Thursday, April 29, 2010


The NY Times had an interesting editorial yesterday on the casino that Wall Street created. The editorial contains the (by now) standard observation that Wall Street's gambling does little more than extract wealth as opposed to creating it. How they do it is particularly noteworthy.

Unlike the farmer who plants wheat in case the corn crop doesn't come in - a practice that focuses on enhancing the production of real goods - many of today's market players are simply making bets on paper contracts (derivatives), knowing that others (pensions, foreign banks, etc.) will be forced to take the financial hit if their bets pay off. To stack the game in their favor, firms like Goldman Sachs are accused of rigging the game so their bets will pay off.

As insightful as the NY Times editorial is, huffing and puffing about market players gambling does little in the way of offering insight into what needs to be done. If we want to get things right we need to look to history - both short term and long term - to better understand what we're facing. This is what makes this contribution from Bethany McLean so insightful.

McLean tells us that Congress is as much at fault for our current economic mess as are the financial players they're now pointing fingers at. I agree. Make no mistake about it, the "Cash-for-Deregulation" game is as insiduous as it is incestuous. And it's not just one party. As I've made clear on air and here, there's enough bi-partisan stupidity to go around on this one.

The primary reason for this is that while most members of Congress understand the power of money, they can't distinguish between markets and the illegitimate market activities they can spawn.

Herein lies the problem. Congress, and most of America, simply don't understand the difference between legitimate investment and hedging activities (which are generally positive sum) in a market economy and gambling activities in a casino (a zero-sum proposition). This, unfortunately, has been a problem that's plagued markets for centuries.

Congress is as much to blame for this mess as the market idiots on Wall Street. But because Congress makes the laws of the land they have the power - and the requisite lack of shame - that allows them to point fingers away from themselves. And they are doing quite well in the process.

What Congress should be doing, however, is looking to history for insight and answers. If it's reckless gambling, a casino mentality, and sheer stupidity on Wall Street that they're worried about, history has plenty of examples to draw from. The following is drawn from Chapter 4 in my book.

In A Short History of Financial Euphoria, John Kenneth Galbraith discusses the famous case of “Tulipomania” in Amsterdam at the beginning of the seventeenth century. What started as simple prestige for those who possessed novel tulip bulbs turned into wild speculation over successive price increases throughout 1636.

Specifically, competition over tulips turned into mania, with single bulbs trading for new carriages and homes, or fetching as much as $25-50,000 each. Demand reached such heights the Amsterdam Stock Exchange developed a futures market for the bulb. This market, as well as the dreams of many speculators, would collapse under the weight of its own nonsense and spectacular avarice.

As sellers demanded their tulip contracts be enforced, they were disappointed when their petitions fell on the deaf ears of the courts. Because the market had little to do with the production of actual goods and services, the courts viewed Tulipomania as little more than a gambling operation. As is the case throughout these histories, panic, default, and bankruptcy followed. Galbraith wrote “no one knows for what reason” the speculation and mania ended, but there’s little doubt common sense finally prevailed in a market spun out of control by deluded buyers and sellers.
Think about what this story tells us today ...

The Dutch courts ruled in the 17th century that the purchasers of tulips were not investing — they were gambling. Wild speculation, in what was essentially a gambling den environment, did not justify supporting contracts built on out of control betting.

With this in mind, you would think that Wall Street's market players (they're not investors) in the modern era shouldn't be allowed to reward themselves for making bets on crap and s*%t that they knowingly sell as crap and s*%t (Goldman Sachs). But they've been doing stuff like this on a grand scale for the past three decades, as the following illustrates.

When you consider that Goldman Sachs' employees sat in front of Congress and brazenly dodged questions as to whether it's their responsibility to "act in the best interest of their clients" (FF to 25:30 in the clip), there's no doubt in my mind that making money — even if it deliberately burns clients, or could lead to a market meltdown — was the dominating mind-set of Goldman's market players. Their focus is on wealth extraction, not wealth creation.

This mind-set has been widespread for some time now. The following example from Chapter 10 of my book makes this very clear:

Founded by a group of Wall Street hotshots and leading academics with Nobel prizes on their resum├ęs, Long-Term Capital Management (LTCM) was created in the 1990s to search markets for price anomalies in goods that had shown historical relationships. It didn’t matter, for example, why the price of toothpaste was diverging from the price of tooth brushes; the fact that a price divergence existed was all that traders needed to make a move.

But LTCM was not trading in tooth brushes and toothpaste. They were trading in complex financial instruments that, according to their formulas, had price relationships that rarely diverged. Because the price anomaly in each “product” that they tracked was small, LTCM had to spend big to make money.

After securing hundreds of millions from investors, no doubt impressed with their pedigreed analysts, LTCM still had to borrow big to make their wagers pay off. At its height, LTCM was highly leveraged and owed investors and banks billions of dollars ...

In many ways, LTCM had fallen into the same trap as the purchasers of Tulipstulips. The company was comprised of speculators who wanted to make a quick buck. As Martin Mayer put it: "The work done at LTCM, while not illegal or sinful, was totally without redeeming social value. This is not 'investing'; it enables the production of no goods or useful services. It is betting."

LTCM came crashing down in 1998 after Russia defaulted on loans, an event that neither LTCM’s computer models nor it's Nobel laureates in economics anticipated ... The company owed so much money to the banks that the Federal Reserve of New York stepped in and brought the banks to LTCM. The Federal Reserve wanted to make sure that LTCM didn’t suddenly dump their its assets to pay the banks.

The Federal Reserve feared that if LTCM was forced to sell its assets they would depress markets by forcing losses on others. The Federal Reserve’s then new chairman, Alan Greenspan, even went so far as to testify that an LTCM “fire sale” could have ended prosperity in our time. The Federal Reserve had to intervene to — in what has become by now a standard refrain — “save the system.”
At the end of the day, if you're betting on the price direction of tulips (the Dutch), market anomalies (LTCM), or securities (Goldman Sachs), one thing is clear: You're not investing. You're trying to extract wealth for yourself, rather than create it. Worse, you're making claims on money that hasn't been created (literally) as a result of legitimate business investments. You shouldn't be on Wall Street. You should be on the Vegas strip ... far away from taxpayer funded bailouts.

Hiding behind spiffy thousand dollar business suits, high rise buildings, and a team of lawyer-lobbyists, many of Wall Street's market players have, unfortunately, managed to create the illusion that they are legitimate capitalists. They're not. They're high-priced street hustlers.

Until we recognize that there's a difference between hedging in real markets (planting wheat in case the corn crop doesn't come in) and gambling in a casino environment (trying to get rich quick at the expense of others) the current pieces of legislation making their way through the halls of Congress won't be sufficient to curb the excesses of Wall Street. They simply paper over the cracks.

Worse, they can always be watered down, or chipped away at, by industry lobbyists in the future.

With the biggest recipients of taxpayer bailout money controlling over 90 percent of the $135 to $592 Trillion derivative market (yes, that $592 Trillion) we need to do more than just paper over the cracks. This is especially the case when you consider the global derivatives market - which took it's cue from the United States - has grown to about $1.14 quadrillion (that's 15 zeroes).

With the total U.S economy producing about $14 trillion worth of goods and services in 2010, all of this should be cause for concern.

- Mark

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