Fixing the Markets' Financial Black Holes

by: Yankee Group

By Carl Howe

This is the last in my series of commentaries on the current financial markets and stock prices in general. Following this, I'm going to return to my more focused and comfortable commentary on Apple (NASDAQ:AAPL) and marketing. But after last week, I felt I had to write one more article.

The US Federal Reserve cut its discount rate Friday, sending the US stock market up about 300 points at the open. Yet, a third of that rise was gone by the close, and today, the stock market is only rallying weakly at the open, waiting for the Fed to do more. To the people who keep asking "Why does the stock market keep struggling even after central banks have injected billions?," I have a simple answer:

Investors are losing their long-term confidence in the US market.

Now that's a pretty extreme statement, so let me try to defend it.

Investors view the US stock market as a proxy for the US economy; investing in US stocks like a bet that the US economy will grow. That's why so many money managers put their money in index funds -- regardless of whether any one company succeeds or fails, a bet on the growth of the Dow Jones Index has paid off with an annual compounded return of about 9.5% a year for about 80 years (annual return non-compounded is about 11.5%). It's hard to argue with a track record like that. It's those kinds of numbers that attract people to put money in the stock marketing instead of their local bank -- many people see the 9.5% average return, compare it with the 5% they could earn investing in CDs, and think, "I'll take the 9.5%."

Of course, there's additional risk that comes with the stock market investment. The market can and does go down. There's no guarantee you'll get your 9.5% return. There's no insurance. You're on your own. But even so, millions of investors take the risk every year because they feel like they understand those risks they are taking, and believe the higher reward over long periods of time is worth it. Their personal experience or their financial advisors have taught them that these risks are 1) known, and 2) not significant so long as they invest for the long run.

The problem today -- and the reasons that markets are falling apart -- is that no one really knows what the risks are any more [NY Times article, subscription required]. After all, if we did, subprime mortgage issues wouldn't have affected BNP Paribas, one of the large banks in France, or the emerging markets in Brazil, Turkey, and Indonesia that were hit, even though they hold no US mortgages. Lowering discount rates is just throwing gasoline and matches on truckloads of $100 bills -- It will create a lot of excitement, but won't fix the root problem: lots of sellers of debt with unknown risks, but not many buyers.

We can trace the root cause of both the credit crunch and other emerging confidence woes to two basic problems -- really marketing problems since marketing is the science of getting consumers to buy -- that make buyers nervous. I call them the "black holes" of financial markets because they have an almost irresistible negative pull on investor confidence. They are:

1. Institutional secrecy. Privacy for US citizens today may be scarce, but it's easy to buy if you're a private equity firm or a hedge fund. Unlike more traditional investment vehicles like stocks and mutual funds that must disclose their holdings quarterly and provide liquidity daily, these institutions don't need to disclose anything about their risks or holdings except to their investors. In a Senate Judiciary Committee hearing last year concerning hedge funds, one witness testified that "No one even knows within a trillion dollars [emphasis added] how large the hedge fund business is." The number of investors interested in possibly betting against the unknown interests of institutions wielding trillions of dollars is understandably small.

2. Assets with unknown values. Financial markets rely increasingly on derivatives, contracts whose price and value derive from an underlying asset. While useful as ways to buy and sell risk, many of these contracts are not priced on markets, but as private deals between institutions or investors. As a result, their actual value for the purposes of being bought or sold may actually be completely unknown, even though they are maintained on balance sheets as having very high values, often in the millions or billions of dollars. Warren Buffett has referred to derivatives as "weapons of mass destruction" and "time bombs for the financial system." Yet those derivatives -- of which the sub-prime mortgage bonds now roiling markets are just one type -- are more prevalent now than they were in 2003 when Buffett issued his warning.

So what could the US do to address the root problems instead of just throwing discounted loans at Wall Street? Here are some regulatory steps that would help bring buyers back into the market long-term:

1. Enforce disclosure rules for institutions managing assets more than $100 million. Despite this existing law, many hedge funds and private equity firms still don't disclose their holdings regularly [Wall Street Journal article requires a subscription to read it.]. With private institutions throwing their the weight of billion-dollar portfolios around the market, public investors should be able to know whether they are betting for or against their interests. If a hedge fund or private equity firm acts like a financial institution, and expects treatment in the markets like a financial institution, shouldn't it have financial disclosure requirements and certification requirements like financial institutions? After all, if a hedge fund fails, the managers still get paid some of their fees, while investors lose all their investments, and creditors may end up waiting years to get paid in bankruptcy court. Public disclosure would at least allow those risks to be more visible.

2. Require conservative accounting for derivatives. Regular investors only can use a fraction of public stock values when they apply for margin accounts, while derivatives are often listed on balance sheets of funds at many times their actual exchange value. The SEC should require companies claiming derivatives as assets to either list them at exchange market values or not allow them to be claimed as assets. While this may sound extreme, it is no different than the rules used for private investors at major brokerage firms. Pretense that large brokerages deserve treatment different from ordinary investors is just that: pretense.

Now regular readers know that I believe secrecy is one of the important strategies behind Apple's success. But that's marketing secrecy, not financial secrecy. Yes, Apple can secretly develop iPhone 2.0, but it can't legally hide the money it spends on that development from investors. In fact, any consumer or prospective investor has access to reams of financial data about where Apple is putting its money. That's just not true when we start talking about today's private institutions like KKR and Blackstone Group. Yet those companies move significantly more money and affect consumers more than Apple does.

Hyman Minsky, the late economist, believed that economic crises like today's credit crunch are inevitable after any period of good economic activity because good economic environments encourage investors to take on more risk than they can handle. But Minsky's theory assumes that investors can actually see the risks they are taking. Regulators today may not be able to eliminate financial crises, but they can do something about today's black holes of investing. And shining light on those black holes is one of the most effective ways to give investors confidence again -- and it will be a lot cheaper than throwing billions of dollars at the problem to no effect.