PrefBlog

Willem Buiter writes a gloomy piece on financial activity, If it’s broke, fix it, but how?. Hat tip to Naked Capitalism, who commented on the piece … but quite frankly, NC’s commentary can’t be taken seriously:

3. Prohibit Level 3 assets; allow only Level 1 and strictly defined and audited Level 2 assets. This means regulators will not have anything overly arcane to assess; they ought to be able to get a clear picture of risks, processes, and exposures if they are dogged.

4. Prohibit these regulated institutions from lending, providing other funding, or investing in concerns that have Level 3 assets

This is the sort of populist nonsense that betrays complete lack of understanding of the issue. In the first place bonds of virtually all kinds are Level 2 assets – even off-the-run government bonds are marked off half a dozen or so benchmarks. A liquid corporate issue might trade a few times a week – and every time (other than in the highly liquid distribution phase) it will be done at a ballpark guess of a spread to governments (by “ballpark guess”, I mean “what the trader thinks he can get away with”). Things like municipals in the States … well, have a gander at what Accrued Interest had to say on the issue.

Level 3 assets? Let’s talk about preferred shares, just for a moment, to lend some credence to the idea that this blog is about prefs. Say I have to value an issue that has something approximating a current coupon … maybe the new NA issue, for instance. If I price NA.PR.M based on the yield of the two other prefs from this issuer, then it’s a level 2 asset. However, this is a really bad mark – it makes no allowance for convexity. If, however, I adjust the “static”, level 2 price in any way to account for the “dynamic” effect of convexity, then my poor little NA.PR.M become level 3 assets … “convexity” is not an observable input.

One may well wish to impose a regime on regulated capital that allows the firm to assign a range to the unobservable inputs and have them use whichever end of the range is least favourable when valuing their securities for regulatory purposes. One may well wish to increase the capital requirements for level 2 and level 3 assets. But to speak of strict controls and prohibitions is simply a sign of hysteria.

Anyway, back to Prof. Buiter. He leads with an assertion that we have achieved the worst of two worlds:

I believe that the Western model of financial capitalism – a convex combination of relationships-based financial capitalism and transactions-based financial capitalism – has, in its most recent manifestations (those developed since the great liberalisations of the 1980s), managed to enhance the worst features of these two ideal-types and to suppress the best.

These worlds are defined as:

Transactions-based financial capitalism emphasizes arms-length relationships mediated through markets (preferably competitive ones), is strong on flexibility, encourages risk-trading, entry, exit and innovation. It is lousy at endogenous commitment: reputation and trust are not a natural by-product of arms-length relationships. Commitment requires external, third-party enforcement.

Relationships-based financial capitalism emphasizes long-term relationships and commitment. It has, however, compensating weaknesses. Investing time and other resources in building up relationships with customers creates an insider-outsider divide that is very difficult to overcome for new entrants. It also encourages, through the interlocking directorates of the CEOs and Chairmen (seldom women) of financial and non-financial corporations, a cosy coterie of old boys for whom competitive behaviour soon no longer comes naturally. At its worst, it becomes cronyism of the kind that was one of the key ingredients in the Asian crisis of 1997.

I think I will be referring to these definitions a lot in the future! Relationships-based financial capitalism describes the standard business model of a stockbroker or retail-level financial advisor. Transactions-based financial capitalism describes the standard business model of an asset manager. But remember – these are my characterizations, not Dr. Buiter’s.

Importantly, virtually everybody will claim that they want and need the latter, but most retail (and a hefty chunk of institutional) clients will go for the former when it comes time to sign a cheque.

So … now we’ve defined some terms, what’s the problem?

It is clear where the problems are. In the past 20 yearns, the financial sector has, starting as a useful provider of intermediation services, grown like topsy to become an uncontrolled, and at times out-of-control, effectively unregulated, hydra-headed owner of licenses to print money for a small number of beneficiaries. The sources of much of these profits turned out to be either a succession of bubbles or Ponzi schemes, or the pricing of assets based on the belief that risk disappeared by trading it. This belief that there is a black hole in the middle of the financial universe that will attract, absorb and annihilate risk if the risk it packaged sufficiently attractive and sold a sufficient number of times is closely related to the firm conviction of every trader I have ever met, that he or she can systematically beat the market. The fact that all traders together are the market did not constrain these beliefs.

This is a rather breathtaking condemnation and, quite frankly, I do not find much support for these assertions in the text. I can hypothesize, however, using the assumption that the explanation of the huge amount of CDO assets on the Merrill Lynch books (discussed on April 16) is correct (and making a few interpretations). In this case, we would say that the CDO-syndicator is using the worst of the transactions model: he didn’t care about the firm, as long as he could get the stuff off his books and onto the trader’s books. The trader, bullied into inventorying paper he didn’t think he could sell, agreed to the deal due to relationships model: he was making good money as a Merrill trader, and refusing the urgent request of the big powerful syndicator could jeopordize his position. If this is the case, it reflects a failure on the part of Merrill’s management to ensure that such asymmetric viewpoints are minimized.

Could it be true? Well, it’s plausible. And I like it a whole lot more than the everybody-is-stupid-except-me model.

Naturally, the first thing that comes to mind after Dr. Buiter’s assessment of the industry is MORE RULES!

It would be part of the solution if we could find and keep the right regulators and design and implement the right regulations.

… which immediately runs into the problem …

regulators involved in intrusive and hands-on regulation are virtually guaranteed to be captured by the industry they are meant to be regulating and supervising. This regulatory capture need not take the form of unethical, corrupt or venal behaviour by the regulators or members of the private financial sector. It could instead be an example of what I have called cognitive regulatory capture, where the regulator absorbs the culture, norms, hopes, fears and world-view of those whom he regulates.

Sure. Especially with revolving-door regulation being such a popular model. There is another problem:

regulators will serve their own parochial, personal and sectional interests as much as or even instead of the public good they are meant to serve. No bank regulator wants a bank to fail on his or her watch. As a result, either excessively conservative behaviour will be imposed by the regulator on the regulated bank or other financial intermediary (ofi), that is, we will have if-it-moves-stop-it-regulation, or the regulator will mount an unjustified bail out when, despite the regulator’s best efforts at preventing any kind of risk from being taken on by the regulated entity, insolvency threatens.

This is especially the case if, for instance, one takes the editorial stance of the Globe and Mail seriously. They decided that Canadian ABCP was a problem indicative of a failure of regulation, then decided that since OSFI is a regulator, they are at fault. This started with misrepresentation of a speech and continues with wild charges of loopholes, as mentioned on April 11. Despite the fact that you don’t really need more than a handful of functional brain cells to dismiss the charges as nonsense, these gross distortions can’t be a lot of fun for a regulator to endure, and will lead Our Beloved Government to impose MORE RULES!

Anyway, Prof. Buiter has the intellectual honesty to admit:

I don’t know the solution to this conundrum.

I suggest, as I have suggested before, that regulations need tweaking. So the off-balance-sheet vehicles weren’t as off-balance-sheet as they might have been? Make the sponsors consolidate them for regulatory capital purposes if they are intimately involved in the vehicle – e.g., by being the selling agents of the SIV’s paper, or having their name on the fund, or by getting miscellaneous fees from the SIV. Allow a reduced hit due to first loss protection. Lots of details will emerge through discussion. If they’re sponsoring a money market fund (same thing, opposite direction), they should take a charge. It would seem that rules on the assets to capital multiple need to be reviewed, since a lot of the problem was the zero risk weight assigned to synthetic-AAAs by the regulatory authorities.

And for heaven’s sake, let’s approach regulation with the idea that the objective is to mitigate and contain harm, not to eliminate it. How many times must I repeat? Risk is Risky!

When will people learn? You can’t regulate fear and greed. Ask a Chinese or Russian pensioner how well that idea works out! As long as we have fear and greed, we will have booms and busts. And as long as we have stupidity, we will have people being hurt – sometimes badly – through over-exposure to a single class of risk.

From the oh-hell-I’ve-run-out-of-time-here’s-some-links Department comes a speech by David Einhorn of GreenLight Capital, referenced by another blog. Einhorn is always thoughtful and entertaining, although it must be remembered that at all times he is talking his book. The problem with the current speech is that there is not enough detail – for instance, he equates Carlyle’s leverage of 30:1 which was based on GSE paper held naked with brokerages leverage, which is (er, I meant to say “should be”, of course!) hedged – to a greater or lesser degree, depending upon the institution’s committment to moderately sane risk management. But there are some interesting nuggets in the speech that offer food for thought.

Accrued Interest speculates that European credit strains make short-dollar a risky trade:

So rising Libor may say more about tight liquidity in Europe than in the U.S. A combination of tough liquidity in Europe and among smaller banks would explain the divergence between CDS spreads and Libor spreads.

To me, this sends two cautions. First, it should remind anyone who thinks the liquidity crunch is over, that it ain’t. Liquidity does seem to be improving in the U.S. bond market, which is a very positive sign. So maybe the worst case scenario has been taken out. But this will be a long process.

Second, it should caution those who are short the dollar. If the next phase of the credit crunch hits Europe as hard as it hits the U.S., then we may see the Bank of England and the European Central Bank get more aggressive with rate cuts.

Barclays PLC disagrees. Takes two to make a market!

No real direction in the preferred share market today – and not much individual issue price volatility either. Volume returned to levels that are normal for now, but would have been labelled light last year.

There were sixteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.

This is about as far as one can get from preferred shares … but it’s interesting! There has been a lot of kerfuffle lately about the seeming randomness of the commodity futures basis in the States. Econbrowser has a guest-poster, Professor Scott Irwin, who explains what this means and why it’s important.

My suspicion is that it will have something to do with unsettled credit conditions. If you’re going to buy spot grain and sell a futures contract about it, you have a storage and financing problem that needs to be solved. First you need storage, then you need a price on your storage, then you need financing, then you need a price on your financing. It’s not just the spot and future price! I suspect that the financing requirements are injecting a little randomness into the process … I was once speaking to a bank rep, who very seriously intoned “The Bank [the capital “B” was audible] does not finance arbitrage.” Now, he was a very junior bank employee, but those were good times! I’m no expert, but I’ll bet on the financing aspect.

Prof. Irwin points out that there is an official hearing April 22 … we’ll see what comes of that. The post has some good comments.

Calculated Risk references a Times article that indicates:

It is understood that the Treasury about to finalise a scheme under which the Bank would allow lenders to swap their mortgage-backed assets for government bonds rather than cash. Lenders would be able to use the gilts as collateral for loans from other banks. It is hoped that the move will ease the seizure in the credit markets and lead to a drop in mortgage rates for homeowners.

It is not clear to me whether the word “swap” means “collateralize a loan with”, as in the Fed’s TSLF, or “trade”, as in Willem Buiter’s idea mentioned yesterday. I think the former is a great idea, provided that the loan is at a penalty rate; I have yet to be convinced that desperate measures such as the latter are necessary.

However, there is no doubt that excesses in the UK were just as spectacular as those in the US:

Richard Lee spent 5.3 million pounds ($10 million) buying 20 rental homes across the U.K. with just 150,000 pounds of his own money. Today, the properties are worth about 60 percent less and owned by the banks that financed the purchases.

The idea of outright government purchases of debt is hardly unique to the UK. There are plans afoot to have the US purchase student loans:

The U.S. House of Representatives, trying to avert a looming shortage in available student loans, approved allowing the Department of Education to buy federally guaranteed loans that lenders are unable to sell to private investors.
…
The global credit crunch has raised student-loan makers’ financing costs, and they’re unable to raise the rates they charge for federally guaranteed loans because the rates are locked in by the government.

SLM Corp., known as Sallie Mae, has stopped offering consolidation loans, which allow borrowers to combine several loans into a single one charging a lower rate. The company said today that new student loans are being made only at a loss.

Agencies in several states including Massachusetts, Michigan and Pennsylvania have announced plans to stop providing federally guaranteed student loans.
…
The legislation passed by the House today would let lenders sell their debt to the Department of Education at a premium. The move is designed to give investors more confidence in securities backed by the loans.
…
A similar bill has been introduced in the Senate. A Bush administration statement yesterday backed most provisions of the House measure while recommending some changes to ensure that the secretary of education has “the necessary authority and flexibility needed to respond to the unfolding situation.” The legislation is H.R. 5715

What tangled webs are a surprise, when first we seek to subsidize!

Volume dropped off to light levels, but the market edged up with low price volatility.

There were nine other index-included $25-pv-equivalent issues trading over 10,000 shares today.