Monday, November 30, 2009

Obama's Two Biggest Blunders: What do They Have in Common?

I'll go out on a limb -- actually, I don't think I have to go very far out -- and wager that wise historians of the future will chronicle two big blunders of President Obama's first year in office. They will be:

1. His kid-glove handling of the banks that caused the financial crisis. There was too much "please" and "if you don't mind" and mucho foot-dragging on reforming a broken system and rooting out wrongdoers. The president expressed a little outrage, maybe once or twice, then drew back into his shell. Meanwhile the government has handed over billions to the banking industry, very few strings attached, as unemployment soars. The perception on Main Street: the Obama administration is beholden to a plutocracy that really runs the U.S. of A.

There is much anger about the bailouts that's on a steady simmer right below the surface, I think. It will cripple Obama's future ability to be effective. Paul Krugman really nailed it with his recent op-ed piece pointing out the great tragedy in how the White House played patty cake with the bankers: our leaders have blown a load of credibility with the American public. Obama an agent for change? Yeah, right.

2. His ramping up of the war in Afghanistan. Public sentiment is already turning hard against this war. We're tired of wars in distant lands that half of us can't locate on a globe; we're tired of the burden they place on our groaning budget deficits; we're tired of the open-endedness of these conflicts.

Obama will buck popular opinion, it appears, by sending 30,000 more troops to Afghanistan. And we should all recognize that poker play: I call you and raise you 30,000 troops. This puts him 30,000 soldiers farther from extricating America from what will probably turn into a quagmire. I think it's a very dumb move from a very smart man. His decision puts me in mind of Hannah Arendt's wonderful book, "The March of Folly." Why do wise men persist in hopeless courses of action?

Anyway, before I get sidetracked too much, the central point: What do both of these blunders share? What's the common element? What weakness do they expose of Barack Obama -- by all accounts a highly intelligent man of a reflective nature, someone who can appreciate nuance, who has the native smarts to master any issue out there, no matter its complexity?

I would submit it's this: Obama has a weakness when it comes to bucking the system. He eagerly seeks compromise, tends to be conflict averse, and falls short on courage of conviction. With Wall Street, he didn't dare face down the banking industry. He expressed a little indignation and backed off. With the war in Afghanistan, he didn't dare to face down the military brass, who have sold him a bill of goods on what's achievable over there. He didn't want to be the guy who lost Afghanistan.

Someone might rebut: Well, what about health care? Someone who's wedded to the status quo wouldn't be trying to overhaul the health care system. That's true, and I think Obama dreams big. But look at how he's behaved with health care: He's introduced reform and made the soaring rhetorical speeches, then backed off to let Congress thrash out the actual bills. Public option? No public option? He's easy. Whatever.

Lyndon Johnson, by all accounts, was an arm twister. Barack Obama appears to be more a speechmaker -- and the words are starting to ring hollow.


Parties in a contract involving Islamic finance are free to structure their dealing to take into account Shariah requirements governing transactions, and have their terms documented in the relevant contractual documents. They can insert whatever clauses of their choice in so far as these clauses are not in any way repugnant to any established Shariah rules and principles. In many jurisdictions it is the requirement of regulatory laws that these parties need to ensure that their transactions are free from any element inconsistent with Islamic teachings. However it is very sad indeed to find out that some parties may sometimes indicate through their agreements that in case any dispute should arise in future between them, they would like to settle the possible dispute not in accordance with any Shariah compliant mechanism of dispute settlement.

What may happen is that the parties would instead prefer to settle such a future dispute through trials conducted by courts that are very clear from the very way they are constituted are far from being a suitable forum to dispose of the case in a Shariah compliant manner. Given that these courts are conventional courts in various jurisdictions that as a matter of judicial process are not from the outset suppose to decide cases brought before them in line with Shariah requirements. Hence the big question is how can it be said that the relevant dispute is to be disposed of in an Islamic way?

It is important that dispute related to Islamic financial transactions is settled in a Shariah compliant manner for two major reasons. Firstly when the parties hold out that they are conducting their affairs in Shariah compliant ways, they thereby make a representation to the general public that they are going to abide by the Shariah requirements in all their dealings. So when it turns out to be that they prefer to settle their future disputes in the above described manner, and to turn a blind eye on Islamic alternatives, the general public has all the reasons to ask why it remains so when other Shariah compliant alternatives are available. Secondly, assuming that an award may have been made by the non-Shariah compliant courts, does it mean that the amount so awarded in the judgment cannot be treated as halal/legitimate incomes for the relevant parties, or at least be described as questionable incomes that need to be purified.

What happened in Malaysia recently in the context of the latest amendment to the Malaysian Central Bank law is very interesting development to note. The amendment made it clear that the Malaysian civil courts and arbitrators must consider the published Shariah resolution passed by the Shariah Advisory Council of the Central Bank in deciding Islamic banking cases brought before them. The amendment also made it mandatory for the Court and the Arbitrator to refer any Shariah issue raised in the dispute which is not yet addressed by any published resolution mentioned above, and they must abide by any decision that the SAC may provide.

It remains to be seen whether this approach will solve the dilemma faced by Islamic finance in this respect. Strictly speaking, from an Islamic classical perspective, a Muslim judge is always reminded to consult learned parties before issuing any judgment, and it is held that this approach, although is not mandatory to be taken, is accepted to be a highly recommended thing to be done by any presiding judge. But to put it in the manner that it is mandatory to be undertaken is something new, firstly because at the end of the day it will be the judge himself who is going to be responsible for the issued judgment.

Secondly, with respect to any opinion that may be possibly given by the consulted learned party the most that can be said is that it is a form of fatwa or shariah opinion that is basically not binding. Any court judgment on the contrary is binding on the disputing parties as a matter of authoritative expediency. Perhaps the reason that may have been relied upon by the Malaysian Parliament when the house passed the amendment is based on the fact that civil court judges were not trained in Islamic law, hence they need to abide by the SAC resolutions. But then, judgments are normally not given solely based on rules or law but they are based also on facts of the cases in question for which only the trial judges have the opportunity to establish. Furthermore trials in the civil court do not involve the same procedural process as normally employed in the Shariah court especially in the context of the role that can be played by oaths in establishing civil claims. The fact is that to dispose any given Islamic finance case is not just limited to the law aspect alone, but also the evidential and procedural aspects as well. Unless the relevant additional issues are properly addressed taking into consideration all that need to be considered in terms of Shariah requirements, the hope to achieve full settlement based on Islamic principle will remain something to be very genuine.

Saturday, November 28, 2009

PPIP Deathwatch, November Edition

The Geithner plan (PPIP), for public-private partnerships to buy up toxic assets saddling banks in the U.S. financial system, has been roundly attacked from the start. For my part, early on, I predicted PPIP would fail for a simple reason: the banks wouldn't offer up any toxic assets for sale (for fear of revealing themselves insolvent) and the U.S. government wouldn't have the stomach (or balls) to compel them to.

So I offer up this article in US Banker (a little late, but it's been a hectic month): PPIP Finally Ready, But Who's Selling?

For me, the impact paragraph comes at the very end (bold mine):
Ron Glancz, a partner at Venable LLP who has clients with toxic assets, agreed. "It's not created a lot of stir," he says. "We have banks that have a lot of toxic assets, and they are not selling to PPIP. It doesn't deal with the fundamental problem that banks can't book these losses, because that's a depletion of capital."
The official storyline is something rather different though. The Treasury Department claims that PPIP is no longer needed, as the economy has improved and major banks have been posting profits. But what's the truth? Here's a quick and dirty rundown:

1. Bank profitability: Well, duh. Banks were given much greater leeway in valuing their assets, back in April. If you can claim multiple pieces of junk worth 40 cents on the dollar are actually worth 80, that's going to boost profits considerably. That, and if you're a major bank, you get to borrow super-cheap from the Fed through an alphabet soup of lending facilities.

2. The economy has improved: The meaningful indicators, such as the rates for unemployment and foreclosures, as well as gauges of consumer sentiment, still look pretty grim. A less meaningful indicator -- the stock market -- of course shows an impressive little runup. Quarterly GDP made an expansionary spurt, but how much of that is temporary stimulus (Cash for Clunkers etc.)?

Which brings us to ...

3. Have the Fed's "cash for trash" emergency backstop programs sopped up a lot of the toxic securities: To me this is a really intriguing question. We know that "Helicopter Ben" is eager to flood the financial system with easy money. The Fed takes collateral from the major banks, and in exchange hands out good ol' dollar bills, usable anywhere. Talk about a jolt of liquidity!

Of course the Fed won't take any ol' piece of crap as collateral. It has to be rated AAA. But ... oops ... weren't Moody's et al rating practically everything AAA, even if it stunk to high heaven? Well, yeah. So one might wonder: how much "AAA" collateral is at the Federal Reserve, and what kind of assets does it represent, and who is it from? The answer: we don't know. The reason: the Fed refuses to tell us. We know that because Bloomberg is chasing the agency through the U.S. court system right now, seeking some details. And the Fed is stonewalling like crazy.

But here's an interesting question: How does the bank that has posted collateral at the Fed account for the value of that security on its books? Because, when you come right down to it, if "A" (the value of that security, as parked at the Fed and exchanged for good hard cash) exceeds "B" (what the bank can get for that security through a PPIP auction, even assuming there will be a little overpaying by the PPIP buyer), the bank will prefer to stick the money with the Fed. And PPIP will fail.

Of course the irony -- which one can spot from a good ways off -- is that the Fed, eager to restore liquidity and restart markets, is actually hampering the necessary clearing activity and proper restarting of the securities markets for dodgy assets, thanks to all its meddling. But then again, what's a good financial crisis without an abundance of irony?

Update: To be fair, I should note that lesser quality securities (below AAA) can be submitted for the PPIP auctions. So, obviously, a bank holding these lower-rated assets can't weigh "what is their value as collateral through the Fed vs. what is their value sold through PPIP"? The Fed, after all, only takes triple A (well, for what that's worth, and it would be interesting to know how much AAA the Fed has scooped up that has then been downgraded). But dodgier securities may not be great candidates for PPIP either, because they can be harder to value, and a bank may want to exploit this uncertainty by carrying them at inflated prices on its books (and conversely, because of the problem of adverse selection, PPIP bidders may penalize such securities, so it's a lose-lose for the bank). That may convince the bank to hold onto these assets and not risk having to do a writedown.

Thursday, November 26, 2009

Phew! Just Flew Back from China and Boy My Arms Are Tired

Or however that joke goes. Right now I'm de-jetlagging after a seemingly endless flight from Hong Kong and trying to catch up on what I missed. I spent a week in China. For today, just a short odds-and-ends entry...

(1) When did passengers turn into "customers"? I noticed this on the Continental flights I took. Had it been only one flight, I would have just written off the incident as someone on the flight crew remembering some half-digested bit of marketing political correctness. But this practice was apparently part of some memo because the "customers" references came up on different legs of my journey. "Customers, please be seated." "We thank our customers for flying with us." That sort of thing.

One thing you gotta understand about me: I love the English language. I love it on a number of levels, right down to the sound of words knocking together. Further, I believe in simple, direct, effective communication. I grit my teeth when corporate America keeps trying to put lip gloss on the fact that they're terminating workers. We have gone from "firings" to "layoffs" to "downsizing" to -- a particularly odiously bland term -- "rightsizing."

Who the hell came up with "rightsizing"? It sounds so laudable. As in: "We were wrongsized before, and when we realized this, we rightsized, and now as a company we feel soooo much better." Compare that to: "We just fired 200 workers." The trouble is, "rightsize," besides having that fuzzy feel-goodness of Newspeak, is maddeningly imprecise. "Rightsize" could mean that you added 200 workers, if your company felt it was too small. Or it could mean you opened another plant, or acquired a rival. I think there should be Useless Euphemism jars, like swear jars, for awful euphemisms. Every time a flack tells you his company "rightsized," he should have to put a buck in the Useless Euphemism jar.

But back to the customers sitting on the airplane, waiting an hour on the tarmac twice on delayed Continental flights (whoops, wrong peeve) ... why not just ditch the marketing PC and call us what we are, most accurately, in our current role? Maybe when we're buying the ticket at the counter, we deserve to be referred to as "customers." But once we're on the plane, we become passengers. There's no shame in that. And the word best reflects our role at that moment.

Say the plane smacks into the side of the mountain, killing 230 people aboard. When Continental holds a media conference on the disaster, are they going to say, "We lost 6 members of the flight crew and 224 customers."

Of course not.

(2) China, tear down this wall! By "this wall," I am referring to the Chinese firewall of censorship on the Internet. While on vacation, I looked forward to keeping current on my favorite blogs only to find the large blogging communities -- WordPress, blogger -- blocked.

Why? Because China, despite its emergence as a global power to be reckoned with, is still a politically immature country, its leaders fearful of independent thought, criticism and debate. As far as they are concerned, the state news service (Xinhua) tells its citizens what they need to know, with an appropriate viewpoint. "Question Authority" is not a fashionable slogan over there.

I'm not trying to China-bash here. Often the Chinese look at Westerners and protest, "You don't understand our country." And I respect that point of view. There is much that we don't understand. I think the U.S. makes its worst blunders abroad when it assumes that the yearnings in the hearts of our citizens are exactly the yearnings of men and women everywhere, and that what is good for our country must be good for any country. It is hubris bordering on madness to think that we can neatly and simply transplant a Jeffersonian democracy to the harsh sands of Iraq for example or to the desolate strife-torn mountainous region of Afghanistan. America would do better with a little more humility.

Yet -- yet -- at some kind of baseline, there should be principles that reasonable men can agree on that make for a better society. One is the open, independent, vigorous sharing of ideas and opinions, I strongly believe. In America, I think we have open and independent sharing, though its vigor has somewhat been sapped by a culture narcotized by entertainment. In China, they have none of the above. I wonder sometimes if they realize the cost.

There is a real cost in lost innovation, across so many spheres: not only economic, but social and cultural too. There is a cost as well in human development of one's citizens (I am sometimes surprised at the number of very smart Chinese I have met who are not particularly nuanced thinkers or debaters; they have never been taught to question and examine things). Then there is the most ludicrous of costs -- the tangible cost of repression: of maintaining the spy networks, of paying the censors' salaries, of having to constantly screen what is acceptable and not -- a cost akin to buying the bullet that you then use to shoot yourself in the foot.

I think China contains the seeds of greatness, but first must have the courage to let a thousand flowers bloom ... from within.

Wednesday, November 11, 2009

Tin Ear of the Year Nominee: AIG's CEO

Man, this guy is -- how to put this gently? -- aw, the hell with it -- the very embodiment of chutzpah. Early in this financial crisis, I noted the curious lack of contrition on the part of Wall Street bankers. There was nothing in the way of an apology, just a lot of hustling out the back door with the bags of TARP money. There wasn't even that mumbled, eyes downcast, insincere "I'm sorry" that you get from your four-year-old who was caught smearing peanut butter on his sister's ponytail. At the time I wondered about the deafening silence of Wall Street's public relations machines.

Lately, Wall Street's head honchos have opened up a bit more, even going on "charm" offensives. And now, you understand why they were silent before. Because these guys radiate arrogance, even when they think they're striking a humble pose. You have Lord Blankfein over at Goldman Sachs, telling us the firm is doing God's work (shades of noblesse oblige) and that a certain amount of income inequality just has to be tolerated.

And then you have AIG's Robert Benmosche, who's threatening to walk off the job after only three months. I love the brutal Huffington Post headline and subhead:
AIG Chief Threatening to Jump Yacht
New CEO Benmosche Spent First Two Weeks on Job Vacationing on the Adriatic ... Now Claims He's Done, Angry About Pay Restrictions

(Note: the pictured yacht is not his, I suspect -- it appears far too small.)

Okay, Benmosche -- who I have yet to see a photograph of, but I imagine most images portray him with foot lodged firmly in mouth, as that's where it appears to have been since his hiring -- is fuming about pay restrictions on AIG executives. Remember, AIG was on the brink of self-immolation last fall when the U.S. government discovered that the company was actually a hedge fund grafted atop a sedate-looking insurer, and was about to go up in flames in a very messy way. And so the government (using our taxpayer dollars) interceded.

So now the U.S. government has the audacity to make rules about how the top executives are compensated, which has a funny sort of logic about it because we own the damn company. AIG is a ward of the state: we purchased four-fifths of this wrong-way bet colossus. Of course we have a say. Don't sell me a hair-covered lollipop then tell me I can't clean it up.

And the top 25 executives at AIG are being forced to work at starvation wages. Anyone want to guess what their annual salary is capped at? $100,000 a year? Well, no -- not that starvation. Any self-respecting AIG top executive is still going to have golf club dues and such. We can't airbrush all that away. Okay, then $200,000 a year? Nah, not that bad. $300,000 a year? Oops, not that low. Not even what the U.S. president makes: $400,000 a year.

Here's the answer: Benmosche is bitching because he can't pay them more than $500,000. By the way, how rich are you if you make a cool half a million? Check this out: you happen to be the richest 107,565th person on the planet. No, actually, you're even richer than that, because the Global Rich List calculator tops out at 107,565 at $201,000 of income. So let's just say you're pretty stinkin' well off.

Benmosche, by throwing a hissy fit about the inability to lavishly compensate his key executives, is displaying a level of Tin Ear-edness that may just win him top honors this year. Since he has no clue about how to run a company without a fat-salaried caste of big bosses, I hereby offer up a few bits of advice (free, because I know he's on a, ahem, budget these days).

1. Grow your own executives, dammit. Surely there are people -- strivers; check the backs of their co-workers for claw marks -- within the relevant divisions, at lower levels, who dream of running the world someday. They're probably not happy with their pittance salaries of $250,000 to $300,000. $500,000 would be a big salary bump. Find them. Mentor them. Put them in place.

2. Split job responsibilities. Okay, if you can't find one guy to run your fire insurance or whatever division for $500,000, find two guys. Better yet, find two women. And a couple of minorities to boot. Use this as an opportunity to introduce a few new faces and spread duties a bit more widely. Checks and balances, right? Maybe, next time, Betty will say to Financial Products co-head Flo Bassano, "Hey, do you really think we ought to be loaded up with so many of these darn CDS things? They look sort of volatile."

In short, be creative. And for God's sake, talk to your PR department. They may, in so many words, tell you what the rest of the world wants to: Stop yer bitchin'.

Tuesday, November 10, 2009

Blankfein Makes the Argument for Heavily Regulating Banks

Imagine a world in which the air that we breathe -- that's right, that air all around you -- wasn't freely available. Let's say it's held in "air reservoirs" and pumped into our airtight houses. Whenever we go outside, we have to take compressed air in tanks because the normal atmosphere can't support life. And we all get used to living this way -- okay, it's a bit inconvenient, but everyone gradually adjusts and life goes on.

How do you think, in such a world, air would be "regulated"? With the same light hand we would use for regulating the sale of frivolous items, such as lawn gnomes and chia pets? Ah, dumb question. Of course not. Air would be the most regulated commodity mankind has ever known. There would be frequent quality checks for air contamination, strict rules about pipes that carried the critical air supply, regulations about every aspect of the portable air tanks that we depended on.

Why? Simple. Without air, we die. This is a life and death matter.

Abstractable principle: the amount of regulation appropriate for an activity (or commodity, or whatever) should be in some direct proportion to how vital it is. Without breathable air, the entire human race perishes. So clearly, there will arise a lot of rules surrounding the proper reserves of air, how it will be supplied to the population at large, what quality is acceptable, and so on.

By this same argument, Goldman Sachs CEO Lloyd Blankfein believes that the financial industry should be heavily regulated. Because, well, it is the vital lifeblood for our economy. Credit is the "air" that businesses, large and small, need to survive. If you don't believe me, here he is, hotly telling a reporter that you can't compare bonus-seeking bankers to coal miners striking for better wages in the 1970s. Because the bankers happen to be involved in something much, much more important:
"I’ve got news for you," he shoots back, eyes narrowing. "If the financial system goes down, our business is going down and, trust me, yours and everyone else’s is going down, too."
Sounds pretty grim. Sounds like an industry that's really, really vital to our economic health. Sounds like a pretty convincing argument for a new, much more intrusive, regulatory regime. U.S. Congress, all you guys have to do is connect the dots for Mr. Blankfein now. He's made the argument for you.

Saturday, November 7, 2009

Must Read of the Day: Kill Credit Default Swaps

At first, my leading "must read" candidate was Roger Ehrenberg's Barking up the Wrong Tree. Roger identifies an ongoing problem with Washington's attempt to knuckle down on the financial industry: legislators get distracted by pander-ready sideshows. Example: dark pools and high-frequency trading in the stock market (note: I'm not saying either is necessarily harmless, but I agree that they're not doing the harm of the big elephants in the room -- unregulated derivatives trading and corrupted credit-rating agencies). Why is this? As Ehrenberg observes, plenty of little investors are in the stock market, so Congress takes on related issues with a lusty sense of outrage. But derivatives and credit raters are willfully ignored because the subjects aren't as sexy and grandma doesn't spend any time checking out, say, how Moody's grades "SocGen CMBS Non-Conforming Pool XII."

Still, that blog entry dropped to second place on my "must read" list after I found this, over at naked capitalism: First, Let's Kill all the Credit Default Swaps. Yves Smith, who has gotten pretty smart about CDS products while researching and writing her soon-to-be-released book related to the financial crisis, says:
Credit default swaps have no redeeming social value. They are a fee machine for Wall Street and their supposed value is considerably overstated (the world pre credit default swaps functioned perfectly well) and their costs, which are considerable, are not given the attention they warrant.
She lists their sins, including their "anti-social" nature. A credit default swap, remember, is basically insurance in case bad stuff happens to a company and renders its bonds worthless or impaired. When you buy this protection though, the only way to cash in is for the bad stuff (a so-called "credit event") to occur. So, like cash-strapped homeowners who have a tendency to play with flames around heavily insured items, a holder of say an IBM credit default swap might prefer that the computer maker declare bankruptcy (a triggering credit event) rather than restructure its debt -- even if restructuring the debt is a smarter move for the company that in the end does more economic good.

Yves also notes that simply moving credit default swaps onto an exchange may simply create a "too big to fail" exchange -- and not extricate us from this mess at all. It's a good point and indicates that the CDS may be too neutron-bomblike to allow in the financial arsenal of weapons.

A casual observer might wonder about this. After all, a CDS is basically insurance, and we have well-capitalized insurers that do just fine. Well, first the insurance industry is well-regulated, unlike the CDS market, but even if the swaps were highly regulated they differ from standard insurance in two big, troubling ways:

1. Unlike with, say, home insurance, you can buy a CDS repeatedly for the same bond. This would be the equivalent of being able to insure someone's house, say, 50 times over -- or even more. Further, you don't have to have any underlying ownership interest whatsoever in the insured bond. So this is a perfect tool for highly leveraged, out-of-control speculation.

2. You can set aside a stockpile of reserves for insurance more effectively, because correlations are weaker. A national insurer may suffer losses from a hurricane in Florida, but chances are good that its claims elsewhere in the country will run at about the same pace as usual (the probabilities of damage events occurring at separate locations, over a wide enough area, are uncorrelated). That makes it easier to absorb the loss from the hurricane. Unfortunately, when the economy tanks, bankruptcies rise in all sectors. It's like a hurricane that sweeps the length and breadth of the U.S. What's worse, with a credit default swap, the hurricane can strengthen off its own destruction, like some evil black hole that becomes more powerful as it draws in more matter. Namely: as we saw in this last crisis, collateral requirements against credit default swaps start to suck liquidity out of the system as the credit markets spiral downward, which in turn exacerbates the plunge.

I don't think our lawmakers are brave enough to try to get rid of credit default swaps, but I find it interesting that a fair number of smart people who know how these products work, in an intricate way, are suggesting such a thing.

Thursday, November 5, 2009

How Much Crappy Collateral is the Fed Warehousing?

The possibly scary answer to this question periodically gets my stomach churning. When the definitive works are written on this financial crisis, in another decade or so, I think the authors will pass judgment not so much on the overt bailout -- TARP is small potatoes, folks -- but on the "invisible bailout" that no one ever voted on, but that the Fed orchestrated behind the scenes. We can't write these definitive books yet, because the outcome of the invisible bailout isn't clear.

What put me in mind of this subject: this paper over at Zero Hedge, allegedly by a "Nathan Jerome Burchfield," that claims the Fed may have accepted crappy CMBS (commercial mortgage-backed security) collateral against loans it made. This occurred through the TALF, or the Term Asset-Backed Securities Facility. And then, after the Fed accepted this stuff as top notch collateral (AAA rated, creme de la creme), the ratings agencies -- interestingly enough -- turned around and downgraded the products.

I'll get to that oddity in a second, but first, let's pause for a moment to look at where we are in this financial mess. Ostensibly, things are going pretty well -- the troubled credit markets seem to have taken a magic calming pill -- but if you whisk back the curtain (which few Americans are inclined to do), you are treated to a crutch-like monstrosity of money-rigged supports that brings to mind that old poster "Building a Rainbow." It's hard to tell what asset prices for securities are really worth, because the Fed is swallowing them up at an astonishing rate, as long as they're bearing a AAA rating from one or two of our not-very-trustworthy credit raters. The securities (most likely generously graded) are accepted by the Fed as collateral, giving them value that they ordinarily would not have. So you give the Fed these "AAA" securities, it gives you dollar bills in exchange -- yee hah! -- then sits on your collateral.

But what's this collateral really worth? And what happens when the Fed takes collateral that then is downgraded to something less desirable -- to a rating that the Fed wouldn't have accepted in the first place?

If the Fed were smart, like say Goldman Sachs -- believe you me, it would start hoovering up more collateral, or insist on $x dollars to compensate for the downgrade. But remember: the Fed's agenda is less about protecting the taxpayer than about invisibly bailing out Wall Street. In fact, a critic might even wonder if the Fed, the credit agencies and the holders of the CMBS have in some way colluded so that the ratings hit occurs only AFTER the Fed accepts the securities. That way, the CMBS owner has already got his cash -- bye bye, so long sucker.

Certainly, at the very least, the Fed seems like the "mark" in the "market" these days. Consider: the Fed announces that, starting in July, it will accept CMBS as collateral ... meanwhile, everyone has been predicting all year that commercial real estate will be the next market to fall flat on its face. So the Fed has accumulated billions in CMBS collateral -- I think the latest figure is $6 billion -- in a sector that's prime for collapse. Dumb or really dumb?

A true-blue capitalist might argue that this is precisely the kind of sector the Fed should avoid -- let the upheaval come, the prices drop, the readjustment occur. Let the free market sort out things. But the Fed, gently intervening through its invisible bailout, helps keep asset prices artificially high.

Outraged about this example? Save some outrage. The Fed is rife with lending programs like TALF. The organization's balance sheet has become an alphabet soup of crutch-supports. And these programs have gotten pretty darn fat. Anyone recall this Yves Smith blog entry, Term Auction Facility: Confirmation of Financial Stress?, from Feb. 19, 2008 (the bold is mine)? God, seems like a lifetime ago huh?
To give a quick overview of the TAF: it was launched December 17, with two $20 billion actions, one for 28 days (the one conducted on the 17th) and a second for the 20th for 35 days. The reason for the program was that the gap between the Fed funds rate and interbank rates had become very large, suggesting that banks were reluctant to lend to each other. That was even more acute in December, since banks customarily curtail their short term lending then so they can tidy up their books for year end.

We’ve called the TAF a discount window without stigma (and in fact, the Fed implemented the TAF because banks weren’t using the discount window even when they should have). Banks can post a wide range of collateral, borrow on a non-disclosed basis, and can hold on to the cash for a while (by contrast, the discount window is overnight)

And what would you expect when you allow "a wide range of collateral"? Probably a rapidly expanding program, as banks shovel in all sorts of junk and get dollars in return. And sure enough:

The Financial Times today raises some concerns, noting that banks are indeed using the TAF to use crappy collateral for borrowing.

And note that, with no announcement I can recall, the facility has been increased to $50 billion even though the year end crunch has passed. That too is not a good sign.

So whatever happened to good 'ol TAF? By the end of June of this year, the Fed said that the value of collateral pledged through TAF was $1,570 billion (edit: actually, to be fair, only $899 billion of that was against current loans). Big, bad and bloated.

And so, the larger questions: where does all this massive intervention end? Does the Fed really think there's an easy way to just quietly and painlessly withdraw such huge levels of support? And what if that collateral turns out to be worth not very much? Who's stuck with the tab?

Sunday, November 1, 2009

Settling the "Was it Lehman?" Dust-up

Was the U.S. government's decision to let Lehman Brothers tumble into bankruptcy last fall a fatal miscalculation? By letting Lehman go, did we precipitate the brutal freeze-up in the credit markets?

Answering that question has become a hot niche topic for debate. The latest contribution by William Sterling is here: Looking Back at Lehman. It's a rather tedious read, so I'll just cut to the chase:
In contrast to the analysis of Lehman skeptics such as John Taylor (2008, 2009) and John Cochrane and Luigi Zingales (2009), the evidence we present supports the view of many practitioners that the decision not to rescue Lehman represented an immediate and massive shock to the financial system that was larger by an order of magnitude than anything seen over nearly two decades.
First, if you examine the day-by-day, blow-by-blow data, I think it's obvious that the Lehman bankruptcy did matter hugely. But if you look at the larger picture, I don't think Lehman mattered much at all. The long historical view: we were poised on the tip of a teetering Seussian-type credit edifice, creaking with hidden risk and towering with high leverage. It was bound to collapse in an ugly way sooner or later.

The "micro" analyses that focus on how the credit markets reacted in the immediate aftermath of Lehman's collapse largely miss the point. Which is: Lehman's failure revealed the Seussian-type credit edifice in all its terrifying precariousness for the first time. There were at least two big problems that came to the forefront with Lehman:

1. The shadow banking system was shown to be extremely fragile.

First, check out this primer on shadow banking; it's what I consider a great introduction to the subject. It's an interview between Mike Konczal (the creator of the always-smart Rortybomb blog) and a Barnard College professor, Perry Mehrling.

Shadow banking was (still is, I imagine) HUGE. This MarketWatch story claims that the shadow banking system had $10 TRILLION in assets in early 2007, making it the same size as the traditional banking system. Just ponder that for a second. That's a tremendous amount of money sloshing about that's meeting demand for funds in the economy, while doing so outside of the reach of regulators.

Big brokers such as -- ta da -- Lehman Brothers were supposedly the largest players in the shadow bank network. How does shadow banking work? An investment bank such as Lehman arranges to sell some securities to what we'll call a "pseudo-bank", then buy them back say a day later for more money (that extra bit of money providing an interest rate on funds, if you will, for the lender). James Kwak at Baseline Scenario breaks it down well here.

Those securities may be AAA-rated, making them appear pretty safe. That's important because the pseudo-bank has to juggle two risks here: (1) That it will get stuck with the securities (2) That, if it is stuck with them, it will have to make enough money selling them to be made whole. Who are the pseudo-banks? Largely, it appears, money market mutual funds swimming in cash, looking for better yields.

So Lehman gets to de facto borrow against high-rated securities (that serve as collateral). Once this collateral looks suspect, or Lehman begins to falter financially, the mutual fund may refuse to "roll over" the buy-resell contract. Then, since these are very short-term agreements, Lehman can very quickly find itself pretty much screwed, unable to raise money that it desperately needs.

Which is what happened when Lehman stumbled. Its financial footing was rapidly whisked away and, because this is a "shadow" banking system, there was nowhere to turn for emergency liquidity (see Mike at Rortybomb for a longer discussion of this gaping weakness).

Now, if you're a pseudo-bank providing funds to this shadow banking system, and you observe Lehman staggering about, badly wounded, what do you think? It's not, "Well, that must be a problem isolated to Lehman." No, it's more like, "Holy crap, almost any of these investment banks could be in similarly rough shape, and how do I know these 'AAA' securities are really worth as much as anyone says."

Meanwhile, the U.S. government begins to realize that it can't let all the investment banks go belly up, en masse, because the Lehmans and Morgan Stanleys have got a million tentacles reaching into many corners of the global financial system, such as through their derivative operations. These guys have been at ground zero in the efforts to launder risk.

So Lehman's failure was about more than Lehman. I think we could've rushed in and bailed out Lehman, sure, but eventually the sprawling, frail shadow banking system would have blown up somewhere else.

2. Lehman was shown to be worth a lot less than it claimed, further scaring the hell out of everyone. Everyone starts to wonder, "How solid are the counterparties I'm doing business with?"; nervousness sets in; credit flow ices over.

September 15, Lehman Brothers Holdings says it will file for bankruptcy. It cites bank debt of $613 billion, $155 billion in bond debt, and assets worth $639 billion. Doesn't sound too bad huh? Assets of $639 billion, liabilities of $768 billion?

Now take a guess how much Lehman's bondholders recovered on the dollar. 50 cents? 40 cents?

Recovery rates for defaulted bonds have declined in the U.S., true. Moody's said they fell, on average, from 61.8 percent on senior unsecured bonds in 2007 to 33 percent in 2008. But Lehman bonds crapped out spectacularly. They fetched less than 10 cents on the dollar. That's pretty awful.

So there you have it.

Here's my takeaway point: Lehman's bankruptcy was a proximate cause of the credit freeze, but that doesn't necessarily mean rescuing Lehman would have been the wise thing to do. Perhaps if we had saved Lehman, that would have only delayed the breakdown of the financial markets to the fall of 2009, and it would have been twice as bad.

I worry about the "No More Lehmans" crowd because they're the ideological heirs of "Bailout Nation," the hopeless model of propping up Too Big To Fail banks. And I'm concerned they don't even seem to realize it.