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A Critique from the Inside - Henry Kaufman
Challenge, Sept, 2000
Interview with Henry Kaufman
Henry Kaufman, president of Henry Kaufman and Company Inc., was long the most influential economist on Wall Street. In this interview, he argues that the Federal Reserve does not fully understand the structural changes in the financial markets. He thinks Alan Greenspan should target overspeculation in stocks. And he thinks we need closer supervision of financial institutions, both domestically and worldwide. Will there be a market crash? Read on.
Q Obviously, the financial world has changed--to say it has changed dramatically is an understatement--since you started on Wall Street. What in particular strikes you?
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A. First is the enormously burgeoning growth of the marketplace for financial assets compared to the growth of the economy. Financial assets have grown much more rapidly than the economy has. Second, the diversity of credit instruments has increased dramatically. We have many more marketable credit instruments today than we had two, three, and four decades ago. The third aspect, of course, is that the financial markets are much more at the forefront of the public mind than they were thirty or forty years ago because the household sector has become an active participant as a buyer of stock. The average household is also very knowledgeable in how to finance a mortgage. And, of course, the financial markets have become globalized. It has become an international business, not just a market for domestic credit instruments.
Q. Much of this situation, you argue, is beneficial.
A. Absolutely. Much more information is readily available. The participant in the market can see creditworthiness increase and decrease far more rapidly than was possible years ago, when loans were hidden in the balance sheets of financial institutions, for example. So today's market is more complex, but certainly also has great opportunities as well as some risks.
Q. Has the market contributed in some respects to a reduction in risk, as is often claimed--say, from derivative securities?
A. No, financial derivatives are used by some investors as a way of hedging risk, but in many instances they are a way of enlarging profit opportunity and risk taking.
Q. What is your definition of financial derivatives, which invariably mystify readers?
A. A financial derivative is really a proxy for a credit instrument. For example, a call option allows you to buy a thousand shares or a hundred shares of stock for a small amount. If the stock price rises, you benefit. If the stock price falls, the value of the option is eliminated. So, for example, today for an expenditure of $3 million you can probably purchase an option on $50 million worth of U.S. government obligations. That is an extraordinary leverage, so a small price change in bonds, which is considered a stable instrument, can result in an extraordinary profit gain or an extraordinary loss on the $3 million investment.
Q In your long career at Salomon Brothers, you witnessed the increasing risk in the stock market and indeed the incresing risk that Salomon itself was taking on. At what point did you believe that it was just too much risk for Salomon, which ultimately you left?
A. Well, that is a difficult way of phrasing it. But what happened in the 1960s, 1970s, and 1980s is that, with the transformation of the financial markets and the rapid growth of many new credit instruments, the nature of the securities business changed, as did the nature of the securities firm. You were not only an underwriter of securities--meaning you brought new issues to market and distributed them--you also traded securities, which meant that you positioned securities--you held them until you had a buyer for them. But security firms also became lenders through the use of repurchase agreements with other borrowers or lenders. There were many new credit instruments, such as derivatives. Also, there were interest-rate swaps and currency swaps of all sorts. In these, you positioned huge amounts of obligations on your own balance sheet--in other words, you increased the leverage on your own balance sheet. The mortgage market became securitized as well, so you traded mortgage securities and positioned them. Therefore, the very balance sheet of a security firm, and eventually of other financial institutions, became bigger and more complex, with more diverse liabilities. There was a diversity of assets on your balance sheet from high grade, to medium grade, to low grade. To properly structure your liabilities, borrowing against your assets also became very complex because you had to try to match maturities if you wanted to avoid taking more risk--assets had to mature when liabilities came due. You needed to increase the volume of capital to do more business--that is, to do more leveraging. I became somewhat more concerned about how much you could leverage a balance sheet--to what extent you could take on lower-quality assets. I thought it required a far more disciplined approach to managing assets and liabilities.
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