Sunday, September 21, 2008

What Will Tomorrow Bring: Finance (what else?)

At the risk of stating the obvious, this list is merely a shotgun shot pattern of data points. Nobody can know the full landscape.

  • Perhaps most irritatingly, the ostriches everywhere will feel (indeed, seem) vindicated by their do nothing approach to everything from regulation to legislation to investment
  • Reports will emerge from Austria that Joseph Schumpeter is turning in his grave as free-marketeers become the 21st century's lepers, especially in government and academia.
  • The Fed wins the Regulator Cage Fight and gains a mandate to be the seamless Uber-regulator of the financial markets. Think UK FSA.
    • All other agencies will be put under the Fed (a political move) but eventually will be dissolved.
    • Clearly, their biggest challenge will be insurance. As I've said and said before, the biggest scariest messes lie therein.
    • The Fed will finally reconcile with the FDIC and the SEC by absorbing their expertise and adopting their methods in those areas.
    • Specifically, the Fed will establish divisions and regulatory teams for each of the types of risk: credit, market, operational, counterparty, interest rate, economic, actuarial, etc.
    • Each financial institution will be subjected to a pot-pourri of regulations and exam teams based on their cocktail of risks.
    • The interesting wild card here will be the opportunity for greater cross-pollination among the divisions. In other words: will the Fed's credit risk team learn anything from the market risk team, or will they maintain their philosophic differences?
  • The next cage fight will center on financial reporting. Are SEC requirements too useless to justify their burden? Are FASB and GAAP just inadequate? Is IAS any better? Was the "mark to market" rule lethal? Why do FIs have one set of numbers from their Finance deparment, and another totally irreconcilable set of numbers from their Risk department? Why are neither in line with market prices? Why don't banks follow valuation methods from the real estate industry for their other illiquid or unique assets? What can be done to REALLY standardize reporting with a common lexicon (think XBRL) and a single database, not of documents, but of raw, equivalent data from which investors can do their own reporting and math?
  • Leverage ratios will finally fall to saner levels, at least in the financial industry. This is one contagion I hope DOES spread to the greater economy.
  • Because of the above, the industry will take a long time to get back to its current size. A dollar is a dollar. Consolidation was necessary anyway. This week just accellerated it.
  • In a few days, I'll be going into detail about how risk management models, leverage, and the decisions people made based on both, ran amok and sabotaged the financial industry. For now, I'll say this: unless and until they are re-jigged, these models will cause numerous perversities:
    • Many models use moving averages of historical prices/spreads/defaults. Our current period of radical change and volatility is the proverbial pig in a python in these models. Until the python poops the pig out, the models will continue to go ballistic by prescribing sky-high interest rates, required rates of return, collateral requirements, and loan eligibility criteria. The wise FIs will simply give their pythons some castor oil and get it over with.
    • The subset of risks considered "uninsurable" will skyrocket and there will be calls for a new "insurer of last resort" ... paid for by guess who.
  • This new "RTC2" (my name, not theirs) is like the new WPA but for financiers, bureaucrats, and, of course, lawyers.
    • There will be no end of confusion about what assets are eligible.
    • There will be no end of debate about what institutions should be eligible.
    • Whatever rules are drawn up will be considered full of moral hazard. Intrepid hedge funds and whale investors (or unscrupulous ones, depending on your POV) will arbitrage between the "covered" and the "uncovered" assets.
    • The bean-spilling is going to be two-thumbs-up entertainment for a long time. I just can't wait to see who fesses up to what.
    • The "RTC2" asset liquidation will ride the line between inefficiency and incompetence It will be nine tenths politics, one tenth theft (just like eastern European voucher auctions). Asset prices will be determined at fiat, since the administrators will lack the know-how to do anything else. Based on what Hank said today, the objective is to re-create markets for asset classes where none exists ... so there's no right or wrong answer about valuation anyway. In the end, though, house prices will fall further in spite of demand.
    • Barney Frank's pet project of nullifying executive compensation packages will inevitably fly, but hopefully will be at the firm's discretion or open to independent arbitration.
  • Hedge funds will be the next front line. We'll all find out that they're not just scams set up to feather the beds of the rich (that's Washington!). Only after they're allowed to go bust will talking heads realize that hedge fund shares are owned by pension funds, banks, and governments. They are integral market participants.
  • Everyone will know who Tim Geitner is ... and will see lots of him for decades
  • Certain people will know who Luigi Zingales is ... and we will see lots of him for decades
  • All levels of corporate governmental America will launch massive lobbying campaigns to get their "fair share" of bailout money, now that the great taxpayer wallet is permanently open for pillage
  • Short-term Treasury yields will actually go down due to flight to quality, saving the Fed's bacon for a while ... but the ultimate effect of this entire fiasco will be:
    • A decade of higher volatility (pinging between inflation and deflation)
    • A ballooning Federal budget deficit
    • Overall increased inflation as the government prints their way out of this massive debt
    • Clearly, increased taxes across the board ...
    • ... Which will chop several percentage points off of GDP for a while ...
    • ... Which will depress corporate revenues (and the stock market) ...
    • ... Which will cause increased bankruptcy and joblessness ....
    • ... Which will lead to poverty, and need for handouts ...
    • ... Which will lead to the vicious cycle of increased government costs, and decreased revenues leading to cycle upon cycle of tax hikes ...
    • ... Unless we, as a nation, can take control of the political process and enforce the desperately needed fiscal prudence.

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