Financial Stability E-Book

Frederick L. Feldkamp

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Editions
• Sprache: Englisch

Seitenzahl: 438

Veröffentlichungsjahr: 2014

Beschreibung

Applying the Lessons of History to Understanding Fraud Today and Tomorrow Financial Stability provides a roadmap by which the world can anticipate and avoid future financial disruptions. This unique discussion of past and present financial events offers new insights that explain economic, political, and legal antecedents of financial crises in Western markets. With a detailed discussion of the history of finance, this book shows modern investors and finance professionals how to learn from past successes and failures to gauge future market threats. Readers will gain new insight into the antecedents of todays financial markets and the political economy that surrounds them. Armed with this knowledge, they will be able to craft a strategy that steers away from financial disorder and toward maximum stability. Coverage includes discussion of capital, forecasting, and political reaction, and past, present, and future applications within all realms of business. The companion website offers additional data and research, providing a complete resource for those seeking a better understanding of the risk at hand. As the world struggles to emerge from the latest financial crisis, professionals in finance, the law and other disciplines, and the people they advise, are searching for understanding to avoid future crises. Financial Stability argues that the best lessons are learned from our own mistakes, and that the ability to look ahead depends upon our willingness to look back. Readers will: * Review the historical laws, practices, and outcomes that shaped the modern day financial markets of the great western economies * Understand the theory of financial stability, the roles of law and transparency, and the importance of action to punish fraud in order to prevent future contagion * Work through the theoretical proofs in terms of math, law, accounting, economics, philosophy, and international trade * Build a strategy for the future with consideration toward needs, sources, balance, and learning from past mistakes Everywhere around the globe, at all points in history, financial crises have always been rooted in the confluence of politics, finance, and law. Financial Stability puts the latest global financial crisis in perspective, highlighting the lessons we have already learned, and those we need to internalize today.

Leseprobe

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Financial Stability

Fraud, Confidence, and the Wealth of Nations

FREDERICK L. FELDKAMP R. CHRISTOPHER WHALEN

Cover image: © iStock.com/mgkaya Cover design: Wiley

Copyright © 2014 by Frederick L. Feldkamp and R. Christopher Whalen. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Feldkamp, Frederick L.     Financial stability : fraud, confidence and the wealth of nations / Frederick L. Feldkamp and R. Christopher Whalen.     1 online resource. — (Wiley finance series)     Includes index.     Description based on print version record and CIP data provided by publisher; resource not viewed.     ISBN 978-1-118-93581-1 (epdf) — ISBN 978-1-118-93580-4 (epub) — ISBN 978-1-118-93579-8 (hardback) 1. Financial crises—History. 2. Economic security—History. 3. Fiscal policy—History. 4. Finance—History. I. Whalen, R. Christopher, 1959– II. Title.     HB3722     338.5′42—dc23

2014027073             

To Judy

For ever-enduring my folly

—Fred Feldkamp

To Nicole

For making me smile again

—Chris Whalen

*Chinese characters for “crisis”.

List of Tables

Chapter 9

TABLE 9.1

Appendix Six Legal Isolation Requirements

TABLE A.1

List of Illustrations

Chapter 9

FIGURE 9.1

Mortgage Spreads and Market Events, 1963–2013

FIGURE 9.2

Crises and Recoveries, 1987–2012

CHART 9.1

Corporate Bond Risk Premiums, 2007–2014

CHART 9.2

High Yield Risk Premiums, 2007–2014

CHART 9.3

Investment Grade Risk Premiums, 2007–2014

Guide

Cover

Table of Contents

Preface

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Preface

As He died to make men holy, let us live to make men free, While God is marching on.

“Battle Hymn of the Republic”

Julia Ward Howe

Christ was crucified in the same city where, in Jewish, Christian, and Islamic tradition, God stopped Abraham from sacrificing his son, Isaac. Christianity holds that God allowed Jesus to be crucified as the grant of universal forgiveness to mankind. The stage for that act of sacrifice was set by Christ’s declaration that freedom would overpower both a brutal Roman dictatorship and the economic fraud of a high priest that violated many laws of his own faith. In death Christ made us holy, and, in resurrection, showed the path to freedom, forgiving even His murderers.

Today, technology allows precise calculation of the greater value of freedom over dictatorship and fraud. We are certainly not holy; by combining the ancient laws of Moses and mathematics with modern data (see Charts 9.1, 9.2, and 9.3 and Chapter 9), however, this book shows:

In the crisis of 2007–2009, a modern day worldwide money changers’ fraud caused investors to lose $67 trillion ($30 trillion in the United States alone).

By 2013, the 2009–2012 recovery of free markets was rebuilding wealth at $34 trillion per year ($17 trillion in the United States).

With the United States as the guarantor of freedom following World War II, Germany has chosen almost 70 years of peace and prosperity over the powers of a king and a dictator that led it to pursue the two most widespread wars in history. Germany stood with the United States early in 2014 to challenge a Russian menace over Ukraine. Measured by similar principles, the cost to Russia of Vladimir Putin’s pursuit of new dominion in Ukraine was a more than 50 percent devaluation of Russian wealth.

Using rates for 10-year bonds as the metric, the value of each dollar of U.S. cash flow (over 30 years) is now more than twice that of Russian cash flow. Because it can rely on U.S. production for assistance in defense (as Russia did when Germany attacked it in World War II), the value to Germany of its cash flows is now 2.4 times that of Russia’s. That’s the merit of living “to make men free” versus today’s cost of aggression.

Experience is knowledge gained through our blunders; wisdom is knowledge gained by understanding others’ blunders. The United States is the world’s oldest democratic republic, but also is still a very young nation. We blundered along for nearly 175 years before our Constitution and courts finally granted universal suffrage: one person, one vote. Americans are still trying to understand how free markets operate. We will try not to bore readers as we describe our experiences and repeat the wisdom of others that developed today’s U.S. financial markets, the world’s best. Few subjects, however, are more likely to induce boredom than the details of finance.

Fraud was defined in the laws of Moses. It was only in response to the 1929 market crash, however, that the United States finally ended some of the off-balance sheet liability frauds of the Gilded Age and the robber barons. Before the United States enacted revolutionary banking and securities laws in 1933 and 1934, speculators used parent company–only financial statements to hide fraudulent schemes under pyramids of subsidiaries and trusts. Mandatory accounting consolidation ended many such practices, but it did not stop the frauds that hid the manipulations and speculations that burst into new financial crises decades later.

This book describes some of the many blunders that are now part of the U.S. financial market experience. The financial crisis of 2007–2009 proved, for example, why we must end the use of all off-balance sheet liabilities. In this book we’ll explain why that is and how to do financial transactions properly. Investors now know that by the time the subprime crisis had exploded, gigantic bubbles of unreported liability had grown, over the course of several decades, to $67 trillion worldwide and $30 trillion in the United States alone. In 2007, that accumulated megabubble burst upon an unsuspecting world. That $67 trillion of unreported claims against shareholder equity nearly destroyed all the wealth created since Moses. Some people still wonder how that hidden fraud triggered a massive flight to quality in 2008. It was a bubble hidden in fraudulent off-balance sheet transactions and made viral by accumulated megablunders.

The last time a similar financial crisis occurred, Franklin Roosevelt said: “The only thing we have to fear is fear itself.” Because of technology and the disclosure requirements that have been in existence since 2005, the United States now precisely measures the level of U.S. corporate bond investors’ fear on a daily basis. Daily disclosure of corporate bond spreads allows leaders to know whether investors deem their daily decisions to be wisdom that will attract new money or blunders that will drive investors away. Before they sit down to dinner, leaders in the United States can now know the actual benefit or cost of their actions with respect to the free market.

The Enron debacle caused the United States to perfect the measures of fear that are contained in bond spreads. These measures are not available at a similar level of precision anywhere else. Except for Ben Bernanke and a few others, however, U.S. leaders largely ignored the new indicators until September 2008. By then the bubble of fraud had burst. It was too late to fine-tune a response. So the United States and its allies were compelled to employ an age-old process: nationalization cum monetization. That expedient saved the financial world by creating a temporary bridge of disclosed liquidity to aid us as we try to convert the experience of our 1998–2008 blunders into wisdom for the future.

Whether other nations elect the path of wisdom over the harder path of experience is up to them. On March 3, 2014, available measures of investor fear warned Vladimir Putin that it was a blunder for Russia to intervene in the free-market development of Ukraine, just as Adam Smith warned King George III that it would be better to trade amicably with Britain’s American colonies than to try to dominate them.

To its initial credit, Russia seemed to show wisdom. It backed away from overt threats, but the choice of learning by the experience of repeating its blunders still seems to guide Russia. During the period of perestroika, Mikhail Gorbachev lamented the servile patience of many Russians. Far too many people, there and elsewhere, seem willing to wait, perhaps forever, for personal and economic freedom. While Jesus lived, Hillel the Elder is credited with saying: “If not us, who, and if not now, when?” We hope wisdom, and the peace and prosperity it offers, will prevail in the world and believe now is as good a time as any to cultivate it. When peace wins, as George Marshall showed Russia after World War II, it can redeem all its current losses. We submit that financial stability is vital to that success.

This book began as a way to thank Robert M. Fisher, a lawyer and economist at the SEC who, 11 years ago, listened patiently for five hours as Fred Feldkamp explained a process some clients had perfected to generate stand-alone financial transactions that create risk-free arbitrages for financial assets, such as home mortgages and automotive loans. Done correctly, that private sector innovation, collateralized mortgage obligations (or CMOs), was the process by which the United States finally brought equilibrium to bond markets. Created in 1983 for residential mortgage markets, and spreading to other financial asset markets in 1993, the CMO expanded sources of finance and economic opportunities in an economy that for decades had been dominated by strictly controlled commercial banks. Similar processes to create financial arbitrage were used by central banks to bring financial markets out of crises in 2009–2013. In the hands of private-sector investors, riskless financial arbitrage is the foundation on which investors can sustain financial stability and economic prosperity around the world.

After listening for all those hours, Mr. Fisher looked at Fred and said, “You’ve just described the solution for financial stability, the last unsolved problem of macroeconomics.”

About two years after that meeting, the SEC insisted that pricing, size, and other details of all U.S. corporate bond trades be immediately reported via the TRACE (Trade Reporting and Compliance Engine) system. Soon thereafter, a self-regulatory group called the Financial Industry Regulatory Authority, or FINRA, used that data to begin publishing daily real-time yield indices that allow all investors to see each day’s movements in credit spreads, information bankers regularly and carefully hid from competitors in the past.

Credit spreads measure the difference in yield between corporate bonds of different grades. They reflect the precise fear response of investors to daily changes in (1) U.S. market policy and (2) all other events with market implications for investors in corporate bonds. Charts 9.1, 9.2, and 9.3 in Chapter 9 show how credit spreads moved up and down in U.S. markets between 2007 and the writing of this book. Table 9.1 translates that data to reveal the macroeconomic impact of changes in credit spreads.

This book thanks Mr. Fisher for the countless hours of fun—and profit—Fred has enjoyed using credit spread data to anticipate market events and to commend or criticize policy actions since retiring in 2006 from his active law firm partnership.

By noting U.S. bond investors’ actual cash trading patterns in response to events each day, and by aggregating that data in a few simple charts, politicians and regulators were able to accurately observe investors’ reactions to each step leading to the worldwide financial collapse of 2007–2009. When the dust settled, they were likewise able to track the success and failure of each step to reform U.S. markets and to observe the rise and fall of credit spreads during each of several lesser crises that have affected worldwide investors since 2009.

Each business day, this bond data is published about 90 minutes after the closing bell rings at the New York Stock Exchange. Each evening after the market close, therefore, everyone who is interested in the reaction of the bond market to what transpired that day can learn whether U.S. leaders succeeded or failed. The data allows for instant course corrections, or celebrations, as applicable.

For the first time in the history of finance, everyone has real-time data, generated by actual cash trades, to understand whether policy actions impress or disgust millions of bond investors who vote with trillions of dollars every single day in response to the actions of world leaders. This data provides the facts needed to replace political rhetoric with knowledge, whether acquired by wisdom or blunder.

Everyone can and should vote at elections. Between those events, however, every economist worth hearing or reading understands, generally speaking, that it is only investors’ votes that determine the success or failure of leaders’ actions. Market indicators like the Dow Jones Industrial Average, the Federal funds rate, and the yield on the 10-year Treasury bond are, after all, the ultimate barometers of political as well as financial success for any U.S. president, Federal Reserve Board chairman, or congressional leader.

As research for this book progressed Fred realized that, when looking at bond spreads, we are not just observing events that impacted the last decade in the United States. Over the centuries, most economic observers had no idea how to generate an accurate and instantaneous daily measure of the fear that drives capital markets. So, this project grew a little bit. As Fred researched the subject further, he began to discuss his findings with Chris Whalen, his friend and coauthor.

Over years of friendship and collaboration, it occurred to the authors that the ebb and flow of confidence and fear in all markets is the essential quality that determines financial and economic stability, and, ultimately, the wealth of nations. The United States is the only nation that has institutionalized the measurement of financial stability by making daily credit spread and other corporate bond market information widely available.

What we observe as daily problems in U.S. corporate bond markets (before, during, and after the Great Recession) has caused crises and wars for perhaps 4,000 years. In A History of Modern Europe: From the Renaissance to the Present, John Merriman notes that “Early in the sixteenth century, an Italian exile told the king of France what the monarch would need to attack the duchy of Milan: ‘Three things are necessary, money, more money and still more money.’” He was describing the relationship between currency debasement and military conflicts (Merriman 2010).

Until 1776, when Adam Smith won praise for publishing a treatise that differentiated central banking from reserve banking, brave individuals who openly opposed their rulers’ use of monetary policy to maintain power and fund wars were regularly executed. In the twentieth century, the expanding use of finance to create new economic opportunities democratized the money game. The fact that investors can vote with their money now empowers individuals to curb bad policy decisions by their leaders.

The solution to financial instability has been sought for at least 2,000 years. We submit that it lies in the public reporting of credit spreads and other bond market data, and in the use of financial structures that contain spreads. Hopefully the financial crisis of 2007–2009 will move us closer to a true democratization of finance and lessen the possibility of future economic dislocations and wars. If we implement the solution correctly, the world can anticipate when the system is beginning to fall out of balance (due to fraud or other sources of instability) and invest whatever it takes to save the world. Once saved, we can sort out a cure that addresses the cause of the crisis.

Central bankers in the United States, United Kingdom, Europe, and Japan have proven that they understood what had to be done in the wake of the financial crisis to raise the value of the economies they guide and restore investor confidence. The question is whether we can institutionalize this knowledge to limit market swings between fear and euphoria and thereby greatly increase the economic well-being of all free people.

Frederick Feldkamp

Christopher Whalen

June 2014

Introduction

This book applies law, logic, and financial history to macroeconomics. Macroeconomics is the branch of economic study that concerns itself with expanding the pie of society. Microeconomics, by far the larger and older branch of economics, concerns itself with expanding the piece of the pie claimed by a particular firm or individual. Microeconomists consider the impact of others’ actions on one firm or individual at a particular moment. Macroeconomists look at an aggregate motion picture created by the millions of offsetting actions that firms and individuals generate for their individual economic benefit.

With one major exception, modest changes in macroeconomic variables all produce offsets. Beginning with Adam Smith in the 1700s, every macroeconomist eventually discovered that one variable—the competitive cost of money, represented by credit spread—consistently increases macroeconomic activity when favorable (low) and destroys economic activity when unfavorable (high). Low and stable credit spreads produce, and are indicators of, financial stability. Every credit crisis begins with a sharp decline in confidence and a commensurate increase or upward spike in credit spreads.

Financial stability is the holy grail of macroeconomics, but it is also a very difficult thing to achieve in a free society. Every respectable economist understands that the world’s ability to sustain long-term growth has been impaired because we have not, to date, solved the problem of sustaining financial stability in a free market. Each time we observe a period of liquidity- driven growth, we convince ourselves that this problem has been solved. Inevitably, it seems, that’s when a new financial crisis or market crash shatters our optimism. The desire for economic prosperity and the freedom to pursue it seemingly ensures acts of fraud and indifference that result in financial instability. Albert M. Wojnilower of Craig Drill Capital wrote in March 2014, “We have booms and depressions not because of lack of economic expertise, but because they are hardwired into human nature.”

The first widely reported effort to remedy fraudulent practices that cause financial crises occurred in the time of Jesus of Nazareth. He observed that fellow Jews celebrating Passover were being overcharged to exchange Roman money for Temple money. Since the days of Moses, it has been considered a fraud to use two measures. That’s the very essence of the term duplicity. As the week of His crucifixion began, Jesus observed how the high priest profited by the fraud and He famously chased the money changers out of the Temple and into the competition of an open market. His action began a tortured journey that created a new religion but also provides a powerful example of the contrast and conflict between free and transparent markets and markets that are corrupt and fraudulent.

Jesus of Nazareth challenged the fraud of the high priest of His day and was killed. After Jesus’ crucifixion, His Jewish backers tried to reform Temple practices, and their next leader was killed as well. That led to a revolt among Jerusalem’s peasants, which got redirected at the Romans who supported the Temple priests (it was convenient for collecting taxes). Rome eventually responded to the revolt by the same tactic used in Carthage—it killed everyone in sight, razed the Temple, and destroyed Jerusalem in 70 CE.

Thousands of people have subsequently sought to free financial markets from similar monopoly practices and frauds. Inevitably, those efforts to impose transparency and fair dealing seem only to foster new forms of financial manipulation that, in turn, generate new cycles of crisis that bankrupt guilty and innocent investors alike. Coming out of what may be the worst worldwide financial market collapse ever, it is challenging for us to suggest that anything can change this depressing cycle of human error. Human beings, after all, are constantly seeking new ways to earn a livelihood. Finance has ever been among the most popular avenues to attain this goal, especially in cases in which the markets can be rigged to increase profits.

In 2013, Fred Feldkamp experienced the same currency exchange scam (in a Christian church, no less) that Jesus saw at the Temple in Jerusalem. In Christian theology, Christ’s prayer on the cross sought forgiveness even for His killers. He said they did not know what they were doing. In that regard, a great deal has changed. Today, everyone can know and expose a money changer’s scam.

We now have data (and means for instant worldwide distribution) that allow victims of fraud to avoid being duped. We have large and liquid markets that provide limitless alternatives to the acceptance of scams. All major equity markets instantly and continuously broadcast the precise level of stock investors’ interest worldwide, throughout each trading day. Most governments, however, continue to concentrate (and/or control) credit allocation and pricing within their banking enterprises, but even that is changing.

Through a process that began in 1971 (and may now be approaching completion), the United States has developed the world’s largest and most open corporate bond market. The operations of the major U.S. banks and federal housing agencies still effectively control the market for mortgage finance, and that remains a significant problem to be resolved. The market for corporate credit, however, is now so large that it is impractical for U.S. banks or even the Federal Reserve to control credit pricing and allocation over the long term.

Daily information relating to U.S. bond market activity is now so accurate that regulators have been able to prove manipulation of several private-sector credit pricing procedures (e.g., the Libor—London Interbank Offered Rate—cases, and more recent commodity and swap index investigations).

The United States suffered several major crises as it created this corporate credit market, but the result is the world’s best hope for gaining and sustaining financial stability. Privately reported daily indices that reveal the temperature of U.S. corporate bond markets were first published in 1987. A breakthrough, however, occurred in 2005. That’s when the U.S. Securities and Exchange Commission (SEC) ordered instant reporting of corporate bond trades. Soon after, FINRA (the Financial Industry Regulatory Authority) began reporting the daily bond indices that were used day by day to monitor the 2007–2009 crisis and to create Charts 9.1, 9.2, and 9.3 in Chapter 9 of this book.

This transparency illustrates how the financial crisis of 2007–2009 became the first worldwide market crash in which every concerned citizen and policy maker could know the precise daily reactions of millions of investors in U.S. corporate bond markets using actual trade information. As we’ve noted, the resulting data summary is published after each trading day.

The data reveals whether bond investors cheered, yawned, or fled in reaction to that day’s policy decisions, eliminating the need to endure the endless speculation over investors’ moods voiced by hundreds of talking heads in the financial media. Instead of having to guess, the data lets everyone follow the money. That knowledge furthers our ability to achieve financial stability, because policy makers can read and understand what the data means. They can frame appropriate responses based on facts rather than biased speculation. The data allows each leader to convert today’s mistake into tomorrow’s opportunity for redemption.

To eliminate crises, moreover, we now know that we must strongly enforce prohibitions on financial fraud by individuals, firms, and nations. Fraud is the force that generates all financial crises. In the first century, Jesus wanted to expose a financial scheme by forcing currency exchange trades into an open market where people could compete and show when a money changer’s price was out of line. The idea carried the risk of Roman interference, taxation, or both. It was therefore rejected by those in charge of the Temple.

That too has changed. Rather than confronting a church that quoted him a 67 percent currency mark-up in 2013, Fred joked with the clerk and paid up. Unlike Jewish peasants in the Temple, he knew the exact amount the fraud was contributing to the financing of the church. Everyone present, including the clerk, smiled at the irony. For Fred, the gift for accepting the mark-up was a priceless lesson. We now have an open-market solution for financial stability—the goal of Moses when he outlawed the use of two measures and of Jesus when He confronted the high priest.

Combining the universal ability to expose fraud with data that instantly reveals investors’ reactions to every policy change lets us open markets and sustain financial stability forever. Attaining that result only requires patient evaluation of all incoming data and the will to remain open to whatever market change is needed if things go wrong. Former Federal Reserve Chairman Ben Bernanke and his colleagues, it seems, are the foremost modern monetary policy practitioners of this theory.

A Goldilocks economy, which is neither too hot nor too cold, occurs when transactions conducted between informed and confident investors generate and sustain low and stable credit spreads. Low and stable spreads correlate with, and create, what academic economists call equilibrium in financial markets. Financial market equilibrium is elusive, however: so much so that many experts say financial stability is an alchemist’s dream. As Ludwig von Mises famously observed, economics is the science of every human action, and is thus impossible to predict (Von Mises 1949).

In 1776, Adam Smith described equilibrium as the state at which the price of a commodity, in all its alternate uses, is equal—that is, determined by one measure. That has been called the most important economic observation in history. It may also be the least understood, and the state itself most difficult to attain. Applied to the role of finance in Smith’s seminal economic treatise, The Wealth of Nations, equilibrium is the state at which the cost burden financial intermediaries impose on the generation and growth of productive assets (defined by Smith as land, labor, and stock in trade) is minimized. Credit spreads represent that cost burden.

Smith called finance the great wheel of circulation. The wheel facilitates conversion of productive assets (and the goods they produce) into money that is either invested in new productive assets or exchanged for other goods and productive assets (thereby increasing demand for new productive assets). Generating new productive assets expands the wealth of nations. Financial markets keep an economy moving and are, therefore, essential to creating wealth. However, with one exception that is pivotal to maintaining financial stability, finance cannot add value. Finance only allows land, labor, and stock in trade to grow efficiently.

Smith observed that any amount by which the cost to maintain finance exceeds the minimum cost of circulating the wheel burdens a nation’s ability to generate wealth. Transactions that generate a low-spread Goldilocks, or virtuous, economy in equilibrium minimize that cost of finance. They are, therefore, essential for nations that wish to maximize opportunities for citizens to succeed and to minimize risk that they will be crushed by a great wheel that circulates an overburden of needless (and often fraudulent) cost in the form of high credit spreads.

Despite the thousands of years mankind has been seeking to establish balanced trading rules and to avoid fraud, only the United States has achieved the elusive state of financial market equilibrium—and this only after a terrible world war. Maintaining financial market equilibrium has been as elusive as harnessing nuclear fusion: Each time the United States has achieved equilibrium in finance we have discovered new means by which dishonest financiers have evaded limits on fraud. In each case, a crisis soon follows and destroys earlier accomplishments, most recently in 2007–2009.

After each crisis, lawyers, traders, accountants, economists, politicians, regulators, businessmen, authors, and other professionals announce the cause of our failure from their perspective. In most instances, experts in one silo attribute the cause to an error committed by some other silo. In truth, all (and none) of us are at fault for periodic market failures. When all sides of the relationship between financial stability and financial crises are examined empirically and empathetically, everybody and nobody can be blamed. That’s because finance causes, and affects, everything. In financial markets, moreover, all things happen at the same time.

We are all human. Try as we may, even with ample use of technology, we will never understand everything that can go wrong in financial markets. If we pretend to be divine, everyone must be forgiven their errors. As flawed earthly vessels, however, we are all guilty of mistakes. Our real hope lies in the ability to overcome and learn from errors, especially blunders that tend to be repeated. As the great physicist and author Freeman Dyson notes:

Mistakes are tolerated, so long as the culprit is willing to correct them when nature proves them wrong. . . . Science is not concerned only with things that we understand. The most exciting and creative parts of science are concerned with things that we are still struggling to understand. Wrong theories are not an impediment to the progress of science. They are a central part of the struggle. (Dyson 2014)

We submit that it is the lack of good data on the perception of investors operating in the financial markets that has made financial stability a problem that heretofore has escaped resolution. Until 2005, the world lacked reliable, widely disseminated, real-time data on how bond investors price debt purchases and sales in response to policy changes. We understood crises in hindsight when we eventually found good data. That’s how Milton Friedman and Anna Schwartz reconstructed the causes of the Great Depression in their seminal 1963 work, A Monetary History of the United States, 1867–1960.

The United States used insight gained from this new data to minimize damage from the crisis of 2007–2009, but preventing crises using the theory of financial stability necessitates immediate data to understand what happens to investor sentiment as a crisis develops. Only then can this theory generate new policy directions that address underlying causes before a crisis triggers an economic collapse.

The problem is akin to what medical doctors experienced before they learned how to accurately measure fevers. Thermometers tell doctors when something is wrong. That’s when they must probe deeper and treat underlying causation before losing the patient. Without data, deciding when and how to medicate is a stab in the dark that can kill the patient rather than fix the cause of disease.

Obtaining accurate and timely financial market data is not simple. Throughout history, bankers carefully guarded specific price and margin data until it was outdated history. For some of those with insiders’ access, having data was a way to control markets or to profit personally. We now know that several markets managed by financial intermediaries (on which investors relied) were manipulated in the years leading up to the Great Depression and the 2008 recession in order to achieve the price results desired by those we trusted to conduct the markets fairly. Until the fall of 2005, a lot of bond market data produced on a daily basis was, in hindsight, nearly worthless for policy planning purposes.

Sometimes we learn from crises. The SEC demanded instant reporting of corporate bond trades as a result of a study it did after the Enron crisis. For those who followed credit spreads using that new data, each and every policy move during the 2007–2009 crisis, good and bad, generated a notable and measurable impact that was revealed by a change in credit spreads. Above equilibrium, each basis point change up (bad) and down (good) in credit spread produces a roughly $10 billion change in the annual wealth-generation capacity of the U.S. economy. When these numbers move too much in one direction or another, policy makers take notice.

Each day, therefore, looking at credit spreads, one could see when mistakes and relief occurred. This new knowledge led to days that were sometimes celebratory and sometimes sickening for investors. For example, credit spreads skyrocketed when the U.S. House of Representatives rejected the Troubled Asset Relief Program, or TARP bill, in September 2008. That meant most U.S. businesses would soon cease to operate. The body blow reversed the instant votes changed and TARP passed. The entire experience of 2007–2013 will be traced later in this book.

Fred began collecting and analyzing available credit spread data in December 1997. He needed a simple way to show Asian finance ministries, using one or two charts, that the Asian contagion of 1996–1997 benignly passed over U.S. credit markets. He was making a speech in February 1998 and needed the audience’s attention before explaining how the United States had developed an effective immunity to that serious crisis. By comparing world markets using credit spreads, the U.S. immunity became obvious and eye-opening.

Being curious, Fred next gathered similar data going back to 1987 and began to track whatever data he could find on credit spreads. In the monotony of daily research, he observed thousands of apparent coincidences between policy moves and credit spreads. The coincidences soon fell into patterns. Using the patterns, Fred learned that changes in credit spreads have correctly predicted the impact of financial-market policy changes on the U.S. economy for 27 years.

In September 1998, Fred used the data to show the SEC how a flawed rule it adopted in April 1998 destroyed the U.S. immunity to financial crises that he had demonstrated to Asian finance ministries in February 1998. That SEC rule had caused the hedge fund crisis of 1998 involving Long Term Capital Management. The September presentation resulted in temporary relief that allowed banks and others to safely unwind the crisis. As the data predicted, when the SEC’s temporary relief ended, the 1998 rule led to the high-tech bubble/crisis. The same rule also undermined the 2004 period of a Goldilocks economy. This eventually led to creation of unstable bank investments that exploded beginning in August 2007 with the failure of several hedge funds sponsored by Bear, Stearns & Co., and then caused the 2007–2009 crisis.

The 1998 SEC rule is terrible. It represents one of the worst pieces of public policy since the Great Depression. By cutting off market access for good structures generated by nonbanks and creating a way for commercial banks to monopolize access to money market funds, the SEC (1) prevented transactions that balanced an earlier bank monopoly in the market for asset-backed securities, and (2) unwittingly encouraged fraud by bankers who learned to manipulate their way into a new monopoly. In spite of our optimism about changes since 2005, we still fear the impact of the 1998 SEC rule will create further contagion in the financial markets.

These problems were, in our view, muted by the extraordinary policy innovations of Fed Chairman Bernanke after 2008. Over his career, Mr. Bernanke has published articles and given speeches describing the transmission of monetary policy through its impact on credit spreads. He clearly gets it. In identical October 2003 speeches, then-governor Bernanke reported on research that he and Ken Kuttner had done relating monetary policy changes to stock market activity. They found anticipated interest rate changes had little impact on stock prices, but that unanticipated changes had a moderate effect, and they wondered why. They wrote:

We come up with a rather surprising answer, at least one that was surprising to us. We find that unanticipated changes in monetary policy affect stock prices not so much by influencing expected dividends or the risk-free real interest rate, but rather by affecting the perceived riskiness of stocks.

Soon thereafter, Governor Bernanke became the primary White House economist and, in 2006, became chairman of the Fed. It also became clear that Vice Chairman Kohn held similar views—they both got it. Let’s hope that their enlightened thinking on credit spreads and markets continues to guide U.S. and worldwide banking authorities in the months and years ahead.

Changes in credit spreads exposed the merit and fault of each event on that awful path to financial Armageddon in November 2008. Whenever Kohn and Bernanke initiated a response, it seemed that the markets recovered. Until the fall of 2008, however, their efforts were consistently overwhelmed by the errors of others, particularly Treasury Secretary Hank Paulson. Changes in credit spreads similarly correlate with each step (and blunder) during the 2009–2013 recovery.

Understanding what moves credit spreads allows us to construct and test policies that allow the United States to create and sustain financial stability. The size of U.S. bond markets and the example that the United States can set will allow the world to do likewise. Through historical data, we know financial crises start with a spike in the spread, a sudden widening of the difference between (1) what high risk borrowers pay for credit, and (2) what high grade borrowers pay. Understanding what generates a spike permits policy changes that reduce the spike before investors panic. With proper rules, incentives created by changes in the credit spread affect the profitability of private-sector transactions that counterbalance the procyclical swings in finance that cause crises. As investors learn to use the theory of financial stability, credit spreads narrow and the magnitude or volatility of credit spread movements lessens. That reduction in the variability of credit spreads generates equilibrium.

Since few economists are active traders, as was John Maynard Keynes, most economists have yet to realize the opportunity permitted by the SEC’s 2005 data disclosure requirements for bond spreads. That’s understandable. Academic economists are renowned for rejecting anything in circulation for less than a few decades. Many economists seem, only recently, to recognize that Irving Fisher solved the problem of a debt-contraction depression in 1933. Part of the reason for this systemic failing among economists seems to be that few of them are truly students of history, especially when it comes to how finance and law interacts with economies.

Fortunately economic researchers now have 27 years of data (more than 5,000 daily data points) with various degrees of reliability by which they can correlate credit spread changes with policy moves and responses in all areas that affect investors’ market behavior. That’s sufficient to model policies that will sustain financial stability. The results of that research will surely modify positions espoused in this book. We accept that.

This book includes three motion-picture graphs (Charts 9.1, 9.2, and 9.3 in Chapter 9) that Fred developed to support the many reports he wrote in response to events of the 2007–2009 panic. The charts are updated through May 2014, comparing daily rates for long-term U.S. Treasury notes, investment grade corporate bonds, and high yield corporate bonds. The charts show how financial stability was lost through errors, then regained after 2008 and sustained after 2012 as these errors were corrected. Each chart follows the money of investment decisions affecting trillions of dollars of assets owned by millions of investors.

The theory of financial stability presented here derives from that data and from the transactions described in the 2005 book Fred coauthored. This market-based solution for financial stability is as old as the invention of money, as mathematically demonstrable as physics, as logical (and theological) as the Golden Rule, as current as modern technology, and as futuristic as the quest to eliminate war and the risk of extinction by global warming. Implementation may be difficult, but the problem must be solved.

So, let’s briefly review financial market history and see how to improve the future.

PART OneA Flight through Financial Market History—Freedom and Fraud

CHAPTER 1The First Few Millennia

The first five books of the Bible are common to the religious heritage of three monotheistic faiths: Judaism, Christianity, and Islam. For believers, these five books record history from Earth’s beginning to the death of Moses. With reliance on one god, monotheism overcame the duplicity of polytheistic faiths where strife was accepted as deceptions of man caused by differences among the various gods.

Deuteronomy is the fifth book of the Bible. Scholars have different theories on the timing and purpose of Deuteronomy. It was written after the Jews escaped slavery in Egypt and before they reached the Promised Land. By the time the book was composed, settlements of anatomically modern humans existed on every continent.

Coming from slavery and having wandered the desert for a considerable time, one can imagine the level of strife and debate within the Jewish tribes over how to treat each other in the face of competition for scarce resources. Deuteronomy seems to be a kind of treaty that lists specific behaviors that followers of Moses required of each other. It let them live in peace while seeking the greater society that was yet to come.

The book is an early statement of the rule of law. Some admonitions (e.g., one requiring that a woman’s hand be cut off if she defends her husband by grabbing the genitals of an enemy) seem unique to a tribal community with a need to procreate. The book’s definition and preclusion of fraud, however, is enduring.

Deuteronomy mandates that followers apply only one measure in their homes and trade. That precludes the use of two measures—that is, duplicity, the core of all fraud. It equally prohibits use of a small measure when a large one is proper (e.g., when selling bread) and use of a large measure when a small one is proper (e.g., when buying wheat).

Deuteronomy dates to somewhere between the twentieth and seventh centuries before the common era denoted by the Gregorian calendar. Precluding the use of two measures is recognition that society has an interest in preventing the threat that fraud poses to peace and prosperity. This side of the rule of law is summed up in the Silver Rule of earliest theology and philosophy: “Do not do to others what you do not want others to do to you.”

The Golden Rule, which emerged around the world near the start of the common era, inverts that proposition. It calls for affirmative individual action: “Do to others as you want others to do to you.”

The Golden Rule creates an individual obligation to step forward and make peace. The Silver Rule creates a collective obligation to preserve peace by avoiding specific behavior. All financial crises are founded in fraud. Precluding fraud will not end duplicity, so the law in Deuteronomy cannot assure financial stability. Precluding fraud is essential to financial stability, however, since it provides a standard toward which we can aspire and measure actions. It is only by disclosure and affirmative support for good transactions (explained later) that society can identify and undo fraud in a manner that sustains stability.

Punishing fraud is necessary to minimize the gotcha effect, or the sudden ebbing of confidence that surprises markets and triggers financial crises when unsuspected fraud is exposed. Instability begins when confident investors lend money to (or otherwise entrust) intermediaries that prove unworthy of trust. Fraud breaks that trust. It hides speculation until the duplicitous activity generates losses or inquiries that lead to discovery, but that generally occurs only after the entrusted money is gone.

When significant or systemic fraud is discovered, trust is shattered (along with fortunes) and is very hard to regain. Revelations of fraud trigger the spikes in credit spread that create crises. When confidence returns, spreads fall. When the cost of Adam Smith’s great wheel falls substantially, however, financial intermediaries perceive a need to hide speculation so that smaller margins can be collected on a larger base.

To do this, it is inevitable that some institutions will stoop to using two measures for investment. Speculation will determine that firm’s actual investments but will not be disclosed. The duplicity of secret speculation benefits managers at the later expense of investors. The use of off-balance sheet finance, discussed later in this book, is a prime example of this behavior. That is what makes such practices a moral hazard problem.

When the fraud fails, investors have no apparent source for repayment, as illustrated by the tiny recoveries in the $7 billion fraud committed by Allen Stanford. As investors rush for the exit, they drag good institutions down because investors lose trust in all institutions and markets contract in synchronicity.

Financial institutions, moreover, can be expected to lose customers when a competitor invades their territory and uses duplicity to permit managers an edge. When fraudulent savings and loans (S&Ls) used accounting gimmicks to hide speculation and undercut the practices of responsible commercial bankers in Texas during the 1980s, the biggest casualties were honest Texas banks that faced the choice of match or die. It is in good times, therefore, that regulators must insist on one measure for all.

Along with preventing fraud, vibrant private markets are also essential to assuring financial stability.