To Our Readers
With this week's offering, we announce a change of title - reflecting the challenges in the new regulatory reality. We launched last year with a weekly oversight of anomalies from the world of regulation, taking our lead from then SEC Enforcement Chief Linda Chatman Thomsen's tip-off to Morgan Stanley, where she commented on an ongoing SEC investigation. ("Smoke, but no fire...")
We are now staring down the barrel of the loaded gun of new global regulation. This gun, as we have experienced repeatedly, fires exploding bullets, and the collateral damage is generally far greater than the damage caused to the target itself, even when hit square on the bull's-eye.
For the record, these bullets are called "dum-dums". We encourage you to bear that in mind during the coming debate over increasing government regulation...
This week starts what is likely to be a long and messy slog through an extended global process of re-regulation. We open by asking - with apologies to William Butler Yeats -
What rough beast, its hour come 'round at last,
Slouches towards Wall Street to be born?
Tim Marches On
Markets can remain irrational longer than you can print money.
It is a platitude of the money management business that "the art of managing money is the art of having money to manage." The new-century corollary might be aptly expressed as, "the art of managing an economy is the art of having an economy to manage."
President Obama is trying to rescue America's economy, and the world's. We must surely all wish him success. While there is much to discuss in his proposal, we are taken by the political posturing around the enhanced role of the Federal Reserve as overseer of the largest and most interconnected financial firms.
Members of Congress claim that the Fed was at the core of the disaster and that it should not be rewarded with expanded powers.
The Fed is already one of the most influential institutions on the planet and, while it enjoys a certain continuity from Chairman to Chairman, and from Presidential Administration to Administration, it may not be accurate to portray the Fed as monolithic in the same way as, say, the great sports franchises are. One might say it is not "the Fed" that wrecked the financial markets. The failure at that institution can be traced to one person - to one moment.
To Alan Greenspan when, in a speech in March, 1999, he declared "By far the most significant event in finance in the past decade has been the extraordinary development and expansion of financial derivatives," and that the functioning of the OTC derivatives markets without regulation, "provides a strong argument for development of a less burdensome regime." Shortly thereafter, Chairman Greenspan led the gang-trashing of CFTC Chair Brooklsey Born for suggesting that the dark market of OTC derivatives should be regulated.
This underscores the true nature of what we are facing: that successful regulation of the financial markets depends more than anything on the sound assessments and actions of those charged with oversight. Had any one of the Gang of Three - Greenspan, Rubin and Summers - voiced a strong demur, it might have brought a different outcome. Going forward, we urge the Administration to remember that all the regulation in the world is not proof against poor judgment.
The Fed's hand is now formally on a seemingly inexhaustible spigot of Federal bailout money. The institutions that the government financed in the past year - from General Motors to Citi - were considered all but independent empires. Now we are in what may be a generation-long spiral of calculating how many years before we break even on the trillions we have TARP'ed and TALF'ed and PPIP'ed down the drain.
President Obama's plan, by establishing a regulatory category of "Tier I FHC's" (Financial Holding Companies), seeks to enshrine in law the accidental concept of Too Big To Fail. Were you afraid an Obama Administration would mean rampant socialism? This is Bushian Corporate Socialism taken to its logical endpoint.
"We should be able to do business with the Federal Reserve -" says one banker (Financial Times, 18 June, "Wall Street Says It Can Do Business With Federal Reserve") "as long as all these new powers do not go to its head."
In what other part of Secretary Geithner's anatomy might they take up residence, then? Because it is Tim Geithner, and not some amorphous entity called "the Fed", who will call the shots.
Fed Chairman Bernanke's term expires at the end of January. The choice of a new Chairman, or the decision to reinstate Mr. Bernanke, will doubtless be taken by President Obama in intimate consultation with Secretary Geithner. As we move forward through the Sargasso of this debate, keep your eye on the degree of power this process will hand to Secretary Geithner.
We applaud President Obama on two counts: first, this is his proposal, meaning he stands to reap the praise for any successes, and he will be targeted for every failure or inefficiency that proceeds from this document. Second, the President has thrown considerable support behind Secretary Geithner. Whatever one may think of Mr. Geithner, anything less than full and public support for him at this moment would be tantamount to eviscerating him. President Obama has voiced the courage of his conviction. We can only hope that his confidence will turn out to have been well placed.
Speaking on Bloomberg television last week, former SEC Chairman Arthur Levitt voiced the belief that President Obama and his team had thoroughly sounded out opinion - both industry and legislative - before announcing this proposal, and that it would likely pass through the legislative process largely intact. On the eve of Secretary Geithner's testimony, Senator Shelby piped up and said "Haste is dangerous, especially when you are dealing with comprehensive change in our financial system." (WSJ 18 June, "Historic Overhaul of Finance Rules"). He has since expressed himself in terms that boil down to "Not so fast!" It remains to be seen whether President Obama has truly pre-sold this critical and vast program to key players in Congress - or if, like the Bozogate surrounding his cabinet appointments, the President and his entire staff are actually clueless. Time - and probably very little of it - will tell.
By formally establishing "2B2F" ("Tier I FHC" = "Too Big To Fail") President Obama's proposal guarantees there will be another Citibank, another Bear Stearns, another Bank of America. But not another Lehman. Rather, every major, poorly managed and highly interconnected financial firm now stands to be given financing. Taxpayers, get out your wallets. Under the proposed new structure, the emergency authority to rescue the 2B2Fs rests with the Fed, but subject to approval by Treasury. In other words, Secretary Geithner will have legislative authority to take steps that his mentor and predecessor - Secretary Paulson - took only with gritted teeth and by sheer force of his character.
And, like the TARP money - we still don't know where it is - we do not see a black and white guarantee built into the proposed legislation to track down which drains and rabbit holes that new money will disappear. President Obama has taken the extraordinary and emergency measures forced through by Secretary Paulson, and written them into a proposed new body of law, possibly complete with the barefaced lack of accountability. The swilling of the next several trillion dollars of taxpayer money down the Johnny-flusher will be at the sole discretion of Timothy Geithner.
President Obama is seeking to write Moral Hazard into law. In doing so, he has a lot riding on the skill and talents of his Treasury Secretary. We wish we could be as sanguine.
(This might be the moment to point out that Brooksley Born received this year's John F. Kennedy Profiles In Courage Award, in recognition of her political courage in calling attention to risks in the derivatives markets. We do not believe she received a congratulatory telegram from Mr. Greenspan.)
Secretary Paulson came to Treasury after one of the most successful careers in the history of finance. Tough, smart - ruthless of course. But also a prudent steward of his firm and its legacy, Hank Paulson brought a lifetime of successful deal making to the office of Chief Deal maker - and when crunch time was upon him, he forced a resolution. To their great and lasting surprise, Congress was hopelessly outclassed. When Paulson acted - agree with him or not - he got results.
Secretary Geithner, you are no Hank Paulson.
Into The Secret Garden
Whoso breaketh an hedge, a serpent shall bite him.
- Ecclesiastes 10:8
The United States is the only country with developed financial markets that does not require money managers to register with a national regulatory authority. Taken on its face, President Obama's proposition to require hedge fund registration should be seen as, at worst, benign. It will add a level of transparency designed to give future investors comfort - and transparency is really what has been lacking from the financial system. The fact remains that, with the exception of outright criminal activity, the disasters in which hedge funds figured prominently were largely the fault of those regulated institutions, the commercial banks and brokers, who lent them money without performing their own due diligence. In so doing, the brokers in many instances raised their own exposure to far greater levels than the hedge funds.
Hedge funds carry average leverage of under four times their assets. This is a far cry from the brokers that had gotten up to stratospheric ratios of 30:1 leverage and beyond. One simple reason is that hedge fund managers almost always have "skin in the game," and if they risk their investors' money, they risk their own alongside it. Brokers, on the other hand, are tied to Wall Street's traditional compensation model, where executives justify their own paydays because of the "value" they bring to the firm. When things work out, they take credit. When things go wrong, they blame everyone else. Or - this is our favorite howler - "adverse market conditions." Is it any wonder that, from the rest of the world's perspective, corporate America looks like North Korea? Average workers are paid small hourly wages, while senior executives make literally hundreds of times the annual compensation of workers on the shop floor. Bankers are paid gargantuan fees by these CEOs in return for lending the corporations money at exorbitant rates, or are given cash plus stock in return for selling the company to someone else who will fire half the employees. When firms lose money, CEO's take multi-million dollar bonuses, and hourly workers are laid off.
We are resigned to hedge fund registration. We urge you to embrace it, too, as it is now as inevitable as tomorrow's sunrise. The first problem - and it will be significant - is the manner in which this will be implemented. Regardless of whether ultimate registration authority rests with the SEC, FINRA, or the individual States, the regulatory agencies do not possess the resources to handle the deluge of paperwork this requirement will unleash.
If Chairman Schapiro reads this column, we offer the following recommendation. The registration process should be staged, starting with the smallest firms, and leaving the largest for last. This is because the largest firms are by and large the most transparent and the most widely watched. In fact, some of them, such as Fortress, Blackstone and Man Group, are publicly traded. If frauds are being perpetrated at these institutions, a new registration requirement is not likely to uncover it because guess what? - they are smarter than your people.
Small operators may not provide increased regulatory fodder, as even truly small hedge funds - those managing $25 million or less - are generally careful about their compliance programs. But from the perspective of gathering information, the SEC - and we believe it will be their bailiwick - should start with those firms not yet on the radar. This will create a database that does not yet exist, and it will provide valuable training for examiners, as well as streamlining the process, as the Commission moves up to larger and more sophisticated operators.
Oh, and by the way, those really big hedge funds - the threshold is not yet clear - will be under the new Financial Services Oversight Council, to be constituted of the heads of the major financial and bank regulatory bodies. Did you guess who is going to be chairing this council? If you guessed Tim Geithner, you were right.
In the Odds 'N' Ends pail, we are told that government will eliminate systemic risks posed by the Tier I FHCs - firms that are now officially Too Big or too interconnected to fail - but we are not told how this is supposed to be accomplished. The conflicts inherent in the Ratings Agencies business are left largely intact, particularly the issuer-pay model. There is to be a new Resolution Authority to take over and wind down failed financial institutions. But juxtaposed with the new 2B2F status - and the political pressure that is sure to be exerted as the 2B2F's start to teeter - we wonder when this resolution authority will ever actually be implemented.
At the end of the day, we generally agree with the assessment of Joe Nocera in the New York Times (17 June, "Only A Hint Of Roosevelt In Financial Overhaul") "Firms will have to put up a little more capital, and deal with a little more oversight, but once the financial crisis is over, it will, in all likelihood, be back to business as usual."
We note that the banks which, this week, paid back the TARP money to great fanfare were institutions Secretary Paulson had forced to take the funding, so that they might be brought under the accompanying restrictions with respect to executive pay and government meddling in general. It is thus no big news that Goldman and J.P. Morgan, for example, have repaid the money. They never needed it in the first place. Is this regulatory smoke and mirrors? You decide.
Our investment thesis for the New Regulatory Reality: go long lobbyists.
As Yoda might say - Good on paper it looks.
ETFs: We Don't Want To Say We Told You So...
Well, actually we do.
The Wall Street Journal (16 June, "A Volatile Mix: Natural Gas, ETF") reports "assets in U.S. Natural Gas Fund recently swelled to almost $3.7 billion from about $670 million in February, even sparking fears it could be disrupting the futures market."
For the first time, price movements in ETF shares appear to be affected by trading in the instruments themselves, and not in the underlying index or futures contracts.
This calls into question the key underlying concept of the ETF model - that the ETF tracks the underlying instruments and is not affected by other ETF traders. The other piece of news is not new - that the ETF causes disruptions in the underlying markets. Indeed, this effect has been observed in the past, but generally pooh-poohed by market participants. Unless, of course, those participants were senior executives of the stocks underlying the indexes on which the ETFs traded.
The ETF has submitted a request to the SEC for substantial new flexibility, asking for a tenfold increase in shares available for issuance. In the current regulatory climate, we do not look for quick relief from the Commission.
Pretend inferiority and encourage the arrogance of your enemy.
- Sun Tzu, "The Art of War"
The China Investment Corp - China's sovereign wealth fund - is publicly talking about making significant investments in Western hedge funds, starting with $500 million in a hedge fund unit of Blackstone. The Wall Street Journal (19 June, "China Ready To Place Bets On hedge Funds") reports "CIC is considering opening its checkbook to a handful of hedge funds, a move that comes as CIC Chairman Lou Jiwei is concerned his fund may miss opportunities near the bottom of the market, according to people who work closely with the Chinese fund."
Miss opportunities? Is this the same kind of opportunity that, as the popular saying would have it, is written with the same Chinese character as their word for "Crisis"? The WSJ article goes on to point out that Chairman Lou has refrained from investing in Western financial institutions because "we don't know what trouble they are in."
Why, then, would they be making these investments now? To us, the answer is obvious: China has too much of our money.
In the global environment that spawned the Yekaterinburg summit, it should be clear that China has few trade partners with whom it can swap its vast supply of dollars. Far from a vote of confidence in the American financial system, this looks like a desperate play by those responsible for China's global investment portfolio. One can almost hear them, as they turn the billions over to us... "you got us into this mess. Now get us out!"
Worth A Thousand Pictures
From the Wall Street Journal (19 June, "Prison Term for Murder Of Financier").
"A Swiss court sentenced the former lover of French financier Edouard Stern to 8 ½ years in prison for murder after she confessed to shooting him during an argument while the two were having sex and he was tied to a chair in a flesh-colored latex bodysuit."
Almost makes you forget about Iran for a moment...