Economics of Contempt

On the Revisions to Basel III’s Liquidity Requirements

2013-01-23T11:20:00.000-05:00

So the Basel Committee finally released its revisions to the all-important Liquidity Coverage Ratio (LCR), which I have written about at length. Most of the press coverage has painted the revisions as weakening the LCR, and it’s true that some of the revisions weaken the LCR, but after delving into the document, I find more of a mixed bag. The bottom line (for those who don’t want to read some of the gory details) is that while there were unfortunately more losses than wins, the core of the LCR is absolutely still intact, and the implementation of the first liquidity regime for major banks will undoubtedly be a huge upgrade to the financial regulatory framework.

Here are some of the major wins and losses, in my opinion, in the revised LCR.

Losses

First, the losses.

Liquidity Facilities to Non-Financial Corporates

The worst change in my opinion is the reduced outflow rate for liquidity facilities that banks have extended to non-financial corporates. Under the original LCR, the outflow rate for these liquidity facilities was 100%. The revised LCR reduces that to 40%. These liquidity facilities are predominantly commercial paper backstop facilities, which corporations will arrange with banks if they finance enough of their day-to-day operating costs by borrowing in the commercial paper market. The revised standard greatly clarifies the definition of a “liquidity facility,” and basically says that the size of a liquidity facility will be equal to the amount of debt that the corporation has outstanding that is maturing in the coming 30 days. This makes sense, and it’s much simpler than trying to distinguish between liquidity and credit facilities by examining the parties’ intent.

But why reduce the outflow rate to 40%? If the commercial paper market shuts down — which it did during the 2008 financial crisis — then companies won’t be able to replace any of their maturing commercial paper debt, which means the outflow rate on the liquidity facilities should be 100%. Why is the Basel Committee assuming that companies will be able to replace 60% of their commercial paper funding during a financial crisis? I think that’s highly unrealistic, even if you’re basing the LCR on funding conditions that prevailed during the 2008 crisis (which, as I’ve said before, is a remarkably stupid idea).

Liquidity and Credit Facilities for Prudentially-Regulated Banks

The revised LCR also reduces the outflow rate on both liquidity and credit facilities extended to banks that are subject to prudential supervision, from 100% to 40%. The original LCR treated prudentially-regulated banks the same as “financial companies” such as securities and brokerage firms. Now, I’m actually okay with prudentially-regulated banks being treated as more reliable than other financial companies — after all, prudentially-regulated banks will be subject to the LCR, and will therefore be better-prepared to meet their liquidity needs during a financial crisis.

That said, I think that reducing the outflow rate on liquidity facilities for these banks from 100% to 40% is, well, imprudent. Any future financial crisis that I can envision will disproportionately impact the big, prudentially-regulated banks that are subject to the LCR (since they sit at the center of virtually all financial markets). Trouble at any of these big banks could have large knock-on effects for the financial system. Given that reality, wouldn’t it be far more prudent to require these banks to pre-fund the majority (i.e., 75–80%) of the liquidity facilities that they’ve extended to each other? Yes, I thought you might agree.

Rehypothecated Collateral on Derivatives

I’m also not wild about the paragraph in the revised LCR (paragraph 117) that allows banks to assume that any high-quality liquid assets (HQLAs) that have been posted to them as collateral on derivatives trades can be rehypothecated to generate cash inflows. The way the paragraph is worded, it appears that banks will be able to simply assume that the HQLAs can be rehypothecated, and will be able to count those cash inflows whether or not they actually rehypothecate the HQLAs.

The obvious reason I don’t like this is that it would allow banks to count cash inflows which may or may not exist. But the other reason I don’t like this is that during a financial crisis, banks will almost certainly not be able to rehypothecate many of the “Level 2A” and “Level 2B” HQLAs (e.g., covered bonds, some equities). Now, it’s true that these kinds of assets are typically not posted as collateral on derivatives trades; however, if banks are allowed to count hypothetical cash inflows from rehypothecating these assets in their LCR calculations, then they might start to allow counterparties to post these assets as collateral on derivatives. Either way, this can be fixed by simply clarifying that banks can only count cash inflows from actual, existing rehypothecations in their LCR calculations.

Wins

Now, some of the wins.

Periodic Monetization

The revised LCR requires banks to “periodically monetise a representative proportion of the assets” in their stock of HQLAs, “in order to test its access to the market.” Here the Basel Committee is taking a page from the Fed’s proposed “enhanced prudential standards” rule, and I’m glad they did. This is a good idea for a variety of reasons. In terms of ensuring that banks have the operational capability to actually monetize their HQLAs during a crisis (an under-appreciated risk), practice will make perfect.

Also, as the Basel Committee notes, requiring periodic monetization will “minimise the risk of negative signalling during a period of actual stress.” Some banks have complained about this requirement in the Fed’s proposed rule by arguing that the market will misinterpret these required periodic monetizations as evidence that the bank is in trouble. Yes, it’s true that the first couple of times, some investors may misinterpret the required monetizations as evidence that the bank is in trouble; but after those investors freak out and scream about how the bank is failing or something, and other market participants respond that no, the monetizations were actually required by law, then the market will no longer consider those monetizations as a signal of trouble. Which will be extremely useful during a real crisis.

In-the-Money Options

In the paragraph on derivatives cash outflows, the revised LCR adds that “[o]ptions should be assumed to be exercised when they are ‘in the money’ to the option buyer.” This is a good example of how the rulemaking process for financial regulations can be beneficial (even though this was not a formal rulemaking). The original LCR didn’t count the cash outflows that would occur from counterparties exercising their in-the-money options. I didn’t think about these cash outflows either — and I thought pretty hard about how cash flows around derivatives would be treated under the original LCR. It was clearly not the Basel Committee’s intent to exclude those cash flows; they just didn’t think about in-the-money options.

But someone (probably someone who works with options) obviously did realize that this was a source of cash outflows that the original LCR did not clearly address, and questioned how these outflows would be treated. As a result, the Basel Committee added the clarification about in-the-money options, which captures a real liquidity drain and makes the LCR more effective. This kind of beneficial clarification occurs rather frequently in the US rulemaking process, although when regulators revise proposed rules to clarify how the rule will apply more situations, they are almost invariably attacked for making the rule more “complex,” or for adding more “loopholes.” But I digress.

Diversification of the Stock of HQLAs

This is a provisional win. The revised LCR states that the stock of HQLAs must be “well diversified within the asset classes themselves” (except for sovereign debt, obviously). This is an important requirement, and will guard against banks overloading their liquidity buffers with, say, corporate bonds in one particular industry. But the strength of this diversification requirement will depend on how national regulators define “well diversified,” and on the compliance regime they implement to maintain this diversification. That’s why this win is still provisional in my mind. So we’ll see how the Fed handles this in their rulemaking. Still, the fact that a diversification requirement was included at all is a win.

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In sum, I think there were both wins and losses in the revised LCR. The losses probably outweigh the wins, but all of the changes were on the margin. As I said before, however, the core of the LCR is definitely still intact, which is a very good thing.

Volcker Rule: “Market Making” and the SEC

2012-12-03T08:36:00.002-05:00

And I’m back! Here’s hoping that my prolonged absence has not cost me my entire audience.

The last substantive update on the Volcker Rule came from the WSJ a few weeks ago. The article contains an interesting — though not altogether surprising — nugget, which highlights one of the key issues in the proposed Volcker Rule. From the WSJ:

The SEC and a trio of banking regulators are butting heads over how to define the buying and selling of securities on behalf of clients, known as market-making, as well as over banks’ ability to invest in outside investment vehicles such as hedge funds, according to officials close to the discussions. Since brokers, which are overseen by the SEC, conduct market-making activities, the SEC is pushing for more influence over the issue, these people said.

So it’s the SEC vs. the banking regulators, and apparently on multiple fronts.

This divide makes sense with regard to the market-making exemption — the proposed Volcker Rule’s market-making exemption leans heavily on the SEC’s existing definition of “market maker.” In order to claim the market-making exemption, the bank’s trading activity must meet the proposed rule’s definition of “bona fide market making,” and the proposed rule explicitly states that “the Agencies expect to take an approach similar to that used by the SEC in the context of assessing whether a person is engaging in bona fide market making.” So it’s not hard to see why the SEC would be pushing for more influence over this issue.

However, the Volcker Rule’s market-making exemption will need to apply to a much larger range of financial products and markets than the SEC has ever had to apply its “market maker” definition to. Because all these markets have varying levels of liquidity, different trading infrastructures, etc., bona fide market making will look different in some markets than it does in others.

To address this, the proposed rule divides the universe of markets into (1) “relatively liquid” markets and (2) “less liquid” markets, and then broadly describes what legitimate market-making should look like in each.

Whether a particular market is put in the “relatively liquid” or “less liquid” bucket will matter a great deal, as it will be much easier for banks to claim the market-making exemption in less liquid markets. For example, in less liquid markets, banks will not have to demonstrate that their trading in that market “includes both purchases and sales in roughly comparable amounts” in order to claim the market-making exemption, which they will have to demonstrate in more liquid markets. In addition, in less liquid markets banks will not be required to “mak[e] continuous quotations that are at or near the market on both sides,” which, again, they will be required to do in more liquid markets.

So what is required for banks to claim the market-making exemption in less liquid markets? Essentially, banks just need to hold themselves out as willing to provide two-way quotes in that market on a regular basis, and be consistently active in that market. It’s fair to say that this is not hugely demanding.

Moreover, the proposed rule also states that bona fide market making in any market can include block trading when it’s done “for the purpose of intermediating customer trading.” Here, again, the proposed rule explicitly points to the SEC’s existing definition of “qualified block positioner” for guidance.

Now, it’s important to note that even within the “more liquid” and “less liquid” buckets, the regulators will almost certainly apply these criteria to each specific market differently — “as the facts and circumstances warrant,” as they say. But who gets to decide which markets go in which buckets, and how stringently to apply the market-making criteria to each market? Will the final rule add separate criteria for all the major markets, or will regulators apply the broad criteria on a case-by-case basis as questions arise.

My guess is that this is what the SEC and the banking regulators are fighting over.

JPMorgan and the Volcker Rule's Hedging Exemption

2012-05-20T23:42:00.004-04:00

In the wake of JPMorgan’s $2 billion trading loss, there’s been lots of talk about whether “portfolio hedging” is allowed under the Volcker Rule, and whether that should be changed. As I wrote in my previous post, the statutory language of the Volcker Rule very clearly allows portfolio hedging, and anyone who claims otherwise is lying to you. That’s just an objective fact, inconvenient though it may be for some people.

But the focus on portfolio hedging in the wake of JPMorgan’s trading loss is entirely misplaced. Portfolio hedging is only one of the seven criteria that a bank must meet in order to rely on the hedging exemption in the proposed Volcker Rule, and far from the most important. Commentators and certain politicians seem to believe that if JPMorgan’s trades met the definition of a “portfolio hedge,” then they would necessarily be allowed under the proposed Volcker Rule. That’s simply not true. Even if JPMorgan’s failed trades qualified as portfolio hedges, they would still have to meet other, more stringent requirements in order to qualify for the Volcker Rule’s hedging exemption.

What are the other criteria that a bank must meet in order to qualify for the proposed Volcker Rule’s hedging exemption? The first two have to do with the “programmatic compliance regime” that banks are required to establish under the Volcker Rule, so we can skip those for now. The third criterion deals with portfolio hedging — the trade has to mitigate specific risks, which can be done on a portfolio basis.

The fourth criterion is the most important, and it requires that the hedge “be reasonably correlated, based upon the facts and circumstances of the underlying and hedging positions ... to the risk or risks the transaction is intended to hedge or otherwise mitigate.”

Would JPMorgan’s trades have satisfied the requirement that they be “reasonably correlated” to the underlying risks being hedged? Maybe, maybe not. JPMorgan’s failed hedging strategy has been described several different ways in the press, so it’s impossible to say at this point. A lot depends on what specifically JPMorgan was trying to hedge in the first (original) leg of the hedging strategy, and what exposures the second leg of the strategy was intended to hedge. At first, the press was reporting that JPMorgan had been worried about weakness in the European economy, which led it — for whatever reason — to buy protection on the CDX.NA.IG.9 index. Now, I haven’t run the numbers, but I would question whether an index of investment-grade corporate credits is “reasonably correlated” to the European economy. So if those press reports are to true, then JPMorgan’s trade might have failed to qualify for the hedging exemption right there. But again, a lot of this depends on what JPMorgan was actually trying to hedge.

The fifth criterion, which is also crucially important, requires that the hedge “not give rise, at the inception of the hedge, to significant exposures that are not themselves hedged in a contemporaneous transaction.” JPMorgan’s trades could have failed to satisfy this requirement in two ways: first, when it initially bought protection on the IG.9; and second, when it later sold short-dated protection on the same index to hedge its original hedge. Why did JPMorgan have to hedge its original hedge? Was it because of changes in the economic outlook, or was it because they bought too much CDS protection initially? If it was the latter, then JPMorgan’s initial hedge may not have qualified for the Volcker Rule’s hedging exemption in the first place. The same analysis also applies to the second leg of the hedging strategy, in which JPMorgan reportedly ended up selling far too much CDS protection on the IG.9 index. If JPMorgan significantly over-hedged by selling too much CDS protection, then those trades also would not have been allowed under the Volcker Rule.

The sixth criterion requires that the hedge “be subject to continuing review, monitoring and management after the hedge position is established.” Jamie Dimon has all but admitted that the trades wouldn’t have satisfied this requirement.

Finally, the seventh criterion requires that “the compensation arrangements of persons performing the risk-mitigating hedging activities are designed not to reward proprietary risk-taking.” Now, I don’t know what Bruno Iksil and Achilles Macris’s compensation arrangements were, but I would actually be very surprised if their compensation arrangements didn’t reward proprietary risk-taking. Mostly this is because the Chief Investment Office (CIO) had something of a dual mandate — the CIO not only hedged the bank’s risks, but it also invested excess deposits, which is a risk-taking role. So I would suspect that compensation arrangements in the CIO accounted for their risk-taking mandate. If so, then the trades may have failed to qualify for the Volcker Rule’s hedging exemption for yet another reason.

The point of all this is that the debate over “portfolio hedging” is a complete sideshow — portfolio hedging is definitely allowed under the statutory language of the Volcker Rule, but this in no way means that the proposed hedging exemption is too weak, or has been “gutted.” JPMorgan’s trades may have qualified as “portfolio hedges,” but still may have failed to qualify for the Volcker Rule’s hedging exemption on at least four other grounds. The “reasonable correlation” and “no new exposures” requirements are far more important than whether portfolio hedging is allowed.

Commentators and journalists would do well to remember this.

The Volcker Rule and “Portfolio Hedging,” Yet Again

2012-04-20T01:52:00.001-04:00

Seriously, Jesse Eisinger needs to stop writing about the Volcker Rule, because he has absolutely no idea what he’s talking about. His latest article makes a number of egregious errors, but I want to focus on the one that’s most demonstrably untrue. Eisinger writes: (emphasis mine)

The Congressional authors of the Volcker Rule worried about this very thing [i.e., the potential to move prop trading into the bank’s treasury operation], and you can trace their concerns through their drafts. The original language of the rule had a broad exception: banks couldn’t trade for their own account, but they could hedge to mitigate their risks.

The authors quickly realized that the exemption was absurdly broad. After moving these businesses to other divisions, banks would then argue that their bets were either market-making activities or simply hedges that offset risks.
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So Congress tightened the language. It wrote that the hedges had to be specific. When the Dodd-Frank financial reform law came out, the Volcker Rule provision defined “risk mitigating activities” as trades that were “designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings.” No macro-hedging, only micro-hedging. That is the will of Congress.

This is patently untrue on so many different levels. For one thing, Eisinger conveniently omits the first part of the hedging exemption, which explicitly allows portfolio hedging. But we’ll get to that. First, let’s do something that Eisinger clearly didn’t do — actually trace the hedging exemption through Congress’s drafts.

Here, in chronological order, are Congress’s main drafts of the hedging exemption in the Volcker Rule (with the key language that was added to each version in red):

Draft 1 — PROP Trading Act (S. 3098), introduced by Senators Merkley and Levin on March 10, 2010:

“(C) Risk-mitigating hedging activities.”

Draft 2 — SA 3931, introduced by Merkley and Levin on May 10, 2010:

“(C) Risk-mitigating hedging activities designed to reduce risks to the banking entity or nonbank financial company.”

Draft 3 — SA 4101, introduced by Merkley and Levin on May 18, 2010:

“(C) Risk-mitigating hedging activities designed to reduce the specific risks to a banking entity or nonbank financial company supervised by the Board.”

Draft 4 (Final Language) — Final conference report (H. Rept. 111-517), which was signed into law on July 21, 2010:

“(C) Risk-mitigating hedging activities in connection with and related to individual or aggregated positions, contracts, or other holdings of a banking entity that are designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings.”

Look at the difference between the last two drafts — as you can see, contra Eisinger, all of the changes in the final version substantially broadened the language of the hedging exemption.

The key is the language that Eisinger conveniently omitted in his article, which specifies that banks’ hedging can relate to “aggregated positions, contracts, or other holdings” — i.e., portfolio hedging. Note also that the final version clarifies that “specific risks” does not mean specific positions, because the “specific risks” that banks must be hedging can also relate to “aggregated positions, contracts, or other holdings.” The interest rate risk in a bank’s mortgage portfolio, for instance, is a “specific risk” that relates to aggregated positions. That’s what portfolio hedging is — it’s hedging the risks of the bank’s aggregate positions.

Eisinger clearly does not understand this distinction — he claims, falsely, that Congress “wrote that the hedges had to be specific.” Not true. Again, it’s the risks that have to be specific, and those risks can relate to aggregate positions.

This is exactly what Congress intended. All of this language about “aggregated positions” was added between Draft 3 and Draft 4 specifically to ensure that portfolio hedging would be allowed under the Volcker Rule. Indeed, there’s no other logical explanation for why Congress added the language about hedging “aggregated positions” between Draft 3 and Draft 4.

Thus, as you can see, it was clearly “the will of Congress” that portfolio hedging be allowed under the Volcker Rule.

So why did Eisinger claim that portfolio hedging is prohibited under the statute when it’s so clearly allowed? Probably because it allows him to self-righteously criticize both the banks and the regulators, and to present himself as far too knowledgeable and savvy to be fooled by all this fancy talk about “portfolio hedging.” (This kind of posturing is becoming increasingly common.)

But the reality is that portfolio hedging is 100% allowed by the Volcker Rule’s statutory language, and this is exactly what Congress intended — and anyone who tells you otherwise doesn’t know what they’re talking about.

The Volcker Rule and 'Flipping the Presumption'

2012-03-03T23:32:00.000-05:00

In my previous post on the Volcker Rule, I admittedly glossed over the real issue in my second prediction. This issue is important, but it’s also reasonably complex (way too complex for some people, I suspect), and it requires some context and explanation to fully appreciate.

The statutory text of the Volcker Rule contained a glaring flaw: the statute prohibited proprietary trading by basically defining everything as “proprietary trading,” and then carving out exemptions for everything else. This was a colossal mistake for a variety of reasons, but the most important reason is that rather than having the regulators simply define “proprietary trading,” it put the regulators in the position of having to define every form of legitimate trading that banks do — underwriting, market-making, hedging, etc. Obviously, that’s a much, much more difficult task, and one that’s significantly more likely to lead to problems due to gaps — whether intended or unintended — in the proposed rule’s exemptions. It’s hardly a targeted solution to the problem of government-backed prop trading, to say the least. (I imagine the ultimate blame for this lies with someone in the Legislative Counsel’s office, although Merkley and Levin’s offices bear some blame here too, as they were clearly in way over their heads during this entire process.)

‘Flipping the Presumption’

The upshot of this is that it creates a presumption that all trades are prohibited prop trades, unless proven otherwise. What the banks want to do is to flip the presumption — instead of regulators scrutinizing whether each trade falls into one of the nine “permitted avtivities” exemptions, regulators would be scrutinzing whether each trade is a prohibited prop trade.

Whether flipping the presumption would dilute the strength of the ban on prop trading depends entirely on the quantitative and qualitative metrics that regulators ultimately use to identify prohibited prop trades. The right metrics would appropriately identify prohibited prop trades, while the wrong metrics could either identify too many trades as prop trades, or too few. But that’s where the debate would shift — or rather, should shift — if the regulators flipped the presumption. (The metrics described in the proposed Volcker Rule would, if anything, be overinclusive, and would require the regulators to apply some judgment to flagged trades — which I think is appropriate.)

Now, regulators only have so much discretion here. The statute is the statute, and flawed though it may be, regulators still have to work within its confines. But there are ways to effectively flip the presumption.

One way to do this is to define the main exemptions (market-making, hedging, and underwriting) very broadly, but include a carve-out for trades done for the “trading account” — which is, bizarrely, where the real definition of proprietary trading is located in the statute. The effect of this would be to allow regulators to focus on whether a bank’s trades exhibit the characteristics of trades done for the “trading account” (i.e., prop trades), based on the quantitative and qualitative metrics the regulators have identified, rather than focusing on whether each trade can fit into one of the defined exemptions. In other words, the presumption would be that a trade falls into the market-making or hedging exemptions, unless the regulators believe otherwise.

This is basically what I predicted the regulators would do in my previous post — although, crucially, I limited my prediction to the market-making exemption, and I said that the regulators would make this an “alternative” market-making test. A broader market-making exemption with a metrics-heavy carve-out for prohibited prop trading would go a long way toward: (a) alleviating concerns about the Volcker Rule’s impact on market-making without necessarily diluting the prop trading ban; and (b) making the regulators’ task a lot less daunting, and a lot less likely to cause unforeseen and unintended disruptions to the financial markets.

CDS Auction Settlements Following a Restructuring

2012-03-01T23:21:00.000-05:00

Since there's evidently a substantial amount of confusion surrounding Greece CDS procedures, I thought it would be helpful to post this:

Volcker Rule Predictions

2012-02-20T03:45:00.000-05:00

The due date for comment letters on the proposed Volcker Rule has now passed. The comment letters are interesting for a variety of reasons. (I had the benefit of seeing draft versions of several of the comment letters, and I’ll just say that I’m amazed at the level of convergence they were able to achieve between the industry letters — both substantively and stylistically.)

Instead of trying to write a single, lengthy post with all my analysis of the competing arguments — an undertaking which I simply don’t have the time to complete — I’m going to sort of provide analysis as I go.

In my first post, I’m going to do something which, in my professional capacity, I never get to do: make predictions. I do this without any inside knowledge or the regulators’ thinking, and with full awareness that it’s far too early to know exactly what the regulators will do. But if you don’t make firm predictions, then how are you supposed to say “I told you so” when you end up being right? With that in mind, here’s what I think will ultimately happen to a few of the key portions of the Volcker Rule:

1. The requirement that market-making activities be “related to clear, demonstrable trading interest of clients” will be completely scrapped. The industry will win this one, and for good reason. The “clear, demonstrable trading interest” standard is simply inconsistent with the statutory text, which permits market-making activities that “are designed not to exceed the reasonably expected near term demands of clients.” Client demand can be “reasonably expected” well before the demand is “clear” and “demonstrable.” The statute permits market-making desks to trade in anticipation of “reasonably expected” near-term client demand, so applying a “clear, demonstrable trading interest” standard would be plainly inconsistent with the statute.

To be honest, I don’t think the regulators ever truly intended to apply this standard. The language about market-making activities being “related to clear, demonstrable trading interest of clients” was included in the criterion for bona fide market making, and NOT in the criterion for “reasonably expected near-term demands of clients,” which was far broader. It’s probably a fair bet that different people wrote those two sections, and they were never properly reconciled before the regulators published the proposed rule. However, I also think that the criterion for “reasonably expected near-term demands of clients” will be broadened as well. While that criterion is broader than the “clear, demonstrable trading interest” standard, there’s still a reasonably strong argument to be made that the language in that criterion is too narrow, and doesn’t reflect congressional intent.

2. Regulators will keep the market-making exemption in the proposed rule, but will add a broader “alternative” market-making exemption that relies more heavily on trading metrics to identify prohibited prop trading. Admittedly, this one is a longshot. The industry wants the regulators to replace their current market-making exemption with a much broader exemption, described in the main SIFMA/Clearing House letter:

“We believe a business should be viewed as customer-focused, and therefore engaged in market making, to the extent it is oriented to meeting customer demand throughout market cycles. This can be evidenced by, among other activity, a focus on offering execution to customers, building relationships with customers and providing sales coverage, providing research to customers and participating in the interdealer market in order to serve customer demand.”

Now, this is clearly way too broad. But it does have the benefit (and, from the regulators’ perspective, the attraction) of being simple and inclusive enough to serve as a uniform standard of market-making across all asset classes. If the regulators press on with their current definition of market-making, which contemplates different standards for each different asset class, then the regulators will be drawn into endless battles over what constitutes permitted market-making in every single asset class and market. That’s a daunting task, and I can’t imagine that the regulators are looking forward to writing 50 different, customized definitions of permitted market-making. I’m sure a simple, uniform definition of market-making for all asset classes will look pretty appealing.

However, because the definition of market-making that SIFMA et al. propose is clearly far too broad (sorry guys, but “providing research to customers” ≠ market-making), the regulators will still need some other, non-definitional way to identify prohibited prop trades. And that’s where the trading metrics come in. The proposed rule already identifies several quantitative metrics that can be used to reliably distinguish between market-making and prop trading, and can also be used across the different asset classes.

I think the bargain that the regulators will end up striking here is to add a broader, uniform market-making exemption that relies heavily on quantitative metrics as an alternative to the market-making exemption in the proposed rule. This alternative market-making exemption would obviously have to be narrower than the definition that SIFMA et al. propose, but would still be broad enough to encompass all legitimate market-making across different asset classes.

3. The “trading account” exemptions will stand. The proposed rule excludes repos, securities lending, and positions taken for bona fide liquidity management from the crucial definition of “trading account” — which effectively means that those positions are exempt from the Volcker Rule’s prop trading ban. While Merkley and Levin (amusingly) tried to argue in their comment letter that there is “no statutory basis” for these exclusions, they failed to offer any, you know, actual evidence for their claims. That’s usually fatal to an attempted legal argument. The group “Occupy the SEC”¹ even tried to describe various scenarios in which banks could exploit the “trading account” exemptions to put on prop trades, but their examples tended to be inaccurate (in that they would not have legitimately circumvented the prop trading ban), or ultimately irrelevant.

At best, I think the repo and securities lending exemptions might be slightly revised to include an explicit “anti-evasion” clause. But past that, I think all three “trading account” exemptions will stand.

4. The regulators will issue a re-proposed Volcker Rule rather than a final rule. I think the changes will ultimately be too significant to go straight to a final rule, and that regulators will want another notice-and-comment period to get feedback on any changes.

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¹ While “Occupy the SEC” should certainly be commended for engaging in the rulemaking process (which is where all the real action is), and for engaging in a substantive manner, I don’t think their Volcker Rule comment letter was terribly persuasive on any major point, and I don’t think it will ultimately result in many (or any) substantive changes to the final rule. Now, a lot of the letter’s problems were the result of this clearly being the authors’ first time writing a comment letter to banking regulators. So allow me to offer some constructive criticism (since I imagine there will be another notice-and-comment period for the Volcker Rule): For one thing, the letter contained far too many sweeping, conclusory statements, for instance about what did and did not contribute to the financial crisis, and these sweeping statements too often served as the sole basis for the group’s desired change. Regulators are not responsive to those kinds of arguments, to say the least. (In general, “a guy I read on Huffington Post said X contributed to the financial crisis” is not a winning argument at this level.)

Occupy the SEC’s letter also spent far too much time making tangential arguments that were often based on a simple misunderstanding of the proposed rule, which is a great way to kill a letter’s credibility and undermine its more legitimate arguments. Lehman’s use of Repo 105 was a scandal, but not one that was relevant to the proposed Volcker Rule. It’s absolutely imperative that you pick your battles in these comment letters — focus on the truly meaningful debates, and emphasize your strongest arguments. Also, your audience is the regulators, not other activists, so tone down the self-righteousness. Big-time. Regulators are professional civil servants, so they’re hardly responsive to letters that lecture them about their duty to the public.

Repeat After Me: “Systemically Important” ≠ TBTF

2012-01-19T07:20:00.000-05:00

Earlier this week, Joe Nocera wrote a puff piece on Karen Petrou of Federal Financial Analytics. In the piece, Nocera and Petrou repeat a frequently-heard — but nevertheless exceedingly superficial — argument that has always bothered me. From Nocera’s NYT column:

[Petrou] also points to a contradiction in the way the Too Big to Fail institutions are being dealt with. On the one hand, Dodd-Frank is very clear that if a big bank becomes insolvent, there can be no taxpayer bailout. It must be wound down, just like any other bank. Yet, at the same time, she says, the federal and international regulators are adding a host of special Too Big to Fail capital requirements and rules. “They are acting as if these institutions are still too big to fail. The two thrusts are incompatible.”

Oy. This is not a contradiction. Applying additional capital requirements and more stringent regulations to certain large financial institutions is absolutely not incompatible with ending Too Big to Fail — or with Dodd-Frank’s new resolution authority for large financial institutions.

The new resolution authority makes is easier for large financial institutions (known as SIFIs) to fail, which is the exact opposite of “acting as if these institutions are still too big to fail.” Moreover, the additional capital requirements and regulations for SIFIs in no way contradict the resolution authority. The purpose of the additional capital requirements and enhanced prudential regulations for SIFIs is to make it less likely that a SIFI will fail. The purpose of the resolution authority is to make sure that when a SIFI fails, it can do so without bringing down the entire financial system. These are not contradictory — they’re complementary.

These are pretty basic concepts of financial reform — I wrote a post way back in October 2009, before Congress even took up the financial reform bill, explaining how a SIFI regime and a new resolution authority would fit together. The fact that so many financially-focused pundits have yet to move beyond the “hey, if they’re ‘systemically important’ they must be TBTF!”-level of analysis is just sad.

Equities and Basel III's Liquidity Requirements

2011-12-07T01:50:00.000-05:00

Last night, Bloomberg reported that the Basel Committee was considering revising Basel III's new Liquidity Coverage Ratio (LCR) to allow banks to use equities in their liquidity pools. This would be a relatively major change, and one which I consider ill-advised. (For background, I've written about the LCR several times before.) From Bloomberg:

"The Basel Committee on Banking Supervision, which coordinates regulations for 27 countries, may let banks use equities and more corporate debt, in addition to cash and sovereign bonds, to satisfy new short-term liquidity standards, said two people with direct knowledge of the plans who requested anonymity because the talks are private."

At a Senate Banking hearing today, Fed Governor Dan Tarullo confirmed this report. He also indicated that the Fed would support expanding the list of assets that are eligible for the LCR's liquidity pool. Here's Tarullo after being asked about the Bloomberg report (from the CQ transcript of the hearing):

We — which is to say the Federal Reserve — was one of the entities which asked internationally to take another look at liquidity coverage ratio.
...
And one of the — one of the precepts, I think, for the — for the renewed look was just the point that you were making, that if you're worried about the liquidity of a firm, what you're really asking is, how well is the liabilities and the assets of that firm matched so that in a period of stress it can cover its needs in a — over some period of time so that it has a plan for — it can develop a plan for longer run survival.

And what I have thought was that the 2008 period gave us a very good real life experiment to test what kinds of instruments actually do remain liquid even during a period of stress like that. For example, highly traded equities of large companies.

So that is in fact one of the motivations for the rethink, and I believe that once the international group at the Basel Committee that's looking at the LCR has finished its evaluation next year, that you will see some changes in things like what qualifies in assumed run rates and the like, to try to conform the requirements somewhat more closely to the experience we actually had in late [2008].

Tarullo, therefore, seems to be willing to allow banks to use certain large-cap equities in their liquidity pools. (Basel III's LCR requires banks to maintain large liquidity pools, which must be made up of "high quality liquid assets," so technically what Tarullo is saying is that certain large-cap equities should be included in the definition of "high quality liquid assets.")

Two points here. First, there's a reason that most banks don't currently include equities in their liquidity pools, and that the Fed applies higher haircuts to equities in its emergency lending operations. The reason is that equities are typically more volatile than other instruments (e.g., fixed-income). Allowing banks to use equities in their liquidity pools increases the risk that a bank will have a large shortfall in its liquidity pool on a given day. Presumably, if the Basel Committee makes this change, equities would be categorized as "Level 2" high quality liquid assets (which I explained here), which means a 15% haircut would be applied. But does anyone honestly believe that a 15% haircut is enough for equities — especially given the wild swings in the equity markets that we witnessed even in 2008? I'm not at all convinced that there's a large class of equities that would be truly liquid in a crisis, and certainly not a large enough class to justify the inclusion of equities in banks' liquidity pools.

Second, I'm disappointed to see Tarullo endorse the argument that we can determine which assets are truly liquid by looking at how they fared in the 2008 crisis. As I've noted before, this is a really stupid argument. It may be true that certain large-cap equities maintained their liquidity throughout the 2008 crisis, but there were also massive government bailouts in 2008 — not to mention the extraordinary amounts of liquidity that the Fed pumped into the financial system.

How much did those large-cap equities that Tarullo refers to rely on the Fed's extraordinary lending programs (directly and indirectly) to maintain their liquidity? The point of the LCR is to ensure that banks can survive a funding crisis without massive government bailouts. Contra Tarullo, 2008 is NOT a very good — or even an appropriate — guide. Regulators will simply have to accept that determining which assets are likely to remain liquid in a TARP-free crisis will require the application of judgment on their part.

This is a development worth watching.

On the Leaked Volcker Rule

2011-10-10T05:16:00.001-04:00

The American Banker leaked part of a draft of the regulators’ proposed Volcker Rule (pdf) last week, which has caused quite a stir. The first thing to note is that the American Banker did not leak the most important part: the text of the proposed rule. Instead, they leaked the “Supplementary Information” (which I call just the “Supplement”), the core of which is a lengthy, section-by-section analysis of the proposed rule. In addition, the leaked portion does not include the Appendices to the proposed rule, which, from reading the Supplement, appear to be very important — Appendix B, for example, contains a “detailed commentary regarding how the Agencies propose to identify permitted market making-related activities,” which is a core issue.

First I’ll give some general thoughts on the proposed Volcker Rule, and then, because I’m such a generous guy, I’ll go ahead and highlight some of the most important pressure points in the proposed rule.

General Thoughts on the Proposed Volcker Rule

In general, the proposed Volcker Rule appears to be very good: it’s a serious effort by a group of smart, market-savvy people to draw a workable distinction between market-making and proprietary trading. The regulators recognize the importance of both market-making and hedging, but they also recognize (most of) the places where market-making and hedging can bleed into proprietary trading. And in those situations, the regulators realize that any effort to distinguish impermissible prop trading from permissible market-making or hedging will — quite appropriately — require a very fact-intensive inquiry. That said, I’m still going to have to withhold my final judgment until I see the actual text of the proposed rule.

Also, even though the WSJ keeps trying to gin up controversy over the proposed Volcker Rule allowing hedging on a portfolio basis, the regulators note in the Supplement that allowing hedging on a portfolio basis is “consistent with the statutory reference to mitigating risks of individual or aggregated positions” (emphasis in original). I explained this a couple of weeks ago; it is a faux-controversy. Moreover, prohibiting banks from hedging on a portfolio basis is a monumentally stupid idea in the first place — it would make risk managers’ jobs 100 times harder, introduce all sorts of new risks into banks’ books (counterparty risk would skyrocket), and dramatically raise hedging costs. This is one thing that the statutory text of the Volcker Rule actually got right.

Some Pressure Points in the Proposed Volcker Rule

Now, to the nitty-gritty of the proposed rule. Here some of the major pressure points in the proposed Volcker Rule that I see:

1. Hedges must be “reasonably correlated” to the underlying risk: In defining “risk-mitigating hedging activity,” the rule requires that the hedge be “reasonably correlated” to the underlying risk(s). The Supplement implies that the correlation must be reasonable at the outset of the hedging transaction, which is absolutely appropriate — a lot of times, you think a trade will be a good hedge when you put the trade on, but because of circumstances beyond your control, it turns out not to be a very good hedge (e.g., liquidity may unexpectedly dry up in either the underlying or the hedge, screwing up the normal correlation).

The real question here is: in normal market conditions, when does the correlation between the hedge and the underlying become “unreasonable”? In other words, how much leeway will banks have in determining how to hedge their books? Say a bank enters into a swap that only hedges 50% of the DV01 of the underlying bond. Would that be considered “reasonably correlated” to the underlying risk? (Obviously, I’m simplifying my examples for illustrative purposes.) After reading the Supplement, I strongly suspect that I know what the regulators’ answer would be: it depends on the particular facts and circumstances. If, for example, the swap was coupled with another transaction that hedged the remainder of the DV01 of the underlying bond, then both transactions would be permitted, because when viewed together, they were both part of a legitimate hedging strategy.

The Supplement also hints at what regulators would NOT consider to be “reasonably correlated” — it states that “[a] transaction that is only tangentially related to the risks that it purportedly mitigates would appear to be indicative of prohibited proprietary trading” (emphasis mine). I think it would be a stretch to say that regulators intend to consider any transaction that’s more than “tangentially related” to be a “reasonably correlated” hedge. But this at least indicates that regulators won’t simply accept a hand-waving, “trust me, they’re related” response to inquiries about the appropriateness of a hedge.

In the end, what we know is that a permissible hedge must be less than “fully correlated” but more than “tangentially related” to the underlying risk, and that if the appropriateness of a hedge is questioned, it will be a very fact-intensive inquiry. Which, by the way, is the way it should be.

2. “Additional significant exposures”: The proposed rule prohibits hedges that themselves introduce significant, unhedged exposures. However, the Supplement also states that:

“[T]he proposal also recognizes that any hedging transaction will inevitably give rise to certain types of new risk, such as counterparty credit risk or basis risk reflecting the differences between the hedge position and the related position; the proposed criterion only prohibits the introduction of additional significant exposures through the hedging transaction.”

There are actually three potential flashpoints in this prong. The first flashpoint is what constitutes “additional significant exposures.” How significant does the new risk that the hedging transaction is introducing have to be before regulators will require it to be hedged as well?

The second flashpoint is what constitutes mere “basis risk,” and what constitutes an impermissible residual risk. The Supplement says that a hedge that merely introduces counterparty or basis risk is permissible. Here’s what I would tell our trading desks if I were still working at an investment bank: start calling every residual risk a “basis risk.” Basis risk evidently doesn’t need to be hedged under the proposed Volcker Rule, regardless of how significant the exposure is. So if you want to profit from the price movement in a certain risk, then just partially hedge the risk with another transaction and call the residual risk “basis risk.”

The third flashpoint has to do with when the “additional significant exposure” must be hedged. The Supplement states that if a hedge introduces a significant new exposure, then the exposure must be hedged “in a contemporaneous transaction.” Assuming that regulators will allow banks some time to hedge the new exposure, the question becomes how much time will they have to hedge the new exposure? An hour? A day? A week? I strongly suspect that the regulators’ answer will be that banks will have to hedge the new exposure “as fast as humanly possible” (not in those words, obviously — the legislative language will probably be something like “as quickly as technologically practicable.”)

3. “Bona fide liquidity management”: This is where I would go first if I was trying to circumvent the Volcker Rule. The statutory text of the Volcker Rule defines proprietary trading in a very roundabout way, such that the real definition of proprietary trading is in the definition of a “trading account.” However, the proposed rule provides an exclusion from the definition of a “trading account” for accounts that are use “to acquire or take a position for the purpose of bona fide liquidity management, so long as [five] important criteria are met.”

The reason I would go here first if I was trying to circumvent the Volcker Rule is that if a trade could fit under the “bona fide liquidity management” exclusion, there would be no need to bother with any of the more complicated “permitted activities” exceptions, and evidently, no need to report nearly as much, if any, quantitative trading data to regulators.

The proposed rule requires that trades done under the liquidity management exclusion be done according to a “documented liquidity management plan” that meets five criteria. But none of the five criteria in the proposed rule appear to me to be prohibitive if a bank wanted to use the liquidity management exclusion for prop trades. The plan has to “specifically contemplate and authorize any particular instrument used for liquidity management purposes” — fine, just write a liquidity management plan that contemplates the use of a (very) wide range of instruments (a lot of instruments have reasonably liquid markets in normal times). The second criterion basically requires that an instrument used for liquidity management not be used “principally” for prop trading purposes, which is easy, since prop trading is prohibited regardless of whether it’s the “principal” purpose of the instrument.

The third criterion requires the liquidity management plan to be “limited to financial instruments the market, credit and other risks of which are not expected to give rise to appreciable profits or losses as a result of short-term price movements.” This criterion simply can’t be enforced terribly stringently — even Treasuries, which are the core of any serious liquidity pool, often experience significant short-term price movements. Fourth, the plan would have to limit liquidity management positions to “an amount that is consistent with the banking entity’s near-term funding needs.” This also can’t be seriously enforced, because it would directly conflict with Basel III’s new Liquidity Coverage Ratio (LCR), and cautious liquidity management in general. Finally, the plan would have to be “consistent with the relevant Agency’s supervisory requirements ... regarding liquidity management.” Seeing as the new liquidity rules set a floor on a bank’s liquidity management, and not a ceiling, using instruments that don’t qualify for the LCR in a broader liquidity management plan would certainly still be “consistent with” the regulators’ liquidity requirements.

4. “Near term” / “Short term”: The statutory text of the Volcker Rule effectively defines a proprietary trade as any trade done “principally for the purpose of selling in the near term.” While the Supplement doesn’t provide much detail on what constitutes “near term,” it does hint at an answer: 60 days or less. The proposed rule will apparently include a rebuttable presumption that any account used to take a position that is held for less than 60 days will be considered a “trading account.” Therefore, it stands to reason that accounts which are used (exclusively) to take positions that are held for longer than 60 days will not normally be considered “trading accounts,” and thus not subject to the Volcker Rule. But, of course, I strongly suspect that the regulators will say that this determination is ultimately going to be based on the particular facts and circumstances of the trade.

Anyway, there are a few more pressure points like this in the Supplement, but that’s all I have time for right now.

Ron Suskind’s “Confidence Men”: A Terrible Book

2011-09-29T02:12:00.000-04:00

No need to beat around the bush here: Ron Suskind’s “Confidence Men” is a terrible book. It’s not even remotely accurate, and contains surprisingly little new, original information.

The fundamental problem is that Suskind is stunningly ignorant of basic macroeconomics, financial markets, the financial crisis, and financial regulations — basically, all the subjects you’d need to understand in order to write a competent book about the Obama administration’s economic team. It also contains so many patently absurd, completely unsourced assertions that it’s really not a question of whether Suskind makes up some of his material, but rather how much of his material is made up.

Curiously, the articles slamming Suskind’s book almost all cite a series of minor errors (e.g., saying Tim Geithner was the “chairman” of the NY Fed rather than the “president”) in order to demonstrate Suskind’s incompetence. The book is riddled with much more major errors — errors which provide the foundation for his cooked-up narrative. To give you a flavor of what I’m talking about, here are a few representative examples.

Suskind’s Ignorance of Basic Macroeconomics/Monetary Policy

On page 22, Suskind claims that the idea of making interest rate cuts the primary tool of monetary policy was “an innovation of previous Fed chairman Alan Greenspan.” Yep, no central banker had ever thought to make interest rate cuts their primary policy tool before Greenspan. It gets worse though. Suskind then claims that Fed interest rate cuts only stimulate the economy because they “prompt everyone, everywhere, to roll over debts of all kinds by replacing whatever is on their balance sheet with its equivalent.” That’s it. Interest rates are cut, everyone refinances all their loans, and that’s it. No new loans being made, no inflation, nothing. This is what he thinks monetary policy is (and he repeats this several more times in the book, so it’s clearly how he thinks monetary policy works). This is not some trivial detail, either — how can Suskind be expected to understand the decisions that were being made if he can’t even understand how the Fed works on the most basic level?

Suskind’s Ignorance of the Repo Market

On pages 72–73, Suskind’s complete ignorance of the repo market causes him to badly misinterpret something Tim Geithner said to him — an interpretation which he then uses to further his very unflattering portrait of Geithner.

First of all, Suskind simply asserts, without any sourcing at all, that in August 2007, Geithner had only a “passing familiarity” with the repo market. The idea that the president of the NY Fed had only a “passing familiarity” with repos is absurd on its face. One of the NY Fed’s primary functions is implementing monetary policy, and one of the main ways it does this is by entering into — you guessed it! — repos. Did someone tell Suskind that Geithner only had a “passing familiarity” with repos? Clearly not, or else he would have sourced it, even anonymously. No, it’s clear that Suskind simply made it up in order to further his ~~fictitious~~ unflattering portrait of Geithner.

Ironically, Suskind then proceeds to demonstrate his own ignorance of the repo market, in a discussion of Countrywide’s difficulties securing repo financing in August 2007. From the book (emphasis on the comically wrong parts added):

“That was really interesting,” Geithner later reflected, “because Countrywide had no idea what its exposure was, no understanding of what it had gotten into. And the fact that the market was unwilling to fund Treasuries if Countrywide was a counterparty was the best example of how fragile confidence was and how quickly it turned.”

Translation: the market would not even lend Countrywide cash to buy Treasury bonds, the safest investment in the firmament. CDOs, MBSs, or similar types of mortgage-based collateral that Countrywide was using to roll over its repo loans were suddenly seen as impossible to value or sell in August 2007, meaning that it was illiquid. The whole point of collateral is that it can be taken — the way the repo man repossesses your car after too many missed payments — and sold in liquid markets for cash. Collateral that is illiquid is no collateral at all. Countrywide’s intended use for the borrowed funds — to go out, like Sal Naro, and buy Treasuries and shore up its balance sheet or to use them as collateral for emergency bank loans — was irrelevant. Its collateral was no good.

Geithner, at the time and looking back, saw this strictly in terms of confidence.

No, no, a thousand times no! Suskind completely misinterpreted what Geithner was saying. Countrywide wasn’t trying to use CDOs and MBSs to fund its repo book — it was trying to use Treasuries as collateral on repos, and counterparties were still refusing to roll over Countrywide’s repos. That’s why Geithner said it was “really interesting” — because market participants had become so scared of counterparty risk that they wouldn’t even lend against Treasuries (which in theory shouldn’t happen). Suskind evidently doesn’t know that Countrywide originated the subprime mortgages that went into the MBSs and CBOs; it wasn’t the end investor in the CDOs. But Suskind uses his horrible misinterpretation to paint Geithner as naïve and in denial about the depth of the problems in subprime MBSs and CDOs. (“Silly Geithner, he thought it was just a confidence problem!”) There’s a mistake like this on practically every page of the book (his misinterpretation of a memo by UBS’s Robert Wolf is classic in its utter wrongness too), and it all contributes to a narrative that, at the end of the day, is simply false.

Suskind’s Ignorance of the Difference Between Creditors and Equity Holders

Finally, in the chapter on Geithner’s alleged refusal to resolve Citigroup (which very clearly never happened) Suskind writes:

Geithner, on this point, would not budge. Debt was sacrosanct. No creditor would suffer. Bair was equally intransigent. Secured creditors, such as equity holders, of course, wouldn’t be wiped out, but they had to face consequences for lending money to an institution whose recklessness had led to its demise. They must, she said, “face some discipline.”

Yes, you read that right: Suskind does not know the difference between secured creditors and equity holders. He apparently thinks that in a resolution of Citi, equity holders “wouldn’t be wiped out” (“of course,” he says). Again, this is not a trivial mistake — this is enormously important, because the entire debate over what to do with Citi revolved around the distinction between creditors and equity holders. The FDIC was (allegedly) advocating putting Citi’s commercial bank subsidiary into receivership, which would haircut creditors, whereas Geithner was advocating the stress tests, which in a worst-case scenario would lead to the government diluting equity holders, but not haircutting creditors.

This demonstrates quite clearly that Suskind lacked the knowledge or ability to understand the central dispute in his own book — the dispute that made headlines all over the country. How can Suskind be expected to understand what happened in this dispute if he couldn’t even understand what the dispute was about in the first place?

The answer, obviously, is that Suskind’s account of the dispute is not credible. (Bolstering that conclusion is the fact that the meeting in which Obama allegedly ordered the resolution of Citi has been reported on several times before, and every other journalist reported that Obama decided against resolving Citi.)

Anyone who is even remotely familiar with the financial crisis, or financial markets in general, would be able to catch 90% of Suskind’s mistakes/fabrications, so I don’t know how anyone who knows this material could possibly consider Suskind’s book credible. His account of the financial reform debate was, if possible, even more riddled with fundamental misunderstandings and mistakes, which renders his telling largely false. I was as close to the financial reform debate as anyone, and Suskind’s account is simply not what happened.

In any event, don’t waste your money.

The Volcker Rule Isn’t Being Diluted

2011-09-25T16:03:00.000-04:00

I want to smack down this particular bit of misinformation before the regulators release their proposed Volcker Rule, so that they don’t get hammered for absolutely no reason.

Last week, the WSJ ran a story claiming that a draft version of the regulators’ proposed Volcker Rule would substantially weaken the original law, because the draft rule defines “hedging” on a “portfolio basis.” The problem with this story is that it’s 100% wrong. From the article (emphasis mine):

At issue is how regulators and banks define “hedging,” or trades designed to offset risk taken by a bank, usually on behalf of customers.

The law originally defined hedging narrowly as trades tied to specific bets.

Actually, no. The law did NOT originally define hedging narrowly as trades tied to specific bets. Here’s how the law defined “risk-mitigating hedging activities,” which are exempt from the prop trading ban (emphasis mine):

“(C) Risk-mitigating hedging activities in connection with and related to individual or aggregated positions, contracts, or other holdings of a banking entity that are designed to reduce the specific risks to the banking entity in connection with and related to such positions, contracts, or other holdings.” (Dodd-Frank § 619(d)(1)(C))

As you can see, it was the original law that defined hedging on a portfolio basis. This means that the regulators had no choice but to define hedging on a portfolio basis — the regulators are simply interpreting and fleshing out the original law, and the original law said that banks can permissibly hedge on a portfolio basis.

The law said that the hedges have to be “designed to reduce specific risks,” but risks can be — and, in fact, almost always are — faced on a portfolio basis. Interest-rate risk, for example, is typically measured and hedged on a portfolio basis — banks don’t hedge the interest rate risk on each Agency MBS they hold in inventory individually, because that would be horribly inefficient; instead, they measure the interest-rate risk of their entire Agency MBS portfolio, and hedge that. (And in reality, this “specific risks” limitation is meaningless anyway, because if a transaction wasn’t designed to reduce a specific risk, then it wouldn’t be a “hedge” in the first place, now would it?)

So, clearly, the original law explicitly stated that banks are allowed to hedge on a portoflio basis. The fact that the regulators’ draft rule allows banks to hedge on a portfolio basis does not weaken, dilute, or otherwise change the scope of the Volcker Rule one bit.

9/11

2011-09-11T21:27:00.000-04:00

Since everyone is telling their 9/11 stories today, I guess I'll share mine. Having experienced the terrorist attacks on 9/11 up close, this day always bring back terrible memories.

My wife and I were both working in the Financial District, and my wife's office was very, very close to the Twin Towers. I had walked over to my wife's office to drop something off that she had forgotten at home, and I was standing in her office waiting for her to finish a call when we heard the first plane hit the North Tower. Most people on her floor went outside to see what was going on / get a better look, because none of us had any idea what had happened. We were standing outside when the second plane hit the South Tower, although I didn't actually see the impact; it was, however, the loudest noise I've heard in my life. I thought there had been a massive explosion in the North Tower at first. Even at that point, we weren't really sure it was an attack, because we still didn't know for sure what had happened to the North Tower. People had been speculating that a plane had hit the North Tower, but no one we talked to had actually seen the plane go into the tower. All you could see was a giant hole in the side of the building with smoke pouring out.

After the second plane hit, people naturally started to panic. My wife always kept a near-lifetime-supply of bottled water in her office, so we went back inside to get them to hand out to people who were coming down the street from the WTC. Handing out bottled water seemed like a very good idea at the time; we hadn't yet realized how dangerous it was to be so close to the WTC. Partly that's because, despite what everyone says in hindsight, a lot of people still weren't sure that we were under attack even after the second plane hit, and so were just standing around staring at the towers rather than fleeing. I wasn't 100% convinced myself, because some people were still claiming that the explosion in the North Tower had been a massive pipe explosion. Anyway, after we handed out the bottled waters and made a few calls on our cell phones to check on friends who worked in the WTC, police officers started telling everyone to clear the entire area immediately. So we started moving down Liberty Street (toward the bridge).

We had only been walking away for about 60 seconds when the South Tower collapsed. I had my back turned initially, but I remember turning around when the rumbling started and seeing the massive cloud of dust and debris rushing toward us. Everyone turned and ran, and I was shocked at how quickly the cloud of dust/debris was on top of us. We barely made it half a block before the cloud effectively engulfed us. (It was very hot.) Once the dust/debris started to clear, it was just pure chaos. There's no other way to describe it. We moved as fast as we could toward the bridge, but everyone seemed to be running in different directions. (No one really knew where we were supposed to run to; "away from here" was the only real consensus.) Eventually we made it to the bridge, where, like everyone else, we remained for basically the rest of the day.

It was, obviously, the most harrowing experience of my life.

The DC Circuit’s Proxy Access Decision

2011-08-22T01:08:00.000-04:00

As you’ve probably heard, the DC Circuit struck down the SEC’s proxy access rule last month, in Business Roundtable and Chamber of Commerce v. SEC. The three-judge panel held that the SEC’s proxy access rule was “arbitrary and capricious” because the SEC failed “adequately to assess the economic effects of a new rule.” Unlike most securities lawyers, to whom proxy access is a huge deal, I personally don’t find proxy access terribly interesting. But the Business Roundtable decision will affect many future SEC rules required under Dodd-Frank, so it’s important to consider the decision, and how the SEC should proceed in light of the decision.

For a variety of reasons, I think the DC Circuit’s decision was terrible — hilariously biased, and generally not worth the paper it was written on. (Not surprisingly, the opinion was written by failed Reagan Supreme Court nominee Douglas Ginsburg, who also wrote the 2005 opinion striking down another SEC rule.)

In the court’s words:

[T]he Commission has a unique obligation to consider the effect of a new rule upon “efficiency, competition, and capital formation,” 15 U.S.C. §§ 78c(f), 78w(a)(2), 80a-2(c), and its failure to “apprise itself — and hence the public and the Congress — of the economic consequences of a proposed regulation” makes promulgation of the rule arbitrary and capricious and not in accordance with law.

The SEC did, in fact, engage in an unusually lengthy cost-benefit analysis in its proposed rule and its final rule. But the court, clearly determined to find some reason to strike down the proxy access rule, found a few arguments raised by commenters that the SEC didn’t completely and definitively rebut, and used that to conclude that the SEC had failed to adequately consider the effect of the new rule on “efficiency, competition, and capital formation.”

As a preliminary matter, I think the court’s reasoning was comically weak. On one issue, the court conceded that the empirical evidence was “mixed,” but then bizarrely refused to allow the SEC any deference whatsoever in arbitrating between competing empirical studies. In other words, the SEC chose to believe the empirical studies that went against the court’s policy preferences. Awesome. On another issue, the court faulted the SEC for not irrationally assuming that “union and government pension funds” would use the proxy access rule to harm “shareholder value.” (Remember when conservatives used to argue that employee ownership schemes would promote glorious efficiency by aligning the interests of labor and management? I miss those days.)

So what should the SEC — which has to write a slew of regulations implementing Dodd-Frank in the next few years — do in light of the Business Roundtable decision? First, where it’s able to, the SEC should certainly humor the DC Circuit and engage in a (very) detailed cost-benefit analysis.

Second, and more importantly, the SEC shouldn’t be afraid to admit that a proposed rule won’t necessarily maximize “efficiency, competition, and capital formation.” The DC Circuit can’t strike down an SEC rule on the grounds that it doesn’t promote “efficiency, competition, and capital formation.” Let’s look at the statute, 15 U.S.C. § 78c(f):

Whenever pursuant to this chapter the Commission is engaged in rulemaking, or in the review of a rule of a self-regulatory organization, and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission shall also consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation. (emphasis mine)

The SEC isn’t required to only promulgate rules that will promote efficiency, competition, and capital formation — it’s only required to consider those factors. And that’s in addition to another, separate, factor — the protection of investors. So if the SEC can’t prove that one of its proposed rules will promote efficiency, competition, and capital formation, the agency can still issue the rule on the grounds that it protects investors. The other relevant statute, 15 U.S.C. § 78w(a)(2), simply requires the SEC to determine that any harm to competition caused by a proposed rule is “appropriate in furtherance of the purposes of” the ’34 Act — which includes investor protection. The Business Roundtable decision just means that the SEC has to lay out its efficiency analysis in detail, even if the conclusion is that the rule won’t promote efficiency.

Essentially, the SEC shouldn’t be afraid to tell the DC Circuit to take its “efficiency, competition, and capital formation” analysis and shove it, and that investor protection is still paramount, thank you very much. Not in those words, of course. But you get the idea.

On S&P, Downgrades, and Idiots

2011-08-08T01:36:00.001-04:00

This is not going to be one of those posts that laments S&P’s decision to downgrade the US, but then says that S&P was probably right about our oh-so-dysfunctional political system.

No, S&P was flat-out wrong — no caveats. They are, to put it very bluntly, idiots, and they deserve every bit of opprobrium coming their way. They were embarrassingly wrong on the basic budget numbers, as everyone knows now, so they were forced to remove that section from their report, and change their rationale for the downgrade. (Always a sign that you’re dealing with hacks.)

S&P’s rationale for the downgrade now is based entirely on their subjective political judgement — and their political judgement is wrong. The brilliant political minds over at S&P said that “the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges.”

That sounds like a Very Serious and Sober assessment, but it’s really not. It’s true that the debt limit debate was ridiculous, and that a large contingent of Tea Party freshmen in the House were threatening to not raise the debt ceiling. But here’s the thing: we still raised the debt ceiling, and in such a way that this Congress won’t have the opportunity to use the debt ceiling as a political bargaining chip again.

S&P’s assessment is only remotely serious if you assume that this particular Congress, with its huge contingent of crazy Tea Partiers, is going to serve in perpetuity. But this Congress isn’t going to serve in perpetuity — there are elections next year, and many of the Tea Party freshmen are likely to lose. They won in 2010 because it was a “wave election” in the middle of a very severe economic slump. But 2012 is a presidential election cycle with an incumbent Democratic president. A lot of these Tea Partiers who won in traditionally Democratic districts (and swing districts) are going to lose. In fact, it’s probably even odds that the Dems take back the House.

The simple fact is that the Tea Partiers are almost certainly at the height of their power in this Congress. And no, the debt ceiling debate doesn’t reflect some sort of secular change in US policymaking — the next time there’s a Republican president, House Republicans will be all about raising the debt ceiling, and Democrats won’t engage in the same kind of political brinksmanship. You’d have to be stunningly naïve not to believe this.

There have also been plenty of political de-escalations over the years — Republicans didn’t shut down the government every year after 1995, for instance. After Tom DeLay won the Medicare Part D vote by holding the vote open for 3 hours, everyone claimed that this would be the new normal on all controversial votes. Didn’t happen. There are plenty of one-off political confrontations. Simply assuming that every political confrontation represents a secular change in US politics and policymaking is ridiculous.

(S&P tries to side-step this obvious weakness in their so-called “argument” by claiming that by the time the 2012 elections roll around, it will be too late. Please. The idea that we have to act in the next 18 months in order to meaningfully affect our long-term solvency is patently absurd.)

Look, I know these S&P guys. Not these particular guys — I don’t know John Chambers or David Beers personally. But I know the rating agencies intimately. Back when I was an in-house lawyer for an investment bank, I had extensive interactions with all three rating agencies. We needed to get a lot of deals rated, and I was almost always involved in that process in the deals I worked on. To say that S&P analysts aren’t the sharpest tools in the drawer is a massive understatement.

Naturally, before meeting with a rating agency, we would plan out our arguments — you want to make sure you’re making your strongest arguments, that everyone is on the same page about the deal’s positive attributes, etc. With S&P, it got to the point where we were constantly saying, “that’s a good point, but is S&P smart enough to understand that argument?” I kid you not, that was a hard-constraint in our game-plan. With Moody’s and Fitch, we at least were able to assume that the analysts on our deals would have a minimum level of financial competence.

I’ve seen S&P make far more basic mistakes than the one they made in miscalculating the US’s debt-to-GDP ratio. I’ve seen an S&P managing director who didn’t know the order of operations, and when we pointed it out to him, stopped taking our calls. Despite impressive-sounding titles, these guys personify “amateur hour.” (And my opinion of S&P isn’t just based on a few deals; it’s based on countless deals, meetings, and phone calls over 20 years. It’s also the opinion of practically everyone else who deals with the rating agencies on a semi-regular basis.)

Treasury has every right to be outraged. S&P mangled the economic argument so badly that they had to abandon it entirely, and then fell back on a political argument which they are in no position to make, and which isn’t even correct.

So to S&P, I say: you should be ashamed of yourselves, and I truly hope this is your downfall.

Should House Dems Support the Debt Limit Deal?

2011-07-31T23:55:00.000-04:00

I’m torn on this one. By any objective measure, the deal is really, really bad public policy. And the one thing that really scares me about failing to reach a deal — defaulting on Treasuries, which would be beyond catastrophic — has been taken off the table by the Treasury, which said that it will prioritize interest payments.

The relevant question in this situation, however, is whether a revolt by House Democrats could move the bill to the left. I think it could, but it unfortunately depends on what the Tea Party freshmen do. The way I see it, the only way the deal moves to the left is if it fails in the House because of a significant Tea Party revolt.

If Boehner loses so many Tea Partiers that he can’t possibly expect to win them back, then his only option will be to pass a bill with the Dems. If that happens, then the Dems could — and should — extract significant concessions from Boehner in exchange for their support. And I think Boehner would absolutely be open to making significant concessions. When Boehner was whipping for his bill last week, he was telling Tea Party freshmen that if his bill failed, then he was going to introduce a clean debt limit bill and pass it with the Democrats and 30 moderate Republicans.

I still think Boehner can be forced into that position — but only if there’s absolutely no chance that he can win enough Tea Partiers to pass a bill with just Republicans. If the deal fails in the House because something like 5–7 Tea Partiers vote no, then Boehner can still probably pick off enough Tea Party holdouts to pass the bill on a second try. But if the deal fails and Boehner loses 20–30 Tea Partiers, then there are no changes that he could realistically make to win them back. His only option would be to pass a bill with the Dems and 30 moderate Republicans. (And yes, I think the Senate will pass whatever deal the House sends them. McConnell would pass a clean debt limit bill if he really had to.)

So at this point, I think House Dems should vote against the debt limit deal. If Boehner/Cantor/McCarthy have enough juice to pass the deal with just Republicans, then good for them. Make them own it though. I’m sure a few conservative House Dems (e.g., Shuler, Matheson) will vote for the deal, but hopefully Pelosi can hold the line with the rest of the caucus.

Dodd-Frank: One Year Later

2011-07-21T17:38:00.000-04:00

For Dodd-Frank’s one-year anniversary, I did an interview with Mike Konczal on how the first year went. You can read the interview here. Unlike the vast majority of commentators who have been talking about Dodd-Frank this week, I’ve been following the rulemaking process very closely (as regular readers know), and I have some positive things to say.

You should also read Mike’s interview with Marcus Stanley, who is the legislative director for the progressive group Americans for Financial Reform. Like me, he’s intimately familiar with the Dodd-Frank rulemaking process, and he also has positive things to say. Funny how that works!

"Wall Street" Has No Sway Over the Tea Party Freshmen

2011-07-17T23:56:00.000-04:00

Dean Baker has a column in the Guardian (via Mark Thoma) arguing that:

The idea that Republicans in congress were going to force big cuts in the country’s most important programs – social security, medicare, and medicaid – by taking Wall Street hostage with the debt ceiling is absurd. It was only necessary for President Obama to call their bluff.

The bottom line is that the debt ceiling is a gun pointed first and foremost at Wall Street’s head. And, there is no way on earth that Wall Street is going to let the Republicans pull the trigger.

This is silly. “Wall Street,” by which Baker means the major banks, has very little sway over the 87 Tea Party freshmen. It’s the GOP freshmen who are currently the key constituency in the debt ceiling negotiations, and if anything, most of them would take pride in rejecting impassioned pleas from JPMorgan and Goldman Sachs. The idea that the major banks can just snap their fingers and get the Tea Party freshmen to drop their debt ceiling demands is beyond ridiculous. The Tea Party freshmen are thoroughly crazy, and there’s no telling what they’ll do. But if you think they’re all tools of Wall Street, then you simply haven’t been paying attention.

Of course, making this argument allows Dean to — what else? — blame Obama, this time for not “calling their bluff.” (It’s easy to call bluffs from the sidelines, isn’t it?) Which, let’s be honest, was the point of his column anyway.

Obama and the “Grand Bargain”

2011-07-11T07:05:00.000-04:00

What are we to make of Obama’s “grand bargain”? My initial reaction to the news that Obama was putting Social Security and Medicare cuts on the table was despair. What was/is the White House thinking? Obviously, no one outside the White House knows for sure, but I think I have a pretty good idea.

As I said in a DM exchange with Mike Konczal on Wednesday night, I think the White House is trying to scare Democrats into accepting a deficit reduction deal with little or no revenue increases. I think Boehner can’t get the votes in the House for a deal that includes any revenue increases, and I think the White House knows it. They know that the final deal will end up being 100% spending cuts. The problem with this is that it might not get enough Dem votes to pass — especially if Dems on the Hill are obsessing about the ratio of spending cuts to revenue increases throughout the negotiations.

So in order to retain enough Dems, the White House needs to make sure that the $2 trillion, all-spending-cuts deal is the “compromise” position. If the alternative is an even larger deficit reduction deal that includes savage cuts to Social Security and Medicare, then plenty of Dems will be downright eager to vote for a deficit reduction deal that doesn’t touch Social Security or Medicare, even if it is 100% spending cuts. If you know that the final deal will be 100% spending cuts, then you don’t want the Dems to make their “line in the sand” the inclusion of revenue increases. By putting Social Security and Medicare on the table, you allow the Dems to make the protection of those programs their “line in the sand,” rather than the inclusion of revenue increases. And that will free enough Dems up to vote for the final, all-spending-cuts deal.

This would also explain why Obama is still saying that he wants a “grand bargain,” even after Boehner said that they should focus on the smaller deal that the Biden-led group had been working on — for the strategy to be effective, the grand bargain needs to continue to be a viable option (that the Dems are afraid of).

Now, we can argue about whether Obama truly wants to strike a “grand bargain” that cuts Social Security and Medicare. I don’t know if he does, and neither do you. (It’s certainly possible that he does, but again, I don’t know.) However, I think that question, interesting though it may be, is ultimately irrelevant. Even if Obama truly does want a grand bargain, there’s simply no way that he thinks they can agree on $1 trillion in tax increases, and an overhaul of Social Security, Medicare, and Medicaid, all in under 2 weeks. Purely as a legislative matter, it’s almost an impossible task, which I’m sure Phil Schiliro would have explained to him. So really, the only way the “grand bargain” makes sense is if it’s a negotiating strategy.

And if this is a negotiating strategy, the best explanation is that the White House is using the threat of Social Security and Medicare cuts to scare Democrats into voting for an all-spending-cuts deal.

Collateral Transformation Services: What Could Possibly Go Wrong?

2011-07-05T22:18:00.000-04:00

Risk has an interesting article ($) on the plans by some dealers to offer “collateral transformation” services to derivatives end-users. Requiring most derivatives to be cleared means that end-users will have to post daily variation margin to the clearinghouse (or “CCP”). Here’s how Risk describes the problem:

The problem centres on the type of collateral required by CCPs — or more specifically, the fact that many end-users don’t hold enough of it. Clearing houses only accept cash for variation margin, and usually insist on cash or sovereign bonds for initial margin. However, many buy-side users of derivatives tend not to invest in these assets — at least, not in the amounts that might be necessary.
...
Clearing members [i.e., the dealers] say they have a solution. ... [C]learing members are responsible for collecting margin from their clients and posting it to the clearing house, charging a fee for the privilege. As an additional service, however, a number of clearing members are also planning to offer collateral transformation facilities — essentially, enabling the client to post non-eligible instruments with the dealer, which will be switched into cash via the repo market and then posted with the CCP.

So the plan is to concentrate liquidity risk at the dealer banks? Gee, what could possibly go wrong?

In all seriousness though, this is something that regulators should pay very close attention to. It’s easy enough* for dealers to tell regulators that their exposure is limited because the agreements are “unconditionally revocable” — that is, the dealer can unilaterally refuse to fund the client’s variation margin if the markets get too rough, and can demand that the client put up the cash. But it’s not nearly as easy for the dealer to tell its big hedge fund and pension fund clients to take a hike during a crisis. Think about it. If, say, Morgan Stanley refuses to fund a client’s variation margin call when the markets get volatile, the client will (a) be pissed, and (b) will start thinking, “What’s going on here? Is Morgan Stanley having trouble accessing the repo markets? If they can’t fund themselves in the repo markets, how much longer can they stay in business? Shit, I better pull my prime brokerage account at MS.” Then the run begins.

I’m not saying that no dealer would ever be able pull the trigger and refuse to fund a client’s variation margin. I’m just saying that this kind of arrangement could very easily turn into a non-contractual commitment to meet clients’ variation margin calls during a crisis. And that would undermine the dealers’ inevitable argument about how the unconditionally revocable nature of the arrangements means that the liquidity risk would be pushed back onto the clients — and away from the dealers — during a crisis.

So what should regulators do about “collateral transformation”? Well, for one thing, they should treat collateral transformation very harshly in Basel III’s Liquidity Coverage Ratio (LCR). Since these arrangements would almost certainly be structured as unconditionally revocable, they would be considered “Other Contingent Funding Liabilities” under the LCR. The run-off rate for “Other Contingent Funding Liabilities,” which determines the size of the liquidity buffer the dealers would have to hold against their collateral transformation arrangements, has been left to the discretion of national regulators. In addition to the run-off rate, national regulators also have to come up with assumptions for how much clients’ variation margins could move against dealers in the LCR’s 30-day stress scenario.

The safest route would be to set the run-off rate at 100% — that is, to assume that the dealers will fund 100% of clients’ variation margin through their collateral transformation services. A 75% run-off rate would probably be appropriately prudent as well — dealers will probably be able to say no to at least some clients, and will likely come up with other ways to mitigate some of the risk to themselves.

———————

* Actually, drafting and negotiating these types of contracts is a fiendishly difficult and contentious process, but that’s neither here nor there.

SIFIs and Capitalism

2011-06-29T06:37:00.000-04:00

Thomas Hoenig garnered a bunch of headlines the other day for, as usual, making a provocative and hyperbolic statement about financial reform. Discussing the concept of systemically important financial institutions (known as SIFIs), Hoenig said:

“I suggest that the problem with SIFIs is they are fundamentally inconsistent with capitalism. They are inherently destabilizing to global markets and detrimental to world growth. So long as the concept of a SIFI exists, and there are institutions so powerful and considered so important that they require special support and different rules, the future of capitalism is at risk and our market economy is in peril.”

Oh no! The future of capitalism itself! Not surprisingly, Hoenig doesn’t explain this bizarre assertion; he just makes the provocative statement and moves on, which is par for the course for him. Of course, anyone who understands this issue beyond the level of superficial sound-bites knows that Hoenig’s claim is ill-informed nonsense.

It’s true that SIFIs are subject to “different rules” — they’re subject to more stringent regulations, and to more conservative capital requirements. They’re subject to a prompt corrective action (PCA) regime, liquidity requirements, resolution plans, enhanced public disclosures, and additional stress tests. (I know what you’re thinking: “How did the big banks convince Congress to shower them with all these goodies? Is there no end to the corruption?”)

SIFIs are also likely (though not automatically) subject to the Title II resolution authority, which makes it easier for SIFIs to fail. The Title II resolution authority mirrors the FDIC’s resolution authority for commercial banks, except Title II is more stringent — e.g., unlike the resolution authority for commercial banks, Title II doesn’t permit “open-bank assistance” for SIFIs. And back during the nationalization debate, Hoenig was absolutely convinced that the resolution authority could successfully wind-down even the largest, most complex financial institutions.

So if SIFIs can in fact fail just like any other bank under the new resolution authority (which Hoenig has said they can), and the only difference between SIFIs and other banks is that SIFIs are subject to more stringent regulations, how exactly are SIFIs threatening the future of capitalism? The answer, of course, is that they’re not. This is just Hoenig looking to get in the papers by saying something mean about the Big Banks.

Just remember that Hoenig is also the guy who’s been warning about runaway inflation for the past two years, and who thinks the Fed shouldn’t “bring [unemployment] down too rapidly.” So take him seriously at your own peril.

Capitol Capitalist

2011-06-26T18:45:00.000-04:00

Sorry I haven’t been able to post much lately; work has been very busy, and I’ve been on the road quite a bit. In the meantime, though, I urge everyone to check out Capitol Capitalist, a new blog on financial regulation by Sara Hanks. Hanks is a longtime securities lawyer, and also served as the General Counsel of the Congressional Oversight Panel (which was created to oversee TARP, and was led by Elizabeth Warren). So she absolutely knows her stuff.

Hanks described the blog to me as “a light-hearted and entertaining take on some very serious subjects, speculative rather than in-depth analysis, with a dollop of silly sci-fi references.” But based on the first few posts, which make several very astute points, I think she might be underselling the seriousness!

In any event, I highly recommend that you check it out.

Deathbed Designations

2011-05-14T12:13:00.000-04:00

One of the biggest issues outstanding in financial reform is which institutions the Financial Stability Oversight Committee (FSOC) will deem “systemically important,” and thus subject to all the enhanced Title I regulations. These systemically important financial institutions, known as SIFIs, will presumably be subject to the new resolution authority rather than the bankruptcy code — although for some reason SIFIs aren’t automatically subject to the resolution authority, a problem which I pointed out within hours of the Treasury releasing its initial legislative language back in 2009. In spite of that anomaly, SIFIs will be required to continually submit comprehensive “resolution plans” to the FDIC, so that the FDIC will have all the information they need to plan, design, and execute a successful resolution of a SIFI. As I’ve said before (see here and here), and as Sheila Bair has been emphasizing repeatedly in recent weeks, the resolution plan requirement is hugely important.

Dodd-Frank does, however, leave open the possibility that a failing financial institution could be designated as a SIFI at the last minute, and then immediately handed over to the FDIC to resolve under the new resolution authority. In that situation, the FDIC would be forced to resolve an institution without the benefit of a resolution plan — that is, without the comprehensive information on organizational structure, funding practices, major counterparties, etc., that will be required in resolution plans. Bair calls these “deathbed designations” (which, you have to admit, is a clever name), and has been understandably arguing that this situation “should be avoided at all costs.”

But how do you avoid “deathbed designations”? Bair argues that the FDIC should be allowed to collect information from a broad class of potential SIFIs:

[W]e need to be able to collect detailed information on a limited number of potential SIFIs as part of the designation process. We should provide the industry with some clarity about which firms will be expected to provide the FSOC with this additional information, using simple and transparent metrics such as firm size, similar to the approach used for bank holding companies under the Dodd-Frank Act. This should reduce some of the mystery surrounding the process and should eliminate any market concern about which firms the FSOC has under its review. In addition, no one should jump to the conclusion that by asking for additional information, the FSOC has preordained a firm to be “systemic.” It is likely that, after we gather additional information and learn more about these firms, relatively few of them will be viewed as systemic, especially if the firms can demonstrate their resolvability in bankruptcy at this stage of the process.

Frankly, I don’t see any other option. Bair is right that “deathbed designations” are the worst of all worlds. At the same time, we can’t rely on the FSOC to accurately identify every single SIFI ahead-of-time, in perpetuity.

The question, then, is: how much and what kinds of information should the FDIC collect from potential SIFIs? One thing to keep in mind is that the FSOC, in figuring out which institutions should be designated as SIFIs, will necessarily be collecting some information from potential SIFIs as well. But that information probably won’t be the same information that the FDIC would ideally want to collect — and since the FDIC is the one responsible for planning and executing these difficult resolutions, I think they should have reasonably broad discretion to say what information they need to collect ahead-of-time.

I think the best approach would be to allow the FDIC to collect the important information that isn’t constantly changing — e.g., typical funding practices mapped the institution’s legal structure, descriptions of the institution’s major business lines, potential acquirers of the major business lines, and so on. Detailed balance sheet information at major financial institutions is typically stale in a matter of days, so requiring that kind of information would probably be more trouble than it’s worth (especially if the institution has 10-Qs and 10-Ks available).

I also don’t see why the required information couldn’t be collected from potential SIFIs discreetly. That would eliminate Bair’s concern about people “jump[ing] to the conclusion that by asking for additional information, the FSOC has preordained a firm to be ‘systemic.’” Financial institutions communicate confidentially with regulators all the time, and I don’t see why this should be any different.

In any event, it’ll be interesting to see if Bair can press upon the FSOC to create this separate information-gathering authority.

Palin vs. Wall Street

2011-05-14T09:55:00.002-04:00

Josh Green has a good article in the Atlantic Monthly about Sarah Palin’s tenure as governor of Alaska. Near the end, Green wonders what would have happened if, after the collapse of Lehman Brothers, Palin had led the anti-Wall Street charge:

What if history had written a different ending? What if she had tried to do for the nation what she did for Alaska? The possibility is tantalizing and not hard to imagine. The week after the Republican convention, Lehman Brothers collapsed, and the whole economy suddenly seemed poised to go down with it. Palin might have been the torchbearer of reform, a role that would have come naturally. Everything about her—the aggressiveness, the gift for articulating resentments, her record and even her old allies in Alaska—would once more have been channeled against a foe worth pursuing. Palin, not Obama, might ultimately have come to represent “Change We Can Believe In.” What had he done that could possibly compare with how she had faced down special interests in Alaska [i.e., the oil industry]?

This would’ve been a sight to see — especially if McCain and Palin had won. I think I can say with a high degree of confidence that Wall Street would not have taken kindly to this. (And by “Wall Street,” I’m primarily referring to the big sell-side banks.)

Unlike the oil industry, which is used to the rough-and-tumble of partisan politics, Wall Street is generally unaccustomed to being broadly vilified by mainstream politicians (as the thin-skinned reactions to financial reform from the likes of Jamie Dimon can attest). Much of Wall Street’s self-image is tied up in the idea that they occupy a higher intellectual plane than everyone else — especially all those poli-sci majors and journalists down in DC.

Having that idea openly and vigorously attacked by any VP would be a huge blow to the Street’s ego, but if it had come from Vice President Palin, I think some heads would have literally exploded in lower Manhattan. Because Wall Street is famous not only for its culture of arrogance, but also for its culture of sexism. Having a proudly unsophisticated, female politician like Palin leading what would undoubtedly have been a ham-fisted, populist-driven effort at financial reform would have been too much for Wall Street to handle.

What’s more, Wall Street would not have known how to respond. Whereas the oil and tobacco industries are used to winning legislative battles by essentially paying off key politicians through campaign contributions, Wall Street, pre-Lehman Brothers, derived the vast majority of its vaunted political power from its ability to convincingly tell politicians and their staffers that “this is all very complicated, and you shouldn’t worry your pretty little heads about it.” (This is a very underappreciated point.) The Street was going to lose its ability to play that card regardless of who won the election, but it would’ve been worse if McCain and Palin had won, because Palin would almost certainly have taken that argument and used it against Wall Street — much in the same way that she turns the tables on the “lamestream media” when they condescend to her. And since Wall Street is practically a market-maker in condescension, the condescension directed at Palin would have reached epic proportions.

Of course, if McCain and Palin had actually won the election, there’s a 0% chance that Palin would’ve been allowed to lead any sort of anti-Wall Street charge. Treasury Secretary Phil Gramm — a hall-of-fame Wall Street sucker — would never have allowed it.

Don’t Bring a Knife to a Gunfight, Lehman Resolution Edition

2011-05-13T12:42:00.001-04:00

Not wanting to waste too much more time dealing with someone who is either unable or unwilling to understand the issues, I’ll confine myself to the worst mistakes in Yves Smith’s latest post. She’s really grasping at straws at this point.

“The FDIC showing up on site and digging through records runs the very real risk of kicking off an even faster response than the Bear rumors did.”

Let me make this clear, yet again: the FDIC would already have permanent on-site personnel, under their Title I resolution plan authority. Since resolution plans are an ongoing process, the FDIC’s on-site personnel would already be routinely requesting the exact same type of information that they would be requesting during pre-resolution due diligence. So this would not have been a situation where there are no FDIC personnel at Lehman, and then suddenly a bunch of FDIC people show up, telegraphing the resolution. How many times does this need to be explained to Yves before she processes it?

“Dodd Frank has no force under English law. That means that the FDIC cannot prevent contract termination for agreements under English law. The FDIC and EoC can huff and puff all they want, but the US regulators do not have the power to overturn foreign statutes and case law.”

Neither I nor the FDIC ever said that Dodd-Frank has any force under English law. The FDIC explicitly stated, however, that it would have conditioned its P&A for the holding company on the acquirer’s acceptance of LBIE (Lehman’s UK broker-dealer). That does not require Dodd-Frank to have any force under English law. It would also mean that LBIE would not have had to file for bankruptcy in the UK (or “administration,” as they call it across the pond), which would have prevented the vast majority of contract terminations for contracts under English law. This is not that difficult to understand.

“Let’s assume that the FDIC had moved to resolve Lehman in March of 2008. What might a smart foreign creditor do? Well, if his agreement with Lehman was under English law, he could argue that the fact that Lehman was being resolved meant it was trading insolvent and it needed to put into administration now to protect him from exposure to further losses.”

Huh? Yves is confusing the start of the pre-resolution planning process (in March 2008) with the actual resolution (in September 2008) — an extremely basic distinction. The FDIC starting the pre-resolution planning process is not termination event, so no, foreign creditors could NOT have pre-emptively put LBIE into administration.

“And the critical point is that Barclays was NOT ready to buy Lehman, unless a liquidity backstop was in place. This has been widely misreported in the US, and EoC falls right into line with that bit of PR, blaming the FSA for killing the Barclays deal.”

This isn’t accurate — and the FSA paper (which is of dubious accuracy in the first place) doesn’t say what Yves claims it says. What prevented Barclays from buying Lehman was indeed the issue of a guarantee of Lehman’s trading obligations. But it wasn’t because they weren’t willing to guarantee Lehman’s trading obligations — that is, it wasn’t the economics of the deal. It was because in order to issue the guarantee, they needed the FSA to waive the UK’s Listing Rules, which required shareholder approval for such a guarantee. The FSA was unwilling to provide that waiver. But Barclays was willing to buy Lehman, contingent on the waiver from the FSA.

“We’ve said before that Economics of Contempt too often relies on slurs and rhetorical tricks, waving his credentials as a securities lawyer when he is on weak ground. His latest post is an extreme example of his reliance on distortions to cover for a bankrupt argument.”

Actually, I didn’t mention my credentials at all. Good try though.

As for which one of us “is simply not to be trusted,” I’m going to go out on a limb and say it’s the one who has made a series of basic legal and factual mistakes.