Friday, September 19, 2008

Resolution? Trust? A Jedi seeks not these things!

I hate to say it. But we need this. There needs to be massive government intervention to create some degree of confidence. It would be one thing if Lehman and Merrill and WaMu and AIG all went under (or were taken out under duress). But now they are coming for Morgan Stanley and Goldman Sachs.

That just can't happen.

Look, the financial world is a confidence game. Even simple trades involves confidence. You put your money into a Merrill Lynch account and buy a stock, you assume they're holding that stock. Hell, you assume the money market fund they use is safe. You assume your bank will be able to cash your checks. Etc. Etc.

Once that confidence is lost, the system can't continue. Everything will break down, and I mean everything. Our whole economic system would collapse.

Spare me the moral hazard arguement. What about the reverse? Should Goldman Sachs pay for the sins of Bear Stearns? Should Morgan Stanley pay for the sins of Lehman Brothers? Look maybe no one is completely innocent here, but it seems to me that Morgan Stanley is petty theft whereas Bear Stearns was a serial killer. Should we execute both?

Its sad that its come to this. But I don't know what else we were supposed to do. I want to live in a Libertarian/Capitalist paradise as much as anyone. But if we waited for the market to figure all this out, we'd be left with no capacity to finance anything. Our economy just won't work like that. No capitalist economy could. Its called capitalist for a reason. We need capital to make it work.

Bonds are highly illiquid right now. Even Treasuries are showing unusual bid/ask spreads. There are many many many players who are going to be caught on the wrong side of this thing. On top of that, there are many players who are going to (quite reasonably) want to flatten their positions and wait to see how this plays out.

In corporates, especially Goldman and Morgan, potential sellers have disapeared so as far as I can tell, little is trading currently. CDS are gapping tighter of course. There will be a serious short-squeeze in CDS before things stabilize.

Some hedge funds are going to get crushed. I mean, anyone who was leveraged short financials may wind up getting busted out. That will result in some weird trading in seemingly unrelated instruments. Hence, I think you would be wise to not chase this move too aggressively. If you can find stuff that's lagging merely because it isn't getting any attention, fine. But don't over play it.

Personally (not professionally) I'm looking to reset a dollar short I've had. While this may be the right move for the economy, it isn't good for our currency.


Unknown said...

"Should Goldman Sachs pay for the sins of Bear Stears?" I agree with the thought but can't help adding that shareholders of Fannie Mae really paid for the sins of Freddie Mac!

You also mention the risk of a short squeeze on CDS: I (and I imagine other nontrade readers) know little about the fine print of these contracts but I wonder if you could answer the following for the benefit of outsiders: if a $100M bond issue goes into default with $200M of CDS outstanding on it, do the "naked short" buyers of CDS insurance forfeit their profit because they can't deliver a bond to the seller?

dkearns72 said...

I do agree with you in the end. We need to save the system. You have to do what you have to do.

But I cant help being bitter that-- when Wall Street gored everybody else with their "efficiencies," outsized pay and "bonuses," disregard for virtue, and the sense that everyone worked for them rather than their being the creation of an American people who accept free enterprise-- we never got a hearing as our values and livelihoods were sacrificed to the financial Baal.

So, we, the rest of the country who didnt breathe the heady air of conspicuous consumption and overweening pride, have to give the Masters of the Universe EXACTLY what they wouldnt give us: help when it's needed.

I'll do it, but I dont have to be happy about it.

Anonymous said...

The proper role of government here is to be the cops, and force everything out into the open, not hand out more candy. The trust isn't there because more than a year into this, Lehman's financial condition still wasn't clear until it imploded because of all of the accounting games. Nobody talked about AIG until it was huge. NO FINANCIAL STATEMENTS CAN BE TRUSTED RIGHT NOW BECAUSE A MOCKERY HAS BEEN MADE OF ACCOUNTING RULES. The government needs to put an end to the accounting games so that investors can see who, to paraphrase Buffett, is still wearing shorts.

- Set up a position liquidation process for BK financials, not a subsidy that will get arbitraged

- Eliminate all off-balance sheet vehicles immediately, force mark to market, then force every financial to produce audited statements (see Soros proposal around this)

- To answer the objection about marks to market being unfair in illiquid amrkets, establish some credible FEDERAL standard for bond values based on conservative and current loss projections and future cash flows in such cases

- Set up and enforce leverage rules for all institutions in all markets

- Force CDS into an exchange

- Force all institutions to mark to market nightly ALL of their positions, not just equities


Financial market credibility can only be re-established when investors believe that the accounting rules are back in place and being enforced. The US markets lost all such credibility at the moment those two Bear hedge funds blew up unexpectedly last July without warning due to lax accounting enforcement.

DAB said...

One point needs to be made. I still think Goldman and Morgan can come through this independent (will may be a different issue), but Goldman is the source of a lot of things. This includes the Treasury Secretary, who is by appearances the principal actor in the current Washington response. He may have a unique insight into the current situation, and he is certainly an upgrade on his worthless immediate predecessor. However, his actions are not without the huge moral hazard that he just came from exactly the industry and companies he is now trying to bail out. It is a valid question whether he is acting the way he is acting because Goldman may be the answer to my question of earlier in the week of whose next?

In the spirit of "remember what I said four hours ago" of a few weeks ago, I still also maintain that the government signaled strongly that they were not going to take over AIG as of Tuesday morning. The fact that they did presents two huge problems. One, even if they are now saying what Wall Street wants them to say with the RTCish solution, where is the assurance that there is any coherent strategy in the administration? Two, the government has been taking banks into receivership for years and by and large knows what to go do with them. It has never dealt with anything like AIG, and the government will turnover either completely or partially in five months...

What this episode in financial history has proven is that the partial deregulation dreamed of by the Republicans for the last thirty years has not worked, and likely can not. I think it is an open question whether the true Libertarian philosophies (which include unfettered redress for almost any grievance in court, by the way) can work. I have long thought it would be an interesting experiment to turn the State of Arizona over to the Libertarians there and see what they go do with it (both because those are usually credited as being the most dyed in the wool and because I don’t live there…). I think it is far more likely that strong, well thought out, economically sound, and relatively simple regulation in the hands of independent, professional bureaucrats (not the political appointee level) is the correct way to organize a modern capitalist society. It doesn’t help, for an example of the complex, that the last time I was at GARP a year and a half ago, it was open knowledge that of the twenty or so huge banks in the world only four really had a handle on Basle II and operational risk. Maybe, in retrospect, that was because they had more risk than known, and quantifying that either scared them or confused them?

We have tried weak and ineffective regulation for the last eight years (many of the seeds of which were sewn earlier, granted). Other countries have tried more or less varying degrees of socialism and communism. None of that has worked.

Just because Glass Steagall was repealed doesn’t mean that it made much sense so to do, even for the company, Travelers/Citicorp, that arguably precipitated that repeal.

One other point is that the RTC did end up making money. It seems to me what is needed now is someone with the balance sheet to take on the long dated mortgages and see what survives, and if someone in the private sector could buy the securities up and assure himself of holding them to maturity he would make a killing. The problem is that even Buffett doesn't have the capital for that given the scope of the problem. The US Government still does.

cap vandal said...

Yea....there was panic.

Something had to be done immediately.

The money market fund situation put it over the line, and they did the right thing, in my opinion, to use all their bullets instead of more ad hoc crap.

dab is exactly right about the moral hazard of Paulson/Goldman. This isn't lost on the American public.

I have a little different take on balance sheet transparency and accounting reform. Perhaps we should quit creating synthetic engineered crap that, in fact, can't be reasonably valued. The details are for later, although the details are essential.

Nevertheless, this will be seen as a massive failure of financial engineering/structured finance. I always thought that we made the faustian bargain with the natural sciences.

I'm going to watch the Ryder Cup. I think the Americans are going to kick ass.

neroden@gmail said...

So, y'know, how do we punish the overpaid CEOs, execs, and managers who led us into this mess, but walked off with piles of cash while their stockholders lost out?....

Well, we can't punish them directly. But *higher income taxes on the top brackets* are the one and only straightforward way to recover some of the "ill-gotten gains", so that there's actual cash to transfer to the cheated. Such taxes will recover some "well-gotten gains" as well, but what can you do?

As for regulation, it seems that the Depression-era regulations of FDR *worked*, and repealing them (a largely Republican project, but one in which many Democrats acquiesced too) has led to disaster.

Why are Goldman Sachs and Morgan Stanley ready to collapse? *Excessive leverage*. In fact, leverage levels which would have been *illegal* 20 years ago -- they got a relaxation of the laws in order to allow themselves to put themselves in this risky position! There's a reason companies with leverage of well under 10:1 are still doing OK, while companies like Morgan Stanley and Goldman Sachs are ready to collapse.

We've got to stop this American scheme where profits are privatized (big bonuses for Merrill and Goldman execs during the bubble) while losses are socialize (what, the bubble burst? Taxpayer money goes in!)

How's about requiring the execs and *former* execs of these companies to be on the hook personally for their policies? Of course, this is part of a larger problem: CEOs in general get away with buckets of cash whether or not their stockholders get wiped out. Personally, I don't really trust any top management which makes huge (>$200/hr equivalent) salaries -- they should be required to invest their money in the stock and make the majority of their money that way. Even stock options and grants are generally abused to be "win-win" for the CEOs.

GeorgeNYC said...

"Everything will break down, and I mean everything. Our whole economic system would collapse."

That is true. The world AS WE KNOW IT will end.

You know. Back in the 70's when I was growing up in a town in Ohio. I heard all kinds of lamentations from Steelworkers who, through the wonder of "creative destruction"

They used to write letters to the editor that sounded a lot like this blog.

But no one listened to them because hey...that's just the way the market works.

Let it all fail. Something will rise from the ashes. THAT is the way CAPITALISM works.

NONE of what is going on will create one new job. We will just transfer debt to the public which will be a huge drain on our economy. We have bankruptcy to allow for the destruction and rebirth of assets. Yes it will be tough for a while but this will all just drag it out for YEARS.

dawnofeurope said...

From an European point of view, where capitalism is a regulated thing, it seems all so wrong...

I used to work in asset servicing for Corporate Trust issues (and as you guess, a LOT of CDO's). There were huge amounts transitting through that bank. But all this for what? I never enjoyed any "huge" bonus and most of my colleagues did not either.

But I rage when I see the taxpayer having to bail out people too greedy.

Even if there has to be a systemic crisis, the guilty bankers have to go down under. It is not only the logic of capitalism, but also a moral requirement.

Kurt Osis said...

We are so fucked. So i'm sitting here randomly thinking about my portfolio of options that were invalidated by fiat yesterday. and it just occurred me we are completely, FUBAR. The ban on short selling was designed help firms like goldman survive hedge fund shorting. While I sit here considering the $30k i didn't make because I couldn't find a buyer for my options contracts and i couldn't hedge my contracts and i couldn't exercise because that may constitute a short sale, couldn't write options against them, i couldn't do anything but watch as the money i made that day evaporated. And then I thought to myself... well you know, I wonder who else's portfolio is based on a set of contractual obligations which the SEC invalidated yesterday. Uh, well Goldman Sachs for one. Their entire business model is based on hedging using the properties of options to define the no-abritrage prices of other securities. So one has to wonder, how Goldman's Value at Risk analysis will hold up when trading starts in Japan on sunday. You can imagine the volatility of the global markets slowly seeping into goldman''s portfolio as securities drift further and further away from their no arbitrage pricing. i would imagine that by the time european equities opened, there would be some serious issues. maybe nothing that could not be adjusted for, but adjusted for at a price never before considered, every transaction more expensive, every hedge less effective. And then there will be their counter parties and their clients coming to goldman to hedge risk the clients never thought they would have. Either goldman can refuse or it can pass on the new costs to its clients, but either when everyone is levered at least 10x and doing thousands or millions of transactions a day in positions you can't unwind because there's not enough liquidity..... well lets just say TICK TOCK.

P.S. I'm sure the class will be ratified for the imminent law suit which will be filed against the SEC.... I'm not lawyer, but personally securities fraud sounds like the right claim to me. When I bought my options I bought with understand that I could exercise at my digression should the market ever be too illiquid for me to liquidate my position.... well the way I see it the SEC just mandated I turn over the value of my options to finance Goldman's repos. The entire market is being deprived of liquidity so that Goldman doesn't have to mark its books to market. This is utterly unbelievable. The real question is, why the hell would anyone ever by another security again if the government is going suspend contract law at will.

Michael Krause said...

great post. Short treasuries and long Aussie dollar are the primary trades in my book, with the Aussie dollar position added on Fri at .82. Now it is quite a worthwhile protection. I even bought a little ABX (Barrick gold) at the open on Friday.

And I think gold is practically a worthless metal (in relation to lets say Uranium) and goldbugs are idiots. But the writing is on the wall.

Michael Krause said...

George: Agreed. Let the bust happen. Those who didn't lever will not be vulnerable to the run.

If the government should have policy here, it should be in the form proper regulation as suggested above, and as programs that move us forward with genuine INVESTMENT, not merely market price interference. In other words, how about diverting a few hundred billion a year to infrastructure jobs, a program to get everyone driving hybrid and Natgas-hybrid cars (facilitating the destruction of our trade deficits!) and even balancing that spending out with reduced defense and military spending.

The reality is that most of southern california homes have a 25+ PE ratio of rents to value. That is NOT a good investment. Why should the government have bought that liability when it fully acquired the liabilities of the GSE's? Why should taxpayers in Ohio have to pay for our bubble overpriced houses? (And I am a homeowner in San Diego that owns one of those 25 PE)

If the government wants to step up and be an investor, I recommend they study potential recovery value on the bulk of the market, not just the subprime liquidation that has already happened. We have a lot of selling down of house prices ahead, and if I as an individual investor see no sense in buying a $600K asset that rents out for only $2500/month (3.5% or so yield after expenses if rented out 100% of the time) when I can buy AAA corporate bonds for 7%+, than it doesn't make sense. Not until the 'house yield' is well above risk free and there is actually a worthwhile spread to make net expenses does it make sense for the government to backstop this market. Anything else is a wreckless wealth transfer, as mentioned above.

Those above rent ratios are where 90% of california homes in any decent area are, or even lower than!

Let the i-banks and leveraged speculators fail. The government can offset this potential catalyst of credit destruction by creating programs to facilitate business borrowing at artificially low interest rates through SOLVENT banks.

Those are my ideas. Somewhat at the next administration can contact me personally if they need a policy advisor.

capitalhill said...

You make good points that certainly reflect the conventional wisdom on the "mother of all bailouts." I almost feel unpatriotic questioning this thing. But there's a gnawing voice in my head that says this is moving too fast. A week ago, nobody was even thinking in these terms. Now the government is going to buy $700 b of toxic, totally illiquid, impossible-to-value assets. All in the blink of an eye.

I know Washington has to move fast on this, but shouldn't we at least consider some alternatives? What about the Feds injecting some capital into GS, MS and others in exchange for super-senior equity stakes? Or continuing to bail out companies on a one-at-a-time basis a la Fannie, Freddie and AIG rather than a blanket bailout?

There's a good op ed in this morning's Washington post that raises these questions more eloquently than I can. It's worth a quick read.

Horace Kent said...

This was never pure capitalism in the first place. I'm 32, and probably emblematic of what the problem is. We've never seen or experienced a true panic. I think 87 kept a majority of the remaining old salts around relatively honest. But with Greenspan, everything was a panic. And he always rode to the rescue. The moral hazard has been festering for a very long time.

I believe the bulk of our problems lie with Fannie and Freddie. In the salad days, they seemed to work. Nobody could ever envision a scenario like what we've witnessed. And so, every bank on the street copied that model and the thought was if we spread this trash around everyone it won't all be in one place.......we're diversified. But, they forgot about market risk - which is much harder to diversify from. So instead of Fannie and Freddie going down, we have everyone going down.

I really believe that the OTC market should be abolished. Put that trash on an exchange where everybody has to post every-night and 99% of this would've been resolved or never have happened.

I also feel the FASB has A LOT of blood on their hands. That's one of the reasons I think the SEC is a joke. You never know someone is fibbing until they wash up on the beach.

In the end though, this is speculation run amok. Same as it ever was. You can put new rules in place - do this, do that. People, or shall I say, the market will find away through the cracks; and in a generation or two, or three when all of this has been laid to rest and we've had bull and bear markets to lose count people will buy too much of this or that and we'll do it all over again.