The dream of making something from nothing is an old one. The Alchemists of the Middle Ages worked tirelessly to create a recipe for gold, the material from which money was coined and was used to store value. The physical sensation of holding a gold bar is a world apart from holding a stack of paper money wrapped in a carton like copy paper, or from watching intangibles move at the stroke of a key. On a private tour of the New York Fed’s gold vaults, my students and I were allowed to hold a bar of gold. We were tickled by its weighty physicality and amused to learn how that Fed employees physically move the gold bars from one vault to another when executing a transaction between two sovereign nations that keep their gold there. We had just spent the term studying the ingredients of money: not precious metals or forge-proof paper, but law.
If there ever was a magic ingredient for seemingly making something from nothing, it is law. Law can transform a simple commitment into an enforceable claim. And with a few additional legal steroids that grant asset holders priority, durability, convertibility and universality, law can turn a simple asset into a capital asset, as I explain in my new book The Code of Capital. Notes, currencies, bonds, asset-backed securities (ABS), and their derivatives exist only in law; without it markets for these assets would neither exist nor have scaled to multi-trillion-dollar markets that span the globe. The history of credit, or private money, is thus inextricably linked to the willingness of states to throw public power behind private commitments made on an unknown future.
France’s haute cuisine was not created overnight; it evolved over centuries in a process of trial and error, through endless efforts to refine the ingredients, the tools and the cooking processes. And so similarly was the evolution of minting private money from law. First came notes, or IOUs, the most basic form of private money. Then, the notes were placed on legal steroids, which gave us the bill of exchange. In legal parlance, they were made “negotiable”: anyone in possession of the note could now demand payment, not only from the original debtor, but from anyone who had endorsed the bill with a signature on the back. And no one who had endorsed the bill could raise objections that arose of the contract for which they had accepted the obligation. Cloaked in these creditor protection devices, bills became highly fungible, or money-like. Long chains of payment commitments linked producers to markets, creditors to debtors, cities to the country side, and major trading centers to each other in early modern Europe. These webs of bills became our first payment system thanks to legal protections offered by common law courts and to special statutes that trading cities throughout Europe adopted to ensure that they could be enforced in their jurisdiction.
Ever since, private money has proliferated, taking new forms along the way: Corporate bonds, asset backed securities, derivatives and claims stacked on top of one another to create squared and cubed variants followed suit. Dissecting these assets into their legal compounds, we find the basic elements of the code of capital: property, collateral, trust, corporate, bankruptcy, and contract law. These devices shield asset pools from too many creditors; they create priority rights by some claimants over others, and they make it possible to tailor assets to the specific needs of investor – to feed their risk appetite or their need for regulatory arbitrage. Refined and perfected over time, the basic legal ingredients have remained remarkably stable throughout the centuries – even as acronyms and financial jargon suggest new creations.
In the end, all cooking is done with water, even in France where in the nineteenth century the Péreire brothers invented the Crédit Mobilier, the first leveraged banking operation on a large scale. They called their invention “banking without money”. They established a bank (the CM), capitalized it with only partially paid up shares, raised additional funds from bond holders and depositors, and invested in major infrastructure projects and banking ventures across Europe. The bank paid huge dividends to attract new shareholders, which in turn attracted more creditors, so that, for a while, the bank boomed. However, it all ended in tears with a bail-out orchestrated by the Banque de France. And yet, the basic scheme was soon emulated by others: “ponzi finance”, or leveraged investment in need of constant refinancing, as Minsky would much later call it, was born. It treats creditors like shareholders in regards to the risk they assume but without the upside potential, as Karl Marx put it dryly in his scathing review of the CM. Writing years before it crashed, he drew a comparison to the paper money scheme, that the Scotsman John Law had sold to Louis XV a century earlier:
“The Regent of France, that worthy sire of Louis Philippe, tried to get rid of the public debt by converting the State obligations into obligations of Law’s Bank; Louis Bonaparte, the imperial Socialist, will try to seize upon French industry by converting the debentures of the Crédit Mobilier into State obligations. Will he prove more solvent than the Crédit Mobilier? That is the question.”[1]
Whether a state is more solvent than the bank that threatens to de-stabilize its financial system is a question that has continued to haunt us ever since. Some states tried to tame the beast by suppressing the private money minting process, whereas others – foremost among them the US and the UK – have encouraged aggressive financial engineering and lent their own law, their courts, and central banks in support. These two countries also belong to the privileged groups of countries that enjoy full monetary sovereignty, meaning that they don’t need to worry about insolvency.
It took a while, but after “banking without money” we got “returns without investment,” as Robert Merton described the aspirations of the hedge fund Long Term Capital Management (LTCM) of which he was a co-founder.[2] He, along with his co-laureates of the Nobel Memorial Prize in Economic Science put their option pricing theory into practice by setting up a legal vehicle organized as a limited partnership that was legally designed to ensure that it would not be regulated as bank. Once the regulatory costs were put to rest, LTCM raised billions of dollars in debt to invest in sovereign debt issued by emerging markets. It gambled that the yields on the debt of emerging markets would converge with yields on similar assets issued by developed countries and positioned itself as a market maker for the relatively illiquid debt of the former.[3] The Russian sovereign default in 1998 upended the hope of quick convergence and threatened the survival of LTCM. Luckily, LTCM’s private creditors were solvent enough to bailout the fund, the latter swapping their debt for equity and thereby assuming the upside potential of share ownership. Still, the Fed’s involvement in orchestrating the bailout indicates the threat LTCM had posed to the stability of US Treasuries, the instruments LTCM had shorted.
Ten years later, in March of 2008, Bear Sterns needed a $30 million dowry from the Fed to force JP Morgan to utter “yes” in their quickly arranged shot-gun marriage. Only six months later, Lehman Brothers stumbled under its debt, but this time around, a private suitor could not be found. The government faced the option to bailout the investment bank or let it go, and it chose the latter. The rest is history – but a history that requires further probing into the legal structures that were used to build a global financial system that threatened to come crushing down on us.
Closer scrutiny suggests that Lehman’s structure was remarkably similar to that of the Crédit Mobilier (CM). Unlike CM, it did not invest in infrastructure, but it issued and traded in what seemed to be highly liquid financial assets – just as LTCM had done. Lehman Brothers had over 200 registered subsidiaries as well as many more investment vehicles. The shares of these subsidiaries comprised the major assets of the parent, which guaranteed the debt its subsidiaries and sub-subsidiaries raised. Lehman operated as an integrated global financial intermediary with its profit center in New York. It made use of every legal tool in the kit to carve out assets, shield these assets from a multitude of competing creditors, and raise funds on repo markets, all the while ploughing profits back to the parent company’s shareholders. When the market for these financial assets dried up, liquidity evaporated. The only truly liquid asset available at that point was (and always is) state money – but Lehman was denied access to it. When the Fed determined that Lehman had no adequate collateral to lend against, this meant the end of Lehman.
In recent years, capital structures similar to that of Lehman have surfaced in several high-profile bankruptcy cases, including old fashioned companies such as Eastman Kodak and Toys “R” Us. They were split into dozens of legal entities, each raising debt finance from creditors who had direct recourse only to the assets in that entity. However, just as in the case of Lehman, the parent company guaranteed the debt of the subsidiaries, effectively waiving the benefit of limited liability that comes with owning shares in a corporation. This leaves creditors with the option to enforce only against the subsidiary, should it default, or to invoke the parent’s guarantee and in doing bring down the entire group. Financial structures like these have been hailed in the literature as efficient, because they allow a creditor to better monitor their loans.[4] In fact, as Marx noted with regards to the CM, they leave these creditors with a risk similar to shareholders but without the upside potential.
Indeed, non-financial companies tend to adopt such debt structures only when they have exhausted all other options. Their ownership structure also makes a difference. Private equity or hedge funds tend favor these arrangements, because they can shift the risk of future default to creditors while benefiting from cash flows in the form of dividends, or better yet, optional share repurchases to lock in any gains in the meantime. After asset backed securities, the balance sheets of non-financial corporations are increasingly being turned into hosts for shadow banking practices. Critically, they employ legal coding strategies that have helped turn simple assets into capital for monetary gains for centuries. If this process will continue unabated, which governments will have the political will or financial capacity to prevent a future financial meltdown? That is the question we now face.
[1] Karl Marx, New-York Daily Tribune, No. 4751, July 11, 1856, available at http://marxengels.public-archive.net/
[2] Quoted from an Interview in McKinsey Global Institute. “Mapping Global Capital Markets.” New York: McKinsey Global Institute, 2008.
[3] Mehrling, Perry. “Minsky and Modern Finance: The Case of Long Term Capital Management.” Journal of Portfolio Management Winter 2000 (2000): 81-89.
[4] Casey, Anthony J. “The New Corporate Web: Tailored Entity Partitions and Creditors’ Selective Enforcement.” The Yale Law Journal 124, no. 8 (2015): 2680-3203.
