I understand it's hard to argue for bank's case on anything nowadays. But I believe the old motto of "easy things are not worth trying" so I'll take a shot here.
(Speaking in evil bank's voice) Uncle Sam, do you want me to be a for-profit entity or a social service? Make up your schizophrenic mind quick because every hour in self-debate will put both of us, along with the society as collateral, in further limbo.
Even though I'm fundamentally a libertarian, I'm far from a fundamentalist libertarian. I readily concur some social services are necessary. I think forcing banks and investors to make mortgage mods is morally wrong nor will it work but I'll not argue it here. Let's assume for the moment we will make homeownership our social goal and banks will be the conduit. Fine. Then take over banks like Fannie and Freddie.
But if you don't have the stomach for it, then let banks be banks. Give banks a chance to do the right (economic) thing for a change. If they decide a credit is worth the risk, they will take it. If they refuse, generally speaking there's a good reason for it.They don't like anyone or hate anyone. They're for profit, remember?
If you force banks to lend to risky credit in this dismal climate, then you're forcing them to repeat the same mistakes that got us into this mess. Only this time you can't blame the banks. And you'd better be ready to keep pumping money into the system. Lots of it. For a long time.
And if you don't want to keep pumping in money, that's fine, too. Let'em fail. There'll be capable and hard-working people starting from scratch in no time. The market and the society will be much healthier and sustainable after rising from the ash.
Pick your poison.
Anything but what the government has been doing so far, which is absolutely the most convenient, irresponsible, morally bankrupt (there! I said bankrupt!), schizophrenic approach.
Saturday, February 21, 2009
Re-privatization, Not Nationalization
No, it's a bit more than rhetorics.
Those who're opposed to government intervention in the banking industry, or anything beyond no-string-attached handouts anyway, wisely choose the word "nationalization" to describe it. The neutrals go along. But I don't understand why those who are for it fall for such an obvious rhetorical trap.
As far as I can tell, no self-respecting mouthpiece is calling for nationalization of any banks. Notionalization is not the goal, but rather a temporary measure, a transient point leading to a better, healthier, and more sustainable form of private banking. The Whitehouse declaration today about how they've been supporting a private banking sector "for quite some time" would be comical if it weren't so sad. Really, only for "quite some time", as opposed to since day 0? Does that imply state-owned banking was on their mind some time ago? Now that's worrisome.
No, I don't seriously believe Team Obama has ever entertained the idea of making banks nationalized as an end-point. I bring it up here only to highlight the sad rhetorical mess we've gotten ourselves in on this critical issue. Messages in the public arena as well as from the government have been drowning in mind-boggling confusion. Real issues such as corporate governance, entitlement society, structural corruption of government regulators, chronical decline of savings and manufacturing are pushed aside by relatively trivial, shallow soundbytes such as office furniture and corporate jet. Congress would've appeared only clueless, no worse than the two executive teams so far, if they hadn't put up pathetic political show after pathetic political show bellowing down shallow, tedious indignation on bank CEOs.
Can we at least get one tiny technicality clarified so as to avoid another sad day like Friday? Namely, are we talking about nationalization or re-privatization?
That's a rhetorical question, as I made clear at the beginning of this post. Of course we're talking about re-privatization, aren't we?
I can't speak for others but here's what I mean by re-privatization.
1. Let insolvent banks fail. Throwing money into insolvent banks in a bad, global, likely prolonged recession/depression will not work. Reasons for why this will not work and examples of how this has not worked have been cited ad nauseum in media and blogosphere so I'll not repeat them here. But some people get a mental blackout right here. But if we could peek beyond the mental block just for sport, perhaps the Great Beyond is not so scary after all.
2. Government immediately puts failed bank(s) into conservatorship. Here's the scary N word but hang on with me for a moment. Guarantee deposits as usual. Restructure outstanding debt. Let CDS settle and common/preferred equity do whatever the market fancies to do. Hang on.
3. Segregate the deposits and traditional commercial banking part, re-IPO it, and regulate them as good'ol commercial banks. Re-enact Glass-Steagall and make it a requirement for any foreign banks wanting to do business here. Push for an international standard along the same line later.
4. Set up an RTC as custodian for "bad assets", classified by a one-time sweep. Minimal administrative cost, no trading. The government has incentive to minimize potentially good assets in this pool so as to faciliate the IPO and sale (see below) process and maximize return.
5. Sell the remaining investment banking and capital markets part to private investors ASAP. Make a law forbidding them to go IPO. As I argued before, private partnership is probably the only sustainable governance model for investment banking and capital markets, and public ownership is most certainly not. Extend the safetyguard to all foreign banks doing business here.
Of course, there're a lot of details that need to be worked out. A critical factor is the international aspect. If Uncle Sam unilaterally takes over a multi-national bank, guarantees deposit accounts in US branches but without regard to those in other countries, it could get very ugly very fast. International coordination and cooperation is pivotal. But if there's ever a time for true American leadership, or true American bullying if you prefer, this is it. Get Cheney to chair the G20 meeting with his loose shotgun on the table if necessary. I'm not saying we could force US interest on everyone. But let's face it, it requires power politics, in addition to masterful diplomacy, to get the global villagers to agree on anything without getting hopelessly boggled down on each one's petty issues and historical grudges.
True leadership, both domestically and internationally. Do we have it?
Those who're opposed to government intervention in the banking industry, or anything beyond no-string-attached handouts anyway, wisely choose the word "nationalization" to describe it. The neutrals go along. But I don't understand why those who are for it fall for such an obvious rhetorical trap.
As far as I can tell, no self-respecting mouthpiece is calling for nationalization of any banks. Notionalization is not the goal, but rather a temporary measure, a transient point leading to a better, healthier, and more sustainable form of private banking. The Whitehouse declaration today about how they've been supporting a private banking sector "for quite some time" would be comical if it weren't so sad. Really, only for "quite some time", as opposed to since day 0? Does that imply state-owned banking was on their mind some time ago? Now that's worrisome.
No, I don't seriously believe Team Obama has ever entertained the idea of making banks nationalized as an end-point. I bring it up here only to highlight the sad rhetorical mess we've gotten ourselves in on this critical issue. Messages in the public arena as well as from the government have been drowning in mind-boggling confusion. Real issues such as corporate governance, entitlement society, structural corruption of government regulators, chronical decline of savings and manufacturing are pushed aside by relatively trivial, shallow soundbytes such as office furniture and corporate jet. Congress would've appeared only clueless, no worse than the two executive teams so far, if they hadn't put up pathetic political show after pathetic political show bellowing down shallow, tedious indignation on bank CEOs.
Can we at least get one tiny technicality clarified so as to avoid another sad day like Friday? Namely, are we talking about nationalization or re-privatization?
That's a rhetorical question, as I made clear at the beginning of this post. Of course we're talking about re-privatization, aren't we?
I can't speak for others but here's what I mean by re-privatization.
1. Let insolvent banks fail. Throwing money into insolvent banks in a bad, global, likely prolonged recession/depression will not work. Reasons for why this will not work and examples of how this has not worked have been cited ad nauseum in media and blogosphere so I'll not repeat them here. But some people get a mental blackout right here. But if we could peek beyond the mental block just for sport, perhaps the Great Beyond is not so scary after all.
2. Government immediately puts failed bank(s) into conservatorship. Here's the scary N word but hang on with me for a moment. Guarantee deposits as usual. Restructure outstanding debt. Let CDS settle and common/preferred equity do whatever the market fancies to do. Hang on.
3. Segregate the deposits and traditional commercial banking part, re-IPO it, and regulate them as good'ol commercial banks. Re-enact Glass-Steagall and make it a requirement for any foreign banks wanting to do business here. Push for an international standard along the same line later.
4. Set up an RTC as custodian for "bad assets", classified by a one-time sweep. Minimal administrative cost, no trading. The government has incentive to minimize potentially good assets in this pool so as to faciliate the IPO and sale (see below) process and maximize return.
5. Sell the remaining investment banking and capital markets part to private investors ASAP. Make a law forbidding them to go IPO. As I argued before, private partnership is probably the only sustainable governance model for investment banking and capital markets, and public ownership is most certainly not. Extend the safetyguard to all foreign banks doing business here.
Of course, there're a lot of details that need to be worked out. A critical factor is the international aspect. If Uncle Sam unilaterally takes over a multi-national bank, guarantees deposit accounts in US branches but without regard to those in other countries, it could get very ugly very fast. International coordination and cooperation is pivotal. But if there's ever a time for true American leadership, or true American bullying if you prefer, this is it. Get Cheney to chair the G20 meeting with his loose shotgun on the table if necessary. I'm not saying we could force US interest on everyone. But let's face it, it requires power politics, in addition to masterful diplomacy, to get the global villagers to agree on anything without getting hopelessly boggled down on each one's petty issues and historical grudges.
True leadership, both domestically and internationally. Do we have it?
Tuesday, February 10, 2009
When Will the USD Carry Trade Finish Unwinding?
Back in Oct 08, I speculated that USD had become a major carry-trade currency, along with JPY. Bad news for US economy made USD stronger, much like what had been happening to JPY for the past few years. That was a dramatic reversal against the usual carry-trade target currencies such as AUD and CHF (Swiss Franc), and to a somewhat lesser degree EUR and GBP, since early 06. FX rates are one of the most complex dynamics in the complex dynamics of financial world. But when bad news is good news for a currency, it's a sure sign of it being a pivotal carry-trade currency.
Recently, and especially today, we're seeing another proof of USD and JPY being the carry-trade currencies. It's implausible to argue the recent USD strength has anything to do with safety or even risk aversion, the latter being the usual explanation for carry-trade currency strength. It's more like forced, maybe even panicking, unwind of existing carry trades.
Hence lies the surprise to me as a casual observer of the FX market: what, there's still a massive amount of carry trades open, a year and half after the crisis blew up in the US and half a year after the crisis became an exported, global one?
But the more interesting question is this: when will this unwinding finish and bad news for US economy becomes bad news for USD? That would mark the next turning point in the dynamics for USD and JPY.
I would appreciate readers' enlightenment as to how to find data, or even if just a guesstimate, on the scope of carry trades.
Recently, and especially today, we're seeing another proof of USD and JPY being the carry-trade currencies. It's implausible to argue the recent USD strength has anything to do with safety or even risk aversion, the latter being the usual explanation for carry-trade currency strength. It's more like forced, maybe even panicking, unwind of existing carry trades.
Hence lies the surprise to me as a casual observer of the FX market: what, there's still a massive amount of carry trades open, a year and half after the crisis blew up in the US and half a year after the crisis became an exported, global one?
But the more interesting question is this: when will this unwinding finish and bad news for US economy becomes bad news for USD? That would mark the next turning point in the dynamics for USD and JPY.
I would appreciate readers' enlightenment as to how to find data, or even if just a guesstimate, on the scope of carry trades.
Monday, February 9, 2009
Can We Go Back To The Old Wall Street?
Michael Lewis hit it on the head when he called the IPO of Salomon Brothers the "beginning of the end of Wall St". Goldman CEO Blankfein almost suggested we go back to the old Wall Street of private partnership in an FT article yesterday.
Let's face it. We screwed up by dismantling Glass-Steagall, a lesson learned the hard way during the Great Depression but thrown away when complacency and greed got the better of us. Basel II is a joke. The European model of combined commercial and investment banks creates way too much systemic risk. Heck, people on the two sides don't even like each other. Commercial banks serve too much social function (taking deposits and making loans) to be aggressive profit seekers. They must be closely and prudently managed and regulated. Investment banks (including capital markets), on the other hand, must be aggressive profit seekers and risk takers in order to serve their social function, which is to keep the capital markets somewhat efficient and fair. But institutions playing such a pivotal social role cannot be public.
Why? Because public ownership is a farce. The concept of "ownership" is a mirage for most modern companies big enough to pass the IPO threshold. But it's like a CDO Squared backed by mirages when it comes to investment banks. I've written specifically about this before so I'll not repeat it here.
But I'd like to stress another point here: regulation alone cannot possibly be adequate for a beast like investment banking. Two reasons:
1. Regulation by definition is rigid and static, while investment banking by nature must be nimble, innovative, and flexible. The result is you end up with either too little regulation, too much, or the wrong kind. Most likely you end up with D) All of the above.
2. Regulators cannot possibly understand the going-ons at investment banks even if they are honest, earnest, and have the authority. There's just too much going on, too fast, that is too complex. There's no way the regulatory bodies can compete with investment banks for high-quality talent without severely corrupting the process, thus defeating its purpose.
While some regulation on investment banking is necessary, it takes the watchful eyes of private partners to keep the beast from hurting itself and taking the society with it. Only private partners have the power, the incentive, and the capability to do so.
So separate commercial banks from investment banks, nationalize the latter, set up RTC for the latter, and then auction off investment banks to private partners. Out of the ashes of the Wall Street everyone loves to hate today, we'll have a lean and nimble Old Wall Street back in no time.
Without costing nearly as much taxpayer money.
Furthermore, not only should we re-enact Glass-Steagall, we should insist on making it an international standard to level the playing field and avoid future contagion. If someone refuses to adopt the standard, they would not be allowed to compete in the member markets.
Let's face it. We screwed up by dismantling Glass-Steagall, a lesson learned the hard way during the Great Depression but thrown away when complacency and greed got the better of us. Basel II is a joke. The European model of combined commercial and investment banks creates way too much systemic risk. Heck, people on the two sides don't even like each other. Commercial banks serve too much social function (taking deposits and making loans) to be aggressive profit seekers. They must be closely and prudently managed and regulated. Investment banks (including capital markets), on the other hand, must be aggressive profit seekers and risk takers in order to serve their social function, which is to keep the capital markets somewhat efficient and fair. But institutions playing such a pivotal social role cannot be public.
Why? Because public ownership is a farce. The concept of "ownership" is a mirage for most modern companies big enough to pass the IPO threshold. But it's like a CDO Squared backed by mirages when it comes to investment banks. I've written specifically about this before so I'll not repeat it here.
But I'd like to stress another point here: regulation alone cannot possibly be adequate for a beast like investment banking. Two reasons:
1. Regulation by definition is rigid and static, while investment banking by nature must be nimble, innovative, and flexible. The result is you end up with either too little regulation, too much, or the wrong kind. Most likely you end up with D) All of the above.
2. Regulators cannot possibly understand the going-ons at investment banks even if they are honest, earnest, and have the authority. There's just too much going on, too fast, that is too complex. There's no way the regulatory bodies can compete with investment banks for high-quality talent without severely corrupting the process, thus defeating its purpose.
While some regulation on investment banking is necessary, it takes the watchful eyes of private partners to keep the beast from hurting itself and taking the society with it. Only private partners have the power, the incentive, and the capability to do so.
So separate commercial banks from investment banks, nationalize the latter, set up RTC for the latter, and then auction off investment banks to private partners. Out of the ashes of the Wall Street everyone loves to hate today, we'll have a lean and nimble Old Wall Street back in no time.
Without costing nearly as much taxpayer money.
Furthermore, not only should we re-enact Glass-Steagall, we should insist on making it an international standard to level the playing field and avoid future contagion. If someone refuses to adopt the standard, they would not be allowed to compete in the member markets.
Sunday, February 1, 2009
Whatcha Gonna Do When 1+1 No Longer Equals 2?
Several widely respected experts have recently said the same thing: all US/European banks are insolvent if they mark everything to market.
How could this be, after so much write-downs and bailouts? I have no evidence to support or refute them. So my only logical choice is to join them.
My guess is, forget about CDS/CDOs. They're past problems, known problems. The hidden toxic dump remaining, the next bomb that keeps blowing up, may be the highly customized, highly complex structured deals they've been accumulating over the years. There's no wholesale market for any of them. Decomposing them carries substantial risk of mismatching due to the various disparities in the market today. Hedging? If Merrill got into a $15B trap doing the simplest CDS/bond basis trade, how can you have any confidence of any hedge/arbitrage/trade working as expected?
Here lies the biggest surprise to the financial world so far throughout this crisis. 1+1 no longer equals to 2.
If the industry is still struggling to explain the CDS/bond basis and determine whether and how to trade it, then good luck with the structured deals. I've seen some of them. It could easily take a highly specialized expert days to digest it, break it down to pieces, figure out how it'd behave under different scenarios, and calculate risk based on existing standard models. Except, of course, the assumptions made by many standard models have been proven way off-base by the market over the past year. Now, on top of this, take away 1+1=2.
Portfolio decomposition is THE foundation for synthetics and much of structured finance. If you take this away, you take away a big part of the foundation of financial pricing. But the world should not be surprised. It happened before for Long Term Capital. Calling the market stupid is as productive as calling reality stupid, even though you could very well be correct. The market is just pricing in some factors omitted by standard models. I have a model that can explain and quantify these factors but it's beyond this article and beside my point.
My point is,
1. it's futile to expect anybody to price/hedge lots of the structured trades meaningfully, even with the best/purest intentions, and
2. even if there is a liquid market, the pricing mechanism is so different now that many tried-and-true, fundamental assumptions in finance are no longer valid.
It's a wild new world. It may be rational still, we have to assume it so. But it's so fundamentally different that it'd take some time (at least months, quite possibly years) for the industry to make sense of it. If you think I'm exaggerating, think about the impact of abandoning Libor and the US treasury curve having a credit spread of 50 bps embedded.
What we're going through is wholesale, across-the-board, fundamental repricing of every financial instrument in existence.
So why are we still debating about which banks are good and which are bad, what their valuation should be, whether to take away bad asset and how to value them, etc etc?
Forget about valuation and risk management! It's not possible! It's a new world that we don't understand!
There, feels better already. Now we can calm down and think rationally.
Now that we admit we don't know how to price them and cannot possibly know for a long time, the solution becomes apparent: don't price them.
1. Ask banks to do a one-time categorization of assets they deem "hard to price". This hard-to-price pool cannot change in the future.
2. Sweep these hard-to-price assets aside. Get rid of all hedging and stop all trading of this pool. It will be held to maturity except, for perpetuals (e.g., real estate), the bank can decide when to sell (but never buy back into the pool) subject to some hard deadline (e.g. 30 years).
3. Provide a total cost, not including operational/financing costs/hedging costs so far since initial trade, future collateral/margin costs, and any realized P&L due to position changes so far since initial trade.
4. The total cost becomes a nominal addition to the bank's Tier-2 capital base for regulatory and accounting purposes.
5. As assets in the frozen pool mature, the realized P&L with respect to the reported cost is accounted for in Tier-2 capital.
6. The frozen asset can be used as collateral, at reported cost, at the Fed window prior to maturity.
7. Everything else will be marked to market.
The final settlement at maturity is the only sure answer to the perennial question of "what's its worth".
Currently banks do have some flexibility in which assets to mark to cost. But there're too many restrictions in some regards while too much flexibility in others. By doing it across the board (regardless of whether the asset is owned by the mortgage division, a trading desk, or the financing department) and at the same time, one time only, we eliminate the regulatory arbitrage and uncertainty.
Under this system, banks will have to prove some illiquidity threshold for assets they put in the pool. Such threshold will be determined by expert panels set up by the government. Other than the illiquidity criterion, banks are free to choose which ones to keep frozen. If they choose assets already marked down, they'd get a one-time boost, which they must disclose in the quarterly report.
The merit of this approach is to provide capital relief to the banks without government subsidy, government guarantee, or some other artificial price intervention. Banks would not be forced to sell assets and/or raise capital in the worst moment. It's the ultimate bailout without spending a penny.
The hope is that, when held to maturity, the macro-economy will recover and most assets will pay off. Nobody is seriously predicting Armageddon after all. In fact, China used essentially the same approach circa 1998 and it worked out beautifully.
This is not the best solution, of course. The best solution is to let all banks fail, use a small fraction of the trillions of bailout money to support deposits and the massive ensuing unemployment, let the good and capable to restart from scratch. We'd have a lean and healthy private partnership Wall Street in no time, in which risk and reward are matched in magnitude and duration, owners actually have control, and stupidity/mediocrity has nowhere to hide.
But that's no going to happen, is it?
How could this be, after so much write-downs and bailouts? I have no evidence to support or refute them. So my only logical choice is to join them.
My guess is, forget about CDS/CDOs. They're past problems, known problems. The hidden toxic dump remaining, the next bomb that keeps blowing up, may be the highly customized, highly complex structured deals they've been accumulating over the years. There's no wholesale market for any of them. Decomposing them carries substantial risk of mismatching due to the various disparities in the market today. Hedging? If Merrill got into a $15B trap doing the simplest CDS/bond basis trade, how can you have any confidence of any hedge/arbitrage/trade working as expected?
Here lies the biggest surprise to the financial world so far throughout this crisis. 1+1 no longer equals to 2.
If the industry is still struggling to explain the CDS/bond basis and determine whether and how to trade it, then good luck with the structured deals. I've seen some of them. It could easily take a highly specialized expert days to digest it, break it down to pieces, figure out how it'd behave under different scenarios, and calculate risk based on existing standard models. Except, of course, the assumptions made by many standard models have been proven way off-base by the market over the past year. Now, on top of this, take away 1+1=2.
Portfolio decomposition is THE foundation for synthetics and much of structured finance. If you take this away, you take away a big part of the foundation of financial pricing. But the world should not be surprised. It happened before for Long Term Capital. Calling the market stupid is as productive as calling reality stupid, even though you could very well be correct. The market is just pricing in some factors omitted by standard models. I have a model that can explain and quantify these factors but it's beyond this article and beside my point.
My point is,
1. it's futile to expect anybody to price/hedge lots of the structured trades meaningfully, even with the best/purest intentions, and
2. even if there is a liquid market, the pricing mechanism is so different now that many tried-and-true, fundamental assumptions in finance are no longer valid.
It's a wild new world. It may be rational still, we have to assume it so. But it's so fundamentally different that it'd take some time (at least months, quite possibly years) for the industry to make sense of it. If you think I'm exaggerating, think about the impact of abandoning Libor and the US treasury curve having a credit spread of 50 bps embedded.
What we're going through is wholesale, across-the-board, fundamental repricing of every financial instrument in existence.
So why are we still debating about which banks are good and which are bad, what their valuation should be, whether to take away bad asset and how to value them, etc etc?
Forget about valuation and risk management! It's not possible! It's a new world that we don't understand!
There, feels better already. Now we can calm down and think rationally.
Now that we admit we don't know how to price them and cannot possibly know for a long time, the solution becomes apparent: don't price them.
1. Ask banks to do a one-time categorization of assets they deem "hard to price". This hard-to-price pool cannot change in the future.
2. Sweep these hard-to-price assets aside. Get rid of all hedging and stop all trading of this pool. It will be held to maturity except, for perpetuals (e.g., real estate), the bank can decide when to sell (but never buy back into the pool) subject to some hard deadline (e.g. 30 years).
3. Provide a total cost, not including operational/financing costs/hedging costs so far since initial trade, future collateral/margin costs, and any realized P&L due to position changes so far since initial trade.
4. The total cost becomes a nominal addition to the bank's Tier-2 capital base for regulatory and accounting purposes.
5. As assets in the frozen pool mature, the realized P&L with respect to the reported cost is accounted for in Tier-2 capital.
6. The frozen asset can be used as collateral, at reported cost, at the Fed window prior to maturity.
7. Everything else will be marked to market.
The final settlement at maturity is the only sure answer to the perennial question of "what's its worth".
Currently banks do have some flexibility in which assets to mark to cost. But there're too many restrictions in some regards while too much flexibility in others. By doing it across the board (regardless of whether the asset is owned by the mortgage division, a trading desk, or the financing department) and at the same time, one time only, we eliminate the regulatory arbitrage and uncertainty.
Under this system, banks will have to prove some illiquidity threshold for assets they put in the pool. Such threshold will be determined by expert panels set up by the government. Other than the illiquidity criterion, banks are free to choose which ones to keep frozen. If they choose assets already marked down, they'd get a one-time boost, which they must disclose in the quarterly report.
The merit of this approach is to provide capital relief to the banks without government subsidy, government guarantee, or some other artificial price intervention. Banks would not be forced to sell assets and/or raise capital in the worst moment. It's the ultimate bailout without spending a penny.
The hope is that, when held to maturity, the macro-economy will recover and most assets will pay off. Nobody is seriously predicting Armageddon after all. In fact, China used essentially the same approach circa 1998 and it worked out beautifully.
This is not the best solution, of course. The best solution is to let all banks fail, use a small fraction of the trillions of bailout money to support deposits and the massive ensuing unemployment, let the good and capable to restart from scratch. We'd have a lean and healthy private partnership Wall Street in no time, in which risk and reward are matched in magnitude and duration, owners actually have control, and stupidity/mediocrity has nowhere to hide.
But that's no going to happen, is it?
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