Saturday, March 19, 2011

Hedge Fund Manager Paul Singer on Too Big to Fail and the Next Financial Crisis

The Wall Street Journal ran a column on hedge fund manager Paul Singer.  Like your humble blogger, Mr. Singer was publicly recognized in 2007 for warning regulators about the impending crisis.

While I have never spoken or met Mr. Singer, it is amazing how closely his comments track with this blog's discussion of the FDR Framework and the need for disclosure of current asset and liability level data by the Too Big to Fail.
At the height of the housing bubble, hedge-fund manager Paul Singer was shorting subprime mortgages. By the spring of 2007, he was warning regulators on both sides of the Atlantic that the world was facing a major financial crisis. 
They ignored him. 
An experience your humble blogger shared.  I am not sure that he was also proposing an easily implemented solution like the FDR Framework.
Now the founder of Elliott Management says the biggest banks are headed for another credit meltdown. ... Rather, he's once again warning financial regulators.
 ... financial reform did little to reduce risks.
"Dodd-Frank has made the system more brittle and has shaped the next crisis in a very negative way," he warns. "The opacity of financial institution financial statements has not been addressed or changed at all. . . . We have a very large analytical research effort here and we have not found anybody that can parse" the sensitivity of big banks to changes in interest rates, asset prices and the like. "You can't do it." 
Even after the crisis, credit ratings "obviously provide no real clue," he says. "Rumor and feeling is all you have. You don't know the financial condition of [Citigroup], JPMorgan, Bank of America, any of them." Mr. Singer believes the big banks still carry too much leverage, and he doesn't trust regulators to monitor them effectively. 
The largest financial institutions, he says, are "a random collection of survivors. Almost none of the survivors exist because of their perspicacity, risk controls and sound management—even the ones that are vaunted along those lines. . . . How and why do they exist? Mostly an accident, meaning who got bailed out first and who was saved next and how did people feel and what did people say the weekend Merrill was under pressure [in September 2008]." 
Mr. Singer also has an interesting insight into contagion and the management of counter-party risk.
Mr. Singer says he does as little business with big banks as possible. "Aside from a large position in Lehman as part of our bankruptcy investing, we have no significant positions in global banks." 
"We institutionally have tried to—way before the crisis of '08—tried to insulate ourselves in every way we can from the counterparty problem," i.e. getting involved in a trade with a partner that might not be able to make good on its obligations down the line. 
But the nature of his business, he says, means that he can't sever all connections. "We've removed as many assets from the Street as we possibly can, and we think we're pretty well insulated. . . . If we could completely avoid being subject to the financial condition of any large financial institution, we would do so." 
Most investors don't share this view, of course, and big banks are still able to borrow at lower rates than their smaller competitors. The reason, says Mr. Singer, is that right now the system "is underwritten by the United States government and the governments of Europe. And the system is perceived as underwritten or guaranteed." 
But, he warns, "at some point that guarantee, in some way that I can't really visualize today, will go away." 
Will it really? 
He asks the question of what happens if the government guarantee is removed and a Too Big to Fail banks needs to be closed.
The authors of Dodd-Frank claim that the law prevents the government from bailing out any particular firm, but the Fed can still provide emergency loans to a failing giant as long as it offers similar financing to other firms. 
"It's a very important part of this equation that a few survivors exist in this peculiar relationship with government, having to kowtow to government, make relationships with regulators," says Mr. Singer. "Are they puppets of the government? Are they cronies of the government? Will their lending be affected by the perceived whims or beliefs of the particular government regulators existing at a particular time? Yes." 
If the government deems a firm not "systemically important," Mr. Singer forecasts, it could spell its doom. "Small and medium-sized financial institutions may be disadvantaged, may be sacrificed in the next crisis to protect these behemoths," he says. 
It gets even worse, Mr. Singer says, if the government ever deems a financial giant "in danger of default"—a judgment that can be made without the consent of the firm or its investors. The business is then taken over by the Federal Deposit Insurance Corporation, with its Orderly Liquidation Authority. 
Once in charge of the firm, the government can discriminate among similarly situated creditors and transfer assets out of the business at will. Because of this, says Mr. Singer, creditors and trading counterparties might flee even faster than they would from a firm headed toward bankruptcy, where at least there is established law instead of regulator discretion. 
Mr. Singer's fund specializes in distressed debt and bankruptcy situations, so perhaps he has reason to oppose changes to a system he knows so well. But he's also well-qualified to examine the government's reforms. 
"You don't know how you will be treated," he says of financial institutions under the new FDIC regime. "If there are companies that are also counterparties alongside you but they've been designated systemically important, that's a clue. It's like a game of treasure hunt. It's a clue that you're going to get disadvantaged compared to them." 
So maybe FDIC chairman Sheila Bair and the authors of Dodd-Frank were right about one thing: Perhaps their new process for resolving failing giants really will discourage some people from lending to the biggest banks—but only at the worst possible moment. 
The problem, in Mr. Singer's view, will be the jarring shift from one day being an investor in a member of the "systemically important" club, to the next day being a creditor whose claim is determined by bureaucratic whim. This may be welcome news to government pension funds that will want to be bailed out, but certainly not for private investors. 
The speed at which a firm will collapse as word gets around that it might be headed to FDIC resolution could be "amazing," says Mr. Singer. And that "speed will drive the size of the losses." 
This "atmosphere of unpredictability" is harmful to America's place in the financial world, he says, and "it doesn't make the system any safer. . . . This is nuts to be identifying systemically important institutions." 
He views it as a poor "substitute for creating soundness and reasonable levels of leverage throughout the system."
The only way to create soundness and reasonable levels of leverage throughout the system is implementing the FDR Framework.  Once all market participants have access to current asset-level data, their actions will drive the system towards soundness and reasonable levels of leverage.


The market will be able to properly price each firm's risk.  It will both increase the cost of funds and lower the availability of funds to high risk firms.  This provides a strong incentive to reduce risk.

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