Friday, September 26, 2008

Possible new sources of the financial contagion

Roubini's RGE Monitor reports that EU banks are not looking so safe, and that their collapse will not be supported by their home countries, many of whom have smaller economies individually than the US.
  • Daniel Gros/Stefano Micossi: The “overall leverage ratio” - a measure of total assets to shareholder equity - of the average European bank is 35 due to large in-house investment banking operations, compared with less than 20 for the largest U.S. banks. This means that relatively small writedowns on their assets could have a devastating impact on a bank’s capital--> some EU banks have become too big for any one European country to save while an official cross-border crisis management mechanism with ex ante burden sharing is not in place.
  • The crucial problem on this side of the Atlantic is that the largest European banks have become not only too big to fail, but also too big to be saved. For example, the total liabilities of Deutsche Bank (leverage ratio over 50!) amount to about €2,000bn (more than Fannie Mae) or more than 80 per cent of the gross domestic product of Germany. This is simply too much for the Bundesbank or even the German state
What are the implications of RGE's analysis? A US bailout is useless if a world contagion can just as easily start in Europe. Maybe we need to start looking at the alternatives. Prof. Roubini gives his idea here.

Tuesday, September 23, 2008

Bank Capital and the law of unintended consequences

Economists make much use of the term “Law of Unintended Consequences”. In brief, unintended consequences are outcomes that are not (or not limited to) what the actor intended in a particular situation. The unintended results may be foreseen or unforeseen, but they should be the logical or likely results of the action.

There have been a lot of arguments lately that a lot of the factors that led to the subprime crisis have been unintended consequences of well-intentioned government policies and regulations. For example, Economist’s View links to this argument that summarizes how the repeal of the Glass-Steagall act, the Bush tax cuts, and the low Federal funds rate have led to the current financial crisis.

Building on a previous post I had on Basel capital adequacy standards, I’d like to add that this well-intentioned set of international standards also contributed indirectly to the current mess. Basel standards recommends banks to have at least a 10% capital-to-risky assets ratio. That means, a bank needs to have at least 10% as much in capital as the amount of risky assets it invests in. By risky assets, we mean all bank lending and investments in risk-weighted assets. By capital, we mean equity capital, and in no way includes funds coming from bank deposits or bank borrowings.

Generally, the riskier an investment is, the more risk-weight it is given by Basel. A credit-grade mortgage loan will be given 50% risk weight, while a credit-grade regular consumer or corporate loan will be risk-weighted at 10%. Only investments in relatively risk-free government securities are given zero risk weight. That means, the more a bank allocates its funds to risk-weighted loans, the more it needs to have in equity capital. The more loans in a bank’s books, the higher its equity capital needs to be to maintain a capital ratio deemed adequate by Basel standards.

But raising bank equity does not happen in a vacuum. Just because a bank has sufficiently high deposits to loan out doesn’t mean shareholders will be flocking to provide it with new capital. To attract these investors, the bank would have to provide a comparable return to other investment alternatives. But to maintain the capital adequacy, the bank would have to redeploy this equity capital in low risk weight assets.

Government securities have zero risk weight, but in the environment of low Fed funds rate, the liquidity that resulted ensured that government securities provided meagre yield. Certainly not enough to increase bank earnings sufficient to attract new equity holders. So a good number of banks and insurance firms chose to put these funds into the asset class available at the time that had the next to lowest risk weight , AAA-rated CDO bonds.

Of course, the fact that these toxic CDOs made up of sub-prime loans were ever rated AAA by ratings agencies has already been widely discussed in public forums. But the fact is, banks and insurance firms, compelled by international best standards to maintain adequate equity cover, for loans in the case of banks, or for cover liabilities in the case of insurance firms, but also compelled by equity holders to provide the highest possible yield at reasonable risk, investing in AAA-rated CDOs seemed like a reasonable thing to do. Granted, much more due diligence should have been done on the underlying assets backing up these securities, but then, the presence of a rating meant that reasonable due diligence had already been done by experts on these matters.

So here we are, with banks loaded up with toxic securities, and no willing market to buy them out. At least, nowhere close to what the banks think they should be worth. With no willing market, the reasonable value for these securities should be what they would fetch for, as Bernanke called it, “firesale prices”.

No bank would of course unload them at firesale prices when they in fact could hold on to them up to maturity, and earn a much higher yield. By how much more, nobody will know til maturity. But given the inevitability of equity writedowns a firesale will result to, holding on is the more rational choice to do.

A consequence of course, is the loss of credibility of banks among each other. No bank will lend to another bank that can, at an instant, need to liquidate at firesale prices, and default on its borrowings as a result.

Suggested modifications to the “Paulson-Bernanke plan” have included making bank shareholders pay the penalty for the sins of the banks in creating the current mess. This is reasonable given that taxpayers will be footing the bill of the bailout, and they had nothing to do with messing up the financial markets.

But an unintended consequence of wiping out all existing shareholders of the banks is that unless the government’s capital injection is sufficient to provide adequate capital cover, these banks will have to operate either at sub-standard capital ratios, or start providing loans at more prohibitive rates, to earn back their lost capital.

Michael Lewis on banking fees

This is an article by popular Wall Street writer, Michael Lewis from back in April 2002. In light of the events of the last year, I will reprint it in its full brevity, and let the reader figure out its relevance to what has happened in the financial industry.

How Banking Fees Corrupt Wall Street, By Michael Lewis Commentary. Michael Lewis, the author of "Liar's Poker" and "The New New Thing," is a columnist for Bloomberg News. The opinions expressed are his own.

Berkeley, California, April 18 (Bloomberg) A report this week that Goldman Sachs Group Inc. declined General Electric Co.'s request for a $1 billion line of credit was the most-read article on Bloomberg. Small wonder.

The world's largest corporation, warned by Moody's Investors Service that its credit rating might slip if it didn't line up more backing for its short-term borrowings, had asked the world's toniest investment bank to lend it money and was turned down. Amazingly, this was treated by many not as a warning signal about GE but as a problem for Goldman Sachs.

The general view, implicitly accepted by the 11 banks and Wall Street firms that bowed to GE's credit demands, was that any firm that didn't give GE what it wanted would be excluded when it came time for GE to dole out its huge banking fees. As the former head of corporate bond research at Deutsche Bank AG put it, "If you say no to GE, you get banished to the underworld."

This is a perversion of the way capital markets are supposed to work. In essence, GE, along with many other big US companies, has been demanding that Wall Street firms extend lines of credit they otherwise would not, in exchange for future banking fees.


The logic of the Wall Street response -- we have to do X, even though it doesn't make financial sense, or we will miss out on a payday down the road -- rings a bell. It's the same argument that these same firms made to themselves when they compromised their stock market research. In doing so, they exhibit their usual willingness to transform the allocation of capital into a system based on kickbacks.

We are now living through one of the great cleanups in U.S. financial history, second only to the one that followed the Crash of 1929. A lot of the more sordid Wall Street behavior of the recent past was the result of breakneck pursuit of exorbitant banking fees.

A few days ago, for instance, New York State Attorney General Eliot Spitzer released snippets of Merrill Lynch & Co. e-mails in which analysts discuss their efforts to curry favor with potential banking clients.

In one, former Merrill analyst Kirsten Campbell declared flat- out that "the whole idea that we are independent from banking is a big lie." In another exchange, an investor asked former Internet analyst Henry Blodget what was interesting about Inc., which Merrill was then plugging to its investors, "except the banking fees." Blodget's response: "nothin."

Protecting the Fees

But we know all about that game. We also know that most of what is being proposed by the regulators no longer troubles the investment banks.

Wall Street firms don't care if they need to forbid their analysts from owning stock in the companies they analyze. They don't care if they are required to pay a lawyer to be present when their analysts and their corporate financiers meet. They don't care if they need to append a few more lines of fine print to the end of brokerage reports, declaring their investment banking interests. They certainly don't care if they need to add even more disclaimers to prospectuses that no one reads.

What they do care about is preserving their fees. And yet no one has breathed a word about these.

Investment banking fees are a curiosity for anyone intimate with the inner workings of a securities firm. Investment banking is not rocket science and investment bankers are nearly as plentiful and fungible as dollar bills. Yet while the typical fee on a bank loan has been driven down to .01 percent of the total, the typical fee for arranging a securities transaction remains stuck as high as 7 percent.

Full-Service Shops

Why? Why don't big companies such as, say, General Electric, play Wall Street firms off one another and drive down the fees? At first glance, this would appear to be a good example of market failure.

But then you see what the investment banks do for the big companies to get the fees -- lie to the investment public on their behalf, extend them credit when they shouldn't get it -- and it all makes a bit more sense.

The big fees are a tool used by big companies to manipulate the investment banks. They are not "earned" so much as "doled out." And because they are vastly in excess of what the work is worth in a competitive market, they cease to function as fees for honest service and begin to look more like bribes.

Whether a business model based on a system of bribes and kickbacks makes sense for Wall Street firms in the long run I do not know. But in the short run, the firms seem to feel that the fees are worth sacrificing their reputations and balance sheets. Even Goldman Sachs in turning down GE was not repudiating the system. Goldman officials were just upset they weren't getting a big enough cut of the take.

You want to clean up Wall Street? You want to minimize the number of future newspaper stories that expose systematic corruption in high finance? There's an easy solution: Regulate banking fees.

Sunday, September 21, 2008

Morgan Stanley, Goldman Sachs to become bank holding companies

This Bloomberg news story announces that Morgan Stanley and Goldman Sachs have been approved to become bank holding companies.

What a difference a decade makes. A decade ago, everybody wanted to be an investment bank, and it was the commercial banks rushing to get in. It was the investment banks who could leverage their investments, thereby achieving superior returns. Now, this business model has been rendered inutile, and the name of the game is now being the fund source yourself.

It’s now way much better to be a commercial bank than an investment bank. You are funded by low-cost deposits, you have more boring but recurring income, and most importantly------you are first in line for a Fed bailout!

Hail to the new masters of the Wall St. universe, the commercial banks.

Saturday, September 20, 2008

Who should we be bailing out?

Paul Krugman posts an interesting question

There’s something I don’t quite understand about how the big rescue plan is supposed to work. Maybe this is naive; but let me put it out there.

So, here’s my problem: what we have now are a bunch of financial institutions in trouble, because they’re highly leveraged, and have mortgage-related assets on their books. And they can’t raise cash because nobody wants to buy those assets. The Paulson plan will in effect create a market for toxic paper, thereby supposedly unfreezing the markets.

But what if the institutions are fundamentally broke, even if the liquidity squeeze is relieved? I think of a hypothetical institution, which tradition says we should call Capital Decimation Partners. CDP’s balance sheet looks like this:

Decimation doubtsNow, obviously CDP is in trouble if it can’t sell the toxic waste at all. But suppose that Hank Paulson does his reverse auction, and it turns out that the Treasury’s price for toxic waste is 40 cents on the dollar. Even so, CDP is still underwater. So what does Treasury do then?

One answer, I suppose, is that we think that there aren’t too many firms in that position — and that those that will still fail, even with the Paulson Plan, aren’t going to disrupt the markets too much when they go down. But do we know that?

What I haven’t heard anything about is how Treasury might recapitalize firms that will be bankrupt even with the purchase facility, yet need to be kept in being. So I’m starting to worry. Is this the son of MLEC, another

My take is that the institutions that resemble this example, with this level of leverage, are likely hedge funds and investment banks. The Fed should allow them to fail.

Commercial banks and insurance firms, the ones who provide the real liquidity to the market, should be the focus of the bailout plan. They should be the ones first in line for any RTC-type program.

But particular focus should also be on the likelihood that many commercial banks are likely to end up writing off large amounts of loans to the failing investment banks and hedge funds. Too big a write-off could result in a run on the commercial bank.

My guess is that those highly leveraged investment banks who are trapped with too much toxic assets will be folded into their largest lender. This will be tricky though if these funds have a lot of different lenders. Implementing a solution will be like LTCM to the nth degree.

Update: Paul Krugman's new post links to a draft of the Paulson plan. The first two sections of the plan:

(a) Authority to Purchase.--The Secretary is authorized to purchase, and to make and fund commitments to purchase, on such terms and conditions as determined by the Secretary, mortgage-related assets from any financial institution having its headquarters in the United States.

(b) Necessary Actions.--The Secretary is authorized to take such actions as the Secretary deems necessary to carry out the authorities in this Act, including, without limitation:

Friday, September 19, 2008

Arguments for and against the ban on ALL short selling

Is the outright ban on short selling a good move by the government? Does it make sense? Or is it a costly brake on a crucial market check and balance from launching the next “irrational exuberance”? There are good arguments for both sides, and many of these arguments can be found in both the main article, and in the comments section, of this post from the UK Telegraph.

Among the arguments against the ban:

From the author: "Liquidity will now dry up in these stocks so that any buying or selling of the affected companies will have massive ramifications on the prices of the companies concerned as dealers and Market Makers just pass the risk on immediately down the line, generating swathes of price action on limited business.

With limited ability to borrow stock, Market Makers will widen prices to reflect the increased risk and costs of transaction. With bank share prices now propped up artificially, it makes it even more difficult to decide on where to place funds as the information provided by share price movements is no longer available."

From the commenters: "Most short selling is done as part of a combined package of trades. The short selling part of which is usually a form of hedging i.e. to reduce risk in a financial position. e.g. convertible bond volatility trading requires the "equity option" element of the bond to be hedged. This is done by selling short enough shares to offset the implied long position in the option. Once hedged the trading position makes money when the price of the shares goes "up" OR "down". This trading strategy is indifferent to share price movements in either direction, only that they do move up or down (hence the name - volatility trading). The embargo on short selling is not only foolhardy, but will not give those seeking a convenient scapegoat a target for long. Sentiment is driving the lack of liquidity in the capital markets(not economic fundamentals or short selling)"

Arguments from those for the ban, all coming from the commenters:

“I’m a fervent believer in the increased market efficiencies of short selling. But, unlike “longs”, “shorts” can create a self-fulfilling prophecy of value destruction when a company needs capital - or when the shorts instil fear in an already fearful marketplace.

Thus, while short selling may well serve a wonderful purpose in nearly all market conditions, the market today is not “orderly”. Instead, it is getting dangerously close to a panic. In this environment, shorting is creating a market inefficiency (immediate business closures / sales based on incomplete information), whereas in normal times it creates a market efficiency. I am not an advocate the ban of all new short positions in the financials indefinitely. Had the regulators failed to do this, I believe that we really could have created a downwards spiral that could unwind both our financial system and our economy in a dangerous way.”

“There is always going to be moral dilemma in a society that has to be guided by 'common humanity' and promotes human rights that allows individual freedom and emancipation. But, we are part of a large society which must be sustained and given vitality. So like in times of great disaster where society is in danger, governments must intervene and regulate.”

“Free Markets are all very well, but when you see them stampeding about like great big herds of cattle that have been spooked, it's time to ask whether they should not be reigned in a little through regulation."

“Now free trading of stocks is an essential element of our society that should be safeguarded. However, borrowing gigantic amounts of stock and then leveraging this borrowed stock to create self-fulfilling market conditions (greatly exacerbated by automatic trading software that will dump stock that crashes through their pre-set minimum) seems to be good for little else than creating instability. In fact, it is most difficult to see how it contributes to equilibrium stock pricing, which is the first function of the stock market. Short-selling may "alert people to the weakness of a stock", but ordinary trading will do that just as well, and more gradually.”

My own opinion is that, though I generally agree with the principle that short selling is a good market corrector, banning it at this time is a crucial component of the government’s solution to the crisis.

Given that the painful solution involves bailing out institutions that are deemed too big and inter-connected to fail, allowing short selling to continue would have only made the bailout more expensive for the taxpayer. Short selling was making it even harder for the financial institutions to raise needed capital. It would have been another form of privatizing gains (for the short sellers) while socializing losses (to the taxpayers). Looking at the larger picture, it is not about rewarding the reckless behavior of the banks.

So I agree that banning short selling made sense, and I also agree that it should be only until this crisis has been resolved. I trust that the government, with the guidance of the market, should know when that ban has had its run.

Similar-themed post here.

Thursday, September 18, 2008

A visual diagram of inter-connectedness

Mark Thoma of Economist's View posts this useful diagram that visually captures how an inter-connected entity can affect the network of entities connected to it. Imagine each entity in such a network functioning as nodes. If one node in the network malfunctions, then each spoke connected to it is affected, and if these in turn function as nodes themselves to other spokes, it doesn't take long before the malfunction of one node short-circuits the entire system.

Prof. Thoma says: Since measures of connectedness exist, and I presume physicists also have such measures (of complexity), I'm wondering if financial market regulators should start developing measures along these lines. Can we measure the connectedness of financial institutions econometrically? If so, can we also follow along the lines of the Hirfandahl index for monopoly power and develop guidelines for when a firm is too interconnected with other firms, so interconnected that it's failure threatens the overall system? Couldn't we then "break-up" the firms the way we do monopolies, "disconnect" the firm until it's failure wouldn't be so devastating?

As pointed out above, size alone isn't the key feature, the degree of connectedness (complexity) is also important, and regulators - as far as I know - don't have good empirical tools for assessing this aspect of financial markets.

Perhaps a way to easily "disconnect" firms is for regulators to emulate what competent electricians have been doing all along - require that firms create alternate connections along crucial nodes in the circuit. Might just add more complexity in the case of financial firms though.

The most sensible containment plan for the credit crisis - so far.

Senator Charles Schumer just now proposed probably the most sensible containment plan for the credit crisis. He suggested the setting up of an entity similar to the Resolution Trust Corporation during the S&L crisis of the '80s.

The plan calls for the government to set up an entity that will take out the toxic CDOs from the books of the financial institutions, warehouse these securities while the banks re-build their balance sheets and start lending again, and at some point in the future, resell the CDOs to the market.

The most potent force propagating the deleveraging in the financial sector is a crisis of trust and confidence among the banks. Because many of them are holding sub-prime CDOs, they are now no longer lending to each other. And because these CDOs keep being written down, the banks who own them have had to take repeated hits on their capital. With each capital hit, banks have had to sell more assets at lower prices, causing the next wave of writedowns.

George Soros has a term for this vicious cycle – reflexivity. Downturns causing panic causing more downturns. But this panic is actually being fuelled by the mark-to-market accounting rule. This rule forces banks to mark the value of ALL their asset,s based on the clearing price of the last transaction, regardless whether they had planned to sell all these assets at a foreseeable future time.

The planned warehousing of CDOs can do the job of short-circuiting this reflexivity. With CDOs no longer in banks’ books, they will no longer have an asset class with a continuously declining value. They can then focus on re-building their asset base, confident of the stability of their remaining assets.

Who knows, at some point in the future, when we have fully determined how much of these CDOs will really default, a market for them will return and the government entity holding them can sell them at a profit.

So here are my two $64,000 questions: How will the government value these CDOs, and how will it raise the funding to buy them? Senator Schumer plans to discuss the plan in detail later today.

If you happened to be a shareholder of AIG, Lehman, Fannie, Freddie or Bear, too bad your firm didn’t make it till today, before all the value of your holdings went down the drain. Such is life.

Update: Senator clarifies that, unlike the RTC solution of the '80s, his plan does not call for acquiring the pool of CDOs from the banks. It calls for acquiring stakes in the banks, in exchange for taking these out of their books. Therefore, it will be cheaper than an outright buyout of the securities, which do not have an alternate market right now, and hence, have no verifiable market value. The money will come from the Fed's reserves, which he says, is enough to acquire the stakes.

New $64,000 question: How will this change Wall St., now that the government is poised to become a minority stakeholder in practically all the financial institutions?

Tuesday, September 16, 2008

How to avoid financial crisis in the future? Decrease the number of banks

So the Fed finally decided to help AIG out. It’s true, as I pointed out in my last post, AIG, an insurance firm not under the regulatory jurisdiction of the Fed - is too big to fail. The Fed had no choice but to come to the rescue.

Unfortunately, nowadays, we do have an abundance of globally inter-linked institutions that are now too big to fail. And they are all prime candidates for a government bailout should any of them end up with unlucky trades. Theoretically, we could have an endless line of institutions who can “privatize profits but socialize failure”.

So what’s a regulator to do?

The Fed need not end up regulating all “non-bank” financial institutions that come into existence. That will only end up giving the Fed responsibility for their viability as ongoing concerns. What the Fed needs to do is to come up with a more stringent framework for regulating the largest counterparty transactions of those institutions that do come under its umbrella – the banks.

Unfortunately, that can amount to endless reams of transactions to review for each bank under the Fed’s purview.

A possible solution? Decrease the number of banks. This lessens the network effects of a larger population of banks inter-dealing with one another. That might still leave us with fewer banks that get to grow even bigger, and definitely too big to fail. But at least, among these few, the level of regulatory scrutiny can be deeper.

Think about it. Less banks. Less unbridled greed. Less destructive maneuvering for profit. Less to bail out. But greater oversight over the few.

Hedge funds and independent broker-dealers can go on being unregulated. But if they enter into a significant transaction with a regulated bank as the other party, the Fed can and will know all the details.

Mr. Bernanke, what about incentivizing more consolidation?

Update: As of mid November, I may have changed my mind.