In the ongoing debate on financial reform several analogies were made by the debaters to illustrate the points they were making, and these were good analogies. However, it must be said that they were incomplete inferences because they missed out on one important detail. The purpose of this essay is not to rehash the entire debate or to put it in a nutshell but to illustrate that one detail and to highlight its importance in the context of the larger debate.
To describe the credit default derivatives, the analogy was made to the effect that such derivatives are like betting that your neighbor's house will burn down, wishing of course that it does so that you may collect. Another analogy was made to the effect that the derivatives are like betting on a team losing the game and wishing that it does. The question was then asked if it were possible to imagine someone being tempted to set ablaze her neighbor's house and collect, or a player betting against his own team then play to lose the game and win the bet. Well, the record does not show someone ever making a bet against her neighbor's house and setting it ablaze but it does show instances where players made bets against their own team then played to lose the game. Worse, the record shows people taking insurance on their spouses and killing them to collect, or taking insurance on themselves and faking their own death to allow the beneficiaries to collect. The point is that where there is the possibility of getting away with a fraudulent insurance claim, people will find ingenuous ways to game the system and to act dishonestly.
This said, what the analogies show is that you can play this sort of game but that you can play it only once. When the house burns down, you win the bet and it is the end of this story. When a team loses the game, you win the bet and it is the end of this story. The difference between these situations and the games they play in the financial world is that the financial instruments stay alive for as long as you want them alive. Their value goes up and down in cycles, never ending the story in a sudden death because the games are played with money, and money is never completely withdrawn from the economy. On the contrary, money is made to gradually increase in the system thus forming a bubble that gets bigger with each cycle till it bursts and takes down part of the system or all of it without killing the economy which keeps on going albeit in a recessionary state or a depressed one. Let me illustrate my point with a real incident that happened long ago.
I started playing the stock market in 1965, never on a full time basis, always as an amateur beginning with the Toronto Stock Exchange (TSX) which had a good reputation. I then traded on the Vancouver and the Alberta Exchanges whose reputations were not so good. With time I became suspicious of the latter two from experience as I felt that trades executed on my behalf were not entirely clean. I decided to check and see if Toronto was as clean as people said it was. It so happened that some two decades ago a company called Joutel was trading on the TSX. It has since merged with another company, changed its name and done a 1 for 6 reverse split. I bought 35,000 shares of the company before the reverse split at an average price of perhaps 20 cents and saw the price go up to about 32 cents where it continued to trade in a range around there.
One lucky day in the winter of 1993, Joutel broke out on the upside, opening higher than 30 cents and reaching close to 40 cents in a matter of hours. To do the test I had in mind, I put a stop loss on 15,000 shares at 29 cents -- below the opening price of that day. Within seconds, Joutel reversed direction and started to go down on a heavy volume. It reached 29 cents where my 15,000 shares were scooped up. The stock then abruptly reversed direction and went up again closing that day around 40 cents. A few months later it had reached a maximum of 75 cents or thereabout, always going up and down like a yo-yo. Undoubtedly some brokerage firms bet several times for and against it during that roller-coaster ride making tons of money coming and going. And the repetition of either the cycle or the bet is what you cannot do with a house that burns down or a team that loses the game.
Now, you can argue all you want it was just a coincidence that several brokerage houses discovered they had a whole bunch of Joutel shares they wanted to dump right after I placed my stop loss order but no one in his right mind will believe this argument. The most likely thing to have happened was that a number of arbitrageurs, specialists and market makers who knew each other but worked in different brokerage houses knew exactly what to do when they saw my stop loss order come in. They delayed for a split second the buy orders that were coming from the outside while they shorted and churned a few Joutel shares over and over again, spiraling the price down to 29 cents where they “legally” grabbed my 15,000 shares. This done, they let the price rise again and sold my shares, each to their respective clients making a handsome profit for their troubles. Call it silent conspiracy, outrageous conspiracy, legal conspiracy or what you want but conspiracy it is no matter what you choose to call it.
Those arbitrageurs, specialists and market makers are people who work in a building where the stock exchange is housed, or they work in buildings near it. Whether they work on the same street or on nearby streets, they are collectively called by the name of the street where the exchange stands. In New York it is Wall street; in Toronto it is Bay Street. The important thing to remember is that all of these people have one thing in common; they want to get rich not by creating real wealth which they have no skill to do but by creating the illusion of wealth in the eyes of others. It is then possible for them to monetize this illusion in the fantasy world of the street then translate the fantasy into a life of fabulous riches for themselves in the real world of the real economy. But what mechanism do they employ to do that?
In the real economy, wealth is something tangible you create using the skills you have. For example, you know how to plant a field or make a piece of furniture or construct a house. Or you have a skill of a different kind whereby you render a valuable service such as teach the young or heal the sick or cook a meal for a large number of people. In the old days, members of a clan exchanged some of the surplus products they made or the services they rendered with products made by someone else or services rendered by still another. When life became more complicated and the variety of goods and services multiplied, people used pieces of precious metal such as gold or silver to exchange for and against those goods and services. When life became still more complicated, paper money in the form of banknotes were printed and used as a medium of exchange. These banknotes are still in use today and they have an intrinsic value that is close to zero but have a higher value ascribed to them, a value that resides in the fact they are promissory notes made by the government to the holders of the notes.
And this is what makes it possible for the people who have no skill to get fabulously rich. Let us go back to the example above to see how these people can do it in practice. I used my own money to buy those Joutel penny stocks and I paid for them in cash. However, I could have bought a more expensive stock that would have been eligible for a margin trade. That is, I could have used my 7,000 dollars and borrowed 7,000 more to invest 14,000 dollars altogether. Borrowing 7,000 dollars from the broker would have prompted the broker to borrow that amount directly from the central bank or by going through a commercial bank depending on the status of the broker. This would not have added one scrap of food to the tables of the nation, one chair around a kitchen table or one shingle to the roof of the house next door. Neither would it have taught one child in school, healed one soul in hospital or cooked one meal in a restaurant. In brief, while my borrowing would not have added wealth to the nation, it would have added to the money supply which would have diluted the monetary holdings of everyone else in the nation while inflating the value of all the hard assets. And it would have done one more thing; it would have expanded my balance sheet thus giving me the opportunity to make more money if things went the way I speculated or lose more money if things went the other way.
But because I did not borrow, all that happened was that 15,000 of my shares were scooped up. They were bought legally but unethically at a low price and sold at a high price where the arbitrageurs, the specialists and the market makers -- known collectively as Bay Street -- made the profit that should have been mine, a client of one of them. Had I borrowed the money, things would have been worse, especially if I had kept on borrowing to buy more of the stock as it went up. The streeters would have waited till such time they felt that the stock had gone high enough before shorting it and spiraling the price down to half the average I paid for it. My holding now worth the amount I borrowed or less, I would have been declared insolvent if I had no other assets in my portfolio; and the broker would have given me that dreaded margin call. He would have asked for cash or failing this, he would have sold the stock and paid for my borrowings, leaving me with a balance of zero or even a negative one. Thus the difference between the stop loss feature and that of the margin buying is that in the first instance I had the opportunity to decide when to act and I set the price at which the stock was to be sold whereas in the second instance the timing to issue the margin call and the decision to set the sale price of the stock would have been left in the hands of the streeters and my broker. This is why the short-sell that guts the portfolio of those who buy on margin is worse than the short-sell that scoops up the stocks on a stop loss.
Most of the time, however, people would have more than one stock, even have assets of different classes in their portfolios which makes it easier to avoid getting a margin call when one stock goes bad. But if all the stocks on the exchange and all the asset classes are inflated at the same time in what is known as a financial bubble, the careless borrowers can neither run nor hide when the bubble is made to burst. They become sitting ducks ready to be scooped up and plucked one feather at a time or they are swallowed whole. And who does the plucking and the swallowing? The streeters do.
Here we see why it is in the interest of the Wall streeters, the Bay streeters and the streeters everywhere to have the bubbles get as large as they can, and to have them form simultaneously in all classes of the financial assets. This is the way that the streeters can turn their clients into objects in whose name money is borrowed legitimately from the central bank, and it is the way that they can use the clients as a conduit to channel the money to their own accounts where it sits for a while. When the time comes, the streeters burst the bubble and scoop up not only the money but the assets as well. And with the price of the real assets in the real world falling like a stone as a result of the mayhem that follows, money becomes king and the streeters buy themselves an empire of little kingdoms. Again, you may call this a silent conspiracy, an outrageous conspiracy, a legal conspiracy or what you want but conspiracy it is; and it is so no matter what name you choose to give it.
Except for the big crash of the nineteen twenties and the meltdown that occurred at the beginning of the twenty first century where the fault could clearly be traced to the streeters, these people were able to deflect all other criticism by blaming the crashes on someone else. The argument has always been that they did not engineer the bubbles or precipitate the crashes which may well be partially correct. But if the streeters were not fully responsible for those calamities, they were the opportunistic predators who took advantage of every circumstance that materialized outside their sphere of influence to encourage the forming of bubbles and conspire to cause the crashes through the use of the short-sell. For example, the Y2K scare and the call to build affordable housing for the poor were not of their doing but were the circumstances they took advantage of to monetize the scare, “bubblize” the call to build and make money on their backs. In essence, what these people did in each incidence is that they turned the printing presses of the central bank into their personal presses. And they did not need a basement to hide their near counterfeiting activities as they let the presses stay where they were and legally used them like subsidiaries of their firms.
The legislators and the regulators of financial institutions must find a way to make the engagement in this sort of activities impossible to happen again.