Paul Krugman drew my attention to a great article in the WSJ about the views of notable hedgie Barton Biggs:
Mr. Biggs, former chief global strategist for U.S. investment banking powerhouse Morgan Stanley, demanded the U.S. government temporarily return to ideas used in the Great Depression as a way to get the country back to higher growth.
“What the U.S. really needs is a massive infrastructure program … similar to the WPA back in the 1930s,” he says.
The plan would be to employ some of the many unemployed people, jump start the economy, as well as help catch up with Asia, which is building state-of-the-art infrastructure from new mechanized port facilities to high-speed trains.
He suggested financing such building through the sale of U.S. Treasuries.
This is so obviously a good idea, so clearly what the US needs, that likely it will never happen. Certainly Obama does not have the vision or leadership to suggest it, and one could not imagine any republican supporting it. America often feels to me these days like a nation seriously handicapped by its political system.
I could be wrong. I had thought that the idea of bank bail ins was to dilute or extinguish ordinary shareholders, to turn bail-in (tier 2 or coco) instruments into new equity, but to preserve senior debt holders. It seems that the last bit is not necessarily true. It is being contemplated, I understand, that bank resolution regimes may also convert some portion of the senior into equity. That’s going to make selling all that long-dated senior debt that the Basel III liquidity requirements demand quite difficult. Perhaps if you took your foot off my head, I might be able to climb out of the water…
What should we do instead? Well, the priority order of securities gives a strong clue. If a bank is in resolution, it by definition it cannot carry on. Therefore shareholders, as bottom of the priority order, should be wiped out. The new equity in turn comes from the sub debt holders; the conversion of their instruments gives us the vast majority of the new equity as we are massively diluting the equity holders. Logically then senior debt holders should step down too, with some of their notional being converted into new sub debt.
Now for a really delicate question: what do you do about covered bonds? Well, a covered bond is a claim which first has assets supporting it and second is senior. Following the logic above, the covereds keep their assets, but a part of their claim should become subordinated. Now I full admit that it is likely that this particular policy choice will be ignored, but it is the logical consequence of the ‘everyone steps down a notch’ theory of bank resolution.
Update. An FT alphaville post on the Swedish bail-in/out/shake it all about regime made me think that it is worth clarifying how much you need to do at each step in the ladder. The first decision is whether to bail in or just let the institution go into bankruptcy. Then if you bail in, you first decide how much equity you need. You compare that with how much you have, based on an independent valuation, with how much you need. Convert enough Cocos to get you there. Then compare the remaining Coco stock, if any, with how much you need, and convert enough senior debt into Cocos to get you there too.
The Bond Vigilantes have some thoughts on financial stability and bank bail-outs.
Taxpayers should be protected. Deposits should fund loans, and loans shouldn’t outgrow deposits to too large an extent. As a result, taxpayers shouldn’t be on the hook again for the banks, and if they did, it would be far easier to tolerate than it has been bailing out the investment banking system. And the deleveraging that we so need to happen to the financial sector could at last happen.
All reasonable stuff. The problem is that the economy’s demand for credit is far larger than the deposits available to fund it. So either you need more deposits or you need less credit. The first implies impossibly higher savings rates; the second, a dramatic and long-lasting recession. A big dose of inflation would help but of course that has other highly negative consequences. Reviving the securitisation and/or covered bond markets would also be good, but that is not looking very likely at the moment. What we face here is a serious how to get there from here problem.
Here’s an interesting idea from Daniel Beltran and Charles Thomas via FT alphaville. Talking about the role of asymmetric information in the collapse of private-label securitisation prices during the crisis, they recommend:
the government buy relatively low value securities and commit to holding them until maturity. The government has no better information than any other buyer. What makes the government special, and hence provides a role for policy, is that it is the only agent that can credibly commit to not sell the securities before they mature. The policy is useful because after the government makes its purchase the market for the remaining securities reopens and these remaining securi- ties trade at prices closer to intrinsic values. Although this policy involves a cost to the government, the cost is smaller than the gains that arise from having the market reopen…
Now I see the idea here but I am not sure that this is precisely right. The issue the authors are trying to address is that securities were trading at prices which were likely far below fundamentals, but that people were reluctant to buy them (a) because they weren’t sure this was true and (b) because thought that the prices might nevertheless fall further. There is also (c) the difficulty of funding the securities due to (a) and (b).
I guess if the government buys and holds then their assets won’t come back and (b) is less likely. They should make a profit. But I’m not sure that it is the most effective use of dollars. Instead the government could offer to repo the assets to term for private buyers, roughly as the TALF did. The loans should be recourse, and they should be available for the lowest rated securities. At least that way the government won’t be suckered into loading up on those ABS that won’t recover more than their selling price…
Ahmass Fakahany says according to Bloomberg:
I don’t know anyone who wouldn’t have done certain things differently in retrospect,
Now to evaluate this, you need to know that Risk Management reported to Ahmass when Merrill had its little problem in 2008, and that some people think that it was on his watch that many of the people who were most trusted in that area at Merrill moved on. So, um, given who Ahmass knew, is this really credible? I have my suspicions, dear reader, but of course I cannot know for sure… Hypothetically though it would be interesting if one of these people were to stand up and say ‘I knew Ahmass, and not only would I have done things differently, I tried to, and I was stopped…’ That might make some waves.
Northern Rock’s results make the question rather moot. As the Guardian says:
The bad bank recorded a pre-tax statutory profit of £349m compared with a £724m loss a year ago. On an underlying basis, the profit was £167m compared with a £243m loss a year ago…
At the good bank – known as Northern Rock plc – the loss was £142m
This makes sense at this stage in the cycle. If assets were moved into the bad bank at a fair price, or even at a not-terribly-unfair one, they will have recovered a bit, and the bad bank will be making money. The good bank is struggling for NII in a low interest rate environment with a tarnished brand name. It is not obviously a better investment than the bad bank. Sadly that means that the taxpayer’s chances of selling off the good bank for a reasonable return any time soon are low, but it does focus attention rather nicely on the attractions of hanging on to ‘bad’ assets acquired close to the low.
By the way, if you really want a smile, look at the good bank’s capital ratio:
The Company is well capitalised with a Core Tier 1 Capital Ratio of 75.7%
Now that is what I call well-capitalised. None of this 8, 9, 10% stuff you get from the other banks, oh no: 75. Never mind the profits, feel the capital.
Larry Elliott has a thought provoking article in today’s Guardian. He quotes Roubini, who says
… that it is precisely because the downturn has been handled more deftly this time that the impetus for deep, structural reform has faltered. “Had policymakers failed to arrest the crisis, as they failed during the Depression, the calls for reform today would be deafening: there’s nothing like ubiquitous breadlines and 25% unemployment to focus the minds of legislators.”
But, thankfully, policymakers did avoid most of the mistakes of the 1930s and we are where we are. In the circumstances, what the future holds is either full-blown recovery courtesy of the breathing space provided by central banks and finance ministries; another crash preceded by what the late socialist thinker Chris Harman described as “zombie capitalism”; or reform and renewal.
Full recovery would mean that the global economy could continue to prosper even when governments withdraw the support provided by low interest rates, tax cuts and higher public spending. That looks improbable, particularly since there is likely to be a simultaneous tightening of fiscal policy in many countries.
Zombie capitalism is where governments continue to buy up worthless paper from banks, where fundamentally insolvent institutions are kept alive for fear that their failure would cause systemic risk, where every country tries to export its way out of trouble, where the shrinkage of the financial sector depresses growth rates, and where the global imbalances between surplus and deficit countries remain worryingly large. That looks a more likely option.
What, then, are the prospects for reform and renewal? At the very least, this route is likely to be long, hard and strewn with setbacks. It may not be chosen … until there is system failure.
This is an interesting thesis. I don’t wholly buy it, but the idea that precisely by doing enough to fix the immediate problem, but not enough to address its causes, we have left ourselves exposed to a Japanese style slow, shallow but long lasting recession is interesting. Certainly by missing the chance to nationalise the worst affected parties, such as RBS, we also lost the opportunity to restructure banking broadly. It might well turn out that that ideologically-motivated decision was a bad one. That won’t be clear for some years, and it may well be that the summer 2010 panic is minor. But if it isn’t, we will be criticising 2008’s crisis management for some time.
From Ben Bernanke’s speech, The Supervisory Capital Assessment Program–One Year Later:
Importantly, the concerns about banking institutions arose not only because market participants expected steep losses on banking assets, but also because the range of uncertainty surrounding estimated loss rates, and thus future earnings, was exceptionally wide. The stress assessment was designed both to ensure that banks would have enough capital in the face of potentially large losses and to reduce the uncertainty about potential losses and earnings prospects.
The premise here is I think entirely accurate: it was not just current losses that were spooking investors during the Crunch, it was uncertainty over how large future losses would turn out to be. I’m not sure the FED’s stress assessment did that much – the capital and liquidity injections were much more important – but still, the phrasing is interesting. (Remember that the stress tests were not that stressful.)
Later in the speech, Ben makes another interesting point:
Importantly, to conduct effective stress tests, banks need to have systems that can quickly and accurately assess their risks under alternative scenarios. During the SCAP, we found considerable differences last year across firms in their ability to do that. It is essential that every complex firm be able to evaluate its firmwide exposures in a timely way. One of the benefits of the stress testing methodology is that it provides a check on the quality of firms’ information systems.
As I discussed, one reason for the success of the stress tests was the public disclosure of the results. We are evaluating the lessons of the experience for our disclosure policies.
Clearly there is the potential for disclosures here to be really insightful for investors. We have seen how useless VAR disclosures were for predicting losses during the Crunch: perhaps stress tests results, especially if standardised across the industry and thus directly comparable, will be more useful. It certainly can’t hurt (well, it can’t hurt unless an actual loss appears in a situation which is close to one of the ones tested, and it is much bigger than that test would have indicated). Stress tests are here to say, and financial institutions will need to get used to them; to resource themselves so that they can run them easily; and to prepare for the consequences of disclosing the results of them.
Slowing down April 23, 2010 at
Deus Ex has tried, and mostly succeeded, to post daily since the start of the financial crisis. Now, though, the posting rate has slowed, and that will probably not change, at least for a while. The reasons are multiple: there is a new stridency about much financial blogging, which I do not want to emulate, and which is clearly a risk; there is a new hostility, too, with both readers and writers willing to blame before seeking to understand. I heard a new definition yesterday of a financial derivative: it is of course that instrument which takes the blame in any problematic situation, regardless of its role.
Clearly regulatory changes are needed. We have argued that all along. But much of what is being proposed at the moment is disproportionate, ill-designed, and badly targeted. Some of it will even make matters worse. (A good example is central clearing: if you can only clear 75% of trades – and that is likely to be the case for some years, regardless of regulatory pressure – then for most counterparties, central clearing will actually increase credit risk, as some of the clearable trades will be offsets for the non-clearable ones.)
The Goldman vs. SEC case also worries me greatly. This is not because I don’t think Goldman did anything wrong: I have no idea if they did anything wrong. But the disconnect between what the case is about and what it is portrayed as being about is deeply unhelpful. The complaint accuses them of failure to disclose relevant information. This has been reported as designing a security which they knew would fail. One can easily be guilty of the former without having contemplated the latter. So, while the headline ‘Goldman accuses of fraud’ might be helpful for certain political agendas, it is actually somewhat distant from the truth.
In an effort to retain a degree of equilibrium, therefore, and to try not to fall into the trap of writing knee jerk posts, Deus Ex is going to slow down. Expect slightly longer posts, rather less frequently.
I like Steve Randy Waldman so I don’t want to cricitise him too much, but I think he makes an error in the following:
On September 10, 2008, Lehman reported 11% “tier one” capital and very conservative “net leverage“. On September 15, 2008, Lehman declared bankruptcy. Despite reported shareholder’s equity of $28.4B just prior to the bankruptcy, the net worth of the holding company in liquidation is estimated to be anywhere from negative $20B to $130B, implying a swing in value of between $50B and $160B. That is shocking. For an industrial firm, one expects liquidation value to be much less than “going concern” value, because fixed capital intended for a particular production process cannot easily be repurposed and has to be taken apart and sold for scrap. But the assets of a financial holding company are business units and financial positions, which can be sold if they are have value. Yes, liquidation hits intangible “franchise” value and reputation, but those assets are mostly excluded from bank balance sheets, and they are certainly excluded from “tier one” capital calculations. The orderly liquidation of a well-capitalized financial holding company ought to yield something close to tangible net worth, which for Lehman would have been about $24B.
What’s wrong? I suspect at least the following:
- First, the costs of bankruptcy are considerable. The Enron liquidation, for instance, involved fees of more than $600M, and Lehman is a lot more complicated than Enron. Therefore we can chalk up at least a couple of billion to bankruptcy costs, and probably more.
- In bankruptcy you are a known, forced seller (and terminator of derivatives contracts). The Lehman bankruptcy happened in a crisis – indeed in some ways it caused it. This meant that Lehman’s assets were liquidated under the worst possible conditions. The fact that they were sold for less than their holding value is unsurprising. A 20% discount to sell an illiquid asset in hurry would not be surprising – and Lehman had at least $300B of illiquid assets. So perhaps $60B here.
- More to the point, while Lehman sailed fairly close to the wind on its valuations, what it did not do – what few firms do – was be honest about the uncertainty in those valuations. If you read the detail of the valuation section of the Valukas report, you will find that a lot of the time, the correct value of assets is simply impossible to determine. What Lehman did was not perhaps conservative, but it was not illegally aggressive according to Valukas. Given Lehman’s assets, a 5% uncertainty in valuation is not surprising. That’s another $15B.
The real point is leverage. If you have (in round numbers) $30B of capital supporting $600B of assets, then $30B of uncertainty in valuation wipes you out. If you were half as leveraged, you could tolerate twice as much uncertainty. No financial will ever be liquidated for anything close to its accounting value, particularly in a crisis. But if firms are less leveraged, then they are more likely to have higher recoveries. Given Lehman’s leverage, going from a going concern value of +$30B to a bankruptcy value of -$50B is not at all surprising.
In an interesting FED paper, How Did a Domestic Housing Slump Turn into a Global Financial Crisis? Steven Kamin and Laurie Pounder DeMarco discuss how the subprime issues created a global financial crisis. They agree with the perspective I took in my two articles in Quantitative Finance (here and here) that direct exposure to subprime did not cause the crisis. There were simply not enough subprime mortgages and they were not widely enough held to cause the intensity of problems that we saw. Rather there were other channels of contagion which combined with direct exposure (and counterparty risk) to cause the crisis. Kamin and DeMarco’s list is similar to mine:
- No one knew who held what, and whether it was fairly marked. Without general confidence that institutions had correctly marked their losses, and that they had disclosed all material exposures, confidence was lost.
- Amid heightened demands for liquidity, financial institutions that depended heavily on short-term funding were subject to runs. This follows from the loss of confidence.
- In particular, following Paribas’ refusal to redeem shares in several of its SIVs and conduits, the ABCP market dried up, forcing assets back on balance sheet (thanks to backup liquidity lines) and intensifying the funding crisis.
- Historically contagion was caused by direct interbank exposure. In this crisis in contrast, it was caused by mark to market. Selling, sometimes forced (by funding difficulties and/or inability to meet margin calls), lowered asset prices, which caused mark to market losses to all holders. In an illiquid market selling a relatively small position caused big falls which affected all holders who were properly marking their position.
- Investors realised that whether or not a bank had direct subprime exposure, it likely had business practices sufficiently similar to troubled market participants that it was vulnerable. Nearly everyone was too leveraged, had too much funding liquidity risk, too much exposure to complex mark to model instruments, and lax supervisors. This ‘wake up call’ caused a widespread loss of confidence in financial institutions of all kinds.
- At the same as losing confidence in their counterparties, market participants increased their risk aversion. Ratings were (rightly) distrusted; structured assets of all types were viewed with suspicion; risk capital became very scarce. This again caused asset selling which reinforced the price falls/losses/capital reduction/loss of confidence spiral/forced deleverage spiral.
If we want to reduce the likelihood and severity of future crises, we need to address these vectors of contagion. This requires:
- Enhanced disclosures from financial institutions, better valuation methodologies, and much better supervision of valuation. Lehman’s ambitious valuations as disclosed in the Valukas report is evidence enough of the need to do this.
- Better liquidity risk management, and tighter supervision of liquidity.
- Intense supervision of funding liquidity risk in vehicles which are not supported by insured deposits.
- Breaking the link between mark to market and capital.
- Increased diversity in the financial system.
- The introduction of anti-cyclical capital measure which reduce the impact of crises on regulated institutions.
We begin with something interesting, if wrong. Did Woodstock hippies lead to US financial collapse? (HT the Economist’s View). The sense in which there might be something to this rhetorical (at least in the author’s mind) question is that changes in morality which started in the 60s in some sense contributed to the current crisis. But so too did flows of money which intensified with the rise of the baby boomer generation, combined with other social and political changes.
Consider the big picture:
- Morality first. There is no doubt that the attitude to debt has changed. North Americans, in particular, used to view repaying debt as more of a moral obligation than they do now. Thus we get more opportunistic (negative equity related) defaults than we used to. This was not a major driver of the credit crunch, but it did have an effect.
- Baby boomer pensions were a major cause. Those dang hippies were just too successful: they made all this money which needed a home. Government bond yields were derisory, so some of this cash was sucked into AAA rated ABS. The same goes for the riches of the newly industrialising BRICS. This wave of hot money, more than hippy morality, was a key crunch driver.
- Transactional, as opposed to relationship capitalism led to the originate-to-distribute model and so to making loans without worrying about whether they would perform. That is not a 1960s invention: it dates back at least to the 19th century, and arguably much further.
- Finally, wealth growth. If GDP keeps growing, and you can tax it at more or less a constant rate, you don’t have to fund current promises as the future will pay. This mañana attitude to government and pension finance allowed higher levels of consumption during the good times. But now times are not good, we need (in Interfluidity’s apposite phrase) ‘redistribution for which there is no overt legal framework or political consensus’.
The make love not war generation didn’t help, then, but it was not permissiveness that was primarily to blame: it was systemic weaknesses in Anglo Saxon capitalism that interacted with a wave of hot money to create the Crunch and its damaging aftermath.
A nice list from the Big Picture of a few crises from 1970-2000 (which I have edited slightly):
The Argentinian default of 2001-2
- The Nifty Fifty stock market boom and subsequent correction of the early to mid 1970s
- Franklin National Bank Failure on 1974
- Penn Square Failure of the early 1980s
- Gold bubble in 1980
- The Savings & Loans crisis of the 1980s
- The Stock Market Crash of 1987
- The bond carry trade of 1994 and subsequent FED tightening
- Mexican Debt crises of 1982 and 1994
- The East Asian Financial Crisis on 1997
- LTCM of 1998
- The Tech Bubble on 2000-2001
Add in Brazil in 1998, Argentina in 2001-2, and the Credit Crunch and its aftermath in 2008-2009, and Greece in 2010, and you might think that the benign markets of 2003-2006 are the exception rather than the rule.
Consider a bank which has:
- Non performing loan coverage of only 105%
- Total assets over 65% of its country of incorporation’s GDP
- With that country having unemployment over 15%
- The bank had falling EPS and efficiency ratios in 2009 despite the recovery of the markets
OK, the leverage (assets to shareholder’s equity) is not that silly at 15.5x, but total assets of over a trillion euros are scary big.
Question for the reader: is this bank too big to fail? If so, should it be broken up?
Update. Not even Charles? One more clue: this bank has c. 50% of the UK mortgage market.
The tax payer can thank the Gods that we have the right result. According to the FT:
Andrew Caldwell, a partner at BDO Stoy Hayward, the accountancy group, who was appointed by the Treasury last year to determine whether investors should qualify for a pay-out, said there was no value in Northern Rock’s shares.
A few weeks ago, I discussed the idea that we could reduce both moral hazard and the profitability of banking by charging banks for the cost of the option the bank has to be rescued by the state. In related work, Elijah Brewer and Julapa Jagatiani at the Philadelpha FED have attempted to estimate how much banks are willing to pay to become too big to fail (and thus ensure that they have that option). The paper is here: hat tip (as so often) FT alphaville.
Dodd gets it December 5, 2009 at
From Naked Capitalism:
in a sudden and uncharacteristic burst of courage, Connecticut Senator Chris Dodd has proposed a federal subsidy for vampire hunting. “Nothing brings a community together like a vampire hunt,” commented Senator Dodd. “Moreover, a vampire hunt requires serious tools. You don’t want to break into that crypt with a cheap stake that might snap or a hammer with a fragile plastic handle. Before you go after that inhumanly powerful undead creature with glowing red eyes, you are going to head down to the Home Depot or your neighborhood hardware store and load up on heavy-duty, top-of-the-line equipment.”
Treasury Secretary Tim Geithner, though, has doubts about Dodd’s proposal. “One problem is that it can be difficult to determine which blood-sucking supernatural parasites are in fact vampires and which are duly authorized and well-regulated components of the financial system, such as investment banks.
A cheap shot perhaps but it made me laugh.
Half of the losses suffered by banks could still be hidden in their balance sheets, more so in Europe than in the United States, the International Monetary Fund’s chief, Dominique Strauss-Kahn, was quoted as saying on Tuesday.
That is what is possible with accrual accounting, as practiced in Europe. Viva fair value.
There has been a lot of discussion recently about the SIGTARP report on the AIG bailout. See for instance here for Krugman, here for Naked Capitalism, and here for the Big Picture. At first I shared this outrage: Geithner undoubtedly underplayed his hand, and showed his usual snivelling obeiscance to the banks. But does it, in this instance, matter much?
What did he really do? He loaned AIG money, at a penal rate, so that they could meet margin calls on CDS. Derivatives receivables are technically pari passu with senior debt (and in practice better than that, due to a wide definition of default in the CSA), so he did nothing worse than lend money to AIG’s counterparties. He did not recapitalise them covertly: these payments were debt, not equity. And many of the counterparties, Goldman included, could have borrowed directly from the FED at that point. By allowing AIG to make the payments, he injected liquidity, and prevented a potentially systemic failure of the CDS market. Moreover, AIG (and thus the taxpayer) is on the hook for the performance of the CDS it had written anyway, and in due course we will see how that goes: the collateral payments were merely based on the current mark to market. If conditions improve (as they have done), AIG and thus the taxpayer will get the money back, with interest.
In conclusion, then, there are many, many things that we can criticise about Timmy’s actions (and inactions) during the crisis. But the AIG margin payments are not on the top ten Timmy screwup list.
See the sun! Ignore the muddy puddle. That’s the regulators’ way, according to a great post at Interfluidity:
In good times, regulators have every incentive to take banks at their optimistic word on asset valuations, and therefore on bank capitalization. It is almost impossible for bank regulators to be “tough” in good times, for the same reason it is almost impossible for mutual fund managers to be bearish through a bubble. A “conservative” bank examiner who lowballs valuation estimates will inevitably face angry pushback from the regulated bank… Valuations can remain irrational much longer than a regulator can remain employed…
When a “systemic” banking crisis occurs, regulators’ incentives are suddenly aligned with bankers: to deny and underplay, to offer forbearance, to allow the troubled banks to try “earn” their way out of the crisis. Regulators, in fact, can go a step further. Bankers can only “gamble for redemption”, but regulators can rig the tables to ensure that banks are likely to win. And they do.
The whole post is definitely worth reading. The key point though – that banking crises make regulators look silly, and thus they have an incentive to underplay the seriousness of the issue and to covertly help the banks earn themselves back into the black – is very well made. Now would be a really good time to be highly suspicious of asset valuations, loan loss provisions, and other counterparty performance evaluations.