The $600 trillion question?

09 August 2011

Has the US learned much from the GFC, asks ADRI's Professor Michael Porter?

By Professor Michael Porter

Outgoing US Treasury Secretary Tim Geithner says the size of the financial derivatives market is now US $600 trillion – that’s $600,000,000,000,000 – or a six followed by fourteen zeros. Unreal stuff! Ten times the estimate of world GDP, reflecting debt packaged and resold again and again.

What is more frightening perhaps than these unfathomably large numbers, is that the short list of candidates to replace Geithner (who is now staying on) includes many whose firms led the creation of derivatives such as “credit default swaps” specifically designed to avoid insurance regulation and monitoring of financial guarantees.

Derivatives that arguably have made toxic an otherwise potentially sound credit system.  Something that can spread its toxicity by trade in securitised packages of derivatives.

Derivatives that shift risk to parties that barely understand the issues – since the joint events underpinning the derivatives seemed as safe as a house.

Now while debt, its packaging and conditionality is not a bad thing, that’s only if it generally finances sound investments capable of being monitored along with the debt.

More trivially, world net debt is also no problem, since it is by definition zero (aside from trades on the moon).

Packages of debt can also be low risk – so long as losses here may be offset by gains there, making diversified securitised packages capable of having lower risk than their component parts for equivalent returns.

The problem then with the new derivatives-based forms of credit risk insurance is that most packages of securities are as transparent as Ned Kelly’s lead mask. Diversification is a plus, but only if you know the contents of the package. And almost by definition, with massive pools adding to $600 trillion, it’s hard to have a clue!

Credit Default Swaps

But what are credit default swaps, or CDS? They are derivatives of packages of debt that enable the transfer of an aggregation of loan default risks to other often unwitting parties, creating a form of insurance or guaranty against default, minus the legally significant words.

Packages of CDS can be traded, re-packaged and sold again. Generating fees that Wall St has enjoyed, despite the appalling outcomes for the borrowers and investors.

The joy for the US banks was that they could pretend to sell off the risk in their securitised packages of loans to parties keen to earn income from assets that seemed as “safe as a house”. For a while it meant they could lend again, further inflating housing prices, increasing loans, and so steadily climb to the precipice.

Nobel or Ignoble

As some Nobel Laureate finance wizzes have now found out, many apparently independent assets or liabilities can all suffer at once – precisely because we share common information or mis-information, or because of common shared events. Herds are very real things. More than ever with instant communications.

This intrinsic impossibility of “solving” the portfolio risk problem, other than in the classroom, means that a whole class of financial institutions have packages of securities they have difficulty valuing.

And while there can be hedges for offsetting risks, there is no such thing as a perfect hedge, since one has to have a net position in something. And everything can have its downside. The very word hedge no doubt came to the world of financial assets because we all understand the concept of getting burnt. And asbestos hedges turned out to be the worst of all.

Currencies as well as debt the problem

But it’s not just debt that is the problem at present.  In terms of security through cash, it is now crystal clear that all the potential “moneys” of the world, as in stores of value and means of exchange, turn out to have their own problems, even potentially gold-backed currencies.

The US dollar once thought under Nixon to be as “good as gold” now turns out to be no more than a  currency of relative convenience thanks to pervasive US banking institutions and Eurodollars, rather than as a liquid asset of choice.

The Euro is the imposed or contrived currency of widely varying European economies, pretending to have common currency risk. This fiction biases real rates of interest (nominal interest rates minus expected inflation) to be lowest in the countries with highest inflation, and thus promoting investment in the wrong economies. A sad side effect is that the Euro is no challenger to the depreciating US dollar.

The Chinese Renminbi may have sound asset and economic backing, but the lack of transparency of Chinese financial institutions and the excessive government financing of poorly structured investment means that there is no chance of a Chinese “dollar” any time soon. So too for the Yen, but for different reasons.

The Aussie dollar is one of the better performing currencies given superior regulation, booming resource markets and  our terms of trade. But with a small market the $A is a potential problem both for investors and for those Australian producers not enjoying improved terms of trade (Dutch disease).

The financial problem post 2008 is that all governments, with support from the IMF, responded to fear of depression of demand post 2008 with fiscal stimulus and increased debt. This was even though the underlying shock was not demand but US financial mis-management and poor regulation; in particular permissive housing finance backed by lead regulatory agencies and the White House.

Agencies that should have known better were the Federal Deposit Insurance Corporation (FDIC), the Comptroller of the Currency and of course, Alan Greenspan’s “Fed”.

The need was for better financial regulation from Clinton onwards; but the policy prescriptions post September 2008 were increased deficit spending! Financial mismanagement was to be cured by extra debt! (While the Keynesian stimulus was conventional wisdom, my hunch is that Keynes the financial theorist would not have been a Keynesian expansionist on this occasion, pointing from his grave to failures in financial regulation and a need to avoid the “printing” of money as adopted in the US.)

Public versus private finance

The balancing of private and public debts gets into the core of the issue – namely only those sovereign forces with money printing presses can really guarantee debt, and even then only by printing more debt or notes. Democracies find it hard to resist taking over the Treasury and the central banks, hence the bias to incredible debt.  

But the fundamental problem with debt – public or private - as a driver of economic activity, arises when market players don’t really know who owns what and to whom. Or when it is unclear just what will trigger a credit crisis. Will the counter parties that assumed underlying risks have a capacity to honour their obligations? If not, then credit default premium rates escalate.

In my own discussions with a typical CEO of a suburban Chicago Savings and Loan Association he confirmed that he was criticised by the FDIC inspectors pre 2008 for not lending up to 100% of housing market valuations and for not purchasing packages of derivatives offering high yields. But after 2008 he was a hero, while many of those who acted on Washington’s regulatory guidance faced collapse.

This line of argument has been confirmed in small and large banks, where it has frequently been observed by bank directors, political leaders and other eminences that with the advent of securitisation and packaging, there was a sense of boards and management not actually being able to assess what was in the “package”, precisely because it contained a diversified aggregation of thousands of loans.

So guess what? Bank directors felt less obliged, or unable, to dig deep and independently to assess asset values and risk exposure. The very complexity of derivatives and diversification of risks became a license for director negligence.

At the level of regulation in the US, while many recognised the risks, the hundreds of $ millions spent by the mortgage finance industry lobbying Congress, meant there was not real pressure for reform, whatever the better professionals argued.

While the lobbying problem does explain part of the appalling policy mistakes in the US, it is also a fact is that most bank directors, politicians, finance theorists and yes, economists including this one, had barely a clue as to what to do about derivatives regulation. That’s no accident.

Assets such as credit default swaps were designed to slip under the financial radar.

So these potentially toxic assets or liabilities continue to have a capacity to undermine investors and economies, large and small. Ask the Greeks. The estimated gross exposure of Greece to CDS has been estimated at $79 billion with some banks having exposure of up to 30% of that figure.

On reflection, it’s all reminiscent of the “names” fiasco in Lloyds Insurance in 1992, when it turned out that the sizable fees the “names” were being paid to stand behind certain insurance liabilities (ships, aircraft etc) actually got called – and the rich “named” individuals were badly burned. The problem today is that we are all “names”, we are all lost in the packaging of the $600 trillions of securitised debt.

Dr Michael Porter is Professor of Public Policy, Alfred Deakin Research Institute, Waterfront Campus, Deakin University. He was also Irving Fisher Visiting Professor, Yale University and formerly with the IMF, the Priorities Review Staff of the Department of PM&C, and a visiting international economist with the RBA and the US Federal Reserve. From 2008 until June 2011 he was National Director, Research and Policy, Committee for Economic Development of Australia.

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