Fixing Wall Street: Cutting The Gordian Knot

by: Tom Armistead

After reading about the protest on Wall Street with 700 arrests, I visited the website, and was disappointed that the movement has no formal agenda. They do have a concern that the system is run to benefit a small minority - 1% by their reckoning - but any further grievances are not clearly articulated. Much of what is wrong on Wall Street can be described under umbrella terms as either Financialism or Financialization. There is a body of well-informed and thoughtful literature on the topic. Here are some links:

I did an article on the subject a few years ago, primarily concerned with the disconnect between financial transactions and the real economy. However, the hyperactive frequency and the excessive leverage are equally symptomatic. Here's a link:

Clarifying Terms

Most academic writers concern themselves with Financialization, which is logically speaking, a process. Financialism is an ideology, a philosophy, a self consistent set of ideas supporting and rationalizing a process whereby the leverage and frequency of financial transactions increase exponentially, while the instruments themselves become progressively less attached to the real economy.

In politics, it manifests itself in an increased control of the government by financial interests, ongoing deregulation, and policies that favor the financial elite over citizens who work, save and invest.

It is characteristically amoral, if not downright fraudulent. Its practitioners resolutely refuse to take responsibility for their own actions. Those who are deceived or defrauded simply failed to do due diligence. The primary concern is this quarter's earnings, and the year end bonus. Nothing else matters.

When the process is complete, the result is a Financial Market Economy. It's about using the power of money to make money, without contributing any productive effort to the real economy. It's about taxing the real economy with profiteering and manipulation. Its about high frequency trading, CDS, derivatives, naked short selling, excessive debt and leverage. It's about privatizing profits and socializing risks. It's about a system that considers the financial markets to be the final arbiter of value throughout the economy.

Abacus 2007-1 - A Poster Child

The story never gets old, how John Paulson worked with the Goldman Sachs (NYSE:GS) and the Fabulous Fabrice to create a CDO of synthetic ABS, stuffed with CDS referencing adverse selected Mezzanine tranches of Subprime RMBS.

A similar story, less often told, relates how the private equity fund Magnetar worked with Mizuho to create the likes of Delphinus CDO 2007-1. It was a CDO of synthetic ABS, stuffed with CDS referencing adverse selected Mezzanine tranches of Subprime RMBS.

From Magnetar the trail leads to Rahm Emmanuel, whose fund-raising prowess is legendary, along with his remark about never wasting a good crisis. Persons associated with Magnetar were big Obama donors, according to this article from Yves Smith at naked capitalism. The financial sector as a whole is extraordinarily generous with their political donations.

The point is, these transactions, of which there were many, created a misallocation of capital. The voracious appetite for substandard loans to bet against begat more and more substandard loans. Billions of dollars were spent, creating mountains of debt that will not be repaid, and a glut of housing that will take a decade to absorb.

So much for the efficient market hypothesis. So much for the market as an efficient allocator of capital to its most productive use. Wall Street created losses in order to profit from them, and bought off our politicians with a minute fraction of the spoils.

Regulatory Arbitrage

Globalization has created the opportunity for playing nations and regulators off against each other. The practitioners of this art are always threatening to take their business elsewhere. If capital requirements inconvenience banking management, they protest that they will not be able to compete with their international peers.

In the US, banks, and a few insurance companies, shopped regulators off against each other in order to find the most lenient. AIG, an insurance company, found OTS, a bank regulator, in order to get away from insurance regulation, which would not have permitted them to do CDS without adequate capital.

Prior to the GFC, the investment banks were regulated as CSEs by the SEC. In effect, there was no regulation. The banks determined what their risk level was, by their own formulas, and reported it monthly. This was done in the name of making them competitive with their European peers. Their European peers are still subject to questions of capital adequacy.

The whole process results in a race to the bottom.

The Abuse of Risk Transfer Mechanisms

CDS and commodity futures are both risk transfer mechanism, a form of hedging or insurance, with potentially large benefits in stabilizing the economy. Unfortunately, Financialism, as a distinguishing attribute, abuses these mechanisms for the purpose of manipulation and speculation.

Commodity futures, as originally developed, permitted those whose business operations exposed them to risks of fluctuation in commodity prices to transfer their risk to those who had the acumen and financial strength to bear them, for a fee, and to make a fair profit. However, as more and more speculative money makes its way into commodities, the amounts involved are seriously in excess of the actual commodities available, and frequently neither side of the trade has any legitimate business exposure to loss from price fluctuations.

When commodity futures are used as a genuine hedge, the hedged party has the benefit of conducting his business in an orderly manner, unconstrained by risk of abnormal price fluctuations. It improves access to credit: as an example, much of the financing of natural gas production has been done with borrowed money, with future prices hedged in order to protect the creditor. As a result, natural gas is plentiful and cheap.

Southwest Airlines (NYSE:LUV) for many years achieved superior results by hedging fuel costs and concentrating on running its basic business of transportation.

However, in the current environment, what was intended as a stabilizing force actually destabilizes the market, injuring those whose businesses would otherwise benefit from hedging.

The Abuse of Market Infrastructure

The hyperactivity of tradebots, algorithms and HFT is well known. Adherents justify their involvement on the grounds that it enhances liquidity. Because of this great benefit they create for the market, they receive preference and privilege in their access to bid/ask information. At times, they flood the market with bogus orders, in order to deny others access to the precious flow of information. The orders are cancelled almost as fast as they are issued.

The result was the confidence destroying mini-crash of May 2010, during which a huge number of trades processed at stub quote levels. The market for about 100 ETFs evaporated in a heartbeat. There was no liquidity. The market makers, if any, had left the building.

The SEC investigated, pored over reams of data, and elected to go with circuit breakers going forward. They found no wrong-doing. The most egregious of the trades were cancelled. Common sense suggests some type of manipulation of ETFs, since that's where the bulk of the trouble was located. As a motive, arbitrage between the ETF and one or more of its constituents comes to mind.

The HFT activity is profitable. The money harvested has to come from somewhere. I would suggest it comes from the pockets of those who are actually in the market to buy and sell shares - mutual funds, pensions, and retail investors.

The situation cries out for a transaction tax. I trade daily, in small amounts, and would gladly pay a nickel a trade, a penny a share, or 20 cents a contract for options, just for the peace of mind of knowing the HFT activity is being discouraged. It could even be applied to cancelled orders, to slow down the activity of flooding the market with bogus ones.

The Relation to Populism

The 99% idea is Populist in nature. Here's an excerpt from my article on the subject:

Populism ultimately unites the 98% of the population who are not among the elite sufficiently to achieve four important goals:

Establish a cadre of elites who perform their function without unjustly enriching themselves or others.

Establish (or re-establish) a rule of law and system of regulation that prevents the greedy from harming others in their pursuit of happiness or personal enrichment.

Reduce the size and power of big business, big banks (and big government) to what is necessary to serve the common good.

Prevent fraud, abuse and manipulation in financial markets from endangering the real economy.

Monetary Policy Has Been Infected

The Federal Reserve is charged with a dual mandate, to implement monetary policy in such a way as to balance inflation and unemployment at acceptable levels. Many on Wall Street believe monetary policy is now directed at propping up asset markets. Bernanke justified QE2 on the grounds that asset inflation would create wealth, which would in turn lead the wealthy ones to spend, thereby stimulating the economy. The effect, while quantifiable, is weak.

The underlying assumption, that monetary manipulation can ensure economic prosperity, is fatally flawed. It simply doesn't work that way. Flooding Wall Street with cheap money will not qualify any of the current unemployed for one of those 3,000 jobs at Siemens (SI).

The excess liquidity does, however, provide plenty of firepower to game commodities markets, taxing those who buy food or fuel with higher prices, and strangling economic growth.

Policymakers in Washington subscribe to the idea that monetary policy has the power to create prosperity. They would do well to direct their attention to conducting fiscal policy on a sustainable long term basis, and finding ways to direct Federal spending in directions that will encourage an educated and productive workforce, investment in new means of production and modern infrastructure, and a financial services segment that serves the real economy rather than its own interests.

Dodd-Frank Inadequate

We all watched in amazement as lobbyists descended on Washington like a swarm of locusts. Financialism is inherently complex, and efforts to regulate it ultimately resulted in a caricature of regulation at its worst.

The apparent strategy, or in any event the actual outcome, was a piece of legislation so complex and byzantine, with so many decisions deferred to regulators at some future date, that it is be a parody of regulatory excess as that phenomenon is viewed by free market ideologues.

Savvy Jamie has been mouthing off at regular intervals: the usual line, US banks won't be able to compete, they won't have money to loan, they will be tangled up in red tape, innovation will be stifled, etc.

Cutting the Gordian Knot

The complexity of the issues raises the temptation to look for a draconian solution, something swift and simple. Ron Paul with his anti-Fed stance, or Herman Cain with his 9-9-9 program, cater to this impulse. Neither of them is a likely candidate for the role of Alexander the Great in the apocryphal tale. Nor for that matter are the leaderless OWS protesters.

Like a tenacious Octopus, Financialism has reached its tentacles into every nook and cranny of the economy, and subtly insinuated its ideology into our very understanding of how the system works.

A very good start could be made by enacting the following, unambiguously and with finality:

  • Regulate CDS as insurance, with a requirement of insurable interest for the buyer, and adequate capital for the seller.
  • Reinstate Glass-Steagall
  • Apply a Transaction Tax, sufficient to deter HFT
  • Impose Position Limits, both individual and collective, sufficient to maintain to volume of commodities futures trades in some meaningful relationship with the amount of the actual commodity in circulation or production.
  • Outlaw synthetic securities
  • Restrict MBS and other securitizations to simple structures, with wide tranches.
  • Extend the statute of limitations for securities fraud and misrepresentation in the Securities and Securities Exchange Acts to seven years.
  • Impose obligations on market makers and liquidity providers sufficient to compensate for the privileges and exemptions they receive.
  • Develop international standards for regulation, strong enough to end regulatory arbitrage.

Disclosure: I'm long US equities based on valuation. I would be far more optimistic if I felt there was a realistic possibility of change along the lines discussed in this article.


This article is part of a series of articles on Seeking Alpha on Fixing Wall Street - a response to the Occupy Wall Street protests. Other articles include: