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Speculation, Scams, Frauds and Crises: Theory and Facts

A systemic crisis in finance results from speculation under deregulation of the financial markets with an unrestrained use of derivatives therein. By making possible the free entry and exit of players in the market, financial liberalisation encourages shorttermism, which fails to generate real assets in the long run.

COMMENTARYEconomic & Political Weekly EPW march 21, 2009 vol xliv no 1215Speculation, Scams, Frauds and Crises: Theory and FactsSunanda SenIt is common knowledge that the possi-bility of moving funds can add to the incentives for speculation in the finan-cial market. Deregulation of the financial sector also makes for financial innovations as it is geared to handle the uncertain prospects relating to asset-prices and their returns. Instruments as are innovated in the process include financial derivatives like futures, options and swaps, which are all contracted on the basis of what has been described as the “underlying”, com-prising securities, currency, commodities or even real estate. Agents who operate in the financial markets face tasks, which require differ-ent kinds of professional skills and exper-tise. One witnesses, as a consequence, the emergence of what can be described as a division of responsibilities, between those who manage, mobilise and deploy resources at their respective financial businesses, and those who undertake what can be described as “risk manage-ment” in the face of uncertainty. The lat-ter, by definition, entails financial engi-neering, aiming to sustain and maximise net returns on these financial assets in un-certain times. Strategies as above, entail a balancing of risks by returns, which may not always be successful. It is worth mentioning here that with a major part of financial flows geared to funding uncertain activities – including those on hedge funds – returns on finance today can only be sustained by volatility in finance itself. This is evident in the calculations of the call/put premiums in the stock market, which often rely on the much celebrated formulations of Black, Scholes and Merton in the standard models of stock markets. The formula indicates that those premiums move up only when stock prices are subject to a wider range ofvariance (Black and Scholes 1973; Merton 1973).Dwelling a bit on derivatives in financial markets, popularly known as hedging, the use of these financial instruments is com-mon under uncertainty. Hedging includes ranges of derivative instruments (for-wards, futures, options, swaps, etc) gener-ating windfall gains/losses in volatile markets. While reliance on these instru-ments adds to the transaction cost of each financial deal, the capital gains/losses on these transactions, in terms of stand-ard conventions in national accounts, are treated as transfers, which are not entered into national output calculations. The multiplicity of financial investments in derivatives, while originating from the same base in terms of specific real acti-vities (or “underlying”), do not expand the base itself. Instead, these amount to a piling up of claims which are linked to the same set of real assets. Finance in its upswing thus becomes increasingly remote from the real economy; while financial in-novations proliferate in the economy, to hedge and insulate financial assets in the presence of uncertainty.To understand fully the implications of financial market activities for the real economy, we need to distinguish between the new and old stocks as are transacted in the market. The two can have impacts on the real economy that are very differ-ent from each other. This is because while new stocks sold in the primary market generate demand for real investments, the same stocks, when resold in the secondary market do not necessarily contribute to new investments even when these trans-actions generate buoyancy by pushing up the prices of stocks. Thus, rising profits (capital gains) on old stocks of a firm, as has been empirically observed, do not nec-essarily signify increased demand and higher prices for the new stocks launched by the same firm. This challenges the argument that a positive change in the Tobinesque1 ‘q’ in the event of an upswing will also raise the demand for new stocks. As can be witnessed, contrary to what is postulated in the rational expectations approach underlying mainstream theory, capital markets have failed to serve as an informational/signalling agent in the real economy (Shackle 1974). It is but natural that the capital (financial) market does not necessarily contribute to efficiency in the financial sector or growth in the real economy. Incidentally, it can be pointed A systemic crisis in finance results from speculation under deregulation of the financial markets with an unrestrained use of derivatives therein. By making possible the free entry and exit of players in the market, financial liberalisation encourages short-termism, which fails to generate real assets in the long run. Sunanda Sen (sunanda_sen@vsnl.com) is with the Academy of Third World Studies, Jamia Millia Islamia, New Delhi.
COMMENTARYmarch 21, 2009 vol xliv no 12 EPW Economic & Political Weekly16out in the above context that uncertainty (and knowledge) are subjective and hence “non-ergodic”. Uncertainty is thus not a natural phenomenon which is time invari-ant. Accordingly it is ontological and is embedded in social reality which, as de-scribed by Shackle, is “kaleidoscopic” and relates to what Joan Robinson called “his-toric time” (Pressman 1996). Aspects as these make it rather tenuous that specula-tion in financial markets would necessari-ly work in sustaining profits, as is evident with what has been happening in the glo-bal economy at the moment. The impact of changes in the financial sector on the real economy, however, sharply differs when it shrinks. Initiating a narrowing of the real economy, the im-pact of these financial sector disruptions is much more pervasive. The underlying asymmetry can be explained by the “dual exposures” which the real economy bears to the financial sector: First, with financial assets as are held by the real sector, a drop in their prices has a second round impact (wealth effect) via a related drop in real demand in the economy. Second, at a micro-level, such reductions in the prices of financial assets mean a proportionate decline in the net asset value for financial institutions. Both of these relate to the exposures of the real economy to the financial, an evidence of which relates to the ongoing spate of output contractions and job losses in different parts of the world, much of which have their origin in the recent financial crisis.With the prevalence of high stakes in financial markets which are subject to un-certainty, risks often turn out to be dispro-portionately high as compared to their re-alised returns. Transactions under the above situations have been identified in the literature as “Ponzi” deals, which, as characterised by the post-Keynesian econ-omist Hyman Minsky in 1986, are both unsustainable and hazardous as compared to acts of simple hedging (or even specula-tion) on asset prices. With Ponzi finance the high returns offered by borrowers to entice new lending often fail to be realised by them when actual investments in the market yield lower returns. To avoid an impending default and an interruption of business, borrowers find it necessary to further continue with new borrowings and investments in order to compensate for the losses incurred on earlier invest-ments. However, as confidence on financial assets on the basis of these transactions tends to erode, such dealings come to a grinding halt, leading to big holes in the balance sheets of the concerned parties. Ponzi deals, however, are very different from hedge finance which to some extent keeps the business going (as long as hedg-ing offsets the losses with possible gains). Even speculatory finance, which takes on more risks than those under hedging, can be sustained until it becomes a Ponzi, with borrowings at high rates no longer gener-ating compensating returns (Davidson 1988) a situation which today plagues the global financial markets.Crises, Scams and FraudsThe analysis outlined above helps to ex-plain the successive crises in the global financial markets as have currently come out into the open. These include the col-lapse of the sub-prime loan market in the United States and its repercussions, the re-cent Madoff scam, and the fraud in Krishna Raj Memorial Scholarships 2008-09The third annual Krishna Raj Memorial Scholarships instituted in memory of the weekly’s distinguished editor of 35 years have been awarded.The Sameeksha Trust has established three sets of scholarships at different levels of education – at a school, undergraduate college and postgraduate institution. The scholarships have been designed for award in either the educational institutions Krishna Raj attended or in the city (Mumbai) where he spent all his professional life.NSSKPT High School, Ottappalam, KeralaFour scholarships, for two girls and two boys have been awarded in the school where Krishna Raj studied for a few years. The scholarships cover tuition fees, uniforms, books and special coaching. In 2008-09, the scholarships have been awarded to Vishnu C K and Bhageeshma K D (VIIIth standard) and Sarika P A, Sreejith P S (Xth standard). SNDT College for Women, MumbaiTwo scholarships have been awarded to adivasi students in the social sciences stream of the BA course. The scholarship cover tuition and examination fees and boarding and lodging expenses in the college hostel. In 2008-09 the scholarships have been awarded to Ruke Veena Vijayanand (Second Year BA Geography) and Sneha Ramesh Yadav (Third Year BA Economics).Delhi School of EconomicsThe aim of the Krishna Raj Summer/Internship Programme is to enable university students to participate in field surveys and related activities around issues that have social relevance.Four teams of 25 university students led by the faculty of the Delhi School of Economics conducted a field survey in December 2008 in collaboration with the Ministry of Rural Development, in Allahabad (UP) and Ranchi (Jharkhand) districts on bank payments of NREGA wages reaching the workers in various panchayats.Satyam. All those indicate, in our view, unsuccessful hedging and speculation in deregulated financial markets as happens in a Ponzi scheme. Successive disruptions in the function-ing of financial markets, as in recent times, indicate the extent of inadequacy in these risk-management strategies. These failures led to the crisis in the housing markets of the US, which by mid-2007, ended up in a turmoil engulfing almost the entire global market, both financial and real; and push-ing a large number of countries into a deep recession. Financial markets have shrunk further over 2008 and asset prices have plunged to levels as have never been wit-nessed before. In the US, the NASDAQ index fell from 2,800 on 1 December 2007 to less than 1,300 in November 2008. Similar de-clines in stock prices could also be observed in other parts of the world economy, en-compassing not just the advanced coun-tries but also the developing economies. A large number of financial institutions in those countries have faced liquidation or are close to it. The repercussions in the real sector include drop in output and
COMMENTARYEconomic & Political Weekly EPW march 21, 2009 vol xliv no 1217closures of industrial units along with massive cuts in jobs all over the world. Securitisation of AssetsThe limits to financial business by using leveraged finance with the help of deriva-tives are amply demonstrated in the tur-moils of financial markets today. The use of asset-based securities (ABS) along with other derivatives like credit default swaps (CDS), collaterised debt obligations (CDOs) and the structured investment vehicles (SIVs) were prominent in the US sub-prime loan market, which has already collapsed. Financial innovations using these devices provide alternate channels of credit and insurance cover with augmented levera-ges, which are outside the usual banking orbits. A large part of these deals also re-main off-balance sheet and are traded over the counter (OTC).As the process continued, large numbers of people with low incomes were then en-dowed with mortgaged property and a lia-bility to pay monthly instalments, usually to the broker-mortgager-cum-bank which organised the deal. These assets were backed by loans which later were discov-ered as “sub-prime”, with mortgaged col-laterals subject to valuation in a sliding market, loans at interest rates higher than the ruling rate in the market, and with poor accountability of the borrowers, many of whom were not bankable in terms of the conventional practices fol-lowed earlier. The euphoria, fed initially by the rising property prices on the one hand and the eagerness on part of the financial community to profit (by using the securitisation route) on the other, did work as long as it lasted. All this business, led by investment banks, was outside the purview of the US Federal Reserve. These sub-prime loans, which prompted the up-swing in the asset market of the US eventu-ally failed to work as property prices start-ed falling in an inflation-rigged economy.The crisis in theUS sub-prime loan mar-ket did not stay within the confines of the same market. As can be expected, the various counterparties linked to the new fangled derivative devices (involvingABS, CDO, CDS) along with the high leverages pulled down a large number of financial houses in the US, and in other parts of the world. It did not take much time for real sector transactions to face contractionary impacts, both with the drop in asset prices and the reduced demand for output. The sharp drop in production and job losses in different parts of the world bear a vivid testimony to such an impact.The crisis in the sub-prime loan market has its close analogue in other transac-tions involving the creation of financial assets. These included the securitisation of loans on credit cards, housing and car loans, etc. Assets as above were sought to be insured byCDS while their repackaging generated opportunities of resale and fur-ther leveraging by those who held them. In the meantime, the financial market had its own pace of expansions, contractions and volatility, none of which can be con-trolled by the monetary authorities.To add to the woes, of late we have wit-nessed disruptions in financial markets and institutions which are of a different genre. These include the $50 bn deceit re-ported for Bernard L Madoff Securities, one of the best known financial houses in US, and then the Stamford scandal. There may be more such irregularities and for-geries which have not yet come to light. These are slightly different but equally malicious aspects of the financial markets as have been much in news today. These have further shaken the financial markets which had already been in a state of shock since the beginning of the third quarter of 2008. Those hard hit included similar oth-er hedge funds. In the US alone, a combi-nation of performance loss and redemp-tions, according to unofficial estimates, pushed down hedge fund assets by $500 mn during 2008 (“Money Flows Out of Hedge Funds at Record Rate” Financial Times, 30 December 2008).Generalising the patterns of scam and forgery as have become common in corpo-rate governance, attention has been drawn in the literature to the notion of “control fraud”, by the chief executive officer (CEO) or other corporate authority who can ope-rate as “super-predators of the financial world”. These involve an elite-orchestrated “looting of the firm” such that “...a single large control fraud can cause greater finan-cial losses than all other forms of property crime combined”. Also “...frauds, by definition, are hidden and elite frauds, e g, the CEO that loots a firm by using abusive accounting to create fictional profits that make his stock options valuable, may never be discovered” (Black 2005). It has been claimed that despite a formal facade of cor-porate governance, these chiefs or the CEOs enjoy at least four important privileges. These include the ability to “suborn inter-nal and external controls and pervert them into allies, (e g) unique ability to ‘shop’ for an auditor that will aid their looting...” They can also “optimise(s) the company by having it invest primarily in assets that have no readily ascertainable market value”. Third, “CEOs have the unique ability to convert company assets into personal funds through seemingly legitimate cor-porate mechanisms. Accounting fraud is the key to this conversion. Fourth, the CEO has the unique ability to influence the external environment to aid fraud.”2 It has also been pointed out, the above tendencies are often facilitated by standard neoclas-sical theories of law and economics which often advocate “...policies that optimise a criminogenic environment to control fraud” (ibid).What Can Be the Way Out?Dwelling on the policy implications, we go back to the central argument of this arti-cle: the systemic crisis in finance results from speculation under deregulation of the financial markets with an unrestrained use of derivatives therein. By making pos-sible the free entry and exit of players in the market, financial liberalisation en-courages short-termism, which fails to generate real assets in the long run. Loop-holes as exist in the high-risk high-profit strategies follow under uncertainty; espe-cially when resort is made to Ponzi finance with the costs of borrowing exceeding the returns on investments. We have also drawn attention to the rising turnover in stock markets which to a large extent are made possible by derivatives (e g, futures or options) since cash needed for transac-tions can only be a margin (percentage of the latter) deposited with the exchanges. There also exists, under deregulated fi-nance, the possibility of securitising all as-sets (ABSs), generating what can be de-scribed as a pyramid of counterparties with successive transfers of risks along the multipleABSs. However these operations, backed by credit default swaps (CDSs) and
COMMENTARYEconomic & Political Weekly EPW march 21, 2009 vol xliv no 1219A Different Route to Justice: The Lalit Mehta Murder CaseFrom a correspondent“We know the killers of Lalit Mehta and they will be brought to justice. We will make the perpetrators of heinous crimes such as mur-der pay with their lives. We have started the process for this and it will soon culminate in strong and decisive action.” – from a pamphlet issued by the Commu-nist Party of India (Maoist) in Palamau, Jharkhand on 22 June 2008 (reported in Frontline magazine, July 2008). Lalit Mehta was a young civil engineer who devoted his life to transform the lives of people in one of the most backward areas of this country. This region of Jharkhand has been afflicted by hunger deaths, lack of basic healthcare and other such debilitating miseries that could have been resolved by the Indian state if only the rulers cared. The illusion of a “shining India” dissolves into a black hole if one visits Palamau – 60 years of independence with no development in sight. Lalit stepped in where the Indian state had failed – he worked tirelessly to build several hundreds of small irrigation projects at half the cost it would take for any governmental agency, thereby earn-ing the wrath of the local contractor lobby. He taught people to be vigilant about mis-use of public funds by educating them about their rights vis-à-vis the State, espe-cially on issues related to the right to food, thereby angering the officials and leaders who have earned crores from siphoning off foodgrains meant for the public distri-bution system. Most importantly, Lalit and his cousin Jawahar were pioneers in social audit, long before this democratic right had become the buzzword for the advo-cates of civil society and governance. The social audit they had conducted brought several instances of state failure vis-à-vis the right to food (eg, issue of hunger deaths, discrepancies in the BPL process, etc) in Manatu and Chattarpur blocs, Palamau into national focus. Predictably, when the United Progressive Alliance government launched its much touted flagship programme, the National Rural Employment Guarantee Act (NREGA), it was again Lalit and his associates who led the way and performed one derivatives in parity with spot transactions. These measures need to be reversed with active official steps as are needed.Measures as above may dampen the in-centives to move away from real sector in-vestments to the financial which used to be more profitable. However, the demand and profitability of real sector investments would only expand with direct fiscal ex-pansions to revamp this sector. Inciden-tally, monetary measures to instil liquidity in the system (as was done inUS under the Bush administration and already prac-tised in India by the RBI) would not work for credit expansion unless the economy expands and generates adequate demand for credit. This demands a shift in priori-ties with fiscal expansion and real sector growth taking precedence over monetary measures to instil credit.Curbs on speculatory finance and an aggressive expansionary fiscal policy are the answers to what has gone wrong in the world today. Notes1 Tobin’s q is the ratio of the market value of a firm’s assets (as measured by the market value of its out-standing stock and debt) to the replacement cost of the firm’s assets (Tobin 1969).2 “Thus, Enron boasted of creating the ‘regulatory black hole’ that left energy derivatives unregu-lated. Enron exploited this systems capacity limitation to form a cartel and produce the California energy crisis by taking production plants off line. During the S&L debacle the most audacious control frauds used their political contributions to fend off the regulators by influ-encing key members of the Reagan/Bush admin-istration and Congress CEOs use the company’s assets to burnish its apparent legitimacy by making charitable contributions. The political and charitable contributions also enhance the CEO’s status and reputation.” See Black (mimeo), op cit.3 This view is based on the notion that uncertainty and knowledge are both “gradable”. Thus “...if uncertainty is gradable, government action may reduce it and thereby increase confidence” (Dequech 1997).ReferencesBlack, Fischer and Myron Scholes (1973): “The Pric-ing of Options and Liabilities”, Journal of Politi-cal Economy, Vol 81, No 3, pp 637-54. Black, William K (2005): “When Fragile becomes Friable – Evidence Contro; Fraud as Cause of Eco-nomic Stagnation and Collapse” (mimeo). – (2005): The Best Way to Rob a Bank Is to Own One (Austin: Texas). Davidson, Paul (1988): “A Technical Definition of Uncertainty in the Long-run Non-Neutrality of Money”,Cambridge Journal of Economics, September. – (1991): “Is Probability Theory Relevant for Uncer-tainty? A Post-Keynesian Perspective”,Journal of Economic Perspectives, Vol 5, No 2, pp 129-43.Dequech, David (1997): “Different Views on Un-certainty and Some Policy Implications” in Paul Davidson and Ja Kregel (ed.),Improving the Global Economy (London: Edward Elgar). Financial Times (2008): “Crackdown on Hedge Funds after Madoff Affair”, 29 December.– (2008): “Money Flows Out of Hedge Funds at Record Rate”, 30 December.Martens, Paul (2008): “A Two Trillion Dollar Black-hole”, Counter Punch, 13 November.Merton, Robert C (1973): “Theory of Rational Option Pricing”,Bell Journal of Economics and Manage-ment Services, Vol 4, No 1, pp 141-83.Minsky, Hyman P (1986): Stabilizing an Unstable Economy (New Haven: Yale University Press).Pressman, Steven (1996): “What Do Capital Markets Do? And What Should We Do About Capital Markets?”, Economie et Societé, Serie M P No 10 2-3, pp 193-209.Shackle, G L S (1974): Keynesian Kaleidics: The Evolu-tion of General Political Economy, Edinburgh University Press.Tobin, J (1969) “A General Equilibrium Approach to Monetary Theory”,Journal of Money Credit and Banking, Vol 1, No 1, pp 15-29.By refusing to investigate and prosecute the alleged killers of Lalit Mehta, the agencies of Jharkhand state had abdicated their duties in delivering justice. The Maoists lived up to their promise of taking on the alleged murderers and administered justice of a different kind by killing some of them. The incidents following Mehta’s death show up the inadequacy and failure of the Indian state as an agency that guarantees justice.

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