Category / Mother of all Bailouts

If it doesn’t work as a hedge fund strategy, try making policy with it March 7, 2014 at 12:24 pm

Capital structure ‘arbitrage’ is largely discredited as a hedge fund strategy for the rather good reason that a lot of people lost a lot of money on it. An arbitrage, remember, is supposed to involve a risk-free profit. But using the Merton model or its variants to ‘arbitrage’ between different parts of the same companies’ capital structure didn’t work very well — or, at least, it worked well until it didn’t. One of the problems (aside from various liquidity premiums embedded in prices) is that the first generation of these models assumed that the value of a firm’s assets follow a random walk with fixed volatility: which they don’t. In fact it has been known for over two decades that the PDs backed out from Merton models are far too high, something that KMV try to fix with some success at the cost of what might kindly be termed ‘pragmatic adjustments’. Now there may well be capital structure arbitrage models which don’t have these first generation problems and don’t involve arbitrary adjustments, but they are not well known (not least because if you had one that worked, you would want to use it to trade rather than to burnish your academic credibility).

There is an exercise by the US Government Accountability Office to determine how much lower big bank borrowing costs are due to expectations of government bailouts. Stefan Nagel suggests on Bloomberg that there is a risk that, by using a simple Merton-type model, the GAO will “underestimate both the banks’ proper borrowing costs and the implicit subsidy they receive from taxpayers”. True, there is. But there is also the risk that they will overestimate it, not least because as we noted above, models like this are flawed, and they tend to overestimate PDs. I absolutely think that taxpayers deserve to know what the implicit subsidy they are providing to big banks is worth – but by the same token, I think they deserve to know the model risk in those estimates. Scaremongering to suggest that the estimate will necessarily be too low is not helpful here.

At last a Republican policy I can get behind February 25, 2014 at 8:26 pm

Bloomberg tells us of a lovely policy idea that I really hope comes to pass:

The biggest U.S. banks and insurance companies would have to pay a quarterly 3.5 basis-point tax on assets exceeding $500 billion under a plan to be unveiled this week by Congress’s top Republican tax writer.

Done right (i.e. without a powerful incentive to move assets to the shadow banking system), this could be a big shove towards ending too big to fail.

Too big to break up December 2, 2013 at 6:51 am

Mark Roe has an interesting point: are the mega-banks so large that the usual market mechanisms by which bad management is punished blunted by the funding benefit of size?

For industrial conglomerates that have grown too large, internal and external corporate structural pressures push to re-size the firm. External activists press it to restructure to raise its stock market value. Inside the firm, boards and managers see that the too-big firm can be more efficient and more profitable if restructured via spin-offs and sales. But for large, too-big-to-fail financial firms (1) if the value captured by being too-big-to-fail lowers the firms’ financing costs enough and (2) if a resized firm or the spun-off entities would lose that funding benefit, then a major constraint on industrial firm over-expansion breaks down for too-big-to-fail finance.

The obvious correction of this externality, I say somewhat with my tongue in my cheek, is for the state to provide M&A finance to activist investors looking to buy and break-up mega-banks. Roll-up, roll-up, $200B at Libor flat just for you today missus, buy a mega-bank cheap cheap cheap while you can…

The price of resolution November 8, 2013 at 10:10 am

Simon Johnson has a very good point. First he points out that most experts agree that

bankruptcy cannot work for large, complex financial institutions in the United States, at least not using the current bankruptcy code.

It can and does work for non-financials, and the FDIC work out process for small banks works well without protecting shareholders or management. Big banks, though, will be resolved and will almost certainly require liquidity assistance from the FED during this process. Even if the process is similar for large and small, the very fact that bankruptcy isn’t possible for the large gives them an advantage, Johnson claims:

Because big banks cannot go bankrupt, they have an unfair advantage against everyone else in the financial sector. The counterparty risk of trading with them is lower, and thus they are regarded as a better credit risk than would otherwise be the case. This allows them to place bigger bets, which in turn creates more risk for the macroeconomy.

The intent behind Title I of Dodd-Frank is clear. If large complex financial institutions cannot go bankrupt, then they must be forced to change the scale and nature of their operations until each and every company is small enough and simple enough to fail without disrupting the world economy.

We have agreed with Johnson’s conclusion in the past here, and pointed out that the current state of affairs represents a real advantage to large firms that has not been endogenized. Indeed, as Bill Dudley points out:

ongoing research by Federal Reserve Bank of New York staff shows that the funding advantage of large versus small banks is higher than the funding advantage for large versus small non-bank financial firms and non-financial firms when other factors are held constant… [Moreover] the major rating agencies add an uplift to their credit ratings for the largest banks due to the prospect of government support. While it is possible that the rating agencies are wrong in their assessment, what matters is perception. If investors share this view or simply follow the ratings, then this should create a too big to fail funding advantage.

Clearly making big banks resolvable is important. But just as important, for me, is endogenizing their cost advantage. Increasingly I prefer an ex ante tax to level the playing field and provide an economic incentive to split up. There are so many advantages to being big that a counterveiling force would be welcome.

A great title: Jamie as Lance November 4, 2013 at 8:33 am

I don’t agree with much in this post, but the title is so good that I have to quote it anyway:

Jamie Dimon, the Lance Armstrong of Finance

A good title doesn’t just provide a bite-sized synopsis, it raises questions by itself: and this one does just that. It’s compelling not because it is true – it isn’t – but because it makes the burden of proof clear.

What is a precautionary recapitalisation? October 21, 2013 at 8:29 am

Mario Draghi’s letter to Commissioner Almunia on European Union bail-in rules (the whole text of which, interestingly, I cannot find on-line), has been making the news. Reuters reports that he suggests that

Banks that are still viable but need state aid to boost their capital base should be allowed to receive help without inflicting losses on their junior bondholders,

The situation under discussion here is where the

bank had a viable business model and its capital was above the minimum threshold, but its supervisor still required it to raise additional funds.

Hmmm. This suggests that we really can tell whether a stressed bank’s capital is above the minimum, which in turn implies that we know what its assets are worth. In reality supervisors will often be requiring banks to raise additional funds precisely because they distrust a bank’s provisioning. In this case the bank is ‘really’ not well capitalised, and the market doesn’t want to buy the new equity precisely because it suspects this is the case without having good information to know for sure. So, Mario, how can we tell if a recapitalisation is ‘precautionary’ or not without a more robust framework for assessing European bank solvency?

Debateable statement of the day September 25, 2013 at 10:55 am

From Douglas Flint, chairman of HSBC:

“Size is too simple a metric… It really doesn’t matter from a systemic point of view whether you have four banks or forty banks in a market. It’s the system’s asset concentration – principally in government debt and in mortgage debt – that can be dangerous.”

Colour me unconvinced.

A few interesting links July 22, 2013 at 10:55 am

  • Izzy on the impact of the Basel leverage proposals on US repo, here.
  • Matt Levine on double standards in treasury losses, here.
  • Red Jahncke on size vs. complexity in TBTF breakups, here.
  • A timely reminder from the bond vigilantes on the impact of interest diversion triggers in RMBS, here.

Happy reading.

8 is the new 0 July 3, 2013 at 6:32 am

From the FT’s account of the new Eurozone bank resolution framework:

From 2018, the so-called “bail-in” regime can force shareholders, bondholders and some depositors to contribute to the costs of bank failure. Insured deposits under €100,000 are exempt and uninsured deposits of individuals and small companies are given preferential status in the bail-in pecking order.

While a minimum bail-in amounting to 8 per cent of total liabilities is mandatory before resolution funds can be used, countries are given more leeway to shield certain creditors from losses in defined circumstances.

Under the compromise, after the minimum bail-in is implemented, countries are additionally given an option to dip into resolution funds or state resources to recapitalise the bank and shield other creditors. The intervention is capped at 5 per cent of the bank’s total liabilities and is contingent on Brussels approval.

Anyone wanna buy two new credit derivatives, one with an 8% digital payout on bail-in, the other a 2nd loss instrument on the remaining 92%?

Recap recap June 6, 2013 at 8:17 pm

Paul Melaschenko and Noel Reynolds have an interesting idea for recapitalisation of a failing bank. The essential idea is:

  • You figure out how much equity the bank needs to be palpably and obvious solvent: call that x.
  • You seize all the existing equity and all the existing sub debt (the holders will get something for that). Say the sub debt par value is y, and the shareholder’s funds are z.
  • You seize x-y-z worth of senior debt too.
  • You set up a HoldCo. The old equity holders get equity in the HoldCo; the sub debt holders get sub debt in it; and the old senior debt holders get senior debt (to make up for their write down).
  • HoldCo has z of equity, y of sub debt, and x – y – z of senior debt as liabilities. It has x of equity in the bank as assets.
  • You sell the re-cap’d bank’s equity to the market.
  • The HoldCo now has cash as an asset. It pays off liability holders in order.

Now, this all depends on getting x right. If the market still doesn’t think the bank has positive value after the recap, you have a problem. But so long as x is big enough, the senior debt holders will get something to compensate them for the bail-in; the equity holders probably won’t, unless you had an itchy figure on the recap trigger. Still, it’s quite neat.

A single supervisor to rule them, a single central bank to recapitalize them June 29, 2012 at 10:02 am

From the Euro area summit statement:

We affirm that it is imperative to break the vicious circle between banks and sovereigns. The Commission will present Proposals… for a single supervisory mechanism shortly… When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could… have the possibility to recapitalize banks directly.

Mario, François and Mariano win this round.

The markets want austerity right? June 11, 2012 at 9:11 am

Post Bailout Spanish Yields

Apparently not. Spain now owes 100 billion euros more, give or take, but yields are compressing and stock markets are rising. Clearly the austerians have, in a limited sense, been defeated.

In the immediate aftermath, two things occur to me. First, this fits alarmingly into the pattern of doing enough to prevent an immediate crisis, but not enough to address the underlying problems, guaranteeing that another crisis will arrive in a few months. Second, I bet the Irish are exceedingly peeved by this. After all, they didn’t get a break anything like this, and have suffered huge pain as a result. Moreover the Spanish bailout doesn’t even give them hope that they can line up at the queue for that sweet sweet Euro-liquidity.

(HT FT Alphaville for the data.)

JPM’s surplus liquidity problem… May 19, 2012 at 8:11 pm

…was huge. Really huge. The FT reports that JPM’s CIO

has built up positions totalling more than $100bn in asset-backed securities and structured products – the complex, risky bonds at the centre of the financial crisis in 2008.

These holdings are in addition to those in credit derivatives which led to the losses and have mired the bank in regulatory investigations and criticism…

The unit made a deliberate move out of safer assets such as US Treasuries in 2009 in an effort to increase returns and diversify investments. The CIO’s “non-vanilla” portfolio is now over $150bn in size.

Just when you thought it couldn’t get any worse. They own

more than £13bn (or 45 per cent) of the total amount of UK RMBS that has been placed with investors since the market re-opened in October 2009,” the BBA said.

Systemic, moi?

Big oops April 17, 2012 at 7:05 am

Bloomberg tells us:

Two years after President Barack Obama vowed to eliminate the danger of financial institutions becoming “too big to fail,” the nation’s largest banks are bigger than they were before the credit crisis.

Five banks — JPMorgan Chase & Co. (JPM), Bank of America Corp., Citigroup Inc., Wells Fargo & Co., and Goldman Sachs Group Inc. — held $8.5 trillion in assets at the end of 2011, equal to 56 percent of the U.S. economy, according to the Federal Reserve.

Five years earlier, before the financial crisis, the largest banks’ assets amounted to 43 percent of U.S. output.

Break them up March 24, 2012 at 8:18 am

From the final paragraph of a wonderful essay by Harvey Rosenblum, Dallas Fed executive vice president and director of research:

The road to prosperity requires recapitalizing the fnancial system as quickly as possible. The safer the individual banks, the safer the fnancial system. Te ultimate destination—an economy relatively free from financial crises—won’t be reached until we have the fortitude to break up the giant banks.

Go read it.

Let’s try to get along February 16, 2012 at 7:16 am

A minor spat in the finance blogosphere – no one died. This is hardly news I know. But for me this fight is unnecessary; both parties have some of the truth. John Cochrane first – his tagline is

As long as some firms are considered too big to fail, those firms will take outsized risks.

That seems pretty reasonable. His account of the mechanism at work around the Lehman failure has a measure of truth about it too:

After the Bear Stearns bailout earlier in the year, markets came to the conclusion that investment banks and bank holding companies were “too big to fail” and would be bailed out. But when the government did not bail out Lehman, and
in fact said it lacked the legal authority to do so, everyone reassessed that expectation. “Maybe the government will not, or cannot, bail out Citigroup?” Suddenly, it made perfect sense to run like mad…

Buttressing this story, let us ask how—by what mechanism — did Federal Reserve and Treasury equity injections and debt guarantees in October eventually stop the panic? An increasingly common interpretation is that, by stepping in, the government signaled its determination and legal ability to keep the large banks from failing. That too makes sense in a way that most other stories do not. But again, it means that the central financial problem revolves around the expectation that banks will be bailed out.

I might quibble with that ‘central’, but certainly too-big-to-fail is a problem, and certainly it needs to be resolved.

Next, Economics of Contempt, who lays into Cochrane. They choose instead to emphasise the liquidity aspects of Lehman’s failure:

…the end result is that LBIE’s [Lehman's main London entity's] failure caused hundreds of billions in liquidity to suddenly vanish from the markets. It also caused other hedge funds to pull their money out of their prime brokerage accounts at Morgan Stanley and Goldman (the two biggest prime brokers), since they were now scared that they wouldn’t be able to access their funds if either of the prime brokers failed…

And there was absolutely nothing minor about the run on the money markets. One of the biggest money market mutual funds, the Reserve Primary Fund, “broke the buck” because of losses on Lehman commercial paper. This caused a massive run on money market mutual funds, with redemptions totaling over $100bn.

This is perfectly fair, and indeed the liquidity aspects of the crisis are rather less well understood than the solvency ones, so EoC is right to discuss them. Having another angle does not justify calling Cochrane’s piece ‘mind-boggling nonsense’ though.

Now, I do think that Cochrane goes astray in his account of the TARP, but I don’t think he is being duplictious, and he does show some sympathy for the complexity of the policy choices the authorities faced after Lehman. He’s good on the fragility of some of the structures such as ABCP conduits used to fund mortgages, and on the ‘huge initiative of mostly pointless regulation that would move derivatives and cds onto exchanges, regulate hedge funds, force loan originators to hold back some credit risk, and so forth’.

Give both of them a read, Cochrane and EoC. They both have worthwhile things to say. There’s plenty of crisis to go around, with no need for a fight.

Careful with the tail there February 6, 2012 at 7:19 pm

This guy is slick. Goodness me yes. Check this out:

One of the most pernicious effects, in my opinion, of the evolution of limited liability in the financial system, and the consequent transfer of more and more tail risk to society at large, has been the weakening of our understanding of the price of risk. Now don’t kid yourself: society always stands as the loss-absorber of last resort, under any capital, economic, or financial regime, because there are some losses which are too large for any system to absorb. (Think about a kilometer-wide asteroid hitting New York City or Los Angeles, for example.) After all, financial losses happen to a society. But the drawback of risk assumed by government and taxpayers is that it is not explicitly priced.

It is, of course, the Epicurean Dealmaker, and I think he is quite right on the essentials. There will always be a tail of financial risk that society must absorb, and the policy debate should be about how much there should be of it and what compensation society extracts from the financial system for taking it, not how to remove it (because that is impossible).

[As an aside, one could imagine trying to price it. For instance, suppose that banks have to be 100% deposit funded, and all deposits must be insured but there is limited insurance. Banks have to bid for the available insurance. That would at least establish a market clearing price for deposit insurance.]

TED puts the general argument nicely though:

But make no mistake, the decisions we make about how we allocate, limit, and distribute financial risk throughout society—including how much to put financial intermediaries on the hook—will reverberate broadly through the system and ultimately affect our very living standards and prospects.

Now, you may hate the following. I certainly do. But what if putting financial intermediaries less on the hook is better for society? What if it creates growth that more than pays for its extra costs? I’m not saying that is true – I don’t know – but the possibility must be acknowledged. Thinking about the problem as tail risk allocation at least saves us from knee-jerk responses which are unlikely to lie on the efficient frontier.

The anatomy of a solvency/liquidity spiral December 13, 2011 at 3:58 pm

I’m reading the FSA report into the RBS failure (so you don’t have to, and because I griped about it not yet being out last week, so I can’t really ignore it). I’ll post in coming days on various aspects of this long and juicy document, but for now let me concentrate on what I think is clearly the mechanism by which RBS failed: a solvency/liquidity spiral.

First, some quotes from the report.

RBS did not have a solvency problem.

“Many accounts of the events refer to RBS’s record £40.7bn operating loss for the calendar year 2008. But that loss is not in itself an adequate explanation of failure. Most of it indeed had no impact on standard regulatory measures of solvency:

  • Of the £40.7bn loss, £32.6bn was a write-down of intangible assets, with impairment of goodwill contributing £30.1bn. Such a write-down signals to shareholders that past acquisitions will not deliver future anticipated value. But in itself, it had no impact on total or tier 1 capital resources, from which goodwill had already been deducted.
  • In fact ‘only’ £8.1bn of the £40.7bn (pre-tax) operating loss resulted in a reduction in standard regulatory capital measures.

Given that RBS’s stated total regulatory capital resources had been £68bn at end-2007, and that it raised £12bn in new equity capital in June 2008 (when the rights issue announced in April 2008 was completed), an £8bn loss should have been absorbable.” (Page 38)

RBS had a liquidity problem…

“The immediate driver of RBS’s failure was … a liquidity run (affecting both RBS and many other banks)… it was the unwillingness of wholesale money market providers (e.g. other banks, other financial institutions and major corporates) to meet RBS’s funding needs, as well as to a lesser extent retail depositors, that left it reliant on Bank of England ELA after 7 October 2008.” (Page 43)

“The vulnerabilities created by RBS’s reliance on short-term wholesale funding and by the system-wide deficiencies were moreover exacerbated by the ABN AMRO acquisition” (Page 46)

… which was driven by concerns about its potential insolvency

“Potential insolvency concerns (relating both to RBS and other banks) drove that run.” (Page 43)

In other words, people were not sure RBS was solvent (even though it was)

“In the febrile conditions of autumn 2008, however, uncertainties about the asset quality of major banks and the potential for future losses played an important role in undermining confidence.” (Page 126)

“The inherent complexity of RBS’s financial reporting from end-2007, following the acquisition of ABN AMRO via a complicated consortium structure, also affected market participants’ view of RBS’s exposures.”

“It is clear that RBS’s involvement in certain asset classes (such as structured credit and commercial real estate) left it vulnerable to a loss of market confidence as concerns about the potential for losses on those assets spread.” (Page 135)

A significant factor in this was that RBS was seen to be too optimistic about what its assets were worth

RBS marks vs ABX

“Deloitte, as RBS’s statutory auditor, included in its Audit Summary report to the Group Audit Committee a range of some £686m to £941m of additional mark-to-market losses that could be required on the CDO positions as at end-2007, depending on the valuation approach adopted… a revision of £188m was made to the valuation of these positions and was treated as a pre-acquisition [i.e. pre-ABN acquisition] adjustment. No other adjustment was made.

Deloitte advised the Group Audit Committee in February 2008 that an additional minimum write-down of £200m was required to bring the valuations of super senior CDOs to within the acceptable range calculated by Deloitte… The Board agreed that additional disclosures should be made in the annual report and accounts, but supported the view of RBS’s management that no adjustment should be made to the valuation.” (Page 150)

“those exposures [i.e. CDO positions] became a focus of concerns by market participants and thus played a significant role in undermining confidence in institutions active in these areas… RBS’s relatively high valuations of super senior CDOs were scrutinised by market comment in early 2008, and there was concern among market participants that further write-downs would be needed, at a time when RBS’s low core capital ratio was already a source of market comment.” (Page 151)

To conclude then

Liquidity risk and opaque/inadequate disclosures, which give rise to concerns about possible insolvency, are enough to doom a bank even if it actually remains solvent.

There will (I know, I know) be more on this tomorrow.

Draghi and transmission December 1, 2011 at 3:03 pm

From Mario Draghi’s speech today:

Dysfunctional government bond markets in several euro area countries hamper the single monetary policy because the way this policy is transmitted to the real economy depends also on the conditions of the bond markets in the various countries. An impaired transmission mechanism for monetary policy has a damaging impact on the availability and price of credit to firms and households.

It is worth spending a moment on why this is true. First and most obviously, falling bond prices causes losses at banks which threaten their solvency – or at least the perception of their solvency. This in turn makes it difficult for them to lend, not least because it is difficult for them to borrow.

There are more subtle and possibly just as significant other mechanisms at work too though. As bond prices decline, repo haircuts increase, and that creates funding stress too. Banks are pushed to fund more at the central bank as less collateral becomes acceptable in the private markets.

Confidence bites too as banks delever so that they can claim to be relatively well capitalized. An arms race of competitive deleveraging can even set in. This is particularly toxic as it further impairs the monetary transmission mechanism: central bank money doesn’t go into increased lending, but rather into reducing private funding.

Liquidity alone is not enough in these circumstances: capital is needed too. That, I fear, will be one of the next steps in the unfolding saga of central bank intervention.

Update. In that context, Bloomberg’s account of the new EU rules on state support for banks is worth reading.

Separately, Bloomberg also reports remarks made by Mervin King today about yesterday’s intervention:

“This is not a solution,” King said at a press conference in London to present the Financial Stability Report. “All this can be is to help with temporary relief for liquidity problems, but those problems are a result of solvency issues.”

How to recapitalize the banks October 5, 2011 at 5:20 am

Timmy did it wrong. (That is hardly a surprise.) So European finance ministers, looking to recapitalize their banks, should not take his example. First the background from the FT:

European Union finance ministers are examining ways of co-ordinating recapitalisations of financial institutions after they agreed that additional measures were urgently needed to shore up the region’s banks.

Although the details of the plan are still under discussion, officials said EU ministers meeting in Luxembourg had concluded that they had not done enough to convince financial markets that Europe’s banks could withstand the current debt crisis.

What he should have done, and what the European finance ministers should do, is buy equity. They should buy it at market – unlike the UK recapitalisation of RBS – and they should vote the stock. It is time to get some control in exchange for the cash European taxpayers will be stumping up.

Update. Carter has some good points, and some I disagree with, in the comments. To begin, where he is right:

I wholeheartedly disagree. First, let’s assume right off that you don’t mean buying equity IN the market, as this would just be a bailout of existing shareholders.

Yes, indeed. I did not mean that.

Buying “equity at market” absolutely ignores the dilution of the existing shareholders. Buying equity “at the market” price even if they are newly issued shares is a subsidy to the existing shareholders. It is paying an above-market price.

Yes again. What I was really thinking was ‘not above the market price’, as in the UK’s case. But you are right, the fair price given dilution is well below the current market price for normal market size.

You criticize the US TARP, but essentially the USG backstopped a public issuance by the banks. Banks that could effectively raise funds at a lower cost than the USG proposed did so, and the market provided the funds. Those that could not were going to be funded by the USG, the equity would have been massively diluted, and the USG would have obtained the requisite voting rights.

Um, but the US Government promised not to vote their equity where they had some, and often they took prefs or warrants where they could have taken equity. It seemed to me – and I would be eager to hear counterexamples – that they bent over backwards to be in a position where they did not have to vote stock.

But the government should not arbitrarily take control of an institution that the market is willing to fund and believes is viable.

Hmmm, I disagree. It should not do it often, that is for sure. But in the European case, where the implicit subsidy of ‘we will step in if we have to’ is worth a great deal (Haldane estimated $50B for the UK banking system, so at least $100B for the EU), taxpayers deserve something for that backstop. I would prefer a system where banks explicitly paid for this insurance all the time – similar to the FDIC model – but they should pay a market rate.