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Another Lehman moment, he writes in his latest letter to investors, could come upon us easily, as financial institutions are still holding massive books of derivatives, private equity, and other illiquid investments.
Yes, Singer admits, banks are probably trying to decrease their positions in these assets, but we can't tell by how much based on the numbers they're reporting. One can only assess that the industry is still risky, opaque, and overleveraged.
But, Singer still has faith that these problems can be fixed — that, if the governments around the globe collaborate to take certain measures, the system can be simplified.
In his letter he lays out nine points for how that aim can be achieved.
- All investors, traders, institutions and counterparties, regardless of size and regardless of whether they are customers or end-users, should put up the same initial margin. In the case of derivatives in which the initial margin is less than 30% of notional value, two-way daily mark-to-market should be required. Special rules may be needed for completely matched trades in which institutions, nominally principals, are mainly intermediaries. But such trades create a lot of counterparty risk, so this area needs to be carefully studied in light of the widespread use of “netting” agreements today.
- The Orderly Liquidation Authority prescribed by Dodd-Frank should be repealed and replaced by an amendment to the U.S. Bankruptcy Code which would operate to prevent cross-default provisions from impacting derivatives books so long as mark-to-market payments are being made in a timely fashion. This way illiquid assets held by bankrupt entities can be handled in an orderly fashion without systemic risk, but the trading positions can keep going unless mark-to-market payments are not being made (in which case the defaulting party would trip the trigger for a termination event).
- Governments need to be authorized to provide “open bank assistance.” The convolutions of Dodd-Frank aimed at “avoiding” this tactic are ludicrous and will prove to be extremely costly to the system.
- Accounting rules need to change to provide investors with much more information about the sensitivity of bank holdings to various parameters, including: exposure to interest rates at different parts of the curve; exposure to moves in equity prices; currency relationships; delta and vega exposures to various underlyings; curve risk; what portion of positions is perfectly matched versus what portion is not matched.
- Credit ratings and risk weightings must undergo a thorough process of review and revision. No security or instrument on the planet should have a zero risk weighting.
- Regulatory regimes should be rationalized to eliminate inconsistent oversight of various instruments that represent exposure to particular assets.
- Derivatives trading should be standardized and as much as possible moved to clearinghouses. Margin rules for bilateral contracts must be made more uniform. A rule recently proposed by regulators (based on a Dodd-Frank mandate) provides numerous exceptions to margin-posting requirements for OTC swaps trades. Each such exception leads to more fragility and less safety for individual counterparties and the system as a whole.
- A globally-integrated study should be undertaken about how to ensure that deposit insurance does not support proprietary trading activities (as distinguished from enabling banks to make whole loans).
- Position sizes must be significantly reduced from current levels. As a result, financial institutions would not be any more leveraged than their customers. The reduced profitability of these institutions would be a small price to pay for the dramatically increased stability of the world’s financial system.
What Singer is proposing is an end to a global Too Big To Fail. But it's not that he wants banks to be out on their own; quite the contrary. He sees that banks are a utility that may, from time to time, need government assistance. That's fine, he says, as long as they're making mark-to-market payments.
If they're not, the banks will trigger a "termination event." Yikes!
Here in the U.S., Senators Sherrod Brown (D-OH) and David Vitter (R-LA) have proposed legislation to end Too Big Too Fail, but it's not nearly this comprehensive — where their bill is black and white (fail or no fail) Singer understands that there is a significant gray area.
The only point where the Brown/Vitter bill directly agrees with Singer is on risk-weighted assets. Otherwise, Singer is on a different plane, and it's something to consider.
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