THE BEAR'S LAIR Downsizing of finance underway
By Martin Hutchinson
A committee led by Gerald Corrigan, former vice chairman of the Federal Reserve
Bank of New York, produced a report that promises to revolutionize finance. It
proposes to place severe limits on derivatives, bringing them under the ambit
of regulators and protecting retail investors from their more egregious
products.
His report met with a favorable reception from the major international banks;
not surprising as it shuts the stable door after horses have bolted to the
extent of about US$500 billion of losses and counting. For investor and market
protection, it doesn't go far enough. However it does represent the first
institutional step
towards a goal that all non-financiers should welcome: the downsizing of
finance in the US and global economy.
The effect of the report, and of the changes currently under way in finance,
can be seen from its treatment of the auction-rate securities market, a $330
billion behemoth that melted down in February. In these transactions, investors
buy long-term bonds or preferred stock, the interest rate payable on which is
determined by an auction process every 30 days or so. Thus investors who no
longer wish to hold the securities can in theory sell them to other investors
who are prepared to hold them, but only with a higher yield. In practice, in a
credit crunch, they didn't work. The report proposes a prohibition on selling
auction-rate securities to retail investors.
In addition, during the last week banks have agreed to repurchase a total of
$41 billion in auction-rate securities from retail investors - $18.6 billion by
UBS (on top of a previous $3.5 billion) and $20 billion by Citigroup and
Merrill Lynch. At least part of the UBS repurchases will be at par, and all
repurchases will be at prices close to par.
The auction-rate securities disaster is symptomatic of what went wrong in the
investment banking industry following the invention of derivatives in the late
1970s, and the move towards dominance of the major Wall Street houses by
traders rather than traditional corporate financiers. Traditional investor
protections, devised by seasoned corporate financiers who understood the
business cycle and wished to preserve the firm's good name in a downturn, were
replaced by the manic bonus-hunting short-termism of the typical trader.
Auction-rate securities have mostly come in two varieties: auction rate
preferred stock, issued by corporations and particularly financial
institutions, and auction-rate municipal bonds, issued by municipalities. There
have been relatively few issues of auction rate conventional corporate debt,
perhaps because a deep market already existed for corporate commercial paper at
the time auction-rate securities were first issued (auction-rate securities are
unlikely to be truly competitive with commercial paper backed by a bank
backstop line, which for the issuer has the same characteristics of a variable
interest rate and guaranteed availability over the medium or long term.)
The first auction rate preferred stock was sold by Citicorp (now Citigroup) in
1984. Within three years, the market had grown to $12 billion in outstandings,
at which point disaster occurred. An issue of ARS for MCorp, a Texas bank
suffering bad debt problems in real estate, suffered a liquidity crisis when
there were no longer sufficient bidders for MCorp's short term paper within the
price parameters set down for the issue (typically, at that stage, ARS issues
prescribed a maximum as well as a minimum rate at which rates would be set.)
This was not surprising. Even the first Citigroup issue had been sold to
investors as "just like short term paper" when it was no such thing. Corporate
financiers with experience of the difficulties suffered by the international
floating-rate note market in the credit crisis of 1979-82, then only a few
years back, were well aware that while interest rates on floating-rate paper
would more or less keep up with market levels, in a period of illiquidity
prices could fall arbitrarily far, as investors' liquidity preference became so
strong that they were no longer ready to bid on new issues of the paper at any
yield.
The ARS market thus rested fundamentally on a lie. It is extraordinary that the
market lasted 24 years before blowing up, reaching total outstandings of $300
billion and spreading from the preferred stock market to municipal bonds.
Retail and institutional investors were fed the market's Big Lie by salesmen,
and so believed that ARS were high-quality, perfectly liquid paper. The blow-up
of February 2008 thus came as a great shock to the market, and it is not
surprising that the banks have felt it necessary to buy back retail ARS, lest
their costs of doing so be dwarfed by settlements on class action suits from
lawyers representing investors - which suits would be justified, for once.
An even more dangerous derivatives-related product, also based fundamentally on
a big lie, is the credit default swap (CDS). Here the big lie is that these
represent hedging transactions and hence a net reduction of risk, passing
credit risk from the overstretched banks to institutions better able to bear
it. Corrigan treats CDS lightly, recommending simply that all these
transactions pass through a central clearing house, a recommendation that has
been generally accepted and that was made more urgent by the Bear Stearns
collapse.
However a moment's thought, and examination of the principal amounts involved,
will tell you that CDS are far more than a hedging instrument. The total amount
of corporate debt outstanding in the United States is about $5 trillion, to
which can be added $12 trillion of home mortgages to get an idea of the
universe of US risks that can be transferred. With bits and pieces, say $20
trillion in total. Yet the principal amount of CDS outstanding exceeds $60
trillion and is increasing rapidly.
In reality the CDS market moved beyond simple hedging and risk transfer many
years ago and became a sophisticated casino in which Wall Street participants
could gamble, look for suckers, transfer income to more convenient years (when
their bonus percentages were higher), hide mistakes and play games with the
accounting.
Given the spurious nature of the motivations behind CDS trading, there can be
no doubt that multiple billions of losses have been accrued already in this
market, only part of which losses have so far been recognized in financial
statements.
When the CDS market is examined closely, it becomes clear that, as with
auction-rate securities, it rests on a lie and has very little value to the
global economy. Like much of Wall Street's activity over the past two decades,
it represents pure rent seeking.
Forcing trades to pass through a central clearing house reduces counterparty
risk but does not alter the fact that the CDS market creates many times as much
risk as it hedges or transfers. Selling a credit risk more than once, or
selling a risk that is not in one's portfolio, is not hedging, it is pure
speculation, increasing the overall risk in the financial system.
The past year has surely demonstrated that excessive credit risks remain the
principal threat to a financial system's stability; hence it is truly crazy to
encourage a product that multiplies them many-fold. Given the size of the
liabilities involved, CDS represent a huge and largely hidden iceberg, which
could strike the shoddily designed financial system Titanic at any time.
One should give CDS the benefit of the doubt and assume that at the margin they
serve a useful function in risk transfer and balancing of obligations between
institutions. However, there can be no reasonable risk-management justification
in selling a credit risk one does not possess, or "going short" in the credit
of a third party, so that one benefits from that third party's collapse. Far
more than mere short selling of stocks, short selling of credit needs to be
prohibited, in order that the total volume of CDS outstanding remains a
fraction of the credit risks involved and not a multiple of them, and the
global financial system is protected from destabilizing games.
A third derivatives-related disaster whose full cost is not yet apparent is the
collapse of Fannie Mae and Freddie Mac. Again, those institutions were based on
a lie, the deceit that they were really private-sector companies that could be
relied upon to pursue profit in a rational fashion without endangering the
national solvency by their default. In practice, they leveraged more than would
have been possible without the government's quasi-guarantee, lobbied like crazy
to ensure they were not properly regulated and collapsed thankfully into the
arms of the taxpayer as soon as ill winds began to blow.
The cost of the collapse will certainly be far more than the $25 billion
estimated by the Congressional Budget Office, since their lending and guarantee
practices were so unsound. Indeed, by their presence they turned the soundest
product in financial markets, the home mortgage, into an obscene speculative
casino, causing collateral damage of many times their own losses.
Finally we have the biggest lie of all, a US monetary policy pursued since 1995
that pretends the free-market system works just fine when government agencies
are playing games with the value of the monetary unit, inflating its
outstanding volume by about 10% per annum, far more than would be justified by
economic growth. That lie will cause the largest losses of all - but I have
written about it many times.
Corrigan is a feeble first step in the right direction; its prohibition on the
sale of auction rate securities to retail investors demonstrates as does
nothing else that much of the financial services innovation of the last
generation was spurious and unsound, and needs to be done away with. Rents
achieved by the financial services industry will thereby become much
diminished, and millions of more or less honest if overpaid toilers will be
thrown out of jobs. Needless to say, stock and bond prices will suffer a
meltdown when this becomes fully apparent to the trading fraternity.
For the rest of the global economy, this denouement cannot come quickly enough.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice & Associates.)
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