Monday, September 22, 2008

Investment Banking's Weak End

Yesterday, while walking our dog with a hundred other dog owners on the seashore at Cramond, the village of Robert Louis Stevenson's story Kidnapped set in 1751 a few years after the defeat of the Jacobite rising, independent investment banking finally surrendered, and on a Sunday too! Subject to a 5 day grace period, the US Fed approved applications by Goldman Sachs and Morgan Stanley to become Federal Reserve-regulated bank holding companies (BHCs). Both firms will be subject to bank regulations and capital requirements (to be phased in over a transition period). We can hardly doubt this was an involuntary move. It also spells out that what has been called 'shadow banking' is now firmly to be accounted for.
It also means that the two firms gain access to term lending facilities with broader collateral base (rather than overnight only) at a time when overnight rates are down but 3 month money continues to be prohibitively expensive. The Fed can now also lend to Goldman, Morgan and Merrill’s London-based broker dealer subsidiaries directly.
In early June it was noted that the financial regulators were eyeing up the $10-$12tn shadow banking market ($2.2tn CP SPE/SIV conduits of ABS & ABCP plus $2.5tn repo/reverse repo market, plus $4tn combined brokerage assets plus $3tn hedge funds) outside regulated banking without adequate "own capital" reserve provisions (plus within the regulated banking system another $10tn or so?). Brokerage firms may face stricter capital requirements. Otherwise, how are "deposits" protected during market runs for cover that no one in official authority can oversee? The investments that performed best during the shadow’s banking's formation were related to Home prices, financial stocks with subprime exposure, consumer-based equities, and selling U.S. dollar denominated net financial assets generally to foreign buyers with trade surplus $ funds.
The run on off-balance sheet shadow financial system funds (a disputed fact) arguably forced the Fed to step in as lender of last resort to non-deposit-taking institutions for which it is not the regulatory superviser. By doing so the Fed would take on unknown credit and market risk of collateral-providing dealers defaulting. In fact, sorting out and recovering collateral from Lehman and others is a current cash-flow headache for many banks.
it is not the job of the Fed to bail out cash-flow insolvent non banks. If a bail out should occur this policy action would have to be decided by Congress after the relevant equity holders have been wiped out and senior management fired without golden parachutes and huge severance deals. Many will say this is market insiders savings other insiders, but there remains a Damocles sword of public anger hanging over the bonus culture, something retail bankers, now emboldened by the credit crunch, also publicly deplore. The press talk of "worthless paper" or "junk" when referencing complex structured products that supposedly "no-one understood". That is not so, but their value is entirely a systemic risk when investors get emotional.
It was back in March (St. Patrick's Day) when the Fed first extended unlimited discount window borrowing facilities to non-bank primary dealers, and therefore it was from then that the end of shadow-banking was but a matter of time. The original Fed policy under The Federal Reserve Act: Direct Fed lending to individuals, partnerships, and corporations (IPC) was much more stringent. Some commentators blame the repeal of the Glass-Steagal Act during the Clinton Presidency for the current crisis. That will be the future subject of many an academic thesis.
Note: in the OECD generally there is about $3tn in cash in CDOs of which hedge funds had $1.4tn exposure by end 2007, banks $0.75tn, asset managers $0.565tn and insurers $0.3tn. I'd like to see someone do a reckoning of how much was dumped into retail investment funds, and we are all still waiting to see how much is in East Asia and the Middle East oil economies including in the much hyped sovereign funds?

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