Last week, a Senate Committee thoroughly grilled Goldman Sachs executives regarding a series of mortgage derivatives transactions and, more generally, conflicts of interests in their fundamental business model. Senator Ted Kaufman's closing statement in his exchange with Lloyd Blankfein transcended the specific subject matter:
What really bothers people the most...is not the bailouts.... What bothers them a lot is the incredible compensation for people that made horrible decisions.... What I think really kind of gets them the most is here we are after this terrible travail and there is one section of our entire economy which has so much money that it has to worry what is going to do with billions of dollars for bonuses.... The idea that Wall Street came out of this thing just fine thank you really grates on them... that you gamed this thing really well.
It was an important reminder of the broader context of the inquiry into specific behaviors by Goldman.
Senator Kaufman articulated the public sentiment well. People believe that the big banks are advantaged by an uneven playing field. As is often the case, the collective wisdom of the public is correct. Financial sector profit has grown to 40% of the US total over the last two decades. Innovation in our economy is morphing from production of new products and services to hedging the prices of existing products and services. This does not sound like a sensible strategy for long-term growth. It is a strategy for stagnation, focused on risk aversion and squeezing profits from existing business activity.
The public views the game as so uneven that the only obstacle to unimaginable profits is hubris. The bankers ascribe success to superior intellect and intrepidity and believe that they can manage any risk (notwithstanding the recent evidence to the contrary). A more detached analysis tells us that the primary reason for success is a market structure that favors financial institutions.
A player sometimes loses, even if the uneven field favors him. This should humble him and change his behavior. Unfortunately, the potential humbling effect of the financial crisis was diminished by the unavoidable bail out of the financial sector. Behavior did not change materially. In fact, Mr. Blankfein has told his associates and shareholders that Goldman plans to profit in the future by following its existing business model.
The uneven playing field is undoubtedly a short-term benefit to the health of financial institutions. However, the long-term effects are in fact dangerous. In the hearings, the Senators gave tribute to the intellect of the investment bankers. However, while history suggests that they are smart enough to exploit immediate opportunities, it also tells us that they are not smart (or wise) enough to understand the imperfection of quantitative analysis. Use of ingenious algorithms requires a heavy dose of judgment, not swagger. After all, since no one knows all of the underlying factors, the algorithms may accurately measure conditions which do not exist (remember the mortgage bonds). Bias toward exploiting immediate advantages (fueled by this year's bonus) can color judgments. The bankers may be just smart enough to assure that their future failures will be monumental.
An excellent example of an unbalanced system is the market for hedging corporate price risk, referred to in the pending financial reform legislation as "end user" transactions and mentioned by Senator Kaufman.
The wave of privatization and deregulation during the last several decades has multiplied the number of activities exposed to price risk (more companies with activities in which unfettered market forces determine both their costs and the price of their products and services). As a result, the opportunities to create and trade derivatives based on these price risks have exploded. The number of markets has dramatically increased, but they tend to be narrow and comparatively illiquid.
To mitigate this profusion of price risk, companies have turned to derivatives hedging, prompted by credit rating agencies, among others. This constitutes a target-rich environment for sophisticated and well-capitalized bank traders.
As price risk along the production chain is transferred to a bank, it then owns a substantial portion of the value of the end commodity. For example, assume a power generator uses a derivative to fix the price of gas it needs to fuel a power plant and another to fix the price of the power it will generate. The bank selling the derivatives owns this spread between fuel and power and will manage it over time. The generator's business is in essence limited to operating the facility which converts the gas to electricity. A significant slice of the business of generating power has been sold to the bank at a price.
The problem occurs when these types of transactions are not struck in open, competitive markets. Financial institutions have huge advantages when dealing in derivatives with non-financial companies. Their balance sheets are far better suited to trading derivatives and their ability to extend credit provides great leverage. Using these advantages, banks, either alone or in oligopolies, can use market power to dominate narrow derivatives markets. Taken collectively, large slices of the economic flows migrate to the banks under favorable terms.
As prices of inputs and outputs have migrated to the banks, they have become dominant in large sectors of the economy. Companies have no realistic choice but to hedge. They become dependent on the banks to supply the hedge. The banks are able to charge more for hedges in opaque bi-lateral transactions because of disproportionate market power. A few pennies more in price may not matter to a company that must hedge to survive; but those few pennies on a huge book of business are extremely profitable to a financial institution.
Mr. Blankfein spoke of the public benefits of providing hedges to industrial companies. While financial institutions do provide this useful service, the question is whether the exercise of market power of a limited number of banks operating in shadowy markets is in the interest of the nation. The very level of financial sector profitability suggests that it is not.
Current financial reform legislation does not address this issue if it carves out the end users. The carve-out is sought to avoid required collateralization of exposures. This is a concern, since the exposures are real enough. Posting collateral merely transfers the risk from the shadowy over-the-counter market to the balance sheet of the end user, where it belongs. It eliminates the risk of liquidity death spirals posed by credit based collateralization triggers, common to these transactions. Finally, it eliminates huge end user exposures to bank credit risk, since the banks do not post either. While the inconvenience and cost of posting collateral are valid points, it may be that the dependence on bi-lateral bank transactions to provide hedges is the greater motivation behind end user resistance.
At a minimum, structures should be imposed on the bi-lateral market to mitigate the ability of the financial institutions to exercise market power if the end user carve-out survives. An alternative market structure could provide:
• Central recordation of bi-lateral trade data;
• Daily measurement of credit risk to both sides based on metrics approved by governmental authorities;
• Confirmation that the transactions in fact constitute hedges;
• Standards and mechanisms for required collateralization as circumstances change; and
• Standardized instruments to allow for predictable results in the event of default.
This structure would preserve the essential bi-lateral nature of the transactions. It would, however, allow regulators to view the overall risk exposures to the market participants based on understandable and uniform metrics. Early warning of the potential triggering of collateral calls and the potential liquidity requirement could be crucial to maintaining stability. And, finally, market power in narrow specific markets could be measured and monitored.
Wallace C. Turbeville is the former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.