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Friday, 19 September 2008

A government-run multi $trillion global credit derivatives exchange?

If you survived the week, congratulations is FT Lex's message to the world. Lex says, It has been the most turbulent week in financial markets since the 1930s, vertiginous drops, the real possibility of a systemic collapse and, finally, on Friday, after a concerted government intervention, a spectacular rally.
All such great crises are different and depend on your hemispherical view. The anglo-saxon banking and economic growth models are on the floor. But Japan and later China, SE Asia and much of the Pacific Basin seemed similarly variously broken through the 1990s. For some years most retail banks across the regions were technically insolvent. Other regions have had their collapses, but if today is truly comparable to the 1930s we should fear a great loss of confidence in capitalism and fear political instabilities leading to war. It is not that bad, surely? Lex says, Many bodies lie strewn by the side of the road just travelled. But, in my view, one roadside victim that will be no great loss is the neo-liberal assault on the role and size of government, another is the arrogance of bulge bracket banks and investment houses, a third is the hubris of structured product guinea hunters that the tabloids love to denigrate as spivs, oiks or bookies' narks. But, perhaps these are just common prejudices?
Big government is here to stay for the forseeable future and governments and regulators now firmly hold the whip hand over whatever new financial regulations will be conceived (that may or may not build directly on Basel II and Solvency II?). The US is taking the lead and taking full responsibility. US Government and agencies are proposing to receipt (up to $700bn) all Level 3 mortgage assets (and their credit derivatives?) in the US, and this follows immediately after AIG was taken over by the Feds for an $85bn loan and with the US Treasury taking over Fannie and Freddy, and after the Fed married Bear Stearns to JPM and Merrill Lynch to Bank of America, and in the UK No.10 married HBoS to Lloyds TSB. Lex predicted that if only a modicum of calm returns to markets, Morgan Stanley and Goldman Sachs should survive. But, Lex adds, the perception of what were perfectly adequate funding and capital positions last week can change within an hour. And that in itself can become fatally self-fulfilling.
The Fed's Bad Bank proposal would raise the Federal US National Debt to $11.315 trillion from $10.615 trillion (though over $3tn of this is non-marketable i.e. internal within central government) and require the Treasury secretary to report back to Congress in 3 months and then semi-annually after that. Paulson has discretion to act as he ``deems necessary'' to hire people, enter into contracts and issue regulations related to a revival of U.S. mortgage finance", according to a 3-page outline proposal. The Treasury would ``take into consideration'' protecting taxpayers and promoting market stability. The Treasury plans to hire managers to purchase the assets through reverse auctions, thereby seeking the lowest prices. The document specifies that Treasury may buy only assets from U.S.-based financial institutions issued or originated on or before Sept. 17...
President Bush today said that he's unconcerned that the price tag on the package may seem high, and "I'm sure there are some of my friends out there that are saying, I thought this guy was a market guy, what happened to him,'' and "My first instinct was to let the market work, until I realized, while being briefed by the experts, how significant this problem became.''
One major, if general outcome of the actions by US and EU governments to save the banking system from itself will be a diminution of Wall Street, The City, Frankfurt, Zurich etc. 's influence (politically and economically) as governments' authority and supervisory role expands. Banks and financial centres will slip to the lowest point of influence and stature since WWII and will slip back considerably in the volume of business they do, the latter probably by at least a third!
At present intervention has been buying time and shoring up bank capital in the expectation that interbank lending confidence will recover. But, to resolve problems that led to the crisis requires other measures, obviously new regulation or more refinement to existing regulation. Since, however, the problems have been systemic in how the debt markets operate, their 'quality', not merely problems of individual banks or the sum of all their over-leveraging, therefore solutions have to extend to reforming the OTC markets or creating new regulated "on exchange" markets. Just as off-balance sheet liabilities have to come on balance sheet and be restructured, so too do the OTC capital markets.
I conclude from all of this, with a bit of lateral thinking, that the Fed backed by US Treasury (and maybe somewhere in the mix the SEC and the US Comptroller of the Currency) possess an obvious solution now (and one they have perhaps even been consciously working towards?). They can (and I think perhaps should) turn all of this government owned or administered assets into a massive regulated and transparant, credit derivatives, stock exchange not unlike CME/CBOT/CBOE.
Whatever happens, hedge funds' vulture funds that were aiming to buy into toxic assets at hugely profitable firesale discounts may now be regretting not having made their moves earlier. They may now be scrambling to see whether the Fed will set up a system for selling or trading in which the hedge funds could participate? But, I suspect that the Fed will take the view that it would be best to simply quarantine all the toxic underlying for a few years until the economic and credit cycles are firmly of the floor and rising again. CDS and other credit derivatives have maturities measured in days and months.
The priority will therefore be to unravel these. And for that mergers between major banks and investment houses is very useful in wiping out the outstanding obligations between them just like JPM's purchase of Bear Stearns wiped out JPM's huge exposure to Bear Stearns. AIG's credit insurance contracts will mostly apply to the toxic assets now owned as collateral by the Fed and to what will be gathered into the Fed's proposed "Bad Bank", thereby also wiping out a huge portion of the $62tn in nominal value of CDS outstandings. This is all very efficient and intelligent and may even simplify the computing and forensic accounting that would otherwise pose gargantuam problems.
Surely, therefore all this takes the pressure off the monolines and the banks and should, along with the rebound in bank shares, result in ratings agencies doing a u-turn on their proposed ratings downgrades?

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