THE BEAR'S LAIR The Wall Street of the future
By Martin Hutchinson
Two weeks ago, the stock market finally returned to its valuation levels of
before the monetary bubble began in 1995, appropriately inflated for the rise
in nominal gross domestic product. The 4,000 on the Dow Jones index that was
first reached within a week of then Federal Reserve chairman Alan Greenspan's
February 23, 1995 Humphrey-Hawkins testimony loosening monetary policy is
equivalent to about 7,900 today; on November 20, the market closed below that
valuation level for the first time in over 13 years.
We are thus in a new world; it is thus time to determine a structure for Wall
Street that will make the new order one of economic growth led by technological
and business methods innovation, with finance playing its appropriate
supporting and
enabling role. Last week (see
Towards a future Wall Street, Asia Times Online, November 26, 2008), I
anatomized the failings of Wall Street during the 1995-2008 bubble; today I
want to look at how it might be restructured.
We cannot look at the new Wall Street structure from the position of an
omniscient deity trying to create the perfect financial system because such a
position is not currently available. Instead, we must examine it from the point
of view of what can be achieved in practice either by the market or by finite
and plausible regulation. By monetary and fiscal policy, market conditions can
be usefully affected, pushing institutional behavior patterns in the right
direction. On top of that, well-chosen regulation can prevent abuses during the
course of bubbles, although tight monetary policy will do most of the work
here.
The downturn itself has caused major institutional changes. Whereas previously,
very large banks were thought to be probably "too big to fail", there was no
certainty about it. Furthermore, the most important role in corporate finance
was played by the investment banks, about which no such assumption then
existed. Today, there are no large investment banks, and very large financial
institutions in general have shown themselves both vulnerable to failure and
entitled to a government bailout if failure occurs. Hence even if we wanted to
return to the 1995-2008 version of Wall Street, we couldn't.
The first problem to be solved is what to do with institutions that are "too
large to fail". Clearly they must not be permitted to leverage themselves, as
did the banks and investment banks of the bubble years, nor must they be
allowed to do "fat tail" high-risk principal trading, nor to invest more than
modestly in private equity and other illiquid and risky securities. Equally,
there is a place for institutions on which the public can unconditionally rely
in taking deposits, making loans and underwriting low and moderate-risk
securities.
The large banks will respond that through their sophisticated risk-management
systems they can protect themselves and the taxpaying public against loss. They
should not be believed. The current crisis has shown that not only did the
"Value At Risk" (VAR) risk-management system pathetically fail, there is no
risk-management system that is capable of controlling complex instruments in a
turbulent market.
While the market remains calm as it did from 1995-2007, these securities'
behavior remains apparently under control, obeying the VAR risk limits in most
cases and deviating from them only modestly in the 1% of cases where they fall
outside their VAR limits. However, in turbulent markets, as we entered for
mortgage securities in July 2007 and for all securities in September 2008,
there is no limit as to where these securities may trade. The problem is
exacerbated by "mark to market" accounting, which forces entities to mark
exotic securities to their value in a thin secondary market, no matter what
their likely long term risk characteristics.
Hence "too big to fail" institutions should not be allowed to have more than a
modest portion of their capital (say one-third, an amount they can afford to
lose and survive) in risky or highly illiquid instruments. In return, "mark to
market" accounting should be abolished for these institutions. There are
essentially public utilities, such as the local water company, and should be
regulated and controlled as such. They will do big deals, and will have a
limited underwriting capability, but they will not be centers of either risk or
innovation. Their staff will be generally bureaucratic in nature, and paid
accordingly, although clearly there will be some modestly challenging
management positions at the top.
The "too big to fail" institutions will include the national commercial banks,
Fannie Mae and Freddie Mac (whose leverage will be severely limited). They will
benefit enormously from their paper being essentially government guaranteed but
will be engaged almost entirely in low-margin commoditized businesses, and
their leverage will also be strictly limited. They will also be highly
regulated.
There will also be three other categories of institutions, each of which will
have limits on their total assets so as not to become a threat to the financial
system if they fail. Their borrowing costs will be greater than the "too big to
fail" banks but they will benefit from being less restricted and, if they wish,
higher leveraged.
The first will be the advisory houses, sources of most financial innovation and
advisory work for major corporations on mergers, fundraising and other matters.
They will be private partnerships with unlimited liability and therefore of
necessity modestly capitalized and able to take only modest principal risks.
They will arrange underwritings but will subcontract the underwriting risk to
the "too big to fail" institutions and to other investment institutions. Their
remuneration for a new issue will thus primarily be a management fee. They will
be lightly regulated, since the partnership form should make them largely
self-regulating; in any case they will not be "too big to fail". In general,
they will employ the most capable people.
The second category of smaller institutions will be those with a primarily
local business, particularly in the field of home mortgages. Since these will
not be "too big to fail", they should be allowed to carry on more or less as at
present, with deposit insurance and a limit on their size. Having higher
funding costs but fewer restrictions than the "too big to fail" houses, they
should be competitive with them in serving their local areas. Certain modern
financial techniques, notably interest rate swaps, will enable them to hedge
their risk of lending long and borrowing short.
Finally, there will be investment institutions themselves, which will include
insurance companies, pension funds, hedge funds and private equity funds. These
will have the choice of obeying the size restrictions to avoid "too big to
fail", in which case they will operate freely, or growing larger, in which case
they will be restricted as to the amount of their funds under management they
can invest in illiquid or otherwise risky assets, and the leverage they can
take on. They would retain the "mark to market" accounting regulations for
their accounts.
The modest hedge fund and private equity fund sectors would be homes for people
with a high level of ability and an equivalent level of greed/aggression; such
people would thus be safely segregated from the advisory business and the
levers of real financial power.
As to business areas themselves, there would appear to be two further necessary
restrictions beyond those which already exist. First, credit default swaps
should only be legal if traded over an exchange; the exchange would then
establish rules as to collateral and so forth and publish records of positions
taken. Second, loans would only be securitizable by their originator for up to
80% of the originator's participation in them (so 20% would remain on his
books) and artificial securitizations that were not tied to a particular loan
would be prohibited.
Thus a manager who took $100 million of a $1 billion loan syndication would be
able to securitize $80 million but would have to keep $20 million; similarly
the originator of a $500,000 home mortgage would have to keep $100,000.
Naturally "too big to fail" institutions would be subject to capital
limitations on their derivatives businesses and loan securitization positions.
This structure would be implemented by a combination of three methods. First,
legislation would be passed tightly restricting the activities and leverage of
"too big to fail" institutions. That would drive the best talent outside those
institutions, either to hedge funds or advisory partnerships.
Second, legislation would tightly restrict conflicts of interest for advisors
in underwritings or merger transactions, basically prohibiting them from taking
more than small participations in deals they arranged. Some thought needs to be
given as to how to push the advisory entities into the private partnership form
which is optimal from a public policy perspective. Maybe particularly onerous
Sarbanes-Oxley type disclosure and auditing regulations on them as public
companies would be appropriate, or maybe "mark to market" accounting itself
would be sufficiently onerous for advisory companies as to discourage public
listings.
Finally, a tight monetary policy would radically change the environment in
which Wall Street operates. The speculation and over-leveraging of the bubble
years was greatly exacerbated by the lengthy persistence of "easy money"
conditions. By 2007, the first stirrings of the downturn were described by the
Bear Stearns chief financial officer as "the worst I've ever seen in 22 years"
- technically quite correct, as he had only entered the business in 1985.
Easy-money markets that last longer than senior management's career lengths are
a serious menace to financial system health. The solution is tighter money -
which reduces the length of bubbles to no more than a few years - and more
experienced senior management, eliminating the "drop-dead money by 40" syndrome
that bedeviled Wall Street during the bubble years.
In the 1987 crash, Kidder Peabody's chairman was Al Gordon, who had got his
start on Wall Street in 1925 and was a full partner before the 1929 Crash; a
properly run financial services industry contains a substantial leaven of such
people at the very top.
A reformed financial services business will play a smaller role in the US and
global economies, and will be only one of a number of attractive career
alternatives for the best and brightest. It will greatly contribute to the
health of the US economy as a whole, in particular sharply reducing the
percentage of the nation's assets that are controlled by crooked or incompetent
short-term operators. It's not that difficult to implement; just a tight
monetary policy and one carefully crafted piece of legislation should be
sufficient. Now, while the industry is chastened by failure, is the time to
arrange its restructuring.
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 2005-08 David W Tice & Associates.)
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