More on the Miller-Moore Amendment and Unintended Consequences

Yesterday, I went after two targets in one post. The primary one was Andrew Ross Sorkin, who despite the considerable reporting and storytelling skills he demonstrated in Too Big Too Fail, seemed unable to keep a heavy-handed pro-Fed posture out of an article yesterday on the Paul-Grayson-DeMint bill, which more popularly goes by monickers like “Audit the Fed.”

A secondary one was an amendment to the bill by Brad Miller and Dennis Moore, which would allow for the debts of fully secured creditors to be haircut by 20%, I had seen this provision only in isolation and objected because a 20% haircut might not be sufficient. A well established practice in commercial bankruptcies is for secured debt to be reduced to the current value of the collateral (any amount above that is treated like unsecured credit). If collateral was badly impaired, a 20% haircut would not be sufficient.

Well, it turns out I was wrong. Another section of the bill provides for collateralized loans to be treated just as they are in commercial bankruptcies, that is, written down to the value of the security (if the security is worth less than the supposedly secured loan) and the balance treated as unsecured. So why the need for the additional 20% haircut?

Brad Miller was kind enough to weigh in on the post and offer this rationale as part of a longer comment:

The creditors to whom the amendment would most likely apply would be existing creditors who see the collapse coming and are in a position to demand more and more collateral. Only a desperate management agrees to tie up all of the firm’s liquid assets as collateral for short term debt. In those cases, the FDIC should probably not wait until Friday night to knock on the door. The resolution would certainly be easier, and cheaper, if the firm still has some assets that aren’t pledged as collateral.

If the amendment deters short term lending to collapsing companies that allows some creditors to grab enough collateral to cut in line ahead of taxpayers on resolution, that’s okay. That’s an intended consequence.

I hate to say it, I still don’t like this amendment, but I’m willing to be persuaded otherwise by experts in repos. I think this amendment has the potential to make runs on big capital markets firms happen even faster.

Those of you who read Richard Bookstaber’s Demon of Our Own Design may recall his discussion of tightly coupled systems. A tightly coupled process progresses from one stage to the next with no opportunity to intervene. If things are moving out of control, you can’t pull an emergency lever and stop the process while a committee convenes to analyze the situation Bookstaber argued that our financial system was tightly coupled. One feature of tightly couple systems is that measures designed to reduce risks often wind up increasing them. Let’s consider some of many examples from the crisis:

1) Congress raises conforming limits on Fannie/Freddie to help unfreeze the mortgage market. Result: agency spreads skyrocket, bringing down Bear and a host of hedge funds. Mortgage markets still remain frozen.

2) Fed opens TSLF to unfreeze mortgage market. Result: Carlyle goes bankrupt as people rapidly arbitrage the difference between holding MBS in firms that can and can’t access the new credit facility. Mortgage markets remain frozen.

Now back to the amendment. Perhaps readers can give me some examples, but I must say, the “borrower going even deeper into hock pledging collateral they have sitting around when on the verge of bankruptcy” strikes me as a projection from the bricks and mortar world onto the financial realm. Why? Well, for starters, banks and investment banks are already up to their gills in debt. Their modus operandi is that they are highly geared.

And aside from perhaps mortgages on owned property or equipment leases (which for banks of any size will be trivial relative to the size of their balance sheet), the big type of secured lending will be repos. And firms that are big repo borrowers and lenders (firms that do repos also have a lot of reverse repos) in general do not have a lot of spare collateral sitting around.

So I struggle to think exactly when this provision might prove beneficial (as in when a financial firm might in the course of normal business have a lot of collateral it could pledge to a loan shark-y lender if it got in financial distress. Maybe it applied in a GMAC type scenario; I’ll confess that equipment lessors are not an area of expertise of mine. But I have trouble seeing how it will be a boon with the most common type of large financial firms that might get themselves in trouble, namely commercial banks and what used to be investment banks, meaning big capital markets players. And I see the amendment having the potential to make matters worse.

Repos are a huge source of financing to broker dealers, meaning large capital markets players. Repo is short for “sale with agreement to repurchase.” It’s a pawn-shop like procedure. Broker dealers lend out high quality securities on a short-term basis, subject to a haircut which depends on the quality of the collateral and the caliber of the borrower. Big financial firms (and even money market firms) lend money via repos. Why? Well, it’s far better secured than putting money in a bank as an unsecured deposit. You have a high quality instrument you can sell if the place you deposited your funds goes poof.

In the stone ages of finance, only very high quality collateral, meaning Treasuries, was eligible for repos. But as the derivatives market exploded, more and more parties needed collateral to secure their derivatives positions. Over time, the standards for what was eligible collateral loosened.

So let’s go back to what happened in the crisis. All kinds of stuff, as long as it had a pretty good rating, was accepted as collateral. AAA tranches of ABS CDOs got a 2-4% haircut, and AAA tranches of CLOs got a 4% haircut. That meant if you repoed an AAA ABS CDO, you’d get a loan of 96 to 98 cents on the dollar.

Now the problem is a lot of those supposed AAA instruments were anything but. Haircuts rose sharply on AAA ABS CDOs in particular. By August 2008, the haircuts were….95%. And the history of this dreck paper shows that at certain points the haircuts jumped massively.

I would submit that this amendment could have either of two effects in a time of deteriorating credit conditions and asset quality. One is that repo lenders (or more accurately, the clearing banks, since they typically the ones that impose haircuts) will raise repo haircuts in anticipation of this provision being invoked, more aggressively than they might have otherwise, to keep from being caught. But perhaps even more important, repo lenders, who even under normal circumstances, are leery of having accounts and collateral frozen in a bankruptcy, will have even more cause for pause (the haircut on their collateral is a new wrinkle), and will thus be even faster to pull back on extending counterparty credit to a party that is starting to suffer credit downgrades.

The second is that it could put clearing banks (meaning JP Morgan) in the position of being cast in the role of the evil organization that demanded more collateral of a failing firm. Students of the Lehman bankruptcy might agree with that characterization, since it was JPM’s seizure of $17 billion of Lehman’s cash and collateral that was the proximate cause of its bankruptcy. But I don’t see this designed to be a “rein in JP Morgan” bill (Morgan was faced with having its actions subjected to fraudulent conveyance clawbacks if they were deemed improper), but informed readers may have better insight here. And I suspect this provision could produce dysfunctional behavior at the worst possible juncture.

Update 2:00 PM. This probably should have occurred to me at the outset (sometimes I am slow to see the obvious), but one might infer that the amendment is designed specifically to deal with AIG collateral posting type situations. The problem here is that the whole reason for bailing out Bear and AIG was to keep from transmitting a shock to the CDS market, since that is a major, if not the major, way that counterparties have enmeshed exposures and the failure of one might lead to the failure of many.

And if the effort to move CDS to a clearinghouse succeed (I have been skeptical that the proposed legislation will produced its claimed results), you have yet another problem. We have said here repeatedly that central clearing of credit default swaps is not an effective remedy because there is no way to allow for adequate margin and have the product work economically (and of course, the whole fantasy is that you can have safe credit default swaps, just like you can have safe dynamite). The result, an undercapitalized clearing, becomes a concentrated point of failure. And if the government can force deeper haircuts on the exchange after the fact, that would exacerbate the problem or even lead to the failure of the clearinghouse (which means the provision would presumably not be applied). As we have pointed out repeatedly, the Merc and the NYSE came very close to failing in the 1987 crash, so this is not an abstract concern.

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17 comments

  1. Ronald Fink

    So what’s your problem with Sorkin’s piece? His main point was that this amendment would increase systemic risk because it would lead to more Lehman-style bank runs, and you seem to agree with that.

    1. Yves Smith Post author

      Ronald,

      No, please read the Sorkin article. His concern was on the effect on bondholders, which are not often (for financial firms) secured and on Fed independence (which I said in my earlier piece were non-issues). And nowhere does he mention runs. I do see that one of his sources mentioned repos as a cause for concern, which I missed in the first reading.

  2. RueTheDay

    “Only a desperate management agrees to tie up all of the firm’s liquid assets as collateral for short term debt.”

    That is correct. Obviously this step is only undertaken when there is no other choice. The additional 20% haircut does not fix this, it only removes a choice and pushes the firm into bankruptcy sooner (with the idea of preserving assets to be divided in BK).

    “In those cases, the FDIC should probably not wait until Friday night to knock on the door.”

    This is the real solution, not the 20% haircut. As soon as it becomes apparent that BK is almost unavoidable, the authorities need to step in and shut it down before the vultures pick the carcass clean.

    When a warehouse two buildings over from a gasoline depot catches fire, you don’t wait until the middle building catches fire before undertaking drastic measures.

  3. brad miller

    Thank you for thinking through how the amendment might work in practice, rather than just warning solemnly of possible “unintended consequences” without specificity. Financial industry lobbyists frequently just do the latter when they don’t like something, as if that’s a real argument.

    I will pass along your piece to the Congressional Research Service, to the Financial Services Committee staff, and to the FDIC staff. My office worked with all of them in preparing the amendment.

    I’m not entirely sure if the amendment applies to the repo market at all. The transactions in the repo market are characterized as a sale with a repurchase agreement. In some cases the law looks past the form of a transaction to the substance. Most equipment leases, for instance, are regarded as secured debt, and repo transactions might well be regarded the same way. We have the CRS looking into that question in light of the discussion here and elsewhere in the last few days. One way or the other, it may be useful to clarify whether the amendment applies.

    Even if repo transactions are regarded as secured lending, however, I am not persuaded that the possible consequences you present are so undesirable in the circumstances in which the amendment would apply.

    Again, the amendment would only apply in extreme circumstances. One of twenty or so systemically significant firms, and everyone involved would have a pretty good idea who they are, would be taken over by the FDIC, and even after all shareholders, bondholders and general unsecured creditors lose everything, the resolution authority would still take a loss. That would not be a case of a firm tipping over into insolvency with liabilities slightly exceeding assets, that would require a spectacular collapse. A collapse like that should not happen if the systemic regulator is paying any attention at all, and the word would almost certainly be out in the financial industry that the firm was living on borrowed time.

    You say that repo lending takes into account “the quality of the collateral and the caliber of the borrower.” Was anyone lending to Lehman last summer, to use your example, paying any attention at all to the caliber of the borrower? Shouldn’t they? That’s the point that Sheila Bair made in urging the haircut provision–it will encourage some due diligence even for secured creditors, which will enforce market discipline.

    If a systemically significant firm is gloriously insolvent, lots of short-term secured borrowing as the lights are flickering does make the ultimate resolution more difficult. If a systemically significant firm is unfairly stigmatized there are other sources of lending that would allow regulators a better view of what is really going on. The firm can borrow from the Fed. And another amendment to the bill allows the federal government to sell insurance for the debt of a significantly significant firm.

    And the parties that lend through the repo market are voluntary creditors, and they will be in front of all other voluntary creditors. The only creditor who will benefit from the haircut will be the taxpayer, whose loss is entirely involuntary (and I can tell you, taxpayers are not at all cheerful about the losses they have already taken). I’m not sure I see the justice of creditors through the repo market being made whole when taxpayers (or the insurance fund) are taking a loss.

    Still, I will consider your thoughts as the bill goes forward.

    I can’t spend every morning doing this, by the way. Either stop writing about me or write at a different time.

    1. Yves Smith Post author

      I am flattered that you have taken the trouble to weigh in here and explain the intent of your proposal.

      However, as I concerned citizen, I am within my rights to discuss pending legislation, so I am not writing about you, but about the amendment that has your name attached to it. I do not post as a means to communicate with particular individuals in authority (my assumption is they either do not know of me or if they happen to find out about a particular post, they ignore me) but for the benefit of my readers. I have criticized many proposals, including those of the Administration, various regulators, both here and abroad, and pending legislation. I am hardly singling you out in this regard.

      And part of my reason for writing is to “open source” my concerns, to see for my own and my readers’ benefits whether my worried are well founded, or whether my thinking is off base. While I have a pretty good broad knowledge of financial services, the tradeoff is that my knowledge is often not deep, and readers who are experts in those areas can offer valuable insights, corrections, and elaborations.

      1. surferdude808

        the primary thrust of this amendment is at the FHLBs. the FDIC mistakenly thinks the secured borrowings by insured institutions leads to higher resolution costs. the actions of the FDIC on this issue are unusual in that they are actually lobbying congress for this amendment. historically, the FDIC will weigh in on legislation when asked, but never to find a sponsor for legislation it wants.

        the FDIC is wrong on the issue. losses to the insurance fund come from the left hand side of the balance sheet or off-balance sheet items, not from the right hand side. FHLBs and brokered deposits to cause bank failures, it is what they do with the funds. bair wants more market review; how about greater review by the regulatory agencies. btw, all of the material loss reviews by the agencies show the malfeasance of duties by the regulatory agencies in curbing risk. if the banking agencies cannot curb risk taking with their access to confidential information and regulatory powers, then how are secured lenders going to do it? also, bair wants to limit the publication of the material loss reviews.

        the FDIC also fundamentally misunderstands this issue with the FHLBs. both systems (FDIC and FHLBs) are mutuals with essentially the same members. the FDIC has no money, it’s fund is paid for by its members (insured institutions). hence, if a bank fails and pre-payment penalty is paid the the FHLB, which increases the loss to the insurance fund, it is not the FDIC cost but rather it is borne by its member. subsequently, the pre-payment penalty received by the FHLB is then dividend to its members. therefore, it is largely a passthrough (there is some friction because of FDIC and FHLB operating costs so it is not 100%). in essence, any higher cost to FDIC members because of a FHLB borrowing is then mostly passed back to same group. this is much easier to understand if there were only 10 insured institutions that were members of the FHLB system.

        the FDIC has not properly studied this issue and have relied mostly on research done by Federal Reserve economists on this topic (see work by vaughn, yeager, etc.). the FRB has a whole other agenda on the FHLB system because of their influence on monetary policiy.

        there are significant unintended consequences if this amendment passes. one other area of secured lending i have not seen mentioned yet is municipal deposits. usually, those deposits are collateralized. will they have to take a haircut as well?

      2. brad miller

        I was teasing. I expect you to write about the financial issues I work on, and I welcome the discussion. It is helpful to me and to the debate generally, and refreshingly honest compared to much of what I have to deal with. Really, my feelings are not that easily hurt.

        I responded to your piece for the same reason you wrote it, to contribute to the discussion.

        I really do value my time in the morning to drink coffee, read the paper and generally putter, however. I hope my morning routine has not now become writing long comments to posts at Naked Capital.

        1. i on the ball patriot

          A little more refreshing honesty here …

          I think the banks should be nationalized totally and be treated as public utilities. Credit should be a public utility and extended on the basis of need and the value of use to society at large — not to benefit some do nothing fat ass parasitic financial industry that has captured the government through graft and corruption and is now gang raping the public with grossly usurious fees and counterfeit financial products that have debased the currency.

          When you work within the confines of such a blatantly crooked system — as the scamerican government has degenerated into — you only serve to legitimize, validate and further empower that corrupt system.

          It is no wonder that pimps, crack whores, and used car salesmen, are now rated more trustworthy than scamerican politicians.

          I hope you consider my thoughts as the bill goes forward.

          Deception is the strongest political force on the planet.

  4. i on the ball patriot

    A perfect example of a Bookstaber “tightly coupled system” would be the ‘progressively connected deceptions’ created daily by the scamerican government.

    This “Audit the Fed” bill, and the amendment, is just another fine example of the workings of the process of ‘progressively connected deceptions’.

    One of my favorites, “of many examples from the crisis”, of a ‘progressively connected deception’, would be the passage of the Gramm-Leach-Bliley Act under the ideological bullshit guise of promoting ‘free markets’.

    These lying sell out pricks should be facing the death penalty! This government is not to big to fail. It HAS failed!!!! Election boycotts and a jubilee rewrite of the constitution are in order!

    Deception is the strongest political force on the planet.

    1. Anonymouse

      Yeah, I don’t really see the purpose of debating the fine points of this ammendment–AT ALL.

      It seems to me that the relevant point is that collusive mortgage and secirites fraud on a mass scale, and the series of legislative changes (and failures to regulate new financial products) as promoted by Fed and Treasury appointments hailing from the financial sector that preceded it, more or less amounts to conspiracy to defraud the government of the United States of America.

      The Federal Reserve bank fiction just provides the most significant mechanism through which such kleptocratic ends can be perpetrated.

      This is the real issue here. It seems to me that debating the fine points of this ammendment and passing it, etc is mostly just a means of institutionalizing fraud.

      Congress needs to back WAAAAAAAYY up and get serious about what just happened in this country instead of greasing the wheels for organized crime in the financial sector.

      You never know, someday the Supreme Court might be forced into going back to doing it’s job. You don’t want to get caught with your pants down.

  5. Bruce Krasting

    A) “that allows some creditors to grab enough collateral to cut in line ahead of taxpayers on resolution, that’s okay.”

    Oh really? Well this tax payer does not think this is such a swell idea. You want to put more of my money ‘at risk’?

    B) What are we talking about here in terms of scope?? Repo is a very big market. This number STARTS at $5 trillion. So for every 1% increase in haircut the system needs $50 billion in new equity. And you want to increase that 20%?? Trust me, that kind of equity money is simply not around today. The banks can’t raise enough to pay back TARP. If you wanted to precipitate another round of credit contraction this would be a good way to do it.

    C) Two years ago this would have had some benefit. It would have calmed things down. It is too late to have much impact. D.C. needs to change it’s focus and look inward. It is the financial credibility of the Central government that is now the issue. The markets no longer care about Citi or BoA. They worry about you.

    D) FHA is making 96.5% LTV mortgages, Fannie and Freddie are doing 125% LTV refi’s, and you are putting a big haircut on collateral? Do you want the government to do all of the lending? You are throwing rocks in a glass house.

    E) Thanks for your efforts. I think “we” realize how difficult this is. We bitch and moan because there really are no “good” choices. Good luck at trying to find the best “bad” choices’.

  6. nowhereman

    Thank-you everyone, I come here everyday, and everyday I am educated. Were it only possible that this knowledge be available to many more people, then, as reality sets in, we would be better prepared for the consequences.

  7. csissoko

    Two comments:

    “Only a desperate management agrees to tie up all of the firm’s liquid assets as collateral for short term debt.”

    But don’t standard derivative contracts fall under the Miller-Moore amendment — and therefore in situations like AIG where derivative liabilities are a problem for a firm aren’t all major financial institutions contractually obliged to post all their liquid assets against derivative liabilities before they declare bankruptcy? What am I missing here?

    “repo lenders … and will thus be even faster to pull back on extending counterparty credit to a party that is starting to suffer credit downgrades.”

    Given that repo pullbacks took down both Bear Stearns and Lehman Brothers in a matter of days, it’s clear that the current system already has this problem. I’m not sure it makes sense to worry about even faster repo runs — you need to give us some idea of the additional cost due to Miller-Moore, not just note that it doesn’t solve a problem that already exists.

  8. David Merkel

    This will mess up secured lending without helping unsecured lending much. One of the risks of being an unsecured lender is that you can be structurally subordinated by the issuance of secured debt. That’s why some unsecured debt has restrictions on the ability of a company to encumber assets.

    If the government wants to ban secured lending, and dry up a funding source for companies in trouble, they are well on their way to it. Unsecured lenders know that they are, well, unsecured. They are used to it, and demand a higher yield.

    If Congress wants to be consistent (please no) will they do the same to the first pledge of assets held by bank debt. Oh, wait, the banks are sacrosanct, at least, if they are big enough.

    Our funding structures, aligned with the bankruptcy code, have developed amazing diversity and volume for the many funding structures that exist. Blindly playing around with such structures is the economic equivalent of letting a kid play around with a loaded gun. Congress does not know what it is doing here.

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