I read a couple of interesting op-ed's this week in The Wall Street Journal: "Have We Seen the Last of the Bear Raids" by former hedge-fund manager Andy Kessler (3/26) and "One Way to Stop Bear Raids" by left-wing billionaire George Soros.
It is also important to understand the underlying valuation debate involving historical cost vs. mark-to-market (MTM) accounting. Robert Arnott, in an excellent letter to the WSJ editor, provides a good summary of the debate (a response to a recent pro-MTM opinion by James Chanos entitled "We Need Honest Accounting"). Historical cost can be misleading because it represents a transaction at a particular point in time, and book value accounting tacitly and often misleadingly implies that the asset price remains stable. On the other hand, MTM accounting, as implemented, including its application to regulatory capital, can result in unnecessary volatility and the need for immediate, short-term deleveraging drastic responses, such as sales of assets in a frozen market or having to raise capital, unduly watering down current shareholder stakes, even if current operations are robust and profitable. Arnott does not argue against transparency or the need to write down unrealistic asset book values but allowing companies to smooth out the effects of fully disclosed bad news over multiple accounting periods. Arnott concludes, and I agree, "We had no need to eviscerate the U.S. financial services industry in the past year."
Kessler argues that the bank bears found a different method of attack. Bears typically make money by borrowing shares at current prices and repaying the shares at lower prices. (Kessler gives us the bear's inverted version of market-manipulative "pump-and-dump" tactics, which I'll call "trash-and-buy".) He says that the bears wanted to exploit the vulnerability of banks holding derivatives in reserves, given MTM accounting. The bears had no hope of cornering the $62B derivatives market. But they could make use of CDS--which regulators required banks to own in order to hedge against losses.
Kessler suggests that bears took advantage of an inverse relationship between CDS's and derivatives. An increase in the price of CDS's was viewed by the market as implying a higher risk and hence lower value of the relevant derivatives. He quotes the GE CEO, whom saw his own company's stock tank from $36 to $6, complaining how a few million dollars of transactions in the unregulated CDS market could threaten the survival of major corporations.
Who were these bears? Kessler says that they were hedge funds. And he finds a great deal of irony in the fact that the US Treasury seems to be encouraging hedge funds to invest in Geithner's Public-Private Investment Program, which he seems to think gives the bears an additional way to profit from the situation they're responsible for (and yet another incentive to redouble the CDS manipulation and depress asset prices further). Kessler suggests that the government fight the bears by turning the tables on them, i.e., dumping CDS's on the market, driving down their prices and stabilizing the CDO's.
Kessler has little sympathy for AIG, noting they never properly hedged against their large CDS exposure (including setting up reserves or collateral, coasting on the reputation of their AAA rating). Soros concurs, accusing AIG of conceptually misunderstanding the nature of swaps, viewing them as primarily insurance but never fully grasping the fact they are tradeable and also served as a proxy for shorting bonds. Soros argues unlike stocks, where risk-reward ratio works against the bear, purchasing CDS's works in favor of the bear through a self-validating adverse effect on CDO's. He view CDS's as warrants which do not require defaults on underlying CDO securities to be profitable.
Soros' suggested response to the bear's tactics of shorting financial service stocks and purchasing CDS's is to restrict short selling to rising markets and to rid the CDS market of market speculators through appropriate regulations.
The Wall Street Journal Friday ran a story I found disturbing that many of the same people whom oversaw and approved many of the disastrous AIG CDS's (roughly 5 of 10 members in the Credit Risk Committee), and a related Enterprise Risk Management group are still working for AIG. Additional questions had been raised (by independent auditors or regulators and recently echoed by current CEO Edward Liddy) as to the limited access and cooperation the risk groups had from the financial services and other divisions. Mr. McGinn, a top deputy to Mr. Lewis, chief risk officer since 2004, however insists that risk evaluators were involved with the CDS business from the get-go. Whatever the case may be in terms of interference with risk assessment, its failure to set up reserves or collateral or otherwise to hedge its risks in the CDS market, I think there was a clear management failure, and I would be looking for alternative, capable leadership.
In response to the question I posed, I think that the company leadership was incompetent. I have no doubt that the financial services group wanted to maximize sales of CDS's, but any insurer from the get-go knows about the need to establish adequate reserves for expected losses.
