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     Aug 13, 2008
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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