In Washington the global financial crisis continues to resonate in the rhetoric of presidential campaign politics and, increasingly, the debate over correct policymaking. Maurice (Hank) Greenberg’s class-action suit against the U.S. government — claiming $40 billion in damages on behalf of American International Group’s shareholders, including C.V. Starr & Co., a holding company that Hank controls — is a wonderful read on that score. (Full disclosure: I was the C.V. Starr senior fellow at the Council on Foreign Relations in the 1990s and have always admired Hank.)
I recall seeing then–Treasury secretary Henry Paulson Jr. sweating in front of a phalanx of TV cameras outside the White House in 2008, explaining the bailouts under the Troubled Asset Relief Program, as I entered the West Wing, where we were arm-wrestling over the North Korean nuclear agreement (ultimately a complete failure, unlike the Wall Street bailouts).
I knew that Paulson and Federal Reserve chief Ben Bernanke were making it up as they went along, but I thought they deserved some latitude to make judgment calls in the face of massive market panic. Judge Thomas Wheeler of the U.S. Court of Federal Claims thinks differently. “The weight of the evidence demonstrates that the Government treated AIG much more harshly than other institutions in need of financial assistance,” he concluded in his June 15 ruling. “The Government did not demand shareholder equity, high interest rates, or voting control of any entity except AIG. What is clear from the evidence is that the Government carefully orchestrated its takeover of AIG in a way that would avoid any shareholder vote, and maximize the benefits to the Government and to the taxpaying public, eventually resulting in a profit of $22.7 billion to the U.S. Treasury.”
That’s quite an indictment. However, Judge Wheeler’s decision handed Greenberg only a moral victory. “The end point for this case is that, however harshly or improperly the Government acted in nationalizing AIG, it saved AIG from bankruptcy. Therefore, application of the economic loss doctrine results in damages to the shareholders of zero.”
The TARP bailouts were understandably controversial, but today there is a political groundswell to limit even the Federal Reserve Board’s ability to conduct monetary policy. Republican presidential candidates Rand Paul, Ted Cruz and Marco Rubio have cosponsored a bill that would require the Government Accountability Office to audit the Fed, including its monetary policy decisions and agreements with foreign central banks. Chair Janet Yellen has been fighting a rearguard action to defend the Fed’s policy-making process, pushing back against the audit proposal and rebuffing suggestions that the Fed adopt a rules-based framework for interest rate decisions. “Efforts to further increase transparency, no matter how well intentioned, must avoid unintended consequences that could undermine the Federal Reserve’s ability to make policy in the long-run best interest of American families and businesses,” she warned a congressional panel on July 15.
At about the same time as that testimony, I noticed that the Fed’s website had put up a special dialogue box titled, “Does the Fed get audited? YES.” It contained no fewer than 16 hypertext links to various entities and reports explaining how thoroughly the Federal Reserve System is “transparent, accountable and audited.”
Notwithstanding all that transparency, no one outside the marble-clad Marriner S. Eccles Federal Reserve Board Building on Constitution Avenue knows how or when Yellen and her colleagues will make the tightening move after nearly seven years of near-zero rates. Speculating about both remains a huge cottage industry for consultants and a matter of deep concern for traders and portfolio managers, with most focusing on the window between September 2015 and March 2016. “I think it is almost certain there will be a U.S. rate hike by the end of Q1 2016,” says Michael Hintze, founder and CEO of London-based hedge fund firm CQS. “My sense is that there is a 60 percent chance it will take place in September 2015 and a 40 percent chance it will be at the end of Q1 2016.”
A survey of three dozen macro traders and strategists taken in mid-June assigned an average 45 percent probability that the yield on the benchmark ten-year U.S. Treasury note will trade between 2 and 2.5 percent by year-end 2015, as the Fed rate hike is priced in, and a 43 percent probability that it will trade above 2.5 percent as December closes.
Years of quantitative easing have suppressed volatility even as they’ve pumped up stock prices. Yet the survey respondents do not foresee the end of QE somehow reigniting the CBOE Volatility Index or deflating the S&P 500 index. Our survey generated a 49 percent average prediction that the SPX will finish the year between 1,920 and 2,100, and 37 percent that it will finish above 2,100 — slightly more optimistic than the January survey. It is still a coin toss whether the VIX will be above or below 15, though the expected minimum and maximum values have tightened to a range of 12 to 22 for the remainder of 2015.
The Fed isn’t alone in facing a challenging decision-making period. In Tokyo’s sleek Prime Minister’s Office, macroeconomics are constraining politics in unexpected ways. Getting Japan back on a positive growth trajectory via Abenomics is the main objective of Shinzo Abe. Since Abe retook office in December 2012, the prime minister’s deeply felt ambitions for a more assertive Japanese security stance have taken a backseat to his first, second and third arrows of economic policy. Abe and his shrewd chief cabinet secretary, Yoshihide Suga, carefully husbanded their political capital to pass economic reform legislation as part of Abenomics. They didn’t bring the security bill to the Diet until this summer, fearing that the heated debate would derail the economic program.
Our traders and portfolio managers are optimistic that Abenomics will continue to succeed in the short and medium term. The survey found an average 40 percent prediction that Japan’s GDP growth rate will be equal to or greater than 2 percent in the second half of 2015. There were few pessimists: The mean bet on sub–1 percent growth is just 15 percent.
Part of the optimism of foreign Japan watchers reflects the lingering impact of the country’s first-quarter blowout, when the economy grew at an annualized rate of 3.9 percent. Another part is a realization that the government has succeeded in harnessing the portfolio decisions of Japan’s huge, traditionally conservative pension funds to the Abenomics game plan. It is ironic that authorities in Tokyo and Beijing are steering billions into their respective stock markets while rhetorically endorsing structural reforms that are supposed to strengthen the role of market forces.
As enthralled as they are by the momentum of Abenomics in 2015, our survey takers — many of whom gathered at Oxfordshire’s sumptuous Ditchley Park manor home in May — are dubious about the long-term prospects for Japanese growth. As one macro trader observed cautiously at Ditchley, “The fundamental demographics are challenging and the country won’t allow immigration. How can it get back on a robust growth trajectory with such unfavorable fundamentals? The Nikkei is at 20,000, up from 10,000 a few years ago, but remains well below its 40,000 all-time high, and I don’t believe it’s ever getting back to that level again.”
In addition to portfolio rebalancing, the Abe administration also persuaded Japan’s pension funds and large institutional investors to embrace corporate governance reform. More-flexible allocation of labor and technology, and more-efficient allocation of capital, are essential for productivity growth, which is the only way to get real growth in an economy with a shrinking labor force. The Abe government has explicitly drawn the connection between the efficient allocation of capital, the return on equity of listed companies and improved corporate governance.
The recent scandal revealing that Toshiba Corp.’s managers had overstated earnings by ¥150 billion ($1.25 billion) suggests that Japanese corporate governance reforms have been more style than substance. Ditchley participant Timothy Rattray, former head of Bankers Trust Asia, says: “My view on Japan is that there may be interesting opportunities in the short term, but in the long term I view with skepticism the idea of structural reforms and improvement in governance. I’m just not seeing it. Ultimately, long-term returns depend upon the quality of capital allocation. The return on assets on Japanese investments has been abysmal going back forever. I just don’t buy into the belief that Abenomics has already changed corporate culture in Japan.”
The Abe government has a lot on its plate. “August will see the first nuclear reactor restart, Abe’s statement on the 70th anniversary of [the end of] World War II and an interim report on the leak of personal data by the Japan Pension Service,” says Wolfango Piccoli, head of research at Teneo Intelligence. “If mishandled, these issues could undercut Abe’s support within the Liberal Democratic Party and make it difficult for the prime minister to implement his policies going forward.”
The Japan pension hack serves as a reminder that systemic financial risk and information systems risk are becoming uncomfortably intertwined.
“Given the potential for another systemic crisis, the Fed’s first move on interest rates presents a critical risk point,” said a London-based trader at Ditchley Park. “There has been soaring bond issuance. There has also been a regulatory slow kill of inventories in the repo market and the ability of major banks to provide liquidity when needed. The regulatory side of central banking has become a game of whack-a-mole, trying to smash leverage and financial risk out of the system wherever it appears. However, risk has simply been transferred from the banks to the big mutual funds, private equity funds and hedge funds.”
CQS’s Hintze concurs: “One could argue that regulation — Basel III in particular — has led to a situation where we have too much solvency and not enough liquidity. This is a sharp contrast to before the financial crisis, when there was too much liquidity and not enough solvency.”
Whether the underlying cause is insolvency or illiquidity, most of the Ditchley participants agreed that the next financial crisis is likely to be triggered by an information technology glitch or a cyberhack. I’ve been doing this survey for almost four years now, and the odds assigned to a major cyberattack have climbed steadily upward, to 36 percent in the June exercise from 31 percent a year ago.
“If Mr. Sarao in his Hounslow basement could bring the CME and the Dow to their knees in the May 2010 flash crash, just imagine what the Russians, Chinese or even North Koreans could do to the financial system,” joked a New York–based portfolio manager at Ditchley, referring to Navinder Sarao, the private investor arrested for allegedly contributing to the flash crash with his trading activity from his parents’ home. “Especially if they had some huge shorts on.”
As we all know, cyberattacks aren’t just about money. I recently attended a security conference in Virginia at which most of the participants were former soldiers, spies or diplomats. We realized that everyone in the room had filed federal form SF86, the exquisitely intrusive Questionnaire for National Security Positions, at least once.
SF86 asks a lot of questions, including every place you have lived and worked for the previous ten years and detailed information on your finances, all of your relatives and your “cohabitants.” Lying on the form can land you in jail for five years, so trust me when I say there’s a lot of sensitive information on there. When I filled it out, I had to ask my wife a couple of questions for the first time.
It is widely believed that Chinese hackers exfiltrated the records of 22 million people from the U.S. Office of Personnel Management, including the SF86s of everyone at that Virginia security conference. “The Chinese are pretty good at database integration,” sighs a former Department of Defense colleague. “The next time I land in Shanghai, the immigration official can probably pull up a screen showing my bank balance and my wife’s birthday, in case I forget.”
James Shinn is a lecturer at Princeton University’s School of Engineering and Applied Science (jshinn@princeton.edu), chairman of Teneo Intelligence and CEO of Predata. After careers on Wall Street and in Silicon Valley, he served as national intelligence officer for East Asia at the Central Intelligence Agency and as assistant secretary of defense for Asia at the Pentagon. He serves on the advisory boards of CQS, a London-based hedge fund, and Kensho, a Cambridge, Massachusetts-based financial analytics firm.
