"On the march
By Gillian Tett and Aline van Duyn
Published: June 8 2009 20:30 | Last updated: June 8 2009 20:30
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| A new day dawns on Wall Street: in the boom years, asset managers allowed big investment banks to make the running in over-the-counter trading. Now, they say this ‘sell side’ has had things its own way for too long |
Samuel Cole was fed up. Some of the world’s largest investment banks were, in the view of the chief operating officer at BlueMountain Capital, playing foul in the credit derivatives market in which his New York hedge fund sought to make its money.
Far from being chastened by their near-death experience in the financial crisis, he seethed, Wall Street’s finest were displaying a stubborn unwillingness to reform trading practices.
So Mr Cole fired off an e-mail last week to more than 100 bankers, investors and regulators, in which he argued that many of the banks that sold those sorts of securities were “not seriously engaged in working with the buy side” – the asset managers who invested in them. Banks needed to co-operate in reforming trading practices to create a more balanced and transparent market.
“The dealer community may be filibustering to protect its oligopoly,” he wrote – echoing the sentiments of many hedge fund managers, who worry that harsh regulatory intervention could kill off the sector.
The banks deny being recalcitrant. But as regulators step up their efforts to reform banking, the angry e-mail is just one sign of a new set of strains building in the financial system between those who sell financial products and the asset managers who buy them – mostly on behalf of clients. The fight, which extends well beyond trading in credit derivatives, could potentially affect far more than just financiers. If the structure of capital markets changes, it could reduce the fees that the financial industry takes from customers that include many of the world’s biggest companies.
The hedge fund’s criticism adds to pressure from regulators and politicians for a better way to run the so-called over-the-counter markets, where deals take place away from any recognised exchange.
During the credit boom, it was clear who had the upper hand. In the City of London and on Wall Street it had long been taken for granted that the world’s largest investment banks dominated the financial markets. These “sell side” institutions had vast resources and tended to structure activity in ways that were most profitable for them, at the expense of investors buying the products. Asset managers – pension funds, mutual funds, hedge funds and the like – often appeared to have little incentive or ability to challenge this status quo.
Now, however, that power balance between buy and sell sides is starting to shift. Wracked by losses incurred in the crisis, and under attack from their own investors for tolerating the dominance of banks, asset managers are starting to take on the establishment.
“The wealth destruction that has occurred has been enormous, although it will probably only become [fully] visible in the next few years, when people go to get their pension and discover it is much less than they thought,” says Hans-Jörg Rudloff, the chairman of Barclays Capital who also heads the International Capital Markets Association (Icma), a financial industry lobbying group. “The end result of that wealth destruction is that investors are looking more closely at what is being bought, how markets are working – they are questioning many things.”
DISTRESSED DEBT
‘Organise to assert your rights or face an adverse outcome’
The sudden involvement of the US government in numerous distressed sectors – from the car industry to the mortgage market – has prompted investors to find a voice in Washington to ensure their interests are protected, writes Aline van Duyn.
When debts exceed the amount of money available to repay them, there is an inevitable scramble among the people owed money as they vie for as much as possible of a shrinking pie. These efforts are usually guided by the contracts that underpin the loans or other debts. In the US, the process of restructuring a company’s debts is well-established through law and bankruptcy judges weigh in whenever it is not clear who stands to benefit.
In the recent fight over the future of Chrysler and General Motors, bondholders and some lenders said the government pushed through terms that favoured workers and overturned relationships established by contract law. Tactics to capture the attention of politicians have included rallies by private investors who owned GM bonds.
Similar arguments are taking place in the US mortgage market, which has long been financed by investors such as pension funds and insurance companies buying bonds backed by home loans.
Seeking to tackle a house price collapse and stem the rise in foreclosures, the government has introduced a series of measures that allow people to renegotiate mortgage payments to make them more affordable.
That hurts asset managers holding mortgage bonds that are backed by so-called “first lien” mortgage loans. These are supposed to incur losses only when riskier, “second lien” mortgages have been written off.
However, hedge funds, pension funds and others have struggled to make their case. That is partly because they are not a homogenous group and because, according to some, they have had few direct connections with senators, having left much of the mortgage industry lobbying in the past to banks.
“It seems very clear in the months ahead that first lien investors must get better at organising to assert their rights, or they will face an extremely adverse outcome,” says Laurie Goodman, analyst at Amherst Securities.
Although there are plenty of hedge funds involved in the mortgage securities battle, it was the mutual funds or pension funds that represent ordinary people who were put forward and who wrote to or met senators.
Another factor behind the power shift is liquidity, or the ease with which investors can trade assets. That is seldom a problem with shares in big companies that change hands in large numbers daily on a public stock exchange – where buyers and sellers have equal clout. But when securities are only thinly traded on an exchange (as is the case with some smaller companies), investment banks can wield more power, since they use their own money to make markets in such stocks. And when assets are traded via private deals in the so-called over-the-counter sector, the banks that act as brokers in the transaction have enormous power at their disposal, since they not only organise trades but also have exclusive access to information about the prices and volumes that are being achieved.
That over-the-counter set-up prevailed in particular for many derivatives and the more complex credit products that were the hot products of the boom years. Opacity enabled the broker banks to charge high fees and organise trades to suit them. Asset managers tacitly accepted this, since brokers made markets and thus enabled others to trade.
Moreover, in the days of the credit boom, banks were willing to provide hedge funds with the loans they needed to make ever bigger bets in search of the best rewards. “There was a lot of competition among the dealers, which resulted in tight bid/offer spreads and good liquidity,” says Rohan Douglas of Quantifi, a provider of credit market analysis.
Now, however, many banks are so short of capital that they are no longer willing to make loans to investors, or even to act as marketmakers. “Instead of being liquidity providers, the dealers have become liquidity users,” says the chairman of one large investment bank. That has made it even more expensive for asset managers to trade – and some parts of the market have frozen up. The climate has changed “and, now, what’s good for banks – as they are constrained in the amount of capital available for trading – is not necessarily good for investors,” says Mr Douglas.
Hence the tensions between the buy and sell sides – which are prompting some investors to seek ways to cut out the middleman. “These days we are seeing lots of corporate [bond] issuers coming to us directly when they want to raise money, not using a broker,” says an executive at a Middle Eastern sovereign wealth fund.
The collapse of liquidity is also prompting a wider rethink of the market structure. Politicians on both sides of the Atlantic are backing a drive to make over-the-counter trading more transparent and egalitarian or move many of those dealings on to an exchange. They are being egged on by securities exchanges, which scent an opportunity.
The future structure of the $27,000bn (£16,900bn, €19,500bn) credit derivatives market – the subject of the angry e-mail from the Park Avenue-based BlueMountain – is one case in point. Until now, it has been dominated by a small coterie of banks. But Tim Geithner, US Treasury secretary, is demanding that activity should move to a central clearing platform, to reduce “counterparty risk” – the danger that a trade will collapse if one party defaults. Some politicians and regulators want to go further and place all activity on an exchange.
Other battlefronts are opening up. The European Commission is pushing for more price transparency in privately traded company bonds. Investors in structured credit – the packages of debt sliced and diced by investment bankers – are demanding the same. America’s mortgage bond market is immersed in a separate collection of fights, because efforts to restructure delinquent home loans are pitching the interests of investors against those of the banks.
“There is a natural tension between all stakeholders – dealers, investors and, uniquely today, governments – that has been aggravated recently due to the extreme economic and market pressures on all participants,” says Tim Ryan, head of Sifma, an industry grouping that tries to represent both banks and investors. “We see the tension up close as we strive for consensus among our members,” he adds, noting that this jostling “has been most pronounced in mortgage modifications, industrial restructurings, equity shorting and derivative markets.”
Or as Armins Rusis of Markit, a data provider, notes: “Some markets will continue to be as they are now, typically with a few big marketmaking dealers trading with many smaller dealers and investors. But some may shift completely.”
How many of these battles will be won by investors remains unclear. Brokers and large banks have in the past been adept at fighting off challenges. “The buy side is very fractured – there are big differences between all the different types of institutions, between those serving retail clients and others,” says Robert Parker of Credit Suisse Asset Management and head of an investor lobbying group within Mr Rudloff’s Icma.
Yet Mr Parker’s creation of the investor group last year is itself evidence of a mobilisation by buy-side interests. Moreover, politicians and regulators appear to be supporting their cause.
In the US, William Dudley, president of the New York Federal Reserve, is trying to give investors a louder voice. The Fed used to garner almost all of its market feedback from the sell side – groups such as JPMorgan Chase, Citigroup, Goldman Sachs or Merrill Lynch. But in recent months the New York Fed has started including asset managers in advisory committees and created an informal advisory group of hedge fund, private equity and asset managers. “Our aim in this is not to disenfranchise the dealers but to enfranchise the buy side. We want the whole market to be part of the decision-making process,” says Mr Dudley.
Whether the “whole market” can be corralled into making collective decisions remains unclear: though groups such as Sifma and the Fed itself stress that it is in everyone’s interest to co-operate, the turf wars are likely to grow more rather than less intense. “All over the place, there are fights going on about who will control the system. It’s ugly,” observes one Wall Street financier.
Yet some see all this as healthy in the long run. “This crisis has been terrible, but it has been good in a way because it is making us rethink things about how the market is run,” says Sandrine Guerin, deputy chief executive of Credit Foncier, the French financial group. “It could make a better system in the future – or so I hope,” she adds. It is an aspiration that millions of savers will share, after two years of brutal losses.
Additional reporting by Hal Weitzman and Michael Mackenzie
TRADING PLACES: CONDITIONS AND TERMS
Only a fraction of buying and selling in financial markets occurs in institutions such as the New York and London stock exchanges. Newer activities, such as the trading of derivatives, are transacted privately in over-the-counter markets. These are split between buy-side institutions, such as pension funds and hedge funds, that have money to invest, and the sell side : banks and brokerages that make investment recommendations and allow investors to buy and sell assets. Much of the sell-side activity is marketmaking, in which banks and brokers commit always to offer a price for an asset. Prime brokerage, where banks lend to hedge funds and other clients so they can invest, is also lucrative.
Copyright The Financial Times Limited 2009"
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