Economics of Contempt has written a rejoinder to our post on FDIC’s paper on how it would have wound up Lehman with its new Dodd Frank powers. Since it’s a mix of smears and broken-backed arguments, it is nowhere near the standards he can attain when he is behaving himself. But as a tell about the officialdom’s propaganda preoccupations and methods, it isn’t entirely devoid of interest.
Before turning to the meat of his post, such as it is, I wanted to point out the biggest slur in the piece: his repeated assertion that Satyajit Das and I did not read the FDIC paper in full. That’s false, and brazenly so: somehow the fact that Das and I can crank out an analysis, quickly, gets twisted into anchoring a more general effort to discredit this site. Regular readers, including EoC, have no doubt seen other occasions where we’ve produced detailed and on target assessments before most of our peers. And Das is in Australia, giving him the ability to respond to evening releases in the US during his business day (in this case, one with specific page references).
EoC’s entire post fails when you look at its and the FDIC’s three central, obtuse misconstructions:
The FDIC can initiate a resolution before market participants started acting to save their skins. This is a critical assumption and the FDIC is explicit about it:
For Lehman, if senior management had not found an early private sector solution, the FDIC would have needed to establish an on-site presence to begin due diligence and to plan for a potential Title II resolution.
The FDIC tells us it would have done due diligence BEFORE putting Lehman down. And indeed, that’s almost certain to be necessary, given that the FDIC cannot act unilaterally, for the approval of three regulators (the FDIC, Treasury and the Fed) is required, to use their “Orderly Liquidation Authority” powers under Title II of Dodd Frank. This would be a politically controversial act and the new forms would need to be observed. (Note that the use of the Orderly Liquidation Authority does not require the leisurely sale process envisaged in the FDIC paper; it could also be used at the courthouse steps to forestall a bankruptcy filing, but that scenario is not contemplated here).
But the faulty assumption is that markets will stand back and respect political and regulatory timetables. History suggests that that’s not the case. It was a mere ten days from rumors of customer withdrawals in Europe at Bear for a run to become serious enough for the firm to need a bailout. Too often, the markets force the authorities’ hands. (In reality, regulators can stop markets per 12 USC S. 95, which is what remains of the the bank holiday provisions of the Emergency Banking Act of 1933. If the President can close the National Banking/Federal Reserve system, that implies he can close the payment system. So the government could hit pause and reorganize the banking system or just a particular firm, but that was never treated as an option during the crisis and is still presumably off the table).
The FDIC showing up on site and digging through records runs the very real risk of kicking off an even faster response than the Bear rumors did. Yes, in ’08 the Fed had two people at Lehman as well as an SEC designee who was reportedly a less consistent presence, and that did not trigger a meltdown. But the sort of staffing needed to do real solvency assessment and transaction planning, which, as we know, did not take place with Lehman, would be more than an order of magnitude larger, and very difficult to keep under wraps for long.
EoC asserts that M&A deals are kept secret all the time, but that is not true of big company or widely shopped deals, and this one would prove well nigh impossible to keep under wraps. First, you have a regulator doing an assessment prior to deciding to pull the trigger, a board meeting to pressure management to be more aggressive about accepting bids with a drop dead date of July to get more capital, then the FDIC entering the picture if needed.
This all sounds great, except it ignores the realities of 2008: that the powers that be were in Mission Accomplished mode post Bear until around June, when Fannie and Freddie concerns ticked up. Even then, Paulson preferred smoke and mirrors to action (recall his bazooka?). So a March start never would have happened.
Second, Fuld was in extreme denial. The board would have had to fire Fuld; he was simply not prepared to take losses on asset sales or do what he would consider to be dismembering Lehman. Recall how he parachuted into negotiations with the Korean Development Bank, which was seriously considering a “good bank/bad bank” deal, and ruined it by trying to persuade them to take the entire entity. So the alternative was not “we pressure the board and they get religion about accepting realistic bids for decent Lehman assets,” it would have to have been “we get the board to fire Fuld” for a private sale to have occurred. How do you think that would have gone over in the media and the markets?
And consider another assumption: that if the sale efforts by management fail, the FDIC can step in and broker a sale of the entire entity. The FDIC is explicit that this is the preferred outcome:
The interconnected nature of Lehman’s operations would have argued for maintaining maximum franchise value by developing a deal structure that would have maintained the continuing uninterrupted operation of the major business lines of the firm by transferring those assets and operations to an acquirer immediately upon the failure of the parent holding company.
Anyone who has dealt in markets knows that the longer an asset is shopped, the more it is perceived to be tainted. Any private effort would have gone to the most logical buyers. And buying the entire entity means acquiring the liabilities. That means the counterparty exposures too. The FDIC argues that that’s not a problem because the positions would be fully collateralized. Um, as Das discussed in our earlier post on this topic:
apparently, the FDIC will value all the positions. I wish them luck. In many contracts, there are two experts and six opinions as to the value of the contract.
Or put it another way, whether a position is adequately collateralized is not as cut and dried as the FDIC assumes. In addition, the FDICs cheery belief that more stringent collateralization requirements will lead to lower creditor/FDIC losses seems more than a tad optimistic (see text page 21). This is a zero sum game. It’s just as easy to argue that the collateral requirements will just cause a run earlier. The reason FDIC will have to step in is because the failing firm won’t be able to post its collateral. That can happen sooner or later. Either way the FDIC stands to lose the difference between what is realized (the position) when the contract expires and balance FDIC pays by providing liquidity/collateral that could not be paid without FDIC stepping in.
The paper also finesses when in its timeline it would put Lehman into receivership if a private sale failed and how it proposed to manage the business during that period. The assumption appears to be that Lehman could operate as a private entity and if needed legally to cram down creditors the FDIC could effectively do a back-to-back transaction, resolving Lehman and then transferring it per the pre-agreed deal to the buyer. There is no contemplation of the alternative, that the FDIC has to put Lehman into receivership due to the failure to concluded a deal before the decay of the business forced action.
The last reason for taking the 90 day timeframe with a fistful of salt: trading firms are dynamic. Due diligence done even a month early will have large elements out of date. That means the a long lead time is not as much of a plus as it is for marketing make-and-sell businesses or financial firms with asset and liability exposures that change less rapidly. It would allow for better due diligence on operations, but as we discuss below, that would not have worked to the advantage of the FDIC.
Barclays was a willing buyer for all of Lehman ex a designated pool of bad assets, and minimal losses to the FDIC would have resulted. This is demonstrably inaccurate. The FDIC’s cheery piece relies critically on this assumption as does EoC.
Barclays can be assumed to be willing to do the deal it said it might do in September 2008, but that is NOT the deal set forth in the FDIC paper. Yes, the FDIC piece does mention that other resolution paths were possible under Dodd Frank; but this is the one it has chosen to hang its hat upon, and it leads to the howler of only a 3% loss to Lehman unsecured creditors.
But the lengthy FDIC resolution process, which is what it maintains would have taken place, would have allowed for proper due diligence. Indeed, with the FDIC now in the role of receiver, there would be no basis for refusing thorough due diligence.
And the critical point is that Barclays was NOT ready to buy Lehman, unless a liquidity backstop was in place. This has been widely misreported in the US, and EoC falls right into line with that bit of PR, blaming the FSA for killing the Barclays deal. This has proven the favored route for the US regulators to try to escape censure for the Lehman fiasco.
But here is the report from the FSA, which paints a very different picture. The first extract discusses September 13, 2008 (click to enlarge). John Varley is the Chairman of Barclays; Hector Sants was the chief executive of the FSA:
Notice that Barclays was not looking at buying all of Lehman, good assets AND with a liquidity backstop. This is a bigger backstop from the authorities than the “loss sharing” notion in the FDIC paper. This is not inconsistent with the account in Sorkin’s Too Big To Fail, which depicts Bob Diamond as eager to snap up Lehman, but Paulson seeing Barclays as not serious about consummating a deal as of September 11.
Later on the 13th:
Do you get what happened?
1. Geithner cheekily assumed Barclays would accept the same deal as JP Morgan did, with NO government backstop.
2. Varley said his board would not approve such a deal. This was NOT the FSA nixing the deal, it was Varley saying it was a non-starter, from Barclay’s perspective.
And here is the denouement with both Barclays and and the FSA saying the terms proposed by Geithner were not viable:
This is consistent with the account in Too Big To Fail, that some felt Diamond was “a bit reckless” in the negotiations and that Varley had said to Sants that “Barclays’ board would only pursue the deal if it could receive adequate help from the US government or another source.” but that would have to be negotiated, and there is no assurance the two sides would have reached a deal.
It’s important to understand this basic point. No one is going to assume the liabilities of the firm the size of Lehman as a pig in the poke. Now the Article II process does allow for “loss sharing,” but that would have to be hammered out in gory detail before any deal could move forward and there is no assurance the two sides would agree (remember, it took over seven years for the FDIC to rid itself of another garbage barge, Continental Illinois, which was the seventh biggest bank in the US at the time of its failure).
In the meantime you have a firm like Lehman with a large balance sheet funded heavily overnight and even bigger derivatives positions that are hedged dynamically, now all on the government dime. And in this scenario, with Uncle Sam on the hook to fund the balance sheet before Barclays consummates the deal, it has plenty of time to kick the tires, and demand bigger subsidies if it thinks they are warranted, and walk from the deal if its demands are not met. Barclays thought there was a real risk it could not conclude a deal before the Administration regime change in January 2009 which suggests that it and the FSA understood full well that the negotiations could become protracted.
And we now know the Lehman derivatives books were a mess. The firm didn’t even have a good handle on how many open positions it had, and even worse, it ran those exposures on multiple platforms that were reportedly not compatible, leading to problems with aggregation and risk management. I’ve had financial services clients repeatedly turn down deals that made strategic sense over systems integration issues when the target had good but not terribly compatible systems. Who in their right mind would take on this Augean stable when it would be easier to cherry pick assets? The FDIC does not appear to have taken at all seriously the idea that it would only be able to sell select Lehman assets and would be forced to wind down its derivatives book.
So the logic is ultimately circular: the FDIC argues that a longer form resolution would have led to a Panglossian outcome. But that relies on its wildly optimistic assumption that a longer timetable would show no more losses beyond those that potential buyers found in their hasty inspection of Lehman’s most suspect assets. The Lehman bankruptcy has instead revealed the holes in Lehman’s balance sheet to be much larger, and a more thorough due diligence process would have found more of them.
The ONLY losses that would have been avoided by the FDIC process were the ones resulting from the disorderly unwind. Alvarez & Marsal, the bankruptcy overseers who has a vested interest in painting lipstick on this pig, has most recently pegged them at $50 to $75 billion; the people I know who are involved in the Lehman BK say this is greatly exaggerated, and $15 to at most $30 billion is the right level. As we discussed, this means losses in the range of $160 to $260 billion in losses to unsecured creditors, not the $40 billion assumed by the FDIC.
The only way the FDIC could increase the value of the estate is by stepping in with cash when Barclays wouldn’t. It’s a zero sum game for everyone except the government so the government stepping in makes sense. But we shouldn’t pretend that there would be any way to get Barclays to pay more. And we should realize that the Fed could have done this under existing law, but chose not to do it.
We must also point out a problem that we raised in our earlier draft, which EoC ignored, that of the government now funding trading businesses if they can’t find a buyer for the entire entity pronto. We pointed to abuses at AIG, which EoC, who has indicated he has good contacts at the New York Fed, was unable to deny. There is no reason logically to expect otherwise in the future. Who in their right mind would want the government overtly backstopping an active trading business that it cannot adequately supervise, particularly when the people executing the transactions have no job security? That’s a license to steal in the form of doing favorable trades with counterparties who are prospective employers to curry good will.
The insistence that the US can cram its Dodd Frank procedures down on foreign jurisdictions. This is naive.
As EoC presumably knows, and Das says in a to-be-published paper:
Derivative transactions are documented using the ISDA Master Agreement. The Master Agreement sets up a framework under which individual transactions are documented in the form of relatively short confirmations detailing the economics and cash flows of specific transactions. ISDA’s remarkable achievement has been to standardise documentation with increasingly all trading instruments being documented under the ISDA Master Agreement framework.
The original idea was that the bulk of trading between institutions would be governed by a single master agreement facilitating management of the contracts. In practice, this has proved difficult because of the complex legal structure and operations of individual institutions. In practice, there may be multiple masters between institutions.
Why is this germane? Because the particular ISDA Master agreement(s) between two firms may be under either New York or English law. The Lehman BK has already shown there to be important differences in interpretation on issues between the US bankruptcy court and the English High Court. That separately serves to illustrate that Lehman had entered into contracts under both legal regimes.
Dodd Frank has no force under English law. That means that the FDIC cannot prevent contract termination for agreements under English law. The FDIC and EoC can huff and puff all they want, but the US regulators do not have the power to overturn foreign statutes and case law. Foreign jurisdictions may harmonise their practices with Dodd Frank, but we are not there, as of the publication of the FDIC paper.
Let’s assume that the FDIC had moved to resolve Lehman in March of 2008. What might a smart foreign creditor do? Well, if his agreement with Lehman was under English law, he could argue that the fact that Lehman was being resolved meant it was trading insolvent and it needed to put into administration now to protect him from exposure to further losses.
Recall further that creditors at the subsidiary level have priority over parent level creditors. So the creditors of any foreign subs will also be scrambling to protect their interests.
Now admittedly, the creditors of the foreign subs have not suffered an actual breach or failure to pay, but I can construe of arguments, and I’m sure clever attorneys can easily trump what I can dream up. Remember, the normal practice under the “home-host” rule has been for banks to keep relatively little in the way of capital in foreign subs; the notion is that if the local regulator finds something he does not like, and the local sub needs a capital infusion, it will ring home to the mother ship. If the mother ship is officially in trouble, this casts a completely different light over the health of local subs.
Now in practice, Lehman was sweeping funds out of LBIE daily, so one could argue the US (and therefore the FDIC) has the upper hand. But on a practical level, this probably depends on the currency. Dollar based assets run on dollar payment systems, so ultimately FedWire is critical. Creditors in other currencies would probably have a better shot at stepping into the daily sweep via launching a court action before the sweep occurred. As a general matter, if you want to ensure your claims on a financial asset denominated in a given currency, get friendly with the justice system of the country whose payment system that currency relies on.
Ultimately, some of these matters are likely to be political, and given how Judge Peck, who is presiding over the Lehman bankruptcy in the US,has gone to considerable lengths to favor domestic creditors over foreign ones, the US may have less good will overseas than the FDIC assumes. The Lehman BK has bred distrust and resentment which may well play out on any effort to secure cooperation in untested legal waters. As we noted in our April 18 post, the sorry experience of foreign creditors under Lehman is leading some foreign regulators to be more bloody-minded in insisting that more assets be held in local entities.
Regardless, it is reasonable to assume some, perhaps many, foreign creditors will try to get in front of US creditors. And they don’t have a Dodd Frank regime to wind up dead financial firms, they have bankruptcy regimes. So former central banker London Banker’s observations in a prescient September 12, 2008 post apply:
Although markets are global, and Lehman Brothers operations span the globe, all insolvency is local. The basic premise is that each jurisdiction buries its own dead and keeps whatever treasure or garbage it finds with the corpse. Local creditors get to recover their claims out of the locally available assets. If, and only if, there are any assets left over will international creditors be invited to make a claim for the rest…
Claims against a bank are deemed located wherever the contract creating the claim is undertaken. If it is under US law then the claimant must look to the liquidator in the United States and assets under his control for recovery. If the claim is in Hong Kong, then the claimant looks to the Hong Kong receiver and assets.
The key to having a happy insolvency, if such a thing exists, lies in ensuring that when a globalised bank goes bust, all the best assets are inside your borders and subject to seizure by your liquidators on behalf of your creditors.
In other words, the idea that banking regulators in foreign jurisdictions can trump existing bankruptcy regimes is a awfully optimistic.
And contrary to EoC’s assertions, the foreign operations were a significant source of liquidity to the parent. Putting LBIE (the main European broker-dealer within the Lehman enterprise) into administration in the UK froze its positions. There is absolutely nothing in Dodd Frank that can prevent a UK sub from being put into receivership. And the London operations were a substantial source of liquidity to the parent; recall it was rehypothecating client assets. Again from Das:
As a result of the collapse of Lehman Brothers International (Europe) (“LBIE”), the London-based broker-dealer subsidiary of the investment bank, over $35 billion of client assets was frozen. Over two years later, over $14 billion of client assets still has not been returned according to the latest report by PricewaterhouseCoopers, the administrators of LBIE.
EoC tries to claim that Das said that LHI (the parent) was providing liquidity to the European operations. Das made no such remark. The parent was IN CONTROL of fund movements: that is not the same as being the source of funding.
And one substantive final point: if the resolution had started in March 2008, that was prior to Lehman raiding its UK broker/dealer for $8 billion. There would have been more assets overseas for creditors to grab.
There’s one other smear to highlight:
Some of Yves’ criticisms, like the one that relies on an unsubstantiated rumor from friggin’ Zerohedge, are definitely not worth my time.
Uh-uh. Despite the rhetoric, we can see that it’s actually worth just enough of EoC’s time to mention this, yet, at the same time, somehow not worth quite enough of his time to spell out exactly what rumor he is talking about; a delicately self-serving calculation, and a classic smear. Except that we gave up on the Zero Hedge conspiracy theory factory two years ago (short form: their signal to noise ratio is unacceptably low), and, since life’s too short, we’ve never revised our opinion. Perhaps EoC is an assiduous reader of Zero Hedge; or perhaps his sources are. Anyway, we have no idea what EoC is talking about here. Which is a shame: it’s obviously a sore point for somebody. It would be interesting to know which of our points is so toxic that EoC doesn’t dare repeat it.
We’ve said before that Economics of Contempt too often relies on slurs and rhetorical tricks, waving his credentials as a securities lawyer when he is on weak ground. His latest post is an extreme example of his reliance on distortions to cover for a bankrupt argument.
This posture also begs the question we have raised repeatedly: why does Economics of Contempt regularly step up to defend the Administration, so faithfully that he must make slipshod or simply incorrect arguments to bolster their case? His allegiance to them is consistent no matter how dubious their position is. In this case, we are hardly alone in saying the FDIC’s counterfactual does not stand up to any kind of scrutiny; it’s hard ex EoC to find anyone not part of the Administration who takes the FDIC’s paper to be anything other than fantasy.
The usual takeaway: when EoC is defending an Administration position, particularly when a considerable majority of experts have come out against it, he is simply not to be trusted.