Credit

I want to pick up on yesterday’s post by Bob and friend and expand upon it a bit. Under section 111 of Chairman Dodd’s proposed bill, the new Financial Stability Oversight Counsel will be made up of

• the Treasury Secretary, who would serve as chair
• the Federal Reserve Chairman
• the Comptroller of the Currency
• the Director of the new Bureau of Consumer Financial Protection
• the Chairman of the SEC
• the Chairman of the FDIC
• the Chairman of the CFTC
• the Director of the Federal Housing Finance Agency
• and an independent member, who must have an insurance background, and would serve a 6 year term

This is a banking heavy group. Especially given that all the key votes by the Counsel require a two-thirds majority.

Felix Salmon noted in a recent post that “[o]ne of the problems with giving lots of supervisory authority to the Fed
is that the Fed is run by economists who care primarily about setting
monetary policy, as opposed to being run by bankers who care primarily
about bank regulation and systemic risk.”

Although this is on track, to my mind it does not go far enough. And from my lawyer’s perspective, the distinction between economists and bankers is kind of like the difference between policemen and constables. Treasury, the Fed, and the rest of the crew are stacked with economists, bankers, and lawyers focused on banking law.

But one of the obvious lessons of the past two years is that there really is no such think as a unique universe of “banking” or banking law in a world where GMAC and E-Trade are offering home loans, people in the Netherlands have passbook accounts in Reykjavik, and seemingly simple online banks have $26 billion derivatives portfolios (table 1, here).

If this new Counsel is going to break out of the echo chamber, and avoid the mistakes of the past, it needs fresh perspectives. If this Counsel is going to oversee the “resolution authority,” why not have an insolvency person at the table — especially given that the Counsel is supposed to determine if the Bankruptcy Code is a viable alternative before invoking the resolution authority. How about somebody from a hedge fund (gasp!), who can provide the perspective of both a non-bank financial institution and that of a major customer of the banks? Maybe a tax lawyer, who can explain why a particular fund is incorporated in Ireland, has its bank accounts in London, its corporate headquarters in New York, and what about that subsidiary in Mauritius? Mauritius?

In short, I think one good amendment to the current structure of the Counsel would be a dramatic increase in the number of independent members — perhaps to five, you don’t want to make the Counsel a faculty meeting — to expand the perspectives in the room and avoid the situation where the same group continues to do what they’ve always been doing, right on into the next next crisis.

BearingPoint’s Trustee has just brought a fraudulent transfer action to get back a donation it paid Yale of $6 million to endow a chair and earn naming rights of certain on-campus buildings at its School of Management.

(If someone can find a link, please post.)

This academic of course thinks summary dismissal is warranted for the suggestion that they might not have received REV for the honor of having their name used in connection with a prestigious professorship!

The New York Times may have thought it had the scoop on the repo man of the future, but the new movie Repo Men has it beat by several hundred years. Jude Law and Forrest Whitaker star as space-age repossession agents who track down debtors and retake their collateral. The twist is that the collateral in question is transplanted body parts. So if, for example, you fall behind on the payments for your new kidney, Law and Whitaker will hunt you down and take it off your hands. Early in the preview – the movie opens later this week – we see the two scalpel-toting contract enforcers taking the Article 9 “breach of the peace” standard to whole new levels and saying over beers that a job is just a job. But, not surprisingly, Law has change of heart, one that appears to be spurred by a literal change of heart, and suddenly . . . the repo man becomes the debtor. (That’s credit-speak for “the hunter becomes the hunted.”)

Judging from the preview, Repo Men looks like your typical sci-fi dystopia flick where good-looking people fight a seemingly losing battle against a behemoth government or corporation that controls every aspect of human life. What’s interesting is that the credit industry has a starring role as the Big Brother. The movie takes two of the worst miseries of the current credit system – overwhelming medical debt and rampant foreclosure – and twists them into one debt nightmare. I never thought the line, “We could come up with a plan that fits your [budget]” could sound so menacing. Does a movie like this mean that there’s enough anger at lenders to, say, get us a Consumer Financial Protection Agency with teeth? I don’t know. But it does suggest that this is our big chance. We may never get an action-movie moment again.

Thank you to UT student Jennifer Carter for the tip!

A recent FT Editorial implicates a topic I — basis risk in emerging markets (EM) credit derivatives.  The problem is this:  If you want to buy protection against default by a big U.S. firm–say, GM–you buy a CDS contract on a GM bond.  But even in the leading emerging markets, it is often difficult to buy protection on major corporate credits, especially if you want to hedge against default on local-currency or other non-dollar/euro/yen obligations.  This is because local financial markets are relatively thin.  Your choice then is to buy a liquid standardized instrument, such as a CDS on foreign-currency sovereign debt, or to negotiate an expensive bespoke contract with a party willing to take the precise local risk off your hands.  If you opt for the liquid standardized sovereign CDS, you get partial protection.  This means that if your borrower defaults but the government is still servicing its dollar-denominated foreign bond, you cannot collect.  Herein the basis risk.  Note that even if you were able to arrange bespoke protection, you could be taking on more counterparty risk, since the only people willing to insure illiquid local instruments might be local institutions more exposed to measures such as capital controls … or risk-hungry fringe elements that might flake out on you.

How is any of this relevant to the current debate on regulating “naked” CDS, or credit protection not matched by exposure to the underlying credit (aka fire insurance on your neighbor’s house)?  It goes to the difficulty of defining the subject.  A CDS that might appear naked at first blush could in fact be partially clothed; and instead of encouraging better hedging, we might end up eliminating what partial protection is available in less liquid markets (damage insurance on your block?).  Not to say that EM basis risk should even remotely drive the discussion, but the example does expose the challenge of figuring out not just the legal terms of the regulated instruments, but the often less-than-intuitive ways in which they are used.

One thing that I think we all agreed on in yesterday’s panel on “too big to fail” was that many of the plans for a separate resolution authority are being driven toward a FDIC model by Treasury and the Fed, both are whom are more familiar with that approach, rarely talk to restructuring or chapter 11 people, and continue to have an unbridled fear of chapter 11.

More of that can be seen in yesterday’s TARP COP report on GMAC, which really seems like the little sister to AIG. I believe both GMAC and AIG would have been better handled in a government-supported chapter 11 process, that would have provided a legal framework for driving a hard bargain with the firms’ counterparties and showing shareholders and bondholders that failure has real consequences.

I’m on a panel tomorrow at the Dow Jones Restructuring and Turnaround Summit about how the government should address “too big to fail” and the collapse of systemically important firms. For those of you who won’t find yourself in lower Manhattan tomorrow, my current thinking on the subject is thus:

• We need a common forum. Be it insurance company, broker-dealer, hedge fund, or bank the entire enterprise needs to be addressed in one place, at one time. Ideally this forum would encompass all the major financial jurisdictions (New York, London, Zurich, etc.) but for now I’d be willing to settle for a single forum for the U.S. part of the problem.
• The mechanism needs to provide liquidity to the failed firm until resolution. And it needs to accommodate the possibility that the liquidity provider might be the government (either the Treasury or the Federal Reserve) or some quasi-governmental thing like the IMF. I note that chapter 11 already has such provision, including provisions for subordinating preexisting liens.
• Regulators need to be able to institute proceedings, because if the failing firm is big enough sometimes nobody else will have the incentives to face the inevitable (see, General Motors, Lehman, etc.).
• Moreover, we need to institute proceedings while the firm still has some working capital, instead of allowing management to drive until the tank is dry (see, Lehman, AIG, Morgan Stanley (almost), etc.).
• Modeling the resolution system on the FDIC approach only makes sense if we think there should be similar goals — namely, protecting customers of the failing firm from losses and reducing the costs to the government. The second one might be applicable, but I’m not sure about the first — that sounds a lot like destroying incentives to monitor counterparty risk (or that “Moral Hazard” thing everyone was talking about in August 2008.).
• I don’t think it makes a lot of sense to “reinvent the wheel” and create an entirely distinct resolution authority that (hopefully) will only be used once or twice every twenty years.
• Instead, why not use a modified chapter 11, that gives the failed firm a brief period (90 days at most) to reorganize, recapitalize, or sell the debtor? Locate the court in New York, but cherry pick the best judges from around the country to staff it. Or at least look to the SIPC proceedings, which bring in Bankruptcy Code provisions except where there is an express need to do it differently.
• I keep hearing that the Bankruptcy Code won’t work because the judge
  has to consider everyone’s interests — I’m not sure that the lack of
  transparency and due process has helped in the current situation — shall we ask the WaMu shareholders and bondholders what they think? — and
  the GM, Chrysler, and Lehman sale hearings show that speed, respect for
  the collateral effects of a case, and due process are not inconsistent.
• Talking about too big to fail or derivatives markets reform without addressing the safe harbors, and their effect on systemic risk,
  leaves the job half-done, unless we really think no big financial firm
  will every fail again. In which case, why are we worrying about a
  resolution authority?
• Overall, the traditional separation between bankruptcy and banking law collapses in a financial crisis. The financial system would be better off if these two disciplines talked more often, and definitely before the petition date.

Pick which blog post you want to read:

The year-over-year increase in bankruptcy filings for February hit its lowest mark since the trough in filings after the 2005 changes to the bankruptcy. February saw only 6,170 filings per business day which was a 13.3% increase over February 2009. The rate of increase in bankruptcies is leveling off, possibly indicating a brightening financial picture for the middle class. The February figures continue a trend that has been developing over the past several months, as discussed in the blog post discussing the January figures and its accompanying graph.

Or, if you would prefer:

The daily bankruptcy filings in February (6,170) hit its second-highest point since the 2005 changes to the bankruptcy law. February daily bankruptcy filing rate was a 14.2% increase over January. If the trend continues, 2010 will be a record year for bankruptcy filings, possibly even eclipsing the aberrational year of 2005 when people filed in a rush to beat changes to the bankruptcy law. These figures show a deteriorating financial picture for the middle class.

The figures in both paragraphs are accurate. It’s all in how you pitch it, and if you read the blog regularly, you will remember me bemoaning the often hyped-up presentation of the bankruptcy figures just to create sensational headlines. To get a balanced sense of what the bankruptcy filing figures are telling us, there are a few key points always to keep in mind.

(1) Don’t confuse the legal action of “bankruptcy” with the underlying condition that creates. Financial distress is the underlying condition. Guest blogger Jim Hawkins raised questions about whether the term “financial distress” is the right one. If you don’t like “financial distress,” then for our purposes here “lack of cash” will do.

(2) Bad economic figures, especially unemployment which is often cited, do not indicate an immediate and proportional increase in bankruptcy filings. The converse is true–bankruptcy filing data are not a direct and immediate measure of economic well-being. People do not file bankruptcy the day they get laid off. They generally struggle for a long time with the financial distress that comes from unemployment. Our work suggests that almost half of bankruptcy filers feel they struggled financially for over two years. The triggering event that leads someone to walk into bankruptcy lawyer’s office is different for different people, but for many people it often has to do with the unavailability of further credit.

(3) Bankruptcy filings are cyclical through the year. This paper from Professors Mann and Porter–aptly titled “Saving for Bankruptcy”–explores in great detail how persons often save up for bankruptcy. The February increase is part of the cycle, but it’s not as great an increase as in past years.

Overall, the situation is a “half empty/half full” thing. Bankruptcy filings are headed toward five-year highs. For the past two years, the first two months of the year have had 13.2-13.3% of all filings for the year. If that pattern holds, we’ll have about 1.65 million filings this year. That will be very close the per capita rate before the 2005 changes went into effect. That is hardly great news.

At the same time, the 2005 changes to the bankruptcy law did nothing to change the underlying reasons why people file bankruptcy. It is hardly surprising that we are at or near a per capita level of filing that had been sustained for years before the 2005 law went into effect. With the amount of consumer debt, we have to expect high bankruptcy filing rates. In the long-term, if consumer credit remains tight, then that will drive down the number of persons with the sort of debt that leads them into bankruptcy court.

The small banks are dropping like flies.  At this rate the only banks left are all is going to be too big to fail.

 Did Congress’ effort to protect you from your card company with the Credit CARD Act inspire you to pore over the new Cardmember “Agreement” that probably arrived in your mailbox this week? I actually read at least part of mine, looking in particular at the implementation of the Credit CARD Act. (I am apparently one of the “consumer advocates” that Ronald Mann thinks has the time to “scrutinize the agreements and bring attention to provisions sufficiently onerous that they would not bear public scrutiny.”) 

The first place I looked in the Cardmember Agreement was the paragraph labeled “Default/Collection.”  I was looking for the much-touted restrictions on universal default. Here is what I read, to my initial surprise: “Your account may be in default if any of the following applies:  . . . we obtain information that causes us to believe that you may be unwilling or unable to pay your debts to us or to others on time.”  Wait a minute? That sounds like my default (or purported default) on my debts to someone else is a default to JPMorgan Chase. Isn’t that what “universal default” is?

Actually, no, at least not as defined in the legislation. The Credit CARD Act prohibits raising ”any annual percentage rate, fee, or finance charge applicable to any outstanding balance” with a few exceptions.  Notably, absent from the list of exceptions is the ability to increase those charges based on a cardholders’ default to other creditors. But of course, that is not what the JPMorgan Chase agreement permits. Rather, it says that I can be in “default” for being unwilling or unable to pay debts due to others, not that my charges can be increased. Under the Cardholder Agreement, a default permits JPMorgan Chase to close my account without notice and require me to pay my unpaid balance immediately. That is pretty grim result for a late payment to another creditor, even if it is not “universal default.”

While they hold some allure for the pointy-headed company I normally keep, the old fixing-floating-IMF-bailout handwringing detailed in my last post is nothing to the titillation of the Goldman-CDS angle on the Greek drama.  FAQ series continues with a focus on lying.

Who lied, to whom, about what?

The accusation is that Greek officials reported their debt figures to the European authorities, and by implication, to the world, in a misleading fashion.  I mentioned in my last post that Euro area countries promise to strive for specific deficit and debt targets.  Until Europe’s statistical reporting rules changed in 2005, Greece appears to have availed itself of their flexibility to move some debt off balance sheet.  They are accused of having done so using, among other things, reasonably straightforward currency and interest rate swaps.   The swap rates were “off-market”, calculated to deliver Greece cash up front in exchange for more cash in the future, a.k.a., to act like a loan without counting as a loan.  This was first detailed in Risk back in 2003; Der Spiegel revived the lies-in-general and the lies-with-derivatives narratives as things blew up in recent months. My colleague Ken Anderson was among the first to put this reporting on lawyers’ radar screens, and has been deep and nuanced ever since.

The more subtle accusation of lying goes against Goldman Sachs, which helped arrange the swaps.  First, they may have aided and abetted the Greek lies.  Second, if Goldman had private knowledge that Greece was in much worse shape than its public appearance would suggest, and used that knowledge to “bet against” Greece in the derivatives market, they committed a separate bad act of their own.  However, timing could be important:  did they use inside information about lies in 2005 to “short” Greece in 2010?

This is obscene and unheard of!  How can we tolerate such behavior in our midst?

Obscene, maybe.  But hardly unheard of.  The FT and Reuters recently ran overviews of derivatives and securitizations used by other Euro area countries (including Germany) to work around various virtue targets.  Felix Salmon mentions in passing that Germany securitized its holdings of Russian government debt at a hefty spread over Russia’s borrowing cost a few years ago, apparently to avoid on-budget borrowing and Maastricht discomfort.  And while Europeans used derivatives to perfume their liabilities, other countries–famously Thailand–used them to puff up their central bank assets.  No child was left behind, and it has been good for the investment banking business.  Even so, Argentina was ahead of the curve in figuring out how to burnish statistics without paying a penny to Goldman. (See also this one from 1976.  Paul Volcker is right, innovation is a sham.)

Governments are incorrigible fraudsters.  Should we take away their sovereign immunity?

Nah.  Private Japanese banks massaged their bad loan books in the 1990s using derivatives specially designed for them by foreign banks … that got slammed when the authorities discovered that “gambling was going on.”  Jeff Skilling is back in the limelight. And in the normal-but-deeply-ironic category, SIGTARP reports that the bulk of AIG’s CDS writing adventures help European banks get capital relief under Basel rules.

More disturbing, it is easy enough to construct a category of deadbeat countries that cannot manage their way out of the fiscal paper bag, until yours ends up among them, and then it becomes all about democracy.  More on democracy in that Ecuador post I keep promising (keep clicking through here to learn more!).  But surely it is part of the sovereign credit decision, just as management quality is for equities, non?

I hear the Fed, the S.E.C., and all of Europe are investigating.  What, how, on what basis?

The Fed is responsible for Goldman because it became a bank holding company in the fall of 2008.  Presumably they will look for fraud, mismanagement, and any threats to safety and soundness.  The S.E.C. might investigate fraud and allegations of trading on inside information.  The Europeans have a host of statistical compliance, plus all the securities and safety and soundness issues to worry about.  But query who would expose both Goldman and Greece without getting the green light from both finance and foreign policy authorities, and an exit strategy for both.

Beyond fraudsters, someone must worry about the implications of the affair for the system as a whole.  For even if the investigators uncover evil, they may feel powerless to sanction it because the world economy and financial markets are still in a fragile state.  The Fed, the ECB and the IMF are probably thinking along these lines, but so far there is no straightforward regulatory path to address these concerns.  We regulate systemic risk by proxy and euphemism.

Wait, Are You Defending Both Goldman and Greece?

In a manner of speaking.  The Euroliar loan imbroglio is a symptom of the bubble-bust cycle and a cautionary tale about fixating on rules and targets.  At the peak of the bubble, lies are either invisible, or more likely, look unimportant. 

“The system did it!”  This is a total cop-out.

This is a partial cop-out.  I recently served on a commission where we struggled mightily with the politics of bubble-bust regulation; I do not think we fixed the problem.  Last week I was struck by the extent to which some economists at the FCIC forum invoked the need for a bad guy narrative.  And there are plenty of bad guys here, and they should be slammed.  But the bad guy narrative–Greece and Goldman alike–lets feckless-rule writers, forbearers, and bubble-boosters act sanctimonious, and tells citizens to go back to sleep now that bad guys are locked up.  Unless we revisit the incentives to lie, new financial products will keep springing up to serve as delivery vehicles for more lies.  It’s an old and boring argument–in other words, a cop-out.

Aha!  Financial Products!  Are you for or against Credit Default Swaps?

I am not one to say that guns don’t kill people.  But the factual predicate for the Greek CDS controversy looks thin for now.  Felix Salmon has persuasive reporting on the topic here and elsewhere in his CDS Demonization Watch series; Stephen and Kim Krawiec have lent law gravitas to this telling of the CDS and broader derivatives story.  I will not repeat, but want to mull a minute on why it would not go away.

It is true that the existence of a bigger, more liquid CDS market makes it easier for people to express negative views on a credit—here Greece.  This could help drive up the spreads and have all kinds of feedback mechanisms thanks to stuff like collateral requirements.  Felix convinces me that the availability of CDS insurance today may make the difference between Greece having market access at a high price, and not at all.  Related, several economists at the FCIC forum (no I have not seen any other movies) revived the argument that having a bigger, deeper CDS market earlier might make bubbles smaller/prevent their formation (more people get negative earlier).  The problem is that CDS emerge “at the worst time,” just as the bubble is bursting.   Indeed they do, because you need enough downers demanding protection to have a market, and downers are scarce as the bubble inflates.  A counterargument is that the bubble might have gotten even bigger without CDS.

Yet I stop short of concluding that CDS demonizers are ignorant or cynical.  CDS are part of the embedded leverage and stratospheric growth story that has made finance too big for our collective mental and political disk space.  I do not think that product banishment helps fix this problem; like bad guys, it can be a distraction.  That is why I would sooner go with Volcker and Turner.  They too propose blunt tools, but are much more self-aware.

So what should happen?

After four nominations, Claude Rains should finally get his Oscar for lifetime achievement in the portrayal of financial regulation.