May 11, 2010

The traditional view is anchored on the notion there exist absolute truths. Modern times have retained only one absolute truth, which states all truth is relative. This might call for some caustic comments but why bother? Our post-modern Information Age is about to succeed making Truth irrelevant.

"I don't know what the economic gain is", Professor Neumann said of the betting on Goldman and its chief to Nelson D. Schwartz (*), "and it's in bad taste". Since Professor Neumann is unlikely to find my life insurer a boor for betting on my death, I beg to disagree as far as taste is concerned. But what gain can we make on Intrade's contracts on "whether Lloyd C. Blankfein [...] will be able to hang on his job through the end of the year"?

Its CEO, John Delaney, asserts Intrade has "a good record of predicting the future". Take this truth with a grain of salt. What John Delaney really means is that it does a good job of predicting the present, i.e. to aggregate "individual opinions" into current "conventional wisdom". Today, the Intrade "crowd" believes "no party will have overall majority after the next UK election". As the election is being held as I write, I expect facts to back the popular truth (1) but cannot but notice it held the contrary opinion until a few weeks ago. "Predicting the future" is all relative.

If it does not unveil future facts, Intrade still gains us precious insights into our Information Age. It does this by pricing pure information, in the instance a bet with no direct accounting reality, Mr Blankfein being hardly a depreciable asset if perhaps an overhead expense, yet based on underlying reality, as the bet is a proxy for the sustainability of a business model free from onerous ethical principles and with the power to influence it in return, since, were popular opinion to turn sharply against him, the board of Goldman Sachs would boost its share price by firing its CEO.

Thus total leverage, recursivity and circularity combine with execution speed in a new creation where truth has become irrelevant. It is true Intrade contracts have a date of settlement. But it is always possible to close one's position well before the truth becomes available and, meanwhile, the more volatile the opinions, the better-off the bettors.

Notice all factors are necessary. Without the increase in automation ushered by the Information Age, it would be too difficult to trade ahead of the events at a scale large enough to matter. Without circularity, rumors could not become self-fulfilling and prudent people would be able to follow Martin Wolf's advice and avoid the dangers of casino finance for the securities of utility banking. Unfortunately the current crisis is all too real for all, what with loss of jobs for workers and of fixed income for pensioners, showing us to be bettors, no matter what we do or want.

"Jimmy Caine, the former Bear Stearns chief executive, [...] blamed market rumors and short sellers for precipitating the bank's demise in 2008", according to Tom Braithwaite (**). In the absence of truth, what else do you trade on if not well-timed rumors? While one "might regard Warren Buffet's statements as predictably self-serving", per Andrew Ross Sorkin (***), his "offer[ing] his full-throated support of Goldman and its chief executive" is but a legitimate attempt to spread rumors (2). The latter may be supportive but, as any banker knows, it takes two sides to make a bet.

Without total leverage and recursivity, one would of course left to deal with cumbersome assets which would weigh down value creation. With $100 available and anticipating before April 30 that Goldman "share price [would that day fall] a precipitous 9.4 percent in an avalanche of selling", as Graham Bowley wrote (****), a true capitalist would have wanted to devote his entire stake to a "naked short" in order to maximize his profit.

But could, despite George R. Neumann's professed doubts, such a pure bet create any economic value?

From a historical perspective, financial value creation has not been easy to recognize. If A has $100 that B wants to borrow, even today faith may forbid A to charge interest. Yet if B has reasonable expectations to get a return of Re% on this $100 and A is discounting future revenues by Di%, allowing A to charge interest will, assuming Re is greater than Di, help create a global value of Re-Di dollars to be shared between A and B (3).

In the previous case the lender enables the borrower's greater opportunity to be tapped. It is a vehicle for innovation. At the opposite end of the spectrum, insurance is a vehicle for social solidarity. If experience has shown that the members of a some group have a known probability to lose their car in an accident, it makes sense for them to get insurance and thus pool their risks at the collective cost of funding the insurer's operations.

Globally insurance does not create any value. Rather it transfers risk and, if the sum of all premiums p is greater than the sum of all risks covered R times risk probability r by enough of a margin to fund the scheme, what would be a catastrophic event for an individual is smoothed into a continous expense born by the insurer. But this very regularity frees both individuals and insurer to focus again on creating value through work and capital.

When A lends to B, their balance sheets do not register any value creation, which will be realized only as future income, only money creation through A's credit to B. When an insurer B insures a client A, their income statements register the payment of premium p but, theoretically, their balance sheets should also reflect the transfer of risk R*r (4). This makes it easier to describe how financial value creation loses its moorings.

If A lends $100 to B who is a crook like Bernard Madoff, B takes A's cash but disregards the corresponding $100 debt, which he kicks forward to future victims. This apparent value creation is as sudden as it is huge, i.e. $100 compared to a measly Re-Di. Let us remember that participants in a bubble behave no differently as they take on obligations which can only be repaid by finding later fools. No wonder bubbles are so intoxicating.

If A pays a premium to B who is not a prudent insurer, it is illusory to speak of risk probability r. While both premium transfer p and underlying risk base R stay the same, the theoretical balance sheet of A should register A's current belief of unloading risk R*ra and B's current belief of shouldering risk R*rb. As rationality suggests rb is no greater than ra, the transaction once again unleashes a pseudo value creation of R*(ra-rb).

That disagreement about a temporarily hidden truth could globally add value should be highly suspicious. Market fundamentalists will say that the market can reveal the hidden probability r. But just as Intrade gives a collective estimate rather than predicts the truth, a market derived risk probability will eliminate pseudo-value creation but still fail to truthfully account for the risk transferred. While useful, liquid markets for pure financial bets are not the same as sound actuarial insurance, which do not apply to them as proven by the current crisis.

Rather than forbidding bets, one should adopt quantum accounting to reflect their illusory character. In so doing, one altogether avoids the "debate about the definition of "sophisticated" investor" mentioned by Gillian Tett (*****). Even if at the race course some bettors know more about the horses than others, the real criterion is whether a bettor can bear losing the entire wager or not. Quantum accounting accordingly sets ra to 0 and rb to 1, i.e. requires bettors to book the entire risk R as a liability when selling "insurance" and shed no risk at all when buying it (5).

Thus the failure of mathematical modeling until the result comes in translates into a temporary destruction of value worth R. When truth finally becomes known and settlement is reached, the uncertainty is lifted and either the liability R is safely removed from B's balance sheet or an asset for an equivalent sum is added to A's balance sheet in fulfillment of the risk transfer.

If Warren Buffet is not a "sophisticated investor", who is? But reported by Reuters to have "sold "put" options [...] with an exposure of up to $63 billion" (******), how has he reflected this liability on Berkshire Hathaway's balance sheet? Unless hedging is involved, writing that "realistically, the market value of [these] liabilities stood at around $9 billion" shows the travails of AIG have been for naught. Aren't fabricated truths true lies?

Even if society makes truth irrelevant and prospers for a time, it still needs what John Kay calls "a practical political philosophy" (*******). The current crisis has so tainted anglo-saxon capitalism that Samuel Brittan now declares "market fundamentalism [...] had no real existence outside of North America" (********). Funny that, didn't the AIG collapse originate in its London office? Since "the case for socialism had collapsed in the face of the practical failures of socialist regimes", John Kay devotes his latest column to asking "what became of the "third way"?".

To speak of a third way is of course to court failure. Besides what some call a spirit of enterprise, others naked greed, and what some call lazy envy, others a sense of solidarity, I see no other human force potent enough to pull forward a whole society. There is no third way. What exists is an infinite spectrum of how to harness the two forces mentioned, whose existence do not depend on people reaching agreement on their name.

At the two extremes, one force may be distorted. It is at work nevertheless. Under communism, excess greed will be focused on climbing the ladder of the nomenklatura. Under anglo-saxon capitalism, repressed solidarity will be reborn as a mix of state bailouts and ostentatious private giving. One could do better but it should be left to society itself to pick the harness it finds to be right at the time. If only we lived under a democracy!

The truth is Western societies live under different versions of pronaocracy, an indirect rule by corporate interests tempered by bouts of populism. Despite the existing controversies surrounding marketing practices by pharmaceutical companies, it would still be an improvement were financial innovation field tested on volunteers the way prescription drugs are. Expect little progress in the US until its constitution is amended. Meanwhile anglo-saxon capitalism remains alive and well and capitalism itself is still a convenient utopia.

From Intrade to pronaocracy, am I relevant though, as a mere defender of eprivacy? Were the Blankfein contract the hit John Delaney predicts, couldn't the use of certain search keywords, the purchase of certain books or other goods and services help gauge Mr Blankfein's resolve against the slings and arrows of fortune? Tasteless? Definitely. Impossible? When Google, Amazon and Mastercard routinely compile this very information, I would not "want to bet" it. How long for Pellicano's pupils to place heavy bets against the staying power of the next CEO under siege?

Harnessing the spirit of entreprise and the sense of solidarity cannot work well without respecting our data rights. But who needs truth anymore?

Philippe Coueignoux

• (*) ............... Think Blankfein Will Resign? Want to Bet?, by Nelson D. Schwartz (New York Times) - April 30, 2010
• (**) ............. Bear Stearns chief blames bank's failure on rumour and speculation, by Tom Braithwaite (Financial Times) - May 6, 2010
• (***) ........... You've Got A Friend In Buffett, by Andrew Ross Sorkin (New York Times) - May 4, 2010
• (****) ......... Goldman's Market Value Plunges $21 Billion, by Graham Bowley (New York Times) - May 1, 2010
• (*****) ....... Sophisticated investor debate takes on a new dimension, by Gillian Tett (Financial Times) - May 7, 2010
• (******) ..... Berkshire's Role In Derivatives, Reuters (New York Times) - April 30, 2010
• (*******) ... The left is still searching for a practical philosophy, by John Kay (Financial Times) - May 5, 2010
• (********) . A credo for a revived capitalism, by Samuel Brittan (Financial Times) - May 7, 2010
• (1) note from the day after: it did.
• (2) self-serving declarations creates no conflict of interest as Warren Buffet is not simultaneously advising some of his clients to short Goldman shares.
• (3) this is actually an approximation which works if Re and Di are small enough. If A and B agree on interest rate I%, A gains I-Di and B gains Re-I
• (4) to some extent this is the purpose behind the so called "unearned premiums" liability of the insurer but the awkwardness of the vocabulary is telling.
• (5) when holding more than one position on the same risk, one should of course only book the algebraic sum of these positions. Hedging one's bets is sound.