COLUMNISTS Woe unto you, scribes and Pharisees, hypocrites! for ye are like unto whited sepulchres, which indeed appear beautiful outward, but are within full of dead men’s bones, and of all uncleanness. Matthew 23:27
Think of the big US banks and dealers, along with their regulators, as the Iraqi government – though without the same unity, purpose or long-term planning. The cash positions and liquidity of both are better now. The Iraqi government is not squandering its money on food for the ration system, medicine, electric plant or water treatment.
The US banks and dealers have got past the first quarter, and are backstopped by a Federal Reserve that has gone from Vestal virgin to campfollower. Some of the accountants would have appended the above quote from Matthew to their opinions on the banks’ and brokers’ quarterly earnings statement, but it didn’t fit the guidelines of SFAS 157, the fair value accounting standard.
It is not fair to say the Fed doesn’t have a plan. It does. The plan is for the banking system to recapitalise for a new on-balance sheet world by raising a minimum of $200bn (£101bn, €127bn) in a short period of time – not longer than two quarters. That way, there’s no credit crunch, according to the model. A credit crunch, in the Fed chairman Ben Bernanke’s own language, is “a significant leftward shift in the supply curve for bank loans, holding constant both the safe real interest rate and the quality of potential borrowers” (The Credit Crunch, Brookings Institution, 1991). That means you can have a decline in the demand for credit as part of a business cycle without a “crunch”.
Let us put the Fed’s plan in the context of the world of the capital markets. Consider Washington Mutual’s $7bn recapitalisation of last week. We would have to have a WaMu recap a week for the next six months to get the Fed’s plan done. All the uncommitted capital available to the private equity funds could be dedicated to this purpose.
All of it? I don’t think so. The private equity people have other ideas. To raise anything like the bank capital the Fed and the other authorities, such as the Treasury, want, it would be necessary to have a series of roadshows for the investing public that would be the size of theme parks. That could be done, with difficulty, and with great dilution for shareholders and, more seriously, career damage for senior management. The Fed itself would have to be a co-sponsor in some form.
Quietly arranged deals, first with sovereign wealth funds, then with private equity partnerships, are not enough. It is sort of like attacking militias in Basra without adequate forces or preparation. Some investors might throw down their arms and defect to the short-selling side.
Another way large banks are deleveraging is to hive off assets, such as the $12bn of leveraged financing commitments Citibank laid off on a group of private equity funds at a discount to the original price. The problem there is that while Citi is providing what a distressed homeowner would call “seller financing”, it is a lot less than the leverage available if the commitments were to be funded on Citi’s own books, or on the books of other banks. Multiply that $12bn by a raft of other deal announcements, and you have the “leftward shift” Mr Bernanke referred to. Maybe more than one leftward shift, come to think of it.
While this is going on, a 40-watt bulb has flickered over the heads of institutional investors. Hey, aren’t the hedge funds also counterparties in the credit derivatives world? What mark-downs and liquidity positions have they been reporting? Oh, that’s right, they don’t have the same reporting requirements as the primary dealers and banks we’ve all been worrying about.
Yes, the hedge funds are required to put up margin as the value of their positions change. The problem is the “jump to default” scenario, or rapid deteriorations in the market value of the assets underlying, say, the credit default swaps. Then the margin calls might not come quickly enough, particularly for complex positions.
Eventually, I believe, as do others, that over-the-counter derivatives such as credit default swaps will have to be cleared and settled through central clearing houses such as those used by the futures exchanges. For all the chicanery of speculators and hedgers on the exchanges, there have been no fears of contagion, of one participant’s failure leading to others, of the sort that led to the Bear Stearns bail-out/ takeover/near collapse.
Tragically, though, this would reduce the profitability of the banks’ derivative businesses, or, rather, the profitability in good times. In bad times, it would reduce potential or realised losses from counterparty risk.
The systemic risks can be managed, though not without pain and loss. However, that will require recognition of problems, reform of badly designed and built structures, and extensive, significant, recapitalisations.
None of that will happen as long as the hypocrisy (see Matthew, above) of the banks’ and dealers’ management is enabled by the regulators and central bankers.
johndizard@hotmail.com
