Shotguns and blowups

From Mark Gilbert on Bloomberg:

If the aftermath of the credit crunch is a financial landscape featuring fewer banks, each even bigger than before because of government-engineered mergers and opportunistic takeovers of weaker brethren, then we should all be very afraid. That, though, is exactly where we are headed.

The whole article is spot on: I recommend it.

Before the bust: AIG's early collateral postings

AIG's collateral postings after the rescue are well known - essentially the firm was saved so that it could continue to fulfil its obligations to the banking system, notably under the CDS it had written. AIG before the fall has received less attention. But now Bloomberg has done some digging, and the story of the collateral calls that brought AIG down is emerging.

Goldman Sachs Group Inc. and Societe Generale SA extracted about $11.4 billion from American International Group Inc. before the insurer’s collapse as the firms demanded to hold cash against losses on mortgage-linked securities, ... “It was precisely that drain of liquidity to Goldman and SocGen that put AIG in a position of illiquidity and ultimately threw them into the government’s arms,” said Charles Calomiris, a finance professor.

Including collateral from before and after the rescue and payments made by Maiden Lane III, a vehicle created by the Fed to retire the swaps, Goldman Sachs received about $14 billion from AIG, Societe Generale got $16.5 billion, and Deutsche Bank AG received $8.5 billion.

MAC make believe

From Ken Lewis' testimony to the House:

In mid December... I became aware of significant, accelerating losses at Merrill Lynch, and we contacted officials at the Treasury and Federal Reserve to inform them that we had concerns about closing the transaction. At that time, we considered declaring a 'material adverse change'... Treasury and Federal Reserve representatives asked us to delay any such action, and expressed significant concerns about the systemic consequences and risk to Bank of America of pursuing such a course.

No one would expect a CEO to tell less than the full truth in a setting like this. But this must surely add fuel to the fire of shareholder litigation burning under BofA.

Update. More (unhelpful to Ken) docs here.

Stiglitz on Corporate welfarism

Joseph Stiglitz has a great piece on state capitalism. I'm sure the original is in a mainstream US publication, but the syndication I picked up via Naked Capitalism was in the Jakata Post. The whole thing is worth reading: here are some excerpts:

With all the talk of "green shoots" of economic recovery, America's banks are pushing back on efforts to regulate them. While politicians talk about their commitment to regulatory reform to prevent a recurrence of the crisis, this is one area where the devil really is in the details - and the banks will muster what muscle they have left to ensure that they have ample room to continue as they have in the past...

It has long been recognized that those America's banks that are too big to fail are also too big to be managed. That is one reason that the performance of several of them has been so dismal. When they fail, the government engineers a financial restructuring and provides deposit insurance, gaining a stake in their future. Officials know that if they wait too long, zombie or near zombie banks - with little or no net worth, but treated as if they were viable institutions - are likely to "gamble on resurrection." If they take big bets and win, they walk away with the proceeds, if they fail, the government picks up the tab.

The Obama administration has, however, introduced a new concept: "too big to be financially restructured"... Restructuring gives banks a chance for a new start: new potential investors (whether holders of equity or debt instruments) will have more confidence, other banks will be more willing to lend to them, and they will be more willing to lend to others. The bondholders will gain from an orderly restructuring, and if the value of the assets is truly greater than the market (and outside analysts) believe, they will eventually reap the gains.

The Obama administration has not restructured the banks. Instead, partly swayed by intense lobbying from the banks, they have rescued bondholders and even protected equity holders, at great cost to the taxpayer. As Stiglitz says

Most Americans view [this] as grossly unjust, especially after they saw the banks divert the billions intended to enable them to revive lending to payments of outsized bonuses and dividends. Tearing up the social contract is something that should not be done lightly.

But this new form of ersatz capitalism, in which losses are socialized and profits privatized, is doomed to failure. Incentives are distorted. There is no market discipline. The too-big-to-be-restructured banks know that they can gamble with impunity - and, with the Federal Reserve making funds available at near-zero interest rates, there are ample funds to do so.

Some have called this new economic regime "socialism with American characteristics." But socialism is concerned about ordinary individuals. By contrast, the United States has provided little help for the millions of Americans who are losing their homes. Workers who lose their jobs receive only 39 weeks of limited unemployment benefits, and are then left on their own. And, when they lose their jobs, most lose their health insurance, too.

America has expanded its corporate safety net in unprecedented ways, from commercial banks to investment banks, then to insurance, and now to automobiles, with no end in sight. In truth, this is not socialism, but an extension of long standing corporate welfarism. The rich and powerful turn to the government to help them whenever they can, while needy individuals get little social protection.

We need to break up the too-big-to-fail banks; there is no evidence that these behemoths deliver societal benefits that are commensurate with the costs they have imposed on others. And, if we don't break them up, then we have to severely limit what they do. They can't be allowed to do what they did in the past - gamble at others' expenses.

Stiglitz is angry about this, and you should be too.

Wot no TALF?

I have been surprised at the slow takeup of the TALF. It looked to me like a license to print money. As Zero Hedge points out, less than $30B has been allocated to a program with a trillion dollar capacity.

Part of my surprise is that to be eligible for the TALF (at the moment at least - this will probably change) a security needs to be AAA rated. And S&P are on the downgrade war path. As Calculated Risk reports, quoting S&P, approximately 25%, 60%, and 90% of the most senior tranches (by count) within the 2005, 2006, and 2007 vintages [of CMBS}, respectively, may be downgraded. So you would have thought that people would have rushed to throw things into the TALF before they became ineligible.

Bloomberg suggests that the TALF, and its brother the PPIP, is stalling. They seem to have a point.

Too many big ones

I'm away from the office at the moment so posting will be a little light, but I do want to pick up an interesting graph from Dick Bove at Rochdale Securities via the Big Picture. It shows the total number of US banks reporting (to the FED? to the OCC?). This is not a helpful trend if you don't want banks to become too big to fail...

Arbitrary conviscation is a good thing

OK, maybe that is a little provocative. But here's the reasoning. Any effective special resolution regime for banks has to intervene early. That means sometimes seizing banks (particularly too big to fail banks) which are well capitalised and liquid because the supervisor thinks that it is better for the system to act now than to wait. They need to have the power to do that.

How would such a regime work? Broadly the regulator would monitor signs of stress: capital ratios, ease and cost of funding, stress tests, loan performance and so on. The range of indicators should be broad, and over time more can be developed. If one or more of these gauges suggest a looming problem, or just because the regulator thinks it wise, the bank would be seized. Either it would be sold to a stronger, well capitalised peer or a good bank/bad bank split would be made, with shareholders ending up with a stake in the bad bank. (I prefer the latter as the former tends make big banks bigger, something I think is a bad thing.)

The result of this kind of power is events like the takeover of WaMu. Some people claim that this was unfair and unwarranted. (See here for John Hempton's take on the FDIC's action here. I don't know enough of the details to know if John's account is fair, but he certainly makes some interesting points.) But even if a seizure is arbitrary, I still think that the supervisor needs to have the power to do this kind of thing, and that that power should be exercised if there is a reasonable suspicion - no more - that the bank is in trouble.

Why? Well because if banks thought that this really was likely, they would take more care to stay safe. Conviscation is an effective moral hazard prevention mechanism. Providing that shareholders know that their rights can be voided by the regulator more or less whenever they like, they will demand that banks are run in a demonstrably prudent fashion. What's not to like about arbitrary conviscation?

Taleb - 3/10 (and that is being generous)

Let's score Nassim Taleb's latest set of ex cathedra pronouncements:

1. What is fragile should break early while it is still small. Nothing should ever become too big to fail.

Fair point. Score one.

2. No socialisation of losses and privatisation of gains.

Exactly. Otherwise moral hazard is enormous and banking is profitable with little risk. Score one.

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.

No. Firstly nearly everyone who knows enough to be helpful was driving (or at least helping to navigate) the bus. And secondly most people even if they did not like the driving, weren't in a position to do anything about it. We cannot afford to get rid of all of our experts, even if they have been wrong in the past. Score zero.

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks.

It depends on the bonus. One year bonuses with no clawback based on mark to market profits clearly provide bad incentives. But multiyear bonuses with clawbacks based on realised gains may provide a good incentive. Score half.

5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products.

No. Balance complexity with appropriate technology. Complex products can be appropriate, simple products can be inappropriate. It depends. Score zero.

6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it.

No. It is enough to ensure that risk takers genuinely bear the consequences of their actions and that there is sufficient capital in the system for the risks being taken. If you ban dynamite, tunneling gets much more expensive. You just want to be sure it is civil engineers not terrorists who have the dynamite. Score zero.

7. Only Ponzi schemes should depend on confidence.

Nonsense. No one knows what a financial system that is not confidence sensitive might be like. That is an unsolved problem in finance. Score zero (with the judge contemplating taking away a mark for idiocy).

8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial.

It depends. Allowing firms to increase leverage is insane, and no regulator I know is permitting that (unless you could accounting games which result in over-stating capital). But governments can and should increase their borrowing at times like these. Score half.

9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement. Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require.

So what, prey, do you suggest people use to save for retirement? Given I know of no asset whatsoever that does not fluctuate in value, this is a real question. Score zero.

10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.

The sheer cliche density of that paragraph alone deserve a minus five.

Change that revolts us

Interfluidity has a nice hypothetical:

Consider a hypothetical asset manager, PIMROCK. PIMROCK reviews a pool of loans held by the bank J.P. Citi of America, and its analysts determine they are worth 30¢ of par value. The bank holds them at 80¢ on its book. PIMROCK agrees to put down $10B to purchase loans from the pool at 82¢ thrilling stock markets everywhere. It was all just a bad dream!

Under Geithner's plan, PIMROCK's $10B permits a $10B equity investment from the Treasury. Then the FDIC levers the whole thing up, providing $6 of debt for every one dollar of equity. So, $140B of bad loans are lifted from J.P. Citi of America, nearly $90B of which is sheer overpayment to the bank.

Of course, as cash flows evolve, PIMROCK's $10B is wiped out entirely, as is the Treasury's investment. The FDIC gets repaid in a bunch of securities worth about $50B, taking a $70B loss... These were real market prices, Geithner or his successor will argue. Our private partners lost everything. There was no subsidy here.

Meanwhile, taxpayers will be out around $80B.

Why would PIMROCK go along with this? Because they feel it is their patriotic duty to work with the government for the good of the financial system, even if that involves accepting some sacrifices. And because they hold $100B in J.P. Citi of America bonds, and they've received assurances that if we can get the nation out of the financial pickle it's in, there will be no haircuts on those bonds. "Shaking hands with the government" means that nothing ever has to be put in writing.

Welcome to America, 2009. Change we can believe in.

I agree, with one exception. PIMROCK doesn't need to buy the whole $10B. It just needs to buy enough that the bank can mark the rest at 82. So probably it only puts in $1B rather than 10. The taxpayer loses less on the subsidy, but more via having to recapitalise JP Citi of America in due course, while PIMROCK loses much less yet still has protection on its bond holdings.

Transatlantic Coup

Simon Johnson has an excellent article in the current issue of The Atlantic magazine. His basic premise, as an ex-IMF chief economist, is that crony capitalism is a fundamental part of many emerging market crises, and it is only when the cronies are forced to take some pain that the crisis can be resolved. Furthermore he argues that this kind of coup, whereby power has been seized by a small group who manipulate the economy for personal profit, took place in the US during the Clinton and Bush years. Thus the Quiet Coup of the article's title. Go and read the whole thing: it is quite persuasive.

Wasteful Timmy

The Geithner plan, understandably, has generated many column inches since it was unveiled on Monday. There is little consensus among the commentariat, but the markets have taken it well. What should we take from Timmy's last (or at best next to last) stand?

First, it might actually work either by accident - because we are through the worst anyway and it doesn't hurt - or by design. It is certainly positive in the short term for the shareholders of American banks. And it betokens a reluctance to nationalise which, while negative for the taxpayer, is the kind of thing markets like.

Second, it is clearly an ineffective use of money. The government is providing nearly all the cash. If the same amount had been spent on recapitalising the banks, then there would be more leverage and hence more assets controlled for a dollar saved. Taxpayers should be outraged by this.

Third, it indicates that Geithner believes that an interestingly modern form of systemic risk is important: the risk that quasi-forced sales by one institution causes losses at others via mark to market. This plan achieves a de facto recapitalisation (albeit wastefully) via the ability for all banks to mark their assets to the purchase price in the plan. This means of course that the plan managers will be strongly encouraged to pay more than the market price for the assets: something they can afford to do given the government subsidy built into the structure.

In summary, then, the plan is far from optimal, but it will probably help a bit. The concern is that it won't be enough. If that happens, then Timmy will need a new job.

Update. Felix Salmon picks up an interesting quote from Sheila Bair. This makes it clear that the intent of the plan is to crush the non-default component of the credit spread:

They [the prices assets are bought into the plan] will still be, they will be market prices. We're just trying to tease out the liquidity premium. What's weighing on market prices right now is that people can't get financing to buy assets, they can't get financing to buy assets not many people want to buy, you don't want to buy. And then you have to hold on to them forever because there's nobody to sell them to. So, that's -- by providing that liquidity that's lacking now, we're hoping to get the prices up to what would really be a true market level.

They are doing this by removing all the risk - funding risk, liquidity risk, and credit spread volatility risk. It's an awfully expensive way to recapitalise the banks.

TALF to Taxpayer

The TALF says: please take a seat.

(The FED press release is here. Useful commentary from Philip Gelston of Cravath, Swaine & Moore via Marketpipeline is here.)

Good bad/bad bank

Willem Buiter has a discussion of how good bank/bad bank separations might work in detail: the mechanics come from Robert Hall and Susan Woodward. I will simplify the argument a little, and discuss the issues.

Consider a bank with:

Assets		Liabilities
Good loans	1000	Deposits	1200
Bad loans	500	Bonds Issued	600
Other assets	380	Shareholder's funds	80

(Let's ignore the off B/S stuff for this post and assume that all of the other assets are good.)

The proposal puts the deposits and good assets in the good bank, and calls the difference between assets and liabilities 'capital'. Thus we have for the good bank:

Assets		Liabilities
Good loans	1000	Deposits	1200
Other assets	380	Shareholder's funds	180

Notice that the good bank is well capitalised under this proposal.

The bad bank owns all of the equity in the good bank. For it we have:

Assets		Liabilities
Bad loans	500	Bonds Issued	600
Equity in good bank	180	Shareholder's funds	80

It is fairly likely that the equity holders in the bad bank will be wiped out over time, which is right and proper. If the good bank makes money and declares a dividend, the bad bank will receive that income as it stands. Meanwhile the debt holders of the bad bank now have a claim on a rather worse quality institution, at least at first sight. This is a proposal with rather little moral hazard.

The issue comes when we consider the bad bank's position. It is not capitally adequate, not least because material holdings in credit institutions (i.e. its shareholding in the good bank) is a deduction from equity. One might argue that it does not need a banking license as it is now in run off, but still, it is so leveraged that its management will have to sell some of the equity in the good bank. Does a forced seller of bank equity (albeit good bank equity) really help financial stability?

Also notice that the bad bank would consolidate the good bank from an accounting perspective. Again, to get deconsolidation it would have to sell at least 50% of the good bank's equity.

The proposal in short makes sense from a moral hazard perspective, and transfers the taxpayer's deposit guarantee to a well capitalised institution. But it does force the bad bank to sell its position in the good bank almost at once, and that is a rather worrying side effect.

Losing Lloyds

Goodness, how the mighty have been laid low. Two large British clearing banks have been destroyed by one bad purchase: RBS by ABN; Lloyds by HBOS. I am heartened that the government has extracted a reasonably high price from Lloyds for its rescue: RBOS got away a little more lightly. A lot of the attention recently (and reasonably) has been focussed on the revisions to AIG's bailout (is it now V4?) and Merrill's dancing before the BoA purchase closed. But, rather quietly, the UK government seems to be acting somewhat sensibly. Now if only it would actually do something with the control that it has acquired, we might be able to move forward rather more quickly.

Stress is bad for you

The FDIC calls this a stress test. Huh?
Seeking alpha suggests fair value in some parts involves a 36% decline from here. Given that downturns usually overshoot fair value, a reasonable stress test would involve at least a 40% fall, and probably 50%. The FDIC has bottled it.

Paying in the last resort

It is clear by now that the lender of last resort function - and especially the capital provider of last resort function - is valuable. How should the state be paid for this function?

The historical answer has been that this is a gift to the banking system, with the state attempting to recoup its investment (and perhaps even make some money) from the liquidity and capital that it provides. At the moment however it seems likely that some of these state investments will not give taxpayers a positive return, so it is reasonable to ask how else we could structure things.

One answer is that financial institutions should pay. The model here is deposit insurance: in the US, for instance, banks are charged by the FDIC, and these premiums are pooled together to support bank rescues where necessary. However it seems that these payments are not adequate, and so deposit insurance premiums are being increased - just at the worst possible time. It is easy to argue that they should have been higher in the past. In practice however banks' success at promoting deregulation and cost reduction in the good times means that fixed fee schemes are always vulnerable.

There is an alternative. Banks could be made to pay by writing call options on their own stock. Suppose every year a bank gives to their regulator, as payment for the lender of last resort and capital provider of last resort functions, one year at the money call options on 5% of their regulatory capital. The regulator then hedges these to lock in their value. The hedge is to short stock, so if the option ends up in the money, the regulator ends up selling the stock position. The profit from delta hedging these 'free' options is then available to recapitalise banks when needed, and so the taxpayer does not lose out (as much) when support is needed. The people who suffer are bank shareholders, but they only suffer dilution when the stock price is increasing, and anyway they are the ones who should be paying for the implicit support the state provides.

Portents of the apocalypse

No, not a woman clothed with the sun, and the moon under her feet, and upon her head a crown of twelve stars. Even Victoria Beckham wouldn't wear that, even if she does occasionally forget to put on a shirt with her tie. Rather, according to the FT:

The US government may have to nationalise some banks on a temporary basis to fix the financial system and restore the flow of credit, Alan Greenspan, the former Federal Reserve chairman has told the Financial Times.

Scarcely before the rain of blood starts, we also find:

“We should be focusing on what works,” Lindsey Graham, a Republican senator from South Carolina, told the FT. “We cannot keep pouring good money after bad.” He added, “If nationalisation is what works, then we should do it.”

I advise taking wellington boots to work for the next few days: a plague of frogs could really mess up your brogues (or Louboutins, depending).

Is Timmy that inept?

If this WaPo story is really true, Geithner shouldn't be left in charge of a sweet shop let alone a bailout.

When you said thousands, you meant 6

Paul Kedrosky has a nice comment on the Obama take on nationalisation. Obama first, from ABC Nightline tonight:

Sweden, on the other hand, had a problem like this. They took over the banks, nationalized them, got rid of the bad assets, resold the banks and, a couple years later, they were going again. So you'd think looking at it, Sweden looks like a good model. Here's the problem; Sweden had like five banks. [LAUGHS] We've got thousands of banks. You know, the scale of the U.S. economy and the capital markets are so vast and the problems in terms of managing and overseeing anything of that scale, I think, would -- our assessment was that it wouldn't make sense. And we also have different traditions in this country.

Obviously, Sweden has a different set of cultures in terms of how the government relates to markets and America's different. And we want to retain a strong sense of that private capital fulfilling the core -- core investment needs of this country.

As Kedrosky says, this is at best disingenuous and at worst outright cowardice. Obama is afraid of what the Republicans will say if he does what he suspects is the right thing, and nationalises. The Thousands argument is clearly nonsense - just nationalising Citi, JPM, BofA, Wells, GS and MS would go a very long way towards resolving the problem. And the last two may not need it. So instead of both resolving the crisis and saving the taxpayer money at the cost of employing the N word, we instead have the Geithner compromise, three ineffectual prongs that run a serious risk of failing to prick the crisis.

Update. Maureen Dowd also puts it nicely. She has a nice opening to an article in the NYT. So much for the savior-based economy. She's right. As she says, there is

a weaselly feel to the plan, a sense that tough decisions were postpone...

Geithner is coddling the banks, setting it up so that either we’ll have to pay the banks inflated prices for poison assets or subsidize investors to pay the banks for poison assets... Geithner prevailed over those who wanted to kick out negligent bank executives and wipe out shareholders at institutions receiving aid.

Just as Gordon Brown's association with James Crosby, Fred Goodwin and Shriti Vadera is currently proving difficult and embarrassing, so I predict will Obama's promotion of Geithner will come back to haunt him.

The Geithner plan so far...

...this sums it up reasonably


OK, that was perhaps unfair. But it is a little short on details, and what he did say is not enormously reassuring. There are three steps Geither detailed in his announcement.

First, a stress test for everyone big enough to matter, and TARP 2 capital for those that need it based on the results of that test. Fair enough, although I would want to be sure that the original shareholders were being sufficiently diluted.

Second, a bad bank, which you, lucky investor, can participate in. But how it will price the assets it buys is currently shrouded in mystery.

Third, a massive expansion of the Term Asset Backed Securities Loan Facility to get the securitisation markets going again (or at least to get them 100% financed by the FED). Clearly Geithner believes that we need securitisation, and that these markets are key to getting credit flowing again. You could read this as quantitative easing (but I'd still prefer it if he repaired a few bridges and such like).

Thus far, then, it is hard to form a comprehensive judgement on the plan. I do think, though, that the lack of tighter controls on compensation is bad, that nationalisation is a necessary step before deploying the bad bank, and that this public/private partnership idea is just screwy. But what do I know.

Update. Because I have a childish streak, I just had to apply cornify to Geithner's website. Well, someone had to.

There, isn't that better looking? Doesn't it fill you with optimism and hope?