I'm sorry, Simon Johnson's argument that the government should seize the worst banks (e.g., Citi, BofA), force a debt-for-equity swap over the weekend, and re-open them as well-capitalized entities on Monday, is really detached from reality. This is, in effect, the "temporary nationalization," or "managed receivership" argument that has become so popular among commentators. (Since everyone knows that Citi would be the first bank to be nationalized or taken into receivership if the government went that route, I'll focus my discussion on Citi.) Let me try this again: Nationalization of a bank like Citigroup is not possible. Receivership is also not possible, even if Treasury's proposed resolution authority for major financial institutions passes. Citigroup is an international financial institution. It has branches and subsidiaries in over 100 countries. As Justin Fox points out, of Citi's $755 billion in deposits, $515 billion are outside the US. In general, each of Citi's foreign offices is subject to the insolvency laws of the country in which it is located. If the government put Citi in receivership or conservatorship, most of these foreign countries would seize the assets of the Citi subsidiaries in their jurisdictions and begin their own bankruptcy procedures. Any legitimate claims the US has on Citi's foreign assets would be governed by a convoluted web of international agreements. The complications don't end there. Citi has over 2,000 principal subsidiaries. The Treasury's proposed resolution authority—which is essentially a scaled-up FDIC resolution, with a few changes—doesn't apply to subsidiaries which are registered brokers or dealers, insurance companies, FDIC-insured depository institutions, hedge funds, investment advisors, or private equity funds. (I'm sure I'm missing some too, since I'm not a bankruptcy lawyer by any means) The insolvency of registered broker-dealer subsidiaries is handled primarily by the Securities Investor Protection Corporation (SIPC) under a resolution procedure designed specifically for broker-dealer liquidations. Insurance company insolvencies are governed by state insurance regulations, and handled by state insurance authorities. Obviously, the FDIC handles insured depository institutions under its traditional resolution authority. The rest of the subsidiaries not covered by the Treasury's resolution authority are thrown into bankruptcy court. And this is all before you get to the actual restructuring, which would almost have to take the form of an FDIC-managed conservatorship. The assets and liabilities that the FDIC ultimately takes into conservatorship would likely be badly mismatched on several levels, and would bear almost no resemblance to Citigroup's pre-insolvency assets and liabilities. Seeing as the only bank stupid enough to buy this kind of mangled, leftover balance sheet outright is .... umm, Citigroup .... the FDIC will have to do some serious restructuring. In all likelihood, that means bondholders will have to take haircuts. How did that work out with Lehman again? Oh, right. It caused an epic financial panic that almost brought down the global financial system. Good luck with that. Cheer up, though: you're almost a third of the way through the vaunted "temporary nationalization" process. I won't bore you any further. Suffice to say that this doesn't even scratch the surface of the legal obstacles to nationalization or receivership. As I'm sure you can see by now, the idea that Citigroup can be taken into receivership, restructured, and recast as a well-capitalized bank all in one weekend, is borderline delusional. The broader point is that no matter how well a Citigroup receivership works in a Paul Krugman or Simon Johnson hypothetical, in the real world it's not a serious option.

I've defended the credit default swaps (CDS) market many times before, but even I wouldn't endorse this proposal from Harvard's Oliver Hart and the University of Chicago's Luigi Zingales. Under their proposal, capital requirements at large financial institutions (LFIs) would be subject to a sort of "margin call" on equity holders in LFIs, which would be triggered when the CDS spread on a given LFI rises above a predetermined threshold. Hart and Zingales explain how it would work:

[A]n LFI will have to post enough collateral (equity) to insure that its liabilities are always paid in full. When the fluctuation in the value of the underlying assets puts creditors at risk, the LFI's equity holders will be faced with a margin call: They will either have to inject new capital or lose their equity. In both cases the creditors will be protected. ... In our mechanism, when the CDS price rises above a critical value (indicating that the institution has reached an unacceptable threshold of weakness), the regulator would force the LFI to issue equity until the CDS price and risk of failure back down. If the LFI fails to do this within a predetermined period of time, the regulator will take over.
Hart and Zingales put way too much faith in the accuracy of CDS spreads. It's true that the CDS market is more liquid than the corporate bond market—that's one of its main attractions. But the CDS market is still much too thinly-traded, and liquidity in single-name contracts is still much too spotty and unreliable, for something as important as capital requirements at major financial institutions to be based on CDS spreads. What's more, liquidity decreases as the spread rises, so the closer the CDS spread gets to the margin trigger in Hart and Zingales's proposal, the less reliable the spread becomes. The pricing mechanism in the CDS market isn't exactly a model of transparency either—pricing services like Markit just use quotes provided by dealers. Since single-name CDS on financials are relatively thinly-traded, any of the dealer banks could push the CDS spread on an LFI up past the threshold (wherever it may be), forcing a "margin call," without even using too much of its balance sheet. Hell, a decent-size hedge fund could push the CDS spread on an LFI up past any threshold level if it really wanted to. For traders at the dealer banks, this would be like hunting squirrels with a bazooka. The CDS market is an extremely useful tool, and recent changes are all to the positive. But let's not get carried away.

Probably.

But a lot of the recent arguments for why the financial sector is too big don't make the case. For example, Simon Johnson cites the financial industry's share of domestic corporate profits:

From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent.
Similarly, Paul Krugman cites the growth of the financial sector as a percentage of GDP: in the 1960s, finance and insurance accounted for only 4% of GDP, whereas in 2007 finance and insurance accounted for 8% of GDP.

But these arguments don't prove that the financial sector is too big. Finance is a global industry, and the U.S. financial sector provided financial services to other countries, including emerging economies, during this period. The growth of China, India, South Korea, etc., meant that the demand for financial services was growing during this time period. Moreover, it was also during this period that competition from low-wage countries like China was slowly eroding the U.S. manufacturing base. The combination of these two trends—rising demand for financial services abroad and a shrinking U.S. manufacturing sector—absolutely contributed to the U.S. financial industry's growth relative to other domestic industries. In this story, the financial industry isn't "too big," it's just growing relative to other domestic industries.

I'm not saying that the financial sector isn't too big—in fact, I strongly suspect that it is. I'm just saying that the evidence most people use to support that argument doesn't actually prove much of anything.

Monday, March 30, 2009

Listen to Roman Frydman

I'm very glad that Roman Frydman's work is getting some much-deserved attention. Frydman and Michael Goldberg's work on "Imperfect Knowledge Economics" is first rate—the kind of stuff Nobels are made of. I've recommended Frydman and Goldberg's work before, but I only knew of their work because Frydman and his wife were both professors of mine way back in the day at NYU. It's nice to see their work getting a wider audience. In his open letter to Gordon Brown and other leaders of the G-20, Edmund Phelps, the 2006 Nobel prize winner, even plugs Imperfect Knowledge Economics as the new conceptual framework upon which regulators should base future policy toward asset markets. That's wishful thinking, but policymakers would be well-advised to at least listen to Frydman. He knows of what he speaks. For anyone with basic statistical literacy, I highly recommend Frydman and Goldberg's book, Imperfect Knowledge Economics: Exchange Rates and Risk.

Friday, March 27, 2009

Blinded by Rage

What do you get when you combine insecurity, a massive inferiority complex, and unbridled populist rage? Matt Taibbi. Taibbi, whose recent Rolling Stone piece is one of the most unintentionally hilarious articles I've ever read, now unleashes a semi-coherent attack on Jake DeSantis, the former AIGFP executive whose resignation letter appeared on the NYT's op-ed page this week. Taibbi spends a majority of the article calling DeSantis is a liar because he undoubtedly knew about the credit default swaps that Joe Cassano was writing. Except that DeSantis never claimed that he didn't know about the CDS deals. The rest of the article is similarly ridiculous, and possibly rivals his Rolling Stone piece for the Unintentional Comedy crown. Apparently Taibbi was too busy making sure that he included the word "fuck" in every sentence to put together a coherent argument. Ah, youth...

Responding to my earlier post on the insurmountable obstacles to nationalization, one of the bloggers at The Economist's Free Exchange writes:

Given the fragility of the current global economy and the real economy impact of financial market spasms (remember, remember that week last September), it's difficult to imagine the Obama administration contemplating nationalisation in the absence of a very clear, legally sound, internationally accepted procedure for taking control of the banks. Economics of Contempt says that this means nationalisation is therefore now and forever off the table. I disagree. The American government has created mechanisms for taking control of financial institutions before, and it can do it again.
I certainly didn't mean to suggest that nationalization is forever off the table. At some point in the future, I suspect we'll have a formal resolution regime specifically for bank holding companies—especially now that Treasury is asking for the authority to develop such a regime. But developing a resolution regime for too-big-to-fail banks will be a very long, multi-year process, and it may not ever produce a mechanism that allows a Citi or a JPMorgan to fail without bringing the entire financial system down with it. The Bankruptcy Code and the FDIC's resolution regime didn't just magically appear and gain the trust of the financial markets. They developed over decades, slowly winning the trust of the financial markets as gaps in their procedures were fixed, and bankruptcy courts and the FDIC proved themselves to be compentent authorities who would apply their respective rules in a consistent and fair-minded manner. Even with the FDIC's resolution procedure as a blueprint, there's no way a workable resolution regime for too-big-to-fail financial institutions could possibly be developed before this recession is over (or at least before financial markets, which always lead the real economy, start to recover). It's just not possible. Developing this kind of resolution regime is an enormously complex undertaking. Remember, a quirk in the way a single clause in the initial merger agreement between Bear Stearns and JPMorgan was drafted caused havoc in the financial markets for a week. The initial merger agreement provided that JPMorgan would guarantee all of Bear's trades until either (a) the deal closed, or (b) the merger agreement was terminated, whichever occurred earlier. But the way the guarantee was drafted, if Bear's shareholders voted down the deal, the merger agreement technically wouldn't terminate for another 12 months, during which time JPMorgan would still be guaranteeing all of Bear's trades. Essentially, the agreement gave Bear a one-year option to use JPMorgan's balance sheet, regardless of whether Bear's shareholders approved the deal. Does anyone think the government could develop a resolution regime for major financial institutions relatively quickly without making this kind of minor but extremely consequential mistake? The consequences of even legal uncertainty could throw the financial markets into chaos, because the specific treatment of an institution's assets and debts in the event of insolvency significantly influences pricing in the market. Treasury would have to specify how the new resolution regime would interact with hundreds (if not thousands) of state and federal laws, as well as hundreds of bilateral and multilateral treaties. Major financial institutions—Citi, BofA, JPMorgan, Wells Fargo, Goldman, and Morgan Stanley—are involved in so many different markets around the globe, and have so many counterparties with such diverse businesses, that successfully winding down any one of them would require clear rules on each and every counterparty's rights under all possible contingencies, the likely timing of each stage of the resolution process, etc., etc. Eventually, all these details will get worked out, and over time the market may come to trust the resolution regime. In this financial crisis, however, nationalization is off the table. It's literally not possible, no matter how many commentators stomp their feet and demand that the government nationalize. The sooner people realize this, the better off we'll all be.

It pains me to say that, as Paul Krugman has been my favorite commentator for about 15 years. But, sadly, it's true. In his latest column, Krugman takes aim at securitization:

But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption. ... I don’t think the Obama administration can bring securitization back to life, and I don’t believe it should try.
There are so many problems with this nonsensical argument, it's hard to know where to start. First of all, the "key promise of securitization" has never been to "spread[] risk more widely." The key promise of securitization is that it allows commercial banks and other lenders to make new loans. More importantly, if securitization is so awful, then why has Krugman defended it so many times in the past?
  1. Just 8 months ago, he penned a strong defense of Fannie Mae and Freddie Mac, which were literally created to securitize home mortgages. He even argued that "the Fannie-Freddie experience shows that regulation works." So which is it: do Fannie and Freddie show that well-regulated securitization works, or is securitization "a collection of cheap stage tricks"?
  2. When Geithner originally outlined the administration's bank rescue plan, Krugman wrote:
    What is in it, in reverse order: 1. Super-TALF: a big expansion of the Fed’s quantitative easing, with Treasury backing. I’m OK with that. [Emphasis added]
    The TALF, of course, is a Fed program that's specifically designed to restart the securitization markets for assets backed by small business loans, student loans, credit card receivables, auto loans, and the like.
  3. Krugman has also praised the Resolution Trust Corporation (RTC) on several occasions, referring to it recently as "a good role model." After Bear Stearns failed, he wrote:
    Looking ahead, we probably need something similar to the Resolution Trust Corporation, which took over bankrupt savings and loan institutions and sold off their assets to reimburse taxpayers. And we need it quickly.
    How did the RTC sell off a substantial portion of those assets? Through—you guessed it—securitization! In fact, the RTC practically invented the market for securitized commercial mortgages (CMBS).
It's disappointing to see Krugman making such comically absurd arguments about banking/financial policy—a subject which, as a theoretical economist, he knows virtually nothing about. It's sad that people take his views on the bank rescue seriously.

Wednesday, March 25, 2009

Nationalization is Not a Viable Option

Kevin Drum asks:

What would it take to nationalize an outfit like Citigroup? What are the likely legal, financial, diplomatic, and operational issues that would have to be resolved? It would be a real public service if someone with a credible background in this stuff could lay out the details in a way that's understandable for all the rest of us.
I don't have nearly enough time to lay out all the legal obstacles to nationalizing a bank like Citigroup, which would require several weeks, if not months, of legal work. But here's one major legal issue: investment rights under Bilateral Investment Treaties (BITs) and some multilateral treaties such as NAFTA. For example, Article 1110 of NAFTA (which is representative) provides:

1. No Party may directly or indirectly nationalize or expropriate an investment of an investor of another Party in its territory or take a measure tantamount to nationalization or expropriation of such an investment ("expropriation"), except:

    (a) for a public purpose;

    (b) on a non-discriminatory basis;

    (c) in accordance with due process of law and Article 1105(1); and

    (d) on payment of compensation in accordance with paragraphs 2 through 6.

2. Compensation shall be equivalent to the fair market value of the expropriated investment immediately before the expropriation took place ("date of expropriation"), and shall not reflect any change in value occurring because the intended expropriation had become known earlier. Valuation criteria shall include going concern value, asset value including declared tax value of tangible property, and other criteria, as appropriate, to determine fair market value.

3. Compensation shall be paid without delay and be fully realizable.

The disputes over valuations of Citi's equity and debt securities would be endless, fraught with uncertainty, and potentially very expensive for the government. What's more, claims under Article 1110 of NAFTA (and similar claims under some BITs) can be brought directly by private investors. This is just one of the seemingly endless legal obstacles to nationalizing an international financial institution like Citigroup, which has operations in over 100 countries. The legal issues alone would immediately create so much uncertainty that international financial markets would be thrown into chaos. What the blogosphere doesn't seem to realize is that nationalization is simply not a viable option. It's literally not on the table.

We still don't have nearly enough information about the various aspects of the Geithner plan for anyone to offer an informed analysis. This isn't just obsessive lawyering on my part. Material terms relating to the financing, fund structure, asset eligibility, etc., are still unknown. For example, regarding the Legacy Securities program (i.e., TALF 2.0), the Treasury's fact sheet states:

Borrowers will need to meet eligibility criteria. Haircuts will be determined at a later date and will reflect the riskiness of the assets provided as collateral. Lending rates, minimum loan sizes, and loan durations have not been determined. These and other terms of the programs will be informed by discussions with market participants. However, the Federal Reserve is working to ensure that the duration of these loans takes into account the duration of the underlying assets.
Does anyone honestly think it's possible to properly assess the Legacy Securities program without knowing these terms? I didn't think so. Most of the terms of the programs announced today haven't been finalized yet, and since a Treasury official told me earlier that they want to get these programs up and running by the end of April, all these terms have to be hammered out in negotiations between the Treasury, the banks, and the buy-side in a very short window of time.

Back when Geithner originally outlined the administration's bank rescue plan, Krugman wrote:

What is in it, in reverse order: 1. Super-TALF: a big expansion of the Fed’s quantitative easing, with Treasury backing. I’m OK with that.
What's the TALF? A Fed program that provides -- wait for it -- non-recourse loans to private investors to buy certain ABS. Now, however, Krugman thinks providing non-recourse loans to private investors to buy certain toxic assets is an unconscionable subsidy, and prima facie evidence of regulatory capture. Sigh. I remember when Krugman stuck to subjects he at least vaguely understood.

The Geithner plan gets rave reviews from the CDS market, with serious spread tightening across the board. The CDX IG12 index closed 14bps lower, at 185bps. Here are today's CDS spread changes for the major U.S. banks: BofA: 21 bps tighter Citi: 27 bps tighter Goldman: 16 bps tighter JPMorgan: 5 bps tighter Merrill: 18 bps tighter Morgan Stanley: 16 bps tighter Wachovia: 13 bps tighter Wells Fargo: 10 bps tighter Other U.S. financials: Berkshire Hathaway: 28 bps tighter AMEX: 13 bps tighter Capital One: 16 bps tighter Clearly the CDS market thinks the banks will be willing to sell their troubled assets under the Geithner plan. I probably agree.

Sunday, March 22, 2009

Premature Punditry

When the broad outlines of the Geithner plan first leaked yesterday, I noted that "it's impossible to offer an informed opinion based on the extremely sketchy details in these articles." The descriptions of the Geithner plan in the WSJ and NYT are so broad and so vague that they can't serve as the basis for any remotely serious analysis. As someone who has practiced structured finance law for many years, the one thing I can tell you for sure is this: the details matter. But that hasn't stopped a host of bloggers (who I normally agree with) from vocally condemning the plan. Yves Smith is calling on people to contact their Congressmen to express their opposition, and thinks she already has analysis that's "damning on its face," despite the fact that she hasn't even seen the plan yet. Yves is either being lazy or intellectually dishonest, and it'll be hard to take anything she says about the Geithner plan seriously. Worst of all, Paul Krugman, who I've been a big fan of ever since he was a columnist for the U.S. News & World Report (yeah, I'm old), continues to embarrass himself by offering absurdly superficial analysis of a bank rescue plan he hasn't seen yet. Krugman is a great academic economist, but he's obviously not qualified to offer an informed opinion on banking/financial policy. In addition to not understanding the difference between default risk and spread risk, he clearly doesn't have the foggiest idea how ABS or CDOs work. For instance, he apparently doesn't realize that the value of an ABS includes a liquidity premium. (Maybe he's just bitter that the solution he advocated last fall—recapitalization instead of toxic asset purchases—didn't work). I sincerely hope Krugman stops offering this kind of pseudo-analysis soon. The bottom line is that anyone who thinks they already have enough information about the Geithner plan to offer informed analysis doesn't deserve to be taken seriously.

Saturday, March 21, 2009

Some Details of the New Bank Rescue

The WSJ and the NYT both have front-page stories with preliminary details of the new bank rescue plan, which will be unveiled in the coming week. It's impossible to offer an informed opinion based on the extremely sketchy details in these articles (and I think the NYT article is getting the details of the FDIC plan wrong). I will say this though: I'm very glad that one of the key aspects of the new plan is an expansion of the TALF program, which got off to a good start on Thursday. The key details of the TALF have been largely ironed out over the past month during extensive negotiations between the buy-side, the primary dealers, and the New York Fed. Market participants are comfortable with the framework, which means that the TALF can be expanded relatively quickly.

Friday, March 20, 2009

Saving Major Banks

Matt Yglesias tries to be too clever for his own good:

I, for one, don’t think that "saving" the too-big-to-fail financial institutions is or was among the legitimate purposes of our financial policy. The idea is—or at least ought to be—that we’re trying to prevent them from failing in a way that causes everyone else’s business to go under.
Is there some secret way, known only to Matt Yglesias, to prevent a major bank from failing in a way that causes everyone else to fail as well? No. Not even close. Until there is (and I doubt there ever will be), "saving" too-big-to-fail financial houses will continue to be a legitimate purpose of our financial policy.

ECB official Lorenzo Bini Smaghi responded to Paul Krugman's recent contention that Europe's response to the financial crisis has been inadequate. One of Smaghi's arguments, though, unfairly places all the blame for allowing Lehman to fail on the US:

[Krugman's argument] doesn’t explain how the most fateful decision of all – the decision to allow a systemically important bank to fail in the midst of a financial crisis – was taken by a single decision-maker, while the 16 euro area governments have managed to avoid making such a large mistake.
Whoa, let's remember what actually happened. The Fed and the Treasury successfully brokered a private-sector rescue for Lehman, in which Barclays would buy all of Lehman except for $40 billion of commercial real estate assets, which would be acquired by a consortium of major banks. Since Barclays is a British bank, the deal required approval from the UK's Financial Services Authority (FSA). On Sunday morning, though, the FSA unexpectedly rejected the deal.

Goldman Sachs finally held a conference call to dispel two widespread myths about its relationship with AIG, both of which originated in a horribly dishonest article by the NYT's Gretchen Morgenson. I've harped on this several times before, and I'm glad Goldman is finally addressing this directly. First, regarding the patently false claim that Goldman CEO Lloyd Blankfein was the only Wall Street executive at a meeting at the New York Fed to discuss the AIG bailout:

There was a Sept. 15 meeting at the NY Fed where AIG’s troubles were discussed. Goldman Sachs was invited to discuss a private-sector solution to AIG’s problems. Tim Geithner asked Lloyd to attend. Lloyd attended. So did Jon Winkelreid, our president, as well Bob Scully at Morgan Stanley who was advising the government. Jimmy Lee, a JP Morgan vice-chairman and AIG’s financial adviser, was there, as well as senior people from the Fed and AIG and Eric Dinallo, the New York State Superintendent of Insurance. Geithner didn’t stay for the meeting. Lloyd stayed for 20 minutes and left. At that meeting it was decided there was no private-sector solution, and at that point GS team left and GS was not party to any discussions with the government after that. After that, they decided a public-sector solution was the way to go. In terms of the government bailout of AIG, GS was not privy to any discussions at all.
Second, regarding the myth that Goldman had $20 billion of exposure to AIG (from Deal Journal's live-blogging of the conference call; italicized text is Deal Journal's translation):
"We established credit terms to them commensurate to those with other trading counterparties…we limited our overall credit exposure to AIG with collateral and market hedges in order to protect ourselves." [Translation: Goldman treated AIG like other counterparties, where it bought "insurance" through special contracts called credit-default swaps that would pay Goldman money if AIG went bankrupt. These CDS contracts are a common feature of trading relationships in the markets.] ... In mid-September, the majority of GS’s exposure, $10 billion, was collateralized or hedged. They held $7.5 billion in collateral. The rest was hedged in CDSs. "We had no material exposure to AIG."
So to sum up:
  1. Goldman never discussed a government bailout of AIG with the Fed or Treasury;
  2. Lloyd Blankfein, along with representatives from Morgan Stanley and JPMorgan, briefly attended a meeting at the New York Fed to discuss a private sector rescue of AIG; no government bailout was discussed at the meeting; and
  3. Goldman had no direct exposure to AIG.
Gretchen Morgenson: consider yourself rebutted.

Josh Marshall unleashes a very strange rant against AIG:

The problem is what appears to be the president's mortifying impotence in the face of bankers and financiers who created the problem. The president speaks and acts for the federal government, which is to say, the American people, who have mobilized more than a trillion dollars and all powers of the state to repair the damage emerging out of the financial sector. And with all that, he's jacked up on a employment agreement between a company the government now owns and derivatives traders who sank the world economy and may quite likely be looking at criminal charges for their activities in the not too distant future? Anyone can look at that and see that the equation of power and accountability is all screwed up. ... [F]undamentally, Obama needs to start showing that he's in charge, that he's operating as the American people's advocate and that he has the power to do it -- which these stories of getting jacked up by some Gordon Gecko wannabes in London just terribly undermines.
What's shocking is that Marshall finds any of this shocking. The government is in control. When the government took an 80% stake in AIG last September, it fired then-CEO Robert Willumstad, and hand-picked Ed Liddy to be the new CEO. The president doesn't have time to run AIG, so the government essentially hired Liddy to do it instead. Liddy is, for all practical purposes, acting as "the American people's advocate." When confronted with the bonus contracts, Liddy consulted outside counsel, who informed him that AIG was, in fact, contractually obligated to pay the bonuses. Liddy determined that refusing to pay the bonuses would ultimately cost the taxpayers more than simply paying the bonuses—which is undoubtedly true, seeing as failure to pay the bonuses would have triggered the "cross-default" provisions in AIG's derivatives contracts. As CEO, that's Liddy's decision to make. Marshall just doesn't like Liddy's decision. Now, some might argue that the bonus contracts wouldn't be enforceable if AIG was in bankruptcy, and that the only reason AIG isn't in bankruptcy is because the government bailed them out at the last minute. That's true, but the fact of the matter is that AIG isn't in bankruptcy. Marshall and others might wish that AIG was in bankruptcy, but it isn't, and so the bonus contracts are enforceable. Marshall seems to be appalled that the majority owner of a public company (in this case, the government) can't just abrogate enforceable contracts. TPM is one of my favorite sites on the internet, but its coverage of the AIG bonus controversy has been sub-par. TPM is way out of its depth on matters of finance, so they've allowed pure emotion to replace thoughtful analysis.

Thursday, March 19, 2009

Why AIG Was Rescued

Felix Salmon argues that AIG was rescued because if it had failed, no one would have known who was ultimately bearing the losses, which would have caused financial markets to freeze virtually overnight:

[T]he web of connections between the thousands of counterparties in the CDS market is so complex that no one really has a clue who would have ended up holding the multi-billion-dollar bag. ... But no one would have had a clue where in the financial system, exactly, those losses would have ultimately come to rest. And given the magnitude of the losses, you can be sure that no one would have wanted to have any kind of dealings with the poor schmucks who ended up on the hook for all those billions of dollars. And since those pooor schumcks could be pretty much anybody, no one would do any kind of business with anybody else: you'd get settlement risk run amok. The entire global financial system could grind to a halt overnight, due to the inability of any given institution to persuade any other institution that it was actually solvent.
I tend to disagree. Incidentally, I think this is more or less the explanation for why Bear Stearns was rescued, but not for why AIG was rescued. The reason AIG was rescued was much simpler: regulatory capital relief. AIG's massive CDS portfolio was providing an enormous amount of regulatory capital relief at the time, primarily to the major U.S. and European banks. Had AIG failed, all the major banks—which were already engaged in mass deleveraging due to Lehman—would have suddenly lost most, if not all, of the regulatory capital relief that AIG's CDS contracts had been providing. This would have put the banks well under their regulatory capital requirements, and thus would have sparked a fresh wave of forced liquidations, depressed asset prices, writedowns, and yet more forced liquidations, as the banks scrambled to raise capital to meet their minimum capital requirements. With the markets already convulsing wildly due to Lehman's failure, this would have been a devastating body blow, and I don't think the markets could have taken it. From what I understand, this is the doomsday scenario that ultimately led Geithner to rescue AIG.

Wednesday, March 18, 2009

Outlaw Ratings Downgrade Triggers

One of the biggest contributors to the financial crisis has been ratings downgrade triggers, sometimes known as ratings-based collateral calls. These are provisions in financial instruments (especially derivatives) that automatically trigger collateral calls when a counterparty has its credit rating downgraded. AIG failed because ratings downgrade triggers in its credit default swap (CDS) contracts forced it to post $15 billion in collateral when Moody's and S&P downgraded its credit rating immediately after Lehman failed. AIG couldn't come up with that much cash on short notice, especially with markets essentially frozen due to the Lehman bankruptcy. Enter the U.S. taxpayers. Similarly, the monolines (e.g., MBIA, Ambac) teetered on the edge of failure in January 2008 because the rating agencies were threatening to downgrade their credit ratings (then AAA), which would have forced them to post billions in collateral that they simply didn't have. All the various rescue plans that were floated that month were aimed at staving off a rating downgrade. Ratings downgrade triggers force a company that is already struggling (hence the downgrade) to then post billions in extra collateral. In other words, the company is being forced to post billions in collateral at precisely the time it's least able to raise that much cash without seriously damaging the health of the company. This creates a downward spiral where the company is forced to liquidate assets at firesale prices in order to post the required collateral, leading to another rating downgrade, which triggers further collateral calls, and another round of forced liquidations, and so on. This could very easily cause a company to go directly from AAA-rated to bankruptcy (which completely distorts the idea of "credit ratings" in the first place). In fact, this almost happened with MBIA and Ambac—had they been downgraded from AAA in January 2008, they would almost certainly have been forced to file for bankruptcy. The justification for including ratings downgrade triggers in derivatives contracts is that less creditworthy counterparties should have to post more collateral, because the risk of nonpayment is greater. But the evaluation of a counterparty's creditworthiness should be done at the outset of the transaction, and reflected in the initial margin required. Less creditworthy counterparties should have to put up more initial margin (i.e., collateral), but after the initial margin is posted, any additional margin calls should be based on changes in the value of the underlying security. Evaluation of a counterparty's creditworthiness shouldn't be outsourced to the rating agencies, which is essentially what ratings downgrade triggers do. Personally, I'd like to see an explicit ban on ratings downgrade triggers in derivatives contracts. They're lazy and unreliable in their accuracy. But worst of all, as AIG and the monolines have demonstrated, they're extremely dangerous.

Tuesday, March 17, 2009

Goldman vs. NYT

It's now official: the NYT editorial board has no clue how financial markets work. Its ignorance is truly embarrassing. I've been following the back-and-forth between the NYT and Goldman Sachs pretty closely, mostly because I think the NYT's outrageous claims about Goldman were patently untrue. The paper's refusal to admit its mistake—and the fact that it continues to recycle the false claims—is just pathetic. One of the absurd claims in the original article about AIG's downfall was that Goldman had $20 billion of exposure to AIG. Goldman aggressively denied the claim (calling it "seriously misleading"), and insisted that it had hedged its exposure to AIG:

For the avoidance of doubt, our exposure to AIG is offset by collateral and hedges and is not material to Goldman Sachs in any way.
Now that AIG has released a list of its largest counterparties and Goldman is on top, having received $12.9 billion from AIG since the initial government rescue, the NYT thinks it has been vindicated. It hasn't, and the fact that it thinks it has been vindicated is pathetic. From an editorial in today's NYT:
The largest single recipient was Goldman Sachs ($12.9 billion). The amount — hardly chump change even by Wall Street standards — appears to contradict earlier assertions by Goldman that its exposure to risk from A.I.G. was “not material” and that its positions were offset by collateral or hedges. If so, why didn’t the hedges pay up instead of the American taxpayers?
Huh? What does that even mean? Clearly, the NYT editorial board doesn't know what it means for a bank to hedge its exposure to AIG. Goldman hedged its exposure by buying CDS protection on AIG; had AIG been allowed to fail, Goldman would have received the payouts on those CDS contracts. As a Goldman spokesman told Reuters today:
The majority of Goldman Sachs' CDS (credit default swap) exposure to AIG Financial Group was collateralized. That means that Goldman Sachs had collateral. To the extent it wasn't collateralized, Goldman Sachs hedged its exposure via the credit default swaps market. If the government had allowed AIG to fail, Goldman Sachs would have received its collateral. A credit event would be triggered, and Goldman Sachs would receive a payout from the credit default swap insurance that it had. This is from other counterparties. ... AIG was not allowed to fail. So there was no payout from the hedges.
FT Alphaville's Sam Jones (who should know better) fell into the trap of equating the list of AIG's counterparties with the extent of each bank's exposure to AIG, and concluded that the NYT was right and Goldman was wrong. This is false. The list of AIG's counterparties does not vindicate the NYT in any way, shape, or form. As I said earlier, the list of AIG's counterparties says nothing about each bank's exposure to AIG. Goldman hedged its exposure to AIG via the CDS market, so if AIG had failed, the money Goldman would have theoretically made on those CDS positions would have offset any money it lost from AIG's failure. That's what it means to be hedged. The fact that Goldman received $12.9 billion from AIG doesn't mean that Goldman had $12.9 billion of exposure to AIG, because, for one thing, AIG never failed. Moreover, it doesn't take into account the money Goldman received on its CDS contracts on AIG—that is, its hedges. If the money Goldman would have made on its hedges would have offset the money it would have lost on AIG's failure, then Goldman would have had no exposure to AIG. It's as simple as that. The fact that the NYT editorial board doesn't understand this is embarrassing.

Sunday, March 15, 2009

AIG discloses counterparties

AIG has bowed to public pressure and disclosed its largest counterparties. Full list here. The loudest (and most self-righteous) critics will probably be surprised by a couple things. First, $12.1 billion went to states and municipalities. Second, like I said, a huge chunk of the bailout money ($43.7 billion) went to counterparties in AIG's securities lending program (i.e., its repo desk). These aren't counterparties that made "bad bets" on mortgage-related securities; these are the counterparties that were providing AIG with the day-to-day cash it needs to run its operations. Finally — and I can't emphasize this enough — this list says nothing about each bank's exposure to AIG. We have no idea how well hedged each bank was. (Goldman has said repeatedly that it hedged its exposure to AIG.) It's plainly inaccurate to say that we "saved" SocGen, Barclays, Goldman, etc., just because AIG used bailout money to post collateral on trades with those banks. A bank that was well hedged would have made money even if AIG failed — it might have bought CDS protection on AIG, for example. So just because AIG paid $11 billion of bailout money to SocGen does not mean that SocGen had $11 billion of exposure to AIG.

Saturday, March 14, 2009

All Bailouts Are Counterparty Bailouts

The recent uproar over the government's refusal to reveal AIG's counterparties on its CDS trades is silly, and reflects a basic misunderstanding of how financial markets work. With regard to AIG specifically: yes, AIG used some of the bailout money to post collateral it owed to counterparties on CDS trades. But it also used a significant amount of bailout money to repay counterparties in its securities lending program (basically a repo desk—AIG lends out securities it owns on a short-term basis in exchange for cash.) To settle transactions with counterparties returning the borrowed securities, AIG has to return the cash (less interest). If the government hadn't rescued AIG, it wouldn't have had enough cash to pay these counterparties back, and it would have essentially defaulted. In fact, a full $19 billion of taxpayer money has gone to AIG's securities lending program so far. So the AIG bailout was also a bailout of AIG's counterparties in its securities lending program. Should the government be forced to reveal the identity of all these counterparties as well? Surely not—and no sane person would disagree. Why should CDS counterparties be any different? More generally, you can see how this reasoning applies to bailouts in general. Yes, AIG's bailout was a bailout of its counterparties, but all bailouts in the financial sector are bailouts of counterparties. The purpose of all bailouts is to avoid insolvency. Avoiding insolvency requires paying counterparties the money they're owed. There's nothing special about the AIG bailout in that regard. Finally, regarding the ubiquitous claim that "taxpayers have the right to know" who AIG's counterparties are: no, we don't. All of AIG's CDS contracts are subject to confidentiality agreements. Becoming the majority owner of a publicly-traded company does not entitle you to breach contracts that are binding on the company.

Wednesday, March 11, 2009

The Swedes Didn't Use Receivership

Paul Krugman has been pushing the Swedish model hard, so it's more than a little troubling that to discover that he doesn't understand what Sweden actually did:

I was not saying “nationalize all the banks”; I was saying do what the Swedes did — in tandem with a guarantee on bank liabilities, take the banks with zero or negative capital into receivership.
Yikes. Sweden never put its banks in receivership. It nationalized the banks by becoming the majority owner of each bank—that is, the government bought well over 50% of the banks' equity. Further proof that "academic economist" isn't the same thing as "banking/financial markets expert." Journalists be advised.

Paul Krugman comments on the rising CDS spreads on US government debt:

Has the risk of a US government default risen? Probably. Nonetheless, the people buying these contracts are crazy. A world in which the US government defaults would be a world in chaos; how likely is it that these contracts would be honored?
Oh my god, repeat after me: CDS on U.S. government debt are spread products. Protection buyers aren't hedging default risk, they're hedging spread risk. For example, a bank that has a large inventory of Treasuries will want to hedge the risk of a significant deterioration in the value of Treasuries. Since standard CDS provide for daily collateral posting based on the value of the underlying reference obligation(s), protection sellers in CDS on U.S. government debt have to post more collateral when the value of Treasuries declines. Default risk vs. spread risk isn't a difficult or terribly advanced concept, and it's definitely something you should know if you consider yourself to be an "informed commentator" on the bank rescue.

Tuesday, March 10, 2009

CNBC ≠ Financial Industry

Ever since the financial panic that followed Lehman's failure, people has been paying a lot more attention to financial markets than they usually do. This has led to CNBC coming in for a lot of criticism, almost all of which seems to be justified. But there seems to be this idea out there that CNBC represents the mindset of the financial industry—because, you know, it's about finance, and therefore everyone in the financial industry must watch CNBC. For example, HBO's Bill Maher said, referring to CNBC:

This is the channel that Wall Street watches all day. ... I think this is more than a channel; I think it affects what happens on Wall Street.
You shouldn't be fooled into thinking that CNBC represents the mindset of the financial industry. I've worked in the capital markets in one capacity or another for almost all of CNBC's 20-year history, and I almost never watch CNBC. None of my friends or colleagues in finance watch CNBC on anything close to a regular basis either—the yahoos on CNBC are too stupid for anyone to stomach. I watch Bloomberg TV every day, and so does pretty much everyone I know in finance (if they watch TV at all). Bloomberg TV is excellent; it's nothing at all like CNBC. As far as I can tell, CNBC is mainly for retail investors, which would explain why CNBC focuses almost exclusively on the stock market. Bloomberg understands that the bond and derivatives markets are 100 times more important than the stock market. (On a side note, Bloomberg Radio, which I listen to whenever I'm in the car, is as good as it gets for financial media. If you want to know what apolitical news coverage sounds like, listen to Bloomberg Radio. Tom Keene is by far the best host out there: he's extremely knowledgeable and fair-minded, but he's also not afraid to push back against flimsy/bullshit arguments. Guests on Keene's shows are given the time to make longer and more complex comments, which is a refreshing change of pace from the soundbite-happy mainstream media.)

I'm puzzled by all the recent hyperventilating over the 2005 bankruptcy bill and the special treatment of derivatives in bankruptcy proceedings. Derivatives and certain other financial contracts are exempt from the automatic stay in bankruptcy, which essentially gives derivatives counterparties priority over all other claimants. (For an explanation of why it's important to give derivatives special treatment in bankruptcy, see the excerpt at the end of this post.) Josh Marshall kicked off the outrage a few days ago, when he highlighted the exemption for derivatives in a post titled, "How the Rules Were Rigged":

But separate from the immediate financial implications related to AIG, it does point us toward the larger political economy point: the self-reinforcing cycle in which financialization leads to vast sums of money concentrated in the hands of paper-jobbers, who then mobilize that money in Washington to rewrite the laws to privilege them for even greater profits.
Arianna Huffington, among others, quickly agreed with Marshall's interpretation:
It's worth noting that, thanks to the industry-written 2005 Bankruptcy Bill, derivatives claims are not stayed in bankruptcy -- so the financial institutions that gambled and lost would nevertheless be the first ones paid off. Isn't gaming the system fun?
The problem with this story is that the 2005 bankruptcy bill didn't create the derivatives exemption (called a "carve-out") — the exemption for derivatives was originally enacted in 1982, and was really solidified when the statutory language was clarified in 1990. The 2005 bankruptcy bill just clarified the definitions of the various exempt contracts. For example, the pre-2005 definition of an exempt "swap agreement" included the catch-all phrase "or any other similar agreement," which almost certainly covered credit default swaps. But just to be sure—to provide that all-important legal certainty—the 2005 bankruptcy bill amended the definition of "swap agreement" to explicitly include credit default swaps. There was no substantive change, just a clarification—a process otherwise known as "modernizing" the financial regulations in order to keep up with financial innovations. Given how rarely our financial regulations have been modernized over the past 25 years, it's a bit strange that one of the few successful efforts to actually modernize financial regulations is attracting so much criticism. Moreover, the special treatment of derivatives and other financial contract isn't unique to bankruptcy proceedings. In old-fashioned FDIC receiverships (which everyone seems to love right now), "qualified financial contracts" (QFCs) — e.g., derivatives and securities contracts — have long been exempt from the FDIC's avoidance powers, in order to permit the orderly netting of derivatives contracts. Since major bank holding companies (e.g., Lehman, Citigroup) aren't covered by the FDIC resolution process, it's only natural for the FDIC's QFC exemption to be extended to the Bankruptcy Code. Essentially, exempting derivatives from the automatic stay in bankruptcy is a way to harmonize insolvency procedures. ------------------------------ This FDIC article provides a nice explanation of why it's important that derivatives and other financial contracts be exempt from the automatic stay. It's all about close-out netting:
As with other financial instruments, including bonds and equity securities, derivatives pose credit, market, liquidity, operating, legal, settlement, and interconnection risks. One of the primary ways to reduce the risks to individual parties in derivative or other financial contracts is the ability to settle the transactions by payment of a single net amount. Netting is simply taking what I owe you and what you owe me and subtracting to yield a single amount that should be paid by one of us. Netting can be a valuable credit risk management tool in all multiple transaction relationships by reducing the credit and liquidity exposures by eliminating large funds transfers for each transaction in favor of a smaller net payment. Close-out netting, or the ability to terminate financial market contracts, determine a net amount due, and liquidate any pledged collateral, is a valuable tool to protect against credit and market risks in cases of default. This is particularly important in the financial markets because, unlike loans or many other financial contracts, the value of derivatives and other financial market contracts are based principally on their fluctuating market value. If one of the parties to a derivative or other financial market contract is placed into bankruptcy or receivership, the normal stays on termination of contracts and liquidation of collateral could create escalating losses due to changes in market prices. As a result, the ability to terminate the contract and net exposures quickly can be crucial to limit the losses to the non-defaulting party because such contracts can change in value rapidly due to market fluctuations.

Monday, March 9, 2009

Advice you can safely ignore

Nobel prize-winner and serial wealth-destroyer Myron Scholes thinks we should "blow up" the over-the-counter (OTC) derivatives market and start all over:

Myron Scholes, the Nobel prize- winning economist who helped invent a model for pricing options, said regulators need to "blow up or burn" over-the-counter derivative trading markets to help solve the financial crisis. The markets have stopped functioning and are failing to provide pricing signals, Scholes, 67, said today at a panel discussion at New York University’s Stern School of Business. Participants need a way to exit transactions and get a "fresh start," he said. The "solution is really to blow up or burn the OTC market, the CDSs and swaps and structured products, and let us start over," he said, referring to credit-default swaps and other complex securities that are traded off exchanges. "One way to do that, through the auspices of regulators or the banking commissioners, is to try to close all contracts at mid-market prices."
Scholes, of course, was a co-founder of Long-Term Capital Management, the hedge fund whose spectacular implosion threatened to bring down the entire financial system a decade ago. After LTCM's failure, Scholes started another hedge fund, Platinum Grove Asset Management, and somehow managed to convince investors to give him more money to invest, using the same fixed-income arbitrage strategy that he used at LTCM. Predictably, Platinum Grove, which managed close to $6 billion, has also imploded—its main fund was down 38% through the first half of October, and in November the hedge fund suspended investor redemptions. Given Scholes' penchant for losing spectacular amounts of money in the fixed income and derivatives markets, I think it's safe to ignore his advice on the OTC derivatives market. (Shockingly, Scholes thinks the OTC derivatives market is mispricing assets. In other news, bank shareholders think nationalization is a bad idea.)

Saturday, March 7, 2009

TALF 2.0: Here There Be Dragons

In a speech at the Council on Foreign Relations yesterday, the new President of the New York Fed, William Dudley, provided important insights on the likely future of the TALF. Dudley hinted that the terms of the TALF might eventually be relaxed to include below-AAA tranches of ABS, as well as legacy (as opposed to newly-issued) ABS. From the speech:

The TALF is being rolled out in two stages. In the first stage, which I’ll call TALF Version 1.0, the Federal Reserve will provide non-recourse loans to investors against AAA-rated consumer asset-backed securities collateral. ... The AAA-rated securities eligible as collateral for this non-recourse lending program are used to fund a wide variety of consumer and business loans, including student, credit card, auto and small business administration loans. The market for these securities had dried up because the traditional investors in these securities—SIVs, bank-related conduits and securities lenders—have either disappeared or are balance sheet constrained. This has reduced the availability of credit for consumers and led to higher borrowing costs. The first subscriptions for financing under TALF Version 1.0 will occur on March 17. The first batch of new securitizations will be funded on March 25. TALF Version 2.0 will follow. This will broaden the TALF into new asset classes such as Commercial Mortgage Backed Securities. Development of this phase is still in its early days. But it [is] anticipated that the size and scope of TALF will expand sharply in the months ahead. ... This is a very exciting program because it provides balance sheet capacity to risk capital that cannot currently get leverage. It goes beyond current programs. Just as important, once it is up and running it can be scaled up and out in many different dimensions. In principle, it could be applied to other distressed asset classes, it could move down the credit spectrum to lower-rated tranches, and it could be used to fund older vintage assets.
I think it's increasingly clear that the Fed will end up using the TALF to provide 3-year (or longer) non-recourse loans against the risky tranches of commercial and residential mortgage-backed securities that are currently stuck on banks' balance sheets. The TALF term sheet states that the program may be expanded later to include other asset classes, and specifically mentions CMBS and private-label RMBS. In addition, there are widespread rumors that the Fed is at least considering (and some say actively planning on) accepting below-AAA legacy CMBS. From there, it's not too difficult to make the jump to risky legacy tranches of private-label RMBS (i.e., Alt-A and subprime). In his speech, Dudley suggests that the Fed will mold the terms of TALF 2.0 to fit the market's needs—that the TALF will be aimed at "risk capital that cannot currently get leverage." There's no doubt that risky tranches of legacy CMBS and RMBS can't get leverage right now. Whether the Fed will expose taxpayers to the high level of risk involved in lending against these risky securities remains to be seen. I think the answer will probably end up being yes. (Treasury's white paper on the program mentions that CLOs and CDOs are also "under consideration" for inclusion in the TALF, but I don't foresee that ever happening.)

Robert Teitelman of The Deal has a magnificent post on financial journalism in the credit crisis. It's long, but well worth it. Here's a taste:

Finance is a complex, nonlinear system, full of noise, chaos, complexity and ambiguity. It's defined by all the waywardness of human psychology. That's what makes it such a fascinating phenomenon to observe and to write about (and also why risk management may be an oxymoron). But if investment professionals and regulators fail again and again to master its perturbations, as academic studies have always shown, then why on this green earth would a financial journalist succeed at predicting the future? Not to understand that suggests either a utopian naiveté about journalism and the markets or an agenda that has nothing to do with either one of them. It also suggests the kind of wishful thinking that will lead to the next inflation of overheated expectations.
Read the whole thing.

Now that Annette Nazareth has withdrawn her name from consideration for Deputy Treasury Secretary, Treasury is reportedly considering Rodge Cohen, the legendary banking lawyer and chairman of Sullivan & Cromwell. Cohen would be a fantastic choice for any top government position, and Treasury would be lucky to have him. Few people in the world have a deeper understanding of the global financial system than Cohen. In today's political environment though, I have a hard time believing that Cohen could get confirmed by the Senate without a bruising political fight. He was heavily involved in the events of last September. He represented Lehman during the weekend negotiations before it filed for bankruptcy, then a few days later represented Barclays in its acquisition of Lehman's U.S. investment banking unit. He also represented Wachovia (his longtime client) in the Citi/Wells Fargo debacle, and presumably advised Wachovia's board of directors that its fiduciary duty required it to accept Wells Fargo's offer, even though that meant violating its exclusivity agreement with Citi. I'm sure Cohen has represented other Wall Street financial houses at various points in the financial crisis as well. Unfortunately, his various representations would add up to the easiest pitch the Senate Finance Committee has seen so far this year, and I'm guessing they'd knock it out of the park. That's sad, because Cohen's vast experience would make him an invaluable asset at Treasury. But that's politics.

ICE Trust—the CDS clearinghouse backed by the major dealer banks—has cleared the final regulatory hurdle (SEC approval), and will start clearing credit default swaps (CDS) on Monday. SEC exemptive order here; Reuters article here; Bloomberg article here. Here are the highlights from ICE's press release:

IntercontinentalExchange(R) (NYSE: ICE), a leading operator of regulated global futures exchanges and over-the-counter (OTC) markets, today announced that ICE US Trust, LLC (ICE Trust), a New York limited liability trust company, will begin processing and clearing credit default swap (CDS) index transactions on March 9, 2009. Clearing of North American Markit CDX indexes is expected to be followed by liquid single-name CDS in the following months. ICE Trust has entered into an agreement with Markit to produce daily settlement prices required for mark-to-market pricing, margining and clearing. ICE also announced the closing of its acquisition of The Clearing Corporation (TCC) on March 6, 2009. TCC developed the CDS risk management framework, operational processes and infrastructure for ICE Trust's clearing operations. ... Bank of America, Barclays Capital, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, J.P. Morgan, Merrill Lynch, Morgan Stanley and UBS have supported the establishment of the clearing house for CDS transactions, and are the initial clearing members of ICE Trust. Each of these participants has completed a rigorous technical testing and validation process over the past several months. In addition, each member has made a significant contribution to establish the ICE Trust guaranty fund, which will continue to increase as positions are transferred into the clearing house.
The press release also highlights a few key provisions from ICE Trust's rules of operating procedures, the most interesting of which (in my opinion) are:
The Board of ICE Trust has been appointed by ICE and consists of seven members, a majority of whom are independent. The Board will soon be expanded to 11 members and will include four additional members nominated by participants in the clearing house, two of whom will be independent. ... ICE has contributed an initial $10 million to the guaranty fund from cash on hand. Over a two-year period, ICE expects to increase its contribution to the guaranty fund to a total of $100 million. The aggregate size of the guaranty fund will be determined by positions held in the clearing house.
Each member must make a $20 million initial contribution to the guaranty fund, and since the press release notes that there are ten initial clearing members (all the major dealer banks), that should put the guaranty fund at $210 million right now. That number will increase significantly as the dealers start novating their CDX contracts onto the clearinghouse on Monday, but that initial $210 million can be thought of as the amount of overcollateralization the clearinghouse is starting with. And away we go....

Wednesday, March 4, 2009

Fed Approves ICE's CDS Clearinghouse

ICE Trust -- the CDS clearinghouse that the dealer banks are backing -- has finally received approval from the Fed to become a member of the Federal Reserve System. The Fed's order approving ICE Trust's application is here. My comments are below, but here are the highlights:

Initially, ICE Trust proposes to clear only contracts that are based on certain CDX North American indices and are submitted by the participants as principals. ... ICE Trust proposes to charge a fee for its CDS clearing services to participants primarily on a per-transaction basis. ... In assessing the adequacy of ICE Trust’s capital levels, the Board has taken into account the financial resources maintained by ICE Trust to enable it to withstand a default in extreme but plausible market conditions by the participant to which it has the largest exposure. ... To limit the risk of default by participants, ICE Trust proposes to establish strong and objective participant eligibility requirements. For example, only a firm with a net worth of $5 billion or more and a credit rating of “A” or better may become a participant. Among other criteria, each prospective participant also would be required to demonstrate that it has systems, management, and risk-management expertise with respect to CDS transactions. ... In addition to margin requirements, ICE Trust would require each participant to contribute a minimum of $20 million to the guaranty fund plus additional amounts based on the participant’s expected level of position exposures. Additional contributions would be assessed at least quarterly. ... To manage concentration risk, ICE Trust will charge additional margin collateral for positions exceeding pre-set notional thresholds. ... ICE Trust would promote greater market transparency by making publicly available the closing settlement price and related volume and open interest data for each cleared product, on terms that are fair, reasonable, and not unreasonably discriminatory.
The first thing to note is that, at least at the outset, ICE Trust will only clear CDX indexes, and even then only contracts in which a participant (i.e., the dealer banks) are principals. Once the dealers novate all their CDX contracts to the clearinghouse, then ICE Trust will probably start clearing non-participants' CDX contracts and single-name CDS on the CDX constituents. I'm not wild about the capital adequacy being designed only to withstand "a default in extreme but plausible market conditions by the participant to which it has the largest exposure." Usually a clearinghouse's capital has to be sufficient to withstand a simultaneous default by two participants (usually the largest two participants). The fact that the test for ICE Trust's capital adequacy has been relaxed significantly is troubling. I'll have more to say later, but for now, my flight is boarding.

Apparently it's "under consideration." From page 4 of the Treasury's white paper on the TALF:

The Federal Reserve and Treasury currently anticipate that ABS backed by rental, commercial, and government vehicle fleet leases, and ABS backed by small ticket equipment, heavy equipment, and agricultural equipment loans and leases will be eligible for the April funding of the TALF. Other types of securities under consideration include private-label residential mortgage-backed securities, collateralized loan and debt obligations, and other ABS not included in the initial rollout. Treasury and the Federal Reserve expect to announce which additional classes of ABS will be eligible under the expanded program as soon as the analysis is completed.
You can't be serious.

The NYT editorial board again recycles Gretchen Morgenson's lies about AIG and Goldman:

The A.I.G. bailouts fail the basic test of transparency: Who ends up with the money? ... The serial A.I.G. bailouts are especially problematic for their connection to the Wall Street bank Goldman Sachs. At the time of the first A.I.G. rescue last fall, it was reported by Gretchen Morgenson in The Times that Goldman was A.I.G.’s largest trading partner, with some $20 billion of business tied into the insurer. Goldman has said that its exposure to risk from A.I.G. was offset, or hedged, by other investments. What is certain is that Goldman has lots of friends in high places — yet one more reason why this bailout has to be as transparent as possible. Lloyd Blankfein, Goldman’s chief executive, was the only Wall Street executive at a September meeting at the New York Federal Reserve to discuss the initial A.I.G. bailout.
As I've pointed out before, this is an absurd (and dishonest) accusation, because the Fed hired Morgan Stanley to advise them on the AIG bailout. From Bloomberg:
The Fed has hired Morgan Stanley to examine alternatives for AIG, a person familiar with the situation said. Morgan Stanley will review what role, if any, the government should play in helping the insurer.
Moreover, Morgenson's claim, repeated by the NYT editorial board, that Lloyd Blankfein was the only executive at a meeting at the NY Fed to discuss the first AIG bailout, is fundamentally untrue:
Paulson's successor at Goldman, Lloyd Blankfein, was the only chief executive at a meeting Sept. 15 at the New York Federal Reserve Bank at which the troubles at AIG were discussed, although representatives of other firms were present, a Fed spokesman said.
The other firms' representatives were also "executives," by the way (as if the banks would send mid-level employees to an emergency meeting at the NY Fed about the failure of the largest non-bank financial institution in the world). The NYT conveniently failed to disclose this, even though a few sentences earlier it had accused the AIG bailouts of "fail[ing] the basic test of transparency." Oh, the irony.

Monday, March 2, 2009

New CDS Contract Terms (Draft)

A draft of the new CDS contract terms, which will be "hardwired" into the standard ISDA documentation, is available here. ISDA press release here. The ISDA also released a draft of the rules for the new Credit Derivatives Determinations Committee, which will make binding decisions about whether a credit event has occurred, whether there will be an auction, and whether certain obligations are deliverable. (Trust me, it's a big deal.) I haven't had time to look over them in any detail, but I've seen earlier drafts of several sections, and they were decent enough. The drafting process has been very rushed, so there wasn't time to build consensus on all the material terms. Some issues will probably remain highly contentious.