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.

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.

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?

• 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.

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.