We've Got Bailouts. How About Fixing the Banking System?

Just in time for the holiday season, the federal government is trying to climb down the chimney with bailouts in hand. It's brought a rate freeze for some mortgage borrowers, a super conduit for SIV-bedeviled banks, and another interest rate cut courtesy of the Federal Reserve Board. There have been many of the usual holiday-season reactions to these gifts. Many borrowers claim that the rate freeze doesn't benefit enough homeowners, and the stock market threw a hissy fit today when the Fed's interest rate cuts felt too much like anthracite from a stocking. Unfortunately, regifting isn't possible here.

The government has only been treating symptoms. If things go well, it might stabilize the situation. But all of the government's announced measures simply re-allocate the mammoth risks and losses from the mortgage mess. The rate freeze benefits some borrowers and hurts banks and investors. The super conduit will provide liquidity to certain SIVs and their affiliated banks, but at risk to the investors in the super conduit and its commercial paper. The Fed's latest interest rate cut, like all its other rate cuts, benefits banks and reckless speculators while shifting some of their losses onto savers and other holders of capital. Re-allocating losses, often in seemingly arbitrary or random manner, does little to promote rational future behavior. It might, indeed, exacerbate the credit crunch as holders of capital simply avoid the asset-backed investments that have given rise to the current financial mess.

That points to the missing piece of the government's response to the mortgage crisis and credit crunch. Securitization of loans is big business today. Most types of loans that banks made and held 25 or 30 years ago are now bundled into investments with various alphabet soup acronyms and sold to investors. These include home mortgages, home equity lines of credit, credit card balances, auto loans and corporate loans. Those things called "banks" are in many respects just administrative functionaries that screen borrowers' creditworthiness (we hope) and process paperwork associated with loans. But actual loans are made by investors. The real bank is the securitization process.

Asset backed securities, as we all know, are not protected by federal deposit insurance. That's much of the reason for the credit implosion this past summer. Investors, who functionally speaking are depositors, were frazzled by mortgage losses and tried to offload their mortgage-related exposure. Cash values of these investments plummeted or became unavailable. Hedge funds and other investment vehicles shut down. If you step back, it all has an uncanny resemblance to the financial panics and bank collapses of the pre-FDIC world. That shouldn't be surprising, since the asset-backed securities market is now a crucial de facto segment of the banking system.

Neither J.P. Morgan nor Jimmy Stewart is around to calm the panic. Federal insurance of asset-backed securities wouldn't fly, for both political and practical reasons. The $100,000 limit on federal insurance of bank accounts is a trivial amount in the multi-millions and billions world of asset-backed securities. A higher amount would look like a bailout of the wealthy, and would probably result in federal examiners moving into the offices of the investments banks peddling these investments in order to prevent undue risk to the U.S. Treasury.

There are ways to improve the asset-backed securities market and thereby strengthen the true banking system:

1. Simplification and standardization. Many asset-backed investments, such as CDOs, are a witch's brew of different loans, including mortgages, credit card balances, auto loans and corporate debt. An important reason why these things can't find cash buyers right now is because a cash buyer would need a supercomputer to analyze the constituent components of the asset pool and calculate a value. On Wall Street's trading desks, buy and sell decisions are often made in seconds. There's no time to dally around with complex, hinky derivatives of derivatives. Simplifying and standardizing asset-backed investments, such as limiting them to just one type of loan--e.g., home mortgages with a first lien, auto loans for new cars, or credit card balances with credit ratings of at least a certain minimum--would go a long way to ensuring that they can find a ready market. Overpaid financial engineers have mixed and matched too many different kinds of debt in a now discredited effort to squeeze AAA ratings out of risky investments. Their cleverness and a half has been costly for all of us.

2. Margin Regulations for Derivatives. Much of the reason for the sudden and severe losses of the past six months is the mainlining of leverage by the investment community. The reckless lending by banks and reckless borrowing by money managers magnified every flaw in the securitization process, and rubbed vats of salt into the wounds suffered in the financial crisis. Borrowing with abandon to buy stocks was one of the reasons for the stock market boom of the 1920s and the flood of margin calls that aggravated the stock market crash of 1929. The Fed has successfully regulated margin lending on stocks ever since. It should get and exercise regulatory authority over margin lending on derivatives.

3. Regulation of Hedge Funds and Derivatives Trading. One of the major reasons for the make-it-up-as-you-go-along quality of the government's response to the financial crisis is that regulators don't know much about the problems. Getting firm information about the full extent of derivatives holdings and trading has apparently been extremely difficult or impossible. It's really hard to formulate effective policy if you can't see the complete contours of the problem. Federal regulators don't effectively regulate either hedge funds or derivatives trading, partly because of a lack of inclination and partly because of questions about their lawful authority. Both of these problems can and should be fixed. Given the hundreds of billions of dollars of losses that now appear certain, there remains no excuse for a regulatory void. The regulation need not overstep reasonable bounds--the crucial things are to be able to gather information about who holds what, who has sustained what losses, and what the trading activity has been.

4. Listed Markets for Asset-Backed Securities. A logical corollary to the preceding measures would be the creation of exchanges or similar markets for asset-backed securities with publicly displayed price quotations and transaction reports. Nothing would instill public confidence and investment interest as much as an open and readily observable market. That's exactly what happened with stocks and bonds. It can happen with asset-backed securities.

The securitization process isn't going to go away. The regulatory structure of the formal banking system, with its risk-based capital requirements, will continue to subtly push banks to offload credit risk. And the securitization process is a primary means of accessing the vast amount of capital it takes to fund banks' lending activities. Back of the envelope bailout proposals won't make the banking system truly functional. Only meaningful reform can accomplish that.


School News: parents with high school age kids, rethink your plans to move to Montpelier. www.wtop.com/?nid=456&sid=1307882.

Stock Market Volatility and How It Bailed Out the Fed (This Time)

Anyone with even a passing interest in the stock markets has noticed the surge in volatility in recent months. The Dow Jones Industrial Average seems clinically manic-depressive, flying in the stratosphere one day and bungee jumping with a frayed rope the next day. Daily movements of 200 or even 300 points have become commonplace. Antacid manufacturers and therapists are celebrating.

Where does the volatility come from? There's no way of knowing all of the reasons. As discussed in an earlier blog, there are unknown factors that probably will never be known. http://blogger.uncleleosden.com/2007/07/why-stock-market-bounces-around.html. But not everything is unknown. Here are a few thoughts to chew on.

1. The Managed Money Problem. The greatest threat to professional money managers is the index fund. Most money managers can't beat the S&P 500, and many don't even do as well. If a money manager can't beat the S&P 500, why would his or her clients not simply move their money to an index fund? Many index funds have low fees and expenses, and are relatively tax efficient. Money managers feel the pressure to step away from traditional stock picking and try out other strategies in order to get even a tiny increment ahead of the overall market. For example, one can trade futures contracts for the S&P 500. This is a game for bigtime money managers and institutional investors. Individual investors should not try this at home. If a money manager senses that the stock market is likely to fall, he could sell S&P 500 futures contracts in an effort to hedge his stock holdings, or simply to bet on the price drop. Alternatively, he could buy S&P 500 put options, which would hedge his losses if the S&P 500 drops.

If the market begins to sink after the money manager has sold S&P 500 futures contracts or bought S&P 500 put options, the counterparty to that transaction will begin to sell the S&P 500 stocks to hedge its exposure (or do some sort of derivatives trade with another counterparty, who will start to sell stock). Either way, sell pressure is added to the market at a time when it is teetering. Financial history buffs will recall that portfolio insurance had a similar effect in the 1987 market crash.

2. Yen carry trade. Interest rates in Japan have been extremely low ever since the Tokyo stock markets rose in the 1980's and then crashed in 1989. The Nikkei 225 fell from an all-time high around 38,900 to the 7,000 to 8,000 level and has risen to around 17,000 today. The Japanese stock market bubble was accompanied by a real estate bubble so extreme that the Japanese imperial palace was said to be worth more than the entire value of all the real estate in America. Some Japanese home buyers took out 100-year mortgages (that's some inheritance for your kids). Needless to say, the Japanese real estate bubble also popped. Between the stock market crash and the real estate bubble popping, Japan's banks were saddled with such enormous loan losses that they very possibly were insolvent. In order to bail out the banks, the Japanese central bank lowered interest rates to virtually zero (which meant the banks could take deposits and otherwise borrow money for almost no cost). These rates have been kept more or less around zero until recently.

The extraordinarily low interest rates in Japan gave rise to a trading strategy called the "yen carry trade." You borrowed yen at the very low rates available in Japan, converted it into dollars, and invested in the U.S. Because U.S. interest rates and other returns were quite a bit higher than your borrowing costs, you made some easy money fairly quickly. There's nothing like easy money. Many Japanese have been using this strategy. So have many other investors, from places like the U.S., U.K., Australia and New Zealand. Anyone who can borrow yen--and in today's globalized financial system, that means almost anyone who can borrow--can do the yen carry trade.

The catch--remember, in all investment schemes, there's a catch--is that currency exchange rates fluctuate. If the dollar drops in value against the yen, the dollar denominated investment gains you get will be reduced by your losses in the dollar. In the last year or so, the dollar has been dropping against the yen. While the drop has been fairly gradual, it's been enough to make yen carry traders nervous.

Then, the stock market fell, sometimes abruptly, in the last two and a half weeks. That's been enough to make a lot of yen carry traders throw in the towel. They've ditched their U.S. investments, and reconverted their money into yen.

3. Hedge Funds. You knew hedge funds would be mentioned sooner or later, and here they are. Hedge funds that invested in subprime and other mortgages (another thing you knew would come up) have been receiving many withdrawal requests from nervous investors who believe too much of what they read in the newspapers. In the case of one Bear Stearns sponsored hedge fund, the fund simply ceased honoring withdrawal requests. But many other hedge funds have been trying to accommodate these nervous Nellies who have a complex about retiring with only Social Security.

The hedge funds have a minor problem, though. There aren't many people paying cash for CDOs these days. Some CDOs, when put up for auction, apparently aren't getting any bids at all. You can't honor a withdrawal request with zero. So, hedge funds have been liquidating other investments, like other debt securities. The private equity debt and junk bond markets have been particularly hard hit by these liquidations, and spreads between these securities and Treasuries have widened sharply. It's also likely that some of the selling in the stock markets has also been hedge funds raising cash to meet withdrawal requests, or just hoping to avoid losses.

4. Short Sellers. Short sellers are viewed by many as a scourge. They are disliked for profiting from misfortune and scorned for scavenging. However, they may assist the pricing function of the market, pushing the price toward its true equilibrium.

Some short sellers have no doubt been shorting the market (through derivatives that allow them to trade the equivalent of the S&P 500 or other broad market indexes). This probably has added to the downward pressure on the market. However, the shorts can also fuel some of the upward pops in the market. When the market begins to rise, the shorts start to take losses on their positions. As their losses increase, the counterparties with whom they traded (in order to assume their short positions) will often ask for cash collateral. If the shorts don't or can't provide cash collateral, or simply want to cut their losses, they'll buy stock to cover their shorts. This "short covering" is fast and intense, and may account for the laughing gas quality of some of the recent upswings in the market.

5. Derivatives Market? The increasingly tattered state of the derivatives market may account for some of the increased market volatility. There's no way to know for sure, since the derivatives market is unregulated and seriously opaque. But many players that might write derivatives contracts to protect holders of stocks from downswings could be inclined to demure these days. They may have taken losses in the subprime and corporate debt markets, and be unable to take on additional equity risk. They may simply be skittish, not knowing how bad things are, and prefer a quiet game of croquet.

Derivatives are said to moderate volatility by shifting risk to parties willing to take it. There's some truth to that. The problem is one of success--they proved so good at risk shifting that more players began investing in risky contracts, with expectation that they'd shift the risk to someone else. That was a clever strategy until it created such a large amount of risk that the mortgage market belly flopped. We discussed these unintended consequences in http://blogger.uncleleosden.com/2007/07/how-cdo-market-increased-subprime.html.

If some of the participants in the derivatives market have stopped playing in that particular sandbox, others seeking to hedge their stockholdings may be unable to lay off their downside equity risk. In that case, they'd have to take old fashioned action to protect themselves--like sell. As the derivatives market pulls back, it won't damp volatility as much.

There may be many other causes of market volatility, although these are probably enough for anyone who owns stock. The past few years have been unusually calm ones for the markets. But an unduly large amount of risk may have been heedlessly created because of the Panglossian perception fostered by that calm. The concern now is that this change in financial climate may have created the conditions for larger and more frequent hurricanes. Let's hope the levees hold.

A Fed Bailout: in the vein of cat-saves-people-from-fire stories, we noted in the preceding blog (http://blogger.uncleleosden.com/2007/08/uncle-alans-legacy-at-federal-reserve.html) that the stock market was hoping the Fed would give the market a little boost at its meeting today. In anticipation of some dispensation, the Dow rose 287 points on Monday (8/6/07), the day before the meeting. With a handicap like that, it was easy for the Fed not to indulge the market, hold interest rates steady and maintain that its primary concern is controlling inflation. The Fed gave the market a bit of a doggy treat by noting the problems in the credit and real estate markets, and the stock market's volatility. But it gave no real indication that an interest rate cut would be forthcoming at any predictable time in the foreseeable future. The Dow closed up 35, apparently satisfied with the crunchy chicken and beef flavor of its treat.

Animal News: you can't take hardly any liquids on board a plane, but if it's a monkey . . .
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