Paul Singer, one of the largest hedge fund managers in the world, sees a slippery slope for the economy and the financial services industry if issues are not properly addressed by government. Among his key concerns is the deterioration of the rule of law, according to a letter to investors, which was first reported by ValueWalk this morning.
VW has obtained Elliott 2013 letter (story to follow); Paul Singer not a bitcoin fan pic.twitter.com/tWcP2WQZbc
— ValueWalk.com (@valuewalk) January 28, 2014
In a wide-ranging letter, the outspoken hedge fund manager, coming off a highly visible speech in Davos, Switzerland to the World Economic Forum where he warned that world wide markets are not safer than before the 2008 crisis, Singer did not hold back. In addition to addressing the negative impact of financial lawlessness he discussed topics ranging from Bitcoin (not a big fan) to the Volcker Rule (lulls people into a false sense of security) to the “new monetary Sheriff” riding into town, Janet Yellen (academics didn’t see 2008 crisis coming and don’t see the next approaching storm).
Paul Singer: Financial lawlessness is a slippery slope leading to corruption
“Lawlessness is a slippery slope,” the letter said, addressing one of the most controversial topics in financial services today, one seldom reported on or discussed in the media. “If a little ‘excess discretion’ is used… or a law is ignored in thousands of subtle ways, then over time the rule of law will be replaced by corruption and whim,” the letter said.
The recent decline in financial criminal enforcement has been a concern among knowledgeable fund managers and sophisticated investors, who note with dismay cases that in the past would have brought about strong criminal prosecution, such as MF Global and various market rigging scandals, are no longer being aggressively tackled by prosecutors. This sends the wrong message and encourages further questionable behavior.
“Laws are not self-executing,” Singer wrote in the investor letter, as he cited a need for those entrusted to interpret the law and handle investigation and enforcement responsibilities to do so “with honesty and intelligence.”
“Tolerance for leaders who abuse or selectively enforce the rule of law is the road to ruin”
Singer did not hold back in the call to rid the U.S. financial system of those who propagate malfeasance and rig the justice system to benefit an elite few. “Tolerance for leaders who abuse their discretion and selectively enforce the rule of law, interpret it in illogical and corrupt ways, or use the law to benefit their cronies and punish those who do not play ball, is the road to ruin, autocracy and/or revolution for any democracy.”
Pulling out the example of Argentina, which is currently considering a default on its loan obligations, Singer put the issue in focus. “When a country such as Argentina thinks that it can save money and score political points with its citizens by eschewing the rule of law and paying whatever it wants to pay, to whomever it wants to pay it, and whenever it feels like paying, the inevitable result is that the society is harmed and ultimately impoverished to a much greater extent than any benefit derived from its defiance,” the letter said, leading to a warning. “In addition, those citizens who are most ardent about the populist flavor of their government’s lawless behavior usually experience the greatest suffering in the aftermath. In certain other regimes, such as Russia, raw power is a substitute for enduring legal structures. It is hard to predict how such places will evolve over a period of time.”
When investors know the game is rigged, asset flows dry up
The rule of law is significant for any financial services industry to attract capital, and diminishing enforcement of financial laws leads to the decline of that country’s financial services sector. “Many of the developing countries are studying what it takes to attract capital and generate growth,” the letter noted. “Chief among the requirements, of course, is the rule of law. Nothing torpedoes a country’s prospects for investment capital faster than institutionalized disrespect for the rule of law. When potential investors identify such conditions, they know that the game is rigged and that they do not have a chance to be treated fairly. Consequently, investment flows dry up or reverse. So we applaud the efforts of those countries that want to take the hard but sustainable route to prosperity by building solid institutional and legal structures.”
While the deteriorating rule of law is a key concern, so too are the growing financial risks the largest banks pose to the economic system. But while he is critical, Singer also notes the goal should not be to damage the reputation of the banks.
Banks used to make loans – now they are overleveraged hedge funds
The key risks that many inside the hedge fund industry are considering include the potential for unregulated derivatives to implode the world economy, a topic Singer has addressed forcefully in the past and this investor letter was no exception.
“Banks used to just make loans,” the letter notes. “There was a banker and a borrower, a savings and a checking account. Maybe the depositor got a toaster, an umbrella or a tote bag. That was then. Now, the biggest surviving banks are combinations of lenders, advisors and traders. Their trading books are huge, driven by the explosive growth of derivatives. The table below examines various leverage metrics for Elliott compared to an amalgam of the largest banks.”
Amazingly, Singer points out that large banks are more significantly leveraged than the hedge funds they now compete against. “The rows including derivatives show how amazingly leveraged the mega-banks are compared with a large hedge fund that uses leverage and trades many of the same instruments. The figures also demonstrate that even when you arbitrarily eliminate 95% of derivative notionals and use 5% as a proxy for “real” positions (in effect, the equivalent of balance sheet exposures but in derivatives form), the resulting effect on big 11 bank leverage is huge. Forty times leverage is ridiculous, but the real scandal is that we were forced to choose an arbitrary number! There is no way to actually know whether the number is really 40x or double or half that, because it is impossible to ascertain from public mega-bank disclosures.”
Proper risk disclosure not in place
Proper risk disclosure is the key, and here Singer brings home key points, offering a solution. “(Bank) disclosures provide adequate detail about the size and nature of the megabanks’ risk profiles, which opens the door to the kinds of contagion effects we saw in 2008, and to the effects of rumors on the financial condition of these institutions,” the letter said. “In modern high-volatility crisis markets, many traders whose positions are experiencing unprecedented price movements are forced to unwind their positions to stem their losses, inevitably leading to cascading unwinds of other positions and pressures at other firms. These