Good Reading -- June 2012
Facts and Figures
More than half of the companies in the S&P 500 have a higher yield than the 10-year U.S. Treasury. There are 271 stocks with a higher yield, 126 stocks with a lower yield, and 103 stocks not paying a dividend. (Note: data as of May 21 stock prices with the 10yr yielding about 1.74%; the number is undoubtedly higher with the 10-year at an all-time low of 1.558% on May 31). (Source, courtesy of Jason Zweig.)
The number of public companies listed on a U.S. exchange peaked in 1997 above 7,800. About three years later the combined market cap of those companies peaked above 130% of GDP. In 2011, those levels fell below 5,000 and 110%, respectively. (Source: The Economist)
The average home price in Canada in March was about $370,000, while in the U.S. it was about $203,000. [*] (Source: CREA and Case-Shiller)
Of the 19,000 corporate bonds that traded at least once during 2011, only 375 (~2%) traded every day.
Broker-dealer inventories of corporate bonds (i.e., bonds held on the balance sheet to facilitate market-making) fell by 50% in 2011 (Source: WSJ)
The stock market has more than doubled from its March 2009 lows, but trading levels are still falling. From its April 2008 peak of 12.1 billion, average daily trades in American stocks traded on all exchanges have fallen almost 50% to 6.5 billion in April 2012. (If you're wondering why NYSE's revenues aren't down comparably, or what's driving all this, have a look at the high-frequency trading firms.) (Source: Credit Suisse)
Electricity consumed (as measured by Kwh) fell by 4.7% in the U.S. during the first quarter (Source: EIA)
[*] Hint: the CAD is roughly at parity with the USD, and Canadian GDP and income per capita are slightly lower than those in the U.S, but Canadians are among the most leveraged consumers in the world with debt-to-disposable-income ratios above 150%. From 2002-2008, Canada's consumer credit grew twice as fast as America's; since then, America's consumer credit has declined while Canada's has continued climbing (at least until recently). Also,Demographia's 8th Annual International Housing Affordability Survey is an interesting read. Books
"The Alpha Masters: Unlocking the Genius of the World's Top Hedge Fund Managers" -- I was initially a little skeptical based on the title, but then I remember that the last time I was turned off by a book title using the world "genius," the book was so good it literally changed my career. This book similarly won me over. In a first for me I actually wrote a review of the book on Amazon, so I won't repeat that. But suffice it to say that the book is highly recommended. A video interview with the author is here and excerpts are here.
"How Will You Measure Your Life?" -- Clayton Christensen is out with a new book that I recommend. If it sounds familiar, the book is based on an article of the same title that I think I sent around two years ago and still recommend. The author is a good writer and a deep, balanced thinker, and this is a worthwhile read. Previews hereand here.
Attachments
Buffett in Beijing Report -- This is the inaugural issue of this newsletter so I can't really vouch for it, but the subtitle is "Global Value Investing Interviews and Insights," which is obviously a promising start. And this issue contains a very thoughtful discussion on China with a partner in McKinsey's Shanghai office that is definitely worth reading. A more recent edition is here.
"The Flaws of Finance" -- a great paper (based on a recent speech) by value investing guru James Montier.
"Man vs. Machine" -- an interesting study looking at "quantitative value" (Greenblatt style) backtested against recommendations posted to the Value Investors Club. (Thanks to a great blog, Greenbackd, for finding this.)
Links
"How Venture Capital is Broken" -- A look at the returns from venture capital investments via the Kaufman Institute (source paper here) and Cambridge Associates by Felix Salmon. "During the twelve-year period from 1997 to 2009, there have been only five vintage years in which median VC funds generated IRRs that returned investor capital… In eight of the past twelve vintage years, the typical VC fund generated a negative IRR, and for the other four years, barely eked out a positive return." I guess it shouldn't be a surprise that the very top VC funds do well and drive the reputation for the industry while the majority of funds are very poor performers, but I was still shocked at how bad those aggregate numbers are.
"Hedge Funds and Chapter 11" -- This paper from April's Journal of Finance looks at almost every large Ch. 11 restructuring from 1996 to 2007, finding that over 90% of them had "observable involvement by hedge funds." The authors show that when hedge funds hold leading creditor positions, companies under Ch. 11 protection tend to reorganize more and liquidate less while also replacing management more often; their conclusion is that hedge funds replace less rational sell/liquidate-at-any-cost creditors and thus improve overall net creditor recoveries. For any fellow distressed-debt nerds out there, this is a fascinating read. Summary here.
"The Frequent Fliers Who Flew Too Much" -- This is one of the more incredible things I've read in a while. I was vaguely familiar with the American Airlines' "AAirpass," which cost a small fortune but enabled essentially unlimited first class travel. What I didn't realize was that American used to sell those policies for life (and suffice it to say that they were a tad underpriced).
Daniel Kahneman at CFA Conference -- these are notes from a recent talk ("Psychology for Behavioral Finance") that Kahneman gave at a CFA conference. See here for the video. There is also video of a talk ("The Flaws of Finance") that James Montier gave at the same event.
"The Shipping News" -- a multi-page graphical look at the global shipping industry.
"The 'Perfect Hedge' Remains Elusive at JPMorgan" -- a good and balanced look at the challenges inherent in hedging and bank "risk management" by Andrew Ross Sorkin.
Eugene Fama -- Is Warren Buffett Lucky or Skilled? -- a very short video interview with the "father of modern finance," Gene Fama. "[Warren Buffett] is a businessperson, he's not an investor per se. He buys whole businesses. And I would imagine helps to run them. You don't buy a whole business and then not say anything." And later: "I don't know if Warren Buffett is lucky or just skilled. But I'd like to do the test, and I can't do the test just on him. I'd have to do the test on everybody to find out if he's unusual or not." No comment.
Articles
"Markets: Out of Stock" -- I find it shocking that Allianz has 6% of its gigantic insurance portfolio in equities and 90% in bonds. Anyway, there are some amazing datapoints in this article and the attached charts -- just be sure to take some of the commentary with a big grain of salt.
"China's Economic Crisis" -- this is a very good op-ed by Fareed Zakaria in which he just repeats the arguments of a new book, "Breakout Nations," by a Morgan Stanley fund manager. In any case, I believe this logic is sound -- China will have more successes than failures and it will continue to grow, but if it goes from 10% to 5% a year, that is going to feel like a crash to all the countries and companies who've been feeding at the China trough in recent years. As of 2010 data, China was about 16% of global (PPP) GDP, but it consumed half of the world's iron ore; more than 40% of the world's coal, lead, zinc, and aluminum; and more than a third of its copper and nickel. That is going to be a painful adjustment on the producers' side.
"Banks’ Hyper-Hedging Adds to Risk of a Market Meltdown" -- an op-ed by preeminent journalist Roger Lowenstein about the JPM debacle. There are a lot of good and nuanced arguments here and I won't dive into them all, but I would add that if we just cleared and settled CDS on a proper exchange a lot of the counterparty and systemic risk issues would be largely mitigated. That said, I think the larger points in this article -- hedging as a zero-sum game; hedging's questionable usefulness; hedging as a driver of volatility; the pervasiveness in banking of the trader's short-term mentality; the fallacy of hypertrading and the liquidity fetish; the ongoing problem of TBTF megabanks featuring private profits and socialized losses -- are extremely important and overwhelmingly valid.
Markets: Out of stock
By John Authers and Kate Burgess
The end of a six-decade passion for equities could lead to a less flexible, more conservative model of corporate financing
Nikhil Srinivasan, the man who decides where one of the world’s biggest insurance funds places its assets, wants to know why he should invest in stocks. “We are delivering what policyholders want,” says Allianz Investment Management’s chief investment officer, speaking from his Munich base. “So there is no need to get aggressive about equities.”
Allianz, with a total of about €1.7tn under management, has only 6 per cent of its insurance portfolio in equities, while 90 per cent is in bonds. A decade ago, 20 per cent was in equities. It is far from alone: institutional investors, from pension funds to mutual funds sold directly to the public, have slashed holdings in the past decade. Stocks have not been so far out of favour for half a century. Many declare the “cult of the equity” dead.
The consequences are already being felt. Even the mighty Facebook is finding it hard to raise equity capital. With equity financing expensive, many companies are opting to raise debt instead, or to retire equity. As equity markets shrink, so does the sway of the owners of that equity, reducing shareholder control over companies – and challenging accepted concepts of corporate ownership.
Further, with equity returns virtually flat for more than a decade, the incentive for investors to take risks by funding smaller, more entrepreneurial companies has declined – eroding a process that has traditionally given managers the flexibility they need to grow. Capitalism with less equity finance would follow a much more conservative model.
“Ultimately what is going on is that fundamental tenets of capitalist society are being questioned,” says Andreas Utermann, chief investment officer of the Allianz division that manages €300bn in assets for external clients.
He forecasts that this will lead to a big transfer from savers to “the profligate and irresponsible” as the benefits of long-term saving are eroded. “The risk is that there will be a backlash by savers. The [impact will be felt] societally, politically, at a regional level and globally. We are still at the beginning of the whole process.”
Compared with bonds, stocks have not looked so cheap for half a century. During this period, the dividend yield – the amount paid out in dividends per share divided by the share price, a key measure of value – has been lower than the yield paid by bonds (which moves in the opposite direction to prices). In other words, investors were happy to take a lower interest rate from stocks than from bonds, despite their greater volatility, reflecting their confidence that returns from stocks would be higher in the long run.
But now investors want a higher yield from equities. According to Robert Shiller of Yale University, the dividend yield on US stocks is today 1.97 per cent – above the 1.72 per cent yield on 10-year US Treasury bonds.
Some hope that the cycle is about to turn and that the preconditions for a new cult of the equity will emerge even if it takes time. Few people doubt, however, that the old cult of the equity – which steered long-term savers into loading their portfolios with shares – has died.
This is stunning in light of overwhelming evidence that, in the long run, equities outperform. From 1900 to 2010, they beat inflation by 6.3 per cent a year in the US, according to a widely used benchmark maintained by London Business School, compared with only 1.8 per cent for bonds. In the US and the UK, public pension funds had allocations to equities as high as 70 per cent only 10 years ago. They are now down to 40 per cent in the UK, and 52 per cent in the US
At least two critical factors have combined. First came two stock market crashes since 2000, which shook faith in equities. Second, institutions have faced growing regulatory and business pressure to withdraw from stocks.
Indeed, equities have not been so cheap relative to bonds since 1956, which turned out to be one of the best moments in history to have bought stocks. George Ross Goobey, the British fund manager who ran Imperial Tobacco’s pension fund, had announced to great scepticism that he was shifting his entire portfolio into equities, sparking the cult of the equity because dividend yields exceeded bond yields.
Some see similar reasons for long-term optimism today – at least once heavily indebted households and governments complete the process of deleveraging. Amin Rajan of fund management consultancy Create Research says: “Equities are now undervalued by any measure. There’s a big wad of money sitting on the sideline waiting for a green light on the debt front. We may see the mother of all rallies at the first hint of a credible breakthrough.”
This year Goldman Sachs published a widely read report arguing that: “Given current valuations, we think it’s time to say a ‘long good bye’ to bonds, and embrace the ‘long good buy’ for equities as we expect them to embark on an upward trend over the next few years.”
However, this argument is more about bonds than stocks. With the recent crashes preceded by great bull markets, stock performance in the past 30 years has not been historically unusual. But yields on US Treasury bonds peaked in 1981 and global sovereign debt prices have risen steadily ever since. Buoyed initially by the US Federal Reserve’s success in bringing inflation (the enemy of bondholders) under control, and more recently by their “haven” status as investors sought to protect themselves against risks elsewhere, government bonds are now more expensive than at any time in history.
The trend cannot continue much longer without yields on bonds turning negative – meaning investors would pay for the privilege of lending to the government.
Ian Harnett of Absolute Strategy Research in London says money could start flowing back into equities once bond yields start to revert to historically normal levels, which will mean investors sell bonds and look for a new use for their cash. But like others, he is reluctant to say the moment has arrived, as central banks and governments are still heavily pushing investors towards bonds. “We are still in politicised markets. And that means you’re gambling, because you don’t know what politicians will do next.”
Meanwhile, fund managers emphasise the increasing regulatory incentives to buy bonds, a phenomenon now known as “financial repression”. “Governments are trying to deleverage by stealth and encourage banks to own as much as they can of sovereign debt,” says Mr Utermann of Allianz: “With all the regulators are throwing at them, it has become more difficult to own risk assets.”
Indeed, in the decades around the bursting of the technology bubble in 2000 that first punctured confidence in equities, governments have changed tax treatments on dividends; insisted companies and banks value assets as they are traded in the markets rather than on the basis of models and assumptions; altered accounting rules on how companies value pension promises to employees; and prodded pension managers to buy bonds by forcing them to match their assets to future liabilities.
These developments have “generated a regulatory regime for pension funds and insurers that is heavily pro-cyclical”, says Keith Skeoch, chief executive of Standard Life Investments, one of the UK’s biggest fund managers, which controls assets of about £200bn. “Even as bond yields fall and prices rise, and equity prices fall,” he says, “the regime is forcing institutions to hold risk-free assets”.
The pressure to cut equity exposures is being felt across the savings industry. Alasdair MacDonald of Towers Watson, one of the world’s biggest actuarial firms, points out that the UK’s savings and retirement funds that use the traditional “with-profits” model, where a bonus for savers is declared each year, are also withdrawing from equities. This is despite the fact they are more risk-tolerant than insurance funds, are not being forced to “de-risk” and have less onerous solvency requirements.
And if equities were to bounce and bonds fall, such funds would be more likely to sell more equities rather than stock up. Mr MacDonald forecasts that equity holdings could halve again in the next two decades.
Meanwhile, company and occupational pension funds are being pushed out of equities. Traditional defined-benefit or “final salary” pension funds in the developed world are relinquishing equities under pressure from actuaries as schemes near maturity. The steady shift to defined-contribution pensions, which do not guarantee a set income and where individual savers must make investment decisions, has also led to lower equity weightings, as private investors tend to be more conservative.
Retail investors’ conservatism has also driven money out of collective investment funds. In the US, inflows to bond funds have exceeded equity inflows every year since 2007, with outright net redemptions from equity funds in each of the past five years.
For Mr MacDonald, the issue is whether there are sufficient bonds to satisfy all the demand that has been created for them. “Does it all add up? There are not enough bonds in the world,” he says. If so, exceptionally low bond yields could continue. That would delay the hoped-for big switch back into equities.
“Overall, the past 10 years have been horrid. The question is why equity markets have not been down more,” says Mr Utermann.
The answer is that reduced demand for equity has been answered by reduced supply. Companies are buying back their own stock, which often makes sense if valuations are too cheap, while investors force them into paying higher dividends. With interest rates low, acquisitions tend to be financed by debt, not equity, leading to a fall in the overall pool of equity.
According to Rob Buckland of Citigroup, who christened this phenomenon “de-equitisation” back in 2005, net equity issuance in the US was negative last year, as it was in Europe between 2003 and 2007. Across the developed world, equity issuance is far lower than in the 1990s, and has made only a feeble recovery since the credit crisis.
For Mr Buckland, this is “the logical response to the collapse in investor appetite for equities evident in the past decade”. But it also implies that capitalism as currently conceived, where corporate managers are responsible to their owners through the stock market, is under threat.
With fund managers under pressure to buy bonds – and companies content to adapt to this rather than create the conditions where equities might look exciting again – it is easy to see why they believe the next cult of the equity is still up to a decade away. For Mr Utermann, there is “no natural flow into equities” for the next five to 10 years. “The rules of the game have changed”.
Dividend payouts: Ross Goobey’s moment
Is this a Ross Goobey moment? George Ross Goobey, the manager from 1947 of Imperial Tobacco pension fund – then Britain’s largest pension scheme, is famous for overturning the orthodoxy that bonds were safe and equities too risky to hold in large quantities, writes Kate Burgess.
One of his first actions was to sell 2.5 per cent of Treasury stock, crystallising a 17 per cent loss as bond prices fell and postwar inflation set in.
Then in 1954, Ross Goobey argued publicly that company pension funds should invest 100 per cent in shares.
For most, that marked the beginning of the “cult of the equity”, which for more than half a century has shaped the relationship between savers, companies and stock markets.
In those days, baby boomers were in nappies and pension liabilities stretched out for decades. Ross Goobey believed the advantage of shares lay in companies continuing over those decades to pay dividends out of rising profits that would keep pace with rising inflation and wages.
Paul Marsh and Elroy Dimson, financial historians at the London Business School, warn that unless “you have perfect foresight on company dividend payouts” it is impossible to predict a single Ross Goobey moment.
After all, it took Ross Goobey five years to implement his plan, by which time share prices had moved higher.
This time, they say, maturing pension funds would still “use the opportunity to rid themselves of more equities” if equity markets rose.
“Even if you think the Ross Goobey moment is now, the message is that it is not for all investors,” say Mr Marsh and Mr Dimson.
China’s economic crisis
By Fareed Zakaria, Published: May 23
There has been much speculation about power struggles in China in the wake of the ouster of Bo Xilai, the powerful Communist Party boss of Chongqing who used populism, money and intrigue to rise to the top. Had he not been brought down this year — by a series of mistakes, revelations and bad luck — Bo might have rattled the technocratic-authoritarian system running the country. China might well survive its political crisis, but it faces a more immediate challenge: an economic crisis.
Every year for two decades, experts have told me that China’s economy was set to crash, felled by huge imbalances and policy errors. They would point to non-performing loans, bad banks, inefficient state-owned enterprises and real estate bubbles. Somehow, none of these has derailed China’s growth, which has averaged an astonishing 9.5 percent annually for three decades.
Ruchir Sharma, who runs Morgan Stanley’s Emerging Markets Fund, makes a different and more persuasive case in his new book, “Breakout Nations,” pointing not to China’s failures but to its successes: “China is on the verge of a natural slowdown that will change the global balance of power, from finance to politics, and take the wind out of many economies that are riding in its draft.” Evidence is accumulating to support his view.
China’s growth looks remarkable. But it isn’t unprecedented. Japan, South Korea and Taiwan all grew close to 9 percent annually for about two decades and then started to slow. Many think that China’s fate will be like that of Japan, which crashed and slowed down in the 1990s and has yet to boom again. But the more realistic scenario is Japan in the 1970s, when the original Asian tiger’s growth slowed from 9 percent to about 6 percent. Korea and Taiwan followed similar trajectories.
What caused these slowdowns? Success. In each case, the economy had produced a middle-income level. It becomes much more difficult to grow at a breakneck pace when you have a large economy and a middle-class society.
Sharma does the math: “In 1998, for China to grow its $1 trillion economy by 10 percent, it had to expand its economic activities by $100 billion and consume only 10 percent of the world’s industrial commodities — the raw materials that include everything from oil to copper and steel. In 2011, to grow its $5 trillion economy that fast, it needed to expand by $550 billion a year and suck in more than 30 percent of global commodity production.”
All the factors that pushed China forward have begun to wither. China became an urbanized country last year, with a majority of its people living in cities. The rate of urban migration has slowed to 5 million a year. This means that soon the famous “surplus labor pool” will be exhausted. This decade, only 5 million people will join China’s core workforce, down dramatically from 90 million in the previous decade. And thanks to the one-child policy, there are few Chinese to take the place of retiring workers.
Sharma’s picture is largely shared by the Chinese government. For years the leadership in Beijing has been preparing for a slowdown. Premier Wen Jiabao argued in 2008 that China’s economy was “unbalanced, uncoordinated and unsustainable.” He sounded a similar note this week, calling for government measures to stimulate the economy.
In some ways, China still has a lot of gunpowder in its arsenal. Its central bank can lower interest rates and the government can spend money. But even its firepower has limits. Sharma argues that on paper China’s debt to gross domestic product is a modest 30 percent but that when you add up the debt of Chinese corporations, many of which are government-owned, the numbers look alarming. The government will spend more on infrastructure but will get diminishing returns for these investments. Chinese consumers are spending more but — in a country with no safety nets and an aging population — saving rates will remain high.
Sharma predicts trouble for countries that have been buoyed by a booming China — from Australia to Brazil — as its demand for raw materials drops. He even predicts a decline in oil prices, which, coming on top of the shale boom, should worry oil-producing states everywhere.
As for China, Sharma suggests that 6 percent growth should not worry the Chinese; these would be enviable rates for anyone else. The country is richer, so slower growth is more acceptable. But China’s authoritarian regime legitimizes itself by delivering high-octane growth. If that fades, China’s economic problems might turn into political ones.
comments@fareedzakaria.com
Banks’ Hyper-Hedging Adds to Risk of a Market Meltdown
By Roger Lowenstein - May 28, 2012
JPMorgan (JPM) Chase & Co.’s lost billions remind us that modern finance has changed the world, and not in ways that we should celebrate. Nothing demonstrates this more than the use of hedging.
It is debatable whether hedging makes individual banks such as JPMorgan “safer,” and very debatable whether it makes them, on balance, more profitable over time. But even supposing that hedging does, or can, assist individual firms, their trading has an unseen and pernicious effect on markets overall. Just as football players armed with kryptonite-strength helmets hit more aggressively, leading to more concussions, hypertrading by firms -- each thinking of their own preservation -- has exposed markets to meltdowns and routs.
Market participants themselves are mostly unaware of their effect on the group because they have grown up in a culture that celebrates trading -- hedging, in particular. The attitudinal change, fostered by technology, has been gradual but vast, and only visible if one steps back and remembers how things were.
Let’s go back a generation, and drop in on the leading banker of the day (we’ll call him Old Jamie). Old Jamie lives in a world with few options for dealing with risk. Suppose that Old Jamie and his team are pouring martinis on a Friday afternoon when the house economist wanders by. “Sorry boss,” the economist says, “but Europe is looking bad. Some of our drachma, franc and lira loans might be underwater.”
“Well,” Old Jamie ventures, staring at his olive as if in search of a solution, “is there a way we can sell these loans?” “No, sir,” his economist says. “You see, other people think Europe is slowing down, too. To be honest, I read about it in this morning’s paper.” “I see,” says Old Jamie, who is thinking he will need a second martini. “Well, I guess we’ll have to take some losses.”
Few Alternatives
And in truth, Old Jamie had few alternatives. Today’s world is vastly different. Let’s review what has been reported about the present-day Jamie Dimon, chief executive officer of JPMorgan. This Jamie has loans in Europe, too. Last summer, you will recall, people were saying the Europeans owe too much money and don’t work enough to pay their debts. This isn’t news to anyone who has ever been to Europe, where the people spend most of their time discussing philosophy in cafes. But when some economists -- probably after having vacationed in Europe -- noticed this, they forecast a debt crisis and a recession. Instead of sitting on its prospective losses, as the old Jamie did, the new Jamie (or rather, his traders) bought insurance.
Of course, JPMorgan didn’t buy regular insurance, such as a policy from Allstate Corp. or State Farm. It bought credit- default swaps tied to an index of corporate bonds. If the bonds went south, according to what has been reported, JPMorgan would collect on its synthetic policy. But if they didn’t, the bank would keep making premium payments, in effect forgoing the profits from European and possibly other loans. (The exact strategy was complex and hasn’t been fully disclosed, but clearly the bank was worried about Europe and possibly spillover effects in North America, too.)
Now some months went by, and Jamie’s economists are not so worried anymore. By now their summer vacations are just a distant memory. So the bank decides it really does want exposure to corporate bonds -- storm clouds in Europe or not. It writes new contracts in which it will receive money if certain corporate bonds hold their own, but it will, of course, pay out if they go under. In a perfect world, the two sets of derivatives cancel each other out -- that is the meaning of the term “hedge.”
’Stupid’ Trades
But the world isn’t perfect -- not even for a trader at JPMorgan. Certainly, the bonds underlying JPMorgan’s opposing hedges weren’t a perfect match, and on a net basis, the bank, it would seem, ended up with exposure to Europe. Now, on toward spring, people are getting nervous again. Maybe they are planning another vacation to Paris or Seville. European government and corporate bonds go back in the tank, and JPMorgan loses $3 billion and maybe more.
Give Jamie credit for describing complex trades with a word you’d hear on the playground -- “stupid.” He didn’t say what, exactly, he was referring to, but one can guess. That second set of trades -- when JPMorgan was using the derivatives market to sell insurance -- was clearly a speculation. And if I were writing the regulations to implement the Volcker rule, which prohibits proprietary trading by banks, I would bar any bank from ever selling a credit-default swap. If you want to gamble, go to a casino. If you want to sell insurance, get a license from the state commissioner (who, by the way, will regulate your capital).
Now, the other part of JPMorgan’s trade, the initial one, when it purchased credit-default swaps, is a little more interesting. What JPMorgan and other banks say is that this isn’t speculating, it is risk reduction: hedging. And the Volcker rule, apparently, would permit such trades.
Of course, JPMorgan doesn’t own the exact bonds it is buying insurance on. It is buying protection on some corporate bonds that it thinks are almost always -- well, usually -- going to move in the same direction as the loans on its books. Of course, there is always the chance that JPMorgan doesn’t own such a portfolio of loans and that it is just speculating. Certainly, that is what some -- actually, most -- people in the CDS market are doing. But let’s assume Jamie is doing what he says: hedging.
Here’s the problem. In the era of Old Jamie, if someone in Europe wanted to borrow money, and if Jamie was a conscientious banker, he had to think long and hard about whether the customer was a good risk. In all likelihood, those customers would be with him for a long time.
Relaxing Credit Standards
The new Jamie, and the people working for him, don’t have to worry quite so much. They know that if they become uncomfortable with the loans they can always hedge them in the derivatives market. I have heard this offered as a defense of credit-default swaps from executives of JPMorgan. Were it not for the ability to hedge, they wouldn’t make all the loans they do. Hedging becomes an excuse for relaxing credit standards.
There’s another problem. When JPMorgan hedges, it doesn’t get rid of the risk. That only happens when the customer repays the loan or, say, improves its balance sheet. JPMorgan’s hedges didn’t make the risk disappear; they merely transferred it to someone else.
Jamie had an escape hatch, but hedging doesn’t offer an escape for markets as a whole. To sum up, thanks to these instruments, banks take more risks than they otherwise would and thus more risky bets are collectively owned by society. Only now the traders who set the market price are removed from the credit itself. In the past, Jamie and his team knew the borrower and evaluated the credit (the original J.P. Morgan Sr. famously testified that an individual’s “character” was the basis of credit).
JPMorgan still issues loans but with half an eye on their “hedging” potential, that is, on the willingness of traders who may be halfway around the globe to assume the risk. These traders are less well-placed to evaluate the risk. They don’t know the customer and, of course, they haven’t the faintest concern for character. By habit and preference, their involvement is apt to be brief.
They assume risk by writing a swap contract in the full knowledge that they can unwind it via another swap days or even hours later. Someone may get stuck with the bad coin but, each trader is certain, it won’t be him or her. So the approach of these traders is inherently short-term -- too short to invest the time and effort to evaluate the risk. Too short, we might say, to really care.
The plasticity of modern finance -- the ease with which institutions can transfer risk -- is a major cause of the heightened frequency of meltdowns and increased volatility. As with a saloon in which each gunslinger comes armed (and with the safety catch released), markets resemble a shooting gallery in which risk takers, each in the name of self-defense, put the group in peril.
Housing Bubble
Faith in the ability to transfer risk (such as from mortgage bank to securitization firm to investors) was a major contributor to the housing bubble. In that case, transferring risk was a polite term for passing the hot potato. American International Group Inc., which famously sold credit-default swaps, was simply the firm holding the most potatoes.
I doubt it’s possible to revert to the world of Old Jamie. Pundits criticize banks for investing in bonds and putting on hedges instead of making loans. In reality, modern bankers make no distinction. They live in a supple world, where every loan, trade or hedge is simply an exercise in risk transference. Inundated with data -- much of it ephemeral -- they are prone to overreact and overtransact, tilting their behavior away from analysis of long-term credit risk and toward the mentality of traders.
Bankers are no different from investors in their short-term focus. We are horrified when bankers lose $3 billion, but the hedging mentality has also corrupted investors who shrink from a commitment, finding shelter in a hedge, which Wall Street peddles in many varieties, including the hedge of extreme and excessive diversification.
To be meaningful, reform would have to change the culture, as well as the rules, but here’s a start: Shut down the credit- default swap pits. Let bankers ply their trade without the deceptive safety of hedging. Let the speculators bet on something else.
(Roger Lowenstein is the author of “When Genius Failed: The Rise and Fall of Long-Term Capital Management.” He is an outside director with the Sequoia Fund. The opinions expressed are his own.)