The problem with narrow banking

A number of people have proposed that one solution to the problem of financial instability is narrow banking.  While the less extreme version of narrow banking (John Kay) appears to be an application of the Volcker Rule (which I think makes sense), a more extreme version (Greg Mankiw via DeLong) proposes that banks should no longer be leveraged institutions.

What I think proponents of the latter view are missing is that the modern business cycle to which we have become accustomed relies fundamentally on flexibility in the money supply — after a recession has eliminated the excesses of the previous boom and the vast majority of the firms that remain are reasonably run and have sound business plans, lending money to support economic growth becomes a win-win solution for everybody.  These businesses need to be able to borrow and everybody’s welfare is improved by allowing them to borrow without any form of rule-bound constraints.

While it is theoretically possible for commercial paper and bond markets to meet the borrowing needs of small and medium sized enterprises (SMEs), to date the problem of creating means for SMEs to access market based lending has yet to be effectively addressed.  So we are left — as our ancestors were before us — with relying on banks to make appropriate decisions about lending to SMEs — and to support robust recoveries from recessions.  If we take away from banks their ability to “create money” by drawing up a loan and issuing funds in form of deposits to the borrower, we take away from them their capacity to lend according to the economic demands of the business cycle, we take away the flexibility of the money supply that is natural to a banking system with fractional reserves — and, I suspect, we do grave damage to the infrastructure that drives the economic growth that pulls us out of recessions.

The benefits of the “speculation in sovereign debt” brouhaha

Well, screaming good and loud about manipulation and speculation in derivatives may actually have some advantages afterall — even when the accusations are groundless.  Don’t know many people who believe in the regulation of finance that will complain about this outcome.

Why regulators waited until September to fail Lehman

Andrew Sorkin at the NYTimes (via Yves Smith) notes that the NYFed and SEC knew all about Lehman’s dubious accounting over the summer of 2008 and didn’t do anything.  He poses two explanations:

Indeed, it now appears that the federal government itself either didn’t appreciate the significance of what it saw (we’ve seen that movie before with regulators waving off tips about Bernard L. Madoff). Or perhaps they did appreciate the significance and blessed the now-suspect accounting anyway.

More realistically the regulators knew Lehman was going down, but they also know that the infrastructure of the CDS market couldn’t support the failure of an investment bank until some clearing mechanism was in place.  Remember that September 2008 was the date by which the dealer-brokers had committed in March 2008 that most dealers would be live with each other for central settlement submission and confirmation.  On July 31, 2008 the dealers confirmed that they were on track for centralized settlement of the CDS market in September.  On September 15, Lehman failed.

It’s my impression that no one in the financial industry thinks the CDS market had the infrastructure necessary to survive the collapse of Bear Stearns in March 2008.  The regulators spent the summer of 2008 putting that infrastructure in place — and only then let Lehman fail.

Do you think that this timing was purely coincidental?

What Lehman reveals about non-disclosing disclosures in 10Ks

For those of us who periodically try to glean genuine information about what is going on financially within a publicly listed company, this statement by the Lehman examiner, Anton Valukas, rings far too many bells:

In a few of its financial statements, Lehman stated that “The Company accounts for transfers of financial assets in accordance with SFAS 140” and followed this statement with a summary of SFAS 140’s three criteria for recognizing the transfer of financial assets as sales.3767 In these instances where Lehman made the general disclosure regarding SFAS 140: (1) the SFAS 140 disclosure was listed under “Consolidation Accounting Policies” along with a disclosure regarding Special Purpose Entities or was part of a “Securitization activities” disclosure; (2) Lehman did not state that it treated some repo transactions as sales under SFAS 140; and (3) the financial statement contained other disclosure(s) stating that Lehman treats repo transactions as secured financings (i.e., not as sales) and/or regarding securities owned and pledged as collateral (as described above).  [h/t zero hedge]

How many times have you looked for information in a financial statement, only to find a statement like “we account for sales under SFAS 140” and a cut and paste of the text of the accounting standard with minimal if any disclosure of what is accounted for using this standard, what the dollar values are of these transactions, etc.?  Reading a financial statement often leaves me feeling that 90% of the “disclosure” is just another form of non-disclosure.

Can the SEC please start randomly reviewing reports and fining firms and their auditors significant amounts for insufficient disclosure?

What proponents don’t get about credit default swaps

In the Atlantic Charles Davi tries to argue that critics of credit default swaps simply don’t understand the market.  However, his arguments don’t show that he has a clear understanding of the market himself.

With the CDS market, we have a market-based measure of the credit quality of a wide variety of debt instruments outstanding for a given issuer. This makes the credit quality of an issuer more transparent, not less.

This is incorrect, because every CDS price necessarily includes not just a premium for protection against default by the underlying, but also some premium for the counterparty risk inherent in buying protection on derivative markets.  (The existence of negative basis trades where the CDS price is below the rate paid by the bond probably reflects the fact that the CDS market — for the limited group of people who are allowed to trade these high denomination products — is indeed more liquid than the bond market.  Note that as far as I am aware, there is neither empirical evidence, nor a theoretic argument that supports the view that more liquid markets produce better prices.)  As noted in earlier posts, the only circumstance in which an over the counter derivative does not involve counterparty risk is in the theoretic example where the derivative is written by a monetary authority.

Because CDS prices necessarily confound a premium for protection against default with a premium for counterparty risk, it’s hard to understand the foundation of the argument that CDS prices give a better measure of credit quality than a model based only on the bond yields themselves — which will as rule include no credit risk premia for parties other than the issuer.

However, even if we were to grant the argument that CDS prices give a superior measure of default risk, then that would immediately indicate that price disclosure in the CDS market must be improved.  While Davi claims that

the level of publicly available information from the CDS market is on par with that from the corporate bond market

as a small scale trader, I can assure you that this statement is incorrect.  I can access intraday corporate bond bids and offers whenever markets are open.  Davi links to the only public CDS pricing data that I know of — and this only gives end-of-day prices after the market is closed.  If Davi’s argument that CDS prices are “better” than bond prices is correct then the bond market is seriously biased against small traders.

In other words, if CDS price information is as valuable as claimed, then it is inexcusable to restrict access to intraday price and quantity information to insiders like the market making banks and their biggest clients.  In short, if the CDS market produces tradable price information, then as Gensler argued it’s time for CDS to trade on exchanges so that intraday prices and quantities can be made public in real time and everybody who trades bonds can benefit from the information created by this market.

Why collateral fails to protect protection buyers

Felix Salmon claims:  “Today, there isn’t a company in the world — not even Berkshire Hathaway — which can write CDS protection without having to put up collateral.”  Felix goes on to imagine a perfect world in which regular margin calls guarantee that CDS are fully collateralized and there is no risk of failure to pay.

Unfortunately the value of CDS contracts tends to move very suddenly and it is precisely when counterparties issue large margin calls that firms like Lehman and AIG are forced to declare bankruptcy.  Collateral posting regimes may work with commodities and interest rate swaps where price movements are far less volatile than CDS, but there are many reasons to be concerned about the success of collateral posting in offsetting the risks of CDS contracts.

The OCC derivatives report has data on the fair value of derivatives from bank call reports (Table 6).  The data does not include derivatives held by investment banks at the holding company level.  It also increases by over $2 trillion in December 2008 due to the movement by Goldman Sachs of many derivatives into the Goldman Sachs bank.  On the other hand it illustrates how much the fair value of credit derivatives can change from one quarter to the next.

The chart below illustrates the sum of the gross positive and gross negative fair value of credit derivatives (red) and of other derivatives (blue) held by banks (that are subject to call reporting).

The fact that the fair value of credit derivative contracts jumped from $186 billion in March 2007 to $1 trillion in March 2008 to $2.2 trillion in December 2008 should be a matter of concern to everybody.  (Note:  GS accounts for $276 billion of the December 2008 figure.)  Can we really be confident that margining requirements will (i) be sufficient to protect protection buyers and (ii) not have the effect of pushing some protection sellers into bankruptcy?

Addendum: Another problem with trillion dollar changes in collateral needs is that to broker-dealers only accept cash collateral (and more rarely Treasuries).  In Q4 2008, it is hard to imagine that collateral could have been met without extraordinary aid from the central banks — which (i) relaxed rules for commercial banks prohibiting them from financing the brokerage assets of affiliates, (ii) lent vast quantities of cash against brokerage assets and (iii) dropped interest rates to zero making it easy to finance the costs of cash collateral.  I certainly hope that in the next credit crisis, the broker dealers aren’t relying on similar policies to facilitate their need to post collateral.

CDS cannot eliminate credit risk

After the debacle of 2008, commentators still like to assume that CDS and other derivative contracts do not involve counterparty credit risk.  (See Greycap’s comment here.)  It is astounding that the near collapse of the financial system is not enough to make people realize that the best a CDS can do is transfer your credit risk from the underlying to a counterparty.  The only circumstance in which a CDS transaction can eliminate credit risk is if the CDS protection is sold by the issuer of the currency in which it is denominated (or in the impractical scenario that initial margin is the full notional value protected).  As far as I know the central banks aren’t in the business of selling protection.

Repeat after me:  Every CDS creates counterparty credit risk.  A CDS cannot eliminate credit risk.  For a given purchaser a CDS may serve to transfer credit risk from a less credit worthy borrower to a more credit worthy counterparty — but it is impossible for a derivative to eliminate credit risk.

I’ll comment on how collateral fails to solve this problem in a future post.

Banks repaying TARP is good

While I agree with commentators like Ed Harrison that the economy and the banks are far from recovery, I don’t understand the claim that banks should not have been allowed to repay TARP money.

Of course, the big banks would be better off with more capital — and some of them are sure to either fail or do more capital raising in the near future.  TARP did provide capital to the banks, but, as the CIT failure demonstrated, it did so in the worst way possible — as a direct transfer from taxpayers to the financial system with nothing close to a fair exchange of assets.

The fact is that reversing TARP is one of the best things the Obama administration has done — especially if there’s another outbreak of financial instability in the next few years.  Given the public’s anger about bailouts, any future government aid to banks is likely to be in the form of DIP lending — which is how TARP should have been structured in the first place.  I say good riddance to a profoundly flawed bailout program.

Worrisome CDS data in the broker dealers 10Ks (Updated)

UPDATE 3-4-10: There was an error in the chart on the dealers’ “matched books” that got JPM’s 2008 exposure  wrong.  It has been corrected.

The broker dealers’ 10Ks are all up on Edgar now, so I was able to update my file on the banks’ credit derivative positions.  What’s neat about the 10Ks is that all (except for Citigroup) reported not only the notional CDS sold and purchased, but also the dollar value of CDS bought that offset CDS sold.  This latter piece of information is very useful, because when a market maker keeps matched books almost all of the contracts will have identical (“matched”) underlyings and will offset each other.  Thus, we can use this data to see to what degree each bank is acting as a “matched book” market maker and to what degree each bank is taking proprietary positions in the credit derivatives market.  (As a reminder of why I am looking at only five banks please recall that according to OCC data the five banks in the charts below hold 95% of credit derivatives in the US banking system.)

For each dealer the first two columns of the chart below look at the net notional value of credit derivatives bought divided by the total notional value of credit derivatives bought at the end of 2009 (blue) and of 2008 (red).  Thus the first two columns are a measure of how much each dealer bank is using its role as a market maker in the credit derivatives market to buy protection.

For each dealer the third and fourth columns of the chart below use the banks’ reported level of offsetting derivatives to calculate the notional value of unmatched derivatives sold and of unmatched derivatives bought.  These two numbers are added and then divided by the total notional value of credit derivatives bought and sold.  For 2009 this fraction is green and for 2008 it is purple.  Thus the second two columns give a measure of what fraction of each bank’s credit derivatives book is “unmatched”.

The most remarkable thing to note about this chart is that only JP Morgan — notably the bank with the biggest credit derivatives book of all — falls below 5% on both measures.  Of JPMs $6 trillion credit derivative portfolio in 2009 only $98 billion is either excess protection on identical names or protection purchased on other names. The other $5.9 trillion in swaps are all matched trades.

In marked contrast, Bank of America bought and sold $2.8 trillion of credit derivatives (and thus has a $5.6 trillion portfolio and no net notional), but only reports $2.3 trillion in trades with identical underlying.  This implies that the bank has half a trillion dollars of unmatched trades both bought and sold.  It would be very interesting to learn what the explanation is for such a large number of unmatched trades — and how well Bank of America is managing these positions.

Morgan Stanley, like Bank of America, has a credit derivative portfolio with a remarkable number of unmatched trades.  Even though MS has only $69 billion in net notional value of credit protection bought, once identical trades are taken into account, we find that MS has about $600 billion in credit protection purchased but not sold and well over $500 billion in credit protection sold without an offsetting position and credit protection sold on identical underlyings that exceeds protection purchased on these underlyings.  Like Bank of America Morgan Stanley needs to explain why such a large fraction of its credit derivative portfolio is composed of unmatched trades and how it manages these trades.

Goldman Sachs has also taken large positions in the credit derivative market, although it is much more conservatively positioned than Bank of America and Morgan Stanley.  It has $217 billion in credit derivatives sold that are not offset by purchases and $381 billion in credit protection purchased with no offsetting trades.  Thus, Goldman has well over half a trillion dollars of unmatched credit derivative trades.

Off the top of my head I can see two problems with this huge overhang of unmatched trades.  First of all like AIG most of the market makers seem to be using the credit derivatives market to expose themselves to losses that are multiples of their equity capital.  While the expected losses on these contracts are of course significantly less than their notional value, the sheer size of the exposures is a problem.  The chart below illustrates this by calculating the unmatched credit derivatives sold divided by equity capital.

Secondly, the fact that these banks are relying on the credit derivative market to sell them protection is also a matter for concern — because, after all, what private firm is there in the current economic environment that can be relied on to honor these contracts?  The fact that the five dealer banks that account for 95% of the US CDS market have as a group bought $430 billion in credit protection from others is hardly comforting until we know who it is that sold the protection.