I'm still getting a lot of emails and reading a lot of stories on the right about the subprime mortgage mess as the cause of the greatest financial meltdown in history. Look, I think Barney Frank is a brain dead socialist blowhard and should probably be in jail along with Franklin Raines and a raft of other crooks at Fannie Mae and Freddie Mac. But the subprime crisis could have happened and its bubble burst without causing the financial collapse we now find ourselves mired in. The cause of this crisis is a change in the structure of financial markets which allowing hedge fund operators and other sharks to leverage bad loans geometrically. Republicans as well as Democrats supported this system and gave it legislative backing.
You could look on the economic collapse as a convergence of socialist and free market (anti-regulatory) ideological manias. Phil Gramm's deregulatory prejudices are at least as responsible for this economic ruin as Barney Frank's ignorant redistributionist fantasies. No one's hands are clean. It is important to understand this if we are are to construct a political way forward, taking the opportunity of not having a Gramm Secretary of the Treasury to reconstitute the conservative cause.
Below are some excerpts from a recent interview with Bill Janeway that appeared in The Institutional Risk Analyst: http://us1.institutionalriskanalytics.com/pub/IRAMain.asp
To continue our search for understanding as to the antecedents of today¹s 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, Bill¹s 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 didn¹t 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 ³replicating portfolio² 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
Janeway: The book comes to an end at the end of 2006 and the start of 2007, 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 conflictŠ
The IRA: We discussed that very issue with Alex Pollock at AEI some time ago (²Conflicted Agents and Platonic Guardians: Interview with Alex Pollock¹, 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
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: That¹s 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
Market efficiency should rise to the point where there isn¹t any spread left
to be captured. The fact that a half a percent unhedged swing in your
sheet can render you insolvent, well it doesn¹t fit with this entire
constructed intellectual universe that goes back 50 years.
The IRA: But doesn¹t this certainty about the ability of science and
mathematics to reveal truth go back to WWII and the Whiz Kids of McNamara¹s
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
The IRA: We¹ve heard similar lamentations from Bob Merton, though perhaps we
need to invite him to an interview with The IRA.
Janeway: We¹ll, wait a minute, Merton did produce those little flashcards
for the traders on the floor of the Chicago exchanges, so let¹s 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 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 ³positive economics.² Now, interestingly, Milton
Friedman, the other philosophical father of financial economics, came
together with Samuelson on this principle applied to the ³real world.² 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 ³as if² principle,
namely that we should do our work ³as if² they were, as if people were
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 (²The Tyranny of Reason: Interview with Timothy
Dickinson¹, 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 ³new hope.² This is an empire which is crumbling. But there is
a new hope.
The IRA: Glad to hear you say that. So you don¹t 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 don¹t really see it as a cycle. It does evolve, but not as a
cycle. Let me back up. I don¹t 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
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
MacKenzie¹s 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 today¹s situation. But we digressŠ
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 Skidelsky¹s 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 ³Where do you want us to put
The IRA: Oh God.
Janeway: He hadn¹t 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 don¹t 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, Reagan¹s 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
technical role and but it also played a linguistic role. Anytime somebody
talks about ³implied vol² 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! That¹s 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
³good idea² that is a practical impossibility, especially in these opaque
markets! But we can¹t help but wonder if the downstream effects we all see
today were not set in motion by the ³innocent² 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 ³Two World
Views.² 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 ³truth,² 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. We¹ve been thinking about publishing a ³Banking for
Dummies² 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.
Janeway: What the accountants did do, what the fair value rule did do, was
something really fundamental. It started getting into the core of what¹s
going on now. There were some $730 billion in subprime mortgages outstanding,
according to some data I¹ve pulled from a very interesting paper by Gary
Gorton at Yale (See Gorton, Gary, ³The Panic of 2007?, NBER Working Paper
14358, p.76). The first version, which came out in 2008, was called the
³Panic of 2007.² In the most recent version, he just calls it the ³Subprime Panic²
with no date. Let¹s say that of that subprime mortgage debt, half will
default over the life of the mortgages and after recoveries we¹ll 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 Gordon¹s view
of the role of the ABX: ³The 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.²
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 Moody¹s 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
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 ³the future² to the period before the Great Crash, but you
suggest that the seed of the concept is much earlier - 40 years earlier.
Janeway: Moody¹s 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 ³The Godfather²: ³You got a nice little bond
there. You want to protect it?²
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 Moody¹s 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 Moody¹s 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 ³issuer pay² 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 - there¹s 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 Keynes¹ General Theory and Ben Graham¹s Columbia lectures from 1948, which
are up on the web and are great reading. Perraudin says: ³Of 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.² 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
dot.com/telecom 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 Robertson¹s 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. It¹s amazing the degree to which market participants and the
media are willing - indeed, eager - to treat CDS spreads as the gospel truth
on a subject¹s 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 isn¹t 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 investors¹ 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 don¹t 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 don¹t 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. Hy¹s
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
Minsky¹s ³fragile financial hypotheses² 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 principalŠ
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 ³hedge mode² 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 ³speculative² 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
³Ponzi² 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
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 don¹t
know which wall he is going to choose.
The IRA: Somebody should remind Ben Bernanke and the Fed of
Janeway: Whether it is in the oil patch in 1981 or subprime
mortgages, they can¹t 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. I¹m 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 Heisenberg¹s 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 don¹t
Janeway: Yes. So when we hear Secretary Paulson¹s 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 we¹ve been going through for 15 months into
the first real panic we¹ve 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). We¹ve 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. It¹s 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 ³real² 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 (²An Economy You Can Bank On,²
New York Times, October 9, 2008?) in which he basically said: if you are not one of the six
percent of the work force that is not employed in finance, don¹t 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 Say¹s 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
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 that¹s 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 didn¹t 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: You¹ve 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 on Geithner. In
terms of speculation, well, we start with the South Sea bubbleŠ
The IRA: Yes, but the age of modern finance your have so
skillfully described has allowed us to make the speculative economy much
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 construction 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 ³if² markets were complete and efficient; ³if²
we had the infinite array of contingent securities so that we could at one
point in time hedge every possible event, we¹d have complete closure, everything
The IRA: It¹s called absolute zero in physics, the end of molecular motion.
It implies the end of days and, thus, is hopefully only a theoretical
possibility. That¹s 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 Arrow¹s 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.