Browsed by
Tag: options

Casino Banking – Article by Gerald P. O’Driscoll, Jr.

Casino Banking – Article by Gerald P. O’Driscoll, Jr.

Comments 0 Comment
The New Renaissance Hat
Gerald P. O’Driscoll, Jr.
July 15, 2012
******************************

JPMorgan Chase & Co., one of the nation’s leading banks, revealed in May that a London trader racked up losses reportedly amounting to $2.3 billion over a 15-day period. The losses averaged over $150 million per day, sometimes hitting $200 million daily. The bank originally stated the trades were done to hedge possible losses on assets that might suffer due to Europe’s economic woes. There is now doubt whether it was a hedge or just a risky financial bet.

A hedge is a financial transaction designed to offset possible losses in an asset or good already owned. The classic hedge occurs when a farmer sells his crop in a futures market for delivery at a specified date after harvesting. He sells today what he will only produce tomorrow, and locks in the price. If the price at harvest time is lower than today’s price, he makes money on the forward contract, while losing a corresponding amount of money on the crops in the ground. In a perfect hedge the gains and losses should exactly offset each other.

How did JPMorgan suffer such large losses on its hedges, and what are the lessons?

It appears the London trader entered into financial transactions on the basis of observed relationships among various bond indices. The market relationships broke down. The indices moved differently from what historical patterns or financial models predicted. Such a breakdown has been at the heart of a number of spectacular financial collapses, notably that of Long-Term Capital Management (LTCM) in 1998 and a number of others during the financial meltdown of 2007–08.

LTCM invested the money of rich clients in financial bets based on the expected relationships among the prices of various assets. According to Nicole Gelinas in After the Fall: Saving Capitalism from Wall Street—and Washington, at the time of its collapse LTCM had $2.3 billion of client money. By borrowing, it leveraged that investment 53 to 1. Further, it employed derivatives to further magnify its bets so that its total obligations were a fantastic $1.25 trillion.

A derivative is any security whose price movements depend on (are derived from) movements in an underlying asset. “Puts” and “calls” on equity shares are relatively simple derivatives familiar to many. Asset prices, like various bonds, move in predictable ways with respect to each other, and values of derivatives linked to the assets similarly move in a predictable fashion with respect to the prices of the underlying assets—in normal times.

But the summer of 1998 was not a normal time. There was turmoil in Asian financial markets, then Russia threatened to default on its domestic debt. Global credit and liquidity dried up, and LTCM could not fund itself. It collapsed spectacularly.

A decade later there was turmoil in housing finance. The housing bubble was bursting. Mortgage lenders were under pressure, and some were failing. Many mortgages had been packed together in mortgage-backed securities, which were sold to or guaranteed by Fannie Mae and Freddie Mac. Fannie and Freddie, allegedly private entities but in reality guaranteed by the government, were failing. Lehman Brothers, an investment bank, was heavily involved in housing finance; it borrowed short-term, even overnight, to finance long-term holdings; it employed heavy leverage; and it made liberal use of derivatives contracts. It declared bankruptcy on September 15, 2008.

The specifics varied between 1998 and 2008, and between LTCM and Lehman. But the reliance on certain asset prices moving in predictable fashion was one shared element. So, too, was the heavy use of borrowed money (leverage) and the reliance on derivatives contracts. The volatility of complex derivatives contracts led legendary investor Warren Buffett to characterize them as “financial weapons of mass destruction.”

The Usual Suspects

In short there is nothing new in what happened to JPMorgan. It claimed it was not trying to make risky financial bets, but hedge risks already booked on its balance sheet. While details of the trades that led to losses are sketchy at this writing, they apparently employed both leverage and derivatives. As documented here, these are elements present in major financial blowups and collapses going back decades (and further). LTCM, Lehman, and Fannie and Freddie all thought they had at least some of their risks hedged. But hedges have a tendency to unravel just when needed most: in times of financial turmoil. Even so, financial institutions permit their traders to make the same kinds of dangerous bets over and over again. We used to have financial crises every decade or so. Now the cycle seems to be halved.

In the past I have dubbed today’s banking practice of placing dangerous financial bets “casino banking.” It differs little from the activities conducted at gaming tables in Las Vegas and has little or no reference to the fundamentally healthy activity of matching viable businesses with capital and credit.

In a Cato Policy Analysis, “Capital Inadequacies: The Dismal Failure of the Basel Regime of Bank Capital Regulation,” Kevin Dowd and three coauthors examined some of the technical problems with standard risk models used by large banks. It is an exhaustive analysis, and I commend it to those interested. The authors delve into many issues, but concentrate on the many flaws of the complex mathematical models used by banks to control risks.

In August 2007 Goldman Sachs Chief Financial Officer David Viniar puzzled over a series of “25-standard deviation moves” in financial markets affecting Goldman. (Returns deviated from their expected values by 25 standard deviations, a measure of volatility.) Such moves should occur once every 10-to-the-137th-power years if the assumptions of the risk model were correct (a Gaussian, or “normal,” distribution of returns). As Dowd and his coauthors put it, “Such an event is about as likely as Hell freezing over. The occurrence of even a single such event is therefore conclusive proof that financial returns are not Gaussian—or even remotely so.” And yet there were several in a matter of days. In Dowd & Co.’s telling, the models lie, the banks swear to it, and the regulators pretend to believe them. All of this goes to answer how the losses at Morgan might have happened. Traders rely on flawed models to execute their trades.

Now to the Lessons

Major financial institutions continue to take on large risks. Why? Assume the trades made by Morgan really were to hedge the bank’s exposure to events in Europe. That implies, of course, that risky investments had already been put in place (since they then needed to be hedged). Additionally, the risks were so complex that even a highly skilled staff (which Morgan certainly employs) could not successfully execute hedges on them.

Reports indicate that senior management and the board of directors were aware of the trades and exercising oversight. The fact that the losses were incurred anyway confirms what many of us have been arguing. Major financial institutions are at once very large and very complex. They are too large and too complex to manage. That is in part what beset Citigroup in the 2000s and now Morgan, which has until now been recognized as a well-managed institution.

If ordinary market forces were at work, these institutions would shrink to manageable sizes and levels of complexity. Ordinary market forces are not at work, however. Public policy rewards size (and the complexity that accompanies it). Major financial institutions know from experience that they will be bailed out when they incur losses that threaten their survival. Morgan’s losses do not appear to fall into that category, but they illustrate how bad incentives lead to bad outcomes.

Minding Our Business

Some commentators have argued that politicians and the public have no business in Morgan’s losses. Only Morgan’s stockholders, who saw its share price drop over 9 percent in one day, and senior management and traders who lost their jobs should have an interest. But in fact losses incurred at major financial institutions are the business of taxpayers because government policy has made them their business.

Large financial institutions will continue taking on excessive risks so long as they know they can offload the losses onto taxpayers if needed. That is the policy summarized as “too big to fail.” Let us not forget the Troubled Asset Relief Program (TARP), signed into law by President George W. Bush in October 2008. It was a $700 billion boondoggle to transfer taxpayer money to stockholders and creditors of major banks—and to their senior management; don’t forget the bonuses paid out of the funds.

Banks may be too big and complex to close immediately, but no institution is too big to fail. Failure means the stockholders and possibly the bondholders are wiped out. Until that discipline is reintroduced (having once existed), there will be more big financial bets going bad at these banks.

Changing the bailout policy will not be easy because of what is known as the time-inconsistency problem. Having bailed out so many companies so many times, the federal government cannot credibly commit in advance not to do so in the future. It can say no to future bailouts today, but people know that when financial collapse hits tomorrow, government will say yes once again. The promises made today will not match the government’s future actions. There is inconsistency between words and deeds across time.

What to do in the meantime? The Volcker Rule was a modest attempt to rein in risk-taking. Former Fed Chairman Paul Volcker wanted to stop banks from making risky trades on their own books (as opposed to executing trades for customers). Industry lobbying has hopelessly complicated the rule and delayed its issuance.

Morgan’s chief executive officer, James Dimon, asserted the London trades would not have violated the rule. If true, it suggests that an even stronger rule needs to be in place. Various suggestions have been made to address excessive risk-taking by financial firms backed by the taxpayers. It is time to take them more seriously.

Gerald O’Driscoll is a senior fellow at the Cato Institute. With Mario J. Rizzo, he coauthored The Economics of Time and Ignorance.

This article was published by The Foundation for Economic Education and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

Creation of an Ethical Business: The Implementation of Virtuous Behavior and Shared Values and Goals – Article by Jessica L. Kuryn

Creation of an Ethical Business: The Implementation of Virtuous Behavior and Shared Values and Goals – Article by Jessica L. Kuryn

Comments 2 comments
The New Renaissance Hat
Jessica L. Kuryn
May 10, 2012
******************************

IN TODAY’S COMPETITIVE BUSINESS ENVIRONMENT, a growing number of firms will do almost anything to gain sales and customers, as well as to increase profits.  For some of these firms, playing by the rules doesn’t achieve the results they are after.  Firms have the choice to act ethically or unethically.  While misguided managers think that unethical behavior can lead the firm, and ultimately themselves, to greater profits over the long term, it is only for the short term.  It will eventually lead to their downfall in that unethical behavior spirals out of control and can be very difficult to maintain.  Once this occurs, a firm’s reputation becomes tarnished and the company fades into non-existence.  On the contrary, “firms that pursue ethically driven strategies realize a greater profit potential than those firms who currently use profit-driven strategies” (Arjoon 159).

The point is that a firm’s leaders do have a choice in how they conduct business.  Creating an ethical business does not happen overnight.  It takes extensive collaboration and several implementation and evaluation processes, as well as continual reinforcement of and changes to established practices and values.  Perhaps one of the most important aspects to creating an ethical business is that it requires cooperation on multiple organizational levels and the implementation of virtuous behavior and values.

Maintaining ethical practices, once implemented, is an ongoing process.  There are many factors that can affect ethical behavior, such as competition for customers and market share, the need for increased profits, and management incentives.  Some firms, such as BB&T have been able to implement an ethical environment that has led to firm success, while others such as Enron, have succumbed to greed and wrongdoing, and no longer are in existence.  BB&T’s story of success will be discussed later in this paper.

CREATING AN ETHICALLY DRIVEN BUSINESS

Business ethics can be defined as “the applied ethics discipline that addresses the moral features of commercial activity” (Marcoux).  The question we have to ask concerning business ethics is how they can be applied to a business.  One of the most important aspects in creating an ethical business entails the need for new and refined organizationalvalues.  A value, as defined by Ayn Rand in Younkins’s article, is “that which one acts to gain and/or keep” (Younkins 9). Antonio Argandoña suggests a business must first identify its currently existing values and from that develop what values are needed (Argandoña 22).  In identifying these needed values, it is crucial that businesses select values that pertain to both the business’s goals, as well as the employees’ goals.  Congruence between the goals of the business and its employees increase the chances that the valueswill be received well and adhered to.

Once the desired values and goals have been determined, it falls in the hands of management to implement and communicate them.  “At the top level of an organization, it takes effective communicators who are clear about what they champion and who establish the company on virtuous behavior” (Younkins 21).Virtues, which are also defined by Ayn Rand in Younkin’s article, are “the act[s] by which one gains and/or keeps an objective value” (Younkins 11).  It is crucial for each employee and manager to establish virtues within themselves in order to pursue individual and organizational values, as well as keep them once they have been successfully implemented.It is the responsibility of management to ensure that these values are clearly communicated and followed, while established virtuous behavior becomes the mean by which these values flourish and exist.“A culture (or climate) of virtue in a business begins with executives who exhibit virtuous leadership through their personal actions and interpersonal relationships” (Younkins 21).

In displaying virtuous behavior throughout an organization, managers are setting an example for employees.   “Employees are influenced by observing visible and legitimate role models who themselves act as virtuous agents.  Not only should leaders openly discuss virtues and values, they should also live the virtues and values that they advocate” (Younkins 21).  I believe that this is one of the most important aspects in creating and sustaining an ethical business environment.  As explained by Kouzes and Posner in Minkes, Small, and Chatterjee’s article, “…leaders who could not personally adhere to a firm set of values, could not convince others of the worthiness of those values” (Minkes, Small, and Chatterjee 330).  People learn through example.  Therefore, managers should be mindful of this and back up their words with consistent virtuous behaviors that champion the organization’s values.

Once organizational values have been implemented, only half of the work has been done.  The remaining half is a continual and never ending process within the business.  In maintaining an ethical business, ongoing promotion and reinforcement is necessary.  Management must continue to display ethical behavior, while continuing to communicate values to employees.  This also includes communicating what actions are and are not acceptable.  Employee evaluations should also frequently be performed, in which employees are evaluated on values implemented by the organization’s managers.  In addition, management also needs to develop systems that reward value-oriented behaviors and reprimand value-destructive behaviors.

In regards to a reward system, “employees should be objectively appraised and compensated based on their contribution toward achieving a firm’s mission, values, and goals” (Younkins 19).  Employees may receive monetary or recognition awards for their display of virtuous and ethical behavior.  In establishing such incentives, there is an encouragement that exists among employees to accept and display the organization’s values and goals.  In addition, such incentives create a pathway in which individuals can fulfill their own self-interests and goals simultaneously.  “The good manager tries to shape employees’ ideas about self-interest by instituting incentives rewarding cooperation and reinforcing the pleasure people take in collaborating with each other” (Koehn 498). When employees act ethically, the business is also handsomely rewarded in that it gains a good reputation as being an ethically driven business.  This can lead to higher profits in that consumers will be more likely to choose that particular business over competitors because of its reputation.  “Many companies are now realizing that ethically driven strategies are resulting in a sustainable competitive advantage” (Arjoon 168).  In addition, “companies that have seriously adopted ethically driven or people-centered strategies have seen clear gains in productivity, sales and profits, customer service, retention rates, reduction in absenteeism, positive impact on employee morale, [and] increased and timely launching of products” (Arjoon 169).

Adversely, a disciplinary system is also necessary in order to maintain organization values and ethically driven behavior that have already been established.  Employees should be aware of the possible repercussions of their actions in advance, and management needs to ensure disciplinary actions are followed through with when dealing with value-destructive behaviors.  This sends a message to employees that unethical behavior will not be tolerated and it should be avoided at all costs.

The acts of Enron and WorldCom have increased consumer demands for ethically driven organizations.  Therefore, the businesses that make ethics a priority will likely obtain a sustainable competitive advantage because more consumers will choose to do business with them.  In today’s economy and business world, businesses must place a large focus on ethics in order to be successful.

FACTORS THAT AFFECT ETHICAL BEHAVIOR

Implementing a form of virtue ethics and values throughout a business can be very challenging, but maintaining it can be just as difficult.  There are many factors that can affect ethical behavior and lead a manager or employee to act unethically.  Competition for customers and increased market share, as well as the need for more profit are common issues that can lead to unethical behavior.  In addition, management incentives, such as bonuses, pay increases, promotions, and stock options can open the gateway for unethical behavior.

With a specific focus on profit, businesses that have an urgency to increase profits are likely to engage in false reporting.  Reporting false financial information makes a business’s financial statements look more appealing to investors and gives a false pretense that the business is in better financial health than it really is.  In addition, management may inflate earnings if they receive bonuses, pay increases, or promotions for increasing profits.  These monetary compensations can prove beneficial for businesses in that management will be more driven to make sales and increase wealth in the business.  Adversely, these monetary compensations can be dangerous if a manager works in his or her own interest and does not act ethically.  It could put the business in a financial position that is difficult to correct.

Stock options are another form of management compensation.  “Stock options allow employees to purchase a particular number of common shares of company stock at a specified price over a specified time period” (Brooks and Dunn 172).  Stock options can be beneficial in that they serve as a motivational devise.  When managers have an interest in the company they work for, they are more willing to strive towards an increase in stock prices.  Shareholders, as well as the managers, enjoy higher returns when stock prices increase.  In addition, stock options enable management to adopt the investor’s perspective in that theyenable both the interests of investors and management to be aligned.

One of the biggest problems with this is that unethical managers can work out of their own self-interest to falsely raise stock prices in order to earn more money.  With the incentive to earn more money comes the high possibility for unethical behavior and false reporting.  Managers that get used to these increasing stock prices are also the ones who will likely forego ethical standards and correct reporting procedures.  The concept of stock options can be extremely dangerous to a firm, especially when stock prices are truly in decline and these types of managers are present.  Reporting false income to increase these prices will eventually catch up to the firm and will result in the company’s non-existence.  Another problem with stock options is that management has the option to exercise their stock options and then sell them immediately.  This does not align with investor interests in that managers are only maintaining a short term perspective.  Making decisions based on the short term only hurts the long term investors.

BB&T – A TRUE ETHICALLY DRIVEN BUSINESS

BB&T is a fine example of a business that has been led to success through the values-driven approach adopted by one its leaders.  John Allison, former CEO of BB&T, now serves as the chairman of the board of directors.  During Allison’s time as CEO, the company has grown from approximately $5 billion in assets to $165 billion in assets.  This substantial growth has placed the company as the eighth largest financial institute in the United States.  Just a few of the issues BB&T has made a bold stand on are a municipality’s right to seize property by eminent domain for the purpose of economic development, and negative amortization loans.  Allison received national attention is his decision to “not provide loans for any economic development projects in which the land for the project had been taken in this manner” (Parnell and Dent 587).  This decision was not initially favored by many mortgage producers.

“When we made the decision not to do these loans, we got beat up in the market.  We also lost a number of mortgage producers who could make more money working for Countrywide – of course a number of these producers would now like to come back to BB&T.  We believe that doing our best to help our clients make the right financial decisions is good for BB&T.  I believe that while there may be short-term trade-offs by sticking to your values, you are never making a sacrifice in the long run, if your values are rational” (Parnell and Dent 589).

“Allison is known for, and attributes BB&T’s success to, operating by a set of principles that are embodied in BB&T’s Values Statement.  These ten values – Reality (Fact-Based), Reason (Objectivity), Independent Thinking, Productivity, Honesty, Integrity, Justice (Fairness), Pride, Self-Esteem (Self-Motivation), and Teamwork/Mutual (Supportiveness) – are not simply platitudes at BB&T but drive the decision-making process of the bank” (Parnell and Dent 588).  These values serve as the foundation that BB&T was built on.  As part of the evaluation process, employees are evaluated on their performance in accordance with the 10 values.  Those employees that perform in accordance with the values are rewarded.

Allison attributes Rand’s philosophy of Objectivism as the framework for these 10 values.  The main aspect of Objectivism is that it relies on truth and blocks out all emotions in the decision making process.  “The purpose of the process is to help you think rationally.  It is about not letting your emotions make decisions that are bad for you.  It is the ability to make logical decisions based on the facts and to pursue our purposes that makes us happy” (Parnell and Dent 591).

In addition, BB&T has also been viewed as being socially responsible.  Milton Friedman, who is referenced to in Parnell and Dent’s article, argues that there are two reasons as to why a firm should act socially responsible.  “First, not doing so can increase the likelihood of more costly government regulation.  A number of regulations over business operations were enacted because some firms refused to be socially responsible” (Parnell and Dent 593).  The second reason as to why a firm should act socially responsible is that “stakeholders affected by a firm’s social responsibility stance – most notably customers – are also those who must choose whether to transact business with the firm” (Parnell and Dent 593).  The point here is that if consumers do not think a firm is socially responsible, they have the option to do business with another company, and they will more than likely do so.  As discussed in Parnell and Dent’s article, studies have shown that consumers will be willing to pay more for products and services that are responsibly produced.  Simply, consumers favor ethically driven and responsible businesses, and will purchase products and services from them considering this factor.  This is why it is crucial for businesses in today’s economy and environment to be ethically driven and socially responsible.  With the events as seen in Enron and WorldCom, it has made consumers extra sensitive to firms and what approach they take in formulating profit.  Consumers want to be valued for their choice to do business with a particular firm, and they take enjoyment in purchasing products from these firms when they display ethically driven strategies.

From a market and environmental perspective, we could argue that BB&T is doing exceptionally well.  “From a market perspective, BB&T has delivered strong growth and financial performance since Allison’s appointment as CEO in 1989.  From a broad environmental perspective, BB&T’s business decisions defending eminent domain rights and eschewing negative amortization loans reflect support for a sustained society that respects personal property rights and responsible mortgage loan practices” (Parnell and Dent 594).  In respect to this, BB&T speaks on behalf of individuals and what they want.  While BB&T suffered somewhat in the short term, they were able to come out on top in the long run.  In my personal opinion, I have much more respect for companies like BB&T because they are willing to forgo potential profits and take a stand, even when it is not the popular decision.  Companies, like BB&T, will be around for years longer than the companies that jump on the popularity bandwagon.  They will also see considerably larger profits because they stand out among their competitors – just as BB&T has come to do

CONCLUSION

In conclusion, it is easy to see how BB&T has come to be a top competitor in the financial institution sector of business.  BB&T is a classic example of an ethically driven firm that has realized greater profits than the firms that have adopted a profit-driven strategy.  The implementation of ethics throughout an organization is a very difficult thing to do.  It requires substantial acceptance from employees and managers alike to be successful.  Most importantly, managers are the driving forces in implementing such a strategy throughout an organization.  They must be effective in communicating the values of an organization to employees, as well as lead by example.  Management cannot expect to preach values that they do not live by themselves.  After all, people learn through example.  A leader that lives by the values it communicates to employees has the best shot at having an ethically driven business.

In addition to the communication process, managers must provide incentives for desirable behavior.  A rewards system based on monetary or recognition awards are great ways to encourage cooperation and motivate employees.  This also encourages the creation of a pathway in which individuals can fulfill their self-interests.  These same values must also be a part of the evaluation process.  Just as there are rewards systems, management must also design a disciplinary system.  It is important that employees are aware in advance what they could encounter by not behaving in accordance with a firm’s values and policies.  Managers must also follow through with any disciplinary action to reinforce their importance on having a values-based business.

The benefits of implementing an ethically driven business strategy can be great, but it can be a difficult thing to do.  Competition for customers and increased market share, as well as the need for more profit are common issues that can lead to unethical behavior.  In addition, management incentives, such as bonuses, pay increases, promotions, and stock options can open the gateway for unethical behavior. However, if a firm is able to successfully implement an ethics-driven approach, these issues can be minimized and the interests of the firm and employees will be satisfied and aligned.  When a firm is able to align individual self-interests with its own interests, happiness and flourishing are more likely to occur for both.

Jessica Kuryn is a student in Wheeling Jesuit University’s Master of Science in Accountancy (MSA) program.

SOURCES

Argandoña, Antonio. (2003).  Fostering values in organizations.  Journal of Business Ethics 45:

            15-28.

Arjoon, Surendra (2000).  Virtue theory as a dynamic theory of business.  Journal of Business

            Ethics, no. 28:159-78.

Brooks, L. J., and P. Dunn. Business & Professional Ethics for Directors, Executives &

Accountants. 5. South-Western Pub, 2011. 172.

Koehn, Daryl. (1998).  Virtue ethics, the firm, and moral psychology.  Business Ethics Quarterly

            8 (3): 497-513.

Marcoux, Alexei, “Business Ethics”, The Stanford Encyclopedia of Philosophy (Fall 2008

Edition), Edward N. Zalta (ed.), URL

<http://plato.stanford.edu/archives/fall2008/entries/ethics-business/>.

Minkes, A.L., M.W. Small, and S.R. Chatterjee. (1999).  Leadership and business ethics: Does it

            Matter? Implications for management.Journal of Business Ethics 20: 327-35.

Parnell, John A., and Eric B. Dent. (2009).  Philosophy, Ethics, and Capitalism: An Interview

            With BB&T Chairman John Allison.Academy of Management Learning & Education

            8 (4): 587-96.

Younkins, Edward W. “Morality, Success, and Individual Happiness in Business: The Virtuous

            Pursuit of Values and Goals,” Libertarian Papers 3, 26 (2011).

Wall Street Math – Article by Douglas French

Wall Street Math – Article by Douglas French

Comments 0 Comment
The New Renaissance Hat
Douglas French
April 11, 2012
******************************

There’s plenty of blame for the financial crisis being spread around. Those on the left say Wall Street wasn’t regulated enough, while those on the right claim government mandates required lenders to make bad loans. The argument is made that the Federal Reserve was too loose, while the other side says Bernanke wasn’t loose enough. Some blame greed. Others blame Wall Street’s investment products. And then there’s mathematics.

Wall Street has become a numbers game played at high speed by powerful computers trading complex derivatives utilizing even more complex mathematical modeling. Writing for the Huffington Post, Théo Le Bret asks the reader to

Take the Black-Scholes equation, used to estimate the value of a derivative: it is actually no more than a partial differential equation of the financial derivative’s value, as a function of four variables, including time and “volatility” of the underlying asset (the derivative being a ‘bet’ on the future value of the asset). Differential equations are well-known to physicists, since such fundamental properties of nature as the wave equation or Schrodinger’s equation for quantum mechanics are given in the form of differential equations, and in physics their solutions seem to be very reliable: so why is this not always the case in finance?

Mr. Le Bret quotes Albert Einstein for his answer: “as far as the laws of mathematics refer to reality, they are not certain; and as far as they are certain, they do not refer to reality.”

Murray Rothbard put it another way:

In physics, the facts of nature are given to us. They may be broken down into their simple elements in the laboratory and their movements observed. On the other hand, we do not know the laws explaining the movements of physical particles; they are unmotivated.

Rothbard goes on to make the point that human action is motivated and thus economics is built on the basis of axioms. We can then deduce laws from these axioms, but, as Rothbard explains, “there are no simple elements of ‘facts’ in human action; the events of history are complex phenomena, which cannot ‘test’ anything.”

Using the models that work so well for physicists, mathematicians on Wall Street got it spectacularly wrong in the mortgage and derivatives markets, just as mathematical economists can never predict the future with any accuracy. Motivated human behavior cannot be modeled.

But the mathematicians or “quants” underscore all of Wall Street’s financial engineering, a process that takes a few pieces of paper and folds their attributes together to make new products, most times hoping to avoid taxes and regulation. Author Brendan Moynihan describes this engineering in his book Financial Origami: How the Wall Street Model Broke.

Origami is the traditional Japanese art of paper folding wherein amazing shapes and animals are created with just a few simple folds to a piece of paper. Moynihan cleverly extends the metaphor to the financial arena, pointing out that stocks, bonds, and insurance are pieces of paper simply folded by the Wall Street sales force into swaps, options, futures, derivatives of derivatives, and the like.

The author is adept at describing derivatives in terms a person can understand. Health-insurance premiums are a call option to have the insurance company pay for our medical care. Auto insurance premiums are like put options, allowing the insured to sell (put) his or her car, if it’s totaled, to the insurer at blue-book value.

Nobel Prize winners have played a big hand in the creation of derivatives. Milton Friedman’s paper on the need for futures markets in currencies paved the way for that market in 1971. But as Moynihan points out, it was Nixon’s shutting of the gold window that created the need to mitigate currency and inflation risk.

Nobel Laureate Myron Scholes was cocreator of the Black-Scholes-Merton option-pricing model. He and cowinner Robert Merton used their model to blow-up Long Term Capital Management.

But it was little-known economist David X. Li’s paper in the Journal of Fixed Income that would provide the intellectual foundation for Wall Street’s flurry into mortgages. “On Default Correlation: A Copula Function Approach” became “the academic study used to support Wall Street’s turning subprime mortgage pools into AAA-rated securities,” writes Moynihan. “By the time it was over, the Street would create 64,000 AAA-rated securities, even though only 12 companies in the world had that rating.”

Robert Stowe England, in his book Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance, says Li’s model “relied on the price history of credit default swaps against a given asset to determine the degree of correlation rather than rely on historical loan performance data.”

“People got very excited about the Gaussian copula because of its mathematical elegance,” says Nassim Nicholas Taleb, “but the thing never worked.” Taleb, the author of The Black Swan, claims any attempt to measure correlation based on past history to be “charlatanism.”

Subprime mortgages were bundled to become collateralized mortgage obligations (CMOs), which are a form of collateralized debt obligation(CDO). CDOs weren’t new; the first rated CDO was assembled by Michael Milken in 1987. But instead of a mixture of investment-grade and junk corporate bonds, in the housing bubble, CDOs were rated AAA based upon Li’s work.

Mr. England wryly points out, “A cynic might say that the CDO was invented to create a place to dump lower credit quality or junk bonds and hide them among better credits.”

England quotes Michael Lewis, author of The Big Short: “The CDO was, in effect, a credit laundering service for the residents of Lower Middle Class America.” For Wall Street it was a machine that “turned lead into gold.”

Wall Street’s CDO mania served to pump up investment-bank leverage. England explains that if level-3 securities were included (level-3 assets, which include CDOs, cannot be valued by using observable measures, such as market prices and models) then Bear Stearns sported leverage of 262 to 1 just before the crash. Lehman was close behind at 225, Morgan Stanley at 222, Citigroup at 212, and Goldman Sachs was levered at 200 to 1.

Leverage like that requires either perfection or eventual government bailout for survival.

The CDO market created the need for a way to bet against the CDOs and the credit-default-swap (CDS) market was born. Bundling the CDS together created synthetic CDOs. “With synthetic CDOs, Wall Street crossed over to The Matrix,” writes England, “a world where reality is simulated by computers.”

It’s England’s view that the CDO market “was the casino where the bets were placed. Wall Street became bigger and chancier than Las Vegas and Atlantic City combined — and more.” According to Richard Zabel, the total notional value of the entire CDS market was $45 trillion by the end of 2007, at the same time the bond and structured vehicle markets totaled only $25 trillion.

So the speculative portion of the CDS market was at least $20 trillion with speculators betting on the possibility of a credit event for securities not owned by either party. England does not see this as a good thing. It’s Mr. England’s view that credit default swaps concentrated risk in certain financial institutions, instead of disbursing risk.

In “Credit Default Swaps from the Viewpoint of Libertarian Property Rights and Contract Credit Default Swaps Theory,” published in Libertarian Papers, authors Thorsten Polleit and Jonathan Mariano contend, “The truth is that CDS provide investors with an efficient and effective instrument for exposing economically unsound and unsustainable fiat money regimes and the economic production structure it creates.”

Polleit and Mariano explain that credit default swaps make a borrower’s credit risk tradable. CDS is like an insurance policy written against the potential of a negative credit event. These derivatives, while being demonized by many observers, serve to increase “the disciplinary pressure on borrowers who are about to build up unsustainable debt levels to consolidate; or it makes borrowers who have become financially overstretched go into default.”

Mr. England concludes his book saying, “We need a way forward to a safer, sounder financial system where the power of sunlight on financial institutions and markets helps enable free market discipline to work its invisible hand for the good of all.”

Polleit and Mariano explain that it is the CDS market that provides that sunlight.

The panic of 2008 was the inevitable collapse of an increasingly rickety fiat-money and banking system — a system where the central bank attempts to direct and manipulate the nation’s investment and production with an eye to maximize employment. In a speech delivered to the Federal Reserve Bank of New York, Jim Grant told the central bankers that interest rates should convey information. “But the only information conveyed in a manipulated yield curve is what the Fed wants.”

Wall Street’s math wizards convinced the Masters of the Universe that their numbers don’t lie, believing they could model the Federal Reserve’s house-of-mirrors market. Maybe the numbers don’t lie, but the assumptions do.

Advising about mathematical economics, Rothbard wrote, “ignore the fancy welter of equations and look for the assumptions underneath. Invariably they are few in number, simple, and wrong.” The same could be said for Dr. Li’s model and Scholes’s model before him.

Until the era of unstable fiat-money regimes ends, the search for scapegoats will continue — because the crashes will never end.

Douglas French is president of the Mises Institute and author of Early Speculative Bubbles & Increases in the Money Supply and Walk Away: The Rise and Fall of the Home-Ownership Myth. He received his master’s degree in economics from the University of Nevada, Las Vegas, under Murray Rothbard with Professor Hans-Hermann Hoppe serving on his thesis committee. French teaches in the Mises Academy. See his tribute to Murray Rothbard. Send him mail. See Doug French’s article archives.

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.