Full disclosure: I am normally a fan of the Financial Times’ Gillian Tett, but her latest piece reveals she has been co-opted by the industry she covers.
While there are matters of substance I take issue with (we’ll get to those soon), the whopper is the positioning. How can Tett possibly depict Gordon Gekko as a model of any sort of remotely desirable behavior?
For those who never saw or have largely forgotten the movie Wall Street, Gekko is a crook. He engages in market manipulation and invests on inside information. His “Greed is good” speech is based on a lecture given by another criminal, convicted risk arb Ivan Boesky.
So Tett starts the piece by saying the markets need more marauding miscreants. Lovely.
Her point is that risk capital has dried up, and provides examples:
But some recent anecdotes are chilling. Last week, for example, a group of senior hedge fund players and chief investment officers gathered in Dublin – and collectively guessed that about 80 per cent of the risk capital that was sitting in the European system a year ago has disappeared….
What is even more dramatic – but less visible – is the disappearance of banks’ proprietary trading desks… traders in London say there is really only one bank in Europe which is even pretending to run an active prop desk now – namely Goldman Sachs. As a result, billions of dollars of risk-taking capital is believed to have quietly vanished.
That has had all manner of extraordinary consequences. Two years ago, a host of hedge funds and prop desks in London were building up their distressed debt-trading teams to take advantage of a future turn in the credit cycle. Logic might suggest such funds should be wildly busy right now, swooping in to buy distressed companies, or securities. Nothing could be further from the truth. As banks have slashed their risk-taking operations, they have also cut their distressed prop desks, and most have stopped making markets in distressed products. Hedge funds dealing with distressed assets have also folded, unable to raise funds.
As a result, there is a dire shortage of capital to organise – or fund – even “simple” restructurings of companies, distressed investment entities or anything else. Hence the gridlock on dealing with toxic assets.
But not just credit assets are being hit. As asset managers hunt for places to put their cash away from the carnage of the credit or property world, some have been tempted by the world of small-cap equities. But trading in small caps can only take place with market makers – and right now, banks are not just cutting prop desks but market making activity too. As a result, fund managers are sitting on their hands. “We would love to buy small caps but we just cannot tolerate the liquidity risk,” explains one large asset manager. “Almost any sector which needs marketmakers is half-dead.” Logic would suggest that eventually this pattern should change. After all, oodles of cash remain in the system. That cannot all stay in government bonds for ever, least of all in a world where the Fed is busy intervening in such a dramatic fashion to suppress yields.
What is wrongheaded about this is the assumption that hedge funds and proprietary trading desks are necessary and desirable sources of “risk capital”. In my view, their wild unsuitability for this role (save as arbitrageurs) is part of why we got in the mess we are in.
Until the recent, explosive growth of hedge funds, the folks who stepped in during down cycles were typically substantial individual financiers and investment-oriented families. It wasn’t hedge funds or proprietary trading desks that hoovered up the bad assets in the savings & loan crisis. Hedge funds were few and primarily global macro players; proprietary trading back then were small by today’s standards and would never have looked at taking assets that were illiquid.
Tett is failing for the same flawed thinking that bedevils many experts and commentators. They keep seeing a restoration of status quo ante (n a somewhat cleaned up and tamed form) as the best solution for our mess. Most expedient, maybe, but remedies like that have high odds of getting us quickly back in trouble.
All the players that Tett mentions have fatally flawed incentives. It’s the OPM (Other People’s Money), heads I win, tails you lose syndrome. Distressed investors in days of yore played substantially, if not entirely, with their own money (they might organize a syndicate, but they would act as lead investor, and would not take a huge promote).
In fact, hedge funds are wildly unsuited to be risk players except in the short term. Remember, they report results monthly to investors. I’ve spoken to hedgies, for instance, who have a very clear view of a market trend over the next say, nine to twelve months, and they often won’t play it (or will play it in smaller size than they would if it was their money) because they might show more than they’d like in interim losses. But waiting means they might miss the trade entirely.
Tett’s point on market making is fair but also misleading. A sudden drop in both number of market makers and the risk appetite of the ones that remain is a standard feature of markets adverse enough that many of the major firms have taken hits., such as the year after the Asian crisis (just about everyone, particularly Goldman, took big bond market losses). Spreads were elevated for a full year after the 1998 LTCM collapse, a casualty of the crisis.
Floyd Norris put the question better:
Where is the next J. P. Morgan?
In times of market crisis, the safest course for any one market participant may be the riskiest course for the entire market. If everyone wants to sell, prices can go in only one direction.
In past financial crises, it has fallen to someone — regulators, investment banks or even a single banker — to organize collective action and avert disaster.
Such moves involved persuading people to take steps that seemed to go against their own private interests. …
In 1907, Morgan demanded that presidents of New York trust companies — then a type of second-class bank — act together to save one of their own, the Trust Company of America, from a bank run.
The presidents, wrote Robert F. Bruner and Sean D. Carr in their book, “The Panic of 1907,” were “convinced that it was their primary responsibility to conserve their assets in order to survive the financial storm that was swirling around them.” Morgan said that would simply assure that all would fail, one by one.
Morgan, then the dominant figure in American finance, called the presidents to a Saturday meeting in his library — and locked the door. Not until dawn Sunday did he let them out, after they had committed the needed cash….
Mr. Bruner and Mr. Carr hailed Morgan’s actions, as well as the Fed’s 1998 move to salvage the [LTCM hedge fund. But they warned, presciently as it turned out, that the current environment might hamper similar efforts in a new crisis.
“In a globally complex financial system, will such collective action be possible if the crisis is triggered beyond the reach of any of today’s regulators?” they asked.
Even though one can argue, correctly, that JP Morgan was far from a paragon of virtue, he is a more estimable figure than modern Masters of the Universe. Morgan and his contemporaries had a sense of noblesse oblige and recognized that they needed to consider the broader social and institutional fabric along with their own interests. Indeed, Morgan, contrary to Gekko, backed men who understood the importance of good conduct :
One of the most famous exchanges in the history of finance took place almost a century ago on Capitol Hill. An aging J.P. Morgan, the most powerful financier in the world and America’s unofficial central banker, testified before a House committee investigating the tangled web of financial interests that dominated the economy of the emerging industrial nation. Morgan’s inquisitor was Samuel Untermyer, a tough corporate lawyer.
Untermyer: “Is not commercial credit based primarily upon money or property?”
Morgan: “No sir. The first thing is character.”
Untermyer: “Before money or property?”
Morgan: “Before money or property or anything else. Money cannot buy it…because a man I do not trust could not get money from me on all the bonds in Christendom.”
So for someone as smart and savvy as Tett to be invoking Gekko types as possible saviors points to the absence of alternatives. This is a variant on George Akerlof market for lemons. It became more attractive for financial experts to operate on an OPM basis, since they could both earn more and shift risk to investors. But now that investors realize that they have been had, and that it is difficult to tell good actors from bad. According to Akelof, the equilibrium is a no-trade market, and that appears to be where we are headed.