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How the Public Misses Out on How Fights Over Bank Regulations Affect Them

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The public keeps losing and losing and losing to big finance because financiers have made an art form of using complexity, opacity, and leverage to cover their tracks.

The last example comes in an anodyne-seeming article in the Financial Times about collateralized loan obligations, or CLOs. CLOs are a structured credit product, in this case, made from leveraged (as in risky) corporate loans. Think of it as the corporate lending analogy to subprime bonds. The major differences between CLOs and RMBS are that CLOs are not secured by collateral (houses) and that CLOs turned out to be much better diversified than RMBS (the mortgage bond designers thought that a geographic mix would provide adequate diversification, since the modern US had never suffered a nation-wide housing market price decline. Whoops!)

CLO volumes exploded in the runup to the crisis due to a cheap-debt-fueled M&A boom, with private equity firms the big source of increased deal demand. And when the music stopped, the big banks were stuck with lots of unsold inventory. While their losses were no where near as bad as the ones they suffered on CDOs, they were still well above what was thought to be consistent with AAA rated paper. In the spring and summer of 2008, Bloomberg would report intermittently on the sorry state of the CLO market, with prevailing prices in the mid to low 80s. There were also reports of dealers selling small lots to compliant hedge funds at inflated so they could use those values to justify the marks on their positions.

Now the banks seem to have amnesia as far as the crisis is concerned, but US regulators (at least for the moment) have taken an uncharacteristic interest in reducing the risks banks carry, including those of CLOs. But the unfortunate aspect of the discussion in the Financial Times, and we assume elsewhere, is that this issue is being framed too narrowly, as being a matter of bank and financial system safety. Absent is the notion of the societal cost of making cheap debt too readily available to what in the 1980s were called takeover artists.

As an unnamed insider noted in Ron Suskind’s Confidence Men, private equity depends on being able to load companies up with debt, and (according to him) only one in ten deals needs to succeed for the fund to do well. Many industry professionals would argue a bigger proportion of deals to work out for a PE player to be deemed successful, but the general point still holds: a leveraged buyout firm can drive a lot of companies into the ditch and still come out a winner. And low cost debt allows them to operate at a much higher level of activity. As we noted in ECONNED:

Cheap funding similarly played a major role in the breakneck pace of mergers and acquisitions, which became more and more frenzied until the onset of the credit contraction, in the summer of 2007. Global mergers for the first six months of 2007 were $2.8 trillion, a remarkable 50% higher than the record level for the same period in 2006. And takeovers for the full year 2006 ran at a stunning seven times the level seen four years prior.

The EU has decided it does not like the nasty propensity of PR funds to lever up corporations, pull out a lot in the way of special dividends, and too often overdo the cash extraction and leave a bankrupt hulk in their wake. The EU has been working on a proposal to restrict investors in the EU from putting funds in private equity and hedge fund firms outside the EU, and also limit the ability of foreign investors to buy European companies. The response was huffing and puffing, that this move would “seriously disturb” the biggest PE firms. So? That was the plan, wasn’t it?

But in the US, the home of the biggest players, you hear nary a peep of this sort of talk, one that would likely argue for even bigger curbs that the ones being contemplated (and sure to be watered down). And the banks are certain to fight hard against any restriction, because M&A is a source of big advisory fees as well as new issue profits. Key extracts from the Financial Times:

Wall Street is set to pick another fight with regulators as the loan industry and big banks push back against new rules that they say could limit lending to companies with low credit ratings…

The desire among regulators – the Federal Reserve, Federal Deposit Insurance Corp and Office of Comptroller of the Currency – to prevent another financial crisis carries the risk of unintended consequences; namely that tough rules could impair market liquidity and ultimately hurt the broader economy.

Yves here. Ah, yes, the perennial threat: cut off our cheap leverage, and you’ll damage the economy. I’d love to see an analysis of how many levered loans went to fund corporate investment as opposed to takeovers (although the percentages deemed a failure vary, pretty much every study that has looked at corporate takeovers has concluded that most fail, so discouraging corporate acquisitions would also be salutary).

The FT article does mention, in a single sentence, that the levered loans used in CLOs stoked acquisitions during the credit bubble. But the political argument is over a proposed increase in capital for CLOs kept on bank balance sheets as a way to reduce systemic risks. This debate may seem a bit overdone, since CLO issuance was a mere $12.5 billion this year versus $97 billion in 2006. But in many ways, these debates are not simply over how the rules should read, but what form of capitalism will have. And unfortunately, despite occasional tough gestures by regulators, the framework and assumptions that produced the last crisis remain largely intact.

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34 comments

    1. tom allen

      Whose economy — the cons’ or my — is the question, isn’t it? (Still working on that; there’s a pun in there somewhere.)

    2. jake chase

      If only economists and regulators would read would read Veblen’s Theory of Business Enterprise (1904) they would understand that business, particularly big business, is about asset grabs and nothing else. Banking is about asset grabs and usury. The “real economy” is merely the hostage to the resulting financial merrygoround resulting from shifting evaluations of collateral.

      1. James

        Although the REAL people don’t need to bother with such theoretical tomes. They realize the truth the HARD way: they LIVE it!

  1. ambrit

    Maam;
    If “the framework and assumptions that produced the last crisis remain largely intact..” then what is the expected ‘size’ of the outcome, all things being equal? Is there a direct correspondence between ‘size’ of ‘risk’ and attendant ‘downside’ effects? Or is there some ‘threshold’ where the downside slips over from largely economic to socio-political? Despite the ‘tough’ talk seen on a lot of the blogs, no real action yet on the street. The American Elites should thank their lucky stars that the #Occupy movement has remained non violent. These are indeed our ‘best and brightest.’ The rest of the nation is letting them carry the torch for us. However, I digress.
    It’s all too much ‘fun’ to play Cassandra and gleefully predict Depression 2.0, but none of us in this generation and later cohorts has ever known real poverty and want. The implied message of this and other blogs lately is that it’s ‘business as usual’ in the City, on Wall Street, down the Bund, etc. It seems to be time to relearn the lessons of post October 1929, not pre October 1929.
    Thanks for letting me rant. Thanks for all your hard work. Merry Christmas to you and yours.

    1. James

      “It seems to be time to relearn the lessons of post October 1929, not pre October 1929.”

      Unfortunately, and THEN SOME. In the long run, it’ll be good for us. In the short run, not so much. Same as it ever was.

  2. Jim Haygood

    ‘Private equity depends on being able to load companies up with debt … a leveraged buyout firm can drive a lot of companies into the ditch and still come out a winner.’

    Yesterday I encountered a real-world reminder: my dad likes fruit baskets from Harry & David, which Bloomberg described as a ‘century-old seller of mail-order pears and holiday fruit baskets … that went bankrupt in March 2011 after private-equity firm Wasserstein & Co. loaded it with $200 million of debt that it couldn’t pay back — even as Wasserstein’s firm took profits for itself.’

    http://www.bloomberg.com/news/2011-10-12/wasserstein-haunts-harry-david-in-buyout-doomed-to-bankruptcy.html

    The company still exists post-organization, but it’s a shadow of its former self. Here’s how the social costs were sluffed off on you and me:

    2,700 workers and retirees had their pensions terminated and shifted to the government-sponsored Pension Benefit Guaranty Corp. after Wasserstein & Co. and other bondholders made dumping the retirement plan a condition for investing $55 million in the company after it emerged from bankruptcy.

    Currently, the tax code makes the interest on non-recourse debt used in buyouts deductible. The non-recourse feature means that if a leveraged buyout succeeds, the owners of the thin slice of equity multiply their investment many times over. But if the company sinks under its debt load, the equity holders walk away with no personal liability. Meanwhile, they’ve often extracted enough in fees and dividends to recoup their initial equity contribution.

    A simple way to discourage debt-fueled speculation would be to make interest nondeductible if a company’s debt-to-equity ratio exceeds a certain level. Setting the limit is difficult because some economic sectors customarily operate with higher debt/equity ratios than others. Nevertheless, it’s a solvable problem. Yet it won’t happen because our social nemesis — the bankster cartel and its motley rabble of money-changers and usurers — fiercely oppose it.

    1. F. Beard

      Setting the limit is difficult because some economic sectors customarily operate with higher debt/equity ratios than others. Jim Haygood

      Without the counterfeiting cartel to suppress interest rates, wouldn’t the debt to equity ratio be much lower? Why can’t business be 100% equity financed? Because the profits would have to be spread around?

      1. Jim Haygood

        Equity capital can be more costly than debt capital. Many investors (e.g. insurers) need to invest in debt to reliably meet future obligations. Debt isn’t intrinsically bad, but in excess it is.

        As a first pass, only the interest on debt amounts less than or equal to equity could be made tax deductible. But this leads to problems under certain circumstances: a troubled company can end up with zero or negative book equity. Losing its debt deductibility as equity shrinks would unnecessarily accelerate its demise.

        Nevertheless, a suitable rule could be developed to distinguish involuntary erosion of equity from the discretionary piling on of debt by private equity operators.

        1. F. Beard

          Equity capital can be more costly than debt capital. Jim Haygood

          Of course it is. Honesty is often more expensive in the short run. But if no one had access to counterfeit money – so-called “credit” – then no one would need access to counterfeit money to keep up with their competition. It’s a “Tragedy of the Commons” situation. In this case, the “commons” is the population’s purchasing power.

    2. petridish

      Tremendously interesting link. Isn’t this how Mitt Romney got the real-world business experience he brags incessantly about on the campaign trail?

      1. Gil Gamesh

        Yes. So he’s qualified to asset strip the US, drive it into the ditch, and shoot the poor citizens as they crawl out of the wreckage. Thank god he’s a Christian. Imagine how cruel US elites might be without the leavening of pious devotion.

  3. F. Beard

    After 19 patches on an air-mattress (all of them new), I finally decided the thing was no good and bought a different one with a reputation for quality. So far so good.

    How long will we keep trying to patch a fundamentally dishonest/unstable money system before we abandon it?

    1. James

      Until it collapses completely and leaves us sleepless on the hard floor of an unforgiving capitalist reality. Won’t be long now, although it’s likely to be longer than is comfortable for most.

  4. Jessica

    “The public keeps losing and losing and losing to big finance because financiers have made an art form of using complexity, opacity, and leverage to cover their tracks.”

    When material production was the core of the economy, capitalism created artificial scarcity of material goods. Now knowledge production is the core of the economy and capitalism creates artificial scarcity of information.

    1. Susan the other

      Good clear point. Just thinking that the first to realize that capitalism is not democratic will be/was the banks. They surely know already that to make capitalism democratic there will have to be gazillions more “dollars” in circulation and accessible to lots more people. So why does it look, at this stage, so feudal? We are being ripped off right and left.

      1. Ransome

        “The 20th century has been characterized by three developments of great political importance: the growth of democracy, the growth of corporate power, and the growth of corporate propaganda as a means of protecting corporate power against democracy.” Edward S. Herman and Noam Chomsky

  5. Peripheral Visionary

    Private equity, thankfully, may be near the end of its glory days. PE operations in recent years have relied heavily on super-cheap debt being bought up by gullible investors who actually believed that portfolio companies could be resold into the markets for a profit. But the IPO market is dead or nearly so, and PE firms are going to have a very difficult time unloading portfolio companies. When and as that happens, the already moribund market for leveraged loans will see a swift demise, and it will be game over for PE, excepting only those firms who have consistently demonstrated that they can improve the value offering of their portfolio companies (which would be . . . hard pressed to think of examples, the only one that comes to mind is Carlyle’s success with the Dunkin Donuts brand).

    “Ah, yes, the perennial threat: cut off our cheap leverage, and you’ll damage the economy.”

    For better or for worse, there is a strong consensus among economists that low interest rates are absolutely necessary to keep the economy from plunging further into recession. Since I am not an economist, so I can freely say: the consensus of economists are fools, and we would be better served by higher interest rates to kill malinvestments, specifically equity-stripping operations like those you have outlined, while restructuring debt as necessary.

    1. Ransome

      “But in many ways, these debates are not simply over how the rules should read, but what form of capitalism will have”

      Interest rates and other conditions drive how idle individuals with idle pools of capital strip the political economy. You can create “constructive” capitalism with capital controls. We have created “destructive” capitalism by eliminating capital controls. Neo-Economists change the subject when capital controls is mentioned. It is the only way to reform capitalism.

  6. scraping_by

    This debate may seem a bit overdone, since CLO issuance was a mere $12.5 billion this year versus $97 billion in 2006.

    Yes, but of course the MBS market was tiny back in the 90′s. It would have been infra dig or alarmist to point out its potential for destruction then. By the time it became the socially acceptable topic of conversation it is today, we were looking over widespread rubble.

    I imagine most people who are ahead of the curve or outside the crowd, such as our dear hostess, have a few moments of social awkardness. But really, it’s not like body odor or last year’s hat. Back in my literary days, we used to say ‘In the valley of the blind, the one-eyed man is king–or a madman.”

  7. EricJ

    Doesn’t anybody understand that by using mathematical programming, game theory, and the ability of computers to solve systems of differential equations, our political and financial leaders have been able to eliminate risk? That they can now detect patterns in random noise? Give them time, I say. It only looks like they’re doubling down on bad bets, or looting their own citizens to paper over their bad judgement. Happy days will soon be here again. In the meantime, just say No to entropy.

  8. Conscience of a Conservative

    Reading over the article I couldn’t help but be struck by a couple of points.
    1) The use of fair value accounting
    2) Arguing over preset agreed upon capital ratios based on
    asset class & rating or loss threshold

    To me this is how government regulation misses the mark and makes the problem worse. Making arbitrary capital ratios based on rating or asset classes means government is once again promoting one asset class, and use of fair value means trusting the guy who bought the asset to place a correct and proper value on that asset.

    This article helps make the case for using market prices as opposed to estimate prices and further supports the view that regulators should be favoring leverage ratios instead of a basel framework of risk based weightings.

    I would even be so bold as to go further and say that ongoing discussions between bank and regulator about proprietary models as the basis of asset prices invites regulatory capture and investing in overly complex investments.

    The best regulator will be making debt holders truly accountable to the risk of write-down and stock holders liable beyond the market value of their stock(the old double liability).

    1. scraping_by

      Con of Con –

      Yeah, well… The last ten years really did happen.

      The source of disinformation on the value of financial instruments has not been the government but the private, corporate, fee-based ratings agency. It wasn’t government taxation increasing for a AAA placed on garbage assets, it was a pricing decision by a business manager. The rating agencies are part of the financial structure, the private, profit-seeking structure, and lied their little company faces off for a little bit of money.

      Arbitrary? The price of these assets have been manipulated by operators rather than regulators. Demanding they put their money where their propaganda is doesn’t sound like a jackboot kicking down a door to me. Cutting down on margin is a normal way of cooling speculative ardor, and even at this late date, it is warm. Or at least, too warm for current conditions.

      Regulatory capture has nothing to do with regulation itself. One symptom of capture is that the regulations aren’t enforced, another that the rules are structurally flawed. That doesn’t mean rules are a bad thing, it just means weasels in the henhouse.

      Back when Harvey Pitt publicly declared the SEC a service organization to stock speculators he defined deviance down to below sea level. It’s like during Prohibition when the Los Angeles PD were the bootleggers, and thereby became the local gangsters. Or during the Occupy movement, when cops are goons for the rich. Just because cops don’t act like cops doesn’t mean there’s something wrong with the idea of cops. It’s just getting them to do their job.

      Putting the burden solely on the investor, especially while excusing the financial professional from any liability, is ingroup loyalty but problematic to the system. Regulation is a form or banding together for mutual protection. Government is, still, the only real method we have for banding together. Letting right wingers, libertarians, anarchists, call them what you will, be the designated protectors is what perverts the result. The alternative is an investment policy of no trust, since even the most plausible investment patter can cover a con game.

      Remember that a large percentage of Madoff’s victims never knew they had given him their money, since they were trusting their business agents to act in their interests. Hard to leave them with all the blame for falling for a con. Chasing trust out of the system will leave it fragile at best, and dead in the water, more likely.

      1. Conscience of a Conservative

        Yes. Wall Street will look at any regulations and look to game them. This will always be the case, so it’s important to come up with regulations that are less prone to gaming. It’s also important to prevent an asymmetric heads I win, tails tax-payers lose mentality. So simple regulations are better than complex ones and the most important way regulations can work is if the government prosecute fraud(which they have not been doing).

        So here’s an example of how bad regulations invite gaming. The 2004 SEC change to the net-capital rule. Overnight bank leverage went up and Wall Street blew itself up.

        Here’s another example , regulators brought back fair value of accounting, so now nobody knows what a bank’s assets are worth, with bank america going straight down to $5 per share

        If you write rules that make it possible for wall street to eat a whole bowl of candy, rest assured they will and be further assured, they will throw up on both themselves and you.

        1. Conscience of a Conservative

          There’s also a school of thought that Canadian banks are safer because their system uses a better measure of leverage, “ratio of total equity over total assets” and is applied at the consolidated banking group level.

        2. scraping_by

          A friend of mine was the psychologist for the state penitentiary in charge of entrance interviews for all the convicted felons. He said the inducts always started by denying their guilt, then admitting their guilt and denying that anyone was hurt by their crime. Since we’re talking about thieves, burglars, and rapists, he had to challenge that assertion, too.

          The hardcore criminals, the lifelong repeaters as opposed to the fuckups, always came down to the same place, saying, often word for word, “If you didn’t want me to do it, you should have stopped me!”

          First off, that’s a hell of a way to run capital markets. Second, if the mechanism of upright behavior is avoiding prison, the law should err on the side of going to prison before the threat gets through.

          Third, if it’s assumed the people in the markets will commit fraud unless actively prevented, it sounds like a good place for investors to avoid.

  9. Damian

    The high multiple LBO’s were paid for in many cases by reducing US based labor costs and maintaining access to the US consumer market with recognized Brands.

    by shipping the factories overseas with an understanding that the WTO and then GATT treaty and then multiple bi-lateral treaties to reduce 40% tariffs to zero would be put in place

    they knew this was all a sham – which would kill cumulatively enormous number of US jobs – aided and abetted by the Banks in the extension of the LBO credits

    GATT must be overturned – the reason the politician­­­­s put it thru – republican­­­­s and democrats – were payoffs by corporatio­­­­ns. Everyone knew that labor rates in China / Cambodia were $250 per month! The promote for passage of the treaty was exports would substantia­­­­lly increase but their “real” objective was to get into the USA consumer market with better margins on recognized Brands with foreign labor content for IMPORTS into USA by shedding US jobs with “free” entry into the largest consumer market in the world. Access given away for “free”-the transfer prices are set without profit in usa – are all manipulate­­­­d. long term there will not be any profits to tax in USA.

    The country needs a VAT and Tariffs that DISCRIMINA­­­­TE against imports essentiall­­­­y two tier rate and take the higher cost of US made goods as a cost of maintainin­­­­g a “balanced” society – Sure there is retaliatio­­­­n from other countries but we have that already from china with currency manipulati­­­­on and other tools and exports are not enough to sustain employment­­­­.

    There was a BILLIONAIR­­­­E who said all of this in 1994.he was a “corporate raider” who understood the margins in this devils trade and the effect on society.

    http://www­­­­.youtub­e­.­c­om/w­at­ch­?v­=­4PQ­rz8­F0­d­BI­&fea­­ture­­=rel­a­ted”

  10. pat b

    simple enough.

    Require LBO be done entirely with private capital. You can’t use loans
    from a chartered bank with access to the discount window to
    fund corporate acquisition. Define that to be share purchase in excess of
    5% or purchases of key assets that create bylaw changes in the underlying
    entity.

    LBO requires high leverage, well, then either they go to I banks at higher rates
    or they put alot more money in. which means they can do fewer LBO’s.

  11. Blissex

    «“tough rules could impair market liquidity and ultimately hurt the broader economy.”

    Yves here. Ah, yes, the perennial threat: cut off our cheap leverage, and you’ll damage the economy.»

    As usual, J. K. Galbraith in “The Great Crash 1929″ is almost always all we need to understand this:

    page 48: «The purpose is to accomodate speculators and facilitate speculation. But the purposes cannot be admitted. If Wall Street confessed this purpose, many thousands of moral men and women would have no choice but to condemn it for nurturing an evil thing and calling for reform. Margin trading must be defended not on the grounds that it efficiently and ingeniously assists the speculator, but that it encourages the extra trading which changes a thin and anemic market into a thick and healthy one.»

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