“Markets are always a puzzle,” Elliott Management founder Paul Singer mused in his June 30 letter to investors reviewed by ValueWalk. As he looks at China and non-cleared derivatives, two seemingly unrelated issues, Paul Singer’s Q2 Letter sees markets that are “sheathed in dense clouds which teasingly part for only brief glimpses of what may lie beyond.”
Paul Singer's Q2 Letter - Chinese "wealth management products" seem much like 2008-like US derivatives
Non-financial sector debt in China has grown over 400% since the 2008 financial crisis, with a debt to GDP level now rivaling Japan near 257%. Looking under the hood of Chinese debt, leverage and financial products that could be causation for the next crisis, Paul Singer's Q2 letter spots two candidates – both of which bear similarities to what was causation for the 2008 version.
Individually-held Chinese “wealth management products” appear more like a parlor game that provide a return to investors without much understanding of how they work. These investment vehicles, offered by mainstream banks, have racked up $10 trillion in assets. But Singer notes troubling similarities with the nontransparent investment products at the center of the 2008 crash.
“They are as gamey and inaccurately-disclosed as any of the contraptions of the American derivatives/structured-products/subprime/credit bubbles, and have all the complexity of cross-holdings, debt hidden under the costume of equity, and insane leverage,” he writes. “Moreover, 60% of these products have maturities of less than three months. A more powerful accelerant of a future market crisis can scarcely be imagined.”
The second issue is debt issued by China’s state owned enterprises (SOEs), which are credited by lifting non-financial Chinese corporate debt to GDP to the highest levels in the world. Singer is not a fan.
“Combined with wild real estate booms and overbuilding, plus an unhealthy dose of corruption and severe neglect in ‘rule of law’ infrastructure, a serious economic dislocation (or crash) is the obvious (but not necessarily correct) expectation based on the numbers, the leverage, the interconnectivity and the likely quality of debt,” he observes.
A market crash in China would ripple around the world, likely pushing the “global economy into a deep recession” which would quickly be followed by central banks doubling down “emergency monetary measures, including unlimited money printing and financial asset price manipulation, that have been in place for the past nine years.”
In a highly interconnected global market, there are no “safe spaces” for one economy to sneeze and the rest of the world to not catch a cold. “Large flows of capital during any unwind of highly-leveraged institutions and structures would go coursing through the global economy and financial system like a wild tsunami,” with a leveraged daisy chain having an unknown impact on markets, including non-cleared derivatives.
Paul Singer's Q2 Letter - Most of Dodd Frank can be scrapped, Singer says, but non-cleared derivatives are not one such area
When looking at the Dodd Frank financial reform act, Singer thinks most of the unnecessary complexity that enriches the coffers of Wall Street lawyers who helped write the indecipherable law can be tossed. But there is one component of the law that has provided a significant benefit to the safety of the financial system, Paul Singer's Q2 letter says.
“The most important element in financial regulation is systemic risk,” he says, pointing squarely to non-cleared derivatives. Looking at the 2008 global financial crisis, he hopes that lessons can be learned. Part of what caused the crisis was uncertainty over the derivatives positions that Lehman Brothers held, an issue currently being addressed by the US Commodity Futures Trading Commission. But the issue of proper balance sheet usage remains a concern:
Pre-GFC and continuing until today, large institutions (primarily the biggest banks) want to post no collateral at all at a trade's inception, and just post money if the positions lose money on a mark- to-market basis. That system is nuts and virtually begs for the creation of gigantic derivatives portfolios, because the bet is so asymmetrical. But that system is the one that we have. Why? Over a period of decades banks increasingly combined traditional banking with all kinds of other activities, including private equity and venture capital, on top of their core banking deposit business which has a federal guarantee. Such guarantees supposedly have a cap, but as a practical matter the limits are highly unlikely to be enforced in extremis. Major institutions became overleveraged because of management ignorance or heedlessness of risk, together with regulatory and legal failure.
The issues to address the problem are nuanced, and Paul Singer's Q2 letter offers some controversial advice, particularly in his opposition to the living wills provision in Dodd Frank.
Paul Singer's Q2 Letter points to seven key features that should be addressed:
- Properly margined derivatives positions, in which every counterparty in the world, regardless of legal status, end-user status or rating, posts the equivalent of customer initial margins on every derivatives position. During the GFC, in the absence of initial margins on bilateral contracts, the world's largest financial institutions had positions which were orders of magnitude too large. When these institutions started losing large amounts of money and were perceived to be troubled, counterparties stepped away and the global financial system almost collapsed.
- Two-way daily mark-to-market on every derivatives position. This limits the amount of unsecured debts between counterparties. During the GFC, no firm which was subject to these two requirements (initial margin and mark-to-market) presented systemic risk, whereas virtually every financial institution which was not subject to initial margin and mark-to-market had serious to fatal problems.
- No systemically important financial institution (SIFI) designations. Every investor and trader should be treated alike with all others of the same type of firm. SIFI designations are arbitrary, and in the modern world of leverage and derivatives any financial company can become, or unbecome, systemically important overnight.
- No living wills. These requirements are the ones the U.S. government imposed on financial institutions to force them to describe in detail their "plans" in the event they are forced to reorganize. These living wills are Potemkin Villages of comfort and will not survive "the first contact with the enemy." The business plans and asset and liability mixes of modern financial institutions are highly dynamic and change all the time.
- No special resolution regimes, no Orderly Liquidation Authority (OLA), and no "single point of entry." OLA gives virtually unlimited and unaccountable authority to regulators to seize any financial company on any pretext of being "in danger of " The "single point of entry" refers to the federal government's fantasy that the next crisis of a troubled financial institution will be fixed by just seizing the holding company, wiping out its shareholders and unsecured bondholders and transferring the assets of its inexplicably-presumed-to-be-solvent subsidiaries to a "bridge company." In fact, there is no way to tell where potential insolvency may exist in a capital structure or how deep it may be. The notion that stakeholders at the holding company lose their investments and the gloriously-solvent subsidiaries proceed on their merry way is ridiculous, because, among other reasons, in the heat of battle nobody outside of Mount Olympus will know who is solvent and who is not. Moreover, the stock and unsecured bond prices of every other large financial institution in the world will come under severe pressure if such a course of action is undertaken by the U.S. government. For its part, the OLA will likely spread panic rather than quell it. The way the first troubled firm (and its stakeholders) is treated will be a wake-up call to stakeholders at any financial firm which could be struggling in the same way, causing a headlong flight of capital.
- Eliminate by law the cross-default provision related to derivatives positions in the standard universal derivatives contract so that solvent derivatives books can continue to pay and receive two-way mark-to-market payments if the liquidity exists to do so. This is the right way to try to avoid the immense friction costs which are caused by suddenly-truncated legs of complicated positions which are held with multiple
- The notion that taxpayers will not write a big check in the next crisis is preposterous. There will be no ability to do accurate real-time assessment of any financial firm's solvency, or that of the system as a whole, and it will take a great deal of government assistance to analyze the situation and take appropriate and timely action.
With Chinese leverage potentially creating a daisy chain reaction that could spill over into untold non-cleared derivatives gambits, much of which are tied to debt and thus currency fluctuations in which the contracts are denominated, Singer hopes that lessons from 2008 will be learned. Nearly 10 years after the last financial crisis started, now might not be a bad time to impose common sense regulations to avoid the next credit crisis.
“It should not be hard to create a sound financial system,” he notes, pointing to easy solutions that are opposed by powerful political interests. “Let us hope changes are made before the next episode tests our views and conclusions", Paul Singer's Q2 letter cautions.