When it comes to the opinions of financial pundits and “experts”, most can be chucked into the garbage heap of groupthink and consensus. However, one person whose opinion stands out is Elliott Management’s Paul Singer. One of the most successful hedge fund managers has consistently stood against the grain of conventional wisdom over the past three decades and been handsomely reward, which is why his opinion is certainly one worth noting. Singer, together with Martin Wolf and several other panelists will be speaking at 45 minutes past the hour on a panel discussing one of the most pressing topics nearly 6 years after the Bear Stearns collapse: “Are Markets Safer Now.” Watch their thoughts on the matter in the session live below.
And here are his recent comments on financial stability, which are certainly worth perusing.
THE GLOBAL FINANCIAL SYSTEM IS STILL IN NEED OF FUNDAMENTAL REPAIRS
We can only assume that the reason the global financial system is still, four-and-a-half years after Lehman, overleveraged, opaque, reliant upon the implicit and explicit support of governments for its very existence, and unprotected against runs and sudden death, is that the straightforward and practical fixes advanced by us and others take too long to read – and, perhaps, that they would be too painful for powerful special interests. Since we believe the costs of the next financial crisis will be extremely high, and the nature of the fixes are quite modest, it is worth taking another crack at trying to get through to policymakers using all available venues and platforms. Our gut feeling, supported by anecdotes from the Street, is that the major financial institutions (those bailed out or implicitly supported in the last crisis) have taken important steps to reduce their trading risks since the 2008 collapse. However, it is impossible to verify such progress from public financial statements or even to assess these institutions’ true financial risks.
Unfortunately, opacity and extreme leverage still reign supreme.
Let us recount what happened to turn the relative safety (relative to their customers) of many of these institutions upside down. Financial institutions are counterparties, borrowers, lenders, traders, custodians and fee-based purveyors of advice and services.
The one essential characteristic for every one of those roles, except the last one, is that these firms need to be safe, in both perception and fact, with their financial conditions above reproach.
There is a system, developed over decades, consisting of both industry practice and federal regulation, to ensure that secured “margin” loans to the trading customers of financial institutions cannot become unsecured by the adverse movement of security prices. Customers must put up initial margin when entering a trade and have to post more if the equity in their account declines by a certain amount. A cushion is thus maintained, which protects the financial institutions and the system.
For the traditional banking side of financial institutions, in which loans are made to borrowers and relationships are maintained between bankers and customers, there is also a time-honored and sound system of industry practice and experienced and alert regulation. Under this system, institutions are monitored for acceptable levels of leverage and business practices, and reserves are booked against probable loan losses and then adjusted against actual losses. Whole loans are not marked-to-market, but reserves are applied and adjusted as necessary. “Actual” banks have occasionally failed, but they never seriously jeopardized the system as a whole.
These systems, of how customers finance securities positions, and how banks are financed and operate, enabled the world’s financial system to work without systemic collapse for more than 70 years after the Great Depression of the 1930s gave policymakers a solid to-do list of fixes which were necessary in order to avoid a repeat.
Over the last 20 years or so, however, many of the world’s financial institutions built astronomically massive books of derivatives, private equity, other illiquid assets and extensive proprietary trading positions which have dwarfed their traditional banking books and fee-for-services activities. Furthermore, to the extent they represent trading between financial institutions, these derivative books in particular have been allowed by regulators, lenders and customers to be established with little or no initial margin, thereby removing the presumptive aura and reality of safety and soundness from the entire universe of major financial institutions. It is certainly debatable whether the system, and many of the 100 largest such institutions, were “unsound” before the 2008 collapse, but it is undoubtedly the case that these firms ceased being unquestionably more sound than their customers. In addition, when things started unraveling in 2007 and 2008, there was (and still is) insufficient useful, publicly available information to enable any customer to determine whether to stay with or run from institutions in which they have assets, trading relationships, claims or securities. This point is both irrefutable and critically important.
It needs to be fixed. Contrary to what many policymakers would have us believe, no combination of regulation and edict anywhere in the world has yet to address the issue adequately.
Therefore, since there is basically no collaborative international process underway to study and fashion adjustments that would make the global financial system sound again, we submit herewith our version of the necessary fixes. It is essential that the fixes be agreed upon by all of the G-20 governments in order to prevent a “race to the bottom” by any one country aimed at picking up market share by allowing more risky behavior than the other countries allow:
- All investors, traders, institutions and counterparties, regardless of size and regardless of whether they are customers or end-users, should put up the same initial margin. In the case of derivatives in which the initial margin is less than 30% of notional value, two-way daily mark-to-market should be required. Special rules may be needed for completely matched trades in which institutions, nominally principals, are mainly intermediaries. But such trades create a lot of counterparty risk, so this area needs to be carefully studied in light of the widespread use of “netting” agreements today.
- The Orderly Liquidation Authority prescribed by Dodd-Frank should be repealed and replaced by an amendment to the U.S. Bankruptcy Code which would operate to prevent cross-default provisions from impacting derivatives books so long as mark-to-market payments are being made in a timely fashion. This way illiquid assets held by bankrupt entities can be handled in an orderly fashion without systemic risk, but the trading positions can keep going unless mark-to-market payments are not being made (in which case the defaulting party would trip the trigger for a termination event).
- Governments need to be authorized to provide “open bank assistance.” The convolutions of Dodd-Frank aimed at “avoiding” this tactic are ludicrous and will prove to be extremely costly to the system.
- Accounting rules need to change to provide investors with much more information about the sensitivity of bank holdings to various parameters, including: exposure to interest rates at different parts of the curve; exposure to moves in equity prices; currency relationships; delta and vega exposures to various underlyings; curve risk; what portion of positions is perfectly matched versus what portion is not matched.
- Credit ratings and risk weightings must undergo a thorough process of review and revision. No security or instrument on the planet should have a zero risk weighting.
- Regulatory regimes should be rationalized to eliminate inconsistent oversight of various instruments that represent exposure to particular assets.
- Derivatives trading should be standardized and as much as possible moved to clearinghouses. Margin rules for bilateral contracts must be made more uniform. A rule recently proposed by regulators (based on a Dodd-Frank mandate) provides numerous exceptions to margin-posting requirements for OTC swaps trades. Each such exception leads to more fragility and less safety for individual counterparties and the system as a whole.
- A globally-integrated study should be undertaken about how to ensure that deposit insurance does not support proprietary trading activities (as distinguished from enabling banks to make whole loans).
- Position sizes must be significantly reduced from current levels. As a result, financial institutions would not be any more leveraged than their customers. The reduced profitability of these institutions would be a small price to pay for the dramatically increased stability of the world’s financial system.
With these fixes, financial institutions, even very large ones, would not be primary drivers of systemic risk, and metaphysical inquiries delving into the difference between proprietary trading, customer facilitation and hedging would be unnecessary. It would also be unnecessary to distinguish between “systemically important financial institutions” and everyone else, or to impose higher capital requirements on larger institutions.