Bretton Woods II - A Roadmap
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Following calls by European leaders for a "Bretton Woods II", the Bush administration has invited the "G-20" countries to come to Washington with the lofty goal to reform the world financial system. Will the way we do business change November 15?
The first Bretton Woods conference, held in 1944, gave birth to the International Monetary Fund (IMF), the World Bank and - albeit with half a century delay - the World Trade Organization. The Bretton Woods conference is best known for firmly anchoring the U.S. dollar as the world's reserve currency. As we will elaborate on below, however, the dollar had to be devalued and taken off the gold standard in 1971 because of market dislocations that are not so different from what we are experiencing today.
As of yet, there is no published agenda for the G-20 meeting. German Chancellor Angela Merkel and French President Nicolas Sarkozy call for "genuine, all-encompassing reform of the international financial system." This doesn't sound like we will know on November 15 how the world will be structured in the coming decades. In 1944, 44 governments met for 22 days. Today, numerous competing groups are trying to seize the opportunity to shape tomorrow's world. The November 15 meeting will start a process that may take some time. Don't forget that the U.S. has a lame duck administration and foreign leaders will want to negotiate with the new, not the old administration. It will be interesting to see how much of a running start the new administration can deliver.
The main goal of the conference should be to discuss ways of lowering the risks of a re-occurrence of a similar crisis. Discussions on how to deal with the current crisis should be dealt with separately as the past 18 months have shown that the heat of the moment leads to rushed decisions with side effects where the cure of the disease may be worse than the disease itself.
We do know that world leaders and the public alike are upset that the current financial crisis has spread to affect just about every business and person around the world - from the CEOs of what used to be investment banks; to Maine fishermen that have to dump Lobster at a loss making $2 a pound on the market because the processing facilities across the border in Canada have vanished as buyers as they relied on now defunct Icelandic banks for their lines of credit; to the retail industry in the U.S. because their suppliers cannot get lines of credit to ship containers from Asia despite an implosion of shipping rates by some 90%; to farmers that may be unable to buy the seeds for next year's crops; to starving children in Africa that may receive less aid. And why are we in this mess? From an Asian and European point of view, it comes down to a simple realization: because they loaned money to the U.S. The rest of the world wants to reign in what it perceives to be Wild West capitalism. There is also a lot of blame to be placed on foreign regulators, policy makers and financial institutions, but it is always more convenient to look for a scapegoat elsewhere, in this case in the U.S.
We believe discussions will center on making the financial system less risky and more transparent. One of the main weaknesses exposed has been that institutions take on low probability / high-risk positions. Akin to being afraid of a potential nuclear war, we tend to dismiss this risk because the odds of one happening are extremely low (see also minimizing the nuclear risk). In the corporate world, these risks are often ignored; one reason they are ignored is because most firms have limited liability: if the trade works, the payouts are huge. In the unlikely event of failure, you close the shop; let the creditors go home empty; then open a new shop. This model has been employed by hedge funds for years: after a bad year, you start a new hedge fund as you don't have to make up prior losses to get fat profit sharing fees. But now we have major corporations act as hedge funds and failure results in massive job losses and taxpayers are the ones footing the bill; the executives responsible, however, received their salaries and bonuses during the good years and are protected. Capitalism is built on risk taking; the concept of facilitating risk taking using limited liability has been very beneficial to economic prosperity. Changing this concept is unlikely to be on the table, especially since a model of unlimited risk has also shown severe flaws: many will remember Lloyds of London, where "Names" assumed unlimited liability for the insurance company. The "low probability / high-risk" event did occur - notably paying claims related to asbestos litigation -, threatening thousands of Names with personal bankruptcy.
In our view, the 'Bretton Woods II' meeting's most visible result may be new regulation on the type and scale of risks institutions may engage in. In focus is the derivatives industry where contracts with no or low margins can be engaged in. Low margin requirements for commodity producers (also called commercials) to lock in prices not only make a lot of sense, but are vital to the industry. If a farmer had to deposit 50% of the value of the crop with a counter-party to lock in a price, the farmer would opt not to hedge, but produce less. There are, however, calls to require speculators to put up far higher collateral in the future, likely driving many away from the markets. As we have already seen, however, the markets need the speculators as well: the commercial player needs to have the speculator as a counter-party to take on the risk so that the commercial producer can hedge in the first place. What policy makers must focus on is that the failure of any risk taker does not cause a systemic risk. And the futures markets have worked quite well in that regard: on a regulated exchange, there are strict rules on providing sufficient collateral; this "mark to market" method is strictly enforced. Part of the recent volatility is due to brokers liquidating positions of hedge funds that cannot meet margin calls. But while such liquidations are painful, they preserve the system by forcing losses to be cut within hours or days.
In off-exchange derivatives, however, the rules are rather opaque. But there is a reason for the opaqueness as well: say, you are the beneficiary of a life insurance policy on your spouse. Your spouse is gravely ill. Will you require your life insurance carrier to deposit part of the insurance into a custody account? Will you require your life insurance to increase that deposit if the doctor says your spouse's life expectancy has just been slashed because he or she is not reacting to a medication? The reason why life insurance companies don't work that way is because they assume that not all of their customers die the same day. The financial services industry requires collateral on derivative contracts, but the collateral required during the boom years was rather small. As a result, the banking community was able to create a derivatives industry in the tens of trillions of dollars, mostly unregulated. In the case of credit default swaps (CDS), as the risk of default for formerly sound companies rose, counter parties required more collateral. Those who wrote insurance against the default of companies of, say, General Electric, now have to post large amounts of money, whereas the business model when such insurance was written assumed that the scenario was all but impossible. In the case of Lehman or AIG, it turns out that formerly "safe" companies were risky, after all. Returning to the example of the life insurance, we tend to only take out insurance on something we have a stake in. In the derivatives industry, however, only a fraction of buyers of CDS insure an underlying bond portfolio; the vast majority of positions are speculative positions that firm ABC fails; the speculator has no underlying exposure to ABC, merely betting on its demise. That's akin to you taking out life insurance on Joe the plumber, Joe Six-pack or any other Joe; Joe never has to know about the insurance, nor is Joe a beneficiary. To fix the problem, the Treasury and regulators in the European Union are urging the industry to agree on central clearing for CDS. By moving such contracts onto regulated exchanges, the counter-party risk is radically reduced. Collateral would need to be posted on a daily basis; importantly, a broker will close out a position if collateral is not posted. While this may create losses that wouldn't occur if the contract was held to maturity, it essentially eliminates the systemic risk and forces participants to be more prudent in the amount of leverage they use. A regulated exchange can also provide transparency, allowing regulators to see who bets on the demise of Joe's plumbing firm.
Regulation can also be counter-productive; capping the tax deductibility of executive pay in the early 90s led to the birth of options based compensation and subsequent scandals. If nothing else, there should be a drive to standardize executive compensation disclosures, so that they are not afterthoughts in financial statements, but become household financial variables that allow investors to evaluate when making investment decisions. Beyond agreeing on more disclosure, policy makers ought to be very careful on how to proceed. No matter what the regulations are, financial institutions may always find a way to abuse them during the peak of a bubble.
In our view, rating agencies will likely see major changes in how they will be regulated. Currently, the issuers of securities pay the agency, leading to a conflict of interest and tend to prefer paying for high rather than low ratings. For example, issuers opted not to pay for optional publication fees when ratings were undesirable. There are a number of models under consideration; ultimately, however, the buyers of securities have been too lazy by outsourcing their analysis. It was also the rating agencies that encouraged municipal bond insurers to broaden their revenue streams by insuring collateralized debt obligations (CDOs) to retain their high ratings; this sort of 'consulting' can backfire as the CDO market has become the downfall for the bond insurers, although it is doubtful that incompetence can be regulated away.
A topic of controversy will be whether to relax fair value accounting standards. Those in favor argue that the downward spiral in financial asset prices could be halted if financial institutions were able to keep assets at cost if their intent is to hold them to maturity and if management believes the ultimate value realized may be a gain. However, it's precisely this attitude that has caused the credit markets to seize because institutions don't trust one another. Housing prices, the ultimate source of many of the problems in financial markets, continue to head lower; to allow companies to fudge their books is plain irresponsible. Unfortunately, the lobbies are strong and there is sympathy with the industry in the U.S., Europe and Japan.
The big fear of Bretton Woods II to the U.S. Treasury is that financial innovation will be stifled. While that's precisely what the public and many policy makers around the world want, the U.S. as a center of the world of finance has the most to lose. Already, many traders and hedge funds are closing their businesses, not just those who have lost a lot of money, but many others who simply do not want to trade when the rules change every day. The damage inflicted here will cost New York and London billions in tax revenue. The likely winner is Singapore that will try to lure some of that business to come to the small state.
The transition from U.S. accounting principles to international accounting principles may be accelerated as part of Bretton Woods II. This may sound insignificant, but has major implications: every new Chartered Financial Analyst (CFA) will no longer be studying U.S., but international rules. Under U.S. accounting rules, corporations can currently reduce the value of their liabilities if their own publicly traded debt is valued at cents on the dollar. That will contribute to a shift from a U.S. centric world to a global world. As healthy as this may be, it will reduce the importance of U.S. financial markets relative to others. There may be restrictions on the amount of leverage institutions may be allowed to use; or on short selling; or on how new financial products are developed. As is often the case with new regulation, the primary implication will be an increase in the barrier to entry. You won't be allowed to engage in short-selling, but those with special licenses will continue to be: note that market makers must be allowed to sell short to ensure an orderly market on the New York Stock Exchange. Or Exchange Traded Funds (ETFs) must allow Authorized Participants to engage in short selling to ensure that the ETF tracks an underlying index.
It is quite likely that the rest of the world will want to impose restrictions that negatively affect the way U.S. financial institutions operate. The question that has yet to be addressed is what will the U.S. demand in exchange for agreeing to reign in its industry. While the answer to this question is open, it can range from strategic to financial. A strategic demand could be concessions on military relationships. We believe there is a reasonable chance that the U.S. will ask the world to accept a substantially weaker U.S. dollar. That's because the U.S. needs to reflate its economy if it does not want housing prices to go any lower. In 2009, an unprecedented amount of debt needs to be raised, raising the odds that creditors will demand higher compensation, i.e. higher long-term interest rates. But if there is one thing the Federal Reserve (Fed) wants, it is to keep the cost of long-term interest rates low. The government may boost the involvement of Fannie and Freddie to offer subsidized mortgages, but sooner rather than later, the Fed may be forced to intervene in the bond markets to keep the cost of borrowing low. Fed Chairman Bernanke has repeatedly praised Franklin D Roosevelt's move to get the U.S. off the gold standard in the 1933 to allow the price level to rise to the pre 1929 level; his main criticism of the Great Depression and that of Japanese authorities in the 1990s has been that they have moved too slowly. As a result, while currently not the main topic of concern for Bretton Woods II, a currency adjustment may well be one of the consequences of the conference; in 1944, too, the realignment of currencies was a result, but not the motivation for the conference. In the end, to prevent a similar crisis from re-occurring, Asian countries in particular must allow their currencies to float higher to allow a normalization of global trade. It is unreasonable to expect the U.S. to start manufacturing consumer non-durables that will be exported to Asia; but a weaker dollar would boost exports and may be seen very favorably by U.S. policy makers.
To give a little more background as to why the dollar may indeed become a topic of the G-20 "Bretton Woods II" meeting, some historic perspective may be in order. In a 2003 analysis entitled "Global Warming", we wrote: "The most recent experience to a serious dollar devaluation dates back to 1971 when the U.S. abandoned the gold standard on August 15. There are parallels to the events at the time. When the 1944 gold standard (Bretton Woods agreement) was put in place, the US dollar quickly became the world's preferred reserve currency, as it was not only the only currency convertible into gold (at $35 an ounce), but - unlike gold - it also paid interest. In the second half of the 1960s, LB Johnson increased government spending in a booming economy with full employment causing major imbalances. LBJ was more interested in re- election than in taming the economy. As a result, more dollars were printed and foreigners started to exchange their US dollars for gold. By 1970, only 55% of the US dollar was backed by gold; by 1971, that ratio had fallen to 22%. To support the dollar, the German Bundesbank (Buba) purchased US$4bn in April 1971. On May 4, 1971, the Buba purchased US$1bn in 1 day, and on May 5, 1971, the Buba purchased US$1bn in the first hour of trading, after which intervention was given up and currencies were allowed to float freely. A severe devaluation of the dollar ensued". Similar imbalances have been re-created today, except that the U.S. dollar is no longer backed by gold and foreigners hold U.S. Treasuries; Asian countries in particular may have little choice, but to sell their holdings as they feel obliged to inject money into their domestic economies.
Asian and European policy makers may not be as excited about such a move because their exports have already fallen sharply in light of a weak U.S. consumer. But an adjustment in exchange rates may be inevitable. Europe in particular would not suffer as much as the European industry is favorably positioned to help build Asian infrastructure. If the euro continues to establish itself as a credible competitor to the U.S. dollar, it will benefit from steady inflows - the kind that in past decades has boosted U.S. economic growth. If Asian currencies are allowed to float higher, Asian countries will be able to more easily afford such projects. For Asia, while exports to the U.S. would drop, potentially causing serious disruptions to some sectors of the economy, the cost of imports, namely commodities, would drop. Countries producing at the higher end of the value chain will also be less affected as they will have more pricing power: China, in our view, benefits most from a revaluation. Think about it from a U.S. point of view as well: ever larger projects will need to be outsourced as all easy projects have already been outsourced. China is the one country that has the capacity, managerial know-how and infrastructure to absorb such projects. At the low end of the value chain, a country like Vietnam can only compete on price. When the world leaders meet, however, weaker Asian countries are unlikely to have a say in how the future of the world of finance will be shaped.
We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com.