How the State uses law to create value from nothing…

Katharina Pistor has a fascinating piece on financial history:

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.

She points how today’s financial firms and crisis in them are all similar to previous firms and crisis in them:

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. 

loser 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.


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