“The reality of the situation is that an open, competitive, and liberalized financial market can effectively allocate scarce resources in a manner that promotes stability and prosperity far better than governmental intervention…”

So said Henry Paulson, U.S. Treasury secretary and ex-Goldman Sachs chief, in Shanghai on March 7, 2007. Hank was lecturing Chinese officials (who this week allowed short-selling on their domestic equity markets for the first time) at the so-called China-U.S. Strategic Dialogue summit.

Of course, Paulson bent their ear before Bear Stearns “Enhanced Leverage” mortgage-bond hedge funds blew up in June ‘07. The following month, Ben Bernanke, chairman of the Fed, made his first guesstimate of total bank losses — “in the order of between $50 billion and $100 billion” — to come from the subprime collapse.

Now the terrified trio of Bush, Bernanke and Hank want $700 billion just to refinance the U.S. investment banks and their foreign landfill sites, let alone home-buyers, mortgage lenders and house builders.

Yet five U.K. banks alone hold $175 billion of qualifying junk — fully one quarter of the sum requested. So no wonder Bill Gross — boss of Pimco, the world’s biggest bond fund, and a cheerleader for governmental intervention ever since Bear Stearns’ hedge funds went “hiccup!” — says the “troubled auction recovery program” will need another $500 billion on top, just for starters.

Paulson’s ideological grandstanding in Shanghai last year preceded a few other events that may have forced his Damascene conversion.

All this while, of course, the developed world’s central banks were pouring cash into the credit market, trying to fix the first big problem, the first of five “big freeze” spikes in world money market interest rates.

It just keeps coming back, however. Because the people who know best the liquidity and solvency of major banks — the other banks — refuse to lend whatever money they get, hoarding it instead for fear of a run at their own branches.

“British banks have squirreled away nearly £6 billion [$11 billion] with the Bank of England rather than lend it to each other for more than a few days,” reports the Financial Times, “using its safe but low-interest deposit standing facility is a sign of the fear gripping money markets.”

Little surprise that inter-bank lending rates are holding near an eight-month high for U.S. dollars — despite the Fed now offering more than $290 billion to foreign authorities for their own domestic money markets — while the banks’ price for borrowing euros has reached a record high for the single currency, launched in 1999.

And all this while as well, of course, the Federal Reserve has been busy slashing U.S. interest rates…finally joined by the U.K., Aussie and New Zealand authorities in making debt cheaper even as the free market — both the interbank market and the commercial market of home-loans, overdrafts and corporate lending — pushed in the other direction.

This privilege, allowing central banks to set the price of money whenever it thinks the economy needs tweaking, might seem to jar with Paulson’s tidbit from Shanghai.

But shepherding the free market is why central banks, regulators and government itself exist today. And as they’ve proven so adept at this task, guiding the lambs of Wall Street to the slaughter of Florida and California condos, it would surely make sense to extend their powers — and shepherd the free market a little more closely — from here.

Right?

“We thought Resolution was just suspended, not delisted,” said a spokeswoman for City watchdog the Financial Services Authority last Friday.

You’d think they might know. But no, Resolution, a U.K. insurer, was delisted in London after being bought out in May. Yet it still found its name on the banned list of 29 “no shorting” stocks proscribed by the FSA.

“It will be removed,” said the all-powerful watchdog. “A revised list will be up on our website later today.”

Meantime in New York — where Hank Paulson’s “open, competitive, and liberalized financial market” is also taking a break — the Securities & Exchange Commission (SEC) has banned short-selling of GLG, the giant London-based hedge fund, along with 798 other financial stocks and 100 or more stray sheep like GE, GM and Ford.

Funny, but GLG itself paid a $3.2 million fine in June ‘07 for “multiple violations” of the SEC code, after shorting some 14 public offerings in the U.S. and making $2.2m over two years in “illegal” profits.

Still, there is more rejoicing in heaven over one lost sheep found, eh?

“Markets are usually right,” says Anatole Kaletsky in the London Times, “but sometimes they are dangerously wrong — and they need to be managed with decisive and competent government intervention.”

Ignore Polly-Ana’s morality if you can; fact is, markets often get dangerous. Whether they’re right or wrong doesn’t matter much if you’re buying high and then forced to sell cheaper.

Here and now, the market — right or wrong — is pricing toxic debt and derivatives at zero or worse. U.S. subprime mortgage bonds, if marked-to-market — rather than against the apparent “final redemption value” used to help pay $66 billion to Wall Street staff in 2007 — are also worth zilch. That’s why there’s no danger of anyone buying them, no one outside Washington, that is. And there’s the true danger today.

The dangerous market has been and gone. It popped when Florida condos stopped selling to buy-and-flip wannabes without a red cent of cash but one million in debt. Only government meddling — just like Hank Paulson said — risks further danger; the danger that U.S. taxpayers will pay through the nose (and through inflation) for $700 billion of utterly worthless “investments.”

Hell, he did run Goldman Sachs, after all. What did you expect! But is there any danger of letting the free market do what needs doing?

Regards,
Adrian Ash
September 29, 2008
BullionVault

Government Regulation and Financial Bailout was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Financial upheaval owes homage to derivatives that shrouded the massive growth in debt and leverage. This murky world inflated the incentives of those who ran the machinery over the cliff — bankers, mortgage brokers, law firms, appraisers, rating agencies, politicians, and on it goes. This is well known. Despite protestations, the parties knew they were behaving either recklessly or criminally at the time. The Federal Reserve encouraged them.

With a straight face, Hank Paulson proposes that the Fed quash future imbroglios. Yet the terracotta soldiers of Xian would bring more initiative to the assignment.

In September 1998, the Federal Reserve didn’t have the slightest idea of how the banking system functioned; it hadn’t the slightest idea of the banks’ exposure to hedge funds; nor had it the slightest idea of the leverage within the financial system. Maybe these deficiencies are excusable, although the Federal Reserve was responsible for regulating bank holding companies (the holding companies being where much of the risk was housed). It is unpardonable in the aftermath, having learned of its own deficiencies, that the Federal Reserve made no effort to improve its oversight or to warn of the dangers it had recently discovered. Instead, the Fed encouraged devious practices.

In the first three weeks of September 1998, Long-Term Capital Management (LTCM), a Greenwich, Conn., hedge fund, lost half a billion dollars per week and everyone knew it. Except, possibly, Alan Greenspan. In mid-September, the Federal Reserve chairman told the House Banking Committee that “Hedge funds [are] strongly regulated by those who lend the money.” On Sept. 21, LTCM lost $550 million. In a virtuoso rejection of every financial institution’s model, all security prices went down. This is normal. In a panic, everyone sells.

The Fed’s lackluster oversight was partly to blame. On May 2, 1998, Alan Greenspan gave a speech in which he emphasized the advantages of “private market regulation.” Greenspan explained, “Rapidly changing technology has begun to render obsolete much of the bank examination regime established in earlier decades. Bank regulators are perforce now being pressed to depend increasingly on ever more complex and sophisticated private market regulation… One of the key lessons from U.S. banking history [is] that counterparty supervision is still the first line of regulatory defense.” He also noted the Federal Reserve’s decision to supervise “risk management procedures, rather than actual portfolios.” The Fed now evaluated how banks monitored their own risks (e.g., their modeling techniques, the process used to monitor counterparties) in lieu of examining specific securities.

The Federal Open Market Committee (FOMC) held a conference call on Sept. 29, 1998. The staff and Federal Reserve governors briefed Greenspan on Long-Term Capital Management’s counterparties — the banks that lent to LTCM. He was told that none of the banks, with the exception of Bankers Trust, had an up-to-date balance sheet for LTCM. Even this was “only a small piece of [Bankers’] whole action because so much of the latter is off balance sheet.” When assets are off balance sheet, the bank’s motivation to “strongly regulate” is diminished.

The Federal Reserve chairman was at a loss: “The question is why it happened in the first place. Is it just that the lenders were dazzled by the people at LTCM and did not take a close look?” Vice Chairman William McDonough replied there “was in place a credit system that made a great deal of sense.” In the next sentence — which simply cannot have been an explanation of this sensible system — McDonough told the FOMC: “For at least some of the lenders, there was no initial margin requirement.” McDonough went on to suggest the Federal Reserve might have taken more initiative: “We do not regulate the firm. But given the number of institutions they dealt with around the world, was there a way that should have enabled us to be more aware of their overall position? One is inclined to say, ‘You bet.’ But exactly how we could have done that I am not so sure.”

This was not the time for the FOMC to design a regulatory apparatus, but the Greenspan Fed never did attempt to fill this gap. In retirement, Greenspan reminds his audiences that the Fed does not regulate hedge funds. True, but the Fed could have worked backward from the foundation that McDonough had suggested. (The SEC is responsible for monitoring broker-dealers. It, too, has failed miserably.) The need for adult supervision of banks was obvious when a staffer commented on the conference call, “It is something of a signature for [LTCM] to insist that if a counterparty wanted to deal with them, there would be no initial margin. Not many other firms have gotten away with that.” For this reason alone, the Fed should have geared up its watchdogs to better monitor the suicidal banking system it regulated.

Another staff member enlightened the FOMC with a frightful prospect: “The counterparties…get comfortable with zero percent margin. But from the [financial] system’s point of view, zero initial margin permits an essentially unlimited amount of leverage. There is no constraint other than the exhaustion on the part of the counterparties.” Greenspan and Bernanke fiddled with their slide rules as financial derivatives grew to 10 times the world’s GDP. In 2007, Bernanke should have known that banks, in a desperate attempt keep dancing, were borrowing at five percent to lend at four percent.

Greenspan was vexed: “It is one thing for one bank to have failed to appreciate what was happening to [LTCM], but this list of [banks without knowledge of LTCM’s positions] is just mind-boggling.” So boggled was the man that the Greenspan (and Bernanke) Fed allowed the banks to lever as never before and write $400 trillion worth of derivatives between then and 2008 — without so much as a dollar bill of reserves: Nor a peep that maybe these off-balance-sheet liabilities might bear closer attention.

A staff member described what he had learned on his field trip to LTCM. On Aug. 31, the hedge fund had a $125 billion balance sheet. It also had $1.4 trillion of off-balance-sheet assets. On Sept. 21, when it appears (from the transcript) the Fed first saw LTCM’s balance sheet, its leverage was 55-to-1 and the “off-balance-sheet leverage was 100-to-1 or 200-to-1 — I don’t know how to calculate it.” He wasn’t alone. Greenspan’s “first line of regulatory defense” didn’t know if LTCM was trading interest rate swaps or stolen cars. The models of LTCM’s “counterparty supervision” were so “complex and sophisticated” that the hedge fund’s portfolio had been translated into a Greek salad — gammas, thetas, and epsilons.

For practical purposes, LTCM had no capital by Sept. 29. It was not able to meet margin calls. The hedge fund had not been required to post margin, but was required to post collateral worth 100 percent of the assets it borrowed. Even this looked amateurish. Greenspan, a former director of J.P. Morgan, shared his view: “If I am a bank lender and I lend $200 million to a hedge find, ordinarily, I would be overcollateralized. I would hold more than $200 billion in, say, U.S. Treasury bills.” Greenspan asked if the collateral was U.S. Treasuries. A staffer replied: “U.S. Treasuries, Danish government bonds, BBB credits — you name it.” Beanie Babies were next on the list. The value of LTCM’s collateral was falling. The balance sheets of the banks LTCM traded with were sinking.

A staffer explained the risk: “I’m going to say this in plain English. If markets keep moving away from [LTCM] in the wrong direction, their future exposure could be large and they might not have the collateral at that point in time to cover the exposure.” McDonough had described the house of cards earlier: “The firm’s position in a variety of instruments was very large. What my contacts were talking about was the effect that the failure of the firm would have on world markets if all these positions had to be dumped on the markets. People who thought they had an offsetting position with [LTCM] would suddenly find that they did not have one. They would suddenly find themselves with big open positions…” Globalization might end in a financial meltdown.

A Fed staffer thought the banks “were saying the right things in terms of the kinds of risk management processes they had in place” but “the question is how effectively the banks were actually implementing them…” The Fed staff had not taken the initiative to check. Greenspan was told the Federal Reserve had not examined the banks since December 1997. In Greenspan’s remaining decade at the helm, his bureaucrats produced masterful studies on counterparty risk, but permitted the banks’ risk models to optimize executive bonus compensation.

This is interesting, but not of great utility in 2008. The 1998 Fed weaknesses are important because the molehill grew into a mountain. Greenspan and Bernanke chaired the most egregious administrative failure in financial history. Paulson’s proposal is on a par with Caligula’s decision to name his horse consul.

In March 1999, Greenspan gave a speech on derivatives. He might have wandered onto the podium from Mars. Derivatives “are an increasingly important vehicle for unbundling risk.” He doused the post-LTCM movement toward a better form of regulation: “Some may now argue that the periodic emergence of financial panics implies a need to abandon models-based approaches to regulatory capital and to return to traditional approaches based on regulatory risk schemes. In my view, this would be a major mistake.” The regulators’ risk models “are much less accurate than banks’ risk measurement models.” The Federal Reserve is not the institution to lead the much-needed bank regulation.

The nominal value of derivative contracts held by U.S. commercial banks (those over which the Fed has direct regulatory authority) leapt from $33 trillion at the end of 1998 to $101 trillion at the end of 2005, about the time Greenspan left office. We mustn’t ignore Greenspan’s successor: By the second quarter of 2007, 18 months later, these banks held $153 trillion in derivatives. The collapsing financial system is in the early stage of unwinding. Ben Bernanke has had time as Fed chairman to do something — anything — to slow the production of bad debt. Instead, the rate of financial claims in the economy accelerated.

The virtues of derivatives (their ability to diversify risk away from the banking system) received full approval from Greenspan and, more to the point, from his audiences. Bernanke is considered a monetary genius. Will we ever learn? Someday, we might ridicule, rather than praise, the Fed. On that day, it should be disbanded.

Regards,
Fred Sheehan
April 14, 2008

Mistakes at the Federal Reserve was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

“Just like natural organisms, the financial system must have death to evolve into a better form…”

NOW THAT HE’S WEARING some sort of do-good government hat, even Hank Paulson is not thinking straight.

Regulate in New York and finance goes to Toronto. Regulate in London, it goes to Frankfurt or Paris — and since Toronto, Frankfurt and Paris are run by the same nervous bureaucrat-types, we can reckon soon enough that the entire financial markets will be hosted out of Singapore and Shanghai.

There they will accept the risks as well as the rewards, to their very considerable long-term benefit.

You simply cannot enjoy being the financial center of the world but start bleating for government bailout whenever asset prices dip a few percent. As Paulson is demonstrating, the regulatory price for being bailed out is far too high. We must all grow up and take a full measure of punishment. The banks must take theirs.

Let the shareholders and depositors take theirs too. Just like natural organisms, the financial system must have death to evolve into a better form. Of course, this sounds like a callous statement, but it may be the only way to avoid the moral hazard that Paulson is seemingly creating.

Paulson’s plan is a dressed-up confiscation of the profits of the cautious, and a transfer of those profits straight back to unreconstructed gamblers in the worst offending banks. This is very unwise. When will they learn their lesson? If reckless behavior is continually bailed out, when will we ever see a reversion to more risk-averse times? Sometimes a sound and safe bet is the correct one.

In these difficult times, profit (or more accurately the avoidance of loss) should be benefiting those who troubled to understand the risks in the system, and avoided them. But Paulson’s plan is currency creation, and a devaluation of the good quality assets owned by the cautious. He fails to understand that unless the system occasionally rewards caution there is no reason ever to be cautious again.

Where Goldman Sachs should be duly rewarded for its safer bets, Bear Stearns should be given its due punishment for its uncontrolled risk. If the stock needs to fall all the way to zero, that’s how Bear’s cookie should have crumbled. Instead, the company has been rescued and placed in the safe, strong arms of JP Morgan. Where is the justice?

The market works better without these rescues. Only by appropriate economic reward to the cautious, when they are right and everyone else is wrong, will caution sit well beside risk-taking in the financial system. The real threat to New York and London’s continued dominance of the world’s future financial system is government regulation itself.

Mr. Paulson should read F.A. Hayek’s classic The Road to Serfdom, and he would understand the inevitable failure of his rescue plans. He would see how these top-down rules remove society’s flexibility until one day we all wake up in a paralyzed “command” economy, where nothing can be done without official sanction.

Instead, he has forgotten what a command economy means. He should study the history of communism’s economic successes. It won’t take him long.

Regards,
Paul Tustain
BullionVault
April 1, 2008

The Problem with Bailouts was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.