Date posted: September 21, 2008

Blogging the Credit Crisis, Again

"The Bank never "goes broke". If the Bank runs out of Monopoly money it may issue as much more as may be needed by merely writing on any ordinary paper." Source: Hasbro, Official Monopoly Rules

What a week! Even though I should be working on other things I couldn’t help being drawn in as the events unfolded. The yield on one and three month U.S. Treasury bills at unprecendented lows, a skyrocketing LIBOR rate, the demise of Lehman Brothers and Merrill Lynch, AIG rescued by the Fed. I couldn’t help being angered by what I believe are the wrong analyses and the wrong measures either.

Once again politicians and commentators call for more regulation. However I’d like to point out (again) that while a year ago there was much talk about the systemic risk from collapsing hedge funds, so far the largely unregulated hedge fund industry has seen few big casualties. Some did go down, but it didn’t cause the shocks many feared and warned against. Of course most hedge funds have lock-up periods, preventing investors from withdrawing their funds. However I also think that the ownership structure of hedge funds has something to do with it. As Tim Harford writes in The Logic of Life, each individual shareholder has only limited influence on a company’s management. The limited owners of hedge funds have large personal stakes in their own company and so have a strong incentive to manage risks.

Short sellers are now getting the blame for the recent fall in bank shares and the Fed, the FSA and the Bafin have all curbed short selling in financial shares. This may be wise in the very short term, but it is the wrong measure in the long and even medium term. The point is that there is a bias towards positive news. It’s fine to be enthusiastic about a company, but wrong to raise some concerns about a company’s strategy, accounting practices etc. A look at stock lending statistics also suggest that there was no surge in short selling of HBOS shares this week.

Some months ago William Ackman of Pershing Capital Management gave some good arguments in favour of short selling. In this interview, when talking about Lehman Brothers, he wondered whether there is still room for a 40 to 1 leveraged financial company. I must say that I disagree with him on the point of short sellers preventing bubbles from happening. Where were they during the internet bubble? But the fact that Lehman Brothers had a 40 to 1 leverage raised my eyebrows. What about capital adequacy ratios?

According to a former SEC official in 2004 the SEC relaxed the capital adequacy ratios for the five big U.S. investment banks while also altering the way capital was measured, thereby allowing them to take on more leverage. So here we may have another root cause, since these banks came to rely more and more on short term debt financing. If the market for short term debt dries up they are in trouble. The old rule was good and enforcing existing regulation is better than announcing ad hoc measures aimed at the trading level. As an aside, I for one have always been sceptical about the valuation of goodwill as an asset, because it cannot be sold as such.

Here's an interesting take on the AIG debacle. Doug Diamond and Anil Kashyap from the University of Chicago answer some questions at the New York Times freakonomics blog. The Financial Times also has good coverage. The media have found their new guru of the day.

I'm not sure whether this is the end of an era and the end of the broker dealer business model as some have argued. Shareholders will decide whether they prefer large financial conglomerates or independent commercial banks, investment banks and insurance companies. There will also be continued demand for M&A advice, private wealth management etc. The remaining U.S. investment banks may seek to change their legal status by becoming regulated banks [update: they just did. This IS a period of rapid change!], so they will be able to tap into the Fed's lending facilities, in return of course, for more disclosure, higher capital reserves and tighter regulationary oversight. But that does not turn them into wholesale commercial banks.

If the current events mark the end of an era, the end play had already begun several years ago with the rise of hedge funds and even further back in time the end of the Glass-Steagall Act. Many star traders left their proprietary trading desks to start their own hedge fund. Investment banks found themselves in a new environment in which they had to compete with former traders to retain employees and clients. In this new environment some banks (Goldman Sachs) were more successful than others. This led the less successful ones (Bear Stearns, Lehman Brothers, Merrill Lynch) to take on more leverage and more risk by aggressively pushing into new areas of finance. If they had limited their exposure to the CDO market, results at Merrill Lynch, Bear Stearns and Lehman Brothers would have lagged even further behind other institutions and shareholders would have demanded the departure of the CEO.

A quick look at some numbers shows that the week has ended almost at the levels of the previous week. So anyone using weekly figures will think that nothing much happened. Apart from that the S&P 500 and the Dow Jones are currently at their 2006 levels. So I wonder whether they reflect the current economic conditions in the U.S. And while there is widespread relief about the latest measures to calm financial markets, no one really knows yet how to actually implement the bail-out and eventually the bill has to be payed.