Commentaries

from Rolfe Winkler:

Lunchtime Links 12-27

How overhauling derivatives died (Smith/Lynch, WSJ)

Debt ceiling raised $290 billion (Rogers, Politico) Another Xmas Eve vote. Dems had wanted to raise the ceiling at least $1.8 trillion to avoid having to raise it again before midterm elections, but they didn't have the votes. Congress has bought itself about 4-6 weeks of breathing room. Senate Repubs made a showing of not voting for the measure, but had they been in the majority, you can bet they'd have done the same to avert default.

At tiny rates, saving money costs investors (Strom, NYT) "Duh" is the obvious response to this piece. Savers have been getting hammered ever since the Fed started dropping rates two years ago. Yet it's well written and important to see in the paper of record. It makes the point that low rates are forcing many folks to chase risk. Low nominal rates would be fine IF the Fed were allowing the economy to delever/deflate as it clearly needs to. If the cost of goods/services is falling, then rates can be zero and savers still come out ahead. But the CPI has stayed positive, so savers lose. Of course punishing savers is precisely what economists like Paul "paradox-of-thrift" Krugman and Greg "confiscate-cash" Mankiw say is needed for the economy to recover. Krugman wants to steal savings via shock-and-awe deficit spending, i.e. future taxation. Mankiw would literally confiscate a portion of unspent savings.

Good news alert: Hunting trash for cash (Hudak, Orlando Sentinel) The recession is causing us to produce less trash. This is problematic for Covanta, which burns trash to create energy. But it's great for the environment.

Investors see farms as way to grow Detroit (Huffstutter, LA Times) Urban renewal...

VIDEO: Stopping purse snatchers (LiveLeak)

Alcohol substitute that avoids drunkeness in development (Rodgers/Alleyne, Telegraph)

from Rolfe Winkler:

Legislation coming to break up big banks?

In a note to clients yesterday, Paul Miller of FBR Capital Markets wrote:

We are hearing that discussion of breaking up large financial institutions that pose systemic risk to the market is gaining traction on the Hill. At this point, discussions are in the early stages, but we understand that an amendment addressing breaking up institutions deemed "too big to fail" could be introduced in the House over the next few days. How does one define "too big to fail" and how would the divestiture process work - these are good questions that Congress will have to address as the discussion moves forward. To our understanding, any amendment that could be introduced in the coming week would likely be vague and would give the regulators discretion to determine which institutions qualify as "too big" and how to address the risk they pose to the system.

[UPDATE: It appears this legislation may be coming from PA's Paul Kanjorski]

Hmmm. A "vague" amendment directing regulators to look into breaking up TBTF banks might not lead to much, not when regulators have made clear they have no interest in breaking up big banks.

[After she gave a speech complaining about TBTF at the Economist's Buttonwood Conference, I asked Sheila Bair if she would favor policies to proactively shrink/break up big banks. She said "no, I don't know how we would do that."]

And breaking up banks is only half the battle. While it's very important to get commercial banks out of the trading business, if derivative books don't shrink dramatically systemic risk won't have gone away.

Neither Bear nor Lehman had a commercial bank. But the size, opacity and interconnectedness of their trading books posed huge risks for the system.

Nothing says recovery like par

It’s not there yet, but the derivatives index that references leveraged loans – the debt of choice for big corporate buyouts during the boom – is just a few cents away from par.

The new, cleaner Markit LCDX index that launched earlier this month is already at 98 1/2 cents, while the older series 10 that included such bad boys as bankrupt General Growth Properties, is trading a little over 97 cents. Astonishing really, considering the series 10 tanked to below 80 cents last year.

Such lofty levels are sure to entice new deals since companies hate to pay a discount when raising funds. Makes you wonder if new collateralized debt obligations are around the corner.

Derivatives moolah

The nation’s top commercial banks are poised to generate record revenue from trading derivatives this year. And that’s as good a reason as any why no one should expect the nation’s bank to go along peacefully with a plan to regulate the trading of these sophisticated instruments.

In the first half of the year, the 25 biggest commercial banks took in $15 billion from trading derivatives, with JPMorgan Chase and Goldman Sachs being two of the biggest beneficiaries. And as things stand now, the nation’s banks will easily surpass the record $18.8 billion in derivatives trading revenue taken in during 2006.

In short, there’s a lot of money to be made from trading derivatives. So don’t expect banks to easily accept new rules that will put a crimp in this important source of income.

Oh, and just where did Goldman get most of its derivatives trading revenue from? Trading credit default swaps and other credit derivatives. The OCC reports that Goldman, in the second quarter, raked-in $1.48 billion from trading CDS-like transactions.

That ain’t chump change.

Banking? Keep it simple stupid

In 1873, Walter Bagehot wrote that “the business of banking ought to be simple; if it is hard it is wrong.” He would have struggled to recognize today’s banking system.

It is not just ever more ornate derivatives that bend the mind. Financial firms themselves have become fabulously complicated. Citigroup lists 2,061 subsidiaries and affiliates while the institutional chart of JPMorgan Chase is 267 pages long.

Complexity — as Bagehot predicted — has become a curse. If nobody can understand financial firms, they will become ever more accident prone.

The crisis that exploded a year ago offered a salutary lesson in the dangers of complexity. Many shareholders and creditors simply did not fully comprehend their investments. Instead they were forced to trust managers and the rating agencies.

Regulators too could be forgiven for scratching their heads.

“Supervisors are at a decided disadvantage in understanding risk-taking and compliance for firms that might involve dozens of jurisdictions, hundreds of legal entities and thousands of contractual relationships,” former Fed official Vincent Reinhart has written.

Indeed Basel II — the international capital code — was an admission of defeat by regulators. The message from the banking accord was that institutions had become so convoluted that only they were able to understand the risks they were taking.

Squeeze is on for investment banks

Investment banks are facing a big squeeze. For an industry that was generating record revenues just months after the collapse of Lehman Brothers, this may seem unlikely. But the revival looks set to be short-lived. Increased regulation and greater competition means the super-charged returns the industry generated for most of the past decade are likely to prove elusive.

Analysts at JPMorgan believe 2009 will prove to be the high point in the investment banks’ relentless upward march. They expect revenues in 2011 to be no higher than in 2006. More significantly, the industry’s return on equity will fall to 10.8 percent, far lower than what they have got used to.

What explains this reversal? Regulation plays a big part. Contrary to the received wisdom that investment bankers are being allowed to carry on much as before the crisis, regulators have whacked up capital requirements for complex, illiquid products. These were the source of much of investment banks’ profit during the boom, and most of the trouble since. Higher capital charges will make a lot of what banks’ structured credit desks used to do unviable, and reduce the profitability of what remains. Caps on leverage will also make it harder for banks to juice returns.

Similarly, the drive to ensure more derivatives are traded on an exchange or, at the very least, cleared through a central counterparty will have a big impact. Blowing away the fog that surrounds derivatives will make it harder for banks to hide their true cost from clients and clear the way for new players to enter the market.

Indeed, competition is on the rise across the board. Investment banks enjoyed near-perfect conditions in the first half of the year, as volatile markets boosted trading activity while those that had survived the crunch were able to demand wider spreads. But many of the banks that got into trouble are now rushing back into the market, helped by cheap state-subsidised funding.

Of course, banks will not sit still. Anyone who witnessed the wholesale shift from equities into fixed income following the stock market crash of 2001-2002 will recognise that the industry has an extraordinary knack for rapid self-reinvention. Most houses are already cleaning up with fat fees as companies issue equity to pay off some of the debt they took on during the credit boom. Banks also have a long track record of circumventing new regulation.

Nevertheless, it’s hard to see any new business permanently filling the hole left by the structured credit collapse. Regulators will also be much more vigilant with banks seeking to pile risky assets — of any description — onto their balance sheets. This means the majority of future business is going to have to come from more old-fashioned activities such as underwriting, advising and trading — all of which are less profitable.

Keeping Wall Street’s hands off the collateral

The idea of prohibiting derivatives dealers from reusing and redeploying the trillions of dollars in collateral they’ve taken in from trading parnters is gathering steam.

Earlier this week, I advocated an outright ban on this Wall Street practice called rehypothecation. I noted that one of the flaws with the Obama administration’s plan for regulating derivatives is that it’s silent on the issue of whether derivatives dealers can continue to reuse the collateral they get as guarantees on trades anyway they see fit. 

In the Lehman Brother bankruptcy, one of the big unresolved issues is tracking down collateral Lehman took in as guarantees on derivatives trades and then used as collateral for its own transactions.

Last week, Gary Gensler, chairman of the Commodities Futures Trading Commission, sent a letter to a number of congressmen urging changes in Obama administration’s derivatives plan. One thing Gensler advocated was a measure that would require derivatives dealers to segregate customer collateral in seperate accounts just the way futures dealers must do. Gensler says doing so would make it easier to deal with the failure of a derivatives dealer.

And now Americans for Financial Reform, an umbrella group of nonprofits, municipalities and union, has sent a letter to Sen. Chris Dodd, chairman of the Senate Banking Committee, endorsing much of what Gensler has called for including the segregating of customer collateral. The group’s letter refers to both Gensler and my column in noting:

The rehypothecation of a customer’s collateral makes the unwinding and returning of these “escrowed” funds to traders in bankruptcy proceedings almost impossible, thereby adding fuel to the fire that instititutions involved in complex financial transactions are “too big to fail.”

Now, I should point that a recent IMF report notes that since the Lehman Brothers bankruptcy more customers have requested that their collateral be segregated.  (A hat tip to Zerohedge.com for pointing this out to me). But memories are short and in time this change in behavior could revert back to form.

The liquidity canard

It’s often said on Wall Street that the more liquidity there is in a given market, the better things are for investors trading stocks, bonds or commodities. And while there’s a lot of truth to that, there are times when too much liquidity can be just the wrong tonic.

After all, Wall Street’s churning-out of one subprime-mortgage backed security after another pumped a lot of liquidity into the U.S. housing market, and that simply encouraged a lot of reckless — even fraudulent — lending.

That’s why I’m not impressed with the securities industry’s main defense of computer-driven high-frequency trading, which essentially is that all this lightning-fast trading provides liquidity and better prices for investors.

It’s a hard argument to swallow when you consider that many high-frequency trading programs are simply engaged in trading the same stock thousands of times a day in less than penny increments. Now maybe all those rapid-fire automated trades are getting better prices for some investors. But when a broker excessively buys and sells securities to generate higher commissions, it’s called churning, and that can result in an investor lawsuit or a regulatory sanction.

Indeed, when fast-fingered day traders were doing much the same thing as today’s high-frequency traders — albeit without the benefit of a sophisticated algorithmic program to guide them — Wall Street’s biggest firms were quick to dismiss them as either amateurs or rogues who were causing unnecessary volatility in the price of tech stocks.

So with critics raising legitimate concerns about the potential of a rogue algorithm sparking an unintentional market meltdown, the notion that high-frequency trading is OK because it creates more liquidity simply won’t wash.

If the main purpose of all that extra liquidity is to simply make fat profits for high-frequency traders at Goldman Sachs, UBS, GETCO, Citadel Investment Group and Interactive Brokers, that’s liquidity the markets can do without.

Citadel’s big Lehman loss

It’s long been suspected that Ken Griffin’s Citadel Investment Group took a big blow when Lehman Brothers went bust nearly a year ago. But Griffin and his management team have been reluctant to put a number on the damage to the Chicago-based fund.

That is, until now.

In a brief, one-page filing, Citadel claims it is owed some $470 million on a derivatives contract. The $12 billion hedge fund conglomerate offers no details about the derivatives deal in the proof of claim, submitted as part of the Lehman bankruptcy filing.

To date, Citadel’s claim is the third largest submitted by a creditor in the bankruptcy.

As the one-year anniversary of Lehman’s collapse approaches, expect more hedge funds and banks to fess-up about their Lehman losses.

Wall Street’s $4 trillion kitty

The Obama administration’s plan for reining in derivatives leaves unchecked one of Wall Street’s dirty little secrets: the ability of a derivatives dealer to redeploy cash collateral that gets posted by one of its trading partners.

On Wall Street, this practice of taking collateral and reusing it is called rehypothecation. In essence, it’s a form of free money for derivatives dealers to use as they please — even to repost it as collateral to finance their parent company’s own borrowings.

And we’re talking big bucks. The International Swaps and Derivatives Association recently reported that derivatives dealers have taken in $4 trillion in collateral from their trading partners. That’s an 86 percent increase over the $2.1 trillion in cash collateral those same dealers reported having on their books in early 2008.

Now it’s not surprising that investment firms took in more collateral from their trading partners over the last year, when the financial markets were in turmoil. Cash collateral is one way for derivatives dealers to protect themselves against the risk of a trading partner defaulting on one of these sophisticated financial contracts.

There’s nothing wrong with a dealer taking legitimate steps to insure an orderly unwind of a busted trade.

But Wall Street firms should not have free license to reuse this collateral any way they see fit. The Obama administration should revise its proposal to require derivatives dealers to hold all cash collateral in segregated escrow accounts that can’t be reused or touched by the dealer.

The same rule should also apply with any collateral that is posted with a regulated exchange on which a derivative contract gets traded.