Mega-Banks and the Next Financial Crisis

Hedge-fund manager Paul Singer recognized the risks of subprime mortgages and bet against them. Now he warns that monetary policy could cripple American banks again

At the height of the housing bubble, hedge-fund manager Paul Singer was shorting subprime mortgages. By the spring of 2007, he was warning regulators on both sides of the Atlantic that the world was facing a major financial crisis.

They ignored him. Now the founder of Elliott Management says the biggest banks are headed for another credit meltdown. Among the likely triggers for the next crisis, Mr. Singer sees one leading candidate: Monetary policy "is extremely risky," he says, "the risk being massive inflation."

In some areas gas prices have reached $4 per gallon, and now Americans must brace themselves for higher grocery bills. This week the Labor Department reported that February wholesale food prices posted their sharpest increase since 1974. News like that has driven Mr. Singer to the history books: He treats visitors to his 5th Avenue office to a copy of a 1931 treatise on German currency debasement, Constantino Bresciani-Turroni's "The Economics of Inflation."

Mr. Singer—who launched Elliott in 1977 and has delivered a 14.3% compound annual return (compared to the S&P 500's 10.9%)—is not comparing today's Federal Reserve to the Reichsbank of the early 1920s. Rather, he's once again warning financial regulators. This time the message is: Don't take for granted investor faith in a major currency.

While at Harvard Law School, Mr. Singer turned down a research job with his intellectual hero, Daniel Patrick Moynihan, to pursue a career in finance. Today, he's still looking for heroes among the stewards of the major currencies. Central bankers, particularly at the Fed but also in Europe, "seem to be acting as if they have unlimited flexibility to ease monetary policy," he says.

He specifically targets the Fed's "unprecedented" policy of sustaining near-zero interest rates and its exercise in money-printing, "Quantitative Easing 2," that has it buying medium- and longer-term securities from the Treasury. "In effect they're treating confidence in fiat money—in paper money—as inexhaustible, that it's a tool that's able to be used not just in the throes of crisis," but also as "a virtually complete substitute for sound fiscal, regulatory and taxing policy."

Fed officials, he adds, "really seem to think that inflation is something they can deal with very easily and very quickly. I don't believe they're right." He notes that, in the late 1970s, inflation was only in the high single digits yet curing it required interest rates of 20% and a collapse of the bond market.

Mr. Singer further warns that investors shouldn't misinterpret apparently bullish signals from a rising market. "Of course printing money is going to support asset prices," but "it's very dangerous" and is not a substitute for trade, tax and regulatory reforms that make America an attractive place for job creation.

"What would a loss of confidence in the dollar actually look like? Gold going absolutely nuts," adds Mr. Singer, who is also a major donor to conservative intellectual causes and think tanks such as the Manhattan Institute. He observes that prices for many commodities are already near all-time highs, even with "kind of a soft recovery" in the U.S. and Europe, and robust growth in Asia. "Imagine if hoarding, speculation, investment positions in [hard assets] accumulate to cause commodities and gold to go rocketing up. Wages, prices will follow," he says.

As destructive as raging inflation would be, why would it hurt the big financial institutions? It could wreak havoc on the ability of big banks' corporate customers to make good on their obligations, Mr. Singer believes—and financial reform did little to reduce risks.

"Dodd-Frank has made the system more brittle and has shaped the next crisis in a very negative way," he warns. "The opacity of financial institution financial statements has not been addressed or changed at all. . . . We have a very large analytical research effort here and we have not found anybody that can parse" the sensitivity of big banks to changes in interest rates, asset prices and the like. "You can't do it."

Even after the crisis, credit ratings "obviously provide no real clue," he says. "Rumor and feeling is all you have. You don't know the financial condition of [Citigroup], JPMorgan, Bank of America, any of them." Mr. Singer believes the big banks still carry too much leverage, and he doesn't trust regulators to monitor them effectively.

The largest financial institutions, he says, are "a random collection of survivors. Almost none of the survivors exist because of their perspicacity, risk controls and sound management—even the ones that are vaunted along those lines. . . . How and why do they exist? Mostly an accident, meaning who got bailed out first and who was saved next and how did people feel and what did people say the weekend Merrill was under pressure [in September 2008]."

Mr. Singer says he does as little business with big banks as possible. "Aside from a large position in Lehman as part of our bankruptcy investing, we have no significant positions in global banks."

"We institutionally have tried to—way before the crisis of '08—tried to insulate ourselves in every way we can from the counterparty problem," i.e. getting involved in a trade with a partner that might not be able to make good on its obligations down the line. But the nature of his business, he says, means that he can't sever all connections. "We've removed as many assets from the Street as we possibly can, and we think we're pretty well insulated. . . . If we could completely avoid being subject to the financial condition of any large financial institution, we would do so."

Most investors don't share this view, of course, and big banks are still able to borrow at lower rates than their smaller competitors. The reason, says Mr. Singer, is that right now the system "is underwritten by the United States government and the governments of Europe. And the system is perceived as underwritten or guaranteed." But, he warns, "at some point that guarantee, in some way that I can't really visualize today, will go away."

Will it really? The authors of Dodd-Frank claim that the law prevents the government from bailing out any particular firm, but the Fed can still provide emergency loans to a failing giant as long as it offers similar financing to other firms.

"It's a very important part of this equation that a few survivors exist in this peculiar relationship with government, having to kowtow to government, make relationships with regulators," says Mr. Singer. "Are they puppets of the government? Are they cronies of the government? Will their lending be affected by the perceived whims or beliefs of the particular government regulators existing at a particular time? Yes."

If the government deems a firm not "systemically important," Mr. Singer forecasts, it could spell its doom. "Small and medium-sized financial institutions may be disadvantaged, may be sacrificed in the next crisis to protect these behemoths," he says.

It gets even worse, Mr. Singer says, if the government ever deems a financial giant "in danger of default"—a judgment that can be made without the consent of the firm or its investors. The business is then taken over by the Federal Deposit Insurance Corporation, with its Orderly Liquidation Authority.

Once in charge of the firm, the government can discriminate among similarly situated creditors and transfer assets out of the business at will. Because of this, says Mr. Singer, creditors and trading counterparties might flee even faster than they would from a firm headed toward bankruptcy, where at least there is established law instead of regulator discretion.

Mr. Singer's fund specializes in distressed debt and bankruptcy situations, so perhaps he has reason to oppose changes to a system he knows so well. But he's also well-qualified to examine the government's reforms.

"You don't know how you will be treated," he says of financial institutions under the new FDIC regime. "If there are companies that are also counterparties alongside you but they've been designated systemically important, that's a clue. It's like a game of treasure hunt. It's a clue that you're going to get disadvantaged compared to them."

So maybe FDIC chairman Sheila Bair and the authors of Dodd-Frank were right about one thing: Perhaps their new process for resolving failing giants really will discourage some people from lending to the biggest banks—but only at the worst possible moment.

The problem, in Mr. Singer's view, will be the jarring shift from one day being an investor in a member of the "systemically important" club, to the next day being a creditor whose claim is determined by bureaucratic whim. This may be welcome news to government pension funds that will want to be bailed out, but certainly not for private investors.

The speed at which a firm will collapse as word gets around that it might be headed to FDIC resolution could be "amazing," says Mr. Singer. And that "speed will drive the size of the losses."

This "atmosphere of unpredictability" is harmful to America's place in the financial world, he says, and "it doesn't make the system any safer. . . . This is nuts to be identifying systemically important institutions." He views it as a poor "substitute for creating soundness and reasonable levels of leverage throughout the system."

Mr. Singer's views on systemic risk are particularly interesting given his prescience about subprime mortgages (to say nothing of his ability to build a firm from zero to $17 billion in assets). In a famous 2006 presentation at a conference hosted by Grant's Interest Rate Observer, he explained in painstaking detail the flaws in subprime-mortgage securitizations, and in the high grades awarded to them by government-anointed credit-rating agencies. In the spring of 2007, he warned the G-7 finance ministers about the grave threat to the banking system, but his words "fell on deaf ears," he says.

Not that Mr. Singer's analytical skills are perfect: In the aftermath of the crisis, he fingered derivatives as a key factor, and he maintains that they will also play a role in the next crisis, even though it's now clear that in 2008 banks were felled by more conventional housing bets, not derivatives. Also, since Elliott largely doesn't play in the derivatives market, Mr. Singer bears few of the costs if that market is regulated more heavily.

Still, Mr. Singer's testimony against Dodd-Frank and Fed monetary policy is compelling.

One reason his firm has survived for 34 years, he says, is that "we try to be very respectful of the unpredictability of markets. We try to at all times at least assume that the world is not being properly run." A safe assumption.