Leveraging the Laughs (and Tears) at Treasury

Commentary on the Proposed Reforms:

Leveraging the Laughs (and Tears) at Treasury

The 18 page Summary of the proposed Financial Reforms released by the United States Treasury Department one day before April Fools day should provide some continuing laughs “going forward,” as they say in policy speak.

Although the term “market stability/instability” appears 35 times, and is the leading repetitive worry phrase, the document does not seem to make the connection between the obvious lack of market stability and the pace of financial product “innovation”, a term which I found 12 times, for second place. It appears they want to grandfather in those innovations and fear that if we don’t continue to load up with even more we will lose out to foreign competitors. For a document so enamored with “innovation,” it’s very curious that “hedge funds” are only mentioned once, as are “derivatives” and “margin,” and the even more crucial word “leverage.” If collateral was in there, I missed it. Same for Collateralized Debt Obligations (CDO’s) and Credit Default Swaps (CDS). And the word “speculation” is missing too. I guess it’s just more polite to subsume them under bigger categories. Not so scary, at any rate.

Now the curious thing about the infrequent mention of these key terms is that hedge funds are increasingly associated with market “volatility,” which certainly has some relation to market instability. And hedge funds are intimately interwoven with investment banks, and we will perhaps some day learn of their role in the unraveling of Bear Stearns. But to have 18 pages on these matters only mention “leverage” once is truly astounding, since it was the front and center word in the initial report of the President’s Working Group on Financial Markets, and mentioned in the report’s cover letter of April 28, 1999 to then Speaker Hastert, a letter signed by Alan Greenspan and Robert Rubin, among others. It stated that “the principle policy issue arising out of…the near collapse of LTCM is how to constrain excessive leverage…” Of course, the report said we should rely upon voluntary “market discipline” to rein in that leverage, in the same way that the Treasury proposals now lean heavily on “self-regulatory organization” powers to curb problem areas. The fact that it wouldn’t be using “market stability” 35 times today if self-regulation had been effective in curbing too much leverage in the spread of bad mortgage CDO’s still has not apparently dawned on the Treasury Department.

Financial markets are in deep trouble today not just because of lax mortgage standards and a bursting housing bubble, but also because derivative “innovations” and hedge funds have spread risk rather than reducing it. And rather than increasing market liquidity, they have frozen markets. Today, we have not only a liquidity crisis but a solvency crisis at some banks. (This was the call by a disciple of Milton Friedman, Anna Schwartz, way back in 12/07: “‘The banks and the hedge funds have not fully acknowledged who is in trouble. That is the critical issue.’” http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/12/23/cccris... [1]) .

Somewhere in all the polite euphemisms and alphabet notation of this report, it loses sight of the basic reality: our financial markets have become distorted by too much speculation in heavily leveraged debt instruments, what it calls “innovation,” but what some other observers like William Gross of PIMCO Bonds simply call “something resembling a pyramid scheme.” The needed reforms will have to be based on very different assumptions than the ones in this report. We might even have to go back to such quaint notions as long-term value investing instead of pure short term speculation as the basic feature – but that probably wouldn’t qualify as “innovation” in this Treasury’s dictionary of terms.

And I’m wondering, if somewhere in the 212 pages of regulatory details, not reviewed here, there might be included a requirement, should they retain their current elevated status, that hedge fund managers and investors be given formal designation as our financial Peerage, and be required to don powdered wigs and robes at their meetings. Our surviving 401(k’s) await a nod from our Eminences.

Join with me now in enjoying the moment, when, just this past week of March 31st, Secretary Paulson was on the road, trying to persuade Chinese financial officials to open their system to some of our recent “innovations.” I kid you not. Talk about timing. Not content with the troubles wrought at home, the Secretary wants to share our secret recipes for financial bliss overseas. And do we ever mean secret – even from our own citizens. Can you imagine the translator’s job of explaining how Collateralized Debt Obligations and Credit Default Swaps work – and not just the plain vanilla versions – the squared and cubed versions as well? Not content with entertaining us at home around April fools day, he’s taken his show on the road. This should supply material for the Daly Show and the Colbert Report for many weeks to come. You have to laugh at this – or you will surely end up crying instead. And what is that Chinese phrase for… “Lock up the family silver?”