How to Understand the Implosion of Frankenstein Finance – Part I

Ethical MarketsReforming Global Finance

By John Fullerton
August 1, 2008

Introduction
To address the modern financial system meltdown head on, we must start with a blunt assessment of the truth. Most outside the system do not understand it and are mystified by its complexity. Many inside the system are either too conflicted to speak the truth, or more often, have such a skewed sense of reality they can no longer see the truth. Candidly, few inside the system truly comprehend the non-linear complexity of the system, and the systemic implications thereof. And many that do understand the complexity are not thinking about firm-wide issues, much less systemic issues. This was true when Long Term Capital imploded in 1998 (I was part of the team that managed the liquidation), and it is certainly true today when the implications are far greater.

To understand what is happening and how to respond, we need a clear and accurate framework. We must distinguish between the present cyclical crisis (“the credit crunch” rooted in a housing bubble) and a more fundamental structural challenge our economic system is facing. The former is something we have seen before, in varying shades and severity. The structural challenge I will discuss in Part II of this paper is a first in the history of the planet challenge. It results from a growth dependent economic system colliding with the finite limits of the biosphere. The world is full and this will change everything. “Full world economics” will need to be profoundly different if we hope to avoid a breakdown in civil society.

The two challenges understandably can be easily mixed together due to the eerie coincidence in the timing of their respective symptoms coming to light. It being the season of overly simplistic political sound bites does not help. The credit crunch and the economic fallout it is driving are very much a cyclical phenomenon, perhaps a very long cycle, but the inevitable consequence of our debt driven, and now overly complex financial system. If energy expert Matthew Simmons and the “Peak Oil” advocates are correct which I believe they are with only the near term timing in question, a far more grave challenge has emerged to our fossil fuel based, expansion driven, materialist economic system. Climate change risk is a more familiar symptom of the increasingly “full world” in which the expanding economic system is in conflict with the limits of the biosphere. Either the cyclical credit crunch or the structural “full world” challenge alone would define the years ahead in all likelihood. However, only if each is understood with clarity, and the implications of their complex interconnections appreciated, can we hope to have the proper framework to make the difficult policy choices facing us in the months and years ahead. As the primary economic power on the planet, and the leader of our global capitalist system that has served as the model for the world, it is imperative that the United States provide courageous and visionary leadership at this critical time. The implications for global civil society are monumental.

The Credit Crisis
“The success of a high-private-investment strategy (this is what our “Washington Consensus” based economic system represents) depends upon the continued growth of relative needs to validate private investment. It also requires that policy be directed to maintain and increase the quasi-rents earned by capital – i.e., rentier and the entrepreneurial income. But such high and increasing quaisi-rents are particularly conducive to speculation (emphasis added), especially as these profits are presumably guaranteed by policy. The result is experimentation with liability structures (emphasis added – think shadow banking system) that not only hypothecate increasing proportions of cash receipts but that also depend upon continuous refinancing of asset positions (emphasis added – think Lehman Brothers, conduits, and much of the hedge fund industry). A high-investment, high-profit strategy for full employment – even with the underpinning of an active fiscal policy and an aware Federal Reserve System – leads to an increasingly unstable financial system, and an increasingly unstable economic performance. Within a short span of time, the policy problem cycles among preventing a deep depression, getting a stagnant economy moving again, reining in an inflation, and offsetting a credit squeeze or crunch. Financial instability and business cycles, which are so evident historically, once again loom on the horizon.”

Hyman Minsky in John Maynard Keynes, written in 1975
Talk about prescient. Minsky wrote this in response to the “financial crisis” that occurred in 1966 and subsequently the one that occurred in 1969-1970 following the long expansion of the early 1960s, really the first post WW II hic-ups. He wrote this prior to witnessing the Latin American debt crisis of the 1980s, the 1987 stock market crash, the S&L crisis of the early 1990s, the Long Term Capital implosion of 1998, the bursting of the tech/telecom bubble in 2000, or of course the current housing debacle that is working its way through the financial system and undoubtedly the real economy at this writing. This pattern of successive shocks, now increasingly referred to as “Minsky moments” by many Wall Street pundits, is alarming mostly because each one seems severe at the time, and yet is followed by a larger and more severe shock the next time. Such a trend should be a cause of real worry. It should cause us to question with open and thoughtful minds the system design itself, rather than blind reliance on ideology. It demands a fresh evaluation of the system guard rails, otherwise know as regulation.

Seasoned market observers, whose opinions I share, believe the current credit crisis is worse than anything since the Great Depression. Some believe we’ve ended a great long cycle, in which the post war (WW II that is) prosperity has been fueled by ever-rising debt in proportion to GDP as depicted in the graph below, borrowed from Wayne Nordberg of Hollow Brook Associates.

What’s more alarming is that this graph dramatically understates the effective leverage in the system that’s imbedded in the massive growth of derivative contracts that can be understood as self-financed “synthetic” leverage, as well as what is now known as the “shadow banking system”, represented by the off balance sheet debt obligations of structured investment vehicles (“SIV’s”) and worst of all, the off balance sheet obligations of the US Government in the form of unfunded Social Security and Medicare/Medicaid obligations. To top it off, our carbon emissions problem can also be understood as an off balance sheet liability on the US (and global) economy that some have estimated to be an additional Trillion dollars in present value terms. Just because we’ve not paid for this cost in the past, does not mean it’s not a liability going forward.

Minsky, in his reinterpretation of the Keynsian revolution, argued that Keynes was often misunderstood. In the passage above, Minsky was describing the inevitable consequences of a public policy strategy that favors private investment to achieve full employment. Critics of capitalism have often argued that the system favors capital over labor and other constituents. Minsky’s concern is less egalitarian than practical (although he clearly held egalitarian concerns as well). What’s critical to learn from Minsky is that “Minsky moments” are an inevitable consequence of a system designed to generate positive returns on capital rather than a system where returns on capital over time approach zero in a world with no capital scarcity.

Keynes expected such a state of no capital scarcity would exist for reasons that were incorrect. Most notably, Keynes expected that once peoples’ essential needs were satisfied, they would shift their pursuits to non-wealth creating activities, such as pursuing self-improvement through study and community involvement. Thus, Minsky states at the beginning of the passage, the imperative of the growth of “relative needs”, meaning a bigger house than my neighbor. In other words, the private investment driven strategy to achieve full employment depends on a materialist economy, in which private “relative needs” are insatiable. This is, of course, the economy we observe in the United States, and now a growing majority of the world, at least until now. We will return to the implications of this in Part II.

But first, there is an important implication to Minsky’s prescience that leads directly to our policy response to the current credit crisis. The logic is quite straightforward. The experience of the post war experiment with private investment driven capitalism, that is, capitalism in which the priority is to encourage risk taking through investment in order to achieve the implicit social goal of near full employment, has yielded several results. On the positive side, despite cyclical bouts of boom and busts along the way, the US economy has become the strongest and largest in the world, median standards of living have risen beyond what could have been imagined in 1945, and a tremendous amount of wealth has been created in the process. The issue now is whether the system has inherent design characteristics that lead to greater and greater financial instability as Minsky warns, that could ultimately lead to unacceptable societal outcomes. We are learning the truth of Minsky’s warning. In Part II of this paper, we will discuss the more profound structural limitations imposed by a “full world” economy.

Any policy response seeking to moderate the negative implications of the private investment driven system must be clear about the causes. In reality, such moderation undoubtedly will hamper some of the positive qualities of the system. The goal should be to seek an appropriate balance, with the social objectives clear in mind. If the social objectives are full employment, then a policy response to the current crisis should be one that limits the negative aspects of the system while minimizing or offsetting any adverse implications for the full employment objective. While not a trained economist, I believe this is what Keynes was saying when he argued in favor of socializing investment (in the form of government investment and spending).

Without delving into that hornet’s nest, it is clear to me that several modifications to the game as it is currently played are essential. Despite what we will hear from Wall Street, these adjustments should have no impact on our full employment objectives other than to encourage what is undoubtedly a healthy reallocation of resources away from certain segments of the financial economy and toward the real economy. Surely the world will not miss a few hedge fund managers at the margin.

Observations and Policy Recommendations
1. From ideology to reality. The era of Reagan/Thatcher “market fundamentalism” is over. Yes, regulation creates inefficiencies and unintended consequences. But clearly, we can no longer rely on markets to self-regulate and self-correct. The social costs to society are far too great. Financial capitalism has become a blood sport for larger and larger players with no interest or concern for system implications. There’s a reason the Roman’s put the gladiators in a ring. But we must understand the difficulty of creating efficient and effective regulations whose cure is not worse than the disease.

2. Control complexity through rules and capital charges. The financial system as it operates today, has grown far too complex and too global to effectively regulate. It must be simplified before we can attempt to regulate it. Some structures, like various off balance sheet funding vehicles should be illegal. Other forms of complexity should receive burdensome capital requirements that will encourage simplicity and protect society. Such requirements cannot be designed by practitioners alone, as history has clearly taught us. The recently implemented regulatory regime, know as Basel II, in which firms are responsible for developing their own risk management framework, models, and limits, needs to be re-designed, with this in mind. No more foxes guarding the hen house, just tell them the new rules. Any complaints – no Fed window and good luck to you.

3. Fix accounting. Despite recent but long overdue efforts to address “off balance sheet items”, GAAP accounting is outdated and conceptually inadequate to deal with the complexity of the large actors in the financial system. The FASB needs support and a spine. Accounting standards will never keep up with financial innovation, so some standards will seem irrational to practitioners. Too bad. There will be a cost of “good business” not done with stricter accounting limitations. Who says that’s so terrible, other than the trader trying to secure a bigger bonus.

4. Hold management accountable. Unchecked competitiveness and greed of a relative few, perhaps no more than several thousand people driving financial complexity and risk taking, have (unintentionally for the most part, Skilling/Fastow notwithstanding) wrecked untold havoc on literally hundreds of millions of people around the globe, and the worst is yet to come. Several more thousands were at the trough for sure, but the leading actors who set the tone are a relatively small group. Most work in public companies, not playing with their own money. This irresponsibility is certainly shameful, and should be criminal gross negligence. I suspect it is fraud. Chuck Prince’s infamous “dance so long as the music continues” was, now in the clear light of day, an act of violence against society that was foreseeable, although surely not intentional. The privileged financial elite should not escape responsibility. Some had absolutely no business running the firms they ran. Only hubris, and boards of directors even more clueless, kept them from knowing better.

5. Control compensation systems. That the “heads I win, tales you lose” compensation structures that “the market” has created are unjust is not debatable. Do not underestimate how powerful such compensation systems are at influencing behavior among those attracted to the big leagues of finance. At current scale and complexity, such compensation schemes are significantly responsible for the systemic risk we are now experiencing, at the trading desk level as well as in senior management. Since the market failed to control these compensation structures, civil society must since it is society that is paying the price. Yes there will be costs to this, but these costs pale in comparison to what we are now experiencing. How to do this will be complicated. The point here is to put the topic squarely on the table.

6. Unwind unnecessary counterparty risk. Counterparty risk exposure of over the counter derivatives is out of control. A technology originally designed to manage risk has become the Frankenstein of finance. Fear of counterparty risk dominos taking down the system was behind the rescue of Long Term Capital in 1998. Despite an acute awareness of this systemic risk highlighted to both the Fed and the CEOs of the leading global financial firms, little was done beyond talk to mitigate it going forward. Similarly a decade later, counterparty risk was behind the bailout of Bear Stearns, considered a bit player only ten years earlier, and still relatively small. Imagine if it had been Citi or JPMorgan/Chase. It still could be – perhaps only one 28 year-old hot shot with a computer away. Credit default swaps present a risk of a different character altogether given the non-linear nature of the underlying risk. Capital charges should shift most of the derivatives business to exchanges with much safer and risk appropriate margin buffers.

7. Limit Leverage. Leverage limitations are a blunt instrument; use them. The SEC’s quiet 2004 decision to eliminate the explicit leverage limitation of investment banks in favor of a “risk based capital” approach led directly to the reckless 30:1 leverage of Bear Stearns and Lehman. Contingent risk and leverage of off-balance sheet SIVs whose sole purpose is to game capital requirements should be terminated. Limitations on liquidity mismatches are also essential.

8. Restore the centrality of the banking system for credit extension to balance and support the capital markets. As a result of the profound business model transition undertaken by the banking industry over the past two decades, on-balance sheet capacity has been dramatically reduced relative to the needs of the economy and will need to be addressed to restore a dependable credit function to the economy. This implies a massive recapitalization of the banking industry beyond that required to offset real credit losses in loan books and losses associated with toxic securities positions. I’m not smart enough to estimate this capital shortfall, but it’s likely to exceed a Trillion dollars. Only an effective semi-nationalization of the banking system can achieve this objective, with all the associated perils. The sooner we face this fact, the less damage will be done to the real economy. This government capital should be targeted to strong regional and local banks to the extent practical in order to reduce the concentration of risk caused by inappropriate consolidation and should be seen as a bridge to the private recapitalization of the industry over time. If capital markets return to some sense of normalcy too soon, and structural changes are not effected to bank capital rules, we will undoubtedly fail to capitalize the on-balance sheet banking system appropriately. This will set us up for the next crisis.

9. Capital charges are the critical tool to reshape banking priorities. In order to make room for essential credit capacity on bank balance sheets, capital charges in the banking system must penalize unproductive speculative use of capital in order to improve the relative attractiveness of the core credit business. Incentivising an allocation of capital to the traditional credit businesses which are the life blood of the economy must be the quid pro quo for FDIC insurance. Bank return on capital will drop from prior (unsustainable) levels, stock price multiples will trend toward 1 times book instead of 2X book value or higher. Banks will yell, but that’s OK. The irony of investment banks being encouraged by the Fed to acquire banks in order to secure their stable deposit base would have Mr. Glass and Mr. Stegall turning in their graves.

10. Restructure the banking industry for durability once the crisis has past. Once the credit crisis subsides, which is will, a reexamination of the architecture of the industry will need to be undertaken with the objective of effecting a far more durable and less concentrated industry. “To big to fail” is not an acceptable description of any institution. Strategic use of capital requirements and targeted taxation to internalize systemic risk should be a central organizing principles endorsed globally. This restructuring will be as complex as it is profound. Time to start planning.

In Part II, we will examine the longer term and more essential implications of a “full world” economy, and the implications for public policy and the financial system.

Unfortunately, much of the crisis management response we have seen thus far by the Federal Reserve Bank, the Treasury Secretary, and by the individual actors in the drama is tactical crisis management rather than systemic in nature. This paper is offered in the spirit of moving the dialogue to the critical strategic realities that must frame the debate. Unfortunately, the history of the world is filled with cycles of financial booms and busts, only to repeat themselves, each time seemingly with three more zeroes added to the bill. Clearly we are now reaching a point where society needs to address the underlying issues head on. The future of the global economic system lies in the balance. History will judge our leadership in how we confront the crisis before us. It’s too late to prevent the crisis. We can only hope to identify root causes and fix them before a financial crisis transitions to a political and civil crisis.

John Fullerton is a former Managing Director of JPMorgan where he worked for 18 years in New York, London, and Tokyo, and subsequently was CEO of an energy focused hedge fund. In 1998, he was JPMorgan’s representative on the Oversight Committee of Long Term Capital Management. He is now launching an investment fund focused on investing in high impact sustainability initiatives, and is working on The Purpose of Capital, a book about the role of investment capital in sustainable economics. John can be reached at [email protected].