Re: Prospects vs Forecasts/Was Minsky non-ergodic?

[Clifford Poirot <cpoirot@xxxxxxxxxxx>]

See my response to specifics below, but first a general point. I do not deny
(and I do not believe that Minsky ever denied-to the contrary) that there
will be periods when asset prices are believed to be supportable-for
whatever reason, when in fact, they are not.

What bothers me about Paul's form of non-ergodicity, is that I interpret him
to be saying that since we have speculation in financial markets and well
managed companies can be victims of downturns, we can make no meaningful
distinctions about valid projects. I disagree with this view (if I do in
fact understand Paul correctly).

You yourself have often argued (at least implicitly) that financial markets
are at least in the long run, driving by fundamentals, even if they depart
in the short run. Sometime ago you suggested a value for the NASDAQ of 1000,
based on long run P/E ratios and current earnings. You may yet hit the 1000
on the head, and even if you don't, that prediction now looks pretty good.

You managed to make this educated guess in spite of all the derivatives
trading that goes on. How in the world was this ever possible, since things
are so complicated these days, mere mortals such as you and I cannot
possibly hope to tell earnings from equity, or equity from debt?

-----Original Message-----
From: Henry C.K. Liu
To: Clifford Poirot; pkt@xxxxxxxxxxxxxxxx
Sent: 8/25/02 4:53 PM
Subject: Re: Prospects vs Forecasts/Was Minsky non-ergodic?

Clifford,

The point you miss is that nowadays hybrid financial instruments, which
are widely used, can be viewed as debt, principle, hedges, collateral or
anything a viewer looks for.

My response:
You can write financial contracts 10 ways to Sunday, and of course, as any
first year finance student knows, you can create contracts that have both
debt and equity features. That does not change the fact that the value of
the contract must be backed by streams of income. It may be difficult to
untangle, but it can be done. There is still an acid test: can the
corporation fulfill contracts out of current earnings or not. They either
make their payments or issue new promises to pay. If a corporation must
issue promises to pay to meet old promises to pay, then it is a Ponzi
scheme.


 So it is not a matter of being dilligent.
Structured finance departments in all investment banks operate on the
basis of whatever the client wants, the client gets.  A credit
instrument is sliced so many ways, sold to so many unidentified
parties, stripped of all unwanted properties that the system is unable
to distinguish it from traditional meanings of assets and liabilities,
or who owns or owes what.

My response:
It might help if you gave a simple short example here. In your previous post
on enron, you provided me with a very interesting and useful picture of how
Enron manipulated its books, but you did not show me how I could not
distinguish between debt and ownership, or current income vs. future income.
I showed you specifically how despite the new instruments and complicated
derivative contracts in the energy market, it was still possible to
approximate different values, distinguish current earnings from projected
earnings, and deconstruct statements to realize that the books were cooked.

 The Chairman of the SEC has officially told
congress that the difference between debt (corporate bonds) and equity
(shares) is only technical levels of risk.

My response:
In some ways this has always been true. Both debt and equity have always
given holders claims on streams of income and assets, in different ways at
varying levels of risk. I repeat, in every contract, there is a payor and
payee. If the payee does not get paid in a timely fashion, then arrangements
must be paid.

  Hedge funds routinely
manipulate markets by manipulating currency futures, interest rates and
equity prices.  When they win, the system is in trouble.  When they
lose, the system is also in trouble.

My response:
You are shifting gears here and moving from the balance sheets of
corporations to the trading of hedge funds. Again, this does not alter the
point that financial assets must be validated (at some point) by actual
income streams. You may defy the laws of gravity. You may manipulate
markets. But there have been many financial manias and attempts to
manipulate markets and they have all ended in busts with many of the market
manipulators finding out the hard way that the income streams did not
validate the asset prices. I would not dispute for a second that in the
process, the general public gets hurt as well.


Paul also made a very important point in response to your post, a point
that I have oberved in detail in analysing the Asian financial crises of
1997.  Securitization of bank loan has changed the basic function of
banks as pillors of financial conservatism to allocate credit only to
the dertserving, to that of a loan shark who passes the risk to the debt
market.  In seeking profit from "carry trade" which is a form of
arbitrage on open interest parity (borrowing hard currency at low rate
and lending soft currency at high rate, and let the central banks
defending the fixed rates eat the difference) the spread being always
small, pushes banks to increase loan volume, thus also increasing
socialized risk.

My response:
That is correct. The rise of liquidity and derivatives has increased the
level of financial fragility in the system.

  My suggestion is that you give serious consideration
to the prospect that the financial system now is fundamentally different
that a decade ago and certainly half a centruy ago.

My response:
As I said before-and as many with much better minds than mine (including
Minsky) have noted- the current financial arrangements have indeed altered
the structure of capitalism and the nature of financial arrangements matter
a great deal. That was in fact, Minsky's point. That is my point. the nature
of financial derivatives has sought to shift risk and to distort underlying
value. You can hide things with sleight of hand for a while. It still does
not change the fact: if you cannot validate a financial asset with an income
stream, it is a Ponzi scheme.

  We are now dealing
with financial viruses, not mere bacteria.  No one expected the Asian
financial crises before 1997, except Krugman who warning Citibank about
it, but based on the wrong reasons a few months before it hit in July.
He thought it was merely fixed exchange rates, while fixed exchange rate
only created the opportunity for carry trade.
It was structured finance that led to a systemic crises.
Read my article in Asia Times on derivatives:

My response:
I do not object to long articles, I merely question the effectiveness of
long detailed analyses over e-mail in a newsgroup format. There has been a
lot of work on the impact of derivatives in financial markets and how this
relates to Minsky.


http://www.atimes.com/global-econ/DE23Dj01.html
<http://www.atimes.com/global-econ/DE23Dj01.html>


Unfortunately, it is long.


Henry


Clifford Poirot wrote:


 Henry, some time ago I worked as a consultant to the International
Brotherhood of Teamster's corporate governance office. I got real good
at reading between the lines on Proxy statements and management
reports.I also offer two items from today's NYT (linked below) that show
that Banks are still important for finance, even in an age of commercial
paper.You may have trouble finding specific references to structured
finance on the Minsky website, but I think it is clear that Minsky (and
a lot of Minskyans) understood very well the direction of finance
implied by the rise of "money manager capitalism" and the potentially
destabilizing role of financial derivatives. That is in fact, precisely
the point. The rise of money manager capitalism has broken down the
ability of the loan officer to ask the difficult tough questions and
makes it more difficult to unwind a company's finances. Yes, these deals
are complex and can be hidden off balance sheets and fudged. That is why
I have argued that asymmetric information is in fact an important
concept (it shows that information is costly and difficult to obtain,
and different people have different levels of access to
information).That said, you do not have to have every single detail of
information to have a big picture of whether or not a company is a)
really able to service its current debt obligations out of current
revenue b) will need to realize x% growth in order to meet its
obligations or c) is going to have to start selling off assets to meet
obligations.I repeat my point, which you have not addressed: The basic
deals that Enron did (whether legal or not) were understandable to
anyone who a) knew how to read between the lines of a balance sheet and
a 1040 filing (aka Proxy Statement) and b) knew the differences between
revenue reporting rules in the energy business versus revenue reporting
rules at stock brokerages.It is quite simple: on the left hand side of
the ledger you have reported liabilities. On the right hand side of the
ledger you have reported assets and income flows. Reading the management
reports on the surface, a casual investor would have concluded Enron had
tons of revenue and very little debt (e.g. he or she would conclude
Enron was hedge financed in a very risky business). Suppose, for the
sake of argument, this report was true and accurate representation of
Enron's finances. That investor would still face substantial uncertainty
about energy price and contract price fluctuations as well as
uncertainty about future economic conditions. The investor would
therefore want a risk premium to buy the stock.Now, let's deal with the
real Enron balance sheet. Read the footntotes to the effect of : Enron
has engaged in several strategic partnerships with X, Y and Z. Enron has
relationships of the following sort. Now find the financial statements
of X, Y and Z and you notice that Enron's strategic partners have a debt
liability structure very, very different from Enron. You don't have to
be a weatherman to know which way the wind is blowing.Now, look at
Enron's reported earnings. Compare these earnings for similar values of
contracts to values of contracts reported in other industries. You still
do not have full information about Enron, but now you know that Enron's
reported balance sheet is cooked. You can know that its earnings are
inflated and its debt underreported. This isn't a big mystery.I am sorry
you do not like my examples to Paul. Home mortagages and small business
lines of credit are believe it or not, incredibly important to the U.S.
economy. The level of risk and exposure in this market has a lot to do
with the level of monitoring that does nor does not take place, as well
as the exposure of many large lenders in the subprime market.I do not
think I can make myself more clear: the rise in financial
disintermediation, the increased securitization of the home mortgage
market, and the incredible expansion of credit into subprime markets
have left the system increasingly vulnerable to financial shocks and
increased the level of financial fragility. The rise of structured
finance has led to increased levels of speculative and Ponzi finance,
thus making financial markets more fragile.

-----Original Message-----
From: Henry C.K. Liu [ mailto:hliu@xxxxxxxxxxxxxx
<mailto:hliu@xxxxxxxxxxxxxx> ]
Sent: Saturday, August 24, 2002 9:15 PM
To: Clifford Poirot; pkt@xxxxxxxxxxxxxxxx
Subject: Re: Prospects vs Forecasts/Was Minsky non-ergodic?

The three examples of  loans you gave have as much to do as with
corporate finance and debt securitzation as they are practised today as
discussing the principles of bike riding to illustrate combat tactics in
supersonic fighters.  Banks hardly dominated the debt market these days.
They have been reduced to the role of back up reditors. GE looks to its
bank credit line oly when it faced difficulties in the commercial paper
market which it mominates, due to a down grade of its dredit rating.
When GE sells commercial paper at near Fed funds rates, it is not
obligated to tell investors what it intends to do with the money.  The
credit is unsecured by any direct collateral. Corporate bond debt
involves covenants and triggers that are highly complex.  Convertible
bonds allow the investor to convert its loan into equity under certain
trigger situations of technical default such as if share prices fall
below a certain level, even if debt service has been kept current.

To anyone who is familar with debt securitization, your post and the
arguments in it appear childish.  I suggest that if you are interested
in credit economics, you familiar yourself with the facts before you
settle on any theory.  Using common sense and school book examples will
not lead you anywhere.


Henry C,K, Liu


Clifford Poirot wrote:




Paul Davidson asserts:
Henry is correct on this Clff.

Minsky's writings (which you quote) require that the agent engaging in
"> "Hedge financing units are those which can fulfill all of their
current
> contractual payment obligations by their cash flows: the greater the
weight
> of equity financing in the liability structure, the greater the
likelihood
> that the unit is a hedge financing unit. Speculative finance units are
units
> that can meet their payment committments on "income account" on their
> liabilities, even as they cannot repay the principle out of income
cash
> flows"


requires that the financing unit "knows" its future cash flows --and in
a nonergodic world this can be done only if one has engaged in forward
contracting to cover all future cash inflows and outflows (assuming no
one defaults on a cash inflow contract).  As long as some inflows depend
on future sales that are not already contracted for, any hedge or
speculative finance can become Ponzi finance.


Paul
[Clifford Poirot] It is because of uncertainty about future cash flows
that current hedge units can become Ponzi units (as Minsky himself
noted). As Minsky noted, the ability to project these cash flows is
dependent on the maintence of aggregate demand (and I would add of other
factors as well such as consumer preferences, technological change,
etc.) which are unpredictable.To argue that a current hedge position can
become a Ponzi position does not mean you cannot make intelligent
decisions today about whether a proposal is a hedge, speculative or
Ponzi proposal. That we cannot form reliable probability distributions
into the future is why loan officers must resort to rules of thumb.Here
is a simple example. A loan officer faces three prospects for a small
business loan:Prospect  1: An applicant requests a loan to buy a
business, that is fully backed by the existing assets of the business.
The income generated by the business for the last five years will cover
the principal and interest payments. The applicant is also willing to
pledge his home equity. This is clearly hedge finance. Anyone can tell,
that this business is not guaranteed success, but it generates a current
cash flow sufficient to meet all obligations.Prospect 2: An applicant
requests a loan to start a new business. In order to meet the principal
and interest payments, the business will have to generate a steady
increase in sales volumes beyond first year projections. It will require
balloon financing. this is speculative financing.Prosect 3: Prospect 3:
the applicant requests a loan for a business in order to pay off
existing debt that the business is unable to pay out of current sales.
In order to meet future interest and liability payments, the business
will have to sell existing assets.Of course, 1 can become 3. But at the
present time, they are in different situations and they can be evaluated
differently. Now, let's suppose the loan officer decides that he can
securitize and sell all three loans and thus makes all three, the level
of instability in the system will increase. That is why the increase in
endogenous money creation and increasingly liquid characteristics have
led to increasing levels of financial fragility.