(This is an edited version of a closing keynote speech I gave at a conference for corporate treasurers and finance heads of banks on 16 October, 2008. I have added to it since to consolidate my thoughts on the subject.)
1. Terminologies and people’s lives
How do we characterise our current malaise – are we in a “financial” crisis or an “economic crisis”? What is the difference between the two? Or are we in a series of different crises – starting with a “market crisis” that became a “banking crisis” and is now imploding into a full scale “economic crisis”?
Breaking concepts into their naturally occurring meaning helps in the analytical process. It makes the current crisis less formidable than it would appear.
The crisis hit many innocent people at a very personal level. What is the difference between “principal protected” and “principal guaranteed”?
In several countries in the region, thousands of innocent depositors were hit with absolute losses, when instead of just renewing a fixed deposit account, they were persuaded by equally innocent sales people in the branches to invest their life savings in “principal guaranteed” “Minibonds” issued by Lehman Brothers.
In the face of the current Lehman’s Minbond mis-selling episode, Martin Wheatley, the Securities and Futures Exchange CEO for HK was reported saying, “I would be shocked if anybody bought a product based on the name of the product.” He said that the term minibond “is just a brand name.”
Try telling that to a 68 year old retiree with the only $100,000 worth of life savings he has, wiped out completely and we get a sense of how cruel semantics has been in the current crisis.
If I were to ask this room, and I assume that all of us are reasonably well-informed professionals, what you thought the word “minibond” meant, I don’t think I will be surprised as to the range of the answers I will get.
With my editorial background, of course my first concern would of course be mis-spelling, and not mis-selling. How do we spell “minibond”? Is it “mini (space) bond” or mini (hyphen) bond or “minibond (one word).”
Then I would ask, what is a “minibond”? The financial equivalent of Mini-me, Dr Evil’s clone in the Austin Powers movies (The Spy who Shagged Me and Goldmember)? A mini version of a Lehman bond?
Well, the Lehman Minibond was neither mini nor a bond. According to MTI-n, a data house, the global size of the Lehman bonds was around $110 billion and in addition Lehman created about $30.5 billion of structured notes for clients.
The term “Minibond” itself is actually a special purpose vehicle, and not a product. To the customer, that was deception number one. The terminologies used by the banking community to camouflage the exact nature of the exotic products they invent, should really be called deception.
(The first case in Contract Law – Carlill vs Carbolic Smoke Balls (1893) – the judge in that case referred to the idea that the Carbolic Smoke Ball was supposed to be a panacea, was tongue in cheek, “a mere puff” and not a deception. But that was different.)
As a special purpose vehicle, Minibond was essentially an insurance policy taken out by Lehman Brothers to protect its own exposure to six prominent banks known as ‘reference entities’. Deception number two was that it was to protect not the investor’s principal but the issuer’s risk.
The money invested by the public formed the insurance payout should any of the six have failed over the period in question, and in return for use of the public’s money, Lehman paid the public an attractive annual coupon of 5 per cent which was, in effect, an insurance premium to protect itself.
It was a brilliant concept: Lehman transferred its risk of loss from any RE failure to the investing public but structured the deal and its sale documents to give the impression this was an investment product. Even if it was an investment class, if it was communicated to the investor correctly, not all investors would have wanted to risk their life’s savings guarantee Lehman’s investments. Why, we do not even expect institutional investors to put their entire AUM into one asset class.
But there is nothing unusual about this in investment banking. If anything, investment banking was a creation of semantics than any kind of financial engineering we imagine today.
2. Finance, the alchemy of the 21st century
Today, the financial engineering undergraduate course at Princeton University is administered as an engineering degree rather than a business or economics degree. I do wonder how much of it is engineering and how much of it is pure English Literature.
There was a time in the city of London, that to become an investment banker, you really needed a degree in Politics, Philosophy or English literature because it was likely that you came from a good family and had that out-of-box thinking to create terminology to justify what is in fact, gambling.
The range and depth of flowery terminology used in investment and trading is part of everyday life. A “Taleb distribution” is a scheme for generating regular small profits interspersed by large losses. Used in all forms of statistical arbitrage today which exploits interest rate differentials by traders in hedge funds and at the proprietary trading desks.
The “martingale”, I am told, is not an exotic bird, but a gambling strategy. How it works is like a coin-tossing game in which heads you win. Every time you lose on tail, you double your bet, so that when you eventually throw a head, you will recoup all your earlier losses and make a small profit. To the foolish, you cannot lose. To the realist, that would be a sure way to bankruptcy.
They add to all the complexities that befuddles us. Fitted with the respectability of rating agencies and simulations of performance, they appear intellectually formidable. Run with the benefit of powerful computers but without the benefit of common sense, we can show how “Taleb” distributions and “martingales” may deliver small, predictable returns when collateralized debt obligations are traded.
We have today made finance the alchemy of the 21st century, what religion was to the dark ages, during the inquisitions of Spain. Through a series of subterfuge, we have created a language and a belief system that only the “priests” can understand and apply, while the rest of humanity has been reduced into a befuddled bunch of persecuted believers thinking that we deserve all of this.
The history of financial deception and self-deception is as old as humanity. I strongly recommend reading the book “A Short History of Financial Euphoria” by John Kenneth Galbraith that takes us back to the Tulip crisis to remind us how we have kept falling into this trap again and again and again.
3. Establishing our current coordinates
The fact we need to take cognizance of is the size and scope of the current malaise.
The Savings and Loans Crisis in 1986-87 incurred bank and other losses of about $240b. At that time, it was less than 5% of the US GDP.
The Japanese crisis, which stretched from 1990-99, resulted in about $650b in total losses and was about 15% of that country’s GDP.
The Asian crisis, believe it or not, resulted only in about $300b in losses. But because of the fragmented nature of the Asian economies, it accounted for an average of about 30% of the GDPs of the economies involved, putting countries as diverse as Korea and Indonesia in huge risks.
The current US-driven malaise is touching about $1.5 trillion but corresponds to only 10% of the US GDP. The planned US stimulus and government spending packages, when fully formulated will probably add to more than 5% to the budget deficit – high but manageable, provided that country does not go and find another war to fight with, from its long list of enemies.
In all likelihood, when this becomes a truly global economic contagion, it would suggest that the US will have the resources to pull through it well enough, but not the smaller economies that are being dragged into the situation. Already, Pakistan, a country that built a strong balance sheet in the past five years, is already derailed because of a number of factors and the new president has had to travel to China to seek for credit that is no longer available in the capital markets.
In analyzing the implications of this crisis, the one question I constantly have to ask myself is how much of this is “markets”, and how much of this is “banking”.
The 1999 dot com crisis was quite clearly a “Ponzi scheme” that promised high returns to investors only by bringing in new suckers to grow the investor base. It was perpetrated by the markets and abetted by the banks. Needles to say, the markets eventually collapsed when the supply of suckers ran out.
The economist John Kenneth Galbraith describes this as “innocent fraud” – the process of ripping off investors but generally falling short of an outright crime.
The difference between the current crisis and the dotcom one is that today the banks have become participants rather than just the organiser of the innocent fraud. In the dot com fiasco, banks collected commissions on transactions. In today’s situation, the industry has deceived itself along with its clients.
4. Still, we have truly lost our way
I think that it is clear today, on the 16th of October 2008, that we have truly lost our way.
If mark-to-market accounting was meant to function as a guide to keep us on the straight and narrow path of always dealing with the true value of an asset, we are confronted today with the two sides of its fallacies.
M2M is being criticized today for forcing banks to recognize that unsalable assets have little value when the market is down. But we also remember how when the markets were up, Enron’s Jeff Skilling made full use of mark-to-market accounting to trade in actual assets and use them as collateral with the express permission of the Securities and Exchange Commission.
Mr Skilling believed, as do many traders today, that people should be rewarded upfront for their ideas, with no recourse should the ideas fail.
On the accounting front, even as the US FASB has been learning to work with the global IFRS board in recent years, the Americans have been asking for a return to rules-based accounting rather than principles based accounting.
Thomas Hoenig, president of the Federal Reserve Bank of Kansas City said at the IMF meeting last week that any set of accounting rules should have three basic elements: They need to be simple, understandable, and enforceable. Nothing wrong with that. He asserted that the more complex a set of principles and interpretations, the less enforceable they become. That is fine as well.
But the problem in his assertion is that the principles-based nature of U.S. GAAP generates about 25,000 pages of rules and interpretations, while the IFSB standards generates only about 2,500 pages, and is more easily applied globally in different jurisdictions.
M2M has become a dangerously faulty indicator not because it is inherently bad, but because we have all forgotten the evil it was designed to deal with in the first place.
We have truly lost our way in another way. We are today standing about 150 years of economic learning on its head.
The global newspapers use semantics as if it were policy. For example, the current US government rescue package is being touted as “Keynesian”. But I would argue, not so fast!
The two contenders for the White House are arguing for fiscal and monetary stimuli. Obama has ideas for $300b in infrastructure, energy and other spending.
But that connection with the real economy, something that is at the centre of Keynes tenet, is a tenacious one. Technically, the US government is not even attending to the root problem today. Many local governments are unable to balance their operational budgets because of pre-existing credit default swap commitments sold to them by investment banks over the past few years.
We do not know to what extent the future US government will be able to tie the current measures back to the real economy. Politics will distract.
During his own time, on whether deficit spending rather than greater taxation could lift a country from depression, Keynes replied to his critique Hayek in the following way:
“I should… say that what we want is not no planning, or even less planning, indeed I should say we almost certainly want more. But the planning should take place in a community in which as many people as possible, both leaders and followers wholly share your own moral position. Moderate planning will be safe enough if those carrying it out are rightly oriented in their own minds and hearts to the moral issue…. But the curse is that there is also an important section who could be said to want planning not in order to enjoy its fruits but because morally they hold ideas exactly the opposite of yours, and wish to serve not God but the devil.”
In other words, applied to today’s context, vested and partisan interests in the US system will distract any government’s ability to reach into its coffers to resolve an economic crisis.
Milton Friedman, Keynes ideological opposite, who promoted smaller government, would look at the same $750b bailout plan and remark as he once did before that…” there is nothing so permanent as a temporary government programme.” His main thesis all through his life has been that good intentions must be measured by their results, not their intentions.
When the US government was running budget surpluses in the late 1990s, Friedman who was still alive then said that spending money that they had was socialism. I wonder what he would say today, spending money that the US government did not have.
But as we enter a real economic depression, the idea that the US and other governments will go into a socialist-type “New Deal” model is inevitable, even if in logic, our minds now familiar with the mechanics of an open economy would reject it.
Unfortunately, Government, and I don’t just mean the US government, has found a new cause celebre that will bring it back to the right and centre of the economies of a number of nations, and take us away from all the work through the 1990s towards smaller government, greater entrepreneurship and liberalisation in general.
5. Hubris will not help us
There is no end of drama in this saga. One European banker suggested that if we did not solve the liquidity trap this past week, the world would have reverted to barter trade within 48 hours. Really? Somebody has to borrow and somebody has to lend, and at the right price they will.
Some of this hubris is being translated into misplaced nationalism.
At a gym in Shanghai last week, I was chatting with an American tourist on the treadmill watching the same wall mounted television set just in front of mine. In the conversation, it disconcerted her that she was coming from a weaker country now than whatever lesser country I could be from, and so at one point she said, “well, it’s a global problem now, isn’t it.”
On television that same night, another American commented “it’s a global problem now, isn’t it. But look at the Europeans, they can’t even get themselves to agree on anything… At least we are dealing with it head on.”
On my flight into Singapore yesterday, I picked up a copy of the latest Time magazine that reads “London’s Sinking.” (October 20th international edition) Well, what about New York sinking?
There is also that anti-Asian bias that persists and just won’t go away. It was the IMF and the US Treasury that taught us to be decisive, not to bail out failed institutions and rehabilitate the economy during our own crisis in 1997.
We see this western tendency towards hubris by the way in which countries like South Korea continue to be bombarded by inaccurate and alarmist reports from the IMF.
In a recent report released in September, Australia received almost nothing but praise in the IMF for its “sound macroeconomic policies.” Now, we are talking about a country that has a huge current account deficit (about 5 percent of GDP), five years of a commodities driven economy, minimal foreign-exchange reserves, very high household debt and a net foreign debt (leverage) of A$600 billion or 65 percent of GDP.
South Korea’s foreign reserves are six times larger, its current account deficit just one third of Australia’s, its household debt just half that of Australia. Its foreign debts are roughly matched by its foreign assets.
Similar reports coming out on China from very respectable organizations in Washington are equally biased and unhelpful in understanding the roles of these countries and how the global contagion can be contained.
We really need a new language and a new universal way of looking at who the winners and losers are in the global financial markets.
If anything, by the time we get to 2010, when the US government will start unraveling its holdings in financial institutions by selling stakes to the highest bidders at market value, we will see the same nationalistic sentiments that prevail in South Korea today as the public expresses outrage for financial institutions sold to foreigners. We call South Korea protectionists. What will we call the United States in two years time?
The mother of all hubris is to watch on television the “chief economists” of the very investment banks that are under great threat, trying to tell us where they think all of this is heading. As if they knew better. It is at this point that we need to snap our fingers to come out of the trance we have allowed ourselves to slip into. An entire system built around such an ingrained community of self-serving professionals, telling us that they are smarter than the rest of us and that thy actually know anything about where themarkets were taking them and their institutions.
We need to see through a lot of smoke screen to understand the issues.
6. So, who do we blame?
So who do we blame for all of this? The reason I ask this question is not to witch hunt the past, but as a background to that all important question on how the future is going to turn out.
The precedence to this question is to understand who we have lost. One of the casualties in the current crisis is the number of good men and women that the system has thrown out. The good together with the bad. Sir Fred Goodwin of RBS. Kerry Killinger of Washington Mutual, Ken Thompson of Wachovia.
In the spate of bank closures and mergers, a whole generation of people who have built sound banking businesses will be leaving the industry. Who will replace them, and what kind of people they will be is not quite known yet.
That is why I think that if there is one operating word that I think will re-shape and re-tool the future, it is Governance. There has been no time than ever before where the quality of the men and women in government, in finance, in the institutions that are being re-created will have in their own character, part of the answers in terms of what the future will look like.
I do think that Alan Greenspan is being pillore today by the same people who were praising him to the heavens when he was chairman of the Feds. My sense is that he asked for neither the praises in the past nor the blame he is getting today. But in his own “Ayn Rand” way, he chose not to be “activist” enough about his friends in ivestment banking who were creating these huge OTC markets during his watch.
(A private thought: I was always enamoured by his obsession with the concept of “productivity”. He was talking about it even late last year, when I saw him speak at a conference in Las Vegas. I have a theory that the productivity he talks about is really a concept that he internalised when he was still in his 40s in the 1960s-1970s, when it was truly making a difference to US corporate history with the advent of computers and so on.
In the 1990s, the US had already moved on to cost containment because it was a mature economy and robust growth had slowed. But here was a man whose last Big Idea was at least 20 years out of date. But we gave him the benefit of the doubt.
The only policy instrument that he was known to use was to reduce interest rates to facilitate the access to cheap credit for his friends in investment banking. We do not remember him pushing any memorable regulations, especially in the aftermath of LTCM, if it was a systemic risk, as he claimed. The only regulation I remember is the dismantling of the Glass-Steagel Act during his watch, but that one as practically forced on him by the banking industry, not the other way around. This man in my mind, is a one-trick pony, but he did what he did during his time.)
One question I would ask Greenspan is why was there such slowness in revamping Freddie Mac and Fannie Mae even though there were a string of warnings since 1999. Another question: Why did the Feds decide not to bring the OTC markets into regulation after the LTCM crisis, if indeed it did pose a systemic risk to the system? This is at the very heart of the current crisis.
The role of chairman of the Federal Reserve Bank today is not simply to chair the board meetings to direct monetary policies. It is really banking regulator, economic policy and even international relations, something that the Feds did not consider actively in their deliberations until recently. Whoever chooses a regulator will have to look for a wider range of institutional skill sets than that which Greenspan demonstrated.
I see Henry Paulson differently. He takes charge, rightly or wrongly, and when the history books are written, we wll have to hold him accountable for every action today.
(I was uneasy when I saw how friendly he has been with the Chinese government. He introduced the US-China Economic Forum, was happy to be seen hugging Chinese Vice-Premier Wu Yi in public, probably thinking that all that diplomacy was going to work in his favour. I think that Paulson would have got more out of China if he counter-balanced that enthusiasm by counter-balancing ties with Southeast Asia and other regions as well.)
So now he has decided to take equity instead of purchasing the bad assets of banks, as the way to stem the demise of confidence in banks. His original preference of buying bad assets revealed his hand as a trader, not a businessman.
Also, there was a vested interest every day that he is at the helm of solving this problem – the financial firms with the “toxic assets” (a semantic that I absolutely dislike) were the same one that the treasury was going to depend on to value and manage them.
The current proposal, mirroring the SWFs approach of taking preference shares at 10% dividends, safeguards the American taxpayers at the expense of the banks. I see that as an afterthought, a discipline placed on him by the actions of private investors like Warren Buffet when he finally went in to invest in Goldman Sachs.
We can go back in time as far back as Richard Nixon, to blame for removing the gold standard in August 1971. There is some value in holding that thought for a second.
Rather than re-balancing the value of the dollar by tweaking its supply and demand in the real economy to the gold standard, Nixon took the US on a journey away from it. Nixon’s move to de-peg the dollar and float it, gave birth to the new era of futures, derivatives and any exotic excuse to trade in the currency itself, the frontiers of which we are witnessing today. It’s a tought worth bearing, especially in setting out public policy, that the original sin can visit us many years hence, and when there is no turning back to the disciplines that could have saved us.
There are other original sins that we can do something about. In their desire to scrape the bottom of the barrel to generate profits, mortgage originators used innovative phrases suc as “undocumented income” to encourage applicants to lie about their incomes. By denying relief to those who did lie, and their accomplices, the US government can indeed retain the moral mechanism that Keynes talks about to rein in future excessess.
7. But here-in lies the secret of the way out for us.
We have moved from the gold standard prior to Nixon’s time, to “perception of value” as the reference point of value.
As someone from the information industry, I am just so surprised that the world has not yet blamed analysts, newspapers and consultants for the current malaise.
The media and analyst industry has been on a witch hunt since December 2006.
– Recount The HSBC interview in HK in Dec 2006 with Mike Smith.
– A number of senior HSBC executives running from Hong Kong to the US just before Christmas.
– We ran a line in Perspectives in Jan 2007. Several calls from analysts in the US.
– The rest of the story was the fall of Household and the witch hunt for sub-prime begins.
Many global finance leaders used the word “confidence” this week alone. For nine months in this year, as the saga unfolded, they were using the word “liquidity” as if the conditions was caused by some structural fault in the markets.
The markets have been liquid for the past six years and more so because of the low cost regime that Mr Greenspan had insisted on. Keynes called it “the liquidity trap.” But in his time, markets were just that – markets – they were domestic, they were backed by real collaterals. But in today’s market, the problem was not the collateral. He could just as well have called it the “confidence” trap – when nobody wants to lend or borrow no matter what the price of the collateral.
8. Will we see any “innovation” coming out of this crisis?
The death of investment banks… when we examine what Goldman Sachs has chosen to do after saying it did not want to be an investment bank, it re-incorporated as a New York state bank instead of a national bank. It is saying now that it will focus on wealthy customers.…. No need branches in other states, obviously looking at international wealth money… nothing unusual there – this brings us right back to the merchant banks of the UK in the late sixties, and if they are successful, to the UBS’ and Credit Suisse of the late 1990s. There is nothing new in this world. The themes in banking are as old as time itself.
9. Apologising is so difficult…..
Coming back to the theme of who to blame, it will be a wonder if we will ever get an apology from any of them.
Just last week, Dick Fuld, the chief executive of Lehman Brothers, told the US Congress that everyone, from the media to regulators, played a role in the failure of his investment bank, but not himself.
“We did everything we could to protect the firm,” he said. The closest he came was to say that he felt “horrible about what happened”.
Some bankers are muttering that regulators should also share blame for the loose rules that set the stage for the current crisis. Asked about a possible apology, an EU regulator joked: “But it is an American problem; surely it is for them to apologise.”
Horst Köhler, Germany’s president, complained “I still haven’t heard a clearly audible mea culpa “?
The Japanese are exemplary in this regard. In 1997, the leaders of a regional bank, Hokkaido Takushoku Bank, bowed in apology during a televised news conference to take full responsibility for the shame of their institution’s collapse.
The one party to this coalition for destruction that the world has not blamed as yet is the information community – the analysts, the journalists, the commentators of the world.
Washington Mutual was doing well after TPG invested $7 billion to shore up its capital after write downs from the mortgage crisis. But an inconspicuous equities research analyst based in California wrote a report to suggest that the savings and loan had liquidity problems. That was picked up by the media and resulted in a run on its deposits, followed by an attack on its share price. The country’s largest thrift did not stand a chance and it went under.
We are the gremlins in the works, and I am afraid that we in the information community are not done yet. We are still digging deeper and deeper. We are only almost done with analysing the mortgage industry. We have barely started on the credit card industry, and the unsecured consumer credit, to map these out to collateralised assets and then exposing those leveraged tradings derived from these assets. Assessed together with the dwindling economies of the world, we are still concocting an explosive mix. You will know that we are there when we have scrutinized institutions like JP Morgan Chase.
The thing we have to apologise for is that we did not collect the data required to show just how leveraged the banking industry had become to the hedge funds and traders.
If we only knew in hard numbers what we were dealing with during the LTCM crisis, we could have monitored more closely how those numbers were growing. But the leveraged positions of the hedge funds were nearly impossible to pin down. The Feds under Greenspan, did not want those numbers, lest the OTC markets had to be regulated.
The chairman of the SFC, Chris Cox say that the credit default swap market is about $55 trillion. Is this industry now so divorced from the real economy that it is larger than the GDPs of all the countries in the world put together? How much of that is based on leveraged trading? Who knows. How much of that is linked directly back to bank borrowing? Who knows. We needed to break that down to its component numbers and the picture will become clearer.
What you cannot measure, you cannot regulate.
We were even collecting the wrong set of data – to show the leveraged positions of perfectly normal banks in the due course of everyday business, instead of that of investment banks over-extending themselves.
We are sorry.