Economics of Contempt

Washington Post reporters by Binyamin Appelbaum and Neil Irwin have a very strange article about the Fed's emergency powers. Well, I guess it's not so much strange as it is completely wrong. They write:

On the day before Thanksgiving in 1991, the U.S. Senate voted to vastly expand the emergency powers of the Federal Reserve. Almost no one noticed. The critical language was contained in a single, somewhat inscrutable sentence, and the only public explanation was offered during a final debate that began with a reminder that senators had airplanes to catch. Yet, in removing a long-standing prohibition on loans that supported financial speculation, the provision effectively allowed the Fed for the first time to lend money to Wall Street during a crisis. That authority, which sat unused for more than 16 years, now provides the legal basis for the Fed's unprecedented efforts to rescue the financial system.

This is just plain wrong. The provision in question is the now-infamous Section 13(3) of the Federal Reserve Act, which authorizes the Fed to lend to non-depository institutions (e.g., investment banks, insurers) in "unusual and exigent circumstances." Section 13(3) was enacted in 1932, and the Fed has had this emergency authority ever since. The 1991 law that Appelbaum and Irwin claim "vastly expand[ed] the emergency powers of the Federal Reserve" was the Federal Deposit Insurance Corporation Improvement Act (FDICIA). But the FDICIA only made one relatively minor, technical change to the Fed's emergency authority, having to do with the "kinds and maturities" of loans the Fed can extend to non-depository institutions in emergencies. The FDICIA didn't address whether the Fed has the authority to "lend money to Wall Street during a crisis," because the Fed already had that authority. I know virtually nothing about how major newspapers operate, but I honestly don't understand how an article like this can get past the paper's editors.

Tomorrow's Washington Post contains a big profile of former CFTC chair Brooksley Born. The Post dubs her "the Cassandra of the credit crisis" because of her infamous showdown with Alan Greenspan and Bob Rubin over the OTC derivatives markets in 1998. So was she, in fact, the Cassandra of the credit crisis? Yes and no. My answer is partly "no" for the same reason I thought back in 1998 that the reaction of the industry and (especially) the other regulators was appalling: there was, and still is, a widespread misunderstanding of Born's actions. The conventional wisdom is that Born proposed regulations for OTC derivatives, and was quickly smacked down by the market-worshipping Greenspan and Rubin. That's only half right. It's true that Greenspan and Rubin quickly and publicly smacked Born down, but she never proposed any regulations on OTC derivatives. Born issued a "concept release," which merely asked questions about the OTC derivatives markets. The concept release didn't propose even one regulation, and actually went to great lengths to emphasize that it wasn't proposing any regulations. Despite this, Robert Kuttner recently wrote that "Born distributed for comment a proposed regulation that would have required greater supervision of these so called over-the-counter derivatives." Alan Blinder even went so far as to suggest that he disagreed with Born's non-existent regulatory proposal, writing in his NYT column that "while [Born's] specific plan may not have been ideal, does anyone doubt that the financial turmoil would have been less severe if derivatives trading had acquired a zookeeper a decade ago?" The concept release essentially asked the financial industry for its analysis of the costs/benefits of a broad range of regulatory approaches to OTC derivatives. For some reason, the entire financial industry flipped out. Just look at how much the concept release bent over backwards to emphasize that it was purely informational, and should not be interpreted as a regulatory proposal:

The Commission urges commenters to analyze the benefits and burdens of any potential regulatory modifications in light of current market realities. The Commission has no preconceived result in mind. The Commission is open both to evidence in support of easing current restrictions and evidence indicating a need for additional safeguards. The Commission also welcomes comment on the extent to which certain matters are being or can be adequately addressed through self-regulation, either alone or in conjunction with some level of government oversight, or through the regulatory efforts of other government agencies.

Sound the alarms! Seriously though, we had clients calling the firm all week long flipping out about the concept release—which they usually referred to as "the new OTC derivatives regulations." They were allegedly concerned about the legal status of existing OTC derivatives, even though the concept release clearly stated that any new regulations would be "applied prospectively only," and that:

This release in no way alters the current status of any instrument or transaction under the Commodity Exchange Act. All currently applicable exemptions, interpretations, and policy statements issued by the Commission regarding OTC derivatives products remain in effect, and market participants may continue to rely upon them.

The way that Greenspan, Rubin, Arthur Levitt, and Larry Summers treated Born was particularly appalling. As regulators, they should have immediately realized how benign and non-threatening Born's concept release was. And even if they had substantive disagreements with her, they should never have aired those disagreements in public. The whole thing reeked of sexism. The reason Born was partly the "Cassandra of the credit crisis" is that she warned about exactly the situation the Fed and Treasury found themselves in with AIG. Born's major concern was that regulators had no information about the enormous OTC derivatives markets, and so it was possible that regulators wouldn't be able to see a financial crisis coming. (As chairman of the Fed, which is charged with protecting the "safety and soundness" of the system, Greenspan should have been thanking Born for doing his job for him.) The Fed was caught completely off-guard by AIG's collapse, and, consequently, they literally had less than 24 hours to decide whether to bail AIG out. So it's indisputable that Born was right. I don't think it's completely accurate to say, "if we had listened to Born in 1998, we wouldn't be in this mess," because—and I think Born would agree about this—she never actually proposed any regulations that would have prevented any of the actions that contributed to the crisis. Her whole point was that regulators didn't know anything about the OTC derivatives markets. If Born had been given full access to information on the OTC derivatives markets, there's no guarantee that she, or any other regulator who had access to the information, would have made the right regulatory decisions. On the other hand, she clearly demonstrated an ability to think about systemic risks and possible preventative steps, so it's not totally crazy to think that she would have seen the crisis coming and taken appropriate action. Whatever one thinks about Born's actions in 1998, her refusal to say "I told you so," or to even comment on the record about the 1998 episode, demonstrates a grace rarely seen in modern politics.

One of the headlines on Bloomberg's front page is, "Geithner Adopts Part of Goldman, JPMorgan Plan for Trading in Derivatives" (when you click through to the article, the headline is "Geithner Adopts Part of Wall Street Derivatives Plan"). Bloomberg reporter Matthew Leising got his hands on a plan for regulating OTC derivatives that Goldman, JPMorgan, Credit Suisse, and Barclays sent to Treasury a few months ago. Leising contends that Treasury's proposal for regulating OTC derivatives "contains recommendations similar to those made by" the banks. The clear implication is that Treasury has bowed to pressure from the Wall Street banks, and has adopted a very bank-friendly plan. But, bizarrely, Leising can only point to one alleged similarity between the banks' proposal and Treasury's proposal—and that similarity turns out to be illusory. What's more, Treasury's proposal differs from the banks' proposal on several key issues, as Leising himself reports. First, here's the alleged similarity between the two proposals:

"All OTC dealers and other firms who create large exposures to counterparties should be subject to a robust regime of prudential supervision and regulation," [Treasury's] proposal said. These included "conservative capital requirements," "reporting requirements," and "initial margin requirements." The bank-written plan, dated Feb. 13, said the systemic regulator "shall promulgate rules" requiring "capital adequacy," "regulatory and market transparency" and "counterparty collateral requirements."

It's very clear that Treasury didn't actually give the banks what they wanted here. The banks' proposal called for all participants in the OTC derivatives markets—and not just the dealers—to be subject to capital and margin requirements. Essentially, the banks are saying that if they're going to be subject to strict capital and margin requirements for OTC derivatives, then everyone else in the OTC derivatives markets should be subject to those requirements too. By contrast, under Treasury's proposal, the "conservative" capital and margin requirements would only apply to the dealers and "other firms who create large exposures to counterparties." In other words, non-dealers who don't create large exposures to counterparties wouldn't be subject to the enhanced capital and margin requirements. (This is why one of the most important issues is how Treasury plans to define "firms who create large exposures to counterparties," which I'll address in another post.) Amazingly, this non-issue is the entire basis for the headline, "Geithner Adopts Part of Goldman, JPMorgan Plan for Trading in Derivatives." Leising literally doesn't identify any other similarities between Treasury's proposal and the banks' proposal. In fact, Leising himself admits near the end of the article that "Geithner’s plan goes further in many aspects than what the banks laid out in their draft." For instance, the banks' proposal doesn't require central clearing for any OTC derivative, while Treasury's proposal requires central clearing for all standardized OTC derivatives, and "encourages" the use of exchanges for standardized instruments. Also, the banks propose giving the Fed sole authority over the OTC derivatives markets, while Treasury declines to weigh in on which agency should regulate OTC derivatives. Finally, the banks propose that reporting requirements on trade data should be made to regulators only "upon request." Under Treasury's proposal, all bespoke OTC derivatives would have to be reported to a regulated trade repository, and all such trade repositories, as well as the central counterparties clearing standardized OTC derivatives, would be required to "make data on individual counterparty’s trades and positions available to federal regulators." To sum up: 1. The only aspect of Treasury's OTC derivatives proposal that the Bloomberg article claims was lifted from the Wall Street banks' proposal is, in reality, materially different from the banks' proposal. 2. Treasury's proposal is much more stringent than the banks' proposal on key issues, such as: (a) mandatory clearing for standardized instruments; and (b) full disclosure to federal regulators of individual trades and positions in both standardized and bespoke instruments. So to answer the question in the title of my post: No, Treasury didn't adopt part of Wall Street's OTC derivatives plan.

The SEC may be going down (good riddance), but apparently not without a fight:

The Obama administration may call for stripping the Securities and Exchange Commission of some of its powers under a regulatory reorganization that could be unveiled as soon as next week, people familiar with the matter said. The proposal, still being drafted, is likely to give the Federal Reserve more authority to supervise financial firms deemed too big to fail. The Fed may inherit some SEC functions, with others going to other agencies, the people said. On the table: giving oversight of mutual funds to a bank regulator or a new agency to police consumer-finance products, two people said. ... SEC Chairman Mary Schapiro’s agency has been mostly absent from negotiations within the administration on the regulatory overhaul, and she has expressed frustration about not being consulted, according to people who have spoken with her. She has pledged to fight any attempt to diminish the SEC, they said.

Stay classy, Mary.

So sayeth the Fed:

The Federal Reserve Board on Tuesday announced that, starting in July, certain high-quality commercial mortgage-backed securities issued before January 1, 2009 (legacy CMBS) will become eligible collateral under the Term Asset-Backed Securities Loan Facility (TALF). ... The CMBS market, which has financed approximately 20 percent of outstanding commercial mortgages, including mortgages on offices and multi-family residential, retail and industrial properties, came to a standstill in mid-2008. The extension of eligible TALF collateral to include legacy CMBS is intended to promote price discovery and liquidity for legacy CMBS. The resulting improvement in legacy CMBS markets should facilitate the issuance of newly issued CMBS, thereby helping borrowers finance new purchases of commercial properties or refinance existing commercial mortgages on better terms.

New term sheet for legacy CMBS is here; FAQs for legacy CMBS is here. Here are the salient terms (on first glance): 1. AAA rating from at least two eligible rating agencies. Eligible rating agencies are Moody’s, S&P, Fitch, DBRS, and Realpoint. 2. Eligible CMBS must have been in the senior tranche at issuance (e.g., A-1 and A-2 classes are both "senior"). 3. Haircuts: Base haircut of 15% for CMBS with an average life of five years or less. "For CMBS with average lives beyond five years, base dollar haircuts will increase by one percentage point of par for each additional year of average life beyond five years." 4. Maturity of TALF loans: Either 3 or 5 years, at the borrower's option. 5. Cost of funds: 3-year Libor swap rate +100bps (for 3-year TALF loans); 5-year Libor swap rate +100bps (for 5-year TALF loans). 6. Fed discretion: The Fed has a lot of discretion in determining whether to reject a legacy CMBS, based on factors such as historical losses, special servicing rights, and diversification of underlying collateral pool. Here we go...

The new MacroShares Major Metro Housing Trusts will start trading soon, and I'm interested to see how they do. The trusts were created by Yale economist Robert Shiller's company, MarcoMarkets LLC. Two trusts will be issued—the Major Metro Housing Up Trust (fact sheet here) and the Major Metro Housing Down Trust (fact sheet here). The trusts are designed to deliver 3 times the percentage change in the S&P/Case-Shiller Composite-10 Home Price Index over a specific period of time—in this case, over the period ending on November 25, 2014. The trusts are designed to measure the market's expectation of where housing prices will be five years from now. The trusts are not ETFs, and they're not designed to track their NAVs on a day-to-day basis. Instead, the trusts should trade based on where investors think the Case-Shiller Composite-10 index will be on November 25, 2014. This article from IndexUniverse offers the clearest explanation of how the trusts will work that I've seen:

The new MacroShares Major Metro Housing Up (ticker: UMM) and Major Metro Housing Down (ticker: DMM) ETPs are designed to deliver 300% and -300% of the return of the leading national home price index, the S&P/Case-Shiller 10-City Composite Home Price Index, over a specific period of time. The last part of that sentence is critical. Most ETFs are designed to track the performance of an index on a daily basis. The S&P 500 SPDR (NYSEArca: SPY), for instance, is designed to track the S&P 500's return today, tomorrow and forever. The fund does that by holding all of the securities in the index. Arbitrage mechanisms exist to ensure that SPY stays close in value to the S&P 500 on a minute-by-minute basis. UMM and DMM are different. For one, they don't hold "housing." All they hold is Treasuries. They deliver the return of the Case-Shiller index because they are contractually obligated to shift those Treasuries back and forth between the two funds based on the direction of the index: If the index goes up, Treasuries go from DMM to UMM; if it goes down, the opposite happens. [EC: Technically this isn't true: no assets are shifted between the trusts until maturity. The trusts enter into repo agreements that allow their underlying values to track the monthly changes in the index, and quarterly distributions are based on each trust's "underlying value."] This unique structure—often called a "teeter-totter"—is what lets MacroShares track nontypical financial metrics like "house prices." Theoretically, they could be tied to anything. The Importance Of The Time Horizon The key thing to understand about UMM and DMM is that they are designed to "expire" on Nov. 25, 2014. At that point, investors will receive a payment based on 300% of the change in the S&P Case-Shiller index over the intervening time period. To be more specific, both UMM and DMM start with a net asset value of $25/share. That NAV is linked to the level of the Case-Shiller index as of Dec. 31, 2008. On Nov. 25, 2014, investors will be paid based on 300% of the change in the index from Dec. 31, 2008 through Aug. 31, 2014. (The end payout will be based on the August 2014 reading because the index is published with a two-month lag.) Where should UMM and DMM trade between now and November 2014? Simple: They should trade based on where investors expect the index to be on Aug. 31, 2014. It's really that simple. It's like a futures contract: Everything that happens between now and expiration is mostly irrelevant.

The prospectuses are available here. The WSJ also ran a nice piece on the trusts a couple weeks ago. Ultimately, I'm not sure the Major Metro Housing Trusts will be successful—they seem like too much of a niche bet to draw enough interest. But it's certainly an interesting idea.

The BIS released its much-anticipated semiannual report on OTC derivatives today. It measures notional amounts and gross market values outstanding of OTC derivatives as of December 31, 2008. For the credit default swap (CDS) market, the gross market value—which measures "the cost of replacing all existing contracts and [is] thus a better measure of market risk than notional amounts outstanding—is $5.7 trillion. The total notional CDS outstanding fell to $41.9 trillion. The gross market value of single-name CDS is $3.7 trillion, and the total notional single-name CDS outstanding is $25.7 trillion. The gross market value of multi-name CDS is $1.96 trillion, and the total notional multi-name CDS outstanding is $16.1 trillion. Read the whole report.

I love the logic of the anti-CDS crowd. First, they claimed CDS were evil because protection buyers weren't required to own the underlying bond—they were mostly used for pure "speculation" rather than hedging. The anti-CDS crowd frequently cited Eric Dinallo's claim that 80% of CDS are held by investors who don't own the underlying bond ("naked CDS") as proof that CDS are evil. Now that it's fashionable to blame CDS for pushing companies into bankruptcy, they look at the net notional CDS outstanding on a company attempting a restructuring, and assume that 100% of them are held by bondholders. What happened to all the anger about naked CDS? If the problem is that you can buy CDS without owning the bond being protected (gambling vs. legitimate hedging), then CDS should be a non-factor in restructurings. After all, aren't 80% of CDS held by investors who don't own the underlying bond? And wasn't that supposedly the problem in the first place? You can't have it both ways.

The video of Rep. Alan Grayson grilling the Inspector General of the Fed Board of Governors, Elizabeth Coleman, has been making the rounds. Grayson says that there's a Bloomberg article which says that the Fed has entered into $9 trillion of off-balance sheet transactions, and asks Coleman if she has investigated those transactions at all. After Coleman fumbles around for a while, she essentially says no. Grayson makes himself look good in this video, especially because Coleman's performance is so bad, but this is grandstanding of the highest order. First of all, the Bloomberg article never said that the Fed has entered into $9 trillion of off-balance sheet transactions. This is the article he was talking about, and the phrase "off-balance sheet" doesn't appear once. And the $9.7 trillion number refers to all money spent, lent, or guaranteed during the financial crisis by the Fed, Treasury, and FDIC. It's also very misleading, because lending $1 billion isn't the same as guaranteeing $1 billion in assets, and $5.7 trillion of that $9.7 trillion is in the form of guarantees. Second, Coleman is the IG of the Board of Governors of the Federal Reserve, not the Reserve Banks. The Fed's various lending facilities are handled by the New York Fed, and Coleman has no authority to audit the New York Fed or any of the other regional Reserve Banks. All the regional Reserve Banks have auditors, and they're all subject to regular external audits as well. Until a few years ago, the Board of Governors conducted examinations of the Reserve Banks in lieu of external audits. But some people thought that was too insular (and I completely agree), so the Board of Governors' examinations were replaced by external audits. Ironically, if there hadn't been concerns about the independence of the Board of Governors' examinations of the Reserve Banks, Coleman might have been able to answer Grayson's questions.

Serial bloviator Simon Johnson writes:

In most countries, the course of action would be clear. The government would take over banks, remove “bad assets” from their balance sheets, inject fresh capital, and put them bank into the private sector. This is essentially what the FDIC does when it takes over a bank. There is some debate about whether the government currently has the power to do this for bank holding companies – Tim Geithner says no, Thomas Hoenig says yes – but if not, this is certainly something the Obama administration could press for.

Let's try this one more time: The government does not have the authority to seize a bank holding company and place it into receivership (or conservatorship). There is no debate about this. Johnson clearly doesn't understand Hoenig's argument, because he was very clear on this point. Hoenig wrote:

One of the difficulties with all of these options is that while there are time-tested, fast resolution processes in place for depository institutions, today's largest financial institutions are conglomerate financial holding companies with many financial subsidiaries that are not banks. The bank subsidiaries could be placed into FDIC receivership, but the only other option under current law for the holding company and other subsidiaries is a bankruptcy process.

Even an MIT professor should be able to understand that.

A group of dissident Chrysler bondholders opposing the Obama administration's restructuring plan—which refers to itself as the Chrysler Non-TARP Lenders—disclosed this interesting fact in a court filing yesterday:

4. None of the Chrysler Non-TARP Lenders hold any credit default swaps or hedges with respect to their holdings of Senior Debt.

There are 9 funds in the group, holding a combined $295 million of senior Chrysler debt. So of the 20 holdout Chrysler creditors, we now know that roughly half of them owned no CDS on Chrysler. Ryan Grim of the Huffington Post wrote a ridiculous article on Tuesday claiming that the holdout creditors may have pushed Chrysler into bankruptcy in order to collect payouts on CDS positions. Grim—evidently unaware that AIG almost never wrote CDS on individual companies—also claimed that the holdout creditors' CDS "were likely mostly issued by AIG." If you're ever arguing with someone about the financial crisis, and it seems like you're arguing about completely different crises, articles like this are the reason why.

Like Glenn Greenwald, I'm puzzled by the attacks on Judge Sonia Sotomayor's intellectual abilities in Jeffrey Rosen's TNR profile. I've appeared in front of Judge Sotomayor twice (admittedly many years ago) and I've practiced in her jurisdiction for many years, and "not that bright" is the last way I would describe her. No lawyer agrees with every opinion a judge writes, and I haven't always agreed with Judge Sotomayor, but the idea that she's "not the brainiest of people" has honestly never entered my mind. She's very bright, and she definitely has the intellectual firepower to sit on the Supreme Court. Questioning a federal circuit judge's "command of technical legal details" is frankly insulting, and I find it hard to believe that those criticisms weren't personal. Very bizarre.

So reports the Wall Street Journal:

Regulators have told Bank of America Corp. that the company needs to take steps to address a roughly $35 billion capital shortfall based on results of the government's stress tests, according to people familiar with the situation. The exact amount of the needed infusion couldn't be determined late Tuesday, and Bank of America officials either declined to comment or couldn't be reached. Regulators began notifying the 19 financial companies subjected to the government tests of the results Tuesday. ... At Bank of America, the government's findings are likely to set off a scramble over how to fill the capital hole at the nation's largest bank in assets. The Charlotte, N.C., bank already has received $45 billion in capital from the federal government, some of it to help the bank cover losses stemming from its purchase of securities firm Merrill Lynch & Co. in January. The amount of capital now needed by Bank of America could exceed what the bank can raise by selling assets or more shares to the public. As a result, the bank may have no choice but to convert the government's preferred shares into common stock.

This isn't too terribly surprising. I think one of the biggest takeaways from the stress test results will be that BofA is in a lot worse shape than any other major U.S. bank, Citi included.

It's amusing that Nouriel Roubini and Matthew Richardson dismiss the (leaked) forecasts in the stress test as not credible because they're not as dire as forecasts from the IMF and Roubini's RGE Monitor. Treasury and the Fed had access to more information about banks' balance sheets in conducting the stress tests than the IMF or RGE Monitor could ever dream of. If the stress test estimates that U.S. banks will suffer lower losses on loans and securities than the IMF or RGE Monitor estimates, then it's far more likely that the IMF and RGE Monitor's estimates are too high, seeing as Treasury and the Fed were working with vastly superior information.

Gary Stern and Ron Feldman, Minneapolis Fed President and Senior Vice President, respectively, are without question the leading experts on the "too big to fail" (TBTF) issue. In 2004, they published an excellent book called, Too Big to Fail: The Hazards of Bank Bailouts. TBTF is an issue they've been thinking and writing about for many, many years. I've argued that the "too big to fail, too big to exist" idea is ridiculous, and is "the kind of thing people say at cocktail parties to make themselves sound smart without having to do any serious work." People who think the solution to the TBTF problem is to cap bank size fundamentally misunderstand the nature of TBTF. Stern and Feldman recently addressed this proposed solution, which they call the "make them smaller" movement. And they agree that it's only satisfying on a very superficial level:

These dynamics of firm risk-taking mean that the make-them-smaller reform offers protection with a Maginot line flavor. That is, it appears sensible and effective—even impregnable—but in fact it provides only a false sense of security that may lull policymakers into inaction on other fronts.

They make many of the same points I made, such as the disconnect between bank size and systematic importance, and the limiting effect such a hard cap would have on FDIC resolution policy. Here's Stern and Feldman on bank size as an inappropriate metric:

[S]uch a metric [asset size] will not likely capture some or perhaps many firms that pose systemic risk. Some firms that pose systemic risk are very large as measured by asset size, but others—Northern Rock and Bear Stearns, for example—are not. Other small firms that perform critical payment processing pose significant systemic risk, but would not be identified with a simple size metric. We believe that a government or public agent with substantial private information could identify firms likely to impose systemic risk, but only by looking across many metrics and making judgment calls. Policymakers cannot easily capture such underlying analytics in a simple metric used to break up the firms.

On the difficulty of maintaining a hard cap on bank size:

The dynamic challenge concerns both the ability of government to keep firms below the size threshold over time and the future decisions of firms that could increase the systemic risk they pose. On the first point, we anticipate that policymakers would face tremendous pressure to allow firms to grow large again after their initial breakup. The pressure might come because of the limited ability to resolve relatively large financial institution failures without selling their assets to other relatively large financial firms and thereby enlarging the latter. We would also anticipate firms’ stakeholders, who could gain from bailouts due to TBTF status, putting substantial pressure on government toward reconstitution. These stakeholders will likely point to the economic benefits of larger size, and those arguments have some heft. Current academic research finds potential scale benefits in all bank size groups, including the very largest.³ (Indeed, policymakers will have to consider the loss of scale benefits when they determine the net benefits of breaking up firms in the first place.) ... Even if policymakers could get the initial list of firms right and were able to keep the post-breakup firms small, this reform does nothing to prevent firms from engaging in behavior in the future that increases potential for spillovers and systemic risk. Newly shrunken firms could, for example, shift their portfolios to assets that suffer catastrophic losses when economic conditions fall off dramatically. As a result, creditors (including other financial firms) of the "small" firms could suffer significant enough losses to raise questions about their own solvency precisely when policymakers are worried about the state of the economy. Moreover, funding markets might question the solvency of other financial firms as a result of such an implosion. Such spillovers prompted after-the-fact protection of financial institution creditors in the current crisis, and we believe they would do so again, all else equal. One might call on supervision and regulation to address such high-risk bets. But the rationale for the make-them-smaller reform seems dubious in the first place if such oversight were thought to work.

Stern and Feldman's longtime proposal for solving the TBTF problem is to set up a credible insolvency regime for systematically significant banks and nonbank financial institutions, funded by insurance premiums that account for firms' spillover costs.

Ezra Klein says that Kansas City Fed President Thomas Hoenig "can't be dismissed as an idealist unaware of the government's workings or an armchair observer with an insufficient grasp of the complexity of the American banking system."

So what should we make of his claim that "In recent weeks, I have outlined a resolution framework for how we deal with the large, systemically important institutions at the center of this crisis in the United States"? It's tough to say.

"Nationalization" clearly means different things to different people. Most nationalization advocates seem to want to place the major financial institutions (e.g., Citigroup, BofA) in an FDIC-style receivership (or conservatorship). They want to treat the major bank holding companies, which currently aren't subject to the FDIC's insolvency regime, like FDIC-insured banks.

The key is that in receivership, the receiver has the authority to impose haircuts on creditors. Outside of receivership, conservatorship, or bankruptcy, there is no legal mechanism for unilaterally imposing losses on creditors of bank holding companies. This legal authority is the key issue in the nationalization debate. So when Hoenig said that he has "outlined a resolution framework for how we deal with the large, systemically important institutions at the center of this crisis," I expected that his plan would deal with this issue.

But here's the thing: Hoenig glosses over this issue, acknowledging how difficult it is and then moving on. From Hoenig's written statement outlining his argument:

The most difficult part of resolving these large firms without a new resolution process is how to make creditors bear the cost of their positions. Ideally, when a firm fails, all existing obligations would be addressed and dealt with according to the covenants and contractual priorities set up for each type of debt. Insured creditors would have immediate access to their funds, while other creditors would have immediate access to maturing funds with the potential for haircuts, depending on expected recoveries, any collateral protection and likely market impact. However, this is difficult because it would require negotiating with groups of creditors, unless there's a process that allows regulatory authorities to declare a nonbank financial firm insolvent.

Hoenig's argument is that we already have a framework for resolving systematically important nonbank financial firms (i.e., bank holding companies) without the new resolution authority that Treasury has proposed. But what good is a resolution framework without the key legal authority given to receivers and bankruptcy courts in the other resolution frameworks? Without a way to place bank holding companies into receivership or conservatorship, I fail to see how Hoenig's proposal is a workable solution.

I'm also unconvinced by Hoenig's argument regarding the government's ability to resolve extremely complex institutions, for which he cites the resolution of Continental Illinois:

At the time of its failure, Continental Illinois had $40 billion in assets and was the nation's largest commercial and industrial lender. It was the seventh-largest bank in the United States. It had 57 offices in 14 states and 29 foreign countries, a large network of domestic and international relationships, and a separate function for making residential and commercial real estate loans.

Citigroup has over $1.9 trillion in assets, which makes it almost 50 times bigger than Continental Illinois by assets. Citigroup also has 2,070 principal subsidiaries, and roughly 12,000 offices in all 50 states and 107 foreign countries. And it took the government 7 years to fully reprivatize Continental Illinois—hardly the model of a successful nationalization.

UPDATE: Ryan Avent is also unimpressed with Hoenig's plan (or lack thereof).

The much-anticipated auction of Whistlejacket's $6bn portfolio of so-called "toxic assets" went very well, fetching an average price of 67 cents on the dollar. Whistlejacket was a large structured investment vehicle (SIV) that failed in February 2008 when its sponsor, Standard Charter, stopped providing liquidity. Whistlejacket's portfolio included CDOs backed by mortgage bonds, CLOs, consumer ABS—pretty much a who's who of "toxic assets." The auction included well over $500 million of CDOs that were issued in 2006-2007. Even the CLOs, which are structured products backed by leveraged loans, went for an average price of 70 cents on the dollar. This was easily the biggest secondary-market sale of toxic assets in the past year, and probably the biggest since mid-2007, so the market was watching the auction very closely, looking for some guidance on pricing for toxic assets. The 33% discount price was much better than most people were anticipating. Overall, I'd say the auction lends support to Treasury's argument that a lack of liquidity is artificially depressing the prices of toxic assets. Chalk one up for Tim Geithner.

MBIA is suing Merrill Lynch over four CDS written on super-senior CDO tranches. MBIA is alleging, inter alia, fraudulent inducement and breach of contract, and is seeking rescission of the CDS contracts as well as compensatory and punitive damages. MBIA has retained Quinn Emanuel, a prominent litigation firm. I assume Merrill will retain Skadden Arps, its usual outside counsel. Now, in suits over complex financial contracts where the defendant is a major investment bank, usually the investment bank's lawyers have considerably more experience with the contracts at issue than the plaintiff's lawyers. The major Wall Street law firms have the advantage of having experienced capital markets lawyers available to help out their litigation departments. Quinn Emanuel is no slouch, but they specialize in litigation, not transactional work. However, Quinn Emanuel recently announced that it was hiring derivatives and structured finance expert Dan Cunningham, currently an Allen & Overy partner, and before that a longtime partner at Cravath. Cunningham is one of the world's leading experts on CDS and CDO contracts (seeing as he was one of the primary authors of the standard ISDA contracts). Quinn Emanuel lost in court against Merrill last time—the case was Merrill Lynch v. XL Capital—but when Cunningham joins the firm, they'll be able to throw some serious heat in these suits.