Steven Pearlstein
Washington Post Columnist
Wednesday, November 1, 2006
11:00 AM
Washington Post business columnist Steven Pearlstein was online Wednesday, Nov. 1 at 11 a.m. ET to discuss new rules the SEC is quietly implemeting on hedge funds.
Read today's column:
A transcript follows .
About Pearlstein : Steven Pearlstein writes about business and the economy for The Washington Post. His journalism career includes editing roles at The Post and Inc. magazine. He was founding publisher and editor of The Boston Observer, a monthly journal of liberal opinion. He got his start in journalism reporting for two New Hampshire newspapers -- the Concord Monitor and the Foster's Daily Democrat. Pearlstein has also worked as a television news reporter and a congressional staffer.
His column archive is online here .
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Laurel, Md.: Now, what kind of risk would the failure of something like Amaranth have on the general financial system? It's at least dubious whether the 1929 stock market crash did anything to CAUSE the great depression, as opposed to simply being symptomatic of the same underlying factors. The failure of Long Term Capital Management and Barings options trading operations didn't disrupt the financial system.
If a private investment firm can fail without triggering financial panic or taxpayer bailout, I'd tend to let them do what they want. The $6 billion Amaranth lost didn't vaporize -- other people profited those $6 billion. What's the loss?
The one part that does concern me is the trend to blur the distinction between banks and investment firms. Would the new proposals possibly make the taxpayer liable for the losses, like if they invoked FDIC guarentees?
Steven Pearlstein: Your points are all well put, and are similar to those I hear all the time now. We've had all sorts of failures of financial firms, from Drexel Burnham back in the late 80s to a couple of hedge funds in the last month. Even Long Term Capital. And still the financial system was able to absorb these negative shocks with no, or little, intervention from the Fed. So why not let these rich guys take whatever chances they want, with as much leverage as they want, and get the advantages of efficiency and risk taking without any significant risk to the global financial system?
Sounds pretty convincing, I have to say. And it will be the correct view right up until its not. That's the job of federal regulators: to be worry warts, not just about a reprise of past crises, but a new type of crisis that nobody has seen yet.
I think I'm pretty practical about this. I'm for some measure of deregulation, and certainly for updated and flexible regulation. What I'm not for is self-regulation, which I think is just silly. And that's the new mantra the the industry is hoping to get to, with the help of ideologues like Alan Greenspan and Wendy Gramm and, I fear, Chris Cox.
It is true that the new many new financial instruments Wall Street has come up with have allowed us to price and spread risk in ways that contribute to the robustness of the financial system and its ability to absorb shocks. That means we don't need to worry so much about many of the same things we used to worry about. But it also means we need to worry about new things we never had to worry about, like the interaction of various markets and trading counterparties. We haven't had a real financial meltdown since all of these new products have been developed, so we simply don't have the experience that would allow a computer model to predict them in the future. So now when I hear about all the computer models that supposedly can manage all the systemic risks, I think there is cause for being more than a bit suspicious.
I guess my point is that we have already had a big increase in leverage in the financial system. So at this point, going to the next increment of leverage is probably going to have some diminishing returns, with a significant step up in the risks. Why don't we slow down a bit, digest the tremendous changes we are already seeing (hedge funds have gone from a speck on the financial system to a driving force in less than a decade), and move a bit more cautiously. Let's be practical, not ideological.
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Washington, D.C.: Some short investors take a position in a company's stock and then work the press and/or regulators to bring attention to a problem at the company to stimulate a correction in value. This technique has been an important part of the uncovering of big problems, e.g., Enron. Why isn't this price manipulation?
Steven Pearlstein: I think, on the face of it, it is market manipulation. The question is whether it is a bad thing, and whether it is illegal market manipulation. If I run a company and I give a speech explaining why the future looks bright for XYZ Corp., I am also manipulating the market, in the same sense. But we probably don't want to make that illegal. So there are all these rules about who can say what, when. I'm not sure its wholely satisfactory, this arrangement, but there it is.
Then there is the example in today's column, of a hedge fund that so dominates the trading in a particular instrument that, when the price starts to decline, he uses his financial clout to buy so many more of the instrument that he props up the price. Is that simply doubling down and having faith in your original investment. Or is it market manipulation akin to cornering a market?
This is why securities lawyers get paid more than newspaper columnists.
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Arlington, Va.: Thanks for taking my question, Steven.
If margin regulations are relaxed, could we be on the road to another stock market crash followed by a major recession? Why does no one seem concerned about this?
Steven Pearlstein: I wouldn't overstate the case. I would also say that we can certainly relax marging requiremetns for some type of investments, but maybe increase them for riskier types of investments. But the proposal from the industry is a one-way ratchet. They only want to decrease margin requirements, or eliminate them, for everyone, every type of investment, in every instance. You'd have a hard time coming up with a single example where anyone's margin requirements would increase under their system.
Now, can we prove beyond a reasonable doubt that excessive leverage is the biggest or only cause of market bubbles, and that market bubbles always lead to market crashes, and that market crashes always lead to economic dislocation. Of course not. But anyone with an open mind and open eyes can see that leverage certainly turbocharges market movements -- why do you think investors like it. That's why its called leverage. And that raises, it seems to me, the legitimate public policy question of how much leverage in the system is optimal for longterm growth and economic security for broad swaths of the population. In the end, this is an issue that pits the ability of Wall Street wise guys to make huge gobs of money versus the desire of large number of people to have a stable economic future. There's a tradeoff there, no doubt about it, and I wouldn't want to go too far in either direction. But the right answer is not trading off all economic security for maximum market efficiency. Efficiency and overall wealth creation is not the end all and be all of economic policy.
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Phoenix, Ariz.: I see the SEC's latest move as further evidence that the United States has departed from a production based economy that makes goods and balances trade by selling things that others want in favor of an asset based economy in which balancing trade no longer matters because market liquidity drives the value of intangible and tangible assets ever higher so that consumers feel wealthy and are stimulated to consume at levels well beyond their real income gains. Doesn't economics teach that true wealth can only be created by those who own the means of production? Your comments, please.
Steven Pearlstein: No, I don't think economics teaches that. That's a sort of Marxist view of things. I do think you raise an important point, which is that finaicial flows can swamp trade flows in the new global economy, which has allowed for huge macroeconomic imbalances, like China's trade surplus with the U.S. This is a relatively new phenomenon but not one to which economic thinking or policy apparatus has adjusted.
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Washington, D.C: Will President Bush be able to have any influence over the hedge fund deregulation process? Do you think he will be against it?
Steven Pearlstein: His influence is appointing Hank Paulson as Treasury Secretary and Chris Cox as SEC chairman and a CFTC that is utterly captive of the futures industry it is supposed to regulate.
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Bowie, Md.: Are you familiar with a book called "Fooled by Randomness" by Nicholas Taleb It's a pretty heavily mathematical commentary on option and future trading.
One of the author's main points is this: a lot of option trading strategies involved weighing the risk of a "black swan" (basically, a change so big the computer models had assigned it effectively zero probability). One can bet either on or against the black swan showing up.
Now, experience has taught that black swans do come up more often than predicted. But professional traders usually bet against them, because otherwise they'll show many small losses and be fired. So in microcosm, the guy at Amaranth figures if he's going to lose his job anyway, he might as well lose his employer $6B, too.
Is this essentially the problem with hedge funds "working until they don't?"
Steven Pearlstein: Yes. You should become an economics columnist. You've explained it well and concisely.
Let me give you a variation on that, which comes from Dr. Greenspan. Greenspan's view is that the regulatory system should be asymetric, in that it should allow and encourage the wise guys to bet against the Black Swans, and earn extra returns in 49 out of 50 years because of it. And in the 50th year, the swan will arrive, but Dr. Greenspan and the Fed will ride to the rescue and "save" the system. That's why we have a Fed, he argues, as the lender of last resort, etc. etc. And that's a cheaper way, he argues, in the long run to deal with really bad and unforseen situations than taking out insurance against it year after year in the form of restrictive regulations. Over the long run, he would argue, you have more innovation and more economic growth.
This is a variation of the old folk wisdom that if you never miss a flight, you're probably wasting too much time in air port waiting areas. As a matter of theory, that's probably right. But what it ignores is the wisdom of behavioral economics, which is that people actually put a high value on avoiding the occasional big, bad outcome, which causes them to buy more insurance than a purely rational, income maximizing homo economus would. But that's what makes us human. Its what we prefer. And its what Dr. Greenspan and his fellow deregulators consistently forget.
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Laurel, Md.: Thank you for the thoughtful answer to my first question, but I'm still a little vague on what I consider the most salient point:
When margined investments fail, who other than the principals are at risk of losing THEIR money? Does the public lose due to deposit guarantees or bankruptcy protection? Or only direct creditors who knew (or should have) their risk?
Steven Pearlstein: The lender loses, and if the lender loses too much and goes bankrupt, then others lose. So, the first line loser if too much margin lending is done would be the brokerage and its investors. But if the brokerage is big enough, the government would probably step in because it was too big to fail -- that is its failure would pose a risk to the financial system. So the Fed would arrange a sale to another brokerage under a deal that would assure it wouldn't lose money. And the Fed (ultimately the taxpayers) would be on the hook for some of the longterm loss).
For a bank, it would be its shareholders and, after them, other banks that pay into the FDIC insurance fund, and after that, the taxpayers.
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Tampa, Fla.: Two points:
(1) Just because the Amaranth didn't fail doesn't mean the next failed trading strategy won't. The risk is not that a particular investor will lose his shirt. The risk is he will default on his obligations. This could trigger a wave of default by his counterparties. Look at the credit default swap market. It has a notional volume of $20 billion now, according to BIS and ISDA. This dwarfs the bond market. Hedge funds are among the largest players in the CDS market. What happens when a couple of hedge funds who sold protection on a particular issuer default when the issuer suddenly and unexpectedly defaults? The counterparties will have hedged their risk, and will be looking to their counterparties. If some of them fail as well, the bond market itself could become more volatile. So this is much more than a bunch of kids with zits in Greenwich losing their made-to-measure shirts. The NY Fed was quite aware of this when Long-Term failed. And now the risks are potentially even worse, given the lack of liquidity in some of the derivative markets. Remember that these are almost all OTC contracts, at least in the USA (unlike Europe). There is not much transparency in these markets, so who knows what will happen. Why gamble?
(2) Why not tie the margin requirements to the BIS capital standards? The BIS takes into account the risks of the various derivative instruments and requires banks to reserve against capital accordingly. The higher the BIS risk weighting, the higher the margin required.
Steven Pearlstein: Its good to hear from someone who really knows more about this than the rest of us. Using the BIS standards is a good idea -- it was what I was getting at when I suggested in today's column that the lending rules/margin requirements should be the same across all lenders, be they brokerage firms or banks.
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Alexandria, Va.: I like your columns! It's the only one in the paper that tells me something I didn't know.
Steven Pearlstein: Thank you so much. That's the highest compliment you can give a columnist.
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Silver Spring, Md.: In reference to today's column.. is that not a reality across the board in our over-debted economy? With the average personal credit card debt at how many thousand per person? The share of the national debt for every man, woman and child being higher than that. The recent(ish) moves by our federal government to remove more and more personal bankruptcy protection. Home ownership getting out of reach of more and more working folk because of outrageous real estate prices, driven largely by low interest rates implemented to "kick start" the economy. And the list goes on... Is your analysis not equally true of the economy in general? Was the past four years of fueling the economy perhaps a bad idea? Did it create a society of out of control consumers with historically astronomical debts in the name of better GDP?
Steven Pearlstein: A very good point, and one I had hoped to make myself, if I hadn't run out of time and space last night. This excessive leverage in the financial system is symptomatic of the excessive leverage in our economy these days, from credit card debt to the federal debt. Its true that, given all the new financial instruments and the globalization of the economy, we can probably now safely absorb more debt than 25 years ago. But there is a sense that you have, and I have, that we've gone too far in that regard, and its time to pull back now, while we are still in good shape. Because if we wait to get the balance right until the economy is in a bad way, it will be a particularly painful process.
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Annapolis, Md.: Have you heard of a German best-seller "World War for Wealth: The Global Grab for Power and Prosperity" by SPIEGEL editor Gabor Steingart?
There are excerpts on the Internet, and a very interesting, international interpretation of the global economy and the diminishing role of the US. I hope it gets translated into English.
Steven Pearlstein: I know of Steingart, but not the book. And I'm afraid I'll have to wait until it comes out in English.
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Burke, Va.: On the Great Depression: I got the impression from my history books that a lot of the effects of the great depression were caused by Banks calling their loans causing people to loose their houses and Banks having a run on their saving causing people to loose their saving (causing less purchasing)and stop putting their money in banks.
Is there a possibility that unregulated hedge funds could cause similar problems?
Steven Pearlstein: The chain of events that lead to the Great Depression probably started with the stock market crash and ended with the bank failures that dried up credit and robbed many families of their savings. And in there somewhere was a whopper of a policy mistake by the Fed and other central banks around the world.
The point about the hedge funds is that they are knee deep in some recent financial bubbles that have many of the characteristics of the stock market of 1928. And one of thsoe characteristics is excessive leverage. The margin requirements were put in during the New Deal, after the market had already crashed, to prevent that chain of events from happening again. Obviously, a lot has changed in the world since then, and the rules probably do need to be updated. But there is a line of thinking in the fianncial services industry, supported by some academics, that there is no such thing as excessive leverage and that margin requirements do nothing other than make the markets less efficient in the allocation of capital. That's where I get off the deregulatory train.
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Steven Pearlstein: I guess we've exhausted the public interest in margin requirements, at least for this week. Hope to see some of you next week. Thanks.
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