A wry and informative article, “Slicing and dicing risk rebounds on banks,” by John Dizard at the Financial Times tells us that newfangled investment vehicles considered to be a good thing because it moved risk assumption away from large banks (and therefore ultimately central banks) to the wealthy. But Dizard explains the rich were too smart to do that, and losses of the financial sector will be socialized as they have been in the past.
From the Financial Times:
Hedge funds and their related speculative vehicles are now so identified with engorged private wealth that we forget that a few years ago the policy tribe saw them as a tool for the general public’s interest. In the late 1970s and early to mid-1980s, the big worry among central bankers and the like was that too much risk was being concentrated in the big banks. “Third World” or “LDC” (lesser-developed countries) debt, speculative real estate loans, unemployed oil tankers – they were all on balance sheets that were ultimately underwritten by central banks and government deposit insurance. The big question was how to avoid the risk of a forced nationalisation of the banking sector.
The answer, in the 1980s and early 1990s, was an artificially steep yield curve and credit risk curve, that gave the banking sector the cash flow necessary to gradually pay down the losses from the previous excesses. This was a huge drag on growth, sentiment, and the electoral prospects of people such as the first President Bush.
While the hedge fund form had been around since the late 1940s, the funds themselves were a small part of the financial world – one and two-person operations run for rich families. Their key attribute, from the point of view of the worried policy people, was that the only people put at risk in the event of their failure were wealthy people who could afford the losses.
So the slicing and securitisation of risk, with the riskier assets going to the hedge fund accounts of rich people uninsured by the state, was the solution. The banking system would act as a lower-risk intermediary and operations manager. The taxpayer-supported insurance funds would be solvent even with low reserves and low premium payments.
Now the crisis over the structured investment vehicles (SIVs) shows all that is going into reverse. In retrospect, one wonders why anyone thought that rich people would graciously assume the losses incurred by the financial sector’s excesses. That is not why they are rich in the first place.
The SIV was invented to be a bank without capital, because this time there would not be any losses to speak of. That is not what happened. They are a pile of securities, some good, some not. The market will not fund them any more, so the bank holding companies and banks have to fund them. But the banks do not have enough room on their balance sheets to keep that up. So they have to sell off assets to the “market”, aka hedge funds and other speculators.
The hedge funds and the like will, in the end, only buy the good paper, and that at a discount. So, after some back-and-forth with deals and lawyers, the worse stuff will be repossessed and go back on the balance sheets of the banks. Any losses on those bad assets will be paid for by a steep yield curve and credit risk curve over the next several years.
In other words, the securitisation-risk- dispersion-hedge-fund-rich-people-eat-losses solution to the problem of financial excess did not work. Profits will be privatised, and losses socialised, just like they were in the last cycle. That will be the reality behind the chit-chat in the form of “public-private” legal constructions, convenient accounting fictions, think-tank chin stroking, and editorial finger waving.