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 ·magicjack.com
1 edit | reply to hoyleysox
Re: Unemployment and Wall Street said by hoyleysox:Two issues I don't have a solution to: 1) Lehman represent a tricky issue, they facilitated so many contracts which became impossible to unwind once they failed. Lehman was merely the first to be allowed to fail. Bear Stearns had the same problem, but was bailed out with a federally-backstopped guarantee to JPMorgan to takeover Bear's contracts.
For about four months it was known Lehman would be next. Treasury Secretary Paulson was in almost daily contact with Lehman's CEO, Dick Fuld, encouraging him to raise capital or find a buyer. Creditors wouldn't put money into Lehman because they saw what happened to Bear's creditors (who were wiped out). Competing banks wouldn't buy Lehman because they all wanted a JPMorgan deal (federal guarantee against Lehman's worst assets).
Paulson, reflecting the political reality at that time (but also due to his own "free market" subjectivism) wouldn't bail out Lehman. He wanted the other players to know that "free markets" aren't about bailouts.
Literally within hours of Lehman failing, Paulson had an "oh sh*t" moment. He realized how interconnected everyone was through derivatives. It suddenly became evident that AIG would have to pay the bets it made.
Even bailing out AIG two days later it didn't stem the panic. Within three more days Paulson and Bernanke went to Congress seeking bailout money, and warning that the entire financial system could collapse within days.
During all this Merrill Lynch arranged a hasty deal with BofA. And, JPMorgan came to the rescue of Washington Mutual, the largest regulated bank failure in US history to that point.
Goldman and Morgan Stanley were both sweating that they were next. They were both saved by
1) The government backstopping AIG's derivative "bets," which both were significant counterparties to.
2) The government made them both regulated "bank holding companies," making them eligible to borrow nearly unlimited amounts of money from the Fed's "Discount Window" (and subsequently anonymous auctions held by the Fed).
Those events (in the span of 2-3 weeks) brought to an end an era of Wall St. investment banking. They formally became regulated institutions. They agreed to it because, at the time, their assets were worth nothing. They had nothing to lose by changing their business model and submitting to regulation.
So, it's incorrect to say Lehman was unique, or none of the other participants in the financial sector posed "tricky" challenges.
If you want to sit through the entire thing, read Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System---and Themselves.
said by hoyleysox:It is also uncomfortable that there can be more puts or shorts on a company than there are available shares. Not sure what to do about that... At least short-selling stocks is done through exchanges. If I want to buy 1000 shares of a company's stock, I can easily see what the short interest is in that stock.
That's the value of transparency. The strong point of US markets are that they are regulated for *transparency*. That's why, as the global middle class rose during the past 5-10 years they wanted to invest in US markets. Our transparency means there is less opportunity for manipulation and corruption ("rigged" games, such as existed in the US in 1929 when investors knew the system was rigged, and were gambling that they could catch the crumbs falling off the table that the big boys were controlling).
That's the problem with the unregulated (OTC) derivative market. You can't see what kind of bets anyone's made. You can't see how much anyone has agreed to pay in bets (whether your underwriter is over exposed). Or, how they might be selling you a security product while taking a derivative interest against it.
said by hoyleysox:Many derivatives contracts already contain provisions for capital reserve requirements, those requirements brought down AIG after they were downgraded and the reserves were not available. I think you're putting the result before the cause.
The fact that derivative contracts contain capital reserve requirements is prima facia evidence that participants expect performance. That's an argument for regulation.
The problem with AIG wasn't that it was forced to pony up more collateral as its counterparty exposure (to paying claims on bad bets) increased. It was that it had made too many bad bets. Too much leverage was applied against existing capital.
In other words, that's a reason to have transparency and limits on leverage. The problem wasn't that AIG had the equivalent of "margin calls." It was that they started out from a highly leveraged (and optimistic) position that the housing market wouldn't tumble, causing systemic failure and resulting in massive claims to pay off its debts.
The way you describe it, when the same over-optimism (which led to massive leverage) existed in 1929, the problem wasn't massive leverage, it was the *margin calls* (capital reserve requirements) that wiped out so many investors. Proof that they were regulated sufficiently(?).
The result in 1929 was limits on how much leverage (margin) an investor could use as a ratio of their liquid assets. This reduced the potential for margin calls have such a negative impact on the speculator (and, counterparties would have a reasonable expectation of being paid).
That's what differentiates a market from a gaming parlor. Positions taken on knowledge, not odds. A level of transparency (like counting cards) that makes it less than a roll of the dice.
said by hoyleysox:I am not in favor of a publicly-available directory that has a line item for every hedge, too much potential for front-running. I can see your point. A hedge fund's livelihood is the strategic positions it takes in the market. Requiring them to disclose their positions would be like requiring Intel to disclose where it is spending its R&D money.
OTOH, the problem wasn't hedge funds per se. It was regulated institutions participating in unregulated derivative markets, essentially making themselves unregulated and their books (the whole point of regulation) untrustworthy.
I don't believe the self-interest of hedge funds should outweigh society's interest in transparent, trustworthy markets. Perhaps actual positions (counterparties) shouldn't be disclosed by an exchange agency. But, at least the exchange agency would have visibility into the positions and counterparty risk, and could somehow distill that information for investors, or to State insurance regulators who may have an interest in derivatives used as insurance.
The risk of doing nothing is like taking Greenspan's hailing of deregulation. Dogmatic market capitalists hailed that trend, none more enthusiastically than Greenspan. He claimed, implausibly, that a lack of margin requirements would "promote the safety and soundness of broker-dealers, by permitting more financing alternatives and, hence, more effective liquidity management." In the week before LTCM imploded, he told Congress, "Market pricing and counterparty surveillance can be expected to do most of the job of sustaining safety and soundness." And, in 2003, he told an investment conference:
quote:
"Critics of derivatives often raise the specter of the failure of one dealer imposing debilitating loses on its counterparties, including other dealers, yielding a chain of defaults. However, derivative markets participants seem keenly aware of the counterparty credit risks associated with derivatives and take various measures to mitigate those risks."
This is the same Greenspan who told Congress that the Fed had to intervene in the LTCM crisis, because:
quote:
"Had the failure of LTCM triggered seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own."
In other words, counterparty surveillance works fine, so long as you're willing to accept the occasional crash of "the economies of the nations." But given the enormous rewards that accrue to top-of-the-food-chain players like LTCM partners, true market-believers may find that a cheap enough price.
I think most people have had just about enough of two decade of derugulatory politics, and "free markets" as a Theory of Everything. We've repeatedly seen the ugly side of non-regulation.
Mark | |
| I agree that there are good grounds for limiting the combination of leverage with hedges, especially if the company borrows from the fed.
I am not sure exactly what you mean by 'transparency.' I do think it was wrong for companies to have a seemingly strong balance sheet carrying massive liabilities associated with derivative exposure.
Surely companies' privacy could be balanced against companies' accountability to investors. In what form do you think 'transparency' should be implemented? | |
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2 edits | said by hoyleysox:In what form do you think 'transparency' should be implemented? Maybe levels of regulation:
1. All derivatives go through an exchange (clearing house, like futures contracts and put/call options do today).
At least then there would be some standardization and reporting about short interest in various things (interest rates, mortgage and consumer-debt defaults, etc.). At least regulators would have real-time access to who is exposed the most, both as a counterparty and underwriter (who might not meet obligations as conditions worsen).
That was part of the problem during the last meltdown. Really smart people like Paulson and Bernanke had no knowledge of just how deep the derivative market ran, or how interconnected everyone was.
To me, that was one of the most remarkable aspects of the meltdown. Sub-prime mortgages were just 20% of the total mortgage market. Just months before the meltdown Bernanke told Congress they posed no significant threat to the economy. He didn't realize how leveraged they were, and how bank books were cooked with Credit Default Swaps to make it look like there was no risk. He didn't know who had committed to pay defaults, or if anyone could.
The exchange could create indexes representing categories of derivative volume, volatility, current leveraged nature of underwriters (reflecting deteriorating conditions). Perhaps report real-time leverage levels of underwriters.
Using those indexes, the exchange could reflect deteriorating conditions of underwriters. In the same way futures exchanges settle contracts every day depending on current value of future contracts.
At least that kind of visibility of the market (participants, level of participation, trends, and health) would be step forward.
This level of regulation/transparency could lead to the commodities exchange enforcing margin calls (settlement) the same way they do with futures contracts. Counterparties have to settle the difference every day, depending on the direction of the contract. The exchange acts as an ongoing "escrow" account until expiration date, with funds continually deposited to meet the direction of the contract.
2. Corporations (publicly traded, thus voluntarily subjecting themselves to regulation and transparency) should be required to disclose more about the positions they hold, who their underwriters are, etc.
Investors in a corporation would know how exposed a corporation is to market conditions.
3. Banks (even more regulated for transparency and trust than publicly-traded corporations). Perhaps limited to participate in derivative contracts that meet certain regulatory requirements. That would feed back to #1, using the tools created there.
4. Hedge funds (unregulated). I'm ok with people operating outside the exchange. But, I don't believe hedge funds should be counterparties to those who are (should be) operating on the exchange (with more visibility, regulation).
That was part of the problem during the meltdown. Hedge funds underwrote derivative contracts (swaps). They had absolutely no concern about whether they could pay off. To them, it was all upside. They could collect premiums. But, if the world blew up, all they could lose was the capital in the fund (which would probably be gone anyway, as a result of such market conditions).
Hedge funds should be able to write things like that with you or me, private businesses, etc. But, I think banks should be prohibited from counter-partying with a hedge fund (who wants total anonymity) the way they did prior to the meltdown (and may be doing now).
Those are my thoughts. There should be a way to improve this highly-speculative market the same way we did individual stock-trading, futures, options, etc. Just because it won't be perfect shouldn't outweigh what is a huge potential to bring stability and predictability (integrity as opposed to corruption) to a market.
At least a stated attempt to achieve those goals. That's what's astounding. We've accepted that corruption (and the profits it can bring until it blows up) is better. There should be a way to balance the benefit of creativity in the market (developing new products and services) and the visibility of how that creativity is performing.
Mark | |
| I think that the clearinghouse exchange is a good idea if it is implemented properly. I could see the exchange concentrating risk though. Lehman sort of acted like that clearinghouse and when it went under, the only people directly were those that used Lehman as an intermediary or counterparty, the trouble was that so many people did. This exchange should just be a broker and not have any 'skin' in the game like Lehman did.
I totally agree with your goal of transparency in the sense that it should increase investor confidence in company's books. It is frustrating that companies can use derivatives to play tricks with their balance sheets, that is deception. | | |
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| said by hoyleysox:This exchange should just be a broker and not have any 'skin' in the game like Lehman did. I was talking about an exchange like CBOT. An exchange like the NYSE and NASDAQ, but they clear futures and stock options. Regulated by the CFTC.
It's not like a private exchange, which more institutions than Lehman engaged in. What you're worried about is the kind of exchange we have today with non-regulation. Investment banks and hedge funds operating their own exchange, using their book.
Mark | |
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