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.