Monday, October 22, 2007

SIVs, Conduits and the Credit Crises in Our Future

Esoteric investment vehicles called SIVs and conduits have become cocktail party topics. The U.S. Treasury and the nation's largest commercial banks are sponsoring a bailout of banks affiliated with distressed SIVs and conduits, to the tune of $80 to $100 billion dollars. The G-7 and IMF issued statements at meetings held this weekend expressing concern about the credit crisis and encouraging central bank action to limit its impact. Financial journalists write about the losses sustained and the losses to be incurred in the future, and the financial engineering games that created the losses. Economists are quoted on cable television predicting recession, or not.

It's clear from both the Fed's surprise half-point interest rate cut in September and the Treasury's sponsorship of the super conduit that supposedly will stabilize the debt market that the government thinks the credit crunch is serious and an ongoing problem. There's plenty of speculation about whether or not the Fed will cut interest rates further, and even a little commentary on the possibility that the taxpayers will have to provide some money to bail out the big banks. In other words, there's plenty of talk about how those responsible for the mess can be insulated from risk. But there's little discussion about the need for increased government oversight to prevent the kind of reckless excess that characterized the CDO market until recently.

The government that simply reacts to the crisis of the moment, and doesn't plan for the next recurrence of problems, is doomed to be unprepared for the next mess. Generals and admirals are sometimes accused of preparing to fight the last war. But at least they are doing something about the future. While the financial regulators and Congress have issued some statements and even held a few hearings, no substantial steps have been taken to prevent a recurrence of the problem.

Market forces have worked poorly in this situation. We have to consider that markets aren't machines or automated processes. They consist of the interactions of people, and people can be irrational, oblivious, gullible, and, most importantly, greedy yet fearful. All of this means that people--and therefore markets--can screw up.

First, over-investment in mortgages resulted in the creation of vast quantities of risky derivatives (CDOs and others of their ilk) that few understood. The valuations ascribed to these investments were based on the assumption that the real estate market would continue rising indefinitely. That a perpetually rising real estate market had never before occurred in the history of the world was no impediment to the belief that it would happen now.

Then, when the ship hit the fan (well, you know what we mean), investors froze up and refused to invest in anything except gilt-edged investments like U.S. Treasury securities. Investors didn't conduct much of a reasoned analysis of anything, especially if it might have something to do with asset-backed securities. They simply wouldn't touch private sector debt. Perhaps this was an overreaction. But it was understandable in light of the absence of transparency in the derivatives markets. In the absence of reliable information, why risk your capital?

Contrast the credit markets with the stock markets. Even with Friday's drop, the Dow Jones Industrial Average is up about 8.5% for the year. The stock markets are vastly more transparent than the derivatives markets. Even though they are sometimes volatile, there hasn't been a freeze up in the stock markets since the Depression. Even after the 1987 crash, investors kept buying, because there is so much information available about stocks that many felt they could reasonably assess their chances.

Without an improved regulatory regime in the derivatives markets and for hedge funds, future crises like the current one are a given. The financial services sector of the U.S. economy has grown larger even as the manufacturing sector has shrunk. Whether or not this makes much sense from the standpoint of national policy can be questioned. There is nothing about America that gives it any special advantage in financial services. Unlike our pool of intellectual capital in the Silicon Valley, our pool of creative talent in the entertainment industry (entertainment is America's second largest export, after commercial aircraft), or our vast farmlands, Wall Street's talents and products are fairly easily replicated in other nations. And that's happening. London is a serious challenger to New York. And China is promoting the growth of its financial markets. Much and perhaps most of the growth in investment capital (i.e., savings) today is overseas. The Chinese, Japanese and other Asians are compulsive savers. The OPEC and other oil producing nations are piling up vast amounts of oil profits to reinvest. There is no particular reason why those savings must flow to Wall Street, and increasingly, they won't, especially with the dollar falling in value.

Nevertheless, the government seems intent on protecting the financial services industry. In that case, it should do so the right way, and build for the long term. Although not without its faults, America does two things really well compared to most of the rest of the world. Americans truly believe in integrity and honesty, and these values have been infused into the processes of American life. When Americans go to a government office, they expect to be able to conduct their affairs in accordance with law, and not have to pay petty bribes to petty functionaries just to get the day-to-day processes of the government to operate. There really aren't that many other places in the world where this is true.

Similarly, Americans expect to be treated fairly and honestly when buying or investing in something. They expect prices to be fair, and howl when they think they've been taken advantage of (witness the controversy over Apple's recent $200 price cut for the iPhone). In most other countries, bargaining is a way of life, and you have live with the bargain you made. Opacity in the market is an advantage for the seller that the seller will strive to maintain.

Thus, Americans do integrity and honesty really well. Let's infuse a serious dose of integrity, honesty, transparency and responsibility into the derivatives markets and the hedge fund industry. Sure, this means increased regulation. But it also means greater investor confidence and a competitive advantage over other nations that don't do integrity and honesty as well.

Animal News: pet cockroaches. Some people are weird.

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