Friday, September 15, 2006

GeithnerSpeaks: On Balance He's Balanced

That Geithner speech in full:

"Markets are not perfect & fail. People too are fallible. Flights-to-quality are scary. The big are getting bigger - huge in fact. Leverage & agency probs may amplify bad market outcomes to the detriment of the system. But balance should be sought and cost/benefit weighed wisely before trying to "save" the system. The large equity of Levered Specs can help transfer risk away from core to periphery. Free-riding on systemic health may be an issue. Central Banker's can regulate & spank. Cascades can happen. CBs can catch them, saving the day, but that may create moral hazard. Errr that's all"

There is a lot of hand-wringing about hedge funds, leverage, and speculation. Probably too much. Geithner said in essence that leverage & modern markets should be monitored as accidents can happen, but on balance its more-than-alright, and quite manageable, though we shouldn't be complacent. I wonder if much of the concern is not at the obscenely outsized spoils that result from their bets, rather then the speculations themselves.

Let it be said that I morally disapprove of highly leveraged betting as a force of habit like I disapprove of smoking. But I doubt the necessity and the wisdom of drawing too-strict a line (for ice-cream, too, is dangerous) to restrict its undertaking, except where damage to the public can be established. And while there are potentially systemic stability issues, there is a great deal of rather sophisticated private equity (bank & nroker equity capital) and their strong self-interest (and domestic and international regulatory regimes) to temper the stupidity and greed all along the way, that insulates "the public", between speculators private losses and such systemic disaster requiring public intervention.

If private nitwits - whether individually or however organized - desire to make big leverged gambles (with their equity), where the collateralised financing arises from others (be they banks, or brokers who as it happens also have plenty of equity), and where margining is in most casea is daily and sacrosanct (particularly where granted leverage is knife-edge), and where said providers of leverage are themselves self-interested, the problem is more likely to be an issue of hoe large will the "self-inflicted wounds" be rather than consituting a serious and unmanageable systemic problem for it is likely that "solutions" don't create issues as meaningful as the problem.

Recall there was no public money lost or directly risked in the LTCM aftermath. The equity holders of the fund lost everything, and where the collateral, ex-post, was insufficient, their leverage providers got stung too. Full-stop. And this was as it should have been, and numerous lessons being learned by all concerned: e.g. How much leverage is too much; Take great care leveraging illiquid OTC positions; Never never never under any circumstances let anyone see your positions; Be careful of pari-passu risk; Be firm in demanding to know a leveraged speculator's entire exposure if granting them "extreme" leverage"; Be sure to warn investors 10-ways to Tuesday they can lose EVERYTHING and things can and indeed might go horribly horribly wrong.

There IS an agent-principal dilemma (as Geithner highlighted numerous times), generally speaking in the financial & investment management industries. But its endemic with few exceptions - from Fidelity Mgmt (yes Vanguard too!) to hedge funds, insurance co's, and prop traders at banks. Buffet to his credit, despite Berkshire's AAA rating, refuses to allow Berkshire & GenRe to participate in the low-margin swaps biz, in order to avoid Herstatt-like cross-default issues. This epitomizes the distinction between "the get-rich & richer specs" and the "Stay Rich" investors. This is the real issue at stake, and it cannot be legislated or directivized out of existince - not in a hugely complex world where regulatory arbitrage is rife.

Higher capital adequacy standards, demands for more regulatory transparency, higher tax rates on leverage-enhanced trading & investment profits, tigher controls on widow, orphan, & general public participation in leveraged funds all can contribute to a greater systemic margin of safety and contribute to official policy that makes a positive policy statement about the utility to society of excessive "greed". But as one goes further down to the path of prohibitions, and overly-wieldy regulation, it's a slippery slope where if one ventures, one must begin to examine the public utility of lotteries, casinos, bungee-jumping, sports cars, trans-fat snacks, sugared-drinks, unprotected sex, or for that matter any form of risk-taking behaviour.


Aaron Krowne said...

I sympathize with your points here. But two criticisms:

1) This one specific: actually, 400 tonnes of public gold owed by LTCM were forgiven by the Fed. No, this was not "public money", but it was something worse: public real assets. The quoted value of this gold was around $3.6 bln at the time, but it is unknown how much it would have cost to actually replace the short position. This point is kept very quiet.

2) A bias is introduced in the system (intentionally or unintentionally) by official public policy of money creation--or a "liquidity bias". Lending money for leverage seems "cheap" when you can simply create money elsewhere to make up for isolated accidents. It is this kind of basis that sets up a situation where the accidents could suddenly and unpredictably become overwhelming, and as a side effect, destroy the ability to make money elsewhere with the usual liquidity tricks.

More generally, one would expect very unwise and unsound lending practices to become commonplace on the upside of a credit bubble, then lead to disaster as said bubble transitions to downside.

In sum, I think there'd be no problem and no need for regulation, but only on a sound basis (sound money and competitive rather than cartel banking system).

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