Porsche, VW – and hedge funds :

The mechanics surrounding Porsche’s attempts to buy VW are obscure because its option positions need not be disclosed. But the wheeling-dealing goes something like this: to increase its 35 per cent stake above 50 per cent, Porsche bought options over much of VW’s freefloat. The banks that sold these options meanwhile hedged their exposure by buying VW shares. Hedge funds, drawn by VW’s pumped-up valuation – 24 times forecast earnings, eight times as high as the sector average – then shorted VW as fast they could.

So far so normal. The rest is speculation. As hedge funds sold short their VW shares, that stock had to be bought by others; perhaps by Porsche, given its €10bn credit line. This buying more than countered the short-selling pressure, boosting VW’s share price. Facing growing losses from their positions, plus redemption calls from panicked investors, the hedge funds had to cover their shorts and buy back the VW shares they had just sold – again, perhaps, from Porsche. As the hedge funds’ losses mounted, so did the short covering. VW’s share price was squeezed to such heights that it became the 11th biggest company in the world, worth more than other European and US carmakers combined. Absurd.

Anna Schwartz says that US banks are insolvent and the current prescription fails to recognize and address that fact: Via WSJ - Interview

A history of the ratings agency Moody’s in FT.com – When junk was gold. It reveals gross incompetence.

Via The Trust Crunch: The New Yorker:

The banking cycle:

fractional reserve lending—/> boom—> bust—> socialism—> regulation—> economic misery—> deregulation ->> fractional reserve lending

Via Free exchange | Economist.com :

At a very, very basic level, the crisis isn’t that difficult to
understand. The world experienced a massive credit glut at a time of
significant financial innovation in an environment in which regulatory
bodies were insufficiently flexible and powerful to identify potential
problems and take steps to minimize catastrophic downside risk. The
worst effects of the crisis were both foreseeable and preventable, and
yet the nature of politics (and people) made it highly unlikely that
appropriate steps would be taken.

The nature of modern economic
growth is such that development will sometimes outstrip institutional
capabilities in dangerous ways. It is therefore important to always
remember that the worst can, in fact, happen, no matter how unlikely it
seems. But it is in our nature to forget this, and so once in a while
we find ourselves working frantically to survive the eminently
predictable.

Via Kevin Depew in Minyanville:

Narratives are linear by design. Scenes are set, characters identified and defined, actions unfold over time in steps that lead toward a resolution. Unfortunately, while narrative is convenient in helping us understand things, it is useless in predicting how things unfold. Why? Because history does not unfold in a linear manner.

....Man, in retrospect, it all seems so clear. Have you ever thought that? .... But why? Why does everything seem so clear in retrospect? Because we are hardwired to recount events in linear narrative fashion… even events that do not unfold in a linear manner!

In other words, our need for linear narrative colors our perception of history. Linear narratives unfold in steps, the output proportionate to the input…. e.g. the Federal Reserve Chairman lowers interest rates, the first a surprise 50 basis point cut, the stock market rallies, credit becomes less expensive, so people borrow and put that money back into the stock market, or in houses. That’s the 2000-2005 period, right? It certainly seems that way.

However in reality, in non-linear systems, the output is not directly proportional to the input. So it’s not the case that, say, if the Fed does X, a proportional outcome will follow, or if the Fed and politicans implement Y and Z, a series of proportionate outcomes will follow

Creative Capitalism: Profit-maximization as the sole goal of a corporation :

By Martin Wolf

What is the goal of the limited liability, joint-stock company, the core institution of the contemporary capitalist economy? What implications does the answer have for such a company’s freedom to be “creative” in the way Bill Gates uses the term? The classic answer to the first of these questions, repeated often in these discussions, is that its aim is to maximise profits. This statement is not false. But it is vastly too limited. Here are ten points relevant to this theme.

First, one has to distinguish the goal of the firm from its role. The role of companies is to provide valuable goods and services – that is to say, outputs worth more than their inputs. The great insight of market economics is that they will do this job best if they are subject to competition. Profit-maximization (or shareholder value maximization, its more sophisticated modern equivalent) is NOT the role of the firm. It is its goal. The goal of profit-maximization drives the firm to fulfill its role.

Second, by creating a competitive market for corporate control, we more or less force companies to maximize shareholder value, or at least behave in ways that the market believes will lead them to do so. If companies fail to oblige, the company will be put “into play.” Thus, in Anglo-American shareholder-driven capitalism, maximization of shareholder value (as perceived by the market) must perforce be the goal of the company. This is not the case in countries where a market in corporate control does not exist. In such countries, companies must earn a high enough return on capital to survive. But this need not be a shareholder value-maximizing return.

Third, a company is viewed in the Anglo-American world as a bundle of contracts. But companies are also social organisms created by a highly gregarious mammalian species with a unique capacity for large-scale co-operation over time and space. Companies have cultures and histories. For many of those most closely associated with them, they also have (and offer) a certain meaning. Committed workers in successful companies do not work in order to maximize shareholder value or even to earn the largest possible living. Indeed, it is impossible to direct most companies solely by the goal of profit-maximization. (Goldman Sachs may be an exception.) They have to be aimed at the intermediate goal of producing and developing goods and services that people want to buy and are worth more in the market than they cost to produce.

Fourth, the idea that a company is an entity that can be freely bought and sold is culturally specific. It is the view, above all, of Anglo-Americans. It is not shared in most of the rest of the world. The reason for this divergence is that, for many cultures, a company is viewed as being an enduring social entity. I once read that, for many Japanese, one can no more sell a company over the heads of its workers than one can sell one’s grandmother. In this view, goods and services can be bought and sold. Companies, like countries (or, as we all now agree, people), must not be.

Fifth, in this perspective, shareholders are not genuine owners. They contribute nothing of value to the competitive strengths of the firm, enjoy the benefits of limited liability and are well able to diversify the risks they run. They are merely an (ever-shifting) group of people with a claim to the residual incomes. Those with the biggest (undiversifiable) investment in the firm—and thus the greatest exposure to firm-specific risks—are not shareholders, but core workers. The interests of the latter are, therefore, paramount.

The salient characteristic of the contracts inside the firm (that is between the company, its employees and, quite often, its suppliers and even distributors) is that they are relational. That is to say, they cannot be written down in any precise form. Companies are hierarchies in which people engage voluntarily. They necessarily work on the basis of trust in what is often a very long-term relationship: I work extra hard to meet a deadline now, in return for consideration when I need to look after my elderly mother later on. For many companies, trustworthiness is an essential ingredient in their long-term success.

Sixth, if companies can be freely bought and sold, relational contracts, which depend on continuing interaction among specific people inside the business, are hardly worth the paper they are (not) written on. Rational employees will act opportunistically, because they will always expect their company to do the same. The longer and more reliable relationships are expected to be, the less likely such opportunistic behaviour is to emerge.

Seventh, accordingly, capital-market arrangements (and associated views of the firm) that enforce shareholder value maximization may (I stress “may”) make companies work less efficiently than otherwise, in terms of their primary role, by precluding (or at least making far more difficult) a range of potentially valuable relational contracts inside the firm. At the least, such restrictions may have powerful effects on comparative advantage, by shifting countries away from those activities in which companies that benefit from long-term relational contracts are likely to be most effective.

Eighth, it is not necessarily even the case that companies which operate under the assumption that they can be bought and sold (like GM) will operate more successfully in terms of maximizing shareholder value than those which do not (such as Toyota). Toyota is a better car company than GM in almost all dimensions. The failure of Japanese capitalism to achieve the highest level of productivity and sustained dynamism may have far more to with repression of domestic competition in many markets for goods and, above all, services, rather than with the absence of an active market for corporate control.

Ninth, consequently the room for enduring divergence in the forms of capitalism is bigger than those working in the Anglo-American intellectual tradition appreciate. In particular, without an active market for corporate control, managements rule companies. It also acts as a trustee for a range of stakeholders, of which core workers are the most important. Because these companies cannot be forced to maximize shareholder value, they can indeed undertake a range of costly “charitable”activities, provided they do not threaten the company’s ability to survive.

Tenth, one of the most interesting questions over the next generation is whether the Anglo-American form of capitalism, which gives primary direction of companies to capital markets, will flourish and expand, or not. Some of the evidence on the (in)effectiveness of takeovers and the recent sad experiences in financial markets rather suggests not.

This is not to deny that such active financial markets bring big benefits, particularly in financing new companies and enforcing greater discipline on badly run businesses.

Anyway, the more “Anglo-American” capitalism becomes and so the more shareholder driven, the less “creative,” in Bill Gates’s sense, it is likely to be. Or, at the least, the less concerned with wider social results it is likely to be.

Click to Enlarge:

FT.com : The Accountancy Column:

By promoting the fallacy that an increase in the value of an asset necessarily makes its owner better off, it has repercussions throughout the economy.

The housing market is an obvious casualty. The amount homeowners can afford to borrow depends on their ability to service the loan – normally out of income. The fair value fallacy encourages the mistaken belief that it is safe to borrow or lend, provided the loan is covered by the market value of the property. The result is a spiral of ever-increasing loans pushing up property values, which make possible ever-increasing loans. Pyramid schemes are normally against the law. Pyramid lending, however, has been made respectable by a fundamental error in accounting theory.

Something to keep in mind as we bail out financial companies and individuals in today’s credit-crunch:

The virtues which are held less and less in esteem in Britain and America are precisely those on which Anglo-Saxons justly prided themselves and in which they were generally recognized to excel. These virtues were independence and self-reliance, individual initiative and local responsibility, the successful reliance on voluntary activity, non-interference with one’s neighbor and tolerance of the different, and a healthy suspicion of power and authority.Almost all the traditions and institutions which have molded the national character and the whole moral climate of England and America are those which the progress of collectivism and its centralistic tendencies are progressively destroying.

It is not ‘unthinkable’ at all ‘that the US may default on its debt’. In actual fact this has already happened.

By virtue of the US$ still being the de-facto world currency, any
overseas entities holding US$ debt have already seen their assets’
values slide versus their own currencies by between a third and a half.
It is not very long ago that the Euro was US80c, now it is close to
double that. This collapse represents the world’s biggest effective
government default in history – a fact that has passed almost unnoticed
in the media.

Via Summer book club: Economist.com: Mr Friedman gives his 14 issues on which government should back off:

1) Agricultural price supports.

2) Trade restrictions.

3) Output restrictions.

4) Rent control (but then what would intro economics professors lecture about?).

5) Wage, price, and interest rate controls.

6) Detailed regulation (presumably, it should be more vague?).

7) the Federal Communications Commission.

Social security.

9) Licensing, especially of professions.

10) Public housing and mortgage subsidies.

11) Conscription.

12) National parks.

13) Prohibition of private mail carriers.

14) Public toll roads.

Money talks, BS walks.

Naomi Klein rails against Capitalism in a book that she sells through Amazon and Barnes and Noble online: Where to Buy The Shock Doctrine | Naomi Klein :

Oh the irony!

Via Minyanville:

The Fed wants to be the systemic risk regulator. But the Fed is the systemic risk,” Bunning said. “Giving the Fed more power is like giving the neighborhood kid who broke your window playing baseball in the street a bigger bat and thinking that will fix the problem. I am not going to go along with that and will use all my powers as a Senator to stop any new powers going to the Fed.”

Bunning was already deep into Fannie Mae (FNM) and Freddie Mac (FRE).
““[L]et me say a few words about the GSE bailout plan,” Bunning
continued. “When I picked up my newspaper yesterday, I thought I woke
up in France. But no, it turns out socialism is alive and well in
America. The Treasury Secretary is asking for a blank check to buy as
much Fannie and Freddie debt or equity as he wants. The Fed’s purchase of Bear Stearns’ assets was amateur socialism compared to this.”