Last night, Bloomberg reported that the Basel Committee was considering revising Basel III's new Liquidity Coverage Ratio (LCR) to allow banks to use equities in their liquidity pools. This would be a relatively major change, and one which I consider ill-advised. (For background, I've written about the LCR several times before.) From Bloomberg:

"The Basel Committee on Banking Supervision, which coordinates regulations for 27 countries, may let banks use equities and more corporate debt, in addition to cash and sovereign bonds, to satisfy new short-term liquidity standards, said two people with direct knowledge of the plans who requested anonymity because the talks are private."
At a Senate Banking hearing today, Fed Governor Dan Tarullo confirmed this report. He also indicated that the Fed would support expanding the list of assets that are eligible for the LCR's liquidity pool. Here's Tarullo after being asked about the Bloomberg report (from the CQ transcript of the hearing):
We — which is to say the Federal Reserve — was one of the entities which asked internationally to take another look at liquidity coverage ratio.
And one of the — one of the precepts, I think, for the — for the renewed look was just the point that you were making, that if you're worried about the liquidity of a firm, what you're really asking is, how well is the liabilities and the assets of that firm matched so that in a period of stress it can cover its needs in a — over some period of time so that it has a plan for — it can develop a plan for longer run survival.

And what I have thought was that the 2008 period gave us a very good real life experiment to test what kinds of instruments actually do remain liquid even during a period of stress like that. For example, highly traded equities of large companies.

So that is in fact one of the motivations for the rethink, and I believe that once the international group at the Basel Committee that's looking at the LCR has finished its evaluation next year, that you will see some changes in things like what qualifies in assumed run rates and the like, to try to conform the requirements somewhat more closely to the experience we actually had in late [2008].
Tarullo, therefore, seems to be willing to allow banks to use certain large-cap equities in their liquidity pools. (Basel III's LCR requires banks to maintain large liquidity pools, which must be made up of "high quality liquid assets," so technically what Tarullo is saying is that certain large-cap equities should be included in the definition of "high quality liquid assets.")

Two points here. First, there's a reason that most banks don't currently include equities in their liquidity pools, and that the Fed applies higher haircuts to equities in its emergency lending operations. The reason is that equities are typically more volatile than other instruments (e.g., fixed-income). Allowing banks to use equities in their liquidity pools increases the risk that a bank will have a large shortfall in its liquidity pool on a given day. Presumably, if the Basel Committee makes this change, equities would be categorized as "Level 2" high quality liquid assets (which I explained here), which means a 15% haircut would be applied. But does anyone honestly believe that a 15% haircut is enough for equities — especially given the wild swings in the equity markets that we witnessed even in 2008? I'm not at all convinced that there's a large class of equities that would be truly liquid in a crisis, and certainly not a large enough class to justify the inclusion of equities in banks' liquidity pools.

Second, I'm disappointed to see Tarullo endorse the argument that we can determine which assets are truly liquid by looking at how they fared in the 2008 crisis. As I've noted before, this is a really stupid argument. It may be true that certain large-cap equities maintained their liquidity throughout the 2008 crisis, but there were also massive government bailouts in 2008 — not to mention the extraordinary amounts of liquidity that the Fed pumped into the financial system.

How much did those large-cap equities that Tarullo refers to rely on the Fed's extraordinary lending programs (directly and indirectly) to maintain their liquidity? The point of the LCR is to ensure that banks can survive a funding crisis without massive government bailouts. Contra Tarullo, 2008 is NOT a very good — or even an appropriate — guide. Regulators will simply have to accept that determining which assets are likely to remain liquid in a TARP-free crisis will require the application of judgment on their part.

This is a development worth watching.

Monday, October 10, 2011

On the Leaked Volcker Rule

The American Banker leaked part of a draft of the regulators’ proposed Volcker Rule (pdf) last week, which has caused quite a stir. The first thing to note is that the American Banker did not leak the most important part: the text of the proposed rule. Instead, they leaked the “Supplementary Information” (which I call just the “Supplement”), the core of which is a lengthy, section-by-section analysis of the proposed rule. In addition, the leaked portion does not include the Appendices to the proposed rule, which, from reading the Supplement, appear to be very important — Appendix B, for example, contains a “detailed commentary regarding how the Agencies propose to identify permitted market making-related activities,” which is a core issue.

First I’ll give some general thoughts on the proposed Volcker Rule, and then, because I’m such a generous guy, I’ll go ahead and highlight some of the most important pressure points in the proposed rule.

General Thoughts on the Proposed Volcker Rule

In general, the proposed Volcker Rule appears to be very good: it’s a serious effort by a group of smart, market-savvy people to draw a workable distinction between market-making and proprietary trading. The regulators recognize the importance of both market-making and hedging, but they also recognize (most of) the places where market-making and hedging can bleed into proprietary trading. And in those situations, the regulators realize that any effort to distinguish impermissible prop trading from permissible market-making or hedging will — quite appropriately — require a very fact-intensive inquiry. That said, I’m still going to have to withhold my final judgment until I see the actual text of the proposed rule.

Also, even though the WSJ keeps trying to gin up controversy over the proposed Volcker Rule allowing hedging on a portfolio basis, the regulators note in the Supplement that allowing hedging on a portfolio basis is “consistent with the statutory reference to mitigating risks of individual or aggregated positions” (emphasis in original). I explained this a couple of weeks ago; it is a faux-controversy. Moreover, prohibiting banks from hedging on a portfolio basis is a monumentally stupid idea in the first place — it would make risk managers’ jobs 100 times harder, introduce all sorts of new risks into banks’ books (counterparty risk would skyrocket), and dramatically raise hedging costs. This is one thing that the statutory text of the Volcker Rule actually got right.

Some Pressure Points in the Proposed Volcker Rule

Now, to the nitty-gritty of the proposed rule. Here some of the major pressure points in the proposed Volcker Rule that I see:

1. Hedges must be “reasonably correlated” to the underlying risk: In defining “risk-mitigating hedging activity,” the rule requires that the hedge be “reasonably correlated” to the underlying risk(s). The Supplement implies that the correlation must be reasonable at the outset of the hedging transaction, which is absolutely appropriate — a lot of times, you think a trade will be a good hedge when you put the trade on, but because of circumstances beyond your control, it turns out not to be a very good hedge (e.g., liquidity may unexpectedly dry up in either the underlying or the hedge, screwing up the normal correlation).

The real question here is: in normal market conditions, when does the correlation between the hedge and the underlying become “unreasonable”? In other words, how much leeway will banks have in determining how to hedge their books? Say a bank enters into a swap that only hedges 50% of the DV01 of the underlying bond. Would that be considered “reasonably correlated” to the underlying risk? (Obviously, I’m simplifying my examples for illustrative purposes.) After reading the Supplement, I strongly suspect that I know what the regulators’ answer would be: it depends on the particular facts and circumstances. If, for example, the swap was coupled with another transaction that hedged the remainder of the DV01 of the underlying bond, then both transactions would be permitted, because when viewed together, they were both part of a legitimate hedging strategy.

The Supplement also hints at what regulators would NOT consider to be “reasonably correlated” — it states that “[a] transaction that is only tangentially related to the risks that it purportedly mitigates would appear to be indicative of prohibited proprietary trading” (emphasis mine). I think it would be a stretch to say that regulators intend to consider any transaction that’s more than “tangentially related” to be a “reasonably correlated” hedge. But this at least indicates that regulators won’t simply accept a hand-waving, “trust me, they’re related” response to inquiries about the appropriateness of a hedge.

In the end, what we know is that a permissible hedge must be less than “fully correlated” but more than “tangentially related” to the underlying risk, and that if the appropriateness of a hedge is questioned, it will be a very fact-intensive inquiry. Which, by the way, is the way it should be.

2. “Additional significant exposures”: The proposed rule prohibits hedges that themselves introduce significant, unhedged exposures. However, the Supplement also states that:

“[T]he proposal also recognizes that any hedging transaction will inevitably give rise to certain types of new risk, such as counterparty credit risk or basis risk reflecting the differences between the hedge position and the related position; the proposed criterion only prohibits the introduction of additional significant exposures through the hedging transaction.”
There are actually three potential flashpoints in this prong. The first flashpoint is what constitutes “additional significant exposures.” How significant does the new risk that the hedging transaction is introducing have to be before regulators will require it to be hedged as well?

The second flashpoint is what constitutes mere “basis risk,” and what constitutes an impermissible residual risk. The Supplement says that a hedge that merely introduces counterparty or basis risk is permissible. Here’s what I would tell our trading desks if I were still working at an investment bank: start calling every residual risk a “basis risk.” Basis risk evidently doesn’t need to be hedged under the proposed Volcker Rule, regardless of how significant the exposure is. So if you want to profit from the price movement in a certain risk, then just partially hedge the risk with another transaction and call the residual risk “basis risk.”

The third flashpoint has to do with when the “additional significant exposure” must be hedged. The Supplement states that if a hedge introduces a significant new exposure, then the exposure must be hedged “in a contemporaneous transaction.” Assuming that regulators will allow banks some time to hedge the new exposure, the question becomes how much time will they have to hedge the new exposure? An hour? A day? A week? I strongly suspect that the regulators’ answer will be that banks will have to hedge the new exposure “as fast as humanly possible” (not in those words, obviously — the legislative language will probably be something like “as quickly as technologically practicable.”)

3. “Bona fide liquidity management”: This is where I would go first if I was trying to circumvent the Volcker Rule. The statutory text of the Volcker Rule defines proprietary trading in a very roundabout way, such that the real definition of proprietary trading is in the definition of a “trading account.” However, the proposed rule provides an exclusion from the definition of a “trading account” for accounts that are use “to acquire or take a position for the purpose of bona fide liquidity management, so long as [five] important criteria are met.”

The reason I would go here first if I was trying to circumvent the Volcker Rule is that if a trade could fit under the “bona fide liquidity management” exclusion, there would be no need to bother with any of the more complicated “permitted activities” exceptions, and evidently, no need to report nearly as much, if any, quantitative trading data to regulators.

The proposed rule requires that trades done under the liquidity management exclusion be done according to a “documented liquidity management plan” that meets five criteria. But none of the five criteria in the proposed rule appear to me to be prohibitive if a bank wanted to use the liquidity management exclusion for prop trades. The plan has to “specifically contemplate and authorize any particular instrument used for liquidity management purposes” — fine, just write a liquidity management plan that contemplates the use of a (very) wide range of instruments (a lot of instruments have reasonably liquid markets in normal times). The second criterion basically requires that an instrument used for liquidity management not be used “principally” for prop trading purposes, which is easy, since prop trading is prohibited regardless of whether it’s the “principal” purpose of the instrument.

The third criterion requires the liquidity management plan to be “limited to financial instruments the market, credit and other risks of which are not expected to give rise to appreciable profits or losses as a result of short-term price movements.” This criterion simply can’t be enforced terribly stringently — even Treasuries, which are the core of any serious liquidity pool, often experience significant short-term price movements. Fourth, the plan would have to limit liquidity management positions to “an amount that is consistent with the banking entity’s near-term funding needs.” This also can’t be seriously enforced, because it would directly conflict with Basel III’s new Liquidity Coverage Ratio (LCR), and cautious liquidity management in general. Finally, the plan would have to be “consistent with the relevant Agency’s supervisory requirements ... regarding liquidity management.” Seeing as the new liquidity rules set a floor on a bank’s liquidity management, and not a ceiling, using instruments that don’t qualify for the LCR in a broader liquidity management plan would certainly still be “consistent with” the regulators’ liquidity requirements.

4. “Near term” / “Short term”: The statutory text of the Volcker Rule effectively defines a proprietary trade as any trade done “principally for the purpose of selling in the near term.” While the Supplement doesn’t provide much detail on what constitutes “near term,” it does hint at an answer: 60 days or less. The proposed rule will apparently include a rebuttable presumption that any account used to take a position that is held for less than 60 days will be considered a “trading account.” Therefore, it stands to reason that accounts which are used (exclusively) to take positions that are held for longer than 60 days will not normally be considered “trading accounts,” and thus not subject to the Volcker Rule. But, of course, I strongly suspect that the regulators will say that this determination is ultimately going to be based on the particular facts and circumstances of the trade.

Anyway, there are a few more pressure points like this in the Supplement, but that’s all I have time for right now.

No need to beat around the bush here: Ron Suskind’s “Confidence Men” is a terrible book. It’s not even remotely accurate, and contains surprisingly little new, original information.

The fundamental problem is that Suskind is stunningly ignorant of basic macroeconomics, financial markets, the financial crisis, and financial regulations — basically, all the subjects you’d need to understand in order to write a competent book about the Obama administration’s economic team. It also contains so many patently absurd, completely unsourced assertions that it’s really not a question of whether Suskind makes up some of his material, but rather how much of his material is made up.

Curiously, the articles slamming Suskind’s book almost all cite a series of minor errors (e.g., saying Tim Geithner was the “chairman” of the NY Fed rather than the “president”) in order to demonstrate Suskind’s incompetence. The book is riddled with much more major errors — errors which provide the foundation for his cooked-up narrative. To give you a flavor of what I’m talking about, here are a few representative examples.

Suskind’s Ignorance of Basic Macroeconomics/Monetary Policy

On page 22, Suskind claims that the idea of making interest rate cuts the primary tool of monetary policy was “an innovation of previous Fed chairman Alan Greenspan.” Yep, no central banker had ever thought to make interest rate cuts their primary policy tool before Greenspan. It gets worse though. Suskind then claims that Fed interest rate cuts only stimulate the economy because they “prompt everyone, everywhere, to roll over debts of all kinds by replacing whatever is on their balance sheet with its equivalent.” That’s it. Interest rates are cut, everyone refinances all their loans, and that’s it. No new loans being made, no inflation, nothing. This is what he thinks monetary policy is (and he repeats this several more times in the book, so it’s clearly how he thinks monetary policy works). This is not some trivial detail, either — how can Suskind be expected to understand the decisions that were being made if he can’t even understand how the Fed works on the most basic level?

Suskind’s Ignorance of the Repo Market

On pages 72–73, Suskind’s complete ignorance of the repo market causes him to badly misinterpret something Tim Geithner said to him — an interpretation which he then uses to further his very unflattering portrait of Geithner.

First of all, Suskind simply asserts, without any sourcing at all, that in August 2007, Geithner had only a “passing familiarity” with the repo market. The idea that the president of the NY Fed had only a “passing familiarity” with repos is absurd on its face. One of the NY Fed’s primary functions is implementing monetary policy, and one of the main ways it does this is by entering into — you guessed it! — repos. Did someone tell Suskind that Geithner only had a “passing familiarity” with repos? Clearly not, or else he would have sourced it, even anonymously. No, it’s clear that Suskind simply made it up in order to further his fictitious unflattering portrait of Geithner.

Ironically, Suskind then proceeds to demonstrate his own ignorance of the repo market, in a discussion of Countrywide’s difficulties securing repo financing in August 2007. From the book (emphasis on the comically wrong parts added):

“That was really interesting,” Geithner later reflected, “because Countrywide had no idea what its exposure was, no understanding of what it had gotten into. And the fact that the market was unwilling to fund Treasuries if Countrywide was a counterparty was the best example of how fragile confidence was and how quickly it turned.”

Translation: the market would not even lend Countrywide cash to buy Treasury bonds, the safest investment in the firmament. CDOs, MBSs, or similar types of mortgage-based collateral that Countrywide was using to roll over its repo loans were suddenly seen as impossible to value or sell in August 2007, meaning that it was illiquid. The whole point of collateral is that it can be taken — the way the repo man repossesses your car after too many missed payments — and sold in liquid markets for cash. Collateral that is illiquid is no collateral at all. Countrywide’s intended use for the borrowed funds — to go out, like Sal Naro, and buy Treasuries and shore up its balance sheet or to use them as collateral for emergency bank loans — was irrelevant. Its collateral was no good.

Geithner, at the time and looking back, saw this strictly in terms of confidence.
No, no, a thousand times no! Suskind completely misinterpreted what Geithner was saying. Countrywide wasn’t trying to use CDOs and MBSs to fund its repo book — it was trying to use Treasuries as collateral on repos, and counterparties were still refusing to roll over Countrywide’s repos. That’s why Geithner said it was “really interesting” — because market participants had become so scared of counterparty risk that they wouldn’t even lend against Treasuries (which in theory shouldn’t happen). Suskind evidently doesn’t know that Countrywide originated the subprime mortgages that went into the MBSs and CBOs; it wasn’t the end investor in the CDOs. But Suskind uses his horrible misinterpretation to paint Geithner as naïve and in denial about the depth of the problems in subprime MBSs and CDOs. (“Silly Geithner, he thought it was just a confidence problem!”) There’s a mistake like this on practically every page of the book (his misinterpretation of a memo by UBS’s Robert Wolf is classic in its utter wrongness too), and it all contributes to a narrative that, at the end of the day, is simply false.

Suskind’s Ignorance of the Difference Between Creditors and Equity Holders

Finally, in the chapter on Geithner’s alleged refusal to resolve Citigroup (which very clearly never happened) Suskind writes:
Geithner, on this point, would not budge. Debt was sacrosanct. No creditor would suffer. Bair was equally intransigent. Secured creditors, such as equity holders, of course, wouldn’t be wiped out, but they had to face consequences for lending money to an institution whose recklessness had led to its demise. They must, she said, “face some discipline.”
Yes, you read that right: Suskind does not know the difference between secured creditors and equity holders. He apparently thinks that in a resolution of Citi, equity holders “wouldn’t be wiped out” (“of course,” he says). Again, this is not a trivial mistake — this is enormously important, because the entire debate over what to do with Citi revolved around the distinction between creditors and equity holders. The FDIC was (allegedly) advocating putting Citi’s commercial bank subsidiary into receivership, which would haircut creditors, whereas Geithner was advocating the stress tests, which in a worst-case scenario would lead to the government diluting equity holders, but not haircutting creditors.

This demonstrates quite clearly that Suskind lacked the knowledge or ability to understand the central dispute in his own book — the dispute that made headlines all over the country. How can Suskind be expected to understand what happened in this dispute if he couldn’t even understand what the dispute was about in the first place?

The answer, obviously, is that Suskind’s account of the dispute is not credible. (Bolstering that conclusion is the fact that the meeting in which Obama allegedly ordered the resolution of Citi has been reported on several times before, and every other journalist reported that Obama decided against resolving Citi.)

Anyone who is even remotely familiar with the financial crisis, or financial markets in general, would be able to catch 90% of Suskind’s mistakes/fabrications, so I don’t know how anyone who knows this material could possibly consider Suskind’s book credible. His account of the financial reform debate was, if possible, even more riddled with fundamental misunderstandings and mistakes, which renders his telling largely false. I was as close to the financial reform debate as anyone, and Suskind’s account is simply not what happened.

In any event, don’t waste your money.

Sunday, September 25, 2011

The Volcker Rule Isn’t Being Diluted

I want to smack down this particular bit of misinformation before the regulators release their proposed Volcker Rule, so that they don’t get hammered for absolutely no reason.

Last week, the WSJ ran a story claiming that a draft version of the regulators’ proposed Volcker Rule would substantially weaken the original law, because the draft rule defines “hedging” on a “portfolio basis.” The problem with this story is that it’s 100% wrong. From the article (emphasis mine):

At issue is how regulators and banks define “hedging,” or trades designed to offset risk taken by a bank, usually on behalf of customers.

The law originally defined hedging narrowly as trades tied to specific bets.
Actually, no. The law did NOT originally define hedging narrowly as trades tied to specific bets. Here’s how the law defined “risk-mitigating hedging activities,” which are exempt from the prop trading ban (emphasis mine):
“(C) Risk-mitigating hedging activities in connection with and related to individual or aggregated positions, contracts, or other holdings of a banking entity that are designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings.” (Dodd-Frank § 619(d)(1)(C))
As you can see, it was the original law that defined hedging on a portfolio basis. This means that the regulators had no choice but to define hedging on a portfolio basis — the regulators are simply interpreting and fleshing out the original law, and the original law said that banks can permissibly hedge on a portfolio basis.

The law said that the hedges have to be “designed to reduce specific risks,” but risks can be — and, in fact, almost always are — faced on a portfolio basis. Interest-rate risk, for example, is typically measured and hedged on a portfolio basis — banks don’t hedge the interest rate risk on each Agency MBS they hold in inventory individually, because that would be horribly inefficient; instead, they measure the interest-rate risk of their entire Agency MBS portfolio, and hedge that. (And in reality, this “specific risks” limitation is meaningless anyway, because if a transaction wasn’t designed to reduce a specific risk, then it wouldn’t be a “hedge” in the first place, now would it?)

So, clearly, the original law explicitly stated that banks are allowed to hedge on a portoflio basis. The fact that the regulators’ draft rule allows banks to hedge on a portfolio basis does not weaken, dilute, or otherwise change the scope of the Volcker Rule one bit.

Sunday, September 11, 2011


Since everyone is telling their 9/11 stories today, I guess I'll share mine. Having experienced the terrorist attacks on 9/11 up close, this day always bring back terrible memories.

My wife and I were both working in the Financial District, and my wife's office was very, very close to the Twin Towers. I had walked over to my wife's office to drop something off that she had forgotten at home, and I was standing in her office waiting for her to finish a call when we heard the first plane hit the North Tower. Most people on her floor went outside to see what was going on / get a better look, because none of us had any idea what had happened. We were standing outside when the second plane hit the South Tower, although I didn't actually see the impact; it was, however, the loudest noise I've heard in my life. I thought there had been a massive explosion in the North Tower at first. Even at that point, we weren't really sure it was an attack, because we still didn't know for sure what had happened to the North Tower. People had been speculating that a plane had hit the North Tower, but no one we talked to had actually seen the plane go into the tower. All you could see was a giant hole in the side of the building with smoke pouring out.

After the second plane hit, people naturally started to panic. My wife always kept a near-lifetime-supply of bottled water in her office, so we went back inside to get them to hand out to people who were coming down the street from the WTC. Handing out bottled water seemed like a very good idea at the time; we hadn't yet realized how dangerous it was to be so close to the WTC. Partly that's because, despite what everyone says in hindsight, a lot of people still weren't sure that we were under attack even after the second plane hit, and so were just standing around staring at the towers rather than fleeing. I wasn't 100% convinced myself, because some people were still claiming that the explosion in the North Tower had been a massive pipe explosion. Anyway, after we handed out the bottled waters and made a few calls on our cell phones to check on friends who worked in the WTC, police officers started telling everyone to clear the entire area immediately. So we started moving down Liberty Street (toward the bridge).

We had only been walking away for about 60 seconds when the South Tower collapsed. I had my back turned initially, but I remember turning around when the rumbling started and seeing the massive cloud of dust and debris rushing toward us. Everyone turned and ran, and I was shocked at how quickly the cloud of dust/debris was on top of us. We barely made it half a block before the cloud effectively engulfed us. (It was very hot.) Once the dust/debris started to clear, it was just pure chaos. There's no other way to describe it. We moved as fast as we could toward the bridge, but everyone seemed to be running in different directions. (No one really knew where we were supposed to run to; "away from here" was the only real consensus.) Eventually we made it to the bridge, where, like everyone else, we remained for basically the rest of the day.

It was, obviously, the most harrowing experience of my life.

As you’ve probably heard, the DC Circuit struck down the SEC’s proxy access rule last month, in Business Roundtable and Chamber of Commerce v. SEC. The three-judge panel held that the SEC’s proxy access rule was “arbitrary and capricious” because the SEC failed “adequately to assess the economic effects of a new rule.” Unlike most securities lawyers, to whom proxy access is a huge deal, I personally don’t find proxy access terribly interesting. But the Business Roundtable decision will affect many future SEC rules required under Dodd-Frank, so it’s important to consider the decision, and how the SEC should proceed in light of the decision.

For a variety of reasons, I think the DC Circuit’s decision was terrible — hilariously biased, and generally not worth the paper it was written on. (Not surprisingly, the opinion was written by failed Reagan Supreme Court nominee Douglas Ginsburg, who also wrote the 2005 opinion striking down another SEC rule.)

In the court’s words:

[T]he Commission has a unique obligation to consider the effect of a new rule upon “efficiency, competition, and capital formation,” 15 U.S.C. §§ 78c(f), 78w(a)(2), 80a-2(c), and its failure to “apprise itself — and hence the public and the Congress — of the economic consequences of a proposed regulation” makes promulgation of the rule arbitrary and capricious and not in accordance with law.
The SEC did, in fact, engage in an unusually lengthy cost-benefit analysis in its proposed rule and its final rule. But the court, clearly determined to find some reason to strike down the proxy access rule, found a few arguments raised by commenters that the SEC didn’t completely and definitively rebut, and used that to conclude that the SEC had failed to adequately consider the effect of the new rule on “efficiency, competition, and capital formation.”

As a preliminary matter, I think the court’s reasoning was comically weak. On one issue, the court conceded that the empirical evidence was “mixed,” but then bizarrely refused to allow the SEC any deference whatsoever in arbitrating between competing empirical studies. In other words, the SEC chose to believe the empirical studies that went against the court’s policy preferences. Awesome. On another issue, the court faulted the SEC for not irrationally assuming that “union and government pension funds” would use the proxy access rule to harm “shareholder value.” (Remember when conservatives used to argue that employee ownership schemes would promote glorious efficiency by aligning the interests of labor and management? I miss those days.)

So what should the SEC — which has to write a slew of regulations implementing Dodd-Frank in the next few years — do in light of the Business Roundtable decision? First, where it’s able to, the SEC should certainly humor the DC Circuit and engage in a (very) detailed cost-benefit analysis.

Second, and more importantly, the SEC shouldn’t be afraid to admit that a proposed rule won’t necessarily maximize “efficiency, competition, and capital formation.” The DC Circuit can’t strike down an SEC rule on the grounds that it doesn’t promote “efficiency, competition, and capital formation.” Let’s look at the statute, 15 U.S.C. § 78c(f):
Whenever pursuant to this chapter the Commission is engaged in rulemaking, or in the review of a rule of a self-regulatory organization, and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission shall also consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation. (emphasis mine)
The SEC isn’t required to only promulgate rules that will promote efficiency, competition, and capital formation — it’s only required to consider those factors. And that’s in addition to another, separate, factor — the protection of investors. So if the SEC can’t prove that one of its proposed rules will promote efficiency, competition, and capital formation, the agency can still issue the rule on the grounds that it protects investors. The other relevant statute, 15 U.S.C. § 78w(a)(2), simply requires the SEC to determine that any harm to competition caused by a proposed rule is “appropriate in furtherance of the purposes of” the ’34 Act — which includes investor protection. The Business Roundtable decision just means that the SEC has to lay out its efficiency analysis in detail, even if the conclusion is that the rule won’t promote efficiency.

Essentially, the SEC shouldn’t be afraid to tell the DC Circuit to take its “efficiency, competition, and capital formation” analysis and shove it, and that investor protection is still paramount, thank you very much. Not in those words, of course. But you get the idea.

Monday, August 8, 2011

On S&P, Downgrades, and Idiots

This is not going to be one of those posts that laments S&P’s decision to downgrade the US, but then says that S&P was probably right about our oh-so-dysfunctional political system.

No, S&P was flat-out wrong — no caveats. They are, to put it very bluntly, idiots, and they deserve every bit of opprobrium coming their way. They were embarrassingly wrong on the basic budget numbers, as everyone knows now, so they were forced to remove that section from their report, and change their rationale for the downgrade. (Always a sign that you’re dealing with hacks.)

S&P’s rationale for the downgrade now is based entirely on their subjective political judgement — and their political judgement is wrong. The brilliant political minds over at S&P said that “the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges.”

That sounds like a Very Serious and Sober assessment, but it’s really not. It’s true that the debt limit debate was ridiculous, and that a large contingent of Tea Party freshmen in the House were threatening to not raise the debt ceiling. But here’s the thing: we still raised the debt ceiling, and in such a way that this Congress won’t have the opportunity to use the debt ceiling as a political bargaining chip again.

S&P’s assessment is only remotely serious if you assume that this particular Congress, with its huge contingent of crazy Tea Partiers, is going to serve in perpetuity. But this Congress isn’t going to serve in perpetuity — there are elections next year, and many of the Tea Party freshmen are likely to lose. They won in 2010 because it was a “wave election” in the middle of a very severe economic slump. But 2012 is a presidential election cycle with an incumbent Democratic president. A lot of these Tea Partiers who won in traditionally Democratic districts (and swing districts) are going to lose. In fact, it’s probably even odds that the Dems take back the House.

The simple fact is that the Tea Partiers are almost certainly at the height of their power in this Congress. And no, the debt ceiling debate doesn’t reflect some sort of secular change in US policymaking — the next time there’s a Republican president, House Republicans will be all about raising the debt ceiling, and Democrats won’t engage in the same kind of political brinksmanship. You’d have to be stunningly naïve not to believe this.

There have also been plenty of political de-escalations over the years — Republicans didn’t shut down the government every year after 1995, for instance. After Tom DeLay won the Medicare Part D vote by holding the vote open for 3 hours, everyone claimed that this would be the new normal on all controversial votes. Didn’t happen. There are plenty of one-off political confrontations. Simply assuming that every political confrontation represents a secular change in US politics and policymaking is ridiculous.

(S&P tries to side-step this obvious weakness in their so-called “argument” by claiming that by the time the 2012 elections roll around, it will be too late. Please. The idea that we have to act in the next 18 months in order to meaningfully affect our long-term solvency is patently absurd.)

Look, I know these S&P guys. Not these particular guys — I don’t know John Chambers or David Beers personally. But I know the rating agencies intimately. Back when I was an in-house lawyer for an investment bank, I had extensive interactions with all three rating agencies. We needed to get a lot of deals rated, and I was almost always involved in that process in the deals I worked on. To say that S&P analysts aren’t the sharpest tools in the drawer is a massive understatement.

Naturally, before meeting with a rating agency, we would plan out our arguments — you want to make sure you’re making your strongest arguments, that everyone is on the same page about the deal’s positive attributes, etc. With S&P, it got to the point where we were constantly saying, “that’s a good point, but is S&P smart enough to understand that argument?” I kid you not, that was a hard-constraint in our game-plan. With Moody’s and Fitch, we at least were able to assume that the analysts on our deals would have a minimum level of financial competence.

I’ve seen S&P make far more basic mistakes than the one they made in miscalculating the US’s debt-to-GDP ratio. I’ve seen an S&P managing director who didn’t know the order of operations, and when we pointed it out to him, stopped taking our calls. Despite impressive-sounding titles, these guys personify “amateur hour.” (And my opinion of S&P isn’t just based on a few deals; it’s based on countless deals, meetings, and phone calls over 20 years. It’s also the opinion of practically everyone else who deals with the rating agencies on a semi-regular basis.)

Treasury has every right to be outraged. S&P mangled the economic argument so badly that they had to abandon it entirely, and then fell back on a political argument which they are in no position to make, and which isn’t even correct.

So to S&P, I say: you should be ashamed of yourselves, and I truly hope this is your downfall.

I’m torn on this one. By any objective measure, the deal is really, really bad public policy. And the one thing that really scares me about failing to reach a deal — defaulting on Treasuries, which would be beyond catastrophic — has been taken off the table by the Treasury, which said that it will prioritize interest payments.

The relevant question in this situation, however, is whether a revolt by House Democrats could move the bill to the left. I think it could, but it unfortunately depends on what the Tea Party freshmen do. The way I see it, the only way the deal moves to the left is if it fails in the House because of a significant Tea Party revolt.

If Boehner loses so many Tea Partiers that he can’t possibly expect to win them back, then his only option will be to pass a bill with the Dems. If that happens, then the Dems could — and should — extract significant concessions from Boehner in exchange for their support. And I think Boehner would absolutely be open to making significant concessions. When Boehner was whipping for his bill last week, he was telling Tea Party freshmen that if his bill failed, then he was going to introduce a clean debt limit bill and pass it with the Democrats and 30 moderate Republicans.

I still think Boehner can be forced into that position — but only if there’s absolutely no chance that he can win enough Tea Partiers to pass a bill with just Republicans. If the deal fails in the House because something like 5–7 Tea Partiers vote no, then Boehner can still probably pick off enough Tea Party holdouts to pass the bill on a second try. But if the deal fails and Boehner loses 20–30 Tea Partiers, then there are no changes that he could realistically make to win them back. His only option would be to pass a bill with the Dems and 30 moderate Republicans. (And yes, I think the Senate will pass whatever deal the House sends them. McConnell would pass a clean debt limit bill if he really had to.)

So at this point, I think House Dems should vote against the debt limit deal. If Boehner/Cantor/McCarthy have enough juice to pass the deal with just Republicans, then good for them. Make them own it though. I’m sure a few conservative House Dems (e.g., Shuler, Matheson) will vote for the deal, but hopefully Pelosi can hold the line with the rest of the caucus.

Thursday, July 21, 2011

Dodd-Frank: One Year Later

For Dodd-Frank’s one-year anniversary, I did an interview with Mike Konczal on how the first year went. You can read the interview here. Unlike the vast majority of commentators who have been talking about Dodd-Frank this week, I’ve been following the rulemaking process very closely (as regular readers know), and I have some positive things to say.

You should also read Mike’s interview with Marcus Stanley, who is the legislative director for the progressive group Americans for Financial Reform. Like me, he’s intimately familiar with the Dodd-Frank rulemaking process, and he also has positive things to say. Funny how that works!

Dean Baker has a column in the Guardian (via Mark Thoma) arguing that:

The idea that Republicans in congress were going to force big cuts in the country’s most important programs – social security, medicare, and medicaid – by taking Wall Street hostage with the debt ceiling is absurd. It was only necessary for President Obama to call their bluff.

The bottom line is that the debt ceiling is a gun pointed first and foremost at Wall Street’s head. And, there is no way on earth that Wall Street is going to let the Republicans pull the trigger.
This is silly. “Wall Street,” by which Baker means the major banks, has very little sway over the 87 Tea Party freshmen. It’s the GOP freshmen who are currently the key constituency in the debt ceiling negotiations, and if anything, most of them would take pride in rejecting impassioned pleas from JPMorgan and Goldman Sachs. The idea that the major banks can just snap their fingers and get the Tea Party freshmen to drop their debt ceiling demands is beyond ridiculous. The Tea Party freshmen are thoroughly crazy, and there’s no telling what they’ll do. But if you think they’re all tools of Wall Street, then you simply haven’t been paying attention.

Of course, making this argument allows Dean to — what else? — blame Obama, this time for not “calling their bluff.” (It’s easy to call bluffs from the sidelines, isn’t it?) Which, let’s be honest, was the point of his column anyway.

Monday, July 11, 2011

Obama and the “Grand Bargain”

What are we to make of Obama’s “grand bargain”? My initial reaction to the news that Obama was putting Social Security and Medicare cuts on the table was despair. What was/is the White House thinking? Obviously, no one outside the White House knows for sure, but I think I have a pretty good idea.

As I said in a DM exchange with Mike Konczal on Wednesday night, I think the White House is trying to scare Democrats into accepting a deficit reduction deal with little or no revenue increases. I think Boehner can’t get the votes in the House for a deal that includes any revenue increases, and I think the White House knows it. They know that the final deal will end up being 100% spending cuts. The problem with this is that it might not get enough Dem votes to pass — especially if Dems on the Hill are obsessing about the ratio of spending cuts to revenue increases throughout the negotiations.

So in order to retain enough Dems, the White House needs to make sure that the $2 trillion, all-spending-cuts deal is the “compromise” position. If the alternative is an even larger deficit reduction deal that includes savage cuts to Social Security and Medicare, then plenty of Dems will be downright eager to vote for a deficit reduction deal that doesn’t touch Social Security or Medicare, even if it is 100% spending cuts. If you know that the final deal will be 100% spending cuts, then you don’t want the Dems to make their “line in the sand” the inclusion of revenue increases. By putting Social Security and Medicare on the table, you allow the Dems to make the protection of those programs their “line in the sand,” rather than the inclusion of revenue increases. And that will free enough Dems up to vote for the final, all-spending-cuts deal.

This would also explain why Obama is still saying that he wants a “grand bargain,” even after Boehner said that they should focus on the smaller deal that the Biden-led group had been working on — for the strategy to be effective, the grand bargain needs to continue to be a viable option (that the Dems are afraid of).

Now, we can argue about whether Obama truly wants to strike a “grand bargain” that cuts Social Security and Medicare. I don’t know if he does, and neither do you. (It’s certainly possible that he does, but again, I don’t know.) However, I think that question, interesting though it may be, is ultimately irrelevant. Even if Obama truly does want a grand bargain, there’s simply no way that he thinks they can agree on $1 trillion in tax increases, and an overhaul of Social Security, Medicare, and Medicaid, all in under 2 weeks. Purely as a legislative matter, it’s almost an impossible task, which I’m sure Phil Schiliro would have explained to him. So really, the only way the “grand bargain” makes sense is if it’s a negotiating strategy.

And if this is a negotiating strategy, the best explanation is that the White House is using the threat of Social Security and Medicare cuts to scare Democrats into voting for an all-spending-cuts deal.

Risk has an interesting article ($) on the plans by some dealers to offer “collateral transformation” services to derivatives end-users. Requiring most derivatives to be cleared means that end-users will have to post daily variation margin to the clearinghouse (or “CCP”). Here’s how Risk describes the problem:

The problem centres on the type of collateral required by CCPs — or more specifically, the fact that many end-users don’t hold enough of it. Clearing houses only accept cash for variation margin, and usually insist on cash or sovereign bonds for initial margin. However, many buy-side users of derivatives tend not to invest in these assets — at least, not in the amounts that might be necessary.
Clearing members [i.e., the dealers] say they have a solution. ... [C]learing members are responsible for collecting margin from their clients and posting it to the clearing house, charging a fee for the privilege. As an additional service, however, a number of clearing members are also planning to offer collateral transformation facilities — essentially, enabling the client to post non-eligible instruments with the dealer, which will be switched into cash via the repo market and then posted with the CCP.
So the plan is to concentrate liquidity risk at the dealer banks? Gee, what could possibly go wrong?

In all seriousness though, this is something that regulators should pay very close attention to. It’s easy enough* for dealers to tell regulators that their exposure is limited because the agreements are “unconditionally revocable” — that is, the dealer can unilaterally refuse to fund the client’s variation margin if the markets get too rough, and can demand that the client put up the cash. But it’s not nearly as easy for the dealer to tell its big hedge fund and pension fund clients to take a hike during a crisis. Think about it. If, say, Morgan Stanley refuses to fund a client’s variation margin call when the markets get volatile, the client will (a) be pissed, and (b) will start thinking, “What’s going on here? Is Morgan Stanley having trouble accessing the repo markets? If they can’t fund themselves in the repo markets, how much longer can they stay in business? Shit, I better pull my prime brokerage account at MS.” Then the run begins.

I’m not saying that no dealer would ever be able pull the trigger and refuse to fund a client’s variation margin. I’m just saying that this kind of arrangement could very easily turn into a non-contractual commitment to meet clients’ variation margin calls during a crisis. And that would undermine the dealers’ inevitable argument about how the unconditionally revocable nature of the arrangements means that the liquidity risk would be pushed back onto the clients — and away from the dealers — during a crisis.

So what should regulators do about “collateral transformation”? Well, for one thing, they should treat collateral transformation very harshly in Basel III’s Liquidity Coverage Ratio (LCR). Since these arrangements would almost certainly be structured as unconditionally revocable, they would be considered “Other Contingent Funding Liabilities” under the LCR. The run-off rate for “Other Contingent Funding Liabilities,” which determines the size of the liquidity buffer the dealers would have to hold against their collateral transformation arrangements, has been left to the discretion of national regulators. In addition to the run-off rate, national regulators also have to come up with assumptions for how much clients’ variation margins could move against dealers in the LCR’s 30-day stress scenario.

The safest route would be to set the run-off rate at 100% — that is, to assume that the dealers will fund 100% of clients’ variation margin through their collateral transformation services. A 75% run-off rate would probably be appropriately prudent as well — dealers will probably be able to say no to at least some clients, and will likely come up with other ways to mitigate some of the risk to themselves.


* Actually, drafting and negotiating these types of contracts is a fiendishly difficult and contentious process, but that’s neither here nor there.

Wednesday, June 29, 2011

SIFIs and Capitalism

Thomas Hoenig garnered a bunch of headlines the other day for, as usual, making a provocative and hyperbolic statement about financial reform. Discussing the concept of systemically important financial institutions (known as SIFIs), Hoenig said:

“I suggest that the problem with SIFIs is they are fundamentally inconsistent with capitalism. They are inherently destabilizing to global markets and detrimental to world growth. So long as the concept of a SIFI exists, and there are institutions so powerful and considered so important that they require special support and different rules, the future of capitalism is at risk and our market economy is in peril.”
Oh no! The future of capitalism itself! Not surprisingly, Hoenig doesn’t explain this bizarre assertion; he just makes the provocative statement and moves on, which is par for the course for him. Of course, anyone who understands this issue beyond the level of superficial sound-bites knows that Hoenig’s claim is ill-informed nonsense.

It’s true that SIFIs are subject to “different rules” — they’re subject to more stringent regulations, and to more conservative capital requirements. They’re subject to a prompt corrective action (PCA) regime, liquidity requirements, resolution plans, enhanced public disclosures, and additional stress tests. (I know what you’re thinking: “How did the big banks convince Congress to shower them with all these goodies? Is there no end to the corruption?”)

SIFIs are also likely (though not automatically) subject to the Title II resolution authority, which makes it easier for SIFIs to fail. The Title II resolution authority mirrors the FDIC’s resolution authority for commercial banks, except Title II is more stringent — e.g., unlike the resolution authority for commercial banks, Title II doesn’t permit “open-bank assistance” for SIFIs. And back during the nationalization debate, Hoenig was absolutely convinced that the resolution authority could successfully wind-down even the largest, most complex financial institutions.

So if SIFIs can in fact fail just like any other bank under the new resolution authority (which Hoenig has said they can), and the only difference between SIFIs and other banks is that SIFIs are subject to more stringent regulations, how exactly are SIFIs threatening the future of capitalism? The answer, of course, is that they’re not. This is just Hoenig looking to get in the papers by saying something mean about the Big Banks.

Just remember that Hoenig is also the guy who’s been warning about runaway inflation for the past two years, and who thinks the Fed shouldn’t “bring [unemployment] down too rapidly.” So take him seriously at your own peril.

Sunday, June 26, 2011

Capitol Capitalist

Sorry I haven’t been able to post much lately; work has been very busy, and I’ve been on the road quite a bit. In the meantime, though, I urge everyone to check out Capitol Capitalist, a new blog on financial regulation by Sara Hanks. Hanks is a longtime securities lawyer, and also served as the General Counsel of the Congressional Oversight Panel (which was created to oversee TARP, and was led by Elizabeth Warren). So she absolutely knows her stuff.

Hanks described the blog to me as “a light-hearted and entertaining take on some very serious subjects, speculative rather than in-depth analysis, with a dollop of silly sci-fi references.” But based on the first few posts, which make several very astute points, I think she might be underselling the seriousness!

In any event, I highly recommend that you check it out.

Saturday, May 14, 2011

Deathbed Designations

One of the biggest issues outstanding in financial reform is which institutions the Financial Stability Oversight Committee (FSOC) will deem “systemically important,” and thus subject to all the enhanced Title I regulations. These systemically important financial institutions, known as SIFIs, will presumably be subject to the new resolution authority rather than the bankruptcy code — although for some reason SIFIs aren’t automatically subject to the resolution authority, a problem which I pointed out within hours of the Treasury releasing its initial legislative language back in 2009. In spite of that anomaly, SIFIs will be required to continually submit comprehensive “resolution plans” to the FDIC, so that the FDIC will have all the information they need to plan, design, and execute a successful resolution of a SIFI. As I’ve said before (see here and here), and as Sheila Bair has been emphasizing repeatedly in recent weeks, the resolution plan requirement is hugely important.

Dodd-Frank does, however, leave open the possibility that a failing financial institution could be designated as a SIFI at the last minute, and then immediately handed over to the FDIC to resolve under the new resolution authority. In that situation, the FDIC would be forced to resolve an institution without the benefit of a resolution plan — that is, without the comprehensive information on organizational structure, funding practices, major counterparties, etc., that will be required in resolution plans. Bair calls these “deathbed designations” (which, you have to admit, is a clever name), and has been understandably arguing that this situation “should be avoided at all costs.”

But how do you avoid “deathbed designations”? Bair argues that the FDIC should be allowed to collect information from a broad class of potential SIFIs:

[W]e need to be able to collect detailed information on a limited number of potential SIFIs as part of the designation process. We should provide the industry with some clarity about which firms will be expected to provide the FSOC with this additional information, using simple and transparent metrics such as firm size, similar to the approach used for bank holding companies under the Dodd-Frank Act. This should reduce some of the mystery surrounding the process and should eliminate any market concern about which firms the FSOC has under its review. In addition, no one should jump to the conclusion that by asking for additional information, the FSOC has preordained a firm to be “systemic.” It is likely that, after we gather additional information and learn more about these firms, relatively few of them will be viewed as systemic, especially if the firms can demonstrate their resolvability in bankruptcy at this stage of the process.
Frankly, I don’t see any other option. Bair is right that “deathbed designations” are the worst of all worlds. At the same time, we can’t rely on the FSOC to accurately identify every single SIFI ahead-of-time, in perpetuity.

The question, then, is: how much and what kinds of information should the FDIC collect from potential SIFIs? One thing to keep in mind is that the FSOC, in figuring out which institutions should be designated as SIFIs, will necessarily be collecting some information from potential SIFIs as well. But that information probably won’t be the same information that the FDIC would ideally want to collect — and since the FDIC is the one responsible for planning and executing these difficult resolutions, I think they should have reasonably broad discretion to say what information they need to collect ahead-of-time.

I think the best approach would be to allow the FDIC to collect the important information that isn’t constantly changing — e.g., typical funding practices mapped the institution’s legal structure, descriptions of the institution’s major business lines, potential acquirers of the major business lines, and so on. Detailed balance sheet information at major financial institutions is typically stale in a matter of days, so requiring that kind of information would probably be more trouble than it’s worth (especially if the institution has 10-Qs and 10-Ks available).

I also don’t see why the required information couldn’t be collected from potential SIFIs discreetly. That would eliminate Bair’s concern about people “jump[ing] to the conclusion that by asking for additional information, the FSOC has preordained a firm to be ‘systemic.’” Financial institutions communicate confidentially with regulators all the time, and I don’t see why this should be any different.

In any event, it’ll be interesting to see if Bair can press upon the FSOC to create this separate information-gathering authority.

Josh Green has a good article in the Atlantic Monthly about Sarah Palin’s tenure as governor of Alaska. Near the end, Green wonders what would have happened if, after the collapse of Lehman Brothers, Palin had led the anti-Wall Street charge:

What if history had written a different ending? What if she had tried to do for the nation what she did for Alaska? The possibility is tantalizing and not hard to imagine. The week after the Republican convention, Lehman Brothers collapsed, and the whole economy suddenly seemed poised to go down with it. Palin might have been the torchbearer of reform, a role that would have come naturally. Everything about her—the aggressiveness, the gift for articulating resentments, her record and even her old allies in Alaska—would once more have been channeled against a foe worth pursuing. Palin, not Obama, might ultimately have come to represent “Change We Can Believe In.” What had he done that could possibly compare with how she had faced down special interests in Alaska [i.e., the oil industry]?
This would’ve been a sight to see — especially if McCain and Palin had won. I think I can say with a high degree of confidence that Wall Street would not have taken kindly to this. (And by “Wall Street,” I’m primarily referring to the big sell-side banks.)

Unlike the oil industry, which is used to the rough-and-tumble of partisan politics, Wall Street is generally unaccustomed to being broadly vilified by mainstream politicians (as the thin-skinned reactions to financial reform from the likes of Jamie Dimon can attest). Much of Wall Street’s self-image is tied up in the idea that they occupy a higher intellectual plane than everyone else — especially all those poli-sci majors and journalists down in DC.

Having that idea openly and vigorously attacked by any VP would be a huge blow to the Street’s ego, but if it had come from Vice President Palin, I think some heads would have literally exploded in lower Manhattan. Because Wall Street is famous not only for its culture of arrogance, but also for its culture of sexism. Having a proudly unsophisticated, female politician like Palin leading what would undoubtedly have been a ham-fisted, populist-driven effort at financial reform would have been too much for Wall Street to handle.

What’s more, Wall Street would not have known how to respond. Whereas the oil and tobacco industries are used to winning legislative battles by essentially paying off key politicians through campaign contributions, Wall Street, pre-Lehman Brothers, derived the vast majority of its vaunted political power from its ability to convincingly tell politicians and their staffers that “this is all very complicated, and you shouldn’t worry your pretty little heads about it.” (This is a very underappreciated point.) The Street was going to lose its ability to play that card regardless of who won the election, but it would’ve been worse if McCain and Palin had won, because Palin would almost certainly have taken that argument and used it against Wall Street — much in the same way that she turns the tables on the “lamestream media” when they condescend to her. And since Wall Street is practically a market-maker in condescension, the condescension directed at Palin would have reached epic proportions.

Of course, if McCain and Palin had actually won the election, there’s a 0% chance that Palin would’ve been allowed to lead any sort of anti-Wall Street charge. Treasury Secretary Phil Gramm — a hall-of-fame Wall Street sucker — would never have allowed it.

Not wanting to waste too much more time dealing with someone who is either unable or unwilling to understand the issues, I’ll confine myself to the worst mistakes in Yves Smith’s latest post. She’s really grasping at straws at this point.

“The FDIC showing up on site and digging through records runs the very real risk of kicking off an even faster response than the Bear rumors did.”

Let me make this clear, yet again: the FDIC would already have permanent on-site personnel, under their Title I resolution plan authority. Since resolution plans are an ongoing process, the FDIC’s on-site personnel would already be routinely requesting the exact same type of information that they would be requesting during pre-resolution due diligence. So this would not have been a situation where there are no FDIC personnel at Lehman, and then suddenly a bunch of FDIC people show up, telegraphing the resolution. How many times does this need to be explained to Yves before she processes it?

“Dodd Frank has no force under English law. That means that the FDIC cannot prevent contract termination for agreements under English law. The FDIC and EoC can huff and puff all they want, but the US regulators do not have the power to overturn foreign statutes and case law.”

Neither I nor the FDIC ever said that Dodd-Frank has any force under English law. The FDIC explicitly stated, however, that it would have conditioned its P&A for the holding company on the acquirer’s acceptance of LBIE (Lehman’s UK broker-dealer). That does not require Dodd-Frank to have any force under English law. It would also mean that LBIE would not have had to file for bankruptcy in the UK (or “administration,” as they call it across the pond), which would have prevented the vast majority of contract terminations for contracts under English law. This is not that difficult to understand.

“Let’s assume that the FDIC had moved to resolve Lehman in March of 2008. What might a smart foreign creditor do? Well, if his agreement with Lehman was under English law, he could argue that the fact that Lehman was being resolved meant it was trading insolvent and it needed to put into administration now to protect him from exposure to further losses.”

Huh? Yves is confusing the start of the pre-resolution planning process (in March 2008) with the actual resolution (in September 2008) — an extremely basic distinction. The FDIC starting the pre-resolution planning process is not termination event, so no, foreign creditors could NOT have pre-emptively put LBIE into administration.

“And the critical point is that Barclays was NOT ready to buy Lehman, unless a liquidity backstop was in place. This has been widely misreported in the US, and EoC falls right into line with that bit of PR, blaming the FSA for killing the Barclays deal.”

This isn’t accurate — and the FSA paper (which is of dubious accuracy in the first place) doesn’t say what Yves claims it says. What prevented Barclays from buying Lehman was indeed the issue of a guarantee of Lehman’s trading obligations. But it wasn’t because they weren’t willing to guarantee Lehman’s trading obligations — that is, it wasn’t the economics of the deal. It was because in order to issue the guarantee, they needed the FSA to waive the UK’s Listing Rules, which required shareholder approval for such a guarantee. The FSA was unwilling to provide that waiver. But Barclays was willing to buy Lehman, contingent on the waiver from the FSA.

“We’ve said before that Economics of Contempt too often relies on slurs and rhetorical tricks, waving his credentials as a securities lawyer when he is on weak ground. His latest post is an extreme example of his reliance on distortions to cover for a bankrupt argument.”

Actually, I didn’t mention my credentials at all. Good try though.

As for which one of us “is simply not to be trusted,” I’m going to go out on a limb and say it’s the one who has made a series of basic legal and factual mistakes.

Tuesday, May 10, 2011

Stay Classy, JPMorgan

Oh god, I see that JPMorgan is already resorting to scare-mongering on Basel III’s new Liquidity Coverage Ratio (LCR), which I’ve discussed many times before.

JPMorgan’s corporate treasurer, Joe Bonocore, warned last week:

There will likely be negative market and economic consequences if regulators don’t modify the liquidity rules, he said.
Banks will have to charge more to finance corporate and municipal bonds, which essentially means that market participants will have less incentive to invest in these types of assets if they don’t qualify, Bonocore said. “As a result we believe it’s going to become more expensive for corporations and municipalities to raise financing,” he said.

He said that right now a sizeable portion of J.P. Morgan’s investment portfolio is invested in municipals. “However, if they don’t qualify as part of the liquid asset buffer we’re going to be forced to look for another way to go about our investment portfolio and manage our risk.”
Wait, the LCR is going to hurt muni bonds? You sure you want to stick with that argument, Joe?

The only way the LCR would raise costs for muni bond issuers would be if banks like JPMorgan had been including muni bonds in their liquidity pools — something which, given the generally illiquid nature of muni bonds, I find highly unlikely. JPMorgan already maintains a liquidity pool based on its own internal standards. The LCR is simply codifying this same type of liquidity pool requirement, albeit with significantly (and appropriately) more conservative assumptions. Unless JPMorgan has been including muni bonds in its liquidity pool — which would be prohibited under the LCR — then the LCR should have no real effect on JPMorgan’s muni bond portfolio.

And if for some reason JPMorgan has been including muni bonds in its liquidity pool, then the bank is guilty of extremely poor liquidity management, and the LCR is saving JPMorgan from its own ineptitude. But, of course, there’s no way JPMorgan has been doing this. They’re just trying to bully regulators into weakening Basel III’s liquidity requirements by warning of the dire (!) consequences for those sweet-and-innocent municipalities.

Oh yeah, and Bonocore is also pushing for gold to be eligible for the LCR liquidity pool. Clearly he has a very different idea of what constitutes a “deep” market.

Stay classy, JPMorgan.

When the FDIC published a paper showing how it would have resolved Lehman under Dodd-Frank’s Title II resolution authority, Yves Smith, as is typical anymore, rushed to denounce it as an outrageous fraud, even though it’s painfully obvious that she didn’t read the entire FDIC paper. (It’s equally obvious that she’s never bothered to read Title II.)

I debated whether or not to even respond to Yves’ criticisms of the FDIC paper (see also here), because they’re hardly even worth the time. It’s also clear that Yves is going to believe what she’s going to believe, facts be damned, and that I’m not going to change her mind. So I don’t write this with the expectation that I will persuade Yves that she’s wrong. I just want to correct some of the egregious misinformation. Some of Yves’ criticisms, like the one that relies on an unsubstantiated rumor from friggin’ Zerohedge, are definitely not worth my time.

Criticism #1: Assumes everything is governed by a single, uniform legal framework

No, it doesn’t. The fact that she thinks this just proves that she didn’t read the entire FDIC paper (which was only 19 pages). The FDIC talked about how it would have coordinated with foreign regulators, including the UK’s Financial Services Authority (FSA), and also how it would have dealt with Lehman’s UK broker-dealer subsidiary, known as LBIE. The FDIC clearly stated that it would have structured the deal so that LBIE was also sold to Barclays. (And Barclays had, in fact, agreed to purchase Lehman’s holding company (LBHI), US broker-dealer (LBI), and LBIE, so you can’t argue that this is fantasy.) The FDIC also stated:

“By completing a sale at the time of failure of the parent holding company, the acquirer would have been able to ‘step into the shoes’ of LBHI and provide liquidity, guarantees, or other credit support to the newly acquired subsidiaries. Were the FDIC unable to promptly complete such a transaction, it could provide any necessary liquidity to certain key subsidiaries, such as LBIE, pending a sale of those assets.”
The FDIC is a national regulator, so it doesn’t have the authority to seize foreign subsidiaries, but the FDIC can structure its “purchase and assumption” agreements (P&As) however it damn well pleases. The FDIC is well within its rights to insist that any acquirers of the holding company under a P&A also take a key foreign subsidiary, such as LBIE. Moreover, Barclays’ acquisition of the holding company (LBHI) would have obviated the need for LBIE to file for bankruptcy in the UK, since LBHI funded and backstopped LBIE’s trading obligations.

So the FDIC does not assume a single legal framework; it just assumes that LBIE wouldn’t have to file for bankruptcy in the UK — an assumption which is entirely justified.

Criticism #2: Egregious underestimation of Lehman losses

This is a non-sequitur, and not even a good one. For one thing, Yves confuses creditor claims with creditor losses, so her so-called “gap” analysis is fundamentally flawed. That’s Bankruptcy 101. More importantly, there’s simply no getting around the fact that Barclays had, in fact, agreed to buy Lehman on Sunday, September 14th, if it could leave behind a $62bn pool of “bad assets” (which would’ve been financed by a consortium of Wall Street banks). The fact that Yves thinks that’s a bad deal is irrelevant. It’s perfectly reasonable for the FDIC to assume that Barclays would have agreed to a deal that Barclays had, in fact, agreed to.

Criticism #3: Assumes unrealistic 90 day preparation time

Yves claims that any heightened FDIC presence would have immediately triggered a run on Lehman. This is pure hogwash. First, the FDIC would already have an on-site presence at Lehman under its Title I “resolution plan” authority. And the type of information that the FDIC would be requesting is the exact same information that the FDIC’s normal on-site personnel would be routinely requesting. Second, huge, market-moving information about things like mergers are successfully kept under wraps all the time. It’s not difficult to set up a secure data room and force people to sign draconian NDAs. Surely Yves knows this. If she doesn’t, then, well, that’s another matter entirely. Finally, remember when the news broke back in the summer of 2008 that the New York Fed had on-site examiners at Lehman who were sending daily reports to Geithner and Paulson about Lehman’s liquidity, and the market freaked out? Yeah, neither do I. That’s because the news never broke, and the market never freaked out.

Criticism #4: Assumes a derivative contract termination process out of a parallel universe

This is perhaps the most egregious — and revealing — mistake that Yves makes. It shows just how little she (and Satyajit Das, who she quotes extensively) really know about the resolution authority. Das throws around a lot of fancy terms and describes a lot of scary-sounding problems with derivatives, but his entire analysis is based on the flawed premise that counterparties would have had the right to terminate their derivatives. Let me make this as clear as possible: there would have been no derivative contract termination process for the vast majority of Lehman’s derivatives under the resolution authority. Just like in FDIC resolutions of regular depository institutions, section 210(c)(10)(B) of Dodd-Frank prohibits counterparties from exercising their right to “terminate, liquidate, or net” their derivatives for one day after the FDIC is appointed as the receiver, during which time the FDIC can transfer the failed company’s derivatives to another financial institution. This supersedes the “Automatic Early Termination” clause in the ISDA Master Agreement.

This is exactly what the FDIC describes happening with Lehman: if Yves and Das had bothered to read the entire FDIC report, they’d know that the P&A transactions would have transferred the holding company, the US broker-dealer, and the broker-dealer’s derivatives dealing subsidiaries (LBSF and LBDP) to Barclays. Because these transfers would have occurred simultaneously with the FDIC’s appointment as receiver, the derivatives counterparties would not have had an opportunity to exercise their termination rights. Period. That’s why the FDIC paper didn’t address how termination and set-off rights work in different jurisdictions. Also, Das claims that the FDIC paper includes “no recognition of how collateral held against trades would work.” Again, yes, it does. (Seriously guys, read the paper.) From page 17:
“Lehman’s derivatives trading was conducted almost exclusively in its broker-dealer, LBI, and in LBI’s subsidiaries. As a result, Barclays’ acquisition of the broker-dealer group would have transferred the derivatives operations, together with the related collateral, to Barclays in its entirety as an ongoing operation.”
Finally, Das claims that LBIE was entirely funded by LBHI. I never said that LBIE was entirely funded by LBHI. But it was absolutely, indisputably dependent on LBHI for the vast majority of its day-to-day funding. From the LBIE administrator’s first Witness Statement:
“As part of its global treasury management, the Lehman Group operated a centralised treasury function. Accordingly, LBIE did not have control over bank accounts. Instead, payments were made into and from accounts maintained at group level (that is, at LBHI level). During each trading day, LBHI transferred cash to enable the Lehman Group companies, including LBIE, to meet their cash requirements during that day. The companies within the Lehman Group were therefore reliant upon receipt of that cash from LBHI each day to enable them to meet their obligations.”
That’s about all I can stomach right now. Like I said, I don’t expect Yves to change her mind, or admit that she was wrong. That’s fine. She can believe whatever she wants to believe. I just wanted to demonstrate that her criticisms are baseless and ill-informed. If anyone wants to have a real discussion of the resolution authority, I’m willing. But I’m done responding to criticisms of the Title II resolution authority from people who can’t be bothered to actually read Title II.

I’ve seen several people — most recently Larry Summers at INET’s Bretton Woods Conference — make an argument that, I have to say, I think is utterly daft. The argument is that before 2008, no one would have considered Lehman or Bear Stearns “too important to fail.”

Summers, in his discussion with Martin Wolf, stated that “Lehman, [which] was less than 2% of the US financial system, would not have been ‘too big to fail’ on anybody’s theory.” Avinash Persaud provided an even cleaner version of this argument, writing that “Any list conjured up in 2006 of institutions that were ‘too big to fail’ would not have included Northern Rock, Bradford & Bingley, IKB, Bear Sterns, or even Lehman Brothers.” And the Cato Institute’s Mark Calabria has also made this argument with respect to Bear Stearns.

I’m sorry, but Lehman and Bear Stearns were both widely perceived to be too important to fail before 2008, and anyone who tells you otherwise doesn’t know what they’re talking about. Lehman and Bear were two of the 14 or so major dealer banks that serve as the critical nodes in the global capital markets. Everyone knows who the major dealer banks are, and everyone knew that Lehman and Bear were part of this group. (The fact that Lehman and Bear were two of the smallest major dealers is irrelevant; someone’s always going to be the smallest, and size is hardly the only, or even the most important, factor in determining whether an institution is too important to fail.) In fact, had most market participants been asked to compile, à la Mr. Persaud, a list of TBTF institutions back in 2006, I expect the first thing they would’ve done was add all the major dealers.

It wasn’t just that the majority of market participants knew how massively disruptive it would be for one of the major dealers to have to unwind itself in bankruptcy. It was also that prior to 2008, the failure of one of these massive global dealers was something that was simply inconceivable to a lot of market participants.

I honestly don’t know anyone in the market who legitimately believed that the Fed would let Bear Stearns just chaotically collapse into bankruptcy. (And the same would’ve been true of Lehman had it been the first one to implode.) There’s a reason that when Bear Stearns started to implode in March 2008, everyone in the market kept saying, “The Fed is going to do something, right?” It’s because Bear (and Lehman) had long been considered too important to fail.

Monday, April 25, 2011

Ringfencing Investment Banks

Speaking of Sheila Bair, she recently floated the idea of forcing the big banks to ringfence their investment banking affiliates. This would primarily affect the universal banks, so as a practical matter we’re really talking about JPMorgan, BofA, and Citi.

Bair only has a couple months left on her term at the FDIC, so it’s understandable that she would want to put this idea out there before she leaves. She wants to ensure that the idea is at least in the mix, even though she knows it’s premature. Hence the very preliminary language she used — saying merely that she’d “like to get some public comment on the idea” of ringfencing.

Her point has been that we may need to make structural changes to the big banks if, after getting all the necessary information through the “resolution plan” process, the FDIC concludes that there’s simply no way to successfully resolve the big universal banks without structural changes. But we haven’t gone through the resolution plan process yet (the rules are still being written), so the FDIC doesn’t have nearly enough information yet to say definitively that structural changes need to be made, let alone what structural changes (e.g., ringfencing) are necessary to make them resolvable.*

Bair is essentially providing cover for her successor, should he/she end up deciding, after going through the resolution plan process, that something like ringfencing is necessary to make the big banks resolvable. By raising the possibility of ringfencing now, she’ll make it easier for her successor (rumored to be longtime Hill aide Martin Gruenberg) to propose ringfencing in the future without it coming as a huge shock and being dismissed out of hand. That’s probably a shrewd move. But I think that’s clearly all that Bair was trying to accomplish.


* I think the resolution plan process will ultimately force the big banks to make changes, but that the changes will be on an institution-by-institution basis. With the possible exception of JPMorgan and Bank of New York, I don’t think any real structural changes will need to be made, since the resolution authority can absolutely work on the dealers.

I know that Yves has a post claiming that the FDIC’s hypothetical Lehman resolution wouldn’t work, but her analysis is quite flawed. Among the myriad mistakes in the post, she and Satyajit Das both invoke scary-sounding cross-jurisdictional problems that simply wouldn’t arise under the resolution authority — since Lehman’s London broker-dealer (LBIE) was funded almost entirely by the holding company (LBHI), selling LBHI to Barclays under the resolution authority would have obviated the need for LBIE to file for bankruptcy in the UK. That’s, umm, kind of the point of the resolution authority.

The WSJ says that it’s “not aware of any governments that have ever asked clearinghouses to manage risks as complicated as those mandated by Dodd-Frank.”

That’s funny, because we still don’t know what financial instruments will be subject to Dodd-Frank’s clearing requirement yet! So how does the WSJ know how complicated the risks that clearinghouses will be asked to manage are? They don’t. The CFTC and the SEC don’t even know yet. The WSJ is just making things up.

This is like the people who make the fairly simple and widely-understood point that clearinghouses don’t work well for illiquid or bespoke instruments, and then claim that because of this, Dodd-Frank’s clearing requirement was a bad idea. They apparently don’t have the patience to wait to see which instruments the CFTC and the SEC decide have to be cleared — they want to demagogue the clearing requirement, and they want to demagogue it now, dammit!

Saturday, April 23, 2011

Dodd-Frank for Dorks

I found this WSJ article on the “new Dodd-Frank lexicon” amusing, since I actually am one of “the small army of lawyers, lobbyists and regulators who speak fluent Dodd-Frank.” That of course means that I have a fancy hard-copy of Dodd-Frank in my office, and an even fancier electronic (PDF) copy. Since I know a lot of lawyers in the financial services area read this blog, as well as non-lawyers who are interested in financial reform, I’ve uploaded my fancy electronic copy of Dodd-Frank here (and embedded below).

By “fancy,” I mean a PDF of Dodd-Frank that has bookmarks to every title, subtitle, and section (and even some subsections) in the law; is fully tagged, so you can copy-and-paste from it without any screwy line breaks; and perhaps most importantly, scales-up the Government Printing Office’s text size (since the tiny text size and unreasonably large page margins make the GPO’s official version practically unreadable). That may all seem trivial, but when you need to be able to quickly locate a specific section in an 848-page bill, having bookmarks to every single section makes a huge difference.

So there, now everyone can benefit from all that expensive software my firm uses for PDFs (which mainly consists of various Evermap products, I believe), as well as the incredible PDF skills of my indispensable assistant.

Dodd-Frank - Full (July 21, 2010)

Thursday, April 21, 2011

Sheila Bair for CFPB Director (Really)

The White House is evidently having trouble finding a nominee for director of the Consumer Financial Protection Bureau* (CFPB). The list of people who have passed on the job includes former Michigan Gov. Jennifer Granholm, former Sen. Ted Kaufman, Massachusetts AG Martha Coakley, Iowa AG Tom Miller, and Illinois AG Lisa Madigan.

Elizabeth Warren, who is currently setting up the CFPB as a “Special Advisor” to the Treasury Secretary, just can’t get the 60 votes required for Senate confirmation. She couldn’t get 60 votes last year, when there were 59 Dems in the Senate — and she even “made the rounds on the Hill herself to check the math, but she came away with the same conclusion: There was no path to 60.” So her chances of getting 60 votes now that there are only 53 Dems in the Senate are somewhere between exceedingly slim and none. Obama could technically recess appoint Warren, and while the chances of that happening have probably gone up, I’d still be very surprised if he did.

I think Obama should seriously consider Sheila Bair for the CFPB job. As a preliminary matter, she can definitely get 60 votes in the Senate. I know that Chris Dodd approached her last year about the job, and she said she wasn’t interested, but that was then. She still had a year left at the FDIC when Dodd approached her. Now, with only a couple months left at the FDIC, she might be more receptive. Plus, a personal appeal from the president is pretty hard to turn down. (Or so I hear — no president has ever made a personal appeal for my help, because they’re all jerks, and I never wanted to be their friend anyway.)

I haven’t been the biggest Sheila Bair fan in the past, but I’ve more or less made my peace with Bair. I still think she’s a self-promoter, and cares too much about her image in the media. But, to her credit, when it comes down to brass tacks on issues that really matter, she always ends up doing/saying the right thing rather than the popular thing.

Bair is also fiercely territorial, which sometimes bleeds into parochial. During the financial crisis, this was supremely unhelpful. But I think this would be one of her greatest strengths as the CFPB director. Given the CFPB’s bizarre legislative structure, in which the Financial Stability Oversight Council (FSOC) can veto the CFPB’s rulemakings, you want a CFPB director who is territorial, and maybe even a bit parochial. The whole purpose of setting up the CFPB was to establish an agency that has a singular focus: protecting consumers. I think this is necessary as a counterweight to banks and non-bank lenders, who have a massive informational advantage over retail consumers. In order to be that counterweight, the CFPB would really benefit from a director who only cares about her own agency.


* According to the statutory text, it’s technically called the “Bureau of Consumer Financial Protection,” which would make it the BCFP. But that’s stupid, and everyone, including the agency itself, calls it the CFPB. Put this one on the “to do” list for the technical corrections bill.