DJ,
A Financial Fairy Tale - Charles Peabody.
Fanny Mae and Freddy Mac hit today. I thought you might like this vignette. Bill
A Financial Fairy Tale
The following story is fictional, written in the style of a Tom Wolfe novel. If the events or individuals discussed seem plausible, it is purely because, in today's marketplace, anything is believable!
The unintended consequences of flawed government and regulatory policy are starting to seep through the seams of the implied safety nets. The leaks are so numerous that desperate actions are being taken to plug the “too many” holes in the financial dike. This fact has brought together the public and private sector together in a duplicitous manner that only a Pecora Commission will be able to unveil. But as always, the discovery process will come after the fact.
This particular story revolves around a product set and marketplace called “derivatives.” This is a product set and a marketplace that was developed by the private sector with the prodding and facilitation of the New York federal regulators. And this was a product set and marketplace that was developed during the 1980s as a way for the New York banking system to generate revenues to offset losses in their LDC portfolios and as a way to transfer credit risk to third parties.
Because of the complicitous nature of the regulatory involvement in the development of this market, the growth has been stupendous (see Chart 1). And because of the implied safety nets, the risks taken have been “systemic” in size. This past summer, the immense size of these risks was exposed through the near failure of Let's Trust Computers More (LTCM). However, because of the quick efforts of the New York Fed to broker a bailout of LTCM, derivative portfolios were never truly marked to market. You see, bank managements knew that regulators would have to turn a blind eye. A true accounting of derivative contracts would be counter to the regulators' desire to see calm come back into the capital markets. As a result, deep losses remain embedded in the derivative portfolios of many of the financial institutions around the world.
Regulators have been turning a blind eye ever since the first devaluation took place in the currency markets in the fall of 1997. In fact, the cumulative credit losses (from the trillions of dollars of derivative exposures) can still be measured in the tens of millions of dollars per institution, not in the hundreds of millions of dollars (see Chart 2). This low level of losses is only incredulous when one considers the large standard deviation moves that currencies, interest rates and economies have experienced since the fall of 1997. I laugh every time I hear U.S. regulators preach to foreign governments about the need for greater transparency and market value accounting. And so, in the absence of regulatory, accounting and market disciplines, what would cause a true accounting of portfolio values to take place? How about an internal power struggle.
Such a struggle recently occurred at Nations Bank America (NBA). Due to stern disagreements during the attempted union of managements, one side was locked out when it was exposed that large losses were housed in an affiliate called D.(isclose) E.(very) Flaw. Another
such situation may exist as I speak. At a foreign firm called Credit Swims Free, so Borrow (CSFB), the board is in the process of trying to separate the Wheat from the staff. One of the ways of accomplishing this ouster would be to expose some of those embedded losses in their large derivatives book. These losses have been hanging around ever since the Russian default this past fall, but until now there has been little incentive to realize them. In fact, to give the process some legitimacy, a fairly extensive audit of the portfolio is currently being conducted. Pending the completion of this audit, the payment of bonuses has been postponed.
The brotherhood of derivative purveyors are feeling somewhat threatened by this internal management power struggle. The last thing that this club wants is a precedent setting mark-to-market accounting of the same derivative positions that they also carry. After all, this was what the rescue effort of Let's Trust Computers More was all about. No member of the brotherhood could have withstood the liquidation of LTCM's positions given that they carried the exact same inventory. Fortunately, the brotherhood has within its membership a player whose ambitions of grandeur are immense. In fact, this company, called Big Merger Coming (BMC), has been trying to differentiate itself from the pack all year. Why, you ask? So that it might gain a P/E high enough to afford a major acquisition.
Due to a significant bet on the domestic fixed income markets, BMC was able to differentiate itself from the pack during the fourth quarter of 1998. While other members were reporting fourth quarter shortfalls, BMC decided to book large gains on the sale of mortgage loans, significant credit card securitization income, sizable debt security gains and robust loan syndication revenues. Management decided to take these discretionary gains in early December when they heard of the brewing troubles at CSFB. You see, there is nothing like a good internal management struggle to put a company in play. And Big Merger Coming had been wanting to expand both geographically and product wise (particularly into equity underwriting). What better way than to buy CSFB. It may surprise some to learn that BMC and CSFB had actually held merger discussions previously, even to the point of having drawn up an organization chart. Of course, if BMC were to buy CSFB, it may pre-empt the need to mark to market the derivatives portfolio, a prospect that no doubt would please the brotherhood of derivative purveyors. Any necessary valuation adjustments could come later in the form of a “meaning less” merger restructuring charge.
In the event that a behind-the-scenes solution to CSFB's derivatives problem does not emerge, the brotherhood has decided to take preemptive action geared toward deflecting any potential political criticism or regulation. The brotherhood has announced the creation of a “Counterparty Risk Management Policy Group.” This group was formed at the urging of the SEC and Treasury Dept. but with the approval of the federal banking regulators. Its goal is to write a set of industry guidelines that would govern everything from trading practices to lending standards to disclosure requirements. Its members are 12 leading domestic and international
investment or commercial banks, most of who were the primary financiers of Let's Trust Computers More. The co-chairmen of this self-proclaimed, self-regulatory body are Mr. Corrugated of Sacs of Gold and Mr. Thick of P. J. Morgue.
This is the point that this financial fairy tale comes full circle. I started off this tale by noting that the creation of the derivatives market was done in partnership with the New York Fed. Well, it just so happens that, during the very early and critical stages of the development of derivatives as a profit center, Mr. Corrugated was president of the New York Fed and Mr. Thick was his key right hand man. We now have the fox guarding the chicken coop. But then again this wouldn't be a fairy tale if it didn't include a wily fox and a vulnerable hen house!
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