Why the fed can’t rule the market
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It’s a tough job, but thank God somebody’s doing it: Henry Hu holds the Allan Shivers Chair in the Law of Banking and Finance at the University of Texas School of Law. If you think remembering his title is a little arduous, try explaining the kinds of topics that he spends his time teaching and writing about — derivative securities, corporate governance, securities regulation, hedge funds, and mutual funds. Mr. Hu is especially busy these days, trying to keep up with the near-Wild-West mentality that has taken over the investing landscape in the United States, and the resultant actions by individuals, corporate managers, and even the government itself. His most recent paper, “Faith and Magic: Investor Beliefs and Government Neutrality” (March 2000, Texas Law Review), hones in on the potential fallout of perceived government intervention in the stock market. Also in March, Mr. Hu was appointed to the National Association of Securities Dealers’ Legal Advisory Board. Red Herring recently caught up with Mr. Hu to ask him about “derivative realities,” “blissful wealth,” and his continuing fascination with the teachings of Warren Buffett. Your March paper, “Faith and Magic: Investor Beliefs and Government Neutrality,” raises the question of the role of the Federal Reserve Board in the stock market. A lot of people are of the opinion that the Federal Reserve cares a lot more than Warren Buffett does about the current level of stock prices. Should the Fed care about stock prices? I think that the Federal Reserve should probably be neutral in terms of asset prices — you don’t want the Federal Reserve to deliberately target asset prices, to basically push stock prices either up or down to the “right” level. You want it to be a neutral referee. Free markets are much better at allocating resources. Government mandarins really should not play too much of a role. That said, I am concerned that the effect of some of what the Federal Reserve has done in recent years has been a departure from neutrality. One possible example was the rescue of Long-Term Capital Management [LTCM], which the Federal Reserve brokered in the fall of 1998. That was a situation where a group of private institutions led by Warren Buffett was ready to buy LTCM. For whatever reason, the Fed either did not want that consortium taking over or did not feel that that would really happen, and the Fed pressured some of the world’s largest financial institutions to step in and bail out this hedge fund. When you think about it, this hedge fund was a collective investment vehicle for rich investors, ranging from extremely wealthy individuals to major financial institutions like UBS, Switzerland’s largest bank, the central bank of Italy, and the like. And on a very public stage — this was coming amidst the Asian and Russian financial crises of 1998 — the image of the Federal Reserve came close to becoming that of a protector of a bunch of rich speculators who had made a bad bet. There were no widows or orphans involved. But sociocultural developments of the last decade have put us in a position where we do have a lot of widows and orphans involved in the stock market. Shouldn’t the Fed should be concerned about a country that is increasing its equity allocation by the day? Perhaps. But it gets interesting. Take mutual funds, for example. It’s possible to see a situation where some mutual fund is in trouble for whatever reason, and there could be enormous political pressure on the Fed, relying on the LTCM analogy as to collective investment vehicles, to basically step in and rescue a particular fund. But you’re right — if all these widows and orphans are in equities, and equities were to collapse, isn’t that a real social problem? But if you really do have a situation where the Fed is guaranteeing some kind of safety net for equity prices, if we get ourselves into that kind of position, it creates a tremendous moral hazard. You’re left with people who would view the stock market as being risk-free. If you really do believe in this kind of Fed safety net set at some percentage level below whatever the current prices are of stocks, then you could literally pay an infinite price for stocks and not worry. But that, of course, does terrible things to the stock market as a resource allocation mechanism. The stock market is one of the central resource allocation mechanisms, not only in terms of the money raised through IPOs and the like, but the market signals it throws off about what managements and what areas of investment are promising and not promising. You don’t want the government stepping in and distorting this central resource allocation mechanism. In another paper called “Behind the Corporate Hedge” [1996, Journal of Applied Corporate Finance], you raise a concept which you refer to as a “derivative reality.” What do you mean by that? In the simplest sense, I mean that corporations can either take the risks presented by the world as is — interest rates can go up or down, the prices of commodities can go up or down, currency exchange rates can fluctuate — or they can use derivative products to create their own alternative reality. The risks are quite clear. Assume, for example, that you’re an appliance manufacturer. If interest rates go up, your sales will presumably go down and you’ll suffer as a result. Alternatively, if you’re an oil producer, if oil prices go down, you’ll suffer, but if oil prices go up, you’ll benefit. That’s taking the world as it is. But instead of that, corporations can effectively create their own reality. If the appliance maker is concerned about interest rates because of the potential impact on sales, the company can buy various interest-rate-related derivatives that would increase in value if interest rates rise. The increase in value of those derivatives will hopefully offset the decline in sales of washers and dryers. In effect, companies can create alternative worlds that only have the kinds of exposure, the kinds of risks, they want to face. |