March 28, 2009

It’s all about Tim Geithner

Weekly Snapshot
• U.S. consumer spending for March-09 improves slightly
• Japan's Topix Index up 7.8 pct on week, biggest gain since 1997, Nikkei at highest point in 2 months
• Hong Kong Shares showed strongest weekly gain in five months
• Tim Geithner proposes ambitious regulatory reforms, calls for a super regulator
• World Trade Organization predicts that global trade volumes would drop by 9% this year
• Tim Geithner asked for more powers to seize failing financial companies
• Czech PM Topolanek condemns Obama's economic stimulus plans as a "road to hell"
• Czech government collapses after losing a non-confidence vote in parliament
• The governor of China’s central bank called for a new world reserve currency to replace the US Dollar
• Germany is considering a temporary tax break for companies as a response to this crisis
• Abu Dhabi investor buys 9% of Daimler
• US Treasury Secretary Timothy Geithner announces $1 trillion plan to clear toxic assets

It’s all about Tim Geithner
Tim Geithner certainly had his share of airtime recently. In addition to effectively slamming the US$ he also called for massive regulatory reforms, the establishment of a new super regulator and gave an outline of the $1 trillion plan to clear up toxic assets.

Geithner’s Plan
The Financial Times has a nice animated graphic that explains the basic principles of the Geithner plan:

Although this doesn’t explain the plan in detail, there are a number of caveats I can think of. First, the assumption that mortgages with a face value of $100 would be worth $84 is a hugely optimistic assumption and doesn’t seem to reflect reality. Remember, these are problem loans (toxic assets) not traditional mortgages and typically from locations and borrowers which have been hardest hit. Second, the FDIC as a leveraged lender? Hmmm… Third, what is the real consideration from the banks for effectively taking these toxic assets off their books? Sounds like a free-ride for them to me. Further, by risking $6 to effectively gain from an asset worth $84 sounds like a very sweet deal to me. If this plan works, these “private” (who are they kidding) investors will have tremendous gains from taxpayer money put at risk. If it doesn’t work, their downside is very limited. I’d like to know more as to who gets to pick which assets and how the bidding process is supposed to work.

Lastly, is there a Plan B? What if this plan works as poorly as previous attempts by Hank Paulson? I wish I could share Mr. Geithner’s confidence when he testified in Congress: "Congressman this plan will work. This plan because of the authority provided not just by Congress but the treasury and the Fed gives us broad ability to do what you need to do to get through a financial crisis like this. It just requires will; It's not about ability. We just need to keep at it. We just need to work with Congress to make sure we do this on a scale that will make it work."

Did I hear that right? “It just requires will; It's not about ability…” Very scary stuff and as the narrator concludes: Don’t bet your last trillion on it.

Geithner’s Call for a New Super Regulator
Market Place had a very good commentary on the proposed plan for yet another regulator:

Susan Lee sums it up best when she said: “The problem, simply, is that a super-regulator requires super-people. People who have super foresight. Since no such people exist, pretending they do will only give us a false sense of security. And we'll feel betrayed the next time a crisis hits.”

I wanted to share some additional insights into the notion of more regulation and this doesn’t just apply to the US because regulators all over the world failed in preventing a systemic crisis such as this one. And, if you recall, 3 regulators were supposedly responsible for regulating the activities of Bernie Madoff, none of them worked. Go back in history and recall the cases of Nick Leesson (Barings Bank), LTCM, WorldCom, Enron etc. It leads straight to a comment made in a previous newsletter on the meaning of regulatory “oversight”.

I believe the concept of regulation has to be smart, efficient and it must focus on some key components i.e. protecting the general public and investment community from too much risk and from fraud.

In my experience with financial regulators, both in Europe and the US, there are some fundamental issues that need to change. For starters, regulators have to understand how companies operate, not in theory but in practice. This means that regulators should spend a lot more time on the trading floors and in dealing rooms of the banks rather than pouring over print outs of financial statements who rarely reflect the true nature of the mechanics and risks involved. Real life example: Trading desk A is assigned to one firm within a group of companies, desk B assigned to another firm within the same group but technically and legally operating outside of the regulatory environment. Because desk B does not fall within the regulators realm it goes un-inspected. The fact that business was separated between 2 different desks is good enough reason for regulators to simply not know about those activities of desk B even when Desk B is within the same office and essentially run by the same company. Effective regulation cannot work that way; point in case: Mr. Madoff.

To improve the efficiency of financial regulation, another fundamental change has to take place. Instead of recruiting accountants and lawyers, both of whom are often clueless about the financial instruments they’re supposed to oversee (they only need to understand trading and risk from reading a book), regulators should find ways to attract real talent, real brokers, traders and market practitioners who can feel and smell when something isn’t kosher.

The typical career move of regulators is to go from college straight into an entry position with a regulator, spend a few years learning the in’s and out’s of the financial regulator, only to then move to the private sector which offers multiples in compensation for finding such insiders. A talent and brain drain has been the norm and needs to be reversed before smart and effective regulation can take place. There is a big chance to set things right but not with more regulation and certainly not with more silly rules. To make a simple example in terms of mortgages: Rather than finding elaborate methods in determining the credit worthiness of borrowers, stipulate a minimum deposit. If someone cannot come up with a 20% down payment, they simply should not get a loan. It works in trading stocks where you need to deposit 50% into a margin account before you can start trading. Very simple and effective risk management. It won’t create the same kind of housing boom, perhaps just a very slow and benign growth but it would take care of many other aspects of risk and would also result in true, non-inflated growth.

As a final note, I would argue that the general public would best be served the same way they look at general service levels. Typically, people don’t mind paying for service if they get superior service quality. Some people also don’t mind not having any service as long as the price reflects that. With regard to regulation, we should either have no or limited regulation and investors need to be made aware that it’s essentially a “buyer beware” investment environment (similar to hedge funds) or the investing public is clearly protected from systemic and fraudulent risk and in that case should be prepared to pay higher prices as well.

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