A recent story from Bloomberg.com reported that two large banks, Goldman Sachs and J.P. Morgan Chase, are using their market power to secure extra large helpings of collateral in derivatives transactions with hedge funds. http://www.bloomberg.com/apps/news?pid=20601109&sid=af6uIAFTSorY. For example, Goldman reportedly obtained $110 billion more in collateral on derivatives transactions than it paid out. In effect, it got $110 billion in low cost funding that it could reinvest at a profit. J.P. Morgan Chase netted $37 billion in a similar way.
On one level, we're glad that hedge funds dancing in the derivatives market are subsidizing Goldman and J.P. Morgan. Otherwise, the Fed might feel compelled to print more money to ensure plenty of cheap funding for the too large to fail.
But the Bloomberg story states that these two behemoths of the financial markets had their way with counterparties because of their market power. In the post-2008 financial markets, there are only a few firms that offer some derivatives products sought by hedge funds, and those few evidently make their customers pay full freight and perhaps more.
On the level of economic theory, oligopolistic behavior is undesirable because the oligopolists extract "monopoly rents" from their customers--i.e., profits above the level that a truly competitive market would provide. This misallocation of economic resources enhances the power of the oligopoly, which can use that power to further entrench itself and secure more monopoly rents. To restate the point in plain English, oligopoly power allows the already megawealthy to become even more indescribably rich.
Surely we taxpayers, who have already subsidized Wall Street to the tune of multi-billions, are gratified to learn that those clever kids at Goldman and J.P. Morgan Chase can look forward to even more wealth. But let's also consider the impact of this collateral disparity on market risks. The derivatives market has a zero-sum quality. If a risk is transferred from one party to another, it doesn't disappear. It simply lands in the second party's lap, who must then figure out what to do with the hot tamale. In a similar way, if more, rather than less, of the hedge fund community's funding is transferred to money center banks, that leaves less for the hedge funds. Prudent hedge fund managers, after having their arms twisted by bank counterparties for extra collateral, would shrink their asset bases in order to keep risk levels in line with their reduced circumstances.
But this is Wall Street. Profits talk and prudence walks. Reduce your assets, and you reduce your money making potential. Do we really think that, just because GS and JPM have reduced their risk levels, their counterparties will do so as well? Or might it just possibly be that their counterparties would simply live more dangerously?
We've seen this video before. It was called The Grasping Counterparties Who Ruined AIG's Entire Day. Recall that AIG reached the brink because its derivatives counterparties, with the largest being Goldman, demanded more collateral than AIG could deliver. Surrounded by a pack of ravenous counterparties, AIG would have been torn to shreds except that the federal government appeared in the nick of time with $180 billion to drive (or rather, buy) off the wolfpack. Goldman claims it was fully hedged from AIG risk. But in order to do God's work it took the taxpayers' money anyway.
If Goldman's and J.P. Morgan Chase's counterparties are now at greater risk, where would that risk fall if the markets turn sour? It's possible that the derivatives markets have become more fragile because of the increasing concentration of market power in the hands a few money center banks. Locating any such fragility is difficult, because the absence of financial regulatory reform leaves us with only the fog of opacity of the derivatives market, circa 2008--well, 2010. Of course, if there is a blowup, the Fed can always print some more money. And that's okay, because there never, ever will be any inflation again. At least, that seems to be close to what some high ranking government officials have told us and they couldn't be wrong, could they?
Tuesday, March 16, 2010
Sunday, March 14, 2010
Maybe Not Bailing Out Lehman Was the Right Decision
Former Secretary of the Treasury Henry Paulson and the current Chairman of the Federal Reserve, Ben Bernanke, have been well-excoriated for their 2008 decision to let Lehman Brothers fail, rather than bailing it out like Fannie Mae, Freddie Mac and, subsequently, AIG. The charges leveled against them are to the effect that the financial markets expected a bailout, and Lehman's failure led to a massive credit lockup that turned a mild recession into the worst economic crisis since the times of Charlie Chaplin. Paulson and Bernanke are, at least implicitly, held responsible for the layoffs of millions of Americans, the near collapse of the financial services industry and the 50% drop in the stock market.
Now we have a bankruptcy examiner's report on Lehman's demise, which depicts a recklessly managed (or mismanaged, to be precise) firm on a hedge fund-like leverage rampage that artfully (in the Dickensian sense of the term) presented itself as an investment bank. Prominent among Lehman's shenanigans was the sly use of British repo transactions to sweep some of its leverage under the carpet at the ends of quarterly financial reporting periods in order reduce the firm's apparent leverage. Now that this stink bomb has exploded, a lot of former high ranking Lehman executives are denying knowledge of these British repos (called "Repo 105s") or not commenting. The auditors insist they did an acceptable job, although it appears they knew of the allegations of a whistleblower. And one can only wonder if, at its meetings, the board was focused on what would be served for lunch instead of the financial condition of the firm.
The press and blogosphere are now swarming the potential culprits like packs of ravenous wolves with litters to feed. Blame is being avidly and abundantly cast. Very possibly, it is well-deserved.
Perhaps, though, along with the zestful mud-slingarama, we should consider whether anyone comes out looking a little better. Maybe Hank Paulson and Ben Bernanke weren't so far off the mark. With what we now know about Lehman's true financial condition, we can see that a bailout would have been much more expensive than it seemed at the time Lehman collapsed. Outrage over bailing out undeserving Wall Street executives would have been all the more magnified if the shameless gamblers at Lehman had received the munificence of taxpayers. The chattering classes would have fulminated about immoral levels of moral hazard and the witlessness of the government allowing potential wrongdoers (top executives, board members and auditors) to live to fail another day.
It doesn't necessarily follow that a Lehman bailout would have precluded the need to bail out AIG. Perhaps, a bailout would have encouraged AIG to extend its leverage even more in the hope of trading its way out of trouble, like the losing gambler who goes in for a dollar after losing a dime. That strategy could have easily led to mega-disaster in the volatile markets of 2008. Then the taxpayers would have been taken to the cleaners even more than they were.
Did Hank Paulson have an inkling of what Lehman was up to? After all, he would have had access to the top levels of Wall Street, and it's quite possible that others on the Street sensed, if not knew, what was going on at Lehman. Did Chairman Bernanke field enough phone calls from Wall Street execs to get the picture? We may never know for sure everything that Paulson and Bernanke knew, heard, sniffed out or suspected. But, in the interest of Monday morning quarterbacking government officials fairly, let us consider that their decision not to extend the generosity of taxpayers to a bunch of rascals really wasn't all that bad. Indeed, had Lehman not gone into bankruptcy, we wouldn't have the comprehensive examiner's report to provide a better picture of how inept risk management in the financial system has been, and why financial regulatory reform, still stalled in Congress, remains desperately needed.
Now we have a bankruptcy examiner's report on Lehman's demise, which depicts a recklessly managed (or mismanaged, to be precise) firm on a hedge fund-like leverage rampage that artfully (in the Dickensian sense of the term) presented itself as an investment bank. Prominent among Lehman's shenanigans was the sly use of British repo transactions to sweep some of its leverage under the carpet at the ends of quarterly financial reporting periods in order reduce the firm's apparent leverage. Now that this stink bomb has exploded, a lot of former high ranking Lehman executives are denying knowledge of these British repos (called "Repo 105s") or not commenting. The auditors insist they did an acceptable job, although it appears they knew of the allegations of a whistleblower. And one can only wonder if, at its meetings, the board was focused on what would be served for lunch instead of the financial condition of the firm.
The press and blogosphere are now swarming the potential culprits like packs of ravenous wolves with litters to feed. Blame is being avidly and abundantly cast. Very possibly, it is well-deserved.
Perhaps, though, along with the zestful mud-slingarama, we should consider whether anyone comes out looking a little better. Maybe Hank Paulson and Ben Bernanke weren't so far off the mark. With what we now know about Lehman's true financial condition, we can see that a bailout would have been much more expensive than it seemed at the time Lehman collapsed. Outrage over bailing out undeserving Wall Street executives would have been all the more magnified if the shameless gamblers at Lehman had received the munificence of taxpayers. The chattering classes would have fulminated about immoral levels of moral hazard and the witlessness of the government allowing potential wrongdoers (top executives, board members and auditors) to live to fail another day.
It doesn't necessarily follow that a Lehman bailout would have precluded the need to bail out AIG. Perhaps, a bailout would have encouraged AIG to extend its leverage even more in the hope of trading its way out of trouble, like the losing gambler who goes in for a dollar after losing a dime. That strategy could have easily led to mega-disaster in the volatile markets of 2008. Then the taxpayers would have been taken to the cleaners even more than they were.
Did Hank Paulson have an inkling of what Lehman was up to? After all, he would have had access to the top levels of Wall Street, and it's quite possible that others on the Street sensed, if not knew, what was going on at Lehman. Did Chairman Bernanke field enough phone calls from Wall Street execs to get the picture? We may never know for sure everything that Paulson and Bernanke knew, heard, sniffed out or suspected. But, in the interest of Monday morning quarterbacking government officials fairly, let us consider that their decision not to extend the generosity of taxpayers to a bunch of rascals really wasn't all that bad. Indeed, had Lehman not gone into bankruptcy, we wouldn't have the comprehensive examiner's report to provide a better picture of how inept risk management in the financial system has been, and why financial regulatory reform, still stalled in Congress, remains desperately needed.
Thursday, March 11, 2010
The Democratic Stock Market
If you believe what many Congressional Republicans and Tea Partiers are saying, the stock market should be down around 3,000. The deficit spending, tax raising Obama administration, hellbent on an expensive reformation of the health insurance system, would surely have driven the economy into the ground by now, with a socialist wasteland our only future. But the market is reaching post-crash highs almost every trading day, and scarcely a wisp of a cirrus cloud mars the clear blue skies over Wall Street.
The stock market and the conservatives can’t both be right. If conservative, free market economists correctly propound that stock prices rationally incorporate all public information, then the Democrats must be on the right path. Onward with health insurance reform, tax increases, etc. Otherwise, you'd have to deviate from free market orthodoxy and conclude that the stock market is really stupid. After all, those humongous deficits and tax increases are about as secret as Kate Gosselin’s new gig on Dancing with the Stars. Maybe now is the time to sell all your equity holdings before the market figures out what a mess things are and crashes.
Yet, one thing's for sure: stock indexes keep rising. That favors the incumbent party. If the market continues to be so friendly toward the Democrats, expect the fall elections to be contests.
The stock market and the conservatives can’t both be right. If conservative, free market economists correctly propound that stock prices rationally incorporate all public information, then the Democrats must be on the right path. Onward with health insurance reform, tax increases, etc. Otherwise, you'd have to deviate from free market orthodoxy and conclude that the stock market is really stupid. After all, those humongous deficits and tax increases are about as secret as Kate Gosselin’s new gig on Dancing with the Stars. Maybe now is the time to sell all your equity holdings before the market figures out what a mess things are and crashes.
Yet, one thing's for sure: stock indexes keep rising. That favors the incumbent party. If the market continues to be so friendly toward the Democrats, expect the fall elections to be contests.
Tuesday, March 9, 2010
Bernie Does Europe
The following is entirely fictional.
The man stood out clearly among the other visitors at the Butner, NC medium security facility. He was trim, and scanned the room with dark eyes. His precisely cut blue suit, narrowed at the waist, the scaloppine soles of his pointed loafers, and his muted silk shirt offset by a mauve tie, would have photographed well east of the English Channel. His face was locked into a faint, bemused smile. It was a well-practiced expression, one perhaps used to mask his thoughts and emotions.
He had no trouble spotting the inmate he came to meet. The latter, an older man who was short and lumpy, would have been obvious even if he hadn't been so often photographed by the press. The visitor waved.
"Mr. Madoff."
"Yes. It's nice to meet you, Mr., uh . . ."
"John Talent," said the visitor, with the accent of someone who'd grown up with light breakfasts, not large ones.
"Yes, Mr. Talent." Bernie suspected that the visitor's registry, where Mr. Talent would have signed in, would not be terribly revealing to the press should they get their hands on it.
"I have the package you requested. Five pounds of shrimp cocktail and a quart of cocktail sauce."
"Wonderful, wonderful. You have no idea how hard it is to get a decent appetizer around here."
"I can imagine, sir," said the visitor, with well-exaggerated sympathy.
"Well, Mr. Talent. What was it you wanted to talk about?"
"I seek insight about your . . . former method of business. That is to say, your financial success."
"My . . . well, I suppose I was successful for a while."
"Yes, yes. How did you succeed in persuading people to give you money, and then keep it there?"
Bernie paused for a moment, seemingly in thought. "It comes down to telling them what they want to hear. Investing consists of putting your money down on a promise. The key is to make the best promise."
"That is interesting in abstract," said Talent quickly. "Let us consider, however, the possibility that the interests raising money are, shall we say, in some difficulty and their difficulties are not entirely unknown."
"Well, let me think. Uhmmm . . . can you tell me what interests you're talking about?"
"Perhaps we can say they are European. More I cannot reveal," replied Talent, his smile tighter than ever.
"Well," said Bernie, through a mouthful of shrimp. "They would have to improve the promises. That is, increase the promised earnings or profits on the investment, and make it appear that they have a very good chance of paying the returns. Look for ways to enhance your revenue, while cutting costs. At least, promise to do those things. By the way, this is excellent shrimp."
"I am pleased that you are enjoying it. Now, let us hypothesize that a . . . bailout, I think the English word is . . . will probably be necessary. That would require a third party--someone to provide the bailout for the interests I represent, so that we appear stronger. How should we deal with the third party?"
"What kind of bailout do you mean: funds, a guarantee of debt, or something else?"
"Any and all of them. Everything is under discussion. The important thing is to inspire confidence among the creditors."
"The creditors," muttered Bernie. "So you are trying to raise money to pay off old debts falling due?"
"Ahhh . . . perhaps I have said too much. But this is true. We must raise money to pay old debts. And there is not so much time."
"And you need a bailout to give the creditors confidence about your ability to repay new debt?"
"Precisely. We have been searching for a bailout, a new source of funds or at least a guarantee."
"How is that search going?" asked Bernie, plunking three pieces of shrimp at once into the cocktail sauce.
"Not very well. The European parties we approached speak in generalities. They don't want to say yes, but they don't want to say no."
"Why won't they say yes?"
"Because they believe we will use the money for consumption, not for investment. So it will not generate new revenues. It is, how you say, like the Ponzi arrangement."
Bernie chewed in silence for a moment. "I see. Then, why won't they say no?"
"Because they have invested in us already. If they say no and we fail, they will be harmed."
"So it is against their interests to say yes, and against their interests to say no."
"Precisely."
Bernie took a deep breath, and then another mouthful of shrimp. "Then you need to find another sugar daddy."
"Pardon?"
"Another benefactor. A new player to give you a bailout. Perhaps someone some distance away, who is not as involved in the situation. You have been talking to Europeans?"
"Yes. Interested parties in Europe."
"Maybe you should hop over the pond."
"Are you speaking of America?"
"That might be the next place to try."
"How could we persuade America to help European interests?"
"Think of something you could offer America."
The visitor stroked his chin, and then spoke. "We have been the victims of speculation in the derivatives market. It is very aggressive and damaging. Perhaps we could offer ourselves as an example of why your government should increase the regulation of derivatives. Your president might be interested, because he wants to add more regulation of derivatives but is having political problems with those people, the lobbyists. The international situation would give him . . . how you say it, political leverage . . . to change the laws. The lack of regulation is increasing international instability. This way, the profit making devices used by your big bankers . . . you call them Wall Street, I believe . . . will now be used against them."
Bernie smiled wryly. "I guess it's fair to say that sometimes, American financiers do go too far, and then the law catches up with them."
"So, if we give your government an international incident they can use to their advantage, perhaps they would have some sympathy for our situation."
"Maybe. Everything would have to be done very subtly. Nothing can be explicit, because the American government has many problems within the country to deal with, and the American people expect their government to take care of problems at home first."
"I understand perfectly. We will be very discreet."
"Good luck, then. And don't hesitate to come back for more advice."
"You have been very helpful, Mr. Madoff. Next time, I will bring ten pounds of shrimp."
The man stood out clearly among the other visitors at the Butner, NC medium security facility. He was trim, and scanned the room with dark eyes. His precisely cut blue suit, narrowed at the waist, the scaloppine soles of his pointed loafers, and his muted silk shirt offset by a mauve tie, would have photographed well east of the English Channel. His face was locked into a faint, bemused smile. It was a well-practiced expression, one perhaps used to mask his thoughts and emotions.
He had no trouble spotting the inmate he came to meet. The latter, an older man who was short and lumpy, would have been obvious even if he hadn't been so often photographed by the press. The visitor waved.
"Mr. Madoff."
"Yes. It's nice to meet you, Mr., uh . . ."
"John Talent," said the visitor, with the accent of someone who'd grown up with light breakfasts, not large ones.
"Yes, Mr. Talent." Bernie suspected that the visitor's registry, where Mr. Talent would have signed in, would not be terribly revealing to the press should they get their hands on it.
"I have the package you requested. Five pounds of shrimp cocktail and a quart of cocktail sauce."
"Wonderful, wonderful. You have no idea how hard it is to get a decent appetizer around here."
"I can imagine, sir," said the visitor, with well-exaggerated sympathy.
"Well, Mr. Talent. What was it you wanted to talk about?"
"I seek insight about your . . . former method of business. That is to say, your financial success."
"My . . . well, I suppose I was successful for a while."
"Yes, yes. How did you succeed in persuading people to give you money, and then keep it there?"
Bernie paused for a moment, seemingly in thought. "It comes down to telling them what they want to hear. Investing consists of putting your money down on a promise. The key is to make the best promise."
"That is interesting in abstract," said Talent quickly. "Let us consider, however, the possibility that the interests raising money are, shall we say, in some difficulty and their difficulties are not entirely unknown."
"Well, let me think. Uhmmm . . . can you tell me what interests you're talking about?"
"Perhaps we can say they are European. More I cannot reveal," replied Talent, his smile tighter than ever.
"Well," said Bernie, through a mouthful of shrimp. "They would have to improve the promises. That is, increase the promised earnings or profits on the investment, and make it appear that they have a very good chance of paying the returns. Look for ways to enhance your revenue, while cutting costs. At least, promise to do those things. By the way, this is excellent shrimp."
"I am pleased that you are enjoying it. Now, let us hypothesize that a . . . bailout, I think the English word is . . . will probably be necessary. That would require a third party--someone to provide the bailout for the interests I represent, so that we appear stronger. How should we deal with the third party?"
"What kind of bailout do you mean: funds, a guarantee of debt, or something else?"
"Any and all of them. Everything is under discussion. The important thing is to inspire confidence among the creditors."
"The creditors," muttered Bernie. "So you are trying to raise money to pay off old debts falling due?"
"Ahhh . . . perhaps I have said too much. But this is true. We must raise money to pay old debts. And there is not so much time."
"And you need a bailout to give the creditors confidence about your ability to repay new debt?"
"Precisely. We have been searching for a bailout, a new source of funds or at least a guarantee."
"How is that search going?" asked Bernie, plunking three pieces of shrimp at once into the cocktail sauce.
"Not very well. The European parties we approached speak in generalities. They don't want to say yes, but they don't want to say no."
"Why won't they say yes?"
"Because they believe we will use the money for consumption, not for investment. So it will not generate new revenues. It is, how you say, like the Ponzi arrangement."
Bernie chewed in silence for a moment. "I see. Then, why won't they say no?"
"Because they have invested in us already. If they say no and we fail, they will be harmed."
"So it is against their interests to say yes, and against their interests to say no."
"Precisely."
Bernie took a deep breath, and then another mouthful of shrimp. "Then you need to find another sugar daddy."
"Pardon?"
"Another benefactor. A new player to give you a bailout. Perhaps someone some distance away, who is not as involved in the situation. You have been talking to Europeans?"
"Yes. Interested parties in Europe."
"Maybe you should hop over the pond."
"Are you speaking of America?"
"That might be the next place to try."
"How could we persuade America to help European interests?"
"Think of something you could offer America."
The visitor stroked his chin, and then spoke. "We have been the victims of speculation in the derivatives market. It is very aggressive and damaging. Perhaps we could offer ourselves as an example of why your government should increase the regulation of derivatives. Your president might be interested, because he wants to add more regulation of derivatives but is having political problems with those people, the lobbyists. The international situation would give him . . . how you say it, political leverage . . . to change the laws. The lack of regulation is increasing international instability. This way, the profit making devices used by your big bankers . . . you call them Wall Street, I believe . . . will now be used against them."
Bernie smiled wryly. "I guess it's fair to say that sometimes, American financiers do go too far, and then the law catches up with them."
"So, if we give your government an international incident they can use to their advantage, perhaps they would have some sympathy for our situation."
"Maybe. Everything would have to be done very subtly. Nothing can be explicit, because the American government has many problems within the country to deal with, and the American people expect their government to take care of problems at home first."
"I understand perfectly. We will be very discreet."
"Good luck, then. And don't hesitate to come back for more advice."
"You have been very helpful, Mr. Madoff. Next time, I will bring ten pounds of shrimp."
Sunday, March 7, 2010
Currencies: the Latest Bubble to Burst. Is Municipal Debt Next?
In the leverage-fueled, easy money world of the turn of the 21st Century, life is just one asset bubble after another. The bubbles du jour are the Euro and the pound sterling. The Euro bloc and the U.K. seem to have achieved faux prosperity with gads of borrowed money, some of it carefully tucked away in quiet, little (or perhaps not so little) derivatives transactions.
But the problem with debt is that creditors expect to be repaid. As creditors sought to have their way, the Euro and pound lost value. This down trend may have been exacerbated by trading in credit default swaps, the hydra of the financial markets. Thus, derivatives seemingly not only heightened the bubble, they also may have intensified the pop. Government officials in EU nations now talk openly about restricting the use of credit default swaps for sovereign debt. The financial engineers of the derivatives markets will likely sprout two or more new contracts for the credit default swap if it is cut off from the sovereign debt markets. Europe will have to search long and hard for a champion to truly kill this beast.
Municipalities in the U.S. also availed themselves of the easy credit offered by not terribly transparent derivatives. Many now find themselves locked into long term contracts that are expensive to maintain and expensive to terminate. Their only consolation is that the Wall Street bankers who sold them these puppies are back to earning big bonuses, thanks to the American taxpayer. Municipal bankruptcies are rare, but perhaps will be less so in the near future. If local governments must choose between police and fire protection, good educations for children, and decent roads, on the one hand, or continuing to enrich multi-millionaire investment bankers on the other, it's not hard to imagine that the sanctity of contract will take a fall. The Bankruptcy Code is intended to give debtors a fresh start, and a goodly number of municipal officials are likely to proceed on the premise that all politics are local.
They may take inspiration from the Chinese government. A news story today on Bloomberg.com (http://www.bloomberg.com/apps/news?pid=20601087&sid=ay..a15ZCHJU&pos=3) reported that China's national government will repudiate Chinese municipal guarantees of debt incurred by financing vehicles local governments set up to circumvent municipal borrowing restrictions, and prohibit such guarantees in the future. Kinda of reminds one of the SIVs and other special purpose vehicles banks set up for mortgage-backed investments to circumvent capital and financial reporting requirements. This Chinese version of the problem doesn't, at first glance, seem likely to precipitate a currency crisis, since the unguaranteed loans appear to be held mostly by Chinese banks. Beijing's purpose is probably to cut back the vast quantities of credit in China that may send inflation spiraling upward. But the notion that governments need not kowtow to banks could acquire increased currency (pun intended) from the Chinese example. While the federal government, almost incapable of achieving even modest reform of the financial regulatory structure, is clenched tightly within the grip of Wall Street's lobbying machine, the populism sweeping the nation could find new expression in municipal bankruptcies, where local government officials could claim heroic status for themselves (and re-election) by telling the big banks to stick it.
But the problem with debt is that creditors expect to be repaid. As creditors sought to have their way, the Euro and pound lost value. This down trend may have been exacerbated by trading in credit default swaps, the hydra of the financial markets. Thus, derivatives seemingly not only heightened the bubble, they also may have intensified the pop. Government officials in EU nations now talk openly about restricting the use of credit default swaps for sovereign debt. The financial engineers of the derivatives markets will likely sprout two or more new contracts for the credit default swap if it is cut off from the sovereign debt markets. Europe will have to search long and hard for a champion to truly kill this beast.
Municipalities in the U.S. also availed themselves of the easy credit offered by not terribly transparent derivatives. Many now find themselves locked into long term contracts that are expensive to maintain and expensive to terminate. Their only consolation is that the Wall Street bankers who sold them these puppies are back to earning big bonuses, thanks to the American taxpayer. Municipal bankruptcies are rare, but perhaps will be less so in the near future. If local governments must choose between police and fire protection, good educations for children, and decent roads, on the one hand, or continuing to enrich multi-millionaire investment bankers on the other, it's not hard to imagine that the sanctity of contract will take a fall. The Bankruptcy Code is intended to give debtors a fresh start, and a goodly number of municipal officials are likely to proceed on the premise that all politics are local.
They may take inspiration from the Chinese government. A news story today on Bloomberg.com (http://www.bloomberg.com/apps/news?pid=20601087&sid=ay..a15ZCHJU&pos=3) reported that China's national government will repudiate Chinese municipal guarantees of debt incurred by financing vehicles local governments set up to circumvent municipal borrowing restrictions, and prohibit such guarantees in the future. Kinda of reminds one of the SIVs and other special purpose vehicles banks set up for mortgage-backed investments to circumvent capital and financial reporting requirements. This Chinese version of the problem doesn't, at first glance, seem likely to precipitate a currency crisis, since the unguaranteed loans appear to be held mostly by Chinese banks. Beijing's purpose is probably to cut back the vast quantities of credit in China that may send inflation spiraling upward. But the notion that governments need not kowtow to banks could acquire increased currency (pun intended) from the Chinese example. While the federal government, almost incapable of achieving even modest reform of the financial regulatory structure, is clenched tightly within the grip of Wall Street's lobbying machine, the populism sweeping the nation could find new expression in municipal bankruptcies, where local government officials could claim heroic status for themselves (and re-election) by telling the big banks to stick it.
Thursday, March 4, 2010
Taboos of the Real Estate Crisis
Today's housing news was that contracts to purchase existing homes fell 7.6% in January from the December 2009 level. Last week, we learned that new home sales fell 11.2% to the lowest level ever recorded since 1963, when the Census Bureau began tracking new home sales. Clearly, in spite of an expanded buyer's tax credit, the housing market remains a sick puppy.
Relief measures have treated symptoms. Defaulting homeowners get opportunities to restructure their mortgages, but lasting success is infrequent. Homeowners who haven't defaulted have trouble getting relief, especially if they are underwater. Underwater homeowners are increasingly tempted to walk away from their mortgages, especially if the loans are nonrecourse.
Treating symptoms often doesn't cure illnesses. Dealing with underlying causes is usually more effective. But the underlying causes of the real estate crisis are taboo. They cannot be discussed openly, not by government officials, nor Wall Street bankers, nor real estate industry professionals, nor consumer advocates. Candor would reveal the intractability of the crisis. At the risk of offending everyone having anything to do with real estate, we offer a little candor.
The 30-year fixed rate mortgage doesn't make commercial sense. It is a difficult loan for banks to manage, since their costs (i.e., the interest expense of deposits and other borrowings) fluctuate while the rate on the mortgage remains fixed for a very long time. Before the 1930s, the 30-year mortgage didn't exist. For all practical purposes, it wouldn't exist today except that, since the Great Depression, the government has promoted it as a way to make home ownership affordable. We can't get away from it, because real estate values would probably take a great fall without its easy terms. Even today's shorter term adjustable rate loans have amortization schedules that contemplate a long term loan of 30 or sometimes more years, so they're really just an elaboration on the 30-year fixed rate.
Banks don't like to hold 30-year mortgages. These loans can be made only by mismatching a bank's shorter term liabilities (like deposits) against a long term fixed rate asset. This mismatch is a formula for lending disaster when short term rates exceed long term rates, and they have periodically, going back to the 1970s. That's why the secondary mortgage market grew so large, first through federal agencies like Fannie Mae, Freddie Mac and Ginnie Mae, and later through private sector innovations like the mortgage-backed security, the CDO, the CDO squared, and so on. Banks became accustomed to offloading their mortgage risks. But the securitization market blew up along with the real estate crisis and remains moribund. Banks haven't been able to adapt to a world without securitization. Mortgage loans are almost entirely unavailable except when they can be guaranteed by Fannie Mae, Freddie Mac, or another federal agency, and resold. Securitization is now a federal program, not a commercial market.
The government and many others continue to believe that if home ownership is good, more home ownership is better. While this argument might make some abstract sense in a middle school civics class, reality is that home ownership in America usually requires credit. Even if some level of home ownership acquired with credit is good, that doesn't make more credit-fueled home ownership better. Only so many people are good bets for mortgage loans, and after that borrowers become riskier. We found that out the hard way in the 2000s, when defaults by the risky borrowers drove down home prices. In a society where home ownership is largely based on credit, there is an optimal level of home ownership, and after that it's a bad idea. However, not one policymaker in a trillion will openly endorse this point.
Another taboo is the proposition that banks should book the full extent of their home loan lending losses. America's banking system continues to hold hundreds of billions of dollars of losses attributable to home financing. Booking these losses would require more embarrassment on the part of banks (along with more capital raising efforts), more official consternation over the stability of the financial system and kabuki outrage over banker bonuses, and more houses in foreclosure sales pressuring prices downward. But not booking them is clogging up the banking system. Banks are afraid to lend because they want to hold onto their cash as a reserve against these unbooked losses. The paucity of bank credit is a crucial reason why the economic recovery is so tenuous. Economic stagnation is likely with the banking system in neutral.
So the wheels spin, caught in the muck of mortgages that don't make commercial sense, a secondary mortgage market that doesn't function except as a government program, the assumption that we need to make more, and then even more, bad mortgage loans in order to advance the goal of home ownership, and the unwillingness of banks and their regulators to fully face up to the losses of the mortgage mess. There's hardly any room for market forces to operate--and that's why they hardly do. Housing isn't a market. It's a government program. It's kept on life support by government subsidies, and can't be weaned off of them because the price collapse that would follow would bankrupt America's middle class.
Perhaps over the next ten years, the housing market will gradually revive. But it will surely continue to be built on the precarious edifice of taboos. Too much of America's capital will be misdirected into housing. Government borrowings will absorb vast amounts of what's left. Manufacturing and other activities fundamental to economic strength will be left with scraps. Growth will be stunted. Americans will squabble over who pays for health care, Social Security and other obligations that seem overwhelming when a slow growing economy doesn't produce wealth commensurate with society's generosity. But taboos cannot be discussed, so we end this essay. Good luck.
Relief measures have treated symptoms. Defaulting homeowners get opportunities to restructure their mortgages, but lasting success is infrequent. Homeowners who haven't defaulted have trouble getting relief, especially if they are underwater. Underwater homeowners are increasingly tempted to walk away from their mortgages, especially if the loans are nonrecourse.
Treating symptoms often doesn't cure illnesses. Dealing with underlying causes is usually more effective. But the underlying causes of the real estate crisis are taboo. They cannot be discussed openly, not by government officials, nor Wall Street bankers, nor real estate industry professionals, nor consumer advocates. Candor would reveal the intractability of the crisis. At the risk of offending everyone having anything to do with real estate, we offer a little candor.
The 30-year fixed rate mortgage doesn't make commercial sense. It is a difficult loan for banks to manage, since their costs (i.e., the interest expense of deposits and other borrowings) fluctuate while the rate on the mortgage remains fixed for a very long time. Before the 1930s, the 30-year mortgage didn't exist. For all practical purposes, it wouldn't exist today except that, since the Great Depression, the government has promoted it as a way to make home ownership affordable. We can't get away from it, because real estate values would probably take a great fall without its easy terms. Even today's shorter term adjustable rate loans have amortization schedules that contemplate a long term loan of 30 or sometimes more years, so they're really just an elaboration on the 30-year fixed rate.
Banks don't like to hold 30-year mortgages. These loans can be made only by mismatching a bank's shorter term liabilities (like deposits) against a long term fixed rate asset. This mismatch is a formula for lending disaster when short term rates exceed long term rates, and they have periodically, going back to the 1970s. That's why the secondary mortgage market grew so large, first through federal agencies like Fannie Mae, Freddie Mac and Ginnie Mae, and later through private sector innovations like the mortgage-backed security, the CDO, the CDO squared, and so on. Banks became accustomed to offloading their mortgage risks. But the securitization market blew up along with the real estate crisis and remains moribund. Banks haven't been able to adapt to a world without securitization. Mortgage loans are almost entirely unavailable except when they can be guaranteed by Fannie Mae, Freddie Mac, or another federal agency, and resold. Securitization is now a federal program, not a commercial market.
The government and many others continue to believe that if home ownership is good, more home ownership is better. While this argument might make some abstract sense in a middle school civics class, reality is that home ownership in America usually requires credit. Even if some level of home ownership acquired with credit is good, that doesn't make more credit-fueled home ownership better. Only so many people are good bets for mortgage loans, and after that borrowers become riskier. We found that out the hard way in the 2000s, when defaults by the risky borrowers drove down home prices. In a society where home ownership is largely based on credit, there is an optimal level of home ownership, and after that it's a bad idea. However, not one policymaker in a trillion will openly endorse this point.
Another taboo is the proposition that banks should book the full extent of their home loan lending losses. America's banking system continues to hold hundreds of billions of dollars of losses attributable to home financing. Booking these losses would require more embarrassment on the part of banks (along with more capital raising efforts), more official consternation over the stability of the financial system and kabuki outrage over banker bonuses, and more houses in foreclosure sales pressuring prices downward. But not booking them is clogging up the banking system. Banks are afraid to lend because they want to hold onto their cash as a reserve against these unbooked losses. The paucity of bank credit is a crucial reason why the economic recovery is so tenuous. Economic stagnation is likely with the banking system in neutral.
So the wheels spin, caught in the muck of mortgages that don't make commercial sense, a secondary mortgage market that doesn't function except as a government program, the assumption that we need to make more, and then even more, bad mortgage loans in order to advance the goal of home ownership, and the unwillingness of banks and their regulators to fully face up to the losses of the mortgage mess. There's hardly any room for market forces to operate--and that's why they hardly do. Housing isn't a market. It's a government program. It's kept on life support by government subsidies, and can't be weaned off of them because the price collapse that would follow would bankrupt America's middle class.
Perhaps over the next ten years, the housing market will gradually revive. But it will surely continue to be built on the precarious edifice of taboos. Too much of America's capital will be misdirected into housing. Government borrowings will absorb vast amounts of what's left. Manufacturing and other activities fundamental to economic strength will be left with scraps. Growth will be stunted. Americans will squabble over who pays for health care, Social Security and other obligations that seem overwhelming when a slow growing economy doesn't produce wealth commensurate with society's generosity. But taboos cannot be discussed, so we end this essay. Good luck.
Tuesday, March 2, 2010
The Donkey-Backwards Housing Finance Debate
One of the biggest questions in housing finance is how to revive the securitization market. During the housing boom of the early 2000s, banks earned massive amounts of fee and commission income by packaging mortgages into mortgage-backed securities. These securities were often sliced and diced into CDOs, CDOs squared and what not, in order to further entice investors (and speculators). What happened next is all too well known. The banks, eager to bulk up low-risk fee revenue while offloading lending risk, thought that if writing a lot of mortgage loans was good, then writing a shipload more would be even better. Lending standards dropped, to the point where banks didn't always document borrowers' incomes, as if to avoid learning that they shouldn't extend the loan. There were plenty of times when they shouldn't have, but did anyway.
That insouciance toward prudence dug a very deep grave for investor interest in securitized loans. Today, just about the only mortgage-backed securities that can be sold carry explicit U.S. government guarantees. Housing finance has become a federal program, and today's housing stock enjoys what is effectively a federal price support policy.
Needless to say, taxpayers can't support housing values indefinitely. In the view of bankers and many regulators, securitization must be improved and revived. The two potential improvements most often discussed are (a) requiring the banks that package mortgages to keep some of the lending risk, or (b) improving underwriting standards without requiring underwriting banks to keep some "skin in the game." The first concept is intended to keep the banks honest. But banks holding increased amounts of lending risk also must increase their capital levels. That is likely to lower profits, anathema to their executives suites and also not to the liking of some bank regulators, who seem to equate lower bank profits with greater aggravations for themselves. The second notion--improved underwriting standards--is clearly necessary, but insufficient by itself. Investors aren't prepared to put down their money with just promises of improvement.
The problem is the discussion focuses on what the banks (and regulators) want, not what investors would like. This is donkey-backwards. A revival of a private securitization market depends on the willingness of investors to plunk their cash onto the barrelhead. There used to be a notion in American business that the customer is always right. A little fillip of customer service--i.e., investor protection--needs to be added to the mix.
First, there's the issue of trust. Trust is the true foundation of the financial system. Investors no longer trust the banks at the heart of the securitization process. That's why the only mortgage-backed securities acceptable to investors today bear a federal guarantee. Banks hoping to securitize on their own seem to be viewed as little more than potential scofflaws. Serious regulatory reform--of both banking and the derivatives market--is essential. Consumer protection must be greatly strengthened, lending standards bearing a reasonable resemblance to prudence have to be enforced, and the derivatives market must become much more transparent. But the scope of reform evolving in current legislative proposals may be inadequate to reassure holders of capital.
Second, the securitization market as it existed in the early 2000s ceased to be risk-sensitive. Investors had no effective way to discern that they were buying bags of digestive waste, and banks securitizing loans ceased to care that they were selling the same. The absence of risk sensitivity created grotesque market distortions that resulted in millions of bad loans being made, which may have enriched underwriting banks but also led to the defaults and foreclosures that have been driving down real estate prices.
Risk insensitivity is the problem that the skin-in-the-game requirement is intended to fix. The continued desertification of the securitization market is a signal that not enough is being done. Further product development is required. Perhaps banks should agree to limit investor losses to a predetermined number of cents on the dollar invested. After that, the underwriting bank would bear all losses. The less the investment resembles a pig in a poke, the more likely people will buy. Such a provision would improve the quality of mortgages in the pool, which would benefit investors--and homeowners. Fewer low quality loans would be made. Even if home ownership levels fall, bad loans do not, in the medium (let alone, long) term, increase home ownership. They do, however, drive down real estate values when borrowers default and end up in foreclosure.
Another improvement would be for banks to open up their databases concerning the underlying mortgages to credit rating agencies, and indeed, investors, for analysis. People are more likely to buy if they can kick the tires and lift up the hood. Any competitive issues would be unimportant if all offerings are subject to inspection. Of course, this may make pricing more accurate, or, stated otherwise, fairer to investors. And that's the idea. People will pay a fair price for what they understand, but not a penny for the opaque, black box CDOs of yore. Bank profits would be lower. But the current miserly dialogue about minimizing the extent of improvements to the securitization process may be holding down underwriting banks' costs, at the expense of expunging investor interest.
The bank-centric orientation of reforming the securitization market isn't even leading investors to water, let alone inducing them to drink. However, if banks and regulators would give a nod to the holders of capital who've been taking it on the chin for the last few years, maybe they'd see the phoenix rise from the ashes.
That insouciance toward prudence dug a very deep grave for investor interest in securitized loans. Today, just about the only mortgage-backed securities that can be sold carry explicit U.S. government guarantees. Housing finance has become a federal program, and today's housing stock enjoys what is effectively a federal price support policy.
Needless to say, taxpayers can't support housing values indefinitely. In the view of bankers and many regulators, securitization must be improved and revived. The two potential improvements most often discussed are (a) requiring the banks that package mortgages to keep some of the lending risk, or (b) improving underwriting standards without requiring underwriting banks to keep some "skin in the game." The first concept is intended to keep the banks honest. But banks holding increased amounts of lending risk also must increase their capital levels. That is likely to lower profits, anathema to their executives suites and also not to the liking of some bank regulators, who seem to equate lower bank profits with greater aggravations for themselves. The second notion--improved underwriting standards--is clearly necessary, but insufficient by itself. Investors aren't prepared to put down their money with just promises of improvement.
The problem is the discussion focuses on what the banks (and regulators) want, not what investors would like. This is donkey-backwards. A revival of a private securitization market depends on the willingness of investors to plunk their cash onto the barrelhead. There used to be a notion in American business that the customer is always right. A little fillip of customer service--i.e., investor protection--needs to be added to the mix.
First, there's the issue of trust. Trust is the true foundation of the financial system. Investors no longer trust the banks at the heart of the securitization process. That's why the only mortgage-backed securities acceptable to investors today bear a federal guarantee. Banks hoping to securitize on their own seem to be viewed as little more than potential scofflaws. Serious regulatory reform--of both banking and the derivatives market--is essential. Consumer protection must be greatly strengthened, lending standards bearing a reasonable resemblance to prudence have to be enforced, and the derivatives market must become much more transparent. But the scope of reform evolving in current legislative proposals may be inadequate to reassure holders of capital.
Second, the securitization market as it existed in the early 2000s ceased to be risk-sensitive. Investors had no effective way to discern that they were buying bags of digestive waste, and banks securitizing loans ceased to care that they were selling the same. The absence of risk sensitivity created grotesque market distortions that resulted in millions of bad loans being made, which may have enriched underwriting banks but also led to the defaults and foreclosures that have been driving down real estate prices.
Risk insensitivity is the problem that the skin-in-the-game requirement is intended to fix. The continued desertification of the securitization market is a signal that not enough is being done. Further product development is required. Perhaps banks should agree to limit investor losses to a predetermined number of cents on the dollar invested. After that, the underwriting bank would bear all losses. The less the investment resembles a pig in a poke, the more likely people will buy. Such a provision would improve the quality of mortgages in the pool, which would benefit investors--and homeowners. Fewer low quality loans would be made. Even if home ownership levels fall, bad loans do not, in the medium (let alone, long) term, increase home ownership. They do, however, drive down real estate values when borrowers default and end up in foreclosure.
Another improvement would be for banks to open up their databases concerning the underlying mortgages to credit rating agencies, and indeed, investors, for analysis. People are more likely to buy if they can kick the tires and lift up the hood. Any competitive issues would be unimportant if all offerings are subject to inspection. Of course, this may make pricing more accurate, or, stated otherwise, fairer to investors. And that's the idea. People will pay a fair price for what they understand, but not a penny for the opaque, black box CDOs of yore. Bank profits would be lower. But the current miserly dialogue about minimizing the extent of improvements to the securitization process may be holding down underwriting banks' costs, at the expense of expunging investor interest.
The bank-centric orientation of reforming the securitization market isn't even leading investors to water, let alone inducing them to drink. However, if banks and regulators would give a nod to the holders of capital who've been taking it on the chin for the last few years, maybe they'd see the phoenix rise from the ashes.
Sunday, February 28, 2010
Will the Greek Debt Crisis Visit America?
The Prime Minister of Greece, George Papandreou, will visit President Obama on March 9, 2010. This follows a meeting between Papandreou and German Chancellor Angela Merkel on March 5, 2010. The earlier meeting is acknowledged to be about Greece's sovereign debt crisis, and the discussion will no doubt concern Greece's progress toward fiscal prudence and the conditions for a German-sponsored bailout. Although the German public is largely opposed to a bailout, the German government may have little choice but to offer some assistance at some point fairly soon. Germany, Greece and the rest of the EU share a common currency and a common market. They're more intertwined than the world's money center banks. Germany profited from Greece's profligacy, which expanded Germany's export markets. Germany will surely have to bear some of the burdens of that profligacy, although we can expect the German government to strike a hard bargain in terms of requiring Greek austerity.
President Obama's willingness to meet with Papandreou is somewhat perplexing. The White House announced that the two would discuss a "broad range of strategic issues." Okay. Like overfishing of tuna in the Mediterranean? Or the effect of air pollution on the physical condition of the Parthenon? Or improved anti-terrorist security measures at the Athens airport? Or a joint condemnation of Iranian and North Korean nuclear ambitions? Or is it possible they might discuss Greece's sovereign debt crisis?
President Obama needs to watch where he's walking, because there's a political bear trap on the trail in front of him. A lot of people outside the Tea Parties wouldn't begin to brook the idea of American assistance to help Greece deal with its sovereign debt crisis. (We don't need to discuss how Tea Partiers would feel about this issue.) Yet, what on earth would Obama and Papandreou talk about at a time like this other than Greece's sovereign debt crisis?
President Obama has an increasing number of political adversaries, and he doesn't need to be his own worst adversary. He's more popular overseas than in the U.S., but he shouldn't heed the siren call (okay, that double entrendre was intended) of his foreign fans. With the resurgence of populism, paranoia about the Trilateral Commission, the Council on Foreign Relations, the Bank for International Settlements, and, of course, the United Nations, is ballooning. A meeting with Papandreou announced with a vague description of an agenda will only inflame the already uncontrolled imaginations of the fearful.
The United States has no business assisting the Euro bloc nations having sovereign debt problems. Government bailouts shift the bailee's losses onto taxpayers. Whatever the plus and minuses of the federal government's bailouts of Wall Street, we cannot take on the burdens of other nations' irresponsibility. Assistance to Greece would raise a firestorm of anger among the American electorate that would snuff out any chances the Obama administration has for health insurance reform and perhaps many other of its key policy initiatives that would benefit the American people.
No doubt, the leaders of Spain, Portugal, Ireland, Iceland and other nations with sovereign debt problems must be maneuvering for their meetings with President Obama. He needs to keep his schedule filled up with appearances at elementary schools and visits by Girl Scouts to the White House. Many of the now prosperous economies of East Asia, which may be the economic engines that pull the rest of the world out of the current recession, went through hell after their own 1997-98 debt and currency crises. The IMF took them to the woodshed and did something with a stiff birch switch. The outcome was much more fiscal discipline and financial prudence, and comparative prosperity today. China, which didn't take IMF money, has always assumed that it would have to get by on its own, and acted accordingly. Its self-sufficiency has paid enormous dividends. People don't prosper when they go on the dole. Neither do countries.
President Obama's willingness to meet with Papandreou is somewhat perplexing. The White House announced that the two would discuss a "broad range of strategic issues." Okay. Like overfishing of tuna in the Mediterranean? Or the effect of air pollution on the physical condition of the Parthenon? Or improved anti-terrorist security measures at the Athens airport? Or a joint condemnation of Iranian and North Korean nuclear ambitions? Or is it possible they might discuss Greece's sovereign debt crisis?
President Obama needs to watch where he's walking, because there's a political bear trap on the trail in front of him. A lot of people outside the Tea Parties wouldn't begin to brook the idea of American assistance to help Greece deal with its sovereign debt crisis. (We don't need to discuss how Tea Partiers would feel about this issue.) Yet, what on earth would Obama and Papandreou talk about at a time like this other than Greece's sovereign debt crisis?
President Obama has an increasing number of political adversaries, and he doesn't need to be his own worst adversary. He's more popular overseas than in the U.S., but he shouldn't heed the siren call (okay, that double entrendre was intended) of his foreign fans. With the resurgence of populism, paranoia about the Trilateral Commission, the Council on Foreign Relations, the Bank for International Settlements, and, of course, the United Nations, is ballooning. A meeting with Papandreou announced with a vague description of an agenda will only inflame the already uncontrolled imaginations of the fearful.
The United States has no business assisting the Euro bloc nations having sovereign debt problems. Government bailouts shift the bailee's losses onto taxpayers. Whatever the plus and minuses of the federal government's bailouts of Wall Street, we cannot take on the burdens of other nations' irresponsibility. Assistance to Greece would raise a firestorm of anger among the American electorate that would snuff out any chances the Obama administration has for health insurance reform and perhaps many other of its key policy initiatives that would benefit the American people.
No doubt, the leaders of Spain, Portugal, Ireland, Iceland and other nations with sovereign debt problems must be maneuvering for their meetings with President Obama. He needs to keep his schedule filled up with appearances at elementary schools and visits by Girl Scouts to the White House. Many of the now prosperous economies of East Asia, which may be the economic engines that pull the rest of the world out of the current recession, went through hell after their own 1997-98 debt and currency crises. The IMF took them to the woodshed and did something with a stiff birch switch. The outcome was much more fiscal discipline and financial prudence, and comparative prosperity today. China, which didn't take IMF money, has always assumed that it would have to get by on its own, and acted accordingly. Its self-sufficiency has paid enormous dividends. People don't prosper when they go on the dole. Neither do countries.
Thursday, February 25, 2010
Will the Europeans Take the Lead on Reforming Derivatives Regulation?
On Leave It to Beaver, when Beav did something to dig himself deep into a hole, his brother Wally would say, "You've really done it now." The big banks on Wall Street may have really done it now in the derivatives market.
News media today report that Goldman Sachs and other Wall Street firms have been buying credit default swaps that would rise in value if Greece were to default on its sovereign debt. This follows other recent reports that Goldman Sachs helped Greece disguise the level of its indebtedness by offering derivatives transactions that wouldn't appear to be debt. Thus, Goldman helped Greece appear more fiscally sober than it was. Moreover, other European nations seem to have drunk of this same derivatives cup to sweep national debts under the carpet.
It would be difficult for an EU member to scold Greece for profligacy if it had indulged in similar extravagance. The Wall Street firms involved in these deals have the EU nations exactly where they want them--financially bound to the Street while mutually lacking the moral standing to police each other.
But then, it seems that Goldman (and other firms) may have also bet on a Greek default, after having aided its fiscal excess. If so, they would have gained perhaps hundreds of millions in fees for their derivatives products and then who knows how much profit if Greece collapses under a heavy debt burden that Wall Street facilitated. To make things worse, credit default swaps are sometimes thought to affect the market for the primary debt to which they relate, with increased credit default swap trading activity and rising prices fostering greater doubt about the debtor's chances. Thus, buyers in the credit default market might exacerbate the debtor's problems and thereby increase the profit potential of their credit default swaps.
If it's true that Goldman and other major Wall Street firms have been on both sides of the table with Greece (for them and then against them), they would have been too clever by half. Continental Europeans almost reflexively mistrust "Anglo-Saxon capitalism." They have limited faith in market forces, and are quite willing to accept the stability of government control over market volatility. Business people are not as highly regarded in the EU as they are in the U.S., and don't have the political pull in Berlin and Paris that they do in Washington. Per capita income in Western Europe was, some 40 years ago, close to per capita income in America. Today, it's about thirty percent lower. The Europeans have been willing to pay the economic price for slower growth in exchange for greater stability. After the American-spawned mortgage crisis and credit crunch of 2007-08, they've lost a lot of faith in market forces. The sovereign debt mess would only reinforce these feelings.
There's a good chance that Europe will take the lead in reforming the regulation of derivatives. The EU already leads the U.S. on antitrust enforcement and electronic privacy. Big American companies like Microsoft and Intel have had to knuckle under to EU regulatory imperatives that reached beyond the requirements of U.S. law. Goldman Sachs, J.P. Morgan Chase and other denizens of Wall Street are not worshiped across the pond. Even worse, they've made various European governments appear to be easy marks. No one likes to be seen as a gullible dupe, especially not high ranking government officials who are the likely dupes. Regulatory fervor is undoubtedly rising east of the English Channel.
By all indications, neither Congress nor the Obama administration are focused on reforming the regulation of derivatives. Heavy duty lobbying by Wall Street is probably the most important reason for their inaction. But that will leave an open field for the Europeans to do as they please. Ninety percent of life is just showing up, as Woody Allen once said. American participation would help shape the future regulatory structure, and make it more closely resemble something we'd prefer. It's fallacious to think that the regulation of the derivatives markets won't change just because of somnolence on the Potomac. The world today is much bigger than the United States, and will move on with or without the United States.
News media today report that Goldman Sachs and other Wall Street firms have been buying credit default swaps that would rise in value if Greece were to default on its sovereign debt. This follows other recent reports that Goldman Sachs helped Greece disguise the level of its indebtedness by offering derivatives transactions that wouldn't appear to be debt. Thus, Goldman helped Greece appear more fiscally sober than it was. Moreover, other European nations seem to have drunk of this same derivatives cup to sweep national debts under the carpet.
It would be difficult for an EU member to scold Greece for profligacy if it had indulged in similar extravagance. The Wall Street firms involved in these deals have the EU nations exactly where they want them--financially bound to the Street while mutually lacking the moral standing to police each other.
But then, it seems that Goldman (and other firms) may have also bet on a Greek default, after having aided its fiscal excess. If so, they would have gained perhaps hundreds of millions in fees for their derivatives products and then who knows how much profit if Greece collapses under a heavy debt burden that Wall Street facilitated. To make things worse, credit default swaps are sometimes thought to affect the market for the primary debt to which they relate, with increased credit default swap trading activity and rising prices fostering greater doubt about the debtor's chances. Thus, buyers in the credit default market might exacerbate the debtor's problems and thereby increase the profit potential of their credit default swaps.
If it's true that Goldman and other major Wall Street firms have been on both sides of the table with Greece (for them and then against them), they would have been too clever by half. Continental Europeans almost reflexively mistrust "Anglo-Saxon capitalism." They have limited faith in market forces, and are quite willing to accept the stability of government control over market volatility. Business people are not as highly regarded in the EU as they are in the U.S., and don't have the political pull in Berlin and Paris that they do in Washington. Per capita income in Western Europe was, some 40 years ago, close to per capita income in America. Today, it's about thirty percent lower. The Europeans have been willing to pay the economic price for slower growth in exchange for greater stability. After the American-spawned mortgage crisis and credit crunch of 2007-08, they've lost a lot of faith in market forces. The sovereign debt mess would only reinforce these feelings.
There's a good chance that Europe will take the lead in reforming the regulation of derivatives. The EU already leads the U.S. on antitrust enforcement and electronic privacy. Big American companies like Microsoft and Intel have had to knuckle under to EU regulatory imperatives that reached beyond the requirements of U.S. law. Goldman Sachs, J.P. Morgan Chase and other denizens of Wall Street are not worshiped across the pond. Even worse, they've made various European governments appear to be easy marks. No one likes to be seen as a gullible dupe, especially not high ranking government officials who are the likely dupes. Regulatory fervor is undoubtedly rising east of the English Channel.
By all indications, neither Congress nor the Obama administration are focused on reforming the regulation of derivatives. Heavy duty lobbying by Wall Street is probably the most important reason for their inaction. But that will leave an open field for the Europeans to do as they please. Ninety percent of life is just showing up, as Woody Allen once said. American participation would help shape the future regulatory structure, and make it more closely resemble something we'd prefer. It's fallacious to think that the regulation of the derivatives markets won't change just because of somnolence on the Potomac. The world today is much bigger than the United States, and will move on with or without the United States.
Wednesday, February 24, 2010
Why the Derivatives Market Will Surpass the Stock Market
After the financial crisis of 2007-08, and now the ongoing sovereign debt crisis, the derivatives market will, for many, live in infamy. Mortgage-related derivatives have pretty much disappeared, although many old ones continue to bedevil the banking system. Derivatives products for governments have been suddenly thrust into the spotlight by the sovereign debt crisis, and it's likely that these products will lose popularity as a result of their newly-found notoriety.
But the derivatives markets will live on, and mostly likely thrive, because the heat is on in the stock markets. Today, the SEC placed controversial limitations on short selling. If a stock's price drops 10% during a trading day, short selling will be permitted only if the national best bid price for the stock rises. This limitation will continue for the rest of the trading day and the following trading day. A number of hedge funds, including some that are known to focus on short selling and others not, opposed this restriction. So did at least one large bank, Goldman Sachs, which earns a lot of profits from proprietary trading.
The fact that professional traders opposed the short selling ban indicates that the prospects for the derivatives market are good. If the pros can't short sell stocks, they'll look for derivatives contracts that accomplish the economic equivalent. Indeed, a big bank like Goldman might take the lead in developing such contracts. An important reason why derivatives were so central to the growth of the mortgage market is that the lack of regulation of mortgage-related derivatives allowed the big banks to develop products and ways of doing business that were highly profitable (at least in the short run, but that's what matters for determining executive bonuses). There is considerable demand in the markets for the ability to sell short. The only question is what alternatives could be created to circumvent the new short selling restrictions.
The obvious stratagem would be to create a derivative in the nature of a single stock futures contract or a similar forward contract for delivery of the stock. Any such contract would presumably not be listed on a U.S. commodities exchange (the point is to avoid regulation), but would be traded over-the-counter. If necessary, it could be transacted overseas, in a friendly regulatory environment where the government didn't necessarily coordinately closely with U.S. regulators. If the firm offering such a derivative wanted to cover its exposure, it could itself trade in this friendly environment to hedge the customer contracts it sells, and just about no one would know the better.
Then again, the firm offering the derivatives equivalent of a short sale might not want to cover its exposure. The big money in proprietary trading comes from making one-sided bets in markets where prices are volatile. The day-to-day humdrum of market making in a stable market is like operating a grocery store--you make pennies at a time if you make pennies at all. If a firm thought itself skilled at making proprietary bets, it might take on unhedged exposure in the hope of hitting a home run. Sometimes, these bets pay off, and the temptation will be there in a world where the size of one's bonus establishes one's social standing. Without regulators around to frown about undue risk, temptation may triumph, as it did in the mortgage derivatives market.
Either way, the new short sale restrictions will hinder the small, individual investor trading a few tens of thousands of dollars in an online brokerage account. But the big boys with financial muscle will further the evolution of the derivatives market.
Another sign that the derivatives market is destined for growth is the news story that emerged in late January reporting that the exchanges are thinking about asking the SEC for authority to price quotes and transactions in increments less than a penny. See http://www.reuters.com/article/idUSTRE60P4PQ20100126. Apparently, alternative tradings systems like the so-called dark pools are pricing in sub-penny increments, and the exchanges are thinking they might need to meet the competition. The problem will be that the bid-ask spread (the difference between the bid price at which investors sell stocks and the ask price at which they buy stocks) will shrink when sub-penny prices are used. The bid-ask spread approximates the profit potential for brokerage and specialist firms making markets. As it shrinks, the profitability of the stocks business will diminish as well. Big bonus mania will push the financial firms toward the derivatives markets, where opacity is king and bid-ask spreads are indeterminate from the customer's standpoint (or, as much as the traffic will bear, from the dealer's standpoint). For a real-life illustration of how opacity and big profits intertwine, see http://blogger.uncleleosden.com/2010/02/will-wall-street-get-pass-on.html.
If serious reform of derivatives regulation by the U.S. and other major economic powers was in progress, the blessings of transparency would spread across the derivatives market and stratagems to circumvent the short selling restrictions would be harder to develop. Furthermore, the expansion of the derivatives market that is rendered inevitable by the shrinking margins in the stocks business would be fairer to investors. But the prospects for meaningful reform have diminished as the stock market has partially recovered and Wall Street has mounted a relentless anti-regulatory lobbying campaign. That leaves unchecked a humongous loophole in the regulatory structure through which the big banks can shove investors' money into an opaque and ungoverned environment where, as with mortgage-backed and mortgage-related investments of the early and mid-2000s, another shadow banking system can evolve, bubble up and pop again.
But the derivatives markets will live on, and mostly likely thrive, because the heat is on in the stock markets. Today, the SEC placed controversial limitations on short selling. If a stock's price drops 10% during a trading day, short selling will be permitted only if the national best bid price for the stock rises. This limitation will continue for the rest of the trading day and the following trading day. A number of hedge funds, including some that are known to focus on short selling and others not, opposed this restriction. So did at least one large bank, Goldman Sachs, which earns a lot of profits from proprietary trading.
The fact that professional traders opposed the short selling ban indicates that the prospects for the derivatives market are good. If the pros can't short sell stocks, they'll look for derivatives contracts that accomplish the economic equivalent. Indeed, a big bank like Goldman might take the lead in developing such contracts. An important reason why derivatives were so central to the growth of the mortgage market is that the lack of regulation of mortgage-related derivatives allowed the big banks to develop products and ways of doing business that were highly profitable (at least in the short run, but that's what matters for determining executive bonuses). There is considerable demand in the markets for the ability to sell short. The only question is what alternatives could be created to circumvent the new short selling restrictions.
The obvious stratagem would be to create a derivative in the nature of a single stock futures contract or a similar forward contract for delivery of the stock. Any such contract would presumably not be listed on a U.S. commodities exchange (the point is to avoid regulation), but would be traded over-the-counter. If necessary, it could be transacted overseas, in a friendly regulatory environment where the government didn't necessarily coordinately closely with U.S. regulators. If the firm offering such a derivative wanted to cover its exposure, it could itself trade in this friendly environment to hedge the customer contracts it sells, and just about no one would know the better.
Then again, the firm offering the derivatives equivalent of a short sale might not want to cover its exposure. The big money in proprietary trading comes from making one-sided bets in markets where prices are volatile. The day-to-day humdrum of market making in a stable market is like operating a grocery store--you make pennies at a time if you make pennies at all. If a firm thought itself skilled at making proprietary bets, it might take on unhedged exposure in the hope of hitting a home run. Sometimes, these bets pay off, and the temptation will be there in a world where the size of one's bonus establishes one's social standing. Without regulators around to frown about undue risk, temptation may triumph, as it did in the mortgage derivatives market.
Either way, the new short sale restrictions will hinder the small, individual investor trading a few tens of thousands of dollars in an online brokerage account. But the big boys with financial muscle will further the evolution of the derivatives market.
Another sign that the derivatives market is destined for growth is the news story that emerged in late January reporting that the exchanges are thinking about asking the SEC for authority to price quotes and transactions in increments less than a penny. See http://www.reuters.com/article/idUSTRE60P4PQ20100126. Apparently, alternative tradings systems like the so-called dark pools are pricing in sub-penny increments, and the exchanges are thinking they might need to meet the competition. The problem will be that the bid-ask spread (the difference between the bid price at which investors sell stocks and the ask price at which they buy stocks) will shrink when sub-penny prices are used. The bid-ask spread approximates the profit potential for brokerage and specialist firms making markets. As it shrinks, the profitability of the stocks business will diminish as well. Big bonus mania will push the financial firms toward the derivatives markets, where opacity is king and bid-ask spreads are indeterminate from the customer's standpoint (or, as much as the traffic will bear, from the dealer's standpoint). For a real-life illustration of how opacity and big profits intertwine, see http://blogger.uncleleosden.com/2010/02/will-wall-street-get-pass-on.html.
If serious reform of derivatives regulation by the U.S. and other major economic powers was in progress, the blessings of transparency would spread across the derivatives market and stratagems to circumvent the short selling restrictions would be harder to develop. Furthermore, the expansion of the derivatives market that is rendered inevitable by the shrinking margins in the stocks business would be fairer to investors. But the prospects for meaningful reform have diminished as the stock market has partially recovered and Wall Street has mounted a relentless anti-regulatory lobbying campaign. That leaves unchecked a humongous loophole in the regulatory structure through which the big banks can shove investors' money into an opaque and ungoverned environment where, as with mortgage-backed and mortgage-related investments of the early and mid-2000s, another shadow banking system can evolve, bubble up and pop again.
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