Amusing quotes of the day

Quote 1

Because the FDIC does not provide insurance for the liabilities of a non-bank financial company, the super powers contained in the bank insolvency statute are inappropriate when applied to non-bank financial companies, regardless of whether a systemic risk determination has been made.

Timothy Ryan of Sifma argues that creditors to “too big to fail” firms should be granted the protections of the Bankruptcy Act in the law that acknowledges that these creditors will never be subject to the discipline imposed by the Bankruptcy Act.  The basis for this view is apparently that there is no government guarantee for “too big to fail” firms.  Hmm.

Quote 2

part of being a bank is trying to hedge as much of your [credit] risk as possible

Dan Indiviglio is just stating a fundamental principle of 21st century “too big to fail” banking.  For centuries  banks were viewed as playing an important role in the process of credit allocation precisely because the asset side of a bank’s balance sheet was full of loans that only the bank had the information to value correctly — that is, a bank’s job was to evaluate and carry credit risk for the rest of the economy.  So just what is it that modern “too big to fail” banks are supposed to be contributing to the economy nowadays?


Thoughts on measuring liquidity

Liquidity is a notoriously ill-defined concept.  On the stock market I think liquidity should be defined as the ease with which you are able to sell your holding at (that is without causing a decline in) current prices.  The most important measure of liquidity is then likely to be the demand for your position at current prices.  An important contrary indicator would be supply of your position at current prices.

Thus I propose that the SEC use as one measure of daily stock market liquidity for each stock:  the dollar value of purchases that resulted in an end of day increase in the buyers’ holdings of the stock.  An important related measure would be reverse liquidity or the dollar value of sales that resulted in an end of day decrease in the sellers’ holdings of the stock.  To keep the definition of the entities trading in the market from being gamed, the SEC would probably have to track these trades using something like the entity’s tax ID number.

These measures of liquidity would have the benefit of ignoring day traders and other trend followers that do little or nothing to ensure that the market is robust at current prices.

It is true that the end of day measure is chosen at random and thus that it would make sense separate hourly, daily, weekly, monthly and annual measures of liquidity.

Another advantage for the SEC of collecting comprehensive data on the trades of investors with a longer-term horizon is that the SEC would have the information necessary to assess whether current market practices impose a tax on long horizon investors by causing them to buy at higher prices and sell at lower prices than the noise traders.

An odd error

Following the collapse of Long Term Capital Management more than 10 years ago, a government report called for derivatives market reform. The report, issued by the President’s Working Group in April 1999, noted that “market history indicates that even painful lessons recede from memory with time”.  Sure enough, once the LTCM headlines disappeared, the impetus for reform vanished.
Kenneth Griffin, Financial Times

Hmm.  Sounds like Kenneth Griffin, the founder of Citadel hedge funds, has never heard of the 2005 Bankruptcy Reform Act.

On “too big to fail” financial markets

Yves Smith is confused by the fact that the securitization industry wasn’t carefully following legal procedure as it sold mortgages from one bank to another and then into the securitization trust.

But it isn’t surprising that judges are plenty unsympathetic, and in cases, outraged. The law is all about sanctity of process, both the underlying law and court proceedings. Cases typically revolve around disputes of fact or grey areas of the law. This isn’t grey (whether a party has standing to file a suit is fundamental) and the law in this area is well established. Basically, the securitization industry tried creating rules outside any established legal framework and judges are having none of it.

She and anybody else who’s confused about the financial industry’s modus operandi when it comes to the law over the past few decades needs to read Kenneth Kettering’s Securitization and its Discontents.

Kettering makes a simple point:  Whether you’re talking about repos or standby letters of credit or any of a number of financial practices of questionable legality, the financial industry has found that the best way to get the law rewritten in their favor to create a “too big to fail” market in the contract.  Once the market is so big that enforcing the law will create large scale disruption in financial markets, each judge is left with a choice — made explicit in “friend of the court” briefs written by financial players — enforce existing law and risk causing a financial collapse or create some pretext for claiming that what the financial industry says is the law is in fact the law.

According to Kettering the huge securitization industry, built on dubious legal foundations, is just the continuation of a long standing process used by the financial industry to overturn centuries of legal precedents and generate precedents and laws that favor the financial industry.

On “Too Difficult to Resolve”

Yves Smith quotes Robert Johnson explaining why a resolution authority will fail when “too big to fail” financial institutions are wrapped in a web of complex derivatives.  He calls these unresolvable institutions “too difficult to resolve”:

Yet opaque, complex entangled derivatives exposures would serve to deter the authorities from invoking those powers [granted by the resolution authority] and taking over a failing institution for fear of setting off a system wide calamity of magnitudes that policy officials can dread but not understand or estimate. Complex entanglements through derivatives exposures discourage government officials who are the risk managers on behalf of the citizens of our nation from invoking and using those powers. The spider web of complex opaque derivatives renders enhanced resolution powers impotent.

It is in this respect that complex and opaque derivatives exposures at large financial institutions contributed mightily to a policy of induced forbearance, as we witnessed in the first quarter of 2009. That experience, as we have seen, was very demoralizing to our citizens who have put their faith in philosophies that emphasize the use of markets as a mechanism for achieving social goals. The inhibitions that authorities experience in applying market discipline to large financial institutions and their managements tend to undermine belief in the use of markets.

What makes induced forbearance of TDTR institutions even more troubling is that their potential creditors would understand that they will not have their debts restructured when government officials are deterred by complex derivative exposures from taking a TDTR institution into receivership and restructuring the entity. …

While there is no question that derivatives make the resolution process more difficult, standard procedure (that is, the rules for FDIC receivership) gives regulators a powerful tool:  They have the right to move the failed institution’s derivative portfolio — or a portion of the derivatives portfolio as long as each portfolio that relates to a specific counterparty is kept intact — to another institution or bridge bank.

I commented on this issue over at Naked  Capitalism and I think I overstated the degree to which Yves is correct that derivatives make resolution very difficult. Yves explained her view that the transfer of the portfolio will not work in a comment:

You can’t just “move them [the derivatives] over.” They trade in relationship to cash markets, and most are hedged dynamically, meaning positions are adjusted several times a day. And the derivatives are used to manage risks in the cash books. Banks and financial firms would have to sell a simply enormous amount of cash positions if they could not lay off risks via derivatives.

This would be like trying to remove someone’s colon using a hacksaw with no anesthesia.

You’d need a bigger balance sheet than that of all the banks (ie, this becomes the biggest commitment of the central bank). You also need people to manage the positions, the trading tools, and the computer infrastructure to manage and monitor positions.

As long as regulators prepare carefully, they can deal with all three of these issues.  First, clearly they need to build the structure for the bridge bank which will handle the derivatives well before they have a bank to resolve.  This is a challenge, but hardly insurmountable.  Secondly, they will need to develop  criteria for determining what derivatives the bridge bank will sell to the resolved bank to replace the derivative hedges that have been stripped by the portfolio transfer.  Thirdly, the resolution authority will need to provide temporary liquidity — possibly in the form of a DIP loan — to give the regulators and the resolved bank time to work through all the issues that are sure to arise in such a procedure.

Would the process be complicated and awkward?  Absolutely.  But that’s not the question we need to answer.  The real issue is:  Would it be better than simply handing out money to insolvent private institutions?  Rob Johnson is concerned that our regulators won’t use the resolution process, even when it’s available to them.  I, on the other hand, think that once the authority has been passed, public opinion will force regulators to use the resolution authority.

Think of how much better AIG could have been handled with a resolution authority in place.  Counterparties who did not buy poorly capitalized CDO protection from AIG could have had their contracts transferred into a bridge bank.  Then when AIG defaulted on its derivative liabilities only those who faced dramatic losses would have had the right to terminate their contracts.  For domestic institutions, any bank that was insolvent after the AIG losses would be put through resolution itself.  Foreign institutions would be a political matter and might well be addressed by government to government transfers.

Alternatively in an environment where it was clear that all the major derivative dealers were insolvent (which was arguably the case in Fall 2008), a single bridge bank could be used to resolve all the dealers simultaneously, creating a central counterparty for derivative contracts in one fell swoop and flattening out a lot of the complexity in the market.   Once again the problem of liabilities to foreign institutions would have to be dealt with via political channels.

Despite the fact that I think that a resolution authority is a good idea and is essential to help address current financial problems, Rob Johnson makes an important point in calling for “a drastic simplification of derivative exposures”.  I think everyone can agree that the best option would be a financial system where a resolution authority is not needed.

The best way to create a financial system which would not use a resolution authority even after it was enacted is to follow the recommendations made in this series of posts:

(i) Prohibit large financial entities from posting collateral on over the counter derivatives.  Eliminating the reliance on collateral in interbank transactions will force financial institutions to evaluate the credit risk of their counterparties.  Healthy concern for credit risk would do wonders to reduce “interconnectedness” in financial markets.
(ii) Repeal the repo related amendments to the bankruptcy code that were passed in 2005.  Eliminating illiquid assets from the repo trade is the best way to put an end to the type of interbank bank run that took down Bear Stearns and Lehman Brothers.

Comments on Frontline’s “The Warning”

The Frontline program, “The Warning“, reports on Brooksley Born’s effort to gain an understanding of over the counter derivative markets.  There are a few things that should have been made more clear than they were:

(1)  The Concept Release issued by the CFTC in 1998 did not in fact propose any regulation of over the counter derivatives. All it proposed was that regulators gather enough information about the market to determine whether or not regulation was necessary.

The opposition she faced under these circumstances was simply inexcusable. The “regulators” took the position that they didn’t even want to gather enough information to understand what it was they were supposed to be regulating. They chose very deliberately to fly blind and ridiculed Brooksley Born for pointing out that flying blind is a bad idea.

(2)  Their response to the Concept Release was to cut down not only the protections that had been put in place by Roosevelt in the form of CFTC and SEC regulation of all legally enforceable derivatives, but also the traditional common and state law provisions that had protected financial markets from excessive growth of speculative derivative contracts for more than a century.  Thus the Commodity Futures Modernization Act destroyed a financial infrastructure that had been carefully developed over centuries of experience with financial contracts.

For more on this issue see here.

The double taxation canard

I’ve never understood the argument that corporate equity is taxed twice.  It seems to be based on simplistic economic models where the owners of the firm are identified with the firm itself, but bankruptcies never take place.

Of course, corporations exist mostly because they grant the owners limited liability in the event of bankruptcy — so it’s pretty clear that any economic model that does not have corporate bankruptcies in equilibrium does not actually have anything to say about corporations.  Limited liability is possible because corporations are persons under the law.  For the same reason corporations have to pay their own taxes and economic models that confound the corporation with its owners fail to capture what a corporation is.  Equity owners who want to avoid “double taxation” have always had the option of forming a partnership.

Double taxation is a canard that exists mainly because economic models don’t capture the costs and benefits of corporations.

Still waiting for the real reform bill

I think I suffer from excessive optimism.  I read harsh critiques of Congress’ and the Obama administrationsregulatory efforts, and I can’t help thinking:  “But this can’t be the real plan.”  The stakes are simply too high to fail at this juncture.  So what’s running through my mind is:  They must be playing a deep game, and have a plan for getting a real reform bill passed.

And then I think maybe my optimism is crazy and pessimism takes over.  Maybe gutted laws are all that will pass and American financial infrastructure will be allowed to continuing careening along at this breakneck pace until it goes completely off the rails taking the world economy with it.

It shouldn’t be possible, but does that mean anything in the world we live in?

You tell me which view is crazy:  optimism or pessimism?  And what can we do to ensure that the optimistic view wins out.

Re comments

My apologies to the two commenters from a month ago whose comments I didn’t approve in a timely manner only because I didn’t know that I needed to do so.   To be honest, I’ve received so few comments I didn’t even notice that I had comments until today.

Comments are, of course, always appreciated, so please don’t take offense.

Update:  I’ve fixed the email notification for comments so I will now actually know when a comment is posted.