Monday, September 22, 2008

Casino Royale: Time for Better Regulation

As we brace for more volatility this week, some politicians are fed up with high stakes finance and are openly calling for tougher new regulations.

But first a little recap of today's action. Stocks plunged again, taking the Dow Jones industrials down more than 370 points amid uncertainty over the impact of its biggest restructuring since the Great Depression.

It didn't help that crude oil climbed more than $25 a barrel, the biggest gain ever, as traders scrambled to unwind positions on the October contract's last day of trading:

"This looks like a squeeze play,'' said Phil Flynn, senior trader at Alaron Trading Corp. in Chicago. "All of the contracts are up, but nothing like October. This is the last day of trading and someone is scrambling to guarantee supply.''

Crude oil for October delivery rose $16.37, or 17 percent, to settle at $120.92 a barrel at 2:46 p.m. on the New York Mercantile Exchange. It was the highest settlement price since Aug. 21.

Another thing plaguing commodity prices are AIG's woes:

The threat of a collapse at AIG has been averted by the US government’s rescue package and loan of $85bn but the troubles of the global insurer continued to cause reverberations in commodity markets on Wednesday.

AIG acts as sponsor to The Dow Jones AIG commodity index which is the second most widely followed popular benchmark in commodity markets after the S&P GSCI index.

My hunch is that pension funds that invested in the DJ-AIG Commodity Index are either getting out of commodities or they are transferring into the Goldman Sachs Commodity Index (GSCI), which is 75% tilted into oil futures (if it's the latter, expect higher oil prices to continue because the DJ-AIG commodity index is more diversified than the GSCI).

The spike in oil prices was also due to the fact that the US dollar weakened the most against the euro since the European currency's 1999 debut on concern a U.S. proposal to buy $700 billion of troubled assets from financial firms will inflate the budget deficit.

Today's uncertainty helped propel gold and platinum prices to multi-year highs as investors fled to "safe haven" assets.

But the big news today was in the U.S. bond market. I found it interesting that Treasuries were little changed amid concern the U.S. will accelerate debt sales to fund a $700 billion proposal to buy soured mortgage securities from troubled financial institutions.

Some think that despite the massive proposal, the bond market is still more concerned about deflation than inflation:

As details of Treasury Secretary Henry Paulson's plan to revive the U.S. financial system by pumping as much as $700 billion into the markets emerged Sept. 19, bond investor Michael Cheah was reminded of Japan.

When that country's real estate bubble burst, leaving a trail of bad real estate loans, officials flooded the economy with cash only to see banks hoard the money instead of lending it out. The result has been a series of recessions and persistent deflation for more than a decade.

"Although the government tried to debase the yen by printing a lot of government bonds, the economy went into a standstill,'' said Cheah, an official at the Monetary Authority of Singapore from 1991 to 1999 who manages $2 billion at AIG SunAmerica Asset Management in Jersey City, New Jersey. "The banks used the money to buy safety. I see a repeat happening here. The banks will use it to buy Treasuries.''

I think this is an interesting viewpoint that you will rarely hear among the cacophony of analysts warning us to brace for stagflation (inflation and low growth).

So what else happened at the casino today? GE, GM and other companies were added to the list of companies banning short-selling.

Shares of American International Group Inc (AIG) rose 23 percent after a report that some leading shareholders are searching for a way to keep the company from being effectively taken over by the Federal Reserve.

Goldman Sachs (GS) and Morgan Stanley (MS) sought and won bank holding company status from the Federal Reserve in an expedited weekend process that waived the rules in the interest of "unusual and exigent circumstances":

"This is a high-cost move," says Brad Hintz, an analyst at Sanford Bernstein. "The SEC was a very light regulator. They have now chosen the most intrusive regulator."

The dramatic changes over the weekend and last week acknowledge the view that Wall Street's business model has broken down. That model included using a combination of unsecured and secured debt financing to fund activities like trading and corporate lending, rather than relying on stable bank deposits to fund some of those activities.

Some are wondering whether politicians' rush to meddle in the financial markets will only wreak more havoc:

But one thing is already clear. The US Government is knee-deep in the financial markets in a way that it has not been in many years. The measures taken by the Federal Reserve and the Treasury to support troubled institutions mean that in the future the authorities will certainly have a much larger role in regulating – or even running – large parts of the banking and financial system. What’s more, there is an emerging consensus in the US that at least part of the problem in the past year has its roots in a regulatory regime that was simply too permissive for the health of the economy.

Indeed, for better or for worse, more regulation is right around the corner. According to Bloomberg, no matter who's elected president in November, Democrats are poised to expand their congressional majority. And that means they will have a leading role next year in pushing through tough new regulation of U.S. financial markets. Moreover, today we learned that New York State will start regulating a part of the $62 trillion market for credit-default swaps (about time!!!).

Others think that this systemic crisis demands systemic solutions:

These are exceptional times. Exceptional for what has happened to financial markets and for what has not happened, at least not yet, to the broader economy – the onset of a severe recession. Perhaps it was the absence of the latter that lulled too many into viewing the bursting of the housing bubble merely as a correction, the defaults in US subprime mortgages just as misfortune and the failure of important financial institutions as collateral damage.

Six months ago, when the International Monetary Fund estimated more than $1,000bn (€691bn, £546bn) in financial sector losses and predicted a sharp slowdown in the global economy, we were criticised for being too pessimistic. But with much of the losses yet to be realised, and with the financial crisis now acute, it has become clear that nothing short of a systemic solution – comprehensive in tackling the immediate fallout and comprehensive in addressing the root causes – will permit the broader economy, in the US and globally, to function with any semblance of normality.

Finally, take the time to read C.K. Liu's excellent article, Too Big To Fail Versus Moral Hazard.

I quote the following passage:

It is an irony that at the very time when the US financial system is showing signs of structural failure, the global trend to adopt US business models and finance practices is reaching its peak. All over the world, governments are rushing to privatize public assets, securitize debts and deregulate their transitional economies away from socialism with the hope of reaping the enviable results that the US free market economy has enjoyed for decades. The bill of this enviable boom is now fast coming due and much of the world will to have pay without ever having enjoyed the benefits. The “race to the bottom” syndrome in wage competition has been enhanced by the “race toward risk” syndrome in finance competition.

The marketplace of ideas, not unlike financial and commodity marketplaces, often operates on mis-information until cruelly pulled back into reality by unforgiving facts. In countries around the world, much governmental and institutional aping of US deregulation practices is based on a misunderstanding of what a fatal virus US neoliberal market fundamentalism really is.

There is some truth in the popular myth that US ways are more flexible, more willing to innovate and to adopt to change. In the last two decades, US innovation and quick response to new business opportunities have produced a record setting long boom with only short recessions, with spectacular rise in profits and asset value. US household net worth, until the recent (and early wave) market crash, peaked at over $58.25 trillion in Q3 2007, doubling in a decade. It declined to $57.72 trillion in Q4.

The end of the Cold War and the global eclipse of socialist tenets have left US faith in market fundamentalism with the aura of a natural philosophy. The US calls her system capitalist democracy. In doing so, care is taken to distinguish democracy from equalitarianism. Conceptually, while the Declaration of Independence claims that “all men are created equal”, the nation that live by it readily accepts the premise that men do not create wealth equally. The US system rejects social democracy which aims to reduce glaring economic disparity between people.

The US system claims it promotes equality of opportunities rather than equality of rewards. It believes that the logic of the market is the most equitable arbitrage. Free-marketeers decry intimate relationships between government, finance and business and oppose even corporatism as an adjunct to the welfare state. They believe that the market’s unforgiving rules of selecting and rewarding winners and penalizing losers are inherently fair, efficient and necessary for maximizing overall economic growth. It is obscene that when they are punished by market forces for their wayward manipulation that they call for government help for themselves in the name of the common good.

The trouble with this view of free market capitalism is that it is a fallacy to assume that truly free markets can exist without regulation. Markets are always constrained by local customs and rules, unequal conditions and unequal information access by participants. In fact, markets come into existence through artificial construction by initial participants with rules that subsequent participants must observe as an admission price. These artificial rules generally favor the market founders and put later comers at a perpetual disadvantage. World Trade Organization (WTO) rules are the latest visible examples. Often the only option left to late comers is to start alternative markets hoping that they will enjoy the very privileges and advantages they oppose in existing markets.

Thus all markets require a wide range of regulations to check and balance their inherent march toward inequality and unfairness. Trade, by definition, is based on mutually balanced weaknesses. Mutual strength leads only to conflict, and unequal strength leads to conquest of the weak.

Whoever wins the presidency in November will inherit a financial mess. There is an urgent need to reform and regulate this massive casino we call the global financial system.

However, policymakers need to remember what George Soros has stated countless times: "it's not a matter of more regulation but better regulation."

***Update (23-09-08):

This morning I read that oil squeeze prompts call to curtail speculators. The Senate Banking Committee on the bailout is taking at 9:30 a.m. You can watch it live on CNN. If oyu want to read an interesting article (by subscription but you might view it one time by Googling the title or clicking the following link), read Regulation of swaps likely legacy of AIG.

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