether these are in fact stationary processes. There is some really, really promising work being done in this area. In Star Wars terms there is a “new hope.” This is an empire which is crumbling. But there is
a new hope.

The IRA: Glad to hear you say that. So you don’t see the present retrenchment as a cycle? We have always thought of the relationship between academic and finance worlds as a feedback loop.

Janeway: I don’t really see it as a cycle. It does evolve, but not as a cycle. Let me back up. I don’t see quantitative methods leaving economics. They will be much more carefully bounded and limited, and the math will be far more difficult. Remember that a large part of what we today refer to as modern economics was defined before the advent of the computer. Most recently, one of the really sick jokes about what brought down the edifice of
modern finance was the fact that, if you are actually trying to construct and price a CDO, it is far simpler to use a Gaussian copula to define the correlation between the different elements of the security – even though everybody knows that using a Gaussian copula implicitly guarantees that you are modeling a normal distribution. Everybody knows that this data is not normal, that the tails are much too fat, that there is skew built in. But it is computationally convenient. So, computational convenience had a lot to do with how we arrived at the present mess.

The IRA: So we can blame the entire mess on Milton Friedman? Did he and Samuelson, two of the most towering figures in the economics profession, open the door to the biggest financial disaster in the history of the market economies?

Janeway: No, but those who followed their work clearly took it too far in terms of practical applications. We will see mathematical models applied to cases where we have inefficient markets, where we posit that people are reasonably rational, that they try to make good decision with inadequate data or incomplete models. I think that most people are rational or try to be, and that accordingly we should treat them as generally rational because they are doing the best that they can. And therefore, they will actually behave in ways that are described by people like John Maynard Keynes and Ben Graham.

The IRA: But to go back to the question of short term cycles and the evolution of risk models, we see an entire community of quant shops and research firms already starting to try and assemble a new framework for understanding value and risk. Many of these firms are going back to basic cash flow analysis as we have with our IRA Bank Monitor product to measure risk and weight assets.

Janeway: There are a couple of steps along the way here that got us to the present circumstance, such as the issue of regulatory capture. When you talk about regulatory capture and risk, the capture here of the regulators by the financial industry was not the usual situation of corrupt capture. The critical moment came in the early 1980s, which is very well documented in MacKenzie’s book, when the Chicago Board appealed to academia because it was then the case that in numerous states, cash settlement futures were considered gambling and were banned by law.

The IRA: We have always believed that credit default swap contracts should be overseen either by the State of New York Insurance Commissioner or the Nevada Gaming Commission. The former would lend the practice some respectability and better collateral requirements, but the latter is probably more appropriate given today’s situation. But we digress…

Janeway: And a good digression, but back to Chicago, the stock index future was the holy grail of the financial industry. You had to get them qualified as non-gambles, like the physical world of commodities, bushels of wheat and corn, pork bellies, where you had speculators who were facilitating true hedging of real commodities.

The IRA: Yes and the buyer could require physical delivery of the underlying. To us, the basic problem with modern finance today is the lack of a limit on the notional via a link to the actual basis. And if there is no real basis, then it is just a gaming contract period.

Janeway: A funny story about Keynes in this regard. He and Ricardo are perhaps the most successful investors among all economists. He ran the money for Kings College Cambridge for many years, from WWI until his death in 1946. Somewhere out there, I think the date is in Skidelsky’s great biography of Keynes, John Maynard Keynes: Hopes Betrayed (1983), he went long wheat
and then went off on holiday to Morocco. So they got a call from the Southampton docks up to Kings College saying “Where do you want us to put it?”

The IRA: Oh God.

Janeway: He hadn’t laid it off. Keynes had not given instructions to close out the position. The only place they could put the wheat was Kings Chapel, but I believe they managed to get rid of it.

The IRA: We don’t mind the cash settlement world on an exchange because we know that the clearing members of the exchange, who are joint and severally liable for all trades, keeps a close eye on positions and collateral. They will sort out any imbalances in the non-stable world.

Janeway: The point here is that Milton Friedman was prevailed upon to write a letter to Secretary of the Treasury Nicholas Brady, Reagan’s Secretary of the Treasury, as a result of which the Chicago Board was cleared to trade stock index futures, all cash settlement. There is another story in which Alan Blinder on the Democratic side played a similar role, by providing the academic legitimacy for the markets and for the integration into the fabric of finance of the derivatives that instrumented modern financial theory. That enabling role – McKenzie has a nice way of putting it – played by modern finance theory can be broken into three separate pieces. Technically, it created a tool through which you could price things that did not heretofore trade. Puts and calls did not trade. The spreads were enormous. So it played a technical role and but it also played a linguistic role. Anytime somebody talks about “implied vol” or implied correlation, they are talking finance theory, they are using the theory as a way of communicating across domains, between quants and traders, between Buy Side and Sell Side. And then finally finance theory played this legitimatory role in that what you are telling people is that you are making the markets more efficient! That’s an unequivocally good thing, right?

The IRA: So was affordable housing and innovative financing, the two buzzwords from the housing bubble that were pushed by Washington, the realtors, the home builders, etc. Same thing with fair value accounting, another self-evident “good idea” that is a practical impossibility, especially in these opaque markets! But we can’t help but wonder if the downstream effects we all see today were not set in motion by the “innocent” but still very powerful actions of economic theoreticians. Just imagine the reaction of most people today if you told them that Milton Friedman and Paul Samuelson are the intellectual authors of the $55 trillion notional CDS pyramid scheme!

Janeway: The point here is that the regulators were captured intellectually, not monetarily. And the last to be converted, to have the religious conversion experience, were the accountants, leading to fair value accounting rules. I happen to be the beneficiary of a friendship with a wonderful man, Geoff Whittington, who is a professor emeritus of accounting at Cambridge, who was chief accountant of the British Accounting Standards Board and was a founder of the International Accounting Standards Board. He is from the inside an appropriately knowledgeable, balanced skeptic, who has done a wonderful job of parsing out what is involved in this discussion in a paper called “Two World Views.” Basically, he says that if you really do believe that we live in a world of complete and efficient markets, then you have no choice but to be an advocate of fair value, mark-to-market accounting. If, on the other hand, you see us living in a world of incomplete, but reasonably efficient markets, in which the utility of the numbers you are trying to generate have to do with stewardship of a business through real, historical time rather than a snapshot of “truth,” then you are in a different world. And that is a world where the concept of fair value is necessarily contingent.

The IRA: Of course. We’ve been thinking about publishing a “Banking for Dummies” book because so many really smart, thoughtful people in the financial world have no idea of the stewardship role played by depositories. Banks are supposed to be havens, repositories for assets that can ignore the short-term movements in price – not value – the market effect of which the fair value regime actually magnifies! But here is a question: we never have suggested that the FASB or the accounting profession wanted to wake up one morning and destroy the world, but the role of unintended consequences here is mind boggling. I doubt anyone at the FASB ever considered non-accounting issues in implementing FAS 157, but these issues such as disclosure, litigation, competition, all played a role in making the fair value accounting rule a catalyst for public panic, both among retail investors and professionals. You differ?

Janeway: What the accountants did do, what the fair value rule did do, was something really fundamental. It started getting into the core of what’s going on now. There were some $730 billion in subprime mortgages outstanding, according to some data I’ve pulled from a very interesting paper by Gary Gorton at Yale (See Gorton, Gary, “The Panic of 2007”, NBER Working Paper 14358, p.76). The first version, which came out in 2008, was called the “Panic of 2007.” In the most recent version, he just calls it the “Subprime Panic” with no date. Let’s say that of that subprime mortgage debt, half will default over the life of the mortgages and after recoveries we’ll be writing off a couple of hundred billion dollars. How did that equate into a ten trillion dollar reduction in global wealth in 12 months? There is a scale factor at work here and something that I have been trying to get straight in my own head, thus the Gorton paper is very useful. One piece is understanding what was involved in the construction of a CDO that was built off of some RMBS that was based upon subprime mortgages. There were two steps there. First step was that subprime was distinctive. Gordon makes the point that in order for subprime mortgages to be confirmed, to make any sense from a credit perspective, then home prices had to continue rising indefinitely. Not just stay the same and not fall. So that meant that they were going to go bust sooner or later. Second, by the time you get to the CDO let alone to a CDO-squared – and this gets back to a point you made before about the banks – the buyer of whichever tranche could not even in principle, much less in practice, see through the layers of securitization and deals to observe the underlying cash flows.

The IRA: Well, your point is borne out by the fact that nobody in the cottage industry of reverse engineers could value these deals accurately, thus you have a index composed of less than a dozen CDO deals. But we know some people who are actually doing the work now. It is interesting to note Gordon’s view of the role of the ABX: “The introduction of the ABX indices created a set of market prices that aggregated and revealed that subprime-related securities were worth a lot less than had been thought. The ability to short subprime risk may have burst the bubble and, in any case, resulted in the market crowding on the short side to hedge, driving ABX prices very low. The panic was then on.”

Janeway: But even Goldman Sachs (NYSE:GS) and everybody else could not value this stuff. The way it was sliced and diced makes it practically impossible. Now, when that happens in this one segment, what segment of the derivative world am I going to trust as representing underlying cash flow? This is where our friends at the rating agencies come in. They built their businesses going back to John Moody on cash flow analysis. One of the great gifts I have from my father is an original 1900 edition of Moody’s book called The Truth About the Trusts. He took apart two hundred of the trusts that had been created in the 1890s and which represented the most brilliant exercise in financial engineering. This is not irrelevant to our point or to where we are
today. What Moody demonstrated was what a revolution in finance the trust represented. Historically, the market valued an equity security based upon its actual cash generation to the investor, the dividend yield. In putting together a trust, Morgan and the others represented a pro forma financial of what the cash flows would be and therefore what the debt carrying capacity would be once the trust was implemented. And that was the moment at which future earning power and not historical cash dividends was invented.

The IRA: So that was the inflection point, the 1890s?

Janeway: That was the inflection point. It was a revolutionary change in perspective.

The IRA: And certainly not a bad thing for the securities sales professional. The revisionist literature of the 1930s, including Graham and Dodd Securities Analysis, attributes this shift in perspective from current
performance to “the future” to the period before the Great Crash, but you suggest that the seed of the concept is much earlier – 40 years earlier.

Janeway: Moody’s goes through the capital structure of each deal, case by case. Two hundred trusts. The Sanitary Ware Trust! They put together a trust based controlling the supply of toilets! Now out of all of these trusts, only five or so out of two hundred delivered the goods to investors. They were able to restrict supply and use monopoly rents to maximize prices. This was the basis on which Carnegie got $900 million of bonds for US Steel, which by the way never traded at its initial offering price except I believe one moment in WW I. In any case, Moody began his business as a subscription business paid for by investors to analyze cash flow. They then discovered the beauty of the issuer pays model. Marlon Brando could have told them the answer from the film “The Godfather”: “You got a nice little bond
there. You want to protect it?”

The IRA: The rating agency monopoly up to this crisis could certainly be viewed as a form of legalized extortion. There was no choice for a global issuer but to go to Moody’s or S&P.

Janeway: Yes, but even so the job of the rating agencies until as little as a decade ago was to evaluate cash flows. Then came the CDO.

The IRA: Yes but Moody’s and S&P were not explicitly paid to notch CDOs each month. They were paid in the primary market effectively acting as an adviser – and sharing in commissions. But there was no “issuer pay” model explicit in the CDO budget for following these deals in the secondary market.

Janeway: On the other hand, the model of what they were doing, namely correlation models – there’s a great quote in the latest issue of Risk Magazine by a very smart guy named William Perraudin of Imperial College in London. It goes side by side with chapter 12 of
Keynes’ General Theory and Ben Graham’s Columbia lectures from 1948, which are up on the web and are great reading. Perraudin says: “Of course, if you are constructing and selling and retaining a piece of a CDO, you have to use the same correlation model as the market because you are going to be hedging in the same market you are selling.” Just as Keynes says it is so much easier to stay with the mob as opposed to being a long term investors. And Keynes says in this regard that you have to be rich to be a long term investor, not just in capital but in terms of your funding base.

The IRA: So where do we go from here?

Janeway: Long before this blew up, one of the things I really remember from 1999-2000 is the fate of two great investors. Each of whom decided that the bubble made no sense: Warren Buffett and Julian Robertson. Warren Buffett had perpetual capital. Julian Robertson was on a three month holdback. Buffett could just watch Berkshire Hathaway (NASDAQ:BERK) stock get hit and stayed in business, but Robertson’s hedge funds got folded.

The IRA: Robertson still has a few people running money for
him. But back on track, the thing we continue to find amazing is the degree to
which people were willing, to you point, to suspend disbelief and ignore basic
warnings even as the rating agencies dropped the ball on structured finance.

Janeway: The credit default swap market began to drive the

The IRA: You see people referencing CDS spreads in bank loan
documentation. It’s amazing the degree to which market participants and the
media are willing – indeed, eager – to treat CDS spreads as the gospel truth on
a subject’s likelihood of default. Personally I see CDS as more of an equity
volatility tool, but that is another story.

Janeway: In bank loans now you are being priced not on LIBOR
but on CDS.

The IRA: But isn’t that ridiculous? The pricing in the CDS
market is like you and I walking down Bishopsgate in London and peering in the
windows of Lloyds of London to see if any risk is being written on FL
hurricanes and at what price. There is no significant secondary market in these
contracts that thus no price quality in terms of projecting probaility of
default. CDS is a primary market much like Lloyds of London, where issuers
write cover on demand and lay off risk via offsetting treaties. Is that fair?
The public pricing in CDS is a function of a survey of sales assistants late in
the afternoon.

Janeway: I agree with you completely. So, one of the notions
built into modern portfolio theory is that you begin with something called
fundamental value and then you see how investors’ behavior tracks with it,
drives you to it or is at variance with it. I was saying to some of my friends
and colleagues at Cambridge last week, when looking at a paper along these
lines, that when it comes to all of these papers, after 37 years in the private
equity world, I still don’t know what is fundamental value. I know when prices
have deviated from what we retrospectively have decided it was, because they
become silly. I know that in the late 1970s, when I could buy shares in a
profitable private company growing at 30% a year for 10x earnings, that was a
silly price and that we were going to get rewarded for it. Similarly in 1999, we
basically liquidated the tech/telecom portfolio at Warburg Pincus into the
market because we knew those valuations were too high. By the summer of 2006,
listening to my partners tell me about the terms or the lack of terms in the
leveraged loan market, it was clearly silly. You don’t need modern finance
theory to generate silly prices. One of the things that really pleases me no end
is the rediscovery of Hyman Minsky, who was a professor of economics at
Washington University in St Louis. I knew Minsky very well. He and my cousin
Dick Gordon, who had been research director of Monsanto, were on the board of
the Mark Twain Banks in St. Louis. That is how I met Hy 30 years ago. Hy’s view
of the world was from the world of the commercial banker. And we had a lot of
discussions because mine was the perspective of an equity investor. Where those
two perspectives met was an interesting interface. The point is that Minsky’s
“fragile financial hypotheses” evolved in the context of a review of the history
of banking and the history of economics and capitalism, completely independently
from anything having to do with modern finance theory. Very simple: You make a
loan and you get paid back. You make a loan to someone whose operating cash
flows cover both interest and principal…

The IRA: Now that is a radical concept.

Janeway: This is a very conservative loan to make. You get paid
back and your views of the world are validated. And it is an inevitable process
that, as you make loans that are paid back, you start making loans where the
interest is fully covered. The first mode is the “hedge mode” of banking
lending, where you are fully hedged for the underlying cash flows of the loan
including principal, but in the second you are covered by the cash flows for
interest payments, but you are basically relying on refinancing for principal
repayment. So you are not talking about a fully amortizing mortgage, for
example. That is the what Minsky called the “speculative” mode of lending. As
this type of lending becomes accepted, over time as the principal does get
refinanced and the interest payments are not missed, lenders loosen terms even
further. Then you move inevitably into the third and final phase, the “Ponzi”
phase, where people are borrowing the interest.

The IRA: As you are describing the three phases of the lending
cycle, the comparison with the different levels of the insurance markets comes
to mind, from low-beta, relatively uncorrelated transactions involving weather
or op-risk events, vs. the high-beta world of CDS. The progression and evolution
of risk taking in lending follows the same pattern. And now in CDS we have $50
trillion or so in contingent barrier options, written against CDOs, corporate
bonds and anything else the derivatives community could dream up, that our
financial system must fund as default rates rise. And these claims are largely
speculative and have no connection to the real economy.

Janeway: Right. These are basically leveraged bets. Minisky
illustrates the cycle, the kind of excess that evolves over time.

The IRA: What do you think Minsky would say about CDS? A fourth
level of risk?

Janeway: Yes. By the way, another name which comes to mind in
this conversation, another fellow I also knew and a remarkable character named
Nick Sibley, of the pioneering Hong Kong investment bank Jardine Fleming, formed
as a joint venture by Jardine Matthiesson and the British merchant Bank Robert
Fleming. The IRA: Sure. We remember the day that they announced the acquisition
of Bear Stearns more than a few years back. Janeway: They were the pioneers in
China. In Hong Kong, they were kings. Sibley was the public face of Jardine
Fleming. He once said that giving liquidity to bankers is like giving a barrel
of beer to a drunk. You know exactly what is going to happen. You just don’t
know which wall he is going to choose.

The IRA: Somebody should remind Ben Bernanke and the Fed of
that fact.

Janeway: Whether it is in the oil patch in 1981 or subprime
mortgages, they can’t help it.

The IRA: Precisely. But the point is that we have all dug a
very large hole here. The losses to banks on and off balance sheet could soak up
all of the marginal liquidity expansion by the G-7 central banks for years,
depressing real economic growth. Do you differ?

Janeway: There are two indictments of modern finance theory
that define the hole we are in now. The first is the distinction between
illiquidity and insolvency. When I was a kid growing up in this business in the
1970s, we thought of illiquidity and insolvency as two fundamentally different
conditions. You were illiquid if the expected net present value of the cash
inflows that I am entitled to by contract exceed the expected present value of
the net outflows. All I have is a timing problem. You can tide me over. You are
insolvent if the reverse applies. I’m bust. In this world, when you mark to
market, liquidity drives insolvency.

The IRA: Correct. This is the point we try gently to get our
friends in the accounting world to accept, namely that the snapshot of price at
a point in time is not value. It reminds us of Heisenberg’s Principle in

physics. We kind of sort of understand the rate of movement and approximate
positions of objects in space, but we have no idea of the precise location at
any point in time. At least the great men of science admit when they don’t know.

Janeway: Yes. So when we hear Secretary Paulson’s explanation
of why he refused to protect the creditors of Lehman Brothers, they made that
theoretical statement about fair value real. That decision shifted the systemic
process of deleveraging that we’ve been going through for 15 months into panic,
the first real panic we’ve seen in this country since the Depression.

The IRA: Correct. We would put the Washington Mutual closure
alongside Lehman. There are investors all over the world that are still trying
to come to grips with the decision to wipe out the creditors of WaMu. We hear
that the reaction to the decision to resolve WaMu forced the FDIC and the Fed to
come up with a buyer for Wachovia (NYSE:WB). We’ve heard that a number of Asian
central banks made strong representations to the US regarding the desirability
of avoiding similar events.

Janeway: The Lehman decision is one indictment. The other is
really the flip side of modern finance theory. It’s the notion that money is a
veil, the financial system is a circus, and somewhere out there is a real
economy whose behavior and performance is driven entirely by “real” factors,
above all growth in the labor force and productivity, TFP, total factor
productivity. And that you can model how this economy will work without taking
note of anything financial except the interest rate, which in fact is determined
by the central bank. So all of this money stuff is excluded. What I am saying is
so silly that it is useful. A professor from the University of Chicago, Casey
Mulligan, wrote a piece in the New York Times (“An Economy You Can Bank On,” New York Times, October 9,
in which he basically said: if you are not one of the six
percent of the work force that is not employed in finance, don’t worry, be
happy. If a bank fails, another bank will emerge to fill its role. There will be
some transitional effects, but the real economy is basically isolated from the
financial economy. The real economy will continue on its course, essentially
proving Say’s Law, that supply creates demand. Keynes never lived and supply
creates its own demand in real terms and we can ignore the fundamental fact of a
monetary economy. Which is, that the non-financial sector lives on the provision
of working capital and fixed investment, to be able to spend money before money
is received. For being able to pay workers and vendors before receivables are
collected. And to increase capacity before the revenues from higher sales are

The IRA: And I would say Mulligan is dead wrong. Middle America
is doing better than the coasts, but you cannot help but be impressed with the
widening range of negative GDP estimates for the 2009-2010 forecasting horizon,
for the entire global economy.

Janeway: We are talking here of the most fundamental economics.
It took real genius to break down this relationship between the real and
financial sectors. All of the assets and liabilities of the financial sector, at
the end of the day, come down to whether or not, back to Minsky, the cash flows
from the non-financial sector validate them. The integration of the financial
and non-financial sectors of the economy is complete. The interdependence is
complete. And that’s why I call the period from the collapse of the Bear Stearns
hedge funds got into trouble, then Northern Rock, from about September 2007 to
today the wasted year.

The IRA: Roger Kubarych starts the reckoning from the collapse
of New Century Financial.

Janeway: The authorities again and again pumped liquidity into
the financial system, adding liquidity to banks but without addressing the
insolvency issue. They didn’t see the issue clearly until almost a year later
and then Washington missed the issue of fiscal stimulus to bolster the cash
flows of the non-financial sector.

The IRA: You’ve just summarized very
nicely why we believe that Fed Chairman Ben Bernake should be replaced by
President Obama and FRBNY President Tim Geithner should not be considered as
Treasury Secretary. But how do you account for the huge increase in the visible
portion of finance that is not connected at all to real economic activity, that
is purely speculative?

Janeway: I think you are too hard to Geithner. In
terms of speculation, well, we start with the South Sea bubble…

The IRA: Yes, but the age of modern finance your have so
skillfully described has allowed us to make the speculative economy much larger.

Janeway: This is precisely my point. This is the role of theory
in modern finance. What we were doing is making the markets complete. One of the
great thinkers and great men of the last half of the 20th Century who, like
Samuelson, is still alive, is Ken Arrow. The Arrow-Debreu general equilibrium mathematical
was one of the precursors to the current mess. If
only we had hung it up on the wall and contemplated it as an aesthetic object,
and never led people down this terrible path towards trying to make it
operational. This notion that “if” markets were complete and efficient; “if” we
had the infinite array of contingent securities so that we could at one point in
time hedge every possible event, we’d have complete closure, everything would

The IRA: It’s called absolute zero in physics, the end of molecular motion. It implies the end of days and, thus, is hopefully only a theoretical possibility. That’s why my partner Dennis Santiago and I prefer Minsky and scientific notions like entropy to describe market behavior.

Janeway: Exactly. Reaching general equilibrium implies that we have extracted ourselves from historical time and that we are frozen in stasis. We had done one trade that was good forever. And remember that the math is beautiful. The practical effect is catastrophic. And that is the catastrophe you are talking about. Because as we build layer upon layer of derivatives, what we were doing was pursuing Ken Arrow’s challenge. These are not bad people, they have simply been chasing the impossible dream of completing the market and, going back to MacKenzie, chasing the legitimatory goal of making the world a more efficient place.

The IRA: The road to hell is paved with good intentions. Thanks Bill.

Comments? Questions?

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