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Posted 3/17/2003
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Im with Buffett: Some derivatives are scary
Its the huge financial transactions that you dont see that worry a lot of people. Poor disclosure and lots of destructive capacity is a lethal combination.
By Bill Fleckenstein
If the red robin of springtime doubled as a harbinger for a new bull market, there'd be birdwatchers on every corner. As it is, people try to spin the least bit of news into reasons why it's upon us. But we are not there yet, not in the aftermath of the biggest bubble in history. When we get closer, the incessant bottom-calling will have given way to total disaffection -- and you also won't find our Fed chairman or The Wall Street Journal pitching derivatives as the greatest thing since sliced bread.
Liquored up on leverage
A preliminary follow-up to last week's comments on derivatives: As I mentioned, Warren Buffett thinks the derivatives market is a time bomb. Though he did not draw the distinction I am about to make, I assume he would agree with me. When discussing the derivatives market, I do not mean to imply that there is a problem with exchange-traded derivatives, a.k.a. stock options, futures, etc. These do not have the same potential for abuse as "over-the-counter" derivatives, because the counterparty risk is policed by the exchanges. Also, since prices are set in a marketplace, valuation is transparent, as opposed to OTC derivatives, where no one knows what the real values are. There, prices are a function of guesswork and people's ability to make things up. And of course, it is in this market where exposure and the potential for cascading risk are greatest.
Last Monday, William Poole, the president of the St. Louis Federal Reserve Bank, amplified Buffett's time-bomb warning in a speech before the Office of Federal Housing Enterprise. (To read the speech, click on the link at left under Related Sites.) Poole's comments set off an incendiary device of their own, as Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs), major participants in the derivatives market, ended the day sharply lower. (Both bounced back as the week wore on.)
Before reprising the remarks that probably got people most upset, let me just mention a couple of his statistics: Housing-oriented debt, which comprised only 5% of nonfinancial debt at the end of World War II and about 20% in the early '60s, has grown to 30% today. Of that debt, 40% is issued by Fannie Mae, Freddie Mac or Ginnie Mae. (The latter, as a government-backed institution, obviously has no credit risk, but the same is not true for Fannie and Freddie.) In addition, Fannie and Freddie are far more leveraged than FDIC-insured commercial banks.
(Editors note: Leverage, sometimes known as the leverage ratio, divides assets by total equity in a company and gives a sense of its ability to withstand shocks. Fannie has a leverage ratio of 63.1. Freddies is 38.0. The leverage ratio of the banks in the Standard & Poors Banking index is 11.3.)
Lack of contrition, public admonition
With that as a warm-up, here is what Poole warned: "The issue with Fannie Mae and Freddie Mac is not primarily one of disclosure. Their annual reports disclose quite well the high degree of complexity of their operations, and the small amount of capital they carry above what is required by law (the emphasis is mine). My questions are these: Given the complexity of their operations, is the capital standard in the law adequate? Why is the standard so far below that required of federally regulated banks? What will happen to the housing market if Fannie and Freddie become unstable?" He goes on to supply this disturbing answer: "Should either firm be rocked by a mistake or by an unforecastable shock, in the absence of robust contingency arrangements the result could be a crisis in U.S. financial markets that would inflict considerable damage on the housing industry and the U.S. economy."
So there you are. I would just like to pose what I believe to be the operative question: Why did Poole choose to make this speech now? Why yell "fire" at a time when the markets are smoldering? Why not express all of those concerns in private? I don't know the answer, but I do have a theory. Perhaps Fannie and Freddie -- which have always been skilled advocates for protecting their turf and their favored status as government-sponsored entities -- wanted no part of Poole's prudence, so Poole hoped to effect a change of heart by sounding a very public alarm.
Windfall from an ill wind
Presumably, it did not register with his colleague, the ever-unflappable Easy Al, who still regards derivatives as the best innovation since indoor plumbing. That brings me to a recent editorial in The Wall Street Journal, titled "Derivatives Thinking." In essence, this embarrassing effort says that Buffett's got it all wrong and derivatives are wonderful because Alan Greenspan says so: "According to the ultimate nanny, Fed Chairman Alan Greenspan, derivatives have strengthened global financial markets by reducing (the emphasis is mine) the possibility of failure at one or more major institutions." And just how is this little feat carried off? "These instruments are little miracles of financial engineering, permitting investors to take a position, or make a bet (the emphasis is mine), without having to actually hold the physical asset." As an example, the editorial cites "weather derivatives, which allow investors to make a bet (the emphasis is mine) about future weather conditions, take their value from a temperature index, for example."
So, if derivatives are this good, then off-track betting and lotteries and casinos must also be wonders of modern finance, and America is indebted to them for its success. The sheer lunacy of this shows that uninformed denial is alive and well, and packaged as truth on the editorial page of a financial daily that seems not to have been embarrassed to capitalize the "n" and "e" in "new economy." I firmly believe that we will need to see sanity restored and an end to all the incessant bottom-calling before this bear market can end. It should be unequivocally clear that we had the biggest bubble in history, and that we are now experiencing a bust commensurate with that bubble. At the end of a bearish cycle, all the bad news (and then some) has to be discounted, just as at the end of the mania, all the good news (and then some, to the nth power) was discounted. (I have expected in all this a war-related relief rally and got it starting on Thursday.)
Beneath contempt breeds the bull
Somewhere down the road, we should expect stocks to become cheap. But also, we should expect people like myself, Jim Grant, Fred Hickey and Marc Faber -- who were bearish because of the bubble and have remained steadfastly bearish because of what we thought the bubble meant -- to become bullish, to be laughed at for being bullish, and to be beaten up with our own arguments. That's how it normally works. A mania like we had is not going to end with expensive stock prices and people still being in denial and buying tech stocks and catching the next rally and all that sort of thing. A mania like we had is not going to end with The Wall Street Journal defending Alan Greenspan over Warren Buffett on the subject of derivatives. (I guess time will tell whether Buffett is getting it right, or Greenspan and The Wall Street Journal are getting it right. But if anybody wants to make any bets, please see me first.)
William Fleckenstein is the president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column for TheStreet.com's RealMoney. William Fleckenstein's investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money.
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