I am more than a bit late to this item, namely, an op-ed piece, “Our Risky New Financial Markets,” by Henry Kaufman in the Wall Street Journal on Wednesday.
I’m puzzled at the lack of commentary on this article in the blogsphere. Kaufman, as chief economist of Salomon Brothers during its heyday in the 1980s (and then nicknamed Dr. Doom), was far and away the single most thoughtful and influential commentator on the fixed income markets.
Unlike many people whose fame is associated with a particular period in time, Kaufman has not remained locked in a dated perspective. While most people who natter about the state of the markets mainly rehash the same observations and opinions, Kaufman offers new insights.
An article he wrote last month in the Financial Times focused on how the distinction between liquidity (having assets one can monetize readily) and access to credit had been blurred. In this article, he touches on that theme while describing how structural changes in the markets have encouraged imprudent risk-taking. He also point a finger at the current regulatory framework which does nothing to discourage speculation and worse, steps in to bail out institutions too big to fail, which would now include major Wall Street players (Bear is too small to make the cut). He also takes a dim view of the enthusiasm for modeling, since models break down in stress periods.
Perhaps no one wants to listen because his conclusion is ahead of its time:
At the heart of the long-term underlying challenges that face the U.S. financial system is the question of how to enforce discipline. One way is to let competitive forces discipline market participants: The manager who performs well prospers, while those who do not fail. This is the central precept of free market economies. But this approach is compromised by the fact that advanced societies typically do not allow the process to follow through when it comes to very large financial institutions. The fear is that the failure of behemoth financial institutions will pose systemic risks both here and abroad.
Therefore, market discipline falls more heavily on smaller institutions, which in turn motivates them to merge into larger entities protected by the too-big-to-fail umbrella. This dynamic has driven financial concentration and will continue to do so for years to come. As financial concentration increases, it will undermine marketability, trading activity and effective allocation of financial resources.
If competition is not allowed to enforce market discipline, the most viable alternative is increased supervision over financial institutions and markets. In today’s markets, there is hardly a clarion call for such measures. On the contrary, the markets oppose it, and politicians voice little if any support. For their part, central bankers do not possess a clear vision of how to proceed toward more effective financial supervision. Their current, circumspect approach seems objectively technical, whereas greater intervention, they fear, would seem intrusive, subjective, even excessive.
What is missing today is a comprehensive framework that pulls together financial-market behavior and economic behavior. The study of economics and finance has become highly specialized and compartmentalized within the academic community. This is, of course, another reflection of the increasingly specialized demands of our complex civilization. Regrettably, today’s economics and finance professions have produced no minds with the analytical reach of Adam Smith, John Maynard Keynes or Milton Friedman.
It is therefore urgent that the Fed take the lead in formulating a monetary policy approach that strikes the right balance between market discipline and government regulation. Until it does so, we will continue to see shocks of even greater intensity than the one now radiating outward from the quake in the U.S. subprime mortgage market. .
Kaufman’s views are consistent with those of former Australian Reserve Bank Governor Ian MacFarlane: we are at the end of a regulatory paradigm and need a new regime. MacFarlane has simply surfaced the problem that central bankers do not have a clear mandate to deal with asset bubbles, even they may be the inevitable result of the low interest rate environment that is now recognized to be a tonic for economic growth. Kaufman goes further to say we likely need a tighter regulatory regime.
If Kaufman is correct, things will have to get considerably worse for adequate remedies to be implemented. The faith in minimal regulation is deeply held and it will take a major crisis to shake it.
There might be a mistake in the text of the op-ed piece. I think parts of it are posted twice.
Thank you so much for this blog! I think it is terrific.
Thankyou for intro of Kaufman.
He looks to be/have been correct in his focus on securitisations dangers and their evolution.
From his 1986 book, Interest Rates, the Markets, and the New Financial World:
“Increased “securitization” of credit obligations is another development that has had unfortunate consequences…what was a “private” loan becomes part of a “public” marketable security. This loosens the link between creditor and borrower. In a nonmarketable relationship, the creditor is tied to the borrower for the life of the loan; of necessity, under these circumstances, credit scrutiny at the inception of a loan or investment is likely to be quite intensive. The same degree of credit investigation is not likely to take place when the relationship between lender and borrower is to be temporary. In a securitized arrangement, many market participants fail to distinguish between the essence of liquidity and marketability. Liquidity means being able to dispose of a financial asset at par, or close to it, while marketability provides the holder an opportunity to sell at some price. The illusion of marketability is that holders believe they will be able to sell their investments before a significant deterioration in credit quality is generally perceived. Thus the initial pressure to be highly circumspect in the creation of the obligation is absent. A world of relatively unrestrained credit growth is also encouraged by the use of credit lines and guarantees. These assurances lead investors to make commitments based on the strength of the guarantor and not on that of the borrower… The heroes of credit markets without a guardian are the daring – those who are ready and willing to exploit financial leverage, risk the loss of credit standing, and revel in the present casino-like atmosphere of the markets.”
It actually appears that at present “marketability” has been confused with his definition of “liquidity” i.e. that the fact that there has been/is a ready market, means one can transact quickly and therefore have liquidity (or the ability to transact at close to par). Liquidity risk has completely disappeared (liquidity illusion) and led to insufficient overcollateralisation and maturity mismatches.
Is this due to structure or to stage in cycle?
Thanks for pointing out the glitch (now corrected) and the earlier Kaufman quote. It must be frustrating for him to have seen early how this was likely to end in tears and to have been ignored.
Kaufman believes that the problem is structural (which makes it much harder to solve), that investors are using liquidity as an answer to risk in two ways: they use market prices to help them assess risk (risk spreads and price trends provide useful information) and liquidity itself lets them assume more risk, since investors collectively believe they can always sell out if things get bad. As Kaufman reminds us, in the bad old days, banks and many investors expected to hold assets to maturity, It was inflation that led bond investors to start trading more as the real value of their assets suffered.
Now Hyman Minsky (and more recently Martin Wolf) would say what we are seeing is cyclical, that capitalism is prone to booms and busts. I imagine Kaufman’s response would be that regulators have a responsibility to modulate this process, and they’ve been largely absent (and perhaps even acting as enablers).