Monday, March 23, 2009

Two Different Approaches to the Rise and Fall of the Age of Leverage: In the Trenches with the Tranches by Judy Joyce

When Harvard history professor and senior research fellow Jesus College Oxford University - Niall Ferguson, was interviewed by Adrian Wooldridge, Washington bureau chief for "The Economist" (available on this website at\books) about his book "The Ascent of Money: A Financial History of the World", Professor Ferguson stated, "the financial systems are responsible for human progress".

The Age of Leverage

"The Ascent of Money" promises to demonstrate to the reader the role money has played historically from the Italian Renaissance and French Revolution to the American Civil War up to the current global financial crisis. Mr. Ferguson contends in the interview that one of the causes of the current crisis is the complete indifference to and understanding of the history of finance by those who develop and control financial policy.

Naming central bankers specifically, he states they often contend "this time it’s different". Much of what bankers do, Prof. Ferguson states is that "most people rely only on their own memory as their data base". This results in a feeling that we can cope with financial crisis. Ferguson believes that the current period in finance should be seen as the rise and fall of the age of leverage.

Philosophy on the Use of Money

Philosophers see the use of money differently. According to the Philosopher, Thomas Acquinas (Ethic. v, 5; Polit. i, 3), money was invented chiefly for the purpose of exchange: and consequently the proper and principal use of money is its consumption or alienation whereby it is sunk in exchange. Hence it is by its very nature unlawful to take payment for the use of money lent, which payment is known as usury: and just as a man is bound to restore other ill-gotten goods, so is he bound to restore the money which he has taken in usury.

Money Lending and Usury

Clearly, the modern practice of borrowing, lending, and leveraging goes far astray from the purpose for which several centuries ago Acquinas states money was invented ie for exchange. Enter the question of what we consider usury in this day and age. When do current consumer\borrowers consider lenders to have acquired ill-gotten gains?

While there are likely as many questions as there are answers to what is "usury" today, any elements of the definition of money and usury effecting the common man is encompassed in the euphemism of affecting "Main Street". These are usually borrowers who are also taxpayers. Elements of "usury" affecting financial institutions and those who run them are generically encompassed in the euphemism of affecting "Wall Street". What is a bit odd about the "Wall Street" euphemism is the way in which non-banks like insurance companies took on quasi banking functions ducking banking regulations in a way that makes the term "Wall Street" less clear as to who and what are at stake.

Tranches in the Trenches

What has confused the relationship of Main Street to Wall Street can be explained in many ways. Now that the economy is in the trenches, new financial terms have emerged that make mere "usury" more apparent and of concern. It is even more difficult to explain than in the ancient times of Acquinas. Furthermore, without a way to explain what is "usurious", it becomes difficult to retrieve ill-gotten gains in an exchange of something tangible.

Referring generously to remarks of Paul J. Cellas in his article entitled "The Great Usury Crisis" published in "The 10th Crusade" it is helpful to recall:

Usury? you say, what is this antique word? Why, it is the process by which a home worth $100,000 rises in value to $250,000 almost wholly on the back of a series of securitizations by which dozens and perhaps hundreds or thousands of investors are able to chase down a few extra basis points of yield.

It is the abstracton of engineered mathematical finance (emphasis added)

with a mass of other mortgages, some high-quality, some middling quality, some risky; it is then sold off to banks, hedge funds, etc. as an instrument called a collateralized debt obligation, which is a fancy word for the complex new mortgage-backed bond.

This bond, with its three tranches of riskiness and three tranches of yield, may be traded as any other bond. It may also be short-sold via the mechanism of another exotic security: the credit default swap. We now know that credit default swaps, derivatives on the abstraction of property, became the foundation for whole new fields of speculation. Their revenue streams were converted into new piles of bonds, which mimicked the mortgage-backed security market to produce vast new paper assets with which to trade and speculate. They became the basis for a formula by which most investment risk was measured: Ten years of market activity with this exotic security (for the credit default swap was literally invented in 1997) -- this alone became the data-set for the world's primary financial risk model.

To speak this truth is to realize the depth of our folly.And all of this frenzied speculation operated upon the assumption that property values in the United States could never fall...normal banking, of course, has its foundation in the individual deposits (and other short-term, low-risk savings instruments) of individual customers: the banker holds the savings of individual citizens in trust, and uses that capital to loan out to other individuals and businesses. He borrows short-term and lends long-term, and makes his profit on the difference in interest rate. Shadow banking leaves the depositor out completely, operating in securitized debt alone. The difference is a crucial one: with standard banking, the source of the deposits is by and large income from productive activity; in shadow banking the source of the short-term borrowing is simply debt securities, commercial paper, for example.

Usury. It was a vast system of usury, value conjured from the fractional increment, skimmed off the top, and inflated by means of engineered abstraction. There was little productive enterprise behind all this usury; this was not legitimate interest on productive activity or innovation. It all depended on the conversion, or pretended conversion, of physical property into mathematical abstraction -- which, quite conveniently, proved much more susceptible to manipulation than the real thing.

.....the tragedy of it is that the crash of a false system of wealth-generation, a false capitalism if you will, is going to have destructive ramifications for what remains of our true capitalism.

Truly productive enterprise, wherever it remains, is about to get squeezed, and squeezed hard. Innovation is going to grind to a halt, or flee for fairer climes. Innumerable good ideas, with the potential to truly create jobs and wealth, will suffer strangulation in the crib.

Ferguson's Theory Substantiated

The "Ascent of Money: A Financial History of the World" can give the reader ample background in what has come before. The knowledge that "usury" developed within historical systems is nothing new. Being reminded can help us act more intelligently when dealing with remedies now.

However, as America’s capitalistic ideals come under scrutiny by Main Street, what we learn to discard is as important as what we keep. It would be a mistake to squeeze "truly productive enterprise" because of the "false system of wealth generation" that has straddled up to it. Without true discernment, the baby could be tossed out with the proverbial bath water. Main Street can stand alert to the Wall Street usurers without losing sight of the need to perpetuate true capitalism. In so doing, America’s financial system can continue an important role in substantiating Professor Ferguson’s theory that money is the path to human progress.

1 comment:

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