I read with amusement this week the “Agreement Among PWG And U.S. Agency Principals On Principles And Guidelines Regarding Private Pools Of Capital.” Now, I think this is a serious issue; I’m not convinced that we are in a better position to deal with systemic risk than we were back in 1998. I think that many institutions are in better shape, but for the system as a whole, the degree of leverage, both implicit and explicit, is higher now.
Now, I can take two paths here. Path one: I like systemic risk, since I am a conservative investor. I like getting bargains that are screaming, as in the Fall of 1987, the Fall of 1998, and the Fall of 2002. What I wouldn’t like is the Fall of 1929 and its aftermath. My risk control methods would allow me to do relatively well even in that scenario, but great relative performance when you are down over 20% is not my idea of a fun time. I prefer scenarios where my neighbors aren’t getting harmed badly. That said, my best relative performance as an investor came during and immediately after panic periods like we have had in the past 20 years. (No guarantees about the future though.)
The second path is more interesting though. What if the government gathered all of data from every major investor? Say, for every firm managing more than $100 million, measured by assets, rather than equity, they asked for inventories of both the assets and the funding sources. For nonpublic assets, they would also need the counterparty data. The purpose of this would be to ascertain who owes cash to whom, and under what circumstances payment would need to be made. Ideally, with this data, one could identify where market players with weak balance sheets are overexposed to risks.
Now, this will never be done, but just imagine for a moment. What would the government do if it had data like this? At present, nothing, like the report that they put out. They wouldn’t know what to do with it. They don’t have the analytical meanpower to deal with the complexity of one derivative swap book, much less all of them, the hedge funds, the securitizations, the CDOs, etcAt best, they could contract it out, asking the investment banks as a consortium to set up a separate company to do the analysis for the New York Fed, and the Department of the Treasury. It takes a thief to catch a thief, but would the government be willing to shell out enough to get effective data and analysis? I would suspect not.
The same problem exists in the auditing of swap books at investment banks. Anytime an investment bank runs into an auditor smart enough to audit their books, they hire him and pay him ten times the salary. So, even if the government makes noises that they want to control systemic risk, I view it as kind of a joke. They don’t have the data or intellectual resources to even begin the project.
Let me put it another way: if the government wants to reduce systemic risk, let them create risk-based capital regulations for investment banks, and let them increase the capital requirements on loans to hedge funds and investment banks. Or, let the Fed change the margin requirements on stocks. These are simple things that are within their power to do now. In my opinion, they won’t do them; they are friends with too many people who benefit from the current setup. If they won’t use their existing powers, why would they ask for new ones?
We will have to wait for the next blowup for the Federal Government to get serious about systemic risk. They might not do it even then. Upshot: be aware of the companies that you own, and their exposure to systemic risk. You are your own best defender against systemic risk.
To extend the physical analogy used a few days ago, consider the quantum nature of matter and energy, in which beneath the apparent order of the macro lies the roiling foam of quantum probability of the micro.
Like a subatomic particle, risk spends most of its time as a probabiliity function. Maybe, like a subatomic particle, just observing it collapses the function to a certainty and thereby affects its future.
Can the universe of derivatives be thought of in similar terms? If so, like Schrodinger’s cat, actual risk exists in a superposition of states. The government can’t measure it without collapsing the probability function and thereby altering that which it seeks only to measure.
In the macro world, we don’t really care what individual subatomic particles are doing, because the behavior of particles mean revert in large numbers and the world becomes quite stable. What we do care about is avoiding the concentration of unstable atoms into a critical mass.
The problem, IMHO, is that we apparently can’t even measure employment with reasonable timeliness and accuracy, let alone detect the metaphorical emission of radiation which might indicate an impending critical concentration of risk.
The question then, is how do we know the extent of exposure to systemic risk in the companies we own? A metaphorical Geiger counter would be helpful.
I like your post a lot. Yes, the moment the government moves to control anything, the system shifts, sometimes in violent ways. Part of my post was trying to point out the impossibility of trying control systemic risk, even while trying to point out what it would take to analyze the system as a whole.
Though I think that the major investment banks have some of the best modeling going on systemic risk, I think that they might trust their models more than they ought. They would have a shot at it if they analyzed it as a group, but only a shot, and antitrust would prohibit it.
If the government tried to do it with their army of Ph.Ds, it would fail without question… they have a hard enough time getting the simple stuff right, as you point out.
And to your question: the Geiger counter that I use is a qualitative one. With non-financials, it comes down to balance sheet quality — how likely would they need financing at a time when it is not available? With financials, it is similar, but with additional attention to the quality of whom they have lent to, and their overall exposure to the equity markets. The only financials that I hold now are a few foreign banks, Allstate, and a Mortgage REIT, Deerfield. Even my insurance portfolio is on the low-levered, conservative side. Boring even.
Thanks for your post, and I hope to hear more from you.
long DFR ALL ABN RBSPF BCS
These were instructive posts; thank you gentleman!