Gambling with Borrowed Chips: The Common Misdiagnosis of the Crisis of 2007–08

Gambling

with Borrowed Chips

The Common Misdiagnosis of

the Crisis of 2007-08

Christopher C. Faille

Gambling with Borrowed Chips

The Common Misdiagnosis of the Crisis of 2007-08

Copyright © 2012 Christopher C. Faille

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ISBN: 978-1-4582-0175-1 (sc)

ISBN: 978-1-4582-0176-8 (e)

Library of Congress Control Number: 2011963749

Printed in the United States of America

Abbott Press rev. date: 2/6/2012

CONTENTS

Acknowledgements

Introduction: Trust the Tale

ONE

TWO

THREE

FOUR

FIVE

SIX

SEVEN

EIGHT

NINE

TEN

ELEVEN

TWELVE

THIRTEEN

FOURTEEN

FIFTEEN

SIXTEEN

SEVENTEEN

APPENDIX

For Hans Schroeder, publisher of The Pragmatist

And although a man always risks much when he breaks away from established rules and strives to realize a larger ideal whole than they permit, yet the philosopher must allow that it is at all times open to any one to make the experiment, provided he fear not to stake his life and character upon the throw. – William James

Acknowledgements

I’ve dedicated this book to Hans Schroeder, because it was through my involvement with his baby, The Pragmatist, that I first became part of the discussion of the great public issues of most concern to me. That magazine, the result of collaboration between Schroeder and estimable Jorge Amador, was dedicated to the proposition that liberty works, in concrete and demonstrable ways, and that coercion fails. The way to advance the cause of liberty, then, is to explain how and why it works. That simple insight has carried me forward ever since.

I’d like to thank Lee Miringoff, of Marist College, Poughkeepsie, New York, who gave me some practical experience polling, back in the late 1970s, at the start of what has since become the Marist Institute for Public Opinion.

I thank Myrna Gans, Steve Leo, and Susan Glass. I retain my memories of their comradeship in a suite of law offices in Bridgeport, CT in the 1980s as among my few pleasant memories of what was, for me, an unhappy experiment.

I thank Robert Katz, also a friend in that place and time, for doing his best to turn me into a practical politicians, hopeless though that cause proved to be.

I thank Associate Justice Clarence Thomas for citing an article of mine in his concurring opinion in 44 Liquormart v. Rhode Island (1996). It was a signal honor and, as a result, I have since flattered myself that I played a small role expanding the scope of first amendment protections. I also thank whatever clerk drew that article to Justice Thomas’ attention.

I thank Henry Cohen, who encouraged and advised me in the course of writing that article and many others over many years.

I’d also like to acknowledge Kristin Fox, Johann Wong, and everybody who did the heavy lifting to bring HedgeWorld into existence as the Clinton years came to an end. Because of their efforts, I had the opportunity to cover and learn about the issues that I discuss in this book in greater depth than would have been possible by any other route – and to do so while pulling down a salary and calling my discoveries work.

Thanks are due to the great figures of the econoblogosphere, the loners sitting at their keyboards in their pajamas who have created a cyberspatial haven for intense debate over how markets work. I have in mind especially the late Greg Newton, of Naked Shorts, who was able to scan a 280 page court filing on the demise of the Plus Funds and find the one newsy nugget.

Gary Weiss, Roddy Boyd, Tracy Coenen, have all made their marks on my understanding of these issues and on this book, as has that discreditable felon, Sam Antar.

I thank Christopher Holt for founding AllAboutAlpha, and Kristin Fox – yes, the same one thanked above! – for carrying on as the AlphaFemale there.

I thank Rosalie Schultz for a long and stimulating correspondence. I am sorry that I let it lapse, and hope she forgives me that.

I thank Cicily for much, but in particular for suffering with me through Oliver Stone’s second Wall Street movie, a crucial moment of inspiration.

Other debts will become obvious within the body of the text. Still others probably won’t. But all those to whom I owe debts know who they are, and to all: Thank you.

Oh, and if it isn’t obvious: No one mentioned above should be held responsible in any way for the opinions or the blatant mistakes of what follows.

Introduction: Trust the Tale

Our subject is the meltdown of the U.S. financial system, and as a result the devastation of much of the economy, through the years 2007 and 2008. We will have much to say about why this happened, but we will have even more to say about the most common wrong answer to the question why.

The common misdiagnosis runs like this: speculation (especially on the short side – speculation that certain assets will drop in value), combined with indebtedness, leverage, deregulation, and greed, produced mayhem. Western economies, beginning with that of the United States, received a deserved rebuke for allowing irresponsible people to turn the economy into a big casino, where most of the gamblers depend on borrowing their chips to stay at the table.

The gist of all that I would like to convey in what follows is this: there is nothing wrong with speculation (gambling if you will). Indeed, it performs a valuable social function. Further, there is nothing wrong with gambling even if one borrows chips to do so. What is wrong is a system in which it is overly easy to borrow those chips. We will come to understand the crisis of 2007-08 only if we first brush aside the blatantly wrong explanations, only if we refuse to blame either the chips or the casinos.

In 2010, as if to codify the misdiagnosis, Gordon Gekko returned to movie screens. Let’s pause over this, because I do believe Hollywood movies give vivid and valuable expression to bad ideas. It is possible that such a movie will also someday give vivid expression to a good idea, but I must confess I can’t think of any examples offhand.

Gekko had been the anti-hero of the 1987 movie Wall Street. That one was a compendium of clichés, starting with the characterization of Carl Fox (played by Martin Sheen), the eternal Hollywood idea of the salt-of-the-earth working man. A Jimmy Stewart character out of time: Carl had worked hard all his life and attained an important position in a labor union consisting of the employees of an aircraft company.

Then there was Carl’s son, Bud Fox. Bud was the young-man-in-a-hurry. Though he loved his father, he didn’t love his father’s life. He wanted something better – which he understood to mean more luxurious. Flashier.

Gordon Gekko, played by Michael Douglas, is the flashiest guy in town, and the one who leads Bud disastrously astray, into the world of insider trading, and toward prison sentences for them both.

Just as Bud seems to have sunk to Gekko’s level, he gets a call telling him that his father has had a heart attack, and he rushes to the hospital. The bedside visit changes everything, and you can cue the uplifting music from there on until the credits roll.

Corn-filled though that was, its redeeming value was Douglas’ performance as Gekko. Gekko has a perverse charm, and gets the movie’s best lines – and since this was 1987, the year Margaret Thatcher secured herself a third term on 10 Downing Street, the year Gorbachev announced perestroika in the Soviet Union, much of the audience seems to have walked out of theatres thinking Gekko was the good guy.

Director Oliver Stone was aghast at that misinterpretation of his opus, and eventually decided to direct a sequel which would make it clear just how bad Wall Street finagling really is. This might cause us to reflect on the notion of an intentional fallacy. Does a view of a work of art become a misinterpretation because the artist says it is? What of the old advice to trust the tale, not the teller?

Setting aesthetic theory aside: the teller tried again. This time, he showed us, in the opening scene, Gordon Gekko released from prison. He is a changed man: gone is his money-making zeal and oily charm. He gets out of prison, in short, a bore. Aside from trying to reconnect with his daughter he is chiefly interested in getting out on the lecture circuit to spread the word. The word is not merely don’t trade on insider information, which is after all the offense that got him locked away. The word, broadened, and repeated in lots of voice-overs, is that speculation, money-lust, finance capitalism, is truly insane.

I walked out of that movie persuaded that I had to convey to the world the message that I hope you find herein. If this short book, and the longer sequels I hope to write, convey between them only one idea, I would like that idea to be the contrary of that: don’t blame speculation.

Yes, speculative activity can become excessive and abusive. The best check upon this, though, is not regulation, much less criminalization – the best check is the systemic one of a hard money policy.

ONE

The Old Stigma: Speculators as Parasites

Over the weekend of September 13-14, 2008, Merrill Lynch sold itself to Bank of America at a once-unimaginably cheap price. In the early morning of Monday, September 15, came news more shocking still: Lehman Brothers had filed for bankruptcy. That day the DJIA opened at 11,416 and headed straight down, ending at 10,917.

On Tuesday, the central bank of the United States, the Federal Reserve, lent $14 billion to the huge insurance company AIG. That achieved its desired effect, producing a bit of an upward blip in the Dow, allowing very uncalm policy makers to declare that they had calmed the markets. There were wild zigzags through the rest of the month as the market absorbed ever-changing news of money-market repercussions, government and Fed reactions, and overseas echoes of all of it. At the end of September, though, the good news – if one can call it that – was that the Dow was still only a little lower than the bottom of that mid-month vertical line.

If September had been startling, October was devastating, bringing the Dow into the 8,000s. On October 11, the head of the International Monetary Fund (IMF), Dominique Strauss-Kahn, spoke for many, saying: Intensifying solvency concerns about a number of the largest US-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.

We need not continue the chronology. Subsequent events, both on and off Wall Street, proved satisfactorily that finance has a critical role to play in the broader economy, for better and for worse. For richer and for poorer. Private sector residential loans disappeared (for the next two years only Fannie and Freddie, now themselves overtly wards of Uncle Sam, financed home buying at all). Commercial loans, too, virtually disappeared. States, municipalities, and a variety of quasi-public entities intertwined with them both felt severe budgetary pressures, and the unemployment rate stayed consistently above 9 percent quarter after quarter.

One sometimes amusing variant of the blame-the-speculators impulse that has come to the fore in the wake of these events is let’s blame it all on Goldman Sachs, in the manner of Matt Taibbi in his July 2009 article for Rolling Stone, who started things off with his vampire squid analogy. The article begins: The first thing you need to know about Goldman Sachs is that it’s everywhere. The world’s most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.

He almost makes it sound like that’s a bad trait.

The Senate Permanent Subcommittee on Investigations was only slightly more subtle in those not-especially-enlightening hearings on Goldman that the Senators staged in April 2010.

The Senators were exercised in particular over the ABACUS special purpose vehicle. Without getting into the jargon involved, we need only say now that ABACUS was a series of transactions in which Goldman offered to serve as the bookie and allow people to take bets for or against the credit worthiness of homeowners.

The first ABACUS deal came about in 2004, when the housing boom still had some way to run. A German bank, IKB, wanted exposure to a specific collection of mortgage-backed securities, because it thought these securities were sound. In other words, IKB wanted to bet that the securities were sound without having to actually own any interest in the mortgages.

For IKB to get the kind of deal that it wanted, Goldman like any other bookie had to find somebody else to take the other side of the bet. It had to find a short, somebody willing to bet that a lot of those underlying mortgages would default. In 2004, it was tough to find anybody willing to short, because optimism about the housing market was very widespread.

Prices and credit worthiness are closely related issues. As long as prices kept going up, it did little harm for people who were not especially credit worthy to buy homes with no money down. After all, they’d just have to last a couple of months, then flip the house to another buyer at the higher price, pocket their profit, pay off their lenders … and everyone would be happy. It was only when the upward trajectory of housing prices changed that flipping ceased to be an option and credit worthiness became a critical issue.

Over the next three years, Goldman used ABACUS as a brand name. It became a market maker, setting the table where optimists and pessimists met.

Fabrice Tourre, a mid-level trader at Goldman, wrote some entertainingly expressed emails about the ABACUS trades, which have helped keep them in the limelight – in one, the most oft quoted, he refers to himself as the Fabulous Fab who didn’t understand all of the implications of those monstrosities.

In a more prosaic moment, Tourre wrote in June 2006 that "ABACUS enables us to create a