In 2007 the leveraged foundations of capitalism crumbled and brought down some of the most powerful institutions in the world. Since then, people have asked questions about the whys and hows of such a catastrophe. Now, it is time to start fixing what is broken, and rebuilding what we've lost.
My name is Clayton Reeves, and as a young financial entrepreneur I am tasked with fixing these systems and preventing future problems. Thanks for reading.... and welcome to The New Finance.
Today, when I heard Warren Buffett’s comments today about the role rating agencies played in stoking the flames of our financial failure, I was markedly disappointed. Buffett has been a great inspiration to me personally, both as an investor and human being, and I expected more honest rebuttal on the part of agencies such as Moody’s, Standard & Poor’s and Fitch.When given the opportunity to bring down the hammer, he simply deflected the blame onto banks that had to be bailed out by taxpayer dollars.One of those banks accepting bailout money (either because they needed it, or were pressured into doing so) was, of course, Goldman Sachs (GS).The same GS that Mr. Buffett helped prop up during the crisis through multi-billion dollar injections of capital. Seems like a mixed message.
A quick history lesson will prove useful when talking about Moody’s and credit rating agencies (CRAs) in general.Credit ratings agencies, mostly Moody’s and S&P, were created to fill a need for an objective rating system for traded firms.The idea was simple; assign a grade to each company depending on their likelihood to repay debt obligations.The system was subscription based at conception, which meant people who needed information on these securities paid for the reports.At this point, the clients of the CRA were primarily investors.The model worked because it was in the best interest of Moody’s and S&P to provide good, honest reporting to the people they were serving. However, soon the business expanded to such a point that the subscription based revenue model was no longer viable.
Enter from stage right one of the stars of our financial show: moral hazard.Believe it or not, there was a decision made that the companies being rated should actually start paying for their own ratings.In a way it makes sense; if companies want to borrow at the lowest cost, they must pay for an auditor to check them out.However, this meant that the companies the CRAs reported on had now also become their clients.Even if these agencies had been government controlled or not for profit entities, most people can agree there was a problem with this model.
However, when Moody’s went public in 2000, the problem became much more serious.Lots of “cozying up” with clients began to take place.Sylvain Raines may have said it best when he said, “people talk about moral hazard at banks, but the moral hazard for rating agencies is extreme.”It is difficult to objectively assess risk and credit worthiness when you are in close personal and business contact with the subjects you are rating.The fact that Buffett does not address this obvious hazard is disconcerting.
The arrival of a third rating agency, Fitch, began to create competition between the three firms.Although Fitch had been a “nationally recognized statistical rating organization” since 1975, they didn’t become relevant until the 1990s.Once Fitch arrived, the duopoly was put under pressure and price competition lowered the intensity of research and increased the rate at which ratings were provided.At the same time, there was another pressure they began to feel; the pressure to produce more favorable ratings than the other CRAs.This created incentive to rate companies more highly than they otherwise may have been rated.One thing to notice is that Moody’s had been notorious for being more severe in their ratings than S&P.This all began to change during the housing bubble.
While the competition between these firms was becoming an issue, MBS/ABS securities were also becoming a more important part of their revenue stream.These two things combined to create an incentive to win as many MBS/ABS contracts for rating as possible.This basically meant giving favorable ratings to companies so that they could win more bids.In fact, since Fitch’s initial MBS ratings were significantly lower than either of the other two agencies, and they were basically excluded from rating these securities altogether!
In regard to Moody’s, they made some severely questionable moves prior to the crisis. First, they eliminated the premium that gave a bonus to a certain package of securities that were diverse.This “diversity score” relied on the financial theory of risk mitigation.When this was abolished in 2000, collateralized debt obligations (CDOs) were just beginning to become a major player in the security market.Eliminating the diversity score coincidentally greatly improved the ratings for these homogenous portfolios overnight.
Another shady move that Moody’s made involves the formula used to rate ABS and MBS.The formula used to rate them had a severe mathematical error.The error was estimated to have increased the CDO ratings by as many as four notches.Instead of correcting the formula, an emergency meeting was apparently held and changes were made to maintain the AAA ratings on MBS/ABS.The SEC is still investigating how accurate these allegations are.
Was this a coincidence?I think not.The combination of these two moves by Moody’s made it almost impossible for the other agencies to compete with the “quality” of their ratings.Fitch refused to rate the MBS market as anything other than slightly above junk.However, S&P felt pressure to stay in business and kept up with the trend of overrating securities.These pressures greatly increased the ratings given to pools of mortgages that should have been rated far below investment grade.The risks were there, but moral hazards prevented the CRAs from doing their jobs.
My major problem with Buffett’s most recent comments is his comparison between Moody’s and the general public. Warren said that the managers at Moody’s “made a mistake that 300 million other Americans made.”This is certainly true, but it is the role of agencies such as this to NOT make those mistakes.If they are held to the same standard as the general public, then why are they paid millions of dollars a year to rate companies and securities?Why do they exist?If what Buffett says is true, we might as well eradicate the ratings agencies altogether.
Should the ratings agencies be held accountable? Absolutely.There is no one person to blame for the housing bubble or subsequent financial collapse.However, these agencies were supposed to be the vanguard of investor protection and they failed miserably.CRAs played a dynamic role in the overconfidence of the market leading up to the housing bubble.Blame must be laid, and there must be creative new ways for investors to research companies.This model is broken, Mr. Buffett, and no amount of public politicking will prove otherwise.
(ref: Sam Jones, “When Junk Was Gold – Part 1/2,” Financial Times, 18 Oct. 2008: 16)
On March 21st (Euronity - The Antonym of Unity) I wrote about the increasing necessity of a quick bailout for Greece and the dangers for the European Union if they did not act decisively and cohesively. They failed to provide that unified front quickly enough, and as a result the reputation and market measurement of the implied strength of the EU suffered badly. This, I believe, has contributed to shaky market response to the massive trillion dollar bailout that the Union finally unveiled. The apprehension from the markets is directly linked to the fact that Europe has never been, and may never be a unified continent.
This is where Germany comes into play. They are the largest economy in Europe and are also looked to from others to provide a leadership role on political and economic policy. Much as the United States attempts to play this role for the entire world (rightly or wrongly), Germany occupies this space for Europe. There is plenty of reason for this.
Germany is the fifth largest economy and the second largest exporter in the world. Their economic engine is efficient and robust, with some of the world’s most technologically advanced production of cars, machine tools, shipbuilding, textiles and basic materials. Much of the growth of Europe is tied to that of the German economy. For this, Europe can be grateful that Germany is a member.
However, the dependence is twofold, and this is where Germany is making a grave error. They have become so inebriated with their own economic and political clout that they continually fail to recognize the fact that they depend on the other member states. The majority of their imports come from countries in the EU, the same countries that will suffer from Germany’s indifference. Their economy might be strong, but it is export dependent to a fault. Without something like China’s Yuan peg, Germany has no way to artificially stimulate their exports. There needs to be a change of mindset if the EU hopes to navigate this dire strait.
Compare, for a moment, Germany to the United States. The United States carries many labels, including: greedy, fat, lazy, arrogant, power hungry, etc. However, there is one thing they do well above all others: consume. Growth is spurred around the world by rabid consumption of goods and services by American citizens. Germany, on the other hand, has practices in place that make sure they limit domestic consumption and instead reward their citizens with national pride. The two models provide a stark contrast. The problem is that right now the EU needs Germany to move closer to the US model and distance itself from the conservative practices of the past. If Germany took measures to decrease their export surplus and began to consume more goods, the entire EU would benefit. The German economy would continue to be world class, and Germany’s consumers would be able to enjoy more consumption. If Germany does not make this shift, as the healthiest and most able country to do so, the EU economic engine could sputter and stall.
It is time for Germany to realize their place in the bigger EU picture. The have reaped the rewards of other countries’ excess through increased exports to those countries and the economic benefits those exports imply. Now, they point the finger at the fiscal irresponsibility of those nations without acknowledging the benefits to Germany. However much they may be right in those accusations is irrelevant. What matters is that they move forward with a plan that will benefit Europe as a whole, not just Germany. There is a fork in the road up ahead. One leads to a slower than expected recovery and a less antagonistic Germany.
The other road is bleaker. It comes with a chance of worldwide double dip recession and a forever weakened European Union. Germany has a chance to pick the right road. It may not be the popular choice at home, but in the long term it is the right decision not only for the world, but for Germany’s citizens. Hopefully, Timothy Geithner’s visit to Berlin today will help to knock loose their conservative economic coils and allow Germany to flex in the way that Europe so desperately needs.
Financial reform, at the most fundamental level, is designed to keep the markets from imploding in both the long and short term. Hopefully we can all agree that after the hardships of the last two years, any reasonable cost to lower the risk of future catastrophe is worth it. Enter from stage left and right the two versions of financial regulatory reform that have been sculpted by our esteemed legislative bodies. There is plenty to be excited about with the progress these two groups of cantankerous banterers have made in a very short while (short only by their standards). Unfortunately, as I wrote a month ago, the incentives that exist in our marketplace will show how full of holes this regulation actually is.
As an example, in the Senate bill they have an altered version (Merkley-Levin) of the Volcker rule endorsed by President Obama. Not only has the Volcker Rule been watered down, it simply doesn’t exist in the version the House pushed through. This, of course, is because the House bill was constructed prior to Obama’s endorsement of Volcker. Regardless of the name under which this idea (restricted prop trading) ruminates and takes form in the final version of the bill, there will be significant issues.
Try to tell a banking exec to stop trading activity because Congress feels it is detrimental to shareholders. On what planet would he decide to listen? There is a reason that congressmen sit where they do, and investment bankers choose another seat. All Congressmen are not created equal, and most do not understand the complexities of the markets that they are assigned to regulate. The only way that Congress can hope to convince bankers to listen to regulations is to approach them with a big stick. There aren’t even any twigs to speak of in this financial reform.
Ambiguities in the wording of the bill mean that, once again, financial regulators will have too much room for interpretation. Therefore, the incentive remains for any profitable firm to find a way around any regulations and a blindfold/lollipop for any regulators. They will simply conduct the same type of activities under a different name.
Having said all that, these are the options moving forward.
1. Proceed as planned - use the regulations in the current versions of the bills and reconcile any differences. This is what will happen. It is the easiest solution, it brings more reform to Wall Street than was there previously, and it provides a convenient peg for congress to hang their hats on in the coming elections. This is a political solution, plain and simple. It avoids addressing some of the most pressing issues in this situation (incentive to cheat the system, banks that are too big to be allowed to exist, predatory financial practices and no explicit powers to enforce the regulations).
2. Reenact the Glass Steagall act - this is far from a perfect solution. The nature of the market is very different from the one that existed when this bill was effective. Also, there would be considerable pain in migrating from the integrated markets that people enjoy today to the ones that would exist after a reincarnation of this act was implemented. This has been on the minds of economists over the last year, but it is still debatable what parts of this legislation would be reasonable to enact in today’s markets.
3. Chop banks into smaller pieces - this is an idea that will probably never gain any momentum, but it has merit. Everyone has heard of the idea of “too big to fail,” but what about “too big to exist?” The problem with these super banks is that their layers of risk vary so much in depth and complexity that there is no way for a CEO or a team of executives to manage the company. Value at risk (VaR) was a misleading idea designed to provide comfort that these layers of risk can be measured. They can’t. The only option is to peel back those layers until they are manageable chunks. This means chopping off arms that have a conflict of interest and separating them into their own companies. Implied firewalls in these banks have been shown to be more comparable to sieves.
At the very least, the reform trudging through our legislative system is designed with good intentions. No one expects this to be an easy or quick fix, but the fact that Congress is only quietly dragging their feet is a good one. It will be interesting to see how the voters decide to reward this political courage. That will certainly influence any more reform movements in the future. As always… it is a matter of incentive.
Today President Obama addressed the titans of Wall Street and asked them to join hands and take preemptive measures to avoiding another financial collapse. As usual, the delivery was eloquent and the message was clear; if you aren’t going to support this reform, then you must be doing something you don’t want regulators to see.
This fails to address the main concerns of many financial minds. It isn’t that every bank is instituting wildly risky trading schemes or hedging their entire book value on the outcome of a Yankees game, and they don’t want regulators to know. The issue is that regulation is rarely done well, and usually put into motion by people that don’t have the slightest idea what they are talking about. For the purposes of this article, I want to discuss derivatives.
If Congress institutes sweeping financial reform it will most likely involve some sort of restriction on derivative creation and trading. This could be in the form of more transparency, tighter valuation rules or limiting what derivatives can actually derive value from. Some congressmen would have them banned altogether! This is not in interest of maintaining efficient markets. However, Congress believes that this is exactly what restricting derivatives will do.
On the contrary, derivatives provide very real benefits to markets in the form of efficient pricing, removing arbitrage opportunities and allowing parties to hedge risk. The problem comes about when institutions and traders begin to layer their risk to such an extent that they cannot see what they are actually doing. Is there a way to implement regulations that can let derivatives provide value to the market without removing most of their functionality? I’m sure there are experienced derivatives traders who have excellent ideas about that.
Unfortunately, there is no incentive for intelligent minds to become the instigators of actual, material reform. What incentive would an ambitious trader have to help Congress develop regulations that could potentially restrict his or his firm’s profits? The money usually provides motivation for people to figure out how to beat the system. So instead, we have politicians spewing partisan rhetoric at each other from both sides of the aisle.
Another issue is that regulation tends to swing wildly from one extreme to the next, and most financial institutions anticipate the pendelum swinging violently against them as a result of this reform. This will lead them to be combative from the start. Financial firms have had it good in the immediate past in terms of regulations being lifted and the markets generally being let loose. The result, however, was not so beneficial to the world as a whole. I anticipate that the initial financial reform put into place will be too restrictive for it’s own good, and end up strangling some of the functions of the financial system.
One of the quotes from President Obama is strangely applicable to both the financial collapse and process of over adding/removing regulations. He said that “it is essential that we learn the lessons from this crisis, so we don’t doom ourselves to repeat it. And make no mistake. That is exactly what will happen.” He should heed well those words as he begins to tackle the issue of financial reform, and make sure he does not implement changes too sweeping and broad to let the financial system operate at all. If he does, we may find ourselves peeling the regulations back in ten years and fighting the same forces at work today. Good luck, Mr. President.
Popular opinion is that the United States will experience some violent inflation over the coming decade as punishment for the reckless borrowing, irresponsible budgeting and rabid consumption that has taken place in the US over the last twenty five years. However, in order for inflation to truly take place, one of these things usually happens: the money supply has to increase rapidly, demand must outpace supply, or the currency needs to depreciate. We’ll start with the money supply.
Most people would assume that the money supply truly has increased violently over the last couple years. This ignores a couple of key factors in the equation. One, is that the housing collapse has destroyed wealth in an equally violent way. It is only the very rare homeowner who feels more wealthy now than they did at the beginning of 2007. So, has the money supply actually increased? Loans have been written off, houses have been marked to market and people have gone bankrupt. In many ways, the stimulus has simply transferred the debt of American homeowners to the government, so that it can be repaid over time at a lower rate using the seemingly bullet proof credit score of the US Treasury.
As a transition to demand, if homeowners feel poorer now than before, what supports the claim that demand will increase in the United States any time soon? Consumer opinion is still negative and sentiment is well below where it needs to be to drive a substantial recovery. The destruction of wealth will most likely influence the savings patterns of US citizens for the rest of their lives. I anticipate higher personal savings for the coming generations than those that have preceded them. In this way, there will be less of the domestic demand necessary to fuel an inflationary move. So if the money supply and demand don’t seem to have the gumption to push inflation significantly higher, where does the dollar stand?
Educated minds have been very bearish on the dollar recently for a variety of reasons. First is the fact that the United States must rebalance their economy by relying more on exports. Secondly, the US government has racked up hundreds of billions of dollars in debt in an effort to stimulate the largest economy in the world. In terms of the trade argument, the United States will already consume less than they have on average over the last couple decades. The recent recession has been a sort of baptism by fire for many people, and it is an experience they won’t soon forget. The impact of the stimulus may be moot because of the points made above and the fact that the government still stands to make a profit from some of the bailouts (AIG and Citi).
With equities no longer being thought of as the end all be all for long term investing, people are now considering saving enough to have a cushion. This should continue into the future. The United States cannot continue to be the driver of consumption for the rest of the world. Trade is a zero sum game (in terms of accounts, not productivity) and the other major players in the world need to work to step up their consumption. Most pointedly, I am talking about China. Regardless, Americans must consume less and save more. If this happens, it will fail to provide a driving force for inflation.
Also, historically the dollar does not always behave as it is told. The crisis in Greece is a pointed example. As cracks seem to appear in the foundations of the European Union, the euro has suffered and there has been a flight to the relative safety of the dollar. There are arguably more pressing fiscal budgetary dangers in the United States, but again, the markets feel relatively more safe holding dollars.
The moral of the story is that the United States will not fail in the near term. It is in the best interests of the world to maintain the dollar’s status. Should the yuan ever be allowed to appreciate or the EU show signs of unity, there may be a challenger. For now, the dollar is the most stable dancer on the tight rope.
There is a stark difference between the financial landscape of the late 20th century and the one facing the United States today. Twice in the last ten years markets of the United States have fell victim to massive bubbles (dot-com, housing) that were largely inflated by greed and overzealous capitalism. Now, the world is more apprehensive towards open markets, globalization, capitalism and taking on risk.
The new finance also has another chess piece added to the board; this new piece bears a striking resemblance to a dragon and hails from the East. Say hello to China, and the vast resources, human and otherwise, that she brings to the table. Paul Krugman wrote just the other week that the United States must meet China head on regarding the yuan. In economic terms, he provides great support for his argument, but I am afraid he is misguided regarding the political implications of that course of action. The other side of the coin is Ryan Avent, a blogger for the economist, who makes some wild claims here.
The new China must be assuaged, not slapped. It will take time and clever strategy to convince the Red Dragon to make any moves. The chest thumping, cruise missile waving days of President Bush are over, and by Godsend we have a more charismatic leader to engage the East (any political affiliation notwithstanding, Obama is the obvious superior to Bush in foreign policy).
Given his recent victories in nuclear arms with Russia (which for now appears to be his greatest tangible foreign policy achievement) and health care reform, Obama now must focus on the looming spectre of China. His next steps must be focused, graceful and choreographed. Over the next eighteen months, the relationship between the United States of America and the People’s Republic of China will take the form of a dance; welcome to the China Tango.
The similarities to dance are obvious. As with any good dance partner, President Obama must lead China without making them feel as though they are being led. The steps must be calculated and planned; any arrogant moves or showy gestures will surely enrage a company that is trying to solidify itself as a world power. In order for President Obama to succeed he must first do the following things.
1.Engage other world leaders - this step would be very much the opposite of what the prior administration would have done. The discussion does not need to be public, but should be material. If a country does not have the fortitude to support a revaluation program for the yuan, then leave them at the kid’s table.
2. Design a program to revalue the yuan gradually - at the present, there is absolutely no incentive for China to revalue their currency to a market price. Their exports depend very much on the depreciated remnibi, and if they were to immediately revalue to market, the effect on Chinese industry would undoubtedly be negative. The only way to convince them to undertake a revaluation process is to coat it in a way that seems to make China stronger. In this particular example, the yuan is basically pegged to the dollar. Sell the change to China in a way that makes them feel more independent and powerful on a global scale.
In my opinion, these would be the first two steps to take towards engaging China. Obviously, the administration has already attempted to engage China. Now, they must be more proactive in procuring allies to aid them in the discussion. It won’t be a short talk and in all likelihood it will strain relations with China, but it is necessary that the administration takes these steps or developed economies will continue to struggle.