The sequel to the global financial crisis is here

High credit ratings have hidden a structural instability, writes Frank Partnoy

by: Frank Partnoy

The dangers of complex investments, as highlighted by the film The Big Short, still loom large

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’

China’s “Double-Freeze” Con

Minxin Pei
. rally in pyongyang

CLAREMONT, CALIFORNIA – North Korean dictator Kim Jong-un says the United States will pay a “thousand-fold for all the heinous crimes” it has committed against his country. US President Donald Trump warns that North Korea will experience “fire and fury like the world has never seen.” Kim threatens to fire four missiles at the US territory of Guam. Trump promises that Kim “will truly regret it” and “regret it fast” if he follows through on that threat, or issues another.
As the unprecedented exchange of white-hot rhetoric and overt military threats between the leaders of two nuclear-armed countries continues to escalate, reasonable people around the world are asking whether there is a peaceful way out of this unfolding crisis. The answer, according to some, is to pursue a “double freeze,” in which North Korea freezes its nuclear and missile activities in exchange for the US and South Korea freezing their joint military exercises.
At first glance, this option – which was originally proposed by China, and has since been endorsed by Russia – appears to be a sensible compromise. Without the ability to test nuclear and missile technologies, North Korea would be stuck with what it already has. Rather than a potent arsenal with credible long-range capabilities, it would have an unreliable arsenal with potentially no miniaturized nuclear warheads. For the US, suspending joint military exercises with South Korea seems like a small price to pay for such an outcome, as it would do little to undercut America’s overwhelming military superiority.
But the US has flatly rejected China’s proposal, ostensibly because it seems to morally conflate North Korea’s quest for weapons of mass destruction (which it appears fully prepared to use) with America’s right to defend itself and its allies. In accepting a double freeze, the US would essentially be rewarding North Korea for ceasing activities that are already in violation of United Nations Security Council resolutions.
In addition to the dangerous precedent that it would set, the double-freeze solution has two fundamental weaknesses. First, the costs of non-compliance for such a deal would not be symmetrical. The Kim regime would incur only modest costs by restarting its nuclear program, but it may be able to impose severe and irreversible costs on the US and South Korea, should that decision lead to a full-fledged nuclear arsenal.
This is partly because of a second key weakness: the difficulties of verification. It is easy to tell whether the US is conducting military exercises with South Korea; it is much harder to ensure that North Korea is not engaging in underground research and development activities.
Indeed, most of North Korea’s R&D, not least its enrichment of fissile materials, occurs in secret facilities inaccessible to outside inspectors. Under a double-freeze arrangement, North Korea might halt only its observable activities, such as its missile and nuclear tests. Worse still, this could even work in Kim’s favor, by buying time for his scientists to master technologies – particularly nuclear-warhead miniaturization – that could then be quickly deployed once the deal is publicly broken.
Such an approach would be nothing new from North Korea. In 1994, when the US and North Korea last agreed to a freeze on North Korea’s plutonium production, Kim’s father, Kim Jong-il, quickly broke the deal, embarking on a secret uranium program. The Americans have no reason to buy the same horse twice.
Of course, the weaknesses of the double-freeze approach are probably not lost on China, either. Indeed, offering this solution was, in all likelihood, largely a tactical decision. As the Kim regime’s principal patron, China is viewed as the key to containing Kim’s nuclear ambitions. But China is reluctant to squeeze North Korea, because it fears that doing so could lead to the collapse of the Kim regime, and the loss of its strategic buffer against the US.
Against this backdrop, the double-freeze proposal was not intended to actually resolve the crisis; after all, China probably expected the US to reject it. Rather, China wanted to shift the international community’s attention away from its own potential leverage over the Kim regime, and toward the Trump administration’s erratic and worrying policy approach. By raising the double-freeze solution, China put the ball in America’s court, and placed the onus for resolving the crisis squarely on Trump’s shoulders.
If China truly does want a peaceful resolution to the escalating nuclear crisis, it should address the two key weaknesses of the double-freeze solution, proposing a detailed, intrusive, and stringent verification regime and committing itself to serve as the principal enforcer of the agreement. China should make it clear that, were North Korea to violate the deal, it would immediately lose all of the protection and support it receives. Now that would be a deterrent.

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 US-China Relations

By Jacob L. Shapiro

North Korea conducted another test of an intercontinental ballistic missile on July 28. This act was met with a number of threatening gestures from the United States over the weekend, including a test of the THAAD anti-ballistic missile system in Alaska and the flight of B-1 bombers over the Korean Peninsula. U.S. President Donald Trump harshly criticized China in a series of tweets, accusing Beijing of doing nothing to solve the ongoing North Korean threat and insisting that Beijing could solve the problem easily if it wanted to. The upshot of all this is that the relationship between the two largest economies in the world now depends on developments in Pyongyang. North Korea is shaping world events far outside its weight class.

The U.S.-China relationship had been cozier during the first half of 2017 than we expected in our annual forecast, in large part because Washington wanted China to help persuade North Korea to give up its weapons program. But that relationship is now beginning to deteriorate and fall more in line with our expectations. The notion that China could fix the North Korea problem was part cheap parlor trick and part wishful thinking. China’s influence in North Korea is far less potent than most suggest. China excels at appearing more powerful than it is on the world stage, which works well until the power that it had flaunted has to be exercised.

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

Distinct Phases

Since Mao Zedong declared the founding of the People’s Republic of China in 1949, U.S.-China relations have moved through three distinct phases. The first phase lasted from 1949 to 1972. The main feature of the relationship was that the United States and China were on opposite sides of the Cold War. The second phase lasted from 1972 to 1991 and amounted to a complete reversal. China feared the Soviet Union, and the United States was reeling from the Vietnam War. The two countries solidified a more cooperative relationship grounded in a shared geopolitical interest in limiting Soviet power. The third phase began with the Soviet Union’s fall in 1991 and continued until very recently, when the fundamentals that defined the relationship began to change.

This third phase was defined by two key elements. The first was economic interdependence between both countries. China grew to become the second-largest economy in the world by relying on exports. Its substantial population enabled China to produce large amounts of goods at a lower cost than most countries. The result was that companies moved their production and assembly operations to China to drive down costs. This had many consequences, but three are of geopolitical importance. First, the United States became the largest destination for Chinese exports. Second, China became the largest source of U.S. imports. Third, millions of American workers lost their jobs because factories in the United States relocated their operations to China – but Americans also enjoyed access to cheaper goods as a result.

The intertwining of the U.S. and Chinese economies created new constraints on both sides of the relationship. China must prolong export-led growth for as long as it can. It needs to preserve access to the U.S. market, which remains the largest market for Chinese goods in the world. In the United States, economic interdependence with China has also created constraints. American consumers are addicted to cheap imports from China and other countries. More than 20 percent of all U.S. imports come from China. Trump came to office touting protectionist policies, but some of those policies would disproportionately hurt the very voters who propelled Trump into office because introducing tariffs would raise costs for consumers. American production could not replace imports overnight, and once it did, the price of goods would increase.

The second defining feature of the third phase of U.S.-China relations is the absence of a common enemy. The United States and China set aside their differences over Taiwan in 1972 because it was more important for both countries to cooperate when it came to the Soviet Union than it was to squabble over a comparatively minor issue. The collapse of the Soviet Union and the general weakness of its successor, the Russian Federation, eliminated one of the main strategic interests the United States and China shared.

It also changed the geopolitics of the situation on the Korean Peninsula. Both China and the Soviet Union had treaties with North Korea, but the fall of the Soviet Union meant North Korea had one less major power to balance off of. Here the United States and China also have divergent interests. Beijing wants to see a pro-China Korean Peninsula. That is beyond its grasp, so instead it seeks to maintain the status quo: a divided Korean Peninsula, with the North in Beijing’s sphere of influence. The United States wants to see a unified, pro-U.S. Korean Peninsula. But in the absence of that, Washington will accept a secure South Korea and a regime in Pyongyang without nuclear capabilities.

Thus, when it came to the Korean Peninsula, U.S.-China relations in the 1990s and 2000s were characterized by both friction and cooperation. But Kim Jong Un’s progress in the development of a deliverable nuclear weapon over the past two years has elevated the importance of North Korea in the U.S.-China bilateral relationship.

Hope Isn’t Enough

The hope was that Beijing could rein in Pyongyang, but hope is not a solid basis for action. When Kim executes family members with anti-aircraft guns and seems to be making progress in developing a deliverable nuclear weapon, it raises doubts about China’s level of control and Pyongyang’s intentions. The question of how much power Beijing has over Pyongyang is now at the center of U.S.-China relations. Unless China has a rabbit to pull out of its hat, it appears that the question has been settled. Either China does not have enough power to convince North Korea to halt its weapons program, or it does not have the imperative to use it. We suspect the former, but either way the result is the same.

U.S.-China relations are now starting to enter a new phase. This was inevitable; politics among nations is not a stagnant affair, and China has seen extraordinary growth of its economic and its military capabilities, especially in the past decade. The U.S. and China were going to butt heads eventually. Their economies remain interdependent, but at the political level China and the U.S. have divergent interests, and the gap is widening. In the past, those differences were mitigated in large measure by the economic interdependence between the two countries, and by the low stakes of the areas where China and the U.S. disagreed, like man-made molehills in the South China Sea. But now North Korea is testing ICBMs and the U.S. cannot tolerate the threat. The U.S. will be focusing on the North Korea issue first, as it is more pressing, but what shouldn’t be lost in all of this is that U.S.-China relations are entering a new phase, and it promises to be a much bumpier ride than the past 26 years have been.

Trump’s Growth Charade

Simon Johnson

Wall Street bull

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.
If they do, it would represent a significant improvement over recent performance: the US economy has averaged less than 2% annual growth since 2000. And, while an increase to 3% might sound small, it would make an enormous difference in terms of employment and wages.
Unfortunately, left to its own devices, the economy will most likely continue to sputter. And the policies that Trump’s Republican Party has proposed – for health care, taxes, and deregulation – will not make much difference. The assumption of higher growth is more of an accounting smokescreen for tax cuts than anything else. If administration officials acknowledge that a 3% annual rate is not feasible, they would need to face the reality that their forecasts for tax revenues are too high, and that their proposed tax cuts, if enacted, would dramatically increase the budget deficit and the national debt.
The US economy used to grow at more than 3% per year; in fact, this was the norm in the second half of the twentieth century. Since then, however, the US has been forced to confront three major constraints.
First, the US population is aging. As the baby boom generation (born after the end of World War II) retires, the proportion of retired people in the total population increases. Over time, this demographic shift has reduced US potential annual growth by perhaps as much as half a percentage point.
The details of what will happen to health insurance remain unclear. But making it harder or more expensive for lower-income and older Americans to get health insurance is not likely to encourage people to work. The best independent assessment of these policies, produced by the Congressional Budget Office (CBO), does not predict any economic miracles – just that around 20 million fewer Americans will have health insurance.
And lurking in the background are potential policies that would restrict legal immigration. The US currently allows about one million mostly working-age people per year to take up residence and work in the country. Moreover, immigrants’ tendency to have more children than non-immigrants do keeps the US population growing faster than in other developed countries (for example, in Europe or Japan). So any move to reduce annual immigration – some Republicans are proposing 500,000 people or fewer – would make 3% annual economic growth even less likely.
The second economic constraint is the slowing rate of productivity growth. There was a major increase in average output per person in the post-World War II years, as better technology was developed across a wide range of sectors. And there were hopes in the 1990s that the information technology revolution would have a similar effect. But the impact on productivity has been disappointing. Northwestern University economist Robert Gordon’s recent book, The Rise and Fall of American Growth, argues that, despite all the hype from the tech sector, we are unlikely to see a dramatic change on this front.
The Trump administration argues that by reducing taxes and “reforming” healthcare, it can boost productivity – for example, by encouraging capital investment. But the tax cuts that will soon be on the table are likely to resemble closely those implemented by President George W. Bush’s administration, which did not lead to any kind of economic boom (a point that James Kwak and I examined in detail in our book White House Burning).
The third constraint stems from the 2008 financial crisis. One danger inherent in pushing for high growth is that it is always possible to juice an economy with short-term measures that encourage a lot of risk-taking and leverage in the financial system. Deregulation in the 1990s and early 2000s did exactly that, leading to slightly higher growth for a while – and then to a massive crash.
The details of the Trump administration’s plans remain to be determined, but officials will most likely push in the direction of relaxing limits on leverage (thereby allowing banks to borrow more relative to equity). Any boom generated in this way is likely to end badly – not just financial ruin for millions of individuals, but also a long and difficult recovery.
The two least political and most influential official forecasts – those issued by the CBO and the Federal Reserve’s Open Market Committee – both foresee 2% growth, on average, for the coming decade and perhaps beyond. Assuming 3% growth is, to put it generously, wishful thinking.
Worse, it is deeply misleading – and potentially dangerous. If those pushing for tax cuts stick to their guns and refuse to accept reality, their agenda, if enacted, would result in a significantly wider budget deficit, which would increase the national debt to unprecedentedly high levels.

Trump Goes Rogue


President Trump at the White House on Thursday. Credit Doug Mills/The New York Times        

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.