The IRA: How did we get into this mess?
Janeway: It took two generations of the best and the brightest who were mathematically quick and decided to address themselves to the issues of capital markets. They made it possible to create the greatest mountain of leverage that the world has ever seen. In my own way, I do track it back to the construction of the architecture of modern finance theory, all the way back to Harry Markowitz writing a thesis at the University of Chicago which Milton Friedman didn’t think was economics. He was later convinced to allow Markowitz to get his doctorate at the University of Chicago in 1950. Then we go on through the evolution of modern finance and the work that led to the Nobel prizes, Miller, Modigliani, Scholes and Merton. The core of this grand project was to reconstruct financial economics as a branch of physics. If we could treat the agents, the atoms of the markets, people buying and selling, as if they were molecules, we could apply the same differential equations to finance that describe the behavior of molecules. What that entails is to take as the raw material, time series data, prices and returns, and look at them as the observables generated by processes which are stationary. By this I mean that the distribution of observables, the distribution of prices, is stable over time. So you can look at the statistical attributes like volatility and correlation amongst them, above all liquidity, as stable and mathematically describable. So consequently, you could construct ways to hedge any position by means of a “replicating portfolio” whose statistics would offset the securities you started with. There is a really important book written by a professor at the University of Edinburgh named Donald MacKenzie. He is a sociologist of economics and he went into the field, onto the floor in Chicago and the trading rooms, to do his research. He interviewed everybody and wrote a great book called An Engine Not a Camera. It is an analytical history of the evolution of modern finance theory. Where the title comes from is that modern finance theory was not a camera to capture how the markets worked, but rather an engine to transform them.
Janeway: Yes, but here the agents were principals! I think something else was going on. It was my son, who worked for Bear, Stearns in the equity department in 2007, who pointed out to me that Bear, Stearns and Lehman Brothers had the highest proportion of employee stock ownership on Wall Street. Many people believed, by no means only the folks at Bear and Lehman, that the emergence of Basel II and the transfer to the banks themselves of responsibility for determining the amount of required regulatory capital based upon internal ratings actually reduced risk and allowed higher leverage. The move by the SEC in 2004 to give regulatory discretion to the dealers regarding leverage was the same thing again.
The IRA: And both regimes falsely assume that banks and dealers can actually construct a viable ratings methodology, even relying heavily on vendors and ratings firms. There are still some people at the BIS and the other central banks who believe that Basel II is viable and effective, but none of the risk practitioners with whom we work has anything but contempt for the whole framework. It reminds us of other utopian initiatives such as fair value accounting or affordable housing, everyone sells the vision but misses the pesky details that make it real! And the same religious fervor behind the application of physics to finance was behind the Basel II framework and complex structured assets.
Janeway: That’s my point. It was a kind of religious movement, a willed suspension of disbelief. If we say that the assumptions necessary to produce the mathematical models hold in the real world, namely that markets are efficient and complete, that agents are rational, that agents have access to all of the available data, and that they all share the same model for transforming that data into actionable information, and finally that this entire model is true, then at the end of the day, leverage should be infinite. Market efficiency should rise to the point where there isn’t any spread left to be captured. The fact that a half a percent unhedged swing in your balance sheet can render you insolvent, well it doesn’t fit with this entire constructed intellectual universe that goes back 50 years.
Janeway: There are a couple of steps along the way here that got us to the present circumstance, such as the issue of regulatory capture. When you talk about regulatory capture and risk, the capture here of the regulators by the financial industry was not the usual situation of corrupt capture. The critical moment came in the early 1980s, which is very well documented in MacKenzie’s book, when the Chicago Board appealed to academia because it was then the case that in numerous states, cash settlement futures were considered gambling and were banned by law.
Janeway: The point here is that the regulators were captured intellectually, not monetarily. And the last to be converted, to have the religious conversion experience, were the accountants, leading to fair value accounting rules. I happen to be the beneficiary of a friendship with a wonderful man, Geoff Whittington, who is a professor emeritus of accounting at Cambridge, who was chief accountant of the British Accounting Standards Board and was a founder of the International Accounting Standards Board. He is from the inside an appropriately knowledgeable, balanced skeptic, who has done a wonderful job of parsing out what is involved in this discussion in a paper called “Two World Views.” Basically, he says that if you really do believe that we live in a world of complete and efficient markets, then you have no choice but to be an advocate of fair value, mark-to-market accounting. If, on the other hand, you see us living in a world of incomplete, but reasonably efficient markets, in which the utility of the numbers you are trying to generate have to do with stewardship of a business through real, historical time rather than a snapshot of “truth,” then you are in a different world. And that is a world where the concept of fair value is necessarily contingent.
Previous posts on Donald MacKenzie's work. MacKenzie is perhaps the most insightful of academics working on the history and development of modern finance.