Sunday, February 28, 2010

Gary Gorton's Somewhat Flawed Take on Shadow Banking

When I saw this Feb. 20 .pdf on shadow banking, prepared for the U.S. Financial Crisis Inquiry Commission, I got kind of excited. Reading material for my one-hour stationary bike workout! And shadow banking no less, my latest pet obsession! Ah, Sunday morning nirvana for a finance wonk.

Then I started perusing the piece and, after turning over the bike pedals oh about 1,100 times (I try to spin at 90 rpm, and when I get involved in my reading, I'll hit the mid-90s), I grew a bit disenchanted.

Read it for yourself of course. If you want a better treatment of the material, Gorton is essentially cribbing off himself from an earlier paper -- "Slapped In the Face by the Invisible Hand" from May 9, 2009 -- which is a bit smarter, dares to be prescriptive and explores the subject in more depth. My nose de-wrinkled a little after reading "Slapped."

But please start with the crisis inquiry presentation because the writing is more accessible for people who aren't finance nerds. He does a few things that I really liked:

1. History: He presents some of the historical sweep of bank panics over the last couple of centuries.

2. Prime mover: He zeroes in on the real nexus where the financial system failed in our current crisis. In case you weren't aware, basically there was a bank run -- but it wasn't retail (i.e., little investors like you and me and Grandma Jones). It was wholesale, the big institutions that make up the "deposit" base of the shadow banking system.

3. Wild haircuts: he shows nicely how the "banking run" of 2008 took place, through the haircuts on repo'ed collateral that, by increasing from negligible levels, effectively "withdrew" money from the system. I know that line is a bit abstruse, so read his explanation on page 12.

But I think Gorton misses enough stuff that his paper ultimately disappoints. Here are four points he makes that left me shaking my head:
Holding loans on the balance sheets of banks is not profitable. This is a fundamental point. This is why the parallel or shadow banking system developed.
He's a bit intellectually sloppy here -- too busy to show his work or cite the evidence? If you read what he says about securitization (shadow banking's backbone and sine qua non) in his earlier "Slapped," you'll see that he is a bit more revealing, and subtle, there.
Why did securitization arise? We do not know for sure. One possibility, discussed further below, is that it was a response to bank capital requirements, which created a cost without a countervailing benefit. Banks, being private institutions, can exit the industry if it is not profitable. Another possibility is that the demand for collateral made securitization profitable, and this could not be accomplished on-balance sheet because deposit insurance was limited.
So there was a huge need for collateral (that $600 trillion worldwide derivatives market perches atop a mound of supposedly rock-solid collateral that, though relatively tiny by comparison, has grown enormously over the last two decades). And banks were chafing under capital rules.

Okay, I'll buy that. But that's a long way from a convincing argument that hold-the-loan-to-maturity banking is inherently unprofitable in the modern age. He rather disingenuously overlooks a big point: it's partly not profitable because of shadow banking which has (1) no capital requirements (2) no FDIC insurance to pay (3) no other regulatory burdens. So the shadow banks can operate more cheaply and pay more for funds, squeezing banks cleaving to a traditional model.

Point two where we don't quite see eye to eye:
In securitization, the bank is still at risk because the bank keeps the residual or equity portion of the securitized loans and earns fees for servicing these loans. Moreover, banks support their securitizations when there are problems. No one has produced evidence of any problems with securitizations generally ...
My reaction to this: ??????? No problems with securitization generally? That seems rather boldly dismissive. If banks support their securitizations when there are problems, why are they allowed to push the risk off balance sheet? That seems to be a legitimate issue. And the way that risk is imperfectly understood and shuffled down the line via securitizations -- a loan originator puts crap in the soon-to-be-securitized ground beef for the RMBS that's leaving his hands in a week and ultimately winds up in a hamburger patty served up to an investor in Singapore who can't make heads or tails of what he's buying and just relies on a AAA stamp bestowed by a team at Moody's that couldn't really understand what the hell they were rating either -- well, some would call that a legitimate issue too.

Another point where I think he's off base:
Why would dealer banks be growing their balance sheets if there was not some profitable reason for this? My answer is that the new depository business using repo was also growing ... Now, of course there is the alternative hypothesis, that the broker-dealer banks were just irresponsible risk-takers.
I'm not really going into this one -- this blog entry is getting too long already -- only to say this appears to be what they call a "false dichotomy" in debating circles. After all, dealer banks could have been pursuing irresponsible risk-taking that had a profitable reason behind it. That's pretty much self-evident if you read the entire section here.

Now, on to one last point, where he contends that AAA rated securities were marked too far down because of fire sales and cites, as proof, the fact that AA rated corporate bonds at certain times paid more than AAA corporate bonds. That's because so many AAA's were being dumped that the spread flipped, he says.

Okay, first, I'll confess I don't have the data set on that graphic he provides. But I'd sure like to explore it in more depth. Because, honestly, it makes no sense.

Quick bond primer: One piece of the yield attached to any bond represents credit risk. Credit risk is the chance that say IBM goes belly up and you're standing in line with other creditors, trying to get back money that you "lent" to IBM by buying its bond. If you assume more credit risk, you are compensated more. For example: if IBM bonds have a small chance of defaulting, but Wal-Mart bonds have a smaller chance, then IBM's bonds (of a given maturity) will be rated say AA and pay 6 percent and Wal-Mart will be rated say AAA and pay 5.4 percent.

Now bond buyers aren't stupid. Aunt Flo isn't a big player in this market; these are institutions and hedge funds and a lot of sophisticated money managers ... take a look at some bond-pricing formulas, study a little duration, and get back to me in the morning if you doubt what I'm saying.

The point I'm making is this: if these yields flipped, there's a good chance that the "fire sale" explanation is probably the weakest one to make. Because look: even if you're a fire sale buyer, scared as hell of what's going on in the financial markets, your IQ doesn't instantly fly out the window. Relatively speaking, you still prefer AAA over AA. If my fire sale price for AAA is 90 cents on the dollar, my fire sale price for AA isn't going to be 93 cents on the dollar. Because that's leaving free money on the table. That's your first lesson in Bonds 101. No one does that.

So how to explain what happened? Here are a couple of hypotheses that I think are probably more believable: (1) There was a lot of mis-rated AAA crap that really deserved to be graded A or below, and for some reason, the AA securities tended to be rated more accurately, or maybe they were mispriced somewhat too, but it took longer for the problems to be evident. (2) Something else -- maybe even fraudulent -- is going on here. Look at his chart and see how nonsensical it is -- in early March of last year, a good four months after the peak of the crisis, AA's were paying about 2.25 percentage points more than AAA's! By way of comparison, that's more than double the amount that AAA's ever exceeded AA's between January of 2007 and November of 2009.

So this is what Gorton asks us to believe: four months after the "panic button" phase of the financial crisis, there was a sudden move to massively offload AAA's at any price -- sellers were willing to get scorched on the asking price and buyers didn't recognize the value that they were getting compared to AA's and never pushed the spread back together. I mean, 2.25 percentage points?!?! That makes no sense to me.

I'm willing to bet there's something else going on there and I'm surprised that Gorton didn't sniff harder to try to find it.

So while I'm glad that Gorton's writing about shadow banking -- we all need to understand its role better -- he comes up a bit short by my yardstick.

Wednesday, February 24, 2010

Where the Courage to Reform is Lacking

The "hey we're missing the shadow banking market in all these reforms" meme is spreading. I like that, after my Jan. 24 post where I bemoaned the lack of attention to the 900-lb. gorilla in the room (or however much that mythical gorilla weighs). Marginal Revolution weighs in here. Mike Konczal at Rortybomb did his usual excellent calmly reasoned and thorough analysis here. And we got a superb Venn diagram by Raj Date (never thought you'd see one of them again after eighth grade -- guess again; check out page 3!) that reveals shadow banking to be the poop that's left unscooped in the proposed financial reforms.

So where is the courage to reform lacking?

Simply: we don't like pain (our politicians, our mirror images of the worst of ourselves, have all along taken the pain-avoidance steps in dealing with the financial crisis). Shadow banking is a means of leveraging up the financial system. Leverage provides the palliative of easy money (along with that extra risk). I'm betting Washington will leave the shadow banking/leverage mess untouched; who wants to prescribe two tablets of austerity for a hungover economy, even if it's good for overall future stability? We're a "now" people, impatient to have what we want, and cranky when we don't get it quickly.

Ah ...

Sunday, February 14, 2010

Imaginary Dialogue with a Fed-Secrecy Defender

The make-believe dialogue that follows was inspired by this New York Times story that recaps the events leading up to, and the arguments surrounding, Bloomberg LP vs. Board of Governors of the Federal Reserve. That's Bloomberg's court battle to get the details on a bank bailout that has reached a staggering $2 trillion (according to the Times and, depending on how you count, may be actually a trillion or two higher). Much of the bailout has been cleverly orchestrated by the Fed behind the scenes, so Americans know little of who got what. Bloomberg wants to pierce the veil of secrecy to find out which banks received money, how much, in exchange for what collateral, under what terms.

And the Fed is stonewalling like crazy, fighting this tooth and nail through the court system.

So here's my imaginary dialogue with a Fed-secrecy defender (abbreviated below as "FD"). The parts in bold are taken right from the Times article; other secrecy arguments I have extrapolated on somewhat, in keeping with what I have read so far is the Fed's position.

Me: $2 trillion ... wow. That's a lot of Subway sandwiches. The mother of all bailouts. Seriously, what's the problem with revealing who got what through this hidden bailout?

FD: It's a terrible idea. Such disclosures could stigmatize financial institutions by suggesting they were desperately in need of government money and, therefore, weak.

Me: Hmm. That's an interesting line of defense. Let's make it more concrete. So you're saying disclosure of significant weakness is a bad idea. Sort of like if someone forced you to reveal you just took $3.4 billion of losses. That certainly might give the market the idea you were pretty weak and ripe for a boost from good ol' Uncle Sam.

FD: Right.

Me: Well, take a look at this. This is Citigroup admitting to investors in its 10Q regulatory filing from the second quarter of 2008 that it wrote down $3.4 billion of subprime mortgages. In fact, this entire filing seems to be full of stigmatizing disclosures of various types.

FD: That's different.

Me: Besides, such a "stigma" may be a good thing.

FD: How do you mean?

Me: We keep talking about "moral hazard" in this crisis, as in an actor tends to be more reckless when he knows somebody else will pick up the tab for his mistakes. So maybe a little "stigma" is a way to reduce moral hazard? Banks, realizing the stigma attached to being a recipient of a federal bailout program, will be more cautious and take on less risk next time.

FD: It's not that simple though. The banks, if perceived as weak, could be subject to 1930s-style bank runs.

Me: Oh really? So you'd say we're as vulnerable to bank runs now as we were in the 1930s. Ok, let's take a look. Most of these bank runs you're referring to were from 1929 to 1933. Do you want to guess what happened on Jan. 1, 1934?

FD: I'm not sure.

Me: Insurance of bank deposits took effect through the Temporary Federal Deposit Insurance Fund. Today most Americans know their bank deposits are FDIC-insured up to a generous limit ($250,000 currently). So bank runs are much less of an issue nowadays. And if you recall, all during this financial crisis, the government has thrown its weight behind the financial industry, further soothing anyone who panics easily. Remember the "Stress Tests" for the banks? Team Obama made it clear upfront that no one would be allowed to fail. So the idea of bank runs seems rather far-fetched.

FD: Listen, releasing this information would be a bad idea for other reasons too. Think of the future impact, if there were another crisis and the Fed had to rescue the financial system again! Even strong banks that were considering taking money might instead retreat in trepidation.

Me: Whoa, hold on a second. I'm a little confused. Why are we bailing out strong banks?

FD: Well, you have to be fair and account for the fact that, in the midst of such a crisis, a strong bank may need more capital than it originally set aside.

Me: Then shouldn't it turn to the capital markets?

FD: It may be too expensive to raise the needed funds in the capital markets. It's a credit crisis!

Me: I hate to sound heartless but maybe the "strong bank" just bites the bullet and raises the money the expensive way. Next time it prepares better for a rainy day huh? Or if it really can't raise the funds at all without being in danger of going under, I would question your premise that it's a "strong" bank. Maybe it's only a "strong" bank when the economy is roaring along. And if we rescue this "strong" bank, what signals are we sending to a more conservative bank that is smaller and less profitable only because it avoided taking the risks of the "strong" bank during the boom times?

FD: Nevertheless, I don't think you realize what damage would be caused, making public the specific, detailed information Bloomberg seeks. It would cause serious competitive harm.

Me: And I hate to sound like a broken record but -- one way a bank could avoid that "harm" is not to tap the government's aid programs. Plan better next time, take less risk, and you won't have to grab hold of the Fed lifeline -- and be exposed for doing so.

FD: That's easy to say, but the fact remains, we have to deal with the hand we're dealt.

Me: Okay, then, tell me what's this "serious competitive harm" exactly? Especially when most of the big banks are already drawing assistance from the panoply of Fed programs. How seriously is Citigroup harmed if we learn it's 85 percent on the government teat and Bank of America, its big competitor, is only 79 percent? Say we find out that JPMorgan has $200 million of collateral parked at Fed Loan Facility X. You think JPMorgan is suddenly going to go out of business as investors panic?

FD: You have a naive understanding of markets. We're not talking about just public perception. Savvy traders could quickly get their hands on such data in the future and use it to their advantage even as the government was trying to stabilize the markets.

Me: Okay. Let me ask you something. Have you ever wondered why a company's share price makes a few suspicious-looking spikes in the days running up to an announced merger in which it will be acquired at a premium?

FD: Obviously someone has gotten wind of the deal and is buying the shares to profit from that knowledge.

Me: Exactly. Markets are notoriously leaky. Savvy traders are already hearing things about Fed aid, and figuring out things, and acting on rumors, when it comes to the bets they're making on these banks. But what you have now is imperfect leakage: investors are punishing some banks that shouldn't be punished, others are being punished to an imperfect degree, and yet others are going scot-free when they should be punished.

FD: Well, still, disclosure has the potential to whipsaw the market at a very volatile and sensitive time.

Me: February of 2010? When Bernanke is saying the economy has recovered well enough that we ought to think more seriously about raising interest rates?

FD: No, I'm talking about the height of the crisis naturally.

Me: But the documents would be released now, and this isn't the height of the crisis. And, if the Fed fears timing is an issue going forward -- if it needs to be able to make decisions during times of stress without the immediate scrutiny of the market -- why not work out a time frame that allows a 60-day or 90-day period before disclosures?

FD: You have to admit that if this information were to come to light all at once, it would be terribly disruptive to the markets.

Me: I agree it could be. But why? Because the Fed has sat on so much information, in the dark, for so long -- almost a year and a half. If the Fed had a timetable for periodically releasing details of what it's doing, and with whom, the market would be better able to assimilate the revelations. So when do you advocate that the Fed come clean? Never, right?

FD: Well, you don't understand the Fed's culture. It has a longstanding policy against disclosure.

Me: So that makes it right? Do you support slavery?

FD: Of course not.

Me: Someone in the year 1850 could have argued that the U.S. Constitution had a longstanding "policy" of condoning slavery. The law of the land at the time said that escaped slaves had to be returned to their rightful owners.

FD: Obviously our Founding Fathers got that one wrong. But you don't understand that the Fed needs to be insulated from public opinion to do its job effectively.

Me: Actually I do and I think we need to be sensitive to that issue. But there are other issues too. Such as who watches the Fed? What if a malevolent personality were to be installed as Fed chairman, and the place became a sinkhole of graft and corruption. It seems ridiculous now, but it's certainly not beyond the pale. What body can effectively rein in the Fed? Shouldn't we be a little worried about an agency that engineers a covert $2 trillion bailout, the details of which we know very little about? It seems that the Fed, in return for the latitude that we give it to make decisions about monetary policy, should reward our trust with more transparency.

FD: Well, rant all you will -- you won't win this one. You'll see.

Me: You know something? That's finally something we agree on. I have little faith the Supreme Court will do the right thing. But "won't win" isn't the same as "shouldn't win."

Saturday, February 6, 2010

5 Reasons Not to Expect the U.S. to Rein in Shadow Banking (or Pass Much Financial Reform)

When I was living in Hong Kong, I once saw a photo of the Chinese leadership that left a strong impression. China's political elite were having their annual conclave. The International Herald Tribune ran a photo of nine of the most powerful men in the country: all with hair dyed black, dark blue suits, red neckties -- except for one man wearing a blue one.

So, Sesame Street redux, one of these things was not like the others -- but the subtext was clear: not by a heck of a lot. Maybe he didn't get the "Red Necktie Memo." Or maybe he felt a little ornery that morning.

In the aftermath of the financial crisis, the U.S. government is the equivalent of the guy in the red necktie. He's different from those he regulates -- but not by much. That's a big reason the needle isn't likely to move much on financial regulation.

Just look at what was at the heart of the crisis: overly complex and leveraged products that sought to evade sensible (but inconvenient) accounting standards; that were blessed by ratings agencies with overt conflicts of interest; that were held at (a fiction of) arm's length through off-balance sheet vehicles (SIVs); and that supported a shadow banking system through such activities as repos and reverse repos.

Why would the government crack down on any of this since it's been captured, cognitively, by the financiers? In effect, the government is now doing all this stuff that caused our problems. Let's look:

1. overly complex and leveraged products: When Treasury Secretary Geithner was given the job of coming up with a proposal to rid the big banks of toxic debt, he created a complicated monstrosity that could've emerged from the Goldman Sachs war room (and for all we know, it did). Known as PPIP, the plan proposed pairing private money with public to buy distressed debt through auctions; private investors would use taxpayer funds to leverage up as high as six to one. Geithner suggested this after it was clear that too much leverage had helped spark the original disaster. All this led one to wonder: Did he sleep through the crisis? PPIP's most redeeming feature: it flopped.

2. sought to evade sensible (but inconvenient) accounting standards: Financial Accounting Standards Board shenanigans anyone? Under government pressure apparently, the standards board ditched mark-to-market accounting for certain bank assets in April last year, making it easier to pretend the shlock on your books was actually gold -- well, tarnished gold at the moment, but it would look better in a year or two, you could argue. So transparency wasn't a priority for Team Obama, it seems.

3. that were blessed by ratings agencies with overt conflicts of interest: The ratings agencies midwifed a lot of ugly babies that they pronounced beauty queens: crap securities that received AAA ratings. And what has Washington done to shake up the agencies, or reform the ratings system? As far as I can tell, approximately nothing. Why? Is it because the government may have an interest of its own in manipulated ratings, for the panoply of Fed lending facilities that require assets graded AAA? Geithner and Co. want to recapitalize the banking system on the sly -- without another ugly headline number like "$700 billion for TARP" -- and maybe the brain trust has decided to lay off the credit raters to ensure there's no avalanche of downgrades that, should it occur, would prevent shovelling that low-cost Fed money out the back door for suspect "AAA" collateral.

4. that were held at (a fiction of) arm's length through off-balance sheet vehicles (SIVs): This one's easy unfortunately. Fannie Mae and Freddie Mac are really the original off-balance sheet vehicles. It's no secret that Fannie Mae was moved off the government's balance sheet in the late 1960s because it was turning into a budget buster. Now it enjoys a funny quasi-public status: a "private" company that will get bailed out again and again (just like the SIVs of the big banks). Oh, and if you need another example, here's the government trying to spin a special-purpose vehicle off from TARP. Yup, they learned well from their Wall Street masters.

5. that supported a shadow banking system through such activities as repos and reverse repos: The Fed isn't so eager after all to shut down the repo market (in a repo, you sell a security to someone at a "haircut" price (that could be 10, 20, 30 percent off, depending on the security) with the promise to repurchase it shortly thereafter, say a day later). Turns out that the Fed plans to sop up extra liquidity through reverse repos of Treasuries. So since the reverse repo is a big part of its strategy, is it such a leap of the imagination to think that in the end the White House economic team will just advocate hands off most/all repos and reverse repos?

There you have it. The government has borrowed Wall Street's playbook. So why is anyone out there surprised we're not seeing reform?