Conjuncted: Long-Term Capital Management. Note Quote.

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From Lowenstein‘s

The real culprit in 1994 was leverage. If you aren’t in debt, you can’t go broke and can’t be made to sell, in which case “liquidity” is irrelevant. but, a leveraged firm may be forced to sell, lest fast accumulating losses put it out of business. Leverage always gives rise to this same brutal dynamic, and its dangers cannot be stressed too often…

One of LTCM‘s first trades involved the thirty-year Treasury bond, which are issued by the US Government to finance the federal budget. Some $170 billion of them trade everyday, and are considered the least risky investments in the world. but a funny thing happens to thirty-year Treasurys six months or so after they are issued: they are kept in safes and drawers for long-term keeps. with fewer left in the circulation, the bonds become harder to trade. Meanwhile, the Treasury issues new thirty-year bond, which has its day in the sun. On Wall Street, the older bond, which has about 29-and-a-half years left to mature, is known as off the run; while the shiny new one is on the run. Being less liquid, the older one is considered less desirable, and begins to trade at a slight discount. And as arbitrageurs would say, a spread opens.

LTCM with its trademark precision calculated that owning one bond and shorting another was twenty-fifth as risky as owning either outright. Thus, it reckoned, it would prudently leverage this long/short arbitrage twenty-five times. This multiplied its potential for profit, but also its potential for loss. In any case, borrow it did. It paid for the cheaper off the run bonds with money it had borrowed from a Wall Street bank, or from several banks. And the other bonds, the ones it sold short, it obtained through a loan, as well. Actually, the transaction was more involved, though it was among the simplest in LTCM’s repertoire. No sooner than LTCM buy off the run bonds than it loaned them to some other Wall street firm, which then wired cash to LTCM as collateral. Then LTCM turned around and used this cash as a collateral on the bonds it borrowed. On Wall street, such short-term, collateralized loans are known as “repo financing”. The beauty of the trade was that LTCM’s cash transactions were in perfect balance. The money that LTCM spent going long matched the money that it collected going short. The collateral it paid equalled the collateral it collected. In other words, LTCM pulled off the entire transaction without using a single dime of its own cash. Maintaining the position wasn’t completely cost free, however. Though, a simple trade, it actually entailed four different payment streams. LTCM collected interest on the collateral it paid out and paid interest at a slightly higher-rate on the collateral it took in. It made some of this deficit back because of the difference in the initial margin, or the slightly higher coupon on the bond it owned as compared to the bond it shorted. This, overall cost a few basis points to LTCM each month.

Open Market Operations. Thought of the Day 93.0

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It can be argued that it would be much more democratic if the Treasuries were allowed to borrow directly from their central bank. By electing a government on a program, we would know what deficit it intends to run and thus how much it will be willing to print, which in the long run is a debate about the possible level of inflation. Instead, it has been argued that decisions made on democratic grounds might be unstable as they are affected by elections. However, the independence of central banks is also serving the interest of commercial bankers as we argue now.

In practice, the central bank buys and sells bonds in open market operations. At least it is always doing so with short term T-bonds as part of the conventional monetary policy, and it might decide sometimes to do it as well with longer maturity T-bonds as part of the unconventional monetary policy. This blurs the lines between a model where the central bank directly finances the Treasury, and a model where this is done by commercial banks since they result in the same final situation. Indeed, before an open market operation the Treasury owes central bank money to a commercial bank, and in the final situation it owes it to the central bank itself, and the central bank money held by the commercial bank has been increased accordingly.

The commercial bank has accepted to get rid of an IOU which bears interest, in exchange of a central bank IOU which bears no interest. However the Treasury will never default on its debt, because the state also runs the central bank which can buy an infinite amount of T-bonds. Said differently, if the interest rates for short term T-bonds start to increase as the commercial banks become more and more reluctant to buy these, the central bank needs to buy as many short-term bonds as necessary to ensure the short term interest rates on T-bonds remain at the targeted level. By using these open market operations a sovereign state running a sovereign currency has the means to ensure that the banks are always willing to buy T-bonds, whatever the deficit is.

However, this system has a drawback. First when the commercial bank bought the T-bond, it had to pretend that it was worried the state might never reimburse, so as to ask for interests rates which are at least slightly higher than the interest rate at which they can borrow from the central bank, and make a profit on the difference. Of course the banks knew they would always be reimbursed, because the central bank always stands ready to buy bonds. As the interest rates departed from the target chosen by the central bank, the latter bought short term bonds to prevent the short term rate from increasing. In order to convince a commercial bank to get rid of a financial instrument which is not risky and which bears interest, the only solution is to pay more than the current value of the bond, which amounts to a decrease of the interest rate on those bonds. The bank thus makes an immediate profit instead of a larger profit later. This difference goes directly into the net worth of the banker and amounts to money creation.

To conclude, we reach the same stage as if the Treasury had sold directly its bond to the central bank, except that now we have increased by a small amount the net worth of the bankers. By first selling the bonds to the commercial banks, instead of selling directly to the central bank, the bankers were able to realize a small profit. But this profit is an immediate and easy one. So they have on one side to pretend they do not like when the Treasury goes into debt, so as to be able to ask for the highest possible interest rate, and secretly enjoy it since either they make a profit when it falls due, or even better immediately if the central bank buys the bonds to control the interest rates.

The commercial banks will always end up with a part of their assets denominated directly in central bank money, which bears no interest, and T-bonds, which bear interest. If we adopt a consolidated state point of view, where we merge the Treasury and the central bank, then the commercial banks have two types of accounts. Deposits which bear no interests, and saving accounts which generate interests, just like everybody. In order to control the interest rate, the consolidated state shifts the amounts from the interest-less to the interest-bearing account and vice-versa.

Financial Entanglement and Complexity Theory. An Adumbration on Financial Crisis.

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The complex system approach in finance could be described through the concept of entanglement. The concept of entanglement bears the same features as a definition of a complex system given by a group of physicists working in a field of finance (Stanley et al,). As they defined it – in a complex system all depends upon everything. Just as in the complex system the notion of entanglement is a statement acknowledging interdependence of all the counterparties in financial markets including financial and non-financial corporations, the government and the central bank. How to identify entanglement empirically? Stanley H.E. et al formulated the process of scientific study in finance as a search for patterns. Such a search, going on under the auspices of “econophysics”, could exemplify a thorough analysis of a complex and unstructured assemblage of actual data being finalized in the discovery and experimental validation of an appropriate pattern. On the other side of a spectrum, some patterns underlying the actual processes might be discovered due to synthesizing a vast amount of historical and anecdotal information by applying appropriate reasoning and logical deliberations. The Austrian School of Economic Thought which, in its extreme form, rejects application of any formalized systems, or modeling of any kind, could be viewed as an example. A logical question follows out this comparison: Does there exist any intermediate way of searching for regular patters in finance and economics?

Importantly, patterns could be discovered by developing rather simple models of money and debt interrelationships. Debt cycles were studied extensively by many schools of economic thought (Shiller, Robert J._ Akerlof, George A – Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism). The modern financial system worked by spreading risk, promoting economic efficiency and providing cheap capital. It had been formed during the years as bull markets in shares and bonds originated in the early 1990s. These markets were propelled by abundance of money, falling interest rates and new information technology. Financial markets, by combining debt and derivatives, could originate and distribute huge quantities of risky structurized products and sell them to different investors. Meanwhile, financial sector debt, only a tenth of the size of non-financial-sector debt in 1980, became half as big by the beginning of the credit crunch in 2007. As liquidity grew, banks could buy more assets, borrow more against them, and enjoy their value rose. By 2007 financial services were making 40% of America’s corporate profits while employing only 5% of its private sector workers. Thanks to cheap money, banks could have taken on more debt and, by designing complex structurized products, they were able to make their investment more profitable and risky. Securitization facilitating the emergence of the “shadow banking” system foments, simultaneously, bubbles on different segments of a global financial market.

Yet over the past decade this system, or a big part of it, began to lose touch with its ultimate purpose: to reallocate deficit resources in accordance with the social priorities. Instead of writing, managing and trading claims on future cashflows for the rest of the economy, finance became increasingly a game for fees and speculation. Due to disastrously lax regulation, investment banks did not lay aside enough capital in case something went wrong, and, as the crisis began in the middle of 2007, credit markets started to freeze up. Qualitatively, after the spectacular Lehman Brothers disaster in September 2008, laminar flows of financial activity came to an end. Banks began to suffer losses on their holdings of toxic securities and were reluctant to lend to one another that led to shortages of funding system. This only intensified in late 2007 when Nothern Rock, a British mortgage lender, experienced a bank run that started in the money markets. All of a sudden, liquidity became in a short supply, debt was unwound, and investors were forced to sell and write down the assets. For several years, up to now, the market counterparties no longer trust each other. As Walter Bagehot, an authority on bank runs, once wrote:

Every banker knows that if he has to prove that he is worth of credit, however good may be his arguments, in fact his credit is gone.

In an entangled financial system, his axiom should be stretched out to the whole market. And it means, precisely, financial meltdown or the crisis. The most fascinating feature of the post-crisis era on financial markets was the continuation of a ubiquitous liquidity expansion. To fight the market squeeze, all the major central banks have greatly expanded their balance sheets. The latter rose, roughly, from about 10 percent to 25-30 percent of GDP for the appropriate economies. For several years after the credit crunch 2007-09, central banks bought trillions of dollars of toxic and government debts thus increasing, without any precedent in modern history, money issuance. Paradoxically, this enormous credit expansion, though accelerating for several years, has been accompanied by a stagnating and depressed real economy. Yet, until now, central bankers are worried with downside risks and threats of price deflation, mainly. Otherwise, a hectic financial activity that is going on along unbounded credit expansion could be transformed by herding into autocatalytic process that, if being subject to accumulation of a new debt, might drive the entire system at a total collapse. From a financial point of view, this systemic collapse appears to be a natural result of unbounded credit expansion which is ‘supported’ with the zero real resources. Since the wealth of investors, as a whole, becomes nothing but the ‘fool’s gold’, financial process becomes a singular one, and the entire system collapses. In particular, three phases of investors’ behavior – hedge finance, speculation, and the Ponzi game, could be easily identified as a sequence of sub-cycles that unwound ultimately in the total collapse.