The Credit Suisse executives who are sacrificial lambs being ousted as a result of that bank’s $4.7B loss from bad margin loans are all over the headlines. For the moment, the CEO, Thomas Gottstein, has survived the mess, largely given the newness of his tenure. That said, it is the second scandal-like loan debacle to tar CSFB in recent months, and may be the second strike of Mr.Gottstein’s three-strike turn at bat. The costs to the bank are enormous, hurting both shareholders and—via bonus eradication—many of its employees as well.
The causal factor, a total return swap, damaged other financial institutions as well. Nomura Securities is said to be another major loser along with smaller damage at other leading banks. The underlying counterparty, Archegos, the Hwang family private equity firm, was decimated, wiping out a reported $10B fortune overnight. Borrowings of up to $60B had been made against the $10B of equity, or leverage of 6X, equity, which proved to be inadequate when the concentrated portfolio fell in value.
These losses are enormous enough, but fortunately were not systemically catastrophic. They harmed but did not ruin the lenders. However, imagine that one underlying loan to one family could cause that much damage. What would the consequences be if the sums were yet greater, the number of participants larger, the snowball effect even more of an avalanche?
In the wake of the collapse of Lehman in 2008, the capital required of banks was strengthened and the Volcker Rule, prohibiting proprietary trading by them, was enacted. The former has prevented widespread failures of deposit and lending institutions since the Great Recession. The latter has been watered down by rule and exemption, but still bars ownership of hedge funds and private equity firms by investment banks. However, as time has passed since the ’08-09 debacle, the risk of pervasive collapse has once again escalated. The Minsky rule, formulated by a once professor of mine, says that borrowing has three phases. In the first, borrowers intend to and do pay back principal and interest. In the next, their plan is to pay the interest as it accrues. In the third phase, the hope is to find someone to buy the assets from them at an inflated price, one that will providentially retire the loan. It is a variant of the greater fool theory.
Mr. Hwang exemplifies a borrower with the third phase mindset. And he is not alone. The raft of retail Robinhooders operating on margin are cut from the same cloth, albeit with far smaller sums, and far smaller pocketbooks, than he had. Margin debt is fluttering above $800B, an all time record and invariably a harbinger of bad times in the offing. Stimulus spending in the Ts, as in trillions, and monetary policy in the 0s, as in interest rates held near zero, are gasoline waiting for a match. Remember that Lehman alone brought down Bear Stearns, Merrill Lynch and a host of real estate lenders. The same vulnerabilities exist today.
What do we do to prevent a financial panic in the wake of the pandemic? Look backward to see the future, as Marcus Aurelius said.
• Reintroduce changes in the margin requirements—Regulation T. It’s a Fed tool that has been in mothballs since 1976. Beyond the actual impact on what can be borrowed to purchase stocks, it is a strong signal that the Fed can use when it sees bubbles forming. It can also easily be expanded to control what is called portfolio margin or total returns swaps, part of the shadow banking world that desperately needs to be reigned in.
• Bring back Glass Stegall. The CSFB problem was not an isolated incident. Recall the London Whale loss suffered by JP Morgan, thought by many to be one of the most tautly run of all the banks. The dozen or so dominant universal financial institutions are so large, so complex, have so many lines of business and are populated by so many people that no one can oversee the totality of their endeavors adequately.
There is no real economic or other advantage in the mammoth scale of these entities and the interconnectivity of their many parts presents a myriad of potential conflicts of interest. The failure of a single major section of one could jeopardize all of them. All. Totally. The right course is to confine each financial service company to narrower, and therefore better understood, activities.
We—the global “we”—don’t need to have a disaster fomented by runaway and misunderstood leverage creating depression that would cripple nations for many years to come. There are simple steps to create a financial vaccine to prevent it. The cures are straight forward and without major political side effects.
George Ball is chief executive officer of Sanders Morris Harris in Houston.