Thursday, December 31, 2009

Annoying Myths on the Bailout

Since I missed my connection and I'm spending New Year's in an airport hotel, I figured I'd take this time when everyone is out celebrating to point out something I know is unpopular, but which still annoys me.

Joe Stiglitz, writing at the New Deal 2.0, echoes the conventional wisdom on the bailouts:

We are accustomed to thinking of government transferring money from the well off to the poor. Here it was the poor and average transferring money to the rich.
But was it really? It was the government transferring money to the rich, that's for sure. But where does the government get its money? Mostly from....the rich. According to the Tax Policy Center, the top income quintile pays 67.2% of all federal taxes; people who make over $100K/year pay 73% of all federal taxes. When it suits their argument, pundits like Stiglitz suddenly forget that we have a progressive tax system.

I'm not saying the bailouts weren't unfair (they were), or that the middle class hasn't suffered for the mistakes of others (they have). I'm just saying, let's stop pretending like the majority of the bailout is being financed by Sally Schoolteacher. It isn't.

Tuesday, December 15, 2009

The Lynch Amendment: Bizarre and Confused

The Lynch amendment has to be one of the most bizarre pieces of legislation relating to derivatives I've ever seen—and that's saying something. Really, the amendment is just illogical. Introduced by Rep. Stephen Lynch, the amendment prohibits swap dealers and "major swap participants" from owning more than 20%, collectively, of a derivatives clearinghouse. Here's how Rep. Lynch justified his amendment on the House floor:

[T]he problem is—and in my view, this is a huge problem with the bill—the bill would allow these same big banks to purchase the clearinghouses that are being created to police the big banks in their derivatives trading. The big banks would be allowed to own and control the clearinghouses and to set the rules for how their own derivatives deals are handled. My amendment would prevent those big banks and major swap participants, like AIG, from taking over the police station—these new clearinghouses.
This makes absolutely no sense. Rep. Lynch appears to be deeply confused about both clearinghouses and the derivatives market. Unfortunately, the Lynch amendment has been cheered on by the blogosphere, which now reliably swoons at any mention of hurting "Wall Street," seemingly without regard for the merits of the proposal. Honestly, what do supporters of the Lynch amendment think clearinghouses are? The purpose of a clearinghouse is risk mutualization. If one clearing member defaults on a cleared contract, the other members—via the clearinghouse—will pick up the tab. That's why the clearinghouse, as the central counterparty (CCP), interposes itself between counterparties to contracts cleared through the clearinghouse, serving as the buyer to every seller and the seller to every buyer. The whole purpose of this set-up is to put all the clearing members on the hook for one clearing member's default. (If after applying a defaulting member's margin account, the money the other clearing members have contributed to the clearinghouse's guaranty fund still isn't sufficient to cover the losses from a member's default, the clearinghouse can generally force the other clearing members to make one-time contributions to cover the remaining losses.) Why on earth would we want to discourage the dealer banks—who, for better or worse, are the only ones capable of being market-makers in OTC derivatives—from mutualizing losses? That's what the Lynch amendment would do. The clearing members are the ones who are ultimately on the hook for a default in a clearinghouse model, so of course they're going to want to have a say in the kinds of contracts the clearinghouse accepts, and in the clearinghouse's risk management practices. A dealer is unlikely to trade through a clearinghouse if it's prohibited by law from having a say in the kinds of contracts that it—as a clearing member—is being put on the hook for. Clearing members should have a say in those kinds of matters—it's exactly the kind of aligning of economic interests that we're looking for! The Lynch amendment would effectively prevent a given clearinghouse from having more than 2 or 3 dealers as clearing members. This would make the clearinghouse much less effective in mitigating the systemic risk of OTC derivatives. When a clearing member defaults, the clearinghouse can generally transfer big chunks of the defaulting member's open positions to other clearing members—like the FDIC does when it resolves commercial banks—minimizing the disruption to counterparties and preventing contagion from spreading. If a clearinghouse only has 2 or 3 dealers as clearing members, and one of those dealers defaults, the clearinghouse wouldn't be able to transfer most of the defaulting member's open positions to other clearing members, because there would only be a couple other clearing members who, under the best of circumstances, have the balance sheet capacity to assume significant chunks of the defaulting member's derivatives book. This would greatly increase the strain on the clearinghouse's guaranty fund. By contrast, if all of the dealers are clearing members and one of the dealers defaults, there's a good chance the clearinghouse will be able to transfer most of the defaulting member's derivatives book to other clearing members, smoothing the resolution of the defaulting dealer and minimizing the strain on the guaranty fund. Another major problem with the Lynch amendment is its potential effect on the liquidity of cleared OTC derivatives. As the name implies, "swap dealers" are the market-makers in OTC derivatives. There's already a question as to whether a lot of standardized OTC derivatives are liquid enough to be centrally cleared. I personally think they are, but the Lynch amendment would make it a very close call. You have to think about why clearinghouses only accept liquid derivatives for clearing — in order to collect the right amount of collateral (or "variation margin") from counterparties, cleared derivatives need to be liquid enough to accurately mark-to-market every day. If mark-to-market prices aren't available, a clearinghouse won't be able accurately value the contract, and it won't know how much collateral to demand from counterparties. If a clearinghouse only has 2 or 3 dealers as clearing members — which, again, would be the ultimate effect of the Lynch amendment — then its access to the (real-time) pricing information it needs to accurately set mark-to-market values will be severely constrained. A clearinghouse needs several dealers to be clearing members (at least 7 or 8) in order to accurately mark-to-market standardized OTC derivatives on a daily basis. Finally, Rep. Lynch is wrong to say that the clearinghouses "are being created to police the big banks in their derivatives trading." Uh, no Congressman, they're not. There's a reason we often say that standardized derivatives should be forced onto "regulated clearinghouses" — it's because the clearinghouses would be "regulated" by the CFTC and SEC! The CFTC and SEC will be the ones policing the OTC derivatives markets, as they'll have nearly unfettered access to clearinghouse data, as well as the authority to impose pretty much whatever standards they want on the clearinghouses. A regulated clearinghouse can only make rules for its members within the confines of CFTC/SEC regulations. Warning that the big banks will be allowed to police themselves without the Lynch amendment is a pure straw man. Let's hope the Senate takes a second to think through the Lynch amendment before it takes up financial regulatory reform.

Thursday, December 3, 2009

Changing My Mind on Bernanke

I think it's pretty obvious that I'm a big supporter of the Obama administration, and particularly of the Geithner Treasury. But I'm surprised at how little I find myself caring about whether Bernanke is reappointed. If you had asked me a month ago, I probably would've given Bernanke my full-throated support. The only thing that's changed in the past month is that I started to think more carefully about how Bernanke, personally, has performed. I still strongly believe that the Fed has performed admirably ever since the Bear Stearns failure, opening wide the money spigots and helping to avoid a second Great Depression. In some respects, Bernanke deserves credit for not repeating the mistakes the Fed made during the Great Depression. But let's be honest: no Fed-Chair-worthy economist would have repeated the mistakes of the Depression-era Fed. The Fed, as an institution, is very much in the middle of mainstream economic thought, and no mainstream economist thinks the Fed acted wisely during the Depression. The Fed has seen itself as institutionally-committed to intervening in a financial crisis for a few decades now. What about all those "creative emergency lending facilities" like the PDCF and the CPFF that the Fed implemented, and that Bernanke is always getting so much credit for? Those were in reality designed largely by the NY Fed's Markets Group (headed at the time by William Dudley, who's now the NY Fed President), not Bernanke. More on that later. If you think about it, two of the decisions that Bernanke actually did have significant influence over were in hindsight pretty terrible decisions: 1. The emergency 75-basis point rate cut when Asian and European markets were tanking due to SocGen unwinding rogue trader Jerome Kerviel's trades — that wasted 3 of the Fed's bullets in one fell swoop. Awesome. It's not like the Fed could've used those bullets later or anything. And the emergency rate cut was definitely Bernanke's call. Here's how David Wessel described it in In Fed We Trust (emphasis mine):

"Flexing his muscles as he had rarely done before, Bernanke won the FOMC’s backing for what — for the Fed — was a king-size rate cut: three-quarters of a percentage point, with a strong hint of more to come at the FOMC meeting scheduled for the following week." (pg. 93)
2. The unreal decision NOT to cut rates on the Tuesday after Lehman's failure. Hoocoohanode that the largest bank failure in world history — 13 months into a still-worsening financial crisis, no less — would've had an effect on interbank lending? Yeah, the interbank markets probably didn't need any help on Sept. 16-17, 2008, and the markets definitely didn't need a confidence boost. Or something. I'm reminded of Paul Krugman's description of Greenspan's emergency rate cut after LTCM's failure (from The Return of Depression Economics):
"It is important to realize that even now Fed officials are not quite sure how they pulled this rescue off. At the height of the crisis it seemed entirely possible that cutting interest rates would be entirely ineffectual—after all, if nobody can borrow, what difference does it make what the price would be if they could? And if everyone had believed that the world was coming to an end, their panic might—as in so many other countries—have ended up being a self-fulfilling prophecy. In retrospect Greenspan seemed to have been like a general who rides out in front of his demoralized army, waves his sword and shouts encouragement, and somehow turns the tide of battle: well done, but not something you would want to count on working next time." (pp. 135-136)
Bernanke didn't even ride out in front of his army. Ultimately, I think these two bad decisions raise questions about Bernanke's "feel for the market" — his understanding of market psychology (hugely important), his ability to interpret market signals that are important to Fed policymaking, etc. A Fed Chair absolutely needs to have a good feel for the market. Greenspan, for all his faults, actually did have a remarkably good feel for the markets during crisis-type situations. Does Bernanke? I'm not sure, but I'm skeptical. Bernanke deserves at least some credit for being willing to sign-off on the "creative emergency lending facilities" that took the Fed into uncharted waters. On the other hand, I don't think he (or the other Fed Governors, for that matter) had much of a choice. As I said before, the Fed sees itself as institutionally-commited to intervening to ease a financial crisis, and there were unquestionably intervention-worthy problems in the credit markets in 2007-2008. For example, Bear's failure vividly demonstrated how important it is, in terms of financial stability, for large investment banks to have access to stable sources of liquidity. After Bear Stearns, any Fed Chair would've seen that the sudden failure of a large investment bank could threaten the stability of the financial system. Since the Fed's traditional emergency lending facility (the discount window) isn't available to investment banks, anything the Fed did to address this problem was necessarily going to take the Fed into uncharted waters. So Bernanke didn't have much of a choice on the Primary Dealer Credit Facility (PDCF) — everyone, and I mean everyone, knew that the Fed had to get involved, and the only real way to do that was with something like the PDCF. Ultimately, I'm not against Bernanke's reappointment. I'm ambivalent on Bernanke personally, and I'm rooting for the Senate to confirm Bernanke just so the Obama administration doesn't take a huge hit to its credibility (I'm also rooting for him because it's effectively a done deal now, and everyone likes to root for a winner). Do I wish that the Obama administration had nominated someone other than Bernanke? In retrospect, yes, I probably do. But now that they've re-nominated Bernanke, I don't want to see him get rejected, and then have the administration forced into accepting someone that Chris Dodd "suggests" can easily get confirmed. The devil you know, and all that. To be clear: I don't think Bernanke will be a bad Fed Chair in his second term by any means, but I don't think he'll be a particularly great Fed Chair either.

In my earlier post on TBTF policy, I started to discuss why "prompt corrective action" (PCA) is the key to making TBTF policy work, and I want to expand on that here. Done right, I really do think PCA could be the glue that holds TBTF policy together. The resolution authority is clearly the most important aspect of TBTF policy, since "too big to fail" just means "too systematically important to put into Chapter 11." Give us a resolution authority that can wind down systematically important nonbank financial firms without causing a financial crisis, and suddenly no firm would be TBTF anymore — the TBTF problem would instantly vanish. The trick is obviously to design such a resolution authority. Easier said than done. One of the biggest problems is that there are no trial runs — we won't know whether the resolution authority we end up with actually works (i.e., allows regulators to wind down systematically important financial firms without causing a financial crisis) until we use it during a crisis, which policymakers will be loath to do the first time because it'll still be untested. But that's where PCA should come in. PCA can act as "foam on the runway" for the resolution authority (to borrow a phrase from Geithner). In the earlier post, I argued that one of the PCA triggers should be contingent on the tenor of a financial institution's overall liabilities—that is, the Fed should be required to take prompt corrective action once a large financial institution allows the tenor of, say, 20% of its overall liabilities, or 50% of its daily funding requirements, to drop below one week (again, I just pulled those numbers out of the air). In other words, the new PCA regime should be focused more on a large firm's liquidity ratios than on its capital ratios. What sort of "corrective action" should a financial firm that runs afoul of this or other similar PCA triggers be forced to take? Broadly, I'd say that the PCA regime needs to force a firm to secure a certain amount of medium/long-term financing for its capital markets activities (e.g., $X >30 days, $Y >100 days; "medium-term" and "long-term" are relative terms here, since we're most talking about capital markets positions). The key is to make sure that a systematically important firm's survival or failure is not contingent on its ability to obtain ultra short-term financing. As a firm relies more and more on overnight repos and rehypothecated collateral and prime brokerage accounts to fund its positions, its balance sheet gets exponentially more chaotic and confusing — securities are being pledged overnight all over the place, the firm is rehypothecating all the collateral it can (and some that it can't), etc., etc. If the firm ends up failing, this makes a smooth resolution 100 times harder, in part because of the inevitable delay required to figure out where everything is. Lehman was still transferring assets in between its various European and North American branches at a furious pace right up until its bankruptcy filing. As a result, a lot of hedge funds and other investors were very surprised to discover that their assets were not in segregated accounts in Lehman's North American unit, but in fact had been transferred to Lehman Brothers International (Europe) and then rehypothecated. This was a huge source of uncertainty in the days following Lehman's bankruptcy filing. It was also the main reason why hedge funds all started pulling their prime brokerage accounts from Morgan Stanley and Goldman, which both investment banks had relied on to some extent for short-term financing (the so-called "free credits"). The new PCA regime should aim to prevent this kind of thing from happening by making a large firm's survival or failure contingent on its ability to obtain medium/long-term financing for its capital markets positions, or by giving the Fed the authority to restrict transactions between affiliates once a large firm passes a certain PCA trigger. If we can use PCA to ensure that a large firm doesn't rely more and more on ultra short-term financing as it edges closer to failure, then a successful resolution under a new resolution authority is very realistic. The point is that PCA needs to be a way to force both the financial institution and the regulators to start getting their ducks in a row in preparation for a resolution. If PCA can ensure the conditions necessary for a smooth (i.e., non-catastrophic) resolution of a large financial institution, then we'll have a legitimately "successful" resolution authority for large nonbank financial institutions, and the problem of TBTF will be no more. Of course, I've been through more than enough rounds of financial regulatory reform to know that it's highly unlikely it'll actually happen that way. But getting a framework in place that could get us to that point isn't out of the question, so long as the fairweather populists can be kept in check.

Sunday, November 22, 2009

Fire Gretchen Morgenson

No way does Gretchen Morgenson get to take a victory lap because of the SIGTARP report, which she tries to do today. As the late great Tanta pointed out time and again, Morgenson is "a tendentious writer with only a marginal grasp of her subject matter and what appears to be an insatiable desire to make uncontroversial facts sound sinister." How she still has a job is an enduring mystery. This is what Morgenson wrote last September, at the height of the crisis:

A collapse of [AIG] threatened to leave a hole of as much as $20 billion in Goldman’s side, several of these people said.
This was unequivocally false, as the SIGTARP report makes clear. The SIGTARP report strains to make a credible argument that Goldman had any exposure to AIG, let alone $20 billion of exposure. In fact, the SIGTARP report doesn't even succeed in proving that Goldman had any exposure to AIG — it basically just says, based on no evidence or argument of any kind, "Well, it's technically possible that things could've gotten even worse than Goldman's already-conservative assumptions." But $20 billion of exposure? Not. Even. Close. So no, Gretchen, you do not get to take a victory lap. Your September 27, 2008 article was materially false, and breathtakingly irresponsible.

Thursday, November 19, 2009

Connie Voldstad to head ISDA

Per the WSJ:

The International Swaps and Derivatives Association, Inc., the trade group representing the global derivatives markets, appointed Conrad Voldstad as chief executive officer. Mr. Voldstad will replace Robert Pickel effective Nov. 30. Mr. Pickel, who held the position for the past nine years, will take on the new role of Executive Vice-Chairman. He will serve on the association's board and continue discussions with regulators globally, including the Federal Reserve of New York. Mr. Voldstad joins ISDA after a tumultuous couple of years in which the derivatives industry came under heavy scrutiny during the financial crisis. Credit derivatives were blamed for exacerbating the crisis and helping cripple the financial system. Some types of credit-default swaps were responsible for the near-failure of American International Group Inc., which needed a massive bailout from the government. Key on Mr. Voldstad's agenda will be coordinating global initiatives to manage counterparty risk, and to continue to work on the guts of the derivatives market's operations – smoothing things to help operations run around the world. Over the past five years, the group has established standard contracts between counterparties, methods and processes for parties to settle up trades when defaults occur, helping establish a clearinghouse for the industry to better manage the risk any counterparty to a contract may pose to another.
Snagging Connie Voldstad is quite a coup for the ISDA.

A few weeks ago James Kwak noted that Goldman had only $270 billion of assets in 1998, and asked, half-rhetorically, whether that was big enough, since Goldman was "probably doing a perfectly good job of serving their clients at the time." I thought the answer to this question was obvious, but I guess it's not, since this meme has apparently persisted. The answer, of course, is that capital markets have exploded upwards since 1998. The international bond markets rose 157%, from $32.5 trillion in 1998 to $83.5 trillion in 2008; bond issuance rose 272%, from $654 billion in 1998 to $2.4 trillion in 2008; etc., etc. I don't have a lot of time, but I think these charts drive home my point. Asking whether banks, which serve as market-makers in capital markets products, need to be bigger than Goldman was in 1998 frames the issue exactly wrong. The issue isn't how big market-makers need to be in order to provide adequate liquidity to the capital markets of 1998. The issue is how big market-makers need to be in order to provide adequate liquidity to the capital markets of 2009 (and beyond).

Wednesday, November 18, 2009

The View from the Ivory Tower

Paul Krugman disagrees with my "legal argument" on the AIG counterparties issue because, according to Krugman, "Wall Street doesn’t work like that, and never has." Oh Paul, won't you please tell us more about how Wall Street works? Seriously though, I'm flattered that Krugman, who's practically a hero of mine, actually read my post. Unfortunately, his vast Wall Street experience fails him. The AIG counterparty negotiations were completely different from the LTCM rescue, because when the banks were negotiating the LTCM rescue, the Fed hadn't already signaled that it wasn't willing to let LTCM fail. When the NY Fed was negotiating with the AIG counterparties, it had already bailed AIG out, and had told the entire world that it wasn't willing to let AIG fail. With LTCM, the Fed could use the threat of bankruptcy to force the banks to agree to a rescue. That simply wasn't the case with the AIG counterparty negotiations, because the Fed couldn't credibly commit to putting AIG in bankruptcy. That's a fundamental, elephant-in-the-room -like difference. Another huge difference is that the AIG counterparty negotiations weren't about saving the system from meltdown. They were purely distributional—this was about justice, not the stability of the financial system. In all of Krugman's examples, the Wall Street firms were better off if they cooperated to save the system. In the AIG situation, there was absolutely no benefit to collective action. None. Finally, Krugman points to TED's speech as proof that the NY Fed could have negotiated haircuts. While TED's speech was admittedly inspiring, and had me reaching for my checkbook, there's one glaring problem: the speech was predicated on the NY Fed having the support of the French regulators, which, as the SIGTARP report makes clear, was not the case. From the SIGTARP report:

The Commission Bancaire spoke again with FRBNY and forcefully asserted that, under French law, absent an AIG bankruptcy, [SocGen and Calyon] could not voluntarily agree to less than par value for the underlying securities in exchange for terminating the swap contracts.
SocGen and Calyon, by the way, held over a third of the $62bn CDS book that AIG was trying to terminate. With SocGen and Calyon explicitly prohibited from agreeing to haircuts, the NY Fed's negotiations were DOA.

Tuesday, November 17, 2009

Geithner Vindicated in TARP Watchdog Report

That's right, vindicated. Read the whole report. It makes clear that the NY Fed did try to negotiation haircuts with AIG's counterparties, but not at all surprisingly, the counterparties (and the French regulators) refused, and the NY Fed was left with no choice but to pay par value. Geithner, contrary to popular belief, didn't have the powers of a bankruptcy court. It's funny how quickly the Immaculate Negotiation argument breaks down in the real world. (I will be accepting apologies in the form of cash or personal checks.) Despite the overtly political "conclusions" and "lessons learned" sections (sadly, the only sections journalists read), the SIGTARP report (finally) gets a lot of the real facts out in the public domain, so we can finally talk about them now. The SIGTARP report confirms that: 1. First, AIG tried to negotiate haircuts on its CDS contracts, but counterparties refused (as was their right):

AIG was attempting to resolve its liquidity crisis caused by the collateral posting requirements by negotiating a cash payment to the counterparties in return for terminating the credit default swaps. ... While FRBNY was conducting analysis on alternative solutions, AIG’s attempts to negotiate the termination of its multi-sector credit default swap book with its counterparties were failing. AIG requested FRBNY’s assistance in securing these terminations.
2. Contrary to the constant claims of ill-informed pundits, the NY Fed did try to negotiate haircuts with AIG's counterparties:
On November 6 and 7, 2008, FRBNY assistant vice presidents, vice presidents, senior vice presidents, and executive vice presidents contacted eight of AIGFP’s largest counterparties (Société Générale, Goldman Sachs, Merrill Lynch, Deutsche Bank, UBS, Calyon, Barclays and Bank of America) by telephone. They described a proposal under which each counterparty was asked to accept a haircut from par. Seven of the eight counterparties told FRBNY officials that they would not voluntarily agree to a haircut. The eighth counterparty, UBS, said that it would accept a haircut of 2 percent as long as the other counterparties also granted a similar concession to FRBNY. FRBNY officials told SIGTARP that their concerns about credit rating downgrades limited the time available for negotiation about reductions in payments.
3. The NY Fed tried to get the French bank regulators to help them negotiate haircuts with SocGen and Calyon—two of AIG's biggest counterparties—but not only did the French regulators refuse to help, they specifically instructed SocGen and Calyon not to agree to any haircuts (rendering UBS's conditional acceptance of a 2% haircut moot). From the report:
During these negotiations, an FRBNY executive vice president and senior vice president contacted the Commission Bancaire to inform them that the FRBNY was conducting negotiations with Société Générale and Calyon, two of the counterparties with the largest credit default swap contracts with AIG, and was requesting their support. The Commission Bancaire then contacted the firms. The Commission Bancaire spoke again with FRBNY and forcefully asserted that, under French law, absent an AIG bankruptcy, the banks could not voluntarily agree to less than par value for the underlying securities in exchange for terminating the swap contracts. Thus, the French banks claimed they were precluded by law from making concessions and could face potential criminal liability for failing to comply with their duties to shareholders.
4. Like I said before, the counterparties refused to accept haircuts because (a) they were contractually entitled to par value, and (b) the government's bailout of AIG had removed the threat of bankruptcy, without which there was no mechanism whatsoever for forcing the counterparties to agree to workouts:
According to an FRBNY senior vice president, the counterparties that FRBNY approached that resisted being paid anything less than the equivalent of par in exchange for terminating their credit default swap contracts cited several reasons for this, including:
  • They had collateral already posted by AIG to protect against the risk of AIG default. The combination of collateral in their possession plus the fair market value of the underlying CDOs also in their possession equaled the par value of the credit default swaps. Thus, from the counterparty’s perspective, offering a concession would mean giving away value and voluntarily taking a loss, in contravention of their fiduciary duty to their shareholders.
  • In addition to the collateral, they had a reasonable expectation that AIG would not default on any further obligations under the credit default swaps because the U.S. government had already demonstrated that it would not allow AIG to go bankrupt.
  • They had already incurred costs to mitigate the risk of an AIG default on its obligations that would be exacerbated if they were paid less than par value.
  • They were contractually entitled to the par value of the credit default swap contracts.
------------------------------------- I also want to knock down one of the more specious—and frankly shocking—arguments that Barofsky makes in the report. He criticizes the NY Fed for "refus[ing] to use its considerable leverage as the regulator of several of these institutions to compel haircuts." Think about what this means: Barofsky is criticizing the NY Fed for not threatening to misuse its regulatory authority for purposes of retaliation. First of all, there would be serious questions about the legality of any such regulatory action, since the Fed would be using one of its regulatory tools for something other than its intended purpose. What's more, this criticism for not misusing regulatory authority is coming from, amazingly, an inspector general. (You think Barofsky is accepting campaign contributions yet?) It takes real chutzpah for an inspector general to criticize a regulator for not threatening to misuse its regulatory authority. Maybe we need an inspector general for TARP's inspector general. The SIGSIGTARP.

In the responses to my post on why we need market-makers with big balance sheets, one thing I've noticed is that a lot of people are completely unable to distinguish between the argument that we need big banks, and the argument that we need the big banks that exist today. I made the former argument, not the latter. I thought this distinction was obvious, but it was apparently lost on quite a few people, who immediately pointed out that Citigroup is a very big bank, and it's been a disaster — as if the fact that Citi was a failure somehow proves that market-makers don't need big balance sheets. In my post, I noted that one of the benefits of having large market-makers is that it allows the use of mark-to-market accounting, which is an important check on management. Both Felix Salmon and Ken Houghton rushed to point out that Citi doesn't mark all its assets to market. Uh, yes, and that proves what, exactly? Citi doesn't mark all its assets to market because it's not required to. But that's an issue of accounting rules, and has absolutely nothing to do with the bank size issue. One of the things I've been trying to do recently is spur people to get beyond this kind of superficial sound-bite analysis. Being able to distinguish between an argument for big banks and an argument for the Wall Street banks that happen to exist today is a prerequisite for getting beyond superficial sound-bite analysis. So when I read a post like Felix's, I honestly despair. The number of clearly fallacious arguments he treats as establish fact is just staggering, and slightly depressing. It is, ironically, a good example of what Steven Pinker just coined the Igon Value Problem: "when a writer’s education on a topic consists in interviewing an expert, he is apt to offer generalizations that are banal, obtuse or flat wrong." On the other hand, when I read a post like this from Steve Randy Waldman, I'm greatly enouraged.

Friday, November 13, 2009

Yes, We Need Big Banks

As I've said before, I think the idea that "too big to fail, too big to exist" idea is just silly—it betrays a fundamental lack of knowledge about the way modern financial markets work. The pundits who push this idea love to argue that banks don't need to have huge balance sheets, and that there's no benefit to having banks with balance sheets of over, say, $400 billion or so. This argument, too, is almost adorably naïve. (The whole thing can also be refuted in four words: Long-Term Capital Management.) It's been odd to watch the debate on bank size though, because the people defending big banks in the media/blogosphere (e.g., Charles Calomiris) have somehow managed to avoid mentioning the one reason banks do actually need very large balance sheets: market-making. The major banks are all market-makers (or "dealers") in fixed-income products, currencies, OTC derivatives, commodities, and equities. In general, dealers in a given security stand ready and willing to buy or sell the security for their own account, at publicly quoted bid and offer prices. Market-making, especially in fixed-income products, is very capital-intensive. You need a very large and diverse balance sheet to be a market-maker in fixed-income products—government securities, investment grade corporate bonds, high-yield bonds, mortgage-backed securities, bank and secured loans, consumer ABS, distressed debt, emerging market bonds, etc. Dealers hold inventories of all these securities because they need to remain "ready and willing" to sell, and because when they buy a security from a client, they need to hold it in inventory until a buyer for the security appears. Dealers are exposed to price movements for the period they hold the security in inventory, and because inventories can grow large in a short amount of time, sharp price movements can result in substantial losses for dealers. So dealers hedge. Constantly. The cheapest way for dealers to hedge is internally—that is, when the security or derivative it buys can offset an exposure elsewhere on its balance sheet. The next cheapest way for a dealer to hedge is generally with liquid, vanilla derivatives (e.g., interest rate swaps). So imagine an MBS dealer that buys a large position from a client, and has to hedge the interest rate risk. If the dealer also happens to be a market-maker in interest rate derivatives, then either: (a) the interest rate risk on the MBS will offset one of the rates desk's exposures; or (b) the rates desk will go into the market and hedge the interest rate risk with a plain-vanilla derivative, which it can do very cheaply because as a market-maker, it does these kinds of trades all the time. So being a market-maker in interest rate derivatives is critical to effectively managing the risks of holding MBS in inventory—and if you can't effectively manage the risks in a large inventory of MBS, then you simply can't offer cost-effective market making in MBS. What's more, dealers also need to set aside capital for their market-making in the OTC derivatives that they use to hedge their fixed-income market-making. Now think about all the different kinds of risks involved in holding inventories of the fixed-income products I listed above. We're talking about foreign exchange risk, interest rate risk, credit risk, basis risk, etc. Hedging all of that, dynamically, is a necessary component of market-making. This is why, for example, Goldman bought CDS protection from AIG on the super-senior tranches of CDOs it underwrote. The point of creating CDOs was to generate a mezzanine tranche, which investors, who had a seemingly insatiable thirst for yield, would gobble up. Goldman (and other dealers) couldn't place the super-senior tranches, so they held the super-seniors on their books and hedged all that risk by buying CDS protection from AIG (and the monolines). There's nothing nefarious about this—hedging is just what dealers do. Alas, this concept is apparently too difficult for the Matt Taibbis of the world to get their minds around. As you can imagine, all the risks that a major dealer bank has to manage on a daily basis—the constantly changing level of their exposures, how those exposures all interact, etc.—gets extraordinarily, mind-bogglingly complicated. The major banks all made huge investments to develop the technological capacity to manage those risks, and it's pretty clear they didn't invest enough in their risk management systems. There are only two banks that I've seen that clearly did make the necessary investments in risk management (Goldman and JPMorgan, not surprisingly). So there are undoubtedly economies of scale there. Another place there are economies of scale is order flow. The larger a dealer's order flow, the more trades it can match internally. This reduces volatility, allows a dealer to hold smaller inventories of securities, and reduces its exposure to sharp price movements. A lot of the financial industry's "merger mania" over the past 15 years was driven by the race to capture order flow. So why do we need these massive market-makers in the first place? They ensure liquidity in the capital markets. And why is that important? For one thing, it lowers borrowing costs—investors are much more willing to buy a bond issue if they know they can quickly and easily sell the position later if they want to. Investors demand higher yields for illiquid bonds. The benefits of having massive market-makers were passed on to all the businesses that were able to borrow in the capital markets at a much lower cost, and to all the investors who enjoyed much higher returns due to the reduced transaction costs. Having liquid capital markets also allows the use of mark-to-market accounting, which is an important check on corporate management. During the whole nationalization debate, everyone was screaming bloody murder about the fact that the banks didn't have to mark their toxic assets to market. Well, if we "break up" the major banks, as some simpletons pundits are urging, then you can forget about being able to mark-to-market lots of fixed-income products and OTC derivatives. Of course, there's no chance that we're going to break up the major banks. Tim Geithner isn't an idiot, and he's not an attention-craving pundit. Unfortunately, most pundits are apparently unable to distinguish between recognizing the benefits of big banks and being "captured by Wall Street" (which is a red herring). So if you've somehow made to the end of this post, I hope you'll be able to see through the claims that Geithner's unwillingness to break up the major banks is proof that he's been "captured by Wall Street."

Sunday, November 8, 2009

Sorkin's "Too Big to Fail"

I've been meaning to pass along my thoughts on Andrew Ross Sorkin's Too Big to Fail. Overall, I thought it was an excellent book. It'll be extremely hard, if not impossible, for anyone to top TBTF as the definitive blow-by-blow account of the September '08 market panic. I was expecting a book along the lines of Roger Lowenstein's When Genius Failed (about the LTCM crisis), but TBTF went well beyond Lowenstein's classic in terms of the level of detail. It was also, not surprisingly, a very exciting story. As anyone who was in the Financial District and/or Midtown for the post-Lehman fallout can tell you, it was a genuinely frightening time, but also a terribly exciting story. I've seen several people complain about the length of the book (624 pp.), but believe me, it's a quick read — I read it cover-to-cover in 2 nights. I also think that's a strange complaint, because to me, TBTF's length is its most attractive feature. The longer the book, the more detail — and as a lawyer, I love me some detail! The fact that Sorkin was able to do as much research as he clearly did in just under a year is amazing. That in itself is an impressive feat. It's also why I think so many of us were pleasantly surprised by TBTF; normally, you'd expect it to take at least a couple years to compile that much research. Both TBTF and William Cohan's House of Cards (about the Bear Stearns collapse) broke the mold in that regard. Stylistically, I really like the fact that TBTF picks up almost exactly where House of Cards left off. It essentially makes the books a pair, and I think it's appropriate to think of the books as Volume I and Volume II of the Financial Crisis of 2008. A few criticisms: First, no table of contents! For OCD readers like me, who enjoy things like a good index, that's torture. (On the other hand, the extensive "Cast of Characters" was much appreciated.) There are a few parts of the story I'd quibble with (but for my professional obligations, of course), but they were mostly along the lines of, "Oh, they were considering that option well before that!" They didn't detract from the overall book, and I don't really blame Sorkin, because let's be honest: sources shade the truth, both consciously and unconsciously. If you ask all 30 people who were in a given meeting last September what happened in the meeting, you'd get at least 15 different accounts. Personally, I would've liked some more numbers — things like, for example, the amount in overnight repo lines and prime brokerage "free credits" that Morgan Stanley was losing each day. Sorkin only got into the nitty-gritty of the major banks' financing positions during the crisis sporadically, and mostly stuck to indicators like share prices and equity indexes. That's fine; I wasn't expecting an appendix filled with statistical tables. It is, however, reflective of the fact that the book was largely an account of the crisis from the perspective of the c-level executives and senior government officials. It wasn't written from the perspective of the trading floor — which, in any event, was eerily boring during the crisis (save for the financing desks of course). Overall, I think it's safe to say that TBTF will immediately go on the semi-official "modern Wall Street classics" shelf with Liar's Poker, Barbarians at the Gate, and the rest. My criticisms, which I consider minor, should be taken in that context. I think the success of TBTF will make books like Charlie Gasparino's The Sellout irrelevant in the long-run — Nicholas Dunbar's Inventing Money to Lowenstein's When Genius Failed, so to speak. I haven't read The Sellout yet, but I haven't heard rave reviews, and like literally everyone else on Wall Street, I generally think Gasparino is a buffoon. (Indeed, one of the most amusing things about watching Gasparino is the fact that he clearly thinks he's a Very Serious, Respected Person.) Now, a few random highlights — Hank Paulson berates Chris Cox:

Cox, for whom Paulson had had very little respect to begin with, was proving how over his head he really was. Paulson had assigned him the task of coordinating Lehman’s filing by, well, now. “This guy is useless,” he said, throwing his hands up in the air and heading over the Cox’s temporary office himself. After barging in and slamming the door, Paulson shouted, “What the hell are you doing? Why haven’t you called them?” Cox, who was clearly reticent about using his position in government to direct a company to file for bankruptcy, sheepishly offered that he wasn’t certain if it was appropriate for him to make such a call. “You guys are like the gang that can’t shoot straight!” Paulson bellowed. “This is your fucking job. You have to make the phone call.” (emphasis mine) (TBTF, p. 366)
During Lehman's final board meeting, in which the board voted to file for bankruptcy, Henry "Dr. Doom" Kaufman, who was a Lehman board member and chaired the firm's Finance and Risk Committee, blamed Lehman's failure on — who else? — the regulators:
Kaufman had been sharply critical of the Fed earlier in the year, accusing the central bank of “providing only tepid oversight of commercial banking.” Now he again took aim at the government for pushing Lehman into bankruptcy. “This is a day of disgrace! How could the government have allowed this to happen?” Kaufman thundered. “Where were the regulators?” (emphasis mine) (TBTF, p. 368)
Robert Kindler, Morgan Stanley's vice chairman of investment banking, on Charlie Gasparino:
As Kindler and Taubman were reviewing the [letter of intent on a $9bn equity injection from Mitsubishi UFJ], they laughed at all the news coverage about their weekend of whirlwind merger talks. Various media outlets had the news backward or were reporting old rumors. Gasparino declared on television that Morgan Stanley was about to do a deal with either Wachovia or CIC. “The most fucking dangerous man on Wall Street,” Kindler sighed. (emphasis mine) (TBTF, p. 482)

I'm not sure I buy this argument from Yves Smith:

Treasury has asked for open-ended authority to resolve large financial institutions, which is pretty much a blank check. That’s a breathtaking power grab by the Executive and should not be acceptable in a democracy. It wasn’t surprising that post the TARP that Congress would be completely unwilling to go there. Any decision to wind up a large bank is going to require Congressional authorization; the amounts at stake are too large for this not to be a political decision.
Leaving aside that Treasury is not, in fact, asking for open-ended authority to resolve large, complex financial institutions (LCFIs), I disagree that resolving a LCFI should necessarily be a political decision. I've seen variants of this argument elsewhere, and when I first read Yves' post, I didn't think twice about her argument, because it kind of sounds like it should be correct. But the more I thought about it, the less I agreed with it. Yes, the amounts at stake are large, but why does democratic legitimacy require Congressional authorization at the very last minute (and on a case-by-case basis)? What would be undemocratic about enacting — through the proper democratic channels (i.e., a bill passed by Congress and signed by the President) — a framework for resolving LCFIs ahead-of-time, which delegates the decision on whether/when/how to resolve a LCFI to federal agencies? I think we can all agree that Congress, as an institution, isn't exactly set up to make the quick, consequential, and technocratic decisions that a successful resolution of a LCFI requires. Exhibit A: the TARP vote fiasco. The extreme uncertainty caused by that situation was bad for everybody, regardless of what side you were on in the TARP debate. Personally, I'd rather not relive that nightmare. There's nothing wrong with Congress acknowledging its own limitations, and making a conscious decision to delegate the authority to resolve LCFIs to better-equipped federal agencies. That's what we've done with the FDIC's resolution authority, for example, and the numbers can get astronomical there too. JPMorgan's commercial bank, which would be resolved by the FDIC, has over $1.6 trillion in assets. BofA's commercial bank has over $1.4 trillion in assets. But I don't see anyone demanding that the FDIC give up any of its resolution authority. (My guess is that that's because most of the critics of Treasury's proposal are big fans of the FDIC's anti-Wall Street rhetoric, and trust that the FDIC will make the "right" decisions. That's not directed at Yves; it's just my general sense.) In Treasury's proposal (pdf), the decision on whether/when to resolve a LCFI would be made by the Treasury Secretary, in consultation with the President, and only after receiving a formal recommendation from the Fed's Board of Governors and the FDIC (or in rare situations, the SEC). It's important to note that all the agency officials who would be involved in this decision — the Treasury Secretary, 7 Fed Governors, 5 FDIC Board members, and 5 SEC Commissioners — are confirmed by the Senate. I'm on record saying that this "systemic risk" determination should be made when an institution is initially deemed a Tier 1 financial holding company, rather than frantically at the last minute, when the officials' main concern is getting the announcement out before Asian markets open. (Because everyone knows that if the announcement isn't made before 8 p.m. on Sunday, it doesn't count. Just ask Hank Paulson.) For our purposes though, it doesn't really matter when the decision is made by federal agency officials; my point is simply that there's nothing about the decision to resolve LCFIs that requires the direct involvement of Congress.

Thursday, October 29, 2009

Janet Tavakoli: All Bark, No Bite

Janet Tavakoli has always been more bark than bite. Being provocative is part of her shtick.

In her latest commentary, she accuses Goldman CFO David Viniar of lying about Goldman's exposure to AIG on a September 16, 2008 earnings call (the AIG bailout was negotiated later that day). This ridiculous conspiracy about Goldman and AIG just won't die, apparently.

On the call, Viniar said: "I would expect the direct impact of our credit exposure to [AIG] to be immaterial to our results." As Tavakoli acknowledges, it's a strong statement to say that a CFO lied to the public. It's also a patently absurd statement in this case. Yes, I know, Goldman is evil, Goldman owns the government, yada yada yada. Anyway, back in the real world, Goldman's exposure to AIG almost certainly was immaterial.

Let's go over this again. The total notional amount of CDS protection that Goldman bought from AIG was roughly $20 billion. But "exposure" in credit derivatives is equal to the cost of replacing a credit derivative in the market, not the notional amount of the transaction. Think about it this way: if you buy a $300,000 homeowners' insurance policy on your house, and your insurer goes bust, you're not out $300,000. The cost to you is simply the cost of buying another insurance policy to replace the first one. In Goldman's case, the cost of replacing its trades with AIG was about $10 billion. Against that $10 billion, Goldman held $7.5 billion in cash collateral. It then hedged the remaining $2.5 billion of exposure with CDS on AIG. This is why Viniar said that Goldman's direct exposure to AIG was immaterial.

So what are Tavakoli's arguments? One is the Immaculate Negotiation argument:

The government could have stepped in and renegotiated its contracts. ... Goldman Sachs would have been out billions of dollars in collateral had a bankruptcy‐like settlement been negotiated with AIG, and that is material.
Saying that Goldman would've taken a material loss if "a bankruptcy‐like settlement been negotiated with AIG" is the equivalent of saying that Goldman would've taken a material loss if they'd agreed to take a material loss. It's true, but there's no way Goldman would ever have agreed to a "bankruptcy-like settlement" — why would they? As someone who has actually been involved in these kinds of negotiations, let me explain how the AIG/Goldman negotiations would have played out:
AIG: Would you be willing to accept, say, 70 cents on the dollar?
Goldman: No.

Seriously, what could AIG have threatened Goldman with? If they didn't accept a haircut, AIG would file for bankruptcy? Fine, Goldman would've just seized the $7.5 billion in cash collateral, and collected the remaining $2.5 billion from its counterparties on the now-triggered CDS on AIG (on which more below), covering Goldman's full bilateral exposure to AIG. That's what it means to be "hedged."

(This is also why the Fed paid Goldman and the other counterparties 100 cents on the dollar to terminate their CDS contracts with AIG, which this Bloomberg article portrays as some sort of gift to the banks. But the Bloomberg article also relies on the Immaculate Negotiation argument — how, exactly, was the Fed supposed to get the counterparties to agree to take a haircut? The Fed had just demonstrated to the entire world that it wasn't willing to let AIG file for Chapter 11. How do you suppose those negotiations would have gone? The Fed couldn't say, "You can either take a haircut to 70 cents or AIG will file for bankruptcy and you'll only get 50 cents," because everyone knew the Fed wasn't willing to put AIG in bankruptcy.)

Now, with regard to that $2.5 billion in CDS on AIG, Tavakoli argues that "It is never a given that hedges will pay off when the chips are down." That's true, and there's no guarantee that the counterparties who sold CDS on AIG to Goldman would've been able to make the payouts. But these CDS trades, like most standard single-name CDS trades, were margined daily. At the close on September 16, the CDS spread on AIG was 53 percent upfront and 500bps running, which means that the counterparties who sold Goldman CDS on AIG would have already posted around $1.4 million in collateral (excluding Independent Amounts). So the maximum potential shortfall to Goldman was about $1.1 billion — and the only way they'd lose that amount is if the counterparties they bought CDS on AIG from all somehow couldn't pay. Viniar was entirely justified in assuming that these counterparties would've paid the remaining $1.1 billion.

Tavakoli also argues that Goldman had exposure because AIG's failure would have caused a system-wide meltdown:
If AIG had gone under, the already illiquid market would have frozen. Collateral requirements for all trading would have increased (just as they did the week Bear imploded), and Goldman would have had problems collecting from many trading counterparties.
That may be true, but not only is that not the issue, there's also no way Viniar could possibly have known how the mayhem following an AIG default would have affected Goldman. It's not like he could've said, "Yes, our exposure is material because an AIG default will cause hedge fund clients A, B, and C to withdraw their prime brokerage accounts, initial margins to rise by X, and 2-year swap spreads to fall Y basis points." No one knew what would happen if AIG was allowed to file for Chapter 11 — not even the Great Janet Tavakoli. Remember also that what Viniar said was that he expected "the direct impact of [Goldman's] credit exposure" to be immaterial. He wasn't talking about Goldman's exposure to a broad systemic meltdown, and no one thought he was either.

Finally, Tavakoli argues that Goldman's exposure to AIG included "reputation risk." Yes, I'm sure that if AIG had failed, Goldman's reputation for having prudently managed its counterparty risk would've been devastating.

I own all 4 of Tavakoli's books, and it's undeniable that she's extremely smart. But like I said before, in her public commentary, she's all bark and no bite.

Treasury and Barney Frank have released their draft legislation on "too big to fail" (TBTF), which includes a special resolution authority, a council of regulators that will monitor systemic risk, heightened prudential standards for systematically important financial institutions ("Tier 1 FHCs"), and a "prompt corrective action" regime for Tier 1 FHCs. Easily the most important proposal in the Treasury/Frank plan is the resolution authority for systematically important financial institutions. (The resolution authority starts on page 164 of the discussion draft.) There's much to like in the proposed resolution authority—although I must say, it has a rather peculiar structure, with the whole receiver/qualified receiver thing. Obviously, the press will love the Systemic Resolution Fund, which is required to recoup the costs of any future bailout from financial companies with more than $10 billion in assets. (The administration's previous proposal had similar language, by the way.) Of course, I still see several problems—bankruptcy is still mandatory for "critically undercapitalized" Tier 1 FHCs, for some bizzare reason. In this post, I want to talk about the proposal's treatment of OTC derivatives and other "qualified financial contracts" (QFCs). This is a critically important issue, and Treasury and Frank get it mostly right. QFCs have long been exempt from the automatic stay in bankruptcy, which means that when a financial institution files for bankruptcy, its counterparties can immediately seize and liquidate the collateral they were holding against the QFCs (e.g., Treasuries, Agency MBS) to recoup their losses. In normal times, this is good policy, because firms use QFCs for things like dynamic hedging. However, when Lehman failed, the QFC exemption was a disaster. Every Lehman counterparty—which included practically every major financial institution in the world—seized and liquidated collateral at the same time, sending asset prices plunging across the board. The Treasury/Frank proposal treats QFCs the same way the FDIC does when it resolves a failed commercial bank. There's essentially a one-day stay on QFCs, during which time the FDIC can transfer the failed institution's QFCs to a healthy third-party acquirer or a bridge bank. But if the FDIC transfers one QFC with a certain counterparty, it has to transfer all of that counterparty's QFCs, or none at all. Once the one-day stay on QFCs expires, counterparties to any QFCs the FDIC didn't transfer can seize and liquidate the collateral. (In practice, the FDIC always transfers all the QFCs.) The reason I said the Treasury/Frank proposal gets QFCs "mostly right" is because it fails to distinguish between cleared and non-cleared QFCs. Clearinghouses have their own procedures for transferring a failed clearinghouse member's QFCs to healthy third-party members. Clearinghouses are also in the best position to quickly take stock of a failed member's outstanding trades and to quickly transfer them to the right institutions. So what the resolution authority needs to do is exempt "cleared QFCs" from the one-day stay, and let the clearinghouses take care of transferring those QFCs to third-party acquirers. The FDIC would still be in charge of transferring non-cleared QFCs, like repos, which would still be subject to the one-day stay. To be perfectly honest, I would extend the stay to 3 days, since we already know that the QFCs we'd be talking about are extremely complex, and potential third-party acquirers would need a little more time to examine the failed institution's derivatives book. ICE Trust (the main CDS clearinghouse) has a 3-day period for transferring contracts to other clearing members, for example. All in all, though, Treasury and Frank get an A- on QFCs.

Monday, October 26, 2009

Oh, the Irony

Does anyone else find it ironic that serial acquirer Sandy Weill wrote an op-ed that says:

It is vital that one regulator be able to see the entire balance sheet of the country's largest financial institutions, and this regulator needs to cut across artificial institutional lines.
Weill couldn't even see the entire balance sheet of his own financial institution back when he was running that monstrosity he called Citigroup. (I wonder how many banks Weill bought while he was writing that op-ed. Three? Four?)

Wednesday, October 21, 2009

Pay Cuts

Hahaha. Get 'em, Ken:

Executives at seven bailed-out companies including Citigroup Inc. and Bank of America Corp. will have their pay cut about 50 percent after negotiations with Kenneth R. Feinberg, the Treasury Department’s special master on compensation, two people familiar with the matter said. Cash salaries for the 25 highest-paid employees will be slashed 90 percent under Feinberg’s plan, which will be announced this week, one of the people said today on condition of anonymity. Employees at the derivatives unit of American International Group Inc., blamed for insurer’s near-collapse last year, can receive no more than $200,000 in total pay, one of the people said.
Good. Jerks. The best part is this:
All perks such as limousine service and private aircraft valued at more than $25,000 must be approved by Feinberg, one of the people said.
Add: This is going to make for some interesting conversations. "Hello, Ken? This is Johnny Risktaker, I trade MBS for Citi. I need to fly my mistress to the South of France for the weekend on a private jet. No biggie. Whaddya say?"

Tuesday, October 20, 2009

"Too Big to Fail" Policy (Warning: Long)

One thing I've been noticing is that many commentators on "too big to fail" (TBTF) policy have clearly never read the Obama administration's financial reform proposals, or at least have an extremely poor understanding of what the administration is proposing to do. This is unfortunate, because TBTF policy is an important, albeit complex, topic. It can't be addressed in a snappy op-ed, or by simply saying "make them smaller" (as if size alone is the problem). It requires serious thought on a number of related issues.

This post is my attempt to have the beginnings of a serious discussion of TBTF policy. It's long, since I took about half of my flight to London to write it. But this is a complex issue — there's no getting around that. If you believe that the Obama administration isn't proposing to do anything about TBTF, or if you believe, like Joe Stiglitz, that the administration is proposing to create "institutions too big to be resolved," then I'm sorry, but you've been seriously misled. My aim in this post is to explain what the administration is actually proposing to do about TBTF, and also to explain where I think the administration's proposals have gone wrong, and what I would do differently. If you really think you understand the administration's proposed TBTF policy, then you can probably skip to the next section on "What I would do differently." But I'm pretty sure that even people who consider themselves close observers of financial news don't fully understand the administration's overall TBTF policy.

What the administration is proposing to do about TBTF

The Obama administration is essentially proposing a three-pronged approach to TBTF.

1. Stricter prudential standards for Tier 1 FHCs.

First, the administration is proposing a new category of financial institution: Tier 1 financial holding companies. A financial institution is a Tier 1 FHC if "material financial distress at the company could pose a threat to global or United States financial stability or the global or United States economy during times of economic stress." So in other words, Tier 1 FHCs are TBTF financial institutions. Tier 1 FHCs would be supervised and regulated on a consolidated basis by the Fed. The Fed would have sole authority to designate Tier 1 FHCs, and, despite the name, any bank or other financial company (not just FHCs) could be designated a Tier 1 FHC.

To mitigate the risks that Tier 1 FHCs pose to financial stability and the real economy, the administration is proposing that Tier 1 FHCs be subject to more stringent prudential standards than regular banks and bank holding companies (BHCs) — including, importantly, higher capital ratios, lower leverage limits, and stricter liquidity requirements. Tier 1 FHCs would also be required to prepare and regularly update a credible plan for their rapid and orderly resolution in the event of distress — a so-called "living will."

2. Resolution authority for BHCs and Tier 1 FHCs.

Subjecting Tier 1 FHCs to stricter prudential standards still doesn't guarantee that no Tier 1 FHC will ever fail, so we still have to figure out what we're going to do if a Tier 1 FHC does fail. Under current law, there is no statutory authority that would allow for the orderly wind-down of a failed nonbank financial institution, such as a bank holding company (BHC) or a Tier 1 FHC. Commercial banks and thrifts are subject to the FDIC resolution authority (the FDI Act), which is significantly more flexible than the Bankruptcy Code, and does allow for the orderly resolution of failed depository institutions. However, virtually all the financial institutions currently considered "too big to fail" are organized as BHCs, which are resolved under the Bankruptcy Code, not the FDI Act.

Allowing a major BHC like Citigroup or JPMorgan to be resolved under the Bankruptcy Code pretty much guarantees that the resolution will be disorderly and highly disruptive to financial markets — just ask anyone who had exposure to Lehman when it failed. That's why the administration is proposing a new resolution authority, modeled on the FDI Act, for BHCs and Tier 1 FHCs. The proposed resolution authority would only be used if a formal "systemic risk" determination is made by the Treasury Secretary, in consultation with the President, and after receiving a written recommendation from the Fed and either the FDIC or the SEC.

To simplify, the proposed resolution authority extends FDI Act-like resolution procedures to BHCs or Tier 1 FHCs. The reason this is so important is that it allows major nonbank financial institutions to fail without causing a complete meltdown of the global financial markets. Under current law, the government's only choices when faced with the failure of a major nonbank financial institution like JPMorgan or Goldman are: (1) allow a disorderly failure under the Bankruptcy Code; or (2) a bailout, using the Fed's Section 13(3) emergency lending powers. The reason the major BHCs are considered "too big to fail" is because everyone in the market knows, especially after Lehman, that the government won't opt for option (1) — the costs are clearly too high — and will instead opt for a bailout. The proposed resolution authority gives the government a third option: allow the nonbank financial institution to fail, but in an orderly manner that insulates the broader financial markets.

Under the proposed resolution authority, Treasury would have the power to place a failed BHC or Tier 1 FHC in receivership or conservatorship (with the FDIC usually serving as receiver or conservator). Treasury, like the FDIC with commercial banks, would also have the authority to provide "open bank assistance" to a failing financial institution, which would include direct loans, asset purchases, and equity injections. The FDIC resolves the majority of failed commercial banks using so-called "Purchase & Assumption" (P&A) transactions, in which a healthy bank assumes certain liabilities of the failed bank in exchange for certain of the failed bank's assets, plus financial assistance from the FDIC in its corporate capacity. Using a P&A is generally the smoothest and least disruptive way to resolve a failed commercial bank. Accordingly, the administration's resolution authority would allow the FDIC to use P&As to resolve failed BHCs and Tier 1 FHCs as well.

The proposed resolution authority would also mimic the FDI Act's treatment of "qualified financial contracts," or QFCs (e.g., derivatives). The receiver would be required to transfer all of the QFCs between a counterparty and the failed institution to a healthy third-party acquirer or a bridge bank, or to transfer no such QFCs. The transfer maintains cross-collateralization, setoff, and netting rights, effectively allowing for the uninterrupted continuation of the contracts. If the receiver doesn't transfer the QFCs within 24 hours of being appointed receiver, then counterparties are allowed to exercise their close-out rights.

The JPMorgans and Goldmans of the world wouldn't be "too big to fail" if there was a way for them to fail without causing a meltdown of global financial markets.

3. Prompt corrective action.

This is, in my opinion, the key to making TBTF policy work. I think the administration blew some important parts of its prompt corrective action proposal, but I'll get to that in the next post. The administration is proposing a prompt corrective action (PCA) regime for Tier 1 FHCs, similar to the PCA regime applicable to FDIC-insured commercial banks and thrifts. PCA essentially allows an institution's regulator to force the institution to undertake progressively more drastic measures to recapitalize itself as the institution's capital ratio declines.

The administration's proposed PCA regime establishes four categories of capitalization for Tier 1 FHCs: (1) well capitalized, (2) undercapitalized, (3) significantly undercapitalized, and (4) critically undercapitalized. At each new level of undercapitalization, the Fed — which regulates Tier 1 FHCs under the administration's proposal — would be required to take progressively more drastic actions to force the institution to recapitalize itself. Here's a summary of the actions required at each level of undercapitalization (for the full PCA requirements, see pp. 24-32 of the administration's Tier 1 FHC proposal):

  1. Undercapitalized:

    • Additional monitoring by the Fed
    • Capital restoration plan
    • Asset growth restricted
    • Prior approval from the Fed for acquisitions and new lines of business
    • Any other action the Fed deems necessary

  2. Significantly Undercapitalized:

    • Required recapitalization or merger
    • Restrictions on transactions with affiliates
    • Asset growth restricted
    • Restrictions on activities deemed excessively risky
    • Management changes
    • Required divestitures
    • Restrictions on senior executive officers' compensation

  3. Critically Undercapitalized:

    • Bankruptcy petition required within 90 days of become critically undercapitalized
What I would do differently

More realistic PCA triggers. First, the prompt corrective action (PCA) regime. The reason I think the PCA regime is the key to TBTF policy is because it makes the new resolution authority for Tier 1 FHCs credible. Some commentators dismiss the resolution authority as a solution to TBTF because they say the market won't believe that the government will actually use it. They say the market will continue to believe that the government will opt for a bailout rather than the new resolution authority. In that case, the new resolution authority wouldn't do anything to fix the moral hazard that TBTF induces — the JPMorgans and Goldmans of the world would still be betting that the government will bail them out, and thus would still have an incentive to take excessive risks. Now, I think those commentators are wrong, and that the government would opt for the new resolution authority over a bailout, even without a PCA regime.

But a PCA regime comes as close as possible to guaranteeing that the government will actually use the new resolution authority. Lehman Brothers was essentially allowed to come careening into bankruptcy court — or, as one former Lehmanite put it to me, Lehman went down with "guns blazing." There was no mechanism to force Lehman to take specific steps to recapitalize itself in the months between Bear's failure and September 15th. All we had was Hank Paulson and Tim Geithner badgering Dick Fuld about raising capital or finding a buyer, which they apparently did, to no avail.

A PCA regime not only minimizes the chances that a Tier 1 FHC will actually fail, but it also prepares a failing Tier 1 FHC for an orderly resolution. Lehman was still transferring assets in between its various European and North American branches at a furious pace right up until its failure. As a result, a lot of hedge funds were very surprised to discover that their assets were not in segregated accounts, but in fact had been transferred to Lehman Brothers International (Europe) and then rehypothecated. This was a significant source of uncertainty in the days following Lehman's bankruptcy filing — it was Knightian uncertainty in action. A PCA regime would prevent this kind of thing from happening, as the Fed would have the authority to restrict transactions between affiliates once a Tier 1 FHC becomes significantly undercapitalized.

So what did the administration do wrong in its PCA proposal? I think the administration focuses too much on capital levels as the relevant measure of a Tier 1 FHC's health. The biggest problem with the PCA regime applicable to commercial banks is that too often commercial banks can go from "well capitalized" to insolvent without ever triggering the PCA requirements. This problem is even worse for Tier 1 FHCs. Lehman had a Tier 1 capital ratio of 11% as of August 31, 2008 — just two weeks before it filed for bankruptcy. Had Lehman been a commercial bank, it wouldn't have triggered the PCA requirements until it was far too late. The administration's proposal requires that the PCA triggers (which it calls "capital standards") include a risk-based capital requirement and a leverage ratio.

I would make the PCA triggers less focused on capital levels, and more focused on the conditions that make Tier 1 FHCs susceptible to modern-day bank runs. For example, I would make one of the PCA triggers contingent on the tenor of the Tier 1 FHC's overall liabilities. As of August 31, 2008, over half of Lehman's $211 billion tri-party repo book had a tenor of less than one week, which made it remarkably susceptible to a run in the repo markets — which, of course, is exactly what happened. Lehman was also relying on roughly $12 billion (at least) of collateral from its prime brokerage clients to fund its day-to-day operating business. These conditions had persisted for several quarters before Lehman's bankruptcy.

The Fed should be required to take prompt corrective action once a Tier 1 FHC allows the tenor of, say, 20% of its overall liabilities, or 50% of its daily funding requirements, to drop below one week. (I just pulled those numbers out of the air, for explanatory purposes; I'd have to get down in the data before I could say what the appropriate tenors should be.) These are the kinds of PCA triggers that would be the most effective. A PCA regime focused on capital levels is unlikely to make much of an impact.

New resolution regime automatically applicable to Tier 1 FHCs. I think the administration makes a big mistake by requiring a separate "systemic risk" determination in order to use the proposed resolution authority for Tier 1 FHCs. This introduces needless uncertainty. Remember, a financial company is a Tier 1 FHC, by definition, if "material financial distress at the company could pose a threat to global or United States financial stability or the global or United States economy during times of economic stress." An institution thus can't even be a Tier 1 FHC in the first place if it doesn't pose a systemic risk. Why require an additional, albeit slightly different, determination of "systemic risk" before the new resolution authority can be used? This will leave the market guessing as to which resolution regime — the Bankruptcy Code or the new resolution authority? — will be used to resolve a distressed Tier 1 FHC. Creditors, unsure which resolution regime will apply and thus how their claims will be treated, will be less likely extend credit at exactly the time we don't want creditors to be pulling back from a Tier 1 FHC.

I would make the new resolution regime automatically applicable to Tier 1 FHCs. By requiring a second "systemic risk" determination, the administration is essentially saying that there are Tier 1 FHCs that can be resolved in an orderly fashion under the Bankruptcy Code as it's currently written. You'd be hard-pressed to find any market participant who agrees with that statement (in fact, I don't believe Tim Geithner honestly believes that statement). I continue to be confused by the insistence on a second "systemic risk" determination.

Okay, that's all for now — I do, after all, have a day job. I hope this discussion can induce at least some commentators to move beyond simplistic (and completely unrealistic) "break up the banks"-style discussions of TBTF policy.

Friday, October 16, 2009

Citi and BofA

Paul Krugman is clearly confused. Regarding Citi and BofA, he writes:

Um, weren’t we being assured that recapitalization by the government — which would probably require temporary nationalization — was unnecessary, because the banks could earn their way back to adequate capital ratios? Just saying.
Um, what? Is Krugman really that unfamiliar with quarterly earnings reports? Citi's Tier 1 capital ratio is 12.7%. Citi's Tier 1 common ratio is 9.1%, up from 2.75% last quarter and 4.8% in Q3-2008. BofA's Tier 1 capital ratio is 12.46%. BofA's Tier 1 common ratio is 7.25%, up from 6.9% last quarter and 4.23% in Q3-2008. For frame of reference, JPMorgan's Tier 1 capital is 10.2%, and their Tier 1 common ratio is 8.2%. Just saying.

Thursday, October 15, 2009

House OTC Derivatives Bill Amendments

Markup of Barney Frank's OTC derivatives bill is now up. Manager's Amendment is here. Frank's exchange-trading amendment is here. Revised definition of "major swap participant" is here. Frank really sandbagged the dealers with his exchange-trading amendment. The dealers support a central clearing requirement for standardized swaps, but not an exchange-trading requirement (with at least some justification). Frank's discussion draft had only required central clearing, and then he surprised everyone on Wednesday with his amendment requiring exchange-trading. It was a politically savvy move if Frank was planning to require exchange-trading all along—don't give the dealers time build up opposition to the amendment and it's much more likely to pass. My sense is that Frank simply changed his mind at the last minute, for whatever reason. All eyes now turn to S. 1691. Senator Reed, the floor is yours.... (By the way, for all Rep. Alan Grayson's bluster, he introduced a total of zero amendments during markup. I guess he was too busy planning his next Youtube clip to do some actual legislating.)

Wednesday, October 14, 2009

R.I.P. Bruce Wasserstein

In addition to being a true investment banking legend, the Lazard CEO and former First Boston dealmaker also had my all-time favorite Wall Street nickname: "Bid 'em up Bruce." Bruce was only 61.

Tuesday, October 13, 2009

"At Times Skeptical Coverage"

This has to be the early front-runner for Euphemism of the Century, from the NYT:

Paul Rittenberg, who oversees ad sales for Fox, said the channel existed in a climate where viewers choose cable news channels based on affinity. His channel, he said, stresses in its pitch to advertisers that “people who watch Fox News believe it’s the home team.” To many Democrats, of course, the “home team” is conservative, a view only compounded by Fox’s at times skeptical coverage of Mr. Obama this year.
I'm looking forward to the NYT's story on the "slight hiccup in the U.S. economy."

Bank of America is waiving attorney-client privilege and will reveal the legal advice it received in the Merrill Lynch acquisition to federal and state officials. Per the WSJ:

[This] will likely result in the bank handing over troves of documents -- including emails and memos between BofA and its outside law firms -- to the federal, state and congressional officials who are investigating the Merrill purchase, according to people familiar with the matter. ... Bank executives, including Mr. Lewis, have said repeatedly that they followed the advice of lawyers in making decisions on what to disclose to shareholders and at the same time asserting the bank did nothing wrong.
BofA's lead outside counsel on the Merrill deal, Ed Herlihy of Wachtell, is a superb lawyer—a brand-name M&A lawyer, to be sure. But boy has he had a rough financial crisis. First Herlihy was JPMorgan's lead counsel on the Bear Stearns merger. The original merger agreement in that deal, of course, included the famously botched guarantee provision, which almost torpedoed the whole deal and forced JPMorgan to raise their offer from $2 to $10 per share. Then he led the team that advised the Treasury in structuring the Fannie/Freddie conservatorship, which has been criticized quite a bit in the markets. And now the BofA-Merrill deal. It turns out that the BofA-Merrill bonus case centers on the decision of the banks' law firms, Wachtell (for BofA) and Shearman & Sterling (for Merrill), on what to disclose to shareholders in the merger agreement and proxy statement, and what to include in the confidential disclosure schedule. (The merger agreement provided that Merrill wouldn't pay bonuses prior to the closing, except as set forth in the disclosure schedule; Merrill's $5.8bn bonus pool was included in the disclosure schedule. I agree with The Deal Professor that the SEC's argument is pretty weak. Like it or not, BofA likely did nothing wrong in this case.) I doubt Herlihy was personally involved in the bonus-disclosure decision, as broad negative covenants are standard in merger agreements, and disclosure schedules typically aren't prepared by senior M&A partners like Herlihy. And Herlihy has had some notable wins in the financial crisis too, such as the Morgan Stanley/Mitsubishi UFJ deal and Wells Fargo's acquisition of Wachovia. But still, BofA's disclosures are likely to include lots of communications between Herlihy and BofA directors, and much of it undoubtedly occurred under incredible time-pressure, which increases the odds that something embarrassing will be revealed exponentially. For my money, the most interesting disclosure would be Wachtell's advice to the BofA board in December that it had legal grounds to invoke the material adverse change (MAC) clause and walk away from the Merrill deal. Like the Am Law Daily says, it's about to get uncomfortable over at Wachtell, Lipton.

Sunday, October 11, 2009

Friendly Reminder

Now that OTC derivatives reform is back in the news, with all manner of hysterical claims about derivatives sure to follow, I just want to throw out this friendly reminder: Collateralized debt obligations (CDOs) are not derivatives. That is all.

I'm sorry, but how does William Cohan's House of Cards not even make the shortlist for the Financial Times/Goldman Sachs Business Book of the Year 2009 prize? With apologies to Liaquat Ahamed and David Wessel, Cohan's book was hands-down the best business/finance book published in the past year. It's really not even close. Cohan managed to write a detailed, definitive account of one of the most important events in modern financial history (the collapse of Bear Stearns), and he did it in just under a year. That should merit at least a spot on the shortlist. On a related note, I highly recommend Steven Davidoff's new book, Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion. It's terrific. I'll try to write more about the book later too, because I think it contains a couple of very interesting insights.