Belmont Club

Double Or Nothing

The Economist magazine has an article which says almost the same thing as Belmont post The Anatomy of a Lie, which was published on July 2. In the Anatomy of a Lie I argued that the fundamental problem with the discovery that LIBOR was being fixed is that it meant the financial system was based on bad data. Why is this a catastrophe? Because much of what you believed about value and who possessed it was false.

But that misses the biggest aspect of the financial crisis. It’s not OK if everyone does it, if in the process, they are unconsciously distorting their own information base …

In a simple system that might not matter. But a global financial system with signals feeding back on each other it has created huge distortions in value, distortions which are the heart of the current world crisis. Ironically LIBOR itself was created as a benchmark to anchor other financial instruments which in turn depended upon it …

The rate fixing process introduces a systematic bias into the price signal and after a while things — especially instruments dependent on that price — wind up in a different place …

But if one the variables in their equations is rigged, and rigged for a long time at a value different from the true rate then error increasingly accumulates within the financial system. The blind lead the blind. No quantitative model can fix bad inputs. The net result of dishonesty in the financial system is that parts of it become grossly overvalued and other parts vastly undervalued. The price distortion inevitably drives resources into the wrong places and money into the wrong — or shall we say right — pockets. It also sets up a system crash.

The financial system can be regarded as a vast database which stores the past, present and future values of “real world wealth”. But operations on a database — any database — can only be safely performed if the data is left uncorrupted; and if the reconciliation process has integrity. But if transactions are routinely and intentionally writing the wrong values into the database it eventually diverges from the objects which it purports to represent. At some point the database becomes effectively worthless. In a financial system this creates a giant element of risk that shakes it to its foundations.

Now here’s how the Economist puts the same idea. They emphasize the fact that many values derived from LIBOR are in fact standing in a puddle of fiction.

What may still seem to many to be a parochial affair involving Barclays, a 300-year-old British bank, rigging an obscure number, is beginning to assume global significance. The number that the traders were toying with determines the prices that people and corporations around the world pay for loans or receive for their savings. It is used as a benchmark to set payments on about $800 trillion-worth of financial instruments, ranging from complex interest-rate derivatives to simple mortgages. The number determines the global flow of billions of dollars each year. Yet it turns out to have been flawed.

In theory, LIBOR is supposed to be a pretty honest number because it is assumed, for a start, that banks play by the rules and give truthful estimates. The market is also sufficiently small that most banks are presumed to know what the others are doing. In reality, the system is rotten. First, it is based on banks’ estimates, rather than the actual prices at which banks have lent to or borrowed from one another. “There is no reporting of transactions, no one really knows what’s going on in the market,” says a former senior trader closely involved in setting LIBOR at a large bank. “You have this vast overhang of financial instruments that hang their own fixes off a rate that doesn’t actually exist.”

The Economist’s version has a lot more oomph because it attaches likely numbers to the problem, whereas my formulation is basically a simple statement of principle that would be felt by any DBA who suddenly realizes his whole database is a joke. What does it mean when “$800 trillion-worth of financial instruments, ranging from complex interest-rate derivatives to simple mortgages” is based on something as factual as Harry Potter and the Goblet of Fire? Maybe it means LIBOR doesn’t really matter. It could also mean they are also fictive themselves.

This creates an even more interesting problem, at least for any DBA. Which is if the database is so corrupt then why hasn’t it crashed yet? What keeps the world spinning round? Why don’t the banks just crumble into dust? What is holding them up?

The answer may lie in the old idea of a doppelganger, in which reality becomes oddly bifurcated. Split in half. Somehow nature has generated two non-identical copies of the same thing.  Now which is the “real me”? Carl Sandburg tells the story of Lincoln meeting his doppelganger.

A dream or illusion had haunted Lincoln at times through the winter. On the evening of his election he had thrown himself on one of the haircloth sofas at home, just after the first telegrams of November 7 had told him he was elected President, and looking into a bureau mirror across the room he saw himself full length, but with two faces. It bothered him; he got up; the illusion vanished; but when he lay down again there in the glass again were two faces, one paler than the other. He got up again, mixed in the election excitement, forgot about it; but it came back, and haunted him. He told his wife about it; she worried too. A few days later he tried it once more and the illusion of the two faces again registered to his eyes. But that was the last; the ghost since then wouldn’t come back, he told his wife, who said it was a sign he would be elected to a second term, and the death pallor of one face meant he wouldn’t live through his second term.

For those with a distaste for mystical Central European concepts like the doppelganger there’s another metaphor which may be more appealing: the temporal paradox. What if you could travel back in time and meet an earlier version of yourself? What would happen when there were two entities in a situation where only one could exist?

For instance, if a time traveler were to meet his double from another time, the double would merge with the time traveler, making the traveler a part of the time he is visiting. The same would hold true for events. Two events would merge into the nearest event which does not produce a paradox.

The merge occurs. What is a merge? A merge is what DBAs do when they have nonidentical copies of the same record and have no basis to clearly determine which of the two is correct. So they pick one, or pick parts of each and make a single record out of two. If the financial system is full of contradictions and yet it works somehow it doesn’t mean the contradictions aren’t fatal. It only means we haven’t been forced to choose yet.  If contradictory facts are not, metaphorically speaking in the same room, the choice is not forced.  A lie can live, if it avoids the truth just as a man can hide a mistress from his wife provided they never meet. When they do all hell breaks loose.

So in a financial system a set of books can exist by fiat, no matter how dishonest, and it can continue indefinitely for so long as confidence in the fake books is maintained. Like Wile E. Coyote the fake system can keep running on presumption, because there is no other reference for value, or to put it another way, for so long as Wile E. does not look down. Once the truth is discovered, there are two answers to the same question — always a nightmare to the DBA — and then a choice must be made.

As soon as the rival record appears, the trust which the fiat record formerly held is destroyed. Suddenly I know Greece is bankrupt. It’s bond rates climb. Of a sudden people realize that a bank is probably insolvent; so deposits are demanded, checks are cashed; the whole of the fiat is compared on a one to one basis with the actuality. And when there are discrepancies the contradictions can only be fixed with a merge.

The world’s recent problems are largely the fault of the truth. If it weren’t for the truth, we’d be in Eden still. But it has unfortunately emerged that people’s home values were inflated; unions and other persons discovered their pensions were undervalued.  We thought we were rich according to the record, but the truth came in the door and told us we were broke.  The record was lying.

It turns out that in reality there are more claims on wealth than there is value to satisfy them. This is a classic bankruptcy resolution scenario. There’s X dollars and there are NX claims where N > 1.  The problem is who gets paid. That is another way of asking: how do the records get merged? And the answer unfortunately is that it usually depends on who is holding the revolver — on who’s doing the merging.

The man with revolver goes to the head of the line. Everybody knows there’s preference order in bankruptcies. The guys with the superior claims get their cut first and a promise is made to pay the rest later, if there is a later.  It happened with GM and it happened  in  Argentina:

Corralito (Spanish pronunciation: [koraˈlito]) was the informal name for the economic measures taken in Argentina at the end of 2001 by Minister of Economy Domingo Cavallo in order to stop a bank run, and which were fully in force for one year. The corralito almost completely froze bank accounts and forbade withdrawals from U.S. dollar-denominated accounts.

The Spanish word corralito is the diminutive form of corral, which means “corral, animal pen, enclosure”; the diminutive is used in the sense of “small enclosure” and also “a child’s playpen”. This expressive name alludes to the restrictions imposed by the measure.

After a time, when the preferred claimants are finished, the deposits of the great unwashed are unfrozen and they are paid in devalued money. The two books of account have met and after the merge the financial system is whole again. There is no divergence. The winners are really rich and the losers are really poor. But the cost of the merge has largely been borne by the guys without the revolvers. One movie maker turned this into a tagline.

“They say that if you meet your double, you should kill him… Or that he will kill you… I can’t remember which but the gist of it is that two of you is one too many. By the end of the script one of you must die.”

What the LIBOR fixing shows is that the financial system is unlikely to be a true database. It is corrupt. The system has been fed too many lies for anyone to believe what it says is gospel. The true value of each claim on will be precipitated when the doppelgangers meet; when the public loses confidence in the nominal or face record and participants force a merge in each financial domain, as is happening in Europe and in America. We call this process the Global Financial Crisis

Who will get the dough? That is for another post.

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