Slouching Towards Wall Street… Notes for the Week Ending Friday, 1 June 2012
The real object of The Game is not money, it is the playing of The Game itself. — “Adam Smith,” The Money Game
Keith quoted from the 1967 classic The Money Game this week (30 May, Early Look: “The Game…”). “Adam Smith” (George Goodman) wrote “true players” do not need money, but “you could take all the trophies away and substitute plastic beads or whale’s teeth.” The Game, it seems, is all about the ability to keep score.
Don’t be misled by Smith’s statement. “Score keeping with plastic beads” makes it look like Wall Street is just a bunch of overgrown babies playing in the nursery. When Smith wrote his book in 1967 the possibility of a plastic bead-induced global meltdown was admittedly remote. But even then signs of the Military-Industrial Complex abounded, including the “Vinogradov” and “Rostow” memos recording the machinations of bankers and traders directing the outcome of the Vietnam and Yom Kippur wars.
Smith wrote about the investment industry at a time when it was still possible to find stockbrokers and traders cute, though there are depths as well. Smith portrays a stock market millionaire who loses his fortune in the market. He describes the smile of the man watching an adding machine display where the number “$1,000,000” appears, then observes that “when the adding machine says 00.00 there is still a man there to read it.”
Now it’s 2012. The loveable and bratty kid that was the stock market of the 60’s has grown up — and grown old. Nearly half a century on, we survey the detritus of a misspent life. Whether with shark’s teeth or dollar bills, if you have been keeping score, it’s not pretty.
Marx derives his theory of money from the notion that objects have different value to different people. Bob trades a hogshead of grain to Fred for a fur coat. To Bob this was not a barrel of wheat, but the means for obtaining the coat. Bob is indifferent whether he trades grain, wine, or furniture for the coat. The key is Bob wants the coat, and there is an amount of commodity that Bob must give to receive the coat which appears reasonable to him. These are subjective judgments. Fred views his coat not as a garment, but as a means of procuring enough grain to feed his family.
We all learned that dollars are fungible, like any commodity of like quality (wheat for wheat, sugar for sugar). When Smith writes about score keeping, he is describing a complex anthropological process whereby objects are stripped of their intrinsic identity and made fungible with unlike objects. This is both fabulously creative, and highly destructive. The value of a case of wine becomes identical to that of a hogshead of wheat, or six dining room chairs. In an extension of the same process, the people who buy from us become depersonalized and their wants and needs are forced like so many square pegs into the round holes of mass production, mass marketing, and aggressive selling. Instead of Customers, they become Consumers.
The economic definition of Capital — the machinery that is the means of production — conflates with the money required to purchase the machinery. Or the money realized by selling it. Instead of Capital, we have “Capitalism” — a religion, or a medical condition where society focuses not on productive capacity, but on how many plastic beads we can obtain by dismantling productive capacity and selling it off piece by piece.
Money is a convention. A dollar bill is a contract — as Cyberpunk author William Gibson would say, a consensual hallucination. Its value is determined by mutual agreement of all its users, therefore it does not need to be backed by tangible assets. Instead it is backed by God, and by the ability of the United States to intervene militarily at the drop of a keffiyeh. The plastic beads conceit is cute, but make no mistake: once they are designated as the scorekeeping unit, those beads become money. Then the gloves come off.
Speaking of taking off the gloves, former Goldman board member Rajat Gupta is in the penalty box where, as “the most prominent corporate figure indicted in the US government’s crackdown on insider trading,” he has created a dilemma for Judge Jed Rakoff. Never mind the question of Gupta’s guilt or innocence — that will emerge in the fullness of time. But in order to get that outcome, Judge Rakoff needs a jury to stay awake during the proceedings (Reuters, 29 May, “Fear of Jury Boredom Seeps Into Insider Trial”). The Judge has “warned prosecutors and defense lawyers to sharpen their presentations” to provide relief for jurors who will spend the bulk of their time perusing “telephone logs, corporate governance guidelines, boardroom minutes, emails and instant messaging records.”
Judge Rakoff said “I am in awe of our jury for being attentive,” and wants to make sure they remain so. Apparently His Honor is willing to run the risk of his courtroom turning into “My Cousin Vinny” in hopes it will not become “Twelve Sleepy Men.” One person we know will be awake and alert throughout is Mr. Gupta — a man who has overseen the creation of plenty of plastic beads in his career, and who now stands accused of helping Raj Rajaratnam to illegally obtain large quantities of plastic beads — or avoid the loss of substantial quantities of whale’s teeth.
Raj Rajaratnam is serving an 11-year sentence for insider trading. The government wants Mr. Gupta to join him. Whatever Mr. Gupta’s fate, at least now we know it will be entertaining.
The price of copper is a global bellwether, signaling industrial health wherever it trades. When China was in its steroid-induced growth phase, copper was Mr. Universe. Then China coughed and copper caught the mother of all pneumonias. Seeing opportunity in volatility and global range, JPMorgan Chase plans to launch an ETF backed by physical copper (Reuters, 23 May, “US Copper User, Trader Attack JP Morgan ETF Plan.”)
Southwire, one of the US’ largest copper consumers, and metals trader Red Kite have filed a complaint with the SEC, claiming the fund will “inflate prices and squeeze supply by removing as much as a third of the London Metal Exchange’s copper stocks.” They say the effect on the markets will be comparable to the Sumimoto scandal when metals trader Yasuo Hamanaka (a/k/a “Mr. Copper”) sucked up 5% of the world’s physical copper and maintained artificially high price levels, enabling Sumimoto Bank to sell its positions profitably while also charging high commissions on customer copper trades.
The complaint says the proposed ETF will “grossly and artificially inflate prices” and “wreak havoc on the US and global economy.” Regulatory filings indicate the ETF could hold as much as 61,000 metric tons of physical copper.
This may not remain an SEC case — the CFTC may want to oversee copper too, if only as an excuse to ask for a budget increase. Depending on how the Commission rules, and on the language they use, this could point to a formal government determination that speculation causes price volatility. One thing is certain: ETF demand is not normal economic demand, and as we have written extensively, contrary to the marketing materials and the definition accepted by the regulators, ETF trading often creates artificial imbalances in the underlying instruments. ETF units are created or liquidated to meet orders, making traders completely price-insensitive. A large order to buy a copper ETF causes a trader to dash out onto the floor and buy all the physical copper they can. Can this disrupt the markets? A Sumimoto trader’s control of just 5% of the world’s copper was enough to disrupt pricing in the marketplace for ten years. The complaint calculates the new ETF could stockpile as much as 30% of the copper held on the London Metals Exchange. This would cause the ETF to buy copper within the US — a net importer — disrupting the flow of supply.
Coincidentally, the Journal noted the recent earnings release from mining equipment make Joy Global, predicting higher prices for copper because “a substantial portion of the current inventory has been pledged as collateral for financing in China” (1 June, Overheard). It appears much of the world’s copper is “off-market in Chinese warehouses as part of complex financing deals among local traders and banks.”
Other sinister players lurk in the ETF markets. There was the recent $800 million ETF trade (etftrends.com, 22 May, “Will More Big Investors Use ETFs To Hide Trades?”) as an unidentified institution redeemed 20 million shares of SPDR Barclays Capital High Yield Bond ETF. Rather than cash out of the instrument, the investor took the bonds, a “customized in-kind redemption” where the investor to bypassed the open market, protecting against liquidity bottlenecks and the ever-present threat of smaller traders looking to pick off small profits while working the large execution. Said one Barclays analyst, “the maneuver adds to the already strong evidence that cash market liquidity remains challenged, as less traditional avenues for accessing cash liquidity have become more attractive.” ETFs, the new Third Market.
We can think of multiple ways in which this trade could have been used to manipulate the markets. The institution placing the ETF order could have used the trade to mark up prices in its own holdings, to create liquidity for its own illiquid positions, or simply to skim small profits on a short sale.
With the potential for a drain of 30% of the LME’s copper for the proposed ETF — plus China’s unknown holdings — copper has become money, a physical good held as inaccessible collateral for bits of paper that people accept in trade. Is America worried that China controls too much of our Treasury debt? How about too much of the world’s natural resources? How about too much of the world’s arable land, with massive farming ventures already established in Brazil and across Africa? Will we push back against global economic encroachment, or will we continue the fire sale as America sells itself off piece by piece? The political fallout from this case is worth watching. A joint SEC-CFTC decision against the ETF would change the entire ETF industry — obviously a hot potato. The ETF market has over a thousand vehicles with well over a trillion dollars in assets, and issued by the biggest names in finance, including Citigroup, PIMCO, UBS, JP Morgan, Morgan Stanley, and Goldman. An adverse SEC decision would call into question the regulatory justification for marketing these funds and could be a first step towards an official government position that speculation, not supply and demand, drives price volatility in the commodity markets. One would not expect a lowly government agency to challenge such a powerful sector.
In an election year, is President Obama willing to bet he can eat Wall Street’s cake and still have it?
Mary Schapiro is cross with those sneaky bankers at JPMorgan. The firm that created VaR is being taken to the woodshed for attempting to improve its metric (Reuters, 22 May, “SEC Looking At JPMorgan’s Financial Reporting”).
Value At Risk is the most popular measure of portfolio risk. Says Wikipedia, “for a given portfolio, probability and time horizon, VaR is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) is the given probability level.” Confused? Imagine how an SEC examiner must feel.
Like so many of JPM’s other financial innovations, such as derivatives-based portfolio hedging, VaR works exceptionally well, except when it doesn’t. Leading hedge fund manager David Einhorn famously said reliance on VaR is “potentially catastrophic,” focusing on obvious risks and allowing managers to ignore possible outlier events that really rock the boat. Einhorn said reliance on VaR led to excessive risk taking by financial institutions, likening the metric to “an airbag that works all the time, except when you have a car accident.”
In the wake of JPM’s recent losses, SEC chairman Schapiro told Congress she is concerned at reports that JPM changed their VaR model without telling the Commission. Several dozen regulators were embedded in long-term residence at JPM. Among their jobs was to monitor the firm’s risk levels. In this exercise they used VaR for assessing the risks in JPM’s portfolios — the exact VaR metric designed and used by JPM. Regulators routinely use the risk models developed and used by the institutions they oversee. The imbalance of resources means the SEC can’t afford the PhD’s that flock to the hedge funds, the Goldmans and JPMorgans of the world. If we want to improve oversight, we must start by giving the regulators the tools — and the personnel — to really understand the markets.
There seems to be a lot of this going around. The WSJ reports (1 June, “Investor Hazard: Zombie Funds”) some 200 private equity funds “now qualify as zombie funds, accounting for as much as $100 billion.” We noticed a couple of years ago there was a rush as major private equity managers pushed assets into less than sterling quality deals. At the time we recognized that, in order to justify collecting their 2%, the managers were going to have to have something more than investor cash to manage. PE managers collect the management fee on uninvested cash — they say their expertise includes knowing when to stay out of the markets, and they deserve to get paid for that as well. This argument only works for a little while, like VaR, and when managers perceive a Career Risk Tail Event, they scramble to buy something so it looks like they are earning their keep.
“Zombie funds” are private equity funds that have gone past the stated life span of the investment — generally 10 years from inception — but have not been cashed out. The “exit strategy” for private equity, often a public offering or a sale to a larger company, failed to materialize. Many of these vehicles no longer have any revenues — a clue to why the managers have not been able to sell them. But they still generate management fees.
Some investors in these funds are fuming. Others, like Pennsylvania’s teachers’ retirement fund PE manager, are willing to be patient. “If you don’t sell at the right time,” he says, “you’re not going to get the full value.” This is an echo of the private equity managers’ mantra — translated as “but I get two percent… but I get two percent…” Among Pennsylvania’s holdings are 15 PE funds aged beyond ten years, representing $40 million in investments. There is no end in sight for the State, though the managers continue to draw fees.
Says the Journal, “to value their own stakes, investors generally rely on the private-equity firm’s valuation.” Meaning even the “smart money” can be outsmarted, and explaining why even state pension fund managers can be duped into believing remaining underwater for more than a decade is preferable to liquidating and booking the loss.
Illinois was less patient. After paying $580,000 in fees on zombie funds in 2010, they wrote to the funds’ managers demanding that they stop charging on the moribund investment. The wrinkle here is that the PE zombie funds Illinois owns are not actual funds, but a “fund of funds” — meaning the managers have bought pieces of actual PE funds that themselves invest in operating companies. We presume the fund of funds managers use the valuation models from the various PE managers in which they have invested, while the State may get some kind of blended gobbledygook representing the overall risk on the portfolio. The fund’s management told the Journal they continue to “maximize value at the fund in a way that would not be able to happen if the fund were to close down.” Meaning that 2% of something is still something, but even an SEC examiner can figure out that 2% of nothing is nothing.
Public health advocates agree it takes radical measures to change behavior. Nonetheless, Mayor Bloomberg’s bid to ban gigantoso sodas has met with a thunder of opposition. “The smoking ban was very controversial at the beginning” (WSJ, 1 June, “Sugar Ban Stirs Up New York”), says Hizzonor, implying the giganormous monster soda ban will one day be seen as exceedingly wise.
As longtime fans of the Darwin Awards, we appreciate the personal liberty that permits folks to assassinate themselves with their instrumentality of choice. But your 200 pounds of excess fat will cost everyone else additional taxes and elevated insurance premiums, so there is a sound economic reason for us to want you to stay healthy and not gain extra weight. What the Dalai Lama calls Enlightened Self-Interest.
There are also sound public policy reasons. We prefer to have our cities, our offices and schools filled with productive individuals rather than people with lifelong illnesses. Ask anyone suffering with diabetes about the cost — both financial and physical — they will tell you that if all it takes to prevent the condition is walking two miles a day and not drinking gigundo quantities of sugared drinks, it would be worth it.
This story dovetails nicely with the moronic screaming anti-broccoli crowd. Those who are angered at the thought of politically motivated broccoli should note that the government can, and does, make you buy all manner of plants; and the government can, and does, make you eat all manner of stuff, though whether animal, vegetable or mineral is often unclear.
The Department of Commerce reports that, through a program of government subsidies, the sugar industry was able to retain employees, at an average cost to the taxpayer of $826,000 for each job saved. Collateral effects of this “jobs program” included the loss of 2-3 jobs in the confectionary business for every sugar producing job saved. “In 2004 the price of US refined sugar was 23.5 cents per pound compared to the world price at 10.9 cents” (“Employment Changes in US Food Manufacturing: The Impact of Sugar Prices.”)
As ethanol subsidies came up to expire in 2010, taxpayers were paying 30 cents for every penny ADM earned in fuel ethanol. A bipartisan group of Senators (9 Democrats, 6 Republicans) made a last ditch effort to save the subsidy. Greed is one thing everyone can agree on.
All right, you say, so the government can make us buy broccoli. But they can’t make us eat it! Sez you. Anyone who attended public school knows the government can — and does — force its citizens to swallow stuff you wouldn’t feed your dog. And who can forget the government cheese? The most famous example remains the Reagan Administration’s designating ketchup as a vegetable — absurd on multiple levels because the tomato, the primary ingredient in ketchup, is a fruit, even though the Supreme Court declared it a vegetable (Nix v. Hedden, 1893). New Jersey has designated the tomato the state vegetable. Not to be outdone, Arkansas has it doing double duty as both the state fruit and state vegetable.
All the hubbub about a plant with multiple personality syndrome occasioned a tremendous amount of government involvement — which saved them having to waste time on frivolities such as health care and education. With regard to ethanol, this year Congress finally did what it does best — nothing. After more than three decades the subsidy expired, relieving us of a $6 billion annual tax burden.
Whatever the outcome, we hope Mayor Bloomberg’s initiative will turn the tide of public health awareness. Maybe his next campaign will be to limit the number of hotdogs folks can eat at the annual Coney Island contests. Either way, we relish the prospect of the upcoming food fisticuff. In an aptly worded challenge, a defiant opponent of the proposal says “Everything is on the table.”
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