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Table 1The Evolution of Production and Its Organization

Handicraft–hand tools

Economy Ownership/ControlProduction Method Purpose Scope

Money Proprietor/Partner Production for use

Local/Regional

Factory – Machines Money > Credit

Capital gains

Stockholder–Absentee Owner/ Managerial

Regional/National

Credit (Mark I)

Technological – Electronic

Machine Process

Industrial – Machine Process

Production for sale

P/P Manager > joint stock company

Asset Value Manipulation

Anational

Stockholder–Absentee Owner/ Managerial Elite

Credit–Derivatives(Mark II)

National/International

New Property Institutions Continued

• Doctrine of Reasonable Value– Supreme Court Decisions

• Series of decisions over a period of several years that creates this doctrine• Compare to Veblen’s concept of differential value based on ability to extract something for

nothing from intangible property

– Intangible Property in the Lower Courts Upheld in Supreme Court• Court cases

– State of Indiana - Railroad Property– State of Ohio – all businesses

• Right to withhold what someone wants but does not own- especially by control of prices

– Leads to other problems – institutionalization of intangible property strengthens instability of financial systems offsetting in part some of the gains of previous institutional changes.

– Instability

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3

Goldman Sachs 1928-29

Goldman

Sachs1868

Goldman Sachs

Trading Co.

1928

Issued 1 million shares

@ $100 per share

Then bought it all with its own money

Public

Then sold 90 percent to the public at $104 It rose to $109, split two for one, then to $116, making an original $109

investment worth $232.

July 1929

7.2 million Shares – 6.2

million owned by Shenandoah –

and Shenandoah mostly owned by

GSTC

Blue Ridge Corp.

Shenandoah– $102 Million

Sold common & preferred shares to

Public

The story opens with an illustration of capital gains in the era of the machine process.

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Time Magazine, announced in July 1929

Last week a select portion of the U. S. public was permitted to buy stock in Shenandoah Corp., a newborn investment trust which came into being with a silver spoon of $102,000,000 resources in its mouth. Eager, the public snapped up one million shares of common, one million shares of preferred, paying up to 42 for common offered at 17½ and up to 60 for preferred offered at 50. By midafternoon of the first day's sale there was no Shenandoah stock available. Brilliant also has been the record of Goldman Sachs Trading Corp., Goldman Sachs Co.'s own investment trust. Issued last December at 104 . . . John Kenneth Galbraith: “It is difficult not to marvel

at the imagination which was implicit in this gargantuan insanity.”

The market tanked in October 1929, as did Shenandoah and Blue Ridge.

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Eventually Goldman brought down the curtain, severely reduced its trading business, returned to investment banking, and with a damaged reputation, survived.

Others did not, and of course, the price was more than lost capital gains. It included ten years of depression.

Adapting to the reality of unconstrained capital gains required a mutation in the controlling institutions. New ideas for constraint and control evolved and the habit of keeping a watchful eye out for those in pursuit of something for nothing gained traction. This traction emerged as new or strengthened collective action—laws, regulations, organizations and more.

Financial and Industrial Instability–A look at instability–Q Theory (quotient or ratio)– Keynes & Tobin

If MV > BV then Q > 1, increased investment If MV < BV then Q < 1, then decreased investment

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Veblen’s QRatio of Market value to Book value

If MV > BV then speculation, Q > 1, means high intangible valueIf MV < BV then liquidation, Q < 1, means loss of confidence and goodwill

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H ( Handicraft/livelihood) Trading (Market /goods prices)MP ( machine process) BC (Business Capital)IP (Intangible property)GW (Goodwill) -- Reputation basis for creditFC Financial Capital -- expected profitsCl (Credit) – first in has differential advantage which spurs others toS (Speculation in BC ) Cs (Additional Credit) /business capital pricesThe path is: (H T) (MP M & Cl BC ) CL (Mark I) 1st degree of separation(IP/GW) FC Cs S) CII (Mark II) Second Degree of Separation

Purchase and sale of securities based on expected future earningsNo end consumer of security – buy and resell to someone who will resell – tends to drive up prices and speculationIncreased Production drives down prices of goods and eventually actual profitHigh prices indicate good times – so this is a sign of hard times - recession

S Cs plus new machines lead to Output Prices

Veblen Financial Instability – Credit Cycle

And eventually Aπ < Eπ

Decline in Market value of Business (BCP)--- Decline in value of intangible property

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The result then is

Liquidation of BC Real sector – loss of goodwill –

reduction of MV toward BV = value of output of goods slowed increase in technological change reduced plant and equipment use and investment rates unemployment of labor

Financial sector – loss of goodwill – liquidation of intangible value MV > BV mostly due to intangible property value based on speculation due to false confidence, fraud and prevailing myths of financeThus fall in MV greater in Financial Sector than Real Sector

Reduced closer to value of tangible property which is relatively small and mostly in labor knowledge

Refinance and reorganization with more control in hands of financial managers

Contemporary examples Savings and Loan Enron, MCI and industry deregulation Sub-prime market – Bear Stearns, AIG, et al

Inadequate recognition of the necessity for institutional adjustment Principles of institutional adjustment – more later

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Financial Instability Stability breeds instability –

Stability leads to comfort and belief that risk is less (example US housing market 1975- 1995)

Expected future income of firm (example, expected 6% average annual increase in US housing prices, used in ratings models) Income of firm – realized vs speculative

Business Fluctuations - Theories

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Production Cycles Marx – simple underconsumptionSchumpeter – innovation and increased investment

End of investment opportunities Lack of creative destruction due to growing firm size and inflexibility

Monetary – Credit CyclesKeynes -- Both production and Monetary & complex underconsumptionVeblenMinsky – financial instability hypothesis – will not go into this-- similar to Veblen in some significant ways

Keynes – Theory of Employment & Money - and Institutional theory

• Fluctuations in economy due to Aggregates – not individuals– Under investment – underconsumption theory of “the trade cycle”– Long term involuntary unemployment

• Solution– Government Borrow and Spend

• Consequences– Deficit finance – functional finance

• Balanced budget becomes part of mythology• Saving is function of income – not interest rate

– Changes the concept of necessity to raise interest rate and other incentives to save

• Capital (physical) accumulation theory of classical theory obsolete (savings centered theory)

• Replaced by knowledge and resource based theory – Resources are a function of knowledge and Become . . . Not “are”– Scarcity as social condition transcends scarcity as natural one11

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To Repeat – Institutionalization of intangible property strengthens instability of financial systems offsetting in part some of the gains of previous institutional changes:Example:A primer on modern housing – Institutional Evolution

Securities, Equity- Debt, from these all else is derived. The innovations in finance are few, just new names for the same things. We add Insurance as a socialization of risk of damage

It has several traits:

•Market Value (MV) = selling price also Collateral value

•A Book Value (BV) = replacement cost

•Debt = Mortgage Balance (MB)

•Equity = MV - MB

•MV > BV = asset appreciation

•BV < MV = asset depreciation

If MV > MB then positive equity

If MV < MB then negative equity

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AS a hedge against MV < MB we developed and expanded several institutions and organizations

1. Down payment, a monetary amount of some percentage of the sales price (MVt), 20 percent in

the early years then less later– Less than 20% usually required “mortgage insurance”

2. Income assurance, rigorous proof of income, employment, etc. (mp ≤ 29% of GAI)

3. Credit rating, a number reflecting an evaluation of the borrowers credit history.

4. Enabling Organizations Local Savings and Loans – Thrifts Capital Federal Savings & LoanArgentine Saving & LoanLincoln NationalFederal Mortgage & Mortgage Assurance InstitutionsFreddie Mac – 1970 – secondary mortgage loan marketFannie Mae – 1938 – national secondary mortgage – less reliance on “thrifts” Securitization of mortgages

VA loans – 1944 – 18 million loansFHA – Federal Mortgage Insurance 1934 – 34 million loansHUD – 1965 Consumer credit rating – credit bureau

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There were ancillary institutions and organizations

Financial Regulation – Interstate or “Branch” Banking Banned Separation of Commercial Banking from Investment Banking (Glass-Steagall Act) Third Party (Independent) Credit Rating Agencies Investment Activity >dominated> Trading Activity

The led to a US housing market and housing that was the envy of the world

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Number of Housing Units Built in US, by Selected years, 1919 and before to

2009

But a House is more than a place to live, it is also an asset, a source of equity and debt.

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Then comes a retrenchment to the old habits

1. A belief in the ever expanding housing market and home prices2. Belief in self-regulating markets to deliver on their utopian promise3. An ideological power structure to assist in removing or forestalling regulatory forces4. Trading as a dominant process for “earning it” 5. SPEED, trading at the speed of light 24 hours per day

This led to

1. Savings & Loan Industry – Deregulated 1981 now can engage in banking activity2. Financial Regulation – Interstate Banking Ban – repealed 19843. Separation of Commercial from Investment Banking (Glass-Steagall Act) repealed 19954. Third Party (Independent) Credit Rating Agencies – compromised 5. Investment Activity > morphs to >Trading Activity – after dot com bubble burst

One consequence was a spawning of new or repackaged investment instruments in the image of Goldman Sachs Trading Company of 1929.

An example

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Credit Default Swap 1 (CDS) — Playing short for the CDO price to go down or to fail (default) – this is roughly equivalent to buying a fire insurance policy on your house with a value greater than MV and then hiring someone to set it on fire. If the CDO goes down, you gain because the CDS (insurance) pays out at the price of the CDO at the time you bought the CDS (the insured amount). CDS 2 – long playing for the CDO price to go up or not to fail (not default) – this is roughly equivalent to buying a fire insurance policy on your house for less than the MV then paying someone to stand watch with a fire hose.

One could buy any combination of the derivatives, CDO (MBS is one) and CDS’s

Now suppose we have an important investment company seeking ratings for instruments that it wants to sell. It uses that position to persuade the rating agency that the instrument is worthy of a high rating.

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Making Collateralized Debt Obligations & Mortgage Backed Securities – Simple Tranche

A AAA

AB B

BB

BC C

CC

CD DD D

D F F FFF

F FF F F

F

Collateralized Debt

ObligationLowest Risk

FundName = Alpha 1

Collateralized Debt

ObligationLow Risk

FundName = Beta

1

Collateralized Debt Obligation

Medium Risk Fund

Name = Junk 1

Collateralized Debt

ObligationRisky Fund

Name = Default 1

Collateralized Debt

ObligationHigh Risk

FundName = Toxic 1

Fair enough, but now the fun starts. We move on to create a “Synthetic”

CDO

These may be rated by a third party and sold based on that rating. The higher the rating the lower the risk and hence the lower the return. Investors may choose the level of risk and return based on the rating and the transparency of the collateral behind the debt. Also, and this is one purpose for these securities, an investor may choose the timing of their income from the tranche they buy.

Rating = AAA Rating = BBB Rating = NANot For Sale

Rating = DDDRating = CCC

A AAA

AB B

BB

BC C

CC

CD DD D

D

Beginning Portfolio of Mortgages

Making Collateralized Debt Obligations – Synthetic Tranche

A AAA

A F F

Alpha 1 Beta 1 Junk 1 Default 1 Toxic 1

B BBB

BC C

CC

CD DD D

D F F FFF

Rating = AAA Rating = BBB Rating = BBB

F FF F F

F

Surplus Toxins

On the theory that several toxic assets in a portfolio are less risky than one of them we create another CDO and rerate it higher.Especially if we can buy insurance and play it short – then we may get a higher rating

We can create many combinations of financial instruments based on the previous portfolios.

With a AAA rating these can be sold to organizations required to buy only AAA securities.

Rating = AAA Rating = DDDRating = AAA

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Goldman Sachs went public in 1999

In 1998 – 72 % of its net income came from investment banking & asset management services

In 2009– 76 % came from trading and the remainder from Investment banking & asset management services

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SEC civil fraud lawsuit, filed in April 2010 Abacus mortgage-backed CDOs

On April 16, 2010, the Securities and Exchange Commission (SEC) announced that it was suing Goldman Sachs and one of its employees, The SEC alleged that Goldman misstated and omitted facts in disclosure documents for a synthetic CDO product it called Abacus 2007. The allegation is that Goldman misrepresented to investors that an independent selection agent, ACA, had reviewed the mortgage package underlying the credit default obligations, and that Goldman failed to disclose to ACA that a hedge fund, Paulson & Co, that sought to short the package, had helped select underlying mortgages for the package against which it planned to bet. The complaint states that Paulson made a $1 billion profit from the short investments CDS’s, while purchasers of the materials lost the same amount. The two main investors who lost money were ABN Amro and IKB Deutche Industriebank. IKB lost $150,000,000 within months on the purchase. ABN Amro lost $840,909,090. Goldman stated the firm also lost $90 million and did not structure a portfolio that was designed to lose money

The New York Times reported that:

After the SEC announced the suit during the April 16, 2010 trading day, Goldman's Sachs's stock fell 13% to close at 160.70 from 184.27 on volume of over 102,000,000 shares (vs. a 52 week average of 13,000,000 shares). The firm's shares lost $10 billion in market value during the trading session. On April 30, 2010, shares tumbled further on news that the Manhattan office of the US Attorney General launched a criminal probe into Goldman Sachs, sending the stock down more than 15 points, or nearly ten percent to $145.

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Goldman Sachs Stock Price 2003-2011

New Theories

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