Economics of Contempt

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.

THE END

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.

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?)

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?"

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.

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.

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.)

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.

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.

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.

One of my colleagues recently sent me a new program called OfficeTab, which could be the greatest program ever created. It adds tabs (à la Firefox) to Microsoft Word, Excel, and PowerPoint! I constantly have 5+ Word and Excel documents open at once when I'm in work mode, so for someone like me, this is a godsend. Now all I need is a program that adds tabs to Adobe Reader (or Acrobat), and I'll be golden.

No one is better than our good friend Simon Johnson at being so smug and yet so completely, embarrassingly wrong. In a post titled, "A Short Question For Senior Officials Of The New York Fed," Johnson writes:

At the height of the financial panic last fall Goldman Sachs became a bank holding company, which enabled it to borrow directly from the Federal Reserve. It also became subject to supervision by the Federal Reserve Board (with the NY Fed on point) – hence the brouhaha over Steven Friedman’s shareholdings. Goldman is also currently engaged in private equity investments in nonfinancial firms around the world, as seen for example in its recent deal with Geely Automotive Holdings in China (People’s Daily; CNBC). US banks or bank holding companies would not generally be allowed to undertake such transactions - in fact, it is annoyed bankers who have asked me to take this up. Would someone from the NY Fed kindly explain the precise nature of the waiver that has been granted to Goldman so that it can operate in this fashion? If this is temporary, is it envisaged that Goldman will cease being a bank holding company, or that it will divest itself shortly of activities not usually allowed (and with good reason) by banks? Or will all bank holding companies be allowed to expand on the same basis. (The relevant rules appear to be here in general and here specifically; do tell me what I am missing.)

Answer: There is no waiver. There is no regulation that prohibits Goldman from engaging in this kind of transaction. Bank holding companies can elect financial holding company (FHC) status, which allows them to engage in a broad range of financial activities, including private equity investments in nonfinancial companies. Virtually every BHC has elected to become an FHC. Under 12 U.S.C. § 1843(k)(4)(H), FHCs are allowed to make "merchant banking investments" in nonfinancial companies, on a principal or agency basis, through affiliated private equity funds or other invesment funds. (Private equity affiliates are dealt with at length in 12 C.F.R. § 225.173.) Goldman carried out the investment in Greely Automotive Holdings through one of its private equity funds, GS Capital Partners VI Fund LP. I find it very difficult to believe that any serious bankers, no matter how "annoyed," wouldn't have known this. The FHC designation was what the whole Gramm-Leach-Bliley debate was about in the first place! Who in banking doesn't know this? I also find it difficult to believe that senior officials at the New York Fed waste their time answering questions that a first-year MBA would know. How many times does Simon Johnson have to demonstrate that he has absolutely no clue what he's talking about, and frequently makes things up, before everyone stops taking him seriously? He's like Ben Stein, but with the veneer of credibility.

Recently I was talking to someone about the mainstream press's coverage of last September's earth-shaking events, and that got me thinking about what the major newspapers were highlighting on their front pages. I thought it would be interesting to see, with the benefit of hindsight, what they were highlighting and how important they thought it was. So here are the front pages (above the fold) of the Wall Street Journal, New York Times, and Washington Post on various days in the financial crisis. I couldn't find PDFs of the Financial Times from last September, which is unfortunate (although FT employees should feel free to help me out on that front!). I also included the full front page of the USA Today from September 15, 2008—the day after Lehman filed for bankruptcy—because it's just too damn funny.

Aside from the USA Today's September 15 debacle, I particularly enjoyed the NYT's front page from Thursday, September 18th. That Wednesday was probably the most terrifying day of the financial crisis—there was a massive run on money market funds, WaMu put itself up for sale, 3-month T-bills went to zero, Libor-OIS spiked up dramatically. And yet the second-largest headline on the NYT's front page the next day is: "McCain Seen as Less Likely to Bring Change, Poll Finds." Classic. Something also tells me the Washington Post wishes it hadn't dedicated the second-biggest headline on September 15th to....the Redskins game.

I'll leave the more substantive critiques to the journalists though.

Monday, September 15, 2008 — Lehman files for bankruptcy. Some other stuff happens too.

Thursday, September 18, 2008 — A massive run on money market funds is underway after the Reserve Primary Fund “broke the buck,” WaMu puts itself up for sale in a Hail Mary play, 3-month T-bills go to zero, the Libor-OIS spread spikes up 300 bps. One of the scariest days of the crisis, without question.










Friday, September 19, 2008 — Plans for a system-wide rescue are leaked. (Thanks, Senator Schumer!)










September 25, 2008 — Politicians and political pundits thrust themselves into the financial crisis. Idiocy ensues.










September 30, 2008 — The day after the House stunned the world by voting down the first TARP.










October 2, 2008 — TARP finally passes.










October 14, 2008 — The first TARP equity injections are announced.

Offering memorandum here. (Summary starts ~20 pages down.) Press release here. I haven't had time to look at it yet, but it had better be damn good. Getting enough CIT bondholders to tender is gonna be like trying to thread a needle with a rope. Exchange offer expires on October 29th. Start the clock.