Public Policy and the Art of Arbitrage

The announcement of Federal Reserve chairman, Bernanke to adjust mark-to-market accounting rules employs a financial tool that determines asset valuations at a particular time. When he suggested that the rule would be eased to facilitate selling the bad assets with a quick and favorable valuation, the stock market rallied on what made the assets bad to begin with.

Bernanke is acting to make good the organizational model that makes the assets bad by making the assets good, manipulating an abstract accounting trick that gives the assets arbitrage value. The fundamental value of the assets--the lack of value due to a lack of income to pay the underlying mortgage debt obligation--is still bad because that value was leveraged into a securitized debt obligation and sold, marked to market, when it was overvalued. The investment made was an arbitrage that did not give value to the fundament. When the leverage unwound, the debt renderred worthless was being hidden off balance sheet to avoid being marked to the market valuation. By easing the rule, the Federal Reserve Bank is attemting to reveal the hidden valuation, give it value and liquidity.

The measure is Hamiltonian. It operates to save the organized dimension of "too big to fail" argued as the result of a free market mechanics, rewarding success in the marketplace with the large size that defeats the function of the free market in which firms inimical to the public welfare will fail. It is a measure that causes the demand for government, not prevent the need for government that the premise of his action advances in support of the free-market mechanism.

While it is politically elegant to lend survivability to a failed model of organizational power, within the Ivy-League list of possible alternatives, economically it is pure junk!

Public policy that confirms the practices of private power that has led to the current crisis will not save it. It will make it worse and the effect will be to discredit what will both prevent crises and the need for government--free-market economics.

When the Federal Reserve announces it will only act to promote ensuring a competitive multiplicity (pluralism) of the marketplace, organizing the economy to prevent economic entities that are too big to fail and threaten the stability of the entire economic structure, is when we will have a technical support for solving our problems rather than saving them.

The Federal Reserve's announcement to increase oversight of banking and lending will combine with Treasury's announcement next week on what will be done to dispose of the bad assets.

Treasury secretary, Geitner looks to attract private capital to buy the bad debt, rather than a public debt to be paid with a more progressive tax code, which will need to be more than worthless at the time of sale and resale. That will be by manipulation of the accounting rules at any particular time or point of the arbitrage transaction that determines the taxable gain on the capital invested in the banks by buying their bad debt, giving liquidity to the leverage that caused the bad debt, and giving us the political-economic phenomenology of successfully failing (see the article, "Restructuring the Elements of Power" at griffithlighton.blogspot.com).

At the same time, congressman, Barney Franks has proposed reactivating the "uptick rule." If arbitrageurs must wait for an uptick to sell short, there is an indication that values are being manipulated on the bid and shorting the bad assets is less likely to occur. That would help give value to the bad debt the taxpayer bought that is essentially worthless because the fundament of its value--the income necessary to pay the debt--has not been supported. Its secondary, derivative value--its leveraged, arbitrage value--is getting the technical support.

Citigroup's report of a quarterly profit provided technical support for equities that, combined with the possibility of favorable accounting rules for valuing the remaining bad debt and diminished capacity for the false technical indicators of short selling practices, comes at a time when equity ownership (the capital) has been largely consolidated.

Both measures, and the timing, to change the technical rules to support asset valuation are Hamiltonian, avoiding support at the fundament of the value--the income to pay the mortgage so that all the parties (the class elements of the power structure) benefit. Rather, the system is maintained in zero-sum in keeping with the Hamiltonian model and recovery will occur to recycle the consolidation of fundamental value with the art of the trage leading the way.

The political economy, rather than lending regulatory stability to the market, operates to add volatility, providing the medium for the art of arbitrage that gains the capital and gives liquidity to the leverage (see the article, "Rebuilding the Economy" at griffithlighton.blogspot.com).