reforming insolvency procedure for investment banks are an important first step towards banishing the Lehman nightmare

TO BE NOTED: From the FT:

"How to avoid another Lehman nightmare

By Andrew Hill and Charis Gresser

Published: May 11 2009 20:15 | Last updated: May 11 2009 20:15

The UK Treasury’s “initial thinking” about how to avoid a re-run of the Lehman Brothers catastrophe should be prescribed bedtime reading for incurable insomniacs. But its ideas about reforming insolvency procedure for investment banks are an important first step towards banishing the Lehman nightmare.

It’s tempting to blame delays in the return of Lehman client assets and settling of trades on the UK regime. The US seemed to move faster. But that overlooks a crucial point: Lehman clients and counter-parties in the US benefited from precious extra days for an orderly winding down. The collapse of Lehman’s European business was more hair-raising. Administrators had to scrabble around for basic information, not to mention cash to pay staff.

But even if the basic legal framework doesn’t need an overhaul, a lot must change. Should any government again decide to let an investment bank go under, pressure on the financial system must be reduced. Some of the Treasury’s ideas are in the motherhood and apple pie category, including the need for better record-keeping and reporting of what assets are held, where, and subject to which liens. It would also be desirable if clients knew precisely what they had ceded to banks (such as the right to use assets posted as collateral). Other possible reforms are more complex: amending liability arrangements for insolvency practitioners, speeding up the return of client assets and establishing default rules for financial transactions not usually covered by such regulations.

The most important suggestion, however, focuses on the stage before insolvency. The administrators from PwC could have been spared the horror of that fateful weekend in September if they had had details of Lehman’s information technology, custodians, trading systems and employees. It sounds like mundane paperwork. But you wouldn’t want to try unscrambling another Lehman-sized mess without it.

Centrica flies a small flag

A few patriotic investors would have preferred an all-British solution to nuclear power production in the UK. But the government never seemed to have much stomach for Centrica buying British Energy outright. Instead, it committed its stake in British Energy to a bid from EDF of France last year, when oil prices were near their peak. As the commodities market tumbled, that seemed to leave Centrica tied to a minority stake in the nuclear group at an increasingly unfavourable price.

But patriots can bring out the Union flags again. Centrica has haggled its way to a usable compromise. It will own 20 per cent of the holding company for British Energy and take 20 per cent of the nuclear company’s available production. EDF also throws in a further 18TWh of power for five years from 2011. That offer doesn’t last as long as a larger chunk of British Energy’s production would have, and it won’t be immune to price fluctuations, but it will help underpin Centrica’s effort to cut its dependency on wholesale markets.

What’s more, by using its shareholding in a Belgian electricity company in part settlement of EDF’s bill for the stake in British Energy, Centrica uses up only £1.1bn of the cash it presciently raised with an early rights issue last year. It may find itself at the toddlers’ table at British Energy board meetings, while les grands garçons from EDF talk nuclear strategy, but even there it will have two seats out of 10, just as the original memorandum envisaged.

Attention must now turn to what Centrica does with the financial flexibility it has won. Its obvious target is Venture Production, the North Sea oil and gas producer where it already owns a 23.6 per cent stake, but there are plenty of other areas, such as gas storage, where Centrica could now invest with more financial freedom. As Sam Laidlaw, Centrica’s chief executive, has shown, energy is now a buyer’s market.

Dive in, the water’s lovely

“Sell in May and go away” usually applies to investors, not issuers. Yet May is again a month when companies are selling and institutions sucking it up. Last May, they were considering issues from Royal Bank of Scotland, HBOS, and Bradford & Bingley (where are they now, I wonder?). This year, Lonmin, Travis Perkins and 3i are diving in and others are said to be testing the water for capital raising. How chilly is the plunge? Fees are higher (although sub-underwriting institutions claim to be getting less of the increase than the banks), discounts are steeper – technically irrelevant, unless you’re an unenthusiastic investor wanting to sit a rights issue out.

But amid the usual grumbling about fees and discounts, a quiet tone of celebration is emerging. Equity capital markets are doing their job. And to think they said the rights issue was doomed . . .

Bank insolvency: charis.gresser@ft.com

andrew.hill@ft.com

To comment, visit www.ft.com/lombard"

Goldman had no direct exposure to AIG.

From The Economics Of Contempt:

"Goldman Finally Sets the Record Straight on AIG

Goldman Sachs finally held a conference call to dispel two widespread myths about its relationship with AIG, both of which originated in a horribly dishonest article by the NYT's Gretchen Morgenson. I've harped on this several times before, and I'm glad Goldman is finally addressing this directly.

First, regarding the patently false claim that Goldman CEO Lloyd Blankfein was the only Wall Street executive at a meeting at the New York Fed to discuss the AIG bailout:

There was a Sept. 15 meeting at the NY Fed where AIG’s troubles were discussed. Goldman Sachs was invited to discuss a private-sector solution to AIG’s problems. Tim Geithner asked Lloyd to attend. Lloyd attended. So did Jon Winkelreid, our president, as well Bob Scully at Morgan Stanley who was advising the government. Jimmy Lee, a JP Morgan vice-chairman and AIG’s financial adviser, was there, as well as senior people from the Fed and AIG and Eric Dinallo, the New York State Superintendent of Insurance. Geithner didn’t stay for the meeting. Lloyd stayed for 20 minutes and left. At that meeting it was decided there was no private-sector solution, and at that point GS team left and GS was not party to any discussions with the government after that. After that, they decided a public-sector solution was the way to go. In terms of the government bailout of AIG, GS was not privy to any discussions at all.

Second, regarding the myth that Goldman had $20 billion of exposure to AIG (from Deal Journal's live-blogging of the conference call; italicized text is Deal Journal's translation):

"We established credit terms to them commensurate to those with other trading counterparties…we limited our overall credit exposure to AIG with collateral and market hedges in order to protect ourselves." [Translation: Goldman treated AIG like other counterparties, where it bought "insurance" through special contracts called credit-default swaps that would pay Goldman money if AIG went bankrupt. These CDS contracts are a common feature of trading relationships in the markets.]
...
In mid-September, the majority of GS’s exposure, $10 billion, was collateralized or hedged. They held $7.5 billion in collateral. The rest was hedged in CDSs. "We had no material exposure to AIG."

So to sum up:

1. Goldman never discussed a government bailout of AIG with the Fed or Treasury;


2. Lloyd Blankfein, along with representatives from Morgan Stanley and JPMorgan, briefly attended a meeting at the New York Fed to discuss a private sector rescue of AIG; no government bailout was discussed at the meeting; and


3. Goldman had no direct exposure to AIG.
   

Gretchen Morgenson: consider yourself rebutted.

Posted by Economics of Contempt at 3:50 PM "

Me:

Don said...

“All we did is call for the collateral that was due to us under the contracts,” he said. “So I don’t think there’s any guilt whatsoever.”

If you look at their actions, don't they support my idea that investors will demand collateral if they think that a business is bleeding funds? I agree that it's fine to write the terms in ahead, as happened here, but collateral calls are in order to keep the investor calm and not demand his money. In that sense, making collateral calls independent of downgrades would simply force them to be written in beforehand. But lowering collateral calls or putting them aside would seem to lead to just the scenario I was describing.

Don the libertarian Democrat

March 21, 2009 11:57 AM

The Place Of Government Guarantees In Avoiding Bank And Calling Runs

I want to briefly talk about the causes of this crisis before the silly explanations like lack of regulations and complex investments win day, as they surely will, guaranteeing that this system will go on and even implode again in the near future, although hopefully not to the this extent.

I want to ask a simple question: Does FDIC Insurance on individual accounts help prevent bank runs? Bank Runs being a result of depositors running to the bank to get their money out before the resources of the bank run dry, leaving a number of depositors to lose their money. If you think that FDIC Insurance is stupid, illegal, unconstitutional, a gift to moral hazard, doesn't help stop bank runs, and should be gotten rid of, then my points going forward won't matter to you. I do, however, address this position at the end of the post.

Now, our current crisis is a Calling Run. As the credit rating of a business goes down, investors or creditors that can demand money from the business do so, forcing the business to sell assets or borrow to fund these calls, which leads to a further deterioration of the finances of the business and a further downgrade, which leads to more calls... Now, if better regulations and higher capital standards are all that is needed to stop runs, why do we need FDIC Insurance? Surely higher capital standards and better regulation should suffice to stop a Bank Run. You see my point.

In the current crisis, the flight to Treasuries was in lieu of an explicit government guarantee concerning their assets. Investors fled into explicitly guaranteed, and hence liquid investments, since they can be priced, and even fled from implicitly guaranteed investments. In other words, investors fled to an equivalent of the FDIC. Simply put, you need government guarantees about losses to stop a run. Regulations and Capital Standards won't suffice. Well, they could, but they would be incredibly onerous and high, making them impractical, so, in effect, you need government guarantees to stop runs.

In the current crisis, it has all been about the extent and particulars of government guarantees. Certainly the gyrations of government actions have led to problems, but only in the sense of not making the extent of the guarantees explicit and particular. Anyone who believes that we could stop this crisis without government guarantees, like US Treasuries, is wrong.

From my analysis, it's clear that regulations and capital standards are not sufficient to stop a run. They might have effected this crisis in some manner, but explaining the crisis by seeing what has just occurred and writing laws that might have prevented it is of very little use, and has no real explanatory power. It's a help going forward, but, taken too particularly, it will result in a set of rules and laws that very smart people will manage to elude.

What to do then going forward?
1) Put in some sort of FDIC Insurance for these investments
2) Accept that runs might occur, and do your best to preclude them and be prepared for them
On 2, I say," good luck". Wishful Thinking at its worst. This is what will happen naturally.
On 1, what can we do? I suggest Bagehot's Principles. We need a LOLR I'm sorry to say in the modern world. All that we can do is make the guarantees explicit and adhere to firm standards going forward. But there is no practical solution without LOLR guarantees. They should be robust enough to preclude Calling Runs. One solution would allow some minimal use of FVA as opposed to MTM in supervised cases, with a government guarantee.

For libertarians, I'm sorry. This is the best that we can do for you. However, by averting Runs, we can avoid the kind's of crises that usher in enormous government intrusion. That should prove sufficient to the practically minded.

Finally, to the FDIC abstainers, a Burkean response. We don't have the FDIC for James Grant. We need it for:
1) Our actual Investor Class, which feeds on government guarantees and intervention.
2) Much more importantly, and let me put this in terms that the Investor Class can understand, in order to stave off social rebellion. A system that leads to mass unemployment, low wages, a very wealthy upper class, is not stable. Telling average workers to accept the pain of recessions and depressions is going to eventually lead to trouble. They don't have to. In other words, some people believe that we live in a world where such events as rebellions cannot occur. Of course, some people live in a world where depressions cannot occur. As a good Burkean, I know that isn't our world, and the bonds of civil society must allow compromise in order to stave off societal dislocations.

"hedge fund activity in the third quarter based on the many 13Fs that were released on Friday"

Here's an argument in favor of hedge funds in Bloomberg, which I came to from Bespoke's Think Big:

"Tepper, Barakett Abandon Stocks as Hedge Funds Shrink Holdings

By Miles Weiss

Nov. 17 (Bloomberg) -- Hedge-fund manager David Tepper entered the third quarter with $3.1 billion of U.S. stocks and exited with $648 million, selling most holdings to reduce risk and raise cash as carnage spread across the financial markets.

``We moved a lot out early because we didn't want to lose money,'' said Tepper, 51, president of Appaloosa Management LP in Chatham, New Jersey. The firm, which switched some money to bonds, has between 30 percent and 40 percent of assets in cash.

The story at Appaloosa, whose returns have dropped more than 20 percent this year, was repeated across the hedge-fund world in the quarter as managers were hit by client withdrawals, tumbling financial markets and tighter credit. Regulatory filings last week by 38 hedge funds with more than $1 billion in assets each show that selling and market declines cut the value of their reported holdings by about 30 percent to $273 billion.

The $1.7 trillion industry, which accounts for about a third of U.S. equity trading, continued to retrench in the past two months, contributing to the 25 percent decline by the Standard & Poor's 500 Index since Sept. 30. At least 75 funds have liquidated or halted redemptions this year. With the Nov. 15 deadline for year-end withdrawal requests now past, fund managers may be forced to unload more stocks to pay off clients.

``Hedge funds generally are the tip of the spear in good times and they are also the canary in the cage in tough times,'' said Andrew Lo, a finance professor at the MIT Sloan School of Management who also helps run a fund for AlphaSimplex Group LLC in Cambridge, Massachusetts. ``They are the first to get hit up with losses and the first to get out.''

It seems to me that Lo makes a case for focusing in on Hedge Fund activity for clues to market movements.

"Money managers who oversee more than $100 million of equities more must file, within 45 days of the end of each quarter, a Form 13F with the Securities and Exchange Commission that lists their U.S. exchange-traded stocks, options and convertible bonds. The filings don't show non-U.S. securities or how much cash the firms are sitting on.

Almost all the major hedge funds submit their reports within a few hours of the deadline, which was Nov. 14 for the third quarter. Managers of the private, largely unregulated pools of capital can buy or sell any assets, bet on falling as well as rising asset prices, and participate substantially in profits from money invested."

That explains why we're getting this info now.

``Movements in financial markets were so volatile, so unpredictable and so seemingly detached from fundamentals'' that many hedge-fund managers ``didn't feel they had an edge,'' said Doug Peta, an independent market strategist in New York. ``The best thing they could do for their investors was to pull back entirely until markets returned to more of a sense of normalcy.''

I have to say that this sounds like a wise policy.

"Some managers sold stocks to build cash that they can use to meet client withdrawals triggered by subpar returns. Even managers who are outperforming have gotten redemptions because their clients need cash and their other funds are frozen.

Funds have also been forced to pare their holdings as prime-brokerage units of investment banks cut back on lending and raise the price of the loans they are willing to make. And many funds may have sold stocks as the quickest and easiest way to raise cash to pay down loans on bets on other assets that had dropped in value, such as energy futures, said Leon Metzger, a former hedge fund executive.

``If you bought oil at $140, you had some margin calls,'' said Metzger, who now teaches courses on hedge-fund management at several colleges including Yale University. ``What you have to do is sell your liquid securities so you can post more collateral.''

At least they're posting collateral.

Here's a possible bright side from Bespoke:

"Bloomberg.com's Miles Weiss has a very insightful article on hedge fund activity in the third quarter based on the many 13Fs that were released on Friday. Hedge funds across the board, including the most established and well respected, moved the majority of their assets into cash last quarter. The one positive from this huge selling trend is that when the dust settles on the credit crisis, all the cash will find its way back into the market, and it could send shares up just as fast as they went down."

Securitization Reconsidered

Okay. Big news. Derivative Dribble explains securitization. Let's go back to the Bloomberg article:

"The bundling of consumer loans and home mortgages into packages of securities -- a process known as securitization -- was the biggest U.S. export business of the 21st century. More than $27 trillion of these securities have been sold since 2001, according to the Securities Industry Financial Markets Association, an industry trade group. That's almost twice last year's U.S. gross domestic product of $13.8 trillion. "

Okay. Claims about securitization:
1) bundles loans and mortgages into securities
2) more than $27 trillion of these securities have been sold since 2001
3) that makes these securities the largest U.S. export since 2000

So what? That hardly seems a bother other than the figure being quite large, but, then, good for the U.S.

So now banks outside the U.S. start doing this:
Result: $667 billion in losses: $260 billion or so outside of U.S.: about $400 billion in the U.S.

Okay. These securities lost this money? How?

"Securitization is a shadow banking system that funds most of the world's credit cards, car purchases, leveraged buyouts and, for a while, subprime mortgages. The system, which pools loans and slices up the risk of default, made borrowing cheaper for everyone, creating a debt culture that put credit cards in wallets from Seoul to Sao Paolo and enabled people to buy luxury cars and homes. It also pumped out record profits for banks, accounting for as much as one-fifth of their revenue over the last decade."

Okay, here, I'm lost.

These securities fund:
A. Credit cards
B.Car purchases
C. Leveraged buyouts
D. Subprime mortgages

The "system"
A. Pools loans
B. Spreads risk
C. Makes borrowing cheaper

Voila: A Debt Culture
Does all lowering of interest rates lead to a Debt Culture?

There's $4.2 trillion in money market funds ( deposits paying interest )
Banks made money with the mm funds by funding subprime mortgages and cutting costs
The cutting costs sounds like a good thing, the subprime loans don't

"Before the invention of securitization, banks loaned money, received payments and profited from the difference between what the borrower paid and the bank's funding cost."

The banks took in deposits, paid interest on the deposits to the depositors, and loaned the money out to borrowers at a higher rate of interest than they were paying depositors or charged fees. This example doesn't make that clear.

Now, after securitization:

"During the mid-1980s, mortgage-bond traders at Salomon Brothers devised a method of lending without using capital, a technique at the heart of securitization. It works by taking anything that has regular payments -- mortgages, car loans, aircraft leases, music royalties -- and channeling the money to a trust that pays bondholders principal and interest."

How do the banks make money in this? If it's lending, do they get interest, fees, what?

"Securitization's biggest innovation was off-balance-sheet accounting. If a bank couldn't sell a bond or didn't want to, the asset could be sold to a trust within a so-called special- purpose entity, incorporated in a place such as the Cayman Islands or Dublin, and shifted off the books. Lending expanded, and banks still booked profits.

With this new technology, a bank could originate $100 million in loans, sell off some to investors, transfer the rest to a special-purpose entity and not have to hold any capital. The profit could be as much as 1.25 percentage points of the amount loaned, or $1.25 million for every $100 million issued.

``The banks could turn a low return-on-equity business into one that doesn't use any equity, which was the motivation for this,'' said Brad Hintz, a Sanford C. Bernstein & Co. analyst and former chief financial officer at Lehman. ``It becomes almost like a fee business because it requires no capital.''

It is a fee business if there's no capital. That's why I asked how the banks make money on these securities. How does the bank originate a loan without capital?

"As securitization caught on, borrowing increased. U.S. consumer debt tripled in the two decades after 1988 to $2.6 trillion, according to the Federal Reserve. Foreign banks used the new technology to expand lending, seeking borrowers on their home turf. ``One of the things the United States exported overseas was a debt culture,'' Haley said."

So, because of these securities, consumer debt tripled in the U.S., and, since we seem to be rich, other nations did the same thing.

I've already gotten a headache, and we're just coming to CDO's.

"Starting around 2005, securitization began to rely more on short-term money-market funds for financing. This was especially true for securities made by pooling other bonds, known as collateralized debt obligations, or CDOs. Investors were loath to buy long-term debt of issuers that didn't have a track record, so new issuers sold asset-backed commercial paper that matured in less than a year. While money markets are the cheapest way to finance, they can also be the most dangerous for borrowers because they can mature as soon as the next day."

Okay. CDO's use short term debt which is cheap but comes due fast.

"SIVs, banks and CDOs sold trillions of dollars of asset- backed commercial paper between 2005 and 2007 in maturities ranging from nine months to overnight. In the U.S., the amount outstanding marched higher almost every week beginning in April 2005, peaking at $1.2 trillion for the week ending Aug. 8, 2007"."

And:

"Once money-market funds began to be tapped for financing, Ocampo said, ``it created a huge appetite for high-yield assets, far more than could be originated on a sound basis.''

To accommodate the demand, banks funded more subprime mortgages, with an average life of seven years, replacing car loans with an average life of three years and credit-card bonds paid off within 18 months."

And:

``Most of the terrible things happening now are because of the presence of money-market assets, taking what used to be long-term funding and making it short-term,'' Bruce Bent, 71, who started the first money-market fund in 1970, said in an interview in July"

Okay. Short term lending is the problem.

"Yet asset-backed securities weren't Bent's undoing. His fund also owned $785 million in Lehman debt, bought before the firm filed for bankruptcy Sept. 15. In the two days following the bankruptcy, Reserve clients asked to pull about $40 billion from the $62.5 billion fund, and its net asset value fell to 97 cents. It was the first time that a money fund ``broke the buck,'' or fell below $1, in 14 years. The fund is now being liquidated, and Bent hasn't given an interview since."

Only it's not. It looks here like lack of collateral.

We've come a long way. Derivative Dribble asked if I was fair to securitization in the first post I did? No, I wasn't. It looks like the culprits are:

A: Lack of capital
B. Poor loans

A poor loan is a poor loan.

Here's Derivative Dribble:

"So What Does That Accomplish?

B wanted to enter the local mortgage market but was struggling to do so because it couldn’t lend at the same rates as national banks. This was due to B’s inferior credit standing relative to large national banks. But the securitization process above allows B to isolate the credit quality of the mortgages it issues from its own credit quality as an institution. Thus, the rate paid on the notes issued by the SPV will be determined by examining the credit quality of the mortgages themselves, with no reference to B. Since the rate on the notes is determined only by the quality of the mortgages, the rate on any individual mortgage will be determined by the quality of that mortgage. As such, B will be able to issue mortgages to its local community at the market rate and profit from this by servicing the mortgages for a fee."

So remember where I said the banks are making money through fees? Banks are making money on these securities, mortgages through fees.

Of course, whether there is enough capital in a bank, or whether a loan or mortgage is sound, are completely separate questions. So until I hear otherwise from Derivative Dribble, it seems to me that, just like CDS's, the problems are lack of collateral and unwise loans, not the investments themselves.

Can people have been deluded?

See my post about coming up about PRDC's in Japan.

"one can only conclude that the market is pricing in a wave of defaults the like of which America hasn't seen in a very long time."

Felix Salmon on AIG:

"What was that about the credit markets improving? Not so fast:

American International Group Inc. has used $90.3 billion of a U.S. government credit line since it was bailed out last month...
AIG's latest balance was revealed yesterday by the New York Federal Reserve, and is up from $82.9 billion a week ago...
The firm needed cash after credit downgrades forced it to post more than $10 billion in collateral to clients who purchased guarantees on bonds that lost value.

... Continue"

Here's my comment:

Posted: Oct 26 2008 00:21am ET

"AIG isn't disclosing ``basic stuff'' about how the Fed money is being used, UBS AG credit desk analyst David Havens said in an e-mail.

``The lack of disclosure has been a point of frustration,'' Havens said. ``We lack granular knowledge as to exactly where this $90 billion is going.''

And:

"Collateral Damage

``To the extent they continue to go down and we have to keep posting collateral, as it's called in the vernacular of the industry, it's possible it may not be enough,'' Liddy said."

How much of the money is going towards this collateral? What else is it being used for? Wouldn't it make sense that you ensure that you can post collateral first? There's something wrong with this picture.

By DonthelibertarianDemocrat

By the way, AIG is currently at $1.70, with a one year high of $64.25. Wow.

More On Credit Default Swaps

Via Crunch Con, the transcript to 60 Minutes on Credit Default Swaps:

"Before your eyes glaze over, Michael Greenberger, a law professor at the University of Maryland and a former director of trading and markets for the Commodities Futures Trading Commission, says they are much simpler than they sound. "A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution, or a financial instrument, fails," he explains.

"It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a 'swap,' which by virtue of federal law is deregulated," Greenberger adds.

"So anybody who was nervous about buying these mortgage-backed securities, these CDOs, they would be sold a credit default swap as sort of an insurance policy?" Kroft asks.

"A credit default swap was available to them, marketed to them as a risk-saving device for buying a risky financial instrument," Greenberger says.

But he says there was a big problem. "The problem was that if it were insurance, or called what it really is, the person who sold the policy would have to have capital reserves to be able to pay in the case the insurance was called upon or triggered. But because it was a swap, and not insurance, there was no requirement that adequate capital reserves be put to the side."

"Now, who was selling these credit default swaps?" Kroft asks.

"Bear Sterns was selling them, Lehman Brothers was selling them, AIG was selling them. You know, the names we hear that are in trouble, Citigroup was selling them," Greenberger says."

Read the whole thing.