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What happens when a crisis hits? There are demands for cash payment, and the payments can't be made because the entities have short liabilities requiring immediate payment, and long illiquid assets that no longer can be sold for a price consistent with average market conditions. When there are many firms for which this is true, and they rely on each other's solvency, that creates a systemic crisis.

Whether through:

  • Owning long assets, and financing short, or
  • Using the repo market to hold long assets, thus disguising it for accounting purposes as short assets
  • Taking deposits, and investing long,

it creates an imbalance. It is almost always more profitable in the short-run to finance short and lend long. But when there is a demand for cash, such institutions are on the ropes and might not survive. Less than half of the major American investment banks existing in 2007 were alive in 2009 to today.

But what if you were clever as a financial institution, and had liability structures that were long, or distributed the risk of what you were doing back to clients. You would always have adequate liquidity, and would not be in danger of default for systemic reasons.

Thus, I think the Financial Stability Oversight Commission [FSOC] is nuts to regulate insurers such as MetLife (NYSE:MET), Prudential (NYSE:PRU), AIG and Berkshire Hathaway (BRK.A, BRK.B). They do not face the risk of a run on the bank. Look at the history of insurers: those that failed due to a run on the bank were those that:

  • Issued guaranteed investment contracts that would be immediately payable on ratings downgrade.
  • Issued P&C reinsurance contracts that would be immediately payable on ratings downgrade.

Aside from that, there were badly run companies that failed but no systemic risk. There was also AIG, which faced a call on cash from its derivatives counterparty, but not the insurance entity.

As for investment managers, they have no systemic risk. It does not matter if Blackrock (NYSE:BLK), Pimco, Fidelity and Vanguard would all fail. Mutual fund holders would find their funds transferred to solvent entities, and any losses they might receive are the ordinary losses they could receive if the management firms were still solvent.

Someone lend the FSOC a brain. Big size does not equal systemic risk. Systemic risk stems from a call on liquidity at financial firms that borrow short and lend long for their own accounts. That does not include asset managers and insurers, no matter how big they are.

What this says to me is that financial reform in DC is brain-dead. (Surprised? Nothing new.) They have fixated on the idea that big is bad, when the real problem is asset-liability mismatches, amplified by size and connectedness. Big banks are a problem. Big insurers and asset management firms are not.

Disclosure: No positions

Source: Systemic Risk Stems From Asset-Liability Mismatches