Title II of Dodd-Frank creates a new resolution authority, called the Orderly Liquidation Authority (OLA), for systemically important financial institutions — which, crucially, includes financial holding companies (all the major US banks are organized as FHCs now). The OLA is patterned on the Federal Deposit Insurance Act, which lays out the FDIC resolution authority for commercial banks. The OLA, like the FDIC resolution authority, gives the FDIC a range of tools to liquidate a large nonbank financial institution while also mitigating systemic risk. No one is arguing that commercial banks that are seized and resolved by the FDIC are being “bailed out,” because they’re not — that’s why we call them “failed banks.” The FDIC resolution authority is just an alternative insolvency regime; but, obviously, it’s still an insolvency regime. So presumably, the people who say that “Dodd-Frank did nothing to end TBTF!” are arguing that a large FHC would not be resolved through the OLA.

The real question, then, is:

If a large financial holding company were on the brink of failing, would regulators resolve the FHC through the OLA?
I think it’s almost certain that regulators would, in fact, resolve a large FHC through the OLA, because it would work.


As I noted in my previous post, one of the main reasons that Lehman’s failure was such a catastrophic event for the markets was Lehman’s complete and total lack of preparation for a bankruptcy filing. Any serious analysis of Dodd-Frank’s resolution authority therefore has to recognize that Dodd-Frank also requires any financial institution subject to the new resolution authority to regularly submit a “resolution plan” (a.k.a. “living will,” or “funeral plan”) to regulators. I’ve slowly become a big fan of the resolution plan. I was never against it, and it still won’t do what its original proponents intended it to do, but it will perform an absolutely vital function: ensuring that the banks keep all the information/data necessary to execute an orderly resolution readily available. Significantly, § 165(d) of Dodd-Frank requires that resolution plans include:
(B) full descriptions of the ownership structure, assets, liabilities, and contractual obligations of the company;

(C) identification of the cross-guarantees tied to different securities, identification of major counterparties, and a process for determining to whom the collateral of the company is pledged; and

(D) any other information that the Board of Governors and the Corporation jointly require by rule or order.
This is hugely important. The absence of this information made everything about Lehman’s bankruptcy significantly worse, as I discussed previously. In addition to the information in (B) and (C) above, the Fed and FDIC should require that the resolution plan describe the terms and conditions that a potential acquirer of the bank’s primary entities would have to be prepared to agree to (i.e., if you buy X, you’d also be legally obligated to assume the obligations of Y). They should also require the resolution plan to include a comprehensive index of customer accounts, and important documents such as clearing agreements and Global Master Repurchase Agreements with major counterparties. All of this is eminently doable, I promise you, and it’s something the banks should have on hand anyway, just as a matter of good business practices. (I know for a fact that at least some banks would be able to pull most of this information together in a single weekend.)

The process prescribed by Dodd-Frank for submitting resolution plans also gives the FDIC an opportunity to identify legal structures and processes that would cause serious problems in a resolution (like, for instance, Lehman’s now-infamous “RASCALS” process). Not only that, but the statute actually gives the Fed and FDIC the authority to do something about problem issues preemptively, which is huge.

In short, the presence of a resolution plan will make the decision to resolve a large FHC under the OLA significantly less daunting.


Now we get to the actual resolution. What would the resolution of a large financial holding company look like under the OLA? First, the FDIC would be appointed as receiver of the holding company, all its US primary entities (except for any insurance companies, which are still resolved by the states), and all its US booking entities. Technically, the FDIC would be appointed as receiver of the US commercial bank under the Federal Deposit Insurance Act rather than the OLA, but this is a distinction without a difference for our purposes, as the statutes are substantially similar. As receiver, the FDIC would succeed to all the rights, titles, powers, and privileges of these companies and their assets — in other words, the FDIC would be in complete control.

The FDIC resolves the vast majority of failed commercial banks through what’s known as “purchase and assumption” agreements (called “P&As”), in which a healthy bank purchases some or all of the assets of a failed bank and assumes some or all of the liabilities, including all insured deposits. For example, the FDIC resolved WaMu — which had over $300bn in assets — through a P&A with JPMorgan, in which JPM acquired all of the assets ($296bn), and almost all of the liabilities ($265bn) of WaMu’s depository instutition. Crucially, JPM left behind some $28bn of WaMu’s senior unsecured debt, subordinated debt, and preferred stock — and those creditors took huge haircuts. The particular structure of the P&A, and of the resolution, depends on the situation the FDIC is facing.

In the case of a large financial holding company, there are essentially four types of situations that the OLA needs to be able to handle:
(1) A buyer for the entire FHC can be identified prior to triggering the OLA;
(2) A buyer for only some of the FHC’s assets can be identified prior to triggering the OLA (most likely);
(3) Potential buyers have been identified, but no agreement has been reached by the time the OLA is triggered;
(4) No buyer can be or will ever be identified (least likely).
Let’s take these situations in turn.

(1) A buyer for the entire FHC can be identified prior to triggering the OLA

This is an easy one. Dodd-Frank gives the FDIC broad authority to arrange for the sale of entities in receivership, or for selected assets of the entities. The FDIC would just do a straight P&A for all the assets and liabilities of the FHC and its subsidiaries in receivership. Done and done.

(2) A buyer for only some of the FHC’s assets can be identified prior to triggering the OLA

It’s likely that a prospective buyer of one or more of the primary entities (i.e., the broker-dealer and the commercial bank) will insist on leaving behind a portfolio of problem assets — for Bear Stearns, it was a $30bn pool of assets that JPMorgan left behind; for Lehman, it was a $62bn pool of assets that Barclays was originally going to leave behind (before the FSA torpedoed the deal, of course). To do this, the FDIC would likely do one of two things. The first option would be to enter into a “loss sharing P&A,” in which the buyer would acquire all of the FHC’s assets, but the FDIC would agree to absorb most of the losses (>80% usually, I think) on a fixed pool of assets.

The second option would be to “bridge” the FHC and the relevant entities being acquired, then sell the pool of problem assets back to the receivership, and then sell the good assets to the buyer. Section 210(h) of Dodd-Frank authorizes the FDIC to create a “bridge financial company” — a temporary, pop-up financial institution that automatically has all the necessary charters and licenses, and is run by the FDIC — to purchase selected assets and liabilities of the entities in receivership. Crucially, before a broker-dealer is handed over to the Securities Investor Protection Corporation to resolve, the OLA allows the FDIC to transfer assets and customer accounts from the broker-dealer to a bridge financial company. This will allow the FDIC to ensure that the full suite of key services can continue uninterrupted: depositors can have uninterrupted access to their bank accounts, prime brokerage clients can have uninterrupted access to their cash and securities, etc.

Moreover, if a buyer can be identified ahead of time, the FDIC can prevent the bank’s derivatives counterparties from seizing the bank’s posted collateral and liquidating it at fire-sale prices (which they’d be allowed to do immediately under the Bankruptcy Code). Section 210(c) prevents derivatives counterparties from terminating the contracts and seizing the collateral for essentially a full business day after the FDIC is appointed as receiver, during which time the FDIC can transfer the derivatives to a bridge financial company. If the FDIC can sell the bank’s derivatives to another financial institution or a bridge financial company within one day, then there will be no interruption in the bank’s derivatives book.

The key, in my opinion, to making this work is that the OLA allows the FDIC to bridge not just the holdco and the primary entities being acquired, but also any booking entities that engage in significant intercompany transactions with those primary entities. This allows the FDIC to avoid the kind of endless intercompany disputes that have absolutely plagued the Lehman bankruptcy. If assets need to be shifted among the booking entities and the primary entities in order to minimize the disruption to clients, or to pave the way for a sale of the entire broker-dealer (and with it the entire “trading book”), then the FDIC has the discretion to get that done.

Now, what would happen to unsecured creditors? That depends entirely on what liabilities the buyers are willing to assume. In normal commercial bank resolutions, the P&A usually includes the senior unsecured and subordinated debt. This was famously not the case with WaMu, where the P&A with JPMorgan left the senior unsecured and subordinated debt holders out in the cold. This came as a huge shock to the market, and we can debate whether or not it was the right move by the FDIC at the time, but one indisputable benefit is that it created a precedent for haircutting senior unsecured and sub debt. Market participants won’t be nearly as shocked if the FDIC does that again.

In any event, I think the FDIC could certainly allow third-party buyers to leave the senior unsecured and sub debt behind without causing a systemic meltdown. The FDIC has the tools to ensure that the bank’s key services continue uninterrupted, which will prevent most of the contagion from spreading. Past that, I don’t really care if unsecured creditors get a haircut.

(3) Potential buyers have been identified, but no agreement has been reached by the time the OLA is triggered

This type of situation is the reason the “bridge bank” option was created back in the S&L crisis, and the bridge financial company option can be used here. The FDIC would likely bridge the FHC, the primary entities that potential buyers are interested in, and any booking entities that engage in significant intercompany transactions with those primary entities. It would be necessary to bridge the key booking entities here in order to prevent any derivatives counterparties from terminating the trades and seizing and liquidating the collateral, which could easily kill any potential sale of the primary entities or holdco.

If it’s starting to look less and less likely that a deal will be reached, the FDIC can start taking steps to minimize the disruption to the markets , like allowing prime brokerage customers to transfer their accounts to other brokers, and allowing derivatives counterparties to novate trades to other dealers. If a deal is struck, however, the bridge companies would transfer the assets being acquired to the buyer, and sell whatever is left back to the receivership.

(4) No buyer can be or will ever be identified

Next stop: Liquidation Station! Honestly, this scenario strikes me as extremely unlikely. You need to have a business that’s important to the functioning of the global economy just to be eligible for resolution under the OLA in the first place, so any company being resolved under the OLA is almost by definition going to have value as a going-concern. Anyway, in the unlikely event that this scenario did occur, the FDIC could keep the assets off the market for a good 2 years, and possibly even longer if necessary, as bridge financial companies have a 2-year life under the OLA, with an option for extensions. Again, it would bridge the FHC and its subsidiaries, and sell the assets off over time, avoiding a messy fire-sale that could depress asset prices and transport the bank’s problems to other financial intermediaries.

What about all those thorny international problems? Well, the truth is that in terms of systemic risk, there’s only one other jurisdiction that really matters: the UK. New York and London are still the two dominant financial centers, and the vast majority of transactions at the major US banks flow through either New York or London. It’s important to understand that it was the UK’s ridiculously backward somewhat dated insolvency regime that forced the liquidators of Lehman’s European broker-dealer to seize so many client assets and assets of affilates. Fortunately, the UK now has their own version of the OLA, which they call the “Special Resolution Regime,” and was enacted as part of the Banking Act of 2009. The Special Resolution Regime is, like the OLA, modeled explicitly on the FDIC resolution authority, and gives the Bank of England the same wide-ranging tools to wind down a London broker-dealer in an orderly fashion — including, significantly, the power to create “bridge banks” to ensure that key functions can continue uninterrupted. Cross-border problems that aren’t identified and dealt with in the resolution plan can, if necessary, be dealt with by bridging the relevant entities until a solution can be fashioned.


I’m not claiming that the Dodd-Frank resolution authority is perfect by any stretch of the imagination. But I think it absolutely provides the FDIC with the tools necessary to resolve a major US bank in an orderly fashion, and that, understanding this, regulators would indeed use the OLA to resolve a major US bank.

This post started out as a defense of Dodd-Frank’s resolution authority, and a description of what the liquidation of one of the major US banks would likely look like under the new law. But I quickly realized that in order to understand how a resolution of one of the major banks would work in practice, you really have to have an understanding of how the major banks/investment banks are structured, legally, and why that structure causes so many problems in bankruptcy. I don’t think this is something that’s ever been explained in the blogosphere (I’d be extremely surprised), but it’s crucial to understanding the real issues surrounding financial reform and the major banks, so I think this post can be useful. Anyway, this is part one of a two-part post; part two will describe what an orderly liquidation of a major US bank under the Dodd-Frank resolution authority would actually look like. That post will come sometime tomorrow (I’m too tired to finish it right now).


Major international banks are organized as holding companies — in the US, the major banks are all financial holding companies (FHCs). The holding company (known as the “holdco”) sits at the top of the legal structure. Right below the holdco is the layer of primary regulated entities, which conduct the vast majority of the bank’s day-to-day business, and employ most of the bank’s employees. The most important primary entities at the major US banks generally include registered broker-dealers in New York, London, and Asia, a chartered US commercial bank, a smaller continental European bank, and an asset manager.

Below the primary entities is a layer of product-specific “booking entities.” (See my very rough org chart below.) These entities are structured to hold specific types of instruments that the primary entities deal in (e.g., FX spot, interest rate swaps, crude oil futures), and are set up for regulatory, capital, tax, or other such noble reasons. Booking entities are generally fully guaranteed by the holdco as well. Here’s how this works: when a trader in New York enters into, say, an foreign exchange swap with a hedge fund, the primary broker-dealer or commercial bank is usually the initial counterparty; however, the bank can immediately assign the swap (which is sometimes done automatically) to the designated booking entity for foreign exchange swaps, as there will likely be a clause in the bank’s ISDA Master Agreement with the hedge fund that allows the bank to unilaterally assign the swap to any subsidiary that’s guaranteed by the holdco. (Sometimes traders execute the trade directly on behalf of the booking entity, although for reasons having a lot to do with excessive laziness and/or ignorance at the trader level, this used to happen a lot less than it should have.)

(Yes, I’m ignoring things like intermediate holding companies and captive issuers in this org chart, but they’re not important for our purposes.)

Booking entities are generally funded by a combination of intercompany repos and securities loans with the main commercial bank and broker-dealer, and unsecured loans from the holdco. So, for example, if a client of the US broker-dealer wants to borrow a security, the broker-dealer might actually enter into back-to-back repos with the booking entity and the client — in effect, the broker-dealer would borrow the security from the booking entity and then lend it to the client. The bank’s primary entities engage in significant intercompany transactions with each other as well. For example, one standard practice at large banks is “local settlement,” the main result of which is that the US commercial bank or broker-dealer clears and settles US securities trades for the European broker-dealer, and the European broker-dealer clears and settles European trades for the US entities.

The reason all of this is important is that the major banks, and particularly the major broker-dealers, are all responsible for customer assets in the hundreds of billions (out of proportion to the banks’ total assets, which is a truly silly metric for systemic risk). The fact that the banks are constantly shifting assets — some of which are the bank’s, some of which are client assets that have been rehypothecated — among their primary entities, booking entities, and holding company makes it difficult, when a major bank fails, to quickly sort out which entity controls which assets, and what rights each party has in those assets. And sorting this out is a precondition to a successful resolution of the bank.


Now, it’s easy to overstate the complexity of all this. There are a lot of moving parts, but 99% of the cash flows follow a standard protocol, and are repeated hundreds of times a day. It’s even easier to overstate the difficulty of dealing with the failure of one of the major banks, given these complicated interrelationships. Will resolving a major bank be a difficult task? Of course. Can it be done? Absolutely.

What’s important to understand — and I don’t think enough people do understand this — is that one of the biggest reasons that Lehman’s failure was such a catastrophic event for the markets was Lehman’s complete and total lack of preparation for a bankruptcy filing. I know this isn’t what most people want to hear or believe, since it doesn’t fit neatly into any of the popular narratives, and fixing it wouldn’t be gut-wrenchingly painful for the banks. But it’s the truth — and if you ask people who worked through the Lehman failure, they’ll all tell you the same thing: the complete lack of preparation was devastating.

It was honestly as if no one in the entire Lehman organization had thought about what they’d need to do in the event of a bankruptcy filing until the moment they filed. As a result, it was the most chaotic, uncontrolled failure imaginable.

To take one example: Lehman’s holding company (LBHI) filed for bankruptcy, but at the last minute its US broker-dealer (LBI) was kept out of bankruptcy by the NY Fed. The problem was that no one knew about this — most people thought LBI had filed too. Lehman had all sorts of problems getting employees to even show up for work; JPMorgan, which was LBI’s clearing bank, unilaterally shut off LBI’s access to its accounts for several days, and actually started seizing assets of LBI’s prime brokerage clients (a huge no-no); clearinghouses improperly limited LBI’s trading activity; the NSCC mistakenly seized a large amount of LBI’s customer securities; Lehman’s European broker-dealer (LBIE) stopped payments to LBI’s omnibus account even though LBI continued to make payments to LBIE; incoming customer securities to LBI weren’t getting properly segregated; counterparties simply stopped posting collateral they owed on OTC derivatives with LBI; and so on. That first week, the biggest challenge was simply getting someone at Lehman on the phone. (I saw a 63-year-old senior partner do a fist-pump you’d have to see to believe when he finally got an account executive at Lehman on the phone. Unquestionably the highlight of my week.)

You get the picture: it was utter chaos, in no small part due to sheer confusion about what was going on. Another crucial consequence of Lehman’s lack of preparation was that there was no sustained effort on Lehman’s part prior to bankruptcy to make sure that client assets were in the right place to effect a smooth transition at the time of the bankruptcy filing. This led to one of the biggest problems of the entire episode, when a large number of US hedge funds discovered, to their surprise, that their assets had been transferred to LBIE, and had been frozen when LBIE filed for insolvency. The LBIE debacle effectively caused about $40bn to unexpectedly disappear from the market at the worst possible time.

What all this shows is that the failure of a major bank is not some deep-seated, inherently insurmountable problem, as some people would have you believe. By contrast, it shows that a well-planned and well-executed resolution would have avoided many of the most significant problems that arose in the Lehman bankruptcy.

And tomorrow, I’ll explain how this can be done under the Dodd-Frank resolution authority.

I wish I could take credit for this, but I can't. A colleague came into my office today with a proposed enforcement mechanism for the Volcker rule, and when I opened my mouth to disagree with him, nothing came out. I just laughed.

The proposal: If a trader is found by regulators to have violated the Volcker rule more than once in a calendar year, his pay cannot be more than $100K for that year. No exceptions. No million dollar bonuses. If the trader has already received more than $100K in base salary for the year, then he has to pay back any amount over $100K. Believe me, once a trader has violated the Volcker rule once, he'll be falling all over himself to document why and how every trade is related to market-making.

I like it: short, sweet, and devastatingly effective. It uses deterrence to compensate for the inevitable inadequacies — that is, over-permissiveness — of the final rule.

Sunday, November 28, 2010

A Proposal for Money Market Fund Reform

There were two major areas of financial regulation that Dodd-Frank left rather conspicuously unaddressed: the GSEs, and money market funds (MMFs). The reason they omitted GSE reform is obvious: GSEs are a fiercely partisan issue, and including GSE reform could easily have — and, I think, almost certainly would have — killed the entire financial reform package. (Yes, the GSEs are that toxic.)

There were two reasons the administration omitted MMF reform: one, the SEC was already in the process of adopting substantial new regulations for MMFs, and two, there was nothing approaching a consensus on MMF reform. With other areas of financial reform, there was generally broad consensus on what needed to be done: an FDIC-like resolution authority, a systemic risk regulator, central clearing for standardized derivatives, a CFPB, etc. But with MMFs, no one really knew what to do yet (myself included). So the administration directed the President's Working Group on Financial Markets (PWG), which consists of the Treasury Secretary, and the Chairmen of the Fed, SEC, and CFTC, to prepare a report on MMF reform options. I give the administration credit for acknowledging that they simply didn't know what to do about MMFs yet.

The PWG released its report on MMF reform options last month. (The author of the report seems to share my title-writing abilities, as the report is creatively titled, "Money Market Fund Reform Options.") The report presents a menu of reform options, some better than others.

I want to endorse one reform option in particular: option (f), which proposes a two-tier system of MMFs, with stable NAV MMFs reserved for retail investors, and institutional investors limited to floating NAV MMFs. One of the main problems was that MMFs' ability to use "stable" NAVs — that is, to round their NAVs to $1 — fostered a perception among investors that MMF NAVs don't fluctuate. MMFs only have to reprice their NAVs (i.e., their share prices) if the mark-to-market per-share value of the fund's assets (known as its "shadow NAV") falls more than 0.5%, and doing so is known as "breaking the buck." (In MMF-land, 0.5% is a substantial loss.) Investors were blissfully unaware of any losses that were smaller than 0.5%.

As the PWG report notes: "By making gains and losses a regular occurrence, as they are in other mutual funds, a floating NAV could alter investor expectations and make clear that MMFs are not risk-free vehicles. Thus, investors might become more accustomed to and tolerant of NAV fluctuations and less prone to sudden, destabilizing reactions in the face of even modest losses."

Reinforcing the idea that MMFs are not risk-free is, I think, crucial. So why not move all MMFs to floating NAVs? Why only require institutional investors to use floating NAV funds? Well, for one thing, institutional investors were the problem in the financial crisis. I can't emphasize this strongly enough. The problem wasn't those supposedly-flighty, oh-so-irrational retail investors. It was the institutional investors. During the week of September 15, 2008, outflows from prime MMFs totaled roughly $300 billion, according to the ICI. Institutional investors accounted for over 90% of those redemptions. What's more, institutional MMFs have always had more volatile cash flows than retail MMFs. According to the ICI, between July 2007 and August 2008 — that is, from roughy the time the institutional investor-dominated ABCP market started blowing up to the time Lehman failed — MMFs received inflows of roughly $800 billion, over 80% of which, or $650 billion, came from institutional investors. This is, as they say, "hot money," and it comes from institutional investors.

In short, it was the institutional investors who panicked and fled the ABCP market in 2007, who panicked en masse again in September 2008, and who are most likely to panic again if one of their stable NAV MMFs "breaks the buck." They are the ones who need to be restricted, not the retail investors. Institutional investors are also the ones with the resources to closely monitor floating NAVs. They don't need to be protected by a stable NAV, nor should they.

One of the main arguments against limiting institutional investors to floating NAVs, which I find utterly unconvincing, is that internal investment policies may prohibit some institutional investors from investing in floating NAV funds. OK, then change your internal investment policies. It's not the SEC's job to make sure that its regulations don't conflict with investors' internal policies. If your internal investment policies conflict with the SEC's regulations, then that's your problem. Switching to a floating NAV doesn't make an MMF any more risky; the assets are still exactly the same. So if an investor's internal policies deem stable NAV MMFs to be appropriate investments, then there's absolutely no reason why the investor should be precluded from investing in floating NAV MMFs.

The biggest unsolved problem with MMFs is still discretionary sponsor support. MMF sugar-daddies sponsors have repeatedly bailed out their MMFs, thus preventing them from breaking the buck. For example, banks like BofA and Wachovia bailed out their MMFs that had invested in SIVs and ABCP in 2007, and JPMorgan, Legg Mason, and Northwestern Mutual all bailed out their MMFs in September 2008. In fact, after Lehman failed, pretty much every major MMF sponsor had to bail out their MMFs. As the PWG report notes, "more than 100 MMFs received sponsor capital support in 2007 and 2008 because of investments in securities that lost value and because of the run on MMFs in September and October 2008." (Guess who didn't have a sugar-daddy sponsor? That's right, the Reserve Primary Fund!) For investors, the repeated bailouts from MMF sponsors have clearly created an expectation of sponsor support. This needs to be dealt with as well, though the solution is not straight-forward.

Probably the best way to deal with discretionary sponsor support is for sponsors' primary regulators to impose punitive (and automatic) penalties on any form of sponsor support. For example, punitive capital charges, or a 12-month moratorium on dividends. Something like that.

As I discussed in my previous post, the Dodd-Frank Act subjects "systemically important" nonbank financial firms to enhanced prudential standards and consolidated supervision by the Fed. All bank holding companies with over $50bn in assets — of which there are currently 36 — are also subject to the heightened Fed supervision. The enhanced prudential standards have to include capital requirements, leverage limits, liquidity requirements, and an ongoing resolution plan (or "living will"), among other requirements. So you can see why being designated systemically important would be a big deal for nonbank financial firms (which, for the sake of simplicity, I'll refer to in this post as simply "firms"). The Financial Stability Oversight Council (FSOC) is required to designate systemically important firms, and it has already gotten the ball rolling on this process.

 So what makes a firm systemically important? Section 113 of Dodd-Frank deems firms systemically important if either (1) "material financial distress" at the firm would pose a threat to financial stability, or (2) the firm's ongoing activities pose a threat to financial stability. The "material financial distress" option is clearly the more important of the two, as it's difficult to imagine a firm whose ongoing activities were systemically important, but whose failure wouldn't pose systemic risks.1

Section 113(a)(2) requires the FSOC to consider 10 specific factors in determining whether a firm is systemically important:

(A) the extent of the leverage of the company;
(B) the extent and nature of the off-balance-sheet exposures of the company;
(C) the extent and nature of the transactions and relationships of the company with other significant nonbank financial companies and significant bank holding companies;
(D) the importance of the company as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the United States financial system;
(E) the importance of the company as a source of credit for low-income, minority, or underserved communities, and the impact that the failure of such company would have on the availability of credit in such communities;
(F) the extent to which assets are managed rather than owned by the company, and the extent to which ownership of assets under management is diffuse;
(G) the nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company;
(H) the degree to which the company is already regulated by 1 or more primary financial regulatory agencies;
(I) the amount and nature of the financial assets of the company;
(J) the amount and types of the liabilities of the company, including the degree of reliance on short-term funding; and
(K) any other risk-related factors that the Council deems appropriate.


As I noted in my previous post, a lot of firms, including hedge funds, are arguing that leverage should be the most important factor. That argument has a superficial appeal to it — after all, everyone knows that leverage was one of the main causes of the financial crisis — but it's still misguided. A highly leveraged firm may be more likely to fail, but the point isn't to identify the firms that are most likely to fail. The point is to identify the firms whose failure would cause the most damage to the financial system. The FSOC should just assume in its analysis that the firm it's examining has already failed — then ask, "What would happen, and how bad would it be?"

How likely a firm is to fail should play almost no role in the FSOC's decision — we don't want the Fed to only regulate systemically important firms that the FSOC thinks have a decent chance of failing. In 2004, almost no one would have thought that an AIG failure was in the realm of possibility, and if the FSOC had been making this determination in 2004, I can easily imagine them giving AIG a pass based on its sterling reputation and perceived invincibility. We don't want to give firms like AIG-circa-2004 the chance to go to the FSOC and push the argument that, "Sure, our failure would be catastrophic, but we're such a strong company that the chances of us failing are practically nil. It's just inconceivable. [Do you know who I am? I'm Hank f*cking Greenberg!]" That argument should be per se illegitimate. (And you're crazy if you think that's not exactly what Hank Greenberg wouldve been saying back in 2004.) Moreover, it was precisely the inconceivability of an AIG failure that caused the markets to hit the Sheer Panic Button in September 2008. Allowing firms to avoid the "systemically important" designation because the FSOC thinks they have sufficiently safe levels of leverage just sets us up for another AIG-like shock.

 Of course, leverage can also magnify the damage caused by a firm's failure, so the FSOC should definitely still consider leverage in determining whether a firm is systemically important. My point is that the FSOC shouldn't be distracted by arguments about how firms with low leverage ratios shouldn't be deemed systemically important because they're less likely to fail.


I think it's hard to overstate the importance of interconnectedness. Size is important, yes, but it's interconnectedness that causes problems to turn systemic. Systemically important interconnectedness can take multiple forms as well. For example, LTCM, which by today's standards was a relatively small hedge fund, was systemically important not because of its size, or the number of counterparties it had, but because of its proximity to the dealer banks — LTCM was
deeply enmeshed with all the dealers, both in terms of raw counterparty exposure and ridiculously correlated trading books. What makes this kind of interconnectedness systemically important is, obviously, the identity of the counterparties, and the nature of the firm's relationships with the counterparties. (Even though this clearly falls under the third factor in Section 113(a)(2), I think this factor is best thought of as a subset of "interconnectedness.")

Lehman, on the other hand, was involved in every corner of the market. The number of counterparties and customers affected by Lehman's bankruptcy was staggering, and meant that practically every market in the world was negatively impacted in some way when Lehman filed. Lehman's interconnectedness transmitted the losses — and the panic — all around the world at a shocking speed. This kind of interconnectedness is marked by the number and variety of markets (and counterparties) that a firm touches.

Proximity to Core Commercial Paper Market

A separate factor I think the FSOC should take very seriously is a firm's proximity to the commercial paper (CP) market — or, more specifically, the effect that a firm's failure would have on the CP market. One of the key lessons of the financial crisis, which is constantly overlooked, is that our domestic economy is critically dependent on the CP market. Even a temporary disruption in the CP market can cause large-scale employment losses. A lot of companies spent months recovering from the temporary breakdown in the CP market in September 2008 — and by "recovering," I mean "laying people off."

Any firm that threatens a repeat of the CP market troubles is, without question, systemically important.

 Ultimately, I expect the FSOC to designate only a handful of nonbank financial firms (i.e., in the 4-8 range) systemically important and subject to consolidated Fed supervision. AIG, GE Capital, and Prudential are no-brainers. (No, I'm not forgetting MetLife — remember, it's a bank holding company now, so it's automatically included because it has over $50bn in assets.) It'll certainly be interesting to see who else is designated systemically important.

1 I suppose a firm would fit that description if the way it conducted its day-to-day business was important to the financial system, and it was also fairly easily replaceable. Like the DTCC, if it was easily replaceable. Which it is not.

Interesting story in Dealbook about how large nonbank financial firms are arguing to the Financial Stability Oversight Committee (FSOC) that leverage should be the key consideration in determining which nonbank firms should be deemed "systemically important," and thus subject to increased regulation by the Fed. (Dodd-Frank requires the FSOC to determine whether nonbank financial firms should be subject to Fed supervision based on a list of factors in § 113(a)(2), the first of which is "the extent of the leverage of the company.")

I guess this makes sense: banks (and broker-dealers) are naturally the most highly leveraged financial institutions, so if the FSOC determines that leverage is the most important consideration, then almost every large nonbank financial firm could point to how much less leveraged they are than the banks. Obviously asset managers and private equity funds would love it if the FSOC focused on nonbank firms' leverage.

This is a particularly interesting argument for hedge funds though. As Dealbook rightly points out, hedge funds, despite their reputation, are in fact generally not very highly leveraged — most hedge funds have leverage ratios between 2 and 3. (Most hedge funds are still equity-focused funds, where leverage is much lower.) But the issue isn't whether most hedge funds are systemically important; the issue is whether any hedge funds are systemically important, and if so, how many. And there certainly are hedge funds that run with high enough leverage, and are large enough, to be considered "systemically important." Regulators seem to be focused on funds that could suffer particularly sharp reversals ("panic-inducing" reversals, if you will), so I would expect those big global macro funds to get a very close look. My hunch is that the FSOC will also look quite closely at the big quant funds (e.g., RenTech, D.E. Shaw) — because let's be honest, they're a complete mystery. And they also have complex trading relationships with the various dealer banks, which at least has the potential to make the meltdown scenario look exponentially scarier.

It's unlikely that the FSOC will adopt the kind of narrow focus on leverage that buyside seems to have in mind, but it's a good effort nonetheless. I'll have more to say about the criteria I think the FSOC should use soon.

Continuing my Volcker rule theme, the current issue of Risk has an article titled, “Dealers Confident on Volcker Exemptions,” which quotes various banking lawyers talking about how easy it will be to get around the final Volcker rule language in Dodd-Frank. From the article: (emphasis mine)

“Last month, we sat down with our counsel and after an hour of question-and-answer, the lead counsel turned to me and said ‘it is not going to be absolutely clear how the provision will work until the rules have been written, but given so much of proprietary trading has a client nexus to it, I’ll be embarrassed if I don’t manage to exempt all your activities from the rule’,” says one head of equity derivatives structuring in New York.
Early reports on the Volcker rule caused astonishment in the banking industry, with predictions of massive changes to the structure and business of certain dealers. Now lawyers have had some time to absorb the clause within Dodd-Frank, many feel the prop trading requirement will be relatively easy to negotiate.
This is exactly what I said Wall Street’s real reaction to the Merkley-Levin version of the Volcker rule would be. (“Merkley-Levin” was the amendment that the conference committee based the final Volcker rule language on.) As I wrote way back in May, when the Senate bill was still being debated: “I spent the majority of my career as a lawyer for one of the big investment banks, and my first thought after reading Merkley-Levin was: ‘Wow, this would be cake to get around.’ Wall Street is scared of the Volcker Rule, but believe me, they’re not scared of Merkley-Levin.”

To be fair, Merkley’s office fixed some of the most glaring problems that I talked about in that post, so the final language is at least an improvement over the original version of Merkley-Levin. (You’re welcome, by the way.) Unfortunately, the final language still has several major flaws, some of which I’ve discussed previously.

The Risk article talks about other problems with Merkley-Levin as well:
[The lawyers’] confidence stems from the language used in section 619. Prop trading is defined as a sale or purchase conducted as a principal on behalf of the trading account of the firm. The trading account is described as any account used for acquiring or taking positions in securities with the main purpose of selling them in the near term or the intent to resell them to profit from short-term price movements.

Lawyers say these few sentences are riddled with ambiguities. “There are many possible unintended exemptions in this definition - it is just not clear at all,” says Scott Cammarn, special counsel at Cadwalader, Wickersham & Taft in Charlotte, North Carolina. “For instance, what happens if the trade occurs outside of the trading account? The definition explicitly states the transaction must be booked in the trading account, so I would argue that if any trade is transacted in a different account, it is not prop trading.”
I don’t think the “trading account” issue is as simple as Cammarn makes it out to be, but it definitely is another potential loophole. I have no idea why Merkley and his staff decided to define prop trading by reference to a trading account, and then include the real definition of prop trading in the “trading account” definition. The real definition of prop trading under Merkley-Levin is “taking positions ... principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements).” So why not just use that as the definition of “proprietary trading”? Why force regulators to regulate accounts rather than trades? It’s bizarre, frankly, and ultimately detrimental to the overall rule.

For instance, seeing as the language in Merkley-Levin’s definition of “trading account” was lifted directly from the Form Y-9C definition of “trading account,” and the Form Y-9C definition is explicitly based on accounting treatment, it’s possible that banks could put on prop trades outside of a “trading account” as long as they agree to use a different accounting treatment for the prop trades. And what if accounting standards change? What if FAS 115 is overhauled in the future? What happens to the definition of “trading account” then?

Also, are we talking about the account where the trade originated? What if a trade is originated in the “banking book,” and then subsequently transferred to the trading book? Since the banking book is (obviously) not a “trading account,” it's not clear if the trade still prohibited. What is clear is that using this incredibly roundabout definition of prop trading was entirely unnecessary, and just created more loopholes for banks to exploit.

Now we get to the real flashpoint, which is how you distinguish “market-making-related activities” from trades done “principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements).” As the Risk article notes:
By far the biggest ambiguity centres on the use of the word ‘intent’. The rule only seems to apply if banks had the intention from the start to sell a position to profit from short-term price movements. “How on earth do you police motive? It is almost impossible. A bank could claim to enter into a five-year put option on the S&P 500 and intend to hold the contract until maturity. If the index then drops 20% in two days and the bank monetises the gain by selling the option, it is arguably not prop trading. The intent was never there to profit from a short-term price move,” says Cammarn.
This is where I disagree. Obviously traders can lie to you about their intent in putting on a trade. But there are signals which are indicative of proprietary trades, and market-making trades can be distinguished from proprietary trades by looking at those signals. For instance, was the position opened on the bid side or the offer side of the market? If the position was opened on the offer side and was legitimately related to market-making, then the trader should also be able to identify the specific risk that he was hedging.

Also, how long has the security been held in inventory? Ace Greenberg, the legendary Bear Stearns trader and former CEO, famously used to require traders on his desk to cut any position that they’d been holding for longer than, say, 30 days. I’m not saying that this should be the hard-and-fast rule for every market — every market really does differ in terms of how long the securities need to be held in inventory. I’m just saying that this is absolutely a legitimate tool, and the inevitable claims from the Street that this would be the end of the world, and would prevent them from effectively managing their risk, etc., should be ignored. This was a risk-management tool for Greenberg, who knows a little something about trading.

Unfortunately, Merkley-Levin exempts not only “market-making-related activities,” but also “risk-mitigating hedging activities,” so even if the Fed writes a perfect definition of “market-making-related activities,” most prop trades will probably still be able to fit under the “risk-mitigating hedging activities” exemption. And this is before we get to the problem of banks setting up Section 2(a)(13) “employees’ securities companies” to do their prop trading. Merkley-Levin inexplicably misses those, which creates a loophole big enough to drive a truck through.

Don’t look for these issues to be mentioned in the notice-and-comment period though; the Street doesn’t generally tip their hand there. Better to make policy arguments during the rulemaking process, and save the legal arguments for the no-action letters. But just be aware that these issues are out there, and if they’re not dealt with during the rulemaking process, then they will be exploited by the Street.

There’s been a lot of discussion recently about the Volcker rule in the popular press, and how it’s going to be implemented. Most prominently, Michael Lewis wrote a widely-read column last week about how the banks are simply shifting their prop trading to market-making desks. While I’ve said before that the poorly-drafted language of the Volcker rule will make it very difficult to enforce effectively for precisely this reason, Lewis’ column is an absolute disaster. Lewis badly misstates the law, identifies the wrong loophole (which is amazing, since there are so many actual loopholes), and generally demonstrates no understanding of the issue whatsoever.

Lewis claims that the loophole is the bill’s definition of proprietary trading as investing “as a principal.” He then goes on to claim that the government agency who must “determine precisely what the phrase means” is....the Government Accountability Office!

First of all, the GAO has absolutely nothing to do with it. The GAO doesn’t write banking regulations. It’s the Fed’s job to write the Volcker-rule regulations for the big banks. The GAO just has to do a study on proprietary trading sometime in the next 12 months, which is completely separate from the rulemaking process for the Volcker rule. Hence why the GAO spokesman clearly had no idea what Lewis was talking about when he called. (The FSOC also has to do a study on prop trading, which actually is part of the rulemaking process for the Volcker rule. Don’t ask.)

Second, the phrase “as a principal” isn’t a even loophole. Everyone understands that both proprietary and market-making trades are entered into “as a principal,” and no one has a problem with that. (That is, after all, what a market-maker does.) There’s no need for banks to try to pretend like they’re not entering into trades “as a principal,” because trading as a principal isn’t prohibited! What’s prohibied is trading as a principal “for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements).” If Lewis doesn’t understand this much, then he really has no business writing multiple columns about the Volcker rule.

Monday, October 11, 2010

Geithner's Foresight

Here's another interesting email from Lehman Weekend, which shows that Tim Geithner was anticipating the need to go to Congress for additional authorities even before the Barclays deal started to fall apart. (The email is from the FCIC's hearing binder, which unfortunately yielded very few interesting documents.)

In an email exchange between Ben Bernanke and Fed General Counsel Scott Alvarez on Saturday, September 13, in which they're discussing a scheduled conference call with other Fed Governors, Bernanke notes (emphasis mine):

However, I have learned that we may want to discuss some broader issues, e.g., should we go to Congress to ask for other authorities. We can't discuss policy issues with more than 3 Board members. [This is due to the Sunshine Act. Bernanke then suggests that Fed Governors Randall Kroszner and Elizabeth Duke hang up when the discussion turns to asking Congress for additional authorities.]
Alvarez then responds with:
That will work. To make it easier, Randy and Betsy can take a cue from Tim, who it sounds like will make a pitch for legislation.
Remember, this was before the FSA torpedoed the Barclays deal, and the working assumption at this point was that Barclays would buy Lehman, with a consortuim of Wall Street banks financing the Lehman assets that Barclays didn't want. So Geithner was anticipating that they would need to ask for additional authorities even if Lehman was ultimately saved by the Barclays/Street-consortium deal.

I'm pretty sure this makes Geithner the first official to advocate going to Congress to ask for additional authorities.

There's no larger point here. It's just interesting to note.

Bernanke-Alvarez Emails (Sept. 13, 2008)

Sunday, October 10, 2010

The Latest Basel III Controversy

In my post on Basel III's liquidity requirements, one thing I didn't cover was the controversy over "committed credit and liquidity facilities." And since I know how disappointed you all were about that, here's my take on the issue. (Sarcasm aside, it's actually a pretty big controversy.)

As a refresher, Basel III's Liquidity Coverage Ratio (LCR) requires banks to maintain a stock of "high-quality liquid assets" that is sufficient to cover net cash outflows for a 30-day period under a stress scenario. "Net cash outflows" is calculated by applying different run-off rates to each source of funding (e.g., repos, unsecured wholesale, etc.). A run-off rate reflects the amount of funding maturing in the 30-day window that won't roll over, and is designed to simulate a severe stress scenario.

The LCR assigns a 100% run-off rate to "draw downs on committed credit and liquidity facilities" to financial institutions (such as banks, insurance companies, and asset managers). It also assigns a 100% run-off rate to draw downs on committed liquidity facilities to non-financial corporates. Essentially, this assumes that every single financial institution that has a lending facility (whether credit or liquidity) with the bank, and every single non-financial corporate that has a liquidity facility with the bank, will draw down 100% of the facility.

The banks are crying bloody murder over this. A 100% run-off rate, they argue, is way too high.

Liquidity Facilities

With regard to liquidity facilities, I think the banks are, for the most part, wrong, and the Basel Committee is right. Most "liquidity facilities" will be commercial paper backstop facilities — a company that issues commercial paper to finance its short-term operating costs will usually arrange a lending facility with a bank as a back-up plan, so that if the company for some reason can't roll over its commercial paper one month, it can draw down its line of credit with the bank to finance its operating costs. The "stress scenario" that the LCR is designed to simulate envisions a shut-down of the commercial paper market. It's only natural, then, to assume that the bank's financial and non-financial customers will draw down their liquidity facilities. That is, after all, what commercial paper backstop facilities are for.

I could be persuaded to lower the run-off rate for committed liquidity facilities to 75%, to reflect the fact that the size of commercial paper backstop facilities doesn't always correspond to the amount of commercial paper that the company will have outstanding at any one time. So, for example, if a company issues $100 million of commercial paper per month, it might arrange a $150 million commercial paper backstop facility. In that case, it wouldn't be realistic to force the bank to pre-fund the entire $150 million facility.

Credit Facilities

I'm of two minds on the 100% run-off rate for committed credit facilities to financial institutions. On the one hand, the banks' argument — that forcing them to pre-fund all of their credit facilities to financial institutions would be just disatrous for them — isn't exceptionally strong. If pre-funding all of your credit facilities to financial institutions would be disastrous, then maybe you shouldn't promise to lend so much money! It's not crazy to require that banks promise to lend only as much money as they can deliver.

On the other hand, it is a bit unrealistic to assume that every single financial institution that has a credit facility with the bank will draw down 100% of the facility. Since these are credit facilities rather than liquidity facilities, their purpose is expressly not to refinance maturing debt. What, then, is the logic behind assuming that every single credit facility will get drawn down all at once? I think a 50% run-off rate would be more appropriate — and even that is probably quite conservative.

Cash Inflows from Credit and Liquidity Facilities

Finally, I don't understand why the LCR assumes that banks can't draw down their own committed credit and liquidity facilities with other banks. With regard to a bank's "cash inflows" during the 30-day stress period, the proposal assumes that "other banks may not be in a position to honour credit lines, or may decide to incur the legal and reputational risk involved in not honouring the commitment." But isn't the point of the LCR to ensure that banks are "in a position to honour credit lines"?

If Bank #1 has a liquidity facility with Bank #2, and both banks are subject to Basel III's LCR, then Bank #2 will have pre-funded the liquidity facility. Pre-funding liquidity facilities is, after all, one of the requirements of the LCR. Thus, it seems very odd to require Bank #1 to assume that Bank #2 won't be in a position to honor a liquidity facility that Bank #2 has pre-funded. I understand — and very much support — the Basel Committee's desire to be conservative. But at some point, the desire to be conservative has to give way to logical consistency.

As I noted in my review of Overhaul, Steve Rattner absolutely savages Sheila Bair. I think Rattner treats Bair a little too harshly, but I agree that in this case, Bair was extremely unprofessional, and almost comically petty to boot. But I'm posting the full excerpt of Rattner's experience with Bair below the fold (it's long), so that you can make up your own mind.

The reason I think Rattner is a little too harsh on Bair is that, as head of the FDIC, she had the right to be concerned about the capital buffer at GMAC's bank (Ally), and to require higher capital levels. After all, it's the FDIC that would be on the hook if GMAC/Ally ever failed.

On the other hand, it's not at all clear that GMAC's capital level was her real concern (in fact, it's pretty clear that it wasn't her primary concern). Moreover, her stated cause for concern about GMAC — dealer floorplan loans — strongly suggests that her concern was less than genuine. Rattner is right that dealer floorplan loans are among the safest type of loans out there. Dealer floorplan ABS, which have a revolving structure similar to credit-card ABS, have miniscule historical loss rates (i.e., less than 1%), and have held up extremely well throughout the crisis. The fact that Bair cited dealer floorplan loans as her reason for requiring unusually high capital levels suggests that she either (a) didn't understand dealer floorplan loans (which would be bad in its own right), or (b) was being disingenuous.

I've always been surprised that Bair managed to become something of a hero among progressives. When Bair was the head of the CFTC in the 1990s, she fended off attempts to regulate OTC derivatives. And immediately after leaving the CFTC, she became a lobbyist for the New York Stock Exchange. Not exactly the profile of a progressive hero.

Anyway, here is Rattner's account of his experience with Bair:

When I first heard that Steve Rattner was writing an "insider's account" of his time as the Obama administration's Car Czar, my first thought was, "Wow, I'm surprised Rattner would be so disloyal." After reading the book, my view has moderated a little — I think Rattner gave an honest and accurate account, and everyone involved was treated quite fairly. I doubt Rattner views himself as disloyal at all for writing the book. But at the end of the day, it was still disloyal — it doesn't matter how fairly you portray people; writing a tell-all is something you just don't do. People need to be able to talk to you without having to worry about whether their words are going to end up in your book. For Rattner to turn around and reveal who said what behind closed doors — even if what they said isn't damaging — is disloyal. (Also, while Rattner portrays most administration officials positively overall, he absolutely savages Sheila Bair, who he describes as "a sharp-elbowed, sometimes disingenuous self-promoter.")

That said, the book itself is a great read. Two things really stuck out for me. First, it's scary how understaffed the Auto Task Force was. They had an enormously important job, and their decisions were going to affect hundreds of thousands of families. And yet the entire Auto Task Force consisted of 14 people, most of whom were extremely young. If the government is going to effectively restructure the domestic auto industry, you'd hope that they'd hire enough people — preferably with a good deal of experience in the field — to do the job right. Don't get me wrong, Harry Wilson is legit, and so is Matt Feldman (and, for that matter, so is Ron Bloom); but there were basically 4 people tasked with restructuring GM, one of the largest companies in the US. That's frankly dangerous.

Second, at several points, the Auto Task Force seemed to discover major problems way after they should have. For example, after they had decided to rescue Chrysler — based on the premise that they could, and most likely would, put Chrysler through bankruptcy — they discovered that bankruptcy might kinda-sorta pose a problem for Chrysler's "finco," Chrysler Financial. This is Rattner describing a meeting with the heads of the fincos (GM's finco is GMAC), which provide necessary consumer and dealer floorplan loans for the auto companies:

As I sat listening to our visitors, I was seized by the enormity of the finco problem. Chrysler Financial was the immediate headache.
Then we learned, to my horrow, that putting Chrysler into any form of bankruptcy would have severe consequences for Chrysler Financial. A very large proportion of its remaining bank credit lines would immediately be withdrawn. In order to keep Chrysler Financial in business, we might have to replace all of its $22 billion of borrowing facilities with taxpayer money. But there was more: we would face very much the same problem with GMAC, which was six times larger than Chrysler Financial.
You're discovering this after you made the decision to rescue Chrysler, and most likely put it through bankruptcy? Yikes. The idea that you would make such a huge decision without fully understanding the role of, or implications for, the fincos, is a little scary. However, I don't entirely blame the Auto Task Force for this. They were given an impossibly short timeline, and like I said before, they weren't given nearly enough people. And it all worked out in the end, largely because the Auto Task Force had some extremely intelligent and capable people who were able to put out these kinds of fires. (The solution to the finco problem was to have GMAC take over Chrysler Financial's post-petition and post-bankruptcy lending, and let Chrysler Financial go into run-off mode.)

So ultimately, my conclusion after reading the book is that the Auto Task Force did an excellent job under impossible circumstances. However, they also got a little lucky, in that they were ultimately able to overcome the clear mistakes they had made.

Thursday, October 7, 2010

Corker and Payday Lenders

Timothy Noah of Slate has an article on payday lending whose heart is in the right place, but which unfortunately says this:

Indeed, one of the sketchier provisions in Dodd-Frank affirmatively prohibits Warren's new agency from setting a maximum interest rate on payday loans. This was inserted at the behest of Senator Bob Corker, R.-Tenn. (The payday-loan business was reportedly born in Corker's home state and continues to thrive there.)
The part about Sen. Corker is just not true, and it's one of those memes that for some reason really bothers me. The article that Noah links to is a March NYT article by Sewell Chan that claimed — falsely, it turns out — that Corker was pushing for a carve-out for payday lenders in the new CFPB law. (At the time, Corker had broken ranks with Sen. Shelby and the rest of the Republicans and was negotiating directly with Chris Dodd on the CFPB issue.) The NYT article doesn't say anything about usury, which Noah clearly confuses with the payday lending carve-out.

I remember when that article came out — people were outraged that Corker would do the bidding of such a heinous industry. (Krugman even posted about it here.) I mainly remember because the always-excellent David Merkel asked me about it in the comments to one of my posts. Here's what I said at the time:
I'd be very much opposed to a carve-out for payday lenders, but I also have a very hard time believing it'll be in the bill. Sure, Corker is from Tennessee, which is home to some big payday lenders, but these stories sound to me like they're coming from other Senators' staffers -- who are just speculating -- rather than Corker or Dodd's offices. (My initial reaction was that the story came from Shelby or some other Republican, in an attempt to start stirring up Democratic opposition to any compromise bill that Dodd and Corker produce.)

It's possible that Dodd could let Corker put a payday lender carve-out in the discussion draft, just so Corker can appease the payday lenders in his state, and then have the carve-out killed in markup. But I really don't think it's a serious option. Corker is independently wealthy, so it's not like he relies on campaign contributions from payday lenders or anything.
And sure enough, the NYT article turned out to be utterly bogus. As soon as the bill came out of markup, Dodd released the following statement:
“During our negotiations Senator Corker agreed to have the Consumer Financial Protection Bureau’s rules apply to all firms providing financial products and services,” said Chairman Dodd. “He never once requested exclusion for any individual lending sector. Senator Corker knows that there needs to be parity in the way banks and non-banks are regulated.”
But the damage had already been done: that Corker pushed for an exemption for payday lenders is now convential wisdom.

Look, I disagreed with Corker on most of the substantive issues during the financial reform debate. (I am, after all, a life-long Democrat.) But he's also one of the rare Republicans who, at least on financial issues, seems to genuinely care about making good policy rather than scoring political points on Fox News. So the least we can do is not indulge fairly obvious attempts by other Republicans to smear him.

Friday, September 17, 2010

Some Unsolicited Advice for Regulators

As the Dodd-Frank rule-making process begins in earnest, I’d like to offer some unsolicited advice to regulators, and specifically the Fed. I spent many years at a large dealer, so I have some thoughts on how an effective supervisory regime for large dealer banks needs to be structured.

Put simply: You need to get in the banks’ face. I’m deadly serious about this. First, significantly expand the dedicated supervisory teams for the dealer banks that qualify as Tier 1 FHCs. It’s not enough to have a 5-10 person supervisory team for dealer banks like JPMorgan, BofA-Merrill Lynch, Morgan Stanley, etc. The capital markets side of each of these banks has tens of thousands of employees, and hundreds of people in senior risk-taking positions. The supervisory team for each Tier 1 FHC needs to have at least 50 people. Again, I am deadly serious.

Second, and most importantly, at least half of the supervisory team needs to be on-site full-time. The CPC (“central point of contact,” who heads the supervisory team) also needs to be on-site, and should have broad information-gathering authority. In other words, the Fed should be a major presence at each dealer bank. Most of the on-site supervisors should be assigned to the Sales & Trading side of the bank, since that’s where most of the short- to medium-term risk is.

The reason for all this is simple: The banks’ trading books turn over constantly, and given how large these trading books have become (relative to the bank’s total consolidated balance sheet), the risk profile of a dealer bank can change very rapidly. It’s flat-out impossible to have a realistic, real-time understanding of the health of a dealer bank without being on-site every day — I’m not even willing to debate this point.

Supervisors need to be at the bank’s main offices — conducting rotating examinations of different business lines, independently monitoring compliance with things like the Volcker Rule, as well as simply collecting anecdotal information, both about the markets and the firm. It’s easy to dismiss anecdotal information as unreliable, but this kind of color can be incredibly useful, especially for regulators. If you only rely on fully-vetted, reportable information, and reports prepared for the board of directors, then you’re guaranteed to be hopelessly behind the curve. You’re far more likely to identify potential problems at a dealer bank, as well as potential sources of systemic risk in the markets, by simply talking to people at the bank regularly.

Traditionally, supervisors for LCBOs (large complex banking organizations) have focused a disproportionate share of their efforts on ensuring that the bank has adequate risk management systems and internal controls. Given supervisors’ limited resources in the past, I actually understand why they chose this approach. But this cannot be supervisors’ primary focus anymore. No matter how sophisticated or expensive their risk management system is, banks can always just ignore internal limits. When a profitable desk uses up all its balance sheet allocation too early in the quarter, or comes up against its risk limits, there’s a good chance the desk will be granted a waiver, or simply have its risk limits raised (“just this once,” they’ll be told, although somehow it never works out that way). Even if the bank tells its supervisors about the breached risk limits — which isn’t a given, by any means — the deed is already done. No, supervisors need to take some responsibility for monitoring compliance, and they need to do it on-site.

Now, I know what the banks’ response would be to this proposal. They would vehemently object to the higher fees they’d have to pay to the Fed to fund this supervisory expansion. They would also be particularly upset about having to give Fed supervisors office space in their main New York offices. (“Do you know how valuable this space is? We have vice presidents working in cubicles!”) And they would complain about the increased compliance costs that would be required to provide the on-site examiners with the information they need (which they would no doubt supplement with a wildly inflated estimate of said compliance costs).

Please, I beg of you, do not give these arguments the time of day. The proper response to these arguments is:

“Yeah, well, life’s tough in the aluminum siding business. Deal with it. This is the cost of being a large dealer bank with access to the Fed window. As long as you have bonus pools in the $15-20 billion range, you’re not allowed to complain about the increased fees. If you don’t like it, you should consider another line of work.”
Think about it.

Wednesday, September 15, 2010

Reliving Lehman Week (and beyond)

I dug these up a while ago, but since this is the anniversary of Lehman’s failure, here, for your viewing pleasure, are the front pages of the major U.S. newspapers (the WSJ, NYT, and Washington Post) on various days of the financial crisis. I was unfortunately never able to find PDFs of the FT from the financial crisis. I also included the front page of the USA Today from September 15, 2008, because I think this post needs some comic relief.

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, 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.

Sunday, September 12, 2010

A Scary Thought

Here's a scary thought: Let's say the European sovereign debt crisis flares up again, and one or two Euro banks fail. (Not a bank like UBS or Deutsche Bank, but a medium-sized bank like Bank of Greece or a Landesbank.) That, in turn, causes a U.S. money market fund — many of which have large exposures to Euro banks — to "break the buck," which leads to another run on money market funds.

The Fed would be powerless to help. The Fed's emergency lending authority (the famed Section 13(3)) requires that any emergency lending facility to non-banks be approved "by the affirmative vote of not less than five members" of the Fed Board of Governors. Currently, there are only four members of the Fed board: Bernanke, Warsh, Elizabeth Duke, and Dan Tarullo. Donald Kohn retired earlier this month, and the Senate has yet to vote on Obama's three nominees (Janet Yellen, Peter Diamond, and Sarah Bloom Raskin).

While I don't expect this scenario to happen, it's certainly not out of the realm of possibility. And if it did happen, the Fed would have to sit on the sidelines and watch the carnage unfold.

I understand that Senate floor time is scarce (really, I do), but this absolutely has to be at the top of the list. Yes, I know it would be time-consuming to overcome Sen. Shelby's opposition, but you know what? Screw Shelby. This has to get done, and soon.

(I'm looking at you, Sen. Reid.)

Sunday, August 15, 2010

The Fed's Backup Plan(s) for Lehman

Here are the last of the documents from the Lehman Examiner's Report that I found interesting (or at least the last ones that I'm planning to post). The first is a list of the top 25 Lehman counterparties by exposure. (CCE is current credit exposure; MPE is maximum potential exposure.) The two counterparties with the highest exposure to Lehman? The Italian government, and Berkshire Hathaway (BH Finance LLC is a Berkshire sub).

Counterparties' Exposure to Lehman (May 31, 2008)

The next two documents are the two backup plans that the Fed had for dealing with a Lehman failure. The first plan is called "Managing a Loss of Confidence in a Major Tri-Party Repo Borrower," and is dated July 11, 2008. While it initially talks about primary dealers in general, it goes on to calculate the financial impact of the plan in the event of a Lehman failure, and was very clearly developed for Lehman. The second is a good bank/bad bank plan, and involves the Fed setting up a Bear Stearns-style SPV. Had the FSA allowed Barclays to buy Lehman, and had the Wall Street consortium been unwilling to fund the entire "bad bank" to facilitate the Barclays sale, it's quite likely that the Fed would have implemented this plan. But, of course, when the time came, BofA bailed on Lehman for Merrill, and the FSA refused to let Barclays purchase Lehman.

NY Fed - Backup Plan for Lehman (July 11, 2008)

NY Fed - Lehman SPV-Style Proposal (July 15, 2008)

Next is an email exchange between Fed Vice Chairman Don Kohn and Ben Bernanke on Lehman from June 2008. The whole thing is interesting, but the most interesting part is when Kohn says to Bernanke: "One of the hedge fund types on Cape Cod told me that his colleagues think Lehman can't survive—the question is when and how they go out of business not whether. He claimed this was a Widely shared view on the Street."

Fed - Kohn Email Exchange With Bernanke on Lehman (June 12-13, 2008)
Last but not least, here's an internal JPMorgan presentation detailing JPM's exposure to Lehman as of Sept. 5, 2008. This is just interesting from a data standpoint, especially because JPM was Lehman's main clearing bank. It also partly explains why JPM decided to make their infamous $5bn collateral call on the Thursday before Lehman failed — even before JPM marked down the value of Lehman's clearing bank collateral, they had a $3bn exposure to Lehman.
JPMorgan - Lehman Exposure Summary (Sept. 5, 2008)

As I noted in my post on Lehman's liquidity pool, the financial crisis of 2008 — and the Lehman episode in particular — highlighted the pressing need for formal liquidity requirements. Fortunately, the Basel Committee has made a new liquidity regime a focus of Basel III. The new liquidity regime can be found in the December 2009 consultative document as amended by last month's Annex.

The main component of Basel III's liquidity regime is the Liquidity Coverage Ratio (LCR), sometimes known as the "Bear Stearns rule." The LCR requires banks to maintain a stock of "high-quality liquid assets" that is sufficient to cover net cash outflows for a 30-day period under a stress scenario. The formula is:

          Stock of high quality liquid assets               ≥  100%
 Net cash outflows over a 30-day time period
Net cash outflows, in turn, is calculated by applying run-off rates to different sources of funding (e.g., repos, unsecured wholesale, etc.). So the action here is in (1) the definition of "high quality liquid assets," and, more importantly, (2) the run-off rates used to calculate "net cash outflows."

1. High-Quality Liquid Assets

In the initial consultative document, the Basel Committee defined "high-quality liquid assets" extremely conservatively, such that the only eligible assets were essentially cash, central bank reserves, and sovereign debt. Crucially, Agencies and Agency MBS were excluded, due to the requirement in Paragraph 34(c)(i) that the assets have a 0% risk-weight under Basel II (Fannie and Freddie obligations have a 20% risk-weight). In last month's Annex, the Commmittee fixed this, adding a "Level 2" category of liquid assets that includes GSE obligations (but with a 15% haircut). Level 2 assets, which also includes non-financial corporate and covered bonds rated AA- or above, can't comprise more than 40% of a bank's total stock of high-quality liquid assets. I have to think this was a deliberate strategy — the Committee was always going to allow GSE obligations in the liquidity pool, but they wanted to give the banks something to howl about, and focus all their energy on.

So in sum, banks' liquidity pools have to be at least 60% Level 1 assets (cash, central bank reserves, and sovereigns) and no more than 40% Level 2 assets (GSE obligations, and non-financial corporate or covered bonds rated AA- or above). That's appropriately conservative, in my view — all of these assets would have been monetizable in 24 hours or less during the financial crisis.

2. Run-Off Rates

This is where most of the action is. The LCR proposal assigns run-off rates to each source of funding, which are designed to simulate a severe stress scenario. A run-off rate just reflects the amount of funding maturing in the 30-day window that won't roll over. I don't have the space to list all of the run-off rates — there's a handy table on pg. 32 of the consultative document, although some of the run-off rates were amended by last month's Annex. Here are the most important run-off rates (as amended by the Annex):
Retail Deposits

- Stable deposits: 5%
- Less stable deposits: 10%

Unsecured Wholesale Funding (e.g., Commercial Paper)

- Non-financial corporates, sovereigns, central banks, and public sector entities:
           - Without operational relationships: 75%
           - With operational relationships: 25% of deposits needed for operational purposes

- Financial institutions and other legal entities: 100%

Secured Funding

- Repos and securities lending/borrowing of non-liquidity pool eligible assets: 25%

Additional Requirements

- Liabilities related to derivative collateral calls related to a downgrade of up to 3-notches: 100% of collateral that would be required to cover the contracts in the case of a 3-notch downgrade

- Liabilities from maturing ABCP, SIVs, and SPVs: 100% of maturing amounts and 100% of returnable assets

- Currently undrawn portion of committed credit and liquidity facilities to non-financial corporates (including central banks, sovereigns, and PSEs):
           - Credit failities: 10%
           - Liquidity facilities: 100%
What do I think of these run-off rates? I think they're mostly appropriate and sufficiently conservative. I was pleasantly surprised by how comprehensive the LCR proposal was — that is, the Committee seems to have anticipated all the meaningful sources of funding outflows. For example, I was impressed that the LCR proposal addressed changes in the value of collateral posted on derivatives trades. I'm also glad the Committee held the run-off rate for unsecured wholesale funding from financial institutions at 100%. Given what we saw during the financial crisis, that's entirely warranted.

I was disappointed that the Basel Committee gave so much back on repos of non-liquidity pool eligible assets. Initially, the run-off rate was 100%. That was probably too high, but not outrageously so. The banks cried bloody murder, of course. Their main argument was that they were able to reliably repo out equities during the financial crisis (albeit with substantial haircuts), due to the deep market, and thus reliable marks, for most equities. That's a legitimate point; I just don't think it merits reducing the run-off rate from 100% to 25%. I thought the Committee would, at most, reduce the rate to 50%, and I think 75% would be more appropriate.

For the most part, though, the Basel Committee held firm. Partly that's because the banks' comment letters were surprisingly weak. Their main argument involved claiming that the run-off rates they experienced during the financial crisis were materially lower than the Committee's proposed run-off rates. This, they argued, demonstrated that the Committee was being excessively conservative. (See e.g., JPMorgan, passim)

The problem with this is that it's a really, umm, stupid argument. Yes, the run-off rates were probably lower during the financial crisis, but there were also massive government bailouts during the financial crisis. After Lehman failed, the market only made it 2 days without a government bailout — the Fed rescued AIG on Tuesday night, and Schumer leaked that the government was planning a system-wide bailout on Thursday. Regulators were kinda sorta hoping that we could do the next financial crisis without massive government bailouts.

Okay, that's enough on Basel III for right now.

Add: It just occurred to me that I didn't address the "expected cash inflows" aspect of the LCR. (Cash inflows are subtracted from cash outflows to arrive at "net cash outflows" for the 30-day window.) It's not that big of a deal though, because the rule for expected cash inflows is basically this: You get no cash inflows for 30 days, and you will like it.