One of my “Five Financial Theorems” for understanding the global financial market is “Trust conspiracy theories – What matters is which theories one trusts.” 1
This may sound like an unscientific proposition for a serious scholar to espouse. If we observe what is really going on in the global financial market, however, one cannot deny the fact that market-moving tactics are abound and there are many who earn big bucks through “big shorts.” Not trusting conspiracy theories is tantamount to denying this reality. If we are serious about understanding the global financial market and drawing realistic policy implications, it is necessary to base our judgement on hard facts and weave them together with common sense.
The most crucial fact about the financial market is that finance is an information industry and asymmetry is a prevalent characteristic of information. Information is unevenly distributed, and the more valuable the pieces of information, the more unevenly they are distributed. This inherent information asymmetry is often ignored, as financial market regulations ostensibly aim at creating a perfectly competitive environment and providing participants with level playing fields by making “equal” information accessible.
The fact is that global banks spend big bucks on gathering information and maintaining networks because they are convinced that they constitute core competitiveness in finance. It is also naïve to assume that those who have exclusive information and networks would use them in an egalitarian manner. Our common sense tells us that it is natural for them to employ various strategies to reap supernormal profits by leveraging on them.
Another fact about the global financial market is that it has evolved into a predominantly “win-or-lose” arena where constant battles are unfolding between those who have short positions and those who have long positions. Foreign exchange investment was a “win-lose” game from the beginning because the rise of one currency’s value is automatically the fall of others’. Stock investment and real estate investment were previously considered as “win-win” games because it was expected that their prices would rise as the economy becomes better. However, markets for derivatives like forwards and options where the divide between short and long is an integral feature, are now much bigger than spot markets. Real estate assets are also securitized and transformed into derivatives.
In this “win-lose” market, it is relatively easier for those with short positions than those with long positions to manipulate the market because the former consists mostly of professionals within dense networks while the latter consists mostly of dispersed amateurs. We are often told, “crisis is opportunity.” This maxim normally means that, if one survives a crisis well, he/she will have good opportunities. In the current financial market, crisis is instant opportunity because those who have shorting positions earn money directly if the others who have long positions are in a crisis. If the others go bankrupt, this is even better. The market is therefore flooded with “innovative” financial products by which investors can receive insurance money when their next-door-neighbors have caught fire. They then have every incentive to commit arson against their neighbors or fuel the fire. Notwithstanding its negative connotations, “conspiracy” can be a scientific term to indicate strategies and tactics that are not clearly visible to outsiders but are benefitting certain groups at the expense of others.
The recent turmoil of the world economy triggered by the US interest rate hike can be understood as a result of various conspiracies to profit from exploiting and creating volatilities. The US was raising its interest rates because its economy was recovering. The fact that the largest economy in the world confirmed clear signs of recovery for the first time in seven years after the 2008 Global Financial Crisis should be good news for the world economy. However, the global financial market movement was detached from the real sector and the world economy barely survived another crisis.
The fact here is that, before and during the turmoil, numerous hedge funds shorted emerging market assets and bragged about it blatantly. George Soros, who shorted the Malaysian ringgit and Hong Kong dollar during the Asian Financial Crisis in 1997, shorted the Chinese yuan and revealed it at none other than at the Davos Forum, where world opinion leaders flocked. Hayman Capital’s Kyle Bass, who became prominent for big shorts during the Global Financial Crisis, now poured 85 percent of his assets in shorting the yuan and publicly claimed "the greatest investment opportunity right now" is to short the yuan. He even predicted that China was “going to go through a banking loss cycle like we went through during the Great Financial Crisis [in 2008]." There were many more hedge funds that were revealed to have shorted the yuan, including Carlyle, Pershing Square, Druckenmiller, Tepper, Schreiber, Einhorn, and Scogging.
This kind of market manipulating behavior is not confined to hedge funds. It is more of a general behavior in the global financial market in which even the most reputable financial institutions are involved. For instance, Goldman Sachs sold USD 1 billion of the ABACUS fund in 2007 by persuading its customers to long collateral debt obligations (CDOs). However, Goldman entrusted the selection of the ABACUS CDOs to Paulson & Co., a hedge fund that was then making big shorts on CDOs. This was no different from entrusting the Japanese national team’s coach to select the Korean team’s players in an international football match between the two countries. It is impossible to expect that the coach would select the best Korean players for the team. On the contrary, he has every incentive to select the worst players. The results of the ABACUS investments left little room for doubt. ABACUS investors lost USD 1 billion. Paulson definitely earned a lot, though the actual amount was not confirmed. And Goldman pocketed USD 15 million in management fees on top of an unconfirmed amount of gains from the potential shorting.
It is difficult to imagine that Goldman let Paulson select the ABACUS portfolio by mistake or without knowing that Paulson was shorting subprime products.
Goldman was charged by the US Securities and Exchange Commission (SEC) for potential fraud and settled the case in 2010 by paying the SEC a record USD 550 million “without admitting or denying allegations.” It is difficult to imagine that Goldman let Paulson select the ABACUS portfolio by mistake or without knowing that Paulson was shorting subprime products. It must have chosen Paulson for reasons. It is a pity that the settlement with the SEC stopped further investigations into who actually benefitted from shorting ABACUS and how much they earned. We are left with an incomplete picture of the incident and need to rely on our reasoned conjectures to fathom the missing elements.
“Trust conspiracy theories” becomes a theorem due to this kind of incomplete information. One characteristic feature of conspiracy is that it is impossible to find every piece of evidence to complete the entire picture. We can only deduce its extent based on the evidence available. Such deductions are often political economy analyses by nature. When we are not able to gather the concrete evidence necessary to confirm the entire picture of a conspiracy, we conjecture it by ascertaining who benefited or suffered under the circumstances in question. This is the best scientific method available.
In the Goldman case, there is quite strong but scattered evidence suggesting a conspiracy. Around the time Goldman was marketing ABACUS in 2007, it was turning its overall trading position on CDOs from long to big shorts. The New York Times reported that, according to the bank’s internal e-mails in late 2006, “there are messages that show Goldman executives discussing ways to get rid of the firm’s positive mortgage positions by selling them to clients.” In one message, “Goldman’s chief financial officer, Mr. Viniar, wrote, ‘Let’s be aggressive distributing things.’” On October 11, 2007, “one Goldman manager in the trading unit wrote to another, ‘Sounds like we will make some serious money,’ and received the response, ‘Yes we are well positioned.’” In the end, the bank’s CDO trading desk alone generated a record USD 3.7 billion in net revenues in 2007.
What should be done about conspiracies that abound in the global financial market? The only way would be to devise policy measures to promote “win-win” finance while minimizing room for “win-lose” finance, thereby reducing room to profit at the expense of others. However, governments around the world are not daring to do so. They are mostly hiding behind the pretext that those policy interventions would hurt the “efficiency” of the financial market. The regulation of derivatives is also being resisted on the pretext that it would reduce market “liquidity,” which is essential for ensuring market “efficiency.”
However, the global financial market is the largest casino ever in history. Can the economy become more efficient by increasing liquidity in a casino? A main problem in the current financial market nowadays is too much liquidity, not a lack of it. And this liquidity is mostly circulating in “win-lose” finance and even obstructing the functioning of the real economy.
In managing the economy, it is a global vogue to clamor for “mutual growth” or “sustainable growth.” In finance, however, policy-makers and academics do not dare to say this. They are probably victims of not trusting conspiracy theories.
1. Shin, J.-S. (2014). The Global Financial Crisis and the Korean Economy. Routledge.