Financial Stability Ch 24: Why Stable Markets Are Mathematically Unstable

Book: Financial Stability: Fraud, Confidence and the Wealth of Nations
Authors: Frederick L. Feldkamp and R. Christopher Whalen
ISBN: 978-1-118-93579-8

Chapter 24 tackles the hardest question in the book. U.S. markets recovered from 2008 faster than most of the world. By early 2013, credit spreads traded near or below the complete-market bands in Charts 9.1, 9.2, and 9.3. That is Adam Smith’s equilibrium: the minimum cost of keeping the great wheel of circulation spinning. Ideal for productive capital growth.

So can the world sustain equilibrium without spawning new crises? The authors say yes, but only if you accept a paradox that most investors hate.

Stability breeds instability (by math, not opinion)

When spreads rise above equilibrium, growth suffers. When they spike, crisis follows. The U.S. now has enough policy experience to handle fear-driven spread spikes. The harder problem is what happens when spreads sit low and calm.

At equilibrium, the same laws of mathematics that guarantee recovery during crisis also guarantee instability during peace. Investors move money in and out repeatedly. When cash flows change direction more than once, return on investment can have multiple valid solutions. You cannot say with certainty how an investment performed.

Tom Savage, the mathematician who built AIG Financial Products, proved this in the early 1980s while drafting the first stand-alone CMO prospectus. A calculator kept showing different equity tranche returns from identical inputs. Savage told the writer: “All your answers are correct.” Same story with a leveraged lease marketed at 30% return that a buyer recalculated at 6%. Both rates were right.

The Duke of York nursery rhyme captures the mood. When spreads head up, bad. When they head down, good. At equilibrium, “when they were only halfway up, they were neither up nor down.”

Low spreads mean more fraud, not less

Narrow spreads give brokers incentive to create more transactions. Each transaction raises the odds that expected gains were exaggerated. Very few periods of sustained low credit spreads have ended well. That is axiomatic under the math.

Instability and fraud rise together at equilibrium. More investments require multiple cash inputs and produce multiple rates of return. That is the two-measure duplicity that has defined fraud for 4,000 years. The leveraged lease fix would have been disclosing both the 6% and 30% returns upfront. Harder sell. Only honest sell.

Too-big-to-fail enters here too. When fraud rises, brokers want government guarantees on returns that might later trigger investor rescission claims.

Burst small bubbles, kill too-big-to-fail

Long-term stability means balancing mathematically assured instability. End too-big-to-fail. Maximize anti-fraud pressure in good times. Pop bubbles while they are small, knowing new ones will form. Never let one grow too big to burst without systemic damage.

The dot-com bust of 2000-2001 hurt investors but did not threaten 1930s-style debt deflation. The 2007-2009 crisis did. The difference was scale and hidden leverage inside government-guaranteed entities.

SIVs, S&Ls, and true sales

Politicians learned in the 1980s that high-risk S&L deposits created jobs like government spending without budget line items. That became an off-balance sheet Ponzi scheme backed by federal deposit insurance. The late 1990s and early 2000s repeated the pattern with fraudulent SIVs and sham asset sales the FDIC tolerated.

AIG Financial Products was uninsured but so entangled with insured banks like Citigroup that failure threatened the whole system. Fraudulent SIV use largely ended once regulators recognized manager liability for SIV losses. Sham sales will end when accountants and lawyers uniformly apply the FASB true-sale standard from 1997 and the FDIC’s 2010 acceptance of it. The book’s appendix gives auditors a six-test worksheet and a model legal opinion.

Sustained financial stability is attainable. It requires worldwide cooperation among financial professionals, regulators, and investors. All three must agree to do the right thing. That is the part history has never guaranteed.

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