naked capitalism

More than four years after Serena Ng and Carrick Mollencamp of the Wall Street Journal first took notice of the highly destructive ways of the Chicago hedge fund Magnetar, which created a series of toxic CDOs, the SEC finally appears to be taking a serious look at some of their deals. More accurately, it seems to be dusting off and perhaps expanding a probe that it started last June (hhm, wonder if this flurry of activity has anything to do with polls showing how independents in swing states are giving Obama thumbs down for his complacency on Big Finance?) The SEC is also reportedly looking at the deceptive role played by collateral managers, something we discussed in ECONNED and that Tom Adams has written about extensively on this blog.

The short version of the story is that Magnetar constructed the perfect trade. It would fund the equity tranche of CDOs, usually 4-5% of their total value. Deal sponsors like Magnetar got significant influence over the deal, at a minimum veto rights over the assets chosen to go into the CDO. Magnetar took a much bigger short bet on these same CDOs (either by buying the CDS that were the majority of the assets in these deals) or by buying CDS on the CDO itself. The equity paid a very high interest rate (15% to 20%) until the deal started to fail. The interest on the equity funded the CDS premiums on the short bet. But these deals paid big money only if they failed, which they did with impressive speed. (For more background, see this post).

Key points from the Wall Street Journal article:

U.S. securities regulators are investigating hedge-fund firm Magnetar Capital LLC, which bet on several mortgage-bond deals that wound up imploding during the financial crisis, according to people familiar with the matter….

If the SEC were to file civil charges, it would be its first enforcement action against hedge funds related to CDOs. No decision has been made on whether to file charges, the people said…

Investigators are looking at whether Magnetar had such a strong influence in designing any of the deals that in effect it took over the role of collateral manager, a person familiar with the probe said.

The article then discusses at some length a lawsuit filed by Rabobank against Merrill Lynch on a Magnetar-sponsored CDO called Norma. That suit was settled but the SEC is apparently looking into that deal.

It is also possible that a suit by Intesa over another Magnetar deal, Pyxis, got the SEC’s attention. Here is the guts of the argument, per Bloomberg:

Intesa claims Calyon told investors that the CDO — known as Pyxis ABS CDO 2006-1 — was based on residential mortgage- backed securities that had been chosen by an independent investment firm, Putnam Advisory Co., when the underlying securities were really selected by Magnetar.

Putnam was also named as a defendant in the case.

“The scheme was designed by Magnetar,” Intesa alleged. “Calyon collected fees on the deal and, through the Pyxis swap, shifted losses on the CDO which it would have otherwise borne itself.”

The Intesa filing is a road map for SEC action. It is detailed and solid on the tradecraft:

Intesa v. Magnetar Complaint

It would be nice to see the SEC get serious on this front. But it’s been poking around Magnetar for a while (it looked into its behavior on a JP Morgan CDO, Squared, and decided not to pursue Magnetar) and has not gone forward. Some of this hesitancy is no doubt due to the fact that disclosure requirements are lower in CDO-land than for SEC-registered offerings. But a lot also appears to be due to a reluctance to try financial complex cases. And until it is willing to do so, the perps will retain the upper hand.

John Whitehead is being proven right.

The former Goldman co-chairman took the unheard of step of excoriating Lloyd Blankfein for Goldman’s “shocking” pay levels of 2006. As anyone who has been following Wall Street knows, compensation levels were even higher in 2007, 2009, 2010 and last year. Per an interview with Bloomberg:

“I’m appalled at the salaries,” the retired co-chairman of the securities industry’s most profitable firm said in an interview this week. At Goldman, which paid Chairman and Chief Executive Officer Lloyd Blankfein $54 million last year, compensation levels are “shocking,” Whitehead said. “They’re the leaders in this outrageous increase.”

Whitehead went even further, recommending the unthinkable, that Goldman cut pay:

Whitehead, who left the firm in 1984 and now chairs its charitable foundation, said Goldman should be courageous enough to curb bonuses, even if the effort to return a sense of restraint to Wall Street costs it some valued employees. No securities firm can match the pay available in a good year at the top hedge funds.

“I would take the chance of losing a lot of them and let them see what happens when the hedge fund bubble, as I see it, ends,” Whitehead, 85, said….

The Galtian traders who carry on as if they are solely responsible for their profits are being shown to be more dependent on the franchise, in particular, the concentrated information flows from dealing with lots of customers and counterparties, than they had persuaded themselves and management. Bloomberg today tells us that the prop traders who have decamped from Goldman, convinced that they’d be able to rack up stellar returns, are floundering. It isn’t just that they aren’t racking up huge wins; they are losing money and falling short of hitting the average for their trading strategy. As the report notes:

Ex-Goldman Sachs (GS) Group Inc. traders led by Pierre-Henri Flamand and Morgan Sze raised more than $4.5 billion for their own hedge funds..

So far, none of them has made money for clients.

The two are among at least six traders who have left Goldman Sachs’s biggest proprietary-trading group in the past two years, which the New York-based bank shuttered in response to new U.S. regulations. All, including Daniele Benatoff and Ariel Roskis, trailed this year’s stock market rally after losing money in 2011, investors said…

Flamand, 41, who was the global chief of Goldman Sachs’s principal strategies group before he quit two years ago to start Edoma Capital Partners LLP in London, has lost about 2.4 percent through February since his $1.8 billion hedge fund started in November 2010, according to investors.

Edoma is an event-driven fund, which invests in companies undergoing events such as mergers, spinoffs and bankruptcies. Such funds returned an average 3.9 percent in the same 16-month period…

Sze, 46, who ran Goldman Sachs’s principal strategies team in Asia before briefly replacing Flamand as global head, left the bank in 2010 to start Azentus Capital Management Ltd. in Hong Kong, hiring 13 former Goldman Sachs traders. His event- driven fund lost about 4.8 percent through February since its April 2011 inception, said a person with knowledge of its returns.

Event-driven funds declined 2.4 percent in the same period…

We’ve long been skeptical of the idea that big firm traders are worth their outsized pay packages. Of course, it nevertheless make sense for management to play along, since higher pay levels for traders justify robust pay for everyone senior to them in the hierarchy (yes, a top trader will often be paid more than the top brass, but it’s an anchoring issue. And pay in banks at the senior levels has become more hierarchical than it was in the 1980s and 1990s).

Long standing readers may recall the 2009 row over the pay level of Andrew Hall, the head of a Citigroup oil trading unit. He had made $100 million in 2008 on a long-standing pay arrangement that gave him a pay deal for his team that was just below 30% of profits, a level unheard of since Mike Milken at Drexel (and we all know how well that turned out). Kenneth Feinberg, Obama’s pay czar, refused to back down, leading to the predictable hue and cry as to how terrible it would be to break Hall’s contract (we pointed out that there were likely ways to do just that, that big producers like Hall were often guilty of expense abuses that would allow for termination for cause).

Consistent with the notion that Hall needed Citi more than he’d pretended earlier, he started negotiating with the bank (if he really was such a hot item, one would think he’d be able to decamp and raise money). As we pointed out at the time:

A LOT of Hall’s performance was due to cheap funding from Citi, and probably massive leverage too, conditions he could not replicate anywhere else. A risky, highly geared operation should pay an interest rate appropriate to the hazards it is taking, not the borrowing costs of its parent (this basic premise is widespread in financial firms, embodied in approaches like RAROC (Risk Adjusted Return on Capital), the Basel I and II rules, and Economic Value Added models.

And the denouement, from ECONNED:

Phibro, along with its richly paid chief, Andrew Hall, is leaving Citigroup for Occidental Petroleum. The price Oxy paid for Phibro was only the current value of its trading positions–liquidation value and not a brass razoo more. There was NO premium for the earning potential of Hall and his supposed money machine. It’s not hard to see why. Hall’s returns were heavily dependent on high leverage, cheap funding, and market intelligence from other trading desks, all huge subsidies from Citigroup. In turn, these concentrated capital and information flows do not come about naturally, but are the product of industry-favoring policies.

His example illustrates that the widely proclaimed view that highly profitable traders are worth their exorbitant pay is often a fiction. The fact that no other buyers, not a financial firm, commodities trader, or consortium, stepped forward when Citi was looking for a graceful exit shows that the business was worth very little on a stand-alone basis.

Instead of seeing the Hall episode as further evidence that industry pay practices are extractive, the media focused instead on “government interference” or how Citi would be harmed by losing the revenues from taxpayer-supported commodities speculation.

The problem, of course is that given how much traders and investors who appear to generate outsized returns (query at what risk and with what information advantages) are celebrated in their circles almost as much as sports stars. Their allure is fading bit by bit, but it will be quite a while before the ascendancy of traders is reversed.

Felix Salmon has been bending over backwards listening to and reporting on Andrew Schiff’s claim that he’s suffering making ends meet on $350,000 a year and only wants to give his kids a “middle class lifestyle” in New York City.

For those who missed the salient points of Schiff’s Howard Beale moment, he’s unhappy because he is making less money than last year and is feeling pinched financially. He is paying for a child in private school ($32,000 a year), a summer rental, saves, and complains that he can’t afford to trade up from his 1200 square foot duplex in Cobble Hill and worries he will feel even more strained when his 7 year old starts to attend private school.

Schiff’s argument to Felix as to why his critics have it all wrong is that the cost of what would have been a “middle class lifestyle” in 1987 has risen much faster than incomes. Felix tried running down some indicators and didn’t reach any firm conclusions, save pointing out that the competition among the rich (which means the proliferating hedgies and private equity barons) has driven up “positional goods” in New York like real estate much faster than wages. (Note to Felix: if you really are going to try to do this more rigorously, you need to factor in the changes in tax rates too).

I’m not about to reach any hard and fast answers either, but that’s in large measure because Schiff’s “middle class” claim is bollocks. I’ve lived in Manhattan since 1981, save two years in Sydney (2002 to 2004). On the one hand, it is absolutely undeniable that the cost of real estate, both rentals and purchases, has gone up so much that it has driven a ton of people into less desirable neighborhoods. You used to have a lot of artists and writers living in Manhattan, along with teachers, small firm lawyers, ad agency professionals, and so on. The more favorably priced areas, such as Manhattan on the West Side just below Columbia, Chelsea, Little India, Harlem, the West 50s, keep gentrifying, and true middle class people either live in smaller space or face longer commutes. I dated artists when I first came to Manhattan, when they lived in artist in residence or illegal loft space in Soho. If you saw one other person on a block there on a Sunday morning, that was a lot. The city has become a lot tidier looking and much less diverse.

On the other hand, what Salmon and Schiff miss is that someone “middle class” in the 1980s would have been very unlikely to raise kids in the five boroughs (Schiff and Salmon really mean upper middle class). The city was not considered safe for children. When I first came to Manhattan, pretty much everyone I knew who did not live in a doorman building had had an apartment break-in. I had my wallet stolen on two occasions in 1987. The subways were gross and no woman would dare ride them wearing real or real-looking jewelry (gold chain snatchings were a regular occurrence). I was a member of the 1% then (although not in terms of Manhattan incomes, trust me, there was a huge amount of headroom between me and them) and I lived in a 1100 square foot apartment on 69th Street between Park and Madison, which is a nice block (yes this was a glam apartment, a wreck I had renovated, long shaggy story as to why I no longer have it). I’d be the first out of the building in the morning. The townhouse kept the inner door locked and the outer door unlocked. I’d always have to step over a homeless man sleeping between the two doors.

So in the 1980s and even into the early 1990s, only the comfortably affluent (those who lived in large apartments in doorman buildings or could afford an entire townhouse, which in those days were cheaper than the bigger apartments in good addresses) expected to stay in the city if they had kids. Everyone else moved to the ‘burbs either as soon as the arrival of a child made their living arrangements unduly cramped or no later than when the young ‘un was going to go to elementary school. And that family would have gone to a nice suburb, ideally one where the children could have gone to public school till at least 6th or 8th grade, and gotten a home with a decent sized yard and would not have spent on a summer rental, but on a nice summer vacation and maybe a winter or spring break getaway.

So Felix’s trying to price out what it would have cost in the late 1980s for a Schiff equivalent to live in the better parts of Brooklyn or the nice but less than prime parts of Manhattan is the wrong comparable. It isn’t what people like Schiff did back then. It didn’t become common to raise kids in the city until into the 1990s. I’ve seen it in my own building (I’ve been here 20 years) and with couples in my peer group (the ones that stayed in the city had two high earners, often one member of the pair in private equity or M&A, the other a partner in a law firm, or else a male super high earner, and they’d have only one or two kids). There was all of one child in the building when I arrived and she was the only one until the early 2000s. Now we seem to have between 6 and 8 (there is also more turnover in the building than there once was).

So the pressure on real estate prices wasn’t simply due to rising Wall Street incomes, although that has been the biggest driver. It has also come from more couples in all professions being more likely to stay in the city once they have kids. You can see it in what has happened to townhouses. Many that had been divided into apartments have been reassembled into single family homes. Similarly, my building, like many other in the city, has been putting one bedrooms together and making them into larger apartments. And on top of that, both with the city being safer and the dollar falling over time, more foreigners have been buying apartments too.

The other part is what it takes to be “middle class” has changed. As Elizabeth Warren pointed out in the Two Income Trap, good quality public education has become more scarce, leading to escalating real estate prices in districts seen as having good schools (note that yours truly only went intermittently to schools that would have been considered pretty good, since I lived mainly in hick towns, but even so did well academically in college. I doubt someone who now went to the schools I had attended would have a shot at going to an Ivy unless they had an obvious sign of achievement, like winning a major math competition). But on top of that, people eat out more (partly due to more working spouses, but it is also a broader cultural shift), spend more on household help, entertainment, even Starbucks. There are a lot of routine spending items now that weren’t routine back then.

So the people who take Schiff on are correct. He has assumed he would have upward mobility in a society where that is no longer generally the case, even for those in finance. And his adjustment to new normal is a lot less painful than that being experienced by most people in their 40s. So instead of grousing, he ought to consider himself lucky.

By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

In the old Soviet Union, Pravda, the official news agency, set the standard for “truth” in reporting. Discriminating readers needed to be adroit in sifting the words to discern the facts that lay beneath. Readers of The Economist’s “Special Report on Financial Innovation” (published on 23 February 2012) would do well to equip themselves with similar skills in disambiguation.

Faith Based …

The Economist sees financial innovation as positive; regarding it in the same sense as charity and goodwill to one’s fellow creatures. The reader is told that: “Finance has a very good record of solving big problems, from enabling people to realise the value of future income through products like mortgages to protecting borrowers from the risk of interest-rate fluctuations.” The definition of the “big problems” of our time is obviously subjective.

The Report lacks doubt: “The evidence of this special report suggests that the market does a brilliant job of nurturing and refining instruments that people want.” A closer review of the evidence suggests that the authors of the Report have followed Adlai Stevenson, the Democratic candidate for president in the 1952 and 1956 elections: “Here is the conclusion on which I base my facts.”

The approach is puzzling as the Report repeatedly admits the difficult of actually measuring the benefits of financial innovation: “… quantifying the benefits of innovation is almost impossible” and “To sift through the arguments on both sides is to confront a basic problem with any financial innovation: the difficulty of measuring its benefits.”

The Economist quotes a 2011 NBER paper by Josh Lerner and Peter Tufano which argues the impossibility of quantifying the impact of a financial innovation because finance involves many (often unintended) externalities. Instead the paper proposes a “thought experiment”, imagining what the world would look like without a particular innovation. The Report undertakes this thought experiment, without the requisite imagination and with a pre-disposition to the self evident benefits of finance.

In David Hare’s play The Power of Yes, Adair Turner, head of the English FSA, is asked whether the fact that nobody understood what was going on was an issue. Turner responds that no, it wasn’t a problem as, for people like Alan Greenspan, it was just a matter of faith. The Economist follows their mentor’s modus operandi.

Finance is as Finance Does….

Arguably, the function of finance is to match borrowers and savers, provide safe and secure payment mechanisms and also provide efficient tools for risk management. But the Report lacks a discernible working thesis as to what finance should do and how specific financial instruments, new and old, either do or do not further these objectives. Finance’s primacy is held by The Economist as another self evident truth.

Despite a self conscious mention of innovations in “microfinance products aimed at the very poor, social impact bonds, and all manner of whizzy payment technologies”, the focus is on “wholesale products and techniques”. This is because “they are less obviously useful than retail innovations and because they were more heavily implicated in the financial crisis”. The Report outlines the case for securitisation, credit default swaps (as an example of derivatives), exchange traded funds (“ETFs”) and high frequency trading (“HTF”).

The thesis is that all financial innovations are prima facie good and useful. Occasionally people push them too far and things go wrong. It is Alan Greenspan’s “irrational exuberance”. Excesses are the work of out-of-control “rogue traders”. The sub-text is that the products and system are fundamentally sound. Occasionally unavoidable accidents are always an acceptable cost of progress – collateral damage for greater good.

In 2008, defending deregulated markets, Greenspan stated: “You can have huge amounts of regulation and I will guarantee nothing will go wrong, but nothing will go right either.” This is the central premise of The Economist’s analysis.

Transference…

Techniques of risk transfer – securitisation (collateralised debt obligations (“CDOs”) and credit default swaps (“CDS”) – are good: “… even now it is hard to find fault with the concept [of the CDO], as opposed to the practical application, of many of the most demonised products.”

The defence of securitisation is: “[a CDO] is really just a capital structure in miniature”. In addition, “securitisation—which worked well for decades—allows banks to free up capital, enabling them to extend more credit, and helps diversification of portfolios as banks shed concentrations of risks and investors buy exposures that suit them”. Europe’s ill-fated and discredited adoption of CDO technology for its bailout fund (the European Financial Stability Fund) is the proof of concept, at least for The Economist.

While securitisation is not without benefits, the extension of the technique, for example, into re-securitisations (CDO2) created problems – as the Report readily accepts. However, the Report does not fully understand the true role and effects of securitisation.

While a CDO might be like a bank (a capital structure in miniature), it is unregulated. Securitisation for the last 15-20 years entailed shifting assets from banks to structure which reduced the amount of capital required, arbitraging regulatory capital requirements.

If a bank already held a loan funded with deposits, then in aggregate by selling the loan to the same depositors does not increase the supply of credit. The increase in credit is a function of the several things: (1) shifting risk into the shadow banking system; (2) alchemy (tranching) to create highly rated securities (AAA or AA) which acts as collateral to allow further re-leveraging; and (3) the ability to re-hypothecate the collateral over and over again, such as in re-securitisation.

The process increased leverage (crudely the capital against risk in reduced), model risk, liquidity risk, complexity and linkages via counterparty risk. It also moves risk from somewhere where it is highly visible to where it is less visible. In cutting and dicing risk, it encourages mis-pricing. It also creates difficulties in resolving problems – a delinquent loan is difficult to restructure when it no longer exists in its original form and different slices of the cash flows are held by different investors.

The case for securitisation also misses that banks sell off risk and then re-acquire it either directly through linkages with the shadow banking system or indirectly by financing investors secured against the securitised bonds created. Instead of actually assisting diversification, the entire process concentrates risk while simultaneously lowering the amount of capital and liquidity reserves held against the loans.

Recent research and enquiries have presented considerable evidence that CDOs were a direct contributing factor for the toxic phase of the asset bubble in US housing, commercial real estate and private equity market. But if The Economist is aware of these problems, then they are not covered in any detail.

The only problem with CDOs apparently was that “they were stuffed full of subprime loans but treated by banks, ratings agencies and investors as though they were gold-plated”. Given that sub-prime mortgages were only a part of the much larger CDO market, the wider fall in value of securitised debt and the losses must have been a collective hallucination.

Giving Credit…

After the expected Oxbridge cross Channel sneer at “choking Europeans”, the Report concludes that CDS contracts are “sound”. Sovereign CDS contracts perform “a useful signalling function”.

The only problem apparently is that banks sometimes sell protection on their own governments increasing their exposures to the sovereign. Given large banks dependence on the sovereign for their own existence, the absurdity of a bank insuring the nation’s risk collateralised by government debt is ignored.

CDS, if it is used as a pure hedge, can be useful. Over time, the market, led by dealers keen to make credit a tradeable commodity, has evolved differently. The major drivers of the market are the ability to short credit and take leveraged positions on bonds. In addition, the fact that CDS contracts are not limited by the availability of underlying bonds or credit assets (at the peak the CDS market was around 4/5 times the available underlying assets) has encouraged the growth of the market.

Standardisation of the contract to facilitate trading has created significant “basis risks” for hedgers. The recent restructuring of Greek debt, designed to specifically, avoid triggering CDS contracts, highlights the problems. A number of episodes over the last 4 years have highlighted documentary issues – trigger events and loss payouts – which cast serious doubts as to the utility of the contract.

Curiously, The Economist cites that fact that “conservative” India has recently given permission for CDS contracts to commence trading as proof of the utility of the product. The Report neglects to mention that approval was highly conditional, being designed to ensure that the only contracts traded were pure hedges of underlying positions.

In the film Casablanca, Rick (Humphrey Bogart) tells Captain Renault (Claude Rains) that he came to the city “for the waters” because of his health. Informed that they are in the desert, Rick ironically rejoinders that he was “misinformed”. The Economist as well as investors and banks, including those who purchased Greek sovereign CDS to protect themselves against the risk of default, may have been similarly misinformed.

ETF….

Exchange Traded Funds (“ETF”) are a hoary old chestnut, a listed and tradeable version of an index fund; hardly a revolutionary “innovation”. As the Supplement notes the absolute size of the ETF market is also relatively modest compared with estimated global assets under the control of fund managers.

Vanguard founder John Bogle might take justifiable issue with the statement that ETFs “allow retail investors access to diversified portfolios of assets that had previously been the sole preserve of institutional investors”. Mr. Bogle founded the Vanguard 500 Index Fund as the first index mutual fund available to the general public in 1975, more than a decade before ETFs.

Argument and analysis is replaced by over energetic prose – “finance’s infectious creativity”; “vibrancy looks like a victory for the investor over the fund manager”; “It is in the nature of finance that experimentation never stops.”

ETFs are “good”, reducing transaction costs and increasing efficiency. The Report notes criticism of ETFs – counterparty risk to delaers where funds use derivatives to replicate exposure to the underlying assets. Closer reading of the IMF report on ETFs suggest deeper concerns that do not merit mention – the market impact of simultaneous trend following trading by ETFs and “innovations”, such as leveraged and other versions.

There is no discussion of a key underlying issue – the idea of diversification. The Economist argues that “the dotcom bust had underscored the importance of diversification”.

Diversification to reduce risk is not without problems. As equity indexes are weighted typically by market capitalisation, as an individual share price rises it becomes a larger part of the index and therefore the ETF. During manic market phases, such as the dot com and now the AGF (Apple Google Facebook) boom, ETF investors may inadvertently find them heavily exposed to such stocks.

In asset classes such as debt, the idea of indexation is more problematic. As the indexes are weighted by the amount of bonds on issue, as an issuer borrows more it becomes a larger part of the ETF, irrespective of its ability to make repayments. As Worldcom and more recently European sovereign debt shows, the results are not pretty.

While successfully managing the portfolios of an insurance company and the King’s College endowment, Keynes insisted that diversification was flawed: “To suppose that safety…consists in having a small gamble in a large number of different [stocks] where I have no information…as compared with a substantial stake in a company where one’s information is adequate, strikes me as a travesty of investment”. Mark Twain’s Pudd’nhead Wilson would have agreed: “Put all your eggs in one basket, and watch that basket.”

HFT….

The Economist sides with the high frequency trading (“HFT”) practitioners who are “frustrated by what they perceive as an unfair onslaught”. The Report resorts to tried and tested rhetoric – HFT is difficult to define; there is not enough data. But these factors present no barrier to the conclusion reached that “high-frequency traders provide liquidity and ‘knit’ together our increasingly fragmented marketplace, resulting in tighter spreads that benefit all investors” (citing testimony delivered to the Securities and Exchange Commission in 2010 by George Sauter of Vanguard, a big fund manager).

Liquidity and lower transaction costs only benefits an investor when they trade. High liquidity and tight bid-offer spreads are only available, as all practitioners know, when it is not needed, becoming the first casualties of market downturns and volatility. Market-making needs adequate compensation for the risk assumed. Forcing return below sustainable levels encourages dealers to boost revenue from proprietary trading (often using the information gained from client activity) and trading structured products, creating different risks.

The Report ignores the real problems of HFT – the problems of potential market manipulation, insider trading, front running client flows and increased market volatility often at critical times. The Economist cannot imagine a world without HFT which is “an “outcrop” of the market structure”.

High trading volumes are regarded as normal and desirable. In the zero sum game of trading, the presence of super fast computers copulating with other super fast machines provides uncertain benefits in financial intermediation.

Average investment periods for shares have shortened from around 7 years to 7 months since 1940. HFT now accounts for over 60% of equity trading, with an average holding period of around 11 seconds. High levels of trading may create excessive “noise” preventing prices from reflecting true value, ultimately leading to a loss of confidence in certain markets discouraging investment. HFT may damage the process of long term capital accumulation and allocation.

Collateral Damage …

The Report believes that collateral is problematic “the whirring of financiers’ minds … spells trouble” but confusingly sees it is as also breeding innovation. The discussion may remind the reader of an observation of Groucho Marx: “A child of five would understand this. Send someone to fetch a child of five”.

The use of collateral contributed significantly to the financial crisis. Secured lending, collateralised by securities, including high quality bonds especially created through securitisation, contributed to the increase in debt. It allowed a shift of focus from repayment ability based on income and cash flow to the value of the asset securing the borrowing. As debt fuelled a virtuous cycle of price appreciation it allowed the level of debt to increase rapidly.

The process relies on a steady and unending rise of debt and prices – a Ponzi scheme, in effect. It also relies on the ability to trade and the liquidity of markets. Unfortunately, the virtuous cycle turns vicious when the supply of debt ceases and prices fall.

The system creates exposure to short term price fluctuations as the amount of collateral required varies. It effectively amplifies the broader financial problems of funding short and lending long.

Collateral also facilitates access to derivative markets for less credit worthy counterparties.

The problems of Bear Stearns’ hedge funds, AIG and Lehman all can be traced, in different degrees, to the system of collateral. Unfortunately, those unlikely to be able to meet demands for payment are unlikely to be able to meet collateral calls – a fact which financial institutions and their regulators failed to understand.

At a broader level, collateral underlies the entire shadow banking system, which proved so problematic during the crisis.

Left Unsaid…

Mistakes of commission are compounded with errors of omissions.

The Report notes that risk transfer may encourage excessive risk taking and lending. It identifies that the illusion of stability may cause instability, an idea first put forward by economist Hyman Minsky (who does not gain a mention).

The systemic side effects of financial innovation are barely recognised. Financial innovation played a crucial role in allowing the increase in debt levels and leverage. It created complex linkages between financial participants increasing systemic risk and informational failures.

The appropriate size of some markets, such as for over-the-counter derivative, is not considered. The Economist points to interest-rate swaps “which are used to bet on and hedge against future changes in interest rates, as an example of a huge, well-functioning and useful innovation of the modern financial era”.

Interest rate derivatives (including interest rate swaps) are about 70% of total derivative outstanding on $600 trillion, which equates to over $400 trillion roughly 6 or 7 times global GDP and a significant multiple of all financial assets in existence. Daily currency turnover is between 30 and 50 times trade flows.

Derivative volumes are inconsistent with pure risk transfer. The necessity for or utility of such high trading volumes does not figure in the discussion.

A quaint economic concept – cost benefit analysis -. weighs the benefits of any actions against the costs. Unable to identify the benefits accurately by their own admission, the Report decides to ignore costs arguing: “Even bad ideas are not a problem when they first arise. If only a few people get burned by a duff product, the wider world need not care”.

Given the high cost of failure of financial innovations as evidenced by the significant and ongoing costs of global financial crisis, the case for financial innovation, at least of many of the products cited, may fail on cost-benefit grounds. Defenders of financial innovation have a high burden of proof to overcome.

Super Smarts…

The Economist fails to understand the real motivations of financial innovation. They believe that: “Products … mutate constantly, in part because patenting is not common”. Citing Franklin Allen of the Wharton School at the University of Pennsylvania and Glenn Yago of the Milken Institute, wholesale financial innovation, they argue, is the creation of new capital structures that align the interests of lots of different parties.

In practice, the major alignment of interests relates to getting a deal done to enable the bankers to receive substantial bonuses based on mark-to-market values of the product. The profit frequently does not fully recognise the long term consequences or risks to either the client or the financial institution.

Confusing bankers with saintly figures in line for beatification, the Report approvingly cites Goldman Sach’s Martin Chavez who explains that innovation is in response to the “clients call”… We can’t tell them ‘no thanks’.” This, undoubtedly, is “doing God’s work”, which the head of the firm once stated was its primary mission.

It is difficult to reconcile this position with statements by another Goldman Sachs’ employee Fabrice Tourre, who sold the Abacus deals to unwitting “widows and orphans”. Among tender emails to his girlfriend Serres, the self-styled “Fabulous Fab” observed in January 2007: “More and more leverage in the system. The whole building is about to collapse anytime now?.?.?.? Only potential survivor, the fabulous Fab[rice Tourre] standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!”

Tourre stated that Abacus was “pure intellectual masturbation”, “a ‘thing’ which has no
purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price”. But Tourre was not assailed by self-doubt: “Anyway, not feeling too guilty about this, the real purpose of my job is to make capital markets more efficient and ultimately provide the U.S. consumer with more efficient ways to leverage and finance himself, so there is a humble, noble, and ethical reason for my job :) amazing how good I am in convincing myself!!!”

Stéphane Mattatia, Société Générale’s global head of equity flow engineering and advisory, told The Economist of a hedge based on the Euro falling and gold rising for a client worried about French CDSs. Of course, SG managed to lose Euro 5.9 billion through its inability to hedge its own risk on positions taken by rogue trader Jerome Kerviel. If the client was concerned about positions in French CDS, wouldn’t it have been just easier to close out its existing position rather than enter into a complex, potentially expensive and illiquid instrument?

There is no acknowledgement that much of what is called financial innovation is economic rent extraction, exploiting lack of transparency as well as information and knowledge asymmetries. There is no discussion of the destructive bonus culture which encourages certain behaviours in financial institutions. Thomas Philippon and Ariel Reshef have estimated that around 30-50% of the extra pay bankers received compared to similar professionals is attributable to economic rents.

In a January 2009 speech, Lord Adair Turner, chairman of UK’s Financial Services Authority, observed that: “Much of the structuring and trading activity involved in the complex version of securitized credit was not required to deliver credit intermediation efficiently, but achieved an economic rent extraction made possible by the opacity of margins and the asymmetry of information and knowledge between…users of financial services and producers…financial innovation which delivers no fundamental economic benefit, can for a time flourish and earn for the individuals and institutions which innovated very large returns.”

The unpalatable reality that few, self interested industry participants and their cheerleaders are prepared to admit is that much of what passes for financial innovation is specifically designed to conceal risk, obfuscate investors and reduce transparency. The process is entirely deliberate. Efficiency and transparency is not consistent with the high profit margins on Wall Street and the City. Financial products need to be opaque and priced inefficiently to produce excessive profits. The Report does not canvas this issue.

Fixing It ….

The Report makes prescriptions for strengthening financial innovation – protection of investors, more capital, improved operational procedures and stronger regulators. The solutions are familiar dictums which have been tried before with limited success. As former New York Federal Reserve President Gerald Corrigan told policy-makers and financiers on 16 May, 2007: “Anyone who thinks they understand this stuff is living in lala land.”

The problem of protecting investors arises because of the difficult in “judging the sophistication of a client”. Not only retail investors, it seems, need protection. The Report approvingly quotes a regulator: “A German Landesbank should be treated like a child”.

The risk management problems of “sophisticated” firms (Citibank, UBS, Lehman, Bear Stearns, Merrill Lynch and Long Term Capital Management (whose numbers included Myron Scholes and Robert Merton as well a large number of highly trained financiers)) suggest that most of the industry have not reached pimply adolescence let alone sage maturity. Given a tendency to self harm, most industry participants need protection from each other and themselves. Regulatory initiatives may need to encompass preventive detention for all parties.

In the last 20 years, capital held by banks and brokers against loss fell, increasing leverage. The definition of capital was expanded to include hybrid capital, debt ranking below deposits and senior borrowings. Cheaper than normal equity, hybrids avoided dilution of existing shareholders. Increases in debt and leverage reflected “improved financial flexibility…the results of massive improvements in technology and infrastructure”, according to regulators. Banks’ liquidity reserves, designed to cover withdrawal of deposits, were reduced, freeing up money for lending.

The risks were ignored. Alan Greenspan argued: “The lack of a spare tire is of no concern if you do not get a flat.”

The prescription for higher capital and liquidity reserves has been tried before. Each capital regime promises more stringent control, but is ruthlessly arbitraged. This time around a fragile global economy means the willingness to compromise the integrity of the financial system for greater credit fuelled growth will be difficult to avoid.

In his review of the global banking crisis, Lord Adair Turner noted that: “An underlying assumption of financial regulation in the U.S., the UK and across the world has been that financial innovation is by definition beneficial, since market discipline will winnow out any
unnecessary or value destructive innovations. As a result, regulators have not considered it their role to judge the value of different financial products, and they have in general avoided direct products regulation, certainly in wholesale markets with sophisticated investors.”

Regulators may always lag markets and financial institutions in knowledge, experience and pay. Regulatory capture ensures over time the loss of oversight and control. History suggests that the next time will not be different.

Realpolitik…

Given its reputation, the weaknesses of The Economist’s Special Report are disappointing.

Information on the issues is all in the public domain. There are a plethora of reports, such as Financial Crisis Inquiry Commission Report, the Turner Report etc, which explore financial innovation and the financial crisis. There is also, I understand, a relatively new innovative Internet-based tool – the “search engine” – with could have been used by The Economist to check and research such facts.

In recent stories and reports, The Economist has presented an increasingly strident defence of bankers and their ‘City’ as well as resistance to regulation of the financial system.

Professor Simon Johnson has pointed repeatedly to one cause of the financial crisis – the political economy of the financial system and the lobbying power of financial institutions. If the press becomes part of this political economy, consciously or subliminally, then the problems are exacerbated. Advertising and sponsorship revenues as well as control over access to information and key decision makers, deemed news worthy, are essential commercial links which make newspapers and media susceptible to being influenced.

Zdener Urbanek, the dissident Czech novelist, observed that assumptions about what was written are dangerous: “In dictatorships…. We believe nothing of what we read in the
newspapers and nothing of what we watch on television, because we know it’s propaganda and lies. Unlike you in the West. We’ve learned to look behind the propaganda and to read between
the lines and, unlike you, we know that the real truth is always subversive.”

There is an important and necessary debate about financial innovation but it is not to be found in The Economist’s Special Report on the subject.

It’s always a pleasant surprise to see a TV program have a long form discussion on a fairly technical topic. Readers should enjoy the RT interview of Caitlin Kline and Alexis Goldstein of Occupy the SEC on its Volcker Rule comments. They discussed the major areas they were concerned with and some loopholes in the draft regulations.

I’d heard from German speaking readers about the Der Spiegel report of an SEC investigation in its German edition over the weekend and they’ve now released it in their English language version.

Der Spiegel is careful about its sourcing, so readers should take this account seriously. The story is about the overall litigation risks facing the German powerhouse, the SEC investigation is a mention in passing (hat tip reader Mary L):

Meanwhile, the US Securities and Exchange Commission is also investigating Deutsche Bank, SPIEGEL reports. According to financial regulatory sources, the bank launched one CDO transaction called “START” in which it allegedly allowed the hedge fund of US speculator John Paulson to choose junk mortgage securities against which he could speculate — without the other investors knowing about it.

Goldman Sachs settled a suit with the SEC in a similar case for $550 million, SPIEGEL reported.

Why is there probably less here than meets the eye? For this investigation to be taken seriously, SEC enforcement chief Robert Khuzami would have to resign. He was the general counsel for the fixed income area at the time when the deals in question were undertaken (contra Der Spiegel, START was a program of synthetic CDOs, not just a single deal, just the Goldman Abacus trade that was the focus of an SEC lawsuit was actually just one of 25 Abacus trades). It would not be sufficient for Khuzami to recuse himself from this investigation. Staff would still be concerned about how the probe might affect their ultimate boss.

In addition, the fact that Paulson approached Deutsche Bank has been in the public domain since October 2009, when Greg Zuckerman’s book, The Greatest Trade Ever, was released. It discussed in detail how Paulson approached Goldman, Deutsche Bank, and Bear Stearns about constructing synthetic CDOs so Paulson could bet against the subprime market cheaply. This is how Scott Eichel, a senior Bear Stearns trader, saw it:

“We had three meetings with John, we were working on a trade together,” says Eichel. “He had a bearish view and was very open about what he wanted to do, he was more up front than most of them.

“But it didn’t pass the ethics standards; it was a reputation issue, and it didn’t pass our moral compass. We didn’t think we should sell deals that someone was shorting on the other side,” Eichel says.

If this conduct was so questionable that the SEC thought it made sense to sue Goldman in April 2010, why was Deutsche not sued then or shortly thereafter? Why is the SEC only “investigating” nearly two years later?

By Wolf Richter, San Francisco based executive, entrepreneur, start up specialist, and author, with extensive international work experience. Cross posted from Testosterone Pit.

Dexia SA, the Franco-Belgian mega-bank that collapsed and was bailed out in 2008 and that re-collapsed in early October, is a big deal in Belgium where it employs 10,000 people and has over 21 million bank accounts. Its assets of $715 billion dwarf Belgium’s $395 billion economy.

The three countries involved in the bailout agreed in October to guarantee €90 billion in loans, of which Belgium will be responsible for 60.5%, France for 36.5%, Luxembourg for 3%. Belgium’s portion, €54.5 billion, represents nearly 14% of its GDP. The process is moving forward. On December 21, the European Commission approved on a temporary basis €45 billion of those guarantees though they violate EU rules on government subsidies for private companies.

Taxpayers are paying a heavy price for Dexia’s bailout. Belgium nationalized the Belgian entities of Dexia, including untold amounts of toxic assets. The French entity, which was involved in an enormous subprime scandal à la française, was taken over by the Caisse des Dépôts and the Banque Postale—both owned by the French government. Precision Capital, a Luxembourg company controlled by Qatari investors, bought 90% of Dexia Bank International Luxembourg, valuing the firm at €730 million, a steep discount from the expected €1 billion. Luxembourg acquired the remaining 10%. Other entities remain on the block.

In trying to bail out its financial sector, Belgium has guaranteed a total of €138.1 billion in debt (35% of its GDP) and has injected €15.7 billion in capital and €8.6 billion in loans, according to Belgium’s Cour des Comptes (Audit Court), which released the results of its annual audit on December 20 (PDF of the 412-page 168th Cahier) . The largest recipients: Dexia Banque Belgique, Dexia SA, BNP Paribas, and Fortis Banque.

The ultimate costs to Belgian taxpayers will be huge and long-term, given how small the country is. Yet there have been no legal consequences for those responsible. Until now….

Lynx Capital, a Belgian investment firm, has sued Dexia SA and former CEO Pierre Mariani for “spreading false and misleading information” and “market manipulation.” The amount in the case is small—and irrelevant. Lynx purchased 5,350 shares on September 5, 2011, for €1.46 per share and lost 82% of its investment over the next few months. But in a potentially significant development for Belgium, where class-action law doesn’t exist, Bernard Delhez, CEO of Lynx, is now trying to encourage other shareholders to join the cause.

The complaint alleges that Mariani and Jean-Luc Dehaene, Dexia’s former president, issued reassuring statements about the financial condition of the bank from the time they took over, following its bailout in 2008, until September 2011. Because the bank was in a precarious situation throughout and engaged in high-risk activities, the information in those reassuring statements was false and misleading and was intended to artificially inflate Dexia’s share price. Hence, Dexia and Mariani engaged in market manipulation.

Moreover, Mariani must have known that the information was false and misleading. For example, Mariani confided in Dehaene in 2008 that Dexia was “not a bank but a hedge fund” (L’Expansion). Dehaene spilled the beans on this conversation last October during the presentation of the breakup plan. Among the others reasons why Mariani must have known about the true condition of Dexia was a note that Luc Coene, Governor of the National Bank of Belgium, had sent to Dexia last August, in which he recommended that Dexia be dismantled.

For Robert Witterwulghe, Lynx’s lawyer, the facts demonstrate that Mariani knew as early as October, 2008, that Dexia was in a precarious situation, and that the reassuring communications since then were willfully false and misleading.

The court action is based on the law of August 2, 2002, concerning insider trading and market manipulation. But: “Why impose a system for everyone when it is not applied in certain cases?” Delhez said (L’Echo), perhaps to justify in part why he is pushing the case though his investment is small and his legal expenses will pile up quickly.

When a bank collapses, the lies behind its financial statements come out of the woodwork—and Dexia is no exception: a report surfaced with the damning results of an earlier investigation by French regulators. And what happened then? Nothing…. Regulators Knew of Dexia’s Problems But Were Silenced.

Yves here. One of our ongoing frustrations at NC is when the media and blogosphere get up in arms about what we think are secondary issues.

We’ve been loath to comment on a Thomson Reuters article that claimed that rehypothecation of assets in customer accounts was the reason MF Global customer funds went missing. The reason we’ve stayed away from this debate is that the article, despite its length, did not provide any substantiation for its claim. While it did contend that US customer accounts were set up so as to allow assets to be rehypothecated using far more permissive UK rules, and described how rehypothecation could be abused, it did not provide any proof that this was what took place at MF Global. Note that this does NOT mean we are saying that rehypothecation did not play a role, merely that the article was speculative.

The bombshell testimony of CME chief Terry Duffy yesterday, that a CME auditor heard an MF Global employee say that “Mr Corzine was aware of the loans being made from segregated [customer] accounts,” suggests that some of the money went missing via much more straightforward means, namely, taking it and hoping to be able to give it back if the firm survived.

But there is plenty of reason to be worried about rehypothecation. Richard Smith, in a post last January, described not only how rehypothecation played a major role in the last crisis, but also waved a big red flag regarding JP Morgan’s push to promote unrestricted rehypothecation.

And it may be completely unrelated to the issue of collateral, but consider this tidbit from the Financial Times yesterday:

Separately, in a court filing, James Giddens, the bankruptcy trustee of MF Global, said that “certain” actions of JPMorgan Chase, a lender to the collapsed company, “are likely to be the subject of investigation”.

Given that it was JP Morgan withholding cash and collateral that struck the fatal blow to Lehman, one wonders if we’ll find a similar aggressive move as a contributor to the scale of MF Global customer losses.

We thought the earlier Richard Smith post would again be of considerable interest to readers.

By Richard Smith

Readers of ECONned will be very familiar with the name of Gary Gorton, author of ‘Slapped in The Face by the Invisible Hand’, which explores the relation of the so-called shadow banking system to the financial crisis. His work is pretty fundamental to understanding some of the mechanisms which made the crisis so acute. Now he’s done an interview, which I would like to have a growl at; but first, he has some basic points about shadow banking, useful later in this rather long post. Gorton explains repo thus:

You take your $200 million to the bank, to Lehman Brothers, say. You deposit it, so to speak, overnight so you can have access to it the next morning if you want to. They pay you 3 percent. And you want it to be safe, so they give you a bond as collateral. But Lehman earns the interest on the bond, say, 6 percent.

..and then “haircuts” (an extra margin of security in case that bond isn’t so safe after all):

There may be a haircut. If you deposit $100 million and they give you bonds worth $100 million, there’s no haircut. If you deposit $90 million and they give you bonds worth $100 million, then there’s a 10 percent haircut.

…and then “rehypothecation”:

If you put a dollar in your checking account and the bank has to keep 10 percent of it on reserve, they lend out 90 cents. Somebody deposits that 90 cents, the bank can lend out 81 cents (because of the 10 percent reserve requirement) and so on. So you end up creating $10 of checking accounts for $1 of demand deposits, assuming there’s a demand for loans…And that can happen in repo as well because if you’re Lehman and I’m the depositor, and you give me a bond as collateral, I can use that bond somewhere else. So there is a similar money multiplier process.

…and finally the link to regulated banking:

And shadow banking very importantly is not a separate system from traditional banking. These are all one banking system.

So much for the preamble. The other point you need to know: we are talking about an unregulated banking system that at its height was just as big as the regulated banking system, yet coupled to it, and apparently more profitable, though, as we now know, much riskier. Now we get to the part of Gorton’s interview that I’m not so happy with:

In summary, I would describe shadow banking as the rise to a significant extent of a very old form of bank money called repo, which largely uses securitized product as collateral and meets the needs of institutional investors, states and municipalities, nonfinancial firms for a short-term, safe banking product.…It’s a valuable innovation.

The bit in bold is where I raised my eyebrows. The truth of the bolded claims depends on the yet-to-be-discovered solutions to repo’s core problem, formulated thus by Gorton:

Of course, the problem with repo and shadow banking is that they have the same vulnerability that other forms of bank money have. We can talk at great length about what that vulnerability is, but loosely speaking, it’s prone to panic. Looking back at history, think about how long it took to devise a solution to the first banking panic, related mostly to demand deposits. That was in 1857. It wasn’t until 1934 that deposit insurance was enacted. That’s 77 years where we’re trying to understand demand deposits and figure out what to do.

The situation that we’re in now, seriously, is one where we are back in about 1860: We’ve just had a big crisis, and we’re trying to figure out what to do. We can only hope that it doesn’t take 77 years to figure it out this time.

That doesn’t sound like a safe banking product to me. Next comes some irritating pussyfooting:

Nobody wants to be given collateral that they have to worry about. And the mechanics of how repo works is exactly consistent with this. Firms that trade repo work in the following way: The repo traders come in in the morning, they have some coffee, they go to their desks, they start making calls, and in a large firm they’ve rolled $40 to $50 billion of repo in an hour and a half. Now, you can only do that if the depositors believe that the collateral has the feature that nobody has any private information about it. We can all just believe that it’s all AAA.

Gorton is polite, and that can mislead. Impolitely: for “private information”, read “knowledge that the collateral is wildly overvalued”, or ”aware that the collateral is backed by assets with massive gearing to fraudulent loans”. The system’s gatekeepers (originators, ratings agencies and credit insurers) had an “agency problem”, (impolitely: issued cows, or rated cows, or insured cows, for money), so the fraud-backed collateral got past them.

Gorton is vague about how this “information insensitive” collateral is to be created. Presumably the options are to have reliable ratings agencies, or some other gatekeeper on the collateral, or a very deep-pocketed credit guarantor (that’s you, dear reader), or all three. But he doesn’t quite spell it out; perhaps that’s just the interview format. What we get instead is this:

We want all securitized product to be sold through this new category of banks: narrow-funding banks. The NFBs can only do one thing: just buy securitized products and issue liabilities. The goal is to bring that part of the banking system under the regulatory umbrella and to have these guys be collateral creators.

Well, I don’t immediately see why a narrow funding bank, thus described, is a more reliable generator of quality collateral than a narrow rating agency, or a narrow monoline insurer, or for that matter, Gorton’s old client, AIG. Why would an NFB be any better than any of those organizations in filtering out low quality collateral, given the demand for collateral? The NFB has exactly the same agency problem.

And are we really sure we know what ‘good collateral’ is? Gorton’s formulation of the problem isn’t quite accurate: it’s the stability of the haircuts that matters, not the reliability of the ratings. In truth, the ’08 crisis in repo was ended by explicit and implicit government backstops. By that time: haircuts on pristine US treasuries had gone from ¼% pre crisis to 3% mid crisis; on investment grade bonds, from 1.5% or so to 10% plus. As we will see later, when there is lots of rehypothecation, those moves would matter just as much as the annihilation of triple-A CDOs. More on this later: identifying a different problem with repo is the meat of this post.

Also missing from Gorton’s picture: how much of the need for repo collateral is simply driven by the increase in OTC derivatives. According to another of Gorton’s papers, there was $2Trillion of derivatives collateral in 2007; $4Trillion in 2008. So is that why Gorton simply assumes that repo “has” to grow: to provide collateral for the OTC derivatives market? So why, then, does the OTC derivatives market have to grow? One would like to see the connection between ETFs and repo worked out by someone, somewhere, too.

Despite my whining, do have a read of the interview:  here it is again. There’s plenty more, and plenty of it is good – why Dodd-Frank is a big miss, how few data are available on the enormous shadow banking system. That’s what happens when you don’t supervise financial innovations: you don’t know what they do, you don’t know how they work, and you don’t know what went wrong. If you are in full geek mode, you can download the papers that underlie the interview here and here (I must get round to that). Metrick and Gorton write about haircuts here. That lot should keep you going…

Now I’m going to double back to something that Gorton skirts: the interaction of repo haircuts, rehypothecation and the credit multiplier. Recall his interview:

If you put a dollar in your checking account and the bank has to keep 10 percent of it on reserve, they lend out 90 cents. Somebody deposits that 90 cents, the bank can lend out 81 cents (because of the 10 percent reserve requirement) and so on. So you end up creating $10 of checking accounts for $1 of demand deposits, assuming there’s a demand for loans. Now, that money multiplier process is very important because it means that the amount of endogenously created private bank money in checking accounts is 10 times the size of the collateral, so to speak, of $1 of government money. So, in a traditional banking panic, if everybody wants their $10 back, there’s only $1. And that’s the problem.

What you have here, in the equivalent language of repo, is a 10 per cent haircut, with unlimited rehypothecation (so that you can just keep reusing the collateral to raise more and more liquidity, haircutting away until the amount you can still pledge isn’t worth bothering with), and a credit multiplier of 10. To get a general picture of how the credit multiplier, haircuts and rehypothecations tie together, we now need a tiny spot of mathematics.

An aside: one of the peculiarities of mathematical economics, as opposed to mathematics, is the relative frequency of “theorems”. In mathematics, theorems are as rare as unicorn droppings, things of near-holy awesomeness; in mathematical economics, by contrast, they occur horribly frequently, like depictions of unappealing sexual acts in the oeuvre of the Marquis de Sade.

So I should probably try to get people to give this shoddily presented and deeply unoriginal formula,

some kind of grand title: Smith’s Unrestricted Rehypothecation Theorem, perhaps. What does it mean? It describes the relation between the credit multiplier under unrestricted rehypothecation, Cm_¥, and h, the haircut, which is a value between 0% and 100%; k keeps count of the number of rehypothecations. Any charges levied for the rehypothecation are assumed to be negligible (I won’t keep saying this, but bear it in mind – it means that the credit multiplier is never quite as big as I say it is, though pretty close, because the charge for a rehypothecation is not huge). As you see, with unrestricted rehypothecation, you just invert the haircut to get the credit multiplier. That is the big picture.

So, as with Gorton’s deposit example above, if the repo haircut is 10%, the ultimate credit multiplier is 10. Which is to say: if you could rehypothecate for ever, liquidity amounting to 10 times the amount of underlying collateral would be created, if the haircut was 10%. Once again his polite example might be a bit misleading. Consider instead the effect of a haircut of just 1% – then the ultimate credit multiplier is 100. With zero haircuts and no rehypothecation charge, the credit multiplier would be infinite…

For anticlimactic comparison, Singh and Aitken estimate that the credit multiplier in force at the height of the bubble was about 4: there were $1Trillion of rehypothecable hedge fund assets, transmuted by the magic of rehypothecation into $4Trillion of pledgable collateral at banks. No cause for concern then? Well, that depends how much you enjoyed the ’08 liquidity crisis; and unfortunately, much higher levels of rehypothecation may be just around the corner, which is a worry.

To show why, we need another theorem, Smith’s Restricted Rehypothecation Theorem this time, I suppose. It’s just as banal as the other one:

This gives you the total credit multiplier Cm_r, when you have a finite number of rehypothecations. The number of rehypothecations is given by r; h is the haircut again. As r tends to infinity, the first term on the right hand side of the equation tends to zero, giving you, in the limit, the Unrestricted Rehypothecation Theorem.

Now we can work out, for a range of haircuts, what number of rehypothecations it takes to give a credit multiplier. I’ll use the example of the IMF haircut table that Yves exhibits in ECONned (figure 9.4 there), assume an initial credit multiplier around 4 per Singh and Aitken, and use the rehypothecation formula to show the impact of the increased haircuts. The table is a bit rough and ready, but it gives an idea. The collateral has been rehypo’d on average just over three times, giving a credit multiplier of 4. Given the assumed proportion of each collateral type, the loss of liquidity amounts to $750 Billion for every $1Trillion of collateral (this is August ’08, is before the crisis got really acute).

The estimate of the amount of each collateral type involved is pretty much a guess. If only we knew! But I hope it doesn’t matter much: the table does illustrate the point that haircuts increasing from a single digit number to 10 or more, on widely held collateral (in this example, investment grade bonds, or Prime MBS), can have just as big an effect on liquidity as total wipeouts on CDOs, or big haircuts on ABS (rightmost column, in bold).

With lots of rehypothecation, it gets worse. To get a better idea of how haircuts, rehypothecation and the credit multiplier work together, it’s time for a picture of Dragon Country.

This is my two equations, graphed. Some more explanation:

• Haircut: the 1.0 (bottom right hand corner) is of course 100% , in other words, there is no repo, and the credit multiplier is 1, so there is no effect on credit. I’ve assumed the charge for rehypothecation is negligible.
• The thick black curving line shows the theoretical maximum credit multiplier when there is an infinite number of rehypothecations. On the basis that a 1000x credit multiplier is absurd enough, I stopped at 0.1% haircuts, though 0% haircuts have supposedly been used in repo.
• The unimaginable top left hand corner won’t fit on the graph: a haircut of zero and an infinite credit multiplier.
• The thin green line shows the credit multiplier for various haircuts when there are just 4 rehypothecations. You can see from the graph that this gives to a credit multiplier of around 4, for a range of haircuts from 0-20% or so.
• The just about detectable blue curve, above the green one, shows the credit multiplier when there are 20 rehypothecations: already enough to move the credit multiplier to worrying levels when the haircut is less than 20%, and when there is only a 0.25% haircut, to an absurd 17x.
• I’ve assumed that Q4 ‘08 is nasty enough for all of us, and that therefore an overall credit multiplier of 4 is as much as we want; so that’s where I’ve put the horizontal red line.
• The red area is Dragon Country, where low haircuts and lots of rehypothecation result in huge credit multipliers, and very great (exponential-like) sensitivity to increases in haircuts.
• I’ve used a logarithmic scale on the y-axis to cram the whole thing in. Dragon country would be impressively vast on a linear scale.
• The graph shows you something else Gorton doesn’t really emphasize: the only reason to like a small haircut is to maximize the amount of liquidity you create via repeated rehypothecation.

Have I just put forward one of those daft theoretical constructs beloved of economists and technocrats? I think not, for a couple of reasons.

First, “infinite” rehypothecation just sets out a limiting case that exhibits some unfortunate but representative dynamics. It doesn’t have to be that bad to be bad. In particular, the graph highlights the critical relevance to banking stability of very small repo haircuts (and by extension, collateral ratings) and the concomitant large credit multipliers. If those ratings are volatile, haircuts are volatile, and your banking system is unstable. That combination of small haircuts and large credit multipliers may be exactly what we saw in the run-up to the crisis of Q4 ’08. It did seem to be the sudden doubts about the value of “AAA” rated CDOs that caused the initial spasm of funding difficulties before March ’08 and the Bear implosion.  But even unimpeachable collateral was tainted somehow. How did that happen? What’s to stop it happening again? Now add some counterparty doubts, courtesy of Lehman, with hedge funds deleveraging and then pulling their assets from Prime Brokers, which stops rehypothecation in its tracks, and by Q4 ’08 you are in a proper crisis. Even if the UK has better bankruptcy processes next time, they will get their first proper test live, in a crisis. There is no particular reason to expect a hedge fund to feel more confident about its UK Prime Broker next time we get a Q4 ’08.

Second, the doubts that have inhibited rehypothecation have been more about rights in bankruptcy than about the very idea of rehypothecation; but it’s rehypothecation that is the bogey. That’s not necessarily how the US lawmakers saw it back in 1934, when they capped rehypothecation in the US, as described by John Hempton, but the 1934 law helped a lot, anyway. Banks operated in London to get around the US restriction; then rehypothecation was a massive factor in the complexity of the Lehman bankruptcy, which dragged lots ($15-$45Bn, depending on how the bankruptcy plays out) of hedge funds’ rehypothecated assets into the mess; surviving hedge funds toned down their agreements to London rehypo, in a rush. But I suspect John is jumping the gun when he announces the end of the City of London; the availability of unrestricted rehypothecation is just too darned convenient, if you can get someone to do it. One notes that two years on, there is no UK reform of rehypo; yet there is consultation on reform of UK bankruptcy processes for investment banks, which might encourage hedge funds to agree again to unrestricted rehypothecation.

It also happens that JP Morgan, originators of those not unmixed blessings, Value-At-Risk and Credit Default Swaps, are thinking hard about how to get rehypothecation going in the grand style. They know a volume business with a cheap government backstop when they see one; they are on a marketing push, and presumably they have the systems and processes that go with it.

JPM is very keen to assure us and potential clients that the right business model (they think they have it) will be bankruptcy proof. So – unrestricted rehypo might breathe again, if enough London hedge funds can be reassured  by the UK treasury and by JP Morgan.

The JPM technologists are still at work, too. Rehypothecation is getting slicker, at least for banks whose custody and treasury systems aren’t a hopeless Augean mess of underinvestment, rubbish outsourcing deals, and unmaintainability. Again, see this JP Morgan offering, for an example of what they think they can do. Presumably they think that with an implicit Government backstop, it’s OK to rehypo to the max; they have a derivatives business to support, too.

That would be a Doomsday Machine: iterated rehypothecation, huge credit multiples multiples, low haircuts, and then – sudden increases in haircuts, due to some credit shock or other. Then add some derivatives margin calls arising from the same shock…

If JPM pull it off, there will be a big credit multiplier and a big area of Dragon Country for us all to visit. Replaying the ’08 repo crash with 20 rehypothecations rather than 4 gives a system that has $17 trillion of liquidity in it, pre-crash, for every $1 trillion of collateral. Apply the crisis haircuts and $8 trillion of liquidity vanishes. That is Doomsday. All it takes is some solvency doubts; the quality of the collateral makes no difference. Indeed, because of the small starting haircuts, the US Treasuries make a larger contribution to the liquidity loss, if the number of rehypothecations is larger.

Still, the rehypo graph above, and the availability of new rehypothecation systems, and JPM’s business model, charging some fraction of a bp for each rehypothecation, do suggest ways to make sure the Doomsday Machine doesn’t blow us all up, as long as regulators get a grip.

So how does one wall off Dragon Country? The ultimate objective must be a UK version of the 1934 Securities Law, which capped rehypothecation quite effectively in the US. Pending that, or as well as, some or all of the following:

• The number of times a given piece of collateral can be rehypothecated is critical. Regulators might consider restricting it.
• Haircuts also matter, especially when they are very small. Regulators might consider increasing the minimum haircut on rehypo’d assets. If haircuts of less than 10% were not permitted, then the credit multiplier could not exceed 10 for any repo collateral, no matter how much rehypothecation there was. If it was 20%, the credit multiplier could not exceed 5.
• Regulators might consider eating some of, or a lot of, JPM’s lunch, by taxing each rehypothecation. The proceeds would build up a fund that provides the liquid assets needed in a crisis…something like an FDIC for repo liquidity.

But I wouldn’t hold your breath; the UK authorities’ response so far suggests that they, like JP Morgan, think unrestricted rehypothecation is a thoroughly good thing. I disagree.

UPDATE 7-Jan: Oops. I think this post overcomplicates things and has a big red herring (“rehypothecation steps”). From a leverage point of view, it’s the haircuts that matter. The ‘run on repo’ comes in two stages a) widening haircuts b) hedge funds pulling their assets from the PB. The effect of the run is magnified if the (London-style) Prime Brokerage agreement allows the PB to rehypothecate all the hedge fund’s assets.

Truth be told, I hadn’t paid much attention to the implosion of MF Global, because so many hedge funds went under during the crisis that yet another levered trading firm death seems less than newsworthy unless it is big enough to constitute a possible systemic event. The collapse of MF Global didn’t seem all that unusual, save for the titilating angle that the firm was headed by former Goldman CEO and New Jersey state governor Jon Corzine (I’d treated the failure of hedge funds by other storied names, such as Jon Meriwether and Myron Scholes as comment-in-passing incidents).

But the picture changes considerably with the report that hundreds of millions of customer assets may be “missing”. If this is true, there are pretty much no savory explanations.
One possibility is the firm raided customer accounts to try to shore up its principal business. That’s a fraudulent use of customer assets, and one would think anyone associated with it (and that would include the managing partner) would be subject to fines and barred from the securities industry for at least a period of time. I’m not certain what level of abuse is considered to be criminal. Informed readers are encouraged to pipe up.

The Times does mention that the missing money may simply be really bad bookkeeping (or more likely, poor internal controls, particularly, sloppy validation of how employees marked trades in illiquid markets, allowing staff to game the system, either to boost their bonuses or to cover up losses they optimistically assumed they’d be able to reverse). But even so, that raises questions about the competence of the firm’s management, and whether past accounting “errors” led to profits being exaggerated.

From the New York Times:

The recognition that money was missing scuttled at the 11th hour an agreement to sell a major part of MF Global to a rival brokerage firm. MF Global had staked its survival on completing the deal. Instead, the New York-based firm filed for bankruptcy on Monday.

Regulators are examining whether MF Global diverted some customer funds to support its own trades as the firm teetered on the brink of collapse.

The discovery that money could not be located might simply reflect sloppy internal controls at MF Global. It is still unclear where the money went. At first, as much as $950 million was believed to be missing, but as the firm sorted through its bankruptcy, that figure fell to less than $700 million by late Monday, the people briefed on the matter said. Additional funds are expected to trickle in over the coming days.

But the investigation, which is in its earliest stages, may uncover something more intentional and troubling.

The trading strategy that blew up the firm appears to result from Corzine not adjusting his trading strategy to a smaller platform:

Mr. Corzine sought to bolster profits by increasing the number of bets the firm made using its own capital. It was a strategy born of his own experience at Goldman, where he rose through the ranks by building out the investment bank’s formidable United States government bond trading arm.

One of his hallmark traits, according to the 1999 book on Goldman, “Goldman Sachs: The Culture of Success,” by Lisa Endlich, was his willingness to tolerate losses if the theory behind the trades was well thought out.

He made a similar wager at MF Global in buying up big holdings of debt from Spain, Italy, Portugal, Belgium and Ireland at a discount. Once Europe had solved its fiscal problems, those bonds would be very profitable.

But when that bet came to light in a regulatory filing, it set off alarms on Wall Street. While the bonds themselves have lost little value and mature in less than a year, MF Global was seen as having taken on an enormous amount of risk with little room for error given its size.

First, readers of this blog are probably not all that sanguine that the Europe mess will be resolved in the way Corzine assumed. This seems an awful lot like betting that subprime would be “contained” as of May 2007.

Second, a basic rule of risk control is not to take excessive risks relative to your capital. As John Manyard Keynes is often cited as saying, “The market can remain irrational longer than you remain solvent.” The textbook case is LTCM, which took hugely levered bets that it was confident would eventually be proven right, but “eventually” turned out to take a little long. And a smaller firm has to be even more careful about its wagers for the very reason that brought MF Global down: counterparties will not cut you all that much slack, particularly if they don’t buy your investment thesis.

But if the customer monies really are gone, this will deservedly be a very ugly episode for Corzine. His investors and the authorities should rake him over the coals.

Update: I’ve corrected the post for my inaccurately describing MF Global as a “hedge fund”. The salient characteristic of a hedge fund is that it has raised third party funds pursuant to an investment agreement, which describes the fund’s investment strategy, among other things, and has typically steep performance based fees. Even though MF Global was using a highly levered trading strategy, it was a principal, using shareholder money, not funds in an asset management vehicle.

As much as I like to think I have a reasonably active imagination, it never ceases to amaze me how a bad situation can easily become worse.

Readers probably know the European authorities have been stunningly late to wake up to the fact that EU banks are undercapitalized, apparently being the only ones to believe their PR exercise known as a stress test. The banks’ options would seem to be limited. One is to raise more equity, which is kinda difficult now since no one is terribly keen about banks in general, and the ones in most need of more capital are the least attractive. Second is to let existing loans roll off. The authorities don’t like that idea, since less lending will increase downward economic pressures. And since bank CEO pay is correlated with size of institution, the banksters aren’t too keen about that either. Third is to cut pay to help accelerate earning their way out. You can guess how likely that is to happen. Last is to suffer state-assisted recapitalization, which under EU rules, would be a draconian exercise.

But never fear, the financiers have an “innovative” way around this problem. And this innovation is a remarkably destructive idea. From the Financial Times:

Banks are striking deals with private equity groups, hedge funds and insurance companies in an effort to preserve their precious regulatory capital.

A growing number of investors is moving to provide beleaguered lenders with special targeted transactions to help them share their risks – for lucrative fees – through a fast developing class of “regulatory capital relief” funds.

Interest in such vehicles comes as banks, particularly those in Europe, scramble to develop new funding tools and identify ways of protecting capital, as they grapple with the prospect of sovereign defaults, forced recapitalisations and new Basel III rules.

The schemes typically involve writing partial guarantees for the assets sitting on banks’ balance sheets through bespoke securitisations, meaning insurance companies or funds absorb the losses on the riskiest portions of banks’ loans.

Such transactions allow banks greatly to decrease the amount of money they must hold in reserve as a backstop for potential losses in their lending books.

David Peacock, co-head of corporate credit at the Cheyne Capital hedge fund in London, which has been striking such deals with banks since 2004, says: “This is a means of capital raising which has been used over a number of years, but the need now is much more acute than it has ever been before.

The Japanese had an interesting attitude toward regulation, which is that they’d tolerate all sorts of things on small scale, but reserved the right to stop any activity cold if it got big enough to warrant scrutiny and they concluded they didn’t like it. Here, the “difference in degree is a difference in kind” logic is even more operative.

Regulatory capital relief is a gimmick that never should have been tolerated in the first place. The lesson of the crisis just past is that the biggest cause was the widespread selling of underpriced insurance by financial firms that were already highly geared. Eurobanks and US investment banks hedged AAA rated CDOs with credit default swaps where the guarantee failed or similarly bought AAA tranches that were synthetic (meaning made of CDS) where the protection writer failed to perform. This is a basic risk management error, called wrong way risk: buying a hedge from a counterparty that it pretty likely to be impaired if the bad event you are worried about comes to pass.

Any regulator that tolerated regulatory capital relief is an idiot. Banks rarely get trouble in isolation; the pattern more often is that multiple banks have fallen victim to the same bad exposures or economic risks. A lot of hedge funds were pummeled in the crisis and quite a few liquidated. Quite a few insurance companies suffered as well. So some, perhaps many, of these guarantees are likely to prove worthless if they are ever put to the test.

And its impact on a larger scale is even worse. The biggest failing of our financial system is its tight coupling. In tightly coupled systems, there are not enough firebreaks and events propagate across the system unchecked. It’s like a badly designed electrical system, where a lightening bolt hitting a single transformer will take down the entire East Coast.

One of the dangers of tightly coupled systems is that actions that are intended to reduce risk actually increase them. We discussed on the blog risk reduction efforts in the pre-Lehman phase of the crisis that made matters worse. For instance, efforts in January 2008 by Congress to use Fannie and Freddie to help deal with the mortgage crisis led Fannie and Freddie spreads to blow out, setting off a chain of events that led to the collapse of Bear Stearns.

The most important thing that needed to happen in the crisis and didn’t was reducing the tight coupling of the system. The stymied Bank of England effort to separate retail from wholesale/investment banks would have been a step in the right direction.

This regulatory capital relief effort gimmick is a massive step in the wrong direction. It enmeshes other financial players into the already-too-tightly connected grid of major financial firms, particularly the big dealer banks at the core of the global debt/over the counter trading markets. It has the effect of enlarging the “too big to fail” complex, so that if any large player gets in trouble, the damage done by its unraveling are greater and even more difficult to analyze in advance. And it creates more points of failure. Recall how the downgrading of comparatively small monolines led to losses at banks as they had to write down the instruments they guaranteed. If key providers of regulatory capital relief were to come into doubt, banks considered to be adequately capitalized would also come up short.

The very fact that this device will apparently be tolerated on a large scale is proof that the officialdom is completely unwilling to stand up to continued banking industry looting and will allow schemes almost certain to create the need for even bigger bailouts to be foisted on ordinary citizens. This is neofeudalism wrapped in the mantle of modern financial technology. I can only hope things blow up quickly enough that the authorities who cast a blind eye on these practices are held to account.

By Philip Pilkington, a writer and journalist based in Dublin, Ireland

As stock markets continue to fall and the eurocrisis rolls on an independent trader called Alessio Rastani appears on BBC live and gives a candid account of how he, as a trader, views the crisis.

He sees it, he says, as an opportunity to make an awful lot of money. He tells viewers that they too should seek out safe havens – such as US Treasury bills and dollar holdings – to weather the continuing storm.

Not long after the Twitterati are out in droves. Some are shocked at the amoralism of it all. Some have their heads buried so deep in the sand that they try to convince themselves that Rastani is just a prankster.

Which group is worse? One has to wonder. The former are fools, blind to the world in which we live and the considerable economic problems that haute finance has caused us in the past two decades. But the latter are arguably more loathsome; they’ve turned a very important statement on where we are today into another bit of fun to fill their time on Twitter.

Think about it. What Rastani is saying has major consequences. If this is how the current system works – i.e. that traders are betting on downturns and in doing so coming out rosy while everyone else suffers – then we have a serious problem on our hands.

Surely the media should perk their ears up and listen. Some do, but many don’t. Instead they curl up in a ball, ROFLing their way ever deeper into ignorance and speculating – baselessly – on whether this is a prank or not.

Rastani’s statement becomes nothing but fodder for baseless internet rumours and these rumours in turn become a veil behind which so many in the media hide.

Rastani is an honest man. Ruthless perhaps, but honest. He harbours no illusions about what is taking place in the world economy today and the consequences this will have for millions of working people. It is the media commentators that faff around, desperately distracting themselves from reality with the latest bit of Twitter gossip that are dishonest.

Indeed they lie, not only to each other, but to themselves.

We discuss what the role of banks should be, given how much government support they have, on Real News Network. Enjoy!

The Administration and its allies have gone after Standard and Poor’s for its downgrade of the US bond rating to AA+. They have attacked S&P’s general competence, its failure to reexamine its decision in the light of a $2 trillion math error (a Wall Street Journal story does not reflect well on S&P’s haste) and the subjective and political basis for its judgment. Even if these attacks have merit, however, they come off as being less than convincing by virtue of sounding like sour grapes.

There is a much more straightforward basis for questioning S&P’s conduct, and it has nothing to do with how S&P arrived at its rating. There is compelling evidence that the ratings agency made selective disclosure of its downgrade decision before it made it public last Friday evening. A reader told us certain hedge funds were informed Tuesday and traded successfully on the information. A separate source had told me certain banks were briefed on Thursday and were told of the US downgrade but assured their ratings would be unaffected. On Friday morning, Twitter was alight with the news.

Disclosing news of a ratings decision is required under SEC rules to be made publicly. All the discussion with favored parties is clear regulatory violation. Here is the germane section (boldface ours):

§ 240.17g-4 Prevention of misuse of material nonpublic information.

(a) The written policies and procedures a nationally recognized statistical rating organization establishes, maintains, and enforces to prevent the misuse of material, nonpublic information pursuant to section 15E(g)(1) of the Act (15 U.S.C. 78o–7(g)(1)) must include policies and procedures reasonably designed to prevent:

(1) The inappropriate dissemination within and outside the nationally recognized statistical rating organization of material nonpublic information obtained in connection with the performance of credit rating services;

(2) A person within the nationally recognized statistical rating organization from purchasing, selling, or otherwise benefiting from any transaction in securities or money market instruments when the person is aware of material nonpublic information obtained in connection with the performance of credit rating services that affects the securities or money market instruments; and

(3) The inappropriate dissemination within and outside the nationally recognized statistical rating organization of a pending credit rating action before issuing the credit rating on the Internet or through another readily accessible means.

(b) For the purposes of this section, the term person within a nationally recognized statistical rating organization means a nationally recognized statistical rating organization, its credit rating affiliates identified on Form NRSRO, and any partner, officer, director, branch manager, and employee of the nationally recognized statistical rating organization or its credit rating affiliates (or any person occupying a similar status or performing similar functions).

The language in Dodd Frank is more strict and specifies that a nationally recognized statistical ratings organization can have its registration revoked for misconduct (see page 1353).

The SEC is actually good at pursuing insider trading cases and even though this is not technically insider trading (as in the leakers presumably didn’t gain personally; this instead appears to be corporate favor seeking/trading) the type of investigation required would be virtually identical. It would be fun to see who S&P saw fit to enrich and how much ill-gotten gains they reaped.

We had thought the authorities and the banks (no doubt with winks and nods from the Fed) would work to make sure that haircuts on collateral were maintained while the Washington game of debt ceiling chicken played itself out.

Either the Merc (more formally, the Chicago Mercantile Exchange) wasn’t on the distribution list or it decided not to play ball. It announced an increase in haircuts on Treasury and agency securities today (meaning Treasuries and agencies are now given less credit than before when posted as collateral). But it increased haircuts even more on foreign sovereign debt. This will force players who have been using any of these assets as collateral that are also pretty fully leveraged to either cut their positions or put up more cash or other collateral. But note the concern stated is “market volatility” rather than creditworthiness per se (hat tip reader Robert M, from Clusterstock):

This is the first sign I’ve seen that looks troubling. The stock and Treasury bond markets have actually been pretty well behaved thus far (we saw vastly bigger one day moves in Tbond prices during the crisis, and the news on Friday was decidedly not pretty). My assumption has been that things would just be wobbly and not go critical until the Federal government started actually shutting operations and the gridlock persisted despite the howling from the public. But forced deleveraging feeding on itself could change that picture.

The financial system operates on leverage. The central bank backstopped players can probably be cajoled into not cutting repo haircuts to each other on Treasuries and agencies. But repo and collateral haircuts are a function not just of the collateral but who you are in relationship to your credit provider. For instance, the big prime brokers (Goldman and Morgan Stanley are over 60% of this market) increased haircuts on a lot of assets during the crisis to a degree where some hedge funds felt they were being abused (as in the increases were in excess of what even the rocky market conditions would buy, and some felt the dealers were trying to take advantage of them). Treasuries are also one of the biggest types of collateral for derivatives positions, and some may blow out if investors start shedding risk at the same time the collateral is worth less.

Mind you, the flip side is even though this is another sign we aren’t in Kansas any more, these changes in haircuts are trivial compared to the ones that blew up the banks in the crisis. Look at this table from ECONNED. Take a look at the “AAA CDO” line.

Translation: AAA CDOs went from 2-4% haircuts, which meant they were seen as super duper good paper, to 95% haircuts, which means they are worthless as collateral.

Notice also that even Treasury haircuts rose during the crisis, so widening haircuts in roiled markets is normal. Nevertheless, this change is a sign that some parties are already starting to trim their sails as a precaution against rough weather.

The fast and furious reports on the state of play with the US debt ceiling theatrics is getting more and more amusing. If we didn’t have a stake in the outcome, this would make for great theater.

The Telegraph blares “Obama and Republicans ‘close to deal‘.” That’s actually not inaccurate. but the problem appears to be Obama is now trading with his real allies, the Republicans, who want entitlement cuts as much as the President does, and also realize they have more to lose than he does if there is no deal. So they are now motivated to get something done.

A lot of Democrats, by contrast, are fiercely opposed to the pact under discussion, which consists of $3 trillion of cuts and no tax increases, or more accurately, an immediate commitment to cuts, and tax increases possibly coming via a to-be-brokered tax reform. The Democrats see the trap being laid for them; reform/increases later is likely to be no reform. (Separately, this package will kill the economy, a consideration that pretty much everyone is ignoring, proving Keynes correct: “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”).

The latest update at the Wall Street Journal was cautious:

With prospects of a government default looming in early August, leaders on both sides denied Thursday that a deal was close…Both sides warned that an agreement is not near. “There is no deal,” Mr. Boehner told radio host Rush Limbaugh. White House spokesman Jay Carney used similar language. And White House officials said Mr. Obama has never considered an agreement that did not include revenue increases.

A good deal can change in the next few days, but the window of opportunity narrows as time passes. And that is why the Treasury’s apparent refusal to consider options for working around the debt ceiling looks colossally irresponsible. This is similar to the behavior of the financial regulators pre-Lehman: they placed all their chips on one outcome, that of a private sector bailout, and failed even to find out what a bankruptcy would look like (at a minimum, if Lehman had prepared a longer-form filing, the implosion would have been less disruptive).

But this “all in” strategy is by design. Obama has long wanted entitlement “reform,” as in gutting; Paul Jay of Real News Network pointed out to me today that Obama told conservatives at a dinner hosted by George Will in the first week after his inauguration that he planned to turn to it once he got the economy in better shape. So this is a variant of a negotiating strategy famously used by J.P. Morgan: lock people in a room until they come up with a deal. But the J.P. Morgan approach used time to his advantage; here the fixed time frame makes this more like a form of Russian roulette with more than one cylinder loaded.

It is also worth noting that what starts happening on August 3, assuming no deal, is “selective” default. It isn’t clear if and when Treasuries would be at risk of having payments skipped, and I would assume Social Security would also get high priority. But with Treasuries, the bigger risk is not a missed payment (which would certainly be made up later) but a downgrade, which is expected to force certain types of investors who are limited to AAA securities to dump their holdings.

A useful article in the Economist describes how Wall Street, which had heretofore assumed that there was no way the US would (effectively) voluntarily skip some interest payment, is now scrambling to figure out how to position themselves should such an event come to pass. Many observers had assumed that the repo market, on which dealers depend to fund themselves and collateralize derivatives positions, would go into chaos (the belief was that counterparties would demand bigger haircuts). But the Economist argues that does not appear to be the case:

SIFMA, a trade group for large banks and fund managers, recently gathered members together to discuss issues like how to rewire their systems to pass IOUs rather than actual interest payments to investors, should a default occur. “It’s one of those Murphy’s Law things. If we do it, it won’t prove necessary. If we don’t, we’ll be scrambling like crazy with a day to go,” says one participant.

But the moneymen hardly have all the bases covered. “I really thought I understood this market, until I tried to map all of the possible consequences of a breakdown,” sighs a bond-market veteran. That is hardly surprising, given that Treasury prices are used as the reference rate for most other credit markets. Moreover, some $4 trillion of Treasury debt—nearly half of the total—is used as collateral in futures, over-the-counter derivatives and the repurchase (repo) markets, a crucial source of short-term loans for financial firms, according to analysts at JPMorgan Chase.

Some fear that a default could cause a 2008-style crunch in repo markets, with the raising of “haircuts” on Treasuries leading to margin calls. The reality would be more complicated. For one thing, it’s not clear that there is a viable alternative as the “risk-free” benchmark. One banker jokes that AAA-rated Johnson & Johnson is “not quite as liquid”. In a flight to safety triggered by a default, much of the money bailing out of risky assets could end up in Treasury debt. Increased demand for collateral to secure loans could even push up its price.

Then there is the impact of a ratings downgrade. Money-market funds, which hold $684 billion of government and agency securities, are allowed to hold government paper that has been downgraded a notch. Other investors, such as some insurers, can only hold top-rated securities but their investment boards are likely to approve requests to rewrite their covenants, especially if a lower rating looks temporary. “It would be a full-employment act for lawyers,” says Lou Crandall of Wrightson ICAP, a research firm. There’s a surprise.

In other words, this event is focusing enough minds that a lot of parties are looking at ways to get waivers or other variances to allow them to continue to hold Treasuries even in the event of a downgrade or delayed payment. But a report from Reuters on the Fed’s contingency planning makes them sound markedly less creative than their private sector counterparts (but it is important to note that Charles Plosser of the Philadelphia Fed, the key source for his story, has been a critic of the Fed’s fancy footwork in the crisis. In fact, the New York Fed is the key actor, and it has been notably, um accommodating in the past).

In addition, the New York Times reported yesterday that some hedge funds are moving into cash to buy up Treasuries in case other investors dump them. I’ve even heard of retail investors planning the same move. That does not mean the volume of buyers will be enough to offset forced sales, but it does say that fundamentally oriented investors would see this event as an opportunity, not a cause for panic.

The financial system is so tightly coupled and there are so many potential points of failure that I’m hesitant to say that the consequences of a default may be far less serious than are widely imagined. But in the Y2K scare, the considerable panic about potential catastrophic outcomes led to a tremendous amount of remediation, which served to limit problems to a few hiccups. Unlike Y2K, the remediation efforts have started very late in the game, so their is a lot more potential for disruption.

But even so, why is the Administration so willing to engage in brinksmanship? S&P expects a 50 basis point rise on the short end of the Treasury yield curve and 100 basis points on the long end, which they expect to reverberate through dollar funding markets and cause all sorts of hell. Remember, we have both Geithner and Bernanke again in powerful positions, and both went to extreme efforts to prevent damage to the financial system. Why are they merely handwringing at such a critical juncture? Might they have a trick or two up their sleeve?

I can think of at least one. I was working for Sumitomo Bank (and the only gaijin hired into the Japanese hierarchy) and was in Japan during and shortly after the 1987 crash. Initially, the reaction in Japan was one of horrified fascination, of watching a neighbor’s house burn down. It then began to occur to them that their house might burn down too.

The volume of margin calls on Black Monday and Tuesday were putting serious pressure on the Treasury market, which was beginning to seize up. On top of that, bank were understandably loath to extend credit to clearinghouses and exchanges (as we’ve discussed elsewhere, the Merc almost failed to open and would have collapsed if the head of Continental Illinois had not approved an emergency extension of credit after a $400 million failure to pay by a major customer. Had the Merc failed, the NYSE would not have opened, and its then CEO John Phelan has said it too might have failed). So keeping the Treasury markets liquid was a key priority in stabilizing the markets.

Japan is a military protectorate of the US. The Fed called the Bank of Japan and told it to support the Treasury market. The BoJ called the Japanese banks and told them to buy Treasuries. Sumitomo and the other Japanese banks complied.

I could see the same phone call being made again in the event of a default or downgrade. First, the yen is already at 78 and change, which is nosebleed territory from the Japanese perspective. The BoJ intervened once in the recent past when the yen got slightly above this level. Purchases of Treasuries is a purchase of dollars, and done on big enough scale would help lower the yen. Second, if you buy the hedgie view, buying in the face of forced (as in AAA mandate driven) and not economically motivated selling means this trade would have near term upside.

Is this scenario likely? I have no idea. Is it possible? Absolutely.

Again, I would not bet on happy outcomes. As Cate Blanchette muttered in the movie Elizabeth, “I do not like wars. They have uncertain outcomes.” And while the negotiators finally seem to have awakened to the risk of entering uncharted territory, the old rule of dealmaking is if one side’s bid is below the other side’s offer, you can’t get to a resolution. That’s where the two sides appear to be now, and even though it would be rational for both to give a bit of ground, rationality has been missing in action on this front for quite some time.