Michael Milken, the junk bond legend at Drexel Burnham Lambert in the 1980s who ended up serving some time in the US federal penitentiary system, is an unlikely source of guidance in the current market crisis. But Milken knew all about disappointment and how to avoid it – an approach that seems ever more prescient as the crisis accelerates.
Milken’s driving philosophy in turning junk bonds from a backwater of the securities industry into a booming business was the avoidance of disappointment. At university, he read a study that showed how low-rated bonds outperformed higher rated bonds over a long period, despite their higher default rate.
He realised that if you buy triple-A or double-A rated bonds you can only ever be disappointed – because they can only ever go down and, over time, they invariably do. On the other hand, invest in junk bonds and, if they survive, all the surprises will be on the upside.
Fast forward 20 years, and his warning that investing in triple-A securities exposes you to nothing but downside surprises and misery looks all the more acute, given that complex highly rated securities based on low-rated underlying credits have been at the heart of the vicious downward spiral in the financial markets over the past six months.
Looking forward at how to drag the financial system out of this crisis, it is difficult not to feel the same sense of disappointment at the announcement last week by the President’s Working Group on Financial Markets in the US of its proposals to avoid a repeat performance.
While it may have been unrealistic to expect the Working Group, chaired by US Treasury Secretary Hank Paulson, to wave a magic wand and wish away the past six months of turmoil, the timidity of proposals is somewhat depressing.
The big problem with the Working Group’s report is the disparity between its proposals and the expectations raised by Paulson in his speech in Washington to announce them.
In the speech Paulson, whose thinking carries unusual weight given his tenure at the head of Goldman Sachs for more than seven years, painted one of the most cogent analyses yet of the financial markets crisis in outlining the Working Group’s objectives.
He listed six central aims: greater transparency; better awareness of risk; stronger risk management; more solid capital management; tougher regulatory policies; and a more robust market infrastructure.
In his comments, some of which must have been difficult to deliver given the closeness of his relationship with Wall Street, he rightly identified excessive complexity as the enemy of transparency and market efficiency.
He castigated the ratings agencies and demanded that they improve their opaque practices. He raised the crucial but sensitive question of whether investment banks and other market participants have “the right people in the right jobs with the right incentive structure?”
He rightly blamed investors for buying things they did not understand, and he demanded that the industry settles its differences and bangs its heads together to sort out the woeful disparity between the growth in the over-the-counter derivatives and the often feeble market infrastructure that supports it.
In contrast, however, the report itself lacked bite and fell short of the most penetrating of Paulson’s observations. Reforming parts of the mortgage market in the US may prevent another mortgage-related meltdown in financial markets in future, but will do little to prevent a future structural failure elsewhere in the system.
Requiring that investors seek better information from issuers and banks on structured products and setting up a committee to review this, opens the stable door for them to be misled in future on less complex products.
Demanding that ratings agencies improve their disclosure and methodologies, and setting up another committee to review their progress falls short of the more radical but increasingly sensible solution of abolishing the statutory accreditation system that would allow the market to decide the value of a rating.
He set up another committee to help review the strengthening of risk management practices at banks, and encouraged regulators to talk to their international counterparts and adopt practices that encourage banks to be more cautious in their valuations and provisions.
Finally, on the central issue of market infrastructure, the report “insisted” that banks set ambitious targets to improve things, but only “urged” them to improve the documentation of credit derivatives and “asked” them to come up with a long-term plan.
In so far as it went, the report was perfectly solid. But faced with an accelerating crisis – as shown by the emergency funding sought by Bear Stearns last week and the gathering pace of hedge fund collapses and defaults – the industry needs something stronger. Paulson is in a unique position given the goodwill and respect he commands on Wall Street and around the world.
His boss, President George W Bush, who officially at least sponsored the report, is also in the unique position of desperately searching for some form of lasting legacy in his (and Paulson’s) last few months in office, given that his attempts to leave one in the Middle East are not looking promising.
It is disappointing that both Paulson and the President have missed the opportunity to leave such a legacy for the world financial system by falling short of the radical thinking and bold action of which at least one of them is clearly capable.
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