How the Government Fosters Market Instability

The U.S. government promotes instability in the financial markets. Not intentionally; but its policies have that effect. Here’s how.

Low Interest Rates. Interest rates once reflected the time value of money--that is, the value that a lender placed on a dollar in the future versus a dollar today. Today, interest rates are established to a large degree by central banks such as the Federal Reserve, as a way of controlling the rate of economic activity. The market dynamic of individual--atomistic, to use the economist’s term--lenders and borrowers interacting with each other to find interest rate equilibriums has been superseded by centralized decisions about the government’s preferred rates of inflation and economic growth. The Federal Reserve kept interest rates low. Recall Econ 101. When the price of something is low, people consume more of it. Since the government kept the price of credit low, people have borrowed more heavily. Large amounts of borrowed funds were used for speculative investment, which inflated asset prices, especially real estate values. That, as we have discussed before (http://blogger.uncleleosden.com/2007/08/uncle-alans-legacy-at-federal-reserve.html), ended with things spinning out of control in the now falling real estate markets.

Risk-based Capital Standards. The Federal Reserve and the central banks of other industrialized nations apply risk-based capital standards to the commercial banks they regulate. In other words, the higher the risks of the assets they hold, the more capital they must maintain. These standards, in effect, raise the costs for banks to hold relatively risky assets like many private sector loans. That would include mortgages, credit card balances, and corporate loans. To keep their capital requirements and expenses down, banks sold off much of their loan portfolios to investors. The problem is that these investors represent a flightier “deposit” base than traditional depositors. When confronted with uncertainty, they stopped making deposits (i.e., stop buying loans from the banks), and tried to extract the money they’d already invested in assets purchased from the banks by dumping those assets on the open market. That led to the buyer’s strike in the CDO market, the commercial paper market, the leveraged buyout market and the overall corporate debt market.

The risk-based capital standards didn't restrain banks from creating risk. The banks created vast amounts of risk and purportedly transferred it to investors because they dodged increased capital requirements and received nice inflows of fee income for doing so. But those risks rebounded back at the banks to the tune of $20 billion plus in recent write-offs, and perhaps more in the future. Bank regulators apparently didn't appreciate that it's extremely difficult for a bank to fully separate itself from a loan it's made. Investors won't buy every risk inherent in a loan; just a contractually defined set of risks whose meaning lawyers can squabble over for years. And bank regulators may not have fully understood the extent to which banks used off-balance sheet vehicles to "purchase" the risky loans the banks were creating. See http://blogger.uncleleosden.com/2007/09/conduits-and-sivs-chill-from-shadow.html. These investment vehicles were usually funded by the banks, and their losses sometimes became the banks' losses. The banks may not, in many cases, have transferred the risk of loss after all. Risk-based capital standards may have made regulators focus too much on the banks' accounting practices, instead on their lending activities. And those activities did much to destabilize the markets.

Tax Policy. The structure of the tax system discourages prudence and encourages risk-taking. Interest from bank deposits, money market funds, bonds and other conservative investments is taxed at high ordinary income rates. Long term capital gains and qualified dividends are taxed at lower rates. Buying a home is favored with mortgage interest and property tax deductions, and the exclusion of gains from income taxation (up to $250,000 for individuals and $500,000 for married couples). While investing in common stocks and real estate confers benefits to society up to a point, the 2000-01 stock market crash, the recent real estate bubble, and older events like the stock market crashes of the 1970s and 1930s demonstrate that over-investment in these particular asset classes can be a problem. But with income from savings taxed at ordinary rates, people have little incentive to invest conservatively and thereby provide a stable pool of capital for borrowers. (The overall negative savings rate of American households demonstrates the point.) Thus, too much capital—whether it be for mortgage, credit card, or corporate loans, or even the federal government’s borrowings--seems to come from flighty investors in the financial markets. Much, perhaps too much, of that capital is short term and ready to fly off to the European Union or Japan on a moment’s notice.

Federal Deficit. The enormous federal deficit is funded to a large degree from overseas. Ordinarily, one would expect the deficit to push interest rates up, since it competes for a large quantity of the world’s holdings of dollars. The Fed, however, has dealt with that problem by holding interest rates down. But the large quantity of Treasury securities held overseas adds to the pressure on the dollar. As the dollar declines, investors will sell off dollar-denominated assets, adding to their volatility.

Lack of Regulation of Derivatives and Hedge Funds. It has been government policy for 20 or more years to refrain from regulating over-the-counter financial derivatives and hedge funds. Hedge funds investing in over-the-counter financial derivatives are at the heart of the current credit crisis. The lack of regulation left the government unaware, until too late, of the reckless use of poorly conceived adjustable rate mortgages that were sometimes marketed through hucksterism and fraud in enormous amounts and packaged into carelessly constructed financial derivatives that presented exceedingly high levels of risk that may not have been fully disclosed to investors. The regulatory shortfall also left the government, at the moment of crisis, not having sufficient detailed information about the high degree of leverage used to finance the intertwined investments, liabilities and exposures of market participants. As a result, it made policy based in part on anecdote and guesswork. The rationalization for not regulating derivatives—that sophisticated market players would use them to spread risk and smooth market turbulence—sounds strained in light of the continuing credit crunch and the $20 billion or so that major financial institutions have written off in the last few weeks. Somehow, in spite of all the brilliant minds on Wall Street, a few tens of billions of dollars of risk wasn’t spread around. And the rationalization for not regulating hedge funds—that they’re market pros who know what they’re doing and regulation would only interfere with their rational allocation of capital—might still be useful as a gag line on late night television, but not much more.

The private sector had the perfect opportunity to get its act together after the Long Term Capital debacle. But it did not heed the warning, since annual bonuses beckoned and the losses that might emerge five years hence were problems for five years hence. The regulation of derivatives and hedge funds can be tailored to focus on the problem areas (http://blogger.uncleleosden.com/2007/08/financial-engineering-money-maker-and.html). But, after everything the hedge funds and their derivatives investments have done in recent months to disturb our tranquility and equanimity, the head-in-the-sand act by the regulators no longer washes.

The government doesn’t bear primary responsibility for the subprime mortgage mess. That falls on the mortgage brokers, banks, investment bankers and hedge fund money managers that created and invested in the dumb mortgages and derivatives that created the losses. These people naturally are the first to call for Federal Reserve interest rate cuts, since they need to foist responsibility on the government before the class action plaintiffs lawyers can get a foothold.

The government doesn’t intend to foster instability; indeed its policies are meant to have the opposite effect. But policies that might have originally served sound purposes now sometimes have unintended consequences. Financial institutions, investors and ordinary citizens are discouraged by the government from subscribing to old-fashioned virtues like prudence, thrift, and moderation.

In heat of crisis, we focus on whether or not we can hear the distant bugle calls of the cavalry riding to the rescue. Fortunately, the Federal Reserve can still, if necessary, fire a few more volleys with monetary policy. However, it will run out of ammunition sooner or later, especially if inflation flares up. Then what? The federal government no longer has a fiscal policy; it simply engages in deficit spending without the slightest hint of restraint. With the tax structure punishing savers, there isn’t much of a domestic pool of capital to finance new private sector investment. The decline in the dollar will motivate foreign sources of capital to demand exceedingly high premiums. So the question remains: then what? When one looks at the last 20 years in Japan, with speculative bubbles in the late 1980s in its stock and real estate markets, followed by stagnation that continues to this day, one can see how an economic juggernaut that lets speculative risk run riot can end up in limbo for a long time.

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Banks Dancing with Hedge Funds

On August 9 and 10, 2007, the last two business days of the previous week, European and U.S. bank regulators injected billions of dollars worth of liquidity into the financial system because of fallout from the subprime mortgage mess. They also expressed sympathy for those that have money invested in the financial markets. But they didn't lower interest rates, and some European regulators even made some noise about raising interest rates. What's with the good cop, bad cop routine?

The regulators are struggling with the dual nature of the world financial system. Part of the system is heavily regulated. These would be the commercial and investment banks. The other part of the system is essentially unregulated. These would be the hedge funds. Both parts of the system operate side by side, doing business with each other in ways that have made them become financially intertwined.

Banks, being heavily regulated, are usually pretty transparent. They have to report their financial condition, and reveal their activities. Examination staff from the federal bank regulators, and inspection staff from the SEC, from time to time visit the banks within their respective jurisdictions to sniff them over. Indeed, federal examiners are continuously on site at the largest commercial banks.

Hedge funds, on the other hand, are virtually unregulated. An attempt to require them to register with the SEC and provide some information about what they were up to was given the thumbs down by the U.S. court of appeals in Washington, D.C. The SEC has been trying to figure out where to go next. But the reality for now is that no one knows what the hedge funds have been doing, where their financial exposures and liabilities are, and how much of a threat to the world financial system they present.

Banks and hedge funds interact in a number of ways. Banks loan money to hedge funds. They sell investments to hedge funds, making commissions and perhaps trading profits, and buy investments from hedge funds, making more commissions and perhaps more trading profits. Banks and hedge funds enter into derivatives contracts, which adds to their liabilities to each other. Some banks may sponsor hedge funds, so they can earn even more money from asset management contracts (that 2% and 20% formula would not have escaped the bankers' attention), and their own proprietary investments in the hedge funds.

All this is hunky dory in a rising market. After all, there is hardly any risk that isn't worth taking in a rising market. Hedge funds proved to be extremely successful. (Then again, who isn't successful in a rising market?) So they grew--and grew and grew. As they grew, so did the amount of intertwined liabilities they had with the regulated part of the financial system, the banks.

However--and in the financial markets, there will always be a however--the market stopped rising. In this case, it was the real estate market. And when the real estate party ran out of booze, mouths dried out and heads started to pound.

At this point, the intertwined liabilities of the banks and hedge funds became, well, liabilities. There wasn't a rising market to smooth them over. Some of them--like margin loans--actually became due and payable. Others, like derivatives contracts, may be partially or entirely uncollectible from hedge funds that have collapsed or shut down. The fee income from ailing hedges is likely to be much lower than it is from the healthy ones. (The ailing ones don't buy as many investments, and the 2%/20% formula is a lot less rewarding when the fund's assets are shrinking like a falling souffle.)

Banks live on a cushion of credit. That may sound strange for institutions that hold so much money. But both investment and commercial banks avidly borrow money every business day for a number of different purposes, and couldn't survive without credit. Ordinarily, banks have an easy time borrowing, since much is known about their activities and financial condition, and because they are heavily regulated (which fosters confidence among customers and creditors).

But with the subprime mess, things have changed. The banks' exposures to hedge funds are largely indeterminate right now. And creditors hate uncertainty. Word on the Street has it that a shipload of losses (well, you know what we mean) from the subprime mess lurks somewhere in the financial system. But there ain't too many folks owning up to those losses.

In such a shadowy environment, lenders pull back. Banks that may or are rumored to have subprime exposure suddenly find it hard to borrow. Without credit, they cannot operate, and are at risk of collapse. Credit for banks is like air for humans--without air, humans expire quickly. Without credit, banks go under and very quickly.

That's why the bank regulators infused liquidity into the financial system last week. Banks that couldn't otherwise breath needed emergency oxygen. However, this is just treating the symptoms. The patient is still breathing, but we can't tell if his condition is stabilized. The root causes of the problem--outsized and reckless risk taking by hedge funds and their bank lenders--remain to rear their ugly heads another day.

One could argue that surely the financial services industry will learn from this experience and be more prudent in the future. After all, a co-president of Bear Stearns and senior executives at a German bank lost their jobs because of subprime stumbles. Hedge funds have collapsed and tastelessly opulent apartments on Fifth Avenue remain unbought.

Let's remember, though, that we've been here before. In 1998, Long Term Capital Management did the love-that-leverage dance, only to end up with a beyond-the-stress-testing-of-our-computer-model mess. The Federal Reserve had to deputize a posse of large banks to ride to the rescue. Perhaps we smell a faint whiff of moral hazard here. The financial services industry's learning curve was apparently warped by the 1998 bailout. Instead of focusing on finding effective ways to identify and manage risk, the industry leaped into the next rising market (this time, real estate) and exuberantly took up where it had left off.

The regulated bank-unregulated hedge fund relationship is like a couple on the dance floor, where one person is doing the tango and the other the waltz. Sooner or later, they will trip over each other. But even with the couple now sprawled on the floor, regulation of hedge funds remains political anathema. Leading politicians can hardly bring themselves to speak of it. So, instead of discussing that whose name shall not be spoken, let's call it broccoli.

Broccoli is quite common. The banking industry has been eating broccoli since 1913, with the creation of the Federal Reserve System. It ate more broccoli in 1933, with the creation of the Federal Deposit Insurance Corporation. Today, both the Fed and FDIC are part of the bedrock of the financial system. The securities industry has been eating broccoli since 1934, and the SEC, too, has become part of the bedrock of the financial system.

Broccoli proved to be very good for banking. It restored depositor confidence, and has prevented the widespread bank failures that plagued the United States before 1933. Broccoli also did much to restore investor confidence in the stock markets. The mutual fund industry, which eats a lot of broccoli, has been one of the fastest growing segments of the securities industry in the last 30 years.

Hedge funds may account for 20% or more of the trading in the stock markets. They engage in untold amounts of derivatives trading and other investment activities. Intertwined as they are with the regulated part of the financial system, their losses create systemic financial risk, and ultimately become our losses. Yet, without any broccoli, there is no way to ascertain the scope or extent of the dangers they pose. When hedge funds first emerged 50 to 60 years ago, they were small and posed no danger to the general public or the taxpayer. Today, neither is true.

Many hedge fund managers have recently been having a new and unpleasant experience. They've received withdrawal requests. 2% and 20% of zero is zero. In the past, they knew what it was like to have investor confidence. Now, they are finding out what it's like to lose investor confidence. Investors are only doing what's rational. They don't know squat about what's going on, and pulling out their money is the one thing they understand.

With hedge funds being such a large part of the financial system, they can now subject the U.S.--and the world--to the types of financial panics that plagued the 19th and early 20th centuries. A historical footnote: some of the men who couldn't find jobs as a result of the financial panic of 1873 joined the Army and rode under George Custer's command into the Little Bighorn valley in 1876. There, they learned that financial panics have all sorts of undesirable consequences.

The current financial panic is driven by fear. Remember that when FDR said that we have nothing to fear except fear itself, he didn't merely offer words. He also offered a serving of broccoli. It proved to be good. The issue of whether hedge funds should eat some broccoli deserves reconsideration. It need not be an enormous serving. Probably moderate amounts would have significant health benefits. The patient is ailing today. And if broccoli helps, the hedge funds may find they like the stuff.

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