The sequel to the global financial crisis is here
High credit ratings have hidden a structural instability, writes Frank Partnoy
by: Frank Partnoy
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The financial scene is familiar, the stuff of films like Inside Job and The Big Short. Rocket-scientist financiers buy up billions of dollars of risky loans and repackage them into complex investments with multiple layers of debt. Credit rating agencies classify the top layers as triple A. Institutional investors, including pension funds and charitable organisations, flock to buy these apparently risk-free yet high-yielding investments. Tension builds.
But the year is not 2006 or 2007. It is today. While the US administration talks of repealing Dodd-Frank, the reality is that regulators have been flouting that law for years and now the shadow financial markets are frothing. Almost a decade after the global financial crisis, the sequel has arrived.
The central culprit this time is the collateralised loan obligation. Like its earlier esoteric cousins, a CLO bundles risky low-grade loans into attractive packages and high credit ratings. In May, there were two deals of more than $1bn each, and experts estimate that $75bn worth are coming this year. Antares Capital recently closed a $2.1bn CLO, the largest in the US since 2006 and the third-largest in history. Although most of the loans underlying these deals are of “junk” status, more than half the new debt is rated triple A. Sound familiar?
During the early 2000s, similar highly rated deals called collateralised debt obligations were popular. At first, they seemed harmless, or at least not so big that their collapse could cause financial contagion. But when regulators ignored their growth, they became more opaque and more profitable, with credit ratings disconnected from reality. Like cracks in a building’s foundation, the risks seemed minor at first. But high ratings hid the instability of the entire structure. Until it was too late.
Dodd-Frank was supposed to stop these credit-rating ploys. But the Securities and Exchange Commission has permitted the agencies to dodge that law. While Dodd-Frank imposed liability on the agencies for false ratings, the SEC exempted them. Likewise, Congress barred the agencies from getting inside information about issuers they rate, but the SEC permitted that, too. As CLOs grow, the cracks are spreading again.
Last Christmas Eve, the so-called risk-retention rule of Dodd-Frank took effect, requiring that arrangers of these complex deals keep a slice of the downside. But clever financiers arranged for third parties to take on this risk.
The credit rating agencies, particularly Moody’s Investors Service and S&P Global Ratings, are the central actors in this story, just as in the original. The computer programs they use to assign triple-A ratings remain flawed. Because loan defaults can come in waves, mathematical models should account for “correlation risk”, the chance that defaults might occur simultaneously. But the models for CLOs assume correlations are low. When defaults occur at the same time, these supposed triple-A investments will be wiped out. CLOs are just CDOs in new wrapping.
Some experts say this time it is different. Earlier this month, Ashish Shah, a managing director of Madison Capital Funding, a subsidiary of New York Life, told a roundtable of CLO experts they should not worry about defaults in 2017. “The appetite for assets is ferocious,” he said. Pension funds, insurance companies and university endowments are demanding both safety and high returns. CLOs seem to offer both.
A new Office of Credit Ratings within the SEC is supposed to provide a check on this appetite. But when I sent a Freedom of Information Act request, seeking to identify which credit rating agencies have been found to violate SEC rules, the regulators refused to divulge names. Violators remain anonymous.
It is hard to police the financial markets. New business school graduates are inevitably one step ahead of their regulator counterparts, and many of the least creditworthy businesses find it easy to borrow, because their loans can be quickly repackaged and sold. During the debates about Dodd-Frank repeal, legislators should keep their eyes on these complex investments and the agencies that facilitate them.
Some might claim CLOs are different or smaller, or that regulators are better prepared today, or that business loans could not possibly default all at once, as home mortgage loans did. But similar arguments were made about risks during the early 2000s, before they spread to the major banks and AIG, and the markets spiralled out of control.
To avoid an even bigger crisis, regulators should heed warnings about financial dysfunction and hidden risks now, before the cracks spread.
The writer is a professor at the University of San Diego and author of ‘Fiasco: Blood in the Water on Wall Street’
THE SEQUEL TO THE GLOBAL FINANCIAL CRISIS IS HERE / THE FINANCIAL TIMES
CHINA´S "DOUBLE-FREEZE" CON / PROJECT SYNDICATE
China’s “Double-Freeze” Con
Minxin Pei
.
RECORD ETF INFLOWS FUEL PRICE BUBBLE FEARS / THE FINANCIAL TIMES
Record ETF inflows fuel price bubble fears
Growing numbers of investors moving into low-cost vehicles that track an index
by: Chris Flood in London
Floor of the New York Stock Exchange: Investors have ploughed $391bn into ETFs in the first seven months of 2017 © Bloomberg
Record-breaking inflows into exchange traded funds this year are fuelling fears that the tide of money surging into passive investment is helping to inflate a bubble in the US stock market.
Demand for ETFs has accelerated sharply this year, as a growing number of investors move into low-cost funds that track an index, and out of traditional actively managed funds in protest at inconsistent performance and high fees.
Investors have ploughed $391bn into ETFs in the first seven months of 2017, already surpassing last year’s record annual inflow of $390bn, according to ETFGI, a London-based consultancy.
The ETF industry has attracted almost $2.8tn in new business since the start of 2008, coinciding with one of the longest bull runs in US stock market history. The US benchmark S&P 500 index hit an all-time high on August 8, up 267 per cent since its post financial-crisis low in March 2009.
The rise of ETFs has prompted a growing chorus of criticism from some of the world’s most influential money managers, who complain about the effect of passive funds on asset prices and the potential for a liquidity squeeze in times of market stress.
“When the management of assets is on autopilot, as it is with ETFs, then investment trends can go to great excess,” said Howard Marks, co-founder of Oaktree Capital, the $100bn US alternative investment manager.
He cautioned that ETFs’ promise of ample liquidity has yet to be tested in a major bear market.
“It is not clear where ETFs and index mutual funds will find buyers for their holdings if they have to sell in a crunch,” said Mr Marks.
Paul Singer, the chief executive of Elliott, the $33bn US hedge fund manager, sharply criticised ETFs in a letter sent to investors in late July.
Demand for passive funds has been supercharged by governments’ manipulation of asset prices. This has “created the illusion that simply holding stocks and bonds in their index weights and sitting back, arms folded, is the perfect investment strategy”, said Mr Singer, according to a copy of the text obtained by the FT.
He added: “What may have been a clever idea in its infancy has grown into a blob which is destructive to the growth-creating prospects of free-market capitalism.”
Scrutiny of ETFs influence by regulators has intensified. Ireland’s central bank called in May for greater clarification on ETF ownership and pricing and the International Organization of Securities Commissions, the global umbrella body for securities regulators, launched a consultation last month that will examine potential risks posed by ETFs.
Most of the world’s largest ETF providers have experienced a surge in new business this year.
BlackRock and Vanguard, the world’s two largest asset managers, have benefited most. BlackRock has attracted net inflows of $158.9bn into its iShares ETF arm, already exceeding the $137.9bn gathered over the whole of 2016.
Pennsylvania-based Vanguard has seen new ETF business reach $91.8bn, nearing the $96.8bn gathered in 2016.
Martin Small, head of US iShares at BlackRock, said fears that ETFs were distorting asset prices were misplaced.
“ETFs combined with index products represent $17tn in assets, which is around 10 per cent of the market capitalisation of global stock and bond markets. The suggestion that ETFs are driving up the stock market or hindering efficient price discovery is fundamentally wrong and not supported by the data.”
ETFs, said Mr Small, were having a “profoundly positive impact”, helping many more retail investors gain access to robust low-cost investment portfolios. Around 10m new shareholder accounts have been opened at iShares over the past year, taking the register to more than 30m accounts.
A NEW PHASE IN U.S.-CHINA RELATIONS / GEOPOLITICAL FUTURES
A New Phase in US-China Relations
By Jacob L. Shapiro
Chinese President Xi Jinping (L) and U.S. President Donald Trump attend a working session on the first day of the G-20 summit in Hamburg, northern Germany, on July 7, 2017. PATRIK STOLLARZ/AFP/Getty Images
Hope Isn’t Enough
TRUMP´S GROWTH CHARADE / PROJECT SYNDICATE
Trump’s Growth Charade
Simon Johnson
WASHINGTON, DC – Officials in President Donald Trump’s administration frequently talk about getting annual economic growth in the United States back above 3%. But they are doing more than just talking about it; their proposed budget actually assumes that they will succeed.
TRUMP GOES ROGUE / THE NEW YORK TIMES OP EDITORIAL
Trump Goes Rogue
By MATTHEW CONTINETTI
In Donald Trump’s White House, Reince Priebus and Sean Spicer were more than chief of staff and press secretary. They were the president’s connection to the Washington establishment: the donors, flacks and apparatchiks of both parties whose influence over politics and the economy many Trump supporters wish to upend.
By firing Mr. Priebus and Mr. Spicer and hiring John Kelly and Anthony Scaramucci, President Trump has sent a message: After six months of trying to behave like a conventional Republican president, he’s done. His opponents now include not only the Democrats, but the elites of both political parties.
Since the start of his presidential campaign, Mr. Trump has made no secret of his dislike of the capital. But his contempt for the city and the officials, lobbyists, consultants, strategists, lawyers, journalists, wonks, soldiers, bureaucrats, educators and physicians who populate it becomes more acute with each passing day.
He ignores pleas to ratchet back his Twitter feed, rails against the inability of Congress to advance his agenda, bashes the press, accuses the so-called deep state of bureaucratic setbacks, and struggles to hire staff. In Robert Mueller, the special counsel, he faces a paragon of D.C. officialdom, investigating not only his campaign but also perhaps his finances.
For Trump, the Senate’s failure to repeal Obamacare was more evidence of Washington dysfunction, and a reason to declare independence from Priebus, the Republicans and political norms. The call to “drain the swamp” is now a declaration of war against all that threatens his presidency.
What we have been witnessing is a culture clash: a collision of two vastly different ways of life, personal conduct and doing business. The principles by which Mr. Trump lives are anathema to Washington. He abhors schedules. He wants to be unpredictable. He doesn’t tune out critics, but responds ferociously to every one. He values loyalty to the executive above all, and therefore sees family, who are tied together by blood, as essential to a well-managed enterprise.
Mr. Trump has no patience for consultants and experts, especially the consultants and experts in the Republican Party who were proven wrong about his election. Insecurity is a management tool: keeping people guessing where they stand, wondering what might happen next, strengthens his position.
Mr. Trump’s bombast, outsize personality, lack of restraint, flippancy and vulgarity could not be more out of place in Washington. His love of confrontation, his need always to define himself in relation to an enemy, then to brand and mock and belittle and undermine his opponent until nothing but Trump catchphrases remain, is the inverse of how Washingtonians believe politics should operate. The text that guides him is not a work of political thought. It’s “The Art of the Deal.”
The difference in style between Mr. Trump and Washingtonians is obvious. D.C. is a conventional, boring place. Washingtonians follow procedure. Presidents, senators, congressmen and judges are all expected to play to type, to intone the obligatory phrases and clichés, to nod their heads at the appropriate occasions, and, above all, to not disrupt the established order. We watch “Morning Joe” during breakfast, attend a round table on the liberal international order at lunch, and grab dinner after our summer kickball game. No glitz, no glam, no excitement.
Washingtonians avoid conflict. When someone is disruptive on the Metro we shuffle our feet, look another way, turn in the opposite direction. Residents of the “most literate city” in America, we do not shout, we read silently. We lament partisanship, and we pine for a lost age when Democrats and Republicans went out for drinks after a long day on Capitol Hill. The extent of our unanimity is apparent in the Politico poll of bipartisan “insiders,” the vast majority of which, regardless of party or ideology, tend to agree on who is up, who is down, who will win, who will lose.
To say that Donald Trump challenges this consensus is an understatement. Not only is he politically incorrect, but his manner, habits and language run against everything Washington
professionals — in particular, people like Reince Priebus — have been taught to believe is right and good.
This is what distinguishes him from recent outsider presidents such as Bill Clinton and Ronald Reagan: Both had a long history of involvement in politics, and thought the Washington political class might play some role in reform. Mr. Trump does not.
In this respect, Mr. Trump has more in common with Jimmy Carter. Neither president had much governing experience before assuming office (Mr. Trump, of course, had none). Like Mr. Carter, Mr. Trump was carried to the White House on winds of change he did not fully understand.
Members of their own parties viewed both men suspiciously, and both relied on their families.
Neither president, nor their inner circles, meshed with the tastemakers of Washington. And each was reactive, hampered by events he did not control.
If President Trump wants to avoid Mr. Carter’s fate, he might start by recognizing that a war on every front is a war he is likely to lose, and that victory in war requires allies. Some even live in the swamp.
Matthew Continetti is editor in chief of The Washington Free Beacon.
Bienvenida
Les doy cordialmente la bienvenida a este Blog informativo con artículos, análisis y comentarios de publicaciones especializadas y especialmente seleccionadas, principalmente sobre temas económicos, financieros y políticos de actualidad, que esperamos y deseamos, sean de su máximo interés, utilidad y conveniencia.
Pensamos que solo comprendiendo cabalmente el presente, es que podemos proyectarnos acertadamente hacia el futuro.
Gonzalo Raffo de Lavalle
Friedrich Nietzsche
Quien conoce su ignorancia revela la mas profunda sabiduría. Quien ignora su ignorancia vive en la mas profunda ilusión.
Lao Tse
“There are decades when nothing happens and there are weeks when decades happen.”
Vladimir Ilyich Lenin
You only find out who is swimming naked when the tide goes out.
Warren Buffett
No soy alguien que sabe, sino alguien que busca.
FOZ
Only Gold is money. Everything else is debt.
J.P. Morgan
Las grandes almas tienen voluntades; las débiles tan solo deseos.
Proverbio Chino
Quien no lo ha dado todo no ha dado nada.
Helenio Herrera
History repeats itself, first as tragedy, second as farce.
Karl Marx
If you know the other and know yourself, you need not fear the result of a hundred battles.
Sun Tzu
Paulo Coelho

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