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'The Physics of Wall Street': The Most Arrogant Book in the World? Part 7


Liquidity versus credit.

Editor's note: The following column is the seventh part of an ongoing series of articles by Aaron Brown examining the claims made in The Physics of Wall Street: A Brief History of Predicting the Unpredictable, a new book by James Owen Weatherall.

Click here to read Part 1.
Click here to read Part 2.
Click here to read Part 3.
Click here to read Part 4.

Click here to read Part 5.
Click here to read Part 6.

James Weatherall's recent book, The Physics of Wall Street, is a flawed account of the engineering behind the modern financial system. This series explains why.

You already knew that our modern financial system runs on liquidity rather than credit. Recall from 2007 and 2008 the CEOs of financial institutions going on television to announce that their firms were safe. They did not say anything about the value of the firm's assets relative to its liabilities, which is what would matter in a credit-based financial system. Instead they only talked about how much cash their firm held. They knew, and everyone knew, that it was liquidity that would determine the course of events, not value. Only Weatherall missed that point, which is odd because he claims he studied the period "obsessively."

Weatherall's arrogance is revealed starkly in his account of the end of Bear Stearns. He knows that one of the precipitating events was when large quant hedge fund managers, including Jim Simons and David Shaw, pulled their business. To fit this into his pre-derivative view of finance, he has to label the hedge funds "depositors"-that is, lenders to Bear-and call this a "classic run on the bank." I'm pretty sure Weatherall knows that these hedge funds were borrowers from Bear, not depositors or lenders. That makes this the opposite of a classic run on the bank. In a credit economy, banks fail when too many depositors demand their money back. In a liquidity economy, banks fail when too many borrowers repay at once.

If Weatherall had thought for a second instead of reversing the facts to fit his story, he would have figured out the reason Bear needed its hedge fund clients. The funds deposit initial margin and prime brokerage equity so Bear does not have to rely on their credit. Bear demands more liquidity from the hedge funds than it has to post itself when it enters into similar transactions. For example, Bear might allow a fund to lever a long-short equity book 3 to 1, while it was willing to lever similar positions 10 or 20 to 1 for its own account. Or Bear Stearns might require $100 million initial margin for a position it could put on with another dealer for effectively no margin.

To simplify for clarity, suppose the $5 billion in cash Renaissance Technologies and D. E. Shaw each gave to Bear Stearns were used to support two $15 billion long-short equity books ($15 billion of long positions plus $15 billion of short positions in stocks). Then suppose Bear Stearns used that $10 billion of cash to support a $100 billion long-short equity book, $30 billion for the two hedge funds plus $70 billion for its own account. In fact, the positions of Bear Stearns and both hedge funds were much more complicated, but the principle is the same. When the hedge funds repaid their loans, Bear Stearns had to give them their $10 billion of cash collateral back, and was left with (in this oversimplified example) $70 billion of unsupported long-short equity positions. Bear could not close out its positions without liquidity, and it could not build liquidity without closing out its positions.

Or consider the fall of Lehman Brothers. Lehman had more assets on its balance sheet than liabilities, which in a credit-based system means it's solvent. There was some doubt about the value of some of its long-term assets, but that should have mattered only to its long-term creditors and equity holders. The problem, however, was that lots of assets on Lehman's balance sheet were actually owned by or pledged to someone else; and the assets Lehman expected to use for its daily transactions were often borrowed from or deposited by someone else.

None of this was illegal, secret, or unusual. This is how the modern financial system works. Lehman had a virtual balance sheet. Lehman sold its physical assets to others under repurchase agreements, often assets Lehman did not own in the first place. If Lehman sold an asset it didn't own, it simply recorded a negative position, unless physical settlement was required, in which case Lehman borrowed the asset from someone else (who might not own it) under a repurchase agreement. As prices moved every day, mark-to-market payments flowed in and out of the firm. As long as everything was liquid, this worked fine, and the value of Lehman's long-term assets was irrelevant. When liquidity dried up, Lehman was dead, regardless of the long-term value of its net assets. The modern financial system may appear to be buying and selling securities, but it's more accurate to describe it as trading promises of future cash flows.

These explanations are wildly oversimplified, of course. Also, quants are making this stuff up as we go along, there are plenty of divergent explanations for the modern derivative economy. But everyone with a brain agrees that (a) derivatives are at the heart of things and (b) the essential aspect of derivatives is not contracts that reduce risk by specifying prices in advance but the system of exchanges, clearinghouses, and standardization that replace credit risk with liquidity risk.

There is a similar story with earlier financial revolutions. People had specified prices in terms of weights of precious metals for at least 2,000 years before the Athenians perfected silver coin money. It wasn't the idea of using precious metal for exchange that was important; it was the idea of reserving an asset specifically for exchange, one designed to be indistinguishable (a silver owl is a silver owl; you don't weigh each one or test it for purity), universal (everything for sale has a price in silver owls; earlier price lists might have some prices in silver, some in barley, some in cattle), and eternal (an individual coin might become worn or lost, but the economic value represented by a silver owl endured). The world had seen plenty of mediums of exchange, stores of value and numeraires; but when all three were combined in something specifically designed to perform all three functions well; it induced an economic revolution whose repercussions are with us today.

Two thousand years after that, paper money was invented. It wasn't the idea of replacing precious metal coins with something of no intrinsic worth; people used token money as a medium of exchange long before there was precious metal money, and there are many examples in earlier history of people using paper, leather, stones, shells, or other items with only symbolic value as money. The key was development of a banking system that created credit and currency as two aspects of the same transaction. This particular feat of financial engineering touched off another burst of economic progress.

Five hundred years after that, the idea of derivative exchange was perfected. As with the earlier innovations, there were superficial links to the past. People had borrowed and lent physical goods for millennia, and had made fixed price contracts as well. It wasn't revolutionary until a complex system was built to regulate economic activity based on liquid trading of a pre-specified set of principal economic components.

Next week we'll consider why replacing credit-based money with liquidity-based money is so consequential.
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