unless they're planning on reviewing every customized derivative prior to execution

From The Economics Of Contempt:

"First Impression of Gensler's OTC Derivatives Proposal

New CFTC chair Gary Gensler provided a much more detailed description of the administration's OTC derivatives reform proposal on Thursday. While we still don't have nearly enough information to render judgment on the proposal, let me just say that I'm extremely impressed so far. The administration—by which I primarily mean Tim Geithner and Gensler—seems to be striking exactly the right balance. While they could still go off the rails on any number of unresolved issues, you get the sense that they understand the derivatives markets too well to make any calamitous mistakes.

Obviously, a description of a new regulatory regime for OTC derivatives that's only 9 pages long is going to generate a lot of questions from the law firms. (I have a treatise on derivatives law and regulation that's over 2,000 pages long, so it's fair to say that Gensler's description leaves some things out.)

On a first read, the one question that jumps out at me as the most important is how the CFTC plans to use the authority to impose initial margin requirements on off-exchange customized derivatives. Are they planning on reviewing every customized derivative prior to execution to determine whether initial margin requirements are needed? In other words, will dealers be required to get a green light from the CFTC on initial margins before they can execute a customized trade?

I highly doubt this is what the CFTC has in mind at this point, but when you consider the scheme the proposal sets up to make sure that derivatives that aren't cleared by a clearinghouse are truly "customized," things get a bit murkier. Presumably, off-clearinghouse derivatives can only be duplicated so many times before the CFTC deems them to be "standardized" and requires them to be traded through a clearinghouse. But if that's the case, then there would only be very limited circumstances in which the CFTC would ever impose initial margin requirements on a customized derivative—that is, unless they're planning on reviewing every customized derivative prior to execution. Of course, that would likely be incredibly cumbersome, and could easily kill the bespoke market.

Anyway, that's the question that really jumped off the page at me. Aren't you glad you don't do this for a living?

Posted by Economics of Contempt "

Don said...

"Lower Systemic Risk. This dual regime would lower systemic risk through the following four measures:
•
Setting capital requirements for derivative dealers;
•
Creating initial margin requirements for derivative dealers (whether dealing in standardized or customized swaps);
•
Requiring centralized clearing of standardized swaps; and
•
Requiring business conduct standards for dealers."

The basic answer is higher capital requirements. Since many of these investments were used to invest with lower capital requirements, raising the requirements should solve the problem. But do they? As far as Systemic Risk is concerned, I don't see how.

In a Calling Run or Flight to Safety, assets get revalued. In our current crisis, this happened very quickly. Some assets lose a lot of value as others gain. Many of these investments will, by their nature, lose value in a Flight to Safety. The problem then becomes one of price. People who own the investments don't want to sell in a panic, while people who would buy them will only pay low prices, since, in a Flight to Safety, they're simply not worth that much. Hence, there's a big gap between buyer and seller. Will this legislation solve that? I don't see how.

Obviously, I see what just occurred differently than other people. It was not the complexity of the investments that caused them to freeze, but the inability to come to an agreed value that caused them to freeze.

Systemically speaking, the answer is to avoid a panic, calling run, flight to safety. This can only be done with appropriate government guarantees. The amounts of capital being considered would not stop a panic. The real problem is how to construct a government guarantee that leads to forestalling panics, not causing them.

I don't mind the legislation, but I do not accept the role of these products in our crisis that others do.

I know my view is odd, but I hope that I was at least clear.

Don the libertarian Democrat

Economics of Contempt labels me an “idiot journalist” for saying that the SEC is charged with regulating securities but not derivatives

From Reuters:

"Felix Salmon

nonrival, nonexcludable

« Previous Post

Next Post »

June 4th, 2009

When the SEC regulates derivatives

Post a comment (2)

Posted by: Felix Salmon

Tags: derivatives, regulation

Economics of Contempt labels me an “idiot journalist” for saying that the SEC is charged with regulating securities but not derivatives. As he points out, the SEC does too regulate securities — specifically, it regulates options on stocks, which are certainly derivatives, as well as exchange-traded options on foreign currency.

My bad. When I think derivatives, I think of swaps and futures in Chicago, rather than exchange-traded stock options — basically, I think of the kind of things which are either regulated by the CFTC, or not regulated at all (like CDS). But yes, there are some derivatives which are regulated by the SEC. My feeling is that all derivatives should be regulated, and that none of them should be regulated by the SEC, which should stick to securities. But of course I shouldn’t get ahead of myself, and for the foreseeable future it is indeed the SEC, and not the CFTC or anybody else, which is in charge of regulating a large chunk of the options market."

Me:

At least he called you a journalist. Come to think of it, it does seem better to be called an “idiot x”, than just “an idiot”, which I normally get called.

Also, you’re on his blogroll. That counts for something.

Still, yesterday:

“Flattered? Yes, obvs. But OMGWTF?”

Today, idiot.

By the way, I eat sardines every day, because my health guru, Andrew Weil, has been recommending them for years. I also managed to order some Chocolate Olivers, no thanks to you, mate.

Just for fun, say something asinine about Adam Smith, so we can find out if Gavin Kennedy reads this blog.

- Posted by Don the libertarian Democrat

And The Economics Of Contempt:

"Yes, the SEC Regulates Derivatives

Felix Salmon apparently thinks the SEC is "charged with regulating securities but not derivatives." Ezra Klein is quick to offer a me-too post, mocking the SEC for saying "derivatives" when it should have said "securities." Klein says that "[i]t's all the worse because the SEC doesn't have the authority to regulate derivatives, even though that appears to be what some of its employees think the agency is doing."

Oy.

The SEC does, in fact, have the authority to regulate derivatives. It regulates options (e.g., calls, puts, straddles) on individual securities, options on certain indexes of securities, such as the S&P 100, and exchange-traded options on foreign currency. Options are unquestionably derivatives.

What Salmon and Klein probably meant was that the SEC doesn't have the authority to regulate swaps. But swaps aren't the only kinds of derivatives by any means. Confusing swaps and derivatives is what leads idiot journalists to constantly mislabel derivatives as "unregulated financial instruments." (If journalists think derivatives are all unregulated, then I'm curious what they think the Commodity Futures Trading Commission does?)

Posted by Economics of Contempt

Treasury's proposal is much more stringent than the banks' proposal on key issues

TO BE NOTED: From The Economics Of Contempt:

"Did Treasury Adopt Part of Wall Street's OTC Derivatives Plan?

One of the headlines on Bloomberg's front page is, "Geithner Adopts Part of Goldman, JPMorgan Plan for Trading in Derivatives" (when you click through to the article, the headline is "Geithner Adopts Part of Wall Street Derivatives Plan"). Bloomberg reporter Matthew Leising got his hands on a plan for regulating OTC derivatives that Goldman, JPMorgan, Credit Suisse, and Barclays sent to Treasury a few months ago. Leising contends that Treasury's proposal for regulating OTC derivatives "contains recommendations similar to those made by" the banks. The clear implication is that Treasury has bowed to pressure from the Wall Street banks, and has adopted a very bank-friendly plan.

But, bizarrely, Leising can only point to one alleged similarity between the banks' proposal and Treasury's proposal—and that similarity turns out to be illusory. What's more, Treasury's proposal differs from the banks' proposal on several key issues, as Leising himself reports.

First, here's the alleged similarity between the two proposals:

"All OTC dealers and other firms who create large exposures to counterparties should be subject to a robust regime of prudential supervision and regulation," [Treasury's] proposal said. These included "conservative capital requirements," "reporting requirements," and "initial margin requirements."

The bank-written plan, dated Feb. 13, said the systemic regulator "shall promulgate rules" requiring "capital adequacy," "regulatory and market transparency" and "counterparty collateral requirements."

It's very clear that Treasury didn't actually give the banks what they wanted here. The banks' proposal called for all participants in the OTC derivatives markets—and not just the dealers—to be subject to capital and margin requirements. Essentially, the banks are saying that if they're going to be subject to strict capital and margin requirements for OTC derivatives, then everyone else in the OTC derivatives markets should be subject to those requirements too. By contrast, under Treasury's proposal, the "conservative" capital and margin requirements would only apply to the dealers and "other firms who create large exposures to counterparties." In other words, non-dealers who don't create large exposures to counterparties wouldn't be subject to the enhanced capital and margin requirements. (This is why one of the most important issues is how Treasury plans to define "firms who create large exposures to counterparties," which I'll address in another post.)

Amazingly, this non-issue is the entire basis for the headline, "Geithner Adopts Part of Goldman, JPMorgan Plan for Trading in Derivatives." Leising literally doesn't identify any other similarities between Treasury's proposal and the banks' proposal.

In fact, Leising himself admits near the end of the article that "Geithner’s plan goes further in many aspects than what the banks laid out in their draft." For instance, the banks' proposal doesn't require central clearing for any OTC derivative, while Treasury's proposal requires central clearing for all standardized OTC derivatives, and "encourages" the use of exchanges for standardized instruments. Also, the banks propose giving the Fed sole authority over the OTC derivatives markets, while Treasury declines to weigh in on which agency should regulate OTC derivatives.

Finally, the banks propose that reporting requirements on trade data should be made to regulators only "upon request." Under Treasury's proposal, all bespoke OTC derivatives would have to be reported to a regulated trade repository, and all such trade repositories, as well as the central counterparties clearing standardized OTC derivatives, would be required to "make data on individual counterparty’s trades and positions available to federal regulators."

To sum up:

1. The only aspect of Treasury's OTC derivatives proposal that the Bloomberg article claims was lifted from the Wall Street banks' proposal is, in reality, materially different from the banks' proposal.

2. Treasury's proposal is much more stringent than the banks' proposal on key issues, such as: (a) mandatory clearing for standardized instruments; and (b) full disclosure to federal regulators of individual trades and positions in both standardized and bespoke instruments.

So to answer the question in the title of my post: No, Treasury didn't adopt part of Wall Street's OTC derivatives plan.

Posted by Economics of Contempt "

AAA rating from at least two eligible rating agencies. Eligible rating agencies are Moody’s, S&P, Fitch, DBRS, and Realpoint

TO BE NOTED: From The Economics Of Contempt:

"TALF Expanded to Include Legacy CMBS

So sayeth the Fed:

The Federal Reserve Board on Tuesday announced that, starting in July, certain high-quality commercial mortgage-backed securities issued before January 1, 2009 (legacy CMBS) will become eligible collateral under the Term Asset-Backed Securities Loan Facility (TALF).
...
The CMBS market, which has financed approximately 20 percent of outstanding commercial mortgages, including mortgages on offices and multi-family residential, retail and industrial properties, came to a standstill in mid-2008. The extension of eligible TALF collateral to include legacy CMBS is intended to promote price discovery and liquidity for legacy CMBS. The resulting improvement in legacy CMBS markets should facilitate the issuance of newly issued CMBS, thereby helping borrowers finance new purchases of commercial properties or refinance existing commercial mortgages on better terms.

New term sheet for legacy CMBS is here; FAQs for legacy CMBS is here.

Here are the salient terms (on first glance):

1. AAA rating from at least two eligible rating agencies. Eligible rating agencies are Moody’s, S&P, Fitch, DBRS, and Realpoint.

2. Eligible CMBS must have been in the senior tranche at issuance (e.g., A-1 and A-2 classes are both "senior").

3. Haircuts: Base haircut of 15% for CMBS with an average life of five years or less. "For CMBS with average lives beyond five years, base dollar haircuts will increase by one percentage point of par for each additional year of average life beyond five years."

4. Maturity of TALF loans: Either 3 or 5 years, at the borrower's option.

5. Cost of funds: 3-year Libor swap rate +100bps (for 3-year TALF loans); 5-year Libor swap rate +100bps (for 5-year TALF loans).

6. Fed discretion: The Fed has a lot of discretion in determining whether to reject a legacy CMBS, based on factors such as historical losses, special servicing rights, and diversification of underlying collateral pool.

Here we go...

Posted by Economics of Contempt "

the gross market value—which measures "the cost of replacing all existing contracts and [is] thus a better measure of market risk than notional amount

TO BE NOTED: From The Economics Of Contempt:

"New CDS Data

The BIS released its much-anticipated semiannual report on OTC derivatives today. It measures notional amounts and gross market values outstanding of OTC derivatives as of December 31, 2008.

For the credit default swap (CDS) market, the gross market value—which measures "the cost of replacing all existing contracts and [is] thus a better measure of market risk than notional amounts outstanding—is $5.7 trillion. The total notional CDS outstanding fell to $41.9 trillion.

The gross market value of single-name CDS is $3.7 trillion, and the total notional single-name CDS outstanding is $25.7 trillion. The gross market value of multi-name CDS is $1.96 trillion, and the total notional multi-name CDS outstanding is $16.1 trillion.

Read the whole report.

Posted by Economics of Contempt "

None of the Chrysler Non-TARP Lenders hold any credit default swaps or hedges with respect to their holdings of Senior Debt

TO BE NOTED: From the Economics Of Contempt:

"Thursday, May 7, 2009

Chrysler Holdouts Own No CDS on Chrysler

A group of dissident Chrysler bondholders opposing the Obama administration's restructuring plan—which refers to itself as the Chrysler Non-TARP Lenders—disclosed this interesting fact in a court filing yesterday:

4. None of the Chrysler Non-TARP Lenders hold any credit default swaps or hedges with respect to their holdings of Senior Debt.

There are 9 funds in the group, holding a combined $295 million of senior Chrysler debt. So of the 20 holdout Chrysler creditors, we now know that roughly half of them owned no CDS on Chrysler.

Ryan Grim of the Huffington Post wrote a ridiculous article on Tuesday claiming that the holdout creditors may have pushed Chrysler into bankruptcy in order to collect payouts on CDS positions. Grim—evidently unaware that AIG almost never wrote CDS on individual companies—also claimed that the holdout creditors' CDS "were likely mostly issued by AIG." If you're ever arguing with someone about the financial crisis, and it seems like you're arguing about completely different crises, articles like this are the reason why.

Posted by Economics of Contempt "

And from Zero Hedge:

"Sunday, May 10, 2009

The Chrysler CDS Question

Posted by Tyler Durden at 11:17 AM

There has been some media and political debate lately over who if any entities may have profited from a Chrysler bankruptcy due to CDS holdings. As is often the case, when you get the mainstream media entering the ever so slightly more complex world of CDS contracts, many of the theories that develop have the same "logic" that is underpinning the current market rally.

A little due diligence in this case reveals relevant facts. The 2019 White & Case filing from the Chrysler docket has some critical disclosure:

4. None of the Chrysler Non-TARP Lenders hold any credit default swaps or hedges with respect to their holdings of Senior Debt.

In other words, the original Non-TARP holdouts, who owned $295 million of Senior Debt, did not have one Chrysler Credit Default Swap to their name. Thus, being unhedged they did not stand to benefit at all from a Chrysler bankruptcy and any claims that they implicitly or explicitly pushed the company into bankruptcy are nonsensical (granted the question stays open of whether they had CDS at any point in the past, although that can not be gleaned from the filing).

If there really are CDS holding culprits (and we really are talking LCDS here) they would be in the non-holdout creditor camp. But most likely, CDS holders did not have secured long positions in the first place, and bankruptcy beneficiaries would likely not be found anywhere in the list of secured or unsecured creditors. However, due to the LCDS nature of the holdings, this is a case unlike GM or the recent finance company bankruptcies. Now, in GM things will likely get more interesting, as DTCC reports that the company has roughly $33.6 billion and $2.4 billion in gross and net CDS exposure, respectively.

As for any allegations that AIG was a taxpayer funnel again, this is not the case, as AIG rarely if ever underwrote single-name CDS (and much less LCDS). Thus comparing the AIG gift to banks in early 2009 with fund flows in the Chrysler and, soon to be, GM bankruptcies is in the apples and oranges realm."

government does not have the authority to seize a bank holding company and place it into receivership (or conservatorship)

TO BE NOTED: From The Economics Of Contempt:

"Bank Holding Companies (Again)

Serial bloviator Simon Johnson writes:

In most countries, the course of action would be clear. The government would take over banks, remove “bad assets” from their balance sheets, inject fresh capital, and put them bank into the private sector. This is essentially what the FDIC does when it takes over a bank. There is some debate about whether the government currently has the power to do this for bank holding companies – Tim Geithner says no, Thomas Hoenig says yes – but if not, this is certainly something the Obama administration could press for.

Let's try this one more time: The government does not have the authority to seize a bank holding company and place it into receivership (or conservatorship). There is no debate about this.

Johnson clearly doesn't understand Hoenig's argument, because he was very clear on this point. Hoenig wrote:

One of the difficulties with all of these options is that while there are time-tested, fast resolution processes in place for depository institutions, today's largest financial institutions are conglomerate financial holding companies with many financial subsidiaries that are not banks.

The bank subsidiaries could be placed into FDIC receivership, but the only other option under current law for the holding company and other subsidiaries is a bankruptcy process.

Even an MIT professor should be able to understand that.

Posted by Economics of Contempt"

Economics of Contempt said...

The regulators got Continental's holding company to agree to a capital injection that gave the government the authority to replace the CEO of the holding company. The government had no authority to simply seize the holding company and replace the management. That's why Hoenig is advocating for a "negotiated conservatorship" of bank holding companies -- because the government would have to get the BHCs to agree to a government takeover.

The only reason Continental's holding company agreed to the government takeover was because the Continental Illinois bank -- which the FDIC did have the authority to seize -- was pretty much its only subsidiary. But today's BHCs own a lot more than just FDIC-insured banks -- Citigroup has over 2,000 principal subsidiaries -- and many (if not most) of their subsidiaries are organized in foreign countries. So even if the government got Citigroup or BofA's holding company to agree to a government takeover, most of the BHC's assets and liabilities would be beyond the power of any receivership or conservatorship. That means the government still wouldn't have the authority to "clean up" the BHC's balance sheet -- because it wouldn't have the power, in particular, to repudiate the BHC's outstanding contractual obligations. And if that's the case, then what would be the point of the government takeover in the first place?

May 8, 2009 2:29 PM

the market was watching the auction very closely, looking for some guidance on pricing for toxic assets

TO BE NOTED: From The Economics Of Contempt:

"Failed SIV's "toxic assets" sold in auction, fetching almost 70%

The much-anticipated auction of Whistlejacket's $6bn portfolio of so-called "toxic assets" went very well, fetching an average price of 67 cents on the dollar. Whistlejacket was a large structured investment vehicle (SIV) that failed in February 2008 when its sponsor, Standard Charter, stopped providing liquidity.

Whistlejacket's portfolio included CDOs backed by mortgage bonds, CLOs, consumer ABS—pretty much a who's who of "toxic assets." The auction included well over $500 million of CDOs that were issued in 2006-2007. Even the CLOs, which are structured products backed by leveraged loans, went for an average price of 70 cents on the dollar. This was easily the biggest secondary-market sale of toxic assets in the past year, and probably the biggest since mid-2007, so the market was watching the auction very closely, looking for some guidance on pricing for toxic assets.

The 33% discount price was much better than most people were anticipating. Overall, I'd say the auction lends support to Treasury's argument that a lack of liquidity is artificially depressing the prices of toxic assets. Chalk one up for Tim Geithner.

Posted by Economics of Contempt "

Whatever you may think of Treasury's approach to the banks, it's hardly "wait and see

From The Economics Of Contempt:

"Since when is Treasury under a "wait and see" policy?

I'll give Simon Johnson one thing: he's great at knocking down straw man arguments.

Today's straw man is Treasury's alleged "wait and see" policy on the banks. Johnson and Peter Boone claim on the NYT's Economix blog that Treasury's plan is to "look the other way on big banks' problems and hope an economic recovery brings them back to sustained profits." They then proceed to show why this "wait and see" policy is a bad idea.

Clever!

Too bad it's just not true. How any semi-informed commentator could describe Treasury's approach as "wait and see" is beyond me. Treasury has adopted a multifaceted approach to the major banks, which includes the Capital Assistance Program (CAP), as well as the Public-Private Investment Program (PPIP), which encompasses the Legacy Securities Program and the Legacy Loans Program.

What do Johnson and Boone propose? Something eerily similar to what Treasury has already proposed:

We know there is a problem in the banks, just not how large it is. So why not do more than is absolutely necessary, in terms of forcing restructuring and recapitalization of the sector (ideally with private money)? Give everyone certainty that the problems are over once and for all.

Gee, that sounds an awful lot like Treasury's Capital Assistance Program, which is designed to determine how large the problem in the major banks is, and then force each bank to recapitalize — "ideally with private money," but if that's not possible, then with government money.

As for forced restructurings, Treasury currently lacks the legal authority to do that, but it has already proposed a new resolution authority for large bank holding companies. (I personally don't think the proposed resolution authority can work, but you can't say that Treasury isn't trying to acquire the legal authority to force restructurings of major bank holding companies.) Oh yeah, and then there's the $1 trillion PPIP, which I hear is kind of a big deal.

Whatever you may think of Treasury's approach to the banks, it's hardly "wait and see."

Posted by Economics of Contempt "

Me:

Don said...

I think that it really has to do with what we expect at the end of this crisis. Johnson believes that it will be a very similar arrangement to what we had before this crisis. That is, in my opinion, one way to look at things. Geithner seems to be saying that, in fact, when he talks about the role of the private sector, etc.

I am in the odd position of defending Geithner for pragmatic reasons. However, I could be wrong, but I believe that he and Bernanke would be open to large changes in our system. But I'm reading between the lines and reading a lot into their past speeches.

I agree with Johnson's critique. We have had a Welfare State in which some interests, faux free marketers, have been very effective in influencing the government, especially during the Bush years. I call it a Crony Welfare State.

We're still going to have a Welfare State after this, but we can make changes that will better serve our country. I'm for Narrow Banking, an idea put forward by those communists Friedman, Knight, Simons, and Fisher. We should also have a self-insured, supervised,not government guaranteed financial sector.

I'm also a follower of Edmund Burke. I don't believe that Politics and political Theory are the same thing. Politics is the art of the possible. Hence, I can support policies that I do not completely agree with.

In that sense, I would expect Geithner to be saying what he is saying, even if he agreed with me, which I doubt. What I take Johnson to getting at in "Wait & See" is that we're wasting our one chance to change things. I don't agree, but I understand and share his concern.

The changes, so far, have weakened the crony system, but there is a lot of work to be done. I would mention one area of disagreement with Johnson and Kwak: the issue of bondholder's rights isn't the same issue as the power of banks. William Gross is correct to be worried about the consequences of wiping out bondholders. I simply believe that, once taxpayers are involved, they are more important than bondholders. But it is not in our interest to imply or assert that the interests of bondholders, who are often lending money so that our businesses can expand and hire more people, are not essential.

So, I'm suggesting that in Chrysler and PPIP, etc., bondholders should be taken care of unless it really makes the taxpayers situation worse off, given an analysis of the trade-offs.

Don the libertarian Democrat

April 23, 2009 12:29 PM

descriptions of the Geithner plan in the WSJ and NYT are so broad and so vague that they can't serve as the basis for any remotely serious analysis

From The Economics Of Contempt:

"Premature Punditry

When the broad outlines of the Geithner plan first leaked yesterday, I noted that "it's impossible to offer an informed opinion based on the extremely sketchy details in these articles." The descriptions of the Geithner plan in the WSJ and NYT are so broad and so vague that they can't serve as the basis for any remotely serious analysis. As someone who has practiced structured finance law for many years, the one thing I can tell you for sure is this: the details matter.

But that hasn't stopped a host of bloggers (who I normally agree with) from vocally condemning the plan. Yves Smith is calling on people to contact their Congressmen to express their opposition, and thinks she already has analysis that's "damning on its face," despite the fact that she hasn't even seen the plan yet. Yves is either being lazy or intellectually dishonest, and it'll be hard to take anything she says about the Geithner plan seriously.

Worst of all, Paul Krugman, who I've been a big fan of ever since he was a columnist for the U.S. News & World Report (yeah, I'm old), continues to embarrass himself by offering absurdly superficial analysis of a bank rescue plan he hasn't seen yet. Krugman is a great academic economist, but he's obviously not qualified to offer an informed opinion on banking/financial policy. In addition to not understanding the difference between default risk and spread risk, he clearly doesn't have the foggiest idea how ABS or CDOs work. For instance, he apparently doesn't realize that the value of an ABS includes a liquidity premium. (Maybe he's just bitter that the solution he advocated last fall—recapitalization instead of toxic asset purchases—didn't work). I sincerely hope Krugman stops offering this kind of pseudo-analysis soon.

The bottom line is that anyone who thinks they already have enough information about the Geithner plan to offer informed analysis doesn't deserve to be taken seriously.

Posted by Economics of Contempt "

Me:

Don said...

You make a fair point, and I find myself generally agreeing with you. However, it does seem to me that the government is stuck in needing to give a subsidy to the buyers to compensate for what I see as incentives to the owners of TAs. If you don't agree, I understand. But, since I do believe this, I understand that there are many people who object to this subsidy in principle. Given that, I don't see what's wrong with them objecting to this deal. It is true that things could work out better than anticipated, but I think that these people have a right to be skeptical.

I do not agree with that government has done, but, now, given their assumptions, or, more generously, limitations, I think that the plan to offer subsidies makes sense.

To me, all this stems from hybrid plans. Since I first mentioned these problems in late September, I feel capable of seeing that my fears have largely been realized. However, even then, I understood the pickle that Bernanke and Paulson were in.

Still, it's great that you're bringing your expertise into the debate.

Thanks,

Don the libertarian Democrat

March 22, 2009 2:19 PM

One of the biggest contributors to the financial crisis has been ratings downgrade triggers, sometimes known as ratings-based collateral calls.

From The Economics Of Contempt:

"Outlaw Ratings Downgrade Triggers

One of the biggest contributors to the financial crisis has been ratings downgrade triggers, sometimes known as ratings-based collateral calls. These are provisions in financial instruments (especially derivatives) that automatically trigger collateral calls when a counterparty has its credit rating downgraded. AIG failed because ratings downgrade triggers in its credit default swap (CDS) contracts forced it to post $15 billion in collateral when Moody's and S&P downgraded its credit rating immediately after Lehman failed. AIG couldn't come up with that much cash on short notice, especially with markets essentially frozen due to the Lehman bankruptcy. Enter the U.S. taxpayers.

Similarly, the monolines (e.g., MBIA, Ambac) teetered on the edge of failure in January 2008 because the rating agencies were threatening to downgrade their credit ratings (then AAA), which would have forced them to post billions in collateral that they simply didn't have. All the various rescue plans that were floated that month were aimed at staving off a rating downgrade.

Ratings downgrade triggers force a company that is already struggling (hence the downgrade) to then post billions in extra collateral. In other words, the company is being forced to post billions in collateral at precisely the time it's least able to raise that much cash without seriously damaging the health of the company. This creates a downward spiral where the company is forced to liquidate assets at firesale prices in order to post the required collateral, leading to another rating downgrade, which triggers further collateral calls, and another round of forced liquidations, and so on. This could very easily cause a company to go directly from AAA-rated to bankruptcy (which completely distorts the idea of "credit ratings" in the first place). In fact, this almost happened with MBIA and Ambac—had they been downgraded from AAA in January 2008, they would almost certainly have been forced to file for bankruptcy.

The justification for including ratings downgrade triggers in derivatives contracts is that less creditworthy counterparties should have to post more collateral, because the risk of nonpayment is greater. But the evaluation of a counterparty's creditworthiness should be done at the outset of the transaction, and reflected in the initial margin required. Less creditworthy counterparties should have to put up more initial margin (i.e., collateral), but after the initial margin is posted, any additional margin calls should be based on changes in the value of the underlying security. Evaluation of a counterparty's creditworthiness shouldn't be outsourced to the rating agencies, which is essentially what ratings downgrade triggers do.

Personally, I'd like to see an explicit ban on ratings downgrade triggers in derivatives contracts. They're lazy and unreliable in their accuracy. But worst of all, as AIG and the monolines have demonstrated, they're extremely dangerous.

Posted by Economics of Contempt "

Me:

Don said...

"less creditworthy counterparties should have to post more collateral, because the risk of nonpayment is greater."

I thought that it was also to stop a Calling Run. If I see that AIG is bleeding money and burning reserves, then I'm calling my money in if I can. If they can post more collateral, that keeps me from pulling my money out because I see that they have the liquid resources should I need my money.

It's true that, if they don't have the resources to come up with more capital, then they're in trouble, but they're also going to be in trouble, at least with me, if they are losing money and are simply asking me to be patient. If I've loaned them money that I can call in, I might not like the idea of being patient.

I don't disagree with you about ratings companies or posting more capital at the beginning of the transaction, but the fact that companies can't come up with cash is a real worry. The solution is to build up reserves in the good times, not concoct exceptions to prudence.

Don the libertarian Democrat

March 18, 2009 5:46 PM

The recent uproar over the government's refusal to reveal AIG's counterparties on its CDS trades is silly

From Economics Of Contempt:

"All Bailouts Are Counterparty Bailouts

The recent uproar over the government's refusal to reveal AIG's counterparties on its CDS trades is silly, and reflects a basic misunderstanding of how financial markets work.

With regard to AIG specifically: yes, AIG used some of the bailout money to post collateral it owed to counterparties on CDS trades. But it also used a significant amount of bailout money to repay counterparties in its securities lending program (basically a repo desk—AIG lends out securities it owns on a short-term basis in exchange for cash.) To settle transactions with counterparties returning the borrowed securities, AIG has to return the cash (less interest). If the government hadn't rescued AIG, it wouldn't have had enough cash to pay these counterparties back, and it would have essentially defaulted. In fact, a full $19 billion of taxpayer money has gone to AIG's securities lending program so far.

So the AIG bailout was also a bailout of AIG's counterparties in its securities lending program. Should the government be forced to reveal the identity of all these counterparties as well? Surely not—and no sane person would disagree. Why should CDS counterparties be any different?

More generally, you can see how this reasoning applies to bailouts in general. Yes, AIG's bailout was a bailout of its counterparties, but all bailouts in the financial sector are bailouts of counterparties. The purpose of all bailouts is to avoid insolvency. Avoiding insolvency requires paying counterparties the money they're owed. There's nothing special about the AIG bailout in that regard.

Finally, regarding the ubiquitous claim that "taxpayers have the right to know" who AIG's counterparties are: no, we don't. All of AIG's CDS contracts are subject to confidentiality agreements. Becoming the majority owner of a publicly-traded company does not entitle you to breach contracts that are binding on the company.

Posted by Economics of Contempt"

Me:

Don said...

I basically agree with you, but was going to contend that this was simple political venting, which, while histrionic, was important. However, the reporting and commentary have been so bad that I have to agree with you entirely.

Don the libertarian Democrat

March 15, 2009 3:20 PM

CDS on U.S. government debt are spread products

TO BE NOTED: From the Economics Of Contempt:

"Default risk vs. Spread risk

Paul Krugman comments on the rising CDS spreads on US government debt:

Has the risk of a US government default risen? Probably. Nonetheless, the people buying these contracts are crazy. A world in which the US government defaults would be a world in chaos; how likely is it that these contracts would be honored?

Oh my god, repeat after me: CDS on U.S. government debt are spread products. Protection buyers aren't hedging default risk, they're hedging spread risk. For example, a bank that has a large inventory of Treasuries will want to hedge the risk of a significant deterioration in the value of Treasuries. Since standard CDS provide for daily collateral posting based on the value of the underlying reference obligation(s), protection sellers in CDS on U.S. government debt have to post more collateral when the value of Treasuries declines.

Default risk vs. spread risk isn't a difficult or terribly advanced concept, and it's definitely something you should know if you consider yourself to be an "informed commentator" on the bank rescue.

Posted by Economics of Contempt at 2:03 AM "

the value of derivatives and other financial market contracts are based principally on their fluctuating market value

From The Economics Of Contempt:

"Special treatment of derivatives in bankruptcy

I'm puzzled by all the recent hyperventilating over the 2005 bankruptcy bill and the special treatment of derivatives in bankruptcy proceedings. Derivatives and certain other financial contracts are exempt from the automatic stay in bankruptcy, which essentially gives derivatives counterparties priority over all other claimants. (For an explanation of why it's important to give derivatives special treatment in bankruptcy, see the excerpt at the end of this post.)

Josh Marshall kicked off the outrage a few days ago, when he highlighted the exemption for derivatives in a post titled, "How the Rules Were Rigged":

But separate from the immediate financial implications related to AIG, it does point us toward the larger political economy point: the self-reinforcing cycle in which financialization leads to vast sums of money concentrated in the hands of paper-jobbers, who then mobilize that money in Washington to rewrite the laws to privilege them for even greater profits.

Arianna Huffington, among others, quickly agreed with Marshall's interpretation:

It's worth noting that, thanks to the industry-written 2005 Bankruptcy Bill, derivatives claims are not stayed in bankruptcy -- so the financial institutions that gambled and lost would nevertheless be the first ones paid off. Isn't gaming the system fun?

The problem with this story is that the 2005 bankruptcy bill didn't create the derivatives exemption (called a "carve-out") — the exemption for derivatives was originally enacted in 1982, and was really solidified when the statutory language was clarified in 1990. The 2005 bankruptcy bill just clarified the definitions of the various exempt contracts. For example, the pre-2005 definition of an exempt "swap agreement" included the catch-all phrase "or any other similar agreement," which almost certainly covered credit default swaps. But just to be sure—to provide that all-important legal certainty—the 2005 bankruptcy bill amended the definition of "swap agreement" to explicitly include credit default swaps. There was no substantive change, just a clarification—a process otherwise known as "modernizing" the financial regulations in order to keep up with financial innovations. Given how rarely our financial regulations have been modernized over the past 25 years, it's a bit strange that one of the few successful efforts to actually modernize financial regulations is attracting so much criticism.

Moreover, the special treatment of derivatives and other financial contract isn't unique to bankruptcy proceedings. In old-fashioned FDIC receiverships (which everyone seems to love right now), "qualified financial contracts" (QFCs) — e.g., derivatives and securities contracts — have long been exempt from the FDIC's avoidance powers, in order to permit the orderly netting of derivatives contracts. Since major bank holding companies (e.g., Lehman, Citigroup) aren't covered by the FDIC resolution process, it's only natural for the FDIC's QFC exemption to be extended to the Bankruptcy Code. Essentially, exempting derivatives from the automatic stay in bankruptcy is a way to harmonize insolvency procedures.

------------------------------

This FDIC article provides a nice explanation of why it's important that derivatives and other financial contracts be exempt from the automatic stay. It's all about close-out netting:

As with other financial instruments, including bonds and equity securities, derivatives pose credit, market, liquidity, operating, legal, settlement, and interconnection risks. One of the primary ways to reduce the risks to individual parties in derivative or other financial contracts is the ability to settle the transactions by payment of a single net amount. Netting is simply taking what I owe you and what you owe me and subtracting to yield a single amount that should be paid by one of us. Netting can be a valuable credit risk management tool in all multiple transaction relationships by reducing the credit and liquidity exposures by eliminating large funds transfers for each transaction in favor of a smaller net payment.

Close-out netting, or the ability to terminate financial market contracts, determine a net amount due, and liquidate any pledged collateral, is a valuable tool to protect against credit and market risks in cases of default. This is particularly important in the financial markets because, unlike loans or many other financial contracts, the value of derivatives and other financial market contracts are based principally on their fluctuating market value. If one of the parties to a derivative or other financial market contract is placed into bankruptcy or receivership, the normal stays on termination of contracts and liquidation of collateral could create escalating losses due to changes in market prices. As a result, the ability to terminate the contract and net exposures quickly can be crucial to limit the losses to the non-defaulting party because such contracts can change in value rapidly due to market fluctuations.

Posted by Economics of Contempt at 12:35 AM"

Me:

Don said...

"This is particularly important in the financial markets because, unlike loans or many other financial contracts, the value of derivatives and other financial market contracts are based principally on their fluctuating market value"

This makes it sound like it is simply a procedure to put these investments on an equal footing with fixed investments, since, theoretically, when the assets were dispersed, the fluctuating claims could be worthless.

Don the libertarian Democrat

March 10, 2009 5:48 PM

All of these officials have to survive a Senate confirmation hearing in a brutal political environment

From the Economics Of Contempt:

"Understaffing at Treasury

Paul Volcker is obviously right that it's shameful that the Treasury Department is so badly understaffed right now (the "Treasury Officials" page is hilarious):

"There is an area that I think is, I don't know, shameful is the word," Paul Volcker said this morning at a Joint Economic Committee hearing. "The Secretary of the Treasury is sitting there without a deputy, without any undersecretaries, without any, as far as I know, assistant secretaries responsible in substantive areas at a time of very severe crisis. He shouldn't be sitting there alone."

Felix Salmon agrees (the same Salmon who called the lack of detail in Geithner's banking rescue "inexplicable" a couple weeks ago). Salmon considers this a huge blunder by the Obama administration, as well as an indication that the Obama administration is being managed inefficiently.

This isn't the Obama administration's fault. The reason Geithner is sitting there alone is that the top 33 positions in the Treasury Department are Senate-confirmable, and not only does that slow down the hiring process by introducing political factors into the search, but the Senate confirmation process also takes a long time. The following Treasury positions are Senate-confirmable:

Deputy Secretary of the Treasury
Undersecretary for Domestic Finance
Assistant Secretary for Financial Institutions
Assistant Secretary for Financial Markets
Assistant Secretary for Economic Policy
Undersecretary for International Affairs
Assistant Secretary for International Financial Markets and Investment Policy
Assistant Secretary for International Economics and Development
General Counsel
Assistant Secretary for Legislative Affairs

All of these officials have to survive a Senate confirmation hearing in a brutal political environment, especially for anyone who has ever worked on Wall Street (at any point during his/her life). Even if the Obama administration announced nominees for all of these positions tomorrow, it would still take weeks to get them all confirmed—and that's assuming they all do get confirmed, which isn't a foregone conclusion in the current environment.

People seem to be surprised that the Treasury is understaffed. Do people think entire federal executive departments are magically staffed in the first week or something? The Treasury won't be fully staffed until June at the earliest, and it's one of the smallest executive departments. Washington is slow. Always has been, always will be. "

Me:

Don said...

Can't people be hired to do work before they are confirmed? Departments often go out and hire independent contractors. Or is that they can't leave their current positions until they are confirmed? It does seem possible for Geithner to have been able to hire help, although he would not have a full staff.

Don the libertarian Democrat

February 28, 2009 4:58 PM

lso that there is a strong political economy case (which I consider dominant)

From the Economics Of Contempt:

"Wednesday, February 11, 2009

Will Wilkinson's strange theory about Krugman

Will Wilkinson mocks Paul Krugman for not including political factors in his economic thinking:

Perhaps more than any economist of his caliber, Krugman understands that policy is largely determined by the outcome of the public opinion shoutfest. Yet this recognition seems to have no effect on Krugman’s ideas. Rather than bring inside his models disagreement over economic theory and the lack of political incentive to faithfully apply them, which would lead him to radically revise his prescriptions, Krugman leaves his textbook theory untouched and simply tries to win the shoutfest. Krugman’s often unbearable stridency seems to reflect an attempt to overcome the problems of democratic disagreement and incentive compatibility through sheer force of will–as if the deep reality of politics is no match for the rhetorical gifts and gold-plated reputation of Paul Freaking Krugman.

It's strange that Wilkinson espoused this theory just days after Krugman laid out the economic case for including the "Buy American" provision in the stimulus bill, and then rejected the provision for reasons of political economy. Here's how Krugman summarized his views the next day:

First of all: my piece was NOT an endorsement of protectionism — it was an explanation that there is an economic case for it, but also that there is a strong political economy case (which I consider dominant) against acting on that economic case. It was, in short, an attempt to be intellectually honest.

If Wilkinson's theory was right, then Krugman would have tried to "win the shoutfest" on the "Buy American" provision. But he didn't. Instead, Krugman essentially acknowledged that he couldn't win the shoutfest—that is, neither he nor anyone else would be able to stop the cycle of protectionist retaliations. Recognizing this, he concluded that the "political economy case" against the "Buy American" provision was dominant.

It would be hard to come up with a better example of Krugman incorporating politics into his economic thinking. Krugman's treatment of the "Buy American" provision definitely disproves Wilkinson's theory about Krugman sticking to the pure economics and trying to "win the shoutfest." Which makes it all the more amusing that Wilkinson espoused his theory a mere 4 days after Krugman disproved it. "

Me:

Don said...

It's actually wonderful and a step forward having an economist who understands that political economy is more important than economics.

Don the libertarian Democrat

February 11, 2009 3:28 PM

Similarly, protection sellers' risk is also limited to the notional amount insured.

From the Economics Of Contempt:

"Soros is wrong

Unless I'm misreading him, George Soros is just plain wrong about this:

Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.

Umm, no. Protection buyers' profit is limited to the notional amount insured. Similarly, protection sellers' risk is also limited to the notional amount insured. "

Me:

Don said...

The whole post is off. He claims the following:

"Putting these three considerations together leads to the conclusion that Lehman, AIG and other financial institutions were destroyed by bear raids in which the shorting of stocks and buying of CDS amplified and reinforced each other."

My understanding is that we are in Debt-Deflation. A Calling Run. The run started when there was a foreclosure tsunami based on fraudulent and poor loans. At that point, anyone who had the ability to call cash from the owner's of these loans started doing so, since it wasn't clear how many foreclosures there would be nor how low home prices would fall. CDSs and CDOs were only some of the investments effected. As for AIG, at the point of this tsunami, they were downgraded, and needed to get capital. The only way to do this would be to sell assets for huge losses, which they didn't want do. In essence, they came to the government for a bridge loan. That's what Liddy said in November.
I don't see shorting as the problem. It was an actual Calling Run based on the mortgages. What am I missing?

Don the libertarian Democrat

January 31, 2009 3:47 PM

When Lehman failed, it did so with clear indications from its regulators that they wouldn't continue with Bear-style bailouts

From Felix Salmon:

"More on Lehman Revisionism

I've been thinking a bit more about the Lehman Brothers revisionism coming from the likes of Bernanke, Paulson, and Geithner: the fact that although they were quite clear about letting Lehman fail at the time, they subsequently have backtracked on that, and said that although they tried very hard to rescue Lehman, they simply weren't allowed to do so.

I still think that's probably bullshit, and that in this crisis, as we've seen, where there's a will, in government, there's a way. Paulson, for one, was not the type of person to let a bunch of Federal Reserve lawyers stop him from doing what he thought needed to be done. But what if he's telling the truth, and rescuing Lehman really was illegal? How can that be squared with contemporaneous statements?

I think the answer might lie in market psychology. When Lehman failed, it did so with clear indications from its regulators that they wouldn't continue with Bear-style bailouts, and that there was no kind of Paulson Put, where failed banks automatically get rescued by Treasury.

If the sun rose the following morning and the world didn't come to an end, that would be an astonishingly strong signal about market resilience in the face of government inaction, and would help boost sentiment a very great deal.

On the other hand, if Lehman's failure really was going to have nasty systemic consequences, then a few statements from Treasury were unlikely to make things substantially worse: an apocalyptic meltdown is an apocalyptic meltdown either way.

So I can see why Paulson and Bernanke said what they did in the immediate wake of Lehman's collapse: there was substantial upside to saying it if markets went up, while if markets went down the downside was so big either way it made very little difference whether they said it or not."

Me:

From the Economics Of Contempt:

http://economicsofcontempt.blogspot.com/2009/01/merrill-and-basis-trade.html

"Any CDS contract with Lehman as counterparty needed to be replaced when Lehman collapsed. Remember the emergency "Risk Reduction Trading Session" the ISDA opened on the Sunday that Lehman was preparing to file for bankruptcy? That was so that the major dealers could start replacing their derivative contracts where Lehman was the counterparty with contracts with other counterparties. The emergency trading session was a disaster (about which more later), but it was especially disastrous for Merrill.

Remember the timing.

The emergency trading session ran from 2 pm to 6 pm on the Sunday that Lehman was preparing to file for bankruptcy. The news that BofA was in advanced talks to buy Merrill didn't break until around 5 pm. Before that announcement, everyone was looking for who would be the next to fall, and the consensus was that Merrill was next in line. So traders turned their guns on Merrill. In a standard CDS, no money is exchanged upfront. But when a firm looking to enter into a CDS contract might default before the contract matures, counterparties start to demand money upfront—known as "points upfront" or "initial margin." Since Merrill was expected to collapse if it couldn't find a buyer, and news of the BofA deal had not yet leaked, counterparties were demanding that Merrill make huge upfront payments in order to enter into a CDS contract. And because Merrill had huge exposure to Lehman as a counterparty, it had a lot of contracts it needed to replace."

Doesn't this show that a Calling Run, Fisher's Debt-Deflation, was a real possibility if Lehman collapsed?

A surprisingly common criticism of the TARP is that it didn't require banks receiving bailout money to lend to small businesses and consumers.

From the Economics Of Contempt:

"Why why shouldn't force banks to lend

A surprisingly common criticism of the TARP is that it didn't require banks receiving bailout money to lend to small businesses and consumers. Joe Nocera of the NYT penned a whole column about "the dirty little secret of the banking industry," which was that "it has no intention of using the money to make new loans."

Elizabeth Warren's TARP Oversight Panel has also criticized the Treasury for not requiring banks to lend money. For example, the Panel's second report stated:

If, as Treasury has stated, the goal of capital infusions was to increase consumer and small businesslending, why were funds not concentrated among businesses with substantial small business and consumer lending or authorized only when a financial institution presented a business plan to use the funds for small business or consumer lending?

The purpose of the equity injections was to recapitalize the banks, which were (and still are) woefully undercapitalized. Forcing them to immediately turn around and make more risky loans—and small business and consumer loans are historically risky loans—is a really stupid idea.

But don't take it from me. Take it from Richard Caballero of MIT, Anil Kashyap of Chicago, and Takeo Hoshi of UC San Diego. Their paper in the December 2008 issue of the American Economic Review, "Zombie Lending and Depressed Restructuring in Japan," examines "the role that misdirected bank lending played in prolonging the Japanese macroeconomic stagnation that began in the early 1990s." The paper is behind a firewall, but there's a draft version (which might differ slightly from the final version) available here. Since it's hard to understate the paper's relevance to the current criticisms of TARP, I quote at length:

This paper explores the role that misdirected bank lending played in prolonging the Japanese macroeconomic stagnation that began in the early 1990s. The investigation focuses on the widespread practice of Japanese banks of continuing to lend to otherwise insolvent firms. We document the prevalence of this forbearance lending and show its distorting effects on healthy firms that were competing with the impaired firms.
...
Aside from a couple of crisis periods when regulators were forced to recognize a few insolvencies and temporarily nationalize the offending banks, the banks were surprisingly unconstrained by the regulators.

The one exception is that banks had to comply (or appear to comply) with the international standards governing their minimum level of capital (the so-called Basle capital standards). This meant that when banks wanted to call in a nonperforming loan, they were likely to have to write off existing capital, which in turn pushed them up against the minimum capital levels. The fear of falling below the capital standards led many banks to continue to extend credit to insolvent borrowers, gambling that somehow these firms would recover or that the government would bail them out. Failing to roll over the loans also would have sparked public criticism that banks were worsening the recession by denying credit to needy corporations. Indeed, the government also encouraged the banks to increase their lending to small and medium-sized firms to ease the apparent “credit crunch,” especially after 1998. The continued financing, or “evergreening,” can therefore be seen as a rational response by the banks to these various pressures.
...
By keeping these unprofitable borrowers (which we call “zombies”) alive, the banks allowed them to distort competition throughout the rest of the economy. The zombies’ distortions came in many ways, including depressing market prices for their products, raising market wages by hanging on to the workers whose productivity at the current firms declined, and, more generally, congesting the markets where they participated. Effectively, the growing government liability that came from guaranteeing the deposits of banks that supported the zombies served as a very inefficient program to sustain employment. Thus, the normal competitive outcome whereby the zombies would shed workers and lose market share was thwarted. More importantly, the low prices and high wages reduce the profits and collateral that new and more productive firms could generate, thereby discouraging their entry and investment. Therefore, even solvent banks saw no particularly good lending opportunities in Japan.
...
We find that investment and employment growth for healthy firms falls as the percentage of zombies in their industry rises. Moreover, the gap in productivity between zombie and non-zombie firms rises as the percentage of zombies rises. These findings are consistent with the predictions that zombies crowd the market and that the congestion has real effects on the healthy firms in the economy. Simple extrapolations using our regression coefficients suggest that cumulative size of the distortions (in terms of investment, or employment) is substantial. For instance, compared with the hypothetical case where the prevalence of zombies in the 1990s remained at the historical average instead of rising, we find the investment was depressed between 4 and 36 percent per year (depending on the industry considered)."

And moi:

Don said...

I just read a Ricardo Caballero post in the FT where he says that we should get rid of capital standards:

http://blogs.ft.com/wolfforum/2009/01/a-capital-less-financial-system/#comments

"The question then is whether it is feasible to run a (nearly) capital-less financial system until panic subsides. If it is, then a solution to the financial crisis is in sight since it would free up trillions of dollars of hard to raise funds, covering more than even the most extreme estimate of losses."

I'm assuming that he means that doing so will allow banks to lend instead of hoarding cash for a call. But I'll ask the question that I posted him before I read that comments were confined to experts: How does this differ from AIG? We gave AIG money so that they could weather the storm and not sell their assets at a huge loss now, but wait and sell later. The FT had Liddy saying just this in November. But what's the difference in lending them money, which pays interest, and simply cutting their capital requirements and guaranteeing their losses, which we charge a nominal insurance fee on ?

As to your main point, I'm bothered by how TARP was sold, and then changed. If recapitalizing the banks without the money being deployed was the plan, then it should have been sold that way. As an average citizen, that's not how it was sold to me. I think that many citizens, like myself, are a little battered by the arguments used to sell us a plan being one thing, and then, once sold, the plans are changed to something else.

Don the libertarian Democrat

everyone was looking for who would be the next to fall, and the consensus was that Merrill was next in line.

From the Economics Of Contempt:

"Merrill and the Basis Trade

Felix Salmon is wondering, after reading this WSJ article, if the main source of Merrill Lynch's staggering $15bn loss in Q4 was the infamous "basis trade."

In a basis trade, an investor buys a corporate bond and simultaneously buys CDS protection on the bond. There's a "negative basis" when the price of the CDS is lower than the price of the bond (usually defined by the bond's asset-swap spread or Z-spread). In other words, the basis is negative when the coupon payments the investor receives on the bond are higher than the premiums the investor pays out on the CDS. Conversely, there's a positive basis when the price of the CDS is lower than the price of the bond. The basis trade, and trades like it, have been extremely popular on Wall Street in the past few years. Deutsche Bank's "star trader" Boaz Weinstein supposedly lost over $1bn on basis trades when the corporate bond market froze in September.

From what I hear, Merrill's biggest losses didn't come from basis trades per se, but came more generally from its massive exposure to Lehman as a counterparty on CDS trades. Now, some of Merrill's exposure to Lehman as a counterparty definitely came from CDS trades that were part of a larger basis trade. Remember, Merrill surprised the Street in October by reporting a $2bn pre-tax trading loss in Q3 that was, according to Merrill:

Primarily related to the default and spread movements of certain government sponsored entities and major U.S. broker-dealers.

Any CDS contract with Lehman as counterparty needed to be replaced when Lehman collapsed. Remember the emergency "Risk Reduction Trading Session" the ISDA opened on the Sunday that Lehman was preparing to file for bankruptcy? That was so that the major dealers could start replacing their derivative contracts where Lehman was the counterparty with contracts with other counterparties. The emergency trading session was a disaster (about which more later), but it was especially disastrous for Merrill.

Remember the timing.

The emergency trading session ran from 2 pm to 6 pm on the Sunday that Lehman was preparing to file for bankruptcy. The news that BofA was in advanced talks to buy Merrill didn't break until around 5 pm. Before that announcement, everyone was looking for who would be the next to fall, and the consensus was that Merrill was next in line. So traders turned their guns on Merrill. In a standard CDS, no money is exchanged upfront. But when a firm looking to enter into a CDS contract might default before the contract matures, counterparties start to demand money upfront—known as "points upfront" or "initial margin." Since Merrill was expected to collapse if it couldn't find a buyer, and news of the BofA deal had not yet leaked, counterparties were demanding that Merrill make huge upfront payments in order to enter into a CDS contract. And because Merrill had huge exposure to Lehman as a counterparty, it had a lot of contracts it needed to replace.

I'm not saying that all of Merrill's losses, or even most of its losses, came in the emergency trading session—it took banks weeks, if not months, to replace all their trades with Lehman. The emergency trading session was just a microcosm of the next few weeks/months. Upfront payments have become relatively common in CDS trades since Lehman's collapse. Even after the BofA deal was announced, counterparties were still demanding points upfront from Merrill (though not as much as in those dark hours before the BofA deal was announced).

My feeling is that a good chunk of Merrill's losses came from the sheer number of CDS contracts it had to replace when Lehman collapsed. Merrill had a lot more CDS contracts with Lehman than anyone thought—Moody's said the number was "outside of our expectations." Merrill has taken a loss on virtually every one of those contracts, as it had to replace them with pricey off-market CDS, some of which required sizable upfront payments. And since Merrill's $2bn Q3 trading loss only reflects the CDS contracts it replaced before Sept. 30, it's a good bet that these losses extended into Q4.

While CDS that were part of basis trades no doubt account for some of the contracts Merrill had with Lehman, I don't think the basis trade is really the culprit here. The culprit is Merrill's outsized exposure to Lehman as a counterparty.

Addendum: When the ISDA announced the emergency trading session on the Sunday that Lehman collapsed, I had a good laugh, and took great pleasure in explaining to my wife all the reasons why the trading session, as well as the following few weeks in the CDS market, would be a clusterfuck of the highest order. At that point I was still a "former structured finance lawyer," so the situation was amusing to me. Of course, a few hours later my old boss called and said: "I need you to come back. This is gonna be Armaggedon." Since he's one of the nicest men on the face of the earth, I couldn't refuse. Karma is a bitch.

Posted by Economics of Contempt at 5:15 PM "

Here's my reply:

Don said...

"Since Merrill was expected to collapse if it couldn't find a buyer, and news of the BofA deal had not yet leaked, counterparties were demanding that Merrill make huge upfront payments in order to enter into a CDS contract. And because Merrill had huge exposure to Lehman as a counterparty, it had a lot of contracts it needed to replace."

What you are describing is what I call a Calling Run. It's just my variation of Fisher's work on Debt-Deflation. From what you wrote, I am assuming that anyone familiar with the idea of a calling run could see the seeds of it when Merrill was hit as you described. From my point of view then, anyone familiar with these concepts could plainly see that allowing Lehman to fail could start a Calling Run, where investors started demanding money back in a ripple effect sort of manner, since that was what the Merrill reaction was. Assuming that you can follow my reasoning, since I'm not an expert in these matters, I am right about this?

Don the libertarian Democrat (I'm stuck with this name now, like the Goo Goo Dolls.)

January 26, 2009 10:43 AM