Henry Kaufman's Mistaken WSJ Editorial

Henry "Dr. Gloom" Kaufman wrote an editorial in the Wall Street Journal on Wednesday in which he makes some serious errors in his diagnosis and prescription for the current credit market dilemma.

One could write chapters on all the detailed issues involved, but it really boils down to just a very few points.

Kaufman is correct to note that debt instruments- e.g., CDOs, credit derivatives- have become much more complex than those which predominated credit markets in 1987 or 1998. However, he is wrong to suggest that, because so many quants at hedge funds have modeled relationships between the instruments, and ignored the potential for markets for these instruments to vanish, the Fed and other authorities need to add/improve/modify regulatory frameworks and procedures.

In truth, I am, and you should be, thankful that commercial banks no longer bear so much of the rate and default risk, due to portfolio lending, that they did as little as a decade ago. The same securitization of assets, such as home loans, credit card receivables, and corporate loans, that have resulted in the CDOs and credit derivatives which Kaufman views negatively, has largely insulated commercial banks from dramatic losses in value of the underlying loans.

To the extent these banks have lent to private equity or hedge fund firms, whose assets, some of which may be complex, risky assets, then, yes, they are still liable for some risk.

However, in the past decades, we have seen the movement of loans from bank balance sheets, where they used to be the subject of dubious reserve and loss recognition treatment, to the marketplace, where their prices and risks are now determined by buyers and sellers.

As such, in my opinion, the current situation is not that serious in terms of overall financial system solvency. Some borrowers misrepresented their ability to handle loans, and secured mortgages which they probably should not have been given.

Some mortgage brokers and lenders looked the other way, or not at all, while processing these sub-prime loans. Some financial engineers at investment banks packaged up these suspect loans into CDOs, and some unwise investors bought pieces of these CDOs, wrongly believing they were earning above-average returns for average-risk assets.

I don't own any CDOs. I don't know anyone who does.

It's my opinion that some large hedge funds, pension plans, etc., own a lot of CDOs which are backed by some sub-prime loans.

Those investors have lost a lot of value in the past few weeks, as market prices for such instruments have plummeted.

So what? How is this different than if they had bought badly performing corporate equity, foreign equities, foreign currencies, corporate debt of weak firms, etc.

Essentially, some large investors thought they could buy risk cheaply, and were wrong.

Better some hedge funds and pension funds lose value and, in the case of the former, go out of business, than our commercial banking system implode as those institutions hold bad loans in large amounts.

See, the beauty of the last decade's financial instrument innovations is that investors know they are taking risks with their money. Or ought to know. They don't receive deposit insurance, and have no guarantee of the return of their capital.

Commercial banks, on the other hand, do have deposit insurance, and guarantee those deposits.

Far better the suspect loans become property of investors with appetites for risk, than remain as collateral on the balance sheets of our large commercial banks.

In the end, this 'credit crisis,' to the extent there is one, involves large hedge funds, investment banks, and wealthy individuals. All of whom are sophisticated, and were capable of understanding the risks they took in buying assets underpinned by sub-prime mortgages.

The Fed might need to offer some temporary collateralized lending to commercial banks, in order for them to extend the time in which their hedge fund customers can repay short term loans. But overall rate decreases to bail out sophisticated investors is a mistake, and will only result in greater moral hazards going forward.

Other than very limited, temporary loans, at high rates, the Fed should remain on the sidelines during this period in which some large investors are realizing losses in their investment portfolios. Because, regardless of what assets are incurring those losses, the losses are the business of those managers and investors, not that of the general financial system.