Consequences of hyper-hypothecation • 13 December 2011 • The SnowBlog
Consequences of hyper-hypothecation
Oopsies
Sadly, that title isn't as much fun as it sounds. And it's not a writing or publishing term so you might want to sit this post out if you're not in the mood for gloom-laden current affairs talk.
Ann Pettifor is someone I mentioned on the blog in 2008. She's an economist and back in 2006 she wrote a book about how the boom in the global financial system would soon end to be followed by a huge debt crisis. Not only was she right about the outcome, she was right about the reasons for it.
The bad news is that she's now saying things are about to get worse. As the more economics-y of you may accept, this business of sovereign debt, where politicians wail about how much the U.K. or the U.S. government has borrowed, is a bit of a red herring. Sovereign debt didn't cause the current crisis and a number of countries currently suffering depressed economies have lower debt levels than they did in the past (in % of GDP terms). Take a look at the graph below (from Nobel Laureate Paul Krugman's NYTimes column) showing British public debt. Borrowing is well within historical parameters.
With the exception of Greece, the same is true of most other countries embroiled in the financial crisis. And given that public debt isn't causing the crisis, introducing severe austerity measures to drive it down seems at best a low priority and at worst a sure-fire way of sabotaging economic recovery. It's never made any sense to me, a non-economist, how spending less and sacking people could boost the economy out of recession, and a good many mainstream economists agree (link). Austerity measures make the the recession worse and they also do not address what got us into this mess.
The real danger, as Ann Pettifor will tell you, was never public borrowing, but speculation by under-regulated banks, the worst examples of which are in the City of London. But despite the recent financial catastrophe, we are still a long way from any serious reform of the banking sector. Only last week, the Prime Minister risked upsetting the rest of Europe and many of his fellow citizens by vetoing an EU-wide treaty because he felt he needed to protect the City from regulation. Shouldn't we all be glad that someone wants to regulate the banks, even if the EU proposals were 90% about protecting banks from their own bad decisions and only 10% about regulating them. But the P.M. has characterised the EU's suggestion of regulation as an attack on the City.
Even if he had a point, and regulation threatened the City's viability, surely there are some big question marks over whether we want financial services to be the sector Britain relies on for growth. Firstly, they've cost us more money than they've made and secondly they do a very mediocre job of providing employment and tax revenue compared to our old mainstay: manufacturing. See here for more on that topic. I wonder how many Brits, if forced to choose, would prefer a vibrant manufacturing sector over a vibrant investment banking sector. My guess would be nearly everyone.
But to get back to Ann Pettifor's warnings: we haven't done anything to curb the speculative excesses of the banks that triggered this recession and they're still playing Russian roulette on a huge scale. Which might not be so bad if, like Iceland, we were prepared to let them fail and to spend our time rescuing the economy and not the bankers (Iceland's banker-jailing, economy-saving miracle recovery is described here). But it's clear looking at the EU, at U.S. treasury policy and at the P.M.'s veto that the banks are still one of the highest priority stakeholders that governments want to please - if not the highest.
Ann Pettifor even shares a colleague's theory about which domino falling may be the start of the next cascade of failures: a firm called M F Global. She links to a piece by Christopher Elias at Thomson-Reuters (link) detailing how M F Global's use of something called 'hyper-hypothecation' allowed it to go spectacularly bankrupt in a way that many others may soon emulate. The problem is that M F Global went bust in the same way that AIG and Lehman's did back in 2008. The problems have not been fixed and the loopholes are still being gleefully and recklessly exploited.
I do hope Ms. Pettifor (and Christopher Elias and the other doomsayers) are wrong about all this, but that's what I said last time... and they were right. (Ms. Pettifor also has much to say on the subject of CDSs, which appear to be bets you can make that will pay out if you find a way to crash part of the financial markets. They also do not sound like something you want vast amounts of in circulation.)
Hyper-hypothecation, by the way, is discussed here. It refers to out-of-control re-hypothecation, which is when a firm uses their client's money as collaterial on the firm's own risky investments. It's legal, but it certainly doesn't sound safe. And worse, by using client's money to secure the firm's investments, a brokerage can act like a bank - but not one that's regulated like a bank. The UK rules - or rather lack of rules - that allow this sort of thing is the reason why Lehman's and AIG and now M F Global did business here... and we've done nothing to rein any of it in.
One of the reasons so much trading occurs in the City and not on Wall Street is that Wall Street, in certain important ways, has tighter regulations. The 're-hypothecation' rules are much tighter in the U.S. which makes it harder to run an entire 'shadow banking' sector the way you can if you set up an office in the City. And it's true that more regulation for the City might drive away business just as the P.M. fears. But the businesses it would drive away are those engaging in exactly the same hand-grenade-juggling act that blew up great chunks of the global economy in 2008.
Even if you don't see another financial collapse in our immediate future, there's no getting away from two points:
1) if we wanted to we could separate the aspects of banks that we need on a day to day basis (i.e. the high-street, 'retail' banks) from the 'casino' banks who make money from high-risk speculation. We could also limit the kinds of end-of-the-world bets the casino banks were allowed to make. And then, when they failed, we could watch them go while heaving a sigh of relief.
2) so long as politicians bend over backwards to give the banks what they want, they're not bending over backwards to help ordinary voters. The banks aren't the same thing as the economy; we know this because a rescue of the banks has plunged the rest of the country into recession. We need to stop politicians conflating the two and getting away with it. They're supposed to look out for the people who vote not the people who donate.
update: some signs of movement toward the separation of 'casino' and 'retail' banks as the Chancellor insists he'll push ahead with a plan to have banks 'ringfence' the capital of their retail operations. It won't go all that far and it won't happen fully until 2019 and it does nothing to address the re-hypothecation or CDS problems mentioned here, but it's certainly better than nothing. (an overview is available here)
A nice quote from that article by an ex-investment banker: "Of course, in the real world, one would expect the views of those responsible for the mess prompting the reform to be heavily discounted by those responsible for executing the reform. But politics and the real world have little in common. Since the political class has a lamentable lack of understanding of how finance actually works, it is forced to rely on advice from roughly the same crew that sank the ship in the first place, in determining how the ship should be remodelled."
Rob