Wednesday, May 30, 2012

“Wall Street’s Death Wish”

Sydney M. Williams

Thought of the Day
“Wall Street’s Death Wish”
May 30, 2012

If an enemy wanted to undermine confidence in our capital markets they could hardly have inflicted worse damage than that which we have done to ourselves.

While his article was interesting and well researched, Azam Ahmed in his Sunday New York Time’s article, “The Hunch, The Pounce and The Kill” missed an opportunity. His piece makes clear that banks remain too big, that they continue to speculate and that Dodd-Frank has done nothing to prevent the abusing of credit default swaps, but he failed to conclude, as I have, that Wall Street is committing self-immolation.

The article detailed the $100 billion bet made by Bruno Iksil (the “London whale”) of JP Morgan and which has cost the bank between $2 billion and $3 billion. Mr. Ahmed also reveals details of those who bet against Mr. Iksil and won big, especially hedge fund manager, Boaz Weinstein. Despite these enormous losses – borne by shareholders, and potentially taxpayers – the “whale” will be leaving JP Morgan a very rich man, indicative of Wall Street’s questionable morality.

It is impossible to read the article without becoming angry that the lessons of 2008 have gone unlearned. We, the taxpayers, remain at risk. While blame for the credit crisis includes almost all aspects of our society, including consumers who purchased homes beyond their means, the accelerant was provided by politicians who placed personal favors above responsibility, regulators who did not regulate, corporate-types from AIG, Fannie Mae and Freddie Mac and investment bankers and traders at banks who created and sold derivatives whose value is solely for speculators. It was crony capitalism at its worst. The passage of Dodd-Frank did nothing to remove the accelerants. Banks are bigger than ever and the trading in naked credit default swaps (CDS) remains.

When one looks back at the 2008 period from a perspective of time and distance what is most remarkable is that not one of the perpetrators, including members of Congress, has gone to jail. An honest adhering to fundamental principles has become a mugs game. Are we considering the lessons we provide future generations?

Bruno Iksil was shorting a security known as Investment Grade Series 9 10-Year Index CDS – a bet that the European debt crisis would moderate and the value of the Index would decline. According to the Times, “Boaz Weinstein and a wolf pack of like-minded hedge fund managers” took the other side. In May, when problems in Europe re-surfaced, the Index rose and Mr. Weinstein and his group began to win. The result cost Mr. Iksil his job, but it remains unclear as to whether his past compensation will be ‘clawed back.’

Credit default swaps, according to Robert Jarrow of Cornell’s Johnson School of Business, were first created in the mid 1990s at JP Morgan. The intent was to limit Morgan’s exposure to bonds they were underwriting and to loans they had outstanding. Like so many Wall Street products, the concept behind them was well intentioned. But, also like many of Wall Streets more creative products, trading in them exceeded the originator’s intentions. The market for credit default swaps grew exponentially. By 2008, the market had grown to $60 trillion, almost double the size of all U.S.’s capital markets.

The concept of a CDS is simple. It is insurance against the possible bankruptcy of the issuer. As such, it protects a buyer or holder of speculative bonds, allowing the owner to measure his return based on the yield of the bond less the cost of insurance. Additionally, CDSs allow higher-risk issuers to more easily and less expensively access credit markets.

The problem is not that the instrument is capable of “mass destruction”, as Warren Buffett once alleged; for insurance, as Professor Jarrow has stated, is “intrinsically a good thing.” The problem developed because regulators never viewed CDSs as insurance. AIG, the largest issuer of CDSs in 2008, never had adequate reserves. The lack of reserving allowed the insurance company to report big gains in the years preceding the credit crisis – defaults at the time were at record lows – but the collapse destroyed one of America’s premier insurers, costing taxpayers an estimated $180 billion. If AIG had treated the product as insurance and had actuaries accurately measured risk they would never have got in trouble. It is unlikely they would ever have condoned naked purchases, and they would have been adequately reserved. Dodd-Frank addresses none of these issues.

The second lesson to be learned from Mr. Ahmed’s article is that it becomes increasingly difficult to believe that Bruno Iksil was hedging. The bets were simply too big. He was playing the game still too common on Wall Street – heads, I win; tails, you lose.

A third lesson is that regulation should curb trading in instruments that have little, if any, economic value. It is in Wall Streets long term interest to do so. The bets that Mr. Iksil was placing could have been made in Las Vegas or Macau, except casino operators are more diligent as watchdogs than are the SEC and the CFTC. In fact, Mr. Weinstein who made $40 million a year at Deutsche Bank before losing $1.8 billion in 2008 (and you can bet there was no claw-back provision in his contract at the bank!) was banned from the Bellagio in Las Vegas for card counting.

As our capital markets have taken on a more casino and carnival-like atmosphere, they have been hugely rewarding for those who take enormous risk, with rewards personalized and losses socialized. The losers have been the millions who seek decent returns for their far more modest investments and legitimate businesses seeking to raise capital. These are the people integral to the original intent of capital markets – providing capital and offering liquidity. The volatile and, at times, out-sized returns, and the amounts of money made by a few speculators (Mr. Ahmed estimates that Mr. Weinstein made $90 million last year!) have attracted the attention of managers of pension and eleemosynary funds, diverting investment dollars away from real businesses and into products like CDSs that have little, if any, economic raison d’être.

Traders like Mr. Weinstein and Mr. Iksil are obviously brilliant; they benefitted from recent technological advances and the leverage provided by the banks for which they worked. But one cannot help wonder what paths their lives may have taken under different circumstances. In another time, people with their genius-like talents might have invented penicillin or rockets. Instead, we have men who have made themselves extraordinarily wealthy by trading obscure derivative instruments, while back in the real world, cancer remains uncured and we have given up exploring the frontiers of space.

What is worrying about Europe is that it raises the specter of 2008. It is concerning that banks are still too big: the risks they assume endanger our financial system; they reward those who risk depositor and shareholder funds, while losses, if they are big enough, become the obligations of taxpayers. Wall Street has been reluctant to call CDSs the insurance product they are, preferring instead to keep them unregulated, regardless of the consequences. We have permitted Congress to pass regulation which complicates the lives of smaller businesses, yet we protest doing anything that might prevent the sort of cataclysmic event that almost brought down our financial system. We have learned very little.

Wall Street is as necessary a component of freedom as is Main Street. When we allow speculators to alter its original purpose we risk the free flow of capital from investors to businesses. There will always be people who come to Wall Street to make their fortune, but the same thing is true on Main Street. The relationship, when it works as it should, is symbiotic. It relies on confidence. When we permit banks to get so big that they endanger our financial system, when we permit trading in instruments that offer no economic value, we risk destroying a system that has worked well for two hundred years. We have enough enemies; we don’t need to commit suicide.

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