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

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

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.  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.  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.  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.

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 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.  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:

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]
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.