Credit

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.

This follows on Stephen’s post earlier in an effort to help sort through the Greece-Goldman-Germany love triangle and the deafening din surrounding its implosion.  This post sets out the background for the Greek crisis, mulls law as a macro commitment device, and the relative merits of EU and IMF bailouts.  The next one goes into more depth on Goldman and derivatives.

Why is everyone talking about Greece?

It’s the Olympics! (Did You See the Inflatable Beavers?)  And because Greece needs to come up with Euro 20 billion (about $27 billion) by April-May to roll over maturing debt.  Greece is having trouble borrowing the money because its debt stock is pushing levels that help poor developing countries qualify for official debt relief, with little prospect of going down.  As a result, Greece may have to pay a 4% premium over Germany, if it can borrow at all.

So what?  What happens if Greece defaults?

When a government defaults, two big things can happen.  First, its creditors—critically, domestic banks, but also foreign banks, bondholders and sometimes foreign governments—lose money and might go belly up.  They say most of the Greek debt is held by European banks, though with derivatives and all, hard to tell where the true economic interests lie.  Second, the Markets get scared, and try to break up in a hurry not just with Greece, but with people and things that rightly or wrongly remind them of Greece (Spain, Portugal, Italy, Ireland, California, the letter G, and the neighborhood souvlaki stand).  This could produce concentric circles of collateral calls, asset sales, price drops, credit contractions, business failures and job losses far, far away from Greece. Even if you could care less about Greece (which would make you heartless), this is the last thing you need in a fragile global recovery.

OMG.  How did it get so bad?

Hard to tell without getting existential.  Greece has had budget and debt problems for over 100 years.   In the immediate case, if Greece had been a regular country, it might have tried to grow its way out of trouble by devaluing its currency, causing tourists to stampede to the Acropolis gorging on souvlaki and generating tax revenue.  But Greece cannot do that, because in 2001 it joined the European Monetary Union, and dropped the Drachma for the Euro—a strong common currency managed by the European Central Bank.  This made it cheaper for Greeks to import German cars.  But it made it harder for Greece to draw Germans to the Acropolis with a sale on souvlaki.  Latvia’s so-far successful effort to adjust without abandoning its currency peg to the Euro shows the magnitude of the political effort required:  drastic budget cuts in the face of a GDP contraction over 17% and near 23% unemployment.  You too would tea party.

Why would anyone limit their options in crisis? 

Because some reasonably see the benefit of the occasional devaluation option as limited compared to that of integrating in the vast European market, and riding the general confidence in the stable European currency associated until recently with German budget discipline, not Greek debt history.

In any event, joining the Euro was also supposed to end the history.  This is because as a condition to joining, Greece promised to get its budget deficit and government debt in line with the European targets of 3% and 60% of GDP, respectively.  As this was a legal, valid and binding commitment made under a bona fide international treaty, people and markets could sleep soundly.

Are you being snide?

Yes.  Saying so rarely makes it so.  Argentina had a law that said one peso was worth one dollar.  The United States issued debt that promised payment in gold.  Both promises lasted until they didn’t.  This is not to say that law is not a commitment device, but that it has limitations.  When the enforcement and reputational cost of breaking or changing the law is dwarfed by the cost of economic collapse and social unrest, the law gives.  And it should.  As the apocryphal saying goes, now we are haggling about the price.  But price is very important.  I will address this later in a post about Ecuador, Iceland and Greece (until then, see Adam Feibelman and Mitu Gulati at Faculty Lounge).  Be that as it may, after almost a decade in the Euro Area, Greece’s budget deficit is 13%, and its debt is on track to hit 120%, of its GDP.

So who will save us from the apocalypse, and how?

Apart from Percy Jackson, Batman and another credit bubble, there are two basic options.  Option 1 is for Europe and/or other Member States to give or lend Greece the money to pay its creditors.  Option 2 is to send Greece to the International Monetary Fund, which has a well-developed line of business doing just this sort of lending.

Problem 1 with Option 1 is that German taxpayers feel about the same about Greece as U.S. taxpayers feel about their brethren of the foreclosed McMansion.  People who call themselves taxpayers tend to have little patience for arguments about network externalities (we all rise and fall with the tide) and may not feel the musketeer spirit (even their names were Greek!) for the profligate.

Problem 2 with Option 1 is that the Maastricht Treaty (via the Lisbon Treaty) has a no-bailout covenant, which has received much press coverage courtesy of German politicians:

The Community shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State …  A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State … [Art. 125, Sec. 1 of the consolidated treaties]

To this complete outsider, the prohibition is oddly narrow, drafted to address mandatory assumption of debt.  All manner of financing including guarantees may not be covered, which may explain the private lending options being mooted, discussed below.  Moreover, there are at least three other treaty provisions that suggest that some form of support may be forthcoming if the right parts of the EU apparatus jump through the right procedural hoops.  No doubt the no-bailout clause saved some serious face for some treaty negotiators, but our own experience with Section 13(3) of the Federal Reserve Act suggests that legal texts acquire a special hue in crisis.  If I get enough on this, I will do another post with questions for the EU law experts out there.  For now, this Issing-Padoa-Schioppa exchange is central banking at its most poignant.

Option 2—going to the IMF—has found favor with the internationalist set, but it too has problems.  First, it is mildly to very embarrassing for the EU to send Greece to reform camp outside the home.  It feels like a status knock-down: since the 1970s, going to the IMF has marked the boundary between governments and sovereigns that I discussed in my earlier post.  FT muses on the subject here. Governments take care of their own business; sovereigns flee to the IMF and hide assets from suing creditors.  In fragile markets, the EU and others on the government side of the bright line might want to hang on to the illusion.

Problem 2 with Option 2 is more interesting.  Emergency (aka bailout) funding usually comes with unpleasant policy strings attached.  Who should pull the strings is an important political question, not just for Europe but also for the Obama Administration.  Stipulate that the string-puller is trading off popularity for a measure of control over the Greek policy program.   Germany might want more certainty that Greece would fix its budget, but it risks fanning uncomfortable political flames (see Kim Krawiec’s Nazi post and references).   The IMF comes with its own political baggage, but surely snagging a high-end case like Greece is an institutional boost of Olympic proportions.  As for the United States, the largest shareholder in the IMF, the upside is less clear.  All things equal, I don’t want us implicated in Greek policy making, and want more love in Europe as the dollar goes up and I go shopping for shoes and souvlaki.

For now, the leading EU option is to avoid both sets of hard choices, but to get the already-over-exposed European banks to tide Greece over, perhaps with explicit guarantees from Berlin, Paris, et al., which are apparently no problem under the no-bailout clause.  This sounds a bit like the 1980s, when the U.S. government nudged the most exposed U.S. banks to roll and top up loans to Latin American governments while regulators forbore, until Nick Brady, David Mulford & Co. hit on a mix of debt reduction, public and private concessions that made for a more durable fix.  Let us see how long this one lasts.  There is always Percy Jackson.

As for the Olympics—what did people think of the stiletto Mounties act? 

I’d like to say thanks again for the chance to share some thoughts at Credit Slips.  I’ve really enjoyed the comments.  I wanted to end with a post about a current issue before Congress. 

One reason it is important to know what financial distress means and to understand the relationship between fringe banking and financial distress is that policy makers consistently use financial distress to justify intervention into fringe markets.  Because financial distress creates externalities, it is a powerful tool to justify regulation.

A speech President Obama made late last year arguing for the Consumer Financial Protection Agency (still working its way through Congress) is a good example of how this works.  To make the case for the CFPA regulating payday lending, the President gave the example of a women who’d taken out a payday loan.  He linked the product to wide-spread financial distress: “Abuses like these don’t just jeopardize the financial well-being of individual Americans—they can threaten the stability of the entire economy.”  As I have argued, I think this claim is really hard to make out.  Financial distress might justify the CFPA regulating credit cards or mortgages, but I don’t think it justifies regulating on the fringe.

Relying on a link between fringe banking and financial distress distracts from the other persuasive arguments for creating the CFPA.  And, in other contexts, it leads to regulation aimed at solving the wrong problems.  People using fringe banking need protection, but we need to rethink regulation aimed at preventing financial distress because it solves a problem that I don’t think exists. 

I’m sure our current guest blogger will have more to say about the current state of the sovereign debt markets, but I could not resist commenting on this rather confusing and odd article in today’s FT about Goldman and Greece. Turns out part of the problem is that the article uncritically rehashes this letter from Representative Maloney, which is itself confusing and odd.

The key quote from both is this: “The increase in demand for insurance on government debt through
credit default swaps harkens back to the activities that brought down
American International Group.” I’m not sure quite what this means, but the apparent analogy is flawed for several reasons. First, AIG was selling CDS with no real risk management, whereas Goldman is now buying CDS. Greece is neither buying nor selling CDS, although the article and letter might leave you with that impression. Second, while I’ve certainly argued that corporate CDS can generate perverse incentives to push a company into bankruptcy, I’ve also warned against the unthinking importation of corporate bankruptcy concepts into the sovereign debt world, and this analogy seems to be headed in that direction. Sovereigns — at least at the national and state level — can’t be pushed into bankruptcy involuntarily, indeed they can’t file for bankruptcy at all. That’s an important difference that is often lost in the breathless commentary that the CDS markets will lead to a Greek/Icelandic/Portuguese/Californian “bankruptcy.” Finally, I’m not sure why the “increase in demand” for sovereign CDS is itself anything to be concerned about — other than what it suggests about the underlying problems with sovereign borrowers.

Indeed, I don’t really understand the basis for the argument, made in the New York Times this week, that sovereign CDS will somehow push Greece to default, although I note that the AIG quote from FT and the Congresswoman could be charitably described as a restatement of the second paragraph of the NYT article. The Times article itself suffers from the sovereign/corporate confusion I discuss above.

At heart, the FT article (along with the Congresswoman’s letter) seems like a rather feeble effort to link the present problems regarding Greece to the new easy target for all financial reformers:  CDS.

I spent most of Friday at the Financial Crisis Inquiry Commission forum, which we are hosting at the American University Washington College of Law.  I am going back on Saturday morning.  The forum is open to the public, the papers are posted, and the proceedings are webcast live.  At a minimum, this is a pretty high-end conference, featuring some of the top names in the crisology business:  Brunnermeier, Geanakoplos, Gorton, Gourinchas, Jaffee, Kashyap, Kroszner, Lusardi and Mayer.  The presentations are quite accessible, reflecting the FCIC’s public inquiry mission.  If it is any indication, a goodly number of my students came, stayed awhile, and seemed to leave happy.  Even where the underlying material is not new, I have found the exchanges among the panelists and the commissioners well worth tuning in for.  A rare mix of economics and civics.