Imagine a former Goldman Sachs CEO, placing massive bets on a small, distant nation. It’s not that he thinks that this small country, whose economy is roughly the size of Dallas, is a good risk – everyone knows the country can’t pay back what it owes. But he’s making a bet that the big European central bank will make sure that the country gets bailed out. It’s what’s known in the industry as “an arbitrage play” on the behavior of central bankers. And most importantly, he isn’t betting with his own money. He’s betting with other people’s money, using what’s known as leverage.
Leverage is a way of magnifying the risk and return of any trade. In this case, the banker makes essentially a handshake bet with other players in the market (known as a “swap”), saying that he’s good for the billions of dollars he’s betting. These people know him from Goldman Sachs, so they don’t require him to put much money down. He’s essentially borrowing a huge amount of capital, cheap, to speculate with. The trade looks riskless now in a world of endless bailouts. Besides, this guy was the top dog at Goldman; he’s so good that creditors of his company demanded a provision on his company’s debt that they would get a higher payout if he left the company and ended up as Treasury Secretary.
The upside of this trade is vast – bonuses and prestige for him and his friends. There is no downside, at least for him, because it’s not his money at risk. There are no capital requirements, the swaps market is a dark area about which regulators know very little. But what in effect is happening is that there is increasingly an incentive to make really big bets, effectively lending large amounts of money based not on prudent standards but on who will get the next bailout. It’s an incentive to create a lot of debt.
This is of course the story of what happened last week with the destruction of broker-dealer MF Global by former Senator, Governor, and Goldman Sachs CEO Jon Corzine. It pretty much defines a market that lacks visibility and integrity. MF Global had leverage of forty four to one – for every dollar of the firm’s capital, it borrowed forty three other dollars to make bets. Regulators had such a poor sense of what was going on inside the company that they are now scrambling to find nearly a billion dollars of its customers’ money. This means the company wasn’t just betting with its own capital, it actually took its customers’ capital and apparently used that to supplement its bets. This is a huge breach of integrity, and possibly illegal, so it’s no wonder Corzine has hired defense attorneys. It now looks like parts of the company were paying bonuses right before filing bankruptcy.
There’s so much wrong with this. Corzine is considered a highly respected banker, someone who operated at the highest levels in Washington as a Senator, and as a Governor of New Jersey. He’s a huge bundler for the Obama administration, and was considered a possible future Treasury Secretary. Yet, there he was, using leverage to make bets so large and unwieldy that they blew up his firm. And of course, he personally doesn’t pay, but his firm and its employees, along with its customers, lose jobs and money. Regulators just didn’t constrain the company, even though it was leveraged at higher levels than the big banks were leveraged before the financial crisis hit. On a larger level, what this episode shows, with the extreme leverage, is that the system is still putting all of us at risk.
What we need, and what we’ve needed for a decade, is capital requirements. Capital requirements are like having a down payment in a mortgage, meaning that even if housing prices drop, you’ll have still have some equity in the home. Good, strong capital requirements keep risk with the risk-takers, rather than allowing risk-takers to offload risk onto other parties. Without being required to make a down payment, without a capital requirement, any of us could borrow an infinite amount of money with essentially no risk, for speculative purposes. Why not? It’s the house’s money, if you lose, it’s your money if you win.
The opposite of capital requirements is leverage. Without capital requirements, the incentive is to do what Corzine did, which is to create as much debt as possible and find someone to pile it on. You’re looking to find ways to bet, to put money where returns are high and liquid. Since you aren’t a long-term investor, the idea is to get in and get out, quickly, benefitting through financial speculation. This isn’t putting money into businesses that will grow, it’s putting money into risky bonds with high interest rates that may have a government backing. Whether the entity that accretes debt is Greece of subprime borrowers or people in 17thcentury Holland buying tulips, if there are no rules on the creation of debt what will happen is an overleveraged debtor. When you have no price integrity and no integrity of credit standards, a crisis will follow.
Corzine couldn’t have made the bet if there were leverage requirements, there just couldn’t be that much debt. Greece couldn’t borrow excessive amounts and mask its debt load if there were capital requirements. Its leaders would have to manage its resources prudently. When there are no capital requirements, or when there are capital requirements but no visibility into firm behavior or integrity of regulation, risk moves away from the risk takers and towards the weakest players. This is the financial system we’ve built over the past thirty years, one dominated by speculative flows of capital and go across borders in dark pools. The financial sector collapsed the economy in 2008.
We knew the problems, and we knew how to fix it. But as we’re seeing with Corzine, Greece, and MF Globa, it’s pretty clear that nothing has changed since 2008. Greece is leverage gone wild, using Goldman Sachs designed accounting tricks to pile on more debt. MF Global is also leverage gone wild. I’m reminded of what Goldman’s Fabrice “Fabulous Fab” Toure, wrote to his girlfriend when selling structured financial instruments he knew would fail.
“More and more leverage in the system,” wrote “Fab” to a girlfriend. “The entire edifice threatens to collapse at any moment. Only potential survivor, the fabulous Fab… standing in the middle of all these complex, highly levered, exotic trades he created without necessarily understanding all the implications of those monstrosities.”
It’s time for our leaders to be honest about this problem, because this Eurozone mess isn’t going away. There will soon be a moment to fix our financial system, when the Eurozone collapses due to Greece, Italy, or some other overleveraged entity. At that moment, we can implement strong capital requirements, and ensure that leverage allowable for financial entities is modest at best. It’s important for us to look at Fabulous Fab’s quote above, at Corzine’s behavior, at Greece, and recognize that these are all part of the same eminently fixable problem. Let’s make sure risk lies with the risk-takers.