Friday, March 09, 2007

Too big to bail (out): a case of Humpty Dumpty Finance

The circuit is now complete. Darth Vader

I've only been alive for a shade over 4 decades but I feel as if my past life as a Wall St. trader occurred in a different era.

No, I'm not referring to the change in technology although I do remember having to share a computer at Chase Manhattan, watching Telerate pages on little green screens and the days before Reuters dealer when voice brokers were charging $10-25 per million $ on spot FX, which allowed them to keep me and my co-workers in the industry fat, drunk and happy. Ah, the memories of those Friday morning hangovers and then the calls from the brokers who financed them asking me to do 20 "switches" sometimes totaling $200Mil, or $2K in bro, thus returning the favor. Switches, for the uninitiated, are back to back deals to allow two parties who didn't have credit with each other to complete a trade with my bank as intermediary. As Chase usually had great credit we could deal with everyone.

But Chase didn't always have great credit, although it now seems that such a thing could never come to pass, and it is the conception of credit and the relation of the government to leading financial institutions to which I refer when I write of a different era.

According to Bloomberg: Moody's announced new guidelines for bank credit ratings last month that consider financial strength along with any support companies may get from government and financial institutions if they get into serious trouble. Such backing might be offered if regulators conclude the effects of a failure would be catastrophic for the nation's economy, a concept rooted in banks' financial woes in the 1980s.

Fortunately, as noted above, I remember those halcyon days of yore, the 80s, when banks could have financial woes.

What exactly caused those financial woes, you might be asking? The same thing that always caused them, too much leverage. That's not what you meant? Ah, you mean what was the catalyst that exposed the overleveraged balance sheets? Funny you should ask. It was the mortgage industry, in the form of the Savings and Loans.

You might recall that period in our history if you are around my age or older, and if so, you might remember when (February 1989, don't worry I had to look it up, I'm not that much of a geek) George Bush the Elder proclaimed the creation of a program to fix the S&L crisis with taxpayer money- a program that, with the help of Congress, became the Financial Institutions Reform, Recovery and Enforcement Act of 1989. You might also remember that up until that point, the fall out from the banking problem was considered to be mostly contained, wink, wink, nudge, nudge Hank Paulson.

You might also, if you are old enough, recall the introduction of the phrase, "too big to fail," into the financial lexicon. I don't have access to lexis-nexis but I did a search on the NYTimes archives and the first instance of the phrase in "the newspaper of record" occurred in mid-1987. The author of the article, Thomas Olson, then President of The Independent Bankers Association of America (I guess this institution doesn't have much longer to live), argued that the US did not need "superbanks." I guess his view was not echoed by others.

The notion of "too big to fail" became a serious topic of discussion during the latter half of 1990 when major US banking shares took a swan dive. To give one example, Citibank, whose share price had just surpassed its 9/87 peak in July of 90 lost more than 50% and tested the 10/87 lows by 9/90. Major US banks were considered so un-creditworthy at that time that I needed to get banks to do switches for me at Chase because our credit was "no good," particularly with the Japanese banks.

After watching Drexel Burnham Lambert go bust that year (which taught me just how nasty unwinding options portfolios can be and that was back when a US$100M position was considered "big") I guess the powers that be decided that certain financial institutions could indeed be too big to fail. By late 1991, Citibank's share price has recouped all its losses.

Meanwhile, in 1991, Salomon Brothers, 12% of whose company stock was purchased by Warren Buffett's Berkshire Hathaway in 1987, got caught submitting false bids in Treasury auctions. After raising the ire of then NY Fed Chief, Gerald Corrigan (details of which can be found here), the US Treasury announced that Salomon would no longer be able to participate in Treasury auctions. This threat from Treasury led Salomon to up the stakes, and threaten bankruptcy.

The Most Important Day: The Treasury spokesman then got Secretary of the Treasury Nicholas Brady, at that moment visiting Saratoga Springs, N.Y., for the horseraces, to call Buffett. The two men had been friendly acquaintances over the years but could hardly have imagined they would be facing off on this Sunday morning. His voice cracking with emotion and strain, Buffett made his case, telling the Secretary that Salomon could not cope with the Treasury ban and that it was bringing in bankruptcy experts to prepare for a possible filing. Buffett stressed Salomon's gargantuan size and the worldwide nature of its business. He predicted that a Salomon bankruptcy would be calamitous, having domino effects that would reach worldwide and play havoc with a financial system that subsists on the idea of prompt payments.

Doomsday scenarios are not easy to get across. Responding, Brady was friendly and empathetic but inclined to think this talk of bankruptcy and financial meltdowns was far-fetched. He could not imagine Buffett refusing to take the job or failing in its execution. Brady was also highly aware of where things stood: The announcement had gone out, and reversing it would be an enormous problem.

But to Buffett's enormous relief, Brady did not cut off the dialogue. Instead, he went off to make some calls and then kept getting back to Buffett. In one of the stranger details of the day, Buffett talked on Salomon phones that had been programmed not to ring but instead flashed a tiny green light when someone was calling. For longer than he cares to remember, Buffett stared at the telephone, waiting for the Secretary of the Treasury to create light. With each call, Buffett tried to make Brady realize the seriousness of the situation and his sense that they were rocketing along on a train that had to be stopped--but that could be, once everybody realized that this was an accident that mustn't be allowed to happen. At one point in the Brady conversations, all of Buffett's anguish and sense of futility got jammed into a single sentence: "Nick, this is the most important day of my life." Brady said, "Don't worry, Warren, we'll get through this." But that didn't mean at all that he had changed his opinions.

It took Corrigan's entrance into the telephone calls in the afternoon to make a difference. This was the man who told Buffett to prepare for "any eventuality" and defined his term by endorsing the ban. But Corrigan now listened hard and seemed to assign credence to Buffett's talk of bankruptcy and of his personal plans to leave were a filing to come. Said Corrigan to Brady and another regulator on the phone with them: "We better talk among ourselves." Buffett went back into the boardroom and waited with the other directors. Six floors below, over 100 reporters and photographers, this author among them, were gathering for the 2:30 press conference. Directly outside the boardroom, some of the managing directors that Buffett had interviewed on Saturday were milling around, summoned because one of their number was to be named operating head of Salomon.

And then, just at 2:30, Jerome Powell, an Assistant Secretary of the Treasury, called Buffett to read a statement the Treasury was ready to go with. It was effectively half a loaf, or maybe two-thirds, saying that the ban on Salomon's bidding for its own account was lifted while the ban on bidding for customers' accounts remained. "Will that do?" asked Powell. "I think it will," answered Buffett. The board then raced through electing Buffett as interim chairman of Salomon Inc. and Deryck Maughan as a director and operating head of Salomon Brothers. Buffett found Maughan and said, "You're tapped," and the two went down to the press conference, entering at 2:45.

And thus too big to fail became policy.

It is now 16 years later, the thin edge of the wedge has done its thing and the circuit is now complete. The financial industry has been, in a sense, nationalized. Credit rating agencies, as already noted, will now simply assume government support for large financial institutions. Moreover, this support has apparently been assumed sufficient to offset any balance sheet imbalances these financial institutions might encounter.

It was with this assumption in mind that the "too big to bail (out)" title came to me. There are limits to the amount of support even the mighty US taxpayers can provide, especially given the expected financing problems created by US population demographics (think baby boom) with respect to US entitlement spending over the next few decades.

My initial concern over the assumption of sufficient support was with respect to derivatives. If the derivatives inspired collapse of LTCM was a problem how much more problematic would be a similarly inspired derivatives collapse at JPMorgan given their US$62.6T in exposure. According to the Office of the Comptroller of the Currency (page 22), this US$62.6T in derivatives exposure is funded by assets of only US$1.2T. While this exposure is spread out over different asset classes and may well be perfectly hedged now, it seems to me that a discontinuous, i.e. unhedgeable, 10-20% move in key markets might be sufficient to drain JPMorgan's assets. And who will fill in the gap, US taxpayers? Are we now willing to upend social harmony, or what little that remains, by breaking promises of social security and other "entitlements" in order to keep big banks that mismanaged their investment portfolios afloat? And all this, by the way, while the upper class has been enjoying its biggest tax breaks in decades. I reckon that will be tough sell.

But, while reading today's news, I find another concern. Hank Paulson would like China to remove the restriction on foreign ownership of China's banks. Given the now enshrined in stone "too big to fail" policy will US taxpayers be expected (and able) to support our domestic banks in the event their investments in China's financial institutions, who already have substantial bad debt problems, go bad?

This seems to me to be a case of one's eyes being bigger than one's stomach. China is not Thailand or Argentina. At current growth rates the Chinese economy will surpass that of the US within a few decades. How can the US taxpayer fill a funding gap created in an economy bigger, thus leading to larger imbalances, than its own? Methinks the US is about to learn the lesson Britain learned when it was overtaken by the US- the tail cannot always wag the dog.

If US financial institutions expect to be bailed out they have to ensure their imbalances stay small enough such that the US taxpayer can, and be willing to, foot the bill. The $150B bail out of the S&Ls in the late 80s caused a recession and cost George Bush the Elder a second term. I wonder what effects a $1T or even $5T bail out would cause, particularly in the event it was engendered by problems in China's domestic economy. Short of a military dictatorship, I can't imagine a bail out of that size for that reason passing through Congress. And even if it did, who would buy Treasury bonds under those conditions?

What if the problem arises due to a collapse of some intervention scheme? Will US taxpayers be expected to bail out a covert scheme to keep the price of Gold down? or oil? More to the point, could US taxpayers bail out such schemes? Again, in the event support was needed and could be obtained under these conditions, why would anyone want to buy US bonds?

While the big banks are likely enjoying their "too big to fail" status, investors might want to consider if they have already become "too big to bail (out)." If one is searching for a conclusion, that, if generally accepted, would send the precious metals to the moon, this seems to me to be it.

A children's rhyme comes to mind.

Humpty Dumpty sat on a wall.
Humpty Dumpty had a great fall.
All the king's horses and all the king's men
Couldn't put Humpty together again.

Got Gold!


STS said...

Interesting story. Isn't the $60T+ counting "notional" rather than cashflow exposures? And JPMC aren't completely unhedged either. What would a more realistic estimate of their "VaR" (in a generalized sense) run to?

I completely agree with the basic point about moral hazard, but I'm interested in understanding the scale of "contagion" required to really knock over the house of cards.

daan said...

Some years ago, in a weekly newspaper column, I mentioned JPM in relation to the derivatives mountain and said something like, "JPM's directors too may not be sleeping well.".

It unleashed a furore, calls from JPM' London office, hinting at law suits etc etc. Long story short - the newspaper's editor and I attended a luncheon with JPM brass who explained to us that the large position on their derivative books is not 'full exposure'. That when two clients A and B want to enter into a deal, JPM structures two legs to it; A-JPM and JPM-B; so that the size of the deal doubles their nominal exposure but it is actually fully hedged.

Over coffee I really spoke for the first time, saying that as I understand it, if something should happen to wipe out A, so that the A-JPM leg of the transaction should disappear, then JPM would end up sitting with the then very unprofitable JPM-B leg.
The JPM people present all glanced at each other for a few moments; then one responded with, "The odds of that happening are very remote, since our risk analysis is very good."

So, partly also in response to the first post, JPM is in principle fully hedged, but the counter-party risk is huge. Their vulnerability lies in a discontinuity in the markets that 'overnight' wipes out one leg of say the interest rates derivatives. That would be an interesting test of 'too big to fail'.

Dude said...

In response to both of your good questions, I'll be doing a piece on Monday speculating how an apparently well hedged options portfolio can create massive liabilities.

"Cassandra" said...

Whether its worth "the risk" for someone JPM BRK etc is the "Get Rich" vs. the "Stay Rich" dichotomy. A 32 yr swaps trader pining for bonus on OPBS's (other people's balance sheets), and his superiors are clearly in "get rich mode". Mr Buffett, on the other hand, upon buying GenRe saw their swaps book of precisely the kind daan describes and, being in "Stay Rich Mode" promptly set about unwinding the entire GenRe FP book. Whether he termed it Herstatt Risk is unclear, but he certainly understood conceptually that no transaction of that type like that was worth the measely 25bp pass-through (at least in respect of his utility curve for the margin al dollar of profit...