LONDON: As US and UK authorities struggle to come up with plans to bailout banks — in the case of the US with a $700 billion taxpayers rescue plan — several regulators have launched inquiries to see whether any executives at the institutions caught in the worst global financial crisis since the 1920s were up to no good and were breaking the law.
Already the FBI has arrested two bankers at Bear Stearns, the first US bank to be rescued, for alleged fraud through miss-selling. No doubt there will be more such dramatic developments as beleaguered governments and regulators are clearly keen to be seen to be taking action for both political survival and the stability of their financial markets and systems.
The blame game has not only centered on individuals but also on corrupt business cultures and dubious practices such as greed and short selling. In addition, inadequate and non-existent regulation has left regulators and governments dealing with the fallout of the excesses of their financial services sectors. The US Treasury has already committed taxpayers $1.835 trillion, with another $700 billion on the cards for the current bailout plan and another $500 billion for the possible recapitalization of Fannie Mae and Freddie Mac, the two major US mortgage providers which had to be rescued through nationalization.
Retribution and regulation seems to be the flavor of the time, although some critics warn that it is the redress of customers and taxpayers that also needs urgent attention. At the same the US model of capitalism has come under severe scrutiny, with the deregulation of the financial markets being blamed following the repeal of the Glass-Steagalls Act in the 1990s, paving the way for a free-for-all banking culture. Investment banks such as Goldman Sachs, Merrill Lynch, Morgan Stanley were allowed to restructure with totally inadequate capital adequacy requirements, as it has been proven, and as if they were oblivious of the requirements of the Basel I and II Concordats, which in turn have and are proving to be wholly off the mark.
However, the two major trends over the last four decades which have contributed to the current state of affairs in the financial markets in the US and Europe, are the blurring of liberal democracy with business; and the rise of the so-called exotics — largely derivatives such as hedge funds, credit default swaps etc in the global financial space.
In the US, from Reaganomics to Dubyanomics, the lines between the democratic process and big business have become increasingly blurred. The world is now firmly rooted in a “bizdemocracy” culture, where poachers are now asked to do the jobs of gamekeepers. A good example is Henry Paulson, the US Treasury secretary, who until a few years ago was the CEO of Goldman Sachs, one of the very institutions now in trouble.
In the UK, we had Thatcherism, the British version of Reaganomics, which also presided over two “boom and bust” episodes leading to two recessions in just over a decade. The cultural shift became even more evident when Tony Blair’s New Labour came to power and was hailed the new Thatcherite kid on the block. The truth is that Blair’s economic supremo for the decade was none other than Gordon Brown, his successor as premier.
As to the cultural shift in banking, institutions such as Goldman Sachs, Morgan Stanley, Deutsche Bank etc., moved away from their traditional conservative investment banking structures to become effectively gigantic hedge funds chasing billions of dollars in profits, bonuses and dividends. Greed not only engulfed senior executives and managers but shareholders themselves. And as this was generating instant wealth, regulators and government treasuries were only too keen on cashing in on the tax dollars and pounds.
There is a truism that innovation drives regulation; and that since bankers are the innovators, regulators always lag. It is a catch-up game where regulators will always lose. Belatedly, regulators are now trying to change the rules of the game, by telling bankers that we will legislate and you will innovate within that framework.
Both the Fed in America and the FSA in the UK have banned the practice of short-selling, albeit temporarily until January 2009, to help stabilize the market by taking pressure off the shares of the troubled institutions through shorting in the market.
While the practice of short selling is completely legal, it is considered very risky. To put it crudely, short selling is basically gambling that stocks will fall in price.
Shorting occurs when a trader, usually acting on behalf of private investment funds called hedge funds, borrows a financial contract such as a number of shares or bonds from an institution (such as bank) for a fee. The trader then sells those shares in the market at a price; with the aim of buying back those shares at a later date but a lower price. The difference in the price is the trader’s margin or profit. The hope is that the share price will fall, but the sheer risk of speculating on this hope makes shorting incredibly risky.
Because the potential financial rewards are often substantial, the incentives to help prices fall are large. Traders have been suspected and accused of spreading rumors about company performances or through the signal that significant amounts of short selling sends to the market that many believe future price falls are likely. The more people act on this generated speculation, the more it can affect the value of an otherwise healthy investment. The shares of HBOS, the British bank, for instance, suffered this fate recently which has seen the bank being taken over by Lloyds TSB.
According to the UK Department of Business, Enterprise and Regulatory Reform’s IFSL Research, assets under management in hedge funds globally totaled $1.9 trillion at end 2007. As such, the problems they could potentially cause when things go wrong are enormous. Unfortunately, the current turmoil in the global financial markets happens to be such one example.
What is amazing is that, while regulators are keen to temporarily proscribe the practice of short-selling, they are only too quick to close ranks with their friends in the financial services industry to defend the practice of short selling. The same breadth they ban the practice, they also defend and laud its efficacy, stressing that short selling make an important contribution to liquidity management and to the orderly operation of the market. Short selling, they argue, can play a key informative role; often exposing the real value of company’s shares.
The governments and regulators cannot have their cake and eat it. This is where the benign blurring of democratic government and business is at its most potentially corrupt. There are plenty of other ways to generate and manage liquidity. The truth is that short selling for decades has been seen as an ideal way of making a quick few billions or so, especially in a decade of economic boom. What has happened to the traditional so-called Protestant ethic of wealth creation through thrift, hard work and generating returns through investments in the real economy, which has the added bonus of generating jobs?
Perhaps the Islamic system of economic and financial management has something new to offer to the conventional financial system. In Fiqh Al-Muamalat, Islamic law relating to financial transactions, short selling is definitively banned because it is tantamount to gambling or speculation in this sense (Maisir, which is similarly proscribed. Under Islamic investment principles, you simply cannot sell or trade a share or bond which you do not own.
The danger of course is for Islamic bankers to fall into the same trap ostensibly from pressure of investors looking for diversification of asset allocation and higher rewards. The fact that many bankers in Islamic finance are from the conventional sector, means that the tendency to imitate or “Islamize” conventional structures is simply too overwhelming.
Hedge funds and shorting are no exceptions. Earlier this year, Shariah Capital Inc. of the US launched the first Islamic fund of hedge funds, in which the Dubai Multi Commodities Center Authority (DMCC), an agency of the Dubai government, is seed investing a $250 million — $50 million in five hedge funds through the Al-Safi Trust alternative investment platform, established by Barclays Capital and Shariah Capital Inc.
The promoters devised a Shariah-compliant equivalent which replicates shorting using the contract of Arbun. Under this arrangement, the trader who wishes to short a stock in the Al-Safi platform can put a sell order through Barclays Capital’s prime brokerage, which would record the transaction as a purchase and not a loan. This process establishes ownership of the asset before sale to the market. In Islamic finance you cannot sell an asset which you do not own.
As such, an investor cannot borrow shares from a brokerage house or a bank and sell them in the market for an eventual gain. Al-Safi also tracks each trade and each position of each hedge fund manager through separately-managed accounts to ensure strict Shariah compliance. But while the mechanics of the structure in this respect is different, the economic effect is similar to the conventional short sell. The reality is that the transaction is more a long-short arrangement.
It would be interesting to know the current situation of these so-called Shariah-compliant hedge funds. Other attempts at Shariah-compliant hedge funds by Fimat, the prime brokerage arm of Societe Generale, and Al-Fanar, owned by Worms & Co. and SEDCO, used the Salam contract, effectively using a forward sale concept for equities. But they failed to thrive.