Have you heard the one about the French army rifle for sale on eBay? It is
advertised as "Never fired, dropped only once". The reason to think about this
item is not to make fun of the French again, but to ruefully consider the
metaphorical bazooka that US Treasury Secretary Hank Paulson holds; and wish as
a free market agent that it had never been removed from its holster, let alone
fired.
For those of you who skipped financial newspapers over all of the summer -
admittedly not a bad idea in itself - the reference here is to the infamous
July speech when Paulson said, "If you have a squirt gun in your pocket you may
have to take it out. If you have a bazooka in your pocket, and people know you
have a bazooka, you may never have to take it out."
The context was the Treasury grabbing power from the US
Congress by insisting on greater powers to deal with the crisis cutting across
the entire financial sector. Proving the rule that a fool and his money are
soon parted, Paulson last weekend had to fire that bazooka after all, in his
rescue of failed mortgage giants Freddie Mac and Fannie Mae; which followed the
March takeover of Bear Stearns by JP Morgan at the insistence of the Fed and US
Treasury.
On the face of it, these events are only loosely related in the bigger
framework of the credit crunch. However, that ignores the key aspects of
behavioral finance - the application of psychology to financial behavior - a
subject that is far more relevant today than at any other time in financial
markets. While this subject itself has multiple branches, I am here only
looking at the most simplistic framework, ie, how do finance professionals
behave in given situations.
The larger framework for studying the interplay of governments with financial
markets in crisis situations is defined in the rules of Pareto Optimality.
Simply put, a Pareto optimal situation is one in which all players in the game
get efficient outcomes. An external agent, like the government, that seeks to
influence the outcome can either create a higher chance of such an optimality
(a Pareto Improvement) or more likely, not.
Dialing back
First, let us dial back a bit: under "normal" situations, a financial
institution such as a commercial bank operates on the basis of trust.
Wafer-thin capital is intended to support gargantuan balance sheets on the
notion that the incidence of losses through defaults and the like are both
miniscule and spread out over a long period; so ongoing earnings can replenish
the capital base. As I have written before, banking isn't exactly rocket
science, though - for all the wrong reasons - it does tend to attract the
world's best brains.
Investment banks - like the dear departed Bear Stearns - had a slightly
different business model, wherein investors depended on their ability to
continuously undersell their positions to investors, or they were paid to
distribute risk. This is like the children's game of passing the parcel, except
of course that something a lot more incendiary than a Barbie doll is being
passed around. Traditionally, investment banks relied on getting the parcel as
far away from themselves as possible, and it would hopefully blow up some
distant investor.
However, as of three years ago, investment banks changed their business model.
The usual phrase that can describe this is unfortunately a bit too racy for an
Asian newspaper; so let us just call it "gun envy". As the old firm of Goldman
Sachs went from strength to strength, other investment banks like Bear Stearns
and Lehman took it on themselves to bolster their own standings. This they did
by boosting proprietary trading, the business of trading on their own account,
and something that Goldman excelled in consistently - providing billions of
dollars of income every year.
Now, the thing with proprietary trading is that while conceptually it looks
similar to investment banking, it is actually the exact opposite as it involves
brokers buying up their own produce. If you have ever come across the sickly
pig farmers gorging on their own produce in Italy, you would begin to
appreciate where I am going with this. Anyway, to fund the book - remember the
wafer thin capital holding up the assets - the brokers increasingly used
short-term "cheap" money.
When the first Special Investment Vehicle (SIV) went kaput last summer and was
swiftly followed into the breach by the money market funds that lend in the
short-term markets, this access to financing quickly disappeared.
This is when all financial institutions turned to "repo financing", or pledging
collateral to each other to get cash. Typically, this works as follows: bank A
sells a security to bank B at say 98, and promises to buy it back after a month
at 100. The difference of two is the interest cost associated with the
financing. For bank A, the process is good because it gets 98 immediately, and
for bank B, it gets a security that is worth a 100 for 98, so if bank A doesn't
honor its agreement to purchase the security back, bank B can sell it in the
open market for 100.
Dr House maxim: Everybody lies
By now, astute readers would have guessed the fundamental flaw with the above
setup, which is, to use the maxim of television's Dr House: "Everybody
lies." The investment banks bought assets that they should have sold on but
instead held on their books to eke out marginal gains, all the while funded by
short-term markets.
As the price of these financial assets started falling, brokers and their
customers soon found an inexorable volume of losses hitting their accounts.
This was only in the most liquid assets though, leaving the issues of less
liquid assets to be sorted at a future date. Like a man with a limp who hides a
serious flatulence problem by pretending that the squeaks emanate from his cane
(and I will leave the Dr House analogies alone after this), brokers and other
financial players preferred to conceal the losses they were running up on their
illiquid assets like Collateralized Debt Obligations (CDOs).
When you think about CDOs though for a few minutes, the idea of funding
long-term assets with short-term liabilities starts looking awfully familiar -
it is in fact a mini-version of a bank. And as with bank runs, the idea of
suddenly removing the availability of funding for these asset vehicles causes a
plunge in the value of the assets they hold.
To complicate matters, all brokers (and their biggest customers including the
hedge funds) held the same kind of assets - see my previous comments on the
general lack of smarts in the banking world. Thus, whenever the weakest link of
the chain cracked, these assets were sold forcibly. Soon, the declines in value
were so perceptible across the whole chain that the haircuts being demanded by
potential lenders on the repo market soon started creating their own set of
headaches.
Even as brokers and others increasingly depended on the repo markets, the
volatility of asset prices was also rising dramatically, thereby forcing
greater care in lending based on such collateral. Worse, by opening the Fed
window (as well as the European Central Bank and Bank of England windows) to
brokers, the day of reckoning was essentially postponed.
This is always the problem with imposing moral hazard on the markets: someone
eventually calls your bluff.
Paulson is not Pareto
By rescuing Bear Stearns in March and Fannie and Freddie last week, Paulson
probably tried to assure holders of long-term debt that the outlook was not all
that bad. However, by doing so he scared the holders of equity and those
holding short-term debt; because a continuous decline in the value of assets
meant that the coverage for short-term borrowing was absent and capital was
meanwhile being wiped out.
By creating a misalignment of interests between different types of creditors -
long- and short-term - and shareholders, in effect Paulson unleashed an
untenable timetable for a turnaround of the financial sector. Effectively, his
strategy to save Bear would have worked had US financial markets enjoyed a
prolonged upturn.
Instead, all players focused on surviving the immediate short term, thereby
pushing more firms to seek securitized financing from the repo market. In turn,
this left firms with both a funding and a capital problem whenever asset prices
fell - Paulson's moves effectively made the US financial system a leveraged bet
on investor optimism.
Stepping away from the rescue of private firms like Bear Stearns though would
have necessitated a quick self-sale of smaller firms like Lehman, even as
greater clarity on asset prices would have followed. However, by saving the
long-term unsecured creditors of Bear Stearns, Paulson set in motion a
precedent that was to cause greater volatility in the financial system.
More pointedly, the interest of long-term unsecured creditors, ie, the people
who had the most capital at risk (given the amount of leverage that Wall Street
firms, banks and agencies had relative to their capital) were frequently
against those of investors in other parts of the capital structure or equity
and holders of short-term secured debt. These investors had only one proven way
of getting their money back and that was to secure government backing for the
debt issued by these private companies.
This was the main "cost" of the rescue of Bear Stearns, it became imperative
for holders of long-term debt to actually push large financial firms towards
bankruptcy to force the government to rescue them. In effect, the arbitrage so
created, that is buying long-term debt for extremely wide spreads that then
tightened when the government took over the firms, became the new mantra for
such investors. This is the exact opposite of Pareto optimality and the blame
for that can be laid straight at the feet of Paulson.
The bigger cost is for the US government. Already, the total debt load has
doubled since the absorption of Fannie and Freddie into the government balance
sheet last weekend (See
Paulson placates China, Russia - for now Asia Times Online, Sep 10,
2008). Now to add the likes of other troubled firms would be to push the
overall debt burden well over 100% of gross domestic product, at which level it
becomes unthinkable that the US government itself will retain its Triple A
rating.
What Paulson may have forgotten though is that for all their mismanagement and
so on, the two agencies actually held the best assets in the US mortgage space.
If they needed to be rescued by the government, investors could easily work out
what the fate of other US institutions holding lower-quality instruments would
be. Three in particular entered crisis mode this week: Lehman Brothers,
Washington Mutual and AIG (American International Group). All three were being
quoted at distressed levels in the credit markets on Thursday.
Market reaction after the Fannie-Freddie rescue is where the behavioral finance
aspect that I described in the beginning of the article began to bite. The
rally on Monday quickly gave way to circumspection as investors worried about
which was the next shoe to drop. The near-term experience of seeing capital
wiped out on Fannie and others meant that there was no capital to be had from
equity investors, even as the repo market was shut down for the affected firms
by lenders afraid of being caught with either counterparty exposure or worse.
All of that meant that capital was pulled out of the affected firms at exactly
the time when they needed it the most: a classic instance of herd behavior, and
one that has become depressingly familiar in the global financial system of
late.
Stung by the market crisis from the beginning of this week and the failure of
Korea Development Bank to top up its capital (about the smartest thing that an
Asian investor has done of late, in my opinion), Lehman advanced its earnings
call to September 10 from September 16. But the announcement proved problematic
as while losses of nearly US$4 billion were confirmed, the management could not
identify the path of any turnaround, nor could it shed light on future sources
of capital.
Lehman's share price continues to fall, and opened under $5 on Thursday in New
York, a quarter of the value on July 1 and just a tenth of the highest price
reached after the rescue of Bear Stearns.
Instead of one single rescue - of Lehman - US authorities are going to have to
think of at least three institutions. A forced sale such as Bear could well
work again, but that still leaves two big institutions in the lurch as of
Monday morning. The number of companies which can potentially bail out these
firms is fairly limited to start with.
It looks to me like the US government and its agencies will have to make some
painful decisions about who to let go by Monday morning. It would be better for
them and global investors if they left the decision to the markets instead.
Essentially, someone has to take the bazooka of intervention from the
trigger-happy US Treasury secretary.
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