On Wednesday, Paul Singer, founder of the hedge fund Elliott Management, was on a panel at the World Economic Forum about safety in out global financial system.
In sum: He believes we’re not safe. More than that, he admitted that the financial instruments he trades, derivatives, aren’t helping.
You’ll recall that a derivative is a financial instrument that takes its value from the performance of another asset — i.e. a mortgage.
“I love trading them,” Singer, whose Elliott Management Corp. manages $US23.9 billion….said. “On balance, there’s been a net negative to society from this particular type of invention.”
The problem, which Singer has pointed out before, is that big, systemically important banks with trillions of dollars in assets are trading these derivatives right along with him. However, those banks don’t actually know their value. The entire market is opaque.
“We can only assume that the reason the global financial system is still… over leveraged, opaque, reliant upon the implicit and explicit support of governments for its very existence… is that fixing the problem would be too painful for powerful special interest groups,” Singer wrote in prepared remarks obtained by ValueWalk.
He continues: “The major financial institutions (those bailed out or implicitly supported in the last crisis) have taken important steps to reduce their trading risks since the 2008 collapse. However, it is impossible to verify such progress from public financial statements or even to assess these institutions’ true financial risks.”
Now here’s the thing: We saw a little bit of this pay out last week when Wall Street reported its Q4 2013 earnings. JP Morgan serves as the perfect example.
JPM’s investment bank reported a $US1.5 billion loss because it started using a different way to value its over the counter derivatives — in finance jargon, this is called a funding valuation adjustment (FVA).
Of all the major banks that reported, only JP Morgan took steps to change the way it reports the derivatives it’s trading/holding on its balance sheet.
What the FVA is supposed to do is force banks to report what it’s costing them to hold the derivatives on their balance sheet — the derivatives’ funding cost.
What makes this possible, is that regulators have been working to force the value of obscure derivatives into light. If we got into that conversation, you’d fall asleep. But it’s happening.
The point is that banks can now use this value data to better understand what is going on in derivatives markets. And apparently what’s going on blows $US1.5 billion holes in bank balance sheets.
To Singer, though, none of this is enough. We need more clarity, and more importantly, we need systemically important institutions to take less risk with these potentially dangerous instruments.
He should know, he loves them.