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Arbitrage: a Critique of the Political Economy of Finance

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Arbitrage: a Critique of the Political Economy of Finance ARBITRAGE: A CRITIQUE OF THE POLITICAL ECONOMY OF FINANCE Carolyn Frances Richter Hardin A dissertation submitted to the faculty at the University of North Carolina at Chapel Hill in partial fulfillment of the requirements for the degree of Doctor of Philosophy in the Department of Communication Studies in the College of Arts and Sciences. Chapel Hill 2015 Approved by: Lawrence Grossberg Sarah Sharma Michael Palm Dick Bryan Michael Pryke © 2015 Carolyn Frances Richter Hardin ALL RIGHTS RESERVED ii ABSTRACT Carolyn Frances Richter Hardin, Arbitrage: A Critique of the Political Economy of Finance (Under the direction of Lawrence Grossberg) In the wake of the 2007-09 financial crisis and growing economic inequality fueled by financial activity, it cannot be left to mainstream economists to define and explain finance. This dissertation reexamines finance and the political, social and cultural foundations ignored by economists. In the first chapter, I argue for the importance of arbitrage, a trading strategy defined by buying low priced securities and selling the same securities for higher prices in two different markets. Arbitrage is the conceptual linchpin of modern financial economics but that discipline fails to explain the source of arbitrage profit. In the second chapter, I explore whether Marxist economics can offer a theorization of arbitrage profit. While much of Marxist scholarship too quickly dismisses the significance of finance, there is room for considering arbitrage to be a form of exploitation. In line with innovative Marxist work on finance, I apply a new framework for understanding value to arbitrage in the third chapter. I suggest that arbitrage can be understood as an apparatus of capture in which value founded on social mattering is captured in uneven relations of power. In the fourth chapter, I review the history of arbitrage and suggest that arbitrage is most successful when arbitrageurs can use advantageous differentials in communication networks and/or price stabilizing derivatives contracts to simulate iii instantaneous trading. A special form of arbitrage I call money machine arbitrage takes place when structural inequalities of price allow for continuous profit making. In the fifth chapter, I offer a final concept necessary for understanding arbitrage as an apparatus of capture: the axiomatic. The axiomatic is the complex system of regulative statements and social relations that enable capture. In the final substantive chapter, I detail the arbitrage in subprime mortgage backed securities in the run up to the 2007-09 financial crisis and sketch some aspects of the axiomatic that can be gleaned from that story. I conclude that the taken-for-granted notion of “risk,” as a necessary way of making wealth and the correlate of return in financial economics, is central to the axiomatic of finance and thus financial profit making. iv To my husband Ted, for your love, support, and endurance. v ACKNOWLEDGEMENTS I’m amazed that I actually wrote this dissertation. In the beginning stages, thinking about the size of the project was overwhelming. But one chapter at a time, I sent it out, got it back, revised, rewrote and sent it out again. I remember glancing at the growing stack of revised chapters, trying not to get too excited because so much work remained. I trusted the process, because I knew that my advisor, Larry Grossberg, would lead me right, and he did. Larry was instrumental in helping me shape the direction of the research and shepherding me through the writing, revising and defending processes. I respect Larry for his brilliance and his bravery, but even more now for his generosity as a mentor. I’m also grateful to Dick Bryan, who steered me to focus solely on arbitrage, offered very constructive comments on early drafts and gave a vigorous examination in the defense. I appreciate his unending support and friendship. Sarah Sharma, Michael Pryke and Michael Palm have also offered generous support to me during my dissertation research and writing, answering my queries, offering advice and reassurance, and reminding me of the responsibility of interdisciplinary work. The ideas in this dissertation were often stimulated and refined through conversations with two partners in crime: Robert Wosnitzer and Adam Rottinghaus. Robert offered his technical expertise as a former bond trader, his critical perspective as a scholar working on the culture of finance and his almost unbelievable kindness as a vi cheerleader and friend. Adam provided the amazing figures in chapter six as well as generative conversations at the Carolina Coffee Shop about the ideas in chapter four. Some of those ideas ended up in a co-authored article we published in the Journal of Cultural Economy. Adam was one of many fellow travelers pursuing Ph.D.s in Communication Studies at UNC-Chapel Hill who formed a sometimes loving, sometimes crazy group of comm-rades. Shout-outs to Erin Arizzi, J Beckham, Bryan Behrenshausen, Jen Cronin, Chris Dahlie, Andrew Davis, Jade Davis, Jonathan Foland, Julia O’Grady, Kashif Powell, Jes Speed, Armond Towns, and Grover Wehman. Chris Lundberg offered an incredible combination of intellectual stimulation, material support and spiritual guidance. Rachel Taicher kept me grounded in mommyland. Carolyn Ellison calmed my nerves. Barry Katz, Belinda Novik and Pablo and Hunter Vega knew I could do it. Finally, my family supported me in countless ways. My mother, Mary Richter, read every word at least twice and helped me enormously with editing and formatting. My husband Ted held the fort during long months of writing from the wee hours of the morning until far too late at night. And my beautiful children, Tyson and Troy, who gestated and grew through the process, gave me excellent reasons to keep going, and to take breaks to play Legos. vii TABLE OF CONTENTS LIST OF FIGURES………………………………………………………………………………x LIST OF ABBREVIATIONS……………………………………………………………………xi INTRODUCTION…………………………………………………………………….…………xii CHAPTER 1: ARBITRAGE AND THE EMBEDDED DISEMBEDDEDNESS OF FINANCE…………………………………………………………………………………….1 Economics and the Context of Prices……………………………………………….10 A Topical History of Financial Economics…………………………………………..12 The Paradox of (No) Arbitrage……………………………………………………….33 Conclusion……………………………………………………………………………...44 CHAPTER 2: ARBITRAGE AND MARXIST THEORIES OF FINANCE………………....47 Marx on Finance……………………………………………………………………….52 Conclusion……………………………………………………………………………...72 CHAPTER 3: ARBITRAGE AS CAPTURE………………………………………………….74 Rethinking Value……………………………………………………………………….75 Arbitrage as Capture…………………………………………………………………..85 Conclusion…………………………………………………………………………….104 CHAPTER 4: ARBITRAGE AND “RISK”: TIME CONTINGENCY AND SIMULATED INSTANTANEITY…………………………………………………………………………….108 viii Time Contingency…………………………………………………………………….109 Simulated Instantaneity……………………………………………………….……..115 Money Machine Arbitrage…………………………………………………………...132 Conclusion…………………………………………………………………………….134 CHAPTER 5: ARBITRAGE AND THE AXIOMATIC………………………………………137 Postone’s Critique of Traditional Marxism………………………………………....139 Axioms and Social Relations………………………………………………………..141 A Contextual Theory of Value……………………………………………………….144 A Critique of the Political Economy of Finance……………………………………146 Conclusion…………………………………………………………………………….147 CHAPTER 6: ARBITRAGE AND THE SUBPRIME MORTGAGE CRISIS……………..149 Subprime Mortgage CDO Arbitrage………………………………………………..153 The Context…………………………………………………………………………...163 The Axiomatic………………………………………………………………………...181 Conclusion: The Crash………………………………………………………………195 CONCLUSION: THE EMPEROR IS NAKED……………………………………………...202 BIBLIOGRAPHY……………………………………………………………………………...214 ix LIST OF FIGURES Figure 1 – Typical Subprime Mortgage Securitization……………………………………156 Figure 2 – Typical Collateralized Debt Obligation Deal…………………………………..158 x LIST OF ABBREVIATIONS ABS Asset-backed securities BSM Black-Scholes-Merton CAPM Capital Asset Pricing Model CBOT Chicago Board of Trade CDO Collateralized debt obligations CDS Credit default swaps CME Chicago Mercantile Exchange DOT Designated Order Turnaround FCIC Financial Crisis Inquiry Commission FHA Federal Housing Authority GSE Government-sponsored enterprise HFT High-frequency trading HUD Housing and Urban Development MBS Mortgage-backed securities NASDAQ National Association of Securities Dealers Automated Quotation NAV Net Asset Value NINA No income no asset NYSE New York Stock Exchange SEC Securities and Exchange Commission SSF Social studies of finance xi INTRODUCTION In 2012, as the resonances of the global financial crisis that unfolded between 2007 and 2009 were beginning to fade, Richard Gere starred in Arbitrage, a film about the morally ambiguous decisions of a hedge fund manager whose mistakes harm his investors and his family and friends.1 Although the plot includes fraud, infidelity and death, there is not a single mention, much less depiction, of the financial strategy for which the film is named. This omission mirrors the attention given to arbitrage by outside observers of finance. Particularly, work on finance in the critical humanities and social sciences, which was reinvigorated by the financial crisis, scarcely mentions the term. Important critiques of finance such as David Harvey’s A Brief History of Neoliberalism, Christian Marazzi’s The Violence of Financial Capitalism, and Karen Ho’s Liquidated: An Ethnography of Wall Street leave out the term altogether.2 I began my own investigations of finance with this literature, and so was bewildered by the pervasive use of the term when
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