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Speculative Games Stage Comeback

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Speculative games stage comeback

Citigroup has been restructured with US$50 billion of public money without significant reform to its operations, the hedge fund industry had its best month in nine years in May and Goldman Sachs is said to be considering giving up its banking license.

The world's monetary and fiscal authorities appear by their feckless policies to have pulled off a feat that I didn't think was possible: resuscitating a financial services bubble that came close to wrecking the world economy, and may still do so on a delayed-action basis.

John Allison, chairman of BB&T Group (about the best-run major US regional bank), spoke on Thursday to the Competitive Enterprise Institute, saying that apart from a gold standard (which he thought unlikely), the financial services business and the country in general needed to change its motivations from short-termism and altruism to enlightened long-term self-interest.

While his altruism/self-interest point is a long-standing one (which to the extent that it means not making "affordable housing" loans to people who can't afford housing, I agree with), the long-term/short-term point is different. It's a product of environment, not of innately bad philosophies. If a country's government engineers market conditions that lavishly reward foolish short-termism, foolish short-termism is what that country will get. Only by changing market structures, rules and incentives will behavior be changed.

In a well-run financial system, the free market automatically rewards prudence and punishes short-term greed and folly. That's not the system the United States has had since at least 1995, and it's certainly not the system that has been produced by the multiple bailouts and stimulus packages since last autumn.

For a start, examine the housing market, the cause of the initial debacle. The combination of commission and other incentives to lend to borrowers who couldn't afford to pay and effective state guarantees of the loans they didn't pay produced a vast wave of toxic "subprime" lending. In a normal market, subprime loans would be a self-liquidating problem because lenders who made them would quickly go bust. Here, lenders who made them were guaranteed by Fannie Mae and Freddie Mac, who themselves were guaranteed by the taxpayer, as it turned out. Any losses that remained were passed off to foreign innocents through securitization.

This system of pass-the-parcel would have broken down last year, except that the government has now ensured its continuance by taking over Fannie Mae and Freddie Mac, making them major conduits for its efforts to "help" the mortgage market, handing out tax subsidies to new homebuyers and attempting to perpetuate the thoroughly unsound securitization market through purchases of up to $1 trillion of dodgy mortgage paper, again at the expense of the taxpayer.

A system that would have collapsed, forcing the reversion to the old, much sounder practice of making home loans directly through local institutions, has been artificially perpetuated. Not only will this cause repeated crises in the home loans market going forward, it will also be considerably more expensive for homebuyers - as I demonstrated in a previous column, the cost of home loans, expressed as a margin over the relevant Treasury securities, increased by about 0.2% as a result of the invention of the new and supposedly more efficient securitization market. Wall Street's rent seeking has, in other words, been subsidized.

Credit default swaps (CDS) were the most dozy extreme of all the dozy new products Wall Street invented during the period it pretended to believe the efficient market hypothesis. Structurally, they were a simple offshoot of derivative technology, although it is notable that they did not come into frequent use during the first 1980s flowering of that technology because it was clear even then that there was no sound way to crystallize the credit swap obligation created by a default.

The "auction" procedure used in the Lehman Brothers and other bankruptcies is obviously inadequate because it uses an auction of a few million dollars to determine the fate of obligations worth billions.

It became clear in the Lehman bankruptcy that CDS could be used to force a company into insolvency, particularly a financial institution with high leverage. The large amount of CDS outstanding and the low cost of credit protection against a good quality borrower give "shorts" seeking to push a house into bankruptcy an immensely useful tool that they previous lacked.

The obvious step at that point would have been to ban CDS, since they generate such a destructive conflict of interest. Instead, the Fed subsidized the market, by bailing out AIG, the least intelligent of the CDS writers, to the tune of $180 billion, thus allowing Goldman Sachs and other houses to profit on the various bankruptcies sufficiently as to pay out everybody's bonuses for the year.

Naturally, since none of the majors lost significant money through CDS, the market went on playing the game. CDS were used to accelerate the bankruptcies of General Growth Properties and Abitibi-Bowater within the past few months and played a significant and negative role in the prolonged restructuring of General Motors.

Now a small house, Amherst Holdings, has beaten the Wall Street titans at their own horrid game, according to the Wall Street Journal. It found a pool of $29 million of particularly repulsive California subprime mortgages, then sold $130 million notional of CDS on them, pocketing around $100 million in premiums, since this waste was so toxic the big houses were prepared to pay up to 80% to insure against it. Clear so far? It sold insurance for four-and-a-half times the maximum possible loss. But hey, that's finance.

Then it quietly went round and paid all the debts of the lucky homeowners owing the $29 million. At that point, since there were no defaults, it was able to keep the $100 million in premiums (net of the loan repayments, a $70 million profit). Simple, really! Wall Streeters are furious and, inevitably, suing, but in fact Amherst's coup was a perfectly legitimate use of this corrupt and foolish structure, far more so than many of the shenanigans undertaken by the likes of Goldman Sachs - after all, Amherst's operation PREVENTED a number of defaults and foreclosures.

George Soros says CDS should be banned. I worry about the periodontal damage caused by teeth-grinding when I find myself agreeing with Soros, but in this case, he's right (he was right on the pound in 1992 as well; fortunately for my dental care, he's been right on no other occasion that I can recall). However, not only have the feds made no move against CDS, they have subsidized the market to the tune of $180 billion of our money, thus ensuring the toxic technique's return to luxuriant growth.

The Troubled Asset Relief Program (TARP) bank capital injections have also contributed to the market's further degradation. They totally failed to discriminate between good and bad banks, so that the worst banks received the most money, without any steps being taken to remove their management or shut down their operations. Essentially, $50 billion of our money has been invested in Citigroup and $45 billion in Bank of America (the perpetrator of the two most foolish acquisitions of the last decade, in Countrywide and Merrill Lynch.) By rewarding incompetence in this way (for example allowing Vikram Pandit to keep both his job and the $600 million with which Citi purchased his failing hedge fund), the government has insured that we will get more of it, since the benefits from the juicy bonuses in good times are so great and the slaps on the wrist when the structure comes crashing down so painless.

Jeff Skilling of Enron was given a 25-year jail sentence for Enron's failure; that was grossly disproportionate to his offense but did ensure that future Enron perpetrators would be discouraged. The fate of Pandit, Ken Lewis of Bank of America and the AIG honchos offers no such deterrent to incompetent looting of the financial system.

A further effect of the TARP process has been to cause a number of perfectly healthy banks to slash their dividends - notably US Bancorp and Allison's BB&T. Should management of those banks, which have now repaid TARP, fail to restore their dividend forthwith while engaging in empire-building acquisitions of battered competitors, the "widows and orphans" who traditionally invest in bank shares because of their reliable income will be further discouraged, and shareholder control of banks will be left still more tightly in the hands of hedge funds and other cowboys.

Finally, we come to monetary and fiscal policy during the crisis. Monetary policy, which had been far too loose for the preceding 13 years, bore a large part of the responsibility for the period's excesses. If the monetary system is managed so that leverage is perpetually rewarded, it's not surprising that intelligent and aggressive bankers will devise new and ever more unsound means to create excessive leverage.

However, monetary policy has been loosened unimaginably further since the crisis, with the monetary base being more than doubled. It is very clear that only evidence of rampant inflation - which we can expect the Bureau of Labor Statistics to suppress for as long as possible - will cause the Fed to return to an appropriately tight monetary policy.

Thus the incentives for Wall Street to indulge in endless speculative games will still be present, complete with the implied taxpayer bailout when it goes wrong. No wonder Goldman Sachs is thinking of abandoning its banking license - why dawdle along with only 15-to-1 leverage when you have tasted the heady joys of 30-to-1 at taxpayer expense. It's also unsurprising that hedge funds have enjoyed their best month for nine years - for dodgy short-term speculators, Happy days are indeed here again!

As for fiscal policy, it is now clear that President Barack Obama's initial "stimulus" was one of the most counterproductive policy initiatives ever perpetrated, both economically and politically. That stimulus pushed the US budget deficit definitively above 9% to 10% of GDP, at which there is no firm assurance of financing it. Thus, it's likely that Obama will spend most of his presidency fighting to restrain an excessive budget deficit, while suffering the adverse economic effects of higher interest rates and "crowding out" that it brings.

Had he held back initially, Obama could probably have pushed through his expensive healthcare reform and his expensive "cap and trade" environmental policy without the bond markets taking too much notice, with any adverse effects of large deficits on the economy postponed until his favored policies were safely and irreversibly in place.

As it is, he will have a much more difficult task to push them through and will do so against a much more skittish bond market and a much more uncertain economic environment. Such a waste of a presidency, just to give House Speaker Nancy Pelosi her lavish helping of pork. (Of course, those of us who oppose both his healthcare and his environmental policies will rejoice, but from the viewpoint of Obama and his supporters he has risked his presidency becoming a colossal failure.)

There will be another crash of course, there always is. But before it happens, some very unpleasant people will have made further speculative billions and doomed the US economy to a decade of stagflation.

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