Lehman, five years later May 17, 2013 at 9:06 am
Almost five years after Lehman Brothers filed for bankruptcy and set off the global financial crisis, managers of the bank’s estate are demanding millions of dollars from retirement homes, colleges and hospitals… [For instance] The Buck Institute for Research on Aging in Novato, California, gave Lehman $2 million in October 2008 to cancel a swap contract used to manage fluctuating interest rates. Lehman [now] says it wants $12.1 million more and has assessed at least an additional $4.7 million in interest, the research center said in its most recent financial statement.
There are at least two important issues here. First, as Levine points out, when you closed your swap out with Lehman matters hugely for valuation. (I have cropped the market data he gives to show the USD 5y swap rate in the period after the default: look at that volatility in late 2008.) The CSA you had with Lehman matters too, as does whether you use market valuation or actual close-out (which in turn depends on the details of your master agreement with them), what CSA you had with the party you closed out with, and so on. Moreover, the naive idea that your claim against Lehman is the price you closed out isn’t necessarily true. Levine quotes from the Federal Home Loan Bank of Cincinnati’s 10-K:
We had 87 derivative transactions (interest rate swaps) outstanding with a subsidiary of Lehman Brothers, Lehman Brothers Special Financing, Inc. (“LBSF”), with a total notional principal amount of $5.7 billion. Under the provisions of our master agreement, all of these swaps automatically terminated immediately prior to the bankruptcy filing by Lehman Brothers. The terminations required us to pay LBSF a net fee of $189 million, which represented the swaps’ total estimated market value at the close of business on Friday, September 12… … On Tuesday, September 16, we replaced these swaps with new swaps transacted with other counterparties. The new swaps had the same terms and conditions as the terminated LBSF swaps. The counterparties to the new swaps paid us a net fee of $232 million to enter into these transactions based on the estimated market values at the time we replaced the swaps.
Now, that difference in value could have been a market risk gain based on a period of open exposure in very volatile markets. But it could also be partly a mismatch between the close-out amount the Home Loan Bank paid Lehman and the real market price. You can see how a lawyer might think that there is a case there, especially one paid to maximise the value of Lehman’s estate (for the benefit, let’s remember, of other creditors).
I am not sure how to react to this. The knee-jerk response is to demand that the close-out process is defined so as to lead to less disputable results, but doing that is not straightforward. What is applicable for the (unusual) Lehman-like events probably isn’t appropriate for much smaller (and more usual) close outs. Moreover, any claim on a bankrupt must, ultimately, be subject to scrutiny by the bankruptcy courts, and must adhere to underlying legal principles (like anti-deprivation). So the right policy here is not obvious. But certainly the risk of closing out then, years later, having that process challenged by the defaulter’s estate with the potential for large amounts of interest being assessed as well as the original claim, is material. Whether there is anything that can be done about it is less clear.
New CDS trigger event proposed – at last May 16, 2013 at 10:48 pm
ISDA is consulting on a proposal to add another credit event… The proposed criteria for the credit event would be a government authority using a restructuring and resolution law to write down, expropriate, convert, exchange or transfer a financial institution’s debt obligations… the rules would allow written down bonds to be delivered into a CDS auction based on the outstanding principal balance before the bail-in occurred.
The defaulter does not pays without CVA May 14, 2013 at 9:16 am
The slogan ‘defaulter pays’ is often used of collateral and other credit support arrangements. It’s seductive: after all, shouldn’t the defaulter pay for the damage their default might do to another party? Yes they should – but they don’t. Instead, as Mark Roe points out in a new article (although the point is hardly new), it is the unsecured creditors of the defaulter’s estate who pay. Taking collateral from someone removes it from their estate upon bankruptcy (if you have done it right, anyway): you get paid, which means that someone else doesn’t. In this sense, CVA has its attractions, in that by paying for credit cost up front, as part of the trade price, the defaulter really is paying as part of their ongoing business: that cost is charged to shareholders as it is incurred. By posting collateral, the company doesn’t pay now, and hence its revenues are higher. Instead, if it defaults, a smaller pool of funds is available to pay creditors. ‘Defaulter’s unsecured creditors pay’ is a less catchy slogan, but it is closer to the truth of financial collateral.
Junk ratings May 11, 2013 at 4:47 pm
Bloomberg reproduces the following chart of Moody’s ratings of major banks with and without government support.
You could read this at face value: the claim would then be that an unsupported BofA and Citi are junk. But really, is this credible? The BB+ one year default rate averages, depending on period, somewhere around 1 – 1.5%. A fair credit spread, without liquidity premiums or other compensation, and assuming a Lehman-type 25% recovery would therefore be at least 1%, with the actual credit spread being bigger than that.
This does not seem credible to me. The PDs are high; the spreads are high; perhaps it is the stand alone ratings that don’t make sense?
The Co-op suggests – co-operative interest? May 10, 2013 at 9:00 pm
Listening to the sad news about the Co-op bank today on the radio, it occurred to me to wonder if with-profits banking might work for them. Let me explain.
- Some banks, the Co-op included, need more equity. Indeed, if Brown-Vitter get their way, all big banks will need a lot more equity.
- No one wants to buy new equity.
- And debt holders want interest.
- An old fashioned insurance solution* to this problem was the ‘with profits’ policy whereby instead of getting a coupon, investors still have a senior claim on return of principal, but interest is paid in equity.
- So why not offer, or even require, that interest paying bank accounts pay a certain fraction of interest in equity, at least until the bank reaches ‘very well capitalised’ (whatever that means)?
- You would of course need an easy cheap way for deposit holders to sell these equity stakes, but that’s OK; for sufficiently low levels of leverage, bank equity would have a rather stable price (like a utility stock), and so this should not be beyond the wit of bankers.
- The dilution for existing shareholders would of course be vicious. Sorry, I can’t see a way around that.
*OK, this isn’t quite what with profits insurance policies do. But it is close enough for these purposes.
The second phase of asset price bubbles… May 9, 2013 at 8:02 pm
…is often buying on margin. So we can worry a little when Pragmatic Capitalism shows us this, courtesy of Orcam:
EMIR for corporates May 8, 2013 at 8:03 pm
Herbert Smith has a nice summary here (HT the OTC space). What I for one had not realized is that from September 2013, EU parties with more than 500 trades, of whatever status, must establish procedures for Portfolio Reconciliation and they must at least semi-annually consider Portfolio Compression and provide valid explanations if they choose not to engage in it.
Giraffe diving May 6, 2013 at 7:58 pm
It’s a holiday here in the UK so I feel the need to give you something a little lighter than usual. And what could be lighter than giraffes leaping into the air and executing perfect dives?
Tarullo prudently prepares May 5, 2013 at 5:13 pm
FED governor Daniel Tarullo gave an interesting speech recently; interesting because he is clearly trying to set out a regulatory agenda while uncomfortably aware that legislators, if anything like Brown Vitter is passed, might pull the rug out from under him. He therefore has to tread delicately. That doesn’t stop him from pushing the FED’s line, but they are gentle nudges.
His first real point is that liquidity reform has not made much progress:
we have not yet adequately addressed all the vulnerabilities that developed in our financial system in the decades preceding the crisis. Most importantly, relatively little has been done to change the structure of wholesale funding markets so as to make them less susceptible to damaging runs… But significant continuing vulnerability remains, particularly in those funding channels that can be grouped under the heading of securities financing transactions.
He has to admit that little has been done about too big to fail as it hasn’t, and the Senate has noticed
With respect to the too-big-to-fail problem, as I noted earlier, actual capital levels are substantially higher than before the crisis, and requirements to extend and maintain higher levels of capital are on the way… But questions remain as to whether all this is enough to contain the problem.
Indeed. He gives the standard spiel on more capital and/or liquidity risk regulation, as in Basel III. But then it gets interesting:
a second possibility that has received considerable attention is a universal minimum margining requirement applicable directly to SFTs.
Or, for that matter, a tax on them. Either would do.
Look at this for a lovely piece of politics. Tarullo says, as he would, that the FED should be allowed to complete its current agenda. But then he pays deference to the law makers:
the first task is to implement fully the capital surcharge for systemically important institutions, the LCR, resolution plans, and other relevant proposed regulations. But, completion of this agenda, significant as it is, would leave more too-big-to-fail risk than I think is prudent. What more, then, should be done? As I have said before, proposals to impose across-the-board size caps or structural limitations on banks–whatever their merits and demerits–embody basic policy decisions that are properly the province of Congress
That leads him to trying to head the B-V posse off at the pass:
One approach is to revisit the calibration of two existing capital measures applicable to the largest firms. The first is the leverage ratio. U.S. regulatory practice has traditionally maintained a complementary relationship between the greater sensitivity of risk-based capital requirements and the check provided by the leverage ratio on too much leverage arising from low-risk-weighted assets. This relationship has obviously been changed by the substantial increase in the risk-based ratio resulting from the new minimum and conservation buffer requirements of Basel III. The existing U.S. leverage ratio does not take account of off-balance-sheet assets, which are significant for many of the largest firms. The new Basel III leverage ratio does include off-balance-sheet assets, but it may have been set too low. Thus, the traditional complementarity of the capital ratios might be maintained by using Section 165 to set a higher leverage ratio for the largest firms.
The other capital measure that might be revisited is the risk-based capital surcharge mechanism. The amounts of the surcharges eventually agreed to in Basel were at the lower end of the range needed to achieve the aim of reducing the probability of these firms’ failures enough to offset fully the greater impact their failure would have on the financial system. At the time these surcharges were being negotiated, I favored a somewhat greater requirement for the largest, most interconnected firms. Here, after all, is where the potential for negative externalities is the greatest, while the marginal benefits accruing from scale and scope economies are hardest to discern. While it is clearly preferable at this point to implement what we have agreed, rather than to seek changes that could delay any additional capital requirement, it may be desirable for the Basel Committee to return to this calibration issue sooner rather than later.
Is this just trying to kick the can down the road? Tarullo must know his chances of getting higher standards agreed in Basel are low. Equally he knows that unilateral action in the US will damage the competitiveness of US banks (while making them safer, of course). If he can’t persuade the Brown-Vitter crew to back off, and he can’t get Basel to agree to similar standards, he will have to doff his cap and do what the law requires. I would suggest, though, that that doesn’t mean that he will like it.
The light has arrived… May 4, 2013 at 9:42 pm
Choice Italian insults May 1, 2013 at 6:08 am
One has to celebrate the creativity of the man. From a single paragraph description of the new Italian government on Beppe Grillo’s website we find ministers described variously as
- a talking mannequin
- the defrosted stock-fish
- the psycho dwarf
- the internationalist and frequenter of Bildeberg
And most cutting of all
- the nephew of his uncle, the one that Goldman Sachs loves the most
Would that we had a commentator his equal among our politicians.
Brown Vitter section-by-section guidance… April 30, 2013 at 7:24 am
…can be found here.
You might think that B-V is impossibly strict and hence impossible to pass, but there is the core of a good idea in this bill, and it would be dangerous to dismiss it entirely. A slightly gentler B-V with phased implementation (say, a simple leverage ratio rising from 3% to 12% by 1% a year starting 2015 for the mega-banks) is entirely feasible. (Whether it would be wholly positive for financial stability or not is another matter.)
Equity, debt, freezers and TVs April 29, 2013 at 9:37 am
My freezer is like equity, my TV is like debt.
Let me explain.
There is a push from electricity suppliers to distinguish appliances that need their power now – like TVs – from those that can wait a few minutes – like freezers. We might even imagine a situation where there are two types of plug connecting to two (virtual) networks with two tarifs: an expensive, power-on-demand one; and a cheaper, give me power when you can one (with some standard over how long it could be delayed etc.) This would typically be achieved using smart devices, so my freezer would say to the network that it needed half a kilowatt hour of electricity sometime in the next ten hours, and the network would deliver it when convenient, given the total load. The plug would contain a network as well as a power connector allowing the freezer to talk to the grid.
This allows much better peak management. You can deny power from freezers in that critical five minute commercial break at half time in the cup final, giving you a better chance of boiling all those kettles.
The problem with debt is not just that it is leverage, but also that it is demand liquidity. The debt holder can demand their payment now. (Thus contingent liquidity schemes like lines of credit are like pumped storage power: they allow a solvent but illiquid party to meet peak liquidity demand.) The two tarif idea is akin to suggesting that there is a place for delayable payment but otherwise senior contracts – like sub bonds but where it is genuinely acceptable to use the deferral feature. Indeed, Islamic finance has always had such an idea, and many firms in practice treat supplier invoices that way. The nice part about the smart freezer though is that there is in some sense a negotiation between the freezer and the grid: could we imagine a similar ‘I need $1M sometime in the next two days… OK I will get it to you on Tuesday at 7.30am’ idea in finance?
The curious case of the risk floor April 28, 2013 at 5:08 pm
Karl Smith has a theory:
… lets imagine a simple model where we have two sources of risk. There is background you cannot avoid. And, there is personal risk that you create by through your own choices.
Policy makers have since Thomas Hobbes been attempting to drive down background risk. They have larger been successful. As a result our lives are getting more and more stable.
As that happens, however, folks are going to tend to take on more personal risk. There is a tradeoff between risk and reward. As you face less background risk, for which you not rewarded it makes sense to go for more personal risk for which you are rewarded.
When I take on more personal risk, however, it bleeds over slightly into everyone else’s background risk. People depend on me. If I take risks and lose so big that I debilitate myself then my family and my friends will surely suffer. But, so will my employer, my creditor and the businesses who count on me as a regular. When I go down, they go down.
So, putting it all back together and we come up with something of a risk floor, if you will.
Now, I should say at once that I don’t wholly buy this. But it is an interesting idea, and there is some evidence to support it. For instance, Australian research on compulsory cycle helmets suggests that cyclists that feel safer as a result of their helmet take more risk, resulting in little change in cyclist mortality* despite the new policy. However, it is not obvious that we can generalise from evident physical danger to financial risk.
Suppose we can though. That would mean, as Smith implies, that risk reducing policies can, if we are near the floor, cause risk to pop up again in a form that might be harder to spot. That suggests that a polluter pays approach, where we try to charge for the risk being taken rather than prevent it. Direct fees to price systemic externalities, then, rather than capital to prevent them. One might imagine that if FDIC deposit insurance fees were truly fair, then they would comprise a floor element plus a systemic surcharge (which was at least quadratic in bank size). Such an approach would attempt to charge for the cost of failure rather than capitalising the risks that might lead to it. As I say, I’m not necessarily recommending it, just suggesting that it is an interesting alternative.
Such laws are however good at discouraging cycling.
Simon Johnson and John Parsons chide Mary Miller April 26, 2013 at 1:11 pm
In a speech on last week Mary Miller, Treasury under secretary for domestic finance, made the case that the Dodd-Frank reform legislation has substantially ended the problem of too-big-to-fail financial institutions. Johnson and Parsons don’t agree, writing in the NYT:
Ms. Miller’s speech is completely unconvincing on the substance of the points that she is trying to make. Dodd-Frank alone will not end too big to fail.
It makes sense that senior Treasury officials should want to put Dodd-Frank into effect. But it is disconcerting when they are unable to confront the market and political realities of too-big-to-fail banks. Any such level of denial will not serve us well.
The detailed analysis is worth going through and, broadly, convincing. It does seem interestingly as if the argument is lining up as some politicians, most independent commentators and much of the voting public saying more needs to be done, with the FED and the big banks against. That isn’t a common side selection, and it will be interesting to see how it plays out.
Victims in Vegas April 25, 2013 at 10:18 pm
As Ed Provost took the stage at the Green Valley Ranch Resort & Spa in Las Vegas to explain how a software malfunction had shut the Chicago Board Options Exchange for three-and-a-half hours, he was surrounded by people who were victims of similar disruptions.
On the panel with him were Jeromee Johnson from Bats Global Markets Inc., which canceled its initial public offering last year after failing to get the shares to trade on its own exchange, and Tom Wittman of Nasdaq OMX Group Inc., whose first-quarter profit was cut in half because of costs related to its mishandling of Facebook Inc.’s IPO in May. Six people on the attendee list were from Knight Capital Group Inc., which almost went bankrupt after a software error flooded the equity market with bad trades.
As the article’s author Nikolaj Gammeltoft says, today’s CBOE hickup underscores how common software-related market disrupting events have become. Yesterday’s events were not, so far as I know, fatal to anyone, merely inconveniencing. But should an exchange like CBOE has a monopoly on trading a benchmark contract as important S&P500 index options if they can go down for three hours unexpectedly?
My ipad, and your derivatives April 22, 2013 at 5:55 pm
Those of you with multiple devices – and most of us these days have at least two out of a phone, a tablet, a laptop, a desktop and an ipod-like thing – will be familiar with the nightmare of sync. This is particularly painful with music: you have it nicely set up in one place, yet somehow it ends up as a mess after transfer. A particular culprit here is itunes, which (1) Apple forces you to use and (2) seems to me to be as respectful of my music labeling as a con man at an easy marks convention. As a result, (be warned, painful confession coming up) my ipad thinks I have music by Pink, P!nk and P!ink with a Kanji character on the end that I can’t even copy; it thinks my Brahms fourth symphony is by Karajan and that Stranglers and The Stranglers are different artists. It has UB 40 and UB40, it puts plainsong under ‘Unknown’, and it is very very fond of ‘Unknown Album, Unknown Artist’. This is rather irritating and it takes a while to fix.
Given the state of this relatively small data set, rather little of which was manually entered*, imagine how good banks legal entity identifiers are, given that they could from a much bigger database much of which has been typed in. There is, it is fair to say, the possibility of error. In particular, just like my multiple Pinks, there is some chance of finding The Goldman Sachs Group, Inc. and Goldman Sachs Group, Inc or even The Goldman Sachs Group, Inc in your counterparty database. (That period is easily missed.) And if one bank can’t always get it right, how much harder is it to sync this data across the whole industry? The legal entity identifier (‘LEI’) project tries to do that, and it is much to be applauded. In particular without initiatives like this, trade repository data is a lot less useful.
Deadlines for getting LEI data into shape are approaching. As Katten Muchin Rosenman remind us:
Every swap end user (i.e., any party to an outstanding derivative contract who is not a swap dealer or major swap participant) should be aware that April 10, 2013 is the deadline for obtaining a “CFTC Interim Compliant Identifier” number (or CICI) in connection with its swap activities. The requirement arises under Commodity Futures Trading Commission Rule 45.6(f), which specifies that every “swap counterparty” must use a legal entity identifier (LEI) in all recordkeeping.
Meanwhile the data cleaners are doing a rather more systematic job than me swearing at itunes. This is well underway at many banks but, for those laggards, Mark Davies has a point: “processes relating to business entity reference data will require attention sooner rather than later”.
*Most of my music is from CD, and most of those auto-load the album and track information when they are ripped. The databases that information comes from, mind you, are not perfect.
The naked CDS ban 6 months on April 21, 2013 at 2:35 pm
The FT has a timely article on the consequences of the EU’s ban on naked CDS:
Investors are buying protection on European banks on the basis that banks and sovereigns are so intimately linked that any increased risk of a sovereign default will increase the value of a bank CDS in a similar way to a sovereign CDS.
“The big downside of the ban is that it is likely to increase borrowing costs for financials,” said Michael Hampden-Turner, Citigroup credit strategist.
“It is hardly good for Spanish and Italian banks if the cost of borrowing is being squeezed up on the back of European regulation.”
Essentially then national champion banks are being used as proxies for the sovereign, with CDS buying (driven in part by CVA hedging) pushing out these banks’ credit spreads. The only way this loop will be broken will be if sovereigns either post collateral against their OTC derivatives (unlikely) or clear (somewhat more likely, but with its own problems).
How not to win the Deutsche Börse Photography Prize April 20, 2013 at 2:00 pm
Wandering around the exhibition ahead of this year’s Deutsche Börse Photography Prize, it seemed to me that there’s a recipe for how some photo prizes work. It might go something like this:
- Select 0, 1 or (exceptionally) 2 artists with some insight for photography, sensitivity to the medium, and technical skill.
- Select 2-4 artists who work with photography but have rather little insight, sensitivity or skill to a total shortlist size of 4. It helps if this second group is made up of conceptual artists making rather trite points about the kinds of topics conceptual artists like to be seen to comment on.
- Be sure when deciding the winner not to take into account the quality of the photographs themselves, because thinking about a photography prize that way is just naive…
Now this may not be how it is with the Deutsche Börse prize, but given that Chris Killip actually has some skill with a camera, I wouldn’t advise that you bet on him winning this year…
The missing futures data repository April 19, 2013 at 10:03 am
While we can clearly agree that Bloomberg has a dog in the futures vs. swaps fight, that does not necessarily mean that all of their comments are wrong. Here for instance is an interesting observation by Bloomberg CEO Daniel Doctoroff in the Huffington Post:
Congress mandated that swap transactions be reported to a “Swap Data Repository” that regulators can monitor to conduct real-time market surveillance and that the public can access immediately and for free. Nothing comparable exists in the futures market. There is no “Futures Data Repository,” and no real-time public reporting of futures data, which means that the public will no longer have the access to market data that it was supposed to have under Title VII. This also creates a firewall between the markets and regulators, denying them access to the real-time trading data they need to determine whether speculators are manipulating the energy markets.
Thank you Bloomberg April 17, 2013 at 6:13 pm
In a move that will at very least make life more interesting, Bloomberg has done as it threatened and sued the CFTC. Their bone of contention is the so-called margin period of risk on OTC derivatives vs. futures. As the FT reports:
Bloomberg objects to how the CFTC has set different margin rules, that favour swap futures at the expense of OTC swaps, arguing that they are similar financial products with the same risk profile for investors.
The CFTC has set minimum margin collateral that can cover five days of possible losses for cleared financial swaps, while margin for futures contracts traded on exchanges presently covers the risks of one to two days of losses.
In other words, swap futures are economically (very nearly) identical to swaps, but have roughly half the margin – and that, Bloomberg suggests, is wrong. The FT quotes their lawyer, Eugene Scalia, as saying “It’s a basic legal principle that similar matters should be treated in similar ways.” Watching the CFTC try to defend this one is going to be fascinating.
Delaware and the sham of shareholder ownership April 16, 2013 at 4:09 pm
…an electoral system unworthy of Soviet-era sham democracies is flourishing today in corporate America is largely thanks to the management- and director-friendly policies of Delaware
Why? Well broadly because even if a majority of shareholders vote against a director of a Delaware corporation, they don’t have to resign, and even if they do resign, the company doesn’t have to accept their resignation. Mr. Stewart, then, has a point.
I’ll take a 1 please, Bob April 13, 2013 at 1:10 pm
JP’s recent research report into investment banking has generated a lot of comment (see for instance here for a nice piece from Matt Levine); Citi came out with their version the day before.
Let’s take (some of) JP’s handy cut-out-and-keep classification, add them into the mix (as they don’t appear on their own chart), and use some of Citi’s insights:
The tier 1 banks have a clear franchise. They have profitable IB businesses, global reach, and, – while challenged by regulatory change, – they clearly will stick around in this space. If you want to own an IB, you have to buy one or more of them*.
The tier 2 agency banks similarly have a clear role in life. They make money from flow, don’t have as high a compensation cost, or as volatile earnings. They are investable from an IB perspective.
The tier 2 institutional banks are where the problems are. They don’t have a strategy that makes sense, and likely won’t make enough money to pay for the costs of competing directly with Tier 1. UBS and RBS have already announced that they are exiting this space, presumably keeping a limited agency franchise. Jefferies could certainly follow the agency model, too. For the rest, there is a stark challenge. It isn’t clear that being an asset class champion (e.g. the French banks in equity derivatives or CS in credit) is viable. There isn’t clearly room for all of these banks to move to the agency box: in particular France doesn’t need all of BNP, Soc Gen and CASA in this space. MS, too, doesn’t have a strategic option that looks very attractive, and no tier 1 player needs what it does have enough to buy it. The political support for IB in Switzerland has waned, so CS might have a hard job pretending to be American in IB but Swiss in private client, especially with a niche IB model.
The play of the day is therefore long Barc, BofA, Citi, JPM, GS; short CS, BNP, Soc Gen, MS, RBC‡. This isn’t JP’s argument: they suggest that the tier 1 players can’t afford to exit a business with regulatory uncertainty and volatile ROEs, while the tier 2 players can. I agree with that, but critically that argument depends on the tier 2 players actually seizing the moment rather than wasting two years pretending to be top tier IBs when they are not, and wasting a lot of money in the process. I don’t believe that all of the players in red will have the guts to cut aggressively, hence the call.
*DB is perhaps the exception due to their need for capital to support the US businesss. Note while we are here that 4 out of 6 of these tier 1 firms are American.
‡Any banking trade that doesn’t have a UCG short in it does feel a little incomplete, though.
The curious case of the 2s of 2023 April 12, 2013 at 8:05 pm
The overnight repo rate on the 2% T bond of February 2023 bond did some odd things in March, as Real Clear Markets reports:
[The repo rate] had been about 20 basis points in the week prior, but fell negative on Monday, March 11. By the close on Wednesday, March 13, the overnight repo rate was -2.95%. That day the Treasury sold $21 billion in a 10-year reopened auction that seems to have abated the negative repo after settlement… Such a negative repo rate indicated a sharp and acute shortage of collateral.
RCM suggests that the withdrawal of deposit insurance above $250K and QE caused a collateral squeeze. I don’t have a clear opinion on that, but I do know that negative repo rates that size are a cause for concern.
Hoenig hits out April 11, 2013 at 6:50 am
This man really knows how to make a speech. The following is from one he gave in Basel (!):
An inherent problem with a risk-weighted capital standard is that the weights reflect past events, are static, and mostly ignore the market’s collective daily judgment about the relative risk of assets. It also introduces the element of political and special interests into the process, which affects the assignment of risk weights to the different asset classes. The result is often to artificially favor one group of assets over another, thereby redirecting investments and encouraging over-investment in the favored assets. The effect of this managed process is to increase leverage, raise the overall risk profile of these institutions, and increase the vulnerability of individual companies, the industry, and the economy… If the Basel risk-weight schemes are incorrect, which they often have been, this too could inhibit loan growth, as it encourages investments in other more favorably, but incorrectly, weighted assets. Basel systematically encourages investments in sectors pre-assigned lower weights — for example, mortgages, sovereign debt, and derivatives — and discourages loans to assets assigned higher weights — commercial and industrial loans. We may have inadvertently created a system that discourages the very loan growth we seek, and instead turned our financial system into one that rewards itself more than it supports economic activity.
Clearly there is some truth to this. I don’t buy Hoenig’s argument (via Admati and Hellwig) that the cost of moving to a high simple leverage ratio is small: it isn’t. But it may still be worth it.
Today’s detention April 10, 2013 at 6:09 am
Go and read Lisa’s excellent post on Pat Hagan’s skills in titling emails and optimising capital.
Downing Drysdale April 9, 2013 at 12:18 am
Scott Skyrm helpfully reminds us of an historic failure, that of Drysdale. The origin of the failure was a glaring arbitrage between the US repo market in the 80s and the treasury market. The former did not account for accured interest on repo’d t-bills, while the latter did. Drysdale’s head trader
started short-selling U.S. Treasurys outright, where he received the price plus the accrued interest. Then he borrowed the securities to cover his shorts in the Repo market, paying only the market price. He was getting the full use of the accrued interest on the bonds at no cost. In order to maximize to amount of cash he was collecting, he concentrated on shorting Treasurys about half way between the semi-annual coupon payment dates. With years of declining bond markets, he had made a lot of money shorting the Treasury market and by February 1982 his trades reached $4.5 billion in short positions and $2.5 billion in long positions… Overall, it was not a bad trading strategy since he won under two out of three possible market scenarios. If the bond market went down, he made a lot of money. If the market stayed the same, he earned free interest on the cash the trade generated. [But] If the Treasury market rallied, he risked a significant amount of money.
The problem, then, was that he was exposed to rising prices which would kill his short. Needless to say, that happened in spring 1982, and Drysdale collapsed. What happened next is insightful.
Drysdale had conducted their Repo trading mostly through Chase’s Securities Lending Department and Drysdale’s counterparties believed they were facing Chase and not Drysdale. Chase believed they were acting “as agent” for Drysdale, so they would not accept responsibility for the $160 million in coupon interest payments on that Monday, but the problem grew even worse. Up until then, the government securities market had operated under the assumption that the buyer in a Repo trade was entitled to liquidate the trade in the event of a default by the seller. There was no law on books differentiating a Repo from a collateralized loan and there had never been a case in court to set a precedent. The market was unsure whether they could liquidate the Drysdale/Chase Repo trades.
The lack of clarity as to the bankruptcy status of a Repo left Chase with a major dilemma. If the bank refused to pay the coupon interest to the Street and that contributed to any of those securities dealers going bankrupt, a future court ruling against Chase could expose them to liability for the damage they caused. However, if Chase made the coupon interest payments for Drysdale, they were clearly taking a loss and would line up as a creditor of Drysdale in the bankruptcy. It was a lose/lose situation.
On Wednesday, the Fed intervened and called together the heads of the 20 largest banks and securities dealers for a meeting at the Fed’s New York office. Not only was there pressure put on Chase from the dealer community, but also by the Fed itself. Though the Fed would later announce that their only involvement was hosting a meeting, quite similar to the future meetings for Long Term Capital Management in 1998 and Lehman Brothers in 2008. The next day Chase relented and, as they say, the rest is history.
The FED, then, prevented a market failure by leaning on Chase in the way central banks do. There were profound financial stability reasons for doing this, not least because of the uncertainty in the legal status of repo. Without knowing if a repo was a collateralised loan or a sale/buyback, no one knew what the exposure was. The law was subsequently clarified in favour of the latter interpretation (thanks to another bankruptcy Scott discussed, that of Lombard-Wall), but the lesson is clear: don’t engage in lots of transaction of uncertain legal status.
On no longer washing April 8, 2013 at 9:05 am
The stock loan business is, paradoxically getting less dirty because it is no longer washing. No longer washing dividends, that is, in tax arb trades. That is because ESMA has acted. The FT reports:
The profitability of lending programmes has been eroded by new guidelines from the European Securities and Markets Authority, which came into force in February, requiring asset managers to return all the revenues from stock lending, net of costs… New tax harmonisation rules in France, forcing domestic funds to pay the same rate of dividend tax as foreign funds holding French equities, are also expected to damp demand for stock lending during the spring “dividend season”. Dividend arbitrage strategies account for 80 per cent of European stock lending revenues, according to BNP Paribas Securities Services.
Step back for a moment. 80%? Surely that an activity is pretty close to being completely socially useless if four fifths of it is tax-driven? European stock loan is down two thirds from the 2008 peak. This is surely a very good thing. I have no problem with stock loan facilitating shorting, but clearly that useful part of the business wasn’t a big part of it.
Go Brown-Vitter! April 7, 2013 at 7:15 am
The largest U.S. banks… would have to hold capital in excess of Basel III standards under a proposal being drafted by Senate Democrats and Republicans to curb the size of too-big-to-fail banks.
The current draft of the legislation would require U.S. regulators to replace Basel III requirements with a higher capital standard: 10 percent for all banks and an additional surcharge of 5 percent for institutions with more than $400 billion in assets. Senators Sherrod Brown, a Democrat from Ohio, and David Vitter, a Republican from Louisiana, have said they intend to introduce the bill this month.
I doubt that they can get this through Congress in this form, but you have to applaud the attempt.
Update. The full text of the bill is here. It’s even more interesting than the Bloomberg story indicates. The highlights are:
- 10% simple leverage ratio limit;
- ‘Continuously increasing’ capital requirements above $400B of total assets (although it doesn’t say how);
- Total assets include gross derivatives unless daily VM is exchanged;
- A ban on Basel III implementation in the US;
- Prohibitions on affiliate transactions and an anti-avoidance clause.