Saturday, May 14, 2011

Deathbed Designations

One of the biggest issues outstanding in financial reform is which institutions the Financial Stability Oversight Committee (FSOC) will deem “systemically important,” and thus subject to all the enhanced Title I regulations. These systemically important financial institutions, known as SIFIs, will presumably be subject to the new resolution authority rather than the bankruptcy code — although for some reason SIFIs aren’t automatically subject to the resolution authority, a problem which I pointed out within hours of the Treasury releasing its initial legislative language back in 2009. In spite of that anomaly, SIFIs will be required to continually submit comprehensive “resolution plans” to the FDIC, so that the FDIC will have all the information they need to plan, design, and execute a successful resolution of a SIFI. As I’ve said before (see here and here), and as Sheila Bair has been emphasizing repeatedly in recent weeks, the resolution plan requirement is hugely important.

Dodd-Frank does, however, leave open the possibility that a failing financial institution could be designated as a SIFI at the last minute, and then immediately handed over to the FDIC to resolve under the new resolution authority. In that situation, the FDIC would be forced to resolve an institution without the benefit of a resolution plan — that is, without the comprehensive information on organizational structure, funding practices, major counterparties, etc., that will be required in resolution plans. Bair calls these “deathbed designations” (which, you have to admit, is a clever name), and has been understandably arguing that this situation “should be avoided at all costs.”

But how do you avoid “deathbed designations”? Bair argues that the FDIC should be allowed to collect information from a broad class of potential SIFIs:

[W]e need to be able to collect detailed information on a limited number of potential SIFIs as part of the designation process. We should provide the industry with some clarity about which firms will be expected to provide the FSOC with this additional information, using simple and transparent metrics such as firm size, similar to the approach used for bank holding companies under the Dodd-Frank Act. This should reduce some of the mystery surrounding the process and should eliminate any market concern about which firms the FSOC has under its review. In addition, no one should jump to the conclusion that by asking for additional information, the FSOC has preordained a firm to be “systemic.” It is likely that, after we gather additional information and learn more about these firms, relatively few of them will be viewed as systemic, especially if the firms can demonstrate their resolvability in bankruptcy at this stage of the process.
Frankly, I don’t see any other option. Bair is right that “deathbed designations” are the worst of all worlds. At the same time, we can’t rely on the FSOC to accurately identify every single SIFI ahead-of-time, in perpetuity.

The question, then, is: how much and what kinds of information should the FDIC collect from potential SIFIs? One thing to keep in mind is that the FSOC, in figuring out which institutions should be designated as SIFIs, will necessarily be collecting some information from potential SIFIs as well. But that information probably won’t be the same information that the FDIC would ideally want to collect — and since the FDIC is the one responsible for planning and executing these difficult resolutions, I think they should have reasonably broad discretion to say what information they need to collect ahead-of-time.

I think the best approach would be to allow the FDIC to collect the important information that isn’t constantly changing — e.g., typical funding practices mapped the institution’s legal structure, descriptions of the institution’s major business lines, potential acquirers of the major business lines, and so on. Detailed balance sheet information at major financial institutions is typically stale in a matter of days, so requiring that kind of information would probably be more trouble than it’s worth (especially if the institution has 10-Qs and 10-Ks available).

I also don’t see why the required information couldn’t be collected from potential SIFIs discreetly. That would eliminate Bair’s concern about people “jump[ing] to the conclusion that by asking for additional information, the FSOC has preordained a firm to be ‘systemic.’” Financial institutions communicate confidentially with regulators all the time, and I don’t see why this should be any different.

In any event, it’ll be interesting to see if Bair can press upon the FSOC to create this separate information-gathering authority.

Josh Green has a good article in the Atlantic Monthly about Sarah Palin’s tenure as governor of Alaska. Near the end, Green wonders what would have happened if, after the collapse of Lehman Brothers, Palin had led the anti-Wall Street charge:

What if history had written a different ending? What if she had tried to do for the nation what she did for Alaska? The possibility is tantalizing and not hard to imagine. The week after the Republican convention, Lehman Brothers collapsed, and the whole economy suddenly seemed poised to go down with it. Palin might have been the torchbearer of reform, a role that would have come naturally. Everything about her—the aggressiveness, the gift for articulating resentments, her record and even her old allies in Alaska—would once more have been channeled against a foe worth pursuing. Palin, not Obama, might ultimately have come to represent “Change We Can Believe In.” What had he done that could possibly compare with how she had faced down special interests in Alaska [i.e., the oil industry]?
This would’ve been a sight to see — especially if McCain and Palin had won. I think I can say with a high degree of confidence that Wall Street would not have taken kindly to this. (And by “Wall Street,” I’m primarily referring to the big sell-side banks.)

Unlike the oil industry, which is used to the rough-and-tumble of partisan politics, Wall Street is generally unaccustomed to being broadly vilified by mainstream politicians (as the thin-skinned reactions to financial reform from the likes of Jamie Dimon can attest). Much of Wall Street’s self-image is tied up in the idea that they occupy a higher intellectual plane than everyone else — especially all those poli-sci majors and journalists down in DC.

Having that idea openly and vigorously attacked by any VP would be a huge blow to the Street’s ego, but if it had come from Vice President Palin, I think some heads would have literally exploded in lower Manhattan. Because Wall Street is famous not only for its culture of arrogance, but also for its culture of sexism. Having a proudly unsophisticated, female politician like Palin leading what would undoubtedly have been a ham-fisted, populist-driven effort at financial reform would have been too much for Wall Street to handle.

What’s more, Wall Street would not have known how to respond. Whereas the oil and tobacco industries are used to winning legislative battles by essentially paying off key politicians through campaign contributions, Wall Street, pre-Lehman Brothers, derived the vast majority of its vaunted political power from its ability to convincingly tell politicians and their staffers that “this is all very complicated, and you shouldn’t worry your pretty little heads about it.” (This is a very underappreciated point.) The Street was going to lose its ability to play that card regardless of who won the election, but it would’ve been worse if McCain and Palin had won, because Palin would almost certainly have taken that argument and used it against Wall Street — much in the same way that she turns the tables on the “lamestream media” when they condescend to her. And since Wall Street is practically a market-maker in condescension, the condescension directed at Palin would have reached epic proportions.

Of course, if McCain and Palin had actually won the election, there’s a 0% chance that Palin would’ve been allowed to lead any sort of anti-Wall Street charge. Treasury Secretary Phil Gramm — a hall-of-fame Wall Street sucker — would never have allowed it.

Not wanting to waste too much more time dealing with someone who is either unable or unwilling to understand the issues, I’ll confine myself to the worst mistakes in Yves Smith’s latest post. She’s really grasping at straws at this point.

“The FDIC showing up on site and digging through records runs the very real risk of kicking off an even faster response than the Bear rumors did.”

Let me make this clear, yet again: the FDIC would already have permanent on-site personnel, under their Title I resolution plan authority. Since resolution plans are an ongoing process, the FDIC’s on-site personnel would already be routinely requesting the exact same type of information that they would be requesting during pre-resolution due diligence. So this would not have been a situation where there are no FDIC personnel at Lehman, and then suddenly a bunch of FDIC people show up, telegraphing the resolution. How many times does this need to be explained to Yves before she processes it?

“Dodd Frank has no force under English law. That means that the FDIC cannot prevent contract termination for agreements under English law. The FDIC and EoC can huff and puff all they want, but the US regulators do not have the power to overturn foreign statutes and case law.”

Neither I nor the FDIC ever said that Dodd-Frank has any force under English law. The FDIC explicitly stated, however, that it would have conditioned its P&A for the holding company on the acquirer’s acceptance of LBIE (Lehman’s UK broker-dealer). That does not require Dodd-Frank to have any force under English law. It would also mean that LBIE would not have had to file for bankruptcy in the UK (or “administration,” as they call it across the pond), which would have prevented the vast majority of contract terminations for contracts under English law. This is not that difficult to understand.

“Let’s assume that the FDIC had moved to resolve Lehman in March of 2008. What might a smart foreign creditor do? Well, if his agreement with Lehman was under English law, he could argue that the fact that Lehman was being resolved meant it was trading insolvent and it needed to put into administration now to protect him from exposure to further losses.”

Huh? Yves is confusing the start of the pre-resolution planning process (in March 2008) with the actual resolution (in September 2008) — an extremely basic distinction. The FDIC starting the pre-resolution planning process is not termination event, so no, foreign creditors could NOT have pre-emptively put LBIE into administration.

“And the critical point is that Barclays was NOT ready to buy Lehman, unless a liquidity backstop was in place. This has been widely misreported in the US, and EoC falls right into line with that bit of PR, blaming the FSA for killing the Barclays deal.”

This isn’t accurate — and the FSA paper (which is of dubious accuracy in the first place) doesn’t say what Yves claims it says. What prevented Barclays from buying Lehman was indeed the issue of a guarantee of Lehman’s trading obligations. But it wasn’t because they weren’t willing to guarantee Lehman’s trading obligations — that is, it wasn’t the economics of the deal. It was because in order to issue the guarantee, they needed the FSA to waive the UK’s Listing Rules, which required shareholder approval for such a guarantee. The FSA was unwilling to provide that waiver. But Barclays was willing to buy Lehman, contingent on the waiver from the FSA.

“We’ve said before that Economics of Contempt too often relies on slurs and rhetorical tricks, waving his credentials as a securities lawyer when he is on weak ground. His latest post is an extreme example of his reliance on distortions to cover for a bankrupt argument.”

Actually, I didn’t mention my credentials at all. Good try though.

As for which one of us “is simply not to be trusted,” I’m going to go out on a limb and say it’s the one who has made a series of basic legal and factual mistakes.

Tuesday, May 10, 2011

Stay Classy, JPMorgan

Oh god, I see that JPMorgan is already resorting to scare-mongering on Basel III’s new Liquidity Coverage Ratio (LCR), which I’ve discussed many times before.

JPMorgan’s corporate treasurer, Joe Bonocore, warned last week:

There will likely be negative market and economic consequences if regulators don’t modify the liquidity rules, he said.
...
Banks will have to charge more to finance corporate and municipal bonds, which essentially means that market participants will have less incentive to invest in these types of assets if they don’t qualify, Bonocore said. “As a result we believe it’s going to become more expensive for corporations and municipalities to raise financing,” he said.

He said that right now a sizeable portion of J.P. Morgan’s investment portfolio is invested in municipals. “However, if they don’t qualify as part of the liquid asset buffer we’re going to be forced to look for another way to go about our investment portfolio and manage our risk.”
Wait, the LCR is going to hurt muni bonds? You sure you want to stick with that argument, Joe?

The only way the LCR would raise costs for muni bond issuers would be if banks like JPMorgan had been including muni bonds in their liquidity pools — something which, given the generally illiquid nature of muni bonds, I find highly unlikely. JPMorgan already maintains a liquidity pool based on its own internal standards. The LCR is simply codifying this same type of liquidity pool requirement, albeit with significantly (and appropriately) more conservative assumptions. Unless JPMorgan has been including muni bonds in its liquidity pool — which would be prohibited under the LCR — then the LCR should have no real effect on JPMorgan’s muni bond portfolio.

And if for some reason JPMorgan has been including muni bonds in its liquidity pool, then the bank is guilty of extremely poor liquidity management, and the LCR is saving JPMorgan from its own ineptitude. But, of course, there’s no way JPMorgan has been doing this. They’re just trying to bully regulators into weakening Basel III’s liquidity requirements by warning of the dire (!) consequences for those sweet-and-innocent municipalities.

Oh yeah, and Bonocore is also pushing for gold to be eligible for the LCR liquidity pool. Umm....no. Clearly he has a very different idea of what constitutes a “deep” market.

Stay classy, JPMorgan.

When the FDIC published a paper showing how it would have resolved Lehman under Dodd-Frank’s Title II resolution authority, Yves Smith, as is typical anymore, rushed to denounce it as an outrageous fraud, even though it’s painfully obvious that she didn’t read the entire FDIC paper. (It’s equally obvious that she’s never bothered to read Title II.)

I debated whether or not to even respond to Yves’ criticisms of the FDIC paper (see also here), because they’re hardly even worth the time. It’s also clear that Yves is going to believe what she’s going to believe, facts be damned, and that I’m not going to change her mind. So I don’t write this with the expectation that I will persuade Yves that she’s wrong. I just want to correct some of the egregious misinformation. Some of Yves’ criticisms, like the one that relies on an unsubstantiated rumor from friggin’ Zerohedge, are definitely not worth my time.

Criticism #1: Assumes everything is governed by a single, uniform legal framework

No, it doesn’t. The fact that she thinks this just proves that she didn’t read the entire FDIC paper (which was only 19 pages). The FDIC talked about how it would have coordinated with foreign regulators, including the UK’s Financial Services Authority (FSA), and also how it would have dealt with Lehman’s UK broker-dealer subsidiary, known as LBIE. The FDIC clearly stated that it would have structured the deal so that LBIE was also sold to Barclays. (And Barclays had, in fact, agreed to purchase Lehman’s holding company (LBHI), US broker-dealer (LBI), and LBIE, so you can’t argue that this is fantasy.) The FDIC also stated:

“By completing a sale at the time of failure of the parent holding company, the acquirer would have been able to ‘step into the shoes’ of LBHI and provide liquidity, guarantees, or other credit support to the newly acquired subsidiaries. Were the FDIC unable to promptly complete such a transaction, it could provide any necessary liquidity to certain key subsidiaries, such as LBIE, pending a sale of those assets.”
The FDIC is a national regulator, so it doesn’t have the authority to seize foreign subsidiaries, but the FDIC can structure its “purchase and assumption” agreements (P&As) however it damn well pleases. The FDIC is well within its rights to insist that any acquirers of the holding company under a P&A also take a key foreign subsidiary, such as LBIE. Moreover, Barclays’ acquisition of the holding company (LBHI) would have obviated the need for LBIE to file for bankruptcy in the UK, since LBHI funded and backstopped LBIE’s trading obligations.

So the FDIC does not assume a single legal framework; it just assumes that LBIE wouldn’t have to file for bankruptcy in the UK — an assumption which is entirely justified.

Criticism #2: Egregious underestimation of Lehman losses

This is a non-sequitur, and not even a good one. For one thing, Yves confuses creditor claims with creditor losses, so her so-called “gap” analysis is fundamentally flawed. That’s Bankruptcy 101. More importantly, there’s simply no getting around the fact that Barclays had, in fact, agreed to buy Lehman on Sunday, September 14th, if it could leave behind a $62bn pool of “bad assets” (which would’ve been financed by a consortium of Wall Street banks). The fact that Yves thinks that’s a bad deal is irrelevant. It’s perfectly reasonable for the FDIC to assume that Barclays would have agreed to a deal that Barclays had, in fact, agreed to.

Criticism #3: Assumes unrealistic 90 day preparation time

Yves claims that any heightened FDIC presence would have immediately triggered a run on Lehman. This is pure hogwash. First, the FDIC would already have an on-site presence at Lehman under its Title I “resolution plan” authority. And the type of information that the FDIC would be requesting is the exact same information that the FDIC’s normal on-site personnel would be routinely requesting. Second, huge, market-moving information about things like mergers are successfully kept under wraps all the time. It’s not difficult to set up a secure data room and force people to sign draconian NDAs. Surely Yves knows this. If she doesn’t, then, well, that’s another matter entirely. Finally, remember when the news broke back in the summer of 2008 that the New York Fed had on-site examiners at Lehman who were sending daily reports to Geithner and Paulson about Lehman’s liquidity, and the market freaked out? Yeah, neither do I. That’s because the news never broke, and the market never freaked out.

Criticism #4: Assumes a derivative contract termination process out of a parallel universe

This is perhaps the most egregious — and revealing — mistake that Yves makes. It shows just how little she (and Satyajit Das, who she quotes extensively) really know about the resolution authority. Das throws around a lot of fancy terms and describes a lot of scary-sounding problems with derivatives, but his entire analysis is based on the flawed premise that counterparties would have had the right to terminate their derivatives. Let me make this as clear as possible: there would have been no derivative contract termination process for the vast majority of Lehman’s derivatives under the resolution authority. Just like in FDIC resolutions of regular depository institutions, section 210(c)(10)(B) of Dodd-Frank prohibits counterparties from exercising their right to “terminate, liquidate, or net” their derivatives for one day after the FDIC is appointed as the receiver, during which time the FDIC can transfer the failed company’s derivatives to another financial institution. This supersedes the “Automatic Early Termination” clause in the ISDA Master Agreement.

This is exactly what the FDIC describes happening with Lehman: if Yves and Das had bothered to read the entire FDIC report, they’d know that the P&A transactions would have transferred the holding company, the US broker-dealer, and the broker-dealer’s derivatives dealing subsidiaries (LBSF and LBDP) to Barclays. Because these transfers would have occurred simultaneously with the FDIC’s appointment as receiver, the derivatives counterparties would not have had an opportunity to exercise their termination rights. Period. That’s why the FDIC paper didn’t address how termination and set-off rights work in different jurisdictions. Also, Das claims that the FDIC paper includes “no recognition of how collateral held against trades would work.” Again, yes, it does. (Seriously guys, read the paper.) From page 17:
“Lehman’s derivatives trading was conducted almost exclusively in its broker-dealer, LBI, and in LBI’s subsidiaries. As a result, Barclays’ acquisition of the broker-dealer group would have transferred the derivatives operations, together with the related collateral, to Barclays in its entirety as an ongoing operation.”
Finally, Das claims that LBIE was entirely funded by LBHI. I never said that LBIE was entirely funded by LBHI. But it was absolutely, indisputably dependent on LBHI for the vast majority of its day-to-day funding. From the LBIE administrator’s first Witness Statement:
“As part of its global treasury management, the Lehman Group operated a centralised treasury function. Accordingly, LBIE did not have control over bank accounts. Instead, payments were made into and from accounts maintained at group level (that is, at LBHI level). During each trading day, LBHI transferred cash to enable the Lehman Group companies, including LBIE, to meet their cash requirements during that day. The companies within the Lehman Group were therefore reliant upon receipt of that cash from LBHI each day to enable them to meet their obligations.”
That’s about all I can stomach right now. Like I said, I don’t expect Yves to change her mind, or admit that she was wrong. That’s fine. She can believe whatever she wants to believe. I just wanted to demonstrate that her criticisms are baseless and ill-informed. If anyone wants to have a real discussion of the resolution authority, I’m willing. But I’m done responding to criticisms of the Title II resolution authority from people who can’t be bothered to actually read Title II.

I’ve seen several people — most recently Larry Summers at INET’s Bretton Woods Conference — make an argument that, I have to say, I think is utterly daft. The argument is that before 2008, no one would have considered Lehman or Bear Stearns “too important to fail.”

Summers, in his discussion with Martin Wolf, stated that “Lehman, [which] was less than 2% of the US financial system, would not have been ‘too big to fail’ on anybody’s theory.” Avinash Persaud provided an even cleaner version of this argument, writing that “Any list conjured up in 2006 of institutions that were ‘too big to fail’ would not have included Northern Rock, Bradford & Bingley, IKB, Bear Sterns, or even Lehman Brothers.” And the Cato Institute’s Mark Calabria has also made this argument with respect to Bear Stearns.

I’m sorry, but Lehman and Bear Stearns were both widely perceived to be too important to fail before 2008, and anyone who tells you otherwise doesn’t know what they’re talking about. Lehman and Bear were two of the 14 or so major dealer banks that serve as the critical nodes in the global capital markets. Everyone knows who the major dealer banks are, and everyone knew that Lehman and Bear were part of this group. (The fact that Lehman and Bear were two of the smallest major dealers is irrelevant; someone’s always going to be the smallest, and size is hardly the only, or even the most important, factor in determining whether an institution is too important to fail.) In fact, had most market participants been asked to compile, à la Mr. Persaud, a list of TBTF institutions back in 2006, I expect the first thing they would’ve done was add all the major dealers.

It wasn’t just that the majority of market participants knew how massively disruptive it would be for one of the major dealers to have to unwind itself in bankruptcy. It was also that prior to 2008, the failure of one of these massive global dealers was something that was simply inconceivable to a lot of market participants.

I honestly don’t know anyone in the market who legitimately believed that the Fed would let Bear Stearns just chaotically collapse into bankruptcy. (And the same would’ve been true of Lehman had it been the first one to implode.) There’s a reason that when Bear Stearns started to implode in March 2008, everyone in the market kept saying, “The Fed is going to do something, right?” It’s because Bear (and Lehman) had long been considered too important to fail.