September 28, 2008

Investment Gambling's Cliffhanging Hangover

This NYT article on credit-default swaps explains a lot. It shows that much of the collapse was due to this market, which is actually simply an insurance against a given financial firms' default on a loan from another firm. Speculators can actually purchase swaps without even issuing a loan to the firm they are insured against. This of course (like short-selling) creates an interest in market failure. And as the market becomes more volatile and investors predict that a firm will not make good on its loans, purchasing swaps against it becomes more and more expensive.

Just to give you an idea, even with the decline, the volume of swaps on the market is three times the debt total. That explains a lot about Paulson and Bernanke's sense of urgency.

Dizzying.

And fascinating on several levels. First, the article and chart above show that the swap market dropped significantly at the start of '08. Why? Could it be that many investors decided to be more conservative, seeing the economy in trouble? Or is it--what I suspect is more likely--that swaps were getting prohibitively high (due to market fragility) to be a good investment? Basically, market saturation of default swaps. Perhaps a bit of both?

It's also culturally interesting to reflect on the general attitude toward gambling in this country. We seem to have an entirely dysfunctional or schizoid attitude about it; damning it as immoral in most places, yet encouraging it at the highest levels of banking.

Short selling and third-party default swaps are perfect examples of this. I also, personally think that bank stock should not be publicly traded. The way it used to be until the mid-twentieth century. Interestingly, Goldman Sachs was the last to cave on this and is still the strongest left standing. Evidently, this is largely the result of its continued conservative behavior. Unlike the other firms it continues to hold majority stake in its own stock.

Morgan Stanley is the only other large firm left standing now, and both have chosen to become more-regulated as bank holding companies, which will have to invest more conservatively as traditional commercial banks must. As the last link above states, Goldman Sachs now has only $1 of capital for every $22 of assets, while Morgan Stanley has $1 for every $30. By contrast, Bank of America’s has less than $11 for every $1 of capital.

That seems like a great start.

As a side note, I'm not sure why Morgan Stanley has remained so strong. It could be that it was not so highly leveraged. It also got itself bailed out late last year with 5 billion from a Chinese firm. And managed high-profile IPOs such as Apple's and Google's--the largest in history.

I wish I knew more about how the government plans to regulate Goldman and Morgan now as holding companies. But from what I can tell, this is all in flux right now, as is the general bailout proposal. Another question is will the other smaller bailed-out banks be able to return to lesser-regulated status when the market rebounds?

At least they won't be able to gamble as much, and the government will retain some amount of equity in return for its investment--at least that's what the democratic congressional majority is requiring. Congress could also ban the bundling and reselling of debt, which in a bull market can create an interest in issuing risky loans. That's what Barney Frank, Chairman of the House Financial Services Committee, has been suggesting.

Here's an excellent recent interview with him on Charlie Rose. He's so witty and down to earth. Clearly a formidable intellect and openly gay to boot. It's nice to have someone of that caliber and flare in the mix. Too bad we don't have a whole lot more like him. He's been called the smartest and funniest member of congress.