Wednesday, March 23, 2011

Paul Singer On Inflation, Dodd-Frank Regulation, & The Next Financial Meltdown

This past weekend's Wall Street Journal main interview was with hedge fund manager Paul Singer. I can't say I was acquainted with his work prior to reading the interview, but I was heartened, in a way, that so much of what he espoused was similar to some of my own previously-written views.

For example, Singer was unequivocal regarding coming inflation. When a guy like this begins citing 1930s era European treatises on the Germany currency debasement, you should be worried. I already am, but, of course, Helicopter Ben keeps telling people like me to have faith and quit being concerned.

Let me put it this way. Singer has built a multi-billion hedge fund by relying on his own analyses, conclusions and instincts. Ben The Bernanke is a high-level civil servant who will probably be offered another high-level, lucrative position after being Fed Chairman, no matter how badly he messes up in that role.

Of the two, Singer or Bernanke, whom do you think has the greater risk in being wrong, and, therefore, is more likely to get the current economic situation correct? And, by the way, Bernanke, as a sitting Fed Chairman, pretty much has to cheer lead on topics like saying economic growth is coming or here, inflation won't be a problem, and the world's investors won't be concerned about continued US monetary debasement.

For once, in Singer, I've found someone who echoes my own views of large US commercial banks as totally unattractive investments. James Freeman's interview quotes him as saying,

"You don't know the financial condition of [Citigroup], JP Morgan, Bank of America, any of them. Mr. Singer believes the big banks still carry too much leverage, and he doesn't trust regulators to monitor them effectively.

The largest financial institutions, he says, are "a random collection of survivors. Almost none of the survivors exist because of their perspicacity, risk controls and sound management- even the ones that are vaunted along those lines...How and why do they exist? Mostly on accident, meaning who got bailed out first and who was saved next and how did people feel and what did people say the weekend Merrill was under pressure [in September 2008]." "

Singer goes further in the next paragraphs, citing one of my own favorite risks- counterparty. He says that his fund complex has removed itself as much as possible from having any of the large US commercial banks and "the Street" as counterparties.

Singer sees Dodd-Frank as I, and many others, do, as described in the interview thus,

"The authors of Dodd-Frank claim that the law prevents the government from bailing out any particular firm, but the Fed can still provide emergency loans to a failing giant as long as it offers similar financing to other firms.

"It's a very important part of this equation that a few survivors exist in this peculiar relationship with government, having to kowtow to government, make relationships with regulators," says Mr. Singer. "Are they puppets of the government? Are they cronies of the government? Will their lending be affected by the perceived whims or beliefs of the particular government regulators existing at a particular time? Yes."
If the government deems a firm not "systemically important," Mr. Singer forecasts, it could spell its doom. "Small and medium-sized financial institutions may be disadvantaged, may be sacrificed in the next crisis to protect these behemoths," he says.
It gets even worse, Mr. Singer says, if the government ever deems a financial giant "in danger of default"—a judgment that can be made without the consent of the firm or its investors. The business is then taken over by the Federal Deposit Insurance Corporation, with its Orderly Liquidation Authority.
Once in charge of the firm, the government can discriminate among similarly situated creditors and transfer assets out of the business at will. Because of this, says Mr. Singer, creditors and trading counterparties might flee even faster than they would from a firm headed toward bankruptcy, where at least there is established law instead of regulator discretion.
"You don't know how you will be treated," he says of financial institutions under the new FDIC regime. "If there are companies that are also counterparties alongside you but they've been designated systemically important, that's a clue. It's like a game of treasure hunt. It's a clue that you're going to get disadvantaged compared to them."

So maybe FDIC chairman Sheila Bair and the authors of Dodd-Frank were right about one thing: Perhaps their new process for resolving failing giants really will discourage some people from lending to the biggest banks—but only at the worst possible moment.
The problem, in Mr. Singer's view, will be the jarring shift from one day being an investor in a member of the "systemically important" club, to the next day being a creditor whose claim is determined by bureaucratic whim. This may be welcome news to government pension funds that will want to be bailed out, but certainly not for private investors.
The speed at which a firm will collapse as word gets around that it might be headed to FDIC resolution could be "amazing," says Mr. Singer. And that "speed will drive the size of the losses."
This "atmosphere of unpredictability" is harmful to America's place in the financial world, he says, and "it doesn't make the system any safer. . . . This is nuts to be identifying systemically important institutions." He views it as a poor "substitute for creating soundness and reasonable levels of leverage throughout the system."

Phrases like "bureaucratic whim" ought to make you cringe. Don't you think they have that effect on investors in, lenders and counterparties to such institutions? I do. Singer's comments confirm what many others, including me, have contended, i.e., that the comparatively predictable existing bankruptcy laws have been replaced by liquidation-by-whim and cronyism. Singer is correct to predict that funds will leave a troubled firm much faster than anyone can imagine. And, ironically, that being in a group of selectively preferred, "systematically important" designated firms lending to or investing in a large bank is actually dangerous, because you will be the least-advantaged party. The one most likely to be at the very end of any line to collect on funds due.

Thus, in Singer's view, you have government-backed large institutions continuing with risky behaviors, and counterparties like them doing the same. This, he worries, is the seed bed for the next financial meltdown. Dodd-Frank and the FDIC have replaced uncertainty with respect to government backing for large firms in the event of another financial crisis with absolute certainty that select "systematically important" banking firms will be rescued. Moral hazard is now legislatively and regulatorily banished, leading to another round of excessive risk-taking.

The final passage of Freeman's interview says a lot about Singer,

"One reason his firm has survived for 34 years, he says, is that "we try to be very respectful of the unpredictability of markets. We try to at all times at least assume that the world is not being properly run." A safe assumption. "

Sad but, in this case, so true.

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