On Economics of Contempt’s Reliance on His Own Brand Fumes

Economics of Contempt is aptly named. While his stand alone pieces on various aspects of regulation are informative, if too often skewed towards officialdom cheerleading (he too often comes off as an unpaid PR service for Geithner), his manner of engaging with third parties leaves a lot be desired. He often resorts to the blogosphere version of a withering look rather than dealing with an argument in a fair minded manner. This then puts the target in a funny position: do you deal with these drive-by shootings which have either not engaged or misrepresented your argument, by cherry picking and selective omission? If you do, you can look overly zealous or argumentative. But if you do nothing, particularly if it’s in an important area of regulatory debate, you’ve let disinformation, at the expense of your reputation, stand.

Since he’s given the same treatment to Neil Barofsky, at least I’m in good company.

The object lesson is EoC’s comment on a detailed post I wrote, with considerable input from derivatives expert Satyajit Das, on the FDIC’s “counterfactual”: a report it released to argue, via a long narrative, that it could have resolved Lehman successfully (and with credulity-straining low losses to unsecured creditors) had it has Dodd Frank resolution powers in 2008.

I know that Yves has a post claiming that the FDIC’s hypothetical Lehman resolution wouldn’t work, but her analysis is quite flawed. Among the myriad mistakes in the post, she and Satyajit Das both invoke scary-sounding cross-jurisdictional problems that simply wouldn’t arise under the resolution authority — since Lehman’s London broker-dealer (LBIE) was funded almost entirely by the holding company (LBHI), selling LBHI to Barclays under the resolution authority would have obviated the need for LBIE to file for bankruptcy in the UK. That’s, umm, kind of the point of the resolution authority.

Although it is tempting to engage in a lengthy discussion, I’m going to try to keep this high level.

First, EoC proceeds from erroneous assumptions. Das, who as we shall so politely put it is in a good position to know granular details about the Lehman BK, wrote (emphasis mine):

You can correct a few facts:

a) Lehman dealt derivatives through a variety of vehicle including LBSF (Lehman Brothers Special Financing) and also a Swiss Entity.

b) I don’t think that LBIE or LBSF was entirely funded by LBHI. It was guaranteed on some transactions but not necessarily all. This means that they would have their own creditors – including derivative counterparties who have posted collateral. I do not understand why these creditors would have submitted to a resolution regime that would not have given them the outcome they believed they were under the applicable law and the jurisdiction’s legal systems.

c) Also there is an issue of structural subordination to deal with. The creditors of each local entity (as senior or junior creditors) would have first claims on any assets of the local entity (this of course includes business licenses and franchise). Lehman’s parent as shareholders would have been subordinated to that claim. Why would local creditors sacrifice that priority in a resolution?

d)The fact is that a portion (probably large) of the contracts are under English law with exclusive on non-exclusive English court jurisdiction. There are fundamental differences in rights in bankruptcy which would complicate any resolution. Given the kind of amount involved and the complexity of the issues, these fights are fierce.

e) Also at law creditors would appoint different bankruptcy trustees or administrators (irrespective of what Dodd-Frank says) to just protect their rights. In fact, the entire resolution authority system would mean a sensible overseas creditor would almost immediately appoint one when entitled to do so to forestall any further action until they had all the information to judge how they should behave.

In addition, EoC’s complaint does not address the other problems mentioned in our lengthy post.
For instance, the FDIC paper rests critically on the assumption that Barclays would have bought all of Lehman has the resolution process gone 90 days and started in March 2008. We shot at the timeline assumptions on multiple grounds, including:

The political drama that would have resulted from taking down a company when the CEO was insistent it was sound (and recall key noisy commentators, notably CNBC, were soundly in his camp, and the other major papers in March to May 2008 were interested in but still skeptical of the bear case on Lehman, led by David Einhorn) would have delayed action, particularly since the FDIC, Fed, and Treasury all have to agree to move forward.

The idea that customers and counterparties would sit pat with an untested resolution regime with unclear creditor priorities that are not the same as in a bankruptcy (a critical defect stressed by Josh Rosner in Congressional testimony) creates uncertainty as to their risks depending on how things play out. Do you think they will sit pat when words gets out the FDIC has taken up residence and the company is being hawked? Financial firms tend not to go down in isolation; they whole sector is usually under stress when key players look terminal. Thus the assumption that a buyer will surface for the whole business is also pretty cheery. There may be no buyer, or only buyers for few trophy operations.

We did not address the assumption that Barclays would buy the whole entity without a subsidy. That with Lehman seems unwarranted. The FSA got involved twice to protect Barclays from itself. The first intervention has gotten attention in the US but not so much the second. The first was the refusal to waive the 30 day shareholder approval period requirement. The alternative was to have Barclays guarantee Lehman’s positions with some sort of government backstop and that was a non-starter. But the second one was in the purchase of certain Lehman assets. The FSA pushed to have the deal sweetened by the inclusion of IIRC $7 billion of good collateral (leaving JP Morgan with “goat poo”).

More broadly, the FSA set a boundary condition in September 2008. Per Bloomberg:

The U.K. financial regulator told Barclays Plc in September 2008 that an acquisition of Lehman Brothers Holdings Inc. might damage the balance sheet of one of the country’s most important banks. The Financial Services Authority told Barclays it would look very closely at the effect any transaction would have on Barclays’ liquidity and capital and “would not countenance” a drop of Tier 1 capital below FSA requirements, according to a statement the regulator gave to Lehman’s bankruptcy examiner in January that was made public today.

In the post, we’ve parsed out the Lehman losses ex what can be attributed to the disorderly bankruptcy (code for derivative positions blowing out). The FDIC’s comparatively leisurely timetable would have allowed for adequate due diligence, including the discovery of the complete and utter mess of the Lehman derivatives books (inability within +/-5% to even know how many open positions they had, numerous systems that were independent and did not aggregate). And the black hole was far bigger than the FDIC suggested, which argues against both their loss estimates and their tidy transfer assumption:

And the last sighting from the bankruptcy trustee Alvarez & Marsal shows losses vastly in excess of what the FDIC reports. This was our summary of the latest sighting in the Financial Times: Take the creditor claims of $250 to $350 billion. Against that we now have assets we will generously peg at $60 billion. So we now have a $190 to $290 billion shortfall. The midpoint is nearly double the last loss estimate.

Of that total, bankruptcy overseer Alvarez & Marsal has tried to claim that $50 to $75 billion was due to the disorderly failure. Even if you accept the high end of their range, you get $115 to $215 billion in losses. But Alvarez & Marsal has reason to exaggerate the “disorderly BK” losses. The experts I am in contact with who are working on the BK say that $15 to at the very top $30 billion in losses is attributable to the rushed process. That gives a range of $160 to $260 billion in losses to unsecured creditors.

By contrast, the FDIC in the report tries to claim the losses were only the asset side overvaluations of $50 to $70 billion of troubled assets and that the losses would have been only $40 billion. This is a gap of roughly $120 to $220 billion. We are supposed to trust them based on their willingness to engage in phony math like this? Yes, the Lehman entities had franchise value that was lost in a liquidation but the scale of the losses being realized demonstrates that the black hole in Lehman’s balance sheet was far greater than the FDIC is pretending that it was.

Finally, EoC naively ignores the sheer logistical nightmare of the valuations and who owed money to whom which has a material impact of the settlement and the negotiating stance of individual parties. Has EoC ever had to deal with this in practice?

It’s a shame that EoC applies his considerable expertise to defending a flawed process when it would serve the public better to take a more skeptical stance. But his stalwart support for the various “reforms”, with only the occasional, not terribly consequential quibble, makes clear where his loyalties lie.