naked capitalism

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.