This week in Outside the Box we take up a topic that should be on the top of the agenda of every regulatory authority, executives at financial services firms of all types, and average investors: How do we fix the credit markets to make sure we do not have such a crisis again? Good friend Michael Lewitt of Hegemony Capital Management gives us his observations, some of which go further than I would personally like to see us go. But this is the conversation that must happen if we are to steer clear of future crises. It is clear to me now that a laissez faire approach to regulating certain financial instruments exposes the entire economy to risks much larger than the loss of a business here or there. While better disclosure is certainly appropriate, it is not enough.
I think that we should seriously consider having an exchange for credit default swaps and other similar OTC derivatives. If Bear Stearns is deemed too big to fail because of the extent of its CDS book, and taxpayers are put at risk in a bailout, which I agree was necessary, then rules must limit taxpayer exposure. Having futures and options trade on an exchange certainly hasn't limited commerce or restrained business, and with instantaneous execution and inexpensive transactions there is little friction from using an exchange.
Getting the rules right in the future is going to be difficult and contentious. But it is something we must begin to do as soon as possible. The footnotes that Michael uses are at the end.
The subprime problem, we were told, would not spread to other markets. It would be "contained." And it has, according to Jim Grant. He quipped last week that it has been contained on planet Earth. The risks coming from rising defaults in the US (now above 600,000 and rising from just 200,000 a few years ago) are clearly spreading to markets far beyond the subprime world.
This week's Outside the Box talks about the next two dominoes that could fall: junk bonds and counterparty risk in the various credit default swap markets. Ted Seides is the Director of Investments at Protégé Partners, LLC, a hybrid fund of funds that invests in and seeds small, specialized hedge funds. He writes this week's piece in Peter Bernstein's Economic and Portfolio Strategy, one of the most respected of market analysis letters. You can learn more about the letter at www.peterlbernsteininc.com.
This piece is a little longer than most letters, but it is one of the more important editions of Outside the Box this year. This is a must read. You absolutely need to understand the nature of the systemic risk we are facing, and Ted does a great job of explaining in very clear terms the nature of the risks that we have created din our modern markets. I have left the footnotes in, and they are at the end of the letter.