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The games will be changed to protect the innocent
But the outfield was not so big. In fact, Ed's house was the outfield. So, balls bouncing off the roof were playable, but anything that cleared the house was a home run. It sure beat the back yard. One day a kid replaced our tennis ball with a rubber ball because it felt more like a baseball when you hit it. The new ball made things riskier, but what the heck, the game was more fun too. Until that line drive to right center. With the house serving as the outfield fence, it just so happened that the living room windows took up much of right center field. When the ball hit one of them, it sounded like a shotgun. . At first we all lurched in different directions. But who were we kidding? We were all identifiable. So we hung our heads and waited. Finally, Ed's dad, probably the biggest Dad in the neighborhood, walked out of the front door tossing the ball in the air and looking at us kids. It was a game changing event. These days, those hitting it big in the financial stocks probably deserve six atta-boys for trading prowess. But if long term investors calling a bottom in financials are right, they will be lucky instead of shrewd. That's because how the financial game will be played going forward is still under review. It's probably no coincidence that as financial markets became increasingly deregulated the financial sector's share of profits increased as well, reaching all-time records before the recent implosion(s). Post implosion (PI) not only do we not know how things will shake out, we don't even know much about what's been shaking in the past. If Bear Stearns boasts a book value of $86 one day and gets taken out at $10 on another, what kind of earning power do investment banks really possess? If Citigroup sold at X times book five years ago, can investors expect Citi to regain that valuation in a PI world? People who study financial manias will tell you that the favorites during the bubble phase never lead after the bubble bursts. They will tell you lots of other stuff too, especially if you are next to them on a ski lift or in an airplane seat, but the point is, financials may have just turned in their best years for years. Sure, Citi shareholders might argue that they didn't see any bubble in that stock's price as it peaked right around the old 2000 highs. Bank's shareholders did better, but they never saw anything like the dotcom rocket charts of 1999. But there were plenty of big winners in the financial firmament, including Bear Stearns, Countrywide, other mortgage makers, mortgage lenders, mortgage insurers, bond insurers-turned-exotic financial instrument insurers and private equity owners wishing to cash in pre PI. There were also bubbles in private equity generally, hedge fund assets, hedge fund manager salaries, trading desk profits, investment banking bonuses, interior decorating businesses in the Hamptons, and confidence in a New Financial Era. Even if we can determine how much capital financial companies really have, and how much will still be around a year from now, the rules of the game are about to change. And it's hard to believe they will change in a way that allows for more risk taking, more leverage, more aggressive prime broker relationships, more pedaling of complex financial products to school districts, fewer disclosures, record earnings growth and higher multiples. Congress is already pitching more regulation of investment banks, particularly those taking advantage of the Fed's helping hand. Just last week Rep. Barney Frank mentioned the two words non-bank banks hate the most: reserve requirements and transparency. Ok, three words. And if investment banks are the Great Enablers, constraints on the big banks will crimp “financial innovation” across the board. And Wednesday, Treasury Secretary Paulson essentially announced that the pendulum that has been swinging toward crazier and crazier risk taking was about to reverse. Even though he was talking to the US Chamber of Commerce, a group that thinks the cock fighting industry can regulate itself, Hank spelled out some game changing plans for investment banks, at least for those who could decode what he was saying: Here are some excerpts: Thank you for inviting me to address your Capital Markets Competitiveness Conference. We share a commitment to competitive markets, and Treasury will soon release a Blueprint for Regulatory Reform that proposes a financial regulatory framework which we believe will more effectively promote orderly markets and foster financial sector innovation and competitiveness. Translation: There are so many regulations coming that we haven't even finished compiling them. Taking this step in a period of stress recognizes the changed nature of our financial system and the role played by investment banks in the post Glass-Steagall world. Look, we gave you guys a chance to do whatever you wanted and you embarrassed us. Now we're changing the rules. We think the utility industry serves as a good model. Such direct lending from the central bank to non-depository institutions has not occurred since the 1930s. Recent market turmoil has required the Federal Reserve to adjust some of the mechanisms by which it provides liquidity to the financial system. Their creativity in the face of new challenges deserves praise, but the circumstances that led the Fed to modify its lending facilities raises significant policy considerations that need to be addressed. And boy will we address them. These changes require us all to think more broadly about the regulatory and supervisory framework that is consistent with the promotion and maintenance of financial stability. Now that the Fed is granting primary dealers temporary access to liquidity facilities, we must consider the policy implications associated with such access. You know, like capital requirements. Collateral requirements. Disclosure requirements. Counterparty disclosures. And I'm just getting started. Historically, commercial banks have had regular access to the discount window. Access to the Federal Reserve's liquidity facilities traditionally has been accompanied by strong prudential oversight of depository institutions, which also has included consolidated supervision where appropriate. Certainly any regular access to the discount window should involve the same type of regulation and supervision. Have you noticed how often I'm using the word “supervision”? A properly designed program of deposit insurance greatly reduces the likelihood of liquidity pressures on depository institutions and as a corollary, makes the funding base of these institutions more stable. The trade-off for this subsidized funding is regulation tailored to protect the taxpayers from moral hazard this insurance creates. So we save your skins, you settle for earnings growth similar to Con Ed's. For the
non-depository institutions that now have temporary access to the discount
window, I believe a few constructive steps would enable the Federal Reserve to
protect its balance sheet, and ultimately protect taxpayers. Second, and perhaps most importantly, the Federal Reserve should have the information about these institutions it deems necessary for making informed lending decisions. If it's off balance sheet, bring it on. Despite the fundamental changes in our financial system, it would be premature to jump to the conclusion that all broker-dealers or other potentially important financial firms in our system today should have permanent access to the Fed's liquidity facility. Recent market conditions are an exception from the norm. At this time, the Federal Reserve's recent action should be viewed as a precedent only for unusual periods of turmoil. If we ever get of this mess, this will NEVER happen again. Bank on it. |
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Back in the
old neighborhood we played baseball in Tommy's backyard because he had the
highest fence. We used real bats but pitched a tennis ball to keep the
collateral damage in check. Eventually we decided our field was too cramped so
we moved around to the front. Sure, the risk that we'd destroy something was
greater, but the game was more fun. With the pitcher throwing from the middle
of the street, we even had a full-sized infield.