The Financial Times published in its Monday edition my Op-Ed column “The Shadow Banking System is Unravelling”. The column was written and posted on their web site a few hours before the sudden announcement of the end of major independent broker dealers with the Fed announcement that Morgan Stanley and Goldman Sachs will become bank holding companies and will be thus regulated as banks. This is the additional step in the demise of Wall Street as we know it and the unraveling and demise of the “shadow banking system” that I described in my Financial Times Op-Ed column.
Here is the text of my Op-Ed column:
The shadow banking system is unravelling
Nouriel Roubini
Financial Times Published: September 21 2008 17:57 | Last updated: September 21 2008 17:57
Last week saw the demise of the shadow banking system that has been created over the past 20 years. Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.
Like banks, most members of this system borrow very short-term and in liquid ways, are more highly leveraged than banks (the exception being money market funds) and lend and invest into more illiquid and long-term instruments. Like banks, they carry the risk that an otherwise solvent but liquid institution may be subject to a self-fulfilling and destructive run on its liquid liabilities.
But unlike banks, which are sheltered from the risk of a run – via deposit insurance and central banks’ lender-of-last-resort liquidity – most members of the shadow system did not have access to these firewalls that prevent runs.
A generalised run on these shadow banks started when the deleveraging after the asset bubble bust led to uncertainty about which institutions were solvent. The first stage was the collapse of the entire SIVs/conduits system once investors realised the toxicity of its investments and its very short-term funding seized up.
The next step was the run on the big US broker-dealers: first Bear Stearns lost its liquidity in days. The Federal Reserve then extended its lender-of-last-resort support to systemically important broker-dealers. But even this did not prevent a run on the other broker-dealers given concerns about solvency: it was the turn of Lehman Brothers to collapse. Merrill Lynch would have faced the same fate had it not been sold. The pressure moved to Morgan Stanley and Goldman Sachs: both would be well advised to merge – like Merrill – with a large bank that has a stable base of insured deposits.
The third stage was the collapse of other leveraged institutions that were both illiquid and most likely insolvent given their reckless lending: Fannie Mae and Freddie Mac, AIG and more than 300 mortgage lenders.
The fourth stage was panic in the money markets. Funds were competing aggressively for assets and, in order to provide higher returns to attract investors, some of them invested in illiquid instruments. Once these investments went bust, panic ensued among investors, leading to a massive run on such funds. This would have been disastrous; so, in another radical departure, the US extended deposit insurance to the funds.
The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years.
Even private equity firms and their reckless, highly leveraged buy-outs will not be spared. The private equity bubble led to more than $1,000bn of LBOs that should never have occurred. The run on these LBOs is slowed by the existence of “convenant-lite” clauses, which do not include traditional default triggers, and “payment-in-kind toggles”, which allow borrowers to defer cash interest payments and accrue more debt, but these only delay the eventual refinancing crisis and will make uglier the bankruptcy that will follow. Even the largest LBOs, such as GMAC and Chrysler, are now at risk.
We are observing an accelerated run on the shadow banking system that is leading to its unravelling. If lender-of-last-resort support and deposit insurance are extended to more of its members, these institutions will have to be regulated like banks, to avoid moral hazard. Of course this severe financial crisis is also taking its toll on traditional banks: hundreds are insolvent and will have to close.
The real economic side of this financial crisis will be a severe US recession. Financial contagion, the strong euro, falling US imports, the bursting of European housing bubbles, high oil prices and a hawkish European Central Bank will lead to a recession in the eurozone, the UK and most advanced economies.
European financial institutions are at risk of sharp losses because of the toxic US securitised products sold to them; the massive increase in leverage following aggressive risk-taking and domestic securitisation; a severe liquidity crunch exacerbated by a dollar shortage and a credit crunch; the bursting of domestic housing bubbles; household and corporate defaults in the recession; losses hidden by regulatory forbearance; the exposure of Swedish, Austrian and Italian banks to the Baltic states, Iceland and southern Europe where housing and credit bubbles financed in foreign currency are leading to hard landings.
Thus the financial crisis of the century will also envelop European financial institutions.
The writer, chairman of Roubini Global Economics (www.rgemonitor.com), is professor of economics at the Stern School of Business, New York University
Let me now elaborate in more details on the arguments of this column also in light of the just announced decision to convert Morgan Stanley and Goldman Sachs into banks that will be regulated like banks...
Peer Pressure: Inflating Executive Pay
Illustration by The New York Times
Published: November 26, 2006
LIKE Lake Wobegon, Garrison Keillor’s fictitious Minnesota town where all the children are above average, executive compensation practices often assume that corporate managers are equally superlative. When shareholders question lush pay, they are invariably met with a laundry list of reasons that businesses use to justify such packages. Among that data, no item is more crucial than the “peer group,” a collection of companies that corporations measure themselves against when calculating compensation.
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Marko Georgiev for The New York Times
James F. Reda, a New York compensation consultant, says inappropriate peer groups are one reason that executive pay has soared.
But according to a handful of pay experts who are privy to the design of pay practices at the nation’s largest corporations, many of these peer groups are populated with companies that are anything but comparable. They also say corporate managers themselves — who have an interest in higher pay — are selecting which companies make it into a peer group. And because these companies are often inappropriate for comparison purposes, their use has helped inflate executive pay in recent years.
“The peer group is the bedrock of the compensation philosophy at a company,” said James F. Reda, an independent compensation consultant in New York. “But a lot of people do it by the seat of their pants, and that is part of the reason why executive pay has really skyrocketed.”
The use of peer groups to calculate executive pay has become ubiquitous in recent years. This is partly in response to the Securities and Exchange Commission’s requirement that companies compare their stock performance with a peer group in tables in the section of their proxy filings devoted to shareholder returns. Theoretically, these tables allow investors to compare their company’s performance against objective benchmarks.
But as is true with much about executive pay, details about exactly how peer groups are compiled have been kept under wraps. The worry among investors, of course, is that executives, consultants and directors simply cherry-pick peer-group members, thereby pumping up pay packages.
Current disclosure rules require neither the identification of companies in a compensation-related peer group nor the rationale behind their selection. Usually, the most a shareholder learns about companies in a compensation peer group is that they are in the same industry or of a similar size.
This ambiguity will change when new Securities and Exchange Commission disclosure rules go into effect on Dec. 15. The rules will require a corporation to reveal which companies it uses in its peer group and to provide an extensive description of its compensation philosophy.
Under the new rules, company officials will also have to certify the accuracy of their pay disclosures. As a result, peer groups are likely to attract increased scrutiny, said Mark Van Clieaf, managing director of MVC Associates International, a consulting firm that specializes in organization design and pay-for-performance standards.
“Is benchmarking pay across companies truly comparing apples to apples?” Mr. Van Clieaf asked. “Failure to have a legally defensible process” can lead to “materially false” disclosures, he said.
POSSIBLE problems with the use of peer groups burst onto the scene in 2003, when the New York Stock Exchange disclosed that it had paid its chairman, Richard A. Grasso, about $140 million in total compensation. Amid a firestorm over the pay, Mr. Grasso resigned.
One reason for the outcry was the makeup of the peer group that the exchange’s compensation committee used to determine Mr. Grasso’s pay. The group included highly profitable investment banks and financial institutions that were far larger and more complex than the Big Board, which, at that time, was a nonprofit organization.
Brian J. Hall, a Harvard Business School professor and an expert on management incentive systems, conducted an analysis of Mr. Grasso’s compensation and provided it to the judge overseeing the case that the New York attorney general’s office filed against Mr. Grasso.
Mr. Hall, hired by the attorney general as an expert witness, found that the companies the New York Stock Exchange board used in its peer group had median revenue of $26 billion, more than 25 times that of the exchange. Median assets of companies in the group were 125 times the Big Board’s assets, and the median number of employees in the peer-group companies was 50,000, or roughly 30 times that of the exchange.
