Saturday Morning Essay: Book Review, Michael Lewis and "Flash Boys"

Michael Lewis's new book about high-frequency trading (HFT) in the stock markets is about systematic cheating in financial investing.

While HFT takes many forms, all of it is based on a couple of simple principles: First, powerful computers using algorithms can execute trades at lightning speed; and second, one can gain enough of an advantage over other investors through sheer proximity to the stock exchanges, even when one is dealing with communication speeds nearing the speed of light, to game the system.

The proprietary trading departments (prop trading) of the big Wall Street banks, the hedge funds, the bucket shops specializing in HFT, all do it.  They all cheat by using HFT.  As a result, HFT investors can take the risk out of investing and can report strings of profitable investing days running into the thousands, as many of them have.  HFT investing acts, in essence, as a kind of tax on the world of finance, a tax extracted at the rate of a fraction of a penny at a time, repeated millions of times each day (this is the "high frequency" of high-frequency trading), money earned simply by gaming the system so the HFT player cannot lose.

Michael Lewis gives many examples of how it's done, but a systems analysis involves these key elements.

1.  Under what is known as Regulation NMS, passed in 2007, a broker-dealer licensed by the Securities & Exchange Commission (SEC), when given an order to buy or sell stock by a customer, must search the available exchanges to find the NBBO, the national best buy or offer.  In other words, the broker-dealer (a company like Paine Webber, when there used to be a Painer Webber and people would stop what they were doing, like stealing home, to listen to them) must seek to execute the order on the best terms available.

2.  It is critical to understand that the world of stock exchanges in America has fragmented over the years into about 16 different and discrete exchanges, mostly located in New Jersey on the far side of the George Washington Bridge.  The New York Stock Exchange that serves as a backdrop for the CNBC show, for example, is mainly a stage set.  The actual trading is done by a computer server in a large room on the west side of the Hudson River.  This is also the case for the other exchanges: stacks of electronic boxes in large, mostly empty rooms, scattered around New Jersey.  There are no "trading pits" where buyers scream out orders to a guy in a colored jacket feverishly scribbling confirmation notes and thrusting them at the reaching hands.  That's the old way. The new way is the silent flow of electrons through circuit boards, executing trades in microseconds, over and over, all day long.

3. The Flash Boys (well-financed Wall Street Banks and hedge funds) bribe the various exchanges (the NYSE, NASDAQ, Direct Edge, various others) to allow them to "co-locate" their electronic connections immediately adjacent to the stacks of computer boxes comprising the exchange. They pay a lot of money for the privilege.  Thus, a communication from an HFT "trader" only has to travel a few feet on fiber optic cable to hit the exchange.  This tiny advantage in speed makes all the difference. A trading floor on Wall Street might reach the exchange in 3 or 4 milliseconds (3 or 4 one-thousandths of a second).  To get a sense of this duration, the blink of a human eye takes a little under 100 milliseconds to complete.

4.  If, for example, a trader on the prop floor of the Royal Canadian Bank (RCB, where Michael Lewis's hero, Brad Katsuyama worked) receives an order to buy 1,000 shares of Procter & Gamble at a price not to exceed $80.05 (a limit order, as most purchasing is done), RCB submits the order on its "slow" 3 or 4 millisecond connection.  Finding 1,000 shares of P&G for sale might involve a search among numerous exchanges, since SEC rules now allow multiple exchanges to sell the same stocks.  The HFT trader exploits this environment by using its connections, which transmit data to the exchanges in microseconds (millionths of a second).  The HFT trader "sees" the RCB limit order, then "front-runs" the order by instantaneously searching the exchanges for a buy at less than the limit order price of $80.05, completes that transaction, and then sells the P&G stock to the RCB trader.  The HFT trader might make a penny a share or less, or ten bucks minus transaction costs, on the whole deal; but scaled up into a full day of trading, where such scams are repeated millions of times a day, it becomes real money.  In effect, the HFT trader is an uninvited middleman standing between a seller and a buyer and taking from both.

This is but one form of differential "arbitrage" used by HFT algorithms.  There are numerous others, limited only by the imagination of the mathematics Ph.D's and computer programmers who comprise the money-making wings of the big U.S. banks and hedge funds.

As noted, Michael Lewis tells the story from the vantage point of Brad Katsuyama, a Japanese-Canadian who worked for RCB, got fed up with HFT tactics, and started his own exchange, the Investor's Exchange (IEX), designed to foil HFT tactics.  Whether it will work in the long run or not remains to be seen.  It IS interesting that contemporaneous with the roll-out of the book, and the renewed focus on HFT brought by the book, the stock market has softened and headed south (even Attorney General Eric "Place" Holder has apparently been jostled out of his customary coma and now vows an "investigation" of a practice which has been the dominant force on Wall Street for five years).  The largely illusory trading of HFT accounts for nearly SEVENTY percent of all investment activity on American stock exchanges, and the total volume of trades on the exchanges has doubled since about 2007, reflecting the "echo" transactions of the HFT players.  It is a cash cow for the exchanges and for the scammers who run these investment games.

It might be difficult to overestimate the impact that a curtailment of HFT might have on the American economy generally.  Our President, who never met a Fat Cat Banker he didn't like (and didn't shield from prosecution, such as the Great & Honorable Jon Corzine, formerly of MF Global), is either aware or has been told that he should be aware, that the old school method of investing, to buy stocks and hold them over time ("going long") has had its day, and that as with mortgage-backed securities and money printing by the Federal Reserve, financial scams comprise at least half of what appears to be purposeful economic activity in the United States.  We might be left with only IPO issuances in social media stocks if this keeps up, and how many more hours do Americans really have left to waste on Facebook and Twitter?

Perhaps the wiser course is to cool out on the moralizing about HFT.  Let Goldman Sachs, J.P. Morgan, Citadel, and the HFT shops in leafy Connecticut continue to game the system (which involves lots of foreign money, after all).  Let them extract their toll of fractional pennies on every stock transaction.  Let the rich get richer.  They pay all the income taxes, after all, and always max out their FICA obligations.  They provide the funding to the feds which allows all the vast hordes of Americans living on government assistance to keep their heads above water, to keep the SNAP cards topped off, to keep those S.S. checks coming, to receive those diabetes treatments as they wallow in their immense lipidinous carcasses in the trailer parks of Bullhead City.  Noblesse oblige.  What the rich are able to save from taxation they send offshore.  That's okay too.  It keeps "bankers" in the Cayman Islands in the market for late-model Benzes.  It's all good.  Let the Flash Boys have their fun.  Brad Katsuyama, after all, was just a greedy bastard with a pang of conscience, or maybe a grudge against playahs who were scamming his trades. So he turned his IEX into his own money-making investment.  He should have called it the BuzzKill Exchange, if you ask me.  What's he going to do when the whole American investment edifice comes tumbling down around his ears, hmm?  And what about Bullhead City?

Nice work, Michael Lewis.  Good luck with your next book, when everybody's flat busted.

Saturday Morning Essay: Life on the New American Plantation

Brought to you by Trader Joe's Dark Roast as the Tropic of Capricorn takes a direct shot from the sun...

From ZeroHedge: "Blackstone Group appears to be trying to oligopolize the business of renting single-family homes in the U.S.. As Bloomberg reports, after the housing crash left more than 7 million foreclosed homes in its wake, the investment firm has spent more than $7.8 billion purchasing about 41,000 single-family homes for rental conversion. The world's largest private equity firm has quickly become the largest landlord (of rental homes) in the U.S. and in October, Blackstone offered the first-ever "rental-home-backed" security on Wall Street. One has to wonder if this was the plan all along?" 

Interesting idea. My older brother predicted The Great Foreclosure many years back.  Maybe this, indeed, was the plan all along. Certainly at the time the prediction was made it seemed vaguely paranoid, but I have come to see that paranoia is a perfectly reasonable adaptive attitude in a world dominated by private corporations. To wit, it is not paranoid to think that they do not have your interests at heart, because they don't. If you think they do, even for a moment, you've been watching way too many Jimmy Stewart movies.

 Get the American hoi polloi to mortgage their houses to the moon with adjustable rate mortgages, pump the consumer economy with equity loans, then when it all pops, scoop up all the distressed properties for pennies on the dollar and rent them to the people who used to own them. As a wise man once said, you'll never go broke underestimating the intelligence of the American people.

Calling this latest grift a "plan" might be a little too grand.  Capitalism simply seeks profit "opportunities."  Regarding Blackstone's raptor-like feeding frenzy as part of a conspiracy may be an example of the "ant in the sandbox" fallacy suggested by the polymath Herbert Simon decades ago; to wit, if you examine the path of an ant across a sand box, you will be impressed with the clever, efficient way he traversed the hills and valleys to follow a fairly straight line.  When, in fact, all the ant was doing at every stage was making a choice to go left, right, over or down the terrain.

So it is with the Great Foreclosure.  The Robber Barons got rich on fraudulent mortgage products, and now they're assembling new fraudulent Rent Backed Securities (RBS - that's even a good logo for Robber Barons) out of the wreckage.  What else are they supposed to do? They're here to make money.  L'argent, c'est moi.

At least someone is still getting rich in this country, something increasingly difficult for the ordinary member of the Booboisie.  Blackstone and other financial predators are helped enormously by the Federal Reserve's policy of "exceptionally low interest rates for the foreseeable future."  If you're big enough to borrow for practically nothing; then buy a house in Florida, say, for $100 k; then rent that 2/2 with lanai charmer for $900/month, annual income of $10,800; then even with a 10% management fee, your gross cap rate is around 10% a year.  Bet you can't get that on your B of A money market, can you?  Now if you're like Blackstone and can do this scam 41, 000 more times, you've got yourself a nice little business going.  And you can build on that by bringing in investors on whom to pawn off the whole operation, pay them a nice 6% on their money, pocket 4% for having the brilliance (and corrupt connections) to pull this caper off, and essentially have no skin in the game. And then when the economy finally and completely collapses, maybe from an attack of acute nausea, Blackrock can let someone else hold the bag. Probably us again!

Sweet.  It's the modern version of a sharecropper's life on the plantation, in a way, and it's what's left to the middle class now that the economy has been completely hollowed out by our decision to globalize and become an "open economy," as the Plantation Liberal Economists have always urged.  As Gail Tverberg notes in her latest insightful post,

Economists, through their wholehearted endorsement of globalization, have pushed industrialized countries into a competitive situation which we are certain to lose. While oil prices tend to push wages down, competition with Asian countries makes the downward push on wages even greater. These lower wages are part of what are pushing us toward collapse.

I wonder to whom Gail could be referring?  Well, this isn't a "Science" post so I certainly won't mention any names.   Globalization and hyper-specialization of the economy, all guided by ruthless capitalism, are the status quo here on the Plantation, and Plantation Liberals always work within the status quo. If your specialized occupation, like assembling auto generators at a plant in Indiana, went away to a warmer clime where the workers aren't so fussy about "benefits," then you're just going to have to learn to do something else, such as Planning or Tanning, admittedly at a lower rate of compensation.

Maybe more "transfer payments" will help the new tenants to pay their new landlord. We can always print the money to send more cash to the poor to keep them in the houses as tenants which they used to own.  And I'm sure Blackstone (probably a description of the company CEO's heart) will be reasonable and charitable lessors.  Just get through the credit check, deposit the four months of rent, and pledge your youngest child as a security deposit.  And if it doesn't work out, as a free gift to all applicants, a large cardboard box and map to the closest bridge.

Austerity, Then & Now

At a very personal, selfish level, I don't really care how "austere" the government decides to become. I don't have any real skin in the game, other than the increasingly perilous adventure of trying to drive on California's potholed roads. America doesn't really have any public amenities which are threatened by greater austerity; for example, we don't have a real passenger rail system, or much of anything in the way of public transportation. The conditions of accommodations and facilities (bathrooms, etc.) in national and state parks are usually a complete disgrace, and so forth. The graffiti-strewn walls, the urban blight, the shitty, cheap, tawdry look of so much of what's been built in this country in the last 60 years, are all reflections of the people who live here, their aesthetic criteria, their social mores. It's how we live and we've all gotten used to it. The public realm in general in the United States is a vast wasteland, in fact, and is the emblem of our governing ethos; to wit, beauty and grace in life are "private virtues" which must be earned and purchased. You must amass enough money to buy your own sylvan enclave, or your house on the beach, in order to escape the crapscape (h/t: James Kunstler) of American life in general. Amazingly, the financial elites who own such an overwhelmingly large proportion of the wealth in this country, and can afford to insulate themselves from the trash heap, have enlisted the help of the some of the most disadvantaged (the Tea Party types and Southern Rednecks, not always the same people) to assist them in enforcing this way of doing things. Thus, the Tea Party has as one of its main platform planks the perpetuation of the "Bush tax cuts," as if such a top-margin benefit could possibly help them at all.

When the public realm is in such a catastrophic state, the key strategic move is to insulate yourself as much as possible from its effects. Although I'm eligible for Social Security now, I don't draw on it; I continue working. I'm too young for Medicare, and I'm self-employed, so I will never receive a penny in unemployment, welfare, public pension, or (currently) government-furnished health care. Thus, I read the weekly reports of new UE (unemployment claims) and even the unemployment numbers themselves (since I will never be counted one way or the other) with a great measure of personal detachment. In a way, none of this has anything to do with me.

I have a lot of company in this state of societal anomie, of course. Millions and millions of people, just like me. Working stiffs with no safety net all. As I said a few posts back, the sense of national "cohesion" in this country is in an advanced state of deterioration. We're kind of a mixture of a Hong Kong-style economy, with a manic desire for deregulation and anything-goes entrepreneurship, and a Greek-style approach to complete fiscal irresponsibility and mass tax avoidance. The same financial elites who own the government and manipulate the Right Wing booboisie (h/t: H.L. Mencken) with empty slogans and rhetoric favor complete deregulation, except when they blow themselves up and need hallucinated "money" to restore them to "balance," and otherwise advocate absolute minimization of any financial support for the country of which they are nominally a part.

Thus, what does "austerity" have to do with anything anymore? The financial elites are just as happy to borrow money on the "credit" of the Treasury as the so-called "liberals." The budget cutting antics of the Republicans are simply Kabuki theater. They know, and we know, and they know that we know, that the paltry reductions they are suggesting will do absolutely nothing to avert American bankruptcy. Their frivolous posturing, however, does impress some of the rubes in the cheap seats, who are too lazy, ignorant and ill-informed to perform the very simple math involved in assessing national income (about $2.2 trillion, the subtrahend), comparing it to national spending (about $3.8 trillion, the minuend), producing a difference of $1.6 trillion. Now let's do some more math: $100 billion/$1.6 trillion = 1/16 = 6.25% of the budget deficit. This is the House Tea Party contingent's big proposal, this is their extreme position, the one that may shut the government down.

Goldman Sachs, that company famous for doing God's work here in His Earthly Kingdom (God, I mean, not Lloyd Blankfein), recently prognosticated that a $50 billion reduction in federal spending would produce a 1% reduction in national GDP. Now, G-Sax is not exactly bearish on American prospects, since part of their scam is to encourage the endless funneling of money from the Federal Reserve into Wall Street, the better to "stimulate" the economy into "recovery." In a linear extrapolation, this would imply that $100 billion (the aforesaid 6.25% "slashing") would cause a 2% loss in GDP, or the current estimate of the entire growth for 2011 (revised downward recently, since the government has begun to notice that despite their rosy UE stats, no one is actually working). Let us continue this morning's math session. Assuming this same linear extrapolation holds for greater amounts of budget "cutting," what would be the effect on the economy of doing the only rational thing, living within our actual means? Well, let's figure it out. If $50 billion = 1%, then since $1.6 trillion is 32 times larger than $50 billion, G-Sax is implying that a balanced budget would result in a 32% fall in GDP. How much did the GDP of the United States fall during the depth of the Great Depression? Answer: 30%.

Such ruminations may suggest to you just how utterly phony this so-called American economic "recovery" actually is, and why despite all of the fake number crunching at the Bureau of Labor Statistics, the country has not actually produced any new full-time jobs for the populace in over ten years. We are sustaining the economy with the same false source of prosperity (massive debt) which fueled the run-up to the crash in 2007-08, only now it is the public sector which is pulling the laboring oar on the slave-galley ship of penury.

Thus, there won't be any austerity. There can't be, because the political class cannot face the ruinous consequences implied in their own austerity rhetoric. They'll run this scam in Washington as long as humanly possible, they'll use every trick in the book, they'll print money, ship it to England, and pretend that the "UK" is buying American Treasury bonds, along with the Federal Reserve, which is already printing money to "buy" bonds from Primary Dealers, who in turn often had just closed the purchase themselves a few moments before, pretending that this indicates bond-buying "interest."

Austerity, like prosperity in this country, will eventually become a "private virtue." It will be what we have left. Thus, 'tis best to cultivate an attitude of mind which anticipates such a state of affairs. The Zen of detachment, an austerity of expectation.

The Cargo Cult Economic Recovery Under the Rahm Emanuel Administration

Sometimes I say to myself, "Self (for I want to get my attention), what's the deal with this Obama Administration? Why is it setting the table for the Tea Party?" I'm willing, you see, to ask myself the tough questions. Others may dodge them, but in the privacy of my own mind, I follow the facts where they lead.

What I'm coming around to is the slow realization that the country is actually led by Obama's Chief of Staff, Rahm Emanuel. If I think of it that way, it mostly makes sense. Rahm is Old School, a political deal-maker who operates pretty much as his brother Ari does in the show biz agency game. If you want to get things done, what you do is get a bunch of power players in one room and cut a deal. This is how Pragmatic People get things done. It's not a lot of airy-fairy, Hopey-Changey bullshit. That's fine for getting elected - give the suckers what they want to hear. But once you're in charge, you have to act like a grownup, and grownups deal with the possible.

Health care "reform" was done this way, the energy bill will be done this way, financial "reform"

is being done this way. Emanuel and his Democratic Leadership Council cohorts are running a kind of Names Project where the big bills have the titles of real change without any of the substance. You want Health Care Reform? Here. And what you get is a large, unfunded expansion of the Medicaid program, and not much else. That looks doable to the Big Boyz, so they do that. Financial reform? Okay, we'll limit what the Bank of America can charge you when you get cash back at Safeway on your ATM. Satisfied? Who cares if you aren't satisfied.

The people summoned to the back offices of the West Wing of the White House do fine under the existing economy, so they don't want to change much. In this sense, Barack is useful to them. Obama, I get the feeling, is something of a naif, a political neophyte, and more or less a tool for the Powers That Be. He's in over his head. His natural inclinations are conciliatory and "compromising," which the political sharks swimming around him take as an invitation to do things their way. It's kind of endearing and touching that Barack has this enduring belief in the good intentions of all the assholes in the federal government, but it's massively displaced and it has shanghaied his Presidency and made him ineffective.

The only satisfaction I get out of watching the U.S. economy thrash and struggle in the La Brea Tar Pits of the current Depression is the realization that Rahm Emanuel's Cargo Cult expectation that the economy will spontaneously "recover" is being systematically destroyed before our eyes. It isn't happening. Barack, Joltin' Joe and Rahm have been reduced to using Census Bureau overhiring (at ridiculous levels) as a sign of recovery. Nothing of the sort is happening. This is not a "cyclical downturn," and blaming all of what is happening on a "subprime crisis" is simply wishful thinking. We are experiencing the natural result of about three decades of allowing the U.S. middle class to be hollowed out and wrecked, and of permitting ever greater fractions of national wealth to be concentrated in financial elites who operate at the multinational level. It's really that simple. The middle class was kept viable for a couple of decades by massive borrowing, but now the collateral for such borrowing has been destroyed, average income will not support the previous standard of living, and the Moment of Truth has arrived.

To extend and pretend for a while longer, the U.S. has led the international community in taking private debt on to the public ledger, running huge deficits and turning what was a private catastrophe into a sovereign debt crisis. The alternative was to face the truth, something the political system will not allow. It would have taken a very forceful, self-confident, visionary, intellectual-sprung-from-the-head-of-Zeus leader to take us in the right direction, and Obama is not that person. Nor is Rahm Emanuel, who is running the show, although he is a great deal more savvy than the President. Rahm decided that it was innovative enough just for Obama to be the first minority President; beyond that, it was to be business as usual, with the Clinton Presidency as the cultural and political model. Thus, vacations on Martha's Vineyard, dinners in Georgetown, flexing of American military muscle to keep the Right Wing off balance, forgiveness of war crimes, continuation of Bush/Cheney outrages in detainee civil liberties abuses, expansion of unnecessary wars. All the same stuff, including (and unlike Clinton) an actual increase in military spending.

The only hope for the American economy in the long run is (a) a fundamental change in the energy paradigm and (b) protectionism in the form of tariffs and abandonment of the free trade fetish. The economy runs on energy. So many people could be employed, so much could be done at so little environmental cost, if we moved to solar power, in all its various forms, on a massive basis. And it here that Obama-Emanuel have been all talk and no effective action. The money, as always, goes to the Pentagon. From the 2011 Federal Budget description:

Encourages the Early Commercial Use of

New, Innovative Energy Technologies that

Will Reduce Greenhouse Gas Emissions.

The Budget substantially expands support for

DOE loan guarantees for innovative energy

technologies, by adding $36 billion in new loan

authority (for a total of $54.5 billion) for nuclear

power facilities and an additional $500 million

in credit subsidy to support $3 to $5 billion in

loan guarantees for innovative energy efficiency

and renewable energy projects. The loan guarantee

program also will continue to support a

range of commercial renewable energy programs

and other facilities that help reduce pollutants

and greenhouse gases while simultaneously

creating clean energy jobs and contributing to

long-term economic growth and international

competitiveness.

There you have it. All of those "millions of Green Jobs" that Obama talked about on the campaign trail: that's what is supposed to get it done. "Loan guarantees" for innovative energy efficiency and renewable energy projects. And the cost of maintaining the military occupations of Afghanistan and Iraq under the new budget? $170 billion, as part of $700 billion in official Pentagon spending. Obama/Emanuel do not want to give the Right Wing ammunition for the accusation that they are "Socialist," so they will not do what needs to be done, a true Manhattan Project for alternative energy. Too "radical." Politics is the art of the possible, and that just isn't possible. I understand the difficulty, I believe, but it doesn't make sense to be pragmatic when practicality keeps a country mired in stagnation. If you're going to Change things, you really have to be willing to Change things. Alas, it is not to be.

So let's wait, like the South Sea Islanders, for the cargo to float ashore again, as it has in years gone by. Let's pay about 16 bucks an hour to one in every 500 Americans to count the rest of us and call it "job growth." Let's screw around and just keep doing the same things and expecting different results. Let's all go to hell in a handbasket, but look Presidential doing it.

Wile E. Updates His Dow Projections

Yes, yes, I know. It was my finest hour, when I predicted a Dow fall to 9,100 when the NYSE was cooking along at about 14,000. Yet Krugman got the Nobel for Economics. Go figure. What's he ever been right about? Well, I won the Nobel Prize of My Mind, which, unfortunately, does not come with a large honorarium and a trip to Stockholm.

Those were the halcyon days, when equipped solely with the back of an envelope (which had once enclosed a late notice from PG&E) and a dull pencil, and unable to find the novel I was reading and yet still needing to...well, never mind. Such details are extraneous. The Swimmer Theorem is simplicity itself, exemplifying the elegant Occamesque eschewal of all frivolous detail. The American "economy" was based on 70% consumer spending, as in, I will mow your lawn if you will wash my car. Or we can all do each other's laundry. The beauty of a "service" economy is that it doesn't really matter what pointless activities we occupy ourselves with. We're not building wealth. That's what the countries do who have the jobs all the multinational corporations in America sent to them so that what wealth remained could be concentrated in fewer and fewer hands, which swag could be used to buy Congress to keep the tax code and "free trade" agreements amenable, and the Out-of-Work Artists Formerly Known as the Middle Class could go straight to Hell, do not pass Go, do not collect your $200 Social Security payment, because the system is bust-o. A moment's reflection will also tell you that the "subprime" crisis (which can now be characterized more generally as the Debt Depression) really was the real estate and credit card (and auto loan & student loan) equivalent of the same offshoring principle; that is, by securitizing everyone's debt, the same cabal of the super wealthy could control this remaining American "industry" (i.e., going in hock up to your eyeballs). This is why, of course, no one on Wall Street pays any price whatsoever for the greatest swindle in history; it's what Washington wanted them to do (gee, let's think - why again are the Chinese and Japanese getting testy? Couldn't be those mountains of fraudulent Fannie & Freddie debt instruments they bought, could it? That can't be it. That would be our fault. So it must be Barack palling around with the Dalai Lama.)

Mondays - I just love 'em. Anyway, back to the Theorem. The Federal Reserve is obviously tiring of manipulating the stock market, so the Dow, obedient to the laws of gravity, is settling back to a more sustainable level below 10,000. Washington couldn't run that con forever, and they never planned to do so. Touching in their naivete, and perhaps motivated by a bad conscience secondary to their enabling of our destruction out here in the land of strip malls and multiplexes, far, far from the Caffe Milano in Georgetown, Congress, the Fed & the Treasury operated on the idea that this Recession was just another cyclical blip, instead of a structural turning point in American economic history. To wit, we're not coming out of this for a very long time. Nevertheless, the Fed and the White House bought up the entire mortgage industry in the United States by taking all of the Fannie & Freddie guarantees onto the Fed's balance sheet or by making the Congressional sponsorship of the GSE's explicit (on Christmas Eve, so no one would notice), to the tune of $6 trillion (which amount, however, is not carried as part of the current deficit, although it is a moral certainty that some significant fraction of this load will go bad over the next few years). Who's got time for reality anymore?

But where was I. Okay, so the Dow is sinking like an anvil in deep water once again. The downward pressure must be considerable to overcome the Fed's habitual trading of stock market futures through its New York prop desk. When you consider that the Fed can, through its prestidigitalization (ah, why do I give this stuff away?) make money up at will, financial g-forces must be Jupiter-like to overcome the levitation. Maybe they're starting to realize that we're just going to have to face it: the equity's gone, everywhere in this country.

So if you'll recall, the original Theorem held that the American peasantry were really only capable of fueling their 70% share of consumer economy to about half the level suggested by the GDP. The rest was borrowing, and a lot of that from mortgage re-fi and lines of credit. Well, we can't do that anymore, now can we? So simple math told you that we should see a fall of 35% from 14,000 to 9,100, at which point the Fed went to work. But as suggested by analysts here at the Walden think tank, there would also be a knock-on effect caused by the results of the general fall-off in economic activity. Rather than measuring this effect through the use of the GDP (another gimmicked number), it probably makes more sense to use the delta in the U-6 unemployment figure, which since the fall began has soared about10 percentage points to its current 17%. That would suggest about 900 points or so, down to 8,000.

Nice and round. Such a number perhaps represents the residual wealth of the American populace. It is about a 43% drop from peak to trough, and perhaps it will apply across the board: houses, commercial real estate, equity stocks. This will assure that the big banks will eventually go broke despite all the efforts to shield them from the effects of realistic accounting, such as actually marking to market all the worthless mortgage-backed securities still on their books.

If Greece (and the other members of the PIIGS) can teach us anything, besides the calculations of force necessary to move something up an inclined plane, or figuring the square on the hypotenuse, it might be that all this additional sovereign debt, in the not-very-long run, is simply going to make a terrible problem disastrous.

Sure, things can get worse

I remain in continual awe of "Tyler Durden" at the zerohedge econoblog, who is an amazingly fecund and trenchant analyst (pretty good adjectives, huh?) of the American economic and financial market scene. Durden (his nom de blogue borrowed from the main character in "Fight Club") does not simply repeat the same tired stats one can read everywhere, e.g., the American economy is 70% consumer spending, we borrow a lot from China, et cetera. By now everyone knows that stuff, and yet blogsters like Jim Kunstler simply use those stats over and over, dressing up the doomsaying with artistic, novelistic writing (entertaining, to be sure) and leave you about where you started.

Not so our man Tyler Durden. His latest Sunday reading (and like many who read his blog, I don't know when the man sleeps) undertakes an analysis of a question I was wondering about: given that U.S. society is now so economically stratified, with both wealth and income so heavily skewed toward a very small ultra-rich investor class, shouldn't any discussion of an American "recovery" take such obvious data points into account? That is, recovery for whom, and how? Tyler to the rescue: http://www.zerohedge.com/article/detailed-look-stratified-us-consumer.

It takes more than one reading, but it's all pretty much there. President Obama and his fearless band of economic tinkerers really have no good options at this point, and it relates to this stratification and imbalance within American society. Things are so messed up, due to the relentless "financialization" of the economy and the systematic destruction of the former middle class, that we've arrived at a point where the top 10% of the population (the Upper Class decile) and the Middle Class (the middle 50%) account for about 42% and 46% of all consumer spending, respectively. The poor (the bottom 40%) only account for about 12% of consumer spending. The Middle Class, however, carries about a 200% leverage of debt to net worth, substantially above the 130% national average, and about 50% of all of the net worth of the Middle Class is tied up in residential real estate, a declining asset base (versus 25% for the upper decile).

Add to these data the observation that it has been the middle and lower end of the residential real estate market that has been hammered most senseless by the economic downturn and you arrive at the salient point: it is really only that Upper Decile which is in any shape whatsoever to "resume" the American consuming orgy which drove the economy in its "boom" years (and made Asia the manufacturing colossus it was). The Middle Class is in deep debt, with heavy unemployment, and with its home ATM system (equity borrowing and re-fi money) completely on the fritz, as larger and larger percentages of Middle Class homeowners see their home values sink below the mortgage debt. The big Obama stimulus was simply palliative, designed to forestall disaster. The stimulus spending and all the bailout money (which began under Bush) do have the implacable effect of increasing the national debt and yearly deficits by trillions of dollars, and it becomes inevitable that at some point Congress is going to have to substantially raise taxes to deal with the deficits, if only to make debt service payments. Yet increasing marginal rates, much as I hate to admit it (being a kind of populist), will slam that Upper Decile where the only slack in consumer spending can be taken up, given the pathetic stratification we have allowed to take hold in this country over the last thirty years or so.

So there are really no good options, which is often where the Designers of Perpetual Motion Machines find themselves at the end of their efforts. The Middle Class feasted for a long time oncheap credit made possible by easy money flowing onshore from Manufacturing Asia and from the Petrostates. That much we know; it is now part of the American Economic Catechism. That game is over; we are fortunate that China and the other investors in Treasury obligations retain any interest at all in buying our mountains of debt, especially at the piddly rates of return available, but they have been captured to a large extent by the huge prior investments they have made in the dollar. But it is simply not realistic to think that the American Middle Class, having lost trillions in equity from the real estate debacle, and with their wages stagnant (a situation which has persisted for a decade), are going to rebound and begin sprees which fulfill their 46% of the national obligation to Buy Stuff to keep the economy going.

I always thought that the MBS (mortgage backed security) disaster, and the "toxic asset" problem generally, was not really the efficient cause of America's economic reversals. More a case of whistling past the graveyard, because if that's all it is, then a few simple fixes (TARP, TALF, some other acronym) would take care of it. Rather, I thought the MBS craze was sort of the final orgy before the lights were turned out. The Middle Class, struggling to survive in an economy that required ceaseless consumption and materialism to keep things going, were given the opportunity by Wall Street Banksters to Go All In, to hock it all, to take debt right up to that ceiling where it was just barely affordable based on income, and then way beyond. The fees and commissions were earned at the front end by Goldman Sachs, Merrill Lynch, JP Morgan Chase, Lehman Brothers, Bear Stearns, Countrywide, Bank of America, Washington Mutual. The pain was reserved for those who signed the promissory notes.

So that's now where we are: the Morning After the Party, and the floor is littered with empty bottles and there are plates of guacamole going bad and the sink is filled with dishes and there's a Repo team out front hotwiring cars. The Middle Class folks are tapped out, the poor were never much in the game to begin with, and the Upper Decile are simply playing games with all the taxpayer money they were given in an effort to swipe what's left. Bernanke's liquidity injections (money printing) have found their way into the stock market, but this isn't real prosperity and it will not endure past the end of "Quantitative Easing" (QE) which ends next month, according to Bernanke, because of all the "green shoots" in the housing sector (uh-huh, right). At some point we have to deal with the reality that the Recession may be "over" in the sense that GDP stops contracting, but that only means that the economy has reset at a substantially lower level of activity and prosperity. It does not mean a return to things as they were in mid-2007. Meanwhile, the banks are zombified with bad debts (held at unrealistic mark-to-fantasy levels to conceal the truth, FDIC is bankrupt, and the Fed and Treasury are scrambling desperately to keep the T-Bill auctions going (playing all sorts of games in the process) to hold the creditors at bay.

The situation is simply too tenuous to imagine that more rude shocks are not in store. It's indeed possible that in a year or so we'll see where we are now as the Good Old Days.

I think we're going to be stuck in the doldrums for a long time, until we recognize we can't get out of a gimmicky economy with more gimmicks.

Audit the Fed?

Friday's Happy Face entry was, I guess, somewhat satirical. Actually, I simply do not see how the United States economy can recover in anything under a decade or so. The interesting part for me is the study of the various components, or shells, under which the Powers That Be are hiding the grim truth from their subjects. In this regard, the "Audit the Fed!" Brigade forming in Congress strikes me as a kind of Suicide Cult. It's borderline treason, in fact, for otherwise estimable pols like Ron Paul to suggest we really, really ought to kick over the slimy rock called the Federal Reserve Bank and see what slithers out. I'm pretty sure we don't want to know.

We don't want to know because the only thing actually propping up the American economy at this point is the ability of the United States Treasury to issue the world's fiat currency. The consequences of losing that capacity, or the worldwide, coordinated denigration of that ability, would spell almost instantaneous disaster. The Fed and the Treasury are playing an elaborate game of creating money out of thin air through the interplay between the two institutions. It is made deliberately complicated and confusing by the principals involved. The last thing they want is clarity. I heard Bill Maher the other night on "Real Time" express his fundamental inability to understand "how it all works." Bill's a smart guy, so you can rest assured he doesn't understand it because no one who could explain it wants him to understand it.

Who or what is propping up American consumer demand? Who or what is propping up the Dow Jones Industrial Average? Who or what is filling in the massive shortfall called the American federal budget deficit? Is the recent stock market rally (March to the present) the result of an improving economy? If it is the American public actually investing in the stock market, why is it that there is no apparent significant transfer from savings (such as money market) into equities?Of the $2.7 trillion runup in the stock market since March, only $400 billion can be traced to transfers from money market and savings. So the balance of $2.3 tril is coming from...? The usual place: the bailout money, laundered through financial institutions which turn around and invest in order to drive up the value of their own equities. And the bailout money comes from? Borrowing?

The surge in the GDP? Well, government spending is up 11%, and government spending (as faithful readers know) is one of four parameters used in computing the GDP. And half of all government spending is borrowed money at this point. So 5.5% of the increase is actually a non-offset liability which is being counted as a positive sign of growth.

The stimulus package (borrowed money) is temporarily boosting consumer activity, somewhat. And when America's payday advance runs out?

Are foreigners actually buying U.S. Treasuries at this point, or has the Treasury/Reserve figured out a way to create the illusion that they are to disguise the Fed's own purchase of America's own debt (through straw men, through compliant foreign banks, through...look, quick, over there!) ? As Dmitry Orlov says, have we moved from IOU to I-Owe-Me? Do Bernanke/Geithner have the fastest set of hands in the history of all shell games?

So where do all these illusions come from? I suppose from the usual source: the inability of the political system ever to admit how dire things really are. We've "stabilized" the banks by allowing them to mark-to-fantasy all those trillions in toxic debt (mortgage-backed securities, other flimflammery) stuffed away in their reeking vaults. It allows them to pretend they are solvent when they are not, to use fraudulent accounting to impress federal "regulators" who are all too willing to believe in the first place.

Audit the Fed? I don't think so. Move along. There's nothing to see here. We're in the middle of an amazing rebound, that's all. Without really dealing with anything (because we can't), we've managed to solve everything. Do you believe it? Good, glad to hear it. Really, that's all we were after.

The Casino at the End of the Universe

I have referred before to a remarkably prescient book, published some years back, entitled Infectious Greed by Frank Partnoy, which detailed the tenuous world of derivatives and the threat they posed to the world's financial stability.  Partnoy took as a jumping-off place the meltdown of Long-Term Capital Management, that giant hedge fund quietly working its sinister magic in the sylvan quiet of the Connecticut suburbs.  LTCM innovated like crazy and had the inspiration, and genius, of sensing it required the services not of standard issue MBAs, but of math PhDs from MIT and Harvard who could construct the arcane and insanely complicated algorithms necessary for LTCM to optimize its computer-driven arbitrage strategies.  The system couldn't miss, until it missed entirely.

The nightmare, house-of-cards scenario which Partnoy predicted in detail has now actually happened.  Usually these sci-fi disaster movies remain fictional; not this time.  Instead of learning anything from LTCM's game-playing and ultimate implosion, what Wall Street learned was that even in a stagnant economy, where nothing of real worth is being produced, enormous sums can still be earned by playing games with money.  Any common financial...thing, such as a residential mortgage or a VISA card balance, could, with sufficient scale, aided and abetted by millions of side bets, become the stuff of new fortunes.  And so we witnessed (we didn't really see it, and we certainly never regulated it) the massive proliferation of mortgage-backed securities, collateralized debt obligations, short selling, and credit default swaps.  

These all interplayed and interacted; for example, Bank A might bundle together a few thousand mortgages into a pool, and base the issuance of bonds upon them, creating a Special Purpose Vehicle to issue the bond (and to keep the liability off the books of Bank A).  The actual bonds were sliced, diced and parsed into tranches of relative risk: top level (AAA), mezzanine, lower equity, which might be retained by Bank A itself.  To insure the risk involved in these mortgages (and the MBS based upon them), credit default swaps were bought and sold, sometimes by the issuer and purchaser, sometimes by insurance companies such as AIG.  

The swap guaranteed payment in the event of default.  To make it all more fun, there was no requirement that the swap be held by someone with any real interest in the MBS at all; anyone could buy one, thousands of people could place bets on whether the MBS would pay or fail. Then to stack the deck a little further, the playuhs, the Big Boyz, could increase their chances of collecting on their bet the MBS would fail by short selling the underlying instrument to drive down its price.  What made it all the more creative and exciting is that no one regulated the world of credit default swaps. Not the SEC, certainly not the Federal Reserve of Ayn Greenspan.  One can only guess as to their total "notional value;" some people estimate a total value of $1.4 quadrillion, or more money than exists in the world.  Did the United States, in purchasing an 80% stake in AIG, succeed to an exposure for $1.4 quadrillion in swaps?  Hey, I guess we'll find out!

Does any of this actually sound like a process by which one puts vegetables on the table or heats one's dwelling?  I think Thoreau said, in more eloquent words than these, that one should beware of solutions to the problem of living that are more complicated than the problem itself.  I was thinking of this last night as I was watching the PBS "Frontline" special called "Inside the Meltdown" which tried (really tried) to explain what's happened to us. Personally, I don't think it came close.  There were the usual tableaux vivants: the big conference room videos with Bush, Paulson, Schumer, Dodd, Reid, Pelosi, Bernanke sitting around a table, and then someone like Chris Dodd standing in front of a microphone saying stuff like, "When we heard how close we were to a meltdown, the oxygen left the room.  We've got to get this right."

It's all so dramatic.  But it occurred to me (a) the ones sitting around the conference table were the ones who let it all happen and (b) they are entirely the wrong people to fix it.  It's as if these same people sitting around the table were asked to come up with an innovative approach to string theory.  The complexity of the problem is simply beyond their understanding.  The only hope, and it's not much of one, would be to enlist the MIT PhDs who constructed the algorithms in the first place to conduct a seminar for a month or so and to suggest ways to unravel and unwind the puzzles they had constructed.

Instead, the Treasury and the Fed are going to continue down a path of reacting to the latest bad news, without really understanding the underlying origins of the problems they're confronting.  How big they are, how long they might go on.  They are going to treat this enormous financial Frankenstein as if it were the normal outcome of "banking" and "investing," and sacrosanct because, after all, these were all "contracts" freely entered into by capitalists pursuing their trade.  No matter how far the contagion spreads, the U.S. government is going to keep doling out billions, hundreds of billions, trillions of dollars in an effort to stanch the infection.  To keep this enormous Casino at the End of the Universe, these palaces of greed and bad judgment, standing for as long as possible, until they topple over from the rot within.