Meaningful tricks at crunch circus
The crunch circus got under way in Washington last week – the great and the bad from Wall Street having to appear in front of the Financial Crisis Inquiry Commission. Media attention, naturally, focused on the big names from those institutions deemed "too big to fail" during the crisis.
But, as ever with such US hearings, the really interesting, useful testimony on the matter tends to come from people who are not on the television networks' "must capture" lists – whose thoughts don't get reported. Luckily, in this digital age, assuming you have the time, substantially all the testimony is available online. You might assume this pre-prepared text to be dry and cautiously worded, but that is not necessarily the case. (Have a root around fcic.gov.hearings.)
Take Kyle Bass, the managing partner of Hayman Advisors, a hedge fund that made spectacular profits by predicting the subprime crisis. He appeared before the FCIC on Wednesday. He was able to deliver his advice in the sort of easily understood language that might even be understood by legislators on Capitol Hill.
Bass's story goes: "Imagine if you were a 28 year-old mathematics superstar at AIG Financial Products Group and you were compensated at the end of each year based upon the profitability of your trading book, which was ultimately based upon risks you were able to take without initially posting any money. How much risk would you take? The unfortunate answer turned out to be many multiples the underlying equity of many of the firms in question."
What Bass was referring to there is the fact that in the over-the-counter derivatives market, where institutions deal directly with one another rather than through a formal exchange, there has been no requirement for participants to post collateral when opening a trade. The only thing that has mattered was perceived credit quality of the counter-party.
As a result, too many 28 year-old math stars took risks that cost them no money upfront. AIG has already cost the American taxpayer $183 billion (Dh672bn).
But it was for two special US institutions that the Hayman man reserved his real contempt: Fannie Mae and Freddie Mac, the two "government sponsored entities" which finance much of the mortgage debt in the US.
"With $5.5 trillion of outstanding debt and Mortgage Backed Securities Guarantees, the quasi-public or now in conservatorship Fannie and Freddie have obligations that approach the total amount of government-issued bonds the US currently has outstanding. There are so many things that went wrong or are wrong at these so-called GSEs that I am not sure where to start.
"First, why were two for-profit companies with boards, shareholders, charitable foundations, and lobbying arms ever given the "implicit" backing of the US Government? The Chinese won't buy them anymore only because our government won't give them the explicit backing. The US Government cannot give them the explicit backing because the resulting federal debt burden will crash.
"These organisations have been some of the single largest political contributors in the world over the past decade with $200 million being given to 354 lawmakers in the past 10 years or so. Yes, the United States needs low cost mortgages, but why should organisations created by Congress have to lobby Congress?
"Fannie and Freddie used the most leverage of any institution that issued mortgages or held mortgage backed bonds. At one point in 2007, Fannie was over 95X levered to its statutory minimum capital with just 18 basis points set aside for losses. That's right, 18 one hundredths of one per cent set aside for potential losses.
"They must not be able to put humpty dumpty back together again. If they are to exist going forward, Fannie and Freddie should be 100 per cent government-owned, and the government should simply issue mortgages to the population of the United States directly since this is essentially what is already happening today, with the added burden of supporting a privately-funded, and arguably insolvent, capital structure."
In what is supposed to be the most advanced capitalist society in the world, the institutions at the centre of the country's key asset class – housing – were effectively operating without any capital. Go figure.
If that wasn't enough to get the Commissioners to sit up and listen, Bass then gave them three key changes to protect people in future: separate retail banks from proprietary trading operations; ban off-balance sheet accounting; and cap bank leverage.
Thereafter, the risk-takers should be free to get on with it.
Bass said: "Capitalism requires failure and bankruptcy as a consequence in order to guide behavior. As the old adage goes – "Capitalism without bankruptcy is like Christianity without hell". If we cannot allow a firm to go bankrupt, then we should regulate its activities so that it cannot engage in the sort of risky transactions that put it at risk of bankruptcy."
- The author is Associate Editor of the Financial Times
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